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September 30, 2008
On rescues and bailouts
I’ve been thinking a lot about this topic lately, and though it seems there are a good many folk who approach the issue with great certainty, I do not share their confidence. I have, however, found it helpful to think through the following (not entirely original) scenario:
I am sitting on my back deck one fine afternoon and notice smoke coming from the kitchen window of my neighbor Joe. The color and volume of the smoke—and the fact that I know that Joe is not home—leave no doubt that the kitchen is on fire.
I begin to calculate my possible responses. I think Joe has a sprinkler system installed, so it is possible that safeguards already in place will soon put the fire out. Of course, I’m not entirely sure the system is up to the task—or even if it exists—so I consider a limited intervention in the form of running inside my own house and calling the fire department. They are a pretty efficient unit, but in the best of circumstances it will take them some time to arrive. So I also contemplate the most extreme measure available to me: grabbing my garden house, breaking down Joe’s back door, and addressing the fire directly.
It’s a hard choice, so I begin to think about the costs and benefits of each option. If I rely on the uncertain quality (or existence!) of the sprinkler system, or wait for the fire department to arrive, the fire could spread rapidly and possibly threaten my property. On the other hand, if I rush in with my hose, I could get hurt—the direct intervention could be costly, too. What’s more, my intervention might not do the trick—the fire could be too big, my garden hose too inadequate a firefighting tool.
I decide to throw caution to the wind, grab the hose, and burst into Joe’s house. I am able to successfully quell the flames, escaping with only a few minor burns and watery eyes. I feel pretty good about the whole business, but the truth is I discovered that the sprinkler system was indeed operating and may have put out the fire on its own (though it hadn’t yet). And just as the last flicker expires, I hear the fire engines in the distance. They may have arrived in time to spare my house (though it is clear that the fire was spreading quickly). So, I wonder. Did I do the right thing?
Actually, my dilemma deepens. When the fire marshal arrives, he discovers that the cause of the fire was a cigarette, foolishly left to burn near a stack of old papers. I knew all along that old Joe was the reckless sort, and now I fear that by stepping in and containing the damage that Joe had brought upon himself I may just be encouraging more such carelessness in the future.
Then again, the kitchen is a total loss, and the smoke has permeated Joe’s house and ruined more than a few pieces of furniture. Though it is obvious that Joe has been spared total ruin, will he really feel that his actions have gone without consequence? Will he feel that the fates have bailed him out?
UPDATE: I'm getting some ribbing over the similarity between my scenario and the analogy offered today by a certain well-known candidate for high political office. Though I did note that my story is not entirely original, I assure you that the present coincidence is, well, entirely coincidental.
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» The "House on Fire" Hypothetical from At These Levels
Dave Altig of the Atlanta Fed explains the rescues-and-bailouts dilemma:Ive been thinking a lot about this topic lately, and though it seems there are a good many folk who approach the issue with great certainty, I do not share their confidence. I have [Read More]
Tracked on Sep 30, 2008 8:52:26 PM
September 25, 2008
Wall Street worries, Main Street woes
A fair amount of the discussion around what now seems to be an imminent rescue plan to settle unsettled financial markets has been focused on a debate as to whether Main Street should pay or Wall Street should pay for the plan. Pimco’s William Gross, however, is suggesting it is a false choice:
“If this were a textbook recession, policy prescriptions would recommend two aspirin and bed rest—a healthy dose of interest rate cuts and a fiscal package that mildly expanded the deficit.… But recent events have made it apparent that this downturn differs from recessions past.…
“And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from ‘troubled financial institutions’ to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury.…
“The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic.”
That assessment—that the goal is to get market-mechanisms working again—was expressed by Chairman Bernanke in his Tuesday testimony before the Senate Banking Committee:
“If you have an appropriate auction mechanism, together with other types of inputs, with flexibility to address different assets in different ways, I think what you will do is you will restart this market. And then you'll get a sense of what the more fundamental value is.”
It may be a good point to note that there is no guarantee that the magic worked by markets will be quick. Yesterday’s report on existing house sales and today’s news on new home sales—covered by the go-to guy Calculated Risk here and here—clearly indicate that the fundamental Main Street adjustments are not yet complete.
Unfortunately, it is difficult to make the case that the trip to stabilization of house prices will be a short one. Simple economics predicts this relationship: movements in house prices are the result, mainly, of movements in land prices (as shown in a good piece of analysis by Morris Davis and Jonathan Heathcote, respectively, from the University of Wisconsin-Madison and the Federal Reserve Board of Governors). The supply of land is fairly inelastic and as a result, changes in house prices should be determined primarily from demand factors. According to Gregory Mankiw and David Weil, this demand is related to the number of prime-aged, child-bearing households.
As the following chart illustrates, house-price growth (measured by the year-over-year growth rate of nominal house prices constructed by the Office of Federal Housing Enterprise Oversight, or OFHEO) and the growth rate of the civilian labor force (CLF)—a reasonable proxy for prime-aged, child-bearing households—were tightly linked for more than two decades.
That pattern broke down around the time of the 2001 recession. This deviation from presumed fundamentals is well known, and we can use the underlying economic theory to get a rough benchmark for how far from complete the adjustment process may be. Consider a hypothetical path for house prices such that the ratio of the growth rate of the OFHEO index to the growth rate of the civilian labor force is maintained at its pre-2001 historical value. That exercise suggests house-price appreciation of 3.3 percent, represented by the green dashed line in this chart:
An estimate of the “overvaluation” of housing is given roughly by the area below the red line (the actual growth in house prices) and above the hypothetical dashed line. With this alternative growth rate series, the OFHEO index would have been at a level of 301 in the second quarter of 2008, instead of the realized value of 381. If the ratio for the post-2000 period is to return to its historical value, house prices would drop 21 percent from second-quarter 2008 levels.
These numbers are, of course, just ballpark calculations. The future need not look exactly like the past, and even if it does there is no way to predict how close we have to get before economic conditions normalize. But to the extent that the past is in fact a reasonable guide, this simple exercise may provide a sense of how much work remains to be done.
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September 23, 2008
I am often amazed by the ability of folks to speak with absolute certainty on subjects that are defined by absolute uncertainty. Here is what we know, as of the moment on Tuesday afternoon when I am writing this, about U.S. Treasury Secretary Paulson’s proposal to obtain authority to purchase troubled assets: A request has been made for Congress to authorize up to $700 billion (with automatic adjustments to the national debt ceiling) for the purpose of purchasing distressed assets from US financial institutions. Here’s what we don’t know: Almost every other relevant detail.
Though a possible version of a possible House bill has been drafted, the final details remain a conjecture. Even more uncertain is the ultimate impact once the program is implemented. I think Tom Maguire nails it:
Suppose Merrill Lynch (to pick a name at random) has marked its sludge down to 50 percent of face value. Let's further suppose that with perfect foresight investors could see that this is the "right" price in the sense that over the life of the assets Merrill will receive that amount in present value, risk adjusted terms.
Does this mean that Merrill's financial statements are reliable and lenders will lend to them? Not in the current environment . . .
Lacking perfect foresight, investors have no idea whether 50 cents on the dollar is fair but even if they suspected it was they also have an excellent idea that lightning could strike and Merrill could go bust tomorrow, which means they won't lend to Merrill today. Or, if the idea of a lightning strike seems too abstract, investors might believe that, although 50 cents is the mean expected value of the assets in question there is a high enough probability that they will ultimately be worth 25 cents that a loan to Merrill is too risky.
However, if Merrill sells those assets at 50 cents, they have not received a subsidy but they have removed a major source of volatility from their financial statement - there is no possibility that Merrill will later mark those assets down to 25 cents because they have been sold. Of course, they will never mark them to 75 and book a profit, but lenders were hardly worried about that . . . So why doesn't Merrill and everyone else sell their troubled assets and move on? Well, sell them to whom? Merrill did sell some of this stuff but the collectively the financial firms simply have too much to move. Hence, there is a role for the government as a patient, well-capitalized investor of last resort—it is *possible* that the government can break even or make money on these assets if the purchase price is fair. Obviously, it is also possible that the government will get stuffed with the worst of the worst at inflated prices, or that the government will consider it its patriotic duty to pay inflated prices in order to quietly re-capitalize some of these firms. But this bail-out can be effective without assuming that to be the case.
In other words, the devil may be in the details, but might be a good idea to see some of those details before judging the final product.
The second line of discussion that I think deserves a time-out is the pronouncements of all sorts regarding the ultimate cost of the plan to U.S. taxpayers. Many others have focused on the analogy to the Resolution Trust Corporation — or lack thereof — but let’s revisit the facts one more time. This is from a 2000 analysis by FDIC economists Timothy Curry and Lynn Shibut:
In response to the deepening [savings and loan] crisis, Congress enacted FIRREA on August 9, 1989, beginning the taxpayers’ involvement in the resolution of the problem… FIRREA also created the RTC to resolve virtually all troubled thrifts placed into conservatorships or receiverships between January 1, 1989, and August 8, 1992. Because of the continuing thrift crisis, however, the RTC’s authorization to take over insolvent institutions was twice extended, the second time to June 30, 1995 . . .
FIRREA provided the RTC with $50 billion to resolve failed institutions… Because the $50 billion in initial funding was insufficient to deal with the scope of the problem, Congress enacted subsequent legislation three times, raising total authorized RTC funding for losses to $105 billion between 1989 and 1995.
Before, during, and even after the RTC’s lifetime, estimates of the costs of the crisis created widespread confusion. Federal agencies, politicians, thrift industry experts, and others put forth myriad estimates on what was called the size of the problem. These forecasts often diverged widely and changed frequently in response to surging industry losses . . . Reflecting the increased number of failures and costs per failure, the official Treasury and RTC projections of the cost of the RTC resolutions rose from $50 billion in August 1989 to a range of $100 billion to $160 billion at the height of the crisis peak in June 1991, a range two to three times as high as the original $50 billion.
As of December 31, 1999, the RTC losses for resolving the 747 failed thrifts taken over between January 1, 1989, and June 30, 1995, amounted to an estimated $82.7 billion, of which the public sector accounted for $75.6 billion…
You can either be concerned by the fact that the RTC workout cost more than originally projected, or take comfort in the fact that the costs did not even approach the worst-case scenarios. It is certainly true that in any case taxpayers are being asked, via their duly elective representatives, to take on large risks. But, as Secretary Paulson and Chairman Bernanke emphasized today, risk is not avoided by doing nothing.
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September 18, 2008
What’s a swap line?
This morning the Federal Open Market Committee (FOMC) authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). According to the Fed’s press release, the changes allow for “increases in the existing swap lines with the ECB and the Swiss National Bank” and for “new swap facilities…with the Bank of Japan, the Bank of England, and the Bank of Canada.”
“These measures…are designed to improve the liquidity conditions in global financial markets,” the release continued.
What did the Fed do and how will this action address some of the strain in liquidity conditions that recently have emerged?
A good place to start is by looking at what, exactly, a currency swap line is. A currency swap is a transaction where two parties exchange an agreed amount of two currencies while at the same time agreeing to unwind the currency exchange at a future date.
Consider this example. Today the Fed initiated a $40 billion swap line with the Bank of England (BOE), meaning that the BOE will receive $40 billion U.S. dollars and the Fed will receive an implied £22 billion (using yesterday’s USD/GBP exchange rate of 1.8173).
An underlying aspect of a currency swap is that banks (and businesses) around the world have assets and liabilities not only in their home currency, but also in dollars. Thus, banks in England need funding in U.S. dollars as well as in pounds.
However, banks recently have been reluctant to lend to one another. Some observers believe this reluctance relates to uncertainty about the assets that other banks have on their balance sheets or because a bank might be uncertain about its own short-term cash needs. Whatever the cause, this reluctance in the interbank market has pushed up the premium for short-term U.S. dollar funding and has been evident in a sharp escalation in LIBOR rates.
The currency swap lines were designed to inject liquidity, which can help bring rates down. To take the British pound swap line example a step further, the BOE this morning planned to auction off $40 billion in overnight funds (cash banks can use on a very short-term basis) to private banks in England.
In effect, this morning’s BOE dollar auction will increase the supply of U.S. dollars in England, which would work to put downward pressure on rates banks charge each other.
Consistent with this move, the overnight LIBOR rate fell from about 5.03 percent yesterday to 3.84 percent today.
The bottom line is that the Fed, by exchanging dollars for foreign currency, has helped to provide liquidity to banks around the world. This effort can help to bring interbank rates back down at a time when restrictively high rates can choke off access to financing that banks and other businesses need to operate.
By Mike Hammill in the Atlanta Fed’s research department
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September 16, 2008
The left and right of it all
What a wild day it was on Monday in U.S. and global financial markets. We heard it quipped that the problem with financial institution balance sheets is that “on the left hand side nothing is right and on the right hand side nothing is left.” This is clearly an exaggeration, but it does raise the question: What do people look at when gauging the rightness or leftness of balance sheets?
A lot of the discussion about asset quality has focused on mortgage backed securities (MBS). The size of the MBS market has experienced phenomenal growth over the last decade or so—MBS issuance grew from around $500 billion in 1997 to over $2 trillion in 2007. As the name suggests, an MBS is a bond that is backed by the collateral of mortgages—either by mortgages guaranteed by Freddie Mac or similar institutions or other pools of mortgages. The MBS, or pieces of it, are then sold to investors, with the principal and interest payments on the individual mortgages used to pay investors.
Underlying the performance of MBS is the performance of mortgages themselves. Mortgage delinquency has been rising for some time, and especially for subprime mortgages.
One of the features of the U.S. financial system is that the debt of financial institutions tends to be weighted toward long-term obligations while the financing has been predominately from short-term borrowing. As the performance of the assets has deteriorated the need for liquidity has risen sharply.
The demand for cash was especially acute on Monday, as can be seen in the large intra-day variability in the federal funds market. Federal funds are the reserve balances of depository institutions held at the Federal Reserve. At times on Monday the federal funds rate traded well above the target of 2 percent before the New York desk intervened with an additional $50 billion injection of reserves. This Bloomberg news story describes Monday’s large movements in the federal funds market.
The demand for liquidity at 1 and 3 month horizons also surged, as indicated by the dollar LIBOR spread over OIS at 1 and 3 month horizons. LIBOR (the London Inter-Bank Offered Rate) is the interest rate at which banks in London are prepared to lend unsecured funds to first-class banks. As such it is a guide world-wide for the rate banks use to lend to each other. In the U.S., it is usually not far off from the fed funds rate. But after the emergence of the financial turmoil last fall the LIBOR has risen relative to the fed funds rate. The OIS (Overnight Index Swap) rate is a measure of the expected overnight fed funds rate for a specified term (1 or 3 months, for example). The LIBOR/OIS spread can be used as measure of the amount of liquidity or stress in short-term unsecured cash markets.
LIBOR spreads edged higher last week amid uncertainty about financial firms, and both spreads jumped higher on Monday and Tuesday, with both at or close to new highs.
Tuesday is another day, but some things will remain the same, including the focus of attention on the left and right of financial institution balance sheets, and the debate about the appropriate role of government in all this.
By John Robertson and Mike Hammill in the Atlanta Fed’s research department
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September 11, 2008
Will automatic enrollment boost 401(k) savings?
In August the Congressional Budget Office updated its annual long-term projection for Social Security and noted that “future Social Security beneficiaries will receive larger benefits in retirement—and will have paid higher payroll taxes—than current beneficiaries do, even after adjustments have been made for inflation and even if the scheduled payments are reduced because the trust funds are exhausted. However, CBO estimates that “under both scenarios, those benefits will represent a smaller percentage of beneficiaries’ preretirement earnings than is the case now.”
Looking ahead, it seems certain future retirees will increasingly rely upon defined contribution 401(k)-type plans upon retirement. That means that millions of workers, with a wide range of preparation and financial literacy, are expected to make sophisticated investment decisions that will shape their future financial well-being. Policymakers are focusing greater attention on ways to increase worker participation in 401(k) type plans. The 2006 Pension Protection Act (PPA) included measures to increase contributions by creating safe harbor provisions that permit employers to offer automatic enrollment in 401k plans. For employers to qualify, contribution rates for those enrolled automatically must be at least 3 percent of salary the first year of participation, rising one percentage point per year to at least 6 percent in the fourth year.
These measures incorporate insights from behavioral economics that 401k default options have a tremendous impact on how much workers will ultimately save for retirement. In the new edited volume Lessons from Pension Reform in the Americas, Beshears, Choi, Laibson and Madrian examined the impact on worker savings when workers are automatically enrolled by their employers compared to when they must actively opt in to a retirement savings plan. They found that when automatic enrollment in retirement plans is the default option, participation rates are much higher than when workers have to opt-in. Furthermore, many workers view the employer default savings option as an implicit endorsement of both the contribution rate and the distribution of funds. They find that default choices are not neutral; they play an important role in every stage of the lifetime savings cycle, including savings plan participation, contributions, asset allocation, rollovers, and decumulation. Default options become even more crucial as defined contribution plans in the United States and the rest of the world introduce more investment options for workers.
Since the Pension Protection Act was just passed in 2006, it is still too soon to know what long-range impact it will have on retirement savings. However, a new paper by VanDerhei and Copeland models the results of automatic enrollment under PPA rules and finds that it will have a significant impact, especially for low-income workers. For the lowest-income quartile, total 401(k) balances would be only 0.1 times final earnings at age 65, compared to 2.5 to 4.5 final earnings (depending on the assumptions used) under automatic enrollment. For the top 25 percent of earners, the jump would be from 1.8 times final earnings to between 6.5 to 10.4 times final earnings.
These automatic enrollees will of course need to decide how to invest their 401(k) savings. Target-maturity date lifecycle funds, where participants select a fund based on a projected retirement date and fund managers rebalance the portfolio over time, offer one solution to problems arising from financial illiteracy, naïve portfolio diversification, and inertia. In a new working paper, Mitchell, Mottola, Utkus, and Yamaguchi find that lifecycle plans will have a more substantial impact if they are designed as the default option, with adoption rates being higher still if employers actively shift participants from existing portfolios to age-based lifecycle funds.
Automatic 401(k) enrollment and lifecycle funds can potentially boost retirement savings. The extent to which employers and workers will embrace these options from the 2006 Pension Protection Act is an open question, but the early signals are positive. At a May 2008 Employee Benefit Research Institute forum on the 2006 PPA, participants noted that an increasing number or employers, especially large ones, are adopting automatic enrollment.
By Stephen Kay, coordinator of Latin American analysis at the Atlanta Fed
Note: Macroblog will not feature postings on monetary policy issues during the Federal Open Market Committee meeting blackout period, which runs from the week before the FOMC meeting until the Friday after it. Also, David Altig, senior vice president and research director of the Atlanta Fed, will not post during this timeframe.
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September 09, 2008
Hurricanes put energy on center stage
Hurricane season is in full swing here in the Southeastern United States. The Atlanta Fed pays particular attention to hurricanes for two reasons: (1) they have significant impacts on the local economies they strike, and (2) they can potentially have big impacts on the national economy.
For example, in 2005, even though the Katrina and Rita storm-damaged area of Louisiana represented only a small fraction of the nation’s gross domestic product (GDP), it cast an outsized shadow because of its very large role in oil and gas production and processing. Katrina and Rita’s disruptions of this production and processing spilled over into the national economy, destroying 113 offshore oil and gas platforms and damaging 457 oil and gas pipelines. This damage generated uncertainty about the availability and price of energy products, causing prices to immediately jump.
After relatively quiet hurricane seasons in 2006 and 2007, 2008’s hurricane season thus far has been quite active, with potentially significant national implications. That’s because the Gulf of Mexico remains a substantial source of oil and natural gas production—just as it was three years ago. In addition, coastal Louisiana is the home to upwards of 50 chemical plants, which produce 25 percent of the nation's chemicals that are used in a wide variety of products such as medicines, fertilizers, and plastics. Compounding the Gulf Coast’s concentration of oil, gas and chemicals is the fact the U.S. economy is in a weaker state today and, as a result, more vulnerable to economic shocks than in 2005, a point made in a recent CNNMoney article about Hurricane Gustav.
One of the questions we are often asked is, “what is the effect of a hurricane on the economy?” Not surprisingly, the answer depends on what “the economy” refers to. From a national accounting perspective, GDP is a measure of the nation’s current production of goods and services; thus GDP is not directly affected by the loss of property (structures and equipment) produced in previous periods.
However, there are usually second-round GDP effects that arise because of disruptions to production, income and consumption flows. The Bureau of Economic Analysis provides a good description. For example, in the short run after a hurricane, incomes in many industries are likely to decline because of cuts in production, while some industries involved in the cleanup and repair may see activity increase. Similarly, incomes and spending could increase in areas that are the recipients of evacuees. The net effect of these flow disruptions on GDP over time is often not large because lost output from destruction and displacement is offset by a big increase in reconstruction and public spending later.
But even if the effects are neutral on a national scale a storm’s impact can be long-lasting in an affected locale. For instance, the flooding associated with Katrina left the economy of New Orleans devastated, and in many dimensions it has not fully recovered three years after the storm. Air traffic through New Orleans International Airport increased 13 percent in June 2008 compared to a year earlier but still remained well below pre-Katrina levels. Hurricane Gustav resulted in another evacuation of the city and the cancellation of numerous tourist and other events. Clearly storms like this have the potential to wreak havoc on the prosperity of the Crescent City.
The Atlanta Fed regularly reports on regional economic conditions on its public Web site. As part of its efforts to monitor storm effects—both local and national—the Atlanta Fed is also providing information on post-storm conditions in the affected areas. So far, these reports have focused on Hurricane Gustav’s impact on key energy and transportation infrastructure. The Bank will provide similar updates on other storms, including Hurricane Ike, which had entered the Gulf of Mexico at the time of this posting.
Note: Macroblog will not feature postings on monetary policy issues during the Federal Open Market Committee meeting blackout period, which runs from the week before the FOMC meeting until the Friday after it. Also, David Altig, senior vice president and research director of the Atlanta Fed, will not post during this time frame.
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September 04, 2008
I pity the folks on the National Bureau of Economic Research (NBER) Business Cycle Dating Committee, burdened as they are with the task of determining if and when the U.S. economy finds itself in an officially designated “recession.” While skepticism about the preliminary report on second quarter U.S. growth is not entirely unjustified, it isn’t so easy to square the presumption of an economy in recession with the gross domestic product (GDP) data we have in hand.
On the other hand, there is the employment picture, which I would rank high among equals on the list of things that the NBER committee says it monitors in making the recession call. A few weeks back, Menzie Chinn noted.
“Over the past few months, I've heard that, while job creation is insufficient to keep unemployment rates constant, job losses have not been consistent with recession…
“What is clear is that while the employment series might not be evidencing a severe dropoff, the hours series is [Update: this point has been made previously by Spencer at Angry Bear]. This is relevant because growth in hours is at levels consistent with at least the last two recessions.”
Actually in the referenced post from Angry Bear, Spencer notes that even the employment series looks awfully recession-like:
For this reason the monthly Bureau of Labor Statistics (BLS) employment report looms large, at least in my own thinking about the state of the economy. And today, of course, brings a sneak preview in the form of the ADP National Employment Report. The news didn’t suggest any break from the recent pattern:
According to Joel Prakken, chairman of Macroeconomic Advisers, LLC, "Nonfarm private employment decreased 33,000 from July to August 2008 on a seasonally adjusted basis, according to the ADP National Employment Report. The estimated change in employment from June to July was revised down from an increase of 9,000 to an increase of 1,000.
"The decline in August continues the recent trend in employment that is consistent with an economy that is growing slowly but has not fallen into recession."
If you follow these things, you know that today’s ADP news is not all that likely to be confirmed by tomorrow’s official BLS report. It’s useful to bear in mind, however, what is one of the main selling points of the ADP statistic:
“There is a very powerful statistical tendency for estimates of growth of establishment employment, as reported by the BLS after annual benchmarking, to be revised in the direction of estimates previously published in the ADP National Employment Report.”
Here’s what they are talking about.
In words, when the ADP stat on employment growth has exceeded the initial BLS number, there has been a tendency for ultimate revisions to the official BLS job growth number that are in the upward direction.
Today, of course, may not be like the past, but it’s something to bear in mind as you process tomorrow’s report.
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September 02, 2008
Does the GDP deflator lie?
Though last week’s report on U.S. gross domestic product (GDP) growth in the second quarter is second-hand news by now, I’ve taken note that Barry Ritholtz’s views on the news has, in particular, continued to rumble through the blogosphere. Barry is not happy with the GDP deflator, and samples approvingly from a Barron’s article by Aaron Abelson:
“GDP, in common parlance, stands for gross domestic product, or the aggregate value of all the goods and services produced on these blessed shores... These days, alas, those initials more typically signify “gross deceptive pap”...
“Comes now the so-called preliminary estimate that claims second-quarter GDP grew by a much more robust 3.3%.
“The key here is the GDP deflator, which purports to adjust GDP for the impact of inflation; it’s a curious calculation in that, contrary to its moniker, it seems designed to do the exact opposite of deflating GDP.
“Thus, according to this accommodating measure (accommodating, that is, if you’re determined to put a good face on a dreary report), inflation grew at an improbably restrained 1.33% in April-June. And maybe it did—but not in the good old U.S. of A. However, obviously more important than accuracy to those doing the calculating is this simple equation: The lower the deflator, the greater the growth of GDP…
“Of course, even by the government’s not entirely extravagant figuring, the consumer price index was up a hefty 8% in the latest quarter. Perhaps the computer that tallies the CPI doesn’t talk to the computer that measures the deflator.”
Strong words, but if you ask me, misguided. Barry actually makes the case against the case in this picture, about which he notes:
“It’s no coincidence that the current situation resembles past ones where oil prices had spiked. Since more than half of the U.S. Crude consumption is imported, the price and quantity go into all GDP calculations as a negative.”
Exactly. Let me provide an elaboration of the spot-on point made at The visible hand in economics blog. For the sake of argument assume that every drop of oil consumed in the United States is imported, and everything imported to the United States is oil. If we leave exports out of the picture for simplicity, we can think of U.S. consumption as consisting of GDP—everything produced in the United States—and imported oil.
Suppose, then, that the price of oil rises precipitously. If both incomes and oil consumption are relatively fixed in the short-run, what would we expect to happen? The answer is more expenditure on imported oil and less spending on everything else. As the demand for domestically produced goods and services falls, so would their prices. (Or more generally, they would rise at a slower than normal pace.) Since domestically produced goods and services by definition constitute GDP, GDP-deflator inflation will be low, while the consumer price index (which would include nonexported GDP plus imports) could well be quite high.
Voila! A simple Econ-101 explanation, with nary an insult hurled at the good folks from the Bureau of Economic Analysis.
That said, there are plenty of reasons to be cautious in interpreting last week’s report. Mark Thoma has a fine roundup of many fine points by many fine bloggers. To that list I’d add comments by Spencer at Angry Bear, William Polley, Lim at The Skeptical Speculator, Ben Leeson at Working Thoughts, Zubin Jelveh and Felix Salmon (both at Portfolio.com), to name a few. But I would delete the suspicion that low GDP-deflator-based inflation suggests shenanigans are afoot.
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» The GDP Deflator and the Inflation Rate from Economist's View
There is confusion between the GDP deflator and other measures of prices such as the CPI and the PCE deflator. Here's one way to think about it that might help to clear things up. The CPI (or the PCE) attempts [Read More]
Tracked on Sep 3, 2008 7:04:58 PM
» Taking a Closer look at Other 3 % GDPs from The Big Picture
Over the years, I have criticized a variety of official data points as misleading: Consumer Price Index (CPI) for woefully understating price increases, Non Farm Payrolls (NFP) due to the Birth/Death Adjustment, Core Inflation for omitting anything goi... [Read More]
Tracked on Sep 4, 2008 7:44:13 AM
» Borrowing future growth from Newshoggers.com
By Fester: Today's employment and unemployment numbers were ugly. The unemployment rate went to 6.1%, another 84,000 jobs were cut in the initial August estimates after the July estimate was increased to a job loss of 100,000 jobs, and wage [Read More]
Tracked on Sep 5, 2008 3:21:21 PM
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- What Seems to Be Holding Back Labor Productivity Growth, and Why It Matters
- Signs of Improvement in Prime-Age Labor Force Participation
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- Are Shifts in Industry Composition Holding Back Wage Growth?
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