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April 6, 2009

Economist's View - 6 new articles

Are the Economy's 'Green Shoots,' Real or Imagined?

Is recovery just around the corner?:

Room for Debate, NY Times Blog: Ben Bernanke, the Federal Reserve chairman, said on CBS's "60 Minutes" that he is seeing "green shoots" showing up in the economic landscape, "as some confidence begins to come back." ... The latest New York Times/CBS News poll finds that Americans are more optimistic about the economy and the direction of the country than they were in January. ...

Is there reason to believe that Mr. Bernanke's view is not wishful thinking?

"A Tale of Two Depressions"

Want some discouraging news about the economy?:

In this column, two leading economic historians show that the world economy is now plummeting as it did in the Great Depression; indeed, world industrial production, trade and stock markets are diving faster now than during 1929-30.

Fortunately, however, they also note that "the policy response to date is much better," but the "question now is whether that policy response will work":

A Tale of Two Depressions, by Barry Eichengreen and Kevin H. O'Rourke, The parallels between the Great Depression of the 1930s and our current Great Recession have been widely remarked upon. Paul Krugman has compared the fall in US industrial production from its mid-1929 and late-2007 peaks, showing that it has been milder this time. On this basis he refers to the current situation, with characteristic black humour, as only "half a Great Depression." The "Four Bad Bears" graph comparing the Dow in 1929-30 and S&P 500 in 2008-9 has similarly had wide circulation (Short 2009). It shows the US stock market since late 2007 falling just about as fast as in 1929-30.

Comparing the Great Depression to now for the world, not just the US

This and most other commentary contrasting the two episodes compares America then and now. This, however, is a misleading picture. The Great Depression was a global phenomenon. Even if it originated, in some sense, in the US, it was transmitted internationally by trade flows, capital flows and commodity prices. That said, different countries were affected differently. The US is not representative of their experiences.

Our Great Recession is every bit as global, earlier hopes for decoupling in Asia and Europe notwithstanding. Increasingly there is awareness that events have taken an even uglier turn outside the US, with even larger falls in manufacturing production, exports and equity prices.

In fact, when we look globally, as in Figure 1, the decline in industrial production in the last nine months has been at least as severe as in the nine months following the 1929 peak.

(All graphs in this column track behaviour after the peaks in world industrial production, which occurred in June 1929 and April 2008.) Here, then, is a first illustration of how the global picture provides a very different and, indeed, more disturbing perspective than the US case considered by Krugman, which as noted earlier shows a smaller decline in manufacturing production now than then.

Figure 1. World Industrial Output, Now vs Then

Source: Eichengreen and O'Rourke (2009).

Similarly, while the fall in US stock market has tracked 1929, global stock markets are falling even faster now than in the Great Depression (Figure 2). Again this is contrary to the impression left by those who, basing their comparison on the US market alone, suggest that the current crash is no more serious than that of 1929-30.

Figure 2. World Stock Markets, Now vs Then

Source: Global Financial Database.

Another area where we are "surpassing" our forbearers is in destroying trade. World trade is falling much faster now than in 1929-30 (Figure 3). This is highly alarming given the prominence attached in the historical literature to trade destruction as a factor compounding the Great Depression.

Figure 3. The Volume of World Trade, Now vs Then

Sources: League of Nations Monthly Bulletin of Statistics,

It's a Depression alright

To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimize this alarming fact. The "Great Recession" label may turn out to be too optimistic. This is a Depression-sized event.

That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline. We therefore turn to the policy response.

Policy responses: Then and now

Figure 4 shows a GDP-weighted average of central bank discount rates for 7 countries. As can be seen, in both crises there was a lag of five or six months before discount rates responded to the passing of the peak, although in the present crisis rates have been cut more rapidly and from a lower level. There is more at work here than simply the difference between George Harrison and Ben Bernanke. The central bank response has differed globally.

Figure 4. Central Bank Discount Rates, Now vs Then (7 country average)

Source: Bernanke and Mihov (2000); Bank of England, ECB, Bank of Japan, St. Louis Fed, National Bank of Poland, Sveriges Riksbank.

Figure 5 shows money supply for a GDP-weighted average of 19 countries accounting for more than half of world GDP in 2004. Clearly, monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, which is a reminder that the stage-setting events were not the same in the two cases. Moreover, the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.

Figure 5. Money Supplies, 19 Countries, Now vs Then

Source: Bordo et al. (2001), IMF International Financial Statistics, OECD Monthly Economic Indicators.

Figure 6 is the analogous picture for fiscal policy, in this case for 24 countries. The interwar measure is the fiscal surplus as a percentage of GDP. The current data include the IMF's World Economic Outlook Update forecasts for 2009 and 2010. As can be seen, fiscal deficits expanded after 1929 but only modestly. Clearly, willingness to run deficits today is considerably greater.

Figure 6. Government Budget Surpluses, Now vs Then

Source: Bordo et al. (2001), IMF World Economic Outlook, January 2009.


To summarize: the world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30.

The good news, of course, is that the policy response is very different. The question now is whether that policy response will work. For the answer, stay tuned for our next column.


Eichengreen, B. and K.H. O'Rourke. 2009. "A Tale of Two Depressions." In progress.

Bernanke, B.S. 2000. Bernanke, B.S. and I. Mihov. 2000. "Deflation and Monetary Contraction in the Great Depression: An Analysis by Simple Ratios." In B.S. Bernanke, Essays on the Great Depression. Princeton: Princeton University Press.

Bordo, M.D., B. Eichengreen, D. Klingebiel and M.S. Martinez-Peria. 2001. "Is the Crisis Problem Growing More Severe?" Economic Policy32: 51-82.

Paul Krugman, "The Great Recession versus the Great Depression," Conscience of a Liberal (20 March 2009).

Doug Short, "Four Bad Bears," DShort: Financial Lifecycle Planning" (20 March 2009).

"From Bubble to Depression?"

Steven Gjerstad and Vernon L. Smith argue that the "events of the past 10 years have an eerie similarity to the period leading up to the Great Depression." More specifically, their argument is that contrary to the usual explanation that the troubles in the banking sector during the Great Depression were caused by stock-market speculation and a monetary contraction, they suggest that "both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt":

From Bubble to Depression?, by Steven Gjerstad and Vernon L. Smith, Commentary, WSJ: Bubbles have been frequent in economic history... Bubbles can arise when some agents buy not on fundamental value, but on price trend or momentum. ...

But what sparks bubbles? Why does one large asset bubble -- like our dot-com bubble -- do no damage to the financial system while another one leads to its collapse? ... How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury. ...

The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression. Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth.

The Great Depression has been attributed to excessive speculation on Wall Street, especially between the spring of 1927 and the fall of 1929. Had the difficulties of the banking system been caused by losses on brokers' loans for margin purchases in 1929, the results should have been felt in the banks immediately after the stock market crash. But the banking system did not show serious strains until the fall of 1930.

Bank earnings reached a record $729 million in 1929. Yet bank exposures to real estate were substantial; as the decline in real estate prices accelerated, foreclosures wiped out banks by the thousands. Had the mounting difficulties of the banks and the final collapse of the banking system in the "Bank Holiday" in March 1933 been caused by contraction of the money supply, as Milton Friedman and Anna Schwartz argued, then the massive injections of liquidity over the past 18 months should have averted the collapse of the financial market during this current crisis.

The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate. It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt -- that was transmitted into the financial sector during a sharp downturn.

What we've offered in our discussion of this crisis is the back story to Mr. Bernanke's analysis of the Depression. Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.

"Steady through This Storm"

Ricardo Caballero believes that if we stick with the Geithner plan, the economy will recover in the near future:

Steady Through This Storm, by Ricardo J. Caballero, Commentary, Washington Post: President Obama recently stated that he is a big believer in "persistence," and he provided examples of how he will persist in many areas of economic policy. That word and his examples gave me more hope for the future of the U.S. economy than I have had in some time.

We are experiencing the mother of all modern financial crises. ... Politicians and commentators from the left and right are in panic mode and have retrenched to their basic instincts, moving away from reasoned analysis. It is, frankly, scary to hear the right regurgitating the untimely liquidationist claims that Treasury Secretary Andrew Mellon made during the onset of the Great Depression. It is also frightening to see the left going after Wall Street "oligarchs" and the financial institutions they have always hated, which finally are easy prey.

Fortunately, some voices of reason remain, and the Treasury, Federal Reserve and Federal Deposit Insurance Corp. are among them. They have been persistent..., one can get a sense of perseverance and determination, which are exactly what an economy needs during times of massive uncertainty. ...

The U.S. financial system is worth preserving, and the only safe policy while investors are in panic mode is to preserve it with as few changes as possible, with the government providing the resources needed to get to a point where we can fix the structural problems that contributed to the crisis. Contrary to popular perception, providing this support has nothing to do with the "zombie" policies of the Japanese experience during the 1990s. There, the problem was that banks kept making loans to unproductive companies to avoid having to recognize the losses associated with old loans to those companies. As a result, good companies had less access to loans than they would have otherwise. But a policy of supporting the sale of troubled assets through public guarantees, loans and equity participation, complemented with a public-private program to strengthen the capital of systemically important financial institutions, is the opposite of the zombie strategy. Such a framework builds a solid foundation for new lending and does not create incentives for banks to lend to the wrong clients.

If the administration's economic team can keep a steady course, and if it is persistent, we have a good chance of getting out of this mess in the near future. I am hopeful.

I have a different view. Of course we should persist if the plan is working, but if it's not, we need to move on to the next step right away instead of persevering on nothing more than the hope and belief that persistence and determination will be rewarded in the end.

"Mark-to-Market Rule Gives More Clarity"

John Berry likes the recent changes in the rules for valuing distressed assets:

Mark-to-Market Rule Gives More Clarity, Not Less, by John M. Berry, Commentary, Bloomberg: Mark-to-market accounting rules are being brought a little closer to economic reality -- accompanied by misplaced howls of outrage. ...[T]he standards have forced many financial institutions to overstate losses on trillions of dollars worth of assets, intensifying the global financial crisis.

Defenders of the rules say they protect bank investors and changing them will allow institutions to hide future losses. To the contrary, they have helped drive down the value of bank stocks, made shorting the shares much easier and caused bank stockholders to lose hundreds of billions of dollars in such companies as Citigroup Inc. and Bank of America Corp. ...

The problem with mark-to-market accounting is that it officially has presumed there's a functioning market in whatever asset is being valued -- and that means a deal between a willing buyer and seller that isn't being forced to sell. Actually, no such market exists for many mortgage-backed securities.

Nevertheless,... accountants have required many banks to calculate values based on distressed sale prices. That has meant large writedowns even on mortgage-backed securities that the institutions intend to hold to maturity.

Take the case of the Federal Home Loan Bank of Atlanta. Following the mark-to-market rules, it wrote down the value of its portfolio of mortgage-backed securities by $87.4 million in last year's third quarter. Its actual projected loss on the securities: $44,000. For the fourth quarter the bank recorded a further $98.7 million loss on the securities.

That result makes no sense when the bank doesn't trade such assets. ... A writedown might still be required under the changes FASB approved yesterday. Yet auditors can now use "significant professional judgment" when valuing illiquid securities. That's what they should have been allowed to do all along. ...

The key points in this example are that almost all the mortgages involved are still performing and the bank plans to hold the securities to maturity -- and yet large writedowns were required. ...

Now accountants are supposed to use their judgment... That's a big improvement over just using the last transaction price, as many auditors have been doing. ...

Here's an opposing view.

links for 2009-04-06

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