Transcript Outlook for the U.S. Economy

Outlook for the U.S. Economy
Phillip LeBel, Ph.D.
Department of Economics and Finance
School of Business
Montclair State University
[email protected]
A primer on economic forecasts:
1. Economic forecasts are based on an extrapolation of past trends.
2. As long as past events are similar, forecasts will tend to be more accurate.
3. Recent turbulence in U.S. financial and economic markets makes forecasting
more difficult.
4. This said, what can we say about prospects for current economic recovery?
5. To answer this question, we have to ask how did we get into this recession in
the first place and how does it compare with previous recessions?
Booms
and
Busts
in
Economic
Activity:
The principal indicators of economic activity are the Gross Domestic Product, or GDP, the inflation rate, and
the unemployment rate. When the GDP grows at too fast a rate we generally have inflation, and when it
grows too slowly we generally have unemployment. Business cycles, which include booms and busts, are
determined primarily by variations in GDP growth around a trend of non-inflationary full-employment growth.
It
is
this
trend
that
serves
as
the
focus
of
monetary
and
fiscal
policy.
The
Gross
Domestic
Product
(GDP)
consists
of
several
components:
1.
Personal
consumption
expenditures
(fairly
stable)
2. Gross Private Investment (fairly volatile, and tied closely to the stability of financial markets)
3.
Government
spending
on
goods
and
services
(fairly
stable)
4.
Exports minus imports (relatively stable and correlated to items 1 and 3)
So what does this tell us? The primary source of economic instability is financial instability, which in turn
affects investment instability and thus the GDP. The primary source of financial instability is shifting
expectations by consumers and investors. These shifts are based on imperfect information between buyers
and sellers. These imperfections can lead to major distortions in the allocation of resources. Evidence shows
up in terms of asset volatility, be that in stocks, commodities, or in housing, and then spreads to the real
economy.
Booms and Busts in Perspective:
Economic Forecasts Are Based on Measures
of Dependence and Interdependence
Many of these models fail to take into consideration information myopia, which leads
to the creation of asset bubbles that cause economic instability.
Asset Bubbles in Stocks, Real Estate, and Commodities
Asset bubbles and financial crises derive from Informational myopia and differing attitudes toward risk. Myopia
derives from three forms of perception bias in which individuals rely on heuristic, or short-term proxies, to make
decisions: 1. The “status quo heuristic” i.e., perceptions of risk anchored in the recent past; 2. The “law of small
numbers heuristic” (also known as the “representative heuristic” as well as “disaster myopia”); 3. The “availability
heuristic” (e.g., relying only on the information of immediate personal contacts). When such perceptions prevail,
one is drawn to the conclusion (and illusion) that rising asset prices somewhere in the economy will persist and
never face a correction that reflects historical patterns over the long run (e.g. “gold and diamonds will never
decrease in value”; “real estate is a risk-free investment because housing prices will never go down”).
Under these circumstances, people engage in herd behavior, looking at what others are doing and assuming that
they have at least as good information as you. You then act accordingly with the same limited information as they
do, which, in the end, works to disastrous results through some kind of “correction” in which defaults and
bankruptcies arise as prices adjust to more sustainable levels in line with longer-term behavior.
Finally, how individuals make decisions depends in part on their fundamental attitudes toward risk, i.e. risk
aversion, risk neutrality (the expected outcome is zero), and risk loving (i.e. gambling, in which the expected
outcome is negative). Although most individuals are to some extent risk-averse, incentives, especially those arising
from public policies, persuade them to take on risks whose true probabilities may not be known to them.
Imperfect asymmetric information and differing attitudes toward risk explain much behavior in the stock market
(e.g. the tech dot.com boom of the 1990s) and in the real estate boom of the 2000’s. In each case, or in
combination, investors think they are in some kind of “new economy” in which prices can never turn downward. As
a result they take on more leveraged financial decisions, be that on Wall Street or on Main Street, in the belief that
increasing asset values will compensate for the perceived small risks they confront. Such behavior is the essence
of a bubble economy. When price increases are no longer sustainable, the bubble bursts to some more historically
sustainable level, as has always been the case in the past. And out of such collapses, inevitably we discover
someone vying for the Ponzi investor fraud scheme award of the century, as Bernard Madoff did until recently with
asset losses of some $50+ billion.
Some Evidence of Asset Bubbles:
Asset bubbles consist of rising prices in such areas as stocks, housing, and
primary commodities such as gold and silver that are unsustainable relative to
historical norms. Individuals have underlying time preferences that may be similar
to prevailing interest rates. If not, individuals will seek, and take the corresponding
risks, of alternative asset investments rather than rely on bank time deposits, cd’s
or even the stock market. Lacking transparent and symmetric information,
individuals thus help to creating and drive asset bubbles.
Asset bubbles arise for two basic reasons:
1. Imperfect information between buyers and sellers that leads to herd behavior.
2. Government policies that create incentives to drive up asset prices beyond historical norms.
In making decisions, we all face the problem of imperfect information. Given that
perfect information is costly, individuals wind up taking risks based on subjective
perceptions of risk. Worse yet, imperfect information is often distributed
asymmetrically between buyers and sellers (e.g. used car “lemons). Even when
government agencies step in to reduce information asymmetries (e.g., “full”
disclosure on credit card contracts, warranties on used cars, FDIC insurance to
protect depositors), institutions and individuals still may engage in moral hazard.
Moral hazard arises when individuals take on additional risk in the presence of
external (e.g. government) guarantees, or insurance, leading to higher default
probabilities, and in which some third party often may be saddled with the
financial costs (e.g. ARM home equity loans to pay off credit card debt that when
resets occur lead to higher default rates on mortgages and credit cards).
Reducing the likelihood of asset bubbles and financial crises depends in part on
measures to create greater transparency that can reduce the problem of
asymmetric information. Greater government regulation may or may not reduce
the problem of moral hazard unless the impact of financial incentives is carefully
examined and taken into consideration.
Government Policies that
Foster Asset
Bubbles:
Public policies are often driven by political incentives that help decide elections. “Helping” individuals to own stocks and
housing seems laudable at first blush, but when the asset bubble consequences are considered, these measures may be
counter-productive.
Some
examples:
1. Federal Reserve Bank (est. 1913) Interest Rates. In the absence of significant general price inflation, low interest rates
foster speculation in housing and equities, a policy that operates through the Federal Reserve, which is ultimately accountable
to Congress.The Federal Reserve Bank was established Congress in 1913, and signed by President Woodrow Wilson.Until
the latest recession, the Fed did not consider it as responsible for asset bubbles, just the macroeconomic tasks of managing
the
money
supply
and
interest
rates
to
achieve
non-inflationary
full-employment.
2. The Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) - By eliminating ceilings on
depository interest accounts at Savings and Loan Associations this helped to create the S&L financial crisis of the late 1980s.
The 1980 legislation also raised the FDIC insurance limit from $40,000 to $100,000. It further allowed Credit Unions and
S&L’s to offer checking account services, while at the same time authorizing financial institutions to charge any loan rate of
interest
they
chose.
DIDMCA
was
signed
by
President
Jimmy
Carter.
3. The Garn-St. Germain Depository Institutions Act of 1982 (GGDIA) (PL97-320) - Extending deregulation of S&L institutions,
GGDIA introduced Adjustable Rate Mortgages (ARM’s) in the housing financing mix. It also allowed anyone to place real
estate assets in a trust without triggering the due-on-sale clause that otherwise would give lenders foreclosure rights on
transfers
of
property.
GGDIA
was
signed
by
President
Ronald
Reagan.
4. The Graham-Leach-Bliley (GLBA), or Financial Services Modernization Act of 1999 (PL 106-102).
This legislation repealed the Glass-Steagall Act of 1933 that had separated commercial from investment banking. GLBA
allowed commercial banks, investment banks, securities firms and insurance companies to form conglomerates to offer
diversified financial services (e.g. Citicorp became Citigroup when it acquired Travelers’ Insurance Company in 1998 that led
to GLBA passage). In a series of votes and amendments, the legislation was approved by a veto-proof Republican majority in
both the Senate and House. The bill did not cover non-bank financial institutions such as AIG, that subsequently used offshore
trading in derivatives that resulted in large losses by 2007-2008. GLBA was signed by President Bill Clinton.
In terms of remaining regulatory functions, The Federal Trade Commission (FTC) has jurisdiction over non-bank mortgage
lenders, loan brokers, some investment advisers, debt collectors, tax return preparers, banks, and real estate settlement
service providers, while commercial banks are subject to regulation by the Federal Reserve, the Office of the Comptroller of
the Currency (OCC), and state agencies. The Securities and Exchange Commission (est. 1935), retains jurisdiction over
stock market transactions. These “alphabet soup” agencies have often had overlapping responsibilities but have not always
shared regulatory standards, findings, or actions. Opacity and laxity in regulation by the agencies helped to create the
downturn that began in 2007. Also, HUD upped the required purchases of mortgages for low and moderate income HH’s.
Financial
Innovations
to
Manage
Risk:
1. Hedge Funds (1966) - Limited Liability Partnerships exempted from the provisions of the 1933 Securities Act and the 1940
Investment Company Act, which restrict the operations of mutual funds and investment banks with respect to leverage and
short-selling. Hedge funds have operated outside of any formal regulatory structure, even though some have been bailed out
(e.g.,
the
Federal
Reserve
bailout
of
Long
Term
Capital
Management
in
1999).
2. Structured Investment Vehicles (SIV’s) (1988) - Created by Citibank, these are funds that borrow money by issuing shortterm securities at low interest and then lend that money by buying long-term securities at higher interest, making profit from
the difference. SIV’s ceased to exist as of October 2008, with the onset of the latest recession. Also known in Europe as
Special
Purpose
Entity
(SPE).
3. Mortgage-Backed Security (MBS) - First used by the Government National Mortgage Association (Ginnie Mae, est. in
1968), in 1970, these consist of government backed securities issued on the basis of mortgages purchased from originators.
These pass-throughs have been used by the Federal National Mortgage Association (FNMA, of Fannie Mae, est. in 1938), and
by the Federal Home Loan Mortgage Corporation (Freddie Mac, est. 1970). During the latest recession, these institutions
have some $14.6 trillion in U.S. mortgage debt outstanding. Mortgage-Backed Securities are also known as Collateralized
Debt Obligations (CD0’s). When Collateralized Debt Obligations are segmented into differing risk tranches (e.g., unsecured,
mezzanine, senior secured), the groups derived from the original pool often are referred to as Derivatives, because their value
derives
from
the
value
originating
in
the
initial
market
mortgage
pool.
4. Derivatives - Derivatives are financial contracts that derive their value from some other asset, index, event, value, or
condition. Derivatives are considered to be risk-sharing instruments that operate as a form of insurance. Derivatives have
largely been unregulated since their expansion in the United States, which started with the Chicago Mercantile Exchange in
the 18th century and accelerated with the creation of the Chicago Board of Options Exchange in 1973. Derivative contracts
typically are exchanged through two types of markets: 1. Over the Counter (OTC) contracts that are traded on formal
exchanges; 2. Exchange-traded derivatives (ETD) that trade via specialized derivatives exchanges.
There are three types of derivative contracts: 1. Futures and Forward Contracts (e.g. commodity futures); 2. Options that
confer the right but not the obligation to purchase or sell assets at some stipulated price at a specific future date ; and 3.
Swaps as contracts to exchange cash on or before a specified future data based on the underlying value of
currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. While some option contracts are visible
on exchanges, their appearance in executive compensation and firm’s 10K statements have remained somewhat opaque,
masking the underlying level of risk that a firm confronts. Up to now, there has been no clearinghouse for swaps, and they
have remained largely unregulated, posing a problem for transparency in measuring institutional risk under existing accounting
standards..
Consequences
of
Financial
Deregulation:
It is easy in retrospect to blame deregulation as the principal cause of the current economic
recession. Yet, as new proposals for regulatory reform are put forth, typically there is a rush to
judgment that does not take into account the subsequent risks of moral hazard and some future
financial
crisis.
Consider,
for
example:
1. The goal of broad-based home ownership. This has been an underlying goal of every US
administration since the Great Depression of the 1930s. In the quest fo an “ownership society”,
Congress has adopted any number of incentives and rules in support of this goal on the assumption
that a more stable and prosperous society would result. Home ownership rates, which rose from 64
to 68 percent in the past five years, have been driven not just by low interest rates. They also have
been driven by government-sponsored public financing entities (I.e., GSE’s) such as Fannie Mae
(1938), Ginnie Mae (1968), and Freddie Mac (1970). These institutions were pressured by the
Clinton and George W. Bush administrations to promote an “ownership society” in housing. Fannie
Mae and Freddie Mac used relaxed accounting standards to issue mortgage-backed securities to
fuel more housing construction and purchases.By 2007, Fannie Mae and Freddie Mac were
becoming insolvent and needed infusions of Federal money to keep issuing mortgage-backed
securities,
thus
feeding
further
pricing
speculation.
3. As housing prices weakened in 2007, rising defaults meant pressure to increase liquidity among
borrowers. Stock market prices, which had risen in tandem with real estate, then took a fall. As
these two assets declined in value, a general recession even more severe than in 1929 began to set
in. Pulling out of this recession has involved over a trillion dollars worth of new public debt spending,
casting a shadow over the health of the economy in the future.
Public Responses to the Economic Recession:
Financial deregulation has spawned an expansion of the value of financial assets and services at a rate far in
excess of the growth the Gross Domestic Product. In turn, it has led to levels and rates of increases in financial
service executive compensation that have dwarfed those in manufacturing or in other sectors of the economy.
When the current recession started in 2007, public attention focused on how such large, unregulated investment
banking institutions as Lehman Brothers could go bankrupt, and why the Federal Reserve chose to provide
bailouts for other institutions such as AIG, Bank of America, and Citigroup, even as bankruptcies and
unemployment rates soared. All of this has led to emergency measures in the fall of 2008, and which are the
subject
of
ongoing
proposals
for
financial
reform
today.
The first key Congressional measure is the Economic Stimulus Act of 2008 (PL 110-185). The law provides for
tax rebates to low and middle income taxpayers, tax incentives to stimulate business investment, and to
increase limits on mortgages eligible for government sponsored enterprises (GSE’s) (e.g. Fannie Mae and
Freddie Mac). It also created the Troubled Assets Relief Program (TARP), which authorized the Federal
Reserve and the Treasury to purchase “toxic” assets of financial institutions. The cost of the legislation was
estimated at $152 billion and was signed by President George W. Bush on February 13, 2008.
Driven by a decline in the stock market , by rising real estate foreclosures, collapsing investment and lending,
Congress adopted in February the American Recovery and Investment Act of 2009 (ARIA). The cost of this
legislation is estimated at $787 billion. The legislation provides for federal tax cuts, expansion of unemployment
benefits, spending increases in education, health care and infrastructure. At the same time, there is continuing
anger from Main Street about the return of large bonuses to Wall Street executives, particularly those that
benefited from TARP Monies. From this we had the appointment of a TARP pay czar whose effect has been
largely to get Wall Street firms to repay more rapidly the money they borrowed than might otherwise have been
the case. Continuing economic weakness has led some members of Congress to call for a new fiscal stimulus.
Economic and Financial Bubble Dynamics
Economic and Financial Bubble Dynamics
Economic and Financial Bubble Dynamics
Economic and Financial Bubble Dynamics
Economic and Financial Bubble Dynamics
Economic and Financial Bubble Dynamics
Economic and Financial Bubble Dynamics
Economic and Financial Bubble Dynamics
The
1999
vote
on
Graham-Leach-Bliley
Economic and Financial Bubble Dynamics
Economic and Financial Bubble Dynamics
Economic and Financial Bubble Dynamics
Are We Moving Out of the Recession Yet?
Continuing Asset Volatility and Weakness
Testing the Limits of Economic Recovery
Economic and Financial Reform Tasks Ahead
Fraud
Require money managers with
more than $10 million to use
an independent custodian for
client accounts
Difficult to legislate moral
behavior beyond reliance on
open and competitive markets
Conflicts of Interest
Require raters to release
details on compensation;
Issuers should provide
information on underlying
assets of a bond.
Credit agencies are paid to
rate bonds by the companies
that issue them.
Toxic Assets
Financial advisers to muni
issuers would have to register
with the SEC and follow new
municipal bond rules.
Little impact on containing
fraudulent declarations on debt
because of limited liability
rules.
Biased Advice
Brokers who advise would be
required to act as fiduciaries,
with greater disclosure
requirements
Industry concentration may
increase as smaller firms lose
a source of income
Speculation
USCFTC and NYME to cap
gains from derivatives
Some firms engaged in
exchange-traded funds used to
trade commodities may leave
and pursue other business.
Source: Business Week, December 28, 2009-January 4, 2010
Market Symmetry and Transparency on Hold
Are We Creating the Next Asset Bubble?
A Cautionary View of the Future
Selected Bibliography
Malcolm Balen (2003, 2002)
The Secret History of the South Sea Bubble, The World’s First Great
Financial Scandal. (New York: Fourth Estate Harper Collins).
John Cassidy (2009)
How Markets Fail: The Logic of Economic Calamities. (New York: Farrar,
Straus and Giroux).
Edward Chancellor (1999)
Devil Take the Hindmost: A History of Financial Speculation. (New York:
Farrar, Straus and Giroux).
Niall Ferguson (2009, 2008)
The Ascent of Money, A Financial History of the World. (New York:
Penguin Books).
David Hackett Fischer (1996)
The Great Wave: Price Revolutions and the Rhythm of History. (New
York: Oxford University Press).
Justin Fox (2009)
The Myth of the Rational Market: A History of Risk, Reward, and
Delusion on Wall Street. (New York: Harper Collins Business Publications).
Charles P. Kindleberger (1996,
Manias, Panics, and Crashes: A History of Financial Crises. (New York:
John Wiley and sons)
1989, 1978)
Roger Lowenstein (2000)
When Genius Failed: The Rise and Fall of Long-Term Capital
Management. (New York: Random House).
Charles Mackay (1841)
Extraordinary Popular Delusions and the Madness of Crowds. (New York:
Three Rivers Press 1980 reprint).
Robert Shiller (2006, 2000)
Irrational Exuberance, second edition. (Princeton: Princeton University
Press)
Andrew Ross Sorkin (2009)
Too Big to Fail: the Inside Story of How Wall Street and Washington
fought to Save the Financial System - and Themselves. (New York: Viking
Publications).