NBER BUSINESS CYCLE DATING COMMITTEE SAYS ITS TOO SOON TO SAY ON THE US RECESSION

The problem is that the committe has to try and be sure the recovery is real, and that there is going to be no double-dip, before giving the green light signal. The situation is complicated by the confusing and conflicting signals which are arriving, especially on the employment front, there seems to be a constant 'two steps forward, one step back, one step forward, two steps back' process going on. In the end, as the saying goes, every recession, and every expansion is unique, and it is the absence of mere repetition of the same that makes the calls so damned tricky.

The U.S. economy continues to experience increases in production and income with no significant growth in employment. According to recently revised data, real personal income has generally been growing over the past year. Employment grew slightly from May through August 2002, but declined in September. These and other signs indicate that the decline in activity that began last year may have come to an end. The NBER's Business Cycle Dating Committee will determine the date of a trough in activity when it concludes that a hypothetical subsequent downturn would be a separate recession, not a continuation of the past one. The trough date will mark the end of the recession. The committee will not issue any judgment about whether the economy has reached a trough until it makes its formal decision on this point. The committee waits for many months after an apparent trough to make its decision, because of data revisions and the possibility that the contraction would resume. For example, the committee waited until December 1992 to announce that a trough had occurred in March 1991.

In November 2001, the committee determined that a peak in business activity occurred in the U.S. economy in March 2001. A peak marks the end of an expansion and the beginning of a recession. The determination of a peak date in March is thus a determination that the expansion that began in March 1991 ended in March 2001 and a recession began in March. The expansion lasted exactly 10 years, the longest in the NBER's chronology.

Because a recession influences the economy broadly and is not confined to one sector, the committee emphasizes economy-wide measures of economic activity. The traditional role of the committee is to maintain a monthly chronology, so the committee refers almost exclusively to monthly indicators. The committee gives relatively little weight to real GDP because it is only measured quarterly.

In 2002, indicators measuring output and income generally have been rising, while employment has been essentially constant. The primary factor accounting for the more favorable performance of income and production relative to employment is the continuation of rapid productivity growth resulting in corresponding growth in real wages.

According to data released in September (http://www.bea.doc.gov/bea/newsrel/gdpnews release.htm), real GDP increased at an annual rate of 1.3 percent in the second quarter of 2002, and 5.0 percent in the first quarter. GDP reached a peak in the fourth quarter of 2000, contracted for the first three quarters of 2001, and has expanded since then to a point above its level in the second quarter of 2001. This performance of real GDP is consistent with the other data considered by the committee. Output fell less than employment during the recession and currently is rising faster than employment because of unusual productivity growth.
Source: NBER
LINK

DEFLATION DENIAL

Glenn Hubbard, the chairman of Bush's Council of Economic Advisers makes it official, deflation is greatly over-rated because the US Economy is going just fine:

This modern deflation scenario seems to make a lot of sense - until you get out your calculator. When you do, the basic features of the US economy look quite good and deflation appears unlikely. To start with, analy sis of the productivity data over the past six quarters confirms some of the best news that economists have delivered in a generation - the acceleration in productivity growth that began in 1995 continues unabated. Thanks to this, today's consumers can look forward to real incomes that grow much more quickly than they have during the past 30 years - a good omen for current consumption.

Of course, one can point to the strength of the housing market as a factor keeping consumption strong. House values have risen and low mortgage rates have encouraged homeowners to take out some of the equity in their homes through refinancing. But while this process has been a part of healthy consumption growth, it has been only a part..............The question of why house prices have risen so much in the past few years is interesting. The surge in immigration during the 1990s and the lack of land suitable for new housing in some cities with tight zoning restrictions are probably part of the answer. But fears that the US housing market is in the midst of a bubble are unwarranted. Behind any bubble is the hope that an investor can purchase an asset for one price and sell it quickly for a higher price. This is hard to achieve with houses, because of the high transaction costs in housing markets. And without a rapid and nationwide decline in housing wealth, it is hard to see how deflation can occur.

While in the long run deflation - like inflation - is a monetary phenomenon, low aggregate demand is not likely to push the US toward deflation any time soon. It is a pretty boring story, compared with those told by the deflationists. But it does pretty well when confronted with the facts.
Source: Financial Times
LINK.

Now perhaps this article would be eminently forgetable, were it not for the fact that Paul Krugman has seen fit to enter the fray. I post the Krugman piece in full.

JOBS, JOBS, JOBS (10/10/02)
Of all the things to be upset about right now, a silly fallacy in Glenn Hubbard's FT article today doesn't rate very high. But it's a fallacy I hear a lot, so let me take a minute to bash it.

Hubbard, like so many people, asserts that one reason for optimism about economic recovery is our continuing high rate of productivity growth. At first this sounds right: higher productivity growth means, other things equal, faster income growth, which means more spending, which means faster demand growth. So all that is good for recovery, right?

No, not really. What most people mean by recovery is job growth - an economy that is growing, but in which employment grows more slowly than the labor force, may be in recovery by some measures, but it will feel like it's still in recession.

Now what does productivity growth do? It raises incomes and hence demand. But it also raises the growth rate the economy needs to achieve to create jobs, and to a first approximation it does so by exactly the same amount. That is, an economy with 3 percent productivity growth will, other things equal, have 2 percent faster demand growth than an economy with 1 percent productivity growth; but it will also need a growth rate 2 percent higher to keep unemployment from rising.

In fact, the "productivity growth helps jobs" story, if that's what it is, is just the flip side of the lump-of-labor fallacy, which says that productivity growth reduces employment - and equally wrong. (There's a different argument, about how productivity growth reduces the NAIRU - but that's about the supply side, not the demand side).

You might say that I'm being too abstract; what about the lessons of history? But they all confirm this point. Terrific productivity performance in the 1920s didn't protect us against the Depression; all through the 70s and 80s Europe had higher productivity growth than the U.S., but worse job growth; you can multiply the examples.

I'm not surprised that Hubbard would make a silly argument; he is not, after all, a free man. But it's a sign of desperation, I think, that so many people have bought into this fallacy.
LINK

Hubbard clearly has it wrong. Rising productivity can be accompanied by either rising incomes, or falling prices, it depends. And it's this 'depends' that really is at the issue here. Hubbard clearly believes that the current increasing LABOUR productivity will lead to increasing real incomes, increased consumption, and thus, presumably increased investment (although this is my deduced mechanism since it isn't presented explicity), because he says so.

"the acceleration in productivity growth that began in 1995 continues unabated. Thanks to this, today's consumers can look forward to real incomes that grow much more quickly than they have during the past 30 years - a good omen for current consumption."

The deflationist argument is that the other possibility exists, that the increased productivity leads to falling prices as firms compete to sell. This is the role of the output gap argument. This argument is also backed by the idea that current consumption has been maintained by borrowing. It's not the wealth loss caused by the drop in the financial markets that's the problem, but the increased debt encouraged by the false sense of security provided by rising assett, and subsequently rising property, values.


One of the problems here is that productivity is a poorly understood phenomenon - by all of us. The majority of the numbers being bandied-about at the moment seem to be numbers for 'labour productivity' from the BLS. And this is where the argument starts, because the 'jobless recovery' is a product of another process, the relentless drive by corporate America to cut costs, ergo increase output while not contracting new labour, or hiring young workers on short term contracts etc. It's very early to start making conjectures about these numbers because the serious analysis isn't through yet. But it is entirely consistent with the deflation/output-gap argument. US workers are trapped in a kind of modern version of the olive press, and at some stage all that can be will have been squeezed.

"Now what does productivity growth do?" Perhaps this is an unfortunate way to present the story, since maybe productivity growth doesn't 'do' anything. In the present context this productivity growth is an effect of something, and it's understanding this 'something' that is the problem.

Paul Krugman himself in another piece on the related topic of the output gap clarifies what he is saying: "Brad DeLong is quite right that there's no such thing as excess capacity for the economy as a whole. I've been vociferous about that myself in the past. What I meant to say was over-investment in short-lived business capital, mainly tech, relative to other resources...."

However it is in this last point, rather than the conjuctural productivity/output-gap argument, where the real problem lies. You see, I think it's just not credible to say that "over-investment in short-lived business capital" is pushing the global economy into a period of secular deflation (I take it as read that Hubbard just doesn't understand what's going on here). The normal expectation would be that this excess capacity would be worked-off, and on we would go again. But it's all too evident that this just isn't happening.

I've already indicated in this column (ad infinitum) some possible candidates: the continuing fall in ICT and biotech prices, the structure of world trade (especially China, but my guess is India won't be too long making its presence felt), and demographic processes in the G3 countries.

If demography is going to be important in the story then the deflation problem should be more acute in the EU countries (Italy and Spain in particular, but also Germany) than in the US, but obviously with Japan and Europe going downwards the US is bound to be sucked in.

Put this another way: if demography is not important, then why, in Stephen Roach's words is the world lacking an alternative global growth engine right now. Surely using conventional growth theory the 'convergence factor' should be offering plenty of catching-up momentum elsewhere.

Perhaps demography will turn out to be the modern economists 'pons assinorum'.

Incidentally, while the Glen Hubbard piece may be eminently forgetable, the ever-to-be-recommended Economist has a very nice (Krugman influenced?) piece on deflation (see below), and especially the dangers for Germany right now - going 'naked into the conference chamber' - thanks to the voluntary Euro disarmament. (It's hard to remember that it was only 10 months ago that the world was cheering on this single currency 'experiment' - so why, oh why, have all the evangelists suddenly gone silent?).
Now as far as the liklehood of deflation goes, either you believe the deflationist story or you don't. But Hubbard is wrong. There are TWO possible outcomes, and this time next year we'll have a better idea which one of the two it is going to be.

THE ECONOMIST RAISES THE DEFLATION ALERT

An extremely comprehensive and well argued piece in this weeks economist - entitled interestingly enough of debt, deflation and denial - draws attention to the growing unease at a possible global drift towards deflation. In particular it points out the highly preoccupying situation of the German economy and the danger that, lacking any domestic policy instruments of her own - thanks to her Euro membership, she may fall defenceless.

The article also draws attention to the ongoing difference of opinion between the ECB and the Federal Reserve. Greenspan obviously takes the threat more seriously than Duisenberg. Time will show who is right

The world is still awash with excess capacity, in industries from telecoms and cars to airlines and banking. Until this is eliminated, downward pressure on inflation will persist. A good measure is the output gap, the level of actual minus potential GDP. Historically there has been a close relationship in most countries between the size of the output gap and changes in the inflation rate (see chart). When the output gap is negative (ie, actual output is below potential), inflation usually declines. The OECD estimates that America's GDP is about 1% below its potential. If growth remains at or below its trend rate of around 3% over the next two years, the negative output gap will persist into 2004, pushing inflation even lower. It would not take much to tip into deflation.

The Fed is at least aware of the risks. However, not all central banks may be either willing or able to learn from Japan's mistakes. Germany probably faces a higher risk of deflation than America. The ECB's interest rate of 3.25% is broadly appropriate for the euro area as a whole, given its inflation rate (2.2%), the size of the output gap, and the bank's chosen inflation target of “less than 2%”. But the ECB seems unlikely to cut interest rates until inflation dips below 2%. And its inflation target is arguably too low.

Even then, however, rates would still be too high for Germany. Since it is the highest-cost producer within the euro area, a fixed exchange rate tends to cause price convergence by forcing inflation to be lower in Germany than in the rest of the euro area. Germany's core rate of inflation (excluding food and energy) has averaged 0.6 percentage points below the euro-area average over the past three years; it is now a full point lower, at 1.1%.

Since interest rates are the same across the whole of the euro area, this implies that real rates will be higher in Germany and growth consequently slower. Germany's output gap, at an estimated 2.5% of GDP, is the second biggest after Japan among the G7 countries, and it is likely to widen. Deutsche Bank recently cut its growth forecast for Germany to only 0.1% for this year and 0.6% in 2003.

Back-of-the-envelope calculations suggest that, if the old Bundesbank were setting interest rates to suit Germany alone, they would now be below 2%. Worse still, not only is Germany unable to cut interest rates, but the EU's stability and growth pact also obstructs any fiscal easing. Nor can it devalue its currency. Stripped of all its macroeconomic policy weapons, Germany now runs a serious risk of following Japan into deflation.
Source: The Economist
LINK

JAPAN BANK CAPITAL: NOW YOU SEE ME NOW YOU DON'T

Japan's Asahi Shimbun has this inteesting piece about the capitalisation situation of Japanese banks. According to this Japanese daily the major banks still have capital adequacy ratios of 10 percent or higher, meeting the internationally accepted minimum of 8 percent. But much of this capital consists of previous government bailouts and deferred tax assets, posted in anticipation of tax refunds. Accumulated profits are apparently near zero, following numerous bad debt write-offs. The question to ask then is major banks really as healthy as they claim they are?

Capital contributed by shareholders, accumulated profits, shareholdings, gains on real estate and other items are considered the tangible capital that constitutes shareholder equity and can be used to cover losses. The last two injections of public funds, in 1998 and 1999, are supposed to be paid back, and deferred tax assets are also considered artificial capital.

Each banking group's capital-adequacy ratio was raised by 2-3 percentage points through the previous injections of public funds, and only Mitsubishi Tokyo Financial Group has repaid that assistance. Although public funds are considered part of shareholder equity under Bank for International Settlements standards, they are not true equity in that they are debts that must be paid back to the government. Banks have almost no surplus cash after writing off bad debts, and they may not be able to pay back the government.The banks, however, counter that the purpose of the public funds was to boost their equity to begin with, and ease their reluctance to lend money. They say it's irrational to claim their capital is weak because it includes public funds.

Real estate property assessments also pose a problem. Since March 1998, banks have been allowed to top up their capital by booking any increase in a property's assessment over its acquisition price as an unrealized gain. Now that major banks are facing unrealized losses on their commercial real estate holdings, however, their equity will likewise have to be revised downward. Banks haven't reappraised their real estate since before its market value fell below its book value, so unrealized losses due to falling land prices remain hidden. The banks say they have disclosed their latent losses in their financial statements, and do not intend to hide them. Land prices, meanwhile, continue to crater.

The use of deferred tax assets-expected future tax refunds-is another questionable technique the banks use to pad their capital. It was introduced in March 1999 to encourage banks to set aside taxable reserves against bad debts. The BOJ says banks' combined deferred tax assets totaled 10.6 trillion yen in March 2002, up 3.5 trillion yen from the previous year. Over the same period they rose to account for 36.5 percent of shareholder equity, from some 20 percent. Deferred tax assets have swelled in tandem with the increase in tax credits the banks are receiving for disposing of bad loans.The maximum amount of deferred tax assets a bank can post is based on its future profit projections. Some analysts want closer scrutiny of banks' profit projections, lest an overly rosy outlook allows a bank to pad its capital too much. Banks can also include up to five years' worth of expected taxes in their shareholder equity. In the United States, on the other hand, they can only post deferred tax assets for the coming year.
Source: Asahi Shimbun
LINK