Rate of growth of real GDP (annual rates), 1947:Q2 to 2009:Q3. Shaded regions represent dates of recessions as declared by NBER.

Consumption spending is the biggest component of GDP and the main contributor to third quarter growth, accounting by itself for 2.4 percentage points out of the 3.5% total, and with consumer purchases of motor vehicles and parts alone 3/5 of the contribution of consumption. Next in importance was inventory rebuilding, which added 0.9 percentage points to the total and could make a significant further contribution in the quarters ahead. Housing is finally making a positive rather than a negative contribution, and nonresidential fixed investment was a smaller drag than I had been expecting. Imports grew faster than exports, though I'm relieved that trade overall is coming back. The government sector made a smaller contribution than one might have thought given the fiscal stimulus, in part because lower state and local spending offset some of the increased federal spending. For a healthier long-run growth path I'd prefer to see business fixed investment and net exports adding rather than subtracting. But, compared with what we've been seeing recently, this overall is a quite welcome report.

With the new third quarter numbers, we are ready to calculate our Econbrowser Recession Indicator Index for the preceding quarter (2009:Q2). This is a pattern recognition algorithm for identifying recessions that waits one quarter for data revisions and clear trend identification before making an assessment. Based on the 2009:Q3 GDP numbers just released, the value that the algorithm assigns to the second quarter of 2009 is 84.6-- based on currently available data, it looks like the economy was still in recession as of the second quarter of this year. We'll declare the recession to be over when the index falls below 33. At that time, we'll use the full set of revised data available as of that date to assign a most probable date for the end of the recession.

The plotted value for each date is based solely on information as it would have been publicly available and reported as of one quarter after the indicated date, with 2009:Q2 the last date shown on the graph. Shaded regions represent dates of NBER recessions, which were not used in any way in constructing the index, and which were sometimes not reported until two years after the date.

Other takes on today's numbers were provided by WSJ Real Time, Calculated Risk, Jon Hilsenrath, Economix, and Justin Fox, whose general theme seems to be concerns about whether this growth will be sustained into 2010.

I don't read very many books. At least not during the academic year. But I have read two books recently that are quite germane to thinking about the buildup to the financial crisis, and thinking about how to respond to the current economic downturn. The first is Akerlof and Shiller's Animal Spirits. The second one is actually not yet out -- it's Justin Fox's The Myth of the Rational Market (I got a prepublication copy; here's a hint of it). They are both important books, well worth reading.

As one can guess from the titles of these two books, neither text is a paean to the predictive power of the neoclassical view of the world. I'd expect that most readers trained in this tradition would then skip this blogpost. But before you do, and go back to reading your financial industry newsletter, you might consider where these seemingly neutral phrases such as "risk appetite" come from. Why did "risk" seemingly disappear in 2005-06, only to reappear in 2008? Why did asset prices (including house prices) climb so much? Think about the traditional asset pricing (Gordon Growth equation):

P_t = D_t/(k_e - g)

Where P is the stock price, D is the dividend today, k_e is the equity discount rate, and g is the deterministic growth rate of dividends; and k_e equals the risk free rate plus the equity risk premium.

Where does this equity risk premium come from? Well, it could come from the covariation of real equity returns with the ratio of the marginal utility of consumption. Or it could come from waves of excess optimism and pessimism. Or it could come from both – although one would need to take a stand on the relative weights of the two effects.

I'm sure there are readers out there at this moment saying "But what about the finding that stock prices follow a random walk; this is consistent with the efficient markets hypothesis." But as Fox writes:

Fama had proposed that the way to test the efficient markets hypothesis was to see if stock price movements obeyed the dictates of the capital asset pricing model, but this was only a relative test. It might reveal whether stock price movements made sense in relation to each other and the overall market, but it was no help in showing whether the overall market was correctly price or not. (p. 184)

Digression 1: To place this in technical terms, the maintained hypothesis is the statistical null hypothesis of no predictability. Failure to reject to no-predictability null is consistent with the random walk hypothesis, and hence the weak form efficient markets hypothesis (EMH). However, it is very difficult for most statistical test to differentiate between no predictability and little predictability. Jeffrey Frankel has called this econometric approach "the zen of perfect nothingness".

Digression 2: Larry Summers (J. Finance, 1985) showed how a financial market pervaded by strong and persistent deviations from the fundamentals ("fads") would take five thousand years to have 50% chance of distinguishing it from a truly efficient market, defined in the statistical sense Fama defined it.

To the extent that these waves of optimism and pessimism -- heck why not call them animal spirits -- are a real world force, then this argues that self-regulation of the financial industry is not likely to be sufficient. It's not a prima facie case in support of government regulation (especially if regulation can be captured, a la Simon Johnson's regulatory capture view). But I think we should at least try to regulation and/or other means of slowing down the excess movements (financial taxes could in principle work this way, as in the Tobin tax).

Akerlof and Shiller conclude Chapter 11 thus:

...financial markets require regulation. And sometimes, when these regulations fail, because of all the feedbacks between financial markets and the real economy, there is also room for thoughtful, careful policies of financial insurance. Rededication to protecting the financial consumer must be one of our highest economic priorities.

In an emergency, as a backup, when we do get into a recession, there is a monetary and fiscal policy. But we know that there are limits to such policy and to its effectiveness. It is now time to redesign financial regulations to take account of the animal spirits that often drive the markets, to make the markets work more effectively, and to minimize the extent to which we will need after the fact bailouts to get us out of the hole.

See also the oped in yesterday's WSJ.

By the way, the authors of both books agree that the point is not to dispense with price theory. That point is made on page 2 of Akerlof-Shiller, and in a quote of one of the fathers of behavioral economics, Richard Thaler, regarding the Shanghai apartment market: "Maybe it's just supply and demand" (p. 286). Rather, the point is that we need to augment price theory with a more realistic depiction of human behavior if we are to avoid a repeat of the current situation.

I leave with two figures from Robert Shiller's paper "Do stock prices move to much to be justified by subsequent changes in dividends," American Economic Review 71(3) (June 1981).

(Hint on interpretation: The dashed line should be more variable than the solid line, under the EMH and assumptions regarding stationarity. See Engel (2004) for updated discussion.)

MarketWatch reports:

President-elect Barack Obama tapped former Federal Reserve Chairman Paul Volcker to run a new White House advisory board tasked with offering independent advice about how to stage an economic recovery. Obama named the 81-year-old Volcker to head the President's Economic Recovery Advisory Board....

The board is modeled on the Foreign Intelligence Advisory Board that gave President Dwight Eisenhower independent opinions on intelligence issues. Austan Goolsbee, another key Obama adviser, will serve as the economic board's staff director and chief economist.

Volcker can be single-handedly credited with ending the great inflation of the 1970s, and has been critical of the unorthodox steps that Fed Chair Ben Bernanke has taken to address our current challenges. Although I share some of Volcker's concerns, it is not clear to me what specifically Volcker would propose to do instead. Certainly the policy for which he is famous and justly praised-- stopping inflation at all costs-- is seriously contraindicated at a time when we just saw the biggest recorded monthly drop in the CPI. A policy of real toughness in dealing with failed financial institutions has some appeal to me, and Volcker may be the sort of person who could insist on that, if given some real power. But is that what Volcker and Obama have in mind?

Chicago Professor Austan Goolsbee is very bright and certainly has my respect. Given his important role in the campaign, it's hardly a surprise that his voice will play a major role in shaping economic policy. But Time's Justin Fox worries about "economic-adviser gridlock", and David Cho and Alec MacGillis warn in the Washington Post of the

central leadership challenge the president-elect will face: how to manage a stable packed with big brains and bigger personalities -- and how to make decisions when those high-powered experts disagree.

There was already some inherent ambiguity and conflict as to what the respective contributions and roles would be for Larry Summers at the National Economic Council, Christina Romer at the Council of Economic Advisors, Tim Geithner at the Treasury, and Peter Orszag at the Office of Management and Budget. Greg Mankiw shares some insights from his experience inside the White House. But based on my knowledge of those four, I could imagine them working together very effectively.

What I'm less clear about is how creating yet another separate advisory group is going to facilitate that. Fortunately Justin Fox has come up with a solution to the potential problem: Obama just needs to appoint Jason Furman to run the "Coordinating Council of Economic Advice-Givers".

Technorati Tags: macroeconomics, economics, Paul Volcker

Note that Figure 1 highlights, by virtue of plotting the previous vintages of employment releases, the constant downward revision of payroll employment figures. While Dash of Insight's Jeff Miller has pointed that these revisions are small relative to the benchmark revisions will come our way, the latest revisions do seem to be getting bigger.

Justin Fox has correctly pointed out that quantitatively, net job loss in September and October is quite small, at 0.4%. Even with expected revisions, this percentage for September-October will not change substantially. Most Americans will remain employed throughout this downturn, and adjustment will occur at the margins. One of those margins is the extent to which employed Americans are working. Figure 2 depicts aggregate hours against nonfarm payroll employment, both normalized to peak values in 2007M12.

While employment has fallen 0.9% (in log terms) from peak at 07M12, aggregate hours worked have fallen 1.8%.

In terms of output, we've certainly had plenty of bad news. Here is the most recent take from e-forecasting.

According to e-forecasting, October GDP is declining 3.7% m/m at an annual rate (in log terms).

Here's Bloomberg's assessment.

Technorati Tags: recession, nonfarm payroll employment, revisions, and GDP.

I think that most observers will concur with assertion that the -3.1% decline in consumption q/q annualized was the most important aspect, as highlighted in Jim's post. To place the consumption drop in perspective, consider the q/q changes in GDP and consumption over the last forty years. The last time consumption growth went negative was in the 1990-91 recession. Figure 1 show the growth rates (not contributions to GDP).

What is the composition of this consumption decline? Figure 2 shows the contribution of each consumption aggregate to GDP growth. It's apparent that the consumption decline is widespread, spanning all categories. Durables I expected to decline, given the procyclicality of consumer durable expenditures. The decline in services and nondurables, however, signals either more binding credit constraints, a downward revision in permanent income, or both.

Returning to overall growth, I have two observations that pertain to growth prospects. The first is that exports are accounting for a smaller proportion of overall growth -- and no longer sufficient to keep growth positive, obviously. With the slowdown going global [1], there will be even less support from this channel. I'll also add a speculative note; it might be the case that the credit crunch impacted negatively international trade, in particular exports, in September, and even more substantially going forward [2]. We'll find out more in a couple weeks when the September trade figures are released. Second, government spending is the single largest aggregate category in GDP growth, at 1.15 percentage points of the -0.3 percentage points total.

Figure 4 illustrates the breakdown of contributions from government spending.

In the government sector, defense is providing the bulk of the growth: 0.86 ppts of overall growth. It would be interesting to find out what this spending is on. Another observation is that state and local spending is accounting for a smaller share of growth. This reflects the increasingly binding constraints on spending imposed by declining tax revenues -- validating the assertion I made in this post several months ago about the inability of state and local spending to maintain growth.

A couple of the requisite caveats. Justin Fox reminds us that the deflators -- particularly consumption deflators -- appear a bit dubious. Revisions in the deflators will induce revisions to real magnitudes.

Looking further ahead, Nouriel Roubini argued in today's JEC panel that when the final final revision of the GDP data is in, negative growth will have started at end-2007 as the 08H1 data are revised downward. To me, a pretty plausible possibility, given the data revisions that occurred around the last recession. [2], [3].

In any case, no reason to modify the view that this particular recession will be very deep, reinforcing the case for effective fiscal stimulus.

See also: WSJ.

...that of the House Republican Study Committee, seems to be a joke. It calls for a two-year suspension of the capital gains tax to "encourag[e] corporations to sell unwanted assets." But the toxic mortgage securities clogging up bank balance sheets are worth less now than when they were acquired. Meaning that no capital gains tax would be owed on them anyway. If you repealed the tax, banks would have even less incentive to sell them because they wouldn't be able use the losses to offset capital gains elsewhere. Seriously, where do these people come up with this stuff?

Eric Cantor, the Republican chief deputy whip, has a more reasonable-sounding if still pretty vague plan to insure more mortgages rather than buy mortgage securities. ....

I'm in agreement with Justin that guaranteeing even more mortgages won't be any better than the original Paulson plan.

My observation here is that the obstructionism of this group is either a manifestion of denial of reality, or a sheer indifference to the needs of their constituents -- to the extent that House Republicans purport to represent small business Main Street.

From CNBC:

Small Business Struggling As Credit Dries Up

Posted By:Kenneth Stier, Sep 25, 2008

While most of the nation's attention is focused on saving behemoth financial firms, small businesses are struggling to ride out a perfect storm of tougher credit conditions in a badly hobbled economy.

The result is that the finance sector's woes -- which has spawned new lending prudence -- is exacerbating, rather than relieving, economic weakness.

Even government programs designed to help small business are falling down on their mandate just when they are needed most, says small business advocates.

"It's always been difficult for small business but now it is become almost impossible" to survive, say Marilyn Landis, chairwoman of the National Small Business Association (NSBA). "Many factors are coming together to make this a perfect storm for small businesses."

Until recently most small business owners could go to their local banks and get unsecured loan of $100,000 or more but those days are long gone.

In the past, owners could put up buildings or equipment for loans needing collateral; similarly service companies could post solid track records of positive cash flow.

But under sharply tightened lending standards these are no longer any guarantee to get needed funding.

Besides, with so much manufacturing having migrated offshore there is less equipment to use as collateral, and property values have plummeted around the country.

As a consequence, small businesses are now using bank loans -- far preferable than relying on credit cards -- is at a 15 year low.

Sixty percent of domestic banks reported having tightened standards on commercial and industrial (C&I) loans to medium and large firms, according to the Federal Reserve Bank's July survey of senior loan officer's opinion on their lending practices.

But for small firms, terms tightened even more. Lending standards to small firms were raised on C&I loans at 65 percent of banks, up from 50 percent in April.

Some 32 percent of small business survey by the NSBA said they were experiencing worsening bank terms, forcing many to use credit cards more.

That's more convenient for banks—which can shift debt off their books to a handful of credit companies – but it subjects borrowers to higher rates and terms that can be changed at will.

In an August survey, 67 percent of small business owners reported worsening credit card terms—up from 57 percent in February.

All this has added to small business owners being "extremely anxious" about the prospect for recession, according to a recent NSBA survey, which found 79 percent anticipating a recession or flat growth at best.

"Even the perception of such limitations on small business sector translates into prolonging the recovery of the US economy," says the survey.

This is critical because small businesses are responsible for 93.5 percent of net new jobs created in the US since 1989, according to the NSBA.

The trade association's survey says near-term prospects for new net job is stagnant.

"It"s a tighter market, it means it takes a little longer, there is a more scrutiny, consumers have to jump through a few more hoops to get that loan," says Tracey Mills, a spokesperson for Consumer Banking Association. "And it's a good thing because banks just want to make sure that whoever gets the loan, will have the ability to repay."

Co-mingled credit histories

One of those new tighter hoops is tighter scrutiny of credit scores.

But that particularly complicates small businesses because many owners' personal and business credit histories are co-mingled, with the debt businesses normally have to carry pulling down overall scores.

...

Another indication of the freeze, from Thursday's FT:

... On Tuesday, the US Federal Reserve quietly admitted that it had been temporarily unable to calculate yield levels for non-financial commercial paper, issued by AA-rated companies for one to three months.

The problem, it seems, was a dire lack of activity; or, as Morgan Stanley says, "extreme levels of stress and illiquidity". More specifically, while investors are still purchasing ultra short-term notes -- say, for one or two days -- on a massive scale, they are reluctant to buy instruments that last longer than a few days. That may be temporary (yesterday yield prices were apparently returning to the AA sector again although they were unusually high). However, even a temporary freeze is remarkable. After all, these non-financial companies typically have nothing to do with Wall Street or toxic mortgage debt.

In other words, the spreads are not just rising; at some maturities in some instruments, markets have disappeared, albeit briefly (for now).

Returning to the CNBC article, I found most startling this statement (I never thought I'd agree with a statement from the US Chamber of Commerce, but these are unusual times):

"Main Street and Wall Street are inextricably connected," said Bruce Josten US Chamber of Commerce executive vice president, urging Congress in a letter Wednesday to act quickly on a bailout out package to stem further market damage. Failure to act, he warned, would make the harm already will in retrospect seem "only the tip of the iceberg because a lockup in credit markets will cripple Main Street's ability to operate and threaten taxpayer jobs and income."

See also this post, as well as

So if we end up delaying until households and small firms individually experience the credit crunch directly for the sake of ideology, well, we'll know where to locate the responsibility.

First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?

....

There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.

These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.

...

I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma) have been similarly dubious.

Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:

WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

...

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person’s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

...

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.

...

And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.

So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])

Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:

U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says

By Sandra Hernandez

Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.

Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.

"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.

The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.

The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.

Deficit Widens

"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."

The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.

Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.

"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."

See also this Bloomberg article.

Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09 [2] -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.

So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.

Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....

The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.

Technorati Tags: , subprime, Fannie Mae, Freddie+Mac, and deregulation, Office of Thrift Supervision, and tax cuts.

First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?

....

There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.

These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.

...

I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma) have been similarly dubious.

Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:

WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

...

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person’s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

...

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.

...

And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.

So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])

Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:

U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says

By Sandra Hernandez

Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.

Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.

"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.

The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.

The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.

Deficit Widens

"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."

The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.

Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.

"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."

See also this Bloomberg article.

Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09 [2] -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.

So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.

Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....

The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.

Technorati Tags: , subprime, Fannie Mae, Freddie+Mac, and deregulation, Office of Thrift Supervision, and tax cuts.

Civilian unemployment rate, from FRED, with NBER recessions as shaded regions.

Sure looks like a recession when you inspect a graph the unemployment rate, doesn't it? And it also looks like a recession from the perspective of a model of unemployment dynamics that I published in 2005. If you use that model to analyze the latest unemployment numbers, you'd calculate the current probability of being in a recession at 95%.

Probability that the economy is in either a mild or severe recession at indicated date, as inferred on the basis of the full sample of revised data on the unemployment rate available as of September 2008 calculated using the model in Hamilton (2005).

As I noted when I discussed that model last month, one reason that the above graph seems to be able to identify recessions so clearly is that it uses the full sample of data available today to infer what was the situation at each historical date. If instead you try to base a call only on the data available at the time, the inference is much choppier. Even so, a 95% probability is not likely to be a miss.

Probability that the economy is in either a mild or severe recession at indicated date, as inferred on the basis of data (as currently revised) on the unemployment rate through the indicated date calculated using the model in Hamilton (2005).

That model distinguishes between a mild recession and a severe recession, with the graphs above combining the two. In fact, the August unemployment report leads to a 14% probability that we just entered the "severe contraction" phase. The last time we had a one-month filter probability of that regime higher than that was October of 1982.

Probability that the economy is in a severe recession at indicated date, as inferred on the basis of data (as currently revised) on the unemployment rate through the indicated date calculated using the model in Hamilton (2005).

Last month I also discussed some thresholds for recognizing a recession recently proposed by UCLA Professor Ed Leamer. Leamer says it usually means recession if the unemployment rate has jumped up by 0.8% within the last six months. When Leamer proposed that criterion two months ago, the 6-month increase of 0.5% seemed to leave us well short of the threshold. Today's numbers imply a 6-month increase of 1.3%, shooting past it pretty definitively.

The 6-month change in civilian unemployment rate, from FRED, with NBER recessions as shaded regions and dashed line at +0.8 threshold.

Leamer also said it would be a recession if the 6-month change in the measure of civilian employment based on the BLS household survey fell by more than 0.4%. Today's number of -0.354% would technically fall short of that, if you're determined to split hairs more finely than the allowable pixels in the graph below.

100 times the 6-month change in natural log of civilian employment, from FRED, with NBER recessions as shaded regions and dashed line at -0.4 threshold.

Finally, Leamer said he'd call it a recession if the 6-month change in nonfarm payrolls fell by over 0.5%. Today's NFP report, while disappointing, still leaves us at only -0.3%. Whew! That was a close call, no?

100 times the 6-month change in natural log of seasonally adjusted nonfarm payroll employment, from FRED, with NBER recessions as shaded regions and dashed line at -0.5% threshold.

No. I think we're better off looking at the 12-month rather than 6-month change in nonfarm payrolls. And the 12-month change, now at -0.2%, is clearly a recession-type number:

100 times the 12-month change in natural log of seasonally adjusted nonfarm payroll employment, from FRED, with NBER recessions as shaded regions and dashed line at 0.0 threshold.

And, by the way, calling it a recession when the 12-month change in nonfarm payrolls becomes negative appears to be pretty robust even given the revisions we know are likely to come in these data later.

100 times the 12-month change in natural log of seasonally adjusted nonfarm payroll employment as it would actually have been reported at any given date, from ALFRED, with NBER recessions as shaded regions and dashed line at 0.0 threshold.

So I don't see any way to slice today's report other than to say, at least as far as the employment numbers are concerned, the U.S. is now definitely in a recession.

And if you won't take my word for it, you can hear pretty much the same thing from Brad DeLong, Justin Fox, William Polley, Paul Krugman, and the various economists quoted by WSJ Real Time.

Technorati Tags: employment, recession probability, recession indicator index, macroeconomics, economics