Several observations:

• As in recent years, the NIIP to GDP ratio continues to deteriorate.
• However, the NIIP to GDP ratio as of end-2007 is improved relative to the originally reported end-2006 NIIP/GDP ratio.
• In the last year, the dollar change in the NIIP deviates substantially (i.e., is more positive) than the corresponding current account reported on a NIPA basis. This repeats the pattern from the previous five years.
• Interestingly, 2005 stands out by far as an outlier, wherein the the NIIP improves while the CA is in substantial deficit.
• There appears to be a measurable correlation between dollar depreciation against other major currencies and the deviation between change in NIIP and CA.

The first two observations are illustrated in Figure 1.

The second two observations are illustrated by Figure 2.

The last observation is illustrated by the scatterplot in Figure 3, applying to data over the 1992-07 period.

While the regression coefficient is not significant, allowing for a dummy for the anomalous 2005 observation (Brad Setser's decomposition attributes this effect to mostly market valuation changes, if I read his graph correctly), one finds that each 10% depreciation in the dollar against a basket of major currencies induces a 2.5% increase in the gap between the NIIP change and the current account (all expressed as a ratio of GDP). Specifically:

dev = 0.01 + 0.25dep + 0.097dum05

Adj-R² = 0.68, SER = 0.017, N=16, all coeffs sig at 5% msl.

Should the dollar appreciate in 2008 against other major currencies, then one should expect the valuation effect to be reversed. A cessation of dollar depreciation will mean on average the gap between the change in NIIP and the CA (as a share of GDP) will be only 1%. (Another point I've highlighted is that the cumulative current account and NIIP converge during recessions -- see "Can Gravity Be Defied?".

In the title of this post, I mentioned "What's Missing". One interesting point highlighted in Frank Warnock, et al.'s paper, presented at the UW-Madison conference on current account sustainability a couple months ago is that it is difficult to rely upon some dark matter explanation for the differential rates of return on US owned assets abroad versus foreign owned assets in the US. Rather, previous studies have mismeasured the stocks of assets, and mismatched flows to stocks, imparting substantial measurement error to rates of return.

In an extensive forensic analysis indicates Warnock et al. conclude:

In this paper we provided a brief summary of some of the theories of U.S. current account sustainability and viewed them through the lens of the relative reliability of various items in the international accounts. From the perspective of relative reliability, the dark matter view fails, as it rests on an assumption that income streams are the most accurate items in the entire set of international accounts. Given that the bulk of income streams are themselves estimates based on other items in the accounts, this assumption is false. The exorbitant privilege view also fails. In its original form it rested on the assumptions that the current vintage of revised positions and flows form a consistent dataset and that all "other adjustments" are best thought of as valuation adjustments. In this paper we show that this is not true, in part by calculating “other adjustments” by asset class and filling some known holes in the international accounts. The set of accounts we produce by doing so are entirely consistent with a small cross-border returns differential, suggesting that there is no evidence that the U.S. can earn its way to current account sustainability.

One particularly interesting point Frank identifies, which was news to me, was that real estate purchases are not included in the balance of payments data, and hence not in the international investment position estimates.

In principle, cross-border transactions and holdings of residential real estate should be included as part of direct investment, as is currently the case for commercial real estate. In practice, individual homeowners are not surveyed and hence these data are omitted from the recorded DI figures. To the extent that foreign activity in the U.S. residential real estate market is of the same magnitude as the level of activity of U.S. residents in the foreign real estate markets, there is no net impact on the international transactions accounts. However, recent surveys conducted by the National Association of Realtors (NAR) suggest that this may not be the case.

Additional discussion of the IIP release from Brad Setser.

The easiest thing to do is to pull down the CBO's measure (interpolated to quarterly frequency). This yields the following picture (in logs):

Two observations: (i) recessions do not necessarily coincide with negative output gaps (although they do seem to coincide with the beginning of periods of negative output gaps); and (ii) recoveries do not always coincide with positive output gaps.

This is obvious when one thinks about it, given the NBER BCDC definition of a recession as the following:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.

That is a recession is the description of the first derivative of output taking on a negative value, while an output gap is a description of output relative to the output level consistent with the "normal" utilization of factors of production (also "full-employment"). For details of how CBO calculates potential GDP, see this document.

Looking at the last ten years provides another insight.

The US economy only barely made it close to full-employment in the expansion of 2001-2007/8/?, and is now declining again. I think I had realized this (especially in the course of various past debates over the surge in tax receipts, which I think has now been resolved -- see [1], [2] for a recollection.)

As I noted in the beginning of this post, I was finding it difficult to discern the most appropriate measure, so I will share the other measures I have investigated as indicators of potential (or "trend") GDP (which can then be used to calculate corresponding measures of the output gap): (1) the Hodrick-Prescott filter; (2) the Band Pass filter; and the quadratic time trend.

The Hodrick-Prescott filter is a ubiquitous two-sided filter used in time series macroeconometrics and elsewhere (I've even seen it used in the analysis of temperature data! [3]). Essentially, the HP filter calculates a trend that minimizes the weighted sum of squared deviations from trend, and squared changes in the the growth rate of the trend. This weighting is controlled by a parameter which is usually set at 1600 for quarterly data. As a public service, I'll note there are serious hazards associated with this filter, especially when trying to correlate various macro series that have been put through the same filter [4].

There is an additional problem (which is often ignored), namely that the HP filter is two-sided, so that running the filter up to the end point of data will tend to result in the trend being too close to the last data point (in our case, the output gap will be pulled to zero).

There are several band pass filters; the one most commonly used in the macroeconometric literature is the Baxter-King version.

Band pass filters are called this because (in the frequency domain) they pass through any cyclical components within a particular frequency band, and elimates the others. In the time domain, this means fluctuations that are shorter or longer than a specific length are ignored. In the business cycle area, then, in order to use this filter, one would have to have a prior on how long a "typical" business cycle is. More on both the HP and BP filters can be found in Tim Cogley's entry for the New Palgrave Dictionary of Economics [5].

The final means of identifying the output gap is to the simplest (at least in implementation) -- take the deviation from an estimated quadratic trend in time. This is not an uncommon procedure, but if you are pretty confident there is a unit root in log GDP, you might feel a little queasy about doing this [6]. But for completeness' sake, I'll show what happens when you do this as well.

Note that in order to circumvent the two-sided filter aspect of the HP filter, I have done a standard fix, which is to use an ARIMA(1,1,1) on log GDP over the 1980-08q1 period to dynamically forecast out 12 quarters, and then apply the HP filter to this "extended" series. I could have done a similar procedure for the BP filter, but opted to use the Christiano and Fitzgerald (2003) one-sided asymmetric version of the band pass filter to estimate the trend series.

First, the good news. Using the band pass filter, one finds that the output gap is still positive, at less than one percentage point of GDP in 2008q1. The HP filter indicates an essentially zero output gap. The quadratic trend indicates something similar to what the CBO indicates -- something close to a 2 percentage point negative output gap in 2008q1, versus 1.5 percentage points for CBO.

I don't want to say that there is one best version. Variations in the sample period, and the parameters used in each filter, will change the results. And of course, data revisions will mean the real-time output gaps will differ from the final revised output gaps we estimate today using either mechanical or judgmental approaches. For a pessimistic view regarding real time use, see Orphanides and van Norden (2004) [pdf].

Nonetheless, the distinction between the rate of change in economic output, and where output levels will gravitate to (and at what pace) is a useful one. And I think it will become of greater usefulness as the slowdown ends, if and when growth resumes. In particular, I'm thinking of whether the pattern of smaller -- but more persistent -- ups and downs continues (the half life of a deviation from potential has risen from 8 quarters in the 1970-90q1 period to 11.6 quarters in the 1990q2-2008q1 period).

Technorati Tags: potential GDP, recession, output+gap, full employment output, trend.

There is no question that we've been experiencing an episode of economic stagnation in which key indicators of output and employment are not growing at their usual historical rates. Some analysts take the position that this is all that really matters, and whether it meets the formal definition of a "recession" is a pointless question of semantics. In support of such a position, there are a number of economic models quite popular among academics today that would warrant just such a perspective, in that they presuppose linear dynamic systems in which a "recession" is indeed just an arbitrary definition you would make up to characterize a string of bad luck.

I espoused the opposing view in a recent academic paper. I argued that recessions represent distinct and objectively identifiable episodes in which the usual dynamic factors that drive economic growth-- technological progress, population growth, and capital accumulation-- are replaced by a distinctly different dynamic in which lost income in some sectors feeds back into declines in output for others. One of the defining characteristics of this phenomenon is the rapid rise in the unemployment rate that we've seen in every historical recession. It's very difficult to generate that kind of pattern from a system governed solely by linear dynamics, or interpret it from a perspective in which there's nothing special going on during a true economic recession.

BLS monthly civilian unemployment rate (from FRED), with NBER-dated recessions as shaded regions.

I was therefore quite alarmed by the 5.5% unemployment rate reported yesterday by BLS. Although the rate itself remains moderate by historical standards, the increase last month is the biggest monthly change that we've observed in over 20 years. King Banian, Paul Krugman, and Howard Gold argue the numbers aren't that bad, reflecting a surge in young job seekers rather than a big decline in employment per se. I personally share the more pessimistic interpretations of Jared Bernstein, Calculated Risk, Michael Mandel, and Mark Thoma; (you can find other interesting discussion from Phil Izzo, Barry Ritholtz, Andrew Samwick, and Angry Bear). It is true that the estimated May employment decline from the BLS payroll series was only 49,000, more moderate than the 285,000 drop implied by the household survey (from which the 5.5% unemployment rate is derived). But we've now seen 5 consecutive months in declining nonfarm employment as estimated from the BLS establishment survey, putting the overall level essentially back to where it was a year ago. Year-on-year employment stagnation is another thing we just don't see outside of an economic recession.

Year-over-year percent change in seasonally unadjusted number of U.S. workers on nonfarm payrolls, from BLS.

And while I'm collecting graphs that make me feel bearish, I can't resist updating this one, despite Menzie's cautions against reading too much into consumer sentiment numbers.

Reuters/Michigan index of consumer sentiment. Data source: FRED and Market Watch.

And how would one reconcile this view that the economy may already be in a recession with the very strong gains in the stock market on Thursday? Oops... never mind.

Source: Yahoo.

Technorati Tags: macroeconomics, employment, economics, unemployment, recession