Wednesday, March 4, 2009

Is it really a financial crisis?

This particular downturn in economic activity has become known as The Financial Crisis. It’s called that because most people—economists, policy makers, and commentators alike—took very little notice of the slowdown in economic activity until mid-to-late summer 2007. In its Monetary Policy Report to Congress in July 2007, the Federal Reserve confidently states, “the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.” This is Central-Bank-speak for “all is well with the world.”

By August 17, 2007, merely a month later, the Fed’s tone had changed. In the press release following the August FOMC meeting, the Fed stated “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward.” The Fed was apparently blindsided by the crisis.

We can weave a similar timing sequence for the financial stress that occurred in September 2008. In the summer of 2008, the Fed, once again, felt that the economic situation was improving. The takeover of Bear Stearns was far behind them and many indicators of financial-market stress were easing. In September, the world was jolted awake by the takeover of Fannie and Freddie and the ensuing failure of Lehmen. Many policy makers attribute the rapid fourth-quarter economic deterioration to the failure of Lehman. A growing chorus (see this WSJ editorial) attributes the deterioration to the takeover of Fannie Mae and Freddie Mac.

I will restate the timing. Deterioration in the performance of U.S. subprime mortgages came to a head in August 2007, initiating the financial crisis. In September 2008, the failure of Fannie Mae, Freddie Mac, and Lehman sent a financial shock through an already fragile system causing a rapid decline in economic activity. The shock runs from the financial sector to the real sector and maybe back again.

With at least the perspective of hindsight, however, the timing and location of changes in economic activity belie the financial crisis story.

Housing led this crisis so let’s look at the housing market first. The picture below shows housing permits for the United States. The series shows a clear peak in January 2006. This decline is too early to have been caused by the financial crisis. At that time, most people were still unclear on the difference between subprime and prime mortgages and subprime originations were proceeding apace. The default rate on both classes of loans was low and stable.

Housing markets do not simply turn. They respond to the economic environment. Residential investment strongly leads the cycle. That permits turned south so early indicates that some shift in the economy was already apparent to the population if not to economists.

Further evidence of the shift in the economic environment can be gleaned from the yield curve. January 2006 is also the month that the yield curve inverted. Inversions of the yield curve, on both empirical and theoretical lines, predict recessions.

Of course, the Federal Reserve, and most forecasters, did not believe that either the decline in permits or the inversion of the yield curve were a cause of concern. Federal Reserve staff at the time published papers using econometric models to dismiss inversions of the yield curve as a statistical anomaly rather than a predictor of recessions. (See this paper by Jonathan Wright.) This was a mistake. The theory is quite clear and I trust theory before econometric models.

The Fed also remained convinced that housing only interacted with the rest of the economy through house prices, and house prices were still rising. They still seem to not understand the concept that housing is a long-lived durable good. As such, the behavior of housing investment should give a very accurate read on household’s views on near-term growth prospects.

Of course, we still don’t know what the underlying shock that hit the households sector, and thereby moving the bond and housing markets. I can speculate, however.

The following picture shows the level of hourly real wages between 2000 and 2008. Real wages began to fall in early 2004. Perhaps households in 2004 and 2005 continued to believe the forecasts of economists, that the economy would grow at a robust pace for the foreseeable future. And, perhaps these households believed they would share in this prosperity. Then the households likely borrowed assuming they would be able to afford their payment stream with their rising wages. When rising energy prices made this assumption wrong, the most fragile, the subprime household, began to default. This would be an oil shock. I don’t know. I am just speculating.
I find this convincing but there is more. The story of the financial crisis has the shock running from the United States to Europe beginning in the summer of 2007. However, as is shown in the picture below, housing permits in the United States and in the European Union turned South at exactly the same time, January 2006. Remember, this is way too early for the financial shock to have been transmitting U.S. subprime problems across the Atlantic.

What’s more the coincidental timing of the downturn does not just rest with housing; it extends to other important macro series as well.

Real retail sales, shown in the picture below, also turned soft with similar timing in both economies. In both economies, real retail sales were both growing solidly when they hit a wall in June 2007. At that time, both series turned flat and did not grow on average for the next year. June 2007 predates the initial wave of financial turmoil. In May 2008, U.S. retail sales turned sour, while EU sales stayed flat. I don’t know why but perhaps the foreclosure crisis in the United States or perhaps the weaker social safety net was starting to show through. In any case, May 2008 predates the increase in turmoil which began in September.
Industrial production, shown next, in the United States and the European Union has not historical moved at the same pace, although business cycles have been somewhat synchronized. In this episode, however, the downturn in IP happens at exactly the same time in the two economies. December 2007 is the peak date in both places. This data is after the initial increase in financial turmoil but the coincident timing still points to a common shock.

In August 2008, IP started to collapse in earnest. August 2008 predates Lehman. August 2008 predates Fannie and Freddie. Indeed, as you can see from the pictures in this post, IP turned South in most economies before September 2008.
It seems amazingly obvious to me that there was a real economic-based reason that all of these financial companies came under stress in September 2008. The economy was weakening and the value of their portfolios was dropping. Although none of us knew enough to price them ourselves, the magic of market was at work and collectively we knew. (By the way, that’s how it’s supposed to work. I am supposed to be able to infer the state of the economy from asset prices using the market as an information aggregator.)

Why has the Fed with all of its resources come to a different conclusion? In September 2008, nobody knew that IP was collapsing. At the time, the latest “real” data on the economy was for July and everything looked fine. The Fed (and many, many others) jumped to the conclusion that the financial turmoil was occurring independent of any disruption in the macro economy: a classic Panic. The low market value of the assets on the institutions balance sheets must reflect fire-sale prices rather than economic fundamentals.

I don’t know the true nature of the original shock. But I do know that that original shock does not appear to have been a financial shock. The timing and global coordination of the downturn do not support a financial shock alone.

We are still debating the cause of the Great Depression, and however this episode turns out, we will be debating its causes for a long time as well.

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