Why is the business cycle elongating?

First, let me wish all my Econoblog readers a Merry Christmas and a Happy New Year!!

Economists have traditionally put the business cycle at between 3 to 8 years long.  But of the last 4 business cycles 2 out of the last 4 have lasted longer than the 8 year limit that economists typically look at.  In fact counting this business cycle, which officially hits 10 years (or 120 months) in December 2017, 3 out of the last 5 business cycles have had periodicity longer than the 8 year economist "consensus" upper limit.

For those geeky enough to be interested in US business cycles see the table below which is lifted from the NBER website.  The longest expansion we have seen in the US economy was through the 1990s through until the tech stock bubble in 2001, which lasted a full 128 months, 8 months than where we are right now.

Source: NBER website

But this then begs another question.  What are the specific reasons as to why the current cycle would be elongated, and how persistent will these effects be in preventing us from entering the contractionary phase of the business cycle?  Well there are several reasons why I believe economists and economic commentators think that we might have an elongated cycle this time.  I will run through each of these reasons below, but to summarize these reason up front:

1.  We started the expansionary phase from a lower base, as the "great recession" of 2007-09 was more severe than all previous downturns with the exception of the "great depression";  

2.  Quantitative Easing (QE) has provided an additional stimulus which combined with the usual countercyclical fiscal policy, allowed the economy to achieve escape velocity, but QE is only now being unwound;

3.  The tax reform bill just passed by the Trump administration, plus the Infrastructure spending bill that the Trump administration has promised in the first half of 2018, will continue the fiscal stimulus for the economy through at least 2018, and possibly to the end of 2019; and

4.  That the "great moderation" which started in the 1980s, has seen a dramatically lowering in volatility for short term cycles in growth, but due to a couple of reasons, this cyclical volatility has transferred to longer cycles in growth which, for the moment implies that the usual business cycle frequency of 3 to 8 years quoted by economists is now incorrect.

So let's start with the first reason.  The main insight here comes from the Great depression, and the fact that when a macroeconomy experiences a really deep recession, where the financial sector is involved, the recovery will be slow and arduous.  The accompanying chart from an IMF publication shows this quite clearly.  The horizontal axis shows the number of quarters into the recession and the reaction of various economic variables (averaged across countries and across time). So for example, residential investment starts to recover after around 4 quarters for non-financial recessions, but for financial recessions that recovery starts 11 quarters after the beginning of the recession.  As the great recession was caused by both the housing market and the financial markets, the recovery pattern has clearly been slower than for other recent recessions in the US. This is also clearly seen in GDP growth itself, which is shown below.  The most recent recession is the first recession since the Great depression where the economy was recovering from a financial recession and it is clear from the rate of growth coming out of the recent recession that the economy has had difficulty growing above roughly a 2% rate.

Source: BEA and authors calcs

While the logic of this argument appears sound, there are a couple of things to notice about the nature of the reasoning here.  First, the fact that the great recession was a financial recession would tend to suggest that the business cycle elongation will be only relevant for this current recovery rather than for business cycles in general. If this reason is correct, then the macroeconomy should return to its usual 3-8 year cycle after the next recession.  Second, it also flies in the face of business cycle dating that we referenced above - the business cycle has definitely been getting longer, and has not remained within the usual 3-8 year periodicity that economists so often cite.

The second reason as to why the current business cycle will be elongated is monetary policy. The amount of stimulus provided by central banks has continued to rise albeit at a slower pace.  As the graph below shows, the US is now reversing it's massive QE program, and that is one of the reasons why rates are rising in the US relative to rates elsewhere.  If we look at the chart below, we can see that indeed Global QE is still rising, mostly thanks to the ECB, who have still not started to taper.  That in itself is a massive boost to financial companies around the world as central banks have brought large amounts of financial assets off the commercial bank balance sheets, thus freeing up capital to be lent elsewhere, and stabilizing balance sheets.  If we look at this in terms of the rate of change of QE globally, we come up with a different impression, which is given by the chart below ( - please ignore the forecasts of a research group which were made in 2015).  These liquidity injections clearly have largely dissipated for most central banks, but net injections are still continuing.as reversals have not yet been substantial enough to make an impact on the total, and some central banks are still continuing their QE buying programs.

Note that this reason would also only imply a temporary one-time elongation of the business cycle, and so doesn't explain why the most recent business cycles appear to have been on a elongating trend.

The third reason is due to the recent US fiscal stimulus in the form of the tax reform and the possible infrastructure package that President Trump has promised next year. This will affect the US, but does come with likely additional public debt implications, which will tend to crowd out investment and in normal circumstances would drive interest rates up.  But the tax reform essentially increases the return on US investment (purchase of plant, machinery and equipment), which will tend to increase private investment, thereby offsetting the crowding out effect.  So on balance, with the individual income tax reductions, these corporate tax changes should further stimulate the US economy, bolstering the monetary policy argument above. Once again, this is a one-time effect, and does not explain the lengthening of the business cycle.

The last reason why we might be seeing an elongation of the business cycle can be explained by recent research that I have been doing with Professor Andrew Hughes Hallett of George Mason University.  The empirical argument is shown in the figure below.

This analysis is called a "multiresolution decomposition" or MRD, and the technique essentially extracts the processes embedded within the series over different frequency ranges which are represented by the series d1 to d5 which are shown in the figure. We have 2 papers, the first of which showed statistically that the longer cycles embedded in real GDP growth (shown by d5 and d6 above (which relate to cyclical activity ranging from above 8 -16 years and from 16 - 32 years respectively) have become more volatile since the early 1980s, while the higher volatility cycles in real GDP (shown by d1 to d4, corresponding to cycles from 2 quarters to 8 years), have become less volatile [see below for academic references].

The second paper, which has been published as a discussion paper by the central bank of Finland (Suomen Pankki) [again see below for academic reference], goes through a lengthy analysis of the theoretical models typically used by macroeconomists to show the factors that could potentially cause this lengthening of the business cycle.  To cut a long story short, the factors that could be shifting volatility in the process that drive economic growth from shorter cycles to longer cycles turn out to be i) an increase in inflation aversion; and ii) a reduction in output stabilization. So let us look at each of these parameters in turn.

Has there been an increase in inflation aversion moving from the pre-mid-1980s period through to the post-mid-1980s period?  I would assert that yes, there has been, and this is due to the fact that many central banks instituted inflation targeting and if he could have done so, we know that ex Fed Chairman Ben Bernanke would have done so.  So has there been a reduction in output stabilization?  That is, has there been a reluctance to fully engage fiscal policy to it's maximum effect during downturns and to offset any rapid growth in the economy?  I think the evidence, once again, is that yes, we are seeing less output stabilization in US fiscal policy for certain, and perhaps a little more emphasis on stabilization by the Fed.  The net effect though would still be for less emphasis on output stabilization.  Now why do I assert that this is the case?  I think the evidence has been on show during the last week in the US.  As we know we are entering the final stages of the business cycle, the Trump administration has effectively announced a tax stimulus package which then will cause a spurt in growth as well as a one time elongation of the business cycle.  This tax reform package is definitely not output stabilization in the classic sense of counter-cyclical fiscal policy.

So note here that this fourth explanation would help to explain a permanent elongation of the business cycle since the mid-1980s.

But what about the markets in all of this?  One of the best visualizations I have seen relating to business cycles and the stock market came in a piece of research out of Goldman Sachs in late November this year (see below).

The figure shows that we are now approaching the 9th year of a bull market, with no signs of any correction coming.  This is not quite the record run yet, but it is fast approaching the 9.1 years of the 1920s bull market.

My own feeling about the financial markets is that we are beginning to move into "borrowed time", and that as soon as these one-time stimulus factors have passed, the downturn will happen. Whether that is in late-2018, 2019 or 2020 I am unsure.  But if there is one thing I am definitely sure of it is that the next downturn is coming sooner or later.

References

Crowley, P. and Hughes Hallett, A. (2015), "Great moderation or “Will o’ the Wisp”? A time–frequency decomposition of GDP for the US and UK", Journal of Macroeconomics, Vol 44, pp82-97.

Crowley, P. and Hughes Hallett, A. (2014), “Volatility transfers between cycles: A theory of why the "great moderation" was more mirage than moderation”, Bank of Finland Discussion Paper 24/2014.

The Global Economy in 2015

Happy 2015 to all my Econoblog readers!  I spent NYE in London by Tower Bridge enjoying a distant view of the spectacular fireworks display (see image on left) that London put on this year ( - but for the first time with a charge for the best viewing spots). Being in London certainly gives you a reminder of how globalized the world has become, as I heard at least 10 languages being spoken in the space of one particular day there. And of course these days the global economy is interconnected as never before with people and funds flowing freely across borders. A few years ago, when we hit the "great recession", there was talk of the reverse of globalization, and although some firms might have pulled back from such a large commitment of resources to international projects and expansion, I believe that this was only a lull, and not a reversal. Today, I was greeted in a British restaurant by a Danish front of house manager, served by a waittress from the Czech Republic and my table was cleared by a Hungarian. This would be almost unimaginable even ten years ago.

The reason why I bring this up is that I believe that the state of the global economy and trends at the global level are very important.  Paul Krugman also emphasized this in his most recent blog (see here) which shows that recent trends have basically transferred income from the developed country working classes to the developing country middle classes (in countries such as China and India). But those are long term trends, trends that will continue slowly over future decades.

Our focus here is what really matters in 2015. In my previous blog posting (see here), I have made the case that oil prices will stay reasonably low for at least 18 months, so that for the most part of 2015 oil prices will not be on an increasing trajectory.  So let's deal with each continent in turn.

Source: Wall Street Journal, Jan 2, 2015

In North America, the Fed has said it will begin to tighten, but will only do so slowly, which means that growth will accelerate here, leaving the Fed further behind the curve, as lower oil prices give a deflationary impulse to the CPI until the end of June.  This will allow the housing market to properly recover, as even with the upward move in interest rates, the amount of the rise will be relatively small, leaving mortgage rates still close to historic lows. In my view, this, coupled with the relaxation of mortgage conditions, will lead to increased demand for mortgages as rental rates are now very high compared with costs of home ownership. That means that although a very modest rise in interest rates will occur, it will still allow strong growth, falling unemployment and a buoyant stockmarket, with the retail and technology sectors doing particularly well.

In Europe, Greece remains the big problem. The "renegotiation of austerity" promised by the leftist party there, Syriza, led by Alexis Tsipras, has already sparked major fears in Europe of a showdown over the so-called Stability and Growth pact and the economic pain and suffering it has inflicted upon Greece. Although an exit from the euro (or "Grexit") has apparently been taken off the table for the moment ( - perhaps to make the leftist coalition more electable?), there is no reason why it could not be put back on the table once Syriza is in a position of power. That would leave the EU with a very interesting problem: do they make concessions to the Greeks and risk having the Portuguese, Spanish and Italians insisting on similar loosening of fiscal austerity conditions?  Or do they just allow the Greeks to then openly talk about exit from the euro, with all the instability that that would cause. Clearly, until the Greek situation is resolved, the uncertainty in Europe will prevent the euro area from emerging from its economic torpor anytime soon.  This means that the euro will remain under considerable pressure.

On monetary stimulus in the euro area, I think that Mario Draghi will continue to try and talk the euro area out of a mild recession, but there is just no consensus on how to do a really large and effective QE in Europe (despite what the pundits say -see here on this), so that although the limited measures still in place in Europe will continue, and may be expanded, no dramatic new programs will be announced unless things take a serious turn for the worse.  Worse here means either deflation appearing or a Grexit occurring and other member states threaten to leave the euro area. This is not beyond the realm of possibility, given that Germany it appears, thinks that the euro area could cope with a Grexit (see here).

The situation in the UK in particular, will also be rather uncertain in 2015.  Elections will occur in May of 2015, and there is considerable uncertainty as to which party or parties will take power. This means that the pound could depreciate in the first part of the year, and then could depreciate further in the second part of the year if a Labour government is formed, or rebound if some form of Conservative government is elected. The Bank of England will only change interest rates in the second half of the year, depending on how fiscal policy changes after the elections. Nevertheless, the UK should have accelerating economic growth as house prices continue to rise in the London area, and the wealth effect takes hold inducing higher levels of spending.

Source: http://krugman.blogs.nytimes.com/2015/01/02/britains-success-story/

The chart above to the left shows how the UK has fallen behind both the US and France due to the austerity measures imposed by the Conservative-Liberal coalition government. The trajectory shown in the figure though suggests a rate of growth of income in the UK similar to that in the US has now emerged. Note how weak income growth is in France though. Both Italy and Spain are experiencing worse rates of economic growth, which gives you a picture of how bad things are right now in the euro area.

Done by author: Data sourced from BoJ and FRED

In Japan, Abeonomics has not really yielded results yet, but there are promising signs that with the hefty new QE announced late last year that Japan's economy will finally emerge from the deflationary slump it has been in over the past couple of decades.  Unfortunately though the other half of the sales tax hike should moderate any uptick in growth coming from the monetary side, which means that even though a new stimulus package was unveiled in Japan on Dec 27th (see here), with a public debt to GDP ratio just under 250%, there is really very little room for any more action here. What is more promising is that there might be further monetary stimulus, which in my judgement is still needed to really get us on a path to achieving the Bank of Japan's 2% inflation target.  The chart on the right above shows that in fact although base money has been significantly stimulated by qualitative and quantitative easing (QQE) in Japan, M2 as a % of GDP appears to have now bottomed in the first quarter of 2014 (right hand axis, in %), and so although real GDP growth is still negative (left hand axis in YOY growth in % using seasonally adjusted data), there appears to be dogged determination by the central bank governor, Haruhiko Kuroda, to stimulate the economy by QQE until Japan finally starts moving in the right direction again. In my view perhaps in 2015 the QQE monetary stimulus may finally have some tangible effect, as expectations of the general public and the financial markets begin to change.

As for the rest of Asia, I see the Chinese economy still growing at a rapid clip, but until the euro area recovers (as it is the biggest customer for the Chinese), the Chinese economy will still have some headwinds. India is probably the most interesting place to invest in Asia right now, although of course whether Narendra Modi can actually achieve the reforms that he wishes to put in place, given the fractious nature of democracy in the country, is anybody's guess. But the potential is nevertheless there, with India now starting to emerge out of the shadows I believe that India will begin to catch up with China in terms of its economic growth trajectory.

In the rest of the world, I think Africa's economy will improve in 2015, as will that of South America, given that 2014 has delivered some hard lessons in how governments and political ambitions can often interfere with delivering and then maximizing economic growth.  

Armageddon and the US debt ceiling

Now that it is obvious that my previous post on Grover Norquist has pretty much come to pass, there are all sorts of pundits predicting what will happen if the US defaults on it's debt next week.  I saw a prediction by Credit Suisse on the CNBC website that stocks might fall by 30% and the US economy would contract by 5%.  Well frankly I think that is a bit of an over-reaction.  The US is not Greece, and although the US debt levels are high this is not a case of "can't borrow to pay", this is only potentially a case of "can't get our political act together, won't pay", which is quite a different thing.

My point is that a Greek default is now becoming a foregone conclusion and therefore causes systemic problems as people start to worry about the solvency of Greek banks if they hold Greek bonds and therefore  whether Greece can stay in the euro area with a growing economy given that it has had inflation that has been far above its partners for a significant period of time. The US is just not in that position and although some in the Tea Party and for that matter in the UK Conservative party appeal to the example of Greece as a reason why the US and the UK need to really tighten the fiscal screws, the logic frankly just doesn't carry over, and there are several reasons for this which I details below.



First, even if the political parties run out of time and cannot strike a deal, a US default is just not a foregone conclusion yet - as the FT made clear in an excellent article yesterday, the 14th Amendment of the US Constitution states that “the validity of the public debt of the United States ... shall not be questioned”. The Supreme Court, in a case back in 1933 when the US was trying to escape paying its gold obligations after it left the gold standard, stated that Congress has to honor it's own contracts, and that that means that the interest payments must be made, whatever else might happen. So that implies that, quite simply, a default cannot happen, and that cuts will have to be made to government to hold spending down so that it does not exceed revenues. If Congress is obligated to pay certain payments then presumably the President must have some role in declaring that Congress is out of order and breaking the law and can issue an executive order to raise the debt limit.

Second, there are other (rather "clever" and obscure) options, described in the excellent piece on the CNN website by Jack Balkin.  I rather like the idea of asking the Fed to issue 2 jumbo sized platinum coins worth $1 trillion each - which can then be credited to the government's account!

But let's get to the "Armageddon" option of a default - some now think that it's not such a remote possibility, and have looked at probabilities of what could happen and the implications of this.  Perhaps the most publicised analysis over the last 24hrs has been that of Willem Buiter (who used to teach me when I was a graduate student) and Ebrahim Rahbari of Citi which was neatly summarized in the FT Alphaville today.  Although a downgrade is clearly not going to be good news for future borrowing or rollover of the current stock of debt, the 2 economists do some serious "back of the envelope" calculations that make clear that GDP would not fall by a third, and that by their calculations the amount would be between 0.2 to 0.5% fall.  Now noone wants GDP to fall given the fragility of the current recovery, but that is a far cry from the 5% fall predicted by Credit Suisse.  In their research Buiter et al put weights on 5 different scenarios and they got them a little askew (in my humble opinion), as given the politics, the one now most likely is a debt default, not Scenario 1 ( - no default as a bill is passed by Congress). Plus there is another scenario which I will label Scenario 6: "The Federal debt ceiling is not raised in time and the US sovereign does not default". This might come about because of some obscure legal manoevering (see above) that the White House might be able to manage, and although it might trigger a downgrade due to the market impression that it is "kicking the can down the road", it may nevertheless be a feasible option.

So what will happen in the event that things don't go well next week? If a political deadlock with no obvious escape means that fiscal policy puts a break on US growth, the Fed is still able to swing into action with a QE3, something that might be necessary if the legality of the President's options is questioned. So I think the prospect of the US stockmarket falling by 30% is just not grounded in reality - and certainly not for any sustained period of time.

I think that a default and downgrade is now the most likely scenario, but I also think that there is an understanding in world markets that this is not a reflection of an unhealthy US economy, this is just a reflection of the dysfunctional politics that the US now finds itself in, due to the Tea Party.  There is one silver lining to all the hysteria of recent days though - at least a public debate is now starting to happen in the US as to what should be done - and that, I believe, is a positive outcome.

European meltdown?

Last week I did a talk for the second time on the European Financial crisis.  Each time I do this talk something nasty seems to happen afterwards. This time it is Irish banks and the impending bailout for the Irish government - last time it was Greece and it's bond market crisis and then the subsequent bailout.  In Europe the din from the masses is increasingly talking of doom and gloom with contagion to Portugal and Spain hitting the financial headlines. Even respected FT commentators are now "twittering" about the demise of the euro (see Gideon Rachman at http://www.ft.com/cms/s/0/85b62490-f66e-11df-846a-00144feab49a.html#axzz165SsmUg9) and Samuel Brittan at http://www.samuelbrittan.co.uk/text381_p.html). 

This is dangerous stuff, as the demise of the euro would indeed have far-reaching consequences way beyond Europe. The ramifications of the most successful example of economic integration to date failing because of market forces and contagion would have global consequences way beyond Europe. The prospects of further Asian economic integration would likely be dashed, and monetary integration that is supposed to occur in South America and Africa would quietly be dropped. Not only that, but the critics of market forces stopping governments ( - who are after all democratically elected) from achieving regional integration objectives would likely spark a big backlash against the financial markets in continental Europe. The British, on the other hand, would likely be thanking their lucky stars that they never took the plunge and joined the euro in the first place.

But despite all the hubris and chatter, there are several important points that the mainstream media appeared to have missed when reporting on Greece and Ireland.  The first is that these are small countries, and that the euro area will remain intact while some countries might decide that it is in their best interest to leave.  As long as these are only small players the euro will likely survive. The second point (outlined in David Mayes's excellent piece on banking regulation that was recently in a review that I edited - now published online at http://www.eustudies.org/files/eusa_review/fall10final3.pdf) is that with a single market in financial services there is an urgent need for banking regulation at a supranational level.  Hopefully EU member state countries will accept the transference of sovereignty in this area to a supranational banking regulator in the not-too-distant future.  The Irish crisis could easily have been averted had this already been in place.  The third is that given the crisis in public finances within Europe, there will hopefully be some agreement on transference of sovereignty in fiscal matters to the supranational level (just among the euro area member states?) perhaps in the same way that Australia has centralized it's debt issuance for it's states.  The fourth, and probably most important point is that it is in noone's interest to see this crisis spread through contagion as it will affect banks in all member states giving rise to even more problems with public finances throughout the euro area, so that action will likely be much more likely now that European leaders have seen the effects of papering over problems with the Stability and Growth pact or allowing inertia to set in in the ongoing evolution of economic integration within Europe. 

As Jean Monnet, one of the founding fathers of the European Union once said "People only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them."

Soros on the euro - but what about the other flaws??

On Fareed Zakaria's CNN show this week we had the privilege to hear the views of the billionaire financier George Soros (see http://www.cnn.com/video/#/video/podcasts/fareedzakaria/site/2010/02/28/gps.podcast.02.28.cnn) on a variety of issues.  What caught my ear though was his comment that the euro was "fundamentally flawed" as the European Union doesn't have a Treasury to enble fiscal transfers to occur, so as to offset the asymmetric shocks ( - unexpected events that occur which affect one member state much more than the others).  This is of course just one of the basic problems with the euro's architecture, and Soros is right in pointing out that this is probably the most obvious flaw to think about in the light of the Greek debacle.

But what really got my attention was that Soros then went on to say that "either Europe takes the steps to make up for it's institutional deficiency or it may not survive" ( - I assume he means the euro here).  So I want to add a little to what Soros said, by i) talking about other things that might be wrong with the euro and ii) by thinking a little about what form these institutional measures might take. i) I'll do today and I'll leave ii) to tomorrow.

So let's start with the other flaws. 

First, the "Maastricht criteria".  These were the hurdles which member states had to negotiate to become a member of the euro club.  The rewards for negotiating these hurdles were significant, as it meant lower interest rates, added credibility internationally, and to be blunt, a seat at the heart of the European integration project. It's like the local neighborhood clubhouse - who wouldn't want to become a member unless they didn't like their neighbors too much (for example the UK).  So if you have to fulfill certain criteria (like having a certain minimum salary - to continue our clubhouse analogy) you would maybe manipulate things a little to get in.  The Commission was aware of this, particularly when certain member states asked if they could sell gold to lower their budget deficits, and so the Commission made up quite strict rules about how to measure budget deficits, which all the "northern" (read less corrupt and less politically manipulated) member states duly abided by.  Southern (read generally more corrupt and more politically manipulated) member states of course stayed relatively silent on this, and now we see why.  Countries like Italy got in because of statistical anomalies and Greece actually didn't get in first time around, so realized what it needed to do the second time around.  The main point here is that the Maastricht criteria were flawed to begin with - the statistics which were used to base the entry decision on were produced by each individual member state - so they depended on the quality and honesty of the statisticians and politicians involved in the production of the stats.  The result is that if you have flawed entry criteria you're going to get problems at some point along the way as members don't live up to expectations.

Second, "surveillance".  The European Commission made a big song and dance about member state surveillance back in 2004 when the Stability and Growth pact (or SGP - see http://europa.eu/scadplus/glossary/stability_growth_pact_en.htm) was revised to soften the actual criteria (because Germany and France had run up against the deficit limits that were supposed to trigger sanctions).  Clearly they haven't worked, and not because it wasn't a good idea, but because the Commission can only monitor what is produced by the member states.  Once again its the member states that produce the statistics, or manipulates the statistics for political purposes, so this wouldn't be detected by the "surveillance" process. 

Third, and probably most importantly, the ECB's treatment of public debt in monetary transactions.  There is no mechanism whereby the ECB can basically "grade" the member states on their fiscal policy. Now of course this doesn't happen in the US, and in the case of Canada there are provisions for it to happen (a line item in the Bank of Canada's balance sheet) but it has never happened.  The reason is that both Canada and the US (and I presume other monetary unions) have federal debt issuing capabilities.  So when the Federal Reserve does open market operations it uses US federal bonds and notes, but in the case of the ECB, it has to use member state bonds because there is no EU federal debt.  So the rules are that the ECB cannot discriminate between different member state bonds.  So this means that the member states do not feel the fury of the markets because there is always a buyer (and therefore a "backstop") for Greek bonds in the form of the ECB.  And from the individual investor perspective this clearly poses an adverse selection problem.  If I'm holding German, French and Greek bonds and the ECB is looking to buy euro-denominated bonds for its monetary policy transactions, which am I going to sell?  It's a no-brainer!! 

OK, so given that the euro design is flawed, what should happen now?  More on this next time in part II!!