Political polarization and the business cycle

It is difficult for politicians to have much of an impact on economic outcomes when policy is set by consensus. Any fluctuation in power changes a policy a little, and the economy is in a rather flat portion around the optimum. In a polarized government where any power shift implies dramatic policy changes, not only are they never close to the optimum policy, they yank the economy around significantly. There are two losses here: first the average is substantially lower in the second case due to the concavity of outcomes, second there are significant fluctuations for the same reason.

This is essentially the explanation of Marina Azzimonti and Matthew Talbert why emergent economies have such wild business cycles, and I suspect this is even more so for developing economies. All they need to do to obtain such results is to take an off-the-shelf real-business-cycle model and add uncertainty to the returns of private investments. Let this be a lesson for more developed economies that are showing tendencies for political polarization.

Why did the panic of 2008 spread abroad?

Why did the Great Recession spread outside the United States? In particular, why did almost all Western industrial countries enter a deep and pronounced recession together? The failure of Lehman Brothers sent ripples throughout international financial markets, plus European banks were heavily involved in the US subprime mortgage market. Yet, financial and goods markets are not perfectly integrated and this should not have lead to such perfectly coordinated business cycles.

Philippe Bacchetta and Eric van Wincoop show that you do not need complete market integration to get there, only partial. All you need is that market integration be sufficiently high. In addition, tight credit, very low interest rates and inactive fiscal policy "help" tremendously with creating a panic, and we certainly were in such a situation at the time. And this panic is what makes it different from "normal" recessions, where synchronization is not perfect. The model hinges on the fact that there are possibly multiple equilibria and a global panic is the optimal coordination on a bad one. Crucial to the model are a couple of rather strange assumptions, though: prices are preset while wages are fully flexible, I would have thought wages to be less flexible than prices; and there are two periods in the model, meaning that the panic state must be permanent. As a consequence, am not quite sure what to make of this paper.

The experimental macroeconomics of monetary policy

One important characteristic of Economics is that it is very difficult to conduct a clean experiment. While one may run little laboratory experiments with a few chosen subjects, there is always the uncertainty whether the experiment generalizes. The randomized experiments typically used in development economics are subject to the same limitations, even if their scope is larger. And in all those experiments, their applicability is limited to microeconomic questions.

Oleksiy Kryvtsov and Luba Petersen venture into experiments directly applicable for macroeconomic policy, and more precisely monetary policy. Monetary policy has bite when there are some frictions, among them expectation formation. Their idea is thus to see how people form inflation expectations in a laboratory setting and within the context of a standard new-Keynesian model. In that model with economic agents having rational expectations, monetary policy can reduce macroeconomic volatility by at least two-thirds. With the bit of irrationality exhibited by participants to the experiment, the reduction is still about half, and thus important. The model is a Woodford-style economy where participants have to provide updates on inflation and output-gap expectations, which can be compared by the observer against rational expectations ones. People learn about changes to fundamentals and can draw on past history. In other words, it is like they would live in the Matrix, they are fed information and are supposed to behave within the confines of a virtual world.

This is very interesting and innovative stuff here. I must concede though that I have still not bought the Woodford model. I cannot understand how one can talk about monetary policy in model with supposedly fundamentals when there is no money.

The central bank should be sector-agnostic

Large Scale Asset Purchases (LSAPs) of mortgage-backed securities have been a major component of recent monetary policy. It is not without critics as this is a policy that has been targeted towards a specific sector of the economy, the real estate sector. This is principle a big no-no, as a central bank should only care about the overall economy, not specific sectors or firms. In a similar fashion, the ECB has been criticized for buying out specific countries following conditions that were differentiated by country, instead of applying one rule to all, or even not buying country debt at all. But if all sectors benefit equally or if that was the most efficient way to conduct policy, that is all good.

In the case of LSAPs, Meixing Dai, Frédéric Dufourt and Qiao Zhang find it was certainly not the most efficient way to deal with a confidence shocks in the banking sector, and it obviously privileged the real estate industry. One could have done better by buying corporate bonds, but in a uniform manner across sectors. This works better than mortgage-backed securities because they are less leveraged and thus free up more bank capital. This is more true if financial markets are more segmented, that is, if bankers cannot freely reallocate resources between sectors. What the paper does not say is how this would have compared to a conventional policy, buying government bonds.

Euro zone: the common cycle is strong

The general thinking is that if you want to create a monetary union, a strong prerequisite is that the business cycles in the involved economies should be well synchronized, among other criteria. The reason is obvious: it allows consensus regarding monetary policy. This synchronization may arise after the merger, though, facilitated by the currency area.

Periklis Gogas looks at the Euro-zone and comes to the conclusion that synchronization has increased, especially with the last global recession. While the paper has plenty of robustness exercises, I fail to be convinced, though. Indeed, this supposed trend is based on two, maximum three, business cycles. And the last recession was of a different kind, being global, so it is difficult to avoid having it more synchronized than any other in the sample. You may argue that there are 86 quarterly observations and this is sufficient for statistical significance. But when you look at such questions, it is turning points that matter, and you only have a handful, and they do not look like a random sample of the population.

Where did the gender unemployment gap go?

There was a time where females had little attachment to the labor force, and employers also considered them to be the easiest to dispense with in the case of a downturn. These lead to a gender unemployment gap, with females proportionally more unemployed. Times have changed. Females are now in many households the main breadwinners and thus more attached to the labor market than men, even during recessions. This has manifested itself in full force during the last one, which has been dubbed a "mancession" by some because the unemployment rate rose more for men than for women. That was new, and needs an explanation.

Stefania Albanesi and Ayşegül Şahin use a three-state labor search model to understand the data in various OECD countries. They confirm that the change in relative labor attachment explains the disappearance of the long-run gender unemployment gap. At business cycle frequencies, and in particular during recessions, the key is in the sectoral distribution of the female and male workforce. And as this distribution evolves, females benefit from more employment stability than men. Is this last recession a breakpoint for the labor market? There are so many things that are different from before, like super-low employment rates, hysteresis, and declining labor income shares. This all points to structural changes, and we should forget getting back to pre-recession labor markets.

Why so much policy focus on home ownership?

Some have blamed the Community Reinvestment Act (CRA) for the too risky lending to US homeowners during the house price run-up. Actual evidence for this is hard to come by, though. In this previous post, I discuss that there was indeed more risk taken, but it is not clear whether that additional risk was priced in or not. And were we to blame CRA, it would show in banks giving loans to neighborhoods that should not have received them for economic reasons, only to satisfy CRA.

Patrick Bayer, Fernando Ferreira and Stephen Ross look at the history of mortgages that they can link to credit scores and demographic characteristics. They find that for the same credit score, blacks and Hispanics were much more likely to run into mortgage trouble. While the authors do not mention this, the CRA was clearly targeting neighborhoods with such populations, and banks had to lend more there to comply. This would indicate that there is at least some truth to the CRA blaming. The authors frame this result rather by writing that this is evidence that favoring homeownership is not a good way to reduce wealth disparities. I would agree, but also because owning a home is very poor diversification, especially when this is all the wealth you can have. And there is no evidence that homeownership is good anyway, to the contrary.

Unemployment benefits extensions and unemployment spells

During the last recession in the US, the maximum duration of unemployment insurance benefits has been extended several times. The justification has been that as the unemployment rate is higher, it is more difficult for the unemployed to find jobs, and they should not be blamed for not finding one in due time. Of course, this raises the specter of moral hazard, as they may not be enticed to search for a job as avidly as before. The question is then, how much has the unemployment rate increased due to this extension and the associated moral hazard? I reported previously on a nice paper that used extensive theory and calibration to come to the conclusion that about a quarter of the increase in the unemployment rate can be attributed to this. By now, though, we have good data that should allow an empirical analysis.

Henry Farber and Robert Valletta provide the first serious estimations I have seen. They exploit cross-state variations in the extensions to identify their impact on job market transitions. They find little effect from the extensions on re-employment probabilities. Rather, they have prevented people from exiting the labor force, which is surprising given the severe decline in the labor force even after the recession was declared over. This means that the impact on unemployment duration is rather modest on average, but larger for the long-term unemployed. In the end, only a tenth of the increase in the unemployment rate can be traced to the benefit extension.

Foreclosure procedures last too long

The handling of foreclosures in the recent housing crisis in the US has been a serious disaster. The drop in household income made that many households could not service their mortgage obligations and had to default. In addition, the drop in house values meant that many mortgages were worth more that the house that serves as collateral. This encouraged owners to walk away from payments. The mass of defaults lead mortgage servicers to resort to automatic treatment of foreclosures, leading to many errors, in particular foreclosing houses that not at issue. The reaction of many US states was to require longer foreclosure delays, first to make sure procedures are properly followed, second to allow owners to renegotiate, recoup and still make payments. The latter did not work out, as reported here previously. Were these state interventions worth it, in the end?

Larry Cordell, Liang Geng, Laurie Goodman and Lidan Yang use extensive databases of foreclosure procedures to quantify the lengthening of foreclosure delays and what this has cost. An important consideration is how foreclosures happen across states. In some, courts need to get involved (judicial states), in others the procedures only follow the stipulations of the mortgage contract (statutory states). In the former, the length of the procedure went from 26 to 44 months, in the latter from 16 to 22 months. During all this time, both parties are left in limbo, owners have incentives not to pay at all and neglect house maintenance, and lenders get no return on investment and may try to find whatever means to get any money out of the house, including reselling the mortgage. Also, there are externalities on neighborhoods as they get blighted. This is costly. The cost went up from 8% to 12% oh house value in statutory states, while it is from 17% to 30% in judicial states. These costs are estimated by adding unpaid property taxes, excess depreciation and unpaid insurance. This is thus the cost to the mortgage servicer, and does not even include capital costs. For a cost to society, one would also have to add the impact on other property values and deduct the fact that owners are living for free in these homes. There is no doubt the costs are considerable.

Complicated Southern European recessions

On both sides of the Atlantic, the last recession was unconventional. This has meant that the mainstream business cycle models needed to be rethought to make good sense of what is happening. By that I mean, they need to be augmented or altered, not thrown out completely, as some have claimed. In doing so, one needs to identify new channels for the transmission of shocks, and possibly new shocks as well. And because this is unconventional, it is sometimes difficult to wrap one's head around some of those models.

One good example of that is the paper by Zhen Huo and José-Víctor Ríos-Rull that tries to understand the last Southern European recessions. They are looking for a model that would explain simultaneously an increase in savings while wealth and employment are decreasing. To make it work, they need frictions in the reallocation of resources across sectors, frictions on the labor market, and some shock that increases the savings rate. The latter generates then a paradox of thrift: even though savings are up, wealth is down. This comes by in the following way: as savings go up, consumption is down in a way that reduces the number of varieties of goods that are demanded. This leads to excess capacity, an apparent decrease in total factor productivity and thus the value of firms and capital decreases.

Now, the shocks triggering this are shocks to patience. Alternatively, it works as well with shocks to financial costs. Yet, I have a hard time believing that these were the triggers of the last recessions in Southern Europe. It seems to me that wealth decreased before the savings rate went up. And the reason of the former was a sudden recall of debt by Northern savers (in particular banks) that needed to cover losses in US mortgage instruments. In other words, it may have been as simple as a negative wealth shock triggering a standard decrease in consumption that gets the ball rolling. The financial costs came after. The labor market frictions and the reallocation frictions should also be enough to prevent labor to increase.

Is an imperfect monetary union leading to more volatility?

The theory of optimal currency areas initiated by Robert Mundell states that a monetary union should be beneficial between regions that have labor and capital mobility, fiscal transfer mechanisms and synchronized business cycles, or at least something approaching these conditions. In the case of Europe, this is clearly not met, but I guess the hope was that these conditions would eventually be met. The literature has been been rather superficial on what it means to not quite meet these criteria and what the consequences are. Yet, we have now techniques to model this better and test policies that could improve outcomes.

Philipp Engler and Simon Voigts do this with a DSGE model where they explicit the market structure, following the situation in the current European Monetary Union: no labor mobility, imperfect goods market integration, incomplete financial markets, no fiscal transfers at business cycle frequency, and asymmetric shocks. They find that adding a monetary union to the mix increases the volatility of consumption and employment significantly, essentially because country-specific monetary policy cannot be enacted. What can be done then? Engler and Voigts show that area-wide fiscal policy can do a lot of good, and much more than isolated fiscal policy would. And this is exactly what is missing in Europe. Absent this, one could imagine increasing labor mobility, but the trend in Europe right now seems to go the other way, with several countries thinking about restricting immigration from member countries. European integration is hard.

The construction sector is key to the business cycle

It is well known that the construction sector is a very important indicator of the business cycle. In fact, residential construction has been a reliable early indicator of economic activity for many decades and this characteristic is occasionally rediscovered. What is there still to learn about the construction sector?

Michele Boldrin, Carlos Garriga, Adrian Peralta-Alva and Juan Sánchez build a business cycle model including an input-output table. Looking at the last business cycle and putting in the model only variations in housing demand, they find that the construction sector contributed to 30-60% of the increase of employment before the recession, and 8-15% for GDP. But during the recession, the importance of this sector was even more massive: 30-40% respectively 45-60%. Part of it comes from the size of the shock, and part for the inter-linkages with other sectors.

Now think about the consequences for policy: if a major part of the recession of the recession is driven by a single and relatively small sector, it makes no sense to rely solely on monetary policy as it is currently the case. Monetary policy cannot distinguish by sector (and if it does, it loses independence). One would need active fiscal policy, like what was initially intended with the stimulus program. The current austerity mood, however, goes exactly in the other direction, as public investment programs are of course the first ones to suffer from cuts. Or you can just declare that this is all a structural shift, and keep any policy out of this.

Optimal deviations from inflation targeting

When a central bank adopts a monetary policy target, such as a targeted inflation rate, should it absolutely adhere to this goal, or are deviations from the goal tolerated? This is not necessarily a rehash of the "rules versus discretion" question, as it is a question about the formulation of the policy rule. In other words, is it OK for a central bank that has a specific inflation target to use a rule that deviates from the target under specific circumstances?

Barbara Annicchiarico and Lorenza Rossi say this is OK, and these circumstances do not need to be extraordinary. The reason here is the often neglected impact of economic shocks, in particular technology shocks, on the growth potential of economy. Without the endogenous growth mechanism, the optimal policy of the central bank is to stick to the target. With it, it can deviate because the dynamics of the economy and the intertemporal trade-offs make it optimal to give a little bit of slack now to be in better shape in the future.

This reminds me about the silly debate about the ineffectiveness of central banks when inflation is below target when unemployment is still high. It is all about the dynamics of adjustment of the economy after a shock. Economic variable do not go back to long-run equilibrium in one shot, it takes time and they can be off long-run values even in equilibrium and under optimal policy.

And what if the Fed were to make a loss?

Whether you think the Fed's actions have been successful or not in pulling the US out of a deeper recession, you have to admit that the gigantic increase in its balance sheet has been hugely profitable. US$88,900,000,000.00 last year. US$79,300,000,000.00 the year before. Despite what conspiracy theorists want to believe, this money is not going into the pockets of private bankers, but to the US Treasury, which is coming to rely on it in these trying budgetary times.

But these profits are not going to last forever. When the economy is going to do better, interest rates will have to be brought to saner, normal levels. And this is going to happen by selling the assets the Fed has accumulated, and this is going to happen at a loss, a substantial loss. Who is going to pay for it. Indeed, the Fed is not provisioning for losses, first because it never made a loss, second possibly because the law may prevent it from doing so. So if it makes a loss, what is going to happen? I could just print money to cover it, but that would run counter the very policy it is trying to implement. Or the US Treasury could cover the losses. I am not quite sure that it stands ready to do so. And in such a circumstance, conspiracy theorists would have a field day.

I have not seen anybody mention anything about the exit strategy of the Fed. So this is all personal conjecture. Am I missing something? The only positive aspect I see in this is that this seems to be an interesting revenue smoothing mechanism for the government. Or, once more, the Fed doing fiscal policy instead on the government.

The unemployed should shop less for bargains, and they would not be unemployed

It sucks being unemployed. You have a significant loss in income and your self-esteem takes a hit, for example. However, you enjoy significantly more leisure time (as mentioned earlier, job search takes on average a ridiculously small amount of time). That leaves unemployed people also with plenty of time to do bargain shopping.

Greg Kaplan and Guido Menzio remind us that this negative externality also works the other way: when a company hires someone from the pool of unemployed, this person does less bargain shopping and increases the profits of other companies. Kaplan and Menzio manage to measure these externalities and argue they are strong enough to generate strategic complementarities that can trigger self-fulfilling equilibria. And in such case, expectations become very important. Another reason why I think it was a very bad idea for Paulson and Bernanke to publicly hit the panic button in 2008 (see I, II).

Large GDP shocks are permanent

Fiscal policy being in complete disarray and unpredictable in the United Sates, economic policy is currently limited to monetary policy. But even there, it is not blindingly obvious what the Federal Reserve should do. If economic activity is below potential (and is forecasted to remain so beyond the "long and variable lags" it takes for monetary action to have an impact), the monetary easing is in order. Define potential, and there disagreement starts. If you look at the evolution of GDP, you cannot help thinking that it went through a permanent downward shift and is now tugging along at the usual growth rate, simply a step below. This would mean we are ready to get off the zero interest rates:



That would go against the idea that there are no permanent shifts in GDP. But while there are usually no such shifts, maybe there are rare circumstances where they happen. Mehdi Hosseinkouchack and Maik Wolters test the unit root of US GDP not only at the conditional mean but also at the tails of the distribution using a quantile autoregression based unit root test. Ad they find that sharp declines in output, like the one we recently experienced, do indeed look permanent. We should therefore not expect GDP to get on the previous path, and this not treat the latter as our current potential GDP. Would the FOMC believe this? I doubt it.

Is the CRA responsible for the crisis?

An important component, if not reason, of the last recession has been the run-up in sub-prime mortgages until 2007. There has been much speculation what could have triggered this, for example distorted incentives in the supply of mortgages, poor evaluation of risk, or predatory lending practices. Also mentioned has been the Community Reinvestment Act, which was implemented to reduce discrimination of lending in poorer neighborhoods and, as its title indicates, encourage mortgage holding in these areas. Could the CRA be the big culprit?

Sumit Agarwal, Efraim Benmelech, Nittai Bergman and Amit Seru claim the CRA did lead to more risky lending. This is based on the fact that mortgages given around the time of CRA examinations were 15% more likely to default. That is not that much a surprise as poorer neighborhoods do have riskier mortgage holders and banks had incentives to lend more during those exam periods. The real question is whether the risk was assessed and priced correctly.

The paper is still of interest. It shows that the effect was the strongest among the large banks (those that got bailouts...) and was more important while mortgage securitization was booming. Banks thus are not clean here.

Strange facts about inequality over the business cycle

The last recession has renewed interest about the distributional impact of business cycles. Clearly, not everyone is affected in the same way by a recession, and the massive policy interventions of the last few years also affected people differentially. For example, what what do we really know about the dynamics of inequality?

Virginia Maestri and Andrea Roventini use the database from a special issue of the Review of Economic Dynamics (which I discussed before). While the sample length is unavoidably short, including only a couple of recessions for every considered country, some general lessons can be learned: income inequality is counter-cyclical while consumption inequality is pro-cyclical. That is going to be tough to replicate in a theory. Imagine a recession. I can imagine that inequality becomes more severe because the people how typically have low incomes are more likely to lose their job. But why would consumption inequality be reduced? Unemployed workers do have lower consumption, and may in fact be more severely affected due to the lack of appropriate savings. So it must be that the consumption of the richer ones drops like a stone, and I do not see a model delivering this.

PS: I realize there was a large drop in income for the richest ones in this recession, and they recovered quickly. But this was not a typical recession.

PS2: And I still hate it when a paper starts on page 9, and the six last pages are back-cover material. What a waste.

How to measure the monetary stance when the interest rate is zero

The United States have interest rates close to zero, and it will stay like this of a few more years according to the Federal Reserve. This has also been the case in Japan for more than a decade. When the interest rate is not informative, it because very difficult to establish when the central bank policy is tight or loose. A Taylor rule may tell you that it should have negative interest rates, but because they cannot be negative, we cannot measure the impact of the unconventional tools the central bank may have used.

Leo Krippner finds a way to tease the monetary stance out of the yield curve. The issue is that the interest rates cannot go negative no matter what the central bank does because there is always the option to hold cash instead of bonds. This gives Krippner two ideas. First, one can then decompose a bond into an option to hold cash and another security, which may have a negative return (a shadow interest rate). The return of this security measures the monetary stance. The second is that the yield curve can help in pricing the option. For example, if long yields are very low the option has a lot more value than if the yield curve is steep.

This decomposition is then executed for the United States. The results are quite fascinating. For example, over the past five years, the shadow interest rate is at -5%, meaning that the Fed is doing a lot to help the economy. Whether this is enough is another question, but it does not look like it is just doing nothing effective. Also, one can easily match movements of the shadow interest rate with actions of the Fed. Sadly, these actions seems to have rather short-lived impacts, beyond keeping the shadow interest rate at roughly -5%.

To log-linearize or not to log-linearize?

Some recent research has shown that there is a free lunch lying there for fiscal policy when interest rates are constrained by the zero lower bound, in particular Eggertsson-Krugman and Christiano-Eichenbaum-Rebelo: the fiscal multiplier is larger than one and a tax rate cut leads to an increase in employment. But there is also a fundamental principle in Economics: always be suspicious of free lunches.

Anton Braun, Lena Mareen Körber and Yuichiro Waki show that the research above is all humbug. The way these new-Keynesian models are built is by log-linearizing around a steady-state with stable prices. There are two problems with that: 1) the fact that prices do change implies that there is a resource cost in these models due to either price dispersion or menu costs, depending on how you model the source of price rigidity; 2) log-linearization by definition implies a unique equilibrium. The sum of the two means that the extent literature has been approximating around the wrong steady-state and possibly looking at the wrong equilibrium.

Why? The cost of price change alters the slope of the aggregate supply, and this depends on the size of the shocks hitting the economy, once you looks at a non-linear solution of the model. Policy outcomes then look much more like those from an environment where there is no zero lower bound for the interest rate. That is, a tax increase reduces employment and the fiscal multiplier is close to one. To possibly get the other, more published result, one needs to have a price markup in the order of 50%, which is wildly unrealistic.

What this shows is that linearization is a nasty assumption, especially when a non-linearity is central to your case. Also, this highlights that the models punt too much on why prices are rigid. Simple rules are not sufficient. But regular readers of this blog already knew that.