The Great Recession

Via Calculated Risk, here’s what Council of Economic Advisors Chair Christina Romer had to say last week in testimony before the Joint Economic Committee about how the stimulus has and will impact growth in the near term:

In a report issued on September 10, the Council of Economic Advisers (CEA) provided estimates of the impact of the ARRA on GDP and employment. ...

These estimates suggest that the ARRA added two to three percentage points to real GDP growth in the second quarter and three to four percentage points to growth in the third quarter. This implies that much of the moderation of the decline in GDP growth in the second quarter and the anticipated rise in the third quarter is directly attributable to the ARRA.

Fiscal stimulus has its greatest impact on growth around the quarters when it is increasing most strongly. When spending and tax cuts reach their maximum and level off, the contribution to growth returns to roughly zero. This does not mean that stimulus is no longer having an effect. Rather, it means that the effect is to keep GDP above the level it would be at in the absence of stimulus, not to raise growth further. Most analysts predict that the fiscal stimulus will have its greatest impact on growth in the second and third quarters of 2009. By mid-2010, fiscal stimulus will likely be contributing little to growth.

In layman’s terms, when first comes online, it adds GDP growth that wouldn’t have otherwise occurred. Then, after a time, it props the economy up at a level it wouldn’t have otherwise seen. (Romer says we’ve seen the first part, and are about to see the second part.) Here’s the thing, when the economy isn’t growing on its own but is being propped up at a higher level than it otherwise would have been due to stimulus, GDP growth will sit at basically zero. That doesn’t mean the stimulus isn’t working – the economy is producing more than it otherwise would have. 

This also means that the stimulus going offline is a “drag” - or has a negative effect - on growth as that government spending is no longer in the economy. What it doesn’t mean as that it’s making the economy worse, and it’s worth inoculating against that misunderstanding of the GDP data that will inevitably arise. Rather, it will have as measurable a positive effect on the economy in the short term and will jumpstart sustained growth (at what level is still an open question). And the investments in the elements of sustained growth – infrastructure, smart grid, energy, education, R%D, etc – will continue to pay off for many years to come.

Via Mark Thoma, Atlanta Fed Senior VP and Research Director David Altig weighs in on the high likelihood of a jobless recovery. He brings to light an interesting number on the permanence of job losses, and the whole post is a good round up what will be a very scary subject:

The percentage of employee separations labeled permanent is at a recorded high.

Underneath the usual total unemployment numbers are the reasons an individual is unemployed: You are on temporary layoff; you quit your job; you have reentered the labor market and have yet to find a job; or you are entering the job market for the first time and have yet to find a job. Or, finally, you have been permanently separated from your previous employer, who has no expectation of hiring you back.

The last category is the dominant reason for unemployment at this time. That might not seem surprising, but it actually is. Never, in the six recessions preceding the latest one, did permanent separations account for more than 45 percent of the unemployed. The current percentage stands at 56 percent as of September and appears to be still climbing:

As Dr. Rob Shapiro tells us, the concept of a jobless recovery is scary, but even worse is that the term may overstate the case. We could be in for what is technically a recovery in which the economy actually loses jobs. 

Since last week's the freak-out about a weak dollar, cooler heads have responded. Paul Krugman led the way this week with a strong (targeted) critique of the idea, coming from regional Federal Reserve banks, that the Fed's Open Market Committee should make "an early return to tighter money, including higher interests rates." Krugman doesn't think that the raising rates makes sense at all:

After all, the unemployment rate is a horrifying 9.8 percent and still rising, while inflation is running well below the Fed’s long-term target. This suggests that the Fed should be in no hurry to tighten — in fact, standard policy rules of thumb suggest that interest rates should be left on hold for the next two years or more, or until the unemployment rate has fallen to around 7 percent.

Yet some Fed officials want to pull the trigger on rates much sooner. To avoid a "Great Inflation," says Charles Plosser of the Philadelphia Fed, "we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels." Jeffrey Lacker of the Richmond Fed says that rates may need to rise even if "the unemployment rate hasn’t started falling yet."

I don't know what analysis lies behind these itchy trigger fingers. But it probably isn’t about analysis, anyway — it’s about mentality, the sense that central banks are supposed to act tough, not provide easy credit.

And it's crucial that we don’t let this mentality guide policy. We do seem to have avoided a second Great Depression. But giving in to a modern version of our grandfathers' prejudices would be a very good way to ensure the next worst thing: a prolonged era of sluggish growth and very high unemployment.

Martin Wolf sees the dollar not as weakening, but as correcting itself in the wake of the financial crisis. Both he and Krugman point out that the reason the dollar’s value increased so much was because investors ran to it as the world melted down. Both think the correction is a good thing; Krugman because it means growing confidence in the stability of the global economy, while Wolf says:

The dollar's correction is not just natural; it is helpful. It will lower the risk of deflation in the US and facilitate the correction of the global "imbalances" that helped cause the crisis. I agree with a forthcoming article by Fred Bergsten of the Peterson Institute for International Economics that "huge inflows of foreign capital to the US facilitated the over-leveraging and underpricing of risk".* Even those who are sceptical of this agree that the US needs export-led growth.

Finally, what can replace the dollar? Unless and until China removes exchange controls and develops deep and liquid financial markets – probably a generation away – the euro is the dollar's only serious competitor. At present, 65 per cent of the world’s reserves are in dollars and 25 per cent in euros. Yes, there could be some shift. But it is likely to be slow. The eurozone also has high fiscal deficits and debts. The dollar will exist 30 years from now; the euro's fate is less certain.

…

The global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong. This is not because the dollar's role is now endangered. It is rather because it impairs domestic and global stability. The time for alternatives is now.

Plus, Ezra Klein says language is the problem and the Economist says to leave the dollar alone right now.

It was an auspicious week for the touchy issues surrounding executive pay.  One after another, President Obama’s pay czar, Kenneth Feinberg, announced new restrictions for AIG executives; Goldman Sachs was reported to be putting aside $23 billion this year’s bonus pool, the largest anywhere, ever; and Elinor Ostrom from Indiana University shared the Nobel Prize in economics for her breakthrough work on how large companies organize themselves, often in ways that encourage executives to put their own financial interests before those of the shareholders.   

Starting with Goldman, it’s obvious that a sheaf of annual bonuses each equal to 10 or 20 times what an average American earns in his or her entire lifetime, coming from a firm which recently received huge, direct and indirect taxpayer-funded assistance, is certain to spark outrage.   That reaction isn’t misplaced, and there’s a sensible response to it based on the core tenets of capitalism which we will get to shortly.   There are other serious matters at stake here, too.   In particular, how does a financial services firm like Goldman Sachs earn such huge profits in difficult times?  And since the operations of Goldman and a few others like it matter so much to the economy – which is why they got their federal assistance – how do the arrangements which produce such huge bonuses affect those operations and thereby the rest of us?   The answers suggest that even as Goldman’s top executives and traders put away enough for a royal retirement, their decisions could lay the foundation for future financial turmoil that would leave the rest of us a lot poorer.  

We didn’t need this latest and most conspicuous instance of greed at Goldman to know that the compensation provided to the uppermost echelons of American business is out of control.  Since 1990, the pay of American CEOs has jumped from 90 times the average workers’ pay to 250 times – compared to 15 to 30 times for British, French and Japanese CEOs.   Nobel Laureate Ostrom’s work helps us understand why:  CEOs name their own top executives and strongly influence who ends up on their boards of directors – and consequently on the committees that set the terms for all of their compensation.  How much they decide to pay themselves, therefore, is essentially limited by the intersection of their own avarice and any vestigial sense of shame they might have.   And the shame is pretty easy to dispose of, since the terms of their compensation are rarely disclosed publically.

There’s a fascinating account of some of these pay packages in a current New Yorker article chronicling the efforts of Nell Minow and Robert A.G. Monks to reassert shareholder rights over these modern robber barons. Almost everywhere, most of the pay comes in stock or stock options, so they’re only liable for the 15 percent capital gains tax.  (The Goldman executives who will claim stock bonuses worth tens of millions of dollars this year will report taxable “salaries” of less than $300,000.)  And if the stock price falls under these executives’ leadership, their options contracts are often revised at a lower strike price.   These packages may also include huge “retirement” bonuses for CEOs that leave voluntarily – like the one federal contractor Halliburton gave Dick Cheney when he left to run for Vice President – and even “retention bonuses” for executives who end up in prison.  Then there are the extravagant perks.  It took public divorce proceedings against GE’s Jack Welch for shareholders to find out that on top of the many hundreds of millions of dollars Welch received in stock and salary, his friendly board had also awarded him lifetime use of the company’s 737 and helicopters; lifetime floor seats for the Knicks and lifetime box seats for the Red Sox, Yankees and the Metropolitan Opera; exclusive lifetime use of a sprawling Manhattan apartment, including fresh flowers, dry cleaning service and even the tips for the doorman; and a catalog of lifetime golf and country club memberships.   His and most other executive contracts also now include “gross-ups,” which means that the shareholders pick up federal and state taxes owed on the executives’ various perks. 

These are all examples of what economists call the “agent-principal problem,” in which the interests of agents – they’re the executives – diverge from those of the principals, who here are the owners or shareholders.  It’s pretty simple: They enrich themselves at the expense of the shareholders who they ostensibly work for – and those shareholders now include a majority of all Americans.  The simple democratic answer to all this, derived directly from the essence of capitalism, is to empower the owners by requiring that boards disclose all aspects of the compensation package of senior personnel and subject the terms of those compensation packages to mandatory shareholder votes, every year.  

Last week, I proposed this step on a CNBC business show.   The other guest predictably squawked about government control – and then the moderators also tried to dismiss the idea as “impossible.”  Come again?  Shareholders vote every year on lots of measures – check out your proxy statements.   And the mere threat that shareholders might publicly reject a CEO‘s payday should moderate the greed of at least some compensation committees.   The House passed a weak version of this proposal recently – annual, “advisory” shareholder votes on compensation.  The Senate should strengthen it with stricter disclosure requirements and an annual vote that actually decides the matter. Why, precisely, shouldn’t a company’s owners determine what their executives are paid?  And does anyone think that Goldman’s shareholders, including strapped pension plans and charitable institutions, are eager to see $23 billion in potential dividends go to the firm’s top tiers?

This particular agent-principal problem also affects the rest of us, since the stock and stock options that make up most of these compensation packages are often tied to the short-term gains associated with an executive or trader’s work, without regard to the transactions’ long-term returns.  So, hundreds of traders and executives at Goldman and other places on Wall Street have closed transactions and other deals that booked large paper profits this year – and will take home huge bonuses tied to them – but bear no consequences if those deals go sour next year or the year after and cost the shareholders billions.   These arrangements directly encourage them to take on enormous long-term risks for their firms and owners, in pursuit of the short-term paper gains that generate their own bonuses.   Since risk and return are closely related, these arrangements help explain how Goldman earned enough this year to dole out that projected $23 billion in bonuses.   And by creating such strong incentives for risky investments on a large-scale, these same arrangements were a core element of the meltdown that nearly pushed the U.S. and global economies into a genuine Depression, and cost shareholders and taxpayers trillions of dollars.    

To prevent a recurrence that could ruin almost everyone, these arrangements have to end.  J.P. Morgan Chase has said it will include new “claw-back” provisions that would reclaim part of the bonuses when a deal’s long-term returns are less than expected.   It’s a nice gesture, but it’s hardly enough.  We need laws and regulations that directly limit the risk levels of the portfolios of institutions deemed “too large to fail,” and specific, claw-back guidelines from the SEC that all public companies will have to follow.  The outstanding question is whether Congress has the cajones to force the country’s richest people and institutions to change the ways that made them so wealthy in the first place.

Yesterday, the U.S. House of Representatives overwhelmingly passed H.R. 3221, the Student Aid and Fiscal Responsibility Act. Included in the legislation were provisions proposed in H.R. 2060, The Community College Technology Access Act, which would offer free computer training to all Americans through the nation’s community colleges. Sponsored by House Democratic Caucus Chair John Larson, H.R. 2060 was based on a 2007 NDN paper by Globalization Initiative Chair Dr. Robert Shapiro entitled Tapping the Resources of America's Community Colleges. These provisions are designed to increase worker skills in a 21st century economy in which facility with and connectivity to the global communications network are prerequisite for success. A companion bill, S. 1614, has been sponsored by Senator Chuck Schumer.

"Community Colleges reach every corner of this country with over 1100 in urban, rural and suburban settings." Larson said. "The legislation we passed today takes a bold step to expand the mission of our community colleges – making them a hub for training our workforce by opening their doors to provide the public with the basic computer training skills our workers need to succeed in a modern economy. I would particularly like to thank NDN and Dr. Robert Shapiro, for their hard work and advocacy on this issue as well as Chairman George Miller for including our language in his legislation."

"I salute the House of Representatives and especially Chairman John Larson for passing legislation that taps the resources and technology of community colleges to provide America's workers with the information-technology skills they'll need to succeed in a very competitive U.S. and global marketplace, particularly during tough times," Shapiro said. "Tens of millions of Americans entered our workforce before computers and the Internet became so ubiquitous. Many of them now are in what should be their most productive and highest-earning years. As non-wired jobs become increasingly rare, Americans without solid IT skills will find themselves economically marginalized. This legislation will help millions more American workers thrive in our idea-based economy."

Last week, Professor Jagdish Bhagwati joined NDN to discuss the changing global economy. At the G-20 in Pittsburgh next week, sure to be discussed is the impact the Great Recession has had on the international trading system. Here are Bhagwati and Dr. Rob Shapiro discussing that very topic:

According to the Financial Times, the G-20 will also address global economic imbalances (Bhagwati and Shapiro discussed that topic as well), a timely topic in light of the ongoing U.S. - China tire spat. 

A couple of interesting notes out on wages today: As background, we've long argued that getting wages and incomes up was the primary governing challenge of the day, going back to the Bush economy that saw wages stagnate and incomes decline. 

David Leonhardt from the New York Times points out that wages are actually increasing in the recession for those who are employed. But those who aren't are having an incredibly hard time finding a new job. Employment churn seems to be at quite the low.

Mark Thoma excerpts the latest Economic Outlook from the San Francisco Federal Reserve, which sees "anemic recovery" and "weakness in wage growth." Not good.

For more on the politics of incomes and wages, take a look at Simon's recent essay on focusing national attention on creating a new economic strategy for America. 

A new Washington Post-ABC News poll says a few things about the politics of the economy that are important to know as we head into the fall. A few points:

Painful personal experiences over the past year continue to dampen the outlook of many Americans. About two-thirds of those polled say they have been hurt financially by the recession, with extensive reports that job losses and pay reductions are hitting home. 

…

Nearly six in 10 Americans are now concerned about job or pay losses in the coming months, little changed since February, and there has been no increase in the percentage who see the federal government's stimulus efforts as having an impact, even as the pace of layoffs has eased in recent months. 

Americans feel like their incomes have decreased because they, in fact, have. So what does this polling data mean? As Simon recently wrote:

Getting incomes and wages up in this new economy of the 21st century is in fact the most important domestic challenge facing the country, and one the American people are demanding a new national strategy for. This fall is the time for the President to make it clear to the American people that he understands their concerns, has a strategy to ensure their success in this new economy, and will make their success the central organizing principle of his Administration until prosperity is once again broadly shared.

Things may be headed that direction. The President spoke Monday about new financial regulations, and, with more and more of the funds from the stimulus being obligated everyday, it shouldn't be too heavy of a lift to increase the number of those who see the stimulus as having a positive impact.

NDN has long pointed out that median household income dropped by roughly a thousand dollars during the Bush era, creating a middle class that was weakened even prior to the great recession. Now, Census Bureau data tells us that household income has again dropped, meaning that everyday Americans have taken a loss over the last decade. From the New York Times:

In another sign of both the recession and the long-term stagnation of middle-class wages, median family incomes in 2008 fell to $50,300, compared with $52,200 the year before. This wiped out the income gains of the previous three years, the report said.

Adjusted for inflation, in fact, median family incomes were lower in 2008 than a decade earlier.

"This is the largest decline in the first year of a recession we've seen since the Census Bureau started collecting data after World War II," said Lawrence Katz, an economist at Harvard University, referring to household incomes. "We've seen a lost decade for the typical American family."

Coupled with rising costs, specifically in health care (I'm sure you've heard about this recently), energy, and pensions, dropping incomes mean that the economic wellbeing of everyday Americans is significantly worse than a decade ago. Add in all the wealth destroyed by the systemic financial meltdown and the collapse of the housing market, and we're talking about an economically crippled American middle class.

There are few better ways to sink one's hopes about the future than to read pessimistic economists. In that spirit, Nouriel Roubini in the Financial Times and Paul Krugman in his New York Times blog write yesterday and today, respectively, about the likelihood that the Great Recession is U shaped or even (in Roubini's case) W shaped. Both see a U shaped recession as probable, and Krugman shows, with this chart, what a U shaped recession looks like and why that means a jobless recovery - aka "purgatory" -

Furthermore, Roubini sees a very real possibility of this recession being W-shaped, which would be very bad news indeed:

There are also now two reasons why there is a rising risk of a double-dip W-shaped recession. For a start, there are risks associated with exit strategies from the massive monetary and fiscal easing: policymakers are damned if they do and damned if they don’t. If they take large fiscal deficits seriously and raise taxes, cut spending and mop up excess liquidity soon, they would undermine recovery and tip the economy back into stag-deflation (recession and deflation).

But if they maintain large budget deficits, bond market vigilantes will punish policymakers. Then, inflationary expectations will increase, long-term government bond yields would rise and borrowing rates will go up sharply, leading to stagflation.

Another reason to fear a double-dip recession is that oil, energy and food prices are now rising faster than economic fundamentals warrant, and could be driven higher by excessive liquidity chasing assets and by speculative demand. Last year, oil at $145 a barrel was a tipping point for the global economy, as it created negative terms of trade and a disposable income shock for oil importing economies. The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly towards $100 a barrel.

In summary, the recovery is likely to be anaemic and below trend in advanced economies and there is a big risk of a double-dip recession.