Marty Feldstein (former President of NBER, just retired 2 days ago) thinks mounting evidence suggests we are already in recession. And he thinks this recession is so different from past ones that monetary policy may not be effective. The highlights are mine.

 

 

Our Economic Dilemma

Although it is too soon to tell whether the United States has entered a recession, there is mounting evidence that a recession has in fact begun. Key measures of economic activity stopped growing in December and January or actually began to decline. The collapse of house prices and the crisis in the credit markets continue to depress the real economy.

The sharp reduction in the federal funds interest rate and the new fiscal stimulus package may, of course, be enough to avert a downturn. Many forecasters still predict that the economy will just slow in the first part of this year and then rebound after the summer. But the hope that monetary and fiscal policies would prevent continued weakness by boosting consumer confidence was derailed by the recent report that consumer confidence in January collapsed to the lowest level since 1992.

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.

But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.

The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.

But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.

The collapse of the credit markets began last summer when the subprime mortgage crisis demonstrated that financial risk of all types had been greatly underpriced, that the market prices of complex financial assets overstated their true values, and that the credit scores provided by rating agencies are not to be trusted. Because market participants now lack confidence in asset prices, they are unwilling to buy existing assets, thus preventing current asset owners from providing credit to new borrowers.

The lack of confidence in asset prices also translates into a lack of confidence in the creditworthiness of other financial institutions, impeding the extension of credit to those institutions. And because financial institutions do not even have confidence in the value of their own capital and in the potential availability of liquidity, they are reluctant to make new lending commitments.

It is not clear what can bring back the confidence in asset prices that is needed for credit to flow again. Some analysts suggest that confidence would return if the financial institutions declare the true market value of their assets by restating balance sheets at the depressed prices at which they could be liquidated today. But this is not a practical solution, since many complex securities are no longer trading in the market. Forcing an actual sale of these securities at fire-sale prices in order to establish market values could also create unnecessary bankruptcies that would further impede credit flows.

The current situation has the elements of a Catch-22: The credit flows needed for economic expansion require confidence in the values of existing financial assets, but market participants may not have such confidence while the risk of recession hangs over us.

There is plenty of blame to go around for the current situation. The Federal Reserve bears much of the responsibility, because of its failure to provide the appropriate supervisory oversight for the major money center banks. The Fed's banking examiners have complete access to all of the financial transactions of the banks that they supervise, and should have the technical expertise to evaluate the risks that those banks are taking. Because these banks provide credit to the nonbank financial institutions, the Fed can also indirectly examine what those other institutions are doing.

The Fed's bank examinations are supposed to assess the adequacy of each bank's capital and the quality of its assets. The Fed declared that the banks had adequate capital because it gave far too little weight to their massive off balance-sheet positions — the structured investment vehicles (SIVs), conduits and credit line obligations — that the banks have now been forced to bring onto their balance sheets. Examiners also overstated the quality of banks' assets, failing to allow for the potential bursting of the house price bubble.

The implication of this for Fed supervision policy is clear. The way out of the current crisis of confidence is not. We can only hope that those who predict nothing worse than a temporary slowdown are correct.

 

Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard and a member of The Wall Street Journal's board of contributors.

Real Time Economics, the economic blog sponsored by wsj has a quite heated debate going on. I find the whole debate interesting: just 2 years ago, economists were still busy trying to find out the empirical evidence to support the notion that China contributed a great deal to the low US/global inflation, now the debate is being changed to 'let's blame China for global inflation'.

 

Most people see rising domestic inflation in China as evidence (the most recent number reads 7.1%) of such argument, and adding to that are China's fast GDP growth above 10% and 1.3 billion population accessing the limited global resources. So an easy blame and simple logic, right?

 

To prove a point, economists like to use counterfactuals. Here I give it a try.

 

First, China's GDP growth has been around 10% since 2003, and on average of 7-8% since early 90s, so why fast growth is blamed for inflation now?

 

Second, on China's exports of high inflation to the world. China's inflation went back to positive territory in 2003 and has been around 2.5 per cent on average, a very low range. Only until 2007, we saw the first big jump from 2.8% in 2006 to 6.5%. Before 2003, and much of late 90s, China got deflation, that's negative inflation.

 

 

How did everything all happen in 2007?

 

What did not change but just changed recently, especially in 2007, was the Fed's monetary policy, and came along with it was sharp falling US dollar. 

 

It is true that US dollar has been falling since 2002, but weak dollar was most talked about and raised most worries in 2007, when even supermodel Gisele was demanding Euro-pay in her contract. In 2007, commodity prices in nominal dollar terms all shot to the roof: Oil first touched $100 since 1980, gold rose above $900 and expected to pass $1000. When expectations changed, you have to worry. And indeed we had a classic exchange rate overshoot, and all of these are reflected in prices.

 

In particular, US dollar is depreciating fast against Chinese Yuan (chart below). When dollar is down against RMB, US import prices naturally rise. After all, what you demand is what you get (see chart below).  There is no such a world that you could have a higher RMB but lower import prices.

 

 

 

How about food prices?  I admit there are some merits when people argue that soaring Chinese and Indian economy put extra pressure on world food prices. But again, China did not start to grow just recently, but why inflation now?

 

My guess is that this is much due to Bush's Energy Policy Act in 2005, in which he basically gave a go-order to convert corn to Ethanol, the alternative energy that's supposed to ease oil price. In reality, what we got is the classic example of poorly designed policy with unintended consequences. Corn itself is food, imagine what will happen to food price when you pull out a large chunk of food supply from the world market, and be reminded that corn is also widely used for many other purposes such as feeding cattle. Converting food to energy is just stupid!  Shall I remind you that there are still 1 billion people living under $1 per day?

 

 

Paul Krugman has a nice chart of oil in Feb. 2008 dollar. We are very close to the historical high. However, with recession mounting (or we're already in it), I don't think the price is sustainable. 

 

Real oil prices in Feb. 2008 dollars:

 

Global macro strategy, which has been out of favor for years, is coming back strong in current turbulent time.

 

 

'Global Macro,' the Strategic Sequel 

As Wall Street firms hunger for dependable trading profits, an out-of-favor strategy is making a comeback.

Now that volatility has returned and interest rates are moving, some traders using a so-called global macro strategy are thriving. By betting on economic trends in currencies, interest rates and other instruments around the world, these traders have been scoring big gains.

Last year, global macro funds rose more than 17% on average, according to Credit Suisse/Tremont Hedge Fund Index. These funds gained 1.7% on average in January, according to Hedge Fund Research, a Chicago-based research firm.

One of the funds with the biggest gains is Alan Howard's $20 billion Brevan Howard Asset Management LLP. The London-based fund racked up winnings of about 10% last month, even as many hedge funds sputtered and global stock markets tumbled. Mr. Howard's profits come on the heels of gains of 25% in 2007 for his firm's flagship hedge fund.

Other winners include GLG Partners Inc.'s macro fund, managed by Greg Coffey, which was up 51% last year, and Peter Thiel's Clarium Capital Management, which jumped more than 24% in January and more than 40% in 2007.

These kinds of funds can include a variety of styles — and returns vary wildly. Paul Tudor Jones's Tudor Investment Corp., one of the largest and most respected macro funds, gained less than 1% in January, investors say, while Goldman Sachs Group Inc.'s Global Alpha fund has been struggling.

The bond market's volatility, falling interest rates and a steep yield curve in the U.S. — or a difference in yields between short- and long-term debt — is causing the "sort of environment that is very good for macro managers," says Gary Vaughan-Smith, a partner at London-based SilverStreet Capital LLP, which has about $700 million under management.

That is advantageous for someone like the 44-year-old Mr. Howard. His firm is blossoming, soaring from $12.5 billion at the beginning of 2007 to become one of the largest hedge funds in the world. Other macro-oriented hedge funds have become hot tickets, too, investors say. Popularized by billionaire investor George Soros, macro trading was widely practiced two decades ago. But its popularity waned as the global economies turned calm, rising in unison.

The macro strategy "seems to be the only thing that is performing in this current period of market upheaval," says Omar Kodmani, senior executive officer in London at Permal Group, a fund of hedge funds that is a unit of Baltimore investment company Legg Mason Inc. It is among investors that have been adding money to macro funds like Brevan Howard over the past year.

In recent years, Brevan Howard's annual gains weren't particularly extraordinary — about 10.5% on average. But Brevin Howard specializes in short-term trades that generally profit as interest rates in developed nations fall, a stance that has helped lately. The fund also has profited from a series of currency investments. It does a bit of stock trading, too, in recent months sticking with consumer staples.

Brevan Howard steers clear of so-called credit wagers, or investments that depend on the improving or deteriorating quality of a company's credit, difficult terrain in the past year. Mr. Howard's traders work independently, judged on their performance. That strategy creates a competitive environment that rewards top performers, say people close to the firm.

As chief investment officer, as well as chief executive, Mr. Howard is responsible for 20% of the flagship fund's investment portfolio, as of October 2006, according to regulatory filings. Mr. Howard, who sits in the middle of the firm's trading room surveying his traders, contributes to Israeli and other charities, such as Holocaust education. He lives near several of his firm's senior partners in Hampstead, an affluent, leafy London neighborhood.

He received a master's degree in chemical engineering in 1986 from London's Imperial College of Science and Technology. Working as a trader for Credit Suisse, Mr. Howard itched to start his own hedge fund as the firm became more conservative under then-head John Mack. But he told an acquaintance that he wouldn't quit the bank unless he could raise $500 million to $1 billion.

He did exactly that, leaving Credit Suisse in 2002 and starting Brevan Howard with $870 million, increasing it to $1.2 billion in its first month. Brevan Howard now invests money for Credit Suisse and the bank acts as a broker for the fund.

Last spring, Mr. Howard raised about €770 million ($1.13 billion) from listing a fund called BH Macro on the London Stock Exchange, falling short of the €1 billion he had hoped to raise, as some investors weren't impressed, at the time, by the firm's returns. Proceeds of the listing were invested in the flagship Master Fund, which is otherwise closed to new investors.

Brevan Howard executives are upbeat that the recent big gains will continue, anticipating that interest rates in a number of countries will head even lower. In a recent shareholder letter, they said they expect the European Central Bank to hold rates steady, that the U.S. is likely to slip into a recession and that the economy of the United Kingdom will continue to slow.

The firm also expects the problems in the banking sector to continue and the "punishing recession" in residential investment to spill into other sectors, it says in the shareholder letter. "In short, [Brevan Howard] sees anemic growth in 2008 with downside risks," the letter adds.

 

 

Is CDS market the next to explode? Imagine that you buy an insurance but the insurance company can't pay you because their counterpary can't pay them either.

 

What's truly astonishing is the size of this market: The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — bigger than the US equity markets, US Treasuries, and Mortgage Securities — COMBINED.
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Krugman is often too liberal for me, but I still trust his economics.

 

 

 

by Paul Krugman