Zero Sum
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Posted Sep 10th, 2010 by ravi    / Permalink /

The world of polling is a murky one. Outside of psychology and economics, it may be the only proclaimed mathematical/scientific enterprise where participants can arrive at wildly variant conclusions, and not have their predictions subject to validation by reality. FiveThirtyEight is a political blog (now part of the New York Times) that has of late shed some long overdue light (in the form of analytical rigour) into these turbid waters and withstood the test of empirical validation.

It is therefore odd that they step into one of the other two suspect areas aforementioned, namely economics, with an opinion that seems shoddily reasoned. The opinion is expressed in the title of a recent post on their blog Potential for Double-Dip Recession Seems Small; an opinion in need of significant substantiation, considering it runs counter to that of Nobel laureate economist Paul Krugman who has been calling things fairly accurately these past few years:

Paul Krugman said he sees about a one-third chance the U.S. economy will slide into a recession during the second half of the year as fiscal and monetary stimulus fade.

“It is not a low probability event, 30 to 40 percent chance,” Krugman said today in an interview in Atlanta, where he was attending an economics conference. “The chance that we will have growth slowing enough that unemployment ticks up again I would say is better than even.”

FiveThirtyEight thinks otherwise. And the author of the post, Hale Stewart, starts out commendably:

[A] key element lacking in the talk of double-dip recessions is what actually caused past recessions – that is, what are the primary reasons an economy slows to the point where its growth contracts for at least two quarters – followed by an analysis of whether those conditions exist in the current economic environment.

But in the very next paragraph, Stewart jumps to “indicators” rather than meditating on “causes” and “conditions”:

Perhaps the most obvious economic indicator of a coming recession is rising interest rates, one of the primary policy tools available to the Federal Reserve. According to generally accepted wisdom, the Fed is supposed to lower interest rates during a recession to spur lending and loan demand, and then raise interest rates after the economy expands to prevent inflation from getting out of hand.

Stewart backs up this idea with a chart that demonstrates that rise in the Federal Reserve’s short-term interest rates exhibit a strong correlation with the onset of a recession. He draws attention the obverse scenario as well:

Finally, the chart shows that short-term interest rates are the lowest they’ve been in over 50 years, an event that typically occurs as the economy is exiting a recession, not entering one.

To summarise, if the Fed’s interest rates are going up, that indicates a recession is on its way, and if the interest rates are at historic lows, that indicates the economy is exiting a recession.

Recall, at this point, that Stewart’s stated desire is to shift the conversation to causes, reasons and conditions that lead to a recession. This is poorly served by launching his analysis with talk of “indicators”, in particular the correlation of Fed interest rates with GDP change. Indicators are, after all, not causes. Unless Stewart believes that Fed jacking up of the rate is a cause of recessions! In fact, there is some reason to suspect that he might indeed believe that interest rate hikes lead to recession: when he does embark on examining causes, he starts out “Another leading cause of recession is some type of financial crisis” (emphasis mine).

But the idea that Fed interest rate variations is the first [listed] cause of recessions is hardly established by charting its behaviour in relation to the state of the economy. After all, one of the first rules of statistics is, as I am sure Stewart knows: correlation does not imply causation. This is made only worse that Stewart can call upon only one data point — the recessions during the 1980s — that pertain to a double-dip recession.

As Stewart himself tells us, interest rates are used by the Fed as a corrective measure to temper an over-heating economy (“irrational exuberance” as one Fed chairman in recent history put it). In that sense, rising interest rates can be more legitimately interpreted as a trailing indicator of an economy heading deeper into unsustainable territory.

All through the growth of the Internet bubble starting from about 1995 all the way to the turn of the millennium, interest rates held steady, gaining about a modest percent between 1999 and 2001. Stewart could appeal to this small rise as being a cause, or even an indicator of a coming recession; but that ignores the majority of the mischief that had occurred by the time this hike was put in place: the eToys IPO, which closed on opening day at three times the start price, occurred in May 1999. The Netscape IPO which made millionaires out of early employees and investors, and paupers of the rest, pushed the infant software vendor up to a total valuation of around $2 billion in 1995. Any number of examples of such speculative excess that preceded the rate hike (and subsequent recession) can be obtained by looking up relevant data for familiar “.com” darlings from the era.

For a different picture of interest rates and recessions, one can take a look at Japan from 1990 onwards (when the country entered an economic slump that it has been unable to shake off). The two charts below (obtained from TradingEconomics) show the annual GDP growth rate and the change in the interest rate (in that order):

Japan experienced recessions in mid-1993, mid-1997 and early 1998 (a double dip!), most of 2001 and 2008-2009. In line with Stewart’s expectations an interest rate peak in 1990-1991 coincides with the economy’s slide into recession. However, things turn less predictable thereafter. Apart from rare fractional upticks, the interest rate takes a controlled descent to zero, but with no significant impact on the economy, which has since that fateful event remained in the doldrums with intermittent recessions to add salt to the wound.

Stewart does get to other considerations shortly after the section on interest rates. In particular, he lists three “causes” for recessions (the bullet list below quotes text from his post):

  • some type of financial crisis that paralyzes a significant portion of the financial intermediary system (e.g: Great Depression, S&L crisis, housing bubble in 2007-08)
  • Commodity price increases (e.g: oil prices, which have an important psychological impact on consumer sentiment)
  • [“A final cause”] bursting of some financial bubble (leading to depressed consumer sentiment)

Two out of the three listed causes reveal the consumer driven nature of the current US economy. That should be worthy of some attention when we attempt to understand the cause of recessions. Be that as it may, at least two (the first and last) are themselves outcomes rather than causes. Financial crises and bubbles, being the result of untrammelled speculation and/or lack of responsibility or accountability, can be symptomatic of the underlying nature of the market in which they arise.

Uncoupled from the base realities of need, feasibility, sustainability, profitability and so on (often achieved through mere word play: “the new economy”), and unhindered by government regulation, the question that remains about the economy is not whether we have put the particular crises of the current episode behind us (a point made by Stewart) but whether the system will regain sufficient amnesia to enter the next boom-bust cycle. As Paul Krugman and Robin Wells point out in the New York Review of Books:

Whatever the precise causes of the housing bubble, it’s important to realize that bubbles in general aren’t at all unusual. On the contrary, as Yale’s Robert Shiller explained at length in his justly celebrated book, Irrational Exuberance, they are a recurring feature of financial markets.

By stating the above, Krugman and Wells are not avoiding the questions that are central to Stewart: what are the root causes of recessions and what do they say about the chances of a double dip? To the contrary, the Krugman/Wells piece, a review of three books that also address these issues, is titled “The Slump Goes On: Why?”, and digs deeper into “the financial crisis that paralyzes” that Stewart considers a cause of recessions: “The … answer”, they write, “is that by 2007 the financial system had evolved to a point where both traditional bank regulation and its associated safety net were full of holes.”. And they point to Minsky:

Minsky’s theory, in brief, was that eras of financial stability set the stage for future crisis, because they encourage a wide variety of economic actors to take on ever-larger quantities of debt and engage in ever-more-risky speculation.

Stewart, in his blog post, mostly eschews such fundamental considerations, taking comfort instead in numbers that indicate that the current set of crises, measured by the criteria of bank earnings and commodity prices, are under control, to conclude that the economy is on the mend — or at the least not facing another recession.

But there are base realities about the economic state of affairs, not captured by bank profitability, that Krugman restores to centrality:

Let’s be clear: a recovery that involves growth so slow that unemployment and excess capacity rise, not fall, isn’t really a recovery. If we have only have 1 1/2 percent growth, that will amount to a double dip in all the senses that matter.

(Federal Fund Rate image courtesy of Wikipedia)