Economic Crises

[Dear new readers: Please click here if you’d like to see the rest of this blog, which focuses on energy, security, and climate.] Do you think that it’s straightforward to figure out whether high oil prices cause recessions? Many people apparently do. The 2011 Nobel Prize in Economics, awarded today to Thomas Sargent and Christopher Sims for “empirical research on cause and effect in the macroeconomy”, should make them reconsider. The basic reason is simple: if it was easy to separate cause from effect and thus measure the relationship between stimulus and response, they wouldn’t be awarding Nobel Prizes for related progress. Indeed the difficulty of distinguishing economic cause from effect is a big reason for economists’ longstanding interest in oil price shocks, particularly those of the 1970s. Those price hikes were clearly spurred by events outside the economic system, in 1973 by the Arab oil embargo, and in 1979 by the Iranian revolution (though even on these points there is some dissent). Identification should thus be simple: the oil shock is the cause, and any macroeconomic change is a consequence. This provides an unusually clean laboratory in which to study economics. Alas, there is a problem. The oil price shocks of the 1970s prompted big interest rate hikes in consuming countries, as policymakers tried to stem inflation. One now must ask: were the economic slowdowns that followed the oil price shocks the result of the shocks themselves, or consequences of the monetary policy reaction? The difference matters, because one leads to an energy policy solution, while the other points to better monetary policy as the right response. In a seminal 1997 paper, Bernanke, Gertler, and Watson (BGW) came down strongly on the latter side. They drew on methodology developed by Sims (one of the new Nobel laureates) and Tao Zha to fit a model that incorporates both the direct response of the economy to oil price rises and a monetary policy component. Then they simulated the model with one change: instead of having interest rates rise in immediate response to increased inflation, those rates remained constant. The result? Most of the economic slowdown triggered by the oil price rises disappeared. The conclusion is clear: it is the monetary policy response, not the oil price shocks themselves, which slowed growth and triggered recessions. This has clear policy implications: it may be more effective to fight oil price shocks with good monetary policy than with energy policy itself. I hadn’t noticed before this morning that the original BGW paper was accompanied by an illuminating critique by one Christopher Sims. Sims offers two related criticisms. The first is that the alternative policy modeled by Bernanke et al is implausible. Superficially, the alternative policy (where interest rates remain unchanged) permits high inflation, which Sims sees as unsustainable. More fundamentally, Sims has trouble seeing a way to get from the pre-shock monetary policy to the post-shock one.  He argues in essence that if your starting point is a monetary policy that responds strongly to oil price shocks (or, more generally, inflationary pressures), it’s basically impossible to credibly switch to one that ignores them. If your new policy isn’t credible, though, the response to it won’t be the one that’s predicted by the model. Sims is basically arguing that, at best, policymakers will eventually be forced to return to their old (tighter) monetary policy rule, that markets will anticipate that, and that the benefits of looser money in the near-term will thus be blunted. Sims’s second criticism, based on the so-called Lucas critique, is closely related. He essentially argues that a fundamentally new policy rule, even if it is successfully implemented, might not have the modeled effects. That’s because some of the parameters identified in specifying the original model might implicitly reflect the old policy rule.  If that’s true, and a policy change thus effects deeper changes in the economy, the model projections of the new policy can’t be trusted; in turn, that makes it impossible to say that it was monetary policy, not high oil prices, that did the real economic damage. How have these two competing views stood the test of time? One can argue, at least superficially, that U.S. policymakers have succeeded in credibly and sustainably changing the policy rule. Back in the 1970s, monetary policy responded to headline inflation; today, it responds only to core inflation, which excludes energy and food prices. To be sure, this only gets you part way to the hypothetical strategy described by BGW and dismissed as not credible by Sims, since changes in oil prices ultimately pass through in part to core inflation, to which the Fed still responds. Moreover, European policymakers have been far less swayed by the case for ignoring headline inflation. Still, the historical track record suggests that on this particular matter, Bernanke et al were, at least in principle, on largely defensible ground. The other critique offered by Sims is tougher to rebut, since it cuts at the heart of the modeling enterprise. Back in the 1970s, market participants pretty much knew that rising oil prices would prompt monetary tightening. That presumably affected their behavior more broadly. Today, they can be similarly (though not entirely) confident that the Fed won’t react to increasing oil prices by cranking up interest rates; once again, that might change their broader behavior. Extracting lessons for today’s economy from patterns displayed in the 1970s may thus be a fraught exercise. And that, to return to where we started, is the real bottom line. Anyone who claims to have looked at the historical data and established a strong, immutable relationship between oil prices and macroeconomics is being overconfident. Cause and effect are tough to disentangle in the macroeconomy. Changes in monetary policy since the 1970s make extracting lessons from the first two big oil shocks exceedingly difficult. Policymakers are stuck with the inevitable uncertainty that remains.

As Greece inches closer to defaulting on its pile of sovereign debt, European leaders must move quickly to recapitalize the continent’s exposed banking sector, says EU economics expert Jacob Funk Kirkegaard.

There is a popular belief that once U.S. petroleum expenditures exceed some threshold, recession results. Writing at the Harvard Business Review blog, Chris Nelder and Gregor MacDonald present this position clearly:   “The connection between oil shocks and recessions has been understood for decades. We have ample historical evidence that when petroleum expenditures reach 5% of GDP, recession typically follows. Annual energy expenditures rose from 6.2% of U.S. GDP in 2002 to a painful 9.8% in 2008, which was immediately followed by an economic crash. And now oil is sending energy expenditures back above 9% of GDP, just as we see fresh indications that the recession persists. This is not a coincidence.”   Some variation on this theme is a consistent feature of both peak oil writings and more moderate warnings about the economic threats posed by expensive oil. Indeed it would not be an exaggeration to say that this sort of worry motivates a large slice of energy policy thinking.   If you scratch the surface, though, claims of a threshold beyond which the economy goes into recession turn out to be pretty shaky.   Let’s start with a basic theoretical point: There is no fundamental reason to believe that 5 percent (or anything similar) should be a magic number. Petroleum expenditures were equal to 4.5, 4.5, and 4.3 percent of GDP in 1970, 1971, and 1972 respectively. Does anyone really believe that the U.S. economy would have gone into recession had that spending been half a percentage point higher?   There’s also an empirical problem: there are many years – 1976, 1977, 1978, 1979, 1983, 1984, 1985, 2006 – in which petroleum expenditures have exceeded five percent that have not coincided with recessions.   In fact the five percent claim rests on only three data points: the two 1970s recessions and the 2007-2009 one.   There is a huge literature attempting to explain all three recessions. None of them, though, tend to be chalked up to high oil spending per se. What does appear to play a large role, particularly in the 1970s cases, is a rapid increase in oil costs that temporarily overwhelms the economy’s ability to adjust. The corollary, though, is that high oil costs reached through gradual increases probably won’t do the same sort of harm.   There is, however, a possible back door explanation for why high petroleum expenditures relative to GDP  seem to correlate with recessions even if they don’t do a good job explaining them: it is easier for petroleum expenditures to undergo big changes in short periods of time if they are starting from a high level. If, say, the price of oil rises 50% from a starting point where petroleum expenditures are 2% of GDP, the change in spending is 1% of GDP; in contrast, if the price of oil rises the same 50% from a starting point where petroleum expenditures are 6% of GDP, the change in spending is 3% of GDP. Whatever your transmission mechanism – supply side contraction, demand destruction, shifts in consumer preferences for durable goods – the 3% jump is going to be far more economically damaging than the 1% one. Indeed the years where oil spending was high but recession was absent generally come from a period where prices were fairly stable.   This is a subtle but important distinction from the oft asserted five percent rule. It suggests that while rising oil costs can lead to substantial economic harm, they do not necessarily need to.  Specifically, it points to the increasing importance of blunting both price volatility and its consequences so long as the world remains in expensive oil territory. Bob McNally and I discussed the volatility problem at some length in a recent Foreign Affairs essay. The compound danger of high and volatile oil prices makes focusing on remedies to that problem all the more important.

In its most recent update to the Budget and Economic Outlook, the Congressional Budget Office projects robust GDP growth of 4.4% in 2014 and 5.0% in 2015.  This projected spurt is unexplained, but appears to have been reverse-engineered from the belief that the United States should return to the trend growth it seemed to be following prior to the financial crisis—as can be seen in the figure upper-left above.  There is precedent for this: after the double-dip recession of the early 1980s, strong growth in 1983 and 1984 quickly closed the gap between actual and so-called potential levels of output—as can be seen above, upper-right.  But the CBO would be wrong to assume that economic history is destined to repeat itself.  In the early 1980s, industrial capacity continued to expand throughout the recession, while the labor force remained at the same level.  The recent downturn, however, has seen declines in both industrial capacity and the labor force of 2% and 5%, respectively—as seen in the bottom figures.  There is little justification for believing that potential economic activity has continued to grow while critical inputs to economic activity—labor and capital—have shrunk.  If potential output has shrunk along with them, then the U.S. faces considerably greater fiscal challenges than the CBO’s analysis implies. CBO: Budget and Economic Outlook Chart Book: Economic Downturn Interview: Reviving U.S. Economic Leadership Steil: U.S. Solvency Rests with 12 Angry Men

The Chicago skyline in fog caused by extreme cold temperatures of -21 degrees. Courtesy Reuters. Regular readers of this blog will know that I’ve had a day job at Eurasia Group, a global political risk consulting firm. And they’ll know, too, that I’ve sometimes blogged or talked about the firm’s work, including what my time there has taught me about the relationship between politics and markets in Asia and around the world. For a guy with a background principally in foreign and national security policy, intensive exposure to the markets—and to financial market participants—has been a great experience. But today is my last day at Eurasia Group. I’ll remain an adjunct senior fellow at CFR and will, of course, continue blogging here at Asia Unbound. But I’m taking up a new job as the first executive director of the Paulson Institute, an independent center, located at the University of Chicago, established by former Treasury Secretary and Goldman Sachs CEO Hank Paulson. The institute will promote economic activity and cross-investment, leading to the creation of jobs, as well as encourage progress in environmental protection and the development of alternative sources of clean energy. Its aim is to promote sustainable economic growth and a cleaner environment around the world, focusing initially on concrete actions by businesses and governments in the United States and China—the world’s two largest economies and energy consumers. I’m readying myself for a steady diet of Cubs games, Bears tailgates, and a very cold winter. And I’m looking forward to continued interchange with readers of Asia Unbound.

Amid fears of another global recession, investors are focused on U.S. policymakers. Restoring confidence in the world’s largest economy will require both national sacrifice and innovation--not more Fed intervention, says CFR’s A. Michael Spence.

A resident cycles past the Wumen Gate of the Forbidden City in Beijing. Reuters/Jason Lee. As Vice President Biden meets with Xi Jinping and other Chinese leaders this week, his number one economic talking point is almost certain to be about “rebalancing.”  Nearly all of Washington’s principal economic concerns, from currency valuation to Chinese industrial policy, touch this central issue.  But, quite frankly, rebalancing is not just an American goal.  It is, too, a Chinese objective because Beijing’s existing growth model—predicated on the two pillars of exports and capital-intensive investment—is delivering diminishing returns, and China’s savvy leaders know it. A major new report from Eurasia Group, China Great Rebalancing Act, explains why. First, a little truth in advertising:  I’m the head of the Asia practice group at Eurasia Group, so I helped write the report.  But our team’s report is well worth reading because it provides a very comprehensive overview of the forces and dynamics shaping the future of China’s political economy. The report looks at Beijing’s rebalancing efforts from various angles, including income; domestic finance; energy supply, demand, and pricing; labor trends; and economic geography.  Its bottom line is this: China’s leaders are committed to altering their country’s macroeconomic landscape.  They have correctly diagnosed many of the maladies that ail China’s economy and, at least on paper, have prescribed many of the right solutions.  But China’s leaders do not have the political stomach to take the toughest rebalancing steps.  And that means they will put off the most difficult decisions about how—and how quickly—to rebalance China’s economy.  From our vantage point, that means Beijing will confront starker political choices down the road. If you’re interested in the future of China’s political economy, I urge you to read the paper at the Eurasia Group website.

As Germany and France look to contain a mushrooming sovereign debt crisis, the eurozone will have to consider greater political integration or face a crumbling of the common currency zone, says EU expert Daniela Schwarzer.

Global markets’ reaction to eurozone turbulence and S&P’s downgrade of U.S. debt add uncertainty to U.S. foreign policy, raising questions about which goals the country has the means to pursue, says CFR’s James M. Lindsay.

U.S. Vice President Biden speaks at the U.S.-China Strategic and Economic Dialogue (S&ED) in Washington, DC, May 2011 (Courtesy Reuters/Kevin Lamarque) In her latest post, my colleague, Liz Economy, asks:  What will Vice President Biden find in China?  I thought I’d try out my own response to this very direct question: 1.  Biden will find a China whose rise depends on economic growth but whose growth model is no longer sustainable. Bluntly put, China’s leaders know that their capital-intensive, export-oriented approach is delivering diminishing returns and threatens to become a major political vulnerability for the government. The global economic crisis provided clear evidence that China’s export-driven economy is vulnerable to dips in demand in the rest of the world. Meanwhile, its dependence on investment has introduced distortions and imbalances into the Chinese economy. Why should this matter to Biden and the United States? Washington has spent years urging China to “rebalance” its economy:  China produces much and consumes little, while the U.S. consumes much and wants to produce more (in part to sell to China). The bottom line is this: Beijing lacks the political stomach to undertake the toughest rebalancing steps (for instance, a rapid appreciation of the renminbi) but the good news is that, for self-interested reasons, its leaders are committed to rebalancing and will take some steps that are in the U.S. interest.  And ironically, it’s probably worth asking whether, from a Chinese perspective, the ongoing U.S. debt crisis may even create some additional incentives to reckon with China’s own imbalances. To use the pregnant phrase from a Reuters article this morning, could China now "reprice U.S. risk"? 2.  Biden will find a China whose social and political fabric is fraying. A spate of headlines about truckers’ strikes and ethnic unrest shows just how brittle China’s polity is. China is beset by rural protest.  It has one umbrella labor federation but faces sporadic and unpredictable strikes. China’s leaders have been effective at blunting the political effects of this discontent through a combination of carrots and sticks. Still, the challenges are growing. (And if you need more evidence, see the angry public reaction to China’s recent high-speed rail crash). Why should this matter to Biden and the United States? Two reasons:  First, it means China’s leaders are preoccupied domestically and will be (mostly) uninterested in what the U.S. has to say. Second, it means China’s leaders will probably dismiss U.S. calls for political reform with even more than their usual vigor. The regime is likely to meet challenges to its stability with an increasingly assertive mix of blandishments and force. Beijing (and local officials) will co-opt some demands of the discontented, not least by hiking wages and funding social housing (which, incidentally, may be marginally helpful in promoting economic rebalancing).  But they will also build, deploy, and ultimately use paramilitary and police capabilities while cracking down hard as incidents arise. 3.  Biden will find a China whose cautious leaders prefer incremental steps to bold action. Beijing is facing this litany of development and social challenges against the backdrop of a cacophony of voices and views. Some voices represent entrenched domestic interests and are deeply invested in the status quo. For their part, as conservative technocrats, China’s leaders tend to split the difference between these competing groups. The result is a strong bias toward incremental policy change that should persist until China’s next leaders take office in 2012, and probably even beyond that. Here are two examples:  Chinese leaders broke the renminbi’s peg to the U.S. dollar in 2010 but have chosen to implement their decision incrementally. Similarly, China voted for new sanctions on Iran in the UN Security Council but offered assurances to insulate Chinese interests from the fallout with Tehran. Why should this matter to Biden and the United States? For one, it means domestic Chinese allies will be essential if the U.S. is to elicit cooperation from China. Foreign pressure generally only works to the extent that it aligns with the objectives of one or another of the interest groups Chinese leaders seek to balance. But perhaps more important, it also suggests that while China’s commitment to rebalancing is real, this process will move more deliberately than anyone in Washington would like. From Beijing’s vantage point, an uncertain global environment, combined with inflationary pressures and a leadership transition at home, dictate caution rather than boldness. And the kind of incrementalism that Chinese bureaucrats favor isn’t going to mesh with American expectations and exhortations. 4.  Biden will find a China that is being asked to assume global responsibilities but is (very) reluctant to do so. To use my former boss, Bob Zoellick’s, famous phrase, China is a “stakeholder” at many of the top tables of international relations. It is a permanent member of the UN Security Council, a WTO member, and a signatory to protocols on everything from ozone depletion to chemical weapons. It is a member of the G20 (which has largely supplanted the G8) and has a seat on the Financial Stability Board. But China has proven itself to be a reluctant stakeholder, often content to continue taking a free ride on the provision of public goods by others. Why should this matter to Biden and the United States? In some areas, China will push back hard against steadily building international expectations that it match its new economic clout to tangible actions in concert with others. Often, China will continue to insist that, as a developing country with its own litany of challenges, it cannot be expected to shoulder "unreasonable" burdens.  And that will mean growing resentment of China, not least in the United States, as many argue that Beijing is punching below its weight. This, in turn, will feed a parallel process of resentment in Beijing, as some Chinese argue that the country is punching above its weight by supporting global growth and becoming a new demand driver in the face of a slowdown in the U.S. and austerity in Europe. 5. Biden will find a China where security hawks preen and posture. Finally, here is something Biden should contemplate: For some in China’s strategic class, recent events have reinforced breathtaking conclusions about China’s “rise” and American “decline.” Many, both in and out of China’s government, want to test what Beijing’s growing weight might yield. They are confident of China’s growing strength. And they relish the opportunity to, at minimum, make Washington work harder for Chinese support of ostensibly shared objectives. Why should this matter to Biden and the United States? As I’ve blogged here on Asia Unbound before, the United States and China share more interests than, say, ten years ago (much less twenty or thirty years ago). But translating that common stake into complementary policies will remain elusive unless the two countries’ threat assessments begin to converge. And even when Beijing does share America’s sense of threat, countervailing interests too often obstruct cooperation. Combine that with other tensions in the relationship—not least in Asia, on everything from U.S. arms sales to Taiwan to the South China Sea—and the U.S. and China are likely to face a period of greater security tension.

U.S. lawmakers’ brinkmanship over raising the debt ceiling could have prompted a series of moves--the downgrading of U.S. debt by Standard and Poor’s being one--that could cause a selloff of U.S. securities and an end to the primacy of the dollar, writes CFR’s Francis Warnock.

Despite global market fears of a U.S. credit downgrade, U.S. treasuries will remain the safest bet for international investors, says global economics expert Kent Hughes.