Tuesday, April 3, 2012

Reinhart and Rogoff Fight the Fed

In 2009, Drs. Carmen Reinhart and Ken Rogoff published This Time Is Different: Eight Centuries of Financial Folly. This academic work became topical as it was nearing its completion due to the "Great Recession". They added a long ending chapter to deal with the crisis and predicted a great deal of what has transpired: several years of falling housing prices, shift of debts to the sovereign, slow employment gains well after the recovery began, among other things. They did this because they felt that the Great Recession was not different from other financial crises throughout history.

There is now revisionism at the Fed, which they rebut in a Bloomberg.com article published yesterday titled Five Years After Crisis, No Normal Recovery. Here are excerpts:

With the U.S. economy yielding firmer data, some researchers are beginning to argue that recoveries from financial crises might not be as different from the aftermath of conventional recessions as our analysis suggests. Their case is unconvincing.

The point that all recoveries are the same -- whether preceded by a financial crisis or not -- is argued in a recent Federal Reserve working paper by Greg Howard, Robert Martin and Beth Anne Wilson. It was also discussed in a recent article in the Wall Street Journal.

It is mystifying that they can make this claim almost five years after the subprime mortgage crisis erupted in the summer of 2007 and against a backdrop of an 8.3 percent unemployment rate (compared with 4.4 percent at the outset of the financial crisis).

Later, they strengthen their case:

What is striking about the Howard, Martin and Wilson Fed study is that it doesn’t really dispute our finding that recessions that financial crises are worse in terms of depth as well as duration. Instead, it argues that one should be more interested in a much narrower question: Once they begin, recoveries after financial crises are typically just as strong as those that follow a typical recession.

We admit that this time is different in one important respect: The goal posts many analysts use to assess economic outcomes seem to shift from data point to data point. When we first identified that financial crises were associated with severe recessions, the rosy-scenario crowd responded that the Great Moderation had smoothed the business cycle. Recessions in the new era were short and shallow.

After the crushing contraction, a new metaphor held that the harder the fall, the more vigorous the bounce back. Nonetheless, what followed was an anemic recovery that has yet to pull per capita annual real GDP back to the level of 2008.

Now, the staff of the Fed hopes to shift the goal posts yet again. Their advice is to forget about the problems of the past few years and focus on the coming expansion that they forecast using their own idiosyncratic interpretation of business-cycle dynamics across 59 countries.

Finally, they suggest that simply avoiding a recession or deceleration in economic growth might be the best we should hope for:

Is the U.S. on track to an ever brisker recovery in which the jobs numbers -- which have already turned from 100,000 to 200,000 a month -- start showing 300,000 or even 400,000 net new jobs a month?

Perhaps. We hope for good news at the end of the week when jobs numbers are released...

But considering the huge and rising debt levels in the U.S., and the very limited extent to which deleveraging has taken place in the household and government sectors, we would be pretty happy to see a few straight years of trend growth, even if that falls short of the V-shaped recovery that some see around the corner. It might happen, but the historical evidence is at best mixed.

To interpret, they are asserting that too many debts were incurred during the booms to make economic acceleration likely. Why were they incurred, and why were so many debts not self-liquidating? It is difficult not to point to central bank stimulative policies as a key reason, though of course the Fed does not act alone.

From an investment standpoint, strangely it can turn out that a muddle-through recovery that avoids other than the mildest of recessions (which might not be defined by the experts until it had passed) can continue to allow the permissive financial environment in which the different assets of bonds, stocks, and gold all appreciate in nominal terms. This in fact is what happened in yesterday's trading. It is an unstable equilibrium, but it is precisely what has been happening the past few years. Eventually these assets "should" have major trend divergences. When and how, or even if, these disparate markets go their own ways is the major question for longer-term investors that I see.

(An unrelated note: Over the weekend, I mentioned that I had sold most of my AAPL stock last week. The price fell late Friday, and a favorable iPad survey was released yesterday morning. I am a member of the group that was surveyed, and the members-only data that was not released publicly was also quite strong for Apple. Thus I took advantage of the dip and bought back in. From here on, because this site is not a stock site, I am not going to comment on short-term trading, and regret that I mentioned it.)