Can it get worse?

A few weeks ago there was some discussion about the prospects of a double dip.  I try to stay out of the fortune-telling business, as I don’t believe I or anyone else can predict the cycle better than markets.  But one line of reasoning that I found less than convincing was the argument that monthly car sales and monthly housing sales are already quite low.  And other parts of GDP aren’t that cyclical.  We know from the 1930s that things can get a lot worse.  If NGDP falls sharply, RGDP will also fall sharply.

But it’s only fair to point out that a month or two later those making the optimistic case (for avoiding the double dip) seem vindicated (knock on wood.)  If so, I’d point to another factor—monetary policy.

In the 1930s the Fed was incredibly passive; hence there was no floor on NGDP, or at least a very low floor.  Since 1982 the Fed has been following something close to a Taylor Rule.  As long as nominal rates are positive, markets have confidence that shocks won’t drive NGDP much lower.  Remember how bleak things seemed right after 9/11?  RGDP actually rose in the 4th quarter of 2001.

In my view there is still a floor on NGDP, even at zero rates, because the Fed still has some credibility.  But the floor is much lower than when rates are positive.  The upshot is that while there might be a mild downturn, I’d be shocked if we had a severe recession.  That’s not to say it can’t happen, but it would certainly be inconsistent with Fed behavior over the past couple of years, when they have used various unconventional stimulus tools when things looked especially bad.  I suppose my biggest fear would be a fast moving crisis, perhaps centered in Europe—with the Fed again letting bygones-be-bygones, and settling for growth rate targeting.

There’s no reason anyone should take any of my hunches seriously.  I didn’t predict the Great Recession until the markets did.  And if there’s another dip, I won’t predict it until the markets do.  All I’m saying is that visualizing the likely Fed response function is the most useful way to explore the possibility of a double dip, not whether various categories of RGDP “can’t go any lower.”


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20 Responses to “Can it get worse?”

  1. Gravatar of marcus nunes marcus nunes
    31. October 2011 at 11:55

    The “technical trader mentality” works like that: “Stock prices are so low, they can oly go up”! “Inflation is so low, it can oly go up”! And on and on. One month ago this report from the ECRI (Economic Cycle Research Institute (what a great name)) caught my eye:

    A second recession in as many years will lead to higher unemployment, lower tax revenue, and poses obvious challenges for stocks, but investors should get used to more frequent up-and-down cycles, Achuthan said.
    “We are in an era of more frequent recessions,” Achuthan noted. The long, benevolent expansions of the 1980s and 1990s that created a generation of stock investors and an equity culture in the U.S. are relics of the past, he said. Going forward, he added, business cycles will be shorter and sharper — as was true in the 1970s and in fact for much of the country’s history.

    It´s good to read that stuff because it gets you to do a post:
    http://thefaintofheart.wordpress.com/2011/10/01/more-gloom-from-ecri/

  2. Gravatar of Gregor Bush Gregor Bush
    31. October 2011 at 11:56

    Scott,

    Have you noticed that many of the economists who “forecast” RGDP by looking at the various expenditure components as if they were all independent variables are also the ones who have trouble wrapping their minds around unconventional monetary policy?

    They model C, I, G, X and M as real variables that are functions of real interest rates, the real exchange rate demographics and of course “pent up demand”. Then they add them up to get RGDP. There are no expectations, there is no real wage channel and only a minimal role for asset prices. They can’t cram an NGDP or price level target into this model so they simply assume that such a policy won’t work.
    Many Wall St/business economists take this approach. I think it’s part of the reason why surveys have consistently found the majority of business economists to be against further monetary stimulus over the past two years. And it’s also why the Goldman Sachs note on NGDP targeting was a big deal (as is the Romer article). Clients are asking economists and market analysts about the idea and what it would mean if the Fed implemented such a policy. And that’s forcing them to re-think their models and to look at the academic work more closely.

    I know it’s been a long and frustrating three years, but you’re making real progress.

  3. Gravatar of JimP JimP
    31. October 2011 at 11:59

    http://blogs.wsj.com/totalreturn/2011/10/31/quantitative-easing-the-wayback-version/

  4. Gravatar of Morgan Warstler Morgan Warstler
    31. October 2011 at 12:09

    Because I think Greenspan now says out loud what Ben thinks, I almost certain this is what the Fed is concerned about:

    “Roughly 10.4 million mortgages, or one in five outstanding home loans in the U.S., will likely default if Congress refuses to implement new policy changes to prevent and sell more foreclosures, according to analyst Laurie Goodman from Amherst Securities Group.

    “Many analysts looking at the housing problem mistakenly assume it is limited to loans that are currently non-performing (or 60-plus days past due). Such borrowers have a high probability of eventually losing their homes. However, the problem also includes loans with a compromised pay history; these are re-defaulting at a rapid rate,” Goodman told a Senate subcommittee Tuesday.”

    http://www.housingwire.com/2011/09/20/amherst-to-senate-10-million-more-mortgages-set-to-default

    ——

    I suspect after ending Obamacare, the single biggest IMMEDIATE benefit to Nov 2012, is that the public / banks will KNOW for certain that the housing is going to clear and fast, without any more discussion about propping up home prices.

    Tax policy will be the real growth mechanism, but it will take a while to get done.

  5. Gravatar of Morgan Warstler Morgan Warstler
    31. October 2011 at 12:11

    “Investors smell a distinct opportunity in this situation: The chance to buy an asset cheaply and rent it out dearly. In fact, close to one-third of the purchases of existing homes this year have gone to all-cash buyers, the bulk of whom are real estate investors,” Humphries said. “Any plan that may upset this balance – such as Fannie and Freddie getting into the rental market and creating competition – will have a chilling effect on private investment in the one segment of the housing market that is performing well.”

  6. Gravatar of W. Peden W. Peden
    31. October 2011 at 12:12

    Gregor Bush,

    The problems of people living in the Real World for so long that they confuse it with the real world are very old. It’s got so bad that one has to explain NGDP as inflation + RGDP, when it is price indexes that we use to derive RGDP numbers.

  7. Gravatar of Ram Ram
    31. October 2011 at 12:13

    Silly hypothesis: things looked bleak until the nominal GDP path targeting discussion went viral. This week, the Fed is expected to at least hint that something like a nominal GDP path target is in the works, and when it doesn’t hint at that, the outlook will again look pretty bleak.

    Silly at least in part because Europe clearly has something to do with the change in market sentiment. But every time I turn on the TV I get the sense that people on the floor of the NYSE really believe the Fed is going to pull a rabbit out of its hat before each meeting, which the Fed then proceeds to disappoint. The markets probably know more than I do, but if recent history is any guide, unless the Fed really raises eyebrows (which it probably won’t), things will start looking foreboding again shortly after its upcoming meeting.

  8. Gravatar of ssumner ssumner
    31. October 2011 at 12:26

    Marcus, Those are good examples.

    Gregor, You are probably right.

    JimP, Interesting article. That makes me think we didn’t really need a Fed. The Treasury could have been lender of last resort

    Morgan, You said;

    “I suspect after ending Obamacare, the single biggest IMMEDIATE benefit to Nov 2012, is that the public / banks will KNOW for certain that the housing is going to clear and fast, without any more discussion about propping up home prices.”

    You mean we won’t have the propping up that occurred last time the GOP held the White House.

    W. Peden, Good point.

    Ram, It may be a silly hypothesis, but that won’t stop me from trying to grab some credit.

    :)

  9. Gravatar of flow5 flow5
    31. October 2011 at 13:32

    “I don’t believe I or anyone else can predict the cycle better than markets”

    It’s only math and that can be taught.

  10. Gravatar of Morgan Warstler Morgan Warstler
    31. October 2011 at 14:12

    Scott, I think you’ll see the GOP be far stronger on:

    1. public employee compensation, note even Romney is saying freeze Federal until 2020.

    2. home prices / fannie freddie

    but they will still run massive deficits, but they’ll be driven by tax cuts, and less spending.

  11. Gravatar of JimP JimP
    31. October 2011 at 14:50

    http://krugman.blogs.nytimes.com/2011/10/30/a-volcker-moment-indeed-slightly-wonkish/

    I suppose everyone has seen this – but I hadnt. Paul K is fully on board.

  12. Gravatar of Tommy Dorsett Tommy Dorsett
    31. October 2011 at 16:05

    Friedman showed that the length and duration of expansions were unrelated to the severity and depth of the recessions that followed. This supports the point that it’s a bad argument to say housing and autos are bombed out so we can’t recess. The big risk is a negative velocity shock that has its roots in Europe’s sovereign debt markets and banks. A nominal GDP level target would help the Fed ward off that risk. Operation Twist and multi-year commitments to ZIRP won’t……….

  13. Gravatar of brian brian
    31. October 2011 at 20:59

    Scott,

    Can it get worse? Yes, and there are scenarios where the Fed could use all the unconventional tools in existence and not have a dent in improve the economy much. Two I can think of are global thermonuclear war and zombie apocalypse.

  14. Gravatar of James in London James in London
    1. November 2011 at 08:42

    We have a saying in equities that once your share has fallen 90% it only has another 90% to go.

  15. Gravatar of ssumner ssumner
    1. November 2011 at 17:34

    Morgan, And far weaker on defense spending, and other GOP favorites.

    Jimp, Thanks for the Krugman link.

    Tommy, That’s a good point.

    brian, agreed.

    James, Yes, that’s true.

  16. Gravatar of John Thacker John Thacker
    1. November 2011 at 17:40

    Scott, I don’t think that the Democrats have been any better on defense recently. Obama even complained that the House GOP budget cut defense too much and threatened to veto it for that reason.

    Higher defense spending is part of the bipartisan consensus.

  17. Gravatar of John Thacker John Thacker
    1. November 2011 at 17:42

    http://www.politico.com/news/stories/0211/49603.html

    “The bill proposes cuts that would sharply undermine core government functions and investments key to economic growth and job creation and would reduce funding for the Department of Defense to a level that would leave the department without the resources and flexibility needed to meet vital military requirements,”

  18. Gravatar of Morgan Warstler Morgan Warstler
    1. November 2011 at 22:37

    Scott, you did it again.

    My argument is the money has to be spent on GOP favorites, otherwise it will go to Dem voters.

    You skipped it and moaned about the GOP again. Their sins are not equal.

    Keeping heroin from your children justifies bad behavior. Keeping Dem voters from thinking they get free shit it worth virtually any cost.

  19. Gravatar of How Will It Get Worse: Monetary Equilibrium in Real Life « Modeled Behavior How Will It Get Worse: Monetary Equilibrium in Real Life « Modeled Behavior
    3. November 2011 at 06:51

    [...] while back Scott Sumner said A few weeks ago there was some discussion about the prospects of a double dip.  I try to stay [...]

  20. Gravatar of ssumner ssumner
    4. November 2011 at 18:27

    John, I didn’t know that. Romney wants to raise defense as a share of GDP, says Obama is spending too little.

    Morgan, I don’t favor the GOP like you do.

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