Another Observation on the Yield Curve

As a follow-up to my recent post about recessions and the yield curve, reader Joan F. points us to a piece by the FT’s James Mackintosh. The money quote:

[T]hose keeping faith in recovery also point to the fact that the yield curve has not inverted – 10-year bonds still yield 2 percentage points more than two-year bonds. Given that the 10-year yield has dropped below the two-year (and the three-month) before every recession since the second world war, perhaps a double dip is not looming.

Unfortunately, a quick glance at Japan suggests that once short-term rates hit the floor, the yield curve may no longer be a valuable indicator. While it warned of the recession that followed the bursting of Japan’s bubble, it missed the three recessions since.

Further Signs of a Slowdown

As expected, BEA’s second stab at GDP growth for the second quarter was even less inspiring than the first. Headline growth was a tepid 1.6%, down from the 2.4% previously reported. Consumer spending and business spending on equipment and software were actually stronger than earlier estimates, but business structures, inventories, and exports all weakened, while imports (which deduct from GDP the way BEA calculates it) grew faster than previously expected.

Last month I pointed out one, small silver lining in the original GDP report: every major category of demand had increased. That is still true in the revised data, although structures just squeaked by with a miniscule 0.01 percentage point contribution to overall growth:

Investment showed particular strength. Business investment in equipment and software (E&S) grew at a 25% pace, thus adding about 1.5 percentage points to overall GDP growth. Boosted by the end (hopefully permanent) of the new homebuyer tax credit, housing investment grew at a bubble-like 27% pace (adding about 0.6 percentage points to GDP).

Despite solid growth in disposable incomes–up 4.4% adjusted for inflation–consumer spending grew at only a 2.0% pace.  As a result, the saving rate increased to 6.1%, compared with 5.5% in the first quarter.

And then there are imports. As I’ve discussed before, BEA calculates GDP by adding up all the components of demand for U.S. products–consumers, businesses, governments, and export markets–and then subtracting the portion of that demand that is supplied by imports. That means that any growth in imports appears as though it subtracts from overall economic growth.

That happened in a big way in the second quarter. Imports grew at a brisk 32% pace, thus subtracting (using BEA’s accounting approach) 4.5 percentage points from overall growth. Which is why all those blue bars in the graph net out to only 1.6% GDP growth.

I should also note that BEA’s calculation of contributions to GDP growth, which I graphed above, is subject to the same criticism that I’ve leveled at the claim that consumer spending is 70% of the economy. In a perfect world, an appropriate share of the imports (the red bar) would be netted against each of the components of demand (the blue bars). The result would be a graph of contributions that would truly illustrate how much each category of demand actually contributed to U.S. GDP growth. I hope to take a crack at that in the future (but I said that last month, too).

The Yield Spread and the Odds of Recession

Worries about a double-dip recession have spawned much economic commentary … and a humorous country and western song. So how likely is a return to recession?

Researchers at the San Francisco Fed took a crack at this question a few weeks ago. Their answer? It depends.

When they used a traditional model based on the leading economic indicators, the probability of a second dip turned out to be about 25% over the next two years (the blue line). When they dropped one indicator from their model, that probability doubled to about 50% (the red line).

That important indicator is the yield spread–the difference between the 10-year Treasury interest rate and federal funds rate. In recent decades, the yield spread has done a terrific job at anticipating recessions. When the federal funds rate has risen above the 10-year rate, the economy has invariably fallen into recession.

As I noted briefly the other day, the relative steepness of today’s yield curve (10-year rate about 2.5 percentage points above the fed funds rate) thus suggests, by itself, that renewed recession is unlikely, despite recent weak economic data. On the other hand, there are reasons to believe that this time things are different (usually a scary phrase). After all, fed funds rate has been pushed down almost to zero and yet the economy no longer appears to be responding. That’s exactly the logic that inspired the SF Fed researchers to try their model without the yield spread.

Investors Should Be Prepared to Face Financial Oppression

That’s the conclusion of a new report by Morgan Stanley analyst Arnaud Mares.

And what, you may ask, is financial oppression? Speaking from the perspective of investors in sovereign debt, Mares defines it as “imposing on creditors real rates of return that are negative or artificially low.” Which doesn’t require outright default. Instead, it

[C]an take other forms: repaying debt in devalued money (e.g., through unanticipated inflation), taxation or regulatory incentives on institutions to purchase government debt at uneconomic prices.

Mares sees sovereign creditors as tempting targets when over-indebted governments decide which of their many fiscal promises they can’t keep.  After all, elderly pensioners cast more votes than coupon-clipping bond holders. And he thinks current low yields provide little protection against that threat.

His piece is definitely worth a read if you want to consider a bearish view on U.S. and European sovereign credit.

A New Price Tag for Stimulus: $814 Billion

Last week the Congressional Budget Office released updated budget projections — a treasure trove of information for budget wonks. For example, CBO released new estimates of the direct budget costs of the 2009 stimulus bill, officially known as the American Recovery and Reinvestment Act (ARRA).

CBO now estimates that ARRA will cost $814 billion from 2009 through 2019. That’s up from the original $787 billion estimate, but down from the revised, $862 billion estimate released in January.

Spending exceeded original expectations because both unemployment and food prices rose more than anticipated, driving up the cost of extended unemployment benefits and expanded food stamp benefits. On the other hand, spending estimates have come down because “recently enacted legislation rescinded some of the funds appropriated in ARRA and limited the period in which higher payments under the Supplemental Nutrition Assistance Program [formerly known as food stamps] will be available.” (CBO did not update estimates for the tax provisions in ARRA.)

For a discussion of why the $814 billion figure (formerly known as the $862 billion figure or the $787 billion figure) is not really the right measure of stimulus, see this post.

On a related note: Earlier today, CBO released an updated analysis of the economic effects of ARRA. It estimates that ARRA reduced unemployment in the current quarter by 0.8 to 2.0 percentage points. In other words, without that stimulus CBO believes that the unemployment rate today would be between 10.3 percent and 11.5 percent, not the 9.5 percent reported in July.

No, the Web Isn’t Dead (Yet)

Wired’s cover story this month, “The Web is Dead,” features the following chart showing the portion of internet traffic in different uses:

Over the past few years, peer-to-peer services and video have gobbled up an increasing share of traffic, while the “traditional” web — you know, surfing from site to site, reading your favorite blog about economics, finance, and life, etc. — has been declining.

Chris Anderson cites this as evidence of the pending death of the web. To which there is only one thing to say: wait a minute buster. Just because the web’s share of total bits and bytes is falling doesn’t mean it’s dying. Maybe it’s just that the other services are growing more rapidly.

One of the benefits of being off the grid for a week-plus is that other commentators have already had the same thought and have tracked down the relevant data. Kudos to Rob Beschizza at BoingBoing for charting the data in absolute terms. Rather than dying, the web is still growing like fresh bacteria in a petri dish:

Double Dippin’

I am more than a week behind on this, but in case you missed it, Merle Hazard has a new ditty out called “Double Dippin’.” This comes with a warning: the opening scene may make you crave ice cream:

Rising concern about a double dip makes sense given the weakness of recent macroeconomic data. On the other hand, it would be highly unusual for the United States to fall into recession with such a steep yield curve.

I Found What I Was Looking For …

Just back from eight days in southeast Alaska. I won’t torment you with too much of a travelogue (my wife and I have another blog for that; so far it covers the first day of the trip).

But I will note that we did find puffins, glaciers, and humpback whales, as wished in my last post. And what about grizzly bears? Well, we got those too, albeit with an asterisk. Turns out that the salmon-eating coastal bears are called brown bears, while their inland cousins are the grizzlies. Learn something new every day.

For bonus points, we also found salmon-eating black bears:

Fiscal Policy in Interesting Times

Back on August 5, I gave a speech at the Retirement Research Consortium’s annual conference “Retirement, Planning, and Social Security in Interesting Times.” I’ve been saving up the link to the C-Span video to share during my vacation.

Here it is. (I hope the link still works; if not, I will fix it once I get back on the grid.)

Keeping with the spirit of the event, I spoke about “Fiscal Policy in Interesting Times.” And with that title, I simply had to mention the famous curse, “May you live in interesting times.”

As the helpful folks at Wikipedia point out, chances are good that this curse originated in England or the United States not, as often alleged, China. Regardless of its origin, it’s still an excellent curse, which I remember my mom invoking often in my childhood (rhetorically, I should note, not at me). For an audience of policy researchers, however, it’s a curse with a silver lining. We may not want interesting things to happen (financial crises, trillion-dollar deficits, 9.5% unemployment, etc.), but they do increase the odds that policymakers, journalists, and the public will pay attention to what we are saying (whether they should is a separate question …).

What makes today particularly interesting is that we face lots of uncertainty and major challenges. That a potent mix. We know less about what’s going on than usual, but we are playing for bigger stakes. Case in point: Fed Chairman Ben Bernanke’s recent statement about the outlook being “unusually uncertain” while the economy still struggles to heal from the financial crisis. Is it a rebound or a relapse? I fear it may be the latter, but we just don’t know.

The meat of the speech considers the economic and fiscal uncertainties and challenges we face. For example, I lament the ridiculous uncertainty in our tax system. Not only do we not know what will happen in 2011, after the scheduled expiration of the 2001 and 2003 tax cuts, we don’t even know what the tax code is in 2010. Will there be an AMT patch? A retroactive change to the temporarily extinct estate tax? What about the (in)famous tax extenders?

I wrap up by sharing one other thing I learned from Wikipedia. The “interesting times” curse is apparently the mildest of a trio of curses.

If you are feeling really mad, the appropriate curse is “May you come to the attention of people in authority.” Which again is rather a mixed curse for policy researchers who want policymkaers to pay attention.

And if you are really, really mad, then you should bring out the worst of the curses: “May you find what you are looking for.”

P.S. At the moment, I am looking for puffins, humpback whales, glaciers, and grizzly bears.

It’s Back-to-School Season, Time to Lay Your Bets

According to an article over at the Huffington Post (ht Natalie), students at 36 colleges will have a new option when they start classes this fall. Thanks to an outfit named Ultrinsic, students can now bet on whether they will get good grades. Students put up money at the start of the semester and then get payoffs at the end depending on how they do.

Calling it a bet isn’t completely fair, however, since the payoff creates an extra incentive for students to do well. So think of it as a combination of betting (if you think your odds of doing well are better than Ultrinsic thinks) and using a financial incentive to get your future self to study a bit harder. Naturally, Ultrinsic emphasizes the incentive perspective in describing its “Reward” product:

Do you like getting good grades? The right amount of cash should provide you with the needed motivation to pull all-nighters and stay awake during the lectures of your most boring professors. At, you will be able to earn cash while working to achieve your academic goals.

Obligatory note to my new crop of students: all-nighters are generally not an optimal learning strategy.

Like a race track, the company offers packages that pay off not only if you do well on a single course, but also if you perform well in multiple courses or over an entire semester. If a new freshman is really feeling motivated, he or she can also put down $20 up front for the opportunity to win (earn?) $2,000 for maintaining a 4.0 GPA throughout college.

And if students are feeling risk-averse, they can also buy insurance against bad grades. Bomb that final and get a cash reward.

Somehow I doubt many students will want to buy such insurance. Or that Ultrinsic will want to sell it given the risks of moral hazard. Perhaps Ultrinsic will screen for “pre-existing conditions” (like failing a related class) in order to limit the adverse selection. Or just offer such high premiums that only a few extremely risk-averse (or mathematically-challenged) students will apply.

The incentives product, however, seems much more promising. Indeed, it resembles some other efforts to help people modify their own behavior through financial incentives. See, for example, the folks at whose service allows users to create their own incentives. For example, you could commit to give $500 to your favorite charity if you fail to lose 10 pounds by Christmas. Even better, you could commit to give $500 to your least-favorite charity if you fail to drop the pounds.

Ultrinsic is just applying this logic to college grades … and kindly offering to take a cut when students fall short.