Outlook for the U.S. Economy

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Outlook for the U.S. Economy
Phillip LeBel, Ph.D. Department of Economics and Finance School of Business Montclair State University Lebelp_at_mail.montclair.edu
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A primer on economic forecasts1.
Economic forecasts are based on an extrapolation
of past trends.2. As long as past events are
similar, forecasts will tend to be more
accurate.3. Recent turbulence in U.S. financial
and economic markets makes forecasting more
difficult.4. This said, what can we say about
prospects for current economic recovery?5. To
answer this question, we have to ask how did we
get into this recession in the first place and
how does it compare with previous recessions?
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Booms and Busts
in Economic Activity The principal indicators
of economic activity are the Gross Domestic
Product, or GDP, the inflation rate, and the
unemployment rate. When the GDP grows at too
fast a rate we generally have inflation, and when
it grows too slowly we generally have
unemployment. Business cycles, which include
booms and busts, are determined primarily by
variations in GDP growth around a trend of
non-inflationary full-employment growth. It is
this trend that serves as the focus of monetary
and fiscal policy.The Gross Domestic Product
(GDP) consists of several components1.
Personal consumption expenditures (fairly
stable)2. Gross Private Investment (fairly
volatile, and tied closely to the stability of
financial markets)3. Government spending on
goods and services (fairly stable)4. Exports
minus imports (relatively stable and correlated
to items 1 and 3)So what does this tell us?
The primary source of economic instability is
financial instability, which in turn affects
investment instability and thus the GDP. The
primary source of financial instability is
shifting expectations by consumers and investors.
These shifts are based on imperfect information
between buyers and sellers. These imperfections
can lead to major distortions in the allocation
of resources. Evidence shows up in terms of asset
volatility, be that in stocks, commodities, or in
housing, and then spreads to the real
economy.
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Booms and
Busts in Perspective
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Economic Forecasts Are
Based on Measures of
Dependence and Interdependence
Many of these models fail to take into
consideration information myopia, which leads to
the creation of asset bubbles that cause economic
instability.
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Asset Bubbles in Stocks, Real
Estate, and CommoditiesAsset bubbles and
financial crises derive from Informational myopia
and differing attitudes toward risk. Myopia
derives from three forms of perception bias in
which individuals rely on heuristic, or
short-term proxies, to make decisions 1. The
status quo heuristic i.e., perceptions of risk
anchored in the recent past 2. The law of
small numbers heuristic (also known as the
representative heuristic as well as disaster
myopia) 3. The availability heuristic (e.g.,
relying only on the information of immediate
personal contacts). When such perceptions
prevail, one is drawn to the conclusion (and
illusion) that rising asset prices somewhere in
the economy will persist and never face a
correction that reflects historical patterns over
the long run (e.g. gold and diamonds will never
decrease in value real estate is a risk-free
investment because housing prices will never go
down). Under these circumstances, people
engage in herd behavior, looking at what others
are doing and assuming that they have at least as
good information as you. You then act accordingly
with the same limited information as they do,
which, in the end, works to disastrous results
through some kind of correction in which
defaults and bankruptcies arise as prices adjust
to more sustainable levels in line with
longer-term behavior. Finally, how individuals
make decisions depends in part on their
fundamental attitudes toward risk, i.e. risk
aversion, risk neutrality (the expected outcome
is zero), and risk loving (i.e. gambling, in
which the expected outcome is negative). Although
most individuals are to some extent risk-averse,
incentives, especially those arising from public
policies, persuade them to take on risks whose
true probabilities may not be known to
them.Imperfect asymmetric information and
differing attitudes toward risk explain much
behavior in the stock market (e.g. the tech
dot.com boom of the 1990s) and in the real estate
boom of the 2000s. In each case, or in
combination, investors think they are in some
kind of new economy in which prices can never
turn downward. As a result they take on more
leveraged financial decisions, be that on Wall
Street or on Main Street, in the belief that
increasing asset values will compensate for the
perceived small risks they confront. Such
behavior is the essence of a bubble economy.
When price increases are no longer sustainable,
the bubble bursts to some more historically
sustainable level, as has always been the case in
the past. And out of such collapses, inevitably
we discover someone vying for the Ponzi investor
fraud scheme award of the century, as Bernard
Madoff did until recently with asset losses of
some 50 billion.
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Some Evidence of Asset Bubbles

• Asset bubbles consist of rising prices in such
  areas as stocks, housing, and primary commodities
  such as gold and silver that are unsustainable
  relative to historical norms. Individuals have
  underlying time preferences that may be similar
  to prevailing interest rates. If not,
  individuals will seek, and take the corresponding
  risks, of alternative asset investments rather
  than rely on bank time deposits, cds or even the
  stock market. Lacking transparent and symmetric
  information, individuals thus help to creating
  and drive asset bubbles.

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Asset bubbles arise for two basic reasons1.
Imperfect information between buyers and sellers
that leads to herd behavior.2. Government
policies that create incentives to drive up asset
prices beyond historical norms.

• In making decisions, we all face the problem of
  imperfect information. Given that perfect
  information is costly, individuals wind up taking
  risks based on subjective perceptions of risk.
  Worse yet, imperfect information is often
  distributed asymmetrically between buyers and
  sellers (e.g. used car lemons). Even when
  government agencies step in to reduce information
  asymmetries (e.g., full disclosure on credit
  card contracts, warranties on used cars, FDIC
  insurance to protect depositors), institutions
  and individuals still may engage in moral hazard.
  
• Moral hazard arises when individuals take on
  additional risk in the presence of external (e.g.
  government) guarantees, or insurance, leading to
  higher default probabilities, and in which some
  third party often may be saddled with the
  financial costs (e.g. ARM home equity loans to
  pay off credit card debt that when resets occur
  lead to higher default rates on mortgages and
  credit cards).
• Reducing the likelihood of asset bubbles and
  financial crises depends in part on measures to
  create greater transparency that can reduce the
  problem of asymmetric information. Greater
  government regulation may or may not reduce the
  problem of moral hazard unless the impact of
  financial incentives is carefully examined and
  taken into consideration.

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Government Policies that Foster Asset
BubblesPublic policies are often driven by
political incentives that help decide elections.
Helping individuals to own stocks and housing
seems laudable at first blush, but when the asset
bubble consequences are considered, these
measures may be counter-productive. Some
examples1. Federal Reserve Bank (est. 1913)
Interest Rates. In the absence of significant
general price inflation, low interest rates
foster speculation in housing and equities, a
policy that operates through the Federal Reserve,
which is ultimately accountable to Congress.The
Federal Reserve Bank was established Congress in
1913, and signed by President Woodrow
Wilson.Until the latest recession, the Fed did
not consider it as responsible for asset bubbles,
just the macroeconomic tasks of managing the
money supply and interest rates to achieve
non-inflationary full-employment.2. The
Depository Institutions Deregulation and Monetary
Control Act of 1980 (DIDMCA) - By eliminating
ceilings on depository interest accounts at
Savings and Loan Associations this helped to
create the SL financial crisis of the late
1980s. The 1980 legislation also raised the FDIC
insurance limit from 40,000 to 100,000. It
further allowed Credit Unions and SLs to offer
checking account services, while at the same time
authorizing financial institutions to charge any
loan rate of interest they chose. DIDMCA was
signed by President Jimmy Carter.3. The Garn-St.
Germain Depository Institutions Act of 1982
(GGDIA) (PL97-320) - Extending deregulation of
SL institutions, GGDIA introduced Adjustable
Rate Mortgages (ARMs) in the housing financing
mix. It also allowed anyone to place real estate
assets in a trust without triggering the
due-on-sale clause that otherwise would give
lenders foreclosure rights on transfers of
property. GGDIA was signed by President Ronald
Reagan.4. The Graham-Leach-Bliley (GLBA), or
Financial Services Modernization Act of 1999 (PL
106-102). This legislation repealed the
Glass-Steagall Act of 1933 that had separated
commercial from investment banking. GLBA allowed
commercial banks, investment banks, securities
firms and insurance companies to form
conglomerates to offer diversified financial
services (e.g. Citicorp became Citigroup when it
acquired Travelers Insurance Company in 1998
that led to GLBA passage). In a series of votes
and amendments, the legislation was approved by a
veto-proof Republican majority in both the Senate
and House. The bill did not cover non-bank
financial institutions such as AIG, that
subsequently used offshore trading in derivatives
that resulted in large losses by 2007-2008. GLBA
was signed by President Bill Clinton. In terms
of remaining regulatory functions, The Federal
Trade Commission (FTC) has jurisdiction over
non-bank mortgage lenders, loan brokers, some
investment advisers, debt collectors, tax return
preparers, banks, and real estate settlement
service providers, while commercial banks are
subject to regulation by the Federal Reserve, the
Office of the Comptroller of the Currency (OCC),
and state agencies. The Securities and Exchange
Commission (est. 1935), retains jurisdiction over
stock market transactions. These alphabet soup
agencies have often had overlapping
responsibilities but have not always shared
regulatory standards, findings, or actions.
Opacity and laxity in regulation by the agencies
helped to create the downturn that began in 2007.
Also, HUD upped the required purchases of
mortgages for low and moderate income HHs.
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Financial Innovations to Manage
Risk1. Hedge Funds (1966) - Limited Liability
Partnerships exempted from the provisions of the
1933 Securities Act and the 1940 Investment
Company Act, which restrict the operations of
mutual funds and investment banks with respect to
leverage and short-selling. Hedge funds have
operated outside of any formal regulatory
structure, even though some have been bailed out
(e.g., the Federal Reserve bailout of Long Term
Capital Management in 1999).2. Structured
Investment Vehicles (SIVs) (1988) - Created by
Citibank, these are funds that borrow money by
issuing short-term securities at low interest and
then lend that money by buying long-term
securities at higher interest, making profit from
the difference. SIVs ceased to exist as of
October 2008, with the onset of the latest
recession. Also known in Europe as Special
Purpose Entity (SPE).3. Mortgage-Backed
Security (MBS) - First used by the Government
National Mortgage Association (Ginnie Mae, est.
in 1968), in 1970, these consist of government
backed securities issued on the basis of
mortgages purchased from originators. These
pass-throughs have been used by the Federal
National Mortgage Association (FNMA, of Fannie
Mae, est. in 1938), and by the Federal Home Loan
Mortgage Corporation (Freddie Mac, est. 1970).
During the latest recession, these institutions
have some 14.6 trillion in U.S. mortgage debt
outstanding. Mortgage-Backed Securities are also
known as Collateralized Debt Obligations (CD0s).
When Collateralized Debt Obligations are
segmented into differing risk tranches (e.g.,
unsecured, mezzanine, senior secured), the groups
derived from the original pool often are referred
to as Derivatives, because their value derives
from the value originating in the initial market
mortgage pool.4. Derivatives - Derivatives are
financial contracts that derive their value from
some other asset, index, event, value, or
condition. Derivatives are considered to be
risk-sharing instruments that operate as a form
of insurance. Derivatives have largely been
unregulated since their expansion in the United
States, which started with the Chicago Mercantile
Exchange in the 18th century and accelerated with
the creation of the Chicago Board of Options
Exchange in 1973. Derivative contracts typically
are exchanged through two types of markets 1.
Over the Counter (OTC) contracts that are traded
on formal exchanges 2. Exchange-traded
derivatives (ETD) that trade via specialized
derivatives exchanges. There are three types
of derivative contracts 1. Futures and Forward
Contracts (e.g. commodity futures) 2. Options
that confer the right but not the obligation to
purchase or sell assets at some stipulated price
at a specific future date and 3. Swaps as
contracts to exchange cash on or before a
specified future data based on the underlying
value of currencies/exchange rates,
bonds/interest rates, commodities, stocks or
other assets. While some option contracts are
visible on exchanges, their appearance in
executive compensation and firms 10K statements
have remained somewhat opaque, masking the
underlying level of risk that a firm confronts.
Up to now, there has been no clearinghouse for
swaps, and they have remained largely
unregulated, posing a problem for transparency in
measuring institutional risk under existing
accounting standards..
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Consequences of
Financial DeregulationIt is easy in retrospect
to blame deregulation as the principal cause of
the current economic recession. Yet, as new
proposals for regulatory reform are put forth,
typically there is a rush to judgment that does
not take into account the subsequent risks of
moral hazard and some future financial crisis.
Consider, for example1. The goal of
broad-based home ownership. This has been an
underlying goal of every US administration since
the Great Depression of the 1930s. In the quest
fo an ownership society, Congress has adopted
any number of incentives and rules in support of
this goal on the assumption that a more stable
and prosperous society would result. Home
ownership rates, which rose from 64 to 68 percent
in the past five years, have been driven not just
by low interest rates. They also have been driven
by government-sponsored public financing entities
(I.e., GSEs) such as Fannie Mae (1938), Ginnie
Mae (1968), and Freddie Mac (1970). These
institutions were pressured by the Clinton and
George W. Bush administrations to promote an
ownership society in housing. Fannie Mae and
Freddie Mac used relaxed accounting standards to
issue mortgage-backed securities to fuel more
housing construction and purchases.By 2007,
Fannie Mae and Freddie Mac were becoming
insolvent and needed infusions of Federal money
to keep issuing mortgage-backed securities, thus
feeding further pricing speculation.3. As
housing prices weakened in 2007, rising defaults
meant pressure to increase liquidity among
borrowers. Stock market prices, which had risen
in tandem with real estate, then took a fall. As
these two assets declined in value, a general
recession even more severe than in 1929 began to
set in. Pulling out of this recession has
involved over a trillion dollars worth of new
public debt spending, casting a shadow over the
health of the economy in the future.
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Public Responses to the Economic
RecessionFinancial deregulation has spawned an
expansion of the value of financial assets and
services at a rate far in excess of the growth
the Gross Domestic Product. In turn, it has led
to levels and rates of increases in financial
service executive compensation that have dwarfed
those in manufacturing or in other sectors of the
economy. When the current recession started in
2007, public attention focused on how such large,
unregulated investment banking institutions as
Lehman Brothers could go bankrupt, and why the
Federal Reserve chose to provide bailouts for
other institutions such as AIG, Bank of America,
and Citigroup, even as bankruptcies and
unemployment rates soared. All of this has led
to emergency measures in the fall of 2008, and
which are the subject of ongoing proposals for
financial reform today. The first key
Congressional measure is the Economic Stimulus
Act of 2008 (PL 110-185). The law provides for
tax rebates to low and middle income taxpayers,
tax incentives to stimulate business investment,
and to increase limits on mortgages eligible for
government sponsored enterprises (GSEs) (e.g.
Fannie Mae and Freddie Mac). It also created the
Troubled Assets Relief Program (TARP), which
authorized the Federal Reserve and the Treasury
to purchase toxic assets of financial
institutions. The cost of the legislation was
estimated at 152 billion and was signed by
President George W. Bush on February 13,
2008.Driven by a decline in the stock market ,
by rising real estate foreclosures, collapsing
investment and lending, Congress adopted in
February the American Recovery and Investment
Act of 2009 (ARIA). The cost of this legislation
is estimated at 787 billion. The legislation
provides for federal tax cuts, expansion of
unemployment benefits, spending increases in
education, health care and infrastructure. At
the same time, there is continuing anger from
Main Street about the return of large bonuses to
Wall Street executives, particularly those that
benefited from TARP Monies. From this we had the
appointment of a TARP pay czar whose effect has
been largely to get Wall Street firms to repay
more rapidly the money they borrowed than might
otherwise have been the case. Continuing
economic weakness has led some members of
Congress to call for a new fiscal stimulus.
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Economic and Financial Bubble
Dynamics
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Economic and Financial Bubble
Dynamics
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Economic and Financial Bubble
Dynamics
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Economic and Financial Bubble
Dynamics
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Economic and Financial Bubble
Dynamics
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Economic and Financial Bubble
Dynamics
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Economic and Financial Bubble
Dynamics
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Economic and Financial Bubble Dynamics
The 1999 vote on Graham-Leach-Bliley

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Economic and Financial Bubble
Dynamics
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Economic and Financial Bubble
Dynamics
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Economic and Financial Bubble
Dynamics
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Are We Moving Out of the Recession
Yet?
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Continuing Asset Volatility and
Weakness
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Testing the Limits of Economic
Recovery
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Economic and Financial Reform Tasks
AheadSource Business Week,
December 28, 2009-January 4, 2010
Fraud Require money managers with more than 10 million to use an independent custodian for client accounts Difficult to legislate moral behavior beyond reliance on open and competitive markets
Conflicts of Interest Require raters to release details on compensation Issuers should provide information on underlying assets of a bond. Credit agencies are paid to rate bonds by the companies that issue them.
Toxic Assets Financial advisers to muni issuers would have to register with the SEC and follow new municipal bond rules. Little impact on containing fraudulent declarations on debt because of limited liability rules.
Biased Advice Brokers who advise would be required to act as fiduciaries, with greater disclosure requirements Industry concentration may increase as smaller firms lose a source of income
Speculation USCFTC and NYME to cap gains from derivatives Some firms engaged in exchange-traded funds used to trade commodities may leave and pursue other business.
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Market Symmetry and Transparency on
Hold
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Are We Creating the Next Asset
Bubble?
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A Cautionary View of the Future
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Selected Bibliography
Malcolm Balen (2003, 2002) The Secret History of the South Sea Bubble, The Worlds First Great Financial Scandal. (New York Fourth Estate Harper Collins).
John Cassidy (2009) How Markets Fail The Logic of Economic Calamities. (New York Farrar, Straus and Giroux).
Edward Chancellor (1999) Devil Take the Hindmost A History of Financial Speculation. (New York Farrar, Straus and Giroux).
Niall Ferguson (2009, 2008) The Ascent of Money, A Financial History of the World. (New York Penguin Books).
David Hackett Fischer (1996) The Great Wave Price Revolutions and the Rhythm of History. (New York Oxford University Press).
Justin Fox (2009) The Myth of the Rational Market A History of Risk, Reward, and Delusion on Wall Street. (New York Harper Collins Business Publications).
Charles P. Kindleberger (1996, 1989, 1978) Manias, Panics, and Crashes A History of Financial Crises. (New York John Wiley and sons)
Roger Lowenstein (2000) When Genius Failed The Rise and Fall of Long-Term Capital Management. (New York Random House).
Charles Mackay (1841) Extraordinary Popular Delusions and the Madness of Crowds. (New York Three Rivers Press 1980 reprint).
Robert Shiller (2006, 2000) Irrational Exuberance, second edition. (Princeton Princeton University Press)
Andrew Ross Sorkin (2009) Too Big to Fail the Inside Story of How Wall Street and Washington fought to Save the Financial System - and Themselves. (New York Viking Publications).