Over the fold, my column in yesterday’s Fin. Not the final version, as I made some last minute changes in response to Lindsay Tanner’s defence of the Razor Gang yesterday.

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This month’s unemployment news was the worst so far in the recession, with the headline rate rising from 4.8 to 5.2 per cent and some of the components looking bad as well (part-time replacing full-time employment, for example). The main good point was that the participation rate rose, so that the increase in unemployment was (in an accounting sense) largely due to people entering the work force, rather than to net job losses.

We are still doing far better than most other countries, and, if a global recovery emerges towards the end of the year, could still get by with only a moderate recession.

The government has reacted promptly with the fiscal stimulus[1], and the relaxation of monetary policy has also helped. But there doesn’t seem to have been much action to develop direct labour-market policy responses to unemployment (I discuss responses to unemployment here). And there’s a real risk that a contractionary budget will wipe out much of the benefit of the surplus (My Fin piece on this will be up soon).

fn1. In this context, I thought Turnbull’s response, treating every piece of bad news as evidence that the government’s policies have failed, while offering nothing positive of his own, has been both incorrect and politically tin-eared.

Every now and then back in the Dark Ages, I would have to deal with the late, unlamented MS-DOS operating system. It wouldn’t be long, as a rule, before I encountered the message “Abort, Retry, Fail?”

Of these, “retry” sounded the most hopeful so I’d choose it a few times, but I don’t think it ever worked. Usually the best thing was to shut down the machine and start again.

This trilemma struck me when looking at the options for US-based banks, and Citigroup in particular.

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Most of the attention in discussion of the December quarter national accounts was focused on the negative sign of the aggregate GDP number, combined with the seemingly unkillable belief that there exists a “technical definition” of a recession, namely two consecutive negative quarters. An aggregate number anywhere zero is pretty good by comparison with the world economy as a whole, so the real interest is in the components. Ross Gittins The Brothers Grimm move has a nice piece going through the details, and concluding, unsurprisingly that we are in a recession. The aggregate number has some negative bits that should be temporary (inventory rundown and the statistical discrepancy) but against that, we are bound to get more bad news on exports over the coming year. Our terms of trade, which rose consistently during the term of the last government (one reason things turned out so well in terms of the macroeconomy) have started turning down, but there is a long way to go.

The (possibly temporary) good news is that household savings have risen greatly, to 8 per cent of income. It’s reasonable to assume that this reflects a combination of precautionary saving as the prospect of recession hits home, reactions to the huge capital losses of 2008 (reversing the process by which illusory capital gains prompted people to run down household savings), less home equity loans (can anyone find me some data on this?) and the fact that some part of the money handed out in the stimulus package was saved. Unfortunately, as the recession hits home we are likely to see lots of households with declining income, raising the question of whether the improvement in savings can be sustained.

There’s been a lot of confused discussion about the stimulus in this context. On the one hand, it’s obviously desirable that the stimulus should increase consumption. On the other hand, the resolution of a financial crisis requires, among other things that household balance sheets are made sustainable, that is, that household debt should be brought down to manageable levels relative to income (not relative to inflated asset values). This is a tricky problem, but its obvious that if households are going to increase savings, and aggregate demand is not to decline too much, someone else needs to increase their net demand. Since private investment and export demand are almost certain to shrink, that leaves government as the only candidate.
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A reader sent me, for comment, one of those letters that circulate through the Intertubes. This one is sent as “an explanation of the stimulus bill”. I wouldn’t call it that, but it is quite a good exposition of what’s known as the “Treasury View”[1]. If you believe that the economy is like a swimming pool, and that no matter how big a splash some shock (such as the collapse of the financial system) might make, the water in it will rapidly find its own level, then you will agree that there is no need for, or possible benefit from, the stimulus package. And conversely, if you think the economy is not like this, you are entitled to wonder about the kind of economist (regrettably not imaginary) who would employ such an argument.

fn1. The reference is to the British Treasury, circa 1931
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Tyler Cowen has a short post which covers a number of themes I’ve been going on about for ages, though never with a fully satisfactory analysis. He starts by pointing to work by Michael Mandel suggesting that much of the measured productivity growth in the US has been bogus (see also Matt Yglesias on this). I agree, particularly as regards the financial sector.

More interestingly, Cowen goes on to note that

there was some productivity growth but much of it fell outside of the usual cash and revenue-generating nexus. Maybe you will live until 83 rather than 81.5 and your pain reliever will work better. In the meantime you will read blogs and gaze upon beautiful people using your Facebook account. Those are gains to consumer surplus, but they don’t prop up the revenue-generating sectors of the economy as one might have expected.

I agree and I think the implications are profound, if still hard to predict with any accuracy. There has been a huge shift in the location of innovation, with much of it either deriving from, or dependent on, public goods produced outside the market and government sectors, which may be referred to as social production.

Some suggestions, not fully argued, over the fold

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Today’s Fin runs a letter from Standard & Poors responding to my column from last week, reprinted here. Unfortunately the letter is paywalled (if anyone would like to email me the text, I’ll make fair use of it), so you’ll just have to take my word that it contains some interesting semantics. For example, the writer takes umbrage at the suggestion that S&P “threatens” governments with the loss of AAA credit ratings, but does not deny that the agency explains to government that certain policies will lead to the preservation of the rating while others will not. (“Nice little state you’ve got here …”)

I’m most interested though, in a claim that, since 1978, the default rate on AAA-rated structured finance offerings has been only 0.5 per cent. Obviously, a statistic like this can mean just about anything, but the claim is surprising to me. AFAIK, the biggest single category of structured finance offerings rated AAA by the agencies were collateralised debt obligations (CDOs) and the vast bulk of these were issued in the last few years. According to Alan Kohler in today’s Business Spectator (I think the ultimate source for this is Gillian Tett in the FT).

Between 2005 and 2007, about $US450 billion of CDOs of asset backed securities were issued. Of those, $US305 billion are in a formal state of default, with those underwritten by Merrill Lynch accounting for the largest proportion, followed by UBS and Citigroup.

The real problem is what has happened after the default. JPMorgan estimates that $US102 billion of the CDOs have been liquidated; the average recovery rate for the super senior tranches – rated AAA – has been 32 per cent. For the ‘mezzanine’ tranches – created from mortgage-backed bonds – the recovery rate is just 5 per cent.

Up to a 95 per cent real loss rate on AAA debt CDOs …

(Note that, although the text is ambiguous, the top mezzanine tranches were typically AAA-rated – the super-senior stuff was supposed to be better than plain old AAA).

The default rate here is over 60 per cent, which is a bit higher than 0.5 per cent, and it’s safe to bet there are more defaults to come. Even assuming that older issues pull the average down, can there really have been anywhere near $60 trillion ($300 billion/0.005) of them issued, as you would need to get the S&P average default rate? Or is this the kind of average that conceals more than it reveals?

Update A kind reader has supplied me with the text, and I’ve selected the relevant bits for reference (OTF). If anyone is still interested, and keen to do an Intertubes meme mashup, we could do a crowdsourced fisking.
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Its time once again for Monday Message Board. Post comments on any topic. As usual, civilised discussion and no coarse language.

My column from yesterday’s Fin is over the fold

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When a car swerves sharply to avoid an obstacle, anything unsecured inside it continues travelling in its original direction, often with unfortunate consequences. We can see something similar happening with the Rudd government’s fiscal policy. The $42 billion stimulus package is as sharp a swerve as you can imagine, justified by the correct expectation that private investment and consumption demand, along with export demand, is about to collapse, leaving government to fill the gap.

Yet the noises coming out of the Budget process suggest that no one has even noticed this. Lindsay Tanner is still talking about spending cuts, as if the emergency measures of the last week can be put into reverse in only a few months time.

And, despite the disappearance of the forward surpluses that were to pay for them, and of any possible economic rationale for aiding high income earners, the government is still promising to proceed with the tax cuts promised in the utterly different world of 2007. Unlike many economists, I supported the government’s delivery of the first-stage tax cuts, on the basis that, while they were bad policy, nothing had changed since the election to justify repudiating a promise. But now, everything has changed. Like Ross Gittins, I hope the government will summon up the courage to say that tax cuts are off the agenda for the foreseeable future.

Update

• Sharp as Marbles dvd

I spell out the rationale for this a bit more over the fold

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