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Financial shocks, reopening the case

Published by Anonymous (not verified) on Thu, 22/10/2020 - 7:00pm in

David Gauthier

Since the tumultuous events of 2007, much work has suggested that financial shocks are the main driver of economic fluctuations. In a recent paper, I propose a novel strategy to identify financial disturbances. I use the evolution of loan finance relative to bond finance to proxy for firms’ credit conditions and single out the shocks born in the financial sector. I apply and test the method for the US economy. I obtain three key results. First, financial shocks account for around a third of the US business cycle. Second, these shocks occur around precise events such as the Japanese crisis and the Great Recession. Third, the financial shocks I obtain are predictive of the corporate bond spread.

Looking for the financial shock

What makes it so difficult to isolate economic fluctuations born in the financial sector? Why not just use the usual credit spreads and asset prices to proxy firms’ credit conditions? 

The reason is simple. Because virtually all shocks propagate via credit conditions, this makes credit spreads and asset prices responsive to pretty much all economic and non-economic events and, as such, quite arduous to interpret. Another muddling factor to be considered is the difficulty to observe credit conditions (see for instance Romer and Romer (2017)). Raising debt requires borrowers’ compliance with countless binding agreements. If credit costs decrease while loan covenants tighten up, have credit conditions eased or not?

I use an off-the-shelf dynamic stochastic general equilibrium (DSGE) model to illustrate these points. I show that under general conditions, shocks shifting firms’ credit conditions through second-round effects are indistinguishable from shocks that directly impinge on credit conditions. Following Uhlig and De Fiore (2011), I then extend the model so that firms can fund production using either loans or bonds. Loan funding is more expensive but allows for renegotiation depending on borrowers’ productivity. 

This new framework has a decisive implication: because a sudden change in credit conditions drives a wedge between the costs of bonds and loans, financial shocks are now the only type of disturbances causing opposite movements in the volumes of the two types of funding.

Let the data speak

Based on this finding from the DSGE model, I use sign-restriction techniques within a simple VAR model to capture financial shocks and identify the sources of US economic fluctuations. More specifically, I identify financial shocks as the only type of disturbances that entail opposite movements in loan and bond volumes. The VAR model allows me to study the responses in investment, prices, and the policy rate to financial shocks. Despite imposing only a minimal set of restrictions on financial shocks, I find they imply impulse responses in line with predictions from various DSGE models for all variables.

Figure 1: Historical shock decomposition for US GDP

Note: Contribution of the different structural shocks to output fluctuations. Grey areas correspond to NBER recession dates.

Figure 1 displays the historical shock decomposition for US GDP between 1985 and 2018. Financial shocks weigh on output growth during the Japanese banking crisis of the early 90s’ and the Russian crisis of 1998. While they constitute one of the leading forces driving US fluctuations, other disturbances on the demand and supply sides of the economy play a significant role, especially during the Great Recession.

Putting the model to the test

The mechanism of debt arbitrage, firms shifting between bond and loan finance, in the DSGE model is the foundation of our identification strategy. Can we provide some tests for it? The answer is yes. I take advantage of the structural nature of the DSGE model to construct the series of financial disturbances that maximizes the model’s likelihood for various US series over the period 1985 to 2018. I study its implications for credit costs, a series I have ignored so far.

Figure 2 shows our index together with the bond spread for US non-financial corporates. The two series are highly correlated. More importantly, the credit shocks captured within the DSGE model are predictive of the bond spread.

Figure 2: Financial stress and the bond spread

Note: The orange line corresponds to the estimate of the financial shock in the DSGE model. The blue line corresponds to the Moody’s seasoned AAA corporate bond rate minus the federal funds rate. Grey areas correspond to NBER recession dates.

This simple exercise highlights two essential properties for our identification strategy. First, the method yields financial shocks that are related to credit spreads, a necessary condition for any operational measure of financial stress. Second, it suggests an explanation for shifts in borrowing costs based on changes in firms’ debt financing following shocks to credit conditions.

In a nutshell

Identifying financial disturbances is difficult as financial variables can respond to all sorts of events. I propose to bypass this endogeneity issue by using firms’ debt arbitrage to identify financial shocks. I find these shocks account for a large share of the business cycle. The method highlights the importance of firms’ debt arbitrage, both as a gauge for credit conditions and as an explanation for shifts in credit spreads. Some practical advantages of the approach are worth mentioning. First, the method is easy to implement and produces results in line with more involved techniques. Second, it is model-based: the conditions for the validity of the identification scheme are set out clearly and can be modified to investigate its robustness.

David Gauthier works in the Bank’s Research Hub Secondees Division.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

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The Coronavirus Recession Is Just Beginning

Published by Anonymous (not verified) on Sat, 03/10/2020 - 2:51pm in

(A couple days ago I gave a talk — virtually, of course — to a group of activists about the state of the economy. This is an edied and somewha expanded version of what I said.)

The US economy has officially been in recession since February. But what we’ve seen so far looks very different from the kind of recessions we’re used to, both because of the unique nature of the coronavirus shock and because of the government response to it. In some ways, the real recession is only beginning now. And if federal stimulus is not restored, it’s likely to be a very deep and prolonged one.

In a normal recession, the fundamental problem is an interruption in the flow of money through the economy. People or businesses reduce their spending for whatever reason. But since your spending is someone else’s income, lower spending here reduces incomes and employment over there — this is what we call a fall in aggregate demand. Businesses that sell less need fewer workers and generate less profits for their owners. That lost income causes other people to reduce their spending, which reduces income even more, and so on.

Now, a small reduction in spending may not have any lasting effects — people and businesses have financial cushions, so they won’t have to cut spending the instant their income falls, especially if they expect the fall in income to be temporary. So if there’s just a small fall in demand, the economy can return to its old growth path quickly. But if the fall in spending is big enough to cause many workers and businesses to cut back their own spending, then it can perpetuate itself and grow larger instead of dying out. This downward spiral is what we call a recession. Usually it’s amplified by the financial system, as people who lose income can’t pay their debts, which makes banks less willing or able to lend, which forces people and businesses that needed to borrow to cut back on their spending. New housing and business investment in particular are very dependent on borrowed money, so they can fall steeply if loans become less available. That creates another spiral on top of the first. Or in recent recessions, often it’s the financial problems that come first.

But none of that is what happened in this case. Businesses didn’t close because there wasn’t enough money flowing through the economy, or because they couldn’t get loans. They closed because under conditions of pandemic and lockdown they couldn’t do specific things — serve food, offer live entertainment, etc. And to a surprising extent, the stimulus and unemployment benefits meant that people who stopped working did not lose income. So you could imagine that once the pandemic was controlled, we could return to normal much quicker than in a normal recession.

That was the situation as recently as August.

The problem is that much of the federal spending dried up at the end of July. And that is shifting the economy from a temporary lockdown toward a self-perpetuating fall in incomes and employment.

One way we see the difference between the lockdown and a recession is the industries affected. The biggest falls in employment were in entertainment and recreation and food service, which are industries that normally weather downturns pretty well, while construction and manufacturing, normally the most cyclical industries, have been largely unaffected. Meanwhile, employment in health and education, which in previous recessions has not fallen at all, this time has declined quite a bit.1

If we look at employment, for instance which is normally our best measure of business-cycle conditions, we again see something very different from past recessions. Total employment fell by 20 million in April and May of this year. In just two months, 15 percent of American workers lost their jobs. There’s nothing remotely comparable historically — more jobs were lost in the Depression, but that was a slow process over years not just two months. The post-World War II demobilization was the closest, but that only involved about half the fall in employment. So this is a job loss without precedent.

Since May, about half of those 20 million people have gone back to work. We’re about 10 million jobs down from a year ago. Still, that might look like a fairly strong recovery.

But in the spring, the vast majority of unemployed people described themselves as on temporary layoff — they expected to go back to their jobs. The recovery in employment has almost all come from that group. If we look at people who say they have lost their jobs permanently, that number has continued to grow. Back in May, almost 90 percent of the people out of work described it as temporary. Today, it’s less than half. Business closings and layoffs that were expected to be temporary in the spring are now becoming permanent. So in a certain sense, even though unemployment is officially much lower than it was a few months ago, unemployment as we usually think of it is still rising.

We can see this even more dramatically if we look at income. Most people don’t realize how large and effective the stimulus and pandemic unemployment insurance programs were. Back in the spring, most people — me included — thought there was no way the federal government would spend on the scale required to offset the hob losses. The history of stimulus in this country — definitely including the ARRA under Obama — has always been too little, too late. Unemployment insurance in particular has historically had such tight eligibility requirements that the majority of people who lose their jobs never get it.

But this time, surprisingly, the federal stimulus was actually big enough to fill the hole of lost incomes. The across-the-board $600 per week unemployment benefit reached a large share of people who had lost their jobs, including gig workers and others who would not have been able to get conventional UI. And of course the stimulus checks reached nearly everyone. As a result, if we look at household income, we see that as late as July, it was substantially above pre-recession levels. This is a far more effective response than the US has made to any previous downturn. And it’s nearly certain that the biggest beneficiaries were lower-wage workers.

We can see the effects of this in the Household Pulse surveys conducted by the Census. Every week since Mach, they’ve been asking a sample of households questions about their economic situation, including whether they have enough money to meet their basic needs. And the remarkable thing is that over that period, there has been no increase in the number of people who say they can’t pay their rent or their mortgage or can’t get enough to eat. About 9 percent of families said they sometimes or often couldn’t afford enough to eat, and about 20 percent of renters said they were unable to pay the last month’s rent in full. Those numbers are shockingly high. But they are no higher than they were before the pandemic.

To be clear – there are millions of people facing serious deprivation in this country, far more than in other rich countries. But this is a longstanding fact about the United States. It doesn’t seem to be any worse than it was a year ago. And given the scale of the job loss, that is powerful testimony to how effective the stimulus has been.

But the stimulus checks were one-off, and the pandemic unemployment insurance expired at end of July. Fortunately there are other federal unemployment supplements, but they are nowhere as generous. So we are now seeing the steep fall in income that we did not see in the first five months of the crisis.

That means we may now be about to see the deep recession that we did not really get in the spring and summer. And history suggests that recovery from that will be much slower. If we look at the last downturn, it took five full years after the official end of the recession for employment to just get back to its pre-recession level. And in many ways, the economy had still not fully recovered when the pandemic hit.

One thing we may not see, though, is a financial crisis. The Fed is in some ways one of the few parts of our macroeconomic policy apparatus that works well, and it’s become even more creative and aggressive as a result of the last crisis. In the spring, people were talking about a collapse in credit, businesses unable to get loans, people unable to borrow. But this really has not happened. And there’s good reason to think that the Fed has all the tools they need if a credit crunch did develop, if some financial institutions to end up in distress. Even if we look at state and local governments, where austerity is already starting and is going to be a big part of what makes this recession severe, all the evidence is that they aren’t willing to borrow, not that they can’t borrow.

Similarly with the stock market — people think it’s strange that it’s doing well, that it’s delinked from the real economy, or that it’s somehow an artificial result of Fed intervention. To be clear, there’s no question that low interest rates are good for stock prices, but that’s not artificial — there’s no such thing as a natural interest rate.

More to the point, by and large, stocks are doing well because profits are doing well. Stock market indexes dominated by a small number of large companies, and many of those have seen sales hold up or grow. Again, so far we haven’t seen a big fall in total income. So businesses in general are not losing sales. What we have seen is a division of businesses into winners and losers. The businesses most affected by the pandemic have seen big losses of sales and profits and their share prices have gone down. But the businesses that can continue to operate have done well. So there’s nothing mysterious in the fact that Amazon’s stock price, for instance, has risen, and there’s no reason to think it’s going to fall. If you look at specific stocks, you see that by and large the ones that are doing well, the underlying business is doing well.

This doesn’t mean that what’s good for the stock market is good for ordinary workers. But again, that’s always been true. Shareholders don’t care about workers, they only care about the flow of profits their shares entitle them to. And if you’re a shareholder in a company that makes most of its sales online, that flow of profits is looking reasonably healthy right now.

So going forward, I think the critical question is whether we see any kind of renewed stimulus. If we do, it’s still possible that the downward income-expenditure spiral can be halted. At some point soon that will be much harder.