Ka-fu Wong School of Economics and Finance University of Hong Kong

1
Ka-fu WongSchool of Economics and
FinanceUniversity of Hong Kong
Calling it a Recession
Prepared for the Professional Development
Seminar for Economics Teachers, October 21, 2009.
2
Outline

• Definition of business cycles
• Why do we care about business cycles
• Causes of business cycles
• Business cycles dating
• NBER, e.g., US
• Shiskin Rule, e.g., HK
• Hong Kongs dependence on US
• Causes of the recent financial crisis and
  recession

3
Definition of Business Cycles
A cycle consists of expansions occurring at about
the same time in many economic activities,
followed by similarly general recessions,
contractions, and revivals which merge into the
expansion phase of the next cycle this sequence
of changes is recurrent but not periodic in
duration business cycles vary from more than one
year to ten or twelve years they are not
divisible into shorter cycles of similar
character with amplitudes approximating their
own. (Burns and Mitchell, 1946, p.3)
Burns, A.F., and W. C. Mitchell (1946), Measuring
Business Cycles. New York NBER.
4
Definition of Business Cycles

• The term business cycle (or economic cycle)
  refers to economy-wide fluctuations in production
  or economic activity over several months or
  years.
• Expansion (or boom) episode from local minimum
  output to maximum output, i.e., from trough to
  peak
• Contraction (recession) episode from local
  maximum output to minimum output, i.e., from peak
  to trough

5
Definition of Business Cycles
6
Definition of Business Cycles
R
7
What if
8
Alternative Definition of Business Cycles

• Deviations of output from trend
• Also known as growth cycles or deviation cycles.
• Expansion (or boom) episode output grows at a
  higher rate than the trend.
• Contraction (recession) episode output grows at
  a lower rate than the trend.

9
Alternative Definition of Business Cycles
10
Alternative Definition of Business Cycles
11
Alternative Definition of Business Cycles
12
Alternative Definition of Business Cycles
13
Alternative Definition of Business Cycles
14
Alternative Definition of Business Cycles
15
Alternative Definition of Business Cycles

• Difficulty
• We need to define and estimate the trend before
  we can conclude about the business cycles
• Trends
• Linear trend
• Quadratic trend
• Stochastic trend
• Filtering out the high-frequency fluctuations and
  the low-frequency fluctuations using some
  advanced statistical technique, known as Band
  Pass Filter.

16
US Industrial production index, levels
Stock and Watson (1998, Fig. 1.1)
17
Estimate of the cyclical component of US
industrial production index
Stock and Watson (1998, Fig. 1.2)
A bandpass filter was used to isolates
fluctuations at business cycle periodicities, six
quarters to eight years.
18
Macroeconomics is about business cycles

• The explanation of fluctuations in aggregate
  economic activity is one of the primary concerns
  of macroeconomics.
• The most commonly used framework for explaining
  such fluctuations is Keynesian economics. In the
  Keynesian view, business cycles reflect the
  possibility that the economy may reach short-run
  equilibrium at levels below or above full
  employment.
• Recessionary gap the economy is operating with
  less than full employment, i.e., high
  unemployment
• Expansionary gap the economy is operating with
  more than full employment, i.e., low unemployment

19
Economic expansion or recession?
a. Expansion
Price Level (P)
b. Recession
c. Cannot be determined
SRAS
P
AD
0
Y
Quantity of Output (Y)
20
Expansionary or Recessionary (I)
Price Level (P)
LRAS
SRAS
a. Expansionary gap
P
b. Recessionary gap
AD
0
Y
Y
Quantity of Output (Y)
21
Expansionary or Recessionary (II)
Price Level (P)
LRAS
SRAS
P
a. Expansionary gap
b. Recessionary gap
AD
Y
0
Y
Quantity of Output (Y)
22
Recession

• A recession is a general slowdown in economic
  activity over a long period of time, or a
  business cycle contraction. During recessions,
  many macroeconomic indicators vary in a similar
  way.
• Production falls
• Gross Domestic Product (GDP),
• employment,
• investment spending,
• capacity utilization,
• household incomes,
• business profits and
• inflation
• Bankruptcies and the unemployment rate rises.

http//en.wikipedia.org/wiki/Recession
23
Why do we care about business cycles?

• While we may love expansion but we would not want
  to experience recession.
• Most of us are risk averse and prefer stable
  income
• Implications for policy makers
• A good understanding of the cycles helps us
  prevent it or reduce the magnitude of the cycles.
• Implications for individual consumers and
  investors
• A good understanding of the cycles helps us
  predict the cycles and hence prepare for the
  cycles.

24
Predictors of a recession

• In the US a significant stock market drop has
  often preceded the beginning of a recession.
• Inverted yield curve uses yields on 10-year and
  three-month Treasury securities as well as the
  Fed's overnight funds rate. Another model
  developed by Federal Reserve Bank of New York
  economists uses only the 10-year/three-month
  spread. It is, however, not a definite indicator
  it is sometimes followed by a recession 6 to 18
  months later.
• The three-month change in the unemployment rate
  and initial jobless claims.
• Index of Leading (Economic) Indicators (includes
  some of the above indicators).
• Lowering of Home Prices. Lowering of home prices
  or value, too much personal debts.

25
Causes of business cycles

• The cause of a business cycle typically is taken
  to be a shock or innovation to a relationship in
  the economy.
• Only deviations from the rule then would be
  admissible as a shock.
• Shocks are defined according to specific models.

http//www.bos.frb.org/economic/conf/conf42/con42_
03.pdf
26
Example of shocks

• An elementary open-economy model
• an augmented IS-LM model or Mundell-Fleming
  model.
• The model distinguishes domestic and foreign
  shocks as well as real and monetary shocks.
• This level of abstraction and general orientation
  of underlying assumptions about the economy is
  typical of the historical literature on business
  cycles in the United States.

Domestic Foreign
Real DR FR
Monetary DM FM
http//www.bos.frb.org/economic/conf/conf42/con42_
03.pdf
http//en.wikipedia.org/wiki/Mundell-Fleming_model
27
Recessionary gap
Price Level (P)
LRAS
SRAS2
SRAS1
B
Higher price Lower output Lower employment Higher
unemployment
P2
A
P1
AD1
0
Y1
Y2
Quantity of Output (Y)
28
Recessionary gap
Price Level (P)
LRAS
SRAS1
Lower price Lower output Lower employment Higher
unemployment
A
P1
B
P2
AD1
AD2
0
Y1
Y2
Quantity of Output (Y)
29
Expansionary gap
Price Level (P)
LRAS
SRAS1
Higher price Higher output Higher
employment Lower unemployment
P2
B
A
P1
AD2
AD1
Y2
0
Y1
Quantity of Output (Y)
30
Expansionary gap
Price Level (P)
LRAS
SRAS1
SRAS2
Lower price Higher output Higher employment Lower
unemployment
A
P1
B
P2
AD1
Y2
0
Y1
Quantity of Output (Y)
31
Business Cycle Dating in the US

• The National Bureau's Business Cycle Dating
  Committee maintains a chronology of the U.S.
  business cycle. The chronology identifies the
  dates of peaks and troughs that frame economic
  recession or expansion. The period from a peak to
  a trough is a recession and the period from a
  trough to a peak is an expansion.
• The NBER does not define a recession in terms of
  two consecutive quarters of decline in real GDP.
  Rather, a recession is a significant decline in
  economic activity spread across the economy,
  lasting more than a few months, normally visible
  in real GDP, real income, employment, industrial
  production, and wholesale-retail sales.

http//www.nber.org/cycles.html http//www.nber.or
g/cycles/recessions.html
32
Identifying the trough in November 2001

• On July 16, 2003, the committee determined that a
  trough in economic activity occurred in November
  2001. The committee's announcement of the trough
  is at http//www.nber.org/cycles/july2003.
• On November 26, 2001, the committee determined
  that the peak of economic activity had occurred
  in March of that year. For a discussion of the
  committee's reasoning and the underlying
  evidence, see http//www.nber.org/cycles/november2
  001.
• Thus, March 2001 (peak) to November 2001 (trough)
  was a recession.

http//www.nber.org/cycles/recessions.html
33
The committees usual procedures in identifying
trough

• Because a recession influences the economy
  broadly and is not confined to one sector, the
  committee emphasizes economy-wide measures of
  economic activity. The committee views real GDP
  as the single best measure of aggregate economic
  activity. In determining whether a recession has
  occurred and in identifying the approximate dates
  of the peak and the trough, the committee
  therefore places considerable weight on the
  estimates of real GDP issued by the Bureau of
  Economic Analysis of the U.S. Department of
  Commerce.
• The traditional role of the committee is to
  maintain a monthly chronology, however, and the
  BEAs real GDP estimates are only available
  quarterly. For this reason, the committee refers
  to a variety of monthly indicators to choose the
  exact months of peaks and troughs.

34
The committees usual procedures in identifying
trough

• It places particular emphasis on two monthly
  measures of activity across the entire economy
• (1) personal income less transfer payments, in
  real terms and
• (2) employment.
• In addition, the committee refers to two
  indicators with coverage primarily of
  manufacturing and goods
• (3) industrial production and
• (4) the volume of sales of the manufacturing and
  wholesale-retail sectors adjusted for price
  changes.
• The committee also looks at monthly estimates of
  real GDP such as those prepared by Macroeconomic
  Advisers (see http//www.macroadvisers.com).
• Although these indicators are the most important
  measures considered by the NBER in developing its
  business cycle chronology, there is no fixed rule
  about which other measures contribute information
  to the process.

35
Figure 1 Quarterly Real GDP
The fact that this broad and reliable indicator
of macroeconomic activity surpassed its previous
peak in the fourth quarter of 2001 was a key
reason that the committee felt that the recession
that began in March 2001 had ended. The fact
that quarterly real GDP grew very strongly in the
fourth quarter of 2001 also helped to limit the
possible months that could be identified as the
trough. The committee felt that the recovery must
have begun before December 2001 for GDP to have
grown so rapidly in the fourth quarter.
36
Figure 2 Real Personal Income less Transfers
The behavior of this series is consistent with
both the identification of a trough and the
placement of the trough in November 2001. Real
personal income fell in early 2001. It reached
its low point in October 2001. However, because
it grew only a small amount between October and
November 2001, the NBER methodology indicates
that it reached its trough in November. Since
then, personal income less transfers generally
rose through January 2003, fell in February and
March, but rose in April and May, the most recent
reported months.
37
Figure 3 Payroll Employment
The fluctuations in this series are quite
different from those in the broader, output-based
measures. Employment reached a peak in February
2001 and declined through July 2002. It rose
slightly through November, took a sharp downturn
in December, rose again in January 2003, but
since then has declined through June 2003, the
most recent reported month. It is now 394,000
below the start of the year, and 2.6 million
below the February 2001 peak. The fact that
employment has continued to decline while
output-based measures have risen reflects the
fact that productivity has risen substantially
since late 2001. The divergent behavior of output
and employment was a key reason why the committee
waited a long time before identifying the trough.
38
Why identified November 2001 as trough with
conflicting data?

• The behavior of other monthly series is also
  consistent with the identification of the trough
  in late 2001. Industrial production fell until
  December 2001 and then rose rapidly until July
  2002. It has fallen slightly since then.
• Real manufacturing wholesale-retail sales reached
  its low in September 2001. It then recovered
  substantially in October 2001, only to fall again
  in November. As discussed in the trough
  announcement, the NBER methodology holds that
  extreme events, such as strikes and natural
  disasters, that affect particular monthly
  observations should be downweighted in
  identifying business cycle turning points. For
  this reason, the committee emphasized the
  November 2001 trough in this series, rather than
  the dramatic decline in sales following the
  tragic events of September 11th. This series has
  generally risen since September 2001. It fell
  sharply in February 2003, but rose substantially
  in March, the most recent reported month.
• The committee also looks at monthly estimates of
  real GDP provided by Macroeconomic Advisors. This
  series reached its low in September 2001 and has
  generally been growing since then. The fact that
  monthly GDP rose dramatically in December 2001
  reinforced the committees decision that the
  trough occurred in November. Monthly real GDP
  fell slightly in March and April 2003, the most
  recent reported months.

39
NBER recession dateshttp//www.nber.org/cycles.ht
ml
Peak Trough Contraction Expansion Cycle Cycle
P-P T-T
August 1929(III) March 1933 (I) 43 21 64 34
May 1937(II) June 1938 (II) 13 50 63 93
February 1945(I) October 1945 (IV) 8 80 88 93
November 1948(IV) October 1949 (IV) 11 37 48 45
July 1953(II) May 1954 (II) 10 45 55 56
August 1957(III) April 1958 (II) 8 39 47 49
April 1960(II) February 1961 (I) 10 24 34 32
December 1969(IV) November 1970 (IV) 11 106 117 116
November 1973(IV) March 1975 (I) 16 36 52 47
January 1980(I) July 1980 (III) 6 58 64 74
July 1981(III) November 1982 (IV) 16 12 28 18
July 1990(III) March 1991(I) 8 92 100 108
March 2001(I) November 2001 (IV) 8 120 128 128
December 2007 (IV) December 2007 (IV) 73 81
40
Suggested exercises

• Go through the NBERs Business-Cycle Dating
  Procedure in class.
• Exercise 1 Give students some US data up to
  different point in time (available at the St.
  Louis Fed, http//research.stlouisfed.org/fred2/).
  Let them work in groups and determine the most
  recent trough or peak.
• Exercise 2 Give students some Hong Kong data
  up to certain time (available at
  http//www.censtatd.gov.hk/hong_kong_statistics/in
  dex.jsp). Let them determine the most recent
  trough or peak.

Re-label the dates if we are concerned that
students may remember the recession dates
previously identified by the official
announcements.
41
Shiskins Rules of Thumb for Spotting a Recession
(two-quarter rule?)

• Real GDP declines for two successive quarters
• Industrial production declines for a 6-month
  period.
• Real GDP declines by at least 1.5
• Payroll employment declines by at least 1.5
• At least two-point rise in unemployment rate
• For six months or longer, less than 25 of the
  industries are expanding when measured by the
  employment diffusion index using 6-month spans.
• The Bureau of Labor Statistics employment
  diffusion index covers 274 industries and asks
  this question What share of the industries are
  enjoying an employment expansion or experiencing
  a contraction? A reading of 50 indicates exact
  balance. Values below 50 indicate contraction.

42
Hong Kong RecessionsYear-on-year Growth rate of
Real GDP (chained)
43
HK recessionsUnemployment rate 198110 - 200909
200908 200909
SA 5.4 5.3
NSA 5.8 5.6
44
Hong Kongs dependence on the US

• Monthly seasonally adjusted unemployment rate
  from 1981 October to 2009 August is obtained from
  the online statistical tables of Hong Kong Census
  and Statistics Department, a total of 335
  observations.
• The data are plotted with NBER recession dates.

45
Hong Kongs dependence on the US
46
Hong Kongs dependence on the US

• Hong Kongs unemployment rate tend to increase
  during episodes of US recessions. The negative
  impact of the US recession or downturn on Hong
  Kong takes a couple of months to realize.

47
Understanding recession

• We have to understand expansion

48
How do bubbles cause cycles?
Higher asset prices
Consumption increases due to wealth effect
Aggregate demand increases
Output increases
49
How does excess liquidity cause a boom?
Excess liquidity and easy credit
Higher asset prices
Consumption and investment increase
Consumption increases due to wealth effect
Aggregate demand increases
Output increases
50
Causes of the financial crisis?
Influx of Foreign Money

• High consumption
• Unprecedented debt load

• Property appreciation

Housing bubbles

• easy initial terms ARM
• Free cash from refinancing

• Kept derivatives market unregulated.
• Underestimated the impacts of shadow banking
  systems, i.e. investment banks and hedge funds,
  which lacked financial cushions.
• Accounting practices allowed commercial banks to
  move new financial products off balance sheets as
  complex legal entities.

• SEC relaxed capital rule prompted banks take on
  higher leverages.
• Encouraged subprime mortgages, incl. Fannie Mae
  Freddie Mac.

U.S. Govt.
51
A note on the financial innovations

• Subprime lending means lending towards those
  borrowers with weak credit histories thus it has
  greater risks of loan defaults.
• Mortgaged-backed securities (MBS) are securities
  derive their values from mortgages payments and
  housing prices.
• A Collateralized Debt Obligation (CDO) bundles
  cash payments from multiple mortgages or other
  debt obligations into a single pool, from which
  the cash is allocated to specific securities in a
  priority sequence.
• A Credit Default Swap (CDS) involves an insurance
  party, such as AIG, receiving a premium in
  exchange for a promise to pay money to party A
  (say an investment bank) in the event of party B
  (mortgage holder) defaulted.

The risks inherent with the above financial
derivatives were not accurately measured nor
reflected by the issuers and rating agencies nor
fully understood by the investors.
52
How bubbled were the Housing Bubbles?

• Price of a typical American house increased by
  124 from 1997 to 2006.
• U.S. home mortgage debt to GDP ratio increased
  from 46 in 1990s to 73 in 2008.
• The value of U.S. subprime mortgages was
  estimated at 1.3 trillion as of March 2007. It
  spiked to 20 of all mortgages in 2005 from 10
  prior to 2004. Delinquency rates increased from
  10-15 before 2006 to 25 in early 2008.
• As of Aug., 2009, 9.2 of all mortgages
  outstanding were either delinquent or in
  foreclosure.

53
How bubbled were the financial Bubbles?

• Between 1996 and 2004, the USA current account
  deficit increased by US650 million, from 1.5
  to 5.8 of GDP.
• The top five U.S. investment banks, plus Fannie
  Mae and Freddie Mac, were estimated to have US9
  trillion in debt or guarantee obligations in
  2008. These shadow financial institutions were
  not subject to the same depository banking
  regulations.
• The top four U.S. commercial banks were estimated
  to have to return between US500 billion to US1
  trillion to their balance sheets in 2009.
• Volume of CDS outstanding increased 100-fold from
  1998 to 2008, estimated at US33 to 47 trillion
  as of Nov., 08.

54
Financial markets impacts (1)

• Troubled banks were nationalized (Northern Rock)
  or acquired (Merrill Lynch), if not gone bankrupt
  (Lehmann Brothers).
• The credit markets were paralyzed, so the U.S.
  government had to extend insurance for the money
  market accounts. A 700 billion emergency
  bailout program, Troubled Asset Relief Program
  (TARP), was signed into law in October, 2008 to
  stabilize the economy.
• It was estimated that Americans on average lost
  more than one quarter of their collective net
  worth from mid 2007 to late 2008, resulting from
  declines in consumption and business investment.

55
Financial markets impacts (2)

• The U.S. financial crisis rapidly spilled over
  and many European banks failed. The
  de-leveraging of financial institutions further
  worsened the liquidity crisis. Although Asia was
  not at the center of the financial crisis,
  weakened economies in the west caused a drastic
  decrease in international trade.
• For the 1st quarter of 2009, the GDP declined by
  14.4 in Germany, 15.2 in Japan, 7.4 in the UK,
  9.8 in the Euro, 21.5 in Mexico and 6 in the
  U.S.A. The unemployment rate in the U.S. was
  9.5 by June 2009.

56
Short-term government remedies

• To avoid a global recession, collective actions
  were taken by many governments, including
• Interest rates were at historical low
• Injected liquidity into the credit markets
• Purchased trillions of government debts and
  troubled private assets from banks
• Raised the capital of the national banks by
  purchasing newly issued preferred stock in major
  banks.

57
The current US recession

• When did the current recession start?
• http//www.nber.org/cycles/dec2008.html
• Has the recession ended?

58
Identifying the quarter of peak

• The product-side estimates fell slightly in
  2007Q4, rose slightly in 2008Q1, rose again in
  2008Q2, and fell slightly in 2008Q3. The
  income-side estimates reached their peak in
  2007Q3, fell slightly in 2007Q4 and 2008Q1, rose
  slightly in 2008Q2 to a level below its peak in
  2007Q3, and fell again in 2008Q3. Thus, the
  currently available estimates of quarterly
  aggregate real domestic production do not speak
  clearly about the date of a peak in activity.
• Other indicators reached peaks between November
  2007 and June 2008
• real personal income less transfer payments,
• real manufacturing and wholesale-retail trade
  sales,
• industrial production, and
• employment estimates based on the household
  survey.
• The decline in economic activity in 2008 met the
  standard for a recession

http//www.nber.org/cycles/dec2008.html
59
Identifying the Month of the peak

• Payroll employment, the number of filled jobs in
  the economy based on the Bureau of Labor
  Statistics survey of employers, reached a peak in
  December 2007 and has declined in every month
  since then.
• An alternative measure of employment, measured by
  the BLS household survey, reached a peak in
  November 2007, declined early in 2008, expanded
  temporarily in April to a level below its
  November 2007 peak, and has declined in every
  month since April 2008.
• Real personal income less transfers peaked in
  December 2007, displayed a zig-zag pattern from
  then until June 2008 at levels slightly below the
  December 2007 peak, and has generally declined
  since June.?
• Real manufacturing and wholesale-retail trade
  sales reached a well-defined peak in June 2008.
• Industrial production peaked in January 2008,
  fell through May 2008, rose slightly in June and
  July, and then fell substantially from July to
  September.

http//www.nber.org/cycles/dec2008.html
60
NBER recession dateshttp//www.nber.org/cycles.ht
ml
Peak Trough Contraction Expansion Cycle Cycle
P-P T-T
August 1929(III) March 1933 (I) 43 21 64 34
May 1937(II) June 1938 (II) 13 50 63 93
February 1945(I) October 1945 (IV) 8 80 88 93
November 1948(IV) October 1949 (IV) 11 37 48 45
July 1953(II) May 1954 (II) 10 45 55 56
August 1957(III) April 1958 (II) 8 39 47 49
April 1960(II) February 1961 (I) 10 24 34 32
December 1969(IV) November 1970 (IV) 11 106 117 116
November 1973(IV) March 1975 (I) 16 36 52 47
January 1980(I) July 1980 (III) 6 58 64 74
July 1981(III) November 1982 (IV) 16 12 28 18
July 1990(III) March 1991(I) 8 92 100 108
March 2001(I) November 2001 (IV) 8 120 128 128
December 2007 (IV) December 2007 (IV) 73 81
61
Additional readings about the crisis

• The Federal Reserve Bank of St. Louis maintains
  an excellent website about
• The recent Financial Crisis (http//timeline.stlou
  isfed.org/)
• The Financial Crisis A Timeline of Events and
  Policy Actions
• The Financial Crisis Glossary
• the current global recession (http//research.stlo
  uisfed.org/recession/)
• the US data (http//research.stlouisfed.org/fred2/
  )
• Slightly more technical papers
• Caballero, Ricardo, J. and Pablo Kurlat (2009)
  The Surprising Origin and Nature of Financial
  Crises A Macroeconomic Policy Proposal, Paper
  presented at the Jackson Hole Symposium on
  Financial Stability and Macroeconomic Policy,
  August 20-22, 2009.
• Taylor, John B. and John C. Williams (2008) A
  Black Swan in the Money Market, Federal Reserve
  Bank of San Francisco, Working Paper 2008-04.

62
Additional reading on Business Cycles

• The National Bureau of Economic Research keeps
  the past announcement of the business cycle
  dating
• Peak and trough dates and announcements
  http//www.nber.org/cycles.html
• An illustration of the NBER Recession Dating
  Procedure http//www.nber.org/cycles/recessions.h
  tml
• Niemira, Michael P. and Philip A. Klein (1994)
  Forecasting Financial and Economic Cycles, John
  Wiley Sons, Inc.
• Cotis, Jean-Philippe, and Jonathan Coppel (2005)
  Business Cycle Dynamics in OECD Countries
  Evidence, Causes and Policy Implications, Paper
  presented at the Changing Nature of the Business
  Cycle, the Reserve Bank of Australia Economic
  Conference, July 11-12, 2005.
• Temin, Peter (1998) The Causes of American
  Business Cycles An Essay in Economic
  Historiography, NBER Working Paper 6692.
• Stock, James H. and Mark W. Watson (1998)
  Business cycle fluctuations in U.S.
  macroeconomic time series, NBER Working Paper
  6528.

63
End