A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Tuesday, July 21, 2009

Podcast transcript 07.21.09 Housekeeping: GDP, VAR, CPI, ETC.

Call this the slick page edition.


I think we've finally settled on a useful format for the blog. On each of the off days from putting up the transcript of the Demand Side podcast, we've been putting up a single useful piece from the demand side perspective. We don't have time to read as much as we want to, much less translate it back to our readers. Besides which, Calculated Risk, the Economist's View, and others like Brad DeLong do it better than we could.

Our one-piece-per-day service on the blog will hopefully be useful for those who want to get meat without picking through a lot of bones. Five pieces per week plus what you're listening to now in more or less transcript form. DEMANDSIDEBLOG.BLOGSPOT.COM

This week, for example, on the blog we see a couple of pieces connected to print magazines. One from Newsweek asking why Joseph Stiglitz is not at the key adviser's table at the White House. Another from Brad DeLong looks at this week's Economist newspaper's examination of economists, an exercise in the pot calling the kettle black.

We relay a piece from Project Syndicate by the great man himself, Joseph Stiglitz, entitled "The UN Takes Charge." Previous to that are selections from Dr. James Hansen, Paul Krugman, Jeffrey Sachs and others. We hope it is useful.

If you want a list of the economists who did badly, go to the link in the transcript which identifies those signing an open letter or petition for Fed independence. As we've reported before, the fear that the Fed will lose its independence ignores the fact that the Fed is captive to the financial industry. So when we hear "independence," we mean independent from the representative government that must back up its actions.

Historically, since it achieved independence in the middle of the night in 1951, with the so-called Treasury Accord, the Fed has operated for the benefit of what Keynes would call the rentiers, keeping interest rates on the plus side and pulling out all the stops to hammer inflation whenever it could. In fact, a huge premium on debt service has been paid by the taxpayer over what would have been paid with the prior regime. This is one reason the current massive deficits will be much more difficult to pay off than the massive deficits of World War II.

Continuing this theme on the next podcast we will have Robert Eisebeis, formerly of the Atlanta Fed and elsewhere in mainstream economics, continuing to pound the table for his orthodoxy after everybody has left the room. That's on the next idiot of the week. A two-fer this week.

because we have our first repeat winner.

A couple of weeks ago I commented that I had not followed the charts very well in my forecast update piece. Aha! I didn't even get them up on the web site . I win! The coveted first repeater on idiot of the week. Those charts are halfway up now. Thanks to one of our listeners, Greg F, for pointing that out. And one of our more energetic listeners took me up on the challenge to research productivity and the hypothesis that much of the change comes from the price of oil and some of it comes from tight labor markets. Thank you, Alex.

In six months we will have the definitive statement, or we will have had a good time trying to get it.

On health care reform:

Faiz Shakir reminds us that this is the explicit strategy of some in the GOP:

A strategy memo authored by GOP consultant Alex Castellanos suggests that “it is crucial for Republicans to slow down what it calls ‘the Obama experiment with our health.’” The memo concludes, “If we slow this sausage-making process down, we can defeat it, and advance real reform that will actually help.”

Peter Orzag on CNBC said it this way.


It should be a line in the sand, from point A: the public option -- to point B -- done deal by September. We cannot afford to carry inefficient corporate health care into the future. It is a public good and should be treated that way.


Industrial Production Declines, Capacity Utilization at Record Low in June
from Calculated Risk

The Federal Reserve reported:

Industrial production decreased 0.4 percent in June after having fallen 1.2 percent in May. For the second quarter as a whole, output fell at an annual rate of 11.6 percent, a more moderate contraction than in the first quarter, when output fell 19.1 percent. Manufacturing output moved down 0.6 percent in June, with declines at both durable and nondurable goods producers. ... The rate of capacity utilization for total industry declined in June to 68.0 percent, a level 12.9 percentage points below its average for 1972-2008. Prior to the current recession, the low over the history of this series, which begins in 1967, was 70.9 percent in December 1982.

From the Census Bureau:

On a seasonally adjusted basis, the CPI-U increased 0.7 percent in June after rising 0.1 percent in May. The acceleration was largely caused by the gasoline index, which rose 17.3 percent in June and accounted for over 80 percent of the increase in the all items index.
The index for all items less food and energy rose 0.2 percent in June following a 0.1 percent increase in May.
The index for shelter rose 0.1 percent for the second straight month, as did the indexes of two of its major components, rent and owners' equivalent rent.

CPI is now off 1.2% year-over-year (YoY) - the largest YoY decline since the 1950s, but core CPI is up 1.7%.

Meanwhile owners' equivalent rent (OER) is up 1.9% year-over-year, although only up 0.1% in June. I expect OER to decline soon.

From Reuters

July 16th, 2009
Goldman, liquidity and VAR
Posted by: John Kemp

Goldman Sachs’ second-quarter earnings release showed a continued increase in the amount of market risk held on the firm’s trading book. Its risk appetite has continued to expand at a time when extreme turbulence has forced others to scale back.

True, Goldman’s publicly reported figures may overstate its actual positions. But the Wall Street bank also appears to be taking advantage of its access to liquidity from the Federal Reserve to increase risk.

Total value-at-risk (VAR) averaged $344 million, on a gross basis before diversification effects, up from $303 million in the second quarter of 2008 and $226 million in the second quarter of 2007.

(VAR is a crude measure of the worst loss the firm would expect to report on 19 days out of 20, given prevailing volatility in the market.)

We have the whole Reuters piece in the blog's transcript.

This is confirmation of our characterization of the Fed's actions as providing more chips to the players, nothing for the real economy.

Beyond this, VAR should have been buried along with the financial collapse, because it failed so well. No wonder Nassim Taleb is crazy.

[Reuter's story continues after the podcast transcript for those wishing to read it]

Why doesn't the real economy get any of the cheap money.

Here from the New Republic

The real problem is that borrowing is down. According to the Fed, during the first quarter of 2009, private borrowing by households declined by 1.1 percent and by nonfinancial businesses by 0.3 percent. Net borrowing--the funds borrowed minus those repaid--was down $151.8 billion for households and $28.3 billion for businesses. If individuals are spending part of their earnings paying off credit-card debts or student loans rather than buying a home or car on credit, and if businesses are using their profits to pay off debts rather than to invest, then the economy is going to shrink. The question is what accounts for this decline in borrowing.

The usual answer is that the banks don't have the money to loan, or the capital to absorb losses on existing or new loans. But much of the money they loan is not from deposits (which, incidentally, have been rising), or from interest made on loans, but rather money they themselves have borrowed at lower interest rates than they plan to charge. With federal interest rates near zero, banks are able to borrow money cheaply and lend it to individuals and businesses at very attractive rates. Even with old loans weighing them down, the banks' risk of losing money on new loans has been substantially reduced.

Could the problem, then, be with the borrowers rather than the lenders? That's the answer given by Richard C. Koo, the chief economist of the Tokyo-based consulting firm Nomura Research Institute, in a new book, The Holy Grail of Macro-Economics: Lessons from Japan's Great Recession. Koo argues that the Great Depression of the 1930s, Japan's 15-year recession beginning in the 1990s, and our current downturn are examples of "balance-sheet recessions."

During balance-sheet recessions, individuals are reluctant to spend, and businesses are more worried about paying down their debts than maximizing their profits, wary of expanding their output at a time when there's little demand for their products. So individuals save money and businesses stop borrowing it even when interest rates, which normally spur such activity, approach zero. And this is pretty much what happened in the 1930s and more recently in Japan.

During the Great Depression, Franklin Roosevelt's initial reforms stemmed the financial crisis, but they by no means revived the overall economy. The private debt of non-financial businesses and individuals fell from $129.6 billion in 1929 to $100.6 billion in 1939. The reason that the rate of unemployment fell at all during this period and that economic growth picked up was because the increase in public debt--from $20 billion in 1930 to $108.7 billion in 1939--compensated for the decline in private lending.

And this brings us back to the Demand Side point. Businesses will not borrow when there is gross overcapacity, as we led with today. There are no productive investments to make in any event, with no strong demand in the offing. Individuals will not borrow when they are saving for retirement or against an uncertain future. Only government can borrow with the object of increasing value in the society.

They should. They will have to.

David Cay Johnston has a column at the Nation

look at it. He is up first with how Dems have created more jobs

not fair to start with 1940, since the war was a different time.

Also up on the blog later this week will be Robert Kuttner's latest piece, Smoking the Green Shoots, which begins with the question: Where is the economic recovery going to come from?

Now we leave you a clip from the other great man himself, John Maynard Keynes.

KEYNES [Continuation of the Reuter's piece on VAR and Goldman Sachs]


Like other banks, Goldman reports VAR on a net basis after taking account of a “diversification effect”. The diversification effect reflects the fact that risks in different parts of Goldman’s book are not perfectly correlated.

The bank would not expect to lose the maximum amount on all its positions at the same time. So net VAR for the book as a whole is less than the sum of the VARs for the individual components (which Goldman reports as currencies, interest rates, equities, and commodities). Goldman’s net VAR in the second quarter averaged $245 million, up from $184 million in the second quarter of 2008 and $133 million in the second quarter of 2007.

How Much Risk?

Banks understandably prefer to focus on the smaller net figure, but when looking at the amount of market risk on a bank’s book, gross VAR is arguably more useful. The whole point of a crisis is that when it hits, contagion ensures that previously uncorrelated asset classes move in the same direction, and the diversification effect disappears. So it is dangerous to rely too much on the diversification effect to reduce overall risk.

Interestingly, Goldman has been forced to reduce its reported diversification effect from $119 million to $99 million over the last twelve months as correlations have increased, reducing the benefit it receives from diversifying its portfolio, even though the overall trading book appears to have grown.

But whether we use net or gross VAR, Goldman’s risk taking has risen by 50-80 percent over the last two years. Even during the last 12 months, as the financial system has suffered its worst crisis since the 1930s, net VAR is up by 33 percent while the gross figure has risen 14 percent.

Adding Risk in Rates

The additional risk has been added very selectively. All the additional VAR is reported in the firm’s interest rate sector, where the average daily VAR has risen $61 million (42 percent) from $144 million to $205 million. For other components (currencies, equities and commodities) average daily VAR is mostly flat or lower over the last year.

The question is why Goldman has continued to grow its risk-taking even as others have found it prudent to reduce market risk, and why all the extra risk has been added in the fixed income area, when the firm has held the line on risk-taking in other asset classes?

Answers must remain speculative because the firm reports only the minimum detail on average daily VAR by categories required by the Securities and Exchange Commission in its earnings statements and quarterly 10-Q filings.

In the past, though, most changes in Goldman’s VAR have appeared at least partly endogenous. In other words, when the underlying volatility in an asset class has increased, Goldman has preferred to “accommodate” it by allowing traders to continue running positions of roughly the same size, even if total risk is higher, rather than forcing them to cut back positions to keep the VAR level the same.

There is some evidence that the increase in rates VAR was at least partly endogenous in this case. Volatility was especially high in the rate sector during the first two quarters of 2009, as the market struggled to balance hopes of recovery and additional stimulus against fears for continuing recession or an early tightening of monetary policy.

Volatility was far higher than in other asset classes. Goldman may have followed past practice and decided to “accommodate” it rather than push back — especially if the firm concluded its activity in the rates segment was profitable, and that forcing position cuts would weaken its ability to provide liquidity to its customers.

Risk - but Over What Horizon?

That still leaves the question why Goldman felt comfortable allowing VAR to rise so much. One explanation is that the firm is comfortable it can rely on the Greenspan/Bernanke put, now enhanced by its access to the Fed’s discount window as a member of the Federal Reserve System, to limit downside risks in the event of a crisis.

In effect, the put allows the firm to ignore the worst “tail risks”. The firm can ramp up risk-taking confident in the knowledge it will be shielded from the very worst outcomes by the government.

The other explanation has to do the limitations of VAR, and particularly what time horizon to use when measuring volatility.

Like its peers, Goldman publishes VAR on a one-day basis, reflecting price changes from one evening’s close to the next.

But there is nothing special about a one-day horizon (and in some ways it is a very unrealistic measure of risk since a large financial institution would find it impossible to exit all its positions over such a short period).

In practice, banks calculate a whole series of VARs for different time horizons, though only the one-day figures are currently disclosed. VARs for longer horizons (one week, 10 days, one month etc) may paint a very different picture of risk in a trading book. When markets exhibit strong trending behaviour, with many small daily changes cumulating in a consistent direction, VAR will be higher when evaluated over longer horizons. But when markets are choppy and directionless, with large one-day changes frequently reversed the following session, VAR will be higher over a shorter horizon.

The first quarter saw precisely these choppy trading conditions in the interest rate sector. The volatility in asset price changes was much smaller when measured over a five-day
period than over the course of single trading session.

Benefit of Unlimited Liquidity

In the circumstances, Goldman’s risk-managers may have decided that the one-day VAR overstated the true risk of loss in the firm’s book and decided to focus on VAR levels evaluated over longer periods, which showed less build-up of risk.

That approach would be sensible for assets the firm intended to hold for more than a single day. The only reason to evaluate VAR over very short periods (daily, hourly) is if liquidity becomes an issue and the firm was not sure it could absorb large one-day profit and loss (P&L) swings and meet margin calls.

But once the firm was sure of unlimited liquidity from the central bank, it could afford to “look through” the one-day P&L swings, holding loss-making positions and waiting for the market to reverse them in coming days.

In one sense, Goldman’s access to unlimited Fed liquidity increased its capacity to absorb short term volatility and conferred a competitive advantage over other institutions, such as hedge funds, that do not have the same access to central bank funding. Armed with a Fed credit line, Goldman understood the risks in its book were smaller than the crude one-day VAR indicated, and could increase apparent risk-taking on this measure without any increase in the real danger to the firm.

The moral is that the basic one-day VAR figures being disclosed by Goldman Sachs and other financial firms in their SEC filings provide a very limited — and potentially misleading — indication of the true amount of risk they are running.

In a world of limited liquidity, VAR measures may substantially understate the true risk. But once central banks step in as market-makers of last resort and guarantee firms against failure arising from liquidity rather than solvency, the one-day VAR measure probably overstates the degree of risk and banks are comfortable ramping it up.

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