Hump-Shaped Dynamics

A few weeks back, Harvards David Laibson gave a fascinating keynote lecture at the Geary Institutes Economics and Psychology Conference. A key theme was the way people form expectations when macroeconomic time series have what he calls hump-shaped dynamics. These dynamics and their implications for expectations are described in a recent paper for the Journal of Economic Perspectives:

Many macroeconomic time series have long‐horizon hump‐shaped dynamics – processes that show momentum in the short run and some degree of mean reversion in the long run.  Such dynamics will generally not be captured by simple growth‐regressions.  Hence, agents with natural expectations will make approximately accurate forecasts at short horizons, but poor forecasts at long horizons, because the economy has more long‐run mean reversion than the agents impute from their intuitive models. In other words, agents with natural expectations will overestimate the long‐term persistence of good news or bad news.

David explained how even a skilled econometrician facing relatively short time series will tend to miss the longer-term mean reversion. The difficulty of seeing the mean reversion can mislead us into believing that a string of good draws on the fundamentals reflects a permanent improvement with Irelands property bubble a good candidate. But equally a string of bad news can lead us to excessive pessimism Wolfgang Munchau’s expectation that Irelands nominal growth will not exceed 1 percent for a decade comes to mind as a possible example.

We have certainly experienced a string of bad news on both economic growth and fiscal cost of the banking losses. Just as during the boom, extrapolation has led to extreme expectations about the economy and solvency. Of course, this pessimism could turn out to be justified. But it is no harm to remember that mean reversion works both ways.

Todays Q3 growth numbers can be considered mildly good news. It is still too early to tell if we will be bumping along the bottom for some time or have turned the corner. (See here for graphs of real and nominal GDP/GNP based on todays release.) For a mild antidote to the competition for who can come up with the biggest number for the banking losses, it is worth taking a look at Ronan Lyons’ analysis of potential mortgage-related losses.

28 thoughts on “Hump-Shaped Dynamics”

  1. Mean reversion works both ways John, but fiscal austerity on the scale that we are experiencing in the absence of devaluation only works one way in the real world. Maybe not enough to lead to continual falls in output, if exports are sufficiently buoyant, but surely enough to prevent the sort of growth rates required to make the State solvent in the absence of the necessary restructuring of our bank debts. In a decade, who knows what the story will be, and I am inclined to concede that you may have a point here, but optimism in the short to medium run run seems hard to justify — especially given what Reinhart and Rogoff have told us about the aftermaths of major financial collapses.

  2. Kevin,

    I don’t deny the substantial downside risk; but I do think perceptions of the distribution have shifted too far to the left.

    Two additional points: First, I don’t think we need particularly high nominal growth to stabilise the debt ratio. A 2 percent nominal growth rate out to 2014 would require roughly an additional percent of GDP of primary surplus (3 percent of GDP versus 2 percent of GDP under the DoF’s projections).

    Second, with the underspending of the capital budget, the economy is experiencing a negative fiscal impulse this year almost as large as will be experienced next year. Given the normal bounce back — and hopefully with the continued strength of net exports — I would expect further improvement in the underlying growth rate, though I don’t deny the headwinds.

    On the negative side, I would agree that the numbers today on domestic demand continue to be sobering, and I don’t discount the Reinhart and Rogoff findings. (Potentially an additional cause for concern is the build up in final goods inventories.)

  3. @John
    “Two additional points: First, I don’t think we need particularly high nominal growth to stabilise the debt ratio. A 2 percent nominal growth rate out to 2014 would require roughly an additional percent of GDP of primary surplus (3 percent of GDP versus 2 percent of GDP under the DoF’s projections). ”

    While I think this makes perfect sense in theory John, what does it mean in practice. After interest payments of €11bn and promissory notes capital repayments of €3.5bn pa what will be left to run the state?

    The question isn’t whether we can get to a budget surplus the question is whether we can run the state on the money that is left over.

  4. @D_E

    I think we have to recognise that we are still a rich country with a relatively low tax share (albeit relatively high marginal tax rates on income) and relatively generous welfare/public sector pay rates. If we default it will because we won’t pay not because we can’t pay.

    Having said that, just because we have to adjust does not mean we should make the adjustment unnecessarily costly by deflating the economy excessively in the short run — that is as much waste as the kind of deadweight losses that keep Colm McCarthy up at night. I reluctantly accepted the need for strong front loading given that we lost market access. I would welcome this being revisited now that we have official assistance and the commitment device of conditionality that would make a more phased adjustment possible. However, I can’t see the EU side being receptive, even if the IMF gets it.

  5. Surely rather than speculating about the future, we should be thinking about what can be done to lower the probability that the State is forced to default?

    Surely paying back unguaranteed bank debt raises this probability? We are still talking about a huge amount of money — the fact that the authorities have already paid back an even huger amount, which is criminal in my view, doesn’t mean we should continue to make this kind of mistake. Shouldn’t we all be screaming from the rooftops about this?

  6. I have to agree with John McHale when he says:
    “If we default it will because we won’t pay not because we can’t pay. ”

    and disagree with him when he says:
    “just because we have to adjust does not mean we should make the adjustment unnecessarily costly by deflating the economy excessively in the short run ”

    Which bit of lower living standards is unacceptable? (Given that current living standards are largely based on debt, previously private sector, now public sector).

    @Kevin O’R:
    “fiscal austerity on the scale that we are experiencing in the absence of devaluation only works one way in the real world. Maybe not enough to lead to continual falls in output, if exports are sufficiently buoyant, but surely enough to prevent the sort of growth rates required to make the State solvent in the absence of the necessary restructuring of our bank debts.”
    You might want to re-read bits of Reinhart and Rogoff. Devaluation is an accompanyment to default (or a method of default), not a substitute for it. Either the state is going to pay its debts, or it will come to some arrangement to not pay them.

    The price of the state continuing on the madness of a slow reduction in the deficit is the price for bailing out banks. You’ve won on one hand (no more austerity than the plan)… pity me, I’ve lost on both.

    Personally, I would be out there hounding every borrower in default until they cough up as much as they can, but are you ready to apply the same treatment to the developers and to the “it just happened Joe, it’s not my fault”?

    Like the AIB vs. DoF bonuses, fairness is not a one-way street.

  7. Kevin,

    I agree with your on the unguaranteed bank debt — you have not always been so discerning. 🙂

    Putting aside the objections of the ECB/EU, making the legacy Anglo seniors bear the costs of their bad investments is a no brainer — it is hard to imagine a more insolvent institution. Things are more complicated for the big two given their current capital positions, even if a portion of that capital has come from the State.

    It is important to our longer term reputation that any loss imposition is done in terms of a proper resolution regime. This has been put off for far too long, and what we get now is emergency legislation that is an affront to the rule of law (in my non-expert legal opinion).

  8. In the long run it will be easy to tell what the long run was, and to show where short run expectations diverged from the beginning of the reversion to the mean. In the short run that’s extremely difficult.

    Will the period be 3 years, as in their model, or 5 years, or 10 years, or longer? Hindsight will tell, but this paper doesn’t seem to offer any way to do that.

    Other than uncertainty over time lines, I still fail to see the justice or logic of our current path, where the lifestyles of many in Irish society are being protected at levels wildly above a justifiable level by persistent and ruinous borrowing that others will have to repay…apparently so that those with protected lifestyles can spend borrowed money in order to “stimulate growth”.

  9. I wonder what would RL estimates say if you plug in 75%-80% fall in house prices as MK has also predicted (presumably with an accompanying fall in rents to stop rates of return getting good)?

    alos about the non nama non mortgage losses

    Indeed what about nama itself?

    MK’s core prediction is house price falls of 75%-80% – i would suspect that his estimates of bank losses flow from that – using other percentages is not really comparing like with like

  10. @John McHale
    ‘It is important to our longer term reputation that any loss imposition is done in terms of a proper resolution regime. This has been put off for far too long, and what we get now is emergency legislation that is an affront to the rule of law (in my non-expert legal opinion).’

    I suggested on another thread that this rushed legislation will be tested probably in a forum other than the Four Courts. Joan Burton is on record stating parts of the Bill are unconstitutional.
    One has to wonder at the competence or lack thereof of the many actors in this whole sorry banking debacle.

    I note today that Timothy Geithner has estimated the cost of the US bailout at 25b dollars. What is our banking cost – 90b Euro.

    When comparing these figures relative to size and assets it is a truly astonishing mess we have been landed in by our government and their highly paid advisers.

  11. Opening salvo of paper

    “In recent decades, research in economics and finance has largely focused on the rational actor model, in which economic agents process all available information perfectly.”

    True. But to actually see that written down is a handy reminder about the capacity of what are trendily referred to as “elites” to subscribe to utter claptrap for astonishing length of time. Were Dublin’s builders, bankers and politicians really any worse, or did reality just bite them in the bum in a peculiarly embarrasing way?

    The humps thing is partly about wanting to be in with the in crowd, the cool people, the herd. Isn’t that what has sustained the efficient markets cult for so long?

    Observant asset price analysts know that the longer a trend continues the more difficult it becomes to doubt it will continue. Usually, when there are essentially no more doubters left the self-reinforcing mechanism stops. It is almost impossible though to translate that cool analysis into confidence in its predictive power.

    I was quite amused by my own reaction to the Irish property situation in mid 2006. One the one hand, I was absolutely convinced it was a kind of pyramid scheme, a classic bubble, partly because, everyone I encountered was a believer.

    One the other, the speed ot the price rises over the past year had left me embarrassed and a bit isolated. In response I stopped banging on about it and started to wonder whether I might have simply got it wrong – at the same time on an intellectual level I was confident that my own doubt was likely a classic signal that the peak was more or less in.

    Really wierd, forcing yourself to be bearish precisely because you no longer felt confident in that view.

  12. @John McHale

    If I can digress to the Roan Lyons article, I must say I find it over-optimistic to the point of not being credible. The fundamental flaw in the analysis is outlined in the article itself. The article is not looking at the “at Risk” loans at all , it is in fact basing most of his analysis on distressed loans. The two are quite different .

    “Instead, we need to look at the proportion of negative equity households at risk of foreclosure, i.e. where circumstances such as unemployment lead not just to arrears and Court proceedings but ultimately foreclosure. The first step is to look at mortgages in arrears: there are currently 40,000, a figure that may rise to 100,000 in a pessimistic scenario. With an average mortgages of €200,000, this suggests that a maximum of €20bn of the mortgage loan book is at risk.”

    The article goes on to further discount the loan losses until finally it comes up with the conclusion that:
    “The punchline is that repossession of 20,000 homes and their resale by banks for two-thirds of their loan value would mean balance sheet losses in the order of €1.3bn.”

    That is a long stretch from the current 40,000 loans in arrears which he alludes to at the beginning of the article.

    Neither is any reference to the effects of the very regressive 2001, that will take significant money from people on low wages. Many of these are the very people that took out out mortgages in critical 2000-2010 period. I am aware that many of these people are in difficulty. Some are availing of mortgage interest supplement. Indeed one could ask how these loans now being paid through availing of mortgage interest supplement are being classified by the banks. Are they in arrears or at risk?
    Overall, and no disrespect to Mr Lyons but I do not accept his benign analysis. One would sincerely hope that the Irish banks are not using his analysis to justify less than realistic reserves on the mortgage loan books.

  13. correction to above -should have read:

    Neither is any reference to the effects of the very regressive 2011 budget.

  14. @ Grumpy: “Really wierd, forcing yourself to be bearish precisely because you no longer felt confident in that view.”

    J K Galbraith coud hardly have put it better. Your previous para encapsulated the true behaviour of the Market (aka: a mindless herd in euphoric/panic mode). Only a person with a clear, stable, functioning cognitive system recognises the Market for what it really is:An Anarchic Place.

    So much for peer pressure and ‘group think’: ‘speculative dementia’ JKG termed it.

    BpW

  15. @BW

    “Only a person with a clear, stable, functioning cognitive system recognises the Market for what it really is:An Anarchic Place.”

    a bordel de merde ?

  16. The Byzantines were waiting for a mean reversion in 1453. Montezuma expected one after he saw his first Spanish horse.

  17. @John
    Thanks for the post and the trackback. You’ve captured the sentiments underpinning my blog-post better than I could.

    @ED
    It’s the number of repossessions, rather than the percentage fall, that really drives bank losses. So, for example, ball-park terms:
    Losses from 20,000 repossessions rise from €1.3bn with a 55% fall to €2.5bn under a 75% fall.
    Losses from 50,000 repossessions rise from €3.25bn with a 55% fall to €6.25bn under a 75% fall.
    Losses from 200,000 repossessions rise from €13bn with a 55% fall to the full contingency of €25bn under a 75% fall from the peak.

    @Joseph Ryan
    Point certainly taken about being optimistic. As John alluded to, I was getting tired of the race to predict the largest losses. Fun and all as that may be, it’s less of a public service than actually trying to get the numbers right. Hence, I’d be very happy if my analysis is completely wrong one way or the other, as long as it helps start a more meaningful discussion of looking at the likely numbers involved, and not just throwing our hands up, predicting social meltdown and battening down the hatches.

    (Un)Fortunately, we don’t have the track record of somewhere like the UK, where Muellbauer and Aron have done a lot of work modelling arrears and repossessions (http://www.economics.ox.ac.uk/index.php/papers/details/department_wp_499/). Their work shows, though, a few things of note for Ireland:
    (1) there are three key drivers of arrears: unemployment, the interest rate and in particular the debt-equity ratio.
    (2) arrears do not always turn into repossessions: in 1992, one in thirty UK mortgages was in arrears of 6 months or more, about the same level as in Ireland now. However, the repossession rate peaked at 1 in 500.

    A general point I would make is that while we may be looking at a €10bn mortgage arrears problem for the banks, not a €1bn one, we are not looking at a €100bn one, which was the implication of Morgan’s article (by design or by accident). Ultimately, Ireland’s households have about €200-€250bn of residential property assets, admittedly down from €450bn, but borrowing against those assets is €117bn. Ireland’s developers have borrowings in the region of €80bn but assets that are worth maybe €40bn. From a banking point of view (and I always have to repeat, not from a social point of view), there is no comparison in terms of the size of the problem.

  18. @RonanL

    Very good piece on the likely losses from defaults on the mortgage book.

    However over time I think we will see larger losses on the banks tracker mortgages. As far as I’m aware the banks value these loans at par on their books but if they were to be sold off as part of the downsizing I don’t believe the banks would get anything close to this.

    On average if you assume no credit losses, that the banks receive an income of circa 2% but it costs at least 3.5% to fund them they probably aren’t worth more than 85c in the €.

    Not sure if you have any stats on the level of tracker mortgages but I believe it is substantial.

  19. @ Ronan L

    “(2) arrears do not always turn into repossessions: in 1992, one in thirty UK mortgages was in arrears of 6 months or more, about the same level as in Ireland now. However, the repossession rate peaked at 1 in 500.”

    Yeahbut……. 1992….. sterling left ERM link and hey presto, two positives for the economy occurred.

    1 Currency devaluation.

    2 Interest rates which peaked at 15% to defend the peg, dropped a lot.

    Oh, and btw inflation peaked at just sort of 10% and started heading lower taking interest rates lower on an asset inflating journey.

    Do you think any of those are likely to occur in Ireland????!!!!

  20. Are repossessions of res property the problem, or is it the inability to service debts as they come due. Seems like the latter.

    The ‘new accounting’ rules will permit the financials to ‘hide-the-parcel’ for a while. And if mortgages are recourse – they will sytill enter any residual debt as an asset. Its a miracle!

    Then we have the un-employment problem. And the credit card debts. So the probability is for an increasing number of defaults on loans. Bankrupcy or writedowns are the only options which extinguish unpayable debt and allow some normalcy to return.

    Where are those guys getting the -55% on property? We are only about half way toward ‘bottom’! Losses are mightly resisted, hence the glacial pace of decline. Mean reversion is probably circa 2015.

    I was somewhat fortunate. My res property value rose to stratospheric heights and I was ‘offered’ 300,000 by way of a mortgage ‘extension’ to do some ‘additions’. I promptly declined. However I know of others who got suckered by this scam. They may be in some bother now. Getting reliable stats is not so easy.

    BpW

  21. @KOR

    Fitch and Moody’s seem to be on your side, and I suspect many ordinary citizens are too.

    I don’t buy that ‘we are a very rich country’ paean. It must sound really delusional to the ears of Rehn and Chopra – ‘yes we do need €85 billion because we are bankrupt, but in reality of course we are a very rich country.’ There’s a large layer cake of value judgments wrapped up in these conclusions. Emigration is probably the vent that’s keeping unemployment ‘stable’. A very rich country shouldn’t have to pass budgets that make most of the population poorer. Anyone with an income who has gone out to do the shopping for a family regularly would conclude that it must be very tough for the unemployed after they lose PRSI to get by.

  22. I’m not sure Ireland is going to have much of a “longer term reputation” the way things are going. Unless the whole EZ collapses. The local political management of this crisis has been abysmal.

  23. More good news on the banking side

    http://ftalphaville.ft.com/blog/2010/12/17/441106/the-luck-of-lloyds/

    Since the release of its Interim Management Statement on 2 November 2010, the Group has seen a further significant deterioration in market conditions in the Republic of Ireland, with concerns over the country’s fiscal position leading ultimately to the approval of its application for EU-IMF financial support on 21 November. Market sentiment has continued to be negatively affected by uncertainty about the political situation and about the economic impact of the austerity measures introduced in the Irish Budget of 7 December.

    As a result, we are concerned that any economic recovery in the Republic of Ireland may take longer to achieve, and that asset prices will remain depressed for longer, than previously anticipated. While the Board will continue to review the status of the Irish portfolio as the Group prepares its year end accounts, it believes that the recent significant deterioration in the Irish market will affect the timing and level of value realisation from this portfolio.

    Therefore, the Board anticipates that, compared to 30 June 2010, approximately a further 10 per cent of the £26.7 billion Irish portfolio will become impaired by the 2010 year end. Furthermore, the Board believes that it is prudent to increase the level of provisions against the portfolio, and currently anticipates an increase in the impairment charge relating to Irish exposures for the full year 2010 to approximately £4.3 billion on a combined businesses basis. This would result in an increase in provisions as a percentage of impaired Irish loans to approximately 54 per cent at the 2010 year end.

  24. @Seafoid
    AND
    ‘The IMF report says the banking problems have eroded the State’s credibility ‘at a gathering pace’. It adds that the banking crisis, low economic growth and concerns about the public finances are feeding on each other.

    The IMF says the threat to other euro zone countries from Ireland’s problems is significant, as markets believe other countries face similar vulnerabilities.”

    @JMcH
    Mary has referred the bill. Must look dodgy

  25. @ceteris
    “Mary has referred the bill. Must look dodgy”
    Of course it’s dodgy! On the one hand we’re being told the banks are grand, on the other the Minister is attempting to push through a war powers act that involves abrogating contracts (specifically), informally liquidating banks, and doing as he pleases with both assets and creditors.

  26. “@JMcH
    Mary has referred the bill. Must look dodgy”

    Maybe she as some subordinated bonds in the banks? Or shares in Anglo? Seriously, I think this was the right move.

  27. This part contained in the IMF report is a hoot-

    12. This reorganisation and downsizing of the banks will be bolstered by raising capital
    standards. While we expect that, in a restructured system, banks will be able to raise capital
    in the market, we recognise that the higher standards may imply that, in the short run, public
    provision of capital will be needed for banks that are deemed to be viable. To support this
    process—and to render it credible—we will undertake a review of the capital needs of banks
    on the basis of a diagnostic of current asset valuations and stringent stress tests (PCAR
    2011).

    reworded
    Banks that we deem viable won’t be able to raise money in the markets and the taxpayer will have to pay up.

  28. @cet. par.

    No surprise there surely. After the bill is referred and has been rubber-stamped by the Supreme Court it’s safe from further legal challenge (except to Europe), right?

Comments are closed.