Author: John McHale

Hump-Shaped Dynamics

A few weeks back, Harvard’s David Laibson gave a fascinating keynote lecture at the Geary Institute’s 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 Ireland’s property bubble a good candidate. But equally a string of bad news can lead us to excessive pessimism – Wolfgang Munchau’s expectation that Ireland’s 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.

Today’s 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 today’s 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.

Debt Buybacks

Commenter zhou_enlai raised the possibility earlier today of a debt buyback from the ECB. Such a buyback provides an interesting “third way” between the problematic bail–out strategy (new lending in the hope that some combination of growth/limited bank losses/primary budget surpluses will restore solvency) and the problematic bail-in strategy (restoring solvency through default).

Continue reading “Debt Buybacks”

Fairness and the budget

The ESRI’s SWITCH model analysis of the distributional impact of the budget is now available (Irish Times article here).   It will come as no great surprise to anyone who actually looked at the numbers that the budget was a good deal more progressive than much of the early commentary suggested.   Given the importance of political acceptance under the current circumstances, I cannot understand why the Government did not have this analysis completed in advance and released on budget day.

Putting brakes on default bandwagon

I draw on arguments from some recent blog posts on the default question in a piece for today’s Irish Independent.

Resilience

Many commentators have used the idea of “vicious cycles” or “feedback loops” to understand the virility of the financial and economic crisis.  (A nice example is this influential piece from last year by Larry Summers on the American situation.) 

This schematic attempts to capture some of the feedback loops operating between the Irish banks, public finances and growth.    One way to think about it is to view all three as facing some nasty headwinds.   For the real economy, growth is retarded by an impaired credit system, budgetary austerity and various multiplier/accelerator effects that intensify the recession.   For the public finances, it is harder to stabilise in the face of costly of automatic stabilisers, bank bailout costs and a self-fulfilling loss of creditworthiness as the risk premium on Irish debt rises.   And for the banks, they are strained by falling assets values, lost credibility of government guarantees and a slow motion run on wholesale deposits.    Everything seems to feed negatively on everything else. 

The adverse dynamics became overwhelming in recent months and international assistance has been required to prevent an effective collapse of the Irish economy.   The “bailout” means that the Government has time to implement a phased deficit reduction rather than face a sudden stop of funding, and the banks have access to recapitalisation funds and continued large-scale funding from the ECB.   This helps to ease some of the most virulent sources of negative feedback.  

The question now is whether it will be enough.    While in no way meaning to minimise the challenge, I think it is worth pointing out some potential sources of resilience in the system.   On growth, there are encouraging signs that despite severe headwinds the real economy is holding up surprisingly well (see here).   With capital spending 16 percent below profile, this is happening despite a fiscal adjustment this year that is not that much smaller than the €6 billion adjustment that the economy will have to bear next year.    

On the banks, a key point of contention is the likely future deterioration in loans, and especially mortgages.   Time will tell whether the resilience view of Elderfield/Honohan or the mass impairment view of Kelly/Matthews is correct. 

On the public finances, the key resilience factor is the capacity of the political system to generate the necessary primary budget surplus over the four- to five-year timeframe.    The coming months will be especially revealing on that score. 

Schematic