The Fed’s Ballooning Balance Sheet

With a return to growth for the Irish economy heavily dependent on economic recovery in the world’s major economies, we must hope that the monetary policy actions being taken by the Fed and other leading central banks will be successful.   Unfortunately, it’s a bit hard to judge what’s going on at the moment, particularly at the Fed.  

I’m teaching a module at UCD this semester on central banking.   I last taught the course in Autumn 2007 but already I’m going to have to rip up many of my old lecture notes, so dramatic have been the changes in monetary policy procedures, most notably at the Fed. 

There have been a number of profound changes at the Fed, including a move away from targeting the Federal Funds rate and towards paying interest on reserves.  But the most notable change has been the massive expansion in the size of the Fed’s balance sheet.  The most useful summary of this development that I have found is this recent post by Jim Hamilton.  Commenting on the huge expansion in the Fed’s balance sheet, Hamilton notes “The bottom line is that Bernanke has made a gamble with something approaching 2 trillion.”

Conference Announcement: Responding to the Crisis

Below are details of a conference on the Irish economic situation. Admission is free, but spaces are limited. Places can be booked by email to, telephone (01) 7168335.

The conference website is here.

Responding to the Crisis

The UCD School of Economics, in association with the Dublin Economics Workshop, has arranged a half-day conference on the current economic crisis at the Royal College of Physicians, 6, Kildare St., Dublin 2, on January 12th. 2009.


14.15 Introductory Remarks

Rodney Thom (UCD)

14.20 Session 1: Fiscal Consolidation

Chair: John Fitz Gerald (ESRI)

Philip Lane (TCD): Fiscal Policy Options in the Euro Area

Ciaran O’Hagan (SocGen Paris): How Much Can Small Sovereigns Borrow?

Colm McCarthy (UCD): Expenditure Control and Fiscal Consolidation

Discussant: Karl Whelan (UCD)

Coffee at 15.45

16.00 Session 2: The Property Bubble and the Banking Crisis

Chair: Brendan Walsh (UCD)

Patrick Honohan (TCD): Resolving the Banking Crisis

Morgan Kelly (UCD): The Irish Property Bubble and its Consequences

Robbie Kelleher (Davy): Bank Solvency, Basle II and Accounting Standards

Discussant: Alan Ahearne (NUI Galway)

Conference concludes at 17.30.

Will This Year’s Contraction Be Much Worse Than Last Year’s?

Media coverage of the current Irish recession has popularized two ideas. The first is that the recession came about very suddenly. The second is that forecasts (such as the ESRI’s prediction of GNP growth of -4.6% for 2009 compared with -2.6% for 2008) imply that economic performance this year is likely to be far worse than last year. It turns out, however, that neither of these ideas are correct. The source of the misconception, in both cases, turns out to be the lack of use of the CSO’s quarterly national accounts (QNAs) in popular discussions of the Irish economy.

Take the first idea — that the recession occurred quite suddenly. The swing from GNP growth of 4.1% in 2007 to a projected decline in GNP of 2.6% in 2008 has been widely cited to illustrate a violent switch from excellent economic performance in 2007 to a slump in 2008. However, the truth is more subtle. These figures for economic growth are the “annual” growth rate, defined as the percentage difference between the average level of output in a year and the average level of output in the previous year. However, this calculation doesn’t always give an accurate indication of economic performance during a year because it is heavily influenced by what are known as “base effects”. To give an example of what this means, consider a case in which GNP expands rapidly one year and then stays constant throughout the next year. We might intuitively view the second year as one in which there was no growth. However, the “annual” growth rate will appear to be quite positive because the average level of GNP in the second year is higher than its average level in the previous year.

A closer look at the quarterly data shows a gradual slide into the current recession. The QNAs show seasonally adjusted real GNP alternated between expansions and declines from 2007:Q1 onwards. GNP turns out to have peaked in 2007:Q3 and the graph below clearly shows the economy was essentially flat over the period from 2007:Q1 to 2008:Q1 before a more pronounced recession set in during 2008:Q2. So, far from being sudden, the quarterly data show the economy stalling for about a year before the public realized a recession was upon us. (My UCD colleague Colm McCarthy made this point in his paper with Rossa White presented at the DEW in Kenmare).

Now consider the second idea, that a swing from -2.6% growth last year to -4.6% this year implies that things will be getting much worse. Again it turns out that this swing is completely due to the dreaded base effects. The ESRI’s figure of -2.6% growth for 2008 is consistent with a 1% decline in seasonally adjusted GNP in 2008:Q4. Combined with the declines from earlier in the year, the implied level of GNP at the end of 2008 is below the average for 2008 as a whole. So suppose, for example, that GNP managed to remain flat at this level for the whole year (a highly unlikely achievement). In this case, the average-over-average calculation for GNP growth for 2009 would give -2.1%. A dramatic turnaround from sharp contraction to flattening out would not be picked up by this measure.

Against the background of a severe worsening of the global economy and serious domestic fiscal problems, perhaps a better starting point is the observation that the year after 2008:Q3 is unlikely to be better than the previous year. GNP declined 4.8% over the year ending in 2008:Q3. Projecting this average decline of -1.2% per quarter through 2009:Q4, gives a figure for annual (average over average) GNP growth for 2009 of -5.1%.

These calculations show that, rather than a severe worsening, forecasts such as the ESRI’s projection of -4.6% for 2009 actually represent a slight improvement relative to the economic performance seen in the year ending in 2008:Q3.

My point here is not to question the ESRI’s forecast, which may turn out to be a good one, but to argue that economists and media commentators should make more use of the QNA figures when discussing the performance of the Irish economy.

One small change that could be made is to switch from discussing the average-over-average figure for output growth to instead discussing Q4-over-Q4 figures, which reflect the level of output at the end of the year relative to the start of the year. From my time working at the Federal Reserve Board, I know that this is the measure of growth that the Fed staff uses when describing its forecasts to the FOMC. In the above example of flat Irish GNP this year, this Q4-over-Q4 figure would show the economy improving from -4.7% in 2008 to 0% in 2009 rather than the marginal improvement cited above of going from -2.6% to -2.1%.

A caveat to this suggestion, however, relates to the use of GDP and GNP figures for projecting tax revenues. Because Ireland’s tax year corresponds to the calendar year, the year-average level of output is the appropriate figure for budget calculations. The calculations above show how far we are now from the projections underlying October’s budget. Taking the ESRI’s figure for 2008, achieving the budget’s projection of a 1% (average over average) decline in GNP in 2009 would require GNP to actually grow at a 2% annual average rate throughout 2009.

Ten Years of the Euro

We now have a full decade of evidence concerning the impact of European monetary union on Ireland and the other member countries. While my view is that the euro has been beneficial in many ways, the next year or two will be highly revealing about the capacity of member countries to undertake economic adjustment while operating within the constraints of a common currency area.

The Economist has a nicely balanced article in its most recent edition: “Demonstrably Durable“, while John Hurley had an op-ed giving the local central bank view in the Irish Times on December 30th.

I gave my own view on the impact of the euro on Ireland in an article for the Sunday Business Post back in May: you can read it here.

I have also recently written a couple of academic survey papers on different dimensions of the euro:

EMU and Financial Integration,” IIIS Discussion Paper No. 272, December 2008. Prepared for the 5th Central Banking Conference of the European Central Bank.

The Macroeconomics of Financial Integration: A European Perspective,” IIIS Discussion Paper No. 265, October 2008. Prepared for the 5th Annual Research Conference of DG-ECFIN (European Commission).

Holiday Reading

Many of you may not read Vanity Fair or be aware that Joseph Stiglitz is a regular contributor.  In the current issue he gives his trenchant version of who is to blame for the mess the US economy is in at the start of 2009.  See

Anyone prepared to do an Irish edition?

Designing a Fiscal Response for the Crisis: The IMF View

The IMF has released a detailed study about the optimal design of fiscal policy to combat the crisis. A key feature of this report is that it accepts that the appropriate fiscal response varies across countries. In particular, this extract from an online interview with two of the report’s authors (Olivier Blanchard and Carlo Cottarelli) is relevant to the Irish situation:

Cottarelli: That said, it is critical that this fiscal stimulus isn’t seen by markets as undermining medium-term fiscal sustainability. That would be counterproductive, including in its effects on demand today. Indeed, we’ve said that not all countries can afford a fiscal expansion.

How the stimulus package is designed is also key: fiscal measures should be reversible, and governments may want to precommit to unwinding some of the policies. Also, any stimulus should be formulated within a robust medium-term fiscal framework, which could be made more credible by strengthening independent oversight of fiscal policy.