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 Kong’s 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. 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 Y2 Y1 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 Y2 Y1 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.org/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/november2001. • Thus, March 2001 (peak) to November 2001 (trough) was a recession. http://www.nber.org/cycles/recessions.html

33. The committee’s 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 BEA’s 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 committee’s 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 committee’s 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.html

40. Suggested exercises • Go through the NBER’s 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/index.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. Shiskin’s 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 1981:10 - 2009:09

44. Hong Kong’s 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 Kong’s dependence on the US

46. Hong Kong’s dependence on the US • Hong Kong’s 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. Low interest rates Great demand for Financial products Easy credit market Mortgage-backed, highly leveraged, complex & hard-to-value financial innovations e.g. MBS, CDO, CDS Financial Bubbles 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.