This Handbook can be accessed from http://www.albany.edu/~renshaw/
By Edward Renshaw,
Professor of Economics,
State University of New York at Albany.
I use this material as a supplement to courses in macroeconomics, money and banking, financial economics, and as an ingredient in helping me to manage my own portfolio.
This introduction to a collection of essays and tables is composed of four parts:
The stock market took its sharpest plunge in five months on the morning of December 6, 1996 after Fed Chairman Greenspan raised the specter of "irrational exuberance" on Wall Street. One of the easiest ways to illustrate this possibility is to examine what happened to the S&P composite stock price index after other cases of two years of double digit financial returns (Table 19.9). Since the recovery of stock prices from the debacle of 1929-32, consecutive years of double digit returns for the S&P index have eventually been followed by cumulative declines or "corrections" of from 7.5 to 47.2 percent.
The possibility of irrational exuberance can also be illustrated by examining new historic highs for the S&P index. Since this index was extended back to 1928 ten or more new highs in the first quarter of a calendar year have (so far) always been followed by six or more new highs in the second quarter. The new high exuberance that was experienced in 1928-29, 1961, 1964-65 and 1985-87 was eventually subdued by nerve racking crashes (Table 19.7).
In the financial world actions speak louder than words. The 4.8 percent new high correction for the S&P 500 associated with Greenspan's first "moral suasion" effort was only about half as severe as the 8.9 percent correction associated with the Fed's preemptive strike against the possibility of accelerating inflation in February 1994. The 64 billion dollar question as of March 1, 1997 is whether Greenspan's second effort to end the specter of irrational exuberance on February 26, 1997 will be any more successful (Table 20.1).
The one indicator in this Handbook that is most likely to provoke action on the part of the Federal Reserve, instead of words, is further evidence in support of wage acceleration (Table 12.2) and (Table 12.8).
Stock market optimists can perhaps take some comfort in the fact that since 1947 increases of one percent or more for the S&P index during January have (so far) helped to produce positive financial returns for the entire year (Table 19.5). In 3 of the 27 resolved cases (1947, 1987 and 1994), however, the S&P index did end the year below its January closing price.
It should also be noted that stocks have outperformed corporate bonds over long periods of time (Table 18.5). Since there are some tax and transaction cost advantages to holding stock, as opposed to bonds, one can argue that it is "rational" for the earnings and dividends associated with the S&P index to be more highly valued at the present time than was the case in the past (Essay 18).
The bull market of 1991-9? has established some new duration records. With no correction in excess nine percent (so far), it has "ruined" many market timing strategies that would have produced trading profits in the past (Table 20.1).
History suggests that one is usually better off to have invested in the stock market after a large one-day decline in stock prices than to have followed a dollar cost averaging policy of investing in the market at the end of each day or a trend chasing strategy of purchasing a portfolio similar to the S&P index after a large one-day increase in stock prices. A better appreciation of the gains to be expected from purchasing equities during downside corrections may have already helped to stabilize the stock market. (Table 17.7)
The best years to have owned stock and long term bonds have been years containing a recessionary trough in economic activity. (Table 3.2) Recessions have often encouraged the Federal Reserve to lower short term interest rates to the point where stock and long term bonds become very attractive in comparison to Treasury bills and other types of money market instruments.
While large spreads between the yields on low grade corporate bonds and three-month Treasury bills are of some value in predicting financial returns in both the stock and bond markets, they are not very reliable in warning investors about the possibility of a stock market correction in the midst of prosperity. (Table 7.6)
The life cycle hypothesis implies that persons who want to even out their consumption over an entire life time should save more when real interest rates are low and save less when they are high. This type of behavior makes it easier for one to understand why personal saving rates sometimes increase during trough years and why monetary policy has acquired the reputation of only working after a long and variable lag. (Essay 3)
Once the economy has begun to recover from a recession, and the actual growth of real fixed investment has increased at least 2.1 percent greater than predicted by the accelerator model in (Table 4.1), optimism on the part of business enterprises and developers has tended to spread to the stock market and produce following year returns for the S&P index that have been positive, at least for the years from 1946-95. A large part of the "exuberance" on Wall Street in recent years can probably be attributed to rapid increases in computers and other types of fixed investment on the part of business enterprises which have helped to increase corporate profits in a dramatic way.
It should be appreciated, however, that the S&P index has long been a main stay component in the index of leading economic indicators that was recently turned over to the Conference Board and that the current business expansion is already the fourth longest in business cycle history. Since the mild recession of 1960-61 the S&P 500 has lost more of its value after a recessionary peak in business activity than before the peak. (Table 14.5)
During the same period of time the US has never experienced a recessionary peak in economic activity until the Conference Board's index of leading economic indicators has declined by at least one percent. (Table 14.1)
From 1945 to 1990 the duration of business expansions was about equal to 15 months plus 1.57 times the monthly lag for a secular rise in the prime rate after months containing an NBER trough in Business activity (Table 5.1). This formula, which was developed by the Center for International Business Cycle Research is predicting that the current business expansion might end in the near future and can be considered a time tested standard for assessing the success of the Fed's efforts to prevent an acceleration in the inflation rate without tipping the economy into another recession.
One reason for hoping that the CIBCR model may be overly pessimistic is a positively sloping yield to maturity curve for Treasury obligations. Since the Korean War wind down recession of 1953-54 the US economy has never experienced an economic recession until at least seven months after the yield on one year Treasury notes has risen above the yield on ten year Treasury bonds (Table 3.5).
Another reason for optimism is the behavior of good year indicators. In the post 1947 period year-year declines in Federal Reserve Bank profits have (so far) never been followed by a year containing a recessionary peak in economic activity. At the end of 1996 there were at least four other economic and financial indicators supporting the prediction that 1997 will not be marred by another recession (Essay 21).
While none of the individual components of real GDP are very reliable recessionary indicators, history would suggest that a noteworthy loss of investment confidence in more than one interest sensitive sector of the U.S. economy will often spread to other sectors and help to tip the economy into a recession once the prime rate charged by banks has increased by a third or more from its cyclical low. (Table 14.3)
The ten poorest growth years in the post 1947 period have all followed a year-year increase in the price of crude oil of five percent or more and an anemic increase in June-December industrial production amounting to .1 percent or less (Table 11.3). Using this type of interaction to identify poor growth years before they occur and moving medians to project past growth rates for real GNP into the future one can do a remarkably good job of explaining what has happened in the following year to the growth of chain weighted real GDP in the last decade (Table 11.5).
The US electorate does seem to hold incumbent political parties responsible for what happens to the economy. Hoover in 1928 represented the last political party to get reelected after an increase in the civilian unemployment rate during the last two years of a presidential term. (Table 10.1)
A relatively simple multiplier model based on a marginal propensity to consume out of current income equal to .5 now fits the US data better than was the case in the early 1960s when Keynesian economics was a dominant school of thought. (Tables 1.1) and 1.2)
Recessionary increases in the federal deficit in the national income and product accounts dramatize the importance of automatic built-in stabilizers in helping to offset the deleterious effect of recessionary declines in gross private domestic investment on real GDP. (Table 1.2)
There has been an over reliance on income transfers and not enough attention paid to government investment during economic recessions. Since the mild recession of 1960 government investment in structures, which can provide long term benefits, has declined more often than not during economic recessions. (Table 1.3)
Tax cuts, regardless of whether they are deliberate or the result of a recessionary decline in sales and income tax payments, can take a long time to pay for themselves. Since the recession of 1957-58 the real value of the cyclical lows for the federal deficit in column (2) of (Table 1.2) have consistently increased from one business expansion to the next.
Chronic government budget deficits and escalating government debt have become major concerns in both developed and developing countries. Concern arises because fiscal imbalances siphon funds from private sector investment, retarding growth and ultimately reducing standards of living. Essay 1 )
If the Fed was authorized to purchase some of the obligations of state and local governments, its regional branches could cooperate with say state bond banks to develop a backlog of infrastructure projects that could be quickly started during periods of economic weakness. ( Essay 1 )
Declines in the share of GDP devoted to federal spending may have helped to tip the U.S. economy into some recessions (Tables 2.1 and 2.2)
The leading indicator quality of some of the more interest sensitive components of real GDP might enable policy makers to take actions that will prolong business expansions. (Table 2.2)
The accelerator principle suggests that real GDP must increase by about two percent per year just to keep private investment from falling and having a deleterious feedback effect on the growth of economic activity. The instability of the GDP growth rate in the zero to two percent range has sometimes made it very difficult for the Federal Reserve to effectively fight inflation without pushing the U.S. economy into a recession. (Essay 3)
The Fed's policy of "leaning against the wind" may be one of the factors that have made it difficult for model builders to identify an inverse relationship between changes in the interest rate and investment in business equipment. (Essay 5)
Financial innovations have made the demand for money more complicated than it used to be. (Essay 6)
Latane's 1960 demand for money equation outperformed the more celebrated Baumol model by a ratio of 9-5 from 1982-95 and may have set the stage for a new role model. (Table 6.2)
Changes in the federal funds rate and other short term interest rates suggest that the Fed dislikes inflation but has reacted even more strongly to increases in the unemployment rate. (Essay 6)
During the 1990s quarterly changes in the yield on ten year Treasury bonds have moved in an opposite direction from changes in the federal funds rate, more often than not. This raises a question as to whether the Fed hasn't lost some of its ability to control the direction of long term interest rates. (Table 6.3)
Post 1947 recessions are not getting shorter if measured from the recessionary peak of a coincident indicator to its recovery to a new high. (Table 7.1)
The Fed's policy with regard to the real, inflation-adjusted return on Treasury bills has varied considerably during employment recessions. (Table 7.2)
In the post 1947 period the duration of employment recessions has been about equal to 15 months minus the monthly lead time for industrial production at its peak relative to the peak in payroll employment. The implication would seem to be that a year or more may be required to turn an industrial recession around and that lower interest rates may not be very effective at halting a decline in employment that begins before or at about the same time as the decline in industrial production. (Table 7.4)
Economic recessions are the only sure cure for inflation. The reduction in the inflation rate one year before an employment peak to one year after the employment trough has been about equal, on the average, to the percentage point increase in the civilian unemployment rate from its cyclical low to its cyclical high. (Table 7.5)
If it weren't for inflation there would be no need for supply-side economics. (Essay 8)
Shifts in demand and supply growth indicators are of some value in helping to identify turbulent periods when the U.S. economy may be especially vulnerable to a recessionary peak in business activity. (Essay 8)
Money and the stock market: Does it make a difference? (Table 8.5)
A shifting Phillips curve can be used to help estimate the natural unemployment rate. (Essay 9)
The growth of payroll employment, however, is a better inflation indicator than the unemployment rate. (Tables 9.2 and 9.3)
Section 2A of the Federal Reserve Act requires the Board of Governors "to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates." The Mack bill would make price stability the primary goal of monetary policy. (Essay 10)
An alternative approach to the problem of conflicting objectives would be to have the Board of Governors try to stabilize the growth of nominal GDP. If the aggregate demand curve is assumed to be unit elastic this would be equivalent to trying to stabilize the growth of aggregate demand. Success in this regard would mean that economic recessions and increases in the inflation rate would be entirely dependent on adverse shifts in supply. (Essay 10)
From 1948-94 the unemployment rate was reduced by half a percentage point or more during the second year of a Democratic administration and was usually allowed to increase during the second year a Republican administration. (Table 10.3)
In the post 1947 period there has only been one year (1977) when the Fed allowed the growth of M1 in constant dollars to increase when the CPI inflation rate was over five percent. (Essay 10)
One reason for preferring a modest inflation rate to no inflation is seignorage, the revenue that governments receive from inflation when they issue currency and do not pay interest on mandated bank reserves at the Fed. If it were not for seignorage profits made in the "underground" economy and illegal activities such as drug trafficking might otherwise go untaxed. (Essay 10)
Oil production in the lower 48 states has been trending downward since 1970. Since that turning point the U.S. has never experienced a recession that wasn't preceded by a yearly increase in the average cost of imported oil at U.S. refineries amounting to 24 percent or more and an increase in the motor fuels component of the consumer price index of 9.4 percent or more. This raises an interesting question: can there be another recession without an oil price shock? (Tables 11.1 and 11.4)
Forecasting what will happen to the inflation rate is tricky since food and energy price shocks are hard to predict and history would suggest that preemptive strikes by the Fed may make a difference. There have also been some changes in the construction of the consumer price index that may make it easier for the Fed to prevent an acceleration of the inflation rate. (Essay 12)
Disillusionment with model-based approaches to forecasting the inflation rate has inspired a more inductive search for inflation indicators with properties similar to the components of the Conference Board's index of leading economic indicators. None of the more widely publicized inflation indicators are very reliable, however. (Essay 12)
If professional forecasters cannot be trusted to examine their own record and adjust their inflation forecasts for upward bias is it reasonable to suppose that the Board of Governors of the Federal Reserve will do that for them? (Tables 12.6) and 12.9)
The five longest expansions in business cycle history have all occurred since the horrendous 43 month contraction in economic activity which lasted from August 1929 to March 1933. The current business expansion is already adding to the average duration of the ten expansions which have occurred since the end of World War II. (Table 13.1)
Employment recessions have been largely confined to layoffs in goods producing industries. The good news with regard to employment in manufacturing is that automation and other improvements in productivity have reduced the share of employment in recession prone industries. (Table 13.2)
In the post 1947 period the stock market has always turned up at least three months in advance of the recessionary troughs identified by the National Bureau of Economic Research.
While no law has been subject to more breakdowns than Okun's law, there is one version of this law which has continued to explain the historical data rather well. If this formula continues to be in tune with the data the potential growth rate may have already fallen to about two percent per year. (Tables 15.1 and 15.2)
The emergence of large trade deficits in association with huge government deficits in the national income and product accounts has inspired the notion of "twin deficits". If domestic savings equal domestic investment it can be shown that the trade deficit will indeed be equal to the government deficit. (Essay 16)
The risk that a country runs in having a large budget deficit that is financed by foreign borrowing is that unfavorable changes in the exchange rate will eventually begin to correct the trade deficit and cause the budget deficit to "crowd out" domestic investment as well as imports from other countries. (Essay 16)
The tendency for economic recessions to begin in the U.S. and then spread to other countries can be verified by examining growth rates for industrial production. (Table 16.2)
The evidence in support of international cooperation to solve an economic problem is most apparent in connection with consumer price inflation. (Table 16.3)
A strong dollar is preferred by the Federal Reserve to a weak dollar which can add to inflationary pressures in this country as a result of higher import prices and by creating a less competitive climate where it is easier for manufacturing enterprises located in the U.S. to raise their prices. (Essay 16)
Since the oil price recovery and shock years of 1989-90 there has been a fairly dramatic convergence of inflation adjusted returns on bank deposits in the more industrialized countries of the world in spite of the inflationary pressures arising from the reunification of East and West Germany in October 1990. (Table 16.6)
What should a young person invest in? The first priority should be to obtain a good education. (Essay 17)
Don't fight the Fed--when investing in stocks and long term bonds. (Essay 17)
Will stocks continue to outperform long term bonds in the future? (Essay 18)
In their (1991) report on "The Status and Prospects of the Economics Major" Siegfried and others note that while most macro courses develop well the rigor and elegance of economic theory, "they tend to slight its evaluation. In particular, the usefulness of theoretical topics and paradigms, largely assessed by confronting theory with data, applying models to various problems, and comparing the outcomes of alternative theoretical constructs, merits greater emphasis. These courses should establish explicit connections between theory and its empirical counterparts, to help students appraise the importance of theoretical constructs, provide a basis for selecting assumptions, and show that theory is relevant."
There are a number of reasons why little is done at the undergraduate level to establish explicit connections between theory and the numbers that are continually being released by data gathering organizations.
The invention of large scale models of the US economy that are either too complex or time consuming to discuss in detail has been an inhibiting influence. Large scale models are now in the process of being replaced, at least for forecasting purposes, by a wide variety of simpler approaches. Many of the newer approaches, however, are not very interesting from a theoretical perspective.
An even more serious impediment to the confrontation of theory with fact is the identification problem. In the real world one seldom observes the independent shifts in say supply and demand schedules that are necessary to confidently identify the shapes of both of these curves.
Another inhibiting influence is parameter instability. Estimates of say the marginal propensity to consume can vary a great deal depending on the time frame and what variables are included in an estimating equation. Many of the variables of interest to macro economists are highly correlated with each other and this, in turn, can sometimes result in "crazy" parameter estimates.
In this handbook we will endeavor to circumvent some of these estimation problems by emphasizing some simple "role models" with generally accepted or otherwise fixed assumptions that allow the reader to more easily appraise how well Keynesian economics and other great ideas in macro economics--such as the accelerator principle--explain the national income and product accounts. It turns out that some of these models are now more in tune with what has been happening in the US economy than was the case when they were first invented.
Some of the problems which are encountered in trying to identify theoretical parameters for variables that are highly correlated with each other and the business cycle may actually be a virtue from a forecasting point of view. Throughout this handbook an effort is made to develop some new and modified forecasting systems that are simple enough to be updated by anyone who has been exposed to at least one course in macroeconomics.
In Essays 19 and 21 the emphasis is on the good year or period approach to economic and financial forecasting. The more indicators that seem to be pointing in that direction, the more comfortable an investor in the stock market is likely to be.
This attempt to merge theory with fact couldn't have been undertaken at a more propitious time. The huge amount of educational material in the public domain that is continually being generated by economists at the various federal reserve banks is already being made available on the internet and has the potential of revolutionizing courses in money and banking. There will still be a need, however, for at least a core type of supplement that covers some of the great ideas or building blocks in macroeconomics and enables readers to observe how well they explain the information that is continually being released by data gathering organizations.
Given a solid core covering the IS-LM and aggregate demand and supply framework, that has become a standard part of most textbooks, professors might then be "liberated" or freed to exposed their students to material on the internet, or use other types of supplements to make courses in economics and money and banking more interesting and useful. Some of the tangents that one might take include: a greater emphasis on competing schools of thought (Snowdon, Vane and Wynarczyk 1994) and symposiums sponsored from time to time by the regional federal reserve banks such as Budget Deficits and Debt: Issues and Opinions which was sponsored in (1995) by the Federal Reserve Bank of Kansas City.
Other possibilities include: one's own "customized" materials, collections of reprinted articles on the economy and its financial markets, letting students read The Economic Report of the President or subscribe to The Wall Street Journal, The Federal Reserve Bulletin, or The Survey of Current Business.
Most of the Tables in this supplement can be updated on the basis of information contained in the appendix to The Economic Report of the President, its interim monthly companion, Economic Indicators, and on the internet from such places as the White House Federal Briefing Room. The main advantage of the tables in this handbook is that the data have been processed and arranged in a manner that will enable readers to more easily observe and perhaps even profit from economic and financial relationships.
Money and banking is one of those courses that can be approached from a macro point of view or from the perspective of financial economics.
Banks are now involved in providing their customers with many types of financial services. With the macro portion of the course covered professors will be free to devote as little or as much time to the mechanics of money creation or go off in other directions and spend a lot of time discussing the banking business and financial economics.
My own bias is in the direction of models and indicators that might provide some clues as to what will happen, not only in the economy, but also in the stock and bond markets. Students should appreciate that the Fed, in its efforts to control inflation and prevent recessions, has become a major redistributor of income and wealth.
While Malkiel's book on A Random Walk Down Wall Street is still a popular supplement to some finance courses, one can now order competing supplements such as Haugen's The New Finance: The Case Against Efficient Markets. By studying some of the tables in this supplement professors and their students might be in a better position to protect the family wealth from the cruel and unusual punishment that is sometimes inflicted on portfolios by an over reliance on monetary policy to achieve the often conflicting objectives of full employment and moderate inflation.
It should be emphasized that models and indicators with an impressive track record sometimes break down and don't explain the future as well as the past. Financial innovations that have altered the demand for money have forced the Fed to abandoned monetary targeting and place a much greater emphasis on its control of the federal funds rate. Most textbooks, however, have been rather slow to explore the empirical connections between this rate and other variables of interest to economists and investors.
In economics there are no immutable laws of nature--only some relationships. And many of them are not very stable. By taking most of the work out of making pertinent comparisons the tables in this handbook should enable readers to quickly obtain a feel for how well economic theory explains the facts and better appreciate how difficult it is to predict what will happen to the US economy. It is hoped that the preceding highlights and tabular index may be of some value in providing readers with an inkling of the range of topics covered and the type of indicators considered in this collection of essays.
This portion of the introduction is still in the process of being researched and expanded.
The White House Federal Briefing Room is a good starting point for obtaining recent values for many statistical series that have been compiled by government agencies. It can be reached at: http://www.whitehouse.gov/fsbr/
Web pages are also available from the following Federal Reserve Banks:
Cleveland: http://www.clev.frb.org.
Kansas City: http://www.kc.frb.org
New York: http://www.ny.frb.org
Federal Reserve Bank of Kansas City (1995). Budget Deficits and Debt: Issues and Options.
Haugen, Robert (1995). The New Finance: the Case Against Efficient Markets(Englewood Cliffs, N.J.: Prentice Hall).
Malkiel, Burton (1973). A Random Walk Down Wall Street(New York: Norton).
Siegfried, John and others (1991). "The Status and Prospects of the Economics Major," Journal of Economic Education, 22(No. 3), p. 216.
Snowdon, Brian, Howard Vane and Peter Wynarczyk (1994). A Modern Guide to Macroeconomics: An Introduction to Competing Schools of Thought (Brookfield, Vermont: Edward Elgar).
Go on to Essay 1:
Go to Renshaw Home Page