tag:blogger.com,1999:blog-59707173233275547232024-03-05T06:39:16.989-08:00Shock Minus ControlThinking out loud about economicsMaggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.comBlogger82125tag:blogger.com,1999:blog-5970717323327554723.post-70918206457630513182010-02-27T18:31:00.000-08:002010-02-27T19:20:05.228-08:00If something can't go on forever, it will stopThis is my last post at/as Shock Minus Control. As I mentioned in my December post, my youngest son (now 7 months) had a congenital heart defect repaired around Christmas time. That repair then failed....was again repaired....and then failed again leading to a replacement of his <span class="blsp-spelling-error" id="SPELLING_ERROR_0">mitral</span> valve with a mechanical valve. A scary couple of months for our family that thankfully has a happy ending. Our little guy is now doing great.<br /><br />So, as much as I love writing about economics, after spending three months bedside in a pediatric ICU, I'd rather be cuddling my little boy.<br /><br />A huge thanks to everyone who has ever stopped by to read what I have to say.Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com5tag:blogger.com,1999:blog-5970717323327554723.post-42431339170034915242009-12-10T04:42:00.000-08:002009-12-10T04:46:48.602-08:00Blogging HiatusHi all,<br /><br />I will be taking a potentially extended hiatus from blogging. My youngest son (5 months) is having surgery today to correct an <a href="http://www.schneiderchildrenshospital.org/peds_html_fixed/peds/cardiac/avc.htm">atrioventricular septal defect</a>. Thanks for your thoughts and I hope to return in the new year.<br /><br />SMCMaggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com5tag:blogger.com,1999:blog-5970717323327554723.post-45816741762572331782009-11-30T06:59:00.000-08:002009-11-30T07:22:00.852-08:00Yikes! - Q3 Real GDP Growth = 0.4%We knew it was going to be far worse than what the Bank or Bay Street was forecasting, but I still expected growth to come in around 1% for the third quarter. Imports subtracted over 2% from growth and businesses have still refrained from significantly adding to inventories. <br /><br />Real GDP growth for Q2 was revised up ever so slightly from -3.4 to -3.1. <br /><br />With such slim growth, there is a good chance that Q3 may be revised into negative territory, indicating that the recession did not end in early Q3 as previously believed.Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com0tag:blogger.com,1999:blog-5970717323327554723.post-40684949195492885142009-11-10T18:45:00.000-08:002009-11-10T18:58:49.546-08:00Exchange Rate Forecast<a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMYnrqFM2dCwa_6JcC8ie_pxfmRuzyOTM5EiDsZZf4fY3cBVDNTji3IY7qFifEvgIei93Lpe2ZPMfE19jYPnU88tV_4DEtpoHRgTFd2efHIymAOGuy_zmhhkuTSd7gruLoybRZyEiIIy5y/s1600-h/loonie.bmp"><img style="cursor:pointer; cursor:hand;width: 400px; height: 243px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMYnrqFM2dCwa_6JcC8ie_pxfmRuzyOTM5EiDsZZf4fY3cBVDNTji3IY7qFifEvgIei93Lpe2ZPMfE19jYPnU88tV_4DEtpoHRgTFd2efHIymAOGuy_zmhhkuTSd7gruLoybRZyEiIIy5y/s400/loonie.bmp" border="0" alt=""id="BLOGGER_PHOTO_ID_5402674876522005810" /></a><br />Barring extraordinary intervention by the Bank of Canada, I expect the loonie to continue a trajectory towards parity, with a strong possibility of eclipsing that mark in early 2010. The graph above sets out my baseline forecast for the quarterly average US/CAD exchange rate from Q4 09 – Q4 10. The forecast is presented with 50%, 70% and 90% confidence intervals to factor the daily volatility of exchange rates and uncertainty underlying the forecast. The confidence intervals were constructed using spreadsheets from the authors of <a href="http://www.imf.org/external/pubs/ft/wp/2009/wp09178.pdf">this (recommended) paper. <br /></a>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com5tag:blogger.com,1999:blog-5970717323327554723.post-69069769769225145262009-11-04T14:23:00.000-08:002009-11-04T14:25:05.971-08:00The Last Honest Man in OttawaParliamentary Budget Officer Kevin Page <a href="http://www.theglobeandmail.com/news/politics/fund-us-or-shut-us-down-budget-watchdog-says/article1350522/">calls out Stephen Harper.</a>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com0tag:blogger.com,1999:blog-5970717323327554723.post-2166438432165177652009-10-25T15:48:00.000-07:002009-10-25T16:27:08.147-07:00"Intervention" is just a fancy word for printing moneyThis week Mark Carney again, and this time with vigor, threatened central bank intervention should the Canadian dollar continue to appreciate beyond what the Bank considers to be its fundamental value. Carney didn’t specify what level of the US/CAD exchange rate might trigger such intervention, but given the lack of action so far, it would seem that a prolonged move to parity might do the trick.<br /><br />The Bank’s chief concern is that a high loonie presents a risk that inflation may not return to target in timely fashion. Under normal circumstances, the central bank would simply reduce interest rates to take some air out of the loonie and spur inflation, but of course these are not normal circumstances.<br /><br />So what exactly is Carney threatening to do? Lets explore the available options.<br /><br />First, an identity:<br /><br /> M = NFA + (NDA – NW) = NFA + DC<br /><br />Where M is the domestic money supply<br />NFA is the central bank’s stock of net foreign assets (gold & foreign currency reserve)<br />NDA is the central bank’s stock of domestic assets (govt. securities, loans on commercial banks, other)<br /> NW is net worth<br />DC = (NDA – NW) is the stock of domestic credit made available by the central bank<br /><br />From the above identity, we see that the monetary base can be increased/decreased by adjusting either the stock of foreign assets or the stock of domestic credit. In a foreign exchange intervention, this can be accomplished one of two ways:<br /><br />1. Sterilized Intervention – the Bank of Canada buys US dollar assets but offsets the effects on the domestic money supply by selling domestic assets. The effectiveness of sterilized intervention is controversial and many economists believe that it in most circumstances it is ineffective in influencing the exchange rate. If any change is expected to occur, it is through the changing composition of assets (referred to by economists who study such things as the “portfolio balance channel”)<br /><br />2. Non-sterilized Intervention - the Bank of Canada sells Canadian dollar/buys US dollar assets (increase in NFA) which is not offset by the sale of domestic assets. The increase in NFA increases the domestic money supply (M) and therefore has the same impact as an open market operation.<br /><br />I think we can take option #1 off the table since sterilization would have no impact on the price level, which is the Bank’s main concern. <br /><br />If option 2 sounds familiar, that’s because it is essentially quantitative easing, only with an expansion in the money supply coming through an increase in NFA rather than through an increase in domestic credit, DC. Economists tend to believe that non-sterilized intervention is an effective tool for depreciating the currency. <br /><br />Will the Bank of Canada finally make good on its QE threats? I think that they have talked about it so much that they have no real choice. You can only bluff for so long before you lose credibility. I would guess the trigger would be a run to parity as a result of weakening USD and consequent rise in commodity prices but I guess we will have to wait and see. <br /><br />How much will the Bank have to increase the money supply to impact the exchange rate? We’ll have to leave that to another post, this one is already too long.Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com1tag:blogger.com,1999:blog-5970717323327554723.post-35143622077410245992009-10-09T22:11:00.000-07:002009-10-09T22:13:28.131-07:00The Training Wheels Economy rolls on<meta equiv="Content-Type" content="text/html; charset=utf-8"><meta name="ProgId" content="Word.Document"><meta name="Generator" content="Microsoft Word 11"><meta name="Originator" content="Microsoft Word 11"><link rel="File-List" href="file:///C:%5CDOCUME%7E1%5CBOGMUN%7E1%5CLOCALS%7E1%5CTemp%5Cmsohtml1%5C04%5Cclip_filelist.xml"><!--[if gte mso 9]><xml> <w:worddocument> <w:view>Normal</w:View> <w:zoom>0</w:Zoom> <w:punctuationkerning/> <w:validateagainstschemas/> <w:saveifxmlinvalid>false</w:SaveIfXMLInvalid> <w:ignoremixedcontent>false</w:IgnoreMixedContent> <w:alwaysshowplaceholdertext>false</w:AlwaysShowPlaceholderText> <w:compatibility> <w:breakwrappedtables/> <w:snaptogridincell/> <w:wraptextwithpunct/> <w:useasianbreakrules/> <w:dontgrowautofit/> </w:Compatibility> <w:browserlevel>MicrosoftInternetExplorer4</w:BrowserLevel> </w:WordDocument> </xml><![endif]--><!--[if gte mso 9]><xml> <w:latentstyles deflockedstate="false" latentstylecount="156"> </w:LatentStyles> </xml><![endif]--><style> <!-- /* Style Definitions */ p.MsoNormal, li.MsoNormal, div.MsoNormal {mso-style-parent:""; margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:12.0pt; font-family:"Times New Roman"; mso-fareast-font-family:"Times New Roman";} @page Section1 {size:8.5in 11.0in; margin:1.0in 1.25in 1.0in 1.25in; mso-header-margin:.5in; mso-footer-margin:.5in; mso-paper-source:0;} div.Section1 {page:Section1;} --> </style><!--[if gte mso 10]> <style> /* Style Definitions */ table.MsoNormalTable {mso-style-name:"Table Normal"; mso-tstyle-rowband-size:0; mso-tstyle-colband-size:0; mso-style-noshow:yes; mso-style-parent:""; mso-padding-alt:0in 5.4pt 0in 5.4pt; mso-para-margin:0in; mso-para-margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:10.0pt; font-family:"Times New Roman"; mso-ansi-language:#0400; mso-fareast-language:#0400; mso-bidi-language:#0400;} </style> <![endif]-->Don’t get me wrong, it’s great that the economy managed to produce 31,000 jobs last month – however, I find it a little hard to shout recovery from the roof-tops when nearly all of the employment gains were from public sector jobs and “self-employment”. Moreover, the fall in the unemployment rate, from 8.7% to 8.4% had just as much to do with the 25,000 people leaving the labour force in September (is this a back to school effect?). The market seemed to agree with my assessment. The <span class="blsp-spelling-error" id="SPELLING_ERROR_0">TSX</span> welcomed the jobs report by falling 50 points.
<br />
<br />All in all, the data released this week continues to point to a modest recovery in Q3 and an economy that would be continuing to slide if not for extraordinary government support.
<br /> <p class="MsoNormal">
<br /></p> Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com2tag:blogger.com,1999:blog-5970717323327554723.post-51626124520422933752009-10-04T18:16:00.000-07:002009-10-04T19:09:08.025-07:00The recovery is not off to a good startA few weeks ago Canadian forecasters convinced themselves that growth in the 3rd Quarter was going to be much better than expected. Unfortunately, the data doesn't seem to be cooperating. Retail Sales for July actually fell 0.6%, and real GDP growth in July was flat, with the retail and construction industries posting declines. This may be a concern given that personal consumption expenditures and residential construction tend to be early indicators of recovery - as shown in this chart from <a href="http://www.calculatedriskblog.com/2009/03/business-cycle-temporal-order.html">Calculated Risk:</a><br /><br /><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhNv72ugIL-pU0pneRrSp5DWtLHlLrJZ9xb6zsTNz1HUu47A1WfPhW5Q0o_UDt-Qvgfy9HhVZPWLdx6zyWdGnnQWvAOZbUAujvpuh34XiiDJ0vQXzMc8Fg1iCzCyIy0CXM1azXoOv_KScmX/s1600-h/indicators.PNG"><img style="cursor: pointer; width: 471px; height: 97px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhNv72ugIL-pU0pneRrSp5DWtLHlLrJZ9xb6zsTNz1HUu47A1WfPhW5Q0o_UDt-Qvgfy9HhVZPWLdx6zyWdGnnQWvAOZbUAujvpuh34XiiDJ0vQXzMc8Fg1iCzCyIy0CXM1azXoOv_KScmX/s400/indicators.PNG" alt="" id="BLOGGER_PHOTO_ID_5388926518081788370" border="0" /></a><br /><br />We should get a better idea of the shape of the recovery this week with data <span class="blsp-spelling-error" id="SPELLING_ERROR_0">for Q</span>3 housing starts, building permits, jobs, and the increasingly important <span class="blsp-spelling-error" id="SPELLING_ERROR_1">BoC</span> Senior Loan offers Survey all being released in the next few days.<br /><br />My own forecast for Q3 growth is still somewhere around 1-1.5%. Consensus from Bay Street seems to be around 2-2.5%, though I notice that BMO has, again (aside: I think BMO revises every week, it's really something) revised their forecast to 1.3%.Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com0tag:blogger.com,1999:blog-5970717323327554723.post-84712763727423965662009-09-15T20:40:00.000-07:002009-09-15T21:49:57.588-07:00TSX hits my target! Now what?All the way back in May I made the <a href="http://shockminuscontrol.blogspot.com/2009/05/is-tsx-fairly-valued.html">bold prognostication</a> (read: wild guess) that the <span class="blsp-spelling-error" id="SPELLING_ERROR_0">TSX</span> should be valued at between 11,400 and 11,500 - up from about 10,200 at the time. I hazarded a guess that the <span class="blsp-spelling-error" id="SPELLING_ERROR_1">TSX</span> might get to that level by the end of 2009, however it decided not to wait until the end of the year, closing at 11,496 today.<br /><br />In my previous post I suggested that the market was undervalued and would be pricing in 2009 <span class="blsp-spelling-error" id="SPELLING_ERROR_2">TSX</span> earnings of about $575 per share. I then applied a long-run average PE multiple of about 20 to arrive at my call of 11,400-11,500.<br /><br />Current estimates for 2010 corporate profits are in a range of 5-10% growth. My own model of corporate profits is spitting out growth of 30% (which I don't quite believe) - so lets say <span class="blsp-spelling-error" id="SPELLING_ERROR_3">TSX</span> <span class="blsp-spelling-error" id="SPELLING_ERROR_4">EPS</span> of around $630-$750. Since so much depends on the multiple applied to these profits, <span class="blsp-spelling-error" id="SPELLING_ERROR_5">i've</span> made a quick and dirty attempt at <span class="blsp-spelling-corrected" id="SPELLING_ERROR_6">incorporating</span> a PE equation based on short and long-term interest rates and nominal GDP growth into my Canadian economy model. The model derived PE suggests an average multiple of between 17-18 over the next year. Applying this multiple to the above range of forward earnings gives a fair value for the <span class="blsp-spelling-error" id="SPELLING_ERROR_7">TSX</span> of between 11,400 and 13,500, suggesting a market going sideways or a market about to pop by about 20%. A big range to be sure, but perhaps that is consistent with the amount of uncertainty in stock prices. <br /><br />Could I have arrived at this range by pulling numbers randomly out of a hat? Probably, but what fun would that be?Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com2tag:blogger.com,1999:blog-5970717323327554723.post-23690564492846236362009-09-07T19:55:00.000-07:002009-09-07T20:03:54.071-07:00The Training Wheels EconomyLooking at the most recent National Accounts data from Statistics Canada provides a sense that the Canadian economy can’t quite stay upright on its own. Luckily, the Government and the Bank of Canada have committed to stabilizing the economy until it can, sort of like a set of training wheels on a bike.<br /><br />For its part, the Bank of Canada has committed to keeping its target rate at an effective lower bound of 25bps until the second quarter of 2010. The fiscal stimulus proposed by the Federal Government is projected by the Bank of Canada to contribute about 2.3% to GDP over the next year and a half, including close to half of the Bank’s projected growth for 2010.<br /><br />So how long might the economy need training wheels? Well, personal consumption and residential investment seem to have turned, which is normally the case at the end of a recession. However, if this recession is anything like the past, private sector investment in non-residential structures and machinery and equipment may not recover for a while, particularly if bank lending remains tight.<br /><br /><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgeIA63th0UHW6IR0skdbPuin60faffxQhlQLIzKFMoTptfvZZ848dHzN457kw0cQObc8luJ8BkZnuCSFowcJb_E4onj4kfW9iLlulj1nK9LLVF06-UCK8M4Vzy-VrsL0oxnkvvbBQxhFym/s1600-h/recovery_5573_image009.gif"><img id="BLOGGER_PHOTO_ID_5378925549121282002" style="WIDTH: 400px; CURSOR: hand; HEIGHT: 213px" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgeIA63th0UHW6IR0skdbPuin60faffxQhlQLIzKFMoTptfvZZ848dHzN457kw0cQObc8luJ8BkZnuCSFowcJb_E4onj4kfW9iLlulj1nK9LLVF06-UCK8M4Vzy-VrsL0oxnkvvbBQxhFym/s400/recovery_5573_image009.gif" border="0" /></a><br /><br /><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg-1U7gK5btGsg00iuY3hl3S5l0WsbRy9INKigwXYCq17We5qd8Bx2_S5pOijfCfZfVrQwftVYVps8AT3j3Yu6QbYDS06FgxOg_RTKMWqDbgwyzQkBEd4ciCs_vxO27G3eaS9gwHQDpTmB-/s1600-h/recovery_5573_image008.gif"><img id="BLOGGER_PHOTO_ID_5378925544590761298" style="WIDTH: 400px; CURSOR: hand; HEIGHT: 212px" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg-1U7gK5btGsg00iuY3hl3S5l0WsbRy9INKigwXYCq17We5qd8Bx2_S5pOijfCfZfVrQwftVYVps8AT3j3Yu6QbYDS06FgxOg_RTKMWqDbgwyzQkBEd4ciCs_vxO27G3eaS9gwHQDpTmB-/s400/recovery_5573_image008.gif" border="0" /></a><br /><br />Non-residential investment in structures and M&E contributed an average of about 1% to annual real GDP growth from 2003-2007 before subtracting growth in 2008 and 2009. The fiscal stimulus should go a long way in replacing that growth in 2010, but if consumption growth stalls or the loonie creates a larger than expected drag on exports, we could be looking at keeping the training wheels on for an extended period. If not, a 1980-1982 style double-dip recession is a real possibility.Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com0tag:blogger.com,1999:blog-5970717323327554723.post-41881000229515801152009-08-31T10:59:00.000-07:002009-08-31T11:15:15.751-07:00Hey I got one right! .......but so did everyone else.Real GDP (quarter-over-quarter annualized) came in at -3.4% for the second quarter, just a shade better than my forecast of -3.5% (I've been having problems with my forecast link not working so I've taken it down until I can figure out a better way to link to it -you'll have to just trust me on this one.)<br /><br />For whatever reason there was quite a bit of (correct) consensus on the growth prospects for the 2<span class="blsp-spelling-error" id="SPELLING_ERROR_0">nd</span> quarter:<br /><br /><strong>Actual: - 3.4</strong><br /><span class="blsp-spelling-error" id="SPELLING_ERROR_1">WCI</span> (Stephen Gordon): -3.4%<br /><span class="blsp-spelling-error" id="SPELLING_ERROR_2">BoC</span>: -3.5<br /><span class="blsp-spelling-error" id="SPELLING_ERROR_3">SMC</span> (Me): -3.5<br /><span class="blsp-spelling-error" id="SPELLING_ERROR_4">BMO</span>: -3.3<br /><span class="blsp-spelling-error" id="SPELLING_ERROR_5">RBC</span>: -3.2<br /><span class="blsp-spelling-error" id="SPELLING_ERROR_6">CIBC</span>: -3.1<br />TD: -2.2<br /><span class="blsp-spelling-error" id="SPELLING_ERROR_7">Scotia</span>: -2.0<br /><br />The one thing the above list ignores is vintage (which I'm too lazy to dig up right now). The last time I made a forecast was sometime in early July, while others like <span class="blsp-spelling-error" id="SPELLING_ERROR_8">RBC</span> and TD were mid-June. <br /><br />Congrats to Stephen Gordon for nailing the number right on the head (I know yours was more of a preliminary estimate based on available 2<span class="blsp-spelling-error" id="SPELLING_ERROR_9">nd</span> quarter data, but still, kudos.)Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com1tag:blogger.com,1999:blog-5970717323327554723.post-67871240764727394552009-08-19T21:09:00.000-07:002009-08-19T21:29:03.127-07:00WTF Econo-Journalism: CBC EditionOkay, this is a minor complaint, but those are my specialty. While watching the news (CBC Vancouver) this evening, I overheard the anchor-woman say the following:<br /><br />"Another sign that the economy is on the road to recovery - inflation in<br />July fell to its lowest level in years"<br /><br />I've asked this before, and I'll keep asking, are there any editors anymore? I assume someone wrote the above for the teleprompter and someone else signed off on it. And yet, there is some <span class="blsp-spelling-error" id="SPELLING_ERROR_0">blonde</span> news anchor on my <span class="blsp-spelling-corrected" id="SPELLING_ERROR_1">TV</span> making an elementary mistake while projecting absolute confidence, leaving me no recourse but to scream <span class="blsp-spelling-corrected" id="SPELLING_ERROR_2">obscenities</span> at the ceiling.Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com1tag:blogger.com,1999:blog-5970717323327554723.post-22673197620247462052009-08-16T13:16:00.000-07:002009-08-18T22:56:32.488-07:00Reconciling the Bank of Canada's forecast or the Importance of Exchange Rate Assumptions<div><div>In its most recent <span class="blsp-spelling-error" id="SPELLING_ERROR_0">MPR</span>, the Bank of Canada produced a growth forecast for 2010 that seems rather optimistic compared to some private sector forecasts:<br /><br />Bank of Canada 3%<br />Merrill Lynch 2.7%<br />Bank of Nova <span class="blsp-spelling-error" id="SPELLING_ERROR_1">Scotia</span> 2.5%<br />Royal Bank of Canada 2.5%<br /><strong>Shock Minus Control 2.5%</strong><br />Bank of Montreal 1.8%<br /><span class="blsp-spelling-error" id="SPELLING_ERROR_2">CIBC</span> 1.5%<br />Toronto-Dominion Bank 1.4%<br /><br />One probable reason for the variance between my forecast and the Bank’s is the Bank's assumption of an 87 cent US/CAD exchange rate versus my model range of 87 to 95 cents. Indeed, I can account for quite a bit of the variance between my own forecast and the Bank's <span class="blsp-spelling-corrected" id="SPELLING_ERROR_3">simply</span> by tweaking the exchange rate assumption.<br /></div><div></div><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhUCVk9Y3PiA40hcwWwUATFz-WnShvD1gKkWdZMYUN3bGEG47Ifp_6zRTORuI1zJ7tu4KWi0Kl_zntTnJmslDSU951fqB-mO3OdeXXq69GqaqVMPoJsMvOdmHLlE_VmQEerkxa82jporqQQ/s1600-h/yoy.png"><img id="BLOGGER_PHOTO_ID_5371549071667814546" style="WIDTH: 400px; CURSOR: hand; HEIGHT: 368px" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhUCVk9Y3PiA40hcwWwUATFz-WnShvD1gKkWdZMYUN3bGEG47Ifp_6zRTORuI1zJ7tu4KWi0Kl_zntTnJmslDSU951fqB-mO3OdeXXq69GqaqVMPoJsMvOdmHLlE_VmQEerkxa82jporqQQ/s400/yoy.png" border="0" /></a><br /><br /><div>Of course, there any number or <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJqHfb46cqiWxfnrpp85itbldo8nEswhOp02PWUCniG640EQ3-ZD5wKxFvE3VWIYwQdhNViAXHXEMf-scZ-dSSnpilHwC23L-qMfaqhCZsoS4lXp15k7_IsGEfhRAjBLnLGeDE-VvehQ0Y/s1600-h/yoy.png"></a>assumptions that could be driving this difference, particularly within a complex model such as TOTEM, the Bank’s primary forecasting model. However, the low exchange rate assumption does seem to be a pretty important one. </div></div>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com3tag:blogger.com,1999:blog-5970717323327554723.post-42385155441728480412009-08-08T16:35:00.000-07:002009-08-08T17:44:25.848-07:00Canadian Economic Forecast 2009-2010The Canadian economy will contract significantly in the first half of 2009 before giving way to a modest recovery in the third quarter. I anticipate that growth in 2010 will be given a boost from combined fiscal and monetary stimulus, but that overall economic growth in 2010 will be sluggish. Overall, I expect the Canadian economy to contract by 2.5% in 2009 before returning to positive growth of 2.4% in 2010. It is important to note that although I've forecast a strong rebound in quarterly real GDP growth in 2010, much of this growth will come from temporary sources such as government stimulus and the rebuilding of depleted inventories by Canadian businesses. Therefore, despite a return to positive quarterly growth, I expect that the economy will remain fundamentally weak, characterized by sluggish employment growth and an over reliance on government stimulus.<br /><br />I expect the unemployment rate to peak around 9.2% before declining at a measured pace as the economy begins a slow recovery. The enormous amount of slack in the economy should keep core inflation well below the Bank of Canada’s 2% target for all of 2009 and 2010. Low inflation, along with a strong Canadian dollar, will allow the Bank of Canada to keep its conditional promise of holding its overnight rate at 25bps until the second quarter of 2010. However, if core inflation remains near target, the Bank may be eager to bring rates back to pre-crisis levels. The forecast suggest that the second half of 2010 could see the Bank increasing its overnight target by 100 basis points with the first increases announced in June or July.<br /><br />I should note that this forecast assumes that the normalization of credit markets currently underway continues without further disruption and that GDP growth in the United States turns positive by the end of 2009 and remains positive but below trend growth in 2010. The forecast also assumes that the Canadian dollar stays within a range of 87-95 cents.<br /><br /><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcJAXagiOI87_Yv_JrLrrWarkn0M86sAzgwWgq0990KMJSMeHFyJIABS3drGvhb_FKaCjNUdRYHXOEUwNVrcavKeAFzz49yNzN53f2adH731v9KCznaY6oa3hFWrE40EE6Avz_1cF8ehNU/s1600-h/forecastgraphs.bmp"><img id="BLOGGER_PHOTO_ID_5367758239559440738" style="WIDTH: 400px; CURSOR: hand; HEIGHT: 275px" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcJAXagiOI87_Yv_JrLrrWarkn0M86sAzgwWgq0990KMJSMeHFyJIABS3drGvhb_FKaCjNUdRYHXOEUwNVrcavKeAFzz49yNzN53f2adH731v9KCznaY6oa3hFWrE40EE6Avz_1cF8ehNU/s400/forecastgraphs.bmp" border="0" /></a>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com0tag:blogger.com,1999:blog-5970717323327554723.post-69368317115429383682009-07-29T21:09:00.000-07:002009-07-29T23:23:53.643-07:00The recession is over!!...now about that recovery...Canada has had three severe recessions in the past 30 years; one in 1981, again in 1990 and the most recent one that began in the last quarter of 2008.<br /><br />The 1981 recession was a classic “V” shaped recession and lasted roughly five quarters. It was also the second part of a double-dip recession, following a brief contraction in 1980. The recession of 1990 was a steep, extremely painful and protracted “U/L” shaped recession, and was followed by a very weak recovery.<br /><br />The Bank of Canada made some noise this past week after the release of <a href="http://www.bank-banque-canada.ca/en/mpr/pdf/2009/mpr230709.pdf">its latest Monetary Policy Report</a> (MPR) predicting an end to the recession in Q3 of this year. If the Bank’s forecast is correct (remember that it is a forecast, not an official statistical release) then the 2008 recession would go into the books as the shortest of the past three Canadian recessions.<br /><br />The following figure illustrates the path of the Canadian economy 12 quarters after the business cycle peak prior to the recession for 1981 and 1990 along with the recent Bank of Canada forecast.<br /><br /><br /><img id="BLOGGER_PHOTO_ID_5364101133220839202" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 241px; TEXT-ALIGN: center" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj6L_AKQEDYDEbnk_tP_3Mauc8TdQHpCVk51YsXgzlAp8IpzcnktTZpNFr4QQnfcILLkPGEPm07KBPerfoY8IytdTbRCclzengQc1hv928IgnWnOp6Pp_yJBNtilJKGEbyYjmDVS8616-py/s400/recovery_20910_image004.gif" border="0" /><br />So where does the BoC expect the recovery to come from? Three places – Personal Consumption Expenditures, Government and Inventories. See below from the July MPR<br /><p><img id="BLOGGER_PHOTO_ID_5364104279773729474" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 293px; TEXT-ALIGN: center" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgNaxgDZP2x1sfMRWrjWGePLXmcXuv-bEc8j6sppYe2umP7SO2TpA7-EtAAWhXaCmmk3wFoDTn-IJ-199_ALYTagCZ4MZl10pdV4xx6Ycozz8Q1sKorMxyEnnO2aH8PPLY3cUtfWOd6LCYo/s400/Book1_30949_image002.gif" border="0" /><br />I have my doubts that PCE will really be that strong coming out of this recession. THe unemployment rate is liklely to approach 10% and household saving is rising in response to massive wealth destruction from falling equity and home prices over the past year. However, indicators such as retail sales and consumer confidence do seem to be improving, so perhaps the Bank is right.</p><p>The real difference maker in the expected recovery from the 2008 recession, compared with past recessions, is the fiscal policy response of the Canadian Government. Government spending in the year following the end of the 1981 recession contributed just 0.3% to real GDP growth and only 0.2% to real GDP growth in the year following the end of the 1990 recession. In contrast, the BoC estimates that Government spending will add 1.3% to growth in 2010. </p><p>Given that inventory rebuild is estimated by the Bank to add 1% to growth in 2010 and you have 2.3% of the 3% growth forecast estimated to come from temporary sources that may not do much for job creation. Add an uncertain outlook for the Canadian housing and non-residential construction sector and it would seem like we have a recipe for a jobless recovery in 2010. But at least the recession is over...right?</p><p></p>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com3tag:blogger.com,1999:blog-5970717323327554723.post-43497348123695599222009-07-16T22:15:00.000-07:002009-07-16T22:18:02.007-07:00Support the PBO!By signing <a href="http://supporttheopbo.blogspot.com/2009/07/open-letter-in-support-of-opbo.html">this</a>.Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com0tag:blogger.com,1999:blog-5970717323327554723.post-26921814978803662052009-07-02T16:28:00.000-07:002009-07-02T16:30:35.029-07:00Baby Induced Blogging HiatusMrs. Shock Minus Control gave birth to our third boy this morning - blogging will be light for a while.Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com2tag:blogger.com,1999:blog-5970717323327554723.post-30883619493638306352009-06-24T13:31:00.001-07:002009-06-24T14:00:45.819-07:00The Canadian Dollar Response to an Oil ShockIn a 2006 Bank of Canada working paper, (highly recommended) <a href="http://dsp-psd.pwgsc.gc.ca/Collection/FB3-2-106-29E.pdf">Issa, Lafrance and Murray </a>showed that, sometime in the 1990s, a structural break occurred in the relationship between the Canadian dollar and energy prices. Whereas prior econometric estimation (see Amano and van Norden 1995) showed that higher energy prices lead to a depreciation in the Canadian dollar, the authors showed that this relationship no longer held and that in fact rising energy prices tend to drive the loonie higher.<br /><br />This finding shouldn’t be a surprise to even casual observers of commodity and currency markets. The loonie has followed oil in virtual lockstep for many years, hitting 1.10 to the US dollar as oil rocketed past $100/barrel.<br /><br />To me, it is not immediatley clear why rising oil prices should impact the loonie. Oil is traded in US dollars and so higher Canadian oil exports shouldn't impact the Canadian dollar since the sale of oil does not create additional demand for Canadian currency. However, higher oil prices do create demand for Canadian dollars for the purpose of FDI – international oil companies developing projects in the oil sands do need to pay for assets, labour, etc in local currency. The oil-price break-even rate on these projects is high and so investment is driven by price. Therefore, oil impacts the loonie through the capital account, rather than the current account. (at least that is my take, if I’m wrong, please feel free to tell me so).<br /><br />I use a version of the Issa, Lafrance, Murray model that, as shown in the dynamic simulation below, tends to track the Canadian dollar fairly closely.<br /><div><div><div><br /><br /><div align="center"><strong>Dynamic Simulation of CAD/US Exchange Rate, 2004-2008</strong></div><img id="BLOGGER_PHOTO_ID_5350998651807963362" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 343px; TEXT-ALIGN: center" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixmP5VhpCIw4C1XHsDXogzMJzzkHvemlEEdPTq0KnYMtm3PFOHPVSCWkj93-BpI1IXe9Cw5QiCpJWw23MUqiz7SWsJx-6MmWoDlIDEaoa2gI2O5gE9rUI6NUfkgHE0tZ7V-n5QZLeD-880/s400/fxgraph%5B1%5D.bmp" border="0" /><br /><br /><div>If we are conviced that oil price are a significant driver of the Canadian dollar, then it may be interesting to ask how a future oil price shock will impact the loonie vs. the greenback.<br />The graph below sets out the baseline scenario for oil prices, based on EIA forecasts, and a somewhat arbitrary path for a hypothetical oil shock that would have the USD price of oil rise to $130 by the third quarter of 2010.<br /><br /><img id="BLOGGER_PHOTO_ID_5351000695995935010" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 251px; TEXT-ALIGN: center" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgimWtmLIqCrdJGN-L8GSgX83Jj-uroBGIqk6Lw3XzfK2bYZKkgNXY6AiSMhT8PzJ113fye4g1dzEb4Qmv-izUBiIRbKLCRhJntq38yIa9lqyMb7E3yoDnitGEchtmiE_lYl6mtBVNbfTv-/s400/Copy_of_EIA_forecasts(1)(1)_31540_image001.gif" border="0" />If the future path of oil prices looks more like the green line than the EIA forecast above, then, from the model, we should expect to see Canadian dollar back to parity early next year.<br /><br /><br /><img id="BLOGGER_PHOTO_ID_5350999654746841122" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 287px; TEXT-ALIGN: center" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEidp8eOJ-C30Rxc_5VLqNTUBJD_OcUMhUCHv6lB6kE4YSq3CK7wz3Dp1SkeJ1Phdk1RYAdnrNqrsozKZELOoTM4k5PgTfwzYLblJgfhWQ0iulLhxzgJjlOfNOgrTuMR_8E66VDkFTTdfn6H/s400/Copy_of_EIA_forecasts(1)(1)_10155_image002.gif" border="0" />Rising oil prices may get the loonie near parity, even without a steep run-up in prices, particularly if accompanied by weakness in the US dollar. But if oil really starts to run, I think it is very likely that the loonie will approach, or possibly surpass, its previous highs. </div></div></div></div>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com2tag:blogger.com,1999:blog-5970717323327554723.post-44379682988838236632009-06-22T22:58:00.000-07:002009-06-22T23:02:40.608-07:00Back from vacation......blogging to resume shortly.Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com0tag:blogger.com,1999:blog-5970717323327554723.post-34335215202151062262009-06-10T13:10:00.001-07:002009-06-10T20:32:27.891-07:00Whats going on with the yield curve part 2: Does a steepening of slope imply growth?I'm having a hard time with this one. The model I use for forecasting real GDP growth relies on changes in the slope of the yield curve as the mechanism by which monetary policy works. <a href="http://shockminuscontrol.blogspot.com/2009/06/whats-going-on-with-yield-curve.html">As discussed previously</a>, the slope of the Government yield curve (10yr - 3month) has steepened dramatically in the past month. This steepening is often interpreted as a positive signal that market participants expect short-term rates to rise in the future as growth and eventually inflation pick-up. What I am having a difficult time with is whether this is the right way to interpret what is currently happening in the Canadian economy. The Bank of Canada is certainly not going to be raising rates any time soon, and <a href="http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/text.pdf">research by the IMF </a>shows that recoveries from recessions caused by financial crises tend to be slow.<br /><br /><br /><p>The forecast implications are significant. Ignoring the signal from the yield curve implies a less robust recovery while accepting it provides a recovery akin to what the Bank of Canada forecast in its last MPR. The figure below illustrates the incremental growth implied by the yield curve shock (versus a control baseline of ignoring the signal, eg, running a simulation in which no steepening occurred</p><p><img id="BLOGGER_PHOTO_ID_5345905592205122898" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 388px; CURSOR: hand; HEIGHT: 300px; TEXT-ALIGN: center" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhk1w78CXqztHsdoMTJfImqrCQot0Q_AUZE3EXydyoqp6tQ1WV4JUa7vHyA03vVgRrot2Uc0FFtCnKrywuIY0hcIk_jygx4ZrTZcwu1q-K28VlWANNS5WGjFUAkz4Rm0PHiyQEiJTLs8bsh/s400/yc.bmp" border="0" />I'm leaning towards interpreting the movement in the yield curve as simply the normalization of inflation expectations and the impact of the "flight from quality" as investors regain confidence. Anyone want to try to convince me otherwise?</p>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com3tag:blogger.com,1999:blog-5970717323327554723.post-6222527409238697872009-06-09T08:23:00.000-07:002009-06-09T09:41:50.897-07:00What's going on with the yield curve?<div>Milton Friedman famously proclaimed that “inflation is always and everywhere a monetary phenomenon”, implying that inflation is inextricably linked to the money supply. This thinking has lead some analysts and others to voice heightened fear that monetary stimulus provided by the Bank of Canada, and the Federal Reserve in the United States, can only lead to a resurgence in inflation.<br /><br />Proponents of this view point to the recent increase in the slope of the government yield curve as a clear signal that purchasers of government treasuries, fearful of the impact of massive monetary and fiscal stimulus, are ratcheting up their inflation expectations and demanding a higher yield on long-term debt. Still others view the steepening yield curve as a positive signal of expected future growth and the end of the recession. So which is it? <img id="BLOGGER_PHOTO_ID_5345363580515019746" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 251px; TEXT-ALIGN: center" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgNX4MCJlT-7KdMrrjHVg4lEcn2hECra2uG__gaNRq4Np5pde7LYLgehpBXwF8hBuyRAmL9AEqLCl4ZOs6ic7t4wt2LeXEnzNYurXzwDOs3RIaVxiyN-BNjG3o9PcE-2ng61efmMnB-6k6k/s400/Changing+YC_32_image001.gif" border="0" /><br />Looking at inflation expectations derived from Canadian real-return bonds, it is pretty difficult to conclude that Canadians, or buyers of Canadian debt, expect runaway inflation on the horizon. Inflation expectations seem to have ticked up recently, but I think only because a Great Depression II induced deflationary spiral seems to be off the table. Moreover, expectations remain firmly anchored in the <span class="blsp-spelling-error" id="SPELLING_ERROR_0">BoC</span> comfort range<br /><img id="BLOGGER_PHOTO_ID_5345363745781742034" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 240px; TEXT-ALIGN: center" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiA-X4SAc1eQD5kaaN52rPTKM5mgdk9iyfsv9L2EvKzBvXzXDz2ZOfCF9OZb0auzegvu572Bol67p7wks1I_Rq-i6J_cmoIM2z63NnZ3NWADxFaFnJ38zEVfq6A6GaZbgUp5zuITRJle8OV/s400/inf+exp_1147_image001.gif" border="0" /><br />It is also hard to conceive of a scenario in which inflation could get out of control while the economy is operating so far below its potential.<br /><br /><img id="BLOGGER_PHOTO_ID_5345367530168800770" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 292px; TEXT-ALIGN: center" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjom6GMIa5xrh7cy9_Twm-cLULnnO5lwe10t3ViDMFbfcep-b9k6cEjo5psXaTObwNJIMNHgJBWZdhhyphenhyphen3Gz7_ng4tTfgkN2R0EQZzrqed0REf5to49QkFQZ_s0hEhrX6PU-KsD3oIWjlL0M/s400/Potential_GDP_Series(1)_8303_image001.gif" border="0" /><br />My own opinion is that the increase in the slope of the yield curve is a function of the following factors (in no particular order):<br /><br />1) Flight from quality – investors getting out of treasuries and back into riskier assets<br /><br />2) Normalized inflation expectations – fears of a deflationary spiral seems to have been successfully beaten back by the Bank of Canada<br /><br />3) Expected Government borrowing due to larger than anticipated fiscal deficits<br /><br />4) Expectations that the worst of the recession is over and the economy will return to positive growth soon. </div>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com0tag:blogger.com,1999:blog-5970717323327554723.post-56432444278508497732009-06-01T16:22:00.001-07:002009-06-02T11:38:50.925-07:00GDP better than expected in Q1Real GDP growth in Canada came in at -5.4% (annualized) for the first quarter of 2009. It turns out that my forecast of -8.2% was off by a wide margin. Thankfully, I had prestigious company with David Wolf (<span class="blsp-spelling-corrected" id="SPELLING_ERROR_0">Merrill</span> Lynch), Marc Carney and the Parliamentary Budget Office all missing substantially on the low side. The figure below shows how some prominent (and not so prominent) forecasters performed for Q1 Real GDP growth - I'll spoil the surprise - we still (mostly) suck at forecasting GDP.<br /><div><div><br /><div><img id="BLOGGER_PHOTO_ID_5342801472627226786" style="DISPLAY: block; MARGIN: 0px auto 10px; WIDTH: 400px; CURSOR: hand; HEIGHT: 158px; TEXT-ALIGN: center" alt="" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjUX7-pFTFHLBt_SVwrgdjoOGZEIh9pMlKVgIzqXvWSLjCRJG37mIaf5XAxfDhxftHlBvuVTVnyndYY-BJ5wKWYVlDJn2zz2nH-_lG69OSnfC1Cmwg4PEDffsdYJz_iguu7KmLl8xvDPxOV/s400/forecast+accuracy.png" border="0" /><br />I haven't had time to delve into the details, but much of the surprise seems to have come from higher than expected consumer spending. Personal consumption expenditures were actually less of a drag on growth in Q12009 than in Q42008. Investment was atrocious, as expected and growth was helped out a little by imports falling more than exports.<br /></div><div>A lot going on in the economy these days - <span class="blsp-spelling-error" id="SPELLING_ERROR_1">loonie</span> above 90 cents, 10-year yields rising rapidly -which means I'll be updating my forecast this week. Stay tuned.<br /></div><br /><br /><br /><br /><div></div></div></div>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com0tag:blogger.com,1999:blog-5970717323327554723.post-12650733698691085152009-05-27T10:27:00.000-07:002009-05-27T10:38:08.968-07:00Stephen Gordon reminds us not to read the National PostTerence Corcoran has a woefully bad article in the National Post this morning in which he seems to imply that the budget deficit has ballooned largely due to the home renovation tax credit (never mind the impact of the recession on revenues, that's just an excuse used by politicians in Corcoran's world) and "out of control" government spending. Strange that he doesn't mention the impact of bad policy like cutting the GST. Must have slipped his mind.<br /><br />As usual when an out of his depth journalist makes a stupid economic argument, <a href="http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/bad-economics-du-jour-the-national-post-on-the-deficit.html#comments">Stephen Gordon pounces. </a>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com2tag:blogger.com,1999:blog-5970717323327554723.post-84863283555981166732009-05-21T11:21:00.000-07:002009-05-21T11:25:03.265-07:00Batttle of SFU EconomistsNice to see some star professors from my alma-mater (Simon Fraser University) contributing to the public debate over the effectiveness of fiscal stimlus.<br /><br />Read skeptic David Andolfatto here: <a href="http://andolfatto.blogspot.com/">http://andolfatto.blogspot.com/</a><br /><br />and stimulus proponents James Dean and Richard Lipsey here:<a href="http://blogs.ft.com/economistsforum/2009/05/will-stimulus-spending-stifle-recovery/"> http://blogs.ft.com/economistsforum/2009/05/will-stimulus-spending-stifle-recovery/</a>Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com0tag:blogger.com,1999:blog-5970717323327554723.post-31817255765799307782009-05-19T12:21:00.000-07:002009-05-19T13:01:06.048-07:00Minsky and Haircuts<a href="http://voices.washingtonpost.com/ezra-klein/">Ezra Klein</a> links to an interesting<a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882"> paper</a> by Gary <span class="blsp-spelling-error" id="SPELLING_ERROR_0">Gorton</span> of Yale University. In that paper, <span class="blsp-spelling-error" id="SPELLING_ERROR_1">Gorton</span> describes how the <span class="blsp-spelling-error" id="SPELLING_ERROR_2">subprime</span> crisis is linked to runs on other structured products through the <span class="blsp-spelling-error" id="SPELLING_ERROR_3">repo</span> market. A sale and repurchase agreement ('<span class="blsp-spelling-error" id="SPELLING_ERROR_4">repo</span>' for short) involves a short term swap of collateral (t-bills, etc) for cash - the value of the transaction is discounted by some margin known as a haircut.<br /><br />For example, Bank A wants to raise cash and pledges an asset worth $100 as collateral. Bank B takes the asset and gives Bank A $98 in cash. The $2 difference is the haircut and depends on the credit risk of the <span class="blsp-spelling-error" id="SPELLING_ERROR_5">counterparty</span>.<br /><br />Here is where Hiram Minsky enters the picture - look at the graph below from <span class="blsp-spelling-error" id="SPELLING_ERROR_6">Gorton's</span> paper:<br /><br /><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEia6glR84NgRqayM0fHZXXt73CKm2orVBjE-SBO2v5LxcN0Vkq34kkD-OPqbcWk9GFCUOlwB9Uc9gTkIvq9AYYk_Q0rdb9uNtqcILZdJ6NpMzsx4m1LDdhTtDixhmIFDG21-vv3B2JZc08q/s1600-h/repohaircut.jpg"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 400px; height: 272px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEia6glR84NgRqayM0fHZXXt73CKm2orVBjE-SBO2v5LxcN0Vkq34kkD-OPqbcWk9GFCUOlwB9Uc9gTkIvq9AYYk_Q0rdb9uNtqcILZdJ6NpMzsx4m1LDdhTtDixhmIFDG21-vv3B2JZc08q/s400/repohaircut.jpg" alt="" id="BLOGGER_PHOTO_ID_5337625346222372434" border="0" /></a><br />Klein makes the point that it is not the spike in haircuts demanded that is troubling, it is the period of extremely low haircuts just prior to the crisis. Minsky warned that such periods of calm <span class="blsp-spelling-corrected" id="SPELLING_ERROR_7">betray</span> extreme underestimation, and hence underpricing, of risk that eventually leads to crisis, asset fire-sales and flight to quality - a scenario that Paul <span class="blsp-spelling-error" id="SPELLING_ERROR_8">McCulley</span> of <span class="blsp-spelling-error" id="SPELLING_ERROR_9">PIMCO</span> termed a "Minsky Moment". A smaller scale example of a Minsky Moment is the collapse of the hedge fund <span class="blsp-spelling-error" id="SPELLING_ERROR_10">LTCM</span> in 1998. Followers of that story may recall that <span class="blsp-spelling-error" id="SPELLING_ERROR_11">LTCM</span> convinced its <span class="blsp-spelling-error" id="SPELLING_ERROR_12">counterparties</span> to allow them to borrow without taking a haircut on collateral. We all know how that <a href="http://en.wikipedia.org/wiki/Long-Term_Capital_Management">ended</a>.<br /><br />I haven't seen any research exploiting the potential predictive information in haircuts, credit spreads, etc in detecting a rising probability of these Minsky Moments. Given the recent rediscovery and surging popularity of Minsky (I certainly had never heard his name in all my years studying economics) perhaps some enterprising economist is already working on it.Maggie Mayhttp://www.blogger.com/profile/08822013439171121624noreply@blogger.com2