No Recession . . . Yet

The press is abuzz with claims that the United States is in recession because real GDP declined in both the first and second quarters of 2022. Many people use this “two consecutive quarters of declining GDP” formula as an informal indicator of a recession. And, they are generally right, it has been useful: since 1950, nine of 11 recessions designated by the National Bureau of Economic Research (NBER) Business Cycle Dating Committee (BCDC) included at least two consecutive quarters of falling GDP. Moreover, given the recent slowdown in economic activity, people are starting to feel as if they are experiencing a recession. Indeed, going forward, we expect that a recession will be associated with the disinflation which the Federal Reserve seeks (see our recent post).

Nevertheless, in current circumstances, there are good reasons not to rely on the simple recipe that equates two consecutive quarters of falling GDP with a recession. Indeed, when people ask us whether the economy currently is in a recession—something that occurs daily—we respond: “not yet, but very likely over the next year.”

In this post, we provide a primer on the criteria that the NBER BCDC uses to produce the authoritative dating of U.S. recessions. (The complete NBER cyclical chronology is here.) We explain how economists improve upon the simple formula by using multiple sources of information that are observed frequently and are less prone to large revisions—especially around business cycle turning points. We conclude with a brief explanation of why the risk that the United States will enter a recession in the near future is very high….

Crypto-assets and Decentralized Finance: A Primer

This week, we saw new heights of turbulence in the tempestuous crypto world. Market capitalization plunged as the loss of confidence in a popular coin—designed to be pegged to the dollar—triggered a run that fueled widespread contagion. At this writing, the estimated value of all crypto assets stands at $1.1 trillion, down nearly 60 percent from the $2.7 trillion peak in early November. What are the broader implications for the crypto world and the traditional financial system? Do we face the prospect of the famously volatile world of crypto-assets and decentralized finance (DeFi) undermining the stability of traditional financial (TradFi) system and the real economy?

So long as all these crypto-assets remain confined to the DeFi world, they pose no threat to TradFi or to economic activity. In practice, the fact that enormous fluctuations in value are met with a global shrug (at least so far) is prima facie evidence that crypto-assets currently are systemically irrelevant.

But will crypto-assets remain so disconnected from TradFi and from real economic activity? Crypto instruments already are escaping the DeFi metaverse in notable ways. These include the use of crypto-assets as a means of payment (see our earlier post on stablecoins), as collateral for loans and mortgages, and as assets in retirement plans. These developments lead us to ask two related questions: First, how will the risks arising from crypto and DeFi evolve? Second, how will regulators deal with them if and when they do?

This post is the first in a series that aims to address these questions. As befits a primer, we start with the basics: characterizing crypto-assets and DeFi. In the process, we define common terms and highlight analogies between DeFi and TradFi (traditional finance). For readers who would like to go deeper, we link to a range of studies that provide useful background information.

In a future post, we will highlight that the problems which frequently arise in TradFi (ranging from fraud and abuse to runs, panics, and operational failure) also appear in DeFi, while the aim of DeFi to avoid any discretionary intervention renders key TradFi corrective tools (such as the court adjudication of incomplete contracts) inoperable. Eventually, we also will post about regulatory approaches that can address the risks posed by DeFi, while supporting responsible financial innovation that lowers transaction costs and broadens consumer choice….

A Primer on Private Sector Balance Sheets

Double-entry bookkeeping is an extremely powerful concept. Dating at least from the 13th century (or possibly much earlier), it is the idea that any increase or decrease on one side of an entity’s balance sheet has an equal and opposite impact on the other side of the balance sheet. Put differently, whenever an asset increases, either another asset must decrease, or the sum of liabilities plus net worth must increase by the same amount.

In this post, we provide a primer on the nature and usefulness of private sector balance sheets: those of households, nonfinancial firms, and financial intermediaries. As we will see, a balance sheet provides extremely important and useful information. First, it gives us a measure of net worth that determines whether an entity is solvent and quantifies how far it is from bankruptcy. This tells us whether an indebted firm or household is likely to default on its obligations. Second, the structure of assets and liabilities helps us to assess an entity’s ability to meet a lender’s immediate demand for the return of funds. For example, how resilient is a bank to deposit withdrawals?

After discussing how balance sheets work, we show how to apply the lessons to the November 2007 balance sheet of Lehman Brothers—nearly a year before its collapse on September 15, 2008….

Stagflation: A Primer

The term stagflation came into common use in the mid-1970s, when many advanced economies experienced higher inflation and slower growth than they had in the 1960s. At the time, the joint behavior of inflation and economic growth confused many economists. Throughout the 1950s and 1960s, growth and inflation generally moved in the same direction. Most important, inflation tended to fall during recessions and to rise in booms. Stagflation meant that these two key summary measures of macroeconomic performance moved in opposite directions. What caused this dramatic, painful, and persistent shift?

To understand the sources of stagflation in the 1970s—and how we subsequently avoided a repeat of that episode (at least so far)—we start with the simple premise that there are two types of disturbances hitting the economy: demand and supply. The first, changes in demand, moves inflation and growth in the same direction. The broad array of things that shift demand include fluctuations in consumer or business confidence, shifts in government tax and expenditure policy, and variation in the appeal of imports to domestic residents or of exports to foreigners. When any of these goes up or down, inflation and output rise and fall together.

Supply disturbances—which alter the cost of production—are fundamentally different. These stagflationary shocks move growth and inflation in opposite directions. For example, an adverse supply shock that raises the cost of production at least temporarily drives inflation up and growth down.

Importantly, these cost shocks cannot be the whole story behind a decade-long surge of inflation. Whether the consequences of a cost shock are one-off adjustments in the price level or an increase of the trend of inflation depends on the monetary policy response. Put differently, monetary policy determines whether we experience stagflation over any longer interval….

Negative Nominal Interest Rates: A Primer

Many people find negative interest rates confusing. Why should anyone pay a bank to make a deposit? Why should a bank pay someone to borrow? How can we value an asset with a future cash flow when the interest rate is negative?

Policymakers also wonder whether the effects of negative interest rates on the economy are favorable or unfavorable. Do negative interest rates help central banks achieve price stability by stimulating economic activity? Do negative rates spur banks to make more good loans or to evergreen bad ones? Will borrowers and banks take on too much risk because they can fund investments at a negative rate? Will households reduce their saving rate because the return is so low, or raise it because low returns leave them farther from their wealth target? Will negative rates influence the ability of pension funds, insurance companies and governments to make good on their long-term promises to future retirees?

In this primer, we examine these questions, starting with key facts about negative nominal interest rates. Our conclusion: there is little magic about having a slightly negative, as opposed to slightly positive interest rates. Thus, much of the criticism of persistently negative nominal interest rates applies similarly to very low, but positive rates. That said, financial system frictions limit the favorable impact from modestly negative nominal rates, but our experience with them remains limited. Given the likely need for unconventional policy tools to address the next recession, learning more about the benefits and costs of negative nominal interest rates is a high priority….

Inflation and Price Measurement: A Primer

People use a variety of statistics to gauge how the economy is doing. It is fairly straightforward to measure nominal GDP, so the challenge of estimating real economic growth arises from the need for accurate measures of prices. Price measurement also is key for inflation-targeting central bankers, who need a number as a guide and for public accountability. To be credible, that number must be based on an index constructed using established scientific methods.

Reflecting a set of well-known (and nearly insurmountable) difficulties, measured inflation has an upward bias. That is, the inflation numbers that statistical agencies report are consistently higher than the theoretical construct we would like to compute. As a consequence of this upward bias in inflation measurement, our estimates of growth in real output and real incomes are systematically too low.

The big question today is whether the bias in inflation measurement, and hence the bias in the measurement of growth, has increased in recent years. As Martin Feldstein describes in detail, the answer to this question is important, as it affects how we collectively view long-run progress. If published statistics show sluggish real growth, as well as slow growth in real wages and incomes, then people may be unduly pessimistic. A worsening bias would add to that pessimism.

In practice, however, careful recent analysis suggests that inflation measurement bias has not changed much since the early 2000s….

Fiscal Sustainability: A Primer

Nobody likes taxes, so public spending frequently exceeds revenues, leading governments to borrow. These budget deficits are a flow that add to the stock of debt. Since the Great Financial Crisis of 2007-2009, public debt in a number of advanced economies has surged. In the United States. the Congressional Budget Office (CBO) recently projected that―in the absence of policy changes―federal debt held by the public is headed for record highs (as a ratio to GDP) in coming decades.

Importantly, there is a real (inflation-adjusted) limit to how much public debt a government can issue (see Sargent and Wallace). Beyond that limit, the consequences are outright default or, if the debt is in domestic currency bonds that the central bank acquires, inflation that erodes its real value leading to a partial default.

Ultimately, debt sustainability requires that a country’s ratio of public debt to GDP stabilize. Otherwise, debt eventually will rise above the real limit and trigger default or inflation. In this note, we derive and interpret a simple debt-sustainability condition. The condition states that the government primary surplus―the excess of government revenues over noninterest spending—must be at least as large as the stock of outstanding sovereign debt times the difference between the nominal interest rate the government has to pay and the rate of growth of nominal GDP. If it is not, then the ratio of debt to GDP will explode….

Sudden Stops: A Primer on Balance-of-Payments Crises

After years of relative calm, in recent months several emerging economies have found the cost of attracting foreign funding is going up. Faced with a halt of external financing, Argentina obtained a three-year financing deal worth $50 billion from the IMF, while funds also appear to be flowing out of Brazil, Turkey, and elsewhere. And, recent bond market turbulence in Italy suggests the possibility that political risks are triggering outflows there.

In this post, we explain balance-of-payments (BoP) crises—the sudden stops or capital flow reversals—that compel countries to restore their external balance between exports and imports or, in the case of capital flight, shift to export surpluses. In addition to describing common features of BoP crises, and characterizing sources of vulnerability that make them more likely, we examine one emerging-market example—the Asian crisis of 1997-98—and one advanced-economy episode—the crisis of the euro-area periphery from 2010 to 2012….

Finance and the Blockchain: A Primer

Blockchain is all the rage. We are constantly bombarded by reports of how it will change the world. While it may alter many aspects of our lives, our suspicion is that they will be in areas that we experience only indirectly. That is, blockchain technology mostly will change the implementation of invisible processes—what businesses think of as their back-office functions.

In this post, we briefly describe blockchain technology, the problem it is designed to solve and the impact it might have on finance.

Understanding Bank Capital: A Primer

Over the past 40 years, U.S. capital markets have grown much faster than banks, so that banks’ share of credit to the private nonfinancial sector has dropped from 55% to 34% (see BIS statistics here). Nevertheless, banks remain a critical part of the financial system. They operate the payments system, supply credit, and serve as agents and catalysts for a wide range of other financial transactions. As a result, their well-being remains a key concern. A resilient banking system is, above all, one that has sufficient capital to weather the loan defaults and declines in asset values that will inevitably come.

In this primer, we explain the nature of bank capital, highlighting its role as a form of self-insurance providing both a buffer against unforeseen losses and an incentive to manage risk-taking. We describe some of the challenges in measuring capital and briefly discuss a range of approaches for setting capital requirements. While we do not know the optimal level of capital that banks (or other intermediaries) should be required to hold, we suggest a practical approach for setting requirements that would promote the safety of the financial system without diminishing its efficiency....

Primers

Money, Banking, and Financial Markets