The Narrative Structure of Global Weakening

Robert J. Shiller

20 September 2012


NEW HAVENRecent indications of a weakening global economy have led many people to wonder how pervasive poor economic performance will be in the coming years. Are we facing a long global slump, or possibly even a depression?

A fundamental problem in forecasting nowadays is that the ultimate causes of the slowdown are really psychological and sociological, and relate to fluctuating confidence and changinganimal spirits,” about which George Akerlof and I have written. We argue that such shifts reflect changing stories, epidemics of new narratives, and associated views of the world, which are difficult to quantify.
In fact, most professional economists do not seem overly glum about the global economy’s prospects. For example, on September 6, the OECD issued an interim assessment on the near-term global outlook, written by Pier Carlo Padoan, that blandly reportssignificant risks” on the horizon – the language of uncertainty itself.
The problem is that the statistical models that comprise economists’ toolkit are best applied in normal times, so economists naturally like to describe the situation as normal. If the current slowdown is typical of other slowdowns in recent decades, then we can predict the same kind of recovery.

For example, in a paper presented last spring at the Brookings Institution in Washington, DC, James Stock of Harvard University and Mark Watson of Princeton University unveiled a newdynamic factor model,” estimated using data from 1959 to 2011. Having thus excluded the Great Depression, they claimed that the recent slowdown in the United States is basically no different from other recent slowdowns, except larger.
Their model reduces the sources of all recessions to just six shocks – “oil, monetary policy, productivity, uncertainty, liquidity/financial risk, and fiscal policy” – and explains most of the post-2007 downturn in terms of just two of these factors: “uncertainty” and “liquidity/financial risk.” But, even if we accept that conclusion, we are left to wonder what caused large shocks to “uncertainty” and to “liquidity/financial risk” in recent years, and how reliably such shocks can be predicted.
When one considers the evidence about external economic shocks over the past year or two, what emerges are stories whose precise significance is unknowable. We only know that most of us have heard them many times.
Foremost among those stories is the European financial crisis, which is talked about everywhere around the globe. The OECD’s interim assessment called it “the most important risk for the global economy.” That may seem unlikely: Why should the European crisis be so important elsewhere?

Part of the reason, of course, is the rise of global trade and financial markets. But connections between countries do not occur solely through the direct impact of market prices. Interacting public psychology is likely to play a role as well.
This brings us to the importance of stories – and very far from the kind of statistical analysis exemplified by Stock and Watson. Psychologists have stressed that there is a narrative basis to human thinking: people remember – and are motivated by – stories, particularly human-interest stories about real people. Popular stories tend to take on moral dimensions, leading people to imagine that bad outcomes reflect some kind of loss of moral resolve.
The European crisis began with a Greek meltdown story, and it appears that the entire global economy is threatened by events in a country of only 11 million people. But the economic importance of stories bears no close relation to their monetary value (which can be measured only after the fact, if at all). It depends, instead, on their story value.
The Greek crisis story began in 2008 with reports of widespread protests and strikes when the government proposed raising the retirement age to address a pension funding shortfall. Reports began to appear in global news media portraying an excessive sense of entitlement, with Greeks taking to the streets in protest, even though the increase was modest (for example, women with children or in hazardous jobs would be able to retire with full benefits at just 55, up from 50).
That story might have invited some gossip outside of Greece, but it gained little purchase on international attention until the end of 2009, when the market for Greek debt started to become increasingly unsettled, with rising interest rates causing further problems for the government. This augmented news reports about Greek profligacy, and thus closed a negative feedback loop by attracting intensifying public interest, which eventually fueled crises in other European countries. Like a YouTube video, the Greek story went viral.
One might object that most people outside of Europe surely were not following the European crisis closely, and the least informed have not even heard of it. But opinion leaders, and friends and relatives of the least informed in each country, were following it, and their influence can create an atmosphere that makes everyone less willing to spend.
The Greek story seems connected in many people’s minds with the stories of the real-estate and stock-market bubbles that preceded the current crisis in 2007. These asset bubbles were inflated by lax lending standards and an excessive willingness to borrow, which seemed similar to the Greek government’s willingness to take on debt to pay lavish pensions.

Thus, people saw the Greek crisis not just as a metaphor, but also as a morality tale. The natural consequence was to support government austerity programs, which can only make the situation worse.
The European story is with us now, all over the world, so vivid that, even if the euro crisis appears to be resolved satisfactorily, it will not be forgotten until some new story diverts public attention. Then as now, we will not be able to understand the world economic outlook fully without considering the story on people’s minds.
 Robert J. Shiller is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. His book Irrational Exuberance presciently warned of the dot-com bubble, and a second edition, released in 2005, predicted the coming collapse of the real-estate bubble. His most recent book, co-written with George Akerlof, is Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.

Why QE3 Won't Jump Start The Economy

In its third round of QE, the Fed says it will buy $40 billion in MBS every month for an indefinite period. To do this, it will essentially create money from nothing, paying for its purchases by crediting the reserve accounts of the banks from which it buys them. The banks will get the dollars and the Fed will get the MBS. But the banks’ balance sheets will remain the same, and the circulating money supply will remain the same.

When the Fed engages in QE, it takes away something on the asset side of the bank’s balance sheet (government securities or mortgage-backed securities) and replaces it with electronically-generated dollars. These dollars are held in the banks’ reserve accounts at the Fed. They are “excess reserves,” which cannot be spent or lent into the economy by the banks. They can only be lent to other banks that need reserves, or used to obtain other assets (new loans, bonds, etc.). As Australian economist Steve Keen explains:

(R)eserves are there for settlement of accounts between banks, and for the government’s interface with the private banking sector, but not for lending from. Banks themselves may ... swap those assets for other forms of assets that are income-yielding, but they are not able to lend from them.

This was also explained by Prof. Scott Fullwiler, when he argued a year ago for another form of QE - the minting of some trillion dollar coins by the Treasury (he called it “QE3 Treasury Style”). He explained why the increase in reserve balances in QE is not inflationary:

Banks can’tdo anything with all the extra reserve balances. Loans create deposits - reserve balances don’t finance lending or add anyfuel” to the economy. Banks don’t lend reserve balances except in the federal funds market, and in that case the Fed always provides sufficient quantities to keep the federal funds rate at its interest rate target. Widespread belief that reserve balances addfuel” to bank lending is flawed, as I explained here over two years ago.

Since November 2008, when QE1 was first implemented, the monetary base (money created by the Fed and the government) has indeed gone up. But the circulating money supply, M2, has not increased any faster than in the previous decade, and loans have actually gone down.

Quantitative easing has had beneficial effects on the stock market, but these have been temporary and are evidently psychological: people THINK the money supply will inflate, providing more money to invest, inflating stock prices, so investors jump in and buy. The psychological effect eventually wears off, requiring a new round of QE to keep the game going.

That is what happened with QE1 and QE2. They did not reduce unemployment, the alleged target; but they also did not drive up the overall price level. The rate of price inflation has actually been lower after QE than before the program began.

Why, Then, Is the Fed Bothering to Engage in QE3?
If the Fed is doing no more than swapping bank assets, what is the point of this whole exercise? The Fed’s professed justification is that by buying mortgage-backed securities, it will lower interest rates for homeowners and other long-term buyers. As explained in Reuters:

Massive buying of any asset tends to push up the prices, and because of the way the bond market works, rising prices force yields (or interest rates) down. Because the Fed is buying mortgage-backed bonds, the purchases act to directly lower the cost of borrowing to buy a home. In addition, some investors, put off by the rising price of the bonds that the Fed is buying, turn to other assets, like corporate bonds - which, in turn, pushes up corporate bond prices and lowers those yields, making it cheaper for companies to borrow - and spend.

Those are the professed objectives, but politics may also play a role. QE drives up the stock market in anticipation of an increase in the amount of money available to invest, a good political move before an election.

Commodities (oil, food and precious metals) also go up, since “hot moneyfloods into them. Again, this is evidently because investors EXPECT inflation to drive commodities up, and because lowered interest rates on other investments prompt investors to look elsewhere. There is also evidence that commodities are going up because some major market players are colluding to manipulate the price, a criminal enterprise.

The Fed does bear some responsibility for the rise in commodity prices, since it has created an expectation of inflation with QE, and it has kept interest rates low. But the price rise has not been from flooding the economy with money. If dollars were flooding economy, housing and wages (the largest components of the price level) would have shot up as well. But they have remained low, and overall price increases have remained within the Fed’s 2% target range.

Some Possibilities That Might Be More Effective at Stimulating the Economy

An injection of money into the pockets of consumers would actually be good for the economy, but QE3 won’t do it. The Fed could give production and employment a bigger boost by using its lender-of-last-resort status in more direct ways than the current version of QE.

It could make the very-low-interest loans given to banks available to state and municipal governments, or to students, or to homeowners. It could rip up the $1.7 trillion in government securities that it already holds, lowering the national debt by that amount (as suggested a year ago by Ron Paul). Or it could buy up a trillion dollars’ worth of securitized student debt and rip those securities up. These moves might require some tweaking of the Federal Reserve Act, but Congress has done it before to serve the banks.

Another possibility would be the sort of “quantitative easingfirst proposed by Ben Bernanke in 2002, before he was chairman of the Fed - just drop hundred dollar bills from helicopters. (This is roughly similar to the Social Credit solution proposed by C. H. Douglas in the 1920s.) As Martin Hutchinson observed in Money Morning:

With a U.S. population of 310 million, $31 billion per month, dropped from helicopters, would have given every American man, woman and child an extra crisp new $100 bill per month.

Yes, it would produce an extra $31 billion per month on the nominal Federal budget deficit, but the Fed would have printed the new bills, so there would have been no additional strain on the nation’s finances.

It would be much better than a new social program, because there would have been no bureaucracy involved - just bill printing and helicopter fuel.

The money would nearly all have been spent, increasing consumption by perhaps $300 billion annually, creating perhaps 3 million jobs, and reducing unemployment by almost 2%.

None of these moves would drive the economy into hyperinflation. According to the Fed’s figures, as of July 2010, the money supply was actually $4 trillion LESS than it was in 2008. That means that as of that date, $4 trillion more needed to be pumped into the money supply just to get the economy back to where it was before the banking crisis hit.

As the psychological boost from QE3 wears off and the “fiscal clifflooms, perhaps Congress and the Fed will consider some of these more direct approaches to relieving the economy’s intractable doldrums.

Up and Down Wall Street


It's the Most Dreadful Time of the Year -- for Stocks


More market upheavals have happened on Sept. 22 -- "Gann Day" --than any other. Can the central banks stave off another one?



"October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February." So wrote Mark Twain, ruefully, given his unfortunate experiences in investing.

But there is something about this time of year. Just when nature is at its best -- still-warm temperatures, but you can sleep with the windows open, summer crops in abundance, leaves still on the trees -- financial markets seem to be at their worst.

Sept. 22 has been dubbed "Gann Day" after W.D. Gann, the legendary financial speculator of the early 20th century, who observed that more major market swings took place on that date, which happens to be the time of autumnal equinox this year and in most years. (Of course, these observations about this time of year come from the vantage point in the Northern Hemisphere. My antipodean cousins eagerly are awaiting the coming of spring.)

Of course, financial markets will be closed this Saturday for Sept. 22, but many huge upheavals came right around that date, especially in the currency markets. As notes Paul Macrae Montgomery, the publisher of the Universal Economics newsletter out of Newport News, Va., and a long-time student of market influences outside the usual financial factors, observes, Great Britain's Depression-era suspension of the pound's link to gold and devaluation took place on Sept. 21, 1931. Sterling's ignominious withdrawal from the European Exchange Rate Mechanism came a few days early on Sept. 16, 1992.

Other currency turning points also came around Gann Day. The so-called Plaza Accord took place on Sept. 21, 1985, which effectively engineered a decline in then-high-flying dollar. The rescue of Long-Term Capital Management -- the culmination of the Asian currency crisis that began in July 1997 -- came on Sept. 23, 1998. And Montgomery notes that the peak in the price of gold resulting from the 1869 attempt by Jay Gould and Jim Fisk to corner the gold market came on Sept. 21 -- three days before the ploy collapsed when the U.S. government sold gold. And in this century, while gold bullion peaked in January 1980, gold and silver stocks made their bull-market highs on Sept. 22 later that year, he adds.

Adds Larry E. Jeddeloh, editor-in-chief of the TIS Market Intelligence Report and another Gann observer: "The next financial crisis I think is going to be in the currencies, so getting by another Gann day without an FX collapse would be cause for celebration in my book."

While the most memorable crashes took place in October -- 1929, 1978, 1979, 1987, 1989 -- markets often peaked during the prior month before starting their steep slides. Specifically, the Dow Jones Utility index peaked on Sept. 21, 1929, weeks before the Great Crash of that year. And Montgomery also notes a panic on Sept. 21, 1873, forced the temporary shuttering of the New York Stock Exchange. In addition, stocks sometime make major lows, as on Sept. 22, 2001, in the wake of the 9/11 attacks.

And of course, the financial crisis of 2008 turned into a panic with the bankruptcy of Lehman Brothers on Sept. 15, the near-collapse of AIG the following day and the rejection of the bailout by the House on Sept. 29., culminating in the waterfall declines in October.

What is it about Gann Day? Montgomery, who is willing to look into the seemingly irrational forces behind market moves, writes that some recent academic research has discovered apparent seasonal anomalies relating to stock prices and blood chemistry. He adds other studies have found "significant increases in human violence proximate to the autumnal and vernal equinoxes." Whether these hypotheses are true or not, the current violence in the Middle East, from Syria to the murder of the American ambassador to Libya to the anti-U.S. protests sweeping the region, appears consistent with them.

What could be making a high now may be complacency, as indicated by the depressed state of the CBOE Volatility Index for the Standard & Poor's 500, which is better known by its ticker, VIX. Also popularly known as the market's fear gauge, the VIX set a low for the year earlier this week under 14 before ticking up over that mark Thursday.

As my colleague, Steve Sears, reported in his Striking Price column Thursday, buyers seeking protection from the clear-and-present risks facing the market -- from the third-quarter earnings reporting season starting next month, the looming fiscal cliff on Jan. 1 and, of course, November's elections -- have stepped up their purchases of VIX calls. Those options would increase in value if the fear gauge rises, as would certainly happen if the stock market tumbles from its recent highs as a result of these or other, unknown risks.

The subdued state of volatility can in large part be traced to the actions of the major central banks, beginning with European Central Bank President Mario Draghi's July 27 declaration to do "whatever it takes" to save the euro. Then on Sept. 13, the Federal Reserve's so-called QE3, involving the purchase of $40 billion of mortgage-backed securities per month until the central bank saw substantial improvement in the labor market, plus extending the period of near-zero interest rates all the way to mid-2015. And this week, the Bank of Japan joined in expanding its QE, lest it be further disadvantaged by the strong yen while other central banks ease.

But even as the monetary authorities have reduced volatility and induced investors into risk assets, especially stocks, they have not attacked the basic problems of Europe's debt crisis or the sluggishness of the economy in the U.S. and abroad, at least not yet. Warnings from economic bellwethers FedEx (FDX) and Norfolk Southern (NSC) this week underscore the string of weaker-than-expected data, notably the steady increase in new unemployment claims, to the 380,000 range from the summer trough around 350,000.

The central banks may be able to stave off Gann Day, for now. But, with complacency seemingly topping out, be prepared for possible October Surprises ahead.

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