Most experts tell us that the recession starting in December 2007 ended in mid-2009 when real GDP and industrial production bottomed and then started growing again. According to the National Bureau of Economic Research (NBER) business cycle committee, domestic production and employment are the primary conceptual measures of economic activity.
The committee views the payroll employment measure as the most reliable estimate of employment.Our employment recovery has been the slower in the 3 quarters following the ‘end of the recession’ than after other recent downturns. However the economy has added jobs in the last three consecutive months, a reversal of the prior 24 months of employment decreases. (First graph below from ADP)
According to Macroeconomic Advisors LLC, the GDP Index was positive each of the months in Q1 2010 and is showing an upward swing, showing a negative annualized growth only twice since mid-2009. (Second graph below from Macroeconomic Advisors)
ADP Employment Graph
MA GDP Index
Unsurprisingly, as we come out of the bottom of this business cycle, hiring will increase and that has already begun. The Q2 2010 U.S. Hiring Forecast shows that 23% of employers increased their full-time, permanent staff in the first quarter, up from 13% in the same period last year and up from 20 % in the fourth quarter. This is the third quarter that employers projected hiring increases. Responses to the survey indicate that many companies are reviewing current employees in light of the upturn ahead, and more than one quarter anticipate replacing low performers with top performers in the second quarter. The top staffing challenges are going to be 1) Competing on salary/compensation, 2) Maintaining productivity, and 3) Retaining Top Talent. Strategies for retaining your top performers include: Flexibility on work time/location; Training and Development opportunities; and Future Benefits and Performance-Based Incentives as the company’s bottom lines improve. Recommended Further Reading: Undoing IT Staffing and ROI Myths by Patty Azzarello U.S. Recovery Approaches One-Year Anniversary in Good Shape May 2010 by the National Association for Business Economics Short Takes, SI Review May 2010 by the Staffing Industry Review Magazine Slowdown Ahead, But Not a Recession by the Economic Cycle Research Institute Q2 2010 U.S. Hiring Forecast by Career.Builder.com and USA Today
So, we have the aggregate supply curve and we have the aggregate demand curve. AD measures levels of production which won't change over time as a function of price AS measures levels of production which suppliers will actually produce at as a function of price. SO... what happens when you put both of them together? Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!
The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level) GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment
This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium
Aggregate Demand Shocks and Macroeconomic Equilibrium: These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!
As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)
You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.
The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve. When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.
When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.
When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.
Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.
We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.
Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.
Its objective is to promote macroeconomic stability, particularly monetary stability. Low inflation promotes savings, increases productivity and promotes low interest rates. All of this encourages investment creating a healthy cycle, i.e. macroeconomic stability –better opportunities–macroeconomic stability.
It also safeguards financial system stability, establishing prudent measures and regulations to assure its financial solvency and enabling it to offer efficient financial services. This reduces operating costs, fostering savings and making credit easier to obtain, thus promoting financial development and economic growth.
2. Financial System Superintendence (SSF)
Its main function is to enforce all provisions applicable to the Central Bank, other banks, financial institutions, insurance companies, non-banking financial intermediaries, mutual guarantee companies, exchange bureaus, and Official Credit Institutions. It is also in charge of their control.
3. Securities Superintendence
Its main function is to enforce compliance with the provisions applicable to the stock exchange, exchange broker companies, bonded warehouses, specialized companies for the safe custody of securities and valuables, risk classification companies, etc. It is in charge of controlling the above institutions. It also inspects and supervises the issuers who are inscribed in the Public Stock Exchange Registry.
4. Pension Superintendence
It is mainly in charge of enforcing compliance with the provisions applicable to the Retirement Savings System and the Public Pension Fund System, and mainly those applicable to Pension Fund Administration institutions, the INPEP (National Institute for Public Employees Pension), and the Disability, Old-Age and Death Program of the Social Security Institution, being also in charge of their control.
5. Deposit Guarantee Institute
In the event that a member bank is forced to be dissolved and liquidated, it guarantees the public deposits for up to US$6,700 dollars. Likewise, it contributes to the restructuring of member banks, which may have solvency problems, in order to defend the rights of the depositors and those of the institution.
* Pursuant to Article 181 of the Banking Law, the Financial System Superintendence is in charge of controlling this institution.
II. PARTICIPANT ENTITIES
1. Banks
They are organized as incorporated companies, having a minimum capital of US$11.43 million. They require prior authorization from the Financial System Superintendence in order to begin operations.
2. Stock Exchange Companies
a) Stock Exchange
Corporations aiming to provide its members with the necessary means to efficiently carry out securities transactions and enable them to carry out securities intermediary activities. The country has a Stock Exchange.
b) Exchange broker companies
Corporations whose objective is to act as securities brokers. They can also carry out portfolio administration operations, prior authorization from the Securities Superintendence.
c) Specialized companies for the safe custody of securities and valuables.
These Corporations receive securities in custody from financial brokers and from the public; they also provide amortization-collecting services. Currently there is only one firm providing such services.
3. Welfare Institutions
a) National Institute for Public Employees Pension (INPEP).
An autonomous institution whose aim is to manage and invest its economical resources destined to the payment of benefits to cover Disability, Old Age and Death of public employees.
b) Salvadoran Institute of Social Security (ISSS): Disability, Old Age and Death Program.
c) Armed Forces Institute for Social Prevision, Disability, Old Age and Death (IPSFA).
An autonomous credit institution whose objective is to achieve welfare and social security goals on behalf of the members of the Armed Forces
d) Pension Fund Administration Institutions (AFP’s)).
These are welfare institutions organized as corporations whose sole aim is to administer a pension fund while they administer and award the benefits and entitlements provided by the Pension Fund System Law.
4. Auxiliary Organizations and Bonded Warehouses
Their main function the oversight and preservation of merchandise submitted to their custody, issuing certificates of deposit and warrants over said merchandise.
5. Non Banking Financial Intermediaries
a) Cooperatives:
These entities are organized to render credit-financial services to their partners and to the public. They may be organized as partnerships, or as cooperative associations. Some of them are supervised by the SSF (the ones authorized to collect funds from the general public) and others shall be supervised by the Federation they belong (receiving funds only from their members).
b) Federations.
These are organizations that group into financial cooperatives. Their aim is to render financial, consultancy and technical assistance services to the member cooperatives.
c) Sociedades de Ahorro y Crédito (Credit and Savings Societies, SAC).
These corporations are authorized to collect deposits from the public and to grant credits, these are incorporated with a minimum capital of US $2.9 million. They cannot collect deposits in current accounts; they must comply with the corresponding requirements set forth for such purpose in the Banking Law and in the Non Banking Financial Intermediaries Law.
6. Official Institutions
a) Banco Multisectorial de Inversiones (Multisector Investment Bank, BMI).
A public credit institution created to promote the development of investment projects from the private sector by granting loans under the current market conditions, through the financial institutions of the system.
b) Banco de Fomento Agropecuario (Agriculture Promotion Bank, BFA).
Official credit institution whose aim is to create, foster and maintain financial conveniences and other associated services necessary to contribute to foster agriculture.
c) Fondo de Financiamiento y Garantía para la Pequeña Empresa (Finance and Guarantee Fund for Small Businesses, FIGAPE).
Autonomous institution whose objective is to grant small loans to small business and Industry holders.
d) Fondo Nacional de Vivienda Popular (National Low-Cost Housing Fund FONAVIPO)
Its objective is to allow low-income Salvadoran families to have access to credit to enable them to procure housing under the most favorable conditions. It also fosters activities of social interest.
e) Fondo Social para la Vivienda (Social Housing Fund, FSV).
Its purpose is to render financial services to solve housing problems of the working population.
7. Mutual Guaranty Companies
Corporations whose exclusive purpose is to grant its associated members endorsements, bonds and other guarantees. They are controlled by the Financial System Superintendence.
8. Insurance Companies
These are Corporations who operate insurance, reassurance, bonds and reinsurance services. In the insurance contract (pursuant to the Code of Commerce) the insurance company is bound, by the payment of a premium, to compensate for damages or to pay an amount of money upon verification of the occurrence of an event provided in the contract. In the bond contract, on the other hand, one or more persons are responsible for someone else’s obligation, being committed on behalf of the creditor to comply in full or in part if the main debtor does not comply.
9. Foreign Currency Exchange Bureau
Companies whose usual activity is the purchase and sale of foreign currency in bills, bank drafts, traveler’s checks and other payment instruments issued in foreign currencies, at prices set by offer and supply.
The Keynesian IS-LM model developed earlier is a model of only demand behavior. It tells us how the equilibrium between planned aggregate demand and output is achieved. It describes demand behavior but says absolutely nothing about supply behavior. Total supply and demand analysis breaks that implicit assumption and introduces the possibility of supply constraints or economic issues that can affect supply behavior.
The total demand curve shows how the Keynesian equilibrium changes for different values of the price level. The total demand curve shows how changes in the price level affect the IS-LM or demand side equilibrium.
Total Demand Curve
The price level determines the real value, or purchasing power, of the nominal money supply, thus positioning the LM curve and determining the aggregate demand equilibrium. The total demand curve is a locus of Keynesian aggregate demand equilibrium for different price levels. If the price level changes while everything else (including the nominal money supply, M) remains the same, then the resulting change in the real money supply ( ) causes the IS-LM equilibrium to change
Total Supply Curve
It describes the amount of output that producers are willing and able to supply to the goods market.
Keynesian Supply Curve: The total supply curve implicit in the Keynesian IS-LM model is based on the notion that there are no supply constraints and that prices are pre-determined in the short-run (one year or less). Thus, whatever output level is demanded will be produced and the total supply curve is a horizontal line.There is sufficient excess capacity so that an increase in demand leads to more production without increasing production costs and prices.
Long-run or Classical Supply Curve: At the opposite extreme to the Keynesian short-run horizontal supply curve lies the supply curve implicit in the long-run equilibrium or classical view of the Macroeconomic world. The classical view implies a vertical supply curve,
The classical vertical total supply curve and the Keynesian horizontal total supply curve represent two theoretical extremes, neither of which is a satisfactory representation of behavior in the real world. The traditional Keynesian approach leaves us without a theory of price determination. The classical approach introduces a theory of price determination, but at the cost of eliminating an explanation of fluctuations in real output. By assuming that competitive markets at all times generate equilibrium levels of output, the model cavalierly does away with fluctuations in output.
Some More Reasons Why Prices are Sticky:
Labor Contracts: Implicit labor contracts are a term that refers to the type of agreements that are often made between employers and employees.
Career Labor Markets: The idea here is that employers adopt policies that promote the long-run attachment of workers to the firm. This is important to employers because finding able workers and providing training can be expensive. In addition, employees find it in their interest to agree to such arrangements.
A Demand Shock: In the short run. The monetary policy expansion leads to a fall in interest rates which gets the multiplier process under way and output increases.
Over time, the multiplier process that leads to an increase in output also leads to increases in prices. Quantity adjustments become less common and price adjustments become more common. Nevertheless, additional output is forthcoming, and after a period of several years, there are both output and price increases.
Expansionary monetary policy: A major theoretical point of our discussion is the tendency to return to a long-run equilibrium—the normal, natural, or long-run equilibrium level of output termed Y*. It is an output level associated with balance in the macroeconomics; in particular, there is an absence of inflationary or deflationary pressures at this output level. It is very important to add that this output need not be one where all resources are fully employed. The long-run equilibrium is “natural” because the economy tends to move toward it. The term does not convey a value judgment that this equilibrium is desirable or good. There may be more unemployment at Y* than a democratic society would like to endure.
INFLATION
Since the inflation rate is probably the most closely followed macroeconomic phenomenon, it will be helpful to have a theoretical framework that concentrates on the determination of the inflation rate directly. Our inflation equation will also help us understand one of the most unusual characteristics of inflation—its persistence. That is, we will discuss the momentum to inflation.
Price Adjustment Function: where π = is the inflation rate. An important implication of this specification of equation is that when Y =Y* , there are not inflationary pressures.
Phillips Curve: The term Phillips curve refers to the empirical relationship between wage or price inflation and the unemployment rate. Since Phillips’ early econometric studies in the 1950s, the relationship has been extended and developed into an important analytic tool for understanding the inflation process.
An expansionary policy could reduce the unemployment rate at the cost of only a small increase in the inflation rate.
Expectations of Inflation
The influence of market supply and demand on the inflation rate that emerges will depend as well on the expected inflation rate. A given degree of slack will result in a higher or lower overall inflation rate depending on how much inflation the price-setting agents expect to occur.
Augmented Price Adjustment
The effect of an increase in expectations of inflation on the actual rate of inflation can be seen by envisioning a particular price or wage negotiation. The parties in a particular negotiating session will be influenced by supply and demand conditions in the market and also by their expectations of aggregate inflation. The price or wage agreement that emerges from the negotiations will be higher if both parties expect more inflation to take place in the overall economy.
Expectations-augmented price adjustment equation
Where the expected rate of inflation and the coefficient b is measures the impact of expectations on the inflation rate.
Rational Expectations
Formation of expectations have indicated that expectations adjust slowly when inflation changes. This has often turned out to be an accurate description of reality, but it is not necessarily true. Starting in the early 1970s an alternative hypothesis about the formation of expectations had a very profound effect on economic thinking. The rational expectations hypothesis states that expectations are knowledgeable and informed predictions of the actual outcome. That is, expectations are formed by individuals with an understanding of the workings of the economy and with available information on all relevant phenomena. Expectations of inflation are thus based on all available information that relates to price determination and with an understanding of how prices are in fact determined. With rational expectations, the expected inflation rate can be expressed as the actual inflation rate (π) plus a random error term:
New Classical Macroeconomics
The natural rate Phillips curve model implies that the unemployment rate differs from the natural rate hen inflation is unanticipated. With rational expectations, unanticipated inflation is always a random or unpredictable phenomenon. Therefore, all deviations, including short-run deviations, of the unemployment rate from the natural rate are random events.
Sources of Inflation
The distinction among the different sources of inflation is somewhat artificial because they can all be present and are often related to one another. However , different inflationary episodes can be often be ascribed to a particular dominant causal factor.
Good news! Not only is the Great Recession over, but it's been over for 15 months, the National Bureau of Economic Research said today. Although this announcement may seem a little tone deaf -- like Geithner's Welcome To The Recovery op-ed -- the truth is in the numbers. The economy hit trough in June 2009, based on 10 NBER indices. The recovery has slowed since then, but it would take a lot before reaching a technical double dip.
The Macroeconomic Advisers monthly GDP chart hit a trough in June '09
The last, 28th Colloquium took place in November 2009. Results of the survey are based on forecasts of 15 domestic institutions (Cyrrus, CNB, ČSOB, Generali, Chamber of Economy, Komercni banka, Liberal Institute, MoF, Ministry of Industry and Trade, Ministry of Labour and Social Afffairs, Patria, Raiffeisen, Union of the Czech and Moravian Production Cooperatives, UniCredit, Wood & Company). To make the survey more representative, forecasts of 3 international institutions were added (European Commission, IMF, OECD).
The aim was to assess key tendencies within the horizon of years 2009 through 2012 where years 2011 and 2012 were regarded as indicative outlook. The key indicators and comparison with October MoF forecast are summed up in Tables 1 and 2.
In general it can be summed up that MoF forecasts keep to the average of other institutions' forecasts but are slightly more pessimistic, not allowing for such a fast recovery of the economy.
Table 1: Results of Survey for Years 2009 and 2010
2009
2010
min.
consensus
max.
MoF CR
min.
consensus
max.
MoF CR
Gross domestic product
increase in %, const.pr.
–5,3
–4,4
–4,0
–5,0
0,0
1,1
2,3
0,3
Consumption of households
increase in %, const.pr.
0,4
1,0
1,6
0,7
–1,5
–0,1
2,0
–1,3
Consumption of government
increase in %, const.pr.
1,0
2,3
4,3
2,0
–2,2
0,3
4,5
–1,0
Fixed capital formation
increase in %, const.pr.
–14,0
–7,7
–5,5
–7,8
–3,9
–1,0
2,0
–3,9
Inflation rate
per cent
0,3
1,0
1,5
0,9
1,1
1,5
2,0
1,4
GDP deflator
increase in %, const.pr.
1,3
2,9
4,2
2,7
0,2
1,3
2,8
0,2
Employment
increase in per cent
–2,5
–1,8
–1,3
–1,3
–2,7
–1,2
1,5
–1,9
Unemployment rate
average in per cent
6,5
7,1
8,3
6,5
7,5
8,4
9,8
8,4
Wage Bill (domestic concept)
increase in %, curr.pr.
-0,3
0,5
2,5
–0,3
-1,1
0,6
3,0
–1,1
Current account / GDP
per cent
–3,0
–1,8
–1,0
–1,4
–3,0
–1,3
0,4
0,4
Crude oil Brent
USD / barrel
60
67
77
61
75
79
85
79
Table 2: Results of Survey for Years 2011 and 2012
2011
2012
min.
consensus
max.
MoF CR
min.
consensus
max.
MoF CR
Gross domestic product
increase in %, const.pr.
1,0
2,4
3,5
2,8
2,0
3,2
4,8
3,3
Consumption of households
increase in %, const.pr.
0,2
1,5
3,0
2,3
1,5
2,6
4,0
2,5
Consumption of government
increase in %, const.pr.
–1,0
1,0
4,5
–0,6
–0,2
1,5
4,5
–0,2
Fixed capital formation
increase in %, const.pr.
–1,0
2,3
4,5
2,5
1,0
3,9
7,0
3,6
Inflation rate
per cent
1,4
2,2
3,0
1,8
1,8
2,4
3,0
2,0
GDP deflator
increase in %, const.pr.
1,3
1,9
2,3
2,3
1,5
1,8
2,3
2,0
Employment
increase in per cent
–0,5
0,5
1,5
0,0
0,4
1,2
2,0
0,9
Unemployment rate
average in per cent
7,0
8,0
9,0
8,2
5,0
6,9
7,8
7,4
Wage Bill (domestic concept)
increase in %, curr.pr.
1,1
3,5
5,7
4,5
2,5
4,3
7,5
5,3
Current account / GDP
per cent
–2,7
–0,7
1,0
0,6
–2,7
–1,1
0,5
0,8
Crude oil Brent
USD / barrel
75
85
95
93
80
97
110
93
Sources: Survey respondents, MoF calculations
Main expected tendencies of macroeconomic developments can be summed up as follows:
For 2009 institutions expect GDP to shrink by 4.0-5.3 %. MoF estimate of the economy's decline by some 5 % ranks the ministry among the more conservative institutions. The same applies to 2010 when stagnation or recovery of the Czech economy is expected; in comparison with average of forecasts, the MoF expects a slighter recovery. Outlook for 2011 and 2012 puts the October MoF forecast close to median values of the entire survey (deviation by 0.4 p.p. in 2011 and 0.1 p.p. in 2012).
Average rate of inflation should stick to low levels. After this year's marked disinflation, average rate of inflation should shift close to new 2 % inflation target of the CNB in the following years. The MoF forecast is in accordance with forecasts' average.
According to consensus forecast, decline in employment and rise in rate of unemployment should be seen in this and next year. As regards outlook for 2011 and 2012, institutions allow for reverse tendencies i.e. for growth of employment and lowering of rate of unemployment. The MoF forecast for 2010-2012 is in full accordance with the consensus.
Current forecasts allow for steep slowdown in growth of wage bill (in current prices) from 8.7 % in 2008 to some 0.5 % in this and next year, while even a decline cannot be excluded. Growth dynamics should gradually recover in the following years. MoF forecast for this and next year is conservative in comparison with average forecast.
List of indicators:Graphic presentation of the past and assumed developments of individual indicators is seen in graphs 1-18. For the sake of comparison, also consensus forecasts of two previous Colloquiums are included. Extreme forecasts of indicators (min. and max. columns in the tables) form thresholds of the highlighted area.
Graph 1: CZK/EUR exchange rate After considerable strengthening and follow-up correction, return to appreciation trend is expected
Graph 2: USD/EUR exchange rate Weakened level of the USD should persist in the long run
Graph 3: Price of Brent oil USD/barrel A gradual growth of oil price to the level of USD 100 per barrel is expected in 2012
Graph 4: Short-term interest rates % p. a. Growth of short-term interest rates should reflect an increase in CNB rates in response to strengthening inflationary pressures
Graph 5: Long-term interest rates % p. a. Long-term interest rates should follow trajectory of moderate growth due to increased supply of government bonds. A considerable decrease in outlook in comparison with the situation 3 months ago
Graph 6: Gross domestic product Real growth in % After unexpected slump of GDP, a slight recovery should be seen in 2010 and an increase in growth dynamics thereafter
Graph 7: Household consumption Real growth in % After stagnation due to fiscal consolidation in 2010, a recovery of dynamics in following years
Graph 8: Government consumption Real growth in % Government consumption should grow only slightly
Graph 9: Gross fixed capital formation Real growth in % Deep slump in investment activity in this and next years
Graph 10: GDP deflator Growth in % Fluctuations of GDP deflator growth between 1-3 % should reflect development of terms of trade
Graph 11: Consumer prices Average rate of inflation in % Moderate growth of consumer prices within the tolerance band of CNB's inflation target in 2010-2012
Graph 12: Employment (LFS) Growth in % Considerable fall in employment in this and next year, stronger growth as late as in 2012
Graph 13: Rate of unemployment (LFS) In % Rate of unemployment should peak in 2010
Graph 14: Wages and salaries (domestic concept) Nominal growth in % Steep slowdown in this year's wage bill growth should be followed by recovery of growth dynamics
Graph 15: Trade balance Fob-fob - BoP, CZK bn Stable, considerably positive balance is mostly expected, with broad variation range reflecting uncertainties
Graph 16: Balance of services CZK bn After this year's correction, surplus of balance of services should tend to moderate growth
Graph 17: Balance of income CZK bn Lower incomes from foreign direct investment
Graph 18: Current account of balance of payments % of GDP Current account deficit of balance of payments keeping on at sustainable level, tending to balanced level
For many months we have argued that the global economy is, despite all the hoopla, actually following a pretty normal course. Yes there are exceptions. The massive fiscal and trade deficits currently experienced by the United States are not normal and represent the tips of a very substantial economic volcano. But investors and financial market operators have grown used to this landscape of peaks and valleys and have come to accept their existence in much the same way that a multi-generational farmer clings to the slopes of, Philippine death trap, Mount Pinatubo. The farmer ekes out a living from the fertile soil aware, at the same time, that at some indeterminate point in the future this livelihood is bound to be swept away in a searing pyroclastic embrace. But for now investment vulcanologists can ease back in their deck chairs. The seismograph chatters quietly in the background, nothing untoward, the economic world is at peace and yet……
Some people are just never happy! In this world of small things monitored so minutely, this world in which the slightest rustle in the hedgerow calls forth a flock of squawking, excitable, pundits babbling hyperbole like a mountain torrent, it can be quite hard properly to discern the true meaning of the almost imperceptible nudges on that same seismograph. They are, however, important and must be recognised as such if this environment in which we inhabit is to be given meaning and context provided for the future.
Consensus: the global economy is slowing
By massive common consensus the global economy is slowing (see chart below). It has taken time for the brakes to start to work, particularly so as economic policy (both fiscal and monetary) has been tightened across the US, eurozone, Japan, China, India, Australia not to mention the UK for a while now.
In part because of and in part exacerbated by, a significant, yet glacial-paced, shift in expenditure patterns this slowdown is causing changes of tectonic proportions beneath the surface, the ripples from which are, however, beginning to show up in market action. Significantly, since the early 1980’s the G7 household sector financial balance has been on a continuous slide from a healthy 6% of global GDP crossing zero in 2001, to a very unhealthy -2% of GDP today. We expect that concerted fiscal and monetary policy tightening will cause this long-term slither to go into reverse, producing a significant squeeze on future consumption patterns.
Over the same period the G7 corporate sector financial balance has been on a shallow upward trend (with the notable exception of the late 1990’s bubble years!) from -2% GDP in 1982 to +0.5% of global GDP in late 2006. There have been a number of good reasons why companies should have wished to have opted for greater financial stability, particularly so in the wake of the creative accounting fuelled late ‘80’s boom and the emergence of pension fund “back holes”. Interestingly perhaps, we see a strong correlation between the steady improvement in company accounting and balance sheet rebuild, the steady demise of volatility and investors’ equally extraordinary creeping acceptance of risk to the point where, in the credit markets, spreads between junk and high grade bond yields have all but disappeared.
The above illustrates something interesting going on too. We have periodically wondered for just how long could companies remain in such control of their wage bills that profit margins can continue to hit new peaks. Perhaps this chart tells us we should start to worry. It reveals that, after several years of extraordinary weakness (the deflation threat years of 2003-2004) in which corporates really held the whip hand in negotiations with employees, the latter have shown signs of fighting back. To some extent this is a reflection of a rising (and pernicious) inflation hedge to wage bargaining but whatever the underlying cause the risk either to future inflation (and monetary policy) or to the sustainability of prevailing profit margins is clear.
Meanwhile back on the markets
The response to the common acceptance that the global economy is following a normal cycle has been to consign the word “risk” to the dustbin of history. The bond yield curve, despite its clear inversion (and thus negative message regarding the economic landscape of the future) is ignored. Relatively low longer dated bond yields have resulted in a historically high equity risk premium (cash today is worth more than cash in the future) and ultra low levels of implied volatility.
The following highly stylised graphic illustrates these financial market inconsistencies and serves as an important frame of reference for what we have already begun to see happening over Q4 2006 and which could, despite the benign macro backdrop, still make for choppy conditions in the equity market.
The diagram, which we reproduce with the kind permission of UBS Warburg attempts to explain a world of macro economic growth, buoyant equity markets and the departure of “risk” from the investor lexicon. The diagram shows that a wide range of hitherto diverse external stimuli have combined, over the past decade, to produce the unusual combination of strong economic growth, wafer thin (skinny) premiums in the credit market, ultra-low volatility and an unusually high equity risk premium (ERP).
The diagram does not explain what might happen in the future but it seems pretty clear to us that any significant change in the external stimuli could produce a marked change in the uneasy equity market status quo. Perhaps the most interesting change is already underway… re-leveraging.
At it’s full year results presentation on Thursday 1st Feb, AstraZeneca lit a fire under its own share price and the Pharmaceutical sector generally by suggesting that the global sector giants should seriously consider gearing up. In fact the process of corporate re-leverage has been going on for a good six months already. The corporate sector is following where the private equity sector has already blazed a trail and already some commentators, such as Standard & Poor’s, identify the growth of leveraged buy-outs as sowing the seed of serious risk for the future.
The return of risk will inevitably give rise to greater volatility, an event which, in our view, should be welcomed by investors as antidote to the duration extension and multiple expansion of the past six months.
By Clarence Norr. First I want to say HAY HOW SHE GO DERE to all my pards! Many tanks to yous dat got me all those free beers at Randy’s Grand Slam after I crooned da “Green Green Grass at Home” at karaoke there, eh. So here we are up to our necks in horse s#it because too many gomers borrowed more dan dey could afford to pay back, combined wit lenders who lent out way more dan dey had to lend. What a rigmarole, eh! Most all of da media excellentays got two groups to blame da whole ball a wax on - borrowers who can't afford to repay and lenders who lent unprofitably. Da fix word is "regulation" as we supposedly go forward. Lately dat self described Einstein “Bernanke” has been harpin’ on his knees to be made head guy of lending and borrowing.. Dat’s just da truth I’m telling,’ to bad if ya don’t like it. Da above stuff aint da root cause of da problem and tings will get pretty much worse for most Americans if da government rummies or even more worse, da private international bankers at dat Federal Reservation, have da main say and regulatory powers in da private economy. So, eh.. what is da root cause you ask dis expert? Da root cause is da money system itself there. Da moola, da dough, you bet. No more green could be legally lent out den what was kept in da vaults at da banks if we had a legal gold and silver based money set up, eh. If banks did lend out more den they were worth they would be committing fraud. So banks would be far more careful lending out their own gold, and dat of their depositor’s den they are these days lending out our same dollar labor credits over and over again. Dis means prices in da economy would remain stable because of not being able to inflate da currency. Stable pricing would mean borrowers would be more likely to repay their loans. So den da market would regulate itself like it had right up ‘til 1913. After 1913 we started having nationwide booms followed by recessions or depressions dat (interestingly) corresponded wit inflation and deflation of da bucks in circulation. DUH?
Clarence Norr
My easy solution right off da bat is dat you rummies should study ‘til you understand Mathematical Economics. Dis refers to da use of mathematical methods to ape economic theories and analyze da wrongs posed in economics. Da formulation and derivation of key relationships in a theory make tings pop wit generality, rigor, clarity and makes stuff more simpler, eh. Dis math stuff lets economists form testable propositions about complex subjects that can’t be more betterly expressed informally. So, dis language of math will let yous make tings more clearer and specific. You’ll also see more clearly positive claims about contentious tings dat would be impossible otherwise.
Study these simple economic models I slapped together for yous. You’ll be learnt stylized and simple mathematical relationships dat will clarify any assumptions and implications.
Equilibrium quantities as a solution to two reaction functions in Cournot duopoly. Each reaction ting is expressed as a linear equation dependent wit da quantity demanded.
An Edgeworth box displaying da contract curve of an economy wit two participants. Referred to as da "core" of da economy in modern parlance, there are infinitely a pretty lot of solutions along da curve for economies wit two participants.
Da surface of da Volatility smile is a 3-D surface where da current market implied volatility (Z-axis) for all da options on da underlier is plotted against strike price and time to maturity (X & Y-axes).
Da IS/LM model is a Keynesian macroeconomic model designed to make predictions about da intersection of "real" economic activity (yah know, spending, income, savings rates, eh) and decisions made in da financial markets (Money supply and Liquidity preference). Da model is no longer widely learnt at da graduate level but is common in undergraduate macroeconomics courses.
Last ting to keep in mind, eh, don’t let those gomers play wit ya when they say dat da use of formal mathematical techniques projects a scientific exactness dat don’t appropriately account for informational limitations in da real world. Dat rummy Hayek contended dat! Dat other piece a cake “Karl Popper” taught dat da fundamental problem wit mathematical economics was dat it was tautological. What da dummy meant was, once economics became a mathematical discipline, it would cease to rely on empirical truth and instead rely on axiomatic proof. WHAT A SIMPLE S#IT! Dese gomers got there heads deep up their butts, eh. Study da stuff I learnt ya and before ya know it, tings will be honky dory again I bet cha. Dere ya go, eh! See yous at Da Slam!
) causes the IS-LM equilibrium to change 
the expected rate of inflation and the coefficient b is measures the impact of expectations on the inflation rate. 
