Panic Spreading Across Nations Outranks Trade: Cutting Research

Panic Spreading Across Nations Outranks Trade
The self-fulfilling panic also applies to businesses. Consumers will cut spending and increase savings if they believe future wages and employment prospects are weaker and more uncertain. Photographer: Tomohiro Ohsumi/Bloomberg

When the U.S. or Europe sneezes, the rest of the world needn’t catch a cold.

Global trade and financial linkages weren’t strong enough by themselves to have caused the global recession in 2008 that followed the U.S. subprime crisis, according to economics professors Philippe Bacchetta of Switzerland’s University of Lausanne and Eric van Wincoop at the University of Virginia. Self-fulfilling panics, not contagion, are to blame, they said.

“The large losses of leveraged financial institutions and associated decline in credit were not directly responsible for the Great Recession,” they wrote in a special feature for the Monetary Authority of Singapore’s macroeconomic review, published Oct. 30. “Rather, a deterioration of macroeconomic fundamentals, such as a negative credit shock, contributed to a panic by generating conditions that made self-fulfilling beliefs, which otherwise would not have existed, feasible.”

In the U.S., 86 percent of goods and services purchased are domestic, while estimates for stock, bond and bank assets show that about 80 percent to 90 percent are domestic holdings, Bacchetta and van Wincoop said.

“The co-movement of asset prices in our model of self-fulfilling risk panics is a result of a global coordination of beliefs about risk around a large trigger event, and subsequently, around a particular macro fundamental that becomes a gauge of fear in the market,” they wrote.

Even with limited trade or cross-border asset holdings, it may be impossible to have a shock in the U.S. that doesn’t spread to the rest of the world, the professors said.

“Either countries panic together or they do not panic at all,” they said.

The self-fulfilling panic also applies to businesses. Consumers will cut spending and increase savings if they believe future wages and employment prospects are weaker and more uncertain. That can drag down aggregate demand and generate a recession, Bacchetta and van Wincoop said.

“This also weakens firms’ profits and discourages new investment,” they wrote. “The associated increased risk of firm bankruptcies implies increased uncertainty about future labor demand and wages, making initial beliefs self-fulfilling.”

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For the Bank of England to be more successful in quantitative easing, it doesn’t have to increase the scale of its asset purchases, according to economists at the Federal Reserve Bank of San Francisco. BOE policy makers should just communicate better.

The U.S. Federal Reserve’s moves have had a greater impact on government bond yields because its QE programs have been of a longer duration -- six to 10 months -- and it provides guidance on the near-term outlook for its policy rates, say Jens Christensen and Glenn Rudebusch. The BOE’s typical duration is three months and it doesn’t give any official direction on the prospects for its benchmark, they said.

“To rely more heavily on explicit forward guidance and less on asset purchases could prove to be a cost-efficient way to obtain a similar effect, but at less risk to the central bank when it is time to exit the unconventional policies and to normalize the size of its balance sheet,” the economists wrote in the November issue of the Economic Journal.

QE can push yields down in two ways, the authors wrote. It can signal that the benchmark rate will remain low longer than initially anticipated, or it can induce investors to add riskier assets to their portfolios as asset purchases reduce risk premiums.

In the U.S., about 60 percent of yield declines reflect lower expectations for future monetary policy and the remainder is associated with lower risk premiums, the economists said. All of the yield declines in the U.K., by contrast, were linked to a drop in risk premiums.

“The findings seem to indicate that program length and communication management could be at least as important for the effectiveness of QE policies as the actual purchase amounts,” they said.

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The computer revolution has transformed U.S. financial markets in the past 50 years, boosted liquidity in stocks and allowed data to be delivered instantly at a negligible cost. Just don’t expect earnings predictions to get any better.

In an analysis of the extent to which stock and bond prices forecast a company’s future profit, Jennie Bai of the New York Fed and Thomas Philippon and Alexi Savov of New York University’s Stern School of Business said what they called financial market informativeness hasn’t increased in the past half century. Earnings surprises have grown relative to total uncertainty, they said.

“These results appear to contradict the view that improvements in information technology have increased the availability of low-cost information,” they wrote in an October New York Fed staff report. “A possible explanation is that the relevant constraint for investors lies in the ability to interpret information rather than the ability to record it. If this is the case, a rise in the quantity of data need not improve informativeness or the allocation of resources.”

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Governments seeking to increase their revenue should consider increasing property and consumption taxes instead of those on income.

Higher income tax rates are associated with slower growth even if officials keep the overall burden unchanged by cutting property and consumption tariffs, according to a working paper published last week by the International Monetary Fund.

“On the other hand, we find that a shift from income to property taxes has a robust and positive association with growth,” said authors Santiago Acosta-Ormaechea and Jiae Yoo. “Similarly, when the increase is in VAT and sale taxes compensated with a reduction in income taxes, we also find a positive effect on growth.”

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