The Economic Principle of Self-Reliance

October 27, 2010 2 comments

During a time of economic turbulence and of heated political debate surrounding governmental powers, programs and pork, I found the following story very enlightening:

“In our friendly neighbor city of St. Augustine [Florida] great flocks of sea gulls are starving amid plenty. Fishing is still good, but the gulls don’t know how to fish. For generations they have depended on the shrimp fleet to toss them scraps from the nets. Now the fleet has moved. …

“The shrimpers had created a Welfare State for the … sea gulls. The big birds never bothered to learn how to fish for themselves and they never taught their children to fish. Instead they led their little ones to the shrimp nets.

“Now the sea gulls, the fine free birds that almost symbolize liberty itself, are starving to death because they gave in to the ‘something for nothing’ lure! They sacrificed their independence for a hand-out.

“A lot of people are like that, too. They see nothing wrong in picking delectable scraps from the tax nets of the U.S. Government’s ‘shrimp fleet.’ But what will happen when the Government runs out of goods? What about our children of generations to come?

“Let’s not be gullible gulls. We … must preserve our talents of self-sufficiency, our genius for creating things for ourselves, our sense of thrift and our true love of independence.” (“Fable of the Gullible Gull,” Reader’s Digest, Oct. 1950, p. 32.)

Hopefully the American people will realize that economic responsibility goes hand-in-hand with economic freedom and resist the proposed “free handouts” so that the Land of the Free doesn’t become the Land of the Dependent, Decrepit, and Regulated.

Foreign Exchange Case Study

September 3, 2010 Leave a comment

Creatively Educating on Foreign Exchange

While co-teaching a course in International Economics at Brigham Young University – Idaho, it became apparent that one of the hardest concepts for students to understand and master is foreign exchange. Staying strictly to the book and continuing with normal lectures was failing miserably to keep the students engaged and develop any kind of understanding. So, I started developing a fictional case study in which students would simulate a business scenario and apply foreign exchange concepts.

The case study is very simplified in terms of a true business transaction, but focuses on some of the details of what firms need to consider as they engage in international negotiations. Exchange rate risk (with its differing implications before and after the contract is signed) is the main topic that the students deal with. Students also need to consider how certain economic indicators will influence the movement of exchange rates in a fictionally volatile international marketplace. Hedging with forward contracts and options is also addressed.

My finished product is far from perfect, but it was received with much excitement and the students finally grasped (and in some cases mastered) those difficult exchange rate concepts. Feel free to use it and give me feedback. Attached below is the current form of the project with the accompanying PPT presentation.

Download in PDF here - Exchange Rate Project

PPT of Days and Exchange Rates

*My favorite currency tracking site: www.x-rates.com

The Yield Curve and Predicting Recessions

As one of my latest projects, I have been working on a model that uses past interest rate data to calculate the probability that the U.S. economy will enter into a recession within the next 12 months. A special thanks to my professor of “Money, Banking, and Financial Markets” who got me pointed in the right direction and encouraged me to push forward.

Jonathan Wright, an FRB economist, expounded on the notion that an inverted U.S. Treasury yield curve can be a leading indicator of a down-turn in the economy: even a warning sign of a future recession. He used econometric probit models to explain the occurrence of NBER-defined recessions by looking at the term structure of interest rates. Wright’s work interested me right off the bat and I dug deeper to try to understand this man’s brilliance. After some intense study, I wanted to build my own model using data that I gathered to see if I could arrive at the same conclusions and, yes, be able to forecast recessions all by myself.

The term spread is calculated as the 10-year T-note rate minus the 3-month T-bill rate. This spread variable indicates the shape of the yield curve and serves as one of the explanatory variables in the regression model.  Improving the model, we can add the effective federal funds rate (as a measure of the stance of monetary policy). The model is specified as follows:

NBER = β0 + β1Spread + β2FedFunds

Probit model results (NBER recession periods overlayed)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The results, in terms of probability, are shown in the graph at the left, with the true recession periods shaded in red. Without getting too deep into the econometrics, this probit regression provides good in-sample fit and quality out-of-sample predictive performance. (Note that the model also predicts the latest recession, which is out-of-sample.) The true predictive power of the model lies in the sustained indicator trends. In other words, it shouldn’t be disconcerting if the probability spikes erratically, but attention should be paid to the overall trend. For example, there are some spikes in probability that are not followed by a recession, but  any time that 20 or more weeks of above-40% probability persisted, a recession followed.

The model is estimated using weekly interest rate data from 1962 to 2005. Unfortunately, data from before 1962 on long-term yields may be unreliable because at that time there were very few long maturity bonds that did not have prices distorted by being either callable or “flower bonds.” While the number of recessions that we have taken into account is too small to draw very strong conclusions, this probit model appears to have strong predictive powers.

The fascinating part of this model is that it captures all of the information included in the term structure of interest rates to predict future recessions. The fact that the yield curve is packed with so much market information is what amazes me.

The simplest theoretical rationale for why term spreads might be a useful leading indicator is that under the expectations theory (neglecting term premiums), the term spread measures the difference between current short-term interest rates and the average of expected future short-term interest rates over a relatively long horizon. A very low average expected future interest rate would indicate a time of recession is ahead. Also, a flat or inverted yield curve indicates a future decline in inflation, which is also associated with recessionary periods.

Once the model was estimated, I made a spreadsheet that keeps a weekly record of the term spread and fed funds rate and uses the estimated model coefficients to calculate the probability of a recession within the next year. After hooking the spreadsheet into live interest rate feeds and doing some rough programming to make sure that my graph and information stay up to date, I had a pretty good economic forecasting tool that I use regularly.

The yield curve has been flattening recently, with the latest 3-month over 10-year term spread at 245 bps. It is still sloping upward, however, and rates continue at historical lows while the current effective federal funds rate can’t get much lower. According to the model, another recession within the next year is only a 1% probability.

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