The credit crunch/recession and why it's likely to continue ...

I often speak with entrepreneurs and managers and, even though unit sales volumes and revenues in their businesses have decreased by between 20% and 50% from 2007 levels (they're mostly in durable  products manufacturing), almost all of them say they're expecting a recovery to begin in the next 3 to 6 months.  The irony is they've now been saying just this for at least the last one and a half years!  So much for the economic theory of rational expectations.  Hope or ignorance springs eternal.  Enquiring minds would, no doubt, like to know which it is.  Let's see ...

The Problem. Most of us know at some level that the overall economic downturn experienced in the US is somehow related to "the credit crunch".  Many of those I've spoken with suggest all that's needed to obtain an economic recovery is to solve the credit crunch problem: "If credit was available, people would be more confident and start spending again.  Then everything would be ok."  There is obviously some truth to this and it seems apparent this is the major premise upon which the Federal Reserve is operating.  But if it were really just a matter of pumping money into the US economy, the US should be in the strongest, most robust recovery in the history of the World.  Sadly, this isn't the case.

So what is the problem?  The problem is that the credit crunch is comprised of two inter-related feedback cycles; the consumer demand feedback cycle and the capital cost and credit default cycle.  Some feedback cycles are good (negative feedback cycles, which tend to be self-correcting) and some are bad (positive feedback cycles, which tend to be self-reinforcing).  The two feedback cycles comprising the credit crunch feedback cycle are the latter kind.; the Bad Kind.  Let me explain.  Consider the consumer demand feedback cycle:

Consumer demand feedback cycle

I think the cycle diagram is fairly self-explanatory, but there are two important aspects to it: (1) trouble in any component of the cycle leads to trouble in the rest of the cycle, and (2) once trouble starts, only some exogenous factor --i.e., something outside the cycle--that influences a component in a beneficial way has the possibility of stopping the self-reinforcing cycle.  So, for example, the Federal Reserve might manipulate the money supply to (artificially) increase reserves in the banking system; hopefully, stimulating lending, reducing consumer credit delinquencies and defaults, increasing consumers' willingness and ability to spend, etc.

So far, so good; but is this likely to work?  It depends on whether all components of the feedback cycle are improved by the Fed's actions.  It turns out that increased producer demand for labor, and the resulting improvements throughout the cycle, might not occur.  Consider (what might be called) the capital cost and credit default feedback cycle:

The capital cost and credit default feedback cycle

The diagram shows the close, positive feedback relationship between banks and producers.  Importantly, it shows that as banks' financial conditions weaken, the availability of credit required by producers decreases, capital costs increase (for banks and producers, and in fact consumers too), producer profits decrease, all leading to an increase in producer credit delinquencies and defaults; thus further damaging banks' financial conditions.  Here too the Fed attempted to intervene in the feedback cycle by (in substance) buying "toxic assets" from the banks, thus improving bank capital ratios and increasing bank lending capacity.

Again, so far, so good.  But why is the US economy (seemingly?) still so weak; long after all the Fed's interventions in the money supply and banks' toxic asset problems?  Consider now a more complete representation of the problem, which I'll call the credit crunch feedback cycle, where the two feedback cycles discussed above interact:

The credit crunch feedback cycle

The diagram just fits the two previous diagrams together by linking (1) consumer credit delinquencies and defaults to decreased bank profits, and (2) decreased consumer demand to decreased capital availability to, and increased capital costs and decreased profits of, producers.  In short, once something in the feedback cycle goes bad, it makes a lot of things go bad. 

I think one begins to see the knotty, entangled nature of the problem here: Basically, to solve the problem in the near term of 2-3 years, it's necessary to positively influence all components of the cycle.  In principle, influencing just a few important components will set everything right in the long-run.  (This is the real problem: In the word of Keynes, "In the long-run we are all dead ...", which is why he advocated manipulating the economy.)  But given real world complexities and frictions, solving the problem(s) in the short-run is, as they say, difficult.

So, which is it?  Is it hope or ignorance that the US economy will begin to recover in the next 3-6 month?  I will let the reader be the judge.

Econometric analysis.  How might the credit crunch feed cycle theory, presented in very skeletal form above, be tested?  That is, how do we reasonably know whether it explains and predicts (part of) what's happening in the US economy?  A fairly simple seemingly unrelated regression model (Zellner 1963) based on the feedback cycle presented above might look something like this:

... where deltas are interpreted as percentage changes, D is demand, S is supply, CDD is credit delinquencies and defaults, M is money supply, and u represents effects of unobservable/unmodeled factors.  Of course, the model would need to be estimated, tested, and probably modified quite a bit to get  a model that might explain and predict well.  Sounds fun, don't you think?  Hmmm ... I thought so.

MMc

São Paulo