Chrysler's Bankruptcy Deals Blow to Affiliates

By ALEX P. KELLOGG and JEFF BENNETT

Pressure mounted on Chrysler LLC as the auto maker was forced to idle four plants and its dealers scrambled to find new sources of credit a day after the company filed for Chapter 11 bankruptcy protection.

The developments sparked fresh questions about Chrysler's prospects for quickly exiting from bankruptcy protection and about the web of suppliers and dealers that are linked to the company. The plants were idled after suppliers halted shipments, while dealers were squeezed when Chrysler Financial stopped providing cut-rate loans.

Fiat SpA Chief Executive Sergio Marchionne, seen as likely to take the helm of a restructured Chrysler, is counting on the bankruptcy process to move swiftly, allowing him to plunge into restructuring the troubled automaker. Over the next month, Mr. Marchionne will begin touring Chrysler plants and sifting through its other operations.

Fiat, which is partnering with Chrysler, is likely to use Chrysler's journey through Chapter 11 to slim its bloated dealership network, according to a person familiar with the matter. In bankruptcy, Fiat can press dealerships that have underperformed to renegotiate or terminate their contracts.

 

For several months Chrysler dealers have been feeling the strain of slumping sales. On Friday, Chrysler reported sales of cars and light trucks fell 48% in April to 76,682.

However, Fiat faces a bumpy road. Gaining Chrysler's extensive sales network is a key attraction for the Italian company, and Mr. Marchionne does not want Fiat's re-entry to the U.S. market after nearly three decades to be marred by a messy court battle.

A Fiat spokesman could not be reached for comment Friday, a holiday in Europe.

Already-strained parts suppliers, hurt by Detroit's plummeting sales, face a squeeze of their own. In court filings, Chrysler warned that many parts makers could follow the company into Chapter 11 if its proceedings drag on. Its largest unsecured creditor is Ohio Module Manufacturing Co., a supplier that is owed $70.3 million. Chrysler in court Friday asked that it be allowed to continue to pay its employees and suppliers.

"Without a clear timeline for when the [bankruptcy] situation will end and production will resume, I believe we will see massive suppliers bankruptcies that will stop Chrysler from resuming production," Chrysler's procurement officer, Scott Garberding, said in a statement filed with the bankruptcy court Thursday.

Chrysler was preparing to shut down all of its vehicle assembly plants for 60 days on Monday. But on Friday two plants in the U.S. and two in Canada were forced to cease production because a few suppliers stopped shipping parts or materials.

Officials from the Obama administration's auto task force cautioned that there was no reason that suppliers should be hesitating over shipments to Chrysler or getting worried about payments.

"It is the company's intentions to continue to pay suppliers in the ordinary course," said one official. "This company will operate in the ordinary course throughout the bankruptcy process."

Chrysler is being given access to $1.3 billion in federal financing to keep it going during the bankruptcy process. And afterwards, the U.S. government is prepared to offer an additional $4.7 billion in loans.

Across the country dealers Friday were scrambling to line up new banks to provide auto loans for buyers after the company's ailing lending partner, Chrysler Financial, stopped providing loans with subsidized interest rates such as 0% deals.

Chrysler Financial is still offering auto loans to buyers purchasing vehicles from Chrysler, said the lending company's chief executive, Tom Gilman. However, he acknowledged his company isn't offering the lowest rates available. "Our rates haven't been competitive for some time because our costs are so high," he said.

David Kelleher, owner of one Dodge store and a Chrysler-Jeep franchise in the Philadelphia area, said he was working on paper work on Friday to be able to get customers auto loans from GMAC LLC to make up for the loss of loans from Chrysler Financial.

"Having those partners at Chrysler Financial was very, very important to the dealer body," Mr. Kelleher said. In the past Chrysler Financial worked closely with dealers to help them sell cars, although it had become less so in recent months as it tightened up credit terms and approved fewer and fewer loans.

Associated Press

A customer outside a Chrysler dealer in Oakland, Calif., on Thursday. The auto maker reported sales of cars and light trucks fell 48% to 76,682 in April.

Mr. Kelleher added he's concerned about working with GMAC because it is affiliated with Chrysler's competitor, General Motors Corp. "It's going to be a real challenge to get GMAC to act on behalf of Chrysler," he said. "It's very difficult if a finance arm is not aligned with you."

GMAC is prepared to handle business from Chrysler customers and dealers, and will handle their business the same as GM customers, a GMAC spokeswoman said. Cerberus Capital Management LP, Chrysler's former parent, has sizable stakes in GMAC and Chrysler Financial.

On Thursday President Barack Obama expressed optimism when he announced Chrysler would seek bankruptcy protection after his administration's auto task force failed to reach a debt-reduction deal with about half of Chrysler's 46 secured lenders.

"The necessary steps have been taken to give one of America's most storied auto makers, Chrysler, a new lease on life," Mr. Obama said.

But bankruptcy adds a new element of risk to the government-led restructuring of Chrysler. Since Chrysler is halting production, shipments of parts and materials from suppliers to its 12 North American assembly plants will cease, putting jobs at suppliers as well as at Chrysler on the line.

"When Chrysler doesn't run, we don't run," said a person at Ohio Module who identified himself as a human-resources manager at the company but declined to give his name.

Other officials at Ohio Module, which builds chassis for Jeep Wranglers and was spun off of Chrysler in 2006, couldn't be reached.

Chrysler's Conner Ave. assembly plant, which builds the Dodge Viper, has been stopped by interruptions in its parts supply for the last three weeks, said Chris Vitale, a worker at the plant.

A Chrysler spokeswoman said she didn't know the reason production was suspended at the Conner Ave. plant.

A parts shortage will not only affect production at Chrysler but would ripple through the industry, which could create some disruption for other auto producers.

"We're all interconnected, so we're evaluating it right now," said Edward Miller, a spokesman for American Honda Motor Co. Honda buys parts from 525 U.S. suppliers. But Mr. Miller notes those companies all buy parts from thousands of other producers as well, some of which could also be forced out of business. "We're anticipating there will be some impact," he said.

The bankruptcy was on the minds of the few customers who were in Chrysler stores on Friday.

The Chrysler showroom of Boardwalk Auto Center in Redwood City, Calif., had a lone customer, Ken Hopkins, who was eying a ruby red PT Cruiser to replace his 2001 model. The retired technology consultant said Chrysler's bankruptcy was making him think twice about a purchase. "You want to have the assurance that they'll have follow-up service," he said. Still, Mr. Hopkins said he hoped to pick up a bargain because of the bankruptcy filing.

Many dealers said they have already been contacted by GMAC and are lining up credit through the company, or are already able to get customers car loans from other banks.

Brian Kelly, owner of Kelly Jeep Chrysler, in Lynnfield, Mass., a Boston suburb, said his dealership plans to arrange financing through local banks. "We have long-standing relationships with banks that do this," he said. "That is primarily going to be our biggest option."

For this weekend, his dealership is advertising a "new cars at used car prices" promotion. "We want the world to know that this makes it a buyers' market," he said. "We are just pointing it out and giving people the opportunity to take advantage."

Will Chrysler Bankruptcy Affect Chrysler Financial Customers

The recent Chapter 11 bankruptcy filing may have customers of Chrysler Financial worried about their loans.

Chrysler bankruptcy

Here at Auto Credit Express, most of weren’t surprised by the bankruptcy filing of Chrysler LLC yesterday. That being said, it certainly isn’t pleasant having one of our neighbors (Chrysler headquarters is just a mile away from the ACE offices), as well as one of the three domestic automakers, have to go through a bankruptcy filing in order to remain a viable business.

But while much has been said about Chrysler’s current situation, very little has been mentioned about Chrysler Financial, the automaker’s captive finance company, other than to point out that GMAC, also partly owned by Cerberus (the investment group that purchased Chrysler from Daimler) will immediately begin financing Chrysler’s customers, as well as eventually take over the financing of vehicles on dealer lots (called floorplanning).

GMAC

Chrysler Financial, it turns out, is in financial straits just as dire as that of Chrysler, itself. And while both Chrysler Financial and GMAC applied to the government for bank status (thus allowing them access to TARP funding), only GMAC was granted this status.

So while GMAC has returned to lending as usual (usual being a relative term given the current economic circumstances), Chrysler’s erstwhile finance arm has been fighting the good fight with one hand tied behind its back – hardly acceptable odds in today’s economy. So with Chrysler Financial on the ropes, the only choice for an emerging “new” Chrysler is, guess what (and you get only one guess)? So where does this situation leave current customers of Chrysler Financial?

Current Chrysler Financial customers

Although Chrysler Financial has yet to issue any press statement, both Chrysler LLC and GMAC have stated that the following will occur:

GMAC will immediately begin to service new Chrysler customers at the retail level. This means that when you finance a new Chrysler through a Chrysler, Dodge or Jeep dealer, the captive lender will be GMAC (through a branded lender for dealers backed by GMAC).

GMAC will immediately begin offering floorplanning financing to all CDJ dealers currently with Chrysler finance.

Finally, Chrysler Financial will continue to service its portfolio. This means that for all current customers of Chrysler Financial, it will be “business as usual.” You will make your payments to CF just as you have in the past.

The future

Although Chrysler Financial customers will see no changes in the near term, it’s difficult to whether or not things may change in the future. If Chrysler has so little faith in the company that it’s partnering with GMAC, then pushing their erstwhile financial partner off the stage can’t be a good sign (especially if you’re a CF employee).

But regardless of the fate of the company, Chrysler Financial customers can rest assured that either CF or another lender (to be named later) will continue to service their car loan.

Chrysler Begins Voyage Down Bankruptcy Route

Deliberations on the fate of Chrysler shifted from Washington to a Manhattan courtroom on Friday as lawyers for the automaker sought to clear the way through bankruptcy, sell or transfer Chrysler’s operations, and keep paying its workers their salaries and benefits.

Chrysler, the third-largest American automaker, filed for bankruptcy on Thursday after months of negotiations with regulators, unions and creditors fell apart when a small group of debt- holders balked at the government’s final terms for an out-of-court restructuring.

Chrysler’s next steps toward settling with its creditors and completing an alliance with the automaker Fiat are taking place in the courtroom of Judge Arthur J. Gonzalez of United States Bankruptcy Court, who received a series of motions from Chrysler’s lawyers Friday morning.

In addition to asking to protect employee wages, which total about $60 million, and basically keep operating, lawyers sought to keep Chrysler’s warranties in place, an effort to reassure current and prospective customers they can still safely buy Chrysler and Jeep products. Lawyers for the automaker said they wanted to move quickly.

“I don’t think that any American can doubt these are extraordinary times,” said Corinne Ball of Jones Day, Chrysler’s lead bankruptcy lawyer. “We have to move at a high speed.” Chrysler’s 22 plants in the United States are to be idled at the end of the day Friday, Ms. Ball said.

As part of its reorganization, Chrysler said Friday that it planned to shut eight plants permanently, lay off about 6,500 workers and close an unspecified number of dealerships.

Judge Gonzalez granted Chrysler’s request to use its existing cash management system, which would enable the company to transfer money to other subsidiaries to keep operating.

Lawyers for various constituencies, including banks, car dealerships, hedge funds, parts makers and others have been working around the clock readying their arguments to make sure their interests are protected in court.

Thomas E. Lauria of the law firm White & Case, who represents a committee of the secured creditors, declined to comment to reporters and did not raise any objections to the motions at the hearing. It is still unclear whether the group, which includes Oaktree Capital Management, OppenheimerFunds, Stairway Capital Management, Schultze Asset Management, Group G Capital Partners and the TCW Group, will object to Chrysler’s restructuring plan at the continuation of the case next week.

The lenders, who say they believe they are being treated unfairly in the process, may request that Chrysler be liquidated. But, according to the company’s own analysis, a liquidation would cost more than $2 billion and there are unlikely to be many buyers for Chrysler’s assets.

More than a dozen photographers and television crews swarmed lawyers and others as they were leaving the courtroom after the hearing.

Chrysler’s chief financial officer, Ronald E. Kolka, and other executives quickly jumped into a minivan waiting outside the courthouse.

Ms. Ball and her team of lawyers from Jones Day attracted a swarm of reporters and photographers, who followed them down into a subway station after the hearing. As they stepped on the train, other riders began asking whether a celebrity had just come aboard.

Judge Gonzalez has experience with major bankruptcy cases, having overseen the reorganization of Enron in 2001, which set a record by filing for bankruptcy with $63 billion in assets, and WorldCom in 2002, which topped Enron with $107 billion assets when it filed.

Court documents filed by Chrysler in New York on Thursday showed that Chrysler’s re-emergence from bankruptcy could take until Aug. 28, or four months from now.

Bankruptcy always contains some element of unpredictability, and the debtholders who oppose the new arrangement could argue in court that the company is worth more to them in liquidation.

No light was shed at Friday’s hearing on how quickly the proceedings might play out.

Administration officials said they believed that it was highly unlikely that a bankruptcy court judge would side with the minority when those holding 70 percent of the debt had signed off on the arrangement.

Micheline Maynard and Jack Healy contributed reporting.

 

http://www.nytimes.com/

'Big Bang' Pioneers Rethink Banking Overhaul

London launched a radical set of market reforms known as Big Bang, turning the city into ground zero of a revolution that begat today's buckling global financial system. Now, as leaders of the world's 20 largest economies gather here to fix that system, some Big Bang architects are questioning the ideal of unfettered capitalism on which it was built.

In retrospect, they say, the movement unleashed unanticipated forces such as global banks whose influence extends beyond the reach of any one regulator. Those forces may be difficult for the G-20 -- or anyone -- to rein in.

View Slideshow

London Prepares for the G-20

London is bracing for angry protests before and during Thursday's Group of 20 summit, which will see fortresslike security for world leaders.

Few events embody the free-market thinking that shaped modern finance better than Big Bang. Under former Prime Minister Margaret Thatcher, a small group of officials, including Treasury chief Nigel Lawson and Secretary of State for Trade and Industry Cecil Parkinson, scrapped decades-old rules at the stock exchange and other institutions that they feared could leave London trailing behind rapidly globalizing markets.

The reforms helped trigger an economic boom and boosted the status of London's banking district, known as the City, as one of the world's financial hubs -- and as a testing ground for some innovations that wound up at the center of the current crisis.

Looking back two decades later, Messrs. Lawson and Parkinson say at least one thing went wrong: Banks were allowed to grow too big for anyone, including their own managers, to oversee.

"The notion that banks would get as big and as bloated as they did get -- that was totally unexpected," says Mr. Lawson, who like Mr. Parkinson is now a member of the House of Lords, the upper house of the U.K. Parliament.

As a result, they take a dim view of G-20 leaders' efforts to expand the global regulatory system to match the size and complexity of the financial system.

Over the past few decades, banking conglomerates have delved into a range of businesses, including buying and selling complex derivatives contracts as well as putting their own money on the line in bets on financial markets. In the process, they have become so large -- U.K. bank assets amount to £7.9 trillion ($11.31 trillion) -- that governments have little choice but to bail them out when they get into trouble.

The solution, Messrs. Lawson and Parkinson say, is to break banks into the separate businesses they used to be. Mr. Lawson recommends introducing a version of the U.S. Depression-era Glass-Steagall Act. The legislation created a wall between commercial banks, which take deposits and make loans, and securities firms, which take bigger risks with their money. By making sure commercial banks don't get too entangled with securities firms, the logic goes, regulators could keep troubles at the latter from infecting the former.

To be sure, restoring a separation among different businesses would be a daunting task, given the deep and complex connections among types of financial institutions.

Big Bang began with a seemingly small move: abolishing fixed commissions at the London Stock Exchange, which at the time was an exclusive association of small financial houses that dominated the U.K. trade in stocks and bonds. The competition unleashed by the move, which went into force in 1986, broke down a barrier that had helped keep the system stable: The separation of brokerage firms, which executed clients' trades, from so-called jobbers, or securities firms that risked their own money by taking positions in stocks and bonds.

In addition to ensuring that brokers weren't betting against their clients, the separation prevented firms from getting big enough to be a systemic threat.

Once the fixed commissions were gone, falling profit margins pushed the brokers and jobbers into mergers with big global banks. That opened the way for U.S. banks such as Citicorp (now Citigroup Inc.) and U.K. banks such as Barclays Bank PLC (now Barclays PLC) to get into the risky business of securities dealing -- something that was still banned in the U.S. under Glass-Steagall, repealed only in 1999.

Attracted by the freedom and later by the U.K.'s famously light-touch regulation, global banks turned the City into a laboratory for new financial products.

Now, as U.K. regulators seek to crack down by expanding supervision to cover the entire universe of banking, including hedge funds and structured investment vehicles, the Big Bang veterans are skeptical.

Amid preparations for the G-20 summit, authorities in England made five arrests Monday, according to the Associated Press. Police arrested five people in Plymouth, 240 milesfrom London under terrorism laws, the AP reported, and recovered a haul of replica weapons, fireworks and activist propaganda. Law-enforcement officials said officers are investigating whether the group planned to target the summit.

Japan Jobless Rate Jumps to a Three-Year High of 4.4%

Japan’s unemployment rate rose to a three-year high in February and job openings disappeared at the fastest pace in more than three decades as the export-led recession spread to households.

The unemployment rate climbed to 4.4 percent from 4.1 percent in January, the statistics bureau said today in Tokyo, the highest since January 2006. The ratio of jobs available to each applicant tumbled to 0.59 last month from 0.67, the biggest drop since December 1974, the Labor Ministry said.

Household spending fell for a 12th month as exporters from Toyota Motor Corp. to NEC Corp. reined in hiring and contained wages. Prime Minister Taro Aso has ordered his third stimulus package since October to prevent the economic slump from deepening as the nation heads for its worst recession since 1945.

“Japan’s labor market will keep deteriorating,” said Yoshiki Shinke, a senior economist at Dai-Ichi Life Research Institute in Tokyo. “The question is how much consumer spending will become a drag on the economy as wages and employment conditions worsen.”

The median estimate of 35 economists surveyed by Bloomberg was for the jobless rate to rise to 4.3 percent. Household spending fell 3.5 percent, a separate report today showed.

The yen traded at 97.39 per dollar at 8:40 a.m. in Tokyo from 97.36 before the report was published.

Oki Electric Industry Co., a maker of communications equipment, said it will cut administrative workers after a slump in demand forced it to widen its profit loss forecast this month.

Contain Costs

New jobs are also becoming harder to come by as companies try to contain costs. Toyota, the world’s largest automaker, this month said it will almost halve recruitment of new graduates in Japan to the lowest level in 14 years after forecasting its first loss in almost six decades. NEC Corp., Japan’s largest personal computer maker, said it plans to cut new hires by almost 90 percent to 100 people.

Bleak job prospects are taking their toll on consumers, whose outlays account for more than half of the economy. Retail sales fell at the fastest pace in seven years in February and weak demand prompted supermarket operators Ito-Yokado Co. and Seiyu Ltd. to cut prices of food, clothing and household products this month.

Some 77 percent of jobless people aren’t receiving unemployment benefits, the highest figure among Group of Seven nations except Italy, whose data weren’t available, the International Labour Organization said in a report last week.

‘Pretty Slow’

“The policy response has been pretty slow in creating a safety net for unemployment, which is putting downward pressure on the whole economy,” said Noriaki Matsuoka, an economist at Daiwa Asset Management Co. in Tokyo.

The jobless rate will reach a postwar high of 5.5 percent in the first quarter of next year, according to the median estimate of 14 economists surveyed by Bloomberg News.

To contact the reporters on this story: Toru Fujioka in Tokyo at tfujioka1@bloomberg.net

Russian Economy Will Shrink 4.5%, World Bank Says

Russia’s economy will probably shrink 4.5 percent this year after oil prices slumped and global contagion spread, driving up unemployment and pushing more people into poverty, the World Bank forecast.

“As the crisis continues to spread to the real economy around the world, initial expectations that Russia and other countries will recover fast are no longer likely,” the bank said in a report today. In November, it saw growth of 3 percent, based on oil prices of $75 a barrel and global expansion.

The slump may last longer and be deeper than in the aftermath of the 1998 government’s $40 billion debt default and 70 percent ruble devaluation, which triggered bank runs and wiped out citizens’ savings. A contraction may be prolonged by a drop in household consumption and a “second wave” of non- performing corporate loans, Zeljko Bogetic, the World Bank’s Moscow-based lead economist, said today in Moscow.

“There is a risk of further deterioration in the world economy and in Russia,” Bogetic said. “The real economy has deteriorated more than expected. I’d call it a silent tsunami, a more gradual tsunami than the one we’ve seen, with the steady increase of non-performing loans that will be potentially damaging for the global economy and Russia.”

Capital Outflow

Russia’s government says the economy will shrink 2.2 percent this year after a decade-long expansion. The Cabinet this month approved a revised budget with the first deficit in 10 years of 2.98 trillion rubles ($88.2 billion), or 7.4 percent of projected gross domestic product.

“We disagree with the World Bank forecast, it’s too pessimistic for Russia,” First Deputy Prime Minister Igor Shuvalov said in Moscow today.

The revision was calculated on an average price of $41 a barrel and an inflation rate of about 13 percent. The budget contains 1.6 trillion rubles in anti-crisis spending.

Inflation will be between 11 percent and 13 percent this year as higher import prices offset falling consumer demand, the unavailability of loans and capital outflow, the bank said.

Net capital outflow may reach $170 billion as Russian banks and companies pay off more than $130 billion of external debt and foreign direct investment dwindles to less than $5 billion this year, Bogetic said. Russia’s central bank estimates that less than $83 billion will be taken out of the economy this year, First Deputy Chairman Alexei Ulyukayev said March 27.

Help the ‘Vulnerable’

The government’s anti-crisis response should shift from a focus on the financial sector and companies toward targeting small and medium-size businesses, infrastructure and “cushioning the impact on the vulnerable” the bank said.

Russia should earmark additional funds, equivalent to about 1 percent of gross domestic product for one year, to provide a temporary fiscal boost on programs including child allowance, unemployment benefits and pensions, the bank said. The spending program would increase the deficit by 0.75 percent this year because it will extend into 2010.

The number of jobless people will probably rise by 2.7 million people in 2009, growing to more than 12 percent of the working population, the World Bank said. The number of poor may climb by 2.75 million, resulting in a 16 percent poverty rate.

The bank estimates about a quarter of the population is vulnerable to poverty. Russia also faces a severe housing shortage, with about 7 percent sharing living space with other households and one in two persons having less than 10 square meters (108 square feet) per capita.

While the government has said it will maintain planned spending levels on priority programs in education, public health and housing this year, Russia needs to implement quicker measures to contain the crisis in the short term.

Limited Space

Russia’s international reserves are sufficient to finance the projected budget shortfall, though the need to preserve funds for next year means “the space for more fiscal stimulus this year appears limited,” the report said.

At the same time, the focus on tax relief in Russia’s stimulus package may undermine the revenue base after the price of oil tumbled. Oil will probably stay at about $40 to $50 a barrel this year, easing pressure on the ruble, and rise to $75 in the “medium term,” Bogetic said.

The foreign-currency stockpile, the world’s third-largest after China’s and Japan’s, has been eroded by 36 percent from an August record of $598.1 billion, as Bank Rossii sold dollars and euros to manage a 30 percent “gradual devaluation” of the ruble against the dollar.

The World Bank predicts new pressures on Russia’s banking sector as credit markets remain frozen and bad loans increase. The share of non-performing loans may exceed 10 percent of the total by the end of this year from 3.8 percent in January.

Russia has allocated 555 billion rubles of budget money to aid lenders and may also allow banks to swap shares for sovereign ruble bonds to help them boost capital, Finance Minister Alexei Kudrin said last week.

-- With reporting by Anastasia Ustinova in Moscow. Editors: Chris Kirkham,

To contact the reporter on this story: Paul Abelsky in St. Petersburg at pabelsky@bloomberg.net.

G-20 Targets Hedge Funds as Leaders Near Consensus

Leaders of advanced and emerging economies are closing ranks behind plans for tougher rules on financial markets to prevent another collapse like the one that wiped out much of Wall Street.

A global approach to regulation has been gaining momentum ahead of the Group of 20 summit April 2 in London. U.S. President Barack Obama, U.K. Prime Minister Gordon Brown and their G-20 counterparts aim to merge their national blueprints for strengthened regulation into a united front to rein in hedge funds, derivatives trading, executive pay and excessive risk- taking by financial firms.

“There is reason for optimism that progress toward stronger global regulation has begun,” says Daniel Price, who was President George W. Bush’s G-20 negotiator and is now senior partner for global issues at Sidley Austin LLP in Washington. “We’re beginning to see the outlines of a convergence.”

Agreement on a shared regulatory agenda would provide the G-20 summit with a measure of success even as leaders remain at odds over trade policy, fiscal stimulus and the status of the dollar. A joint regulatory approach is crucial to prevent investors from seeking out markets with the most permissive rules, setting off a race to the bottom as countries vie to attract capital.

The call for greater regulation unites China, possessor of the most vibrant economy in the developing world, and the U.S., possessor of the world’s largest economy. China’s central bank governor, Zhou Xiaochuan, challenged the West to fix flaws in financial supervision on March 26, the same day U.S. Treasury Secretary Timothy Geithner outlined a broad initiative designed to do just that.

International Framework

“Having the U.S. and Chinese on board makes it a whole lot more likely” that an international framework will eventually emerge, says Harvard University’s Kenneth Rogoff, former chief economist of the International Monetary Fund.

Rogoff says that “it seems virtually certain that four to five years from now, the world will have either a global financial regulator or, more likely, a treaty on global financial regulation with a secretariat, akin to the World Trade Organization.” Still, he adds, “nothing is going to happen quickly.”

‘Lobbying Ferociously’

John Taylor, a former U.S. Treasury official and now at Stanford University, says the process is “going to be drawn out” as lawmakers in individual countries wrangle over rewriting the rules. That will give financial firms the opportunity to seek changes that dilute new restrictions, says Richard Portes, a professor at the London Business School.

“Banks are lobbying ferociously against anything that will undermine their businesses and pay,” he says.

When G-20 leaders last met in November, with the Bush administration in its final months, the U.S. resisted European suggestions for a single global regulator and government oversight of hedge funds. Now, proposals from the Obama administration are giving the push for a global regulatory overhaul a second wind.

“We must ensure that global standards for financial regulation are consistent with the high standards we will be implementing in the United States,” Geithner told Congress March 26.

Calling for “new rules of the game,” Geithner plans to bring hedge funds, private-equity firms and derivatives markets under federal supervision for the first time. A new systemic- risk regulator would have power to force companies to increase their capital or cut their borrowing, and authorities would be able to seize them if they came unstuck.

‘More Effective Role’

Geithner suggests empowering the Financial Stability Forum, a group of international market regulators, to “play a more effective role” alongside the IMF and the World Bank in promoting and monitoring new international regulations.

“There now appears to be common interest in pushing for a global systemic regulator,” says Stephen Roach, chairman of Morgan Stanley Asia in Hong Kong. “It won’t be easy, however, for Europe and the U.S. to come to a consensus on who that new regulator should be and what type of enforcement mechanism can be used to empower any such body.”

The U.S., which has long expected other nations to follow its lead on regulations, may now have to yield to more cooperation, says former Federal Reserve Chairman Paul Volcker.

Zhou’s Advice

“The U.S. is no longer in a position to dictate that the world does it according to the way we’ve done it,” Volcker, head of Obama’s Economic Recovery Advisory Board, told a March 6 conference at New York University.

China’s Zhou underscored that point in an article published by the People’s Bank of China March 26 that criticized western economic policies and recommended regulators be allowed to “act boldly and expeditiously without having to go through a lengthy or even painful approval process.”

“China has to be listened to,” says Glenn Maguire, chief Asia-Pacific economist at Societe Generale SA in Hong Kong. “What they are trying to do is exert maximum influence on the design of the new global financial architecture.”

A new collaborative strategy was evident in a working paper released on March 27 by the Canadian government on behalf of the G-20, which comprises 19 developed and emerging economies plus the European Union and represents 85 percent of the world economy.

The working paper recommended that leaders agree to regulate hedge funds and other nonbanking pools of capital that pose “systemic” risks and strengthen rules requiring financial institutions to build up capital cushions.

First Rules

“We have reason to believe that there will be a fair degree of consensus,” Canadian Prime Minister Stephen Harper said in an interview with Bloomberg News.

The EU will propose its first rules for the $1.4 trillion hedge-fund industry next month, while the U.K. is also considering stepping up oversight.

After financial firms raced to raise more than $1 trillion of capital to cover losses, governments want “institutions to take less risk and build up buffers in good times,” says Marco Annunziata, chief economist at UniCredit MIB in London.

The U.K.’s market regulator cites Spain as a model, after preemptive cushioning helped its biggest lenders, including Banco Bilbao Vizcaya Argentaria SA, avoid the need for government recapitalization at the end of a real-estate boom. The country was nevertheless forced to mount its first major bank rescue today, of Caja Castilla-La Mancha savings bank.

Revamp

In addition, central banks and regulators are signed up to a revamp of the so-called Basel II bank-capital standards after a 2003 rewrite was never fully applied in the U.S., leaving European banks to compete under different rules.

G-20 countries are also spurring accounting-standard setters to speed up the work of narrowing differences so investors can compare financial statements around the world.

Any agreement at the G-20 would hand leaders a way of papering over other policy differences. European governments have resisted a U.S. push for more stimulus spending. The World Bank says most G-20 members have taken actions that restrict trade, even after pledging to avoid protectionism.

A fresh split emerged last week as China proposed the creation of a new international reserve currency, only to run into immediate U.S. opposition.

On regulation, at least, “there’s definitely a unified framework forming now,” says Jim O’Neill, chief economist at Goldman Sachs Group Inc. in London. “Whether it works will only be known when the next crisis hits.”

To contact the reporters on this story: Simon Kennedy in Paris at skennedy4@bloomberg.netMatthew Benjamin in Washington at mbenjamin2@bloomberg.netJohn Rega in Brussels at jrega@bloomberg.net.

U.S. Economy: Spending Growth Slowed in February

American consumers’ spending slowed in February and their confidence remained near a three-decade low this month, reflecting the toll of a deteriorating job market.

Purchases advanced 0.2 percent after climbing 1 percent in January, the Commerce Department said today in Washington. The Reuters/University of Michigan final index of consumer sentiment was 57.3 in March after 56.3 in February.

Taken together with the spending jump in January, today’s figures offer a picture of an economy that remains in recession, while no longer worsening. With a separate report showing California and six other states have unemployment rates above 10 percent, the data make it critical that Federal Reserve and Obama administration stimulus actions take effect by mid-year.

“We’re certainly not out of the woods by any means, but perhaps we’re seeing some signs of stabilization,” Jay Bryson, a global economist at Wachovia Corp. in Charlotte, North Carolina, said in a Bloomberg Television interview.

A report yesterday from Best Buy Co., the largest U.S. electronics retailer, matched Bryson’s assessment. The Richfield, Minnesota-based company reported that profit fell less than analysts forecast for the quarter ended Feb. 28. Chief Executive Officer Brad Anderson said “we were pleased when the quarter finished stronger than it began.”

Stocks Drop

The Standard & Poor’s 500 Stock Index fell 2 percent to close at 815.94. Treasuries fell, with yields on benchmark 10- year notes at 2.76 percent.

Much of the February gain in consumer spending was because of an increase in prices, leaving so-called real purchases with a decline for the month. Economists had forecast spending would rise 0.2 percent, after an originally reported 0.6 percent gain the prior month, according to the median of 68 estimates in a Bloomberg News survey.

Incomes fell 0.2 percent, after a 0.2 percent increase in January. The survey median projected a 0.1 percent decrease.

Because spending rose as earnings fell, the savings rate decreased to 4.2 percent from 4.4 percent in January. As recently as August, the rate was at 0.8 percent, indicating Americans are trying to boost savings as unemployment climbs.

The Reuters/University of Michigan index continues to hover near the 28-year low of 55.3 reached in November. The median forecast was 56.8. The index of consumer expectations six months from now, which more closely predicts the direction of spending, rose to 53.5 from 50.5 in February.

‘Bottoming Out’

“Overall confidence, even though it’s at low levels, is kind of bottoming out,” said Brian Bethune, chief financial economist at IHS Global Insight in Lexington, Massachusetts. “A lot of incentives are at play to get consumers to do things they ordinarily wouldn’t” given the downturn, he said, referring to the fiscal stimulus and efforts to revive credit.

President Barack Obama today meets with chief executive officers of some of the nation’s biggest banks, seeking support for his plan to stabilize the financial system.

Today’s Commerce report showed inflation accelerated. The price gauge tied to spending patterns rose 1 percent from February 2008, up from a 0.8 percent 12-month gain in January. The Fed’s preferred gauge of prices, which excludes food and fuel, climbed 1.8 percent, more than forecast.

Adjusted for inflation, spending dropped 0.2 percent, following a 0.7 percent gain the prior month.

Disposable income, or the money left over after taxes, decreased 0.1 percent, after rising 1.6 percent the previous month. Adjusted for inflation, disposable income dropped 0.4 percent.

Durable Goods

Inflation-adjusted spending on durable goods, such as autos, furniture, and other long-lasting items, dropped 1.5 percent last month after rising 3.2 percent in January. Purchases of non-durable goods and services were unchanged.

Still, the inflation-adjusted spending so far this quarter is higher than the fourth-quarter average, setting the stage for a gain after plunging late last year.

The economy shrank in the fourth quarter at a 6.3 percent annual pace, the worst performance since 1982, in what may be the depths of the recession. Consumer spending fell at a 4.3 percent rate, marking the first back-to-back declines in excess of 3 percent since records began in 1947.

“We’re seeing a minimal amount of consumption, as people are just spending on bare necessities,” Lindsey Piegza, an economic analyst at FTN Financial in New York, said before the report. “You can’t have stable consumer spending until you have stable incomes or wealth accumulation.”

Carmakers General Motors Corp. and Chrysler LLC are still counting on government aid for survival. U.S. auto sales in February slid to the lowest rate since December 1981, led by a 53 percent plunge for Detroit-based GM.

To contact the reporter on this story: Shobhana Chandra in Washington at schandra1@bloomberg.net

Jobless Rate Exceeds 10% in Three More U.S. States

The number of U.S. states with a jobless rate exceeding 10 percent almost doubled in February as the worst employment slump in the postwar era spread.

Nevada, North Carolina and Oregon last month joined the four other states that had previously climbed above 10 percent, according to Labor Department data released today in Washington. Michigan, at 12 percent, remained the state with the highest unemployment rate, followed by South Carolina at 11 percent and Oregon at 10.8. California and Rhode Island bring the total number of states to seven.

Job losses have spread from areas battered by the housing recession and auto slump to states like the Carolinas where non- auto manufacturers and service companies are cutting staff. Economists at Merrill Lynch & Co. in New York and Wachovia Corp. in Charlotte, North Carolina, are among those projecting joblessness nationwide will surpass 10 percent.

“We so seldom see an economy down so broadly,” said Steve Cochrane, a senior economist at Moody’s Economy.com in West Chester, Pennsylvania. ‘The impact from the downturn in manufacturing is heading south from the Midwest. Job losses have broadened out across all industries because of the credit crunch, the lack of consumer confidence and the global slump.”

Forty-nine states and the District of Columbia registered increases in the unemployment rate last month, led by Oregon, North Carolina and New Jersey, the Labor Department said. Nebraska was the only state to post a decrease after the rate jumped the prior month.

Housing Slump

The states where home prices surged and then crashed remain among the hardest hit, including Nevada, with its 10.1 percent joblessness. Nicole Wolf, 39, was working for Harrah’s Entertainment Inc. in Las Vegas for the human resources department until this month when she was laid off from her job that paid $94,000 a year.

With her home worth less than her mortgage, and paying $800 a month to cover student loans, Wolf is trying to find a job in marketing or communications before her severance pay runs out.

“I’m assuming I’ll have a job or declare bankruptcy,” Wolf said in a telephone interview.

The outlook for finding work this month hasn’t improved. The world’s largest economy probably lost more than 600,000 jobs in March for a fourth straight month, and the jobless rate jumped to a 25-year high of 8.5 percent, according to the median estimate of economists surveyed by Bloomberg News before next week’s report from Labor.

Bernanke on Unemployment

Federal Reserve Chairman Ben S. Bernanke said in Washington March 10 that it was “certainly well within the realm of possibility” that unemployment nationwide could rise above 10 percent “for a period.”

With the recession already matching the longest in the postwar period, the jobless and the needy are becoming more evident across the country.

Gabriela Romero, who works for the Fresno County Economic Opportunities Commission, last month organized a food drive in Mendotta, California, a city where four of 10 workers are unemployed, and arrived to find a crush of people seeking assistance.

“It was just a free-for-all,” she said. “You have people waiting in line for hours, pregnant women, disabled people.”

Since the recession began in December 2007, the economy has lost 4.4 million jobs, already more than the 3.5 million jobs President Barack Obama is targeting to save or create with his $787 billion recovery program.

California, Florida

Payroll employment in February decreased in 49 states and the District of Columbia, led by California’s loss of 116,000 jobs. Florida had the second-biggest drop with 49,500 workers dismissed, followed by 46,100 positions cut in Texas, 41,600 in Pennsylvania and 37,200 in Illinois.

Surpassing 10 percent unemployment has a psychological impact and may further curtail spending, said Doug Woodward, a University of South Carolina regional economist in Columbia.

“It’s creating more anxiety and more fear,” he said. “It’s feeding on itself.”

Job losses are spreading from manufacturers such as General Motors Corp., Caterpillar Inc. and International Business Machines Corp. to other firms like lumber producer Weyerhaeuser Co., media companies like the New York Times Co. and even the U.S. Postal Service. They are affecting all income brackets and professions.

Quarter Million

Fred Herrmann, 33, of Minneapolis, lost his job as a mortgage broker making $250,000 a year in December when his company folded. He said he’s applied for 25 finance and sales jobs, each making $14 to $18 an hour plus commission.

“There’s not a whole lot of high-paying jobs,” he said. “When you go from making a quarter of a million a year to 15 bucks an hour, that’s not good.”

On the lower end of the scale, Arthur Bolden, 61, is finding it harder than ever to get a job as a day laborer.

While he used to get $10 an hour, the prevailing wage now is $7 or $8 an hour, he said, as he waited for work outside of a Mecklenburg County, North Carolina, social services building. “People don’t even have money to pay for landscaping or to cut grass.”

The jobless rates in North Carolina, at 10.7 percent, and Rhode Island, at 10.5, were the highest for those states since records began in 1976. Georgia, at 9.3 percent, also set a new high mark.

To contact the reporter on this story: Bob Willis in Washington at bwillis@bloomberg.net

U.K. Recession Worse Than Estimated on Spending Slump

The U.K. economy’s contraction in the fourth quarter was deeper than previously estimated as consumer spending and construction slumped the most since 1980.

Gross domestic product fell 1.6 percent from the third quarter, exceeding the prior measurement of 1.5 percent, which was also the median forecast of 27 economists in a Bloomberg News survey. Construction dropped 4.9 percent and consumer spending declined 1 percent.

Bank of England Chief Economist Spencer Dale said today that the British economy’s short-term prospects are “bleak.” Spending in shops and on homes has plunged after banks rationed loans and the financial crisis wiped 1.9 trillion pounds ($2.7 trillion) off consumers’ wealth. The pound fell against the dollar after the report.

“The headline figure is very disappointing,” said Philip Shaw, chief economist at Investec Securities in London. “We see the economy shrinking until the middle of the year. It’s very difficult to see it gaining any momentum of recovery until the third quarter at the earliest.”

The pound dropped as much as 0.6 percent after the release of the data, which showed the worst contraction since 1980, when Margaret Thatcher was prime minister. The U.K. currency was at $1.4290 as of 5:56 p.m. in London.

Prime Minister Gordon Brown, whose popularity has faded as the recession deepened, said agreements the government signed with Royal Bank of Scotland Group Plc and Lloyds Banking Group Plc requiring the banks to boost lending will help the economy in the coming months.

‘Obligation to Lend’

“The banks are now under an obligation to lend 50 billion pounds,” Brown told journalists in Vina del Mar, Chile, as he finished a five-day diplomatic tour. “So the position we were in last year where the banking system had frozen, we now seeing results.”

From a year earlier, the economy shrank 2 percent in the fourth quarter, the statistics office said. That compares with the previous estimate of 1.9 percent, which matched the median forecast of 25 economists.

Officials revised their measurements of manufacturing in the quarter, saying it dropped 4.9 percent instead of 5.1 percent. Services fell 0.8 percent, compared with the previous estimate of 0.9 percent. The drop in construction was more than four times as much as the earlier measurement.

Government Spending

Government spending rose 1.3 percent, compared with the previous estimate of 1.5 percent. Fixed investment fell 1.4 percent instead of 2.3 percent as measured in the last release, the statistics office said.

U.K. retail sales posted the smallest annual gain in more than 13 years last month, the statistics office said yesterday. Sales plunged 1.9 percent from January, four times as much as economists forecast.

Next Plc, the U.K.’s second-largest clothing retailer, said yesterday full-year profit fell 15 percent as Britons cut spending at its stores and home-shopping catalog. Moss Bros Group Plc, the U.K.’s third-largest suit retailer, said yesterday it will cut capital spending by as much as 69 percent and is omitting its dividend as customers rein in spending.

Unemployment Jump

Unemployment rose at the fastest pace since 1971 in February as companies were forced to lay off staff. HSBC Holdings Plc, Europe’s biggest bank by market value, said on March 25 that about 1,200 U.K. employees may lose their jobs as it responds to a “challenging” environment.

Consumers still saved more money during the quarter. The household savings ratio rose to 4.8 percent, the most since the first three months of 2006, from 1.7 percent in the third quarter, the statistics office said.

The central bank has embarked on a program to spend as much as 150 billion pounds ($219 billion) to buy U.K. government debt, corporate bonds and other assets with newly created money in order to ease credit strains and encourage spending.

To contact the reporter on this story: Svenja O’Donnell in London at sodonnell@bloomberg.net.

Do Changes in Stock Prices Cause Recessions?

The economy and the stock market are closely related. Many people examine the stock market to find out how the economy is doing. It's long been known that if the stock market is in a period of decline, the economy is sure to follow. However there is little evidence that the stock market causes the economy to rise or fall. The stock market does not directly affect the economy. It is simply a mirror of people's generally correct beliefs about what is about to happen in the economy. The best way to understand this is to realize that a stock market index the Dow Jones Industrial Average (DJI) is simply a price. Because the value of index is a price, it only has two determinants: supply and demand.

Supply


Any first year college textbook in Economics states that for most goods if the supply increases in the short run then the price of the good should decline. For example, if the car companies suddenly doubled their supply of cars then we would expect the price of cars to fall.

If we thought that changes in the supply of stocks are the main cause of stock market rises and declines then, according to this rule, when a company issues new stock we would expect the price of stock to decline. If stock prices are largely determined by the supply of stocks and the market declines prior to an economic decline, we should see a flood of new stock issues before a recession. This does not happen in practice, as new stock issues tend to occur as the economy enters a growth period. This is because the money made from a stock issue is used to increase the output of the company, which causes economic growth to rise.

Demand


It appears that if we want to understand why the economy tends to move in the same direction as the stock market, we'll have to consider the demand for stocks. To do this, we'll need to understand what motivates an investors decision to buy or sell shares. Many investors such as Warren Buffett evaluate their stock portfolios on their inherent value. The inherent value is the total expected earnings of the company over a time period, discounted by the fact that a dollar today is not worth as much as a dollar tomorrow. If investors believe that a recession is coming, then they will believe that company earnings will be less in the future (since that typically takes place in a recession) which will decrease the inherent value of the stock. When the inherent value of the stock is far below its current price, investors will sell the stock, driving the price of the stock down. If investors believe a boom is coming, they will increase their estimates of the inherent value because future earnings should be higher than they previously expected. Often this will lead to the inherent value being far higher than the current price of the stock, so investors buy the stock. This leads the price of the stock to rise.

The belief that the stock market drives the economy is due to an error in logic. Generally we think that if A came before B that A caused B. Philosophers refer to this as the post hoc, propter hoc fallacy. In this case, the expectation of a decline in the economy causes the stock market to decline today. Or in logical terms, A came before B, because the expectation of B caused A. It's also important to realize that it's not the expectation of future economic changes that is causing changes in stock prices. It's the fact that people are acting on these expectations. If investors bought and sold stocks based on astrological factors or Barry Bonds' current homerun total then these would be causing the price of stocks to change. In a situation like that, it would seem that the stars are causing the price of stocks to change; the economy would have nothing to do with it.

It is because a large number of investors act on this inherent value principle that the economy tends to follow the stock market. Investors are constantly watching macroeconomic variables to try and determine when the next downturn in the economy will happen. Investors are often right when they predict the future growth rate of the economy. As a result, they often sell off their shares before the economy goes into a decline making it look like the stock market is causing a recession. In reality the causality runs the other way because the two things that causes price to change are changes in supply or changes in demand.

Does Wired's Page Count Predict NASDAQ Movements?

The thing I love the most about the internet (other than the fact it provides me with a steady income!) is that I get exposed to a bunch of interesting ideas and theories that I would otherwise not hear about. One such idea making it's way through the blogosphere is the relationship between the number of advertisements in Wired, a technology and society magazine, and the NASDAQ, an American market for high tech stocks. I first learned about this relationship from the blog Marginal Revolution, though the original idea seems to come from The Podcast Network. After correcting for a mistake in his statistics, the author found the following:

I received this months Wired yesterday. I sat down for a few moments to have a flick through, and noticed two things. Firstly, it has a nice swish glossy cover, and secondly, it's fat-just like the dot.com days.

That got me thinking. I wondered how Wired's page count might reflect the technology industry. So I plotted page count against the Nasdaq, and received this surprising result.

Other than a few missing magazines, I've got most of the collection since 1996. You'll note that the Nasdaq (red) tracks Wired's page count (blue). I'm not suggesting you go an buy technology shares, but gee, I'm thinking the reports of money pumping back into technology companies might just be true given the big up-tick in this months page count (294).

It's an interesting concept and would make for a terrific econometrics project for a student looking for ideas.

Any good economic study should begin with a theory and a question with a testable hypothesis. A common theory is that the demand for labor is downward sloping - thus a rise in wages should, all else being equal, cause a reduction in the quantity demanded for labor. The question we can then test based on that theory is, "Have past rises in the minimum wage caused the unemployment rate to rise?" We can collect the data then run a number of statistical tests to see what our data tells us about the answer.

In this case our theory would be that just before or during a boom in a particular sector we should a rise in advertisements for that sector's products. Our particular question is "Does a high tech boom cause more companies to advertise in Wired Magazine?"

We've got data (though it's on the number of pages in Wired, not on the number of ads), but of course, there could be many other possible explanations why the number of ads might rise. We should try to control for these as much as possible. The obvious one, as brought up on Marginal Revolution, is that companies are probably more likely to advertise in the months before Christmas. This is something any good study should control for, by seasonally adjusting the data.

Is there anything else we might want to adjust for? If we're just concerned with fluctuations of the number of pages (or ads) and the level of the NASDAQ, we may want to de-trend the data, as there might be a natural growth trend to both. Is there other trends we might want to account for, such as the rise in personal disposable income?

There are many different directions you can take such a study in. Many economics students often think their project has to be about "classic" economic issues such as interest rates and GDP growth (I know I did when I was a student!), but if you look around the web, you can find all sorts of interesting questions (with data) to investigate. This one in particular interests me, but if it's not your cup of tea, I'm sure you can find something more to your tastes.

What does the value of the Dow Jones represent?

If you read the newspaper, listen to the radio, or watch the nightly news on television, you'll probably hear about what happened to "the market" today. It's all fine and good that the Dow Jones finished up 35 points to close at 8738, but what does that mean?

The Dow Jones Industrial Average (DJI), commonly just referred to as "The Dow", is an average of the price of 30 stocks. The stocks represent 30 of the largest and most widely traded stocks in the United States. The Dow Jones Corporation, the administrators of the index, changes the stocks in the index from time to time. On November 22, 2002, the following 30 stocks were components of the index:

3M, Alcoa, American Express, AT&T, Boeing, Caterpillar, Citigroup, Coca-Cola, E.I. DuPont de Nemours, Eastman Kodak, Exxon Mobil, General Electric, General Motors, Hewlett-Packard, Home Depot, Honeywell, Intel, IBM, International Paper, J.P. Morgan Chase, Johnson & Johnson, McDonald's, Merck & Co., Microsoft, Philip Morris, Procter & Gamble, SBC Communications, United Technologies, Wal-Mart, and Walt Disney.

The Dow Jones Industrial Average is computed by taking the average price of the 30 stocks and dividing that figure by a number called the divisor. The divisor is there to take into account stock splits and mergers. Otherwise the index would decrease whenever a stock split took place. Suppose a stock on the index worth $100 splits is split or divided into two stocks each worth $50. If we did not take into account that there are twice as many shares in that company as before the DJI would be $50 lower than before the stock split because one share is now worth $50 instead of $100.

The divisor is determined by weights placed on all the stocks (due to these mergers and acquisitions) and changes quite often; at November 22, 2002 the divisor was equal to 0.14585278. So if you took the average cost of each of these stocks on November 22 and divided this number by 0.14585278, you'd get the closing value of the DJI on that date which was 8804.84. You can also use this divisor to see how an individual stock influences the average. If the price of International Paper increases by two points, the DJI would increase by 13.7 points assuming none of the other stock values changed (13.7 = 2 / 0.14585278). Because of the formula used by the Dow a one point increase or decrease by any stock will have the same affect, which is not the case for all indices.

So the Dow Jones number you hear in the news each night is simply this weighted average of stock prices. Because of this, the Dow Jones Industrial Average should just be considered a price in itself. So when you hear that the Dow Jones went up 35 points, it just means that to buy these stocks (taking into account the divisor) at 4:00pm today (the closing time of the market) it would have cost 35 more dollars than it would have cost to buy the stocks the day before at the same time. That's all there is to it.

Why Don't Prices Decline During A Recession?

[Q:]When there is an economic expansion, demand seems to outpace supply, particularly for goods and services that take time and major capital to increase supply. As a result, prices generally rise (or there is at least price pressure) and particularly for goods and services that cannot rapidly meet the increased demand such as housing in urban centers (relatively fixed supply), advanced education (takes time to expand/build new schools), but not cars because automotive plants can gear up pretty quickly.

First, do you agree with this and if not, how do you see it?

Second, when there is an economic contraction, supply initially outpaces demand. However prices for most goods and services don't go down, and neither do wages.

My main question is why don't prices go down for goods and services? I expect for wages, it's just stickiness from the corporate/human culture... people don't like to give pay cuts... managers tend to lay off before they give pay cuts (though I've seen exceptions). Why don't prices go down for most goods and services?

[A:] Great question! Your analysis is spot on. Now on to your question:

In my article titled Why Does Money Have Value we saw that changes in the level of prices (inflation) was due to a combination of the following four factors:

1. The supply of money goes up.


2. The supply of goods goes down.


3. Demand for money goes down.


4. Demand for goods goes up.

In a boom, we would expect that the demand for goods to rise faster than the supply. All else being equal, we would expect factor 4 to outweigh factor 2 and the level of prices to rise. Since deflation is the opposite of inflation, deflation is due to a combination of the following four factors:

1. The supply of money goes down.


2. The supply of goods goes up.


3. Demand for money goes up.


4. Demand for goods goes down.

We would expect the demand for goods to decline faster than the supply, so factor 4 should outweigh factor 2, so all else being equal we should expect the level of prices to fall.

From my article titled A Beginner's Guide to Economic Indicators we saw that measures of inflation such as the Implicit Price Deflator for GDP are procyclical coincident economics indicators, so the inflation rate is high during booms and low during recessions. The information above shows that the inflation rate should be higher in booms than in busts, but why is the inflation rate still positive in recessions?

The answer is that all else is not equal. The money supply is constantly expanding, so the economy has a consistent inflationary pressure given by factor 1. The Federal Reserve has a table listing the M1, M2, and M3 money supply. (To learn about these definitions, see How much is the per capita money supply in the U.S.?). From Recession? Depression? we saw that during the worst recession America has experienced since World War II, from November 1973 to March 1975, real GDP fell by 4.9 percent. This would have caused deflation, except that the money supply rose rapidly during this period, with the seasonally adjusted M2 rising 16.5% and the seasonally adjusted M3 rising 24.4%. Data from Economagic shows that the Consumer Price Index rose 14.68% during this severe recession. A recessionary period with a high inflation rate is known as stagflation, a concept made famous by Milton Friedman. While inflation rates are generally lower during recessions, we can still experience high levels of inflation through the growth of the money supply.

So the key point here is that while the inflation rate rises during a boom and falls during a recession, it generally does not go below zero due to a consistently increasing money supply.

Why Do Government Budget Deficits Grow During Recessions?

There is a relationship between budget deficits and the health of the economy, but is certainly not a perfect one. There can be massive budget deficits when the economy is doing quite well - the past few years of the United States being a prime example.

That being said, government budgets tend to go from surplus to deficit (or existing deficits become larger) as the economy goes sour. This typically happens as follows:

1. The economy goes into recession, costing many workers their jobs, and at the same time causing corporate profits to decline. This causes less income tax revenue to flow to the government, along with less corporate income tax revenue. Occasionally the flow of income to the government will still grow, but at a slower rate than inflation, meaning that flow of tax revenue has fallen in real terms.

2. Because many workers have lost their jobs, their is increased use of government programs, such as unemployment insurance. Government spending rises as more individuals are calling on government services to help them out through tough times.

3. To help push the economy out of recession and to help those who have lost their jobs, governments often create new social programs during times of recession and depression. FDR's "New Deal" of the 1930s is a prime example of this. Government spending then rises, not just because of increased use of existing programs, but through the creation of new programs.

Because of factors one, the government receives less money from taxpayers, while factors two and three, the government spends more money. Money starts flowing out of the government faster than it comes in, causing the government's budget to go into deficit.

Do Changes in Stock Prices Cause Recessions?

The economy and the stock market are closely related. Many people examine the stock market to find out how the economy is doing. It's long been known that if the stock market is in a period of decline, the economy is sure to follow. However there is little evidence that the stock market causes the economy to rise or fall. The stock market does not directly affect the economy. It is simply a mirror of people's generally correct beliefs about what is about to happen in the economy. The best way to understand this is to realize that a stock market index the Dow Jones Industrial Average (DJI) is simply a price. Because the value of index is a price, it only has two determinants: supply and demand.

Supply


Any first year college textbook in Economics states that for most goods if the supply increases in the short run then the price of the good should decline. For example, if the car companies suddenly doubled their supply of cars then we would expect the price of cars to fall.

If we thought that changes in the supply of stocks are the main cause of stock market rises and declines then, according to this rule, when a company issues new stock we would expect the price of stock to decline. If stock prices are largely determined by the supply of stocks and the market declines prior to an economic decline, we should see a flood of new stock issues before a recession. This does not happen in practice, as new stock issues tend to occur as the economy enters a growth period. This is because the money made from a stock issue is used to increase the output of the company, which causes economic growth to rise.

Demand


It appears that if we want to understand why the economy tends to move in the same direction as the stock market, we'll have to consider the demand for stocks. To do this, we'll need to understand what motivates an investors decision to buy or sell shares. Many investors such as Warren Buffett evaluate their stock portfolios on their inherent value. The inherent value is the total expected earnings of the company over a time period, discounted by the fact that a dollar today is not worth as much as a dollar tomorrow. If investors believe that a recession is coming, then they will believe that company earnings will be less in the future (since that typically takes place in a recession) which will decrease the inherent value of the stock. When the inherent value of the stock is far below its current price, investors will sell the stock, driving the price of the stock down. If investors believe a boom is coming, they will increase their estimates of the inherent value because future earnings should be higher than they previously expected. Often this will lead to the inherent value being far higher than the current price of the stock, so investors buy the stock. This leads the price of the stock to rise.

The belief that the stock market drives the economy is due to an error in logic. Generally we think that if A came before B that A caused B. Philosophers refer to this as the post hoc, propter hoc fallacy. In this case, the expectation of a decline in the economy causes the stock market to decline today. Or in logical terms, A came before B, because the expectation of B caused A. It's also important to realize that it's not the expectation of future economic changes that is causing changes in stock prices. It's the fact that people are acting on these expectations. If investors bought and sold stocks based on astrological factors or Barry Bonds' current homerun total then these would be causing the price of stocks to change. In a situation like that, it would seem that the stars are causing the price of stocks to change; the economy would have nothing to do with it.

It is because a large number of investors act on this inherent value principle that the economy tends to follow the stock market. Investors are constantly watching macroeconomic variables to try and determine when the next downturn in the economy will happen. Investors are often right when they predict the future growth rate of the economy. As a result, they often sell off their shares before the economy goes into a decline making it look like the stock market is causing a recession. In reality the causality runs the other way because the t

Recession? Depression? What's the difference?

The difference between the two terms is not very well understood for one simple reason: There is not a universally agreed upon definition. If you ask 100 different economists to define the terms recession and depression, you would get at least 100 different answers. I will try to summarize both terms and explain the differences between them in a way that almost all economists could agree with.

Recession: The Newspaper Definition


The standard newspaper definition of a recession is a decline in the Gross Domestic Product (GDP) for two or more consecutive quarters.

This definition is unpopular with most economists for two main reasons. First, this definition does not take into consideration changes in other variables. For example this definition ignores any changes in the unemployment rate or consumer confidence. Second, by using quarterly data this definition makes it difficult to pinpoint when a recession begins or ends. This means that a recession that lasts ten months or less may go undetected.

Recession: The BCDC Definition


The Business Cycle Dating Committee at the National Bureau of Economic Research (NBER) provides a better way to find out if there is a recession is taking place. This committee determines the amount of business activity in the economy by looking at things like employment, industrial production, real income and wholesale-retail sales. They define a recession as the time when business activity has reached its peak and starts to fall until the time when business activity bottoms out. When the business activity starts to rise again it is called an expansionary period. By this definition, the average recession lasts about a year.

Depression


Before the Great Depression of the 1930s any downturn in economic activity was referred to as a depression. The term recession was developed in this period to differentiate periods like the 1930s from smaller economic declines that occurred in 1910 and 1913. This leads to the simple definition of a depression as a recession that lasts longer and has a larger decline in business activity.

The Difference


So how can we tell the difference between a recession and a depression? A good rule of thumb for determining the difference between a recession and a depression is to look at the changes in GNP. A depression is any economic downturn where real GDP declines by more than 10 percent. A recession is an economic downturn that is less severe.

By this yardstick, the last depression in the United States was from May 1937 to June 1938, where real GDP declined by 18.2 percent. If we use this method then the Great Depression of the 1930s can be seen as two separate events: an incredibly severe depression lasting from August 1929 to March 1933 where real GDP declined by almost 33 percent, a period of recovery, then another less severe depression of 1937-38. The United States hasn't had anything even close to a depression in the post-war period. The worst recession in the last 60 years was from November 1973 to March 1975, where real GDP fell by 4.9 percent. Countries such as Finland and Indonesia have suffered depressions in recent memory using this definition.

Now you should be able to determine the difference between a recession and a depression without resorting to the poor humor of the dismal scientists.