Credit Spread Model Predicts Massive Job Losses

I find a lot of interesting ideas in the Wall Street Journal's "Heard on the Street" column, which is published daily on the back of the Money & Investing section. Today's lead article, Giving Corporate Credit Its Due, describes an economic model from a forthcoming research article by Simon Gilchrist, Vladimir Yankov, and Egon Zakrajsek. The model uses corporate credit spreads to forecast job market activity. Take a look at the chart, below, which compares nationwide hiring activity with the results of the authors' model.

The shaded green line shows the year-over-year percentage change in nonfarm payrolls. The blue line shows the corresponding prediction from the authors' model. Evidently, the model fits the historical data rather well.

There's a big difference between explaining the past and predicting the future. In other words, there's no guarantee that the model's predictions will be accurate. So much for the disclaimers. The current prediction is bleak. It calls for nonfarm payrolls to fall by 7.5% during calendar year 2009. Even if you assume that some of those job losses have already turned up in the official statistics, that would still take the unemployment rate well into double digits by the end of the year.

Reflecting on one of my earlier blog postings about jobs and home prices, this new model suggests that home prices will remain soft at least through the end of the year.

(By the way, a 'credit spread' is the difference between two interest rates, i.e., the rate that a corporate borrower pays and the rate that the government pays. Government debt is assumed to be free of default risk, while corporate debt exposes the holder to the possibility of not being repaid. The difference between the two interest rates encapsulates the bond market's estimation of the likelihood that the corporate borrower will default.)

Benchmarking the Financial Crisis - Part 2

In December of last year, Carmen Reinhart and Kenneth Rogoff published an article comparing the current financial crisis to historical financial crises from around the world. I summarized their findings in a previous blog entry. Yesterday, Barry Eichengreen and Kevin O'Rourke published a similar article comparing the current crisis to the Great Depression. Such comparisons have become commonplace. They've generally found that the current crisis has been mild compared to the Great Depression...in the United States. Eichengreen and O'Rourke depart from the usual analysis by comparing the two crises at a global level. Their findings are sobering.

Using the peak in global industrial production (i.e., April 2008) as a starting point, Eichengreen and O'Rourke found that:

• Global industrial production has fallen by over 10%. Thus far, it has more or less followed the same trajectory as in the Great Depression.
• Global stock prices have fallen by 50%. In contrast, stock prices had fallen by only about 10% in the first twelve months following the 1929 peak in industrial production.
• Global trade has fallen by over 15%. Again, the rate of contraction is much greater than in the first twelve months of the Great Depression, when trade fell by only about 5%.

The authors point out that global policy responses have thus far been much more aggressive (and appropriate) than in the Great Depression. Evidently policy makers have learned from past mistakes. Let's hope that we get better results than the last time.