Our good friends at the National Bureau of Economic Research have made it official; the U. S. economy has been in recession since December 2007. For what it’s worth, the US.RECESSION.08 contract is up 5.5 points on this news, with the last trade occurring at 97.4. The contract rules define recession as constituting two consecutive quarters of negative GDP growth, and since this information has yet to be officially released by the government, it is still an actively traded contract.

Since we are nearly 1 year into this recession, this already qualifies as one of the longer recessions since the Great Depression. Apparently the longest one since then occurred 1973-1975 and lasted around 15 months. At this point, it would appear highly likely that we’ll be setting a new record with this recession. The “good” news is that the Intrade US.DEPRESSION.09 contract (which defines depression as a cumulative decline in GDP of more than 10.0% over four consecutive quarters) last traded at 13.6, which represents a 1.3 point drop on the day.

I highly recommend Mark Perry’s blog posting entitled “A Cancer on the Big Three: The $29/Hr. Pay Gap“. This gap is graphically illustrated in the figure posted on Mark’s Perry’s weblog, which I reproduce here:

Michael Levine, who is a former airline executive and currently holds a position as distinguished research scholar and senior lecturer at NYU School of Law, has written a very compelling essay in today’s Wall Street Journal entitled “Why Bankruptcy Is the Best Option for GM”. Last week, I wrote a blog entry entitled “Bailout Blues” in which I noted, among other things, that “…it would make sense to let these firms go through bankruptcy, which would enable them to abrogate and renegotiate existing contracts, sell off or liquidate parts of their businesses that don’t make any sense, and reorganize so that they can come out of bankruptcy with sustainable business models. All that a bailout does now is to encourage the continuation of a broken business model…”. Mr. Levine picks up where I leave off, making a very cogent argument that not only is a Chapter 11 bankruptcy an option, in fact it represents by far and away GM’s best chance at once again becoming a viable business entity.

Lately, we have been discussing in my classes that a necessary, although not sufficient policy question concerning bailout economics is whether the bankruptcy of a given firm creates a systemic risk with effects which go well beyond the direct stakeholders (e.g., shareholders, creditors, employees, suppliers, customers) of the firm in question. Based upon this criterion, I think that a logically coherent case can be made for infusing capital into commercial banks as part of a risk management strategy designed to prevent a financial contagion which could take down the entire economy.

However, when we look at GM, Ford, Chrysler, etc., it isn’t clear to me that these firms pose a substantial systemic risk. In the case of the U.S. auto industry, I think that it would make sense to let these firms go through bankruptcy, which would enable them to abrogate and renegotiate existing contracts, sell off or liquidate parts of their businesses that don’t make any sense, and reorganize so that they can come out of bankruptcy with sustainable business models. All that a bailout does now is to encourage the continuation of a broken business model, including things like the UAW job banks which comprise workers who get UAW negotiated compensation in exchange for not producing any automobiles. I take this as prima facie evidence that there is way too much overcapacity in the US auto business as it is currently structured.

In the Business section of yesterday’s New York Times, there was an excellent article entitled “In Modeling Risk, the Human Factor Was Left Out”. Among other things, this article points out the dangers of people treating financial models like black boxes and not fully grasping model limitations. The article’s main premise is not that the models are wrong or culpable as far as the financial crisis concerned. Rather, the problem boils down more to fundamental failures in human judgment.

So asks George Mason University Professor Tyler Cowen. Professor Cowen also warns against “huff-and-puff polemic discussion” by policymakers which does not properly take into account the dynamics associated with recalibrating the price of risk. Unfortunately, huff-and-puff is probably the best that we can hope for out of Congress during the coming week.

Last week, I attended the Conference on Financial Innovation at Vanderbilt University. The purpose of this meeting was to commemorate the 35th anniversary of the publication of two of the most important and influential articles in finance: one by Fischer Black and Myron Scholes, and the other by Robert Merton, both on the theory of option pricing. Scholes and Merton were awarded the Nobel Prize in Economics in 1997 for these and other related research contributions (Fischer Black probably would have been so named had he been alive in 1997 but he passed away in 1995 and the Nobel is not posthumously awarded). Since the conference was given in the honor of Scholes and Merton, quite appropriately both men were present at this meeting.

Options are commonly referred to as “derivative” securities because their values derive from the values of other assets. For example, the Chicago Board Options Exchange (CBOE; coincidentally founded in the same year as these papers were published) makes a market in exchange-traded call and put options on individual stocks as well as on various equity market indices; e.g., S&P 500, DJIA, NASDAQ, etc. Before Black-Scholes and Merton, an important unresolved question in finance concerned how to price and manage risk, and Black-Scholes-Merton provides a remarkably robust framework within which to do just that.

Besides spawning substantial literatures concerning options theory and applications, these papers were also seminal in the sense that they also helped spawn a number of important financial market innovations. The conference sessions featured papers that either build upon or apply the Black-Scholes-Merton framework to the following set of “real world” topics: volatility markets (e.g., VIX), real estate markets, credit markets, index option markets, real options (which involves the application of options theory to corporate decision-making (e.g., the “optionality” of investing or divesting in a capital asset), and valuing managerial compensation contracts.

There was also a panel discussion that featured Merton, Scholes, and Leo Melamed. Not surprisingly, the panel discussion addressed the financial crisis in some depth. Merton picked up on the idea (originally floated by MIT’s Andrew Lo) of creating a “financial NTSB” for the purpose of having experts do some serious analysis of the financial crisis. The problem with political exercises such as the ones that are slated for this coming week is that Congressional hearings held on the eve of a general election are not likely to provide appropriate forums for serious analysis; rather, they are designed primarily to fulfill various political objectives. There is an historical precedent for a financial NTSB; in the aftermath of the 1987 crash, a presidential commission called the Brady Commission (named after Treasury Secretary Nicholas Brady) was formed for the purpose of studying the causes of the 1987 crash and recommending various market reforms which were designed to help restore investor confidence (although in retrospect, a strong subsequent performance by the economy may have been more important than the Brady commission reforms in terms of accomplishing this objective). All three panel members expressed concern about the risk of unintended consequences which may stem from a failure to fully grasp the nature and scope of the crisis. Merton commented that now more than ever, we need more innovation, not less. However, in the rush to “do something” about the problem, a substantial re-regulation of the financial sector could very well undermine incentives for innovation, which in turn could have the unintended consequence of impeding the resiliency and vitality of the financial sector going forward (thereby rendering it all the more vulnerable to future crises).