Thursday, August 27, 2015

A third scenario for stock markets

Robert Shiller on the New York Times argues that the stock market is expensive by historical standards using the cyclically-adjusted price earnings ratio (CAPE) that he has made popular through his writings since the late 1990s.

There is no doubt that the CAPE ratio for the US stock market is high by historical standards. Using Shiller's estimates it stands around 26 today, clearly above the historical average of about 17. What a higher CAPE means is that you are paying more for the same earnings. Earnings' growth could, of course, be different in the future. They might be lower because potential GDP growth is slowing down but they might be higher as profits as a share of GDP increases. If we assume the same number just for simplicity, a higher CAPE means that investors should expect a lower return if they buy the stock market today compared to an average year in the past.

What does it mean for the future price of the stock market? Shiller concludes that maybe we will see the stock market returning to historical averages (which implies a massive fall in the current values) or maybe we see what we saw in the late 90s where the market continues going up and reaching a CAPE of over 40 before crashing. As Shiller puts it we "just don't know".

But what about a third option? The market remains at a level around 25, as it is today and this implies that returns will be lower than historical averages. Is this possible and consistent with investors' expectations? Yes, under two assumptions. One is that returns in all other assets are also lower than historical averages. This is certainly the case today where interest rates on bonds are at very low historical levels and it is difficult to foresee a large increase in the coming years. The other justification for high CAPE ratios is that the risk aversion of investors has gone down relative to previous decades. While talking about low risk perception this week might not sound right, the reality is that the years while the stock market had CAPE ratios of around 17 where also the years where academics wondered about why risk aversion was so high among investors (what we called the equity risk premium).

How much do we need those numbers to change to justify higher-than-normal CAPE ratios? A quick calculation using current bond interest rates would tell us that the stock market at a 25 CAPE ratio offers a risk premium over bonds that is similar to what the stock market offered when the CAPE ratio was 17 (around 6-7%). In that sense, the stock market is not expensive, it is prices in a way that is consistent with historical levels. If you want to make the stock market cheap you just need to argue that risk premium should be lower than that. If you want to make the stock market very expensive you need to argue that interest rates on bonds will soon go back to historical levels. In that scenario the US stock market should go down by about 30-40% relative to current levels.

Predicting which scenario will be realized is not easy, as Shiller argues. But I wished that he would have considered as well the third possible scenario where current CAPE levels are fine and investors should get used to lower-than-historical returns but returns that are consistent with what is going on in other asset classes. Maybe we put too much emphasis on the bouncing back and crashing scenarios when we talk about stock prices and we forget a much more boring but as plausible one that delivers a less volatile stock market.

Antonio Fatás

Monday, July 13, 2015

Micromanagement of European reforms

The agreement between Greece and its Euro partners is full of very detailed policies to be approved by the Greek government in the coming week. How did we end up in a situation where the domestic policies of a Euro country are decided by other countries? I recently wrote a paper on the European reform agenda where I had a discussion on the role of Europe in the reform process. Here are some of what I wrote in the paper which is very appropriate for what we just witnessed over the last 24 hours.

Historically Europe has served as a catalyst for reform in some of the least-advanced EU economies. Through the imposition of requirements to join certain European initiatives it has fostered enough social consensus around the need for compromises. As an example, it worked well to transform and standardize the macroeconomic institutions of European countries, especially when it comes to monetary policy and inflation.

But these dynamics are not always productive. Reform is ultimately a domestic political business where trade offs are being made between economic efficiency, social goals and the way power and income are distributed in a society. Having Europe always as the reason why reforms need to happen is likely to generate unhealthy dynamics. In addition, it is not always easy to link reforms to the benefits of European integration.

The only way to change these dynamics would be through a much more contractual and ex-ante approach to reforms. This was partly the spirit of regulations of the Maastricht Treaty that established rules of behavior to be a member of the Euro. But, as experience has shown, those were not enforceable rules. The rules only worked well as an entry condition but once the entry decisions were made the rules became very weak. Rules have been renegotiated, changed, and violated on numerous occasions. Why not make the entry conditions more binding? The reality is that if countries were asked to reform or adopt irreversible commitments before joining any process of European integration, there would be very few members of the European Union or the Euro area left.

We need to be realistic as well and Europe needs to find a way to deal with countries and governments that do not want to go along with the reform process or that they are unable to do so. At the end of the day the speed of reform remains the decision of individual countries. Its citizens are the ones that will suffer the consequences of no reforms and low growth. This is true for any country, advanced or emerging, and this is true for Europe.

The reason why the reform debate becomes more visible and relevant in the European context relative to other advanced economies that struggle with similar issues of performance is that the process of European integration might occasionally force countries to move together. When you share risk via the balance sheet of a central bank or when you design a program of transfers from rich to poor regions, the reform agenda becomes a supranational issue not anymore a pure national debate. Maybe Europe needs to find ways to separate the two. Either through a much more contractual approach to institutions that leaves no room for further negotiation (e.g. a true no bailout clause) or by changing the design of those institutions so that the links between countries and the shared risks are minimized ("less Europe"). This might be suboptimal as it might come at a cost of reducing the effectiveness of those institutions but it might be the only way to make the process of European integration and economic reforms compatible.

In summary, maybe "more Europe" is not always the solution to all the European economic problems.

Antonio Fatás

Friday, July 3, 2015

Did the IMF provide support to Syriza?

The IMF published yesterday a preliminary analysis on the debt sustainability of the Greek government. The timing of the publication, a couple of days ahead of the referendum, has triggered a variety of interpretations of the conclusions. The Greek government has quickly jumped to argue that the results confirm that government debt in Greece is not sustainable and a substantial haircut is needed.

Is the interpretation of the Greek government correct? Yes and no. The IMF analysis suggests that under reasonable assumptions on growth and interest rates for Greece, it is very difficult to imagine a path of primary budget surpluses that makes the current situation sustainable. This is what the Greek government says and in that sense it seems that the IMF is providing empirical support to their claims. However, the analysis is full of other subtleties that do not warrant this quick conclusion and that in some cases contradict the views of the Greek government.

First, the report makes it clear that since Syriza came to power the situation has deteriorated because of a combination of lower growth, lower privatization revenues and a worsening of budget balances. So here the IMF seems to support the German (and others) view that the situation would be better if the right policies were applied. The need for haircuts is partly the responsibility of the current Greek government.

Second, there is nothing new in the IMF analysis and almost everyone agrees to it, including the other Euro partners. The real issue and where there is possibly some disagreement is on how to deal with an unsustainable level of debt. Here is where the subtleties start.

Let's go back in history first. In 2012 it was also clear to most that Greek debt was on an unsustainable path. Because of this the Euro partners and bond holders agreed to a haircut on the face value, an extension of maturities as well as a reduction in interest rate that implicitly reduced the value of the Greek liabilities. How much that reduced debt is debatable but it is likely that it reduced it by about €100 Billion.

But that first restructuring was clearly not enough. What went wrong? Growth never returned, in fact, the economy continued on its path of collapsing changing all the assumptions made by the Troika at the time of the negotiation. Why did growth fail to live up to the assumptions? Because the Troika underestimated the effects of fiscal austerity (in Greece but also anywhere else) and possibly because some of the projected reforms in Greece either did not take place an they did not pay off as much and as fast as planned.

What about going forward? Can we be more realistic regarding Greek prospects of growth? That's what they IMF is doing now. It forecasts growth in Greece to be input 1.5% in the long term. This is what I would say a very pessimistic number (even if it might still be realistic). It assumes that a country that has a GDP per capita of less than 50% of the most advanced economies in the world will fail to converge to that level, in fact it is likely to get stuck at that level or even diverge.

And here is where the Greek government and the IMF projections might be at odds. The Greek government argument is that once debt is reduced and all the reforms are implemented, the Greek economy will take off and start finally growing. But if growth returns, is debt really unsustainable Greek debt is unsustainable because the Greek economy will not grow in the long run (and this is not just about austerity). But if the Greek government is right and the reduction in debt does indeed raise the potential growth of Greece then the current debt level might be closer to being sustainable than what the IMF says. In other words, the IMF tells the Greek government something that they want to hear (debt needs to be reduced) but in an scenario that the Greek government cannot accept (growth is going to be dismal for decades).

The way out of this inconsistency is to make default a function of GDP growth rates. This goes back to the old idea of indexing the value of the debt (or the interest rate) to economic growth (here is a very good description of its virtues from Paolo Mauro). If the Greek government is right and Greece growth prospects are very good, the debtors will get back most of what they are owed. But if the IMF is right and growth in Greece will remain low over the coming decades, the debtors will get a lot less, whatever the low growth prospects allow for.

Antonio Fatás

Thursday, June 25, 2015

Greece: negotiating without trust

The Eurozone and Greece are going through the last hours of a negotiation to ensure release of additional funds from the previous agreement and possibly setting the basis for the next one.

The leaked details of the latest Greek proposal and the Eurozone counterproposal is full of details and discussions around technical issues (for example, whether the pension reform is effective from October 31 or July 1st). But what the technical discussions reveal is a negotiation that can only lead to an outcome that will not satisfy any of the parties.

Reading between the lines of the technical details we see the Eurozone asking Greece for a strong package of front loaded fiscal measures many of which are exactly the ones the Greek government wanted to avoid as they go against the electoral platform under which they were elected.

It would be very easy to criticize Germany, Brussels (and the IMF) for failing to see that we are possibly doing again the same mistakes as in previous agreements and that this one is also bound to fail. But the reality is that it is very difficult to imagine any other type of agreement give the lack of trust between the two parties.

Many argue that this government should not be asked to pay for the mistakes of previous governments. After all Syriza was not in power when the Greek government and the Greek economy were running very large deficits. This is correct but it is also true that Syriza was not elected on a platform of economic reform, even if some of the economic reforms being discussed are not contrary to their ideas.

I am very sympathetic to the logic that the Greek finance minister Varoufakis has very well expressed that Greece needs growth first and that insisting on fiscal austerity will not deliver the necessary growth. But I also understand the view of the Eurozone when negotiating with a Greek government that was elected on a platform that is not clear that will deliver sustainable growth. Because of the lack of trust, what the Eurozone is looking for in this negotiation is a strong early commitment that the Greek government is willing to take steps that might go against its own electoral platform. In an ideal world those steps would all be about making growth happen: reforms in an environment where demand is not a constraint for growth. But many reforms cannot be implemented in the short run so the only way to get a signal of commitment is to put on a table a set of fiscal measures to improve primary balances, what the Greek government wanted to avoid.

So we are back to a proposal that looks too much like the previous ones and it is very likely that, even if there is an agreement over the coming hours or days, we will witness again in the near future yet another negotiation between Greece and the Eurozone once it is clear that the current plan will not work.

This is the unfortunate outcome of a negotiation that started without trust between the two parties and where the only possible outcomes where both suboptimal: either another unrealistic agreement or a break up of the negotiations that leads to a Greek default and possibly exit from the Euro area. In the next days we will see which of the two (bad) scenarios turns into reality.

Antonio Fatás

Monday, June 8, 2015

Interest rates: natural or artificial?

The debate about who is responsible for the low level of interest rates that has prevailed in most economies over the last years heated up when Ben Bernanke wrote a series of blog posts on what determines interest rates. He argued, once again, that it is the global dynamics of saving and investment the one that created a downward trend in interest rates starting in the mid 90s and that it accelerated as a result of the crisis. In his story, central banks are simply reacting to economic conditions rather than driving the interest rate (always refreshing to see a former central banker explaining how powerless central banks are). What Bernanke described can be interpreted as a decrease in what economists called the natural real interest rate.

There are, however, those who have a very different interpretation of the persistent low levels of interest rates. They see central banks as the main drivers of this trend and they think about current levels of interest rates as being artificially low and forced on us by central banks. The popular press is full of references to artificially low interest rates causing bubbles, imbalances, hurting savers and being the seed of the future crisis (about 1 million results if you do a Google search).

From the academic world, John Taylor has been very vocal about the negative effects of artificially low interest rates. He stresses the fact that interest rates have been below what a Taylor rule indicates, a sign that there is a mispricing created by central banks. In a recent blog post he refers to the the results of a paper by Fitwi, Hein and Mercer that tests whether Bernanke or Taylor are right when it comes to explaining interest rates. The paper shows that both theories are possibly right. That low interest rates are the result of both a saving glut (Bernanke's explanation) and central banks pushing rates below the Taylor rule level. I find the evidence that the paper presents very weak but my main issue is much more on the interpretation of the hypothesis of artificially low interest rates.

The first question is how can central banks be seen as so powerful as to control and distort a market price for such a long period of time? Typically, the models where central banks are powerful enough to do this are those with nominal rigidities in prices and wages. But these rigidities are assumed to be temporary as prices and contracts adjust. How can it be that central bank have managed to affect a real price (the real interest rate) for more than a decade? I cannot think of an accepted model that would support this. What is more paradoxical is that those who tend to support this view are in some cases those who are critical of models with price rigidities. So on hand they dislike models where central banks are powerful and on the other hand they argue that central banks have been super powerful over the last 10 or 15 years. This is very inconsistent.

The second question is how can it be that such a low level of artificially low interest rates has not had any effect on inflation. The original interpretation of the Taylor rule was always about the level of interest rates that was consistent with a stable inflation rate. How can we explain a deviation from the Taylor rule that lasts for many years and that instead of causing an increase in inflation it is producing a low level of inflation everywhere where interest rates are low? Once again, not sure what model can explain this.

Finally, the view of those who talk about artificially low interest rates tends to be driven by an analysis of the US economy in isolation. Interest rates are low at a global level, they are at low record levels everywhere in the world. What type of coordination exists between all central banks in the world to keep artificially low interest rates everywhere without generating inflation anywhere? The paper by Fitwi, Hein and Mercer tries to look into this issue by analyzing capital inflows to the US and its potential influence in interest rates (as a test of the Bernanke hypothesis) but this is not a good test. If you take the world, there are no capital inflows from other planets but a shift towards higher saving will still cause lower interest rates. 

In summary, there are two very simple facts that provide strong support to the Bernanke hypothesis on why interest rates are (naturally) low:

1. Interest rates are low everywhere in the world.
2. Inflation remains low everywhere in the world.

These two facts are very difficult to square with a world where the US federal reserve is keeping interest rates artificially low for many years. 

Antonio Fatás

Sunday, May 3, 2015

The Greek Dra(ch)ma is back?

One more round of negotiations between Greece and the rest of is European partners to seek a last-minute solution before the Greek government runs out of money. Negotiations could end up going in any direction. Greece is unlikely to score a massive win but it could buy itself some time if there is agreement around a reasonable set of reforms that are to be implemented over the coming months. Reforms that could be sold domestically very differently from the way they are presented in Brussels.

What Greece really wants out of these negotiations is straightforward: a restructuring/reduction of its current debt that allows them to survive over the coming years with a primary balance in (small) surplus. This would mean that their pressure is gone and and that they can implement any policies they want without worrying about new loans as long as they can keep a primary surplus, which might be feasible given the current state of the budget. In return it will be easy to promise reforms that can have enough support at home (removing bureaucratic barriers, broadening the tax base, improve government efficiency). Of course, when it come to the actual implementation of those reforms, the support could turn into strong opposition. Greece also does not want to leave the Euro. Support among Greek voters is very high and the government understands the uncertainty and likely downside risk that they would face if Greece has exit the Euro area.

What the European partners want is much less clear. They would love to get paid back on all the current Greek government debt that they hold but that's unlikely to happen. Some would love to see Greece outside of the Euro area so that they do not have to deal with this again. There is a sense that whatever agreement is found now will not be the last one. The lack of trust has reached levels that has made it clear to some that Grexit is the best long-term outcome. But they are afraid of the consequences, both in the short run and in the long run in terms of credibility of the membership that would be left after Greece was gone. What no one wants is an agreement that does not offer a permanent solution to the problem. But is this possible? You need a credible commitment from Greece on implementing reforms in a way that can guarantee a large enough primary balance so that the possibility of future crisis goes down significantly. But credible commitment on reforms is not feasible. Reforms take time to be designed and implemented and there is enough uncertainty about growth and interest rates to ensure that a future crisis can be ruled out.

The intersection between what the Greek government wants and what the European partners want is an empty set today (once we remove all the unfeasible solutions). And that's why a risk of collapse in the negotiations is real. The only thing that can stop the collapse is the willingness by Germany (and the others) to compromise out of the fear that a default by Greece and the possibility of an exit from the Euro area can generate a crisis of unknown consequences. No doubt that this fear has decreased over the last years as markets are happy with low rates on Spanish, Italian debt while these negotiations are going on. But maybe they are happy because they assume a last-minute compromise will be reached (a good prediction given what we have seen in the past) or maybe because they believe the ECB could protect the other periphery countries from contagion with yet another 'whatever it takes' statement.

But the power of the ECB to contain a potential exit from from Euro is not infinite. It will depend on how the exit is played. Maybe they can contain some of the economic risk but what about the political risk?  With coming elections in key EU countries (UK, Spain) with interesting political dynamics when it comes to EU membership or policies, the range of political outcomes remains very wide to feel comfortable about an exit from the Euro area.

Antonio Fatás

Monday, March 2, 2015

Missing the anti-inflation central bankers.

In two recent posts, Martin Feldstein and Andrew Sentance (former member of the Bank of England monetary policy committee) criticize the recent actions of central banks to bring inflation back to its 2% target.

Andrew Sentance clearly misses the central bankers of the 1980s, the fighters against high inflation. He has an interesting definition of a central banker job:

"The job of a central banker is to make unpopular decisions when politicians will not. We saw that in the 1970s and 1980s from the Bundesbank and the US Federal Reserve."

And, unfortunately, central bankers are not fighting inflation anymore (maybe because inflation is too low?):

"It is a measure of how much has changed in the world of central banking that the very institutions that won their credibility by keeping a lid on prices now seem to be trying to create inflation, not subdue it."

And it gets even worse when he looks back at 2011:

"Central banks now seem ready to do whatever it takes to sustain growth — to a degree that casts doubt on the genuineness of their commitment to price stability. Monetary policy deliberately turned a blind eye to relatively high inflation in 2011-12."

There are two central banks that were worried about inflation in those years: the ECB and the Swedish central bank. Not sure they are the example to follow.

What both articles share is an asymmetric view of inflation. In some sense inflation can only be too high. High inflation represents a real risk with significant costs while inflation below target might just be ok (despite all the evidence to the contrary of the recent crisis).

Their criticisms would have a lot more power if inflation was going up anywhere in the world, but it is isn't. So they need to find another cost of this unreasonable policy of trying to raise inflation back to its target. And what Martin Feldstein finds is the financial instability that "low interest rates" create (a point also made by many other critics of current central bank actions).

But, as Paul Krugman points out, it is really odd to hear these arguments coming from those who tend to believe in the power and efficiency of markets (relative to government policies). How can it be that financial markets are so easily fooled by monetary policy and end up mispricing assets in such a bad way as to create a bubble that will have large and negative consequences on the economy? Because we are not just talking about asset prices going up as interest rates are low, we are talking about bubbles and instability. If this is really what we believe, wouldn't this be an argument to enforce some strong regulation on markets that are unable understand how interest rates and other macroeconomic trends affect asset prices?

This is not to deny that periods of unusually low interest rates can indeed create confusion in investors and markets (what some call "search for yield"). But to make this argument one needs to first understand the global nature of this phenomenon that suggests that the reasons for low interest rates extend beyond the particular actions of a central bank. And then we need a theory of financial markets, their irrational behavior and how the central bank can influence this behavior. It is unclear to me that the history of financial market bubbles teaches us much about the ability of central banks to stop excessive optimism. Real interest rates in the 1990s were high and they did not stop the largest stock market bubble the US stock market has ever seen.

Antonio Fatás