Using a hammer or a wrench to pop asset price bubbles?

In a recent speech Adam Posen (recently appointed a member of the Bank of England's Monetary Policy Committee) argues that monetary policy should not be used to deal with asset price bubbles. His main argument, which has been expressed before by different central bankers, is that monetary policy is the tool to deal with price stability and it is not appropriate to deal with asset price bubbles. Quoting from his speech:

"Just because we want there to be a policy response to a problem does not mean that the problem can be solved with the tools at hand. Again, if I have a hammer, it can be useful for all sorts of household tasks, but useless for repairing a leaky shower head – in fact, if I take the hammer to the shower head, I will probably make matters worse. I need a wrench to fix a pipe leak, and no amount of wishing will make a hammer a wrench. This is the essential reason why central bankers are now looking around for what has been called a ‘macroprudential instrument’, that is a tool suited to the job – and a tool additional to the one that we already have in our toolkit."

I am very sympathetic to this argument, interest rate is probably not the right tool to deal with asset price bubbles and using regulation or a 'macroprudential instrument' is the right thing to do.

However, we still need to ask the question: What if those instruments are not available or are simply failing to do their job? Is there a role for monetary policy? He cites the example of Spain as a country where the central bank was stressing the importance of dynamic provisioning for banks and still went through a real estate bubble. It might be that the Bank of Spain was not aggressive enough, but how do we know that the systems that we are setting in place now will take care of the next bubble or financial imbalance?

One can argue that interest rates should not be used to deal with an imbalance in financial markets, because this is not part of their mandate, but I think this is a very narrow view of the role of central banks. There is no doubt that imbalances in financial markets spread to the real economy. In fact, there were many signs of a macroeconomic imbalance prior to the crisis such as excessive consumption, current account imbalances. Aren't interest rates the tool to deal with macroeconomic imbalances?

If we apply Adam Posen's logic to some of the previous recessions, we could come up with the conclusion that central banks should never use the interest rate as a stabilizing tool. We could always claim that previous recessions originated in a specific sector of the economy and it would be better to deal with these developments using 'sector-specific' tools. Adam Posen uses as an example a procyclical tax on real estate that might avoid real estate bubbles like the one we just went through. We could apply the same logic to the internet bubble of the 90s and argue that a tax on internet-related companies would have avoided that bubble. This might be true but how do we know where the next bubble will come from so that we set up the right 'procyclical tax' to avoid it? In my view, if the next bubble generates a macroeconomic imbalance, then it is the role of monetary and fiscal policy to deal with it. The next business cycle, the next bubble is likely to be different from the current one and we will learn from it and set up additional policies to make sure that it does not happen again, but until we figure out policies to avoid any potential bubble or imbalance that can cause a recession, monetary policy still has a role to play. And yes, using a hammer to fix a pipe leak will be a challenge...

Antonio Fatás

Central Bank Transparency

Here is an excerpt from an interview by Jean-Claude Trichet, President of the ECB with De Tijd and L'Echo (the full interview can be found at the ECB web site).

Q. For some financial assets, such as gold, we are seeing a return to risk-taking on the part of investors. Is this a parameter that the ECB takes into account in its strategy?

A. I will not make any specific comments regarding gold.

Generally speaking, one of the fundamental lessons of the crisis is that when we underestimate financial risks and focus only on the short term, we set the stage for a future catastrophe. The new principles for bank remuneration, which the international community have agreed within the framework of the Financial Stability Board, were established precisely in order to ensure that there is no incentive for operators and traders in particular to favour the most risky attitudes and decisions, leading to illusory profits in the short term at the expense of the long-term interests of the financial enterprises concerned and the stability of the financial system as a whole.

It is always interesting to see how central bankers tend to start their answers by saying that they will not make any specific comment on a market or an asset price and then make a broad statement about how financial markets need to be careful and not create bubbles. This reminds me of the famous question by Alan Greenspan back in December 1996: "How do we know when irrational exuberance has unduly escalated asset values?" Great question and I would like to know the answer!

Should central banks provide more guidance to help us answer our questions and doubts about asset prices (or other financial market developments)? Should they share their views and forecasts on the evolution of asset prices as they do for other financial variables, such as interest rates? I do not know what the right answer to these question is but I find the current communication style from central banks ("no specific comment on that question but...") unsatisfactory.

Antonio Fatás

The "investmentless" recovery

The behavior of U.S. employment at the end of the last two recessions (1991 and 2001) was different than in previous recessions. Employment did not grow fast and it took several years to reach the pre-recession levels. Because of this, the recovery years that followed both of these two recessions have been labelled "jobless recoveries". Below is a chart from Brad de Long that compares them to two other previous recessions (original posting is here).

Employment was flat in 1991 and 2001 instead of increasing fast as in 1975 and 1982. Because of the current high level of unemployment combined with what might be weak growth there is a fear that the current recovery will also be a jobless one and that the unemployment rate will take a long time to reach a normal level (here is Krugman on this issue).

The behavior of employment will depend on many factors (amount of labor hoarding, productivity) but at the end of the day, the major factor be remain the strength of the recovery and how fast GDP and demand can grow. If we look at different components of demand (or GDP) there is an interesting factor about the last two recessions: In both of them, investment played a weaker role during the recovery phase. Below is a chart comparing the behavior of investment (measured as a % of GDP) around the recovery time (0 is the quarter when the recovery started according to the NBER).

What is interesting in this chart is that the last two recoveries were also special when it comes to the behavior of investment. In fact, the behavior of investment seems to mimic what we see above in the employment chart. While during the 1975 and 1982 recoveries investment grew faster than GDP (so the ratio increased), during the 1991 and 2001 recessions, investment grew at the same pace as GDP (so the ratio is flat). And this is more of a surprise if we take into account the fact that real interest rates remained very low during these two recoveries (more so in 2001).

We know that investment is the most volatile component of GDP so the V-shape that we see in 1975 and 1982 is what we would normally expect. By definition, it has to be that other components of GDP played a stronger role (relative to previous recessions) in 1991 and 2001 (consumption, exports). What was the exact role of those components will (hopefully) be the subject of a future post in this blog. What is interesting so far is the similarity in the behavior of employment and investment across the most recent recessions.

Antonio Fatás

Inflation or Deflation?

There is an ongoing debate on whether we will see inflation or deflation during the coming years. Inflation could be a result of the expansionary monetary policies we have witnessed in many countries around the world. Deflation could be caused by the effects of the economic slowdown (asset price deflation, deleveraging, low growth) and its global nature.

Despite these concerns, inflation indicators remain very stable. After a period where they were pointing in the direction of deflation, they are now back to levels which are fairly consistent with inflation in recent years. The stability of inflation forecasts and how they seem to be ignoring some of the theories that suggest more radical changes ahead are a reflection of the strong anchoring of inflation expectations that has been achieved in recent decades. This anchoring of expectations is the result of very low and stable inflation in most economies since the mid 90s. Here is the evolution of World inflation since 1980 (source: IMF World Economic Outlook database October 2009).

It is remarkable how after 1996 inflation has remained almost constant. While it is true that this was a stable period of time from an economic point of view, there were several episodes (the Asian crisis, the recession in 2001/2002) that could have had an effect in inflation. The fact that inflation did not react and remained in a very narrow range (between 4-5%) is behind the strong anchoring of inflation expectations. And this is a virtuous cycle: the more anchored inflation expectations are, the more stable inflation will be.

What is also interesting is to see that the behavior of inflation has been very similar across developed and developing countries. In the case of advanced economies, inflation decreased very fast in the early 80s and came down even more in the mid-90s. In the case of emerging markets we witnessed a period of high inflation during the early 90s but after 1995 inflation has come down and remained stable for 13 years.

While 13 years of stable inflation cannot guarantee that we will not see large changes in the inflation rate in the coming years, there is no doubt that this is a reflection of the strong anchoring of inflation expectations, more so than in any other period in recent history and this stability is likely to keep inflation volatility low even in the presence of many uncertainties.

Antonio Fatás

It will continue to go up until it stops.

One of the best quotes I have recently seen in financial news sites. This is from CNBC Monday November 16th (link to the article and video here):

Dennis Gartman, founder of The Gartman Letter told CNBC Monday that the price of precious metal will "continue go go up until it stops." "It is a gold bubble, Gartman told CNBC. He called the trade on gold "mind boggling," but also said that he is currently long - or betting gold will go higher.

Well, I am sure he is right, the price of gold will continue to go up until it stops...

By the way, Willem Buiter has an interesting blog entry on the market for gold.

Antonio Fatas

The definition of strong (dollar)

Timothy Geithner said this week "I believe deeply that it is very important to the United States, to the economic health of the United States, that we maintain a strong dollar." It would be interesting to know what his definition of "strong" dollar is.

When John Snow was asked the same question back in 2003 (May 18) when he was Secretary of the Treasury he said: "You want people to have confidence in your currency (...) You want it hard to counterfeit, like our new $20 bill."

Antonio Fatás

9.5% productivity growth. How unusual?

As reported by the Bureau of Labor and Statistics yesterday, US labor productivity grew at a 9.5% in the third quarter of 2009. Fast productivity growth is normally a sign of economic strength, but in this case because it is the result of a combination of GDP growth and destruction in employment, this has raised further concerns about the possibility of a jobless recovery (see Brad DeLong, among others).

How unusual is to see productivity growing that fast during a recovery phase? No doubt that 9.5% is a very large number but we have seen similar patterns before. For example, the 1981Q3 recession showed a very similar pattern of productivity growth as seen in the picture below.

Six or seven quarters after the recession had started, productivity was growing at rates which are very similar to what we are seeing now. Interestingly, the 1981 recession was also a long recession, it lasted 16 months. It is possible that the current recession ended in the summer of 2009 which would make it very similar in length to the 1981 recession.

There is, however, a big difference between the two: in the 1981Q3 recession, we saw GDP growth rates close to 10% (quarter to quarter) seven quarters after the recession started - i.e. the last observation in the above chart. This time GDP is only growing at 3.5% and it is only because of the large decrease in employment that productivity growth is so high. This is not good news (unless we believe that this trend is about to reverse).

What did productivity growth look like in shorter recessions?

This second chart shows productivity growth in the previous two recessions (1990 and 2001). Both of these recessions were short, about 8 months. Productivity also increased in the quarters after the recession started. It started growing earlier (this is probably related to the short nature of the recession) and it did so in a smoother manner with peaks below the current levels.

Antonio Fatás

Reality check (fiscal policy)

The IMF has just published their November 2009 edition of "The State of Public Finances Cross-Country Fiscal Policy Monitor". It is a great analysis of the current state of public finances and the risks ahead.

Some good news: if one looks carefully at the numbers, while deficits and debt levels are high, they are manageable. They require an effort in the years (decades?) ahead but we have seen large fiscal consolidations in the past of a size which is similar to what is required from today's perspective. This seems to be the perspective of financial markets as interest rates on government bonds remain low and there is no obvious pricing of a default risk.

The arithmetics of fiscal discipline are simple and the future effort will depend on the difference between the interest rate that governments will face and the growth rate of their economy. In emerging markets, we have seen rapid changes in this difference (interest rate getting very high as growth rates slow down) leading to crisis as the burden becomes unmanageable. While this is not the scenario that one might expect for advanced economies, it all depends on the credibility that governments established. And theoretically one could imagine a self-fulfilling prophecy where a crisis starts with a small change in the perceived credibility of governments which increases interest rates and leads to unsustainable interest payments.

The bad news is that there is no guarantee that governments will behave better going forward. Yes, we know the effort that is needed to stabilize debt-to-GDP ratios but history is full of examples where once the crisis is over we forget about fiscal policy discipline. And here is where we need an exit strategy. It is not about about announcing a short-term schedule to remove the current fiscal stimulus is about giving reassurances that in the next decade or decades we will look at sustainability of government finances in a different way. I have argued in some of my academic research (together with my co-blogger Ilian Mihov) that there is a need to think about institutional reforms that change the way we think about fiscal policy and budgets. Other academics have presented similar proposals, all of them implying the creation of some constraints around the power of governments to decide on all aspects of fiscal policy. While numerical rules are the simplest way to think about constraints (budget balance rules, stability and growth pact), the empirical evidence is that implicit constraints - such as those created by the political process through which budgets are decided- can be as powerful and less rigid. A change in this direction would be a good "exit strategy" for governments. Without the need to harm the current recovery, it would provide the necessary foundations for a credible fiscal policy in the years ahead.

Antonio Fatás

Extending the (EMU) Stability and Growth Pact to take care of global imbalances

Last week Eswar Prasad had an interesting article in the Financial Times on how to deal with global imabalances. As the G-20 seems to be taken the issue of global imbalances seriously, there is the question of how to make their commitment operational.

Reducing global imbalances requires a reductio in national imbalances between income and spending or, in other words, between saving and investment. The difficulty is that this imbalance is the result of both government and private sector imbalances. Because it is difficult to think about how to effectively impose a balance on private income and spending, the only valid alternative seems to be addressing large imbalances in government spending.

This is the suggestion of Eswar Prasad:

"The scheme would work as follows. The G20, in consultation with the IMF, develops a simple and transparent set of rules for governments on policies that could contribute to global imbalances - for instance, that government budget deficits and current account balances (deficits or surpluses) should be kept below 3 per cent of national GDP"

If deficits go beyond 3% there is a financial penalty (implemented through the SDR holdings of the IMF). If we focus on budget deficits, this looks like the Stability and Growth Pact under which EMU governments have lived for several years. There is a limit on budget deficits (3%) and a set of mechanisms to enforce this limit.

The history of the Stability and Growth Pact has shown us that it does not work. While it provided some discipline in the earlier years, we soon realized that there were many issues associated to its implementation that have led to failures to comply with the limits and a revision of the Pact that has left very little power over national government balances. The issues were many:

- What do you mean by 3%? You probably want to adjust this by the cycle, but then how do you adjust it by the cycle? Do you allow for exceptional circumstances?

- How do you punish government? Who decides that governments should be punished? (in the case of EMU, it was the council of finance ministers who had to punish some of its own members, not very effective).

In practice, many countries ended up with deficits above 3% without significant consequences. There were also periods where the government deficit was below 3% but the government was clearly helping create a current account imbalance (i.e. the government should have had a large surplus as opposed to let's say a 2% deficit).

The G-20 commitment to address global imbalances is no doubt a good step in the right direction but it is unclear how this commitment will translate into specific outcomes or actions.

Antonio Fatás

Content of economic blogs

Here is a snapshot of recent content of some economic blogs (thanks to Wordle).

Greg Mankiw

Mark Thoma

Brad de Long

Casey Mulligan

Antonio Fatás

How low is 1.48 (USD/EUR)?

As we witness increasing signs of economic optimism about the recovery, the focus of the analysis turns into the exact form that the recovery will take and how to ensure that it is as fast and smooth as possible. One of the areas that has received recent attention is the evolution of the US dollar. In recent months the US dollar has gotten weaker and there are many questions about whether this is a trend that will continue and how far the US dollar will fall.

In an FT article yesterday Wolfgan Munchau made the case for a weaker dollar. Many of the arguments are not new and we had heard them before the crisis when global imbalances were on their way up. As the US current account deficit got larger and larger there was the question of how those deficits would be reduced. Given that (US) consumption rates looked unsustainable, it seemed that a price adjustment (through a change in the exchange rate) was the only way to produce that adjustment. In addition, now that the crisis has started, and if one takes the perspective of the US economy, a depreciating currency can help with the economic recovery, an argument made by Wolfgan Munchau in yesterday's article

"A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ."

This argument is similar to the one made by Krugman to oppose those who are voicing concerns about the fall in the value of the US dollar.

I will not argue here with this textbook logic of how currency movements can help address current account imbalances and business cycles (although I must admit that I find the empirical evidence much weaker than most people). But I have some concerns about blank statements that argue that the US dollar has to get weaker:

1. It is not enough to say that the US dollar has to get weaker you need to say how weak it should get, we need a number, there is a need for a medium/long-run anchor. As the chart below shows, the US dollar is already weak by historical standards. Sure, it has room to get to the historical low of 2008 but was is the right reference value?

As a technical and historical explanation of the chart: this is the nominal exchange rate between the US dollar and the Euro (before 1999 the German Mark is used as the Euro) and the upward trend is a reflection of the differences in inflation between Europe/Germany and the US. But even if we were to correct for inflation differences, the US dollar is still weak by historical standards. Also notice that some of the waves that we see were reversed by some statement coming from central banks and government officials, such as the September 1985 Plaza Accord, the February 1987 Louvre Accord and the interventions of November 2000. By historical standards, we would have expected similar statements in 2008 when the US dollar reached the 1.60 USD/EUR level. We did hear some comments about "excessive volatility" but not about the actual value of the currency.

2. Related to the point above, but more from a theoretical point of view: how much do we want to introduce price distortions (changes in relative prices via changes in the exchange rate) to ensure that the spending patterns of different countries are sustainable? The textbook logic of currency depreciations to smooth recessions is one that applies to countries that are suffering an asymmetric shock. Today we face a global recession, so according to the textbook, most advanced economies need an exchange rate depreciation. We might argue that all these currencies need to depreciate relative to countries that are doing well (China and other emerging markets) but we cannot simply argue that the US dollar has to get weaker. It is interesting how many criticisms China has gotten for "manipulating" the value of its currency to affect economic outcomes and now we are willing to argue that the US should be doing something similar. Just to be clear, I am not arguing that currencies cannot be a good adjustment mechanism, but the context matters and one needs to be explicit about the difference between an asymmetric recession and a global recession and the difference between smoothing business cycles and addressing structural imbalances.

3. The perspective of the other countries. A weak dollar can help the US increase its exports, which goes in the direction of reducing the current account deficit, but why would other countries see this as a "return to equilibrium"? Wolfgang Munchau argues that "A strong Euro would nicely take care of of Germany's persistent current account surplus". I am not sure all the Germans agree with this statement. I am also not sure that a fall in revenues (i.e. fall in German exports) would lead to a decrease in the saving rates in Germany. It might lead to the opposite behavior - an increase in saving rates because the decrease in income leads to more uncertainty and precautionary savings (which will make the current account surplus even larger not smaller).

Antonio Fatás

More on the medium-term outlook for the recovery

The magazine The Economist has an article this week on the persistence of the current recession and whether output will return to its trend. The arguments that the article present are similar to those made in the Chapter 4 of the recent World Economic Outlook by the IMF (see our previous post on this matter): it is likely that the current recovery is not strong enough to bring output back to trend. In a recent NBER working paper, Cechetti, Kohler and Upper also provide empirical evidence suggesting that financial crisis leave long-lasting (negative) effects on output.

The question on the connection between recessions (or business cycles in general) and potential output ("the trend") is one that has not been studied much in economics. Most of the models we use tend to think about the trend as being independent of business cycles - so recoveries always bring output back to the pre-crisis trend. Policy makers tend to use the concept of the output gap, the deviation of output from its potential, to think about the strength of the recovery under the assumption that in a "normal" year the output gap should be back to zero.

The strongest evidence one can find in favor of this hypothesis (that recessions are temporary) comes from the US economy. The US economy has displayed a surprising tendency to return to trend even after some major events such as the great depression, World War II or the recessions of the 70s. Below you can see a chart that shows the evolution of GDP per capita in the US during the period 1870-2008. The red line represents a (log-)linear trend using data up to 1928. It is remarkable how close the blue line is to the red line and how the economy recovers to return to trend.

In fact, using 1870-1928 data, a prediction using that (log-)linear trend leads to an error of only 1% for the level of GDP per capita in 2008. Of course, the picture is misleading in the sense that in some cases it took a long time for the economy to come back to this trend, but it is still interesting that it returned to the same trend. It could have returned to the same growth rate but at a different level but that's not what we see, we see that the output loss is always recovered after a number of years. This suggests that the supply side of the economy (innovation, technology) is unaffected by output fluctuations.

If one looks more carefully at the data, the evidence becomes much weaker. In contradiction to what we see in the picture above, empirical economists know that output fluctuations are very persistent. In fact, one cannot reject the hypothesis that all output fluctuations leave a permanent scar in the economy. If we suffer a recession, output never goes back to trend, it remains at a lower level forever (this is what is known in the academic literature as the existence of a "unit root" in output).

From a theoretical point of view, there are two ways to justify the fact that recessions always leave permanent effects:

1. Technological changes are the cause of business cycles. Recessions are period where we are not good at innovating and this causes both a recession and a permanent loss in output. This is what we know as "real business cycle theory".

2. Innovation is affected by recessions. During recessions firms invest less and this lead to a temporary slowdown of technological progress, so the economy never returns to the same trend. It will go back to its normal growth rate but the temporary effects on growth will leave a permanent scar on the economy. This is the argument that we hear these days to support the fear that the current recovery will not be strong enough. A few years ago I wrote a couple of academic papers that presented this theory and some international evidence in favor of this hypothesis (the papers can be found here and here). This is an area of macroeconomics that I believe deserves more attention in terms of academic research (but I am biased, given that I have written on the subject). And it is not just about financial crisis but, more generally, about what happens to innovation, technology and growth during recessions.

Antonio Fatás

Will output return to the pre-crisis level?

How strong the economic recovery will be depends on whether we believe that output will quickly return back to the trend that was following before the crisis. Economists tend to think in terms of potential output as driving the trend of output and recessions as being temporary deviations from this trend. During the recession the output gap becomes negative (output is below potential) and the recovery brings output back to its trend, closing the output gap.

There is, however, evidence that output does not always return to its trend after a deep crisis. The IMF World Economic Outlook has just released its two analytical chapters from the September/October issue. Chapter 4 (which can be found here) deals with this issue: whether output will return to trend after the crisis. Their conclusion, after looking at many different historical cases, is that banking/financial crisis tend to leave a permanent (or at least a medium-term) scar on the economy. Here is a picture from Korea after the 1997 crisis (picture borrowed from Chapter 4 of the World Economic Outlook).

As we can see, 7 years after the crisis, output is still far from the pre-crisis trend. There are many other examples like this one and the evidence supports the notion that there is a mid-term costs of financial crisis so that output stays below trend for several years.

There are, however, some examples where the output loss is smaller. Some of the conditions under which the mid-term output cost could be low are:

- having a low initial decline on output (e.g. the severity of the recession during the first quarters).

- having a level of investment before the crisis which is not far from historical standards (e.g. the pre-crisis boom did not drive investment rates too far from historical levels)

- having more policy room to maneuver (low inflation, current account balance) before the crisis

The conclusions of the article state that:

"For the most part, the implications of our analysis are sobering for the medium-term output prospects in economies with recent bank- ing crises. The historical evidence suggests that output in many of these economies may remain well below precrisis trends in the medium run."

And policy makers are warned once again about the difficult balance in their exit strategies.

"Looking ahead, the timing for the withdrawal of the extraordinary amount of monetary and fiscal stimulus that has been implemented in many countries will be impor- tant. On the one hand, a premature exit could stifle the recovery. On the other hand, delaying the withdrawal of stimulus could be inflationary."

Antonio Fatás

Output, employment and productivity during the crisis

While most advanced economies have displayed significant drops in GDP during the last years, the behavior of labor market variables (employment, unemployment, number of hours) has been quite different across countries.

In countries such as the US or Spain we have seen a large decline in employment/hours and the corresponding increase in unemployment. In countries such as Germany or France or Sweden, employment and hours have fallen much less.

Below is data on labor productivity measured as GDP per hour worked in four countries (data is annual so we are missing the first quarters of 2009). In the case of Sweden and Germany we can see that the fall in GDP has been much larger than the decrease in hours worked leading to a decline in productivity. In the case of the US productivity has remained stable. In the case of Spain the fall in employment and hours has been much larger than the decrease in GDP which has produced a doubling of the productivity growth rates in 2007/08 relative to the 2003-06 period.

Behind these figures we probably have a composition effect (different sectors being affected differently by the crisis) but also different labor market responses to the crisis, where in some cases there has been a conscious effort to reduce the impact on employment.

Antonio Fatás

Update (Sept 23): some have emailed me asking for an explanation of the differences among these countries. I do not have a great answer, my last paragraph was an attempt to put forward some hypothesis. It could be that the sectors that are being affected in a country like Sweden are the most productive ones, while in a country like Spain they are the least productive ones (e.g. construction). I have no evidence that this is the case but it is a plausible mechanical explanation. The second explanation that I proposed is probably more realistic: in some countries (Germany, Sweden) there has been a conscious effort with the help of trade unions to reduce the impact of the crisis on employment (e.g. accept a pay cut if the level of employment is maintained). We have not seen this in the US. In the case of Spain, the dual structure of the labor market has led to a large termination of temporary contracts and a significant reduction in employment.

Household debt, consumption and wealth

It is very common these days to hear that the global economy has no way of recovering because the most powerful engine of global demand – the American consumer – is choking in debt. US household debt has reached $14 trillion in 2009, or 100% relative to GDP. At a recent conference in China, panelists were wondering how growth in the global economy would resume given that the American consumer had disappeared under the burden of debt.

On September 17, the Federal Reserve released their “Flow of Funds” report, where we can find data on household debt for 2009Q2. Indeed, this debt stands at $14.068 trillion or slightly less than 100% of GDP. Does this mean that the economy is doomed? There are two points that one has to take into account when evaluating the role of household debt in the economy.

1. Debt is only one side of the story. Households also own assets. Consumption is a function of (net) wealth, not only of indebtedness. Up to a first approximation what matters is the difference between assets and liabilities. Indeed, no one thinks that a person with $10 million in debt is going to cut his or her consumption, if you know that this person has $10 billion in assets. So, how do American consumers fare in terms of net worth? Below is a graph with three ratios – assets-to-GDP, debt-to-GDP and net-worth-to-GDP. Although household debt stands at 100% of GDP, assets owned by US households currently stand at $67.2 trillion or 475% of GDP. The net worth of the American households is estimated to be over 375% of GDP.

Are these assets sufficient? This is hard to tell because theory does not provide convincing guidance as to what the wealth-to-GDP ratio should be. But we can look at the data to see how these numbers compare to historical averages. The average ratio of US household net worth from 1952Q1 to 2009Q2 is about 350% (if we exclude the two bubbles, the ratio is 330%). In short, US households today have more net wealth than they had in normal times in the post WWII period. Contrary to all complaints, US households today are richer than at any point in time in the pre-1995 period (and again, this is relative to GDP; in absolute terms no one will be surprised that this statement is true).

But maybe it is the composition of debt that matters – people today live off their credit cards. It turns out that consumer credit has increased indeed over the past 20 years but the numbers are not shocking. From about 14% in 1990, consumer credit rose to 17.3% in 2009 (again the numbers are relative to GDP).

One counter-argument to the points that I raise above would be that all of this wealth is only on paper – we saw how bubbles deflate and therefore we cannot count $67.2 trillion is assets at their face value. To accept this argument, however, we must admit that the real estate bubble has not deflated yet. It could be true, but looking at data we find that house prices relative to income are close to their historical averages from the pre-bubble 1980s and 1990s. In other words, an argument that the wealth is only paper wealth should argue that the US is in a permanent state of a bubble.

2. Even if we concede that debt can reduce consumption for an individual, it is a bit trickier to make the same argument for the national economy. The reason is that the liability of one individual is an asset for someone else. In the graph above, the thin blue line is in fact included in the thick red line!

At first, it might be startling to think that indebtedness of one household is an asset of another one. But if you imagine a bank and its balance sheet, you can quickly realize that all the loans that banks give (assets for the bank) must be financed with a deposit, equity or another instrument on the liability side.

There are ways in which this “neutrality of debt” may break down. For example, if those who are indebted have a higher propensity to consume than the lenders, then debt will lead them to cut their consumption by more than the lenders will increase theirs (due to the wealth effect). This is possible and even plausible, but it is not clear whether empirically this effect is significant. Second, it might be that household debt is held by foreigners. Again, the data are not very supportive of this hypothesis because the net foreign asset position of the US is not (yet) devastating – less than 20% of GDP.

In general, many other “imperfections” in the market economy can result in the importance of debt for aggregate consumption, and I do agree that some of these imperfections are realistic and important. The main point of the argument is that we need a more nuanced view of why debt matters. We should keep in mind that the net worth of US households is still quite high (375% of GDP) and that debt should be viewed from a general equilibrium point of view and not only in absolute terms.

Ilian Mihov

More on the shape of the recovery (CNBC Interview)

Stretched V or U? The shape of the last three recessions.

Here is a nice chart from John Fernald at the San Francisco Fed that shows the path of GDP after the last three recessions, including the current one. Using the NBER dates to set the beginning of the recession you can see that the first quarters of the current one were similar to those of the previous two but that a year into the recession the economy accelerated its decline. This made the current recession much longer and deeper than the previous two.

Looking at the forecast for the next 6 quarters, the pace of recovery is not that different from what we have seen before but we start at a much lower level and this makes GPD to remain below the path of the 1990 and 2001 recessions for the quarters (and years) ahead.

Antonio Fatás

Healthcare and global imbalances

By now we all know that the global imbalances were created by excessive consumption in the US and high savings in China (and other countries). Indeed, if we recall that the current account balance is the difference between saving and investment, we will find that for the US over the past 20 years the increase in the current account deficit is almost entirely due to the increase in private consumption.

But what is exactly behind this increase? Do Americans spend more on cars, or toys from China, or is it something else? Here are the data:

As the graph below shows, consumption-to-GDP ratio stood at 62.71% in 1980Q1. The dramatic rise in consumption in the 1990s and early 2000s is clearly seen on the graph (the blue line). By 2009Q1 consumption-to-GDP ratio rose to 70.73%! When we look a little bit deeper, we realize that almost the entire increase is due to two factors: healthcare and education. Medical care plays the major role as its share in personal consumption expenditures rose from 10.2% to 18.3%. Education accounts for one percentage point in the increase in consumption.

Dealing with the rising costs of healthcare may indeed help not only resolve issues of healthcare provision in the US, but indirectly might be the most important tool for addressing global imbalances.

Ilian Mihov

Did economists ever get it right?

Paul Krugman has written a nice essay on the NY Times about How did economists get it wrong?. Other economists have written on the same topic: Eichengreen, Lane, Thoma, DeLong.

My reading of these articles is that there is a good deal of consensus around the following points:

1. Many (economists and non-economists) had expressed concerns prior to the crisis about economic imbalances such as excessive asset price appreciation or current account imbalances. They pointed out to the need of an adjustment, which could come in the form of a recession. As it has always been the case with recessions, forecasting the exact timing is not easy - it depends on how long imbalances are kept alive by markets, investors, policies (and luck).

2. There were several scenarios that were discussed prior to the crisis that could lead to a significant economic downturn. They involved a crash of the real estate market (which took place) and in some cases a reversal of capital flows as foreigners would stop lending to the US (or they would do so at much higher rates). This second scenario never materialized - the crash in real estate prices was enough.

3. Even among those who were concerned with the possibility of a crisis, very few understood the potential magnitude of the crisis, mainly because they could not foresee the collapse of the financial system that we witnessed a year ago. Here is a quote from Frederic Mishkin (who was a member of the Board of Governors, Federal Reserve 2006-08) in August 31 2007:

“The big gains in housing prices we have seen here and in many other countries have raised concerns about what might happen to economic activity if those price gains are reversed. Developments in the housing market can also affect credit markets. Furthermore, problems in the subprime mortgage market have led investors to reassess credit risk and risk pricing, thereby widening spreads in general and weakening the balance sheets for some financial institutions. Fortunately, the overall financial system appears to be in good health and the US banking system is well positioned to withstand stressful market conditions.”

Clearly, our knowledge of what was happening inside the financial system and the associated risk was very limited. This is a failure of regulation and we learned the lesson the hard way.

4. No doubt that some of the research that was done by economists (those in academia) did not provide any clue about what was about to happen. As Phil Lane argues in his article, this is partly a result of specialization, not all researchers are into the business of forecasting economic downturns. But there is also no doubt that some of the research in macroeconomics has been anchored in models that do no recognize enough failures in markets or deviations from rational behavior to produce or understand some of the phenomena that led to the current crisis. Part of this is because of ideological reasons (some want to believe that markets always work), part of this is because the "beauty" of dealing with simple models (the argument made by Krugman in his article).

One thing that I find missing in all those articles is to know whether there was any difference between the current crisis and the previous ones. I am not sure there is much difference. Prior to the (mild) recession of 2001 we also witnessed very similar dynamics: many expressed concerns about the valuation of stocks (more so for tech stocks). But they called the crisis way before it happened. Once it happened, we all asked the question "How did we get it so wrong?". The difference with the current crisis is that this one is bigger, so more questions are being asked. Also, economic policy has played a much stronger role during the crisis, which has probably led to a stronger debate around economics.

It is also interesting to see that during the boom year, there was as much skepticism of economists' forecasts as today so even if some economists were getting it wrong, it is unclear how much they were driving market expectations or investment and spending decisions.

We will have to wait for the next crisis and see if things have changed or we just need to conclude that economists "will never get it right".

Antonio Fatás

Growth Forecasts Revised Upwards

For the last year and a half we have seen a worsening of forecasts of growth for most countries around the world. As we discussed in an earlier post, forecasts for GDP growth for 2009 had been revised downwards every single quarter starting in 2007Q4 until 2009Q1. Since then we have seen that these forecasts are becoming more stable and in the recent update by the OECD of their economic outlook we now see forecasts for the third quarter of 2009 being revised upwards - in some cases significantly. For example, the forecast for Germany was close to zero in June and it is now being revised to more than 4% (this are annualized growth rates). Below is a picture from this report.

Antonio Fatás

Government Debt. Going up (and then down?).

There is a growing debate about the increasing burden of government debt in advanced economies. As a result of the recession and the large stimulus packages, government debt is likely to increase over the coming years to levels that we have not seen in many decades. In the case of the US, the Congressional Budget Office expects government debt to go from 40.8% in 2008 to 68% of GDP in 2019 (more details here, this figure corresponds to the debt held by the public which is lower than the overall level of debt, as some of it is held by public institutions).

Is 68% too high? The debate is open and some think that while high debt in itself is not desirable, this is a number that we have seen before (Krugman has made this argument here). Others disagree and believe that this level of debt will impose a large burden on the economy (Hamilton makes the argument here).

Many countries (including the US after the second World War) have dealt with levels of debt as high or even higher than what we are likely to see over the coming years. In the US debate, there is a reference to the case of European countries that in the 90s saw levels of debt above 100% of GDP and "survive". What was their experience? Here is the picture from two of the "worst offenders": Belgium and Italy.

In both cases, the debt to GDP ratio increased above 110% of GDP. What did we learn from that experience? The good news is that countries can "survive" with such levels of debt. In fact, we need to realize that the burden that this debt imposed on the Italian or Belgian government budget was substantial because the interest rates were much higher than the rates that governments in advanced economies face today (more so the US government). Even with those high rates, levels of debt above 100% did not lead to insolvency and what we saw over the years that followed was a gradual reduction of those levels as a result of increased fiscal discipline and GDP growth.

The first piece of bad news is that the economic performance of these two countries was not great but it is hard to argue that government debt was the main reason for such a low performance. The second piece of bad news is that while the levels have been coming down, they have done so at a very low rate. The slope going up seems to be much faster than when it goes down.

Here are two other European countries that might provide a more optimistic perspective: Ireland and Sweden.

In both cases we see a much faster decline in the debt-to-GDP ratio. In Ireland, the ratio went from 105% to 25% over two decades. In the case of Sweden, the ratio decreased from 75% to 35% in about ten years. We know that high growth played a role, much more so in Ireland than in Sweden, but the trend is also a reflection of the efforts to bring discipline to the budget. The bad news is that these figures are likely to explode in the years ahead because of the current recession, a reminder once again, that the effect of the discipline of the last year might vanish quite soon.

Here is my reading of these experiences:

1. Advanced economies can live with high levels of debt-to-GDP ratios. The levels that European countries or the US are likely to see over the coming decades are manageable.

2. How easy will it be to manage the burden of the debt depends on interest rates and growth. An environment of low interest rates (the one we have seen so far) and healthy growth (to be seen) will make the lives of governments much easier.

3. There is no need to pay back the debt within the next "x" years. What matters is to keep the level of debt-to-GDP ratio under control. [Of course, there is an issue of fairness that I am ignoring, about which generation should pay for the current expenditure]

4. Having said that, we need to plan for the next crisis, even if we are still trying the get out of the current one. The real fiscal discipline shows up during good times when government manage to save the necessary resources to pay for the extra spending and the reduced taxes that the next recession will bring. In many countries, including the US, the high projected levels of debt are a result of the consequences of the current recession but also the inability of previous administrations to bring the level of debt down when growth was high.

Antonio Fatás.

Fed’s Exit Strategy

After the reappointment of Ben Bernanke, discussions about the exit strategy from the massive increase in liquidity intensified again. On Squawk Box of the CNBC Asia channel one guest expressed his doubt that the Fed will be able to withdraw the liquidity because they are holding a lot of illiquid assets.

The Fed has more levers to control money supply than just open market operations and I will discuss them below, but let’s focus first on the balance sheet.

The inflationary danger arises from the fact that banks (depository institutions) hold over 819bln in deposits at the Fed (the second line in the liabilities side). If these institutions withdraw their deposits at the Fed and start lending out, there will be inflation. In order to reduce inflationary pressures, the Fed should be able to withdraw money from circulation. In normal times, the operation is very simple – the Fed officials sell some of Fed’s assets on the open market. By doing this, the Fed gets back cash and thus money supply in the economy goes down. To be able to perform this operation, however, the Fed must have liquid assets.

If we look at the asset side, we will see that the Fed has over 600bln in mortgage backed securities. Clearly, these are not good candidates for an open market operation. But in addition, there are at least three items that can be quickly sold or cancelled – US Treasury securities ($736bln), Term Auction Credit (credit with short maturity of about $220bln), and Commercial Paper facility of about $50bln. The last two items are part of credit facilities that the Fed can cancel easily once commercial banks start lending. The total amount is above 1trillion. In short, the Fed has enough balance sheet instruments to counteract the potential conversion of bank deposits into money.

Consolidated Balance Sheet of All Federal Reserve Banks (August 20, 2009) (Billions of USD)

Assets		Liabilities and capital
Gold US Treasury Securities Mortgage-backed Securities Term Auction Credit Commercial paper Other portfolio holdings Liquidity swaps Other assets	11 736 609 221 53 61 69 304	Banknotes Deposits of deposit. institutions US Treasury Other Capital	871 819 240 83 51
Total	2064	Total	2064

But these balance sheet tools do not exhaust the ammunition of the Fed to counteract any raise in inflation. Let me enumerate here some of the possible actions:

1. Open market operations (as described above).

2. Closing down of lending facilities (as described above)

3. Change in reserve requirements. What matters for inflation is the increase in broad measures of money. The Fed can raise required reserves ratios and by doing this they can reduce dramatically the speed at which money enters the economy. Required reserve ratios are used rarely because they are a very powerful tool (too powerful, one might say) in the control of money supply.

4. Change in the interest rate paid on the deposits of commercial banks. The Fed currently pays interest to banks that deposit their money in the Fed. If they increase this rate, the process of conversion of deposits into currency will slow down.

5. Issuance of central bank bonds. Currently the Fed does not have the authority to issue bonds (why would they borrow money, if they can print money?). But for the purposes of controlling money supply, they may ask the Congress to authorize them to issue bonds if they run out of Treasury bonds (i.e. they use all of them in open market operations) and they still need to reduce money supply further. This is a less conventional tool, but it has been used in China since 2003. Indeed this is how the People’s Bank of China sterilizes the effect of capital inflows and trade surpluses on money supply.

Armed with all these instruments, it is clear that, technically at least, the Fed possesses the levers to control the supply of money, so that rate of inflation does not increase above their (implicit) target persistently.

If you want to monitor the balance sheet of the Fed, it is published weekly on the following site: http://www.federalreserve.gov/releases/h41/Current/ (scroll down to where you see “Consolidated Statement of Condition of All Federal Reserve Banks”.)

Below is my interview for CNBC Asia from August 26, 2009, about the reappointment of Ben Bernanke as the chairman of the Fed (I know that I am biased). I also discuss Fed’s exit strategy briefly.

Ilian Mihov