The stock market and the value of the US dollar

I already wrote a note on this topic earlier in the blog but I thought it was useful to refresh the discussion with a picture. See below a picture of the evolution of the US stock market and the USD/EUR exchange rate since January 1st, 2009. The correlation between these two series is close to 0.9 (you get a similar correlation if you look at a longer series that starts in the summer of 2008). Whenever the US stock market goes up, the dollar goes down (relative to the Euro).

This correlation is not easy to explain with traditional macroeconomic models (to some this might not be a surprise given how bad some of our traditional macroeconomic models have helped us navigate through the current financial crisis,...). 

To explain exchange rates we normally look for changes in the economic fundamentals of one economy relative to another (the exchange rate is by definition a bilateral variable). If this was just news about the US economy, what is normally assumed (and, under certain assumptions backed by economic theory) is that good news about the US economy get reflected in an appreciation of the currency. But here we have the reverse, the dollar depreciates when the US stock market does well. 

Of course, if we truly want to make a relative statement about the US versus Euro economies we are missing information on the Euro countries in the chart. We know that during these months the behavior of these stock markets has been almost identical, influenced by news about the global economy. So, in some sense, it is not clear whether this is a correlation between the US stock market and the exchange rate or between global equity markets and the exchange rate. Should there be a correlation between global equity markets and a currency? It cannot be that all currencies appreciate when equity markets are doing poorly (some currencies need to depreciate!).  But the US dollar is not just a regular currency. We are constantly reminded these days that the US dollar is still perceived as the currency of the world and that the only true "safe assets" are assets denominated in US dollars (treasury bills). If that's the case, bad news about the global economy trigger a "flight to quality" and this means moving away from equity but also away from currencies other than the dollar.  This is consistent with the picture above although it is unclear how to make this consistent with other mode fundamental theories of the exchange rate (or the stock market) that are relevant at longer horizons -- but in times of panic, who cares about longer horizons? 

If this the explanation for the correlation above, then we should expect that as signs of the economic recovery become strong, there will be a corresponding move away from the US dollar, which could lead to a significant depreciation (and more so if the US dollar starts losing its status as the safest currency in the world).

Antonio Fatás

A stronger role for the IMF in times of crisis

During the current crisis the IMF (International Monetary Fund) has been lending to countries in need of funds. Despite this increase in activity there is a sense that the IMF could play a much stronger role in times of crisis. One of the constraints was the limited pool of funds available but this is about to change as there has been an agreement to increase substantially these funds. But, in addition, some countries where not willing to go to the IMF because of the conditions that it imposed on the borrowers. The IMF has just approved new lending facilities that address some of these concerns. Some of the changes include

• increase in the amount of lending that countries can obtain from the IMF
• additional flexibility in the terms of the loan as well as the lending processes
• loans are conditional on pre-qualification criteria rather than ex-post outcomes (this is probably one of the most significant changes as these conditions were many times seen as unnecessary impositions on domestic economic policy

If you want to know more, the IMF provides details on all these changes in their web site. 

It will be interesting to see how the new lending facilities change the attitude of some of the countries that today do not consider the IMF as the first place to go for funding in times of crisis. These changes are also happening at the time when we hear additional demands for the need of an international authority in matters such as exchange rate or the creation of a world currency which is independent of national governments (as expressed by Zhoe Xiaochuan, the Chinese central bank governor).

Antonio Fatás

Yet another paradox of thrift

The most recent IMF projections for the world economy indicate that in 2009 we will see world output contracting for the first time in the last thirty years. The global nature of the crisis has come as a surprise to some. A few years ago as we witnessed an increasing divergence of growth rates between advanced and emerging economies (see chart below) there was much talk about the “decoupling theory”. While for many decades advanced economies and emerging markets had displayed very similar growth rates, after the mid-90s, partly driven by the fast growth rates of the largest emerging countries, there was an increasing gap between the two.  It was this increasing gap that led to the "decoupling theory" and the assumption that a slowdown in advanced economies would not affect emerging markets.

Why is this recession global? Why is it that problems originating in some (not even all) of the advanced economies that were on a path of unsustainable spending, current account deficits and asset price bubbles has spread everywhere? How can it be that countries that prior to the crisis had a current account surplus, limited appreciation in asset prices, no subprime mortgages are also being dragged into a recession?

The global nature of the current recession is clearly a consequence of the increases in trade and capital flows that we had witnessed in previous decades. But, more importantly, it is also a reminder that imbalances (such as current account imbalances) always have two sides. When adjustments are needed they require changes not only in countries with deficits but also in those with surpluses. In fact, under some circumstances, the changes can be as dramatic for those who were seen as the cause of the problem (the countries with a deficit) than for those who seemed to be doing everything right.

Here is the intuition: Let’s split the world into countries with current account deficits (the ”spenders” (US)) and countries with current account surpluses (the “producers” (Germany, Japan, China)). The countries with deficits were, of course, financing their excess spending by borrowing from those who had a surplus. At some point, the countries with a deficit realize that they are not as rich as they thought and they are forced to cut their spending. They were the ones with a problem, with an imbalance to solve but what happens to the “producers”?Clearly they will see the demand falling for their products (their exports). What is interesting is that, under some circumstances, they might see a drop in GDP which is as large as the countries that “were in trouble”. In fact, and what might look like a contradiction, it is likely that the larger the initial imbalance, the more the countries with a surplus will suffer, in terms of GDP (think about an extreme case where the spending countries do not produce anything, all the fall in GDP will happen in the producing countries). So for the countries with large current account surpluses, their apparent position of strength before the crisis has turned against them when the crisis takes place and they might see larger drops in GDP than the countries that started with a deficit.  In addition, if their exports were in goods that are highly cyclical (durable goods, cars, equipment, IT), the effect can be even more dramatic, and this is an important factor for Japan, Germany or some of the Asian exporters. Finally, how much of the necessary adjustment of spending in the US will fall on imports versus domestic goods will be a function of the exchange rate.

Let me be clear that this does not mean that the countries that started with a deficit are not suffering the consequences of the crisis, what I am looking at here is the evolution of GDP, a measure of production. What we have is a very different pattern of adjustment when it comes to spending or consumption. In a country like the US we have consumption falling at a rate similar to GDP while in countries like Germany or Japan, consumption is not falling that much. So if we take the perspective of consumers we can say that consumers in Germany or Japan are not feeling the pain of the recession as much as the Americans. But when we look at GPD and because of the collapse of their exports, German of Japanese GDP are expected to contract at a similar or even faster pace than in the US (the most recent IMF forecasts for 2009 are -5.8% for Japan, -3.2 for the Euro area and -2.6% for the US).

In summary, generating current account surpluses and accumulating reserves as protection against the possibility of a future crisis cannot be seen as a a guarantee against a global recession, especially if it is caused by the need to adjust global imbalances. The accumulated savings will serve as a buffer to avoid a fall in domestic spending but we might still see a significant slowdown in GDP growth or even a recession. 

Antonio Fatás

CNBC Interview on monetary policy

Ilian on monetary policy in the US and Japan (aired on Tuesday March 17th, CNBC)

Euro countries: missing their old currencies? Maybe not.

The current financial crisis is the first real test that the Euro area has faced since its launch in January 1999. While the idea of sharing one currency sounds very good from the perspective of lowering transaction costs and uncertainty, it comes with a cost. There is always the fear that individual members will not be able to cope with recessions as they have lost their ability to decide on their monetary policy (and the exchange rate).

For some, the current crisis is already showing the large costs of sharing a single currency. In a recent column, Paul Krugman argues that for a country like Spain, the fact that they do not have their currency and they cannot simply devalue it to get out of the current recession means that they will endure a bigger pain over the coming years. Some go further and forecast that several countries will soon leave the Euro area.

The economic logic behind these arguments is standard and one can find it in any macroeconomic textbook: facing a recession, monetary policy needs to be aggressive (lower the interest rate) which is likely to lead to an exchange rate depreciation. Both the lower interest rate and the depreciated currency increase the demand for domestic goods and allow the economy to escape the recession faster.

 Let me question this logic and argue that a country like Spain would be in a much more difficult situation if it still had its own currency (the Peseta). Just to be clear, this is a difficult debate (whether sharing a common currency is good or bad) and there is a very large academic literature out there that I will ignore in this note (apologies). My goal is simply to share a few facts and arguments supporting the common currency arrangement.

 Let’s first think about what the Spanish Central Bank would be doing if they still had power over their interest rate. It is unclear that they would be choosing a lower interest rate than the ECB has chosen. In fact, according to the IMF GDP growth forecasts, the Spanish economy is expected to grow at rates which are almost identical to those of the Euro area as a whole, it is therefore unclear that the Spanish economy needs an interest rate which is different from that of the Euro area (of course, we can argue that the ECB is not choosing the right interest rate and the Bank of Spain would be better at it, but that’s a very different argument).

GDP Growth Rates

	Spain	Euro
2008	1.2	1.0
2009	-1.7	-2.0
2010	-0.1	0.2

Source: IMF World Economic Outlook

But what about the exchange rate? Wouldn’t it be nice if Spain could devalue its currency to boost their exports? Maybe, but it is unclear that this would translate into a stronger GDP growth and it could have damaging long-term consequences. Some anecdotal evidence: a country like the UK is “lucky” enough to have the Pound. In fact the Pound has depreciated very strongly relative to the Euro and the US dollar. This means that the UK economy should benefit from this and be able to escape the recession faster, right? Well, the IMF forecasts for the UK economy are marginally worse than for the Euro area (or Spain). I am aware that there are many other factors to consider and that this is not a (scientific) proof that exchange rates are not powerful, but I think that the numbers make clear that the assumption that a depreciating currency is powerful macroeconomic stabilization tool should be, at least, questioned. Another interesting case is the US where despite the fact that they have their own currency, the currency has appreciated in recent months and following the logic above this should be hurting the US economy rather than helping it (i.e. even if you have your own currency, it might move in the “wrong” direction).

GDP Growth Rates

	UK
2008	0.7
2009	-2.8
2010	0.2

Source: IMF World Economic Outlook

Finally, if Spain still had their own currency and the currency had depreciated, we would have likely observed two very damaging outcomes in financial markets. First, the Spanish government as well as some of the Spanish multinational companies and banks would have seen their foreign-denominated liabilities explode because of the depreciation of the Peseta (as it is likely that they would have been borrowing in foreign currencies in previous years). In addition, when issuing new debt Spain would have faces a much higher interest rate. The Spanish government is already facing today an interest rate that is about one percentage point above the one, faced by the German government. This is all because of the fear of default; there is no uncertainty with respect to the value of the currency (both of them are denominated in Euros). If the bonds were denominated in the Spanish currency, it is very plausible that this differential would be even higher.

So having the King of Spain (or the Queen of England) printed on your bank notes is, for some, a strong sign of independence and of your ability to decide on your own destiny. But how much can a depreciation of these pictures of the King or the Queen help us getting out of a recession is much less obvious when one looks at the data.

Antonio Fatás

Will there be hyperinflation in the US?

Often in discussions of the policy actions undertaken by the Fed in response to the financial crisis a concern is raised that the massive injections of liquidity will create inflation and even hyperinflation in the near future. This concern is based on the assumption that the money created by the Fed will translate at some point into purchasing power that will put pressure on prices to go up. Indeed from September 10, 2008 to December 31, 2008 the monetary base in the US – i.e. a narrow measure of money supply controlled by the Fed – has doubled from about $840 billion to over $1.68 trillion. In normal circumstances, this increase in the base will create too much liquidity in the system, which will increase lending, spending, and inflation. In the current environment, however, this is not happening. The money created by the Fed is stored in banks’ vaults (or technically, kept as deposits in the Fed). As a result, there is almost no increase in broader measures of money.

The graph below illustrates this quite vividly: Banks are required to keep a certain amount of deposits as cash in their vaults or as deposits in the central bank. It is in their interest to keep as little cash as possible because by not lending the money they lose the opportunity to earn interest. In normal times the US banking sector keeps about $2 billion in excess reserves (the dark blue area is hard to see before September 15, 2008) – i.e. cash above and beyond of what is required by regulators. In the post-Lehman six months the excess reserves have ballooned from $2 billion to over $600! In mid-March, the commercial banking sector in the US was required by law to keep about $57 billion dollars in reserves (light blue area), but the actual reserves are $670 billion.

In fact this graph shows why liquidity creation does not create inflationary pressure, but it also shows the biggest problem in dealing with the crisis: the lack of lending. We have seen this kind of piling up of reserves in a couple of other episodes – the Great Depression and the long slowdown in Japan in the 1990s and early 2000s.

What if banks start lending? Won’t this create inflation? If the Fed realizes that the money that they have injected in the economy creates inflationary pressures (i.e. lending resumes), then they can slowly or quickly (it is their choice) mop up the excess liquidity. They can do this in several ways – by closing down some of the newly created lending facilities or by a straightforward and simple increase in interest rates (and open-market operations). Will it work? It did in Japan. The next chart shows the near-doubling of the monetary base during the quantitative easing from 2002 to 2006. As the quantitative easing came to an end because the economy started growing and lending resumed, the central bank promptly withdrew the excess money and thus avoided the rise of inflation.

Ben Bernanke has made it clear several times that the increase in liquidity is only temporary and it can be promptly reversed to avoid inflation. If economic growth resumes and banks start pushing this liquidity to consumers and firms, there is little doubt that the Fed will react promptly to reduce the risk of inflation.

Ilian Mihov

More on macroeconomic imbalances and the current recession

As a follow up to our earlier entry in this blog, the US Federal Reserve released today the flow of funds accounts of the United States (you can find the release here). These data provide an overview of the assets and liabilities of both the private and public sector in the US. The data reveals that all the increase in wealth that households had experienced over the 2002-2006 period is gone. In fact, the ratio of household wealth to GDP has gone down to a level which is consistent to the historical average (somewhere around 350%), very far from the peak of 2007 of 450%. The (perceived) increase in wealth in the 2003-2006 period was one of the factors behind the increased in US spending, consumption in particular, that we have documented in our earlier entry. If you want to know more, the blog calculated risk has a detailed note on this issue. You can find their chart of household wealth to GDP here.

Antonio Fatás

The IMF and the financial crisis

After several years in which very few countries went to the IMF (International Monetary Fund) to request funding, the current financial crisis has reversed this trend and the IMF has already come to the rescue of several countries that could not find the necessary funds anywhere else (Iceland, Hungary...). As the crisis spread to more emerging countries it is very likely that we will see more of them knocking at the IMF's door. The IMF has boosted its resources with a $100 billion loan from the Japanese government and today Timothy Geithner has proposed expanding the IMF's capacity to borrow to $500 billion. 

If you are interested in reading more about the IMF role I recommend that you visit their web site on the Financial Crisis where they talk about their programs but they also present their views on their crisis. Very useful if you are interested in emerging markets. 

Antonio Fatás

P.S. This academic year I am on sabbatical from INSEAD and spending some of my time at the Research Department at the IMF, a great source of content and inspiration for this blog. 

Macroeconomic imbalances and the current recession

While there is no doubt that the current recession is fundamentally linked to excesses in financial markets and asset prices, there were still some classic macroeconomic imbalances that preceded the crisis. For years we have been talking about global imbalances and how certain advanced economies (the US in particular) were building large deficits. A current account deficit is simply a measure of the difference between spending and income for a country. The source of spending can be many (government, companies – in the form of investment- or consumers). In the case of the US, consumption grew to levels that we had never seen before. The chart below displays household consumption as a ratio to GDP for the US and four other advanced economies.

This is a ratio that we expect to be fairly constant for a country with stable growth rates (as it is the case for these economies). In fact, in the cases of Germany, France and Japan, consumption remains fairly stable during the sample, as we expect. It is true that in the case of Japan we see the ratio increasing in the 70s but this has an explanation: as convergence in living standards materializes, the country’s saving rate goes down from the very high rates of previous decades; rates that were needed to sustain the very high growth rates of Japan in the 50s and 60s.

The US, and to a much smaller extent the UK, have seen consumption increasing at rates much faster than GDP for the last two decades. In the case of the US the ratio reached a peak of almost 72% in 2007. How could this trend be justified? For this number to go up, a combination of these things should happen:  

• Lower taxes (current or future) that increase disposable income
  
•  Expectations of larger future income (through faster productivity growth
  
•  Related to the previous one, expectations of more productive investment which reduces the need to save and invest to generate the same amount of future income
  
•  A demographic transition that makes the future (income or wealth) look “better” than the present. 
  

While one can always debate about whether some of these assumptions were reasonable during the last decades, overall one finds more arguments that go in the opposite direction and might have justified a lower consumption rate. An aging population and a growing government debt make the future look worse than the present. If any, there is the need to increase saving (i.e. reduce consumption). In terms of productivity growth while the 90s looked good, there is no consistent signal that productivity growth is accelerating dramatically in the US or UK economies.

How can it be that in the light of such strong evidence of a macroeconomic imbalance very little was done about it? During those years asset and housing prices were booming and this was used as a justification for the consumption increase: as a ratio to wealth (not income or GDP), consumption was not growing that fast. Of course, for this to be true those asset prices had to be sustainable and this could only happen if one of the arguments above was true (for housing prices to remain as strong as they were before the current crisis one had to assume very high future demand for houses because of large income or population increases).

Today’s perspective is, of course, very different as asset prices have collapsed and consumption looks also very high relative to wealth; it is clear that these imbalances need to be addressed. Unfortunately, this is the wrong time to address such an imbalance. In the middle of a deep recession, economic policies work to stimulate consumption, not depress it.  If consumers starts saving now they will make the recession even worse and this will reduce income and wealth even further, a recipe to make the adjustment even more difficult. No surprise that policy makers, such as Larry Summers today in an interview with the FT, are making the arguments that this is not the time to save. Point taken but let’s make sure that when we are out of the recession we look back at this chart and make a conscious decision to avoid these growing imbalances reappear again in the future.

Antonio Fatás

The Great Wall: Institutions and Growth

We just published a short note in the most recent issue of Harvard Business Review about our research on the link between institutions and growth. In recent years, economists have emphasized the link between institutions (both economic and political) and economic growth. The chart below shows that there is indeed a strong link between the quality of institutions (on the vertical axis and as measured by governance indicators produced by the World Bank) and income per capita (horizontal axis). What is more interesting is that the relationship is weak for low levels of development and it only becomes strong (and positive) for higher levels of income per capita. 

Our interpretation is that countries can grow fast at low levels of income per capita even if the quality of their institutions is not high (and China could be an example). But once you get to levels of income per capita around $12,000, it is impossible to grow unless institutions improve. We call this level "The Great Wall". We have seen in the past countries approaching this level of development and getting stuck because of the lack of proper institutions ("they hit the wall"). Only countries that improve their institutions manager to join the ranks of rich economies ("they climb the wall"). 

We elaborate these thoughts on a teaching note (it is not an academic paper) that we have posted on our web site. The HBR article can be found on their site.

Antonio Fatás and Ilian Mihov

When you hit the panic button buy some US dollars

It looks as if today will be another difficult day for financial markets as AIG just announced the biggest loss in history ($61.7 billion for the last quarter of 2008). As markets in Asia and Europe opened with significant loses, the US dollar has climbed against all other major currencies. At $1.26 per Euro is back to the level it reached in November and December 2008 when financial markets were close to collapse.

What this crisis has shown us is that the US dollar remains the currency of choice for investors when panic reaches financial markets. Over the last months we have witnessed an interesting negative correlation between the daily performance of the US stock market and the dollar. In days where the stock market does poorly, the dollar tends to gain relative to other currencies, a sign that there is a flow towards US dollars when uncertainty increases and bad news spread.

The recent appreciation of the dollar stands in contrast to what we had seen in the run up to the current recession. The US dollar had depreciated heavily relative to the Euro and reached a minimum of about $1.6 to the Euro. The depreciation of the US dollar was seen as the way for the US to rebalance the deficit in the current account as imports became expensive and US goods improved their competitiveness.

It is interesting that after the crisis becomes evident in the Spring of 2008 and when the US current account deficit has not improved that much, the US dollar starts reversing course and appreciating. Also, this trend has been very much ignored by policy makers on both sides of the Atlantic. From the perspective of the US, the appreciation of the dollar at the time that the US government is engaging in a massive fiscal stimulus cannot help. Increased spending in the US will only help the US economy if it translates into purchases of US goods. If all the increase demand goes abroad, the rest of the world will be very happy but the fiscal stimulus will have limited effect on the US GDP.

Of course, one can argue that the current depreciation of the US dollar is bringing it back to “fundamental” levels (closer to what purchasing power parity tells us), but I am not sure the capital flows that are moving the exchange rate are motivated by these arguments.

How long will the US dollar remain the currency of choice in times of uncertainty? How long will foreigners be willing to hold US assets that pay a very low interest rate? There is no doubt that the future evolution of the US economy relative to other countries will be a key factor to answer these questions. Until then, and as we are seeing today, confidence and a long history of being the world reserve currency will determine capital flows and the value of the US currency in difficult and uncertain times.

Antonio Fatás