Monday, November 24, 2014

Is 0% growth for 90% a successful economic model?

Via Greg Mankiw I read the review of Piketty's book by Deirdre McCloskey. The review reminds me of the conversations I have in my class when I bring up the issue of income inequality. While most people express initial concerns about recent trends of increasing inequality, there tends to be a negative reaction about accepting that this is indeed a failure of our current economic model and most become very defensive when that argument is being made.

I do not want to discuss the details of the review but more the overall message. The review presents a strong defense of capitalism relative to alternative economic models potentially proposed by the "left". Very few, including Piketty, would disagree with the merits of capitalism. The fact that all advanced and prosperous economies have reached their current level of income by relying on markets, the fact that the fastest growing emerging markets are those that move closer to that model and by doing so are able to lift a large percentage of their population from below poverty levels, all speak up in favor of the power of markets and incentives to unleash growth.

But the debate cannot end up there. The success of capitalism as an economic model does not imply that we should accept current outcomes and that we should not discuss alternative models that, in comparison to other economic paradigms, might all look very similar but they could produce very different distributions of income. What Piketty and others have done is to raise awareness that since the early 80s, the economic model that we call capitalism has generated an outcome that is different from the one we had seen in the previous decades and that this outcome, in some countries, resemble what we saw before the Great Depression.

While we can debate the exact magnitude of these changes, it is clear that the strong correlation between productivity and wages has weakened over these decades. It is also clear that income growth has been going to a small part of the population, those with the highest earnings. And for a large majority of the population, income stopped growing (or started growing at a much slower rate). [On a technical matter: yes, we can discuss whether national income or GDP are capturing all the increases in welfare of the average citizen, but that discussion can go in both directions and to be fair we should also apply it to the earlier decades (if we believe that GDP growth underestimates welfare growth)].

Here is how I try to challenge the thinking of my students when I discuss income inequality. We all agree that the current economic model has allowed the income of many Americans to increase at a rate close to 2% for more than a century based on continuous productive accumulation of capital and innovation, an amazing success. But how would we think about the same economic model if this rate of growth slowed down and was very close to 0%? This would represent a big change in the economic outcome and would, for sure, raise concerns about why the model is failing to deliver relative to our expectations (that is the argument we use to call alternative models, like those of planned economies, a failure).

While it is true that GDP per capita growth has remained in line with historical experience over the last decades, the income of a large % of US households has either stopped growing or is growing at a rate much closer to 0% than to 2%. So if 0% growth for 100% of the population would represent a failure, what about 0% growth for 90% of the population? Regardless of how well capitalism has performed in the past, we need to open for a debate on the merits and outcomes of such a model that takes into account how the income and wealth that it generates gets distributed. There is no just one form of capitalism, there are many. Current tax rates, regulations are not set in stone and they are very different from what they were during many periods of the recent economic history so a debate on how inequality trends reflect on the successes and potential weaknesses of the current model is not only a healthy one but one that is needed.

One more comment regarding McCloskey's review. While I said I did not want to go into the details of the review, there was one that I found very surprising. The review argues that while income inequality might have increased, consumption inequality is a lot lower. One of the reasons is that the actual consumption of those who own six houses is not that different from those who own one as you can only live in one house at a time. That's an odd argument. If taken seriously it provides support from those on the "left" who argue for very high levels of taxation for the rich. Let's tax 100% of the value of those 5 extra houses given that they are not providing any consumption or welfare to those who own them.

Antonio Fatás

Thursday, November 20, 2014

Macroprudential policy and distribution of risk

There is very little doubt that housing prices and leverage played a strong role in the global financial crisis that started in 2008. As the effects of the crisis disappear many countries still struggle with the fear that the dynamics of household debt and leverage resemble those of the pre-crisis period (e.g. Sweden).

While I am sympathetic to the idea that increased leverage and debt increases risk, I am less convinced by the theoretical justifications that are commonly used. Typically, there is an assumption that leverage and debt are associated to the notion of "living beyond our means", which makes this behavior and unsustainable. This is not correct and there are plenty of subtleties that should not be ignored that are related to distributional issues.

Let's keep things simple. Imagine a world where the stock of housing is not going to change (we have enough houses for everyone). And imagine no population growth either (we do not need more houses). In this world, someone needs to own the assets, either those who live there or those who rent them to others. Imagine there is some utility that we all derive from owning our place. So if you ask me to choose between owning and renting assuming the financial cost of both is the same, I would rather own a place.

Initially, there are some people who rent their house because they do not have access to enough credit to buy a property. This requires that someone out there owns property and is happy renting it to others. Let's now change the access to credit of some of the constrained households. Either because changes in financial regulation, interest rates or simply because of economic growth, more households have access to mortgage financing. We expect to see an increase in the purchases of houses by tenants, an increase in the price of housing and an increase in the amount of leverage. Realize that the households that are buying houses are not living beyond their means. They are simply buying a good (the ownership of the house) that they did not have access to before. Their wealth (i.e. "equity") has not gone down, only their leverage has increased. So they are not living beyond their means, they simply hold more wealth in assets that is backed by the debt they now have access to. [There will be as well other general equilibrium effects that I am ignoring it].

How much macroeconomic risk does it represent the increase in debt and leverage? It all depends on how close these new households are to being financially constrained. If now there is a shock that reduces their income and housing prices, they might find themselves financially constrained and possibly bankrupt. This risk could be related to the increase in the level of debt prior to the shock but it does not need to be. What really matters is not the aggregate level of debt but the % of households that are now in a riskier position because they hold an illiquid asset whose price might change. To assess this risk we need to know something about the distribution of income, wealth and risk. In the aggregate, if there is a shock, the change in wealth associated to a decrease in housing prices is always the same. But what matters is who owns those assets. Is it those who have access to funding or those who are at the edge of being financially constrained? It might not be unreasonable to assume that as debt and leverage increase, it is mostly due to increases happening at the margin (those with lower financial resources) but it does not always need to be the case.

There are plenty of other examples one could make to reach a similar conclusion (housing prices grow because of changes in population, move to cities, increases in ownership of a second house, reduction in the size of household,...).

In summary, this is what I learn from this and other similar examples;

1. Debt should not always be equated to living beyond our means. It could be if the borrowing goes straight to consumption spending but when it goes to purchases of assets, in particular housing, the real issue is one of leverage and potential risk.

2. Leverage through acquisitions of assets can add risk to a household as long as we believe that the prices behind those assets are risky (and more so if we already know they overvalued). Understanding the fundamental driving forces behind the changes in asset prices is a must.

3. While leverage can increase macroeconomic risk, it can also be a sign of economic development. As countries develop leverage tends to increase because of increased sophistication and size of financial markets (this is what economists called financial deepening). This is normally seen as a positive development.

4. The macroeconomic risk of increased debt and leverage depends on the distribution of income, wealth and asset purchases. While the overall risk could be related to the aggregate amount of debt and leverage, the relationship is a lot more complex than that. Macro prudential policies need to be sophisticated and incorporate distributional issues in their assessments. One more reason why understanding the distribution of income and wealth is important.

Antonio Fatás

Sunday, November 16, 2014

German economic policy and chameleons

Wolfgang Munchau's FT article today is one of the most complete explanations I have seen about the origin and contradictions of the German economic orthodox dogma. The only issue that he does not address is how these economic views have survived over time despite the increasing evidence that their advice does not deliver the expected results.

Here is my guess from what I have learned from many heated discussions over the last years about economic policy in Europe: the resilience (stubbornness) of this view on economic policy comes from a combination of faith and the inability of the economic profession to apply enough real world filters to models.

Faith in a certain economic model comes from many years of being trained about the beauty of markets and all the inefficiencies that governments generate. But faith also comes from the belief that only through (individual) hard work and sacrifice (saving) one can achieve any economic progress. In this world (what Wolfgang Munchau refers to as Germany's parallel universe) there is no room for an economic crisis caused by lack of demand. Recessions only take place as a result of misbehavior, debt and lack of willingness to work hard (and reform). The only way to get out is to behave.

But faith alone might not be enough, policy makers and their advisors are required to look at the data and check how their priors allow them to understand economic outcomes. Here is where the economics profession and its ability to hide under economic models that have little empirical relevance provide the necessary support. A recent paper by Paul Pfleiderer about the misuse of theoretical models in finance and economics explains this logic very well. Many economic models are used in ways that make them "chameleons", they do not go through any real world filter and they fight back their criticisms with the argument that "the empirical-test jury is still out". In other words, we start with unrealistic assumptions, we generate a result that fits what we are looking for, we do not find evidence to support it but we can always claim that the evidence cannot conclusively reject the model either and we continue using the model for our economic policy advice.

So it is faith and the use of "chameleon" models that keeps the stubbornness of the German economic policy advice alive in Europe. And while this is going on, the Euro fatigue and discontent in many European countries keeps growing and polarizing the political landscape. The next round of elections will be an interesting test for the Euro/EU project.

Antonio Fatás

Sunday, November 9, 2014

The false rhetoric of (Euro) victims and offenders

Hans-Werner Sinn has written a new book with an analysis of the causes and potential solutions of the Euro crisis: "The Euro Trap: on Bursting Bubbles, Budgets and Beliefs". I have not read the book yet but I just went through a video of the presentation he made about a month ago at the Peterson Institute for International Economics. The video of the presentation as well as a transcript are available at the PIIE web site.

For those who have followed the writings of Hans-Werner Sinn there should be no surprise in the presentation. His views are very consistent and they put most of the emphasis on the price imbalances that were built prior to the crisis (the periphery becoming uncompetitive, interest rates being too low). These imbalances partly supported unsustainable growth that hid the need for structural reforms that were badly needed. His analysis of the crisis years is very similar: bailouts from the ECB and others, not enough austerity have also supported governments in their actions to avoid  reform.

After Sinn's presentation, Fred Bergsten provides some insightful comments. He gives credit to the book as it highlights some of the weaknesses among Euro countries (it is hard to disagree with the view that reforms move very slow in Europe and that government will find any excuse to slow them even further). But Bergsten also provides very critical comments about Sinn's view of the crisis and its solutions. I like in particular Bergsten's emphasis on the economic benefits that Germany has derived of the creation of the Euro area. He goes as far as saying that Germany is possibly the only country that has so far benefitted from the Euro (going against the German conventional wisdom of who are the winners and the losers of EMU).

One of the issues that Bergsten does not bring up enough is the misplaced (in my view) emphasis that Sinn puts on relative prices and competitiveness. The idea that in periphery countries the cost of production became too high and unsustainable and that it now requires deflation in the periphery (and some inflation in Germany) is a constant argument in Sinn's presentations. But the data does not fully support his views. It is not that relative prices do not matter, but they do not matter as much as he claims and I would go as far as saying that they are not a central part of the pre-crisis or post-crisis experience of Euro members.

Here is a quick chart to support my views. This is the value of goods exports (data originally in in billions of US dollars, from the OECD) for Germany, France and Spain since the Euro was launched. Data is rebased so that it equals 100 in 1999Q1.

It is hard to see in this chart the story of the periphery (Spain) high prices reducing growth via lack of competitiveness (before or after the crisis). Even compared to Germany where we know that there was a significant internal devaluation via very low nominal wage growth, exports in Spain grew at a similar speed before the crisis and faster than in Germany. Yes, the current account in Spain was on an unsustainable trajectory but it was caused by capital flows supporting excessive imports.

Then, why the insistence on prices? Because it fits well the rhetoric of misbehavior that led to the crisis. Under this view, countries belong to one of two groups: the victims and the offenders. And it explains everything: the differences between the savers and the borrowers, the ones who reform and the ones who never do, the ones who control debt and the ones that just let it increase, the ones where workers are reasonable and they accept lower living standards and the ones where they are not and want to live beyond its means. Reality is more complex than that, countries do not always belong to the same side of these imbalances, some imbalances are not central to explain the crisis and all imbalances have two sides to them.

Antonio Fatás