Counting backwards to the next recession

In most advanced economies business cycles can be well characterized by a succession of long expansion phases that are interrupted by short recessions. Given this pattern it is sometimes natural to think about the length of expansions as a key feature that describes the business cycle. While other variables matter (such as the depth and length of recessions), in the case of the US and to some extent in the case of European countries, the parameter that has changed the most across cycles is the length of the expansion phase.

In the case of the US (using the NBER business cycle dates), in the post-WWII period expansions have lasted from 12 months in the expansion ending in 1981to 120 months in the expansion ending in 2001. The current expansion is already 77 months long, longer than the previous expansion of 2001-2007.

While counting months is not a good way to forecast the timing of the next recession it is at least a reminder that there is another recession waiting for us in the not-so-distant future. And when we start counting backwards to the next recession a key questions is whether we will be ready for it. In particular, will monetary policy be back to normal and able to react to it?

Interest rates have not yet moved away from zero in either Europe, the U.S. or Japan. This is, of course, very unusual given the length of the expansion. Another way to see how unusual monetary policy and interest rates look like is to plot the difference between long-term rates and the central bank rate.

For the case of the US we can see that this difference (the term premium) has stayed very high since the 2008-09 recession. Unlike in previous expansion where after two to four years the term premium started declining (mostly through increases in the short-term rate), in this case the number remains unusually high. 

There is a positive reading of the chart that suggests that we are far from the next recession. Under the assumption that the term premium has to get very close to zero before a recession happens, it will take a while before we see the next one. But that reading ignores the fact that today short-term rates are not normal, they are stuck at the zero lower bound. Recessions do not happen because the term premium decreases, recessions happen for other reasons and it happens to be that the term premium moves with the cycle. But this expansion is not like the others because of the constraints on short-term rates so it might possibly be that the difference with long-term rates will this time be a really bad indicator of how close we are to a recession.

And this second reading the chart reminds us of the risk that we are facing if the next recession is somewhere in the near future and monetary policy has not had the time to go back to normal, to go back to levels of short term rates that allow for a decrease in these rates that is consistent with what we have seen in previous recession. And entering the next recession in Europe or the U.S. with interest rates that are too close to zero does not sound like a good idea and in addition there is a lot of uncertainty given that we have not seen such a case in the recent business cycles. 

So in addition to all the reasons why we want economic conditions and monetary policy to quickly go back to normal, there is an additional sense of urgency from the scenario that in the near future there is either a domestic or global event that causes the next recession. So in a world with very low interest rates central banks and government need to look forward and make sure that planning for the next recession is part of their strategy to ensure the fastest possible recovery from the previous one.

Antonio Fatás

The missing lowflation revolution

It will soon be eight years since the US Federal Reserve decided to bring its interest rate down to 0%. Other central banks have spent similar number of years (or much longer in the case of Japan) stuck at the zero lower bound. In these eight years central banks have used all their available tools to increase inflation closer to their target and boost growth with limited success. GDP growth has been weak or anemic, and there is very little hope that economies will ever go back to their pre-crisis trends.

Some of these trends have challenged the traditional view of academic economists and policy makers about how an economy works. Some of the facts that very few would have anticipated:
- The idea that central banks cannot lift inflation rates closer to their targets over such a long horizon.
- The fact that a crisis can be so persistent and that cyclical conditions can have such large permanent effects on potential output.
- The slow (or inexistent) natural tendency of the economy to adjust by itself to a new equilibrium.

To be fair, some of these facts are not a complete surprise and correspond well with the description of depressed economies that have hit the zero lower bound level of interest rates because of deflation or "lowflation". We had been warned about this by those who had studied the Japanese experience: both Krugman and Bernanke, among others, had described these dynamics for the case of Japan. But my guess is that even those who agreed with this reading of the Japanese economy would have never thought that we would see the same thing happening in other advanced economies. Most thought that this was just a unique example of incompetence among Japanese policy makers.

Now we have learned that either all central bankers are as incompetent as the Bank of Japan in the 90s or that the phenomenon is a lot more natural, and likely to be repeated, in economies with low inflation, more so when the natural real interest rates is very low.

But if this scenario is more likely to happen going forward it might be time to rethink our economic policy framework. Some obvious proposals include raising the inflation target and considering "helicopter money" as a tool for central banks. But neither of these proposals is getting a lot of traction

My own sense is that the view among academics and policy makers is not changing fast enough and some are just assuming that this would be a one-time event that will not be repeated in the future (even if we are still not out of the current event!).

The comparison with the 70s when stagflation produced a large change in the way academic and policy makers thought about their models and about the framework for monetary policy is striking. During those year a high inflation and low growth environment created a revolution among academics (moving away from the simple Phillips Curve) and policy makers (switching to anti-inflationary and independent central banks). How many more years of zero interest rate will it take to witness a similar change in our economic analysis?

Antonio Fatás

GDP growth is not exogenous

Ken Rogoff in the Financial Times argues that the world economy is suffering from a debt hangover rather than deficient demand. The argument and the evidence are partly there: financial crises tend to be more persistent. However, there is still an open question whether this is the fundamental reason why growth has been so anemic and whether other potential reasons (deficient demand, secular stagnation,…) matter as much or even more.

In the article, Rogoff dismisses calls for policies to stimulate demand as the wrong actions to deal with debt, the ultimate cause of the crisis. As he argues, given that government expenditures have kept expanding (he uses the number for France at 57% of GDP) it is hard to argue in favor of more spending.

But there is a perspective that is missing in that logic. The ratio of debt or government spending to GDP depends on GDP and GDP growth cannot be considered as exogenous. Assuming that the path of GDP is independent of the cyclical stance of the economy does not sound reasonable but, unfortunately, it is the way most economists think about a crisis. A crisis is seen as a temporary deviation of output but the trend is assumed to be driven by something else (innovation, structural reforms,..). But that logic runs contrary to evidence on the way investment and even R&D expenditures behave during a crisis. If growth is interrupted during a crisis output will never return to its trend. The level of GDP depends on its history, what economists call hysteresis. In that world reducing the depth of a crisis or shortening the recovery period has enormous benefits because it affects long-term GDP.

[To be fair to economists, we are all aware of the persistent dynamics of GDP, but at the theoretical level we tend to explain it with models where the stochastic nature of the trend is responsible for the crisis itself rather than assuming that other factors caused the crisis and the trend reacted to them.]

In a recent paper Olivier Blanchard, Eugenio Cerutti and Larry Summers show that persistence and long-term effects on GDP is a feature of any crisis, regardless of the cause. Even crisis that were initiated by tight monetary policy leave permanent effects on trend GDP. Their paper concludes that under this scenario, monetary and fiscal policy need to be more aggressive given the permanent costs of recessions.

Using the same logic, in an ongoing project with Larry Summers we have explored the extent to which fiscal policy consolidations can be responsible for the persistence and permanent effects on GDP during the Great Recession. Our empirical evidence very much supports this hypothesis: countries that implemented the largest fiscal consolidating have seen a large permanent decrease in GDP. [And this is true taking into account the possibility of reverse causality (i.e. governments that believed that the trend was falling the most could have applied stronger contractionary policy).]

While we recognize that there is always uncertainty when estimating this type of macroeconomic dynamics using one particular historical episode, the size of the effects that we find are large enough so that they cannot be easily ignored as a valid hypothesis. In fact, using our estimates we calibrate the model of a recent paper by Larry Summers and Brad DeLong to show that fiscal contractions in Europe were very likely self-defeating. In other words, the resulting (permanent) fall in GDP led to a increase in debt to GDP ratios as opposed to a decline, which was the original objective of the fiscal consolidation.

The evidence from both of these paper strongly suggests that policy advice cannot ignore this possibility, that crises and monetary and fiscal actions can have permanent effects on GDP. Once we look at the world through this lens what might sound like obvious and solid policy advice can end up producing the opposite outcome of what was desired.

Antonio Fatás

Savings glut and financial imbalances

Martin Wolf in today's Financial Times discusses the reasons for low interest rates and suggests some interesting scenarios for the years ahead. I agree with most of what he says but I have doubts about the role that he assigns to central banks.

Let me start with the arguments with which I agree 100%. The logic of the Bank for International Settlements that low interest rates are the outcome of central banks managing to keep interest rates artificially low for decades is "wildly impossible". And the main reasons are that we have no economic model (or evidence) that suggests that central banks are able to manipulate real interest rates for decades and we do not either have any model (or evidence) that supports the idea that a central bank policy of low interest rates will not generate substantial inflation.

As Martin Wolf argues, any explanation for low interest rates has to start with some version of the savings glut hypothesis. Economic, demographic and social changes have expanded the desire to save among a significant portion of the world economy and this has kept interest rates low. This is an explanation that is consistent with any economic model that has an intertemporal dimension built into it and there is plenty of evidence that supports it.

What is the role of monetary policy in this story? Martin Wolf believes that because of the increase in desire to save in the world, central banks

"in seeking to deliver the monetary conditions needed for equilibrium between savings and investment at high levels of activity, the central bank has to encourage credit growth"

Here is where I am not sure I follow Martin's argument. Why do central banks have to encourage credit growth? The fact that there is a savings glut that puts lower pressure on interest rates already means that somewhere in the world there will be an increase in credit/borrowing. There is no need for central banks to encourage credit. We can talk about whether central banks could have discouraged it, whether they had the tools and whether it was within their mandate, but there is no need to have central banks driving the process of credit growth to make the story consistent with what we have observed.

What makes the description of the dynamics of interest rates and financial flows that result from a savings glut difficult is the fact that we need to understand heterogeneity among economic agents (individuals, companies, governments). And this heterogeneity, combined with a regulatory framework that is limited, can drive dynamics that are unhealthy, excessive and lead to bubbles and financial crisis.

If there is a savings glut and interest rates are coming down this is a signal for someone to borrow more. Some of that borrowing will for sure be reflected in increase leverage because it will take the form of house purchases and creation of mortgages. Within some countries (e.g. China) we might observe that while the country as a whole saves, the private sector increases its internal debt exposure and leverage because of the exchange rate policies, government demand for foreign safe assets and capital controls that are part of their financial environment. There are plenty of stories like these that are triggered by a significant change in the economic scenario (lower interest rates) that might result in the financial imbalances that lead to crisis. The same way new technologies can create bubbles and financial instability (as in the 90s), the savings glut generated new and possibly excessive behavior as economic agents adapted (and not always well) to the new equilibrium.

Martin Wolf finishes with some thoughts on what come next. This is a difficult exercise as it requires a good understanding of economic trends across all regions in the world. There are some short-term forces that are playing against the savings glut hypothesis: oil producers countries are quickly reducing their saving, in some cases turning them into borrowers. But this is more than compensated by the Euro area that has become a large saver after the borrowers (Greece, Spain,...) have brought their current account deficits to zero while the savers (Germany, Netherlands) have not changed their behavior. So interest rates are likely to stay low and the saving surplus of some countries will have to be absorbed somewhere else (although it is not clear that the surpluses will be larger than in the past). Yes, this means a "credit boom" somewhere else but this should not always be a recipe for imbalances.

What the world is missing is investment demand. The real tragedy is that investment in physical capital has been weak at the time when financial conditions have been so favorable. Why is that? Jason Furman (and early the IMF) argues that the best explanation is that this the outcome of a a low growth environment that does not create the necessary demand to foster investment. And this starts sounding like a story of confidence and possibly self-fulfilling crises and multiple equibria. But that is another difficult topic in economics so we will leave that for a future post.

Antonio Fatás 

A third scenario for stock markets

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

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

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

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

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

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

Antonio Fatás

Micromanagement of European reforms

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

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

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

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

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

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

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

Antonio Fatás

Did the IMF provide support to Syriza?

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

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

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

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

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

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

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

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

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

Antonio Fatás

Greece: negotiating without trust

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

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

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

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

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

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

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

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

Antonio Fatás

Interest rates: natural or artificial?

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

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

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

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

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

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

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

1. Interest rates are low everywhere in the world.

2. Inflation remains low everywhere in the world.

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

Antonio Fatás

The Greek Dra(ch)ma is back?

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

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

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

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

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

Antonio Fatás

Missing the anti-inflation central bankers.

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

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

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

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

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

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

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

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

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

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

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

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

Antonio Fatás

The Taylor rule conundrum

Back in February 2005 Alan Greenspan referred to the abnormal (low) level of US long-term interest rates as a conundrum:

"For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience."

A month later, Ben Bernanke, proposed the idea of a global saving glut as the main reason for low long-term real interest rates. In a world where capital markets are global, interest are determined by global forces and not by domestic macroeconomic conditions.

This behavior is also very much related to the discussion around "global liquidity" and the potential influence of monetary policy in the US on monetary policy conditions in emerging markets. The difference is that in this case we are talking about short-term rates where we typically expect more control by the central bank and a stronger correlation domestic conditions.

To illustrate this point let me use a slide from a presentation two days ago by Hyun Song Shin (BIS) at the Bank of England discussing the future agenda of central banks. The slide includes the following chart (click on it for a larger image).

The chart shows the behavior of emerging markets central bank interest rates in comparison with a standard Taylor rule. The chart shows that since 2000, central banks have set interest rates significantly below the level implied by the Taylor rule (the same behavior is also true among advanced economies although not to the same extent). If one looks carefully at the scale, interest rates are 6 to 8 percentage points lower than those implied by a Taylor rule. This would imply an incredibly expansionary monetary policy. The chart comes from a paper by researchers at BIS (Hofmann and Bogdanov) who on their discussion of this result they argue that

"This finding suggests that monetary policy has probably been systematically accommodative for most of the past decade. The deviation may, however, in part also reflect lower levels of equilibrium real interest rates that might introduce an upward bias in the traditional Taylor rule."

Monetary policy can be too accommodative when central banks follow US interest rates to avoid appreciations of their currencies. But if monetary policy was that accommodative for more than a decade we should have seen increasing inflation rates during those years. That was not what we saw, inflation rates remain stable (and even decreasing) in most of these markets. Today, where interest rates remain very low compared to those implied by the Taylor rule, we talk about global deflation, not global inflation.

So it must be that the fundamental cause must be related to lower levels of equilibrium real interest rates and these are determined by global forces (otherwise why would all countries behave in the same way). Interestingly, the deviations from the Taylor rule coincide with the period where global imbalances started.

So here is yet another interest rate conundrum, this time related to short-term interest rates. How much do central banks control short-term rates in a world where capital markets are global? How relevant is a Taylor-rule approach to analyze the appropriateness of central bank interest rates?

Antonio Fatás

Financial crisis, the Euro and the need for political union.

In today's Financial Times, Gideon Rachman discusses the flaws of the Euro and the possibility of failure. He admits that from the beginning he believed that the Euro project would eventually collapsed because

"First, a currency union cannot ultimately survive unless it is backed by a political union. Second, there will be no political union in Europe because there is no common political identity to underpin it. And so, third — the euro will collapse."

I have always been very skeptical about statements arguing that a currency union needs a political union. The political consequences of sharing a currency (the Euro area) are in many ways much smaller than the political consequences of being part of the European Union, why don't we make the same argument about the European Union? (just to be clear, some make the same argument but clearly it is much less common, as can be seen in the article by Rachman).

There are plenty of example where the European Union (EU) requires some serious political consensus: the EU requires partial transfers of sovereignty to a supranational authority when it comes to legislation, the EU has economic mechanisms that imply a significant transfer of income across countries (via its budget, the structural and cohesion funds). Then why is it that the EU does not require to be backed by a political union in the same way the Euro project does?

My view is that the request for more political union in the Euro area is not so much the result of sharing monetary policy and a currency, I think that the answer comes much more from the power and size of financial flows and how these flows create a risk that is centralized and needs to be managed through the ECB.

The current debate between Greece and others in the Euro area is not about monetary policy. While there have been disagreements about the best course for monetary policy during the crisis, the fact is that the ECB has not been "too far" from what other central banks have done, interest rates have been close to zero for years and while QE has been different from that of other central banks, it is unlikely that a US-style QE would have made that much of a difference (we are still debating how effective QE was in the US or the UK).

The real debate in the Euro area today is about dealing with a debt crisis. The real issue is that the financial flows in the period 2000-2007 established links between countries and spread a risk across all Euro members, in a way that other countries (including EU members) not part of the Euro did not see. And the creation of the Euro was instrumental for this.

The role of the Euro was twofold. First it facilitated flows across countries as exchange rate risks had disappeared and provided the illusion of no risk. Second, once the flows had taken place it created financial links between banks and governments across countries that made them exposed to the same risk. In addition, the ECB because its connections with banks became a central repository of that risk and a solution for some of the countries facing a credit crunch -- the ECB acted like the IMF in many ways.

None of this is exactly about monetary policy, even if the ECB is involved. This is about financial risk and how financial crises have painful economic consequences. When sharing a currency the risk of financial crisis and its potential solutions bring countries and governments together in a way that a political consensus seems to be necessary because transfers might be involved and because common political solutions need to be found. And while these transfers might be smaller than the ones agreed as part of the Social and Cohesion Funds of the European Union, they come as a surprise and they are uncertain (we cannot agree ex-ante on their final size). This is what makes the Euro project a much more difficult one to manage without a sense that we all belong to the same group and are willing to work on this together.

For many, the Euro was one of the projects within the much bigger ambition behind the European Union (which came with the idea of a partial political union). But the recent financial crisis has shown that the risks associated to sharing a currency when financial and sovereign crises are possible, are a lot larger than what we thought. And these risks are much larger than the risks associated to simply sharing the same currency and the same monetary policy (yes, one interest rate does not fit all but this is not the real issue this time).

If there was a way to avoid the next financial crisis I would go back to my original idea that a currency union can survive without a political union. But as long as financial flows (and sovereign debt) can potentially generate the same type of risk as in this crisis, then the Euro might not survive the next one without stronger political ties between all its members.

Antonio Fatás

Those mountains of debt (and assets)

A recent report by the McKinsey Global Institute on the increasing amount of debt among advanced and emerging markets made it to the front page of many financial newspapers yesterday (e.g. the FT). The report reminds us that in many countries debt is still going up as a % of GDP, that there is limited deleveraging. The Financial Times offers an interesting graphical tool to compare debt evolution for different countries.

The data is interesting and it highlights the difficulties in deleveraging but, in my mind, it might lead to readers to reach a simplistic conclusion that is not correct: that everyone is living beyond its means, that we are not learning and that this will not end up well.

Let me start with the obvious point: your debt is someone else's assets. The increase in debt as a % of GDP can be rephrased as an increase in assets as a % of GDP. It implies that the size of financial assets and liabilities is growing relative to GDP. That is not always bad. In many cases we think the opposite: the ratio of assets (or liabilities) to GDP is referred to as financial deepening and there is plenty of empirical evidence that it is positively correlated with growth and GDP per capita.

To illustrate why only looking at debt can give you a very distorted picture of economic fundamentals  let me choose a country that best illustrates this point: Singapore. In the graphical tool developed by the Financial Times one can see that government debt in Singapore has increased over the last years. Here is a longer time series from the World Economic Outlook (IMF) going back to 1990.

The current level of government debt is above a 100% (much higher than in 1990) and it puts Singapore in the same league as Spain or Ireland. But here is the problem: the government of Singapore has been running a budget surplus since 1990 (and many times a very large budget surplus).

What is going on? As the government of Singapore explains here, debt is not issued to deal with funding needs but to generate a set of Singapore government securities in order to develop a safe asset for the Singapore financial markets as well as for the compulsory national savings system called the Central Provident Fund. So while debt is very high, the value of assets is even higher and the balance sheet of the government of Singapore looks very healthy.

This is admittedly an outlier among governments, most governments do not have assets that equal in value their liabilities. But even in those cases someone is holding government debt. And it might be that government debt is held by its own citizens that are in many ways the shareholders of the government. So the consolidated balance sheet of the country might still look great (e.g. Japan). 

This argument does not deny that the actual composition and ownership of assets and liabilities matters (even if by definition they always have to match). We know well that certain credit booms are indeed associated with crisis so worrying about debt is a good idea. But one has to be very careful interpreting analysis (and newspaper headlines) that only refer to the debt side of the balance sheet. A richer analysis that understand where the assets are and how they relate to issuance of debt is necessary.

Antonio Fatás