Thursday, February 26, 2015

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

Monday, February 23, 2015

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

Thursday, February 5, 2015

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 

Sunday, February 1, 2015

Which countries managed the Great Recession better?

As we compare countries' performance since the beginning of the global financial crisis we try to look for patterns that explain differences in behavior and lessons on how to handle the next crisis. When doing that comparison we some times forget that looking at GDP growth does not always give us all the information we need to understand cross-country variation in performance. This variation can be due to demographic, labor market, productivity factors and while these three might be correlated over time, this is not always the case.

Here is a quick look at the years 2007-2013 for a group of advanced economies. The charts below plot the level of activity in 2013 measured as a ratio to the level in 2007.

We start with GDP.

We see the usual suspects at the bottom of the list and we also see on the right hand side the ones that have managed to do better during the crisis years. Japan and the UK sit in the middle of the table. 

We now correct for the potential effect of changes in demographics in particular working-age population (defined as 16-64 years old).

Not many changes except for Japan where the performance looks a lot better as it ranks #2 in this list.   [A caveat: any definition of working-age population is likely to be problematic. In many countries (in particular the US) activity rates above 64 years old and significant and increasing so this statistic might be giving us a distorted pictures of the true level of potentially-active population.]

Finally, what about if we look at GDP per worker? This will give us a sense on performance on productivity of those working, abstracting from the labor market performance (ability to employ the working age population). 

While this is a rough measure of productivity it is affected by many factors including the possibility of sectoral shifts as least productive sectors see a bigger downturn.

Some things do not change, Italy and Greece remain at the bottom of the list. But more movements on the other side. In particular, the UK is now the third-worst country and Japan goes back to the middle of the table. In the Euro area the biggest change happens in Ireland and Spain, both made it to the top 3. This means that for these two countries the labor market performance is the main drag on their GDP performance. Germany falls to the bottom half of the table suggesting that the strong German labor market performance has compensated a not too stellar growth rate of GDP per worker.

Antonio Fatás