The difficulty of building counterfactuals

What are the effects of the monetary policy actions that central banks around the world have taken since the start of the crisis? How many jobs will be "saved or created" by the stimulus packages put forward by governments? These are crucial questions for policy makers but they are also very difficult to answer. The only way to provide a proper answer to these questions is by building a counterfactual: "what if those actions had not happened?". Easy to say, very difficult to do (at least in a credible manner). This leads to very interesting debates and, in some cases, confusion.

For example, the Obama administration has switched from talking about "jobs created" (by the stimulus packages) to "jobs created or saved". The reason was that they realized that over the first months (years?) of their mandate, we would only see negative growth for employment - i.e. jobs will only be destructed - so it did not make much sense to talk about "jobs created". To claim success of their policies, they need to talk about the jobs that would be saved and claim that without the stimulus packages there would have been even more jobs destructed. Wiliam McGurn in a recent Wall Street Journal article does not like this. Quoting from the article:

"If the "saved or created" formula looks brilliant, it's only because Mr. Obama and his team are not being called on their claims. And don't expect much to change. So long as the news continues to repeat the administration's line that the stimulus has already "saved or created" 150,000 jobs over a time period when the U.S. economy suffered an overall job loss 10 times that number, the White House would be insane to give up a formula that allows them to spin job losses into jobs saved."

I agree that it is difficult to hold governments accountable when we do not have a clear baseline on what would have happened without their actions, but this issue does not just apply to the Obama administration or to the "saved and created" formula. Even if we were in a period of job growth, any claim on "jobs created" would also have to be judged in relation to what would have happened if policies had been different. So whether politicians talk about "jobs created" or "jobs saved", we always need to question the assumptions in their economic projections.

Much of the empirical research in economics is about designing tests that can allow us to build counterfactuals and measure the true effects of policy actions. But in most cases this requires the use of historical time series and bundling together many episodes. And then the difficulty is to extrapolate what we learn from those historical episodes and see whether their lessons apply to the current scenario. As an example, our research might tell us that fiscal expansions have had in the past positive effects on output and employment and we can quantify those effects. But circumstances are always changing and it could be that under the current economic conditions those effects will be smaller or larger. As much as we have historical data on similar episodes, each episode is different from the previous one and it is impossible to control for all relevant factors. Having said that, this is not an excuse that can justify any claim on the number of "jobs created or saved". Baseline scenarios and counterfactuals can be built even if they are uncertain, and they should always be used to judge the impact of economic policies - in bad times and in good times.

Antonio Fatás

When will the U.S. recession end? (Ilian on CNBC)

Fiscal policy

I attended today a very interesting conference on the role of fiscal policy at the IMF. I presented a paper on the role of automatic stabilizers. It is interesting that there are very few academic papers that have looked into the effectiveness of automatic stabilizers. In my paper I argue that the evidence suggests that automatic stabilizers are effective and should not be ignored. I also find that in recent years countries with smaller automatic stabilizers have compensated with more aggressive discretionary fiscal policy (e.g. the US has smaller automatic stabilizers than Europe but in the current crisis has used discretionary fiscal policy more aggressively). The program of the conference and copies of the papers can be found at the IMF web site.

If the link above stops working, you can find a copy of my presentation here.

Antonio Fatás

The yield curve and the credibility of central banks

An increase in the yield for 10 year bonds put the yield curve in the US at one of its steepest since the mid-70s raising concerns about the evolution of long-term interest rates and the effect that they might have on the economic recovery. From Bloomberg, you can see that there are two ways to interpret the increase in the yield: Timothy Geithner thinks this is a good sign

Geithner also said that the rise in yields on Treasury securities this year “is a sign that things are improving” and that “there is a little less acute concern about the depth of the recession.”

Others see this as a sign of concern

Gross said in an interview today on Bloomberg Television that 

while a U.S. sovereign rating cut is “certainly nothing that’s going to happen overnight,” financial markets are “beginning to anticipate the possibility.”

Typically, a steep yield curve is a sign of a strong recovery, but there is nothing typical about current monetary policy. Here and here are two blog entries that discuss the recent steepness of the yield curve in the US.

One thing that I find interesting is that despite the uncertainty surrounding the current economic situation, the yield curve is almost identical in the Euro area (Germany), the UK and the US (see chart below). This means that not only the perception of a default risk for these three government is similar, which is probably a reasonable guess, but also that inflation expectations are almost identical for the ECB, the Bank of England and the Federal Reserve. 

While it is difficult to imagine circumstances where the inflation rates in these three areas deviates by a large amount, it is not that unlikely to build scenarios where inflation differentials are larger than the ones implied by those yield curves. Given the uncertainty and the difficulty predicting which ones of these scenarios will prevail, the yield curve seems to be anchored by the assumption that the three central banks will adopt very similar policies and will deliver an almost identical inflation rate. That's a strong sign of confidence on these three central banks.

Antonio Fatás

Three different views on the role of monetary policy leading to the current crisis

John Taylor thinks that the Federal Reserve is to blame for the crisis because of the low interest rates in the year 2003-2005 period. 

"Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust."

You can see the full article at the Wall Street Journal (Feb 9, 2009).

Alan Greenspan, as you would expect, disagrees with John Taylor and claims that the central bank was doing the right thing but the problem was the disconnect between short-term interest rates and mortgage rates (which were being kept too low partly because of the increase in saving rates coming from Asia).

"Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have "prevented" the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.""

You can see the full article at the Wall Street Journal (March 11, 2009).

Lucas Papademus, Vice President of the ECB looks forward in a recent speech (May 15, 2009) and asks what monetary policy should do in a similar future situation. He advocates for a symmetric reaction of monetary policy: not only it makes sense to lower rates when the crisis starts but central banks should also act when financial imbalances are accumulating.

"In order to reduce such potentially dangerous side-effects of non-standard measures of liquidity provision and of the very low policy rates during a crisis, monetary policy would have to be sufficiently tightened during the financial boom phase. Such a policy would dampen financial market excesses through two channels. It would tend to reduce asset prices by increasing the rate at which an asset’s future income stream is discounted. Most importantly, the anticipation of such a policy response would reduce the likelihood of a speculative bubble emerging in the first place, by affecting investment behaviour and reducing the level of risk incurred by financial intermediaries in their lending."

Papademus falls short of making a statement on whether interest rates were too low during the years that preceded the crisis (as Taylor argues). But his argument supports the view that standard monetary policy (i.e. via interest rates) also has a role to play in dealing with speculative bubbles in financial markets, it is not just a matter of proper regulation and supervision.

Antonio Fatás

No wonder why we see bubbles in financial markets.

Here is an article written  about 18 months ago that was justifying the low personal saving rate in the US using the argument that the standard national accounts' measure of the saving rate did not take into account the increases in wealth associated to rising asset prices. The article was written in September 2007 right before the crisis started. It was written by David Malpass, who was at that point chief global economist for Bear Sterns. That increase in wealth is gone (and so is Bear Stearns).

Antonio Fatás

The end of the Overworked Americans? (and the end of the 35-hour week)

The decade of the 80s was characterized by a continuous increase in the number of hours worked in the US. It was a combination of an increase in the number of individuals who were part of the labor force and an increase in the average number of hours worked by a typical worker. This increase in number of hours represented a break in the historical trend were productivity gains led to an decrease in the number of average hours worked in favor of additional leisure. This trend led to the label of "overworked Americans" for US workers. It did not help that the Europeans were following the opposite trend by accelerating the historical trend of decreasing hours per worker (as in the 35-hour week in France) and by increasingly generous early retirement programs, which were a political response to the high unemployment rates of previous decades.

This divergent trend between the US and European economies continued during the 90s. This was a decade where the US outperformed Europe in terms of GDP growth. While some of this was due to larger increases in productivity (the "new economy"), the majority of it was due to an increase in the employment to population ratio as seen in the chart below. 

The story has changed since the end of the 90s. The Europeans realized that there was a need to reverse the trend of recent years, which led to labor market reforms and increases in employment. The US labor market suffered large employment losses during the 2001 recession and the recovery that followed was unusual in terms of low employment growth. And before the employment to population ratio could reach the pre-recession level, the current recession started. The US is now at a level which is below the one in 1992. The Euro economies did not suffer much through the 2002/03 crisis and so far the fall in employment in the current crisis has not been as dramatic as in the US.

There is no easy explanation for why the US labor market has not performed better since the end of the 90s. It is true that it had reached a level of employment from where it was difficult to continue growing so maybe there was some truth to the expression "overworked America" (be careful reading the chart above as both series are normalized to 100 in 1992, the employment to population ratio in the US remains substantially higher than in Euro countries). Going forward, it is possible that we see employment growing fast again in the US. With the large destruction of wealth in the US because of the collapse of housing and stock prices, the only way to keep up with the previous living standards is by working longer hours and having more than one income in every household. And those who had planned to retire soon, might be required to work some extra years to compensate for the loss of their pension plans. 

Antonio Fatás