Content of economic blogs

Here is a snapshot of recent content of some economic blogs (thanks to Wordle).

Greg Mankiw

Mark Thoma

Brad de Long

Casey Mulligan

Antonio Fatás

How low is 1.48 (USD/EUR)?

As we witness increasing signs of economic optimism about the recovery, the focus of the analysis turns into the exact form that the recovery will take and how to ensure that it is as fast and smooth as possible. One of the areas that has received recent attention is the evolution of the US dollar. In recent months the US dollar has gotten weaker and there are many questions about whether this is a trend that will continue and how far the US dollar will fall.

In an FT article yesterday Wolfgan Munchau made the case for a weaker dollar. Many of the arguments are not new and we had heard them before the crisis when global imbalances were on their way up. As the US current account deficit got larger and larger there was the question of how those deficits would be reduced. Given that (US) consumption rates looked unsustainable, it seemed that a price adjustment (through a change in the exchange rate) was the only way to produce that adjustment. In addition, now that the crisis has started, and if one takes the perspective of the US economy, a depreciating currency can help with the economic recovery, an argument made by Wolfgan Munchau in yesterday's article

"A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ."

This argument is similar to the one made by Krugman to oppose those who are voicing concerns about the fall in the value of the US dollar.

I will not argue here with this textbook logic of how currency movements can help address current account imbalances and business cycles (although I must admit that I find the empirical evidence much weaker than most people). But I have some concerns about blank statements that argue that the US dollar has to get weaker:

1. It is not enough to say that the US dollar has to get weaker you need to say how weak it should get, we need a number, there is a need for a medium/long-run anchor. As the chart below shows, the US dollar is already weak by historical standards. Sure, it has room to get to the historical low of 2008 but was is the right reference value?

As a technical and historical explanation of the chart: this is the nominal exchange rate between the US dollar and the Euro (before 1999 the German Mark is used as the Euro) and the upward trend is a reflection of the differences in inflation between Europe/Germany and the US. But even if we were to correct for inflation differences, the US dollar is still weak by historical standards. Also notice that some of the waves that we see were reversed by some statement coming from central banks and government officials, such as the September 1985 Plaza Accord, the February 1987 Louvre Accord and the interventions of November 2000. By historical standards, we would have expected similar statements in 2008 when the US dollar reached the 1.60 USD/EUR level. We did hear some comments about "excessive volatility" but not about the actual value of the currency.

2. Related to the point above, but more from a theoretical point of view: how much do we want to introduce price distortions (changes in relative prices via changes in the exchange rate) to ensure that the spending patterns of different countries are sustainable? The textbook logic of currency depreciations to smooth recessions is one that applies to countries that are suffering an asymmetric shock. Today we face a global recession, so according to the textbook, most advanced economies need an exchange rate depreciation. We might argue that all these currencies need to depreciate relative to countries that are doing well (China and other emerging markets) but we cannot simply argue that the US dollar has to get weaker. It is interesting how many criticisms China has gotten for "manipulating" the value of its currency to affect economic outcomes and now we are willing to argue that the US should be doing something similar. Just to be clear, I am not arguing that currencies cannot be a good adjustment mechanism, but the context matters and one needs to be explicit about the difference between an asymmetric recession and a global recession and the difference between smoothing business cycles and addressing structural imbalances.

3. The perspective of the other countries. A weak dollar can help the US increase its exports, which goes in the direction of reducing the current account deficit, but why would other countries see this as a "return to equilibrium"? Wolfgang Munchau argues that "A strong Euro would nicely take care of of Germany's persistent current account surplus". I am not sure all the Germans agree with this statement. I am also not sure that a fall in revenues (i.e. fall in German exports) would lead to a decrease in the saving rates in Germany. It might lead to the opposite behavior - an increase in saving rates because the decrease in income leads to more uncertainty and precautionary savings (which will make the current account surplus even larger not smaller).

Antonio Fatás

More on the medium-term outlook for the recovery

The magazine The Economist has an article this week on the persistence of the current recession and whether output will return to its trend. The arguments that the article present are similar to those made in the Chapter 4 of the recent World Economic Outlook by the IMF (see our previous post on this matter): it is likely that the current recovery is not strong enough to bring output back to trend. In a recent NBER working paper, Cechetti, Kohler and Upper also provide empirical evidence suggesting that financial crisis leave long-lasting (negative) effects on output.

The question on the connection between recessions (or business cycles in general) and potential output ("the trend") is one that has not been studied much in economics. Most of the models we use tend to think about the trend as being independent of business cycles - so recoveries always bring output back to the pre-crisis trend. Policy makers tend to use the concept of the output gap, the deviation of output from its potential, to think about the strength of the recovery under the assumption that in a "normal" year the output gap should be back to zero.

The strongest evidence one can find in favor of this hypothesis (that recessions are temporary) comes from the US economy. The US economy has displayed a surprising tendency to return to trend even after some major events such as the great depression, World War II or the recessions of the 70s. Below you can see a chart that shows the evolution of GDP per capita in the US during the period 1870-2008. The red line represents a (log-)linear trend using data up to 1928. It is remarkable how close the blue line is to the red line and how the economy recovers to return to trend.

In fact, using 1870-1928 data, a prediction using that (log-)linear trend leads to an error of only 1% for the level of GDP per capita in 2008. Of course, the picture is misleading in the sense that in some cases it took a long time for the economy to come back to this trend, but it is still interesting that it returned to the same trend. It could have returned to the same growth rate but at a different level but that's not what we see, we see that the output loss is always recovered after a number of years. This suggests that the supply side of the economy (innovation, technology) is unaffected by output fluctuations.

If one looks more carefully at the data, the evidence becomes much weaker. In contradiction to what we see in the picture above, empirical economists know that output fluctuations are very persistent. In fact, one cannot reject the hypothesis that all output fluctuations leave a permanent scar in the economy. If we suffer a recession, output never goes back to trend, it remains at a lower level forever (this is what is known in the academic literature as the existence of a "unit root" in output).

From a theoretical point of view, there are two ways to justify the fact that recessions always leave permanent effects:

1. Technological changes are the cause of business cycles. Recessions are period where we are not good at innovating and this causes both a recession and a permanent loss in output. This is what we know as "real business cycle theory".

2. Innovation is affected by recessions. During recessions firms invest less and this lead to a temporary slowdown of technological progress, so the economy never returns to the same trend. It will go back to its normal growth rate but the temporary effects on growth will leave a permanent scar on the economy. This is the argument that we hear these days to support the fear that the current recovery will not be strong enough. A few years ago I wrote a couple of academic papers that presented this theory and some international evidence in favor of this hypothesis (the papers can be found here and here). This is an area of macroeconomics that I believe deserves more attention in terms of academic research (but I am biased, given that I have written on the subject). And it is not just about financial crisis but, more generally, about what happens to innovation, technology and growth during recessions.

Antonio Fatás

Will output return to the pre-crisis level?

How strong the economic recovery will be depends on whether we believe that output will quickly return back to the trend that was following before the crisis. Economists tend to think in terms of potential output as driving the trend of output and recessions as being temporary deviations from this trend. During the recession the output gap becomes negative (output is below potential) and the recovery brings output back to its trend, closing the output gap.

There is, however, evidence that output does not always return to its trend after a deep crisis. The IMF World Economic Outlook has just released its two analytical chapters from the September/October issue. Chapter 4 (which can be found here) deals with this issue: whether output will return to trend after the crisis. Their conclusion, after looking at many different historical cases, is that banking/financial crisis tend to leave a permanent (or at least a medium-term) scar on the economy. Here is a picture from Korea after the 1997 crisis (picture borrowed from Chapter 4 of the World Economic Outlook).

As we can see, 7 years after the crisis, output is still far from the pre-crisis trend. There are many other examples like this one and the evidence supports the notion that there is a mid-term costs of financial crisis so that output stays below trend for several years.

There are, however, some examples where the output loss is smaller. Some of the conditions under which the mid-term output cost could be low are:

- having a low initial decline on output (e.g. the severity of the recession during the first quarters).

- having a level of investment before the crisis which is not far from historical standards (e.g. the pre-crisis boom did not drive investment rates too far from historical levels)

- having more policy room to maneuver (low inflation, current account balance) before the crisis

The conclusions of the article state that:

"For the most part, the implications of our analysis are sobering for the medium-term output prospects in economies with recent bank- ing crises. The historical evidence suggests that output in many of these economies may remain well below precrisis trends in the medium run."

And policy makers are warned once again about the difficult balance in their exit strategies.

"Looking ahead, the timing for the withdrawal of the extraordinary amount of monetary and fiscal stimulus that has been implemented in many countries will be impor- tant. On the one hand, a premature exit could stifle the recovery. On the other hand, delaying the withdrawal of stimulus could be inflationary."

Antonio Fatás

Output, employment and productivity during the crisis

While most advanced economies have displayed significant drops in GDP during the last years, the behavior of labor market variables (employment, unemployment, number of hours) has been quite different across countries.

In countries such as the US or Spain we have seen a large decline in employment/hours and the corresponding increase in unemployment. In countries such as Germany or France or Sweden, employment and hours have fallen much less.

Below is data on labor productivity measured as GDP per hour worked in four countries (data is annual so we are missing the first quarters of 2009). In the case of Sweden and Germany we can see that the fall in GDP has been much larger than the decrease in hours worked leading to a decline in productivity. In the case of the US productivity has remained stable. In the case of Spain the fall in employment and hours has been much larger than the decrease in GDP which has produced a doubling of the productivity growth rates in 2007/08 relative to the 2003-06 period.

Behind these figures we probably have a composition effect (different sectors being affected differently by the crisis) but also different labor market responses to the crisis, where in some cases there has been a conscious effort to reduce the impact on employment.

Antonio Fatás

Update (Sept 23): some have emailed me asking for an explanation of the differences among these countries. I do not have a great answer, my last paragraph was an attempt to put forward some hypothesis. It could be that the sectors that are being affected in a country like Sweden are the most productive ones, while in a country like Spain they are the least productive ones (e.g. construction). I have no evidence that this is the case but it is a plausible mechanical explanation. The second explanation that I proposed is probably more realistic: in some countries (Germany, Sweden) there has been a conscious effort with the help of trade unions to reduce the impact of the crisis on employment (e.g. accept a pay cut if the level of employment is maintained). We have not seen this in the US. In the case of Spain, the dual structure of the labor market has led to a large termination of temporary contracts and a significant reduction in employment.

Household debt, consumption and wealth

It is very common these days to hear that the global economy has no way of recovering because the most powerful engine of global demand – the American consumer – is choking in debt. US household debt has reached $14 trillion in 2009, or 100% relative to GDP. At a recent conference in China, panelists were wondering how growth in the global economy would resume given that the American consumer had disappeared under the burden of debt.

On September 17, the Federal Reserve released their “Flow of Funds” report, where we can find data on household debt for 2009Q2. Indeed, this debt stands at $14.068 trillion or slightly less than 100% of GDP. Does this mean that the economy is doomed? There are two points that one has to take into account when evaluating the role of household debt in the economy.

1. Debt is only one side of the story. Households also own assets. Consumption is a function of (net) wealth, not only of indebtedness. Up to a first approximation what matters is the difference between assets and liabilities. Indeed, no one thinks that a person with $10 million in debt is going to cut his or her consumption, if you know that this person has $10 billion in assets. So, how do American consumers fare in terms of net worth? Below is a graph with three ratios – assets-to-GDP, debt-to-GDP and net-worth-to-GDP. Although household debt stands at 100% of GDP, assets owned by US households currently stand at $67.2 trillion or 475% of GDP. The net worth of the American households is estimated to be over 375% of GDP.

Are these assets sufficient? This is hard to tell because theory does not provide convincing guidance as to what the wealth-to-GDP ratio should be. But we can look at the data to see how these numbers compare to historical averages. The average ratio of US household net worth from 1952Q1 to 2009Q2 is about 350% (if we exclude the two bubbles, the ratio is 330%). In short, US households today have more net wealth than they had in normal times in the post WWII period. Contrary to all complaints, US households today are richer than at any point in time in the pre-1995 period (and again, this is relative to GDP; in absolute terms no one will be surprised that this statement is true).

But maybe it is the composition of debt that matters – people today live off their credit cards. It turns out that consumer credit has increased indeed over the past 20 years but the numbers are not shocking. From about 14% in 1990, consumer credit rose to 17.3% in 2009 (again the numbers are relative to GDP).

One counter-argument to the points that I raise above would be that all of this wealth is only on paper – we saw how bubbles deflate and therefore we cannot count $67.2 trillion is assets at their face value. To accept this argument, however, we must admit that the real estate bubble has not deflated yet. It could be true, but looking at data we find that house prices relative to income are close to their historical averages from the pre-bubble 1980s and 1990s. In other words, an argument that the wealth is only paper wealth should argue that the US is in a permanent state of a bubble.

2. Even if we concede that debt can reduce consumption for an individual, it is a bit trickier to make the same argument for the national economy. The reason is that the liability of one individual is an asset for someone else. In the graph above, the thin blue line is in fact included in the thick red line!

At first, it might be startling to think that indebtedness of one household is an asset of another one. But if you imagine a bank and its balance sheet, you can quickly realize that all the loans that banks give (assets for the bank) must be financed with a deposit, equity or another instrument on the liability side.

There are ways in which this “neutrality of debt” may break down. For example, if those who are indebted have a higher propensity to consume than the lenders, then debt will lead them to cut their consumption by more than the lenders will increase theirs (due to the wealth effect). This is possible and even plausible, but it is not clear whether empirically this effect is significant. Second, it might be that household debt is held by foreigners. Again, the data are not very supportive of this hypothesis because the net foreign asset position of the US is not (yet) devastating – less than 20% of GDP.

In general, many other “imperfections” in the market economy can result in the importance of debt for aggregate consumption, and I do agree that some of these imperfections are realistic and important. The main point of the argument is that we need a more nuanced view of why debt matters. We should keep in mind that the net worth of US households is still quite high (375% of GDP) and that debt should be viewed from a general equilibrium point of view and not only in absolute terms.

Ilian Mihov

More on the shape of the recovery (CNBC Interview)