Maybe economists should only have one hand

We have all heard many jokes about economists and how difficult it is to get them to agree on anything. Most economists always answer a question starting with the words "it depends" and then follow with the expression "on one hand...". I am not here to defend (or criticize) my profession but to point out how difficult it is these days to get a consensus among some basic macroeconomic issues.

As an example, the debate about whether inflation or deflation is more likely, and about whether the aggressive response of central banks is appropriate today is at the heart of some of the most basic issues in macroeconomics. The disagreement could potentially be the outcome of a more uncertain world but seeing how strong are the beliefs of those who express a view on this subject, it seems that we do not have that much uncertainty at the individual level (those who believe that there will be inflation seem quite sure about, same for those who are concerned about deflation) but rather a polarization of views.

One example that I always find interesting is the debate that one finds in the minutes of the monetary policy meetings at the Bank of Japan. When discussing the inflation outlook in Japan in recent yeras, you can always find views on both sides, those who are concerned with deflation and those who are concerned with inflation picking up. Here is a paragraph from the meeting back in April 2010.

"Regarding risks to prices, some members said that attention should continue to be paid to a possible decline in medium- to long-term inflation expectations. One member expressed the view that attention should also be paid to the upside risk that a surge in commodity prices due to an overheating of emerging and commodity-exporting economies could lead to a higher-than-expected rate of change in Japan's CPI."

Of course, given the last 10 years of data in Japan, it seems awkward that some are concerned with the upside risk to inflation. While one cannot completely rule out this possibility maybe erring on the other side, making the mistake of letting inflation be "too high", for a few years would be good for the Japanese economy.

Clearly the US or Europe are not in the same situation as Japan but given some of the recent commentary about inflation I wonder whether we are getting close to a debate with too many hands and too many scenarios that leads to a lack of strong actions in the right direction. One can make mistakes in both directions (too much or too little inflation) and only time will tell in which direction our mistakes go, but given what we know about inflation, inflation expectations and long-term interest rates (all of them are low, stable or falling), it seems that we are worrying too much about the potential mistake of being too aggressive when it comes to monetary policy.

Antonio Fatás

Gold Standard?

Robert Zoellick, president of the World Bank, has an interesting piece on today's Financial Times about the need for a new mechanism for currency co-ordination. I like the idea of stronger co-ordination but I was surprised to read about the potential role of gold:

"The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today."

In this case I have to agree with the textbook view of gold as the "old money". The best argument in favor of using gold as a reference for currencies or central bank policies is to provide a nominal anchor in order to avoid inflationary policies (i.e. constraining central bank policies). The debate today about currency values/manipulation is about the relative price of different currencies and not about irresponsible monetary policy that might lead to inflation (to be more precise, some are afraid that the current monetary policy stance of many central banks will lead to high inflation but so far there is no evidence of high inflation and some countries are still facing the risk of deflation).

So I am all in favor of debating the need to come back to a system of fixed exchange rates (or even a one-currency world) but I cannot see how gold could play a role in that system.

Antonio Fatás

Inflation or Deflation (CNBC Interview with Ilian)

Filling the Gap

What do you do when you find out that the house that you live in is not worth as much as you thought? Or you realize your salary will not increase at the speed you anticipated? Or you simply realize that your debt levels are higher than what you had assumed? The recipe is likely to be a combination of reducing spending and coming out with some good ideas to increase your income.

Many advanced economies face a situation of excessive debt (public, private or both) that resembles one of the examples above. As a result, we talk about the need for fiscal adjustment, deleveraging in the private sector, increased saving, etc. But all these adjustments are required at a time when the economy is suffering from the consequences of a very deep recession. While those adjustments are necessary, they can have negative consequences on the economy (i.e. lower growth) which will make the adjustment more painful. As an example, it might be necessary to lower the consumption to income ratio, but the pain that the consumers will feel depends on what happens to the denominator (income); it is easier to reduce the consumption to income ratio when income is growing than when income is stagnant or even decreasing.

I do not think that many disagree with this logic but there are two aspects where I find some confusion in the discussion: they are about the speed (how fast to go?) and timing (when to start?) of the adjustment.

On the speed of adjustment, we read many times the argument that the adjustment needs to be fast. We hear, for example, the need for ambitious targets for government debt reduction or how we have to ensure that households’ or companies’ balance sheets become healthy as soon as possible. There are some merits to these arguments. Governments need to show commitment to sustainability and consumers or companies need to be in a financial position to be able to do business as usual. But there is also an argument that says that we need to go slowly. The argument comes from what economists call “consumption smoothing” that refers to the principle that most individuals prefer a stable consumption pattern to a volatile one. If you win the lottery, it makes sense to spread the new income across many years. If, on the contrary, you realize that your wealth is smaller than what you thought, it also makes sense to spread the pain over many years. This logic applies to individuals as well as to governments, as discussed in our previous blog entry.

The second issue is timing. How to you achieve the necessary adjustment without hurting growth and income? Here the analogy of an individual fails to capture the complexity of this issue for a whole economy. As an individual I can reduce my consumption as much as I want without affecting my income. As a country, this is not true, as my consumption is linked to somebody else’s income. Of course, there is the rest of the world and a country could potentially reduce its consumption if the rest of the world replaced the demand for the locally produced goods but this is unlikely. This issue of timing is even more important in the current environment because we just went through a very deep recession. Should the adjustment towards reduced spending start now? When should governments start reducing budget deficits? The answer depends on our assessment of the output gap (the difference between potential and actual output). While there might be some questions about the size of the output gap, there is no doubt that it is significant. If this is the case, even if our main objective is to bring the necessary adjustment to the economy by reducing spending the best way to do this is by reducing the output gap first.

Many times, reducing the output gap is portrayed as getting out of the crisis by spending more (which some see as a contradiction because excessive spending is seen as the cause of the crisis). This is not correct, reducing the output gap requires both spending and production. It is about ensuring that the economy produces as much as it can, generates the maximum (potential) amount of income so that the adjustment towards lower spending is done in the least painful manner.

Discussions on the size of the output gap are always subject to uncertainty and today we witness a debate about the extent to which structural issues, not just cyclical, are behind the current low level of output in advanced economies. I am willing to admit that we need a combination of policies to reduce the output gap and some might be seen as “supply-side” policies. But it is difficult to believe that a large and quick adjustment towards a path of lower spending will bring the economy closer towards potential in the short term; it is likely to make matters worse. And whether excess spending is responsible for the crisis we just went through is irrelevant. Regardless of how we got here, we need to figure out a way to reduce the output gap by ensuring that the level of income, spending, production are all as close as possible to potential and this means more of all of them, not less.

Antonio Fatás

Fiscal adjustment: fast or slow?

As growth slowly comes back governments in advanced economies are facing the question of when they should start reducing their deficit and address the growing debt problems. While there is no question about the need for an adjustment, there is a debate about its timing and speed. These are the two sides of the debate:

1. Go slow: given that growth is still not strong enough and unemployment remains high, adjustment should be postponed as much as possible. A cut in government spending or an increase in taxes will decrease aggregate demand and growth. The costs of keeping the debt high are small compared to the costs of high unemployment.

2. Governments need to act fast because their high level of deficits and debt are creating too much uncertainty and fear of a crisis. In some cases this is showing up as higher interest rates (which can harm growth). In others, interest rates remain low but the fear of an unsustainable path for fiscal policy can lead to low investment and growth. A quick fiscal consolidation (reduction in deficits) is what the economy needs now.

Both sides of the argument have merits and it is not a question of which one is right and which one is wrong. Circumstances are different in each country and it is likely that the optimal speed of adjustment is different for each economy. What I would like to highlight in this post is an area where I feel there is some misperception: the burden that interest payments on the debt impose on taxpayers, an argument that is used in favor or speeding up the fiscal adjustment.

It is possible, although empirically it is not that obvious, that a high level of government debt has negative consequences on investment or economic growth. The high level of government debt can be seen as an accumulation of previous errors or misbehavior: governments spent too much or did not have the political willingness to collect enough taxes. But the past cannot be changed and the question we face now is how to pay for our previous “mistakes”: Do we do go for a quick payment of our debt or do we spread the pain over a long number of years? This is an economic decision that depends on many parameters but mainly on the relative value of current versus future income and the interest rate that we are charged on the debt (which in general equilibrium they have to be related). What we need to understand is that the cost of the debt will be there whether we pay now or we pay later. We might find good reasons why we should pay earlier but there might also be reasons why we want to postpone the payment (spread the pain over several years).

Think about an individual who inherits some debt or that realizes that the total value of his debt is higher than what he initially thought. Is there an economic argument that he should cut his consumption as much as possible to avoid the higher interest payments on the debt? Not clear. This decision is about the trade off between consuming today and tomorrow and the price at which this trade off takes place. In most economic models, we assume utility functions for individuals that generate a preference for consumption smoothing, so we normally think about an optimal solution that requires slow payment of the debt. Same for governments, we normally think about tax decisions as being driven by a “tax smoothing” argument, which suggests that spreading the burden of high debt over many years or decades, is optimal. In addition, if we think about the present as a period where income is unusually low (because of the recession), this might not be the right time to start paying off our debts by cutting our consumption even more.

In summary, one needs to be careful using the argument of the high burden of the debt to push for a quick reduction in government debt levels. The level of government debt is what it is and the burden will have to be paid in some form over the future. The question on how fast we reduce the debt is about the timing of those payments and not so much about the total cost of the debt. Paying earlier has to be a statement about how we are willing to cover the cost of debt with reduced current spending as opposed to reduced future spending.

Of course, if financial markets are not willing to fund our debt anymore, we will be obliged to pay the debt faster. Or, in a milder scenario, if the interest rate we face is “unreasonably” high because of the fear of default, we might find it optimal to pay the debt now to calm that fear and reduce the overall burden of the debt – this might apply to Greece but it clearly does not apply to the US.

Antonio Fatás

Completing the Eurozone rescue

VoxEU has published a new eBook on the current economic situation in Europe. The book is called "Completing the Eurozone rescue: What more needs to be done?". The book contains 13 short articles with an analysis of what went wrong and some concrete policy proposals to ensure a successful recovery and avoid similar crisis in the future.

Here is a summary of some of the findings:

"Although the essays were largely uncoordinated – and the authors hark from diverse backgrounds – a remarkably coherent message emerges. The authors unanimously believe that the crisis is not over, and that the Eurozone rescue is not finished. More needs to be done.

As Charles Wyplosz puts it, the Eurozone is levitating on the hope that European leaders will find a way to end the crisis and take steps to avoid future ones. Unless more is done, however, this levitation magic will wear off and the Eurozone crisis will resume its destructive, unpredictable path.

The crisis, in our view, is a thorny tangle of incipient debt and banking crises. Until this tangle is sorted out, any further shock could threaten the Eurozone as we know it. After all, Eurozone bank systems remain in a parlous state. Confidence in the financial system has not been restored. The losses from the Spanish real estate binge have only partially emerged. Greek public finances have still not been stabilised. Large competitiveness imbalances persist.
In short, none of the underlying causes of the crisis have been addressed.

Massive shocks could come from any number of sources ranging from the Spanish banking sector to political crisis in member countries facing fiscal austerity. Indeed, we already see ominous signs. Risk premiums on some Eurozone government debt have resumed their upwards trend despite the two May packages.

We also know that even small shocks can lead to a major crisis given the interconnected fragility of the Eurozone. Remember that it started with fiscal problems in a country which accounts for only 2.5 % of Eurozone GDP. Banking crises in a number of European countries could cause sovereign debt crises – a la Reinhart and Rogoff (2009) – which could spark contagion, thus triggering more bank crises. Trying to muddle through would be like sleepwalking through a minefield.

The time for action is now, for, as Barry Eichengreen puts it, “financial crises feed on uncertainty. The longer uncertainty is allowed to linger, the greater the damage to confidence…”.

Ilian and I wrote on of the essays where we are argue in favor of an institutional solution to the fiscal problems of the Eurozone. Our essay can be found here. The full set of essays can be found on this link.

Antonio Fatás

The Architecture of the new Global Economy

Last Friday INSEAD hosted its 4th Leadership Summit in its Fontainebleau campus. I participated in a debate on the architecture of the new global economy. The other members of the panel were Shanti L. Poesposoetjipto (Chief Executive Officer, PT Ngrumat Bondo Utomo), Ernest-Antoine Seillière (Chairman of the Supervisory Board, Wendel Group), Lord Simon of Highbury (Director GDF Suez, Former British Minister for Trade and Competitiveness in Europe, Former Chairman of British Petroleum) and it was moderated by Geoff Cutmore (CNBC).

A video with a summary of the session is below. Other videos from the event can be found in the INSEAD YouTube channel.

Antonio Fatás