Bill Gross on the Big Mac and QE

These are good days for someone who teaches macroeconomics, because it is easy to find articles that misrepresent the basic concepts we teach in class - this always motivates our students who now feel that they can make better arguments than those writing in the financial press.

Bill Gross, founder and co-chief investment of Pimco is back in the Financial Times. This time he is not trying to explain why higher interest rates are good for investment and growth, but instead he is trying to help investors make decisions on foreign exchange markets. His argument is that the traditional theories of exchange rates (Purchasing Power Parity = Big Mac Index) do not matter much today, what matters is the behavior of central banks when it comes to quantitative easing.

The first thing that is odd in the article is that he misses the connection between the different theories he discusses. Someone making an argument that quantitative easing leads to inflation and a depreciation of a currency is implicitly using Purchasing Power Parity as an argument to talk about exchange rates. That argument is standard in any macroeconomics textbook.

What is not standard and where, in my view, he is not being accurate is the way he describes quantitative easing and its implications on exchange rates. First, there is the constant reference to "money being printed". This is wrong. Most of the increases in the monetary base (the size of the balance sheet of central banks) do not correspond to increases in the amount of currency in circulation but to increases in the deposits that commercial banks hold at the central bank (reserves). This increase in the monetary base do not always lead to an increase in the money supply or inflation. Or you can put it in a different way: the increase in liquidity is matching the demand for liquidity by the financial system. If demand and supply are balanced, prices do not change (exchange rates do not change).

When it comes to the exchange rate he cites Japan as an example where his theory is working (the Yen has depreciated because of quantitative easing). Correct, but only up to a point: it is not because the balance sheet of the central bank is increasing, it is because there is the perception that the central bank is finally committed to deliver high inflation and if this is the case, PPP tells us that a currency will get weaker.

His advice: to pick winners and losers (in terms of currencies) by looking at the size of the central bank balance sheet. Way too simplistic and possibly wrong. It sounds more as one additional attempt to criticize central banks for what they have been doing (QE). If anyone had followed that advice during the crisis years, they would have gotten their bets on currencies wrong several times (same for those who followed his earlier advice that inflation was around the corner and interest rates would increase fast).

Yes, monetary policy matters for the exchange rate because it affects all nominal variables: prices, inflation and the nominal exchange rate. But mislabeling quantitative easing as "printing money" and call it a sure bet to increase inflation in future years has proven to be wrong enough times in the last years that one would think that the argument would not be repeated again. But I should not complain, I have to teach a few more sessions on monetary policy in about three weeks, so these articles are making my search for interesting readings much easier.

Antonio Fatás

Dove or Hawk? Bernanke's record

In yesterday's testimony at the U.S. Senate Ben Bernanke was accused of policies that could potentially generate high inflation. Senator Corker accused the Fed Chairman of nor being concerned enough about inflation by saying "I don't think there's any question that you would be the biggest dove since World War II". The term "dove" in the context of central banks is used to describe policies that put more weight on unemployment and less on inflation (as opposed to "hawks" who do the opposite). Ben Bernanke defended himself by mentioning that he has one of the strongest records in terms of inflation of any previous Chairman.

Below is a quick check on both the inflation as well as the unemployment record of the last six chairmen of the US Fed. Ben Bernanke has so far produced one of the lowest inflation rates since the 1950s. When it comes to unemployment, his record is not that positive, only second to Paul Volcker in terms of high unemployment rates.

Comparing performance of central banks without controlling for other factors (such as the depth and frequency of economic crisis or shocks during their mandates) is not fair but at a minimum it provides some basic facts to back the statement by Ben Bernanke that it is difficult to see his record as someone who put too much weight on unemployment and too little on inflation.

Antonio Fatás

The Euro depression

As we wait for the results of the Italian election, Europe is heading for yet another period of uncertainty. Governments in key countries (Italy, Spain, Greece, France,...) do not have the support to continue the path that has been followed so far but there is still no real alternative and a strong sense of complacency: we will continue the same policies that we have followed so far.

According to the European commission recent forecasts, the Euro area will see negative growth rates again in 2013 and growth rates as low as 1.4 in 2014. This means an average growth of 0.16% in the period 2012-2014, assuming we do not end up revising downwards our views on 2014 - which is very likely. And this comes after Europe has gone through its worst recorded recession during the 2008-2010 years.

This is now worse than a double-dip (great) recession. What is really frustrating (maybe we should call it depressing, to match the economic situation) is the complacency with which some European politicians look at what is happening. When Olli Rehn (EU commissioner for economic and monetary affairs) commented on these negative forecasts produced by the EU commission, he called them disappointing but then he just said that current policies are finally paying off. The introduction letter to those forecasts, produce by Marco Buti, the Director General responsible for the forecasts, talks about several factors that are contributing to weak growth: the negative feedback between public finances, banks and the weak macroeconomy, lack of credit growth, uncertainty about policies,... These are all external factors (austerity is not even mentioned as a possible factor), so the best we can do is to continue the policy agenda "to ensure the sustainability of public finances". There is no learning here, it does not matter how strong the facts are (I will not present again the facts here, see Krugman or De Grauwe for a recent analysis and a reaction to these forecasts).

But let me look at some (depressing) data from Italy, where election results are expected by the end of the day. Below is the evolution of the Italian economy compared to the US and South Korea since 1980. Data is GDP per capita (in logs) from the IMF World Economic Outlook, including their forecast for 2013 and 2014.

After the Italian "miracle" of the 1960s and 1970s where Italy was growing fast and converging towards the other rich countries, the economy stagnated in the 80s and then started falling apart in the years that follow. Since 1990, not only Italy has stopped converging towards the US levels, it is now drifting down and away from the US level. If this trend continues, Italy will follow the path of Argentina in the 20th century when it went from one of the richest countries in the world to a middle-income country. As a comparison we see how South Korea continues its path of convergence towards the US and has recently passed Italy in terms of GDP per capita.

We talk a lot about the lost decade for Japan, but if there is an advanced country where the label lost decade applies is Italy during the last 10 (or 15) years. But, of course, we can always be optimistic (as Olli Rehn seems to be is), Italy still exists as a country, it is still a member of the Euro area and bond yields are not as high as the ones in Greece - although all this can change in a few hours if the election results end up being a (bad) surprise!

Europe can and should do much better than zero growth over a decade. If this is not understood by political leaders then the downward drift that some countries started 10 or 15 years ago will continue or even accelerate and this might drag all the other European countries with them.

Antonio Fatás

Celebrating negative growth

GDP growth during the last quarter of 2012 turned negative in the US (-0.1%) and this came as a surprise to many.  Looking at the different components of GDP, the biggest decline happened in government spending and in net exports (due to the weakness in other economies). This is just one quarter and the data is likely to be revised later in the year, but what is to be learned from the data? The answer is whatever justifies your priors. Here is the interpretation that Larry Kudlow does in CNBC, which is a good example of how statistics can be interpreted in so many different ways.

He makes the claim that this is indeed a good quarter because private spending (consumption and investment) grew at about 3.4% - after removing inventories that fell significantly. From here he concludes:

"Even with the fourth-quarter contraction, the latest GDP report shows that falling government spending can coexist with rising private economic activity. This is an important point in terms of the upcoming spending sequester. Lower federal spending, limited government, and a smaller spending-to-GDP ratio will be good for growth. The military spending plunge will not likely be repeated. But by keeping resources in private hands, rather than transferring them to the inefficient government sector, the spending sequester is actually pro-growth."

So this is an interesting test that he is using to prove that decreasing government spending is good for growth. As long as we see any growth in private spending it means that the decrease in government spending is helping the private sector grow. Of course, the real test is to compare the -0.1% to what would have happened to GDP growth if government spending had not decreased. Reading Larry Kudlow's article it sounds as if GDP growth would have been even lower (although his statement is not as precise as this). Yes, consumption grew and investment (once we exclude inventories) grew as well, but how much? Not enough to compensate the decrease in government spending so the final outcome is a negative (literally negative) performance for GDP growth.

So if we were to use just this observation to understand the fiscal policy multiplier, what would we learn? [Just to be clear, we should not be doing this, to understand fiscal multipliers we need more than one quarter of data, but I am just trying to follow his logic] I see that GDP growth is low and certainly much lower than what anyone would expect taking into account that the US economy is still below potential. We see that government spending fell and this is a component of GDP. A natural reaction might be to argue that the fall in government spending had a negative effect on GDP. Given that the GDP growth number is so low (and lower than expected), this is a reason to believe that the multiplier is positive and possibly large. But, as Larry Kudlow shows, there are always other interpretations.

Antonio Fatás 

Doomsday, gold and the Bundesbank

Noah Smith has a great blog post on the obsession with gold as a store of value or as an investment strategy. I fully share his views on gold and in particular about the arguments made by those who see gold at the center of the world economy and the best investment one can do these days.

Interestingly, his blog post comes the same day that all business media report on the announcement of the Bundesbank that they are moving some of the gold reserves back to Germany. The move of these gold reserves is partly seen as a response to an earlier report by the German court of auditors that was concerned with the lack of checks on the gold reserves held abroad.

The story not only made up the headlines but it also came with a quote from Mr Thiele, Bundesbank board member who commented on the purpose of the reserves and the move by saying

"To hold gold as a central bank creates confidence. We build trust at home and have the possibility to exchange gold at short notice into foreign currency abroad."

I am really curious about what (doomsday) scenarios he has in mind where the gold reserves of the Bundesbank would become crucial to restore confidence. By the way, the gold reserves of the Bundesbank which at 130 Billion Euros are large compared to other central banks seem small compared to many other magnitudes that matter in financial markets, more so during crisis time. And I am assuming that these scenarios are catastrophic, otherwise why would gold be needed to buy foreign currency. And given that they are thinking that those scenarios are likely, is there anything that they are planning to deal with them?

There is, however, one positive outcome out of this news and Mr Thiele's quote. I need to teach my students tomorrow about central banks and the history of the monetary system (including the gold standard) so I know have some good material to motivate my lecture.

Antonio Fatás

The Euro-model scare tactics

Regularly The Wall Street Journal writes an opinion article about the failure of the European economic model. A bloated welfare state, high taxes, heavily-regulated labor markets have led to a disappointing economic performance. The predictions are generally dire and after reading the article it seems that the only remaining question is how long the European countries and the Euro project will survive.

The latest of these articles was published yesterday under the title "Europe's Bankrupt Welfare State".

The article reminds us that despite the recent optimism, the Euro economies are doomed and that this has to do with all the structural problems that these countries face. Quoting from the article:

"Some observers will blame the joblessness and lack of growth in the euro zone on the austerity supposedly being imposed on the Continent by Berlin. But the real story is more ominous. (...) Europe's vaunted social model has struggled to generate growth or jobs for decades. (...) The euro zone may be enjoying a respite. But the economic evidence shows how little has been fixed. Mr. Draghi's blank check addressed the symptom, but not the cause, of the euro zone's economic woes. And unless those are addressed—with more flexible labor markets, a smaller state and lower taxes—the crisis will be back in the form of social unrest, political populism and a generation of young Europeans who don't know what it is to be able to find a good job."

I have no trouble with the statement that Europe needs structural reforms. But the notion that "economic evidence shows how little has been fixed", that "Europe's model has struggled to generate growth or jobs for decades" and how the European model is "bankrupt"seem to be overstated. Even worse, these articles seem to be written as a way to scare those in the US economic policy debate that argue in favor of anything that resembles the European model (higher taxes, more regulation, a universal healthcare system). But is the evidence as clear as the Wall Street Journal suggests? Has the Euro failed so badly in terms of generating employment and growth? Below is the employment to population ratio (for those over 15 years of age) for the Euro area compared to the US during the years where the Euro has been in existence. The series are rebased so that their value is equal to 100 in 1999.

Since the Euro was launched, its members have seen a small increase in this ratio, but the performance has certainly been better than that of the US labor market. Just to be clear, the level of the employment to population ratio in the Euro area still remains below that of the US today, mainly because of historically low female participation rates in Southern Europe. But given that claim in the WSJ article is about growth and creation of jobs since the Euro has been in place, using the year 1999 as a reference seems the right thing to do.

Antonio Fatás

Lack of progress in Macroeconomics

In today's Financial Times, an article by Jeffrey Sachs presents all kinds of arguments to conclude that Keynesian economists have been wrong during the crisis, that fiscal and monetary policy tools have not worked and that the US and other advanced economies need a different kind of policy (education, infrastructure,...).

The issues raised are complex and there will always be a debate on the mix of economic policies that are right to help growth in a given circumstance. But the article does two things which are difficult to justify: first it reaches conclusions about what we have learned without citing any proper empirical evidence (the "it is so obvious" syndrome). And, second, it presents arguments which are inconsistent. Let me take on both of these issues separately.

The article argues that Keynesian policies have not helped and cannot help in the current economic environment. This has been and still is a debate where one needs to go to the data and come up with some clever way to produce a proper test. Jeffrey Sachs knows this and opens up his argument by saying:

"We can’t know how successful (or otherwise) these policies have been because of the lack of convincing counterfactuals." 

Yes, empirical tests in macroeconomics are challenging. But then he says


"We should have serious doubts. The promised jobs recovery has not arrived. Growth has remained sluggish. The US debt-GDP ratio has almost doubled from about 36 per cent in 2007 to 72 per cent this year."

Is that a test? Is this the counterfactual that was so difficult to build? That was easy!

And if you want to know what is the cause of low economic growth in Europe, it is not austerity:

"The crisis in southern Europe is often claimed by Keynesians to be the consequence of fiscal austerity, yet its primary cause is the countries’ and eurozone’s unresolved banking crises."

I wonder what type of counterfactual he built to reach this conclusion.

And as it is also obvious that austerity is not responsible for the UK slowdown, it is all due to

"the eurozone crisis, declining North Sea oil and the inevitable contraction of the banking sector"

That was another quick conclusion to reach.

Let me move now to the second point I wanted to make, one of inconsistencies in the logic used. The article criticizes monetary policy for ignoring the risk that current low interest rates might be creating another bubble. Here is what I find interesting: the only mainstream models that I know where monetary policy can affect real interest rates are Keynesian models (the ones he is criticizing). It is only in models where prices are sticky that you have the central bank, who sets the nominal interest rate, having an effect on the real interest rate and economic activity. But even in these models, this effect is transitory. As soon as prices adjust, real interest rate go back to equilibrium, out of control of the central bank.

The narrative that suggests that the Federal Reserve is responsible for low interest rates since 2003 is not supported by any economic model I know. The drift in real interest rates that we have witnessed for more than 10 years has to be more fundamental than a switch to expansionary monetary policy.

And nothing more fundamental than supply and demand which in this market is represented by world saving and investment. It is well documented that there has been a significant shift in global saving during the last decade. One that justifies the global imbalances that we have witnessed and also the fact that global interest rates have decreased. And after 2008 a global crisis that resulted in yet another increase in the supply (saving) and a decrease in demand (investment) has brought these rates to even lower levels. Central banks are not responsible for this trend. And if you do not believe in Keynesian models they cannot be even responsible for the small movements around the trend.

Economists will never agree on everything and the excuse we (economists) have is that it is impossible to build empirical tests that definitely prove or disprove alternative theories. But we can do better than this article. We can at least build on a set of knowledge that is commonly accepted rather than reopening the debate starting from zero whenever we want to make a clever or controversial point.

Antonio Fatás