BIS: Bank for Inconsistent Studies

The BIS just published its annual report (and some of its arguments are also presented in a lecture that Raghuram Rajan gave at the BIS at the time of the launch). Paul Krugman has posted a reaction to the report where he expresses surprise at how the report seems to ignore evidence we have accumulated during the crisis. I will not repeat Krugman's arguments here but instead focus on what I perceive to be a series of inconsistencies in the arguments used in the BIS report - inconsistencies that are also present in the lecture by Rajan.

Both the BIS report and the speech by Rajan present a critical view of the fiscal and monetary policy stimulus we have witnessed over the last years. It is a soft criticism as they seem to agree that some of it was needed, but then they present arguments that suggest that both policies have gone too far, are not being effective, they might be slowing down growth and they will be a source of uncertainty going forward. The criticism is not always accompanied with an alternative. There is a recognition that this is a crisis caused by low demand but at some point the arguments is turned around to argue that more demand might not be a solution (given all the structural problems we have).

The report is long so let me focus on two issues where I feel their arguments are not only not supported by the evidence but also lack some internal consistency.

The report in unclear about whether the short-run and long-run recipes to get out of the crisis should be different. Everyone understands that some of the trends that we witnessed before the crisis were unsustainable from a long-run point of view. Some of the spending patterns of the private sector (and the public sector in some cases) were leading to an accumulation of debt that needed a correction. No disagreement here. But when the adjustment took place it did it in a way which was not efficient. A deep recession started (and the BIS report explains very clearly why lack of demand created this recession).

How do you deal with a recession that is defined as a period where output is below its trend? Even if we agree that the trend is not growing as fast as before (although I am not sure we have enough evidence to prove this but I am open to the argument), isn't it obvious that we are producing below trend? And if we are, what we need are policies that restore full employment, that bring output close to equilibrium. These are the policies that can increase output in the short run. Supply (structural) policies can be a source of output in the long run and there might be great benefits to those policies as well, but unless one is willing to argue that output today is at potential, there must be room for demand policies. The BIS does not take a clear stance on this. It simply criticizes those who argue in favor of additional stimulus on the basis that they ignore structural problems. But this is not correct. Those of us who have argued in favor of demand policies have never denied that there is room for structural reform in many advanced economies. It is a matter of timing.

And what about the evidence? The argument from Rajan that "what is true is that we have had plenty of stimulus." is at odds with the evidence. Both fiscal policy and monetary policy have been less expansionary (or more contractionary) than in any previous recession.

When it comes to monetary policy the report adopts a similar attitude: while it admits that many of the policies were necessary there is a criticism that central banks have gone too far and now they are going to cause trouble as they clean up the mess that they made. Let me focus on one of the arguments they make: that central banks has been too accommodative and that interest rates have been too low. The report makes the argument that this has been going one for years now.

Below is a chart from section VI.6 of the BIS report to show that interest rates are too low today and they have been low for most of the years since 2000, both in advanced economies and emerging markets.

The chart uses the Taylor rule as a benchmark for what constitutes appropriate interest rates. The Taylor rule was proposed by John Taylor in 1993 to describe the behavior of the US Federal Reserve during the 80s. The tool became very popular because it could explain interest rates just by using two variables: inflation and the output gap. Anyone who has studies Taylor rules knows that the moment you apply it to a different period or a different country, the rule does not work as well. There are many problems: which is the appropriate measure of the output gap or inflation, are the coefficients changing over time, during recessions, etc.

But the fundamental issue with the Taylor rule is about the appropriate benchmark for the real interest rates in normal times. The original Taylor rule used the value 2% as the "natural" real interest rate.  This number worked well because it was coming from the data that Taylor was looking at (in some sense Taylor estimated this number using data from the 80s in the US). But this is an equilibrium concept and as such it can change. What we teach our students is that this rate is determined by the balance between Saving and Investment. What we know is that since the end of the 90s some countries started saving at much higher rates than before, what Ben Bernanke called the Saving Glut back in 2005. What we also know is that the global recession has pushed Saving higher in depressed economies and that we have seen limited reason to invest (e.g. the anecdotal reference to companies sitting in a pile of cash not wanting to invest). In that environment, we expect the equilibrium real interest rate to go down significantly. The BIS report and Rajan's speech keep referring to the "Keynesian" view that equilibrium real interest rates have turned negative. What is "Keynesian" about that view? The Saving / Investment imbalance is an equilibrium concept that is present in any economic model I know. The BIS report takes no stance in this debate, it simply criticizes others. What is the real equilibrium interest rate in the world economy today according to the BIS? 2%?

Finally, if it is true that monetary policy has been so accommodative for about 13 years, where is inflation? The Taylor rule was partly proposed as a benchmark on how to maintain a stable rate of inflation. If we keep the interest rate below what is appropriate for 13 years we should see massive inflation everywhere in the world. But there is no inflation. Isn't this enough evidence to stop the BIS from producing the chart above as a proof that central banks have gone too far?

Yet another day when one feels that this crisis has been a wasted crisis for economists to learn about our mistakes.

Antonio Fatás

The power of statistics (Ferguson and the WSJ)

Dean Baker complains about the high number of inconsistencies and mistakes that Niall Ferguson manages to put together in a Wall Street Journal piece written three days ago. There seems to be a pattern here given the article that Niall Ferguson had written just a few days earlier (June 7) also in the Wall Street Journal.

The way I found that second article is interesting and it shows the negative influence of these articles -- even if the mistakes are obvious. I found that second article by Ferguson because as I was teaching some of my students here at INSEAD about the connections between institutions and growth, one of them mentioned an article in the Wall Street Journal that was showing data that contradicted some of my statements. The article, by Niall Ferguson claimed that according to the using data from the Doing Business report from the World Bank, ranked the US as the sixth-worst country in the world when it comes to how easy it is to do business -- I was, of course, showing data that the US remains one of the countries on top of that list.

[Update: Here is the quote from Ferguson's article:"In only around 20 countries has the total duration of dealing with "red tape" gone up. The sixth-worst case is none other than the U.S., where the total number of days has increased by 18% to 433."]

I had to read the article several times to understand how the statistics from the World Bank report were manipulated (I cannot find another word) to produce such a misleading picture of (excessive) regulation in the US. Here is the trick: what Niall Ferguson does is to look for countries that have gotten worse when it comes to the number of days it takes to get certain procedures done. It then ranks them by this criteria (the increase in the number of days) measured in percentage terms. Because the US has indeed increased the number of days and because the initial number was very low, measured as a % makes the US look like the 6th worst country in the world (when you go from 1 day to 2 days it is a 100% worsening; much better than when you go from 300 days to 500). Of course, if you look at the actual number of days the US remains one of the best places to do business in the world (according to this report). The US is ranked #4 in the overall ranking - same position as last year- and #13 when it comes to "Starting a Business" indicators (one position lower than last year).

I am sure that there are some areas in which the US is not as good as it was as a place to do business. But misusing statistics to make the US look like the 6th worst country in the world is just wrong. And the fact that the argument was convincing enough for that student in my class to bring it up as an argument shows the power that media can have in the political debate.

Antonio Fatás

QE and Stock Markets: Boom or Crash?

Here is a follow up to my previous post about what to expect when Quantitative Easing is reversed. The point I made earlier is that the more likely scenario for tightening of monetary policy is that this will happen when growth gets stronger. Krugman makes the same point in his latest post. But I can also see plenty of articles talking a much more pessimistic view and describing all the bad things that will happen when central banks change their current monetary policy stance from expansionary to neutral, including a large downward adjustment to stock markets. I am surprised that there are very few historical references in those articles, so let me produce two to refresh our historical memory.

What has happened to the stock market in previous cycles after the central bank decided to abandon its policy of low interest rates and start raising those rates? I will use US data and I will focus on the last two episodes:

1. After the 1990 recession, interest rates remain low until February 1994 when the Federal Reserve started increasing rates from a level of 3% to 6.6% in May of 1995.
2. After the 2001 recession, interest rates were lowered to 1% and then started to increase in June 2004 from that level to 5.25% in June 2006.

The image below plots the evolution of the stock market in the months that followed both episodes. The Dow Jones Index is rebased to be equal to 100 the month when interest rates started going up -- I also provide the previous 12 months to get a perspective on what happened during the previous year. [Note: I stop the series when I see interest rates declining again as growth slows down in 1997 or as we enter the recession of 2007.]

In both cases we see a similar patter. Initially the stock market moves sideways. During the first year there are gains of about 1%. But the years that follow, and once the increases in interest rates have stopped we see large increases in the index -- interest rates stopped increasing in the first episode 12 months after they started going up; in the second episode it happened about 24 months later. This is more or less when the stock market starts its climb. 

As always it is hard to know what the market was thinking during those months. We clearly do not see a fall in the stock market in any of the two episodes, we seem to see a period of wait and see while interest rates are increasing but once interest rates stabilize we see significant booms in stock prices driven by the positive economic dynamics (high growth) that drove interest rates up in the first place.

Antonio Fatás

Looking forward to the end of QE

Good piece in the FT online today by Gavyn Davies on what wil happen to markets when QE (quantitative easing) ends. As we have witnessed last week, comments on the potential end to QE can generate significant volatility in financial markets. But there is something in this debate that still confuses me and it has to do with the interpretation that some make of the end of QE.

QE will end one day, this must be the assumption of anyone who understands monetary policy. The day the recovery is strong enough, when central banks feel that the economy is close enough to full employment we will see a normalization of monetary policy conditions. From an expansionary stance we will move towards a more neutral stance. This has always been the case in the past although we used to think only in terms of interest rates and not QE. One way to see how this will happen is the chart below (which I am borrowing from a recent Brad DeLong blog post).

This is a plot of long-term (10 years) and short-term (3 months) interest rates for the US. The pattern that we see after each of the last recessions is that short-term rates deviate from long-term rates as a sign that monetary policy is hitting the accelerator (the yield curve becomes steep). A few years after the recession is over, short-term rates are raised and they reach a level similar to long-term rates. After that we see the two continuing at similar levels until the next recession comes. [Note: the chart above plots nominal interest rates so we need to be careful in our interpretation, differences in inflation over different horizons can be relevant to explain the shape; I am ignoring inflation in my analysis.]

We expect a similar patter this time, the red line will catch up with the blue line at some point in the future and before that happens we will see a statement from the US Federal Reserve that QE is about to end (or to slow down at first). What is clear from the chart is that it is taking longer than before for short-term rates to go back up to meet long-term rates, a sign that the current recovery is much weaker than previous recoveries.

What will we learn the day Ben Bernanke announces that we are starting that path towards normalization? It might be that we simply learn that he is becoming optimistic about growth in the US. This will be good news. It might not be a surprise to some who expected that type of growth going forward, but it could be a positive surprise to others that thought growth would never come back. In this scenario, it is difficult to think about such an announcement as bad news. We know that QE will end one day, we know that short-term rates will have to increase, so if the announcement was to be a surprise in the sense that it is coming too early, it would mean that there is a positive surprise in terms of growth happening early than expected -- and this has to be good news.

There is a second and more pessimistic scenario: the day Ben Bernanke announces that QE is ending we learn that the economy is not doing much better but that the FOMC has simply changed their mind. That they do not care about low growth, that they want to be tough and that they are ready to stop QE to signal a change in policy. This would be bad news because it represents a change in policy and not a change in our expectations about growth.

Understanding what will happen to markets when QE ends requires to decide about which of the two scenarios above is more likely. I personally see the first scenario more likely than the second one. I do not see a policy reversal in the near future but I do see the end of QE as good news accumulate. But this is my view, what matters is how the stock market will read the communications of the central bank. The words chosen to communicate their actions at that point as well as their credibility will make a great difference.

One final point to notice in the chart above: while the pattern of deviations between the red and blue line are clear, there is also a clear downward trend in long-term rates (in nominal terms in the chart but we know that there is a similar downward trends in real rates). As Gavyn Davies points our in his article, there is some uncertainty about this trend. Is this trend real or is it the outcome of a bubble? This is a second potential source of uncertainty. When the red line starts climbing, what will happen to the blue line? Will it stay around where it is and the two will meet at a level that will be low by historical standards? Or will we see a significant increase in long-term rates as expectations of monetary policy are challenged? I have argued before that there are fundamental reasons why long-term interest rates are low that are independent of what monetary policy is doing. But others argue that long-term rates are distorted and ready to go up when QE ends. If this is the case, then stopping QE will suddenly increase all rates up and it will certainly be be bad news for financial markets.

Antonio Fatás

Search for yield

More on the issue of bubbles in the stock market. Here is a chart from Google Trends on the worldwide trends for the search of the term "stock market rally". An upward trend but still below the levels in October 2010 or 2011 and much lower than at the height of the financial crisis (2009-2009).

The myth of liquidity and bubbles in financial markets

Gillian Tett at the Financial Times wonders today about how long the stock market rally will continue. Her argument is that we see data that are at odds with historical norms: the stock market goes up when unemployment is still rising in Europe, earnings come short of expectations and the rally continues. uncertainty is still high but spreads are low. How can this be? Her explanation:

"It is easy to identify the reason for this: as this data has gone haywire in the past couple of years, western central banks have been unleashing an estimated $7tn worth of quantitative easing. This has lowered interest rates on government bonds, forcing investors to search elsewhere for yield."

So it is the Central Banks and quantitative easing that is supporting the behavior of financial markets and we need to worry about how sustainable it will be. Gillian Tett refers to the 2003-2007 experience when we witnessed something similar and we know how it ended.

This is now a common argument and a concern, that the behavior of central banks and the enormous amount of liquidity that they are introducing in financial markets is simply creating mispricing and bubbles in financial markets.

While it is possible that periods of low interest rate create behavior in financial markets that is associated to bubbles and potential instability, the argument that puts all the burden in central banks and liquidity is simply wrong. In fact, articles like this one reminds me of how disconnected the analysis of prices in financial markets is from the analysis of fundamentals and it is this disconnect and what you read in the article that makes me worry about instability in asset prices. Let me explain.

The first source of confusion is to that rates and returns are low just because central bank actions. As I have argued before, interest rates are low because of a trend that started in the mid 2000s of increased saving in some emerging markets and the effects of the great recession that increased saving in advanced economies and made investment collapse.  When no one wants to invest or consume, interest rates are low. And they are unusually low this time because the patterns of investment and saving are driven by a  crisis that is very large compared to historical patterns. As a reminder, interest rates are low everywhere not just in countries where quantitative easing is taking place:

The chart above (from the most recent IMF Asia Pacific Regional Outlook) shows that real rates are negative in all countries in the Asia-Pacific region. And, sure, you can still blame Ben Bernanke for all this by arguing that the liquidity that he is creating is crossing oceans and reaching all these countries but that is just nor right. The right explanation is that in a world with fairly well integrated capital markets, returns are similar everywhere.

And this basic fact: that it is the balance between real flows that is mostly behind the abnormal behavior in financial markets is wildly misunderstood. Here is a quote from the Financial Times piece:

"(Quantitative easing) has lowered interest rates on government bonds, forcing investors to search elsewhere for yield. But what has intensified the crunch is that, while central banks have been gobbling up bonds, the supply of assets has declined."

Why is the supply of assets declining? There must be a reason why companies or individuals do not borrow (or borrow less). Equilibrium is about demand and supply. Why is it that companies are not borrowing in what seems to be extremely favorable financial conditions? When asset prices are too high and the cost of capital is below its fundamental value we should observe an excessive amount of (real) investment. But we do not see it. Isn't it more natural to think about an equilibrium where relative high saving and low investment are resulting in low returns and yields across all assets? It is, but it is probably less interesting to write an article about it.


The final confusion is about how low interest rates (or equilibrium returns) should be reflected in asset prices. If markets suddenly learn that the fundamentals of the world economy are pushing the real rate on safe assets down, we expect asset prices to increase to adjust to this new equilibrium. What we should NOT expect is that stock market returns are higher going forward. In fact, stock prices should go up so that equilibrium returns are lower across all asset classes. And this is the biggest source of confusion in the commentary we often read about the stock market rally. The question is always: "How long will the rally last?" as opposed to "Are current stock prices supported by fundamentals?" Bubbles occur when markets think in terms of arrows and not in terms of levels. Some of the rally in the stock market now, as well as in 2003-2007, is associated with the fact that the market is learning that interest rates and equilibrium returns are going to be lower for longer than what they though (this is what some call the search for yield). Asset prices increase to reflect this new equilibrium. But this increase, this "rally", leads to a reading in terms of the high short-term returns that it has generated. And then investors extrapolate and assume that they have finally found a place where yields are high! This is a bubble. When asset prices are not consistent with fundamentals.

The current value of the stock market is consistent with a world where returns are likely to remain low (by historical standards) across all assets, and this is why stock prices are high. But this story is inconsistent with a world where stock prices keep going up and generate an excessive return in the future. If we keep looking at the stock market in terms of arrows we will end up once again in a very unstable world. And it will not be the liquidity of central banks who caused it but the lack of understanding about some basic principles of asset pricing.

Antonio Fatás

Time travel in Euroland

Unfortunately, this is not news by now, but the president of the Euro group, Jeroen Dijsselbloem in an interview with CNBC yesterday dismissed the role that fiscal policy and monetary policy can have to address the economic crisis (emphasis is mine):

"Monetary policy can really not help us out of the crisis. It can take away the pressure, it can accommodate new growth, but what we really need in all countries is structural reforms in the first place. I'd just like to stress the point that in the policy mix of fiscal policy, monetary policy and structural reforms — I'd like the order to be exactly the other way around. Structural reforms in the first place, fiscal policy and viable targets in the mid-term for all regions in second place — and monetary policy can only accommodate domestic economic problems in the short-term."

It is not exactly clear what to make out of his statement but it seems that long-term solutions should come first before we implement those that will help us in the short term. It is surprising that even today there is such a great confusion about long-term versus cyclical problems.

This confusion comes from a basic belief that some hold that there is nothing inherently different in the dynamics of an economy when one looks at the short run and the long run. This is part of a never-ending academic debate but when it comes to policy makers and politicians it seems to be more a matter of beliefs.

What it is not always understood is that we are dealing with two separate problems and therefore we need two different set of tools or solutions to deal with them.

It is possible that irresponsible behavior, excessive spending and accumulation of debt (private or public) are the cause of the Great Recession. And if this is true, it will require future adjustments to spending plans, deleveraging, and fiscal discipline to avoid a repetition of this event in the future.

But once the crisis started we are dealing with a second problem: a recession that moves us away from full employment. This is a cyclical phenomenon that is well described in macroeconomic textbooks and to deal with it we use monetary and fiscal policy. The fact that potentially debt and excessive spending were the cause of this cyclical event does not mean that we need to deal with these imbalances now to get out of the crisis. We are dealing with two separate phenomena that are only related because one possibly led to the second one, but the dynamics associated with each of them are very different and the recipe to get out of them can be, in some cases, the opposite.

This is what we write in all macroeconomics textbooks: what works in the short run might not work in the long run. As an example, we emphasize the importance of saving in the long run to drive investment and growth. But when we talk about the short run we emphasize the importance of spending to understand fluctuations in economic activity. Excessive spending hurts growth in the long run but it is spending and demand what drives growth in the short run.

There will be a day when we will have to debate about whether the cyclical phenomenon has already been addressed because we are back to full employment and therefore all our focus should be on the long term, but it is very hard to argue that this is where Europe is today. My point is not to deny that there are many deep structural issues to be addressed among Euro countries, but to recognize that we are dealing with two set of dynamics that require different solutions and until we invent time traveling the short term still comes before the long term.

Antonio Fatás