Via Barry Ritholtz I read the analysis of Lacy Hunt about how recent Federal Reserve policies have been a failure to lift growth. I am somehow sympathetic to the argument that Quantitative Easing has had a limited effect on GDP growth -- although one has to be careful when analyzing the effectiveness of QE by comparing it to the alternative scenario (no QE at all) rather than simply measuring the observed GDP growth. But I find that the analysis of the article is not accurate when it come to the working of central bank reserves (and I have made a similar point before). Maybe it is a matter of semantics but the way the author analyzes the relationship between reserves and the money multiplier is not consistent with the conclusions reached about the lack of effectiveness of monetary policy actions.
Let me highlight two pieces of the analysis that I have difficulty understanding. First, there is the argument that increasing the amount of Reserves (deposits of commercial banks at the central bank) not only is not helpful but can be a source of speculation and bubbles. The actual quote from the article is:
"If reserves created by LSAP (Large Scale Asset Purchases) were spreading throughout the economy in the traditional manner, the money multiplier should be more stable. However, if those reserves were essentially funding speculative activity, the money would remain with the large banks and the money multiplier would fall. This is the current condition."
How can reserves be funding speculative activities if they remain in the balance sheet of the banks? Reserves represent an asset in the balance sheet of commercial banks. They have increased by having commercial banks selling other assets to the central bank. So the amount of "riskier" or "less liquid" assets must have decreased. The author suggests that what is going on is the following:
"(Banks) can allocate resources to their proprietary trading desks to engage in leveraged financial or commodity market speculation. By their very nature, these activities are potentially far more profitable but also much riskier. Therefore, when money is allocated to the riskier alternative in the face of limited bank capital, less money is available for traditional lending. This deprives the economy of the funds needed for economic growth, even though the banks may be able to temporarily improve their earnings by aggressive risk taking."
Yes, banks can trade their Reserves for either bank loans to the private sector or by purchases of risky assets (stocks). But in both cases the amount of reserves has to go down. One can make the argument that the injection of liquidity is triggering one type of lending more than another but this is inconsistent with the view that the problem with QE is that banks are simply sitting on reserves without doing anything with them.
Finally, the author argues that the fall in the money multiplier is a way to see the failure of QE.
"Today the monetary base is $3.5 trillion, and M2 stands at $10.8 trillion. The money multiplier is 3.1. In 2008, prior to the Fed's massive expansion of the monetary base, the money multiplier stood at 9.3, meaning that $1 of base supported $9.30 of M2. The September 2013 level of 3.1 is the lowest in the entire 100-year history of the Federal Reserve. Until the last five years, the money multiplier never dropped below the old historical low of 4.5 reached in late 1940. Thus, LSAP may have produced the unintended consequence of actually reducing economic growth."
The money multiplier has collapsed because the panic from the financial crisis triggered a very large increase in demand for liquidity. The money multiplier is inversely related to the demand for liquidity of households and financial institutions. In those instances, if the central bank does not increase the monetary base, the money supply will collapse with catastrophic consequences for the real economy (these were the dynamics of the Great Depression). By increasing the monetary base (QE) the central bank is ensuring that the money supply is not falling and therefore supporting growth. Reading the fall in the money multiplier as a failure of monetary policy to stimulate growth is not correct.
The rest of the article makes some good points and refers to recent academic articles that suggest that QE has not been very powerful affecting interest rates or lending and I think that some of that evidence is useful and a good starting point to debate on the effectiveness of monetary policy when interest rates are zero.
Antonio Fatás
Monday, October 21, 2013
Thursday, October 17, 2013
Evidence on the (limited) power of exchange rates
The benefits and costs of different exchange rate regimes is one of the most debated topics in international macroeconomics and it is crucial for a very important decisions that policy makers regularly face on how to manage exchange rates. The launch of the Euro gave great impetus to this debate as some countries had to decide whether they wanted to be in or out and the rest of the world was looking at this experiment as a way to think about similar arrangement in other regions of the world. The 2008-09 crisis and the dismal performance of some Euro countries have reopened the debate about what life would have looked like for some of these countries if they had stayed out of the Euro.
I have written before my views that run contrary to the conventional wisdom. Many believe that while the Euro might make sense as part of a political process of European integration, it has had clear negative consequences on economic performance, consequences that are obvious when one looks at the effects of the current crisis in the Euro periphery countries. In several blog posts (here or here) I have provided anecdotal evidence that this conclusion is not supported by the data by comparing the performance of countries in and out of the Euro area and also by looking at the consequences of previous crisis when some of the Euro countries still had their exchange rate.
But what happens if one goes beyond the anecdotes and tries to systematically analyze the difference in performance of different exchange rate regimes? Unfortunately this is a difficult task. My own reading of the literature was that the evidence is mixed and inconclusive, there are no strong empirical results that prove that the exchange rate system has a significant effect on economic performance. But most of these academic papers were quite old.
Andrew Rose has just produced a study that looks at the performance of different exchange rate regimes during the global financial crisis. He includes as many countries as possible and he carefully controls for any potential determinant of economic performance (growth, inflation,...). His conclusion:
"Roughly similar countries are happy to maintain radically different monetary regimes. In this paper, I have found that this decision has been of little consequence for a variety of economic phenomena, at least lately. Growth, the output gap, inflation, and a host of other phenomena have been similar for hard fixers and inflation targeters in the period of and since the global financial crisis. That is, the "insulation value” of apparently different monetary regimes is similar in practice. Since the international finance literature has found few substantive macroeconomic differences across monetary regimes, I expect this result to be banal for some. Since this stylized fact is not well known outside international economics, I expect it to seem implausible to others."
He finds very little difference in performance when comparing across different exchange rate regimes. The exchange rate regime matters very little. I do not think the result is banal, as he argues, it is an important result that is necessary to check the validity of our priors and the theoretical predictions of our models. But I agree with him that some would consider the result implausible and would, unfortunately, continue with their current beliefs that exchange rate regime decisions have strong consequences on growth and volatility.
Antonio Fatás
I have written before my views that run contrary to the conventional wisdom. Many believe that while the Euro might make sense as part of a political process of European integration, it has had clear negative consequences on economic performance, consequences that are obvious when one looks at the effects of the current crisis in the Euro periphery countries. In several blog posts (here or here) I have provided anecdotal evidence that this conclusion is not supported by the data by comparing the performance of countries in and out of the Euro area and also by looking at the consequences of previous crisis when some of the Euro countries still had their exchange rate.
But what happens if one goes beyond the anecdotes and tries to systematically analyze the difference in performance of different exchange rate regimes? Unfortunately this is a difficult task. My own reading of the literature was that the evidence is mixed and inconclusive, there are no strong empirical results that prove that the exchange rate system has a significant effect on economic performance. But most of these academic papers were quite old.
Andrew Rose has just produced a study that looks at the performance of different exchange rate regimes during the global financial crisis. He includes as many countries as possible and he carefully controls for any potential determinant of economic performance (growth, inflation,...). His conclusion:
"Roughly similar countries are happy to maintain radically different monetary regimes. In this paper, I have found that this decision has been of little consequence for a variety of economic phenomena, at least lately. Growth, the output gap, inflation, and a host of other phenomena have been similar for hard fixers and inflation targeters in the period of and since the global financial crisis. That is, the "insulation value” of apparently different monetary regimes is similar in practice. Since the international finance literature has found few substantive macroeconomic differences across monetary regimes, I expect this result to be banal for some. Since this stylized fact is not well known outside international economics, I expect it to seem implausible to others."
He finds very little difference in performance when comparing across different exchange rate regimes. The exchange rate regime matters very little. I do not think the result is banal, as he argues, it is an important result that is necessary to check the validity of our priors and the theoretical predictions of our models. But I agree with him that some would consider the result implausible and would, unfortunately, continue with their current beliefs that exchange rate regime decisions have strong consequences on growth and volatility.
Antonio Fatás
Wednesday, October 9, 2013
Wait a (second) moment...
Marco Buti and Pier Carlo Padoan reply to the criticism that I had raised in an earlier blog post to their previous article on how to strengthen the European economy recovery. I can see that their argument is now more balanced where fiscal policy consolidation is mentioned as a potential factor to explain the dismal recovery. We still probably disagree on how much of a factor it was and whether there were alternatives to the policies that Euro countries implemented but at a minimum it is good to see that it is not included as a possible factor. On the issue of reforms it is hard to disagree with them on the need for further reforms in Europe, the real debate is whether these reforms will pay off fast enough and if they do not, what is the role for traditional demand policies (monetary and fiscal).
But there is something else in their article where my reading is quite different from theirs: the role of policy uncertainty. Before I express my views let me state that one of my most cited research papers is about the role of fiscal policy volatility in reducing economic growth (here is an example of my work in this area), so I am very open to the idea that volatility in policy can be detrimental to growth. But I have always been surprised that uncertainty and volatility are some times used to refer to episodes where the possibility of a bad scenario is increasing and this is not quite the same as an increase in uncertainty. Let me explain.
When we talk about volatility we are referring to an increase in the variance (which is a "second order moment" in statistics, that's the origin of my title) while we keep the mean constant (the mean is a "first order moment"). So increases in uncertainty or volatility only apply to circumstances where on average we expect a similar outcome but now we have a higher probability of both a better and a worse outcome. What we have seen in Europe during the crisis is very different. Quoting from Buti and Padoan:
"The unprecedented increase in tail risks in 2011 and first half of 2012, when the survival of the Eurozone was widely questioned, qualifies as such an uncertainty shock."
This is not (just) an uncertainty shock. The mean is also changing. The average scenario ahead looks much worse now that the Eurozone might collapse. Strictly speaking it might be that the variance has also increased but the change in the mean is probably more relevant than the change in the variance. The fact that a Eurozone collapse is now possible means that we face a much worse scenario ahead for the Euro countries (regardless of how uncertain we are about that scenario). And why was the Eurozone about to collapse? Because we are in the middle of a really bad crisis. And what is making the crisis so bad? Many things but one of them is the inappropriate policy mix (fiscal and monetary). So it is really uncertainty? No, it is simply a measure of how low expectations are getting and expectations are endogenous to current outcomes. There are, of course, statistical methods to try to separate each of these factors and establish a proper measure of uncertainty and a true causal relationship to growth but my reading of the academic literature is that this is not what we are doing and we are still dealing with correlations and comovements in variables without a clear understanding of the truly exogenous variation in policy uncertainty. All the bad news are included in what is being called an uncertainty shock.
Antonio Fatás
But there is something else in their article where my reading is quite different from theirs: the role of policy uncertainty. Before I express my views let me state that one of my most cited research papers is about the role of fiscal policy volatility in reducing economic growth (here is an example of my work in this area), so I am very open to the idea that volatility in policy can be detrimental to growth. But I have always been surprised that uncertainty and volatility are some times used to refer to episodes where the possibility of a bad scenario is increasing and this is not quite the same as an increase in uncertainty. Let me explain.
When we talk about volatility we are referring to an increase in the variance (which is a "second order moment" in statistics, that's the origin of my title) while we keep the mean constant (the mean is a "first order moment"). So increases in uncertainty or volatility only apply to circumstances where on average we expect a similar outcome but now we have a higher probability of both a better and a worse outcome. What we have seen in Europe during the crisis is very different. Quoting from Buti and Padoan:
"The unprecedented increase in tail risks in 2011 and first half of 2012, when the survival of the Eurozone was widely questioned, qualifies as such an uncertainty shock."
This is not (just) an uncertainty shock. The mean is also changing. The average scenario ahead looks much worse now that the Eurozone might collapse. Strictly speaking it might be that the variance has also increased but the change in the mean is probably more relevant than the change in the variance. The fact that a Eurozone collapse is now possible means that we face a much worse scenario ahead for the Euro countries (regardless of how uncertain we are about that scenario). And why was the Eurozone about to collapse? Because we are in the middle of a really bad crisis. And what is making the crisis so bad? Many things but one of them is the inappropriate policy mix (fiscal and monetary). So it is really uncertainty? No, it is simply a measure of how low expectations are getting and expectations are endogenous to current outcomes. There are, of course, statistical methods to try to separate each of these factors and establish a proper measure of uncertainty and a true causal relationship to growth but my reading of the academic literature is that this is not what we are doing and we are still dealing with correlations and comovements in variables without a clear understanding of the truly exogenous variation in policy uncertainty. All the bad news are included in what is being called an uncertainty shock.
Antonio Fatás
Sunday, October 6, 2013
Underestimating economic potential as a justification for inaction
The narrative about the 2008 financial crisis is about the notion that several economies were following an unsustainable path before the crisis started. We talk about excessive spending, exploding debt levels, bubbles in asset prices and the imbalances they create. These imbalances are the seed of the crisis. While the story sounds simple, it is not well understood by standard macroeconomic models and this has led in my view to excessive pessimism about growth and the recovery.
In macroeconomics, the notion of "growing too fast" or "producing too much" is normally captured by measures of potential output or the output gap. When GDP is above its potential (or the output gap is positive) we label that situation as unsustainable. But in reality, most times we only see this after the crisis. It is only when we are in the middle of the crisis or even out of it that we recalculate all the measures of potential output to argue that the pre-crisis level were unsustainable. A good example is Latvia, an economy that suffered a large loss in GDP and it is recovering from it. But a recent paper by Olivier Blanchard and co-authors at the IMF argues that the current level of output might not be too far from its potential because the 2007 level represented a level of GDP that was clearly above its potential (Krugman has provided some critical comments on that paper). [Update: Jeremie Cohen-Setton also provides a critical view on how potential output was calculated in the context of European countries].
What do our economic models tell us about producing above potential? Not much. Neoclassical models of the business cycle are characterized by fluctuations that are always optimal, so it is hard to talk about unsustainable growth. It is true that we can have shocks that produce adjustment that have a shape similar to what we see in the Latvian economy but it would require a lot of ad-hoc assumptions about the type of shocks that hit the Latvian economy to replicate those dynamics. Keynesian models do talk about situations where output is "too high" because prices or wages are stuck at a very low level but it is also very difficult to fit that story to the Latvian case and to justify the swing in output that we have seen.
Here is where I think the narrative of the years that preceded the financial crisis does not fit well into traditional macroeconomic models and has led us to excessive pessimism. To describe the pre-crisis years we are telling a story about economic behavior that is unsustainable which will trigger a future adjustment that will have negative consequences in the economy. We can think about a bubble in asset prices or real estate as an example of that behavior. But in this story it is unclear why this leads to the economy operating above potential. The economy has engaged in behavior that is unsustainable and leads to a crisis, that we all agree. But many make the mistake of establishing a one-to-one relationship between an unsustainable level of asset prices or consumption with a level of production that is too high. In an open economy consumption growth can be supported by imports and production abroad leading to a current account deficit (this fits well the narrative of countries like Latvia or Spain or even the US or the UK before the crisis). But in terms of the productive capacity of the economy it is unclear why we have gone in anyway above its maximum. Employment might be high but not "too high" and I cannot see how these dynamics can make productivity go above what is possible.
The way I see the story above is very different from the standard narrative. It is that the unfolding of the imbalances created before the crisis that lead to years of underproduction and a negative output gap. From a macroeconomic point of view maybe we never produced above potential. Or if we did, the magnitude was small. If we perform an ex-post statistical analysis of GDP and simply think about trends we will make the mistake of calling the pre-crisis years as years where we produced too much. If we do that, we are going to become very pessimistic and assume that potential is lower than what it is. In other words, we will make a cyclical downturn look like a structural problem. And alternative way to think about these events is to start with a framework that represents business cycles as asymmetric deviations from potential, which is seen as a maximum level of output. This is what I argued in this blog post. While I do not want to take that too literally (maybe there are times where production is slightly above potential), I think it is a much better representation of economic fluctuations than the notion of economies fluctuating around a trend. In my framework the goal is to minimize the time we spend producing below output and there is also a role to understand and avoid the imbalances that lead us into a crisis.
This is not just an academic debate. Using the wrong framework delivers the wrong recipe for economic policy and affects the lives of many. We have high levels of unemployment, underused capacity, we are not investing at rates which are consistent with the levels one would expect to see but we still justify inaction by arguing that we are not too far from potential and worrying about inflation and the next bubble.
Antonio Fatás
In macroeconomics, the notion of "growing too fast" or "producing too much" is normally captured by measures of potential output or the output gap. When GDP is above its potential (or the output gap is positive) we label that situation as unsustainable. But in reality, most times we only see this after the crisis. It is only when we are in the middle of the crisis or even out of it that we recalculate all the measures of potential output to argue that the pre-crisis level were unsustainable. A good example is Latvia, an economy that suffered a large loss in GDP and it is recovering from it. But a recent paper by Olivier Blanchard and co-authors at the IMF argues that the current level of output might not be too far from its potential because the 2007 level represented a level of GDP that was clearly above its potential (Krugman has provided some critical comments on that paper). [Update: Jeremie Cohen-Setton also provides a critical view on how potential output was calculated in the context of European countries].
What do our economic models tell us about producing above potential? Not much. Neoclassical models of the business cycle are characterized by fluctuations that are always optimal, so it is hard to talk about unsustainable growth. It is true that we can have shocks that produce adjustment that have a shape similar to what we see in the Latvian economy but it would require a lot of ad-hoc assumptions about the type of shocks that hit the Latvian economy to replicate those dynamics. Keynesian models do talk about situations where output is "too high" because prices or wages are stuck at a very low level but it is also very difficult to fit that story to the Latvian case and to justify the swing in output that we have seen.
Here is where I think the narrative of the years that preceded the financial crisis does not fit well into traditional macroeconomic models and has led us to excessive pessimism. To describe the pre-crisis years we are telling a story about economic behavior that is unsustainable which will trigger a future adjustment that will have negative consequences in the economy. We can think about a bubble in asset prices or real estate as an example of that behavior. But in this story it is unclear why this leads to the economy operating above potential. The economy has engaged in behavior that is unsustainable and leads to a crisis, that we all agree. But many make the mistake of establishing a one-to-one relationship between an unsustainable level of asset prices or consumption with a level of production that is too high. In an open economy consumption growth can be supported by imports and production abroad leading to a current account deficit (this fits well the narrative of countries like Latvia or Spain or even the US or the UK before the crisis). But in terms of the productive capacity of the economy it is unclear why we have gone in anyway above its maximum. Employment might be high but not "too high" and I cannot see how these dynamics can make productivity go above what is possible.
The way I see the story above is very different from the standard narrative. It is that the unfolding of the imbalances created before the crisis that lead to years of underproduction and a negative output gap. From a macroeconomic point of view maybe we never produced above potential. Or if we did, the magnitude was small. If we perform an ex-post statistical analysis of GDP and simply think about trends we will make the mistake of calling the pre-crisis years as years where we produced too much. If we do that, we are going to become very pessimistic and assume that potential is lower than what it is. In other words, we will make a cyclical downturn look like a structural problem. And alternative way to think about these events is to start with a framework that represents business cycles as asymmetric deviations from potential, which is seen as a maximum level of output. This is what I argued in this blog post. While I do not want to take that too literally (maybe there are times where production is slightly above potential), I think it is a much better representation of economic fluctuations than the notion of economies fluctuating around a trend. In my framework the goal is to minimize the time we spend producing below output and there is also a role to understand and avoid the imbalances that lead us into a crisis.
This is not just an academic debate. Using the wrong framework delivers the wrong recipe for economic policy and affects the lives of many. We have high levels of unemployment, underused capacity, we are not investing at rates which are consistent with the levels one would expect to see but we still justify inaction by arguing that we are not too far from potential and worrying about inflation and the next bubble.
Antonio Fatás
Tuesday, September 24, 2013
Ignorance and bias in economic models
Greg Mankiw's latest post discusses the potential effects of increasing the minimum wage. He refers to a recent paper by Lee and Saez that argues that increasing the minimum wage can be optimal (for everyone not just those receiving a higher income). But according to Mankiw, the argument of Lee and Saez is based on a model that uses an implausible assumption that drives all the results. Given how unrealistic the assumption is we should dismiss the results.
I do not want to go into the details of the particular assumption of the Lee and Saez paper and how plausible it is (I have no views on it), but let me comment on the reliance of economic models on implausible assumptions.
All models rely on assumptions and economic models are known (and made fun of) for relying on very strong assumptions about rationality, perfect information,... Many of these assumptions are unrealistic but they are justified as a way to set a benchmark model around which one is then allowed to model deviations from the assumptions. The strategy of setting up a benchmark model might sound like a reasonable one as we need to start with a tractable view of the world before one can get "closer" to the complexities of the real world.
But the problem is that the model becomes (or has become) the reference in a way that sets a high burden of proof for any deviations from it. If you think individuals are not rational, go ahead and model their behavior but you should do it in a way that is realistic and backed by data (good luck). If you want to allow for government spending to be productive, you can do it but you better have perfect econometric results that prove that returns to government investment is indeed high. Given that experiments are not possible in economics, it will always be very difficult to produce supporting evidence for some of these assumptions that is not controversial. So what do we do? We claim that we do not know enough about the real world, we claim ignorance, and that would be ok except that we do not stay quiet when we are asked for our opinion. We go back to the results of our benchmark model and if someone asks us about a relevant policy question we use them to justify our answer. Do we care about the fact that the assumptions of that model have never been proven and have no connection to reality? No, we don't.
This subtle (or not so subtle) bias in economic analysis is my biggest source of frustration with my profession. Not being able to predict crisis, the stock market or exchange rates does not bother me, it is just a reflection of the limits of our knowledge and I can live with it. But using the same naive predictions of models that refer to a fictitious world as the reference and only moving away from them when someone produces an unquestionable piece of empirical evidence is in my mind the true cost of our profession to society.
Antonio Fatás
I do not want to go into the details of the particular assumption of the Lee and Saez paper and how plausible it is (I have no views on it), but let me comment on the reliance of economic models on implausible assumptions.
All models rely on assumptions and economic models are known (and made fun of) for relying on very strong assumptions about rationality, perfect information,... Many of these assumptions are unrealistic but they are justified as a way to set a benchmark model around which one is then allowed to model deviations from the assumptions. The strategy of setting up a benchmark model might sound like a reasonable one as we need to start with a tractable view of the world before one can get "closer" to the complexities of the real world.
But the problem is that the model becomes (or has become) the reference in a way that sets a high burden of proof for any deviations from it. If you think individuals are not rational, go ahead and model their behavior but you should do it in a way that is realistic and backed by data (good luck). If you want to allow for government spending to be productive, you can do it but you better have perfect econometric results that prove that returns to government investment is indeed high. Given that experiments are not possible in economics, it will always be very difficult to produce supporting evidence for some of these assumptions that is not controversial. So what do we do? We claim that we do not know enough about the real world, we claim ignorance, and that would be ok except that we do not stay quiet when we are asked for our opinion. We go back to the results of our benchmark model and if someone asks us about a relevant policy question we use them to justify our answer. Do we care about the fact that the assumptions of that model have never been proven and have no connection to reality? No, we don't.
This subtle (or not so subtle) bias in economic analysis is my biggest source of frustration with my profession. Not being able to predict crisis, the stock market or exchange rates does not bother me, it is just a reflection of the limits of our knowledge and I can live with it. But using the same naive predictions of models that refer to a fictitious world as the reference and only moving away from them when someone produces an unquestionable piece of empirical evidence is in my mind the true cost of our profession to society.
Antonio Fatás
Thursday, September 19, 2013
Does competition get rid of waste in the private sector?
It is very common to hear comments about the waste of resources when referring to governments and the public sector. Paul Krugman does his best to argue against this popular view by showing that most of what government do is related to services that we demand and value as a society (it is not about hiring civil servants that produce no useful service). As he puts it, the government is an "insurance company with an army". But critics will argue that even if this is the case, the functioning of that (public) insurance company is extremely inefficient. In fact, we all have our list of anecdotes on how governments waste resources, build bridges to nowhere and how politicians are driven by their own interest, their ambitions or even worse pure corruption. If only we could bring the private sector to manage these services!
In addition to the anecdotal evidence there is something else that matters: we tend to use framework that starts with the assumption that in the private sector competition will get rid of waste. An inefficient company will be driven out of business by an efficient one. An inefficient and corrupt manager will be replaced by one who can get the work done. And we believe that the same does not apply to governments (yes, there are elections but they do not happen often enough plus there is no real competition there).
But is competition good enough to get rid of all the waste and inefficiencies in the private sector? I am sure there are many instances where this is the case but I am afraid there are also plenty of cases where competition is not strong enough. And just to be clear, I am not simply talking about large companies that abuse monopoly power, I am thinking of all the instances where the competitive threat is not enough to eliminate inefficiencies.
I think this applies to financial institutions: the financial crisis has undermined our perception that these institutions were acting in the benefit of their shareholders (even Alan Greenspan said so). Profits and rents going to that sector (and to a reduced group of individuals) did not seem justified by the value they added. Why don't we see entry of new banks? Why don't we see new entrants taking over this market, finding the necessary funding to build scale and attracting the depositors or investors of the current established institutions? Why don't we see new CEOs rising to the leadership of these institutions with a platform that promises to behave in a different way and possibly be much better at maximizing the creation of long-term value? It must be that competition is not strong enough.
Same in the healthcare sector: How good is the private sector at managing healthcare? Are medical doctors truly competing with each other (in both quality and price)? Luckily we can find some data here from Uwe Reinhardt on excess costs in US health spending that include among other things $190 billion of excess administrative costs.
But this table looks to me like an exception, but not an exception in the sense that we do not find similar waste in other sectors, we simply do not know about it, we do not even attempt to measure it (at least at the macro level). And the reason why we do not bother measuring it is because we assume that markets and competition must make this number close enough to zero. Maybe it is time to challenge this assumption.
Antonio Fatás
Sunday, September 15, 2013
The only uncertainty is why some cannot see facts.
The idea that policy uncertainty is the main reason why advanced economies and Europe in particular are not recovering fast will not go away. Marco Buti and Pier Carlo Padoan in Vox bring back this argument in their attempt to figure out why the recovery in Europe is so weak.
They explore the differences between the Eurozone and US recoveries to understand what are the factors that explain the divergence in performance ("the growth shortfall of the Eurozone compared to the US is striking"). So what are the differences between the two economic regions? Three according to the authors: policy uncertainty, weak financial system and lack of investment opportunities.
The evidence?
1. Measures of uncertainty are correlated with growth. But as many others have argued, measures of uncertainty are (in most cases) endogenous to growth.
2. Reform in the years 1998-2003 is a good predictor of the potential growth gains in the five years that followed (2003-2008). I am not sure how relevant this is to explain the post-2008 growth performance but let me argue that the chart presented in the blog post is not too convincing either. Here it is:
First, notice that their measure of growth is potential (not actual). Second, while the estimated regression suggests a positive correlation, when one looks at the Euro countries, there is no obvious correlation between the two variables. And if we compare some of them to the US (this was the comparison that the authors wanted to understand), the evidence runs contrary to their argument. Spain or Italy or France or even Greece improved their (product markets) regulation much more than the USA or Canada but their (potential) growth performance was significantly weaker.
So while talking about uncertainty and reform always sounds right, the evidence is either weak or inexistent.
But what about alternative explanations? Could it be that policy, in particular fiscal policy, can explain differences in growth performance since 2008? It must be that the evidence is not that strong, otherwise how could it be that is nor mentioned in their article?
Here is my attempt to provide an alternative explanation to the cross-variation in GDP growth rates.
I compare the change in real GDP in the 2008-2012 period with the change in real government consumption during the same years. This variable is an indication of the fiscal policy stance during those years. I include all OECD countries in the sample (removing some, including only the Euro countries makes no difference to the slope or fit of the regression). The correlation is very strong with a a coefficient that is not far from 1.
But isn't government consumption a component of GDP? Isn't the correlation always there? Yes and No. Yes, there is plenty of endogeneity in my chart and if you want to get the numbers right you need to read all the literature on fiscal policy multipliers (which will tell you that the effects are in fact stronger than what the casual analysis above shows). But, No, we also know that many of these countries implemented explicit cuts in government spending in response to changes in their interest rate and the financial markets reaction to sovereign debt crisis. So there is a significant exogenous component to government spending in that picture, enough to be used as an explanatory variable. And remember that there are those who believe that this correlation should be zero or even negative -- those who believe in zero or negative fiscal policy multipliers. So when Greece (bottom left dot) cut government consumption by 17%, they expected private spending to increase by at least the same amount. But it did not happen, private spending also fell and GDP has fallen by almost 25% during that period.
The chart above is just a reminder of how strong the evidence is in favor of the hypothesis that fiscal policy can explain most of the relative underperformance of some economies in the post 2008 period. The evidence is certainly much stronger than any of the factors that Buti and Padoan present. But somehow fiscal policy did not make it to their list of top three factors.
Antonio Fatás
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