Why Sinn was wrong to write this FT article

When I teach these days about the negative performance of the Euro economies over the last six years I always get asked about how policy makers could get it so wrong. The answer can be found in the article that Hans-Werner Sinn published today in the Financial Times (Why Draghi was wrong to cut interest rates). It is hard to know where to start commenting on the article. It is not only inconsistent but also full of arguments that go against any economic logic and misleading use of partial data.

Interestingly, the article starts with the argument that given that inflation in the Euro area is below its target and falling (down to 0.7% in October), it seems that "last week's interest rate cut is understandable". Correct. That's the only reasonable paragraph of the article as the next one opens with the sentence:

"However, deflation in parts of a currency union is not the same as deflation of a union as a whole, because its internal effects on competitiveness cannot be compensated for by exchange rate adjustment.".

Let me start with the first part of the sentence. It is interesting proposition to argue that the ECB should not manage just average inflation (and growth?) but also try to manage these variables at the regional variable. This is not the mandate of the ECB. And what is exactly what Hans-Werner Sinn proposes, that the ECB tries to keep inflation in any region (country?) of the Euro area below 2%? This will imply overall deflation in the Euro area.

The second part of the sentence is even worse. If it is true that we need a realignment of relative prices within the Euro area, you will NOT get it by keeping inflation low. The article argues that the "printing presses" from Souther Europe have slowed down the realignment of the relative prices of goods needed for improving competitiveness. Wrong. There is plenty of evidence that prices and wages exhibit downward nominal rigidity and that it is much easier to allow changes in relative prices when inflation is positive. It is the low inflation level of the Euro area that is limiting the adjustment in relative prices (Krugman makes this point today in his blog).

The article also argues that the ECB policies have kept the value of the Euro down and this is one of the reasons why the German economy is running a current account surplus (not sure which chart he is looking at to argue that the value of the Euro is low...).

Antonio Fatás

Party like it's 1995?

For some it is clear that the all-time record levels in the stock market are supported by loose monetary and the day policy starts changing, stock markets will suffer a sharp drop. While I also worry about the tendency of stock markets and investors to be overoptimistic, I am less concerned by the fact that we are hitting all-time record levels. First, we keep forgetting that we are talking about nominal variables and they will keep setting record levels as long as inflation remains positive. But I am also less worried because tightening of monetary policy normally happens when growth is picking up so the stock market will have to decide if they like more faster growth than higher interest rates. And the reaction might surprise some.

A historical example that I have mentioned earlier and that I find interesting is the period 1993-1996. In 1993 the recovery from the previous recession was slowly taking shape and the stock market was going up and, yes, setting all-time records. What did the newspaper headlines say at the time and also in anticipation of a future when monetary policy was about to get tighter? A quick search in Google reveals the following headlines:

Whatever else might be wrong with the U.S. economy, the stock and bond markets of Wall Street are thriving on the strength of falling interest rates. Sluggish job growth, subdued consumer spending and worries about how the nation will fare in an increasingly competitive world have not stopped the steady advance of stock prices to record highs. Fort Worth Star-Telegram. August 26, 1993.

Fed Fears a Market Bubble If It Lowers Interest Rates. New York Times, September 16, 1993.

Stocks climb to a record Surge in bonds, lower interest rates are behind it. It was the Dow's fourth record close this month. The Associated Press, August 20, 1993.

Jump in interest rates sends shiver through bull market. The bull market that carried blue chip stocks to record highs last week may be running out of steam - and the next move could be nasty as small investors try to get out of the market, analysts say. Indeed, there is concern on Wall Street that the record flow of money into stock and bond mutual funds has created a potentially dangerous situation.
Signs of market fragility reappeared Friday when a jump in interest rates on the bond market triggered a selloff in stocks. The Washington Post, May 30, 1993.

A lot of these headlines look identical to the ones we read today. What happened in that historical episode can be seen in the chart below where I compare the evolution of the interest rate (Fed Funds Rate) with the Dow Jones Index (click for a larger image).

As interest rates started increasing towards the end of 1993 the stock market moved sideways (and it fell during some of the quarters). But as of the second quarter of 1994 the stock market recovered, paused towards the end of the year and then started a bull run that would continue for several years. What is interesting is that during 1995 monetary conditions continued to get tighter but the stock market kept booming. [I stopped my chart in 1996 but in the four years that followed the stock market doubled again]

I have no reason to expect the same behavior in the stock market this time (and given what happened after 2000, it might not be a desirable outcome), but these years serve as an illustration of how markets reacted positively to a significant reversal in monetary policy. Initially there was uncertainty and weakness in the stock market but it was later followed by strong optimism even if interest rates kept going up.

Antonio Fatás

Sudden stops and exchange rates (again)

I did not realize that some of my earlier posts on sudden stops and the Euro area would be so controversial, I thought I was making a simple point. And this time those who disagree with me are the ones that I always agree with so it makes you think even harder about whether the argument that I was making are right!

Brad DeLong wrote a post yesterday to show that sudden (capital) stops should not be a concern for countries that have their own currencies. Let me start with all the arguments where I do not have any disagreement:

- Taking about the possibility of a sudden stop in the UK or the US makes no sense. I agree. The comparison that some establish to argue that the "US is the next Greece" is idiotic.
- Countries with fixed exchange rates that have accumulated a large amount of debt denominated in foreign currency are more likely to be exposed to crisis caused by sudden stops. Correct.

Where we disagree is on whether sudden stops are relevant to other countries with flexible exchange rates. My argument was that in cases where countries have been running large current account deficit for years, a sudden stop of capital could be contractionary (i.e. cause a crisis). Brad DeLong is more optimistic and argues (using the IS-LM model) that, on the contrary, a sudden stop will be expansionary because the exchange rate depreciation will boost exports. The argument is correct within the context of that model but I think that the model is missing several ingredients.There is no one real interest rate in financial markets. You might fix this by adding some risk premium to the model (e.g. the interest rate in the investment equation has an extra term). As long as that extra term is constant it will look as if you can still generate an expansion by controlling the real interest rate but I think that in some cases markets just fail to even provide a proper price for certain assets/risk and we are in a world with multiple equilibria (or simple some markets disappearing) and this changes the predictions of this very simple linear model. That is the point that Blanchard and Leigh do that Brad DeLong also disagrees with. I used to think that these scenarios where impossible in advanced economies but my view on financial markets and the possibility of multiple equilibria has changed substantially during the 2008-2013 crisis.

But is the real disagreement about financial markets or about the role of exchange rates as an adjustment mechanism during times of crisis? Let me argue that they are related. There is a divide between US and European economists when it comes to this debate. Even among those who come from similar ideological backgrounds and support similar models, I have found that US economists tend to put a larger weight on the benefits of flexible exchange rates. Europeans tend to be more skeptical. It might be because there is a bias (Europeans are "proud" of the Euro). But I think that there is also a belief that financial markets (and foreign exchange markets) are more imperfect than what the traditional model of flexible exchange rates suggest. Bubbles, mispricing of currencies, financial imperfections, animal spirits, multiple equibria all move you away from the theoretical benefits of flexible exchange rates.

Who is right? I have no disagreement with the logical arguments that Brad DeLong makes, but what would really make me change my mind is empirical evidence about the behavior of interest rates or exports or exchange rates during the crisis that supports those models (e.g. why did the depreciation of the british pound not have a larger effect on exports?). My latest post had been motivated by the results of Rose on the irrelevance of exchange rate regimes during the crisis. The results are interesting and suggest that exchange rates matter less than what we think. They are not definitive, there are always hypothesis that cannot be tested with the data we have but to me that's the only place to make progress in this debate, we need more and better empirical analysis.

[Update: Paul Krugman does not like my arguments either and he asks for a model. Fair point and I do not have one but I see my arguments as being consistent with models that others have written. Looking for one when I find more time. But my argument is mostly empirical: I cannot think of many countries where a sudden stop has led to an expansion. To be continued.]

Antonio Fatás

Dealing with a sudden stop

My post yesterday on how the US economy would have performed if it was going through the crisis as a member of the Euro area was an attempt to explain that the perspective of a small Euro country with limited credibility can be very different from that of the US. Robert Waldmann at Angry Bear is surprised by the macroeconomic logic I use so let me clarify what I had in mind -- given that what I am saying is quite standard.

A country with a current account deficit must have a matching capital inflow to finance the excess of spending above its income (this is an accounting identity). During the financial crisis many European countries faced a sudden stop -- which is defined as a situation where international financial markets are not willing anymore to fund the current account deficit of a country. This is something that any textbook discusses although normally in the context of emerging markets [by the way, it is not easy to use the IS-LM model to deal with sudden stops given that the IS-LM model is not the best model to analyze current account imbalances and situations where there is no price at which capital will fund a current account deficit].

If capital inflows stop it means that the country cannot afford to run a current account deficit (unless the rest of the world is willing to hold more of your currency (which is in fact a capital inflow). To close a current account deficit you need to reduce imports. If there was a way to engineer a fall in imports, there would be no consequence to domestic demand and GDP. And if at the same time your currency is depreciating you could see an increase in exports and possibly in increase in activity. But there is no way to engineer a fall in imports to close the current account deficit. Some of these imports are part of the supply chain in the domestic production but, more importantly, when foreign capital stops coming in you simply get an aggregate fall in spending that will affect domestic demand and production. In other words, when individuals of corporations who were borrowing abroad stop getting credit, there will be a fall in demand that will affect both domestic and imported goods. I am not saying anything new here, this is the way we teach about sudden stops and that's why we have mechanisms to provide liquidity during these times (e.g. lending by IMF) to ensure that the adjustment in the current account does not come in a very sudden way. There is no way to get out of this by inflation. Inflation can help dealing with monetizing internal debt (government debt) but cannot help smooth the consequences of sudden stop of capital that was financing a current account deficit. An exchange rate depreciation can help by increasing exports but this effect cannot be fast enough.

Before the crisis the US looked very similar to some of the Euro periphery countries (asset price bubbles, fast credit growth, large current account deficit,...). When the crisis started, the US managed to survived much better than Greece or Spain or Ireland. The point of my blog post was that the main reason for that is that the US maintained access to capital inflows (if any there was an increase in the desire of foreign investors to out their money in the US). The exchange rate itself did not help much, in fact the US dollar appreciated because of the capital inflows. And for Euro countries, the real problem was the large swing in capital flows from excessive inflows to a sudden stop. Competitiveness and the exchange rate played a much smaller role. That is my assessment after looking at the data. I think most economists agree with the existence of both effects but we seem to disagree with the relative importance of each of them.

[Update: I have written one more post that explains more of the logic behind my arguments.]

Antonio Fatás

Ben Bernankepoulos

Paul Krugman responds to my earlier post about how exchange rate regimes do not matter much (I was referring the work of Andrew Rose). Krugman has a different view on the issue and argues that countries in the Euro area have suffered from not having their own currency and this is visible by the higher interest rates that they faced relative to other countries. He makes a good point and the data speaks in favor of his hypothesis. I also think that Euro countries have suffered from being part of the Euro area because of many other reasons (e.g. they ended up adopting the wrong policy mix). Where I am less sure is about how much the ability to control the exchange rate mattered relative to other factors.

The only way to understand these effects would be to build a counterfactual: what would life without the Euro have looked like for these countries? I have tried to answer this question before and it less clear than what some might think. As an example, for those who see the current levels of unemployment in Spain as an example of the negative effects of not having your own currency, it is important to remember that job creation or unemployment in Spain look substantially worse when Spain had its currency (1980-1999) than since Spain has been a member of the Euro (1999-2013).

Let's build other counterfactuals just for fun: first, what if US economy had been a member of the Euro and, second, let's have Ben Bernanke running the central bank of a hypothetical Euro country that decides to leave the Euro area or did not even bothered joining the Euro (say Greece, that's the origin of the not-so-smart title for this blog post).

1. US as a member of the Euro area. 

Let's start with the US economy being part of the Euro area. Of course we need some assumptions about the role that the US would be playing in this enlarged version of the Euro area. Imagine the US played a similar role to a small country in the periphery (Greece, Ireland or Spain). The ECB is still in Frankfurt and run by the German central bank ideology. Prior to the crisis it is very likely that the US would have seen an even larger inflow of capital from other European countries because there would be no exchange rate risk within the Euro area. So, for example, institutional investors or financial institutions in Germany would have invested even more of their portfolios in the US given that there would be no exchange rate involved (in some cases regulations limit the amount of exchange rate risk for these institutions). It is possible that this would have made asset prices in the US increase even further than what they did in the run up to the crisis and possible have the US run an even larger current account deficit. In other words, the imbalances that led to the crisis would have possibly been much larger.

Once the crisis started, there would be no room for depreciation of the exchange rate but if one looks at the data, the US dollar did NOT depreciate when the crisis started. The other way around, it appreciated relative to the Euro and other currencies.

It is very difficult to know what the Euro would have done if the US had been a member of the area, it is likely that it would have appreciated relative to other countries (because there would be no USD), but what seems plausible is that relative to the actual data the US would have seen a lower loss of competitiveness if it did not have its own currency (not sure how much that would have mattered but just trying to get some facts right). So this could have been good news for the US [This is coming from the fact that when your have your own currency some times it moves in the opposite direction than what you would like].

What about interest rates? Given the strength of the US economy one would have not expected the US becoming part of the periphery so interest rates would have remained low (as in Germany). But clearly, the large current account deficits that would have preceded the crisis could have put more pressure on the US than on a country like Germany that had large surpluses. The potential negative effect for the US would have been that membership in the Euro area would have made the pre-crisis imbalances worse possibly leading to more risk in terms of funding when the crisis started. This is my reading of what has happened in the Euro periphery: one the biggest cost of the Euro membership was the bubbles that the Euro facilitated in the years before, not so much the inability to adjust via exchange rates after the crisis exploded.

2. Ben Bernankepoulos. 

Here is my second scenario: let's have a Euro periphery country leave the Euro (or never join) and have monetary policy follow the policies that Ben Bernanke has followed in the US (bring interest rates down to zero, aggressive quantitative easing). The ECB has already followed some of these policies so there will be some similarities but the fact that now this country would be managing its own currency would bring some additional effects. The currency would likely depreciate and that should help exports. How much is less obvious. The effects of exchange rates on exports or the trade balance is not easy to measure - as a comparison during the crisis the UK saw its currency depreciate relative to the Euro but the performance of exports was clearly weaker than that of similar countries such as Spain that did not have their currency.

And what would happen to capital flows? It is likely that capital will flow out of the country, given that the country started with a current account deficit this would be a problem (dealing with a sudden stop is never easy). If debt is denominated in foreign currency the situation could be dramatic (as in the Asian crisis in the 90s). But even if debt is denominated in local currency there is still an issue: there is the need to finance a current account deficit and in the absence of capital inflows it would lead to a collapse of internal demand. Yes, exports might be increasing but it is hard to see that this adjustment would be fast enough to compensate for the immediate correction required given the lack of funding. Unless the rest of the world is happy holding more of our currency, in which case we can finance our expenditures via monetary expansion. But for Euro periphery countries their credibility of their currency is of course not where the US dollar is. A sudden stop would require liquidity from external sources (IMF or other governments) to avoid an economic collapse. Not too different from what Euro periphery countries had to deal with as members of the Euro area -- except that as members of the Euro area they had more negotiating power because the other countries (e.g. Germany) were really scared of the idea of a break up of the Euro area.

The message from these two scenarios is that we are dealing with a complex question where there are potentially many effects going in different directions. No doubt that the policies that Euro countries have adopted during the crisis have very likely exacerbated the negative effects of the crisis (in particular the slow reaction of monetary policy and the contractionary nature of fiscal policy).  But if any of these countries had been outside of the Euro area they would have struggled with other issues and the outcome might not have been too different. The biggest benefit I see of having stayed out of the Euro area is that the capital flows that fed the pre-crisis bubble would have probably been smaller and maybe made the crisis more manageable.

So the US, the UK or Japan offer some interesting lessons to Euro countries about the virtues of being able to manage your own currency and monetary policy during the crisis. But I think that those lessons are not easily applicable. Not every country has the credibility of the US or the UK to maintain capital flows during and after the crisis allowing for a slow adjustment in the current account. Japan starts with a current account surplus and a very strong home bias when it comes to the funding of the large government debt so the notion of a sudden stop does not apply. So currency regimes matter in significant ways but the effects go in different directions and measuring the net effect is not easy. In addition, this effect can be very different for different countries or periods so it is hard to generalize. The paper by Rose provides a way to measure these effects by analyzing a large sample of countries and shows that there are no significant differences in performance across different exchange rate regimes. It is a good starting point of a debate that is complex and likely to continue over the coming years (or decades).

Antonio Fatás

The wrong reading of the money multiplier

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

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

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

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

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

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

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

The Euro counterfactual

Since the financial crisis started we have heard many commentators telling the Euro countries: "I told you so, this was a very bad idea". The argument is that the Euro area is not an optimal currency area - a jargon used by economists to argue that the costs of having a single currency are larger than its benefits. While until 2008 things have looked fine, the crisis is the real test for the Euro area and it has failed. And it has failed because of what any standard macroeconomics textbook tells you: that once you give up your exchange rate you lose a stabilization tool and when a crisis that is asymmetric in nature comes along you suffer a prolonged crisis as the only way out is to let prices and wages fall (internal devaluation), a painful and inefficient process.

In a recent post, Paul Krugman reminds us once again of these arguments by comparing Ireland during the current crisis to Thailand or Indonesia during the Asian crisis. His argument is that the Asian economies recovered quite fast from their crisis while Ireland has not (and Greece has not even started any recovery). As Kevin O'Rourke puts it, Ireland looks like Thailand without the Baht.

The arguments seem solid and the evidence strong but I am somehow skeptical that we can that quickly conclude that the Euro was a failed experiment and that life without the Euro would have been better (and maybe I am reading too much into those posts and they are not really going that far in their statements). 

What one wants to do is build a counterfactual: where would Greece or Spain or Ireland be if they had never joined the Euro? What would their currency have done for them before and after the 2008 crisis? Unfortunately we cannot build such counterfactual so the best we can do is to look for similar examples (such as Thailand during the Asian crisis). But let me argue that if one extends the set of examples and anecdotes some of the data does not speak that clearly against the Euro.

Before I start let me make two points:

1. I have no disagreement with the argument that rigidities in prices and wages make an internal devaluation a painful way to get out of a recession. A depreciation is a much faster way to reset relative prices. This is what I teach to my students.

2. I agree that the Euro area comprises a set of countries that are performing way below their potential. A combination of failed reforms, lack of economic leadership, a not very proactive central bank is producing a growth rate that is below potential (both before and during the crisis). 

The point that I am trying to make is that among the list of problems that the Euro countries have, the Euro itself might not be the biggest one. While a devaluation could have helped established a faster recovery, its effects would have been uncertain and possibly small. I reach that conclusion by looking at data the same way Krugman and O'Rourke do. It just happens to be that I look at different data. Are my comparisons much better than theirs? Not sure (this is just a blog post, not a research paper). But I find them more relevant even if I have to admit that we have a great deal of uncertainty here, that our knowledge about the potential performance of countries with flexible versus fixed exchange rates is limited. And by knowledge I mean empirical not theoretical. We understand very well how exchange rates work but my reading of the literature is that we are not very good at quantifying these effects.

Below is a list of random and unconnected empirical facts that suggest that the Euro itself might not have caused as much damage as the comparison between Thailand and Indonesia to Ireland and Greece might suggest. 

1. Comparing across countries with different GDP per capita is tricky. It is hard to imagine Ireland to grow at rates similar to Thailand and Indonesia at any point in time after 2008 given that Irish GDP per capita is as high as that of Germany or the US (in 2012 and according to the IMF GDP per capita in Ireland is higher than in Germany; In contrast, in 1996 the GDP per capita of Indonesia was less than 10% of the US level). Finding a better comparison is difficult. Very few advanced economies adopt fixed exchange rates or go through large devaluations. But we can still find some anecdotal evidence.

2. The European countries were in a crisis also during the years 1991-1993. A crisis that brought their system of fixed exchange rates down. Some countries abandoned the fixed exchange rate and devalued while others stayed. This is the closest we have to an experiment of countries leaving the Euro area (yes, the experiment is not perfect, the crisis was much smaller, but it can help us understand the role of exchange rates). Below is a chart with the path of GDP that different countries followed.

There are 9 countries in the chart. Some of them let their currencies be devalued (and a subset of those completely left the system). These are represented by dotted lines. The others stayed within the system and their value of their currencies remained fixed to each other (they are represented by the solid line). The chart reveals that there is no clear pattern between the two groups. Growth differences do not seem to correlate well with the behavior of exchange rates. It might be that only those who devalue "had to devalue", possibly, but what is remarkable is how similar the growth patterns are for all countries.

3. Here is a second piece of evidence from the most recent crisis. Both Spain and the UK have suffered the consequences of the 2008 financial crisis. Both are large economies that before the crisis saw real estate prices booming. But once the crisis started one them let its currency depreciate (the UK) by about 30% relative to the Euro while the other (Spain) was stuck with a currency that it did not own. The theory says that the UK should have benefited from a strong boost in exports as a result of the depreciation of its currency. Below is a comparison of exports (real) after the crisis erupted at the end of 2007.

Contrary to our priors, Spanish exports have grown faster than UK exports. So it seems that the depreciation did not help that much the UK (or the lack of control of your currency did not hurt Spain that much either).

4. So maybe exports in Spain did not behave that badly but isn't unemployment extremely high, at levels that are as high as during the Great Depression in the US? Yes, they are, but unemployment rates in Spain were also extremely high when Spain had a currency (the peseta).

	Annual Employment Growth	Unemployment Rate
1980-1998	0.81	18.87
1999-2012	1.45	14.00

Above is a table that summarizes the Spanish labor market before and after the Euro. In the pre-Euro years unemployment was on average 18.9%. After the Euro, it has been "only" 14%. Employment growth before the Euro was 0.81%, after the Euro 1.45%.

None of the above facts provide a perfect test of what life without the Euro would have been for some of the Euro countries but they, at a minimum, question the conclusion that the recent financial crisis has clearly proven that the creation of a single currency in Europe was a really bad idea. For some of these countries life is hard and volatile (with or without the Euro).

Antonio Fatás

What $3.4tn will not buy you.

Paul Davies at FT Alphaville argues that the $3.4tn in foreign reserves that China holds cannot be used to address with their problems of bad debt. The article follows a series of  reports by the FT on the increasing and unsustainable amount of debt that we see in China these days. As an example, here is a chart from one of those earlier reports.

From the chart we see increasing levels of debt by all sectors of the Chinese economy. So China looks like the US now... or not. The data on debt is just a partial view on the balance sheet and the potential instability of a financial system. It measures liabilities, it does not look at assets. 

What happens if we look at the value of assets in the Chinese economy? They are increasing at a faster rate than debt. How do we know that? Because we know that China has been running a current account surplus, a sign that income exceeded spending and therefore the country was a net saver. 

The accumulation of current account balances does not exactly correspond to the net foreign wealth of a country because there can be valuation changes over time. I might save $100 today and buy shares in the stock market or a foreign government bond. My wealth tomorrow might change by more or less than $100 depending on how the prices of those assets change. Pierre-Olivier Gourinchas and Helene Rey have produced some neat analysis on how these two magnitudes differ for many countries, here is their chart for China.

The red line corresponds to the accumulation of current account surpluses (expressed as $ of GDP), this is the flow of saving. The blue line is the actual value of their "net foreign wealth". In the case of China the blue line is below the red one which means that China has suffered valuation losses in their external balance sheet; the value of their assets has appreciated less than the value of its liabilities (this could be partially due to the fact that their assets tend to be riskless while their liabilities tend to be of the form of FDI).

Where do foreign reserves enter into the picture? The accumulation of foreign reserves comes from two sources: the funds generated from current account surpluses and the (net) investment flows into China. For example, when a multinational invests in China (FDI), that flow, if unmatched by any other flow, leads to an accumulation of foreign reserves. As Paul Davies points out in his article, those reserves cannot be simply considered wealth of China because FDI represents a liability. Correct. The right number is the one where all assets and liabilities are taken into account, which is the blue line in the Chart above, the net foreign asset position which stands just below 30% of Chinese GDP (about $2tn). This number is indeed lower than the total amount of foreign reserves that China holds ($3.4tn). 

So China is a country of savers and borrowers, like any other. In aggregate, the country saves as reflected by a current account surplus. Its nets foreign asset position is about $2tn, a true measure of the health of the external balance sheet of China. The amount of foreign reserves is not the right measure as it exaggerates the foreign wealth position. And for the same reason, the first chart with the debt numbers provides a too pessimistic view of the Chinese financial health. Both of these figures are just partial views on the Chinese balance sheet.

Given that net foreign wealth in China is positive and increasing, does it mean that there should be no concerns about the increasing debt in some sectors of the economy? No. There are two things to worry about. First, the fact that some (individuals, corporations, government) are accumulating debt could put them at risk even if others in the economy are saving. Financial fragility is not only about the average position it is also about the individual saving/borrowing positions. Second, some of the borrowing goes to fund purchases of domestic assets that might have an inflated value. So even if today when we aggregate assets and liabilities the balance sheet looks healthy, we could have asset values collapsing and sending the net wealth of individuals to a situation that leads to defaults, need for deleveraging and a crisis (as we have seen in many advanced economies). 

Antonio Fatás

Teaching about inflation is fun (but dangerous)

Teaching about inflation is fun. Most people who have never been exposed to macroeconomics before are surprised when you show the correlation between inflation and money growth in a large sample of countries. You then produce some data about some hyperinflation countries that include a picture of some bank note with lots of zeros (thank you Zimbabwe) and the students love it.











The notion that inflation is (mainly) a monetary phenomenon is new to many students and going through the history of inflation and monetary policy regimes is a very rewarding exercise for a teacher.

But there is a problem with the way we teach inflation: in many countries inflation has been under control for decades now. And this control does not come from the fact that monetary policy was anchored to a physical commodity such as gold but from the actions and credibility of the central bank. Here is a nice chart from recent work from Jan Groen and Menno Middeldorp that measures inflation expectations in the US going back to 1970.

After the early 90s the line becomes flat, there is very little to say about either the level or the volatility of inflation. In this environment, inflation is almost constant and the correlation between money supply and inflation is inexistent. But we leave this fact for the last five minutes of the class given how much fun it was to talk about Germany in 1923, Hungary in 1946 and Zimbabwe in 2008.

So given the way we have been teaching about inflation it is not that surprising that for the last five years some have been worrying so much about inflation or even hyperinflation as central banks balance sheets have grown very fast. [There is, of course, the mistake that many do of not understanding the difference between the monetary base and the money supply but I will leave that for another post.]

Next time I teach my macroeconomics course I will spend less time talking about inflation and if I talk about it, I will not show the picture of the one hundred trillion dollars note from Zimbabwe, instead I will spend more time about the incredible stability of inflation in many countries. And I will use the extra time to talk about long recessions and even longer recoveries.

Antonio Fatás