Via the Irish Economy Blog I find this very interesting interview of Mario Draghi with Der Spiegel. I was first surprised by the aggressive responses from Draghi every time he is asked about the German negative assessment of recent ECB monetary policy. I like his honesty and clarity when he asserts that all German fears about increasing inflation in the Euro area have turned to be wrong. Here is one of his answers:
"DRAGHI: No, but the fears felt by some sectors of the public in Germany have not been confirmed. What haven’t we been accused of? When we offered European banks additional liquidity two years ago, it was said there would be a high rate of inflation. Nothing has happened. When I made my comment in London, there was talk of a violation of the central bank’s mandate. But we had made clear from the beginning that we are moving within our mandate. Each time it was said, for goodness’ sake, this Italian is ruining Germany. There was this perverse Angst that things were turning bad, but the opposite has happened: inflation is low and uncertainty reduced."
Of course, the journalist is not convinced and continues asking questions about the potential damage that ECB policies are inflicting in Germany. He follows with a set of questions on how the low interest rate policy of the ECB is hurting savers in Germany. Here is the first one:
"SPIEGEL: In Germany, ECB policy is unpopular because you have now pushed the interest rates for investments down so far that they are often no longer enough to compensate for inflation. In other words, only fools save."
This question reflects a really poor level of understanding of some basic economic principles. The statement "only fools save" can only be consistent with the data if the number of fools has increased dramatically in recent years. Interest rates are low because saving is high (and investment is low). Not the other way around.
And here is the next one:
"SPIEGEL: People can see in the statements from their life insurance companies that they are getting ever smaller payouts from year to year because of the interest rates. The truth is that savers are paying the price for rescuing the euro."
Savers are paying the price of fear and a long-lasting crisis. Both have reduced spending and as a result the equilibrium (real) interest rate. And more so in countries that are perceived as safe (as in the case of Germany).
Draghi is good at responding to both of these questions but I find his tone less aggressive than when he answers the questions on inflation. Maybe central bankers need to be more explicit about their (limited) influence on interest rates. The (wrong) perception among many is that interest rates, both nominal and real, for all maturities and risk profiles are determined by central bank policies.
Antonio Fatás
Wednesday, January 8, 2014
Monday, December 16, 2013
Four missing ingredients in macroeconomic models
It is refreshing to see top academics questioning some of the assumptions that economists have been using in their models. Krugman, Brad DeLong and many others are opening a methodological debate about what constitute an acceptable economic model and how to validate its predictions. The role of micro foundations, the existence of a natural state towards the economy gravitates,... are all very interesting debates that tend to be ignored (or assumed away) in academic research.
I would like to go further and add a few items to their list that I wished could become part of the mainstream modeling in economics. In random order:
1. The business cycle is not symmetric. Most macroeconomic models start with the idea that fluctuations are caused by a succession of events that are both positive and negative (on average they are equal to zero). Not only this is a wrong representation of economic shocks but is also leads to the perception that stabilization policy cannot do much. Interestingly, it was Milton Friedman who put forward the "plucking" model of business cycles as an alternative to the notion that fluctuations are symmetric. In Friedman's model output can only be below potential or maximum. If we were to rely on asymmetric models of the business cycle, our views on potential output and the natural rate of unemployment would be radically different. We would not be rewriting history to claim that in 2007 GDP was above potential in most OECD economies and we would not be arguing that the natural unemployment rate in Souther Europe is very close to its actual.
2. As much as the NBER methodology emphasizes the notion of recessions (which, by the way, is asymmetric in nature), most academic research is produced around models where small and frequent shocks drive economic fluctuations, as opposed to large and infrequent events. The disconnect comes probably from the fact that it is so much easier to write models with small and frequent shocks than having to define a (stochastic?) process for large events. It gets even worse if one thinks that recessions are caused by the dynamics generated during expansions. Most economic models rely on unexpected events to generate crisis, and not on the internal dynamics that precede the crisis.
[A little bit of self-promotion: my paper with Ilian Mihov on the shape and length of recoveries presents some evidence in favor of these two hypothesis.]
3. There has to be more than price rigidity. Keynesian models rely on price rigidity to explain business cycles and why demand matters. There is plenty of evidence that price rigidities are important and they help us understand some of the features of the business cycle. But there must be more than that. There are other frictions in the real economy that produce a slow adjustment and are responsible for the persistence of business cycles. They might not be easy to measure or model, they might be different across different economies but it is difficult to imagine that an adjustment of prices and wages to its optimal level would automatically restore full employment. Larry Summers referred to these frictions in his recent IMF conference speech although he did not elaborate on them.
4. The notion that co-ordination across economic agents matters to explain the dynamics of business cycles receives very limited attention in academic research. It some times appear in our economic policy debate (e.g. Olivier Blanchard (at the IMF) has referred to multiple equilibria as a way to explain the sovereign-debt crisis in Europe) but it does nor receive the credibility it deserves in academia.
I am aware that they are plenty of papers that deal with these four issues, some of them published in the best academic journals. But most of these papers are not mainstream. Most economists are sympathetic to these assumption but avoid writing papers using them because they are afraid they will be told that their assumptions are ad-hoc and that the model does not have enough micro foundations (for the best criticism of this argument, read the latest post of Simon Wren-Lewis). Time for a change?
Antonio Fatás
I would like to go further and add a few items to their list that I wished could become part of the mainstream modeling in economics. In random order:
1. The business cycle is not symmetric. Most macroeconomic models start with the idea that fluctuations are caused by a succession of events that are both positive and negative (on average they are equal to zero). Not only this is a wrong representation of economic shocks but is also leads to the perception that stabilization policy cannot do much. Interestingly, it was Milton Friedman who put forward the "plucking" model of business cycles as an alternative to the notion that fluctuations are symmetric. In Friedman's model output can only be below potential or maximum. If we were to rely on asymmetric models of the business cycle, our views on potential output and the natural rate of unemployment would be radically different. We would not be rewriting history to claim that in 2007 GDP was above potential in most OECD economies and we would not be arguing that the natural unemployment rate in Souther Europe is very close to its actual.
2. As much as the NBER methodology emphasizes the notion of recessions (which, by the way, is asymmetric in nature), most academic research is produced around models where small and frequent shocks drive economic fluctuations, as opposed to large and infrequent events. The disconnect comes probably from the fact that it is so much easier to write models with small and frequent shocks than having to define a (stochastic?) process for large events. It gets even worse if one thinks that recessions are caused by the dynamics generated during expansions. Most economic models rely on unexpected events to generate crisis, and not on the internal dynamics that precede the crisis.
[A little bit of self-promotion: my paper with Ilian Mihov on the shape and length of recoveries presents some evidence in favor of these two hypothesis.]
3. There has to be more than price rigidity. Keynesian models rely on price rigidity to explain business cycles and why demand matters. There is plenty of evidence that price rigidities are important and they help us understand some of the features of the business cycle. But there must be more than that. There are other frictions in the real economy that produce a slow adjustment and are responsible for the persistence of business cycles. They might not be easy to measure or model, they might be different across different economies but it is difficult to imagine that an adjustment of prices and wages to its optimal level would automatically restore full employment. Larry Summers referred to these frictions in his recent IMF conference speech although he did not elaborate on them.
4. The notion that co-ordination across economic agents matters to explain the dynamics of business cycles receives very limited attention in academic research. It some times appear in our economic policy debate (e.g. Olivier Blanchard (at the IMF) has referred to multiple equilibria as a way to explain the sovereign-debt crisis in Europe) but it does nor receive the credibility it deserves in academia.
I am aware that they are plenty of papers that deal with these four issues, some of them published in the best academic journals. But most of these papers are not mainstream. Most economists are sympathetic to these assumption but avoid writing papers using them because they are afraid they will be told that their assumptions are ad-hoc and that the model does not have enough micro foundations (for the best criticism of this argument, read the latest post of Simon Wren-Lewis). Time for a change?
Antonio Fatás
Tuesday, December 10, 2013
Debt and secular stagnation
In a recent post Paul Krugman refers to the potential link between rising levels of debt prior to the 2008 crisis and the current discussion on secular stagnation. The argument can be illustrated by the chart below (borrowed from Krugman's post).
Quoting from Krugman's post:
"Debt was rising by around 2 percent of GDP annually; that's not going to happen in the future, which a naive calculation suggests a reduction in demand, other things equal, of around 2 percent of GDP"
In summary, increasing debt ratios area unsustainable and the adjustment can have a negative effect on growth. The argument is probably right but when it comes to assessing the real impact on growth I think we need to do a more careful analysis before reaching that conclusion.
Here is where I think the reading of the previous chart becomes more complicated: Why was debt going up? For some this is simply a reflection of excessive spending that directly feeds into demand. The fact that it is excessive leads to the need to reverse the trend in the years that follow and, using the same logic but now going back, it will lead to a reduction in demand. But to reach that conclusion we first need to do a more careful analysis of the balance sheet of US households by looking not only at their liabilities but also at their assets. Below is a chart of total assets (blue line) and just financial assets (red line) during the same period of time (and both measured as % of GDP).
We also observe an upward trend. How do these two trends (assets and liabilities) compare? We can measure it by looking at the difference between assets and liabilities = net wealth of US households (as % of GDP).
What we see is also an upward trend with large volatility around the last two recessions. An upward trend means that asset values are growing faster than debt. Today's net wealth is below the peak of 2005-2006 but it is above the level of any other year in the sample. With this new perspective it is more difficult to conclude that debt is still high or that it cannot grow from current levels.
What I find more interesting (and intriguing) is that rising debt (as a % of GDP) at the same time as asset values increase (even faster) is not the exception but the norm when one looks at a larger sample.
Below is the evolution of Household Debt (blue, right axis) and Net Worth (red, left axis), both as % of GDP during the 1975-1995 period. So I am excluding the last two asset price bubbles to look at a more "normal" period. We still see rising trends for both series. So debt ratios were increasing fast but asset values were growing at an even faster rate, so the net worth kept going up through those 20 years.
What these charts suggest is that the analysis of debt is a complex one and it requires a careful look at both sides of the balance sheet. And unless I am missing some relevant academic research, we do not have a good framework to think about these trends. And things can get a lot more complicated if we start adding other issues, such as the distribution of holdings of assets and liabilities. It could be that the households that are holding the assets are not be the same as the ones holding the debt, and this can change the way we think about the implications of these trends.
Antonio Fatás
Thursday, December 5, 2013
Battle lost: austerity won.
It has been surprising to see how over the last five years some have been holding to their economic theories even if the facts kept proving them wrong (Yyperinflation? Confidence and austerity?). At the end, it seems that ideology dominates much of the macroeconomic analysis we see these days. But what is more surprising is how broad this phenomenon is and how the general economic commentary that one reads in the press cannot move away from those theories either.
One statement that will not go away is the constant reference to "printing money" which is not only incorrect from a factual point of view (most of the increase in the monetary base corresponds to reserves not to bank notes being printed) but also misleading when it comes to the understanding of the role of central banks. Even those who support central bank actions during the crisis have to add a sentence at the end to warn us about the danger of so much liquidity.
And austerity, as much as the data has disproven the claim that it would be through reduction in government spending and increased confidence that advanced economies will return to healthy growth rates, it does not seem to lose its appeal either. As an example, here is a CNBC article that provides a long list of arguments of why austerity is winning the war. The arguments: the UK is finally growing, Spain's GDP is not falling anymore and even in Greece we now start seeing the possibility of positive growth. And where is this coming from? From the austerity that these wise governments have implemented over the last year. This is, of course, a misleading analysis of the data. It is still the case that countries where austerity was the strongest have seen the lowest growth rates (and the largest increase in debt). The only reason why these three countries are either returning to growth or not collapsing anymore is that after such a deep crisis, growth must return at some point. Yes, even without any policy actions to support growth, economies recover. But they do so slowly and they will never return to where they should have been. And just to get the facts straight, in these three countries, governments have stopped being a large drag in the economy. When you reduce government spending growth suffers. Once government has stabilized at a low level it does not become a drag on growth.
The last five years have provided an incredible macroeconomic experiments to learn about the effects of monetary and fiscal policy to stabilize cycles. But it seems that this crisis will be wasted, not so much in terms of implementing reforms but in terms of our ability to use data to improve our understanding of macroeconomics.
Antonio Fatás
One statement that will not go away is the constant reference to "printing money" which is not only incorrect from a factual point of view (most of the increase in the monetary base corresponds to reserves not to bank notes being printed) but also misleading when it comes to the understanding of the role of central banks. Even those who support central bank actions during the crisis have to add a sentence at the end to warn us about the danger of so much liquidity.
And austerity, as much as the data has disproven the claim that it would be through reduction in government spending and increased confidence that advanced economies will return to healthy growth rates, it does not seem to lose its appeal either. As an example, here is a CNBC article that provides a long list of arguments of why austerity is winning the war. The arguments: the UK is finally growing, Spain's GDP is not falling anymore and even in Greece we now start seeing the possibility of positive growth. And where is this coming from? From the austerity that these wise governments have implemented over the last year. This is, of course, a misleading analysis of the data. It is still the case that countries where austerity was the strongest have seen the lowest growth rates (and the largest increase in debt). The only reason why these three countries are either returning to growth or not collapsing anymore is that after such a deep crisis, growth must return at some point. Yes, even without any policy actions to support growth, economies recover. But they do so slowly and they will never return to where they should have been. And just to get the facts straight, in these three countries, governments have stopped being a large drag in the economy. When you reduce government spending growth suffers. Once government has stabilized at a low level it does not become a drag on growth.
The last five years have provided an incredible macroeconomic experiments to learn about the effects of monetary and fiscal policy to stabilize cycles. But it seems that this crisis will be wasted, not so much in terms of implementing reforms but in terms of our ability to use data to improve our understanding of macroeconomics.
Antonio Fatás
Monday, December 2, 2013
Where did the saving glut go?
I have written before about the investment dearth that took place in advanced economies at the same time that we witnessed a global saving glut as illustrated in the chart below. In particular, the 2002-2007 expansion saw lower investment rates than any of the previous two expansions.
Antonio Fatás
P.S. All data used to produce the charts above comes from the IMF World Economic Outlook. Individual country data has been aggregated using PPP GDP weights (using market exchange rates GDP weights provides very similar insights).
If one thinks about a simple demand/supply framework using the saving (supply) and investment (demand) curves, this means that the investment curve for these countries must have shifted inwards at the same time that world interest rates were coming down.
But what about emerging markets? Emerging markets' investment did not fall during the last 10 years, to the contrary it accelerated very fast after 2000.
This is more what one would expect as a reaction to the global saving glut. The additional saving must be going somewhere (saving must equal investment in the world). As interest rates are coming down, emerging markets engage in more investment (whether this is simply a move along a downward-slopping investment curve or a shift of the investment opportunities for any given level of interest rates is impossible to tell from this simple analysis).
We can also look at the world as whole
Starting in the year 2000 we see a trend towards higher investment driven by emerging markets.
In equilibrium, both saving and investment have to move by the same amount (at the global level) so how do we know that this is a saving glut and not an increase in investment opportunities? The fact that interest rates were declining during these years means that these changes were dominated by an outward shift in the saving curve (if it had been investment shifting we would have seen interest rates increased). The resulting lower interest rates led to higher investment in emerging markets, as expected, but they did not foster any additional investment in advanced economies signaling that there has been a decline in investment opportunities in these countries. Whether this is a sign of a structural weakness that affects the inability of advanced economies to keep innovating at the same rate or purely a reflection of other, possibly cyclical, factors remains an open question.
Antonio Fatás
P.S. All data used to produce the charts above comes from the IMF World Economic Outlook. Individual country data has been aggregated using PPP GDP weights (using market exchange rates GDP weights provides very similar insights).
Sunday, November 24, 2013
Euro workers: no systemic risk
In his last press conference Mario Draghi said that the ECB was ready for negative deposit rates if necessary. His comments led to several European bankers rejecting this as a possibility (here and here). The comments of the Deutsche Bank and Commerzbank CEOs reflect on either their ignorance of how monetary policy works or their fighting against an ECB action that could make their lives harder (and their profits lower).
Martin Blessing from Commerzbank argues that "too much cheap credit could lead to future crises" and he concludes that he does not know "how too much cheap liquidity can solve a problem that was created by too much cheap liquidity." This argument has now been wrongly used for 5 years, I thought that by now we would have learned that this is the wrong analogy.
Fischen from Deutsche Bank complains that setting negative interest rates on deposits at the ECB would be like "penalizing banks". And this "will later be felt in a painful manner so that's what I've been warning about" (a threat?). This is the usual argument that banks are so important that you cannot do anything that annoys them. But what if negative interest rates are the right equilibrium value? In what way are we penalizing banks? Banks can go and invest their funds somewhere else if they find that this is not a competitive rate. In addition, it is not uncommon to have these CEOs arguing that what the Euro zone needs (in particular countries in the periphery) is a large reduction in wages. I guess this is fine. "Penalizing" workers is ok because they do not pose any systemic risk to the economy as a whole.
Antonio Fatás
Martin Blessing from Commerzbank argues that "too much cheap credit could lead to future crises" and he concludes that he does not know "how too much cheap liquidity can solve a problem that was created by too much cheap liquidity." This argument has now been wrongly used for 5 years, I thought that by now we would have learned that this is the wrong analogy.
Fischen from Deutsche Bank complains that setting negative interest rates on deposits at the ECB would be like "penalizing banks". And this "will later be felt in a painful manner so that's what I've been warning about" (a threat?). This is the usual argument that banks are so important that you cannot do anything that annoys them. But what if negative interest rates are the right equilibrium value? In what way are we penalizing banks? Banks can go and invest their funds somewhere else if they find that this is not a competitive rate. In addition, it is not uncommon to have these CEOs arguing that what the Euro zone needs (in particular countries in the periphery) is a large reduction in wages. I guess this is fine. "Penalizing" workers is ok because they do not pose any systemic risk to the economy as a whole.
Antonio Fatás
Wednesday, November 20, 2013
Saving glut or investment dearth?
Martin Wolf at the Financial Times argues that the future of the world economy, in particular that of advanced economies, looks sluggish because investment rates have displayed a downward trend over recent years, even before the financial crisis started. I made similar points in my blog post yesterday, let me add some evidence to that story.
It is a fact that since the mid 1990s interest rates in the world started a downward trend. This trend was explained by Ben Bernanke in his March 2005 speech
“To be more specific, I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain the relatively low level of long-term real interest rates in the world today”
This can easily be represented in a standard demand and supply chart for the global market for funds where the saving glut is simply a shift of the saving (supply) curve to the right.
What was interesting about the saving glut hypothesis is that it not only explained the decrease in interest rates but it was also able to account for the growth in global imbalances. One simple way to represent that is to separate the world in two blocks: those whose saving increased and the rest of the world. We can use again a simple demand and supply chart to represent this two group of countries: we represent the countries whose saving was increasing on the left hand side and the rest of the world on the right hand side to get the following picture:
This shows that we should expect the countries that increase their saving to display a growing current account surplus and the countries where the two curves are not shifting to display a growing current account deficit. This simple framework matches well the data during those years. Current account surplus in countries such as Germany, Japan, Oil producing countries, China and other emerging markets in Asia increased while deficits in countries such as the US and Greece, Spain, Portugal, Ireland, the UK increased as well. Here is the data (from the IMF World Economic Outlook):
But in this story there were some predictions that were never tested. In particular, as interest rates fell, investment should have increased globally. If you look at the saving and investment curves above, investment should have increased both in countries where the supply of saving was shifting as well as in the other countries. Unless we believe that investment rates do not depend on the interest rates we should have seen a generalized increased in investment around the world. Did we see that? No. In fact in advanced economies (including the US, as I showed yesterday) we have seen the opposite. Below is a chart that I have constructed using data from the IMF (World Economic Outlook database). I have calculated the aggregate investment rate (as % of GDP) for all advanced economies using the GDP share of each of these countries as weights [using PPP adjusted weights makes no difference for these countries].
There is a clear downward trend in the data. Even if we ignore the post-2008 data. the expansion in the 2000s was weaker that that of the 90s or the 80s. And remember that we expected exactly the opposite. The only way to make this last chart compatible with the saving glut story is to argue that at the same time that the saving curve was shifting to the right in some countries, the investment curve was also shifting (this time inwards) in other countries.
The shift of the investment curve would also help explain the lower interest rate during the decade. But in addition it would explain why growth rates (and labor market performance) remained weak during the expansion of the 2000s in some advanced economies. And given what we have seen so far during the current expansion it might be a source of additional pessimism about the coming years.
Antonio Fatás
It is a fact that since the mid 1990s interest rates in the world started a downward trend. This trend was explained by Ben Bernanke in his March 2005 speech
“To be more specific, I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain the relatively low level of long-term real interest rates in the world today”
This can easily be represented in a standard demand and supply chart for the global market for funds where the saving glut is simply a shift of the saving (supply) curve to the right.
What was interesting about the saving glut hypothesis is that it not only explained the decrease in interest rates but it was also able to account for the growth in global imbalances. One simple way to represent that is to separate the world in two blocks: those whose saving increased and the rest of the world. We can use again a simple demand and supply chart to represent this two group of countries: we represent the countries whose saving was increasing on the left hand side and the rest of the world on the right hand side to get the following picture:
This shows that we should expect the countries that increase their saving to display a growing current account surplus and the countries where the two curves are not shifting to display a growing current account deficit. This simple framework matches well the data during those years. Current account surplus in countries such as Germany, Japan, Oil producing countries, China and other emerging markets in Asia increased while deficits in countries such as the US and Greece, Spain, Portugal, Ireland, the UK increased as well. Here is the data (from the IMF World Economic Outlook):
But in this story there were some predictions that were never tested. In particular, as interest rates fell, investment should have increased globally. If you look at the saving and investment curves above, investment should have increased both in countries where the supply of saving was shifting as well as in the other countries. Unless we believe that investment rates do not depend on the interest rates we should have seen a generalized increased in investment around the world. Did we see that? No. In fact in advanced economies (including the US, as I showed yesterday) we have seen the opposite. Below is a chart that I have constructed using data from the IMF (World Economic Outlook database). I have calculated the aggregate investment rate (as % of GDP) for all advanced economies using the GDP share of each of these countries as weights [using PPP adjusted weights makes no difference for these countries].
There is a clear downward trend in the data. Even if we ignore the post-2008 data. the expansion in the 2000s was weaker that that of the 90s or the 80s. And remember that we expected exactly the opposite. The only way to make this last chart compatible with the saving glut story is to argue that at the same time that the saving curve was shifting to the right in some countries, the investment curve was also shifting (this time inwards) in other countries.
The shift of the investment curve would also help explain the lower interest rate during the decade. But in addition it would explain why growth rates (and labor market performance) remained weak during the expansion of the 2000s in some advanced economies. And given what we have seen so far during the current expansion it might be a source of additional pessimism about the coming years.
Antonio Fatás
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