Increases in stock prices over the last years combined with bond prices that remain high (yields are low) have raised the possibility of mispricing in assets, potential bubbles and future crashes. Are all assets too expensive? Some think so and refer to the current situation as a "gigantic financial asset bubble" where all assets (bonds, stocks, commodities,...) are priced too high. Others see trouble just in stock markets where valuations seem to be growing much faster than the real economy. But there are also those who think the stock market still offers a good return.
Here are two perspectives that can hopefully help understand such diverging views on asset prices:
1. How can it be that all asset prices are overvalued? When all asset prices look too high, we are making a statement about the disappointing returns these assets offer. The key question is whether we are really taking about mispricing or simply about surprisingly low (equilibrium) returns that saving is offered these days? Martin Wolf in today's FT offers many arguments on why low interest rates are here to stay because in a world of abundant saving, returns will be low and asset prices will be very high (I have written about this before). So maybe all asset prices are not too high, it is just that returns are not as high as they used to be.
2. How do you define a bubble? Before answering the question, it is good to get a perspective on the data. Neil Irwin at the New York Times has a great summary of the US stock market in six charts. What do we learn? Stock prices compared to the current level or earnings are high by historical standards. In other words, if you buy the stock market today, you should expect returns that are lower than typical returns. Is this a bubble? Maybe not if those low returns are consistent with the low returns that are offered anywhere else in the economy (back to the argument that "all asset prices are high"). If you do that comparison (see Irwin's article) and calculate the difference between returns one would expect from current stock prices and the returns that bonds offer, the difference is still positive and consistent with historical values (this is the same point that Brad DeLong makes). So stock prices look high but so do every other asset price. Once again, get used to low returns in a world where everyone wants to save.
So does it mean that everything is fine? No, it all depends on what are the expectations of current investors. A bubble in the stock market is not about how high stock prices are or about how low expected returns are. A bubble is about expected returns that are inconsistent with the current stock prices and their relationship to the fundamentals of the economy. If investors are buying stocks today having as a reference the returns that we have witnessed in the last years, then we are in a bubble. But if investors are buying stocks today as an investment that offers a low but consistent return with any other form of saving, then we are fine. From Irwin's article at the New York Times:
"Add it all up, and and it leads you to a conclusion.. Stocks may not be wildly overvalued relative to fundamentals. But for them to rise much from here, a lot of things will have to go just right for investors."
Correct. Stock are not a bargain like they were two years ago (when risk aversion was very high). Their prices are back to levels that are consistent with fundamentals and those fundamentals can deliver returns that are reasonable given other investment opportunities. But if all your fellow investors are hoping for yet another great year in the stock market, then run, because there is no way fundamentals can justify another couple of years of very high returns.
Antonio Fatás
Tuesday, May 6, 2014
Sunday, May 4, 2014
Refocusing economics education.
Via Mark Thoma I read an interesting article about how the mainstream economics curriculum needs to be revamped (Wren-Lewis also has some nice thoughts on this issue).
I am sympathetic to some of the arguments made in those posts and the need for some serious rethinking of the way economics is taught but I would put the emphasis on slightly different arguments. First, I am not sure the recent global crisis should be the main reason to change the economics curriculum. Yes, economists failed to predict many aspects of the crisis but my view is that it was not because of the lack of tools or understanding. We have enough models in economics that explain most of the phenomena that caused and propagated the global financial crisis. There are plenty of models where individuals are not rational, where financial markets are driven by bubbles, with multiple equilbria,... that one can use to understand the last decade. We do have all these tools but as economics teachers (and researchers) we need to choose which ones to focus on. And here is where we failed. And we did it before and during the crisis but we also did it earlier. Why aren't we focusing on the right models or methodology? Here is my list of mistakes we do in our teaching, which might also reflect on our research:
#1 Too much theory, not enough emphasis on explaining empirical phenomena. Models are easy to teach. Answering questions like "what caused the 2008 crisis?" or "what are the effects of an increase in the minimum wage"? is so much harder. So not only we tend to avoid them but also criticize those who provide answers by saying that there is too much uncertainty and no one really knows the answer. This is just a bad excuse because policy makers need to make decisions regardless of uncertainty. Economics students should be aware of the uncertainty surrounding these questions but they should also be taught how to answer them.
#2 Too many counterintuitive results. Economists like to teach things that are surprising. Teaching that consumption increases when taxes go down is not too exciting. But teaching that under some very implausible assumptions, consumers will save all the tax rebates to pay for future taxes makes you feel that you added some value in your class. Yes, clearly teaching something that our students have not thought about before can potentially be of more value, but this is only true if what we teach is relevant. If it just introduces confusion and makes our students be cynical about every economic policy proposal then we failed.
#3 The need for a unified theory. The idea that economics is a rigorous science pushes economists to look for consistency via a unified framework when we teach the subject. We want to have one model to explain everything. The use of small and some times inconsistent partial equilibrium models to explain real-world phenomena is seeing as a sign of weakness. A unified theory that is consistent (even if it does not explain much of what we seen in the real world) is always the way to go. Yes, a unified theory would be great, but we need to be realistic. Small ad-hoc models can be a lot more effective to learn about economic issues than the insistence on using the same unrealistic model to explain everything. And in most economics courses we spend all our time building this model and once we are done there is very little time to answer relevant questions. And when asked, we simply argue that "this model cannot capture that" (so back to mistake #1, too much theory, not enough emphasis on understanding empirics).
#4 We teach what our audience wants to hear. We conform too often to social beliefs about how the economy works and we simply support those beliefs with our teaching. Here is one example: when we teach about governments, cracking a few jokes about government inefficiency, bureaucrats, politics is very easy. Using models where government spending plays no productive role feels natural. But when we look at the private sector, we start with the opposite view, one of efficiency and absence of rents given the competitive environment in which firms operate (the famous analogy of no $100 notes sitting on the sidewalk). If you want to argue that it is the other way around be ready to fight a difficult battle. An it is not that we have plenty of empirical evidence to back up these statements. There is very limited research and in some cases with very uncertain results on the role of rents, inequality, market power in modern economies (although this might be changing). But rather than teaching about this uncertainty we start with models that take a very strong stance on these very fundamental questions. So we are being inconsistent. While in some cases we use uncertainty to criticize certain economic policies, in other cases we use the same argument to support a certain view of the world because it matches either the status quo or the beliefs that most in the audience have.
Antonio Fatás
I am sympathetic to some of the arguments made in those posts and the need for some serious rethinking of the way economics is taught but I would put the emphasis on slightly different arguments. First, I am not sure the recent global crisis should be the main reason to change the economics curriculum. Yes, economists failed to predict many aspects of the crisis but my view is that it was not because of the lack of tools or understanding. We have enough models in economics that explain most of the phenomena that caused and propagated the global financial crisis. There are plenty of models where individuals are not rational, where financial markets are driven by bubbles, with multiple equilbria,... that one can use to understand the last decade. We do have all these tools but as economics teachers (and researchers) we need to choose which ones to focus on. And here is where we failed. And we did it before and during the crisis but we also did it earlier. Why aren't we focusing on the right models or methodology? Here is my list of mistakes we do in our teaching, which might also reflect on our research:
#1 Too much theory, not enough emphasis on explaining empirical phenomena. Models are easy to teach. Answering questions like "what caused the 2008 crisis?" or "what are the effects of an increase in the minimum wage"? is so much harder. So not only we tend to avoid them but also criticize those who provide answers by saying that there is too much uncertainty and no one really knows the answer. This is just a bad excuse because policy makers need to make decisions regardless of uncertainty. Economics students should be aware of the uncertainty surrounding these questions but they should also be taught how to answer them.
#2 Too many counterintuitive results. Economists like to teach things that are surprising. Teaching that consumption increases when taxes go down is not too exciting. But teaching that under some very implausible assumptions, consumers will save all the tax rebates to pay for future taxes makes you feel that you added some value in your class. Yes, clearly teaching something that our students have not thought about before can potentially be of more value, but this is only true if what we teach is relevant. If it just introduces confusion and makes our students be cynical about every economic policy proposal then we failed.
#3 The need for a unified theory. The idea that economics is a rigorous science pushes economists to look for consistency via a unified framework when we teach the subject. We want to have one model to explain everything. The use of small and some times inconsistent partial equilibrium models to explain real-world phenomena is seeing as a sign of weakness. A unified theory that is consistent (even if it does not explain much of what we seen in the real world) is always the way to go. Yes, a unified theory would be great, but we need to be realistic. Small ad-hoc models can be a lot more effective to learn about economic issues than the insistence on using the same unrealistic model to explain everything. And in most economics courses we spend all our time building this model and once we are done there is very little time to answer relevant questions. And when asked, we simply argue that "this model cannot capture that" (so back to mistake #1, too much theory, not enough emphasis on understanding empirics).
#4 We teach what our audience wants to hear. We conform too often to social beliefs about how the economy works and we simply support those beliefs with our teaching. Here is one example: when we teach about governments, cracking a few jokes about government inefficiency, bureaucrats, politics is very easy. Using models where government spending plays no productive role feels natural. But when we look at the private sector, we start with the opposite view, one of efficiency and absence of rents given the competitive environment in which firms operate (the famous analogy of no $100 notes sitting on the sidewalk). If you want to argue that it is the other way around be ready to fight a difficult battle. An it is not that we have plenty of empirical evidence to back up these statements. There is very limited research and in some cases with very uncertain results on the role of rents, inequality, market power in modern economies (although this might be changing). But rather than teaching about this uncertainty we start with models that take a very strong stance on these very fundamental questions. So we are being inconsistent. While in some cases we use uncertainty to criticize certain economic policies, in other cases we use the same argument to support a certain view of the world because it matches either the status quo or the beliefs that most in the audience have.
Antonio Fatás
Thursday, May 1, 2014
Honey, I blew up a few economies.
The International Comparison Program (hosted at the World Bank) just released its new estimates of Purchasing Power Parity that are used to compare GDP across countries. These estimates are released about every 5 years and they serve as the basis for the PPP-adjusted statistics used by most international organizations or statistical sources. These estimates get updated on an annual basis using inflation rates but it is the 5 year survey that produces the complete data that allows us to compare purchasing power across countries.
The release was picked up by all news outlets by emphasizing the fact that China looks bigger than what we thought before and it is likely to become the number one economy by the end of 2014 (e.g. Financial Times). The news on China makes for great headlines but the reality is that many countries saw significant changes in their PPP estimates, let's look at some magnitudes.
Before looking at magnitudes, a clarification on methodology: PPP estimates are done for a particular year (2011 in this case). The PPP adjusted figures released this week take the same GDP data that we already were using for that year and what they do is to publish a new set of PPP estimates that allows for a conversion of GDP to a purchasing-power basis just for that year (2011). Soon most databases will start using those PPP estimates (from 2011) to extrapolate and calculate the recent annual GDPs (2013). But this calculation will be done by adjusting 2011 PPP estimates with domestic inflation rates. To understand what has really changed with these new estimates and avoid the possible distortions that using inflation rates could cause let me do a simpler calculation: let's stick to 2011 GDP and ask the following question: How different is the size of economies as calculated using 2011 PPP compared to what we thought before these estimates were released? Before these estimates were released we were using PPP estimates calculated in 2005 updated using domestic inflation rates.
If you do that calculation, China increased its size by about 21%. But China is not alone. In fact there are 65 countries whose size increased even more than that. And there are about 30 countries where the increase was larger than 50%. Below are some examples:
The release was picked up by all news outlets by emphasizing the fact that China looks bigger than what we thought before and it is likely to become the number one economy by the end of 2014 (e.g. Financial Times). The news on China makes for great headlines but the reality is that many countries saw significant changes in their PPP estimates, let's look at some magnitudes.
Before looking at magnitudes, a clarification on methodology: PPP estimates are done for a particular year (2011 in this case). The PPP adjusted figures released this week take the same GDP data that we already were using for that year and what they do is to publish a new set of PPP estimates that allows for a conversion of GDP to a purchasing-power basis just for that year (2011). Soon most databases will start using those PPP estimates (from 2011) to extrapolate and calculate the recent annual GDPs (2013). But this calculation will be done by adjusting 2011 PPP estimates with domestic inflation rates. To understand what has really changed with these new estimates and avoid the possible distortions that using inflation rates could cause let me do a simpler calculation: let's stick to 2011 GDP and ask the following question: How different is the size of economies as calculated using 2011 PPP compared to what we thought before these estimates were released? Before these estimates were released we were using PPP estimates calculated in 2005 updated using domestic inflation rates.
If you do that calculation, China increased its size by about 21%. But China is not alone. In fact there are 65 countries whose size increased even more than that. And there are about 30 countries where the increase was larger than 50%. Below are some examples:
Country
|
Increase in
2011 GDP PPP
|
UAE
|
109%
|
Myanmar
|
103%
|
Indonesia
|
85%
|
Saudi
Arabia
|
65%
|
Egypt
|
64%
|
Pakistan
|
53%
|
Thailand
|
51%
|
Philippines
|
41%
|
Russia
|
36%
|
Iran
|
33%
|
Malaysia
|
32%
|
Romania
|
30%
|
India
|
28%
|
Nigeria
|
25%
|
Brazil
|
24%
|
Turkey
|
23%
|
China
|
21%
|
The UAE doubled its size and becomes a $500+ billion economy (larger than Belgium). Indonesia increased by 85% to pass $2 trillion and becomes the 10th largest economy in the world (larger than Italy and very close to the UK). All these are very large changes that clearly show that the most recent PPPs have introduced a completely different lens to compare price levels and living standards across countries. The pattern is that emerging markets tend to look a lot cheaper than what we thought earlier and therefore their GDP measured in purchasing power parity looks much larger.
What is interesting is that this has not always been the case. The previous release of PPP estimates (2005) caused a lot of controversy because they reduced the size of the Chinese economy by about 15%.
One can argue that changes in the PPP-adjusted size of countries have very little practical impact, GDP has not really changed. It does have an impact on those who care about size and rankings of countries and think that PPP-adjusted series are better are capturing size (which is probably not correct, but I will leave this for another post). But it also has a large impact for those who care about comparisons of living standards (for which PPP correction is a must): these large movements in PPP estimates completely change our reading of living standards for many countries. if you are a researcher, get ready to update all your regressions!
Antonio Fatás
Antonio Fatás
Monday, April 21, 2014
The contradiction in economics
Somehow a graduation speech by Tom Sargent (nobel prize in Economics in 2001) from back in 2007 made it to Vox two days ago and it has been reposted by several bloggers. The article in Vox did not include the full speech but just listed the 12 valuable lessons that economics has taught the world. While some have found those lessons interesting and insightful, others have criticized them as either too simplistic, partial or just wrong (among the critics, Noah Smith, Paul Krugman or Chris Dillow).
I share some of the criticism that have been raised by others but my initial reaction was different. Several of the 12 lessons that Sargent lists are about individual behavior and decision making (not even about how individual behavior affects economic outcomes). For example, "individuals face trade offs" or "many things that are desirable are not feasible" or "people are satisfied with their choices".
Why is it that economics is so good at understanding individual behavior is already a puzzle, but my real concern is the following: if these are the lessons that economics has taught the world, how do people who have not learned those lessons behave? Is it the case that someone who has not been taught economics does not understand the existence of trade offs? And if this is true, why do economists tend to assume that everyone is so good at decision making?
This contradiction in economics is present when academics write complex mathematical models. It takes a PhD in economics and a lot of hard work to solve these model and we are rewarded by being the first ones who figured out how to solve them. But in these models we assume that every individual in an economy is capable of solving for the equilibrium! Somehow in our models everyone has already learned all the lessons of economics.
Antonio Fatás
I share some of the criticism that have been raised by others but my initial reaction was different. Several of the 12 lessons that Sargent lists are about individual behavior and decision making (not even about how individual behavior affects economic outcomes). For example, "individuals face trade offs" or "many things that are desirable are not feasible" or "people are satisfied with their choices".
Why is it that economics is so good at understanding individual behavior is already a puzzle, but my real concern is the following: if these are the lessons that economics has taught the world, how do people who have not learned those lessons behave? Is it the case that someone who has not been taught economics does not understand the existence of trade offs? And if this is true, why do economists tend to assume that everyone is so good at decision making?
This contradiction in economics is present when academics write complex mathematical models. It takes a PhD in economics and a lot of hard work to solve these model and we are rewarded by being the first ones who figured out how to solve them. But in these models we assume that every individual in an economy is capable of solving for the equilibrium! Somehow in our models everyone has already learned all the lessons of economics.
Antonio Fatás
Wednesday, April 16, 2014
Secular stagnation or secular boom?
The notion that some countries are caught in a long and protracted period of low growth has received an increasing amount of attention and has been labelled "secular stagnation". The pessimism that the idea of secular stagnation has created has been reinforced by the notion the potential for emerging markets to grow is becoming weaker. The point that I want to make in this post is that one of these notions (secular stagnation) is looking backwards at the performance of advanced economies while the other one (potential pessimism about emerging markets) is looking forward and speculating with their inability to do as well as in the last decade.
Let's start with a simple chart that summarizes the pattern of annual growth in the world over the last decades. Data come from the World Economic Outlook database (IMF). I have decided to include the last 13 years for the decade that starts in 2000.
Two observations: growth (by decades) has been remarkably stable in the world, between 3.2%-3.6%. Second observation: during the last 13 years growth has increased relative to the previous two decades. No global stagnation, if any, acceleration of growth.
But if we split the world into advanced and emerging markets we see a very different pattern. [I will use the label emerging for any country which is not advanced - the IMF will call them emerging and developing countries].
While in the 80s, and some extent in the 90s, both groups grew at a very similar rate, in the last 13 years annual growth rates in emerging markets have been three times higher than those of advanced economies. So stagnation might be the right label for 50% of the world, but accelerating growth is the right label for the other half.
And if we look at the engines of growth, in particular investment rates (in physical capital) we can see again the divergence in performance.
Investment rates for the world are fairly stable over all these years with possibly some mild increase in the last 13 years. And that increase is driven by an explosion in investment rates in emerging markets (by 50%) at the same time that investment falls in advanced economies below the 20% level.
Looking at the above charts, one wonders whether the divergent performance of emerging markets and advanced economies is related. Could it be that investment opportunities in emerging markets moved capital away from advanced economies? Not obvious because we know that the explosion in investment rates in emerging markets came in many cases with even larger increases in saving rates and (financial) capital flew away from these countries. In fact, interest rates in the world were trending downwards during this period. And this makes the performance of advanced economies even more surprising: despite a favorable environment in terms of low interest rates, investment and growth declined.
Antonio Fatás
Let's start with a simple chart that summarizes the pattern of annual growth in the world over the last decades. Data come from the World Economic Outlook database (IMF). I have decided to include the last 13 years for the decade that starts in 2000.
Two observations: growth (by decades) has been remarkably stable in the world, between 3.2%-3.6%. Second observation: during the last 13 years growth has increased relative to the previous two decades. No global stagnation, if any, acceleration of growth.
But if we split the world into advanced and emerging markets we see a very different pattern. [I will use the label emerging for any country which is not advanced - the IMF will call them emerging and developing countries].
While in the 80s, and some extent in the 90s, both groups grew at a very similar rate, in the last 13 years annual growth rates in emerging markets have been three times higher than those of advanced economies. So stagnation might be the right label for 50% of the world, but accelerating growth is the right label for the other half.
And if we look at the engines of growth, in particular investment rates (in physical capital) we can see again the divergence in performance.
Investment rates for the world are fairly stable over all these years with possibly some mild increase in the last 13 years. And that increase is driven by an explosion in investment rates in emerging markets (by 50%) at the same time that investment falls in advanced economies below the 20% level.
Looking at the above charts, one wonders whether the divergent performance of emerging markets and advanced economies is related. Could it be that investment opportunities in emerging markets moved capital away from advanced economies? Not obvious because we know that the explosion in investment rates in emerging markets came in many cases with even larger increases in saving rates and (financial) capital flew away from these countries. In fact, interest rates in the world were trending downwards during this period. And this makes the performance of advanced economies even more surprising: despite a favorable environment in terms of low interest rates, investment and growth declined.
Antonio Fatás
Monday, April 14, 2014
The price is wrong
The Euro area inflation came lower than expected in March and this has raised concerns about deflation (or "lowflation" as labelled by the IMF). In today's Financial Times, Jurgen Stark, a former ECB board member argues that deflation or low inflation is not a problem. One of his arguments is that there are benefits for low inflation, in particular:
"It is likely we are living in an extended period of price stability. This is good news. It boosts real disposable income and will eventually support private consumption."
(By the way, Mario Draghi used the same argument in his last press conference).
So low inflation raises real income and it helps boost demand and output. The economic logic behind this statement is at best unclear, at worst completely wrong. Unfortunately, the misconception involved in this sentence is not that uncommon and it reflects the poor understanding of the general public (and public officials) about inflation, nominal and real variables. But it also reflects poorly on academic arguments based on models with price rigidity that, in my view, are not always as clear as they should when it comes to the dynamics of absolute and relative prices.
Let me start with Jurgen Stark's comment: his assumption is that prices are growing at a slower rate than income. But he forgets that income is linked to prices as well. It is possible that as a result of low inflation the real income of some agents is growing but it would be at the expense of the real income of others. For example, if wages are growing at a decent rate but prices are falling (or growing at a lower rate) it means that real wages are increasing. But this is a redistribution effect that shifts income towards workers and away from profits. Total demand can only be affected if we assume some differences in the propensity to consume of different groups. And if this is the model that we have in mind, then let's push for higher wages across the board to get out of a crisis (I doubt Jurgen Stark favors this conclusion).
But what do academic models have to say about the relative price effects of changes in inflation? Not much or, at least, not in a way that is clear enough to drive consensus in policy recommendations.
Let's start with the basic model we teach in macroeconomics: the textbook IS-LM model. In most textbooks this is originally presented as a pure demand-side model. Inflation (or prices) matter: lower prices increase demand. Demand depends on the ratio of nominal money to prices (M/P) and lower prices are associated with increases in output. This is indeed the main mechanism by which lower prices help restore the long-term equilibrium. So in this world low inflation or deflation are good (i.e. Jurgen Stark is right).
The notion that M/P drives demand and output is not always intuitive for many students so it is very common that when we teach the IS-LM model we also make a reference to the potential role that some relative price can play to generate the same output dynamics. In particular we bring wages into the story. But here is where the logic becomes confusing. By bringing wages we argue that recessions are periods where nominal wages are rigid and as prices go down the real wage increases and causes employment and output to contract. The recovery from a recession corresponds to a period where nominal wages are going back to normal (decreasing relative to inflation) and helping employment and output grow. But there are two problems with this logic: this is a supply effect, not anymore a demand effect. Second, if this logic is true, higher prices/inflation is the way to restore the equilibrium (as opposed to lower prices in the first argument). The relative dynamics of different prices are crucial to support the logic of this argument and talking about inflation (as Jurgen Stark does) without making a clear statement on how different prices and wages are moving will be misleading.
But what happened to demand in that story? The real wage argument is a supply-side argument and the assumption is that demand will match supply. But what if we consider the possibility that different agents have different propensity to consume in the short run? Then any change in relative prices might affect demand. In that world, it might be that lower prices help raise real wages (and lower profits) and under the assumption that workers have a higher propensity to consume than capital owners, this could raise demand and output (so Jurgen Stark is right again).
It gets more complicated as real wages are not the only relative price that matter. There are two other arguments that can affect the potential effects of low prices. First, if nominal interest rates are fixed (or stuck at the zero-lower bound), falling prices/inflation will raise real interest rates and reduce demand. In addition, if financial assets and liabilities are denominated in nominal terms any unexpected fall in prices/inflation will raise the real value of the debt. This is again a redistribution effect (the real value of savings falls so those agents are hurt by inflation) but under the assumption that either borrowers have a higher propensity to consume or simply need more help to restore their damaged balance sheets, there could be a positive effect on demand.
And things get a lot more complicated in an open economy where prices (and wages) play a role determining exports and imports. Typically we teach that lower prices is the right recipe to engineer a real exchange rate devaluation that helps regains competitiveness and improve growth (but when we do so, we ignore the other potential negative effects of low prices or inflation).
Finally, it might be that the effects of low inflation are not at all related to relative prices. The confusion between nominal and real variables has been documented many times and falling inflation even if all prices and interest rates are moving in sync could trigger real effects if it is misinterpreted as a real change in income or relative prices.
So we are left with a set of arguments using models with some type of nominal rigidity that are not always consistent in their predictions. They make use of both supply- and demand-side arguments and under some scenarios inflation (in some prices) is good, under other scenarios inflation (in some prices) is bad. In this environment, making policy recommendations becomes very difficult.
As an example, what do we want to see in the Euro periphery? Lower inflation or higher inflation? Lower inflation sounds good as a way to generate an adjustment in the real exchange rate. But do we want lower price inflation or lower wage inflation or both? How do nominal wage rigidities and potential income distribution effects (from capital to labor or from savers to borrowers) affect demand?
My sense is that the consensus is that we want a high enough level of inflation in the Euro area that allows for significant changes in relative prices within countries (this is what the IMF argues in this blog post. But exactly which relative price has to move and in which direction it might be less obvious. We normally thing that the periphery will need lower wage inflation (to be more competitive). But not too low so that do not run into the fact that wages are unlikely to fall in nominal terms or that potential deflation increases the real value of debt. This all sounds reasonable but implicitly we are assuming that falling real wages in the Euro periphery is good. But are we sure that the redistribution effects of such policies do not affect demand (the same way we argue that the redistribution effects between savers and debtors affects demand)? It would be nice to have more clarity both on the theoretical arguments and the empirical size of each of these effects.
Antonio Fatás
"It is likely we are living in an extended period of price stability. This is good news. It boosts real disposable income and will eventually support private consumption."
(By the way, Mario Draghi used the same argument in his last press conference).
So low inflation raises real income and it helps boost demand and output. The economic logic behind this statement is at best unclear, at worst completely wrong. Unfortunately, the misconception involved in this sentence is not that uncommon and it reflects the poor understanding of the general public (and public officials) about inflation, nominal and real variables. But it also reflects poorly on academic arguments based on models with price rigidity that, in my view, are not always as clear as they should when it comes to the dynamics of absolute and relative prices.
Let me start with Jurgen Stark's comment: his assumption is that prices are growing at a slower rate than income. But he forgets that income is linked to prices as well. It is possible that as a result of low inflation the real income of some agents is growing but it would be at the expense of the real income of others. For example, if wages are growing at a decent rate but prices are falling (or growing at a lower rate) it means that real wages are increasing. But this is a redistribution effect that shifts income towards workers and away from profits. Total demand can only be affected if we assume some differences in the propensity to consume of different groups. And if this is the model that we have in mind, then let's push for higher wages across the board to get out of a crisis (I doubt Jurgen Stark favors this conclusion).
But what do academic models have to say about the relative price effects of changes in inflation? Not much or, at least, not in a way that is clear enough to drive consensus in policy recommendations.
Let's start with the basic model we teach in macroeconomics: the textbook IS-LM model. In most textbooks this is originally presented as a pure demand-side model. Inflation (or prices) matter: lower prices increase demand. Demand depends on the ratio of nominal money to prices (M/P) and lower prices are associated with increases in output. This is indeed the main mechanism by which lower prices help restore the long-term equilibrium. So in this world low inflation or deflation are good (i.e. Jurgen Stark is right).
The notion that M/P drives demand and output is not always intuitive for many students so it is very common that when we teach the IS-LM model we also make a reference to the potential role that some relative price can play to generate the same output dynamics. In particular we bring wages into the story. But here is where the logic becomes confusing. By bringing wages we argue that recessions are periods where nominal wages are rigid and as prices go down the real wage increases and causes employment and output to contract. The recovery from a recession corresponds to a period where nominal wages are going back to normal (decreasing relative to inflation) and helping employment and output grow. But there are two problems with this logic: this is a supply effect, not anymore a demand effect. Second, if this logic is true, higher prices/inflation is the way to restore the equilibrium (as opposed to lower prices in the first argument). The relative dynamics of different prices are crucial to support the logic of this argument and talking about inflation (as Jurgen Stark does) without making a clear statement on how different prices and wages are moving will be misleading.
But what happened to demand in that story? The real wage argument is a supply-side argument and the assumption is that demand will match supply. But what if we consider the possibility that different agents have different propensity to consume in the short run? Then any change in relative prices might affect demand. In that world, it might be that lower prices help raise real wages (and lower profits) and under the assumption that workers have a higher propensity to consume than capital owners, this could raise demand and output (so Jurgen Stark is right again).
It gets more complicated as real wages are not the only relative price that matter. There are two other arguments that can affect the potential effects of low prices. First, if nominal interest rates are fixed (or stuck at the zero-lower bound), falling prices/inflation will raise real interest rates and reduce demand. In addition, if financial assets and liabilities are denominated in nominal terms any unexpected fall in prices/inflation will raise the real value of the debt. This is again a redistribution effect (the real value of savings falls so those agents are hurt by inflation) but under the assumption that either borrowers have a higher propensity to consume or simply need more help to restore their damaged balance sheets, there could be a positive effect on demand.
And things get a lot more complicated in an open economy where prices (and wages) play a role determining exports and imports. Typically we teach that lower prices is the right recipe to engineer a real exchange rate devaluation that helps regains competitiveness and improve growth (but when we do so, we ignore the other potential negative effects of low prices or inflation).
Finally, it might be that the effects of low inflation are not at all related to relative prices. The confusion between nominal and real variables has been documented many times and falling inflation even if all prices and interest rates are moving in sync could trigger real effects if it is misinterpreted as a real change in income or relative prices.
So we are left with a set of arguments using models with some type of nominal rigidity that are not always consistent in their predictions. They make use of both supply- and demand-side arguments and under some scenarios inflation (in some prices) is good, under other scenarios inflation (in some prices) is bad. In this environment, making policy recommendations becomes very difficult.
As an example, what do we want to see in the Euro periphery? Lower inflation or higher inflation? Lower inflation sounds good as a way to generate an adjustment in the real exchange rate. But do we want lower price inflation or lower wage inflation or both? How do nominal wage rigidities and potential income distribution effects (from capital to labor or from savers to borrowers) affect demand?
My sense is that the consensus is that we want a high enough level of inflation in the Euro area that allows for significant changes in relative prices within countries (this is what the IMF argues in this blog post. But exactly which relative price has to move and in which direction it might be less obvious. We normally thing that the periphery will need lower wage inflation (to be more competitive). But not too low so that do not run into the fact that wages are unlikely to fall in nominal terms or that potential deflation increases the real value of debt. This all sounds reasonable but implicitly we are assuming that falling real wages in the Euro periphery is good. But are we sure that the redistribution effects of such policies do not affect demand (the same way we argue that the redistribution effects between savers and debtors affects demand)? It would be nice to have more clarity both on the theoretical arguments and the empirical size of each of these effects.
Antonio Fatás
Thursday, April 3, 2014
The many hands of Mario Draghi
Mario Draghi press conference yesterday was yet another exercise of creating confusion about what the ECB intends to do. Maybe what he referred to as an unanimous consensus in the ECB council is not really there or maybe the consensus is simply to keep arguing that there are risks to both sides, that the data is not clear enough, that it can be interpreted in so many ways and in the absence of certainty it is better not to act.
His answers looked like the perfect parody of an economist that will always play it safe by starting with one argument and them arguing that "on the other hand" we could also be doing the opposite.
Here is the best example of this:
".. my biggest fear is actually to some extent reality, and that is the protracted stagnation, longer than we have in our baseline scenario. Right now, it’s pretty severe, with levels of unemployment that – even though they have stabilised, and we see marginal improvements here and there – are very high. And the longer they persist, the more likely it is that they will become structural, namely much harder to lower through conventional policy measures. So that’s my biggest fear, and that’s why monetary policy is important, but it’s not the only thing. To respond to this fear, one needs a complex package of policies and, as we always stress, structural reforms come first, because many of the problems of the euro area are structural."
So his biggest fear is that cyclical unemployment turns into structural unemployment, so I guess this means that the ECB is ready to act to ensure that this does not happen. Wait! Not so fast, because his biggest fear is also that monetary policy is important bot not as important as structural reforms that are the first priority. So I guess all the cyclical unemployment turned into structural unemployment so we are too late to act.
And he recognizes that low inflation is bad and it is below the ECB target. But low inflation can also be good
"..but there are also some positive aspects (of low inflation) in the sense that it supports the real disposable income especially of those people who have a fixed nominal income."
Interesting argument to justify low inflation (should we lower the inflation target?)
And even if inflation is low it is not fully under the control of the ECB
"this is being caused by exogenous factors. In fact, if you see what is the inflation rate in other countries, for example in the United States, where they are much more advanced in their recovery than we are, or in Sweden, you can see that the low inflation contains a high percentage of global factors."
Yes, inflation in the US is also low but Janet Yellen words and actions are very different from those of Draghi. She does not simply find excuses why inflation is low, she is committed to make it go back to its target.
So I guess that we are left with "protracted stagnation". We will wait for the April inflation number that Draghi thinks it will be higher than the one in March and if it is not, we will continue feeling very good about the fact that long-term inflation expectations are still anchored. What the ECB is showing these days is that their obsession with inflation is even worse than what we thought. It is hard to imagine how low the inflation data has to get so that they pay some attention to their mandate.
Antonio Fatás
His answers looked like the perfect parody of an economist that will always play it safe by starting with one argument and them arguing that "on the other hand" we could also be doing the opposite.
Here is the best example of this:
".. my biggest fear is actually to some extent reality, and that is the protracted stagnation, longer than we have in our baseline scenario. Right now, it’s pretty severe, with levels of unemployment that – even though they have stabilised, and we see marginal improvements here and there – are very high. And the longer they persist, the more likely it is that they will become structural, namely much harder to lower through conventional policy measures. So that’s my biggest fear, and that’s why monetary policy is important, but it’s not the only thing. To respond to this fear, one needs a complex package of policies and, as we always stress, structural reforms come first, because many of the problems of the euro area are structural."
So his biggest fear is that cyclical unemployment turns into structural unemployment, so I guess this means that the ECB is ready to act to ensure that this does not happen. Wait! Not so fast, because his biggest fear is also that monetary policy is important bot not as important as structural reforms that are the first priority. So I guess all the cyclical unemployment turned into structural unemployment so we are too late to act.
And he recognizes that low inflation is bad and it is below the ECB target. But low inflation can also be good
"..but there are also some positive aspects (of low inflation) in the sense that it supports the real disposable income especially of those people who have a fixed nominal income."
Interesting argument to justify low inflation (should we lower the inflation target?)
And even if inflation is low it is not fully under the control of the ECB
"this is being caused by exogenous factors. In fact, if you see what is the inflation rate in other countries, for example in the United States, where they are much more advanced in their recovery than we are, or in Sweden, you can see that the low inflation contains a high percentage of global factors."
Yes, inflation in the US is also low but Janet Yellen words and actions are very different from those of Draghi. She does not simply find excuses why inflation is low, she is committed to make it go back to its target.
So I guess that we are left with "protracted stagnation". We will wait for the April inflation number that Draghi thinks it will be higher than the one in March and if it is not, we will continue feeling very good about the fact that long-term inflation expectations are still anchored. What the ECB is showing these days is that their obsession with inflation is even worse than what we thought. It is hard to imagine how low the inflation data has to get so that they pay some attention to their mandate.
Antonio Fatás
Subscribe to:
Posts (Atom)
