Wednesday, February 27, 2013

Bill Gross on the Big Mac and QE

These are good days for someone who teaches macroeconomics, because it is easy to find articles that misrepresent the basic concepts we teach in class - this always motivates our students who now feel that they can make better arguments than those writing in the financial press.

Bill Gross, founder and co-chief investment of Pimco is back in the Financial Times. This time he is not trying to explain why higher interest rates are good for investment and growth, but instead he is trying to help investors make decisions on foreign exchange markets. His argument is that the traditional theories of exchange rates (Purchasing Power Parity = Big Mac Index) do not matter much today, what matters is the behavior of central banks when it comes to quantitative easing.

The first thing that is odd in the article is that he misses the connection between the different theories he discusses. Someone making an argument that quantitative easing leads to inflation and a depreciation of a currency is implicitly using Purchasing Power Parity as an argument to talk about exchange rates. That argument is standard in any macroeconomics textbook.

What is not standard and where, in my view, he is not being accurate is the way he describes quantitative easing and its implications on exchange rates. First, there is the constant reference to "money being printed". This is wrong. Most of the increases in the monetary base (the size of the balance sheet of central banks) do not correspond to increases in the amount of currency in circulation but to increases in the deposits that commercial banks hold at the central bank (reserves). This increase in the monetary base do not always lead to an increase in the money supply or inflation. Or you can put it in a different way: the increase in liquidity is matching the demand for liquidity by the financial system. If demand and supply are balanced, prices do not change (exchange rates do not change).

When it comes to the exchange rate he cites Japan as an example where his theory is working (the Yen has depreciated because of quantitative easing). Correct, but only up to a point: it is not because the balance sheet of the central bank is increasing, it is because there is the perception that the central bank is finally committed to deliver high inflation and if this is the case, PPP tells us that a currency will get weaker.

His advice: to pick winners and losers (in terms of currencies) by looking at the size of the central bank balance sheet. Way too simplistic and possibly wrong. It sounds more as one additional attempt to criticize central banks for what they have been doing (QE). If anyone had followed that advice during the crisis years, they would have gotten their bets on currencies wrong several times (same for those who followed his earlier advice that inflation was around the corner and interest rates would increase fast).

Yes, monetary policy matters for the exchange rate because it affects all nominal variables: prices, inflation and the nominal exchange rate. But mislabeling quantitative easing as "printing money" and call it a sure bet to increase inflation in future years has proven to be wrong enough times in the last years that one would think that the argument would not be repeated again. But I should not complain, I have to teach a few more sessions on monetary policy in about three weeks, so these articles are making my search for interesting readings much easier.

Antonio Fatás

Tuesday, February 26, 2013

Dove or Hawk? Bernanke's record

In yesterday's testimony at the U.S. Senate Ben Bernanke was accused of policies that could potentially generate high inflation. Senator Corker accused the Fed Chairman of nor being concerned enough about inflation by saying "I don't think there's any question that you would be the biggest dove since World War II". The term "dove" in the context of central banks is used to describe policies that put more weight on unemployment and less on inflation (as opposed to "hawks" who do the opposite). Ben Bernanke defended himself by mentioning that he has one of the strongest records in terms of inflation of any previous Chairman.

Below is a quick check on both the inflation as well as the unemployment record of the last six chairmen of the US Fed. Ben Bernanke has so far produced one of the lowest inflation rates since the 1950s. When it comes to unemployment, his record is not that positive, only second to Paul Volcker in terms of high unemployment rates.

Comparing performance of central banks without controlling for other factors (such as the depth and frequency of economic crisis or shocks during their mandates) is not fair but at a minimum it provides some basic facts to back the statement by Ben Bernanke that it is difficult to see his record as someone who put too much weight on unemployment and too little on inflation.

Antonio Fatás

Sunday, February 24, 2013

The Euro depression

As we wait for the results of the Italian election, Europe is heading for yet another period of uncertainty. Governments in key countries (Italy, Spain, Greece, France,...) do not have the support to continue the path that has been followed so far but there is still no real alternative and a strong sense of complacency: we will continue the same policies that we have followed so far.

According to the European commission recent forecasts, the Euro area will see negative growth rates again in 2013 and growth rates as low as 1.4 in 2014. This means an average growth of 0.16% in the period 2012-2014, assuming we do not end up revising downwards our views on 2014 - which is very likely. And this comes after Europe has gone through its worst recorded recession during the 2008-2010 years.

This is now worse than a double-dip (great) recession. What is really frustrating (maybe we should call it depressing, to match the economic situation) is the complacency with which some European politicians look at what is happening. When Olli Rehn (EU commissioner for economic and monetary affairs) commented on these negative forecasts produced by the EU commission, he called them disappointing but then he just said that current policies are finally paying off. The introduction letter to those forecasts, produce by Marco Buti, the Director General responsible for the forecasts, talks about several factors that are contributing to weak growth: the negative feedback between public finances, banks and the weak macroeconomy, lack of credit growth, uncertainty about policies,... These are all external factors (austerity is not even mentioned as a possible factor), so the best we can do is to continue the policy agenda "to ensure the sustainability of public finances". There is no learning here, it does not matter how strong the facts are (I will not present again the facts here, see Krugman or De Grauwe for a recent analysis and a reaction to these forecasts).

But let me look at some (depressing) data from Italy, where election results are expected by the end of the day. Below is the evolution of the Italian economy compared to the US and South Korea since 1980. Data is GDP per capita (in logs) from the IMF World Economic Outlook, including their forecast for 2013 and 2014.

After the Italian "miracle" of the 1960s and 1970s where Italy was growing fast and converging towards the other rich countries, the economy stagnated in the 80s and then started falling apart in the years that follow. Since 1990, not only Italy has stopped converging towards the US levels, it is now drifting down and away from the US level. If this trend continues, Italy will follow the path of Argentina in the 20th century when it went from one of the richest countries in the world to a middle-income country. As a comparison we see how South Korea continues its path of convergence towards the US and has recently passed Italy in terms of GDP per capita.

We talk a lot about the lost decade for Japan, but if there is an advanced country where the label lost decade applies is Italy during the last 10 (or 15) years. But, of course, we can always be optimistic (as Olli Rehn seems to be is), Italy still exists as a country, it is still a member of the Euro area and bond yields are not as high as the ones in Greece - although all this can change in a few hours if the election results end up being a (bad) surprise!

Europe can and should do much better than zero growth over a decade. If this is not understood by political leaders then the downward drift that some countries started 10 or 15 years ago will continue or even accelerate and this might drag all the other European countries with them.

Antonio Fatás