Thursday, February 13, 2014

The permanent scars of economic pessimism

Gavyn Davies at the Financial Times reflects on the growing pessimism of Central Banks regarding the growth potential of advanced economies. In the US, the Euro area or the UK, central banks are reducing their estimates of the output gap. They now think about some of the recent output losses as permanent as opposed to cyclical.

It output is not far from what we consider to be potential, there is less need for central banks to act and it is more likely that we will see an earlier normalization of monetary policy towards a neutral stance.

Why did they change their mind? Is this evidence consistent with the standard economic models that we use to think about cyclical developments?

Measuring potential output or the slack in the economy has always been challenging. One can rely on models that capture the factors that drive potential output (such as the capital stock or productivity or demographics) or one can look at more specific indicators of idle capacity, such as capacity utilization or unemployment rate.

Narrow measures of idle capacity do signal a potential permanent reduction in output. For example, unemployment rates, in particular in the US, are coming down. Capacity utilization is also approaching levels that can be considered as close to normal. As an example, in the most recent Inflation Report, the Bank of England writes "Surveys suggest that the margin of spare capacity within companies narrowed in 2013 such that companies were, on average, operating at close to normal levels of capacity utilization".

But both of these measures while they might be ok are capturing short-run idle capacity are very problematic as indication of potential growth . In the case of unemployment, one of the main reasons why it has decreased in the US is because of the fall in participation rates. But some of these permanent changes in the labor force are the result of a long recession. There is evidence that in the US long-term unemployed workers are giving up, and leaving the labor market at increasing rates. A similar argument can be made about capacity utilization: it might be that we are getting close to normal utilization levels, but is capacity at a normal level? A long period of low investment rates will naturally lead to lower installed capacity. This is Say's Law backwards, demand (investment reacting to cyclical conditions) creates its own supply (capacity). [Several years ago I wrote a paper with a model and some empirical evidence in favor of this hypothesis].

Both of these arguments point in the same direction: business cycles can leave permanent (or at least very persistent) scars on output through the effects they have on the capital stock or the labor force. But it is important to understand that the permanent effects are the consequence of the recession itself. If we could manage to reduce the length and depth of the recessions we would be minimizing those permanent effects. And in that sense, accepting these changes as structural and unavoidable is too pessimistic, leads to inaction and just makes matters worse. If you read the evidence properly, you want to do the opposite, you want to be even more aggressive to avoid what it looks at a much bigger cost of recessions.

Antonio Fatás

Friday, February 7, 2014

ECB and its excuses for inaction

Mario Draghi showed great skills in handling all questions in yesterday's press conference. When pressed about why the ECB is not doing more in the presence of low inflation and possibly deflationary pressures he answered that they are are doing enough and that there is no deflation in the Euro area but simply a period of "low inflation from a protracted period of time". Technically he is right, inflation is low but remains positive and expectations of inflation do not point in the direction of immediate deflation.

But what remains unclear is the message that he is giving about future actions. How low should inflation be and for how many months before the ECB considers that it is necessary to have more expansionary monetary policy? And why is the ECB ignoring the second pillar of its strategy (the money supply) when the numbers show growth rates that are clearly below target? [I am not a fan of the monetary pillar but it is always fascinating to see how the ECB feels compelled to report M3 growth numbers and then ignores them.]

Draghi gives two reasons to justify his inaction. One is the usual statement that there are risks on both sides:

"Both upside and downside risks to the outlook for price developments remain limited, and they continue to be broadly balanced over the medium term."

This sentence reminds me of the language used by the Bank of Japan to defend their inaction during the many years with deflation. Here is a quote from the minutes of the Bank of Japan monetary policy meeting in April 2010:

"Regarding risks to prices, some members said that attention should continue to be paid to a possible decline in medium- to long-term inflation expectations. One member expressed the view that attention should also be paid to the upside risk that a surge in commodity prices due to an overheating of emerging and commodity-exporting economies could lead to a higher-than-expected rate of change in Japan's CPI."

How could it be that in 2010 in Japan, after more than 20 years of struggling with deflation and in the middle of a global crisis, the perception of risks looked balanced and that some had the fear of overheating? And even if risk look balanced, what about erring once on the other side of this balance?

The second reason that Draghi gives is that the situation is very complex and that they need to wait for more data in March. Maybe this was a way of saying that action is coming, but it is confusing and it remains unclear why uncertainty should lead to inaction.

Draghi is right, the Euro area does not have deflation today, but if the risks to price developments are perceived as balanced by the ECB, and uncertainty is another excuse for inaction it looks as if the ECB is doing its best to ensure that the Euro area remain close enough to deflation (not to 2%) and Draghi can be sure that he will get the same exact questions in future press conferences.

Antonio Fatás

Tuesday, February 4, 2014

The conservative bias of economic models

Chris House has an interesting post on why economists tend to be more conservative than academics in other fields. His argument is that many economic facts have a conservative bias (e.g. when you look for evidence on politically loaded questions such as the effects of the minimum wage or high taxes).

Noah Smith replies and argues that there is no such bias in economic facts, quite the opposite, the evidence is weak for some of these questions. So where is the bias coming from? My sense is that it is coming from models to which most economists feel very attached to. And this is partly the case because these models and their economic logic is the one that allows us to show the value that our profession adds. Let me explain.

Economists do not have a great reputation when it comes to forecasting. Given the number of jokes about the inability of economists to forecast anything, about how we assume away any interesting real world phenomena, many macroeconomists stay away from practical questions about policy [As an example, when Chris Sims was awarded the 2011 Nobel Prize in economics, he was very reluctant about giving policy recommendations to get out of the economic crisis.]

But even if you avoid those difficult empirical questions you can still impress your friends by showing how the logic of simple economic concepts can go very far in understanding complex real world phenomena. Talking about opportunity cost, the difference between nominal and real variables, introducing a general equilibrium effect in a macroeconomic question or using game theory to help improve the analysis of a strategic situation are examples where economists thrive and show the added value of the discipline.

And in this spirit, when someone asks us why don't we raise wages to increase demand we use our economic logic to explain that this does not work, that increases in wages will do the opposite by reducing employment and GDP because of the effects on labor costs. And when someone suggests that the central bank should print money and distribute it to every household so that we are all richer, we explain to them that this will only create inflation. This is the origin of the conservative bias of economists, the conservative nature of the benchmark model that economists use. Of course we also have models where increases in wages could lead to higher GDP and there are situations where large increases in the money supply could not generate much inflation but those are much more complex models and they represent an exceptions to the benchmark model that economists tend to start with when they teach or explain their subject to others.

And what is interesting is that this bias does not always show in casual conversations. Many macroeconomists do not use the intuition of the benchmark model when having a casual conversation about economic policy. For example, as Paul Krugman argues today in his blog, most economists share the view that during the current crisis monetary and fiscal policy should have been more aggressive. Similarly, in casual conversations and when confronted with questions about efficiency of financial markets or labor markets or health care economists tend to describe a world full of inefficiencies and where government intervention makes sense. But it is rare that you hear the same strong message when you read their research or when they speak about it in public. Paul Krugman is right in the sense that his views are in many ways mainstream today but it is the fact that he expresses them in such an open manner that sets him aside from many other macroeconomists. I can see why some feel uncomfortable about making such strong policy recommendations given the uncertainty we have about our models or the evidence. I personally find it very refreshing to see more academics being willing to share their views to a broader audience through blogs or articles in a way that enriches the economic debate (even if, unfortunately, it might not have such a big impact on economic policy).

Antonio Fatás