Let's increase interest rates to encourage credit growth

Since I read this article in yesterday's Financial Times from Bill Gross I have been searching all my macroeconomics books for a model that explain the logic of the article. I have not found it yet. I am glad that I am not teaching a macroeconomics course now because I do not know what I would answer if my students asked me to explain the logic of the article...

The argument is that Ben Bernanke has destroyed credit creation in the US by making the yield curve flatter in the 0-2 years horizon (and he did this with his statement that Federal Funds rate will be zero for the next two years). According to the article, the flattening of the yield curve reduces lending by banks because it reduces the potential return to banks of borrowing short term and lending at a two year horizon.

I understand that a strong recovery is normally associated with an upward slopping yield curve and the fact that we have a flat curve is bad news. But by committing to keep short term interest rates low for an extended period of time, the Fed is providing incentives for banks and investors to move into riskier assets (lending to companies, consumers) within that horizon. This should create lending, nor destroy it. This is what a macroeconomics textbook says (including the one written by Ben Bernanke). Reducing Fed rates does not change per se the returns of investment in other assets, it just makes the differential with the riskless asset even larger and creates an incentive to borrow/lend. There are many yield curves, one for each class of asset and the Fed policy can only influence (directly) the one associated to riskless assets.

Of course, it can be that Ben Bernanke's action changed our expectations of the future and we are now more pessimistic than before so lending will be destroyed after all, but this is not a direct consequence of lower interest rates but of the management of expectations.

Antonio Fatás

Two examples of gaps in Macroeconomics

Much has been said about the failure of Macroeconomics (and macroeconomists) to explain, predict or find solutions for the last financial crisis and its aftermath. The topic came back to my mind after reading two recent articles about current macroeconomic events, articles that capture well some of the gaps of the academic economics literature. 

The first article is by Robert Shiller in The New York Times. Robert Shiller is well known for his work around excesses in financial markets. He has produced many interesting pieces of academic work on this subject but he is better known to the public for his book Irrational Exuberance about the asset price bubble during the 90s as well as his warnings on the real estate bubble prior to the collapse in 2007. His article discusses recent volatility in the stock market in terms of the "beauty contest" analogy suggested by Keynes. His view of markets is one of volatility and behavior which is more about predicting what others do than understanding the fundamental value of assets. The article presents a view of stock markets which might not be far from what many (investors, those involved in financial markets, the general public) believe about those markets. But it is not the view that most macroeconomic or financial models have of how investors behave. Yes, we have models that try to capture some of the anomalies and volatile behavior described by Robert Shiller, but these models have very limited influence when it comes to macroeconomic analysis or advise for policy makers. Erratic and volatile behavior in financial markets and asset prices can be a source of volatility for the economy, lead to unsustainable behavior (bubbles) and make the recovery from those events much harder because of how pessimism spreads through trade and interactions among investors. Ignoring this behavior makes it impossible to talk about the most recent business cycles.

The second article is from Brad DeLong and it talks about what to do with the US labor market. This is another area where macroeconomic models struggle to deal with current events, in particular the very negative labor market that the US economy has had for the last three years. And in this case it is not because the labor market was not part of macroeconomic models. All macroeconomic models include a labor market and they discuss the issue of unemployment. But their discussions are not too helpful in understanding the current US environment. Most macroeconomic models have a view of labor markets clearing around a certain unemployment rate (structural unemployment, natural rate of unemployment,...). Some models only generate movements in unemployment when the equilibrium level changes - but it is hard to argue that this is what we have witnessed since 2007. Other talk about cyclical unemployment caused by frictions. But there is no agreement on the origin of these frictions. In the standard New-Keynesian model, frictions come mostly from price rigidity. These frictions are temporary and as time passes unemployment returns to its natural value. But as Brad DeLong correctly argues:

"Excess supply on the labor market not is registering at all, is not leading to any upward pressure on the rate of matching workers who want jobs with jobs that want workers. We have an awful lot of people who are answering the CPS survey by saying; "No, I don’t have a job, and yes, I have done something to look for one over the past four weeks". Your most basic economic matching model says: multiply the fraction of workers looking for jobs by the fraction of jobs looking for workers and that will b proportional to your job-finding rate. It isn't. The equilibrium-restoring forces in the labor market at the macro level appear to be much much weaker than I thought they were in 2007, appear much weaker than I would have believed back in 2007 that they possibly could be."

As a final point, and to be fair to the academic literature, there are plenty of models that incorporate volatile or irrational behavior in financial markets and there are many models that include a variety of frictions in the labor market that could account for some of what we see today. But these features are not at the core of the standard analysis of the current macroeconomic environment and they are not articulated in a way that allows for concrete and specific policy advise. And those who dare using some of these features in their analysis and policy recommendations seem to do it mostly when talking to "outsiders" and less so in conversations with other academics. 

Antonio Fatás

News or Noise?

I always find it amusing to read headlines from the business press (and their web sites) regarding macroeconomic news. In particular, headlines about exchange rates many times refer to dramatic movements in currency prices. No doubt that some currencies are very volatile and there is room to talk about interesting changes affecting exchange rates, but it also seems the case that most of these headlines do not correspond to what one sees in the data. Days were there is very little movements in exchange rates produce headlines such as "Dollar tumbles" or "Euro falls sharply".

As an illustration, I have collected headlines regarding the US dollar / Euro exchange rate for the last thirteen days (source CNBC.com). What we see is a succession of headlines (and stories) that talk about dramatic upward and downward movements of this exchange rate. There are days where one can even get three headlines on this subject, each of them pointing in a different direction. The list of headlines is below, together with a plot of what the Euro/Dollar exchange rate did during those days. Interestingly, despite the dramatic tone of the headlines the exchange rate was very stable moving in a range 1.4350 to 1.4500 (which is a fairly narrow range for this exchange rate).

List of headlines (CNBC.com)



Fears of weak global economy helps support dollar 
Thursday, 18 August 2011 10:51 PM ET

FOREX OUTLOOK-Dollar drops but respite in sight if economy dims 

Friday, 19 August 2011 11:25 PM ET

FOREX-Fed speculation hurts dollar vs high-yielders, euro 

Monday, 22 August 2011 3:32 PM ET 

Dollar wavers as stocks jump on lack of bad news 

Monday, 22 August 2011 5:32 PM ET

FOREX-Euro edges up on German data, hopes for Fed easing 

Tuesday, 23 August 2011 5:57 PM ET

Dollar Slides as Investors Look to Fed Move 

Tuesday, 23 August 2011 10:26 PM ET

Dollar Gains on Stock Selloff, Bets on Bernanke Speech 

Thursday, 25 August 2011 10:31 PM ET 

FOREX-Dollar slips vs euro, yen ahead of Bernanke speech 

Friday, 26 August 2011 3:30 PM ET

Dollar gains strength after Bernanke speech 

Friday, 26 August 2011 4:50 PM ET

FX OUTLOOK-Dollar tumbles after Bernanke; U.S. jobs data ahead 

Friday, 26 August 2011 11:30 PM ET

Euro Held Up by Asian Banks 

Monday, 29 August 2011 1:30 AM ET

Dollar Slips, Poland Talks Tough 

Monday, 29 August 2011 3:21 PM ET 

FOREX-Dollar rises vs franc, yen as US recession fears fall 

Monday, 29 August 2011 6:56 PM ET

Bernanke speech weighs on dollar in thin trading 

Monday, 29 August 2011 7:41 PM ET 

Dollar Rises vs Franc, Yen and Franc Fall on US Data 

Monday, 29 August 2011 8:37 PM ET

Dollar to Hit $1.50 to Euro? 

Monday, 29 August 2011 10:17 PM ET

Euro Falls Sharply on Euro Zone Debt Worries 

Tuesday, 30 August 2011 2:47 PM ET

Source: Oanda.com

Antonio Fatás

Yields for some Euro government bonds falling fast

A move in the opposite direction would have made it to the headlines of all financial newspapers but, just in case you missed it, here are the yields on 10-year government bonds for Ireland and Spain. They are still high relative to where they were before the crisis but they have been falling very fast over the last weeks. Some of this fall has to do with lower interest rates everywhere else (so the spread with the German yields has not fallen as much as what you see in these figures), but from the perspective of sustainability of government debt what matters is the interest rate you pay on your bonds and not the differential with a safe asset. 

Spain 10-Year Government Bonds

Ireland 10-Year Government Bonds

Antonio Fatás

Mind the ($5.1 Trillion) Gap

The debate between whether governments should focus on helping the economy grow faster or imposing discipline and austerity in their budgets is not going away. No one disagrees with the statement that governments needs to find ways to bring discipline to fiscal policy. Given current policies, governments are on an unsustainable path and there is a need for reform that will require a combination of lower spending and additional source of revenues.

The debate is on whether there is also a need to increase economic activity via expansionary fiscal policy (which in the short run is likely to make the deficit bigger). Not every country is in the same situation so it is difficult to provide an answer that is valid for every economy, but here are the two principles that should not be forgotten in this debate:

1. Bringing sustainability to public finances is about ensuring sound fiscal policy over the coming decades, not months. For many of the advanced economies, the future deficits look worse than the accumulated debt. Putting fiscal policy on a sustainable path requires reforms that should be long lasting, and we are talking about decades, not quarters. The difference between implementing these reforms in 2011 or 2013 is insignificant compared to the challenge that governments face. What matters is the commitment to get it right in the long run, not now. Yes, what governments do today could be a signal of what they will do over the coming decades, but this is only true up to a point. There will be new governments in the coming years and what is really required is not a contractionary budget one year but a structure and a set of constraints that ensures discipline for future governments.

2. The need for additional fiscal stimulus is based on the assumption that we are not in a normal year. If unemployment was at a normal level, if the output gap was zero (output was equal to potential), then there is no reason to postpone the necessary adjustment. But there is a dimension of economic policy (both monetary and fiscal) that works towards the stabilization of the business cycle. We do not expect monetary policy or fiscal policy to be the same in a recession than in an expansion. And while fiscal policy might require to show discipline over the coming decades, the amount of discipline should be different depending on the phase of the business cycle. Letting the economy be producing below potential for a long number of years is not only socially costly but it leads to a permanent loss in output which is a potential source of tax revenues.  And the most recent projections from the CBO (Congressional Budget Office) in the US show that GDP will be significantly below potential output for about 8 years, from 2008 to 2015 (see image below, source).

If we accumulate the output gap for all these years we are talking about a $5.1 Trillion gap that represents a permanent loss in output (and income, and tax revenues). Some might see this as a natural and unavoidable adjustment which almost amounts to claim that GDP and potential output are identical, the output gap is zero, unemployment is all structural. But given that the US economy has a strong tendency to return to its trend regardless of economic shocks, it is difficult to argue that there is no output gap to be filled in 2011 (or any other year before we get to 2015). 

Antonio Fatás

Eurobonds or Political Union are not the solution

I agree with Daniel Gros that Eurobonds are not the solution to the current European crisis. I also do not understand the argument that economic and monetary integration in Europe is failing because of the lack of political integration.

The only possible argument in favor of the idea that Eurobonds (or more political integration) would have solved the current crisis is that Greece, Portugal, Ireland, Italy or Spain are all doing fine and their only problem is that they are being attacked by speculators in such a way that the (high) market interest rate makes them insolvent. By attaching a different label to the bonds of these countries, the speculators will not be able to attack them anymore. There will be no PIIGS bonds out there, only Euro bonds.

This is a possible story and if indeed speculation is the only source of all of Europe problems, this might work. There are, of course, other solutions to the problem: a guarantee by the German or French government or by the IMF or the EFSF or any other credible institution that the bonds will be repaid and the interest rates will adjust to a level that makes those governments insolvent -- this is to some extent the solution being adopted.

The idea that having German tax payers being responsible for the debt that all Euro governments issue sounds not only politically unfeasible but also, from an economic point of view, it could have made matters worse instead of better. What is needed is a credible and transparent fiscal framework that ensures sustainability of public finances. Hiding the "country label" when issuing bonds or pooling all the risk together and making all taxpayers responsible for the misbehavior of any government does not seem to be setting the right type of incentives.

One could argue that the same argument applies to the Euro as a common currency that replaced the national currencies of countries with limited credibility. Does this mean that the creation of the Euro is also a bad idea? No. Sharing a currency is very different from sharing a label (and the risk) when issuing bonds.  Sharing a currency does not imply sharing the risk of unexpected changes in income or the cost of the mistakes that national governments or central banks might do.

Antonio Fatás

Dow Jones at 11,000 might not be that low.

Here is an interesting article from the Federal Reserve Bank of San Francisco on the potential effects that demographic changes could have on the stock market in the US over the coming decades. As baby boomers retire and sell their assets, including stocks, their prices are likely to go down. The issue is not new and has been debated before but what is novel in their research is the correlation between a standard measure of the demographic composition of the population and the price-earnings ratio in the stock market.

The image below shows the price earnings ration (P/E) and the ratio of the middle-age cohort (age 40-49) to the ok-age cohort (age 60-69). This is labelled as M/O in the chart. There is a clear correlation between the two series.

And if we look forward, this is what their paper predicts:

Their model generates a return of the P/E ratio to the low levels of the late 70's early 80's. 

There remains, of course, uncertainty about this prediction given that it relies on many factors (such as demand coming from other countries, changes in retirement age), but the correlation of the first figure provides a strong enough argument so that the issue cannot be ignored.

Antonio Fatás