An insider's view on the financial crisis (Interview with Sir Win Bischoff)

Here is a video of an interview I conducted recently at INSEAD with Sir Win Bischoff. He is the current chairman of Lloyds Banking Group and was the chairman of Citigroup in the Fall of 2008, during the worst of the financial crisis. We talked about the days around the fall of Lehman Brothers and his views on the current debate on financial regulation.

Click on this link to access the video (which is hosted at the INSEAD YouTube channel).

Antonio Fatás

Labor markets and the current cycle (and the death of Okun's Law)

There are growing concerns about the labor market performance in the US during the current crisis, concerns that might extend to the recovery phase. Unemployment has risen faster than in any previous recession, even taking into account the depth of the recession. As Brad DeLong, Robert Gordon and many others have pointed out, 2009 is a clear outlier in the relationship between unemployment (changes) and output growth, known as Okun's Law. See chart below borrowed from Brad DeLong's blog.

Here is an alternat

ive view of the labor market dynamics during this time but focusing on employment growth rather than unemployment rate changes, which are affected by decisions regarding labor market participation (this is also the US economy).

The year 2009 remains an outlier in this chart: employment growth was much lower than what GDP growth would suggest, based on the historical relationship captured by the red (regression) line. Of course, this means that productivity was growing faster than normal that year, at least as measured as GDP per employee.

It is also interesting to see that 2007 and 2008 were normal years - so it cannot be an argument that prior to 2009 companies were hiring "too many" workers.

The chart also shows how the last recovery (2002 and 2003) are also outlier years where employment growth was below what was suggested by GDP Growth.

Why is employment growth being so weak in these years? Are there significant structural changes in terms of sectoral composition that can explain the weak behavior of employment growth? For 2009, did restrictions on access to credit cause an abnormal behavior by companies when it comes to hiring and firing? If we are talking about structural changes, we cannot expect a fast recovery in the labor market. If it is all a matter of credit availability then there is some hope that as the economy recovers we see a quick recovery in employment that will feed into faster GDP growth.

Antonio Fatás

Using a hammer or a wrench to pop asset price bubbles?

In a recent speech Adam Posen (recently appointed a member of the Bank of England's Monetary Policy Committee) argues that monetary policy should not be used to deal with asset price bubbles. His main argument, which has been expressed before by different central bankers, is that monetary policy is the tool to deal with price stability and it is not appropriate to deal with asset price bubbles. Quoting from his speech:

"Just because we want there to be a policy response to a problem does not mean that the problem can be solved with the tools at hand. Again, if I have a hammer, it can be useful for all sorts of household tasks, but useless for repairing a leaky shower head – in fact, if I take the hammer to the shower head, I will probably make matters worse. I need a wrench to fix a pipe leak, and no amount of wishing will make a hammer a wrench. This is the essential reason why central bankers are now looking around for what has been called a ‘macroprudential instrument’, that is a tool suited to the job – and a tool additional to the one that we already have in our toolkit."

I am very sympathetic to this argument, interest rate is probably not the right tool to deal with asset price bubbles and using regulation or a 'macroprudential instrument' is the right thing to do.

However, we still need to ask the question: What if those instruments are not available or are simply failing to do their job? Is there a role for monetary policy? He cites the example of Spain as a country where the central bank was stressing the importance of dynamic provisioning for banks and still went through a real estate bubble. It might be that the Bank of Spain was not aggressive enough, but how do we know that the systems that we are setting in place now will take care of the next bubble or financial imbalance?

One can argue that interest rates should not be used to deal with an imbalance in financial markets, because this is not part of their mandate, but I think this is a very narrow view of the role of central banks. There is no doubt that imbalances in financial markets spread to the real economy. In fact, there were many signs of a macroeconomic imbalance prior to the crisis such as excessive consumption, current account imbalances. Aren't interest rates the tool to deal with macroeconomic imbalances?

If we apply Adam Posen's logic to some of the previous recessions, we could come up with the conclusion that central banks should never use the interest rate as a stabilizing tool. We could always claim that previous recessions originated in a specific sector of the economy and it would be better to deal with these developments using 'sector-specific' tools. Adam Posen uses as an example a procyclical tax on real estate that might avoid real estate bubbles like the one we just went through. We could apply the same logic to the internet bubble of the 90s and argue that a tax on internet-related companies would have avoided that bubble. This might be true but how do we know where the next bubble will come from so that we set up the right 'procyclical tax' to avoid it? In my view, if the next bubble generates a macroeconomic imbalance, then it is the role of monetary and fiscal policy to deal with it. The next business cycle, the next bubble is likely to be different from the current one and we will learn from it and set up additional policies to make sure that it does not happen again, but until we figure out policies to avoid any potential bubble or imbalance that can cause a recession, monetary policy still has a role to play. And yes, using a hammer to fix a pipe leak will be a challenge...

Antonio Fatás

Central Bank Transparency

Here is an excerpt from an interview by Jean-Claude Trichet, President of the ECB with De Tijd and L'Echo (the full interview can be found at the ECB web site).

Q. For some financial assets, such as gold, we are seeing a return to risk-taking on the part of investors. Is this a parameter that the ECB takes into account in its strategy?

A. I will not make any specific comments regarding gold.

Generally speaking, one of the fundamental lessons of the crisis is that when we underestimate financial risks and focus only on the short term, we set the stage for a future catastrophe. The new principles for bank remuneration, which the international community have agreed within the framework of the Financial Stability Board, were established precisely in order to ensure that there is no incentive for operators and traders in particular to favour the most risky attitudes and decisions, leading to illusory profits in the short term at the expense of the long-term interests of the financial enterprises concerned and the stability of the financial system as a whole.

It is always interesting to see how central bankers tend to start their answers by saying that they will not make any specific comment on a market or an asset price and then make a broad statement about how financial markets need to be careful and not create bubbles. This reminds me of the famous question by Alan Greenspan back in December 1996: "How do we know when irrational exuberance has unduly escalated asset values?" Great question and I would like to know the answer!

Should central banks provide more guidance to help us answer our questions and doubts about asset prices (or other financial market developments)? Should they share their views and forecasts on the evolution of asset prices as they do for other financial variables, such as interest rates? I do not know what the right answer to these question is but I find the current communication style from central banks ("no specific comment on that question but...") unsatisfactory.

Antonio Fatás

The "investmentless" recovery

The behavior of U.S. employment at the end of the last two recessions (1991 and 2001) was different than in previous recessions. Employment did not grow fast and it took several years to reach the pre-recession levels. Because of this, the recovery years that followed both of these two recessions have been labelled "jobless recoveries". Below is a chart from Brad de Long that compares them to two other previous recessions (original posting is here).

Employment was flat in 1991 and 2001 instead of increasing fast as in 1975 and 1982. Because of the current high level of unemployment combined with what might be weak growth there is a fear that the current recovery will also be a jobless one and that the unemployment rate will take a long time to reach a normal level (here is Krugman on this issue).

The behavior of employment will depend on many factors (amount of labor hoarding, productivity) but at the end of the day, the major factor be remain the strength of the recovery and how fast GDP and demand can grow. If we look at different components of demand (or GDP) there is an interesting factor about the last two recessions: In both of them, investment played a weaker role during the recovery phase. Below is a chart comparing the behavior of investment (measured as a % of GDP) around the recovery time (0 is the quarter when the recovery started according to the NBER).

What is interesting in this chart is that the last two recoveries were also special when it comes to the behavior of investment. In fact, the behavior of investment seems to mimic what we see above in the employment chart. While during the 1975 and 1982 recoveries investment grew faster than GDP (so the ratio increased), during the 1991 and 2001 recessions, investment grew at the same pace as GDP (so the ratio is flat). And this is more of a surprise if we take into account the fact that real interest rates remained very low during these two recoveries (more so in 2001).

We know that investment is the most volatile component of GDP so the V-shape that we see in 1975 and 1982 is what we would normally expect. By definition, it has to be that other components of GDP played a stronger role (relative to previous recessions) in 1991 and 2001 (consumption, exports). What was the exact role of those components will (hopefully) be the subject of a future post in this blog. What is interesting so far is the similarity in the behavior of employment and investment across the most recent recessions.

Antonio Fatás

Inflation or Deflation?

There is an ongoing debate on whether we will see inflation or deflation during the coming years. Inflation could be a result of the expansionary monetary policies we have witnessed in many countries around the world. Deflation could be caused by the effects of the economic slowdown (asset price deflation, deleveraging, low growth) and its global nature.

Despite these concerns, inflation indicators remain very stable. After a period where they were pointing in the direction of deflation, they are now back to levels which are fairly consistent with inflation in recent years. The stability of inflation forecasts and how they seem to be ignoring some of the theories that suggest more radical changes ahead are a reflection of the strong anchoring of inflation expectations that has been achieved in recent decades. This anchoring of expectations is the result of very low and stable inflation in most economies since the mid 90s. Here is the evolution of World inflation since 1980 (source: IMF World Economic Outlook database October 2009).

It is remarkable how after 1996 inflation has remained almost constant. While it is true that this was a stable period of time from an economic point of view, there were several episodes (the Asian crisis, the recession in 2001/2002) that could have had an effect in inflation. The fact that inflation did not react and remained in a very narrow range (between 4-5%) is behind the strong anchoring of inflation expectations. And this is a virtuous cycle: the more anchored inflation expectations are, the more stable inflation will be.

What is also interesting is to see that the behavior of inflation has been very similar across developed and developing countries. In the case of advanced economies, inflation decreased very fast in the early 80s and came down even more in the mid-90s. In the case of emerging markets we witnessed a period of high inflation during the early 90s but after 1995 inflation has come down and remained stable for 13 years.

While 13 years of stable inflation cannot guarantee that we will not see large changes in the inflation rate in the coming years, there is no doubt that this is a reflection of the strong anchoring of inflation expectations, more so than in any other period in recent history and this stability is likely to keep inflation volatility low even in the presence of many uncertainties.

Antonio Fatás

It will continue to go up until it stops.

One of the best quotes I have recently seen in financial news sites. This is from CNBC Monday November 16th (link to the article and video here):

Dennis Gartman, founder of The Gartman Letter told CNBC Monday that the price of precious metal will "continue go go up until it stops." "It is a gold bubble, Gartman told CNBC. He called the trade on gold "mind boggling," but also said that he is currently long - or betting gold will go higher.

Well, I am sure he is right, the price of gold will continue to go up until it stops...

By the way, Willem Buiter has an interesting blog entry on the market for gold.

Antonio Fatas