Sunday, 26 April 2015

The Swiss have eliminated the Zero Lower Bound

So, this is fun. Via Zero Hedge comes this report from a little Swiss website, Schweizer Radio und Fernsehen (SRF). It seems that a pension fund tried to evade negative rates on deposits by withdrawing a very large amount of physical cash with the intention of vaulting it. But the bank refused to allow it to withdraw the money in the form of physical cash.

Is this lawful? Zero Hedge thinks it isn't. But the bank has not refused to allow the money to be withdrawn. It has simply restricted the form in which the money can be taken. Since electronic money and physical cash are fully fungible, it is hard to see how this restriction can be regarded as unlawful without undermining the value of electronic money - which would be highly destabilising in a modern monetary economy.

And this effectively means that the zero lower bound does not exist.....

Read the whole article on Forbes.

Related reading:

The ECB's policy mix is poison for banks - FT
The strange world of negative interest rates

Saturday, 18 April 2015

Rediscovering old economic models

Krugman says we do not need new economic models, we just need to make better use of the ones we already have. Indeed, even very old models that we long since consigned to dusty archives can help remind us of things we have forgotten about. Financial crises, for example.....

In his response to my speech at Manchester University in February - which became the post that whipped up the "state of macro" debate to which Krugman responded - Andrew Lilico gave four examples of economic models that in his view form the foundation of modern economics and (he claims) have not been shown to be inadequate or wrong. Lilico's four models are these:

- Capital Asset Pricing Model
- Modigliani-Miller Theorem
- Efficient Market Hypothesis
- Black-Scholes Option Pricing Model

Hmm.Only the EMH would I think be regarded as a macroeconomic model - and even then, is it really more fundamental than Shiller's irrational exuberance? When I was doing my MBA, we covered the other three in corporate finance, not macroeconomics. And all four have been seriously criticised.

But finance is the heart of a modern monetary economy and financial economics should be part of macroeconomics. I might disagree with Lilico's choice of models - for example I would regard the quantity theory of money as more fundamental than Black-Scholes - but I don't disagree with his point. The problem is that models of the financial economy DON'T form the heart of macroeconomics.

So, since Krugman pointed me towards Diamond & Dybvig's model of banks, liquidity and deposit insurance, I got it out and re-read it.

For those of us used to endogenous money theory, there is an immediate and very obvious problem with Diamond & Dybvig's model. It is a loanable funds model with no central bank - which is odd, considering that by 1983 when it was written the world had been off the gold standard for more than ten years and every Western country had a central bank. But this is how banking is modelled all too often: banks as passive intermediaries channelling household savings to corporate borrowers. If only that were true. For the last decade or so the flow has been in the other direction - corporate savings channelled by banks to households in the form of mortgages against ever-rising property prices.

But the problem with loanable funds models is bigger than simple reversal of the savings flow. Loanable funds models are unable to explain how exuberance in credit creation results in the buildup of unsustainable leverage. Hyung Song Shin used a loanable funds model in his Mundell-Fleming lecture on the role of regulatory arbitrage in the credit boom leading to the financial crisis, which unfortunately managed to give the impression that the money lent to American and European banks by American households came from Mars. When I translated Shin's model into an endogenous money framework (though admittedly in a manner that was enormous fun and not at all rigorous) it became a dangerously unstable two-way leveraging spiral of credit creation and rising collateral prices, which is much closer to what we know actually happened. Loanable funds models do not adequately portray the role of credit creators in the modern monetary economy - banks, and things that aren't called banks but behave like them.

So Diamond & Dybvig's model needs to be used with some care. It can't simply be "taken off the shelf" and deployed in a crisis, as Krugman suggests. Apart from anything else, providing unfunded deposit insurance ex ante to everything that looks or behaves like a credit creator, regulated or not, creates moral hazard on an almost galactic scale. We already worry about implicit taxpayer subsidies to too-big-to-fail banks: but explicit taxpayer guarantees to too-big-to-fail asset managers, wealth funds, conduits, SPVs? Really, Paul?

Diamond & Dybvig's model is a multiple-equilibrium model, but it does not adequately model how leverage is created. It might be amusing to translate it into endogenous money terms, adding a central bank and establishing both the precedence of lending and the creation of deposits. This would of course make it a lot more complex, since endogenous money creation is by definition non-linear. It might make it a lot more fun, too. But does that mean it would necessarily be less rigorous, as Krugman seems to suggest? Surely not. "Fun" does not exclude rigour.  So, here is a challenge to a student econometrician who fancies a holiday project. Have some fun translating Diamond & Dybvig's model into endogenous money terms. But do it rigorously.

A bank run can be defined as sudden unravelling of bank leverage. And just as leverage creates money, so deleveraging destroys money. This is implied in Diamond & Dybvig's description of deposit insurance even though their model does not show it.

It works like this. A bank faced with sudden unexpected demand for cash withdrawals by depositors or investors is forced to sell assets to obtain the cash. This depresses the price of the remaining assets, destroying value on the asset side of the balance sheet and making it impossible for the bank to realise enough cash to satisfy depositor demand.

I say banks, but it is actually easier to see the "fire sale" effect when there is a run on a money fund, such as the run on Reserve Primary after the fall of Lehman. Reserve Primary was unable to guarantee return of par value to its investors because the value of its assets crashed. A bank facing a similar crash of asset value is also unable to return par value to its depositors. But instead of "breaking the buck" as Reserve Primary did (i.e. returning less than par to its investors), in the absence of central bank liquidity support and/or deposit insurance, the bank must close its doors (in Diamond & Dybvig this is "suspension of convertibility"). If the bank's balance sheet is very illiquid - for example, if it consists mainly of specialist loans for which there is no market - then doors will be closed earlier. Either way, the effect is the same. Deposit balances that cannot be withdrawn because the bank has closed its doors are effectively worthless.

Deposit insurance replaces the money destroyed in a run by drawing on future tax revenues (if unfunded) or drawing on money created by other banks ex post or ex ante. Central bank liquidity support does the same by drawing on future seigniorage. Without this, the economic effects of bank runs can be economically devastating. However, as Diamond & Dybvig point out, the essence of insurance is that it should not be called upon. The existence of credible deposit insurance and/or credible lender-of-last-resort support should be sufficient to prevent runs. In 2007, the run on Northern Rock occurred because deposit insurance was inadequate and it was not clear that lender-of-last-resort support would be forthcoming. In 2008, the most damaging runs occurred in the shadow banking network where there was no insurance or lender-of-last-support.

The fact that Diamond & Dybvig's model is framed in loanable funds terms means that it does not fully show the destructive economic effects of bank runs. After all, in their model, the money still exists, it has simply been converted into a different form (cash) which is equally useful. And nowhere do they state that their single bank can call in illiquid loans to pay depositors. If it can't, then investment is not suspended: the bank fails, but the borrowers still have their funds. Their assumption that production stops when money is removed from the bank is therefore questionable in terms of their own model, though it would be correct in a model that accurately modelled the destruction of money and the collapse of asset prices.

But this does not make the model useless. From the point of view of the depositors trying to remove their funds, whether those funds were created by the bank in the course of lending or came from Mars is irrelevant. What matters is whether depositors believe that they can convert their deposits to cash. And that, as Diamond & Dybvig note, depends on the depositors' view of the creditworthiness of the bank. If depositors believe that the value of the bank's assets is less than its liabilities, they will rush to withdraw their money: no-one will want to leave their money in the bank and risk not getting it back at all.

Deposit insurance in effect replaces the bank's own deposit guarantee, which in Diamond & Dybvig's "bad" equilibrium is not credible, with a guarantee from a more reliable source. In the past that has been the sovereign, though the public mood since Lehman has pushed regulators towards requiring the banking system as a whole to guarantee the deposits of each of its members and fund that guarantee at least in part ex ante. Those promoting full reserve banking might like to recall that bank funded guarantee schemes amount to full reserve banking for insured depositors. And those who think that deposit insurance schemes are about protecting depositors might like to think again. The original purpose of deposit insurance was to prevent banks failing.

Diamond & Dybvig explain that central bank liquidity support can have the same effect as deposit insurance, but with an important caveat: if depositors do not believe the bank is solvent then injections of central bank liquidity cannot stop the run. This is not just a theoretical effect. In 2007, injections of liquidity by the Bank of England failed to stop the run on Northern Rock. It took unlimited guarantees from HMG, including for wholesale deposits (which are more likely to run than retail deposits and can be far more destructive). This is the reason for Bagehot's dictum about lending to SOLVENT banks, although for a very large bank mitigating the destructive economic effects may justify lending even if it is believed to be insolvent. And in a systemic crisis it can be hard to decide which bank is alive and which is dead anyway: throwing money at everything is usually the best approach until the panic calms down, as I have explained before.

The point of all this is that models don't have to model everything, and even "wrong" models can be helpful if used in the right way. And narrative has its uses too. Diamond & Dybvig's paper has some interesting insights into the behaviour of banks and their customers. I particularly like this:
If the technology is risky, the lender of last resort can no longer be as credible as deposit insurance. If the lender of last resort were always required to bail out banks with liquidity problems, there would be perverse incentives for banks to take on risk, even if bailouts occurred only when many banks fail together. For instance, if a bailout is anticipated, all banks have an incentive to take on interest rate risk by mismatching maturities of assets and liabilities, because banks will all be bailed out together.
Perverse incentives and moral hazard. This presumably is one of Krugman's "self-fulfilling prophecies". What a pity we forgot about it....

Then there is this:
Internationally, Eurodollar deposits tend to be uninsured and are therefore subject to runs, and this is true in the United States as well for deposits above the insured limit.  
Uninsured deposits have a tendency to run. You don't say. In the rush to limit taxpayer liability in a crisis and ensure that senior creditors - including large depositors - share in the losses, has everyone forgotten this?


Sunday, 12 April 2015

Colds, strokes and Brad Delong

Brad Delong takes issue with me over my criticism of Olivier Blanchard. Here's the paragraph from my piece "The failure of macroeconomics" that he finds particularly uncharitable:
Blanchard's call for policymakers to set policy in such a way that linear models will still work should be seen for what it is–the desperate cry of an aging economist who discovers that the foundations upon which he has built his career are made of sand. He is far from alone…
"It's not that bad", says Brad. And he goes on to use the analogy of heart attacks and the common cold to explain why linear models are ok really, mostly:
A more charitable reading of Olivier is that he wants to make this point:

  • Heart attacks have little in common with the common cold.
  • You treat heart attacks with by shocking the heart to restart it.
  • Heart attacks and the common cold are both diseases that debilitate.
  • Nevertheless, to get out the defibrillator pads when the patient shows up with the sniffles will probably not end well.
Well yes, true. So, when the economy catches a cold, by all means treat it with a hot toddy (plenty of whisky, please!). And if we all keep warm and dry, eat well and get plenty of sleep, we might not get so many colds anyway. This is indeed within the remit of policymakers: avoid obviously stupid or high-risk policies and try to keep the economy on a steady path. If policymakers do this, then clearly linear models will generally be adequate.

The trouble is that in 2008 the economy did not catch a cold. No, it had a stroke. (Brad Delong's heart attack analogy is good, but I like the stroke better.) A stroke is sudden interruption of blood flow to part of the brain, causing tissue death and brain damage. If damage is not too extensive, the brain can rewire itself, creating new connections and activating new regions to take over functions previously done by the damaged areas. But such redirection of activity can take a long time, and during that time the patient may be unable to care for herself unaided, let alone work at previous output levels.

The authorities did not recognise the stroke for what it was. They thought it was simply a particularly nasty cold, so they put extra whisky in the hot toddies. When the patient developed pneumonia, they gave powerful antibiotics (TARP, TALF, QE....). And they carried on giving some of them long after the pneumonia had cleared up, because the patient was still obviously ill. But they failed to see the underlying problem.

Just as the patient was beginning to show signs of improvement, it experienced a second stroke. This one was not as catastrophic as the first, but it seriously set back the patient's recovery. Once again, the stroke was misdiagnosed, this time as a hospital-acquired infection. More antibiotics were given, and the hospital was placed in special measures. The staff had to deep clean the entire place, which redirected many of them away from patient care, leaving the patients to look after themselves. Unsurprisingly, several of the patients got worse, though so far none has died.

Now, seven years after the first stroke and three years after the second, the patient is still partly paralysed down the left side and has a speech impediment, which makes working difficult. As can be seen from this chart (h/t John Van Reenen), UK output is well below its previous level and shows no sign of returning to previous trend growth:


Nor is the UK the only economy to show such a pattern. Indeed it is now one of the better-performing Western economies: output in the Eurozone, for example, is much worse. So economists are scratching their heads and wondering why the patient is still in such a state. After all, the patient recovered well from previous nasty colds (1975, 1981, 1992) and there was no significant change in output trend growth. Surely the patient should be back to normal by now?

And herein lies my beef with Blanchard. Hot toddies and antibiotics are not the right treatment for strokes. Nor is deep cleaning of hospitals, important though this is. But the economics profession's toolkit seems to be limited to hot toddies, antibiotics and cleaning ladies. It can only treat nasty colds and hospital-acquired infections. It didn't even recognise the 2008 and 2012 strokes, let alone know how to treat them. And it justifies its limited diagnostic skills and inadequate toolkit by arguing that if only we keep warm and dry and eat well, we won't catch colds or suffer strokes anyway. But economists do not know why economies catch colds and have strokes. The argument that if we get policy settings right we will never be ill is an old wives' tale - or rather, an old economists' tale.

To be fair, the economics profession seems to be waking up to the idea that 2008 and its aftermath was no ordinary recession. Central banks and supranational institutions seem to be leading the way on recognising the monetary nature of the modern economy and the critical importance of accurate modelling of the financial system: Haldane at the Bank of England, Borio at the BIS and various researchers at the IMF have all explored non-linear modelling for the financial economy. Borio has called for financial cycles, which are longer than business cycles and seem to be increasing in amplitude, to be incorporated into economists' models. But the financial system is known to be in disequilibrium much of the time. I confess I find it difficult to see how a system that is normally far from equilibrium can be adequately represented by a general equilibrium model, but then I am not a mathematician. I am encouraged therefore to see that Borio seems to share my concerns (my emphasis):
Modelling the financial cycle raises major analytical challenges for prevailing paradigms. It calls for booms that do not just precede but generate subsequent busts, for the explicit treatment of disequilibrium debt and capital stock overhangs during the busts, and for a clear distinction between non-inflationary and sustainable output, ie, a richer notion of potential output – all features outside the mainstream. Moving in this direction requires capturing better the coordination failures that drive financial and business fluctuations. This suggests moving away from model-consistent expectations, thereby allowing for endemic uncertainty and disagreement over the workings of the economy. It suggests incorporating perceptions of risk and attitudes towards risk that vary systematically over the cycle, interacting tightly with the waxing and waning of financing constraints. Above all, it suggests capturing more deeply the monetary nature of our economies, ie, working with economies in which financial intermediaries do not just allocate real resources but generate purchasing power ex nihilo and in which these processes interact with loosely anchored perceptions of value, thereby generating instability. In turn, this in all probability means moving away from equilibrium settings and tackling disequilibrium explicitly
So, sorry Brad, but I do not think I am wrong to say that the economics profession's love affair with linear models must be ended. Multiple equilibria, disequilibrium and non-linearities are the new flame.

Having said that, Brad's last comment is spot on:
The key questions of macroeconomic political economy then are not the questions of the construction of nonlinear multiple-equilibrium models that Frances Coppola wants us to study. They are, instead, the questions of why ideological and rent-seeking capture were so complete that North Atlantic governments have not deployed their fiscal and credit policy tools properly since 2008.
Indeed, if policymakers want to deny stroke patients essential treatment and force them back to work before they are properly recovered, there is not a great deal economists can do to stop them. Such is democracy.

I must say, I do like being described as femina spectabilis. And despite my criticisms, Olivier Blanchard deserves credit for acknowledging the hubris of the 1980-2008 economic paradigm, and for attempting to change it within his own organisation. Some of the IMF's economic research in recent years under his leadership has been outstanding. He is indeed a vir illustris.

Related reading:

When the Nile floods fail

Saturday, 11 April 2015

The limits of monetary policy

Here is Cullen Roche quoting Ben Bernanke:
"Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to ‘pop’ an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability."
And Cullen then goes on:
That’s a pretty interesting quote. You could actually apply that perfectly to, well, using monetary policy for anything. After all, it is an inherently indirect and imprecise policy tool. It works only through indirect transmission mechanisms like overnight interest rate changes, expectations channels, wealth effects, etc. If the past five years haven’t proven that monetary policy is a rather indirect and blunt policy, then I don’t know what would.
Basically, monetary policy is weak sauce....
This is from Cullen's commentary on Ben's post about financial stability. Ben argues that monetary policy is not the right means of addressing financial stability concerns, and makes the case for greater use of macroprudential tools. The whole post is well worth reading, but I've summarised Ben's key argument here:
  • The Fed has kept interest rates very low ever since the Lehman shock. Because of Fed easy money policies, the US economy is now recovering, unemployment is at near normal levels and deflation risk is low.
  • Nonetheless, Fed easy money policies have come in for continual criticism. Initially the criticism focused on fears of high inflation, but since inflation has failed to materialise, criticism now centres around financial stability concerns.
  • Monetary policy is not the right tool to address financial stability concerns. It is too blunt an instrument to pop asset bubbles safely, and using it to address financial stability concerns may conflict with using it to achieve primary mandates of price stability and full employment. 
  • Therefore central banks should use macroprudential measures to ensure financial stability, not monetary policy
So, monetary policy is not a cure-all. It has a specific purpose, namely to influence demand in the economy so as to achieve the Fed's twin mandates of price stability and full employment. And that is ALL it should be expected to do. But that doesn't make it useless, as this tweet from Ralph Musgrave suggests:

No, Ralph, Ben never said any such thing. On the contrary, he said that monetary policy over the last few years had reduced unemployment and created recovery.

Ben acknowledges that there might be a role for monetary policy in financial stability, but expresses concern that the costs may outweigh the benefits. He cites the experience of Sweden in 2010-11, which hiked rates to take heat out of the housing market despite poor economic indicators and ended up squashing economic growth and tipping the country into outright deflation. Ben observes that current research, though limited, does not support the idea that monetary policy should be used to address financial stability concerns:
As academics (and former academics) like to say, more research on this issue is needed. But the early returns don't favor the idea that central banks should significantly change their rate-setting policies to mitigate risks to financial stability.
However, the limited remit of monetary policy does not necessarily mean that Janet Yellen's commitment to financial stability is undermined, as Cullen seems to suggest. Macroprudential measures are also part of the central bank's toolkit. They are as yet underdeveloped. untried and their effects are to some degree unknown: as Richard Sharp of the Bank of England's Financial Policy Committee explained in June 2014, central banks are engaging in "an experiment in macroprudential management". But the fact that these measures are experimental does not mean they are useless. The Bank of England successfully used macroprudential tightening in June 2014 to take some of the heat out of London's prime residential housing market. It remains to be seen how effective macroprudential measures will be on future occasions, and what their unintended consequences might be.

But Cullen goes on to make an important and far-reaching point:
....Maybe we should stop believing in the idea that central bankers can steer the economy in certain directions and fix all of the world’s problems.
Belief in central bank omnipotence has led the world to dump all responsibility for generating economic recovery and preventing further crises onto the shoulders of central bankers. Belief in the uselessness of fiscal policy has encouraged central bankers to accept that burden even when it was clearly too great for them to bear alone. And belief in the evils of deficit spending and sovereign debt has led fiscal authorities to make central bankers' job even more difficult by engaging in fiscal tightening when their economies are already on the floor. Though central bankers hardly deserve our sympathy. They have actively encouraged the denigration of fiscal policy and reification of monetary policy. "Whatsoever a man soweth, that shall he also reap...."

Unlike Ralph, I do not think monetary policy is powerless: but neither do I think it can single-handedly generate economic growth when fiscal authorities are determinedly squeezing demand out of the economy with tax rises and spending cuts.

Cullen calls for greater use of other tools - such as "regulatory changes". Err, these wouldn't in any way be related to the measures that Ben talks about, would they? Ben seems to think so:
Effective financial oversight is not perfect by any means, but it is probably the best tool we have for maintaining a stable financial system. In their efforts to promote financial stability, central banks should focus their efforts on improving their supervisory, regulatory, and macroprudential policy tools.
But Cullen goes further. He calls for tax reforms and infrastructure investment. We can disagree over the details, but in principle this is eminently sensible. When the economy is on the floor, the public sector should invest in the infrastructure that will support business in the future, and make fiscal reforms complementing, rather than counteracting, the central bank's efforts to support demand and encourage business investment. What a pity that governments around the world have done the exact opposite, hiking taxes and cutting investment.

Artificial separation of fiscal and monetary policy cripples policymaking. It is time for monetary and fiscal policymakers to acknowledge their joint role in generating economic growth and preventing future crises.

Saturday, 21 March 2015

Repeat after me: sectoral balances must sum to zero

I do like sectoral net lending charts. This one is from the OBR's latest Economic Forecast:


The thing to remember about sectoral balances is they must sum to zero. It is not possible to have a negative external balance, as the UK does, with concurrent surpluses in the public, household and corporate sectors. If the UK is a net borrower from the rest of the world because of its current account deficit, then somewhere in the domestic economy must be a balancing deficit.

It is pretty obvious where this deficit has been. In 2010, the external sector was in deficit (green line on chart) and corporates (yellow line) were net saving. The external balance had been in deficit for a long time, but corporate net saving commenced at the same time as the public sector (red line) switched from surplus to deficit. This may have been a traumatic response to the dot-com crash, but to me this looks more like a policy change around 2001 that encouraged corporate saving. I wonder what it was. Any suggestions?

The net saving of corporates and foreigners during the pre-crisis years was balanced both by a public sector deficit and by a growing deficit in the household sector (blue line). We now know that the household deficit was associated with unsustainable credit growth. When the crash came, households switched abruptly from deficit to surplus. Foreigners, corporates and households were all net saving at the same time. As I said, the sectoral balances have to sum to zero: so the increase in the government deficit balanced the desire of all three private sectors to save at the same time. When no-one wants to spend, someone must, and that someone is inevitably government. Government is the "spender of last resort".

The trouble is that when everyone is saving like crazy (including paying down debt, which economically is equivalent to saving) people get very worried indeed at the sight of apparently out-of-control government deficit spending, failing to see the relationship of that spending to their own saving behaviour. So governments then embark on austerity programmes to shrink the deficit. The result of this (assuming no fall in GDP) is that deficit spending moves around. The public sector deficit is shifted back to the private sector.

If you are Germany, deficit spending moves abroad, and you run an ever-larger trade surplus. But if you are the UK, with a deeply entrenched external deficit in part because of a still-dominant financial sector, deficit spending moves to domestic households and corporations. George Osborne's claim that he wants to build an economy "based upon savings and investment" is economic gibberish, since his plans aim only to eliminate the fiscal deficit, not the trade deficit. As the chart above shows, the OBR forecasts - based upon the Treasury's spending plans as outlined in the Budget last week - that for the foreseeable future the only people doing any significant saving will be foreigners.

Saving is not necessarily a good thing. Generally, we expect households to save (for their old age, for rainy days) but corporations to invest. The problem prior to the financial crisis was that corporations were saving and households were investing (in property). Now, despite everything we have heard about corporations hoarding cash, corporate saving is falling and the corporate sector has switched from surplus to deficit. This is a welcome development, since it suggests that corporations are investing. And indeed they are:


Business investment is now back to its 2000 level. This is no doubt what has generated the UK's recovery. Perhaps the malaise that has affected corporations ever since the dot-com crisis is over? The OBR seems to think so. It forecasts corporate investment continuing to rise to historically unprecedented levels. Is this credible? I confess that I am unconvinced. The path of business investment has never been smooth. Not only the level of investment projected for 2020 but also the rate of change looks unsustainable to me. I reckon it would level off or dip sooner than that. Indeed there was a dip at the end of 2014 which the forecasters chose to ignore. Hockey-stick projections always worry me.

Sadly, the picture for households is not so encouraging. The household saving ratio has already fallen considerably from its 2010 high:


Perhaps more worringly, there is an evident downwards trend in this chart. Household saving has been diminishing since the late 1990s. The OBR projects that the household sector will be in deficit by 2018, no doubt as a result of the planned sharp fiscal squeeze in 2016-18. As older and richer households would still be net savers, the growing deficit of the household sector would be due to sharply rising debt, particularly among younger and poorer people. Here is the OBR's projection for household debt to income:


The OBR expresses some concern about this:
Strong growth of residential investment and ongoing growth in house prices and property transactions leave households’ gross debt to income ratio rising back towards its pre-crisis peak by the forecast horizon. That seems consistent with supportive monetary policy and other interventions (such as Help to Buy and further support for first-time buyers announced in this Budget), but it could pose risks to the sustainability of the recovery over the medium term.
This concern is well-founded. Despite all his rhetoric about encouraging saving, the Chancellor's fiscal plans actually depend on blowing up a household debt bubble of larger proportions than that which burst disastrously in 2008, and using various forms of government support to delay its inevitable implosion. Why do we have to repeat the errors of the past?

Perhaps more importantly, it is by no means clear that such an increase in debt is actually possible. Productivity is on the floor and nominal wage growth remains poor. The OBR identifies this as a key risk to the recovery:
Domestically, productivity and real wages remain weak and the pick-up we forecast from 2015 is a key judgement. If productivity fails to pick up as predicted, consumer spending and housing investment could falter as the resources to sustain them would be lacking
If productivity and wage growth do not pick up, then the fiscal squeeze planned for 2016-18 would have serious consequences for the recovery. The OBR points out that deep spending cuts to unprotected government departments and the welfare budget would have a direct impact on GDP, and expresses concern about the scale and pace of the cuts:
We expect some significant changes in the composition of expenditure associated with the fiscal consolidation and, in particular, with the fact that on current policy so much of that consolidation is delivered through cuts to day-to-day spending on public services that will directly reduce GDP. The scale and speed of the adjustments this switch in spending implies may also represent a risk to the economy evolving in line with our central forecast.
 The OBR's central forecast for the path of GDP shows real GDP growth over the next 5 years of around 2% per annum. But there is a considerable amount of uncertainty around this forecast:


Note that the worst-case scenario here is for the UK to fall into recession from 2016 onwards. This would be likely to be the case if productivity and wage growth disappointed and the fiscal squeeze hurt household incomes sufficiently to eliminate debt-fuelled consumption and investment spending.

And this brings me back to my sectoral net lending. Remember that sectoral balances must sum to zero. If household income falls so much that spending and borrowing cannot be sustained, as the OBR suggests, then there are two possibilities. The first is that there is a sharp correction to the trade balance. This would be due to collapse in imports as domestic demand falls, and rising exports as corporations seek markets elsewhere. We have seen this in many EU (not just Eurozone) countries in the last few years. It is always accompanied by recession, which may be severe.

But if the trade balance does not correct - and remember that the UK's trade deficit is deeply entrenched - then fiscal consolidation becomes all but impossible. Deficit reduction slows to a crawl, as this chart from the OBR shows:



The worst-case scenario here (deficit of 4% of GDP in 2020) would be associated with the worst case in the GDP fan chart, i.e. the UK in recession. When GDP is falling, public sector borrowing as a proportion of GDP naturally rises. This chart therefore assumes that fiscal consolidation efforts would continue despite recession, no doubt because of disappointing deficit reduction. But continued attempts to eliminate the deficit and reduce the deficit would drive the economy ever deeper into recession. Although the deficit itself may reduce further, debt/GDP actually rises in this scenario. As Irving Fisher put it, "the more the borrowers pay, the more they owe". For Greece, this nightmare was probably inevitable. But the UK has no reason whatsoever to go down that path. If it does, it will be because of political stupidity on a simply mammoth scale.

Unfortunately the simple fact that sectoral balances must sum to zero is currently being ignored by all of the main parties. I do wish politicians would pay more attention to national accounting. It would save a lot of grief.




Sunday, 15 March 2015

Happy days are here again

Here's a shocking chart from the LSE's John Van Reenen:


This chart deserves to be seen by every adult in the UK. It charts all too clearly the true cost to them of the financial crisis and its aftermath.

It is clear that the financial crisis was severe. The sharp drop in GDP per capita in 2008 is unprecedented since 1970. That was bad enough. But what is far worse is the evidence that the UK still has not recovered. Even with recent encouraging growth, GDP per capita remains far below its long-term trend. Those who argue that the financial crisis simply eradicated debt-fuelled "bubble" income are clearly wrong, unless they think the whole of the last 45 years was a bubble.

So what exactly has caused this awful fall in per capita income? Was it due to Coalition policy, as some think, or were there other causes?

In the report from which this chart comes (pdf), John offers a balanced explanation:
The failure to recover lost output shown in Figure 1 cannot be attributed to UK austerity only. The eurozone crisis, the lingering effects of the banking crisis, higher commodity prices, and the decline of high productivity sectors like oil and gas should also be apportioned some part of the blame (Corry et al, 2012, offer an assessment). 
But what is striking is how much worse the UK performed during the first half of this Parliament when austerity bit hardest. Between 2010 and 2013, GDP per capita growth was worse than in the United States and Japan, both of which had independent currencies like the UK. UK performance was similar to the countries in the eurozone hit by even more severe austerity and a currency crisis.
So although the UK was hit by severe secondary shocks, the fiscal policy pursued by the Coalition government in its first three years contributed to the UK's poor recovery. The OBR estimates that Coalition fiscal consolidation cut GDP growth by 2% in 2010-12. John suggests the real figure may be higher because the OBR uses conservative multipliers and ignores hysteresis effects.

Using data from the OBR, John shows that in 2010-12, the UK's deficit reduction actually proceeded faster than planned:


But despite this front-loaded consolidation, the Coalition's intention of eliminating the current budget deficit by the end of this Parliament has not been achieved. John says that this is because the austerity programme has tailed off since 2013: in the current financial year there has been no fiscal austerity at all. Funny, that. As the election approaches, austerity diminishes.....

So having failed to deliver on their original mandate, the Conservatives now plan to repeat the whole exercise again. Severe austerity in the first three years of the next government (assuming they win the election), followed by relaxation in the last two years. The economic effect would be similar:
Explicit macroeconomic modelling of the impact of alternative paths of fiscal consolidation suggests that by 2019-20 output, employment and debt would be a bit higher under Labour and Liberal Democrat plans compared with the Conservatives (Kirby, 2015).  
I find it odd that the opposition parties are not shouting about the negative prospects for employment and per capita incomes in the short term that Conservative plans imply.

But the really scary part of all of this is the effect on investment. The Coalition government has achieved the majority of its deficit reduction by means of sharp cuts to investment: as the chart shows, public sector net investment has fallen from 3.3% of GDP before it came to power to 1.4% in the current financial year. The Autumn Statement committed the Conservatives to achieving an overall budget surplus by 2019-20, achieved through spending cuts alone. John points out that this leaves little room for investment:
By including public investment in plans for balance, this would prevent a future Conservative government from borrowing for additional public investment. The Autumn Statement pencils in public investment as just 1.2% of GDP from 2017-18 onwards.
 How is the "long- economic plan" going to create long-term economic prosperity if it includes little or no long-term investment in infrastructure, human capital and innovation?

Sadly, it seems increasingly unlikely that the public will hold the Conservatives to account for their part in the UK's poor economic performance in recent years. It seems unfair that the Conservatives can claim to have generated a recovery that they actually did their level best to prevent, but people have short memories. Recent fiscal relaxation coupled with giveaways for key voter groups has created a "feel-good factor": people whose real incomes are rising now after years of falls don't notice that they still are poorer than they were in 2007.

In the interests of balance, however, I should point out that Labour and the Liberal Democrats also plan further austerity after the election. The parties really only differ over the pace of consolidation and the means by which deficit reduction would be achieved. Whichever party wins, the next few years will be tough.

Happy days are here again....until the election.

Related reading:

Austerity: growth costs and post-election plans - Pieria
Be careful what you wish for, Mr. Cameron - Pieria
The Chancellor's incredible spending cuts - Pieria
What derailed the UK recovery?

Wednesday, 11 March 2015

Greece's real problem

Professor Hausmann has responded again to my reply to his reply to my criticisms of his Project Syndicate post. It is a very gracious response.

We are substantially in agreement on the three points that I raised in my previous post: the long-standing nature of Greece's fiscal fragility, the illusory GDP growth fuelled by the pre-crisis debt bubble that obscured the deterioration in Greece's financial position, and - above all - the long-term decline of Greece's competitiveness. And oddly enough, this means that we are also in agreement about the current situation in Greece, though we frame it differently. Professor Hausmann says that austerity is not the problem. I say that Greece's fiscal finances are not the problem. We are really saying the same thing. The real problem is competitiveness.

Greece's problem has been competitiveness for a very long time. It has run a large and persistent trade deficit for the last half-century (blue dotted line):


Exactly why Greece's competitiveness has been so poor for so long is unclear. Tomas Hirst attempts to explain it in terms of oil shocks and politics, which I think is partly true. But I also think there are other factors at play, notably the ageing of Greece's population, the unusually high number of small and micro businesses in the Greek economy, and the influx of cheaper labour into Western markets after the fall of the Iron Curtain. I shall have a look at this in another post.

However, there is a widespread perception that Greece's problems are primarily due to fiscal profligacy and excessive public sector debt. The story goes that out-of-control government spending caused the deficit and debt to rise to the point where markets refused to fund it any more, causing a "sudden stop". The primary focus of the EU & IMF adjustment programme so far has been on eliminating Greece's fiscal deficit and reducing debt/gdp in the hopes of preventing a further fiscal crisis: growth was supposed to return once confidence had been restored through successful fiscal adjustment. The fiscal deficit has indeed been more-or-less eliminated. But there is no sign either of improved confidence or much in the way of growth. And the aim of reducing debt/gdp has been thwarted by Greece's deep and persistent recession. Greece is therefore still under pressure to make further improvements to its fiscal finances.

So is the Troika right to focus on restoring Greece's fiscal finances, including reducing debt? And is Syriza also right to focus on it, though from a different standpoint?

Professor Hausmann does not think that Greece's debt overhang is such a big deal:
But the truth is that the recession in Greece has little to do with an excessive debt burden. Until 2014, the country did not pay, in net terms, a single euro in interest: it borrowed enough from official sources at subsidized rates to pay 100% of its interest bill and then some. This situation supposedly changed a bit in 2014, the first year that the country made a small contribution to its interest bill, having run a primary surplus of barely 0.8% of GDP (or 0.5% of its debt of 170% of GDP).
Philippe Legrain, in a comment on Tyler Cowen's blog, disagrees:
It is fair enough to point out that Greece was living well beyond its means until 2009, and that its productive structure needs upgrading. That inevitably implies a painful adjustment. But the pain has been unnecessarily great - a cumulative loss of more than 100% of GDP over the past five years - because Greece has laboured under unpayable debts, with most of the 'generous' EU loans used to pay private-sector creditors (notably, German and French banks) who should have taken a big hit in 2010. Had Greece's debts been restructured in 2010, austerity would have been less brutal, the private-sector recovery swifter and the slump less deep than they have been. Even now, Greece's massive debt overhang - and the uncertainty about Grexit and the chill to investment that this creates - is a huge obstacle to recovery 'whatever reforms' Greece does.
How can we reconcile these two views?

Philippe is absolutely correct that Greece's debt overhang seriously impedes recovery, But it is not just public sector debt. The real problem is that both the public AND private sectors are over-indebted. This chart shows how the private sector balance shifted from surplus to deficit in the late 1990s:


Since during that time the government deficit did not grow, the private sector deficit was funded by external capital inflows. In other words, the private sector borrowed from foreigners to fund domestic investment spending, resulting in a worsening external balance:


As can be seen from this chart, the private sector's debt-financed investment boom came to an abrupt end in 2008-9 when the capital inflows reversed. The external deficit reduced, the private sector deficit disappeared completely, the government deficit ballooned and real GDP fell off a cliff.

So the story of the Greek crisis is not really one of fiscal profligacy resulting in a "sudden stop". It is one of PRIVATE sector profligacy fuelled by rising external debt, itself resulting from (or caused by) falling competitiveness. As happened to so many countries in 2008, the banking crisis forced private sector debts on to the public sector balance sheet.

The difference between Greece and other Eurozone countries is that when it was forced to socialise private sector losses, it already had legacy debt of 100% of GDP. The fact that debt/GDP had been that high since 1993 was not the point. Seeing Greece's debt/gdp soaring, frightened by papers such as this from Reinhart & Rogoff suggesting that high debt/gdp was economically disastrous and angered by the disclosure that Greece's fiscal position was far worse than they had been led to believe, investors ran for the hills, causing Greece's borrowing costs to spike and creating a real risk of default. Their behaviour brought about the very situation that they feared.

The often-repeated argument that capital inflows to Greece were used for consumption rather than investment (which supports the "profligacy" story)  is not wholly supported by evidence. Consumption was indeed high, but there was also significant capital investment. Here is gross fixed capital formation for Greece since 1995 (OECD data via the St. Louis Federal Reserve's FRED database):


Clearly, there was substantial investment in fixed assets, which abruptly reversed in 2008. The spike just prior to 2004 is probably construction for the Athens Olympics. But what was the spike after that? The fact that the capital flows reversed so dramatically in 2008-9 suggests that this was generated by "hot money" looking for return without commitment. Similar spikes in other countries at the same time are associated with residential and commercial property booms. Did Greece have a property boom in the mid-2000s? Whatever it was, it wasn't long-term productive investment.

The present position is that both the public and private sectors are significant net foreign debtors. Neither is in a position to lend, so the only source of funds is external. And since neither can pay back what it already owes, foreigners are understandably reluctant to lend more. Restoring fiscal finances without further falls in real GDP is therefore only possible if there is a large and sustained external surplus. Professor Hausmann is indeed correct about this. In the absence of international funding, Greece's only hope is to export its way to recovery.

But this is where the competitiveness problem comes in. Greece has struggled to maintain its current account in balance, let alone surplus, for the last half-century. Even with the enormous falls in unit labour costs in recent years, it is hard to see that it would be able to maintain the substantial trade surplus that is needed to restore its economy.

Professor Hausmann says that Greece's problem is that it doesn't make products that the world wants. But I don't buy this line of argument. Demand for Greek olive oil or feta cheese would be significantly higher if they were properly marketed and sensibly priced. No, the real problem is that businesses are far too short of capital investment and productivity is far too low. And Greece is also hampered by the abject failure of the EU to deal with the large and growing trade surpluses in certain core countries, and by general shortage of demand both within the Eurozone and globally. This is not a good time to be trying to generate an export-led recovery from an appallingly low base.

And for that reason, I stand by my original argument. Greece's fiscal problems are not the "core" issue. Rather, they are symptomatic of a long-term private sector malaise. Furthermore, trying to restore Greece's public finances without addressing Greece's dismal business investment and the shortage of aggregate demand in the Eurozone as a whole is doomed to failure. The EU & IMF adjustment programme is fatally flawed, not because it is "unfocused" as Professor Hausmann suggests, but because it focuses on the wrong things.

Greece needs debt write-down in both the public and private sectors, plus business and infrastructure investment. The core countries that are allowing their trade surpluses to grow well beyond agreed limits require EU adjustment programmes of their own. And measures are required to improve Eurozone aggregate demand: the ECB's QE programme may help, as may Juncker's investment scheme, but it is questionable whether these will be sufficient to offset what remains an unjustifiably tight fiscal stance across the entire bloc.

Greece's post-war recovery was made possible by the Marshall Plan. Who now will provide a credible plan for its post-crisis recovery?
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All charts in this post except the FRED chart come from this 2012 Levy Institute paper:

Current Prospects for the Greek Economy - Papadimitriou, Zezza & Duwickquet

I recommend reading the whole paper.