Tuesday, September 2, 2014

Wage moderation: a recipe for growth?

In the economic policy debate in the Euro area it is common to hear a reference to the need for structural reforms in order to improve competitiveness, under the assumption that this is the recipe that Germany has followed so successfully over the  last years. To this logic it is common to add a recommendation for wage moderation. Low wage growth seems to be a necessity in Europe given the increased competition from emerging markets. While there can be some truth to this argument, let me show some evidence that questions some of the facts and then present some additional conceptual concerns with the way wage moderation and competitiveness are normally linked.

Below is a chart that summarizes data provided by the OECD on productivity, compensation and unit labor costs. I computed the accumulated change from 2000 to 2013 (except for the US where there was no data for 2013, so the period is 2000-2012).

The blue column (real GDP per hour) represents improvements in productivity. This is the ultimate source of sustainable improvements in living standards. What we see is a significant gap between the US and Europe (more so if we consider that the US is 'missing' one year). When we look inside Europe we see a big outlier: Italy, where GDP per hour has barely changed in the last 13 years. There are some interesting differences among the other countries with Spain seeing an 18% increase over the period compared to 15% in Germany and 12-13% in France and the UK. In this first column, there is no obvious German miracle during this 13 years.

The second number is labor compensation per hour. This is measured in nominal terms (i.e. current Euros or US dollars or UK pounds) as it should be when talking about competitiveness. One expects that increased productivity gets reflected in increased compensation (in real terms) and in addition we should see the effect of inflation. Here Germany stands out as the country with the lowest wage increase (per hour). To make sense out of this number we should compare it to the increase in productivity as measured by GDP per hour. This is what the third column, the unit labor cost (ULC) does, it is simply equal to the change in labor compensation per hour minus the change in output per hour.

When looking at ULC we see that Germany has seen the lowest increase in labor costs per unit of output but not because of the highest increase in productivity but because of wage moderation relative to productivity gains. Italy and the UK are the countries with the largest increase in ULC through a combination of zero (Italy) or average (UK) productivity gains combined with significant wage growth. This is the German "miracle", the ability to convince workers to get paid less (relative to productivity) than in other countries. This is good news for German firms.

To make the "German miracle" look even stronger we can replicate the same analysis for the pre-crisis period (2000-2007).

Here we can see how Germany was even more of an outlier in terms of ULC. Once again we see wage moderation combined with good productivity growth. We also see that during those years Spain looks much worse than once we add the post-crisis period with lower productivity growth and much higher increase in ULC. Comparing the two charts we can see that there has been a significant adjustment in Spain after the crisis both when it comes to GDP per hour and ULC relative to Germany.

So can low wages be the solution for some of the Euro problems? If the goal is to improve living standards, the focus must be on improving GDP per hour, that is the only way to ensure sustained progress. Having said that, for a given increase in GDP per hour, wage growth has to be consistent with these improvements in productivity so that unit labor costs do not grow too fast, otherwise a country will be pricing itself out of the market (and we will see that in a decline in the number of hours, unemployment)

Finally, the connection between wages and prices is also not as straightforward as some would argue. The numbers for labor compensation above are all in nominal terms, which is the right way to compare labor costs across countries and its relationship to competitiveness in global markets (more so when we compare two Euro countries so we do not need to worry about exchange rates). But the evolution of nominal wages can be very different from the evolution of real wages. Below I reproduce the first chart (excluding the UK) where I adjust wages and ULC for domestic inflation (using CPI).

If we compare Germany to Italy or Spain now we see that real wages did not grow significantly faster in Italy or Spain than in Germany, and this is of their higher inflation. When compared with GDP per hour we could still argue that real wage is high in the case of Italy but it looks as low in Spain as it does in Germany. Notice that when real wages grow slower than GDP per hour it must be that we are seeing a decline in the labor share, so an increase in the capital share. In other words, prices are not only related to labor compensation but also to profits.

In summary, no doubt that wage growth can in occassions be excessive and generate increases in labor costs with negative consequences on labor market outcomes. But insisting on moderation in wage growth regardless of the circumstances as a recipe for growth is not right. First, sustained growth in living standards can only be the result of increases in productivity (otherwise, why don't we just make wages equal to zero to maximize our competitiveness?). Second, what matters for competitiveness is prices and those depend not only on labor costs but also on the pricing power and decisions of firms. Excessive wage growth might be a drag on competitiveness but so can an excessive increase in profits or other forms of rents.

Antonio Fatás

Monday, August 18, 2014

Irrational exuberance meets secular stagnation

Robert Shiller warns us in the New York Times about the potential risks of high stock market valuations in the US. According to Shiller "the United States stock market looks very expensive right now". Brad DeLong and Dean Baker disagree with Shiller and argue that stock prices might look higher than historical averages but this could be ok given other changes in the economic environment.

Here is a restatement of their debate (and I will be repeating arguments I have made before):

Shiller's concern comes from the fact that price-to-earning (PE) ratios in the US are high by historical standards. Using his own measure, they stand at above 25 which is much higher than the 15 level that was common before the massive 2000 bubble that took that ratio all the way to 44. There is no disagreement about this fact.

Where Brad DeLong and Dean Baker disagree is in how relevant history is an indicator of what constitutes the right level for the PE ratio. The easiest way to think about the PE ratio is to first look at its inverse: earnings as a ratio to prices (EP). This gives us a sense on the yield that a share delivers today (let's keep aside for the sake of simplicity the difference between earnings and dividends). But this is just the static return that shares promise. We know that earnings will be higher in the future and the total return will then be the sum of the "static" return (EP) plus the expected growth of earnings.

Using similar numbers to Dean Baker's post, we can see that historically, a PE of about 15 corresponded to an EP of 6.7%. If we add to this real growth of earnings that was not far from the real growth in GDP, so about 3%, we ended up with a historical return of about 9.7% in real terms. How good was 9.7%? It was a good return. In fact, it was so good that many academics were puzzled by how high this level was. The way they expressed this puzzle is by comparing this return to the returns of alternative assets. Bonds paid somewhere below 4% (real) during most of those decades, which means that stocks yielded close to 6% premium over safe assets (this is what economists called the risk premium and because of its high level it led to a very prolific literature trying to explain the "equity premium puzzle").

Today, a PE of 25 translates into an EP of only 4%. This looks low compared to the historical average and that's where Shiller's concerns come from. But there are three potential reasons why the historical average might not be relevant:

1. Returns on other assets have gone down. Here is where secular stagnation meets irrational exuberance. A new eBook released by VoxEU presents convincing evidence in favor of the idea of secular stagnation. Secular stagnation is characterized, among other things, by real interest rates that are very low, possibly negative. But if this is true, it means that an EP of only 4%, which is about 2.7% lower than the historical one can be entirely justified by equilibrium real interest rates (returns) that are significantly lower than historical ones. What used to be a typical real return for bonds of 3-4% is now 0-1% (or even lower). This means that the return of stocks still remains significantly higher than those of other assets by a margin which is not far from historical levels. In other words, what used to be an EP of 6.7% should now an EP of 4%.

2. Not so fast! Secular stagnation also suggests that the growth rate of real GDP (and therefore earnings) is slowing down. This means that while the static EP ratio might look ok, when we factor in the lower growth of GDP we are back to stocks being too expensive. Correct but what matters here is the relative change in interest rates relative to the growth rate of GDP (earnings to be more precise). CBO projections of potential GDP for the US are lower than historical averages by somewhere around 0.5%. In contrast, interest rates are much lower, on the range of 2-4% relative to historical averages. Let's put these two numbers together: let's assume GDP growth slows down from 3% to 2.5%. This means that with an EP of 4%, stocks promise a return of about 6.5%. Much lower than in the past but still about 6% higher than bonds (if we take 0.5% as the real return on bonds). So we have the same risk premium as in the past and stocks are still a great investment even if prices are high relative to earnings. Of course, if you pick a much more pessimistic growth rate and a higher real equilibrium rate then stocks become expensive again (and if you go in the other direction then they become an even better deal).

3. Finally, why should the stock market risk premium be 6%? Is this a reasonable number? It is certainly be a function of the perceived risk of investing in stocks and arguments can be made in both directions. It is indeed very difficult to argue in favor of a particular number here but a historical perspective is useful: we cannot forget the fact that in the past such a high risk premium led to the conclusion that stock markets were undervalued and that investors were too-risk averse.

One final reflection: as much as I am offering support for the reading that Brad DeLong and Dean Baker do of the today's US stock market, we cannot forget that what will really matter is the perception of the market about how all these variables are likely to evolve going forward. And as Shiller argues, "sociology and social psychology" can be more useful in determining the future returns of the stock market than PE calculations or statements on equilibrium interest rates. But one still hopes that in the long run, fundamental analysis will produce a good indicators of rates of returns. But until the long run arrives, hold tight. As Brad DeLong puts it "If you are not in stocks for the long term, your stock portfolio should not consist of money that you cannot afford to lose."

Antonio Fatás

Tuesday, August 12, 2014

The September 2014 recession?

Here is a thought experiment: what if the US economy entered a recession next month? Would it be too early for a recessions? How would it compare to previous recessions? And what stories we would tell to explain why the recession happened?

Let's start counting months using the two phases of the business cycle as defined by the NBER business cycle dating committee. How long is the current expansion? The current expansion started in June 2009, which makes it already 62 months. Compared to all the previous post-WWII expansions it is already above average (60.5 months).

Another way to look at it is to realize that we are only one year away from reaching the length of the previous expansion (73 months). It is true that we are still far from reaching the 92 or 120 months of the previous two, but these were two of the largest expansion the US has ever seen. So for those who like to think about expansions and recessions in terms of length and they have the idea that crisis happen with a "certain" frequency, there would be nothing unusual if a recession started today.

What would be more unusual is the way the economy would look like as it entered a recession. There are no indications of the economy running out of slack (inflation, wage growth). It would also be very hard to find large financial excesses as we saw at the end of the 90s (the stock market reached price-earning ratios that are a lot higher than what we see today) or something similar to the large increase in investment in real estate in addition to highly overvalued housing prices that we saw in the years prior to the December 2007 recession. We could of course argue that the recession happened because of geopolitical uncertainty but any historical analysis of political events over the last decades would suggest that what we are seeing today (so far, keeps fingers crossed) is not that unusual.

And if a recession started today, one pattern that would also be very different is the stance of monetary policy. If we measure it by the difference between long-term and short-term rates we typically see that this difference displays a strong and consistent downward trend as we approach a recession, something that we have not seen at all in recent months (or years). Here is a quick comparison of the difference between 10 year and 3 month interest rates for the average of the last four recessions compared to what the data would look like for a recession starting today.

The average of the past 4 recessions shows that the interest rate difference displays a steady downward trend towards zero in the quarters that precede the recession. And if you want more details, here is the data for those 4 recessions (I am removing the July 1981 recession because the expansion before was too short to say anything meaningful).

While there are some differences across each of the cycles, they all share the same overall trend. We have not seen any of this pattern over the last quarters or years. The difference between 10 year and 3 month interest rate remains flat. And while it is possible that short term interest rates are about to start increasing in the US, it is very likely that when they do we also see increases in the 10-year rate. So if this was a typical cycle, we are far from seeing a flat or downward-slopping yield curve.

So what would a US recession today do to our understanding of business cycles? While it would not be a large surprise in terms of how soon it happened relative to the previous one, it would open many questions about the reasons why recessions happen and about the behavior of interest rates and monetary policy around the turning point of the cycle. It would be yet another "new normal", this time for business cycles.

Antonio Fatás

Sunday, August 10, 2014

ECB needs to talk about slack and not structural reforms

In today's Financial Times, Matteo Renzi, Italy's primer minister defends the pace of Italian reforms. In doing so he responds to comments by Mario Draghi last week that the pace of structural reform in Italy was responsible for the low GDP growth figures. From the FT interview:

I agree with Draghi when he says that Italy needs to make reforms but how we are going to do them.

So no disagreement between Draghi and Renzi on the need for structural reforms in Italy. The fact that improvements in regulation, labor markets, competition can increase growth rates in Europe is undisputed. The real debate is about the right timing and speed of those reforms. Here Renzi disagrees with Draghi.

I will decide, not the Troika, not the ECB, not the European Commission,” he said. “I will do the reforms myself because Italy does not need someone else to explain what to do.”

But beyond the question of who decides on what are the appropriate reforms and at what pace they should be done, I find that there is a more fundamental problem with the dialogue between central banks and governments about the need of reforms. Why do central bankers need to remind governments of the need to do reforms? The only reason I can think of is because they feel too much pressure to lift growth rates and they want to explain to the public at large that the low economic performance is not really their fault but the fault of governments' failure to reform. But I find that the way the argument is being made creates unnecessary confusion and leads to a behavior of the central bank that sounds defensive and a justification for inaction.

Clearly, during any period of low growth there is a debate about the extent to which this is due to cyclical conditions or structural ones. What I expect the central bank to communicate is their view on how close the economy is to potential output, how much slack there is in the economy and how they plan to use their economic tools to address that gap. In the ECB press conference last Thursday, Draghi acknowledged that some of the low growth in Italy (and Europe) is due to demand/cyclical factors. But then he immediately brought up the need for structural reforms. And when he had to compare the importance of the two arguments in the case of Italy, he said that "it's mostly the lack of structural reforms" instead of low expected demand that is keeping investment low. I would find more reassuring if Draghi provided a stronger and more quantitative statement on the perceived slack in the economy (or the deviations of inflation from its target) and what the ECB plans to do about it than trying to guess the potential effects of structural reform.

The contrast between the ECB and the US Fed is, as usual, very interesting. The statements from the FOMC in the US tend to focus on their views about the current slack in the labor market and the potential effects of monetary policy actions to address this slack. There can be an occasional (justified) comment on how fiscal policy conditions are affecting the cyclical position of the US economy. No mention on the potential role of other long-term growth-enhancing policies that could be undertaken in the US government, as it should be.

Antonio Fatás

Thursday, August 7, 2014

A recession without a boom?

Simon Wren-Lewis in one of his latests posts dismisses the idea that the pre-recession UK economy was in an unsustainable debt-fueled boom. The argument, which I have made before in earlier posts, is that focusing only on the path of debt can give a misleading picture of the sustainability of growth or spending. Wren-Lewis presents data for the UK showing that the large increase in debt in the UK prior to 2007 was matched by an increase in the value of the assets that UK households held so that net wealth was indeed increasing (despite the increase in borrowing). The role of housing prices is key to understand these developments. Wren-Lewis argues that in the case of the UK, because of a combination of lower interest rates and limited supply, housing prices are trending upwards.

The simplest way to understand the argument is to think about two alternative scenarios when it comes to the purchase of housing services: renting versus borrowing to buy the house (no rent is paid in the future but mortgage payments will have to cover the cost of borrowing).

In the first scenario, there is no debt, in the second one there is an increase in debt. In what sense the presence of debt makes the second scenario or decision more unsustainable than the first one? One could argue that because of the ownership of the asset, there is the possibility of decreases in asset prices that could result in financial pressure and need to reduce other spending. Correct, but the same could be argued in the first scenario where a potential increase in the price of houses (and rents) will reduce the after-rent income for the household and will result in the same need to reduce other forms of spending (there will be no need to "deleverage" but the need to cut other expenditures will be identical). There are, of course, differences in terms of the ability to adjust to shocks because of the illiquidity of housing as an asset, but fundamentally there is a great deal of symmetry where ownership of the asset will give up potential returns if the asset price goes up but risks if it goes down while renting will exposes you to a risk of increases in rents if housing prices go up.

What can make the analysis more difficult is the heterogeneity across agents. Housing happens to be a special asset where it is mostly held to enjoy the services that it provides. In addition, we are all somehow exposed to fluctuations in housing prices because we either rent or buy the asset. This means that when we think about an individual scenario of renting we cannot forget that someone else owns the asset. This can in some cases reduce the aggregate risk as increases in prices benefit owners but hurt renters but the aggregate effects can depend on the characteristics of the individuals who are exposed to different risks. For example, while aggregate net wealth today in the US is higher than before the crisis (according to the US Federal Reserve flow of funds database), this fact hides strong difference across different households as there is evidence of increased wealth inequality during that period using alternative datasets. And this heterogeneity could have aggregate consequences because of differences in accessing to financing or spending patterns. But in this case the story is more complex than the notion of a country living beyond its means through a borrowing spree.

So increases in debt alone cannot be interpreted as a definite signal that the economy is in an unsustainable boom. But we might not rule out either that it might be a reflection of other economic trends that can put growth at risk. in particular when we take into account the heterogeneity of agents. Unfortunately the lack of available disaggregated data as well as solid and accepted theoretical models with heterogeneous agents make this analysis a lot more speculative.

Antonio Fatás

Thursday, June 26, 2014

Addicted to central bank painkillers?

Claudio Borio (BIS) and Piti Disyatat write about the dangers of low interest rates at VoxEU. Using an argument that has been put forward many times by the BIS (Claudio Borio and co-authors), low interest rates during booms and expansions can create bubbles and financial instability. Central banks need to be aware of the costs of low interest rates.

The authors, while accepting the idea that low real interest rates might be the outcome of low growth and secular stagnation,  argue that central banks cannot simply be seen as passive agents adapting their policies to the macroeconomic environment; they are responsible for low interest rates. In their words "money and finance are not neutral". Quoting from the article:

"Not only can financial factors – especially leverage – amplify cyclical fluctuations, but they can also propel the economy away from a sustainable growth path. By influencing decisions to invest, variations in financial conditions affect the evolution of the capital stock, and hence, future economic fundamentals. An expanding capital stock during booms may help to constrain inflation and obviate the perceived need for monetary-policy tightening. At the same time, large changes in relative prices that typically occur in financial booms divert resources into surging sectors in ways that are not easily reversible. The long-lasting impact of the financial cycle becomes especially evident in the bust phase. The cumulative build-up in debt and associated resource misallocations – especially the overhang of capital – leave a legacy that takes time to resolve."

To support their claim, the authors produce a chart that shows how debt (public and private) has increased dramatically during the years where interest rate were coming down.

Their conclusion:

"More stimulus may boost output in the short run, but it can also exacerbate the problem, thus compelling even larger dosages over time. An unhealthy dependence on painkillers can be avoided, but only if we recognise the risk in time."

I have no objection to the idea that money and finance are not neutral and that central banks can have an important role in financial markets. But the analysis above is too simplistic and potentially misleading.

The logic it puts forward is that arbitrarily-low interest rates set by the central bank generate an unsustainable behavior in terms of accumulation of debt that is behind the bubbles we built in the good years and the crisis that resulted from the bursting of those bubbles.

What is always missing in this analysis is the fact that the world is a closed system. The debt that appears in the chart above has to be bought by someone. Those liabilities are assets for someone else. Who are the buyers? And who "forces" them to buy those assets at that price/yield?

Before we continue any further let's rule out the hypothesis that it is the central bank who is buying those assets. The easiest way to understand that it cannot be the central bank is that the chart above starts a lot earlier than the time when central banks' balance sheets started to increase (the second reason is that for every asset that the central bank buys it issues a liability but this will get us to a more complicated argument).

There is a simpler way to explain the chart above. A shift in the supply of saving by some agents/countries resulted in a decrease of interest rates and an increase in borrowing by the rest of the world. Some of this happens within countries, some happens across countries. This could still be an unsustainable development as borrowers go too far and lenders do not understand the risk involved but it is not simply be caused by the irresponsible policies of the central bank.

It could also be that, in addition, we have seen a significant increase in gross flows of assets and liabilities that do not result in a change in equity or net wealth but that they lead to an increase in the size of balance sheets across agents (i.e. increased leverage). Simplest example is households buying real estate with mortgages but it can also be financial institutions increasing leverage. This increases debt but it increases assets as well. This, once again, can generate instability but the borrowing that we see must come from somewhere else in the economy (not the central bank). Understanding that side of the balance sheet is important to have a complete story of what caused the crisis and what it takes to get out of it.

Antonio Fatás

Monday, June 9, 2014

Is liquidity stuck at banks?

Last week the ECB announced new monetary policy actions to help restore growth in the Euro area and bring inflation closer to its 2% target. Interest rates were reduced and further provision of loans to commercial banks were announced. In addition, there is a plan to implement purchases of asset based securities.

The effectiveness of recent monetary policy actions by central banks has been met with some skepticism because it does not deliver the necessary increase in lending to the private sector. While liquidity is introduced, it seems to get stuck in the accounts that the commercial banks hold at the central bank (reserves). Because of this, both the Bank of England and now the ECB are implementing injections of liquidity that are linked to increased lending to the private sector by the financial institutions that are borrowing that liquidity.

The role that reserves play in the recent monetary policy actions by the ECB leads some times to confusion. Some seem to think that the high level of reserves that banks hold is a measure of the failure of central banks to generate additional loans to the private sector. The logic is that reserves stay high because of the lack of willingness to lend. This is the wrong view of reserves, they cannot simply be seen as resources that are waiting to be provided as loans to the private sector.

Reserves are a liability in the central bank balance sheet that it is created when the central bank decides to allocate more loans to commercial banks or when it decides to buy securities. If a commercial bank decides to give a loan to one of its customer (household or business), the reserves do not disappear. Once that customer uses its loan for a purchase, these reserves are transferred from one commercial bank to another, but the level of reserves remains constant.

How can reserves go down? In the case of the ECB, most of the injections in liquidity have been done via loans to commercial banks. Reserves will only go down when commercial banks pay back their loans with the central bank (or when the central bank decides to reduce the amount of loans it provides as some of the outstanding ones are repaid). So any increase in the provision of loans by the ECB will lead to an increase in reserves. Below are the two series: loans to commercial banks (an asset for the ECB) and reserves of commercial banks at the ECB (a liability at the ECB). Both series are in Billions of Euros (Source: ECB).

The evolution of both series is identical. The large increase in loans (LTROs) that started in the Fall of 2011 led to a large increase in reserves. Since then, both series have been coming down as Euro commercial banks have been repaying their loans (voluntarily). So the balance sheet of the ECB has been shrinking dramatically over the last months. The new wave of loans announced by Mario Draghi is likely to increase both series again (although by how much will depend on how Euro financial institutions feel the need to tap into additional ECB funding).

The fact that the two series move together does not mean that the actions of the central bank are ineffective. It is possible that the availability of funding for some banks leads them to provide more loans to the private sector. What one cannot do is judge the success of these actions by the level of reserves in the financial system. The level of reserves will not change when the private loans are given.

As a point of comparison, the profile of the series above for the US Federal Reserve is very different: they keep trending up, no decrease at all. The reason is that the US central bank has increased its balance sheet by buying securities. So reserves are created agains the purchase of those securities. In this case, the level of reserves is even more directly linked to the actions of the central bank. It is only when the central bank decides to sell those securities that the level of reserves will come down. And this is the new step that Draghi has promised in his press conference last week, the ECB is willing to engage in true quantitative easing via the purchase of asset based securities.

Antonio Fatás