Wednesday, April 16, 2014

Secular stagnation or secular boom?

The notion that some countries are caught in a long and protracted period of low growth has received an increasing amount of attention and has been labelled "secular stagnation". The pessimism that the idea of secular stagnation has created has been reinforced by the notion the potential for emerging markets to grow is becoming weaker. The point that I want to make in this post is that one of these notions (secular stagnation) is looking backwards at the performance of advanced economies while the other one (potential pessimism about emerging markets) is looking forward and speculating with their inability to do as well as in the last decade.

Let's start with a simple chart that summarizes the pattern of annual growth in the world over the last decades. Data come from the World Economic Outlook database (IMF). I have decided to include the last 13 years for the decade that starts in 2000.

Two observations: growth (by decades) has been remarkably stable in the world, between 3.2%-3.6%. Second observation: during the last 13 years growth has increased relative to the previous two decades. No global stagnation, if any, acceleration of growth.

But if we split the world into advanced and emerging markets we see a very different pattern. [I will use the label emerging for any country which is not advanced - the IMF will call them emerging and developing countries].

While in the 80s, and some extent in the 90s, both groups grew at a very similar rate, in the last 13 years annual growth rates in emerging markets have been three times higher than those of advanced economies. So stagnation might be the right label for 50% of the world, but accelerating growth is the right label for the other half.

And if we look at the engines of growth, in particular investment rates (in physical capital) we can see again the divergence in performance.

Investment rates for the world are fairly stable over all these years with possibly some mild increase in the last 13 years. And that increase is driven by an explosion in investment rates in emerging markets (by 50%) at the same time that investment falls in advanced economies below the 20% level.

Looking at the above charts, one wonders whether the divergent performance of emerging markets and advanced economies is related. Could it be that investment opportunities in emerging markets moved capital away from advanced economies? Not obvious because we know that the explosion in investment rates in emerging markets came in many cases with even larger increases in saving rates and (financial) capital flew away from these countries. In fact, interest rates in the world were trending downwards during this period. And this makes the performance of advanced economies even more surprising: despite a favorable environment in terms of low interest rates, investment and growth declined.

Antonio Fatás

Monday, April 14, 2014

The price is wrong

The Euro area inflation came lower than expected in March and this has raised concerns about deflation (or "lowflation" as labelled by the IMF). In today's Financial Times, Jurgen Stark, a former ECB board member argues that deflation or low inflation is not a problem. One of his arguments is that there are benefits for low inflation, in particular:

"It is likely we are living in an extended period of price stability. This is good news. It boosts real disposable income and will eventually support private consumption."

(By the way, Mario Draghi used the same argument in his last press conference).

So low inflation raises real income and it helps boost demand and output. The economic logic behind this statement is at best unclear, at worst completely wrong. Unfortunately, the misconception involved in this sentence is not that uncommon and it reflects the poor understanding of the general public (and public officials) about inflation, nominal and real variables. But it also reflects poorly on academic arguments based on models with price rigidity that, in my view, are not always as clear as they should when it comes to the dynamics of absolute and relative prices.

Let me start with Jurgen Stark's comment: his assumption is that prices are growing at a slower rate than income. But he forgets that income is linked to prices as well. It is possible that as a result of low inflation the real income of some agents is growing but it would be at the expense of the real income of others. For example, if wages are growing at a decent rate but prices are falling (or growing at a lower rate) it means that real wages are increasing. But this is a redistribution effect that shifts income towards workers and away from profits. Total demand can only be affected if we assume some differences in the propensity to consume of different groups. And if this is the model that we have in mind, then let's push for higher wages across the board to get out of a crisis (I doubt Jurgen Stark favors this conclusion).

But what do academic models have to say about the relative price effects of changes in inflation? Not much or, at least, not in a way that is clear enough to drive consensus in policy recommendations.

Let's start with the basic model we teach in macroeconomics: the textbook IS-LM model. In most textbooks this is originally presented as a pure demand-side model. Inflation (or prices) matter: lower prices increase demand. Demand depends on the ratio of nominal money to prices (M/P) and lower prices are associated with increases in output. This is indeed the main mechanism by which lower prices help restore the long-term equilibrium. So in this world low inflation or deflation are good (i.e. Jurgen Stark is right).

The notion that M/P drives demand and output is not always intuitive for many students so it is very common that when we teach the IS-LM model we also make a reference to the potential role that some relative price can play to generate the same output dynamics. In particular we bring wages into the story. But here is where the logic becomes confusing. By bringing wages we argue that recessions are periods where nominal wages are rigid and as prices go down the real wage increases and causes employment and output to contract. The recovery from a recession corresponds to a period where nominal wages are going back to normal (decreasing relative to inflation) and helping employment and output grow. But there are two problems with this logic: this is a supply effect, not anymore a demand effect. Second, if this logic is true, higher prices/inflation is the way to restore the equilibrium (as opposed to lower prices in the first argument). The relative dynamics of different prices are crucial to support the logic of this argument and talking about inflation (as Jurgen Stark does) without making a clear statement on how different prices and wages are moving will be misleading.

But what happened to demand in that story? The real wage argument is a supply-side argument and the assumption is that demand will match supply. But what if we consider the possibility that different agents have different propensity to consume in the short run? Then any change in relative prices might affect demand. In that world, it might be that lower prices help raise real wages (and lower profits) and under the assumption that workers have a higher propensity to consume than capital owners, this could raise demand and output (so Jurgen Stark is right again).

It gets more complicated as real wages are not the only relative price that matter. There are two other arguments that can affect the potential effects of low prices. First, if nominal interest rates are fixed (or stuck at the zero-lower bound), falling prices/inflation will raise real interest rates and reduce demand. In addition, if financial assets and liabilities are denominated in nominal terms any unexpected fall in prices/inflation will raise the real value of the debt. This is again a redistribution effect (the real value of savings falls so those agents are hurt by inflation) but under the assumption that either borrowers have a higher propensity to consume or simply need more help to restore their damaged balance sheets, there could be a positive effect on demand.

And things get a lot more complicated in an open economy where prices (and wages) play a role determining exports and imports. Typically we teach that lower prices is the right recipe to engineer a real exchange rate devaluation that helps regains competitiveness and improve growth (but when we do so, we ignore the other potential negative effects of low prices or inflation).

Finally, it might be that the effects of low inflation are not at all related to relative prices. The confusion between nominal and real variables has been documented many times and falling inflation even if all prices and interest rates are moving in sync could trigger real effects if it is misinterpreted as a real change in income or relative prices.

So we are left with a set of arguments using models with some type of nominal rigidity that are not always consistent in their predictions. They make use of both supply- and demand-side arguments and under some scenarios inflation (in some prices) is good, under other scenarios inflation (in some prices) is bad. In this environment, making policy recommendations becomes very difficult.

As an example, what do we want to see in the Euro periphery? Lower inflation or higher inflation? Lower inflation sounds good as a way to generate an adjustment in the real exchange rate. But do we want lower price inflation or lower wage inflation or both? How do nominal wage rigidities and potential income distribution effects (from capital to labor or from savers to borrowers) affect demand?

My sense is that the consensus is that we want a high enough level of inflation in the Euro area that allows for significant changes in relative prices within countries (this is what the IMF argues in this blog post. But exactly which relative price has to move and in which direction it might be less obvious. We normally thing that the periphery will need lower wage inflation (to be more competitive). But not too low so that do not run into the fact that wages are unlikely to fall in nominal terms or that potential deflation increases the real value of debt. This all sounds reasonable but implicitly we are assuming that falling real wages in the Euro periphery is good. But are we sure that the redistribution effects of such policies do not affect demand (the same way we argue that the redistribution effects between savers and debtors affects demand)? It would be nice to have more clarity both on the theoretical arguments and the empirical size of each of these effects.

Antonio Fatás

Thursday, April 3, 2014

The many hands of Mario Draghi

Mario Draghi press conference yesterday was yet another exercise of creating confusion about what the ECB intends to do. Maybe what he referred to as an unanimous consensus in the ECB council is not really there or maybe the consensus is simply to keep arguing that there are risks to both sides, that the data is not clear enough, that it can be interpreted in so many ways and in the absence of certainty it is better not to act.

His answers looked like the perfect parody of an economist that will always play it safe by starting with one argument and them arguing that "on the other hand" we could also be doing the opposite.

Here is the best example of this:

".. my biggest fear is actually to some extent reality, and that is the protracted stagnation, longer than we have in our baseline scenario. Right now, it’s pretty severe, with levels of unemployment that – even though they have stabilised, and we see marginal improvements here and there – are very high. And the longer they persist, the more likely it is that they will become structural, namely much harder to lower through conventional policy measures. So that’s my biggest fear, and that’s why monetary policy is important, but it’s not the only thing. To respond to this fear, one needs a complex package of policies and, as we always stress, structural reforms come first, because many of the problems of the euro area are structural."

So his biggest fear is that cyclical unemployment turns into structural unemployment, so I guess this means that the ECB is ready to act to ensure that this does not happen. Wait! Not so fast, because his biggest fear is also that monetary policy is important bot not as important as structural reforms that are the first priority. So I guess all the cyclical unemployment turned into structural unemployment so we are too late to act.

And he recognizes that low inflation is bad and it is below the ECB target. But low inflation can also be good

"..but there are also some positive aspects (of low inflation) in the sense that it supports the real disposable income especially of those people who have a fixed nominal income."

Interesting argument to justify low inflation (should we lower the inflation target?)

And even if inflation is low it is not fully under the control of the ECB

"this is being caused by exogenous factors. In fact, if you see what is the inflation rate in other countries, for example in the United States, where they are much more advanced in their recovery than we are, or in Sweden, you can see that the low inflation contains a high percentage of global factors."

Yes, inflation in the US is also low but Janet Yellen words and actions are very different from those of Draghi. She does not simply find excuses why inflation is low, she is committed to make it go back to its target.

So I guess that we are left with "protracted stagnation". We will wait for the April inflation number that Draghi thinks it will be higher than the one in March and if it is not, we will continue feeling very good about the fact that long-term inflation expectations are still anchored. What the ECB is showing these days is that their obsession with inflation is even worse than what we thought. It is hard to imagine how low the inflation data has to get so that they pay some attention to their mandate.

Antonio Fatás

Sunday, March 9, 2014

The difficulties of reducing long-term unemployment

Since the global financial crisis started there has been a debate about how much of the increase in unemployment is cyclical versus structural. Arpaia and Turrini summarize the results of their analysis of the EU labor market in a recent Vox post.

They start by showing that there has been a significant shift in the relationship between vacancies and unemployment (what is known as the Beveridge curve) in many of the EU countries. This shift, combined with further analysis of how unemployment reacts to changes in labor demand leads them to conclude that there has been a decline in the matching efficiency of the labor market in these countries. From their post:

"...a major drop in matching efficiency was recorded in 2009 in most countries. Unsurprisingly, matching efficiency has been falling mostly in the countries that witnessed a marked outward shift in the Beveridge curve, although some signs of stabilisation or even recovery are visible by 2013Q1"

They then try to understand the reason for matching efficiency to decline and they test several hypothesis: mismatch in skills, industry or regions. It is interesting that although the three play a role in the full sample none of them are statistically significant in the post-2007 period (only skills mismatch is close to being significant).

But out of the controls that they introduce in their regressions, there is one that shows up as a strong determinant of the change in labor market efficiency: the change in long-term unemployment. In other words, one cannot reject the view that a deep recession resulted in a large increase in cyclical unemployment that turned into long-term unemployment because of the duration of the recession and this has led at a decline in the efficiency of the labor market. This is not far from what Blanchard and Summers (back in 1986) labelled as hysteresis in the labor market when describing the performance of also European labor markets in the 70s and 80s. The added insight of Arpaia and Turrini is that the difficulty in reducing long-term unemployment is related to the effect that its high level reduces the overall matching efficiency of the labor market.

The role that long-term unemployment and hysteresis could be playing in the US during the current crisis relative to more structural factors is also a source of debate. What is clear from the data is that the increase in long-term unemployment during this crisis is a lot more pronounced than in any previous crisis, which matches well the deterioration of other labor market indicators (such as the employment to population ratio).

Antonio Fatás

Wednesday, March 5, 2014

Global interest rates and growth (r-g).

The difference between interest rate and growth rates appears as an important parameter in many macroeconomic models. It is also a key variable to assess the sustainability of public finances: higher interest rates make the cost of carrying over debt higher while high growth rates help keep the debt to GDP ratio under control.

In a recent post Floyd Norris criticizes the assumptions used by the US Congressional Budget Office for its fiscal projections because they are assuming lower growth rates ahead but a return to "normal" interest rates. The point that Norris makes is that we tend to think that interest rates and growth rates are correlated, so if growth is going to be much lower going forward we should also forecast lower interest rates (and this will make the fiscal outlook look more positive).

Paul Krugman initially supports Floyd Norris' arguments but later, after checking the data, he realizes that growth and interest rates are not that correlated. Here is the picture of the difference between interest rates and growth rates for the US (from Krugman).

The relationship between interest rates and growth rates shows no clear pattern in the chart. During the 60s interest rates were lower than growth rates (when growth was high). We see a similar pattern in recent years but in this case growth is low. The 80s stand out as a period of high interest rates compared to growth (and growth was around its long-term average).

But there is an additional issue regarding the difference between this analysis of interest rates and growth: Norris and Krugman are looking at interest rates and growth in the context of one economy (the US). But given the global nature of capital markets the relationship between interest rates and growth (if any) should only be present at the global level. What happens if we look at the  differential between interest rates and growth for the world? Here is a quick attempt to measure this difference:

[See footnote for data sources and calculations]

To understand better how the pattern above matches that of GDP growth, here is World growth in each of these decades (measured both in real terms -constant US dollars- and nominal terms - current US dollars).

What is the World pattern of growth and interest rates? As in the US data, the relationship between interest rates and growth rates has varied over the past decades. Real growth is stable across all decades although increasing after 2000 (because of emerging markets).

The 80s stands out as a decade with very high interest rates relative to growth. The 2000s and the 2010-13 period are characterized by very low rates relative to growth (while global growth remains strong).

What determines interest rates then? The usual narrative of the post 2000 sample is that of the saving glut that stars in the late-90s with the increase in saving rates in regions like Asia (partly as a response to the Asian crisis). Theoretically, such a global shift in saving should lead to lower interest rates and increasing growth rate in the world.

In summary, given that interest rates are determined by global conditions, anything could happen when comparing them to growth rates for a given country (of course if the country is large enough to influence global variables then national and global conditions are correlated). The right way to look at these two variables is at the world level. But the empirical evidence confirms that, even if we look at a global level, one cannot rule out future scenarios of movements in interest rates and growth rates in opposite directions (they still need to be justified in terms of the global dynamics of investment and saving, but they are possible).

Antonio Fatás

[Some data issues: World GDP is coming from the IMF World Economic Outlook (converted to USD using market exchange rates; using PPP does not make a difference). I have taken the average of interest rates and growth rates over a decade (each of these decades includes some global recession so cyclical factors might not matter much except for the 2010-2013 period). Unfortunately data starts in the 80s so I cannot say much about the 60s and 70s (yet). Interest rates are from US treasuries under the assumption that this is the closest we can get to a World interest rates on riskless assets (using interest rates from other advanced economies will not change the pattern much; using interest rates from emerging markets can make some of a difference because of the volatility of risk premia). I have done the calculation using both a 10-year and a 1-year bond -- as it is clearly from the chart, the overall pattern is similar.]

Sunday, March 2, 2014

Financial markets arbitrage: reassuring or lovely?

John Cochrane has a new blog post summarizing recent research by Budish, Cramton and Shim on the effects of high frequency trading. The paper shows that as high frequency trading spreads the correlation of a particular asset price across two US markets (Chicago and New York) has become higher at intervals that are very short. Any price deviations across the two markets disappear in less than one second. As Cochrane puts it,
It is lovely to see the effect of "arbitrageurs" making markets "more efficient."
As an academic I enjoyed reading the post as it provides a very nice example of a clean empirical test of how high frequency trading makes the comovements of two markets stronger. This is what we look for in academic papers, a clean test of a very simple theory that produces very credible and robust results.

But as much as I enjoyed reading the post, it also reminded me of how limited is the ability of academic research to help us understand phenomena that really matter. In this particular case, the analysis compares the price of the same security in two nearby markets (geographically but also linked by very fast communications). As communications and trade become faster and faster, price deviations between the two markets disappear in a shorter period of time. This is really nice to see but is this a big surprise? One would expect that at a minimum, very basic arbitrage opportunities do not exist in integrated financial markets. So it is reassuring that arbitrageurs help markets be more efficient but I am not sure I would go as far as saying that this is "lovely".

What would be more interesting (at least to me) is understand whether high frequency trading helps getting financial prices right. And by "right" I mean prices that are consistent with economic fundamentals, prices that do not generate volatile dynamics and bubble-type behavior. If we could prove that this is the case then I would find the result "lovely".

Antonio Fatás

Thursday, February 13, 2014

The permanent scars of economic pessimism

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

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

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

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

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

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

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

Antonio Fatás