Jagjit Chadha's Macro View Point

Insider Trading in China – what is and what should never be

2011-10-26T12:24:00.000+01:00

Several newspapers reported yesterday that two Chineseofficials have received jail sentences of six and five years for leakingconfidential economic data to traders prior to their official release. In one of my favourite films, TradingPlaces, the anti-heroes Randolph and Mortimer Duke try to obtain the cropreport in advance of its release so they can corner the market in frozen orangejuice. Like their Chinese counterpartsnearly 30 years later no good became of them either. Insider dealing laws prevent those who haveinformation in advance of the market, or public, from acting upon it. And quite rightly so.

The news from China though can be understood at a number oflevels. First it confirms that economicnews on the Chinese economy is sufficient to move to asset prices in asubstantive and predictable manner. Thusthe market having formed expectations, news that does not completely verifythose expectations leads to asset prices adjusting. By the by, rational expectations does not meanthat we know the news, it means that we have worked out the probability ofdifferent events and the payoff from those events. When the uncertainty is resolved by theactual publication of the news, the event that actually happened goes frombeing a mere probability to a certainty and that is why asset prices move. That Chinese data is valuable enough tochange asset prices is significant enough and a positive development, per se. We, or the financial intermediaries we employ on our behalf, aretherefore forming views about the Chinese economy and then re-evaluating thoseviews as news emerges. The scrutiny,rather than the tyranny, of the market is a good thing.

Secondly, the successful prosecution means that authoritiesunderstand that market sensitive data must be released to all marketparticipants simultaneously. This doesnot mean that no information should be released or that only certain bits ofinformation should be released. All data onthe state of the economy, revisions, warts and all, should be released on awell understood timescale and produced by a well-documented statisticalprocess. Such a process will facilitatethe development of views on the likelihood of different state of nature andalso – this is the important bit – facilitate the transfer of information fromthe private information set to the public domain. The trader or analyst with a bearish viewwill 'sell' his or her analysis to market participants and be amply rewarded ifthey turn out to be right as prices will move to reflect the accuracy of theoriginator’s private information set. The key is that the traders are rewarded for their private informationand so have an incentive to work out what it might be through analysis.

What is less clear is whether any of the clear sanctionsagainst the release of public information will have any impact on what we havecome to call 'guidance'. It should not. Guidance involves statements by policymakers on the implicationof a given stream of data for likely future policy or backward-lookingexplanations of why what was carried out when. Guidance, if given to all and is free to access, is helpful as itclarifies public thinking and so pools information. The guidance is not private information noris it data per se. It helps marketsinterpret the large flow of information and understand better the conditionsunder which policy is currently being set and the parameters that might causeit to change. To the extent thatguidance accelerates learning and forces policy makers to spell out theirreaction functions, guidance is less something to be proscribed but more anobligation. The debate about the effectiveness oftransparent as opposed to opaque policy relies on such guidance. So at the same time that sanctions are developedagain insider information, governments should work harder to explain, warn andadvise.

Have the MPC Blown It?

2011-10-20T13:21:00.001+01:00

Inflation measured by either the CPI or the RPI has risen to over 5% this summer and autumn and is at levels clearly inconsistent with price stability. At these inflation rates the price level will double in less than fifteen years. The battle for price stability in the UK was fought over a prolonged period from the IMF programme of 1976 onwards and it seemed for a brief period in the 1990s and 2000s that the battle had been won. The war, however, continues and there has been a significant rearguard action.

The chart shows not only an upward creep in the level of inflation but also its volatility from around 2003/4 onwards. And to some degree that seems mirrored in the financial market perceptions of the inflation 10 years ahead, which also seem to have drifted up from lying in the range of 2-3% in 1997 through to around 2005 to now lie between 3-4% since 2008. There are a number of technical reasons why the inflation forwards cannot be read at face value, particularly given the liquidity characteristics, but the trend does not seem terribly encouraging. If we also believe that QE has lowered nominal forwards then the measures from the inflation forward may in fact be biased downwards. And worryingly the Bank's own survey of inflation expectations from August places the median of medium inflation expectations at 3.5% compared to 3.2% and 2.8% a year and two years ago. The temporary inflation overshoot looks as though it may turn out to be more persistent.

Perhaps it should not really surprise us. In response to a cost-push shock over the past few years, the MPC has eased monetary condition by allowing real rates to fall and committed to low interest rates via its programme of QE. In the kind of models the Bank used to use, a cost-push shock required higher interest rates not lower ones and the argument used to be that acting against inflation was the best way to ensure that an inflation shock was temporary rather permanent. It seems that we are now hoping that "something will turn up", or rather down.

Naturally, the policy decisions have been rather more complicated than having to deal with a single cost-push shock as we did not start from steady-state and financial conditions remained tight in a recession. As the cost-push shocks emerged at a time when there was considerable slack in the economy they will have acted to help close any output gap, it may then mean that the low current rate of growth is as likely to be related to the supply side as it is the demand side and so may not really be responsive to further monetary stimulus. Low growth and high inflation? That sounds curiously familiar.

Spot the Asymmetric Shock

2011-10-15T09:51:00.000+01:00

The crisis in the Eurozone has dominated financial market sentiment over the summer. And so I shall restart my blog by asking the following question. What is an asymmetric shock? The question, of course, stems from the basic condition for a sustainable monetary union: that the kind of shocks that lead to changes monetary policy should be highly correlated across any such union. If they are not highly correlated this will place the sustainability of the union under pressure as member countries face less then ideal policy rates. The more a country is different from the average the more it larger the boom and bust we will will observe over succesive business cycles.

The chart above shows the soveriegn debt bond spread over the Bund (10 year German benchmarks) from 1993 onwards for the nations that went on to join the Eurozone. The changes in spreads represent changes in market prices for default risk, liquidity premia and domestic preferences for holding debt. What we note is that there was dispersion in bond spreads prior to the adoption of the Euro and again after the start of the financial crisis. The bit in the middle corresponds to both the heyday of the Euro but also the period of excessive liquidity creation by the financial system.

It would seem at first glance that going back my original question it is the first and third periods that suggest asymmetric shocks. And that it is the middle period corresponds to some elimination of differences. The compression of spreads in the middle period tells that financial markets were treating different sovereign debt instruments denominated in Euro as very close substitutes during the Euro's heyday. In effect, the markets treated the price of sovereign debt of countries that had different fiscal paths and growth prospects almost identically.

This equal treatment of unequals seems to me to have imparted the ultimate asymmetric shock. Rather than rationing debt with higher prices, the heyday of the Eurozone - possibly as the result of some form of implicit centralised guarantee - encouraged financial markets to treat the various nations' debt as identically priced and so cheap to issue by any government. In fact, many treated the convergence of spreads as evidence of Eurozone credibility when in fact it was storing up future problems. Some of these nations responded, in some degree, by issuing too much debt and not correcting dangerous fiscal paths. This meant that when there was a negative demand shock - a recession - some fiscal paths became unsustainable and financial market fears of default triggered contagion. Asymmetric shocks are in the eye of the beholder.

Financial Markets Finally Awake to Eurozone Risk

2010-10-11T15:18:00.006+01:00

This year the Eurozone has suffered its first existential crisis. Ongoing turmoil in financial markets has exposed the vulnerability of the public debt position in several Eurozone member states. The financial spreads amongst Eurozone countries against the benchmark (10-year German bond) Bund, which gauge the medium-term risk in the Eurozone, have not only escalated to historic highs but also have displayed increasing tendency to be skewed (roughly measured by the gap between median and average), as a group of countries are finally perceived as increasingly risky by financial market participants. A typical response to this crisis has been to ask for a Stabilisation Fund to support distressed Eurozone (EZ) economies and for meaningful restrictions to be placed on public debt levels for EZ member states. This may not be where to begin.

Two obvious factors explain the widening of these spreads, which in a credible monetary union ought to be negligible (as they should reflect mostly some small liquidity preferences for holding one country's public debt over another, with currency risk not really a concern). One of the consequences of the financial crisis is that financial markets are more willing to price risk into financial contracts and so a given quantity of risk, will wish to be paid a greater excess return than in the period prior to the crisis. The second reason is that the perceived quantity of risk has risen on average but also for some states in particular, as the first round response to tightening credit conditions and a contraction of world demand has been a large one-off increase in the level of public indebtedness.

The OCED report that that the level of outstanding government debt for advanced economies in 2009 was around 50% higher than its 2006 level (http://www.oecd.org/dataoecd/10/41/45988118.pdf, p. 19) but this alone seems unlikely to be able to explain the overall and specific increase in sovereign spreads. Part of the reason for the increase in spreads is their ‘compression’ to very low levels in the period leading up to 2007, which exaggerated the apparent change pre- and post-crisis. The question then is why did financial market prices, traded by highly intelligent and resourced investment bankers, for Eurozone sovereign debt display such insouciance to both the construction of a “non-optimal currency area” EMU and to the ongoing implication that public debt levels would have to rise as countries increasingly turned to fiscal policy to stabilise their domestic economies? What were the impediments to use of all available information? It is surely not that much news that certain Mediterranean states have public debt overhangs and were not especially well synchronised to the German economic cycle?

The favourite set of theories may be that there is a tendency for financial prices to herd, in the absence of full information. Some story involving the end of the business cycle, the longevity of the Euro, and belief in an implicit bail-out encouraged some herding which promoted a compression trade – buying higher yield sovereign debt funded in the currency of a lower yield sovereign. But a little more transparency on fundamental debt positions in the event of a prolonged asymmetric shock might have scared the markets into demanding country-level risk premia somewhat earlier. And so I can't help thinking that this kind of information and scrutiny on an on-going basis, alongside assessment of debt positions, may be of more value than a currency stabilisation fund.

How much growth divergence will spit the Eurozone?

2010-10-02T09:41:00.007+01:00

The main economic criterion for a monetary union across a set of economies is that they should be sufficiently synchronised so that the a single interest rate does a reasonably job in stabilising each economy in response to shocks. For this observation, Robert Mundell was awarded a Nobel prize in 1999. But even in any one long established nation state, this criterion often seems be a major challenge. In the UK, for instance as the story goes, the industrial north in the 1980s suffered a depression while south the benefited from a boom – on average there may have been some form of balance but perhaps not one that was ideal. This kind of schism also seems to have inflicted itself on the Eurozone.

A recession is a particular test of a monetary union, as it seems likely that the patience to accept slightly awry monetary policy from the perspective of any individual state may be more severely tested in a recession rather than boom. In this case, the credit shock that triggered the economic bust may have impacted in a different manner on the individual members of the monetary union and it seems likely that different countries may pull out of the recession more quickly than others, which implies a persistent divergence in growth rates. So has recession been associated with a wider distribution of growth rates in the Eurozone wider? Has it been associated with increased national differences in economic growth?

Let’s take a peek. The chart above gives the median year on year growth rate of members of the Eurozone (I exclude Slovakia, Malta and Luxembourg) and the inter-quartile range of annual growth rates, which acts to trim any extremes. Median year on year growth in the Eurozone was negative in the final quarter of 2008. The average inter-quartile range of growth rates was 2.4% prior to that quarter and it has been just over 3% subsequently. So there has been some increase in the dispersion of growth rates and in the first quarter of 2009, the inter-quartile range of growth was over 4%. So in principle, the one interest rate does not fit as well as it did.

But to me the increase is dispersion does not seem that great, I leave as an exercise the calculation of whether the differences in dispersion of growth rates are significant. Part of the reason here is that countries have been able to resort to an increase in public indebtedness to deal with their domestic output gaps. This response may well be a once-and-for all increase so could be replicated in the event of another downturn. But I do not know, and neither does anyone else know what the trigger point would be for a collapse in monetary union.

What is more important than the unconditional dispersion in growth rates in any one quarter across the countries, is the persistence of the deviation in any individual country from the median and what we can observe, even for Greece, is that sometimes it has been a winner and sometimes a loser so if the state can be patient enough EMU may even work for them, financial markets willing. (The chart below simply plots the inter-quartile range of growth rates and as red blobs year on year Greek economic growth.) We will return to that question next time.

Getting to Grip with a Double Dip

2010-09-20T23:00:00.014+01:00

All I seemed to get asked at the moment is whether there will be a double dip. By which, I think, people mean whether the economy will experience another sustained period of negative growth. The UK recession started in 2008Q1 and continued until 2009Q3, which was relatively prolonged by the 'normal' standards of industrialised nations. Since then we have benefitted somewhat from three positive quarters of growth. As to whether we will have more quarters of negative growth, unfortunately I do not have the answer – and we shall simply have to wait. The typical forecast error of one-year ahead GDP growth is well over 1% and probably nearer to 2% of GDP warns me to be careful in making predictions. So much so that I would have be forecasting strong GDP growth of well over 2% in order to be reasonably sure that growth would be positive in the year ahead.

As with many question of economic policy, this one is badly formulated. It may matter, to some extent whether we think the economy is going to grow at +0.1% or -0.1%, with zero demarcating the difference between a happy and unhappy future for all. And some people do believe in some notion of a stalling speed for an economy, under which low or negative growth rates are more likely to lead to sustained lower and more negative growth rates in future: such a view might be based on the conjecture on confidence-based feedback loops from growth to employment prospects and vice versa. But ultimately more or less growth over a short period is less important than the extent of spare capacity.

And so the questions about which we ought to be thinking hardest, are not only about the extent of spare capacity but whether it will ultimately be dissipated by strong positive growth in demand or the scrapping of output potential. If the former, the long-lived consequences of the financial crisis and subsequent economic recession would be minimal but if the latter then we may have to learn some very hard but also permanent lessons about relative impoverishment. The chart above shows real GDP in the UK, Euroland, Japan and the US relative to their level at the end of the second quarter of 2007, which you will recall was a month or so before the financial crisis took its grip and I have arbitrarily normalised that quarter’s GDP level to 100. I also draw a simple trend line (dotted line) from 2001 to 2010, which shows where we might have expected the income to be this year if we had been foolish enough to believe a straight-line forecast in 2007. Even though the various recessions seem to have ended, the gap between expected income and actual income remains very large. In general, we can see, there is a shortfall of around 5-10% between the expected level of GDP and current income. A double dip or not, what matters is the persistence of this gap, which can be only be eroded quickly by some combination of fast growth and supply side scrapping. When we consider the indebtedness of household balance sheets, a nervous corporate sector and a trickle of bank lending – it is difficult to see how demand will quickly erode the gap. And if the decision-makers on the supply side then think that the gap must be closed by scrapping output, then we will all be permanently worse-off. Double dip or not that is the real question.

Is a Love of Finance the Root of All Evil?

2009-07-23T13:14:00.005+01:00

There is a syllogism that has gained currency just as financial markets have been devalued. And it goes something like: (i) finance is dangerous (ii) the economy is in danger (iii) finance must therefore be constrained. I regularly attend conferences and hear a panoply of dirigiste sentiment directed against the financial sector, arguing that not only that financial markets and banks been the root cause of the final crisis but that they must now be bound like Prometheus to a stone. Though such a conclusion is tempting, it may not be quite right.

The critiques are well known: financial markets underpriced risk, created excessive liquidity and leverage, unbundled exotic near-worthless debt instruments and at the limit, often via hedge funds, promised semi-permanent excess returns. All activities that rewarded participants on the upside and ended up having government support on the downside. The argument then is that faced with such a skew in returns, too many resources have been devoted to financial activity. It is said that banks and financial institutions have become too large both in absolute size because they cannot then be allowed to fail without creating systemic risk and relative to the size of the economies they service. Maybe.

Let us rehearse the arguments about why finance matters. Finance allows individuals and firms to disconnect in time and space their abilities to earn and their abilities to spend and hence concentrate on one or other at any particular moment. The advantages of specialisation are clear – everyone can benefit from the greater production of goods and services by allowing agents inter-temporal as well as geographical options to share resources. But we do know that the efficient allocation of funds from savers to borrowers is subject to severe informational constraints and also various temptations to renege: the avoidance of these problems requires significant regulation, institutional capability and investment in reputation-building. These kind of first order problems do not in general sort themselves out and it is possible even to write about the vast sweep of economic development itself in terms of the history of solutions, failed or otherwise, to these types of problems.

So we can expect that alongside the development of financial instruments we will have to re-write the book of rules and regulations every generation or so, as we moved from heavyweight capital controls in the immediate post-war era under Bretton Woods to an era of neo-liberalism running from the late 1970s to about now and hopefully beyond. And so let us not take the initial premise too far in that the problems with the global financial system are best solved by reducing the size of that system because it seems likely that at least some of the problems stem from its incompleteness rather than its dominance. Let me illustrate: it is entirely proper that capital flows from “impatient” countries to “patient” countries and at some real interest rate the deficits of the impatient must equal the surpluses of the patient. Over time the patient countries will then build up claims or assets against the debts of the impatient countries. Now let us suppose that the patient countries become wealthier, say as their productivity levels catch-up, and all this extra wealth is saved, global savings will then initially exceed investment and interest rates will have to fall to clear the global market for savings, encouraging the impatient to become more impatient and increase their overall level of indebtedness.

For impatient read the US and for patient read China. Under this equilibrium real rates are low and capital flows uphill from fast growing to mature economy. The problem here is that the extra savings are all being sent to the impatient, as there are limited vehicles for the patient to invest in their own economy. In a closed economy, the extra income would have to be channelled domestically and domestic growth would be stimulated in order to use the savings. And so by the same token, if there is an inadequate development of savings vehicles in the patient economies then these savings will tend to drive up the prices of existing assets, for example, US Treasuries which will be in short supply. This global excess demand for assets hence drives down real interest rates raising other asset prices in turn, for example housing, equity or real commodities.

It is thus the lack of financial development in emerging economies which arguably lies at the heart of the problem of this financial crisis and not, perversely, the excess of financial development. An example from the most recent IMF Article IV report from October 2006 for China suffices to illustrate the point, which reports that the foreign exchange rate market remains tightly managed, there seems to be little development of bond markets even at maturities of less than one-year and little or now availability of bonds in the 1-10 year maturity range and equity markets seem not to allow firms to access the market. Overall the IMF view was that the “limited role of capital markets in China…reflects the dominance of state banks in intermediation, but these markets are plagued with regulatory and governance problems”. Obviously a report form late 2006 may well be rather out of date but it does clearly illustrate the point about a lack of liquid assets in newly emerging economies at the high watermark period of so-called financial excesses.

So rather than shunning financial market development, global policies ought also to think more about deepening capital markets and encouraging the development of assets across the risk spectrum, particularly in parts of the world where surpluses are being generated. By helping the development of such assets, policy makers will help raise global real rates, help prevent the conditions under which asset price bubbles will develop and also help get various parts of the world onto more sustainable growth paths that are not reliant on the capacious appetites of Western-style consumption alone. And if as a consequence, we become a little more patient and they become a little more impatient, then we have all become a lot closer to each other, which is a rather pleasant thought.

Those Can't Get Enough of Them Fiscal Blues

2009-06-25T21:13:00.009+01:00

In a recession it is easy to motivate some form of discretionary fiscal policy. Let us rehearse the arguments: aggregate demand is shocked downwards as real and financial wealth falls; under heightened uncertainty, consumption and investment plans are delayed; and the ongoing difficulties in obtaining (bank and other financial) credit seem likely to amplify the impact of these effects on the economy. Furthermore we can point to a co-ordinated international downturn, which not only is likely to increase the size of the initial shock but also limit individual country responses with no individual option available to increase external demand. Furthermore it has become clear that monetary policy has reached its limits, with the zero bound and resort to quantitative easing, which means that there is an "interest rate gap" to be mopped up by fiscal policy expansion.

So if we can agree that there is a demand gap going forward and fiscal policy is part of the answer, what form should the fiscal stimulus take? One background point first - there has been an upward shock to the level of public debt in all economies with substitution of private claims for public claims on banks and this means that all economies are nearer some notion of the threshold of public solvency than they were prior to the crisis. And implies that the overall room for manoeuvre is somewhat limited. The IMF use a number of key phrases in thinking about the fiscal response. That it should be timely (now); large (expensive); contingent (could be end up being even larger); collective (all join hands) and diversified (to deal with the uncertainty of multipliers in any one sector). What really worries me is that large is no substitute for well directed and that for any discretionary fiscal policy to work what it must put spending into the economy in exactly those areas where demand has been weakest during contraction, which implies to my mind that it is temporary in nature and well targeted rather than scattergun. For example, a scheme to help the recently unemployed maintain consumption or for idle construction projects to go ahead is preferable to one that raises the wages of public sector workers, even academics.

The temporary nature of the fiscal expansion is also key. If treated as permanent, the fiscal expansion is more likely to lead to higher nominal interest rates at term and hence crowd out private sector investment or expenditure as it will be perceived to reflect more probability of default or inflation risk. Obviously this kind of concern will limit the accommodative stance of monetary policy at zero nominal rates. Think flat LM curve with IS shocks and upward sloping LM curve with the same shocks - in the latter case with higher interest rates, output (and the multiplier) is lower. In this respect funding choices also matter - a government that raises discretionary expenditure with index-linked bonds may be treated as more credible than one that does so with nominal bonds and hence may be able to reduce the crowding out. It also likely to be the case that a more permanent increase in expenditure is one which people will save against. The Ricardian equivalence hypothesis may not work when there are liquidity constraints and when the government can borrow more cheaply than the private sector but if government behavior more clearly starts to resemble the private sector and of more equal risk, any advantage will be watered down.

So how should fiscal policy state what is does during a deep recession in order to maximise its effectiveness? It helps to start with monetary policy as an example. The solution to the zero bound problem for monetary policy involves some kind of commitment to inflate. Which is a long run commitment to do what is necessary to drive inflation up. This is possible because monetary policy ultimately controls the price level. But fiscal policy cannot promise to spend, spend and spend again to save the country it loves (passim Gaitskell) because that raises the spectre of fiscal solvency and increases the present value of the burden on tax payers, reducing their marginal propensity to consume. Ultimately we believe that income is supply side determined. In this sense fiscal policy is more like a one-off expansion of a deflated tyre - some air should go into the gap but not too much. The expansion should be just enough to offset deflation and leakages ought be minimised. And when the tyre gets back to the correct pressure all expansion must be turned off immediately.

So how can we answer the key question on fiscal policy? How vocal should fiscal authorities be about the exit strategy, by which we mean the relaxation of high levels of discretionary expenditure? The key is to ensure some belief in the government's present value budget constraint. That spending will be undertaken to the extent that it does not threaten fiscal solvency. But who should judge whether a government's spending is solvent? Certainly not the government itself or the(ir) IMF (representatives) and probably the financial markets should play a role, which they will do in the pricing of nominal and real government liabilities at term. But while QE continues it will be very hard to treat market prices as telling as much about the financial markets' views. And so under uncertainty about the preferences or ability of the government to cut back on fiscal expenditure, there needs to be some conditional plans about the path of real expenditure and revenue which are measurable. Which sounds very complicated and rather difficult to convey and so what so the danger is that we might end up with is something more of a random walk, which seems to increase uncertainty.

If we want to keep the public sector as large as it is now, there will have to be increases in expenditure and tax increases over the longer run. But some serious discussion about the appropriate size and role of the public sector is also required, which does seem somewhat bloated. So as well as plotting a course out of the current sequences of deficits, responsible government would also call for a debate on the appropriate size and government involvement in the economy, as well as the magnitude of both public and private indebtedness.

The Party's Over...

2009-04-22T16:45:00.002+01:00

...and here’s the bill. So now we know more clearly the cost of this bust (in which GDP is now forecast to fall some 3.5% this year) and it is shocking. Public sector net debt was 36.5% of GDP in the fiscal year 2007/8 and today the Chancellor has projected public debt to rise to just a shade under 80% of GDP by 2013/14. Public debt was previously as large as 80% of GDP in 1968 when the trajectory was still gradually adjusting downwards after WWII. This government’s self-imposed Golden Rule, or threshold, for public debt of 40% of GDP has been shattered with some £790Bn of borrowing planned over years from 2008/9 to 2013/14.

Admittedly, accompanying this debt projection are some plans for taxes to rise and for the growth in government spending to fall somewhat more than earlier plans. But these new plans represent second order modifications around a potentially explosive path. The risks to the path for debt to GDP seem to lie on the upside should the economy continue to remain longer in the doldrums and, which may follow, should there be further calls on the public purse to bail out financial institutions.

The big picture is that a large quantity of debt, created during the long 1990s expansion which ended in 2008, has now been transferred from the private sector to the public sector. And the trick that the public sector is trying to pull off is to smooth the increase in taxes that need to be levied on the private sector to pay-off these debts. But the danger is that financial markets will see through this trick and start to treat the public sector as more risky, like the hapless private sector, and that is why the initial reaction has been for bond yields to rise some 8-10bp. Now where’s that aspirin?

Are we in another Great Depression?

2009-03-03T22:55:00.003Z

Too early to tell. The chart below shows data from the Angus Maddison’s well known dataset on long run growth in world economies (the data can be downloaded from http://www.ggdc.net/maddison/), which compiles national data sources into a comprehensive annual dataset. The data was mostly constructed postwar by various academics and research institutes in the countries concerned, that is after the fact, and is probably subject to some huge measurement errors but I found the chart highly instructive when thinking about the scale of the recessionary problems we might face in comparison to the so-called Great Depression.

Before discussing the chart, let me point to an old debate that seems to have been re-ignited between those who judge business cycle phenomena such as a possible Depression to be the result of shifts in productive potential or whether such phenomena are always the result of demand deficiency. Peter Temin (MIT, JEL, September 2008) recently reviewed work by Tim Kehoe and Ed Prescott (Minnesota School, Response FRB Minneapolis, December 2008) on the causes of Great Depressions and severely questioned the basic hypothesis that it was possible to think of the Great Depression as resulting from the former rather than the latter. In recent work, Kehoe and Prescott point to a sharp fall in US productivity in 1929-33, which was associated with a sharp fall in labour hours which did not recover even when productivity recovered later in the 1930s. Temin argues that: “(a)ny description of sort run macro events needs to pay attention to the effects of monetary and fiscal policy”. I am very sympathetic to the Minnesota School but when I start to think about the current debate and possible causes of this downturn, in a world of immense and prolonged analysis, I have seen little or no reference to a productivity slowdown as a cause of the financial crisis. Maybe it will come.

Turning to the data. The data gives us 1990 US$ price GDP in a variety of countries and I simply normalise the GDP at 100 for 1929 and see when output returned back to its previous level for a few countries. The results surprised me. The UK seemed to have a relatively mild output recession following its exit from the Gold Standard in 1931. Following my previous blog, it is remarkable how often the exchange rate helps adjustment in the UK. The US did not return to its previous output level until 1936/7 but that masks positive growth from as early as 1933.

In some senses the US path is probably the worst we might expect given an absence of effective countercyclical monetary (Friedman and Schwartz, 1963) and fiscal policy and the adoption of protectionism, which exacerbated negative trade multipliers. The stylised fact for the Great Depression is that world trade (exports plus imports) in 1913 US$ constant prices was around US$36bn in 1929 and fell to $25bn in 1938 i.e. around 33% and world output over the same period moved from US$241bn to US$270bn, which meant that the fraction of trade to GDP fell from around 15% in 1929 to 9% by 1938 (Estevadeordal, et al, QJE, 2003).

For obvious reason, we may not want to dwell on the militaristic solutions in Japan and Germany but, at a stretch, these might be analogous to making some kind of point that with the right kind of demand management, economic growth might return quickly and rapidly. So the question then is whether extreme monetary and fiscal policy stimuli currently being developed are sufficient to drive demand in the absence of much global demand (recent market inflation expectations data suggests this might be the case)? And under what circumstances will the saving nations (e.g. China) shift their investment functions outwards – as this will probably require some reform of their financial institutions it will probably not happen anytime soon? A financial crisis is difficult as it impacts on demand, as agents’ wealth and ability to smooth consumption evaporates, and it impacts on supply, with capital and labour shedding resulting. So we know that output will fall and demand management can have, at best, a temporary impact. So in the end the authorities simply do what they can, given tremendous uncertainties, and hope that confidence returns.

Whither Sterling?

2009-02-04T17:47:00.007Z

Much ink has recently been split on the causes and consequences of the sharp decline in UK exchange rate. The bare facts look to be a concern, since mid-September 2008 sterling has fallen by 14% against the Euro and some 25% against the US dollar. In combination with the confirmation of a deep recession, it seems that the world is shunning the UK. The speed and extent of the decline is remarkable and is not dissimilar to that which occurred in the days and weeks following ERM exit in September 1992. It is even argued that if Sterling is to lose its role as an international store of value then far better to consider joining a large currency zone where the external unit of value cannot be so easily buffeted around by gales blowing though the world of international finance.

So just how much of a problem is the depreciation of Sterling and does the scale of the decline provide a potential cure or kill for the UK economy? The Chart (below) shows a weighted average of the UK exchange rate versus the US$ and the Euro on a daily basis since 1985, with down signalling a depreciation in Sterling. The red-line shows the ratio of share prices in banks relative to those of the FT All-Share Index and is a measure of the news on banking profits relative to the whole economy. We can see that ERM exit was broadly a good thing for bank shares, most probably signalling that UK policy rates were more likely in future to reflect domestic growth prospects – implying that the bank profitability would benefit from such a re-direction. Furthermore, in the mid-1990s, once growth had been re-established Sterling did recover its previous level. On the other hand, we can see that the more recent fall in the exchange rate after the start of the Credit Crunch in 2007 (vertical line), seems to have been driven (at least in part) by the relative downgrading of bank profitability compared to the rest of the economy. In other words rather than being an exogenous cause of bank profitability and recovery, the widespread perception that this crisis will continue to constrain financial intermediation for some time to come may have led to a fundamental re-assessment of the Sterling’s fair value.

So where is the gain from the fall in the currency? Those involved in international trade will not be pleased, importers of goods and services will face higher bills and yet because of weak UK demand may find that it is not possible to pass on these higher costs and their profits will be directly reduced. Exporters may superficially benefit but much of UK exports are simply added value to imported raw materials or component manufacture and so the direct gain will be somewhat militated. It also seems likely that international corporations may dislike to notion of being sited in an economy where the exchange rate fluctuates widely as this will tend to disrupt profit forecasts and the lead to volatile remittances priced in foreign currencies.

But even if the exchange rate channel offers a rather weak form of direct support, it might be that every little bit helps. And so to the extent that the fall in sterling simply reflects an anticipated reduction in interest rates in the UK relative to those overseas, then exchange rate adjustment may help the economy adjust to its new equilibrium following a constellation of shocks. For the UK economy a list of these shocks might include: (i) a persistent downward shock to the value of financial intermediation; (ii) a downward shock to asset prices and hence net wealth; (iii) a realisation that the household balance sheet was becoming too heavily indebted and (iv) a global reduction in overall demand for UK goods and services.

As well as the possible impetus to net exports there are two further ways that the exchange rate depreciation may help the UK economy. First in the midst of mounting deflation pressures, a large exchange rate depreciation offers a one-off increase in the UK price level that will hold those pressures in abeyance for some time. The depreciation will increase the price of traded goods and lead to a temporary inflation as the increased costs of imported goods feeds though the economic pipeline as typically it is still the case that there is a large pass through from a nominal exchange rate change into the domestic price level. By keeping inflation temporarily higher than it would otherwise be, the economy may avoid some of the problems brought about by too rapid a disinflation. Secondly, the reduction in the foreign currency price of UK assets means that they may now offer a good prospective return in foreign currency terms and lead to some support for both the domestic housing market and equities from foreign capital, which may be looking for a place to park itself.

The danger really is that the depreciation in Sterling hinders in some way the government’s ongoing ability to deal with the financial crisis. By which I mean that we can characterise the policy response to the crisis as a transfer of risk from the private to the public sector, as we are using public debt to hoover up private debt contracts. If the decline in the exchange rate becomes widely thought of as a reflecting risk in the UK, rather than an adjustment associated with economic fundamentals, then the upper bound on the government’s ability to sell its debt will bite somewhat earlier than would otherwise be the case. And that in the end is the real risk from a Sterling sell-off – that it somehow signals looming fiscal insolvency.

Orthodox and Heterodox Monetary Policies

2009-01-13T23:36:00.004Z

The financial crisis has shaken some core beliefs of central bankers as they find themselves running increasingly heterodox policies. Having spent much of the last two decades developing simple rules about the operational conduct of monetary policy, they now find that this new rule book has to be torn up. Although initially controversial, the adoption of the interest rate as the main operational instrument in pursuit of a clearly defined policy objective had become a near universal article of faith.

But with interest rates heading towards zero and having little impact on lending behaviour, because a freeze in financial intermediation, central bankers have had to think of new policy measures. Attention is moving from the price of money to ensuring that a sufficient quantity of money is held by the private sector in order to effect transactions. In this blog I outline the crossing of the central bank Rubicon.

The nice, linear story central banks liked to tell about monetary policy was illustrated in my blog: Deflation: A Real Problem and a Possible Cure and also in a recent working paper. The policy rate sets the base level for the funding costs of the banking sector and acts as the floor to financing in a given currency. Central banks ensure that the policy rate remains at or near the floor by draining the overall banking system of reserves and selling these back at the policy rate via open market operations, which have no monetary consequences. The hidden assumption in this framework is that the constellation of all other market interest rates, from interbank to long term corporate bond rates and beyond, will respond proportionately to any impetus from the central bank’s policy rate. The set of market interest rates are thus thought to be akin to a sequence of mark-ups over costs, related to the costs of monitoring credit and market risk. And so much of the transmission of monetary policy operates through its impact on other market interest rates.

When setting the policy rate, the central bank commits to supplying central bank money perfectly elastically at that interest rate to commercial banks. At lower interest rates, the demand for narrow money should increase, as the opportunity cost of its holding has fallen, and this extra demand is satisfied by central bank provision of base money. The expansion in narrow (central bank) money is multiplied through the economy by the money multiplier, which is the extent to which commercial banks increase their balance sheets by more than the amount of narrow money alone by extending bank credit to the private sector. And it is arguably this money multiplier that has collapsed in the current banking crisis.

In the stylised balance sheet of a fractional reserve commercial banking sector, commercial banks hold central bank money as liquid assets and loans as illiquid assets. Loans to the private sector will ultimately correspond to deposits by the private sector in the banks, which are liabilities. The ratio of broad to narrow (base) money is the money multiplier and so we can observe that when the market for central bank money clears at a higher quantity and if the money multiplier remains constant, then broad money will expand by the change in the central bank money times the money multiplier. To the extent that broad money is required to fund private sector transactions, a change in broad money will correspond to a given level of nominal transactions. If the banking system is unable to convert base money into a sufficient quantity of broad money activity may suffer in the short run and over the longer run a deflationary impetus will be established.

Clearly when and if interest rates arrive at zero, central banks can no longer control the policy interest rate via open market operations and so monetary policy is driven by the need to set the quantity of base money in circulation directly. Furthermore if financial intermediation is severely impaired, policy may also have to provide a direct impetus for the creation of broad money liabilities and this is our working definition of quantitative easing.

The central bank balance sheet typically comprises assets of foreign exchange reserves, loans to the government, bonds, claims on banks and on the private sector. Liabilities comprise currency, commercial banks’ reserves deposited with the central bank, central bank securities, government deposits and any capital reserves. Central bank balance sheets are typically dominated by the main liabilities of base money (notes, and in some cases coin, on issue) and foreign assets and claims on financial institutions.

When the central bank effects a purchase of government bonds, the following changes to the balance sheet occur. Central bank assets will rise and liabilities will expand by the exact amount of currency issued to pay for the bonds. The currency is remitted to the commercial bank, government or insurance company from whom the central bank has bought the asset and this will be measured as a commercial bank deposit. And so the purchase of government bonds will show up as both an expansion of the central bank balance sheet, an increase in base money and an increase in broad money.

At some point in the future, the central bank can close out its position in government bonds by selling back to the private sector the bonds it holds on the asset side of the balance sheet, soak up the currency created and deflate its balance sheet. This begs the question of what is the initial purpose of buying government bonds? The hope is that by creating more short-term deposits in the commercial bank sector, this will generate commercial bank lending, given a reasonably stable money multiplier. The problem is that when commercial banks are uncertain about both the availability of future liquidity, losses from past lending and the riskiness of new lending in a recession, the new monetary liabilities may not translate very easily into new lending.

And so central banks have already gone further. The purchase of commercial bank assets and mortgage backed securities at discount provide both succour to commercial banks’ balance sheets by providing liquidity against possibly undervalued long term assets, as well as expanding broad money, and the possibility that central banks may profit from the resale of these assets. The open questions here are then at what price are these assets bought – not so high as to endanger the sustainability of the central bank balance sheet but not so low as to question the sustainability of the commercial banks and to discourage their future lending.

With such a large expansion of the central bank balance sheet, central banks increase the relative supply of short term debt (including central bank debt) to long term debt, which should lead to a change in the relative price of short to long term debt, with the latter becoming relatively expensive. And if long term interest rates do indeed fall during a quantitative easing then the private sector will have an incentive to invest as the user costs of capital falls, household balance sheets should be ameliorated with lower interest and debt burdens and asset prices should be stabilised, underpinned by lower long term rates. The question then is when all this activity starts to take off when will inflationary pressures start to re-emerge?

Deflation - a real problem and a possible cure

2009-01-08T20:59:00.007Z

I ended my previous post with the question: so what’s the problem? And I suppose it is Deflation. A persistent deflation poses particular problems for monetary policymakers because with nominal policy rates facing a lower bound of zero, central banks can, in principle, lose control of real rates that will continue to rise if inflation expectations follow inflation down. Deflation is, of course, not a new phenomenon and prior to WWII year on year deflation was over the long run as likely as inflation but as long as inflation expectations remained in line with notions of long run price stability real rates would perhaps not destabilise the economy. The real worry for policymakers as we head into a deep recession is that inflation expectations fall markedly in line with deflation. Wide-ranging monetary and fiscal policy responses will then be designed to try and prevent a significant and persistent fall in inflation expectations.

Over the past decade or so we had become used to the following story about monetary policy. Short-term policy rates are nudged, with some reluctance, in one direction or another in order to limit the deviation of short-term inflation forecasts from an explicit (or implicit target). These short-term inflation forecasts are projections of the output gap and so the basic story says that by stabilising inflation, output is kept as close to potential as possible at the same time. The parable finishes by soothing us with the observation that providing the economic shocks are not too large and monetary policy continues to have traction on the economy via its influence on financial prices, then the economy should tend towards stable outcomes.

This nice, linear story is illustrated in Chart 1 (see http://econpapers.repec.org/paper/ukcukcedp/0815.htm for more details). Here we show a Fisher equation, which relates short-term nominal rates equiproportionally to inflation (or inflation expectations). The intercept corresponds to the economy’s natural real rate, which is essentially exogenous to monetary policy and is closely related to the expected growth of per capita consumption. The inflation target determines the long-run expected level of nominal rates, which are equal to the natural real rate and the inflation target. The central bank’s policy reaction function is to respond actively to any expected deviations in inflation from target and so is drawn steeper than the Fisher equation line so as to suggest policy induced real rates that are lower or higher than the natural rate, when inflation is correspondingly lower or higher than target, which acts to boost or bear down on demand as required.

But things can change quite radically once we move out of this comfortable little space. Specifically, if inflation starts to decelerate quickly, the central bank can find itself bumping near to its zero bound on nominal rates and might, in principle, lose control of its ability to set real interest rates. At this point short-term debt instruments and money yield near-identical nominal returns, and given that bonds bear a default risk, there will be a strong preference to hold liquidity in the form of cash. This means that even though the central bank will continue to supply private agents with escalating levels of narrow money to meet this increased demand, it will not be spent and demand will not emerge to chomp up the large output gap.

Chart 2 shows the limits to the standard mode of interest rate control. Once nominal rates hit zero at Point A, if inflation continues to fall real rates will then start to rise. And so there is a possibility that the output gap will get even higher as rising real rates bear down even further on demand, leading to a loop of lower inflation, higher real rates, lower demand and even lower inflation. The classic answer to the deflation trap is that at some point money demand will be sated and the decrease in the price level will mean that money holders will feel wealthier and start to spend. But in a world of debt that may not be sufficient because if those money holders are also indebted, the fall in the price level will increase the real value of their debt and so ultimately the existence of a deflationary trap will depend on whether the increasing indebtedness of debtors outweighs the increasing wealth of money holders.

So will a deflation lead to a complete economic collapse? Not necessarily. Chart 3 shows two annual inflation distributions in the UK from 1800 to 1947 and again from 1948-2007. The first distribution seems reasonably symmetric around zero and suggests that deflationary years approximately matched inflationary years in the nineteenth century and the first half of the twentieth century. Subsequently, we have hardly any evidence of deflation to draw upon, with inflation mostly moderately positive (with occasional lapses in good behaviour). It is not at all clear that we can make a simple comparison between a financially complex economy and one that was still in the midst of industrialisation. But one clear distinction can be made as there seems to have been long-run price stability in Britain in the earlier period: which implied offsetting years of positive and negative inflation, but these did not necessarily bring about sustained economic crises. Why?

One reason might be that the maintenance of long-run price stability means that a temporary deflation, which lowers the price level, was also accompanied by expectations of an inflation, which would return the price level back to its long-run average. The advantage of a positive inflation expectation during a deflation is clear because even though current inflation falls, expected inflation rises and this means that the expected real return on stable nominal rates falls. And so the likelihood of a deflation taking hold in a persistent manner may be significantly mitigated.

Unfortunately, in the current deflation scare, in the UK inflation expectations have moved very much in line with current inflation, which is rather unfortunate and suggests that credibility, the belief in the inflation target, may be less than complete. The rise in CPI inflation from 2004 to 2008 was accompanied by an increase in both breakeven inflation and NOP inflation expectations and as CPI inflation has started to decelerate in the second half of this year we have almost immediately noticed a decline in inflation expectations. The nominal anchor seems to be being dragged around by contemporaneous developments and hence the monetary constitution may ultimately be in need of some reform.

An important part of the answer in dealing with a deflation is to conduct monetary and fiscal policy in such a manner that inflation expectations do not fall along with prices: that, in fact, as far as possible they remain at or near the inflation target. Convince agents that inflation will be higher in the future than it is now, so enabling real rates to fall as nominal rates fall to zero. And so if the risk of deflation is real, and in the most recent Inflation Report the Bank of England placed the probability at around 20%, we can expect a highly accommodative monetary and fiscal policy stance to be maintained.

The Portfolio Approach to...Monetary Policy

2008-12-16T18:08:00.008Z

Let me start with a poser. You have the chance to allocate your income across two assets A and B, which currently trade at the same price. The eventual payoff from holding these assets depends on one of two states. You do not know which will occur but are given the probabilities of each state at 0.5. Which asset do you hold?

Your choice on relative assets holdings will, of course, depend on the payoff in the various states. In the example below, the expected payoff from Asset A is 5 (10*0.5+0*0.5), as is the payoff from Asset B (2*0.5+8*0.5). So should you be indifferent between holding asset A or B? Not necessarily. Let imagine you decide to hold A, then you will receive either 10 or 0, when the state is revealed. Similarly if you decide only to hold B, then you receive 2 or 8, when the state is revealed. But if you hold 50% in A and 50% in B, then you will receive 6 or 4 when the state is revealed, which may be preferable to the outcome from holding only A or B. Note that your expected return across the states is the same and is independent of your allocation in this case but the variability of your payoff across the states can be reduced by choosing a combination of assets in inverse proportion to their variability. So if we choose 3/8 in Asset A and 5/8 in Asset B, we will have an income of 5 whatever the state turns out to be and this may be preferable to the alternatives.

The observation that an investor is likely to have mean and variance in his or her utility function won Harry Markowitz a Nobel prize in 1990. And there are a number of areas to which we may be able to apply these insights. Let us, for example, use this framework to think about the recent monetary policy problems facing the UK. It is becoming fashionable to argue that the Bank of England’s Monetary Policy Committee (MPC) should have responded in a forward-looking manner to offset the strong possibility of recession and so cut policy rates much earlier and decisively this year. Using our previous analysis would such a policy have been especially wise?

Imagine that Asset A is inflation and Asset B is output and payoffs are negative rather than positive. So the policy maker’s problem is to minimise losses by choosing an appropriate path for Bank Rate. So under X1 there is an inflation problem and something of a downturn and under X2 there is no inflation problem but a severe downturn. Should the MPC have kept interest rates mostly on hold, because of offsetting risks, until it was clear which state would obtain or taken a gamble and judged that X1 was simply not going to happen? In other words should the MPC have behaved like a speculator with his or her own strong prior beliefs and plumped for one outcome or the other? Or more like a portfolio manager and adopted a policy that delivers some stability in either possible state?

Some MPC members and one in particular seem to have adopted the speculator’s stance to go overweight on one asset rather than manage the possible portfolio of risks. Some might consider this to be a dangerous way to set policy because even though you may get lucky, and the inflation threat may dissipate, you may also get very unlucky and exacerbate the inflation threat. The MPC as a whole plumped for the portfolio approach. In the August 2008 Inflation Report (http://www.bankofengland.co.uk/publications/inflationreport/irspnote130808.pdf), the collective judgement of the MPC was that there were upside risks to inflation and downside risks to output and so like our portfolio manager they played it safe and did not move interest rates radically until it had become clear on which side the risks emerged.

The financial markets were perhaps more circumspect (!) than some MPC members. The chart below shows the five year inflation forwards calculated from the difference between the yield on nominal and index-linked (real) government bonds, which are linked to the retail price index (RPI). It is not a simple matter to interpret the inflation forwards as necessarily measuring inflation expectations as they may encompass either or both of inflation and liquidity premia. But if we hold those concerns to one side temporarily (and perhaps heroically), we can see a drift up in the expected inflation rate five years ahead from mid-2002, possibly reflecting concerns about the house price boom and second round effects from oil and commodity price rises. And throughout this year these inflation expectations also continued to drift upwards and it seems that only after end-August did these start to fall, and then somewhat precipitously. (Some of this fall seems relate to a flight to liquid assets as the financial crisis once again took a turn for the worse.) And that was the time interest rates should have started to fall as we found out that we were likely to have arrived in State X2. Since that August Report, Bank Rate has come down in three large steps from 5% to 2%, so what’s the problem?

The US Presidential Election Results – what did the markets predict?

2008-11-05T12:55:00.006Z

It is a truism often stated that what seems obvious with hindsight looked less obvious before the fact and this is no less so in the realm of finance than politics. And so as we all start to debate the inevitability of President-elect Obama’s victory it is worth reminding ourselves to what extent this result was in doubt as we approached the election date. Prediction markets are a useful device to check the extent to which we dabble in ex post rationalisation. They allow agents to trade the likely outcome of economic and political events in real-time in advance of and all the way up to the event itself.

The charts here show one well known prediction market run by Iowa University (http://www.biz.uiowa.edu/iem/). There were two US Presidential markets: the first for the respective share of Democratic and Republican votes and the second a winner-take-all market for the Party that would secure the greater number of votes. The vote share market represents the purchase or sale of futures on the Democratic or Republican share of the popular vote. On expiry, after the election, the future will be worth the fraction of US$1 equivalent to this percentage share. So, for example, early indications suggest that the Democratic share of the popular vote was 52% yesterday and so the price of the Democratic contract on expiry will be likely to be around 52 cents - meaning that anyone who bought at less than 52 cents or sold at more than 52 cents, prior to expiry, will make money. The official source for the liquidation price will be this Friday’s New York Times.

The first chart shows the prices of Republican and Democratic contracts since the contract started trading in June 2006 and we can see that apart from some glitches in May this year, there seems to have been a consistent lead for the Democrats, with some evidence of an increasing divergence since mid-September, after the collapse of Lehman Brothers. I do not have data on previous elections to hand but the consistency in the lead for the Democrats is interesting but so perhaps is the relatively small difference projected in the share of the popular vote. The spread of prices on the close Monday 3rd November data was 53.4-54.1 cents for the Democrats and 46.1-47.0 cents for the Republicans, which seems to have turned out to be reasonably accurate.

The second market is a simple horse race bet on which party will win the greater share of the popular vote with the all the pot distributed to those betting on the winner. In this case, the winner-take-all future is bought on either of the two parties at a discount to $1 with the sum of the prices equal to one dollar. The payoff on the contract, to those holding a future on the winning party, is paid for by the losses of those holding contracts in the losing party. Again the liquidation prices will be set by the report of the election in this Friday’s New York Times. So let us suppose that there was a 50:50 chance ex ante of either party winning the major share of the vote, this would be reflected in an equal amount of money being placed on either possibility and the prices of the two futures would trade at 50 cents. If this market felt that the Democrats became more likely to win, the price of the Democrat future would rise and that of the Republican future would fall. And in this case, as the Democrats have received the majority share of the vote anyone holding a contract for the Democrats, for which the price on Monday 3rd November close was 90.3 cents, will be paid $1 and anyone holding a Republican contract for which the price on Monday was just under 10c will get nothing and lose their stake.

The second chart shows a similar picture to the first, in terms of a consistent lead for the Democrats but also suggests that after the re-emergence of financial turmoil in September betting on the blue corner took a hold. With prices of the futures going from 53c on September 12th to over 90 cents by Monday morning, representing a 70% return in under seven weeks. Clearly Democratic Party Futures were the hedge against stock market turmoil. The prediction markets do seem to tell us that the Democrats were the most likely winners all along but it was perhaps only after the further bout of financial turmoil in September that this became very likely.

There are, of course, many reasons why we should not trust the signal from prediction markets completely. The financial stake may not be meaningful (in Iowa prediction markets investments are limited to between $5 to $500 per investor). Relatedly, liquidity may be low and prices thus too sensitive to lumpy trading. And the markets may simply reflect other evidence from opinion polls rather than promote a process of information discovery. But as a device for aggregating information across diverse individuals and for allowing a hedge against unwanted outcomes, these types of markets may well be able to help all markets become more complete. If you happen to be a Republican supporter my commiserations, but if you had also bought those Democratic futures at 53 cents in September you may not have felt quite so miserable this morning!

Global Imbalances - The Basic Story

2008-10-31T07:55:00.012Z

One of the root causes of the financial crisis has been the unnatural sight of capital flowing uphill, that is from poor to rich countries. In a famous calculation, Robert Lucas (1990, AER) showed that if a rich and poor country have equivalent production technologies and differ only in income per head, then because the amount of capital employed in the poorer country will be less than in the richer country, the marginal efficiency of capital must be higher in the poorer country and so attract capital. For example, latest EIU data suggests that Chinese PPP per capita income is around $5,000 and the US is $45,000 which implies (calculation available on request) that the rate of return on capital in the US should be around 3-4% of that in China and should mean that China runs a current account deficit financed by a US surplus. The reality has, of course, been the obverse with US recycling China’s capital flows.

Let us examine the basic problem. Global savings equal investment at a single world interest rate (absenting risk). Figure 1 draws the equilibrium for the two country world of China and the USA, given their savings and investment schedules. In a closed economy, US interest rates would clear the domestic market for saving above R* and output would be determined accordingly. But when we open up to capital flows at the world interest rate, R*, the US expands its investment demand relative to savings, running a deficit, and at those interest rates China generates a current account surplus. The surplus (deficit) in each year adds (reduces) to net foreign assets in each year in the creditor (debtor) country.

The counterpart of savings excess in China is excessive investment in the US - recall that this comprises both public and private investment. Is a small reduction in US demand (investment) the answer? Not necessarily. Even if demand falls sufficiently to eliminate the US current account deficit at stable world rates, R*, then China would still have excess savings. This excess would drive rates down from R* and lead to the re-mergence of a current account deficit, albeit with lower world rates and a lower level of global imbalances. Obviously with large enough falls in US demand you could get zero current account balances in both countries at very low R and low US demand. Perhaps this is the solution, as we stare at a global recession, that we are heading towards?

We can also consider a number of alternative solutions. For example, a shift up in Chinese demand to clear the surplus at R*, at the original equilibrium, will mean excess demand in the US continues and thus world rates R* will go higher and there will still be a Chinese surplus and a US deficit. Obviously again if Chinese demand shifts up even further we can have no capital flows but at significantly higher world interest rates and high world demand. This may not be the solution we are heading towards!

The problem with this diagram as far as I can see is that any R can lead to an initial equilibrium providing China is willing to lend (or borrow) and US is willing to borrow (or lend). And what we learn is that if we want to adjust to some different level or direction of capital flows is that if only one country adjusts the overall change in rates and output will be greater than if they both adjust somewhat.

So what is the constraint or target? It must be something to do with the equilibrium level of net foreign assets to GDP and flows from one country to another to meet that target. The US is a debtor nation, (at around 6-7% of global GDP) implying that its current demand will be met by saving from higher future income. In this scheme (and I do not know the actual numbers but according to the IMF’s WEO Emerging Asia is in credit by around 5% of global GDP) then China will be the creditor. But for the reasons given earlier China should probably be the net debtor and borrow from its higher future income. And so if we are to get to a situation when eventually China becomes a debtor so capital flows downhill (from rich to poor), this will imply the need for a surplus in the US and a deficit in China, which implies lower US demand, greater US savings, higher Chinese demand and lower Chinese savings. But we probably knew that!

Here’s That Rainy Day

2008-10-23T11:02:00.007+01:00

Like the visitation of a medieval plague, Recession seems to have returned to our shores. These events are rare. So what exactly is a recession? I quite like Christopher Dow’s (Major Recessions, Britain the World, 1920-1995, OUP, 1998) definition of a fall in the level of GDP in one year compared to the previous year. According to Dow we only had five major recessions in the post-WW1 20th century (three after WWII) and it looks as though we are about have our first of the 21st century. In a book which will now be re-read, Dow finds that in these recessions, which typically have duration of around 1-3years, the level of output typically falls by up to 10% below the level it would have arrived at if trend growth was maintained. (He attributes around half this fall to a reduction in productivity.) During these episodes unemployment typically rises by up to 3-4% points.

A key additional finding is that recessions seem to have been unpredictable in real time, reflect changes in demand as much as any supply reductions and occur nearly simultaneously in major economies. Clearly the simultaneous occurrence of negative growth across economies might well be a candidate explanation for the severity, as trade multipliers will be running at full pelt. I do not know whether this recession will be a major one or not but the extent of the fall today in Sterling (closed on 22nd October 88.3 compared to previous day at 90.4 with Sterling falling over 6c against the US$ alone) and in the equity index (FTSE-100 and FTSE All-Share both fell by over 4%) suggests that the financial markets expect both a strong negative domestic interest rate response, which drags down sterling, and a large fall in corporate profitability, which drags down the equity index (recall that equity prices should be present value of expected corporate profits, which are in return a function of output).

In a speech on Tuesday, the Governor of the Bank of England gave two reasons for the recession. The credit market shock, which has deprived household and firms of liquidity against their collateral in some degree and so reduced demand, and a global price shock to fuel and commodities that has reduced household disposable income, rather like a large unanticipated tax rise levied by a foreign government. I suspect the financial shock has another consequence. The impecunity of the UK household balance sheet has been exposed - as perceptions of net wealth have been eroded with sustained falls in asset prices. And this means that the UK private sector balance sheet, currently well in deficit to the tune of around 5% of GDP, is certainly even more in need of a sustained bout of savings, which will surely reduce demand further.

Each of these arguments concern demand and so can, to some extent, be offset by appropriate interest rate policy. The Table above dates the trough and peak in the business cycles around the time of Dow’s major recessions. I also note level of policy rates at around the same time with their nearest peaks and troughs.

The peaks in interest rates occurred sometime after the business cycle peak but there is no clear pattern in the interest rate troughs (as in the most recent recession, policy rates were constrained by ERM membership). When inflation was more of a problem, in the earlier recessions, interest rates did not move especially far in proportional terms – falling by around 25-30% of their peak value in both cases. But when inflation was reasonably under control, as in the most recent recession, interest rates fell by a much larger fraction, by around 65%. If we mechanically apply these boundaries to the current scenario, we arrive at a corridor for base rate at 4.00% to 2.00% as the floor this time round. Clearly the current consensus is for inflation to reduce radically as commodity prices fall in response to lower world demand and the increasingly large negative UK output gap drives down pricing power of firms.

And so we might conclude for the moment that the markets have priced more of the latter scenario in than the former and hence the large exchange rate and equity price responses we have observed. But as ever we shall have to wait and see what that rainy day actually brings.

Part-Nationalisation of the Banks and the Tide of History

2008-10-14T12:55:00.003+01:00

At school I learnt about Atlee’s post-war Labour government nationalising large swathes of the British economy. At about the same time in the real world, there was a prolonged period of de-nationalisation of many of those self-same swathes under the Tory government of Mrs T. The tide of time had first pushed up the size of the state, partly in response to the fatigue of war, and then cranked it down again, as the wave of free market ideas reached an apogee and I thought that was that. The part nationalisation of three major UK banks yesterday, following the nationalisation of Northern Rock and Bradford and Bingley earlier this year, seems, by general consensus, to have been as unavoidable as it was surprising given the recent tide of ideas.

In fact, as recently as this spring, I argued at a Public Policy Round Table that the state had already become too large and that during a sustained period of full employment growth a succession of government budget deficits, since the fiscal year 2002/3, did not make a great deal of macroeconomic sense. I argued that we needed a commitment to a smaller state and with it would come the room for manoeuvre the Bank of England would need to cut interest rates and offset the ongoing credit market shock. The sequence of deficits meant that the public sector net debt to GDP, excluding bank liabilities, was pushing pretty hard at the government’s ‘self-imposed’ target of around 40% to GDP. But the bail out of the banks now seems to have made my wish for a smaller state pretty unlikely as public debt looks likely to swell to postwar levels, which will in the longer term increase the incentive for a bout of sustained inflation and cause me to dust off my textbooks on the dangers of public ownerships and directed state action.

So how did we overturn the tide of history over a weekend and (partially) enact an infamous promise in the 1983 election manifesto of the Labour Party to nationalise the banking system? The short answer is that the banking sector found itself desperately short of capital and could not find sufficient funds from the private sector to raise that capital. The irony is that banks normally stand on the other side of this problem, as they are themselves reluctant to lend to individuals who need capital and ask for significant collateral or evidence of good standing before parting with any money. Or as many a businessman has put it, banks do not give out umbrellas when it is raining. But in this case, there has been no rain for a long time and a drought has resulted as liquidity has dried up and many of our banks have had no option but to buy some water from the largest reservoir in town: The State. For exercising that right to buy, they have given up a controlling stake in their future.

To recap, the UK government, in a plan that seems now to have been mimicked throughout the world, has taken preference shares (hybrids of debt and equity, where an fixed dividend rather than a profit share is paid to holders and where holders have senior claim on assets in the event of any liquidation) in three major UK commercial (or high street) banks. These preference shares mean that the government in return for an injection of £37bn owns over 55% of RBS and HBOS and around 43% of Lloyds TSB. The UK government thus has a (temporarily until the share are sold back) controlling stake in these banks. It has also offered to insure interbank lending for UK banks providing they re-capitalise privately or through the state. Recall that interbank lending has all but ceased and the interbank rate spread over LIBOR has shot up to reflect both liquidity and credit risk. The insurance, if appropriately priced, offered by the government should help eliminate the liquidity risk I would expect as a spillover also help to alleviate credit risk. Various extensions to the Special Liquidity Scheme have also been announced.

In sum these measures aid liquidity of banks and by shoring up capital allow them to have a cushion against losses and thus promote some semblance of confidence in the financial sector. All this has been required because having extended loans on the basis of relatively little equity capital, with the blessing of the regulators, the banking sector faced extinction of their equity capital from a number of possible avenues. That the default rates on loans would be higher than expected, that collateral held against those loans would be insufficient and that funding for those loans from short term deposits from households or the wholesale money markets would dry up. Given the interconnected nature of these events, it turned out that a shock to collateral triggered defaults which triggered mistrust in wholesale money markets, not only between banks but also between the net supplier of funds (pension and insurance companies) and banks.

So what we discovered was the correlated nature of these risks, that they were not independent events and that the scale of liquid reserve or capital that banks held against these shocks was insufficient. And so banks have to ratchet up their levels of capital to cover both previous losses and to have a sufficient liquid store of wealth against future shocks. The trick is to try and engineer this capital injection quickly so that lending can now resume in the face of a rainstorm...the banks need to giving out galoshes a well as umbrellas right now.

As far as temporary part-nationalisation of the banks, to coin a phrase: There Is No Alternative (for the moment).

“Countries Don’t Go Out of Business...”

2008-10-07T11:39:00.011+01:00

I was this morning reminded of the Chairman of Citicorp’s 1982 famous injunction that a country cannot go bust. What Walter Wriston said at the time of Mexico’s default on its debt to commercial banks was: "Countries don't go out of business....The infrastructure doesn't go away, the productivity of the people doesn't go away, the natural resources don’t go away. And so their assets always exceed their liabilities, which is the technical reason for bankruptcy. And that's very different from a company." But when it was reported today that the country of Iceland may indeed go bankrupt I wondered, not for the first time, where the bottom of this financial crisis may lay. There is a nice irony here in that this time it is banks that are threatened with bankruptcy and they require the help of the nation-states to bail themselves out. To some extent, the early 80’s debt crisis was the other way around.

Developments across European banks, starting with Ireland last week, really are quite disturbing. The unilateral guaranteeing of all deposits and Tier 2 debt is basically akin to the guarantee given by the UK government for Northern Rock last year after its bank run. But as we know this was insufficient to prevent its eventual nationalisation - as no buyer could be found. The guarantee stopped the run on the Rock as far as retail depositors were concerned but did not allow the bank to continue with its wholesale funding model. These recent decisions seem to have been made at the national level with no real consultation with the EC (and in this case the ECB) which as a side-issue will raise a pretty big question mark over co-ordination within the EU and the Eurozone.

But these or any guarantees do not address the fundamental problems of banks that have been far too reliant on wholesale funding and whose asset quality has deteriorated markedly. That problem has been replicated again and again in the UK and elsewhere in Europe. In the case of Ireland and Iceland it is also magnified as it is not one or two banks among many but the whole banking system which seems to have adopted the same model. A blanket guarantee does not help the quality of assets and hence funding liquidity - all it does is re-assure depositors (retail rather wholesale) that their money is as safe as the finances of the Irish state or Icelandic state.

So how much can individual European states help their banks? I plot here the ratio of the sum of major bank assets to GDP for the many of the main European nations (Source: http://www.ft.com/). The ratio tells us neither about the riskiness of each Euro of assets on the bank’s balance sheet nor about the capability of the state to capture its tax base, GDP, per se but does perhaps allow us to put the scale of the problems into some national context. And immediately we can see the scale of the Icelandic problem with bank assets at nearly 11 times GDP, where even a 10% default (if it was backed by the state) would increase public debt to GDP by nearly 110%. Under these circumstances the blanket guarantee would simply not be credible, as an increase of debt-GDP permanently of this size will require a permanent increase in the primary fiscal surplus by some 2-3%!

We also learn that Irish bank assets to GDP are around 250%, which is only around the Eurozone average (obviously not the UK, Iceland or Switzerland) and tells us that in asset terms the Irish banking system is perhaps no larger (or vulnerable) than that of the EZ average. But the extent of the fragility, which despite not having an excessive level of asset creation by international standards, was such that a government guarantee was required. And the need for this commitment device tells us something important about perceptions about the quality of bank assets and the likelihood of continuing funding.

The extent of heterogeneity of individual countries bank asset size is interesting and of particular note is the relative strength of the German state with respect to German banks with major bank assets at only around 140% of GDP. And that even though Italy looks superficially well off the raw number of 170% does not probably deal with the relatively poor credibility of the Italian fiscal authorities, where the provision of a guarantee may be proportionately more difficult. (That said the lending there may not have been quite so risky.) So even if the Irish and others have dealt with their banking stress with a government guarantee - if a scheme of this sort was to be extended to the whole of the Eurozone it is likely to need the guarantee of the German state.

This situation is not unlike trying to devalue a currency within a fixed exchange rate zone. The analogy is that other countries will not be happy with the unilateral increase in relative competitiveness. And there will be some pressure for a further round of devaluations (guarantees), which we have now seen. Most obviously those countries who are most vulnerable and whose assets are closest substitutes will be under most pressure to give a similar guarantee. And again that is what we are now seeing.

Given the juxtaposition of dwindling deposits and deteriorating assets, I would expect governments to will want banks to increase their Tier 1 capital, if at all possible, and that may mean some deals to be struck with Sovereign Wealth Funds and also perhaps the need for governments to take a direct capital stake in banks. Bank mergers will also be a regular event as the market compresses. But given that the root cause is poor quality assets, this may only be the first step on the road to a proliferation in TARPing or some form of insurance support for assets as well as liabilities in the Eurozone and elsewhere. The onus of the government or the public sector as a solution to the immediate crisis will mean that nation-states look likely to become inextricably linked to banks once again but this time as creditors.

What a great time to be an economist…rather than banker...

2008-09-22T17:43:00.000+01:00

The financial crisis has dominated the headlines for over a year now and provided a chronic migraine to bankers, policymakers and academic economists as we try to locate the causes, cures and consequences of this crisis. Whilst I am not going to provide a definitive answer in this column (yet), what I think I can do is set the scene in the first instance about some causes of this crisis. I will deal with some other aspects in future weeks.

Early commentary on the current financial crisis treated it as a necessary re-pricing of market risk and it is still difficult to disagree with that basic point. Promulgated by the emergent-saver nations, such China, world interest rates fell in the past decade or so. And taking a lead from Japan and then the US, the early years of the 21^st century had been characterised by low policy rates, which were accompanied by a widely-offered argument about the possible end of the business cycle and a series of innovative ways for the financial sector to expand the liquidity of financial intermediaries. All of which perhaps contributed to a sense of hubris or infallibility within the financial sector and in the wider economy and certainly a sense that risk had somehow dissipated. Accordingly, the price of risk fell as likelihood of bad outcomes was collectively judged to have fallen markedly.

Under these circumstances, asset prices could not help but be bid up and the risk premia required by investors to hold various classes of risk evaporated. High asset prices provided the means for further liquidity creation for the private sector, as owners of capital and homes found themselves with bankable quantities of equity. They also provided an impetus to financial engineering, with liquidity combining with a search for yield to produce new methods of handling the consequences of financial intermediation. Banks found that they could borrow their liabilities increasingly from other banks rather than from arguably more reliable retail customers and create loans (assets) that would amount to many times their underlying level of capital.

The relaxation of credit constraints provided a boost to economic activity, which might typically have been managed with a temporary increase in policy rates to ensure that demand did not run away from the gradual increase in supply. But at the same time there was a deflationary impetus from newly industrialising economies that placed downward pressure on traded goods inflation. So that inflation targeting, in some cases quasi-inflation targeting, central banks did not feel that it was necessary to raise policy rates to a sufficient degree. And so the long expansion, or what we might eventually look back upon as a boom, continued unabated.

It was argued that the overall risk from extending loans could be mitigated by more sophisticated forms of risk management (which we will explore in future weeks). But as loans are extended to more and more agents, the quality of the marginal agent – in terms of ability to repay - will at some point deteriorate. Escalating debt levels and greater coverage of loans amongst a given population leads to two possible sources of instability, that the private sector expectations about the path of interest rates and the growth of future income have been too optimistic and that the asset price-based collateral used to back a given loan may deteriorate. The former will make debt service more difficult and any downward shock to asset prices will increase the implied level of gearing for any loan and so threaten net worth. And so it would seem that higher levels of more widespread debt may actually tend to increase overall market risk.

To some extent this is indeed what happened. Even though risk was spread amongst many financial institutions many of the original loans became riskier. So we ended up with a position of low market rates, high asset prices and escalating rather than declining economic risk. The trinity is impossible and something would have to change and in this case it was the first two relative prices. Banks and private individuals both had to re-assess the viability of their balance sheets and seem to have come to a similar conclusion that capital and savings have to increase. Households may be able save, if their income flows are maintained but that is a big if, but banks cannot re-capitalise when liquidity is low and so governments came to the rescue with a fiscal bail-out.

To some extent the crisis has finally come to a head in the past week. The recent bail out of two large Government sponsored enterprises, Fannie Mae and Freddie Mac, the bankruptcy of the once-venerable institution Lehman Brothers and the take-over of HBOS by Lloyds TSB. It seems likely now that the as well as continuing to offer short term liquidity to help banks finance their ongoing operations, there will be some attempt by the US authorities to buy up the bad assets from banks who own them at a deep discount and hope fully try to develop some form of secondary market for these assets.

If we are now to move from a regime of easy money (low interest rates, low inflation, high asset prices and high gearing) to one of tighter money (higher interest rates, higher inflation, lower asset prices and lower gearing) what are the implications? By which I mean what will the landscape of the financial and banking system look like, how will it be regulated and how will the transition from one regime to the other be managed.

In a market economy, with collateral required for lending, raising the required rate of return on marginal projects will reduce the level of capital employed in the long run and hence the rate of economic growth. So we will have to transition to a lower than expected level of growth. The transition will probably lead to a public and private debt overhang, along with further possible bail-outs for the financial sector. And the danger is that this will change the terms of trade for monetary policy, particularly as deflation will have to be avoided, with a strong inflationary incentive re-emerging. Tighter regulation of the banking and financial sector will be difficult to avoid and so we may end up with an economy that ultimately is less reliant on the financial sector for its growth, I am not quite sure that lower growth, higher inflation, higher taxes and a less dynamic financial sector will be preferred by all. But if the alternative is occasional busts on this scale, there may in fact be little alternative, even if we did mostly enjoy the ride.