Monday, November 23, 2015

Counting backwards to the next recession

In most advanced economies business cycles can be well characterized by a succession of long expansion phases that are interrupted by short recessions. Given this pattern it is sometimes natural to think about the length of expansions as a key feature that describes the business cycle. While other variables matter (such as the depth and length of recessions), in the case of the US and to some extent in the case of European countries, the parameter that has changed the most across cycles is the length of the expansion phase.

In the case of the US (using the NBER business cycle dates), in the post-WWII period expansions have lasted from 12 months in the expansion ending in 1981to 120 months in the expansion ending in 2001. The current expansion is already 77 months long, longer than the previous expansion of 2001-2007.

While counting months is not a good way to forecast the timing of the next recession it is at least a reminder that there is another recession waiting for us in the not-so-distant future. And when we start counting backwards to the next recession a key questions is whether we will be ready for it. In particular, will monetary policy be back to normal and able to react to it?

Interest rates have not yet moved away from zero in either Europe, the U.S. or Japan. This is, of course, very unusual given the length of the expansion. Another way to see how unusual monetary policy and interest rates look like is to plot the difference between long-term rates and the central bank rate.
For the case of the US we can see that this difference (the term premium) has stayed very high since the 2008-09 recession. Unlike in previous expansion where after two to four years the term premium started declining (mostly through increases in the short-term rate), in this case the number remains unusually high. 

There is a positive reading of the chart that suggests that we are far from the next recession. Under the assumption that the term premium has to get very close to zero before a recession happens, it will take a while before we see the next one. But that reading ignores the fact that today short-term rates are not normal, they are stuck at the zero lower bound. Recessions do not happen because the term premium decreases, recessions happen for other reasons and it happens to be that the term premium moves with the cycle. But this expansion is not like the others because of the constraints on short-term rates so it might possibly be that the difference with long-term rates will this time be a really bad indicator of how close we are to a recession.

And this second reading the chart reminds us of the risk that we are facing if the next recession is somewhere in the near future and monetary policy has not had the time to go back to normal, to go back to levels of short term rates that allow for a decrease in these rates that is consistent with what we have seen in previous recession. And entering the next recession in Europe or the U.S. with interest rates that are too close to zero does not sound like a good idea and in addition there is a lot of uncertainty given that we have not seen such a case in the recent business cycles. 

So in addition to all the reasons why we want economic conditions and monetary policy to quickly go back to normal, there is an additional sense of urgency from the scenario that in the near future there is either a domestic or global event that causes the next recession. So in a world with very low interest rates central banks and government need to look forward and make sure that planning for the next recession is part of their strategy to ensure the fastest possible recovery from the previous one.

Antonio Fatás

Thursday, October 29, 2015

The missing lowflation revolution

It will soon be eight years since the US Federal Reserve decided to bring its interest rate down to 0%. Other central banks have spent similar number of years (or much longer in the case of Japan) stuck at the zero lower bound. In these eight years central banks have used all their available tools to increase inflation closer to their target and boost growth with limited success. GDP growth has been weak or anemic, and there is very little hope that economies will ever go back to their pre-crisis trends.

Some of these trends have challenged the traditional view of academic economists and policy makers about how an economy works. Some of the facts that very few would have anticipated:
- The idea that central banks cannot lift inflation rates closer to their targets over such a long horizon.
- The fact that a crisis can be so persistent and that cyclical conditions can have such large permanent effects on potential output.
- The slow (or inexistent) natural tendency of the economy to adjust by itself to a new equilibrium.

To be fair, some of these facts are not a complete surprise and correspond well with the description of depressed economies that have hit the zero lower bound level of interest rates because of deflation or "lowflation". We had been warned about this by those who had studied the Japanese experience: both Krugman and Bernanke, among others, had described these dynamics for the case of Japan. But my guess is that even those who agreed with this reading of the Japanese economy would have never thought that we would see the same thing happening in other advanced economies. Most thought that this was just a unique example of incompetence among Japanese policy makers.

Now we have learned that either all central bankers are as incompetent as the Bank of Japan in the 90s or that the phenomenon is a lot more natural, and likely to be repeated, in economies with low inflation, more so when the natural real interest rates is very low.

But if this scenario is more likely to happen going forward it might be time to rethink our economic policy framework. Some obvious proposals include raising the inflation target and considering "helicopter money" as a tool for central banks. But neither of these proposals is getting a lot of traction

My own sense is that the view among academics and policy makers is not changing fast enough and some are just assuming that this would be a one-time event that will not be repeated in the future (even if we are still not out of the current event!).

The comparison with the 70s when stagflation produced a large change in the way academic and policy makers thought about their models and about the framework for monetary policy is striking. During those year a high inflation and low growth environment created a revolution among academics (moving away from the simple Phillips Curve) and policy makers (switching to anti-inflationary and independent central banks). How many more years of zero interest rate will it take to witness a similar change in our economic analysis?

Antonio Fatás

Thursday, October 15, 2015

GDP growth is not exogenous

Ken Rogoff in the Financial Times argues that the world economy is suffering from a debt hangover rather than deficient demand. The argument and the evidence are partly there: financial crises tend to be more persistent. However, there is still an open question whether this is the fundamental reason why growth has been so anemic and whether other potential reasons (deficient demand, secular stagnation,…) matter as much or even more.

In the article, Rogoff dismisses calls for policies to stimulate demand as the wrong actions to deal with debt, the ultimate cause of the crisis. As he argues, given that government expenditures have kept expanding (he uses the number for France at 57% of GDP) it is hard to argue in favor of more spending.

But there is a perspective that is missing in that logic. The ratio of debt or government spending to GDP depends on GDP and GDP growth cannot be considered as exogenous. Assuming that the path of GDP is independent of the cyclical stance of the economy does not sound reasonable but, unfortunately, it is the way most economists think about a crisis. A crisis is seen as a temporary deviation of output but the trend is assumed to be driven by something else (innovation, structural reforms,..). But that logic runs contrary to evidence on the way investment and even R&D expenditures behave during a crisis. If growth is interrupted during a crisis output will never return to its trend. The level of GDP depends on its history, what economists call hysteresis. In that world reducing the depth of a crisis or shortening the recovery period has enormous benefits because it affects long-term GDP.

[To be fair to economists, we are all aware of the persistent dynamics of GDP, but at the theoretical level we tend to explain it with models where the stochastic nature of the trend is responsible for the crisis itself rather than assuming that other factors caused the crisis and the trend reacted to them.]

In a recent paper Olivier Blanchard, Eugenio Cerutti and Larry Summers show that persistence and long-term effects on GDP is a feature of any crisis, regardless of the cause. Even crisis that were initiated by tight monetary policy leave permanent effects on trend GDP. Their paper concludes that under this scenario, monetary and fiscal policy need to be more aggressive given the permanent costs of recessions.

Using the same logic, in an ongoing project with Larry Summers we have explored the extent to which fiscal policy consolidations can be responsible for the persistence and permanent effects on GDP during the Great Recession. Our empirical evidence very much supports this hypothesis: countries that implemented the largest fiscal consolidating have seen a large permanent decrease in GDP. [And this is true taking into account the possibility of reverse causality (i.e. governments that believed that the trend was falling the most could have applied stronger contractionary policy).]

While we recognize that there is always uncertainty when estimating this type of macroeconomic dynamics using one particular historical episode, the size of the effects that we find are large enough so that they cannot be easily ignored as a valid hypothesis. In fact, using our estimates we calibrate the model of a recent paper by Larry Summers and Brad DeLong to show that fiscal contractions in Europe were very likely self-defeating. In other words, the resulting (permanent) fall in GDP led to a increase in debt to GDP ratios as opposed to a decline, which was the original objective of the fiscal consolidation.

The evidence from both of these paper strongly suggests that policy advice cannot ignore this possibility, that crises and monetary and fiscal actions can have permanent effects on GDP. Once we look at the world through this lens what might sound like obvious and solid policy advice can end up producing the opposite outcome of what was desired.

Antonio Fatás

Thursday, October 8, 2015

Savings glut and financial imbalances

Martin Wolf in today's Financial Times discusses the reasons for low interest rates and suggests some interesting scenarios for the years ahead. I agree with most of what he says but I have doubts about the role that he assigns to central banks.

Let me start with the arguments with which I agree 100%. The logic of the Bank for International Settlements that low interest rates are the outcome of central banks managing to keep interest rates artificially low for decades is "wildly impossible". And the main reasons are that we have no economic model (or evidence) that suggests that central banks are able to manipulate real interest rates for decades and we do not either have any model (or evidence) that supports the idea that a central bank policy of low interest rates will not generate substantial inflation.

As Martin Wolf argues, any explanation for low interest rates has to start with some version of the savings glut hypothesis. Economic, demographic and social changes have expanded the desire to save among a significant portion of the world economy and this has kept interest rates low. This is an explanation that is consistent with any economic model that has an intertemporal dimension built into it and there is plenty of evidence that supports it.

What is the role of monetary policy in this story? Martin Wolf believes that because of the increase in desire to save in the world, central banks

"in seeking to deliver the monetary conditions needed for equilibrium between savings and investment at high levels of activity, the central bank has to encourage credit growth"

Here is where I am not sure I follow Martin's argument. Why do central banks have to encourage credit growth? The fact that there is a savings glut that puts lower pressure on interest rates already means that somewhere in the world there will be an increase in credit/borrowing. There is no need for central banks to encourage credit. We can talk about whether central banks could have discouraged it, whether they had the tools and whether it was within their mandate, but there is no need to have central banks driving the process of credit growth to make the story consistent with what we have observed.

What makes the description of the dynamics of interest rates and financial flows that result from a savings glut difficult is the fact that we need to understand heterogeneity among economic agents (individuals, companies, governments). And this heterogeneity, combined with a regulatory framework that is limited, can drive dynamics that are unhealthy, excessive and lead to bubbles and financial crisis.

If there is a savings glut and interest rates are coming down this is a signal for someone to borrow more. Some of that borrowing will for sure be reflected in increase leverage because it will take the form of house purchases and creation of mortgages. Within some countries (e.g. China) we might observe that while the country as a whole saves, the private sector increases its internal debt exposure and leverage because of the exchange rate policies, government demand for foreign safe assets and capital controls that are part of their financial environment. There are plenty of stories like these that are triggered by a significant change in the economic scenario (lower interest rates) that might result in the financial imbalances that lead to crisis. The same way new technologies can create bubbles and financial instability (as in the 90s), the savings glut generated new and possibly excessive behavior as economic agents adapted (and not always well) to the new equilibrium.

Martin Wolf finishes with some thoughts on what come next. This is a difficult exercise as it requires a good understanding of economic trends across all regions in the world. There are some short-term forces that are playing against the savings glut hypothesis: oil producers countries are quickly reducing their saving, in some cases turning them into borrowers. But this is more than compensated by the Euro area that has become a large saver after the borrowers (Greece, Spain,...) have brought their current account deficits to zero while the savers (Germany, Netherlands) have not changed their behavior. So interest rates are likely to stay low and the saving surplus of some countries will have to be absorbed somewhere else (although it is not clear that the surpluses will be larger than in the past). Yes, this means a "credit boom" somewhere else but this should not always be a recipe for imbalances.

What the world is missing is investment demand. The real tragedy is that investment in physical capital has been weak at the time when financial conditions have been so favorable. Why is that? Jason Furman (and early the IMF) argues that the best explanation is that this the outcome of a a low growth environment that does not create the necessary demand to foster investment. And this starts sounding like a story of confidence and possibly self-fulfilling crises and multiple equibria. But that is another difficult topic in economics so we will leave that for a future post.

Antonio Fatás 

Thursday, August 27, 2015

A third scenario for stock markets

Robert Shiller on the New York Times argues that the stock market is expensive by historical standards using the cyclically-adjusted price earnings ratio (CAPE) that he has made popular through his writings since the late 1990s.

There is no doubt that the CAPE ratio for the US stock market is high by historical standards. Using Shiller's estimates it stands around 26 today, clearly above the historical average of about 17. What a higher CAPE means is that you are paying more for the same earnings. Earnings' growth could, of course, be different in the future. They might be lower because potential GDP growth is slowing down but they might be higher as profits as a share of GDP increases. If we assume the same number just for simplicity, a higher CAPE means that investors should expect a lower return if they buy the stock market today compared to an average year in the past.

What does it mean for the future price of the stock market? Shiller concludes that maybe we will see the stock market returning to historical averages (which implies a massive fall in the current values) or maybe we see what we saw in the late 90s where the market continues going up and reaching a CAPE of over 40 before crashing. As Shiller puts it we "just don't know".

But what about a third option? The market remains at a level around 25, as it is today and this implies that returns will be lower than historical averages. Is this possible and consistent with investors' expectations? Yes, under two assumptions. One is that returns in all other assets are also lower than historical averages. This is certainly the case today where interest rates on bonds are at very low historical levels and it is difficult to foresee a large increase in the coming years. The other justification for high CAPE ratios is that the risk aversion of investors has gone down relative to previous decades. While talking about low risk perception this week might not sound right, the reality is that the years while the stock market had CAPE ratios of around 17 where also the years where academics wondered about why risk aversion was so high among investors (what we called the equity risk premium).

How much do we need those numbers to change to justify higher-than-normal CAPE ratios? A quick calculation using current bond interest rates would tell us that the stock market at a 25 CAPE ratio offers a risk premium over bonds that is similar to what the stock market offered when the CAPE ratio was 17 (around 6-7%). In that sense, the stock market is not expensive, it is prices in a way that is consistent with historical levels. If you want to make the stock market cheap you just need to argue that risk premium should be lower than that. If you want to make the stock market very expensive you need to argue that interest rates on bonds will soon go back to historical levels. In that scenario the US stock market should go down by about 30-40% relative to current levels.

Predicting which scenario will be realized is not easy, as Shiller argues. But I wished that he would have considered as well the third possible scenario where current CAPE levels are fine and investors should get used to lower-than-historical returns but returns that are consistent with what is going on in other asset classes. Maybe we put too much emphasis on the bouncing back and crashing scenarios when we talk about stock prices and we forget a much more boring but as plausible one that delivers a less volatile stock market.

Antonio Fatás

Monday, July 13, 2015

Micromanagement of European reforms

The agreement between Greece and its Euro partners is full of very detailed policies to be approved by the Greek government in the coming week. How did we end up in a situation where the domestic policies of a Euro country are decided by other countries? I recently wrote a paper on the European reform agenda where I had a discussion on the role of Europe in the reform process. Here are some of what I wrote in the paper which is very appropriate for what we just witnessed over the last 24 hours.

Historically Europe has served as a catalyst for reform in some of the least-advanced EU economies. Through the imposition of requirements to join certain European initiatives it has fostered enough social consensus around the need for compromises. As an example, it worked well to transform and standardize the macroeconomic institutions of European countries, especially when it comes to monetary policy and inflation.

But these dynamics are not always productive. Reform is ultimately a domestic political business where trade offs are being made between economic efficiency, social goals and the way power and income are distributed in a society. Having Europe always as the reason why reforms need to happen is likely to generate unhealthy dynamics. In addition, it is not always easy to link reforms to the benefits of European integration.

The only way to change these dynamics would be through a much more contractual and ex-ante approach to reforms. This was partly the spirit of regulations of the Maastricht Treaty that established rules of behavior to be a member of the Euro. But, as experience has shown, those were not enforceable rules. The rules only worked well as an entry condition but once the entry decisions were made the rules became very weak. Rules have been renegotiated, changed, and violated on numerous occasions. Why not make the entry conditions more binding? The reality is that if countries were asked to reform or adopt irreversible commitments before joining any process of European integration, there would be very few members of the European Union or the Euro area left.

We need to be realistic as well and Europe needs to find a way to deal with countries and governments that do not want to go along with the reform process or that they are unable to do so. At the end of the day the speed of reform remains the decision of individual countries. Its citizens are the ones that will suffer the consequences of no reforms and low growth. This is true for any country, advanced or emerging, and this is true for Europe.

The reason why the reform debate becomes more visible and relevant in the European context relative to other advanced economies that struggle with similar issues of performance is that the process of European integration might occasionally force countries to move together. When you share risk via the balance sheet of a central bank or when you design a program of transfers from rich to poor regions, the reform agenda becomes a supranational issue not anymore a pure national debate. Maybe Europe needs to find ways to separate the two. Either through a much more contractual approach to institutions that leaves no room for further negotiation (e.g. a true no bailout clause) or by changing the design of those institutions so that the links between countries and the shared risks are minimized ("less Europe"). This might be suboptimal as it might come at a cost of reducing the effectiveness of those institutions but it might be the only way to make the process of European integration and economic reforms compatible.

In summary, maybe "more Europe" is not always the solution to all the European economic problems.

Antonio Fatás

Friday, July 3, 2015

Did the IMF provide support to Syriza?

The IMF published yesterday a preliminary analysis on the debt sustainability of the Greek government. The timing of the publication, a couple of days ahead of the referendum, has triggered a variety of interpretations of the conclusions. The Greek government has quickly jumped to argue that the results confirm that government debt in Greece is not sustainable and a substantial haircut is needed.

Is the interpretation of the Greek government correct? Yes and no. The IMF analysis suggests that under reasonable assumptions on growth and interest rates for Greece, it is very difficult to imagine a path of primary budget surpluses that makes the current situation sustainable. This is what the Greek government says and in that sense it seems that the IMF is providing empirical support to their claims. However, the analysis is full of other subtleties that do not warrant this quick conclusion and that in some cases contradict the views of the Greek government.

First, the report makes it clear that since Syriza came to power the situation has deteriorated because of a combination of lower growth, lower privatization revenues and a worsening of budget balances. So here the IMF seems to support the German (and others) view that the situation would be better if the right policies were applied. The need for haircuts is partly the responsibility of the current Greek government.

Second, there is nothing new in the IMF analysis and almost everyone agrees to it, including the other Euro partners. The real issue and where there is possibly some disagreement is on how to deal with an unsustainable level of debt. Here is where the subtleties start.

Let's go back in history first. In 2012 it was also clear to most that Greek debt was on an unsustainable path. Because of this the Euro partners and bond holders agreed to a haircut on the face value, an extension of maturities as well as a reduction in interest rate that implicitly reduced the value of the Greek liabilities. How much that reduced debt is debatable but it is likely that it reduced it by about €100 Billion.

But that first restructuring was clearly not enough. What went wrong? Growth never returned, in fact, the economy continued on its path of collapsing changing all the assumptions made by the Troika at the time of the negotiation. Why did growth fail to live up to the assumptions? Because the Troika underestimated the effects of fiscal austerity (in Greece but also anywhere else) and possibly because some of the projected reforms in Greece either did not take place an they did not pay off as much and as fast as planned.

What about going forward? Can we be more realistic regarding Greek prospects of growth? That's what they IMF is doing now. It forecasts growth in Greece to be input 1.5% in the long term. This is what I would say a very pessimistic number (even if it might still be realistic). It assumes that a country that has a GDP per capita of less than 50% of the most advanced economies in the world will fail to converge to that level, in fact it is likely to get stuck at that level or even diverge.

And here is where the Greek government and the IMF projections might be at odds. The Greek government argument is that once debt is reduced and all the reforms are implemented, the Greek economy will take off and start finally growing. But if growth returns, is debt really unsustainable Greek debt is unsustainable because the Greek economy will not grow in the long run (and this is not just about austerity). But if the Greek government is right and the reduction in debt does indeed raise the potential growth of Greece then the current debt level might be closer to being sustainable than what the IMF says. In other words, the IMF tells the Greek government something that they want to hear (debt needs to be reduced) but in an scenario that the Greek government cannot accept (growth is going to be dismal for decades).

The way out of this inconsistency is to make default a function of GDP growth rates. This goes back to the old idea of indexing the value of the debt (or the interest rate) to economic growth (here is a very good description of its virtues from Paolo Mauro). If the Greek government is right and Greece growth prospects are very good, the debtors will get back most of what they are owed. But if the IMF is right and growth in Greece will remain low over the coming decades, the debtors will get a lot less, whatever the low growth prospects allow for.

Antonio Fatás