Monday, 21 July 2014

The not-so-new (but very uncertain) neutral

My latest post at Pieria considers the likely future path of interest rates and central bank reaction functions. History shows that central banks delay raising interest rates for too long after a recession, then panic and raise them too much, causing another one. Will they do this again? Probably....

Read the whole post here.

FOMC meeting. Photo credit: Wikipedia

The clash of micro and macro

As I said in a recent blogpost, failing to provide microfoundations for a macroeconomic argument doesn't make the macroeconomics wrong. Conversely, providing lots of lovely microeconomic detail - right down to the "I met a man" level - does not necessarily add up to a convincing macroeconomic argument. 

So here is Chris Dillow taking Tim Montgomerie to task for claiming that the UK's remarkable employment performance is due to the Coalition government's welfare reforms. Montgomerie isn't the only one making this claim: Fraser Nelson does so too in more detail, in an op-ed in the Telegraph. Both Tim and Fraser say that the Coalition's welfare reforms, by forcing lots more people into work, have somehow created a massive jobs boom. Say's Law, applied to labour markets? Hmm. Maybe I'm a bit fonder of microfoundations than I thought. I want to know where these workers really come from - the increase looks too much to be entirely due to benefit reforms. And I want a proper explanation of the jobs boom. Simply saying "there are more workers, therefore there are more jobs" doesn't do it for me. 

Here is Giles Wilkes providing a pretty good explanation for the increase in workers. No, it isn't just benefit reforms. A quarter of a million or so pensioners have returned to the labour market, for starters - and no-one is suggesting that benefit cuts are forcing them back to work (though the Bank of England might be).  Tax changes have improved incentives to work at the margin, which would draw some people into the workforce. Tax credit changes have forced some people to work longer hours in order to qualify. And above all, the squeeze on living standards caused by falling real incomes in recent years, on top of a horrible shock to both incomes and wealth, has forced people who weren't working to do so and part-timers to increase their hours. 

But what about that increase in jobs? Well, Giles says that as the supply of labour increases, we would expect its price to fall, encouraging employers to create more jobs at lower wages. And as Chris points out, the effect of pushing people into work by making life on benefits either impossible or totally miserable is to force down wages. I know I have said this many times already, but it's worth repeating it. Workfare depresses wages not just for those being forced to earn their benefits, but for everyone. So it may be that making life on benefits more miserable does increase jobs, but at the cost of lower wages. And the re-entry to the workforce of people who have a basic income (pensioners, married women with children) is also likely to depress wages, since these people don't usually face the benefit withdrawal trap that forces people to choose between benefits and employment, so can afford to take lower-paid work.

So to paraphrase Chris's conclusion: if welfare reform significantly increases the supply of labour, and all that labour can be productively employed, then in the absence of strong economic growth, welfare reform depresses wages - which might not be the message the Conservatives really want to give. They would do better to point to improving economic conditions as the principal driver of rising employment. Despite Fraser's claim that Coalition welfare reforms are popular, the macro argument seems more likely to win votes than the micro policies.

But Simon Cooke nevertheless criticises Chris Dillow for ignoring the human stories underlying rising employment. To him, the macro argument that improving economic conditions and/or falling wages are the primary cause of rising employment implies that micro policies aimed at helping individuals into work are a waste of time and money. And he disputes this, using as examples some of the real human stories that he has encountered in his work as a local politician. I don't think many people would disagree with his conclusion: getting the long-term unemployed into work is indeed hard, not least because of the barriers that society - often with the best of intentions, such as protecting the public from possibly dangerous ex-cons - puts in their way. We should respect those who devote time and energy to helping these people into work.

But Simon's argument that there is a fundamental disconnect between macro and micro policies does not follow. Chris's macro argument actually supports Simon's micro policies: if economic conditions improve and/or wage levels fall, then helping the most disadvantaged people into work becomes easier. The Work Programme seems to be doing a decent job, though it is much less clear that Help to Work justifies its cost. But it has been greatly hampered by the prolonged economic downturn. As the economy improves, the Work Programme's results will improve too - though admittedly, some of the people it will "help into work" would have found work anyway. Sometimes improving economic conditions really is all that is needed.

The Coalition has rightly been criticised for trying to force people to work who were not able to do so, for completely fouling up the administration of the fitness to work tests, and for some frankly pointless and even harmful policies (the "bedroom tax" springs to mind). But the biggest problem is that they tried to do all of this at a time when economic conditions were utterly unhelpful. If Giles is right, then the changes intended to "make work pay" (tax changes as well as benefit reforms) have actually pushed down wages and made life harder not just for the thousands who were forced into work, but for millions. That is quite an indictment of a government.

Saturday, 19 July 2014

U.S. sanctions on Russia are financial warfare

At Forbes:
On June 17, the US announced further sanctions against Russia because of its support for rebels in the Ukrainian civil war. The new sanctions are widely considered to be tough. But they are also difficult to understand. The extent of their legal and practical application is by no means clear. Yet – they are very clever. However they are interpreted, they are bad news for Russia.
Find out here how they should be interpreted and why they amount to financial warfare.

Thursday, 17 July 2014

Espirito Santo: complexity, opacity and moral hazard

There is absolutely nothing holy or spiritual about Portugal's Espirito Santo Group. It's a complex, opaque structure much of which is incorporated in a tax haven and part of which is suspected of fraud. It's impossible to regulate and some of the funding relationships are distinctly odd. And it includes a bank. Moral hazard de luxe. 

But haven't we seen this before? Oh yes. Read about it here

Wednesday, 16 July 2014

The Bulgarian "Game of Thrones"

No, not a film. Or a book. And as far as I know there are no Starks. Or dragons. But otherwise, the saga of the Bulgarian oligarchs and their political machinations is remarkably similar to "Game of Thrones". Politicians are the puppets of oligarchs, oligarchs are controlled by mobsters, banks are pawns in the game, and the people of Bulgaria pay through economic stagnation and entrenched poverty.

All three posts in the saga (so far) are linked here.

What on Earth is Going On in Bulgaria?

The Curious Case of the Bulgarian Bank Runs

The Bulgarian Game of Thrones

Bank run on First Investment Bank, Bulgaria. (Photo credit: BBC)

Tuesday, 15 July 2014

Why did they borrow?

In my last post, I placed into a sectoral balances framework Piketty's argument that rising US inequality drove the financial crisis. This is not to say, as some do, that excessive savings from China fed directly through into excessive household debt in the US. If only it were that simple. My argument is that trade dynamics between the two countries fed a capital surplus in the US, which inevitably found its way into higher household borrowing because of a relatively tight fiscal position and a sustained surplus in the corporate sector. 

Various people have criticised this on the grounds that it is not microfounded. Philip Booth of the IEA, probably my severest critic, says is "not economics". I think this is a somewhat narrow definition of "economics": just because I have not given a microeconomic explanation for a macroeconomic argument doesn't mean the macroeconomics is wrong. But we do need a human explanation for the high borrowing of low-to-middle income US households that is widely recognised as a key driver of the financial crisis. Accounting identities and global flows alone are not enough. 

Firstly, though, I want to unpick the causes of the trade and capital imbalances. It is very easy to blame the US's trade deficit on "consumerism" and "profligacy", and praise the "prudent savers" in China and Germany. But this is to make a morality play out of economics and ignore the actions of policy-makers that encourage and even enforce high saving and/or high borrowing. The US trade deficit is pretty intractable largely because the two major surplus countries - China and Germany - do not have currencies that float with respect to the USD. Germany uses the Euro, which does float, but the Euro is persistently undervalued relative to fundamentals in Germany because of the presence of weaker countries in the union. If the currency cannot adjust, then neither the trade deficit nor the capital surplus can correct unless unit labour costs fall, which means very significant falls in wages and employment costs. This is what is happening in the Eurozone periphery: it has not happened in the US thus far because of the US's willingness to borrow and the world's willingness to lend to it. 

However, there is a cost. As Philip Booth points out, China will not be able to suppress inflation forever if its currency is under-valued. Germany, too, faces high inflation relative to others in the Eurozone if its economy is  out of equilibrium: the ECB's tight money policies keep German inflation below 2%, but this forces weaker countries into outright deflation. 

Booth also observes that "if there are positive balances in the US private, corporate and government sectors then the dollar can float down easily enough." I'm afraid this is not really true. The dollar cannot float down against the Chinese yuan because of the currency peg, and it cannot float down relative to the real exchange rate in Germany because the Euro is effectively fixed at too low a rate relative to fundamentals in Germany. This is why devaluing the dollar would not necessarily reduce the US's trade deficit, as Dean Baker thinks: China would simply adjust the yuan to maintain its desired exchange value, and Germany would tighten fiscal policy to stop a fiscal deficit developing as a consequence of a falling trade surplus in a low-demand economy. The only way to resolve the currency problem is for China to allow the yuan to float and Germany to abandon austerity. Hell might freeze over first. 

Booth's general position is that the trade imbalances between the US, China and Germany are due to low saving in the US.  I was implicitly taking the opposite position, that the trade imbalances are due to low demand in China and Germany. But In fact these are simply aspects of the same phenomenon. We can argue about whether lack of saving in the US or lack of demand in China and Germany is more important, but it is hard to do this without slipping into moral argument again: the irrational belief that saving is "prudent" and spending "profligate" is very, very strong. The truth is that for one person to be able to save, another person must spend: one person's savings are another person's debt: one country's surplus is the deficit of others. The US's deficit is as much a reflection of financial repression in China and wage repression in Germany as it is of consumerism and loose monetary policy in the US. 

Booth further argues, as do others, that if the US spent less and saved more, then its trade deficit would come down and the imbalances resolve themselves. This is true, but that wouldn't necessarily result in an increase in US exports. After all, Chinese and German demand doesn't have to rise to compensate for falling US demand. The result might simply be a reduction in everyone's trade. And to me this is NOT a good thing. It is global trade above all that pulls people out of poverty. I don't wish to see it reduce.

So that's the global macroeconomic context fleshed out a bit. Now for US domestic economics.

Johnson Nderi argues that loose monetary policy in the aftermath of the bubble bursting and the 9/11 tragedy expanded the US money supply and pushed down interest rates, encouraging borrowing. But this too succumbs to Booth's criticism - it does not explain WHY borrowing increased. After all, households don't have to borrow, and as Scott Sumner says, if their incomes are stagnating, they wouldn't really want to.  If they don't want to borrow, cutting interest rates is pushing on a string. So why did they borrow? There are several reasons.

1. Low interest rates. 

Falling interest rates give households the impression that they are better-off than they really are, because debt becomes more affordable. This is particularly true when there are variable interest rates. So they will borrow more even if their incomes are stagnating, because the debt is more affordable.
I don't find this a rational explanation. In fact I find it astonishing that the same people who think that temporary tax cuts are pointless because of Ricardian equivalence also think that cutting interest rates in the aftermath of a negative shock encourages higher borrowing. People are just as capable of understanding that interest rates can rise as they are of understanding that tax cuts can be reversed. And for this reason, I don't buy the frequently-used argument that household borrowing increased because of pressure from lenders or Wall Street, either. Household borrowing is a decision. In economics we assume that people make rational decisions. If households didn't perceive borrowing as being in their best interests, they wouldn't have borrowed.
So low interest rates alone won't do as an explanation. But they might be an amplifier for other effects.
2. Individual expectation of higher incomes. 
Booth asks: "Why would a poor individual wish to borrow if his income is not expected to increase?" But the fact that incomes were actually stagnating at that time says nothing about people's expectations. Individuals below the age of 50 tend to believe that their future income will be higher than their present one. This is a reasonable expectation, particularly for men: the incomes of prime working-age men do tend to rise as they acquire skills and experience. The picture is much less clear for women, many of whom drop down to lower income levels when they have children. Over-50s, too, tend to have declining income. And as we know - and Booth concedes - US income inequality did in fact rise during this period. So what the data actually tell us is that increasing income for some was balanced by falling income for others. The data do NOT tell us that individual incomes were stagnating, still less that individual incomes were expected to stagnate. 
For individuals to borrow in expectation of future income rises is clearly rational, even if incomes in aggregate are stagnating. Indeed, it was rational for people to believe that as growth improved, so would their incomes. The problem, of course, is that for many people their rational expectations of better jobs and higher incomes have been dashed by the reality of techological change, offshoring, and since the crisis recession, stagnation and unemployment. 
3. Wealth effects. 
Most household borrowing is against property. When house prices rise, households' net worth rises, they "feel" wealthier and are therefore more willing to borrow. 
Prior to the financial crisis, there had been no housing market correction in the US since the 1930s: households had no reason to believe that house prices might fall, especially as the Fed was giving the impression that it had monetary policy sorted and there would never be another crash. It is hardly surprising that they were willing to leverage their rising net worth. Nor is it surprising that lenders were willing to help them do this: lenders also believed that house prices would never fall, or if they did, the Fed would bail everyone out. Wealth effects don't just apply to households. 
4. Government. 
After the 9/11 shock, George Bush and others exhorted the American people to borrow and spend, claiming it was their "patriotic duty" to do so. Being a cynical Brit, I find it hard to believe that people would borrow and spend more simply because the President told them to do so. But I guess it is possible - not least because people are far more likely to do what a Government says if they think it helps the war effort. As a direct response to 9/11, the US invaded Afghanistan and later Iraq. Had there not been high household borrowing and a consumption boom during this period, the US government's borrowing would have been far higher. We could say that the tax revenue generated from the consumption boom went to finance the War on Terror.
So there are four reasons why households might have chosen to borrow and spend - some more rational than others. But their decisions should be placed in the context of the decisions of two other groups in the US: the corporate sector, and the government.

As the chart shows, the US government's fiscal position deteriorated sharply when the dot-com bubble burst. President Bush was under pressure from Congress to restore the budget balance that had been achieved under Clinton. Fiscal policy was therefore relatively tight during this period despite the war effort - note the reduction in the budget deficit from 2004-2008:

What is more mysterious is why the US corporate savings rate was rising for much of this period:

and why it was apparently investing its surplus more in US property and its derivatives than in overseas FDI. It is hard not to conclude that stagnating wages and a rising corporate surplus were related: it seems the corporate sector preferred to lend to its workforce (indirectly) rather than paying them. And Booth and Sumner are probably right that financial innovation encouraged the corporate sector to invest in US property-backed securities rather than supposedly riskier projects overseas - or even in much-needed infrastructure development in the US. A capital surplus is not necessarily well spent. 

It is astonishing that one paragraph in Piketty can generate so much debate. I don't pretend to have covered everything even though this is my third post on this subject and as usual it is far too long and rambling. Piketty may or may not be right that inequality was a principal cause of the high borrowing that led to the financial crisis: my analysis above suggests there is more to it than that. But clearly there is far more still to discuss: the reasons for the corporate surplus, for example - and above all, the effects of war.

Related reading:

Sumner on Piketty
Perverting Piketty - Unlearning Economics (Pieria)

Friday, 11 July 2014

Inflation is always and everywhere a political phenomenon

My latest at Pieria picks apart the irrational basis for beliefs about inflation:
"So we don't understand the causes of inflation, we don't agree about what we mean by inflation and we have no reliable means of measuring it. Yet we are absolutely terrified of it. And we want government (via its central bank) to make sure that inflation NEVER HAPPENS. How very dare government rob us of our precious savings by means of inflation!
Underlying this statement, and indeed all statements about the control of inflation, is a powerful and fundamentally irrational belief. Inflation can be prevented by government. Therefore, if inflation happens, it is because government has allowed it to. Inflation is therefore always and everywhere a POLITICAL phenomenon."
There is lots more - and a worrying conclusion. Read the whole piece here