EMU Can’t Fly

For the next couple of sessions we turn our attention to foreign currency and capital flows. There will be something for everyone: accounting revision, trade and financing riddles, geeky equations, financial arbitrage, politics and institutional design, model simulations. What’s not to like?

Our feature video takes up just one of the threads covered; specifically, whether structural flaws are tainting the Eurozone (euro area). The video focuses on one particular view that not all economists would agree with. Some, for example, would say that the region’s problems reflect bad policy choices rather than poor structure. However, it is hard to deny that Economic and Monetary Union is not really a union at all. It is a dog’s dinner that serves countries with very different economic structures, languages, legislatures, customs and regulations.

For sure, there is a huge common purpose – primarily to bind social and political ties so as to prevent a rerun of European wars that have plagued the region for many centuries. However, the project has too often required large, and painful, sacrifices that undermine essential co-operation and trust. The GFC delivered severe recessions (via required internal devaluations) in the so-called European “periphery”, creating bitterness and fuelling old rivalries between the North and South. For many economists this is no surprise since the Eurozone is hardly a convincing optimal currency area.

As the interviewee makes clear, and I agree, it is not the euro per se that is the problem. Rather, the flaw arises from the institutional setup of the Eurozone itself, principally revolving around the lack of policy flexibility.

The key problems areas are,

  • inadequate provisions for national central banks to support liquidity-strained governments
  • no sign of fiscal integration
  • legal and social constraints on labour mobility
  • insufficient supply of euro safe assets

Perhaps there is too much impatience. It takes a long time to move from old boundaries to new frontiers. The US in its infancy was arguably in a similar place to where EMU is now. But, almost twenty years on since the euro’s launch, there is precious little sign of governments engaging in supportive fiscal transfers. Full political union is unlikely and possibly unwarranted. That said, it would be a catastrophe if EMU itself were dissolved – especially in the midst of social and/or economic stress. The only way now is to push forward and reform: but so much more needs to be done on banking unions, fiscal co-ordination and structural integration if further EMU crises are to be contained.

On a more light-hearted note, another problem with the Eurozone is that few are actually clear as to what and where it is! Formally, the euro area consists of those Member States of the European Union that have adopted the euro as their currency.

It sounds straightforward but you do not have scratch far below the surface before confusion arises. Take Scandinavia…

  • Finland is an EU member, uses the euro as its principal currency and so is a fully signed-up member of the euro area.
  • Norway is not an EU member, retains its own currency and so is not in the euro area.
  • Sweden is an EU member, retains its own currency and has not yet adopted the euro. That said, Sweden is obliged to use the euro once it fulfils the necessary conditions but, until then, it remains outside the euro area.
  • Denmark is in a similar, but not identical, position as Sweden in that it is outside the euro area. Denmark is an EU member, retains its own currency but the krone shadows the euro. However, unlike Sweden, Denmark negotiated an opt-out from the euro and thus is not obliged to introduce it.

Are there European countries that are not EU members but who use the euro as their principal currency? Yes, the European microstates of Vatican City, Andorra, Monaco and San Marino all officially use the euro – with formal EU agreements – but are not part of the EU (hence, not part of the euro area). Kosovo and Montenegro both adopted the euro unilaterally in 2002 although, given the absence of an EU agreement, the currency is not de jure legal tender just de facto.

Then there is the issue of whether a country needs to be in Europe to be a euro user. Indeed, can you be outside Europe and yet still qualify as a euro area member?

Euro users such as the Canary Islands do not belong to Europe geographically but are an autonomous community of Spain and so qualify as part of the EU and the euro area. Similar considerations apply to the Azores and Madeira (in the Atlantic and belong to Portugal), Mayotte and Réunion (in the Indian Ocean and belong to France). French Guiana in South America uses the euro, qualifies as an EU member (via France) and is part of the euro area. But then Saint Pierre and Miquelon – just off the eastern coast of Canada – are formally part of France and use the euro but, as an “overseas collectivity” rather than “overseas departments”, do not qualify as members of the EU and thus are not formally part of the euro area.

So here’s a suggestion. Why not take a field trip to the Caribbean and determine the precise EU/euro area status of Guadeloupe, Martinique, Saint Martin and Saint Barthélemy? Research conclusions, please, on pretty postcards.

13 Nov 2018


Policy Puzzles

“I can’t believe that!” said Alice.
“Can’t you?” the queen said in a pitying tone. “Try again, draw a long breath, and shut your eyes.”
Alice laughed. “There’s no use trying,” she said. “One can’t believe impossible things.”
“I dare say you haven’t had much practice,” said the queen.
“When I was your age, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

Through the Looking Glass, Lewis Carroll (1871)

Here’s a possible final exam question…The Fed increases its nominal policy rate. Will inflation rise or fall?

So what’s your answer? Rise? Fall?

Hopefully, you now know me better than to expect either answer is correct in all circumstances. Our world of intermediate macroeconomics is too complex, too nuanced for easy binary outcomes. The “right” answer, though you would need to explain it, is that “it all depends”.

A few years ago the blogosphere was replete with economists getting their heads in a spin over Neo-Fisherianism. It was all a bit silly, but – like any good puzzle – it did raise some interesting issues about causality, dynamics and stability; issues that good macroeconomists need to care about. If you want to dive deeper try this, this and this.

Here’s the puzzle. Does higher inflation lead to a higher fed funds rate? Or does a higher fed funds rate lead to higher inflation? To put the question in a more contemporary context: did the Fed’s post-GFC hesitation in raising interest rates reduce or increase the risk of deflation?

The mainstream (liquidity) view is that higher interest rates, supported by temporarily lower monetary growth, would lead to lower inflation. Remember that the nominal interest rate is just the real interest rate plus expected inflation. If lower monetary growth is just temporary then there is no need for inflation expectations to change. This means that the higher nominal interest rate is reflected, one for one, in a higher real interest rate. That higher real rate temporarily dampens demand and thus actual inflation (relative to counterfactual trajectories).

But the Fisher (or neo-Fisherian) view says the opposite. Real interest rates are sticky since they are fundamentally driven by long-run forces of savings, productivity and global market conditions. Therefore, given that the nominal interest rate = “sticky” real rate + inflation expectations then higher nominal rates must largely be reflected in higher inflation expectations and thus higher actual inflation (with expectations of future monetary growth also increasing). If the Fisher view is right then, to avoid deflation, the Fed could have just raised interest rates without bothering with all that QE. Indeed, by not raising interest rates the central bank was actually undermining the impact of QE as a tool for lifting inflation expectations.

A little bit of thought suggests that the Fisher view puts too much reliance on long-run equilibria (expressed via identities) and pays insufficient attention to the dynamics of getting from A to B.

Comparing two different countries, both close to equilibrium, I would not be at all surprised if the country with higher inflation also had higher interest rates and vice versa.

However, if the country with high inflation decided it wanted permanently lower inflation then, as a practical matter, it seems very doubtful that cutting interest rates would do the trick. More likely, interest rates would need to rise a lot more first, reinforced by a recession to get the message embedded in expectations, before – ultimately – interest rates could fall to a lower level, commensurate with the desired lower inflation path. The Volcker disinflation of the 1980s provides a good example.

The debate is not new, as this 2001 piece from FRB Minneapolis illustrates. The key lessons to learn are that nothing can be taken for granted, that there is nothing new under the sun and that it’s good mental gymnastics to dream the impossible dream.

31 Oct 2018

Tinker, Taylor

In session 8 we explored a link between GDP spending and real interest rates called the IS curve.

It turned out that “IS” was a misnomer and would be better described as a WJ curve – the combination of output gaps and real interest rates where planned withdrawals W and planned injections J are (possibly only temporarily) in alignment.

In session 10 we look at another curve – often called the MP (monetary policy) or TR (Taylor Rule) curve. Like the IS curve it describes potential balancing acts of real interest rates and output gaps, but this time from the perspective of financial rather than non-financial products.

Unfortunately, like the IS curve, the name attached to our new line is also misleading. We are given the impression that the MP/TR curve is all about monetary policy and is primarily pushed around by central banks.

For sure, central banks play a role in guiding the economy’s interest rate/activity mix towards more friendly levels than what unsupervised markets might deliver. However, it is worth emphasising once again that real interest rates comprise three elements:

  • a nominal policy rate (such as the fed funds rate)
  • inflation expectations
  • market risk premia

The central bank has most control over the first – the fed funds rate. Yet, even here, there can be exceptions. This became evident in the GFC when, for all practical purposes, the Fed could not reduce the rate below its Zero Lower Bound (ZLB). Moreover, with evidence that r-star is much lower than previously thought, this problem might well become more frequent going forward.

In contrast, inflation expectations and risk premia are subject to market vagaries and sentiment swings. Clearly these are not levers that a central bank can easily pull. Yet we should not be too disheartened. The GFC and its aftermath illustrated that the Fed (and Government) can gain traction in these areas if they work together, bolster confidence and enjoy credibility. The economy at large will then take on board that the State machinery will “do whatever it takes” to restore normality.

Such mind games require deploying the “dark arts” of central banking – forward guidance, communications, QE shock and awe. But to be credible, they also require governmental co-operation – supportive fiscal policy, new legal frameworks, recapitalisations. Central banks can do a lot more than just tinker with interest rates but they are not all-powerful.

So where does this leave us and our new-found MP/TR curve? Certainly we shall need to tread carefully. The mechanistic Taylor Rule, adopted by many a textbook, cannot be taken too seriously with its dependence – explicit or implicit – on imperfectly measured and/or dubious concepts such as output gaps, Phillips Curves and natural real interest rates.

And surely the Taylor Rule is too narrowly focused. As well as monetary stability, central banks are charged with the task of financial stability, seeking to ensure the integrity of the banking and payments system. The Taylor Rule has nothing to say about credit growth, lending standards, asset prices, capital adequacy – all vital if benign business and financial conditions are to co-exist. No surprise then there was some nervousness in 2017 about the potential appointment of John Taylor to the Fed.

More fundamentally, the benefits of inflation targeting in ZLB-infested waters have also come under scrutiny. Ben Bernanke’s suggestion about temporary price level targets looks interesting and has been considered before. The FRB San Francisco’s John Williams has also weighed in about the need for more policy space. Going further, more commentators are coming round to the view that we ask too much of monetary policy. Fiscal and structural policies need to make a bigger contribution, not just to supply-side strength but also demand-side stability.

23 Oct 2018

Debt Traps

In the early part of our course we explored some of the structural problems challenging policymakers. Specifically, we identified evidence of stagnation in productivity growth and thus a slowing in the growth of living standards. Not unrelated, we have seen clear signs that the “normal” real interest rate, r-star, has fallen in recent decades.

In our sessions dealing with business cycles, the implications of a low r-star for demand management will become clearer. For any given inflation target, a lower “normal” real interest rate must mean that a central bank’s “normal” nominal interest rate must also be lower. In the US’s case, for instance, our session 10 exercise in Fed Watching (using dot plots) will suggest that the FOMC is indicating 3% as the new normal for the fed funds rate rather than 4% as was assumed pre-GFC.

This downgrading of normal policy rates is important since it suggests that central banks will have less headroom than in the past should we be afflicted by another recession which necessitates aggressive interest rate cuts. The effective lower bound, not significantly different from zero, is much closer than it was over a decade ago.

So with signs that monetary policy is more constrained – at least in its conventional interest rate setting form – it comes as no surprise that fiscal policy will probably bear more of the burden of demand management in future business cycles. Governments, as well as central banks, will need to be more proactive.

But fiscal policy also has its problems.

  • Automatic stabilisers are not that large and discretionary shifts in tax & spend programs can take time – too much time – to plan, agree and implement in modern democracies. In addition, even when fully implemented, fiscal policy may fail to gain to gain traction. 
  • Multipliers, even if they are positive in the short run, often fade to nothing within a short space of time.
  • As we discussed in session 8, crowding out is not always a problem – especially in large recessions – but the potential for failure in the transmission mechanism cannot be denied.

In session 9 we explore in more detail the challenges that arise when fiscal policy is more actively used to cushion a weak economy. In particular, after becoming more familiar with budget accounting measures, we are going to address the question of long-run fiscal sustainability.

Unless matched by productive assets, high debt can hamper growth, diverting resource from more productive uses and so undermining the long-run tax base. High debt also means high debt payments (our INT of T = TX – TR – INT fame from early accounting sessions). But high debt payments mean higher budget deficits which mean more debt in future. If you’re thinking “this sounds like a doom loop” – well, you’re right!

If the economy is stagnating, and thus not producing much growth in tax revenues, then interest payments will feed a vicious cycle leading to ever increasing debt. But ever increasing debt will get investors twitchy who will then sell that country’s debt – forcing interest rates even higher! Like so many financial cycles, we get into a nasty, self-fulfilling prophecy of doom. Fiscally weakened governments, recessionary economic conditions and failing banks – a toxic brew indeed.

Following the GFC, when both central banks and governments pulled out all the stops to prevent a socio-economic collapse, many countries have been left with a huge public debt legacy. As the introductory video makes clear, governments are striving to contain this debt overhang by running underlying budget surpluses as well addressing some of the structural barriers to higher growth (and thus a stronger base for tax revenue).

The bottom line is that fiscal largesse – perhaps launched with noble, anti-depression motivations – can exacerbate problems rather than solve them.

The analysis contained in the video accompanied the IMF’s April 2013 Fiscal Monitor. The narrative focused on 10 major countries that accounted for the bulk of global public debt. The list included the US, Japan and several Europeans. So how are they getting on now?

For an update let’s look at the IMF’s latest projections for government debt (as a % of GDP) for 2020 and compare that forecast with the outturn for 2013, when the IMF’s analysis was compiled. One country appears to be back on the straight and narrow. Ireland seems set to reduce its debt ratio to around 60% from 120%. Portugal is also making modest progress although its debt ratio is projected to remain significantly above 100% in 2020. However, all the rest have either seen their debt ratios stabilise at high levels or, in some cases, are even set to increase.

The US is a case in point. The legislative changes in the 2017 Tax Act plus additional measures in early 2018 will set America on a much more fiscally expansive path.

The Congressional Budget Office’s April 2018 assessment makes for sober reading…

“federal debt is projected to be on a steadily rising trajectory throughout the coming decade. Debt held by the public, which has doubled in the past 10 years as a percentage of gross domestic product (GDP), approaches 100 percent of GDP by 2028 in CBO’s projections. That amount is far greater than the debt in any year since just after World War II. Moreover, if lawmakers changed current law to maintain certain current policies — preventing a significant increase in individual income taxes in 2026 and drops in funding for defense and nondefense discretionary programs in 2020, for example — the result would be even larger increases in debt.”

“Over the 2021–2028 period, projected deficits average 4.9 percent of GDP; the only time since World War II when the average deficit has been so large over so many years was after the 2007–2009 recession.”

Part of our session will explore what the projections mean for US fiscal sustainability (if time permits, the outlooks for Brazil and Russia will also come under scrutiny). Other than eating humble pie, reversing the tax cuts and spending programs, there are no easy fixes for the problems we uncover.

  • Selling the family silver? …buys some time but asset stripping is, itself, unsustainable
  • Resource bounty? …unlikely that shale is enough and then there’s that dreaded resource curse
  • Inflate the debt away?… quite possibly, it’s been done before!
  • Financial repression?… capping interest rates is a throwback to WW2 and its aftermath, again not a new idea but much harder to implement in today’s market environment
  • Rebound in productivity growth? …ok, now you’re talking. Good luck with that, but at least it underlines the key point that fiscal sustainability is more about supply-side policy than occasional budget squeezes. Moreover, supply-side policy needs to pay close attention to the financial sector; poor bank capitalisation, inadequate liquidity, weak regulation will only intensify fiscal sustainability problems. As the GFC debacle proved, private banking problems quickly morph into massive public debt headaches. If you have great policies with great institutions nurturing great ideas then great results follow. Fiscal space can be created by additional public spending in carefully chosen infrastructure and other projects. Crowding in can happen and it is certainly worth trying. But , if it were that easy, you wouldn’t have a fiscal sustainability problem!

Of course, the US enjoys an “exorbitant privilege” in that it has a captive audience as regards creditors. America’s perceived safe haven status, also reflected in the primacy of the US$ in international finance, means that it can preside over widening deficits and mounting debt burdens without necessarily suffering a crisis of credibility. For sure, it is doubtful that the dollar and US Treasury bonds are about to collapse any time soon. But, as history and playground antics teach us, you can only stretch the elastic so far before it snaps back in your face!

19 Oct 2018

Spending & Interest Rates

Models are a key tool in macroeconomics and we need to invest time in learning the key tricks, checking that,

  • we know the difference between exogenous and endogenous variables
  • the number of equations equals the number of endogenous variables to solve for
  • a solution actually exists
  • where models are dynamic, stability is feasible

Models are useful. They help us to focus on key issues at hand, removing unnecessary detail and sometimes revealing conclusions that were not immediately obvious. But models can also lead us astray if we are not careful. Key pitfalls include

  • catching partial derivative disease; assuming all other things equal (ceteris paribus) when, in real life, they are not
  • thinking that the whole is simply the sum of the parts; not always so as we move from micro motivations to macro consequences, with the Paradox of Thrift a great example
  • believing that the model will work in all circumstances; parameters and behaviour often change, for example, when an economy moves from boom to bust
  • assuming that all driving forces are objective, measurable variables; our case studies will touch on the the power of expectations – how beliefs about the future shape the present and how uncertainty (the degree of comfort with the expectations formed) can play an additional role in spending decisions
  • supposing that governments (and central banks) can always get matters under control; it is not always obvious what fiscal and monetary levers to pull, nor are the impacts easy to predict given limited information about the future and the vagaries of human behaviour 

The standard workhorse model of domestic business cycles comprises three equations. One is the Phillips Curve – the relationship between the output gap and inflation that we tackled in Session 6. Another is the TR/MP curve that examines one relationship between real interest rates and expenditure, operating through monetary policy and financial markets. That we shall leave to Session 10 where we draw on material from our Money & Finance session, recognising that real interest rates are not simply an outcome of monetary policy but also inflation expectations and risk premia.

For session 8 we focus on another relationship between real interest rates and expenditure – called the IS curve – that operates through non-financial goods and services markets, notably consumption, investment and government spending. We shall follow convention, and the textbook, in calling that relationship an IS curve although the name often confuses and misleads. Strictly speaking it is the combination of real interest rates and the output gap that ensures planned withdrawals (W) equal planned injections (J). As you know from our accounting identities, W=J does not require I=S so the properties of the IS line would be clearer if we all called it the WJ line!

In constructing the IS curve and examining its slope and shift factors we focus on consumption (C), investment (I) and government spending (G). Net exports are dealt with only briefly since we shall delay discussion of external trade and cross-border capital flows to Sessions 12 and 13.

The Jones textbook (notably chapters 16 and 17) devotes a lot of space to the micro foundations of domestic private sector spending,  so we do not need to repeat that in the lecture. In any case, the empirical evidence supporting neoclassical-style models is somewhat patchy.

  • For example, the so-called Euler Equation (Jones, pp 452-455) – derived from intertemporal models of utility-maximising consumption models – appears not to fit the facts. The Euler Equation predicts that, for any degree of impatience, higher real interest rates are associated with stronger planned consumption growth – in other words, present consumption is restrained in favour of more consumption in the future. In practice, it seems that the opposite is the case. This could be a mirage (the statistical problems of separating out causes and effects are notoriously hard) but it could reveal more fundamental problems such as the absence of assumed perfect financial markets and, even more damning, the wholly misleading use of a representative individual to reflect decisions by a heterogenous mix of consumers who build habits and sometimes “act dumb”. Even if individuals do act rationally, outcomes can still end up in a collectively irrational “bad equilibrium”.
  • As for investment, we examine evidence that accelerator (output gap) influences, together with expectations and uncertainty, appear much more important than variations in posted interest rates. The past affects the present but, arguably, the future is even more important; and no-one knows for sure what is going to happen. Hence, a huge role for sentiment, confidence and speculation – fickle stuff that is hard to capture or model. Such Keynesian-style thinking is nonetheless well suited to exploring hysteresis (cycle-trend interactions) and the stagnation themes revealed in Session 4. Indeed, problems of self-fulfilling prophecies – and thus the possibility of persistent deviations from the full-employment steady state  – underpin the rationale of contra-cyclical fiscal and monetary policy. Moreover, the policy instruments can be extended from classic “hard” tools (spending, taxes, interest rates) to “soft” brushes (nudges, guidance, artful communications).
  • Government spending is another focus of Session 8. This leads us into a discussion of the so-called “crowding out” phenomenon, automatic stabilisers and the concept of the Keynesian expenditure multiplier (topics that shall be examined more deeply in Session 9). Again, we learn that elementary textbook “rules” are often invalid – the real world does not easily fit into simple theoretical boxes. Sometimes government action works as intended, sometimes not; the state of the economy and the degree to which private sector behaviour is influenced are key variables that can be tricky to pin down. “Partial derivative disease” is particularly dangerous; assuming other things equal (ceteris paribus) is often misleading, sometimes just plain wrong. On Planet Earth, “fixed” rarely happens.

A key conclusion from our session is that there can be no decisive right answers about the impact of government spending on the economy. You should dip further into that debate but not get discouraged by the enormously wide range of views on offer. Your opinion is as good as anyone else’s but the important point is that you should see where the arguments are coming from and what assumptions are most in need of further investigation.

Macroeconomics is full of such belief-challenging controversies and intellectual fisticuffs. It is what makes the subject so interesting and relevant. As Banksy said about his own trade, “People say graffiti is ugly, irresponsible and childish… but that’s only if it’s done properly.

17 Oct 2018

Money & Finance

Session 7 dips into the murky waters of money and finance. Oceans of uncertainty; troubled waters, a rareness of calm. We are journeying far from the safe and certain world of Solow!

One thing for sure is that macro without finance is Hamlet without the Prince.  Finance predates industrial revolutions and has been the essence of economic life since time immemorial. Finance is one of the core components of TFP – bad finance invariably means bad growth outcomes. Finance delivered the GFC (Great Financial Crisis) – a defining moment of the 21st century. So the first key takeaway from this session is that there is no dichotomy between the real economy and the financial world. Main Street is joined at the hip with Wall Street; you cannot divorce what happens in the real sector from what is going on in the money sector.  Indeed we shall find that financial yield curves (or term spreads as they are sometimes known) can be useful leading indicators of real economy business cycles.

In discussing finance we need to identify the key players (basically everyone!) and acknowledge that money and credit are flip sides of the same coin. Credit – or debt if you are looking at it from the point of view of the borrower – is good. Living standards depend on the ability of households to smooth their consumption over time. Companies would not be able to lift society onto higher growth paths unless credit was available to implement good ideas and diffuse new technology.

Another key takeaway is that bubbles – speculative and maybe unsustainable  asset price booms – are a necessary evil. Bubbles are a way of mobilising capital when the world is full of radical uncertainty and incomplete markets. The alternative is that the State would do the heavy lifting in terms of financing and promoting new ideas. Possible, but an unlikely and arguably an unhealthy way of economic life.

But you can have too much of a good thing. Excessive debt may put the economy onto an unsustainable growth path that ends in tears. Repayment promises are broken, hopes and plans are dashed, and the economy tumbles into recession. 

Before we go too much further, we need to acquire some basic financial tools – especially balance sheet analysis – to help judge whether financials/debt cycles could generate unwelcome shocks further down the road. So prepare yourself for more jargon – leverage, gearing, capital, liquidity. Jones ch10.4 offers some prep for basic financial economics although his definitions of liabilities and leverage are off-beam. As such, I shall stick with wider industry convention. So be careful and use the lecture notes for the correct usage of balance sheet terms! 

Armed with our expanded toolkit we observe that business cycles (usually defined as variations in real GDP performance) are only part of the volatility that macro-economies are subject to on a short- and medium-term basis. Variations in asset prices (especially those of equities, bonds and property) need to be carefully watched. As bitter GFC experience proved, favourable real GDP/inflation performance can mislead the unwary. While politicians were lauding the abolition of the business cycle, the lesser-watched global financial cycle was already close to a Minsky meltdown that engulfed us all by 2008.

A key instrument in the world of finance is, of course, money.  Money is certainly useful and commands a price. Indeed it is so useful that its price can be expressed in at least four ways. However, that discussion would require too much of a digression in class so our key focus will be on the interest rate price. Money itself rarely generates a return so interest rates can viewed as an opportunity cost: the return that is foregone by holding money rather than holding US Treasury bills or bonds (with their typically positive returns).

The principle sounds easy enough but then we unveil another key takeaway – there are many different types of interest rates. Nominal and real, spot and forward, natural and….well… unnatural. Moreover, where debt is involved, interest rates will vary according to the repayment period: payback in a few weeks’ time, 30 years? And then there is a critical debt question: how risky is the borrower? Understandably, the US Treasury can borrow at much lower rates than a company with a poor credit history. Finally, we need to embrace assets that do not have repayment promises attached (equity as opposed to debt).

New journeys, new challenges. Your Intermediate Macroeconomics voyage continues!

12 Oct 2018




How Much For That Dollar?

Money is a special product in that it performs several must-have functions. Yet money comes in different shapes and sizes – physical, digital and in various denominations. Essentially money is a promise, a debt. We no longer inhabit a world of commodity-backed money, ye olde gold standard. Money is what is generally accepted as money and the principal suppliers are private sector banks that have licences to “print” deposits, typically as counterparts to loans. A big helping hand that gives money its moneyness is, of course, official blessing. Namely, State-backed legitimacy and the generous provision of government/central bank support for the private banking system.

So, for fiat money,

  • how much is the promise worth?
  • what, exactly, is the price of money?
  • how will money’s value change if the promise is suspect?

For this exercise, let’s focus on money in its “top quality” format, that is a liability of a government, or more typically, a central bank. This “top quality” money – the best that money can buy – is called the monetary base or high-powered money and FRED is at hand with data. Now let’s illustrate, with the help of simple demand-supply diagrams, the four prices of money, namely

  • the interest rate price
  • the foreign exchange price
  • the goods price (inverse of the CPI), and,
  • the par price (a $ is always a $, right? Wrong!)

Interest rate price. A price is an opportunity cost and the most frequently quoted price for money is an interest rate, reflecting the fact that money (as a demand deposit or cash) typically earns no yield. By having wealth in money format, you are forgoing the opportunity of earning interest on, say, a bill or bond. Using a standard demand and supply diagram we can illustrate this “price” and how it might change, if, for example, the Fed tightened policy by raising interest rates (necessarily being supported by a reduction in the monetary base).

Forex price. An alternative to holding a dollar is to hold another currency, say, sterling. Say the Fed supports a decision to slash interest rates by pumping up money supply, perhaps via Quantitative Easing. Other things equal, the price of a dollar – in sterling terms – will go down. You get less sterling for a dollar. Note you need to be careful as to how you express the exchange rate. Typically, “cable” – the nickname for the dollar-sterling exchange rate – is expressed as $ per £. That’s not going to work in our diagram since we are interested in the price of a dollar, NOT the price of a pound! More of this in sessions 12 and 13.

Goods price. Instead of holding value as $ money you could buy goods and services – we’ll use the catch-all term “Widget” for products in general. Our diagram this time shows a demand-side shift, a weakening of demand for money perhaps because people are worrying that product prices will go up. Buy now, before stuff gets more expensive! The effect is to weaken the price of money (in Widget terms). Expectations of inflation have actually become a self-fulfilling prophesy. We’ll be returning to that issue before too long.

Par. Remember that our focus here is “top quality” money. Cash, such as Federal Reserve notes, falls into this category as do electronic deposits at the central bank (usually only available to a select group of banks).  FRED can show you that high-powered money increased sharply during the Great Financial Crisis, representing a surge of demand for safe, as opposed to risky, money. We illustrate this surge in the relevant diagram below. In 2008 some types of money – such as funds placed in Money Market Mutual Funds (MMMF) – suddenly “broke the buck“. For a while, an MMMF dollar was worth only 97c of a “proper” dollar (eg cash). Par was broken, a sure sign that the financial system was close to meltdown. Little wonder that the public authorities acted swiftly and aggressively to avoid the apocalypse. Restoring par, the litmus test of a functional banking system, required the authorities both to boost “top quality” money supply as well as contain the loss of confidence in substitute money (sometimes called quasi-money or shadow money). The GFC reminded us of a very important historical lesson: not all moneys are born equal.

10 Oct 2018

four prices of money

Indiana Jones does Economic Models

Our focus is about to shift to the shorter-term; that is to say, 5yr-7yr periods where real GDP fluctuations show recurrent, persistent and variable patterns that economists call business cycles. Why do they occur, do they matter, should policymakers get involved? And we need to tackle inflation, labour markets, finance. Maybe venture further into the world of exchange rates, cross-border capital flows, fiscal sustainability? Easy, tiger – we’ll deal with that later on.

For the next few weeks we shall add more analytical kit; new problems, different tools. To aid analysis of the inflation-activity relationship we explore the so-called Phillips Curve, named after Bill Phillips who “discovered” the inverse relationship between UK wage inflation and unemployment in the late-1950s. Although we shall cast some doubt about the existence of such a relationship in modern times, we acknowledge its importance in model-building.

Arguably, more interesting is the story of Bill Phillips himself – often portrayed as the Indiana Jones of economics. He was born in New Zealand and trained as an electrical engineer in the 1930s. He then moved to Australia, making a living as a busker, gold miner, cinema manager and crocodile hunter. He came to London, via the Trans-Siberian railway, at the start of World War II. He joined the Royal Air Force at the outbreak of war but was subsequently captured in Asia, spending most of the war in a Japanese POW camp, where he learned Chinese and some Russian from fellow prisoners.

After the war, Phillips returned to London (to the London School of Economics) and studied Sociology. However, he also developed an interest in Keynesian economics and resorted to his engineering skills to build a physical hydraulic model of the economy (using parts of a Lancaster bomber aircraft); coloured water, tubes, pumps, the works! When Phillips presented his model to the London School of Economics the impact was huge. Nicholas Barr’s tribute picks up the story…

“Over the following year [1949], with encouragement from James Meade, he completed the machine and demonstrated it to Lionel Robbins’s seminar. Everyone who mattered was there. They gazed in some wonder at this large, 7 foot high ‘thing’ in the middle of the room. Phillips, chain smoking, paced back and forth explaining it in a heavy New Zealand drawl, in the process giving one of the best lectures on Keynes and Robertson that anyone in the audience had heard….”

“Phillips rise thereafter was meteoric. He became an Assistant Lecturer in Economics in 1950, Lecturer in 1951, Reader in 1954 (the year his PhD was awarded and the year he married) and Tooke Professor in 1958.”

“His subsequent work at LSE was broadly of two sorts. He is best‑known for his 1958 paper on what later became known as the ‘Phillips Curve’ (a name he would never have given it himself), which explored the connection between the UK unemployment rate and wage inflation over the business cycle. That work was a progenitor of important later theoretical developments, in particular the analysis of expectations in macroeconomics. The second strand was the application of dynamic control theory to economic processes, so as to strengthen the ability of the economy to return to macroeconomic stability.”

Around fourteen of Phillips’ machines were built, one of which was used as a teaching aid at the London School of Economics until 1992. It now graces the new maths wing in London’s Science Museum although, regrettably, is not in working order. As far as I know there are only two machines left that are still working. One at the University of Cambridge (see this hilarious presentation by an engineer in 2010) and the other in The Reserve Bank of New Zealand’s museum (and you can turn it on, virtually, here). Further background on the fascinating story of hydraulic economic models is available herehere and here.

3 Oct 2018

Bill Phillips, MONIAC (Monetary National Income Analogue Computer) and a cigarette!

Bill Phillips with Moniac

MONIAC as represented in a Punch cartoon in 1953

Punch cartoon of MONIAC

Distribution, Rent & Institutions

In session 5 we tackle the thorny issue of distribution. We already know about growth under-performance in recent decades. Now we learn that what extra scraps there are may have been pocketed by the rich, leaving the vast bulk of society no better off, maybe even worse off in real terms. This is hardly a sustainable base from which to build better productivity and living standards all round. Politically, of course, non-inclusive income gains have already proved toxic.

In reviewing what is one of the top problems facing 21st century society we look at inequality from three angles (given limited time we shall focus primarily on income flows rather than wealth stocks).

  • Functional distribution: the share of GDP going to wages and profits
  • Personal distribution: the distribution of income across individuals and families within any given country
  • Global distribution: the distribution of GDP (typically on a per capita basis) across different countries at any point in time

Functional distribution

The Solow model predicts stable income shares and assumes the existence of perfect competition. However, recent data paint a very different picture. Labour’s GDP share has eroded and, to understand that, we need to recognise the imperfectly competitive nature of markets – a feature which has become more prominent with the rise of so-called superstar firms. Dipping into the latest research we examine the links between imperfect competition, higher mark-ups and rising supernormal profits (rent).

Useful, easy reads on this topic are available from Bob Solow himself, writing for Pacific Standard in Aug 2015, as well as a summary of Simcha Barkai’s work on a Chicago Booth blog (Nov 2016). Following is another picture to whet your appetite from The Rise of Market Power and the Macroeconomic Implications, De Loecker & Eeckhout, Aug 2017.

evolution of average markups 1960-2014

If you need it, background revision on rents, imperfect competition and market power can be found in this section of the CORE Economics textbook.

Personal distribution

With the aid of Gini coefficients and quantile data we shall explore the dramatic rise of within-country equality over recent decades. General interest in the topic soared in 2014 when Thomas Piketty’s Capital in the Twenty-First Century was published in English. A 700-page economics tome topping the Amazon sales list!  Just one word – RESPECT.

Not everyone is convinced by the Piketty thesis which blends modern growth theory with history and Marxism. But the writing is beautifully crafted and the book is full of fascinating data that are supported by painstaking research. As part of his historical contextualising, Piketty makes reference to some great works of literature (it inspired me to revisit Balzac and Austen). Taking grand sweeps of gilded ages and updated Great Gatsbys we tackle his two “laws” of capitalism and place them in the context of the Solow model that you know and love. 

Global distribution

Comparing GDP across countries can trip up the unwary. A key problem is exchange rates which do not always properly reflect purchasing power. So we take the opportunity to learn about international dollars and apply the concept to comparisons of the US with India and China.

We also focus on the issue of convergence. Can we reasonably expect poor countries to catch up with their rich neighbours? Or are regions like Sub-Saharan Africa doomed to poverty? The Solow model is partly useful in organising our thoughts although we need to break free from its many restrictions to get to the heart of the matter.

As underlined in session 3, TFP is not simply about technology but also about institutions and politics. If you are not convinced then maybe we need to talk about Britain’s surge in GDP per capita since the mid-18th century. Was it just tech know-how (steam engines and all that)? Or maybe the extraordinary public-private partnership with, for example, the East India Company had something to do with it. Military domination is undoubtedly part of the reason as to why Asia – at the tech frontier in the middle ages – went into sharp relative decline after the various voyages of “discovery” in the 16th and 17th centuries. If you feel inclined to pursue, Niall Ferguson’s Empire and Shashi Tharoor’s Inglorious Empire offer plenty of uncomfortable truths about politics, power and growth. Combinatorial forces really come into play when you mix armies with steamships, cables, railways, theodolites and maps. Commerce, conquest, colonisation – hard to disentangle when they are working in such harmony.

And we should also recognise, ahead of session 7, that financial institutions are critical to TFP. Indeed many historians cite British and Dutch innovations in the banking, insurance, security and derivatives markets as principal drivers of economic (and military) success from the 17th century onwards; innovations that generally preceded the first Industrial Revolution.

In class we refer to Acemoglu and Robinson’s work on Why Nations Fail as well having a discussion about topical geopolitical-TFP overlaps such as Brexit and China’s Belt and Road Initiative. If we have time we might also touch on the view that, in the 21st century, the battleground is not so much between sovereign nations but between sovereign nations collectively and the major tech corporations.

27 Sep 2018

Innovation & Stagnation

For the next couple of sessions we tackle some of the most pressing issues facing 21st century economies: stagnation and inequality. The Solow model will help set the scene but we shall need to break out of its restrictive assumptions to start finding answers. Recall that the Solow model emphasises perfect competition and smooth, continuous efficiency; effectively, finance and politics are pushed out of sight. Needless to say, the model does not make much of a case for State intervention, except perhaps for nudging the savings rate towards its Golden Rule level.

For session 4 we start with looking at the evidence of so-called secular stagnation. Our focus is on the United States but we shall touch on similar trends for other advanced economies. We make frequent reference to recent, cutting-edge research to help gain insights.

We soon find that a principal concern is the slowdown in total factor productivity growth – the fountainhead of rising living standards. We discover that the problem may be far worse than previously thought. Since the end of the Second World War US GDP growth has averaged around 2% per annum. But some recent estimates suggest that over three-quarters of that trend represent transitional factors. “Core” (steady state) US growth may already be close to zero.

Yet surely something is wrong. Every day we hear stories about the latest gizmos that make up the 4th Industrial Revolution. AI, driverless cars, biotech advances – surely these must count for something? Taking a brief historical sweep of innovation it seems reasonable to argue that we are witnessing the emergence of yet another General Purpose Technology that could transform society’s future.

So we shall meander through several arguments to try and explain this apparent paradox of technological advance and GDP stagnation. Firm conclusions are hard to come by, understandably. But, while our destination is unclear, enjoy the scenery, it’s really worth soaking in.

Argument #1: GFC & policy legacies

Are we just seeing the after-effects of a particularly nasty recession that we call the GFC (Great Financial Crisis of 2008 onwards)? We note that easy monetary policy may have over-cushioned inefficient (and unproductive) zombie companies. Successful innovation often requires creative destruction; you can’t make omelettes without breaking eggs. So maybe the central banks’ well-meaning policy of low interest rates needs to be toughened up – clear out the dead wood and all that.

Moreover, as we shall discuss, the State has hitherto played a huge role in supporting innovative activity (especially DARPA’s “starring” role in making the iPhone smart). Yet the State’s increased debt burden – following its 2008 rescue of the finance system, may have weakened its risk appetite. That would be a shame because, left to its own devices, private markets will typically underinvest in projects that are necessarily infected by radical uncertainty.    

It is hard to come to firm conclusions but there may well be something in this line of argument. The key problem, however, is that the evidence of a slowdown in TFP growth significantly predates the GFC. For a full story we need to look further.

Argument #2: Measurement Error & Aggregation Issues

Superficially there is something to be said for the idea that stagnation reflects GDP measurement shortfalls. But scratching deeper below the surface suggest that while mis-measurement could lead to an understatement of the level of per capita GDP there is a compelling view that measured growth has not been significantly biassed. 

What does emerge of interest is that once aggregate data are unbundled into various sectors and firms there is clear evidence of sharp divergence in productivity performance between the frontier and the laggards. This is interesting because it suggests that any tech pessimism (see below) does not extend to all companies. Some firms are doing very well; it is disappointing that there are not more of them!

Argument #3: Tech Pessimism

Bob Gordon’s famous comparisons of new technology with flushing toilets and paved roads cannot be ignored. He makes an entertaining case for the view that innovation is not what it used to be and is certainly not strong, or impressive enough, to counter macro headwinds of unhelpful demographics, the peaking of educational attainment, excessive debt and growing inequality. We supplement Gordon’s thesis with evidence of a deceleration in Moore’s Law and a marked slowdown in ideas productivity growth. We also consider the view that diminished industrial competitiveness has dulled incentives to research new ideas.

The pessimistic view has plausibility but, in my view, is a bit too pessimistic. So, in the interest of balance, we turn to a more optimistic thesis – you ain’t seen nothing yet!

Argument #4: Diffusion Dynamics

Using historical evidence on the steam engine and electrification a convincing argument can be made that the path from ideas to diffusion (implementation in wider technologies) does not happen quickly. Indeed it can take several generations. The fourth industrial revolution is just in its infancy. And, arguably, the full benefits of its IT predecessors has still not been fully embraced.

Looking at the rise in R&D spend by chip-makers and others it is hard to escape the conclusion that there is still plenty of room for optimism. 

Introducing Risk, Challenging Convention

We conclude this session’s journey through secular stagnation by talking about r-star and its slow motion “crash” in recent decades. The story is undoubtedly linked to the (apparent) slowdown in trend GDP growth – we saw it in our Solow steady state equation. But we can also put forward a richer narrative that introduces risk and its impact on both savings and investment.

We’ll be coming back to that risk topic in future sessions, especially in trying to understand business cycles, the nature of finance and the challenges posed for monetary policy. 

Hopefully, our discussion has also encouraged you to think about models and their assumptions. We have found that there is strong evidence to support active engagement by government in the supply-side of the economy. That said, in examining innovation and entrepreneurship we should also question conventional views that advise stability and the absence of bubbles. Maybe we should live life dangerously; risk-taking is arguably the feedstock of TFP and the future growth of living standards. So does demand management smoothing  conflict with a buccaneering supply-side spirit? Hold those thoughts please for future sessions.

22 Sep 2018