Policy Divergence & the Dollar

In our session on exchange rates, we introduced the concept of interest rate parity. The basic idea is that efficient market forces will set a global benchmark for safe real interest rates. Safe usually means the short-term rates paid by State institutions such as the Fed, the US Treasury and their equivalents in other parts of the world. And short-term means just that – the yield paid on debt maturities that are often significantly less than one year. For such financial instruments, any interest rate divergences will prove temporary and associated with real exchange rate disequilibria.

Once we move beyond these short-term official rates it gets more complicated. Market  rates, the longer-term interest rates that drive consumer and investment spending, typically involve risk. However, uncertainty is variable, not fixed, and depends on circumstances – not least the business cycle and mercurial expectations.

Moreover, beyond the short term, uncertainty is not confined to credit risk (where payment promises – if they exist – might not be honoured). Market rates will be buffeted by varying risk premia connected with liquidity, geopolitics, sentiment, inflation outlook and growth prospects. As we learnt in session 7, asset prices – even of high credit quality US Treasury Bonds – can change simply because of fluctuations in policy or the inflation outlook. For most advanced economies, governments are hardly likely to default on their borrowing. But, US Treasuries and other government bonds can be highly volatile if investors alter their views about the likely path of short-term policy rates, perhaps because the inflation target seems less likely to be achieved. Even prospective moves in the regulatory environment or tax treatment of government debt could shift market prices, creating headaches for investors despite secure cash flow promises.

In Session 13, our penultimate teaching week, we explore the interactions of mobile capital, floating exchange rates, policy choices and international economic performance. As with our domestic AD-AS model we soon discover that fickle expectations play a key role. However, unlike goods and services, global financial asset prices are far from sticky. Valuations are highly sensitive to changes in beliefs. Moreover, such expectations are not always firmly rooted or classically rational. Bob Shiller’s article on potential reactions to the Fed’s widely-expected rate hike in December 2015 is highly recommended. His references to behavioural finance are worth noting with the theme of human psychology prominent in the literature on rational inattention. And take a look at the worked examples especially the topic of risk-on and risk-off dollar trading. Our session touches on the point that, when analysing shocks, it is important to assess whether that shock is expected to be temporary or permanent. Similarly key is whether markets see the “”shock” coming (an anticipated shock) or whether it comes completely out of the blue.

IMF analysis confirms the importance of risk premia and interest rate differentials. A July 2016 study presents a plausible narrative explaining 2014-16 US$ strength in terms of risk premia and yield differentials. There is also evidence of a dollar safe haven effect in the context of heightened global risk; a feature that has been amply confirmed in the Covid crisis.

A 2016 Fed study on international spillovers of monetary policy tackles another important theme. Specifically, changes in US monetary policy can significantly impact foreign economies.  Taking the example of GFC-related cuts in US interest rates, the analysis shows the quantitative importance of three distinct channels:

a) exchange rate: a softer dollar, reflecting lower interest rates, will boost US exports and so weaken foreign GDP
b) domestic demand: but, in the opposite direction, better US GDP performance – on the back of a weaker dollar – sucks in imports, so providing offsetting benefits to overseas producers
c) financial spillovers: lower US interest rates will pull down foreign asset yields so benefitting foreign GDP (although note BIS concerns about potentially greater risk-taking in emerging markets)

The Fed’s empirical work suggests that a) and b) net out. In other words, the overall effect of US monetary easing, represented by c), is GDP-positive for the world economy.

Of course, it is not always a one-way street as our feature video makes clear. Foreign developments can also independently impact the US. America is a large and powerful country, but we should never underestimate the importance of global networks and feedback effects. The dollar can change not just because of what happens in the US but also because of overseas shifts in asset prices and risk tolerance.

In quantifying these monetary spillover effects the Fed makes use of its SIGMA model, one of several that US officials use in framing interest rate and other policy decisions. As such, the empirical studies cited above are a useful prelude to our final session that focuses on large-scale macro models – both conventional DSGE models widely in use amongst central banks as well as increasingly popular Agent-Based Models (ABM).

Throughout the course we have gradually expanded our modelling expertise. But you will be aware that macro-analytical techniques faced extensive criticisms after the GFC. Are these models too pointy-headed, too remote from reality, to be of any use? Hopefully, I can persuade you that these quantitative techniques are worthwhile. But, as with their epidemiological equivalents, models can only get us so far. And, as with coronavirus, models can be unnervingly revealing about how much more we need to learn!

SPH
22 Apr 2021

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 once Covid-related travel restrictions are lifted. 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.

SPH
15 Apr 2021

The Model Student

Recent sessions have looked at fluctuations of the economy around long run trends, encompassing both real and financial cycles. So far, domestic variables have been the focus of attention. Issues such as trade, global value chains, exchange rates and cross-border capital flows are being left for Sessions 12 and 13.

Our modelling of cycles started with core concepts such as the output gap and real interest rates. And we reviewed key relationships including the Phillips Curve, which links inflation to the output gap.

In strengthening modelling skills, we have recognised the importance of dynamics, whether shocks are short- or long-lived and how those shocks might be propagated through the economy. Cyclical stability is not necessarily a given and even if mean reversion takes place, the journey could be long and arduous – perhaps leaving permanent scars. We called that trend-cycle interaction “hysteresis”.

Indeed, markets left to their own devices often generate unacceptable outcomes for society. So, we look to governments and their agencies to guide events in more favourable directions. In studying stabilisation policies such as fiscal policy, monetary policy and macro-financial policy we have found plenty to keep public officials busy – on both the demand and supply-side of the economy.

Certainly, one of the frequent takeaways in recent sessions is that the macro economy is far from easy to analyse – there are so many moving parts. It is no surprise then that forecasts can sometimes be very wide of the mark and “what-if” exercises (simulations) are but a tiny sample of the range of possibilities.

But that does not mean that we should not try. That is why we use models – to help simplify and focus on the essentials. To see the wood for the trees. To improve our chances – in a highly uncertain and complex world – of making good decisions, either as private individuals or companies, or as policymakers. Our models have so far been relatively simple, involving limited algebra and generally making use of diagrams. Impulse response functions were especially illuminating for dynamic processes such as multiplier-accelerator interactions. But the key graphical workhorses for AD-AS analysis comprise,

  • Curves in real interest rate/output gap space – the IS and TR curves of Sessions 8 and 10 respectively
  • Curves in inflation/output gap space, such as the Phillips curve of Session 6 – a proxy for aggregate supply. There is another curve we need, an aggregate demand (AD) curve that has yet to be tackled

So, Session 11 not only reviews where we have got to but also fills in the gaps. By the end of this session you will be a fully-fledged AD-AS Model Student.

Following a review of IS and TR curves, including reminders about slopes and shifts, we construct the missing AD curve. The good news is that this curve simply combines the interaction of IS and TR curves and maps outcomes into inflation/output gap space. We take time and care to examine its slope, shifts and dynamics.

As for the AS curve we have already done some groundwork with a simple Phillips relationship. However, there is more to do. We recall that in practice, inflation and prices tend to sticky – not terribly responsive to the state of the business cycle. We look at a model of sticky prices that brings into play a core variable for us – inflation expectations. Expectations are a central feature of modern macro models and are the means by which perceptions about the future – sometimes fickle and irrational – can influence the present.

Once having considered a more general form of the AS curve (the accelerationist Phillips curve) and broadened our understanding of inflation expectations, we then have all the necessary elements to perform some intermediate AD-AS analysis.

We start by looking at a very simple closed economy model comprising four equations which you can solve manually and play around with in Excel. This model will form the basis for in-class discussions and student presentations.

We finish by moving up a gear, seeking to apply AD-AS analysis to the Covid-19 crisis. Here we appreciate the benefits of more complex software available to macroeconomists and make more extensive use of impulse response functions. The IS/TR and AD/AS workhorses can only go so far as informative graphical tools.

When we gear up further, adding many more moving parts from international trade and finance, IRFs come into their own as a better graphical choice ahead of finishing the course, in Session 14, by looking at cutting-edge macro models used by top academics, Wall Street researchers and policymakers.

SPH
9 Apr 2021

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 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 blog article from John Cochrane and these slides from James Bullard at the FRB St Louis.

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.

SPH
8 Apr 2021

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 market-determined fed funds rate. Yet, even here, there can be exceptions. This becomes evident in crises such as the GFC and Covid-19, when, for all practical purposes, the Fed cannot reduce the rate below its Zero Lower Bound (ZLB). Moreover, given that r-star appears stuck at low levels, this problem will reoccur in future periods of stress.

As for inflation expectations and risk premia, these are subject to market vagaries and sentiment swings. They are not levers that a central bank can easily pull. Yet we should not be too disheartened. 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, emergency liquidity, QE shock and awe. But to be credible, they also require governmental co-operation – supportive fiscal policy, new legal frameworks, recapitalisations. Central banks 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. Moreover, when an economy is hugging the ZLB the Taylor Rule is effectively redundant.

Even when rates are above the ZLB, 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.

Following the GFC, the Fed has adopted many new monetary policy tools. Old textbook descriptions of reserve requirement ratios, the frequent use of open market operations and the backdrop of limited reserves are no longer relevant. In the new world, the policy rate (a market-determined fed funds rate) is primarily driven by administered rates such as the IOR (interest rate on reserves), supplemented by the Fed’s overnight reverse repo rate.

Also, following the pandemic, it is clear that the relationship between fiscal and monetary policy has been transformed. The notion of an independent central bank doing its own thing was, in any case, always suspect. The supply-side functions of monetary and macro-financial policy are now in clear focus with co-operation between governments and central banks proving vital for the huge macroeconomic challenges that lie ahead.

SPH
1 Apr 2021

Debt Traps

In the early part of our course we identified some core structural problems challenging policymakers in the 21st century. Specifically, we noted the stagnation in productivity growth and the associated brake on living standards as well as the dip in the “normal” real interest rate, r-star.

In our sessions dealing with business cycles, the implications of a low r-star for demand management are clear. 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, even before Covid-19 struck, the FOMC indicated 2.5%-3.0% 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, in crises such as this pandemic, central banks have limited headroom as regards conventional monetary policy. The effective lower bound, not significantly different from zero, is on our doorstep.

So it comes as no surprise that fiscal policy is already bearing more of the burden of demand management. Governments, as well as central banks, need to be more proactive. And, in contrast to the post-GFC recovery, the IMF, OECD, even the ECB, seem positively gushing about the benefits of fiscal largesse and remain remarkably relaxed about big deficits and debts persisting well into the future. For sure, to revitalise the supply-side, governments are under unprecedented pressure to tackle productivity impediments.  That generally translates as less inequality, better public infrastructure – physical, intellectual, R&D – and greater public preparedness for climate change/further pandemic threats.

But while we all expect a lot from fiscal policy, there are no guarantees that it will work. Certainly, significant efforts have to be made to ensure that publicly-funded programs are efficient, equitable and sustainable:

  • 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 this session, session 9, we explore 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 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 ( INT of T = TX – TR – INT fame). 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! Policy that is meant to be stabilising can become destabilising.

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 might get investors twitchy who 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.

The bottom line is that fiscal generosity– albeit launched with noble, anti-depression motivations – can lead to problems of their own unless carefully managed and targeted towards long-run growth enhancement. The scarring versus overheating tradeoff is tricky to navigate.

In response to Covid, the US administration has already committed many trillions of US$ to budget measures. Such a huge sum is comparable to a wartime manoeuvre, which effectively it is. Of course, Uncle Sam enjoys an “exorbitant privilege” in that it has a captive audience as regards creditors. America’s perceived safe haven status, reflected in the primacy of 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!

Monetary injections (sometimes called helicopter money), courtesy of a supportive Fed, can temporarily skirt round problems associated with bond finance. But too much liquidity, over a sustained period of time, can introduce fresh dangers such as heightened inflation expectations.

If there is one key takeaway from this session, it is that fiscal policy is no silver bullet and that the “right” choices to be made are certainly not self-evident.

SPH
25 Mar 2021

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 can focus on key issues, removing unnecessary detail and sometimes revealing conclusions that were not immediately obvious. But models can also lead us astray if we are not careful. Major 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 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) invariably 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 even though 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 micro/neoclassical models is somewhat patchy.

  • For example, the so-called Euler Equation (Jones, pp 464-467) – derived from intertemporal models of utility-maximising consumptionappears 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 notorious) 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 scarring (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 to 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 are 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.

SPH
18 Mar 2021

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) – an early 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 (term spreads) and  risk premia (credit spreads) 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.

Armed with our expanded toolkit we observe that business cycles are often “shocked” into existence by financial impulses. Moreover, finance is not a tame lackey of the real economy; it has a life of its own! 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. The Covid-19 episode similarly carries more than just health threats, The disruptive influence on activity and corporate solvency could well add a financial trauma to the mix; a scenario that we all want to avoid.

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!

SPH
10 Mar 2021

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.

SPH
10 Mar 2021

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 the links with inflation and labour markets (as well as financial markets but we leave that until Session 7). Some tentative thoughts will be offered on the characteristics of the Covid recession – not least on the issue of scarring (also called hysteresis).

Our first task is to understand what Jones (textbook author) means by “short-run” output and what everyone else calls the output gap. In principle, this gap is central to effective macro analysis and policymaking but, in practice, is notoriously difficult to estimate and a source of many heated controversies. The gap acknowledges that, contrary to Solow Land, actual GDP can over- or under-shoot its long-run potential. This, is turn, can give rise to inflation volatility and swings in employment prospects that typically require evasive policy action from governments and/or central banks.

Another task is to explore whether disturbances (shocks/stochastics) around the equilibrium path burn themselves out or whether they lead to explosive/implosive behaviour. Typically, macro models assume long-run stability even though we might need fiscal and monetary policy to hurry things along.  The issue of stability is not without controversy and we touch on this with the aid of the famous Multiplier-Accelerator model, developed by Nobel Prize winner Paul Samuelson in the 1930s.

We quickly learn that, like R-Star, potential output (and hence the output gap) is a “hidden” – often called latentvariable. The same is true of its labour market equivalent, the “natural” rate of unemployment, sometimes referred to as NAIRU (the non-accelerating inflation rate of unemployment). To help us, we deploy a useful relationship between the jobless rate and the output gap called Okun’s Curve.

There is nothing out there that tells you what the values of these latent variables are. You have to estimate them, with models, from observed data that themselves are volatile, imperfect and subject to revision. Needless to say, different models give different answers. One thing applied macroeconomists learn is humility in the face of such uncertainties. Point projections are out, confidence intervals are in.

And, given the importance of R-Star, output gaps and employment gaps to policy, there is clearly plenty of room for argument. There have been numerous bust-ups in Europe about fiscal austerity – often centred around differing views of output gaps. Recently, the controversy surrounding the $1.9trn Biden package – will it let the inflation genie out of the bottle? – offers yet another example.

So, for the next few weeks we 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.

SPH
4 Mar 2021
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