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.
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!
14 Mar 2019