Archive for the Category Eurozone

 
 

Make sure you follow the right crowd

Over at Econlog, I have a post explaining why Brexit is not about Britain.  That’s clearly not the conventional view, if you read the pundits.  Philo asked this question:

Scott, you really do think for yourself, rather than just following the crowd–for example, the crowd of economists. (That means you are a genius or–somewhat more likely–a crank.) All the more surprising, then, that, in some of your epistemological posts, you advise *us*, your readers, to *follow the crowd*!

The best way for me to explain this issue is to point to those European stock markets that fell by 3 times as much as British stocks.  The French and German markets were down around 7% or 8%, while the southern markets fell even more sharply. In contrast, the British market was only down 2.75%.  This has been called the biggest day in British history since WWII, but it’s probably not that big a deal for the UK economy.

So yes, pay attention to the crowd, but make sure it’s the crowd who puts their money where their mouth is.  That would be the asset markets, plus Bryan Caplan.

I’m also seeing a lot of confusion about the nature of uncertainty.  Unlikely things happen every day; it’s no big deal.  Every time the Dow moves more than 1% in a day, that’s an unlikely event.  A couple weeks ago, Cleveland was down 3-1, and had about a 5% chance of winning it all.  They did.  So when something with a 25% chance occurs, it’s no big deal.  One in every 4 elections sees an upset of that magnitude.

Let’s think about what the markets are telling us.  In my view the 7% or 8% fall in European stocks should be viewed as a 20% chance of a catastrophic eurozone breakup as a result of Brexit (as compared to the previous probability) in which case markets might plunge 30%, and an 80% chance that this crisis will be papered over, as previous Greek crises were papered over, and markets recover. I think this confuses people, as the 7% or 8% fall is almost certain to be “wrong”, ex post.  Either stocks should have fallen 30%, or almost not at all.

Those who see Brexit as a “real shock” that disrupts British trade are missing the big picture.  (Here I agree with Krugman; changes in trade rules at the margin are not of much macroeconomic significance, although they are certainly unwelcome if protectionist.)  The conventional pundits who focus on Britain have no explanation for the stock market figures I cited, and probably attribute it to “irrationality”, or “fear”.  It much simpler than that—the eurozone is a dysfunction monetary regime, and the UK pound is not.   (I suspect that’s why the Japanese market fell sharply—the BOJ is an increasingly dysfunctional institution, which has recently seemed to give up on its goal of 2% inflation.)

I know that we like certainty, but the truth is that we just don’t know what will happen.  We don’t even know whether Britain will leave the EU.  I think it will, but I’d guess there’s at least a 25% chance that Scotland won’t, and at least a 5% chance that the negotiations about how to do so will drag on for several years, by which times the voters will be asked once again.  The young favored staying by a 3 to 1 margin, so time is on the side of those Brits who favor a cosmopolitan UK. Every day another Little Englander dies off, and another pro-EU Brit turns 18. Recall that in Europe, every time the voters of a country voted the “wrong way” on an EU referendum, they were asked to re-vote until they “got it right”.  Again, I think Britain will leave, but nothing is certain in the world of politics (as I learned when I said Trump had no chance of getting the nomination.)

Here’s the wisest way to view market forecasts:

1.  Market reactions will almost always later be shown to have been “wrong”.  But which way?

2.  Nonetheless, market forecasts are the best read we have on the implications of any shock, including Brexit.

PS.  If you believe the claims I made in my earlier “You’re not special” post, then objectively speaking it’s more likely that I’m a crank than a genius.  Keep that in mind, and read all my posts with a very skeptical eye.

PPS.  Those who claim that Britain may have done the rest of the world a favor by providing a cautionary tale for a withdrawal from globalization better take another look at those stock markets.  There are cautionary tales of illiberalism out there, like Venezuela, but don’t assume the UK will become one of them.

Long run NGDP growth and long term nominal interest rates

If you had to write down a simple model of long-term nominal interest rates, you might start with long run expected NGDP growth, although as we’ll see it’s actually a lot more complicated.  Here are some recent data on NGDP growth over the past 8 years, and 10-year bond yields:

Country   NGDP growth rate   10-year yield

USA               2.75%                1.69%

Eurozone        1.17%                0.05%  (German)

Britain           2.41%                 1.28%

Japan           -0.21%                -0.15%

Australia        4.15%                 2.15%

In the first three cases, bond yields are a bit over 1% below long-term NGDP growth.  If we applied that to Japan, you’d expect negative 1.25% bond yields.  Why are actual rates so much higher (less negative) in Japan?

1.  Perhaps the zero lower bound prevents deeply negative nominal rates.  This is the best argument for Abenomics–the Japanese Treasury has been paying excessive interest on its debt.  They need at least Eurozone levels of NGDP growth, to get equilibrium bond yields up to zero.

2.  Perhaps rates are not lower because NGDP growth has recently established a higher trend, under Abenomics.  Bond yields are a forward-looking variable.

3.  Perhaps what matters is NGDP/person growth, not NGDP growth.  Thus Texas and Illinois have the same risk free rate, even though Texas’s population (and NGDP) are probably growing about 2 percentage points faster than Illinois.  Japan has a falling population, and hence growth in its NGDP per person is closer to European levels.

I’d guess all three factors matter, and others as well.

Australia is sort of the opposite of Japan.  In Australia, NGDP growth has recently slowed, not accelerated.  And they have faster than average population growth.  Those factors might help to explain why nominal bond yields are 2 percentage points behind NGDP growth.

Even so, there’s a very strong correlation between long run NGDP growth and long term interest rates.  It’s up to each central bank to determine the long run NGDP growth rate, and by implication the long-term bond yield.  If you want higher interest rates, ask for easier money.

PS.  A few corrections on recent posts:

1.  Commenter BJ Terry pointed out that in my recent Bullard post I misunderstood they way he used the term ‘regime’. I thought Bullard meant policy regime, but after reading his paper it’s clear he means macroeconomic regime (expansion or contraction).

2.  When I wrote the recent post on the Modi government, I was unaware of a decision to liberalize foreign investment regulations, which was announced yesterday. I hope my post was wrong.

 

The opportunity cost of helicopter drops

Tyler Cowen links to a Wolfgang Münchau post advocating helicopter drops:

I have argued in favour of a ‘helicopter drop’ , even before the recent deterioration in economic growth and the outlook.

A helicopter drop means that the ECB would print and distribute money to citizens directly. If it were to distribute, say, €3,000bn or about €10,000 per citizen over five years, that would take care of the inflation problem nicely. It would provide an immediate demand boost, and drive up investment as suppliers expanded their capacity to meet this extra demand. The policy would bypass governments and the financial sector. The financial markets would hate it. There is nothing in it for them. But who cares?

The ECB has not run out of ammunition but the number of effective policy tools is clearly finite.

I criticized this view in many different ways, so today I’ll use the “opportunity cost” argument.  First of all, the ECB never runs out of ammunition, as there is an almost infinite set of assets that they could purchase, at least in principle.  Second, while some types of asset purchases would be controversial, obviously a helicopter drop would be 10 times more controversial.

Münchau’s proposal could actually be seen as combining two distinct policies:

1.  First, buy up enough assets to hit your inflation target, no matter what it takes.

2.  Then give the assets away to the public.  This would be like if Norway were to suddenly do a helicopter drop of its Sovereign Wealth Fund onto the residents of Norway.

Since step 1 already solves the AD problem, step two must be evaluated separately, on its own merits.  Unless Münchau thinks it would be a good idea for the Norwegian government to suddenly drop all of its assets on the Norwegian public, there is no argument for helicopter drops.

Suppose the ECB were to use the “whatever it takes” approach, and buy €X trillion in assets.  Then it could move from OMOs to a helicopter drop by simply giving away these assets.  So what’s wrong with that?  One problem is that if the ECB is actually successful, then interest rates may rise above zero.  In that case to prevent hyperinflation the ECB would have to buy back much of the money that’s been injected.  But what would they use to buy back the money?  After all, they’ve given away their bonds in a helicopter drop.

Instead, Eurozone governments would have to raise distortionary taxes in order to recapitalize the ECB.  This is just another example of the basic proposition that if a fiscal action can only be justified on the grounds that it would boost AD, then it’s completely unjustified.   Obviously the Norwegian government would never do a helicopter drop of bonds on classical public finance grounds, which means they should never do a helicopter drop of bonds.

Münchau does briefly address the option of buying bonds instead of doing a helicopter drop, but in a completely unsatisfactory fashion:

My second recommendation is about measures that should not be taken — policy gimmicks. These are decisions that get some people excited but will not lift the rate of inflation. For example, the ECB should not buy bank bonds, or indeed any other form of corporate bonds, or equity. The reason banks are not lending is not a lack of funding but the presence of too many toxic assets on their balance sheets. It would be much better to address this problem directly.

This makes no sense.  If you were going to buy exotic assets then the whole point would be to raise inflation (or NGDP.) That is, you’d want to buy enough to boost inflation up to target.  So it makes no sense for Münchau to suggest the policy might fail to boost inflation.  If it were not going to be pursued aggressively enough to succeed, then what would be the point of doing it at all? And of course bank lending is completely beside the point, and has no relevance for whether OMOs would boost inflation.  OMOs are inflationary because they boost the money supply relative to demand, and that sort of OMO would be inflationary even in an economy where banks did not exist at all.

The opportunity cost of doing a helicopter drop is that you forego a much cheaper option, merely relying on a “whatever it takes” set of OMOs, which do not require distortionary taxes to recapitalize the central bank.

Here’s one of those rare cases where the common sense of the man on the street is correct.  Dropping money from helicopters really is too good to be true.

PS.  The anti-helicopter drop message of this post should not discourage fans of eurozone reflation.  A helicopter drop would be very politically contentious.  In contrast, much more effective tools such as OMOs are less controversial, and also superior policy options.  It’s a win-win.  I very much doubt the ECB would even need to buy exotic assets like stocks and corporate bonds; God knows the eurozone has plenty of public debt to buy.

PS.  I have a related post over at Econlog.

Greg Ip on monetary policy

Where does all the time go?

I just noticed that I’ve fallen behind on the set of podcasts by David Beckworth, so I will work through the ones I’ve missed, starting with the Greg Ip, one of our best economic journalists.  Here’s my favorite comment by Ip:

And it actually may be better to have lots of small financial disruptions than one big financial disruption.

In Greg’s recent book he discusses this idea in more detail.  In the interview, Greg uses analogies such as the danger of continually preventing small forest fires, and thus building up fuel for a catastrophic fire.

Over the past 50 years the government has prevented financial crises about every decade or so, by either bailing out depositors of large banks, or arranging assistance in the case of LTFC (1998).  And this had the effect of storing up fuel (moral hazard) for an even bigger crisis in 2008.  But I would go much further that Ip, who approves of FDIC.  It’s not politically possible to abolish FDIC, but perhaps we could create a two-tier system where insured deposits are backed by safe assets, so that taxpayers are not put at risk.  Deposits used for lending to businesses and homebuyers would not be insured, but would offer higher interest rates to depositors.  Let bank depositors choose how much risk they are willing to take.  Ip also is appropriately critical of the regulatory overreach of Dodd-Frank. BTW, banks would hate my FDIC reform proposal, but it could be combined with the complete repeal of Dodd-Frank.

There are also a few areas where I disagreed with Ip.  At one point he wondered why there was so much discussion of the need for monetary stimulus. After all, unemployment in the US and Japan is relatively low, and the unemployment rate in the eurozone is now declining at a decent clip.  This is a good argument, but I think he’s also missing something important.  Monetary policy must be judged as a regime, not in terms of day-to-day considerations of macroeconomic stability.

For better or worse, central banks now focus most of their effort on inflation targeting, with some attention also paid to keeping unemployment close to the natural rate. Recall that the natural rate hypothesis predicts that the public will eventually adjust their expectations to match any inflation rate, and unemployment will eventually move back to the natural rate.  When viewed from this perspective, I think what Greg’s really asking is what difference does it make if the Eurozone has 1% inflation, or 1.9% inflation, as long as it is reasonably steady and as long as unemployment seems to be adjusting back to the natural rate.

I see two problems with the ECB allowing 1% inflation to be the new normal:

1.  If this were to occur, the public would lose faith in the ECB’s inflation promises. This would make ECB policy less effective in the next crisis.  If central banks are going to set inflation targets, then those targets should mean something.  If they decide not to target inflation (as I’d prefer) then it’s essential that they set some other target, such as NGDPLT.

2.  If 1.0% inflation, rather than 1.9% inflation, becomes the new normal in the ECB, then nominal interest rates will move to a permanently lower track.  And since real interest rates seem to be entering a new normal which is well below the rates we saw in the 20th century, a lower trend rate of inflation would mean that the ECB will be stuck at the zero bound for a much greater percentage of the time.  Indeed financial markets are already quite pessimistic about the future course of eurozone rates, especially for safe assets like German and Swiss long-term bonds.

Notice that points 1 and 2 relate to each other; both make it more difficult for the ECB to achieve its goals in the future.  So there is real value in taking an announced inflation target seriously, and trying to hit it.  BTW, the US is doing much better than the eurozone and Japan on the inflation front, but just today Kocherlakota warned that even the US is likely to fall short of 2% inflation going forward.  (I’m a moderate on this question—I think they’ll probably fall a bit short, but perhaps not as much as Kocherlakota and some of my fellow MMs believe.  I see something around 1.8% as the new normal.)

At one point Ip asked David the question of what should the Fed actually do to implement an NGDPLT policy regime.  I hate these “concrete steppes” questions, but we need to face the fact that this is what everyone wants to know.  The reason why I hate these questions is because I know the sort of answer people are looking for:

Desired answer:  Some big bazooka of a monetary policy instrument that is so powerful that it can clearly move NGDP to the desired policy path.

My answer:  NGDPLT is the big bazooka, and once implemented you merely need to do tiny little OMOs, like we did back before 2008.

And I know that this answer won’t satisfy anyone.  They think money has been very easy, and if we’ve fallen short then we must need very, very, very easy policy.  We MMs think money has been tight, and that a NGDPLT target could be hit with the sort of moderate policy we had before 2008.  In other words, if 5% NGDPLT were adopted in 2007, or right now, the policy would look pretty much like what you saw in Australia after 2007, or what you see in Australia today.  Positive interest rates.

But yes, you do need a big “instrument” bazooka lurking in the background, just in case.  That makes the system credible, so that you don’t actually have to use it. For David the big bazooka is the Treasury, promising to do a coordinated fiscal/monetary expansion if the Fed runs out of ammo.  For me the big bazooka is a Fed promise to buy any and all financial assets, anywhere in the world, until market expectations of NGDP growth are equal to 5% (or whatever the target chosen.)

And the other point I always make is that the lower the NGDP target (i.e. the lower the trend inflation rate) the bigger the Fed balance sheet as a share of GDP.  If NGDP growth is so low that nominal rates fall to zero, then the Fed balance sheet can get very large.  If the NGDP target rate is set high enough where rates stay above zero, then the Fed balance sheet stays small.  I prefer a small Fed balance sheet.

Inflation or socialism?  It’s your choice.

Forza Italia!

In the 1990s, Berlusconi founded a new political party called “Forza Italia”, which means something like “Go Italy!” or “Be Strong Italy!”  He was going to push his country past the inept Italian politics of the past.  Although nominally conservative, Berlusconi’s party didn’t have much of an ideology.  It appealed to all sorts of disgruntled people, especially the less educated, and mostly relied on media image making.  Berlusconi was very wealthy, and involved in TV, and also was involved with a string of beautiful young women, some underage.  A walking ad for Viagra. He was also the kind of guy that would sue people for libel when they criticized him, so perhaps I need to be careful here.  (The Economist won its libel suit, and warned the Italians that Berlusconi was unfit for office.  When the Economist says a candidate is completely unfit for office, it’s worth listening.)

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Voters didn’t have much to go on except his promises to rejuvenate Italy.  But since traditional parties had failed, and the Italian economy had been growing very slowly, they decided to put their faith in a politician with a macho image, who made crude jokes and was a fan of Vladimir Putin.  What could be worse then an economy mired in a malaise of slow economic growth?  Wait and see.

Between 2001 and 2011, Berlusconi was in power for all but 2 years.  So I went to Eurostat (which is insanely confusing) to see how the Italian economy had done in the 21st century, compared to other European economies.  Yes, I know it’s been a tough period for all of Europe, but let’s see how Italy did in relative terms.  At least they avoided a big Greek-style financial crisis.

In all of Europe, the slowest growing economy was Portugal, whose RGDP increased by 0.8% between 2000 and 2013 (the most recent data available.) That’s not 0.8% per year, that’s a total increase of 0.8% in 13 years!  So at least Italy wasn’t the worst?  Not quite, I said Portugal was the slowest growing.  There was one country where the economy actually shrank over the 13 year period between 2000 and 2013.  Can you guess which one?

That’s right, the one presided over by the jerk with the smirk:

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PS.  During the same period Germany grew by 14.9%, France grew by 14.3%, Spain grew by 19.0%, and even Greece managed to grow by 1.5%.  But Italy shrank.  Apparently Viagra is not enough to make an economy grow.

PPS.  I’m not trying to tell you how to vote. But if you encounter any Berlusconi-type macho politicians, who brag about their sexual prowess, just recall what he failed to do for Italy.

PPPS.  Here’s how The Economist reported its victory in the libel lawsuit:

Cash will do nicely, Silvio

He may have heard that phrase before, but at least we kept our clothes on

PPPPS.  Isn’t it nice to finally have a post with no mention of American politics!