Sunday, November 17, 2013

Secular Stagnation and the Yellen Put

An interesting discourse about "Secular Stagnation" has broken out in the economics profession, and this seems to be quite appropriate given the replacement of Ben Bernanke by Janet Yellen as the Chairperson of the Fed, and her reputedly dovish stance on monetary policy. "Secular stagnation" is really a forgotten relic of 1930s macroeconomics (by Alvin Hansen), and has fed into similar thinking in the current state of both the US and EU economies.

So first, what is "secular stagnation"?  As Gavyn Davies points out in his excellent FT piece, it is a situation where after a financial crisis, as nominal interest rates remain close to zero, deflation causes real interest rates to go negative ( - recall that real interest rates are nominal interest rates minus inflation).  In other words, if you borrow money, the gain in its value due to deflation outstrips the low nominal interest rate, meaning in real terms it's actually costing you quite a bit. The problem originates from the fact that although inflation can be negative ( - and is termed deflation), nominal interest rates cannot (under normal circumstances) go negative. This means that real interest interest rates remain above where they should be ( - the equilibrium rate being the Wicksellian "natural" interest rate), so that chronic underinvestment occurs and the economy crawls along at much lower growth rate than it should do, with in fact a widening of the output gap even though the economy is no longer in recession.  

Source: Board of Governors: Federal Reserve System

But Paul Krugman in his commentary (see here) on Larry Summer's comments at an IMF conference, takes this one step further. He says that in fact bubbles in the economy are a good thing, as they keep the economy moving along, rather than sinking into stagflation and deflation as they have in Japan.  But as Krugman points out, this might be due to the slowing growth in population and in the labor force participation rate in particular. This in turn reduces the equilibrium natural real rate of interest, and so current real rates are above this level and this consequently fosters below average growth. The further corrollory is that stricter financial regulation might be bad for growth as irresponsible lending is actually good for the economy and also presumably creating housing bubbles by QE is actually a good thing as it presumably puts money in people's pockets. The chart above shows that less food and energy, inflation is around 1.7 percent currently.

My problem with this entire thesis is that it is predicated on QE not being in place.  QE is in place and by keeping short term interest rates near to zero, it does create negative real rates on these government rates as long as inflation is positive, which it now is. The 90 day non-financial commercial paper rate is currently 0.25 percent, which means that the core real rate calculates to around -1.5%. Obviously the danger is deflation, as this pushes real rates up creating a disincentive to invest. But in fact right now companies have a great incentive to invest, as money is still cheap and likely to become more expensive once the Fed tapers. No, the real problem is that companies and banks are sitting on a huge pile of cash - lending standards are extremely strict and so the stimulus that is supposed to be funding house purchases and small business expansion is just not at the level it should be.

No the best way to get the world economy moving forward is not really in the hands of the Fed anymore - it is in the hands of the politicians - so in my view completion of the Transatlantic Free Trade Area (TFTA), the Trans-Pacific Partnership (TPP) and also perhaps the re-starting of the Doha Round of the GATT/WTO talks will lead to an upswing in growth in 2015 and beyond if these agreements are concluded.  These agreements will boost world trade and although yes, they are likely to depress prices for traded goods, they will lead to greater quantities of goods being traded between the major trading blocs leading to a one-time stimulus for all economies.  Plus the wealth effect from the US stockmarket right now will hopefully continue as more bystanders are convinced that the return on stocks far exceeds that of interest bearing deposits, so this should support US consumption and investment going forward.

And this brings us round to the Yellen Put.  Yellen clearly is going to follow in the footsteps of Bernanke, so the support underlying the stockmarket and the financial sector should continue into 2014, but as long as no further government shutdowns are likely, the taper should start in 2014. As I have stated in previous blog postings the taper will likely start on just the purchases of government paper, given that government really doesn't need this support anymore and continue to stimulate the housing recovery.

As I believe in the persistence of economic cycles, it is not unlikely that we will have a downturn anytime from 2015 onwards, so getting the Fed to move away from an extremely expansionary stance is now taking on some urgency, otherwise it will have limited ammunition to fend off another economic downturn.  But this is also where the completion of these Free Trade deals is extremely important, as their completion should delay any future downturn beyond 2015 through to 2016 or beyond.

Wednesday, September 18, 2013

How I would propose to taper - my response to Harding in the FT on Sept 18th

Despite the fact that the FOMC decided not to "taper" today, I believe that it missed an opportunity to inject less funds into the market and begin the process of exiting from QE3.  Part of the reason that the Fed decided not to "taper" this month is that there are considerable uncertainties regarding US fiscal policy and whether the labor market improvements will be sustained at current levels through into next year.

In today's FT (see here), Robin Harding outlined how he thinks the FOMC will implement the taper of monetary policy which I've been discussing in my most recent blogs.  Although it will not occur now, I think it is instructive as a dynamic "exit strategy" from QE3.  So this is my (edited) response ( - posted as a response earlier today after Harding's article) in the comments section of the FT:

"The taper is largely misunderstood, but it clearly needs to happen sooner rather than later in my opinion, as I believe that inflation expectations have now bottommed, and are on the rise again. The taper though is a dynamic animal, and although Harding is right in assuming that the FOMC will rightly err on tapering Treasury purchases at a faster rate than MBSs, the static scenario he sets up likely will not be enough "forward guidance" on what the Fed has planned for the rollback. If they do not give some guidance on the taper going forward then every FOMC meeting from now on is going to be a financial media circus and lead to a lot of uncertainty.  And I make this statement knowing that Bernanke will likely want to put in place a dynamic policy that anchors expectations about Fed actions going forward, but that can be modified as needs dictate.

Harding asks, for example, "if a taper were 100% Treasuries, then does that communicate no reduction in MBS purchases until Treasuries are reduced to zero? Or just no reduction in MBS with the first tapering move – in which case how does the Fed make that clear?" 

I think that if the FOMC really deliberates on this point they will come to the conclusion that although monetary policy should be neutral by June 2014 - in other words, there is no "net" purchasing occurring in June, the only way to taper and allow for transparency is to make the rollback dynamic. That means that purchases need to be ramped back month by month, but perhaps so that Treasury purchases reverse before June, but MBSs reverse after June.  As far as I am aware, the Fed has been purchasing $40bn of MBS per month, and so must have been purchasing about $45bn of Treasuries.  That implies that if the taper is proportional roughly equal amounts of Treasuries and MBSs would not be bought.  Obviously that will have a much bigger impact on the housing market than the Fed would like at this point in the housing recovery. 

So given this, I would modify Hardings options to read:

Option 1: Bond purchases to fall by $9bn per month, and MBS purchases to fall by $1bn per month.  That means in terms of bond purchases, this will likely reverse purchases in about 5 months into sales, but MBS purchases would continue beyond the June 2014 "end" date and well into 2015. 

Option 2: Bond purchases to fall by about $7bn per month, and MBS purchases to fall by around $3bn per month.  This would put more onus on adjustment in the housing market, but would nevertheless would have the Fed selling MBSs by 2015. 

Option 3: Bond purchases to fall about $4.5bn per month and MBS purchases to fall by $4bn as well.  This would have the Fed neutralize policy by June of 2014, and then decide how much to sell going forward.

One thing I think is not known by anyone is how the Fed's buying or selling will change the market.  Why?  Because both markets are very different beasts.  The market for Treasuries is extremely international and dominated by foreigners because of the US's hegemonic place in the current economic world order.  MBSs on the other hand might be way more difficult to unload internationally, given the lessons of the finaniclal crisis, and so the buyers for these will more likely come from financial institutions based in the US.  That poses a problem for the Fed, as unloading these securities is going to require some judgement in terms of how much help the US housing market requires.  I am glad that I"m not on the FOMC making this decision today!!"

Tuesday, September 17, 2013

Taper talk and inflation expectations

Any student of economics knows from his or her money and banking course that there are two different effects that occur when you inject money into the economy.  The first is called the "liquidity effect" and it operates when the money supply is increased.  It operates in the short run when prices are sticky, so that no price adjustments take place.  Using the diagram below, you would just increase the supply of money, hence shifting the vertical M curve to the right in the diagram below.  That lowers interest rates.  Of course that should lower interest rates in normal circumstances, unless you hit extremely low interest rates in which case you could find yourself on the flat portion of the L or money demand curve.  In this case, as Keynes pointed out, you find yourself in a so-called "liquidity trap".  In a liquidity trap, increasing money supply will not lower interest rates further, so will not stimulate the economy. We used to teach this as an academic curiosity until it occurred in Japan ( - a zero bound on interest rates), but now most monetary economists realize that it is not just a curiosity - it can happen, and it did, even in the US!!

That is the reason why we have QE, or quantitative easing.  It is a way of stimulating the economy without relying on pushing official interest rates lower. In the longer run though, prices are flexible, and they adjust to changes in the money supply, according to the quantity theory of money.  The mechanism whereby this transition happens though is related to the so-called Fisher effect.  The Fischer effect basically says that higher inflation rates should be reflected one for one in higher nominal interest rates. So as inflation begins to rise after a monetary injection, at some point we should see interest rates rising. Obviously though the Fisher effect only works if you have a response in inflation.  At the moment, as the chart below shows, we really don't see too much response in inflation during 2013 ( - this includes the data release for August, released today, September 17th).
The key thing though is that it is really not actual inflation that matters as interest rates are a forward looking variable.  The interest rate is how much you charge or are charged for lending or borrowing from now into the future.  So it is really inflation expectations that are important here, as they are the equivalent forward looking variable, rather than the current level of inflation.

Luckily the Federal Reserve Bank of Cleveland has come up with some new methodology for teasing out inflation expectations from inflation swsps (a financial derivative in which investors swap a fixed payment for payments based on the CPI), which run the gamut from one to 30 years. The results of this academic work by Joseph G. Haubrich, George Pennacchi, and Peter Ritchken of the Cleveland Fed is updated every month on a special Cleveland Fed website which can be found here.

I have reproduced the current chart of Inflation expectations from the Cleveland Fed's methodology in the chart on the left.  What is striking is that if we use the ten year swaps we appear to be at a turning point in terms of expectations.  Inflation expectations now appear to be potentially moving up again. And that means that if 10 year bond rates are yielding just over 2.8%, that given that inflation expectations are roughly 2%, that the real interest rates, in other words the real gain lenders get from loaning their money out is around 0.8%.

The real interest rate is important in an economy because it signals the rewards from lending.  For very short term loans these are now negative - in other words it is not worth lending short term for most banks.  We can see this if we calculate the short term real interest rate - which is given as say a 2 year bond yield minus the expected inflation rate over a 2 year horizon.

Short term real rates are about -3%.  This means that the Fed has really pushed short term interest rates down to an incredibly low level - well we know this already from my previous blog which you can read here.

But in terms of policy implications, and what needs to happen this week at the Fed's monetary policy meeting, is that these short term lending rates need to rise to turn the real interest rate positive again.  That means that in fact the Fed should, if anything, extract much more short term credit from the market when it tapers than long term credit so as to allow short term nominal interest rates to run to more normal levels again and make it profitable to lend short term.  At the moment, in one sense, the Fed's critics are right - the Fed's monetary policy is distorting the yield curve, and the sooner the Fed extricates itself from this the better.

Sunday, September 1, 2013

Growth Cycles, Interest Rates and the Yield Curve

Watching the news this week we saw the recent ramp up in bond yields pull back with terrible US housing data.  Although the news was somewhat overshadowed by the breakdown at the NASDAQ ( - more on that some other time), it did cause stocks to resume their climb after a few days of heavy selling. Most economists think of this as "overshooting" - in other words, interest rates may have gone up too much too fast, which has caused a stall in the housing pickup leading to the Fed stating that it would be flexible if the economic sputters rather than slowly accelerates, which in turn leads bond yields to fall again.

US real GDP growth - quarterly at an annual rate
Source: BEA
But in my opinion for whatever reason what we are seeing here is the growth cycle at work. Growth does not occur in a straight line as most economists assume in their models - growth appears to occur in small cycles, and this is pretty clear from the graph of real GDP shown above.  So you might ask why we are seeing a slow down in the housing market and other data, and yet the 2nd quarter growth rate was revised upwards.  Well part of the reason is that the real GDP release is a "rear view" measure - as it only captures growth up until the end of June, and the spike in interest rates largely occurred in July.  So likely we are in for a lower real GDP growth figure for the 3rd quarter as interest rates increased in the 3rd quarter.

Some commentators are now saying that this might give the Fed pause in terms of starting it's "tapering" program to scale back purchases or bonds and other financial instruments.  I really don't think so as US growth is still positive and at a 2.5% rate, hardly sluggish now.  And remember that the "taper" only slows down the purchases, leaving the Fed the room to vary the rate of decline in these purchases if it wishes.

So "tapering" is really going to be happening sooner rather than later in my view.  But we know that expectations usually act ahead of policy actions, and indeed some of the run up in bond yields has already occurred, but I thought it would be good to review exactly what might happen to the yield curve over the next year or so given where we currently are in the business cycle.  The yield curve is a plot of the bond yields of different maturity government bonds at any given point in time.  So the exercise here is to try and deduce where bond yields should be at this stage of the business cycle without the monetary stimulus that the Fed has injected into the monetary side of the economy.

The big problem is what to compare the current level of bond yields to, so I decided to take two dates, so as to make an informed judgement about how far current yields are below where they should be at this stage of the business cycle. Given that we are now about 4-5 years since the end of the recession in June 2009, we are now 4 years from the end of the recession. Given this, I thought it would be good to compare the yield curves for roughly 4 years after the previous 2 recessions to where we are now.  Here are the results.

Yield curve comparisons
This comparison in one sense is not the best comparison as the peak of the business cycle after the 2001 recession occurred in 2006, and this can be seen as the flattened yield curve in 2006, but it does give us an idea about where interest rates should be under normal circumstances.  As can be seen, 5% appears to be roughly where bond yields should be - but current bond yields are far below this level, with only the really long term bonds now approaching roughly 1% below the 5% level.  This is due to "operation twist" ending, and the surge in long term bond yields that has occurred this year.

Here, we compare current yields to where the yield curve was about 5 years after the 1991-2 recession, and in 1997 the yield curve did have it's typical positive slope, as a recession was still a few years off in 2001, but in this instance yields were between 5 and 7%, way higher than where they are now.  Nevertheless we have the same general result - that short term rates are way lower than where they usually were at this stage of the business cycle.

The two charts really beg another question though - how will the yield curve move through time?  Obviously the "taper" implies that bonds will still be bought by the Fed, which will depress the short end of the curve for some time.  Some are betting that it's the 5 and 10 year bond yields that will move upwards most quickly now, but either way it is clear that the short end is where the biggest moves will occur once the Fed's exit strategy is fully realized.

Much will depend on economic developments over the next couple of years and how the new Fed Chairman decides to execute the Fed's exit strategy.

[Investment tips: If you want to ride the wave to higher bond yields at the shorter end of the yield curve, two ETF investment vehicles that would correspond to this movement are DTUS and TBZ, both inverse short term maturity bond ETFs ( - TBZ is a 2x leveraged ETF); if you are interested in the middle of the yield curve, TBX and TYNS are the inverse non-leveraged ETFs and TYO is the 3x leveraged equivalent]

Sunday, July 7, 2013

Of tapers and feral hogs

As readers of this blog will know from my previous musings on the Federal Reserve ( - see here), the Fed responded to the downturn in the economy during the last recession and consequent sluggish growth this engendered, by stimulating the economy using a variety of unconventional monetary measures as interest rates approached their lower bound, in other words zero.

This was an unprecedented experiment in stimulating the economy by a variety of measures, including buying government bonds in various proportions along the yield curve (at a variety of different maturities) to force interest rates down ("Operation Twist"), as well as unprecedented purchases of non-government paper, such as "Mortgage-Backed securities" (MBS) which are essentially bundled together mortages. This latter measure is known as "Quantitative Easing" of QE.

In fact there were three phases of the Fed's QE measures as follows:

i) QE1 - In late November 2008, the Fed started buying $600 billion MBS. By March 2009, it held $1.75 trillion of bank debt, MBS, and Treasury notes, and reached a peak of $2.1 trillion in June 2010. Further purchases were halted as the economy had started to improve, but resumed in August 2010 when the Fed decided the economy was not growing as rapidly as they wanted. After the halt in June holdings started falling naturally as debt matured and were projected to fall to $1.7 trillion by 2012. The Fed's revised goal became to keep holdings at the $2.054 trillion level. To maintain that level, the Fed bought $30 billion in 2–10-year Treasury notes a month.

ii) QE2 - this was initiated in November 2010 when the Fed announced plans to buy $600 billion in long-term Treasuries, in addition to the reinvestment of an additional $250 billion to $300 billion in Treasuries from earlier proceeds from mortgage-backed securities.

iii) QE3 - A third round of quantitative easing, QE3 was announced on 13 September 2012. In an 11-to-1 vote, the Federal Reserve decided to launch a new $40 billion a month, open-ended, bond purchasing program of MBS. Additionally, the FOMC announced that it would likely maintain the Fed funds rate near zero "at least through 2015." On 12 December 2012, the FOMC announced an increase in the amount of open-ended purchases from $40 billion to $85 billion per month.

Earlier this month the Chairman of the Fed hinted in testimony before Congress that the Fed would consider tapering QE ( - so scaling it back), and after Friday's good employment figures yields on bonds shot upwards, signifying that we are now nearly at the point where there have been consistent additions of around 200,000 workers per month to the non-farm payrolls, but due to people coming back into the Labor force because of the better conditions, this has caused the unemployment rate to get stuck at just over 7.5%.  Other heads of central banks (such as the newly installed Mark Carney of the Bank of England) said on Friday that interest rates will not be ramping up in their jurisdictions, but that didn't stop bond rates in their countries from spiking. The Fed has of course said that it will keep short rates at near zero until the unemployment rate has fallen to 6.5 per cent, subject to projected inflation remaining under 2.5 per cent. One way of forcing home the message that this will not happen soon would be to reduce the unemployment threshold to 6.0 per cent, but I think that this is unlikely, as I think the Fed now wants to exit from QE.

So what can we expect will happen from now going forward?

Source: Wall Street Journal
First, let's remember that "tapering" is not tightening monetary policy.  Tapering simply means that an easy monetary policy gets easier at a slower rate.  The reversal itself isn't expected until 2015 at the earliest, so that's 18 months away.  That's an extremely positive situation for stocks and economic growth, so the stockmarket should continue on an upward trend and those employment numbers are likely to get better and not worse.  Althought the unemployment has not fallen fast enough for some, it has definitely been falling, as the figure below shows.

Second, what about the balance sheet of the Fed?  Obviously buying all these MBS and Treasury bills and bonds will undoubtedly have swelled the balance sheet and this will clearly have to be undone.  But that will be fairly easy for the shorter-term bonds as once they reach their maturity dates, the Fed will basically not roll them over and will collect the cash payment that is made for any dated financial instrument.
Fed's Balance Sheet (Assets)
Source: Federal Reserve Board
What is interesting in the chart is how aggressive QE3 has been, in the way the purchases of securities are clearly seen going up in step increases since 2012 at a rate that is clearly faster than any previous stimulus with the exception of the beginning of QE1.

As can be seen, the balance sheet of the Fed will need to shrink back from over $3.5tr back to less than $1tr in order to completely reverse the effects of QE1 to 3 on the economy.  That will take at least $2tr out of the economy, which represents about 15.6% of US GDP right now, which is a sizeable amount of liquidity.  That will clearly either cause inflation to rise if left in the economy for an extended period of time, or will push interest rates up back to normal levels or perhaps beyond normal levels if the acceleration in economic growth is significant.

Looking at the issue from this perspective it is understandable why bond yields have shot up on 2 occasions, despite the accusations coming from Fed officials such as my local Fed District President, Richard Fisher (see here), that markets are acting like "feral hogs" by testing whether Fed policy to continue easing can be sustained into next year. Fisher said “Markets tend to test things. We haven’t forgotten what happened to the Bank of England [on Black Wednesday]. I don’t think anyone can break the Fed . . . But I do believe that big money does organise itself somewhat like feral hogs. If they detect a weakness or a bad scent, they’ll go after it.”

Third, the Fed has really been the best friend of the stockmarkets in recent years.  But when we consider the Fed's actions and their impact on the markets, we have to keep a few things in mind.  First, this is an unprecedented loosening of monetary policy, and eventually it has to come to an end, so interest rates have to rise, whatever happens.  In fact, I would suggest that they will probably overshoot where they should be in the long run simply because the stimulus has been so significant and because the Fed probably will reverse the loosening of monetary policy at the long end at a more rapid pace than people expect simply because they need to get these long interest rates back to something approaching normality.  That means that "operation twist" will be the first to be unwound, so that the Fed can also keep it's promise to make sure short rates stay low until the economy has finally reached "escape velocity" again.

So although interest rates have ramped up already at the long end, how much further do they have to go?  Well we can look at 2 perspectives on this.  First, look at a 5 year plot of US bond rates to see what has happened in recent weeks ( - but not including last Friday's hike in rates).  The blue line is the 20 year bond yield and the 10 year bond yield is the 10 year bond yield.  The difference between the yields is shown in the thin grey line at the bottom of the chart.  What is apparent is that rates need to go back to roughly 4.5% to 5.5% before we are in more normal territory for long term bond yields (with low rates of inflation), and we are only in the 2.5-3.5% range right now.

The point being that although Fed officials might be correct in pointing out that the ramp up in rates recently is a little overdone considering that the Fed hasn't started tightening yet, markets do not care for current conditions, they are forward looking and want to incorporate future moves in monetary policy.

So what about really long rates and the prospects in terms of where they should be.  In the figure below I plot both 10 year and 30 year bond yields for the last 5 years to show how bond prices have changed for these two financial instruments since July of 2008, when bond yields (from the chart above) clearly started to react to QE.  As of last Friday 30 year bond yields were still about 20% below where they were 5 years ago and 10 year bond yields were 30% below where they were back then.

Note that the increase in rates necessary to get back to where we were 5 years ago is still significantly below the usual level for long bond yields, and that there may be some overshooting as well, particularly if inflation picks up once the output gap in the economy is closing. So once the Fed's monetary policy is unwound, it implies a large increase in long rates and perhaps as much as a doubling of these long bond yields from where they are currently.

The chart below shows that in fact inflation expectations have been falling, despite the large injection of money into the economy.  This is to be expected according to Keynes, as any student of monetary theory knows, but once the increase in money supply does it's work and stimulates economic growth, inflation will inevitably start to pick up again ( - in fact the chart seems to suggest that expectations are currently bottoming), which implies higher nominal interest rates as well.

So the stage is set.  The only big unknown is who Ben Bernanke's successor will be and what their opinion is of the current monetary policy stance.  I would hazard a guess that President Obama will be unlikely to pick an unknown quantity to take up the reins once Bernanke goes, and my guess would also be that that person is likely to be more of a "dove" than a "hawk" on the FOMC.  So in other words the process of tapering and then tightening might actually take longer than expected.

Saturday, April 13, 2013

The passing of 2 contrasting figures in my life

This week past was a strange week.  The big events were the passing of two people I have known extremely well, one personally and one not so, but two people whose views I understood, and two people whose views have had profoundly different impacts on my own life.

So let's start with Joshua Sherman.  Joshua was a mentor to me when I was at Middlebury College going through some pretty difficult times.  He was intellectually as sharp as a knife, but had compassion for people and valued people for what they were, taking a lively interest in the world around him.  One of the things that I remember he and his partner did within the community was to have an annual party ( - a barbeque as I recall), inviting everyone from the neighborhood and also all their friends.  In other words, they valued the small Vermont community they came from and took a definite interest in the people that were part of this community.  

Joshua was the embodiment of the renaissance man. He was interested in just about everything and everyone and was a writer ( - good example of his work is here and a book review from the NYT here), a lawyer, a musician, an historian, a financier, a teacher and both a great talker and a good listener.  His background was unique - the son of a Jewish and British parents who was born in British Palestine (which is now Israel) but won a scholarship to be educated in history at Oxford, and then went into investment banking in the City of London. Having such a cross-cultural, cross-disciplinary background allowed him to appreciate that people can have different perspectives on things, and can approach things differently. As an illustration of this, one of the things he showed me was that sometimes to understand other people you have to imagine how it must feel to be in their shoes. Obviously in terms of negotiations and also climbing the corporate (or in this case educational) ladder, such insights can be extremely valuable.

Perhaps one of the things that Joshua will likely be best remembered for is his book "Mandate Days: British Lives in Palestine, 1918-1948."  In this book Joshua documented the lives of the British occupiers of Palestine during the first part of the last century.  The book is fascinating, and a review of it is available here.

Unfortunately another book which happen to be shortlisted for the Orange book Prize in the UK stole various pieces of Joshua's research and wove them into the fabric of a novel without acknowledging the source of the material.  Joshua rightly sued and won.  

In more recent years our communications became more sporadic, but Joshua was an optimistic soul, and encouraged me to try and do all I could to further my own research and career, as well as continue my musical diversions.  I shall miss him.

To link with the other figure that passed this week, I remember in one conversation that Joshua and I had, that the subject matter turned to Thatcherism and the Thatcherites.  Joshua simply frowned and said "but my dear Patrick, these people were simply delusional".  On one level I had to agree, but although I loathed the woman on a personal level ( - where did that plummy accent come from?), on other levels Thatcher did change everything in the UK.

I remember growing up in the UK when Trade Unions were incredibly strong, particularly in the north of the UK where I am originally from.  When we went through the "winter of discontent" after the period of "prices and incomes controls" which limited the amounts that prices and incomes could rise as the form of a "social pact" between the government and the Trade Unions broke down, it was clear that something had to change.  Thatcher, in my view, happened to be in the right place at the right time, because when you look her career, she certainly did not excel in any of her previous cabinet posts. No, a tipping point had come, where it was recognized that change had to come, and so she achieved an overwhelming electoral victory in 1979.  

Everyone I knew voted for her, just simply because the alternative was just too horrible to contemplate.  
My own relationship with Mrs. Thatcher was ambivalent to say the least.  I admired her honesty as a politician.  One has to remember that the UK had just been through an era where governments just didn't seem to be able to execute policy properly, and there was no real direction in terms of ideology - it was literally made up as they went along.  I think she was a disaster economically in the early years, but her government was rescued by an upturn in the global economy in the mid-1980s, and then the focus started shifting the Europe, where the single market and single currency were being formulated.  The UK could have been a much more central figure in these initiatives, but Thatcher's clear ideological division with nearly all other European nations meant that the country was usually not in sync with what was happening over on the continent.  The divisions within Thatcher's own party in relation to Europe was the real reason that she was eventually deposed.  

Economically though during these years, Thatcher immediately thrust a group of unconventional economists to the fore ("monetarists"), who inflicted immense damage on the economy, pushing up interest rates to unprecedented levels which pushed the UK pound up to dizzying heights as well, decimating the manufacturing export sector. The economy reeled, but luckily for her the Argentinians decided to invade the Falkland Islands, giving her campaign a jingoistic tone, leading her to another electoral victory in 1983.  Once inflation was down to reasonable levels, her privatisation program proceeded at a blistering pace.  Many of the industries which she privatised or deregulated (the City for example) needed an injection of competition to shake them up a little (or a lot), but some industries were just not good candidates for privatisation (water, railways, coal, for example) - mostly because these industries were already natural monopolies, so more effective regulation would have been a better approach.  

The industrial North, Scotland and south Wales suffered tremendously under Thatcher's policies, but because they were Labour strongholds, she really didn't have to worry about this.  It led to a deeply divided country, with the South being rich and prosperous, and the north and industrial regions turning into  wastelands in many places.  Her policies with regard to London were also spiteful.  The Mayor of London at the time, Ken Livingstone, happened to be from the Labour party, and with the setup of Boroughs in London, there was little chance that the Mayor change hands to the Conservatives, so she simply abolished the position and a whole layer of government.  For her, compromise was weakness.

Those years were a mess in London, with little coordination of transport services, warring borough councils and massive cuts to Social services.  The last straw was the poll tax which her government proposed for payment of local and municipal taxes.  She advocated a per head charge which did not relate to the value of property or income. Riots ensued.

So how did Thatcher affect my life?  Well, I decided in the 1980s that I really didn't want to live in such a divided country where greed and money were celebrated and the existence of society and by extension community were irrelevant.  The cult of the individual was just not for me.  So I made the momentous decision to leave the UK, with some sadness but also happy to get to a country that seemed to value social policy as something that mattered to some extent.  And while I didn't have a drink when I heard that Thatcher had passed ( - I think all that celebrating in the north of the UK was rather tasteless), I recall that I did have a drink the day she was deposed from power.  

In summary, although I admired Thatcher because she had the gall to do what others didn't dare to suggest, I  do think she went too far with a lot of her policies. As I have stated already, compromise was failure.  So unlike most politicians when she said something, you'd better believe it, because once it was stated as an objective, the wheels started turning to achieve that objective.  And in hindsight, I don't necessarily have quibbles with everything she did, but rather more the manner in which she did them.  In the UK, what came after, in my opinion, was much better.  But perhaps there is some truth in claiming that what came after wouldn't have been possible without Thatcher coming before.  But that is a universal truth as the Reagan revolution in the US would have eventually cause a turn to the right in the UK, it was a question of how far right.  One thing is for certain though, Thatcher did make the UK into a country that resembles the US much more than it resembles a country like France.  

Sunday, March 31, 2013

Where are we in the business cycle?

I was at a conference recently in Tokyo, and one of the keynote speakers was Robert Engle (Nobel Prize winner in economics and Professor at NYU), who spoke about his recent research which looks at the notion of what would happen if there was a financial crisis in the future.  This is extremely useful as instead of doing so-called stress tests to see what would happen if specific assets fall in value as far as the financial institutions are concerned ( - hence putting the emphasis on diversification), this turns the approach on it's head and says what happens if all financial assets are worth 40% less, as they were in the 2007-2009 economic downturn.  As Engle and co-authors state in a recent conference paper, "To be specific, whenever the broad (stockmarket) index falls by 40% over the next six months,this is viewed as a crisis."  They then derive a measure called SRISK, which is a measure of systematic risk.

For all those that are interested, the following graph shows the results by country.  So this graph shows a measure of how much current companies (mostly banks) would be underwater if the stockmarket fell by 40% from where we are right now.  Japan is right at the top of the list, principally because Japanese banks are allowed to hold stocks and shares (whereas US banks are not).  But also Japanese banks also hold a lot of Japanese bonds (many on behalf of their customers), so this means that they are not really subject to international contagion.  

This whole exercise though becomes much more interesting if you do the exercise as a % of GDP.  What this gives you is the following chart:

What this now gives you is very interesting as it mirrors recent events.  Cyprus has just had to bail in and bail out it's banks, and of course there have been rumblings of major problems with banks in France as well.  I think the possibility of trouble in France and the Netherlands was the reason why the Netherlands Finance minister, Jeroen Dijsselbloem (who is head of the Eurofin group) said that the Cyprus deal was to be the template for future requests for assistance from the EU.  What is also clear in this chart is that the US is certainly not that risky compared to other countries.  I guess that's one reason why the US stockmarket has been powering ahead, and why although Europe is fretting about the solvency of its banks, whereas the US is not.

But all this talk of future financial downturns got me to thinking about the probability of a recession in any given year and the likelihood that it will be a "financial" sector recession.  The IMF can help here, as they have done a lot of work on recessions, and what might cause them.  One extremely interesting paper is by three economists, Prakash Kannan, Alasdair Scott, and Marco Terrones (see here for the paper).  They look at recessions for all countries, and try to categorize what basically caused these recessions (the so-called "shocks").  The figure below (extracted from their paper), shows their conclusions.
From my perspective what is interesting here is that although financial crises have become more common, so have fiscal policy contractions. We can see the effect of this very clearly now in Europe and in the UK in particular where the cuts are now forcing the UK into a "triple-dip" recession.  In the second part of the figure what is also notable is that there are "shocks" happening all the time, but shocks do not necessarily cause recessions, as we know that recessions are highly correlated between different countries.

One last part of this paper also caught my attention - it is an attempt to compare recessions caused by financial crises to other types of recessions in terms of how the business cycle might change.  The figure is below:
It is clear that on average financial crises cause longer recessions and the recovery takes longer, plus when it does occur it is a much "shallower" recovery than would take place with other types of recession.

So what does this all mean?  Well I would venture to say that although Europe might be struggling to stay out of recession because of the position of their banks and declining stockmarkets, the US appears to be OK, and when the next recession comes here, it will likely not be bank related.  It therefore implies that we have quite a lot of steam left in this expansion cycle this side of the Atlantic, and so we are likely only mid-way through the recovery period.  More on this next time.

Friday, February 22, 2013

El-Erian FT Comment

Here is my response to a commentary in the FT today by the "A-Lister", Mohammed El-Erian, which you can read here.

What Mohammed fails to recognize is that the Fed's actions are difficult to reverse without creating either a "shock" or a longer terms "dampening" dampening effect on economic growth. In short, they have unintentionally boxed themselves in.

In particular, the Fed is now heavily invested in the government bonds and mortgage backed securities, so in fact if sequestration happens (or some more comprehensive "can-kicked" compromise later this year), then the Fed can start to unwind it's operation twist and bond position as it's presence will no longer be essential to support fiscal policy stimulus. What will be left though is the Fed's underpinning of the housing sector, which it has now (mistakenly in my view) made its "quasi" monetary policy instrument linked to an unemployment rate target.

This puts the Fed in a very awkward position though - as if sequestration goes through, then although the Fed's government bond purchases can be unwound, if the expenditure cuts cause a shock to the real economy, what does the Fed do? Obviously some might say it should stimulate the housing sector by increasing it's purchases of mortgage-backed securities, but that i) may start pumping air into a housing bubble again and ii) have little effect on the rest of the real economy if smaller new houses look less attractive than older houses thereby dampening the employment effect of the stimulus.

All I can say is that I'm glad I"m not on the FOMC at this time!! 

Tuesday, January 8, 2013

Having found a Pass around the Fiscal Cliff, What lies Ahead? Or Critiquing the World According to Roubini!

Nouriel Roubini wrote a very elegant piece in the FT onJanuary 4th about the fiscal cliff being averted being a signal that the “US has been let down by it’s leadership”.  Now let me preface this piece by saying that I have the utmost respect for Professor Roubini, not only because he is an excellent economist, but also because he has managed to traverse the void between academia and the perilous world of finance - indeed quite a feat.

His reasoning was that basically the US cannot afford to pay for what it wants if it refuses to raise taxes, so that implies that the leadership didn’t do the right thing in raising taxes on only the very wealthy.  While readers of this blog will know that I favored going over the fiscal cliff because it helps to get the country on the road to fiscal sustainability, I would not go as far as to state that the leadership has let down the country by coming to a deal hours before the effective deadline.  My view was simply that I didn’t see Republicans yielding to demands for higher taxes for anyone, so in those circumstances I thought it better to go over the cliff.  I presupposed that any deal would basically kick the can down the road again.

So in contrast to Professor Roubini, I would assert that the deal demonstrated that the leadership can come together when they really need to, but when they don’t really need to they simply won’t agree.  What he is right about is that voters are going to be hearing a lot more about fiscal issues as they are going to continue to be in the limelight for the next few months at least. 

The raising of the debt ceiling will likely spark more brinkmanship, but how “successful” the sequestrations on the fiscal cliff were, the politicians are likely to opt for a similar strategy again in 2013.  I would suggest that this might be the most successful strategy for the Democrats in terms of forcing the hand of Republicans, in the sense that a further downgrade in the creditworthiness of the US is likely if the country’s politicians don’t compromise again.  This will hang like a Damoclesian sword over the Republicans and will force some modest tax increases maybe in 2014. 

Roubini states that “the US could quite easily come perilously close to stall speed this year – or worse, if the eurozone crisis worsens”. But Roubini ignores several things: i) the US is still on an upswing with the housing and stockmarkets causing wealth effects which will not be hugely impacted by changes in tax rates or cuts in government expenditures; ii) the US dollar is at low levels still which is stimulating the export sector, particularly in relation to EU exports; iii) the best way to generate more tax income is by more economic growth, and iv) why would the eurozone crisis worsen now that Greece appears to have swallowed a growth “poison pill” and the institutional mechanisms are now in place to stem any panic in Spain or Italy? 

In fact, the more I thought about Roubini’s argument, the more I realized that it was contradictory.  How can you claim to be concerned about stalling US growth this year, while at the same time predicting a looming “fiscal nightmare” which implies a preference for going over the fiscal cliff?  The only way I could square Roubini’s circle was to assume that he is concerned about growth in the short term, while being concerned about the US fiscal situation in the long term.  But given the former, why would he want the US to go over the fiscal cliff? 

Let’s pick out a few of Roubini’s other points.  He states that we should “expect a big fight about entitlements, and a series of little fights over tax reform: should the US introduce a value added tax? A flat tax? Higher (or lower) income taxes? A carbon tax? Should we close corporate tax loopholes to raise more revenue? It’ll soon get messy.”  Entitlements indeed form an ideological pivot between the Republicans and the Democrats, but as Roubini states later on in his piece, both parties want to maintain them as they are popular with their voter base. So how to pay for them on an ongoing basis?  Closing corporate tax loopholes would be a good start, and if I was a Democratic strategist, I would suggest that the next sequester should include closing those corporate tax loopholes.  A flat tax, and a VAT, while academically appealing will not be acceptable in terms of a compromise, so I doubt would be part of any negotiation or sequester. 

There is a reason that Roubini is called Dr. Doom.  It’s because he always assumes the worst scenario, and in recent years, he has been right.  But cycles are cycles, and we are now in an upturn, albeit a shallow one, so doom and gloom is unlikely to be the correct scenario.

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