The Economist on R*

I was interested to see that this week’s “Free Exchange” is about estimating the natural rate of interest (R*). The Economist points out that one way to infer the Fed’s views is to subtract the target inflation rate from the dot plot projection of long run interest rates. In their September 18th update of the 19 officials involves there were 11 different forecasts (ranging from 2.38% to 3.75%). They point out a 2021 paper by Claudio Borio (which you can read here) which finds a notable increase in attention for the natural rate from top policymakers.

Borio also has a 2024 paper surveying various estimates (read it here) which are summarised in this chart:

The key takeaway seems to be that a lack of consensus around these estimates should make policy makers wary of relying on it as a consideration. Indeed The Economist concludes:

Aiming for an imaginary and almost certainly false variable is just as likely to hurt as to help. In that sense, the collapse of consensus in the Fed’s r-star projections is welcome. It is a form of intellectual honesty.

But this just begs the question - then what instead? I think monetary aggregates have proven a useful guide throughout the recent inflation but this view is contested. Indeed any criticism of how central bankers attempt to conduct monetary policy should consider the fact that it may be a fool’s errand overall. After all, the best response to nihilism is to accept defeat and give up.

Macro Trends: Live and online

I’ll be delivering a live webinar on Monday November 20th, 5pm UK time. The focus will be on Macro Trends with some commentary on the main policy stance across the Eurozone. This is an experiment to see if there’s sufficient demand from students and interested non-students for ad hoc extra content, and I’m looking forward to it.

The link is here: https://escp-eu.zoom.us/j/95163589937

Edited: The original version of this post said 6pm. Apologies.

R* at 2% for the UK for 2023 Q2

Back in 2020, the journal ‘Economic Affairs’ published an article of mine that attempted to estimate the natural rate of interest for the UK economy. I followed Beckworth and Selgin (2010) to provide a rough approximation using the following formula:

In other words, the neutral rate today is equal to the long run steady real interest rate (set at 2%), plus the difference between expected Total Factor Productivity Growth, and the long run average TFP growth rate. The average is calculated as follows, with λ = 0.7:

I haven’t given it much attention since then, but I recently received an email from someone asking if I could update the figures, which I’ve done. The natural rate is of 2023 Q2 is estimated to be 1.9%, having slumped to -12.3% in 2020 Q2 and then bouncing back to 10% in Q3. Further evidence that covid times need to be looked through, somewhat, and why level targets are more important than growth ones. The r* estimate from 1998-2023 looks like this:

If we wish to look at the last 5 years, we can see the following:

This is obviously a rudimentary estimate and should be used with caution. But I hope it’s a useful contribution to the conversation about taking the natural rate more seriously.

Have the Bank of England lost control?

Last Thursday the Bank of England increased interest by half a percentage point, to 5%. As you can see, the recent trajectory and pace of interest rate changes have been significant:

The rationale is simple: the primary job of the Monetary Policy Committee (MPC) is to keep inflation at around 2%, and it has remained stubbornly high. As you can see over the last 3 years, the conventional measure of inflation has been on a strong upward trend.

My explanation for what’s happened rests on a few claims:

  • The initial impact of Covid was primarily a negative demand shock, (not a supply shock), which therefore put downward pressure on prices. There was a necessity for monetary policy and fiscal policy to be accommodating and expansive.

  • Policymakers seemed to have learned their lesson from the global financial crisis by responding to the collapse in total spending by allowing subsequent spending to rise quickly. Rapid growth in the economy in 2021-2022 was necessary and important to return to the previous trend line.

  • The challenge was always going to be ensuring a “soft landing”. If they withdrew demand too quickly, we’d slip back into recessionary territory. If they failed to withdraw it early enough, we would have entrenched inflation.

  • Clearly Central Banks were naive about the extent to which high inflation in 2022 was driven by aggregate demand as opposed to supply side issues relating to post covid bottlenecks, and shocks to energy prices caused by Russia’s invasion of Ukraine. They’ve been complacent and have reacted to the threat of inflation too late.

  • Now, there’s a real danger of an overreaction. We can already see that inflation is subsiding. Once more interest rate rises flow through into the real economy, there’s a danger that by avoiding +10% inflation we fall below the 2% target, and cause a major and unnecessary slowdown.

Back in December 2021 I discussed whether central banks were listening to those who argue that trend rates are more important than growth rates. I was hopeful, but consider this chart, published by David Beckworth in September 2022.

You can see three really important things:

  1. In 2008/09 policymakers allowed NGDP growth to fall below where it needed to be to ensure neutral monetary policy, and for several years it stayed there.

  2. In 2020 policymakers ensured that after NGDP growth fell below the neutral path it was then allowed to quickly catch back up again (big success!!)

  3. As of 2022, however, it was overshooting and way above the rate required for monetary neutrality.

The above rests on my preference for using stable growth in the cash value of economic transactions (NGDP) as the optimal monetary regime. But you don’t need to advocate NGDP targets to be concerned by current central bank decision making.

When I teach monetary policy to MBA students I use an exercise called “Monetary Implications” which shows how to assess decisions from 3 perspectives. We can do the exercise now:

  1. Money growth rule

    Broad money growth has been slowing for some time and is now just 1.6%. Divisia money growth is an even bigger concern, contracting by -2.9% in April.

  2. Inflation target

    As already shown, inflation is high. CPI is growing at 7.9% and core inflation seems worryingly stubborn.

  3. NGDP target

    2023 Q1 saw growth of 6.6% which is higher than the average prior to covid (which was around 4%), but it has fallen in every quarter since the start of 2021. The MPC don’t explicitly target NGDP so there’s no reason to think they are paying close attention to it. But my major concern is that the current path of interest rate rises will reduce total spending such that NGDP continues to fall below the long term appropriate rate of around 4%.

Here’s a summary:

If all three alternatives point in the same direction, policy decisions are non-controversial. The problem now is that money growth data and inflation data provide two polar opposite implications for policy. If we use NGDP as a decider, I think that the greater concern for downward trend probably means that we should be more cautious about waiting for the consequences of previous interest rate decisions to pass through. These are strong reasons against raising interest rates. Even more importantly, the real focus should be on market expectations regarding where these indicators are heading. If it’s the case that inflation expectations have become dislodged from the 2% target, while NGDP expectations are also on a decline, we have a truly terrible situation where we’ve chosen the wrong policy objective and failed to even achieve that. Scary times ahead.

Finally, I’m not a monetarist, but I think it’s important to acknowledge those who’ve been warning about high inflation for some time, and also when they stopped worrying about it. I’ve been using this chart for the US since January 2023:

It shows high a big increase in M2 preceded the rise in inflation. It also shows that M2 subsequently became negative, and that inflation was starting to fall.

Here’s data from the UK from mid 2022. Once again, and as standard old fashioned monetarism implies, the inflation measure follows what happens to the money supply (in this case I use a Divisia measure). If we expect that relationship to continue, our concern is about falling inflation not persistently high inflation.

Raising interest rates under the current circumstances seems to be a case of too much, and too late. Things would have been better had the MPC taken inflation more seriously in 2021, but that’s in the past. They shouldn’t make a new error in response.

A quick and clear growth recipe

I think the recent political turmoil affecting the government stems from two key things that they’ve done:

  1. Advocating economic growth as a policy ideal without providing a coherent plan to deliver it.

  2. Neglecting the difference between campaigning and delivering, and buying into the myth that fiscal discipline can be abandoned under certain circumstances (permitting large increases in public debt in a pandemic, when interest rates are very low, is fiscally sensible. Unfunded tax cuts outside of a crisis situation, is not).

Although I am surprised, and still a little confused by the strength of the market reaction, I am also a little reassured that the Cameron/Osborne’s prioritisation of fiscal consolidation has been somewhat vindicated. (One can argue on whether austerity was the right way to achieve that, but they were not wrong to warn about the dangers posed by markets losing confidence in credible public finances). That said, the new Chancellor’s strong signal of a return to pragmatic attention on short term tax fudges as a mean to permit limitless spending intentions is a real shame. I liked Truss’s optimism, and agree that there are lots of ways we can move onto a higher growth trajectory. We shouldn’t fall back into a low growth mindset that leaves the UK on a slow march to social democratic tax burdens and substandard infrastructure and public services. Here are what I would priorities as part of a quick and clear growth recipe:

  1. Build homes - we need to unlock the housing market to allow people to move where their labour is most productive and start to unwind the unhealthy concentration of personal wealth within property. The fix must come from the supply side and focus on planning reforms that enable more houses to be built.

  2. Generate power - our shift toward clean energy and away from geopolitical hostility has always had an obvious solution, which is investment in nuclear power. The fracking debate seems an unfortunate distraction where the real focus should be on SMRs and fusion reactors.

  3. Boost trade - the EU constitutes our largest, richest and closest market and finding ways to mitigate the costs of Brexit are crucial for future growth prospects.

  4. Encourage talent - the best way to mitigate the problems associated with a demographic trend of an ageing population is encouraging more immigration. For high skilled labour this is win-win and

The above would contribute to a quick and clear impact on growth, but they aren’t necessarily easy. There are reasons why existing inefficiencies and problems become entrenched, and there seems to be a reduced appetite to take them on. I am contributing to the first problem mentioned above with such a rudimentary list of ideas. The real difficulty is implementation and the politics of reform. And regrettably good economics is often bad politics. But one thing we can do is unite around a growth agenda, and publicise the good ideas that would contribute to that.

Does the UK economy look on the verge of a currency crisis?

No.

The recent market reaction to the mini budget has prompted wider discussions about the potentially perlilous state of the UK public finances. In this post I want to provide some clarity on what constitutes a “currency crisis”, and how the typical warning signs help to illuminate the current UK situation.

A currency crisis is routinely used to describe situations where a currency loses a lot of value relatively quickly. However this definition is vague, and when the trigger for quick market movements is a political speech, in the context of a highly polarised and poorly motivated public discourse, it is unhelpful. When I teach my MBA students we use this classic Harvard case and apply the following definition:

A 10% or more fall in the value of a currency, within a week, relative to a suitable external benchmark.

This poses three questions: how much value is lost? over what time period? and relative to what?

Prior to 2016 I told students that by using this definition it is almost impossible to imagine that a currency crisis can occur to a floating exchange rate. When the value of a currency is set by demand and supply, on a competitive market, it would take a ridiculously large shock to prompt such a dramatic and immediate reappraisal. Therefore our discussion in class is focused almost entirely on countries that have some sort of fixed exchange rate, where the crisis is the moment at which authorities abandon their target. In other words, while there are many causes of a currency crisis, the trigger is almost always the abandonment of a fixed exchange rate.

Then, in 2016, we had the results of the Brexit referendum and the UK pound lost more than 10% of its value, relative to the USD in a day. So much for useful rules of thumb!

Some minor quibbles would be at what points we are measuring the rise and fall (i.e. should we only compare an average daily rate, the rate at the end of the trading day, or the most extreme moments within any trading period); and the relevance of the external benchmark. By definition, a fixed exchange rate will have an obvious external benchmark (whether that’s the USD, the Euro, or a clearly defined basket of other currencies). For a floating exchange rate we make a choice.

Indeed the danger of focusing too much on the GBP/USD exchange rate is that it can be hard to distinguish between the weakness of the pound and the strength of the dollar. Most currencies have been weakening against the USD and so we aren’t seeing entirely UK news that is influencing that ratio.

I think it’s better to focus on a trade weighted composite index (i.e. the effective exchange rate) and using BIS figures this is what’s happened recently:

The mini budget isn’t a step change here, but if we take the level on Sep 22nd and read through until the trough, which was September 28th, that’s a 4% fall. So no currency crisis.

Having said this, taking the GBP/USD is also sensible, but as Reuters points out this is ~8% fall. So still not a currency crisis.

Of course foreign exchange markets were not the only arena of disturbance, and it’s telling that as the pound has recovered more attention has switched to gilt yields. These are a more useful macroeconomic indicator because they provide a reflection of the premium the UK government is required to pay investors in be willing to buy their sovereign debt. Gilts spiked following the mini budget and it is because of the ramifications that this had to pension companies that prompted the Bank of England to intervene, calming things down.

CNBC

https://www.cnbc.com/2022/09/28/bank-of-england-delays-bond-sales-launches-temporary-purchase-program.html

So I think it’s overblown to call these events a “currency crisis” and would require a clear definition from those who claim otherwise. But this leads us to the main point of this post, which is to consider whether indicators are suggesting that a currency crisis may occur.

The simple answer (Brexit referendum result to one side) is of course not, the GBP is a free floating currency! Indeed the very large price adjustments being made recently reduce the necessity for big swings later. This is the market doing it’s job: rapidly incorporating new information such that single events have less importance. The underlying causes of why a currency is losing its value get incorporated drip by drip, rather than all at once.

That said, we can go back to my MBA classroom discussions and consider the standard list of indicators that might forewarn about an impending currency crisis:

  1. Is the current a/c deficit over 5% off GDP? - when a country imports more than they export they tend to run a current account deficit. For many relatively wealthy countries being a net borrower is no bad thing - it means consumers get access to more products, and we have inflows of foreign investment. A typical rule of thumb is that 5% of GDP amount to a “large” currency account deficit. According to the ONS the current account deficit has been quite volatile recently but most recent data (for 2022 Q2) shows -5.5% (down from -7.2% in Q1). So it’s large, but it’s not deteriorating. Direction can be as important as overall size. I’d say this is flashing orange.

https://www.ons.gov.uk/economy/nationalaccounts/balanceofpayments/timeseries/aa6h

2. How is the current account deficit being financed? - it’s one thing to run a large currency account deficit, but if the predominant source of inward foreign investment (which is being used to finance it) is formed of Foreign Direct Investment (i.e. in fairly large and stable projects like building factories) then there’s little risk of a sudden reversal. By contrast, if the deficit is being funded by portfolio flows, which are prone to sudden reversal, then we’d be more concerned. According to the ONS we can see outflows of portfolio investment but at declining rates over the last few quarters. Inward FDI has been quite stable, and other investment (i.e. short dated bonds) are positive and stable. This looks green to me.

3. How large are reserves? - if sources of inward investment dry up, the key question is whether the government can continue to fund its current account deficit through other means, such as the use of foreign reserves. One of the key indicators that Vladimir Putin was going rogue was his steady stockpiling of international currency, since 2015, reducing dependency on voluntary trade and international cooperation. On the contrary, if a country has a low amount of international reserves, or begins haemorrhaging them, it is a sure sign they are losing control. UK foreign exchange reserves have steadily increased since the global financial crisis, and given that a free floating exchange rate doesn’t require any reserves to manage the stability of the currency, this represents a strong position.

https://www.ceicdata.com/en/indicator/united-kingdom/foreign-exchange-reserves

4. Is the real exchange rate deteriorating? - if a country has a fixed exchange rate then it fails to serve as an indicator of impending devaluation, but the real exchange rate will provide more of a clue given that it adjusts for inflation. As shown, an effective exchange rate is a good indicator of general trends, and the trajectory is a concern for the UK. Rather than treat the real exchange rate as indicator, however, we can just look at inflation. The current inflation rate using the traditional CPI basket (which is what the Bank of England use to determine monetary policy) is 9.9%. The CPIH measure, which adjusts for types of housing cost, and is the primary focus presented by the ONS, is 8.6%.

This is obviously way above the target rate of 2% but is subsiding and the general consensus seems to be that the Bank of England are starting to apply the brakes such that it will not remain elevated for long. When using inflation as a predictor of a currency crisis, however, we shouldn’t confuse cause and effect. Rather than viewing the inflation rate as a sign of potential currency deterioration, it is in fact another view of the same problem. While a fall in the exchange rate is measuring the currency against an alternative currency, a rise in inflation is measuring it against a basket of goods and services. These are simply two different ways to revealing the same common issue - a reduction in purchasing power.

5. Is the budget deficit out of control? - According to the ONS, in the first quarter of 2022 the budget deficit was 2.6% of GDP which is smaller than the EU27 average and within the 3% threshold typically deemed to be a red flag. There is a more recent publication, showing a more detailed look at public sector finances, released in September, but I’m not aware of a stable link for a more timely snapshot of the fiscal position. The key issue, of course, is where this is heading. The NIESR forecast the deficit will rise to 8% in 2022/23 and we are still awaiting confirmation of when the OBR’s updated forecasts will be made public. Either way, the deficit is contentious partly because it relies so much on growth projections and what goes into the GDP calculation can have much of an impact on the outlook as any claims about spending relative to tax revenue. For now, however, the warning lights are green.

Public debt rose dramatically during the pandemic and for good reason. Despite recent rises in yields debt isn’t high in comparison to equivalent historical circumstances, and prior to Truss/Kwarteng we’ve all been repeatedly led to believe that debt remains cheap and easy to finance. That can change quickly, but there’s room to manoeuvre.

As a classroom exercise, and looking at publicly available data, there are no clear warning lights indicating an imminent currency crisis. And we should not be surprised - floating exchange rates don’t have currency crises. But the real art is taking more timely, pertinent indicators and anticipating sudden changes in market sentiment. Indeed the main conclusion from my MBA class is that regardless of what data we look at, we can’t reliably predict a currency crisis. So there’s no need to panic. Yet (!)

Verdict on the mini budget

I am finally catching up on the mini budget, which was announced on September 23rd. The market reaction has been almost as frenzied as the Twitter reaction, but I shall do my best to look at it constructively.

Firstly, as Ryan Bourne points out here, it reveals a strong conviction that:

a combination of marginal tax rate cuts and supply-side liberalizations of important markets will raise GDP by increasing hours worked, improving productivity, attracting more talented people and businesses to the UK, and raising net investment

I think that’s broadly accurate, but won’t be transformative. The political calculus is probably dominating the economic one. The actual growth agenda was more of an intent, in terms of:

deregulation in the provision of all of energy, infrastructure, childcare, and housing

As a work of PR, that combination of surprise announcements and vague intentions clearly struggled. But policy wise it is encouraging, and I’m broadly in favour of these types of supply side reforms. I’m honestly not sure whether the criticisms are that these are bad policies and shouldn’t be pursued, or that they weren’t sufficiently fleshed out to warrant a confident assessment about their impact on growth. Maybe the problem was that it was a “mini budget”, whatever that means.

That said, it is refreshing to see a reframing of the public policy objective from redistribution toward growth, and whether or not a 2.5% target is too optimistic, it could well serve as a useful focal point.

But that seemed to get sidestepped by the noise and chatter. I really noticed the low quality of public debate within the context of social media and increased political polarization. I saw several tweets that would be commented on and prompting great derision that had entered my feed quite long after being outdated. Imagine having a real time discussion about a football match where key events are revealed out of sequence. I’m not sure a rolling ticker is conducive to sensible analysis. People are freaking out that the pound is below $1.06, but it wasn’t. A 3% depreciation is big, but how much has it fallen over the last 6 months? Are these events or continuing trends?

I also noticed the odd situation where the left used the immediate response from financial markets as a judgment of the validity of the plans. It would be absurd for them to argue that a positive verdict from financial markets should be an objective of a budget. Maybe they would argue that for a Conservative budget, where the stated objective is to stoke markets, such attention is justified because it reveals that the policy has failed on its own terms. I’m not so sure though. I wish people would identify their success criteria before they, or their political opponents, announce something…

Putting the various reactions to one side, the main point I’d like to make is that in isolation most of these measures are pretty sensible. The main criticism, therefore, is about (i) choosing priorities; and (ii) how the plans were presented and communicated. But firstly, let’s look at the pros.

The pros

  • “Moving house” tax - stamp duty is stupid and everyone agrees. Cutting stamp duty isn’t the best way to improve the housing market, but it does, at the margin, improve allocative efficiency, which is good. As Paul Johnson said, “Perhaps a smaller change that we might have hoped for from such a radically tax cutting chancellor, but welcome nonetheless”. A key priority for any government should be moving toward a system where we tax property/land values rather than property transactions, and any attempt to reduce stamp duty is to be commended.

  • Corporation tax - corporation tax is a hobby horse of mine because it’s such a counterintuitive policy. Superficially it appears like an alternative to taxing labour, but not only does a large share of the incidence fall on employees, it contributes to the inefficient ways in which we tax capital, which in turn harms labour. And UK corporation tax is particularly bad. No sensible economist would advocate a large increase (i.e. 6 pp) in corporation tax as we head into a recession, therefore it’s perfectly reasonable to take the opportunity to maintain the current rate at 19%.

  • Income tax - this is where most of the headlines have focused, but the fact that these are the “biggest tax cuts in 50 years” also tells us something about how high the starting point is.

  • Revoking planned increases in NICs is a good move and has been largely ignored in the analysis because it’s a good move.

  • It also seems a good idea to scrap IR35 (which forces companies to withhold tax from self-employed labour as if they were permanent employees).

  • Reducing the basic rate from 20% to 19% is a meaningful policy to help typical workers, and a step in the right direction. I would like to see larger tax cuts for lower rate payers, but notice that more than twice as much of the “cost” of this budget is from cutting the basic rate rather than removing the top rate.

  • Removing 45% top rate - this is probably a useful way to encourage high productivity workers to increase output without forsaking a large amount of potential revenue. I’d have liked to see more simplification, particularly with the absurd marginal rate of 60% on income over £100,000 (which occurs because the personal allowance is removed above that amount), but there clearly is some attention to the costings here.

Overall, some would argue that this isn’t sufficiently targeted at lower income taxpayers. I agree with this, but the fact that the chart below became so widely shared reflects a really stupid approach to the debate. Of course tax cuts disproportionately affect people that pay more tax. Of course people that don’t pay tax won’t benefit from a tax cut. Come on.

There also seems to be something refreshing about a Conservative budget so clearly focused on undoing policies that were controversial at the time. Let’s not forget that when Labour introduced the 50% top rate in 2009 it was supposedly an emergency response to the global financial crisis. There was no strong economic case for such a high marginal tax rate and it would have been highly controversial outside of such serious conditions. When the subsequent Tory/LibDem coalition reduced it to 45% this seemed to take the psychological edge off the punitive rate, but was hardly a return to an optimal amount. A top rate of 40% is not particularly high, and by removing an entire band a welcome step toward simplification occurs. Labour turned this into a political football, and I think it’s strategically understandable for Truss’s team to send a credible commitment that such gestures get swiftly undone once power changes hands. Perhaps it incentives both sides to engage in sensible policy rather than contentious point scoring.

Cons

Regardless of how desirable those announcements are, in isolation, however, let’s consider the two big counterpoints.

  • Choosing the the wrong priorities - the headline tax figures are all focused on the top end and that presents bad optics in a cost of living “crisis”. To be fair to Truss, however, she is an incoming Conservative Prime Minister and Tories are going to Tory. I would have liked to see more focus on poverty reduction but we shouldn’t ignore the previously announced energy price cap (which may actually be a more sensible policy than I first feared, given the difficulties in targeting direct support where it’s needed). Maybe I am paying attention to the wrong vocal critics of the mini budget, but I’ve struggled to see a viable and plausible alternative being proposed.

  • Bad expectations management - the big lesson should be the importance of traditional public finance responsibility - the encouragement of independent impact assessment and some form of baseline forecast. I think a large part of the market reaction was the disregard for any fiscal rule and lack of attention to costings. And this is what I find most interesting about the issue. If Cameron/Osborne held an overly tight commitment to fiscal discipline (arguably overstating the threat from financial markets for unfunded spending commitments) then May/Hammond/Johnson/Sunak all took a hybrid position of paying lip service to Conservative commitments to fiscal prudence while in practice demonstrating immense profligacy. (Perhaps profligacy is the wrong word here - recent Conservative spending is insufficient in some areas that desperately lack investment, and is entirely justified given the Covid-19 pandemic and situation in Ukraine). The difference with Truss/Kwarteng is the complete sidestep of fiscal concerns in the favour of a bigger growth perspective. In doing so, they actually reveal that 2010s austerity might not have been such an unnecessary act of self harm. It almost feels as if they’ve seen how Labour have behaved in opposition, downplaying market discipline, and flirting with MMT, and thought “sod it, let’s do the same.” ERROR.

I think it’s uncharitable to conclude that these plans are chaotic and have been exposed as lacking coherence (of course an alternative narrative is circulating, that the Pound crash was a deliberate ploy, because Kwarteng used to work for a hedge fund. This ties into an existing conspiracy theory relating to how Brexiteers supposedly profit from economic chaos. It’s interesting, but thus far unproven. Personally, I don’t see evidence that the market response was the intention).

Interpreting the market reaction isn’t straightforward, but Ryan Bourne provides the most thoughtful response that I’ve seen:

Working out the precise economics of why we saw the combination of the falling pound and rising gilts is difficult to parse from financial market data, but can only really logically be explained as a fear in markets that the UK might engage in “fiscal dominance,” with the Bank of England eventually being too permissive on inflation, and keeping rates too low, to help out a government with high and rising debt.

This means that I also have some sympathy for the view that the markets reaction is in part an assessment of the Bank of England’s ability to deliver a soft landing.

Kwarteng: here are our plans. Assuming the Bank of England does their job, it shouldn’t have a reckless impact on inflation.

Bailey: hmm, we’ll let you know what we think of all this in November.

Ultimately, this mini budget is a fascinating reversal of typical strategy, which ordinarily sets out spending commitments and then attempts to retrospectively finance them through some combination of tax rises or additional borrowing. Instead, we see a clear focus on taxation, and spending plans are (thus far) treated as a secondary consideration. I think this is the right way round, although such a radical decision may have surprised and jolted market response. But let me outline a possible scenario:

  • Truss doubles down on a growth objective

  • The political legitimacy of the Conservative Party rests on achieving it

  • Usual resistance to serious supply side reforms is weakened

It’s bold, naive, and possibly reckless. But if you have identified low productivity growth as the biggest problem facing the long term prosperity of the British people, it might be a gamble worth taking.

Note: The two best insights on Truss’s economic policies are Ryan Bourne and Julian Jessop. I highly recommend their commentary.

The higher inflation survival guide

One of the key issues facing the global economy right now is the extent to which present inflation is a temporary consequence of supply chain disruptions, or the long awaited consequence of more than a decade of emergency monetary policy. Regardless of the proximate or underlying cause, the data is clear: inflation is high and rising:

This is important. Central bank competence rests on their credibility - i.e. do the public believe that they will achieve their stated objectives? And I think we can split credibility into two elements:

  1. Their capability to fight inflation. Since the global financial crisis central banks have obtained a whole suite of new tools to conduct monetary policy in different ways. For example, a “corridor system” uses three different interest rates to guide policy and was introduced in large part to mitigate the risks of QE.

  2. Their commitment to fighting inflation. Historically the Fed in particular have been behind the curve in responding to fast changing macroeconomic conditions. Now that the Fed and the ECB have greater room to permit inflation to go above target, it becomes less certain that they will act early and decisively to quaff it.

Personally, I am confident that central banks have the tools to prevent inflation getting out of control, but I have more doubts about their commitment. It’s therefore worth considering how to proceed if inflation continues to rise.

The purpose of this post is to consider some of the implications for managers.

How to deal with inflation: revenues

The obvious response to how managers should respond to inflation is to raise their prices. But of course that is what inflation is. It’s not a plan.

One option is to follow the lead of the Japanese ice cream company who, in 2016, released this video to apologise to their customers for having to raise the price from 60 to 70 Yen (see here for more):

But don’t forget that there are alternatives to raising prices. Akagi Nyugyo could have:

  • Reduced the amount of ice cream contained in a serving

  • Used lower quality ingredients

So firms need to make adjustments to their products and their pricing.

Inflation also poses a much deeper problem. If the economy were always in equilibrium, inflation wouldn’t matter. Higher total spending would cause all prices to move instantaneously, and relative prices wouldn’t change. In the real world, however, problems occur because some prices rise faster than others. Typically, revenues are more flexible than costs, and therefore inflation boosts profits and encourages (unsustainable) expansion.

Inflation therefore poses a real problem to entrepreneurs. They have to solve “the signal extraction problem”, which asks the following question: “what proportion of any increase in demand for your products is due to consumers placing a higher value on them, and what proportion is due to inflation?” It’s an impossible question to answer, but an important one to ask. How much of your profitability should you attribute to successful entrepreneurial activity, and how much is a reflection of wider macro events?

How to deal with inflation: costs

The main justification for positive inflation targets rests on that fact that wages (i.e. the “price” of labour) are particularly slow to adjust. Few people want their wages to perfectly track economic conditions, because we like to have some financial stability. Many people’s salary is only adjusted once a year, and labour markets are therefore much slower to adjust than things like commodities or share prices. This generates a macroeconomic problem, however, because the labour market is so important. One way to enable people’s real wage (their actual purchasing power) to adjust, without relying on firms to change their nominal wage, is through inflation. If central banks engineer system wide positive and moderate inflation (e.g. 2%) then employers can reduce their (real) costs without having to reduce anyone’s pay packet. So it is important to be careful with automated cost of living adjustments. If your business has consistent performance, and you want to ensure that your employees receive the same actual compensation, you must increase their nominal payslip in line with inflation. (But don’t forget that the signal extraction problem is boosting profit and thus overstates performance). For companies that are struggling right now, and need to cut costs, inflation provides scope to do so. Afterall, it isn’t corporations who cause inflation, it is central banks. Central banks are the one to blame.

That said, we are still in competitive labour markets and across the board wage freezes are a terrible strategy for your high productivity employees. So I was particularly interested to see Lance Wigg’s advice on coping with inflation:

  • Invest more time in benchmarking salaries and recognise these need to be updated more frequently

  • Early career employee’s market value will change more quickly than others, so they need more frequent reviews

  • If you are worried about losing talent don’t be afraid of paying more than the market, and then allowing inflation to catch up later

Looking beyond labour markets, his further advice includes:

  • Buy expensive items earlier in the cycle than you were previously planning

  • Minimise cash holdings

  • Move toward index linked debt

Finally, inflation is very tough on groups that have fixed incomes and (often) lower salaries. As a society we should recognise these costs of inflation and hold central banks to their mandate of protecting us from it.

Did the NGDP crowd win the battle of ideas?

Perhaps not, given that no major central bank has adopted an explicit nominal income (or NGDP) target. However…

I recently spent a very pleasant train journey to Turin catching up on various podcasts. This included several episodes of Macro Musings (the best monetary economics podcast by far, and one that I highly recommend), including:

And I also noticed that Scott was talking about his new book, ‘The Money Illusion’, with Larry White on the Hayek Program podcast:

First off, I found the contrast between the practitioners vs. academics to be fascinating. I’ve learnt so much from George, Larry and Scott and consider them to be three of the most important monetary economists around. I sometimes disagree on points of emphasis, but can’t say that I ever consider their arguments to be flawed. And yet the actual implication of their work is so opposed to the reality of how central banks behave! Perhaps there’s also some context with my recent review of Mervyn King’s ‘Radical Uncertainty’, which frustrated me greatly. There’s something about central bankers downplaying the formalism of the discipline, giving attention to concepts like uncertainty or subjectivism, once they’ve finished their term, that rankles. Carney is so smooth, so confident in his analysis and reflections. And I do think his tenure was a (qualified) success. But he seems oblivious to the depth of insight that free bankers/market monetarists provide. Megan Greene is also an impressive expert, but sidesteps any consideration of public choice, mission creep, or the knowledge problem to present a confident vision of a more powerful central bank. They both provide clarity, and optimism. And I believe that knee jerk critiques are ill founded (clearly there’s scope for central banks to pay attention to climate change within their existing mandate). But just imagine the world we’d live in if Selgin, White and Sumner had the legitimacy and authority conferred by high office …

I haven’t yet read ‘The Money Illusion’ and although I intend to, I suspect I’m familiar with the key points. In terms of these interviews, here are some good points that Scott made, across both of those podcasts, that I hadn’t fully considered before now:

  • The Fed is usually operating behind the curve. In other words, the natural rate moves faster than their response. That being the case, cutting interest rates are more likely to indicate tight policy than loose policy and raising rates will coincide with loose monetary conditions. More recently, there’s evidence that the Fed are more forward looking, and this implies a major improvement in policy.

  • The natural rate of interest (R*) can move quickly in a crisis. I’d add that this is in large part because central bank incompetence affects it. This is the “supplier induced demand” argument I made in the chapter of ‘Getting the Measure of Money’ relating to velocity shocks.

  • Advocates of fiscal policy can be unclear on how they define and use the term ‘liquidity trap’. If it simply means that interest rates are low, and that there’s high demand for base money, then it does indeed exist. But there’s nothing about this situation that implies monetary policy has become ineffective. The issue is whether policymakers have sufficient credibility to use the monetary policy tools necessary to raise nominal growth expectations. Some commentators may favour fiscal policy because they don’t believe that (typically) conservative central bankers will do “whatever it takes”. But the optimal strategy is to hire central bankers that know how to do their job.

  • Scott argued that we shouldn’t expect central banks to be able to forecast recessions because if we can predict them, we can prevent them. As he has shown us, however, events in 2008 demonstrate that central banks don’t always prevent demand side recessions. Therefore, in trying to predict a recession, we are really trying to predict central bank incompetence.

  • Despite being an Austrian-school economist I don’t like to use the term “bubble”, and try not to violate EMH. I do think we can talk about “booms” (as in the manifestation of loose monetary policy), and about the difference between primary (Austrian) and secondary (Monetarist) recessions. But Scott argued that many “bubbles” can be plausibly explained by fundamentals:

    • The 1990s stock market (especially Nasdaq) only made sense of US tech firms would come to dominate the global economy - they did!

    • The 2000s housing market only made sense if we would be able to rely on very low interest rates and NIMBY restrictions on new housing construction to generate a secular rise in house prices - which is exactly what happened!

What I found most interesting was Scott’s optimistic take on the influence of NGDP targets. He made a few key points:

  1. A flexible average inflation target is one way to permit NGDP playing a role without the embarrassment of abandoning an inflation target.

  2. The Fed’s decision to cut interest rates in 2019, despite inflation being high, indicates an increased concern for market expectations (see falling inflation expectations here) and a triumph of market monetarism.

  3. We’ve now got back to the pre-covid NGDP trendline (see David Beckworth’s charts, shown below) which is why this recession hasn’t prompted a debt crisis.

This, in the context with being attributed as “the blogger who saved the economy”, due to the influence he had over the Fed’s late 2012 QE3 program, is a cool achievement. Scott deserves this recognition, and he’s a hero.

My own take, however, is a bit more pessimistic:

  • Scott emphasises that it’s the level targeting he’s really interested in, not NGDP per se. In which case it might have been a strategic error to focus so much on NGDP when other economists were advocating price level targets (see Chapter 1). Personally, I want to move away from giving consumer prices such an important role in policy decisions and so I’m wary of pinning too much hope on level targets per se.

  • Although an average inflation target approximates a level target over a suitable time horizon, it provides much more discretion and relies on better decision making than if it were a clearly defined rule (i.e. an explicit level target). There is now a lot of uncertainty about time horizons and too much flexibility is a bad thing for monetary policy. I’m worried that the Fed won’t be able to handle this additional epistermic burden.

  • It’s clear that Nominal GDP data is too lagged, flawed, and large scale (released quarterly) to provide a meaningful guide for covid related policy. Scott said that we should only be looking 1-2 years ahead and that there’s no point to maintain NGDP on a month to month basis. But this presents a curious problem. One of the main advantages of an NGDP target over inflation targets is the fact that they deal better with supply shocks. If covid is interpreted as a supply shock, but can’t use NGDP data, then we’re really not contributing to the public debate. (This is why I have been using Average Weekly Earnings as a measure of nominal income rather than NGDP, but I don’t advocate using it as a policy target).

Regarding covid, Scott’s attention seems to be more on unemployment data than inflation data and seeing in the former real problems associated with health risks. In this situation, stimulating normal incomes won’t help much because although it would create inflation it wouldn’t provide the nominal receipts required to prevent the downsizing that occurs in a traditional recession. He therefore thinks it’s ok to let NGDP contract sharply, provided there’s a commitment to get back to the previous trend path over a reasonable time period.

Scott considers it to have been a massive unanticipated real shock that monetary policy shouldn’t be expected to do anything about. But if that’s the case it should put upward pressure in inflation. In the UK, inflation didn’t exceed 1% throughout 2020 and has jumped from 2.1% in May 2021 to 4.2% in October. This implies two things to me:

  • There’s been a lag, and the inflation has only showed up in the data following the reopening of the economy (and the interplay between Brexit and covid re supply chain disruptions). Or

  • The immediate impact of covid was an unusual demand side recession caused not by a fall in confidence (the typical Keynesian explanation) but by a government mandated fall in spending.

When we entered the first lockdown and saw widespread mothballing my inner Austrian was warning against an assumption of a quick recovery because I felt people were underestimating the intricacies of the supply chain and the capital disruption that would occur. Keynesian appeals to hysteresis can be complementary to Austrian attention to capital heterogeneity (which tells us that recessions take time to correct and cause real damage). However, Aggregate Demand clearly fell in 2020.

Even if you treat 2020 as a demand “problem” it still doesn’t imply that monetary policy was wrong. Imagine that a nuclear superpower invades a sovereign European nation, drawing the US and UK into a third world war. The UK government dramatically ramps up military spending such that measured GDP grows. In such as a case, we would prioritise winning the war over ensuring stable nominal income growth and a temporary boom may be a necessary side effect. Perhaps a similar argument can be made regarding covid - that it’s not a failure of NGDP targets to ignore them in extreme circumstances, and that such instances necessitate government to do more. I don’t think we have the state capacity for government spending to (temporarily) offset the reductions in private sector activity during lock down, so we just put this down to force majeure.

***

When I sat on the IEA’s ‘Shadow Monetary Policy Committee” I struggled to find the balance between interpreting the brief as “what I would do given the remit and constraints faced by central bankers” and “what I’d like to do if I were in charge”. Therefore, I was fascinated to learn that Mark Carney himself admitted to (partially) neglecting the inflation target in order to follow the implications of an NGDP level target. He said that Osborne’s letter (e.g. here, from 2015) that reminded him if the flexibility over time scale gave him the scope to see through some types of temporary deviations from target. What’s really telling, however, is that this is subtle, and being revealed now. But the outcome is clear, and was suspected - if you look at q-on-q4 growth of NGDP from 2010 (with Carney's tenure starting around the orange line) you do see better performance, with 4% NGDP growth +/- 1%.

So, let me close by quoting Carney’s parting words to David Beckworth:

I hope we get your nominal GDP target some day

Some may argue, we no longer need it.

Monetary conditions

I’m not paying close attention to the debate about monetary policy at the moment, but I routinely update the following table which attempts to assess the current situation from three different perspectives: (1) those who advocate money growth rules; (2) those who advocate inflation targets; (3) those who focus more on NGDP. As you can see, recent CPI data is causing great concern, but monetary aggregates and nominal income remain stable.

Who to follow on Twitter

To keep on top of the UK monetary policy debate, here are who I consider to be the best people to follow on Twitter:

Not dead yet: the future of monetary policy

I recently read, with great interest, the Resolution Foundation’s “Recession ready? Assessing the UK’s macroeconomic framework”. Written by James Smith and three co authors, I was in the mood for a broad and solution-led survey of how monetary, fiscal, and structural policy might be reformed. But it shouldn’t take 113 pages to say “when monetary policy becomes ineffective use fiscal policy instead”. I know that I’m being a little harsh to suggest that’s all they do, but I can’t help but feel that the Keynesian conclusion can be readily anticipated from the Keynesian premise, which is “what tools do we need to escape a future recession?” The alternative approach would be to ask “what macroeconomic framework will prevent recessions from occurring” - a deeper question, and one which may well lead to different answers.

Screenshot 2019-10-18 at 16.36.57.png

I totally accept that low interest rates have caused a major problem for the Bank of England, but only to the prevailing approach of inflation targeting. An attack on the status quo isn’t an effective criticism of monetary policy more generally. The report pays lip service to a higher inflation target, and more systematic QE (something I approve of), but seems keen to dismiss those as minor tweaks to an approach that didn’t adequately draw attention to fiscal policy. But demonstrating that different fiscal policy improves on current monetary policy is not a fair fight.

(As an indication of the pernickety way in which I read the report, Figure 3 reveals that “Recessions always result in falling GDP and rising unemployment”, but a recession is falling GDP. Also, Figure 32 claims to show that “tax receipts have fallen since the financial crisis”, but given that it shows receipts as a proportion of GDP, it could also label this as “GDP has risen”.)

Screenshot 2019-10-18 at 16.35.38.png

To consider how to fix monetary policy, such that we’re not left with fiscal policy as a last resort, I recommend “Facts, Fears and Functionality of NGDP Level Targeting: A Guide to a Popular Framework for Monetary Policy”, written by David Beckworth and published by the Mercatus Center. This is the paper I’d been hoping he’d write for some time, covering the basic idea behind a nominal GDP target, as well as dealing with some common criticisms.

The first criticism he deals with is how to respond to changes in the potential real GDP growth (Y*). If we set an NGDP target of 4% (let’s say we want ~2% inflation and believe the long term growth rate of real GDP is 2%), then what happens if a productivity slowdown reduces Y* to 1%? Beckworth points out that there’s two options. The first is to recalibrate the NGDP target, e.g. by bringing it down to 3%. But he also mentions George Selgin’s preference, which is to allow the trend inflation rate to change instead. I see three main reasons to favour the latter: (i) by permitting inflation to rise to 3% you are utilising the price systems ability to signal information, rather than be used as an arbitrary means to shape expectations; (ii) a little inflation volatility is tolerable given that by adopting an NGDP target you’ve already decided that nominal income stability is more importance than price stability; and (iii) in this situation you’d need to adjust an inflation target anyway.

The second criticism is that data revisions make NGDP targets impractical. I think this is a valid concern - CPI data is more immediate and reliable than GDP figures - and I don’t find Beckworth’s reassurances totally convincing. His first counterpoint is that a Taylor rule also requires an estimate of GDP (and potential GDP to boot), but this is precisely why many policymakers avoid using it. Certainly in a UK context I believe MPC members place much more weight on the latest CPI figures than on their impression of the output gap. Beckworth’s second counterpoint is that there are ways to improve our real-time estimates. He suggests using income data, or high-frequency nowcasting (such as that used by the Atlanta Fed), or credit card companies payments systems. I’m intrigued by this, and looked into payment data in my book on alternative monetary indicators (see chart below). But whenever I read people getting excited by the possibilities of big data my Austrian instincts kick in and I question whether a lack of data, or computing power, has ever been the constraint on central planning? And even if big data would help, it isn’t ready yet. And I want an NGDP target now! His third counterpoint is my favoured approach, which is using markets rather than computing power - in particular Scott Sumner’s proposal for an NGDP futures market. But it’s never been clear to me how such a futures market would deal with revisions to past GDP figures. (It seems to open the door to policy changes in response to revisions to past data, but this may just be a downside of any level target.)

UK payments growth (% change on previous year)

UK payments growth (% change on previous year)

The third criticism that Beckworth responds to is that the public won’t understand NGDP targets, and I like Beckworth’s framing of a “dollar income growth” as the improvement over a “cost of living index”. But this does cut against the political difficulty of having to wind back an overshoot. In the same way that it’s difficult to sell a need for higher prices to the public during a downturn, it would not be popular to put the breaks on wage growth when the economy is strong.

Finally, Beckworth made a strong case in favour of the financial stability angle of NGDP targets. As he says,

the countercyclical inflation created by an NGDP level target will cause real debt burdens to change in a procyclical manner

This is a big improvement on the status quo. Currently, a recession means that prices fall and the real debt burden on debtors is increased. Under NGDP targets a downturn will lower the real debt burden and share some of those losses with the creditor. Beckworth points to empirical literature showing this risk sharing is useful in a world of incomplete financial markets.

Two bold papers, both worth reading.

Getting the Measure of Money

The IEA have recently published my book on UK monetary policy, called "Getting the Measure of Money".

Throughout the last century or so, economic theory and history have marched together. At certain times, in certain places, new ideas (and the new packaging of old ideas) have captured the attention of the public and policymakers, and been adopted. At other times, and in other places, experiences have prompted an appetite for something different. Arguably, for much of the twentieth century we have seen the latter – the perceived failure of the existing system has required something new. The experience of the 1930s led to the rise of Keynesianism. The experience of the 1970s led to the rise of monetarism. I believe that the experience of the 2008 financial crisis has led to an ongoing revival in Austrian economics. Whilst I do not anticipate the Austrians matching the scale the Keynesian and Monetarist revolutions, the book is my modest attempt to help, by applying some specific Austrian insights to a UK context.

2012 saw the centenary of the original publication of Ludwig von Mises’ The Theory of Money and Credit. I wrote an article (co-authored with Robert Thorpe) that was published in the Review of Austrian Economics, justifying Mises’ position as a quantity theorist. We argued that Mises’ understanding of the equation of exchange differs from both of the conventional textbook versions, and warrants recognition as being a distinct contribution. Most importantly, the equation of exchange can be utilized for distinctly Austrian analysis.

Austrians might argue that you can’t show the business cycle in an aggregated way, but I would argue that the equation of exchange is still the best way to approach it. Indeed according to Ludwig Lachmann, “Austrian aversion does not pertain to these aggregates as such… It pertains to the construction of an economic model in which these aggregates move, undergo change, and influence each other in accordance with laws which are devoid of any visible reference to individual choice” (1978, p.8). It therefore isn’t non-Austrian to utilize economic aggregates, provided they have adequate microfoundations. As Cachanosky (2009) has pointed out, Mises rejected the use of price indices for pure theory. However,

“Their application is appropriate for history and politics. Catallactics is free to resort to them only when applying its theorems to the interpretation of events of economic history and of political programs. Moreover, it is very expedient even in rigid catallactic disquisitions to make use of these two terms whenever no misrepresentation can possibly result and pedantic heaviness of expression can be avoided” (Mises 1949 [1996], p.423).

According to Egger (1995), Athur Marget was a neglected economist because he became known purely as a historian of the “Quantity Equation”, and this focus on aggregate variables was at odds with claims of being attentive towards methodological individualism and subjectivism. However Egger goes on to argue that Marget helped show that the “conceptual organisation” of the “Quantity Equation”, is “capable of the disaggregated, individualistic, and subjective analysis of temporal process that has always identified the Austrian method (Egger, 1995, p.20)”.

Finally, the aim isn’t to provide a definite “Austrian” account of the crisis, because that is simply too ambitious. Indeed as Opper (2002) says an intention to provide one would be falling into the same trap as the mainstream of the profession,

“it appears that the wholesale rejection of Austrian ideas in the post-war era went too far. This rejection reflected a drive by the economics profession to develop a detailed theoretical macroeconomic framework that applied to all business cycles, a goal that is now recognized as overly ambitious”

Rather, if you are engaged in UK monetary policy debate, but are worried that our standard indicators are misleading, this book shows what the Austrian school can add. Data and appendices are available on my personal website.

The defence lines for the war on cash

The Cato Institute has recently published a paper by Jeff Hummel, called “Should Governments Restrict Cash?” As you should expect it’s an excellent overview of the topic and contains multiple astute insights. Hummel considers the two main cases for abolishing cash - (1) to crackdown on criminal activities; and (2) as a means to conduct monetary policy. He notes that some economists stress the former (Larry Summers) and some the latter (Willem Buiter) and his central target is someone who advocates both - Kenneth Rogoff.

Hummel persuasively argues that the burden of proof should fall on those who want to abolish cash to demonstrate that the benefits of doing so would outweigh the costs. And I think he’s right to point out that thus far they’ve neglected a number of important insights. Such as:

  • Actual welfare analysis needs to take place which distinguishes between wealth creating black market activity and wealth destroying illegal activity.

  • Inflation is a tax on real money balances and therefore is currently used as a tax on illegal activity. Therefore going cashless would alter the tax rate facing criminals.

  • The highest denominated banknotes provide the highest amounts of seigniorage. Abolishing them would therefore impact public finances.

  • The US Dollar is a global public good and affects welfare in dollarised countries as well as non-dollarised countries. There’s no evidence to say that restricting the ability of Russian criminal gangs to use US banknotes would compensate for depriving normal Russian families of diversifying from Ruble holdings.

I’m open minded about the so called “war on cash” and conscious of the fact that my instinctive support for anonymous forms of payment cuts against the potential for central banks to solve coordination problems in systems where they are in fact the monopoly provider or currency. However Hummel nicely presents where the defense lines are and since they’re yet to be breached it seems clear that monetary economists have an obligation to protect people’s rights to use cash.

Why r* matters

In an interesting post, Eric Lonergen provides a nihilistic reflection on the relevance of r*. He points out that there's "no simple link between growth and real policy rates" when you look at cross-sectional global data, and that the habit of assuming the long run equilibrium real interest is 2% is lazy. I agree with his claim that the determination of r is "strikingly vague" and that the yield curve, the cost of equity, the term premium and credit spreads are important indicators that shouldn't all be subsumed into r*. But that is because r* is unique and important. 

He writes,

As a practitioner, and a global investor, I gradually came to the conclusion that demographic factors (notably youth dependency), GDP per capita, and changing risk properties were the most important variables in determining the centre of gravity for policy rates and government bond yields.

However consider the Beckworth/Selgin estimate of r*. They use a Ramsey growth model to define the real natural rate as the sum of productivity growth, population growth, and the household rate of time preference. Such factors are indeed the important determinants of "the centre of gravity", but that's exactly what r* is. 

Shadow banks

“Shadow Banks” permit credit intermediation outside of the conventional banking system. Typical examples include

  • Insurance companies
  • Pension funds

While shadow banks are not part of the central bank regulatory system (and therefore eligible for  liquidity provision) they are still regulated depending on their specific functions.

As the chart below shows shadow banking really took off prior to the global financial crisis. Since then commercial banks have continued on trend whilst shadow banks have leveled out

shadow.png

The growth in shadow banking is likely driven by:

  • Regulatory arbitrage (as a result of harsher regulatory requirements on conventional banks)
  • Search for yield (money being funneled into riskier investment funds)

Quick thoughts on balance sheet recessions

The basic "balance sheet recession" (Koo 2011) story begins with a debt-fuelled asset price bubble, for example:

  • Japan housing 1992
  • US housing 2007

The main argument is that when the bubble bursts the value of people’s assets collapses, but the value of their liabilities remain. Their balance sheets are “under water”.

In this situation, people need to engage in balance sheet repair. This involves private sector deleveraging (increase savings, pay off debt); or firms trying to reduce debt rather than maximise profit. Collectively, this reduces AD and generates a prolonged slump.

The problem is that the central bank can’t do much, for three reasons:

  1. People don’t want to borrow because they are focused on balance sheet repair (therefore low interest rates aren’t enticing)
  2. People draw down bank deposits to pay debt (money supply contracts and the money multiplier becomes 0)
  3. Lenders themselves (i.e. banks) have their own balance sheet problems

Reinhart and Rogoff provided empirical support, showing that recoveries following financial crises are inherently weaker. However this has been challenged by Nelson and Lopez-Salido (2009):

“We find that the regularity that recoveries are systematically slower in the aftermath of financial crises does not hold for the postwar United States. The pace of the expansion after recessions seems to reflect deliberate aggregate demand policy. A weak lending outlook does not appear to pose an insurmountable obstacle to the functioning of stimulative aggregate demand policies”

Scott Sumner provides an alternative (simple) explanation to balance sheet recessions:

  • Recession caused by tight money
  • Tight money reduces nominal income (one might ask why recipients of debt repayments don’t spend it, but this implies there’s an excess money demand problem)
  • Since most debts are nominal, this implies bigger declines in spending in more highly indebted areas

In other words, weak NGDP growth explains things perfectly well

  • “the weak economic recovery is a failure of policy to fully restore aggregate demand, nothing more” (David Beckworth)
  • “increase in government deficits may introduce the uncertainty that causes deleveraging to occur” (Vuk Vukovic)

And even Allan Meltzer (1995, p.67)

  • A further reason to doubt the importance of bank lending as an independent channel propagating the Great Depression is that the decline in bank lending can be readily explained as a response to the decline in nominal GDP… there is no need for any separate explanation of the decline in bank lending

To conclude, we should factor in the structural problems at the onset of the crisis (i.e. not simply an AD shock out of nowhere) and the regime uncertainty caused by big players (government and central bank).

Koo, Richard, C., 2011, “The world in balance sheet recession: causes, cure and politics” Real-World Economics Review, Issue 58