Summertime in the Fed

I'm half certain there's been a slight overkill in the whole "Next-Fed-Chair" frenzy and it's still continuing. You have people defending Summers, people defending Yellen, a lot of people attacking Summers and even a few ushering in the issue of gender. So here's a short two-cent bit not on who should be the next Fed Chair, but why it shouldn't be Summers.

It's just near-impossible to quantify the impact of Fed statements. And when appointing the leader, consensus-builder and in many ways, the most important economic figurehead for the entire world, you need to check off a gazillion boxes before making such a decision. 

It's hard to argue against Summer technically, but then again, this is the Chairman of the Federal Reserve! 
I guarantee you - if someone released an audio-less 10 second clip on Vine of Bernanke mouthing a few words that looked anything like "pinterest's fate", lip-readers would pile onto it and that thing would go Gangnam viral. 

But here's why the technical aspect matters. The more you know, the more you appreciate how little you know. And in the past decade, nothing holds truer. One of Bernanke's greatest strengths, apart from his demeanor and rigorous analytic way of thinking is his latent humility. He understands how little we still know about business cycles and capital flows, how data still lacks, how little conventional monetary policy can accomplish in extraordinary circumstances. 

This is where Summers might fail. Here, try this little exercise, close your eyes and imagine a voice shouting "LARRY SUMMERS!" in your head. Then list what comes to mind. 

By all accounts, here's what I came up with (in no particular order):

1) Bleeds blue - (Samuelson and Arrow)
2) Came off as an arrogant jerk in 'The Social Network' as Harvard President
3) Harvard era (Women in science + Schleifer (Russia) + Cornel West + bad interest rate gamble for Harvard's endowment)
4) Smiley-Face on the Committee to Save the World :)
5) Glass-Steagall
6) BROOKSLEY BORN
7) World Bank
8) Ill-timed "Luddite" barb directed at current RBI governor
9) General consensus-based impression of arrogance, abrasiveness and aptitude - a deadly combination for someone in power.

Now to be fair, those are negatives. There's no denying the fact that Summers has held influential positions (Treasury Secretary anyone?) and is aware of how to conduct himself, manage relationships and delegate responsibility. But being a Treasury Secretary, or a Harvard President or a World Bank Chief Economist is DIFFERENT from being the Fed Chair. 

You have to: 
1) bite your tongue a million times, 
2) swallow your pride even more, 
3) measure your words by the letter, 
4) build consensus, 

and above all, 

5) bask in the humility of your position and its limits, and understand and appreciate that there are things you don't know and things you won't understand. 

Somehow, I have a hard time imagining Summers fitting this bill. Accomplished economist, suitable for anything and everything, but Chairman of the Federal Reserve? 

They play a different game there.

No(ah) More Excess Reserves

Noah Smith has a far better critique of Feldstein's attempt to link excess reserves with the inflationary dog that didn't bark. It's a bit late in the day and believe me, it's not an admission of guilt. Rather, you could view it as a sort of I-know-why-this-hasn't-happened-somebody-gamed-the-system sort of article.

But Smith's approach is simple. Treat the IOER (Interest on Excess Reserves) as the 'safe asset'. If it's less than the T-bill rate then the latter is the safe asset. Thus,

"The IROR is 0.25%. The T-bill rate is just over 0%. This means that the difference in the expected real rate of return between a world with an IROR and a world without an IROR is about 0.25%. In a world without an IROR, banks lend to any risky project with an expected real rate of return of S. In a world with an IROR, banks lend to any risky project with an expected real rate of return of S + 0.25%"

What he means in terms of Feldstein's claim, is that the band between a project's real rate of return and the +0.25% IOER has a lot of activity (projects to lend for) - R<project<R+0.25%

Basically it is, as Feldstein tries to assert, this that is holding back the excess reserves. If that spread disappeared and the 'safe asset rate' decreased by 0.25% (IOER), the reserves would flood the economy like chimera and inflation would finally bite, forget bark.

So where does the answer lie?

"The answer must lie elsewhere; it must be the case that either S is very high, or there are very few projects with decent expected rates of return, or maybe some sort of institutional constraint on the speed with which banks can ramp up lending. But that little 0.25% IROR can't be what's holding the economy back."

It's true, and it makes sense both on the surface as well as with a bit more thought. Otherwise, the moment the Fed cuts the IOER (stops paying interest on excess reserves), all hell will break loose. I'm pretty sure that's not happening.

And of course, it never hurts to look at Japan.

World Economic Outlook Update (July)

The July WEO update doesn't really say much. Well, on second thought, it doesn't say much that wasn't already known. Perhaps a bit more could have been said on the recent rise in treasury yields and the resulting constraints being faced by EM economies but all in all, the outlook seems muted and there seem to be very few notes of optimism.

A few more points:

- Weakening commodity prices

- Tail-risk mitigation including no more US debt ceiling drama and euro-backstop action on the do-what-it-takes front.

- The forecasts assume that recent volatility and associated rises in yield reflect a sort of one-off repricing of risk due to a protracted EM growth outlook slowdown and taper-talk in the US. This also comes with the warning of additional portfolio shifts and further rises in yields (USTs) that exacerbate capital outflows from EMs and diminish the growth outlook even more.

- For advanced economies, the priority remains near-term growth accompanied by credible medium-term fiscal consolidation (yep!). It cites low inflation and sizeable slack while advocating for continued monetary stimulus and mix of regulatory and macroprudential policy. Of course, clear communication continues to be an integral factor in mitigating volatility.

- For the euro-area, another push towards a full(er) banking union and policies to reduce fragmentation, lift demand and reform product and labor markets.

- Lastly, it stresses cyclical vulnerability in EMs - that sudden capital flow reversals have amplified trade-off risks. Lower than expected potential output has lead to higher fiscal constraints and while monetary easing can still function as the first line of defense, real rates are already low enough and outflows putting depreciation pressure on exchange rates are likely to constrain further easing.

- And there's a footnote (almost like a post-script) on sustainable consumption rebalancing for China and investment for Germany.

On a September Taper

Over at Tim Duy's Fed Watch, there's a marked consensus on the tapering taper talk of a few weeks ago. The point to be stressed here is not the Fed's reaction function but the market's. The blur between QE and interest rates is what caused and perhaps is still causing global jitters and flow reversals and even if the Fed realized that it jumped the gun, or that it needed to appear like it didn't jump the gun, the focus now should be on actual policy.

With the state of the labour market in mind (as it should be because essentially QE was a safety net to provide some semblance of a 'bottom' for the economy'), Duy says that three scenarios look probable

From BAML:

1) The economy converges to the labor data and the Fed starts to steadily move toward a September exit
2) The Fed thinks that reduced downside risks warrant a one-off taper (September) but then move to a wait-and-watch approach for broad-based improvement
3) The Fed plays the wait-and-watch game and doesn't move until December

Option 2 is the relative enigma here but according to Duy, "as we approach the September meeting, weak economic data will be considered less important for the outcome of that meeting relative to subsequent meetings. Barring a substantial negative turn in the data, the Fed will cut the pace of asset purchases in September, but a softer data flow may reduce the magnitude of the cut and the pace of subsequent tapering."

The problem, as evidenced by the recent reaction of the markets, is that a one-off taper followed by a pause doesn't seem to be entirely in the Fed's interest. The easiest path is a calendar path and therefore, it's possible that they start trimming their asset purchases by $15-20 billion per meeting till it hits zero by the end of the year.

Either way, it's important that the Fed convinces the markets of the distinction between QE and the path of short-term rates as policy tools - exactly how they differ in use and function. Most importantly, although it should seem more obvious than it is - a reduction in asset purchases does not and should not signal the end of the ZIRP.

What it does end up signalling, unfortunately, is an around-the-corner-possibility, which then leads to an invariable jumping of the gun. And that's why a September taper seems more and more likely. 

On Reserves, Excess Reserves and Yes, Inflation

Martin Feldstein has long since (make that loongg!) been warning of inflationary doomsday scenarios. Perhaps not to the tune of Meltzer but significantly nonetheless. Meltzer, as Krugman loves to recall has repeatedly stated his opinions such as: 

"Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation. When will it come? Surely not right away..."
Of course, you could nitpick right away. The US budget deficit as compared to an EZ budget deficit, the rapid growth of money supply is not relatively not very rapid at all. And currency devaluation? Currency devaluation??

But Feldstein backs the excess reserves argument once again over in a piece at Project Syndicate. While the warnings are less dire, they're still present. And it brought to mind the Keister/McAndrews paper back in 2009 on excess reserves. 

Now to be sure, you can't argue with the logic on the surface. If the money multiplier had a temporary demise and the Fed is paying interest on the excess reserves (the IOER has long since been 0.25%), then those parked reserves might see the day of light soon. After all, rapid monetary growth is the best harbinger of inflation!

This is what's happened over the past 10 years as far as inflation and the monetary base and M2 are concerned. All have been indexed to the start for a clearer comparison:

And this is what the money growth actually looks like on a monthly and year on year basis:

Lastly, the level of excess reserves is, in fact, unprecedented:

So when Feldstein states, "When businesses and households eventually increase their demand for loans, commercial banks that have adequate capital can meet that demand with new lending without running into the limits that might otherwise result from inadequate reserves. The resulting growth of spending by businesses and households might be welcome at first, but it could soon become a source of unwanted inflation," does he have a point?

What about the Fed? Feldstein has little faith - "The Fed could, in principle, limit inflationary lending by raising the interest rate on excess reserves or by using open-market operations to increase the short-term federal funds interest rate. But the Fed may hesitate to act, or may act with insufficient force, owing to its dual mandate to focus on employment as well as price stability."

You see, you can't forget a few things. For starters, the fractional reserve banking system operates on the premise of a money multiplier. So the idea of excess reserves contradicts the existence of a multiplier. It works like this: 

increase in bank reserves -> increase in broad money (lending/deposits) -> expansion of deposits raises reserve requirements. 

Clearly this has not occurred. And this is where the IOER (interest on excess reserves) checks in. Any bank holding excess reserves should seek to lend at a positive rate and this lending, in turn should decrease the short-term rate. 

From Keiseter/McAndrews, this: 

"leads to a small increase in reserve requirements, as described in the previous section. Because the increase in required reserves is small, however, the supply of excess reserves remains large. The process then repeats itself...until one of two things happens. It could continue until there are no more excess reserves,...In this case, the money multiplier is fully operational. However, the process will stop before this happens if the short-term interest rate reaches zero. When the market interest rate is zero, banks no longer face an opportunity cost of holding reserves and, hence, no longer have an incentive to lend out their excess reserves. At this point, the multiplier process halts."

But the Fed does pay interest on these excess reserves, so the multiplier process stops far sooner. Instead of continuing till the market interest rate is 0, it continues till this rate reaches the rate paid by the central bank on reserves. So if the central bank pays interest on excess reserves at its target interest rate, the multiplier ceases to exist. 

As for the looming inflationary risks lurking deep within, they hold in a traditional framework - where the Fed influences interest rates by changing the quantity of reserves. But if it's paying interest?

With no interest being paid, as demand for loans pick up etc. etc., the central bank must remove the excess reserves to arrest or check this multiplicative process. Only by removing these reserves can the CB check banks' willingness to lend and cause a rise in short-term rates.

But with interest being paid, the link between the quantity of reserves and willingness to lend breaks. It allows the CB to be independent, (in a way), of the level of reserves. 

Which is not to say that the point or the process is moot. It's not. But to suggest, weakly as Feldstein does, that the Fed may act hesitatingly or insufficiently because of its dual mandate is not correct.

At some point, trade-offs between labor market conditions and price levels may emerge. But that's an argument for another occasion. 

External Scenario Update: India

Courtesy Alex Etra, some updates on the external scenario over in India:

"Total external debt rose to 390 billion at March-end (21% of GDP), up from 376 billion in December and 345 billion in March 2012. Of particular concern is the rising share of short-term debt at residual maturity (44% of total) which comprises both short-term debt and long-term debt maturing in the next year. Combining the 172 billion in short-term debt at residual maturity and the expected CAD of about 100 billion provides a starker picture of the external financing requirement facing India over the next year (~13% of GDP)"

Furthermore,

"With 57% of total external debt denominated in dollars (~89 billion) and previous estimates that about 50% of companies’ foreign borrowing is unhedged, the 10% depreciation of INR over the last month will further add to the rollover risk this year"

There's pressure. The Fed's played it a bit wrong this time and shifts in flows have become a bit messy. As usual, while external scenarios don't factor into Fedspeak and Fedthought, that's where the major consequences are seen.

And I think the RBI's hands seem more tied than before. Any possible room has certainly got smaller and the transmission mechanism, in any case doesn't work too well (e.g: 100 bps of rate cuts in 2012-13 leading to 30 bps in bank lending rates?), not to forget that real deposit rates have been in negative territory for over a year approximately. Moreover, corporate and bank balance sheets are far from healthy and if anything at all, understated in terms of risk.

And you know what's worse? 
It's an election year.

EM sell-offs and more Taper Talk

In a few days, we'll have the latest BOP numbers that according to an RGE note will show a narrowing of the Indian CAD. It cites, "seasonal effects, moderating crude and gold prices (particularly towards the end of the quarter) and lower gold imports following a hike in import duties in January".

The problem is that the tapering talk is nowhere near consensus and there's a whole lot of clearing (corrective pricing?) happening in most Emerging market economies. Any BOP numbers on the wrong side of the estimates are likely to increase downward pressure on the INR in lieu of persistent external financing gaps.

But that's a general scenario that has been enhanced by recent actions by the Federal Reserve. And while in general, a depreciating currency provides a bit of relief to the current account of an economy, India has a lot more to worry about in terms of its imports. From RGE,

"Looking specifically at crude imports is instructive. Already the INR price of a barrel of Indian crude is back above 6000 while losses per liter of diesel (i.e. the government subsidy) have inched back up to 6.31 (from roughly 4.5 a month or so ago). Between January and end-May India imported roughly 541 million barrels of crude and petroleum (~USD 83 billion). Over the same period Brent prices dropped by about 10% and INR depreciated by 6%. 
 In fact in April INR strengthened as capital inflows were robust and the market saw the commodity selloff as INR positive given the latter’s expected impact on the CAD. But that hope turned out to be short lived. Since then INR has fallen another 5% while Brent has stabilized thus reversing the previously expected positive impact on the CAD.
Aside from widening the CAD the higher INR price of crude will raise the subsidy bill (in spite of recent upward revisions to administered prices) and/or raise imported inflation if higher international prices are passed through to domestic consumers via more diesel hikes. This will exacerbate the tension between fiscal commitments to contain subsidies and politically unpopular (and inflationary) price hikes ahead of elections."

It's not pretty. Global sentiment has significantly adverse affects and there are strong headwinds that are waiting to provide more problems through higher deficits and more inflationary pressure. And India stands out economically among all the EMs, in the worst macro-way possible.



And in terms of the big picture? At least, the EM sell-offs have led to a slight unwinding of carry trades and corrective pricing; and while the lessons of '97 have been learnt, vulnerabilities continue to exist in the form of sizeable CADs. slowing growth and stickily high inflation. But this is just the beginning and as US real yields inch upward, there are EM economies with some monetary policy room to ease a bit or at least not tighten.

What the sell-off is undeniably doing on the surface, is making EM local currency debt attractive where inflation is less of a concern. Statistical research on EM LCY debt in the past decade shows a significant shift in the behavior of LCY debt post the Global Financial Crisis. Whereas domestic monetary policy (expectedly) is observed to be a significant determinant of yields before the crisis, the significance of treasury yields and other global factors is far more pronounced over the past few years leading to a sort of temporary "safe-asset-syndrome" for EM debt.

As another RGE note categorically states,

"On a structural basis, EM growth prospects and external balance sheets have worsened as export growth has stalled. Government balance sheets mostly look strong, even if there isn't a lot of stimulus capacity/willingness, but its the corporate balance sheets that may suffer the most from the combined slowdown in growth and higher financing costs (either actual or effective). Those high inflation/low growth countries will be most exposed to rising financing costs, which could undermine growth prospects further, holding back any reacceleration"

A round-up analysis in the FT has differing opinions on whether this is a "mini-bust" that will be handled easily or just a mild tremor and a harbinger of a bigger quake. We may not see as much "original sin" anymore but that doesn't mean that conventional macro-vulnerabilities have vanished into thin air. In all likelihood, they've been replaced by different combinations of variables spurred on by the accommodating global monetary regimes of the past few years. 

And now that tapering talk has begun (never mind that there is no sign of short-term rates increasing or a favourable US employment picture), the downward pressure on bond prices in EM economies will increase. Accompanied by detrimental volatility in the markets, there will be lots of investor jitters before anything else.

As for some of the EM central banks, they might find a need to tighten monetary policy (or keep it tight) when it is perhaps the last thing desired, but something completely required.

Taper Talk

James Hamilton has a post on all the tapering talk and the accompanying rise in yields. Mainly, he emphasizes that it's not as if the purchases had no effect. The markets know of QE(x) before it is announced and implemented. Rather,

"One of the reasons that everyone expected QE2 was that we could all see for ourselves that the economy remained weak. Part of what persuaded the Fed to move, and what persuaded everybody else that the Fed was going to move, was a very weak labor market and signs of disinflation. But these same factors would also tend to depress interest rates even if the Fed didn't buy a single bond. Some of the drop in rates in the fall of 2010 was likely caused by anticipation of QE2, but some was also due to a very weak economy."

Essentially, the effect of what is expected of future short term rates also holds current long term rates. Ultimately,

"When it does announce tapering, the Fed will try to reiterate that the rise in short-term rates will still not come until much later. But just as QE3 added emphasis to the declaration of a commitment to an extended period of low interest rates on the way down, ending QE3 will tend to detract from that message as we start to look at the path back up.

And just as a weak economy was the primary reason the Fed embarked on QE3, a strengthening economy will be the primary reason the Fed ends it. And if the economy is strengthening, interest rates will be headed up, regardless of whether the Fed keeps buying bonds or not. It's worth emphasizing that the recent rise in interest rates has been a global phenomenon, not just something seen in the United States."

Some kind of __flation

Even if inflation is the dog that never barked, there's no harm in asking whether it's still a dangerous dog and might it bark and perhaps bite at some point in the future?

Martin Wolf has a piece from a few days ago which sadly ends with a safe and logical answer amid talk of public debt levels and central bank balance sheet expansion. If i tell you it starts with a 'g', you'll guess it in a second.

Nevertheless, Wolf does have a few important points to make. Firstly is the point about a US Republican warning of hyperinflation three years ago (Okay that's not an important point but it would be fun guessing who if the sample size wasn't so large!)

But the point about the money multiplier (or the lack of it), is important. Because common sense initially makes you wonder upon observing the explosive growth in the base contrasted with the growth of broad money - that is the link between the reserves of commercial banks held at the central bank and their lending to the public. An assumption that banks will eventually lend more (future monetary expansion) is almost unfounded.

This is where the bank's own solvency comes into question. If, as Wolf states, equity capital of a bank is a far more significant determinant of its lending ability than its reserves...and furthermore, the excess reserves are controlled by the Fed, then a lowering of excess reserves can be accomplished by simply raising reserve requirements (the IOER) or selling government debt to the public.

What's more important from the inflationary standpoint, is not the indicator of the behaviour of excess reserves but the impact that inflation has upon debt. Enter redistribution issues and the generational balance queries.

Thus, under some fairly basic assumptions, the strategy of 'growing out of the debt' seems plausible. At the same time, the threats don't seem to be receding - that a sharp contraction in real growth would have a negative impact on house prices, unemployment, price levels in general and make every government balance sheet far worse off. The low interest rate offsetting could be mitigated and one has to look no further than Japan to observe this.

Ultra-low interest rates simply cannot protect an economy against stagnation, deflationary pressure and adverse fiscal deficits among other things.

The JGB Paradox

Are the rising yields in JGBs a sign of an incipient expected real economic recovery? Are they a sign of the market being ahead of Abenomics? And what about the paradox, that on the one hand the massive bond-buying BoJ is seeing bond prices fall instead of rise, should they be concerned about the impact this has on their debt servicing costs?

On the one hand, the rational-investor-Kyle-Bass approach makes a bit of sense. If the BoJ is trying to drive up inflation to 2% (and erode the value of JGBs), this would imply the success (somewhat) of Abenomics and the selling of JGBs to buy foreign bonds/equities.

But this is similar to Richard Koo's balance sheet approach to doomsday. It's the same end but different means really. Once inflationary expectations pick up, the BoJ will essentially lose control of any ability to control a rise in yields. And then you can let your imagination run...loss of faith...beginning of the end...(insert apocalypse now scenario here).

It's pretty obvious that there's a time variant issue here. That economic recovery is relatively a more long-term implication than the volatility in interest rates. The reaction of the markets is immediate and often ahead of policy action. But if investors start selling, are they anticipating success or failure? And if long-term rate rises precede signs of real economic recovery, will lenders choke off borrowing and bring the whole experiment to an end?

Abe himself, is not one to discount the worrying impact of short-term volatility and rises in borrowing costs. In parliament, he said that, "sharp increases in long-term interest rates could have a grave impact on the economy and the government's fiscal conditions".

But perhaps Abe should not be overly worried at the moment. After all, the BoJ is the BoJ - a central bank with more in its arsenal.

And this sort of runs contrary to what Nick Rowe says over at Worthwhile Canadian Initiative. He claims that it's not just what you buy, but what you buy it with; and his example is paying for taxi medallions with newly produced bicycles. Thus, an increase in the stock of money in circulation (we have to be careful here!), will have an effect on the demand for bonds (by raising the expected future price level thus reducing the demand).

But the key here (and the paradox too!) is that if you're flooding the monetary base and forcing yields down in the hope that inflation expectations will pick up and spark a real recovery...and this will cause "a rise in investment, fall in savings..." and if you intend for all this to happen and will gladly accept the consequence of rising yields then are you really trying to force yields down in the first place? And if yields rise (we've come full circle here), has your policy succeeded or failed?

Rowe says that the easiest way to think about this (and he's mostly right) is that it's a battle to push bond yields down but a war for economic traction and recovery. Thus, if you win the war, you'll lose the battle and essentially, you'd want to lose that battle.

Because this we do know, that when and if the Japanese economy recovers from its deflationary trap and stagnant growth, nothing much can (and perhaps should) be done about an accompanying shift in the yield equilibrium. In that sense, the more any attempt is made, the higher it might rise. And if there's a real economic recovery (Not just expectations of it)? Then a new equilibrium might be the point at which the BoJ stops restraining yields.

So throw Econ 101 out of the window, which tells us that the more you buy of something, the higher its price goes. The expectations of Japanese and foreign investors could be different. As Noah Smith points out, JGB investors are largely Japanese which most equity flows have been driven by foreign funds. And in this sort of a Keynesian set-up, a rapid interest rate rise perhaps could only be explained by a multiple equilibria theory where "Abenomics kicks the economy out of its bad equilibrium very abruptly, and the economy is shocked back to a sustainably higher rate of nominal growth".

Thus, according to Smith, "Japan's only hope is to cause the kind of recovery where interest rates stay very low for a very long time". But he says this with the debt ratio in mind, assuming rationally that sharp rises in borrowing costs would have unwanted consequences on the fiscal position. From Rowe's point of view, this prolonged-low-rate environment will prove impossible by the design of its theory.

Lest we forget though, that instead of rises in nominal rates, the reason for the rise in nominal rates will impact the function of real interest rates. And if things seem to be working and Japan really kicks itself out of its deflationary liquidity trap then real rates will go down irrespective (barring a vigilante attack I suppose) and the real value of existing debt stock will be eroded even though debt-servicing costs rise.

In that sense, Koo is right but he's just a bit wrong too. With balance sheet constraints, budget deficits and NOT monetary policy moves are the solution but this ignores the fact that even in a balance-sheet scenario, there will be creditors who respond to lower real rates.

Once again, the key here is the time boundary. Volatility may not be something to be over-worried about and  neither is the paradox. And therefore, betting on Abenomics to end up as a failure is definitely not the right move to make at the moment. 

Politically Correct or Woefully Ignorant?

Question: I have two questions. The first one is: do you see any risk of deflation in some countries in the euro area?

The second question is, yesterday, the IMF issued another mea culpa with regard to the austerity measures which were imposed on Greece. I wondered if the ECB also had some mea culpa to offer.

Draghi: Well, not really.

First, on deflation: ... we do not see it. In addition, some of these changes I hinted at are actually changes in relative prices, so they are positive. They show that there is real adjustment taking place, which can be seen in the export levels, which have gone up in some of the stressed countries.

On your second point, on the issue of mea culpa, no, I do not think we do; in fact, one good thing, as far as I understand, about this IMF paper is that the ECB is not being criticised. So, that is one thing. There has been a statement by the European Commission this morning which responds to this IMF paper. It makes several points and I do not want to go back over these points. I would not to say something different. Looking at the present situation, Greece has undertaken an extraordinary adjustment process. There is ownership of this adjustment by the government and we have to acknowledge the progress that this country has made. If we think back to a few years ago, it would have been unthinkable. Of course, if this paper by the IMF – which I have not read – decides to offer mea culpa and identifies the reasons for mistakes that have been made and other things, we will certainly have to take them into account in the future. However, often this mea culpa is in fact, as I will call it, a mistake of historical projection, i.e. you tend to judge the past by today’s standards. We cannot forget that four or five years ago, when the discussions about the adjustment in Greece were taking place, the climate was, in general, much worse. There was a fear of contagion there and very high volatility. That is, in a sense, where the fragmentation of the euro area really started. So, it is always very hard to pass ex post judgement on what happened four years ago. Having said that, rather than looking backwards, why do we not look forward and take stock of the extraordinary progress made and the positive path that has been taken?

Question: You talked about dramatism a few minutes ago and I am afraid I will be a little bit dramatic now because I am from a country that has an unemployment rate of 27%, which is a number of a great depression, a fiscal policy that is contractionary and a monetary policy in Spain and also in other countries that is also contractionary because credit is not available to small and medium-sized companies. Are you telling the Spanish, Portuguese, Irish or even Italian people that the ECB can’t do anything else with inflation actually lower than 2%?

Draghi: Well, I am not sure I get the point, but I think I get it. 

First, the fact that inflation is low is not, by itself, bad; with low inflation, you can buy more stuff. 

Second, we don’t see deflation and that is what we have to fear. We don’t see that yet. 

Third, fiscal consolidation is and remains unavoidable. It should be clear I think to everybody that you cannot have growth with endless debt creation. Sooner or later, you are going to be punished and the whole thing stops and that’s exactly what happened after the financial crisis in many countries. 

Fourth, are there ways to make fiscal consolidation growth-friendly? The answer is yes. Fiscal consolidation in most countries has taken the shape of increasing taxes and there are many reasons for that. Often this was done in an emergency situation or unfortunately because the easiest thing to do is to raise taxes. Now that is not growth-friendly and it is not growth-friendly because it happens in parts of the world where taxes are already very, very high. So what would be a better way? A better way would be the difficult way, namely to reduce unproductive government expenditure and reduce taxes together. But once you have done that – and in a sense I hinted at this before – you also have to ask yourself why these countries were not competitive. Why did they have to rely for growth in the good times, or “fairyland” times, on the protected sectors that were shielded from international competition? And then you ask yourself what should these countries change to become more competitive? And then what adjustments are needed in order to achieve this objective? The encouraging thing is that we see that most countries, if not all of them, are in this process, which of course is very painful, and I don’t think I miss one opportunity to make sure that you all know how aware of this we all are in the ECB.

Because I'm sick of R, R (and R)

I promised myself that although I wouldn't shut my eyes if i came across more RR to-and-fro (should we make that RRR now?), I would at least not ever blog about it again unless it was something seriously worthwhile.

I broke my promise and Michael Heller made me do it. Now to be fair, it's a bit unfair to say that this hasn't been going both ways because it has. The difference is that one side (PK, JBL etc.) has been substantive. They've focused on content, on causation and on concept...

...which (I may have got the chronology wrong)...led to a longg letter from Reinhart to Krugman, a sort of dismissive, lazy and im-tired-of-arguing-with-walls response and then....a severely ungracious piece on Project Syndicate by Michael Heller that reeks of being stuck in a corner and throwing jabs into thin air.

Dean Baker's retort includes a gem or two:

"This is the sort of piece that should really have the general public thinking about defunding economics programs everywhere"

"Anyhow, if Heller can read Krugman's latest column and declare R&R the winner, he must also believe that George Foreman defeated Muhammed Ali back in Rumble in the Jungle back in 1975. Such is the state of the economics profession."

WHY DOESN'T THIS END?!

Moby Ben and the Widowmaker - A Post Script

I'm late on this but it's worth thinking about. Post Bernanke-bashing at the Ira Sohn conference, JBL came out with one of the best pieces I've read in a while. What he essentially does is draw a contrast between two counter-parties with a common 'party' - the fund guys.

Of course, you know the backdrop to the London whale:

a) For while, he was more famous than Moby
b) He still ain't a patch on the real whale i.e: Moby Ben

So while the big funds may have finally sighed in relief as their counterparty could no longer continue (because naturally JP was seeing far too much red ink already), that logic doesn't apply to the Fed. And the way to go about this is to think along a more general line of thought and keep it simple.

If the treasury yield is reflected by the path of expected short term rates, inflationary expectations and the term premium, and the Fed shows no concrete signs of future QE moves then it's not entirely unreasonable to see why its easy to get attracted to the 'widowmaker'.

As JBL states, back in the late 90's toward the end of the Clintonia surpluses, the treasury bond traded between 5% and 7% while after the turn of the century, in a relatively much weaker economy, it hovered around the 4-5% mark. Hence the questions such as why was there a low-yield peak and why/when does it return to the 'fundamental'.

Cue Big Ben, printer of deposits, mass purchaser-in-chief of treasuries thus acting as chief culprit in pushing prices up well beyond 'fundamentals'. But here's where reason takes a short step out the window.

Rather than easing off, the buying persisted and fund managers made a very wrong comparison between the little whale and the big whale. While the little one was severely constrained due to obvious reasons, the big one should have been constrained by goals of financial stability and price stability. And just as the little one was answerable to Ina Drew and eventually Dimon, so should the big one have been....waitaminit...

Moby Ben answers to no one, and any dissent that he faces at the FOMC is not even worth writing home about relative to the broader consensus. While the CDX IG9 had a fundamental (the payouts of the bankruptcies times the probability of occurrence), the little whale could not alter the fundamental through his bets and positions.

And the key here is a healthy economy. Because in a healthy economy, the treasury has a fundamental. In a healthy economy, pricing power is partially determined by workers and the Fed's mandate is keeping inflation in check. Is this a healthy economy? No pricing power. Downward nominal wage rigidity. Unlimited market appetite for zero interest cash. Far from it.

Moreover, the Fed is not a profit-making enterprise. It's balance sheet stands at seeming odds with its goals. Unwinding positions and incurring portfolio losses is something the Fed will gladly take if it returns the economy to a steady and healthy state.

Now sure, it's logical to expect a rise in rates and you'd be well-off if you were a very patient investor. Use a crude Taylor rule (for example, the Mankiw rule) with an indicator of about 9.5 and you'll end up plotting an S-shaped curve picking up somewhere in the latter half of 2014.

And if you're screaming inflation and hyperinflation from every rooftop like a lot of people have over the past few years, then you might do well to read about the dog that never barked.

I don't know why exactly it's called the widowmaker but the real widowmaker is a coronary artery that is fatal if blocked.

The analogy seems dubious but still, shorting the bonds:

1) of a sovereign nation that
2) issues debt in not just a currency it controls
3) but a currency that acts as the global reserve currency
4) in a depressed economy
5) is foolish

Pooling Debt

Paul De Grauwe of the European Institute at LSE has a cry out for an EU fiscal union over at Project Syndicate. The good news is that he tries to be practical about it. As you might recall, De Grauwe sort of popularized the self-fulfilling prophecy theory for the EU - that namely the fundamental flaw of the EU is that its members issue debt in euros and the euro is a currency that they have no control of.

Thus, none of them can provide any sort of guarantee to their bondholders. A little fear in the markets prompts sell-offs that can lead to liquidity crises and drives these sovereigns closer to default. With not much to play with, they implement austerity programs that exacerbate recessions and lead to further banking crises.

De Grauwe used very simple univariate relationships among debt-to-gdp ratios, credit spreads, austerity, and growth to illustrate this concept. What you expect to observe is strong relationships between austerity and spreads (in 2011) - thus higher spreads -> greater austerity. you can consider the causation both ways here too.

Further, he charts the change in spreads to the initial spreads (to look at the impact of the ECB's announcement), the change in debt-to-gdp vs spreads (a negligible fit), and the usual austerity vs growth and austerity vs increases in debt-to-gdp.

But I digress: the voxeu article is here and the CEPS "Governance of a Fragile Eurozone" can be downloaded here.

To get past this fundamental flaw of the EU - that member nations have no control of the currency in which their debts are issued - debts must be pooled. The immediate response to this, of course, is that's not happening. Germany, for one, is highly unlikely to even look down that path.

Still, De Grauwe mentions the obstacles involved. The first obstacle is naturally that of moral hazard. But there are some more obvious ones such as the willingness of 'stronger' countries to accept inevitably higher interest rates on their own debts with the advent of any sort of joint liability.

To overcome these, he offers the following three:

1) The share of pooled debt must be strictly limited to the extent that each member nation remains largely responsible for a significant portion of their own debt (you can see the grey area already!)

2) An internal transfer mechanism between member nations to counter the "one-way-traffic" argument. Essentially, less credit-worthy countries must compensate their polar counterparts.

3) A supervisory authority to monitor members' progress toward sound public finances and the ability to implement consequences on those that don't adhere (remember the Maastricht treaty anyone?)

Just like the rest of us, de Grauwe understands that a fully fledged fiscal union a la the US is wholly unrealistic. The point is, however, to be practical and begin with really small steps. He emphasizes the need for the EU to convince financial markets that it is there to stay - permanently. And for this to happen, a process must start.

But see, that's the problem. If the process was to start, it would have started. The opposition is far too great and powerful and the false sense of contentment with a kick-the-can approach has manifested itself with the polity that makes decisions. There are factions, there are vested interests and then there are the people.

De Grauwe ends with the Alexander Hamilton narrative - that rather than wait for a political integrating process, he took action that spurred the United States to a full-fledged m-f-p union.

The question is, who on earth is Hamilton here? Rehn? Weidmann? Merkel?

Initial Claims vs the SP500

The initial jobless claims as a variable is basically a quicker indicative measure of what's happening in the labor market before you really see the effects. Because it reflects individuals filing official jobless claims (for unemployment benefits etc.), it's sometimes seen as a valuable enough indicator or measure-of-health by analysts. 

Starting from 2008, a simple plot between the S&P 500 index and an inverted claims variable reveals phases of high co-movement. Overall, there's a -.92 correlation and a simple regression line has a fit of roughly 0.85.  The key though, is not the relationship necessarily (right now, for example, the claims aren't low enough to justify the additional buoyancy in the stock market). Or for that matter, since the S&P 500 was/is close to 1620, a claims estimate would be around the 250,000 mark - a far cry from the 324,000 it is now. 

This is what the graph over time looks like:

And the scatterplot looks like this:

The main thing over this time period though (beginning 2008 to present) is the convergence of the two. The gap widens (I rebased them to start as an index and looked at the difference) till it peaks in March 2009 and then a convergence begins till it hits zero in January this year and turns once again:

A simple equities-fundamentals disconnect? A rotational impact? Where to now?

Why this time is not different - revisiting debt and growth for the infinite time

Well, if I don't get this out now, I'm not likely to do it later because I would have read the whole paper and a lot more people would have too. It turns out there is something amiss this morning! - namely this. It's a paper by 3 UMass researchers that sought to duplicate the famous (infamous to me!) Reinhart-Rogoff narrative on what high debt levels do to growth, and among other things- median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower.

I don't think I've been quite critical enough of these debt-growth studies - but most of the time, there are enough people doing the taking down. This time is not different.

Tim Fernholz at Quartz lays less into the study and more into the blatant disdain political figures showed while repeatedly misusing it. He quotes a passage from Republican senator Tom Coburn's book of debt that describes a scene where, in April 2011, 40 senators met R&R for a briefing - here's what transpired (all emphasis is mine):

“Absolutely,” Rogoff said. “Not acting moves the risk closer,” he explained, because every year of not acting adds another year of debt accumulation. “You have very few levers at this point,” he warned us.

Senator Kent Conrad...explained to his colleagues that when our high debt burden causes our economy to slow by 1 point of GDP, as Reinhart and Rogoff estimate, that doesn’t slow our economy by 1 percent by 25 to 33 percent when we are growing at only 3 to 4 GDP points a year.

Reinhart echoed Conrad’s point and explained that countries rarely pass the 90 percent debt-to-GDP tipping point precisely because it is dangerous to let that much debt accumulate. She said, “If it is not risky to hit the 90 percent threshold, we would expect a higher incidence.”

I present to you -  the "scratch-your-head-till-it-hurts-and-you-find-the-least-smart-comment-game"...STARRING...:

 -  “[I]t is widely acknowledged, based on serious research, that when public debt levels rise about 90% they tend to have a negative economic dynamism, which translates into low growth for many years.” — European Commissioner Olli Rehn.

 -  “Economists who have studied sovereign debt tell us that letting total debt rise above 90 percent of GDP creates a drag on economic growth and intensifies the risk of a debt-fueled economic crisis.” — House Budget Committee Chairman and former Republican vice-presidential candidate Paul Ryan.

 -  “It’s an excellent study, although in some ways what you’ve summarized understates the risks.”— Former US Treasury Secretary Tim Geithner. 

 -  “[W]e would soon get to a situation in which a debt-to-GDP ratio would be 100%. As economists such as Reinhart and Rogoff have argued, that is the level at which the overall stock of debt becomes dangerous for the long-term growth of an economy. They would argue that that is why Japan has had such a bad time for such a long period. If deficits really solved long-term economic growth, Japan would not have been stranded in the situation in which it has been for such a long time.” Lord Lamont of Lerwick, former UK chancellor and sometime adviser to current chancellor George Osborne.

 -  “The debt hurts the economy already. The canonical work of Carmen Reinhart and Kenneth Rogoff and its successors carry a clear message: countries that have gross government debt in excess of 90% of Gross Domestic Product (GDP) are in the debt danger zone. Entering the zone means slower economic growth.”— Doug Holtz-Eakin, Chairman of the American Action Forum.

This is a close one but I've just got to give it to L-cube for those really fancy initials and of course the Japan parallel. Your winner emeritus - Lord Lamont of Ler...

...Anyway, on to more serious critiques, Mike Konczal (Rortybomb/NextNewDeal) summarizes the three issues of the HAP do-over (I would think that this was the post on the econoblogosphere that set off things):

"First, Reinhart and Rogoff selectively exclude years of high debt and average growth. Second, they use a debatable method to weight the countries. Third, there also appears to be a coding error that excludes high-debt and average-growth countries. All three bias in favor of their result, and without them you don't get their controversial result."

There's more detail on these three here if it interests you. But there's something else too!

That would be the average excluding Belgium, which had a robust 2.6% growth in a "time of high debt". Yes, that's the cell not being dragged all the way down - it leads to the average being 2.2 instead of -0.1%. 

But Krugman has some more insight on this. He points to two studies that have acted as a sort of foundation for this harmful austerity drive. The first is the Alesina-Ardagna paper on the expansionary macro-benefits of austerity. The second of course, is the R-R study, and the point he makes (perhaps justifiably!), is that while some could obviously observe the effects of observed correlation and reverse causation, the "crime" so to speak, lies with all the policymakers that actually used it as a public defense of their agenda. Think of this in a David-Li-and-the-Gaussian-Copula way. Should he blamed because rating agencies and investment firms adopted his interpretation?  

Anyway, Krugman uses his own scatterplot but differentiates between countries so as to test the effects of the weighting system. His sample is only 1950-2009 and works for the G-7 only (which in retrospect might not be a bad thing at all). While he concedes that there does seem to be some sort of an association, "most of the apparent relationship is coming from Italy and Japan; Britain didn’t seem to suffer much from its high debt in the 1950s. And it’s quite clear from the history that both Italy and (especially) Japan ran up high debts as a consequence of their growth slowdowns, not the other way around."

But I saved the defence for the last! Here's what Reinhart-Rogoff state in a WSJ piece (in response to the HAP research):

"...On a cursory look, it seems that that Herndon Ash and Pollen also find lower growth when debt is over 90% (they find 0-30 debt/GDP , 4.2% growth; 30-60, 3.1 %; 60-90, 3.2%,; 90-120, 2.4% and over 120, 1.6%). These results are, in fact, of a similar order of magnitude to the detailed country by country results we present in table 1 of the AER paper, and to the median results in Figure 2. And they are similar to estimates in much of the large and growing literature, including our own attached August 2012 Journal of Economic Perspectives paper (joint with Vincent Reinhart) . However, these strong similarities are not what these authors choose to emphasize.

The 2012 JEP paper largely anticipates and addresses any concerns about aggregation (the main bone of contention here), The JEP paper not only provides individual country averages (as we already featured in Table 1 of the 2010 AER paper) but it goes further and provide episode by episode averages. Not surprisingly, the results are broadly similar to our original 2010 AER table 1 averages and to the median results that also figure prominently.. It is hard to see how one can interpret these tables and individual country results as showing that public debt overhang over 90% is clearly benign...

...By the way, we are very careful in all our papers to speak of “association” and not “causality” since of course our 2009 book THIS TIME IS DIFFERENT showed that debt explodes in the immediate aftermath of financial crises. This is why we restrict attention to longer debt overhang periods in the JEP paper, though as noted there are only a very limited number of short ones...

...Lastly, our 2012 JEP paper cites papers from the BIS, IMF and OECD (among others) which virtually all find very similar conclusions to original findings, albeit with slight differences in threshold, and many nuances of alternative interpretation.. These later papers, by the way, use a variety of methodologies for dealing with non-linearity and also for trying to determine causation. Of course much further research is needed as the data we developed and is being used in these studies is new. Nevertheless, the weight of the evidence to date –including this latest comment — seems entirely consistent with our original interpretation of the data in our 2010 AER paper."

=================================

In a way, it's kind of what you expect, perhaps a bit more defensive, a little less calm - I wouldn't know, I'm not too good at gauging reactions. 

What I do know is that any kind of study that seeks to establish an association, tries to imply causation and uses historical data that might be of little use in the world we live in today must be taken with a pinch of salt. 

It can be used to provide perspective and complement or contradict other lines of thought. What it shouldn't do however, is be misused as a tool, and treated as "evidence" just so that politicians and policy makers can advance an agenda. 

================================

P.S: Some further further reading (because it just never stops):

 - Ryan McCarthy has a good encapsulating summary at Counterparties

 - Matt Yglesias at Slate asks what exactly this will really change

 - The folks at Alphaville (Garcia/Cotterill) have a far more specific critique of the study in general and the lack of vetting that went along with it

 - Tyler Cowen, at Marginal Revolution, on a lighter note, has an interesting and fair point-by-point take on future consequences. He asks whether this should change the ratios (quant/narratives) of what he reads.

 - Dean Baker at CEPR emphasizes the implications that this paper led to (it's provocatively  titled "how much unemployment was caused...") along with a follow-up of his own post post-response

 - Noah Smith has his own noahpinion where he chooses to focus instead on the book that sheds light on historical financial crises. He also excuses the "gotcha" excel moment (which I do think is fair, hey it could happen to me!)

 - Owen Zidar has his own take presenting us with two graphs from a collaborative effort on an IMF presentation with Tyson and DeLong.

 - Dylan Matthews at Wonkblog had a detailed "debt/deficits/spending etc" piece just over a week ago. One of the sections is "Countries with debt over 90 percent of GDP enter a danger zone". Worth the read

 - Ryan Avent plays the twitter role

 - The last word should go to Robert Shiller for his Project Syndicate piece almost two years ago with this gem, 

"A paper written last year by Carmen Reinhart and Kenneth Rogoff,...found that when government debt exceeds 90% of GDP....

...One might be misled into thinking that, because 90% sounds awfully close to 100%, awful things start happening to countries that get into such a mess. 

But if one reads their paper carefully, it is clear that Reinhart and Rogoff picked the 90% figure almost arbitrarily. They chose, without explanation, to divide debt-to-GDP ratios into the following categories: under 30%, 30-60%, 60-90%, and over 90%. And it turns out that growth rates decline in all of these categories as the debt-to-GDP ratio increases, only somewhat more in the last category".

More on the dog that did not bark...

Picking up where I left off last time, the next step of course, is attention to detail - namely, what role does 'economic slack' or the output gap play along with the anchoring of expectations?

Ryan Avent over at free exchange asks that if you factor in the change in central bank credibility over time, and assume that it was effective, then what happened to unemployment?

Anyway, the key here to take away is to zero in on the notion that slack in demand affects quantity shifts rather than price shifts. Essentially, "Workers expecting prices to stay flat amid falling demand will resist wage cuts, and firms expecting workers to resist wage cuts will be reluctant to cut prices. Instead firms will produce and sell less and lay off workers, turning a given shock into much more of a real output loss". 

But that's not something new. To that extent, Avent draws back to an '88 paper by Mankiw, Ball and Romer on  the inflation-output trade-off titled, "The New Keynesian economics and the Output-Inflation trade off". Essentially, they empirically observe the same - during high inflationary periods, firms and workers are likely to adjust prices and wages more thus increasing responsiveness to shifts in demand. In contrast, during low inflationary periods, nominal rigidity sets in.

What the authors conclude is this: 
High inflation -> relatively flatter Phillips Curve (changes in nominal AD have significant effects on output). Low inflation -> steeper curve (shift in demand is reflected faster in the price level).

But back to Chapter 3.

I won't dwell much on output gaps but this is what the estimates suggest - Capacity Utilization decreased by about 5-6% since the beginning of the GFC while Unemployment gaps averaged roughly 2%. The study clearly states that what this suggests is a considerable share of the GFC unemployment increase being cyclical (the gap between current unemployment and NAIRU).

More importantly, on the anchoring of expectations angle, it turns out that although current and expected inflation are positively correlated (as you might expect), the slope is low, implying that expectations are anchored to targets rather than the current level. 

The basic approach involved here is again, eerily simple. Two differences are used, the regressor is the difference in the actual inflation rate (at the time expectations are collected) and the central bank's target level. The dependent is the difference between the long-term expectation at a given time and once again, the central bank's target level rate. If you visualize this, you can see why:
1) If the regression coefficient estimate is zero, then the relationship between expectations and the actual inflation would not be significant
2) If the estimate of the intercept is zero, then expectations would be centered at the central bank's target rate.

The results are best explained in a graph of the coefficient estimates:

For the record, these are rolling (five year window) regression on a 12 advanced economy sample since 1990. 
Further, evidence on the relationship between the inflation level and its responsiveness to economic slack shows that slack persists and that "the recent stability of inflation is indicative of greater anchoring of expectations and a more muted relationship between economic slack and inflation".

But these are naturally tentative observations (what about headline CPI, import-relative price inflation, lags, shocks etc?) - whether this approach holds consistently can be explored further in a more formal framework and model. 

More on that soon.