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.

The WEO's inflation primer - the dog that never barked

From the chapter with a witty opening quote from Silver Blaze, here's a small excerpt from the forthcoming WEO which has a whole chapter (about time too!) devoted to inflation or in their own words - the dog that didn't bark, forget bite! 

I just wanted to get in a quick reasoning on the whole inflationary quiescence in an era of unprecedented and unconventional monetary accommodation. But before that, here's a nice graph from the chapter that shows the staggered short-medium run behavior over the long-term between inflation and unemployment. As expected, it differentiates between the GFC and the rest - the '70-'79 decade is characterized by that vertical spike while the GFC has a horizontal extension closer to the principal axis:

The fund begins by looking at a New-Keynesian framework of a Phillips curve variant. It assumes that inflation (p(t)) is impacted by inflation expectations (pe(t)) and the level of cyclical unemployment (u(t)) (you can leave the cyclical/structural debate for later!). 

So, p(t) = (pe(t)) - k.u(t)
 where k is the parameter that is the slope of the curve. Using this basic framework, the following explanations can then be discussed retrospectively.

First - if the increase in unemployment had a dominant structural component instead of a cyclical one, then the change in u(t) will have little impact on p(t).

Second - (Bernanke might have a lot more to say on this), inflationary expectations may well be a lot more anchored than people presume they are. This could be a direct or indirect result of the difference in perspective of central bank credibility. 

Third - prior to the GFC, inflation was still the dog that didn't bark and this initial level or "other changes" could well have impacted the response mechanism of inflation to cyclical developments. That is, you would expect a somewhat flatter curve and hence, a smaller coefficient for the slope (k). 

I'll get more wonkish on this (as they do), tomorrow.