The Free Exchange column of The Economist recently had an article which addressed the concern that in order to create or revive economic growth developed economies will just create a bubble environment. However this concept was around in the 1930’s as economist Alvin Hansen thought a slowing of both population growth and technological progress would reduce opportunities for investment. Savings would then accumulate and growth would slow unless the government intervened to bolster demand in the economy. Today interest rates are low and therefore saving has limited avenues to earn reasonable returns from productive investment opportunities. But according to The Economist this story doesn’t fit the current conditions for the following reasons:
1. There is at present an IT revolution
2. Private investment has recovered since the GFC and technology investments are doing very well.
But some investment managers are paid by the value of the share price and these get boosted in the short -run. This encourages them to put large amounts of cash into buy-backs, which raises stock prices, rather than into productive investments that might do more to boost growth.
Saving could also be seen as a reason for secular stagnation. High levels of saving reflect the reduction in consumption and this is thought to have come about by an in the increase in income inequality - high income households save more than those on lower incomes. In 2007 – 23.5% of all American income went to the top 1% of earners – the highest percentage since 1929. Research has shown that saving by the top 5% has been surppressing demand since the mid-1980’s. Carmen Rheinhart and Ken Rogoff in their book “This Time is Different” (which I have blogged on in previous posts) concluded that post war banking crises are followed by weak recoveries, whether or not they were preceded by a surge in income inequality.
Since the Aussie dollar was floated in 1983 its value closely followed that of its commodity exports – see graph from The Economist. However since 2003 commodity prices have increased 400% but the dollar rose by much less and no longer had a direct relationship to commodity prices. There are 3 possible reasons for this:
1. The deregulation of financial markets which facilitates the ease of currency trading
2. The current account deficit in Australia which got to 6.2% of GDP in 2007
3. Interest rates in Australia up to the GFC were realtively low compared to other developed countries
2011 saw commodity prices drop but the Aussie dollar has remained strong. As most economies employed a lose monetary policy and proceeded to drop interest rates aggressively after the GFC, the Aussie economy didn’t in fact go through a recession and its interest rates remained relatively strong – see below.
Although a weaker exchange rate could help the Aussie economy especially as it has been susceptible to the resource curse – the strength of the exchange rate and higher interest rates is already putting pressure on some industries, particularly the tourism, manufacturing, education exports and retail industries.
Yale University economist and Nobel Laureate Robert Shiller describes a bubble as a “psycho-economic phenomenon. It’s like a mental illness. It is marked on excessive enthusiasm, participation of the news media and feelings of regret among people who weren’t in the bubble”
Others have suggested that bubbles are an increase in the price of an assets of no more than two standard deviations above the trend taking inflation into account. Bubbles have been a lot more prevalent since the 1960’s and this reflects the liberalising of financial markets and the end of the Bretton Woods system of fixed exchange rates in the 1970’s. Many economists have struggled to understand bubbles as in a rational and perfectly informed market assets that are overpriced should be sold. However the frenzy of the market can last much longer than investors think and the bursting of the bubble will be a gradual and slow process or a sudden drop in prices.
Housing bubbles tended to be supported by the banking industry.
* As most people take out a mortgage from a bank, rising house prices encourage banks to lend out more money as there is more security for them. However this greater availability of credit allows borrowers to afford higher prices.
* In contrast when the banks become reluctant to lend money and house prices can drop greatly. According to The Economist’s house price- indicators property in New Zealand (or should that be Auckland), Australia and Canada is overvalued. However could higher prices just reflect the level of income inequality that is clearly visible in most developed economies and conspicuous consumption. Thorstein Veblen wrote about this in his book The Theory of the Leisure Class (1899).
Very good video from Ray Dalio in which he believes that the three main forces that drive most economic activity are:
1) trend line productivity growth,
2) the long-term debt cycle and
3) the short-term debt cycle.
What follows is an explanation of all three of these forces and how, by overlaying the archetypical short-term debt cycle on top of the archetypical long-term debt cycle and overlaying them both on top of the productivity trend line, one can derive a good template for tracking most economic/market movements. While these three forces apply to all countries’ economies, in this study we will look at the U.S. economy over the last 100 years or so as an example to convey the Template.
In October Spanish authorities reported a 0.1% decrease in the general level of prices which has suggested a repeat of a Japanese style stagnation. With the ECB cutting rates to 0.25% earlier this month to avoid such an issue it could be too little too late. Also with rates as low as they are they are starting to run out of ammunition to stimulate the economy. With little support in the eurozone area for quantitative easing or fiscal stimulus one wonders how they avoid the slide in prices.
The US Fed has used three rounds of quantitative easing to avoid a deflationary environment and Fed Chairman Ben Bernanke alluded to this in 2002 when he said:
“Deflation is in almost all cases a side effect of a collapse of aggregate demand – a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending – namely, recession, rising unemployment, and financial stress,”
Speaking before the Global Financial Crisis Bernanke debated the idea of QE as a potential solution after the lowering of interest rates. But the biggest worry for low inflation countires in the eurozone is deflationary expectations as cosumers delay purchases which ultimate reduces demand.
To measure policy-related economic uncertainty, the Economic Policy Uncertainty construct an index from three types of underlying components.
1. The first component is an index of search results from 10 large newspapers. The newspapers included in our index are USA Today, the Miami Herald, the Chicago Tribune, the Washington Post, the Los Angeles Times, the Boston Globe, the San Francisco Chronicle, the Dallas Morning News, the New York Times, and the Wall Street Journal. From these papers, they construct a normalized index of the volume of news articles discussing economic policy uncertainty.
2. The second component of our index draws on reports by the Congressional Budget Office (CBO) that compile lists of temporary federal tax code provisions. They create annual dollar-weighted numbers of tax code provisions scheduled to expire over the next 10 years, giving a measure of the level of uncertainty regarding the path that the federal tax code will take in the future.
3. The third component of our policy-related uncertainty index draws on the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters. Here, they utilize the dispersion between individual forecasters’ predictions about future levels of the Consumer Price Index, Federal Expenditures, and State and Local Expenditures to construct indices of uncertainty about policy-related macroeconomic variables.
They find that current levels of economic policy uncertainty are at extremely elevated levels compared to recent history. Since 2008, economic policy uncertainty has averaged about twice the level of the previous 23 years. See animation from The Economist below.
America’s debt row makes economic policy more uncertain than amid actual war.
A hat tip to colleague David Parr for this great graphic. It shows which administrations have been America’s biggest borrowers from 1940-2012. What is interesting to note is the level of borrowing during recessions – grey columns. During the 1970′s there was very little borrowing as the policy of the day was to reduce the inflationary pressure and cut the money supply. Compare that with 2002 onwards and you will see an increase in debt to get out of the recessionary periods. Click the link below to go to the enlarged image.
New Zealand households have gone through a period of deleveraging since the GFC in 2007 in which borrowing against the house has dropped significantly. Consequently household savings has gone up. However the increase in household debt from 2000 to 2007 was rapid and is forecast to increase further especially with house price inflation on the rise. But this house inflation doesn’t correlate to the economic conditions of the country and RBNZ Governor can be justified in saying that house prices are over-valued. Graph below from the BNZ Economy Watch.
KAL, The Economist’s resident cartoonist and animator, explains the dangerous history of bubbles.
Some alarming figures have been banded about with regard to America’s infrastructure. It is estimated that over 700,000 bridges are rated as structurally deficient. In 2009 Americans lost approximately $78 billion to traffic delays – inefficient use of time and petrol costs. Also crashes which to a large extent have been caused by road conditions, cost a further $230 billion.
According to the American Society of Civil Engineers the US needs to spend $2.2 trillion bring their infrastructure up to standard. The Congressional Budget Office estimated in 2011 that for every dollar the federal government spent on infrastructure the multiplier effect was up to 2.5. Other indicators state that every $1 billion spent on infrastructure creates 18,000 jobs, almost 30% more than if the same amount were used to cut personal income taxes. – The Economist
Positive Externalities from infrastructure.
Investment in infrastructure has a lot of positive externalities – faster traveling time for consumers and companies, spending less time on maintenance. Research has shown that the completion of a road led to an increase in economic activity between 3 and 8 times bigger than it initial outlay with eight years after its completion. But what must be considered is that now is the best time to invest in infrastructure as it is very cheap – much cheaper than it will be when the economy is going through a boom period.
The race for countries to devalue their currency (make their exports more competitive) has led to massive increase in monetary stimulus into the global financial system. We are all aware of the three rounds of Quantitative Easing from the US Fed and the indication that they would keep the Fed Funds Rate at virtually zero until 2015. To add fuel to the ‘dim embers’, in 2013 the US is going to inject US$1 trillion into the circular floe. However in China they have also embarked on some serious stimulus:
* More infrastructure development – US$60bn
* Additional credit – US$14 trillion in extra credit since 2009 (equal to entire US banking system)
Nevertheless even with all this artificial stimulus there might be some short-term growth but I can’t see it being sustainable when you consider the extent of global deleveraging. Also IMF figures show that the world saving rates are on the increase (* forecast):
With increased saving rates accompanied by significant austerity measures in many parts of Europe where is the consumer demand going to come from? Unemployment in Spain is 26% and predicted to hit 30% this year- more worrying is 50% of those under 25 are unemployed. Spanish protesters chanted “We don’t owe, we won’t pay” in a march against austerity. So in the US we have massive fiscal stimulus but across the water in Europe it’s all about “tightening the belt” and cutting government spending. Neither seems to be working and are we just putting off a significant downturn for a later date?
Part of the Cambridge A2 syllabus studies Macro Economic conflicts of Policy Objectives. Here I am looking at GDP, Unemployment, and Inflation (improving Trade figures is another objective also). The objectives are:
* Stable low inflation with prices rising within the target range of 1% – 3% per year
* Sustainable growth – as measured by the rate of growth of real gross domestic product
* Low unemployment – the government wants to achieve full-employment
New Zealand Growth, Jobs and Prices — 3 Key Macro Objectives Inflation, jobs and growth
1. Inflation and unemployment:
From the graph above you can see that low levels of unemployment have created higher prices – demand-pull inflation. Also note that as unemployment has increased there is a short-term trade-off between unemployment and inflation. Notice the increase in inflation in 2010-2011 as this is when the rate of GST was increased from 12.5% to 15%. Also today we have falling inflation (0.8% below the 1-3% band set by the RBNZ) and unemployment in on the rise – 7.3%
2. Economic growth and inflation
With increasing growth levels prices started to increase in 2007 going above the 3% threshold in 2008. This suggests that there were capacity issues in the economy and the aggregate supply curve was becoming very inelastic. In subsequent years the level of growth has dropped and with it the inflation rate.
3. Economic Growth and Unemployment
Usually you find that with increasing levels of GDP growth unemployment figures tend to gravitate downward. This was apparent between 2006-2008 – GDP was positive and unemployment did fall to approximately 3.6%. However from 2009 onwards you can see that growth has been positive but unemployment has also started to rise.
Some figures for September show that the Chinese economy is tentatively starting to come out of its slowdown.
Exports rose to 9.9%
GDP for Q3 rose by 7.4%
CPI – 1.9%
The CPI figure is encouraging in that it gives the Peoples’ Bank of China plenty of room to ease monetary policy if they need to as the Inflation target rate is 4%. They have also pumped an additional US$42.15bn into the economy in order to stimulate growth. According to the National Australia Bank (NAB) the use of these measures appears to be the preferred method of monetary easing ahead of the start of the Communist Party Congress which starts on 8 November, where a new leadership team is set to be installed. The installation of the new leadership team could pave the way for a cut to the reserve requirement ratio and for fiscal stimulus. Many commentators envisage a soft landing for China.
Michael O’Sullivan wrote an interesting chapter in “Understanding Ireland’s Economic Crisis” about Ireland’s bubble. He talked about the anatomy of a bubble and went through various examples from history. There are 3 stages of the bubble which he describes:
Stage 1 – Favourable shock
The Favourable Shock – in many cases this a change in economic policy or a technological shift. Examples:
The Mississippi bubble – the creation of paper money
Railways booms in the US and UK during the 19th Century
Dot.com bubble – 1990’s
Foreign Direct Investment – Ireland 1990’s
The above events enhance expectations of future economic growth and earning potential. What helps turn the boom into a bubble is the ease of credit – expansionary monetary policy (low interest rates), relaxed lending conditions etc. This then leads to rising asset values which allows corporate and the household sector the ability to take on more debt (leverage). In Ireland real interest rates (Interest rate – CPI) was 0% in 1998-2001 and was approximately -4% in 2000.
Stage 2 – Speculative growth
The Speculative Stage is one where the ecstatic enthusiasm for risk chases high returns and investment becomes speculation. A quote from J.M.Keynes describes the change in mood:
As the bubble gains momentum some people come to believe there is a greater fool who would buy their inflated assets. With this aura of confidence and supporting arguments from the periphery – e.g. “the world has changed” or “this time it’s different” – a mood of speculative optimism becomes rampant. An example of this positive rhetoric was from former Irish Taoiseach (Prime Minister) Bertie Ahern. He stated that those warning of the property bubble should “commit suicide”.
Stage 3 – Irrational Exuberance
Irrational Exuberance starts to dominate the “herd” and often this stage sees the sharpest and most bewildering rise in asset prices. However, there comes a time when this sort of frenzied activity cannot be maintained and eventually the bubble bursts. Most bubbles end with a tightening of monetary policy – higher interest rates – credit controls – limited borrowing potential. For Ireland, as was the case with other economies, the global financial crisis was the “lighting of the fuse”
The Irish Credit Bubble
Morgan Kelly wrote a paper on this and below is a chart from the book “Understanding Ireland’s Economic Crisis” which shows how bank lending assisted the bubble. In 1997 Irish bank lending to the non-financial private sector was only 60% of GNP compared with 80% in most eurozone economies and the UK. By 2008 bank lending grew to 200% of national income. Irish banks were lending 40% more in real terms to property developers alone in 2008 than they had been lending to everyone in Ireland in 2000, and 75% more as mortgages.
It is important that you are aware of current issues to do with the New Zealand and the World Economy. Examiners always like students to relate current issues to the economic theory as it gives a good impression of being well read in the subject. Only use these indicators if it is applicable to the question.
Indicators that you might want to mention are as follows:
The New Zealand Economy
The New Zealand economy expanded by 0.6 percent in the June 2012 quarter, while economic growth in the March quarter was revised down slightly to one percent. Favourable weather conditions leading to an increase in milk production was a significant driver of economic growth over the June quarter. The current account deficit rose to $10,087 million in the year ended June 2012, equivalent to 4.9 percent of GDP. Higher profits by foreign-owned New Zealand-operated banks and higher international fuel prices were factors behind the increase in the deficit during the year. Unemployment is currently at 6.8% but is expected to fall below 6% with the predicted increase in GDP. Annual inflation is approaching its trough. It is of the opinion that it will head towards the top end of the Reserve Bank’s target band (3%) by late next year.
The Global Economy
After the Global Financial Crisis (GFC) the debt-burdened economies are still struggling to reduce household debt to pre-crisis levels and monetary and fiscal policies have failed to overcome “liquidity traps”. Rising budget deficits and government debt levels have become more unsustainable. The US have employed the third round of quantitative easing and are buying US$40bn of mortgage backed securities each month as well as indicating that interest rates will remain at near zero levels until 2015. Meanwhile in the eurozone governments have implemented policies of austerity and are taking money out of the circular flow. However in the emerging economies there has been increasing inflation arising from capacity constraints as well as excess credit creation. Overall the deleveraging process can take years as the excesses of the previous credit booms are unwound. The price to be paid is a period of sub-trend economic growth which in Japan’s case ends up in lost decades of growth and diminished productive potential. The main economies are essentially pursuing their own policies especially as the election cycle demands a more domestic focus for government policy – voter concerns are low incomes and rising unemployment. Next month see the US elections and the changing of the guard in China. In early 2013 there is elections in Germany. The International Monetary Fund released their World Economic Outlook in which they downgraded their formal growth outlook. They also described the risk of a global recession as “alarmingly high”.
Nobel Laureate Joseph Stiglitz came out strongly against the recent QE3 by the US Fed and the ECB’s announcement that it would buy government bonds of indebted eurozone member countries. With this announcement stock prices in the US reached post-recession highs although some worried about future inflation and significant government spending. According to Stiglitz these concerns are unwarranted as there is so much underutilisation and no serious risk of inflation. But the US Fed and the ECB sent three clear messages:
1. Previous actions didn’t work – ie QE1 and 2
2. The US Fed announcement that it will keep rates low until 2015 and buy $40bn worth of mortgage backed securities suggested the recovery is not going to take place soon.
3. The Fed and the ECB are saying that the markets won’t restore full employment soon – fiscal stimulus is needed.
In textbook economics increased liquidity means more lending, mostly to investors thereby shifting the AD curve to the right and thereby increasing demand and employment. But if you consider Spain an increase in liquidity will be cancelled out by an austerity package.
For both Europe and America, the danger now is that politicians and markets believe that monetary policy can revive the economy. Unfortunately, its main impact at this point is to distract attention from measures that would truly stimulate growth, including an expansionary fiscal policy and financial-sector reforms that boost lending. Joseph Stiglitz
Here is a cool graphic from the WSJ that looks at the impact of the US Fed’s monetary policy of dumping trillions of dollars into the economy in order to stimulate economic activity – it covers the period from September 2008 through to today. The graphic shows the impact on the following:
* 10 year treasury yields
* DJIA – Dow Jones Industrial Average
* WSJ US dollar index
Click WSJ Interactive Graphic to go to the page.
You will no doubt have seen the Keynes v Hayek Rap which was produced by econ stories. Now the debate turns to the Chinese economy – which of these economist’s policies is more prevalent? The Economist Free exchange column addressed this issue recently.
In order to maintain the level of economic activity in an economy Keynes believed in investment spending to maintain aggregate demand and employment. However, Hayek believed that investment spending might be directed in the wrong areas and would leave the economy poorly coordinated and workers stranded in the wrong jobs. Economist Andrew Batson has argued that Hayek seems to be gaining the upper hand in the battle of ideas as China is now keen to avoid the Hayek malinvestment even if there is less aggregate demand and growth which Keynes favoured. As mentioned in previous posts there has been huge investment in China in areas that normally stimulate growth in downturns – eg. creation of new cities or infrastructure projects.
There are others that say the Chinese economy has areas of its infrastructure that need to be developed. Cities like Beijing and Shenzen are congested and need investment spending on them. Although Hayek believed that malinvestment would result in a worse downturn what is different in China is that their high investment is backed by even higher savings. This means that investment projects don’t need to generate high returns in order pay back external creditors. According to The Economist the real cost of malinvestment is with the empty shopping malls, vacant apartments etc when there are poor medical facilities and overcrowding in housing. Might a more market approach be a better driver of the economy rather than that of central planning?
With continued global weakness the RBA is becoming increasingly worried about the prospects for the Australian economy. According to the National Bank of Australia there are 3 factors that the RBA are concerned with:
1. Although house prices are stabilising there are some sectors of the economy that remain in a depressed state – residential construction has a record low capacity utilisation (see graph).
2. A tightening of state and federal fiscal policy has meant that there is less aggregate demand in the economy.
3. The high value of the AUS$ affects the competitiveness of exports. However business now see the high AUS$ as permanent rather than cyclical. This is important as the RBA is not expecting lower rates to significantly lower the AUS$ but rather is trying to offset some of the economic damage to the economy.
It could be that a rate cut by the RBA is an insurance policy in an environment where inflation appears stable. The graph below looks at the RBA Cash Rate and the Taylor Rule.
The Taylor Rule
This is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. Taylor argued that when:
Real Gross Domestic Product (GDP) = Potential Gross Domestic Product and
Inflation = its target rate of 2%,
then the Federal Funds Rate (FFR) should be 4% (that is a 2% real interest rate).
If the real GDP rises 1% above potential GDP, then the FFR should be raised by 0.5%.
If inflation rises 1% above its target rate of 2%, then the FFR should be raised by 0.5%.
This rule has been suggested as one that could be adopted by other central banks – ECB, Bank of England, etc for setting official cash rates. However, the rule does embody an arbitrary 2% inflation target rather than, say 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such as explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help shape business people’s and consumers’ expectations. Central banks prefer to maintain an air of intelligent discretion over the conduct of their policies than to follow rules, but to some extent they do unwittingly follow a Taylor rule. This makes the rule a useful benchmark against which actual policies can be judged.
The Chinese authorities have cut interest rates for the time since the Global Financial Crisis (GFC). One year lending and deposit rates were cut by 0.25%.
Lending rate – 6.31%
Deposit rate – 3.25%
Although this should encourage spending with an increase in the money velocity in the circular flow some commentators are concerned that the Chinese authorities know something about their economy that the rest of world is in the dark about.
It is interesting to see the reaction of main central banks in the aftermath of the GFC and how aggressive they were in cutting rates – US, EU, UK – relative to the other countries on the graph, namely China, India and Australia. Furthermore notice that some economies seem to have been at a different part of the economic cycle namely Australia, India, and the EU as their central bank rates have risen in order to slow the economy down. This is especially in India as they have had strong contractionary measures in place but have now started to ease off on the cost of borrowing.
Indian growth has slowed to 5.3% this year and although this seems very healthy it is the lowest level in 7 years. A developing nation like this needs higher levels of growth to create the jobs for their vast working age population and without employment there could be a situation not unliike that of Spain where over 50% of those under 25 don’t have a job. The main cause of the slowdown seems to be from a lack of private investment.
Also look how low rates are in the US, UK, and EU. With little growth in these economies the policy instrument of lower interest rates has been ineffective and they are in a liquidity trap. Increases or decreases in the supply of money do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.