A level Economics: Russian central bank raises interest rates by 3.5 percentage points

 

What an amusement park can teach us about central banks

Tim Harford in The FT

To Tivoli Gardens in the heart of Copenhagen, one of the world’s oldest amusement parks. It was founded 180 years ago, and its creator George Carstensen secured the land by petitioning King Christian VIII, arguing, “When the people are amusing themselves, they do not think about politics.” 

In Tivoli, I don’t think about politics either. But during the wait to ride the Demon and the Star Flyer, I can’t help but think about economics. Specifically, I think about Robert Lucas’s charming speech, “What Economists Do”. It was delivered as a commencement address in 1988, seven years before the hugely influential macroeconomist was awarded the Nobel memorial prize. 

I revisited the speech when news reached me of Robert Lucas’s recent death at the age of 85. “We are basically storytellers,” wrote Lucas, “creators of make-believe economic systems.” 

To illustrate his point, he told a story about a depression in an amusement park. In Lucas’s imaginary park, people buy a wad of tickets at the entry kiosk and spend them on anything from rollercoaster rides to hotdogs. Each attraction is run as an independent business, while the ticket desk serves as a central bank. 

On a slow day, the ride owners will send their workers home. Both employment (hours worked) and the number of tickets bought (call that GDP if you wish) will vary depending on school holidays, the weather and chance. 

Should we call a slow Monday in March a depression? No, said Lucas. “By an economic depression, we mean something that ought not to happen, something pathological.” 

So then imagine that the central bank — sorry, the ticket kiosk — decides to crack down on fun by squeezing the money supply. Instead of issuing 100 tickets for DKr100, the kiosk charges DKr100 for 80 tickets. Importantly, it doesn’t tell the businesses in the park that it has decided to make this change. Without their consent or knowledge, it has effectively raised all their prices. What happens? 

Some customers grit their teeth and spend a bit more to ensure they get all the tickets they would have expected anyway. Others buy fewer tickets. Some walk away without buying any. 

Inside the park, tumbleweed. There are fewer customers, and they bring sandwiches rather than buying hotdogs. They spend less on the rides and take more time to enjoy freebies such as walking around the lake. Operators who had been planning to expand in the face of long queues will now not be so sure. Other operators who had worried that their ride was going out of style see gloomy confirmation and may close permanently to cut their losses. The amusement park as a whole will lose its mojo, with physical capacity, output and employment shrinking to match a misunderstood fall in demand. 

As Lucas explained, this slump “is indeed a kind of pathology. Customers are arriving, eager to spend . . . Concessionaires are ready and waiting to service them.” All the pieces are in place, but they don’t fit together because of a monetary policy mistake. 

Eventually, the park should recover its equilibrium. The ride owners can ask for fewer tickets per ride; the customers will come to realise that 80 tickets will buy as much as 100 tickets did before the price change. The amusement park will be lively again. But all this will take time, and permanent harm may have been done. 

Flip the story around: what if the central bank — sorry, the ticket kiosk — gets excited and hands out too many tickets instead? In effect, the kiosk has slashed all the prices without telling the concession-holders. Expecting bargains, people cram into the park. The hotdog stand runs out of hotdogs; the mustard and ketchup run dry. Park-goers spend most of their time queueing rather than rollercoasting. The businesses inside may call up extra staff, even borrow money to expand. Yet eventually they will realise the double-handfuls of tickets they’ve taken in aren’t worth as much as they expected. 

These stories tell us how a central bank might engineer a recession — or cause shortages and inflation. I find them a delightful window into how economies work. 

True, there are other types of recession. In my book The Undercover Economist Strikes Back, I told a true story about a recession in a prisoner-of-war camp in the 1940s, as described by one of the POWs, the economist R­­­­­­­­­­­­­­­A Radford. 

The camp, like the amusement park, had a simple economy. It was fuelled by the supply of packages from the Red Cross, the contents of which were then traded: the Sikh prisoners didn’t want razor blades or beef, the French were desperate for coffee, the English craved tea. 

The prison-camp recession occurred, not because the money supply was constricted, but because the Red Cross parcels stopped arriving — what an economist might call an “exogenous shock”. (For a real-world example, imagine a war interrupting the supply of oil, natural gas and food. It shouldn’t be too much of a stretch to do that.) 

These little stories teach us that sometimes an economy can be dragged down by a simple mistake in monetary policy, while sometimes a recession occurs because the economy has hit an implacable obstacle. One job of a good central bank is to make sure that it perceives the difference, something central bankers are puzzling over right now. 

The disadvantage with such stories, admitted Lucas, “is that we are not really interested in understanding and preventing depressions in hypothetical amusement parks . . . the analogy that one person finds persuasive, his neighbour may well find ridiculous.” 

So then what to do? “Keep trying to tell better and better stories . . . it is fun and interesting and, really, there is no practical alternative.”

Governments can borrow more than was once believed

 From The Economist

 

If people know one thing about the thinking of John Maynard Keynes, who more or less founded macroeconomics, it is that he was in favour of governments borrowing lots of money, at least under some circumstances. The “New Keynesian” orthodoxy that evolved from his work in the second half of the 20th century was much less liberal in this regard. It put less faith in borrowing’s purported benefits, and had greater concerns about its dangers.

The 2010s saw the pendulum swinging back. In large part because they feel bereft of other options, many governments have borrowed heavily—and as yet they have paid no dreadful price. Can this go on?

Keynes’s ideas about borrowing reflected his view of recessions—and in particular, the Depression of the 1930s, during which he wrote “The General Theory of Employment, Interest and Money”—as vicious circles. Recessions come about when the economy is hit by a sudden rise in the desire to save money; such desires lead to lower spending, which leads to more unemployment, which leads to yet less spending, and so on. If the government borrows enough to offset lower private spending with increased spending of its own the circle can be broken—or stopped from getting going.

Most early Keynesians assumed that the deficits caused by borrowing to stimulate the economy would be temporary; after borrowing more than they raised in taxes in order to provide a fiscal stimulus, governments would be able to raise more in taxes, and thus pay off their debts, in the good times that followed. Some, though, suspected that the structure of the advanced economies of the 1930s might mean they were low on demand even in the good times, and that a permanent deficit might be necessary to keep the economy going at a rate that minimised unemployment.

Debates about the proper role of fiscal stimulus became less urgent in the decades after the second world war, as robust economic growth eased worries that demobilisation might bring a return of Depression-like conditions. Faith in Keynesian orthodoxy was further shaken by the economic developments of the 1970s and 1980s. Some economists began to argue that the public would eventually adjust to stimulus measures in ways that weakened their impact. Robert Barro, a leading proponent of this “rational expectations” approach, argued that a fiscal stimulus paid for by borrowing would see households spend less and save more, because they would know that tax rises were coming. This decreased private spending would then offset the increased public spending.

Linked to, but broader than, such academic questions was the fact that, by the 1970s, the ways in which Keynesian governments had been running their economies seemed to have failed. A trifecta of slowing growth, soaring inflation and high unemployment brought the idea of governments being able to avoid recessions through stimulus into disrepute.

The new orthodoxy was that governments should instead rely on monetary policy. When the economy slowed, monetary policy would loosen, making it cheaper to borrow, thus encouraging people to spend. Government borrowing, for its part, should be kept on a short leash. If governments pushed up their debt-to-gdp ratio, markets would become unwilling to lend to them, forcing up interest rates willy-nilly. The usefulness of monetary policy demanded a sober approach to fiscal policy.

The 2000s, however, saw a problem with this approach beginning to become plain. From the 1980s, interest rates had been in a long, steady decline. By the 2000s they had reached historical lows. Low rates made it harder for central banks to stimulate economies by cutting them further: there was not room to do so. The global financial crisis pushed rates around the world to near zero.

Governments experimented with more radical monetary policy, such as the form of money printing known as “quantitative easing”. Their economies continued to underperform. There seemed to be room for new thinking, and a revamped Keynesianism sought to provide it. In 2012 Larry Summers, a former American treasury secretary, and Brad DeLong, an economist, suggested a large Keynesian stimulus based on borrowing. Thanks to low interest rates, the gains it would provide by boosting the growth rate of gdp might outstrip the cost of financing the debt taken on.

In the following year Mr Summers followed some 1930s Keynesians, notably Alvin Hansen, in suggesting that borrowing in order to stimulate might be needed not just as an occasional pick-me-up, but as a permanent part of the economy. Hansen had argued that an ageing population and a low rate of technological innovation produced a long-term lack of demand which he called “secular stagnation”. Mr Summers took an updated but similar view. Part of his backing for this idea was that the long-term decline of interest rates showed a persistent lack of demand.

Way down we go

Sceptics insisted that such borrowing would drive interest rates up. But as the years went by and interest rates remained stubbornly low, the notion of borrowing for fiscal stimulus started to seem more tenable, even attractive. Very low interest rates mean that economies can grow faster than debt repayments do. Negative interest rates, which have been seen in some countries over recent years, mean that the amount to repay will actually be less than the amount borrowed.

Adherents of “Modern Monetary Theory” (mmt) went further than this, arguing that governments should borrow as much as was needed to achieve full employment while central banks focused simply on keeping interest rates low—a course of action which orthodox economics would expect to promptly drive up inflation. Currently mmt remains on the fringes of academic economics. But it has been embraced by some left-wing politicians; Senator Bernie Sanders, the candidate beaten by Joe Biden for the Democratic nomination, counted an mmt enthusiast, Stephanie Kelton of Stony Brook University, among his chief advisers.

The shift in mainstream thinking on debt helps explain why the huge amounts of government borrowing with which the world has responded to the pandemic has not worried economists. But now that governments have, if only for want of an alternative, become more willing to take on debt, what should be their limit? For an empirical answer, it is tempting to consider Japan, where the ratio of net public debt to gdp stood at 154% prior to the pandemic.

If Japan can continue to borrow with that level of debt, it might seem that countries with lower levels should also be fine. But this ignores the fact that if interest rates stagger back from the floor, burdens a lot smaller than Japan’s might become perilously unstable. There is no immediate account for why this might be likely. But that does not mean it will not happen. And governments need to remember that debt taken on at one interest rate may, if market sentiment changes, need to be rolled over at a much higher one in times to come.

Given this background risk, governments ideally ought to make sure that new borrowing is doing things that will provide a lasting good, greater than the final cost of the borrowing. If money is very cheap and likely to remain so, this will look like a fairly low bar. But there are opportunity costs to consider. If private borrowing has a high return and public borrowing crowds it out, then the public borrowing either needs to show a similarly high return or it needs to be cut back.

At the moment private returns remain well above the cost of new borrowing in most places: in America, for instance, the earnings of corporations are generally high relative to the replacement cost of their capital. This makes it conceivable that resources used by the government would generate a greater level of welfare if they were instead mobilised by private firms.

But it does not currently look as though they would be. Despite the seemingly high returns to new capital, private investment in America is quite low. This suggests either that there are other obstacles to new investment, or that the high returns on investment reflect an insufficient level of competition rather than highly productive companies.

Both possibilities call for government remedy: either action aimed at identifying and dismantling the obstacles to investment, or at increasing competition. And until such actions produce greater investment or lower returns, the case for government borrowing remains quite strong. This is even more the case for public investments which might in themselves encourage the private sector to match them—“crowding in”, as opposed to crowding out. Investment in a much better electricity grid, for example, could increase investment in zero-carbon generation.

In the long run, the way to avoid having to borrow to the hilt is to implement structural changes which will revive what does seem to be chronically weak demand. Unfortunately, there is no consensus over why demand is weak. Is technological progress, outside the realm of computers and communications, not what it was? Is inequality putting money into the hands of the rich, who are less likely to spend their next dollar, rather than the poor, who are more likely? Are volatile financial markets encouraging precautionary saving both by firms and governments? Is the ageing of the population at the root of it all?

Making people younger is not a viable policy option. But the volatility of markets might be addressed by regulation, and a lack of competition by antitrust actions. If inequality is at the root, redistribution (or its jargony cousin, predistribution) could perk up demand. Dealing with the structural problems constraining demand would probably push up interest rates, creating difficulties for those governments which have already accumulated large debt piles. But stronger underlying growth would subsequently reduce the need for further government borrowing, raise gdp and boost tax revenues. In principle that would make it easier for governments in such situations to pay down their increased debt.

The new consensus that government borrowing and spending is indeed an important part of stabilising an economy, and that interest rates are generally low enough to allow governments to manage this task at minimal cost, represents progress. Government borrowing is badly needed to deal with many of the world’s current woes. But this consensus should ideally include two additional planks: that the quality of deficit-spending still matters, and that governments should prepare for the possibility of an eventual change in the global interest-rate environment—much as 2020 has shown that you should prepare for any low-probability disaster. 

A political backlash against monetary policy is looming

Martin Sandbu in The FT

Three weeks ago, Sanna Marin, Finland’s prime minister, retweeted a link to an article by a Finnish academic together with the following quote: “There is something seriously wrong with the prevailing ideas of monetary policy when central banks protect their credibility by driving economies into recession.” 

Defenders of those prevailing ideas predictably pushed back, warning against second-guessing independent central banks or not valuing their credibility. But defensiveness is the wrong response. Not just because Marin didn’t actually criticise any central bank actions. But, more profoundly, because avoiding a debate over whether our macroeconomic regime is fit for purpose is more perilous than having one. 

Comparisons with the 1970s often fail to notice one important lesson of that decade: a macroeconomic regime that cannot justify itself will be toppled, first intellectually, then politically. It was from the ashes of 1970s monetary chaos that theories were born justifying independent central banks with a mandate to keep inflation low. Before the century was out, independent inflation-targeting was de rigueur in most advanced economies. 

Forty years on, a new intellectual and political reckoning would be less surprising than the absence of one. The “great moderation” produced by the 1980s monetary revolution has in many countries long been accompanied by stagnant wages for the low paid. The glacial recovery from the global financial crisis prompted the world’s two biggest central banks to revise their policy framework during the pandemic. In 2020 and 2021, the Federal Reserve and the European Central Bank vowed to tolerate a period of higher inflation if employment had further to rise or there would be little room to loosen policy in case of a downturn. But this new attitude fell at the first hurdle. 

With cost of living crises biting and recessions looming in key advanced economies, what are the odds of avoiding a more profound reckoning for much longer? Marin is not the only national leader expressing unease about central banks. French president Emmanuel Macron recently worried aloud about “experts and European monetary policymakers telling us we must crush European demand to contain inflation better”. 

Precisely because central bankers are independent, it falls to political leaders to tell their citizens why it is right to meet Russian energy blackmail with actions to clamp down further on incomes and jobs. They would be remiss if they did not question whether this is the best we can do. 

In comparison, central bankers have it easy. They have legally imposed inflation-fighting mandates, which are not for them to question. And they have an argument: that losing their “credibility” — by which they mean people no longer believe they can keep inflation low — will cost even more jobs and lost income. 

But the credibility of central banks itself is only as good as the credibility of the macroeconomic regime as a whole. That is not to say central bank independence should be jettisoned, but to ask openly whether it actually works for the economy. 

In pursuit of individual mandates central banks may be collectively overtightening, as Maurice Obstfeld has suggested. Or monetary policy uncoordinated with fiscal policy may be making matters worse, as Marin hinted in follow-up comments. 

The IMF has warned governments against budgeting “at cross-purposes” with monetary tightening. But raising interest rates puts monetary policy at cross-purposes with fiscal policy priorities such as investing in the green transition or, indeed, in energy infrastructure that would itself remedy energy-induced inflation. Even if monetary considerations should take priority, such monetary dominance is undoubtedly something to be democratically debated, not technocratically imposed. 

It may even be that central bankers are not independent enough but cave in to the political pressure arising from each new monthly record in current inflation, rather than coolly focusing on their benign medium-term forecasts. 

Like in the 1980s, in time bright economists will suggest better ways of designing monetary policy against energy price shocks. And unless we have a lucky escape from a sharp downturn this winter, a political backlash is surely coming too. The alternative to openly debating these issues in a democratic space is to let that backlash fester until it breaks out in the more radical and dangerous form of a populist assault on institutions. Central banks’ credibility would not be worth much then.

The US’s selfish war on inflation will tip the world into recession

Phillip Inman in The Guardian


As the Fed raises interest rates, dollar-denominated loans become an unsustainable burden to states around the globe

The Federal Reserve is planning a second interest rate rise in a year this month. Photograph: Chris Wattie/Reuters 


Later in July US interest rates are expected to jump for a second time this year, and that’s going to wreck any chance of a global recovery.

The Federal Reserve could push its base rate up by as much as a full percentage point, ending 15 years of ultra-cheap money, intended to promote growth.

This jump, to a range of 2.5%-2.75%, would take the cost of borrowing money in the US to more than double the Bank of England’s 1.25%. And yet the Fed could just be taking a breather as it contemplates even higher rates.

This column, though, is not about the US. It is concerned with the terrible impact on Britain and countries across the world of America’s selfish disregard when it decides to tackle high inflation with higher borrowing costs. Britain is already feeling the effects of the Fed’s pledge to tackle inflation until it is “defeated”, come what may.

Higher interest rates in the US make it a more attractive place for investors to store their money. To take full advantage, investors must sell their own currency and buy dollars, sending the price of dollars rocketing higher.

In July the US dollar increased in value against a basket of six major currencies to a 20-year high. The euro has slipped below parity with the dollar in the last few days. The pound, which has plunged by more than 10% this year to below $1.20, is losing value with every week that passes.

In Japan, the central bank has come under huge pressure to act after the yen tumbled to its lowest level against the dollar since 1998.

There are two important knock-on effects for those of us that live and work outside the US.

The first is that goods and raw material priced in dollars are much more expensive. And most commodities are priced in dollars, including oil.

Borrowing in dollars also becomes more expensive. And while getting a loan from a US bank is beyond the average British household, companies do it all the time, and especially those in emerging economies, where funds in their backyard can be in short supply.

The Bank of England interest-rate setter Catherine Mann recently said that her main motivation for wanting significant increases in the UK’s lending rates was her fear that the widening gap with the dollar was pushing up import prices. And higher import prices meant higher inflation.

If only she could persuade her colleagues on the Bank’s monetary policy committee that the devaluation of the pound was a serious issue, maybe they would push up the Bank’s base rate in line with the Fed rate increases. After the Fed makes its move, more may join her.

Until January this year, Britain’s inflation surge was on course to be short-lived. Now it seems the Russian invasion of Ukraine and a splurge of untargeted handouts by the Biden administration during the pandemic, which have served to push up prices in America, will keep inflation in the UK high into next year. 

Those governments that have borrowed in dollars face a double whammy. Not only will they need to raise domestic interest rates to limit the impact of import price rises, they will also face a massive jump in interest payments on their dollar borrowings.

Emerging markets and many developing-world countries will be broke when these extra costs are combined with a loss of tourism from the Covid pandemic. Sri Lanka has already gone bust and many more could follow.

For the past three decades, western banks have marketed low-cost loans across the developing world as a route to financial freedom.

Zambia’s government borrowed heavily before the pandemic to become self-sufficient in electricity. It is a laudable aim, but has left the central African state with a ratio of debt to national income (GDP) much the same as France’s – about 110%.

The problem for Zambia is not the same as for France, which pays an interest rate of 1.8% to finance its debts, measured by the yield on its 10-year bonds. The Zambian 10-year bond commands a rate of 27%. Now Zambia, like France and so many other countries, must borrow simply to live. To invest is to borrow more.

There is no sign that the US will change course. Joe Biden is in a panic about the midterm elections, when fears of spiralling inflation could favour the Republicans. This panic has spilled over to the Fed, which has adopted hysterical language to persuade consumers and businesses that higher rates are coming down the track and to curb their spending accordingly.

The Fed knows inflation is a problem born of insufficient supply that only governments can tackle. But that doesn’t look like stopping it from pushing the US economy, and everyone else’s, into recession.

Stagflationary global debt crisis looms – and things will get much worse

 


The global financial and economic outlook for the year ahead has soured rapidly in recent months, with policymakers, investors and households now asking how much they should revise their expectations, and for how long. That depends on the answers to six questions.

First, will the rise in inflation in most advanced economies be temporary or more persistent? This debate has raged for the past year but now it is largely settled: “Team Persistent” won, and “Team Transitory” – which previously included most central banks and fiscal authorities – must admit to having been mistaken.

The second question is whether the increase in inflation was driven more by excessive aggregate demand (loose monetary, credit, and fiscal policies) or by stagflationary negative aggregate supply shocks (including the initial Covid-19 lockdowns, supply-chain bottlenecks, a reduced US labour supply, the impact of Russia’s war in Ukraine on commodity prices, and China’s “zero-Covid” policy). While demand and supply factors were in the mix, it is now widely recognised that supply factors have played an increasingly decisive role. This matters because supply-driven inflation is stagflationary and thus raises the risk of a hard landing (increased unemployment and potentially a recession) when monetary policy is tightened. That leads directly to the third question: will monetary-policy tightening by the US Federal Reserve and other major central banks bring a hard or soft landing? Until recently, most central banks and most of Wall Street occupied “Team Soft Landing”. But the consensus has rapidly shifted, with even the Fed Chair, Jerome Powell, recognising that a recession is possible, and that a soft landing will be “very challenging”.

Moreover, a model used by the Federal Reserve Bank of New York shows a high probability of a hard landing, and the Bank of England has expressed similar views. Several prominent Wall Street institutions have now decided that a recession is their baseline scenario (the most likely outcome if all other variables are held constant). In the US and Europe, forward-looking indicators of economic activity and business and consumer confidence are heading sharply south.

The fourth question is whether a hard landing would weaken central banks’ hawkish resolve on inflation. If they stop their policy-tightening once a hard landing becomes likely, we can expect a persistent rise in inflation and either economic overheating (above-target inflation and above potential growth) or stagflation (above-target inflation and a recession), depending on whether demand shocks or supply shocks are dominant.

Most market analysts seem to think that central banks will remain hawkish but I am not so sure. I have argued that they will eventually wimp out and accept higher inflation – followed by stagflation – once a hard landing becomes imminent because they will be worried about the damage of a recession and a debt trap, owing to an excessive buildup of private and public liabilities after years of low interest rates.

Now that a hard landing is becoming a baseline for more analysts, a new (fifth) question is emerging: Will the coming recession be mild and short-lived, or will it be more severe and characterised by deep financial distress? Most of those who have come late and grudgingly to the hard-landing baseline still contend that any recession will be shallow and brief. They argue that today’s financial imbalances are not as severe as those in the run-up to the 2008 global financial crisis, and that the risk of a recession with a severe debt and financial crisis is therefore low. But this view is dangerously naive.

There is ample reason to believe that the next recession will be marked by a severe stagflationary debt crisis. As a share of global GDP, private and public debt levels are much higher today than in the past, having risen from 200% in 1999 to 350% today (with a particularly sharp increase since the start of the pandemic). Under these conditions, rapid normalisation of monetary policy and rising interest rates will drive highly leveraged zombie households, companies, financial institutions, and governments into bankruptcy and default.

The next crisis will not be like its predecessors. In the 1970s, we had stagflation but no massive debt crises because debt levels were low. After 2008, we had a debt crisis followed by low inflation or deflation because the credit crunch had generated a negative demand shock. Today, we face supply shocks in a context of much higher debt levels, implying that we are heading for a combination of 1970s-style stagflation and 2008-style debt crises – that is, a stagflationary debt crisis.

When confronting stagflationary shocks, a central bank must tighten its policy stance even as the economy heads toward a recession. The situation today is thus fundamentally different from the global financial crisis or the early months of the pandemic, when central banks could ease monetary policy aggressively in response to falling aggregate demand and deflationary pressure. The space for fiscal expansion will also be more limited this time. Most of the fiscal ammunition has been used, and public debts are becoming unsustainable.
 
Moreover, because today’s higher inflation is a global phenomenon, most central banks are tightening at the same time, thereby increasing the probability of a synchronised global recession. This tightening is already having an effect: bubbles are deflating everywhere – including in public and private equity, real estate, housing, meme stocks, crypto, Spacs (special purpose acquisition companies), bonds, and credit instruments. Real and financial wealth is falling, and debts and debt-servicing ratios are rising.

That brings us to the final question: will equity markets rebound from the current bear market (a decline of at least 20% from the last peak), or will they plunge even lower? Most likely, they will plunge lower. After all, in typical plain-vanilla recessions, US and global equities tend to fall by about 35%. But because the next recession will be stagflationary and accompanied by a financial crisis, the crash in equity markets could be closer to 50%.

Regardless of whether the recession is mild or severe, history suggests that the equity market has much more room to fall before it bottoms out. In the current context, any rebound – such as the one in the last two weeks – should be regarded as a dead-cat bounce, rather than the usual buy-the-dip opportunity. Though the current global situation confronts us with many questions, there is no real riddle to solve. Things will get much worse before they get better.

There is ample reason to fear big economies such as the US face recession and financial turmoil writes Nouriel Roubini in The Guardian

The Fed Chair must acknowledge that free money has made asset prices unsustainably high

Gillian Tett in The FT 

This week financiers’ eyes have been firmly fixed on the Federal Reserve. No wonder. On Wednesday the US central bank raised rates at the most aggressive pace for 22 years, as Jay Powell, Fed chair, finally acknowledged the obvious: inflation is “much too high”. 

But as investors parse Powell’s words, they should spare a thought for a central bank on the other side of the world: the Reserve Bank of New Zealand. 

In recent years, this tiddler has often been an unlikely harbinger of bigger global trends. In the late 20th century, for instance, the RBNZ pioneered inflation targeting. More recently, it embraced climate reporting ahead of most peers. 

Last year, it started tightening policy before most counterparts. And this week it went further: its latest financial stability report warns of a “plausible” chance of a “disorderly” decline in house prices, as the era of free money ends. 

Unsurprisingly, the RBNZ also said it hopes to avoid a destabilising crash. But the key point is this: the Kiwi central bankers know they have an asset bubble on their hands, since property prices have jumped 45 per cent higher in the last two years and “are still estimated to be above sustainable levels”. This reflects both ultra-low rates and dismally bad domestic housing policies. 

And it is now telling the public and politicians that this bubble needs to deflate, hopefully smoothly. There is no longer a Kiwi “put” — or a central bank safety net to avoid price falls. 

If only the Fed would be as honest and direct. On Wednesday Powell tried to engage in some plain speaking, by telling the American people that inflation was creating “significant hardship” and that rates would need to rise “expeditiously” to crush this. He also declared “tremendous admiration” for his predecessor Paul Volcker, who hiked rates to tackle inflation five decades ago, even at the cost of a recession. 

However, what Powell did not do was discuss asset prices — let alone admit that these have recently been so inflated by cheap money that they are likely to fall as policy shifts. 

A central bank purist might argue that this omission simply reflects the nature of Powell’s mandate, which is to “promote maximum employment and stable prices for the American people”, as he said on Wednesday. In any case, evidence about the short-term risk of asset price falls is mixed. 

Yes, the S&P 500 has dipped into correction territory twice this year, with notable declines in tech stocks. However, the American stock indices actually rallied 3 per cent on Wednesday, after Powell struck a more dovish tone than expected by ruling out a 75 basis point rise at the next meeting. 

And there is no sign of any fall in American property prices right now. On the contrary, the Case-Shiller index of home prices is 34 per cent higher than it was two years ago, according to the most recent (February) data. 

However, it beggars belief that Powell could crush consumer price inflation while leaving asset prices intact. After all, one key factor that has raised these prices to elevated levels is that the Federal Reserve’s $9tn balance sheet almost doubled during the COVID-19 pandemic (and has expanded it nine-fold since 2008.) 

And, arguably, the most significant aspect of the Fed’s decision on Wednesday is not that 50bp rise in rates, but the fact that it pledged to start trimming its holdings of mortgages and treasuries by $47.5bn each month, starting in June — and accelerate this to a $90bn monthly reduction from September. 

According to calculations by Bank of America, this implies a $3tn balance sheet shrinkage (quantitative tightening, in other words) over the next three years. And it is highly unlikely that the impact of this is priced in. 

After all, QT on this scale has never occurred before, which means that neither Fed officials nor market analysts really know what to expect in advance. Or as Matt King, an analyst at Citibank, observes: “The reality is that tightening hasn’t really started yet.” 

Of course, some economists might argue that there is no point in the Fed spelling out this risk to asset prices now, given how this might hurt confidence. That would not make Powell popular with a White House that is facing a difficult election, Nor would it help him achieve his stated goal of a “soft” (or “softish”) economic landing, given that consumer sentiment has wobbled in recent months. 

But the reason why plain speaking is needed is that a dozen years of ultra-loose policy has left many investors (and households) addicted to free money, and acting as if this is permanent. Moreover, since the Fed has repeatedly rescued investors from a rapid asset price correction in recent years — most recently in 2020 — many investors have an innate assumption that there is a Fed “put”. 

So if Powell truly wants to emulate his hero Volcker, and take tough measures for long-term economic health, he should take a leaf from the Kiwi book, and tell the American public and politicians that many asset prices have been pumped unsustainably high by free money. 

That might not win him fans in Congress. But nobody ever thought it would be easy to deflate a multitrillion dollar asset price bubble. And the Fed has a better chance of doing this smoothly if it starts gently and early. Wednesday’s rally shows the consequences of staying silent.

Covid is forcing economists to look at other disciplines for recovery clues

Larry Elliot in The Guardian

Three times a week an update on new Covid-19 cases is published by the economics consultancy Pantheon. Vaccination rates are monitored by the Swiss bank UBS. The scientists advising the government are in regular contact with the Bank of England’s monetary policy committee – the body that sets interest rates.

Richard Nixon may or may not have said “we are all Keynesians now” after the US broke its link with gold in 1971 but one thing is for sure: all economists are epidemiologists now. And there’s a downside and an upside to that.

The downside is that economic forecasting is currently even more of a mug’s game than usual because even the real (as opposed to the amateur) epidemiologists don’t really know what is going to happen next. Are there going to be new mutations of the virus? Assuming there are, will they be less susceptible to vaccines? Will Covid-19 go away in the summer only to return again as the days get shorter, as happened last year? Nobody really knows the answers to those questions.

The upside is that the pandemic has forced economists to look beyond their mechanical models and embrace thinking from other disciplines, of which epidemiology is just one.

For a start, it is hard to estimate how people are going to react to the easing of lockdown restrictions without some help from psychologists. It is possible that there will be an explosion of spending as consumers, in the words of Andrew Bailey, “go for it”, but it is also possible that the second wave of infection will make them a lot more cautious than they were last summer, when there was still hope that Covid-19 was a fleeting phenomenon.

An individual’s behaviour is also not entirely driven by their own economic circumstances. It can be strongly affected by what others are doing. If your peer group decides after having the vaccine that it is safe to go to the pub, that will probably affect your decision about whether to join your mates for a drink, even if you are slightly nervous. Sociology has a part to play in economic forecasting.

As does history, if only to a limited extent, because there are not a lot of comparable episodes to draw upon. A century has passed since the last truly global pandemic and there is only so much that can be learned from the outbreak of Spanish flu after the first world war. But when Andy Haldane, the chief economist of the Bank of England, says the economy is like a coiled spring waiting to be unleashed, that’s because he thinks there are lessons to be learned from the rapid recovery seen last summer. Back then, the economy followed a near 19% collapse in the second quarter of 2020 with a 16% jump in the third quarter.

Naturally, economics has a part to play in judging what happens next. Millions of people (mostly the better off) have remained in work on full pay for the past year but have struggled to find anything to spend their money on. Millions of others – those furloughed on 80% of their normal wages or self-employed people who have slipped through the Treasury’s safety net – are less well-off than they were a year ago and may fear for their job prospects.

In an ideal world, the better-off would decide that the amount of money saved during lockdown was far in excess of what they needed and would then go on a spending spree: heading out for meals, taking weekend breaks, buying new cars; having their homes re-decorated. That would provide jobs and incomes for those on lower incomes.

But it might not work out like that. If the better-off leave their accumulated savings (or most of them, at least) in the bank, that means higher unemployment for those working in consumer-facing services jobs – such as hotels and restaurants – and an economy with a dose of long Covid.

There are two conclusions to be drawn from all of this. The first is that precise forecasts of what is going to happen to the economy over the next year, or even the next few months, should be treated with caution. Assuming the vaccination programme continues to go well, assuming that there are no further waves of infection, assuming restrictions are lifted steadily from early March onwards, and assuming that people come out of hibernation rapidly and in numbers, then the economy will start to recover in the second quarter. But there are a heck of a lot of assumptions in there: it might take until the third quarter for the bounce back to begin; the recovery might prove weaker or stronger than the consensus currently expects.

The second conclusion is equally obvious. If, as is clearly the case, the existence of so many imponderables makes precision forecasting more difficult than normal, it makes sense for economic policy makers to act with caution. For the Bank of England, that means no dash to embrace negative interest rates, which won’t be necessary if Haldane’s bullishness proves to be justified; and for the Treasury it means extending financial support and ignoring calls for higher taxes, especially those that might lead businesses to collapse or cut back on investment.

It would appear that Rishi Sunak has reached the same conclusion. There has been far less talk from the chancellor recently about the need to reduce the UK’s budget deficit, a process that has now been delayed until the second budget of 2021 in the autumn. By that stage, it might well once again by Sunak rather than the epidemiologists running the economy. Well, perhaps.

Economics for Non Economists 3 – Explaining GDP and Economic Growth

By Girish Menon

Introduction

You will have recently read:

-     At 13%, Economist Intelligence Unit Pegs India's Growth In 2021 Higher Than IMF

-    Western economies recovering faster than expected from Covid, says IMF

 -   UK GDP rose 0.4% in February

 -  China's economy grows 18.3% in post-Covid comeback

 

What does this mean?

Just like the Forbes magazine compiles an annual list of the richest individuals on planet earth, most countries participate in an annual ‘show of wealth’. The most commonly used measure in this competition is called GDP. At the end of 2019 the top six countries were:

Table 1

Country	GDP ($ trillions)	Economic growth over previous year (%)	Per Capita GDP ($)	Share of World GDP (%)
USA	19.5	2.2	59, 939	24
China	12.2	6.9	8,612	15
Japan	4.9	1.7	38,214	6
Germany	3.7	2.2	44,680	4.5
India	2.7	6.7	1,980	3.28
UK	2.6	1.8	39.532	3,26

SourceWorldometers

What do these terms mean?

Simply defined, GDP or Gross Domestic Product is the money value of all goods and services (goods) produced within an economy in a period of time. In Table 1 the GDP is estimated over the year of 2019. The data quoted in the introduction compares GDP changes over the first two quarters of 2020.

Economic growth is a measure of the additional goods produced by an economy over the last period of time  (say a year or a quarter).

Per Capita GDP means the value of goods each resident would get if all goods produced in an economy is shared equally. This is calculated by dividing the GDP with the residents of the country. Do you think per capita GDP is an accurate description of how goods are actually distributed in an economy?

Share of World GDP means the share of global goods produced by an economy. This is calculated by dividing each country’s GDP with the whole world’s total GDP.

Why is GDP and the rate of Economic growth so important?

Materialism is the underlying principle of using GDP and economic growth as the most important indicator of economic performance. Materialism, according to the Cambridge English Dictionary, is the belief that having money and possessions is the most important thing in life. It follows that as one’s material goods increases one’s standard of living (happiness) tends to increase.

GDP is a tool that measures the volume of material goods produced by an economy. A high rate of economic growth demonstrates the rate at which the material goods in an economy is increasing and as a result the happiness of the residents as well. So, when the rate of economic growth becomes negative, as in the data mentioned in the introduction, it follows that your happiness will decrease.

Are GDP and GNP the same?

They are similar but not the same. GDP measures the volume of goods produced by people living within the boundaries of an economy. The output of Nissan’s Sunderland plant will be included in UK’s GDP. In other words the output of Britons and foreign nationals living in the UK will be added to calculate UK’s GDP.

GNP stands for Gross National Product. It is a measure of the volume of goods produced by British nationals living in the UK and outside. It will exclude the output of foreign nationals (say Nissan Sunderland) operating within the British economy.

Is GDP an accurate measure of the volume of goods produced within an economy?

The answer is No. The calculation is arduous and with questionable assumptions which I will not go into here. I will however mention some weaknesses here:

1. Even though there are some standardised procedures for its computation governments are known to deliberately intervene in its methodology and computation.

2.   Not all goods are included. For example if you clean your own house and look after your family – these services are not included. However, if you employ a cleaner, a cook, a nanny and a driver then their services are included.

3.   In some countries where there is a large informal economy. The goods produced by such activities are not be included in GDP computations.

Does an increase in GDP necessarily improve residents’ happiness?

In economics, happiness is better known as welfare.

If there is an earthquake in your country and many roads, buildings, bridges, stadia are destroyed. Then rebuilding them will increase the national GDP but has it improved the citizens’ welfare?

As a resultant of economic growth the quality of air you breathe has gone down and the water supply is polluted. Has this improved your standard of living?

Due to increased standard of living everybody has a car and you are now required to spend one hour extra in commuting time. Has this resulted in improved happiness?

What is the prognosis for GDP and economic growth?

It appears that due to Covid-19 the GDP of most nations will be lower than in 2019. These economies will have negative economic growth which means that in 2020 they will produce fewer goods than in 2019.

When the GDP falls, the terms most used are recession and depression. The difference between the two according to Harry Truman is ‘It's a recession when your neighbour loses his job; it's a depression when you lose yours’ .

As you have seen in the news, firms are busy firing staff which means there will be increased unemployment. Since more people are unemployed they will not have money to buy goods in the future and so there will be even less demand for goods in the future and those who have jobs today may lose their jobs next year in a downward spiral of negative economic growth begetting even more negative growth.

Will there be lower emphasis on GDP and economic growth in the future? For such a change to happen there needs a material change in organising the world economy. (If you wish to read further click here)

I hope it happens in my lifetime.

* - annualised rate

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