Wednesday, August 26, 2009

Ronald McKinnon: a concerted modest increase in interest rates?

Ronald McKinnon (Stanford), by way of comment to my post on exit strategies [Exit Wounds, 3 August] sent me an article of his, "Liquidity Traps and the Credit Crunch", that appeared in the Financial Times Forum of 14 August and "emphasizes the importance of getting out of the liquidity trap in order to restore the normal flow of credit even before full 'exit'".

In brief, "...starting from a position where interest rates are already low, say 2 per cent, reducing them to zero has only a second-order effect on expanding aggregate demand. But going from 2 per cent to zero leads to a tightening of the credit constraint on the supply side. Although there may be a “dead cat bounce” to the economy on the demand side in 2009, leaving the Fed funds rate at zero makes it impossible for the resumption of “normal” bank credit to support growth in future. A condition for restoring normal borrowing and lending in the interbank market is to have positive rates of interest at all terms to maturity. Only then will banks that are liquid lend to those that are illiquid. But if the risk free (i.e. federal funds) rate is close to zero, banks with excess reserves will not bother parting with them for a derisory yield." This - he argues - might lead to a trade contraction by causing supply constraints in the export sector, starved of credit.

I readily accept Ronald's general concern for the implications of low interest rates; I never thought - unlike Willem Buiter - that negative interest rates were the right policy to get out of recession, not least because they could not survive in globalised financial markets. But there are two points in RMcK's argument that I found difficult to accept. (1) While undoubtedly he is right on the importance of foreign trade credit, I could not bring myself to consider the cut in trade due to stricter credit constraints as a supply constraint (which term I would reserve for capacity constraints); (2) I could not see why low policy interest rates should deter banks from raising their margins between lending rates and policy rates to the point that it pays them to lend.

Faced with these objections, Ronald sent me an excellent reply, and developed the second point into a full-fledged argument that I reproduce below with his permission, for which I am most grateful. The bottom line of Ronald's argument is that "The Exit Problem: When to Reduce Monetary and Fiscal Stimuli?", has a "Partial Solution: concerted modest increase in interest rates?" [from his paper on "The Global Credit Crunch: China and the United States", Beijing 29 August 2009, which he also kindly sent me but is not reproduced here other than for figures 9 and 10 below].

"On your two points: (1) it is a matter of semantics. You may or may not like my referring to a credit constraint as a "supply" constraint. But credit is an input into working capital. If working capital is unavailable or restricted, then dumping more liquidity into the system will not increase output as if there was a constraint on physical capacity.

(2) Your second point: in the liquidity trap, why don't banks just raise their interest rates to final (retail) borrowers to maintain their profit margins and willingness to lend? This is an important and very subtle point which I did not explain very well in my FT post.

The willingness of banks to make forward commitments to lend at "retail ", to nonbank firms and households, depends very much on the wholesale interbank market. If the wholesale interbank market works smoothly without counter party risk, then even currently illiquid banks can make forward loan commitments--say 3 months in advance--to their retail customers. These banks know that if they are still illiquid when three months are up, then they can always bid for funds in the wholesale market at close to the "risk-free" interest rate to cover their retail commitment.

Now suppose some upsetting event, such as a crash in home prices that makes all mortgage related assets on bank balance sheets suspect. Then counter party risk becomes acute, and banks become less willing to lend to each other unsecured. The LIBOR market is unsecured. So illiquid banks become less willing to lend forward at retail because they don't know what their wholesale cost of capital will be 3 months hence. Indeed if any one bank tries to bid more than the going interbank rate of interest for funds, it is immediately suspected of being a more risky counter party!

Now enter the central bank concerned with the drying up of retail bank credit. It reacts in a text book fashion of flooding the interbank market with liquidity so that the interest rate on federal funds is driven to zero. Bank trading in federal funds is collateralized--usually through short-term re-po agreements, where the collateral is usually U.S. Treasury bonds.

Normally, without significant counter party risk in banks, there isn't much of a difference between the interest rate on federal funds and LIBOR. (See Figure 9 for January 2006 to July 2007 [reproduced below with RMcK's permission, from his Beijing paper quoted above, 29 August 2009]). Then when the crisis struck beginning in July 2007, LIBOR increased substantially above the Fed funds rate indicating the reluctance of banks to lend unsecured. This inhibited banks from making forward retail commitments .

(Incidentally, we could do a similar parallel analysis for foreign exchange transacting. Forward foreign exchange contracting in "wholesale" inter bank markets becoming difficult when bank counter party risk rises. The constriction in the forward market increases currency risk for both exporters and importers and inhibits the granting of trade credit--including letters of credit. Whence the surprising crash in foreign trade.)

However, by August 2009, we are in a purer form of the liquidity trap where both interest rates have been driven toward zero (Figure 9). Now we are in the situation referred to in my FT paper that liquid banks, those with excess reserves, won't bother parting with them for a derisory return. So I would guess (without knowing) that interbank trading is now at a low level .

The implication for all of this is that retail lending in the U.S. has stagnated (or fallen slightly) since August 2008 even when base money in the U.S. has skyrocketed--as shown in Figure 10 [also reproduced below, from the Beijing paper of 29 August 2009].

Figure 9. U.S. Short-term Interest Rates in the Liquidity Trap

Source: FRED and From: Ronald McKinnon, "The Global Credit Crunch: China and the United States", Summer Palace Dialogue, Aug 29, 2009, Beijing

Fig. 10. Loans of U.S. commercial banks, Base Money and M2 (2006 Jan = 100)
Source: FRED. From: Ronald McKinnon, 2009, cited.

Thursday, August 20, 2009

Markets: Incomplete, Inefficient, Self-Fulfilling – But Irreplaceable

A major review of “The state of Economics” was published by The Economist of 18 July 2009 (printed version; online version 16 July). It consisted of a general introduction on What went wrong with economics – And how the discipline should change to avoid the mistakes of the past, and two articles on “The turmoil among macroeconomists”, The other-worldly philosophers and on the foundations of financial economics: Efficiency and beyond, (all three pieces unsigned).

The review has both the merit and the demerit of being non-partisan, trying to be impartial and, therefore, being doomed to inconclusiveness. For instance, while it begins by defining Robert Lucas as “one of the greatest macroeconomists of his generation” it reports on many of the telling criticisms to which Lucas has been subjected. On The Economist‘s Blog (16 July), maxreuter soberly but most effectively commented on Lucas:

“Surely you jest. A more accurate description would be ‘successful economist’ or perhaps ‘leading economist’ of his generation. Remember, this is the gentleman who claims that there is no such thing as ‘involuntary unemployment’ – that all unemployment is purely voluntary. No doubt he believes that what happened during the Great Depression, and what is going on now is really an epidemic of laziness.”

“As the article points out: ‘...economists missed the origins of the crisis; failed to appreciate its worst symptoms; and cannot now agree about the cure. In other words, economists misread the economy on the way up, misread it on the way down and now mistake the right way out’. To refer to an economist whose theories were in large part responsible for much of the above as 'great' is a somewhat unorthodox use of the word indeed.”

“Finally a memorable quote from the 'great' Mr Lucas: ‘...the central problem of depression-prevention has been solved, for all practical purposes...’ – Robert Lucas, Presidential Address to the American Economic Association 2003. Perhaps we should leave it to history to judge the greatness of Mr Lucas and the usefulness, if any, of his contributions to economics.”

In spite of inconclusiveness, by and large The Economist’s review is useful and timely. There is no point in trying to summarise it, as it is already dense and condensed, it is available online and has been subjected to various commentaries in the press and on the blogs.

Three comments are offered here instead, on the importance of markets incompleteness and sequentiality, on the implausibility of the so-called Efficient Markets Hypothesis (EMH), and the frequent self-fulfilling nature of expectations. While these arguments amount to a strong criticism of any market system and its efficiency, in the end it must be emphasised that markets – for all their incompleteness, inefficiency, self-fulfilling nature – are the irreplaceable engines that keep an economic system moving. When these engines are running, a government can try and steer the economic machine. This machine may get out of control on its own, or the government itself may drive it off the road, or crush it. But when the markets/engines are not running, the whole economic system grinds to a halt. However, financial markets are different and do not deserve the same positive appreciation and the consequent free reins.


The Economist‘s review rightly criticises those economists who conveniently “assume that markets are ‘complete’ – that a price exists today, for every good, at every date, in every contingency”. These are the followers of the modern general equilibrium approach developed after Léon Walras by Kenneth Arrow and Gérard Debreu (Econometrica, vol. XXII, 265-90; Debreu’s Theory of Value 1960, etc).

An irrefutable criticism, as futures markets – apart from a handful of currencies, and standardised raw materials over a short time horizon of 3-6 months – are not the rule but the exception, not to speak of contingent markets. But this is the least of those economists’ worries, for they can and do argue – as Christopher Bliss did when I raised this issue with him a long time ago – that markets have a cost, and therefore only those markets will be activated whose expected benefits exceed their costs. Thus in spite of missing markets we remain in the best of all possible worlds.

As a matter of fact the incompleteness of markets cannot be dismissed, for there is one commodity – labour services – for which a forward market could be contemplated only in a society of serfs or slaves, not in a society of free individuals. An irrevocable commitment to deliver one’s labour services in the future to a given master, or a given firm, at a price agreed in the past, would involve a feudal/slave tie inconceivable in a capitalist economy characterised by wage labour (a tenured job involves an option to sell one’s labour at a predetermined wage, but not an obligation to deliver it). Therefore market incompleteness is not a question of costs exceeding benefits of missing markets (unless we tautologically define an institutionally impossible market as infinitely costly), but of the incompatibility between capitalism and feudal institutions in labour relations. It is no accident that Gérard Debreu never speaks of capitalism, but of an unspecified exchange economy. It is not (only) a question of realism, but of which economic system we are talking. One thing are the “parables” often indulged in by neo-classical economists, another thing the science fiction of imaginary planets on which with absolute certainty nobody has ever set foot or ever will.

The lack of future markets for labour services is also why lower wages may not deliver higher labour employment – because those lower wages cannot be guaranteed to continue in the future once unemployment falls – and why a social contract between capital, labour and government may be a superior arrangement with respect to labour market flexibility.

Sequentiality of markets

Nevertheless, the real problem is not so much markets incompleteness but their sequentiality, which is largely ignored. For markets to deliver an efficient resource allocation they should open for the very short time, ideally an instant, that it takes for all economic agents (including representatives of future generations, but let this pass) to express their demands for and supplies of all goods, on the basis of their individual preferences and original “endowments”, thus determining inter-temporal, contingent, equilibrium prices and quantities. Then, once an intertemporal equilibrium is reached for all states of the possible world, markets should shut for ever while all transactors and their successors execute without fail all their transactions to kingdom come. (We leave aside here the thorny issues of existence, uniqueness and stability of such equilibria; complications with externalities, increasing returns, public goods; and the only too often forgotten departures from perfect competition, not because these issues are negligible or unlikely but because they are too large and complex to handle here, and even in their absence there is more than enough to shake anybody’s complacency).

Fortunately for us, and unfortunately for market efficiency, our markets do not function as in this unknown and grotesque economic system. Markets open, shut and reopen incessantly, indeed in the global economy today they seldom shut, for almost invariably you can transact anything at any time of the day and the night somewhere or other on the globe.

In the world as we know it, in order to secure a good’s availability tomorrow, we do not have to express our demand for it today, even if in principle the good could be transacted today in any number of future markets. Therefore all the time, beside taking into account current prices of current goods, we act on the basis not of today’s spot prices of future goods, but of our expectations of their spot prices tomorrow (and of the quantities associated with them). This is the ultimate foundation of the keynesian theory of unemployment due to lack of effective demand; of liquidity preference and of the associated need for fiscal policy. If today’s savers had to express today a demand for future goods, current investment would be activated for their future supply and a generalised excess capacity could only be structural, i.e. due to mismatching of the structure of capacity and of demand. As things are now, whoever saves creates unemployment unless his savings are being spent simultaneously by someone else. It is odd that even critics like Joseph Stiglitz should concentrate on markets incompleteness (as well as asymmetry of information, see his Whither Socialism?, Cambridge Mass, MIT Press, 1994) and neglect their sequentiality.

The trouble is that the Arrow-Debreu model is the only rigorous theory that would support the claim of an efficient market economy. From this viewpoint we can conclude that an efficient market economy is a utopia, in the literal sense that it does not exist, it has never existed and will never be capable of existing anywhere. What had began as an attempt to theorise the efficiency of markets ended up, by the successive tightening of all the conditions necessary to such efficiency, conclusively demonstrating their inefficiency.

Paradoxically the most effective critique of this kind of general equilibrium theory has come from within that same theoretical tradition, from Jacques Drèze and his work on temporary equilibrium. This is a Hicksian concept (from Value and Capital), infinitely more destructive and promising, at the same time, than anything produced by neo-marxian or neo-ricardian or neo-keynesian economists, so much so that it leads straight to keynesian conclusions.

The Efficient Market Hypothesis

In the 1960s Eugene F. Fama at Chicago University and Paul A. Samuelson at MIT independently put forward the Efficient Market Hypothesis, i.e. the proposition that “prices fully reflect all available information” (Fama 1965). The title of Samuelson’s 1965 article, ‘Proof that Properly Anticipated Prices Fluctuate Randomly’ says it all: if markets are informationally efficient, in the sense of prices incorporating the information and expectations of all market participants, price changes cannot be forecast, and viceversa. Everybody will exploit the slightest informational advantage in profitable transactions. As the old story goes, if you see something looking like a $100 bill on the pavement you should leave it where it is, for if it really was a $100 bill someone else would have picked it up already.

Lucas (1978) buttressed this hypothesis with his notion of “rational” expectations, efficiently embodying the sum total of economic information (although really we should call them “successful” expectations, for there is nothing rational or irrational about them). These are the foundations of the denial of the Phillips trade-off between unemployment and inflation; of the presumed ineffectiveness of government policy; and of the theory of Central Bank Independence with sole responsibility for inflation targeting.

This Panglossian view of the efficiency of markets is reminiscent of the parallel claim, by Soviet planners, that their central planning was always necessarily optimal, because if they had known any better they would have made it better. Admittedly it should be easier for countless, decentralised market transactors to recognise mutually advantageous improvements through bilateral exchanges, than for a single central planning agency to spot and implement planning improvements unilaterally; but if plan construction was decentralised, as Oskar Lange had proposed back in 1937, mutatis mutandis the Efficient Market Hypothesis and the Optimum Planning Hypothesis would be equally plausible (or, rather, equally implausible).

The Economist‘s review covers some of the criticisms raised in the literature to this construct. “In 1980 Sanford Grossman and Joseph Stiglitz [AER 70, 393-408], pointed out a paradox. If prices reflect all information, then there is no gain from going to the trouble of gathering it, so no one will. A little inefficiency is necessary to give informed investors an incentive to drive prices towards efficiency.” This is a confusion between the properties of the end-result and those of the process by which that end-result is obtained.

The Economist‘s criticisms of EMH include also the neglect of “institutional frictions” in markets, such as the presence of some less well-informed “noise traders”. But The Economist‘s strongest criticisms rest on the challenge to markets’ inherent rationality raised by behavioural economics in the past decade.

The behavioural approach

Andrew W. Lo (2007), a contributor to the EMH who now seeks its synthesis with behavioural economics, i.e. the Adaptive Markets Hypothesis, characterises the behavioural approach thus:

“Human decision-making under uncertainty” exhibits systematic biases “several of which lead to undesirable outcomes for an individual’s economic welfare – for example, overconfidence (Fischoff and Slovic, 1980; Barber and Odean, 2001; Gervais and Odean, 2001), overreaction (DeBondt and Thaler, 1985), loss aversion (Kahneman and Tversky, 1979; Shefrin and Statman, 1985; Odean, 1998), herding (Huberman and Regev, 2001), psychological accounting (Tversky and Kahneman, 1981), miscalibration of probabilities (Lichtenstein, Fischoff and Phillips, 1982), hyperbolic discounting (Laibson, 1997), and regret (Bell, 1982). These critics of the EMH argue that investors are often – if not always – irrational, exhibiting predictable and financially ruinous behaviour” (see Lo’s references list for bibliographical details).

The latest contribution to this approach is Animal Spirits, by George Akerlof and Robert Shiller, entitled after what Maynard Keynes regarded as the ultimate urge to practice enterprise and to invest[1]. More power to their elbows. But ultimately the strongest criticism of EMH is epistemological, for that hypothesis is based on a peculiar theory of knowledge.

The EMH suffers from what we could call the X-Files Syndrome, “The Truth Is Out There”. Out there is The Truth, some of which is naked and visible to all market participants; some of which is covered in such a way as to be visible only to some of them – either with total certainty or with an attached probability which is the same for all – and the rest of which is unknown but is known with certainty to be unknown. Information available therefore is somewhat limited, but what information is available is true – or likely to be true with equal probability for all those who share it – otherwise its privileged use would not necessarily give an advantage.

Instead of which, in the world as we know it, market participants have different beliefs about the probability of truth of the information they possess; the same “quantum of information” may be viewed as a gold nugget by some and as utter rubbish by others (for instance, the time sequence of numbers generated by a fair roulette to date, with a view to predict future numbers). Otherwise it would not be possible to even talk of “noise traders”; whoever uses this concept should explain what can be relied upon to contain the noise level below a critical, deafening number of decibels, while a bubble inflates up to the point when it bursts. I guess one can belong to the behavioural school without even realising it.

Self fulfilling expectations

If he were to re-write The General Theory – Maynard Keynes wrote in the Introduction to one of its later editions – he would distinguish between economic agents acting on the basis of wrong expectations and of right expectations. He also wrote: “For if we consistently act on the optimistic hypothesis, this hypothesis will tend to be realised; whilst by acting on the pessimistic hypothesis we can keep ourselves forever in the pit of want” (Preface, Essays in Persuasion, 1931). Joan Robinson used to quote Shakespeare to express the possibility of self-fulfilling expectations: “[… for there is nothing either good or bad, but] thinking makes it so”(Hamlet to Rosencrantz, Act 2, scene 2).

The Economist‘s review states: “… Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.” But in a recent, inspiring article (Economics is in crisis: it is time for a profound revamp, FT 21 July 2009). Paul De Grauwe explains beautifully the self-fulfilling nature not just of expectations but of dominant economic theories.

“Take government budget deficits, which now exceed 10 per cent of gross domestic product in countries such as the US and the UK. One camp of macroeconomists claims that, if not quickly reversed, such deficits will lead to rising interest rates and a crowding out of private investment. Instead of stimulating the economy, the deficits will lead to a new recession coupled with a surge in inflation. Wrong, says the other camp. There is no danger of inflation. These large deficits are necessary to avoid deflation. A clampdown on deficits would intensify the deflationary forces in the economy and would lead to a new and more intense recession.”

“Or take monetary policy. One camp warns that the build-up of massive amounts of liquidity is the surest road to hyperinflation and advises central banks to prepare an ‘exit strategy’ [see our post on Exit Wounds”, 3 August 2009]. Nonsense, the other camp retorts. The build-up of liquidity just reflects the fact that banks are hoarding funds to improve their balance sheets. They sit on this pile of cash but do not use it to increase credit. Once the economy picks up, central banks can withdraw the liquidity as fast as they injected it. The risk of inflation is zero.”

“Does it matter that economists disagree so much? It does. Take the issue of government deficits. If you want to forecast the long-term interest rate, it matters a great deal in which of the two camps you believe. If you believe the first one, you will fear future inflation and you will sell long-term government bonds. As a result, bond prices will drop and rates will rise. You will have made a reality of the fears of the first camp. But if you believe the story told by the second camp, you will happily buy long-term government bonds, allowing the government to spend without a surge in rates, thereby contributing to a recovery that the second camp predicts will follow from high budget deficits.” …

“This conflict matters not only for market participants, but also for policymakers.” … “The cacophony of analysis helps to explain why policymakers react in different ways to the same crisis and why it is so difficult for them to come up with co-ordinated action.”… “How to resolve this crisis in macro-economics? The field must be revamped fundamentally” (De Grauwe, cited).

Back to the drawing board, then: “We need a new science of macroeconomics. A science that starts from the assumption that individuals have severe cognitive limitations; that they do not understand much about the complexities of the world in which they live. This lack of understanding creates biased beliefs and collective movements of euphoria when agents underestimate risk, followed by collective depression in which perceptions of risk are dramatically increased. These collective movements turn uncorrelated risks into highly correlated ones. What Keynes called ‘animal spirits’ are fundamental forces driving macroeconomic fluctuations” (De Grauwe, cited).

Markets as indispensable homeostatic mechanisms

Well, markets are incomplete, sequential, inefficient, self-fulfilling… So what? All of these considerations taken together do not eliminate the absolute need for markets in resource allocation, for they are irreplaceable homeostatic, self-regulating mechanisms that adjust prices to excess demand (Walras), quantity produced to excess price over cost (Marshall), and actual capital stock to desired capital through investment decisions. Axel Lejonhufvud stressed long ago the markets’ self-regulating role (which should not be confused with self-regulation of their own functioning). More generally, markets also adjust production capacity and production of inputs to those of outputs (Dick Goodwin on the Multiplier as a Matrix).

Sometimes the self-adjustment is too fast, sometimes it is too slow - as it happens with all homeostatic mechanisms, like thermostats - but it is there; the alternative is manual control, i.e. central planning. As I tell my students, there may be special circumstances in which manual control is superior to an automatic mechanism. In Star Wars, when Luke Skywalker targets the heart of the Empire, he disables automatic controls and goes manual, and succeeds. But he only had one target; there were only two alternatives, hit or miss; and … the Force was with him. In Central Eastern Europe, on the contrary, the inability to introduce markets in almost forty years of attempted reforms – primarily because of persistent endemic excess demand, but also for the leadership’s fear of loss of political power and control – was the ultimate economic cause of collapse of centrally planned economies in 1989-91.

We could paraphrase Wiston Churchill’s dictum about democracy, and say that the market economy is the worst economic system except all the others that have been tried. But markets alone do not, on their own, characterise an economic system. We are engaged now, as never before, in an intellectual struggle over what ownership mix, what rules of the game, what share of government expenditure, what social and re-distributive policies, what global governance institutions should prevail in the modern market economy. While economic arguments are used, the choices involved are essentially political, and attempts to control or replace markets as the economy’s engines are always grabs for political power and control.


… that the markets' homeostatic properties praised above demonstrably do not apply to most credit and financial markets, where products may multiply instead of reducing and spreading risk; securities may go toxic; transactions are more likely to be fraudulent because of lack of transparency; there is a corporative system of rewards masquerading as a market for managerial skills; leveraged bets in derivatives markets can inflict massive damage on innocent bystanders; banking pyramids proliferate; profits are privatised and massive losses are eventually socialised. Here the primacy of markets must give way to effective regulation, first national then global.

[1] “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” (The General Theory of Employment, Interest and Money, 1936, pp.161-162). Akerlof and Shiller take “animal spirits” to imply irrationality, but the urge to action rather than inaction could well be a rational survival strategy, instead of the neglect of reason.

Friday, August 14, 2009

The Economist‘s Burgernomics: Too Silly for Words

Mid-summer is generally known as the silly season. This post is devoted to the silliest piece of economics around, moreover originated, supported and spread by The Economist, that only last month pontificated on the state of macroeconomics today.

The Economist's Big Mac index provides an alternative to the actual market exchange rate, for assessing the foreign trade competitiveness of different countries. “It is based on the theory of purchasing-power parity (PPP), which says that exchange rates should equalise the price of a basket of goods in each country. In place of a range of products we use just one item, a Big Mac hamburger, which is sold worldwide. The exchange rate that leaves a Big Mac costing the same in dollars everywhere is our fair-value benchmark.” (Cheesed off, 16 July 2009, Burgernomics points to uncompetitive currencies in continental Europe).

Hold it right there

The theory tells us that there is an infinite number of PPP exchange rates, each for an alternative basket of goods. If we choose a basket of internationally tradeable commodities, actually traded by a country, trends of the implicit PPP exchange rate with another currency will be one of the many factors that will determine whether or not a country is internationally competitive and whether its exchange rate will be sustainable. Provided that the reference currency is not itself undervalued, a condition amply satisfied by the dollar today but not invariably by reference currencies. The very notions of competitiveness and sustainability are conditional on a given growth rate: a country may be competitive, and its exchange rate sustainable, at a low growth rate but not at a more ambitious one; the concept of competitiveness is undetermined until a target growth rate is specified. There are other factors affecting the exchange rate and its competitiveness and sustainability, such as Foreign Direct Investment and portfolio investment flows; the stock of public and of private external debt; the sustainability of government deficits; credit-ratings; interest rates and their comparative trends.

What is more, for a given set of all significant factors other than PPP, a country does not necessarily have to be competitive in a wide range of tradeables. It is perfectly sufficient for a country to be competitive in one single commodity, as long as its world demand is sufficiently elastic with respect to price and with respect to income – oil for instance, or microchips – for that country to be internationally competitive, even at an ambitious growth rate and a PPP rate which is overvalued in terms of a broader basket of tradeables. It is completely irrelevant whether a country is or is not competitive on any number of non-tradeables, let alone one single non-tradeable like the Big Mac, whose only attraction is its global homogeneity thanks to stipulations of the McDonald franchises. The price of perishable good, that deteriorates within minutes of its preparation, together with its chips going immediately and irredeemably soggy, is no indication of a country’s foreign trade competitiveness. A country might as well worry about its competitiveness in the export of frozen omelettes.

A hair-cut PPP Index?

It would be much better, at that point, to take into consideration another non-tradeable, such as a hair-cut. For haircuts have a much lower incidence of non-labour costs than a Big Mac, and lower variability of labour productivity in hair-cutting across countries, and therefore at least a better indication of relative wage rates – which are very important factors in affecting international competitiveness. A hair-cut PPP exchange rate has some kind of meaning, instead of being utterly meaningless and irrelevant like the Big Mac PPP. Although its relevance will depend on a country’s incidence of baldness, fashion for hair length and colour, just as the relevance of the Big Mac PPP index will depend also on the incidence of vegetarians, health-minded consumers, gourmets and Hindus (so much so that there is no Big Mac index for India). Moreover in some countries (Russia, Brazil and China) burgers are posh, in other countries they are the pits.

The same considerations, and more, vitiate the use of a one-good PPP index – whether tradeable or not – for another purpose to which PPP exchange rates are commonly put, namely income or consumption comparisons (per capita or total) across countries. With the added complication that the basket appropriate to one country may be inappropriate to another, and diverging results are likely to obtain according to the arbitrary choice of one or another basket. And a basket appropriate for the rich is bound to be inappropriate for the poor. For instance, the recognition that the poor tend to buy lower quality food, in smaller and more frequent purchases, and enjoy lower quality public services, in 2008 forced the World Bank to revise upwards its estimate of the world poor from just under 1 billion to 1,400 million – at a stroke. A classic, thorny, insoluble index number problem. Here too the use of a single good is laughable.


“When demand is scarce and jobs are being lost, no one relishes a strong currency. A country with an uncompetitive exchange rate will struggle to sell its wares abroad and will also cede its home market to foreign firms. A weak exchange rate, by contrast, encourages consumers to switch from pricey imports to cheaper home-produced goods and services. So which countries has the foreign-exchange market blessed with a cheap currency, and which has it burdened with a dear one? The Economist's Big Mac index, a lighthearted guide to valuing currencies, provides some clues.” (CLICK ON THE TABLE BELOW TO ENLARGE, OR ON THE LINK IN THE SECOND PARAGRAPH ABOVE TO ACCESS THE ORIGINAL ARTICLE AND TABLE)

It is not so much that the table above, or the conclusions drawn from it, look serious rather than lighthearted. “The dollar buys the most burger in Asia. A Big Mac costs 12.5 yuan in China, which is $1.83 at today’s exchange rate, around half its price in America. Other Asian currencies, such as the Malaysian ringgit and Thai baht, look similarly undervalued. Businesses based in continental Europe have most to be cheesed off about. The Swiss franc remains one of the world’s dearest currencies. The euro is almost 30% overvalued on the burger gauge. Denmark and Sweden look even less competitive.” According to the table, the Norwegian Krone is 72% overvalued.

It is the reasoning behind the lightheartedness that is faulty: “Care is needed when drawing quick conclusions from fast-food prices. The cost of a burger depends heavily on local inputs, such as rent and wages, which are not easily arbitraged across borders and tend to be lower in poorer countries. So PPP gauges are better guides to misalignments between countries with similar incomes.” Why, are the prices of burgers and hair-cuts easily arbitraged across borders? Bankers, businessmen and students love simplistic, unqualified propositions about economics. But the Big Mac Index is dis-educative and misleading to the point of being dangerous.

“On that basis, the markets have been kindest to British exporters. A year ago the pound was overvalued by more than a quarter on the Big Mac gauge. Now it is close to its fair value against the dollar and looks cheap against the euro. That shift has upset some other EU countries that had relied on selling to spendthrift British consumers. But after years of struggling with an overvalued currency, British firms will feel they deserve a little mercy.”

Silly economics for a silly currency in the silly season. I wish all my readers a good Ferragosto.

Monday, August 3, 2009

Exit Wounds

The amazing scale – absolute and relative – of the global response to the current financial crisis, and therefore the difference with respect to the similar crisis of 1929-32, is dramatically illustrated by a simple comparison. According to the United Nations Millennium Campaign, “since the inception of aid (overseas development assistance) almost 50 years ago, donor countries have given some $2 trillion in aid. And yet over the past year, $18 trillion has been found globally to bail out banks and other financial institutions. The amount of total aid over the past 49 years represents just eleven percent of the money found for financial institutions in one year.” (Deputy Director Sering Falu Njie, 24 June 2009).

One of the most important items on the agenda of L’Aquila G-8 meeting of 8-10 July was the discussion of the appropriate exit strategy from the extraordinary fiscal and monetary policies with which national governments, central banks and international financial institutions have responded – some more than others – to the global crisis.

At L’Aquila the German Chancellor Angela Merkel was the first to raise the issue of a collective exit strategy. Apparently Barak Obama, Nicolas Sarkozy and Gordon Brown responded negatively, wishing to continue to implement the stimuli and deeming the exit premature. No common strategy was eventually agreed, national governments retaining total discretion over their own exit policy, which is exactly what would have happened without the G-8.

In the United States the $789 billion Economic Stimulus package finally approved on 17 February ($507 billion spending and $282 billion tax relief) is being implemented rather slowly. By early July, $158 billion expenditure had been committed, only one third of that actually spent, plus temporary tax cuts totalled $43 billion; the bulk will be spent in 2010 (NYT, 9 July). “A debate had developed over whether the stimulus bill was having the desired effect or not, with some economists and Democrats arguing that a further economic boost was needed, and many Republicans saying that the rise in unemployment was proof that Mr. Obama's approach had failed. Concerns were also rising about whether the surge in government debt would lead to higher interest rates that would undo much of the effect of the package.” (ibidem).

By mid-2009, out of France’s $36 bn stimulus package 50% was already spent and a further 25% is due in the second half of 2009, with the last 25% in 2010. In Germany two stimulus packages were worth a combined €81bn. Both countries are sticking to their plans but “appear determined to resist a further large-scale discretionary boost to their economies” (Ben Hall and Chris Bryant, FT 21 July). German attitudes may change after the election, though a recent decision of the German Constitutional Court has tightened fiscal rules.

The same division on the urgency of exit characterises the position of official financial institutions. An exit strategy was urgently called for by the European Central Bank President, Jean-Claude Trichet, while the Federal Reserve does no more than the reviewing of the instruments available for possible use in an exit, and the IMF considers it premature.


The IMF used to be criticised – rightly I believe – for its responsibilities in past crises such as the post-socialist transition recession of the early 1990s, the South East Asian crisis of 1997, the Russian crisis of 1998 (see for instance Joseph Stiglitz, Globalisation and its Discontents, 2002). But times have changed and so has the IMF, which played a leading role in the current initiative for a global fiscal stimulus, first proposed by IMF Managing Director Dominique Strauss-Kahn at the emergency summit of G-20 leaders on 15 November 2008. On that occasion the focus shifted from rescuing failing financial institutions to supporting domestic demand, which had fallen off sharply almost everywhere: a global fiscal stimulus of the order of 2% of global GNP was first mentioned.

In an interview with IMF Survey Online on 29 December 2008 Olivier Blanchard, the IMF Chief Economist and Carlo Cottarelli, Director of the IMF Fiscal Affairs Department, fleshed out the call for such a global fiscal stimulus. Blanchard listed three parallel sets of measures necessary for the recovery. First, banks’ recapitalization and isolation of bad assets, in order to resume a sustained flow of credit; the execution of this measure “is complex and will take time”. Second, “the use of monetary policy to increase demand”, except that “room for further monetary easing … is shrinking: in some countries, policy interest rates are approaching zero. Moreover, the effect of lower interest rates on demand is weakened by the disruption in credit markets. This points to a central role for the third set of measures, fiscal stimulus. In the short run, such a stimulus, if designed right, can limit the decline in demand as well as output”. Was this not rather against the grain of IMF traditional policies? “In normal times, the Fund would indeed be recommending to many countries that they reduce their budget deficit and their public debt. But these are not normal times, and the balance of risks today is very different.“

“If no fiscal stimulus is implemented, then demand may continue to fall. And with it, we may see some of the vicious cycles we have seen in the past: deflation and liquidity traps, expectations becoming more and more pessimistic and, as a result, a deeper and deeper recession. If, instead, a fiscal stimulus is implemented but proves unnecessary, the risk is that the economy recovers too fast. Surely, this risk is easier to control than the risk of an ever deepening recession.”

Olivier Blanchard then goes further: “I would put it even more starkly. What is needed is not only a fiscal stimulus now but a commitment by governments that they will follow whatever policies it takes to avoid a repeat of a Great Depression scenario. If they do so, the fear that people and firms have today will fade, and demand will pick up. “

The IMF would take a lead in coordinating the fiscal stimulus. “When economies are linked by a high degree of trade openness, fiscal expansion in one country translates in part into an increase in demand for the goods of other countries, and so may result in a larger trade deficit. Thus, each country is, rightly, reluctant to embark on a fiscal expansion on its own. The best solution is for all countries to act jointly. But this requires some form of commitment or coordination. This is why the IMF has been closely engaged in discussions with member countries on how to design an appropriate fiscal response. Given our global membership, we are uniquely placed to do so.” In other words, Maynard Keynes is alive and well and inspiring the IMF.

To put its money where its mouth was, the IMF raised its lending commitments to a record $157 billion. It loosened the conditionality attached to its programmes, both on fiscal policy and on inflation (for instance in Hungary in October and in Iceland in November 2008). It sought “to take account of the needs of the most vulnerable by developing or enhancing social safety nets.”(A changing IMF, Factsheet, May 2009). It is seeking to triple its lendable resources to $750 billion; to this purpose it has raised much of its $250 billion target in bilateral government loans (Japan $100 billion; Canada $10 billion, Norway $4.5 billion; EU members have committed around $100 billion, and Switzerland $10 billion). It is working at an injection of $250 billion additional liquidity into the global economy, through a general allocation of an IMF Special Drawing Rights (SDRs). The IMF also plans to go ahead with its first issuance of interest-bearing promissory notes to supplement its lendable resources; China is already committed to purchase up to $50 billion, with both Russia and Brazil committing up to $10 billion each (the notes have an initial maturity of three months, extendable for up to five years). The Fund has held discussions with the 26 members of the New Arrangements to Borrow (NAB) and its potential new members about expanding it and making it more flexible. Currently, the IMF can raise about $50 billion through the arrangement, with the U.S. share being about $10 billion. There is an envisaged increase in the NAB of up to $500 billion, of which $100 billion US contribution has already been approved (Andrew Tweedie, the Fund’s finance chief, 6 July 2009).

At the end of June the IMF urged “governments to fully implement the spending measures they have announced to combat the global economic crisis and not to relax in supporting an incipient recovery. (John Lipsky, IMF First Deputy Managing Director, in Paris on June 26). For “although experience varied across countries and programs, actual spending of announced stimulus measures was relatively low in many cases.” Lipsky paid lip service to the “need to start preparing a clear exit strategy for government intervention in both the fiscal and monetary areas” but said no more than that, not even an inventory of policy instruments like that of Bernanke (see below).

In a recent interview with on 24 June 2009, Olivier Blanchard reckoned that in the advanced countries the upturn might take place at the end of 2009, with a weak slow recovery “going back maybe to a stable path within three to five years, it’s going to take a long time”. “Until [the end of 2010], unemployment is going to increase and then, after this, you need growth higher than normal in order to decrease unemployment.”

Central banks “have increased their balance sheets enormously. It was largely because they bought assets that private investors didn´t want to buy. … as the recovery comes, private investors are willing to buy these assets and central banks will be able to sell these assets back to them. So, I am not really worried about the inflation”.

“…the fiscal part is more worrisome.” “What [governments] should not do is stop the fiscal stimulus now. Because if they did this – private demand at this stage is still very weak – if they stopped, basically, pushing demand, we would probably not see the recovery. So, there has to be fiscal stimulus at least this year, probably next year and maybe even the year after. “

“Surely, now, it is not time to take away the fiscal stimulus or to start increasing interest rates. The economy is very weak, private demand is very weak. If you think about consumers, they are not in the mood to spend. If you look at firms, they are not in the mood to invest. So, if you were to take away the stimulus, you´d basically stop the recovery.” “It´s absolutely essential for the moment to continue with the monetary policy and fiscal policy that we have had in the last year.“ God bless you, Olivier, even though you used to disapprove of my taste in ties.

Ben Bernanke

In an article in the Wall Street Journal (21 July 2009) the chairman of the Federal Reserve confirms the consensus within the Fed that “accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. … We are confident that we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner”. Nobody ever doubted that the Fed has the necessary tools, it is their smoothness in use that is problematic.

Above normal reserves of $800 trillion need to be eliminated or their effects neutralised; their unwinding might take too long without additional measures, such as paying an interest to banks on their reserve balances (which puts a floor - currently at 0.25% - under short-term market rates). If that did not work (because many non-bank financial intermediaries are not eligible for getting such an interest), Ben Bernanke lists four additional instruments. First, “large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions”. Second, “the Treasury could sell bills and deposit the proceeds with the Federal Reserve”. Third, the Fed has been authorised by Congress to pay interest on banks’ balances at the Fed, which would not be available for the federal funds market. Fourth, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market – a time honoured, classic operation. “Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.”

This is no exit plan, simply an inventory of exit vehicles, with no indication of timing, scale, sequencing of their deployment. “The Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening with the mix of tools to best foster our dual objectives of maximum employment and price stability.” In other words, we can and will do it at some point in a distant future, but let’s keep the markets guessing. Excellent.

Jean-Claude Trichet

In a key address at Munich University on 13 July, Jean-Claude Trichet stated that “preparations for exit are important. The [ECB] Governing Council will ensure that the measures taken are quickly unwound, and the liquidity provided is absorbed, once the macroeconomic environment improves. Long-term refinancing operations (like operations with shorter maturity) provide liquidity over a fixed time horizon and run off in a fully predictable way. By contrast, the unwinding of outright purchases typically requires an additional decision, namely whether to hold the securities to maturity – and if not, when to sell. The route taken by the Eurosystem limits such decisions to our covered bonds purchases and for the rest relies on built-in mechanisms for the re-absorption of liquidity.“

“A return to sound, sustainable public finances, thus strengthening overall macroeconomic stability, must be ensured. Euro area governments should prepare and communicate ambitious and realistic fiscal exit and consolidation strategies within the framework of the Stability and Growth Pact.” …

Trichet then puts it even more explicitly and strongly: “I would warn against a common and unfortunate view suggesting that it is currently too early, or even totally inopportune, to envisage appropriate exit strategies. Such a view is, in my opinion, plain wrong – for three reasons:”

“First, because decision-makers’ primary quality is that they always display “sang froid” and keep their composure, particularly in the most demanding and turbulent times. Viewing today’s actions and decisions from a longer-term perspective is part of the necessary intellectual discipline.” [Objection: this is no reason at all, it is simply monetary machismo, of a kind often indulged in by central bankers].

“Second, because nobody should confuse the existence of a credible exit strategy – which can be activated at the right moment – with the decision to actually embark on that strategy. Often such confusion explains people’s fierce opposition to the mere existence of exit strategies.” [Objection: sure, but scheduling a surgical operation does not do much to help the patient to recover without it, especially from an illness that depends so much on the patient’s morale and will to recover; one might as well provisionally book a funeral].

“And third, because the very existence and the visibility of a credible exit strategy will foster confidence today and will therefore contribute to the re-activation of the economy here and now. This is true for monetary policy: our [euro-area] 329 million fellow citizens are very profoundly attached to price stability in the medium term, and the credibility of our policy is essential for improving their confidence now.” [Objection: surely you don’t book a plane until you know when and where you are going, who with and how many, what for and on what budget and how fast you need to get there].

“This is equally true for fiscal policy: economic research has demonstrated that two-thirds to three-quarters of European households are “Ricardian”. This means that they consume less and save more if they lack confidence in the soundness of future public finances.” [Objection: even those alleged two-thirds/three-quarters “Ricardian” households will not be 100% Ricardian, matching their higher taxes exactly with higher savings. Indeed it seems more rational to respond to higher government expenditure, especially in deficit, with higher rather than lower private expenditure in view of expectations of higher employment and income continuity. I know from introspection that I am 0% Ricardian].

No Deficit, We Are German

The German “fiscal space” has been severely constrained by a decision recently taken in Berlin – unilaterally, without the statutory consultations with EMU partners and institutions – to introduce a balanced-budget law in the German constitution. As if the so-called Stability and Growth Pact were not enough of a fiscal straightjacket, from 2016 it will be illegal for the federal government to run a deficit of more than 0.35 per cent of GDP, and from 2020 the federal states will not be allowed to run any deficit at all. Once this is done, it can only be with a two-thirds majority: “future fiscal policy will be in the hands of the justices of Germany’s Constitutional Court,” while until now structural deficits were allowed by the German constitution as long as they were covered by public investments – the “golden rule” (Wolfgang Münchau, FT 21 June).

Münchau sees the danger that “Germany might end up in a procyclical downward spiral of debt reduction and low growth”… “the prescribed pursuit of a balanced budget would require ever greater budgetary cuts to compensate for a loss of tax revenues. … the new government will have to start cutting the structural deficits by 2011 at the latest. There is clear danger that the budget consolidation timetable might conflict with the need for further economic stimulus, should the economic crisis take another turn for the worse. One could also construct a virtuous cycle … If Germany were to return to a pre-crisis level of growth in 2011, and all is well after that, the consolidation phase would then start in a cyclical upturn.” … “Either of those scenarios, even the positive one, is going to be hugely damaging to the eurozone. In the first case, the German economy would become a structural basket case, and would drag down the rest of Europe for a generation. In the second case, economic and political tensions inside the eurozone are going to become unbearable.” …

“…there is no rule in economics to suggest that zero is the correct level of debt, which is what a balanced budget would effectively imply in the very long run. The optimal debt-to-GDP ratio might be lower for Germany than for some other countries, but it surely is not zero. … While the balanced budget law is economically illiterate, it is also universally popular. Average Germans do not primarily regard debt in terms of its economic meaning, but as a moral issue. … The balanced budget constitutional law is therefore not about economics. It is a moral crusade, and it is the last thing, Germany, the eurozone and the world need right now” (Münchau, cit.)

Burden sharing

A serious side effect of the G-8 inconclusive discussions on a collective exit strategy was that it buried the issues of fleshing out the details of several of the April G-20 proposals; and of the “fair sharing of the burden of the stimulus among countries” (raised by Jean-Paul Fitoussi and Joseph Stiglitz, Chairmen of “The Shadow GN” – a group of independent experts they set up at Columbia University and the Luiss University in Rome – on “The Ways Out of the Crisis and the Building of a More Cohesive World”, May 2009). “To our knowledge, – Fitoussi and Stiglitz say – a state of fair sharing has not yet been reached: the efforts made by the EU, in particular, appear to be well below what should have been done in view of the size of its GDP and high savings rate” (ibidem). Not to speak of the G-8 host country, Italy, the ultimate free rider that never really entered the coordinated reflationary effort, limiting its net participation to a token, miserly 0.2% of its GNP – according to the IMF – plus a few purely cosmetic measures in the very long run, the brainchild of creative accountant Giulio Tremonti, who therefore at L’Aquila was wisely silent on exit strategies in general and Italy’s own exit (de che? as Romans say) in particular.

A Goldilocks exit strategy?

In an article on “In search of a Goldilocks exit strategy” Jean Pisani-Ferry, Director of the Bruegel Think Tank in Brussels, recognises that “it is still too early to act”, and that “against the background of a still very weak economy it is advisable to err on the side maintaining support for a little too long” [for the non initiated, ‘Goldilocks’ is economic jargon for a state of the economy which is neither ‘too cold’ nor ‘too hot’, thus ruling out both high unemployment and high inflation]. All the same Pisani-Ferry calls for early discussions of an exit’s possible course, in order to reassure and calm markets about fears of inflation resurgence, to formulate an appropriate sequence of exit measures, to confront and solve the accompanying problems and to facilitate a coordinated approach. His optimum sequencing envisages first the cleaning up of the banking sector; second, consolidation of fiscal policy, in strict cooperation between governments and central banks; third, the “normalisation” of monetary policy; here he rightly sees monetary authorities reluctant to accept “being hostage to potential government procrastination”.

One thing that should not worry us at all is the lack of exit strategies coordination. That the stimuli should be coordinated simultaneously on a global scale was necessary to enhance their effectiveness, but the problem with an exit strategy is precisely the opposite: a simultaneous global exit raises the danger of a cumulative recessionary drive. As long as the exit is not premature and does not turn into a stampede, it is much better if every country goes its own way, staggering their respective exits. The only desirable coordination would be a coordinated staggering of exits - when the time is right - to simulate a random process, instead of an uncoordinated early exit by precisely those countries that have been running the stronger stimuli.

In turn, the coordination between monetary and fiscal policy, recommended by Pisani-Ferry, is desirable at a national level in any case and not just in the exit from macroeconomic stimuli; it should not necessarily take the form of the coordination between an internationally coordinated monetary policy and an internationally coordinated fiscal stance on a global scale. The problem is in the euro area, because the territorial scope of fiscal policy is national and that of monetary policy is European. It is very hard to coordinate the ECB monetary policy with the net collective fiscal stance of its 16 members – which is what matters – in spite of the so-called Growth and Stability Pact, for this only sets ceilings to individual fiscal stances.

Unsustainable, but why not for as long as it’s necessary?

Clearly the current high fiscal deficits, record low interest rates, large-scale monetary easing and other state interventions are not sustainable indefinitely. The general problems surrounding exit measures and their sequencing are worth discussing, as something that sooner or later – let’s hope sooner rather than later, for it will imply that the crisis is over sooner – will have to happen at some uncertain date in an indefinite future. But inflation has been falling everywhere to rates unseen for several decades; in the euro area it was down to negative average rates in June-July 2009. And even Jean-Claude Trichet says that “Looking ahead, we expect prices to remain dampened over the medium term… all indicators of inflation expectations over the medium to longer term remain firmly anchored in line with the Governing Council’s aim of keeping inflation rates below, but close to, 2%.” (cited).

Therefore fears of inflation resurgence are definitely exaggerated and premature. Moreover it is not only a question of prices, but also of wages and of asset prices. “Wage deflation seems to have begun even in the industrialised countries. If it continues, it will further depress aggregate demand. Asset price inflation has been the destabilizing factor at the immediate origin of the crisis” (Fitoussi and Stiglitz, cited).

The sheer official mention of a possible early end to extraordinary measures will reduce and possibly annul the impact of those measures, such as were taken. Given the self-fulfilling nature of pessimistic expectations, loose talk may cause unemployment.