The Atlanta Nowcast estimate for Q1
The New York Nowcast estimate for Q1
"The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist."
The General theory of employment, interest and money (1935)
US quarterly GDP for the first quarter with a growth rate of 3.2% came in surprisingly strong yesterday. However, a substantial part of this can be attributed to inventories and net exports, meaning that another big upside surprise for next quarter is rather unlikely. I have kept track of the different Nowcast models on this blog before (see here, for example). So far, the Atlanta GDP Nowcast has turned out to be the most accurate (see table below). Not only does it have the smallest absolute forecast error, but it’s missed also seem to be unbiased, i.e. they average out over time.
More importantly, the Atlanta Fed model revised its Nowcast upwards on several occasions over the last few months whereas the New York Nowcast and all the private forecasters revised their GDP estimate downwards. Clearly, the Atlanta's model forecast got better overt time as this quarter progressed whereas most other GDP estimates got worse. It therefore seem that the GDP Nowcast model has a significant edge, not only compared to the other Nowcast models, but also compared to private sector estimates. This quarter's GDP Nowcast estimate is another big win for the Atlanta model!
The Atlanta Nowcast estimate for Q1
The New York Nowcast estimate for Q1
I have written previously on the US yield curve inversion. An inverted yield curve has historically been one of the best recession predictors. While it is not entirely clear why, one of the reasons seems to be that when the short-term rate is higher than the long-term rate, the Fed usually has tightened monetary policy too much. Low long-term rates obviously indicate a combination of expected lower future short-term rates and low growth prospects in the future. Moreover, given the degree of interest rate inertia and the Fed’s unwillingness to reverse course, the monetary tightening produces a recession. While I’m not entirely sure why this should be different, the Fed has recently proven that it will abandon its monetary tightening until the inflation rate accelerates. Markets are even pricing in this year a Fed rate cut now. However, this also implies that monetary policy might actively become tighter if the Fed does not fulfil market expectations. As the charts below show, the yield curve has not only inverted in the US, but also in other countries: Canada, Japan, and Germany. The Canadian inversion actually looks particularly nasty (see pictures below). However, the US and Canada still have short-term interest rates that are above zero (even though not very far above). This implies that the two Central Banks do actually have some room for rate cuts and monetary easing to respond to the global synchronized economic slowdown that is currently happening. Both the Eurozone and Japan are not so lucky because short-term interest rates are still constrained by the effective lower bound, thus also explaining why both Germany’s and Japan’s yield curve are only slightly inverted as interest rates cannot fall substantially below zero. The ECB, of course, just ended its asset purchase program last December, and is now presiding over yet another economic slowdown in the Eurozone. This does not seem to be a coincidence. Japan is still executing an asset purchase program right now, which has been extremely substantial in size. Further easing therefore seems to be unlikely. While a rewind of the ECB’s QE might be warranted, it rather seems unlikely to happen. Of course, Central Banks can theoretically never run out of financial assets to buy. So the current constraints are rather political and institutional in nature. Precisely for these reasons, we should be worried about the current economic slowdown because Central Banks have limited capacity for further easing and fiscal policy makers do not seem to intend to pick up the slack. These yield curve inversions therefore seem to be a harbinger of pretty bad news.
Yield curve inversions for the US and Canada:
Both countries feature an inverted yield curve compared to just a few months ago. However, short-term rates are still above zero, meaning that both Central Banks have potentially some room to ease monetary policy.
Yield curve inversion for Germany and Japan
Both countries have a slightly inverted yield curve despite short-term interest rates already being below zero in nominal terms, which is insane.
Turkey has a completely inverted yield curve. This could indicate two things. First, inflation rates, which are currently running at 20% or so, are expected to come down again in the very long-run. But it also probably implies the prospect of slower economic growth in the immediate future. After growing reasonably strongly in recent years, Turkey's economy seems to be in recession territory right now.
In my previous two blogposts (here and here), I have written about the fact the fact that the global economy is currently slowing down quite rapidly, especially in the Eurozone. However, GDP predictions for Q1 for the US were looking quite miserable as well. However, this might have been maybe a too hasty judgement since the most recent data has shown some improvement. I have written before on the different GDP Nowcast models. Historically, the GDP Nowcast model used by the Atlanta Fed has been the most accurate with an average absolute forecast error of under 0.6%. Just in the beginning of March the model forecasted a Q1 GDP figure of less than 0.5%. Now one month later, this estimate has increased to 2.1% and is therefore much more bullish than both the NY Fed Nowcast (at 1.3%) or the Blue Chip consensus (see figure below).
There is still a good chance that the first quarter growth rays might come in at only 1%, which would be well-below the Fed’s estimate of the economy’s long-run potential (~2%), but the probability of this happening seems to be lower now than just a few weeks ago.
According to the Atlanta model, the increase in its GDP estimate comes mostly from a higher contribution of net exports as well as inventories. While both items were supposedly subtracting from GDP growth more than a month ago, their contributions have now turned positive in recent weeks, therefore leading to the revised GDP estimate. As previously stated, the Atlanta model has so far outperformed its NY counterpart in terms of forecast accuracy. The upward revision in its GDP estimate has been quite dramatic and as far as I recall there are very few quarters where the forecast has changed to such an amount in one direction within just a few weeks. Furthermore, the Blue Chip consensus estimate as well as the NY Fed Nowcast have remained fairly stable/slightly trended downwards over that time period. We will find out in a couple of weeks from now whether the dramatic improvement in the Atlanta Fed’s model was warranted or whether it will turn out to be an outlier. Stay tuned!
I have written about the various GDP Nowcast models the Fed uses on this blog before. Both the Atlanta Fed Nowcast and the New York Fed Nowcast model are based on the dynamic factor methodology. The idea is to extract on common factor variables from a large number of macroeconomic time series data that is available at a higher frequency than GDP. The latent factor then helps us to recover an estimate for GDP in real-time. The St. Louis Nowcast, on the other hand, is based on a different methodology that extracts information from economic surprises.
Based on my previous analysis, I found that the Atlanta GDP Nowcast model has so far the best track record with an average absolute forecast error for quarterly GDP figures of about 0.6% whereas the New York Nowcast and the St. Louis Nowcast produce absolute forecast errors of 0.9% and 1.1%, respectively. By the way, the St. Louis Nowcast doesn't seem to produce much better results than a simple random walk (simply predicting that next quarter's GDP growth will be the same as the previous quarter), and thus seems to be relatively inaccurate as a forecasting device.
Last year's GDP figure came in very strong with an annual growth rate of about 3% for 2018 despite the fact that the Fed hiked interest rates 4 times. It is now a relatively safe bet to assume that the massive Trump tax cut provided a short-term stimulus to the economy. However, it does not seem to have done much to the economy's long-run potential. Business investment is not substantially higher and most estimates of the economy's long-run growth rates have remained unchanged.
As for 2019, we can already see a substantial slowdown in economic activity across the globe. While the economic data for the Eurozone seems to be worse, GDP Nowcast models suggest that the first quarter of 2019 might come in at just about 1.5% while the NY Nowcast for the 2nd quarter is at 1.7%. Both values are therefore slightly below the economy's long-run potential which Fed economists have pegged at just a little below 2%.
For those who want to keep track of the GDP Nowcast forecasts and its accuracy, have a look at the table below. Both the Atlanta as well as the NY model seem to be unbiased, meaning that errors cancel out over time, whereas the St. Louis model consistently overestimates GDP growth. As mentioned above, the Atlanta model produces the lowest absolute forecast errors. Taken all the predictions into account, it wouldn't surprise me if Q1 GDP growth comes in somewhere in between 1% and 1.5%, which would represent a significant slowdown from last year's expansion.
GDP Nowcast models
On the right hand side of the table, you can find the forecasted values compared to the BEA's advanced GDP estimate for the quarter in question. On the left hand side, I have calculated the error and absolute value of the error for each model.
It therefore seems that last year's Fed rate hike cycle was somewhat premature and that it has now turned into a drag for the overall economy. Financial markets are already pricing in that the Fed will lower rates again this year. This also implies, by the way, that monetary policy is actively becoming tighter as we speak if the Fed persists on not lowering rates, given that the natural rate of interest seems to be decreasing again. The recent yield curve inversion, historically one of the only reliable predictors of a future recession, seems to indicate to me that the Fed has already increased the short-run rate above the natural rate, and that is why the risk of a recession has increased sharply.
Furthermore, as Paul Krugman recently pointed out on Twitter, it might make a fundamental difference that the yield curve inversion happened when rates are just at 2.5% instead of at more than 5%, as during the previous expansion. In the past, the Fed has lowered interest rates by about 500 basis points each time when an economic downturn occurred. Given that long-term rates indicate the expected future path of short-term interest rates, any yield curve inversion in the past must have reflected at least some probability that the Fed would lower rates by at least 500 basis points to combat an upcoming recession. However, as of right now, the Fed can lower rates by only about 240 basis bounds until it hits the zero-lower bound again. Bond markets therefore already price in the possibility that the Fed cannot ease monetary policy to the same extent as it did in the past. It would therefore only be prudent for the Fed to take out some recession insurance right now, meaning that it should aggressively ease monetary policy before it's too late. A strong commitment to keep nominal GDP on a stable path of 4 to 5% annual growth combined with a rate cut of maybe 50 basis points might actually do the trick. Unfortunately, I believe that the Fed board will be reluctant to decrease interest rates again just half a year after they announced that the rate hike cycle would continue in 2019. While in the Fed meeting of last week Powell and Co. have now sworn off any further rate hikes for the rest of the year, I do not think that this will be enough to keep the economy from decelerating. Current policy is still characterized by too much interest rate inertia, and more likely than not, the Fed will find itself behind the curve again in a few months' time. Last week’s Fed meeting was therefore much less dovish than the financial press has acknowledged so far.
The recent decline in long-term interest rates indicates that the global economy must brace for another economic slowdown, thus confirming Larry Summer's theory on secular stagnation. Some 10 trillion of debt are having a negative yield again, which is totally crazy when you think about it, with 10-year German government bonds having a yield of zero and their Japanese equivalent having a yield that is a few basis points below zero.
While a coordinated strong fiscal expansion across the Eurozone could be the cure, it is extremely unlikely that Europe will get any positive fiscal impulse any time soon, as the German government still insists on balanced budgets. Given that the ECB just ended its asset purchase program in December of last year and interest rates are still negative, the ECB has even much less room to maneuver than the Fed. More likely than not, the next recession will start in the Eurozone whereas policy makers in the US potentially have the capacity to engineer a soft ending for the end of this now 10-year long expansion. Unfortunately, history is not on their side.
Last year, the Federal Reserve undertook a major tightening cycle and hiked rates 4 times. Just half a year ago, members of the Fed board thought that in 2019 they would be able to accomplish the same feat and hike interest rates another 4 times to reach a level of about 3% by the end of the year. This was always utopian thinking. It is unfortunate that I didn't mark my beliefs to market lat the time because in my mind it was never plausible that they would reach a level of 3% by the end of this year, or any time soon. So unfortunately I cannot link to any previous writing of mine in which I called out that such a substantial rate hike cycle for 2019 would be quite unlikely.
However, now it turns out that this view is vindicated. In fact, the yield curve has just inverted on Friday, meaning that interest rates on 3-months Treasuries are now higher than rates on 10-year bonds. The yield curve inversion has been in the past the only and most reliable signal of a future recession. Furthermore, it now looks more likely than not that the next interest rate moves will be a decrease rather than an increase. It therefore increasingly looks like the tightening cycle of last year was somewhat premature. With the global economy slowing down quite substantially and the stimulatory effect of the Trump tax cut wearing off right now, it might be necessary now to cut rates again even though they are only at a little over 2%. And financial markets seem to agree, given that they are pricing in at least one rate decrease over the next year.
Secular stagnation is therefore a reality now. Nominal interest rates are still negative in Japan, the Eurozone, Sweden and Switzerland. In fact, interest rates are low across the globe because several structural factors have pushed them down for decades now: Ageing societies, low productivity growth, rising inequality, and maybe rising monopolization.
Even though the Fed is to some extent the global Central Banker, providing dollar liquidity to the entire world, they also are not immune from these long-run macroeconomic forces that have affected the global economy substantially. Interest rates in the US have already decoupled from other advanced economies quite substantially. However, a further divergence always seemed unlikely, given that the gap between US rates and Euro rates already exceeds 2 percentage points. Further interest rate hikes would push up the value of the dollar substantially, making US industries uncompetitive and slowing down domestic demand. In fact, my own research shows that interest rates are to a very large extent determined by global factors in today's world of global capital flows. This is also true for the US economy.
While I do not predict a US recession over the next 12 months, GDP Nowcast models already show a substantial economic slowdown compared to the 3% growth the US economy achieved last year. However, the odds of a recession have increased with the inversion of the yield curve, which seems to indicate to me that the Fed tightened too much over the last year.
Everything will now depend on the reaction function of the Fed. Just this week, Powell indicated that they will not increase rates anymore this year. While the US economy never really accomplished a soft landing, a recession does not necessarily have to be baked in by now. It will mostly depend on the degree of interest rate inertia, meaning how quickly the Fed will respond to a slowdown of the economy by starting to ease monetary policy again.
While the past does not give us too much hope, maybe this time is different?
PS: We should be much more worried about the Eurozone where the latest economic data has been extremely disappointing just as the ECB stopped its program of Quantitative Easing. Coincidence? Given that rates are still negative, the ECB can only ease policy by purchasing new assets. However, this seems to be a relatively unlikely step, given how much political backlash such a policy would produce. So we should all be very worried if the slowdown in the Eurozone turns out to be much more severe and persistent.
Another US yield curve inversion: Harbinger of bad news?
Secular stagnation: it's time to admit that Larry Summers was right about this global economic growth trapJulius Probst, Lund University
In the autumn of 2013, former US treasury secretary Larry Summers proposed in a seminal speech at the International Monetary Fund headquarters in New York that the global economy had entered a long-term economic slump. Invoking a previously discredited 1930s theory known as secular stagnation, Summers argued that it may have become all but impossible to boost growth by using the age-old trick of lowering interest rates to encourage more investment and consumer spending. The answer, he argued, was for governments to spend more instead.
Summers would go on to suggest that secular stagnation “may be the defining macroeconomic challenge of our times”. There followed a major debate between heavyweight economists about whether he was right, but for several years the global economy contradicted him by growing steadily.
Now, however, this looks to be at an end. Look no further than the OECD projections from March 6, which foresee all advanced economies growing much more slowly than anticipated a few months ago. The left-hand chart below shows the OECD projections from last May, while the right-hand chart shows the latest outlook, complete with red arrows to indicate the sharpest downward revisions.
The overarching global theme seems to be Donald Trump’s trade war and the fact that central banks have been tightening monetary policy: the US Federal Reserve has hiked interest rates four times in the past year, while the European Central Bank is no longer “printing” money through its programme of quantitative easing. There are additional local reasons, such as UK fears about a hard Brexit, or excessive levels of private sector debt in China. Underlying all of this, however, is the growing feeling that secular stagnation is a major drag behind the scenes.
Back in fashion
The theory was originally put forward in 1938 by the Harvard economist Alvin Hansen in response to the Great Depression. He argued that America’s economy was suffering from a lack of investment opportunities linked to waning technological innovation; and not enough new workers due to an ageing population, too little immigration, and the closing of the old economic frontier in the American West.
In Hansen’s view, the weak growth in the economy was therefore here to stay – “secular” means “long term” in this context. Yet he would soon be proved spectacularly wrong as World War II provided a big temporary boost to the economy in the form of military spending, followed by a post-war baby boom and rapid technological progress in the 1950s and 1960s. Little more was heard of secular stagnation until Larry Summers’ intervention.
At the core of the theory today is real interest rates. This refers to the long-term interest rate, meaning the rate of return on ten-year government bonds, after inflation has been stripped out. For example, if a country’s long-term interest rate is 1% but the rate of inflation is 2.5%, the real interest rate is -1.5%.
When you take a global average of real interest rates from different countries, my own research shows that the global rate has declined from more than 5% in the early 1980s to below 0% after the financial crisis of 2007-09. Today, real interest rates remain negative in many advanced economies, including Japan, Sweden, Switzerland and the entire eurozone.
Summers has pointed to several structural factors behind this long-term decline. In an echo of what appeared true in 1938, rich countries are ageing as birth rates decline and people live longer. This has pushed down real interest rates because investors think these trends will mean they will make lower returns from investing in future, making them more willing to accept a lower return on government debt as a result.
Other factors that make investors similarly pessimistic include rising global inequality and the slowdown in productivity growth. It is a major paradox that labour productivity, the most important source of long-run economic growth, is actually rising much slower today than for decades, even though technological progress has seemingly accelerated.
This decline in real interest rates matters because economists believe that to overcome an economic downturn, a central bank must drive down the real interest rate to a certain level to encourage more spending and investment. This is referred to as the level required to reach full employment. Because real interest rates are so low, Summers and his supporters believe that the rate required to reach full employment is so far into negative territory that it is effectively impossible.
Summers argues that this problem is why the massive cuts to headline interest rates after the financial crisis did not solve the problem. In other words, monetary policy was actually much less expansionary than many people believe (even though quantitative easing was actually helpful here). Not only that, there is now substantial evidence that austerity policies in places like southern Europe made things significantly worse.
The upshot is that in the eurozone and elsewhere, there is little or no room to cut interest rates when the next recession comes – probably fairly soon given the current expansion is already a few years old. Central bankers will meanwhile be wary of using more quantitative easing, since it has generated a lot of political backlash.
So what to do instead? Interestingly, the one country not to have had a recession in almost 30 years is Australia, which has enjoyed very high population growth and has never seen interest rates as low as many countries. This suggests that in the long run, more immigration might be a vital part of curing secular stagnation. Summers also heavily prescribes increased government spending, arguing that it might actually be more prudent than cutting back – especially if the money is spent on infrastructure, education and research and development.
Of course, governments in Europe and the US are instead trying to shut their doors to migrants. And austerity policies have taken their toll on infrastructure and public research. This looks set to ensure that the next recession will be particularly nasty when it comes. Alvin Hansen may have been wrong in the 1930s but his analysis is looking increasingly persuasive today. Unless governments change course radically, we could be in for a sobering period ahead.
A thanks to CATO
Last July I attended a summer program called "Alternative Money University" at the CATO Institute in Washington DC. The main theme of the course was to learn lessons from economic history, alternative monetary arrangements as well as alternative monetary theory. The course thus offered a rather unique approach to monetary economics that one might not get exposed to when doing a regular economics undergraduate or even graduate program, which all too often only contain "mainstream" ideas. I was one out of 30 students who got accepted for this summer school, which CATO organized for the first time. Not only was the summer school an amazing experience, but it was also fully funded by the CATO institute and I hereby would like to express my gratitude to George Selgin, the director of the Center for Monetary and Financial Alternatives at CATO, all the organizers of the event as well as the speakers who participated in the program.
The program included, amongst others, lectures by George Selgin on the history of banking and the Federal Reserve. Larry White was talking about free banking and cryptocurrencies. Scott Sumner and David Beckworth, on the other hand, were mostly focusing on modern Central Banking, the Great Recession, and the mistakes that were made by Central Bankers and other policy makers in response to the crisis.
Some thoughts on financial history and free banking:
In what follows, I will mostly focus on free banking as an alternative monetary regime, which was in some way the most interesting to me because my knowledge of this topic was somewhat more limited, and I suspect that the same is true even for some economists.
While most people simply assume the existence of a Central Bank as well as the fact that the government has a natural monopoly on printing money and issuing bank notes and currency, this state of things cannot by any means be described as the natural order of things. Instead, governments realized over time that they had an incentive to monopolize money and money creation. They therefore created Central Banks as to become the sole beneficiary of seigniorage, the profit the Central Bank makes by issuing costless fiat currency and investing the proceeds in interest rate bearing assets, usually government bonds. Of course, it should be noted here that the Central Bank cannot issue currency without limits as in the long-run the rate of inflation is almost correlated one to one with the rate of money growth.
The development of modern finance took place in early modern Europe a few centuries ago. The first modern banks emerged in Italy during the Renaissance era. Later on, the Netherlands and the UK took over and became the most financially developed countries in the world during the Age of Enlightenment (18th century). Modern bond markets, both for private bills of exchange as well as for government bonds, developed in the Netherlands and the UK just prior to the Industrial Revolution, and so did modern stock markets (Neal, 2015).
Some economists have made the argument that finance has significantly contributed to modern economic growth and that the Industrial Revolution would not have been possible without the development of modern financial markets (Neal, 2015). There is in my mind no doubt that there is some truth to that claim, given that any entrepreneurial activity, let that be just commercial trade or the development and production of some kind of good, requires some kind of financial funding and startup capital
That being said, financial markets are also occasionally prone to excessive euphoria. The first financial bubbles formed alongside the development of financial markets, one example being the South Sea Bubble of 1720 when a large number of companies, some of them fraudulent, attracted a large inflow of money on the promise for spectacular returns based on potential trade opportunities with the New World. Markets eventually crashed when the speculative frenzy ended (Kindleberger, 2000).
The financial system during that time looked fundamentally different from nowadays, as modern Central Banks did not exist yet. Bank notes were issued by commercial banks instead, one but by far not the only aspect of a free banking regime. Note that the Scottish pound, which is on par with the British pound and also accepted as currency in England, is still issued by three commercial banks in Scotland.
There is in the public some mysticism about banking and money creation, a lot of it coming from the modern monetary theory crowd (MMT), as those issues are in general not very well understood. According to some people, standard economic textbooks do not cover financial topics adequately. Mostly, the claim that banks can create credit out of thin air (which is basically true) is indeed sometimes swept under the rug, at least in Econ 101. Regardless, it does not really change what Keynes, Friedman, and Tobin have been teaching us about monetary economics, Central Banking, and the extent to which Central Banks can determine and influence aggregate demand and the aggregate price level (Tobin, 1969).
Banks have been creating credit for hundreds of years, and during the period of free banking in Scotland in the 18th century banks were also issuing private bank notes competitively. The fact that banks can issue notes does not by any means imply that they will do so without bounds, just like the fact that nowadays banks will not create credits without bounds (Selgin and White, 1987). Banks are constrained by the economic environment they face, and issuing additional credit or even bank notes is not free. The graph below displays the balance sheet of a bank under free banking. Assets must equal liabilities plus bank equity. On the asset side of the balance sheet you have reserves plus loans, the liability side consists of demand deposits as well as privately issued bank notes in circulation (plus equity capital).
Bank's balance sheet in a free banking regime
It should be immediately clear then that it is not possible for a bank to costlessly extend the liability side of the balance sheet. Issuing more currency is not free, since the bank either has to attract additional reserves or make more loans, both of which are not costless. It is thus rather obvious that commercial banks in a regime of free banking do not have an incentive to issue more and more currency ad infinitum. By the way, a similar argument holds for the asset side of the balance sheet. The marginal cost of extending credit and issuing more loans is an increasing function as banks are constrained by the public's willingness to hold their liabilities, meaning demand deposits (and currency in the free banking world).
Just as for other companies, a profit-maximizing bank must ensure that its equi-marginal conditions hold. More specifically, the marginal benefit of lending must be equal to the marginal cost of financing via note issuance. Simultaneously, the marginal benefit of lending must also equal the marginal cost of financing via bank deposits.
While it is in a way very cheap to simply issue more notes and put them into circulation, a bank must make sure that the clients are also willing to hold the additional currency and keep them in circulation, thus effectively putting a number of constraints onto the bank that prevent it from over-issuance of bank notes. One costly way to increase the demand for one's banknotes is to attract more depositors. However, in the free banking world, there is a number of banks that are actively competing with each other, both in terms of attracting new deposits as well as in terms of issuing new currency. The banknotes that are privately issued by commercial banks thus compete with each other and circulate simultaneously, but should effectively be traded at par, unless regulatory constraints prevent the system from working (Gorton, 2012). The US is one example where commercial bank notes were not trading on par during the 19th century, this was to some extent the result of legislation that did not allow banks to branch out across states (Calomiris, 2006).
In a more or less competitive banking system, moral hazard should also be much less of an issue, especially if deposit insurance and the problem of "Too big to fail" are eliminated. Consumers would monitor their own bank deposits and switch to a competing bank if there is any sign of trouble, thus effectively imposing some market discipline on the system.
Of course, the argument that an unregulated banking system based on market discipline works rests on the assumption that both consumers and bankers are mostly rational and that many of the human tendencies that behavioral economics has described in recent years, human heuristics, pretty much cancel each other out in aggregate on the macroeconomic level. In other words, the efficient market hypothesis must be more or less true and the banking sector must also, for the most part, not exhibit any major information asymmetries, or other externalities that would require government involvement. However, if you believe instead like Minsky that financial markets are prone to instability and speculative behavior that is built into the system, a result of the human psyche to be overconfident and leverage up during the boom, only to become excessively pessimistic and deleverage during the bust, then unfettered financial markets combined with an unregulated banking system might not be such a good idea after all (Minsky, 1986). Paraphrasing Keynes, who actively speculated in financial markets and lost quite a bit of money at times: Markets can stay irrational longer than you can stay solvent (Keynes, 2018; Leijonhufvud, 1967).
Selgin and White have discussed how the period of free banking in Scotland during the 17th century was mostly characterized by financial stability (Selgin and White, 1987). It is not entirely clear to me though whether such a regime would also work in today's world of integrated financial markets and rapid capital flows across borders. Furthermore, we are as far away from the free banking world as one can possibly imagine. The financial crisis of 2007 has actually aggravated the "Too big too fail problem" as concentration in the US banking sector has actually increased over the last decade. Even more concerning, the Fed has significantly changed its "modus operandi" over the last 10 years as well. Given the problems Central Bankers faced when they hit the zero-lower bound in the aftermath of the financial crisis, they introduced a variety of tools that were outside the usual monetary tool box. While asset purchases of Treasuries and long-term government bonds are basically standard monetary policy operations, purchases of private sector bonds are not. These are credit easing policy tools, which can potentially have a distortionary effect on the economy. They do not operate by increasing aggregate demand in general via an injection of base money, but more or less act as a subsidy to one single sector, thus shifting resources from away from potentially more productive enterprises and undertakings. The same can be said for interest rates on reserves, which is a contractionary policy that at the same time is a direct transfer to the banking sector (see Selgin's blog posts at Alt-M on this topic).
The current monetary system, especially in the US but also in Europe, is thus the exact opposite of what market monetarists or free banking advocates have in mind. Market concentration in the banking sector is abnormally high and the federal government subsidizes large banks with an implicit bailout guarantee because "Too big to fail" is even more of an issue nowadays than it was 10 years ago. Furthermore, deposit insurance leads to a moral hazard problem as depositors do not have to actively monitor their banks, which can assume additional risks in a world where the state or the Central Bank is the lender of last resort. Finally, instead of pursuing monetary policy, the Fed is also in the business of paying interest on reserves and making credit policy, which has distortionary effects on the economy by potentially misallocating resources.
So where do we go from here?
I am very skeptical that we will ever experience and return to something that will resemble a free banking system. Regardless, we can and should strive to go in that direction. As a starter, the banking system should be made more competitive. Eliminating too big to fail subsidies and allowing free entry would be a good start. Furthermore, the Fed should end its credit policies and go towards a system where monetary policy is the main and only objective.
Scott Sumner (2012) has argued repeatedly that the Fed's particular target, and even more importantly, its toolkit is somewhat flawed. The fixation on interest rates is outright dangerous, given that most people are confused about this particular issue and equate low interest rates with easy money. However, interest rates are a very poor and misleading measure for the stance of monetary policy. The so-called natural rate of interest, which is consistent with economic and price stability in the long-run, is unobservable, and even ex-post, our measures of the natural rate are quite unreliable.
Ultimately, the best indicator for the stance of monetary policy is inflation and/or the rate of nominal GDP growth. The Fed should therefore move towards a system where they ensure a nominal GDP level target consistent with a NGDP growth rate of maybe 4 to 5% per year (Sumner, 2012). They could achieve this target with one particular policy tool: Open market operations that increase or decrease the amount of base money in the system by agreeing to buy and sell NGDP futures in unlimited amounts as to hit the nominal GDP target. The base money supplied by the Fed then simultaneously serves as reserves for the banking system. Market prices in the NGDP futures market are used as an indicator of whether the economy is growing at the target rate and also as an indicator for how much base money is demanded by the banking system. The Fed would then simply adjust the supply of base money in accordance with shifts in demand, thus eliminating more or less any discretionary policies and putting monetary policy on autopilot, a framework that has been advocated by Scott Sumner (2015).
The history of free banking as an alternative monetary regime, suggestions for reforming the current operating framework of the Federal Reserve, current Fed policy, as well as other monetary topics were all discussed during Cato's Alternative Money University. Of particular notice last year was also James Bullard's discussion of cryptocurrencies. However, the entire week's program was far too extensive to summarize in one long or even several shorter blogposts. I hope that future students at Cato will love the program as much as I do.
Seven charts that show the world is actually becoming a better placeJulius Probst, Lund University
Swedish academic Hans Rosling has identified a worrying trend: not only do many people across advanced economies have no idea that the world is becoming a much better place, but they actually even think the opposite. This is no wonder, when the news focuses on reporting catastrophes, terrorist attacks, wars and famines.
Who wants to hear about the fact that every day some 200,000 people around the world are lifted above the US$2-a-day poverty line? Or that more than 300,000 people a day get access to electricity and clean water for the first time every day? These stories of people in low-income countries simply doesn’t make for exciting news coverage. But, as Rosling pointed out in his book Factfulness, it’s important to put all the bad news in perspective.
While it is true that globalisation has put some downward pressure on middle-class wages in advanced economies in recent decades, it has also helped lift hundreds of millions of people above the global poverty line – a development that has mostly occurred in South-East Asia.
The recent rise of populism that has swept across Western countries, with Trump, Brexit, and the election of populists in Hungary and Italy, among various other factors, is thus of great concern if we care about global welfare. Globalisation is the only way forward to ensure that economic prosperity is shared among all countries and not only a select few advanced economies.
While some people glorify the past, one of the big facts of economic history is that until quite recently a significant part of the world population has lived under quite miserable conditions – and this has been true throughout most of human history. The following seven charts show how the world has become a much better place compared to just a few decades ago.
1: Life expectancy continues to rise
Even during the Industrial Revolution, average life expectancy across European countries did not exceed around 35 years. This does not imply that most people died in their late 30s or even 40s, since it was mostly very high levels of child mortality rates that pulled down the average. Women dying in childbirth was obviously a big problem too. So were some common diseases such as smallpox and the plague, for example, which now have been completely eradicated in high-income countries.
2: Child mortality continues to fall
More than a century ago, child mortality rates were still exceeding 10% – even in high-income countries such as the US and the UK. But thanks to modern medicine, and better public safety in general, this number has been reduced to almost zero in rich countries.
Plus, developing economies like India and Brazil now have much lower child mortality rates today than advanced economies had at similar income levels about one century ago.
3. Fertility rates are falling
Even though many are concerned about the global population explosion, the fact is that fertility rates have fallen significantly across the globe. UN population estimates largely expect the global population to stabilise at about 11 billion by the end of this century.
Moreover, as can be seen from the chart, many developing countries such as Brazil, China and a number of African nations have already switched to a low-fertility regime. While this transition took many advanced economies almost 100 years, starting with the Industrial Revolution, many others have since achieved this over just two to three decades.
4. GDP growth has accelerated in developed countries
Technological leaders, the US and Western Europe, have been growing at about 2% per year, on average, for the past 150 years. This means that real income levels roughly double every 36 years.
While there were many long-lasting ups and downs, like the Great Depression or the recent Great Recession, the constancy of the long-run growth rate is actually quite miraculous. Low-income countries, including China and India, have been growing at a significantly faster pace in recent decades and are quickly catching up to the West. A 10% growth rate over a prolonged period means that income levels double roughly every seven years. It is obviously good news if prosperity is more shared across the globe.
5. Global income inequality has gone down
While inequality within countries has gone up as a result of globalisation, global inequality has been on a steady downward trend for several decades. This is mostly a result of developing countries such as China and India where hundreds of millions of people have seen their living standards improve. In fact, for the first time ever since the Industrial Revolution, about half of the global population can be considered global middle class.
6. More people are living in democracies
Throughout most of human history people lived under oppressive non-democratic regimes. As of today, about half of the human population is living in a democracy. Out of those still living in autocracies, 90% are in China. While the country has recently moved in the other direction, there is reason to believe that continued economic development might eventually lead to democratisation (according to modernisation theory).
7. Conflicts are on the decline
Throughout history, the world has been riven by conflict. In fact, at least two of the world’s largest powers have been at war with each other more than 50% of the time since about 1500.
While the early 20th century was especially brutal with two world wars in rapid succession, the postwar period has been very peaceful. For the first time ever, there has been no war or conflict in Western Europe in about three generations, And international organisations including the EU and the UN have led to a more stable world.
Asset markets are crashing. What's going on?
Well, Central Banks are tightening monetary policy too fast. The ECB is ending Quantitative Easing just as the Eurozone economy is slowing rapidly. Abenomics in Japan is loosing some pace because the BOJ has boosted its balance sheet to more than 90% of GDP while still not hitting its 2% inflation target. Why stop now though? Full steam ahead, please.
Finally, the Fed is increasing interest rates, probably too rapidly. The following graph shows how US rates and Eurozone rates have been diverging over the last few years.
The picture also shows that Eurozone interest rates follow US rates quite closely, usually with a lag of one to two years. That is because the Fed is the monetary superpower and providing liquidity for the entire world. My own research has shown that a significant variation of interest rate movement can be explained by global factors. See here.
Source: Spiegel Online
I strongly believe that the Fed is largely overestimating its capacity to increase interest rates in our new world of secular stagnation, i.e. low global real interest rates. Further US tightening of monetary and financial conditions would come with a significant dollar depreciation and strangle US manufacturing.
The divergence between US rates and Eurozone rates cannot last forever. Since the ECB is committed to keep rates low for at least another half a year, the Fed will not be able to push up rates very much further, at least if it doesn't want to strangle the US economy.
Another US recession, most likely the result of too rapid tightening, would of course bring US rates down again, and in alignment with rates across most other advanced economies.
So I was having a look at the VIX recently, which is a measure of volatility of the US stock market (and more specifically the S&P 500). If volatility in the stock market goes up, the VIX increases (see picture below). While the efficient market hypothesis suggest that asset prices are mostly driven by fundamental values, there is a a lot of evidence that asset prices can actually diverge from fundamental values for longer periods of time. This might be especially true for the housing market since it is more difficult to go short housing and bet against price increases. However, as Keynes already noted, the market can stay irrational longer than you can remain solvent. A remark he surely made after loosing quite a bit of money as an investor in financial markets himself. Especially during times of irrational exuberance, it might be very painful to go short the stock market since the time of euphoria might last longer than you can afford to bet against it. In the movie the big short, legendary investor Michael Burry was almost priced out of the market by losing cash flow before his big bet on shorting the housing market eventually market paid off.
While most macro models, including neo-Keynesian macro, assume that the economy is inherently stabilizing, Keynes would probably have dismissed this extremely rigid assumption. He never regarded the economy as returning back to equilibrium after being hit by negative shocks.
Economists like Kindleberger and Minsky have also written extensively about financial panics and crashes as well as about financial instability. According to the financial instability hypothesis suggested by Minsky, financial risks build up endogenously within the system over time. We have a lot of evidence that after large macroeconomic shocks like the Great Depression that affect an entire generation, people change their behavior for many years. They become more risk-averse, stock market participation decreases for many years. Similarly, after long periods of financial stability, individuals, firms, and market participants assume more and more risky positions. Gambling starts to pay off, leverage increases, and ultimately so does fraud. As financial leverage and exposure to risky positions increases, the system becomes more fragile. Then it is ultimately only a matter of time when a shock hits the system, culminating in a large macroeconomic event as the entire house of cards built on leverage and debt crumbles.
It is maybe not a coincidence that the financial crisis of 2008 and the Great Recession that followed was proceeded by the Great Moderation, a time period from the late 1980s spanning to the mid-2000s characterized by relatively high macroeconomic stability, at least across advanced economies. It is still a matter of debate whether the Great Moderation was the result of luck or policy makers like Central Bankers becoming better at their jobs. Regardless, while macroeconomic management was reasonably well, financial risks were starting to build up within the system that went undetected for a long time. It was also mistakenly believed that financial globalization would actually work in favor of stabilizing the system and diversifying risks, an assumption that turned out to be dangerously wrong. Some recent research based on the Macrohistory data suggests that financial globalization has actually increased the correlation between national asset prices and national business cycles across countries. The benefits of global diversification might thus quickly evaporate as financial linkages and global capital flows imply that asset prices across the globe move in the same direction, regardless of fundamentals.
It is thus interesting to see that the VIX was extremely low during the early 2000s, before exploding in 2008 as financial markets froze up during the financial crisis. Similarly, the VIX has been trading at very low levels over the last few years while as of this year it has edged upward quite a bit as a result of much higher volatility in the stock market, surely a result of the escalating trade war by Trump and the Fed tightening monetary policy for the US (and the rest of the globe).
While there have been some attempts to model endogenous financial crisis, I am not aware of any of the research achieving major breakthroughs, to be honest (but happy if proven wrong). The problem is that these kind of endogenous forces are very hard to model. It is easy to understand how after a long period of calm and stability market participants start to forget about the risk, increasingly engage in risky and fraudulent behavior, and also increase their leverage and exposure to bad market events. However, to show that agents systematically behave in a certain way is an entire different thing altogether. There are very few of any good predictors of economic and financial crisis. While policy makers often screw up in one way or the other, again how and why they do so cannot be modelled in any systematic way, thus also making any major economic shock unpredictable. Some recent research has shown that most financial crisis are preceded by asset price bubbles and result from the dangerous interaction between asset price deflation and exposure to debt. However, again these two variables alone cannot help us to predict the exact timing of a bursting bubble, and as a market participant or monetary picky maker, timing is everything.
So where does this leave us ?
Well, I’m afraid that all of this basically means the following. Policy makers and market participants cannot predict bursting bubbles, financial crisis or even economic recessions. The only thing we can do is to make the system more robust so that it can withstand even major economic shocks. Unfortunately, also on this front little progress has been made. Lobbying and other political obstacles mean that higher capital requirements for financial institutions have not been imposed to the extent that it would be necessary to prevent the next financial crisis.
In terms of the VIX, we have sent that a couple of years of really low volatility have now been followed by one year of increased uncertainty, heightened volatility, and the occasion market crash followed by a rebounce. Really hard to say what all of this implies for the future. Since asset prices are mostly unpredictable and economists cannot forecast recessions with any reasonable degree of accuracy, I won’t make any futile attempt to forecast the unknown.
PS: I wrote all of this before yesterday’s market crash. It should be noted that one part of the yield curve inverted today, which has historically been one of the only predictors of a future recession. The risks of a downturn just increased dramatically with the spectacular crash hat happens at the long end of the yield curve. If the Fed continues to tighten aggressively, we can expect a recession in about 12 to 18 months from now.
My name is Julius Probst.