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John Maynard Keynes

"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)

Other Economics Blogs

Stock market crash: Benign or malign?

10/11/2018

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Stock markets took a really big hit yesterday with the Dow Jones and S&P 500 falling by more than 3%. Stock markets also fell in Asia and Europe and are in the red today again across most advanced economies (see below).
It is not entirely clear to me what exactly precipitated this selloff. The first thing to remember is that the stock market is not the economy. Equities can crash without dragging the macroeconomy down with them like in 1987. However, it helps if the Central Bank does its job and stabilizes aggregate demand. In that case, a more accommodative monetary policy can offset all the negative effects of a market selloff.
The projections for quarterly GDP for the US economy for the third quarter look extremely good with the Atlanta GDP Nowcast now forecasting a growth rate of just about 4%. While the New York Fed's Nowcast model predicts only 2.8%, the Atlanta model has historically been more accurate. Moreover, most private forecasters now expect a growth rate of more than 3% as well.
While the Fed was widely expected to raise rates one more time by the end of the year, the current stock market turmoil might actually lead to a different path of rate hikes now. However, this is far from certain. A significant portion of the stock market is hold by the top 10%, who have a very low marginal propensity to consume.  
Ultimately, a temporary selloff will only have very limited effects on the macroeconomy since it is not supposed to affect consumption or investment decisions in any significant matter. While there is a case to be made that American equities were already highly valued, please don't buy into the popular bubble theories since most of them are wrong. In the world of low global real interest rates we live in, asset prices are supposed to be high, even from a fundamental value perspective, since all future cash flows are discounted at a very low rate. Furthermore, even ex-post, it is not always easy to identify bubbles.
Of course now, after one decade, the US interest rates are finally starting to edge higher, both at the short end as well as at the long end of the yield curve. Part of this has to do with Trump's 1 trillion dollar tax cut, which has led to a significant increase in yields of US treasuries. This massive economic stimulus, while leading to somewhat higher growth in the very short-run, has forced the Fed to raise rates at a faster rate to offset the effect since they do not want to be in charge of an overheating economy.
It is feasible that the concerns about rising interest rates and the flattening of the yield curve combined with high equity valuations to begin with have now lead to market jitters. Ultimately, only time can tell how this selloff will affect the macroeconomy. Note that US Treasury yields are down from just a few days ago. The price of Bitcoin has declined as well, pointing towards a risk-off moment in financial markets.
While the Fed has ample room to counter a negative macroeconomic shock, there is some concern that they might not be willing to do so, given that they just recently managed to raise interest rates for the first time in a decade. Regardless, as of right now, the growth projections for quarter 3 and quarter 4 for the US economy still look extremely solid, and so does the labor market. This is definitely not the time to worry yet. My best guess is that this selloff will be relatively benign, just as the stock market jitters we had in the beginning of the year. But only time will tell.
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Trade complexity:  Australia and Czech Republic are the outliers

9/9/2018

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I have recently made a few changes to my blog. I have included here a bunch of economic models and economics data bases that I follow occasionally. This economic trade complexity database is especially interesting. It displays world wide trade flows for countries and breaks down a country’s export by goods and sector. It then creates a ranking for each country to determine a country’s trade complexity, meaning how technologically advanced and diversified a country’s export is. Primary products, commodities and raw materials, are obviously the most basic goods a country can export. The most technologically advanced goods are machines, computers, phones, car parts, etc. The website has produced a ranking for all countries of a certain size, ranking a country’s trade exports by complexity. It should not be a surprise that this measure is also highly correlated with GDP per capita. The richest countries are also the most technologically advanced, thus procuring and exporting the most complex products. In the table below you can find the top 10 countries and here the link for a more complete list. While there are no big surprises, Switzerland, Germany, and the US are all in the top 10, the list also has some notable outliers.
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The Czech Republic can be found as number 10 in the list of the most complex exporting countries in the world. This might be somewhat surprising at first. After all, belonging to the Eastern European countries, Czech Republic’s income level is still only at about 70% of the GDP of Western Europe (in PPP terms, meaning adjusted for differences in price levels). However, the country has been catching up quite rapidly in fence decades as it became one of the Eastern European countries that joined the European Union in 2005, this benefiting quite substantially from access to the common market as well as the transfer payments one can enjoy as being a poorer member of the club. It should be noted though that the Czech Republic was initially one of the richer countries in Eastern Europe and has achieved a remarkable amount of convergence to Western Europe.
The fact that the Czech Central Bank has performed really well in the aftermath of the crisis has helped as well as the country was not constrained by the straight jacket of the Euro, a topic I might elaborate on in a future blog post because it is quite interesting how the country escaped the so-called liquidity trap.
The graph below depicts the goods that Czech Republic is exporting to the rest of the world and you can find many high-tech products among them, especially cars and car parts as the country has become a major automobile producer.
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Just like Slovakia, the Czech Republic has become a major car exporter as many German carmakers have set up their factories in the country, given its favorable geographic location close to Western European markets combined with what was back then still extremely low wages.
While the communist epoch has obviously hindered the country’s economic development for decades, it should ultimately be not that surprising that the Czech Republic has the potential to catch given its economic history.
In fact, during the Austrian-Hungarian empire, Bohemia was one of the most economically developed and industrialized regions of the empire. Given the very clear correlation between the level of trade complexity and GDP per capita, one should expect the Czech Republic to perform well in the future and continue its path of convergence with Western Europe. Note that the country has already caught up with some of Southern European states like Greece and Portugal and of its current trajectory might achieve Western European levels within the next three to four decades or so.
Economic convergence is unfortunately a slow process. The Solow model predicts a speed of convergence of 4%, which empirically has been found to be too high. Even at that rate, the Czech Republic would close half of the gap only every 18 years, thus moving from 70% to 85% of Western European income levels in about two decades.
Note, by the way, that Slovenia and Slovakia are two other Eastern European countries that rank very highly in terms of trade complexity (rank 12 and 16, respectively). Those two countries have also grown very rapidly in comparison to Western Europe in recent years and convergence is very likely to continue. 
The aberration Down Under
The second large outlier in the trade complexity database is Australia. While the country is generally known for being one of the largest commodity exporters in the world, it is also the only advanced economy that hasn’t had a recession in now almost three decades. This track record is particularly impressive given that commodity prices are quite volatile, meaning that the commodity sector is more prone to boom and bust cycles in general.
One of the big benefits of the country has been its large population growth rate in recent decades, mostly a result of immigration. About every fourth inhabitant was initially not born in Australia. The massive economic expansion the country experienced was thus to some extent a result of a population boom, which allowed for much higher trend growth than many of the other advanced economies. As the country went into the global financial crisis with much higher interest rates, the Central Bank of Australia could cut interest rates to a greater extent without ever facing the zero lower bound that constrained many other Central Banks, thus allowing the country to escape the Great Recession. Unfortunately, the populist wave has reached Down Under as well, meaning that this big bonus point might soon go away.
In terms of trade complexity, Australia ranks extremely globally (rank 69) despite being one of the richest countries in the world. The graph below shows that the country is primarily exporting commodities (coal, iron ore, oil, gas, etc.) as well as other primary products (grain, meat). While the global commodity boom of the early 2000s definitely led to an economic boom in Australia, one must keep in mind that in the aftermath of the Great Recession commodity prices plunged for several years. As commodity prices are extremely volatile, the country's track record of almost 3 decades without a recession is all the more impressive. Kudos to the Bank of Australia!
Of course, in recent years the country also experienced an extraordinary housing boom. While some have expected a the burst of the Australian housing bubble for many years, such a prediction never came to fruition. I have written before that I am not a firm believer of the crude bubble theories. Housing prices have appreciated in metropolitan areas around the world across most advanced economies, and it seems to be mostly a story of rising demand facing inelastic supply, at least in the short to medium run (the result of zoning laws, regulations, high constriction costs, etc.).   
One big concern, however, is the interaction between rising asset prices and debt. In fact, debt bubbles are much more dangerous. Private sector debt, and especially mortgage debt, has been rising at unprecedented levels: Household debt now exceeds 120% of GDP.
Good macroeconomic policies can make sure that house prices and debt levels do not rise without bounds and the Central Bank of Australia can definitely engineer a soft landing. One concern though is that now even in Australia interest rates barely exceed 1%, thus giving its Central Bank little leeway in the face of an adverse macroeconomic shock.  
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Some final thoughts on Australia and its missed opportunity

While Australia's track record in recent decades is quite impressive, it feels like the country missed one large opportunity. Given its abundance in resources, Australia could have set up a sovereign wealth fund like Norway to save for a time after the resource boom has ended. While taxes are usually distortionary (because they distort incentives and thus lead to a misallocation of resources), a proportional tax on economic profits from resource extraction is actually efficient. While many developing countries suffer from the resource course, corrupt elites and failed institutions prevent those countries from economic development, there are some notable exceptions. The oil states on the Saudi Arabian Island, the United Arab Emirates, have transformed into the biggest financial center, a popular tourist destination, and a transportation hub in the Middle East.
Norway is known for its Sovereign Wealth fund based on the oil revenues, which has now a value of more than one trillion dollars and holds about 1% of all the stocks in the world.
While the economies of Australia and Canada have certainly benefited from the massive commodity boom in the 2000s, both counties have so far not taken the opportunity to develop their own sovereign wealth fund based on the potential income stream the state could extract from the commodity sector.
While Australia introduced in 2012 the so-called resource super profit tax, the tax was strongly opposed by a lobbying group of Australian and foreign mining companies. The tax was killed just a year later in 2013 by a new government.
An Australian sovereign wealth fund based on the Norwegian model with money coming from the resources Australia wealth is partly based on could ensure the country’s future success for a time when some of those resources will eventually be depleted.

Reference:

AJG Simoes, CA Hidalgo. The Economic Complexity Observatory: An Analytical Tool for Understanding the Dynamics of Economic Development. Workshops at the Twenty-Fifth AAAI Conference on Artificial 2011)
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Are the stars useful as a guide to policy making in an uncertain world?

9/7/2018

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Fed chairman Jerome Powell recently gave his remarks at the annual monetary policy conference at Jackson Hole. The speech was extremely interesting and it was also seen as slightly dovish as the dollar slightly dropped on the day whereas stock markets were slightly up. While the speech was certainly written by a Fed economist, Powell is originally a lawyer, he has been a Fed insider and monetary policy maker for many years to understand the issues at hand clearly and to communicate them to the public. And sometimes an outsider’s view can be actually helpful.
The main topic of the speech was the uncertainty monetary policy makers face when assessing the macroeconomy. There are two variables in particular, the natural rate of interest r* (r-star) and the natural rate of unemployment u*, which Central Bankers rely on. r* is the interest rate that is consistent with price stability, usually defined as an inflation rate of 2%, and u* is the unemployment rate consistent with full employment. The problem with these two variables is that they are unobservable, and even more problematic, there is a high degree of uncertainty about these variables. While macroeconomists use a variety of models to estimate r* and u*, the confidence intervals around those estimates are usually extremely large, meaning that they cannot be estimated with any precision. As an example, the New York Fed recently released an estimate for the natural rate of interest for the US economy. While the current estimate for the natural rate is relatively close to 1% (see chart below), the confidence interval for this estimate can easily exceed more than one hundred basis points, depending on the model at hand. Also note that current real interest rate is still negative, with the Fed funds rate being close to 2% while the inflation rate is running at about 2.2% at the moment, thus implying a negative real interest rate of just about minus 20 basis points. According to the New York Fed’s model, real interest rates have been persistently below the natural rate ever since the financial crisis in 2008, so basically for an entire decade now. According to the new-Keynesian model, monetary policy was thus super accommodative for almost 10 years. This begs the question why we haven’t experienced runaway inflation and high levels of nominal GDP growth given the amount of monetary accommodation. The answer, is of course, that monetary policy was actually tight until quite recently, given that unemployment rates were still relatively high, nominal GDP growth was low, and the economy still experienced extremely large negative output gaps in the aftermath of the crisis.
All of this suggests that the actual natural rate must have been considerably lower for a prolonged period in the aftermath of the crisis than what their model suggests.
The second “star variable”, the natural rate of unemployment, also cannot be known with any degree of certainty. Just a few years ago, the Fed suggested that it could not push the unemployment considerably lower than 6.5% without accepting a rising inflation rate above their 2% target. This turned out to be a super hawkish projection. Well, unemployment declined to less than 4% this year and both inflation as well as wage growth are still quite moderate, suggesting that the economy might still have some extra spare capacity left (even though considerably less than a few years ago). However, all of this also implies that monetary policy was actually much tighter in retrospect than what we thought and that a higher degree of monetary policy accommodation could have restored full employment much earlier. The US economy basically spent an entire decade having excessive unemployment and the same can be said for most of Europe.
​This is by far the biggest policy blunder since the Great Depression as millions of people suffered from unemployment and/or underemployment for many years. Trillions of economic output have been lost during those years, and according to some estimates the Great Recession even depressed the economy’s long-run potential, thus scarring the economy for many years: We are most likely on a much lower growth path going forward than we would have been if the Great Recession was avoided.
The policy mistakes that are associated with a failure to correctly identify the natural rate of interest and the natural rate of unemployment can thus be quite severe. It is, in my opinion, a severe mistake to pursue monetary policy based on these immeasurable variables alone, which economists cannot even correctly identify ex-post. And there are much better alternatives. Ultimately, the rate of inflation and the rate of nominal GDP growth are the only correct way to identify the stance of monetary policy. The Fed should target the level of nominal GDP instead and largely ignore the estimates of the “star variables”, which more often than not are just a silly distraction instead of being a useful guide for future monetary policy.
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PS: Note how according to the model trend growth for the US economy is still estimated to be above 2%. This seems to me another dubious assumption. Trend growth since the crisis has been lower, and will most likely remain relatively low in the foreseeable future according to the "secular stagnation" theory put forward by Larry Summers (or the supply-side pessimism story put forward by Robert Gordon).  
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Some thoughts on bulls, bears, booms, and busts

9/2/2018

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So there have been literally a thousand financial articles in recent weeks on how the current bull market is now one of the longest, and by some measure, maybe the longest bull market in US history. So here some thoughts on bull markets, bear markets, and economic downturns.

1) The stock market is not the economy!!! More than 40% of the sales from the S&P 500 companies are now generated abroad, meaning that international factors will also have an impact on US stock market performance. Of course, recent research suggests that both the business cycle as well as asset prices, equities as well as bonds and even real estate, have become increasingly correlated across countries in recent years as the global financial cycle becomes more predominant. As a side note, maybe this also means that the benefits of diversification have somewhat decreased.

2) While it is true that every (severe) economic downturn is associated with a substantial decline in asset prices, mostly equities but also housing, the reverse is not true. There is definitely some truth to the old saying that the stock market has predicted 9 out of the last 5 recessions. Equity prices can tank without dragging the economy down with it, as shown by the famous crash of 1987 when the Fed's decisive interventions in financial markets made all the difference. Even with declining asset prices, the economy can be fine of the Fed keeps aggregate demand stable. While some economists assert that in the case of the Great Depression and maybe also the Great Recession the stock market crash led to the economic downturn, this seems to be mostly false. In both cases it was tight monetary policy, which led to a decline in economic activity and dragged equity prices down with it.

3) Some recessions are more severe than others. Stock market declines might be less consequential than a severe bust in the housing market. About 80% of the stock market in the US is hold by the top 10% who have a much lower marginal propensity to consume. The home ownership rate, on the other hand, exceeds 60%. While a large decline in equity prices might only have a very limited impact on consumption, a large decline in real estate is felt much more broadly, especially if home owners equity is wiped out and of there was a substantial amount of debt and leverage involved.

4) Debt and leverage matter, and so does liquidity. As Perry Mehrling points out in his course on money: “Liquidity kills you quick”. Macroeconomists neglected these factors to some extent before the crisis. While it is true that for the aggregate one person’s liability is another person’s asset, the distribution of debt matters a great deal as individuals and companies face different borrowing and cash constraints.

5) The financial system matters a great deal. Almost every transaction in the economy involves money in some form or other. Disruptions to the financial and payment system can have large macroeconomic effects because financial shocks will interrupt the invisible hand of the market economy as price signals get distorted during fire sales and amidst larger spikes in risk premiums and interest rates. The Central Bank’s lender of last resort function is therefore of key importance. During a panic, the Central Bank can insure that the financial network remains intact by providing enough liquidity to the system and maybe even providing a backstop to falling asset prices if deemed necessary.

6) Most modern recessions in large advancers economies are monetary in nature, very often caused by misguided monetary policy. There is definitely some truth to Dornbusch’s assertion that expansions don’t die of old age, but that every single one of them was murdered by the Fed. Most recessions are mostly negative aggregate demand shocks, meaning that the level of nominal spending in the economy has fallen for one reason or the other. Total spending falls as the propensity to hoard money increases. While there are several ways of getting rid of excess cash balances, there is only one way to increase your money stock: by buying less goods and services, meaning a decline in spending. While it is certainly possible for one person to increase their money stock, it is certainly not possible for many agents in the economy to do the same. The fallacy of compositing clicks in. As people try to increase their money stock and reduce their spending, overall spending in the economy falls as well. As one person’s expenditure is another person’s income, economy-wife GDP falls, and unemployment rises.
Of course, Central Banks would have the ability and firepower, and some of them also have a more or less an explicit mandate, to keep the economy on an even keel. However, very often Central Bankers have found themselves being behind the curve. They certainly got completely sidetracked by the Great Recession, despite the fact that the some of the root causes were monetary in nature.

7) Central Banks can always increase aggregate demand and inflation, even in a liquidity trap. The constraints they face are not economic but rather political and institutional. While most economists agree that Quantitative Easing did stimulate the economy, there is some debate about its effectiveness. Furthermore, QE1 was probably had a much bigger impact than subsequent rounds of asset purchases, the reason being that QE1 started when financial markets were still in turmoil, asset prices were falling across the board, and risk premiums were extremely high. The Fed's asset purchases reduced market volatility, put on a floor on asset prices, and reduced risk. Subsequent rounds of asset purchases provided much less bang for the buck for several reasons. First, the Fed made it abundantly clear that they were never really willing and even considering overshooting their inflation target, even for temporary catch-up growth following one of the largest recessions in modern history. This was essentially a very hawkish signal and widely reduced the effectiveness of asset purchases. Second, it is widely agreed upon that monetary injections at the zero-lower bound of interest rate will actually be ineffective if they are perceived to be temporary instead of being permanent. This is Krugman's famous irrelevance result. Insofar as the Fed always signalled that the Fed's balance sheet will go back to normal one day, they practically ensured that their asset purchases will have less of an effect. At the zero-lower bound, monetary policy is essentially all about forward guidance and expectations management, even more so than in usual times, because open market operations are just swapping one zero-interest rate bearing asset for another, Treasuries for base money, meaning that the economy-wide effect should be basically zero (There can be some effect if you buy longer-term bonds instead that have interest rates above zero. The question then is how large are the purchases going to be and how will the macroeconomy respond if Central Banks are in the business of compressing yields and managing the yield curve).
As Angel Ubide points out in his book "The paradox of risk", Central Banks that were much more conservative in the beginning of the crisis of 2008 and the subsequent recession ended up having to stimulate the economy much more and resort to more aggressive policy tools than Central Banks that moved somewhat earlier, such as the Fed. That being said, even the Fed pursued extremely tight monetary policy in 2008/2009 and only began to act more aggressively as soon as it became clear that a second Great Depression could become a reality.
As far as changing the Central Bank's mandate to a price level target or a nominal GDP level target is concerned, which both would have been much more stimulative during the downturn, the effectiveness of monetary potency was never really tested.
The ultimate weapon against a severe negative demand shock would obviously be Milton Friedman's helicopter drop, an injection of cash that is directly targeted at the consumer. While such a policy blurs to some extent the line between monetary and fiscal policy, such an extreme measure might actually have the best chance of increasing aggregate demand and rendering monetary policy more potent when interest rate changes are constrained by the effective lower bound. 

8) The long-run secular downward trend in real interest rates is one of the most important macroeconomic trends in recent decades. It vastly increases the chance of Central Banks hitting the lower bound on interest rates when faced by a severe demand shock. Moreover, lower real interest rate also imply that the fundamental value of asset prices rises. This is true for equities, bonds, and both land as well as real estate. Over the last two decades, we have experienced already several "bubbles", Dot-Com followed by the housing bubble. In all likelihood, most advanced economies will continue to experience rich equity valuations in the foreseeable future. While these are not necessarily "bubbles", low real interest rates might exacerbate the financial cycle and produce boom and bust cycles in asset prices, which obviously will also affect the real economy, a phenomenon that Larry Summers has called secular stagnation.
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An update on the GDP Nowcast models

8/27/2018

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In recent years macroeconomists have started to use dynamic factor models as a new tool to predict quarterly GDP figures (and potentially other macroeconomic variables of interest) in real time. These factor models extract information from a large number of macroeconomic variables that are available at a higher frequency, such as industrial production, consumer expenditures, employment numbers, housing starts, etc., to forecast quarterly GDP growth rates. The GDP Nowcast model of the Atlanta Fed and the New York Fed are two examples of such a model. It is thus interesting to track the performance of these two competing models over time and to assess their accuracy, keeping in mind that quarterly growth are extremely volatile and thus also hard to predict. The two GDP Nowcast models also allow us to track the quarterly GDP estimate to be over the course of the quarter as their predictions are getting updated almost on a weekly basis with new incoming macroeconomic data in real time, something which was not possible before.
In that light, the recent divergence of the Atlanta Fed Nowcast and the New York Fed Nowcast are extremely interesting, with the former displaying an improved outlook and projecting a quarterly growth rate of now 4.8%, up from about 4.3% at the beginning of the August. The New York Nowcast, on the other hand, has shown a declining growth rate of now just about 2%, down from exactly 3% at the beginning of the quarter.
Atlanta Fed GDP Nowcast
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New York Fed GDP Nowcast
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I have updated the table below to track the performance of the models over the last few years. Keeping in mind that these models have not been around for very long yet, thus limiting the data points to just a few years, the Atlanta Fed Nowcast as of now seems to perform better than the New York Nowcast model (while the St Louis model also predicts quarterly GDP, it is based on a different methodology). Not only does the Atlanta model produce unbiased forecasts (the average error is close to zero), but it also produces the most accurate prediction with the smallest absolute forecast error of about 0.6% in absolute values.
The correlation between the forecast error of the Atlanta Fed Nowcast and the NY Nowcast is 33%, meaning that most of the time both models are producing forecast errors in the same direction. The recent divergence of the two models over the last two months is thus especially interesting. Unfortunately, I haven't had the time to dig deeper into the two models and can thus not comment to what extent they differ and what the source of the different prediction for this quarterly GDP figure is.
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Using a very simple linear regression model with the very little data we have, one can see that the most accurate prediction of quarterly GDP figures is a weighted average of the two Nowcast models, with a much higher weight on the Atlanta model as it is the superior forecast. The New York Nowcast model does not seem to add much explanatory power as the coefficient is statistically insignificant (note that one of the problems though is that there are very little data points). The "error correlation" between the two Nowcast models is surely another reason on why a weighted average between the two models is not vastly superior than just relying on the Atlanta model instead.
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Using this weighted average approach, produces a quarterly GDP forecast for Q3 of just a little over 4%, given the current Nowcast values. Trump might get his >3% annual GDP growth for the current year after all, keeping in mind though that most of it is due to extraordinarily policy accommodation as a result of the substantial corporate tax cut, in a way a fiscal stimulus package. With real interest rates still being negative and below the Fed's estimate of neutral, monetary policy is accommodative as well. This effectively means that huge problems are baked in for 2020 when fiscal policy will tighten by necessity at the same time as Fed policy will tighten as well. There is good reason to believe that this could actually produce a recession. Note that the yield curve is most likely to invert, if not with the next rate hike then with the one that follows, with the inversion of course historically being the best recession predictor we have.
PS: Some additional comments

1) The dynamic factor models as a tool for GDP predictions have not been around for very long. They are purely data driven and thus completely differ from the DSGE models Central Banks have used over the last few decades. Many of those DSGE models have failed quite spectacularly during the financial crisis (Not in terms of failing to predict the crisis. Crises are by definition more or less unpredictable. Don't believe anybody who tells you otherwise. But the models failed in predicting some of the important dynamics in the aftermath of the Great Recession, such as the failure of interest rates and inflation to rise, etc.). I have not seen any study so far that compares the accuracy of those DSGE models with the data driven dynamic factor models, but my gut feeling is that the data driven approach can be superior. The DSGE methodology rests on some highly dubious assumptions on how the macroeconomy works. There is no doubt that the core neo-keynesian model is quite flawed, a topic I have written about before. See here, for example.

2) Quarterly GDP figures are highly volatile. One might think that an average forecast error of 0.6% is quite high, but given the state of current macroeconomic models this is at the moment the best macroeconomists can do. Other variables are much more sticky, especially inflation and also interest rates to some extent, at least in recent years, thus making a prediction somewhat easier.

3) Financial markets efficiently aggregate information, at least most of the time. Financial market predictions about the future path of interest rates, the Fed funds future market, has repeatedly turned out to be more accurate than even the Fed's internal forecasts on where interest rates will be in one year's time. 
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My second article for The conversation

8/21/2018

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Explainer: why some current account imbalances are fine but others are catastrophic

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Ins and outs. MNBB Studio
Julius Probst, Lund University

In the recent economic crises in Turkey and Argentina, there was much talk about how current account deficits played a big part in their problems. Nothing unusual in that, of course: many economic crises are associated with such deficits. It’s one reason why the business press focuses on the current account as one of the key measures of a country’s macroeconomic performance.

The current account balance is primarily the difference between a country’s total exports and imports of goods and services, usually measured as a share of GDP. Surpluses tend to be reported as “good” or “healthy”, while deficits are often regarded as “bad”. While the deficits run up in Turkey and Argentina certainly did cause problems, this way of looking at current accounts is fundamentally flawed.

Most people probably tend to think of exports and imports in terms of products being bought and sold by a country. In reality, they also refer to the amount of capital flowing in and out to finance government and business spending. When a country has a current account surplus, it is exporting capital to the rest of the world. Consequently, it is a net lender. Countries with deficits are the opposite: they import capital from the rest of the world and are net borrowers.

The point is that being a net borrower or net lender is not usually bad in itself – it depends on what is happening to the money. Take the US and Australia, whose current accounts as a percentage of GDP since 1980 are in the chart below. The US has been running persistent deficits for almost the entire period.

US and Australia current accounts

OECD

The US deficit peaked at about 5% of GDP in the mid-2000s, just before the outbreak of the global financial crisis. Yet US economic growth has been comparable or better than that of many other large economies for much of this period.

While that is true, some economists argue that deficits are not sustainable in the long run. The US, they say, has only been able to run one for so long because of the unique role of the US dollar as the international reserve currency.

Yet what about Australia? The Australian dollar has no such special status and that country has been running more sizeable deficits than the US over the same time period. Australia finances this by selling domestic assets to foreigners, such as wealthy Chinese families buying expensive apartments in Sydney. Australia clearly has enough space to build more and more real estate to keep financing its imports. Whether this is socially desirable is a different question, of course.

Surplus troubles

In some situations, running excessive imbalances over a prolonged period of time might be more problematic. Some economists believe that the long-term imbalances in the world economy that were partly thanks to America’s deficits caused the financial crisis and the great recession that followed.

Yet surpluses can be troublesome, too. The world’s biggest surplus countries in recent years have been China, Germany and Japan. Germany has seen a large increase in its current account surplus in recent years and has been criticised by the likes of the IMF for not investing enough at home. The country is currently exporting capital of more than €250 billion a year to the rest of the world, helping to finance unstable imbalances elsewhere, while Germany’s infrastructure seems to be in dire need of additional funding.

Leading surplus offenders

OECD

China started running a massive surplus in excess of 8% in the early 2000s after becoming more integrated with the world economy and exporting goods heavily on the back of ultra-low manufacturing costs. China, too, came under international pressure for helping to cause global imbalances. While China’s trading position has now swung almost towards being balanced, it still has a substantial surplus with the US, which explains Donald Trump’s recent trade war with Beijing.

Turkish blight

Current account deficits are more dangerous if the inflow of capital does not represent productive long-term investments, but rather short-term “hot money”. Capital flows can rapidly reverse as foreign lenders abruptly start withdrawing their money. This can make the country’s currency plummet, culminating in a financial crisis if domestic banks, businesses and even consumers have been borrowing in foreign currency and the repayments are suddenly beyond their reach.

This is exactly what has happened in Argentina and Turkey this year. Turkey’s persistent deficits were a sign of the country’s reliance on foreign borrowing to fuel its domestic consumption boom under the Erdoğan regime, which came unstuck as the West called time on quantitative easing and started raising interest rates.

Emerging economy deficits

OECD

Indonesia and South Africa are two more emerging markets whose current account balances have been shifting. Both the Indonesian rupiah and South African rand have depreciated by about 10% against the US dollar over the last year.

While economists mostly agree that floating exchange rates and mild depreciations can be rather helpful in absorbing macroeconomic shocks, both countries look potentially vulnerable in a similar way to Turkey and Argentina – particularly if the rand or rupiah were to experience a “run” similar to the one on the Turkish lira. Unfortunately, just like a banking panic, currency crises and financial contagion are usually unpredictable beforehand.

At any rate, it’s important to be more accurate about current account imbalances. Large and continuous deficits or surpluses can either be totally benign or the result of some underlying economic problem. Still, some people persist in seeing only the bad in deficits. Donald Trump is a good example: he promised to eliminate America’s deficit during the presidential campaign and believes his massive tax cut will produce a growth surge that will achieve that goal in the years ahead. The irony, of course, is that in all probability it will achieve precisely the opposite.

Julius Probst, Doctoral Researcher in Economic History, Lund University

This article was originally published on The Conversation. Read the original article.

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A cautionary note on liquidity and money-like assets                        (and a personal story about a "worthless" piece of paper)

8/16/2018

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Perry Mehrling at INET has two fantastic courses on money and banking at Coursera, which I highly recommend. One of the main themes of the course evolves around the hierarchy of money depicted in the graph below.
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During the time of the gold standard, gold was the ultimate money because it was the internationally accepted means of payment. Central Banks domestically issued currency, which was backed up by gold. In that sense, national currencies were a sort of credit in the sense that they represented a promise to pay gold on demand.
Next in line in the hierarchy of money are normal bank deposits. Of course, nowadays everybody assumes that deposits can be redeemed at par value into national currency. This, however, is mostly a result of modern deposit insurance, which provides a safeguard against bank runs and bank failures. In the case of a bank failure, deposits will probably not be redeemed at par, meaning that deposits are not quite as money-like as hard currency.
One of the main features of modern finance is the property of the private sector to issue credit and money-like assets. Money and credit allow for the production and private exchange of goods and services to take place that would otherwise not be feasible under a pure barter system. While the elasticity of credit is one of the main features of the modern economy, it might also be the source of economic and financial instability, a point that Minsky has raised numerous times but has been somewhat neglected by mainstream macroeconomics. 
During the boom one can usually detect an expansion of private sector credit. Corporations and private individuals can issue IOUs, money-like assets, which enter the circular flow. Those IOUs can be accepted as means of payment as long as the issuer is deemed to be creditworthy and trustworthy.
The main problem with private sector credit, however, is that during a time of a financial panic all those privately issued IOUs might suddenly not be deemed as safe anymore. When asset markets like stocks and housing tumble and everybody is scrambling for safe assets, including banks, as liquidity freezes up, suddenly all those money-like assets are not liquid anymore. All that counts now is the hard money, meaning gold and currency when countries where on the gold standard, with today's equivalent being Central Bank reserves as well as safe government bonds.
This effect could also be observed during the financial crisis of 2008. Even though the financial crisis originated in the US, the dollar actually sharply appreciated as investors from all over the world were looking for a safe haven and put their money into US Treasuries and other US-dollar denominated safe investments (As a side note: the strong dollar appreciation was also a result of tight US monetary policy). Meanwhile, other money-like assets were completely freezing up during the fall of 2008. One such example are money market funds, basically investment vehicles that were holding short-term debt securities, such as US Treasuries but also, and more importantly, commercial papers (short-term IOUs). While those money market funds were widely regarded as safe, the key difference was that in contrast to bank deposits they were actually not backed up by the Federal Government. 
The crisis of 2008 turned into a liquidity crunch in the fall of that year as some money market funds experienced the equivalent of a bank run. Furthermore,  companies started to experience increasing financial difficulties as investors refused to roll over commercial papers. This is the key aspect of liquidity: Financial markets giveth, and financial markets taketh away. During the crisis of 2008, suddenly a bunch of money-like assets froze up with with hard currency and Treasuries suddenly being the only and ultimate safe haven.
As the elasticity of credit can disappear very quickly, the Central Bank must step in as a lender of last resort and provide all the liquidity that has suddenly evaporated from the system if it wants to restore sanity in financial markets again. Moreover, financial disruptions can have large negative macroeconomic effects, disrupting the economy for even years to come, which is why Central Bank intervention is desperately needed (while there is some truth to the moral hazard argument, it really does not justify creating a second Great Depression in order to punish bad-behaving banks or investors).

Now a personal story about money and liquidity
  
Last but not least, a short personal story about money-like assets. My father received a couple of month ago the following check from the US Treasury, 56 USD worth (for obvious reasons I made my Dad's address unreadable):
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Now here is where it gets interesting.​​ The check from the US Treasury should rather be one of the safest and more liquid money-like assets in the world. It is a dollar denominated IOU from the US Treasury, not very much unlike a US government bond in a way (except that it does not pay interest). Now here is where it gets interesting. Commercial banks in Germany have stopped a couple of years ago accepting foreign currency denominated checks. I am not entirely sure of why that is, but I can think of at least two reasons. First, checks are simply not used as a means of payment in Germany anymore. Second, transaction costs are just too high.
A few years ago I actually worked as an intern in a regional bank in Germany (Volksbank Paderborn) in their "foreign sales department". Back then some customers would still receive foreign currency denominated checks. So if a customer presented us a foreign currency denominated check in British pounds, let's say from the Barclays in the UK, then Volksbank Paderborn would deposit the Euro-equivalent amount (minus a transaction fee) into that customer's bank account at the Volksbank. However, this is not the end of the story. Volksbank Paderborn now also has to mail the check to the UK to a British partner bank (let's say for simplicity that the UK partner bank is also Barclays) so that Barclays can deposit the British pound amount (minus a small transaction fee, maybe) of the check at one of the Volksbank's foreign denominated currency accounts at Barclays. So depositing a foreign currency check involves currency conversion, up to two transaction fees, as well as mailing the actual check back to the country from where it was issued in the first place. Given this somewhat complicated procedure and the fact that almost nobody uses checks anymore in Germany, it is quite understandable that banks refuse to accept foreign denominated checks.
I just travelled to the US and took my father's check with me. However, since it was signed by him, banks refused to cash out the check to me. In essence, I was carrying around a "worthless" piece of paper issued by the US Treasury, which is rather ironic !!!
The broader point I am trying to make obviously is that there are a bunch of money-like assets, money market funds, checks, commercial paper, IOUs, etc., and all of these assets can serve as money and are almost equivalent to money in one state of the world. However, there are other states of the world, a financial panic where suddenly everybody is scrambling for safety as companies, investors, and private individuals alike are defaulting on their debts. In a financial panic all those money-like assets might suddenly freeze up and loose their money-like status, becoming more or less worthless, and in the end it is only hard currency and Central Bank reserves that can be considered as the ultimate money.    
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About economic literacy and Russia's dollar reserves

8/13/2018

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A recent article in the German journal "Der Spiegel" was about Russia wanting to dump its dollar reserves in response to the tougher US sanctions that were recently imposed on the country, a consequence of Russia's continuous meddling in US elections and Putin's attempts to undermine Western democracies.
The article (in German) claims that Russia dumping all the government bonds it is currently holding would be detrimental to the US as it would raise America's cost of borrowing. Quite frankly, this is a highly dubious claim and it makes me wonder whether the person working on that article did even bother to check whether the numbers actually add up.
According to Wikipedia, the total outstanding US national debt is about 21 trillion USD, which is in excess of 100% of GDP. Total Russian foreign currency reserves are a little less than 460 billion USD, and less than half of them are dollar denominated assets (see Reuters). Even if we assume that all of the dollar denominated assets are US government bonds, which seems somewhat unlikely, then Russia is only holding about 220 billion USD of American debt, which would be just about 1% of the total.
Even if Russia were to dump all of her dollar denominated securities within a relatively short time period, I doubt that this would have any meaningful impact on financial markets and the US interest rates on government securities. The best and safest bet is that other market participants would simply swallow the additional debt and that US yields would not move very much. How do I know this? Well, the Republicans just passed a trillion dollar tax cut, which was basically a handout to the super-rich and American corporations, which also blew a huge hole in the fiscal budget. As a result, the US fiscal deficit increased from about 580 billion USD in 2016 under Obama to about 830 billion USD under Trump in 2018, and is likely to approach about 1 trillion USD for the years 2019 and 2020. Because the tax cut will only have modest supply side benefits and the any substantial demand side boost will be offset by the Federal Reserve, the claim that the tax cut would pay for itself was always a bad joke. Trump and the once fiscally conservative Republican Party just managed to engineer one of the largest increases in the federal debt under peace time while being in a regime where the economy is rapidly approaching full employment. So what happened to US interest rates over the last couple of years as both the deficit and the US debt are surging? Well, the chart below shows that US interest rates barely moved upwards over the last couple of years. The claim that Russia dumping all its dollar reserves will substantially alter the path of US interest rates does not stand up to scrutiny. And even if there was some substantial movement in the very short-run, the Fed could always act as a buyer of last resort and swallow up some of the US government bonds that would be dumped on the market.

PS: Please don't read my post as saying that the increase in the US debt as a result of the tax cut does not matter. While it doesn't really affect US borrowing costs at the moment, it is still a bad idea to increase public debt by such a degree and with such waste because it reduces fiscal space when the next recession hits the US economy. 

PPS: The claim that Republicans are fiscally conservative is also one of the biggest jokes ever. The only president in recent decades who managed to reduce the debt to GDP ratio is Clinton. Under Obama, it basically was all about sabotaging the presidency of a black president. The entire Tea Party movie was basically racist, the precursor to Trump.
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Update: According to this Business Insider article, Russia’s Treasury holdings were actually significantly smaller than I reported above (only in the ballpark of about 100 billion USD). More importantly, the country did already dump up to 50% of its US government holdings, with no significant impact on US interest rates.
​
http://www.businessinsider.com/russia-may-have-more-us-debt-than-people-think-2018-8
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Turkey, a currency crisis live in action

8/10/2018

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A few months ago I wrote a blog post on emerging markets and how some countries might be vulnerable to a classic currency crisis. At the time, my thoughts were prompted by Argentina, which experienced a rapid depreciation and even had to go to the IMF for help.
Now, however, it looks like Turkey is in even more trouble. Just today its currency depreciated sharply, by about 15% (see chart below). It’s down by more than 20% from a week ago and more than 80% from a year earlier.
The big worry here is that interest rates are already really high by international standards, well exceeding 10% and so is inflation. It will require really drastic policy change now to halt this crisis, and I’m not very confident that the Erdogan regime will do what would be required.
The Central Bank would need to hike interest rates by several percentage points to stop further depreciation and the government would have to commit to consolidate fiscal expenditures in the years to come. As both measures combined would probably cause a relatively severe contraction in output, I am far from convinced that Erodgan’s government will actually come through and do what is required.
As a result, one can probably expect a further decline in the currency in the weeks to come, triggering a potential stock market crash as well. That is because the Turkish corporate sector has a large part of its debt denominated in foreign currency (dollars and euros). Given the large depreciation over the last few days, the value of the debt has ballooned now and Turkish corporations will have increasing difficulty servicing them he foreign currency denominated debt outstanding. But he way, this entire dynamic is classic third generation currency crisis model as summarized by Krugman, and very similar to what South East Asia experiences in the late 1990s. Saying that all of this will be over in a couple of days is probably betting on the wrong horse. Expect the Turkish economy to undergo a painful adjustment in the next year(s) to come.
As a side note, some observers are worried about potential contagion effects as it is mostly Southern European banks that seem to hold Turkish debt (France, Italy, and Spain). While this is certainly a possibility, it is rather unlikely if the ECB exerts its function of life lender of last resort and provides enough liquidity to the banking sector should problems arise.
Turkish Lira / USD exchange rate (3 month)
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Update: The Lire continues its decline today and the exchange rate now stands at about 6.88 to the dollar, a depreciation of more than 95% from a year ago. This ain't pretty, and absent drastic policy changes Turkey will experience a couple of extremely bad years with very high inflation rates. Even a banking crisis is possible right now as the value of foreign denominated debt has exploded. This is what happens when a country experiences an unsustainable economic boom based on years of fiscal profligacy (unsustainable fiscal deficits) combined with large current account deficits, which in the case of Turkey represented a dependency on foreign debt.
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Is there a new Tech bubble and could the bubble bursting have macroeconomic impacts?

8/6/2018

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The answer to both questions is probably not, but let me elaborate. About two weeks ago the Facebook stock plummeted by about 20% over night, meaning that the company lost about 120 billion dollars in market capitalization in one day, which represented the biggest wipeout in equity a company has ever experienced. There were no obvious news that should have led to such a fundamental decline in the company's stock market value other than the fact that future returns might disappoint to the downside.
A couple of days later Twitter experienced a similar decline in its market value (in percentage points) and its stock price is now down by almost 30% from its peak just a few weeks ago.  
Facebook and Twitter stock market price, 1 month
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It is certainly true that stock markets have performed extremely well since the end of the financial crisis, and this is especially true for the Tech sector. Consequently, some market observers have repeatedly called the high stock market values as being frothy. Let me just observe here that most "bubble theories" are relatively useless. While I do certainly agree that asset prices can diverge from economic fundamentals even for prolonged periods, in most cases "bubbles" can only be observed ex-post, which renders the theory relatively useless from an investor's point of view. The majority of market participants simply fail to get the timing right and fail to make a profit even if they correctly identify a sector or a specific asset as being overvalued.
Paraphrasing Keynes who stated a long time ago: The market can stay irrational much longer than you can stay liquid.
While the strong form of the efficient market hypothesis is certainly in doubt, its weaker form seems to be right on insofar as it is almost impossible for the individual investors to outperform the market in the medium to long-run (meaning a time horizon of several years). A few years ago Warren Buffet spectacularly engaged in a famous bet that hedge funds would actually fail to outperform the stock market in the years to come, and he won the bet as most hedge funds have underperformed the market by sizeable margin since the financial crisis.
Furthermore, even if investors correctly identify overvalued asset classes or sectors that seem to be frothy, it is almost impossible to get the timing right, meaning that the average investor will certainly not profit from "bubbles" even if predicted ex-ante.  
​While it is certainly true that stock markets and especially the Tech sector have performed extremely well over the last 10 years since the end of the financial crisis, there are some reasons to doubt the current narrative of a new emerging stock market bubble.
First, real interest rates are still well below the long-run historical average, meaning that from a fundamental value point of view asset prices should be higher. Note that this is also true for P/E ratios. With global real interest rates being way down, it is not entirely clear that we can rely on historical price-earnings ratios as a reliable guide as to whether the stock market valuations are out of line with fundamentals or not.
Second, US GDP growth has slightly accelerated over the last year, some of it being the result of the trillion dollar tax cut the Republicans have recently passed. Moreover, economic growth in 2018 will most likely outperform annual growth rates from the previous years. It is somewhat difficult to imagine a scenario where stock markets tank right after profits surge as a result of the handout due to the much lower tax rate on corporate profits.
Third, while corporate debt levels have surged again in recent years, one should bear in mind that interest rates are still extremely low, thus also implying a lower debt service. Furthermore, while corporate debt levels have increased as a share of GDP, they are still relatively low as a share of corporate profits, which seems to me the more meaningful measure here.  
Finally, could a severe stock market decline cause an economic meltdown? Sure it could but the probability of another financial meltdown is relatively low. First, it should be noted that while housing is an asset class largely owned by the middle class, about 80% of the stock market, and maybe more, is owned by the top 10%.
Furthermore, there was much more leverage in the housing bubble than in the stock market. Consequently, even a relatively large wipeout in equity values could have a very limited effect on consumption and investment and thus the broader macroeconomy, especially if the Fed is willing to offset such a negative shock with easier money, just as they should. With short-term interest rates being close to 2% again, Fed officials certainly do have the firepower to offset a substantial negative demand shock, should such an event occur.  
Nasdaq vs. Dow Jones, 5-year period
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The Nasdaq is heavily weighted towards the information technology sector and has gained 118% over the last 5 years, corresponding to an annual return of almost 17%, while the Dow Jones has gained only 70% over the same time period (corresponding to an annual return of about 11%).
Note that these numbers only contain the pure capital gain and exclude dividends, meaning that the true return was even higher (including dividends would increase the return of the Dow Jones by another 3 percentage points annually). 
Note also that the recent returns have been exceeding their long-run historical average, which could potentially indicate that stock markets are somewhat overpriced and that future returns might be lower than what we have experienced over the last decade since the end of the financial crisis.

PS:

Here a very handy tool to calculate total returns for the Dow Jones for any time period from the late 19th century onwards.

https://dqydj.com/dow-jones-return-calculator/   
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    Author

    My name is Julius Probst.
    I started a Phd in Economic History at Lund University, Sweden, in September 2015.
    I received a Master in Economics from Lund and a Bachelor in Economics from Maastricht University (Netherlands).
    During my Bachelor I also spent an exchange semester at the Australian National University.

    I am mainly interested in macroeconomics, both long-run economic growth and business cycle analysis.
    This blog is all about discussing the heated debates that have characterized the field of macroeconomics over the last couple of years.

    You can find out more about my research here.  

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