Austerity and Stupidity

 
A thoughtful piece by Professor Lorenzo Bini Smaghi via Vox: Austerity and Stupidity.

Employment slumps in Canada and the U.S.

Some time ago I wrote about the prospect of the U.S. economy going through a Canadian-style slump (see here). To summarize: The recession that hit Canada and the U.S. in the early 1990s was much more severe in Canada than in the U.S., and the recovery in Canada took almost a decade to complete. In 2008, the tables appear turned. In what follows, I plot the employment-to-population ratio for Canada from 1989:1 - 2003:1 and match it up against the same ratio for the U.S. beginning in 2007:1 - present. The parallels thus far are striking.

Let's start with the employment ratios (courtesy of my able research assistant, Li Li) for the whole population in both countries: (All starting points normalized to 100 -- the actual employment rates are close in any case.)

This shows that the slump, as measured by the drop in employment, was about the same magnitude for Canada in 1990-91 as for the United States in 2008-09. The recovery dynamic in both cases appears to be painfully slow.

Let's now decompose employment across various age groups.

In terms of young and prime-age workers, the U.S. looks a little more depressed relative to the Canadian experience. The experience of older U.S. workers seems less depressed (but the behavior of older workers since the mid 1990s is influenced by a change in secular dynamics, so perhaps should not be viewed as a recovery dynamic.)

Now let's decompose by age and sex. Here we have the data for adult men:

And here we have the age-sex decomposition for men:

The correspondence between those aged 20-55 (the bulk of the population) is very close. Here is the data for adult females:

And here is the age-sex decomposition for women:

The most recent U.S. recession is sometimes labeled a "mancession" in reference to the fact that men appear to have been particularly hard hit (my colleague Silvio Contessi and my RA Li Li talk a bit about this phenomenon here.) It is interesting to note that while this may have been the case, the data here suggest that U.S. females were nevertheless hit harder than their Canadian counterparts in the 1990s.

Just for fun, I asked Li Li to plot broad stock market indices: the TSX composite index for Canada and the S&P 500 for the U.S. (both series have been adjusted for inflation).

Anyone willing to bet against the EMH?

At this point, I'm not entirely sure how to interpret this data. My feeling is that something useful may come out of studying the Canadian episode in greater detail. Maybe a few Ph.D. students are willing to take up the challenge?

 

Employment Gaps

Is the level of employment in the U.S. currently too low? To many people, the answer to this question seems obvious: of course it's too low, you moron.

But "too low" relative to what? Relative to historic averages? Employment seems low relative to recent history, but high relative to more distant history; see here. Moreover, secular employment dynamics across demographic groups often move in different directions, making the question even more difficult to answer. (Marcela Williams and I talk at length about the "many moving parts" of the labor market here.)

Maybe we can learn something by comparing the U.S. experience with Canada. As far as different countries go, Canada is about as "close" to U.S. as one can get. Moreover, as I've pointed out before, the Canadian economy experienced a great slump in the 1990s, a phenomenon that appears to be playing out now in the U.S.

Let me start by looking at the employment-to-population ratios across these two countries. (In Canada, the population constitutes those aged 15+, in the U.S., those aged 16+). Here is what the picture looks like for prime-age males:

Employment is similar early in the sample, but a gap emerges in the 1980s, growing even larger during the "great Canadian slump" of the 1990s. But for most of the 2000s, up to 2008, the employment gap appears to have vanished. Since 2008, the employment gap has reversed itself: the employment rate among prime-age American males is now significantly lower (2 percentage points) than their counterparts in Canada for the first time in about 40 years.

Can we use these employment gaps to infer something about the slowness of the U.S. recovery? I'm not sure. Well, we have to be careful. But this picture might make one more sympathetic to the idea that there is an "output gap" in the U.S. that's at least as large as the value-added associated with increasing prime-age male employment by 2 percentage points. (Of course, this says nothing about what the source of the gap is.)

What does this data look like for other age groupings? Let's take a look. Here's the picture for "adult" teens:

A lot of this employment must be in the form of part time work. The employment ratios are low relative to other demographic groups, as one would expect, but the two countries are quite similar here until about 2000. What happened?

Here we have young adult men:

The picture here looks similar to the one for prime-age males. Together, the two pictures above show that the recent recession hit younger men in the U.S. harder than their counterparts in Canada, and also relative to older men in general.

As for older men:

Evidently, older men are immune from negative aggregate demand shocks. Interesting.

Let me now report what the same data looks like for females. For prime-age females, the picture is this:

For most of the sample, the employment ratios track each other fairly closely, with the Canadian ratio slightly below its American counterpart. Again, as with teenage men, something appears to have happened in 2000. The female employment rate appears to be in secular decline while, in Canada, it has remained elevated and stable. What are the implications of this recent divergence? And how should it be evaluated by policymakers? We need more data to answer these questions.

Here's the picture for teenage women. Again, a large cross-country gap emerges around 2000.

It is interesting to note that the upward trend in female employment is absent in this age category. It is also less apparent in young women:

But once again we see a significant divergence across these two countries beginning at around 2000. The recession in 2008 served to enlarge these differences.

Finally, for older women:

As with older men, older women seem largely impervious to the business cycle.

What is it that is leading older people to devote more time to market work -- seemingly at the expense of younger people? It is tempting to argue that the financial crisis, by wiping out retirement portfolios, compelled older people to work more to rebuild their lost wealth. But the trends here appear to have been in place since before 2000.

  

Thought rigidities in macroeconomics

Ah, a fine Sunday morning. Made the mistake of reading Wren-Lewis and Krugman. Usually they have some interesting things to say. But not always. And recently, they have said some rather strange things. Time to weigh in.

First, Simon Wren-Lewis complains (again)  about something that may or may not have been true at one time:

My first complaint is that too many economists follow what I call the microfoundations purist position: if it cannot be microfounded, it should not be in your model. Perhaps a better way of putting it is that they only model what they can microfound, not what they see. This corresponds to a standard method of rejecting an innovative macro paper: the innovation is ‘ad hoc’.

"Too many" economists. Like who, Simon? Give us names! A long list of names.

I don't think he can do it. He can't because all economic models and theories embed ad hoc assumptions. (Btw, I've addressed this complaint before, here.) So why does he say things like this? I'm not entirely sure. 

 

He seems to want to tell us that nominal wages are sticky, something that standard economic theory is evidently incapable of explaining, and that a set of economists belonging to some sort of commission have made terrible policy mistakes by ... um, refusing to admit that wages are sticky ... because economic theory cannot be used to support the observation? I am confused. 

 

I am also confused about what the following statement has to do with his opening complaint:

 

While we can debate why this [the sticky wage assumption] is at the level of general methodology, the importance of this particular example to current policy is huge. Many have argued that the failure of inflation to fall further in the recession is evidence that the output gap is not that large. As Paul Krugman in particular has repeatedly suggested, the reluctance of workers or firms to cut nominal wages may mean that inflation could be much more sticky at very low levels, so the current behaviour of inflation is not inconsistent with a large output gap.

Now, let's see if I understand. Some economists evidently believe that the "output gap" cannot be very big because, if it was, we should be seeing deflation. Let me point out that the very concept of an "output gap" relies on the presumption of sticky nominal prices -- an ad hoc assumption forming a center piece of NK theory. So what Wren-Lewis appears to be saying here is that his ad hoc assumption is better than their ad hoc assumption. This may very well be true--but again, what it has to do with his original complaint, I have no idea. 

 

No big deal. Wren-Lewis, who I think usually makes for a good read, was maybe a bit sloppy on this occasion. I can certainly relate. Let's just move on. 

Oh, but no. Nope. My favorite curmudgeon has to take an unsolicited hand-off and proceed to let loose his canon (ha ha) here: Sticky Wages and the Macro Wars. 

 

O.K, we get it. Nominal wages are sticky. But it is important to understand precisely what he means by this. In particular, he does not just mean that nominal wages appear not to move very much in the data. We can all see that. What he means is that the reason they do not move is beyond the comprehension of standard economic theory. He makes this explicit here, where he says:

I’ve written quite a lot about sticky wages, aka downward nominal wage rigidity, which is one of those things that we can’t derive from first principles but is a glaringly obvious feature of the real world.

Well, it is my humble opinion that he is just plain wrong. We've known since at least Barro (1977) that spot wages are not "allocative" in job-worker relationships, where bargaining (and not any auctioneer) determines the terms of trade and how these terms evolve over time (I discuss this at length here).  In short, wages can "look sticky" empirically, even if they are not theoretically. Let me also refer you to this interesting paper by Eichenbaum, Christiano and Trabandt (2013). This latter paper belongs to a class of papers (see Hall and Shimer, in particular) who "microfound" price rigidities via bargaining theory. In a nutshell, the details of the bargaining process matter and this is something that is (deservedly) receiving a lot of attention by theorists. (I may be wrong, but I never see Krugman citing such work. Either he finds it uninteresting, or wrong, or ... ). 

 

But enough of Krugtron. As for Wren-Lewis, I think his main message is for young economists: do not to be led into thinking that every macroeconomic theory needs to be "microfounded." That's fair enough advice. But by the same token, young economists should also not feel threatened or bullied into thinking a priori that social phenomena are beyond the reach of economic theory--especially when such sermons are delivered by bitter Nobel-prize economists still suffering from the intellectual wedgies applied to them in their youth. 

Another look at the Koizumi boom

In my previous post, I reported on the remarkably different trajectories that consumption and investment have taken in Japan since the Asian financial crisis. Consumption has boomed at the expense of investment.

Junichiro Koizumi conducting the Japanese economy orchestra

The aggregate investment series I reported earlier included both private and government investment expenditure. The government component of investment in Japan is sizeable. In 1980, it comprised over 30% of gross fixed capital formation. (It's relative size has diminished since then.)

But as Mark Sadowski has pointed out to me, private and public investment in Japan have behaved quite differently over the past couple of decades. I want to explore this property of the data in a little more detail today.

In case you missed it, the Japanese economy experienced a sort of "boom" that roughly corresponded with the time Koizumi was prime minister of Japan. Here is a plot of real GDP in Japan from 1980 to present:

OK, so it wasn't much of a boom relative to what Japan experienced in the 1980s, but it's definitely there.

The boom started shortly after Koizumi took office and lasted for a couple of years after he left -- up until the 2008 crisis. What factors were responsible for this period of relative prosperity? Noah Smith, in a very fine post that I encourage you to read, argues that the episode constitutes a bit of a macroeconomic puzzle.

Keiichiro Kobayashi argues that the root of Japan's lacklustre performance prior to the Koizumi boom was the bad debt problem. The bad debt problem was finally dealt with by two government-backed agencies -- the Resolution and Collection Corp. (RCC) and the Industrial Revitalization Corp. of Japan (IRCJ) -- which were established to dispose of soured loans and restructure troubled corporate borrowers. Kobayashi, who was writing in 2009, also warned against "wishful thinking" on fiscal stimulus.

This latter remark drew the attention of Paul Krugman here. According to Krugman, the Koizumi boom was nothing special--it was driven by an export boom. And, of course, in a world recession, one cannot export one's way out of trouble...unless. In any case, I think Krugman is wrong in his assertion. Take a look at the first figure here. Yes, it is true that exports boomed--but so did imports. And the last time I checked, only net exports constitute contributions to GDP.

In response to Kobayashi's column, Krugman writes:

But it’s true that I’m a bit puzzled by the attribution of Japan’s recovery to bank reform. If the bank-reform story were central, you’d expect to see some “signature” in the data — in particular, I’d expect to see an investment-led boom as firms found themselves able to borrow again. That’s not at all what one actually sees.

The reason Krugman does not see the signature investment boom in the data is the same reason I did not see it in my earlier post, where I obscured the boom by lumping private and government investment together. The following figure shows a rather robust boom in private investment during the Koizumi era:

It is interesting to note that this boom took place despite the era of "fiscal austerity" over the Koizumi boom period. In particular, note the significant reduction in public sector investment and the noticeable slowdown in the growth of public sector consumption during that episode. I might add that the boom took place despite the moderate deflation  (and relatively slow growth in nominal GDP).

Moreover, the evidence does point to a resolution of Japan's bad debt problem over this period; see here:

What role did Koizumi's administration have to play in this? Read this press statement, dated September 27, 2001: Bad Loans Gone by 2004: Koizumi. Remarkable.

Addressing the bad loan problem was only a small (but important) part of the "structural reforms" implemented by the Koizumi administration; see here. Among other reforms listed here include significant cuts to public investment. Note that these cuts were presumably motivated by the belief that public investment had gone too far -- this is arguably not the right policy now in the U.S. where public investment seems to have been underfunded in recent years. Nevertheless, the experiment shows that "austerity" does not necessarily induce economic contraction and, indeed, may be consistent with helping to foster an economic boom.

PS. For academic economists, I came across this interesting paper explaining how government delay in resolving a debt crisis can prolong a slump: Nonperforming Loans, Prospective Bailouts, and Japan's Slowdown, by Levon Barseghyan.

What's up with Japan? (G, evidently)

There is a very interesting monetary policy experiment happening in Japan these days. The outcome of the project will surely be discussed in future macro textbooks. While we are waiting for events to play out, I thought it might be of some interest to provide some context in terms of Japanese GDP data since 1980.

The first diagram reports the behavior of expenditure shares. C is private consumption (including imports), G is public consumption (including imports), I is both private and public investment (including imports), X is exports, and M is imports. By definition, the GDP can be decomposed into its expenditure components as follows: Y = C + I + G + X - M.

Recall that the great slowdown in growth occurred in 1990-91. Here is the picture:

Since the great slowdown, (C/Y) increased from 53% to 60% and (G/Y) increased from 13% to 20%. That's one heck of a consumption boom!

That consumption boom has been financed by a dwindling expenditure share accruing to domestic investment. In 1990, (I/Y) was about 32%, today, it is about 21%.

The next diagram plots real GDP, with its components C, I and G all normalized to 100 in 1980.

We see the great boom early on in the sample, fueled by domestic investment spending. Over that period of time, both private and public consumption grew at essentially the same rate as income (GDP).

Since the time of the great slowdown, the trajectories of these expenditure components have diverged significantly (so much for the "balanced growth" assumptions we frequently embed in our theories!).

What really stands out in this data, to my eye at least, is how G and I appear to have gone their separate ways.

It would be of interest to dig deeper into the data to find out what is going on. What is all that G being used for? Was it too low to begin with and is now just approaching its desired level? Is the increase in G crowding out investment I? Or are there other forces responsible for this pattern--and does the increase in G represent a desirable response to these other forces?

And, of course, the big question for monetary policy wonks: Is a massive asset-purchase program on the part of the Bank of Japan really what that economy needs? Or are policy interventions better directed elsewhere?

Confessions of a rehypothecating fractional reserve banker

I've been trying to wrap my mind around the new 4-letter-word in finance: rehypothecation. I found out that it seems to be related to an old 4-letter-word: fractional reserve banking. I want to argue that these phrases do not deserve to be viewed as cuss words. At least, that's what I think so far. Let me explain why.

An acquaintance approaches you asking for a money loan of $100. He sheepishly offers his vehicle as collateral for the loan. The market value of the vehicle just happens to be $100. (Your acquaintance would prefer not to sell his vehicle because he only needs the cash on a short-term basis, say, one month). You both agree on a one-month loan at an (annualized) interest rate of 5%.

The technical term for this is hypothecation--i.e., when a borrower pledges an asset as collateral to secure a debt. The borrower retains ownership of the asset, but the asset is "hypothetically" under the control of the creditor, who is granted permission to take possession of the asset if the borrower defaults.

In the example above, your loan is 100% secured by your acquaintance's vehicle. But let's imagine instead that the vehicle is only worth $10. After talking with some friends who know your acquaintance a bit better than you do, you decide to go ahead with the $100 loan, secured by the $10 vehicle.

What a nice guy you are. But not everyone thinks so. There are people who rail against your recklessness. Some even call you a fractional reserve banker (I talk a bit about fractional reserve banking here).

A fractional reserve banker? Yes. Let me relabel you a bank and your acquaintance a depositor. The depositor is in possession of $10 in cash (not a vehicle) and he goes to the bank to borrow money (not necessarily cash). The depositor opens an account with the bank and deposits his $10 of cash. The loans officer credits the depositor's account with $90 of electronic digits. (In the old days, the $90 would have taken the form of banknotes and the $10 deposit would have been in the form of specie.) The depositor now has $100 in money to play with (he can buy stuff using his debit card).

Some observations. First, banks do not lend cash. Banks create money. More precisely, they transform illiquid promises (the depositor's IOU) into liquid payment instruments (bank liabilities). Second, fractional reserve banking is absolutely critical to this process. If the bank was restricted to lending only up to the value of its cash deposits, there would be no point to banking (apart from serving as secure repositories). Insisting on a 100% reserve requirement is like insisting that you are not permitted to lend your acquaintance more than the value of his collateral. A restriction like this would certainly make the loan safe. But are such restrictions efficient? (And if you've ever made an unsecured loan to anyone, you have practiced the absolute worst form of fractional reserve banking.)

Well, alright, but what does any of this have to do with rehypothecation? Rehypothecation occurs when a creditor uses the borrower's pledged asset for his own use (e.g., selling it, or using it as collateral for his own borrowing). Rehypothecation plays a big role in the so-called shadow banking sector. The practice is often likened to fractional-reserve banking and is widely blamed for the failure of Lehman Brothers and MF Global; see here.

But just like fractional reserve banking, rehypothecation has its upside. To see this, let  me return to my original example of you and your acquaintance.

Returning to that story, recall that the agreement is to lend your $100 cash to your acquaintance for one month at 5% interest, collateralized by his $100 car. But you know what? It's not entirely clear that you won't be needing some of that cash yourself over the month. You don't think you will, but you might. Hmm, what to do if you do need the cash?

Just before signing the loan agreement with your acquaintance, you come up with this idea. You explain the circumstances to your acquaintance and ask him whether he would be willing to let you use his car as collateral for your own loan, should you find yourself strapped for cash. You acquaintance says sure, but what's in it for me? You offer to lower the interest rate on his loan to 2%. Agreed. (For an example, consider section IV-F in this brokerage account agreement issued by the discount retail broker Scottrade.)

Notice something interesting here. Suppose that you trust your acquaintance fully to repay the loan. Then, you might say, no collateral is needed to support repayment. I want to suggest, however, that the creditor may nevertheless ask for collateral and an associated rehypothecation right. The purpose of the collateral in this case is not to support repayment of debt between broker and client (you and your acquaintance), but to support the broker's (your) promise-making ability in some future transaction with some less trusting third party. The rehypothecation right essentially allows the broker to use deposited collateral as "money on demand."

To see how rehypothecation relates to fractional reserve banking, imagine that you find yourself borrowing $100 mid-month from some third party using your acquaintance's vehicle as collateral. There is at that point $200 in outstanding debt obligations that are supported by only $100 in assets. If rehypothecation rights are granted to the third party (in exchange for lower financing costs) and if the third party in turn uses the same collateral to secure a $100 loan from some fourth party, then we have $400 in debt supported by $100 in assets. And so on.

At each stage in this process, rights over the collateral are passed on to the last creditor in the chain. All previous debts are rendered unsecured; which is to say, the debts are supported by the debtors' desire to maintain their reputational capital. Creditors become more trusting. Is this a bad thing?

What can go wrong, of course, should be obvious: some event happens in which a debtor is either unwilling or unable to fulfil a promise. Those creditors that are secured will emerge relatively unscathed. But unsecured creditors will pay the price. None of this has anything to do with fractional reserve banking or rehypothecation, per se. It is the nature of unsecured credit; that is, credit supported by trust (in the willingness and ability of debtors to make good on their promises).

A credit crisis is, as the Italians used to say, un mancamento della credenza; literally, a suspension in the general belief that any promises will be kept. Credit (derived from credere, or to believe) plays an important role in financial markets and in the payment system. Legislation that restricts or prohibits unsecured lending would surely make financial markets safer. But at what price? There are no financial crises in a society ruled by financial autarky, in particular.