Flatlining in the UK

How bad is the UK recovery dynamic?

Bottomed out -- let's hope so! Can things get any worse?

Here's what real (inflation adjusted) GDP per capita looks like for the U.K. (1992:1 - 2013:2)...

 Because the real GDP is flat, any rise in the nominal GDP is attributable entirely to inflation (increases in the general level of prices). From 1992-1997, the BoE targeted the RPIX inflation rate at 2% per annum. In 1997, the target was raised to 2.5%.

In 2003, the UK switched to targeting CPI inflation at 2% per annum.

So unlike in many other countries, inflation appears to be running at a robust rate. Is this helping, hurting, or innocuous as far as determining real economic activity? (Would like the NGDP targeters to weigh in on this question.)

The following diagram decomposes real GDP (total, not per capita) into consumption (private and public), investment (public and private) and net exports.

So both domestic (real) expenditure components, consumption and investment, took a big hit in the recession. If we take the same data and normalize each series to 100 in 1992, we see that investment grew relatively faster during the boom, and took the bigger hit in the bust.

Now let's break down the (real) expenditure components between the private and public sectors. Again, normalize the levels to 100 in 1992. Here is what consumption looks like:

The big drop seems to be in private consumer spending. Government purchases of consumption goods appears to have held pretty steady through the downturn. What about capital spending? Here, we can only get a breakdown between private and public investment going back to 1997. Government investment is small relative to total investment, but has nevertheless remained elevated relative to private capital spending through most of the sample period:

Note: In April 2005 British Nuclear Fuels plc (BNFL) transferred to the Nuclear Decommissioning Authority (NDA) nuclear reactors that were reaching the ends of their productive lives. BNFL is classified as a public corporation in the National Accounts and the NDA as central government.

In terms of the UK's much publicized austerity measures, the data here suggest that most of any cuts in government spending must have been in the form of reduced transfer payments. Government spending on goods and services seems to have held up relatively well throughout the contraction in economic activity.

Andrew Huszar: Confessions of a Quantitative Easer

Former Fed employee, Andrew Huszar, lays into the Fed here: Confessions of a Quantitative Easer. His opening salvo is a doozy:

I can only say: I'm sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed's first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I've come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.

What supports his claim that QE is a "bailout" for Wall Street? The fact that stock prices have risen. Goodness. Was he hoping instead that the Fed's QE program might have caused asset prices to plunge?

Perhaps not. But what about "Main Street?"

Despite the Fed's rhetoric, my program wasn't helping to make credit any more accessible for the average American. The banks were only issuing fewer and fewer loans. More insidiously, whatever credit they were extending wasn't getting much cheaper. QE may have been driving down the wholesale cost for banks to make loans, but Wall Street was pocketing most of the extra cash.

What justifies this claim? He doesn't really say. He doesn't really need to. Everyone who wants to believe this already knows it is true. And yet, inconveniently, we have the evidence:

I love the contradictions that emerge from his ill-thought-out diatribe. On the one hand, he claims that QE has had a marginal (but positive) impact on the real economy. But on the other hand, he suggests that QE has averted (postponed) an economic disaster -- a situation that would have forced our policymakers to confront the real structural problems that beset this great nation.

Here is Mr. Huzsar on CNBC, where he appears to backtrack a bit. And for good reason: Melissa Lee dismantles him immediately with facts that contradict his argument. Most of his discourse is a babbling brook of incoherence. What is the man saying? What is his point?

At its most basic level, QE is simple to understand in terms of its motivation and its operation. To begin, it's not about printing money and injecting it as "gifts" or "bailouts" to various agents in the economy. The Fed is legally prohibited from such activites (which lie in the domain of fiscal policy).

All the Fed is permitted to do with the new money it creates is to buy securities--mainly government securities, but recently also agency debt (mortgage backed securities issued by Fannie and Freddie). Agency debt currently yields about 3%. Fed paper yields (1/4)% or less. The Fed makes a profit on the interest rate differential. It remits this profit to the U.S. taxpayer (remittances have hit record levels in recent years).

The purpose of printing money to buy agency (and other) debt is to drive up the price of these instruments--equivalently, to drive down their yields. Savers who have government bonds and other securities in their wealth portfolios experience capital gains as interest rates fall. Homeowners refinance their mortgages at lower rates, releasing purchasing power for other purposes. Lower interest rates will hopefully stimulate capital (and other forms of) spending. That's the basic idea.

How well has it worked? The effects have likely been modestly positive. But nobody knows for sure. What are the costs? I am hard pressed to identify immediate costs. Huszar suggests that one cost has been to divert attention away the real structural problems that need to be fixed. I agree with this sentiment, but disagree that it has anything to do with QE per se. It has more to do with the general belief that monetary policy can fix the problems at hand. There may, of course, be future costs to contend with, like future inflation. But inflation and inflation expectations remain low and anchored.

I'm not sure what Mr. Huszar was expecting when he took his "dream job." What did he expect a bond buying program to entail? What would he have done differently and why?  And as for his apology, I'll take it more seriously when I see him return his salary to the American people.

QE in Japan: Past and Present

Japanese Prime Minister Shinzo Abe

One of PM Shizo Abe's "three arrows" of economic stimulus entails a massive "monetary stimulus" designed to slay Japan's persistently moderate deflation.

This is the second time in the last decade that Japan has experimented with QE (quantitative easing). How did the experiment work out in the past? And is there any reason to believe that the outcome will be different this time around?

Let's begin by taking a look at the supply of base money in Japan (Jan 1980 - Oct 13).

The first QE program started in March 2001 and ended in 5 years later in March 2006. The second QE program is evident from the chart.

According to this source, the original QE program had four goals: (1) stabilize the banking sector; (2) lower long-term interest rates; (3) increase inflation expectations; and (4) stimulate bank lending. Evidently, the program had some success with (1) and (2), but failed with (3) and (4).

Here is how core inflation behaved in Japan over the period 1992-2012:

So basically just a moderate deflation since 2000. Is this a bad thing? The conventional wisdom seems to think so. For example, here is Barry Eichengreen on the subject:

Recall that deflation wreaks its damage by discouraging spending – investment spending in particular. No one questions, therefore, that putting Japanese prices on a gradual upward trend is needed to encourage growth.

Hmm, I find these to be rather odd statements, especially from an excellent economic historian. Theoretically, it is doubtful that a moderate expected deflation (or inflation) is really that harmful (it's the large unanticipated swings that potentially hurt). Here is some work by another set of fine economic historians on the subject: Good vs Bad Deflation: Lessons from the Gold Standard Era.

But never mind Gold Standard eras. What about Japan? As I've pointed out here, Japan actually experienced a robust boom in private investment spending from 2002-2008 (as part of the so-called Koizuma boom). So I'm not entirely sure what Eichengreen is on about here.

Let me reproduce my chart for real GDP in Japan:

To my eye, it looks like Japan was basically getting back on track after the interruption of the Asian financial crisis in 1997. In fact there are signs of accelerating growth in the two years leading up to the 2008 financial crisis. Did Japan's QE policy have anything to do with the Koizuma boom? I can hardly see how. The massive injection of cash was removed in 2006 with no noticeable impact on real economic activity (or inflation, for that matter).

Why didn't the original QE have an impact on inflation? We could talk all day about this. Let's start by looking at a broader measure of money: M2 (currency in circulation plus bank deposit liabilities). 

Bank liabilities are created whenever a bank makes a new loan (the liabilities are destroyed whenever a bank loan is repaid). Because bank liabilities are used widely in making payments, they are money. Thus, the red line in the figure above -- the growth rate in M2 -- largely captures the growth rate in bank lending activity. As you can see, the growth rate of M2 is much lower and much more stable than the growth rate in the money base.

To a first approximation, it seems that the effect of QE is on bank reserves and not on currency in circulation/bank lending (sound familiar?). Here is the money multiplier (M2 divided by base money) in Japan:

But on the other hand, maybe this time is a bit different; at least, in terms of inflation expectations. Here are some market-based measures of inflation expectations in Japan (based on the expectations implied by comparing the yields on nominal Japanese government bonds and their inflation-protected counterparts at various maturities).

Here, we only have the 10-year inflation expectation going back to 2004 (it ends some time in 2008 and reappears right at the end of the sample there at about 1%). I've plotted all available maturities here to give us the broad picture. As with the U.S., inflation expectations took a dive during financial crisis (see here). While inflation expectations have been trending upward since before Abe took office, it is notable that they have continued to climb significantly past 1%.

Here is a plot of the expected real interest rate on Japanese government bonds at different maturities:

So it appears that Abeconomics has "succeeded" in driving the real interest into negative territory. I suppose this is a good thing if for some reason the market "wants" negative real rates, but is prevented from achieving them owing to the zero lower bound on nominal interest rates.

But the deeper question is: Why do real rates want to be so low? And why should we  expect a resumption of "normal" economic activity once these negative real rates have been achieved?

Data source for Japanese inflation expectations: Bloomberg

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.