Wednesday, 29 February 2012

Graph of the week: money multiplier

So the M1 multiplier for the US is still below 1:

Source: St. Louis FED, FRED database
What does this mean? Essentially it means that every dollar created by the FED (an increase in the monetary base M0) will result in a <1 dollar increase of the money supply (M1), as is evident from the figure below. So, the credit and deposit creation of commercial banks is limited in this case. The banks are still holding on to a lot of excess reserves. 

M0 (St.Louis adjusted, green) and M1 (red) are both on the right scale.
Source: St. Louis FED, FRED database
The effect of a 0<m<1 multiplier is that the monetary base is larger than the M1 money supply (remember that M1 doesn't take into account savings deposits or time deposits, which are included in the M2). This kind of a situation is obviously not good, as there is more money in the economy created by the central bank than it is created by commercial banks. One could say this is a clear example of a liquidity trap, as the central bank is powerless in trying to encourage banks to take on more lending. 

The multiplier is reciprocal to the reserve requirement of a bank (meaning the more money a bank is required to hold as reserves, the less it can use it for credit and deposit creation), so the reason it is low is the fact that banks have increased their reserves and are not producing as much credit as the economy needs (not lending enough). And the reason why banks are still careful is that they are unwilling to accept any further losses or take on risks partially due to the already high levels of public anger aimed against them (hint: bailouts). So they lower their lending to businesses and consumers, increase their reserves, meaning that the multiplier decreases. And the fact that it's below 1 means that the recovery is still holding back. A way to get it started isn't via quantitative easing or any other form of increasing the money supply; rather the focus should be on restoring confidence

Sunday, 26 February 2012

Imported instability: examining the causes of eurozone contagion

Note: this article is an update and summary of the sovereign eurozone debt crisis page. I've added a few things and broadened the analysis.

In light of the expansionary austerity debate in peripheral Eurozone, the conventional solution surrounding Eurozone’s recovery has been a call for fiscal adjustment. The idea supporting austerity arises from the viewpoint of recklessness of peripheral Eurozone governments and their extensive debt accumulation and crippling welfare states. Even though a certain level of fiscal profligacy and strong accumulation of debt were apparent in peripheral Eurozone (and it is certainly the main issue holding back its recovery), this was hardly the most important reason behind a strong and severe recession that struck these countries. The focus of the article will be on the spread of financial contagion onto the peripheral Eurozone economies, namely Greece, Portugal, Ireland, Italy and Spain. 

The problems that occurred for the peripheral Eurozone economies can be described through three features they all shared: domestic preconditions and instabilities, current account deficits and the euro, and outside contagion from the US. 

The first are local instabilities and the way these countries ran their economies in the wake of the crisis. This doesn’t in all cases imply budget deficits and debt accumulation, rather each country was characterized by specific conditions which endangered the sustainability of their economies. Ireland and Spain experienced a housing and construction boom and suffered an immediate impact of deteriorating housing prices and loss of construction jobs. Before the crisis, their fiscal position was fine, with decreasing debt and a balanced budget, but after bank bailouts (Ireland) and bankruptcies of the largest construction companies (Spain), decreasing revenues and increasing expenditures increased their budget deficit and public debt beyond sustainable. Portugal had over-expenditures into large public projects (including building stadiums for the Euro 2004), mismanagement in public services and investment bubbles which all led to a rising public debt and an unsustainable fiscal position. Greece and Italy, both on very sensitive high public debt levels before the crisis (see Figure 1) had an additional constraint – corrupt politicians who cared more of self-preservation than the well-being of their country. Their politicians used expensive populist policies to remain in power. They used cheep borrowing on the international market to fund their electoral victories by broadening its welfare states and offering concessions to particular electoral groups. They ‘bought’ votes by increasing pensions, hiring more public sector workers and increasing their wages in order to create a perception of high employment. Their governments were perfect examples of how the inflow of foreign capital was used inefficiently to finance consumption and maintain political power. 

The second characteristic was the introduction of the euro. Due to a common currency it became cheaper for the peripheral economies to borrow on the international market which induced large current account deficits. This was the point of a single currency – to ease the movement of capital across borders. But what it created was a dependency on credit from abroad. Once this credit flow stopped the stage was set for the spread of the crisis. They found themselves in a typical sudden credit stop (as explained in Reinhart and Rogoff, 2009), usually a characteristic of emerging economies that pegged their currencies. 

And third, what brought to the sudden stop of credit, worsening their fiscal balances, was the spread of outside contagion, particularly from the US. The financial crisis that started in the US quickly spread worldwide through decreasing trade and a loss of investor and consumer confidence causing a credit squeeze. All this made it harder for the peripheral economies to borrow on international markets, and since their economies became dependent on cheap capital from abroad to finance their consumption and government expenditures, the credit squeeze proved to be particularly painful. Outside contagion brought the domestic instabilities of the Eurozone economies onto the surface, and created the final trigger for the sovereign debt crisis.

Figure 1: Eurozone countries’ current account balances and gross government debt (click to get a better view)

CA balance (left axis, blue) compared with gross government debt (right axis, red), 
both in percentage of nominal GDP. Source of data: IMF World Economic Outlook, 
September 2011. Note: All data for 2012 are estimates.
Observing Figure 1, a common feature is obvious: right before the start of the crisis, and mostly since the introduction of the euro, all peripheral economies experienced rising current account deficits, while the same period saw a large CA surplus in Germany. Even though Greece didn't have a CA surplus for over 30 years, Portugal, Spain, Ireland and Italy all experienced CA surpluses at some point prior to the introduction of the euro, only to see them decrease rapidly from the beginning of the decade. 

Government debt increase, on the other hand, fails to give such strong implications. Spain, Italy and Ireland were actually decreasing their government debts and improving their fiscal positions, while Greece kept it steady. It wasn’t until the actual start of the crisis that the debt levels started rising in every country. 

Therefore, fiscal profligacy isn’t as crucial as often made to believe. Some instabilities certainly did exist, but they couldn't have caused a crisis so severe and so widespread. It is more likely that outside contagion combined with dependence on foreign capital inflows exacerbated the systemic risk of each country. Domestic imbalances became more visible once the foreign inflow of credit stopped. They are now the cause of problems of structural adjustments, but they weren’t the cause of the contagion itself.

Instabilities from abroad: problems with a CA deficit and the common currency

When one country runs a current account deficit, this implies it runs a surplus in its capital account. A capital account surplus means an inflow of foreign capital into a country (foreigners buying more domestic assets) which is essentially a good thing since money will always flow to where it expects the highest and safest returns. However, the question is where is the money from abroad being transferred to domestically? If it is used to finance investment (into manufacturing, productivity increase or any other wealth creating activity) instead of consumption, then the deficit can carry on rising as the country is using the inflow of capital to boost its production facilities and increase growth. If it is used to finance consumption and government expenditures focused on politically popular policies, then the outcome might be an asset price boom or an unsustainable fiscal position of the government who is becoming dependent on foreign capital to finance its exaggerated expenditures. Ireland, Spain and to some extent the US suffered from the first, while Greece, Portugal and Italy suffered from the former. 

Before the euro Greece had a history of debt defaults, financial contagion, inflation crises and banking crises (see Reinhart and Roggof, 2009). This was usually reflected in its higher bond yields – a risk premium for investing in its debt. The spread between Greek and German bonds was historically always high. However, once the euro was introduced, its yields and the spread started decreasing making the Greek debt as safe an investment (financially) as the German debt. The reasoning behind it was that the ECB would make sure inflation and currency instability will never again be the problem of Greece or any other peripheral country. Soon enough, every peripheral Eurozone bond on the market traded as the German Bund – the spreads were smaller and the risks were perceived as non-existent (Basel II recognized their debt as zero risk-weighted assets). 

This meant one thing; all these countries could borrow at cheap rates, while its politicians had no need to be fiscally responsible and could resort to populist policies that would keep them in power. Borrowing cheaply meant that credit from abroad was used to fuel domestic consumption which led to a rapid increase in GDP above its potential levels, either through high government spending (Greece, Portugal) or housing market booms (Ireland, Spain). 

Figure 2 observes how the inflow of capital was used in peripheral Eurozone. It compares levels of consumption, government expenditures and gross fixed capital formation (fixed investments) for each nation observed to evaluate the sustainability of the CA deficit.
(click to get a better view)

Government expenditure (blue), fixed capital formation (red) and consumption 
(right axis, green) are all taken as log variables. Source of data: 
St. Louis Federal Reserve Economic Data (FRED), February 2012.  
From the graphs it can be inferred that in all these countries, except Italy, consumption was growing much faster and more stable than fixed capital formation. In Italy and Ireland they grew simultaneously right about two years before the crisis until the housing prices started to fall - the same effect can be noticed in Spain. Greece and Portugal saw steadily increasing consumption, with investments being more cyclical and volatile. In Germany, fixed investments have deteriorated immediately since the introduction of the euro, when a lot of German capital flew across borders. 

Government expenditures also show a rising trend for each country (represented by the blue line). For all the countries government expenditures were closing the gap between investments. In Spain they grew simultaneously with investments, while in Ireland they grew simultaneously with consumption. In Greece, they grew rapidly, doubling in absolute terms over the past decade, while Portugal experienced a significant decrease of the gap between investments and government expenditures after the introduction of the euro. 

Summary of outside contagion

Interest rates were low across the Eurozone, and investors in core countries seized this opportunity to invest in periphery economies. In Germany lack of domestic demand was substituted by investing abroad. It became more attractive to invest in the periphery as the risk of default was diminished by the fact that the euro was backed up by all Eurozone nations. Capital outflows came mainly from the core as it became available for German and French investors to broaden their portfolio onto new, yet stable markets. The system of borrowing to fuel domestic asset bubbles worked as long as the asset prices kept rising. Borrowers could pay off their loans simply by borrowing more even cheaper. The problem arose when the inflow of capital suddenly stopped due a spread of the US financial contagion across the globe. Investor confidence rapidly declined worldwide and the peripheral Eurozone countries faced the same fate of the Latin American countries in the 90ies, since they were no longer able to issue debt in their own currency. Investors didn’t react well to this. The sudden stop in 2009 made it difficult for these countries to roll over their debts which increased the European crisis of confidence and led the peripheral economies into a sovereign debt crisis. 

Essentially the idea of the euro was to increase and smoothen convergence in the Eurozone. Adoption of the euro made it easier for capital to flow into the peripheral countries. Their CA deficits prove this. However, this was an anticipated reaction and a welcomed move from the Eurozone policymakers. It indeed helped fuel and sustain economic growth way above its potential level for some of these countries. It was supposed to be used to make their economies more competitive. But consumption and government expenditures (and an asset price bubble in Ireland and Spain), rather than investments, were fuelling growth creating dependency on foreign capital to service current liabilities. An increase of systemic risk and asymmetric outside shocks that led to a stop of credit exacerbated the existing instabilities in peripheral Eurozone.

See the full analysis, including the outcomes and the consequences here.

Thursday, 23 February 2012

UK recovery policy – Austerity! What austerity?

Note: This blog post was also published at the Adam Smith Institute blog (1st March 2012). For all my other ASI writings see here

Recently a lot of attention has been given to the case against British austerity. It has been blamed for the inability of the UK economy to pull itself out of border-line recession. Krugman, DeLong, Baker and many others attack it claiming that contractionary expansion makes no sense, while on the other hand Sumner and Boudreaux tend to overturn the argument by claiming there is no austerity in the UK. And opposing to both of these views, UK Chancellor George Osborne surprisingly claims it is working. 

Who is right? Well, one thing is certain, Britain isn't experiencing any form of robust economic growth, so whatever policy is done by the government clearly isn't working. 

The UK government is leading an ambiguous recovery policy which is, unsurprisingly, producing ambiguous results. It is sending wrong signals to the private sector. When it is trying to subsidize, this yields no effects as the people expect it to cut further. When it is trying to build high-profile infrastructural projects, it isn't working as the anticipated costs are much higher than the benefits (even though they claim otherwise). When it’s trying to make banks increase lending, it creates less competition in banking making the price of credit still too high. Any intervention it’s trying to make is yielding no positive outcomes. Surprise, surprise. 

Austerity or expansion?

The UK had the one of the strongest fiscal stimuli (relative to the size of its economy) in the world as a response to the crisis, during the premiership of Gordon Brown. The result was making the situation much worse with a rising public debt and the third highest budget deficit in the world behind only Greece and Egypt in 2011, and behind Greece and Iceland in 2010. This comparison is striking since these countries were doing much worse than the UK at the time and were countries with highly unstable economies – Iceland before the restructuring, Greece whenever, and Egypt after a year-long revolution which saw the downfall of a dictator and an inability to consolidate ever since.

So the argument of Keynesists is that this wasn’t enough, and that Britain is crippled with austerity. The media is supporting the former view as well. Britain is running the hardest austerity policy in Europe and this is resulting in terrible growth performance and the inability to start up the recovery. However, Britain is far from austerity. Yes, some painful cuts have been made, tuitions were rising, unions were hit, wages in the public sector are stagnant, a lot of public sector workers have been laid off, but what does the government do with this saved up money? It invests into credit easing, housing subsidies, the youth contract and infrastructural projects. On the other hand, it's guiding private sector investment and centrally planing credit, it announces an increase of the minimum wage, abolishing of the default retirement age, more regulation after claiming to remove regulation, the 50p tax rate and so on. None of these policies are policies aimed at growth. They are all part of a Keynesian response to the crisis. 

After all, if one would just observe the spending data for the UK, it is still increasing, both relatively (as percent of GDP) and absolutely.

 As a comparison, during the Thatcher government, spending as percentage of GDP went down from 46% in 1981 (where it stands currently) to 34% by the end of 1989. The New Labour government(s) simply reversed that trend. To be fair, it took the Thatcher government two years to see spending to GDP rapidly decrease, so one might say to give the current government a chance. However, according to the announced policies which haven’t all even kicked in yet, I highly doubt the outcome will be the same.  

The outcomes of the Thatcher government then and the current conservative government are very likely to produce different results. In the 1980s Thatcher removed the dependency of the economy on the government and was able to restore the competitiveness of the private sector. The current government is actually looking how to increase this dependency and yet it naively expects the private sector to step in and grow on its own. 

The initial call for austerity in the UK was a necessary solution for an economy left in dire straits after the previous government’s response to the crisis. They needed to avoid the peripheral eurozone scenario and a possible sovereign debt crisis. They have succeeded in doing so and have sent positive signals to foreign investors. But now they need to be brave enough to send similar signals to the domestic economy. Continuing with the cuts is futile if the dependency on the government isn't removed. Having subsidies for youth hiring, housing, banks or businesses won’t remove this dependency. 

One does not simply enforce austerity without clearing the way for the private sector to grow again on the principles of competition and an unconstrained business environment. This crucial assumption still hasn't been made in Britain. Until we don’t see signs of reducing business and consumer dependency on the government and until we don’t see signs of more competition and less regulatory constraints to foster economic growth, the current situation will extend itself even further than projected. 

Monday, 20 February 2012

US debt and deficit - graph of the week

From the latest US budget proposal, I found an interesting graph that was given attention to in Congress.

Source: US President's Budget for Fiscal Year 2013. Analytical Perspectives, pp. 58 

It describes a long term fiscal challenge facing America, where the current administration (led by the Treasury secretary Mr Geithner) stresses the importance on short-term deficit control and debt reduction, something vehemently opposed by Paul Krugman

The idea is to decrease the short term deficit and decrease the growth rate of the public debt by the end of the decade. The deficit is projected to be around 2.8% of the GDP by 2019, which is a goal within reach.
"Beyond 2022, however, the fiscal position gradually deteriorates mainly because of the aging of the population and the high continuing cost of the Government’s health programs." Analytical Perspectives, US Budget (February 2012), pp.58
These expected costs will drive up the deficit and cause a huge increase of the public debt in the next 50 years. Mr Geithner stresses out how this graph describes the two-way approach of the administration; one to take care of the short-term deficit, and the other where they apparently don't care on the long-term sustainability of their solution, rejecting other views cause they "don't like it"

Now, even though the projections can be biased and shouldn't be completely trusted (as it's unlikely that the debt could grow so big in the course of the next 50 years - there is always an upward bias in forecasting models) it does show a unfavourable trend for the US public finances. 

Even more surprising is the reason why the current administration decided to reject the proposals made by their own non-partisan fiscal commission. In fact, here is how the Bowles-Simpson report projected the movement of the US debt under three scenarios:

Source: "The Moment of Truth" National Commission on Fiscal Responsibility
and Reform. December 2010, pp. 10.
Pay attention to the blue line denoting the Commission proposal's debt levels for the next 30 years. From comparing the two graphs it seems that the current budget proposal chose the current policy scenario (green line in the second graph), only smoothing it a bit until 2020, and then letting it rise unsustainably. 

Furthermore, where the current budget proposal finds no way of eliminating the deficit (the aforementioned 2.8% is the lowest it can go), the Bowles-Simpson report actually does manage to get the deficit under control and seriously decrease the public debt. 

Source: "The Moment of Truth" National Commission on Fiscal Responsibility
and Reform. December 2010, pp. 16.
Perhaps the current administration is worried about the upcoming elections later this year and doesn't want to engage into necessary entitlement cuts and the welfare state reform, which is a sad motive to be guided by, at least for the economy. 

Friday, 17 February 2012

Effectiveness of credit targets

Note: this blog post was first published at and intended for the Adam Smith Institute blog, on Friday, 17/02/2012, entitled "The fallacy of Project Merlin"

Project Merlin – the idea that the UK Treasury can centrally plan the amount of credit needed in the real economy – was a predestined failure.

The recent data released by the Bank of England was disappointing for the UK SMEs. The lending target fell short by £1bn, even though total lending did rise to overshoot its target by £25bn. The banks claim they did their job as required, while accusing the sluggish economic recovery and poor demand for credit from small businesses as the reason behind lower SME loans. On the other hand, SMEs blame high credit costs and unfavourable loan terms, calling for more competition between the banks to offer better products and lending models. 

The reaction from both sides, the banks and the businesses, was as expected, proving once again the short-sightedness of politicians. Banks don’t want to loan to risky borrowers fearing new potential losses they are unwilling to accept. Businesses realize this and want more competition as the only possible way to lower the costs of credit.

However, with ideas such as credit targets the government is doing the opposite – it is undermining any possibility for more competition. When you set an artificial target applying to only the 5 largest banks, those banks will strive to meet the targets by increasing their dominance and taking a larger share of the market than usual. The result is that 5 biggest banks accounted for 90% of all SME lending last year. 

The end result of the target was political pressure on banks to increase lending, no matter how and to whom, meaning that the banks channelled funds not guided by commercial incentives or market signals, but by the bulk of funds needed to be deployed to satisfy the central authority. This resulted in a huge misappropriation of resources where money, instead of flowing to projects where it might generate new value and growth for the economy, is artificially drawn to various projects simply to fulfil the given target. 

Besides, how is the government supposed to determine the threshold of credit big enough to start up the recovery? Even if such a threshold existed, a target to reach it means the government can only influence the supply of credit, not its demand, which is what the results have showed. In addition, having credit targets, whether achieved through bank lending or by the Treasury itself (via credit easing) the ultimate effect will be dependency on government transfers and credit flowing only to politically selected companies, instead of those who could actually use the funds to create value. 

Targeting a mandatory level of spending, savings or credit always reminds me of the misguided EU policy on mandatory expenditures on R&D in the IT industry to 3% of the GDP for every EU member (this was a goal of the 2000 Lisbon Treaty for 2010). Not surprisingly many of the countries fell short of the 3% target, and have tried to artificially move closer to it, by dumping huge amounts of money into R&D only to satisfy the target. Needless to say this yielded poor results and almost no substantial technological innovation or progress (these results were evident before the crisis even started). R&D is proven to have positive effects on technological advancement and economic growth, but when it’s promoted by subsidies and investment interventions, the market gets distorted by receiving wrong signals of what is a good investment and what innovation is most likely to deliver growth. 

One can go a step further and compare this sort of reasoning to the Soviet Union planned targets for its heavy industry. Both are based on the same principal; that politicians and bureaucrats believe they are better qualified than individual businesses to make decisions on how much money should be invested in a particular industry. Just as the Soviet Union and the EU planning failed to create a competitive and a dynamic economy, so has the Merlin Project in the UK. And this wasn’t a policy enforced by the EU – it was a product of domestic thinking. 

You don’t solve a problem in the economy by pumping taxpayers’ money into banks, technology or manufacturing, you do it by enabling a fair and competitive environment where successful firms triumph, while unsuccessful and those unable to adapt are forced to closed down. There is nothing more fair than the system of meritocracy. In a market economy it is a travesty to have private sector decisions and strategies be guided by politics.

Thankfully, Merlin won’t be repeated this year, but Mr Osborne is instead negotiating a new £20bn loan guarantee scheme with the banks in order to support his credit easing policy. What he doesn’t realize is that although this may provide a temporary short-term relief, it will have deeper consequences by creating dependency of the businesses on government transfers. In addition, it is very difficult to make a temporary policy work effectively, particularly when future expectations may undermine its temporary desired effects. The problem is always what happens when the government ceases its lending scheme. 

A decrease of regulatory constraints and taxes will level the playing field for all businesses, making sure that competition gives rise to successful and adaptable companies. A much better way than a stimulus in any form of ‘easing’, is to lower costs for the SMEs

Finally, can someone tell me what type of economic policy requires huge spending and stimuli from the government to the real economy in times of crisis? Is it called austerity? 

Tuesday, 14 February 2012

Business and consumer confidence

Business cycle tracking series

Continuing with the business cycle tracking analysis, I will take a brief look at the business and consumer confidence indicators for selected countries. I will observe the OECD indicators of business and consumer confidence to verify their total effect on predicting the recovery.

First up is business confidence.
Source of data: OECD Main economic indicators database

As can be seen on the graphs, business confidence was severely struck during the last adverse shock, even though the data seem to show the deterioration of business confidence started earlier last year, which is probably due to uncertain expectations on the development of the recovery. Even though policy uncertainty culminated in August 2011 with the debt ceiling argument in the US Congress and the eurozone situation, business confidence simply followed down that same trend in Europe, while recovering in the US following a shift of the debate toward electoral topics and positive signs from the economy. 

In Europe, German business confidence, even though experiencing a rapid rise ever since the official end of the crisis in 2009, reacted with caution to the recent eurozone development which resulted in a slightly poorer economic performance of Germany in the final quarter of 2011.

Regarding peripheral eurozone, it seems that the bond purchases of the ECB in the summer didn't do much good for Italian or Spanish business owners. It was a temporary relaxation for their governments at the time to take care of their debt burden. Obviously, the businesses weren't fooled as their anticipations of an uncertain future grew and their confidence deteriorated.

Once the data for the first quarter of 2012 is available I expect to see an improvement of the business confidence indicator, as the businesses are more likely to positively react to reforms enacted by the Italian and Spanish governments, than to a temporary liquidity offering of the ECB to the governments to ease their debt burden. 

The second indicator is the consumer confidence indicator (CCI), which is signaling more ambigous performance and a much stronger reaction. The consumers are obviously reluctant to spend.

Source of data: OECD Main economic indicators database
Unlike business confidence, except for Germany and Spain, every other country experienced a decrease (or stagnation) of consumer confidence since 2009. The US, after having stagnating low confidence levels throughout the last two and a half years, reached a bottom point in August 2011 and has experienced an increase ever since, as policy uncertainty started falling. The UK and the eurozone are still in a free-fall as ambiguous policy solutions from their policymakers reflect the economic environment. The UK is still hoping for better news in 2012 with the Olympics and the Diamond Jubilee, which might result in a rapid increase of both consumer and business confidence, and consequently a higher aggregate level of spending.

In peripheral eurozone, again observe the reaction in consumer confidence after the first set of Italian and Spanish bond buying from the ECB in the summer. Consumers obviously didn't see the same effect the bond markets did. Even though this decreased the yields substantially at the time, consumers failed to see how this could be helpful for them. This might shine new light on the effectiveness of monetary actions from the ECB to help start growth. In my option, it can do no such thing. Its end result is a temporary easing for the governments in support of the reforms. It will yield a positive effect for growth only if the reforms are done effectively and efficiently.  

Friday, 10 February 2012

Business cycle tracking - Europe

The series of business tracking continues with observing the development of the cycle in the eurozone and in the UK. The analysis will constrain itself only on observing the leading indicators from the OECD database and the Conference Board.

The first is the leading indicator for eurozone from the Conference Board. They compare the LEI with a coincident economic index and the quarterly RGDP growth rate.
Source: The Conference Board, Global indicators, Euro Area
What can be noticed is a small increase of the index in December 2011 (which is the last available data), offering a slightly better perspective for the eurozone after the latest fiscal treaty conference in December and signs of reforms in Italy and Spain. However, it is still ambigous to conclude whether the index itself will show a rising signal for the rest of the year, or whether the bottom of the possible 'double dip' has been reached. 

The index comprises of the following indicators: Economic sentiment index, Index for residential building permits, Index of capital goods new orders, Euro Stoxx index, Money supply (M2), Interest rates spread, Manufacturing purchasing index and the Service sector future business activity expectations index. To see more and to see the technical details, visit their website.
You may notice that apart from the service sector expectations index and the interest rates spread, all of these indicators were observed and analyzed separately in the previous business cycle tracking post on the US. By observing each of them we could infer on which indicator could be driving the LEI upwards or downwards. But what is essentially important is the final signal received by the market that comprises the index. Upon observing this signal we may draw inferences on future economic activity. This is why the analysis for Europe will focus only on the end product, i.e. the LEI itself. 

OECD offers an opportunity to look at the indicators for individual eurozone countries and compare the recovery for each of them.

Note that the eurozone LEI includes only data from January 2010, while
the rest of the countries include a longer series from January 2008. 
Source of data: OECD Main economic indicators database

Comparing across countries it is obvious that almost all of the selected countries are sending negative signals of future economic activity. Note that the last available data is for November 2011, meaning they didn't account for any of the new developments in December which could have, if included, corrected the indicators slightly upwards (as was shown in the previous graph from the Conference Board).

The data from November, during the biggest uncertainty in Europe over the faith of the eurozone (which was covered in detail on the blog), clearly show that the situation was going from bad to worse. However, recent developments in Italy and Greece in January (not accounted in either of the indicators) could result in a much better future signals for the eurozone (and consequently(!?) higher levels of the LEI index). 

But then, is the leading indicator really that good at predicting recoveries? Is it 'leading' at all? Its values for the final quarter of 2011 were clearly influenced by the huge level of rising uncertainty after the summer months and the shock following the US rating downgrade, which translated itself through stock and bond markets onto peripheral eurzone, once again emphasizing its instabilities. The value of the LEI at the time was pointing out to a possibility of a euro break-up and various other adverse effects, meaning that its sudden decreases in the last two quarters should hardly come as a surprise to anyone. However, when there is lack of confidence and huge uncertainty, political decisions will act as better signals on the market, as they will send signs of increasing or decreasing confidence which will influence business decisions on whether to order more goods, build more houses, pile up on inventories or anticipate a break-up of the whole currency. When they were anticipating this break-up and when they were disappointed in political abilities to provide a favourable solution, the outlook was grim and investment was low, implying decreasing values for all the observed leading variables. 

In the mean time the politicians didn't come up with a particularly good solution (the Treaty), but they could have nevertheless restored some confidence to investors. Also, the reformist governments of Italy, Spain and Greece (although a lot of uncertainty still arises here, meaning that it isn't likely to expect the Greek LEI to recover for the next quarter), will set the eurozone LEI on higher levels. 

So, in a crisis of confidence, policy uncertainty and political decisions are proven to have a huge impact on all variables, including the ones who are supposed to be signaling future trends in the economy. Therefore, it would be better simply to observe political solutions and immediate market reactions than the LEI to form expectations of upcoming economic activity. However, I refuse to be discouraged and will continue to observe both. 

Tuesday, 7 February 2012

Policy uncertainty - graph of the week

In today's VoxEU set of most recent articles, I ran into a very interesting one measuring economic policy uncertainty in the US as a way to explain the trails of the current recovery. 

Source: Baker, Bloom, Davis (2012) "Has Economic Uncertainty Hampered the Recovery"

Baker, Bloom and Davis (first two from Stanford, the third from Chicago) devised an economic policy uncertainty index based on three types of information: "frequency of newspaper articles referencing economic uncertainty and the role of policy, federal tax code provisions set to expire soon and the disagreement among forecasters on future inflation and future government spending." They have the index database, as well as their results and methodology explained on their webpage and this short paper for the Hoover Institution Press. Here's a good summary of what they're trying to say:
"We previously argued that policy uncertainty was a key factor stalling the recovery. When businesses are uncertain about taxes, healthcare costs and regulatory initiatives, they adopt a cautious stance. Because it is costly to make a hiring or investment mistake, many businesses naturally wait for calmer times to expand. If too many businesses wait to expand, the recovery never takes off. Weak investments in capital goods, product development and worker training also undermine longer-run growth." (Baker and Bloom, 2012, VoxEU)
They find very interesting correlations of the policy uncertainty index and economic outcomes. They also explain for the current set of good results of the US economy by noticing a sharp decrease of economic policy uncertainty in the past few months (the drop was 40% from its August 2011 peak to January 2012). 

Not surprisingly, the August peak is explained by the Congressional quarrels over the debt ceiling that brought to the historical S&P ratings downgrade. It was approximately the same time when the eurozone problems re-appeared. 

The current crisis was very often depicted as the crisis of confidence. This index fully reflects that as it can provide a good insight on the proper policy instrument to resolve the recession and kick-start the recovery. The most important finding is that whatever policy chosen, it should be done transparently and with an aim of boosting confidence. The less political implication, the better. 

Saturday, 4 February 2012

Graph(s) of the week: velocity of money

Still on the US business cycle, here is the look at some monetary indicators. The first graph depicts the velocity of money (V in the famous quantitative theory of money equation MV=PQ) and the employment-population ratio (employment adjusted for the discouraged workforce - the most precise unemployment indicator): 

Source: St. Louis Fed database (FRED)
The natural log of M2 velocity is depicted on the left scale (blue), while the log of the E-P ratio is on the right scale (red). The correlation is obvious and can be explained in the following way: the velocity of money measures the rate of circulation of money in the economy, i.e. the rate at which goods and services are bought. So it makes sense that with decreasing levels of employment and decreasing consumer confidence (as seen in the previous post), the rate of money used to buy goods or services will decrease. And since the E-P ratio still isn't showing any signs of improvement (even with the latest jobs report), the velocity of money is still decreasing without showing any positive signs so far. (Note: the M2 velocity is calculated by dividing the nominal GNP with the money supply M2).

On a different note, to further examine the quantitative theory of money in the current situation, here is a graph depicting the M2 money supply for the US:
Source: St. Louis Fed database (FRED)
Its steady increase, multiplied by the velocity decrease and divided by the stagnant nominal GNP can explain why the price level hasn't erupted due to a large level of QE. The thing pondering many economists is whether this inflation will pick up once the velocity of money rises with the recovery. Perhaps this can shed new light on the ultimate determinants of inflation particularly in times of crises, as it seems that the velocity of money can explain inflation better than the growth rate of the money supply. But this is just a though.
One thing is certain though, parameter V isn't constant as assumed by the QTM - it is clearly highly volatile and sensitive to the aggregate demand shocks. 

Wednesday, 1 February 2012

Business cycle tracking - USA

This is a beginning of a series of quarterly (or half-year) posts on the business cycle conditions of some of the selected world economies. I aim to observe and analyze certain leading business cycle indicators to try and show where the current recovery stands. Even though observing these indicators doesn't necessarily imply a move of the entire variable in that direction, the leading indicators can prove to be good signal of upcoming economic behaviour. 

The analysis will be simple in the beginning, and will add observations and indicators along the way, all in hope of creating a better picture of when the recovery might end, and the period of economic prosperity begin. The series itself will probably be presented in a separate page on the blog, where up to date data on selected indicators and economies will be available. I will provide summaries as a blog post by the end of each quarter to show the direction of the recovery.

In order to avoid having to explain real business cycle theory and its indicator variables (which might take up a lot of time and space), I suggest a few sources to familiarize with it: Roubini's business cycle indicators (outdated, but still excellent as an introduction), the Conference Board (offering the finest measures of leading indices for selected countries - make sure to check out their useful handbook), NBER (officially tracing US cycles, measuring 33 cycles so far from 1854 to 2009; they also provide a downloadable book on the subject), the European Commission (tracks the European cycle based on joint business and consumer surveys), and the best source of data for individual indicators is the St. Louis Fed database (FRED).

One needs to distinguish between three types of economic variables: leading (move before the cycle and predict it; example -  building permits, new orders for investment goods etc.), coincident (move with the cycle; example - personal income, consumption, non-farm employment) and lagging (move after the cycle; example - nominal wages). Also, variables can be counter-cyclical, pro-cyclical and acyclical (implying the direction of their movement with the business cycle). What is most interesting to observe are leading indicators, which could tell us where the economy is currently heading. We can observe both cyclical and counter-cyclical indicators to see the direction of the cycle more clearly. An index comprising of a set of the most powerful leading indicators is the Leading Economic Index (LEI). 

Having known all this, I will randomly select indicators proven to have a history of leading indication and observe them for the following countries (for now): US, UK, eurozone (and some of its members individually). Not all data for all countries is available, but fortunately, for the US, the data is abundant. 

United States

New housing building permits (a good leading indicator, as it provides insight into upcoming activities in housing construction and economic activity - induced in LEI)

We can see that this powerful indicator of future activity still doesn't show any signs of recovery for the economy. This could be biased by the fact that the US housing market experienced an unprecedented slump in housing and is still unable to recover. Hence, there is not so many building permits issued.

New orders in manufacturing: durable goods (maybe not so precise as a leading indicator for recessions, but may signal a potential recovery, although the indicator can be biased due to the volatility in transportation sector and defense, which can drive monthly figures unexpectedly) - depicted upper left on the figure below:

An increasing number of orders in manufacturing in durable goods is showing positive signs for the recovery; however, when looking at the index of new orders (upper right), the picture is slightly different and still inconclusive on the state of recovery. It is obvious that this indicator is highly sensitive to worrying signs of investor confidence that will constrain businesses in their expansion and new orders. Even though currently the situation is improving - as reported by the WSJ - those reports are based on monthly changes, so one should be careful in their interpretation in positive signs of recovery. It is more likely a reaction on positive changes in US GDP growth and investor confidence. Therefore, the manufacturing purchases can be a good indicator but are more likely to be coincident than leading in this case. 

One can also observe hours of production of workers in manufacturing (lower left) or the index of supplier deliveries (lower right) but both serve more as coincident indices and show the same signs as the new orders index. 

Fixed domestic investment (a powerful leading indicator that can drive aggregate demand; it falls faster during a recession and grows faster during a recovery than the GDP) - depicted in the upper left corner of the figure:

It consists of non-residential (lower right) and residential fixed investment (lower left), where residential is still low (for the same reasons as the new housing permits indicator, which is what residential investment mostly comprises of). Within the category of investment, the best thing to look at is the inventories index (upper right) which is showing volatile movement in the past few years. Inventories were the main reason behind the latest US GDP growth data, which can be observed in the graph above in the final observations of the inventory index. Even though they are treated as a positive sign of recovery, there is a caveat - is it due to a higher expected future demand (good), or are they pilling stock due to an overestimated demand ending up with a bunch of unwanted goods (bad)? Currently, it is hard to tell. 

Unemployment insurance claims (these can be a good indicator of falling levels of unemployment, but they fail to predict the unemployment movement if they are biased with exiting labour force data, which is why the employment-population ratio serves as a much more precise indicator)

Consumer confidence (an important leading indicator based on a survey of households - it tends to be correlated with unemployment, real income, stock market prices)

As is obvious from the graph, consumer confidence hasn't yet fully recovered. This could be the ultimate reason behind a still low aggregate demand. 

Finally, here is a joint, weighted-average US Leading economic index (LEI).

Source of all data: St.Louis Fed database; FRED
It fails to currently predict the momentum of recovery, as it is too volatile to be conclusive at this point. Also, its final observations show a move in the negative direction, contrary to the latest GDP growth data. It is possible this is due to signals coming from Europe or the signals of the stock market (which is also one of the components of the LEI index). Also, new building permits and consumer confidence, which are both not very encouraging, could present further downward pressure on the index. 

Verdict: Unable to comply - the current given set of data show positive signs on one end, but still sluggish signs on the other, making the LEI itself become inconclusive. The entire 2012 was signaled as a bad year for the economy, so its best to wait for the first quarter to finish to see where we stand.