Sunday, 28 April 2013

Richard Koo's "balance sheet recession"

On Thursday last week I participated at the ZSEM and Bloomberg Investment Conference, entitled "Redesigning Global and Regional Finance". In addition to a series of interesting speakers, the keynote address was done by Richard Koo, Chief Economist at Nomura Research Institute, and the main advocate of the "balance-sheet recession" argument. This is, after all, the argument he is presenting in his 2008 book "The Holy Grail of Macroeconomics" (the idea has received a lot of attention in mainstream economics). 

The presentation itself was excellent. He has managed to keep my undivided attention for the whole two hours, which is even more surprising since I didn't agree with some of his major points. Not since Arthur Laffer at the IEA last year has a speaker caught me with so much enthusiasm. 

Anyway, his major argument is that the current crisis is a "balance-sheet" recession, a term relatively new to the economic science, primarily because Mr Koo himself came up with it (he was observing a bunch of graphs on borrowing and spending and reached, in his own words, paradigm-altering conclusions). The presentation he did a couple of days ago in Zagreb is more or less similar to the one you can find here (which he presented in the Berlin conference last year). Or in pdf form, his standard argument can be found here.

Balance-sheet recession explained

A balance-sheet recession is characterized by an initial AD shock (such as the housing bubble burst in Japan in 1992 or in the US in 2007), after which the consequential effects of rapidly declining housing prices are causing massive private sector deleveraging. Both households and the corporate sector start saving, while on the other hand there is no one left to borrow and spend. So the idea is for the government to step in and provide the necessary liquidity in the system on the borrowing and spending side in order to prevent output from dropping down even further. And this is, in Mr Koo's words, exactly what Japan did to ease the effects of the bubble-induced financial crisis in the 90-ies.

To support this story Mr Koo provided a series of graphs verifying his position, first on the Japanese problems in the past few decades, and then in the US and some Eurozone economies as well (all these graphs can be found in an earlier presentation of his).

After stressing the ineffectiveness of monetary policy in initiating the recovery (he has shown rapid expansion of monetary base in the US, UK, ECB and Japan and concluded that due to the ZLB, a low multiplier, and the fact that no one was borrowing, this money was being stuck in the banking system), he went on further to describe the shock in Japan that translated itself into a balance-sheet recession: 
The first graph shows this story which has occurred in Japan from 1990 to 2006. Since the burst of the Japanese housing bubble firms started with massive deleveraging and the effect was a substantial decrease of borrowings from financial institutions and funds raised in markets. Firms were basically using their positive cash flows (which they still had due to good business results from exports) to cut down their debt. Since everyone was deleveraging, no one was left to borrow. The reason this is called a balance-sheet recession is because firms balance sheets were bad ("under water", as Koo calls them), while their cash flows were good, so they needed to use the cash flows to pay down their debts. Since there were no borrowers left on the market (households saving, businesses not borrowing - this is visible by looking at the aggregate balance sheets of banks in Japan), someone had to step in to provide the liquidity - the government. 

Koo pointed out that Japan's government has never allowed nor real nor nominal GDP to fall below the pre-crisis peak (as can be seen from the graph above). This was a big mistake in my opinion. The housing bubble implied that Japan needed a correction, and by keeping GDP at artificially high levels was a wrong signal to the real economy. Japan needed a correction after its economy overheated and after its previous growth model ran out of steam. It needed to switch to a new, more sustainable growth path. The effect of its high levels of government spending is record high peacetime debt, bringing to question its sustainability.

The Japanese government underwent a huge decade long stimulus to provide the liquidity in the system, which has resulted in a cumulative deficit from 1990 to 2005 of 315 trillion Yen, which is about 3 trillion dollars, and has resulted in Japanese public debt to rise above 200% of GDP. Mr Koo didn't see any negative implications of these highly unsustainable debt levels (regardless of the Reinhart-Rogoff argument - I asked him later). He is after all a proponent of the approach that it's slow growth that causes high debt since the government must intervene during AD shocks. In my opinion this is a self-defeating negative spiral of ineffective government stimuli, consequential rising public debt, and slow growth (after all, Japan has usually been the counter-example of stimuli policies, particularly with respect to local effects).

The stimulus might have been helpful in not allowing Japanese GDP to plummet, however its effects were so slow that even after 20 years the Japanese private sector is still risk-averse and is not lending or borrowing as it did before. Koo points out to a reversal of the trend in 2005/06 which was unfortunately stopped by the global crisis, but I don't see the big shift at all. Japanese government in 15-20 years of stimulus has done very little on the financial market, and even less in the psychological aspect to induce people to spend. This is why, in my opinion, the Japanese example remains to be a failed approach to starting a recovery. They have failed to reignite their economy despite years of similar approaches (and some unsuccessful patches and reforms attempts on the way - he made the point that premature fiscal reforms in Japan only worsened the deficit in 1997 and 2001).

Anyway, Koo's implication for the reemergence of the balance sheet recession in current times in Japan is to support new PM Abe's economic policies focused on stronger stimuli (fiscal and monetary) to once again provide the necessary liquidity in the economy and encourage people to borrow and spend. So more of the same approach. 

The US and EU balance sheet recessions

In the US case he draws similar conclusions: 
As he does for the Eurozone and the UK (click to enlarge; first graph is Eurozone, second UK): 

The story is the same, everyone is deleveraging (corporates cutting debt - blue line, households saving - red line), no one is borrowing so the government has to step in to provide the excess liquidity. As we can see  this is happening in all three examples (notice the particularly sharp reaction of both households and businesses in the US in 2008, after which the budget deficit, thanks to bank bailouts and stimuli, increased rapidly). The same thing is true for individual country examples (he mentions Ireland, Portugal and Spain). Along with this he also provides the bar graph of both the households and the corporate sectors in each country to show the deleveraging process. But by looking at these graphs, while no one is disputing that deleveraging is occurring, one can't help at notice that in every example government deficits immediately increase (the green dashed line). So in each case the government does react via excess liquidity. I would in fact argue that after the initial shock which causes the private sector to panic, the government announces bailouts to which the private sector reacts with even more caution and increases savings even higher. This can slightly be visible from this graph. Bottom line is that governments in all these cases reacted with immediate greater liquidity into the system.

Has this been a successful strategy so far? Not really. The only effect it has caused was a substantial increase of public debt and rising budget deficits (just as it did in Japan), which has forced the politicians into austerity measures to cut these deficits. This is why Koo emphasizes that it's hard to maintain the stimulus for too long in a peacetime economy. But this is far from an excuse. What those graphs rather remind me of is the "World's most important chart" from Goldman Sachs which epitomizes the clear-cut relationship between government deficits and private sector savings. They move perfectly opposite one to another. 

Concluding points - is the balance sheet recession a phenomenon, or is it just a clear market signal?

Koo mentioned a recovery in Japan after 15 years of government stimuli (albeit some fiscal reform episodes imposed by the IMF) that started giving effects around 2005/06, when credit activity once again started in the private sector. However, I wouldn't call that a recovery. There is something seriously wrong when a mountain of funds from before the 1990s gets blown apart so strongly during the next 20 years. To me this is a typical example that something structural was wrong with Japan's economy. The AD bubble shock was a trigger for bringing the systemic instabilities of an overheated economy on to the surface. The firms balance sheet deleveraging is a normal reaction in an uncertain environment. It's not a big puzzle why this is happening - huge uncertainty and lack of confidence in the economy, just as we have now. Naturally, both households and corporates (and banks) are being careful and risk-averse. Koo made a good point of how this is purely a psychological issue of recovering from a traumatic event. And I agree. However, he thinks that more government borrowing and spending will be enough to help the households and businesses forget about the trauma. Not likely. The reason the Japanese started borrowing again (even slightly) is not due to persistent government stimuli, but simply because enough time has elapsed. When the problem is structural, when one engages into a rapid productivity decline and an inability to adapt to a new technological shock, then the standard answer isn't a fiscal stimulus, it's institutional reforms that enable new patterns of specialization and trade and new jobs emerging, which guides the economy towards a new sustainable growth model. 

Friday, 26 April 2013

CPS: "Re-evaluating Reinhart and Rogoff" (part 2)

Yesterday the Centre for Policy Studies published a joint article by Ryan Bourne and myself on the criticism of Reinhart and Rogoff's findings on the link between high debt and slow growth. Here are some parts of the text:

(You can read it in full here. For all my other CPS text see here.)
"Having had chance to think about it for a week, the reaction seems pretty hysterical. Sure, the coding error was a dreadful mistake to make. Period. And some policymakers and journalists have been too keen in the past to take the stylised fact which RR presented as if it was a gospel truth that the world would end once the debt-to-GDP ratio approached a certain threshold, which was daft. And, certainly, more attention should be paid to the intricacies of different country-specific factors and effects 
But these points should not be used to re-write history, or in fact be used to rubbish the important work that RR have presented over the last few years on the fall-outs from financial crises and the historical impacts of debt burdens. So it’s worth spelling out a few key points:

1) RR’s work was not, by any means, the only justification for fiscal restraint 
Indeed, it is far from the only paper which identifies a threshold over which a high debt burden tends to be associated with lower annual GDP growth, either. Cecchetti et al (2011), for example, identified a debt to GDP threshold of about 85% as a point beyond which tends to be associated with lower annual growth. Furthermore, there has been tonnes of literature on optimum fiscal consolidations, which suggest that those which focus on cutting current spending and welfare whilst protecting capital spending and keeping/lowering tax rates have the best effect on output and debt outcomes. These have been well-highlighted on this blog and elsewhere, as we have been critical of the over-reliance thus far of European countries significantly raising taxes and slashing investment spending while often protecting growth-retarding current expenditure. Finally, a point that has been made by both us and Andrew Lilico on numerous occasions is that looking beyond the short-term and into the medium-term, there is a huge range of literature which suggests that lower government spending and/or a lower tax burden, other country specific effects given, actually enhances medium-term growth. In other words, a smaller government is a supply-side enhancement for the economy. Thus, even if you were not worried about the level of debt per se, there is still a strong case for fiscal restraint and a medium-term deficit reduction plan based on spending cuts, which is what the Coalition originally outlined in 2010.

2) The critique by HAP doesn’t change RR’s essential insight, which is that higher debt-to-GDP above 90% is associated with lower growth 
...
3) The HAP result is being reported disingenuously 
Reinhart and Rogoff have admitted to the coding error. But the coding error is not what significantly changes the results. Look at the table below, which highlights the correction for the coding error in isolation. 

Ratio of public debt to GDP
< 30 
30-60%
60-90%
> 90
Average GDP Growth, RR (2010)
4.1%
2.8%
2.8%
–0.1%
Average GDP Growth, RR (2010), corrected
4.0%
3.0%
2.8%
0.2%
Would these revisions really have been enough to cause the storm we have seen in the past week? No. So what did? Well, HAP calculated different results using a different methodology and different data. They then wrote in the Financial Times: 
““When we performed accurate recalculations using their dataset, we found that, when countries’ debt-to-GDP ratio exceeds 90 per cent, average growth is 2.2 per cent, not -0.1 per cent.” 
But these different methodological and data issues are debatable. HAP appear to have used the fact that RR made a mistake in the coding to, as one blogger puts it, conflate “alternative computations”, “new data” and “a mistake” into just “a mistake”. This has seemingly been reported as they would have liked, which is unfair and disappointing.

4) But far from “debunking” the link association between debt and growth, the stylised fact of HAP is still extremely significant 
But, for the sake of argument, let’s suppose all HAP’s changes are justified. So let’s suppose we live in a world where the original RR paper was never published and HAP was the first insight into this dataset. We are presented with the fact that the mean GDP growth rate is a percentage point lower for countries with debt-to-GDP ratios above 90 per cent compared to those with debt-to-GDP ratios in the range 60-90 per cent. Would we just shrug this off? 
Of course we wouldn’t. As Reinhart and Rogoff’s analysis of historical debt episodes have shown, these tend to last for over two decades. Two decades of growth 1 percentage point a year slower is very, very significant. In fact, they estimate that output would be 25% lower under the average debt episode where debt is above 90% of GDP than it would have been if debt was 1 percentage point higher. It goes without saying that this is a big, big result, which should still be taken seriously.

5) Which brings us to the real point of contention – the direction of causality 
Given that even the revised paper acknowledged the association, the real contention then is not whether association exists but what is the, or whether there is a, causation between the two. This has nothing to do with the past week’s events. Indeed, even many economists on the pro-spending cuts side of the original debate have been critical of the original RR paper’s reporting, when people seemingly asserted that high debts caused low growth without providing a causal mechanism. 
This is a fair critique. But it works both ways. Several journalists have indicated that, contrary to the original reporting of RR, it is in fact slow growth which causes the high debts. But this doesn’t explain why the debt episodes tend to last for two decades. If there was a one-time exogenous shock to growth which led to an increase in the debt burden, then we might expect growth to then recover and the debt burden to gradually erode. RR’s work clearly shows that this is not the case – the average length of these high debt episodes is 23 years. Do “the growth causes debt crowd” have an explanation for this? What else, except for the boom in debt itself, may have caused the growth rate of the economy to fall so dramatically? 
The financial crisis could be one explanation, but so far this crowd has not been able to explain ‘why’. Why would a one-time event permanently lead to two decades of slow-growth? 
...
In fact, there is good reason to expect a reinforcing mechanism through which higher public debt = lower growth. If the public debt stock is high, governments tend to hike taxes, expropriate wealth, inflate or financially repress – all of which will tend to be harmful to private investment. So whilst the initial collapse of growth might lead to a high debt stock, there’s good reason to think a high debt stock might result in lower growth rates from then on. 
In the UK’s case, it was not just the financial crisis which caused the high debt jump. As Andrew Lilico has noted, lots of the additional spending wasn’t automatic stabilisers, but a discretionary decision to stimulate the economy. Thus, the inevitability of slow growth leading to high debt is baked in if you believe Keynesianism is necessary and desirable.

6) Of course, high debt situations aren’t always the same, and do not prevent all supply-side improvements/breakthroughs 
In accordance to the review of the original findings, Martin Wolf in yesterday’s FT makes the following comment: 
“In 1816, the net public debt of the UK reached 240 per cent of gross domestic product. This was the fiscal legacy of 125 years of war against France. What economic disaster followed this crushing burden of debt? The industrial revolution.” 
His develops a point of reverse causality in the interpretations of the initial RR finding; it’s slow growth that causes high debt, not vice-versa. And it was the crisis that has caused high debts. 
However, isn’t his initial claim a perfect example of reverse causality, or even better an omitted variable bias? Did high debt accumulated at the time create space for or in any other way favour the industrial revolution? Absolutely not! Acemoglu and Robinson explain what did. The industrial revolution was a critical juncture of history that resulted in the largest technological breakthrough the world has experienced so far. It happened despite the large debt. 
...
Conclusion 
The original RR work threw up some huge economic debates, which deserve to be continued. Despite all the noise this week, their stylised fact that high public debt levels tend to be associated with lower GDP growth endures. Yes, we need more research on the mechanisms – why these debt episodes tend to lead to slower growth over a long period. But to suggest this past week ‘debunks’ the large economic literature which endorsed public spending consolidation is nonsense, and there are clear mechanisms through which we might expect high public debts to feed through into lower growth."

Wednesday, 24 April 2013

Graph of the week: British austerity, three years on

How effective has British austerity been so far? This graph from Ryan Avent during the budget debates (taken away from the Spectator) might shed some more light on the story (I was meaning to comment on this before, but anytime is a good time). It is entitled "Not what they had in mind" (click to enlarge)

Source: The Spectator 
I've written about European countries' austerity measures quite often and have almost every time emphasized the faulty of their tax-based consolidation approach. More and more research papers from both camps (the pro- and against- austerity) are stressing the failure of an approach focused on increasing the tax burden and keeping spending high at the same time. 

Alongside the UK (which was the focus of the graph), we can see Ireland, Spain, Greece, the US (among others); all countries which had large government stimuli and more importantly large bank bailouts in the years in before the crisis. From an earlier post (and in an article for the ASI), I have emphasized that it was precisely these classical Keynesian solutions (bailouts and stimuli) which have led to large deficits and ballooning government debt, and not the immediate shock of the crisis as some tend to claim, since the crisis shock by itself wouldn't have led to a two-fold or a four-fold increase in debt over just a few years. No, the culprit were bank bailouts done in Ireland, Spain, UK and the US.

To go back to the above graph, the causes of the UK's budget instabilities are well known (in 2010 they had the second highest budget deficit in the World, behind only revolutionary Egypt). However, the reason why they still haven't recovered from it is their stagnant GDP growth and declining productivity. So all the proponents of growth as opposed to austerity in the UK are right - the UK should switch to pro-growth, but surely not in the way the pro-growth proponents desire. Higher government spending (combined with a gradual austerity approach that extends over a few more years), combined with picking-winner strategies won't be very helpful. On the contrary, it could yield unwanted side-effects of creating a new bubble. I've stressed on several occasions the temporary vs permanent income hypothesis and a range of other reasons why such approaches are not welcomed in times of fragile recoveries, and why they will mostly end to be ineffective to start a robust recovery. This is something the current Chancellor also fails to understand when he attempts to spur activity in the UK housing market, setting stage for another potential disaster looming to happen. I can't seem to stress enough the need for a change in approach focused on tax cuts not hikes, and change in composition of spending.

To go back to the initial issue, how effective was British austerity so far in cutting the deficit? Not too much, is it? Some would argue that a decrease from around 10% down to 6% of GDP is quite an achievement, but others would argue that this would have been even faster if proper spending-side reforms have been done.

One can't help at noticing what would have happened if the British government was cutting spending faster, while simultaneously cutting taxes as well (as Sweden did in the 1990s). Perhaps today we would have had the same size of deficit (around 6% of GDP), but with stronger growth led by the currently highly constrained private sector. That would have undoubtedly been the better solution. However, take this with caution as this is purely my guess. Further research and forecasts would be needed to prove something like this (who is to say that Britain would perfectly emulate Sweden after all?).

Sunday, 21 April 2013

Clash of ideas: Sumner vs Kling

Scott Sumner has produced a post providing a neat introduction to the theory of money and monetary shocks. He did so in 9 short, concise and very interesting lessons (which he attempts to update regularly). I recommend it to anyone interested in some of the basic foundations of the monetarist school of thought (and NGDP level targeting). 

On the other hand, Arnold Kling responds to Sumner's ideas calling upon some of his own previous essays on the state of macro, providing the answer of "what's wrong with the economics profession". These essays are also a welcomed reading for those interested in basic macro theories. Kling summarizes the main factions and explains each of them, starting of with conspiracy theorists and behavioral economists in the first essay, keynesians vs monetarists in the second, and the establishment vs anti-modernists in the third













I recommend first reading Sumner's posts and then switch to Kling's second and third essay as a sort of a direct response. It could be a nice weekend read.

Here are some of the most interesting ideas. In his first two texts Sumner explains that it's monetary shocks, not real shocks that cause recessions: 
"...real shocks don’t matter (very much) for business cycles. The tsunami [in Japan, March 2011] did cause a temporary dip in industrial output, but nothing severe enough to constitute a recession. However when you turn your attention to the labor market you can really see how little real shocks matter. Real shocks do not cause big jumps in unemployment. ... Recessions are caused by unstable NGDP, which is in turn caused by unstable monetary policy ... But it’s not a tautology that the recessions themselves are caused by monetary policy, indeed it’s surprisingly difficult to explain why NGDP instability causes unemployment to fluctuate so much. Especially when the NGDP shocks are caused by rather obvious changes in monetary policy, rather than errors of omission."
While in the final post he explains the causal relationship between tight money and lower output and employment: (a brief summary of the model is also presented here)
"Tight money leads to lower NGDP, which reduces output and employment. ... money is non-neutral in the short run; a change in M leads to a change in output, not just prices... The P/Y split is determined by the slope of the SRAS curve, which reflects the degree of short run wage/price stickiness. 
In the long run wages and prices adjust, and hours worked/output return to the natural rate. Of course like any macro model, it simplifies certain aspects of reality. For instance, during a depression investment may be postponed and workers may lose touch with the labor market, and hence there may be a permanent loss of output. However I’d argue that the permanent effects are relatively small, as we saw in the strong bounce back after the Great Depression. 
Another non-neutrality can occur if workers have “money illusion,” which means they confuse nominal and real wage changes. For this reason, the bell-shaped distribution of wage rate changes has a discontinuity at zero percent—workers are irrationally reluctant to accept nominal wage cuts [a questionable assumption about the mentioned irrationality]. Thus very low trend rates of NGDP growth, per person, may lead to a higher natural rate of unemployment. ...
Putting aside these special factors, most US business cycles are a pretty simple phenomenon. Because of excessively tight money, NGDP growth slows relative to what was expected when labor contracts were signed. Because hourly nominal wage growth is very slow to adjust, a sharp slowdown in NGDP growth raises the ratio of W/NGDP, which leads to fewer hours worked and less output. It may take many years for the labor market to fully adjust. (Note: if NGDP had started growing again at 5% in mid-2009, we’d be mostly out of the recession by now. The recovery was slowed by further unexpected (negative) NGDP growth shocks after 2009.)"
In addition to these explanations of the monetary business cycle I encourage readers to read Sumner's explanations of fiat money, the quantitative theory of money, and the crucial role of expectations in monetary policy. 

I have to say that Sumner provides an excellent explanation of how macro shocks work and how they get translated across the system. However, his starting point is tight money which I believe wasn't the case in the current crisis (even though this is the crucial assumption market monetarists make). In addition, Sumner emphasizes that the current recession is an AD shock, and that it could be solved by monetary stimulus via influencing forward-looking expectations. This is where I disagree and align more closely with Kling's approach
"...stubborn Keynesians and stubborn monetarists have put their debate right back to where it was in 1970.
Many other economists see the current macroeconomic situation as having unusual characteristics. Some emphasize that financial crises tend to produce long, deep recessions, as Ken Rogoff and Carmen Reinhart have documented in This Time is Different. Others emphasize structural factors, including those I described in “What if Middle-Class Jobs Disappear?” Neither stubborn Keynesians nor stubborn monetarists see a need to take into account financial markets or structural unemployment. Instead, they take the view that any desired macroeconomic outcome can be achieved with the right fiscal and monetary policy approach.
Just as in 1970, the Keynesians emphasize fiscal policy and favor discretionary policies. And just as in 1970, the monetarists emphasize monetary policy and favor rules. Each side is certain that it is correct, although in my opinion both sides are probably wrong."
He goes on further to explain the consensus of mainstream economics and their shortcomings: 
"Like the economy, the modernist economic project goes through cycles. When the economy has undergone a long period of low unemployment, macroeconomists become increasingly confident that their models and policy prescriptions are working. Like the rooster believing that his crowing brings the sunrise, they take credit for the good times. ... in the 1960s, it was fashionable to boast about “fine-tuning” the economy. The boom that began in the late 1980s and took off in the 1990s was proclaimed “The Great Moderation,” and ... Alan Greenspan was viewed as “the maestro” by macroeconomists of all political persuasions. 
When something goes wrong, the macroeconomic profession enters a period of brooding introspection, with patches applied to the previous models. ... in the 1970s, the fine-tuners were beset by a combination of high inflation and high unemployment that was inexplicable within the models that had worked so well in the 1960s. The 1970s and 1980s were spent arguing and patching ... 
Now that we are experiencing another major downturn in the economy, the mainstream modernists will be doing another round of patching. ... Once the economy recovers, I predict that the patching exercise will settle down. At some point, economic strength will have persisted long enough that macroeconomists will believe that they have overcome their previous shortcomings and arrived at models that are robust. A consensus will form, and leading macroeconomists will write once again that “the state of macroeconomics is good.”
And the whole thing will repeat itself when the economy goes into a downturn again. This is where PSST kicks in: 
"...Those of us who hold this view [anti-modernism] do not believe that small models can be used to explain and control a complex economy. Instead, we believe that the complexity is irreducible. The economy is too intricate to be understood by any one individual. As Leonard Read famously wrote, nobody knows how to make a pencil. By the same token, nobody knows how to create a job.
I have tried to sketch the ways in which a complex economy can suffer unemployment in a couple of papers on what I call Patterns of Sustainable Specialization and Trade (PSST). The implication of these ideas is that job creation requires local knowledge of entrepreneurs, and this must be acquired through time-consuming trial and error. It is not clear what fiscal or monetary policy can do, if anything, to speed this process. 
The PSST explanations for unemployment cannot attain the modernist standards of mathematical precision. By those standards, it is another exercise in hand-waving or pulling explanations out of the air. However, I think this may be the best that anyone, modernist or otherwise, can do." 
Finally, his insightful conclusion on the "state of macro":
"If I am correct, then the “million mutinies” we are experiencing are the normal cyclical response of the economic profession to adverse events that are beyond our ability to control. The economy presumably will recover, and professional self-confidence will rise along with it. But the modernist project of technocratic tuning of a complex economy is, as Hayek warned, beyond our ability to undertake successfully."

Thursday, 18 April 2013

Reevaluating Reinhart and Rogoff

This week one of the most cited papers and research findings in the past few years has been questioned. Reinhart and Rogoff's findings that GDP growth slows down after government debt levels reach 90% of GDP, which allegedly became the justification to use austerity as the best way to cut down the debt and reignite economic recovery, has been recalculated by three economists from University of Massachusetts  Thomas Herndon, Michael Ash and Robert Pollin. They have found coding errors in the excel spreadsheet, selective exclusion of some data, and unconventional weighting of summary statistics in the original paper. After fixing for these errors they found that GDP growth for countries above 90% public debt-to-GDP ratios is 2.1% on average, and not -0.1%, which was the initial Reinhart-Rogoff finding. This implies that it doesn't make a difference whether or not an economy is burdened with high public debt. You can read the details behind the mistakes on the Rotrybomb blog, or from Matt Yglesias, the FT, Tyler Cowen's comments, and some pretty harsh criticism from Paul Krugman

In comparison the findings from the two papers look something like this (data from 1945 to 2009): 

Reinhart & RogoffHerndon, Ash & Pollin
Debt/GDPMeanMedianMeanMedian
< 304.14.24.2NA
30-602.83.93.1NA
60-902.82.93.2NA
>90-0.11.62.2NA
While a table with a longer time span, going back to 1800, looks like this (HAP paper didn't look into this data): 

Reinhart & RogoffHerndon, Ash & Pollin
Debt/GDPMeanMedianMeanMedian
< 303.73.9NANA
30-6033.1NANA
60-903.42.8NANA
>901.71.9NANA
Source: FT 

Both tables still yield the same conclusion: GDP growth tends to diminish as debt-to-GDP increases. The difference is that the effect isn't as severe as the initial results of RR seemed to show. 

Source: The Economist
The database used in the original paper was from Reinhart and Rogoff's brilliant and several award-winning financial history book, This Time is Different. Their paper that followed afterward concluded the following:
"First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. We find that the threshold for public debt is similar in advanced and emerging economies. Second, emerging markets face lower thresholds for external debt (public and private)—which is usually denominated in a foreign currency. When external debt reaches 60 percent of GDP, annual growth declines by about two percent; for higher levels, growth rates are roughly cut in half. Third, there is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the United States, have experienced higher inflation when debt/GDP is high). The story is entirely different for emerging markets, where inflation rises sharply as debt increases."
All these findings were highly receptive because they made a lot of logical sense. As was their financial contagion mechanism, and suggestions for policymakers. However, once it came under scrutiny, Reinhart and Rogoff admitted to the coding error, but dismissed other attacks and stood firmly by their conclusions: 
"…Herndon, Ash and Pollin accurately point out the coding error that omits several countries from the averages in figure 2. Full stop. HAP are on point. The authors show our accidental omission has a fairly marginal effect on the 0-90% buckets in figure 2. However, it leads to a notable change in the average growth rate for the over 90% debt group. 
HAP go on to note some other missing debt data points, which they describe as “selective omissions”. This charge, which permeates through their paper, is one we object to in the strongest terms. The “gaps” are explained by the fact there were still gaps in our public data debt set at the time of this paper. 
Our approach has been followed in many other settings where one does not want to overly weight a small number of countries that may have their own peculiarities. 
So do where does this leave matters on debt and growth? Do Herndon et al. get dramatically different results on the relatively short post war sample they focus on? Not really. They, too, find lower growth associated with periods when debt is over 90 per cent. Put differently, growth at high debt levels is a little more than half of the growth rate at the lowest levels of debt."
You can read their full response here and here. Cowen defends them.

What are the implications of all of this? The first one is the trustworthiness of non-peer reviewed papers (like NBER working papers of AER proceedings) to be used for policy implications. On the other hand, since journal articles became more restrictive to information access, it is no wonder working papers became much more attractive and widespread. As Ryan Avent concludes, this should "convince economists that more openness is better. Retreating back behind ivory walls will only protect their ideas by helping to make them irrelevant."

This brings us to the second implication; the blogosphere and the consequential immediate reaction of economists to the research has become more important than economic journals in enhancing and stimulating economic discussions and even at influencing policy, as Krugman has noted a few years back:
"First of all, policy-oriented research was never as centered on refereed journals as we liked to imagine. A lot of the discussion always took place via Federal Reserve and IMF working papers, and even reports from the research departments of investment banks. The rise and fall of Fed policy via targeting of aggregates, for example, was not a debate played out in the pages of the JPE and the QJE. 
Second, even for more academic research, the journals ceased being a means of communication a long time ago – more than 20 years ago for sure. New research would be unveiled in seminars, circulated as NBER Working Papers, long before anything showed up in a journal. Whole literatures could flourish, mature, and grow decadent before the first article got properly published – this happened to me with target zones back in the late 1980s, where my original 1988 working paper had spawned a large derivative literature by the time it actually got published. The journals have long served as tombstones, certifications for tenure committees, rather than a forum in which ideas get arguedWhat the blogs have done, in a way, is open up that process." 
Couldn't agree more, journal articles have a much higher influence on academic tenure than on spurring new ideas into discussion, especially if the discussion is on economic policy. 

As for the policymakers using new economic research as their justification for austerity, I only wish they are so receptive. It has been signaled by numerous research papers, discussions, op-eds, blogs, etc. that every European country is conducting a wrong tax-based approach to austerity, but this hasn't stopped the policymakers from doing so, hasn't it? The reasons are purely political, and have little to do with economics (as I've summarized back in September). 

Finally, how have these new findings affected our feelings on the issue of debt and the recovery? Well, not much. Debt is still bad. Even if there is a reversed causality in the debt and slow growth link, there is bound to be something wrong with an economy that doubles or even quadruples its public debt in a few years while using the classical Keynesian response to the crisis. In order to avoid several decades of stagnation that seems to be a necessary outcome of such an approach (combined of course with tax-based consolidations), the focus should still stand on broad-based pro-competition, pro-market reforms. Or to be more topical, revoke the Margaret Thatcher approach

Thursday, 11 April 2013

Graph of the week: Thatcher's economic legacy

Following the death of Margaret Thatcher, her legacy still remains a controversial issue for some. However, the data on the economic recovery of the British economy during her tenure are relentless - they point out to declining unemployment (after an initial necessary spike in order to allow the economy to restructure), falling inflation, lower government spending, lower tax rates, a balanced budget by the end of the tenure, falling debt-to-GDP by the end of the tenure, rising disposable income, rising productivity, and high levels of GDP per capita growth. Her reforms enabled a new sustainable growth model for the UK which kept their economy rising steadily for quite some time. Privatization of inefficient state industries, the fight against vested interest and oligopolies (both in the financial industry and among the unions), the Big Bang of 1986, opening up the country to new competition, and a whole range of other industrial, regulatory and legal reforms all led to the modernization of Britain and made it restore its former glory in the years that followed. It is through those achievements that her legacy should be observed.

The graphs below confirm this to a certain extent, even though her transition of the British economy should be observed from several dimensions, not just through crude numbers. On that perspective, I recommend Nicholas Crafts Vox EU column as a sort of an economic obituary of Lady Thatcher. 

Source: The Economist
Source: The Economist

Monday, 8 April 2013

The Lady that brought the Great back to Britain

Margaret Thatcher, one of the greatest political leaders in the 20th century, has passed away earlier today at the age of 87. In the words of UK PM David Cameron, "today we lost a great leader, a great Prime Minister and a great Briton". 

Margaret Thatcher has died of a stroke at the age of 87. Follow all the reaction to the news of the death of Britain's longest-serving prime minister
Source: The Telegraph
Out of the many kind words expressed for her today, I particularly enjoyed the one from Nick Robinson at the BBC: 
"As prime minister, she was determined to repair the country's finances by reducing the role of the state and boosting the free market. Cutting inflation was central to the government's purpose and it soon introduced a radical budget of tax and spending cuts. Bills were introduced to curb union militancy, privatise state industries and allow council home owners to buy their housesMillions of people who previously had little or no stake in the economy found themselves being able to own their houses and buy shares in the former state-owned businesses. New monetary policies made the City of London one of the most vibrant and successful financial centres in the world. Old-style manufacturing, which critics complained was creating an industrial wasteland, was run down in the quest for a competitive new Britain."
Madsen Pirie of the Adam Smith Institute provides a standardly persuasive argument:
"Within a few short years Margaret Thatcher had transformed the nation and its prospects. Britain went from having the highest record for days lost through strike action to the lowest, and from the lowest growth rate to one of the highest. No less importantly people reacquired self-confidence in the future, together with the optimism that their children would inherit a better world than they had lived in. They acquired in addition a stake in the nation, with huge numbers of ordinary people who had never before had the opportunity becoming home-owners and investors in Britain's future."
While the Economist focuses on the extension of her ideas and policies on the societies today:
"But today, the pendulum is swinging dangerously away from the principles Mrs Thatcher espoused. In most of the rich world, the state’s share of the economy has grown sharply in recent years. Regulations—excessive, as well as necessary—are tying up the private sector. Businessmen are under scrutiny as they have not been for 30 years. Demonstrators protest against the very existence of the banking industry. And with the rise of China, state control, not economic liberalism, is being hailed as a model for emerging countries. 
For a world in desperate need of growth, this is the wrong direction to head in. Europe will never thrive until it frees up its markets. America will throttle its recovery unless it avoids over-regulation. China will not sustain its success unless it starts to liberalise. This is a crucial time to hang on to Margaret Thatcher’s central perception—that for countries to flourish, people need to push back against the advance of the state. What the world needs now is more Thatcherism, not less."
...and there is a whole range of other reactions worldwide.

It is difficult to sum up all of her greatest accomplishments. Have in mind that she came to power to combat the longstanding socialist tradition in Britain (of the 60s and the 70s) that has made the country poor, locked down by vested interests, constrained by heavy regulation, and seemingly trapped in a downward spiral of zero growth, falling productivity, and unsustainable welfare state model (does it ring a bell? History always repeats itself; hence the Economist's conclusion). 

I wrote about her legacy for Britain only once on the blog (published first at the CPS website), emphasizing her importance in transforming Britain back into a world powerhouse, both politically and economically. She opened up Britain to foreign capital and provided incentives for a  (harsh but necessary) restructuring and re-specialization of the UK labour market, where a lot of old inefficient jobs were abolished and a lot of new jobs were created. Many of her critics still fail to understand the magnitude of this generational switch in Britain that has significantly increased the wealth of the British society. 

I will commemorate her with a series of her own quotes I find particularly inspiring or simply up to the point:

When she was elected, upon entering 10 Downing Street:
"Where there is discord, may we bring harmony. Where there is error, may we bring truth. Where there is doubt, may we bring faith. And where there is despair, may we bring hope."
Responding to the criticism of her economic policies a year after she won the '79 elections (the famous U-turn remark):
"To those waiting with bated breath for that favourite media catch phrase, the U-turn, I have only one thing to say. You turn if you want to... the lady's not for turning."
On compromise: 
“If you just set out to be liked, you will be prepared to compromise on anything at anytime, and would achieve nothing”
At the start of the Falklands war:
"Defeat? I do not recognise the meaning of the word."
Some of here more general quotes:
"My policies are based not on some economics theory, but on things I and millions like me were brought up with: an honest day’s work for an honest day’s pay; live within your means; put by a nest egg for a rainy day; pay your bills on time; support the police."

"I am extraordinarily patient, provided I get my own way in the end."
 "If you want to cut your own throat don't come to me for a bandage."
"It’s the Labour Government that have brought us record peacetime taxation. They’ve got the usual Socialist disease - they’ve run out of other people’s money."

"I never hugged him, I bombed him." (While watching old TV footage of Tony Blair embracing Colonel Gaddafi, at a reception in House of Commons, March 2011)
Responding after a failed bomb attack on her and her husband in Brighton by the IRA:
"This attack has failed. All attempts to destroy democracy by terrorism will fail."
Her reaction upon leaving office in 1990, after having won the popular vote for the third consecutive time (1987) only to be betrayed by her own party members:
"It was treachery with a smile on its face."
Her views on benefits and the role of government:
"I think we have gone through a period when too many children and people have been given to understand 'I have a problem, it is the government's job to cope with it!' or 'I have a problem, I will go and get a grant to cope with it!'; 'I am homeless, the government must house me!' and so they are casting their problems on society and who is society? 
"There is no such thing! There are individual men and women and there are families, and no government can do anything except through people and people look to themselves first. It is our duty to look after ourselves and then also to help look after our neighbour and life is a reciprocal business and people have got the entitlements too much in mind without the obligations."
Her views on economic and political freedoms, the role of governments and the free society are best summed up in this interview she gave before becoming PM. 

And finally, in her own words:

Saturday, 6 April 2013

Tracking the recovery (3): Business and Consumer Confidence

Continuing with the Recovery Tracking series in its third edition, we look at business and consumer confidence in the US, UK and Eurozone, comparing them to the situation from 6 months ago. The OECD once again offers the database of tracking these indicators, in particular the Business Confidence Indicator (BCI) and the Consumer Confidence Indicator (CCI). As I've mentioned in the previous post, the consumer and business confidence indicators will give us a more precise picture on the effects of Draghi's speech,  and whether or not ECB's actions came through where they haven't done so before (recall the previous actions done in August 2011, December 2011, April 2012, and so on, when the effect on business and consumer confidence was either negligible or nonexistent). 

Business confidence
Source: OECD Standardized Confidence Indicators. Latest data available
for February 2013. Click on graph to enlarge. 
So far, by simply looking at the main OECD business confidence indicators, it seems that things started to improve for businesses in most of European countries over the past 6 months, except for USA and Britain. They are the only ones experiencing a slight decline. For the US this was expected due to the fiscal cliff bargaining by the end of last year, while for the UK it does come as a bit of a surprise, since most of Europe's businesses were increasing in their confidence. I have included in each graph a straight line which is suppose to correspond to Mario Draghi's speech from the end of July 2012. It seems that businesses in many European (peripheral) countries took this "momentum" as a welcomed solution from the ECB. Greece is particularly encouraging as this is the first indicator that is starting to show good news for Greece in a long time. I have also included the upper right graph on the Nordic countries, where it was quite obvious that their business climate over the past couple of years was dependent on how things were shaping up in the rest of Europe at the time (with a certain lag of course). 

So far so good. Things are starting to improve, businesses are gaining more confidence, but Europe is still vulnerable to outside shocks, like the one in Cyprus. It will be interesting to see the reaction to this shock in a few months time. 

Consumer confidence 

Source: OECD Standardized Confidence Indicators. Latest data available
for February 2013. Data for Norway was unavailable. Click on graph to enlarge. 
Consumers were more careful, but even this data is showing sings of improvement, especially in the peripheral Eurozone economies. Although you can notice that the consumer confidence indicator didn't react immediately after the Draghi momentum as the business confidence did. This is normal as it takes time for the business confidence to translate into more investments, more expansion and more new jobs. With higher employment, aggregate consumer confidence will improve and eventually yield an increase in aggregate spending. This still has yet to happen in Eurozone, but the favourable conditions were created. Now it takes time to wait and see and hope for the best - which isn't the best possible solution out there, but with lack of political will to solve serious issues, I guess we're stuck with it.


However, to end on a more serious note, a survey done by the FT and the Economist with the final data for Q1 2013 point out that even though "overall confidence, measured as the balance of respondents who think global business conditions will improve against those who expect them to get worse, rose from a dismal minus 11 percentage points in the last quarter of 2012 to plus seven in the first quarter of 2013", a lot of businesses (around 80%, see graph below) still feel that the crisis is not over, and are skeptical on the current regulatory solutions. Also, one of the conclusions was that some of the new growing confidence is yet to be translated into new job opportunities (which is probably why we haven't yet seen a strong upward shift in consumer confidence from the graphs above).

Here are some of the figures depicting this sentiment:

Source: The Economist/FT global business barometer survey
Global confidence is improving for the first time since 2011, with some industries (like construction, services, chemicals and consumer goods) driving this positive change, while others are still in relative decline or stagnation (manufacturing being the most problematic since the start of the crisis).

Finally, the Markit Eurozone PMI (purchasing managers' index) indicator is showing a steady decline for the first quarter of 2013 (latest data in March), thanks to a contraction of business activity, which still means that the recovery in Eurozone is in a very fragile state. 

Wednesday, 3 April 2013

Tracking the recovery (3): Europe

After two brief intermissions which I simply had to comment on, the Tracking the recovery series continues in its third edition featuring Eurozone and the UK. This analysis, unlike the US one, will constrain itself only on observing the leading indicators from the OECD database and the Conference Board, and compare these to their levels from 6 months ago. (Note: World Economics also has a decent overview of the recovery at their pages; they refer to it as Growth Monitors. Here is their Eurozone Growth Monitor). 

As I've pointed out in the previous post, last year was apparently much better for America than it was for Europe. The graph below sums it up pretty well:  


While the US was mildly recovering, Eurozone started to diverge into a double-dip recession (adding the stagnating UK into the above graph will only worsen the picture). The events from the begining of last year following the uncertainty in Greece and Spain, were extended to Italy and Cyprus this year, and further problems in Greece and Spain. Mario Draghi's "do whatever it takes" speech was enough for a brief turning point in Europe, but the real effects won't be visible until real reforms start (which was the initial idea behind ECB's actions - let's help the economies reform by supporitng them through easier monetary policy. Moral hazard problems still loom). The final effects of all the events from last year on business and consumer confidence will be available in the next blog post. For now we just focus on assesing the leading economic indicators to anticipate until when will Europe's "recovery" last.  

Eurozone LEI

As always we begin by looking at the Eurozone leading indicator (LEI) published by the Conference Board. The LEI in their graph is compared to the Conicident economic index (measuring current economic activity) and the RGDP, both of which seem to be declining. (click on image to enlarge)

Source: The Conference Board, Global indicators, Euro Area.
Published on March 27th 2013.
The LEI itself (blue line) is also not particularly impressive. Observe the critical juncture of August 2011 and how the LEI started to decrease significantly after that, only to recover briefly in the start of 2012, and the descended back into stagnation only to improve marginally by the end of last year. In the past few months, as can be seen in the graph it has been stagnating, thus signalling further hardship in Europe and still no sign of any robust recovery any time soon.  

According to this stagnation of the LEI, it seems that my predictions from last July were correct. I said back then:  
"Looking deeper into this can we conclude of a European double-dip, similar to what the UK is experiencing at the moment? Not really, I would rather refer to this situation as 'levitating in a status quo', with dire consequences of inaction."
That precisely depicts the current situation in Europe. And unfortunately it's not showing any signs of change (according to all possible indicators: LEI, the current set of unchanged faulty economic policies, lack of real reforms, and the upcoming uncertainty resulting from the Cyprus shock). 

Individual LEIs

Moving on, the OECD business cycle database offers an opportunity to look at the indicators for individual Eurozone countries and compare the recovery for each of them. 

All countries' LEIs were drawn within the same scale for easier 
comparison. Source: OECD Main economic indicators database
The last available data is for January 2013. So the recent events still haven't translated into the LEI. Since the last time I looked at this data (May 2012) the situation is surprisingly better. Particularly for Portugal and Greece, whilst Spain and Italy seem to be showing slow positive signs of higher future economic activity. France is the only country that seems to be at a declining path, while Germany and the UK are signaling slightly better times to come. The Eurozone as a whole seems to have shown some improvement by the end of last year (as the Conference Board index from above seems to suggest as well), however, it is likely that recent shocks will slow down this increase (as was shown for the January and February data in the Conference Board indicator). 
No improvement for the BRICs either. Since last time when
Brazil was the only one showing positive signals, they
have all more or less resorted in stagnation, with
China and India continuing their descent. 

As for the predictions, I anticipated the Spanish LEI to show a declining trend in the summer months. However that didn't happen, and one of the reasons for this (as for the positive trends in other peripheral economies' leading indicators) could have been the Draghi speech from last July. It's around that time when things start changing in a more positive direction (even in Germany). It still remains to be seen how this spur of confidence in the leading indicator was reflected onto market participants (businesses and consumers).  

Generally from observing the individual country LEIs it could be inferred that the recovery is on its way in Europe, while it really isn't. I have concluded last time that using this methodology doesn't give us precise leading data, as it generally reacts only to ex-post changes. I stand with that conclusion since there is too much uncertainty in Europe and too much potential exogenous shocks that even in small magnitudes can cause great instability, for the LEI to make a plausible prediction of future economic activity. In Europe we should still pay more attention to announcements and implementation of economic policies. Until we see some significant improvement in pledging to reform, we will not see a recovery.