How Germany benefited from Eurozone

As the Eurozone tethers on the brink of collapse, questions are being raised about Germany's reluctance to play a more aggressive role in stabilizing the situation. More specifically, about its opposition to a lender of last resort role by the ECB and even some form of fiscal transfers to the peripheral economies.

Critics find this German attitude surprising since the German economy is one of the biggest beneficiaries of the monetary union. The far reaching labour market reforms and wage restraint exercised in Germany over the last decade enhanced its labour market competitiveness over the other Eurozone economies.

The tight embrace of a single currency meant that Germany's competitors did not have access to the most conventional instrument used to address trade competitiveness - exchange rate devaluation. In fact, far from exercising similar reforms and wage restraints to match Germany, the peripheral economies experienced a decade of asset bubble and/or debt driven economic boom, which drove up labour wages. The graph below shows how wages remained more or less stagnant in Germany, even as it rose elsewhere.



Labour market was not the only source of distortions. The monetary union and the attendant boost to their sovereign risk ratings meant that the peripheral economies suddenly had access to very cheap capital, a major share of which came from German and French banks. This too went towards fuelling asset bubbles (Spain and Ireland), wage price spirals (Portugal), government spending (Greece and Italy), and a consumption boom. Thanks to its increasing competitiveness, Germany provided the natural supplier for consumption booms in these countries. German exports ballooned.



So, as I have blogged earlier, among other things, the recovery path for the peripheral economies will certainly have to involve efforts to restore labour market competitiveness. This can be achieved either through internal devaluation or wage moderation in the peripheral economies or inflation in the core economies. Given the magnitude of re-balancing required, it may be necessary to have both.

But even with all this and without some form of radical debt restructuring and extendend period of monetary accommodation by the ECB, the survival of the Euro project looks increasingly in doubt.

Postscript

Paul Krugman points to the importance of export growth in Germany's economic growth of the last decade. A large share of these exports are to fellow Eurozone members, including the PIIGS. As the consumption elsewhere tanks, German exports will take a hit. It is impossible to expect consumption in these economies to regain its strength any time soon. In the circumstances, the only option left is for a massive German fiscal stimulus. This would not only keep aggregate demand in Germany up, but also provide an anchor for imports from the weak peripheral economies. In other words, German pump priming could boost growth both domestically and in the rest of Eurozone.

There are obviously two issues of concern. One, what magnitude of stimulus would be required to have any meaningful impact? Two, does Germany have the fiscal fire-power to sustain a big bazooka?

Update 1 (10/12/2011)

Nowhere has the benefits of euro integration more apparent than in the labour market as the graphic below shows. The German unemployment rate has steadily fallen since 2006, while that elsewhere has risen. German unemployment rate fell from 9.6% (4 million out of work) at the end of 2006 to 5.5% (just 2.3 million people out of work) today, both the figures being the lowest since the 1991 reunification.



As Floyd Norris writes, "It held down its labor costs during the boom, strengthening its competitive position relative to other members of the euro zone. The fact that those countries were in the euro zone helped to depress the currency’s value relative to other currencies, which made German exporters even more competitive."

This is a stunning statistic about the contrasting fortunes of the two parts of Europe,

"Put another way, at the end of 2006, 32 percent of the unemployed workers in the euro zone were Germans. Now the figure for Germans is 14 percent. The peripheral countries’ share went to 61 percent from 39 percent."

The meaning of the gold price surge

Conventional wisdom on the surging gold prices has been that it is in indicator of inflation wary investors fleeing to a traditional safe asset. Accordingly, conservatives have invoked the recent spike in gold price in support of their advocacy for fiscal consolidation.

Paul Krugman has an interesting post, where he argues that contrary to conventional wisdom, deflationary fears may be driving gold prices. He points to the famous Hotelling Rule which says that people have an incentive to hold onto an exhaustible resource (by storing it or keeping it unextracted) because of rising prices. Economically this means that "a mineral deposit in the ground has the same significance as a bond, and is in some sense interchangeable with such a financial instrument".

A consequence of this Rule is that, assuming negligible storage costs and the major part of the stock has already been extracted (so the choice is between storing it for the future or selling it now), the "real price must rise at a rate equal to the real rate of interest". If the real rate of interest is lower, as is the case now, people have an incentive to "hoard gold now and push its actual use further into the future" because the lower rates reduces the return on investment of the sale proceeds. This translates to higher prices in the short run and the near future. Krugman writes about its implications,

"(T)his... 'real' story about gold, in which the price has risen because expected returns on other investments have fallen; it is not, repeat not, a story about inflation expectations. Not only are surging gold prices not a sign of severe inflation just around the corner, they’re actually the result of a persistently depressed economy stuck in a liquidity trap — an economy that basically faces the threat of Japanese-style deflation, not Weimar-style inflation... And if you view the gold story as being basically about real interest rates, something else follows — namely, that having a gold standard right now would be deeply deflationary. The real price of gold 'wants' to rise; if you try to peg the nominal price level to gold, that can only happen through severe deflation."

In other words, since interest rates are low and rational expectations are for an extended period of low rates (and therefore low inflation), people prefer to hoard or store gold, thereby boosting gold prices in the short-run. This analysis would see the increase in gold price as a signature of deflation.

In another post Krugman also makes the distinction between gold and other commodities, in so far as their applicability to this hypothesis. Unlike gold, most other natural resources, including oil, does no conform to atleast one or both of the assumptions - negligible storage costs and most stock has been extracted out.

The economic growth way out of debt trap?

The Great Recession continues to ravage the US economy. The unemployment rate remains stuck at a very high rate; inflation continues on its downward trend and deflation looks round the corner; aggregate demand shows no signs of any rebound; corporates, sitting on record cash surpluses and experiencing prductivity surge, look disinterested in new investments.

The recent Congressional election results which saw Republicans making gains, has brought debt and deficit reduction to the forefront of economic policy debate. It appears that the Age of Austerity is about to begin. This despite clear warnings and much evidence from history that stabilization of economic growth and lowering of unemployment (instead of debt reduction) should be the immediate priority of any Government faced with such a deep recession. If the "pain caucus" pushes ahead with their spending cut plans, it is inevitable that the economy will slip deeper into deflation and recession. It is possible that when the history of the Great Recession is written, historians will point to the Congressional ballot as a defining event in US history.

Debt reduction can be achieved through four methods - spending cuts, tax increases, inflation, and economic growth. The Tea Party activist led "pain caucus" in the US are propogating spending cuts-based approach. However, as I have blogged earlier, fiscal austerity during an aggregate demand slump recession will only deepen recession. One only need to look at evidence from America's own Depression-era history or Japan since the nineties. Or the fate of austerity poster-child Ireland which is today tethering at the precipice of a sovereign default. The extent of tax hikes required to make a meaningful dent on the US public debt appears politically not feasible. Inflating away debt carries its own risks and will erode the long-term economic credibility of the US economy.

In the circumstances, economic growth driven debt-reduction looks a win-win strategy. However, given the massive size of the current US debt and future liability additions, economic growth alone will not be able to address the problem. Any meaningful attempt to reduce the debt will have to involve a combination of growth, spending cuts and tax increases. Ideally, given the persistent recession, both spending cuts and tax increases should be deferred till the economy starts on the recovery path. Growth should take immediate priority.

In this context, David Leonhardt has an excellent article in the Times which argues that if the US economy grows "one half of a percentage point faster than forecast each year over the next two decades... the country would have to do roughly 40 to 50 percent less deficit-cutting than it now appears". He points to the experience of the debt-laden post-War US economy to drive home the effectiveness of growth-led debt reduction.

When World War II ended, the federal government had debt equal to a whopping 122% of GDP. But in the 1950s and 1960s, the economy grew at an average rate of 4.3% a year, and the debt steadily dropped, falling to to just 38% of GDP in 1970. In contrast, the CBO forecasts the public debt of the US Government to be 94% of the GDP or $1.4 trillion at the end of 2010. See also this post (and its graphics) about the importance of growth for debt reduction.

Times recently initiated a discussion on US government deficit reduction with a nice interactive feature on the topic which carries the work done by economists Alan Auerbach and William Gale on federal deficit reduction. Auerbach and Gale study three fiscal scenarios for the US economy over the next decade - the CBO Baseline (which assumes no change in current law - or all tax cuts expire etc - and projects deficits declining sharply to 2.3% of GDP by 2014 and remaining below 3.0% through 2020), future Congresses will act like the previous ones and extend expiring provisions, and the Obama Administration's current policy stance. They write,

"Under either the extended policy or the Obama policy scenarios, deficits are high and rising over the second half of the decade, despite the assumption that the economy is in full employment. In 2020, the deficit is projected to be between 5 and 7 percent of GDP and the debt/GDP ratio is projected to exceed 90 percent. These figures only deteriorate with the passage of time. The long-term fiscal gap - the size of the immediate and permanent change in spending or taxes needed to keep the long-term debt/GDP ratio at its current level - is in the range of 6-9 percent of GDP. Further health care reform can be an important part of reducing the fiscal gap, but the problem is far too large to be solved by plausible reductions in health care spending alone. Postponing the onset of a fiscal package will make the problem even harder: even just a 5-year delay in implementation would raise the required fiscal adjustment by about 0.4 percent of GDP, or almost $60 billion per year."

The immediate trigger for the US public debt crisis is the deficits created by the Iraq and Afghanistan wars, the 2003 Medicare drug plan, the Bush tax cuts, the recession and the government’s responses, like the stimulus. Assuming all the current policies continue, the deficit in 2015 will be about $400 billion larger than the level that economists consider sustainable.

However, in the long-term, the health of America's finances will be determined largely by Medicare, Medicaid, and Social Security, both of which face the pressure from the retirement of the baby boom and the aging of the population. The baby boomers will pay far less in taxes than they will draw in benefits. Steep cuts in the other areas, including on discretionary spending, will not generate the required amounts to make a meaningful dent on the national debt. The importance of health care reforms should be seen in this context, as the single biggest contributor to improving America's long-term finances.

The Obama administration had appointed a bipartisan Fiscal Commission, chaired by Erskine B. Bowles and Alan K. Simpson, which recently submitted its proposals. It includes cuts to the pay of federal workers over the next several years, closure of military bases, reduction in foreign aid, elimination of tax breaks so that income and corporate tax rates could be reduced across the board, a gradual 15-cents-a-gallon increase in the federal gasoline tax, expansion of the payroll tax, cuts to Social Security benefits for high earners, and increased retirement age for Social Security. Some conservatives have criticized that plan for raising taxes at all, and some liberals dislike its emphasis on spending cuts and eliminating middle-class tax breaks.

The most stunning statistic about the US government finances is its dramatic turnaround in less than a decade. When Bill Clinton left office in 2001, the budget for 2009-12 were forecast to have an average surplus of almost $854 bn. But the early 2000s downturn, Bush tax cuts, Afghanistan and Iraq wars, Bush-era expansion of Medicare prescription durg coverage, and the sub-prime mortgage and Great Recession bailouts and stimuluses have pushed the budget to a $1.3 trillion deficit for 2010. See also the CBO's latest long-term Budget Outlook here, here, and here. See this and this for how the trillion dollar deficits were created.

The QE 2 debate in perspective

Ben Bernanke's recent speech has set-off heightened speculation about a second round of quantitative easing (QE) being round the corner in the US.

The debate about QE represents the classic economic problem. On the one hand, the supporters point to an economic environment with idling resources - both capital (cash surplus businesses postponing investment decisions) and manpower (unemployed labor) - and weakened animal spirits. In the circumstances, restoration of market confidence can be done only through government interventions, either by way of direct government spending or incentives to encourage businesses to change their investment and consumers their consumption decisions.

On the other hand, such interventions result in increased deficits and debt stock. And this is where opponents draw attention to the danger of stoking inflationary pressures, which in turn puts upward pressure on interest rates. They also point to government borrowing ultimately (and through different channels) crowding out private borrowers and investments. And we know that all this will end up tipping the economy back into recession.

The supporters counter by arguing that all the aforementioned "Treasury View" arguments do not apply when the economy is facing the nominal zero interest rate and resultant liquidity trap. When faced with the zero bound and pervasive gloom, all conventional approaches loose traction, and only governments have the firepower to lift the economy back into a sustainable growth path.

They claim that the danger of doing nothing for fear of inflation and debt spiral is the real possibility of a long-drawn out deflation-induced recession, even a depression. And they highlight the case of Japan and the striking pre- and post-crisis similarities between the US now and Japan of the nineties. They say that Japan's nearly two-decade long troubles underlines the fact that a deflation-induced stagnation is much worse than an inflation induced recession.

Opponents see a slippery slope in this argument. They question the benefits of the earlier round of quantitative easing. They allege that far from saving the economy from any collapse, the TARP doled out tax payer money to bailout greedy bankers and their financial institutions, which they argue should have been allowed to fail. They also point to the fact that even after the $787 bn fiscal stimulus, unemployment rates and output gaps remain at historic highs.

They also argue that any further monetary accommodation and credit expansion will only exacerbate the process of resource mis-allocation in the financial markets, already evident from the rising stock markets. The QE way of stimulating recovery, they caution, carries the considerable risk of inflating another bubble with all its attendant market distortions. It only postpones the inevitable and necessary rebalancing required to wring out the excesses that had got built into the world economy. They therefore not only oppose further QE, but also calls for exiting monetary accommodation.

So who is correct? I am inclined partially to both sides. The fiscalians are correct that there exists the possibility of a long-drawn equilibrium of stagnation, which can be averted only with government intervention. The austerians are correct about the slippery slope and the dangers of a new bubble. The difficulty, even impossibility, of separating cause and effect (like in so many other areas of economic policy making) means that we will never be able to satisfactorily resolve the dispute about whether TARP and ARRA succeeded or failed, leave alone how much they contributed towards the present employment and output conditions.

As Nobel laureate Myron Scholes recently pointed out, a decision to proceed with expansion through policies like the QE has uncertain consequences. Though it lowers the uncertainty associated with government's commitment to keep interest rates low and stimulate the economy, going ahead it also engenders uncertainty about the economy, especially about the problems with exiting from QE and the possibility of inflationary pressures taking hold.

On the policy makers' third-hand, the challenge then is to reconcile these two apparently contradicting yet plausible positions and tailor policies that mitigate dangers without sacrificing the benefits of fiscal and monetary expansion. For a start, they could begin with interventions that deliver the greatest bang for the buck with the least macroeconomic distortions and adverse long-term consequences. Continuation of the automatic stabilizers and interventions like assistance to states are the least controversial of such policies.

The fears about crowding out and inflation taking hold are easily dismissed. Deflation and not inflation looks like the more important concern. The fears about crowding out looks positively out of place in an environment where business expectations are anemic and the credit markets are flush with funds.

Also, the fears of stimulus spending rocketing up deficits and debt stock are not borne out by facts. The stimulus expenditures - even with a large third round of stimulus - a very small proportion of the long-term debt projections. The deficits have exploded due to a stagnating economy and reduced revenues, and even without any spurt in government expenditures.

The more pertinent dangers are with resource mis-allocation. Is it possible to structure expansionary policies which have minimal resource mis-allocation possibilities? Should we raise sectoral capital adequacy ratios and their risk weights so as to disincentivize and limit resource flows into those sectors? Ultimately, debates about macroeconomic balancing reverts back into issues of appropriate regulation of the financial markets.

What should be the policy transmission channels and how should the recovery look like? The ideal outcome would be for the expansionary policies to stimulate aggregate demand without generating financial market distortions. Fiscal policy should employ idling labor resources and government spending should put money in the hands of people who are likely to spend and thereby boost aggregate demand. This in turn should increase business confidence and encourage businesses to go ahead with their investment and hiring decisions.

The unconventional monetary expansion should lower the cost of capital, especially long-term capital, for businesses and governments, and thereby encourage and bring forward business investment decisions and lower the real cost of the public debts run up to finance the fiscal stimuluses. It should also provide the time and opportunity for businesses and households to repair their badly bruised balance sheets. All the while, the aforementioned specific regulations should play their role effectively in preventing the build-up of financial market imbalances.

In other words, instead of debating the relative merits of the respective positions of fiscalians and austerians and fighting fictitious (and ideological) battles against inflation and debts, we ought to be discussing about having in place approppriate regulations to address the possibility of market distortions arising from the expansionary policies.

Update 1 (24/10/2010)
Paul Krugman questions the effectiveness of QE 2, since the net risk remains within the government. He writes that "QE2 amounts to a decision by the US government to shorten the maturity of its outstanding debt, paying off long-term bonds while borrowing short-term".

Taking the Treasury and the Fed as a single entity, any quantitative easing would merely involve redemption of long-term debt (through re-purchases by the Fed) using money generated by expanding the monetary base. sales of new short-term debt instruments. Given the fact that at close to the zero-bound, cash and T-Bills are close substitutes (both pay nearly zero interest rates), it is just as if Treasury sold 3-month T-bills and used the proceeds to buy back 10-year bonds.

Update 2 (17/11/2010)

Mark Thoma has an excellent post on QE II. He describes QE II as, "It is conventional monetary policy that operates at the long end of the yield curve through the buying and selling of long-term financial assets rather than through the more traditional buying and selling of short-term assets. The need to operate at the long end of the yield curve presently is not because the Fed has lost control of long-term rates... it’s because the Fed can no longer move rates at the short-end."

More on the Japan then and the US economy now

Via Mark Thoma, from Mary C Daly of San Francisco Fed, comes a graphic that compares core-inflation trend in the US with Japan of the nineties, and the similarity is striking. A long-term deflation trap is a real possibility.



The deflation trend accompanies a steady slide in GDP growth rates, after a brief recovery. Real GDP growth trajectory has already been revised downwards thrice this year.



The worries about deflation coupled with stagnation comes even as the potential output crossed more than a trillion dollars and is estimated to persist well into the next few years.



Update 1 (30/10/2010)

Excellent Times article that compares Japan and US. The interesting thing is that US may be worse off than Japan in so far as it cannot draw on a large domestic savings pool to finance stimulus spending like Japan. See also this article about the problem faced by the Japanese policy makers and central bank on the financial market mess.



Update 2 (5/11/2010)

Bernanke now feels that the US economy faces the prospect of undergoing the Japan experience.

Debts, unemployment, deflation and recovery - lessons from history

The logic in favor of fiscal expansion when faced with a recession, in which aggregate demand has tanked precipitously, unemployment is high, business investments have dried up, and debt-to-GDP ratio is rising (and when monetary policy has run into the zero-bound) is that it utilizes idle resources (labor and capital), sustains (and even boosts, depending on the size of the stimulus) demand, and prevents government revenues from declining (and thereby increasing the debt/GDP ratio). It also provides the required traction for the economy to climb the steep slope of recession and return to normalcy.

Temporary deficit-financed, fiscal expansion, has been opposed by the "austerians" on the grounds that it would amplify the already large debt stock and deficits, drive down market confidence, crowd-out private spending, and finally unleash an inflationary spiral that would only serve to worsen the precarious economic prospects of an economy fighting a recession. These posts - here, here, and here - are among those replying to this argument.

However, as with all economic theories, the true test of its utility lies in its application to real world events/issues. In this case, what has been the historical experience with countries facing similar macroeconomic conditions? The two big comparable events are the post-Depression (including wartime) US and Japan during the nineties. I have already blogged about them here.

This comparison of the total US debt (public plus private) from 1929 to 1948 in billions of dollars and the total debt as a percentage of GDP shows how a robust economic recovery can quickly wind down the debt/GDP ratio and lower the real debt burden. While from 1929 to 1933 when everyone was trying to pay down debt, the debt/GDP ratio skyrocketed thanks to contraction and deflation, whereas during and immediately after WWII, despite the massive borrowing the GDP grew faster than debt, and the debt burden ended up falling.



As a recent WSJ article opined, the persistence of decade-long fall in consumer prices in Japan had raised questions about the dynamics of deflation. The inflation-adjusted Phillips curve predicts not just deflation, but accelerating deflation in the face of a really prolonged economic slump.

However, though standard Phillips curve models claim that falling inflation results in rising unemployment, the experience of Japan with rising unemployment in the nineties led to a surprisingly mild, long drawn-out deflation instead of the expected deep, destructive and concentrated (depression-style) deflationary spiral. Japan's bitter and frustrating experience with economic stagnation and slowly falling prices since the early nineties raises fears that the US too could be stuck in the groove of sustained gradual deflation.



There is also mounting evidence that "prolonged periods of economic weakness are, with almost no exceptions, associated with falling inflation rates". Further, as the inflation rate goes toward zero, it seems to get "sticky", and as in the case of the US now, slight positive inflation persists in the face of an obviously depressed economy. Krugman has written that this slow movement towards deflation is also in keeping with theories of downward nominal wage rigidity (probably due to bounded rationality, there’s some downward inflexibility in prices and wages even after expectations have had time to fully adjust).



See also this episodic comparison of recessions in the US which shows that inflation falls with rising unemployment. However, as the aforementioned nominal wage and price stickiness theory would suggest, the decline in inflation (or disinflation) has been muted when the core-inflation rate has been low.



Update 1 (14/10/2010)

Jon Hilsenrath has this excellent account comparing Japan and the US.

Analyzing the bond market surge

One of the defining characteristics of the bond markets in the last few months has been the steady and continuous decline in yields. Therefore, bond market yields have assumed center-stage in an intense debate about the impact of rising sovereign debts across developed economies.

Bond yields have been falling in the major economies of US...



... United Kingdom ...



... Japan...



... and Germany



However, even as these bond yields have been falling, those of the weaker peripheral PIIGS economies have been rising, as reflected in the widening spreads with the benchmark 10-year German Bunds.

Bond vigilantes argue that the burgeoning deficits mean that it is only a matter of time before inflation returns and interest rates rise, thereby driving up bond yields. However, there are others who argue that the high unemployment rates, dismal short and medium-term economic prospects, and reluctance of governments to undertake further fiscal expansion, means that deflation (and not inflation) is the greater danger. In the circumstances, they argue that declining bond yields are a natural market reaction.

A third point of view that is getting louder is the claim that a bond market bubble may be inflating. They argue that faced with uncertain economic prospects, deflationary expectations, and possible sovereign-debt crises, investors are abandoning equities and postponing investments, and fleeing to the relative safety and liquidity of bond markets.

As Paul Krugman has written, the bond bubble hypothesis looks suspect in an environment where everyone expects unemployment rates to remain high and inflation to remain low (or even negative) for a long time. This effectively means that short-term federal funds rates are most certain to remain at its zero-bound level for "and extended period of time", in turn ensuring much the same with longer-term rates. Further, all the common interest rate forecasting models point to rates remaining at the zero-bound for a very long time. Also, as Krugman argues, currently none of the major market players are gorging on leverage to inflate a bubble.

The rising sovereign debt-burdens too have been generating uncertainties in the financial markets about the dangers of sovereign debt-defaults. This too has generated a increased demand for safe and liquid assets among investors. As Ricardo Caballero has written, the sub-prime crisis has seriously disrupted the private supply of safe assets and the recent European crisis destroyed part of the public supply of safe assets, thereby leaving investors with few options but to invest in the few remaining perceived (atleast till now) safer assets. He writes, "Moreover, each of these crashes raised perceived uncertainty and hence the demand for safety, thus the quantity gap keeps growing, and the yield of the few remaining "safe" assets has to implode in order to restore equilibrium."

The rising bond prices now, especially when supply of government bonds has increased dramatically following the spurt in government borrowings to finance stimulus programs, only means that the demand for government bonds has been increasing much faster than the rapidly growing supply. Since the regular purchasers like China have been net sellers on the US government debt markets in recent weeks, most of the buyers of government bonds have been cash-rich domestic banks which have been using the huge amounts of money released by the monetary accommodation into purchasing government bonds. In other words, the money printed and released by the central banks is getting locked up within the financial markets itself without flowing into the real economy, thereby perpetuating a liquidity trap.

Finally, for the bond vigilantes, there is the remarkable decade-long experience of Japan with ultra-low interest rates and bond yields, despite the country's rising sea of debt, which has been hovering at nearly 200% of GDP for many years now. Japanese 10-year bond yields are ruling below 1% and has been on a continuously falling trend, and the 5-year CDS spreads are comparable to those of Germany.

But the sceptics may have grounds for concern since, irrespective of whether we call it a bubble or irrational exuberance, the fact remains that bond yields have deviated considerably from other benchmarks. Equity risk-premiums, the expected excess return of shares over government bonds, are at record highs in America, Germany, Japan and Britain.



The critical issue will be how the exit proceeds. How will the markets react at the first signs of deflationary expectations bottoming out and central banks look towards raising rates? How will the markets react to any central bank efforts to contain and emergent inflationary pressures by selling huge quantities of bonds to drain out the massive quantities of liquidity injected?

Given the fact that markets over-react in both directions, it is very much possible that the larger the decline in bond yields, greater and more violent could be the upward correction. Further, since it may be a few years before the first signs of recovery (in unemployment and inflation) appears, the bond market fundamentals may deviate even further before the return journey begins (though long-term bond yields cannot fall below 0%!).

If an indiscriminate and excessive market reaction then takes place, everyone would start blaming the current policies for having inflated the bond prices (Note that this illustrates how bubbles are often a post-event market reaction). The Economist points to the surge in ten-year government-bond yields from 0.5% to 1.5% in just three months in Japan in 2003 following expectations that deflation was fading off and fueled by casual remarks by the Bank of Japan.

In conclusion, all macroeconomic and market indicators appear to amply justify the declining trend in bond market yields, though the extent of declines may be somewhat debatable (ultimately, post-facto, if there is a bubble and it bursts with a violent surge in yields, then the extent of deviation will be held up as having signaled the bubble). However, the big challenge will be to manage (or more realistically, hope for) a smooth market turn-around once the deflation fears ease off and unemployment rate starts to fall. On the brighter side, given the prevailing economic environment it is hard to expect any recovery before 2012-13, thereby giving the bond markets more time to assess the fundamentals and return to normalcy. In other words, though the current market reaction is justifiable, it is to be hoped that the bond yields return to normal with a soft landing.

See an excellent Economist debate on the issue here - I am inclined towards Paul Seabright and Tyler Cowen's caution, purely due to the uncertainties associated with any exit.

Update 1 (30/8/2010)
Nick Rowe makes the interesting point that since bonds and money (the medium of exchange) are close substitutes (and more so now, at ultra-low rates), a bond bubble becomes a problem once it spills over into a bubble in money. He writes, "An excess demand for the medium of exchange is what causes, and is the only thing that can cause, a general glut of all goods. And that causes employment and output to fall, and both consumption and investment to fall."

From a general equilibrium perspective, he writes, "if we define the "fundamental" value of an asset as the price that asset would have if all markets, not just the market for that asset, were in long-run equilibrium (and with inflation at target), then bond prices are above their fundamental values."

Where is the evidence of inflation?

While following the debate on exiting fiscal expansion in the US, I thought of listing out all available graphics on inflation based on different types of indices and expectations to see where does the evidence point to. As can be seen below, all of them point unmistakably southwards.

The 12-month percentage change in core inflation has been going downhill...



... as is the CPI for all urban consumers stripped off food and energy components. Core inflation has fallen from more than 2 percent to less than 1 percent.



David Beckworth shows thee steeply declining trend in inflation expectations as reflected in the difference between 5 year treasury yields and 5 year TIPS for the
January 4, 2010 - July 15, 2010 period.




Menzie Chinn finds no signs of inflation with either annualized 3 month changes in price indices...



... inflation expectations from either Survey of Profession Forecasters...



... or from market-based measures of inflation expectations.



The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.69%, or in other words, the public currently expects the inflation rate to be less than 2% on average over the next decade. This is borne out by the expected inflation yield curve.



On a historical perspective too nothing appears to have badly unsettled the inflation trend.





Paul Krugman points to the 10 year TIPS spreads (difference between the interest rate on ordinary government bonds and bonds indexed to inflation), which is a measure of the inflation rate, and finds much the same declining inflation trend



And Rebecca Wider finds that the trend is global, atleast among the developed economies. She illustrates using the respective inflation-indexed bond markets that the 10-yr break-even expected inflation rates for the UK, Germany, Canada, Italy, and the US are falling.



See also this and this by James Hamilton.

Update 1 (1/8/2010)
More evidence from Free Exchange which points to the continuously declining trend on the interest rates on 10 year US government debt.



Update 2 (3/8/2010)
University of Michigan estimates (survey-based) of inflation expectations appear to indicate that they are currently well anchored. Indeed, except the early 1980's which experienced a period of rapid disinflationary expectations, expectations have been relatively stable.



Financial market inflation expectations, as manifested in the difference between 5 year Treasuries and 5 year TIPS fell slightly in recent months, but nothing like the clear taste of deflationary expectations at the end of 2008. It too appears to be well anchored.



Update 3 (4/8/2010)
David Beckworth has a series of graphs on falling inflation expectations.

Update 4 (10/8/2010)
Menzie Chinn finds that over certain horizons, we already have deflation; and for certain segments of the population, inflation has been at zero for a year already.

More evidence against the "austerians"

The recent G-20 summit at Toronto was the clearest signal that collectively the leaders of the major economies had, in the face of rising deficits and debts, decided to move away from any further stimuluses and embrace debt reduction. The leaders pledged "at least" to halve their deficits by 2013. With an estimated collective fiscal adjustment worth around 1% of its combined GDP next year, the Economist decribes it the "biggest synchronised budget contraction in at least four decades".

Notwithstanding this turn into the path of fiscal contraction, the case against fiscal austerity gets stronger with every passing day, atleast for the US. This is especially so given the present macroeconomic environment where austerity could not only tip the economy back into recession and further increase unemployment but also lower tax revenues and worsen the medium-term budget balance.

Faced with the zero-bound, the monetary policy has lost all traction, and efforts to lower long-term rates and reduce the cost of private debt are not likely to yield much without an unacceptably (politically) massive expansion of the Fed's balance sheet.

The San Francisco Fed has this graphic of increasing vaccancies in office, retail, and industrial spaces across the US, a reflection of the weak demand for business investments.



Paul Krugman points to the lock-step nature of co-movement between the US non-residential fixed investment spending (or business investment, as a percentage of GDP) and the US output gap (the percentage difference between real GDP and the CBO’s estimate of potential real GDP) over the past two decades, to argue that business investment should, if anything, be even lower.





Austerians attribute the weak business investment environment to the lack of confidence about economic prospects and aggregate demand due to the massive deficits and debt stocks (that would presumably force people into cutting down on spending in anticipation of higher taxes in future).

The central thrust of the austerians' arguement have been that the massive expansion of the monetary base will unhinge inflationary expectations and the rising deficits and debt stocks (which in turn is attributed to the stimulus spending) will put upward pressure on interest rates besides crowding out private investment. They also argue that since the stimulus spending has contributed to the deficits, phasing it out will reduce the debt stock.

However, these fears are not borne out by any market indicators. Far from the illusory bond market vigilantes driving up the yields, the rates on long-term T-Bonds remain low and have been on a southward trend.

Menzie Chinn points to a series of indicators - annualized 3 month change in price indices, 10 and 1 year inflation expectations, 10 year Treasury-TIPS and 5 year-TIPS spreads, and money supply - and finds no signs of any inflation surge.



Instead, there are ample signs that deflation should be the immediate concern for policy makers across much of the developed world. Deflation would raise real interest rates, exacerbate the debt problems, and push the can further down the recovery path. John Makin of the American Enterprise Institute has warned that the United States and Europe are heading toward "deflation, a classic prolonger of crises that boosts the real burden of debt and crushes profit margins". Paul Krugman uses monthly inflation data to point out that the US economy may already be in the deflation territory. Mike Bryan from the Atlanta Fed too thinks that the US economy may be much closer to deflation than is widely perceived.

Update 1 (15/7/2010)
David Beckworth points to Rebecca Wider's article about inflation expectations falling globally. She has this chart which illustrates the 10-yr break-even expected inflation rates for the UK, Germany, Canada, Italy, and the US using their respective inflation-indexed bond markets (TIPS in the US).



Update 2 (16/7/2010)
Superb explanation by Mark Thoma of why the massive expansion in monetary base has not generated inflation and instead deflation may be on the horizon. Boston Fed’s Rosengren too feels deflation is an emerging risk.

Update 3 (17/7/2010)
In June, the headline figure on consumer prices fell slightly while the core number rose slightly. Here's the 12-month percentage change in core inflation.



Update 4 (18/7/2010)

Paul Krugman points to the steeply falling 10 year TIPS spreads (difference between the interest rate on ordinary government bonds and bonds indexed to inflation). Also the Cleveland Fed too points to declining inflation expectations.



Update 5 (27/7/2010)
Brad DeLong looks at the numbers and writes,

"The Administration's mid-session review - released last week - projects that the unemployment rate will rise in the next several months and will be at 9.3% in February 2011. It projects that Q4/Q4 real GDP growth will be 2.9% this year - and I don't see how we are going to get there with a 2.7% growth rate in the first quarter, a likely 2.0% growth rate in the second quarter, and with the tracking third-quarter growth at at 2.9%. We would need 4.0% growth in the fourth quarter of this year. Nor do I understand where the 1.7% decline in unemployment over 2011 is supposed to come from: a simple Okun's Law coefficient of 2 would suggest that we need 2 x 1.7 + 2.6 = 6% real GDP growth to generate such a decline.

According to Mark Zandi, in the fourth quarter of this year the phase-out of the ARRA is likely to shave 0.3% off the real GDP growth rate. in 2011, the contractionary effects of the ARRA phase-out on the quarterly growth rates are likely to be -0.8%, -1.2%, -0.7%, and -0.2%."

Fiscal austerity is not the answer

Sparked off by belt-tightening in Euro-zone, the calls for fiscal austerity elsewhere (especially the US) has grown louder. These voices (Paul Krugman calls them the "Pain Caucus") point to the burgeoning public debt burdens and the possible unraveling of inflationary expectations, and are now even advocating increasing interest rates.

The OECD set the pace in its latest Economic Outlook by suggesting that the US Fed raise the benchmark federal funds rate by 350 basis points by end-2011, even though its own forecast says that unemployment then will still be 8.4% and inflation under 1%. It also advocated an early exit from exceptional fiscal support, preferably now or atleast by 2011, in view of the "unfavorable government debt dynamics".

Raghuram Rajan has raised doubts about the effectiveness of accommodative fiscal and monetary policies and argues against both any more stimulus, including a jobs bill, and favors raising interest rates. He feels that such policies fuel inflationary pressures, endangers fiscal balance, creates asset bubbles not only in the US but in developed economies, and all this with little beneficial effects.(However, as this later post appears to indicate, his argument is for raising rates from ultra-low to low, so as to prevent the build-up of systemic-risk generating distortions)

Jeff Sachs points to the harmful effects of unsustainable debt burdens and calls for cutting spending. He argues that fiscal policy, at least in the US now, cannot credibly manage expectations to raise growth and lower unemployment.

And all this despite the fact that unemployment is still very high in all developed economies, decrease in unemployment rates far too slow to make any meaningful impact, and economic growth environment remains subdued. Moreover, both prices and long-term bond yields show no signs of inflationary expectations becoming entrenched. As Glenn Rudebusch pointed out in a superb recent article, even the doubling of the Fed’s balance sheet has had no discernible effect on long-run inflation expectations measured in the Survey of Professional Forecasters, consistent with Japan’s decade-long spell of price deflation.



Mark Thoma has this point to point answer to Raghuram Rajan's article, where he points to the CBO's assessment, consistent with a wide range of estimates, of the Obama administration's fiscal stimulus program. Brad De Long has this superb post on Jeff Sachs' argument by pointing to the lack of any signs of inflationary pressures building up and of prospects of higher interest rates that could result in "crowding-out" of private investments. Paul Krugman has this response to the OECD's recommendations.

Krugman has been amongst the most strongest critics of those calling for fiscal austerity and raising interest rates. As he and others have argued, the immediate macroeconomic problem is lack of demand, and not inflation or rising debt burden. Any contraction now, fiscal and monetary, at a time when some recovery is taking hold, is certain to end up stifling those green shoots of economic recovery. Instead of enacting contractionary policies, the objective now should be to tailor targeted stimulus policies that would specifically address the unemployment problem, boost aggregate demand and smoothen the recovery path.

And it is not as though any exit from stimulus is going to dramatically alter the fiscal balance of the US economy. Krugman points to a rough estimate (of US economy) that cutting spending by 1 percent of GDP would raise the unemployment rate by .75 percent compared with what it would otherwise be, yet reduce future debt by less than 0.5 percent of GDP.

Further, as the graphics below points out, the fiscal position has been compromised not by stimulus spending, which forms a surprisingly small share of the overall debt burden, but by other more important issues. The OECD's own estimates indicate that of the 35.5% increase in debt burdens across developed economies in the 2007-14 period shows, only 3.5 percentage points will come from fiscal stimulus, and the rest will come from other sources, most notably from revenue losses due to the drops in asset prices. At the current long-term inflation-protected securities rate of 1.75%, the long-term cost of servicing an extra trillion dollars of borrowing is $17.5 billion, or around 0.13 percent of GDP.



The IMF too estimates that of the almost 39 percentage points of GDP increase in the debt ratio in 2008-15 period, about two-thirds is explained by revenue weakness due to the adverse impact of recession. Interestingly, the IMF report estimates that the fiscal stimulus contributed to only one-tenth of the increase in debt.

In the US, the contributions to the increase in debt stock due to stimulus spending dwarfs those due to other fundamental factors like health care and social security spending. As the graphic below illustrates, the ARRA related deficits and debt stock is very small compared to those brought about by Bush era tax cuts and other aforementioned structural problems.



See also this post which puts the current stimulus spending in historical perspective.

In fact, lessons from a very recent precedent makes a strong case for continuing the expansionary policies. The Japanese government indulged in massive fiscal pump-priming throughout much of the nineties in response to the recession brought about by the property market crash in the early part of the decade. However, as the debt burdens grew, much like the present situation in countries like US, the Japanese government reacted by raising interest rates in 1998 and 1999. The economy, which was showing definite signs of recovery, plunged back to recession and deflation trap and a lost-decade ensued which carried well into the last decade.

The work of economists like Adam Posen have subsequently shown that the Japanese policy makers erred by raising rates mid-way and snuffing out recovery. The long-term fiscal costs of the entire process for Japan has been much larger than could have been the case without the mid-term contraction. The Americans and others could face much the same outcome if they exit prematurely from expansionary policies. See also Paul Krugman here highlighting the lack of any adverse inflationary impact in Japan due to its extraordinary expansion of the monetary base.

And a co-ordinated global fiscal austerity movement could be devastating for the world economy as a whole. As Krugman again points out with the case of Europe, the Mundell-Fleming model informs that "fiscal contraction in one country under floating exchange rates is in fact contractionary for the world as a whole. The reason is that fiscal contraction leads to lower interest rates, which leads to currency depreciation, which improves the trade balance of the contracting country — partly offsetting the fiscal contraction, but also imposing a contraction on the rest of the world." And now if the US too joins the fiscal contraction bandwagon, we will most certainly have global contraction all-round. Who will then act as the buyer of all these goods?

The supporters of fiscal austerity base their argument on the implicit premise that China and other emerging economies will provide the engines - either through their cheap exports (that would contribute to keeping domestic inflation in check) or by acting as robust markets for the developed economy exports (and thereby provide a boost for economic growth). However, as this and this shows, even China may not be immune to the inevitabilities of the economic growth cycle, and not be able to shoulder the burden. And even assuming that all these fears do not materialize, will China permit a large enough devaluation of the renminbi and will its consumers start loosening their purse-strings?

The parallels with Eurozone and invoking the threats of sovereign defaults there as a justification for fiscal austerity in the US may not be appropriate since the problems and prospects facing these economies are vastly different. The fundamental problem with Eurozone economies, like the PIIGS, are that in the absence of the conventional macroeconomic adjustment tools (currency devaluations, interest rate independence, stoking inflation etc), these economies are left with limited policy options to manage a reasonably painless transition to normalcy. See this, this, and this on the problems facing Euroland.

Finally, there is little evidence to show that fiscal austerity is, leave alone actually generate economic growth, even restore market confidence. Paul Krugman points to the examples of Canada and Ireland to show that it is wrong to conclude that fiscal austerity brought economic growth there. He also points to the recent example of Ireland's large fiscal austerity campaign, which does not appear to have had much real impact, as evidenced by the CDS spreads, in restoring market confidence.

In the absence of policies that boost aggregate demand and with a strong dose of fiscal austerity, the long-run fiscal and economics costs could far outstrip the short run fiscal benefits. As Krugman has said, the movement in favor "fiscal consolidation" can only be explained as a manifestation of the ideological position on fiscal discipline and a desire to be seen to be being fiscally tough.

Update 1 (20/6/2010)
Paul Krugman lists out the fiscal contraction in recent times and shows that they did not depress the economy since the "depressing effects were offset by huge moves into trade surplus and/or sharp declines in interest rates", both of which are impossible now.

Brad Delong shows how the adjustment of microeconomic imbalance is far different from that of macroeconomic imbalances.

Update 2 (21/6/2010)

Nouriel Roubini favors c-ordinated policy measures to answer to avoid a double-dip global recession - "deleveraging by households, governments, and financial institutions should be gradual—and supported by currency weakening—if we are to avoid a double-dip recession and a worsening of deflation. Countries that can still afford fiscal stimulus and need to reduce their savings and increase spending should contribute to the global current-account adjustment—through currency adjustments and expenditure increases—in order to prevent a global shortage of aggregate demand."

Paul Krugman writes, "Spend now, while the economy remains depressed; save later, once it has recovered".

See David Leonhardt on the perils of an early exit from monetary accommodation. Ben Bernanke himself is deeply aware of the huge challenge with unemployment, especially the nearly half share of those who have been unemployed for more than six months. See also this post on the consequences of the early exit in 1937, which led to the double-dip.

Update 3 (23/6/2010)

The new British coalition government unveiled the most severe package of spending cuts and tax increases since the early days of Margaret Thatcher’s era and the steepest fiscal spending reductions since the 1930s. They include average budget reductions of 25 percent for almost all government departments over the next five years, and will make Britain a leader among European countries, including Ireland, Greece and Spain, competing to show they can slash spending and appease investors worried about surging $1.4 trillion national debt.

It would cut the annual government deficit by nearly $180 billion over the next five years, shrinking Britain’s public sector and instituting tough reductions in public housing benefits, disability allowances and other previously sacrosanct aspects of the country’s $285 billion welfare budget. Also announced was a two-year wage freeze for all but the lowest paid among Britain’s six million public servants and a three-year freeze on benefits paid to parents for rearing children, in addition to new medical screening for people claiming disability benefits, part of a bid to cut $16 billion from the annual welfare budget.

A raft of tax increases were also announced - an increase next year to 20 percent from 17.5 percent in the value-added tax on most goods and services, and an increase in the capital gains tax, to a new high of 28 percent. At the same time, changes in income tax will remove nearly 900,000 of Britain’s poorest people from the income tax system altogether, and corporate taxes will also be reduced over a five-year period, to 24 percent from 28 percent.

Update 4 (25/6/2010)

Martin Wolf writes,

"A reduction in the fiscal deficit must be offset by shifts in the private and foreign balances. If fiscal contraction is to be expansionary, net exports must increase and private spending must rise, or private savings [must] fall. Thus, experience of fiscal contraction is going to be very different when it occurs in a few small countries... when the financial sector is in good health... when the private sector is unindebted... when interest rates are high... when external demand is buoyant... and when real exchange rates depreciate sharply..."

Brad Delong wonders why it is so difficult to understand the merits of fiscal expansion, especially now.

Update 5 (29/6/2010)

In many ways Ireland is a classic example of the failure of the austerity medicine. Nearly two years ago, an economic collapse forced Ireland to cut public spending and raise taxes (by upto 20%), the type of austerity measures that financial markets are now pressing on most advanced industrial nations. Lacking stimulus money, the Irish economy shrank 7.1 percent last year and remains in recession, jblessness among its 4.5 million population is above 13 percent, and the ranks of the long-term unemployed — those out of work for a year or more — have more than doubled, to 5.3 percent. The budget went from surpluses in 2006 and 2007 to a staggering deficit of 14.3% of GDP last year, and continues to deteriorate and its once ultra-low debt could rise to 77 percent of GDP this year.

But the rewards to austerity remain invisible. Ireland’s risk spreads are worse than Spain’s, even though Ireland wasted no time on self-flagellation while Spain hesitated. It now pays a hefty three percentage points more than Germany on its benchmark bonds, in part because investors fear that the austerity program, by retarding growth and so far failing to reduce borrowing, will make it harder for Dublin to pay its bills rather than easier.

And all this despite Ireland being a classic case of growth by adopting neo-liberal policies. Its labor market is one of Europe’s most open and dynamic. After its last major recession in the 1980s, it lured knowledge-based multinationals like Intel and Microsoft — and now Facebook and Linked-In — with a 12.5% tax rate, giving Ireland one of the most export-dependent economies in the world, and massive investments in higher education.

Update 6 (30/6/2010)
David Leonhardt feels that relying on private sector to pull the world economy out of recession may fail. He draws attention to the thirties when between 1933 to 1937, the United States economy expanded more than 40 percent, but the recovery was still not durable enough to survive Roosevelt’s spending cuts and new Social Security tax. In 1938, the economy shrank 3.4 percent, and unemployment spiked.

Update 7 (6/10/2010)

Alberto F. Alesina and Silvia Ardagna examined the evidence on episodes of large stances in fiscal policy, both in cases of fiscal stimuli and in that of fiscal adjustments in OECD countries from 1970 to 2007, and found that

"Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments, those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions."

Robert Barro argues against fiscal expansion describing the impact as "voodoo multipliers". Paul Krugman critiques Alesina and Ardagna study. And the IMF too finds flaws in Alesina study and argues that fiscal austerity during a crisis will only exacerbate the crisis. See a summary here.