Happy New Year!

My 2009 can be summed up thus,

The world economy witnessed many tumultuous events over the past year, and I learnt most of my macro while following the debates surrounding them!!

Wish you all a very happy and rewarding year ahead!

Decade of the zero!

Paul Krugman has described the first decade of the new millennium as being characterized by four zeros for the US economy - stagnant income for the typical family; zero job creation (even as population increased by 35 m), with private sector employment declining; zero gains for homeowners; and zero gains in the stock markets. Further, the value of assets per person, minus debts, adjusted for inflation fell from $200,076 by end-1999 to $173,684 by third quarter of 2009.







Job growth was essentially zero, as modest job creation from 2003 to 2007 wasn't enough to make up for two recessions in the decade. There has been zero net job creation since December 1999.



Unlike the US and other developed economies, equity markets in the emerging economies have, despite the events of the last two years, made substantial gains.



Further, even as the world grappled with terrorism and financial market turmoil, thanks to economic liberalization and globalization, penetration of IT in the emerging economies was turbo-charged.



See also this caricature of America's decade.



Update 1

For cricket enthusiasts, the most gratifying development was the rise and rise of India's test match record graph (HT: Are you a left-arm Chinaman?)!



Though the BSE Sensex has been on steep upward curve, one only needs to remember that the rise this year has almost mirrored the equally spectacular collapse last year before drawing premature conclusions.





See this excellent interactive timeline financial history of the decade. And this of the build up to the sub-prime crisis here.

Update 2 (3/3/2010)

The most striking representation of the lost decade for the US comes from the Economist

Shares in national GDP?

Robert Shiller has long advocated issuing shares that have claims on a country's GDP. I have blogged earlier about Prof Shiller's proposal to issue paired macro securities (up-macro and down-macro) on the GDP of a country, with its value determined by the expected revenue streams or economic growth potential of that country, and paying out dividends in proportion to the performance of the country's GDP.

In a slight variation from the macros, along with Mark Kamstra, Shiller recently proposed that a country could issue sovereign securities called "trills", that commits them to paying shares with a coupon payment tied to the country's profit measured by its current dollar GDP. He describes trills thus,

"Each trill would represent one-trillionth of the country’s GDP. And each would pay in perpetuity, and in domestic currency, a quarterly dividend equal to a trillionth of the nation’s quarterly nominal GDP."

Trills issued with the full faith and credit of the respective governments would be a major new source of government funding and its dividend payouts would reflect the performance of the country's GDP. The value of the trills itself would depend on the expected dividend payouts, and would fluctuate depending on the changes in the country's future growth prospects. Financing government expenditures with trills would also play a role in stabilizing budget imbalances, since coupon payments fall in a recession with declining tax revenues.

Prof Shiller argues that trills could play a major role in remedying the imbalances in global capital flows. He writes,

"People who expect strong economic growth in a country would bid up the price of a claim on its GDP, creating a cheap source of funding for the issuing government. So a country with good investment prospects gets the resources at a low current cost. There would be no need for central bank machinations to try to correct global imbalances."

He also claims that trills, tied to nominal GDP, could protect its holders from erosion in value due to inflation, and thereby add a new dimension to portfolio diversification strategies, even as it enables them to partake a share in the country's GDP growth

"Now TIPS, or Treasury Inflation-Protected Securities, are offering disappointingly low yields, which may have to be raised to attract more investment. Trills, even at an ultralow dividend yield, would seem more exciting as an inflation-protected prospect, because they represent a share in future economic growth."

Shiller and Kamstra have proposed trills for both the United States and Canadian governments, and feel that there would be a lively appetite for it from institutional investors, public and private pension funds, as well as the individual investor.

However, trills, while attractive to indebted governments now, are likely to face some serious objections, especially given their perpetuity nature. David Merkel raises some of the issues here. Given the continuous actual and information shocks that an economy is likely to be exposed to, trills can be expected to be extremely volatile and thereby adding to the market volatility. As Merkel argues, the danger is that irresponsible governments will mindlessly issue trills to meet their immediate (and often revenue expenditure) needs and the future generations will end up making the perpetual annuity payments.

Strategies for financing government debt

The rising government deficits across many countries and deep uncertainty about economic prospects raises questions about the approach to be adopted towards financing these debts, specifically the maturity choices of financing government debts. The dilemma is over the expected costs of debt service and the risk of facing a situation in which costs are much greater than forecast. Further, apart from determining the cost of financing the debt, it also determines the "shape of the yield curve, the extent of private sector maturity transformation, and the value of the currency (for instance if foreign lenders have different preferences over maturities relative to domestic lenders)".

The US treasury has been adopting a strategy of "exchanging short-term borrowings for long-term bonds", also in an effort to lower the real long term interest rates, to finance its deficits. Given the prevailing higher than expected long term rates (given the zero-bound in nominal short term rates), Paul Krugman has advocated that in addition to the Fed buying more long-term debt,the government can issue more short-term debt (T-Bills). He points to the fact that the overall borrowing by the non-financial sector hasn’t risen (and hence long term rates have not risen), since the surge in government borrowing has less than offset a plunge in private (long-term) borrowing (in view of the uncertain economic circumstances the private sector is fleeing into short-term securities).

In uncertain times, as Rajiv Sethi points out, since short-term debt becomes the preferred habitat for lenders, their rates typically tend to be lower than long term rates, which are inflated by their liquidity premium. This is another reason for preferring the financing of deficits with short term debt over long-term obligations. He also writes, "Other things equal, greater uncertainty (about future rates) should lengthen maturities. However, greater uncertainty will also steepen the yield curve and raise the expected costs of long-term (relative to short-term) financing, and this effect should reduce desired maturities."

Andy Harless (see also Rajiv Sethi's comments) too argues in favor of financing government debt through issuance of Bills by the Treasury. He makes an interesting case against borrowing long-term, so as to hedge against the possibility of unexpected increases in short term rates, and thereby reduce its risk of default. Any such unexpected increases would arise out of greater demand for short-term financing by private businesses and/or inflationary expectations taking hold, both of which would be signalling a sudden (unexpected!) economic recovery and therefore a welcome development. The recovery would also generate higher than expected revenues and reduced expenditure on fiscal stabilizers and other stimulus spending, thereby mitigating the higher costs of financing government debt.

In this context, Rajiv Sethi also draws attention to a paper by Joseph Gagnon, who advocates that the Fed purchase long term securities. Further, the Fed's purchases of long term securities, coupled with the Treaury's issuances of short term T-Bills, will ensure greater maturity diversification and also reduce the "vulnerability to unexpected fluctuations in interest rates".

Monetary policy options at zero-bound

The simplest intuitive case for the superiority of fiscal policy over monetary policy in retrieving a recession-hit economy, especially in the major economies, comes from the fundamental reality that the economy is ravaged with over-capacity across most sectors and private consumption demand is extremely weak. The only way out of this is to generate enough aggregate demand to first absorb the slack and in the process instill enough confidence among businesses to then invest in expanding capacity.

Monetary policy, through lower long term real interest rates, seeks to incentivize businesses to invest by lowering their cost of capital. But, as discussed above, the challenge is not to expand capacity as to fully utilize the existing capacity. The demand side stimulus by way of lower rates (on say hire purchase schemes for consumer durables etc) is marginal and takes effect with a lag. In contrast, fiscal policy, especially those that puts disposable income in the hands of people who are likely to spend it, has an immediate impact on boosting aggregate demand.

Monetary policy becomes even more ineffectual when the economy is facing the zero-bound interest rate and deflation has taken hold (or even when inflationary expectations are firmly under control). In the circumstances, the deflationary shock will lower short-term inflation expectations and therefore increase the real interest rate. Further, with nominal rates touching zero, the real interest rates cannot be lowered beyond a level and remains higher than desired. Even with massive purchases of long-term securities through quantitative easing, real interest rates on them will remain high.

Though economists like Brad De Long and Paul Krugman have advocated fixing a high enough inflation target to generate inflationary expectations and thereby put upward pressure on real long-term rates, the Fed Chairman Ben Bernanke fears that it could undermine the Central Bank's credibility. But the danger with such conservatism during such times is that the deflation may set in motion a self-fulfilling spiral of entrenching deflation and falling output, like that what gripped Japan in the nineties. It has also been suggested that Central Banks should communicate specific interest rate targets or bands, though its success is a function of their existing credibility. Further, the results of this has been mixed to give any meaningful lessons.

Charles T. Carlstrom and Andrea Pescatori of the Cleveland Fed advocate price-level targeting to demonstrate an unequivocal commitment to preventing deflation, "With a price-level target, the central bank commits to sticking to a given path for the level of prices over some horizon. If prices start rising faster than a pre-specified rate, policymakers must lower inflation in the future to get the price level back to the target. Similarly, if there is a deflationary shock, the central bank must inflate in the future because it has to bring the price level back up".

And about the different between inflation target and price-level target, they write,

"There is an important difference between an inflation target and a price-level target. An inflation target 'lets bygones be bygones', while a price-level target corrects for past misses. If prices fall on a year-over-year basis, a price-level target requires the central bank to reinflate prices until they are back to the target. An inflation target requires only that the rate of inflation be returned to its target rate from the present onward. A price-level target is essentially a promise that a deflationary shock today will increase inflation in the future and thus expected inflation today. This promise of future inflation will lower real interest rates even when short-term nominal rates are zero. Long-term inflation is still pinned down as it is with an inflation target."

Economists like Paul Krugman (and here, here, and here) have argued that at the zero-bound since banks’ cash reserves and short-term securities are perfect substitutes, banks have no incentive to lend the money out, and therefore any quantitative easing that focuses on purchasing short-term securities will fail. They simply substitute the cash they receive from the central bank for the securities they were holding in reserves, and therefore the supply of money in circulation is not affected. In other words, they attach no value whatsoever on any liquidity or safety advantage that might be had from holding assets in the form of cash.

Carlstrom and Pescatori however argue that even purchases of long term securities are not likely to yield the desired results in getting banks to lend money since the banks are more likely to sit on the cash they receive from the sales of those securities than lend them out. Even if there is some immediate impact by way of decrease on long-term interest rates (as evidenced in the yields of those securities), it is not likely to be large enough and lasting as long-term inflation expectations take hold.

Further, even if banks transact with the cash available, they are likely to use it to purchase short-term treasuries, whose relative risk-adjusted returns increase. Expectations on long term rates are also likely to keep banks invested in short-term instruments. The long-term interest rates are eventually determined by market fundamentals, namely long-term inflation expectations in conjunction with expected long-term economic growth, which are non-monetary factors. In any case, given the aforementioned excess capacity problems and weak consumer demand, the demand for borrowings is likely to be subdued.

Update 1
Andy Harless feels that one way to have adequate fire power in central bank arsenal to respond to severe financial crisis induced deep recession is to "target an inflation rate that is high enough to give it a lot of room to respond to a crisis (or an incipient crisis) by cutting interest rates far below the inflation rate". He argues that such an arrpoach ensures long term financial stability and minimizes the damage without relying on authorities to behave better or more presciently than they normally do behave.

Update 2
Mark Thoma points to a working paper by Chris Sims about difficulties of policy at the zero lower bound - the difficulty of credible commitment to higher future inflation that is necessary in most New Keynesian models, the difficulty in achieving fiscal and monetary policy coordination, and the problems that may arise when the central bank takes quasi-fiscal actions

Update 3 (17/3/2010)
Paul Krugman has a nice explanation of liquidity trap. He defines liquidity trap as one where conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero. Apart from the liquidity expansions, Central banks can also purchase longer-term government securities or other assets (so as to bring down long term rates), and they can try to raise their inflation targets in a credible way.

Update 4 (23/3/2010)
More evidence of the claim that central banks can apply further monetary stimulus by lowering long-term borrowing costs even when short-term interest rates are stuck at zero.

A New York Fed assessment of the Fed's purchases of medium and long-term maturity assets since December 2008 by Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack find evidence that it led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than (normally expected) lower expectations of future short-term interest rates. It found that the Federal Reserve lowered long-term interest rates about 50 to 60 basis points last year through its purchases of $1.7 trillion of longer-term bonds. Joe Gagnon writes,

"The reduction in long-term interest rates applies not only to Treasury securities, but also to mortgages and corporate bonds. Households buying and refinancing their homes took out mortgages worth over $2 trillion in 2009 and they will save about $11 billion in interest payments each year because of the lower interest rates. With interest rates remaining low for new borrowers in 2010, these benefits will continue to grow and will help to support consumer spending and economic recovery. Thanks to the low interest rate environment, corporate bond issuance (net of redemptions) reached a record $381 billion in 2009, helping to finance a turnaround in capital spending late last year that exceeded most private forecasts."

Gagnon had earlier advocated (see also this and this) that the "Fed could push down long-term yields another 75 basis points by buying a further $2 trillion of long-term bonds. Current yields on 10-year Treasury notes, at 3.7 percent, are far above the zero rates on short-term Treasury bills. The benefits to the economy would be rapid and similar to those already observed from the first round of Fed purchases. Moreover, lower long-term interest rates and a faster recovery would also reduce our national debt."

See also this post by Mark Thoma.

Update 5 (13/7/2010)
Paul Krugman advocates buying longer-term government debt and private sector debts, moving expectations by announcing intent to keep interest rates low for a long time, raising long-term inflation target. All this would "convince the private sector that borrowing is a good idea and hoarding cash a mistake".

Scott Sumner too feels that central banks have insufficiently boosted expectations for businesses to have enough confidence to start making investments.

Update 6 (22/7/2010)
Ben Bernanke discusses four options to increase monetary accommodation when faced with the zero-bound

1. The Fed could signal to the markets that it intended to keep its benchmark federal funds rate at zero to 0.25% for even longer than the "extended period" the Fed has been projecting.

2. The Fed could lower the interest rate it pays on excess reserves, the deposits that banks keep at the Fed in excess of what they are required to keep, from its current level of 0.25%.

3. The Fed could again expand the size of its balance sheet, which stands at about $2.3 trillion, by buying additional Treasury debts or mortgage-backed securities, or even other classes of assets, like municipal bonds.

4. On a smaller scale, the Fed could also reinvest the cash it received when the underlying principal on mortgage bonds on its books was repaid, a step that would also keep the Fed’s balance sheet from shrinking.

See also Joseph Gagnon's suggestions on the same issue.

Update 7 (28/8/2010)

Bernanke has this speech outlining his monetary policy options if further accommodation is called for - conducting additional purchases of longer-term securities, modifying the Committee’s communication, and reducing the interest paid on excess reserves.

How Airline industry is combatting recession?

The International Air Transport Association estimates that the world’s airline industry will lose a combined $11 billion this year and $5.6 billion next year. Interestingly, while all Airlines have been dropping routes, shedding employees and scrapping aircraft orders, those from developed and emerging (especially Asian) economies have been responding in contrasting ways to the crisis.

Carriers in the developed world, especially the US, have been feverishly cutting costs and finding out new ways to charge fliers for in-flight services - charging for toilet use, headphones, food, pillows, additional cabin bag, even use barstools instead of regular seats - even to the extent of diluting service standards. Tapping into such "ancillary income" has become central their business models.

In contrast, as NYT reports, many Asian carriers have been investing on improving service standards, especially for the business class travellers. These include more diversity in in-flight entertainment, more comfort and luxury both at the airport lounges and inside, greater variety in food and drinks and so on.

Asian airlines’ obsession with service shows through in the quality rankings of Skytrax, a consulting firm based in London - five of the six airlines in Skytrax’s five-star category are based in the Asia-Pacific region, as are nearly half of the 27 carriers that hold four stars, only a few four-star carriers are North American and fewer than 10 are European.

The difference in approaches among arilines are an example of how cultural factors and specific market structures are critical towards determining business strategies. As the Times reports, Asian airline passengers expect top service because it is part of the region’s cultural makeup and because no-frills budget carriers are not as established here yet. People are yet to experience the lows of no-frills carriers.

Commercially, more than the US and European carriers, a larger share of the margins and revenues in Asia come from the high-end travellers, and none can afford to be the first to cut corners when it comes to service levels. Further, the top end of the market is the fastest growing segment of airline market in many countries, in terms of revenues and profitability, and there is naturally intense competition to capture new and retain old customers in these segments.

Rock climbers in demand!

In Kerala there is an acute shortage of people who can climb coconut trees amd pluck coconuts, so much so that the Kerala government even announced an international design competition to develop commercial coconut picking machines.



In California, they are searching for people who can climb up the massive blades of wind turbines for inspecting turbines, cleaning them and repairing them.



And both jobs are highly remunerative. A coconut plucker in present day Kerala can make Rs 300-500 a day for a couple of hours work. Similarly, the cost of a basic one-day job by two blade climbers in California starts at $2,000!

In California, the free-wheeling spirit of capitalist America has tapped into the supply of recreational climbers to incentivize them into cleaning and repairing blades. Is there a similar market in Kerala, as part of tourist packages to Kuttanad? How does "coconut tree climbing adventure tourism" sound???