Beckworth Smackdown

Arpit Gupta pushes back on my post about why safe assets matter.  He invokes Jeffrey Friedman and Vladimar Kraus' argument that implies regulatory arbitrage created by the Basel reforms can explain the demand for safe assets. Here is Gupta:

If a bank decided to hold a AAA-rated sovereign bond, for instance, they typically had to hold zero excess capital to meet regulatory standards. However, if they held an equivalent amount of an unsecured private loan, they were required to hold substantially more capital in response.  The net effect of these capital regulatory standards is that safe assets came to be valued not just for their economic riskless value — but also for how alter bank capital requirements. Banks that face fewer capital requirements can be more levered, risky, and potentially profitable than banks whose assets force them to raise substantial amounts of additional capital. This motive, arguably, is why banks around the world are eager to purchase safe assets — not because they are useful in conducting repo. 

Gupta also makes some other points, but this is his main one.  His point sounds reasonable, but I wonder how important this effect is explaining the overall trend.  As I mentioned in my previous post, this shortage of safe assets can arguably be traced all the way back to the bursting of Japan's asset bubble.  It is also influenced by the gap between the rapid economic growth in the emerging world and their own inability to produce safe assets.  And then there is the demographic challenge: all the baby boomers in the rich world are shifting out of riskier assets into safer ones as they retire.  Is Basel really more important than all these other factors? 

P.S. Gupta also has an interesting post on whether deleveraging matters, which is timely once again given Richard Koo has a new paper pushing his balance sheet recession view.  My view is that deleveraging can have dire consequences as described by Koo, but only if monetary policy is failing to do its job.  Look no further than Sweden which has a lot of household debt, but managed to restore nominal incomes following the financial crisis and thus keep debt burdens manageable.  Monetary policy was also not limited in the United States when it was tried during the Great Depression, a time of high debts too. If only balance sheet recession advocates would spend as much time gazing at the asset side of the household balance sheets as they do the liability side they might see the potential for monetary policy.  Oh, and don't forget this Scott Sumner smackdown of the balance sheet recession view.

P.P.S.  Matthew Yglesias does a better job than me summarizing why safe assets matter.

What Really Caused the Crisis?

I was looking at some employment data and was reminded of this figure:

This figure shows that construction employment reached a peak in April, 2006 and started descending thereafter.  The housing recession was on, but remarkably employment in the rest of the economy continued to grow through early 2008.  In fact, layoffs and discharges did not dramatically change during this almost 2-year period as seen below:

In other words, the Great Recession did not emerge because of the collapse of the housing market in early 2006.  Something else had to happen about 2 years later to turn a sectoral recession turn into the Great Recession.  As the figure above suggests, I see the evidence pointing toward a failure by the Federal Reserve to stabilize nominal spending and by implication nominal income. This failure meant that nominal income growth expectations of about 5% a year assumed by household and firms when they signed nominal debt contracts would not be realized.  A debt crisis was therefore inevitable. 

This understanding is corroborated by the data on personal income. The figure below shows that despite the fall in the growth rate of personal income from construction and real estate services that began in early 2006, personal income in the rest of the economy continued to grow at about 5% a year up through mid-2008.  The Fed was able to stabilize nominal incomes overall for almost two years while structural changes were taken place in those sectors closely tied to the housing boom. 

This stabilization between early 2006 and mid-2008 was no small feat given the problems in the financial system.  The figure below shows that the rise in financial distress in mid-2007, as indicated by the Ted Spread, did not stop the nominal GDP from growing for about another year.  Again, a remarkable performance.  However, what this figure also shows is that once the Fed allowed nominal GDP to fall and made no effort to reverse it the financial crisis intensified.  Thus, the Fed's failure to act and prevent the fall in nominal income meant, just as it did during the Great Depression, a systematic financial crisis was going to happen.  

This is an argument I and others have made many times before, but it is worth repeating. It is also a story that can be told for the Eurozone crisis. Another way of saying this is that central banks are just as responsible for passive tightening as they are for active tightening.  They should be held accountable for both. 

The Real Negative Real Shock

Are all the problems in the U.S. economy nominal?  Robert Gordon implicitly says no in a new paper on the long-run outlook for U.S. productivity (hat tip Reihan Salam).  He makes the case that rapid productivity gains from 1995-2005 will not persist going forward:

The 20‐year period 1987‐2007 combines the inexplicably slow productivity growth of 1987‐95, the temporarily ebullient period 1995‐2000, and the interesting 2000‐07 period that in some dimensions looks like more normal behavior.  The seven years between 2000:Q4 and 2007:Q4 were neatly divided in half, with extremely rapid productivity growth between 2000:Q4 and 2004:Q2 (2.68 percent), and much slower growth from 2004:Q2 to 2007:Q4 (1.36 percent), averaging out to 2.02 percent for the seven‐year interval.   As argued above the productivity growth “explosion” of 2001‐04 rested on a combination of savage corporate cost cutting and delayed learning from the internet revolution.  Once profits had recovered the pressure for cost cutting disappeared, and eventually the delayed learning subsided as well.   

[...]

The paper approaches the task of forecasting 20 years into the future by extracting relevant precedents from the growth in labor productivity and in MFP over the last seven years, the last 20 years, and the last 116 years.  Its conclusion is that over the next 20 years (2007-2027) growth in real GDP will be 2.4 percent (the same as in 2000‐07), growth in total economy labor productivity will be 1.7 percent...

So over the next two decades Robert Gordon sees labor productivity growing at annual average rate of 1.7% compared to about 2.5% for 1995-2004.  If his view is widely held then that means firms will expect lower returns to investment and household will expect lower incomes.  Such lower expectations, in turn, would translate into lower investment and consumer demand today.  This, then, may account for some of the prolonged slump. 

So is Gordon's view widely held?  Is the forecast for productivity falling?  The Quarterly Survey of Professional Forecasters can answer these questions.  It asks forecasters what they expect the average annual productivity growth rate to be over the next 10 years.  The data starts in 1992 and is at an annual frequency.  Here is a figure of the data:

So yes, the consensus forecast is that productivity growth is expected to decline over the next 10 years.  It is hard not to look at this figure and conclude at least some of the ongoing slump can be attributed to it.  However, this does not necessarily mean it is the most important factor.  And I do not think it can be because we do not see a sustained uptick in the inflation rate, something that should be present if the permanently lower productivity growth rate were the main culprit.  Rather we see muted inflation since 2007 with the core inflation rate actually falling, something far more consistent with a large amount of insufficient aggregate demand.   And there is the negative output gap.  I still believe that the failure by the Fed to return nominal spending to its pre-crisis trend is the most important reason for shortage of aggregate demand.

Update:  Bill Woolsey notes that the lower expected productivity growth should only affect real variables but have no bearing on nominal expenditures if properly stabilized. 

More on the Shortage of Safe Assets

As a follow up to my earlier piece on the shortage of safe assets, I direct you to Rebecca Wilder's post where she documents the broad decline of investment grade sovereign debt.  As I mentioned before, this increasing shortage of safe assets matters because many of these assets serve not just as a store of value but as transaction assets that  either back or act as a medium of exchange. In other words, this problem matters because it adversely affects the demand for money and therefore nominal spending. 

One solution is for producers of truly safe assets, primarily the U.S. Treasury, to create more safe assets.    Brad DeLong takes this view.  This approach, however, worsens the Triffin dilemma for the world's go-to safe asset, U.S. Treasury debt.  Another solution is for the Fed and the ECB to restore nominal incomes to pre-crisis trends. Doing so would spur a sharp recovery that would lower the demand for safe assets and increase the stock of safe assets.  Both of these developments would reduce the excess money demand problem and avoid worsening the Triffin dilemma for U.S. treasury debt.  See my previous post for more.

Jan Hatzius Interview on NGDP Targeting

The FT interviews Jan Hatzius of Goldman Sachs and spends time discussing, among other things, the Fed adopting a nominal GDP level target.

Much Ado About Nothing: Financial Repression Edition

There has been a lot of discussion on financial repression emerging in advanced economies as way for governments to handle the looming debt crisis.  According to some, financial repression is already in play in the United States as the Federal Reserve is keeping long-term interest rates artificially low to minimize financing costs to the Treasury.  Advocates of this view go on to note that the lowering of long-term interest rates is narrowing the net interest margins for banks and reducing the incentive for savers to fund the shadow banking system.  Financial repression, therefore, is causing financial intermediation to fall and is preventing a robust recovery. 

There is a big problem with this view: it wrongly assumes that the drop in long-term interest rates over the past few years is solely the result of the Fed's large scale asset purchases (LSAPs).  While it is true that there has been a spate of empirical studies showing the LSAPs have lowered the term premium portion of long-term interest rates, most of these studies only show modest effects.  It is unlikely, for example, that the LSAPs can account for much of the 300 basis points plus drop in the 10-year treasury interest rate since 2007.  The financial repression advocates, however, want to attribute all of this decline to the Fed's actions.

A far better explanation for the large drop in long-term interest rates is one, the growing global demand for safe assets and two, the ongoing slump in the economy.   The first of these factors is about the increasing scarcity of safe assets in the world economy even as the global demand for them grows.   U.S. treasuries remain the go-to safe asset for the world.  As I discussed previously, there are both structural and cyclical factors behind this shortage of safe assets with both implying a reduction in the term premium for U.S. public debt.  The second factor is that since the current and expected economic outlook continues to look bleak, the current and expected path of the short-term natural interest rate is low.  With the short-term natural interest rate expected to remain low, actual short-term interest rates will be expected to remain low too and thus pull down the long-term interest rate. Some observers seem to forget that the natural interest rate itself is determined by the state of the economy.

Another problem with the financial repression view is that the Fed's LSAPs, while very imperfect, were never explicitly intended to keep down government financing costs.  They were always about either saving the financial system (e.g QEI) or more recently the broader economy (eg. QEII and Operation Twist).  These programs had serious flaws--they should have explicitly targeted the level of nominal spending  without committing dollar sums upfront--but to attribute to them a motive of repressing the financial system to help save public finances seems unfair.   

For these reasons the financial repression view seems untenable to me.   It is much ado about nothing.

Bill Gross Forgets About the Natural Interest Rate

Like Paul Krugman, I am am puzzled by Bill Gross' Op-Ed in the Financial Times.  Gross argues that the low interest rates of the Federal Reserve are causing the financial system to deleverage.  Thus, he concludes that Fed policy is actually hampering the recovery of the U.S. economy.  Now I agree with Gross that Fed policy is hampering the recovery, but it is not because monetary policy has been too loose.  Rather, it has been too tight.   

What Gross fails to consider is that interest rates would be low now even if there were no Fed. This is because the economy is weak and as a result the natural interest--the interest rate consistent with economic fundamentals--is low.  As I constantly tell my students, never draw any conclusions about the stance of monetary policy by looking just at the target policy interest rate.  Instead, I tell them, look at the policy interest rate relative to the natural interest rate over the entire term structure.  Given the large output gap and the economic uncertainty, the natural interest rate is currently low and may even be lower than the actual federal funds rate.  

Now this discussion should not be a surprise for Bill Gross.  PIMCO previously published a nice piece by Paul McCulley and Ramin Toloui on the neutral interest rate--another way of saying the natural interest rate--back in 2008 that argued the Fed may be slow to act and thus end up chasing down the neutral interest rate without ever getting to it.  Here is an excerpt:

If the central bank does not act quickly enough – and financial conditions deteriorate further – the central bank may end up just chasing the neutral rate down without ever reaching the level needed to provide monetary stimulus to the economy.

In short, even though the Fed may lower its policy interest rate monetary policy may still be tight.  And that is exactly how I view the current situation.  By failing to prevent the collapse of aggregate demand  in late 2008 and having failed to restore it to since then, the Fed has passively tightened monetary policy.  This passive tightening of monetary policy is the reason for the sluggish economy and the low interest rates.  The financial deleveraging that has Bill Gross so worked up is therefore the result of tight monetary policy, not loose.  If Gross really wants to stop the deleveraging then he needs to be calling for something like a nominal GDP level target.

Update: John Carney and David Glasner make similar observations.