News clips

Two seemingly disconnected news articles today ..
Interest paid on savings in the UK is below inflation, implying investment is underperforming while the savings rate is (presently) substantially higher than in recent months.

The apparent contradiction is plausible as a consequence of currency depreciation concurrent with a strong pace of economic growth that reduces the real interest rate. The ECB concludes “expansionary” currency depreciations are met with lower interest rates. Both 10-year yield and exchange rate trend lower, as depicted below.

Another news article speaks of a slowing labour market as proxied by the earnings of a recruitment company. The observation could perhaps be understood in the context of a chart recently published in another post: 

Zooming in to 2018, the positive trend in inflation and wages remains unscathed while increasing sales and lower inventory-to-sales are concomitant with monetary policy normalisation.

The economy seems to be booming and peak employment achieved.

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Public budgetary rules and GDP growth

New paper on Public budgetary rules and GDP growth published at Wiley.

We study the long-term effects of budgetary rules on GDP growth rate and analyse the determinants of the short-term GDP growth dynamics. For both a sample of 19 OECD and a subsample of 12 European countries, we show that, in the long run, improvements in the cyclically adjusted budget balance, as well as increases in the tax burden, have negative effects on GDP growth. 

The highest effect of fiscal policy on GDP growth would be obtained if the structural deficits were used to increase the market size by reducing the tax burden. In line with Barro (1990), a deficit-financed reduction of tax burden has a stronger effect for European than for OECD countries, because in Europe the government size with respect to market size is too large. 

Therefore, if GDP growth is a dominant policy objective, in Europe specific actions should redress the 2012 Treaty toward a reduction of the tax burden.

2012 deflation explained

Robert Hall’s seminal work on firms’ marginal cost and price strategies shook the foundations of market competition. Hall found firms fix prices above marginal costs when output increases. 

Firms seek to maximise profits, forecasting profit as a consequence of its pricing decision. Demand is assumed with constant elasticity such that a lower price shall increase revenues regardless of volume. 

This profit forecast mechanism helps understand what happened to consumer prices in the recession, plotted below (US in blue, EU in red)

The behaviour of price indexes between 2012 and 2015 (an expansion) is more puzzling and research concludes price stickiness may be the culprit.

A possible explanation is the high inventory-to-sales ratio observed after 2012.

After 2008, monetary expansion increased markups that in turn “increase the inventory-sales ratio to an even greater extent by reducing sales“, an effect amplified after 2012 by a slower pace of wage gains until 2014.

Furthermore, when wages picked up pace after 2014, firms were even more enticed to increase inventories to profit from lower relative marginal costs.

In essence,

If the marginal cost of acquiring and holding inventories is indeed lower in times of a monetary expansion (…) we should see this lower cost reflected not only in a slow response of prices to the monetary expansion, but also in an increase in firms’ inventory holdings.

Moreover, since the firm’s price reflects its shadow valuation of inventories, an increase in the stock of inventories is necessary for the firm to find it optimal keep its price low. (…) If the firm is unable to purchase more inventories, either because of quantity restrictions by suppliers, or because of other costs of adjusting the stock of inventories, the relatively lower factor prices do not translate into a lower shadow valuation of inventories, and the firm finds it optimal to change its price fully in response to the monetary shock.

As data shows, this is precisely what happened: 

Firms held prices lower because their relative marginal cost of inventories was also lower, as depressed interest rates erode the opportunity-cost and the cost of holding inventories.

Chairwoman Yelled announced a 2015 interest rate hike in May and confirmed this outlook in June while hiking in December, a clear drop in inventories as plotted in the chart 


EU-13 should spend more

Still on the nominal spending limit rule advanced by French and German economic advisers. Were small open economies exposed to foreign markets subject to an exogenous shock, the adjustment to nominal spending required by either rule (and particularly by the rule drafted by German advisers) would most likely be achieved by reducing discretionary spending and revenue.

The European Commission acknowledges the link (plotted below) while research concludes public spending is primarily discretionary.

If Member-States are encouraged to reduce discretionary spending to meet institutional obligations, it may be wise to consider the effect of such reduction before encouraging it – namely, of reducing public fixed capital formation.

Consider the following chart. It depicts the ratio of public to private capital and the rate of growth as regressed in 48 contiguous states of the United States:

similar study for the EU shows that s public capital to GDP ratio between 32% and 52% and a public to private capital ratio at 33.7% optimise growth. 

third study finds a growth-maximising public to private capital ratio for OECD countries between 50% and 80%. The chart below, computed from the IMF’s Investment and Capital Stock Dataset demonstrates most Member-States, particularly Cohesion Member-States, are not yet at such level.

Perhaps more importantly, these Member-States debt ratio to GDP are not necessarily near their computed growth-maximising threshold.

A rule limiting nominal spending at EU-27 while ignoring such distinct realities would clearly go against evidence that the distance to growth-maximising and optimal public capital and public spending levels vary significantly across Member-States. That is not to say a more rational structure of spending is unwarranted.

Perceptions of the neutral interest rate

Amongst the rules and indicators available to Central Banks for informing the Central Bank interest rate is the Taylor Rule.

Conceived as a descriptor rather than a prescriber, the Taylor Rule considers the inflation rate and applies a coefficient to both the deviation from steady-rate growth of GDP and the inflation target to compute a prescribed rate.

The Fed actually uses other versions of interest rate-setting rules along with the Taylor Rule. Some of these rules assume the long-term neutral Fed funds rate at 2% (the interest rate seen as consistent with 2% inflation in full employment), an assumption that is somewhat questioned in literature.

For instance, Judd and Rudebusch write that 

Thereafter, it is not possible to tell if the high real funds rates (relative to the Greenspan period) reflects a very low inflation target or a belief that the equilibrium real interest rate was unusually high, possibly because of a perceived need to offset the effects of highly expansionary fiscal policy.” 

Estimating the rate using models that consider inflation rate, output gap, trend growth and trend output produces a neutral interest rate. 

Beyond doubts on the accuracy of these measurements, statisticians must also consider the mismatch between determining the rate going forward and looking backward, as plotted in the following chart

Because the neutral interest rate is indifferent to an increase in consumption output or investment output in defining an expanding economy, it is disconnected of the fundamental distinction between cycle-determined consumption and individually-determined investment identified by Keynes (the latter known as the ephemeral animal spirits).

The rate varies with mismatches and variations of Price and Output levels – and Roger Garrison wisely continues explaining how it equates unemployment and inflation.

What is of concern is how this adjustment of the neutral rate of interest, fixed by Taylor at 2%, happens at the Fed. 

Chairman Powell is adamant in its implications

“Many projections of the natural rate of unemployment fell roughly 1 full percentage point, as did assessments of the neutral interest rate. Estimates of the potential growth rate of GDP slipped about 1/2 percentage point. 

These changing assessments have big implications. For example, the 1 percentage point fall in the neutral interest rate implies that the federal funds rate was considerably closer to its longer-run normal and, hence, that policy was less accommodative than thought at the beginning of normalization.”

This neutral interest rate, or the long-run Fed funds rate, is the average of Fed Board members’ forecasts, a “personal assessment”  influenced by the economy’s risk aversion or propensity.

Therefore, an increase in investment demand could push the neutral rate upwards such that the Fed Funds rate is, hypothetically, set higher than it should. 

Regulatory failures in containing excessive risk may have contributed to a decoupling of the loan rate from the Fed funds rate in 2003 thus a higher rate of riskier loans that defaulted more easily as house prices collapsed in 2007. 

Furthermore, the Fed funds rate setters could have been led to believe in faster output or price growth in 2005 as its foundational neutral interest rate does not distinguish between consumption and investment outputs. These misleading signals could have been influenced by securitisation in a mutually reinforcing trend that culminated, as a report for the House of Commons observed, in 2007: 

house-owners with adjustable-rate mortgages simply could not face the rise in their payments resulting from the steep rise in the Fed funds rate.

The EU’s debt limit

Currency Unions typically establish rules to avoid the unsustainable buildup of debt and ensure that members’ fiscal policies remain consistent with the inflation objective or the commonly chosen exchange rate regime.

IMF Program Design in Currency Unions

Some readers questioned the reasoning underpinning the deficit and debt limits constraining public finance of European Member-States. 

The limits are Union-wide because the Exchange Rate Mechanism enables capital convertibility across borders in a tariff-less region – that is, there are no capital nor goods controls when selling a Hungarian product priced in forints to France and converting the revenue to Euro in Budapest. Henceforth, the Euro is the currency of the European Union because it imposes conditions on Member-States that are not Euro Members. 

The reasoning behind both a debt and deficit limit ensures manageable debts don’t become uncontrollable too fast considering interest accruing on existing debt. Thus the deficit limit (also) measures how Member-States fare in funding interest on their existing debt. If the deficit is measured above 3% while debt remains below 60% tax receipts (rather, economic growth that is not controlled by the SGP) may be insufficient to ensure debt sustainability.

Public finance underpins private finance considering Basel III. Amonsget the few risk-free assets EU banks may hold as collateral to consumer loans is public debt. In a fractional system, it implies public debt is an asset that may increase money supply while funding the Member-State’s economy. 

That is, funds drawn from domestic or foreign sources to finance public debt from a given Member-State are likely to fund investments in that Member-State – banks thus ensure a return on investment concomitant to the capital scarcity in that Member-State (and thus fund interest paid on deposits).

This may seem a legacy of the years when national Central Banks determined money supply – but by behaving as such, banks link their liabilities (interest paid on deposits) to the economic cycle, trusting on adequate institutions to effectively tax the economy and fund public debt obligations.

Although we could consider the role of public debt in capturing private funds, how banking uses public debt remains the main risk to currency valuation. The risk results from excessive issuance that devalues the currency regardless of peers’ business cycle, thus motivating the SGP.

French and German Experts’ could hamper EU-13 catch-up 

In recent opinions, French and German economic advisers suggest replacing the current deficit and debt limits enshrined in the TFEU by a limit to nominal public expenditure. 

The limit would solve long-standing structural disequilibria in the Union:  preventing high public debt in some Member-States thus precluding the need for debt mutualisation. By indexing the spending limit to potential growth, the EU would ensure the Euro’s stability. The limit would be consider with the currently instated long-term limit to public debt and medium-term limit to the structural deficit.

The expenditure limit would also consider adjustments and a path towards correction of excessive debt as defined on the Stability and Growth Pact. 

The rule would prevent Member-States from investing and spending past their computed growth capacity, enforcing efficiency in government spending. It would also limit growth potential to those Member-States public capital is significantly inferior than incumbents.

Considering only nine of the 28 Member-States, and only three of the 11 Cohesion Member-States, are forecast to respect the structural deficit limit, this consequence is of relevance. 

The 3% deficit limit ensures Member-States employing more labour-intensive structures, thus with lower umemployment benefit costs, may increase capital expenditure to catch-up and improve both public and private capital. As these Member-States’ economies growth rates converge with the EU’s cycle, the nominal limit to expenditure would restrain these Member-States’ catch-up process.

For instance, the IMF concludes “changes in public capital stock can explain growth differences across countries, even though the evidence on the impact of public investment is mixed.” Creel finds evidence both public investment and investment are relevant for growth in Europe and Marvão Pereira finds significant evidence of the impact on growth of not only capital levels but also of spillovers on other European regions. 

The IMF’s Investment and Capital Stock Dataset (factsheet) shows Romania’s capital stock is 74% of Netherlands, whereas the Czech Republic’s is at 76% of Belgium’s – both pairs with similar populations within. 

Just so we may assess the impact, Portugal’s is 89% of Belgium’s after 32 years of Membership. 

Notice the German Council of Economic Advisers explicitly refuses the role debt adjustment would have in increasing the nominal expenditure of catch-up Member-States with lower public debts.

The wage growth puzzle

Wages are finally picking up amongst the G7 economies where unemployment is lowest. Economists remain puzzled with the slow increase in wages and earnings and even more with prolonged subdued growth even after successive quarters of recordo-low unemployment.

Mark Carney, Governor of the Bank of England where unemployment was recently measured at 4%, sees subdued wage gains as the result of low productivity growth (3% wage growth, 1% productivity growth and 2% inflation growth). I agree.

Higher productivity implies more value added per unit sold. The MPC argued low investment, lenient lending practices and persistent low-skill employment hamper productivity, imposing less value-added on firms’ revenues. Lower productivity is perceived on lower value added yet wage adjustments do not match adjustments to value added.

The ECB found wages are more reactive to institutional settings while firms would pass on exogenous wage increases to consumer through prices. Yet in another study the ECB also found firm prices are mostly reactive to changes in intermediate inputs. Leamer concluded as much, determining Asian competition lowered wages of North American unskilled workers.

It thus seem exogenous price changes (through foreign competition, import tariffs or regulations affecting labour costs) impact on wages whereas firms internalise wage costs with stable labour costs.

The chart below plots the flow of earnings, ULC and wages on prices net of ULC (green). This indicator of firms’ capacity to increase remuneration above labour costs increases when prices are slower in capturing increases in the ULC. When prices evolve favorably (or ULC are lower than prices) earnings are bound to increase. Prolonged high ULC above prices seem to bode negatively for earnings effectively forecasting an earnings reduction within two quarters.

Thus it must be that both Mr Carney and the ECB are correct: stable or decreasing ULC and increasing prices foresee wage increases whereas prices lagging increasing ULC forecast decreasing earnings.

It says much to firms’ wariness of price increases since 2008 – and most recent economic and commercial developments that protect American producers.

Trump’s tirade du jour

President Trump compared growth in GDP and unemployment to much displeasure and negative criticism of macroeconomists and pundits.

Specifically, the President described the current economic moment positively as the unemployment rate percentage was nominally lower than the percentage rate of GDP growth.

How could unemployment and GDP be linked?

For instance, Rudd and Whelan argue the labour wages portion of GDP is not a good measure of either output gap or inflation, contradicting Woodford’s estimation of the new Philips curve – that assumes ULC and unemployment are related.

Conversely, Tatierska for the Central Bank of Slovakia validates the curve’s prediction and finds a nexus between labour costs and prices via marginal costs that vary proportionately to the cost of labour.

Labour costs increase the elasticity of labour demand for industries where labour costs are a high proportion of total costs such as certain service industries. The elasticity of labour demand is also affected by the rate of substitution between capital and labour – and it has impacted the participation rate, at least in Europe

The effect of either increasing investment or capital on labour intensity of GDP is not immediately visible in German statistics plotted above. Bruegel concludes labour and capital in Germany are in fact complementary.

Assuming a stable savings rate, a declining labour intensity in GDP that would hint at lower consumption even as employment and investment are increase. 

What Trump notices is (perhaps) the low elasticity of labour substitution that enables increasing investment and wages to positively influence GDP. 

The twin increase is not new nor it directly determines growth of GDP – yet it is still good news.

Capital-gains tax and the talk of town

In the midst of the dabs taken at each other by Joseph Stiglitz and Larry Summers, Stiglitz brings about the usual criticism of cuts to the capital gains tax, criticism so often heard it became tantamount to the fiscal policy option.

Fairly, cuts to taxing capital gains benefit those claiming those gains – namely investors. Yet mostly, cuts to capital gains tax ensure savings are invested as effectively as possible.

Mr Stiglitz purposefully ignores (what else to say of a Nobel Prize laureate?) the Eurodollar created such shortage of funds and capital diversion to the East that it effectively “lifted countries out of poverty“.

If monetary rather than fiscal policy was used, the Federal Reserve Bank could opt between supply-led deflation and technological stagnation or risk demand-driven stagflation as the US economy still is amongst the world’s most competitive and internationally integrated.

Specifically, if the FRB were to let higher interest rates cripple investment (p.582) and jeopardise growth while propping up imports, lower domestic demand and imported deflation would place downward pressure on prices. 

If instead the FRB were to lower interest rates such that lending to firms would remain constant, the US could become locked-out of innovation elsewhere while bracing with the same inequality brought by higher exports Mr Stiglitz assumes is the result of a capital gains tax cut.

It would seem the option between inequality and lower long-term growth prospects was not really an option for policy makers who understand inequality is firmly anchored elsewhere than low taxes over capital gains.