When the Fed Chair is an Academic

The big economic news of the week was, in fact, big economic news: the Fed's announcement of significant changes from past practice in the the quantity of its next round of large scale asset purchases ("unlimited"), and in the timing of any future reversal of this expansionary policy ("a considerable time after the economic recovery strengthens").

I view this as a pretty fundamental shift in how the Fed hopes to affect the economy.  Rather than trying to push economic activity one way or the other through its management of interest rates (which can alter economic activity through its portfolio-rebalancing and wealth effects, for example), the Fed is now quite explicitly trying to affect economic activity by altering interest rate and inflation expectations.  As Krugman has put it, the crux of the matter here is that this is pretty close to a "credible promise to be irresponsible".

This is ground-breaking stuff for a central bank.  This type of expectations-management hasn't really been done before -- at least not as an expansionary policy in a zero-lower-bound environment.  And that is why I think that this could only have happened with an academic as Fed chair.  There's a vast academic literature on the channels of monetary policy transmission (important bits of it written by Ben Bernanke himself), and a growing body of academic evidence that suggests that monetary policy's biggest impacts may often be through changing expectations.  Woodford's already-famous August 2012 paper summarizes and crystalizes much of the current thinking on this subject, but the evidence and literature on the expectations channel has been steadily building for more than a decade.

But despite this, it's hard for me to imagine Alan Greenspan, or any Greenspan-like Fed Chair who has primarily a Wall Street background, enacting such significant changes in how monetary policy is conducted purely on the basis of a body of academic research, without prior experience or Wall Street conventional wisdom to fall back on for support.  The academic literature is often theoretically and mathematically complex, and employs statistical techniques that are pretty opaque to most people -- sometimes even to other economists. So unless you're immersed in the field yourself, it would take a pretty big leap of faith to set a new course for monetary policy based solely on the arguments and evidence in such papers.

But Bernanke is immersed in the field.  And so he is in a position to fully understand -- and perhaps more importantly, to really believe -- the conclusions of the academic literature, and therefore to allow that literature to guide the Fed's actions, even though its conclusions have not yet had time to become received wisdom in the financial world more broadly.  And in the current situation, that may make all the difference.

Sometimes a deep understanding of markets and institutions -- such as what one might gain from working on Wall Street -- is probably most helpful to running a central bank.(Think 2008, for example.) But at other times, an academic background can give a Fed Chair profound advantages.  I do not think we would have seen this relatively rapid and remarkably direct implementation of the policy recommendations of academic papers if the Fed Chair had been anyone other than an academic himself.  And with just a little bit of luck, we'll soon have more evidence about whether the academic literature was right.

Government Job Destruction

Another jobs report in the US, another month where part of the private sector's job creation was undone by continued job destruction by the government sector.

The 15,000 additional jobs lost in April brings total job losses in the government sector since January 2010 to over 500,000. While the US has not quite been experiencing European-style austerity over the past two years, that's still a pretty tough headwind to fight as it emerges from recession.

Eurozone Unemployment and the Recession of 2012

Europe is on its way back into recession. During the second half of 2011 several EU countries already met the most common definition of recession, namely two consecutive quarters of falling output, including Spain, Italy, the Netherlands, Denmark, Ireland, Greece, Cyprus, Czech Republic, Portugal, Slovenia, and the UK. Correspondingly, European unemployment rates began rising again during 2011, more than undoing the modest recovery they enjoyed in 2010.

But while the prospect of a European recession in 2012 is quite bad enough, this understates the scope of the problem. Because not only will this year's recession directly impact millions of unemployed and soon-to-be unemployed EU workers, as well as (for those more fiscally minded) seriously damaging this year's government budget balances, it will have lingering effects on Europe's economies for many years to come.

Hysterisis is the notion that the state of the world today has lingering effects on the future. In the context of labor markets this primarily arises because the state of being unemployed tends to make it harder for workers to find a new job, and the longer someone is unemployed the harder it becomes. Unemployment -- especially long term unemployment -- therefore has permanent negative effects on an economy even after economic growth has resumed. Unemployment today damages the economy's potential tomorrow.

This should be of particular concern for European policy makers, because the European labor markets have proven to be particularly slow to recover from recessions.

To get a rough sense of this, I calculated the weighted-average annual unemployment rate of what I call the "EZ6" -- the six largest eurozone economies, i.e. Germany, France, Italy, Spain, Netherlands, and Belgium -- over the past 20 years. If we compare the EZ6 unemployment rate with real GDP growth over those years, we find that every percentage point of real GDP growth reduces the unemployment rate by about 0.33 percentage points. In other words, for every percentage point that the unemployment rate goes up in the EZ6 this year, those economies will need three years of real GDP growth 1.0% above trend to undo the damage.

This is significantly longer than in the US. For the US, every percentage point of real GDP growth causes the unemployment rate to fall by almost 0.5 percentage points, meaning that it takes about two years of growth that is 1.0% above trend to undo a one point rise in the unemployment rate, rather than three.

The following chart shows the fall in unemployment rates after the past three recessions in the US. Unemployment rates have been normalized in each case so that the peak rate of unemployment is set equal to 100.

Somewhat surprisingly (at least to me), the current unemployment recovery in the US is roughly on par with the previous two recessions. Granted, those previous two recessions were also characterized by frustratingly slow improvements in the labor markets (so presumably we should still hope to do better), but it's nice to be able to place our unhappiness with the present labor market recovery in some context.

The next picture shows the same thing for the EZ6, and makes clear that unemployment increases in the eurozone tend to be considerably more sticky. Sometimes, it appears, what goes up comes down only very, very slowly. Even during the relatively successful recovery of 2005-2008 the EZ6 unemployment rate only dropped to about 81% of its peak.

To be fair, it's important to recognize that unemployment rates also tend to rise more slowly in Europe than in the US. In 2009, for example, the unemployment rate in the US rose by 3.5 percentage points, while in the EZ6 the unemployment rate only rose by 1.6 pp. However, this doesn't take the sting out of the fact that when unemployment rates do rise in the eurozone -- as they are doing now -- their negative repercussions last considerably longer than in the US.

European policy-makers need to remember this fact. Their misguided fixation on austerity as the solution to the eurozone's crisis has done a lot to push Europe back into recession. But importantly, the damage and pain caused by this will not just be felt in 2012, but rather for many years to come.

Furthermore, this considerably increases the likelihood that expansionary fiscal policy (i.e. tax cuts and/or more government spending) in Europe would actually pay for itself and reduce government debt burdens in the long run. DeLong and Summers (pdf) recently expounded on this idea and illustrated how fairly reasonable parameter values -- at least in today's economic environment in the US -- can result in such an unconventional outcome. But if hysterisis effects can cause expansionary policy to be debt-reducing in the US, this must be all the more true for the eurozone given the sluggishness of its labor markets. Every additional drop of austerity added to the eurozone's economic brew this year will, more than likely, not only worsen the European Recession of 2012, but will also worsen the eurozone's long run budget picture.

Turning the Tide on Austerity

This week the Economist places François Hollande, the socialist presidential candidate who is likely to win the election in France on May 6, on its cover with the headline "The rather dangerous Monsieur Hollande". A socialist in charge of Europe's second-largest economy is apparently cause for serious concern.

But why? France is overburdened with a massive welfare state and needs to make changes, argues the Economist: "Public debt is high and rising, the government has not run a surplus in over 35 years, the banks are undercapitalised, unemployment is persistent and corrosive and, at 56% of GDP, the French state is the biggest of any euro country." But looking at the data, France actually does not seem to be doing particularly badly. A look at a few basic economic indicators over the past ten years fails to reveal any obvious signs of an economy that has been oppressed by an oversized government sector, as seen below.

Yes, the French have chosen to allow the government to perform more functions than in many other countries, but economic growth has not been notably worse than its neighbors, and its public debt burden is on par with Germany and the United Kingdom. Despite ideological wishes to the contrary, there is little evidence that countries that choose to have a larger government (within a reasonable range) perform worse economically.

Hollande's chief sins are, according to the Economist, that he advocates a very high top income tax rate, that he supports a suspension of a planned increase in the retirement age for those who have contributed the longest to the nation's pension fund, and that he has a generally "anti-business attitude". But it's hard for me to see how any of this could spell doom for the French economy. And on the other side of the ledger, Hollande has something extremely important to recommend him to those who care about European economic performance: a potentially strong voice against the counterproductive austerity madness that has dominated eurozone politics for the past couple of years.

The tide may be turning more widely in the battle for the eurozone's macroeconomic sensibilities; perhaps the steady repetition by certain prominent voices of the simple truth that austerity is counterproductive under current circumstances may finally be bearing some fruit. But if Hollande becomes France's president, the relative weight of the anti-austerity camp will grow considerably in the eurozone. And that can only mean good news for the future of the eurozone.

Won't eurozone bond markets be spooked by Hollande's softness on deficits, though? I doubt it. I tend to think that bond market participants are, on average, quite savvy. And they fully understand (probably quite a bit better than a lot of politicians do) the arguments for why pro-growth policies are the best ways to restore long run fiscal health to eurozone (and other) economies. Instead of causing fiscal armageddon, expansionary fiscal policies could actually reduce national debt burdens in most eurozone countries, given present circumstances.

So rather than be afraid of things like a possible Hollande victory, or the collapse of the conservative, austerity-promoting government of the Netherlands, I actually see such developments as reason for the slightest bit of (cautious) optimism. The eurozone crisis is and always has been primarily a balance of payments crisis, not a fiscal crisis. So if we are finally nearing the end of the disasterous blanket prescription for austerity as the solution to the eurozone's financial market crisis, that can only be a good thing.

Eurozone Austerity by the Numbers

Today Eurostat released its official tally of the budget deficits recorded by the EU and eurozone countries during 2011:

In 2011, the government deficit of both the euro area2 (EA17) and the EU27 decreased in absolute terms compared with 2010, while the government debt rose in both zones. In the euro area the government deficit to GDP ratio decreased from 6.2% in 20103 to 4.1% in 2011, and in the EU27 from 6.5% to 4.5%. In the euro area the government debt to GDP ratio increased from 85.3% at the end of 2010 to 87.2% at the end of 2011, and in the EU27 from 80.0% to 82.5%.

During 2011 the borrowing requirements of the eurozone's governments fell by about €180bn, of which nearly 60% was accounted for by the two largest economies, France and Germany.  But expressed as percent of GDP, it was the countries that have been forced to implement tough austerity measures that were at the top of the deficit reduction list between 2009 and 2011.  The following table illustrates.

Greece, Portugal, and Spain have substantially reduced their deficits over the past two years, despite the fact that their economies were stagnant or contracting. And of course, their terrible economic performance can be attributed in large part precisely to those very same austerity measures, as contractionary fiscal policy in each country has depressed their economies.  Yet eurozone politicians' obsession with deficit reduction continues -- and continues to have new repercussions every day on the eurozone's economies and governments. 

False Starts

This recovery has taken us on several emotional ups and downs. After a truly horrifying 2008-09, when the financial crisis and plunging real economic activity threw the US economy into the deepest recession since the 1930s, there were glimmers of optimism in 2010. But that proved to be a false start, and by late 2010 the economy was doing little better than during the darkest days of the recession. Again in early 2011 things seemed to be getting decidedly better... only to turn worse again and remain pretty lousy through most of last year.

But over the past couple of months we have now been experiencing a third round of positive signs on the recovery in the US. Is this spring likely to reveal yet another false start for the US economy?

I don't think so. I think this time the improvements are for real, and more sustainable. There are two primary reasons that I say this (putting aside the obvious one, which is "third time's the charm"). First, the housing market finally appears to be well and truly near its cyclical bottom. Yes, house price indexes are still showing some declines, but there is good reason to think that there's very little further for house prices to fall. House price-to-rent ratios and real housing prices are just about where they were in the late 1990s, before the housing bubble was even a glimmer in any home-owner's eye. It's not likely that prices will fall much further. And construction activity has already bottomed out, with changes in real estate construction now adding to economic growth rather than subtracting from it.

The second reason is that the process of debt deleveraging by American households is further along than it was during the false economic starts of 2010 and 2011.

Note: debt figures are from the Fed's Flow of Funds data; figures for 2011 Q4 are forecast.

This debt overhang has been a stubborn impediment to consistent growth in spending activity -- US households have been quite busy paying down the debts they racked up during the 2000s -- but over the past couple of years it has been eroded to a significant degree. This will make it easier for any gains in income to be translated into sustainable increases in spending, supporting the recovery in a way that didn't happen a year or two ago.

No one sensible is likely to be carried away by their excitement about this recovery. It will probably continue to be frustratingly slow in many ways, particularly with the relatively slow pace of job growth. But I do think that the recovery is likely to at least remain a real recovery through the rest of this year, which will be a welcome change from the past few years.

International Capital Flows, House Prices, and the Euro

Free Exchange’s weekly reading list includes an excellent recent paper by Jack Favilukis, David Kohn, Sydney C. Ludvigson, and Stijn Van Nieuwerburgh: “International Capital Flows and House Prices.” Lots of observers (including me) have noted the suspicious correlation between surges in international capital flows into certain countries in the early 2000s (e.g. the US, Ireland, Spain, Greece, Iceland, Australia) and simultaneous or near-simultaneous surges in house prices in those countries. This paper addresses the question of whether there is in fact a systematic relationship between capital flows into a country and house prices. Were the house price booms of the 2000s caused by international financial flows?

The answer provided by this paper is no, or at least not directly. When different possible macroeconomic explanations for changes in average national house prices are considered, it turns out that by far the most important factor is the ease of bank credit. In other words, rising house prices in the 2000s (as well as their subsequent fall) probably had much more to do with the willingness of banks to lend than any other factor. When banks are happy to lend money and they relax lending standards, house prices go up. When banks reverse course, house prices go down.

The importance of bank lending standards to the US housing bubble has been well documented and discussed, but this data suggests that the same may be true for a number of other countries as well. On the other hand, countries that did not experience a general relaxation in lending standards in the early 2000s did not experience house price booms. Once changing lending standards are taken into consideration, changes in international capital flows seem to have little additional explanatory power for house price changes.

This raises an obvious question: why did credit standards change in certain countries in the early 2000s? Bank lending standards are surely partly endogenous (as the paper discusses) – when banks expect house prices to continue rising, they are more willing to lend, which helps to push house prices higher. That sort of self-fulfilling logic is exactly why changes in house prices (first up and then down) were so extreme in the boom countries between 2002 and 2009. But this story doesn’t explain how the cycle got started in the first place in those countries.

For that, we need to look for some factors that can affect bank lending standards that are external to the housing market. Surely, general prospects for macroeconomic growth must play a role there, as well as overall risk tolerance. When a country seems to be headed for better economic times and risk tolerance grows, banks become generally more willing to lend. And that is where we come to the euro. (Were you wondering when I would bring that into the story?)

The peripheral euro countries benefited in specific tangible ways from adoption of the euro in 1999, not least from surges in international capital flows that reduced interest rates. Yet this research demonstrates that there is no direct connection between those capital flows and house price booms. So how is the euro involved?

This paper provides some evidence that in addition to truly exogenous changes in the supply of bank loans, expectations about future economic growth also have an impact on house prices: all else being equal, when growth prospects improve house prices go up. And more generally, bank lending standards depend heavily on their perception and tolerance of risk.

Now consider the likelihood that the adoption of the euro by the peripheral European countries (e.g. Spain, Ireland, and Greece) created expectations for higher growth (and lower interest rates) in those countries, and helped persuade banks to become less risk averse. House prices start to rise and banks become more willing to lend. House prices rise more. Banks respond by relaxing credit standards further. And the bubble begins to inflate.

Surges in capital flows don’t directly create house price bubbles. But this paper does help us understand a mechanism by which the adoption of the euro could have indirectly caused house price booms: by changing expectations and altering the perception of risk in the eurozone periphery, a self-reinforcing cycle of easier credit was sparked in those countries. That’s not all there is to it, of course – other factors surely must have also caused changes in risk aversion and bank lending standards in the housing bubble countries – but it does seem to be a likely piece of the puzzle for the peripheral eurozone.

Putting it all together, we now have a plausible contributing explanation for why almost all of peripheral Europe experienced a house price boom following the adoption of the euro, while the euro core (Germany, Austria, Benelux) missed it. It’s yet another way in which adoption of a common currency by economically dissimilar countries may have vastly important but completely unforeseen consequences.

China in the News

While 2011 was a busy year for Europe-watchers, I suspect that 2012 is going to be a big year for China-watchers, at least when it comes to developments that will have the potential to dramatically affect the world's financial system and economy. And as has been the case with the eurozone debt crisis, the most significant developments will probably be purely internal. (Note that I don't mean to suggest that we're done with the euro crisis, by any stretch of the imagination.)

After years of seemingly unstoppable growth, China's economy has shown some sign of cooling off in recent months. But as always, the sharpest dangers to China's and the world's economy are fundamentally financial. China's property boom seems to be coming to a sputtering halt, and the big question is whether this will turn into a full-blown bubble-burst. But in China such things have an additional layer of significance, because in addition to potentially causing financial disruptions, falling property values could create political disruptions as well. From Marketwatch:

China faces social unrest from housing woes

HONG KONG (MarketWatch) — Irate Chinese homeowners are among the top policy concerns for Beijing this year, according to analysts who say weakening house prices are stoking serious tensions.

...City University’s Cheng says tensions over the housing market are emerging, even as authorities are proving more adept at defusing conflict in other areas. He points to December’s protest in the southern costal community of Wukan as one example.

Frustrations in Wukan over corrupt land deals by the village elite — and the death of a protester there — boiled over when 13,000 Chinese citizens took to the streets, sending the local Communist Party officials fleeing and beating back attempts by police to retake the town.

Not exactly the reaction we would expect in the US or Europe to events in local property markets. So while the Chinese government has substantial resources (both financial and adminstrative) that it can throw at this issue if it becomes a serious problem, this is something that we'll have to keep an eye on.

Note that one important way that events in China impact the rest of the world is through its exchange rate, which is substantially controlled by China's central bank. With that in mind, Caixin Online recently published an interesting interview with the governor of China's central bank (the People's Bank of China), Zhou Xiaochuan. I admittedly know relatively little about him, but based on what I do know about him Zhou strikes me as a relatively thoughtful policy-maker who has softly but consistently pushed for market-oriented reforms. I encourage you to read the whole thing, but here are a couple of interesting tidbits:

Regarding prospects for China's economy in 2012:

Caixin: China's macro-economic policies were adapted to fit changing economic situations in 2011. How do you see the economic situation in 2012 and corresponding policy options?

Zhou Xiaochuan: The Central Economic Work Conference clearly articulated macro-economic policy, taking into account two considerations: Efforts to prevent an economic downturn, and efforts to restrain inflation.

First, we are encountering concurrent issues in the international arena, including an evolving European debt crisis, U.S. economic uncertainty, and slowing growth in emerging economies. More importantly, the international economy is changing rapidly, and its outlook remains uncertain. Thus, we must be prepared to respond to new situations.

On the other hand, looking at China's domestic economy, local governments will have leadership reshuffles in 2012 and the capacity for growth in the Chinese economy is still great. At the same time, the consumer price situation has changed for the better, and the need to control inflation is not as pressing as it was in early 2011. Of course, there are still uncertain factors, such as the impact that the real estate market will have on the national economy.

And regarding continued yuan appreciation against the dollar:

Caixin: Is the current two-way volatility of the yuan a temporary phenomenon, or does it fundamentally indicate that the yuan exchange rate has already been overshot?

Zhou Xiaochuan: In the past, people said expectations for the yuan were one-way appreciation. Until close to the equilibrium level, it would experience two-way expectations and two-way volatility. This sort of natural, bi-directional floating state is the goal that reform has pursued. But to truly reach this state may take more time. The movement in the current foreign exchange market is still mainly related to the external environment.

That's as close to an explicit statement as you could expect from the PBOC's governor that the yuan has quite a bit further to go in its appreciation against the dollar. I'll have more to come soon regarding recent developments in the yuan-dollar exchange rate.