The man who knew better
Oct 19th 2016, 14:56 BY R.A. | WASHINGTON
I HAVE not yet had an opportunity to read Sebastian Mallaby’s new biography of Alan Greenspan (pictured), The Man Who Knew. I have heard great things about it; you can read Martin Wolf’s review of the book in The Economist here. (Full disclosure: Mr Mallaby is a former Economist journalist and is married to our editor-in-chief, Zanny Minton Beddoes.) In reading coverage of the book, I have been intrigued by one of Mr Mallaby’s judgments of Mr Greenspan: that he was insufficiently committed to keeping control of asset prices. Mr Wolf quotes the book as follows:
The tragedy of Greenspan’s tenure is that he did not pursue his fear of finance far enough: he decided that targeting inflation was seductively easy, whereas targeting asset prices was hard; he did not like to confront the climate of opinion, which was willing to grant that central banks had a duty to fight inflation, but not that they should vaporise citizens’ savings by forcing down asset prices. It was a tragedy that grew out of the mix of qualities that had defined Greenspan throughout his public life—intellectual honesty on the one hand, a reluctance to act forcefully on the other.
In an interview with Greg Ip (another former Economist journalist; they’re everywhere), Mr Mallaby says more:
What I discovered in my five years of research was that the Fed tried more than we realised to do things about subprime mortgages, about Fannie and Freddie, the GSE lenders. The New York Fed tried a bit on excess leverage at the banks. And these regulatory efforts were stymied by the fact that the U.S. regulatory system is extremely balkanised, very political, and it’s extremely hard to really drive down risk through regulation. Therefore, I think, the real mistake was not to push with interest rates.
This, it seems to me, is wrong. There are many aspects of Mr Greenspan’s career deserving of criticism, but his decision to give up on the attempt to steer the economy by manipulating asset prices was one of his better judgments. Using interest rate increases to try to bring down asset prices would be a very bad idea.
Why? To begin with, central banks’ mission to keep inflation under wraps is not drawn from thin air. Rather, their aim is to stabilise demand growth. Working out how best to do that has been the subject of decades of intellectual debate within economics, leading to the majority view (if not the consensus) that targeting a low but positive rate of inflation provides a balance of costs and benefits as good as or better than alternative policy targets. The economic ideas underpinning this approach could be wrong, but economists do have a reasonable idea how it all is supposed to work.
We do not, by contrast, have a good understanding how targeting asset prices might lead to more stable demand growth. I understand the sentiment behind Mr Mallaby’s argument: when big bubbles deflate it is very painful, therefore reining in potentially dangerous asset-price growth should be helpful to the economy. Unfortunately, things are not so simple. Which asset prices should we worry about? What is the right level for those prices? How do we expect reduced asset prices to propagate through the economy: what will happen to the outlook for inflation (and therefore to real interest rates) or to the demand for cash? How will broader expectations adjust? Can the policy of pre-emptive bubble popping survive the Lucas critique; that is, is the way Mr Mallaby thinks the policy should work invariant to people realising that asset prices have become a policy target? This stuff is really important! Before inducing a major recession in order to shrink household wealth dramatically, one should have a pretty good idea what step two is going to be. A few economists—like Jeremy Stein, for example—have made tentative steps toward incorporating financial stability variables into a normal monetary-policy framework: but they have been very tentative steps indeed and quite recent.
Another problem: it is not clear that step one would do what Mr Mallaby would like it to do. He tells Mr Ip that a repricing of assets can occur without a massive economic dislocation, pointing to the “taper tantrum” of 2013, when Fed officials began discussing plans to bring quantitative easing to an end, leading to a surge in Treasury yields. “[T]he Fed did effect a repricing of asset market, and the amount of tightening needed was 0%,” Mr Mallaby says. This seems like an odd example, however. The spike in yields proved short-lived; Treasuries now yield less than they did before the tantrum, even though the Fed has tightened policy substantially, by bringing QE to an end and raising the short-term interest rate.
Neither is that the only recent example. In the 2000s, the Fed did ultimately move to tighten monetary policy significantly, increasing the federal funds rate by four full percentage points between 2004 and 2006. The effect on mortgage rates, however, was somewhat smaller than anticipated (see chart).
Housing prices did begin falling in 2006, calamitously. Yet that decline seems more closely linked to tumbling growth in demand, as captured in growth in nominal output. Both NGDP growth and housing-price growth began a sharp deceleration in 2006. That leads to an important question: how much of the pain of the Great Recession was a necessary consequence of the unwinding of the housing bubble, and how much was the result of a dramatic decline in demand which both worsened the housing crash and which would have been a necessary component of any earlier attempt to reduce housing prices by raising interest rates? What Mr Mallaby is arguing for, remember, is more tightening earlier in the 2000s. But we saw what a large dose of tightening accomplished from 2004-6. Prior to 2004 the American economy was struggling through a jobless recovery, flirting with deflation: hardly an ideal environment in which to raise interest rates substantially.
The right conclusion to draw from the experience of the 2000s is not that Mr Greenspan showed poor judgment and weakness in failing to punish American households with more rate hikes. The right conclusion to draw is that Mr Greenspan’s options were constrained by global macroeconomic dynamics that were poorly understood at the time, and to which he responded about as well as could be expected. The financialisation of the global economy has clearly affected the operation of monetary policy. The interest rate that matters now is the global real interest rate, and national central bankers face constraints in setting domestic monetary policy as a result. As a result of those constraints, central bankers cannot easily raise long-term borrowing costs, since efforts to tighten policy attract capital inflows. Weak demand is a chronic condition in this world, outside of circumstances in which asset prices are growing rapidly or government borrowing is used to prop up demand. It is somewhat extraordinary that in the wake of the crises of the last decade we are more open to the idea that growth should be slower, and slumps deeper and more frequent, than to entertaining the possibility that the benefits of free capital flows might not be worth the macroeconomic costs, and that governments should bear greater responsibility for stabilising demand. If Mr Greenspan’s career teaches us anything, it is that we should not expect too much of our monetary maestros.
China’s uncannily stable growth versus the price of reform
Oct 19th 2016, 7:17 BY S.R. | SHANGHAI
IN THE pantheon of economic clichés, the concept of “short-term pain for long-term gain” is surely a contender for top spot. It is trotted out again and again when discussing why Country X must undertake such and such difficult reforms to reap untold benefits down the road. For those analysing or reporting on the Chinese economy, it has become a familiar refrain. This does not mean it is wrong; China’s old growth model of credit-fuelled investment has led to a vast accumulation of debt and a big drop in productivity. Change is needed, even though there will be costs. But being a cliché, it can obscure details. What exactly is this short-term pain?
To start, one thing that should be clear: China has so far felt little in the way of pain. Although some regions, especially the north-east, have endured a tough few years, China has kept defaults to a minimum and held its credit spigot wide open. Thanks in large part to that, the economy grew 6.7% in the third quarter from a year earlier, according to data published today. This marks the first time in China’s modern economic history (ie, since detailed quarterly records began in 1992) that it has turned in identical year-on-year growth rates for three consecutive quarters. That is uncanny tranquillity for a $10 trillion economy which is supposed to be going through a wrenching transition from heavy industries to modern services.
In nominal terms, the trend looks even better. Annual growth actually rebounded, from a shade less than 6% in third quarter last year to 7.8% over the past three months. The precise size of the rebound is open to debate, but there is enough in the way of alternative indicators to lend credence to the picture of a rebound. Property sales are booming; corporate earnings have strengthened; prices of goods as they leave the factory gate have started rising after more than four years of deflation. Little wonder that investors’ concerns about China have subsided since the start of the year.
Yet beneath the surface, risks from the debt build-up continue to mount. Total credit has grown roughly 16% this year, twice as fast as nominal growth, meaning that the economy is still leveraging up at a rapid pace. The rise in China’s debt-to-GDP level—from roughly 150% before the 2008 global financial crisis to more than 250% today—puts it in the same league as countries such as Spain and Japan that went on to suffer serious slowdowns or financial turmoil.
Hence the calls for short-term pain to avoid long-term pain. What that means in general terms might seem evident: China should trade lower economic growth today for slower debt accumulation, reducing the chances of a crisis. But that general statement does not take the analysis very far. Done hastily or heavy-handedly, a slowdown in debt accumulation could bring about the very crisis it is meant to defuse. Clichés can be dangerous, not just dull.
A new working paper by the International Monetary Fund is particularly good in outlining what “short-term pain” might involve. The IMF has been among the loudest of voices in warning about China’s debt risks. But it also takes a very measured tone in assessing what can be done.
Let's be realistic
The IMF contrasts a purist market approach with a government-led solution. The virtue of a market approach is that it would be transparent, laying the foundations for better allocation of credit in the future. But it is also susceptible to extreme volatility, even in the most sophisticated of economies. In China’s case, the IMF argues that it is just not realistic. The biggest creditors are state-owned banks and the biggest debtors are state-owned companies. They are too cosy with one another and cannot shift to market rules overnight.
Instead, the IMF says that a high-level decision is needed to address debt problems, and quickly. Rather than leaving creditors and debtors to sort out their mess by themselves, financial regulators should participate alongside them. This is more likely to produce a disciplined, consistent solution across different sectors of the economy. To that end, China also needs standards for triage in determining which companies are viable. The IMF argues that, for one thing, banks need to come clean about their true bad-loan levels (officially, less than 2% of loans are non-performing; the IMF estimates that about 15% of corporate loans are at risk).
But it is not just bitter medicine. Removing implicit guarantees on the debts of state-owned companies is, for instance, bound to hurt. Rather that doing it all at once, the IMF suggests that China start from newly issued products rather than bonds that are already trading. It also sees plenty of scope for the central government to step up support for laid-off workers. Municipalities manage unemployment insurance, providing little, if any, coverage for the 200m migrants who work in places where they are not registered to live. And by opening up sectors such as telecommunications and energy to private investors, China should be able to generate more productivity growth.
China is already moving on some of these fronts. Notably, regulators have started co-ordinating debt-for-equity swaps to trim the liabilities of state firms. However, judging by the continued drift upward in debt levels, it is still moving far from fast enough.
What is perhaps most striking of all is the price that the IMF puts on “short-term pain”. It reckons that, if implemented, the array of reforms would cut growth to about 6% next year, followed by a long stretch of annual growth of 6.5%. Inaction, by contrast, would allow for stronger growth next year but then lead to a steady decline to as low as 3% by 2020. These are of course just estimates. But the message ought to embolden China’s reformers: short-term pain need not be unbearably painful.
Making sense of the Wallonian veto
Oct 23rd 2016, 21:52 BY R.A. | WASHINGTON
IF CLEVELAND were given the right to veto any potential trade agreement between American and another country, how many trade agreements would ever be enacted? One reasonable guess is: none. If the federal government then deprived Cleveland of the right to veto trade agreements, would that be anti-democratic?
For those who missed the news: last week the parliament of Wallonia (one of the three regions which make up the state of Belgium) voted to block the Comprehensive Economic and Trade Agreement (CETA), which is an ambitious trade deal negotiated between Canada and the European Union. Wallonia’s population is less than 1% of that of the EU has a whole: comparable to the share of America’s population residing in the Cleveland metropolitan area. It seems slightly perverse that so small an area could block so important a deal which had been so long in the making. Especially when the other party in the deal in question is Canada, seemingly as innocuous a trade partner as one could wish for.
Dani Rodrik, an economist at Harvard University, says the vote is in large part a statement of frustration with elites. He writes:
I’d put a large part of the blame on mainstream elites and trade technocrats who pooh-poohed ordinary people’s concerns with earlier trade agreements.
Those concerns include worries that gains would be smaller than promised, that sovereignty would be compromised, and that there might be serious distributional inequities. Walloons, it seems, were in this case all too aware of the possibility of an unequal distribution of costs and benefits. A piece in The Economist this week points out that:
Wallonia boasts one cow for every three humans and its lavishly subsidised farmers are wary of cheap Canadian competition. Erwin Schöpges, a Walloon dairy farmer who joined the protests outside parliament, says he already faces milk prices below his production costs. “We want to trade with Canada, but we would rather not abolish tariffs,” he says.
Another thought experiment: were London (or, to separate things from the elites, Scotland) able to block the Brexit vote, would it? The answer, of course, is yes. Would empowering British regions in this way then represent a move toward greater democracy? Or different democracy?
Many readers will be familiar with Mr Rodrik’s globalisation trilemma, the idea that the world can have at most two of: economic integration, national sovereignty and democracy. Liberalisation, like many economic shifts, creates winners and losers. Many existing political structures advantage the votes of the losers, giving them, in many cases, the ability to block changes that generate net, though unevenly distributed, benefits. In order to move toward greater liberalisation, then, one either has to ignore popular opinion in these places (abandoning the democracy leg of the trilemma), or change the locus of political decision-taking (abandoning national sovereignty). Indeed, Mr Rodrik once argued that globalisation implied a long run shift toward supra-national rules and democracy.
Sometimes, however, we seem to confuse the abandonment of a particular hierarchy of sovereignty with an abandonment of democracy. But that need not be the case. Shifting political power from Wallonia to the Belgian federal government, or to the European parliament, is not less democratic. It is, however, a shift in power. One important question for those pondering the future of globalisation is: what distribution of political power can best reconcile global openness and broad-based prosperity (the latter being relatively important to maintaining the legitimacy of the former).
Broader polities should support more openness than narrow ones, since the balance of winners and losers within them is closer to the global balance, which should be positive. If disadvantaged groups within those broad polities are unable to form effective coalitions, however, in order to bargain for compensation against the costs of liberalisation, then trouble is bound to result. It is possible that the Wallonia vote, or Brexit, for that matter, are less about the legitimacy of particular policies, like freer trade, than about the legitimacy of particular polities. And that, actually, should worry us more.
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