20/06/2011: Activism, laissez faire and the counterfactual

In the summer of 1853, New Orleans was hit by a yellow fever-epidemic. It eventually killed 8,000 people (roughly 6% of the population back then). In the mid-nineteen century it was not clear what caused yellow fever and how the disease was transmitted. Scientists at the time called “analytical chemists” assumed that yellow fever was airborne and had something to do with the composition of the atmosphere, which was intensely hot and humid; they declared that there was a “lack of ozone in the air.”
According to one account of this event, “to purify the atmosphere, the Board of Health of New Orleans ordered that four hundred discharges should be fired from several six-pound cannons; but the thunder of the artillery had a fatal effect on many of the sick, throwing them into convulsions. Then another mode of clearing the air was tried. Barrels filled with tar were burned all over the city.”
Knowing in hindsight that yellow fever is transmitted by mosquitoes, we can smile at these futile measures, which far from mitigating the disease actually increased the death toll. However, we should acknowledge the moral of the story and be humble. One hundred fifty years from now, the second program of quantitative easing by the Federal Reserve to mitigate weakness in the US economy after the financial crisis may well be interpreted as a similarly bizarre measure to firing cannons at yellow fever.
Would doing nothing, i.e., “laissez faire,” then have been the better alternative? If we consider what quantitative easing 2 (QE2) has achieved so far – basically nothing – this seems pretty obvious. Comparing November 2010 with the latest available statistics, we note that housing starts in the US are still significantly below 600,000 units (to be compared with over 2 million at the peak of the housing bubble). Moreover, house prices measured by the Case-Shiller index are now lower than in April 2009. Unemployment has retreated somewhat, but its rate remains above 9%. Finally, US growth in the first quarter 2011 only posted a dismal 1.8% annualized (to be compared with the 6% of Germany or the 4% of France).
But there is a caveat to this: the argument is counterfactual because it assumes that without QE2, we would be exactly in the situation we are now. Therefore, activists will argue that without QE2, the US economy could currently be in much worse shape than it presently is.
Richard Koo, the Chief economist of Nomura Research Institute, makes a similar point in his 2008 book “The Holy Grail of Macroeconomics - Lessons from Japan’s Great Recession.” While many economists have bashed the Japanese economic, monetary and fiscal policies of the last two decades as ineffective and expensive, he sees such critique as counterfactual and argues that Japan would be in even worse shape had the policies not been enacted.
Does the counterfactual argument “if we had done nothing, then we would be worse off” always justify activism? In the New Orleans yellow fever anecdote, the alternative scenario of not shooting cannons would have led to a better outcome.
The main difference between this anecdote and monetary policy lies in the fact that the causes and transmission channels of yellow fever are scientifically established by now. However in economics, despite having thought intensively about the issue at least since the Scottish philosopher David Hume wrote about it in 1752, we economists still don’t have a common and scientifically solid understanding of the transmission mechanisms of money.
Hence, whenever the economy derails and people expect active measures to mitigate the situation, politicians and central bankers are likely to continue shooting cannons at yellow fever, pretending to know what they are doing even though the results – as in the case of QE2 – might be far less than spectacular.

17/06/2011: The neutrality of money and flaccid monetary policy

The US Federal Reserve (Fed) marks the official end of its second program of quantitative easing (QE2) on 30 June 2011. By then the Fed will have bought USD 600 billion in Treasuries, increasing the US monetary base by the same amount to roughly USD 2.6 trillion. In fact, the Federal Reserve will have more than tripled the monetary base since mid-2008, before the financial crisis started. This sort of monetary policy in peacetime is unprecedented.
Some investors, even some savvy ones, fear that the end of QE2 will have massive negative repercussions on the US economy and hence on the markets by pushing up interest rates. Others, including ourselves, have particular apprehensions when looking at long-run inflation prospects of such an extreme policy. Nevertheless, a detached view of the whole QE2 reveals that so far it has not had the expected positive effects. Hence as a mirror image, it shouldn’t have the now anticipated negative effects. Or should it?
When Ben Bernanke, Chairman of the Federal Reserve, announced its QE2 program in November 2010, he listed a catalogue of things which were supposed to happen: “Easier financial conditions will promote growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence.”
Comparing November 2010 with the latest available statistics we note that housing starts in the US are still significantly below 600,000 units (to be compared with over 2 million at the peak of the housing bubble), moreover house prices measured by the Case-Shiller index are now lower than in April 2009. Unemployment has retreated somewhat, but its rate remains above 9%. Finally, US growth in the first quarter 2011 only posted a dismal 1.8% annualized (to be compared with the 6% of Germany or the 4% of France).
Interestingly enough, the 10-year Treasury yield stands today near 3.0%, roughly 0.2% above its November 2010 level, but 0.7% below the peak reached in February. Trade-weighted, the US dollar has weakened some 6% since last November, but this hasn’t boosted exports. The trade balance has worsened since, due to an increased oil bill.
The only really significant effect which could be attributed to QE2 among others has been a rise in the US stock market of roughly 8% since November until now, though we have retreated almost 7% from the April peak. This has still barely moved US consumer confidence, which remains at levels near last November.
This year’s first quarter turmoil in the Arab world and the catastrophe in Japan spawned a volatile and risk-adverse environment. However, overall and compared with Bernanke’s expectations, QE2 has been a huge disappointment. It will likely be cited in academic courses in the future as a case study to prove the neutrality of money and the ineffectiveness of monetary policy.In his last statement on 7 June even Ben Bernanke had to admit that the economic recovery is “frustratingly slow” and that not much can currently be done about it, contradicting somewhat the activism showed previously. This said, like the market consensus, he still expects the US economy to rebound in the second half of 2011. Knowing the forecasting track record of the Federal Reserve, one shouldn’t take this for granted.

10/06/2011: On sequels and series

Each year during the summer season, Hollywood comes up with sequels, prequels and spin-offs of successful movies. 2011 is no exception. After The Fast and The Furious 5, Pirates of the Caribbean 4, Hangover 2, Kung Fu Panda 2, and the prequel X-Men: First Class, we will be treated over the next couple of months with Transformers 3, Mission Impossible 4, and the conclusion to Harry Potter, just to name a few of the biggest franchises.
Looking at the markets over the last couple of weeks, we get the impression that we are also reliving several stories already seen a year ago.
Double-Dip 2: After a rather dismal series of US data culminating in a less-than-impressive job-creation figure in May, last year’s question about the possibility of a renewed recession in the US has gained momentum again lately. However, many economists stick to the “soft patch” version of the story by attributing the current business cycle weakness in the US to special factors. High oil prices have taken their toll on private consumption and disruptions in supply chains after the earthquake in Japan have slowed down production – so goes the consensus narrative.
In our view, this sequel is only worth half a thumb-up. While we agree with the overall interpretation of the soft patch, which should ultimately lead to better growth in the second half of 2011, we find the Japanese earthquake explanation too far-fetched to be taken seriously. Regular readers of our research will notice that market participants have yet to adapt to the fact that the US growth seen in the last two decades will not be achieved in the next couple of years. Deleveraging is ongoing. The longer high unemployment rates last, the higher is the likelihood that they become structural and therefore also weigh on growth. And last but not least, the main driver of US growth from 2000 to 2007, the housing market, still has not bottomed out. Hence, a Double-Dip 3 is only a matter of time.
Chinese Real Estate Bubble 3: Over the last few weeks, many analysts have also started to refocus on the Chinese real estate market. It was already a hot topic in 2008 and back then it led the Chinese authorities and the People’s Bank of China to step on the brakes, resulting in a rather strong slowdown of Chinese growth at the beginning of 2009. The story resurfaced in the spring of 2010, but the six hikes in reserve requirements last year and the five since the beginning of 2011 should have made it clear that the Chinese officials are aware of the issue and are trying to deal with it. The latest data from China showed that in April, exports and investment activity remained strong but imports and industrial production were slowing down. Moreover, our view is that Chinese inflation is likely to peak in June and retreat from there. Hence, we don’t think that we will see a Chinese remake of the US housing bubble horror movie, though we remain on alert.
Euro Crisis XX: The term sequel is not really correct for the European sovereign debt tragedy. It rather resembles a TV series. Desperate Public Households would be my title of choice for it. The latest episode, staged in Greece again, has all the necessarily ingredients for a good thriller: another downgrade by a rating agency, tough negotiations regarding the next tranche of the rescue package – including a threat from the Greek finance minister that “the shutters of the country will come down” – as well as public demonstrations and strikes. The next episode of the drama is likely to occur again in Portugal, where the incumbent government was ousted in the recent elections. In my view, this series is poised to continue for another couple of months, bouncing in true Eurovision fashion from one country to the next. However, what makes it somewhat boring is the fact that the end is already known (despite all the denials of European officials): a restructuring of the Greek debt, and maybe of the other European peripheral countries as well. My favorite quote so far in this series comes from Jean-Claude Juncker, the Luxembourg Prime Minister and Head Eurozone Finance Minister: “When it becomes serious, you have to lie.” An instant classic!So forget Hollywood. Markets currently offer as good and as intense a drama. And come the end of the summer heading into the winter season, we might even be so blessed as to see the third sequel of Quantitative Easing.

03/06/2011: Exorbitant privilege adieu?

Presently, international economic organizations are all doom and gloom regarding the future of the US. In April the International Monetary Fund reported that China would surpass the US as the largest economy in the World already by 2016 if measured by purchasing power parity. The World Bank came out soon after with a study “Multipolarity: The New Global Economy,” assessing that the US dollar will surrender its role as the major reserve currency by 2025, de facto ending what former French President Valéry Giscard d’Estaing once called the “exorbitant privilege” of the US currency.
The World Bank diplomatically sidesteps naming a successor to the dollar and instead states that by 2025, several currencies will be equally important in the world economy: the US dollar, the euro and an Asian currency, most likely the Chinese renminbi. Fifteen years is a long time, and it is likely that by 2025, no one will remember the World Bank study. This said, I have my doubts that it will be so easy to oust the old greenback.
Realizing such a scenario requires several assumptions, each of them likely, but not certain. First and foremost, the current erosion of confidence in the US dollar would have to continue for years. Considerable erosion of confidence has already occurred recently due to the current unorthodox US monetary policy (to use a euphemism). Surprisingly, though, the greenback still enjoys confidence as a storage of value in emerging market countries. For the Swiss, history shows the US dollar always on a weakening path, while for Brazilians, the dollar has been much better than the local currency over the last forty years.
Second, the Eurozone must solve its current problems to enhance its international position. But if a break-up scenario or one in which some European peripheral countries leave the common currency are to be excluded, then the only viable solutions for the present crisis lead through a default and restructuring of at least part of the European peripheral debt and/or monetization thereof. Clearly these are not alternatives which will boost confidence in the euro.
Finally, while many see the Chinese renminbi as the true challenger to the US dollar, its broader use as an international currency would require a much deeper financial market. This would mean availability of much more investable assets like stocks and bonds denominated in renminbi, and would thus imply free flows of capital and ultimately greater confidence in the rule of law in China than presently exists. There have indeed been many improvements over the last twenty years; the Chinese can move swiftly, but I think fifteen years is too short a period for such changes.Throughout history, only a handful of currencies have achieved leading currency status. It took two World Wars to establish US-dollar domination after the British pound had ruled over 150 years. Even the loss of confidence after the abandonment of the gold standard in the early 1970s didn’t seriously harm the status of the dollar. What many forget when proclaiming the dollar’s loss of privilege is that a currency need not be strong to hold this leading status as long as it does not have any serious challengers. In my view, a weak dollar will still be the currency of choice in 2025. That said, it is unlikely that anyone will remember my forecast then.