Category: Predictions

At least the Fed won’t Undershoot its Inflation Target now

Before today I had been worried that the Fed would (again) undershoot its 2% inflation target. After the Fed’s announcement of unlimited QE today, those worries are gone:

The Federal Reserve on Monday announced aggressive new emergency measures to support the economy and ensure that credit flows to households and businesses as the country faces the prospect of a deep downturn from the coronavirus pandemic.

The central bank is committing to buying as many U.S. government bonds and mortgage-backed securities as needed “to support smooth market functioning.”

 

Meanwhile, inflation expectations in the Euro area have collapsed. I wish the ECB would announce to do “whatever it takes” to bring those inflation expectations back on track. But I’m doubtful.

Explaining the Absence of Stagflation Expectations

As I wrote before, the corona shock constitutes a supply shock. Normally, a supply shock reduces the long-term productive capacity of the economy resulting both in reduced output and inflationary pressure. Hence Bryan Caplan was wondering on Twitter why nobody is talking about stagflation:

I replied on Twitter already but want to provide a more thorough discussion of the topic here.

The corona shock is different from other supply shocks because, in principle, it does not need to result in reduced long-term productive capacity. Basically, the corona shock constitutes a deliberate temporary shutdown of large parts of the economy. The goal should be to enable businesses which had to shut down temporarily to start right up again once health experts have given the green light for that to happen. The long-term productive capacity of the economy will only be hurt, if businesses that needed to shut down go bust before the economy is turned on again.

Since the corona shock does not permanently reduce the productive capacity of the economy, there is no need for real wages to adjust and hence no need for rising prices. That’s one part of the answer.

For the rest of the answer consider the economy as a whole. Let’s say 20% of the economy is shutdown by public-health mandate, voluntarily or because of a break-down of supply chains.

If NGDP in the economy (under normal circumstances) is roughly 20 trillion USD, this means that the NGDP produced by the part of the economy that is still running would, under normal conditions, amount to roughly 16 trillion USD (= 80% x 20 trillion USD). Let’s call the NGDP produced by the running part of the economy NGDP_r and the NGDP produced by the other part of the economy NGDP_h (whereby “h” stands for “hibernation”).

Under normal conditions we would have NGDP_r = 16 trillion USD, NGDP_h = 4 trillion USD and therefore NGDP = NGDP_r + NGDP_h = 20 trillion USD.

Under shutdown, NGDP_h obviously equals 0 USD. But what will happen to NGDP_r? The development of NGDP_r (= nominal spending on products and services produced by the part of the economy that is still running) determines how prices will develop. If NGDP_r increases, there will be inflationary pressures. If NGDP_r shrinks, there will deflationary pressures. If it stays at roughly 16 trillion USD,  neither inflationary nor deflationary pressures will arise.

Intuitively, one will probably expect nominal NGDP_r to shrink. After all,  a sizeable part of the population has just lost their sources of income. But intuition is not what matters. What matters is monetary policy because monetary policy controls nominal spending in the economy.

In normal times, monetary policy can (by reducing the real interest rate) counterbalance or at option outweigh any negative effect on NGDP_r resulting from the shutdown. That is, in normal times NGDP_r may grow or shrink or stay the same – depending on the objectives of the central bank.

However, we do not live in normal times. Nominal interest rates have been close to or at the zero lower bound (ZLB) for a decade. Reducing real interest rates (enough to significantly boost nominal spending) by simply adjusting the nominal rate downwards no longer works. In order to boost NGDP growth at the ZLB, the central bank has to commit to temporarily higher inflation (NGDP growth) in the future.

But since the central bank’s inflation targeting regime cuts off this route to boosting NGDP at the ZLB, NGDP_r is likely to fall during the shutdown.

Hence, the hit to Real GDP caused by the corona shutdown will most likely be accompanied by (moderate) deflationary pressures. Stagflation (reduced RGDP accompanied by higher inflation) is not on the table.

Brexit and the Unforecastability of Demand-Side Recessions

Simon Wren-Lewis claims the Brexit slowdown is about to begin because its negative effect on the economy is no longer masked by unusually strong consumption. Hence, GDP is going to take a hit.

The thing is: all the effects the Brexit vote could conceivably have in the short-run pertain to aggregate demand (AD). Since AD is controlled by the BoE, there is no reason to assume that Brexit will have any short-run consequences on GDP – as I already pointed out immediately after the Brexit vote.

One may argue that at the Zero Lower Bound (ZLB) and under strict inflation targeting, the central bank might lose this control. But since monetary policy in the UK is not even at the ZLB, this theoretical possibility does not apply in the case of post-Brexit Britain.

In general, if the central bank is doing its job properly, any slow-down or reduction of GDP caused by demand-shocks is impossible to predict ahead of time.

Why has this basic fact been ignored by so many economists in the case of Brexit?

Well, most of the economists who have been predicting a negative effect of Brexit on GDP in the short-run believe that Brexit will have a negative effect on the long-run supply side of the British economy. Whether the long-run effect of Brexit will be negative or positive is debatable but taking a pessimistic view is certainly not inherently flawed.

Since economists are human and few humans are immune to the passions involved in political arguments, I guess that, being of the conviction that the long-run effects of Brexit will be negative, these economists have been tempted to loosen their intellectual standards and to sex up their arguments by making gloomy predictions about the short-run as well.

That so many economists have been making these predictions may make them seem respectable. It doesn’t make them well-reasoned or correct.

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The Inexact Science of Economics – and Brexit

Some argue that economics is not a science because it is not able to prove  theories ‘beyond doubt’ the same way as the hard sciences can. Or put another way: most economic theories cannot be disproved in the same way that Popper thought scientific theories could be disproved.

Simon Wren-Lewis objects, defining economics as an inexact science, but science nevertheless. He concedes that in economics no single experiment or regression can kill a theory but points out that economists “[…] have accumulations of evidence that confirm the applicability of some theories and reject the applicability of others. Economists’ views about what models are applicable change as this evidence accumulates.”

I find the term inexact science very fitting and basically agree with Wren-Lewis’ remarks on the topic. But then he ruins it in the last paragraph of the post:

This is why economists views about the (negative – ed) long term impact of Brexit should be treated as knowledge rather than just an opinion. Here knowledge is shorthand for the accumulation of evidence consistent with plausible theory. Sometimes the theories are common sense, like making trade more difficult will reduce trade. Estimates of the size of trade reduction based on evidence are uncertain, but they are better than estimates based on wishful thinking. Empirical gravity equations consistently show that geography still matters a lot in determining how much is traded. Finally there is clear evidence that trade is positively associated with productivity growth. To say that all this has no more worth than some politicians opinion is ultimately to degrade evidence and the science which interprets it.

Not so fast. Economists indeed know that making trade with EU countries more difficult, which Brexit undoubtedly will, will have a negative effect on British incomes. However, the EU is not only a free trade area but also (and arguably more importantly) a political union, producing a large amount of legislation each year.

For example, banking regulation is basically completely defined at the EU level, with national discretion restricted to a couple of unimportant parameters and risk-weights.

That is, Brexit will also have an effect on the laws and regulations under which the UK economy is going to operate. Will this legislative effect of Brexit be positive or negative for British incomes? As I said before, nobody can know for sure.

However, EU legislation certainly has room for improvement (to put it politely) and, in general, smaller political entities tend to be governed better than larger ones. Hence, the legislative effect on British incomes may well be positive. Furthermore, the legislative effect of Brexit might not only be positive but also strong enough to more than offset the negative effect of making trade with EU countries more difficult.

In short, the net effect of Brexit on British incomes may well be positive.

The undue certainty with which many economists have made their predictions on the economic consequences of Brexit is based on ignoring its legislative effect. This effect is, of course, more difficult to measure and to predict than the effect of restrictions to free trade with EU countries. That doesn’t mean it’s not important.

Why the Eurozone will break apart

The basis of a monetary union is the agreement of all member states on a uniform development of the price level across the member states and nothing else.

If, for example, the monetary union’s central bank has an inflation target of 2%, this means that the price level in each of the member states is to increase by 2% each year.

This fundamental basis for the functioning of a monetary union has been utterly disregarded in the case of the European Monetary Union (EMU), resulting in a huge gap in competitiveness between Germany on the one hand and Southern European countries on the other.

The following chart shows the development of the prices of new, domestically produced, final goods and services in the largest economy (Germany) and the third-largest economy (Italy) of the Eurozone as well as the development of Unit Labour Costs (ULC) in these two countries.

Eurozone2

Unit Labour Cost growth, which is roughly equal to the growth in nominal wages minus the growth in labour productivity, closely corresponds with the development of the price level over time: if nominal wages grow by more than labour productivity, prices will rise. Assume, for example, that nominal wages increase by 5% and labour productivity increases by 3%. Then Unit Labour Costs have increased by (about) 2% and will eventually translate into (roughly) 2% inflation.

As the chart demonstrates, the development of Unit Labour Costs (and therefore of the prices of goods and services) within the Eurozone has been dramatically divergent. Furthermore, the European strategy of “internal devaluation”, which means expecting Italy to cut wages and thereby restore competitiveness has failed to achieve a significant reduction in the competitiveness gap vis-a-vis Germany.

The meagre results of Italian internal devaluation have been associated with tremendous economic and social costs. What would have been needed was German boom-and-inflation helping internal devaluation in Italy. Alas, Germany, which has never been big on basic macroeconomics, has been ruled by a curious obsession with fiscal probity, so the much needed German boom-cum-inflation has not happened.

Closing the competitiveness gap vis-a-vis Germany inside the Eurozone may well be too painful to be politically feasible. Already, all of Italy’s opposition parties favour exiting the euro. As is common in democracies, they will eventually come to power.

But even if the Eurozone managed to emerge from the ongoing crisis intact, the next euro crisis would not be far away because the EMU has no mechanism to prevent asymmetric shocks from leading to substantial differences in Unit Labour Costs between member states. Instead of a fiscal rule requiring member states to set the budget balance in such a way that Unit Labour Costs and prices develop in line with inflation in the EMU as a whole, there is a nonsensical deficit limit of 3%.

That is, the EMU would be as unprepared for the next asymmetric shock as it has been for the last. And given how painful and costly the not-yet-completed realignment of the regional price levels within the EMU has turned out to be, I cannot imagine Europeans would be willing to go through that all over again.