Friday, 28 February 2014

Your Neighbourhood Economist turns 100

Not much cheer considering how little progress in dealing with economic stagnation has been made since the blog began

There has not been much to celebrate of late but Your Neighbourhood Economist is happy to have reached a satisfying milestone – 100 blogs (not years).  This blog started by asking “so what is going on?” back in November 2011, lamenting weak growth in the global economy.  Little did Your Neighbourhood Economist (or many others) know that there would still be few signs of improvement over two years later.

Perhaps the only consolation is that things could be worse.  At least the Eurozone has not self destructed (yet) thanks to the European Central Bank stepping in.  US politicians also showed some surprising good sense despite all expectations to the contrary.  But the positives are few and far between.

Governments in many countries have too much debt to be able to boost spending which is leaving monetary policy as the main route out of the current weak economic growth.  However, expansive monetary policy has not been enough to generate much economic stimulus despite record low interest rates and loads of newly printed cash in the global financial system.  In fact, monetary policy may be doing more harm than good.  

Movements of surplus funds are creating havoc in emerging marketsUncertainty over the direction of monetary policy is a major obstacle in the way of a return to economic growth.  The costs of such policies are becoming more evident as the benefits are increasingly being called into question.

Central banks have struggled as the traditional tools of monetary policy have failed to have much of an effect.  New ideas have been tried (such as forward guidance) but the desired results have proved elusive.  Policy makers are getting side-tracked as new problems, such as concerns about deflation in Europe, draw their attention away from more pressing issues such as reforms.

Chances to celebrate may be a long way off so Your Neighbourhood Economist is glad for reasons to be cheerful (such as reaching 100 blogs) whenever possible.

Wednesday, 26 February 2014

UK government needs to play its part to lift the economy

The government and the Bank of England should be working in tandem but one is taking a free ride

A good partnership is crucial in many aspects of life.  Take the UK economy for example - it is vital that the government and the central bank work in harmony if they are to provide support for the stumbling recovery.  Both seem to share a common view of the task in hand, painting a gloomy picture of the economy.  Yet, to borrow an analogy from the recent Winter Olympics, the combination is more like an ice skating duo that not only can’t stay in synch but where one is sabotaging the efforts of the other.

Working from same play sheet

The starting point of the government and the Bank of England is the same.  Economic data coming out of the UK shows that the country is performing better than most – GDP was up by 1.9% in 2013 with unemployment down to 7.2% in the three months through December.  Yet, if an economic upswing is on its way, neither the government nor the central bank wants anyone to know.  “Neither balanced nor sustainable” is how Mark Carney, the head of the Bank of England, described the UK economic recovery.  The Chancellor, George Osborne, claims that the “recovery is not yet secure”.  A more pessimistic outlook on the UK economy is actually closer to reality.  GDP in the UK is still lower than before the onset of the global financial crisis.

Despite some signs the economy is picking itself up, a fully-fledged return to form is still some way off.  Key drivers of growth are still frozen with UK businesses neither investing nor finding much business in overseas markets.  The economy also scores poorly in terms of long-term prospects with low levels of investment translating into few gains in productivity as well as stagnating wages.

Are you pulling my leg?

The UK central bank is the more diligent of the pair.  It has been working hard to convince people that interest rates will not be rising anytime soon.  The hope is that businesses and households can be convinced to borrow if they feel secure that interest rates will remain at their current low levels.  Mark Carney has tried to use forward guidance to this end but the policy fell flat (as outlined in a previous post).  Downbeat comments on the state of the UK economy are another avenue for soothing concerns over interest rate hikes.

George Osborne seems to be skating off in a different direction.  His remarks on the economy are part of a routine designed to push his austerity program promoted as painful but necessary due to the high levels of government debt.  Austerity did seem to have its merits amid the Eurozone crisis when investors with cold feet were pulling their money out from indebted countries.  Worries about debt levels have eased but the UK government is still sticking with its harsh spending cuts.

Doing more harm than good

The austerity measures are proving harmful in two ways.  Firstly, there is a shortfall in demand in the UK economy which is exacerbated by lower government spending.  The ideal response to weak demand is a fiscal stimulus with the actual benefit to the economy larger than the actual increase in government spending.  Yet, despite the negative effects, the UK government has chosen to do the opposite due to an ideological dislike of large government.

The other negative is that the Bank of England has been left solely in charge of generating an economic recovery.  It is bad enough that the duet has turned into a solo performance but the austerity measures act as a further handicap.  The one-man act has proven tough even for someone with the stellar reputation of Mark Carney but this situation also creates its own problems.

Loose monetary policy has been a factor behind increased asset prices showing up in the property valuations and the stock market.  This has helped to push up consumer spending as households with property or stocks feel wealthier.  Yet only a small portion of the population are benefitting.  Monetary policy by itself is not the route to a balanced or sustainable recovery (as argued in a previous blog).  A change in direction by the government is needed to give more balance or the economic ice may prove thin indeed.

Monday, 17 February 2014

The True Cost of Quantitative Easing

Quantitative easing has been short-term pain relief with long-term damage and some ugly side-effects

Life on drugs must be great – but the high cannot last for ever.  Such has been the case with quantitative easing.  The financial markets have been buzzing due to the money pouring out of the Federal Reserve as part of its monetary stimulus program.  The costs of shot after shot of extra cash are easy to forget when times are good.  It is only now that the Federal Reserve has decided that it is time to wean investors off their quantitative easing fix that we are seeing the true repercussions of addiction to easy money.

Costs of kicking the habit

Investors are already getting the shakes as the Federal Reserve moves to lower the dosage of its monetary policy.  Stock markets around the world wobbled in early 2014 as the Federal Reserve trimmed US$10 billion off its monthly bond purchases in December and January.  The extent to which stock markets have benefitted from the monetary stimulus is unclear but substantial.  This means that volatility is likely to continue as share prices find their appropriate level without any interference from the Federal Reserve.

Investors have reacted strongly to any attempts by the Federal Reserve to renounce its role as drug dealer for the financial markets.  The policy of quantitative easing in itself has been like a drug habit – easy to start but tough to break.  As is often the case with bad habits, it is only when trying to quit that the real costs become apparent.

It looks as if the comedown will take the form of a lethargic economic recovery that may last for years.  Uncertainty is one of the primary stumbling blocks standing in the way of economic rehabilitation.  The slow tapering of quantitative easing followed by interest rates being gradually pushed upward will be enough to keep even the experts on edge.  Thus, while the monetary stimulus has eased the pain of the global slowdown, the economy will be held back by the “ifs” and “buts” of monetary policy.

Emerging Markets Hit by Side-Effects

If the past few weeks of stock market jitters are anything to go by, it may be emerging markets that suffer the worst withdrawal symptoms.  Many developing countries had benefited from the extra cash in the global financial system coming from quantitative easing.  Low levels of domestic savings mean that such countries rely on funds from overseas and their chronic cravings for growth make poorer countries prone to overdosing.  Their vulnerable position leaves them at the mercy of the money peddlers from wealthy countries who often have the upper hand.

It is a sad twist of fate that the worst consequences of monetary policy in the US will be felt far from its shores.  One of the reasons why quantitative easing has had little effect in boosting the US economy may be due to a considerable portion of the newly printed money heading overseas.  The amount of cash flowing out of the US has been large enough to warp the economies of some developing countries.  The hit on their financial wellbeing as the money returns back to the US has also been a downer.

A silver lining is that past crises have taught emerging markets to be more resilient – this time at least the IMF will not be kicking down any doors (like the police at a narcotics bust) as might have been the case in the past.  It is also clear that emerging markets still need to do more to better manage their addiction to foreign funds.  While emerging markets have learnt some lessons from past predicaments, we can only hope that the Federal Reserve can do the same. 

Friday, 14 February 2014

Nasty Breakup from Forward Guidance

Central banks have been led astray by the policy of forward guidance and it is time to move on

There has been a big breakup in the world of economics just before Valentine’s Day.  Central banks in the US and the UK had been wed to the concept of forward guidance.  This policy involves keeping interest rates low will have greater potency when combined with an outline of how long the policy will remain in place.  With the impact of low interest rates on the wane, central banks in the US and the UK were courted by the idea of forward guidance as a way to eke more out of current policies.  Yet both the Federal Reserve and Bank of England have been caught with their pants down due to the failure of forward guidance to deliver an economic boost.  The falling out has been made worse by debilitating issues with policy execution.

Seemed like a good idea at the time

The Federal Reserve slashed interest rates to 0.25% in December 2008 while the Bank of England pruned UK interest rates back to 0.5%.  In the face of the harshest recession in a generation, this normally dependable form of monetary stimulus failed to have much of an effect.  Continued weak economic growth spurred on a search for something extra and resulted in central banks delving into more unconventional measures.  Quantitative easing (buying bonds with newly printed money) is one example of such measures, forward guidance being another.

It was thought that forward guidance would act as a means to encourage economic growth as low interest rates were not having much of an effect on borrowing by themselves.  The hope was that a pledge that rates would be kept low for at least a few years would be the catalyst that would kick-start lending.  However, the assumption that there was a pent up demand for loans was wrong (as Your Neighbourhood Economist thought it might be). 

Bad idea made worse by shoddy execution

If the thinking behind forward guidance was not the best, the implementation was worse.  Both the Federal Reserve and the Bank of England based the forward guidance on the unemployment rate.  Unemployment was seen as a reliable yardstick of economic performance so the two central banks used it as a marker for changes in policy.  This later became a stumbling block when the number of people out of work declined faster than expected catching out many others along with the central banks.

Having to readjust the policy of forward guidance has been a PR disaster for central banks for whom reputation is key to influencing the financial markets and achieving their goals.  The Bank of England recently explicitly dropped the link between interest rates and unemployment and the Federal Reserve is sure to follow suit.  The necessity for central banks to assuage concerns that interest rates may rise defeats the whole purpose of forward guidance in the first place.

The Bank of England has instead stated that it will rely on a wider range of economic data.  Despite protestations by Bank of England governor Mark Carney that forward guidance is working, the new policy is too vague to act as any guide to the future of interest rates.  The reworking of forward guidance has failed to find any love from the markets.  Expectations that the Bank of England would not be faithful and would hike interest rates sooner rather than later resulted in the value of the UK currency jumping following the statements by Carney.  The saga over forward guidance has left central banks wondering what went wrong but it is time to get out and start afresh. 

Wednesday, 12 February 2014

Fragile Five – the Silver Lining

A deeper look into the problems of the Fragile Five shows that the fault does not lie with global finance.

There are times in life when it is tough to figure out who is the hero and who is the villain.  Such may be the case with the current turmoil engulfing emerging markets.  Adding ignominy to injury, economists have tarred Brazil, Turkey, India, Indonesia, and South Africa with the dubious epithet of “the Fragile Five” as an outflow of funds has sparked a multitude of economic imbalances.  Investors have been quick to yank their money out as higher investment returns are expected to follow the paring back of monetary stimulus.  First impressions might suggest that the blame lies with the fickle nature of global finance. 

Yet, as with all good detective novels, it is not always the obvious culprit who is in the wrong.  It is entirely logical that money should move out of badly run countries in the same way as shoddy companies are shunned by investors.  It is more often corrosive politics that are to blame for driving investors away.  With this in mind, a shake-up at the (invisible) hands of the financial markets may work out for the best.

The blame game

Politicians themselves have been quick to blame the Federal Reserve in the US.  The Federal Reserve was buying US$85 billion in bonds each month in 2013, which drove down the yields on US bonds and prompted investors to shift their money overseas in search of better returns.  Reductions in these monthly bond purchases have triggered a return of funds from overseas which has caught out many emerging economies.

If politicians in emerging markets were honest (admittedly, an odd concept), their fingers would be pointing closer to home.  Many emerging economies benefited from the cheap capital but came to rely on it too much.  Economic growth which had been sustained past the global financial crisis began to slow as governments put off reforms to keep their economies going.  Instead, governments tapped into funds from overseas to ramp up spending and cover growing shortfalls in demand.  This only masked the problems which have since been laid bare by the countries being stripped of their external financing (see No need to fear for the Fragile Five for more on this). 

No more excuses for politicians

All of the talk surrounding the Fragile Five tends to focus on their economies but the real issue is with their politics.  The rise of the middle classes in these countries has been a catalyst for more responsive government.  Minor issues have triggered large protests fuelled by frustrated voters.  A rise in transport costs incited upheaval in Brazil.  A sit-in protest at a park in Istanbul escalated into unrest throughout Turkey.  The rapid rise of an anti-corruption party threatens to derail the major parties in elections in India.  Workers strike in South Africa demanding higher wages.

The faltering economic growth has revealed the inadequacies of government.  Slower economic growth means that voters cannot be bought off with higher incomes.  Their dissatisfaction has now been coupled with that of investors who hold the upper hand in terms of where they stash their cash.  Being spurned by investors does involve some short-term pain.  However, this can be limited by countries building up foreign currency reserves.  Other measures such as controls over inflows and outflows of funds are increasingly gaining acceptance (for more, see beware of a flood of funds).

There are clear long-term benefits from keeping politicians in emerging markets honest by means of checks rooted in global finance.  Voters everywhere are disillusioned with their politicians (a sentiment shared by Your Neighbourhood Economist) and emerging countries are no exception.  But levels of wealth in poorer countries are considerably more dependent on the quality of their politicians.  Governments in developing countries also have a tendency to fiddle with the economy through state-owned firms or measures against free trade.  Argentina is probably the best example of this - the country is so badly run that it does not even attract enough foreign capital to merit inclusion in the Fragile Five.

Extra incentives for governments to adopt appropriate policies should thus be welcomed.  Trying to stick to the economic equivalent of a diet may not be easy but there are rewards at the end of it.  In conclusion, there is no point in blaming someone who keeps you on the straight and narrow, in fact, there is a lot to gain.

Tuesday, 11 February 2014

No need to fear for the Fragile Five

While it may look like emerging markets are being tormented by global investors, there could be a happy ending.

What's in a name?  Well, the moniker “Fragile Five” suggests all is not rosy but the countries (Brazil, Turkey, India, Indonesia, and South Africa) labelled thus have things other than name calling to worry about.  Namely, the fact that it appears as though the Fragile Five are being picked on by the international financial system.  The leader of the pack has been the Federal Reserve whose trimming back of its stimulus package has triggered a massive shift in global finances.  While no country would choose to be browbeaten by investors, a lecture on bad economic policy might help these countries avoid a story of more woe in the future.

What is going wrong?

Emerging markets have fallen victim to the fleeting nature of foreign investors.  The global financial system has been awash with money due to central banks such as the Federal Reserve printing cash to stimulate Western economies.  Low financial returns in developed countries have prompted investors to look abroad for places to park their money.  Perkier economic growth in developing economies has been an oasis for investment as options elsewhere dried up.

Emerging markets are typically in need of extra cash.  There are little savings available to fund the investments needed to build homes, roads, and factories as the economy develops.  These cash-starved countries are a good fit with cash-rich investors but there is a need to get the balance right.  Unfortunately, many emerging economies come to overly depend on the cash provided by investors to fund their economic growth.  As is the case with things offered up on the cheap, the good times don’t always last and investors always have the option of taking their money elsewhere.

Along with slumping stock markets, the effects of emerging markets falling out of favour with investors are most keenly felt through a drop in currencies in emerging markets.  A weaker currency results in emerging markets having to pay more for their imports, which exacerbates the problem of high spending on overseas goods such as oil.  Higher prices for imports also push up inflation which is already too high in many emerging markets.  Many of these countries also struggle with large government budget deficits as slower economic growth prompts greater fiscal spending.

How things are being put right

While the Federal Reserve has been measured in its approach to changing policy, central banks in the Fragile Five have been all action.  The central bank in Turkey lifted its overnight lending rate for banks from 7.75% to 12% while their counterparts in other countries also increased their rates by smaller amounts.  The higher interest rates are designed to make it more attractive to hold the currency of that country as part of an attempt to stem the selling on the foreign exchange markets.  An increase in the costs of borrowing also has the effect of cooling the economy and reducing the demand for imports.

It is lucky for the Fragile Five that the most important actions have already been taken to prepare them for the ebb and flow of global capital.  Emerging economies have learnt from the Asian financial crisis in 1997 when many economies in Southeast Asia were decimated due to high levels of foreign debt and a system of fixed exchange rates.  The adoption of floating exchange rates along with large foreign currency reserves means that another crisis is unlikely.  Inflows of foreign funds are treated with less welcoming arms and greater acceptance of the need for controls over the movement of money in and out of economies with less developed financial systems (for more info, see beware of a flood of funds).

Your Neighbourhood Economist would even argue that there are some positives.  The global financial crisis and the Eurozone crisis have shown what can happen when imbalances in an economy get out of hand.  Investors can be a fickle bunch (many people are where money is concerned) but investor sentiment is typically a good gauge of how well an economy is operating.  If subprime mortgages or lending in southern Europe had also led to a revolt in the market, most of us would be better off (see bond investors ain’t all bad for more on this).  With this in mind, perhaps foreign investors should not be seen as bullies, but more like an older brother (who may not always be nice) keeping you out of trouble.

Wednesday, 5 February 2014

The Productivity Puzzle and the Rise of the Self-Employed

Economists are struggling to explain why labour productivity is so low but Your Neighbourhood Economist could be part of the underlying reason

Puzzles can be fun but also frustrating if a solution proves elusive.  Such is the case with the “productivity puzzle” which is a phenomenon economists are having a tough time explaining.  Productivity of workers measured in output per worker has fallen following the global financial crisis and has remained weak.  The lack of an explanation for this is even more irritating as growth in productivity is one of the key factors in pushing up wages and generating higher levels of wealth.  But this dilemma may not be worth all of the worry.

What is so puzzling?

There are a number of pieces to this puzzle which are not fitting together.  The first is that companies are not investing as much.  This in itself is difficult to explain at a time when interest rates are at record lows and profitability for many companies is high.  One reason typically given is that firms are reluctant to risk money on long-term bets as the future is clouded with uncertainty.  Banks have also cut off funding to many smaller up-and-coming businesses who want to expand.  Others have pointed the finger at companies paying their executives with bonuses which prioritise rising share prices rather than investment for the future.

The next part of the riddle is falling unemployment.  A typical recession involves companies taking the opportunity to trim back their workforces.  This results in a jump in productivity as similar amounts of work are carried out by fewer workers.  Yet almost the opposite has proven true over the past few years.  Unemployment has not been as severe as in the past and the number of people out looking for work in countries such as the US and the UK is already falling.

This enigma appears even stranger when considering that unemployment in the UK has fallen to a four-year low of 7.1% while real GDP is still less than in 2008.  Companies seem to be holding onto their workers and hiring more staff instead of buying new equipment or upgrading their offices.  This may be a strategy to deal with an uncertain future (which would be temporary).  Alternatively, it could be a part of a larger shift in the way that business is done.

A reason not to worry

One of the key missing pieces could be technological change shaping new forms of work.  The Internet, along with innovations such as cloud computing, has brought down start-up costs for businesses.  Running a business these days can require little more than a laptop.  This combined with a dearth of decent jobs has seen a dramatic rise in the number of self-employed in the UK (including Your Neighbourhood Economist).

The self-employed are apt to rely mostly on manpower with little need for investment.  Output from operations with just a few workers is likely to be low or else others would have already taken advantage of such business opportunities.  Examples might include freelance web designers or landscape gardeners willing to live off sporadic work while enjoying extra spare time.

This is still not likely to be sufficient to entirely account for the low productivity that is vexing economists.  It is true that business is changing on many levels as people find new ways of harnessing the Internet and economists (including yours truly) are still grappling with what it all means.  However, if the solution involves making work less of a burden and more days working from home, it need not be so troubling after all.