Economists crash but don’t burn

Economists have been caught up in their own tale of hubris but have come out barely unscathed

Sometimes life plays out like fiction and such has been the case with economists.  The advocates of economics had been riding high at the beginning of the century as everything seemed to be running smoothly.  Economists look on a renewed sense of swagger stemming from the (mistaken) belief that fluctuations in the economy had been mastered.  But as often happens in a tale of hubris, the world comes crashing down just at the point where the hero starts to get carried away.  Such has been the tragedy for economists but it is the rest of us that have paid the price.    

Set for a fall

Like the rest of us, economists are liable to go too far when things go their way.  This is made worse by the way in which economics can be seen as more like a religion than a science as it is difficult to prove that economic ideas are wrong.  This means that faith can mean more than fact.  But when faith and fact align is when the problems really begin.  Such was the case for a couple of decades after economists increasingly took charge of central banks since the 1980s. 

Central banks took on the mission of combating the scourge of inflation and their success with this began to build up confidence in their capabilities.  Their theories led economists to believe that low and stable inflation was the key to economic wealth and well-being.  But this meant that problems were allowed to fester elsewhere in the economy due to this narrow focus on consumer prices.  The dot com bubble just over ten years ago should have been a wakeup call.  Prices for tech stock had gotten out of hand but central banks preferred to stand back with the plan of letting the boom and bust run its course and then mop up afterwards.  The mild recession that followed reaffirmed the notion that central banks could fix any problems.   

No so clever after all

Economists made the most of their time in the sun.  Thinking that they had all of the answers, economists started applying their ideas to other topics.  Economists also increasingly plugged their ideas to the public fuelled by the claim that economics could explain almost everything (see the photo above).  Thinking that they knew it all, economists weren’t afraid to let other know about it.  As is typical for a Greek tragedy, it is precisely at this point (where the hero thinks that the world has been conquered) that everything comes crashing down. 

The turning point in this tale of woe came with the global financial crisis.  Economists were not just unfortunate victims of unforeseen circumstance but were the architects of their own downfall.  Their conviction in their own ideas prompted economists at central banks to overlook growing distortions in the economy.  Interest rates were kept too low for too long which allowed for the levels of debt to get out of hand.  The dogma of the almighty central bank also led to complacency at banks that chased after profits without worrying about risks in the economy.

Skipping over the lesson of the tale

It does not take the wisdom of hindsight to see that catastrophe was just around the corner.  But it does help with realizing that the success that central banks achieved may have been more due to luck than clever management.  The surge in exports from China was always going to keep prices down whatever central banks did.  Inflation may not even be a major concern any more considering that prices did not jump despite the surge in lending heading into the global financial crisis or with central banks printing loads of cash as part of quantitative easing.

The saga proved to be something similar to the tale of Icarus.  Emboldened economists also flew too close to the sun but it was their ideas that went into eventually went into meltdown.  But the main difference is that, while economists have fallen from grace, it was others who got badly burnt.  This would be easier to take if economists were busying themselves coming up with better ideas to allow for less turbulence in the economy.  But economists are slow learners and policy is still guided by the same old ideas.  Change may happen and hopefully it does before we all crash and burn again.  

Question – Interest rates

In response to an inquiry from a reader, Your Neighbourhood Economist explains how low interest rates should have but didn’t affect the economy (with a surprising culprit)

Your Neighbourhood Economist was pleasantly surprised to have a proverbial knock at the door (a photo of which was posted on the blog recently along with an email address for questions) with the following inquiry on interest rates…

I read your blog entry on BOE interest rate hike and needed an opinion. I'm not a finance student but am trying to understanding why something so unusual is happening with the BOE interest rate. You have explained why there is a need to hold the rate low at the moment, seeing there isn't enough inflation yet (as posted in UK Interest Rates – putting off the inevitable). But could you explain to me in layman's terms how this has affected our economy and what other solutions could have been used?

Interest rates are a hot topic at the moment with changes afoot at the Bank of England.  Sometime over the next six to twelve months, the UK central bank is likely to raise its benchmark interest rate off its record low of 0.5% where it has been for more than 5 years.  Low interest rates are the most common way that central banks will try to raise economic growth.  The theory behind this is that cheaper loans will push businesses and households into borrowing money and this extra spending will boost the economy. 

Good in theory but not in practice

In practice, things have not worked out so well.  Businesses have held off taking out loans due to uncertainty over the future direction of the economy.  Companies need to be assured of a decent return from any investment which will typically only make money over the span of several years.  Worries about the future earning potential of any new operations have outweighed the lower costs of borrowing money to invest.   As a result, business lending in the UK has fallen for seven consecutive years with companies preferring to hoard cash instead. 

The main benefactor of low interest rates has been the property market.  House prices in London held up despite the global financial crisis and added to the myth that property values never fall.  So once the worst of the crisis was over, low mortgage rates prompted many to scramble to buy property.  The buoyant housing market has boosted the economy a bit by making people who own property feel richer and spend more.  But more mortgages only pushes up house prices rather than making the economy more productive as investment by businesses would have done.

So the actual effect from low interest rates has been less than hoped.  This resulted in central banks also using quantitative easing – creating new money to buy bonds and other financial assets.  The aim of quantitative easing is increase the amount of money in the economy and help out the banking sector.   Quantitative easing too has been somewhat of a disappointment with few places for the extra cash to be put to good use.  The banking sector typically acts as one of the main means to move cash around the economy but banks have had to focus on their own survival.  The surplus of cash has created its own problems such as distortions in the financial markets which may cause trouble in the future.

Other solutions…?

With businesses not spending and mortgages not adding much to the economy, the obvious solution would be for government to make up the shortfall.  A fiscal stimulus is the typical response to a slowdown in the economy with the extra spending by government making up for weak demand from consumers and businesses.  Yet, government finances in the UK and elsewhere were already stretched before the crisis and deteriorated further with higher welfare payments and falling tax revenues following the crisis.

The Eurozone crisis from 2010 resulted in investors shunning any countries with high levels of government debt.  This prompted the UK government to launch its austerity program with the hope convincing investors that it would sort out its finances.  The plan worked in that the interest rates on UK government debt remained low (also with help from quantitative easing) unlike some countries in Europe such as Ireland and Spain.  However, cuts to government spending hurt the economy and prolong the slump in the economy while also ironically making even more cutbacks necessary.

Still struggling

Getting ourselves out of trouble following the global financial crisis was always going to be tough going.  Recessions stemming from banking crises are typically longer than normal recessions as it takes time to work down the excessive levels of debt and fix the banks.  Less expected was how the economic recovery has been further hampered by ineffective and lacklustre policies. 

Fiscal policy has been working in reverse and the UK government should do more to boost the economy considering that investors are no longer so worried about government debt.  The Bank of England could have done more with monetary policy considering that it can print as much money as it likes but it held back due to misplaced concerns about inflation.  Your Neighbourhood Economist would have liked to have seen more spending by the government and quantitative easing going straight into the economy.

Perhaps the biggest factor holding back the recovery is that economists are slow learners.  Policies such as quantitative easing are new and have helped but more could have been done if economists had not been so caught up with their own ideas.  It is of some consolidation that lessons from the Great Depression (such as the bank bailouts) have been applied to ensure that a similar type of crises has resulted in less fallout.  We can only hope that this crisis is bad enough to ensure better policy in the future.  

(Please add any further questions on this topic using the comments section at the bottom of the page or email any inquiries on different issues related to the economy to Your.Neighbourhood.Economist@gmail.com)

Time to rethink the role of Government

While their reputation has suffered at the hands of economists, it is time for governments to show that they have wised up

It must be tough being repeatedly told that you are stupid but that is what governments have had to put up with.  Mainstream economic theory tells us that markets know best and clumsy governments only get in the way.  But the global financial crisis has highlighted that financial markets are not smart enough to be left to their own devises.  This is just one of several areas where it would be wiser to bring back government as a power for good.

The Invisible Hand was always seen the clever one

Economists like to think that markets are the smartest thing around.  Markets refer to not just places where anything from sausages to shares are sold, but also to the economic system where numerous companies compete to offer goods or services.   The clever thing about markets is that prices and output can change to reflect demand from consumers and this helps to determine the best allocation in an economy.  The best bit is that this optimal outcome is not based on decisions made in one controlling body but market information gleaned from the individual decisions of consumers and firms. 

This belief stems all the way back to the father of economics, Adam Smith, who argued over three centuries ago that the private actions of individuals in the market would work for the public benefit.  Governments, on the other hand, are seen as more of a heavy hand in the economy.  Governments get in the way by creating red tape that strangles business and misallocating resources by dishing money out to favourite sectors.  Examples of misspent money abound as do unworthy recipients of taxpayer cash.  

Yet, all economists would also agree that some government actions are needed for markets to function properly.  Basics such as national defence and policing are essential for any business to operate and can only be provided by governments.  Companies also rely on a supply of workers with some degree of education as well as communication and transport infrastructure.  So while some level of government intervention is necessary, the extent to this is something that is defined by politics.   

The trend started by Thatcher and Regan has been for an increasingly shrinking role for government in the economy.  Economic theory was enlisted to make the case for smaller government which came as a backlash against decades of expanding government.  Much of the initial cases for privatizations and deregulation were justified due to numerous areas where government had overextended itself.  Yet, faith in markets and distrust of government has become so embedded in politics that cases where more government might be good are dismissed.  Governments are so timid in their actions that much of policy to do with the economic recovery has been outsourced to central banks (which creates its own problems).

Who looks stupid now?

Government policy does not always work out as hoped.  But bureaucrats are not alone in making mistake – just think of Enron or BP.  Yet, the most obvious example of where government involvement has been missed is the finance sector.  Deregulation over the past few decades let loose forces that even the banks themselves were not smart enough to understand.  Banks messed up in terms of the seemingly common sense notion of putting long-term survival ahead of short-term profits.  

More proactive government policy would have gone a long way to preventing many elements of the crisis and is something that we should apply now with the benefit of hindsight.  But the notion that more government is good can also be applied elsewhere.  Transport infrastructure has been neglected amid the trend for smaller government while other areas such as R&D and training for workers could do with more government input.  Governments which are not willing to take an active role in the economy leave voters feeling frustrated and opens the way for the rise of populist parties.

This is not an argument to re-establish government dominance over the economy.  A bigger government need not involve significantly higher taxes and large welfare payments.  But, there are parts of the economy where action is needed to ensure the public good and only government can respond to this.  While politicians on the right need to be more accepting of the positive effects of government, it is up to left-wing parties to make a better case about the good that government can achieve.  It is time that we were all smarter in the way they think about government.  

Central Bank – Emperor's New Clothes

With the myth of its power having been shattered, central banks need to get nasty to win back respect

Central banks are looking a bit naked as if stripped of their power.  Previously, central bankers such as Alan Greenspan were held in awe and ruled over the hearts and minds of investors.  This position of power stemmed from the perceived ability to soothe the fire-breathing financial markets.  Yet, the global financial crisis and its aftermath have shown this to be but a myth.  Part of the problem was that central banks wanted to be liked and keep investors onside.  With its generosity proving its downfall, the naked emperor may need to stop being so nice.

Pretenders to the throne

This fall from grace has happened swiftly.  The powers of central banks reached their peak just before the crisis hit.  Quick to blow their own trumpet, economists talked of a “Great Moderation” – a prolonged period of steady and stable economic growth coupled with low inflation.   Central banks had also shown themselves willing to step in during moments of strife and prop up the stock market.  This won them a strong following among investors who could be sure that central banks would send in the cavalry if there was trouble. 

The proverbial crown slipped and fell dramatically with the global financial crisis.  Not only were central banks proved to be not suitable guardians of the economy but their capacity to rally at times of trouble was limited.  Low interest rates and quantitative easing offered little respite from the plague eating away at the economy.  The potency of central bank policy has been eroded as its primary source of power, the ability to print money, does not mean much in a world awash with money.

The problem was exacerbated by central banks not having the freedom to act as their almighty reputation might suggest.  Part of this was due to internal restraints such as a chronic (but misplaced) fear of inflation.  Such worries about rising prices keep central banks from unleashing their full firepower when faced with crisis.  In addition to this, politics also often acts to stifle central banks.  Germans’ heightened aversion to inflation has kept the European Central Bank from doing more.  The Federal Reserve has also had to be mindful that its actions did not draw ire from Republicans who are typically hostile to any government intervention. 

Cursed by hubris

It also became obvious with hindsight that central banks may have built their dominance on a dubious myth.  The “Great Moderation” may have just resulted from good luck rather than good management.  It is easy to keep inflation down when cheap goods are flooding in from China while money was cheap as China was sending a considerable portion of its earnings as reserves and sending it back to the US.  Yet, the misplaced belief in the rule of central banks over the economy lead to ignorance of risks that central banks thought they had slayed. 

Central banks were happy to live off this aura while also being generous in its dealing with investors.  Yet, this kindness turned out to have a cruel twist with the support shown by central banks to financial markets sowing the seeds of crisis.  Although lauded at the time, the reign of Alan Greenspan has instead been shown to be like a king trying too hard to please his subjects.  Over this period, the Federal Reserve kept interest rates too low while investors made merry amid a booming stock market.   

Better to be feared than loved

The unruly nature of financial markets coupled with the flood of cash sloshing around in global finance means that a guiding hand is needed more than ever.  Having been knocked from their high towers, central banks have to restore some assembly of order in a world where the pull of its ability to print cash is diminished.  It may be best to follow the words of Machiavelli, a renaissance philosopher who theorised on power struggles in Medieval Italy, in that it is better to be feared than loved. 

In this vein, if it was a need-to-be-loved that got central banks, and the rest of us, into trouble, it might be time to get nasty.  Taking a harsh line against any potential distortions in the economy (using macroprudential policies) would win more respect than being too friendly.  To rule with a firmer fist seems a better fit at a time when the consequences of financial excesses are so pertinent.  This would help to usher in a more peaceful period if combined with greater regulation to keep the banking sector from getting out of hand.  More stability may even get investors to appreciate the value of tough love.  

Global Economy - Half-time Report

It is game on in Brazil but many are hoping for less thrills in the financial markets in the second half of 2014

Just like in a football match, the half-way point (of 2014) is a good time to assess progress so far and look ahead to the second half.  The first six months have been relatively boring but in a good way, after participants and spectators of financial markets have been riding by the seat of their pants over the past few years.  The game plan so far has been an emphasis on defence with central banks in Europe and Japan providing more support for their economies while tapering by the Federal Reserve has been at a measured pace.  Investors are betting on a quiet second half to 2014 but this will depend on whether the markets can hold their nerve when confronted by the prospect of tighter monetary policy.

Tension is building

The start of 2014 could be considered a success on a number of fronts.  There are reasons for optimism in terms of the economic recovery such as swiftly falling unemployment in many countries.  Share markets are buoyant suggesting that investors are willing to take on risk.  Interest rates on government debt have dramatically fallen for most countries in Europe whose debt has previously been shunned by investors.  The focus of policy makers is no longer on dealing with the potential for crisis but instead on bolstering the economy recovery.

The only problem with this is that much of the progress has been built on loose monetary policy which is due to come to an end.  Investors will have to manoeuvre around the winding up of quantitative easing and higher interest rates.  This will be like a football team losing one player in defence – not the end of the world but it opens up the potential for calamity.  One consequence is that it is unclear how the second half of 2014 will play out.

May 2013 proves us with one example of what is likely to happen sometime soon .  In this month last year, financial markets went into spasms as the Federal Reserve signalled that it would cut back on its monthly bond purchases that constituted its quantitative easing program.  A repeat of what has since been labelled “taper tantrum” seems likely but with higher interest rates as the trigger (maybe prompting headlines of “rates rampage”).  Another popular phrase has been “fragile five” after countries who suffered at the hands of financial market who can turn nervy at any time.

When will things kick off?

The game plan from policy makers adopted so far this year is likely to stay in place considering the relative calm in the financial markets.  The aim will be to not let in any goals (especially any own goals) rather than pushing to score gains in economic growth.  As a result, it is tough to see any big changes in the economy itself.  Dramatic improvements in the economy are not likely with governments continuing to mend their finances.  Loose monetary policy may also not be as useful as hoped in boosting spending by consumers or investment by firms even as the economy shows sign of getting a second wind. 

Whether the benign economic conditions continue into the next six months depends on the fickle nature of investors.  Like an erratic football striker who often gets stroppy, investors need to get their way in order to be kept happy.  Central banks will likely take a cautious approach so investors don’t retreat to the side-lines.  This is likely to result in the first hike in interest rates by the Bank of England, which is ahead of its peers in this regard, being pushed back to at least next year.  Further reasons for delay include other policy options being available to the UK central bank and a likely negative effect on the pound from any rise in interest rates.  Others such as the European Central Bank and the Bank of Japan likely have even more to offer in terms of loose monetary policy to play ball with investors.

The football world cup in Brazil has been notable for its outstanding goals and nail-biting action.  In contrast, many will be hoping that the financial markets in the second half of 2014 will be as exciting as a nil-all draw. But just like a game going into extra time and penalty, some excitement is inevitable as monetary policy tightens and it is something that the financial markets will have to cope with this year or next.

Interest Rate Hike – Easy on the Brakes

The Bank of England threatens to be too heavy on the brakes with higher interest rates and the economic recovery may stall as a result

Tinkering with complex machinery is tricky as changing one thing may have unintended consequences elsewhere.  This also applies to the economy.  The prospect of having to raise interest rates at a time when the economic recovery is still fragile is daunting enough.  Yet, there is a number of moving parts of an economy linked with interest rates which could throw an extra spanner in the works – one concern is that higher interest rates will push up the currency and hurt exporting firms.  This may push central banks to use other monetary policy tools to bide their time.

Complicated piece of machinery

What we refer to as the economy is the accumulation of an incredibly intricate multitude of monetary transactions in which we all are a small part.  In comparison, monetary policy is rather basic relying mainly on the lever of interest rates with extra bells and whistles, such as quantitative easing, added only when needed.  Monetary policy has been exceptionally loose but has still struggled to get the economy moving again.  These expansive polices cannot stay in place for ever and there are growing calls for interest rates to be raised off record lows. 

Interest rates normally affect the economy through the costs involved with taking out a loan.  But this is not the only route of influence.  One example is how higher interest rates will attract in money due to a higher pay-out for savings and this extra cash coming into the economy will push up the value of the currency.  A strengthening currency will adversely affect firms exporting to other countries as prices for their goods typically must rise and this risks putting them at a disadvantage relative to competitors. 

The potential for this is larger when one country moves to tighten its monetary ahead of its peers.  Such is the predicament facing the UK as the Bank of England contemplates the possibility of raising interest rates sometime in the next six to twelve months.  The mere expectation of this has propelled the pound higher relative to other currencies and may put further upward pressure on the pound if interest rates are predicted to rise faster than elsewhere. 

This problem comes about due to the freedom of money to chase around the globe after the best return.  Financial firms have made of most of moving cash around using strategies such as the carry trade – borrowing in a currency with a low interest rate and changing the money into a currency where the interest rates is higher.  This is just one way of how excess liquidity in global markets can work to distort exchange rates relative to the actual physical economy.

Warning lights flashing

Normally higher interest rates are used to slow an overheating economy and a stronger currency would help with this.  Yet, the upcoming hikes to interest rates have the goal of returning monetary policy to normality – a state where interest rates and the rate of growth in the economy are roughly equal.  An accompanying rise in exchange rates therefore acts as a further obstacle to economic recovery which is not intended or desirable. 

The weak recovery means that the UK economy is not quite ready for the double whammy of higher interest rates and a stronger pound.  The effects of both may be benign considering the lower rates of borrowing among businesses and sluggish demand for exports from markets such as Europe.  But there is still the potential for a rise in interest rates to put the economy in reverse at a time when the economy is gearing up for recovery. 

The main issue behind calls for tighter monetary policy is a buoyant housing market.  Yet, the Bank of England has a new range of tools to deal with this such as caps on mortgage lending.  So there is room to wait for other countries, most significantly the US, to catch up in terms of interest rates.  With the threat of waiting too long to act mitigated by housing market measures, it is the downside of braking too soon that the Bank of England should watch out for.

Monetary Policy – Surgery Needed

Current monetary policy is still primitive and will remain so without making use of new measures such as macroprudential policies

Monetary policy has come a long way but it is still in its initial stages of development.  Serious shortcomings mean that the tools of monetary policy are still rudimentary just as those of medicine were crude in the past.  In the same way that leeches would be prescribed for every ailment in medieval times, central banks have tended to rely solely on interest rates to manage the economy.  The tendency to “reach for the leeches” is still with us even though the global financial crisis has highlighted the flaws inherent in this approach and a range of new techniques for managing the economy have been made available.

Learning some hard lessons

Doctors often did more harm than good in antiquity due to a lack of understanding of the workings of the human body.  With our knowledge of the economy also deficient in places, economists may be guilty of causing similar damage.  Hubris led economists to believe that booms and busts could be eliminated but their faith was shown to be spectacularly misplaced.  Despite this, economists have been slow to adjust their view of the world even though their remedies are proving both ineffective and costly.

The global financial crisis and its aftermath have taught us a few valuable lessons.  The limitations of using interest rates to moderate the business cycle (both before and after recessions) are now apparent.  Higher interest rates do little to temper lending when both bankers and borrowers want more debt.  It is also becoming clear that different sectors of the economy react to interest rates in different ways.  Consumers have shown themselves willing to take on excessive debt in order to spend or to buy property.  On the other hand, businesses cannot always be enticed to borrow for investment when the economy is weak. 

The limits of monetary policy have been laid bare by the faltering economic recovery.  Low interest rates and cheap cash have spurred on some lending but not the right type to generate sustainable economic growth.  Households have taken on debt to buy property (which mostly just increases prices) rather than businesses or the government borrowing to make the economy more productive.  Surplus funds have also built up prices in the stock market which, while somewhat beneficial in the short term, will create problems down the line.  The abundance of cash in the financial system may also reduce the effectiveness of central banks’ control over interest rates. 

For a better world

Monetary policy needs to continue to develop as economists learn more about the economy and how it reacts to different policies.  Manipulating interest rates is a blunt instrument that is applied across the whole economy.  Interest rates need to be raised eventually but it seems rash to do so in response to distortions in certain sectors.  An early interest rate hike has been proposed as a countermeasure to the booming UK property market.  Yet, this is like chopping off an arm to treat an infected finger.

A more measured approach would be preferable but will take time to realise.  Techniques such as minimally invasive surgery have been developed in medicine over many years and economists should aim for similar progress in monetary policy.  Disparities between policies in theory and practice mean that trial and error will be necessary.  Using a still sickly economy to trial new policy options may seem reckless.  Yet experimentation is the main route to breaking fresh ground even in medicine where there are actual lives at risk.  Forward guidance is an example of a policy which seemed useful in theory but whose application was fraught with issues.

A wider range of policies would help deal with problems now and in the future with greater effectiveness.  These two goals can be achieved by the Bank of England trialling the much-discussed macroprudential policies such as caps on mortgages and other limits on property lending.  Having a greater range of options allows for better tailoring of policy while targeted measures enable greater freedom in setting interest rates to reflect the overall economy.  Just as modern medicine has had to advance beyond leeches, future monetary policy will need to progress past what we currently have and such an evolution will only happen as a result of taking bold actions today.