There is no bond market bubble

Bubbles, bubbles, everywhere bubbles. There is a lot of talk of bubbles among commentators and central bankers. One of the most common bubble fears is a fear of a bubble in the US bond market (just take a look at this recent “bond bubble”-story). Generally I am very skeptical about all kinds of bubble fears and that also goes for the fear of a bubble in the US bond market.

The general bond bubble story more or less assumes that quantitative easing from the Federal Reserve and other central banks has pushed down bond yields to artificially low levels and once QE is over the bond bubble will burst, bond yield will spike dramatically and send the US economy back into a major recession.

Should we fear this? Not really in my and I will try to show that in this blog post.

Inspired by Krugman and Mankiw

I very often disagree with Paul Krugman, but no one can dispute that he is a great communicator. Krugman is able to present complicated economic stories in a few sentences. This is exactly what he did in one of my favourite Krugman-blog posts back in 2010. The topic of the post was exactly the “bond bubble”. This is Krugman:

Here’s a thought for all those insisting that there’s a bond bubble: how unreasonable are current long-term interest rates given current macroeconomic forecasts? I mean, at this point almost everyone expects unemployment to stay high for years to come, and there’s every reason to expect low or even negative inflation for a long time too. Shouldn’t that imply that the Fed will keep short-term rates near zero for a long time? And shouldn’t that, in turn, mean that a low long-term rate is justified too?

So I decided to do a little exercise: what 10-year interest rate would make sense given the CBO projection of unemployment and inflation over the next decade?

… I decided to use the simplified Mankiw rule, which puts the same coefficient on core CPI inflation and unemployment. That is, it says that the Fed funds rate is a linear function of core CPI inflation minus the unemployment rate.

Krugman is basically using the Mankiw rule to forecast the Fed funds rate 10 years ahead and then he compared this forecast with the 10-year US government bond yield. It turned out that the 10-year yield was pretty well in line with the forecasted path for Fed Funds rates. I will now show that that is still the case.

Using the Mankiw rule to predict US monetary policy 10-years ahead

I have recently been playing a bit with the Mankiw rule (see here and here) so it is only natural to re-do Krugman’s small “experiment”.

Krugman is using CBO’s projections for core PCE inflation and unemployment. I will do the same (see the latest CBO forecast here) thing, but I will also use the FOMC’s recent projections (see here) for the same variables. I plug these projections into the Mankiw rule that I recently estimated. This gives us two forecasts for the Fed funds future rate for the coming 10-years. The graph below shows the two “forecasts”.

Mankiw rule FOMC CBO

Both forecasts (or maybe we should say simulations) point to interest rate hikes from the Fed in coming years. The forecast based on FOMC projections for unemployment and core inflation is a bit more “aggressive” in the rate hiking cycle than Mankiw rule based on the CBO forecasts for the same variables.

The reason for this is primarily that the FOMC members expect unemployment to drop faster than forecasted by the CBO. Both the FOMC and CBO expects inflation to gradually increase to 2% over the coming 4 years.

The rule based on FOMC projections indicates that the Fed funds target rate should be close to 3% in the “long run” (after 2018), while the CBO based rule is indicating a Fed funds rate around 2.6% i the long run. This difference is due to the FOMC expects unemployment at 5.0% in the long run, while the CBO expects unemployment at 5.5% in the long run.

I should stress that this is not my forecasts for the Fed funds rate as such, but rather an illustration of how we should expect the Fed’s policy rate to development over the coming 10 years if the Mankiw rule in general holds and we use the FOMC and CBO’s macroeconomic forecasts as input in this rule.

Drawing a (simplified) yield curve

We can now use these “predictions” to construct a (quasi) yield curve. Not to make things overly complicated (and spending to much time calculating the stuff…) I have simply constructed the “yield curve” by saying that “forecast” for for example the 2-year yield is simply the average of the predicted of the Fed funds rate in 2014 and 2015. Similarly the 5-yield is the average of the forecasted policy rate for 2014-2019. Hence, I disregard compounded interest and coupon payments.

The graph below shows the actual US yield curve compared with the two quasi-yield curve based on the two Mankiw rule based predictions for the Fed funds rate in the coming 10 years.

yield curve Fed Mankiw

Looking at the graph we imitatively spot two things:

First of all we see that the FOMC curve and CBO curve are considerably “higher” than the actual yield curve for the next couple of years. This should not be a surprise given the fact that we already know that forecasts based on the Mankiw rule is too “hawkish” compared to the actual Fed policy in 2014. Hence, the “predicted” rate for 2014 is 75-100bp too high. The reason for this is among other things that the simple Mankiw rule does not take into account “discouraged worker”-effects on the labour market, which seems to have been a a major problem in the past 5-6 years. Furthermore, the rule ignores that the Fed over the past 5-6 years more or less consistently has undershot it’s 2% inflation target. I have discussed these factors in my previous post.

These factors mean that we should probably pushed down the “rate path” in the next couple of years and that means that the yield curve does not look to be too “low” for 2-year or 5-years (very broadly speaking).

Second, we see that if we look at the 10-year yield we see that it is more or less exactly where the FOMC curve “predict” it to be (around 2.6%). We can of course not directly compare the two as I have not taken compounded interest and coupon payments into account (which would push the FOMC curve up), but on the other than we should also remember that the Mankiw rule is too “hawkish” for the “early period” (which should push the FOMC curve down along the curve).

There is no “bond bubble”

I believe that the discussion above shows that US bond yields pretty well reflect realistic expectations to Federal Reserve policy over the coming decade given the FOMC’s and the CBO’s expectations for US unemployment and core inflation and it is therefore hard in my view to justify the claim that there is a bubble in the US bond market. That of course does not mean that yields cannot go up. They very likely will if FOMC’s and CBO’s expectations particularly for the US labour market are correct.

And the bond market might of course also be 50bp wrong is one or the other direction, but I find it very hard to see why US bond yields should suddenly spike 200 or 300bp as some of doomsayers are claiming.

And finally I should stress that this is not investment advice and I am not making any recommendations to sell or buy US Treasury bonds and the market might go in whatever direction.

Instead my point here is to argue that policy makers – the Fed – should not be overly concerned that quantitative easing has caused a bond bubble. It has not. If anything bond yields are this low because the Fed has not eased monetary policy enough rather than too much.

Related posts:

There is no bubble in the US stock market

The stock market has reached “a permanently high plateau” (if the Fed does not mess up again…)

If there is a ‘bond bubble’ – it is a result of excessive monetary TIGHTENING

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The Mankiw-Darda rule tells the Fed to wait a bit with hikes

Greg Mankiw has a blog post commenting on my previous post on the so-called Mankiw rule.

I show in my post that according to both the original and a re-estimated version of the Mankiw rule the Federal Reserve should be hiking rates right now. I should stress again that I don’t think the Fed should hike interest rates – I am only using the Mankiw rule to illustrate why we likely are moving closer to a rate hike from the Fed (that is the is a difference between thinking about what the Fed will do rather than what it should do).

Greg makes some good points why the Fed should not hike rates yet:

Taken at face value, the rule suggests that it is time for the Fed to start raising the federal funds rate.  If you believe this rule was reasonably good during the period of the Great Moderation, does this mean the Fed should start tightening now, as the economy gets back to normal?

Maybe, but not necessarily. There are two problems with interpreting such rules today.

The first and most obvious problem is that odd things have been happening in the labor market for the past several years. The unemployment rate (one of the right hand side variables in this rule) may not be a reliable indicator of slack.

The second and more subtle problem is the nagging issue of the zero lower bound.  For several years, the rule suggested a target federal funds rate deeply in the negative territory.  We are out of that range now, but should the past “errors” influence our target today?  An argument can be made that because the Fed kept the target rate “too high” for so long (that is, at zero rather than negative), it should commit itself now to keeping the target “too low” as compensation (that is, at zero for longer than the rule recommends).  By systematically doing so, the Fed encourages long rates to fall by more whenever the economy hits the zero lower bound. Such a policy might lead to greater stability than strict adherence to the rule as soon as we leave negative territory.

I agree with both points. It seems particularly problematic for the original Mankiw rule that there seems to be a major problem on the US labour market with a discouraged worker effect – as a result the actual unemployment data tend to underestimate just how bad the situation has been (and still is?) on the US labour market. Many have simply given up looking for a job and left the labour market.

My good friend Michael Darda (MKM Partners) has suggested to deal with the discourage worker effect and other demographic problems by use the prime age employment ratio rather than the unemployment rate when estimating the Mankiw rule. Michael also uses core CPI rather than the core PCE deflator as a measure of inflation. The graph below shows the Mankiw-Darda rule (Michael’s estimate):

Mankiw Darda rule


We see that while the Mankiw-Darda rule has become increasingly “hawkish” since early 2011 it is still not “recommending” a rate hike – the predicted Fed fund rate is still negative (around -1.5%). Hence, it seems like the Mankiw-Darda rule is better at actually describing what the Fed is doing than the original Mankiw rule. This is not totally surprising.

Inflation targeting or price level targeting?

In an update to his post Greg makes some highly relevant comments, which will appeal to any Market Monetarist including myself:

There is another (related) argument for not raising rates now to offset shortfalls in the past. It is not about the interest rate. It is about the price level, the ultimate goal of monetary policy and measure of its performance.

If you plot the PCE deflator, there is a clear shortfall relative to a 2% price-level target. A 2% price level target fits very well during Greenspan’s time.  By the end of 2008, we were exactly on the 1992-target. But when I look at that plot starting in 2009 until the most recent data I see a gap.

A price-level target rule is optimal in normal times (Ball, Mankiw, and Reis) but is also an optimal policy in response to the dangers of the zero lower bound (Woodford). We have to catch up for the shortfall in the price level right now. And if you look at inflation expectations from surveys or markets, there seems to be no catch up expected, indicating that policy is still too tight.

Obviously I would prefer a nominal GDP level target to a price level target, but I think a price level target as here suggested by Greg is much preferable to an inflation target.

As I noted in my own previous post “inflation has drifted lower” since 2008. This is exactly the point Greg makes (based on comments from Ricardo Reis). Since 2008 the Fed has failed to keep the PCE price level on a 2% path trend. The graph below illustrates this:

Price gap US


The graph shows that it looks as if the Fed prior to 2008 had a 2% price level target and the actual price level closely followed a 2% trend line. However, since then inflation has consistently been below 2% and as a result the “price gap” has become increasingly negative.

This is paradoxical as the Fed now officially has 2% inflation target, while it prior to 2008 did not have such a target.

This is obviously another argument for why the original Mankiw rule at the moment is too “hawkish”. On the other hand one can certainly also discuss whether the Fed should close the “price gap” or not. Here I have the relatively pragmatic view that the Fed should let bygones-be-bygones as we over the past five years have seen some supply side adjustments. Furthermore, the decline in the price gap does not only reflect demand-side factors but likely also reflects a positive supply shock. In that regard it should be noted that longer-term inflation expectations in the US still remain above 2% (5-year/5-year US breakeven inflation this morning is 2.4%).

Therefore, if I was on the FOMC I would not favour a one-off money injection to close the price gap, but on the other hand the Mankiw-Darda rule and the consideration about the price gap also shows that the FOMC should not be in a hurry to tighten monetary conditions either. The Fed’s gradual and fairly well-communicated policy to continue “tapering” and then sometime next year gradually start increasing the fed funds rate therefore is consistent with a policy of ensuring nominal stability and it is also reducing the risk of a 1937-style premature tightening of monetary conditions, which would send the US economy back in recession. Said in another way I find it hard to be very critical about how the Fed at the moment is balancing risks both to the upside and to the downside.

A NGDP level target rule solve our problems

The discussion about the Mankiw rule illustrates two problems in common monetary policy thinking. First there remains a major focus on the US labour market. The problem of course is that we really don’t know the level of structural unemployment and this is particularly the case right now after we in 2008 got out of whack. Second, while inflation clearly has remained below 2% since 2008 we don’t know whether this is due to supply side factors or demand side factors.

There is of course a way around these problems – nominal GDP level targeting – and as I have argued in a recent post it in fact looks as if the Fed has followed a 4% NGDP level target rule since July 2009.

That would not have been my preferred policy in 2009, 2010 or 2011 as I would have argued that the Fed should have done a lot more to bring the NGDP level back to the pre-crisis trend-level. However, as time has gone by and we have had numerous supply shocks and some supply adjustments have gone on for nearly six years I have come to the conclusion that it is time to let bygones be bygones. We can do little to change the mistakes of six years ago today. But what we – or rather what the Fed can do – is to announce a policy for the future, which significantly reduces the likelihood of repeating the mistakes of 2008-9.

Therefore, the Fed should obviously announce a NGDP level target policy. Whether the Fed would target a 4% or a 5% path for the NGDP level is less important to me. It would be the right policy, but it would also be a pragmatic way around dealing with uncertainties regarding the state of the US labour markets and to avoid having supply side shock distorting monetary policy decisions.

PS My friend Marcus Nunes also comments on the Mankiw rule. Marcus seems to think that I am advocating that the Fed should tighten monetary policy. I am not doing that. All I have been saying it that the original Mankiw rule indicates that the Fed should tighten monetary conditions and that this is an indication of the direction we are moving in.

PPS My “playing around” with the Mankiw rule should be seen in the perspective that I am currently thinking quite a bit – in my day-job – about when the Fed will actually hike relative to what the markets are thinking the Fed will do. If the Fed moves earlier than expected by markets then it obviously is going to have clear implications for the global financial markets.

Mankiw rule tells the Fed to tighten

The most famous monetary policy rule undoubtedly is the so-called Taylor rule, which basically tells monetary policy makers to set the key monetary policy interest rates as a function of on the one hand the inflation rate relative to the inflation target and on the other hand the output gap.

The Taylor rule is rather simple and seems to at least historically have been a pretty good indicator of the actual policy followed by particularly the Federal Reserve. Often the Taylor rule is taken to be the “optimal” monetary policy rule. That of course is not necessarily the case. Rather one should see the Taylor rule as a empirical representation of actual historical Fed policy.

A similar rule which has gotten much less attention than the Taylor rule, but which essentially is the same thing is the so-called Mankiw rule. Greg Mankiw originally spelled out his rule in a paper on US monetary policy in the 1990s.

The beauty of the Mankiw rule is that it is extremely simple as it simply says that the Fed is setting the fed funds rate as function of the difference between core inflation (PCE) and the US unemployment rate (this of course is also the Fed’s “dual mandate”). Here is the original rule from Mankiw’s paper:

Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment)

The graph below shows the original Mankiw rule versus actual Fed policy.

Mankiw rule

I have also added a Mankiw rule estimated on the period 2000-2007: Federal funds rate = 9.9 + 2.1 (Core inflation – Unemployment)

We see the Mankiw rule more or less precisely captures the actual movements up and down in the Fed funds rate from 2000 to 2008. Then in 2008 we of course hit the Zero Lower Bound. From the Autumn of 2008 the Mankiw rule told us that interest rates should have been cut to somewhere between -4% (the original rule) and -8% (the re-estimated rule). This is of course is what essentially have justified quantitative easing.

Mankiw rule is telling the Fed to hike rates 

Since early 2011 the Mankiw rule – both versions – has been saying that interest rates should become gradually less negative (mostly because the US unemployment rate has been declining) and maybe most interestingly both the original and the re-estimated Mankiw rule is now saying that the Fed should hike interest rates. In fact the re-estimated rule has just within the past couple of months has turned positive for the first time since 2008 and this is really why I am writing the this post.

Maybe we can use the Mankiw rule to understand why the Fed now seems to be moving in a more hawkish direction – we will know more about that later this week at the much anticipated FOMC meeting.

BUT the Mankiw rule is not an optimal rule

I have to admit I like the Mankiw rule for its extreme simplicity and because it is useful in understanding historical Fed policy actions. However, I do certainly not think of the Mankiw rule as an optimal monetary policy rule. Rather my regular readers will of course know that I would prefer that the Fed was targeting the nominal GDP level (something by the way Greg Mankiw also used to advocate) and I would like the Fed to use the money base rather than the Fed funds rate as its primary monetary policy instrument, but that is another story. The purpose here is simply to use the Mankiw rule to understand why the Fed – rightly or wrongly – might move in a move hawkish direction soon.

PS One could argue that the Mankiw rule needs to be adjusted for changes in the natural rate of unemployment, for discourage worker effects and for the apparent “drift” downward in the US core inflation rate since 2008. Those are all valid arguments, but again the purpose here is not to say what is “optimal” – just to use the simple Mankiw rule to maybe understand why the Fed is moving closer to rate hikes.

PPS One could also think of the Mankiw rule a simplistic description of the Evans rule, which the Fed basically announced in September 2012.

Certainly not perfect, but Fed policy is not worse than during the Great Moderation (an answer to Scott Sumner)

Scott Sumner has replied to my previous post in which I argued that the Federal Reserve de facto has implemented a 4% NGDP level targeting regime (without directly articulating it).

Scott is less positive about actual Fed policy than I am. This is Scott answering my postulate that he would have been happy about a 4% NGDP growth path had it been announced in 2009:

Actually I would have been very upset, as indeed I was as soon as I saw what they were doing.  I favored a policy of level targeting, which meant returning to the previous trend line.

Now of course if they had adopted a permanent policy of 4% NGDP targeting, I would have had the satisfaction of knowing that while the policy was inappropriate at the moment, in the long run it would be optimal.  Alas, they did not do that.  The recent 4% growth in NGDP is not the result of a credible policy regime, and hence won’t be maintained when there is a shock to the economy.

I most admit that I am a bit puzzled by Scott’s comments. Surely one could be upset in 2009 – as both Scott and I were – that the Fed did not do anything to bring back the nominal GDP level back to the pre-crisis trend and it would likely also at that time have been a better policy to return to a 5% trend rather than a 4% trend. However, I would also note that that discussion is mostly irrelevant for present day US monetary policy and here I would note two factors, which I find important:

  1. We have had five years of supply side adjustments – five years of “internal devaluation”/”wage moderation” so to speak. It is correct that the Fed didn’t boost aggregate demand sufficiently to push down US unemployment to pre-crisis levels, but instead it has at least kept nominal spending growth very stable (despite numerous shocks – see below), which has allowed for the adjustment to take place on the supply side of the economy and US unemployment is now nearly back at pre-crisis levels (yes employment is much lower, but we don’t know to what extent that is permanent/structural or not).
  2. Furthermore, we have had numerous changes to supply side policies in the US – mostly negative such as Obamacare and an increase in US minimum wages, but also some positive such as the general general reduction in defense spending and steps towards ending the “War on Drugs”.

Given these supply side factors – both the adjustments and the policy changes – it would make very little sense in my view to try to bring the NGDP level back to the pre-2008 trend-level and I don’t think Scott is advocating this even though his comments could leave that impression. Furthermore, given that expectations seem to have fully adjusted to a 4% NGDP level-path there would be little to gain from targeting a higher NGDP growth rate (for example 5%).

The Fed is more credible today than during the Great Moderation

Furthermore, I would dispute Scott’s claim that the Fed’s policy is not credible. Or rather while the monetary policy regime is not well-articulated by the Fed it is nonetheless pretty well-understood by the markets and basically also by the Fed itself (even though that from time to time could be questioned).

Hence, both the markets and the Fed fully understand today that there effectively is no liquidity trap. There might be a Zero Lower Bound on interest rates but if needed the Fed can ease monetary policy through quantitative easing. This is clearly well-understood by the Fed system today and the markets fully well knows that if a new shock to for example money-velocity where to hit the US economy then the Fed would most likely once again step up QE. This is contrary to the situation prior to 2008 where the Fed certainly had not articulated a policy of how to conduct monetary policy at the Zero Lower Bound and this of course was a key reason why the monetary policy stance became so insanely tight in 2008.

This does in no way mean that monetary policy in the US is perfect. It is certainly not – just that it is no less credible than monetary policy was during the Greenspan years and that the Fed today is better prepared to conduct monetary policy at the ZLB than prior to 2008.

NGDP has been more stable since 2009/2010 than during the Great Moderation

If we look at the development in nominal GDP it has actually been considerably more stable – and therefore also more predictable – than during the Great Moderation. The graph below illustrates that.

NGDP gap New Moderation

It is particularly notable in the graph that the NGDP gap – the percentage difference between the actual NGDP level and the NGDP trend – has been considerably smaller in the period from July 2009 and until today than during the Great Moderation (here said to be from 1995 until 2007). In fact the average absolute NGDP gap (the green dotted lines) was nearly three times as large during the Great Moderation than it has been since July 2009. Similarly inflation expectations has been more stable since July 2009 than during the Great Moderation and there unlike in the euro zone there are no signs that inflation expectations have become unanchored.

It is easy to be critical about the Fed’s conduct of monetary policy in recent years, but I find it very hard to argue that monetary policy has been worse than during the Great Moderation. 2008-9 was the catastrophic period, but since 2009/10 the Fed has re-established a considerable level of nominal stability and the Fed should be given some credit for that.

In this regard it is also notable that financial market volatility in the US today is at a historical low point – lower than during most of the Great Moderation period. This I believe to a large extent reflects a considerable level of “nominal predictability”.

No less sensitive to shocks than during the Great Moderation

Scott argues “(t)he recent 4% growth in NGDP is not the result of a credible policy regime, and hence won’t be maintained when there is a shock to the economy.” 

It is obviously correct that the Fed has failed to spell out that it is actually targeting a 4% NGDP level path and I agree with Scott that this is a major problem and that means that the US economy is much more sensitive to shocks than otherwise would be the case. However, I would also stress that first of all during the Great Moderation the Fed had an even less clear target officially than is the case today.

Second, we should not forget that we have actually seen considerable shocks to the global and to the US economy since 2009/10. Just think of the massive euro crisis, Greece’s de facto default, the Cyprus crisis, the “fiscal cliff” in the US, a spike in oil prices 2010-12 and lately a sharp rise in global geopolitical tensions. Despite of all these shocks US NGDP has stayed close to the 4% NGDP path started in July 2009.

This to me is a confirmation that the Fed has been able to re-establish a considerable level of nominal stability. It has not been according to Market Monetarist game plan, but it is hard to be critical about the outcome.

In regard to the so-called “fiscal cliff” – the considerable tightening of fiscal policy in 2013 – it is notable that Scott has forcefully and correctly in my view argued that it had no negative impact on total aggregate nominal demand exactly because of monetary policy – or rather the monetary policy regime – offset the fiscal shock.

This is of course the so-called Sumner critique. For the Sumner critique to hold it is necessary that the monetary policy regime is well-understood by the markets and that the regime is credible. Hence, when Scott argues that 2013 confirmed the Sumner critique then he is indirectly saying that the monetary policy regime was credible in 2013. Had the monetary policy regime not been credible then the fiscal tightening likely would have led to a sharp slowdown in US growth.

It is time to let bygones be bygones

Nearly exactly a year ago I argued in a post that it is time to let bygones be bygones in US monetary policy:

Obviously even though the US economy seems to be out of the expectational trap there is no guarantee that we could not slip back into troubled waters once again, (but)…

… it is pretty clear to most market participants that the Fed would likely step up quantitative easing if a shock would hit US aggregate demand and it is fairly clear that the Fed has become comfortable with using the money base as a policy instrument…

… I must admit that I increasingly think – and most of my Market Monetarist blogging friends will likely disagree – that the need for a Rooseveltian style monetary positive shock to the US economy is fairly small as expectations now generally have adjusted to long-term NGDP growth rates around 4-5%. So while additional monetary stimulus very likely would “work” and might even be warranted I have much bigger concerns than the lack of additional monetary “stimulus”.

Hence, the focus of the Fed should not be to lift NGDP by X% more or less in a one-off positive shock. Instead the Fed should be completely focused on defining its monetary policy rule. A proper rule would be to target of 4-5% NGDP growth – level targeting from the present level of NGDP. In that sense I now favour to let bygones to be bygones as expectations now seems to have more or less fully adjusted and five years have after all gone since the 2008 shock.

Therefore, it is not really meaningful to talk about bringing the NGDP level back to a rather arbitrary level (for example the pre-crisis trend level). That might have made sense a year ago when we clearly was caught in an expectations deflationary style trap, but that is not the case today. For Market Monetarists it was never about “monetary stimulus”, but rather about ensuring a rule based monetary policy.  Market Monetarists are not “doves” (or “hawks”). These terms are only fitting for people who like discretionary monetary policies.

This remains my view. Learn from the mistakes of the past, but lets get on with life and lets instead focus fully on get the Fed’s target well-defined.

PS I hate being this positive about the Federal Reserve. In fact I am really not that positive. I just argue that the Fed is no worse today than during the Great Moderation.

The Fed’s un-announced 4% NGDP target was introduced already in July 2009

Scott Sumner started his now famous blog TheMoneyIllusion in February 2009 it was among other things “to show that we have fundamentally misdiagnosed the nature of the recession, attributing to the banking crisis what is actually a failure of monetary policy”.

Said in another way the Federal Reserve was to blame for the Great Recession and there was only one way out and that was monetary easing within a regime of nominal GDP level targeting (NGDP targeting).

NGDP targeting is of course today synonymous Scott Sumner. He more or less single-handedly “re-invented” NGDP targeting and created an enormous interest in the topic among academics, bloggers, financial sector economists and even policy makers.

The general perception is that NGDP targeting and Market Monetarism got the real break-through in 2013 when the Federal Reserve introduced the so-called Evans rule in September 2012 (See for example Matt Yglesias’ tribute to Scott from September 2012).

This has also until a few days ago been my take on the story of the success of Scott’s (and other’s) advocacy of NGDP targeting. However, I have now come to realize that the story might be slightly different and that the Fed effectively has been “market monetarist” (in a very broad sense) since July 2009.

The Fed might not have followed the MM game plan, but the outcome has effectively been NGDP targeting

Originally Scott basically argued that the Fed needed to bring the level nominal GDP back to the pre-crisis 5% trend path in NGDP that we had known during the so-called Great Moderation from the mid-1980s and until 2007-8.

We all know that this never happened and as time has gone by the original arguments for returning to the “old” NGDP trend-level seem much less convincing as there has been considerable supply side adjustments in the US economy.

Therefore, as time has gone by it becomes less important what is the “starting point” for doing NGDP targeting. Therefore, if we forgive the Fed for not bringing NGDP back to the pre-crisis trend-level and instead focus on the Fed’s ability to keep NGDP on “a straight line” then what would we say about the Fed’s performance in recent years?

Take a look at graph below – I have used (Nominal) Private Consumption Expenditure (PCE) as a monthly proxy for NGDP.

PCE gap

If we use July 2009 – the month the 2008-9 recession officially ended according to NBER – as our starting point (rather than the pre-crisis trend) then it becomes clear that in past five years PCE (and NGDP) has closely tracked a 4% path. In fact at no month over the past five years have PCE diverged more than 1% from the 4% path. In that sense the degree of nominal stability in the US economy has been remarkable and one could easily argue that we have had higher nominal stability in this period than during the so-called Great Moderation.

In fact I am pretty sure that if somebody had told Scott in July 2009 that from now on the Fed will follow a 4% NGDP target starting at the then level of NGDP then Scott would have applauded it. He might have said that he would have preferred a 5% trend rather than a 4% trend, but overall I think Scott would have been very happy to see a 4% NGDP target as official Fed policy.

The paradox is that Scott has not sounded very happy about the Fed’s performance for most of this period and neither have I and other Market Monetarists. The reason for this is that while the actual outcome has looked like NGDP targeting the Fed’s implementation of monetary policy has certainly not followed the Market Monetarist game plan.

Hence, the Market Monetarist message has all along been that the Fed should clearly announce its target (a NGDP level target), do aggressive quantitative easing to bring NGDP growth “back on track”, stop focusing on interest rates as a policy instrument and target expected NGDP rather than present macroeconomic variables. Actual US monetary policy has gradually moved closer to this ideal on a number of these points – particularly with the so-called Evan rule introduced in September 2012, but we are still very far away from having a Market Monetarist Fed when it comes to policy implementation.

However, in the past five years the implementation of Fed policy has been one of trial-and-error – just think of QE1, QE2 and QE3, two times “Operation Twist” and all kinds of credit policies and a continued obsession with using interest rates rates as the primary policy “instrument”.

I believe we Market Monetarists rightly have been critical about the Fed’s muddling through and lack of commitment to transparent rules. However, I also think that we today have to acknowledge that this process of trail-and-error actually has served an important purpose and that is to have sent a very clear signal to the financial markets (and others for that matter) that the Fed is committed to re-establishing some kind of nominal stability and avoiding a deflationary depression. This of course is contrary to the much less clear commitment of the ECB.

The markets have understood it all along (and much better than the Fed)

Market Monetarists like to say that the markets are better at forecasting and the collective wisdom of the markets is bigger than that of individual market participants or policy makers and something could actually indicate that the markets from an early point understood that the Fed de facto would be keeping NGDP on a straight line.

An example is the US stock market bottomed out a few months before we started to establish the new 4% trend in US NGDP and the US stock markets have essentially been on an upward trend ever since, which is fully justified if you believe the Fed will keep this de facto NGDP target in place. Then we should basically be expecting US stock prices to increase more or less in line with NGDP (disregarding changes to interest rates).

Another and even more powerful example in my view is what the currency markets have been telling us. I  (and other Market Monetarists) have long argued that market expectations play a key role in the in the implementation of monetary policy and in the monetary policy transmission mechanism.

In a situation where the central bank’s NGDP level target is credible rational investors will be able to forecast changes in the monetary policy stance based on the actual level of NGDP relative to the targeted level of NGDP. Hence, if actual NGDP is above the targeted level then it is rational to expect that the central bank will tighten the monetary policy stance to bring NGDP back on track with the target. This obviously has implications for the financial markets.

If the Fed is for example targeting a 4% NGDP path and the actual NGDP level is above this target then investors should rationally expect the dollar to strengthen until NGDP is back at the targeted level.

And guess what this is exactly how the dollar has traded since July 2009. Just take a look at the graph below.

NGDP gap dollar index 2

We are looking at the period where I argue that the Fed effectively has targeted a 4% NGDP path. Again I use PCE as a monthly proxy for NGDP and again the gap is the gap between the actual and the “targeted” NGDP (PCE) level. Look at the extremely close correlation with the dollar – here measured as a broad nominal dollar-index. Note the dollar-index is on an inverse axis.

The graph is very clear. When the NGDP gap has been negative/low (below target) as in the summer of 2010 then the dollar has weakened (as it was the case from from the summer of 2010under spring/summer of 2011. And similarly when the NGDP gap has been positive (NGDP above target) then the dollar has tended to strengthen as we essentially has seen since the second half of 2011 and until today.

I am not arguing that the dollar-level is determining the NGDP gap, but I rather argue that the dollar index has been a pretty good indicator for the future changes in monetary policy stance and therefore in NGDP.

Furthermore, I would argue that the FX markets essentially has figured out that the Fed de facto is targeting a 4% NGDP path and that currency investors have acted accordingly.

It is time for the Fed to fully recognize the 4% NGDP level target

Just because there has a very clear correlation between the dollar and the NGDP gap in the past five years it is not given that that correlation will remain in the future. A key reason for this is – and this is a key weakness in present Fed policy – that the Fed has not fully recognize that it is de facto targeting a 4%. Therefore, there is nothing that stops the Fed from diverging from the NGDP rule in the future.

Recognizing a 4% NGDP level target from the present level of NGDP in my view should be rather uncontroversial as this de facto has been the policy the Fed has been following over the past five years anyway. Furthermore, it could easily be argued as compatible  with the Fed’s (quasi) official 2% inflation target (assuming potential real GDP growth is around 2%).

In my previous post I argued that the ECB should introduce a 4% NGDP target. The Fed already done that. Now it is just up to Fed Chair Janet Yellen to announce it officially. Janet what are you waiting for?

End Europe’s deflationary mess with a 4% nominal GDP (level) target

From the onset of the Great Recession in 2008 the ECB has been more afraid of doing “too much” rather than too little. The ECB has been obsessing about fiscal policy being too easy in the euro zone and about that too easy monetary policy would create bubbles. As a consequence the ECB was overly eager to hike interest rates in 2011 – way ahead of the Federal Reserve started to talk about monetary tightening.

The paradox is that the ECB now is in a situation where nobody can imagine that interest rates should be hiked anytime soon exactly because the ECB’s über tight monetary stance has created a deflationary situation in the euro zone. As a consequence the ECB under the leadership (to the extent the Bundesbank allows it…) of Mario Draghi is trying to come up with all kind of measures to fight the deflationary pressures. Unfortunately the ECB doesn’t seem to understand that what is needed is open-ended quantitative easing with proper targets to change the situation.

Contrary to the situation in Europe the financial markets are increasing pricing in that a rate hike from the Federal Reserve is moving closer and the Fed will be done doing quantitative easing soon. Hence, the paradox is that the Fed is “normalizing” monetary policy much before the ECB is expected to do so – exactly because the Fed has been much less reluctant expanding the money base than the ECB.

The tragic difference between monetary policy in the US and Europe is very visible when we look at the difference in the development in nominal GDP in the euro zone and the US as the graph below shows.


The story is very simple – while both the euro zone and the US were equally hard hit in 2008 and the recovery was similar in 2009-10 everything went badly wrong when the ECB prematurely started to hike interest rates in 2011. As a result NGDP has more or less flat-lined since 2011. This is the reason we are now seeing outright deflation in more and more euro zone countries and inflation expectations have dropped below 2% on most relevant time horizons.

While the Fed certainly also have failed in many ways and monetary policy still is far from perfect in the US the Fed has at least been able to (re)create a considerable degree of nominal stability – best illustrated by the fact that US NGDP basically has followed a straight line since mid-2009 growing an average of 4% per year. This I believe effectively is the Fed’s new target – 4% NGDP level targeting starting in Q2 of 2009.

The ECB should undo the mistakes of 2011 and copy the Fed

I believe it is about time the ECB fully recognizes the mistakes of the past – particularly the two catastrophic “Trichet hikes” of 2011. A way forward could be for the ECB to use the performance of the Fed over the last couple of years as a benchmark. After all the Fed has re-created a considerable level of nominal stability and this with out in any having created the kind of runaway inflation so feared in Frankfurt (by both central banks in the city).

So here is my suggestion. The ECB’s major failure started in April 2011 –  so let that be our starting point. And now lets assume that we want a 4% NGDP path starting at that time. With 2% potential real GDP growth in the euro zone this should over the cycle give us 2% euro zone inflation.

The graph below illustrate the difference between this hypothetical 4% path and the actual level of euro zone NGDP.

EZ NGDP path 4pct

The difference between the 4% path and the actual NGDP level is presently around 7.5%. The only way to close this gap is by doing aggressive and open-ended quantitative easing.

My suggestion would be that the ECB tomorrow should announce the it will close ‘the gap’ as fast as possible by doing open-ended QE until the gap has been closed. Lets pick a number – lets say the ECB did EUR 200bn QE per month starting tomorrow and that the ECB at the same time would announce that it every month would monitor whether the gap was closing or not. This of course would necessitate more than 4% NGDP growth to close the gap – so if for example expected NGDP growth dropped below for example 6-8% then the ECB would further step up QE in steps of EUR 50bn per month. In this regard it is important to remember that it would take as much as 8% yearly NGDP growth to close the gap in two years.

Such policy would course be a very powerful signal to the markets and we would likely get the reaction very fast. First of all the euro would weaken sharply and euro equity prices would shoot up. Furthermore, inflation expectations – particularly near-term inflation expectations would shoot up. This in itself would have a dramatic impact on nominal demand in the European economy and it would in my opinion be possible to close the NGDP gap in two years. When the gap is closed the ECB would just continue to target 4% NGDP growth and start “tapering” and then gradual rate hikes in the exact same way the Fed has done. But first we need to see some action from the ECB.

So Draghi what are you waiting for? Just announce it!

PS some would argue that the ECB is not allowed to do QE at all. I believe that is nonsense. Of course the ECB is allowed to issue money – after all if a central bank cannot issue money what is it then doing? The ECB might of course not be allowed to buy government bonds, but then the ECB could just buy something else. Buy covered bonds, buy equities, buy commodities etc. It is not about what to buy – it is about increasing the money base permanently and stick to the plan.

PPS Yes, yes I fully realize that my suggestion is completely unrealistic in terms of the ECB actually doing it, but not doing something like what I have suggested will condemn the euro zone to Japan-style deflationary pressures and constantly returning banking and public finances problems. Not to mention the risk of nasty political forces becoming more and more popular in Europe.

Is Karnit Flug jeopardizing Stan Fischer’s “straight line policy”? Not yet, but…

It is no secret that I think that Stanley Fischer did a good job as governor of the Bank of Israel from 2005 to 2013. He basically saved Israel from the Great Recession by essentially keeping Israeli nominal GDP “on a straight line”. During his time in office the Israeli NGDP level diverged no more than 1-1.5% from what we could call the Fischer-trend.

However, Fischer is no longer at the BoI. Instead former deputy governor Karnit Flug has taken over – effectively from July 2013 and officially from November 2013. The question then is has Mrs. Flug been able to maintain Fischer’s “straight line policy” in place? The graph below gives us the answer.

Karnit Flug NGDP

The picture is pretty clear – essentially coinciding with Flug taking over as BoI governor the slowdown in NGDP growth (already started in 2012) has accelerated and we have now dropped somewhat below the Fischer-trend. It would be foolish to say that this in any way is catastrophic, but the change is nonetheless visible and should give reason for serious concern if it is allowed to continue to “drift off”.

Are inflation expectations becoming un-anchored? 

I have earlier warned that there is a risk that we are seeing inflation expectations becoming un-anchored in for example the euro zone because policy makers are preoccupied with everything else than focusing on their nominal target (for example an inflation target).

On the other hand I have also praised the Bank of Israel for always communicating in terms of (market) inflation expectations relative to the BoI’s 1-3% inflation target (range). However, one could argue that the Bank of Israel is beginning to look more like the Swedish Riksbank (which is preoccupied with household debt and  property prices) or the ECB (which is preoccupied by “everything else”).

A look at inflation expectations can tell us whether these fears are justified or not.

Inflation expectations Israel

The graph shows five different measures of inflation expectations. The first four are inflation expectations based on financial market pricing (BoI’s calculations) and the last one is based on a survey of professional forecasters.

Most of the measures show that there has been a pretty consistent downtrend in most of the measures of inflation expectations for little more than a year. However, it is also notable that we are still within the BoI’s 1-3% inflation target range and 5-year and 10-year inflation expectations are still close to 2% and as remained fairly stable.

Therefore, it is too early to say that inflation expectations have become un-anchored, but it should also be noted that we might be risking a sneaking un-anchoring of inflation expectations if policy actions is not taken to avoid it.

Bringing us back on the “straight line”

The recent rate cuts from the Bank of Israel shows that the BoI is not completely ignorant to these risks and I believe that particularly the latest rate cut to 0.25% on August 25 is helping in curbing deflationary pressures. However, more could likely be done to insure against the deflationary risks.

So what should Karnit Flug and her colleagues at the Bank of Israel do to bring us back to the Fischer-trend and to avoid an un-anchoring inflation expectations?

I have three suggestions:

1) Avoid repeating the mistakes of the Riksbank. The Swedish Riksbank has consistenly for some time now undershoot its official inflation target and in my view this has very much been the result of a preoccupation with household debts and property prices. Historical the Bank of Israel has avoided making this mistake, but there are undoubtedly voices within the BoI that what monetary policy to be more dependent on the development household debt and property prices (these voices are within all central banks these days…)

That said, the Bank of Israel is far from being the Riksbank and so far the emphasis on property market developments in communication about monetary policy has not been overly problematic, but that could change in the future and if the BoI became more focused on these issues then I fear that that could led to a more fundamental un-anchoring of inflation expectations and therefore a more unstable economic development.

2) Avoid repeating the mistakes of the ECB. While the Riksbank has been preoccupied with property prices the ECB has been preoccupied with fiscal policy. There are some signs that the Bank of Israel is getting a bit too focused on fiscal policy rather than focusing on monetary policy. Hence, Mrs. Flug has recently been in a bit of war of words with Finance Minister Yair Lapid about the public budget deficit (see for example here).

While I have sympathy for Mrs. Flug’s fiscal conservatism it is not really the task of any central bank to have a view on fiscal policy other than just take fiscal policy as an exogenous factor when setting policy instruments to hit the central bank’s target. The Bank of Israel should make this completely clear so market participants do not come to think that the BoI will keep monetary policy overly tight (ECB fashion) to punish the Israeli government for overly easy fiscal policy.

3) Pre-announce what to at the Zero Lower Bound. With the BoI’s key policy rates at 0.25% we are effectively at the Zero Lower Bound (ZLB). It is no secret that (Market) Monetarists like myself don’t think that the ZLB is a binding constraint on the possibility for further easing monetary policy. However, the ZLB is often a mental constraint on monetary policy makers.

I think that most observers of the BoI knows that the BoI does not have major “mental” problem with using other instruments – than the interest rate – to ease monetary. Hence, the BoI has since 2008 both bond quantitative easing by buying government bonds and intervened in the currency market to weaken the Israeli shekel. It could easily do that again and I think most market participants full well knows this. Hence, in that sense Israel is in a much better than for example the euro zone.

However, instead of letting the market guessing what it might do in the future if necessary the BoI should already today announce what instrument it would be using to conduct monetary policy at the ZLB. Personally I think the most suitable “instrument” to use for small open economy is the exchange rate channel either in the way it has been done for years by the Monetary Authority of Singapore (MAS) or in recent years by the Swiss and Czech central banks.

I think the best option would simply be for the BoI to announce that it – if needed – could put a floor under USD/ILS and at the same time announce that it will keep the door open for moving up this floor until inflation expectations on all relevant time horizons are between 2 and 2.5%. That in my view would likely lead to a weakening of the shekel of a magnitude to bring inflation expectations immediately in line with this narrow “target” range.

Karnit Flug doesn’t have an easy job to do, but she has a solid foundation to build on

There is no doubt that there is a risk that Stan Fischer’s achievements as Bank of Israeli governor could be jeopardized. However, Karnit Flug has not failed yet and she still have the opportunity to continue the success of Stan Fischer.

But then this has to focus on bringing back the “straight line policy” and ensuring that inflation expectations do not become un-anchored. Hence, she needs to not allow herself to be distracted by the development in property prices and fiscal policy and instead focus on how to conduct monetary policy in a transparent and efficient way at the Zero Lower Bound.

PS I am well-aware that Stan Fischer no longer officially is a proponent of NGDP level targeting and that the BoI does not have an NGDP level target, but rather an inflation target. However, thing of a NGDP target as an intermediate target to implement the “ultimate” target – the inflation target. If the BoI for example keeps the NGDP level on a 5% path and we assume that potential real GDP growth is 2% then the outcome will be 2% over the cycle.

Don’t bet on a real appreciation of the renminbi

It rarely happens, but Scott Sumner and I do sometimes disagree on something.

Not surprisingly this time it is on a (mostly) non-monetary matter – the long-term outlook for the Chinese economy.

In my recent post I argued that China might NEVER become the largest economy in the world. Scott – a self-proclaimed Sinophile – strongly disagree with my claim. Here is Scott:

I have several problems with this argument.  First, if Lars really feels PPP is wrong, and that we should use nominal figures, then he should not be talking about China having recently grown at 7 to 7.5% per year.  In PPP terms China may have been growing at 7.5% vs. 2% in the US, but in nominal terms the gap is far wider, due to the Balassa-Samuelson effect.  China’s real exchange rate has appreciated strongly over the past decade.  So if Lars is right that nominal exchange rates are the right test, then China’s been catching up to the US at a rate far faster than either Lars or I assume. And in that case China’s nominal growth could slow dramatically and yet still be growing far faster than the US (where trend NGDP growth is now about 3%, in my view.)  Lars avoids this problem by assuming the Balassa-Samuelson effect will suddenly come to a screeching halt, whereas I think the yuan is headed to 4 to the dollar.  He also assumes a 3% RGDP growth rate for the US, whereas I believe it will be closer to 1.2%, growing over time to perhaps 2% in a few decades.

Other than it is a bit paradoxical that Scott aka Mr. NGDP is so eager to dismiss using nominal terms rather than real terms when it comes to comparing the absolute size of an economy the real disagreement comes down to whether there is a Balassa-Samuelson effect or not. According to the the BS effect relatively poorer countries – such as China – will see its exchange rate appreciate in real terms relative to richer countries such as the US.

In my China-post I assumed that there was no BS effect – and that the relative exchange rate between China and the US in the future would be determined by the Purchasing Power Parity (PPP). This assumption of course means that there is no difference whether we use real or nominal growth rates in GDP when comparing the relative size of the Chinese and the US economy (both measured in US dollars).

I acknowledged in my post that my no-BS effect assumption was a bit brave and I would happily agree that there is nothing theoretically wrong with the Balassa-Samuelson effect. However, I would also say that having worked professionally with forecasting Emerging Markets currencies for nearly 15 years I would be extremely skeptical about its importance of it from an empirical perspective. I will return to that below.

Scott often argues that the markets is the best thing we have to predict the future. I strongly agree with that. Despite of that Scott makes a bold prediction on the outlook for the Chinese renminbi.

Hence, Scott not only predicts a real appreciation of the renminbi, but he also argues “I think the yuan is headed to 4 to the dollar” – hence significant nominal appreciation.

That is an extremely bold prediction given USD/CNY today is trading around 6.15. Said in another way Scott is basically predicting a 50% appreciation of the renminbi! This is in direct contrast to what the markets are predicting. If we for example are looking at a 1-year forward for USD/CHY the market is now predicting around 2% depreciation of the renminbi. So we should ask Scott – do you believe markets are efficient or not?

A look at South Korea and Taiwan tells us we should not expect Chinese real appreciation

There is also another way to think about whether or not we will see a real Chinese appreciation or not in the coming decades and that is by looking at the experience of similar countries. China’s transition and its catching-up process is often compared to South Korea and Taiwan. Therefore, I have looked that the historical development in in the South Korean won and Taiwan dollar.

I have chosen 1990 as my “reference year”. The reason is that at that time South Korea’s and Taiwan’s GDP/capita relative to the US were more or less where Chinese GDP/capita is today compared to the US.

Lets first have a look at South Korea.

Real won.jpg

The first thing we see it that PPP seems to have been a pretty good “predictor” of the long-term development in the won over the long-term. I have calculated PPP based on the relative development in the GDP deflators in South Korea and the US.

But lets return to the question of real appreciation. Has there been a real appreciation of the won (against the dollar) since 1990? The answer is NO. In fact there has been a slight depreciation of the won in real terms.

But of course South Korea went through a major crisis in 1997 so it might be special. So lets instead look at Taiwan.

real TWD

Guess what? Since 1990 the Taiwan dollar has actually depreciated significantly in real terms against the US dollar. Maybe exactly because it has appreciated in the years ahead of 1990.

No matter the reason both the Taiwanese and the South Korean experience tell us that real currency appreciation is no given or automatic part of the catching up process for economies like South Korea, Taiwan or China.

A closer look at the renminbi’s recent real appreciation

In his comment Scott makes the following comment China’s recent appreciation of the renminbi:

“China’s real exchange rate has appreciated strongly over the past decade”

The graph below shows that Scott’s claim is correct.

Real CNY

But the graph also shows that the renminbi was more or less flat against the dollar in real terms from the early 1990s until 2005-6. Hence, we had at least 15 years of economic catch-up without any real appreciation of the CNY at all. Hence, again it is fair to argue that real appreciation does not automatically follow from economic catch-up. The period from 1990 to 2006 shows that quite clearly.

Furthermore, we want to ask ourself whether the real appreciation over the past decade really is a result of economic transition and catching up or something else. Hence, it is quite clear that over this period the People’s Bank of China have tried to curb inflationary pressures by undertaking a managed strengthening of the renminbi against the dollar – both in nominal and real terms. That process might now be coming to an end as the Chinese economy has slowed rather dramatically and inflationary pressures clearly have eased as well – particularly since 2011-12.

Finally let us again return to the examples of South Korea and Taiwan. The graph below shows the real exchanges of South Korea, Taiwan and China (against the US dollar). ‘Year zero’ is 1990 for South Korea and Taiwan, while ‘year zero’ is 2014 for China. Hence, the graph is “calibrated” so all three countries are at a similar income level versus the US in ‘year zero’.



I think the graph is quite telling – the appreciation of the renminbi over the past decade has been fairly similar in size to the appreciation in the in won and the Taiwanese dollar in the decade ahead of 1990. However, as also illustrated above that real appreciation didn’t continue. In fact a decade later both KRW and TWD had depreciated more than 10% in real terms against the US dollar.

This of course is not a prediction for what will happen – it is just an illustration that based on the experience of Taiwan and South Korea there is no reason to expect continued real appreciation of the renminbi.

So my message to Scott is – don’t bet on a real appreciation of the renminbi!

PS Scott uses the term yuan and I here have used the term renminbi. Renminbi is the official name for the Chinese currency and yuan is the main unit of currency.

China might NEVER become the biggest economy in the world

It is often assumed that given China’s remarkable growth rates over the past three decades – around 10% real GDP per year – China is on the way to soon becoming the largest economy in the world. In fact earlier this year it got a lot of media attention that when the World Bank argued that China already had overtaken the US as the largest in economy in the world. However, the argument was completely bogus as it was based on Purchasing Power Parity (PPP) rather than on actual exchange rates (To be fair we should blame the media rather than the World Bank for this interpretation of the data).

PPP based measures of GDP (per capita) might make sense if we want to measure how much an average citizen can buy for given an average income, however, it does not make sense when we want to measure the size of the economy. There we have to use measures based on actual exchange rates and if we do that then it turns out that the Chinese economy is still significantly smaller than the US economy. Hence, total Chinese GDP today is around 10 trillion USD, while US GDP is around bn 17-18 trillion USD. Said in another way the US economy is still nearly double the size of the Chinese economy.

And what I will argue in this post is that China might never overtake the US as the biggest economy in the world.

Chinese growth set to slow dramatically in the coming decades

There is a broad consensus among long-term macroeconomic forecasters that the Chinese economy is likely to slow significantly in the coming quarters – starting today!

There are overall three reasons why this is the case:

1) The catching-up process means less and less: A very large part of China fantastic growth performance over the past three decades is due to a “natural” catching up process. When poor economies – like the Chinese economy three decades ago – is freed up a catching up process is started. This means a lot for low-income economies, but as income levels increase the catching up process slows down. This is already the case for China.

2) Investment growth is likely to slow significantly: Fixed investments as share of GDP in China is extremely high – well above 40% of GDP. This is at least 10-15 %-point more than in other countries with a similar GDP/capita level. This to some extent reflect capital misallocation in the Chinese economy as investment decision in the Chinese economy to a large extent still is a result of quasi-central planing. It is therefore natural to expect investment growth to slow quite significantly in the coming decades.

3) China is facing serious demographic challenges: You can blame the Communist Party’s one-child policy or come up with other explanations but the fact is that the Chinese labour force is now already in decline and the decline will continue in the coming decades and soon the Chinese population will be in outright decline.

So from a growth-accounting perspective we have it all – less Total Factor Productivity growth – as the catch-up process slows, a slower increase in the capital stock and finally a declining labour force.

It is therefore hardly surprising that most long-term forecasts made for the Chinese economy forecast a rather significant slowdown in Chinese growth in the coming decades (See for example here.)

Closing in on the US, but China might never make it

It is commonly argued that trend growth presently is around 7-7.5% in China, however, it is equally common to argue that we will see a slowdown in real GDP growth to an average of around 5-6% in the coming 10-15 years. But the real slowdown comes after 2030 where the Chinese economy is expected by most long-term forecasters to start to approaching Japanese style growth rates and outright negative trend-growth should not be ruled out in the 2050s based on reasonable expectations about demographics, the investment ratio and the catching-up process.

Obviously it is difficult to make any macroeconomic forecasts. However, I would actually argue that it in many ways it is easier to make forecast 10-20 years ahead than 1-2 years ahead. When we do short-term forecast the shocks will always mess up our forecasts, but over a 10-20 years horizon the positive and negative shocks tend to even out. Furthermore, in the long-run it is all about supply side factors and with the growth rate of the labour force being a major factor we already know quite a bit. Hence, we have a pretty good idea about the growth of the Chinese labour force in 15-20 years as the people entering the labour force as young adults in 15 or 20 years already have been born.

I have gone through a number of studies of the long-term growth perspectives for the Chinese economy and based on that we can make a simple “simulation” of how the level of Chinese real GDP will develop from now and until 2060. I should stress it is not a forecast as such and lets therefore just stick with the term “simulation” of future Chinese real GDP under reasonable assumptions about the development in technology and in productions factors.

The graph below illustrates my argument that China might never overtake the US as the largest economy in the world. Here is my assumptions (and they can certainly debated, but they are not much different from the “consensus” forecasts for long-term growth in China and the US). I assume that trend real GDP growth in China over the next 15 years will be 6% – slowing from presently 7.5% to 4.5% in 2030. Hereafter the negative demographics in China really kick in and as a result trend growth drops to an average of just 2% for the period 2030-2060.

I have indexed Chinese real GDP at 55 in 2014 – reflecting that Chinese GDP (in USD) is around 55% of US GDP. In my simulation I have assumed that US trend real GDP growth is 3%. This is probably slightly optimistic compared to the “consensus” among long-term forecasters, but it is basically the growth rate we rather consistently have seen in the US economy since the early 1960s. The American demographic challenges are somewhat smaller than is the case for China and I find it rather likely that the US gradually will adjust immigration policies so meet these challenges (I certainly hope so…)

It is important to stress that I here assume that the there is no real appreciation or depreciation in the USD/RMB exchange rate (no Balassa-Samuelson effect). Hence, the exchange rate development is determined by relative inflation in the US and China. This might twist the results slightly against China. On the other hand I have also assumed that the output gap is zero in both countries. In fact the output gap in the US is still negative, while the output gap in China likely is close to zero or even positive. This twists the results against the US. Lets just (completely unreasonably) say that these factors even out each other.

China will NEVER catch up

So there you go. You see under these – simplistic – assumptions the Chinese economy will continue to gain on the US economy over the next two decades. However, under these assumptions (and I again stress it is assumptions) it will be close (around 90%), but no cigar for the Chinese economy – the Chinese economy will never be the largest economy in the world – or at least not in my life time and I do plan to live to at least 2060.

Furthermore, starting around 2040 China will stop catching up and instead see its economy decline relative to the US and in 2060 we will be more or less back where we started with Chinese GDP being around 60% of US GDP.

Now you might say that these results are too negative in terms of China or too positive in terms of the US and that might very well be the case. However, I do think that my simulations illustrate that China is not automatically set for global economic and financial domination. So while China – for a period – might become a bigger economy than the US – if we for example assumption 2.5% US trend growth rather than 3% – the negative demographics will start to kick in soon and that will ensure that the US economy will remain the biggest economy in the world – also in 50 years. This also means that it is quite hard to imagine in my view that the “financial centre” of the world will move to China and I find it extremely hard to imagine that the Chinese renminbi will take over of the role as the leading reserve currency of the world from the US dollar.

But there is no reason to cry for the Chinese

So China might never become the biggest economy in the world. However, that should really not be important for the Chinese. It might be for Chinese policy makers, but the average Chinese should instead celebrate the fact that outlook for his/her income level remains very bright and income growth for the individual Chinese is likely to remain very high in the coming decades. So the discussion above should not really be seen as being “bearish” on China. In fact I am rather optimistic about the Chinese “miracle” continuing in the coming decades. We should celebrate that, but we might never be able to celebrate the day the Chinese economy overtakes the US in absolute size.

Guest post: What an Enlightened Immigration Policy Would Look Like (Nathan Smith)

Guest post: What an Enlightened Immigration Policy Would Look Like

-By Nathan Smith

Lars suggested that I follow up on my guest post about the global economic impact of open borders, with some policy advice about what advanced nations ought to be doing. Maybe that sounds like a short post blog. Mustn’t an open borders advocate’s advice on immigration policy be simply… “Do nothing”? Send the employees of ICE and USCIS home. Stop checking passports at the airport. Lay off the State Department’s consular officers. Fire the Border Patrol. Laissez faire.

Well, no, it’s not quite that simple. Being a sort of Burkean conservative, I prefer, even when justice ultimately demands a radical departure from the status quo, to arrive at justice by a path of gradualism and compromise. I prefer to leave traditional privileges intact as much as possible, and not to make anyone worse off than he is accustomed to be. That said, the moral law prohibits certain actions, and governments today do many things in the name of immigration enforcement that are morally impermissible, things which have the moral character of crime. For example, the US government separated an estimated 1 million family members by deportation in 1997-2007. Governments must recognize that absolute control over who resides in their territory, which the hubris of the 20th-century state has claimed as part of “sovereignty,” cannot be achieved by morally permissible means, and must be abdicated.

But first, what would an efficient immigration policy look like? The slogan Don’t restrict immigration, tax it (DRITI) expresses the core of my answer to this question, and I use “DRITI” as the umbrella term for policy proposals in Chapter 9 of my book (also see here).

It was in 2006 that I first published the idea of taxing rather than restricting migration. For an economist, it is rather obvious. The standard prescription in trade policy is to embrace free trade, and if you’re concerned about the fate of people in import-competing industries, tax the winners to compensate the losers. This works even better in the case of migration, because one major group of winners—the immigrants themselves—is easily identifiable and has a distinctive legal status. Many, including Richard Vedder and Gary Becker, have proposed replacing arbitrary bureaucratic discretion with an explicit pricing mechanism as a means of regulating migration. An economist cannot but be appalled at seeing decisions highly consequential for individuals’ lives being made on the basis of meaningless criteria such as (to quote USCIS) whether “there are insufficient available, qualified, and willing U.S. workers to fill [a given] position at the prevailing wage.” Other advanced nations, too, try to tailor migration to meet specific labor market needs, as if they were Gosplan. Some sort of price mechanism is obviously the rational substitute. I compared these proposals in an Open Borders: The Case blog post, “Auctions, Tariffs, and Taxes,” but I am convinced that Vedder’s and Becker’s proposals are suboptimal and mine is the best approach.

I plan at some point to estimate numerically the economic consequences of adopting DRITI in the US or the UK, but for the moment, I can only offer back-of-the-envelope calculations. Suppose the USA adopts DRITI, and 200 million immigrants arrive. They pay an average $10,000 of migration taxes per annum. The US government receives $2 trillion annually in migration tax revenue, enough to finance an average transfer of about $7,000 per US citizen. Since the 2012 poverty line for a family of four (in the 48 contiguous states and DC) was $23,050, DRITI could, under this scenario, eliminate “poverty,” in the official sense of that word, among US natives. For the UK, a Gallup poll finds that at least 45 million want to emigrate there. If they came, and paid an average of ₤6,000 per person per year in migration taxes, these revenues could finance an average of ₤4,500 in extra transfers, tax cuts, and public services per British citizen.

In addition to migration taxes and transfers to natives, my plan would have a forced saving aspect to it. Money would be deducted from migrants’ paychecks, and deposited in savings accounts, from which it could only be withdrawn, by the migrant, on the physical territory of his or her home country. If not withdrawn, these savings would accumulate up to a certain threshold, say $50,000 or ₤30,000, at which point the migrant could apply for citizenship, at the cost of forfeiting their forced savings.

Migrant savings accounts serve two purposes. First, they would channel more of the gains from freedom of migration into lifting poor countries out of poverty, by encouraging many migrants to go home, bringing with them the skills, savings, connections, and new social norms and values they’ll gain as sojourners in more advanced countries. Second, it should help to allay rich countries’ fears about their institutions being “swamped.” Migrants would only vote after first showing their value to the host country by earning money in it, then showing by a financial sacrifice the value they place on citizenship in it. The new citizens could be expected to be disproportionately skilled, productive, and patriotic for their new homelands.

The world is too complex and random for a criterion like “Pareto improvement” ever strictly to apply, but in rough terms, DRITI would be a Pareto improvement over the status quo. Many natives in rich countries, especially the unskilled, would earn less under DRITI due to competition from immigrants. But lost earnings would be offset by government transfers. Immigrants would presumably be better off, despite the taxes and forced savings, else they would not come. Those who stayed behind in poor countries would benefit from reduced wage competition and the beneficent impact of return migrants and diasporas on capital formation, institutions, and technological diffusion.

But is it just? Under DRITI, citizens and immigrants would be treated unequally. Why should a person receive transfers from the government just because they had the good luck to be born in the US or western Europe? Why should a person have to pay special taxes just because they were born abroad? While that may not be fair, DRITI is clearly fairer than the current system, which excludes most potential migrants altogether. Enormous differences in one’s access to the good life based on the accident of where one was born are one of the most appalling and indefensible features of global capitalism today. DRITI would not eliminate that inequality, but all its impact would be in the direction of mitigating it.

If DRITI is such a good idea, why isn’t it already the law of the land? Why would anyone oppose a policy Pareto-superior to the status quo? For one thing, I believe people are addicted to the border as blindfold. They want the government to keep poverty out of their field of vision so that they can be prosperous in a world full of dire poverty, while feeling morally upright. To mention this motive is to discredit it.

Many also seem to have an odd notion that a nation’s people are morally obligated to take care of people who happen to be physically located on the national territory, but not otherwise, so they can exclude people physically, in order to avoid incurring moral obligations to give them material aid. At Open Borders: The Case, we call this fallacy “territorialism.” I don’t know how to argue against it, since I am not aware of any argument in its favor against which to direct my fire. I regard its falsity as self-evident. But I tried to argue against it indirectly in my 2010 book Principles of a Free Society, by re-exploring the moral and historical foundations of political freedom.

There would be a national security exception to the principle of open borders—terrorist suspects and career criminals may legitimately be excluded, for citizens’ safety—and maybe for carriers of contagious diseases. It is also important to insulate the welfare state from immigration, by making immigrants ineligible for welfare and perhaps various other government benefits. If Milton Friedman really said that you can’t have open borders and a welfare state, it was an uncharacteristic blunder on this part. You can have a welfare state for natives and freedom of migration for foreigners who want to come and work for a living, or possess independent means. But to make open borders fiscally sustainable, rich countries’ governments would probably have to target taxpayer-funded benefits to natives and a few naturalized citizens, and have ways to deny them to most resident foreigners. My DRITI proposal requires immigrants, upon receiving a visa, to make a deposit sufficient to pay for the cost of sending them home if they become destitute.

Under DRITI, deportation would be abolished. Minor exceptions aside, foreigners would have a right to be on US soil, and illegal immigrants would breach the law only by failure to pay the deposit. The logical penalty would therefore be a fine. Since it’s much cheaper, pleasanter, and safer to come to the US legally on a bus or plane, than in a shipping container or on foot through the Arizona desert, making a legal option generally available could be expected to render illegal immigration a negligible phenomenon. So DRITI would restore the rule of law, which has proven so elusive under the status quo.

Some deny that I’m an open borders advocate, because they don’t think a universal DRITI regime would qualify as “open borders.” I think it would, because people would be allowed to move anywhere, even if they wouldn’t necessarily be treated “equally” (whatever, if anything, that means) with the locals everywhere they went. Semantics aside, I would rather see a universal DRITI regime established than “pure” open borders (with no migration taxes), at least in the short run, in order to safeguard social institutions and prevent a negative economic shock to the Western working class. Yet DRITI is still rather a rather radical reform, and I might favor gradualist approaches even to this compromise policy, but human rights considerations give me pause.

Human rights is a difficult subject, but too important to neglect. In discussing them, I am partly handicapped, but perhaps partly helped, too, by my lack of legal training. Legal knowledge would help me to think clearly and foresee the ramifications of rights-claims, but what one most needs to discern human rights is a conscience, and conscience is blunted in some lawyers by the habit of flattering the powerful and defending any and every party that might hire them.

I see the history of human rights—formerly called “natural rights” or (by Adam Smith) “natural liberty”—as a tug-of-war between (a) a growing appreciation of what human beings need, in order to flourish and realize the potentialities of their nature, persistently fostered by art, philosophy, religion, and civil society, and woven into the scruples and sensibilities of classes and nations, and (b) many factors, including moral laxity, coarse cynicism, corruption, tyranny, religious or revolutionary enthusiasm, the exigencies of war, the envy of the poor, and the acquisitiveness of the rich, which induce people to wrong their fellow human beings. Moral progress must perpetually struggle against backsliding, and often has a reactionary character. We codify and sanctify human rights when we are determined to say “never again” to a French Revolution or a Nazi genocide.

Indeed, while mankind really has made moral progress in the course of history—the abolition of slavery and polygamy, and the establishment of freedoms of religion and speech, are the most important advances—the assumption that moral progress is natural and inevitable is dangerous and corrupting. People often slip into feelings of complacent superiority to ancestors who were better than themselves. They may also commit terrible crimes for the sake of a misguided vision of moral progress, as in the case of the Soviets, who would have perpetrated such great evils had they not had before their eyes a lofty vision of socialist utopia. The most durable advances of human rights are made in a spirit of reclamation and restoration, not revolution. The slaveless world for which William Wilberforce and the abolitionists strove had already been a solid societal fact in the European Middle Ages, still largely intact on the European continent itself, though betrayed in the new European dominions of the New World. Open borders advocates, too, do not champion something new, but rather, seek to reverse disastrous innovations by the 20th-century state. We want little more than to restore freedom of migration as it existed in the Victorian era.

An example of the kind of anxieties that can give rise to moral progress is furnished by the contemporary United States, where a feeling has grown in recent years that it is unacceptable to deport people who, though never authorized by the government to live in the USA, came here as children and have no other home. Obama’s DACA policy, though legally anomalous, seems to be driven by the moral necessity of halting the deportation of innocent child migrants. But by appearing to recognize a right of minors to stay in the US, DACA has probably helped to trigger the “unaccompanied child” crisis at the border. When Americans see thousands of children being held by force in detention camps along the border, they feel that it is wrong, but why exactly? What moral principles are being trespassed? What ought we to do? Such efforts to understand what conscience is demanding of us can enrich our understandings of human rights, and lead to moral progress.

Civil disobedience is often the midwife of insights about human rights. A person like Martin Luther King in the civil rights era, or Jose Antonio Vargas and my co-blogger Michelangelo Landgrave in our times, openly does what is against the law, but is not morally wrong, and thereby becomes a walking, talking reductio ad absurdum of the law, a proof that the law and the right have parted company, and the law is therefore illegitimate. But to understand why the law is illegitimate, and how it must change to recover its legitimacy, involves an inquiry into human rights.

Now, I have sometimes written of a “right to migrate,” but, strictly speaking, I do not assert a general right to migrate across international frontiers just because one wishes to. (I assert rather that there is a liberty of international migration, using a distinction between rights and liberties which I learned from Anthony de Jasay, because there is generally no one with a proper right to use force to prevent it… but I won’t venture into those subtleties here.) However, conscience compels me to assert a human right to international in certain cases.

First, I believe the human rights consensus has come to recognize a right to emigrate, yet even as the international community condemns regimes that prohibit emigration, it fails to guarantee the right to emigrate by ensuring that everyone has somewhere to go. How can it be a human rights violation when Soviet Russia, or Communist China, or North Korea, forces citizens to stay home, but not when the rest of the world conspires to force people to stay home by denying them visas? Countries that, by refusing to accept people as immigrants, force them to live under regimes that oppress and persecute them, are serving as jailors for those regimes, and share in their guilt. This ought to change.

Second, families have a right to be together. Attachments to spouse and children often are, and should in any case be presumed to be, as central to a person’s identity and needs as the integrity of the body itself. To deprive a mother of her children, even for a short time, might be a crueler form of torture than severe physical pain, and other family separations can also cause extreme distress. Governments whose migration restrictions prevent parents and children, brothers and sisters, spouses, or those desiring to marry, from being together, violate human rights. People’s mutual needs for one another’s society may extend beyond family to friends and communities, such that governments wrong such people by forcibly separating them.

Third, the right to use and develop one’s own personality and property may sometimes entail a right to invite certain people. For example, a community chorus might need to recruit a pianist from Korea, a farmer to recruit harvesters for his crops from Mexico, or a parish to recruit a priest from Russia or Africa. Governments that prevent migration by force in such cases wrongfully interfere with hospitality and the flourishing of their subjects.

Now, a universal DRITI scheme would satisfy both the desideratum of efficiency, and that of respecting human rights. But, if I am told that DRITI is too radical, and that I must compromise further, or if I am asked to propose intermediate steps by which the world might establish a universal DRITI scheme by gradual steps, I would split my advice between measures to achieve efficiency by partially implementing DRITI, and measures to bring policy into line with the urgent moral imperative to respect human rights. On the one hand, I would reserve welfare benefits to natives, introduce migration taxes, implement DRITI through bilateral and multilateral deals, perhaps among relatively close or similar countries like the USA and Great Britain, and curtailing bureaucratic discretion in migration control wherever possible. On the other hand, I would call for a worldwide archipelago of passport-free charter cities, in order to make the right to emigrate a global reality, even if many continued to be denied access to the developed democracies. I would call for a major expansion of citizens’ rights to invite and sponsor international visitors. I would call for family reunification to be recognized as a natural, prepolitical entitlement that states must accommodate without delays and discretionary obstacles. I would demand a complete, permanent, and global prohibition on the forcible separation of families by deportation. I would demand that long-term residency in a country, and especially residency that starts during childhood, be recognized as conferring permanent residency and a right to work, though not to citizenship or political representation. But as this human rights agenda would make comprehensive migration restrictions even more unenforceable than they already are, the destination of the changes could only be open borders.

Ultimately, the efficiency case for open borders and the human rights case for open borders converge and supplement one another, a little like the Good Cop and the Bad Cop in police movies. The Utilitarian Advocate shows why we should want to open the world’s borders to migration, the Human Rights Advocate shows why we must. The Utilitarian Advocate lures us on with glittering promises of prosperity. The Human Rights Advocate goads us forward with the whip of a guilty conscience.

The intelligent restrictionist says: “I can see that it seems very wrong when deportation forcibly separates families, or when children are deported who grew up here and have no other home. But suppose we let them stay. Amnesty sets a precedent. If we let these ones stay, others will want to come, in order to benefit from the next amnesty. You’ll make the same objections to deporting those people as you do to deporting these. Then, if we listen to you, and let those people stay too, the precedent will be reinforced, and people will expect the next amnesty all the more confidently. In the end, we’ll lose control of the border altogether. What will that lead to?”

Here the Utilitarian Advocate answers: “Well, at most, it will lead to open borders, and that’s probably a good thing. There’s a lot of uncertainty here, but as best we can guess, open borders will roughly double world GDP, with the benefits falling disproportionately to the poorest members of mankind. Human geography will be transformed forever, as billions of people will migrate in search of a better life, and find it. In the West, investors and landowners, and probably some skilled workers too, will see big gains. It’s true that a lot of people in the Western middle and working classes will face a difficult transition and may end up worse off than before. But for mankind as a whole, open borders will be very beneficial.”

To this, the intelligent restrictionist replies: “All right, fair enough. I know you have reason to think open borders will be good for the world. But the best that can be said for these projections is that they’re the best on offer right now. They’re still very tenuous, simplistic, and even jejune. Surely one runs at least a slight risk of societal collapse, by adopting policies that, according to you, will triple the West’s population, and make Westerners minorities in their own countries. Open borders could fray the social fabric beyond repair. There are risks of crime, of terrorism, of contagious disease, of class alienation, of new and dangerous ideologies spreading, of revolution. Democratic norms could be undermined, with incalculable effects on the legitimacy of governments and the maintenance of civil peace. We in the West have built a remarkably peaceful and prosperous society, and our peace and prosperity seem to be spreading to the rest of the world, if more slowly than one might wish. Are we supposed to gamble all that solid good for the sake of your castle in the clouds?”

And here the Human Rights Advocate answers: “And to appease these vague fears of yours, you would seize innocent children, and send them to countries they hardly know? You would separate families by force? You would lay waste to verdant agricultural landscapes, so that in a world not free from hunger, good fruit will rot upon the ground for lack of harvesters? You would deny people living in terror under totalitarian tyrants the chance to escape from living nightmares? It would be easier to forgive these cruel and destructive actions, if you did them in the face of some dire, immediate peril. But while you speak of crime, crime has been plummeting in your country, so that on the vast majority of your streets one may walk without fear, not only in broad daylight, but in the middle of the night. You speak of threats to civil peace, but there has hardly been a country in the history of the world where the civil peace is as secure as it is in yours today. You speak of contagious diseases when modern medicine has vaccinated you against the great plagues of the past, and few of you have suffered a contagious disease much worse than the flu. You speak of the social fabric being frayed, but what does that mean? Do you mean that in a world of open borders, you might be less likely to invite the neighbors over for a beer and the Saturday night football game? Aren’t you ashamed even to suggest that such a minor harm could be set in the balance, when the alternative includes people being forced to live in terror under totalitarian tyrants, parents being separated indefinitely from their young children, and destitute people being denied the chance to earn their daily bread? You speak of class alienation as a danger to be avoided, yet today, a favored fifth of humanity is born to privilege in wealthy countries, while billions around the world are born to lifelong poverty, political repression, and/or fear of violence, which your migration restrictions make it difficult or impossible for them to escape. What moral evil can you possibly see in any class-stratified society that might emerge in the West, which is not exceeded ten-fold by the injustices of our current system of global apartheid?

“By all means, let us be vigilant for any sign of the dangers you fear. If we see such signs, let us consider what precautions to take. If at some time in the future, there really is strong evidence that we are on the brink of catastrophe, we might even condone desperate measures, such as the forcible separation of families, the ruination of valuable property, and the exile of innocent people to countries they hardly know. But you are carrying out these extreme measures when you are well-fed, well-housed, and in no fear of violence, from a mere ideological obsession, unrelated to any real, solid, substantive human good, with ‘sovereignty.’ Come to your senses now, and do the right thing. It may not prove so difficult and dangerous in reality, as you have painted it in your dark daydreams.”


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