The real problem is a nominal problem – also in 2016

In 2009 Scott Sumner wrote an article – The Real Problem was Nominal – in which he explained – was later became known as the Market Monetarist explanation for the causes of Great Recession.

The Market Monetarist explanation for the Great Recession is that the Federal Reserve (and other central banks around the world) allowed monetary conditions to become far too tight in 2008 and that the crisis was not caused by a banking crisis, but rather that the banking crisis was a consequence of the extreme tightening of monetary conditions during particularly the summer of 2008.

Hence, the Fed and other central banks gravely misdiagnosed the problem and as a consequence applied the wrong medicine for the problem. Furthermore, by focusing on nominal interest rates central bankers were led to believe that monetary conditions were very easy, while they in fact monetary policy became extremely tight during the second half of 2008.

This explanation for the crisis is not yet commonly accepted but more and more economists now acknowledge that particularly the Federal Reserve failed greatly in 2008 as it failed to response appropriately to the spike in dollar demand.

Unfortunately, I fear that the Federal Reserve today are in the midst of repeating the mistakes of 2008. Hence, the Fed continues to argue that monetary conditions are very accommodative, while in fact monetary policy has become increasingly tight over the past two years and particularly in recent months we have seen a significantly tightening of US (and global) monetary conditions.

To illustrate this lets, look at six indicators Scott highlighted in his 2009 article to show that US monetary conditions became insanely tightening in 2008:

  1. Real interest rates soared much higher.
  2. Inflation expectations fell sharply, and by October were negative.
  3. Stock markets crashed.
  4. Commodity prices fell precipitously
  5. Beginning in August, industrial production plunged.
  6. The dollar soared in value against the euro.

This is the core Market Monetarist story. We believe that markets are the best indicators of the “tightness” of monetary conditions. If for example market-inflation expectations drop, the dollar strengthens and commodity prices fall at the same time then it is a very strong indication that money demand growth exceeds money supply growth and hence that US monetary conditions are getting tighter.

This also means that monetary policy works with long and variable leads (rather than lags) – the policy changes starts to impact the economy once the they are announced rather when they are “implemented”.

So lets look at what these indicators have been telling us recently.

First lets look at real interest rates – here we look at real 5-year US bonds (nominal bond yields minus 5-year TIPS breakeven inflation expectations).

 

Real 5 year bond yield

Looking at real bond yields we get an clear indication that monetary conditions have been tightening since May 2013 when then Fed Chairman Ben Bernanke announce the Fed would “taper” it monthly asset purchases and gradually scale back quantitative easing.

Hence, it is also clear that the Fed didn’t initiate the rate hiking cycle in December 2015 as we are normally told, but rather in May 2013 if we focus on real rather than nominal interest rates as every textbook would tell would be the thing to do.

I am not arguing here that it was a wrong decision to start tapering in 2013, but rather that we need to get the facts right – the Fed has been tightening monetary conditions for more than two year – at least if we focus on real interest rates.

The same picture clearly emerges if we just look at the bond market’s inflation expectations. This is 5-year breakeven inflation expectations:

5y BE inflation expectations

As the graph shows Ben Bernanke’s Fed had essentially managed to anchor inflation expectations around 2% before tapering was initiated. However, that has dramatically changed since then and inflation expectations has consistently been drifting downwards for more than two year with out the Fed taking any corrective actions to halt the decline in inflation expectations – effectively telling the markets (and everybody else) that the Fed really isn’t that concerned about hitting its 2% inflation target.

That message has further been strengthened after Janet Yellen took over as Fed chair in February 2014. Yellen has again and again told the markets that she really don’t trust market expectations and that inflation would soon rise. She, however, has been badly wrong and 5-year breakeven inflation expectations have now dropped to 1%.

This is the story seen from the stock market:

SP500

If we look at the stock market the story is slightly different than when we look real bond yields and inflation expectations. Hence, S&P500 continued to inch gradually up essentially until a year ago when stock prices started to flatline and after Yellen in October pre-announced the December rate hike stocks have essentially fallen of a cliff.

A way to interpret the stock market action is that even though monetary conditions were becoming tighter after May 2013 monetary continues weren’t getting excessively tight before sometime during 2015.

This was essentially also the story that I was telling in 2014 and early 2015 – most indications were that nominal GDP was growing along the post-2009 4% path, which I at that time considered to be Fed’s de facto monetary policy target. See for example this post from March 2015 where I agued that monetary policy more or less was on track.

At that time there was no real signs that the post-2009 recovery in the stock market was about to come to an end. However, that changed shortly thereafter and I personally became quite worried about what I considered to be an overly hawkish Fed in August last year. A concern I voiced in a number of blog posts in August. See for example here and here.

I was particularly concerned that Yellen apparently ignored both what the markets and nominal indicators (M, V, P, NGDP) were telling us about monetary conditions.

Hence, in August it was becoming clear that nominal GDP was falling below its post-2009 4% path and that inflation and inflation expectations consistently were undershooting the Fed’s 2% inflation target and despite of that Yellen continued to argue that we would get a rate hike in September.

The Fed then postponed that rate hike after the first round of market jitters and the stock market sell-off in the late Summer of 2015, however, it was clear that the Fed desperately wanted to “normalize” interest rates (whatever that is!) and the Fed then in October pre-announce the December hike. Ever since then financial market distress has increased.

Returning to the market indicators – we also got a clear message from the commodity markets. This is the oil price:

oil price brent

Here the story is the same as from the stock market – it might be that the Fed initiated tightening in May 2013, but did it was not before the Summer of 2014  that oil prices started to drop.

There are many theories (and conspiracy theories) about why the oil price have dropped and it often argued that the drop in oil prices is driven by the supply side – more oil being put on the market by the Saudis.

However, if that was indeed the case one should have expected global stock markets to have rallied and we should have seen a pick up in growth. That, however, has certainly no been the case, which makes me think that the drop in oil prices mostly is about global monetary conditions becoming increasing and excessively tight. This is the combined effect of both the Fed and the PBoC tightening monetary conditions at the same time.

So that is yet another market indicator that strongly suggests that US monetary conditions have become increasingly tight – too tight – for some time.

The final market indicator to look at is the dollar.

dollar rally

Once again the story is the same – there is some effect of the ending of quantitative easing and the dollar trended moderately stronger indicating a gradual, but not dramatic, tightening of monetary conditions.

However, shortly after Janet Yellen became Fed chair in February 2014 the dollar started to appreciate strongly and that has been going on for two years more or less uninterrupted.

All market indicators are tell us that monetary policy has become excessively tight

Hence, looking at real bond yields, inflation expectations, the stock market, commodity prices and the dollar the message is uniform – monetary conditions have gradually become tighter over the past 2-3 years.

Initially the tightening of monetary conditions were likely not excessive, but the signs are now very clear that since August-October 2015 the Federal Reserve got way away ahead of the curve and it is now very clear that the markets are telling us that monetary conditions in the US are become far too tight and it is only a matter of time before this will be very visible in the macroeconomic data.

In fact it is already visible. Just take a look at the final indicator that Scott highlighted in his 2009-article – industrial production.

Industrial Production US

Again the picture is very clear – the post-2009 recovery in the US manufacturing sector was doing fine until mid-2014 whereafter we have seen a clear downward trend in industrial production.

It is hard not to conclude that this is a direct consequence of the tightening of US monetary conditions over the last couple of years.

The question is of course whether this will turn into an economy-wide recession or not, but if we compare the recent developments with the situation in 2007-9 then we certainly should be worried.

Misdiagnosing the crisis once again

In this 2009-article Scott Sumner argued that a key contributing factor the mistakes of the Fed in 2009 was the that Fed simply misdiagnosed the crisis. Hence, while Scott clearly showed that the crisis was caused by an excessive tightening of monetary conditions, which in turn led to a banking crisis the Fed on the other was convinced that the banking crisis was the cause rather than the consequence of the crisis.

Furthermore, all through 2008 the Fed continued to argued that monetary conditions were highly accommodative, while in fact if you where tracking market indicators then it was clear that monetary policy had become insanely tight.

I fear that the Fed today is making the same mistake once again. The Fed is convinced that monetary policy is very easing (nominal interest rates are very low), but the fact is that market indicators – as I have shown above – clearly are telling us that US monetary policy not only has become gradually tighter since the announcement of tapering in May 2013, but also that monetary policy has become excessive tight since the Autumn of 2015 and that Janet Yellen and her colleagues in the FOMC has been overly focused on labour market conditions and have completely ignored market and money indicators and as a consequence the US manufacturing sector is already in recession and it increasingly seems like that we soon will see an outright recession in the US economy and if the Fed continues to ignore that message from the markets then we might risk this turning into a banking crisis once again.

And without commenting too much on the state of Deutsche Bank it is obvious that commentators and central bankers alike once again are becoming overly focused on the banking sector rather than on focusing on monetary conditions and most alarmingly all the major central banks of the world presently seem to be ruling out stepping up quantitative easing and instead continue to focus on short-term nominal interest rates.

Or as Scott wrote in his brilliant 2009-article:

Central bankers misdiagnosed the problem, they were not able to come up with an effective policy response. It was as if a doctor prescribed medicine for a common cold to someone whose illness had progressed to pneumonia. And because economists were confused by the nature of the problem, it appeared as if modern macro offered no solutions. Thus policymakers turned in desperation to old-fashioned Keynesian fiscal stimulus, an idea that had been almost totally discredited by the 1980s.

I so hope that the Fed has learned a lesson from 2008, but I fear the worst.

PS if you wonder what I think the Fed should do then you should read this recent blog post of mine.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

Talking to Ambrose about the overvalued dollar

The Telegraph’s  has an excellent article on the sharp sell-off in the dollar this week. Ambrose quotes me in the article:

Lars Christensen, from Markets and Money Advisory, said the Fed made a grave policy error last year – long before its first rate rise in December – by talking tough and pushing up the dollar.

“They have been looking at notoriously lagging indicators like jobs and downplaying the forward market indicators, like equities and the yield curve. This is a repeat of what they did in 2008. The US is very likely heading into a recession, and the data may start to show this soon,” he said.

It is unusual for the Fed to tighten at a time when the manufacturing index is below the boom-bust line of 50 and nominal GDP growth is trending down, falling to 2.9pc from 4.8pc in late 2014.

Mr Christensen said the Fed’s policy had unwisely compounded the crisis for the whole “dollar bloc”, including China, Hong Kong, the Gulf region and a string of states with dollar ties.

I might be overstating the risk for a US recession and it might be slightly premature to call the recession, but if I would take a bet on this I would certainly be positioning myself for a US recession in 2016.

In terms of the US dollar I am actually a bit split. I think it is quite clear that the dollar is overvalued in real terms against most currencies in the world. However, that does not mean that the dollar should weaken right now.

That to a very large extent dependents on when the Federal Reserve will realize that it has made a policy mistake. My bet on that is that the Yellen’s Fed will remain stubborn for a bit longer and as a consequence keep monetary conditions too tight and postpone monetary easing for some time.

However, the fact that the Fed now certainly has tightened monetary conditions too much and as a consequence might send the US economy into recession in the coming quarters soon or later will cause the Fed to dramatically change course (or at least I hope so!)

Therefore, I think it is a good bet to say that the dollar will be significantly weaken in 12 months than today.

PS I have no clue how the US labour market numbers will come out today and fundamentally I think the labour market data is a pretty worthless indicator of what is going on in the US economy, but since Janet Yellen is obsessing about the US labour market then I guess that I will have to have a look at the data later today…

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

 

‘Googlenomics’ predicts sharp rise in US unemployment

It is no secret that I am quite fascinated by the the idea that social media data might be very useful as early/leading indicators of macroeconomic variables. Said in another way I think that social media activity can be seen as a form of prediction markets.

So recently I have been tracking what Google Trends is saying about the development in searches for different terms that might give an indication about whether we are heading for a recession in the US economy.

Lets start with the world ‘recession’.

Recession Google Trend

The picture is not dramatic and the Google searches for ‘Recession’ clearly is much lower than at the onset of the Great Recession in 2007-8. That said, there has recently been a relatively clear pick up in the ‘recession indicator’ that could indicate that ‘Google searchers’ are increasingly beginning to worry about the US economy entering a recession.

How about the labour market? This is Google searches for ‘Unemployment’.

Unemployment Google trends

This is much more alarming – there has been a very steep rise in Google searches for ‘Unemployment’. In fact the rise is more steep than it was in 2008. This certainly is an indication of a very sharp deterioration of US labour market conditions right now.

The question then is whether Google searches have any prediction power and here the evidence is quite clear that, that is indeed the case. At least that is the conclusion in a recent paper – The Predictive Power of Google Searches in Forecasting Unemployment – by Francesco D’Amuri and Juri Marcucci.

The evidence is in – the Fed should re-start QE rather than hike rates

Janet Yellen’s Federal Reserve have been extremely eager to say that inflation would soon rise due to the continued decline in unemployment and has essentially ignored all monetary and market indicators, which for a long time have indicated that monetary conditions should not be tightened as fast as the Fed has signaled.

That in my view is the main reason why US economic activity now is slowing significantly in and paradoxically that will now very likely push up unemployment. In fact if we trust the signals from Google searches then we are in for a significant deterioration in labour market conditions in the US very soon.

So while the Yellen-Fed seems to ignore monetary indicators at least the fact that unemployment might soon shoot up again should tell the Fed that it is time to dramatically change course.

In fact it now seems more likely that we will have a new round of Quantitative Easing in the next couple of quarters rather than more rate hikes. Or at least that is what the Fed should do to avoid another recession.

PS have a look at a couple of other Google searches as well: ‘jobs’, ‘loan+default’, ‘economic crisis’, ‘bear market’

PPS I seriously thought that Janet Yellen was well-aware of the dangers of repeating the mistakes of 1937. Apparently I was wrong.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

Ted Cruz – Market Monetarist?

Some have recently suggested that Ted Cruz has been inspired by Market Monetarist thinking. I have no clue about that, but at least it seems like Cruz understands now that the Great Recession – as the Great Depression – was caused by too tight monetary policy.

Listening to this recent question to Janet Yellen from Senator Cruz could make you think that has moved away from his former goldbug thinking. That would certainly be good news.

Watch Ted Cruz question Yellen here.

PS No I am not endorsing any US presidential candidate.

Update: A friend sent me this one.

Finland continued economic nightmare

This is from an excellent article from Bloomberg:

A chronically depressed economy, rising unemployment and an aversion to free-market reforms. Sound like a familiar European tale?

But it’s not Greece, Spain or Portugal. It’s Finland.

As the indebted and ailing countries in the euro region’s southern rim struggle out of their six-year crisis, some with more success than others, Finland is succumbing to its own.

Its economy, which has contracted every year since 2012, was the worst performer in the common-currency area in the first three quarters of 2015, according to Eurostat data. Its deficit is relatively higher than Italy’s, despite being ranked fourth in the European Union in terms of how much taxes and social charges it demands from its citizens, and its unemployment rate exceeds those of its Nordic neighbors. The latest data published Wednesday by Statistics Finland showed the jobless rate rising to 9.2 percent in December, the highest level since June 2015.

I have written a lot about Finland (see for example here, herehere and here). It is really a textbook example of how to drag out a recession – no currency flexibility and too tight monetary policy (euro membership), extremely rigid nominal wages (collective bargaining and overly generous welfare benefits) and quite a bit of bad luck (Russian recession and negative terms-of-trade shocks – primarily in the pulp and paper industry). And of course the demise of Nokia…

It is not really that different from Denmark. Denmark has just been a lot more lucky in terms of terms-of-trade shocks (LEGO and Novo are doing great, Nokia has died), but the pegged exchange rate regime is causing the same problems for Denmark as euro membership is for Finland. 

That said, Denmark seems to have significantly higher wage flexibility and Danish labour unions seem to have understood much better than their Finnish counterparts that when there is no currency flexibility then you need downward wage flexibility.

Denmark and Finland’s lacklustre economic performance is particularly striking when you compare it with the performance of Sweden, Norway and Iceland – three other Nordic, but with floating exchange rate regimes.

I have used this graph before, but I think it tells the importance monetary policy quite well.

So either the Finns have to leave the euro or hope for a lot more monetary easing from the ECB and then of course it is time for Finland to scrap the 1970s style collective bargaining system. It is a job killer.

Three simple changes to the Fed’s policy framework

Frankly speaking I don’t feel like commenting much on the FOMC’s decision today to keep the Fed fund target unchanged – it was as expected, but sadly it is very clear that the Fed has not given up the 1970s style focus on the Phillips curve and on the US labour market rather than focusing on monetary and market indicators. That is just plain depressing.

Anyway, I would rather focus on the policy framework rather than on today’s decision because at the core of why the Fed consistently seems to fail on monetary policy is the weaknesses in the monetary policy framework.

I here will suggest three simple changes in the Fed’s policy framework, which I believe would dramatically improve the quality of US monetary policy.

  1. Introduce a 4% Nominal GDP level target. The focus should be on the expected NGDP level in 18-24 month. A 4% NGDP target would over the medium term also ensure price stability and  “maximum employment”. No other targets are needed.
  2. The Fed should give up doing forecasting on its own. Instead three sources for NGDP expectations should be used: 1) The Fed set-up a prediction market for NGDP in 12 and 24 months. 2) Survey of professional forecasters’ NGDP expectations. 3) The Fed should set-up financial market based models for NGDP expectations.
  3. Give up interest rate targeting (the horrible “dot” forceasts from the FOMC members) and instead use the money base as the monetary policy framework. At each FOMC meeting the FOMC should announce the permanent yearly growth rate of the money base. The money base growth rate should be set to hit the Fed’s 4% NGDP level target. Interest rates should be completely market determined. The Fed should commit itself to only referring to the expected level for NGDP in 18-24 months compared to the targeted level when announcing the money base growth rate. Nothing else should be important for monetary policy.

This would have a number of positive consequences.

First, the policy would be completely rule based contrary to today’s discretion policy.

Second, the policy would be completely transparent and in reality the market would be doing most of the lifting in terms of implementing the NGDP target.

Third, there would never be a Zero-Lower-Bound problem. With money base control monetary policy can always be eased also if interest rates are at the ZLB.

Forth, all the silly talk about bubbles, moral hazard and irrational investors in the stock markets would come to an end. Please stop all the macro prudential nonsense right now. The Fed will never ever be able to spot bubbles and should try to do it.

Fifth,the Fed would stop reacting to supply shocks (positive and negative) and finally six the FOMC could essentially be replaced by a computer as long ago suggested by Milton Friedman.

Will this ever happen? No, there is of course no chance that this will ever happen because that would mean that the FOMC members would have to give up the believe in their own super human abilities and the FOMC would have to give up its discretionary powers. So I guess we might as well prepare ourself for a US recession later this year. It seems incredible, but right now it seems like Janet Yellen’s Fed has repeated the Mistakes of ’37.

PS What I here have suggested is essentially a forward-looking McCallum rule.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

 

A framework for understanding Tunisia’s economic crisis

The Arab Spring started in 2010-11 in Tunisia and until now Tunisia has been highlighted as basically the only country, where the Arab Spring has not ended in disaster. Unfortunately over the last couple of days social unrest and violent confrontation between demonstrators and police have erupted across Tunisia.

I this blog post I will have a look at the Tunisian economy and try to give my take on what is wrong with the economy. There is of course a lot of ground to cover and I can naturally not cover it all in one blog post, but I will try provide an overall framework for how to understand the economic situation in Tunisia.

The economy has been in crisis since 2011

A look at real GDP growth in Tunisia shows that the economy essentially has been suffering since the outbreak of the Arab Spring in 2010-11.

tunisia-gdp-growth

Prior to 2011 real GDP growth was averaging 4-5% a year – not very impressive given the high growth rate of the labour force and compared to for example Turkey, but nonetheless fairly robust and stable growth.

However, during the 2011 revolution GDP drop in around 2% and after initially recovering in 2011-12 growth have once against slowed significantly and as a consequence the level of real GDP today is more or less unchanged compared to early 2011.

It is hard not to see the latest social unrest and demonstrations in the light of this lackluster economic performance.

AS/AD – a framework for analyzing the crisis

Whenever I want to analyse the economic situation in any country in the world I find it very useful to start out with a simple AS/AD framework. I particularly like the AS/AD framework described in Tyler Cowen and Alex Tabarrok‘s textbook Modern Principles.

This gives us the possibility to think of three kind of shocks to the economy – An Aggregate Demand (AD) shock (essentially a monetary demand shock), a short-run Aggregate Supply (SRAS) shock and a shock to the long-term growth rate of the economy (this is also supply shock). Cowen and Tabarrok terms the long-term growth rate the Solow growth rate after Robert Solow’s famous growth model.

ASAD framework

We can relatively easily apply this model to the Tunisian economy and by looking at the development in inflation and real GDP we can assess whether the development in the economy is driven by supply shocks or demand (monetary) shocks.

Don’t blame monetary policy for the crisis

If the economy is hit by a negative demand shock – either a contraction in the money supply/base or a drop in money-velocity – the AD curve shifts to the left causing both inflation and real GDP to drop and hence therefore also nominal GDP to drop.

The graph below shows the development in real GDP (y), nominal GDP (y+p) and the GDP deflator (p) in Tunisia.

RGDP NGDP P

The graph shows that over the past 15 years nominal GDP growth has been relatively stable about 8% and even though there was a slowdown in nominal GDP growth in the period 2008-11 we have since seen a rebound in NGDP growth back to the old trend about 8%, which indicates that there has not been a major negative demand shock to the Tunisian economy.

This is further confirmed by the fact that inflation – measured by the GDP deflator – has in fact shifted upwards since 2010-11. If there had been a negative shock to aggregate demand (AD) we would have expected inflation to drop rather than to increase.

This all indicate that the we cannot blame the the present crisis on monetary policy failure and in fact the Tunisian central bank deserves some credit for – knowingly or not – to have kept nominal GDP on a pretty “straight line”, which in my view certainly is the preferable monetary policy.

NGDP trend

This obviously does not mean that monetary policy is perfect – far from it – and I certainly think that monetary reform is badly needed to ensure that monetary policy failure is avoided in the future, but at least over the past 15 years the Tunisian central bank very broadly speaking has got it more or less right.

The biggest risk as I see it now is that the central bank will be tempted to focus on inflation rather than nominal GDP growth and that that might cause the Tunisian central bank to tighten monetary conditions unduly in response to rise inflation caused by non-monetary factors (a negative supply shock).

The best away of avoiding this is to communicate and explicitly target nominal GDP growth at 8% as de facto has been the policy for the past 15 years. Alternatively the central bank could target nominal wage growth as a proxy for NGDP growth.

The real problem is a real problem

As the discussion above slows the main problem in the Tunisian economy right now is not a lack of demand and monetary policy failure cannot be blamed for the marked slowdown in growth particularly since 2011 and the crisis can therefore not be resolved through an easing of monetary conditions.

As a consequence we have to conclude that the problem is one of real factors (the supply side of the economy) rather than nominal factors (monetary conditions).

The question is, however, whether the the slowdown in growth is permanent or temporary. Said in another way has the crisis been caused by a shift to the left of the Short-run Aggregate Supply (SRAS) or is it rather the Solow growth curve, which has shifted to leftwards?

Whether it is the SRAS curve or the Solow growth curve, which has shifted leftwards does matter in terms of the impact on the economy presently, but only a shift in the Solow growth curve should be expected to cause a permanent decline in the long-term growth rate of the Tunisian economy. Below I will argue that it is a bit of both, but that it likely is short-term shocks that has dominated in the last couple of years.

The horrors of terror 

Tunisia has been hard hit by a number of terror attacks in recent years and particularly in 2015 a number of horrible terror attacks hit Tunisia.

One can think of a terror attack both as a demand shock and a supply shock. Hence, it is obvious that a terror attack will tend to scare tourists away and this is certainly also what we have seen.

This obviously is a negative demand shock. However, as we have seen above the Tunisian central bank has more or less kept nominal GDP growth on a 8% growth path. This means that any drop in tourism revenues will be compensated by higher demand growth other places in the economy. This essentially is a version of the so-called Sumner Critique, which says that if a central banks targets nominal GDP or inflation then it will keep aggregate demand growth stable and this will offset other shocks to aggregate demand.

Obviously Tunisian nominal GDP growth has not been completely stable at 8% and we have indeed seen a drop in NGDP growth over the past year, which do indicate some contraction in aggregate demand growth, which could indicate that the Tunisian central bank has not fully offset the shock to aggregate demand from the drop in tourism revenues, however, if the Tunisian central bank – hopefully – continues de facto to target 8% NGDP the effect on aggregate demand from the tourist attacks should prove to be short-lived.

More worryingly is, however, the fact that the threat of new terror attacks and more generally speaking the rise of islamist extremism is causing a more permanent increase in the cost of doing business in Tunisia.

It is hard to quantify just how big these effects are, but it is notable that real GDP slowed from around 2% to 0% during 2015 so the effects have certainly not been small. Whether they are permanent is another question.

The untold story of the ‘Phosphate Crisis’

When I started to think about the slowdown in the Tunisian economy I initially thought that it mostly was about the terror attracts in 2015 and I was unaware of something, which in reality is at least as important – namely what we could term the ‘Phosphate Crisis’.

This is from an article from Al-Monitor from May 2013:

While phosphate is a pillar of the Tunisian economy, it also represents a social time bomb that nearly ousted the regime of former President Zine El Abidine Ben Ali in 2008, when the residents of the mining basin in southwestern Tunisia rose in rebellion, demanding their rights to employment, development and equitable distribution of wealth. Post-2011, protests paralyzing phosphate production became so rampant that the government announced in April the suspension of negotiations with the protesters. It also began a mass media campaign to explain the “phosphate crisis,” stressing these statistics:

The struggles faced by Tunisia’s economy following its 2011 popular uprising have been exacerbated by a decrease in phosphate production, one of the country’s most lucrative resources.
  • Production fell from 8 million metric tons a year to 2.7 million metric tons in 2012.
  • Financial losses reached 3 million dinars ($1.82 million) a day, amounting to a loss of nearly 2 billion dinars ($1.22 billion) in 2011 and 2012.
  • The phosphate company’s workforce tripled from 9,000 to 27,000 workers over the course of three years.

The government even went so far as to threaten to shut down the Gafsa Phosphate Co. The threat baffled [Tunisians], as the company serves as the only operator in mining basin cities and because phosphate is considered a significant source of hard currency in the country. Additionally, the government is currently experiencing several crises of its own, so this sort of escalation would not balance in its favor. Is the threat a political maneuver or an official admission of failure? If the latter is true, does the admission pave the way for the state to give up on “reforms” in the phosphate sector?

Even though the official rhetoric considers the Jan. 14, 2011, Revolution, which toppled Ben Ali, a societal revolution whose flame has been sparked inside the mining sector, all of the post-revolution governments have only shallowly looked into the problem, resulting in the adoption of ineffective administrative solutions.

The government regards the “phosphate crisis” as a mere blip in the flow of production caused by protests that are first and foremost demanding employment. Through the lens of the government, the crisis is temporary, isolated, and related to a lax security and social situation. Some officials even believe that the crisis has “separatist” aspects, and is even a political conspiracy fomented by “extremists who aim to sabotage the economy for political purposes.”

While this is from a 2013 article the crisis continues to this day. Just have a look at this graph of the output in the Tunisian mining sector.

tunisia-gdp-from-mining

Hence, mining output dropped sharply in 2011 and has remained more than 30% lower since then. This obviously is a major negative supply shock to the Tunisian economy and it seems of outmost importance to solve this crisis to get the Tunisian economy out of this crisis.

Corruption is just getting worse and worse

At the core of the protests in 2011 was anger over the widespread corruption in Tunisia and corruption remains a main problem for the Tunisian economy and it is certainly something, which is causing long-term growth to be lower than it could be been (permanently shifting the Solow curve to the left).

The graph below illustrates this.

tunisia-corruption-index@2x

The graph shows Transparency International’s so-called Corruption Perception Index. A lower score in the index indicates more corruption. The development is far from uplifting. In fact of nearly 15 years corruption has been constantly rising in Tunisia as seen by the consistent drop in the Corruption Perception Index.

And the business environment has become less friendly

Another factor that is contributing to shifting the Solow growth curve to the left – permanently lowering real GDP growth – is the fact that despite of the democratic revolution in Tunisia the general business environment has become less friendly.

A way to illustrate this is to look at the World Bank’s Ease of Doing Business survey.

tunisia-ease-of-doing-business@2x

A rise in the index indicates a worsening of the general ‘ease of doing business’ in Tunisia. The picture since 2010 is clear – the business environment has become less friendly in Tunisia. This surely is something, which is lowering Tunisia’s lower term growth potential.

A similarly negative trend is seen in for example Fraser Institute’s Economic Freedom of the World survey, where Tunisia’s overall ranking also have been declining in recent years.

Conclusion – reform is needed to unleash Tunisia’s economic potential

Tunisia is in the midst of a serious political, social and economic crisis. In this blog post I have tried to give an overview of what I believe are the main causes of the economic crisis.

Based on this analysis I would like to offer the following general recommendations for reform and crisis resolution in Tunisia:

  1. Despite the fact that the that Tunisia monetary policy overall has been successful in maintaining nominal stability in the past 15 years monetary reform is needed to ensure that nominal stability is also maintained in the future. A starting point for reform should be to the succes of monetary policy in the past 15 years – that means any new regime should continue to ensure nominal GDP growth around 8%. That would also ensure low and stable inflation in the future.
  2. The threat from terrorism and extremism should to be reduced. That is partly a question of law enforcement, but much more likely it is of outmost importance to empower low-income Tunisians so they to a larger extent are in control of their economic and social destiny and to create economic opportunties for all Tunisians. Other than general economic reform I also think that Tunisians should be given direct ownership of Tunisia’s many government owned companies for example through a Citizen’s account framework.
  3. Bold steps are needed to end the crisis in the Tunisian mining sector. Here privatization of the mining sector should be at the core of these efforts.
  4. Long-term economic growth needs to be increased through massive structural reforms with the purpose to reducing government intervention in the economy and empowering the Tunisian population.

Overall, I think Tunisia has an enormous economic potential – the country has a young and growing population, relatively low public debt, a historical and geographical closeness to (Southern) Europe and by Northern African standards a relatively open economy and access to (some) natural resources.

However, Tunisia cannot unleash this potential without reforms. We have had political revolution – now we need an economic revolution to free up the Tunisian economy.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

Guest post: Tight Money, High Wages: a review of Scott Sumner’s The Midas Paradox

My friend the great economic historian Clark Johnson has written a review of Scott Sumner’s new book The Midas Paradox.

I am very happy that Clark has given me the possibility to publish the review on my blog as a guest post.

If you are interested in the causes of the Great Depression you should certainly read Scott’s new book, but you should not miss Clark’s own book on the Great Depression Gold, France, and the Great Depression, 1919-1932

Here is Clark’s review…

Tight Money, High Wages: a review of Scott Sumner’s The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression (Independent Institute, 2015)

By Clark Johnson

January 2016

Scott Sumner’s new book, The Midas Paradox, uses a “gold market approach” to understand the causes and persistence of the depression of the 1930s.  By wide agreement, the roots of the 1929-1932 depression lay in a shortfall of aggregate demand – which was a consequence of systemic monetary constraint.  Sumner uses the world’s quantity of monetary gold and the ratio of gold-to-money to determine the stance of monetary policy and to identify lost opportunities.  The more usual indicators of interest rates and the quantity of money turn out to be misleading under a gold standard.

He then moves beyond the roots of the downturn to the reasons for persistence of weak economic conditions for years after the underlying monetary problem was solved.  He develops the unexpected view that the US in particular saw a supply-side depression that began in 1933, one driven in large part by New-Deal-driven interferences in labor markets.

Monetary Origins of Depression

Sumner credits what he calls the Mundell-Johnson hypothesis, according to which the roots of the depression were in the post-WWI undervaluation of gold, as a precursor to his study. As the junior placeholder on that hypothesis, I recap my understanding of it here.  The purchasing power of an ounce of gold changed little from the middle of the seventeenth century to the middle of the twentieth.  Gold constraints were typically relaxed during wars to facilitate official spending and borrowing – and allowing price inflation.  But English deflation restored prewar price levels in the years after the Puritan wars of the seventeenth century and the Napoleonic wars of the nineteenth.

A similar deflation was likely to occur after the First World War as major economies of Germany, Britain, and France would return to gold convertibility at the prewar value of $20.67/ ounce during the 1920s.  The low postwar gold value affected monetary reserves in two ways: 1) it depressed the value of outstanding stocks; and 2) it reduced the price incentive for new gold production.  In France, the US, and Germany, which had traditionally had large gold coin circulations, gold was mostly taken out of circulation during and after the war, which lessened confidence in convertible paper money.  Economist Gustav Cassel drew attention to the “gold standard paradox,” by which a gold-based monetary system would require ever-increasing gold production to accommodate economic growth while maintaining reserve ratios.

Yet world gold production during the 1920s was below what it had beezn in the decade before the war; and given the postwar decline in gold’s purchasing power, the real value of new gold produced in the mid-1920s was just over 50 percent of what it had been in 1914.

Read the rest of the review here

‘Currency instability’ should NOT be a concern for Canada

The commodity currencies of the world continues to take a beating on the back of the sharp drop in oil prices. This is now causing some to fear “currency instability”. Just these this story from Canada’s Financial Post:

The Canadian dollar is falling too far and too fast, damaging public and business confidence in Canada, say economists.

National Bank Financial Markets warned in a new report Monday that the loonie is now out of line with fundamentals and the Bank of Canada cannot risk driving it even lower with a rate cut.

“Currency instability has become a concern, and we think the Bank of Canada must take note,” said Stéfane Marion, chief economist at National Bank. “For Canadian businesses, currency depreciation has already sent the price of machinery and equipment (73% of which is imported) to a new record high. This is bound to complicate Canada’s transition to a less energy-intensive economy.”

Marion said that by his team’s calculations, the loonie should have shed about 10 cents against the U.S. dollar in the past few months. But it has fallen by 25 cents.

…“Rarely has it tumbled so far so fast, and against so many currencies,” Marion said. “The steepness of the CAD’s depreciation against the USD is without precedent — 33%, or 3.5 standard deviations, in 24 months.”He warned that in order to help create some stability for the loonie, the Bank of Canada should not cut interest rates at its Wednesday meeting. Doing so would risk sending the currency as low as 66 cents this week.

“In our view, the Bank of Canada would be better to keep its powder dry this month and act, if need be, after the next federal budget when it will be better able to assess fiscal support to the economy,” Marion said.

Economists aren’t the only ones warning about the damage of a lower loonie. Jayson Myers, chief executive of Canadian Manufacturers & Exporters, told Bloomberg Monday that exchange rate volatility has hurt business confidence and put a chill on spending decisions.

“My advice right now would be to even take a look at increasing interest rates by a quarter of a point,” he told Bloomberg. “Interest rates are low already. A little bit of dollar stability would be better.”

Sorry guys, but this is all nonsense. There are absolutely no sign of “currency instability” (whatever that is) and there are no signs at all that the drop in the Canadian dollar is causing any financial distress.

In fact if we look at the development in the Canadian dollar in recent weeks it has developed completely as we would have been expected given the drop in oil prices and given the developments in global currency markets in general.

I have earlier argued that we could think of the Canadian free floating currency regime basically as a regime that shadows an Export Price Norm. Hence, the Loonie is developing as if it is pegged to a basket of oil prices (15%), the US dollar 65% and Asian currencies (yen and won, 20%).

The graph below shows the actual development in USD/CAD and a “predicted” USD/CAD had Bank of Canada pegged the Loonie to 65-20-15 basket.

CAD EPN

The graph is pretty clear – there is nothing unusual about the development in the Loonie. Yes, the Loonie has weakened significantly, but this can fully be explained by the drop in oil prices and by the weakening of the Asian currencies (in the basket primarily the drop in the won) and of course by the general continued strengthening of the US dollar.

If anything this is a sign that the Bank of Canada remains credible and that the markets are confident that the BoC will be able to ease monetary conditions further to offset any demand shock to the Canadian economy due to lower export prices (oil prices).

Therefore, it is also obvious that the BoC should not undertake any action to curb the weakening of the Loonie. In fact if the BoC tried to curb the Loonie sell-off then the result would be a dramatic tightening of monetary conditions, which would surely push the Canadian economy into recession and likely also create public finance troubles and increase the risk of a financial crisis. Luckily the Bank of Canada for now seems to full well-understand that there is absolutely no point of intervening in the FX market to curb the Loonie sell-off. Well-done!

HT Dr. Brien.

Yellen’s recession and that horrible Phillips Curve

The global stock markets are taking yet another beating today and as I am writing this S&P500 is down nearly 3.5% and the latest round of US macroeconomic data shows relatively sharp slowdown in the US economic activity and more and more commentators and market participants are now openly taking about the risk of a US recession in the coming quarters.

Obviously part of the story is China, but at the core of this is also is the fact that Fed chair Janet Yellen has been overly eager to interest rates despite the fact that monetary and market indicators have not indicated any need to monetary tightening. It is only the defunct Phillips Curve that could led Yellen to draw the conclusion that monetary tightening is needed in the US.

Back in August I wrote:

To Janet Yellen changes in inflation seems to be determined by the amount of slack in the US labour market and if labour market conditions tighten then inflation will rise. This of course is essentially an old-school Phillips curve relationship and a relationship where causality runs from labour market conditions to wage growth and on to inflation.

This means that for the Yellen-fed labour market indicators essentially are as important as they were for former Fed chairman Arthur Burns in the 1970s and that could turn into a real problem for US monetary policy going forward.

…Central banks temporary can impact real variables such as unemployment or real GDP, but it cannot permanently impact these variables. Similarly there might be a short-term correlation between real variables and nominal variables such as a correlation between nominal wage growth (or inflation) and unemployment (or the output gap).

However, inflation or the growth of nominal income is not determined by real factors in the longer-term (and maybe not even in the short-term), but rather than by monetary factors – the balance between demand and supply of money.

The Yellen-fed seems to be questioning Friedman’s fundamental insight. Instead the Yellen-Fed seems to think of inflation/deflation as a result of the amount of “slack” in the economy and the Yellen-fed is therefore preoccupied with measuring this “slack” and this is what now seems to be leading Yellen & Co. to conclude it is time to tighten US monetary conditions.

This is of course the Phillips curve interpretation of the US economy – there has been steady job growth and unemployment is low so inflation most be set to rise no matter what nominal variables are indicating and not matter what market expectations are. Therefore, Yellen (likely) has concluded that a rate hike soon is warranted in the US.

This certainly is unfortunately. Instead of focusing on the labour market Janet Yellen should instead pay a lot more attention to the development in nominal variables and to the expectations about these variables.

…If we look at nominal variables – the price level, NGDP, the money supply and nominal wages – the conclusion is rather clear. The Fed has actually since 2009 delivered a remarkable level of nominal stability in terms of keeping nominal variables very close to the post-2009 trend.

If we want to think about the Bernanke-Fed the Fed had one of the following targets: 1.5% core PCE level targeting, 4% NGDP level targeting, 7% M2-level targeting or 2% wage level targeting at least after the summer of 2009.

However, the Yellen-Fed seems to be focusing on real variables – and particularly labour market variables – instead. This is apparently leading Janet Yellen to conclude that monetary conditions should be tightened.

However, nominal variables are telling a different story – it seems like monetary conditions have become slightly too tight within the past 6-12 months and therefore the Fed needs to communicate that it will not hike interest rates in September if it wants to keep nominal variables on their post-2009 path.

Obviously the Fed cannot necessarily hit more than one nominal variable at the time so the fact that it has kept at least four nominal variables on track in the past 5-6 years is quite remarkable. However, the Fed needs to chose one nominal target and particularly needs to give up the foolish focus on labour market conditions and instead fully commit to a nominal target. My preferred target would certainly be a 4% (or 5%) Nominal GDP level target.

And Chair Yellen, please lay the Phillips curve to rest if you want to avoid sending the US economy into recession in 2016!

Obviously Yellen did not get the memo and now we are exactly risking that recession that I warned about in August.

And no I am not bragging about my ability to forecast. In fact I am doing the exact opposite. In August the markets were telling us that there was no inflationary pressures (and I was only repeating that), but Yellen has all along insisted that the market expectations about inflation were wrong and that the Phillips Curve was right. That might turn out to be a costly mistake.

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