All posts tagged Regime Uncertainty

Guest post: Thoughts on Policy Uncertainty (Alex Salter)

Even though I think the primary economic problem in the US and in Europe at the moment is weak aggregate demand due to overly tight monetary policy I certainly do not deny the fact that both the US and the euro zone face other very significant problems. Among these problems are considerable “regime uncertainty”. In fact I believe that regime uncertainty is the key economic problem in a number of countries such as Venezuela, Argentina and Hungary. I have in earlier posts (see links below) argued that regime uncertainty primarily should be seen as supply side phenomena. However, regime uncertainty can also be seen as a demand side problem.

In today’s guest post the young and talented Alex Salter discusses a framework in which to discuss regime uncertainty or policy uncertainty – both as a supply side and a demand side phenomena. I think Alex’s discussion is highly relevant  and is quite useful in understanding regime uncertain conceptually .

Enjoy Alex’s guest post.

Lars Christensen.

Guest post: Thoughts on Policy Uncertainty

By Alex Salter, George Mason University

There’s been some talk lately about policy uncertainty and its effect on economic activity.  It’s important to pin down just what economic effects we’re talking about here.  In particular, we need to decide whether policy uncertainty (also called ‘regime uncertainty’ by economist Robert Higgs, who was talking about it before it was in vogue) is a demand-side or a supply-side phenomenon.  I’ve seen arguments for both sides.

Here’s my take on it: In the short-run it’s a demand phenomenon.  But it has long-run supply consequences.

Policy uncertainty stems from uncertainty with respect to the future structure of property rights.  If I’m not sure what regulatory policy, tax liability, etc. for various economic activities will look like, then there’s a real option value to holding off on investing in an enterprise (Avinash Dixit has some really interesting papers on this).  This, of course, means lower investment spending than there would be otherwise.  The standard Aggregate Demand-Aggregate Supply (ADAS) framework provides a quick-and-dirty way of looking at this.

First off, let’s work in growth rates instead of levels.  I think it makes the analysis easier.  The AD curve is given by.  This is the dynamic form of the familiar quantity equation,.  The little g denotes growth rates.  Note that the AD curve shows all combinations of inflation and real income growth that map to a constant level of nominal income growth.

AS is, as usual, broken down into short-run and long-run components.  SRAS is a standard Lucas supply curve, which is an increasing function of inflation expectations.  LRAS depends on the real productive capacity of the economy; it is vertical to reflect long-run monetary neutrality.

In the short run, policy uncertainty manifests itself as reduced investment expenditure.  Assuming a constant level of money supply growth, this is essentially a negative velocity shock, and hence a negative AD shock, as shown below:

The economy, initially in long-run equilibrium at point a, moves to point b, below its long-run potential growth rate.

Ordinarily, the reduction in money flows throughout the economy would put downward pressure on prices, leading to disinflation (or outright deflation if the shock is big enough).  The SRAS curve would shift down as the economy adapted to the new expenditure pattern, bringing us back to long-run equilibrium with the same growth rate as point a, but lower equilibrium inflation.

However, this is not the whole story.  Policy uncertainty, by hampering investment spending, has lowered the rate of capital formation relative to what it would have been in the uncertainty-free counterfactual.  The old long-run growth rate, given by the position of the LRAS curve, is no longer sustainable due to this reduced rate of capital accumulation.  The long-run effects of policy uncertainty are reflected in a reduced potential growth rate for the economy, represented by an inward shift of the LRAS curve:

As I have drawn it, the inward LRAS shift meets the transition down AD’ (reflecting larger income growth relative to inflation growth over time, still yielding a constant level of nominal income growth).  The result is long-run equilibrium at point c.  Again, real income growth is permanently lower because regime uncertainty, by hampering capital formation, has reduced the economy’s real productive activity vis-à-vis the no-uncertainty world.

This is obviously an oversimplified (and overaggregated!) model, but I think it captures the short-run/long-run distinction well enough for the purposes of getting our thinking straight.  There are all sorts of bells and whistles you could add to this.  For example, you could look at what happens after the uncertainty plays out (property rights become better-defined, either at a permanently “stronger” or “weaker” level).  The new equilibrium would be different depending on how you model actor expectations (rational, adaptive, etc.)  The grad students out there might want to spice things up by examining this in a Ramsey-style model and playing with the dynamics.

Now that we’ve got our terminology squared away, we can proceed to the really interesting questions—namely, how regime uncertainty plays out at the micro level, with the accompanying distortions in relative prices (and thus resource misallocations).  There are all sorts of political economy implications to work through as well.

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Related posts:

Regime Uncertainty, the Balkans and the weak US recovery
Papers about money, regime uncertainty and efficient religions
”Regime Uncertainty” – a Market Monetarist perspective
Monetary disorder in Central Europe (and some supply side problems)

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4 Comments
by Lars Christensen on November 12, 2012  •  Permalink
Posted in Alex Salter, Guest blog, Guest post, Regime Uncertainty, Robert Higgs
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Posted by Lars Christensen on November 12, 2012

http://marketmonetarist.com/2012/11/12/guest-post-thoughts-on-policy-uncertainty-alex-salter/

Regime Uncertainty, the Balkans and the weak US recovery

Today I have been in Oslo, Norway for client meetings. The topic on the agenda is Central and Eastern Europe and particularly the investment climate in South Eastern Europe. That gives me reason to discuss a favourite topic of mine – “regime uncertainty – as defined by Robert Higgs – and why the present lacklustre recovery in the US economy is unlikely in anyway to be related to such regime uncertainty.

As an economist who have been working professionally with Emerging Markets for more than I decade I know about regime uncertainty. In fact I think you to some extent can define an Emerging Markets economy as an economy where regime uncertainty is a dominant factor in the economy.

Robert Higgs basically defines regime uncertainty as a lack of protection of property right and a lack of respect for the rule of law. This is a serious problem in many Emerging Markets – including in the South Eastern European countries, which has been the focus of my meetings today.

My favourite source for a numerical measure of these uncertainties is the conservative Heritage Foundation’s Economic Freedom Index. We can use the sub-index for “Rule of Law” in the Economic Freedom Index as a proxy for “regime uncertainty”.

Let’s as an example look at two random South Eastern European countries – Albania and Bulgaria. Here is what Heritage Foundation has to say about the “Rule of Law” in Albania:

“Albania still lacks a clear property rights system, particularly for land tenure. Security of land rights remains a problem in coastal areas where there is potential for tourism development. Although significant reforms of the legal system are underway, the courts are subject to political pressures and corruption. Protection of intellectual property rights is weak. Albania is a major transit country for human trafficking and illegal arms and narcotics.”

And similarly for Bulgaria:

“Respect for constitutional provisions securing property rights and providing for an independent judiciary is somewhat lax. The judicial system is unable to enforce property rights effectively, and inconsistent application of the rule of law discourages private investments. Despite legal restrictions, government corruption and organized crime present a threat to Bulgaria’s border security.”

In my view the Heritage Foundation’s description of the lack of respect for the rule of law and property rights in Albania and Bulgaria is pretty close to the reality in these two countries. So there is no doubt that there in both countries are a considerably degree of regime uncertainty.

This heightened level of regime uncertainty very likely is having a considerably negative impact on both foreign direct investments and domestic investments in both countries and therefore on the long-term growth prospects of these countries. Who would for example invest in a sea sight hotel in Albania it might be stolen from you tomorrow or in a year – maybe even with the tacit support of government officials?

Bulgaria and Albania are just two examples of serious regime uncertainty, but many (most!) developing economies and Emerging Markets around the world have serious problems with regime uncertainty. Therefore, as an Emerging Markets economist I find this issue highly relevant. However, I should also stress that I believe regime uncertainty is a supply side phenomenon. Regime uncertainty hampers investment, which reduces the productive capacity of the economy and hence reduces productivity growth, but as aggregate demand in the economy is determined by monetary factors regime uncertainty – in Higgs’ sense – cannot be a demand phenomenon. Yes, regime uncertainty can impact the composition of demand but not aggregate demand in the economy.

The best way to illustrate that regime uncertainty is a supply side phenomenon is to look at three contemporary examples – Venezuela, Argentina and Iran. The regimes in all three countries obviously have very little respect for the rule of law and there is weak protection of property rights in all three countries. However, all three countries also are struggling with high – and to some extent even escalating – inflation. If regime uncertainty were a demand phenomenon then inflation would be low and falling in these countries. It is not.

When I listen to the present political-economic debate in the US many conservative and libertarians economists and commentators (who I would normally tend to agree with) point to regime uncertainty as a key reason for the weak US recovery. Frankly speaking while I acknowledge that there might have been a rise in regime uncertainty in the US – in frank I am certain there has been – I doubt that it in any meaningful way can be said to have had a notable and sizable negative impact on US investment activity. Furthermore, the US economy is showing all the signs of having a demand side problem rather than a supply side problem. If the US economy had undergone a serious negative supply shock then US inflation would has been increasing – as is the case in for example Iran. US inflation is not increasing – rather since 2008 US PCE core inflation has averaged a little more than 1% a year on average.

Furthermore, even though uncertainty about the outlook for US tax rules have increased and Obamacare likely have had a negative impact on the overall investor sentiment in the US it would be rather foolish to claim that property rights are not well-protected in the US.  This is what Heritage Foundation has to say about the rule of law in the US:

“Property rights are guaranteed, and the judiciary functions independently and predictably. Serious constitutional questions related to government-mandated health insurance have been under consideration in the courts. Corruption is a growing concern as the cronyism and economic rent-seeking associated with the growth of government have undermined institutional integrity.”

Even though Heritage Foundation highlights some negative factors the US can hardly be said to be Bulgaria and Albania. In fact the US is in the very top in the world when it comes to protection of property rights and the respect for the rule of law. I therefore doubt that US multinational companies like Apple of Coca Cola are seriously concerned about the rule of law in the US when you take into account that these companies have been seeing there strong sales and income growth in Emerging Markets like China, India, Russia and Brazil.

In fact I could understand if these US companies would be concerned about the present regime uncertainty in China in connection with the ongoing leadership change in the Chinese communist party, the crackdown on freedom of speech in Russia under president Putin’s leadership, the scaling back of economic reforms in India or the ad hoc nature of changes to taxation of inward investments into Brazil.

So while I certainly remain concerned about the regulatory developments in the US over the past decade (yes it started well before Obama became president) I doubt that the present lacklustre recovery can be blamed on these problems. The reason for the lacklustre recovery is rather monetary uncertainty rather than regime uncertainty. Since 2008 US monetary policy has moved away from a ruled based regime to a highly discretionary and to some extent highly unpredictable regime. That is the problem.

So yes, US companies are likely worried about regime uncertainty, but it likely worries about regime uncertainty in China or Brazil rather than regime uncertainty in the US.

A simple way to illustrate this is to look at the Heritage Foundation’s score for protection of property rights in some of the countries mentioned in this blog post. Heritage Foundation considers a score between 80 and 100 to be a “free country”. It is very clear from the graph that investors should worry (a lot) about the protection of property rights in Albania, Bulgaria or in the so-called BRIC economies, but I doubt that many international investors have sleepless nights over the whether or not property right will be well-protected in the US.

Finally I am as worried about the rise of interventionist economic policies in the US and in Europe as anybody else, but we should be right for the right reasons. Interventionist economic policies surely reduce the growth prospects in the US and Europe, but that is supply side concerns for the longer run and we can’t blame these failed policies for the weak recovery.

6 Comments
by Lars Christensen on October 31, 2012  •  Permalink
Posted in Argentina, Regime Uncertainty, Robert Higgs
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Posted by Lars Christensen on October 31, 2012

http://marketmonetarist.com/2012/10/31/regime-uncertainty-the-balkans-and-the-weak-us-recovery/

Monetary disorder in Central Europe (and some supply side problems)

Last week we got GDP numbers for Q2 in both the Czech Republic and Hungary. Both countries plunged deeper into recession and as it is the case in most other countries in Europe the cause of the misery is monetary disorder. This is documented in two news pieces of research. One on Hungary by Steve Hanke and one the Czech Republic by myself.

Both pieces of research are actually more traditional monetarist in nature than market monetarist as the focus in both papers are on the lackluster growth in the broad money supply rather than on nominal GDP or on market pricing. However, the same analysis could easily have been conducted by looking at nominal GDP rather than the money supply.

Even though the two countries are similar in many ways – population size (around 10 million), economic development (transitional economies, middle income economies) and monetary policy regimes (inflation targeting and floating exchange rates) – there are also many differences such as the level of indebtedness (Hungary is high indebted and the Czech Republic have low levels of public and private debt).

I think both countries are highly interesting in terms of understanding the present global crisis. The Czech Republic is in a deep recession and is showing no signs of recovery and seems to be caught in a disinflationary trap. While many argue that the present global crisis is a “balance sheet recession” or a natural hangover after a too wild party that can hardly be argued for the Czech Republic. The country has quite low levels of private and public debt and the banking sector is quite healthy compared to most European economies. So it is hard to argue that the Czech recession is the result of too much debt or a bursting property market bubble. There is really only one cause: A failed monetary policy. I try to document that in the paper I have written in my day-job as head of Emerging Markets research at Danske Bank. Read the paper “Time for the CNB to take bold action” here.

I have for some time seen Hungary as the odd man out in Europe as Hungary’s main problem at the moment in my view is not monetary, but rather a deeper structural problem. Hungary has basically not seen any economic growth since 2006 and despite of that inflation has continued to run well above the Hungarian central bank’s inflation target of 3%. This to me is an indication of significant supply side problems in the Hungarian economy. The main supply side problem in Hungary is massive political uncertainty and a highly erratic conduct of economic policy. Hence, political uncertainty has dominated all economic decisions in Hungary for at least a decade. Hungary is probably the best example in Europe of what Robert Higgs has called “regime uncertainty”. Regime uncertainty basically mean that political and institutional uncertainty – such as uncertainty about tax rules – hampers investments and general entrepreneurial activity and therefore lowers productivity growth. Regime uncertainty therefore is a supply side phenomena. I strongly believe that this is at the core of Hungary’s lack of growth in that last 6 years. That said, I also agree that particular since 2010 monetary conditions have become tighter in Hungary and the monetary contraction has become especially nasty in the last six months of so.

In his new piece at Cato@Liberty Steve Hanke discusses particular the monetary developments in Hungary in the last couple of quarters. I especially like Steve’s discussion of the policy mix in Hungary – that is fiscal policy versus monetary policy:

“When monetary and fiscal policies move in opposite directions, the economy will follow the direction taken by monetary (not fiscal) policy – money dominates. For doubters, just consider Japan and the United States in the 1990s. The Japanese government engaged in a massive fiscal stimulus program, while the Bank of Japan embraced a super-tight monetary policy. In consequence, Japan suffered under deflationary pressures and experienced a lost decade of economic growth.

In the U.S., the 1990s were marked by a strong boom. The Fed was accommodative and President Clinton was super-austere – the most tight-fisted president in the post-World War II era. President Clinton chopped 3.9 percentage points off federal government expenditures as a percent of GDP. No other modern U.S. President has even come close to Clinton’s record.”

This is of course is two examples of the so-called Sumner critique, which I discussed in recent post on German monetary and fiscal policy after the German reunification.

I agree with Steve – the reason for lack of growth in the Hungarian economy is not due to fiscal tightening. It is due to supply side problems – massive regime uncertainty – and recently also due to an unwarranted tightening of monetary conditions.

So yes, the recent drop in economic activity in both the Czech Republic and Hungary is certainty due to a renewed monetary contraction, but while I think the “fix” is it pretty simple for the Czech Republic (ease monetary policy aggressively and soon) I am more skeptical that monetary easing alone will provide a lot of longer lasting help for the Hungarian economy. Hungary desperately needs to improve the general investor climate and implement real supply side reforms and most of all there is a need to reduce regime uncertainty. One might add that the tight monetary conditions in the Czech Republic likely is also creating supply side problems as the Czech government has reacted to the deterioration of public finances caused by low growth by sharply increasing taxes. Supply side problems and tight monetary policy is hardly a combination that gets you out of recession.

7 Comments
by Lars Christensen on August 20, 2012  •  Permalink
Posted in Czech Republic, Hungary, Regime Uncertainty, Robert Higgs, Steve Hanke
Tagged , , , , ,

Posted by Lars Christensen on August 20, 2012

http://marketmonetarist.com/2012/08/20/monetary-disorder-in-central-europe-and-a-some-supply-side-problems/

”Regime Uncertainty” – a Market Monetarist perspective

My outburst over the weekend against the Rothbardian version of Austrian business cycle theory was not my normal style of blogging. I normally try to be non-confrontational in my blogging style. Krugman-style blogging is not really for me, but I must admit my outburst had some positive consequences. Most important it generated some good – friendly – exchanges with Steve Horwitz and other Austrians.

Steve’s blog post in response to my post gave some interesting insight. Most interesting for me was that Steve highlighted Robert Higgs’ “Regime Uncertainty” theory of the Great Depression.

Higg’s thesis is that the recovery from the Great Depression was prolonged due to “Regime Uncertainty”, which hampered especially growth in investment. Here is Higgs:

“The hypothesis is a variant of an old idea: the willingness of businesspeople to invest requires a sufficiently healthy state of “business confidence,” and the Second New Deal ravaged the requisite confidence …. To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights.”

Overall I think Higgs’ concept makes a lot of sense and there is no doubt that uncertainty about economic policy had negative impact on the performance of the US economy during the Great Depression. I would especially highlight that the so-called National Industrial Recovery Act (NIRA) and the Smoot-Hawley tariff act not only had directly negative impact on the US economy, but mostly likely also created uncertainty about core capitalist institutions such as property rights and the freedom of contract. This likely hampered investment growth in the way described by Higgs.

However, I am somewhat critical about the “transmission mechanism” of this regime uncertainty. From the Market Monetarist perspective recessions are always and everywhere a monetary phenomenon. Hence, in my view regime uncertainty can only impact nominal GDP if it in someway impact monetary policy – either through money demand or the money supply.

This is contrary to Higgs’ description of the “transmission mechanism”. Higgs’ description is – believe it or not – fundamentally Keynesian in its character (no offence meant Bob): An increase in regime uncertainty reduces investments and that directly reduces real GDP. This is exactly similar to how the fiscal multiplier works in a traditional Keynesian model.

In a Market Monetarist set-up this will only have impact if the monetary authorities allowed it – in the same way as the fiscal multiplier will only be higher than zero if monetary policy allow it. See my discussion of fiscal policy here.

Hence, from a Market Monetarist perspective the impact on investment will be only important from a supply side perspective rather than from a demand side perspective. That, however, does not mean that it is not important – rather the opposite. What makes us rich or poor in the long run is supply side factor and not demand side factors.

The real uncertainty is nominal

While a drop in investment surely has a negative impact on the long run on real GDP growth I would suggest that we should focus on a slightly different kind of regime uncertain than the uncertainty discussed by Higgs. Or rather we should also focus on the uncertainty about the monetary regime.

Let me illustrate this by looking at the present crisis. The Great Moderation lasted from around 1985 and until 2008. This period was characterised by a tremendously high degree of nominal stability. Said in another way there was little or no uncertainty about the monetary regime. Market participants could rightly expect the Federal Reserve to conduct monetary policy in such a way to ensure that nominal GDP grew around 5% year in and year out and if NGDP overshot or undershot the target level one year then the Fed would makes to bring back NGDP on the “agreed” path. This environment basically meant that monetary policy became endogenous and the markets were doing most of the lifting to keep NGDP on its “announced” path.

However, the well-known – even though not the official – monetary regime broke down in 2008. As a consequence uncertainty about the monetary regime increased dramatically – especially as a result of the Federal Reserve’s very odd unwillingness to state a clearly nominal target.

This increase in monetary regime uncertainty mean that market participants now have a much harder time forecasting nominal income flows (NGDP growth). As a result market participants will try to ensure themselves negative surprises in the development in nominal variables by keeping a large “cash buffer”. Remember in uncertain times cash is king! Hence, as a result money demand will remain elevated as long as there is a high degree of regime uncertainty.

As a consequence the Federal Reserve could very easily ease monetary conditions without printing a cent more by clearly announcing a nominal target (preferably a NGDP level target). Hence, if the Fed announced a clear nominal target the demand for cash would like drop significantly and for a given money supply a decrease in money demand is as we know monetary easing.

This is the direct impact of monetary regime uncertainty and in my view this is significantly more important for economic activity in the short to medium run than the supply effects described above. However, it should also be noted that in the present situation with extremely subdued economic activity in the US the calls for all kind of interventionist policies are on the rise. Calls for fiscal easing, call for an increase in minimum wages and worst of all calls for all kind of protectionist initiatives (the China bashing surely has gotten worse and worse since 2008). This is also regime uncertainty, which is likely to have an negative impact on US investment activity, but equally important if you are afraid about for example what kind of tax regime you will be facing in one or two years time it is also likely to increase the demand for money. I by the way regard uncertainty about banking regulation and taxation to a be part of the uncertainty regarding the monetary regime. Hence, uncertainty about non-monetary issues such as taxation can under certain circumstances have monetary effects.

Concluding at the moment – as was the case during the Great Depression – uncertainty about the monetary regime is the biggest single regime uncertain both in the US and Europe. This monetary regime uncertainty in my view has tremendously negative impact on the economic perform in both the US and Europe.

So while I am sceptical about the transmission mechanism of regime uncertainty in the Higgs model I do certainly agree that we need regime certain. We can only get that with sound monetary institutions that secure nominal stability. I am sure that Steve Horwitz and Peter Boettke would agree on that.

8 Comments
by Lars Christensen on February 14, 2012  •  Permalink
Posted in Monetary institutions, NGDP Targeting, Nominal Income Targeting, Peter Boettke, Reading recommendations, Steven Horwitz, The Great Depression, The Great Moderation, Transmission mechanism
Tagged , ,

Posted by Lars Christensen on February 14, 2012

http://marketmonetarist.com/2012/02/14/regime-uncertainty-a-market-monetarist-perspective/

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