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Narayana – this might be love

Narayana Kocherlakota is fast becoming my favourite US central banker (leaving out a number of fed economists like Bob Hetzel who obviously is my main man at the fed…). Here is Kocherlakota:

“Let me turn then to the current stance of monetary policy. Five years ago, in October 2007, the Federal Reserve had under $900 billion of assets, mostly in the form of short-term Treasuries. It was targeting a fed funds rate—the short-term interbank lending rate—of just under 5 percent. Five years later, the Federal Reserve owns nearly $3 trillion of assets, mostly in the form of long-term government-issued or government-backed securities. It plans to buy still more over the remainder of 2012. It has also been targeting a fed funds rate of under a quarter percent for nearly four years—and anticipates continuing to do so through mid-2015. In the language of central banking, the Fed’s policy stance is considerably more accommodative than it was five years ago.

Some observers argue that the Fed has done too much, has been too accommodative. I strongly disagree. These critics are certainly right that the Fed’s actions—tripling its balance sheet and keeping the fed funds rate near zero for years—are historically unprecedented. But it is also clear that the economy has been hit by the worst shock in 80 years. Over the past five years, Americans have lost jobs and a great deal of wealth. Relative to 2007, people remain uncertain about future employment and income. Businesses, too, are less certain about future demand for their goods. These changes and uncertainties make firms and households less willing to spend, and so push down on both employment and prices. In order to fulfill its dual mandate of promoting price stability and promoting maximum employment, the FOMC must offset these adverse shocks by making monetary policy more accommodative.

In light of the unusually large macroeconomic shock, I believe that it is misleading to assess the FOMC’s actions by comparing its current choices to policy steps taken over the past 30 years. Instead, we have to assess monetary policy by comparing the economy’s performance relative to the FOMC’s goals of price stability and maximum employment. In particular, if the FOMC’s policy is too accommodative, that should manifest itself in inflation above the Fed’s target of 2 percent. This has not been true over the past year: Personal consumption expenditure inflation—including food and energy—is running closer to 1.5 percent than the Fed’s target of 2 percent.1

But this comparison using inflation over the past year is at best incomplete. Current monetary policy is typically thought to affect inflation with a one- to two-year lag. This means that we should always judge the appropriateness of current monetary policy using our best possible forecast of inflation, not current inflation. Along those lines, most FOMC participants expect that inflation will remain at or below 2 percent over the next one to two years. Given how high unemployment is expected to remain over the next few years, these inflation forecasts suggest that monetary policy is, if anything, too tight, not too easy.”

I used to think Kocherlakota had no clue about monetary policy. I was obviously completely wrong –  Kocherlakota is very clearly one of the most clever fed voices around.

PS Scott Sumner also comments on Kocherlakota.

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Sandy is BAD NEWS. The two graph version.

Let me just quote Steve Horwitz’s latest Facebook update:

“It’s a good thing I shaved my head this morning or else I’d be tearing out my peach fuzz with my fingernails thanks to the plethora of broken windows fallacies being bandied about in the media today. If you think Sandy is “good for the economy,” you are hereby remanded to my Econ 100 class (and ordered to read endless Bastiat) and I expect to see you cheering the next disaster that kills people because it boosts the demand for funeral homes and cemeteries.

Disasters, whether natural or social, DESTROY WEALTH AND MAKE US WORSE OFF. Period. End of sentence. There is NO “silver lining.” The economy would be BETTER OFF HAD SANDY NEVER HAPPENED. Got it?”
I got more hair than Steve, but he is spot on. It is unbearable to hear the stories about Sandy being good news for the US economy. Sandy is horrible news – for the the victims and for the US economy. Any other view is bordering idiotic.
Here is the two graph version of Sandy. Sandy is a negative supply shock and not a positive demand shock (that is what the journalists – and some keynesians – apparently fail to understand…). Sandy destroys production resources and disrupts production. That shifts the AS curve to the left (from AS to AS’) and reduces productions (from Y to Y’) and increases prices (from P to P’). That’s not good news. That is BAD NEWS.
But it could be worse! Imagine you have a inflation/price level targeting central bank that targets prices at P. Then it would tighten monetary policy and shift the AD curve to the left (to AD”) – maintaining prices at P and reducing production to Y”. This is what would have happened if Sandy had hit Europe. Yes, the ECB would have tightened monetary policy in reaction to Sandy – just remember what the ECB did in 2011 after the Japanese tsunami.
Update: I decided to add a picture to this post – this guy knew about the “Sandy fallacy”.

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.

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