Why China’s forthcoming economic transition is bigger than you think and why its exchange rate is still the key

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China is on the verge of making a number of important economic transitions.  First, China is on the cusp of becoming the world’s largest economy.  Depending on how you measure it, this could quite possibly happen by 2020. Second, as a result of the lagged effects of its one child policy, China is aging and in the next 3 years or so, labour force growth in China will turn negative.  Third, China’s officials must now (having spent 5 years dealing with the fall out of the global financial and European crises) get serious about reforming an economy whose economy former premier Wen Jiabao famously described as unsustainable, uncoordinated, unbalanced, and unstable, into one that that none of these. If Torrens was one of China’s new crack squad of policy makers responsible for all this (TH wanted to think up an interesting acronym but failed), he might do the Le Freak.

Which could lead to this:

There is a lot that can go wrong, and if it does, it will affect you.

China’s economy is big and complex. Every day, 1.3 billion people and millions of firms make billions of economic transactions trying to do the best they can, while government authorities seek to guide them, the best that they can, in the direction that they think is right.  How can we possibly make sense of all that.  And how can you fix it if it needs fixing? The answer, of course, is to simplify and simplify down to the most important elements of the issue you want to think about.  TH reckons that there are three essential bits:

1)      While investment is declining in relative importance, it will still be the most important contributor to China’s growth.

2)      The labour supply will soon begin to shrink.

3)      Productivity growth will still likely be pro-manufacturing.

If you put those together what do you get?  1) If nothing else changes, the capital-intensive manufacturing sectors will likely continue to grow faster than the labour-intensive services sectors.    If nothing else happens, then the supply of manufactured goods will increase while growth of its services sectors will be constrained.  2) If nothing else happens, this will create an excess supply of goods that flows into global markets, and drives net exports up.  While the rate at which this process will take place will be slower than the boom years in the mid 2000’s after China reformed its state-owned enterprises at the turn of the millennium, it will quite likely describe the sort of growth that China can expect going forward.  That is, if nothing else happens, China will find itself stuck with the same growth model that it had in the lead up to the Global Financial Crisis.

Of course something else might happen.  The government is seeking to introduce social safety nets that will transfer income from China’s corporate sectors and reallocate it to China’s aging households.  This should reduce spending on investment and increase it on consumption.  This is an important part of the rebalancing that most people have in mind.  Does this help China to rebalance in the way that Wen Jiabao would have wanted?

Since investment spending tends to go on goods like machinery and equipment, or iron and steel, while consumption spending will go, at least partly, on services, these reforms means that there will be a change in the composition of Chinese expenditure, away from goods and into services.   And because services are not readily tradeable, but goods are, this policy will cause China’s propensity to import to fall.  In other words, while this demand-side policy will reduce import demand, it will come at the same time as the above mentioned supply-side forces continue to be pro-manufacturing.  As a result, if nothing else happens, net exports will start to rise again.

There will be some benefits though. The transfer of income to aging households will help them pay for age related spending on health services and simple domestic services. It will make households happier, but it won’t rebalance the economy, there will be an excess supply of goods and an excess demand for services.  And, since it reduces the amount of resources available for investment, it will slow growth for China’s next generation.

Torrens can hear some of the economists in the room jumping up and down and saying  “Hang on, China is a market economy and in a market economy prices adjust to get rid of excess demands and supplies.”  Torrens’ reply, … “Exactly!.”

If there is to be one single lesson for China’s elite crack squad of policy maker since Smith penned his Wealth of Nations 235 years ago, it is that markets, by determining the “right” prices to balance demand with supply, are the most efficient way of coordinating those billions of daily transactions to bring about a desirable out come.

In this case, the most important price is the one that eliminates the excess supplies of internationally traded goods and excess demands for domestic services – and that price  is the exchange rate.  That is because the exchange rate is effectively the price that determines how much a local restaurant meal is relative to an internationally traded colour TV.  Just ask any Aussie or Canuck, If, in response to the excess demand for services, the exchange rate appreciates and TVs get cheaper as happens when your currency appreciates from between 50 and 65 US cents to the US dollar to trading at par, then households will buy more of them and firms will make less of them.

The same would be true in China. The imbalances between the supply of goods and demand for services would be largely eliminated.  The economy will be better coordinated.  Economic activity will be more sustainable and stable.

It is for this reason that China must make greater progress developing the still nascent framework for a truly market determined exchange rate. If not, China’s economy will not make the difficult transitions that it needs to, and in five years time, it will be the world’s largest economy that is unsustainable,  uncoordinated, unbalanced, and unstable. And that is something we should all be worried about — just like  it was when the United States was that way in 2008..

Global Adjustment

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TH hasn’t blogged lately  …  but he has been reading Jim Haley’s series of posts on the burden of international economic adjustment on his New Age of Uncertainty blog.  The burden of economic adjustment refers to the idea that when a country (or many for that matter) is suffering high unemployment and low growth, other countries in the global economy will inevitably bear some of the pain of adjustment to get the weaker going again. The trouble is that while getting the whole team running at full capacity is ultimately in everyone’s interests, in the near term it creates economic and political challenges.

In the series, Jim discusses how the burden of adjustment happened under the Bretton Woods system that governed the international monetary system from 1945 to 1971 and asks what the lessons are for today. After all we are living in a world in which some countries have terrible unemployment and lousy growth rates while other seem to be coping much better (though few countries are experiencing conditions better than before the 2007/2008 crisis). Jim is in his element on this stuff and his posts are good reading.

In the second post in the series, Jim reminds us that one of the most important things for us to understand about economic adjustment between countries is the degree of international capital mobility that we live with today.

To understand the this better, it helps to simplify and imagine a world working under the Bretton Woods system with just two economies (domestic and foreign), immobile capital (i.e. no international borrowing or lending) and a fixed but adjustable exchange rate between the two countries.  In this situation, it is easy to show that, in the long-run, the foreign economy will be largely unaffected by a major domestic fiscal or monetary policy shock and vice-versa. The reason is simple, demand shocks are transmitted via net exports and if net exports are constrained to be zero because no one can borrow or lend internationally, then demand shocks can’t spill over. The only spillovers are in the short-run, before exchange rates and prices have fully adjusted, and even these arise because of the preference for a stable exchange rate.

For example, imagine that the domestic economy is in external balance but is suffering underemployment and, in response, engages in a substantial loosening of monetary policy. The lower interest rate and rise in income in the domestic economy had the additional consequence of an increase in import demand and, as a result, a domestic current account deficit and a corresponding foreign surplus.  The increase in domestic imports spilled over to cause a temporary expansion in the foreign economy. But with capital controls in place, that was it. There was no need to worry about the fall in interest rates causing a capital out flow, because capital controls prevented this from happening. Lower interest rates served only to help the domestic economy to move towards full employment. Nor do we have to worry about increased private borrowing from abroad to pay for the domestic imports because the imports are paid for by running down the central bank’s foreign exchange reserves.

Still, a key point here is that with the exchange rate fixed, imports rose and this acted to impede the effectiveness of the expansionary monetary policy.  Indeed, some of the increase in domestic demand spilled over into the foreign economy boosting demand there.  At the same time the local economy was running down reserves, and was faced with the possibility of either a current account crisis if it ran out of reserves or having to abandon its expansionary policy and languish with high unemployment.

Under the Bretton Woods system, the solution was to “strike the right balance” between official lending from the Fund to cover the any short fall in reserves and adjustment to reduce the current account deficit.   Adjustment came in two forms.  One was to encourage wages to fall.  Indeed, Australia’s current system of arbitrated and somewhat centrally fixed wages is a hangover from that by-gone era.  Alternatively, exchange rates could be adjusted and the authorities could go to the Fund and announce a devaluation of their exchange rate to bring it in line with “fundamentals.” So long as the lags involved were not too great and the trade balance responded in the right way to the exchange rate adjustment, the trade deficit would soon be eliminated by the devaluation; and, in so doing, so would the export-led stimulus to the foreign economy. That stimulus, which had effectively leaked out of the domestic economy, would now be channelled back into it.

The point here is that, because there was no private net lending or borrowing under zero capital mobility, there could be no domestic trade deficit in net exports or foreign trade surplus in the long run. The exchange rate adjustment is not technically necessary since the drag from net exports in the domestic economy could have been offset by wage and price adjustments, but it helps to hasten the recovery in the domestic economy, enhance the effectiveness of the policy stimulus and reduce the potential for foreign overheating. In other words, in a system of fixed but adjustable exchange rates without capital mobility, the foreign economy was largely insulated from domestic economy efforts to maintain full employment, while the domestic economy could respond quickly to changing economic conditions.

But the outcome would have been quite different if capital mobility was permitted.  In that case, domestic monetary expansion would have caused the interest rate to fall and capital flow out of the economy in search of a higher yield. This capital outflow would have resulted in a rapid erosion of foreign exchange reserves requiring either the exchange rate to be devalued or the expansionary monetary policy to be abandoned. Lending from the fund was no longer an option because that money would have leaked out in search of yield as quickly as it was lent.

If devaluation was pursued, it would have been the expansion in net exports that ultimately brought the domestic economy back to full employment, not the lower interest rate, which could not persist under perfect capital mobility because arbitrage would have eliminated it. Moreover, and importantly, the expansion in net exports, and the current account surplus would have ended up persisting as long as it was required to maintain full employment and domestic residents were willing to save the current account surplus.

What is important is that with perfect capital mobility and the adjustable exchange rate, the expansionary domestic monetary policy also resulted in a corresponding trade deficit in the foreign country and a reduction in foreign demand. So the burden of adjustment is different when capital is mobile compared to when it is not. This is not necessarily a problem, but it is a complication. And it raises many questions about what foreign policy makers can and should do about it.

 

 

 

 

The growth in international US dollar banking

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Torrens has been busy looking for an “educational” Christmas gift for his son and was looking at the Raspberry Pi. It’s an ultra cheap, tiny computer. The makers want to encourage young teenagers to get into programming and messing about with computers rather than using them just for games. Anyway, that is a digression. While perusing the Raspberry Pi website, Torrens discovered that this British firm (it’s actually a charity) prices and sells the RPi in US dollars despite not having much of a market in the US. They explain why in the FAQs:

The components we buy are priced in dollars, and we negotiate manufacturing in dollars. Because currency markets are so volatile at the moment, we price the final board in dollars too so we don’t have to keep changing the price.

That all seems pretty sensible and it got TH thinking about the creation of money denominated in US dollars after all, if your sitting in New Zealand and want to buy one of these, you are going to have to get the dollars from somewhere, so where?

In reality, many firms that make goods for sale on world markets using imported inputs do the same and price (and transact) in US dollars rather than local currency. And, because they make that decision, it encourages others to do the same. Because RPi use US dollars so will you if you want to buy the RP for Christmas. And you will probably turn to your local bank (say the ANZ if you are in Australia or New Zealand). An earlier post talked about the amount of US dollars that the bank could create. This post talks about the driver of the global demand for US dollars (outside the US) and the implications for global banking.

The Raspberry Pi example demonstrates how international trade helps drive the demand for US dollars. It’s not a US government conspiracy. It’s just that the US economy is the world’s largest and as a big trading nation. Thus trade with the US creates a demand for its currency to make international transactions. And once that happens the network externality takes over (if one person uses a particular money it tends to encourage another person to use that money too) and before you know it, the US dollar is being used for all sorts of international transactions – using US dollars saves on having to use multiple monies unnecessarily. (To understand the network externality, just think that, for a non-US resident, once you get paid in US dollars the first thing you want to do is spend them, because they are not much use to you, but then the next person finds themselves in the same position).

Here is a chart that shows just how fast international trade has been growing relative to the size of the global economy.

Since 1980, while world GDP has grown at just under 3.5% annually, trade has been growing at about 5.7% annually. The growth in trade is interesting because it largely reflects the effects of specialisation and trade in intermediate goods (the components that the Raspberry Pi manufacturer was discussing in the above quote). Whatsmore, most of the growth in trade (and GDP) has happened outside the US (mostly in Asia) and it has created a demand for US dollars to facilitate much of it. This demand, in turn, transformed the global banking system.

Thirty years ago, global banks channeled the savings of oil rich OPEC nations via London to the US to fund the US trade deficit. But when commodity prices collapsed in the 1990’s , the banks had to find a new business model. Asia was booming (with a big blip in 1998) and trade in the region was deepening fast. East Asia was becoming an export platform to satisfy demand global demand for increasingly inexpensive manufactured goods. This involved not only shipment of not only the final good but also intra-regional trade in parts and components for everything from t-shirts to the device that you are using to read this.
Because of a large share of the global market (especially for the final goods) was the US, and because of the network externality associated with using US dollars, this trade was creating a large and rapidly growing demand for US dollars to pay for all these transactions. In the laissez faire world of international banking, the demand for this money was met, not by the US Federal Reserve, but by banks. As per the earlier post on this subject, in order to facilitate this business, the global banks increasingly sourced highly liquid US dollar assets to act as reserves for their US dollar operations. In some instances, these dollar assets were the accumulated claims on the US that the Asian economies had acquired by running persistent current account surpluses, but often the global banks borrowed them directly from US banks by issuing short term US dollar denominated debt.

Global US dollar banking became a bit like a pyramid scheme with US banks at the centre, and the world’s global banking community making up the rest. This has important consequences. You can see on the Chart what happened to global trade in 2008 when the US dollar liquidity at the heart of the pyramid scheme suddenly dried up (i.e. when the US dollar assets that banks were holding as “reserves” for their dollar operations lost their money-like quality) – global trade collapsed. If you go back to the last post – you would recognise that this sudden loss of reserves to the US dollar operations of non-US banks would have increased the perception that these banks would experience a run. And consequently, the supply of deposits that were treated as money would have been greatly reduced. Without money to pay for the different iPad (or car, or whatever) bits and pieces that were being traded and turned in to goods for global consumers, a lot of the trade just stopped. These effects were rapidly transmitted into the real economy. Growth in the Korean economy decreased by about 7 percentage points in 3% to minus 4%). If TH recalls correctly the fall in Japan’s growth rate was even higher.

Local authorities were somewhat powerless to do much about the problem. If local central banks had US dollar foreign exchange reserves, then they could have injected those into the banking system. In many instances they did, but because foreign reserves were in limited supply, people who feared a run on the global banks ran anyway knowing that those reserves would soon be eliminated. The trouble is that when there is a run, a fixed fraction of cash reserves to deposits isn’t enough. Moreover, the problems for the local banks were likely to be multiplying with the run on their US dollar business. That run was quite possibly creating significant losses for the bank as a whole, which in turn was raising concern about their local currency business. But on that side, the local central banks could stand ready to act as a lender of last resort.

Of course, local currency could have been used to finance trade, or clients could have sought to find a US bank to do business, but because of the network externality, these alternatives were likely to be more expensive. This highlights a point – using a currency other than the one used by everyone else serves to act a bit like a tax on those who use the “other” currency. It taxes production and consumption of traded goods.

What does TH take from all this. Money has real effects and national monies are not just an issue of national significance. International liquidity is a complex issue that economists still need to understand better.

Many moneys. Many, many, many moneys

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This post is about the creation of non-bank money. TH reckons there is something missing from the way we think about it.

Economics is full of assumptions. They serve a role of course – the world is highly complex and we have limited capacity with which to analyse it, so assumptions help. But assumptions can also be a hindrance because you tend to rely on models that don’t always fit the reality you want to think about.

TH reckons that one of the assumptions that the profession might need to relax is the idea that we use only one money. In reality, we most likely use many moneys. Sometimes we use cash, sometimes bank deposits, sometimes other assets as money. Sometimes it is also foreign cash, foreign bank deposits or other money like foreign financial assets. This might not be so true for individuals, but it is true for many businesses.

Most macroeconomic models don’t really have much room for money at all let alone many moneys. This is a big failing of macroeconomics. When they do, the models typically assume just one money. Sometimes domestic bank deposits are treated as money, but they are treated as perfect substitutes for cash so it doesn’t really change much.

This is probably OK when bank deposits are created by a solvent bank that is a member of the central bank’s clearing house. But what about for other deposit taking institutions that aren’t “banks” because they don’t belong to the central clearing house (in the sense that they can’t rely on the central bank to settle any unsettled balances with other banks)? Now matters get more complicated. You could think of deposit taking institutions like the now defunct Banksia in Australia, for example. Banksia deposits were money-like in that often they were used as a means of payment, but in reality they were likely to be less liquid than bank deposits or cash – i.e. they were less money-like than cash.

Here is a different example, consider a Korean bank that issues US dollar deposits (perhaps to a computer manufacturer that sells computers and prefers to trade in dollars) and makes US dollar loans (perhaps to similar Korean computer company that uses the credit to buy imported computer components). Clearly, the Korean bank customer treats the US dollar deposit as money, but it is not so clear just how liquid that deposit is. Why? Because if there was ever a run on the Korean bank’s US dollar deposits, it would not have access to the US Federal Reserve to satisfy its customers or to settle unsettled balances with other banks. Instead it has access to the clearing house run by the Bank of Korea, which can print won, but not dollars. TH reckons people would only treat these deposits like money if they could be fairly sure that the bank had some means of satisfying a large unexpected increase in withdrawals.

This raises an interesting question. How would one model the supply of US dollar money created by banks in Korea? There are two dimensions to this issue. One is how do you add cash and mere money substitutes to come up with a measure of the money supply (or the abundance of liquidity perhaps)? The second dimension is, suppose that under some conditions, the Korean bank US dollar deposits could be considered to be money, then how much money does the Korean bank produce?

Not sure about the answer to the first question, but here is TH’s thought on the second. The supply of Korean US dollar bank deposits is determined by demand and supply. The supply is given by the old fashioned money multiplier:

Ms= 1/rr. Reserves.

Where rr is the ratio of Reserves to its deposit base, and Reserves are the value of US dollar reserve assets (say cold hard cash) that the Korean bank has in its vault.
The demand for those US dollar Korean bank deposits is probably a function of a bunch of things, which TH will divide into the reserve ratio and everything else, X. The reserve ratio affects demand because the higher the reserve ratio, the less likely that the bank will have a run – no need to run if there is a tonne of cash in the vault. From a bank’s point of view, since reserves are expensive to hold, they will hold the minimum necessary to satisfy depositors concerns about a run. Let’s suppose that:

Md= a.rr +X

These two equations solve for the equilibrium values of M and rr (labelled on the axis with *s).

Remember the M on the axis refers to the value of US dollar deposits created by a Korean bank (or domestic deposits created by a “non bank”). The model helps us to think through how the supply of US dollar deposits is determined. Do a couple of simple thought experiments. First imagine what happens if the Korean bank, gets its hand on more reserves. Perhaps it borrows them from the central bank of Korea, then the Ms curve shifts up (as per the Ms equation), but to be induced to treat the extra deposits as money, the bank must increase its reserve ratio.

The other experiment to do is to think about a fall in the willingness to hold US dollar Korean bank deposits. This shifts the Md curve down. In this case, the bank can offset some of the fall in demand for its deposits by increasing the reserve ratio.

Thinking about Thinking, Fast and Slow

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TH has been taking some time with friends and family and not much else except a spot of reading over the last little while. He has been trying to read the book – Thinking, Fast and Slow – by Daniel Kahneman that he started back last Christmas. It is a neat book that is filled with examples of how quick and intuitive reasoning generates all sorts of biases. So far, there are two things that I think economists should get from the book. The first is that it teaches us about how policy makers think – especially at times of crisis and great uncertainty, when quick intuitive decisions are called for. Understanding the systematic biases in their decisions is important if we want to understand why they are doing what they are doing and the implications of their actions (TH has written about this before). Second, TH reckons you can learn a bit about how we have collectively overcome some of our inherent flaws through the power of the markets – instead of being a challenge to the economic model, the book helps us to understand better why markets have evolved and what a wonderful job they do.

Apparently Torrens wasn’t the only one reading it. Conversations with friends revealed that the material in Kahneman’s book is making good material for workshops and seminars, as well as the talking head “experts” on radio and TV who want to chastise other experts for their biased reasoning – oh the sensation of it all.

TH hasn’t finished the book yet, but he is starting to understand why it’s getting all that attention. First, Kahneman is not the first to write a book on the subject – there are a few out there – Predictably Irrational by Dan Ariely jumps to mind (which TH is also halfway through). This means that the market has been broken in a bit by the other writers and there is a bit of a band wagon effect creating an “availability cascade” as Kahneman might call it. Second, Kahneman won the Noble prize in Economics (back in 2002) for his work that challenged the economic model of rational decision making, so it is no surprise that at a time when the global economy has gone so awry, people look to the insight of scholars like Kaheman for insight.

The book is good. Kahneman writes clearly and “intuively”. He uses plenty of simple examples that help us to understand how we think and how intuitive reasoning can lead us into dreadful mistakes. That said though, TH is starting to get a bit worn down by the book – to be blunt, he seems to get it already. Individuals have small brains not massive super-computers and the world is a complex place. To get through life we rely on a quick working portion of our brain that generates rules of thumb, which is frequently wrong, or biased, but saves a lot of energy, effort and time. This is especially true for reasoning that requires statistical analysis, which our brains seem to have most trouble with.

And then there is the point that financial analysts and people like us are incapable of making money through stocks. This all makes TH wonder, how does the economy function at all? After all, as TH likes to continuously stress, the economy is not an entity to itself, it is just a big bunch of people like us all constantly making decisions and frequently, it seems, consistently wrong ones.

TH reckons the answer can be found in Adam Smith, one of the founders of modern economic thought, in his theory on the division of labour and the gains from specialisation. As any first year economics student should know, the economy is made up of people who specialise in tasks. Just think, what is your current job? TH is certain that you are not a psychologist and a police officer and a nurse and a window washer (though mums might disagree). You might be one of these – specialising and thinking deeply about things related to your work, so that the rest of us don’t have to. Sometimes you might even offer intuitive advice to others on matters related to your work, for which you get paid. That is, you give others a simple “intuitive” story that seems plausible and can be readily summoned and used quickly when they need to. In other words, while we might individually be prone to bias, collectively we find ways around the biases by relying on people who think deeply. And, even if these deep thinkers also make mistakes, hopefully they are not as bad as the ones we make individually.

The other aspect of the answer is competition. At one point in the book Kahneman goes out of his way to argue that financial market analysts are essentially worthless. He seems to be arguing that you may as well have a bunch of monkeys picking stocks, because you can do no better than the market. In a way, he is right, you can’t do better than the market; you may as well hold the market portfolio (buy the index) rather than trade. The reason that the return is equal to the “market” return is competition. Competition drives the profit from trying to pick stocks to zero. By profit we mean economic profit – you can make some money by picking stocks, but just enough to cover your costs from doing it.

OK, so perhaps it is a waste of time for someone at the margin to pick stocks. But here is a different question. What if we replaced all those market analysts with monkeys, would the market be efficient? Would it even work? What Kahneman has failed to acknowledge and explain is how all those financial analysts work to collect, think about and synthesise all that information about the tens of thousands of firms in the economy and then allocate credit to them. As a result these firms receive the funding they need to create jobs and wealth, to create new technology and innovate; and fund your favourite restaurant or café and even publish books like Kahneman’s. While there are examples of how he credit may have been misallocated (no better exemplified by the global financial crisis), generally financial market analysts do a good job. Whatsmore, the information they gather produces a most remarkable public good – the price of credit and stocks, which generally convey most of the relevant information that markets need. It is really a most remarkable phenomenon, and Torrens was disheartened that a Nobel Prize winner in Economics could not see the value that is created even if the economic profit from financial analysts efforts does get driven to zero.

In sum, what you can take away from all this is that despite our logical failings it is a wonderful world.

More thoughts on the relationship between money, prices and liquidity (not to forget the incredible Mr Beckwith)

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As this is another post on “liquidity”, it is only fitting we should pause for a minute to reflect on the passing of Ray Beckwith, who died on Nov 7, 2012 at the age of 100.  Ray Beckwith was a quiet achiever –  you have probably never heard of him, but without this great scientific mind, the good wine that we take for granted would not exist. He was the science behind the global wine industry. You can read a bit about him here, while you pour yourself a glass of your favourite red.

Back to the topic of money and liquidity. This post gets at a question: why can we experience a contraction in global liquidity and real GDP without deflation?  It takes a bit to get to the answer, so be patient.

Let’s try a few thought experiments. First one is simple. Suppose to start with that we live in a world where the only money was central bank money.  There are two countries in the world: call them Australia and Canada (though this is all fictional/hypothetical).  The same quantity of money circulates in both countries. Australia, though, is “drier” than Canada in the sense that money is not quite as liquid down under in Australia as up-over in Canada. Bob Clower’s axiom that “money buys goods and goods buy money” doesn’t quite hold there – money isn’t quite as liquid as it is in Canada where money *is* the medium of exchange.  Hypothetically, you could imagine why this might be the case: in Australia population density might be low – people living in small isolated towns;  not knowing for sure what a dollar is worth in another town, but being fairly comfortable about what a pound of salt case of beer is worth. In Canada, everyone lives in Toronto or Montreal, and they know exactly what a dollar is worth; they might lug a “two-four” around, but that’s just in case one of their mates happens to be watching the hockey and invites them in.

This might seem counter intuitive, but because money is less valuable (its marginal utility is lower) in Australia, the general level of prices in terms of money is higher. Basically, in Australia, money is a “hot potato”; it’s not useful for much, so as soon as you get it, you try and fob it off to someone else by buying whatever you can, so prices, in terms of money, are higher in Australia.  In Canada, you hold on to it, because it’s readily accepted as a means of payment (including for beer – and you never know when you might get invited over to watch the hockey).

In addition, despite money having the hot potato element to it, there are probably fewer transactions happening in Australia because people are relying more on barter, and the transactions that they do make are less efficient because they don’t get what they really want for their efforts (you can read about this happening in Greece).  Since the economy is founded on the gains from trade, the relative illiquidity of money also reduces the gross domestic product in our hypothetical Australia compared to our hypothetical Canada (and in our real world Greece too).

Now suppose that liquidity suddenly improved in Australia – the internet is introduced and people in different towns now know exactly what money is worth (in terms of goods) all over Australia. The price level would now fall because money has become more valuable.  Essentially, the increase in liquidity of money makes it more valuable and, given that the supply of money is fixed, it creates a shortage of cash.  At the same time the improvement in liquidity means that more people are using money to facilitate trade and productive activities, there are more monetary transactions and real GDP is higher.  This may produce a network effect that further enhances the liquidity of money (presumably at the expense of salt beer). In a way, it’s like Australia had a sudden a dramatic fall in inflation. Indeed, arguably monetary liquidity and inflation are pretty similar things.

But that is not all.  The improvement in monetary liquidity is likely to increase the liquidity of “private” financial assets too and this means that the stock of non-central bank money-like assets will endogenously expand in response to the increase in money demand.  For example, suppose a young Aussie bloke wanted to buy a house, but lacked the cash to do it, so he issued some IOUs to his family and friends to raise the cash. Those IOU’s are financial assets and when money becomes more liquid, it not only makes it easier to buy and sell not only goods and services, but IOUs too – even if just from one family member to another. To the extent that those IOUs can be more readily traded, they could also be more readily used as a form of money (see the earlier post on liquidity here). I guess we could call these IOUs a primitive form of mortgage backed securities.

You can start to extend the analogy further. Typically, most of us don’t engage in day to day buying and selling of mortgage backed IOUs.  Instead we deposit cash at banks that in turn pool the funds and lend to home buyers.  In so doing, banks create liquidity.  They transform a relatively illiquid asset (a home loan) into callable cash deposits, which, because they are callable, are often treated as money.

The trouble is that in the process of creating liquidity, the bank exposes itself to the potential for a run, ‘cos depositors know that if all depositors wanted their money back at the same time, the bank wouldn’t be able to convert the mortgages to cash.  As a consequence, the more likely that a bank could suffer a run, the less liquid its deposits will be. But a run on the banking system is less likely to occur the more easily the bank could sell its mortgages on some secondary market (because then the bank could more easily cover a large withdrawal of deposits).  And that is more likely when central bank money is more liquid.

Thus, an improvement in monetary liquidity broadens the range of financial assets that are money like and helps to increase the money supply.  Indeed, when there is an increase in the demand for money created by an improvement in the liquidity of central bank money (as described in the first example above), it is likely that the increase money demand could be satisfied through the creation of bank deposits, which itself is made possible because the improvement in monetary liquidity makes other financial assets more liquid too.

What does all this mean?  Well it means that when certain events affect the monetary environment and change liquidity conditions, the range of money like assets adjusts endogenously.  It is not clear whether it more than compensates for the change in money demand that changing liquidity implies or not.  But it happens.  This means that there may not be a dramatic effect on the price level from a change in monetary liquidity. However, as our hypothetical Australian example (or the real world example of Greece) illustrates, although prices might not change, real GDP will.  That is why we can experience a contraction in global liquidity and real GDP without necessarily experiencing deflation.

Wicksell and Open Mouth Operations

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According to Knut Wicksell (one of TH’s favorite economists) this is how you conduct monetary policy in an economy that relies purely on banks to generate money in the economy.

simply in a proper manipulation of general bank-rates, lowering them when prices are getting low, and raising them when prices are getting high.

He came to that simple conclusion in 1906 after writing a brilliant book on the subject some years before. And although it sounds obvious, it was somewhat “out there”. Why? Because Wicksell was arguing that in a world where the government had no control over the amount of money being produced in society, it could still determine the price level. At the time it was radical and foresighted – money was tied to gold, and national central banks often didn’t even exist.

Anyway, this is (briefly) how the idea works.  When you borrow money, you care about the real cost, which is the interest rate minus the inflation rate that you expect over the term of the loan (and a negligible interaction term that we’ll ignore).

r=i-p,

where r is the real rate of interest (which is what you care about), i is the interest rate you pay on the loan, and p is the expected inflation rate.  If the interest rate is 5% and the inflation rate is 3%, then the real cost of borrowing is only 2%.   The lower the real rate of interest, the more borrowing that will take place  and the greater the level of aggregate demand and the more expansionary monetary conditions are.

There are two ways to implement monetary policy in this framework. The first is to do what Wicksell suggests.  Suppose, just for illustrative purposes, that prices are falling and people expect that to continue so that p is negative.  Then, the real cost of borrowing will be above the nominal rate and rising, so firms and households that are borrowing to buy goods and services, will tend to borrow less.  To prevent a fall in aggregate demand (which would just add to the process of already falling prices — Wicksell’s cumulative process), the central bank must cut interest rates to get the real cost of funds down.  That is fairly straight forward.

But suppose the central bank can’t cut rates because, say, they are already close to zero, what then? Well, in this framework, the only other variable that the central bank can tweak is the expected inflation rate.  And they can do this, through what is known as “open mouth operations” (a play on “open market operations”, which is a traditional way that central banks can implement monetary policy, and a term that was coined, TH believes, in a Reserve Bank of New Zealand discussion paper in the mid 1990’s but he can’t find it – though it has since become somewhat common amongst monetary economists).

How do open mouth operations work?  Well, the central bank just tells you what you should expect in terms of inflation. That’s it! And so long as you believe them, it should work in pretty much the same way as a cut in interest rates (Torrens knows that this is probably not quite true, but for now he’ll roll with whatever flack he gets).

This raises an interesting question.  Why don’t central banks engage in open mouth operations more fully?  There have certainly been some efforts to do something similar – central banks pay careful attention to their monetary policy statements because they  know that markets pore over them for tid bits that will help them to understand what to expect in the future. The Fed, has stated that it expects to maintain an exceptionally accommodative until mid 2015, while highlighting that if monetary policy wasn’t accommodative, inflation would be too low.  But the efforts at conditioning expectations fall short of directly conditioning inflation expectations altogether. See Jim Haley’s musings here.

It’s somewhat understandable when there is a mandated inflation target that binds the hands of a central bank, but that is not the Fed? Couldn’t the Fed simply say (hypothetically – TH doesn’t know what the right numbers are) that it will keep monetary sufficiently loose so that inflation can be expected to rise to say 4% over the next 2 years, after which, if the output gap has closed, it will tighten monetary policy to bring inflation back down to its target?   The effect of telling people that once the economy was operating at its potential it would reduce inflation would simply signal that it would tighten policy once conditions were right, so surely no problem there. This would be a bit like price level targeting or nominal GDP targeting, but without the central bank tying the inflation outcome to the growth of potential GDP, something that the central bank has no control over.

I guess one reason might be a time consistency type argument.  What happens if in 2 years Inflation is at 4%, and due to some unforeseen circumstances, the economy is still in the hole? Then the central bank has two problems – inflation and unemployment.  And, indeed, this could soon be the predicament that the ECB will find itself in. And it is a predicament that no inflation targeting central bank wants — recession and inflation. Euro area inflation is currently 2.5%, which is above its target of 2% (though technically the ECB does not really have an inflation target – it just aims to keep inflation below, but close to 2%). And this leaves the ECB in an awkward position because, since it has a defacto inflation target and inflation is above target, people will start to expect that inflation will fall.  This means that the real interest rate will rise if not offset by a further interest rate cut, which could lead to a further fall in aggregate demand. That most certainly will lower inflation, but it will hurt growth, and boost unemployment. So maybe the ECB should just say that it expects that inflation to rise further as the economy comes out of recession and that the rise will be reversed thereafter.  That would be better than the alternative of leaving markets unsure of what to expect – after all uncertainty is currently killing growth.

Money, Liquidity, Public Goods and Externalities.

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Torrens has been trying to write this post for a week or more. It’s about the public good nature of liquidity. He remembers learning about this sometime, but it’s one of those things that he can’t exactly remember where he read it, or who taught it to him.  So he won’t attribute it to anyone (but his old professor TK might have had something to do with it). Regardless, it is likely many people have had the same thought (just google the title of this post).

This is a bit dense — apologies in advance. Some thought starters to get us going. On money first. Money is an asset that can be readily exchanged for goods and services as well as other financial assets. There are two types of money: central bank money (aka outside money or public money) and private money (bank deposits are a good example).  Money is quantifiable – it makes sense to talk about the quantity of money.  Also money (whether private or public) is just an asset that can be bought or sold in markets – money has a price.

Now liquidity. An asset’s liquidity is related to the moneyness of the asset – the more like central bank money an asset is the more liquid the asset is. That is, the more readily the asset can be exchanged for goods and services or other financial assets, the more liquid it is. For this reason, an increase in the liquidity of privately created financial assets is effectively an increase the supply of inside money because an increase in overall market liquidity broadens the range of assets that can be used as money.

That being said, liquidity is a quality measure rather than a quantity measure. The liquidity of an asset is characteristic of the asset that is derived from the environment in which it trades – the more people that trade in a financial asset, or the more actively traded an asset is, the more liquid it becomes. In this sense, liquidity is a something of a public good. The market environment (or market condition) affects all traders, whether they like it or not.  It’s hard to exclude people from a liquid market. And market liquidity is mostly non-rivalrous – one person’s use of the market doesn’t detract from the ability of another to use it. That being said, a person’s use of the market might improve market liquidity because of the well-known networking effect; so not using it can detract from the quality of the market in the same way that polluters can detract from the quality of the natural environment.  Thus, in a way market liquidity could also be considered to be a common property good (like a fishery).

Unlike other public goods, market liquidity is typically privately provided – it results from the actions of those who trade in financial assets, including money. But because there is generally no way of pricing market liquidity (I can’t generally prevent people from using a market in order to charge them for it, and even if I did it should generally be free or perhaps even subsidised), market liquidity is unlikely to be optimally provided. People can pay a premium for an asset that is liquid, but that does little to help create more liquidity, it just affects the price of the assets in the market. Even if it did encourage more people to create that type of asset, the creator of the asset doesn’t realise to full benefit of his actions, he only shares in it. Similarly, unlike most commons, financial market liquidity is not over-exploited, but you could think of a situation in which a market participant might erode market liquidity without considering the consequences for others (e.g. a bank that fails to meet hid obligations vis-à-vis another bank).

Generally speaking, public goods are underprovided and common property goods are overused. It is not clear that market liquidity is necessarily under provided by private participants, but what is clear is that some the market for some financial assets wouldn’t be liquid if it wasn’t for the efforts of the central bank. Most importantly, by acting as a central clearing house for bank deposits, the central bank ensures that bank deposits can always be treated like money – it increases people’s willingness to use bank deposits to buy goods and services and other financial assets.  The Euro Area Target 2 system is a great example.  If it wasn’t for the remarkable eurozone clearing house, euro area bank liquidity would have completely dried up by now, and banks (and the common currency area) would have gone bust because no one would accept deposits at Spanish or Greek banks as money.

What about the relationship between monetary policy in the traditional sense and liquidity?  Suppose that monetary policy is done the old fashioned (or is that the new fashioned) way and the central bank goes out and buys government bonds in exchange for money it “printed” (so called open market operations). Some of that money gets held as cash and some gets spent on other financial assets (and goods).  The price of those other financial assets goes up, which makes it more attractive for people to issue those assets.  So the supply of the assets might rise in response to the extra demand (and higher price) for them. By inducing more participants into the market, the open market operation may trigger an increase in market liquidity.

Furthermore, changes in liquidity in one market quite likely affect liquidity in another.  For example, if interbank liquidity was to improve then markets that depend on the interbank market will also experience an improvement in liquidity. This reflects the fact that counterparties in various transactions are often dealing in different instruments – bond dealers trading with currency dealers and currency dealers with bond dealers.  So there is a “strategic complementarity” between participants in the two markets.  An improvement in the liquidity of one market tends to make it easier for dealers to deal in the other. On the other hand, some markets might be substitutes for one another. In which case, an improvement in liquidity in one market might draw traders away from another, with the improvement in market liquidity having a self-reinforcing effect in the former market and a liquidity eroding effect in the latter. When the markets are complementary and something boosts liquidity in one market, it will act as if there was an increase in the supply of money in both markets. If the markets are substitutes, the improvement in liquidity in the first market will have an expansionary effect on the effective money supply in the first market and a contractionary effect in the second.

Taking into account the public good nature and externalities/complementarities associated with liquidity, it will not be “optimally” supplied and it is not surprising, therefore, that central banks intervene to affect liquidity conditions (especially when a negative shock erodes liquidity). But despite good intentions, it is not clear that central bank action will provide the right amount of liquidity either.

First, the central bank’s primary monetary policy objective is to achieve an inflation target of some sort, liquidity management is subservient to that and it is not obvious to TH that such an objective would also produce the optimal amount of liquidity (but it might).

Second, even if the central bank produced the optimal amount of overall liquidity for its own citizens, would it be optimal for the variety of local markets or for foreign market (since most financial markets are not bound by borders)? Probably not, but who knows, maybe.  It’s easy to think of some examples – a central bank might set monetary policy just right to keep inflation low, but there may be excessive liquidity in subprime mortgage markets that causes a housing bubble and a shortage of liquidity in markets for markets for public-private infrastructure financing. Or, the amount of liquidity being created by the US Federal Reserve right for the US but not for the rest of the world considering that the big US bank operate in other markets (and foreign banks operate in the US).

Last main point here. It seems plausible that in some instances public policy may exploit the common property nature of liquidity.  Establishing liquid financial markets requires considerable effort – it requires that contracts can be readily written and honoured, governance and accountability mechanisms, trading facilities, good financial regulation and supervision and so on.  These are costly, and it can be tempting to not bother – even if it means issuing financial instruments in other markets that results in a mis-match between the needs of the parties involved. Policy makers are also free-ride on market liquidity when they make decisions (or fail to make decisions) that erode confidence and liquidity.

So let’s sum up what has been a dense post.  There is money – both inside (private) and outside (central bank) money – that can be counted and measured.  There is liquidity which results from the quality of the environment in which financial assets are traded – this is a market characteristic that is difficult to measure.  If the environment is sufficiently good (i.e. if market liquidity is good) then the financial asset could become money too (as bank deposits are).  Improvements in market liquidity can create more money, but more money does not necessarily create more liquidity, but it can. And, generally speaking there is probably not an optimal amount of liquidity being produced either by public or private actions.

So you have read this far. We’ll come back to the issue of liquidity again, I am sure, but before wrapping this one up, TH wanted to show you this chart.  It shows how employment in the financial services sector has changed across a variety of countries in Europe. Specifically it shows, for each year the change in employment in the financial sector compared with four years earlier.  This 4 year moving window was chosen so that the last observation shows the change in employment today compared with before the crisis.  TH reckons that this shows how financial markets in some jurisdictions might be thought of as more liquid than in others.  Losing jobs in the financial sector, means that financial instruments aren’t being actively traded in that country, increasing employment means more transactions and more liquidity. Interestingly, in Europe, France (green) seems to be the big winner – it didn’t batter an eyelid, while Germany (large purple bars), which was struggling with its landesbanks before the crisis, seems to have stemmed the tide. But apart from that — the financial services sector in Europe has been doing just what you would expect — shedding jobs.

European Financial Services Employment (change over last 4 years)

 

 

Since writing this, TH sees that Nick Rowe over at the Canadian Worthwhile Initiative has a post on liquidity and velocity, which is closely related to this one.  Check it out

http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/10/liquidity-velocity-multipliers-menger-money-and-bubbles.html

IMF’s world economic outlook

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According to the IMF World Economic Outlook (WEO), global growth is slowing.  In the IMF’s words:

Projected global growth, at 3.3 and 3.6 percent in 2012 and 2013, respectively, is weaker than in the July 2012 WEO Update, which was in turn lower than in the April 2012 WEO.

This revised-downward growth forecast is also lower than their 2011 forecasts for 2013.  It seems like the IMF might be repeatedly making the same mistake. So here’s a question, could they be doing the same again this year?

According to the IMF, their new growth forecast depends on two critical assumptions. To quote:

The first assumption is that, consistent with the October 2012 GFSR baseline scenario, European policymakers take additional action to advance adjustment at national levels and integration at the euro area level (including timely establishment of a single supervisory mechanism). As a result, policy credibility and confidence improve gradually while strains remain from elevated funding costs and capital flight from the periphery to the core countries. If these policy actions are not taken, the WEO forecast may be disappointed once again and the area could slide into the GFSR’s weak policies scenario, which is described in further detail below.

 

The second assumption is that U.S. policymakers avoid the fiscal cliff and raise the debt ceiling, while making good progress toward a comprehensive plan to restore fiscal sustainability.

The IMF is saying that the failure to implement policy (implementation risk) is likely to turn a pessimistic growth forecast into an even worse reality. And, unfortunately, there is good reason to think that this is true.  Both of the IMF’s assumptions require large irreversible political investments. The decisions are large because politicians’ career prospects in Europe and the US depend on whether they make the right decision. Make the wrong one and your political career could be over. As we’ve discussed before, that means that the option of waiting is valuable — you could be better off delaying that decision until more information becomes available (like outcome of the US elections in November, or whether the economy will pick up in Europe). So politicians wait and the IMF’s weak policies scenario comes to fruition.

The IMF goes to great length to explain that we are living in very uncertain times and that risks are high. If you apply the theory of options, the outlook for the global economy doesn’t look so good.

 

 

China then, now and tomorrow

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China is one of the world’s most important economies (equal in some sense to the US and Europe) because it is so large and dynamic. It is even more important for countries that export to it like Australia and Germany.  In the next 5 to 10 years, China will probably become the world’s largest economy (the IMF World Economic Outlook forecasts that this happens in 2017 once purchasing power differences are accounted for). But the China of tomorrow is likely to be much different from that of today or yesterday.

China then

After the social uprising in 1989, China had a few years of reflection before China’s fatherly leader, Deng Xiaoping travelled to the South of China and declared that it was glorious to be rich. China was poor (per capita GDP of less than $2000 compared with advanced economy average of $28,000). And, Deng’s words re-ignited the desire for economic reforms – as the word’s left his mouth, China set out to further liberalise markets, exploit the profit motive, and grow (economically). These reforms really started to gain momentum around the turn of the millennium, so we’ll call the whole package of reforms “the millennium reforms”.

Under the millennium reforms, private property was allowed (even for members of the communist party), and state-owned enterprises were restructured, broken up and, in many, cases privatised. The right to make money and keep it was a dramatic shock to the Chinese economy – it effectively legalised capitalism.  It came at a time when China joined the WTO, giving it greater access to markets, FDI was encouraged, giving foreign firms access to Chinese labour and China access to foreign know-how, and at a time when China was experiencing strong growth in its labour supply, which could not be prosperously absorbed by the rural sectors. In short, it sowed the seeds for a growth miracle – per-capita GDP in China is has doubled *twice* since 1990.

The combination of the sudden emergence of a capitalist class combined with abundant and cheap labour, had a dramatic effect on productivity and growth. But the 1997/1998 Asian balance of payments crises and China’s own (near) banking crisis put some serious constraints on the liberalisation path.  The authorities deemed that the financial sector would not develop like that of loosely regulated Singapore’s or Hong Kong’s, but would remain heavily regulated and controlled in order to contain and eliminate China’s problematic non-performing loans. They also pegged the exchange rate along and tightened capital controls to ensure that it would avoid a capital account crisis like that experienced in Thailand, Indonesia and Korea.

Lastly, the government gave the central bank a strong mandate to maintain price stability in order to avoid inflation that had been one of the factors contributing to the social unrest in 1989.

All this meant that China would experience a surge in growth fueled by cheap wages, an expanding labour supply, strong investment and big improvements in productivity (more efficient use of resources).  It also meant that there was no real mechanism to encourage local residents to buy the rising supply of manufactured goods produced by these more efficient and profitable firms. Normally a productivity surge like that experienced by China would result in a stronger exchange rate, but the exchange rate was fixed. So the local price of manufactures stayed relatively high, which discouraged consumption of, but encouraged production of, manufactured goods. In short, China produced more manufactures than it wanted to buy at the officially set exchange rate and it created a large trade surplus.

The nation’s excess savings were not accumulating with the nation’s relatively low paid workers, but with its new capitalist class.  The banks were being regulated and controlled to reduce risky lending, which meant less money for the entrepreneurs and more for the large state owned enterprises.  The entrepreneurs though saw great opportunity for future investment and growth, but they realised that they would have to save the money to finance that investment themselves. So they did. China ended up with stellar growth, high investment, high (especially corporate) savings and low levels of consumption (although consumption was also growing at a rate that was almost as stellar as the economy as a whole).

China Now

China now is much different from the China at the turn of the millennium. Today’s China has been dramatically shaped by the reforms.  It is much more well-off, its banks are (fairly) safe, and its capital controls protected it from the worst of the global financial crisis.  But China now has a very low level of consumption (around 35% of GDP) and very high levels of investment (50% of GDP). It is unlikely that, as a share of GDP, investment could rise, or consumption fall, much further. In fact, the latest figures show that so far this year, consumption growth in the economy has been faster than GDP growth.

Most importantly, as we’ve discussed before, the size of its labour force is peaking, meaning that the abundant supply of cheap labour is going to start to run out and wages will start to rise much more strongly than in the past.

China Tomorrow

In ten years time the average age of the Chinese population will be older. The changing labour force dynamics will make China somewhat less competitive and create some incentives to reduce the level of investment spending. In addition, aging will encourage people to run down their savings as workers retire. If things go as planned, the next decade will see the rise of the Chinese consumer. That said, the savings that China has accumulated are probably not very evenly distributed – they have generally accumulated with firms and the new entrepreneurial class, so retiring workers won’t be drawing on that portion of China’s wealth, so savings may not decline as much as people expect, and dependence on exports may therefore remain a feature of China’s aging economy.
Interestingly, estimates seem to show that labour force growth doesn’t account for much of China’s overall growth, so it is tempting to think that the slowdown in labour force growth won’t affect GDP growth much.  But it is fair to think that investment (mostly in machinery and equipment, which has accounted for around a quarter to a third of growth – productivity growth accounts for most of the rest), will probably slow. If you don’t need to equip as many workers, you don’t need as much machinery. And as the labour force ages, while it may become wiser, it might become more risk adverse, which could slow productivity growth.  Investment in human capital (learning) may slow too. It is also interesting to note that the combination of declining investment and savings will have an ambiguous effect on China’s trade surplus (which by definition is equal to  savings minus investment).

In addition, it is unlikely that China will be able to replicate the boost to productivity growth which came from the millennium reforms (more efficiently applying advanced and foreign technology to the abundant supply of rural labour and China’s vast pool of savings). Other reforms, such as improving social services might improve the quality of growth, but not the pace. Thus, productivity growth is likely to slow too.  China tomorrow will be one of continuing advancement, but at a slower pace than that which we have become accustomed.