Money and Sovereignty

It’s no wonder that Dr Varoufakis was quietly preparing a parallel currency. He was trying to safeguard Greek sovereignty.

Even Julius Caesar knew that no government is really sovereign unless it has its own currency. If you use someone else’s then ultimately you are at their mercy, economically at least. Without its own currency, a country has no means of safeguarding its payments system. The reason is very simple. The little pieces of paper that we call money (along with the electronic bits of information that are central bank reserves) can only fulfill that function because we believe that they will. If ever we were to lose faith that money is money, the monetary system is pretty much doomed — valuable pieces of paper and electronic bits become worthless, and life gets pretty complicated since virtually every transaction we make is made with money.

Our faith in the currency ultimately comes from the knowledge that our government will do whatever is needed to safeguard the monetary system and has the power to do it. In Greece’s case, as became clear during the last few months of bailout negotiations, the government could not credibly backstop the Greek banking system, and so people lost faith in their money (the electronic bits used by banks) and a bank run ensued.  That is why the run continues today. The Greek people just can’t be sure that a euro deposit in the bank today will be a euro deposit in the future and the Greek government is powerless do anything about it. Unless, of course, it is willing to cede sovereignty to the Troika.

While this is an immediate problem for Greece, it is ultimately a problem for every euro area member. It means that no nation is truly sovereign.  Torrens reckons this is the reason why Greece captivates us all and explains the discussions about Greek democracy and sovereignty on the web. It also explains why, deep down, we all understand that Greece may be better off with its own currency.

The flip side of the problem is that there is no supra-national government that can legitimately supersede the authority of any euro area national government. People legitimately look to the only supra national organisations with power and credibility to do something. But no matter what they say, the ECB and IMF do not have the mandate to “do whatever it takes”. They can’t recapitalize banks, or restructure debt, or change laws. Their policy instruments simply weren’t designed to safeguard the entire monetary system of a whole country. As Mario Draghi said in the last ECB press conference, Emergency Lending Assistance (ELA), was designed to deal with runs on individual banks, not a systemic failure at the national level. Likewise, on of the main lessons from the 1997 Asian crisis, the IMF can lend to finance adjustment, but that commitment alone cannot stave off capital account crises.

Nevertheless, when a monetary crisis (like that happening in Greece) occurs the pressure to resolve it falls on the ECB and IMF to try. The sad fact, however, is that by trying, and not succeeding, the credibility of these vitally important institutions is eroded. (If you don’t think so you just need to watch the press conference. Poor Dr Draghi was like a deer caught in headlights — having to justify to the press corps why he had failed to prevent  the imposition of capital controls in Greece, which for all intents and purposes, amounted to a temporary, albeit, partial, suspension from the eurosystem, and a failure to preserve the integrity of the European monetary system as a whole).

The quandary that Europe finds itself in is that the loss of sovereignty that a country suffers from having no currency of its own can only be mitigated if other countries are willing to cede a little more of their their own to allow supranational institutions to do more to act in the interests of Europe. At the moment the members of the main decision making bodies — the Eurogroup of finance ministers and Euroarea leaders only have incentives to act in their national interests.

On the merits of Option #2

From his perch, Torrens reckons that Mr Tspiras should listen to the the advice of Marx (Groucho, that is) and choose not to belong to a club that would have Greece as a member. Particularly when that club is the euro zone, and the conditions of membership are those laid out by Mr. Schäuble (his Option #1, which Greece agreed to). Instead, Greece should take Mr Schauble up on his alternative offer (his Option # 2) for a “time out” from the euro as he put it.

Although the second option was most likely intended as a belittling negotiation tactic to force Greece to capitulate (had he been serious,  Mr. Schäuble would surely have put it on the table months before), there may be some merit to the option, and one should think it through before dismissing it.

In many respects, Mr Schauble’s Option 2 harks back to the Bretton Woods system in roughly 20 years before 1971 when most of the world had fixed, but adjustable exchange rates. Under the system, if a country’s exchange rate had become misaligned (typically over-valued and uncompetitive) leaving the county short of the money it needed to meet its import needs, it could have gone to the IMF for short term financing to cover the import bill while at the same time it took remedial measures to address its external imbalance. The adjustments typically included a devaluation of its exchange rate and reforms to reduce spending.

In addition, like the Bretton Woods system before it, Mr. Schäuble’s second option would also allow Greece to write down its debts. Right now, Greece cannot do this because doing so would force the ECB to withdraw its emergency lending assistance (this is what allows Greece to stay in the euro and ensures that its banks remain functional, albeit barely).

But if Greece exited the eurozone and had its own currency, Greece would be able to announce a standstill on its debt payments. It could use that time to renegotiate with creditors. This would put Greece in a fairly good bargaining position because it could conceivably threaten not to pay back anything.

Given that nearly all the debt is held by official creditors, writing off most of that debt would allow Greece to access private markets again. Moreover, if it also implemented many of the proposed structural reforms, Greece could also become a favourable investment destination.

Torrens reckons that it’s time to take Mr. Schäuble’s second option seriously.  To paraphrase Einstein, is it not insane to keep repeating the same mistakes over and over in the hope that the outcomes will change?

Some worry that the Greek currency would fall by 50%. But to put that into perspective the Australian dollar has fallen about 30% in the last year and no one has battered an eyelid (the RBA is even calling for more)!

Don’t get me wrong, eventually Greece will overcome the negative consequences of the bailout program and economic conditions in Greece will improve. Markets do work, even in the face of huge debt over-hang and excessive austerity. But that could take a long time and progress will be slow.  An exit and substantial debt write down would be better.

Last, is it just me, or is Varoufakis another incarnation Peter Garret, the leftist lead singer of Midnight Oil, and Australian Labor Party MP?

Life at the zero lower bound part 2: The inflation tax

In simple terms, most economists think that inflation is not really a good thing (as do many people TH has the pleasure of knowing: older folk, like TH’s dad and father-in-law, really don’t like inflation, and it seems neither do people from Germany, and many US republicans). The reason is that when there is inflation, money will earn a negative rate of return equal to the negative of the inflation rate.  This is the typically thought of as an inflation tax on cash (both TH’s father and father-in-law have a strong preference for holding cash as an asset and hate the idea of inflation eroding the value  of their savings). But inflation is only part of the inflation tax because even if inflation is zero, you could be holding other assets, which typically have earned a positive real rate of return.  Thus, even a zero rate of inflation means that money loses value over time relative to these other assets.   If, for example, the real rate of interest on other investments such as land was, say, 5 percent, then with a zero rate of inflation, money would lose out to land at a rate of 5 percent per year.

The inflation tax is truly only zero if the inflation rate is such that the real return on money equals the real return on other assets.  In the example just given, the deflation rate would have to be 5 percent (i.e. inflation of minus 5 percent) if money was to earn the same rate of return as land.  Any inflation rate higher than that would effectively be a tax on money and induce people to hold less of it.

In simple terms, the inflation tax is equal to the real rate of return that can be earned by investing in physical assets such as land) plus the inflation rate meaning that the inflation tax is lessened by two things: 1) a fall in expected inflation, and 2) a decrease in the natural real rate of interest.

Chart 1 shows a rough and ready estimate of the trend  inflation tax for the US using the Laubach and Williams natural real rate estimates and an estimate of long run trend inflation by your truly.

US inflation tax

From the chart you see that back in the 1970s, when the natural rate of interest was about 3 to 4 percent in real terms and the expected inflation rate in the United States was about 7 percent, the inflation tax amounted to about 11 percent.   Since then, it has come down considerably.  The inflation tax is now about between 1 to 2 percent – the lowest that it has been in the last forty years or more (and if you did this for just about any other advanced country, you would find the same thing).  If you used actual inflation and the current estimate of the short-term neutral rate (i.e. one that allows for temporary weakness in aggregate demand), then the inflation tax would currently be around zero maybe even slightly negative.  This situation is a result of low inflation and a low real rate interest rates and is very much a part of life at the zero lower bound.

Torrens reckons this is interesting.  Right now, we find ourselves in what according to Milton Friedman’s optimal quantity of money, is an almost perfect monetary equilibrium – where the inflation tax is zero and we hold just the right amount of cash.  Is this an unexpected silver lining of our times? Or could it possibly be a cause of our economic woes?

TH is not sure, but he is sure that this phenomenon is important and certainly warrants thinking about more because it raises all sorts of questions.  For example, perhaps the Federal Reserve’s balance sheet, which has expanded significantly from $869 billion on August 8, 2007, to almost $4.5 trillion, is now just as it should be.  Maybe the problem was that in the years leading up to the crisis, the amount of Federal Reserve liabilities was just too small (relative to the amount of leverage in the banking system for example).

Thinking of grumpy old men and taxes …





Life at the Zero Lower Bound

Torrens feels like he is in some topsy turvy Alice in Wonderland world.  It has been a year since he last wrote.  And, to be frank, Torrens reckons that maybe he went down a hole and came back in the past.  Twelve months ago, the global recovery that was meant to start in 2010, was faltering in much the same way as it is today.

Indeed, this situation has lasted not just one or two years, but much longer. For the last 5 years or so, central bankers in many countries have kept interest rates at close to zero (pretty much as low as they can go) and employed other tools in an effort to provide the support that the global economy needs.

This got Torrens wondering about life at the zero lower bound – how did we get here and what is different about  the world when interest rates are at the zero lower bound?

So why are interest rates at the zero lower bound?  Short term interest rates reflect a combination of two elements – the expected rate of inflation and a real return.  The real return is just the inflation adjusted rate of interest — the monetary interest rate minus inflation. The inflation rate is largely determined by central bank policy (and for now, let’s just assume that central banks are able to keep inflation on target at 2 percent per year). That leaves the real return as the main explanation behind the currently low level of interest rates. The real rate of interest reflects the ability and willingness of firms to invest today’s savings and transform them into future production and the willingness of households to save in the first place.   Right now, if you live in the UK, the yield on a 1 month government bond is just about 0.3 percent (see Chart 1) – pretty close to zero (its zero in the US, even slightly negative in Germany, but somewhat higher in the Lucky Country).  With UK inflation at about 1.2 percent, the inflation adjusted real return in the UK is minus 0.9 percent (i.e. = 0.3-1.2).

Chart 1FT Yield Curve


Source: Financial Times


That real interest rates should be so low is not really all that surprising. Of course the current poor performance of the global economy and the monetary policy response to that is one reason for low interest rates, but it is not the only one.  Real interest rates have been falling for a long time – long before the Great Recession and the current level partly reflects that long-run trend.

Figure 2 shows estimates by Thomas Laubach and John C. Williams of the US Federal Reserve for what we could term a cyclically adjusted real interest rate (also referred to as the natural rate), meaning the one that we would have if the economy wasn’t in a recession (or a boom).  Their estimates indicate that the real rate has been declining more or less since the late 1960’s and has recently gone to close to zero.  TH poked around and found some other research on the factors behind this “secular” decline.  This research suggests that the decline from the early 1990’s to around 2004, was largely due to weakening of investment demand. According to this hypothesis, firms in the 1970s were busy investing in machinery to equip the baby-boomers that were starting to enter the labour market at the time, so interest rates were high at the time. But as that cohort has aged, the need for investment diminished causing investment demand and interest rates to fall.   Now, as the baby boomers retire, investment demand has weakened even more, adding to the downward pressure. Other factors, such as the increase in savings supply from China that started 2004, have likely contributed to the downward pressure too. Interestingly, some findings suggest that easy credit policies in the 1990’s and early 2000’s may have helped to prevent interest rates from falling by keeping household consumption high and savings low, so it is likely that when easy credit came to an end with the crisis, the real interest rate fell.

Real Rate L&W


Source :Thomas Laubach and  John C. Williams. Board of Governors of the Federal Reserve System.

Some of those forces that have driven real interest rates down — especially the aging population — are likely to continue for some time to come.  And while TH has some difficulty believing that the inflation adjusted return on his investments will be negative, it is possible (especially once you adjust for risk) and it may have further to go.

The next post will try to think through some of the implications of the slow but continual decline in the real interest rates. But, in the meantime …


The ceiling can’t hold us: What to expect on D-Day and why it’s more likely than you think

TH woke up this morning with that catchy tune “the ceiling can’t hold us” and thought how apt it is to describe the behaviour of the US congress, which may soon recklessly drive the global economy into yet another financial crisis by choosing not to lift the US debt ceiling before October 17 (D-Day). It also got TH thinking about what would actually happen if no agreement is reached and congress actually failed to act, and how we might end up in that situation.

To think through, it is helpful to imagine what would happen if nothing else happened except that the  debt ceiling is reached and the government loses the ability to issue new debt. First, the US government shutdown, which is underway at present, would have to sharply accelerate to constrain expenditures to avoid new borrowing. The sharp acceleration will have all sorts of macro consequences, the most notable of which would be a sudden contraction in US GDP growth and loss of jobs. The more interesting and worrisome complication is that because certain expenditures can’t just be constrained or stopped, the US government will probably have to default on some liabilities.

Sovereign default is never good; especially for people who are holding the debt that the government defaults on.

So imagine that there you are on October the 16th (the date when congress votes (or doesn’t vote) to raise the debt ceiling. And as the votes come in, it becomes clear that you are holding debt that is due to be redeemed in the next few days and will therefore most likely be defaulted on. You are holding the hot potato. Of course you try and sell it, as does everyone else.  The price of the debt plummets; you wished you had sold the day before. Of course in reality, many people wouldn`t have been as optimistic as you, and would have sold the day or week before.  There will be a point where bond selling along with the various uncertainties will cause markets to start behaving badly. Something a kin to a run starts. Liquidity dries up, short-term interest rates spike, banks stop making loans, and so on.  You know the drill.  Something like what happened when Lehman Brothers was forced to default. It would be nothing short of a financial and economic calamity that could make the Lehman Brothers moment look good.

But that scenario assumes nothing else happens.  And of course something will.  The US Federal Reserve will have its “whatever-it-takes” moment and intervene to avoid disaster.  The simplest way would be for it to stand ready to buy any US Federal government debt, including (and most importantly) the debt that the government is about to default on. It would effectively take on the debts for the US treasury even the debt on which the government is in arrears on.  This would effectively amount to a new (fourth) round of quantitative easing – QE4

Some will no doubt worry that this will be inflationary.  It need not be.  The US Fed does not only have to issue money in exchange for those dodgy US Treasuries.  It can issue its own bonds instead. In practice it would probably to a bit of both.  The problem is that this will affect the well-being of the financial system in general, raising the overall costs stemming from the excessive reliance on monetary policy. But for now, calamity avoided.

Phew, so now you breathe a sigh a relief. You don’t need to panic now.  You can just wait until D-Day and for the Federal Reserve to come to the rescue.  The trouble is that you are not the only ones that can do the calculus.  The members of the US congress can too.  The fact that the situation has gone this far shows that congress is already willing to overburden the US Fed. The question is how much further they are willing – how much larger are the nips of liquidity going to get?

As the famous Mental As Anything song goes:

Started out, just drinkin’ beer
I didn’t know how or why
Or what I was doin’ there
Just a couple more
Made me feel a little better
Believe me when I tell you
It was nothin’ to do with the letter

I ran right out of beer
I took a look into the larder
No bones, nothin’
I’d better go and get somethin’ harder
Back in a flash
I started on a dash of Jamaica rum
Me and Pat Malone
Drinking on our ow-ow-ow-own

Woh-hoh-oh, the nips are gettin’ bigger
Woh-yeah, the nips are gettin’ bigger
Wo-hoh-oh, the nips are gettin’ bigger
Yeah-eah-eah, mmm they’re gettin’ bigger


Keep Calm, Cross Your Fingers and Press On — monetary policy in today’s world

That might have been the thinking of the Federal Reserve when it surprised markets and chose not to start tapering back its quantitative easing policy. It had no choice given its mandate to target inflation low support the economy.  But its decision reminded TH about the reason why we have inflation targeting central banks in the first place.

Just like as a wee scotch is for an alcoholic, what seems to be a good idea right now is often inconsistent with our longer term interest.  In the case of central banks, it could be appealing to keep interest rates low today to help create jobs and growth and worry about the inflationary hangover tomorrow. To deal with exactly this problem, the New Zealand government revolutionised macro-economic policy making forever way back in 1991 when it was the first place in the world introduce inflation targeting – a system that ties the hands of the central bank by giving it strict mandate to keep inflation low and stable and operational independence to achieve that objective.  It was a huge success and during the years since many other governments followed suit.  But these days, it is hard not to ask whether the ultra easy monetary policy that one seems to see almost everywhere in the advanced economy world (including the US Federal Reserve decision to postpone tapering for a while longer)  is best.  Indeed, the nips might not being getting bigger, but the drinking (or liquidity) sessions are lasting longer and some are asking whether unintended consequences might be starting to reveal themselves.

The problem

More often than not, pursuit of the inflation objective is quite consistent with growth and job creation.  This is especially true when the economy is suffering from the effects of a recession.  In that case, the excess economic capacity (i.e. weak growth and unemployment) puts downward pressure on prices and creates the potential for disinflation (falling inflation) or even deflation.  To combat this, the central bank will ease monetary policy, encouraging firms and people to borrow and spend; hopefully on productive investments and job creation. This is the situation advanced economies have been in for over  5 years now.

Generally speaking central banks have achieved their goals pretty well. The problem is that given that they have a mandate and a reputation to “do whatever it takes”, other branches of government may felt that they have had some scope to slacken off a bit.  This wouldn’t be a worry if using loose monetary policy to stimulate the economy was costless.  The truth though is that loose monetary probably does have some costs.  For example, if interest rates are too low for too long, it could create a bit of a housing bubble (and you will recall that it was the bursting of US and UK housing bubbles that was one of the factors behind the severity of the global financial crisis in 2008).

Here is a picture that illustrates the problems.    The illustration shows the “marginal benefits” and “marginal costs” from loosening monetary policy.  Each time the central bank adopts a looser monetary policy there is an extra cost (the marginal cost) of doing so shown by the height of the marginal cost curve. It slopes upwards because central banks choose the most effective way of loosening policy first, before moving to more unconventional and potentially costly means.  The cumulative, or “total”, cost of all the central banks actions (each quarter of a percent interest rate cut, each $100million in asset purchases etc.) is shown by the area under the curve.  Similarly the extra benefits of loosening monetary policy are shown by the height of the marginal benefits curve and the total benefit is shown by the area under that curve.

costs and benefits of monetary policy

The curves labelled MB* and MC* are the curves that reflect the costs and benefits when all policy makers (central banks, treasuries, and financial sector policy makers) make the best decisions to keep the economy fully employed and growing while maintaining low and stable inflation in the longer term.   If the central bank is doing its job to the best of its ability, it will loosen policy until the marginal benefits of extra loosening just equal the marginal costs of that loosening.  When you do that, the  total net benefits will be as big as they can possibly be and the central bank, along with all the other branches of policy, will have done as well as they possibly can.

When other macropolicy makers slacken off, however, the benefits of using monetary policy increase so that central bankers keep interest rates lower for longer or engage in more quantitative easing. The result of excessive reliance is a higher total cost from monetary policy.  This is shown by the blue area.

The problem for those evaluating the cost and benefits of monetary policy is that central banks always seem to  do what is “optimal” – equating marginal benefits with marginal costs so that the costs of monetary policy action will never seem to outweigh the benefits.  What they should really do is a counterfactual calculation which assumes that other macropolicy branches of government (the Treasury, financial regulators, etc.) are fulfilling their responsibilities and rather than relying on their central banks.  The problem is that this is almost impossible to do.  As a result, we will never really know whether monetary policy is excessive.  But given the state of the fiscal debate in the United States and efforts to deal with financial fragmentation in Europe, TH has some concerns — perhaps time inconsistency in monetary policy has given way to moral hazard in other policy areas.



How to balance inflation on the end of your finger

Five years after the  beginning  of the financial crisis, there are still a lot of people trying to come to grips with monetary policy and inflation. Here is an analogy that TH thinks might (usefully) help make monetary policy setting seem less like rocket science and more like child’s play.

Imagine that you have a stick balancing on the end of your index finger.  It’s a nice straight stick, about a metre or so long – perhaps a pool cue made for a child.  The stick is unstable, it could fall any which way, but for the sake of this thought experiment, imagine that it can only fall forwards, away from you, or backwards towards you.

If you are standing still and are lucky, you have it perfectly balanced, but at any moment, some random event could cause the still to fall forwards or backwards. If you do nothing, the force of gravity will quickly cause the pace at which the stick falls forwards or backwards to increase.  If the stick starts falling forwards, your natural instinct will be to push your finger away from you so that the base of the stick gets out in front of the top of the stick and halts the stick from falling over. With some skill, you’ll soon have it well-balanced on the end of your finger again.

By now, you have a pretty well-developed model in your mind of that stick.  It is also a pretty good model of (the Wicksellian cumulative process of) inflation and monetary policy. Where the bottom of the stick is and what it is doing (remember it can’t go sideways, only backward or forward) tells you about the nominal rate of interest; closer to you is a lower rate of interest, further away from you  is a higher rate of interest.  The top of the stick tells you about inflation – if it is falling forwards, inflation is increasing, backwards and prices are falling.  Clearly there is going to be a relationship between interest rates and inflation – you can play with the model in your head – or get a stick and try it out for yourself. The model has some pretty good predictive power. Try pulling the (virtual) stick towards you (cut interest rates) and what see happens to inflation.  Anyway, before going further you need two simple equations that might help to better convert our balancing stick into a model of inflation:


which simply says that the real rate of interest on a financial investment (a loan) is the nominal rate of interest (i.e. the interest rate on loans, which we will assume to be the same as the policy rate set by the central bank) minus the inflation rate, p*.

The other equation is


In this equation, R is the natural rate of interest – it is the rate of return on physical investments – from building a house or a factory.  The equation says that inflation is a function of (which is what the f stands for) the gap between the natural rate of interest and the real interest rate expected to be earned on a financial asset.  If r is less than R, so that it is profitable to borrow money and buy a real investment (a house or a factory), then the increased demand for goods such as these will cause the inflation rate to rise.

Let’s return to our stick analogy. Suppose you have the stick perfectly balanced on your finger.  It’s not falling forward or backward.  The base of the stick is right under the top. You are standing still. Remember that top of the stick tells you about inflation.  Since the top of the stick is not moving, inflation is currently zero. The real rate of interest is therefore equal to the natural rate of interest (this comes from the information summarised by Equation 2).  If you expect things to stay this way, or at least that the chances of the stick falling forward in the future to be the same as it falling backwards, then the expected rate of inflation would be zero too. And since the expected rate of inflation is zero, it is also the case that the nominal rate of interest must just equal the real rate of interest, which, as we said, is equal to the natural rate of interest.   Got it?     p* =0 and  p=0, so from Equation 2, R=r and from Equation 1, r=i, so i=R too.

Now all the hard work is done, try doing the same thought experiment again.  Imagine that you pull your finger towards you just a bit so that you pull the base of stick from under the top. This shock causes the nominal rate of interest and consequently the real rate of interest to fall below the natural rate and stimulates people to borrow and invest. It drives up demand in the economy and prices start to rise – i.e. inflation goes up.  The top of the stick starts falling forward.  Quickly, people start to realise that, unless something is done soon, there is going to inflation in the future.  The higher expected inflation means that, given the nominal rate of interest, the real rate of interest (real cost of borrowing) is now even less than before, which further fuels an increase in investment and inflation.   The process feeds on itself in a vicious circle, creating a process of accelerating inflation and the stick is soon accelerating rapidly towards the floor.

The inflationary process can be stopped by pushing forward on the bottom of the stick – this is analogous to increasing the interest rate.  Just as you would have to push the bottom of the stick forward to get in front of the top to stop its fall, to make the real rate of interest equal to the natural rate of interest and set inflation back to zero, the increase in the interest rate will have to overshoot the rate of increase in prices. For example, if the shock has caused inflation to increase from 0 to 5%, then the increase in the nominal rate of interest – the policy rate – will have to be more than 5%.  This is because of the effect of inflation expectations.  Just like the stick has some momentum, so do expectations about future inflation, and the policy rate must increase by enough to offset not only the current rate of inflation but any expectations that are forming based on the current behaviour of the economy about future inflation.

So what does our simple model tell us about current monetary policy? TH reckons it tells us quite a lot. First, monetary policy, like balancing a stick on your finger, is more of an art than rocket science. You don’t need to know the laws of physics to balance the stick, you just need practice. There are also different styles too.  Some stick balancers (read inflation-targeting central bankers) could prefer slow graceful adjustments to the policy rate – that allows for longer periods of inflation away from the central bank’s target (Australia says inflation will be around 2 to 3 percent, on average, over the course of the cycle, which could be up to 10 years!). Others might prefer swifter, sharper policy adjustments and more stable prices.    Both could work. We could call the two types of policy reactions  as Type I and Type II. Australia would be a Type I inflation targeter.

Expectations about inflation

As you might have guessed, expectations about future inflation are also important in this model.  Suppose that the central bank has a zero inflation target, and people are firmly convinced that the central bank will keep inflation close to zero, then an inflationary shock won’t need such a swift or large interest rate response from the central bank because it won’t need to offset the stimulatory, self enforcing  effect of inflation expectations causing a reduction in the real interest rate and stimulating demand.  To make their life easier, central bankers will continuously remind you of their inflation objective to do what they can to keep you convinced that inflation expectations are “well-anchored.”

The zero lower bound on interest rates and forward guidance

You can do the inflation thought experiment for deflation too. Imagine that the stick starts falling towards you.  What do you do? The obvious thing is  to pull the base of the stick towards you and cut interest rates. With some manoeuvring, the deflation will be halted.  But what do you do if you can’t pull the still towards you.  If there was nothing else you could do, then there would be a deflationary spiral and you would have lost the stick. But of course there are other things you can do.  Suppose you were once a quick reacting (Type I) central bank that kept inflation close to target with swift and large if necessary interest rate responses.  Now you only have a little bit of lee-way, maybe to cut the interest rate to zero from say, 2%.  One trick is to switch type from a Type II central banker into a central banker that prefers slow and small adjustments (Type I).  If you don’t tell people that you have switched to Type II from Type I monetary policy, they may mis-read a small interest rate cut for policy ineffectiveness. Those deflationary expectations could start getting away from you, reinforcing the downward spiral.  So what do you do? You provide guidance to the markets that you are going to stay “low for long”, possibly until some condition outside of the control of the central bank like unemployment is met, and remind them of your inflation target to keep inflation expectations well anchored. This has become known as forward guidance. TH prefers Open Mouth Operations.

The zero lower bound on interest rates and quantitative easing

But interest rates are not the only game in town.    Everyone knows that printing money (aka quatitative easing) is inflationary right?  So another way to prevent deflation when you can’t pull back on the stick is to print money.  This will create the expectation that there will be some inflation, which will lower the real rate of interest for borrowers and stimulate demand.  Effectively, it’s finding a way to push on the top of the stick.  Again, by helping to anchor inflationary expectations (in this case offsetting expectations about deflation), quantitative easing can give help make the interest rate tool more effective at the lower bound.

Monetary policy to increase inflation with rational expectations

As noted above, inflation expectations are important in this model .  The momentum in the stick, which keeps it falling forward or backwards, even after some policy response, is a proxy for what economists call adaptive expectations. It simply means that people form expectations, at least partly, on the basis of what happened in the past.   What would happen if they were fully rational or forward looking? In that case, then things might be a bit topsy turvy. For example, suppose that the central bank announced a new inflation target of 10% (up from 0).  If the natural rate of interest was 3%, then, if everyone fully believed that the central bank would hit is target, starting a year from today (or tomorrow at annualised rates), all the central bank would have to do is INCREASE interest rates immediately to 3+10 = 13% to create inflation.  Using our stick analogy, the central bank would announce a new inflation strategy, which would stimulate demand and get the top of the stick moving forward, and then simultaneously start walking forward, pushing on the bottom of the stick.  The central bank would then just keep on walking forward at a constant pace that was analogous to constant increase in prices of 10% (perhaps ten steps a minute), with the top of the stick perfectly aligned with the bottom.

If you are quick, you might wonder whether the model with adaptive expectations could ever be consistent with the model with rational expectations.  After all, in the adaptive expectations case you cut interest rates to create inflation, in the rational case you raise them.  The answer is relatively simple, once you think of monetary policy as just balancing a stick on your finger.  After all, you know that you could, with practice initiate a process where you went from standing still while balancing the stick, to walking forward at a constant pace of 10 steps per minute. First you would cut interest rates, get inflation moving and soon adaptive expectations would learn that you were serious about targeting 10% inflation. Once you were advancing forwards at close to 10 steps per minute, you would tighten policy by pushing forward on the stick to alleviate the acceleration created by gravity and momentum. It might require a bit of back and forth, but eventually you’ll achieve  your goal.  You understand this, and so do market participants who seek to learn to come to rational conclusions through adaptive means.  All you need to know is that, in addition to cutting rates to increase inflation, you can raise them in the future to prevent accelerating inflation. So long as you know that, you will quite rationally understand that you can raise inflation by cutting interest rates.


Mispriced CO2 — the great big subsidy and the unbalanced, overheating global economy

People respond to incentives.  For the economy, the most important incentives are prices.  The marvellous thing about a market based economy is the ability of prices to adjust in a way that induces us to behave in a way that elevates our societies from chaos into orderly, well functioning economies that produce wealth and a high quality of life.  This self-organising nature of the economy and the role that prices pay is an amazing thing that we take for granted.

But prices aren’t always right. There are some prices that markets can’t set properly. Carbon dioxide is possibly the most important example of a price that is not properly set by markets. The reason that CO2 is mispriced is simple: it is almost impossible to prevent people from producing it, so businesses, big and small, and households, rich and poor, treat it as free.  Its effectively a great big subsidy to the production of CO2.  Everyone therefore produces too much carbon dioxide – way more than what would be produced if the rest of the world could refuse to accept it (unless induced to do so by a payment that appropriately compensates them for the negative side effects that the emitter imposes).  This problem is well-known to economists as the tragedy of the commons, and TH fears that future generations will look back at today’s and say that it was the greatest tragedy to ever affect planet earth.

Because the production of carbon dioxide is treated as free, those industries that use carbon intensively have become too big.  And since they draw resources (labour and capital) away from other sectors of the economy, the zero price on carbon has encouraged other sectors of the economy to become too small.  So not only has cheap carbon dioxide led to too much CO2 in the atmosphere and fueled an unexpected type of economic overheating in the form of global warming, it has also distorted the global economy making it unbalanced.

To get an idea of which sectors have become overweight on CO2  and which sectors have been crowded out, you need to know which goods emit carbon dioxide most intensively in production.  TH poked around a bit and found some data for the United States (  For a variety of reasons, carbon dioxide intensities would be a bit different for a country like Australia, but the data is good and comprehensive and it should give you a reasonable idea.

The following Chart ranks industries from low CO2 intensity to high.  There are no real surprises here.  The industries which use carbon dioxide most intensively in production are often in the mining sector —  iron ore mining, gold mining and coal mining are all big culprits (7 to  8 metric tonnes of CO2 per thousand dollars of output). Part of the reason that mining sectors get high scores could be technical – to measure intensity you look at the amount of CO2 per dollar’s worth of output.  Since inflation causes the dollar value of stuff to grow over time, the calculated CO2 intensity tends to decline over time.  To control for the inflation effect, the US Economics and Statistics Administration picked a year (2000) as a base year and measures the value of output using prices from that year in every year.  It just so happens that 2000 was a bad year for commodity prices.  If they used 2013, the story would probably be a bit different with the commodity producing sectors not looking so bad.

Other sectors that are CO2 intensive include the cement industry (cement is among the most intensive, producing around 12 metric tonnes of CO2 per $1000 of output using prices from the year 2000), metal production (producing between 1mt/$1000 and 3.5mt/$1000 for steel and aluminium respectively) and transportation (at 4mt/$1000, water transportation is particularly bad, worse that air transportation which produces almost 2mt/$1000 of output).   As you may expect manufacturing is worse than services. On average, manufacturing has a CO2 intensity of about 0.9 mt per $1000 of output compared to services (excluding transportation), which use less than 0.3 mt/$1000 (employment services, management consulting, sound recording, environmental, architectural and legal services all produce less than 0.15 mt of CO2 per $1000 of output).  Health care is low in CO2 too. As is movie production and banking.  Grain farming is somewhere in the lower to middle range.



So what can we learn from all this?  Well the last 20 years has seen some pretty drastic changes to the world economy.  Check out this graph from Arvind Subramanian and Martin Kessler’ neat blog post ( with links to their paper).  Look at what they call the period of hyperglobalisation in world trade, which saw global trade increase from around 20% to 30% of world GDP in about a decade starting in the mid 1990’s.  As you can see, merchandise trade (i.e. trade in CO2 intensive manufactured goods and commodities) accounted for nearly all of this increase, while services trade has increased slightly around the 5 percent of world trade mark).  And all this merchandise has to be shipped — mostly by sea.

At the same time, the process of industrialisation has promoted a rapid increase in the rate of urbanisation (the share of the world’s population living in cities has increased from less than 40 percent in the mid 1990’s to over 50 percent today).  Like manufacturing and transportation, urbanisation and the construction that goes with it is somewhat CO2 intensive.  It is not clear how much extra CO2 production, if any, has happened because of the effects of trade, but it seems intuitive that trade has contributed to increased manufacturing output and therefore increased CO2 production.



Source: Arvind Subramanian and Martin Kessler (

It is almost impossible to say definitively that these changes have been due to free CO2, even in part.  But we can say that they wouldn’t have been quite so dramatic if CO2 emissions were constrained by the true cost of producing it.  International merchandise trade requires water transportation, merchandise must be manufactured, urbanisation – requires construction and infrastructure, which in turn requires cement and steel, steel requires iron ore.

It is also possible that because of the principle of comparative advantage, the hyperglobalisation of trade has helped production of CO2 intensive goods to shift to places that specialise in the manufacture of these types of goods.  Similarly, comparative advantage can help encourage specialisation in low emission industries. For example, using the US emissions data, which tells us not only about the emissions by growth in each of the 349 sectors that they collected data on, you can calculate that over the decade from 1996 to 2006, US manufacturing industries in the survey grew just 3 percent while services expanded by 24 percent. This no doubt reflects service biased technological advancement and factors such as population aging in the US, but trade could also have something to do with it.  Tradeable services like banking and management consulting expanded by 45 percent and 109 percent respectively, such as photographic equipment declined by 50% and printing machinery by 25%. This process can shift CO2 emission to rapidly manufacturing driven countries such as China (Australia for commodities), and free up resources for less CO2 intensive sectors in countries that import those goods (such as the US).

There are two points to be made on this.  First, if you look at data for a country such as the US, you find that CO2 per unit of GDP is falling.  But this is not necessarily reassuring.  It partly reflects that sectors that were high emitters of CO2 have shifted offshore and allowed low emitting industries to grow.  This process just shifts the emission of CO2 from one place to another. The second point is that the problem is not trade per se. Since comparative advantage is determined by the price of inputs into the production process, the freeness of CO2 has affected the location decision for these industries.  The problem is the effective subsidy to CO2.

The freeness of carbon is reshaping the global economy in a way that not only causes too much CO2 production and global warming, but encourages the production of too few goods such as health care, education, arts and entertainment, and too much stuff like cheap plastic toys. It also encourages firms to shift production to places to reduce cost pressures based on the wrong signal about costs, and ship those goods at effectively subsidised prices.

The solution to all these problems is to properly price carbon dioxide.


What determines the liquidity of the housing market?

This is a hard question to answer.   TH likes to think about liquidity describing the ease with which a transaction can be reversed (i.e. as a description of the state of a market).  When liquidity is good, a transaction can readily be reversed at the market price that the transaction took place at (assuming that there have been no changes to the underlying demand and supply conditions).

With respect to the housing market, sometimes it is easy to buy and sell a house (meaning that the transaction can be fairly easily reversed and houses are fairly liquid).  Of course you may not be able to sell a house and then buy the exact same house back again, but, if market liquidity is good, you could buy back a house with essentially the same attributes for pretty much the same price as you sold the first one for. On the other hand, sometimes the housing market is slow, you may find a house to buy, but it could be quite difficult to sell what is essentially the same house at the same price that you bought the first for so houses are illiquid.

So what determines the liquidity of the housing market?  Money goes a long way, because it reduces the need for barter. To paraphrase Robert Clower  –  “houses buy money and money buys houses, but houses don’t buy houses.” But that is a somewhat, though not entirely, uninteresting answer.  What TH wants to think about is what causes churning in owner occupied housing markets.  The more churning in the market (i.e. the more people looking to buy and sell a home), the greater the chances people can make transactions that are relatively reversible and the more liquid the market will be.

There are two main sources of churning.  The first is demographics – kids leaving their parents’ homes for their own, which ultimately means churning of the housing stock from the old to the young.  Call this sort of market participant a Type 1 churner. The second source of churning occurs when some event makes a household’s current house unsatisfactory relative to their needs requiring them to want to switch homes. Call this group Type II churners.

Consider a market with only switchers (Type IIs) in it. If you assume that switchers are not prepared to go homeless, then when a switcher decides to sell their home and buy another, they will either have to find another home that settles on the exact same day, or they will need to carry two properties for a period of time.  When they have two properties, it means that one property is, for all intents and purposes, vacant. It turns out that the supply and demand for this vacant housing is key to understanding housing market liquidity.

In the short-run, because the supply of houses is more or less fixed and the number of households (people living in houses) is also fixed, the number of vacant homes (inventory for lack of a better word) must be fixed as well.  So everything then depends on the demand for the vacant housing stock.

An example might help.  Imagine what happens when there is some shock to the market that lowers the cost of holding a second house, such as a cut in interest rates for example.  There are two offsetting effects to consider.  First, on one hand, when the cost of holding a vacant house decreases, the number of market participants willing to switch houses will go up, on the other hand, the period that they are willing to carry the vacant house also goes up.  Both can’t happen.  But because both represent an increase in demand for houses, the unambiguous effect is that the price people are willing to pay for the use for a house as inventory will increase.  In a competitive market, that means that the price of housing in general also rises.

The effect on liquidity, however, depends on whether the resulting equilibrium involves more participants churning through the stock of vacant houses quickly, or fewer households using the inventory to extend their house search for longer.

When individuals hold on to the vacancy for an extended period, they reduce the supply of the pool of vacant houses available to others and drive participants out of the market and reduce liquidity.  This effect could be termed the liquidity using (or draining) effect. On the other hand, if more people enter the market, with each searching for less time, but contributing to turnover and a greater variety of houses, then there is a liquidity creating or enhancing effect.

Which of the two effects dominates is not clear.  But because a more liquid market is more attractive to both buyers and sellers, it will attract even pore entrants, and put additional pressure on prices.  On the other hand a less liquid market will be less attractive and alleviate pressure on prices.   What this means is that a shock to demand caused by a cut in interest rates, for example, would almost certainly cause housing prices to rise, but it could cause either an increase in housing market liquidity (i.e. a hot market where Flip that House shows on prime time TV) or a slowing housing market, where despite lower interest rates and high prices, homes a slow to sell.

Japan’s “seniors’ moment”

Torrens read somewhere that Japan’s working age population is set to decline by something like 17% over the next 17 years (though data  from OECD says it’s more like 14%). This can be seen by the shift from the green distribution to the red.


Regardless of whether its 17% or 14%, it got him thinking about what the implications would be for the world’s third largest economy from such a significant decline in its workforce. The prospect of an aging Japan is starting to worry investors.  And, to borrow from Paul McCartney, TH reckons Mrs Suzuki might now be wondering whether financial markets will still love her when she turns 64? (Mrs Suzuki was the hypothetical representative Japanese investor that Canadian economist Kenneth Courtis used to use to animate discussions like this).

The demographic shift gives us two main issues to think about.  On the one hand, there is the effect on the labour force and the underlying structure of the economy.  On the other, there is the effect on savings.  In practice, the two issues are different sides of the same coin, but it helps to think about them independently.

The structural shift in Japan’s economy

First, it probably means that the labour force will contract, even if people like stay at home mums (or dads) are encouraged to enter the work force.  Second, given that Japan is a relatively high cost manufacturing location, it probably won’t be able to attract investment in quite the same way that China, Korea or Vietnam can. Put these two pieces together and it becomes fairly obvious that Japan’s GDP growth might well turn negative simply because the supply of productive resources (the amount of capital and labour) will be shrinking.  And unlike China, which can import productivity improvements from advanced economies, Japan which is on the technology frontier and may struggle to boost productivity growth in the future (though enhancing technology is something the Japanese clearly excel at).

Second, unless there are some other adjustments, most of the decline in productive capacity is likely to be in Japan’s labour intensive services sector rather than the capital intensive manufacturing sectors.  That is, the declining labour supply will likely result in a fall in the supply of services relative to manufacturing.

A savings shift

During the last 40 to 50 years, the Japanese have been notoriously thrifty.  It has consistently sold more onto world markets than it bought and saved the difference.  As a result, it is now the world’s largest net creditor. Its net international investment position was around 60% of its GDP in 2011. As its population ages, it will start running down those savings and it will start to spend a larger share of its income.

The increase in spending will probably go on both goods and services, but to the extent that the spending is likely to be age related, the mix is more likely to be on services than at present.

Bippity Boppity Boo

So put all this together and what do you get?  If this analysis makes sense to you, then you will likely conclude that over the next 17 years, demographic change in Japan will result in an increased demand for services at a time when the supply of services starts to decline.  As a result there will be an excess demand for services relative to goods, and one should expect the price of Japanese services to start rising (or alternatively the price of goods will start falling).

There are two ways this adjustment in relative prices can happen: either through inflation, or an appreciation of the exchange rate.   Until the recent dramatic change in policy regimes in Japan, it was the exchange rate that was appreciating.  Going forward, given the new monetary stimulus, inflation could play more of a role than previously expected (especially services prices).   Arguably, the sharp yen appreciation during the financial crisis and the shift of Japan’s trade deficit into surplus is an indication that these forces are already at work.

So why the worry about Japan?

By itself the forthcoming adjustment should not be a major source of concern so long as markets are able to adjust and clear the excess supplies and demands, all should be OK.  So why is everyone so worried about Japan these days?

The answer has to do mostly with the savings shift.  You see, despite Japan’s sizable holdings of foreign assets, it is widely believed that Japanese investors have a strong bias for Japanese assets. A phenomenon called home bias. Such a bias tends to mean that the price of these assets is driven up and correspondingly the yield on these assets is driven down.  In this respect, home bias has been a good thing for the Japanese government, which has issued a lot of debt (in net terms, it’s just under 140% of GDP).

Essentially, the Japanese government sold bonds to its high-saving, middle-aged population with the promise that future generations would repay them (you could imagine that one of them was Mrs Suzuki).  Now, instead of raising taxes (or cutting spending) to repay its debts, the government (with a budget deficit of around 9% of GDP) is borrowing heavily and rolling-over its existing debts.

But with Japanese saving less, the Japanese government will have to start relying more heavily on foreign investors to hold its bonds, and these investors are not likely to be as kind as Mrs Suzuki was to the Japanese government.  Increasingly, the marginal buyer of Japanese bonds won’t have a strong bias for Japanese assets; they will treat them just as they would any other asset and so the yield on Japanese government bonds is likely to start to rise.

Age related mis-calculations

Additionally, when fundamentals change (as they are in Japan), there is the chance that people (including policy makers) don’t recognise the changes that are underway and make decisions that are inconsistent with the new reality. In this case, the natural slowdown that the Japanese economy is experiencing might be misinterpreted as a lack of demand. Policy makers may be tempted to engage in too much stimulus for two long, creating excessive burdens of government debt and credit growth.

From Torrens Hume’s perspective, an aging population, increasing financing costs and excessive credit growth sound like a combination of factors to take pause over.