Central bank policy

Japan’s gross domestic product shrank in the third quarter of 2014 at 1.6 per cent per annum over the quarter and 1 per cent over the previous 12 months. This disappointed the stock market, which fell by more than 2 per cent. It then recovered almost fully the next day on the news that Prime Minister Shinzo Abe had called a snap election, designed to give him a mandate to postpone the increase in consumption tax otherwise due in October 2015.

Governments can boost demand by increasing expenditure or by cutting taxes. Disappointing GDP data do not therefore provide much reason for gloom unless the government appears unwilling to boost demand or the data reflect a problem of supply rather than demand. Read more

Japan cannot put its economy on to a sustainable path unless it reforms its corporation tax system. Fortunately, this is now under active discussion. Unfortunately, it is far from clear that the right changes will be made.

One sector of the economy cannot lend unless another borrows. The sum of the net lending and net borrowing in an economy must therefore equal zero. Japan’s government is a huge borrower and, if this is to be brought down to a sustainable level, the net lending of other sectors must come down by an equal amount. As chart one shows, it is the corporate sector which has moved into massive cash surplus since 1988, when Japan’s fiscal balance moved into a structural deficit. It is therefore the corporate sector which must take the brunt of any fall in government borrowing through a similar decline in the sector’s net lending. Current tax arrangements and regulations are the key cause of the massive cash surpluses run by companies which must be brought down if the fiscal deficit is to be reduced to manageable proportions. Read more

The damage done to the UK and US economies by buybacks in preference to capital investment was a central theme of my book The Road to Recovery, and it has found its way, not too often I hope, into these blogs. I have therefore been heartened by the growing interest shown by the financial press in this threat to our economies. The Economist recently devoted a major section to the issue, as did the Financial Times on October 12.

The change in the way managements are paid drives buybacks but this has yet to be widely appreciated. The US Federal Reserve’s quantitative easing programme was rightly underlined by my colleagues as adding the fuel of cheap debt but, without the preference for buybacks, low bond yields would have encouraged capital investment. This they markedly failed to do. An important paper, shortly to be published in the Review of Financial Studies, “Corporate Investment and Stock Market Listing: A Puzzle?” by John Asker, Joan Farre-Mensa and Alexander Ljungqvist demonstrates that a huge difference has appeared in recent years in the levels of investment by quoted and unquoted companies. Read more

The following comment on my blog post about quantitative easing and the eurozone struck a chord:

“The unaddressed and unanswered question about fiscal stimulus in the eurozone is about why it will be anything other than another short-term sugar rush?” Read more

The eurozone’s economy appears to have stalled. It was widely expected that growth would pick up to 1 per cent this year, but these estimates are now being toned down as the first two quarters of 2014 have been below expectations. The pattern shown in chart one (below) is, at best, one of stagnation. It is therefore agreed with near unanimity that the eurozone’s economy needs a boost.

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In my previous post I showed why it seems likely that profits published by US companies are currently overstated by much more than they have been in the past. This does not necessarily mean that the degree of overvaluation of the stock market shown by cyclically adjusted price-earnings ratios is understated. The profits as published have been far more volatile than shown in the national accounts, and it is probable that published profits were heavily understated in 2008, as earnings per share in Q4 2008 were negative, while those shown in NIPA Table 1.14 remained strongly positive. Read more

Asset prices fall if investors’ liquidity preference rises or if their liquidity falls (ie, if investors need the money or want to have more cash in their portfolios). Liquidity depends on central banks; they can create it or soak it up. The US Federal Reserve seems unlikely to reduce liquidity unless inflation picks up, but is likely to stop creating it in October. Therefore, one way in which asset prices will fall is a rise in inflation or pre-emptive action by the Fed to stop it.

When the Fed creates liquidity, it takes a larger rise in liquidity preference than before to hit asset prices. The Fed is thus in the process of increasing the market’s sensitivity to rises in liquidity preference and, as small changes are the normal response of investors to new information, the volatility of the market is therefore likely to rise. In the absence of increased interest rates, large changes in liquidity preference, however, are likely to depend on falling profits. Read more

After a period when consensus ruled, economists are as much at odds today as they were in the 1980s, and policies can alter sharply when those in charge change. Quantitative easing is today the main bone of contention among policy makers and economists.  Read more

A few weeks ago, I promised to write about claims that the stock market could be valued by comparing earnings yields to bond yields. This approach is sometimes called the “Fed model”. This was fashionable in the 1990s and seems to have some followers even today. It is not only nonsense but is the most egregious piece of “data mining” that I have encountered in the 60-plus years I have been studying financial marketsRead more

In the past governments have funded their deficits – for example, they have borrowed in the bond market rather than through treasury bills. This is despite the fact that, for the past 80 years, the rate of interest on bonds has been greater than that on Treasury bills; that is, we have had an upward sloping yield curve.

I suggested in a recent blog that this was because governments correctly perceived that there were considerable economic risks in not funding, and that it was worth paying the additional cost to avoid these risks. Quantitative easing, which is a form of underfunding, must therefore have increased these risks. Defenders of QE need either to argue that these risks have not risen or that the benefits we have received from QE outweigh the rise in risks. To be consistent, those who hold that no additional risks have been incurred must now hold that governments should not have funded in the past and must now stop. But their silence is deafening, and such views are implausible, being held, I think, in the hope of dissuading discussion rather than from any conviction that they would survive much debate. Read more