Central bank policy

The worst postwar recession has been followed by weak growth. It is readily assumed that this is cause and effect. Such an analysis is both wrong and damaging. If the weak recovery is due to the recent recession, then its causes must be short-term rather than structural. This belief is behind the frequent calls for more fiscal or monetary easing and the resulting failure to discuss, let alone address the deeper structural problems.

Periods of slow growth can be caused by insufficient demand or insufficient supply. If demand is the problem, the resources of the economy are not being fully utilised. But, if supply is the constraint, then those resources have not been growing fast enough. Read more

Japan’s economic policy is a battle between those who want inflation, on one side, and the fiscal hawks on the other. Prime Minister Shinzo Abe’s decision to hold a snap election suggests that the inflationists, of which he is one, are currently winning. The market rose on the news of the election, so it seems that investors believe that inflation would be good for both share prices and the economy.

Inflation, as measured by annual changes in the consumer price index, is currently well over 2 per cent. But according to the Bank of Japan, prices for producers are actually falling relative to three months ago, after the effects of this year’s consumption tax increase are excluded. The central bank goes on to state that this is a reflection of declining prices for international commodities, and that the annual rate of increase for consumer prices is just 1 per cent after fresh food is removed from the calculations. Read more

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.

 Read more

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

While it is sometimes useful to make a distinction between treasuries and central banks, they are fundamentally both part of government. When central banks buy bonds as part of quantitative easing, governments are in practice ceasing to fund, ie, they are issuing short-term rather than long-term debt. If this is potentially harmful, we need to worry; if not, we need to ask why have governments funded in the past? Read more

Abenomics, the term given to the reform package Japanese prime minister Shinzo Abe launched to revive the country’s economy, is based on two myths. One is that the economy has performed badly and the second is that this non-existent failure has been due to deflation. Despite its lack of intellectual justification, the attempt to stop deflation has been a success as the accompanying rhetoric and monetary policy have produced yen weakness. This was an essential step towards solving Japan’s fiscal problem and, as the rhetoric has been about deflation rather than devaluation, the dramatic weakness of the currency has been achieved without international opprobrium.

Over time the devaluation should result in an improved current account. This will allow the fiscal deficit to fall while the economy moves ahead, but it is not enough on its own. The other essential is to reduce the cash flow surplus of the business sector. Having achieved success in step one, largely by accident, there is a chance that Abenomics will succeed in step two. If it does, it is again likely to be an accident. Read more

Ian McCafferty, an external member of the Bank of England’s Monetary Policy Committee, believes “Britain’s ‘productivity puzzle’ will persist as the economy recovers because much of the decline in output is structurally entrenched.” As a result, Mr McCafferty believes that the Bank of England “should not ‘hold back too long’ on interest rate rises”.

Scarcely a day passes without some reference to the UK’s “productivity puzzle” and a claim that the poor productivity is “inexplicable”. This reflects a failure to understand how and why the economy has changed. Poor productivity is so readily explicable that it should cause no surprise. It is, as I have sought to explain before, the natural result of the change in management incentives. Read more

“Janet Yellen, the Fed’s head, rather bizarrely used the prospective price/earnings ratio, one of the weakest of all measures, to justify a statement that Wall Street was not overvalued. (This was doubly strange since her husband, George Akerlof, co-wrote a book with Robert Shiller, who has championed a much better measure…” I quote from a recent Buttonwood column in The Economist.

Calling Ms Yellen’s comment “strange” seems very kind. Many people would rate the use of bad data in preference to better as irresponsible rather than strange, particularly when it carries with it the authority of the US Federal ReserveRead more

In my last blog I emphasised the importance of foreign investors for the Tokyo stock market, but suggested that their future behaviour was either unpredictable or momentum based. If the latter assumption is correct, foreigners are likely to amplify rather than lead changes in the market’s direction and to assess its prospects we therefore need to look at the other participants. Read more

When a central bank buys government bonds, the liquidity of the sellers rises. In the absence of changes in liquidity preference, this will drive the sellers to buy other assets, in particular non-government bonds and equities. Unless the supply of the alternative assets increases, the buying will push up their prices. Read more

Since its trough in the second quarter of 2009 living standards in the eurozone, measured by real gross domestic product per head, have recovered less than those of other major developed economies, due to less stimulatory fiscal and monetary policies.

Things now seem to be looking up and the eurozone has several relative advantages. It has higher household savings’ rates, lower fiscal deficits and higher unemployment compared with Japan, the UK and the US. Read more

The UK economy may stall but expectations for growth are generally being upgraded. Unemployment is falling rapidly and, as chart one shows, it is at or below its long-term average, depending on which measure is used. The rapid decline in unemployment indicates that growth is well above trend and the rate seems unlikely to be very different from the level at which wage rises will start to accelerate (ie, the Nairu – non-accelerating inflation rate of unemployment).

 Read more