Central bank policy

It is an old adage that the market is a weighing machine in the long-term and a voting one in the short-term. The latest data published by the Federal Reserve in its Z1 Financial Accounts of the United States show the weighing and the voting pointing in sharply different directions. Read more

There has been a steady decline in the efficiency of capital over the long-term in developed economies, and this deterioration has continued over the postwar period. We have also had a large fall in investment over the past 30 years. Unless there is a sharp reversal in these two adverse trends, the sustainable rate of growth will be much slower than it has been in the past. Read more

One of the most encouraging features of the US economy has been the recent improvement in the level of labour participation, which is the proportion of those aged 15 to 64 who wish to work (i.e. employed plus unemployed).

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The dramatic expansion of central bank balance sheets as a result of quantitative easing produces two extreme views. One is that it will cause hyperinflation and the other that it has had no adverse consequences. Neither of these strikes me as at all probable. Hyperinflation is not a serious risk, at least in the developed world, but it does seem likely that QE has adverse consequences. Having instituted QE, central banks are understandably unwilling to talk about its dangers and adjust their policies for them. However, it has probably increased the risks of a pickup in inflationary expectations and the dangers that this poses for the economy.

As chart one shows, we have had an upward sloping yield curve for the past 80 years, i.e. borrowing through issuing bonds has been expensive. Governments have nonetheless chosen to fund this. If this wasn’t just a stupid decision, then the added cost of funding must have produced a large benefit for the economy. I think that this benefit was real in that it helped to moderate inflationary expectations. Read more

Usually the Fed waits too long before raising interest rates. The pressure to delay is particularly strong today. One reason is the sharp decline in the trend growth rate of the US. As I have pointed out in these blogs, this is the result of a sharp fall in the growth of the population of working age and in productivity. In the decade prior to the financial crisis (1997 to 2007), the numbers in the US of those aged 15 to 64 grew at 1.38 per cent per annum and is now forecast to rise over the next decade at only 0.18 per cent per annum (chart one).

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Conventional wisdom, those wrongheaded comments that sound authoritative, is flourishing. Much comes from seeing gross domestic product as the measure of economic success. As Japan’s GDP has grown slowly this has led the unreflective to assume that the country’s performance has been poor. As readers of this blog will know, this seems to me to be nonsense. GDP is a fair measure of a country’s economic power, but changes in GDP per head provide a better guide to the progress of a country’s welfare and GDP per person of working age is a better guide to the success of economic policy. The number of Japanese aged 15 to 64 has been falling and this has limited the country’s ability to expand its GDP. If the changes in GDP per person in major developed countries are compared, Japan stands out for its success rather than its failure.

I am by no means alone in pointing this out; the former Bank of Japan governor, Masaaki Shirakawa has also regularly done so. Judging, however, by comments in the financial press we seem to have been talking to brick walls. The damage done from seeing GDP as a valid measure of economic success has been magnified by an association that is commonly made between low growth and deflation. It is widely believed that Japan’s economy has performed poorly and that this has been caused by deflation. It would be more reasonable, though not much more, to praise deflation for the relative success of Japan’s economy. Read more

Quantitative easing involves buying bonds and this increases the Bank of Japan’s assets and the monetary base which, depending on the precise definition used, is nearly the same thing. As a result of the BoJ’s aggressive QE policy, its balance sheet has grown from 30 per cent of gross domestic product at the end of 2012 to 60 per cent at the end of 2014. Over the past year it has grown relative to GDP by 14 per cent (chart one). This compares with a fiscal deficit of around 8 per cent of GDP. Japan’s central bank is thus buying more than 100 per cent of the securities issued by the government to finance the deficit. Read more

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.

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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

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