Major economies

Bad policies breed even worse ones. The disillusionment of voters provides the link. Disappointment with the economy is reinforced by the conviction that “‘They’ don’t know what they are doing.” Voters want new policies and new people. Sadly, this does not usually produce sound policies advocated by those who have correctly analysed the faults of the past. Realism seldom offers the instant gratification sought by the disgruntled, and populist policies thus usually represent a retreat from reason rather than a rise in analytical rigour. When countries have embraced populism, the resulting policies have habitually made matters worse.

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Financial crises commonly arise when there is too much debt and asset prices fall from excessive levels. Examples are to be found in 1929 in the US, 1999 in Japan and 2008 worldwide. Hyman Minsky, in his famous book Stabilising the Unstable Economy, set out the three stages in the pattern of borrowing that involve increasing risk. It starts with borrowers expecting to be able both to pay the interest and to repay the principal from the cash they expect their investment to generate. In the next stage their hopes are limited to paying the interest and refinancing the principal when the repayment falls due. In the final stage not even the interest is expected to be covered and the expected profit derives solely from the hope of being able to sell the debt financed asset at a profit. When continually rising asset prices cease to be an article of faith, the house of cards collapses.

There is then a rush to sell assets which sets off a recession, as borrowers seek to repay their debts. Companies which wish to reduce their borrowing don’t just avoid new borrowing — they seek to repay their existing debt. To do this they need to generate cash. This means spending less than they earn, and their intentions to invest then fall short of their intentions to save. The attempt to improve private sector balance sheets can therefore be described as a balance sheet recession, whose severity can be moderated as fiscal deficits cause the balance sheet of the public sector to weaken, offsetting the negative impact that comes from the strengthening of private sector balance sheets. Read more

Since the financial crisis, growth has slowed in the developed world. It is often assumed that this is an example of cause and effect. I showed in my previous post that this assumption is improbable, as much of the slowdown is the result of changes in demography — changes which are themselves largely the result of birth rates, which predate the crisis by many years. The other major cause of the slowdown has been a decline in productivity. Taken together, demography and productivity appear responsible for a minimum of 79 per cent of the decline in growth among the five developed economies I focused on — the US, UK, France, Germany and Japan.

Increases in productivity usually require investment in new equipment, but the extent of any productivity improvement will depend not only on the amount of the investment, but also its effectiveness. Where investment declines, a fall in productivity is likely unless the change is offset by a rise in the efficiency of new capitalRead 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

In two earlier blogs I explained why the cyclically adjusted price earnings yield (Cape) could not sensibly be applied to valuing Japanese shares. (One of several reasons is that Cape is only valid if profit margins are mean reverting over relatively short periods of time, such as 10 years or so, and this has not been the case in Japan.) This does not mean that they cannot be valued by other means. In this and the next blog I attempt one possible way to do this. 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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According to an article in The Economist on August 2, “economists trying to explain the feeble pace of America’s recovery regularly blame deleveraging”. This raises two questions: can the US recovery sensibly be described as feeble and, if it can, is deleveraging to blame? Read more

The UK has a seriously unbalanced economy, with little spare capacity and a slow trend rate of growth. To correct its imbalances, the current account deficit and the cash flow surpluses of the corporate sector need to fall. This would permit a fall in the fiscal deficit, but requires a fall in the real exchange rate and in the share of consumption in gross domestic product.

The fall in the trend rate of economic growth comes from a combination of a slower growth in the population of working age and a drop in productivityRead 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

US gross domestic product was increased last year by much more than the growth of the economy. This sleight of hand was achieved by changing the way GDP is measured. The UK is due for a similar make-over this year. Reality won’t change and we need to be alert to the comments of those who will think it has.

“Nearly all scientists believe that there is a clear-cut distinction between fact and theory…William Whewell (1794-1866) denied that any such sharp distinction existed.” Peter Medawar, the Nobel laureate, whom I am quoting, agreed with the denial; and, as GDP data are generally considered to be facts, the revisions show that Whewell was spot on. The calculation of GDP depends on the theoretical model on which it is based. The change in GDP involves a change in the model being used and, in my view, the new model is worse than the old one. 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

Cyclically adjusted price-earnings ratio (Cape) appears to be a valid way to measure the value of the US stock market, but this does not mean that it can sensibly be used for other indices. As I explained in a previous blogpost, Cape is only valid if it can pass two tests: first, that the real return on equities has been mean reverting; and second, that profit margins have also been mean reverting and have rotated quickly around their average.

Real returns on equities has been less strongly mean reverting in other markets than they had been in the US. This weakens the case for Cape in other major stock markets, but does not, I think, necessarily rule it out. Even if returns would otherwise have been mean reverting, they will not have been if countries had suffered unexpected and catastrophic losses, such as occurred in world wars. I had already explained in Growth and returns, another blogpost, that these losses were the probable explanation for the exceptionally low returns on equity investment in the first half of the 20th Century in countries such as Germany and Japan. Read more

The cyclically adjusted price-earnings ratio (Cape) has become well known as a way of valuing the US equity market. Its moderate success in this role has led to the assumption that the same approach will be valid for other markets. Unfortunately this seems doubtful, as I will try to explain. I should warn readers that, despite trying to make my explanation as simple as possible, I have been unable to avoid raising some quite technical points.

There are two fundamental and very different ways in which equity markets can be measured. One of these is q, by which the market value of companies is compared to the real value of their assets. This follows from the basic principle that, in any reasonably competitive economy, the value of anything depends on the cost of creating it — and it is therefore the macroeconomic approach. The other way treats equities as financial assets and values them by discounting the expected future returns at an appropriate rate. Cape is based on this approach and depends for its validity on the data for any particular stock market being consistent with the theory behind it. Read more

It is widely, but by no means universally, accepted among economists that the “rate of interest” is closely related to growth. It is, however, also generally accepted that this applies to a closed economy, such as the world as a whole.

The growth rate of G5 countries has been declining steadily for years, and this trend has recently accelerated, as chart one shows. It seems likely that low growth has become endemic and this is being widely interpreted as implying that real interest rates will remain low. This view strikes me as being unjustified on theoretical grounds and is also a very dubious conclusion to draw from the past. 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).

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Janet Yellen, the US Federal Reserve’s chairwoman, gave an important speech earlier this month which raised several interesting issues. One of them was emphasised by the FT US economics editor Robin Harding in an article headlined “Yellen warns inflation may lag recovery”. In the April 16 article, he said that “Ms Yellen said that high levels of unemployment had put less downward pressure on inflation than expected, so higher employment might not pull prices up again”.

There are two diametrically opposite interpretations of the change in the relationship between inflation and unemployment to which Ms Yellen has drawn attention. It is either a one-off aberration which will unwind, or a structural change. If the former, then inflation is likely to remain low for longer than would otherwise be likely; but, if the latter, inflation is likely to pick up more quickly. The difference is crucial as the former interpretation would reasonably allow the Fed to delay raising interest rates, while the latter calls for an even earlier rise than would otherwise be appropriate. Read more

Olivier Blanchard, chief economist of the International Monetary Fund, has egg on his face. He attacked George Osborne, the UK chancellor of the exchequer, for seeking to reduce the UK’s fiscal deficit too rapidly, claiming that it would prolong recession. Mr Blanchard has had to admit that he was wrong but his admission has been reluctant and ungracious. (This is the same mistake that cost former UK culture secretary Maria Miller her seat in the cabinet this month.) Read more