Sunday, May 31, 2009

Global Imbalances

The global imbalances story explaining the current crisis is gaining ever more adepts. It's fairly straight that U.S. officials claimed it, looking for guilt abroad will always be far easier, but now academics are pledging the same. Eichengreen wrote a piece based on the imbalances story that is worth reading.

Saturday, May 23, 2009

Quarterly GDP

Recent data from the statistics institute showed that Mexico's GDP decreased by 8.2 per cent. This is certainly the worst quarterly figure since the so called tequila crisis.

To have a broader perspective of the economic slump, it is necesary to state differences between both downturns.

First, clearly this is an external crisis, this is, it is not due to Mexico or any other emergent economy. Second,current crisis has not distorted prices in the same magnitude as in 1995. It is worth noticing that despite pressures on Mexican currency, the "pass through" has not pushed prices so high. Actually, inflation is only one eighth of that of the first quarter of 1995.

Third, this time around exports will not pull Mexico out of recesion. Worst, they are dragging it down. Take the following equilibrium condition that states how public and private domestic savings equal net capital outflows


There are two features that characterize the Mexican economy: it saves poorly and it's tax revenues are poorer. This implies that the left hand side of the latter equality is negative. This lead to conclude that the right hand side must be negative.

So far there is nothing different. However export intensive the Mexican economy is, the very nature of it's exports imply considerably high imports. Most part of exports are manufactured goods, so intermediate imported goods are needed.

So, XN is negative as it has been in the last 14 years or so. The only channel remaining to adjust is investment. A strong argument can be constructed to explain how the current economic slump is explained by the fall of in-flow capital and the expectation of poor investment returns.

Sadly the latter argument lead to conclude two things. First, Mexico will not grow until the exports demand grow, inherently there is little to do in economic policy. Second, it is a necesary condition for growth that capital flows reach back to Mexico.

One paliative to the current recesion could be found in the increase of T (a decrease in G would be possible too, however this looks politically harder in the current G boom all around the globe). As the equation shows this will re-balance the lack of domestic savings, painfully this means a revenue intensive fiscal reform.

Mexican policy-makers should aim to survive the storm then.

Friday, May 15, 2009

Negative Interest Rates? Seriously?

The latter discussion that has been going on about the possibility of the Fed pursuing a negative target of interest rate seemed shallow at first. But, honestly, there would be a few advantages of having inflation at a positive level soon.

So far we are certain that inflation is not a problem -though we are that it WILL BE because of debt issuing- so why is it too hard to think about having negative -real- interest rates?

Mankiw poses the thought in a provocative way and he says that it attracted a number of negative comments. So which is the right approach to conclude that negative interest rates are useful? First, you should be a dove in terms of inflation, that is, you price higher unemployment than inflation. Second, you must be convinced that a demand pull will put the economy on a stable path. Third, you have to neglect the fact that excess of borrowing got the U.S. Economy in to this mess, and the negative interest rate will not solve this.

Once those three conditions are met, then yes, a negative interest rate can pull the economy out of recesion. Lets assume that this is the case. Then it is useful to analyze some advantages of the scheme. First, inflation is better that deflation, and recent numbers show that deflation is already here. Even if future inflation can be a big issue, deflation should be avoided because the latter will imply that the former will not appear, by definition.

After deflation is avoided, a second possible advantage of having positive inflation in the current environment is that public debt would be inflated away, and this would prevent a default from the U.S. Treasury. This second possibility deserves deeper analysis, observe however, that it is equivalent in a certain fashion, to a rise in taxes without Congress. Lets not forget that this is one of the most regressive taxes there are. So the lower income layers of population will shoulder a considerably high part of the tax burden.

Furthermore, a negative interest rate scheme implies that capital tax revenues will not be positive. Another shock to inflation that may be overlooked is that in strict terms it is natural to expect dollar to depreciate. This would help to balance the current account of the U.S.

It is rather hard to forsee all consequences of negative interest rates, however, it is fairly straight that it would work as an increase in future taxes, the most distortive kind, the only positive side would be to inflate away debt.

Monday, May 11, 2009

Inductive and Deductive Methods in Economics

Lately, as a consequence of the economic events, the way economics should work as a scientific method and as a social science has been challenged. Eichengreen addresses how Economics should aim to a more inductive analysis fashion.

There are a few points in the same spirit that should be taken into analysis. First, is ever more clear that mathematical models are useful to test facts observed in reality. It is indeed frustrating that there are thousands of tons of papers about economics written, and despite the latter, bubbles in financial markets exist and policy makers are doubtful of the effects of public spending and tax multipliers.

Second, it's true, economic theory has advanced considerably in microeconomics, game theory, even in macro theory, however it is rather slow the process of applying theory to economic policy. Naturally, the question rose: when will developments in theory will help policy makers?

In years to come is fairly likely that research in macro will have to address specific problems, which prove directly related to reality and not with theoretical problems, such as existence or uniqueness of equilibrium.

This in turn gives an advantage to the keynesian and new keynesian economics approaches, as opposed to the classical one, the former are far easier to contrast in reality.

The latter implies that all of us who are interested in macro will have to put a lot -more- effort to empirical and programing techniques, whether they come from econometrics or from calibration.

All of the latter shows that the deductive method, in which a chain of logical facts is sufficient in order to prove one hypothesis has been seriously challenged.

Theory based in the deductive method should be regarded as a first step in the analysis, yet, making decisions without the appropriate empirical -inductive- evidence should be avoided.

An illustrative example of the latter appears in the interview Catherine Mansell made to Arnold Harberger. Harberger emphasizes that every economic policy recommendation and economic theory assertion must come from sound contrast with reality.

It is true, econometrics sometimes looks like some black magic that would tell the researcher what he wants to hear. This approach of econometrics should be corrected too.

Economists as social science researcher must base any conclusion in observation, with the valuable help of formality provided by mathematics.

Wednesday, May 6, 2009

Inflation Targeting and Central Bank Independence

Recently a number of articles from economist regarding Inflation Targeting (IT) and Central Bank Independence (CBI) have put some thoughts out there that must be analyzed carefully. Those articles aim at causes of the current financial crisis and up-to-date policy efforts to tame it.

A quick review of the pre-dominance of IT and CBI should include that, the former is the result of taking inflation as a great monetary phenomena. This is, inflation is less related to the real economy, and the premise that the biggest contribution from any central bank to economic growth is keeping inflation rates low -thus interest rates low, thus increasing rates of investment thus increasing aggregate demand.

The IT scheme provides information about future policy decisions by the central bank, clearly, if observed inflation is above the targeted one, interest rates will go up, and if current inflation is below the targeted one, interest rates MIGHT go down.

CBI, as Becker explains is important because if any central bank finance treasury fiscal deficits, the medium term result is a high rate of inflation. So both IT and CBI contribute to low inflation. Indeed the world has seen a period of low inflation rates in the last twenty years. We all know that there are two direct causes of rising inflation: 1) If Aggregate Demand expands or 2) if Aggregate Supply retracts.

The key issue evaluating IT and CBI is finding how does monetary policy controls prices? Is it through Aggregate Demand or Aggregate Supply or both? Both is the most accurate answer. When a central bank increases the interest rate, aggregate demand diminish as credit and investment are relatively more expensive. However, aggregate supply can expand since as the interest rate increases, expectations on prices fall, thus increases in wages are moderate and thus firms can expand output lowering prices at the end by those two channels.

The latter example illustrates that monetary policy is important both for consumers and firms. This approach lacks an important feature, market bubbles. Evidence suggest that when output is considerably weak, central banks aim for a loose monetary policy, this is, low interest rates achieved by an increase in money supply. This loose monetary policy creates, fairly as a consistent result, an excess of money holdings. The latter in turn creates an excess of savings and thus a great probability of the rise of a market bubble. As financial firms compete for the excess of savings, and interest rates are low, managers have greater incentives to invest in riskier assets.

So there is a strong argument that blame central banks for the existence of market bubbles. This leads to a first direct conclusion, CBI is a key feature because it guarantees low inflation and can decide with the least political bias whether or not to sustain low interest rates when output is weak. If this were not the case, every time a political decision implied a monetary stimulus a bubble could arise. Is fairly straight to conclude that is better to have bubbles as an undesirable outcome, than every time the economy is weak and politicians need votes.

As for the IT case, it is true that its results in terms of inflation are rock solid. However, Martin Wolf argues that it should address market bubbles as well. This argument needs further analysis. Lets not forget that recent evidence suggest that, in the short-run, there is an undeniable positive relation between low interest rates and market bubbles. So how can a central bank achieve a dual objective involving market bubbles and inflation? The short-run Phillips curve suggests that this dual objective would have a negative impact in output growth. But why should the central bank look at the unemployment rate when making monetary policy decisions?

What if the central problem with IT is precisely that it has not stopped worrying about output? Even in Volker's Fed mantaining interest rates "too high for too long" did not represent a massive breakdown in any system, it did pushed the U.S. recession, but the economy grew more than eight years in a row after that. Today, the Fed mantained interest rate "too low for to long" stimulating bubbles in house markets and later in commodities. We can conclude that "too high for too long" addressed inflation and "too low for too long" addressed unemployment.

From the last argument a strong conclusion should state: IT will not be enough, central banks should address bubbles too. It remains out of the question to add to the central bank's responsabilities low unemployment.