Confidence and Crashes

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The Dow dropped 4.6% on Monday February 5th.  This was the biggest recorded point drop, 1,175, in history. The markets regained some ground on Tuesday and, as of writing this post, we have simply wiped out the gains that have accumulated since the beginning of January. But we are not yet out of the woods. If the markets continue on their precipitous decline there is real cause for concern.

The vagaries of the market are caused by the animal spirits of market participants. They have little or nothing to do with the ability of the economy to efficiently produce value. Most market participants buy and sell stocks not because they see value in the underlying companies: They buy and sell stocks because they believe that future market participants will be willing to pay more or less for the same shares. There is, after all, a sucker born every day.

But although the market does not reflect social value, it does reflect economic value. My research has shown that the ups and downs of the stock market are followed by ups and downs in employment and I have provided a theory to explain why. When we feel wealthy we are wealthy.  When we feel rich, we buy more goods and services, employment increases, and unemployment falls. There is a causal mechanism from market psychology to tangible economic outcomes.

Normally, the Fed and other central banks around the world would react to a market crash by lowering the interest rate. The cause for concern arises from the fact that they have no room to react to a market drop in the traditional manner as interest rates in the US, the UK, Europe and Japan are at historically low levels. We may be approaching a crisis of the kind I warned of in my book, Prosperity for All.  The solution, as I argue there, is for the Fed to put a floor (and a ceiling) on movements in the S&P by actively buying and selling the market.

What We Know for Sure that Just Ain't So

“What gets us into trouble is not what we don't know. It's what we know for sure that just ain't so.” Mark Twain

David Smith has a piece in the Times yesterday that, as always, is worth reading. But David is a little too certain for my taste. I prefer to follow the dictum that prediction is difficult; especially about the future.

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David discusses the Buzzfeed leak of the assessment of Brexit prospects by 'experts' at the behest of the Conservative government. Here is David with a defense against the Brexiteers:

"It was a great scoop for BuzzFeed, though no surprise to economists. Overwhelmingly, credible analysis shows a similar picture. It also produced the usual nonsense, of the kind that says that if you cannot forecast next year how can you forecast for 15 years? This, of course, is not standard economic forecasting but conditional analysis, which looks at the relative difference compared with the baseline when you introduce frictions into trade with your largest trading partner, reduce your attractiveness for foreign direct investment and cut the supply of EU migrant workers. It sets that against modest gains, only over a very long period, from non-EU trade deals."

Brexit may indeed be bad for the economy. But it doesn’t help to overstate the case. However you look at it, the statement that remaining in the EU would lead to an 8% larger economy, 15 years from now,  than leaving the EU with a 'Hard Brexit', is a forecast. And that forecast has standard errors attached. Those standard errors are very large indeed. 

It is also worth remembering that all forecasts assume that we can plan for the future using known statistical probabilities: Like rolling a die that comes up heads with a known probability. That is not the real world. The Bank of England famously produces fan charts that show not only the median forecast but the probability distribution of likely outcomes. For several forecasts in a row following the 2008 crisis, all the realized values of projected inflation were outside of the range of statistical projections. They were Black-Swan events.

Some of us will probably be worse off under Brexit in the near future. Perhaps all of us will be. I have no idea what the consequences will be relative to staying in the EU in 15 years time and nor does anyone else. "What gets us into trouble is not what we don't know. It's what we know for sure that just ain't so." Fifteen years from now, every outcome is a Black-Swan event.

The Brexit arguments are political. They are not Economic. The Economics is clear. Trade between countries increases the ability to produce goods and services. But when the relative prices faced by a country change, some people will gain and others will lose.

The gainers from globalization were those who have skills that are valued internationally and those who own capital that can be combined with cheaper labor abroad. The losers were those who are now competing with cheaper labor in distant lands. 

It is not enough to repeat the trite phrase that the gainers can compensate the losers unless we come up with a credible plan of how that compensation will be achieved. That is not a trivial matter.   David Autor and co-authors have made a credible case that trade with China caused a loss of US manufacturing jobs and recent research at NIESR by Francesca Foliano and Rebecca Riley finds similar results in the UK. 

When the job of the car worker in Northumberland moves to Eastern Europe because his factory was physically dismantled and shipped overseas, that person can be forgiven for blaming EU membership. And that person understands uncertainty better than 90% of experts who, we are told, agree that Brexit was the wrong decision. When you have been let down by politicians on both sides of the aisle, the unknown seems a lot less scary.

Freedom of the Press and Internet Filters

Here are a few thoughts that were inspired by Richard Baldwin's tweet, Random Sunday Findings...

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“Freedom of the Press is guaranteed only to those who own one”. A.J. Liebling. It was naïve to think that the internet would change the balance in favor of a more balanced flow of ideas when social media filters the content of our feed

Internet filters feed us ideas that reinforce our own existing biases. If you are on the left, try creating a new internet persona on the right and follow only right leaning feed. If you are on the right, try the opposite.

Justin Lahart points me to this page on the WSJ that lets you run your own experiment on facebook.

The problem of self-confirming biases existed before the advent of social media. In the UK some people read the Daily Mail, some read the Guardian. And it did not only apply to print media. Our perception of social reality was heavily influenced by a small number of TV stations.  In the UK in the 1960s there were two stations; the BBC and the ITV. In the US there were three Network News stations. 

For better or worse, before the internet, most of us shared our window on the external world. Internet filters are polarizing our views in a way that is destructive to social cohesion by feeding us very different self-reinforcing views of the external world.

A UK Sovereign Wealth Fund

In a recent piece in the Financial Times, Tristan Hansen and Eric Lonergan make the case for the U.K. government to “think big and tap the bond markets to invest in a bold growth agenda for the UK economy”.  They go on to argue that

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“A sovereign wealth fund, [SWF] tasked with boosting socially useful investment in the UK economy from inadequate levels could be the answer. … Increasing investment through a sovereign wealth fund can be used to tackle deficiencies in housing, infrastructure, as well as support innovation and small businesses. It will create productive assets from which future generations will benefit.”

In a series of published scholarly papers, books and op eds dating back ten years or more, I have been making the case for an asset fund, backed by bond purchases. And I have provided the economic theory to explain what such a fund would do, and why we need it. Miles Kimball, first called this a sovereign wealth fund and he explains the case rather nicely here.  I see a SWF as a strong form of qualitative easing that should be used to stabilize inefficient asset price swings. I’m less clear about the objective of the Hansen-Lonergan plan.

Here is how I put it in my latest book, Prosperity for All

“When the Fed was created in 1913, central bank intervention in the financial markets to control a short-term interest rate was considered to be a radical step. A century later, we have learned that interest rate control is an effective way to maintain price stability, but we have not yet learned how to prevent financial crises. Modern policymakers have been assigned one instrument—control of the money interest rate—and two targets: low inflation and full employment. A single instrument is not sufficient to accomplish both tasks.
Asset market fluctuations are not caused by inevitable fluctuations in productive capacity. They are caused by the animal spirits of human beings. The remedy is to design an institution, modeled on the modern central bank, with both the authority and the tools to stabilize aggregate fluctuations in the stock market.
Since the inception of central banking during the seventeenth century, it has taken us 350 years to evolve institutions to manage prices. The path has not been easy and we have made many missteps. Let us hope the adoption of a new financial policy that can prevent and/or mitigate the effects of financial crises on persistent and long-term unemployment will be a much swifter process than the 350 years it took to develop the modern central bank.”  [Farmer, Prosperity for All, Pages 206—207]

In 2013, I testified to the UK Treasury Select Committee, urging the UK to adopt an active financial stabilization policy and in an academic article in 2014, I explained how this would work.  I argued there that an entity like the Monetary Policy Committee (MPC) of the Bank of England, perhaps attached to the Bank or perhaps an independent body, should be charged with the operation of a Fund that purchases risky assets paid for by issuing Treasury debt. The existing FPC in the UK would be an ideal body to carry out this task.

If an FPC were to be created in a sovereign state, modeled on the UK Financial Policy Committee, what should be its mandate? There are two possible answers to this question. The first is that the FPC should be concerned solely with financial stability and should target the price-to-earnings ratio of the ETF. The second, and one that I favor, is that the FPC should target the unemployment rate….[Farmer, Prosperity for All. Page 194]

I have long recommended that a SWF should consist of a value weighted index fund defined over all publicly traded stocks. In my view, the purpose of such a fund would be to act as a stability mechanism for the asset markets. The FPC would be charged with trading the index fund countercyclically. When unemployment is deemed to be about right, the FPC would announce a growth path for the index fund that is coordinated with the MPC interest rate decision. For example, if the Bank Rate is 3%, the Fund would grow at 3%.

If the unemployment rate moves above target, the FPC would trade shares to support a growth rate of the stock market that is higher than Bank Rate.  If the unemployment rate moves below target, the FPC would trade shares to support a growth rate of the stock market that is lower than Bank Rate. My books and articles explain the economics behind this plan. The asset markets are inefficient and excessively volatile and asset price fluctuations are translated into inefficient swings in the unemployment rate.

What do Hansen and Lonergan see as the purpose of a SWF?

“We advocate a sovereign wealth fund as the vehicle for boosting UK investment since such an entity explicitly recognises public assets, while, in the absence of such a fund, boosting investment in the economy has been proven difficult. Adopting a diversified investment approach is also preferable to the standard prescription of large-scale infrastructure projects, given how long it can take for the benefits of [the] latter to be realised.”

There seem to be as many visions of a sovereign wealth fund as people who have written about it: But a bond financed investment strategy in housing, infrastructure and small businesses is not a sovereign wealth fund. It is an industrial policy. Issuing bonds and purchasing the stock market does not provide an incentive to anyone to invest in tangible capital investments. It is not enough to simply buy stocks and shares. The purpose must be to target the prices of those stocks and shares and, in my view, to reduce excess asset price volatility and alleviate and or prevent future financial crises.

Myself, Miles, and Tristan and Eric agree that national treasuries can borrow very cheaply and that national governments have the potential to generate substantial revenues by issuing debt and investing in the stock market. Tristan and Eric want to use borrowed funds to invest in specific projects although they are not particularly clear about how that would work. Miles and I want to see a sovereign wealth fund used to stabilize bubbles and crashes in asset markets and, for us, a UK SWF offers a promising alternative to traditional fiscal policy that deserves to be seriously considered before the next major financial crisis hits.


Here is some background reading for those who would follow the genesis of the idea of creating a Sovereign Wealth Fund with the goal of stabilizing asset price movements. If you learn something from these pieces, please cite them when discussing the ideas.

Farmer, Roger E. A., “What Keynes Should Have Said”, VoxEU February 4th 2009

Farmer, Roger E. A. “Macroeconomics for the 21st Century: Part 2, Policy”, VoxEU February 28th 2010

Farmer, Roger E. A. How the Economy Works, Oxford University Press, 2010

Farmer, Roger E. A., Macroeconomics for the 21st Century: Full Employment as a Policy Goal. National Institute Economic Review, 211(January), pages R45-2R50, 2010

Farmer, Roger E. A. How to Reduce Unemployment: A New Policy Proposal. Journal of Monetary Economics: Carnegie Rochester Conference Issue, 57(5) 2010.

Kimball, Miles, “Why the U.S. Needs its own Sovereign Wealth Fund” Quartz January 3rd 2013.

Kimball, Miles, “Libertarianism, a US Sovereign Wealth Fund, and I” Confessions of a Supply Side Liberal, January 23rd 2013

Kimball, Miles, “How a US Sovereign Wealth Fund can Alleviate a Scarcity of Safe Assets”, Confessions of a Supply Side Liberal January 25th 2013

Farmer, Roger E. A. “Quantitative Easing”, Written Evidence to the Treasury Committee of the U.K. Parliament, Session 2102-13. Oral evidence presented, 24th April 2013

Farmer, Roger E. A. “Qualitative easing: a new tool for the stabilisation of financial markets: The John Flemming Memorial Lecture. Bank of England Quarterly Bulletin,” December Q4, pages 405-413, 2013

Kimball, Miles, “Roger Farmer and Miles Kimball on the Value of Sovereign Wealth Funds for Economic Stabilization”.  Confessions of a Supply-Side Liberal, January 8th 2014.  

Farmer, Roger E. A. “Financial Stability and the Role of the Financial Policy Committee.”  The Manchester School, 82 S1, pages 35-43, 2014

Farmer, Roger E. A., Prosperity for All, Oxford University Press, 2016.

 

How much debt do we need? My answer: 70% of GDP

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In a post in 2015 I pointed out that government debt is not a bad thing. Here, I elaborate on that idea and I ask, and answer, a simple question: how much debt do we need? My answer: 70% of GDP is a good guess.

In a recent post, Simon Wren-Lewis asks and answers some of the same questions I discuss here. My focus is narrower than Simon’s. I will focus in on the question: what is the right amount of debt?  I will also abstract from one reason why debt should not be zero. That reason, discussed here by Martin Wolf, and here by Isabella Kaminska, is that the public sector does not only accrue debt; it also owns public assets. I will claim that, even if we did not need to build roads and bridges, it would still be a good idea for the public sector to accumulate debt. My argument is based on a remarkable implication of basic economic theory that was first discussed by Paul Samuelson. If we borrow from our children and our grandchildren, everybody, including all future generations, will be better off.

If a household borrows money to pay for a new car, that debt might be paid back over a period of five years or more. Debt that is accrued to help pay for an investment good, like a car, is widely understood to be a good thing. By borrowing to pay for a car, we arrange for the series of benefits we receive by driving to work or to school every day to be matched with the series of payments we make as we pay back the loan used to purchase the car. Debt accrued by a household to facilitate an investment is widely perceived to be privately beneficial.

Suppose instead, a person borrows to pay for an extravagant lifestyle. Instead of taking out a loan and buying a car, that person maxes out their credit cards to throw expensive parties. To pay back that debt, he or she will need to plan for a period of austere living in future years.  Debt accrued by a household to finance an extravagant lifestyle is widely perceived to be deviant behaviour that is discouraged by social norms. But should we apply those same norms to government behaviour?

If government borrows money to pay for a new road or rail network, the new transportation infrastructure will generate benefits to future generations. It is only fair that those generations should help pay for the investments they enjoy and, for that reason, debt accrued to pay for social investment is widely recognized to be socially beneficial. The principle that all government debt should be used to finance infrastructure investments is sometimes called the golden rule of public finance. It is a commonly held belief that government debt should only finance government investment; but it is a belief that does not survive more careful scrutiny.

Governments are not like households. If a household borrows from a bank it will eventually need to repay the money it borrowed. If a government borrows money from the public, it may never repay that money. It is a myth that government debt is repaid by running public surpluses. In reality, the ratio of outstanding debt to GDP shrinks as the economy grows faster than the interest rate at which the government is borrowing.

In the title to this post I raised the question: How much debt do we need? Economic theory provides an answer to that question and it is never zero. In a series of papers that I am writing with Pawel Zabczyk of the Bank of England, soon to be circulated, we show that a fairly standard model of trade between generations can lead to some very non-standard conclusions. We use Samuelson’s  overlapping generations model, which has been widely used to analyse questions of trade between people of different generations. For a calibrated version that we use as an example, the right answer to my opening question; How much debt do we need? is 70% of GDP.

The main theme of my work with Pawel is that governments are not like households. That point has been made many times by many people. Paul Krugman, for example, makes the case here in a NY Times piece. Although the reason often given is that government expenditure can raise employment through a fiscal multiplier, there is a more fundamental reason why we should not eliminate government debt. And this reason applies even if the economy is always operating at full employment. Debt facilitates trade between current and future generations.  

The figure of 70% that I give in this blog is based on some back of the envelope calculations that Pawel and I use to calibrate our theoretical paper and my subjective confidence bands around that figure are large. The optimal size of public sector debt in the UK might be 5% and it might be 140%. But of one thing I am certain. The right answer to my question; how much debt do we need? is never zero!