Monetary Policy Round Up

So from time to time I go round my reading list, just to pull out the best things on the Web. Its been an exciting time for Monetary Policy, as BOJ has crushed all believers in Keynesian orthodoxy.

This month Britmouse takes the prize for best post. He has been my favourite blogger on UK economics for a while. He has nailed Dr Weale, member of the BoE’s policy committee, on a cross of his own hypocrisy. Apparently any statistic will do, as long as the answer is higher rates. Since pretty much all of his posts this month have been awesome, I won’t bother listing them all, just go and take a look!

In other news, Japan has successfully exited its `liquidity trap’. After 15 years of pain and not really trying, it took….three months to produce 2% inflation and the strongest RGDP growth Japan has seen for twenty years.

Scott Sumner has continued to bash zombies. In this case it was another “Money is not easy” rant. Everyone should read Scott Sumner. He has the helpful attribute of being right about monetary economics.

The Sumner Critique has even made it into UK politics, in which Osborne gave a really quite good summary.

Lars Christensen has put together a nice graphical post on the empirical evidence for Market Monetarism in the US.

In the meantime, the Eurozone is the same sad story, unemployment rising, NGDP stagnant or falling. ECB doing nothing.

If your central bank crushes income growth…….

It is a self evident fact, given that wages are sticky, that if the sum of total income falls, unemployment must rise. What is less evident, but nonetheless true, is that Nominal GDP is tautologically equivalent to the sum of nominal incomes. What almost no one believes, but is true, is that the central bank has complete control of where it wishes to send nominal variables. Since it controls the price of money, it can always devalue money sufficiently to make it sensible to employ people again. Hurrah!

Some people believe that lowering the price of money is synonymous with inflation, but this is not the case. I lot of people envision inflation along the following lines: there is a stock of real goods, and a stock of money, and if the money supply increases faster than the stock of real goods, then we have inflation. This is an insufficient conception of inflation, in particular, this would mean that high fiscal multipliers would render money printing deflationary! Why? Because a high multiplier means that one dollar printed and spent generates more than one dollar in extra output.

To successfully conceptualise inflation, we must concentrate on money spent. If multipliers are high, then each dollar printed generates multiple extra dollars of demand, and multiple extra dollars in output. In an ideal world this would hold inflation at zero until output approached potential output, at which point extra stimulus will generate purely inflation and no extra real output. In the real world, we get some split between extra output and higher prices. At the moment in a depressed economy like Europe that split favours real output, as we approach full employment/supply side constraints, the split moves towards more inflation and less output.

The critical point is then twofold: in the current environment, monetary stimulus will not lead to inflation in the Eurozone. The second point is that we are in a severely disinflationary environment. Any time NGDP moves below trend, that is the definition of disinflation. Definitions of inflation based around the final prices of goods are a hostage to fortune, since it allows supply side shocks to prices to morph into demand side shocks. The costs of weak demand are immense, as years worth of output goes unused. The costs of supply side shocks which are correctly managed, is a slight one off rise in the price level.

Here is the unemployment graph for selected european countries, so we can all meditate on the ongoing human tradgedy, which is the cost of poor ECB policy:

Credit to SocGen via Alphaville for this one

And lets not forget that the forecast for improvement two years from now is simply the obligatory european forecasting tool of assuming that two years from now things will get better for no clearly specified reason except the general disbelief that they cannot get any worse. In 2010 the EU was predicting spain’s unemployment would peak in 2011 at 20%. That didn’t exactly go according to plan…

 

It’s a Good News-Bad News Situation.

So the bad news is, even the German economy is now struggling. The good news is, now that German inflation has gone off a cliff, the ECB might take some meaningful action.

Eurozone inflation goes off a cliff.

More importantly, German inflation also goes off a cliff.

We are now going to see Jens Weidman’s commitment to low inflation tested. Has his opposition to monetary stimulus been purely a cover to get the best possible policy for Germany at every stage, or does he genuinely believe that it is ineffective and the wrong policy? If the ECB `suddenly’ , after years of rising unemployment in the periphery, that monetary stimulus is appropriate, it exposes the fact that it was pretty much just ignoring the needs of the periphery to help the Germanic Bloc to force through reforms that they wanted. If it refuses to do anything as Europe slips into yet another deflationary recession, then it exposes itself as grossly incompetent, but at least not malicious.

Its a bit of a Morton’s Fork for the Bundesbank. If it now supports monetary stimulus, and it successfully raises demand in the Eurozone, it will be very hard to take it away before the periphery is out of trouble. If it refuses stimulus, it gets to watch the european economy continue contracting.

My own bet is that the ECB will do nothing, at least at first, and when the stock market realises it has wrongly assumed that, when push came to shove, the ECB would follow the other central banks, then European stocks will be crushed.

Meanwhile, in the background, the Bank Of Japan has crushed Keynesian orthodoxy. The question of whether an economy with long and entrenched deflation can get out of its `liquidity trap’ whenever it wants just by announcing that it is going to, and will print unlimited quantities of currency in order to hit its target. All hail Scot Sumner. Because he was right.

The Ongoing Train-wreck of EU governance: Bundesbank Sues ECB

Sometimes it appears that the EU is run by children. The rest of the time it is obviously true. This is one of the latter occurrences. Bundesbank President Jens Weidmann  the anti-hero of the European Depression, has thrown his toys out of the pram. After being out-voted 22-1 on the ECB governing council on instituting the ECB’s bond buying program, he stamped his feet and yelled “I’m telling Mummy”. `Mummy’, in this case, being the German Constitutional Court.

The OMO program is the one truly successful program the ECB has produced. The mere threat of its existence, announced last June, has calmed sovereign bond markets. Jens’ Weidmann apparently believed that it constitutes `direct funding of sovereigns’ and has asked the German Constitutional Court to rule on whether the ECB is violating its own mandate.

This all happened last summer, and so why am I bringing it up now? Because the German Court is finally ready to make a ruling. If the court rules against the ECB, what does that even mean? Is a supra-national organisation going to be held hostage to legal rulings of each and every state? What is Draghi to do? What will Merkel do? How will the ECB be held to account? Will it merely ask the Cyprus High court for a dissenting opinion, I am sure they would have no trouble sticking one in Germany’s eye, and then claim that in the absence of a consensus legal opinion they intend to ignore everyone.

Will Germany threaten to stop funding the ECB? A comical threat against an institution that holds the printing presses, and in fact, legally owns all of the currency in circulation. Will Germany boycott ECB rate meetings, which I would regard as very good news, as it would almost certainly lead to more policy easing.

There is going to be one very bad outcome if this court case comes out against the ECB, the return of massive uncertainty and volatility to peripheral sovereign bonds.  Does anyone want to see the Germany attempt to put another millstone around Spain’s neck?

There is nothing good to come out of this, just extra pain for a Eurozone that is continuing to implode in the absence of any serious policy easing.

The Cause of the Crisis

Pretty much ever since the crisis of 2008, there are those who have been arguing that the sharp fall in NGDP/demand was the cause of the financial crisis, rather than the other way around. Further evidence has now come to light in both the US and the UK, courtesy of David Beckworth and Britmouse, suggesting that the causes of the crisis go back as far as 2005 at least, and largely vindicating the view that the fall in nominal incomes destroyed banks balance sheets. I strongly urge you to read the Beckworth post.

In particular, in the US, expectations of nominal income growth started falling in 2005:

By the time Lehman Brothers went under, income growth was already well below trend, with predictable results for default rates.

where as in the UK, Nominal income growth has been below trend since 2001,

That is a pretty big gap in incomes by 2010.

Interpreting why this happened is obviously tough, but I lay the blame on inflation targeting. If you wish to target the price level of outputs, in the face of real cost pressure on your inputs, you must restrict nominal wage growth. Since someones income is someone else’s expenditure, this means that you are restricting NGDP growth.

Ever since monetarism was put forward as a theory by Freidmann (and others), they have emphasised that there are two nominal variables which are important, income growth, and inflation. The first because income ultimately determines demand, and the second because nominal wage stickiness makes it hard for employers to adjust wages competitively. The first effort at monetarism, was the targeting of the monetary growth rate, the rational was that both incomes and inflation were strongly correlated to monetary growth. In the US and the UK this turned out to be a transient correlation, and money growth targeting failed (-although it largely succeeded in Germany and Switzerland for nearly thirty years, under a slightly different model, you can get a quick overview from this Mishkin paper).

The next logical step was inflation targeting. Why look to target some intermediate variable when you can target them directly. This works just great as long as the two remain strongly correlated. We targeted inflation and got stable income growth for free. . Of course, this means that had we targeted nominal income/NGDP, we would have got stable inflation `for free’.

The graphs above demonstrate that this correlation started to break down. This is probably a result of falling world inequality. We outsourced a lot of our labour intensive manufacturing to countries where labour was cheaper. Now income in those countries are rising, and we in the developed world must therefore pay more for the basic raw materials that we use as inputs. Thus, by targeting two percent inflation under rising real costs, we crushed income growth. Over the long term this makes it harder for households to meet their debt repayments. Perhaps the small fall in income growth rate in the UK was stable enough not to contribute materially, but the much sharper fall in the US was probably the cause of the financial crisis.

The good news is that central banks can do a lot about this type of nominal problems. By expanding income growth we can put the unemployed back to work. On the other hand, rising wages in the developing world are not going away, so real cost pressures will remain, and higher inflation (in the UK) might be needed in order to keep incomes/demand on a stable trajectory. To my mind, a slightly higher price level is a small cost compared to millions sitting unemployed, so we should do that.

This picture also makes sense in of the UK’s productivity puzzle. If raw material costs increase 4%, productivity increases 2% and wage growth is 0%, we get get roughly two percent inflation. However, its not clear that this type of cost inflation is really captured by the productivity statistics. If productivity is measured by output, then it is negative in the above example, since I am producing the same amount of stuff at a higher cost, despite productivity increases.

A mixed bag for the Uk then: We must increase nominal wage growth to increase spending, and suffer slightly higher inflation as a result, since the central bank cannot overcome the real cost pressures that are a result of the rising living standards of much of the rest of the world.

The Astounding Hypocrisy of Jens Weidmann

The Eurozone crisis has been replete with politicians and ECB board members declaring victory after miscalculations of tragic proportions. We have seen plenty of congratulatory back-slapping on the Cyprus bailout, which is only predicted to destroy a quarter of their economy. We have seen pious talk of the need for “reallocation” in periphery economies, and that  only “confidence boosting austerity” will allow their economies to recover, despite virtually every reputable study showing the exact opposite. We have had Olli Rehn, EU commissioner for finance, berating the economics profession for publishing studies showing the failure of austerity, because they are destroying confidence and making the problem worse. But this weeks pronouncement really takes the biscuit. Jens Weidmann, inflation hawk extraordinaire, has topped all that.

This week he was quoted as saying:

 that eurozone interest rates could be cut, if warranted by further weakness in the region’s economic data.

Now what weakness was he referring to that day? Was it the fact that Eurozone unemployment has risen for the sixteenth consecutive month? Was it that fifteen months in a row wasn’t enough for a rate cut? But sixteen, that really shows weakness. But no, instead he was referring to a sharp fall in orders for German cars. Twelve percent unemployment is nothing to get worked up about, but if they stop buying German cars, that’s a disaster.

Surely Weidmann just believes that Germans are in need of some belt tightening to improve confidence. Austerity is for the periphery, if the German economy is slowing, obviously monetary stimulus is the answer.

Its an outrage.

Fund Managers and Passive Investing

The fund management industry has been getting a lot of bad press recently. Firstly because so many of them fail to beat simple strategies like investing in a FTSE100 index tracker. Of course, in aggregate the fund universe is the stock market, so its clearly impossible for them to beat the stock market in aggregate. Ironically, if all the funds controlled by active fund management where placed in passive funds, it would create exactly the situation needed for the fund management industry to create alpha and thrive.

However, its especially hard to understand, because almost every other passive strategy, e.g. buying an equal weighted portfolio instead of a cap weighted portfolio like the FTSE100, will massively outperform a cap weighted index. The Nasdaq-Apple phenomenon illustrates precisely the danger of Cap weighting. At one point Apple comprised nearly 40% of the index (it was later limited to 20% by official decree), which means that you are not getting the benefits of diversification that you would expect in a portfolio, since most of your value is in a handful of positions. The top ten positions of the S&P500 have 20% of the value, you need just 32 to companies to have half the index by value. The bottom fifty companies make up just 1% of the market cap. Is it really worth the trading costs to rebalance 50 positions worth just 0.02% each? Its trivial to see that if every company has identical profiles, the minimum variance portfolio will be equally weighted.

We have not even talked about Fee structures. Many funds have total expense ratios exceeding two percent. Truly awful. Investment trusts as a group seem to do better, averaging about 1%. Still, in all this, I came across a surprising graph in the small cap sector:

Virtually every small cap fund substantially outperformed the FTSE small cap benchmark over three years. That blue dot over on the left is the benchmark. Risk is vertical and return is horizontal.

I have no idea how this can even be true. Perhaps the FT is selecting only the best performers. Perhaps many or most small cap funds are actually only partially invested in small caps? Here is the graph for Flex cap equity.

Again the Benchmark seems to be a bizarrely low performer.

These graphs were quietly snipped of the FT website, but again, the FTSE all share has indeed managed just 2.5% annualised, so it seems plausible that their `flex cap’ index might have done this badly. But how can every fund outperformed so massively? A quick check on my morningstar driven research platform finds 28 small cap funds, but only 9 of them are more than three years old.

Does the fund industry routinely close and reopen funds in-order to erase the memory of bad performance? This is really the only possible explanation. No wonder funds look attractive to retail investors when fund managers continually erase fund that under-perform the index, and only those that look good survive.

If that is what is happening, the regulators ought to step in, as these graphs are deeply misleading, despite being superficially accurate.

However, there is a slight  upside in this for the retail investor. If funds are killed of for relative under performance (and your money returned), then sooner or later you will end up in a fund that is beating the index. Of course, if that out performance is essentially random, then you would be better off indexing and saving your fees, since it is impossible to generate useful work from a random process*. On the other hand, if manager out performance is persistent, and there is reasonable, though not conclusive, evidence that it is, then sooner or later you are likely to end up in a winner. This is interesting enough that I would like to model it. Does anyone have access to fund data including funds that were closed? Ten years would be enough.

*Yes, I did just apply the second law of thermodynamics to Finance. It really works too. Try this brain teaser: suppose you wish for a population to have more boys than girls, is there any strategy which can produce this result? Strategies like: I will keep having children till I get a boy. I will continue having children till I have more boys than girls, etc. Strategies involving killing people are not allowed.