Two Opposite Articles On WSJ

Here are two opposite articles on WSJ published on the same day. The first one, accuses the FED’s policy for bringing into a difficult position Brazil and the rest of the world, and even accuses the U.S. for mindlessness and purposeful action to damage the other countries. The second one, explains that buying medium to long-term Treasuries is a valid monetary policy of the FED in order to stimulate the economy. The first one is written by a journalist. The second one by Alan Blinder, economics professor at Princeton. Who speaks logic is your call. Just read them.

China’s Dagong Credit Rating Firm Lowers U.S. Credit Rating

China’s Dagong credit rating firm lowers U.S. credit rating from AA to A+. At the same time Moody’s rates the U.S. credit at AAA, the highest credit rating according to the same firm. You can read about today’s developments on Bloomberg, on Barrons, on MarketBeat and other sources.

Even though the reasons why the credit rating of the U.S. may come under pressure is self evident, it is interesting to see how the articles treat the downgrade by the Chinese firm. They clearly state that their downgrade may be politically motivated and connected with the exchange rates war that is currently ongoing.

Bloomberg’s article mentions that Dagong’s application to become a Nationally Recognized Statistical Rating Organization in the U.S. was denied by the SEC. And Barron’s article mock’s the logic of Dagong’s report that the U.S. has been using the “virtual” financial economy to improve its GDP numbers.

Negative TIPS Yields!

Indeed it sounds as impossible, but it is a reality. Even though it initially sounds as a very-very bad thing about the economy, it is the opposite. It means that investors believe that we will have inflation and they even accept a negative yield. So strong is their belief that prices will increase. This may prove right or wrong. This conviction is definitely due to the QE2. TIPS investors bet that the program will work and we will have inflation. Remember that for TIPS the face value is not fixed, like in Treasuries. The face value increases or decreases according to the inflation rate. Hence, negative yields can exist and it can be rationalized by a big probability of inflation, or higher values of inflation than previously thought, or both of the above.

Here I give some articles on this phenomenon. Article in Yahoo!Finance, in Bloomberg, in Reuters and in FT.

Why Increasing China’s Labor Costs Is Good For Everyone (Almost)

The featured article on Economist is about the rising power of the Chinese worker. Indeed. A long waited increase in Chinese workers salaries will have many good implications for China itself and the rest of the world. This article analyzes some of these benefits. In addition to the mentioned benefits in the article, which I summarize briefly bellow, there is one more.

This is that an increase in Chinese workers salaries will improve the competitiveness of other countries, like the Europe’s south, who now suffer, from the abundance of cheap labor in motherland China. In sort, the benefits from increasing China’s labor costs are:

1. Increase the ability for the Chinese workers to enjoy the fruits of their labor.
2. Balance the Chinese economy which is currently heavily depended upon investment.
3. Boost the world economy, by increasing consumption.
4. Balance the China’s trade imbalances with the rest of the world.
5. Adjustment in the Juan’s exchange rate.
6. Increase the employment in the rest of the world, as less jobs from the other countries are going to be lost to China.
7. Improve the competitiveness of other countries.

The main cost from this increase, will be the increase in the price of Chinese products, but this is counterbalanced with all the above benefits, especially that of increasing employment in other countries, and also the fact that at this time a little inflation is not bad.  The ones who may lose more form this rise, is going to be the shareholders of the big corporations who have factories in China.

Austerity vs Stimulation: The Questionable Effectiveness Of Spending

Austerity measures are usually combinations of government spending cuts and increased taxes. Stimulating practices, on the other hand, are consisted of combinations of the exact opposite actions, increasing government spending and/or reducing taxation. Therefore, it is clear that perhaps one has to choose one or the other, austerity or stimulation.

The above premise is based on the belief that one can create stimulation in the economy by increasing government spending or reducing taxes, and that one can save money by cutting spending or increasing taxes. But how much of it is true? Are the policies that help the country’s balance sheet hurt the economy’s growth? This article attempts to answer both questions.

It is always the case in economics, that an action generates more than one effect and often times these effects move in opposite directions. This is the case also here. Let us start with the alleged austerity measures and their effects.

Austerity Measures

1. Spending Cuts
   1. Effect on Output: Output may decline.
   2. Effect on Balance Sheet: Interest rates may decline.
2. Tax Hikes
   1. Effect on Output: It may decline.
   2. Effect on Revenues: Collected taxes may go up or down.

Spending Effect on Output

In what follows I will discuss the consequences of spending cuts, or increasing spending, on output. I focus on this because this is the most relevant topic these days. The current economic situation is described by anemic growth and high debts. In order to address one we may deteriorate the other and vice versa. Currently the discussion has focused on whether one, for example the U.S., should engage in tight fiscal policy, and more specifically, in cutting spending. This week FT hosts a debate on the same topic inviting articles from renowned economists.

Whether spending has an effect on output is summarized by the value of the spending multiplier. This is a number that stands for the number of dollars is generated in output by one dollar spent by the government. Advocates of spending policies justify their opinions on spending multiplier greater than 1.0. How much of it is true?  

The answer is that, at best, the academic community has been inconclusive about the effectiveness of spending on stimulating output. This means that there is a lot of doubt, in the academic community, that spending works, i.e. that spending has a multiplier value greater than one.

For example, Barro and Redlick (paper link, WSJ article) find that defense spending has a multiplier of 0.6-0.7 at the median unemployment rate – while holding fixed average marginal income-tax rates – and there is some evidence that the spending multiplier rises with the extent of economic slack and reaches 1.0 when the unemployment rate is 12%. Estimating spending multipliers for non-defense spending is problematic as the nondefense government purchases are positively correlated with the business cycle and it is difficult to establish causality. Is it the spending that created growth or the growth that spurred government into spending? Barro and Redlick think the latter.

The same ideas are reiterated also in Wednesday’s FT article by Kenneth Rogoff. He believes that:

“At the same time, the stimulus benefits of massive fiscal deficits are not nearly so certain as proponents of a new surge of spending maintain. The academic evidence on Keynesian growth effects of fiscal deficits is thoroughly inconclusive. Ironically, a lot of the newfound conviction comes from the casual empiricism on the growth effects of the Bush tax cuts, evidence that few academics consider sufficient to outweigh the mass of previous results. Indeed, it will take researchers many years, perhaps decades, to sort out the effects of the massive fiscal stimulus that many countries undertook during the crisis. My guess is that scholars will ultimately decide that fiscal policy was far less important than monetary policy and measures to stabilize the banking system.”

In addition, a rough method I employ gives me a spending multiplier of 0.6, less than 1.0, rendering spending an ineffective policy. Finally, there are people who argue that the multiplier is negative, in which case, spending by the government decreases the output. This is also called crowding out.

There are however economists who argue that the multiplier is greater than one. Christina Romer, head of the President Obama’s Council of Economic Advisers, and Mark Zandi, from Moody’s, claim that the multiplier is 1.6. Note that, Keynes believed that the U.S. multiplier in the 1930s was 2.5.

Policy Implications

It is clear, now, that if the value of the multiplier is what the consensus has it in the academic community, around 0.6 or lower, cutting spending will have a small effect on output, as it is also the case that giving another stimulus package will generate little additional growth in the economy. Clearly, the opposite is true if the multiplier is 1.6 or higher, like some people advocate. However, the benefits of any policy have to be weighed with the benefits or costs of contingency scenarios. A policy creates repercussions that also need to be evaluated. For example, spending cuts may or may not decline the economy’s output, but it also has an effect on the country’s balance sheet, the expectations of both the bond investors and the consumers. A policy decision is an act of balancing the fears of all the groups that are involved in a given situation. (For more, read on the big number of factors that affect the value of debt.)

Not Exactly, Mr Krugman.

Paul Krugman expressed his view against austerity measures at this time. Even though I also think that we should not take austerity measures right now, I have to disagree with the argument he gives in his posting entitled “Self-defeating Austerity”. The point of the article is that austerity measures have a toll on output which will decrease the government revenues (taxes). Therefore a tight fiscal policy, at this time, will be detrimental for the economy as well as the budget deficit.

Is this right? The devil lies in the details and indeed this is where it again lies in the argument Krugman gives. The key assumption to his argument is the spending multiplier, which is assumed to be 1.4. This means that every dollar spent by the government generates 1.4 dollars in the economy. It is not difficult to understand that if such a multiplier is really at works, then cutting spending really hurts the economy, while pilling up debt “pays for itself”.

Spending Multiplier Debate

So the question is whether the spending multiplier is as high as 1.4. The answer is that, at best, the academic community has been inconclusive about the effectiveness of spending on stimulating output. This means that there is a lot of doubt, in the academic community, that spending works, i.e. that spending has a multiplier value greater than one. There are also people who argue that the multiplier is negative, in which case, spending by the government reduces output. For a more complete discussion of this debate, click here.

In addition, a rough estimate I come up with by reversing Krugman’s argument I find that the spending multiplier is 0.6, much less than the 1.4 used in his article, rendering spending an ineffective policy.

Back to Krugman’s Argument

The whole argument is that since 1% of GDP spending could produce 1.4% GDP growth, cutting it, shrinks the economy by 1.4%, while the savings amount to only 0.65% of GDP, since a 0.25 marginal tax effect implies that the government losses 0.35% of GDP in taxes.

Now, using an arguably more accurate multiplier estimate of 0.6, we have that a 1% of GDP cut in spending, shrinks the economy by 0.6% and results to savings of 0.85% of GDP. These numbers describe a much more appealing picture in favor of fiscal tightening.

Evaluating the Benefits of Spending Cuts

In addition, Krugman calculates the current benefits of not getting additional debt. Assuming that an increase in spending is coming from borrowing at a real interest rate of 3%, the government by not borrowing saves the expense of 3%*1% of GDP or 0.03% of GDP. This amount, using the same marginal tax rate as above, implies that the government does not have to generate an additional 0.03%/0.25 of GDP or 0.12% of GDP. Given that the current interest rates are way lower than 3%; this number is actually an overstatement of the current debt benefits from cutting spending.

Even though the current interest rates are not high, so perhaps this exercise may not be relevant now, I would like to calculate the general benefits of spending cuts, i.e. the maximum benefits, by considering a case in which the interest rate constraint is binding, i.e, when debt reaches its ceiling, so that the reader gets a feeling of the benefits of these policies in extreme cases, when they are really needed. In those days interest rates increase rapidly to very high values, like 10%-20%. With a 10% real rate, the same computation done above implies that, the savings from servicing the new debt amount to 0.4% of GDP.

However, measuring the benefits of spending cuts just by looking at how much less debt we need to service, in a strictly output-measure sense, is not complete. There are other benefits which are difficult to quantify,[1] like the increased confidence of the bond community on the sovereign entity’s bonds and the benefits from escaping default. Alleviating fears and escaping from the worst, which are worthy way more than 0.4% of GDP.

Parameters as Functions of the State of the Economy

My next comment has to do with the partial approach that we usually employ in economics.[2] The costs calculated above are marginal costs when all the other parameters are fixed to the assumed values. However, these parameters are not constant in the economy. They too change with the state of the economy. For example, the marginal tax rate changes; it increases (or decreases) if taxes are increased and it declines if output declines. The same is true about the spending multiplier; it can increase if the government becomes more efficient, if the economy improves, or if the quality of projects increases. Also, it decreases as it crowds out private sector’s investments and it perhaps increases as the private sector holds on on investing, anticipating high taxes in the future. The same, at last, is true about the interest rate; it is considered to be procyclical, it increases as the credit quality of the country deteriorates, and it increases as fears or expectations about inflation increase.  

Acknowledging this fact but also ignoring to some extent, for now, and taking his argument to the extreme can reveal some of its weaknesses, which I have already mentioned. Assuming that the marginal tax effect and the multiplier are as above, the new revenue is always 0.35% of the previous period’s GDP. What is the interest rate that would make taking additional debt impossible to service? This rate would be such that r%*1% = 0.35%, hence r=35%! This means that this scheme could be played as long as real long interest rates are less than 35%. Of course, we all know that a scheme like this would have stopped way earlier, most probably at rates around 15% (this is itself arbitrary but historically justifiable).

A Spending Multiplier Estimate

Reversing the above exercise, we can estimate maximum multiplier that can sustain the above pilling up debt scheme. As the country’s balance sheet deteriorates, both the marginal tax effect and the multiplier change. Assuming that the tax effect is less volatile than the spending multiplier, we can estimate the maximum value the multiplier can get in order to facilitate servicing debt at 15%. Multiplier = 15%/0.25 = 0.15/0.25 = 0.15*4 = 0.6. So, an estimate for the spending multiplier we get by reversing Krugman’s argument is 0.6. This means that for each dollar spent in the economy by the government, the economy increases its output by 0.6 dollars, revealing that government spending is not a very efficient use of the public money.

A More Robust Answer Why We Do not Need Austerity Measures

Instead of going on and giving examples that are based on questionable estimates, a much more direct and unquestionable approach is to look at what the markets say. Interest rates are bottom low. For more, read on my answer to this question.

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[1] Putting a number on these benefits depends on the level of interest rates, the amount of debt, the growth rate of debt, the state of the economy and other factors.

[2] This is a general comment, not necessarily against Krugman’s argument, of course. After all, he warns against generalizations of his argument and taking it to the extreme.

Do The U.S. Need Austerity Measures?

The current state of the U.S. economy is described by an anemic growth and a huge debt that is increasing in a fast rate. This situation has led economists and policy makers to debate on the necessity of taking austerity measures, especially in light of countries like Germany and U.K. who proactively and willfully have taken tough austerity measures.

But do we really have two hot potatoes in our hands? My short answer is no. We definitely have one, the anemic economic growth, and, at least until now, we do not really have a U.S. debt problem, if the U.S. debt holders would require higher interest rates or if the CDSs on U.S. debt would start to get dangerously high. However, the last months we have seen the exact opposite. If nothing else, the last debt crisis in the eurozone has helped the U.S. by bringing the long term yields down to extremely low levels. Let me remind you that a few months ago long term yields touched, and even exceeded, the psychological threshold of 4%. At the time, everybody was nervous about it and people started circulating stories about the unattractiveness of the U.S. debt.

The flight to quality (quality meant in relative sense) that started with the resurgence of the eurozone debt fears reversed that trend and since then the long term interest rates have been constantly declining. Today the 10-year yield is a stunning 2.89%. Really, how bad can the outlook out there be so that there are people willing to get a 2.89% for the next 10 years?

At the same time the supposingly inflation protected assets, like gold, silver and other commodities, have not increased in value during this last period. Gold reached a new high at almost $1257.2 per pound and since then it has declined to 1191.6 today. This tells us that the markets do not fear inflation as much, which would be the case if they anticipated that the U.S. would not be able to tackle its debt and resort to printing money.[1] In addition the yield on TIPS is 1.29% for a 10-year security and 1.95% for a 30-year security. If anything else, the markets are telling us that there are big problems out there, but the U.S. pilling debt is not one of them. At least not for now.

Three Schools of Action

And the question is: should we wait until it really becomes a problem? Should we wait until the bond vigilantes take notice of the bad debt outlook of the U.S. and start requiring higher rates? There are three schools of thought about it.

The first wants everybody who even silently thinks on the issue to stop thinking! This is the most extreme view and the loudest of the three schools out there. There are people who get annoyed by even thinking or talking about it, which is incomprehensible to me.

Some of the people in the first group argue that we have time in the following grounds. For the U.S. to start having problems investors have to dislike the U.S. debt and to also like other securities, like other countries’ debt, stocks, commodities, cash and TIPS. Since this is not on the horizon right now we can wait.

This approach is risky. It basically relies on optimally timing the behavior of the investors, something that it is not very easy to do. Also, it requires we know and monitor the return behavior and flows to all the assets that could be substitutes to U.S. bonds.

The second line of thought is consisted of people who stand on the other extreme, demanding measures on fighting the mounting debt. According to my understanding, they are not so many or forceful about their views.

And the third school is consisted of people who want to start thinking and discussing the policies that eventually we will need to take at some point, sooner or later. These people encourage a healthy dialogue that will get us prepared and ready to face the Armageddon that is coming. There is a consensus among the people in this school that the mounting debt is an issue that we cannot ignore. On the contrary, it is an issue we need to start addressing right now.

The last group advocates that deciding on and laying out the policies that we will have to take when time comes, has many benefits. By having the policy makers committing on a set of policies to fight debt, will (a) alleviate the fears of bond vigilantes, therefore interest rates will not skyrocket, (b) calm the central bankers that the government will not go on with an inflationary policy, and (c) will alleviate the concerns of the public sector and hopefully they will not hold on on consumption and investment more than it is necessary based on the plan to fight debt. The performance of the economy is based on expectations. Therefore, laying out the plan, showing sternness and sturdiness in solving the problem, is as important as actually fighting it.

My view is closer to the one described by the third group. It is more prudent to, at least, start thinking about the problem, even though we may not have a problem right here right now. Since the problem is lurking, growing at a fast pace, and since we do not know how far from today the problem is going to arise, therefore how much time we have, it is sounder to decide on the policies and actions to be taken when time comes. The benefits from doing it are great, the risks from not doing it are even greater and there is no reason not to decide on policies now.

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[1] I do not include the strengthening of the dollar during this period in my calculations which could explain some of the decline in the price of gold in dollars.