Quantitative Tightening and Next Eleven economies

Major concerns were raised with respect to the prospect of the exit strategy from Quantitative Easing. However, most of these concerns were related to US and the other developed economies which implemented this monetary policy. Less attention has been given the impact on emerging economies.

Once the prospect of a gradual exit from monetary policy appeared, following the speech by Bernanke in May 2013, emerging markets were hit by capital outflows and exchange rate depreciation. The basic reasoning for this is that investors became less willing to hold risky assets. But, were all emerging affected in the same manner?

Fernanda Nechio discusses this issue in a small article here. She finds that countries most severely affected by capital outflows and exchange rate depreciation were those with weak fundamentals, like high current account deficits or high fiscal balances.

What is even more interesting is how the group of countries labeled as Next Eleven behaved. This group consists in those emerging economies with a high potential of growth that could enable them to reach and surpass the BRICs economies.

Capital_flows_emerging_economies

Exchange_rate_depreciation

 

The figures above (from Fernanda Nechio’s paper) contain a consistent number of Next 11 economies. We can focus on the largest economies in this group, i.e. Indonesia, Mexico, South Korea and Turkey. Except South Korea, all other large N11 economies passed through consistent and even severe (for Indonesia) depreciations. While these countries might have good prospects of growth, they should also have very sound and solid economies, able to cope with large unexpected shocks.

It seems that the way towards becoming significant actors in the world economies is not easy. This can also be seen from the history of crisis in economies like Mexico, South Korea and Turkey.

 

Read more:

Quantitative Easing Risks

Quantitative Easing: the Exit Strategy

A micro-founded IS-LM model

Traditional Keynesian models, like the IS-LM one, were discarded as they lack micro-foundations. They were also subject to the Lucas critique (in the sense that one cannot properly estimate a macroeconomic model if the parameters respond to changes in monetary/fiscal policy).

What mainstream macro has come up with was first the real business cycles approach, and then, the so called dynamic stochastic general equilibrium models which include various nominal and real frictions. Not all economists however think that the old-style IS-LM model is not useful anymore. A known proponent of this approach is Krugman who said: “That doesn’t mean that you have to use Mike’s [Woodford] model or something like it every time you think about policy; by and large, ad hoc models like IS-LM are actually more useful, in my judgment. But you probably do want to double-check your logic using fancier optimization models” (see here and here). Yet another economist who adheres to this point of view is Brad DeLong who says that “To have fake micro foundations for your model is not a feature, but a bug”. Simon Wren-Lewis does an interesting discussion here.

A possible significant contribution to this topic might be the paper by Pascal Michaillat and Emmanuel Saez, “An Economical Business-Cycle Model”. They constructed a micro-founded IS-LM model using the money-in-the-utility function a la Sidrauski. They also introduced unemployment through labor market frictions. Admittedly, their analysis focused rather on the steady state dynamics, excluding issues of key interest, like the effects of monetary policy shocks, the second order moments or estimating the model. Nevertheless, their analysis has shown that the gap between IS-LM could be much smaller than thought

Time for Expansionary Fiscal Policy?

While it appears that Quantitative Easing has reached its limits and the FED intends to implement a strategy of gradual exit, there is less clear what available options exist for stimulating the economy.

That austerity is not the way to go it’s quite clear for most of us. There are increased evidences of its failures when applied, see the case of peripheral European economies (also, read The Failure of Austerity Measures in Portugal), while the academic studies hardly find evidences of its stimulating effects (except maybe for the isolated cases of Denmark and Ireland in early 1980; read the earlier post on Can Austerity Be Expansionary?).

Thus a reasonable alternative for many is an expansionary fiscal policy. This is what DeLong and Summers discuss and propose in their new paper “Fiscal Policy in a Depressed Economy”. While they support in general the view that only monetary policy should be used for stabilization purposes (my note: I hope that this does not include Quantitative Easing), according to them, in a zero lower bound situation, with cyclical unemployment and excess capacity, an expansionary fiscal policy might be self-financing.

What the paper does not answer to, or it answer in an unconvincing way, is the issue of the debt constrained economies which is present in most of the Western world. Following their argument, this expansionary fiscal stimulus would be self-financing, but in the real world the government might find that it is not (fully) self-financing. What would imply this, a rising debt? What is the stimulus is run for several years? In the end, if the fiscal-stimulus is not self-financing it might lead to additional taxes or debt, both with negative effects on the economy. But we should also note that the case of negative effects of debt would be more negatively felt by small open economies than the United States.

Quantitative Easing is not Neutral

The recent statements by Eugene Fama, Nobel Laureate in Economics (by the way, the actual title is Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel), on the fact that Quantitative Easing is neutral have puzzled many. According to him, “QE doesn’t do much”. When analyzed from the perspective of current debates in macroeconomics, this view is rather hard to be categorized, since no serious approach I know of really thinks about QE in these terms.

Take for example Keynesians like Krugman who thinks that the issue with QE is rather not being strong enough. In his words, more quantitative easing is needed, although it might lead to higher inflation. This is hardly a view that quantitative easing is neutral. Similarly, Brad Delong completely dismisses Fama’s view, simply suggesting that Fama completely misunderstands the current issues in financial markets (which sound pretty ironic).

On the other side of the debate, neither Cochrane (also from University of Chicago) thinks that QE is neutral. Surely, he contradicts the usual views on QE (stimulative vs inflationary). But he also views the idea of US having a lot of short term debt as risky, since it would make it “vulnerable to bad news”.

Of course, we should not ignore the inflationary views on Quantitative Easing. Such is the example of Martin Feldstein. Although he admits that up to now, inflation remained low despite the massive bond purchases, he sees the inflation as a real danger in the longer run, as the economy will eventually recover.

 

Also read:

Macroeconomics Wikipedia: Quantitative Easing

Did the crisis affect the potential GDP

While much of the debate has centered on growth prospects of the US economy in the aftermath of the crisis, a slightly overlooked issue is how the potential output has been affected by the crisis.

Admittedly, the measure of potential output is a bit hard to measure (take a look at the Wikipedia article on Macroeconomic Analysis), as is the related output gap variable. Standard measures range from pure statistical filter (like the Hodrick-Prescott Filter, or simply HP, the Band Pass filter), simple economic models (like the production function) or structural models (like state space models or even DSGE models). This is the reason why simple measures of potential output, like the one provided by CBO (Congressional Budget Office), are quite controversial, given their emphasis on the use of simple filters (see also the comments on Econbrowser).

It appears that studying the effects of the crisis is a daunting task. Nevertheless, a few studies discussed this topic. Furceri and Mourougane (2012) used panel data on OECD economies to estimate univariate autoregressive process for output, with a sample between 1960 and 2008. Their main finding was that financial crises tend to decrease potential output by 1.5 to 2.4%. However, the way financial crises impact potential output is much more complex than simple filters can reveal. For example, financial crises can affect the investments in capital, while the effects of labor participation are ambiguous.

A slightly different focus is found in the paper by Haltmaier (“Do Recessions Affect Potential Output?”). Again data panel techniques were used, however, unfortunately, only the HP filter has been applied to determine the trend. The most significant result is that the effects differ for emerging and developed economies. While emerging economies are mostly affected by the length of a recession, developed economies are actually affected by the depth of a crisis.

The number of studies on this topic remains rather low, given the importance of the concept of potential output. There is much work to be done here which could, for example, link austerity or Quantitative Easing policies to potential output.

 

Also read:

Macroeconomcis Wikipedia: Potential Output

Macroeconomics Wikipedia: Output Gap

Fiscal Policy and Quantitative Easing

 

The monetary policy has been preferred to fiscal policy to fight the recession, at least for United States. While Quantitative Easing has been recurrently applied in many episodes, from QE1 to the more recent QE4, there has been less attention paid to the possible uses of fiscal policy.

It is true that, in 2008, the Economic Stimulus Act of 2008 was passed and enacted (and was subsequently followed by American Recovery and Reinvestment Act of 2009).  But, besides these steps, not much effort has been done. As Quantitative Easing has reached its limits and it appears that will not be continued, it is not clear what use of fiscal policy could be made.

Fiscal policy has been certainly tried in other ways, and probably the most known use is that of austerity, see here some opinions about its meaning, as well as its notable failures in the peripheral European economies involved in the European sovereign debt crisis.

A few interesting thoughts are offered by Duncan Weldon in the article “Monetary and Fiscal Stimulus are not the same”. Pointing to the research by Aghion, it is argued that the countercyclical fiscal and monetary policies have different effects: the first helping firms dependent from external finance, while the latter positively affects mostly the firms more dependent on finance or on liquidity.

An article by Richard Wood at EconoMonitor reviews the main fiscal and monetary strategies available as for now. According to the author, the best strategy would to finance the budget deficit through new money. In this strategy, the new money is used by the Treasure to finance its budget deficit and enter money directly into the economy. However, the author should explain better how this approach would be radically different from the current Quantitative Easing episodes.

And of course, we have the opinion by Krugman arguing that the right track for now is not more austerity, but more economic stimulus.

At the same time, the rising national debt puts serious limits to a possible fiscal stimulus. An interesting call to put a stop to the further rise of national debt has been made by Hubbard and Kane who suggested an implementation of constraints on expenditures (to prevent over-expenditures and severe cuts), and amendments focused on fiscal balance.

What are the effects of Quantitative Easing

There is a growing literature on what exactly the Quantitative Easing has achieved. As we are going see, there is an agreement that QE has led to both higher output and higher inflation, however, there is less agreement on the magnitude and persistence of these effects.

Probably, the earliest studies were carried on the case of Japan; see the survey on empirical studies by Ugai. Quite interestingly, the largest effects were identified for the channel related to the expected short-term interest rates.

The paper by Kapetanios et al. (“Assessing the economy-wide effects of quantitative easing”) discussed the effects of QE run by the Bank of England. The paper focused mostly on the short term interest rate channel, although the authors acknowledged that this might have been a limitation. The methodology consisted in using three different VAR models: a large Bayesian VAR, a time-varying VAR as well as a change-point structural VAR. On average, they found a peak effect on output around 1.5% and a peak effect on inflation of about 1.25%.

A more innovative paper in terms of methodology is the one by Pesaran and Smith. Their study proposed an ex-post evaluation of the effects of Quantitative Easing based on outcomes conditioned on the ex-post variables (which are, at the same time, both invariant to policy and also determinants of outcomes). It also suggested a possible test for ex-post policy ineffectiveness. In terms of magnitudes, they found a peak effect on GDP of about 1%, however they also found that this effect quickly dissipates in about 9 to 12 months.

As we could see, usually the quantitative approach has been based on time series like VARs. An exception to this is the study by Falagiarda who used a DSGE model to evaluate the QE effects. The model has two important features that help capture the portfolio rebalancing channel: imperfect asset substitutability and a feedback from the term structure to the economy. His findings indicate a peak effect on long term rates of about 60 points, a peak effect on GDP around 1% and on inflation about 0.40%. As the author underlines, his work me be extended by including the credit channel of the QE.

The topic of the effects of QE is surely not a closed subject. Probably more evidences will be uncovered in time. A question probably not answered yet is whether these effects of quantitative easing outweigh the costs and potential risks.

Quantitative Easing: The Exit Strategy

            The Fed has recently announced that it will renounce to Quantitative Easing policy. Alan Blinder has a very interesting material that explains pretty well the rationales for why has the FED chosen this approach, how was implemented and what are the exit strategies.

Without stressing this point too much, the main reason for choosing to implement Quantitative Easing was, in the first place, the liquidity trap. Unfortunately, this concept is quite controversial and I discussed a bit about it here: “Is the US in a liquidity trap?”.

However, it is much more interesting to see what the options for exiting the quantitative risks as well as the potential risks associated to the exit strategy, see the speech by Bernanke on the exit strategy by the FED. One natural course is to let assets flow free, that is, to close the liquidity facilities (which was almost done through the completion of TAF and MBS purchase programs). On the other hand, the exit strategy also has to deal with the open market operations. They could have contractionary effects by reverse repurchases or by direct sales.

Blinder correctly underlines the difference between an exit strategy based on lending facilities and an exit strategy using open market operations. In the first case, the exit is rather natural, while in the second, there are potentially many risks.

The most dangerous issue seems related to the issue of shrinking the bank reserves. It is well known that excess reserves have piled up in huge amounts. Probably this is a potential source of inflation (see the article by Feldstein on why US inflation remained low).

The IMF has also underlined possible risks to the exit from Quantitative Easing. According to IMF, the tightening could imply an increase in interest rate volatility (and potential negative effects on emerging economies). A potential solution to the possible interest rate volatility was suggested by Alan Blinder in the form of setting an interest rate corridor, with both a floor and a ceiling.

As the FED exits the Quantitative Easing, we might see new development which could prove if this strategy was a wrong approach or not.

Quantitative Easing Risks

 

I’ve discussed in previous posts about several aspects of Quantitative Easing, focusing on the possible effects on inflation as well as on whether QE has been successful or not. Here, the focus is on the potential risks associated to quantitative easing.

Some of the risks were already outline in the previous posts on the success of QE. As John Doukas underlined, quantitative easing can lead to capital flight. Some casual evidence, as reported in this Bloomberg article, seems to support this thesis. As one of the interviewed managers noticed, “The Fed has no control over how that liquidity is used”.

Another major concern is related to one of the essential features of Quantitative Easing. By buying assets like bonds, the FED achieves a lower yield for the government bonds which is not drive by the markets. This has however some perverse effects since it might directly affects those who have invested in bonds, among them the pension funds.

One other concern is, of course, that of inflation. Although many expected that QE will lead in the end to more inflation (if not to hyperinflation), the time has proven that these expectations were wrong. Feldstein has an explanation on why Quantitative Easing did not lead to inflation (so far).

Probable a more subtle effect of QE is that of income and wealth redistribution. The logic is quite simple: since QE artificially raises the value of the stocks, it will lead to an increase in the wealth of the stock holders. However, only a minor share of the households holds most of the stocks. This assertion is backed by recent studies run by the Bank of England (which implemented QE too…), see here.

Not at last the, the QE implemented in the developed economies has raised concerns in the fast emerging economies, like the BRIC ones, which perceived this monetary policy as a de facto competitive devaluation (since the currencies of the countries that implemented Quantitative Easing are weakened).

As FED (and probably, the other major central banks will follow it soon) prepares itself to abandon QE, some of the concerns might be become futile, but ironically, it might be post-QE that we could find and experience some unpleasant things.

Liquidity Trap Criticism

Quite surprisingly, although there is so much talk about the liquidity trap and its close concept, the zero lower bound (see the definition of liquidity trap), the criticism of these concepts is rather thin. This is even more puzzling since the liquidity trap concept is known for a long time, ever since Keynes proposed it (Rhodes did not find any mention of it in the work By Keynes).

To properly discuss the liquidity trap criticism, I would start by mentioning the two different understandings of this concept. In its original view, the driver of the liquidity trap is the “liquidity preference”. In a typical IS-LM model, once the interest rate hits a sufficiently low interest rate, the demand for money practically becomes infinite. In the modern interpretation, the liquidity trap emerges in a zero lower bound situation and it depends not on the current interest rate (as in the IS-LM model) but on future expected interest rate (as in a typical DSGE model). Both views have been criticized using theoretical and empirical arguments.

The older view has been criticized by renowned economists like Pigou and Haberler which advocated the real balance effect (also known as the Pigou effect). It has also been criticized by Friedman and other monetarists on the basis that the monetary policy has more channels through which its effects work (and thus the liquidity preference should not be taken in an absolute view). An elaborate rejection of the liquidity trap in its old and newer versions was done by Scott Sumner. Among his arguments: cash and T-bills carrying zero interest rate are not perfect substitutes. A second argument (supported by Tyler Cowen too, who underlines that Quantitative Easing is effective) is that monetary policy was actually effective during the Great Depression.

On the empirical side, as Tyler Cowen observes, even Keynes did not see any liquidity trap during the Great Depression. He also notices that, although many currently see the US in a liquidity trap, the consumer spending was rising in 2010, contrary to the predictions of the liquidity trap. On top of that, the stock market also responded in a positive manner to the Quantitative Easing measures.