The US 2012 budget (CNBC Interview with Ilian)

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Supply or Demand? Beyond the labels.

Philadelphia Federal Reserve President Charles Plosser has questioned the usefulness of using monetary policy as a stimulus tool by saying “monetary policy cannot retrain people”. This statement is the result of his belief that the current problem with unemployment in the US is mainly structural. The only way to reduce it is by retraining workers from industries in decline (construction workers) to industries that are supposed to grow faster (nurses).

This is not a new debate and others have already replied to Plosser’s comments by showing strong evidence that the high unemployment rate in the US economy is present in practically every sector, every group or every region, so it is difficult to see how the data supports Plosser’s statements (see for example Paul Krugman making this point).

The debate about what causes business cycles: changes in demand or changes in supply is certainly not new to academics and it is normally seen as a differentiating point between groups of economists (Keynesians versus neoclassical). From the perspective of non-academics the debate is not always clear partly because of the way economists use the words demand and supply at the aggregate level and how it relates to the concepts of demand and supply in the market for a single good.

When you look at one market, demand and supply are always equal. One can explain fluctuations in prices or quantities by referring to movements in supply or demand but we normally do not think about periods where demand is too low or supply is too high (unless the market is not clearing).

When it comes to aggregate output, recessions are understood as periods where there is slack in the economy: unemployment is high, capacity utilization low. Some immediately associate these periods with the notion that demand is low. We have enough supply (workers, factories) to produce more but companies do not have enough demand to operate at full capacity. If we ask someone who has not studied economics before it is likely that they will find this story intuitive (and this is probably the reason why most people tend to have a “Keynesian” view of the world event if they have not been taught economics before). But I could also refer to recessions as a period where employment and output are low and this is about production, not just demand. So can we talk about recessions as periods where aggregate supply is also low?

Let’s ignore the supply and demand labels for the moment and separate the issue in several questions and see when there is agreement and when there is not.

Q1. Are there periods where the economy is producing below potential as measured by full utilization of all our resources? I am sure everyone agrees that this is the case. High unemployment represents a use of our labor resources below potential.

Q2. Why aren’t we using all of our productive resources during recessions? While most will agree that recessions are temporary, they disagree on what causes the friction that keeps employment temporarily below the level that ensures “full employment”. Charles Plosser's statement indicates that the friction (today) is mostly about a mismatch of skills (construction workers need to train themselves to become nurses). Keynesians believe that a low level of “aggregate demand” is keeping output low. But what type of friction explains the low level of aggregate demand? A textbook Keynesian model will talk about price rigidity as the main mechanism for such a friction. Price rigidity leads to changes in some key relative prices (such as the real wage) that generate a low level of production. Price rigidities are not that intuitive for those who have not studied economics. Does this really mean that if we let the price level drop we will go back to full employment? How fast?

What the traditional Keynesian model is probably missing is a more realistic friction that explains why “aggregate demand” remains low for such a long period of time. This mechanism cannot be a friction a la Plosser (mismatch of skills or sectors or regions) otherwise the Keynesian prescriptions do not work. If you ask someone who has not studied economics before they will probably tell you a story of companies getting stuck (at least temporarily) in a low output equilibrium. If I do not hire more workers then there is not demand for your goods and the reason why I do not hire more workers is that you do not hire them either. This is what economist refer to as models with multiple equilbria, which have been proposed by academics often but they tend not to be too popular because they are almost impossible to test and some see as an ad-hoc explanation of cycles. Notice that, strictly speaking, in those stories or models the problem is one of demand as much as supply (the coordination failure is as much at the production level as it is at the demand level).

Q3. Should fiscal policy and monetary policy be used to stimulate an economy during a recession? The answer depends on how we answered the previous question. If the friction is a mismatch of skills in the labor market, it is difficult to imagine how monetary or fiscal policy can speed up the adjustment. But if we believe that:

a) Companies are ready to hire workers who happen to be unemployed and waiting to be hired.

b) They do not do so because they do not see enough demand for their products.

Then there is room for monetary fiscal policy to increase the demand and the output (supply) of the economy. Whether one believes that the friction is just price rigidity or simply a failure to coordinate to a quick return to full employment, traditional “aggregate demand” policies such as monetary and fiscal policy will do the job (even if one could call them aggregate supply policies as well).

Antonio Fatás

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Looking ahead: US and Europe

Here is a recent CNBC interview where I discuss the economic situation of the U.S. and European economies.

Ilian Mihov

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The future of the Euro

Here is an interview published by INSEAD knowledge where together with one of my colleagues (Douglas Webber, a political scientist) we answer questions regarding the future of the Euro both from a political and an economic angle.

Antonio Fatás

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Accumulating foreign reserves: private or public?

The global imbalances that we have witnessed over the last years have led to significant changes in the net investment position of some countries. Those with persistent current account deficits (e.g. the US) have seen their net investment position deteriorate, while those with persistent current account surpluses have seen their net investment position improve (such as China). An improvement in the net position represents an increase in the foreign assets held by that country relative to its liabilities (domestic assets held by foreigners).

In some of the surplus countries (certainly in China), the majority of the accumulation of foreign assets has resulted in large increases in the amount of foreign assets held by the public sector (government or central bank), what is known as foreign reserves. Have they gone too far? Is there an optimal amount of foreign reserves for a country such as China?

SAFE (the State Administration of Foreign Exchange in China) provides on its web site an interesting list of FAQs regarding the current level of foreign reserves in China. To the question "What is the appropriate scale for China's foreign reserves?" they provide an intriguing answer. They start with the assertion that "Too much foreign exchange reserves can be bad." and then they follow with the paragraph:

"In terms of aggregate foreign exchange assets, in a broad sense, at year-end 2009, China held USD 3.46 trillion in foreign financial assets, far lower than the developed countries in North America and Europe. The main problem at present is that most of China 's foreign exchange assets are controlled by the government, leaving only a small proportion in private hands. Specifically, foreign exchange reserves held by the Chinese government account for two-thirds of all foreign assets in China, compared with only one-sixth in Japan. Therefore, we encourage businesses and individuals to hold and invest in foreign exchange so as to diversify the mix and to distribute foreign exchange within the private sector. This, of course, takes time. With the development of our national economy and the increase in income, enterprises and individuals will have greater demands for diversification of asset allocations. If more foreign exchange investment channels and products are provided for the public to reap concrete benefits from the foreign exchange, then the foreign exchange pressures on the government will be greatly relieved."

The opening sentence is a claim that the overall level of foreign assets in China is not that high if you consolidate the public and private sector. Is this true?

The table above summarizes the gross international investment position for the US and China in 2009. By looking at the first row we can see that the claim by SAFE is correct. The overall level of foreign assets (public and private) held by domestic individuals, companies or institutions in the US is more than 130% of GDP, significantly higher than in China (around 58%). However, in the case of China the majority of these assets are held as foreign reserves, i.e. they are in the hands of the government or central bank; foreign reserves in China represent more than two thirds of all the foreign assets. It is this unusual volume of foreign reserves what drives the headlines about excessive foreign reserves accumulation in China. But the SAFE claim is correct: if one is willing to consolidate the public and private holdings of foreign assets China is still far from the levels of the advanced economies.

But is the public/private composition relevant to understand these numbers? Let's first understand the comparison between China and the US. No doubt that as a country opens up to international capital flows and individuals and companies diversify their portfolio of assets, we expect to see an increase in the amount of foreign assets (as % of GDP); that's why the US (or advanced economies) have a much higher ratio of these assets relative to GDP.

In the case of China, the flow of foreign assets (a result of exports and capital inflows) ends up in the hands of the government because of restrictions on capital flows (domestic agents see no value in holding foreign assets or are not allowed to invest in the assets they might want to hold), which is unusual.

But if we take the view that what matters is the aggregate (public + private), does this mean that the level of foreign reserves in China is too low? No, this would be the wrong reading of the numbers or the debate. What matters in this debate is the net investment position which keeps improving (+30.5% in 2009) and it is the outcome of current account surpluses that reflect an imbalance which is not sustainable (or, possibly, optimal). It is true that if capital markets in China were more integrated with the rest of the world and more individuals and companies diversified their portfolios by holding foreign assets, we would not see such a high level of official foreign reserves in China. But this would not change the diagnosis of the situation. As long as the exchange rate remains undervalued and the current account in surplus, we would still see a continuous improvement in the net investment position as a sign of unsustainable global imbalances, regardless of the ownership composition of the foreign assets.

Antonio Fatás

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One lesson from the tax cuts deal in the U.S.

The recent agreement on tax cuts in the U.S. has generated a heated reaction. There are different readings about the economic and political consequences of the agreement (Mark Thoma provides a nice summary of some of the reactions).

The deal represents a very interesting political agreement between the Obama administration and the Republicans. Obama concedes by maintaining all the "temporary" tax cuts of the Bush administration, even for individuals earning above $250,000 and the Republicans decide to ignore their campaign statements that reducing the deficit should be a priority.

The outcome becomes an additional fiscal policy stimulus in the form of tax cuts and, obviously, a higher projected deficit for the coming years. I am very sympathetic to the idea of using again fiscal policy as much as possible to bring the economy back to potential, so there is an element of good news in the announcement (although maybe the agreed policies are not the best, spending might still be a more powerful fiscal policy tool to deal with the current circumstances).

But beyond the economic consequences of the announced tax cuts, there is one clear lesson from this experience: reducing budget deficits in the U.S. will be a challenging task. And if the plan requires increasing taxes then you need to wait until there is a real crisis of confidence and this crisis leads serves as a wake up call to politicians. Given what we have seen this week, finding a balance between short-term goals and long-term sustainability and making difficult decisions to reduce budget deficits will require substantial changes in the way politics and policy are done in the U.S.

Antonio Fatás

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The Irish bailout: Barry Eichengreen is mad (and he is right)

Barry Eichengreen has written a great piece for the blog The Irish Economy. He is known (as he states himself in the introduction) as being one of the most pro-Euro(pean) of the U.S. academics but he feels that the handling of the Irish situation is a disaster. The fact that the Irish government that had a very healthy fiscal position before the crisis ends up with an exploding debt because of the bailout that it provided to private banks, does not sound right to him. Why were holders of Irish bank bonds protected from the failure of these banks? This is not a new question, it has also been raised in other countries where governments have stepped in to ensure the viability of the financial system. But the magnitude of the debt burden that the government is passing to tax payers in Ireland is such that is potentially making the Irish government insolvent.

Eichengreen is pessimistic and he thinks that the provision of the liquidity that the Irish government will receive is simply postponing the inevitable. And the only reason why the other countries agreed is because they are trying to protect their own banks who hold the debt of the Irish banks.

So Barry Eichengreen sees debt restructuring happening soon and he is probably right. And his prediction is not about the economics of debt and deficits; in principle, governments could pay a very large amount of debt with future tax revenues. The real question is whether this is politically feasible. Will Irish tax payers be willing to pay for the failures of these banks? Not obvious when you look at the potential payments associated with current debt levels.

Antonio Fatás

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