Thursday, 2 January 2014

Economists playing with fire

I have a sixteen year old daughter who is working hard on her final secondary school exams (UK ‘A’ levels) the results of which will determine the type of degree and which university she will attend – these are important times!  Being a more focused individual than her father she is already weighing her options and it’s straight fight between Economics and History.  Over the Christmas holiday we had a number of discussions around the relative merits of these options; initially I supported the view that Economics would be a more relevant and “useful” degree but now I am not so sure.
Having missed the vital signs of the credit crunch and the ensuing recession in 2008/09 economists around the world are red faced again and having to play catch up on the startling and unexpected rebound that the US and UK economies kicked off in 2013.  Not a single note-worthy economist was able to forecast up-tick in GDP growth or the stellar year stock markets enjoyed in 2013!   Famously, Olivier Blanchard (the International Monetary Fund's chief economist)  warned George Osborne that his austerity programme was "playing with fire" just as the UK emerged into recovery!


Economists playing with fire  

So if they can't tell us what is going to happen what are economists for?  It's a legitimate question to ask - if economist can’t forecast what is going to happen do they have any practical use? Being increasingly unsure of the future, they spend their days trying to piece together the past and polishing their excuses.  But why should economists worry about the past - as James Buchan told us “Economists, like royal children, are not punished for their errors”.


These hesitant souls are unable to move on until the residual policy polemics of this recession are resolved.  The profession is mired by questions around the effectiveness of Quantitative Easing (QE) and Austerity. The Keynesian wing maintain the view that ultra-loose monetary condition and high level of public expenditure would have seen the West recovery more quickly and at lower cost. The Monetarist believe that much of the QE effort has been a dangerous experiment and that the slow pace of debt reduction has hampered recovery.  

The political consensus following the credit crunch was that economic policy should have two main threads – extremely loose monetary policy combined with austerity in the public finances, in a sense each side of the economic divide was thrown a bone but neither was satisfied. The Keynesian wing wanted more government borrowing to go with the QE and the Monetarist wanted to rely on low interest rates and fiscal measures without additional QE.  The key question at this point was how to provide more stimuli at the “zero bound of interest rates” – both sides agreed on the need for this but, as ever, they disagreed on the mechanism.


Least we forget this all started with violent agreement; when in 2008 Lehman Brothers went bust, the central banks immediately flooded the financial system with extraordinary amounts of much needed liquidity.  This was achieved through large scale open market purchases of debt and direct lending to the tottering Banks.   Without this massive injection of cash / liquidity there would have been a full blown banking crisis.  Both sides of the economics spectrum broadly agree that this injection of liquidity was absolutely necessary, but from this point forward there is no consensus at all.


The next phase (2009) can be characterised by realisation that growth was being hampered by broken banks who were caught in a liquidity trap manufactured by the need to increase regulatory capital, reduce leverage ratios  and improve capital adequacy.  These rules were designed to create safer banks had the unintended consequence of dramatically reducing bank lending across the globe.  The antidote to this credit squeeze was further bouts of QE and some new “marco prudential” measures.  In the UK the Bank of England started the funding for lending scheme and the Fed turned to buying longer-dated assets, in an effort to reduce credit spreads and remove bad assets from the balance sheets of the banking sector. Confidence in the banking system began to improve, mortgage interest rates fell and credit spreads narrowed.  

Monetarist were worried about to outcomes of these ultra-loose monetary policies as budget deficits had doubled or tripled as a result of the recession.   The credit rating agencies (not completely discredited by the credit bust) were marking down sovereigns (Most of Europe and even the US got down-graded).  This raised the spectre of higher borrowing costs and kicked off the “Euro Crisis” in late 2010 ushering in the third phase in the drama - AUSTERITY!  Some heavily indebted EuroZone (EZ) countries were forced by the ECB and IMF into bail-out plans to slash government spending at an unprecedented rate and even in countries outside the EZ followed the mantra – the US and UK adopting “Austerity Lite”.  As a counterbalance to these tough measures the scale of QE was increased once again (the UK ended up increasing the national balance sheet by £375bn).  At this point the simmering differences in between economists boiled over and attitudes hardened unhelpfully.   The additional QE and austerity were bitterly criticised by economists from both persuasions.  Keynesian economists were affronted by economic waste of austerity and monetarist warned that yet more QE it would result in an unhealthy search for yields, which would create bubbles in parts of the financial system (housing, equities, emerging markets, etc). Following this the UK and the US, deployed employment level targets to frame the eventual tightening of monetary policy causing much excitement around “tapering” – the politicisation of central banking was now complete!


So what can these new-age “historians” tells us today?  The answer is not much, although Paul Krugman will swear he has been proved right on the waste and damage caused by austerity and Kenneth Rogoff will swear that debt reduction is an essential party of recovery.  Opinions on the later stages of QE are also deeply divided - we now know that it involved large re-distributions of wealth. Small scale savers lost as borrowers gained from exceptionally low real interest rates and this created some frothy activity in various markets (initially in emerging markets and latterly in the London housing market).  Central bankers in the US and the UK, however, can point to a sustained improvement in labour markets.  But the main risks associated with QE maybe the sting in its tail. The BoE’s Mark Carney has said that his central bank balance sheet may be permanently higher than it was before the crisis and this may well effect inflation and interest rates in the longer term.


The main learning to come out of the recession of 2008 - 09 and the subsequent painful recovery is that it is better to start a recession with a good economy and a poor one.  In those economies like the UK that are emerging into growth and prosperity it’s possible to concoct an academic narrative that says the mix of unbridled QE and “austerity lite” was a winning formula.  A more likely reason for our premature recovery is that we have a half decent economy after all.  Whereas in economies where recovery is still a distant dream politicians have to walk the tightrope: balancing vast public debts, long term interest rates and the health of the banking system, this is particularly so in the Eurozone – probably their only hope is the outstretched arm of rich friend – come on Germany don’t be shy!


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