Thursday, 10 April 2014

So what exactly can the ECB do, anyway?

My latest post at Forbes considers what the ECB's alternatives are for easing in the Eurozone:

The ECB is not going to do QE, or indeed any other form of monetary easing at the moment. But they are talking about it. And for the moment, it seems, talk is enough. The Euro is up and bond yields are down, even for Greece (which isbravely attempting to return to the capital markets this week). European stock markets are worrying about the Ukraine crisis. It’s back to business as usual.
But as Andrew Clare of Cass Business School caustically remarks, “markets won’t be satisfied forever with hot air”. Unless Euro area inflation somehow reverses its current downward trend – which seems unlikely, since the world is on a general disinflationary trend at the moment and the Euro area is hardly a stellar performer  – the ECB will eventually be forced to do more than talk.

Read on here.

UPDATE: The ratings agency Fitch is rather more positive about the ECB buying SME loan securitisations than I am.

Monday, 7 April 2014

GDP and its critics

I've just finished reading Diane Coyle's excellent book on the history of GDP. For a measure that has only been used since the 1940s, GDP has amassed an extraordinary following. Whole economic theories now depend on it. 

But there are those who argue that GDP is fundamentally flawed and should be replaced. Sadly, some of them show a lamentable lack of understanding of accounting and the methods used to calculate GDP. For example, here is Steve Forbes:
GDP represents the value of all final products and services. It ignores all the steps that go into the making of these things. It’s sort of like looking at a carton of milk and paying no heed to everything that goes into creating that milk and getting the carton onto the store shelf.
GDP thus gives a distorted picture of the economy. How many times do we read that consumption represents 70% of the economy and therefore it’s important to “stimulate demand” by increasing government spending?
And he goes on to recommend using gross output (GO) instead of GDP, arguing that it "measures the economy in a far more comprehensive and accurate manner".

To show why this is seriously flawed, I need to explain a bit about how GDP is calculated. Experts on this will no doubt call me out on being far too simplistic - GDP is an incredibly complex measure and its calculation is close to being a black art. But this post is not aimed at experts. It's aimed at ordinary people whose opinions are swayed by the likes of Steve Forbes. 

GDP can be calculated in three different ways - the expenditure approach, the income approach and the production approach. The first of these adds up all the forms of expenditure in the economy, giving us the familiar formula:

GDP = C + I + G + (X-M)

where C is consumption spending, I is investment spending, G is government spending and (X-M) is net exports(imports).

Steve Forbes complains that imports are treated as negative for GDP. But this is a no-brainer. If you buy imports, money leaves the country. If you sell exports, money comes into the country. Purchases of imports are therefore correctly a negative for GDP. (But profits from sales of products made with imported goods are positive.)

The second way of calculating GDP adds up all the sources of income in the economy:

GDP = W + P + R + I + D+ (T-S)

where W = wages & salaries, P = corporate profits (or operating surplus), R = rents, I = interest, D = depreciation and (T-S) = net taxes after subsidies.

As total spending = total income, the first and second methods should give approximately the same result, though measurement errors do create some difference. 


But it is the third way of calculating GDP - the production approach - that Steve Forbes is complaining about. It takes gross output (yes, THAT gross output) and eliminates intermediate outputs to give the gross value-added output for the economy. Like many, Steve Forbes does not seem to understand why intermediate outputs are eliminated. But it is because intermediate outputs are used to create final output. To show this, I'm going to use Steve Forbes' own example of milk production. (Please note the figures are entirely fictitious. I have absolutely no idea how much it actually costs to produce, package and market a litre of milk.) 
  • Farmer X has a herd of dairy cows. The cost of maintaining his dairy herd is $1,000. They produce 1,000 litres of milk which he sells to a supermarket for $1.10 per litre. Gross sales are $1,100 and profit is $100.
  • Manufacturer Y produces the cartons for milk. Production cost is $200 for 1,000 cartons and he sells the cartons to the supermarket for 25 cents per carton. Gross sales are $250 and his profit is $50.
  • The supermarket puts the milk into one-litre cartons and sells it to customers at £1.80 per litre. The supermarket's unit costs are $1.10 + $0.25 = $1.35 per litre and they have staff costs and overheads amounting to a further 15 cents per litre. So if they sell all the milk, the gross sales revenue is $1800 and profit is $300.
The gross output is the total sales revenue from all three of these, i.e. $1,100 + $250 + $1,800 = $3,150. But there's a problem. Since the supermarket has to pay for its supplies, the sales revenue of the suppliers is already included in the supermarket's production cost. So by adding in the suppliers' sales revenue, we are double counting. This is the same problem that accountants face when creating group accounts: if you include sales from a subsidiary to its parent, you artificially inflate the sales revenue of the whole group. It's known as grossing-up. Here we are talking about supply chains, but for national accounting purposes the same applies. If you include intermediate outputs, you gross up the private sector's value-added contribution. To obtain an accurate figure for value-added GDP, therefore, we need to eliminate the intermediate outputs. When you do this, it is evident that only the supermarket's sales contribute to GDP. The rest disappear. 

So GDP does not recognise the value of intermediate outputs. But that doesn't make GDP wrong, any more than a set of consolidated group accounts is wrong because it has eliminated intra-group transfers. What Steve Forbes is proposing is replacement of consolidated business output with grossed-up business output to make the contribution of business to the national economy look bigger. I think they call this "cooking the books". 

Currently, the US's National Income and Product Accounts only show gross output by sector. It is now planning to produce overall gross output figures as well, in parallel with GDP figures (this is the change that Steve Forbes is crowing about). This is a good addition to the national accounts: we do need to understand the contribution of intermediate producers, and sector analysis isn't always adequate since final products may be made from intermediate sources in several sectors. Also, in these days of global supply chains, intermediate sources may not be in the same country as the final output, in which case the intermediates arguably should be regarded as imports and their cost deducted from gross output (no wonder Steve Forbes wants imports to be treated as positive!). So gross output will be a useful measure. But it is not by any stretch of the imagination a replacement for GDP. 

But it is the conclusion that Steve Forbes draws from this that worries me. Returning to the familiar expenditure equation GDP = C+ I+ G+ (X-M), Steve Forbes in effect argues that grossing-up business output would considerably inflate the importance of I in relation to C and G, since all those intermediate outputs would have to be included in investment spending. This would, in his words, "put business and investment in their rightfully large place". But this is bizarre. In what way is milk bought daily from a farmer "investment spending"? It is simply a cost of production and therefore belongs in C, not I. If you are grossing up, then businesses consume too.  

Of course, it suits businessmen like Steve Forbes to claim that the driver of the economy is business output and consumption is an optional extra. But the sole purpose of business output is consumption. Businesses don't produce products unless there are people willing and able to consume them. Without C, there would be no I.

And this brings me to Steve Forbes' view that government spending is a negative. In days gone by, when governments mainly raised money to finance wars, this was a reasonable view: money spent on wanton destruction leaves the country never to return. But that's not what the majority of government spending is used for these days. Most government spending goes into the economy: whether or not it is effectively spent entirely misses the point. Businesses sell to government just as they sell to households. Government spending should therefore correctly be seen as positive in the GDP expenditure calculation, just as household consumption and business investment are. 

So Steve Forbes's criticism of GDP is ill-informed and irrational. But GDP is certainly not without its problems. Its extreme complexity makes constant revision inevitable, and even with all that complexity it is still at best only a rough indicator of economic growth. If the inputs to the GDP calculation change significantly, the result can be large swings in apparent economic standing that have nothing to do with reality - for example, Nigeria has just reported an 89% increase in GDP that is entirely due to rebasing the components of GDP. And it leaves out all sorts of things - such as unpaid "home work" - for no particularly good reason other than that they are difficult to measure. Critics of GDP complain that it doesn't measure wellbeing (true), it doesn't adequately account for intangibles (also true), it gives greater importance to "making stuff" than providing services (true, but not surprising given when it was invented), and it ignores depletion of natural resources. All of these are valid criticisms. 

Coyle gives a good summary of these criticisms in her book. But she then dismisses most of them. Replacing GDP, or changing it to include other factors, is not the point. The real problem is that we are expecting far too much of GDP. There cannot be "one measure to rule them all". The fact that GDP focuses narrowly on measures of expenditure, income and output is not a bug, it's a feature. We need other measures as well. Coyle suggests a "dashboard" of economic indicators for policymakers to enable them to judge the health and prospects of the economy and set policy accordingly. GDP (nominal and real) would be included in this dashboard but would not be the sole driver of monetary or fiscal policy. 

As I am no fan of single targets such as CPI or NGDP, I like Coyle's idea. I am encouraged by the fact that both the Bank of England and the Fed are now using a "basket" of indicators, though they have not yet ended the primacy of the inflation target, because we still have not exorcised the 1970s inflation demons. But I am hopeful that we will gradually move towards a more balanced approach and start to include other indicators such as wellbeing and sustainable resource use in our measures of economic health. 

Sunday, 6 April 2014

Why labour markets don't clear



New Keynesians argue that sticky wages prevent labour markets from clearing. I disagree - I think labour markets can eventually clear. But we don't allow them to do so, because the social costs of are far too high. At Pieria, I explain why this is. Read the whole article here.


Wednesday, 2 April 2014

On the persistence of inadequate ideas

For years now, I have been complaining about excessive focus on "diaphragmatic support" in singing tuition*. Although breathing involves the diaphragm, support of the vocal tone actually uses deep core muscles, and the diaphragm is not under voluntary control anyway so telling students to "support from the diaphragm" is pointless.

And yet the other day I found myself teaching diaphragmatic support.....because for one student, it was the right technique. She needed a counterbalance to her tendency to pull in her upper abdominals (shrinks the waist but is disastrous for singing). In effect, she was singing as if she was wearing a corset. And therefore she needed a singing technique specifically designed to counteract the constrictive effect of a corset. For her, it worked. For most people, it is unnecessary.

The point is that although support of the vocal tone does indeed come from deep core muscles, the diaphragm itself plus the intercostal muscles and upper abdominals (which are incorrectly called the "diaphragm" by most people) still have a role to play, and when they don't do it adequately, the rest of the system doesn't work properly. But that doesn't mean that they should be the only - or even the main - focus of technical singing tuition. We can say that "diaphragmatic support" is an inadequate but occasionally helpful description of the role that the diaphragm and associated muscles play in the physical generation of singing tone.

Now, you don't really think this post is about singing technique, do you? Of course not. I am using this as an analogy for the money multiplier, about which there has been a fierce debate in the economics blogosphere ever since the Bank of England produced its (now notorious) paper on money creation.

I have been saying for years now that the money multiplier does not adequately explain how money is created in a modern fiat money economy. In particular, the idea that banks are passive intermediaries who simply respond to injections of central bank money by creating more loans is fundamentally wrong. Banks actively determine the amount of "inside money" circulating in the economy. When they create loans or buy securities, inside money increases. When loans are repaid or written off, or securities are sold, inside money reduces. The constraints on bank lending are multiple and complex, and don't include reserve availability (though the price of reserves is a constraint). The Bank of England's description of the process is broadly accurate.

Having said that, though, as a descriptor of the relationship between inside and outside money in the economy, the money multiplier is not wrong. It is merely inadequate. For example, I might look at this chart:
























and conclude that there was no credit bubble in the run-up to the financial crisis - in fact if anything, lending slowed. I would be wrong, wouldn't I? Indeed I would. The money multiplier did not move, because the production of M0 was tracking the production of M1 (which was leading which is not obvious, but they were approximately correlated):
























The money multiplier was therefore pretty much constant, not because banks weren't increasing lending but because the central bank was increasing base money in response to the increase in bank lending, or perhaps vice versa. When base money and M1 are so closely related, the money multiplier tells us very little about aggregate demand. No wonder various "modern money theorists" describe the money multiplier as a myth.

But of course that is how things worked before the 2008 crisis. Since the crisis, central banks have been creating base money at an unprecedented rate. And now our money multiplier might actually be some use, since base money is no longer simply responding to reserve demand - it is exogenously determined. Oh wait, though....LSAPs cause M1 to increase too, because most purchases are made from investors rather than banks. Therefore M1 itself is now to a considerable extent exogenously determined. So the money multiplier now tells us even less than it did before.

Of course, you might believe that the behaviour of one monetary aggregate gives you enough information to enable you set a credible path for future growth and/or inflation, and you don't need to concern yourself with the mechanism by which this controls aggregate demand. But if this is your belief, then you are similar to a singing teacher who is not remotely interested in the behaviour of the deep core muscles but believes that getting the diaphragm properly braced will automatically result in the whole skeleto-muscular system working efficiently to produce the desired singing tone. I suppose it's possible, but it seems a pretty heroic assumption. Is there really a reliable mechanical relationship between base money and broad money that can be exploited solely by controlling the base without taking account of the role of bank lending decisions in the multiplier effect? It seems most unlikely to me.

Monetary wonks may at times find the money multiplier to be the most effective way of explaining some particular aspect of the monetary system, just as I found diaphragmatic support an effective technique for my "virtually corseted" student. Indeed I used the money multiplier myself recently in a post about the IS-LM model in an endogenous money context. It is therefore occasionally helpful. But I don't think it is by itself an adequate description of how the monetary system works. And I can't see how the money multiplier is remotely suitable for teaching to first-year economics undergraduates, or first-year students of banking and finance for that matter, unless it is accompanied by modules that explain how bank lending and broad money creation work in practice.

I'm with Simon Wren-Lewis on this. At undergraduate level, the money multiplier is long overdue for replacement with an accurate description of how money creation actually works in a modern fiat money economy.

Disclaimer: I was taught the money multiplier myself as a first-year MBA student. 

Related reading:

Two first-year multipliers: their truth, beauty and usefulness - Nick Rowe
The Uselessness of the Money Multiplier - David Glasner (Nick Rowe smackdown)
Money creation: propagating confusion - Stephen Williamson

* In classical singing, diaphragmatic support technique braces the upper abdominals and intercostals to keep the diaphragm taut as breath is released, enabling the student to maintain constant subglottic pressure. In classical acting, diaphragmatic support involves a hard outwards push from the upper abdominal muscles, creating a powerful edged tone. The classical acting version is used in contemporary musical theatre. You really wanted to know that, didn't you?


Monday, 31 March 2014

The Chancellor's "full employment" ambition is not quite what it seems

"The UK’s Chancellor of the Exchequer, George Osborne, has announced that his priority is jobs. In his words (from his Twitter account):

"This is more than slightly confused."

Read on here. (Pieria)


The UK's Real Problem

The UK's current account deficit is a matter for some concern, as is its fiscal deficit, because both make it vulnerable to sudden reversal of capital flows. But these aren't its real problem....

More here (Forbes).

Sunday, 30 March 2014

Spain, the ECB and the power of talk

Over at Forbes, more on why the ECB won't do QE despite Spanish inflation having turned negative:
Spain is in a mess. Over a quarter of its adult workforce is unemployed, and according to CIB Natixis it has lost 25% of its production, even more than Greece. Spain’s inflation rate has been falling steadily and has now turned negative: the most recent retail sales figures show a fall of 0.2%. Various people anticipate ECB easing monetary policy because of the growing threat of deflation in Spain.
But this is to misunderstand the role of monetary policy in a currency union. The ECB sets monetary policy for the union as a single unit, not for its individual components. Deflation in Spain is a driver of ECB decisions only to the extent that it depresses Euro zone CPI. And I’m sorry if this sounds brutal, but Spanish unemployment is of no consequence, since the ECB does not have a mandate to target unemployment even at the Euro zone level, let alone in an individual country. The ECB can no more set policy to tackle deflation or unemployment in Spain than it can set policy to meet the desire of German savers for better returns. Its mandate is to maintain inflation close to 2% across the Euro zone economy AS A WHOLE.....
Read on here