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  • 1
    object(stdClass)#14413 (59) {
      ["id"]=>
      string(4) "6170"
      ["title"]=>
      string(55) "Sabotaging the Competition: A Home Construction Example"
      ["alias"]=>
      string(54) "sabotaging-the-competition-a-home-construction-example"
      ["introtext"]=>
      string(305) "

    Why are monopolies bad? In a standard intro-econ textbook, the problem of monopolies is that because of the lack of competition, they can reduce output from what it would otherwise be, jack up prices, and thus earn higher profits.

    " ["fulltext"]=> string(14057) "

    Some books also mention that monopolies may have less incentive for quality or innovation--again, because of a lack of competition.

    James A. Schmitz, Jr.  at the Federal Reserve Bank of Minneapolis refers to this standard intro-econ model as a "toothless" monopoly, because in that model, all the monopoly firm can do is raise prices. He argues that it doesn't capture what bothers most people about monopoly. There's also also a concern that monopolies take actions to take action to sabotage and even destroy their rivals--especially the rivals who might have provide low-cost competition. Moreover, monopolies may form concentrations of power with other monopolies or with with political allies to accomplish this goal, and in this way corrupt institutions of law and politics as well. 

    Schmitz is in the middle of a substantial research project that encompasses both the intellectual history of these two views of monopoly and also a set of concrete examples. As a work-in-progress, he has posted "Monopolies Inflict Great Harm on Low- and Middle-Income Americans"(Federal Reserve Bank of Minneapolis, Staff Report No. 601, May 2020), which is nearly 400 pages long but described as the "first essay" in a collection of essays to be produced in the next year or two. It can usefully be  read as a preliminary overview of an ongoing research project. 

    However, it's worth noting that Schmitz doesn't focus on the conventional everyday meaning of "monopoly"--that is, a super-big company that dominates sales within its market. Instead, he referring to "monopoly power" in a way that refers to when a group (not just a single large firm) acts restrict competition. Thus, his main examples are where existing producers have exerted political power to sabotage lower-cost competitors, including residential construction, credit cards, legal services, repair services, dentistry, hearing aids, eye care, and others.  

    Here, I'll just focus on sketching his discussion of residential construction. Schmitz writes: "The most extensively used technology, by far, is often called the stick-built technology because sticks (two by fours) visually dominate the construction sites. This technology has been used for centuries. Homes are built outside, with a highly labor-intensive technology. It also requires highly-skilled-labor. The other technology is factory-production of homes. This technology substitutes capital for labor and also semi-skilled workers for highly skilled workers."

    There has been a battle going back about a century between stick-built technology and factory technology for residential construction.  Schmitz traces the early legal conflicts back to the late 1910s. Here's a summary comment from Thurman Arnold, who was Assistant Attorney General for Antitrust in the 1930s, in a 1947 article. 

    When Arnold left the DOJ, he did not stop challenging monopolies in traditional construction. He did not stop trying to protect producers of factory-built homes. In “Why We Have a Housing Mess,” Arnold (1947) began with a picture of a homeless Pacific War veteran, with his wife and five children, sitting on the street with their belongings (see Figure 2). The caption said: “This Pacific War veteran and his family are homeless because we have let rackets, chiseling and labor feather-bedding block the production of low-cost houses.” Arnold began his text this way: “Why can’t we have houses like Fords [i.e., automobiles]? For a long time, we have been hearing about mass production of marvelously efficient postwar dream houses, all manufactured in one place and distributed like Fords. Yet nothing is happening. The low-cost mass production house has bogged down. Why? The answer is this: When Henry Ford went into the automobile business, he had only one organization to fight [an organization with a patent] . . . But when a Henry Ford of housing tries to get into the market with a dream house for the future, he doesn’t find just one organization blocking him. Lined up against him are a staggering series of restraints and private protective tariffs."

     
    Sabotaging the Competition

    Essentially, Arnold and other (including a substantial multi-author research project at the University of Chicago in the late 1940s) claimed that while no one explicitly passed rules to make factory-built housing illegal, building codes were carefully written in a way which had that effect. 

    Some standard issues were that local building codes were different everywhere, which was fine for local stick-built construction firms, but posed a problem for a factory producer hoping to ship everywhere. There was often a distinction in building codes about living in "trailers" or in permanent structures, in which a "double-wide" home brought to the site in two parts was treated as a "trailer," even when it was installed permanently on-site and looked much the same as a stick-built home of similar size. 

    In the 1960s, economic pressure had gathered for factory-built homes, which are typically much cheaper on a per-foot basis. But in the 1970s, regulators pushed back hard, with the the newly-created US Department of Housing and Urban Development playing a big role. Here are some snippets from how Schmitz tells the story. 

    Many housing industry observers noted that stick-builders were facing such threats from factory-built home producers in the 1960s. Though they did not have direct measures of productivity, they compared the costs and prices of new, site-built homes to the costs and prices of other consumer durables. Alexander Pike (1967), an architect, compared the prices of new homes and the prices of new cars from the 1920s. Though he did not have productivity statistics, his point was clear: the productivity of construction badly lagged that of the car industry. At roughly the same time, the research department of Morgan Guaranty Trust Company (1969) wrote about this productivity divergence when discussing the potential for industrialized housing ... in “Factory-Built Houses: Solution for the Shelter Shortage?” They noted the serious problems facing the stick built industry as its productivity lagged. They showed that, over the period 1948-68, the prices of consumer durables rose roughly 22 percent, while residential construction costs rose roughly 100 percent.

    Modular construction for single-family homes took off in the 1960s. Schmitz cites statistics that they "increased from roughly 100,000 units to 600,000 units" annually. "The share of factory production of single-family residential homes began growing in the mid 1950s, rising from about 10 percent of home production to nearly 60 percent of home production by the beginning of the 1970s (where total home production equals stick-built production plus factory production)."

    But the stick-built industry, assisted by local and federal regulators, pushed back: 

    While the sabotage of factory housing has been going on for 100 years, there was a dramatic surge in the ferocity of this sabotage in the middle 1970s. During this period, laws were passed, and regulations implemented, that sent the factory-built housing industry into a tailspin. These regulations, and additional harmful ones introduced since the 1970s, remain on the books and mean the industry is a shell of its former self. When this new sabotage was unleashed in the middle 1970s, the producers of factory homes were well aware of it, of course. They fought the HUD and NAHB monopolies to reverse the sabotage but lost the fight. Today the members of the factory-built housing industry are unaware of this history.

    As Schmitz documents, the pushback came in many forms, including regulations and subsidies. As one  example: Who knows how high the factory share would have risen if new sabotage of factory production would not have commenced in 1968. At that time, a national subsidy program was started

    for households buying stick-built homes (see below). Under these programs, households purchased 430,000 stick-built homes (per year) in the early 1970s." There have been court battles, and the "is it a trailer, is it a house" battle has been refought many times. For example, there is often a rule that a manufactured home must be built on a permanent and unremovable chassis--like a trailer--even though that's not what many customers would want. 

    For those with at taste for irony, there were also complaints from stick-built construction firms that manufactured housing was "unfair competition" because it could be built so much less expensively. Schmitz cites estimates from the US Census Bureau in 2007 that manufactured homes are one-third the price per square foot. One suspects that if manufactured housing was encouraged and allowed to flourish, the cost advantage from economies of scale would only increase. 

    The US economy is widely acknowledged to have a shortage of affordable housing. It has also for a century has monopolizing, competition-reducing forces that have favored more expensive stick-built housing and sabotaged the economic prospects of manufactured housing. As Schmitz points out, whatever defense one wishes to offer for these kinds of competition-restricting rules, the unavoidable fact is that the costs of the rule are carried by those of low and middle income levels, who would benefit most from lower prices. 

    For readers who are interested in antitrust discussions as they apply to the FAGA companies (Facebook, Amazon, Google, and Apple), here are a couple of earlier posts that offer a starting point. 

    A version of this article first appeared on Conversable Economist

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    Sabotaging the Competition: A Home Construction Example

    Timothy Taylor
  • 2
    object(stdClass)#14412 (59) {
      ["id"]=>
      string(4) "6145"
      ["title"]=>
      string(40) "Fiscal Federalism: An International View"
      ["alias"]=>
      string(39) "fiscal-federalism-an-international-view"
      ["introtext"]=>
      string(243) "

    What is the appropriate balance of taxes and spending between the central government of a country and the subcentral governments--in the US, state and local government?

    " ["fulltext"]=> string(10210) "

    Countries vary, and there's no one-size-fits-all mode. But Kass Forman, Sean Dougherty, and Hansjörg Blöchliger provide an overview of how countries differ and some standard tradeoffs to consider in "Synthesising Good Practices in Fiscal Federalism Key recommendations from 15 years of country surveys" (OECD Economic Policy Paper #28, April 2020).   

    Here are a couple of figures to give some background on the underlying issues. On this figure, the horizontal axis is the share of spending done by subcentral governments, while the vertical axis is the share of taxes collected by subcentral governments. Being on the 45-degree line line would mean that these were the same. However, every country falls below the 45-degree line, which means that for every country, some of the revenues spent by subcentral governments are collected by the central government. 

     

    Its interesting to note the different models of fiscal federalism that prevail in various countries. At the far right, Canada is clearly an outlier, with nearly 70% of all government spending happening at the subnational level, and half of all taxes collected at the subnational level. Other countries where about half or more of government spending happens at the subnational level include the US, Sweden, Switzerland (CHE) and Denmark. 

    Mexico is an interesting case where 40% of government spending happens at the subnational level, but tax revenues collected at that level are very low. Germany (DEU) and Israel are countries with a substantial level of subnational spending that is also nearly matched by the level of subnational taxes--and thus a relatively low redistribution of revenue from central to subcentral governments. Many countries huddled in the bottom left of the figure are low both subnational spending and subnational taxes. 

    Here's a figure showing the change in these patterns across countries from 1995-2017. 

     

    The crossing point of the horizontal and the vertical lines means relatively little change: for example, the US had a small rise in the share of spending happening at the subnational level and a small drop in the share of revenues raised at the subnational level. 

    Some countries with a big rise in the share of spending happening at the subnational level include Spain (ESP), Belgium, and Sweden. Some countries with a big rise in the share of subnational taxes collected include Spain, Belgium, and Italy. Clearly, Spain stands out as a country that has been decentralizing both government revenue and spending. Conversely, Denmark (DNK) stands out as a country that has been decentralizing government spending, but centralizing the collection of tax revenue. Hungary and Netherlands stand out as countries that have moved toward centralizing their spending, and Hungary in particular seems to be both increasing subnational taxes while decreasing subnational spending. 

    What are the key tradeoffs here?  Forman, Dougherty, and Blöchliger write (citations omitted): 

    Fiscal federalism refers to the distribution of taxation and spending powers across levels of government. Through decentralisation, governments can bring public services closer to households and firms, allowing better adaptation to local preferences. However, decentralisation can also make intergovernmental fiscal frameworks more complex and risk reinforcing interregional inequality unless properly designed. Accordingly, several important trade-offs emerge from the devolution of tax and spending powers. ... 

    For example:  

    [D]ecentralised fiscal frameworks allow for catering to local preferences and needs, while more centralised frameworks help reap the benefits of scale. Another key trade-off derives from the effect of decentralisation on the cost of information to different levels of government. While greater decentralisation implies that sub-national governments can access more information about the needs of a constituency at lower cost, it simultaneously increases the informational distance between central and sub-national government. In turn, this may make information more costly from the perspective of the central government, impeding its co-ordination and monitoring functions.

    Decentralisation could also engender a costly misalignment of incentives. For example, a “common pool” problem may arise when decentralisation narrows the sub-national revenue base and raises the vertical fiscal gap. In this case, the necessary reliance on revenue sharing with central government to ensure SCG [subcentral government] fiscal capacity may also distort the cost/benefit analysis of sub-national governments—particularly in situations where an SCG realises a payoff without bearing the entirety of the associated cost. Rigid arrangements that entrench fiscal dependence on the central government may drive SCGs to manipulate tax-sharing agreements in order to increase their share while undermining their motivation to cultivate the local tax base. Therefore, the possible efficiency and equity gains from decentralisation are closely linked to mitigating the pitfalls of poorly designed revenue sharing.

    What does this mean in practical terms? Their survey of the cross-country research has a number of intriguing findings: 

    OECD research has found a broadly positive relationship between revenue decentralisation and growth, with spending decentralisation demonstrating a weaker effect ...

    [D]ecentralisation appears to reduce the gap between high and middle-income households but may leave low incomes behind, especially where jurisdictions have large tax autonomy ...

    In healthcare, research suggests costs fall and life expectancy rises with moderate decentralisation, but the opposite effects hold once decentralisation becomes excessive (Dougherty et al., 2019[11]). With respect to educational attainment, Lastra-Anadón and Mukherjee (2019[27]) find that a 10 percentage point increase in the sub-national revenue share improves PISA scores by 6 percentage points ...

    Decentralisation has also been linked to greater public investment, with a 10% point increase in decentralisation (as measured by both SCG spending and revenue share of government total) “lifting the share of public investment in total government spending from around 3% to more than 4% on average”. The investment driven by decentralisation appears to accrue principally to soft infrastructure, that is human capital as measured by education.

    In the US version of fiscal federalism, states and local governments face constraints on their borrowing, while the federal government does not. In the case of disruptions from a national recession or pandemic, when a surge of government borrowing is needed, as in the case of a pandemic, it will thus be natural for subnational governments to turn to the US federal government for support. However, it's worth remembering that in more normal times, having state and local governments bear a substantial responsibility for their there own tax and sending levels can have real benefits for accountability and government services. 

    A version of this article first appeared on Conversable Economist.  

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    Fiscal Federalism: An International View

    Timothy Taylor
  • 3
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    Irwin Stelzer and Jeffrey Gedmin have a wide-ranging interview with Lawrence Summers in The American Interest (May 22, 2020, "How to Fix Globalization—for Detroit, Not Davos").

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    As always, Summers is his habitually and incorrigibly interesting and provocative self. Here re a few of many quotable remarks. 

    China

    In general, economic thinking has privileged efficiency over resilience, and it has been insufficiently concerned with the big downsides of efficiency. Going forward we will need more emphasis on “just in case” even at some cost in terms of “just in time.” More broadly our economic strategy will need to put less emphasis on short-term commercial advantage and pay more attention to long-run strategic advantage. ...

    At the broadest level, we need to craft a relationship with China from the principles of mutual respect and strategic reassurance, with rather less of the feigned affection that there has been in the past. We are not partners. We are not really friends. We are entities that find ourselves on the same small lifeboat in turbulent waters a long way from shore. We need to be pulling in unison if things are to work for either of us. If we can respect each other’s roles, respect our very substantial differences, confine our spheres of negotiation to those areas that are most important for cooperation, and represent the most fundamental interests of our societies, we can have a more successful co-evolution that we have had in recent years. ...

    Attitudes on Globalization

    Someone put it to me this way: First, we said that you are going to lose your job, but it was okay because when you got your new one, you were going to have higher wages thanks to lower prices because of international trade. Then we said that your company was going to move your job overseas, but it was really necessary because if we didn’t do that, then your company was going to be less competitive. Now we’re saying that we have to cut the taxes on those companies and cut the calculus class from your kid’s high school, because otherwise we won’t be able to attract companies to the United States, and you have to pay higher taxes and live with fewer services. At a certain point, people say, “This whole global thing doesn’t work for me,” and they have a point.

    So we need a global agenda that is about broad popular interests rather than about corporate freedom—that is, cooperation to assure that government purposes can be served and that global threats can be met. If we have an agenda like that, we can rebuild a constituency for global dialogue.

    Government Debt

    The deepest truth about debt is that you can’t evaluate borrowing without knowing what it’s going to be used for. Borrowing to invest in ways that earn a higher return than the cost of borrowing, and provide the wherewithal for debt service with an excess leftover, is generally a good and sustainable thing. Borrowing to finance consumption, leaving no return to cover debt service, is generally an unsustainable and problematic thing. ...

    I think we need to be very careful, with respect to the expectation that we now seem to be setting of having government cover all the losses associated with the COVID period. For the life of me, I cannot understand why grants should have been made to airlines to enable them to continue to function, rather than allowing their share values to be further depressed, and allowing those who would earn substantial premiums by taking risk on airline bonds to do so, accepting the consequences of an investment gone wrong.

    Looking towards an economy that is going to be very different than the one we had before COVID, we cannot aspire to maintain every job or every enterprise with a compensation program indefinitely. So as I look at the 30 percent of GDP deficit that we are running in Quarters Three and Four of Fiscal 2020, I don’t think that can be sustained over a multi-year period.

    Enforcing Existing Tax Laws for Those With High Incomes

    We could raise well over a trillion dollars over the next decade by simply enforcing the tax law that we have against people with high incomes. Natasha Sarin and I made this case and generated a revenue estimate some time ago. If we just restored the IRS to its previous size, judged relatively to the economy; if we moved past the massive injustice represented by the fact that you’re more likely to get audited if you receive the earned income tax credit (EITC) than if you earn $300,000 a year or more; if we made plausible use of information technology and the IRS got to where the credit card companies were 20 years ago, in terms of information technology-matching; and if we required of those who make shelter investments the kind of regular reporting that we require of cleaning women, we would raise, by my estimate, over a trillion dollars [over ten years]. Former IRS Commissioner Charles Rossotti, who knows more about it than I do, thinks the figure is closer to $2 trillion. That’s where we should start.

    Coronavirus Priorities

    The real crime is not that we miscalibrated on some economic versus public health trade-off. The real crime is that we have not succeeded in generating far greater quantities of testing, far greater mechanisms for those 40 million unemployed people to do contract tracing, far more availability of well-fitting, comfortable, and safe masks, and that we’re under-investing in the development of new therapeutics and vaccines.

    When something costs $10 to $15 billion a day, you need to make decisions in new ways. We should not be waiting to see which of two tests works best. We should be producing both of them. We should not wait for vaccines to be proven before we start producing them. We should be producing all the plausible candidates. Remember, one week earlier in moving through this is worth a hundred billion dollars: two months’ worth of the annual defense budget.

    A version of this article first appeared on Conversable Economist.

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    Interview with Larry Summers: China, Debt, Pandemic, and More

    Timothy Taylor
  • 4
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      string(348) "

    David A. Price interviews Joshua Angrist in Econ Focus (First Quarter 2020, Federal Reserve Bank of Richmond, pp. 18-22).

    " ["fulltext"]=> string(9408) "

    Angrist is well-known for his creativity and diligence in thinking about research design: that is, don't just start by looking at a bunch of correlations between variables, but instead think about what you might be able to infer about causality from looking at the data in a specific way. A substantial share of his recent research has focused on education policy, and that's the main focus of the interview as well.

    To get a sense of what "research design" means in this area,  consider some examples. Imagine that you want to know if a student does better from attending a public charter school. If the school is oversubscribed and holds a lottery (as often happens), then you can compare those attending the charter with those who applied but were not chosen in the lottery. Does being surrounded by high-quality peers help your education? You can look at students who were accepted to institutions like Harvard and MIT but chose not to attend, and compare them with the students that were accepted and did choose to attend. Of course, these kinds of comparisons have to be done with appropriate statistical consideration. But their results are much more plausibly interpreted as causal, not just as a set of correlations. Here are some comments from Angrist in the interview that caught my eye.

    Peer Effects in High School? 

    I think people are easily fooled by peer effects. Parag, Atila Abdulkadiroglu, and I call it "the elite illusion." We made that the title of a paper. I think it's a pervasive phenomenon. You look at the Boston Latin School, or if you live in Northern Virginia, there's Thomas Jefferson High School for Science and Technology. And in New York, you have Brooklyn Tech and Bronx Science and Stuyvesant.

    And so people say, "Look at those awesome children, look how well they did." Well, they wouldn't get into the selective school if they weren't awesome, but that's distinct from the question of whether there's a causal effect. When you actually drill down and do a credible comparison of students who are just above and just below the cutoff, you find out that elite performance is indeed illusory, an artifact of selection. The kids who go to those schools do well because they were already doing well when they got in, but there's no effect from exposure to higher-achieving peers.

    How Much Does Attending a Selective College Matter? 

    I teach undergrad and grad econometrics, and one of my favorite examples for teaching regression is a paper by Alan Krueger and Stacy Dale that looks at the effects of going to a more selective college. It turns out that if you got into MIT or Harvard, it actually doesn't matter where you go. Alan and Stacy showed that in two very clever, well-controlled studies. And Jack Mountjoy, in a paper with Brent Hickman, just replicated that for a much larger sample. There isn't any earnings advantage from going to a more selective school once you control for the selection bias. So there's also an elite illusion at the college level, which I think is more important to upper-income families, because they're desperate for their kids to go to the top schools. So desperate, in fact, that a few commit criminal fraud to get their kids into more selective schools.

    Charter Schools and Takeovers

    The most common charter model is what we call a startup — somebody decides they want to start a charter school and admits kids by lottery. But an alternative model is the takeover. Every state has an accountability system with standards that require schools to meet certain criteria. When they fail to meet these standards, they're at risk of intervention by the state. Some states, including Massachusetts, have an intervention that involves the public school essentially being taken over by an outside operator. Boston had takeovers. And New Orleans is actually an all-charter district now, but it moved to that as individual schools were being taken over by charter operators.

    That's good for research, because you can look at schools that are struggling just as much but are not taken over or are not yet taken over and use them as a counterfactual. The reason that's important is that people say kids who apply to the startups are self-selected and so they're sort of primed to gain from the charter treatment. But the way the takeover model works in Boston and New Orleans is that the outside operator inherits not only the building, but also the existing enrollment. So they can't cherry-pick applicants. What we show is that successful charter management organizations that run successful startups also succeed in takeover scenarios.

    Angrist has developed the knack of looking for these ways of interpreting a given data set, sometimes called "natural experiments." For those trying to find such examples as a basis for their own research, he says: 

    One thing I learned is that empiricists should work on stuff that's nearby. Then you can have some visibility into what's unique and try to get on to projects that other people can't do. This is particularly true for empiricists who are working outside the United States. There's a temptation to just mimic whatever the Americans and British are doing. I think a better strategy is to say, "Well, what's special and interesting about where I am?"

    Finally, as a bit of a side note, I was intrigued by Angrist's neutral-to-negative take on the potential for machine learning in econometrics:

    I just wrote a paper about machine learning applications in labor economics with my former student Brigham Frandsen. Machine learning is a good example of a kind of empiricism that's running way ahead of theory. We have a fairly negative take on it. We show that a lot of machine learning tools that are very popular now, both in economics and in the wider world of data science, don't translate well to econometric applications and that some of our stalwarts — regression and two-stage least squares — are better. But that's an area of ongoing research, and it's rapidly evolving. There are plenty of questions there. Some of them are theoretical, and I won't be answering those questions, but some are practical: whether there's any value added from this new toolkit. So far, I'm skeptical.

    Josh has written for the Journal of Economic Perspectives a few times. Interested readers might want to follow up with:

    A version of this article first appeared on Conversable Economist.

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    Interview with Joshua Angrist: Education Policy and Causality Questions

    Timothy Taylor
  • 5
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    The promise of freedom without responsibility is, in reality, slavery without escape. We think we do what we want when, in reality, we do what we are told.

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    There Is No Equality Without Economic Freedom

    An interventionist government’s promise of equality is the recipe for stagnation because governments can only equalize down. They can only make the rich poorer, never the poor richer, thus weakening everyone.

    Defending free will, individual initiative, and freedom does not mean that we disregard society. Society is a conscious, personal choice by which we bring together our individual needs and purposes, driven by personal initiative, and choose to invest in a way to improve our lives. This ultimately delivers better results for the vast majority.

    Society doesn’t strive to make people the same, requiring us to surrender our individual rights. Society is not created to make everyone equal, but to make each of us able to achieve our individual best.

    Society and free will are not enemies. Society and absolute power are.

    A version of this article first appeared here

     

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We think we do what we want when, in reality, we do what we are told." 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    There Is No Equality Without Economic Freedom

    Daniel Lacalle

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What to Expect from Central Bankers

Colin lloyd 06/04/2018 6

As financial markets adjust to a new, higher, level of volatility, it is worth considering what the Central Banks might be thinking longer term. Many commentators have been blaming geopolitical tensions for the recent fall in stocks, but the Central Banks, led by the Fed, have been signalling clearly for some while. The sudden change in the tempo of the stock market must have another root.

Whenever one considers the collective views of Central Banks it behoves one to consider the opinions of the Central Bankers bank, the BIS. In their Q4 review they discuss the paradox of a tightening Federal Reserve and the continued easing in US national financial conditions. BIS Quarterly Review – December 2017 - A paradoxical tightening?:

Overall, global financial conditions paradoxically eased despite the persistent, if cautious, Fed tightening. Term spreads flattened in the US Treasury market, while other asset markets in the United States and elsewhere were buoyant…

Chicago Fed’s National Financial Conditions Index (NFCI) trended down to a 24-year trough, in line with several other gauges of financial conditions.

The authors go on to observe that the environment is more reminiscent of the mid-2000’s than the tightening cycle of 1994. Writing in December they attribute the lack of market reaction to the improved communications policies of the Federal Reserve - and, for that matter, other Central Banks. These policies of gradualism and predictability may have contributed to, what the BIS perceive to be, a paradoxical easing of monetary conditions despite the reversals of official accommodation and concomitant rise in interest rates.

This time, however, there appears to be a difference in attitude of market participants, which might pose risks later in this cycle:

…while investors cut back on the margin debt supporting their equity positions in 1994, and stayed put in 2004, margin debt increased significantly over the last year.

At a global level it is worth remembering that whilst the Federal Reserve has ceased QE and now begun to shrink its balance sheet, elsewhere the expansion of Central Bank balance sheets continues with what might once have passed for gusto.

The BIS go on to assess stock market valuations, looking at P/E ratios, CAPE, dividend pay-outs and share buy-backs. By most of these measures stocks look expensive, however, not by all measures:

Stock market valuations looked far less frothy when compared with bond yields. Over the last 50 years, the real one- and 10-year Treasury yields have fluctuated around the dividend yield. Having fallen close to 1% prior to the dotcom bust, the dividend yield has been steadily increasing since then, currently fluctuating around 2%. Meanwhile, since the GFC, real Treasury yields have fallen to levels much lower than the dividend yield, and indeed have usually been negative. This comparison would suggest that US stock prices were not particularly expensive when compared with Treasuries.

The authors conclude by observing that EM sovereign bonds in local currency are above their long-term average yields. This might support the argument that those stock markets are less vulnerable to a correction – I would be wary of jumping this conclusion, global stocks market correlation may have declined somewhat over the last couple of years but when markets fall hard they fall in tandem: correlations tend towards 100%:


Source: BIS, BOML, EPFR, JP Morgan

The BIS’s final conclusion?

In spite of these considerations, bond investors remained sanguine. The MOVE* index suggested that US Treasury volatility was expected to be very low, while the flat swaption skew for the 10-year Treasury note denoted a low demand to hedge higher interest rate risks, even on the eve of the inception of the Fed’s balance sheet normalisation. That may leave investors ill-positioned to face unexpected increases in bond yields.

*MOVE = Merrill lynch Option Volatility Estimate

Had you read this on the day of publication you might have exited stocks before the January rally. As markets continue to vacillate wildly, there is still time to consider the implications.

Another BIS publication, from January, also caught my eye, it was the transcript of a speech by Claudio Borio’s - A blind spot in today’s macroeconomics? His opening remarks set the scene:

We have got so used to it that we hardly notice it. It is the idea that, for all intents and purposes, when making sense of first-order macroeconomic outcomes we can treat the economy as if its output were a single good produced by a single firm. To be sure, economists have worked hard to accommodate variety in goods and services at various levels of aggregation. Moreover, just to mention two, the distinctions between tradeables and non-tradeables or, in some intellectual strands, between consumption and investment goods have a long and distinguished history. But much of the academic and policy debate among macroeconomists hardly goes beyond that, if at all.

The presumption that, as a first approximation, macroeconomics can treat the economy as if it produced a single good through a single firm has important implications. It implies that aggregate demand shortfalls, economic fluctuations and the longer-term evolution of productivity can be properly understood without reference to intersectoral and intrasectoral developments. That is, it implies that whether an economy produces more of one good rather than another or, indeed, whether one firm is more efficient than another in producing the same good are matters that can be safely ignored when examining macroeconomic outcomes. In other words, issues concerned with resource misallocations do not shed much light on the macroeconomy.

Borio goes on to suggest that ignoring the link between resource misallocations and macroeconomic outcomes is a dangerous blind spot in marcoeconomic thinking. Having touched on the problem of zombie firms he talks of a possible link between interest rates, resource misallocations and productivity.

The speaker reveals two key findings from BIS research; firstly that credit booms tend to undermine productivity growth and second, that the subsequent impact of the labour reallocations that occur during a financial boom last for much longer if a banking crisis follows. Productivity stagnates following a credit cycle bust and it can be protracted:

Taking, say, a (synthetic) five-year credit boom and five postcrisis years together, the cumulative shortfall in productivity growth would amount to some 6 percentage points. Put differently, for the period 2008–13, we are talking about a loss of some 0.6 percentage points per year for the advanced economies that saw booms and crises. This is roughly equal to their actual average productivity growth during the same window.


Source: Borio et al, BIS

Borio’s conclusion is that different sectors of the economy expand and the contract with greater and lesser momentum, suggesting the need for more research in this area.

He then moves to investigate the interest rate productivity nexus, believing the theory that, over long enough periods, the real economy evolves independently of monetary policy and therefore that market interest rates converge to an equilibrium real interest rates, may be overly simplistic. Instead, Borio suggests that causality runs from interest rates to productivity; in other words, that interest rates during a cyclical boom may have pro-cyclical consequences for certain sectors, property in particular:

During the expansion phase, low interest rates, especially if persistent, are likely to increase the cycle’s amplitude and length. After all, one way in which monetary policy operates is precisely by boosting credit, asset prices and risk-taking. Indeed, there is plenty of evidence to this effect. Moreover, the impact of low interest rates is unlikely to be uniform across the economy. Sectors naturally differ in their interest rate sensitivity. And so do firms within a given sector, depending on their need for external funds and ability to tap markets. For instance, the firms’ age, size and collateral availability matter. To the extent that low interest rates boost financial booms and induce resource shifts into sectors such as construction or finance, they will also influence the evolution of productivity, especially if a banking crisis follows. Since financial cycles can be quite long – up to 16 to 20 years – and their impact on productivity growth quite persistent, thinking of changes in interest rates (monetary policy) as “neutral” is not helpful over relevant policy horizons.

During the financial contraction, persistently low interest rates can contribute to this outcome (Borio (2014)). To be absolutely clear: low rates following a financial bust are welcome and necessary to stabilise the economy and prevent a downward spiral between the financial system and output. This is what the crisis management phase is all about. The question concerns the possible collateral damage of persistently and unusually low rates thereafter, when the priority is to repair balance sheets in the crisis resolution phase. Granted, low rates lighten borrowers’ heavy debt burden, especially when that debt is at variable rates or can be refinanced at no cost. But they may also slow down the necessary balance sheet repair.

Finally, Borio returns to the impact on zombie companies, whose number has risen as interest rates have fallen. Not only are these companies reducing productivity and economic growth in their own right, they are draining resources from the more productive new economy. If interest rates were set by market forces, zombies would fail and investment would flow to those companies that were inherently more profitable. Inevitably the author qualifies this observation:

Now, the relationship could be purely coincidental. Possible factors, unrelated to interest rates as such, might help explain the observed relationship. One other possibility is reverse causality: weaker profitability, as productivity and economic activity decline in the aggregate, would tend to induce central banks to ease policy and reduce interest rates.


Source: Banerjee and Hoffmann, BIS

Among the conclusions reached by the Central Bankers bank, is that the full impact and repercussions of persistently low rates may not have been entirely anticipated. An admission that QE has been an experiment, the outcome of which remains unclear.

Conclusions and Investment Opportunities

These two articles give some indication of the thinking of Central Bankers globally. They suggest that the rise in bond yields and subsequent fall in equity markets was anticipated and will be tolerated, perhaps for longer than the market anticipate. It also suggests that Central Banks will attempt to use macro-prudential policies more extensively in future, to insure that speculative investment in the less productive areas of the economy do not crowd out investment in the more productive and productivity enhancing sectors. I see this policy shift taking the shape of credit controls and increases in capital requirements for certain forms of collateralised lending.

Whether notionally independent Central Banks will be able to achieve these aims in the face of pro-cyclical political pressure remains to be seen. A protracted period of readjustment is likely. A stock market crash will be met with liquidity and short term respite but the world’s leading Central Banks need to shrink their balance sheets and normalise interest rates. We have a long way to go. Well managed profitable companies, especially if they are not saddled with debt, will still provide opportunities, but stock indices may be on a sideways trajectory for several years while bond yields follow the direction of their respective Central Banks official rates.

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  • Gary Morris

    China has a high level of debt servicing ratio, which made its banking system more vulnerable. The country is one of the economies most at risk of a banking crisis.

  • Mackenzie Moore

    Today's U.S. government debt yields fell on after the monthly jobs report missed Wall Street expectations.

  • Chris Loft

    Concerns over a potential trade war between China and the U.S continue. Markets across the globe have been on a roller coaster ride during recent sessions.

  • Kumar Mohit

    Good analysis

  • Jade Steadman

    Billions of dollars currently held in short-term assets are expected to be repatriated to the US, and that money is likely to be spent in a variety of ways: to honor tax obligations.

  • Harry Midgley

    The future market volatility could provide attractive opportunities on the shorter end of the investment grade yield curve.