Author Archives: Mark

Post coronavirus policy with new normals: low interest rates and liquidity trap

I blogged yesterday regarding the shape of recovery after the coronavirus pandemic and have been reading Paul Krugman who suggests that conventional monetary policy can’t offset an economic shock like coronavirus.. Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap (see graph below) for 8 of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.

Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors

  • First, when the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
  • Second, if the investment is productive, it will expand the economy’s productive capacity in the long run. This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost.
  • Thirdly, there’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015). Again, by avoiding these effects a sustained fiscal stimulus would partially pay for itself. Put these things together and they probably outweigh any fiscal effect due to stimulus raising interest rates.

Can the Japanese experience tell us anything?

The policies proposed are similar to those by Japan in the 1990’s but the environment there was unique from what most other developed economies are experiencing. Krugman makes two points:

  1. Japan allowed itself to slide into deflation, and has yet to convincingly exit.
  2. Japan’s potential growth is low due to extraordinarily unfavourable demography, with the working-age population rapidly declining.

As a result, Japan’s nominal GDP has barely increased over time, with an annual growth rate of only 0.4% since 1995. Meanwhile, interest rates have been constrained on the downside by the zero lower bound. Even with this Japan still faces no hint of debt crisis.
Therefore according to Krugman, with negative shocks to economies becoming more prevalent it maybe better to implement a productive stimulus plan instead of trying to come up with some short-term measures every time there are shocks to our economy.

Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro

What kind of recovery after coronavirus – L U V W

Like after the GFC in 2008 can China kick start the world economy? The FT’s global China editor James Kynge explains why China’s indebtedness means it is probably both unwilling and unable to launch a stimulus package like that of 2009. A lot depends on how quickly their own economy can bounce back and if it is a L U V W shaped recovery. Also can it act as a locomotive for the rest of the world. The video below contains some excellent graphs concerning China’s debt problem.

Although from 2011 the video below from the PBS Newshour shows reporter Paul Solman and Simon Johnson – former IMF economist and now at MIT. Johnson explains the different types of recoveries – L U V W shapes.

Covid-19 – The economic recession is a public health measure

No doubt you will have heard in most government press conferences the aim of flattening the curve. In trying to flatten the epidemic (epi) curve there will be a trade-off with reduced economic activity. By having a lockdown you reduce the exposure of people to the virus but it also means less employment and consumption.

The graph above shows the following:

  • steep red curve shows – (medical outcome) without some sort of lockdown
  • latter blue curve – impact on cases of the virus with a lockdown
  • flatter red curve shows – the impact on economic activity if there was no lockdown
  • steep blue curve shows – impact on economic activity if there was a lockdown

Therefore if you flatten the infections curve you steepen the recession curve.

This unavoidable trade-off is surely behind some leaders delaying containment policies – not wanting to experience a severe recession especially in US as it is election year. It seems that if you don’t act to contain early you pay for it later

These desperate times call for desperate measures – a version of shock therapy. Society has a pressing need for a massive increase in government spending but what we don’t want to happen is a COVID-19 recession gradually turning into a COVID public debt crisis.

Source: Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes. Edited by Richard Baldwin and Beatrice Weder di Mauro

Covid-19 and Global Debt

Below is an informative video by CNBC which covers the history of debt waves and brings us up to date with regard to government spending and Covid-19. The have been 3 previous debt waves since the 1970’s

  1. 1970s and 1980s, with borrowing by governments in Latin America and in low-income countries in sub-Saharan Africa. This wave saw a series of financial crises in the early 1980s. 
  2. Ran from 1990 until the early 2000s as banks and corporations in East Asia and the Pacific and governments in Europe and Central Asia borrowed heavily, and ended with a series of crises in these regions in 1997-2001. 
  3. Private sector borrowing in Europe and Central Asia, which ended when the global financial crisis disrupted bank financing in 2007-09 and tipped several economies into sharp recessions.

Today
The latest wave of debt accumulation began in 2010 and has already seen the largest, fastest, and most broad-based increase in debt. Add in Covid-19 and these are very worrying times for government budgets. Global debt has topped $US250 trillion, or 322% of global GDP – a record level. But more debt has been used to acquire expensive assets, rather than on developing productive capacity with capital investment. Lower interest rates, have also made it possible to borrow more, leading to more debt and less equity being deployed to buy these assets. Furtermore Covid-19 will only increase this debt by a significant amount.

Covid-19 hits oil prices hard

With the demand for oil dropping over covid-19 and the over supply in the market, oil prices have collapsed. Brent crude fell by more than half in March to below $23 per barrel. For many years OPEC – Organisation of the Petroleum Exporting Countries – has manipulated supply to maintain higher prices. Since 2017 both Saudi Arabia and Russia have been working together to prop up oil prices but have had a falling out over Saudi Arabia’s insistence on cutting oil supplies by 1.5 million barrels per day.

The Economist – 26th March 2020

Cost of extraction v Price of a barrel

Like any business you need to consider costs relative to the price of your good or service. Some shale oil wells in the US may have a break-even point of $40 a barrel despite the high fracking costs. However some sources say that it is above $60 a barrel with the higher-cost wells coming in at over $90 a barrel. These industries cannot survive in this environment of such low oil prices. Also the Canadian tar sands are another costly method of extracting oil and this could lead to a shut down of production.

By contrast in Saudi Arabia the extraction cost is around $9/barrel with Russia coming slightly higher at $15/barrel. The Middle East and North Africa are also very efficient, producing oil as cheaply as $20 per barrel. Worldwide, conventional oil production typically costs between $30 to $40 a barrel.

Nevertheless countries like Venezuela and Nigeria depend hugely on oil revenue for their spending. Although Russia and Saudi Arabia have significant foreign reserves the more the virus persists and demand keeps falling the greater the damage. Useful video from Al Jazeera below.

Game Theory and why we go to a coronavirus lockdown

Michael Cameron posted a nice piece on his blog about this – Sex, Drugs and Economics.

Game theory refers to the decision that a firm/individual makes depends on its assumptions about other firms/individuals. Ultimately this means that individuals will try and calculate the best course of action depending on how others behave. When we were in a Level 2 situation the advise was no mass gatherings, physical distance on public transport, limit non-essential travel etc. Although the announcements of the four levels were made clear on the Saturday it was inevitable that we would be moving to Level 4 very quickly – Wednesday. Being able to police Level 2 would have been near impossible and the risk of community transmission meant that complete lockdown was needed.

In a Level 2 situation, which was somewhat voluntary, people had two choices – Stay home (cooperate) or Act Normally (defect). The table below looks at the payoffs if you don’t lockdown early and already have community transmission.

As Cameron points out: For most people, acting normally is a dominant strategy, at least in the early stages of the coronavirus spreading. They are better off acting normally if everyone else stays home (because they mostly get to go on with their lives as normal, and have low risk of catching the coronavirus; whereas staying home they would be giving up on things they like to do), and they are better off acting normally if everyone else is acting normally (because life goes on as normal, rather than giving up on things they like to do). So, individually people are better off acting normally.

Any voluntary measure is subject to the prisoners’ dilemma which is why we went to an early full lockdown. As we are in lockdown repeated games requires trust and the correct behaviour outlined by the government – this is essential to eliminate the virus. Therefore the dominant strategy of ‘Act Normally’ is no longer an option. Cameron quoted Robert Frank whom I have blogged on here

‘smart for one, dumb for all’.

Stay safe everyone

Market Economy – Mindmap

In lockdown here in NZ but still teaching classes online. Looked at types of economies over the last few days and put together this mindmap. I found it useful to talk through different parts of the mindmap on the computer screen – using Cisco Webex for the online learning.

Adapted from – CIE Economics Revision Guide by Susan Grant

RBNZ announce QE

Below is a link to a very good interview with RBNZ Governor Adrian Orr on Radio NZ ‘Morning Report’ programme. Loads of good material on monetary policy – useful for discussion purposes with my A2 class today – online.

Radio New Zealand – Adrian Orr interview

The Monetary Policy Committee decided to implement a Large Scale Asset Purchase programme (LSAP) of New Zealand government bonds. The programme will purchase $30 billion of New Zealand government bonds, across a range of maturities, in the secondary market over the next 12 months. The programme aims to provide further support to the economy, build confidence, and keep interest rates on government bonds low. The low OCR – 0.25%, lower long-term interest rates, and the fiscal stimulus recently announced together provide considerable support to the economy through this challenging period.