Category Archives: Economic Cycle

V U Z W L recoveries and the inverted square root

Usually we talk about U V W or L recoveries but with the impact of Covid-19 there has been much mention of an inverted square root (as mentioned by George Soros in video below) in some countries as an economy tries to gain some semblance of pre-covid normality. Below is an image from the Wall Street Journal that describes each of the following recoveries: – V U Swoosh Z W L.

Probably the inverted square root sign illustrates the most likely scenario today, with some recovery of the lost GDP but not a return to the previous trajectory. This represents a surge in demand after the relaxing of restrictions but it doesn’t last and starts to plateau after a period of time. For a lot of countries a second wave of Covid-19 has meant a return to lockdown and a further dampening of demand with the economy unable to compensate for people in bars / restaurants / sports events etc. Furthermore the fear of physical proximity will keep the recovery of services subdued.

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. Note George Soros and the inverted square root sign.

The Ancient Art of Economic Forecasting – 2019 Coronavirus?

I came across this piece from a colleague on economic forecasting. The article below appeared in the Sydney Metropolitan Press in the late 1920’s. Although economic cycles don’t run to an exact time period the graph below would indicate that this model is not too far out of kilter.

  • The top line = years in which panics have occurred and will happen again
  • The middle line = years of good times, high prices and the time to sell stocks
  • The bottom line = years of hard times, low prices and good times to buy stocks

The past panic century of dates are 1911, 1927, 1945, 1965, 1981, 1999, 2019. Except for 1981, these were all pretty good years to sell stocks – The Big Picture blog. 2016 suggests the top of the present cycle with 2019 being a year of panic.

“The Ancient Art of Economic Forecasting” – Sydney Metropolitan Press 1920’s

The graph below professes to forecast the future trend of Australian business conditions, was first brought under the notice of the public in 1872. It was prepared by a Mr Tritch, whose origin and activities are shrouded in mystery.

  • The top line shows years in which panics have occurred, and will occur again. Their cycles are 16, 18 and 20 years.
  • The centre line shows the years of good times and high prices; the cycles are 8, 9 and 10 years.
  • The bottom line shows the years of depressions and low prices; the cycles are 9, 7 and 11 years.

The panic which occurred in 1893 is shown in 1891. Nevertheless, that year witnessed the beginning of the depression. 1915, just after the war started was a year of depreciation, and 1919, the year following the cessation of hostilities, was a period charcterised by good times.

As this chart was published in 1872, it is interesting to note the forecast of the panic in 2019 – coronavirus? It will be seen that there has been a general upward trend since 1926 with the panic occurring in 1927 after the high is reached. The bottom of the depression is reached at the end of 1930 and the upward trend begins in 1931.”

Japanification – how to cope with low interest rates.

Economists use the term Japanification as shorthand for the situation where economic growth remains stagnant even with significant monetary easing – lower interest rates and increased government spending. With interest rates already at record low levels it seems that a lot of economies are going the same way as Japan. However as discussed in the video below from the FT, Japan is a nice place to live and has a very high life expectancy. The concern for central banks is what other policy instruments do they have after really low interest rates – they are running out of ammunition. To boost growth in the USA is a lot different than in Japan according to Ben Friedman. He states that Japan does not have the problems of widening inequality and the stagnation of the middle income groups.

The question is why Japanese society seems to cope with an economy that doesn’t respond to very low interest rates and increase government spending? The FT look to Robert Pringle’s book ‘The Power of Money’ and suggest three reasons:

  • Long established business – 5500-odd companies that are 200+ years old, more than 3,000 are Japanese. They are much more resilient to change and have less of a focus on short-term profits but too service, patience and a disdain for pecuniary motives.
  • Immaterialism – unlike a lot of western countries (US in particular) money in Japan is less significant in showing success. Therefore there is less social conflict.
  • Japanese version of capitalism – US = individualism and democracy. Japan = individual is part of a group and discourage competition = a stable society.

Source: How Japan has coped with Japanification

UK Economy – Goldilocks and the output gap

Chris Giles of The FT wrote a very good article explaining the output gap using Goldilocks and the three bears. As you may know in the story Goldilocks found the first bowl of porridge too hot, the second bowl too cold but the third bowl just right. We can use this analogy with regard to the economy:

  • running too hot – a positive output gap – the economy is overheating and higher interest rates and less government spending is needed to slow the economy down.
  • running too cold – a negative output gap – the economy has a lot of spare capacity and needs to be stimulated by dropping interest rates and increasing government spending.
  • running just right – no gap – there is neither a requirement for an expansionary monetary and fiscal policy nor a contractionary monetary and fiscal policy.

Just as Messrs Friedman and Phelps had predicted, the level of inflation associated with a given level of unemployment rose through the 1970s, and policymakers had to abandon the Phillips curve. Today there is a broad consensus that monetary policy should focus on holding down inflation. But this does not mean, as is often claimed, that central banks are “inflation nutters”, cruelly indifferent towards unemployment.

If there is no long-term trade-off, low inflation does not permanently choke growth. Moreover, by keeping inflation low and stable, a central bank, in effect, stabilises output and jobs. In the graph below the straight line represents the growth in output that the economy can sustain over the long run; the wavy line represents actual output. When the economy is producing below potential (ie, unemployment is above the NAIRU), at point A, inflation will fall until the “output gap” is eliminated. When output is above potential, at point B, inflation will rise for as long as demand is above capacity. If inflation is falling (point A), then a central bank will cut interest rates, helping to boost growth in output and jobs; when inflation is rising (point B), it will raise interest rates, dampening down growth. Thus if monetary policy focuses on keeping inflation low and stable, it will automatically help to stabilise employment and growth.

Gapology

 

However policymakers rely on estimates of the output gap – which compares actual GDP with a country’s full capacity when all resources are fully employed. The concern that the Bank of England have is that official data shows that the UK economy is showing sluggish growth rates with a tight labour market.

Almost all employment indicators suggest the economy close to overheating – recruitment difficulties and industry facing capacity constraints. This is in contrast to economic growth which suggest that there is room for expansion. Add to this the uncertainty about Brexit, the reliability of the output gap even more dubious. Current techniques might correctly measure the output gap but what about the contribution of potential capital projects which are underway?

Some economists have suggested that output gaps are inherently political and chosen to rationalise existing policies, rather than to set the correct prescriptions. However for economists is there an alternative to taking the temperature of an economy.

Economic Consequences of Trump

Very good video from Project Syndicate looking at the recovery of the US economy and if it is sustainable. Also was Trump responsible for the growth or Obama? Maybe Janet Yellen and central bankers with such low interest rates for a long period of time. However if there is another downturn do governments have the tools to grow the economy again? It seems that central banks have run out of ammunition i.e. no room to cut interest rates further. There is agreement that the levels of employment are not sustainable in the future and the focus should be on assisting low wage work and help people prepare for and keep work- ‘reward work’.

  • Features Nobel laureates Angus Deaton and Edmund Phelps, along with Barry Eichengreen,
  • Rana Foroohar author of ‘Makers and Takers’
  • Glenn Hubbard Dean of Columbia Business School

Central Banks could cause next financial crisis

A Buttonwood piece in the Economist (30th September 2017) looked at how central banks can trigger the next financial crisis. Deutsche Bank have looked into long-term asset returns in developed markets and suggest that crises have become much more common. They define a crisis when a country suffered one of the following:

  • a 15% annual decline in equities;
  • a 10% fall in its currency or its government bonds;
  • a default on its national debt; or
  • a period of double-digit inflation.

Pre the Bretton Woods system of fixed exchange rates and a central bank’s limited ability to create credit, very few countries suffered a shock in a single year. But since 1980 there have been numerous financial crisis of some kind. Under the Bretton Woods system a country that expanded its money supply too quickly would encourage an increased demand for imports which would ultimately lead to a trade deficit and pressure on its exchange rate; the government would react by slamming on the monetary brakes. The result was that it was harder for financial bubbles to inflate.

But with a floating exchange rate a country has more flexibility to deal with economic crisis as they don not have to maintain a currency that is pegged to another. A weaker currency makes exports more competitive and imports more expensive. But it has also created a trend towards greater trade imbalances, which no longer constrain policymakers—the currency is often allowed to take the strain. See flow chart below.

As well as companies and consumers taking on debt, government debt has also been rising as a proportion of GDP since the mid-1970’s:

  • Japan – a deficit every year since 1966
  • France – a deficit every year since 1993
  • Italy – only one year of surplus since 1950

This has resulted in significant credit expansion and collapse – by allowing consumers to borrow more money the cost of assets (esp. houses) is pushed higher. However when lenders lose confidence in borrowers ability to repay they stop lending and mortgage sales follow. This is then reflected in the credit rating of borrowers. In order to try and rectify the problem the central banks intervene and reduce interest rates or buy assets directly. This may bring the crisis to a temporary halt but results in more debt and higher asset prices.

Deutsche Bank suggest that could mean another financial crisis especially if there is the withdrawal of support from central banks who saved the global economy when the GFC started. Indicators suggest that this may be the case:

  • US Fed – has pushed up interest rates and cut back on asset purchases
  • ECB – likely to cut asset purchases next year
  • Bank of England – has recently pushed up interest rates

However rates are still at a stimulatory level and developed economies have been growing for several years. According to Deutsche Bank any kind of return to “normal” asset prices from their high levels would constitute a crisis. This would then force central banks to once again lower interest rates again but they will not want to appear to be the ambulance at the bottom of the cliff every time this happens. Remember the bailouts of AIG and the investment banks. It seems that the investment banks are happy to privatize the reward but socialise the risk – when it all “turns to custard” they need to be bailed because they are too big to fail. The question that people are now asking is what is the vulnerable asset class? Mortgage-backed securities was the cause in 2008.

IMF World Evaluation from the FT

Below is a very good video put together by the FT which summarises the recent IMF Report on the World Economy. Includes:

  • Better growth in China and the Euro zone makes up for slow US growth.
  • US infrastructure spending and tax reform still has to be approved by the senate.
  • Europe looking stronger than expected.
  • Emerging economies still face tough conditions.

Housing bubble and zero sum game

There has been a lot of talk in the media about an Auckland housing bubble and its impact on the New Zealand economy.  Below is a very informative graph I got from http://www.housepricecrash.co.uk which looks at the anatomy of a bubble.

Anatomy of bubble

Zero-Sum Game

When house prices are increasing rapidly we tend to feel better off but also have increased mortgage debt. House price inflation is a zero-sum game in that society as a whole does not benefit from a rise in house prices as those on the property ladder can only gain at the expense of prospective homeowners that cannot afford to enter the market. Over a short period of time house price inflation can provide a boost to economic growth if they deceive people into believing they are wealthier.

Positive-Sum Game

However, when a business invests it tends to have a positive-sum game in that if it employs 50 more workers that doesn’t mean that there are 50 other workers in the economy that are going to lose their jobs. This is real GDP growth rather than investing in property which tends not to generate growth as it is a finished asset – however some will argue that maintenance will always be needed.

Macro Conflicts in New Zealand

Part of the Cambridge A2 syllabus studies Macro Economic conflicts of Policy Objectives. Here I am looking at GDP, Unemployment, and Inflation (improving Trade figures is another objective also). The objectives are:

* Stable low inflation with prices rising within the target range of 1% – 3% per year
* Sustainable growth – as measured by the rate of growth of real gross domestic product
* Low unemployment – the government wants to achieve full-employment

New Zealand Growth, Jobs and Prices — 3 Key Macro Objectives Inflation, jobs and growth

1. Inflation and unemployment:

From the graph above you can see that low levels of unemployment have created higher prices – demand-pull inflation. Also note that as unemployment has increased there is a short-term trade-off between unemployment and inflation. Notice the increase in inflation in 2010-2011 as this is when the rate of GST was increased from 12.5% to 15%. Also today we have falling inflation (0.4% below the 1-3% band set by the RBNZ) and unemployment is on the rise – approximately 6%

NZ Economy 2006-2015

2. Economic growth and inflation

With increasing growth levels prices started to increase in 2007 going above the 3% threshold in 2008. This suggests that there were capacity issues in the economy and the aggregate supply curve was becoming very inelastic. In subsequent years the level of growth has dropped and with it the inflation rate.

3. Economic Growth and Unemployment

With increasing levels of GDP growth unemployment figures have tended to gravitate downward. This was apparent between 2006-2008 – GDP was positive and unemployment did fall to approximately 3.6%. From 2009 onwards you can see that growth has been positive with unemployment falling. 2015 saw the unemployment rate rising with lower annual growth rate.