Friday, June 24, 2016

Brexit: the Biggest Global Monetary Shock Since 2008

Scott Sumner is right. Brexit is the biggest global monetary shock since 2008. This could be the tipping point that turns the existing global slowdown of 2016 into a global recession. Here is why.

First, Brexit is adding further strength to an already overvalued dollar. The trade weighted dollar had appreciated roughly 25 percent between mid-2015 and early-2016. That is a very sharp increase in so short a time. It has come down some, but not much as seen in the figure below (red line):



The figure also shows that this sudden increase in the dollar is closely tied to the policy divergence between the Fed and the ECB (blue line). That is, as the Fed began talking up interest rate hikes in mid-2014 the ECB was talking up the easing of monetary policy. The rise in the blue line shows this policy divergence1

Brexit is now adding fuel to this dollar fire. The dollar has appreciated almost 4 percent since the Brexit fate became clear last evening, as seen in the figure below.


Why does a strengthening dollar matter? There are two reasons. First, over 40 percent of the world economy ties its currency to the dollar in some form. This can be seen in the figure below. That means when the dollar strengthens, these currencies strengthen too. This is the curse of the so called 'dollar block' countries--they import their monetary policy from abroad. Via this channel, Brexit has just further tightened monetary conditions in all these countries. This added pressure makes it likely China will be forced to devalue soon. And we saw how well that went last time it was tried.


The second reason the rising dollar matters is the rapid growth of what the BIS calls the 'parallel dollar system'. This is a system of dollar loans and dollar debt securities that has emerged outside the United States. This dollar credit to and from non-U.S. residents has tripled since 2000, while non-resident Euro and Yen financing has remained relatively stable. In fact, the dollar's share of this non-resident credit growth has increased from 62% to 75% according to BIS data. This means there is a lot of dollar-denominated debt outside the United States that is very vulnerable to dollar shocks. Brexit just increased the real debt burden of these borrowers. 


So between tightening monetary conditions for the  dollar bloc countries and increasing real debt burdens for all the non-resident issuers of dollar debt, the global economy has been hit with a large dollar shock. Put more crudely, the strong dollar noose that has been choking emerging economies since mid-2014 has now been complemented by the opening of  trap door on the gallows via Brexit. This makes the strangulation of global economy complete. 

A second reason Brexit might be pushing the global economy into a global recession is that it hastening the the frantic race to bottom on safe yields. As I noted in a recent post, yields on safe assets around the world have been going down since the demand for safe assets remain unmet. Given global capital markets this also means there is a race to the bottom on safe yields as noted by Caballero, Fahri, and Gourinchas (2016) :
In the open economy, the scarcity of safe assets spreads from one country to the other via the capital account. Net safe asset producers export these assets to net safe asset absorbers until interest rates are equalized across countries. As the global scarcity of safe assets intensifies, interest rates drop and capital flows increase to restore equilibrium in global and local safe asset markets. Once the ZLB is reached, output becomes the adjustment variable again. 
Brexit massively intensified this race to the bottom as seen in the the 10-year yield below. Incredibly, the yield fell from 1.74 to 1.43 this evening! Brexit, in other words, just jolted the demand for safe, liquid assets in a major way. 


This frantic race to the bottom of safe yields will eventually run up against the effective lower bound (ELB). When that happens something else will have to adjust. And that something is output, as noted by Caballero, Fahri, and Gourinchas (2016)

So there you have it. The world has been hit with a massive global monetary shock. And via dollar bloc countries, the parallel dollar system, and the shortage of safe asset problem this monetary shock may be what pushes an already slowing global economy into a global recession.

Will central bankers and finance ministries be ready for it? I hope so.

Update: For some soul searching on the why of Brexit, see my previous post.

1The blue line shows the spread between the 1-year US treasury rate and the 1-year Euro rate. Based on the expectation hypothesis, the 1-year interest rate approximately equals the expected average of short-term interest rates over the same horizon. Consequently, if 1-year rates are going up it implies short-term rates are expected to rise on average over the next year. The spread between the treasury and euro rates, then, reveals the expected divergence between the expected path of policy interest rates over the next year. 

Wednesday, June 22, 2016

Brexit, Euroskepticism, and ECB Policy

The Brexit vote is upon us and most polls show a race that is too close to call. Much ink has been spilled debating this historic vote as well as trying to explain why it emerged in the first place. Most of the analysis on the latter point has been good, but I do think there is something that has been missing in these discussions. And that is the role the ECB's monetary policy played in helping bring about this referendum on Great Britain's future in the European Union (EU).
  
Most discussions on the causes of the Brexit vote point to concerns over immigration, burdensome EU regulations, and a general desire for more British sovereignty. These issues are important and confirmed by polling, but I see them as a proximate cause rather than the ultimate reason for the Brexit referendum. For, as The Economist notes, the UK has always been a "semi-detached member of the EU" and never has fully bought into it. This tendency was seen way back in the 1950s when the UK was reluctant to negotiate with the precursor to the EU. It was also evident in its decision to hold onto its own currency when the Euro was introduced in 1999. 

So why has this natural British skepticism toward the EU only now risen to the point of a Brexit vote? I submit that this timing is the consequence of the tragic policy mistakes by the ECB that culminated in the Eurozone crisis. Recall that the ECB signaled and followed through with monetary policy tightening in 2008 and 2011. As I show in a new working paper, it was this tightening by the ECB that sparked the sovereign debt crisis, strained inter-European creditor-debtor relationships, and gave teeth to fiscal austerity. Had the ECB instead eased in 2008 and 2011 and began QE sooner, the Eurozone recession would have been much milder and the recovery more brisk. 

Instead, the weight of the Eurozone crisis made what would have been minor irritations over immigration and regulations into something far more painful. Just like a healthy person can easily handle a minor cut or a cold, a healthy economy in Europe could have more easily handled the challenges of immigration and regulations.  

There is evidence supporting this view. The Pew Research Center conducted a multi-nation survey this month on how Europeans view the EU. Below is a chart from this report that summarizes what they found: increasing skepticism towards EU from most countries surveyed. The rise in this EU skepticism coincides with the Eurozone crisis.


While the above chart maps the overall favorability scores of the EU, another question in the survey (50a) more narrowly asks whether the respondents approved or disapproved of the EU's handling of economic issues. In the figure below I plotted the disapproval rate for each country found in this question against their output gap (as measured by the OECD). 


Since the output gap is economic slack induced by the business cycle, the clear implication is that better macroeconomic policy would lead to a more favorable view of the EU. And, again, the biggest failure of macroeconomic policy has been the ECB's policy mistakes in 2008 and 2011 for which the Eurozone is still suffering today. 

So the Brexit vote can, in part, be laid at the feet of ECB policy makers in 2008 and 2011. These mistakes led to the Eurozone crisis which greatly accelerated the distrust of the EU and intensified concerns over immigration. Add this to the existing British skepticism toward the EU and the Brexit vote becomes a reality.

Now one could argue that these ECB's policy mistakes were the inevitable outcome of a poorly-designed currency union. The Eurozone was never an optimal currency area and therefore a one-size-fits all monetary policy applied to very different economies in Europe was going to end badly at some point in time. Maybe so, but as I argue in my working paper the ECB's mistakes of 2008 and 2011 were not inevitable. They were the result of the ECB overreacting to temporary inflation surges that should have been ignored. Until we better appreciate the ECB's errors of that time, we have failed to learn from the mistakes of the past.

Update: Now the Brexit is a reality, let me share my immediate concern with it: the further strengthening of the dollar. The global economy is already weighed down by the rise of the dollar that started in mid-2014. This is because (1) a sizable share of the global economy has their currency tied in some form to the dollar and (2) there has been a surge in dollar debt outside the United States.  As I said on twitter, the strong dollar noose that is choking emerging economies has now had the trap door released via Brexit to make the strangulation of global economy complete. Strap yourself in for a very bumpy ride.

Related Links

Monday, June 20, 2016

Macro Musings Podcast: Robert Hetzel


My latest Macro Musing podcast is with Bob Hetzel. Bob is a senior economist and research advisor at the Richmond Federal Reserve Bank where he has worked since 1975. He joined me to discuss the rise of monetarism and how Milton Friedman, his dissertation advisor, shaped his thinking on macroeconomics. Monetarism challenged the conventional Keynesian consensus in the 1970s and caused Keynesians to reformulate their views into a new doctrine called, “New Keynesianism.” However, in the wake of the Great Recession, “Old Keynesianism” has made a comeback and Bob shares his thoughts on it.

Bob also holds that the standard explanations of the Great Recession--household deleveraging and  the financial crisis--are lacking. He has argued in a published paper and in a book that poor Fed policy in 2008 turned what would have been an ordinary recession into the Great Recession. That is a remarkable view for a Fed economist! We discuss this view of the Great Recession.

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player. And remember to subscribe since more guest are coming!


Related Links
Robert Hetzel's web page at the Richmond Fed


Wednesday, June 15, 2016

Global Safe Yields Continue Their Downward March

So yields on Germany's 10-year government bonds have gone negative. Put differently, investors are now paying the German government to take and hold their funds for ten years!  Many are blaming this development on Brexit fears and the ECB's bond buying program. While this is a reasonable proximate explanation, the recent decline is part of a far bigger story: interest rates on safe assets across the world have been declining since 2008. This can be seen in the figure below.


This downward march of safe yields is a consequence of the safe asset shortage problem. What we are seeing in Germany is just the latest manifestation of it. What the above figure should make clear is that this safe asset shortage problem has been going on outside of QE programs and before central banks started doing negative interest rates. So don't blame central banks for the low interest rates.1

This downward march of safe yields across the globe is a big deal. It indicates the global economy needs more safe assets and lower interest rates to clear. However, at some point, the effective lower bound (ELB) will kick in and prevent rates from going lower. When that happens something else will have to adjust--output--and there will be a global race to the ELB. Here is Caballero, Fahri, and Gourinchas (2016) making this point:
In the open economy, the scarcity of safe assets spreads from one country to the other via the capital account. Net safe asset producers export these assets to net safe asset absorbers until interest rates are equalized across countries. As the global scarcity of safe assets intensifies, interest rates drop and capital flows increase to restore equilibrium in global and local safe asset markets. Once the ZLB is reached, output becomes the adjustment variable again. 
In other words, be ready for more! If you think pension funds, banks, insurance companies are scrambling for yield now, you ain't seen nothing yet! More importantly, the Cabellero, Fahri, and Gourinchas analysis suggest a global growth slowdown is likely too. 

So what are the solutions to the safe asset shortage problem? I will refer you again to the figure I used in my last safe asset post for the answers. My preferred solution is to try the 'shock and awe' approach to improve the economic outlook via a NGDP level target backstopped by Treasury. 


Related Link:
US as a Banker to the World

1Though one can blame central banks for allowing us to get in this position in the first place. As I have argued elsewhere, the Fed and ECB could have done more to avoid the Great Recession. The did not and now the safe asset problem horse is out of the barn.

Tuesday, June 14, 2016

Recession Watch and the Global Reach of Fed Policy

It is 'recession watch' time again. The May jobs report seems to have awakened the dormant recession concerns that emerged earlier in the year. See, for example, Josh Zumbrun, Jeff Spros, Edward Harrison, and Sam Ro. I was one of those observers who was concerned about a recession in early 2016. But unlike some, I never stopped worrying about it for one big reason: the global reach of Fed policy. It's tightening cycle, which began in mid-2014, has been  putting a choke hold on the global economy and this, in turn, has been straining the U.S. economy. This is something the FOMC should keep in mind as it meets this week.

Here is how this has unfolded. First, the Fed began talking up interest rate hikes in earnest in mid-2014. We know this from the 1-year ahead fed fund future rate, which start rising in June 2014. One can also see this by looking to the 1-year treasury yield, which provides as an approximate guide to where interest rates are expected, on average, to go over the next year.1 The blue line in the figure below shows the 1-year treasury yield. Here we see it start to rise in 2014 about the same time the 1-year Euro yield--the red line--begins to fall. In other words, just as the Fed began raising the expected path of interest rates the ECB began doing the opposite. This policy divergence has persisted until this day as seen below:


This policy divergence, unsurprisingly, drove up the trade-weighted dollar with it as seen in the next figure:


The trade-weighted dollar appreciated over 20% between mid-2014 and December 2015. This sharp appreciation of the dollar also meant those countries in the dollar block saw their currencies rise rapidly too. The most important of these countries is China. Its trade-weighted currency closely followed the dollar as seen blow:


As I have noted  before, this appreciation of the RMB seems to have been the straw the broke the camel's back in China. The Chinese economy was already slowing down and was laden with the burden of its rapid debt growth since 2008. The Fed's talking of up of interest rates hikes could not have come at a worse time for China. Among other things, it appears to be the key reason for the capital outflow from China during this time.

So the Fed's talking up interest rate hikes put a stranglehold on the dollar bloc countries. Below is a figure from a recent coauthored paper of mine that shows how big the dollar bloc is as percent of the global economy (on a PPP basis). The dollar bloc is far bigger than the next two largest currency blocs. This means Fed policy--including its rate hike talk-- gets transmitted to a large part of the global economy.


Fed policy is also felt abroad for another important reason. There has emerged outside the United States a parallel dollar system where loans and securities are issued in dollars to non-U.S. residents. Credit to non-residents has tripled since 2000 with the dollar share of this growth increasing from 62% to 75% according to BIS data. Here is another figure from my coauthored paper that highlights this fact:


What this means is that when the Fed talks up rate hikes and causes the dollar to surge, it also increases the real debt burden for parallel dollar system outside the United States. This makes the global financial system more vulnerable to U.S. monetary policy. (See here and here for more on this point)

The financial stress that emerged in the late 2015 and early 2016 can arguably be traced back through these two global linkages to the Fed's talking up of rate hikes. Greg Ip provides further corroborating evidence for this view:


Interestingly, not only has the Fed's rate hike talk seem to have resulted in increased financial stress, it also appears to have helped contribute to the sharp drop in oil prices since mid-2014. Both Ben Bernanke and James Hamilton show in separate pieces that about 40-45% of the decline in oil prices since that time can be traced to weak global demand. The obvious candidate is the policy-induced rise of the dollar constricting growth in the dollar bloc countries. If so, the low oil prices reflect as much Fed policy as increase supply.

To be fair, the Fed has being paying more attention to global developments. Just see the March FOMC minutes or this article about Governor Lael Brainard. What it has not been doing (at least publicly) is connecting the dots between its rate hike talk and the problems in the global economy. And until it does so figures like the one below are bound to get worse:


This could be, as Greg Ip notes, the first recession the Fed has caused simply by talking about interest rate hikes.  The FOMC should take note.

Related Links

1 Based on the expectation hypothesis view of interest rates which says the long-term rate (here, the 1-year treasury yield) is equal to the average of the short-term rates over the same horizon plus a term premium. Since the 1 year treasury is relatively short-term the term premium here should not be too big. Consequently, the observed yield should largely be the average expected short-term rate over the next year.

Monday, June 13, 2016


My latest Macro Musings podcast is with Lars Christensen, an internationally renowned Danish economist and Senior Fellow at London’s Adam Smith Institute. Lars joined me to discuss the Eurozone crisis and the current challenges facing the international money system.

One of the key questions we covered is whether Europe was an optimal currency region to begin with and whether it can survive in its current form. We also spent time considering the role the ECB played in making the crisis worse with its tightening of monetary policy in 2008 and 2011. Finally, we examine the role the Fed plays internationally through its influence on the “dollar bloc” countries--those countries that either use explicitly or implicitly peg to the U.S. dollar--and global monetary conditions more generally.

It was a great conversation and readers can learn more about Lars and some of the topics by looking at the links below.

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player. And remember to subscribe since more guest are coming!

Related Links
Lars Christensen's Blog
Lars Christensen's Twitter Account
Eurozone Counterfactual--David Beckworth
The Origins of the Eurozone Monetary Crisis--David Beckworth
International Impact of the Fed When the US is Banker to the World--David Beckworth & Chris Crowe

Monday, June 6, 2016

Macro Musings Podcast: Josh Hendrickson

 
My latest Macro Musings podcast is with Josh Hendrickson, assistant professor of economics at the University of Mississippi. Josh and I sit down for a wonky and fascinating discussion of the role of money in monetary economics. 

The standard New Keynesian view is that money does not matter for monetary policy. Josh pushes back against this view by making the case that money does still matter, both empirically and theoretically. Empirically, he points to the run on the shadow banking system and studies using the Divisia monetary measures that show money still matters. On the theoretical side, he notes that the latest innovations with monetary search models put money's transaction role front and central in the business cycle. He sees this approach as a much more promising way to understand money than the standard New Keynesian view. 

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player. And remember to subscribe since more guest are coming! 

Related Links
Josh Hendrickson's Webpage
Redundancy or Mismeasurement? A Reappraisal of Money (non-gated version)--Josh Hendrickson
An Evaluation of Milton Friedman's Instability Hypothesis--Josh Hendrickson
Money Still Matters--David Beckworth and Josh Hendrickon
The Supply of Transaction Assets, Nominal Income, and Monetary Policy Transmission--David Beckworth and Josh Hendrickson