26/02/2012: What happens when debt is too high and taxes are distortionary?

An interesting paper: Public Debt, Distortionary Taxation, and Monetary Policy by Alessandro Piergallini and Giorgio Rodano from February 7, 2012 (CEIS WorkingPaper No. 220 ).

In traditional literature, starting with Leeper’s (1991):

• if fiscal policy is passive (so that it simply focuses on a guaranteed / constitutionally or legislatively mandated public debt stabilization irrespectively of the inflation path), 
• then monetary policy can independently be set to focus solely on inflation targeting (ECB) ignoring real economy objectives, such as, for example, unemployment and growth targeting. 

The twin separate objectives of fiscal and monetary policy can be delivered by following the Taylor principle. This means if the monetary authorities observe an upward rise in inflation, they can hike nominal interest rates by greater proportion than the rise in inflation. This is feasible, because in the traditional setting, fiscal policy objective of sustaining public debt at stable levels can be achieved - in theory - by raising non-distortionary taxes that are not linked to inflation (for example, distortionary VAT and sales taxes yield revenues that are linked to inflation, so monetary policy to reduce inflation will lead to reduced economic activity and reduced revenues for the Government at the same time; in contrast, non-distortionary lump sum taxes yield fixed revenue no matter what income or price level applies, so that anti-inflationary increase in the interest rates is not going to have any impact on tax revenue).

Of course, if fiscal policy is active (does not focus on debt stabilization), monetary policy under Taylor rule should be passive (so interest rates hikes should of smaller percentage than inflationary spike). Such passive monetary policy will allow Governments to inflate their tax revenues without raising rates of distortionary taxation and

In many real world environments Governments, however, can only finance public expenditures by levying distortionary taxes (progressive taxation). So in this environment, the question is - what happens to the 'passive fiscal - active monetary' policies mix? According to Piergallini and Rodano, "It is demonstrated that households’ market participation constraints and Laffer-type effects can render passive fiscal policies unfeasible. For any given target inflation rate, there exists a threshold level of public debt beyond which monetary policy independence is no longer possible. In such circumstances, the dynamics of public debt can be controlled only by means of higher inflation tax revenues: inflation dynamics in line with the fiscal theory of the price level must take place in order for macroeconomic stability to be guaranteed. Otherwise, to preserve inflation control around the steady state by following the Taylor principle, monetary policy must target a higher inflation rate."

Ok, what does this mean? It means that if you want passive rules (public debt targeting - e.g. fiscal compact EU is trying to legislate) you need inflation (to transfer funds to the Government from the private individuals and companies).

Per authors: "The analytical results derived in this paper give theoretical support to the argument recently advanced by Cochrane (2011) and Davig, Leeper and Walker (2011) that the large fiscal deficits decided by governments to offset the crisis can lead to the “Laffer limit” beyond which inflation must endogenously jump up according to the fiscal theory of the price level."

Now, we often hear the arguments that in the near term there will be no inflation as slow growth will prevent prices from rising. Sure, folks. Good luck with that.

28/10/2011: Euro area leading indicator points to a recession in October

Euro area leading indicator for economic activity, Eurocoin, has crossed into contraction territory in October. Based on the latest data from CEPR, Eurocoin is now at -0.13%, with corresponding quarterly growth rate of between 0% and -0.05%, signaling the likelihood of a recession for the euro area as a whole.

We are now at the lowest reading since August 2009 when Eurocoin stood at -0.21% moving to the upside in September 2009. Eurcoin 3mo average is now at 0.04% and 6 mo average at 0.285%. Year on year Eurocoin has dropped 132%. Per CEPR: "The fall is the result of deterioration in most of the variables that are included in the indicator, and in particular of the worsening climate of confidence among firms and consumers."

Worsening Eurocoin now signals Taylor rule divergence for the future direction in the interest rates, as illustrated in charts below.

Inflation-consistent rates are in the 3%+ territory, while growth-consistent rates are in the range of at or below 2%.

03/10/2011: Eurocoin September 2011: continued weakness in euro area growth

Euro area leading indicator for growth, eurocoin, was released last week, showing dramatic decline in economic activity for September. Eurocoin has peaked in May 2011 at 0.62, having dropped persistently since then.

In September, eurocoin reading stood at 0.03, barely above the recession reading (below zero) and down from 0.22 in August.
This marks the second consecutive month that eurocoin is statistically indifferent from economic stagnation. The projected quarterly growth rate for Q3 2011 is now down to 0.08% from 0.1% estimate in August and from Q2 2011 actual reading of 0.2%. Annual rate projection based on 9 months through September averages is 1.82% and dropping rapidly from 2.5% in May to 0.12% in September.

In terms of ECB monetary policy stance,
Eurocoin-consistent policy rate is now around 2.0-2.25%, while inflation-consistent rate is now closer to 2.75%.
The divergence of the current rate from both targets and the gap between inflationary and growth targets suggests that the likely direction of the economy is toward moderate stagflation with inflation anchored around 1.8-2.5% and growth around zero.

And here are the core components of eurocoin showing significant downward trends:

28/08/2011: Eurocoin August 2011 - signalling sharp contraction

Euro area leading economic indicator, eurocoin posted a sharp contraction in August, confirming rapid slowdown in the economic activity.

• Eurocoin fell from 0.45 in July 2011 to 0.22 in August, a drop of 51.1% - the sharpest since August 2008. This marks third consecutive month of declines.
• Eurocoin 3-mo running average is now at 0.40 and 6-mo average at 0.50. Year on year, the indicator is down 40.5%.
• The leading indicator is now reading within the band of 1/2 standard deviation from zero, making current growth reading virtually indistinguishable from stagnation.
• The indicator is now at the lowest level since September 2009.
  

• Annualized rate of growth is now running at 0.88%.
• Inflation - per ECB latest data, is running around 2.5%.

Updated charts relating Eurocoin to the ECB policy rates show lower expected fundamentals-determined repo rate at 2.5-3.5% based on Eurocoin and 2.75-3.25% based on HICP - both well ahead of the current rate of 1.5%.
The core drivers for Eurocoin decline in August were:

• H1 2011 growth rates (see earlier post here)
• H1 2011 slowdown in industrial production - impacting Germany and Italy and contraction in industrial production in France and Spain
• PMI Composite indicator through July 2011 showing contracting activity in the Euro area and in particular - Italy and Spain, plus significant deterioration in German business confidence (see detailed post here) and close-to-contraction reading in France
• Consumer confidence remaining in contractionary territory for the Euro area and, specifically, for France, Italy and Spain
• Sharp sell-offs in the stock markets across all 4 major economies, and
• Zero growth in exporting activity in the Euro area, with sharply falling exporting activity in Germany, zero exports growth in France, near zero growth in Italy and contracting exports in Spain
  

In short, all components of growth forecast are showing substantial deterioration, with 3 out of 5 main headline readings in contraction and 2 main readings in zero growth ranges.

29/07/2011: Euro area leading economic indicators - July 2011

The new Euro area leading growth indicator - eurocoin - published by CEPR and Banca d'Italia is out for July, showing signficant slowdown in economic activity in the Euro area ahead. Headline numbers are:

• Euro-coin fell in July for the second month in a row, declining from 0.62 in May to 0.52 in June and to 0.45 in July.
  
• 3 months average through June was 0.58 and 6 months average through June was 0.56. In July these declined to 0.53 and 0.555 respectively.
• Year on year June 2011 reading was 13.04 higher. July 2011 reading was 12.5% above that for July 2010.
• With historical standard deviation for eurocoin at 0.4594 > current July 2011 reading, this month reading is statistically insignificantly different from zero. The same is confirmed by looking at the crisis period standard deviation from January 2008 through current reading, which stands at 0.6288.

• The latest eurocoin implies Euro area growth rate of 1.81% pa, down from 2.24% pa growth predicted by the 6mo moving average.
• Core drivers of slowdown are: falling business confidence, stock market performance and widening spreads between long and short-term interest rates (cost of capital rising).
  

Updating figures for ECB rate policy determinants:

The above still support my view that equilibrium repo rate consistent with ECB's medium term inflation target is around 3.0-3.25%, well ahead of the current rate.

Latest industrial production (through May 2011) shows downward turn in growth in Germany, France and Spain, with Spain posting contraction in output, while France virtually reaching zero growth point. Italy is the only country of the Euro area Big 4 still showing accelerating growth in industrial production. Hence, overall for the Euro area, industrial output was nearly at zero growth line in May 2011, having posted 4 consecutive months of declining growth.

PMI composite for Euro area business confidence is now for the second month in a row firmly in the contraction zone. Consumer confidence is now at zero expansion in July, having declined over the last 2 months, with Italy, Spain and France all showing persistent declines in consumer confidence.
Chart source (here).

Lastly, exports show falling rates of growth over a number of consecutive months through May 2011 in France, Italy and Spain.

04.07/2011: Eurocoin for June 2011

In advance of ECB decision and with a week delay - here's the latest leading indicator for Euro area growth - eurocoin - as issued by CEPR (link to release here).
As shown above, eurocoin posted a small decline from 0.62 in May to 0.52 in June. This reading is below 3mo MA of 0.57 and behind 6mo MA of 0.56, but is 13% ahead of the June 2010 reading of 0.46. The series continue to signal expansion, albeit at a slower pace.

Mapping out eurocoin alongside quarterly growth rates suggests, should eurocoin lower trend be established in July-August - slower growth in Q2/Q3 2011:

Lastly, a chart mapping eurocoin against ECB decisions:
The above suggests that although eurocoin signals alleviation in the pressures on ECB to raise rates this month, there is, nonetheless continued disconnect between the historical rates and eurocoin readings. Historical relationship between level and changes in eurocoin and ECB repo rate implies repo rate around 2.0-2.5% or roughly double current rate.

Economics 28/06/2010: G20 to euribor: beware of the central banks

Update: with a slight delay on this blog's timing - Reuters picks up the same thread here.


Another Monday, another set of pear shape stats.

First, we had a farcical conclusion to a farcical meeting of G20. If Pittsburgh summit was a hog wash of disagreements, Toronto summit had a consensus view delivered to us, mere mortals who will pay for G20 policies. This consensus was: G20 leaders called for

• austerity, but not too much (not enough to derail growth, but enough to correct for vast deficits - an impossible task, assuming that public deficit financing has much of stimulating effect in the first place);
• generating economic growth (with no specifics as to how this feat might be achieved);
  
• increased tax intake (to help correct for deficits); and
• no changes to be made to the global trade and savings imbalances.

In other words, G20 decided that it is time to have a 4 course meal without paying for one.

Then , on the heels of these utterly incredible (if not outright incompetent) pronouncements by G20, Bank for International Settlements (BIS) came in with a stern warning to the Governments worldwide to cut their budget deficits "decisively", while raising interest rates. Funny thing, BIS didn't really see any irony in cutting deficits, while raising the overall interest bill on public debt. Talking of Aesopian economics - let's pull the cart North and South, in a hope it might travel West.

In many ways, BIS got a point: “...delaying fiscal policy adjustment would only risk renewed financial volatility, market disruptions and funding stress” said BIS general manager Jaime Caruana. Extremely low real interest rates distort investment decisions. They postpone the recognition of losses by the banks, increase risk-taking in the search for (usually fixed) yield, perpetuating nearly economically reckless financing of sovereigns that cannot get their own finances in order, and encourage excessive levels of borrowing by the banks.

Continued water boarding of the western economies with cheap cash through Quantitative Easing operations by the CBs risks creation of zombie banks and companies with sole purpose in life to suck in liquidity from the markets. Alas, the problem is - shut these zombies down and you have no means for monetizing public debt in many countries, especially in the Eurozone. Boom! Like the main protagonists in Stephen King's movies, governments around the world now need zombies to rush into their disorganized homes before the whole plot of deficit financing blows up in their face.

BIS also warned that many economic experts and central banks are underestimating inflation risks. And this is just fine, assuming you are dealing with short term investment horizons. However, for a Central Bank to ignore the possibility of a restart of global inflation - fueled by the emerging markets growth and later also supported by accelerated inflationary pressures in the advanced economies following the re-flow of liquidity out of the bank vaults into the real economy once writedowns are recognized and banks balancesheets stabilise - is a very dangerous game. inflation, you see, is sticky.

And inflation might be coming. Look no further than the Fed (here) and the US Administration insistence on the need for continued debt-financed stimulus.

Or, look no further than the movements in the interbank lending markets:

So the long term Euribor is up, up and away despite all the Euro area leaders' talk about fiscal solidarity funds and tough austerity measures. Think: why? Either the interbank markets don't believe in Euro area's ability to get its own house in order (which they certainly don't) or they believe that future inflation will be higher (which of course they do)...

Hence, shorter maturities are in an even more pronounced push up:

While dynamically, the trends are deteriorating:
Now, think about the Irish banks (Spanish, Portuguese, Greek - etc) that are on life support of interbank markets and ECB. Can they sustain these credit prices?.. While facing continued writedowns?.. Don't tell I did warn you about these.

Economics 13/02/2010: Inflation targets and What's in a name?

One interesting observation – Oliver Blanchard in yesterday interview with Wall Street Journal suggests (here) that “If I were to choose inflation target today, I’d strongly argue for 4%. But we have started with 2%, so going from 2% to 4% would raise issues of credibility. We should have a discussion about it.”

I have argued for some time now that a combination of

• continued tightness in the credit markets,
  
• long-term stickiness of European unemployment and
  
• massive national deficits and debt issuance since 2008 imply the need for inflationary reductions in debt levels accumulated by the euro area states, especially those members of the APIIGS club

will mean continued need for unprecedented liquidity injections by the ECB through 2010. The three forces mean that the ECB will have no option but to shift away from its current ‘below 2%’ target for inflation and move on to 4% target.

Good to see serious heavy hitter in policy economics, like Oliver Blanchard, also thinking the same.



Now, to more ‘fun’ economics.

Remember Shakespeare’s “What’s in a name? / That which we call a rose by any other name would smell as sweet.” (Romeo and Juliet).

In the world where information moves much faster and where uncertainty is much higher – in other words, in the world we inhabit today – this view is no longer true, for what is in the name does tell us much about what is in the name bearer.

A recent paper by Aura, Saku and Hess, Gregory D., What’s in a Name?, Economic Inquiry, Vol. 48, Issue 1, pp. 214-227, January 2010 (link here) shows exactly this.

“Expectant parents lie awake at night, consult books, and some even hire a consultant to choose their new child’s name. Is it similar to the process that manufacturers undertake when branding a new product? Viagara pretty much speaks for itself, but to what extent does Gregory, Saku or even Jamaal convey information and/or meaning.”

The study attempts to answer two main questions:

1. does a person’s name convey information about their background?
2. does a person’s name have an impact on the person’s long run economic outcomes, such as income, education, fertility, social standing, happiness or prestige?”
   

“In our dataset, this would mean comparing the outcomes of otherwise similar individuals with a name like Mark (exclusively a white name in our data) with Marcus (exclusively a black name in our data) or comparing Alice (white name) with Tanisha (black name)…

…More specifically, we investigate the extent to which a respondent’s first name features affect his or her years of formal education, self reported financial relative position as well as social class, to have a child before 25, and occupational prestige. …we can examine the gender differences between lifetime outcomes and first name features.”

There are broadly speaking three main findings:

1. there is a strong empirical relationship between an individual’s first name and their background;
2. there is a weaker (but still significant) empirical relationship between an individual’s lifetime outcomes and their first names. Taken together, these first two findings imply that names do convey information about an individual’s labor market productivity. A rose is not quite a rose by any other name.
3. both non-black non-whites with ‘blacker’ names as well as blacks with more popular (i.e. predominantly ‘whiter’) names have significantly worse financial outcomes. “This last piece of evidence can be interpreted in light of a subtle form of discrimination: namely, while black names come with discrimination and identity costs and benefits for black individuals, non-black non-whites with ‘blacker’ names face the costs of such names though not the benefits. A similar identity/discrimination channel would also hold for blacks with more popular (i.e. whiter) names, …though it does not provide conclusive proof of discrimination.”
   

First, names indicate a great deal of information on

• gender (and this conclusion is not based on linguistic gender of the name, but on standard phonetic characteristics);
• the year when one was born,
• a respondent’s higher parental education background "can be partially inferred from higher popularity, fewer syllables, more standard spellings, fewer ‘oh’ endings, not starting with a vowel, ending with a consonant and having a lower Blackness Index (the extent to which a given name is race-specific). This latter result …is actually quite large: moving from a purely non-black name to a fully black name is associated with a Father having 2 fewer years of formal education and a Mother having 1 year less.”
• more popular names are associated with better lifetime outcomes: that is, more education, occupational prestige and income, and a reduced likelihood of having a child before
• names with higher values for Blackness Index are “associated with poorer lifetime outcomes: that is, less education, occupational prestige, happiness, social class and income, and an increased likelihood of having a child before 25".
• ‘ah’ and ‘oh’ ending sounds in a name are also related to poorer lifetime outcomes, though popularity is related to better lifetime outcomes.
  

So first names just by themselves convey information about a respondent’s lifetime outcomes. But does "your first name features affect one’s lifetime outcomes after learning information that may be readily available in a job resume".

It turns out that when this is controlled for,

1. Name popularity remains a significant explanatory variable in education outcomes, but not in financial outcomes;
2. Blackness Index is statistically significant again in the class determination, and whether or not a person has higher happiness quotient in the future, as well as in educational attainment: “Higher values for BIND lead to a lower assessment of social class, happiness and an increased chance of having children before 25. However, as with POPULARITY, BIND is now no longer statistically significant in the income responses. Again, the role of education and labor market experience is clearly soaking up the role that POPULARITY and BIND played in the income response” in earlier analysis.
   

“It would thus seem that first names retain a strong role overall in determining lifetime outcomes even after controlling for a respondent’s labor market experience.”

“There is the further possibility that these quasi economic outcomes may also be correlated with labor productivity: simply unhappy workers and those that feel that they are lower class (or even upper class) may have differential labor productivities. Based on the findings… controlling for a myriad of exogenous family background characteristics, a first name’s popularity and/or ‘blackness’ appear to have an impact on intermediate economic outcomes that are likely correlated with labor productivity but not on actual economic outcomes. It would thus appear that …the ‘blackness’ of a name is correlated with factors that can affect labor productivity which could in turn be reflected in discrimination at the resume level [but not at face-to-face level]. As we demonstrate, however, this potential channel of discrimination does not have an impact on pure economic outcomes in our sample.”

In general, this explains why past immigrants to the US – from Europe and elsewhere – tended to automatically adopt most popular local names for their children to ‘assimilate’ into the American mainstream.

It also shows that, for example in the case of Ireland, one would expect past emigrants to be selected on the basis of those with more common names experiencing more favorable in outcomes. Furthermore, currently, within the country, Irish first names might provide for better outcomes - as they serve as more acceptable norms here, while at the same time placing children at relative disadvantage to their peers if they should emigrate out of Ireland.

Lastly, when looking at the trends in names, since the onset of recession, more mainstream names have moved up the popularity chain in Ireland with more Gaelic-derived names becoming less popular. This too might be explained by the findings - when times are tough, implicitly, parents tend to focus more on real economic and social outcomes than on the feeling of being in tune with Eamon O Cuiv's 'national culture'.


Overall, instead of the Shakespeare’s idea that it is the inherent subject characteristic that matters, not the name, is no longer true. Instead, modern relationship between the name and the person is probably better described by a different quote – from Johnny Cash’s (1969), A Boy Named Sue: “So I give ya that name and I said goodbye / I knew you’d have to get tough or die / And it’s that name that helped to make you strong”.