How much spare capacity does the world have left?

January 13, 2013 5:12 pm

by Gavyn Davies

Most economists accept that the developed economies have been operating considerably below potential GDP since 2008, but there is much less agreement about the size of the output gap, and what should be done about it. This is obviously crucial. The larger the output gap, the greater the waste of resources (and, from an investor’s point of view, the greater the scope for future growth). Furthermore, the larger the gap, the smaller is the budget deficit when economies return to potential, so the greater is the scope for fiscal expansion today.

Keynesians have been focused on these issues for some time, and have generally had the better of the argument in the current recession. Recently, their thinking has been developing in some important respects. An example is Paul Krugman’s contribution to a panel discussion on the macroeconomics of recessions at the annual meeting of the American Economic Association in San Diego last week.

Brad DeLong, the panel chairman, has posted a transcript of the session here.

In his contribution, Professor Krugman asked the following question: if the output gap is really as large as the Keynesians have claimed, why has inflation not fallen into negative territory? In most developed economies, the core rate of inflation has remained stuck at close to 2 per cent, despite the fact that real GDP has been about 10-13 per cent below its long term trendline for several years in succession. Does this not tell us that potential GDP is in reality much lower than the simple extrapolation of previous trends would suggest? If so, the case for fiscal and monetary expansion suddenly looks much weaker.

Paul Krugman’s explanation for the absence of any significant decline in inflation, despite what he believes is a massive output gap, is that nominal wages get stuck at zero instead of turning negative as the recession takes hold. He says this:

The inflation process is one area in which I have changed my views. It has become much more apparent that downward nominal rigiditynot just stickiness but people don’t like to cut nominal prices and wages—is a very significant factor. When you have a depressed economy in a state of initially low inflation, the zero bound not just on interest rates but on wage changes becomes a really big deal. The reason that average wages continue to rise is that we have truncated the left edge of the distribution, not that we have anything close to full employment.

This is sound reasoning. In 2010, Andre Meier at the IMF published an analysis of persistently large output gaps (summarised in this earlier blog), in which he concluded that global inflation should be dropping each year by about 0.5 per cent, but that this would stop happening as the rate of wage and price inflation approached zero. The estimated impact of the output gap on inflation would therefore be expected to decline as inflation falls. This prediction seems to have proven accurate.

Furthermore, to the extent that inflation expectations have becomeanchored” at 2 per cent as a result of central banks’ inflation targets, we would expect the link between the size of the output gap and the change in inflation to weaken. Again, this seems to have happened. Jan Hatzius at Goldman Sachs has recently estimated a model of the US inflation process which finds evidence of both anchoring and of a drop in the estimated coefficient on the output gap as inflation moves closer to zero.

Jan Hatzius concludes that “the model implies that there is little risk of a significant rise in inflation until we are much closer to full employment”. In other words, fiscal or monetary expansion should be met with a rise in real output, not in inflation. Similar reasoning appears to underpin the Fed’s current thinking, and especially the recent change in its policy reaction function to place more importance on reducing the output gap as quickly as possible.

None of this, however, tells us anything definitive about the exact size of the output gap; a gap almost certainly exists, but is it really as large as 10-13 per cent of GDP? On that question, the following graphs are pertinent:


The graphs compare a simple extrapolation of the pre-2008 trend for GDP (red lines) with various estimates of potential GDP made by official bodies like the IMF, OECD and the Congressional Budget Office in the US. The estimates of these official bodies are all made with similarfundamental economicmethods, which attempt to allow for developments in labour supply, the capital stock, total factor productivity and the natural rate of unemployment, or the “NAIRU”.

The implication of these estimates for potential GDP is that about two-thirds of the shortfall in GDP relative to the linear trendline in the G4 countries has been due to supply side phenomena, notably the low level of capital investment, the fall in underlying productivity growth as the IT revolution has waned, and a rise in the NAIRU. For the US, real GDP at present is 13 per cent below the linear trendline, but only 4.2 per cent below the average of the threefundamental economicestimates shown for potential GDP.

This estimate is not far from that implied by recent work at the Fed. For example, the latest update to a paper on the size of the output gap by Justin Weidner and John Williams at the San Francisco Fed shows that the output gap is in a range of 0.4 to 5.7 per cent, with a mean and a median of 3.2 per cent [1].

What does all this imply for the future? In the short term, it suggests that any rise in nominal demand, stemming from expansionary policy or a recovery in private spending, is much more likely to be reflected in rising real output than in higher inflation. Demand management policy can be expansionary.

However, in the longer term, it does not support the view that the developed economies can easily return to their pre-2008 trendlines for GDP through demand expansion alone. Perhaps they can never get there, or perhaps there is a speed limit which cannot be safely exceeded [2]. In either case, supply constraints would not be as remote as the use of linear trendlines would imply.



[1] The Laubach-Williams estimate is an outlier, which is derived from observing the inflation rate, not the behaviour of labour market data. Since inflation has been stuck at around 2 per cent for a long period, this method suggests that the output gap is very small. The method would produce estimates of the output gap which are too small if the relationship between the output gap and inflation has changed, as discussed above.
[2] Some of the reasons for a drop in potential GDP relative to previous trends may be indirectly caused by a shortage of demand. For example, capital investment might fall, and some workers might leave the labour force. Some of these effects might be reversible if demand recovered strongly. In that event, the supply potential of the economy would be “endogenous” to the level of aggregate demand.

January 11, 2013 7:07 pm

Japanomics strikes a revolutionary note
Reflationary policies could have a profound impact everywhere, writes Peter Tasker

Suddenly it is game on in Tokyo – and the world is watching. For the past 15 years Japan has been trying to shrink its way out of its problems. That did not work. Now it is about to try the opposite approach.

Japan’slost decades” have long been an awful warning to the world of the damage that a spectacular boom and bust can inflict on an economy’s long-term prospects. Now Japan could become another kind of example. If the pedal-to-the-metal reflationary policies of Shinzo Abe, the recently elected prime minister, succeed, there will be a profound impact on post-crisis policy making everywhere.

History shows that Japan rarely does things by half-measures. The financial bubble of the 1980s was probably the biggest in history. At its peak the Tokyo stock market was worth more than half of global market capitalisation.

The contraction was equally intense. Twenty-three years after the Japanese bubble burst in 1989, the Nikkei Index was flirting with new bear market lows. Weak growth and deflation have meant that Japan’s nominal gross domestic product is no higher now than it was in 1992.

Even so, macroeconomic policy has remained contractionary. Just last year Yoshihiko Noda, the former prime minister, pushed through a bill to double consumption taxes.

Unfortunately the reward for such rectitude has been an explosion in the debt to GDP ratio. Tax revenues have collapsed and social spending has soared – a phenomenon now familiar in Europe.

Monetary policy has done little to support growth. The Bank of Japan’s balance sheet is barely larger now than in 2005. Its unconventional crisis-fighting operations have been fairly cautious, consisting largely of buying short-term bonds from the banks in order to increase liquidity. The mood music from BoJ officials was that they did not believe that monetary policy could or should be deployed more aggressively.

When a group of investors visited the BoJ last spring to hear about the central bank’s self-created inflationgoal” (the Japanese text was left deliberately vague), they were treated to a 45-minute discourse on demographics. The message was cleardeflation was the fault of Japan’s inadequately fertile womenfolk, not the elite officials of the central bank.

Fifteen years ago, Milton Friedman memorably ascribed Japan’s economic woes to “a decade of inept monetary policy”. He also warned against the error of identifying easy money with low interest rates.

The high interest rates of the 1970s, he said, were a signal that monetary policy was too loose, not too tight. Likewise the low interest rates of Japan today – as in the US of the 1930sshow that monetary policy is too tight, not too loose.

Sooner or later a Japanese politician was going to get the message. That politician turns out to be Mr Abe, whose landslide victory last month followed a campaign based on a promise to boost the economy. Already he has started to revive public works spending – a sensible move, given Japan’s ageing infrastructure and the risks of natural disasters.

However, the greatest emphasis will be on monetary policy. Mr Abe has demanded much greater aggression from the BoJ, threatening to remove its independence if it fails to deliver. He wants an explicit inflation target and a weaker yen, secured by an “accord” between the government and the central bank.

Here he is breaking at least two taboos of central banking. The first is that a more competitive exchange rate should not be a policy target, as that would constitutemanipulation” – an activity widely frowned upon, not least by the US Congress.

In truth this is humbug. Everyone knows that currency depreciation is a crucial mechanism for reflating demand-starved economies. Sir Mervyn King, outgoing Bank of England governor, hinted as much in interviews. Since the collapse of Lehman Brothers in 2008 the US has benefited from a weaker dollar.

Elsewhere, the Swiss central bank has drawn a line in the sand that it will not allow the franc to cross; the Koreans have effectively been managing the won rate for years. But these are not major currencies. Japan is the first G8 country to breach this monetary correctness.

The second taboo is to re-establish political influence over monetary policy. It has become axiomatic that central banks should be independent entities, insulated from the grubby machinations of politicians.

Again, the reality is more complex. Sophisticated operators such as Sir Mervyn, Ben Bernanke and Mario Draghi – his counterparts at the US Federal Reserve and European Central Banktake account of the wider political and social context.

Furthermore the benefits of independencegreater transparency and predictability bringing lower interest rates – were more obvious in the inflation-racked 1970s and 1980s than in today’s world of excess capacity and rock-bottom interest rates.

More fundamentally, is it safe to assume that monetary policy is an apolitical activity and that central bankers are objective arbiters of what is best for the national interest? The Japanese experience suggests not. Monetary policy is inherently political since it affects the balance of interest between savers and borrowers and, in Japan’s case the old and the young.

Neither are central banks disinterested parties. Like all bureaucratic entities, they aim to expand their prestige and influence. For the BoJ to admit that its previous strategy was misconceived would leave it open to Friedman-like accusations of responsibility for Japan’s long malaise.

What if Abenomics works? Imagine Japanese exporters recovering market share, tax revenues surging, stock prices in a multiyear bull market, and the doomsters predicting bond market apocalypse getting it as wrong as the Mayans. “Turning Japanese” would be then be something to envy, not fear.

The writer is a Tokyo-based analyst at Arcus Research

Copyright The Financial Times Limited 2013

ECB rules out stimulus despite record jobless and fiscal squeeze

The European Central Bank has dashed hopes of further stimulus to pull the eurozone out of recession and fight record unemployment, deeming the economy strong enough to heal itself.

By Ambrose Evans-Pritchard

6:29PM GMT 10 Jan 2013

Mario Draghi, Euro
ECB President Mario Draghi unveils the new €5 note on Thursday

He even spoke of "exuberance" creeping into pockets of the credit system, with leveraged buy-outs and private equity deals becoming frothy - the first warning by the ECB of an incipient bubble as the fresh cycle gathers momentum.

The euro surged more than two cents to $1.32 against the dollar after he revealed that the ECB’s governing council had agreed "unanimously" to hold interest rates at 0.75pc, implying that "doves" who called for rate cuts last month have been silenced by a clutch of rising confidence indicators.

However, the ECB is gambling that the rosier mood will be enough to lift the real economy out of a deep slump during another year of fiscal contraction, with the sharp squeeze spreading from Italy and Spain to France.

Athanasios Orphanides, a former ECB governor and a world expert on deflation, said the bank has misjudged the severity of the underlying economic crisis and is once again claiming victory too soon.

"I don’t subscribe to the optimistic view that the worst is behind us. None of the fundamental issues has been addressed," he told Bloomberg, warning that the ECB pledge to buy Club Med bonds has created "a false sense of calm".

He said there was no excuse for policy-makers "to stand idly by" as unemployment climbs to crippling levels across southern Europe, reaching 26.6pc in Spain.

Mr Orphanides said the eurozone is sliding into an even deeper slump than 2009. "We are in the middle of a policy-induced recession and monetary policy can do more to contain it, without compromising price stability."

Mr Draghi’s pledge to back-stop Spain and Italy has caused a sharp fall in bond yields for these two countries in what amounts to a surgical rate cut, but businesses are still paying twice the rates of German counterparts to raise funds.

Andrew Bosomworth from PIMCO said Europe’s financial system is still partially broken. "Your borrowing cost depends on your postal code, not on your credit quality or business model. The ECB will instead have to think of unconventional ways of getting credit to those worthy of receiving it," he said.

Mr Draghi acknowledged that Europe is still at risk and will not start to recover until later this year. "We have signs that fragmentation is being gradually repaired, but this is not feeding through to the real economy yet," he said.

Currency analysts said he has invited further inflows into euro by signalling that the ECB would stand aloof as other central banks around the world take action to drive down their currencies. "The very last thing that Europe needs right now is a strong euro. The risk is that the European economy will bear of the full brunt of the world’s currency wars," said Simon Derrick from BNY Mellon.

French finance minister Pierre Moscovici has begun to complain openly about the effects of currency strength on France’s struggling industry. "We have no interest in an over-valued euro," he said, vowing to raise the issue in talks with China.

Lars Christensen from Danske Bank said the ECB is making the same mistakes as the Bank of Japan in the early 1990s, allowing stagnation of the money supply and an asphyxiating exchange rate.

"They think monetary policy is loose because interest rates are near zero, but what long bond yields in the market are telling us is that monetary conditions are in fact very tight," he said.

"Their view is that quantitative easing will be hyper-inflationary and lead to a collapse of credibility, but if you look at the contrast in unemployment between the eurozone and the US, it is clear that the Fed has been vindicated," he said.

Mr Draghi said the ECB does not have a "dual mandate" like the Fed to target jobs and must stick to its one designated task of ensuring price stability, but added that the bank could not alleviate structural unemployment even if it tried. "Monetary policy cannot do much about that," he said.

The comment underscores a deep split in thinking on the two sides of the Atlantic. The Fed has vowed to keep adding stimulus until the job rate reaches 6.5pc.

"The contrast is now striking," said Julian Callow from Barclays. "The eurozone has corrected some of the external imbalances but at enormous costs and chiefly suppressing demand."

The ECB’s hardline stance is also at odds with the findings of the European Commission’s 400-page report on the EMU jobs crisis this week. It concluded that the chief cause of rising unemployment is a "demand shock" to the Euroland economy and that structural flaws in the labour markets were "less relevant".

The report said a widening gap between North and South had emerged that was pulling peripheral Europe into a downward spiral and a "poverty trap".

The eurozone remains as fragmented as ever. The stress has merely switched from the financial markets to the real economy.


January 13, 2013, 6:10 p.m. ET

Bragging Banks Keep Mum on This Number


My fortress is stronger than yours.

Ever since J.P. Morgan Chase started referring to its "fortress" balance sheet, other banking giants have sought to portray themselves in a similarly strong light. The latest front in this bragging battle has been estimates of Tier 1 common capital under new Basel III capital rules.

Agence France-Presse/Getty Images

As big banks roll out fourth-quarter results in the coming week, investors can expect to hear more chest-thumping on this front. Besides being the main gauge of bank strength, this ratio also will figure in the Federal Reserve's consideration of requests by big banks to return capital.

Banks have been far quieter, though, about another important measure of their financial strength: leverage ratios under the new Basel rules. Those have received far less attention than the Tier 1 common ratio or new liquidity rules, which central banks recently eased.

Yet given all the criticism of the Basel rules, in large part due to the emphasis many of its gauges place on risk-weighted measures of assets, the leverage ratio should be getting far more attention and disclosure. That is because it is based on total assets, not an adjusted measure of them.

And the difference between the risk-weighted and unadjusted measure of assets can be telling. Risk-weighted assets were equal to just 67% of total assets at U.S. banks at the end of the third quarter, according to Federal Deposit Insurance Corp. data. That is down from about 75% before the crisis.

The gap is even wider at the biggest banks. At the big fourJ.P. Morgan, Bank of America, Citigroup and Wells Fargo risk-weighted assets averaged 60% of total assets at the end of the third quarter. The lower risk-weighted assets are, the higher capital ratios appear, meaning banks need to hold less equity. Moreover, calculations of risk-weighted assets are in many cases dependent on models devised by banks themselves.

Granted, this year investors might start to get a glimpse of what leverage ratios look like under the new Basel rules, but not in the U.S. Banks in the U.K., for example, are supposed to begin disclosing these as they report final 2012 results. In its November Financial Stability Report, the Bank of England said this will "represent an important first step in helping to reduce investors' uncertainty about firms' resilience, given market concerns about inconsistencies in risk-weighted asset calculations."

Although European banks generally have far lower levels of risk-weighted assets to total assets, it is still too bad U.S. banks aren't being pressed by regulators to follow suit. None of the big U.S. banks so far have chosen to disclose estimates of their leverage ratios under the new Basel rules.

Until banks do so, it will be easy for investors to assume they are playing coy because the figures might not be as flattering as their Tier 1 common ratios, which in most cases are now close to or have met minimum thresholds. That is especially the case because the biggest U.S. banks are likely to see their assets rise under the new Basel leverage-ratio rules.

Unlike banks that report under international accounting rules, U.S. banks show the "net" value of their derivative assets and liabilities on the face of the balance sheet. Under the Basel leverage rules, though, some of these will be included in their assets.

That will potentially make them look more levered. This could call into question claims about how thick their fortress walls actually are, even as they look to return "excess" capital to shareholders.

And while the banks' leverage ratios are likely to be comfortably above the 3% minimum called for by the Basel rules, some banking observers have called on regulators to raise this to an 8% threshold.

So, the sooner U.S. banks start showing this measure the better, given questions about the risk weighting of assets. With banks still trying to water down new regulations, it is easy for investors to forget that questions over bank capital, and just how thick it is, are far from resolved.