Prices without borders

Low inflation is a global phenomenon with global causes

The price of commodities, trade in goods and capital flows all play a part

ECONOMIC MODELS say that less slack in an economy leads to more inflation. But what defines an economy’s borders? As inflation-targeting took off in the 1990s, globalisation also accelerated. Trade grew from 39% of world GDP in 1990 to 51% at the turn of the millennium, cross-border finance was liberalised and the internet slashed the cost of communicating.

In the 2000s policymakers began to wonder whether integrated markets had made inflation a global process. Economists generally pooh-poohed the idea.

But with central bankers searching for explanations for today’s low inflation, the idea that global forces might be at work has come back into fashion. It has also become more relevant. If globalisation has held down inflation, might its reversal—thanks to the trade war and Brexit—send it shooting back up?

Inflation has been getting more synchronised across borders. On average, a common global trend accounts for nearly a quarter of the variation in national inflation rates since 2001, according to Jongrim Ha, Ayhan Kose and Franziska Ohnsorge of the World Bank.

Add in factors specific to advanced economies and emerging markets, respectively, and trends spanning borders account for more than half the movement in inflation in the rich world and nearly a third of it in poorer countries.

This partly reflects simultaneous trends in monetary policy. But it may also indicate a growing role for global factors. Kristin Forbes of MIT, formerly a Bank of England rate-setter, has studied the drivers of inflation in 43 countries between 1990 and 2017.

She includes in her models global factors such as exchange rates, an estimate of global economic slack, and commodities prices, and finds that their input appears to have increased over the past decade. This is especially true when considering only temporary deviations in inflation from its long-term trend.

There are three main sources of global influence on inflation: the price of commodities, trade in goods, and capital flows. Commodities prices are the most obvious and longstanding.

Synchronicity of inflation rises after large movements in the oil price, such as the shocks of the 1970s. More recently commodities prices have, on the margin, been driven by demand in emerging markets, especially China.

Between 1996 and 2016 the seven largest emerging markets accounted for almost all of the rise in global consumption of metals and two-thirds of the rise in global consumption of energy. As a result, booms and busts in emerging-markets’ demand for commodities are felt everywhere.

In the mid-2010s it was a commodities bust that helped push Europe into deflation.

That much is not controversial. But another effect of globalisation has been to bring down the price of manufactured goods as their production has shifted to economies with low labour costs.

Unlike with commodities, this has been a one-way bet, not a cycle. For decades goods have been getting cheaper relative to services.

Economists can get annoyed by claims that goods trade has dragged down overall inflation.

In theory just some things getting cheaper should not be disinflationary because, with the right monetary policy, average prices will still rise fast enough to make up the shortfall.

In practice monetary policy works only with a delay.

That means changes in relative prices matter. Today, because the Phillips-curve relationship seems to have weakened, central banks often find themselves at the mercy of short-term trends.

Goods trade does not just mean imports of finished products. The recent growth in cross-border supply chains has created conduits along which cost changes in one part of the world flow into the prices of goods that emerge from factories elsewhere.

Research by Raphael Auer of the Bank for International Settlements (BIS), Andrei Levchenko of the University of Michigan and Philip Sauré of Johannes Gutenberg University in Mainz has found that half of global synchronisation in producer-price inflation is attributable to prices that can be traced through supply chains.

Via this mechanism the average country imports one-fifth of any change in inflation in the rest of the world. Prices are more intertwined in integrated trading regions such as America, Canada and Mexico.

If firms can locate their supply chains where costs are lowest, it becomes easier to avoid economies that are running hot. Only if inflation is driven up everywhere are rising costs inescapable.

In other work with his colleagues at the BIS, Claudio Borio and Andrew Filardo, Mr Auer finds that the greater a country’s integration into cross-border supply chains, the more inflation tracks slack in the global economy.

If imports of inputs to production double as a share of GDP, the sensitivity of inflation to global economic conditions also appears to double.

Messrs Ha and Kose and Ms Ohnsorge also find that global factors explain a greater share of inflation in countries which participate more in global supply chains.

This view implies that prices in non-tradable sectors, such as services, will remain sensitive to domestic economic conditions.

That is what James Stock of Harvard University and Mark Watson of Princeton University find in America. Hotels and restaurants, for example, remain fairly sensitive to labour-market slack. Messrs Stock and Watson are even able to separate inflation into an index that is “cyclically sensitive” and one that is not.

The third global factor is capital flows. As inflation has synchronised across borders, so too have long-term real interest rates. For the past four decades they have moved in tandem as saving and investment have been brought into balance globally. And they have moved in one direction: down. In other words, there appears to be a glut of global saving.

The potential reasons for this phenomenon, which was first identified in the mid-2000s, include ageing populations, slower productivity growth, a scarcity of safe assets relative to risky ones, and a dearth of lucrative opportunities for private-sector investors.
It is not just long-term rates that have fallen in tandem. So have the “equilibrium” short-term rates which anchor monetary policy, according to estimates by John Williams, president of the New York Fed, and Kathryn Holson and Thomas Laubach of the Fed in Washington, DC.

Falling equilibrium rates mean that any interest rate central banks choose is less stimulative than it would have been a decade or two ago. In other words, the effects of excess saving spill across borders. Current-account surpluses in, say, Japan and Germany, which together totalled nearly half a trillion dollars in 2018, bear down on the interest rates that must be set by the central banks of other countries to keep inflation on target.

That is fine if central banks adjust accordingly. The problem is that equilibrium rates have been driven close to zero. Unable to cut rates much, central banks find that the only way to fight disinflationary pressure is with unconventional measures like quantitative easing (QE). These are themselves policies with global consequences.

QE is supposed to work in part by getting investors to buy riskier assets. That adjustment happens on the balance-sheets of asset managers who invest worldwide. As a result it sends billions of dollars of capital looking for interest rates to drive down elsewhere.

Ironically, the recent incremental reversals of globalisation provide good examples of the importance of global financial conditions to inflation. In theory tariffs should boost inflation in the country that sets them.

But as the trade war between America and China heated up during 2019, it sparked fears about global growth and triggered a rush into safe assets such as Treasury bonds. Long-term bond yields fell to new depths and the dollar surged. In response the Fed has cut rates and the ECB has restarted QE.

The deflationary impact of a change in global risk appetite has proved far more significant than the modest inflationary impact of the tariffs themselves. Only in Britain has the rolling back of globalisation, via its vote to leave the EU, had a very noticeable upward effect on prices. But even that was due to a fall in the value of the pound; the direct effect of Brexit, if and when it happens, could seem small in comparison.

One group of countries feels the effects of the global financial cycle above all others. For emerging markets, it is so important that they face a distinct set of monetary-policy challenges.

Brexit is a journey without end for Britain

No majority exists for any deal option with the EU. Brexiters are as much to blame as Remainers

Martin Wolf

WEB Comment illustration Martin Wolf
 © Daniel Pudles 

In 1933, Joseph Goebbels stated that, “The modern structure of the German State is a higher form of democracy in which, by virtue of the people’s mandate, the government is exercised authoritatively while there is no possibility for parliamentary interference, to obliterate and render ineffective the execution of the nation’s will.” It is a measure of how far the UK has fallen that Boris Johnson, the prime minister, often sounds rather like this.

Mr Johnson sought to prevent “parliamentary interference” in Brexit negotiations, by proroguing (or suspending) it for five crucial weeks. He dissented from the Supreme Court’s unanimous decision that this was unlawful. He has suggested he could ignore the Benn Act requiring him to seek an extension to the Article 50 deadline, should he not achieve a deal. He condemned this legislation as the “surrender act”. Worst of all, he plans to frame the next election as a battle of “people versus parliament”.

How did the UK reach a position in which its prime minister regards parliament as an obstacle to be ignored? The simple answer is that it decided to insert a particularly ill-considered referendum on an exceptionally contentious subject into a parliamentary system. This created conflicting sources of legitimacy. Worse, the meaning of the option that won a small majority in that referendum was ill-defined. “Brexit means Brexit” is perhaps the silliest sentence ever uttered by a British prime minister. But it was also all that could be said.

Contrary to what Brexiters insist, parliamentary involvement is not an unwarranted intrusion. Any referendum requires legislation. This one also required negotiation and agreement. Alas, no majority exists for any option for a deal with the EU. Brexiters are as much to blame for this as Remainers.

Consequently, “no deal” has emerged as the fallback position. But the Leave campaign said essentially nothing about a no-deal exit. There is no mandate for what every informed observer, including the civil service, knows would be a disruptive and costly result. It would also be just the beginning of negotiations, not their end.

But those talks would occur in worse circumstances. There would be pervasive economic uncertainty. This would be a mad choice. Governments exist to help their countries, not harm them deliberately.

A graphic with no description

Among the most important reasons for this outcome is the refusal, especially on the Brexit side, to try to understand the EU. They needed to comprehend that the EU is an existential project for its members, not just a trade deal. Application of European law, under the European Court of Justice, is a central part of that project. The EU, with 27 remaining members, was also sure to be an inflexible counterparty.

What next? The government’s Heath Robinson-esque plan, in which Northern Ireland is to be inside the EU’s regulatory system for goods but not its customs area, will be rejected as leaky, legally unenforceable and incompatible with border-free trade in Ireland.

It also represents a rejection of the UK’s 2017 commitments on the Irish border. This is sure to have further weakened trust in Britain’s reliability. Remember, too, that the EU has long land borders. It will not allow the precedent of intentionally porous borders.

A graphic with no description

Some believe this plan ought to fly with the EU. It will not. If Northern Ireland were inside the EU’s customs area, too, it could work. But, if the rest of the UK is to have its own trade and regulatory policies, this would make the Irish Sea the UK’s customs and regulatory border with the EU. That would be unacceptable to the Democratic Unionist party and the Conservatives. It might reignite violence in Northern Ireland.

So what happens if no deal can be agreed before October 31?

One question is whether the EU agrees to another extension when the British government clearly does not want one. Assume that it does, but only with conditions. What might those be?

One possibility would be to try to ratify Theresa May’s withdrawal agreement. That would allow the UK and the EU to move on to negotiating a new relationship. This would also mean a compromise between Brexiters and Remainers, itself highly desirable. But it seems impossible.

For Remainers, it is too little; for Brexiters, it is too much. Remainers want to stay in the EU.

Brexiters reject the Irish backstop that would keep the UK in the EU’s customs area and restrict its trade policy indefinitely.

A graphic with no description

A second possibility is another referendum, probably on a choice between no deal and Remain. Such a vote should be legitimate since no deal played so little part in the referendum. But it would require creation of a caretaker government. That would be hard enough to do. It might also be impossible to agree a question and then carry out a referendum, without large-scale violence. To me, another referendum is the least bad option. But it creates great risks.

Finally, there could be an early general election. A drawback is that this would involve many issues apart from Brexit and might lead to another hung parliament. With Mr Johnson campaigning against parliament, it could have dire consequences in both the short and long runs. But it might resolve the Brexit issue, temporarily.

Yet the issue now is not just Brexit. It is far deeper. The Conservative party has become an English nationalist party, busily stoking populist resentment. Meanwhile, the hard left has seized the Labour party. The curse of extremist politics has only just begun.

Once people see opponents as “traitors” to an imaginary “people”, demons of hatred are unleashed. Brexit awoke those demons. Mr Johnson, aided by Nigel Farage and his Brexit party, will seek to win by freeing them. They are sure to wreak havoc for a very long time.

A graphic with no description

China and the US Are Dealing With the Easy Stuff

By: Phillip Orchard

The trade war is far from China’s biggest economic problem, but it’s nonetheless starting to become a problem. U.S. imports from China have fallen 12.5 percent so far this year, compared to 2018.

An International Monetary Fund forecast released this week said Chinese growth will plummet by another 1.6 percent next year if Trump follows through on his threats to tax another $267 billion worth of Chinese imports.

It’s unsurprising, then, that over the past two months, Beijing has been quietly laying the groundwork for concessions needed to strike at least a “truce” with the U.S., if not a more substantive deal. On Friday, for example, it confirmed that a deal would include a pledge to keep the Chinese yuan stable in relation to a basket of currencies. Also in the past few weeks, Beijing lifted caps on foreign ownership in the asset management and auto industries, passed a new foreign investment law that received widespread positive reviews, and pledged a host of new measures such as export tax rebates, improved trade financing and credit insurance. It expanded quotas for tariff-free imports of some U.S. farm goods. According to U.S. officials, Beijing has also committed to make new concessions on intellectual property protections.

U.S. Agricultural Exports to China

Senior Chinese officials, meanwhile, have been on a PR blitz at home and abroad aimed at wooing foreign investors. Most prominent among them has been Premier Li Keqiang, a longtime economic liberalization advocate, and Vice President Wang Qishan, Xi’s trusted “firefighter” who is held in relatively more high esteem abroad. When Li and Wang take high-profile trips abroad and feature prominently in Chinese state media, it’s often a signal of growing concern in Beijing about its souring reputation in foreign business circles (and, occasionally, hints at a power struggle in the upper echelons of the CPC).

The timing of the CPC’s Fourth Plenum this week is also noteworthy. Beijing was expected to hold the plenary session a year ago, per tradition, but delayed it about as long as possible under party rules. This, combined with occasional hints of dissent about Xi’s reassertion of state control over the economy, suggested deep factional divides may have been emerging within the party over China’s handling of the economy, including the trade war.
Xi is loath to risk having these divides on display at the plenum, so the fact Beijing is finally moving forward with the meeting, along with the aforementioned rollout of various reforms, could suggest he’s succeeded in restoring enough consensus for China to move more aggressively with reforms going forward.

More likely, though, the plenum will underscore the reality that Beijing is still operating amid tight political constraints and trying to thread the needle between a number of bad options. Based on official releases, at least, the emphasis of the conclave will be on themes like ideological purity, party loyalty and combating the evils of Western-style capitalism – not, say, the virtues of reform and opening.
This would suggest that Xi remains preoccupied with restoring party solidarity and appealing to nationalist forces to curry support. When the party leadership gets nervous, it typically either gets trapped in paralysis or resorts to the tools it trusts most to entrench its power. In short, China wouldn't be capable of inking anything more than a “truce” anytime soon.
The plenum will be held behind closed doors, so watch for subtle shifts in state media coverage, unexpected personnel changes and so forth for clues on Beijing’s ability to move decisively in one direction or another.

What a Deal Won’t Resolve

Already, it’s fairly clear what won’t be resolved in the immediate future, even if a phase one deal is finally put on paper. There’s a common theme among China’s recent moves and expected concessions: They’re all measures China increasingly needs to do anyway. Its moves to boost foreign participation in its financial sector, for example, come on the heels of a near-crisis in which the Chinese banking sector, especially state-owned lenders, proved exceedingly ill-suited for channeling funding to the private sector.
The resulting credit crunch did far more damage to the Chinese economy than U.S. tariffs have yet to do. China’s increased agricultural purchases would come at a time of surging food prices resulting from a devastating outbreak of African swine fever. If it agrees, as reported, to a deal on stabilizing the yuan, it will be at least in part because it hasn’t been intentionally driving down its currency and has a crippling fear of capital flight.

Similarly, its measures aimed at wooing foreign investment come amid mounting concerns about the country’s reputation as a place increasingly hostile to foreign businesses. Beijing needs new foreign investment to sustain employment, boost its flagging growth, and stem the slow-motion exodus of foreign firms to other low-cost manufacturing hubs.
Moreover, it has long relied on Western business circles to block anti-China and protectionist political forces abroad from translating into punitive policy measures. But over time, as homegrown competitors to foreign firms began hoarding market share in China (with ample help from the state), and as well-documented allegations of things like intellectual property theft proliferated, disenchantment among foreign firms with the Chinese model has become widespread.
This is why opposition to Trump's trade war has proved manageable for the White House.
Beijing won’t be able to make the sweeping changes needed to restore foreign confidence. But it makes sense for it to bend over backward to at least appear to be sincere about addressing foreign firms’ concerns.

In contrast, there’s been nary a hint of evidence that Beijing is preparing to make concessions on the main U.S. grievances. On some issues, like forced technology transfer, there’s realistically not that much Beijing can do to fully snuff out the practice. On others, like more meaningful IP protections, it can pass new laws and push courts to enforce them, but it sees such U.S. demands as an infringement on Chinese sovereignty and is thus loath to spark a nationalist backlash by following through with a gun to its head.

On the biggest issues, moreover, Beijing is going in the opposite direction. Its structural slowdown, trade pressure and soaring debt risks are forcing it to lean even more heavily on the state sector, for example. And to avoid falling into the fabled “middle-income trap,” bolster the People’s Liberation Army and reduce its dependence on foreign technologies, it's doubling down on its support for advanced manufacturing sectors. Deepening state control at the expense of market-driven dynamism may ultimately do more harm than good to China’s economy and industrial development. But resistance to liberalization from entrenched state-sector stakeholders in China, combined with the party's existential fear of widespread job loss, means Beijing is defaulting to the tools it trusts most to sustain stability.

There are also a number of points of contention that the U.S. itself isn’t willing to negotiate on – particularly those with national security implications resulting from China’s development of “emerging and foundational technologies." As we’ve long said, the U.S.-China “tech war” will far outlast the trade war. U.S. concerns over military issues or things like Hong Kong will also remain separate. Thus, expect U.S. measures targeting Chinese tech firms like Huawei, scrutiny on research and development collaboration, and inbound Chinese investment to only intensify from here. And since the U.S. will need to hold on to leverage to ensure implementation of whatever Beijing concedes on trade, expect most of the existing tariffs to remain in place for the time being as well.
Looking Ahead in the U.S.-China Trade War

The U.S. will still have ample political and economic interest in striking a more comprehensive deal. The tariffs are accelerating the U.S. downturn, and an election year is approaching. And while the U.S. needs to do far more to reset its trade relationship with China and find ways to pressure Beijing to change, the problem for the U.S. is twofold: One, reaping the easy, low-hanging fruit in negotiations now leaves only the hard stuff. 

Two, absent a cataclysmic loss of CPC control, Beijing can’t and won’t concede on most of the hard stuff just to get out from under tariffs. Rather, they’ll just push China deeper into its Shell.

China’s Political Correctness: One Country, No Arguments

The Communist Party has spent decades preparing the people to defend a united homeland. Hong Kong’s protests show it has paid off.

By Li Yuan

A military parade honoring the 70th anniversary of the founding of the People’s Republic of China was held in Beijing in October.CreditCreditWu Hong/EPA, via Shutterstock

Hong Kong’s protests have disrupted Yang Yang’s family life. Though the 29-year-old lives in mainland China, he was inspired by the demonstrations to write a song about freedom and upload it to the internet. When censors deleted it, he complained to his family.

They weren’t sympathetic. “How can you support Hong Kong separatists?” they asked. “How can you be anti-China?” His mother threatened to disown him. Before Mr. Yang left on a trip to Japan in August, his father said he hoped his son would die there.

Hong Kong’s protests have inflamed tensions in the semiautonomous Chinese city, but passions in the mainland have been just as heated — and, seemingly, almost exclusively against the demonstrators.

A pro-protest tweet by a Houston Rockets executive, Daryl Morey, ignited a firestorm of anger against the N.B.A., demonstrating the depth of feeling. Joe Tsai, the only N.B.A. owner of Chinese descent, said all of China — yes, more than one billion people — felt the same way.

“The one thing that is terribly misunderstood, and often ignored, by the western press and those critical of China is that 1.4 billion Chinese citizens stand united when it comes to the territorial integrity of China and the country’s sovereignty over her homeland,” he wrote. “This issue is non-negotiable.”

For Westerners, this is strange language. You don’t hear about the common feelings of 300 million Americans or 60 million Brits, especially in the era of Donald Trump and Brexit.

Yet, in China, there is some truth to it. Of course, it’s a vast country brimming with opinions.

But the Communist Party has spent decades preparing the Chinese people for a moment like this. The stir over Hong Kong shows, in dramatic fashion, how successful it has been, and how the world could be shaped by it.

“As soon as the Communist Party pushes the patriotism button, Chinese will rise up like zombies to unite against the foreign forces, be it Japan or N.B.A.,” said Mr. Yang, the singer-songwriter. “They don’t always know why they’re against those things. In fact, many Chinese like Japan and the N.B.A.”

Until Thursday, when China’s internet minders dialed down the passions, the Chinese online world was filled with denunciations of the protests. Some Chinese people have even scaled the Great Firewall, China’s highly effective online censorship system, to post anti-protest messages on services like Facebook and Instagram that their own government doesn’t want them to see.

Their comments reflect a narrative that China’s top-down education system delivers from a young age. A united China, a country with a common purpose, can stand strong against outsiders, according to this narrative. A divided China could slip backward, losing decades of progress and plunging the country back into chaos.

Any Chinese person who has gone to elementary school or watched television news can explain the tale of China's 100 years of humiliation. Starting with the Opium Wars in the 19th century, foreign powers bullied a weak and backward China into turning Hong Kong and Macau into European colonies. Students must memorize the unequal treaties the Qing dynasty signed during that period.

There’s even a name for it: “national humiliation education.”

This narrative glosses over a lot of history, including the cruelty of Mao’s revolution, the starving of millions during Mao’s Great Leap Forward and the madness of his decade-long Cultural Revolution. When it does include the 1989 crackdown on protesters in Tiananmen Square, the protest and its aftermath is mentioned in one sentence and portrayed vaguely as a political incident.

These lessons and propaganda sound crude, but they work. For years, I regarded Chris Patten, the last Hong Kong governor under the British rule, as “a sinner condemned by history.”

That’s what state media called him, especially after he approved spending heavily to build Hong Kong’s new airport, leading to accusations of waste. Today, I regularly use that airport, a marvel of modern transportation, as do millions of others.

Of course, my friends and I watched with great pride Hong Kong’s handover ceremony from Britain to China in 1997. Territorial integrity achieved! 
At the graduate school of journalism at Columbia University in 2002, one American student told me about his trip to Tibet. I was so incensed by his remarks that I blurted out, “Tibet is part of China!”

For Westerners, perhaps one way to understand would be to read “Educated,” a memoir by Tara Westover about escaping her survivalist Mormon family in the mountains of Idaho. It has nothing to do with China. But her struggle to unlearn what her parents taught her felt familiar to me after I left China and began to learn its history on my own.

The rise of the internet and China’s opening were supposed to widen views there. Instead, the party is narrowing them more. Education officials over the past two years have been increasingly enforcing a widely ignored 2004 effort to make education even more Chinese focused.

In some middle school history books, the Cultural Revolution is described as “a detour in the Communist Party’s expedition,” rather than as a mistake. Some universities have replaced textbooks by Western academics such as Milton Friedman and N. Gregory Mankiw with books written under a program called “Marxist theory research and building project.”

Textbook publishers have cut back on essays by Lu Xun, a writer known for his acerbic criticism of the nationalist government in the 1920s and 1930s. They were once a mainstay of school texts, but some Chinese people have used his articles to criticize current events. One, about how Chinese people should welcome criticism from foreigners, was posted on the social media platform Weibo this past week after the N.B.A. debacle, then was pulled down.

Already, China has become more effective at delivering its message to its people. Slogans that I learned without much conviction more than 30 years ago — like “Without the Communist Party, there would be no China” — are making a comeback.

These lessons might seem removed from the situation in Hong Kong, where the protesters are mainly Chinese, not foreigners. But state media has portrayed the protests as foreign driven, sometimes identifying Western bystanders and journalists — including one working for The New York Times — as American instigators.

State media also portrays the protests as a push for Hong Kong independence from China, a direct effort to tap into those feelings of territorial integrity. That thought has echoed. Mr. Tsai, the N.B.A. owner, called the protests “a separatist movement.”

But only a fringe group of protesters support full independence from the mainland. The five core demands of the protesters don’t include it. It’s an important distinction, one that Mr. Tsai’s newspaper — The South China Morning Post, owned by Alibaba, the Chinese e-commerce giant where Mr. Tsai is executive vice chairman — is careful to make.

For China, the big danger is that it will become even more intolerant of criticism and different opinions.

A Chinese blogger wrote this week that a renovation project at a top Beijing middle school was causing widespread health issues, giving students bloody noses several times a day. The reaction was strong, and strongly against him. Many students told him there was nothing wrong with their school and even if there was, it was none of his business. “He should have shut his mouth just like N.B.A.’s Morey,” wrote one commenter.

Mr. Yang, the singer-songwriter, said “all hell broke loose” after his family and members of his band learned that he supported the Hong Kong protests. His younger brother told him he was sick in his mind. Former classmates castigated him online.

“The Hong Kong protests have definitely made them a lot more patriotic,” he said.

Over the years, he had tried to show people around him the videos of the Tiananmen Square crackdown and other events. His family told him that he should look at the brighter side of the history. The party has since provided education, jobs and pensions, they said.

“I feel as alone as an island,” he said. “I’m surrounded by very familiar strangers.”

Li Yuan writes the New New World column for The Times, which focuses on the intersection of technology, business and politics in China and across Asia.

Tale risk

How stories can help explain booms and busts

Once a narrative takes hold, it can drive markets

EVERYONE KNOWS, or thinks they know, the story of the Wall Street shoeshine boy. In 1929 Joseph Kennedy, patriarch of the Boston-Irish political clan, had an epiphany while his shoes were being cleaned. When the boy who shined his shoes offered him stock tips, he realised the stockmarket was about to implode. Kennedy promptly sold all his shares and took a short position, betting that the market would fall. When it crashed that October he made a killing.

In his new book, “Narrative Economics”, Robert Shiller, a Nobel laureate, offers this tale as an example of a contagious narrative that becomes part of folk wisdom. A story need not be accurate to spread. Mr Shiller searched archives of newspapers from the period, and could find no record of it.

But he did find a similar kind of story in the Minneapolis Morning Tribune. The stockmarket, it said, could not yet have peaked because “we do not hear of the chamber maids and bootblacks who have cleaned up fortunes by lucky plays.” That story was published in 1915.

Whatever their provenance, says Mr Shiller, it matters which kinds of narratives are contagious and why. The ones that catch on have the power to influence behaviour. Stories sway decisions to hire or fire; to buy or sell; to spend or save.

These individual choices, writ large, move markets and drive the business cycle. Fundamentals such as prices and profits are just one part of the reckoning. The stories that people tell themselves and each other matter at least as much.

To wield such influence, economic narratives must first become popular. Epidemiology offers a model for how they take hold. Disease epidemics are hump-shaped when plotted on a graph. In the rising phase, the rate of increase of newly infected people (the contagion rate) is faster than the recovery rate plus the death rate.

When the recovery rate exceeds the contagion rate, the epidemic falls off. It is the same with stories. A growing number of “infected” people spread the narrative; later on comes a period of lost interest and forgetting.

The most contagious economic narratives drive boom-and-bust cycles. Such narratives have common features. They tend to be oversimplified models of reality and thus catchy.

Their success may owe to a “super-spreader”, perhaps a celebrity, capable of infecting many people. And they are often part of a narrative cluster, which adds weight to their plausibility.

The stockmarket boom of the 1990s was powered by an array of stories: the triumph of capitalism; the rise of the internet; the decline of inflation; and so on.

Some of the most contagious narratives are newer, more resistant variants of old ones. Behind every property boom is a mutation of the eternal narrative about the scarcity value of land.

“Who could think of tilling or being contented with a hundred acres of land, when thousands of acres in the broad west were waiting for occupants,” says a tract documenting the follies of America’s land boom of the 1830s.

The global housing boom that led up to the Great Recession of 2007-09 was driven by narratives that persuaded people to think of their homes as speculative investments in scarce land.

A science of economic narratives, of the kind Mr Shiller calls for, would require high-quality data. It would need regular surveys designed to draw out people’s justifications for their economic decisions.

But interpreting even good data would be tricky. Narratives tend to be ignored by economists because their links to events are complex and variable—as Mr Shiller himself notes. Any official data on narratives would, once published, surely become part of the narrative itself.

The most prominent economic narratives today are not cheery. A monthly survey conducted by Bank of America finds that two-fifths of fund managers expect a recession in the next year. The same proportion thinks the trade dispute between America and China will never be resolved.

Besides the trade war, fund managers list the impotence of central banks and a bubble in bond markets as their biggest worries.

Take these messages, add to them bleak surveys of business confidence worldwide, and you might decide to batten down the hatches for a coming storm.

If so, you may still be troubled by a nagging doubt, a sense that the story does not quite add up.

The usual end-of-cycle euphoria, which causes companies to make unwise investments and draws greenhorns into speculative assets, is not there.

The chambermaids and bootblacks have gone missing.