Is more education always a good thing?

“It is the mark of an educated mind to be able to entertain a thought without accepting it.” Aristotle

The motivation for this post largely stems from something that I’ve been looking in my macroeconomics classes. In particular, we’ve been studying Romer, Mankiw and Weil (1992), where they put the Solow model through its paces. Amongst other things, they find a positive correlation between % of child population at school and GDP. It is this result that I focus on in this post.

One inference from this result is that education increases GDP. Specifically, the higher proportion of people that are in education, the higher your GDP level will be. Bear in mind that this isn’t a controversial statement - it makes sense intuitively, and there has been a large amount of academic work on this topic (see here for a comprehensive review of the literature).

But does this mean that governments should strive to make every child go into as high an education as possible? Does it necessarily mean that if 100% of country's young population went to higher education, it will have higher GDP than if only 90% did? A simple model that I’ve tried to construct suggests that this might not be the case.

First, we have to define the role education takes in society, of which there are many theories. The obvious one is that it is an investment for the future (the idea of human capital) - going to school gives you the skills required to do any job. Though this may be true by-and-large, there are other theories put forward as well. An interesting one is that education is a consumption good, meaning that people enjoy learning just like they enjoy going to the movies or eating at a restaurant. Another, and the one that I embrace here, is that education acts a signalling mechanism for employers. Michael Spence (1973) was the pioneer of this line of thinking, and went about characterising it famously in his seminal paper. In discussing the effect of education on economic growth, I develop a variant of the Spence model to express my ideas.

The model

Say there are two types of individuals: ones with high ability and ones with low ability. There are also two types of education: high education or low education By assumption, education works predominantly as a signalling mechanism of ability. As the employer doesn’t know what type of ability an individual is, they can only gauge this by level of education. Thus, the employer can only characterise high education as synonymous with high ability, and low education with low ability.

The table below summarises the model, using two elements, wages and productivity stemming from jobs for the two types of individuals and education levels.



Wages (denoted by the first entry in each cell of the matrix element):
As a result, high ability individuals who have pursued high education are hired into industries where they receive a wage of 4, while high ability people who have low education are hired into industries where they receive a wage of 2 (note that the employer can’t tell they are high ability, so only offers them a low ability job).

A low ability person with high education gives an employer the impression that they are of high ability. This gives them a chance to earn the same wage as a high ability person - 4. Through the vetting process though (interviews etc), some low ability people are found out, and only get jobs where the wage is 2. But some low ability individuals pass these interviews and get a wage of 4. The average wage for them ends up being somewhere in the middle, say 3. Similar to the high ability worker with low education, a low ability worker with low education receives a wage of 2.

Let there be some outside opportunity that ensures not all individuals can enrol in high education. There may be, for example, monetary or family circumstances restricting them from pursuing higher education. This ensures that the signalling mechanism remains intact. (As the expected wage after high education is higher than low education for both ability types, there has to be an outside opportunity or else everyone would pursue higher education, rendering the signal useless to employers.)

Productivity (denoted by the second entry in each cell of the matrix):
Because education solely serves as a signal for employers, no matter how much education someone gets, their ability is the single determinant of which jobs they will be good at. Consequently high ability people will be more productive at jobs requiring high ability and low ability workers will be more productive at jobs requiring low ability. High ability workers can only offer productivity of 4 in jobs that require high ability. Similarly, low ability workers can only offer productivity of 4 in jobs that require low education (and hence low ability). The other productivity entries are 2, signifying the loss of productivity of workers in the wrong jobs.

Intuitively, this could be for a number of reasons. High ability people might, for example, feel demotivated - they know they should be getting paid more, but instead are having to do jobs which they dislike. This could easily lead to a reduction their productivity in these low ability jobs. Likewise, low ability workers just do not have the cognitive skills to be productive in a job requiring high ability individuals, and so can only offer productivity of 2.

It's worth noting here that I am not using the notion of linking wages to productivity, like the vast majority of economic literature does. In fact, as education is purely a signal for ability (and hence productivity), I link wages to the employee's PERCEIVED productivity, gauged by his education level.

So what?

Due to the existence of this wage differential between high and low ability workers, low ability individuals are incentivised to pursue high education in the hope of employers classing them as high ability and giving them the associated job (with the corresponding high wage). As education hasn’t taught them anything meaningful about how to do the job, they aren’t as productive in the jobs requiring high ability as they would be doing a low ability job. On the macro-level, this leads to an inefficient allocation of workers, who are employed in ill-suited industries. This then amounts to a less-than-optimal growth profile for the economy as a whole.

A couple qualifiers

Clearly, this is a gross oversimplification of the distribution of ability and education levels across an economy. There are obviously not just two types of education and abilities. However, as is common in economic modelling, simplifying the problem into ‘bitesize chunks’ or taking an idea to one extreme allows for easier inference of outcomes. Subsequent analysis of the effect of relaxing assumptions also become easier once this is done.

Education is by no means only a signalling mechanism. There are certainly things that I have learnt in university that are useful for any job. But a quick look at the cohort of any graduate class shows that there certainly is an element of signalling in the hiring process. Generally, graduate recruitment schemes do not solely hire from one department in a university that teaches only the specific set of skills required for a job. More often than not, young employees are urged (some even required), to undertake further professional qualifications in their field of work. This, to some extent, shows that employers see education as more than just an accumulation of human capital, but rather a signal of motivation, ability and so on. It is within this context that I think this idea relevant to the debate of economic growth.

The bottom line

As many studies have shown, the returns to higher education is positive. Inferring that increasing student school rates from any beginning level will increase a country’s GDP, I think is taking the prescription too far. Furthermore, it could actually reduce the growth rate of the economy, as workers (hoping to get a higher wage) go for higher education and aim for jobs in industries where they are not well-suited, eventually reducing the economy’s productivity.

I hope to do some further empirical work on this in the future before accepting this theory for something legitimate, but for now, it’s something I think is worth contemplating nonetheless.

Special thanks to Professor Alwyn Young and Tejus Morland for acting as sounding boards for ideas on this topic.

Reasons behind the effects of a weaker Euro

“The art and science of asking questions is the source of all knowledge.” Thomas Berger

In Getting low: the effects of a weaker Euro I discussed, through the lens of exchange rate pass-through, how the potential (and foreseeable) loosening of Eurozone monetary policy will likely affect Euro area economies. Considering the importance of this characteristic in determining the outlook of both growth and inflation, as well as the extent of easy monetary policy in the Euro area, it seems worthwhile to discuss why these countries show the pass-through that they do. In this post, I’ll outline the main theoretical aspects that determine the magnitude of PT. For those who are interested, Burstein and Gopinath (2013) carry out a more comprehensive (and better written!) review of the current academic literature around this topic.

Recall the chart and a couple of observations from my last post:

Observation 1: The import price PT is less than 1 for all countries. Put simply, a 10% depreciation in the euro translates to a less-than-10% rise in import prices. 

Observation 2: Export prices rise when the currency falls. This means that exporters raise the price of their goods (in Euros) as the euro depreciates.

Explanation 1: Invoicing currency decisions

An exporter can choose to price their international goods in either their own currency, or the currency of the foreign consumer. Choosing to price their goods in their own currency, defined as Producer Currency Pricing (PCP), means that a given depreciation of the currency will mechanically feed through into a lower price for the foreign consumer. As such, this pricing strategy gives rise to high PT and the expenditure-switching effect. 

If the producer prices their good in the currency of the foreign consumer, called Local Currency Pricing (LCP), then the currency depreciation has no effect on the effective price for the foreign buyer (as its already denominated in their own currency). Consequently, there is no PT, the foreign buyers don't buy more of the good and so there is no expenditure-switching effect.

This goes some way in explaining observation 1. Given the reserve-currency status of the Euro (it is one of the most important currencies in the world), it doesn’t seem inconceivable that some of these imported goods are priced in Euros. Indeed, that’s what we see in the data. According to Eurostat, 41% of imports to the euro area in 2012 were priced in euros in 2012, second only to the USD (which stood at 55%). As a euro depreciation won’t directly change the price of those imports priced in euros, 41% (as of 2012) of the imports to the euro area won’t change in effective price - explaining why the data do not show full import price PT.

Explanation 2: The currency of costs

In this day and age, an exporter will not build his whole product in one country. For example, VW in Germany will not source all its materials and parts within the Eurozone. Rather, it import parts from the US and China etc. and then combine these to build a VW Golf that is then exported. Consequently, a depreciation does not only affect a firm’s revenue (by affecting how much the car sells for abroad), but also its costs in the form of imported intermediate goods. If the euro depreciates, the cost of a car part from the US (contracted in USD - remember around 55% of euro area imports are priced in dollars) becomes more expensive, raising its production cost for the entire car. This means then, that the German exporter has to raise its price to ensure its profit margin stays constant.

This can be used to explain observation 2. As the euro depreciates, producers try to maintain their profit margins by raising their export prices to counteract the increase in imported intermediate-good costs.

Explanation 3: The production capabilities of firms

This explanation stems from the economic theory of returns to scale. Broadly, this states how a firm’s costs change as the quantity it produces increase. The normal assumption (and one that has a large standing in the empirical literature as well as lot of theoretical models) is decreasing returns to scale (DRS). This states that the more a firm produces, the more costly it is to produce one unit of output. Imagine VW produced 5 cars at a cost of €5,000 (€1,000 each). If VW had DRS, producing 10 cars would cost them €15,000 (€1,500 each). [Incidentally, if it cost them €10,000 to make 10 cars (€1,000 each), we would say VW had constant returns to scale.]

How does this fit into our PT story? Well, a depreciation means that euro area goods are somewhat cheaper for foreign consumers (not 1-to-1 cheaper, because we know PT isn’t full, but we know that there is some change in prices), so demand for these goods rise. To meet this increased demand, that firms have to increase their output. But if they exhibit DRS, then each unit (on average) now costs more than before. Similar to in Explanation 2, firms raise their export prices in response, as they try to maintain their profit margin. The result is that we end up with another explanation for observation 2, where exports prices (in euros) rise as the euro depreciates.

It is important to note that explanation 3 works better if we see large changes in the exchange rate. An increase in demand from 5 to 6 cars would not affect a firm’s costs as much as an increase from 5 to 20. Given I used monthly changes in last week's analysis, this may not include large enough changes in the euro to capture explanation 3 in its entirety. Even so, I think it's still an aspect worth appreciating to understand the drivers of pass-through more generally.

The bottom line

While there are many other aspects determining the magnitude of exchange rate pass-through (see Burstein and Gopinath (2013) for a more technical discussion), the three highlighted above seem the most relevant given we are looking at the relationship between aggregate price indices and the trade-weighted euro. Though the previous post states and discusses this relationship, this post goes some way into explaining why these relationships exist. Consequently and importantly, it allows us to have a framework by which to understand how and why these relationships might change going forward. It is, no doubt, a great example of how important asking the question ‘why?’ is to the attainment of knowledge. 

Getting low: the effects of a weaker Euro

“Insanity: doing the same thing over and over again and expecting different results.” Albert Einstein

Following last week’s European Central Bank (ECB) monetary policy meeting, Mario Draghi was very clear in stating that the Governing Council stood ready to embark on further monetary easing should the Eurozone growth and inflation outlook deteriorate further. More specifically, he said that the QE programme could be adjusted in size, composition and duration while deposit rates charged to banks be lowered into negative territory, if necessary. As he spoke, financial markets moved sharply. Euro-USD exchange rate fell sharply, from just above 1.135 to a low of 1.10. (For those who aren’t familiar with FX magnitudes, that’s a large move in a short space of time!). 

Draghi for the past two or three years has quite often made a point of ‘talking the Euro lower’, with phrases like ‘the Euro is increasingly relevant in our assessment of price stability’ and ‘a strong Euro is a cause for serious concern’, so this new signal of monetary easing could easily push the Euro lower still. The question then remains: what does a weaker Euro actually mean for growth and inflation? This post tries to address this question.

(OK - so I must confess, this topic is now significantly more relevant than when I first started thinking about this issue, but hey, I’ll take it!)

A good way to think about exchange rate effects on economic variables is by looking at exchange rate pass through (PT). Pass-through is normally associated with inflation, but choosing which inflation measure to look at is clearly paramount. In this case, the exchange rate should work primarily through the trade channel (affecting import and exports), and as such I define PT as the effect of a change in the exchange rate on import and export prices. To get a reasonable idea of the Euro area as a whole, I look at the four largest Euro economies - Germany, France, Italy and Spain - which account for 78% of Euro area GDP.

The theory

Basic economic theory suggests that for exchange rates to matter for the economy, there has to be large or 'full' PT. This is the idea that import prices move one-for-one with the exchange rate while export prices (denominated in the home currency) do not move at all. 

For example, if the EUR depreciates by 5%, full PT would require German import prices (in Euros) to rise by 5% and export prices to remain unchanged in Euros and hence fall by 5% in foreign currency terms. This rise by 5% in import prices would mean foreign goods are now more expensive, and domestic German goods relatively cheaper. Both foreign and German consumers then switch to buying German goods, leading to higher German growth. This, in economic parlance, is called the expenditure-switching effect.

In addition, those goods that were previously imported are now more expensive, so prices of goods in the ‘consumer basket’ are higher, pushing inflation higher. Note that this is based on the assumption that all exported goods are priced in the currency of the producer. But let us work with this simplifying assumption for now. 

What does the data say?

I collect and calculate monthly changes in import price (IPI) and export price (EPI) indices for each country (both in home currency and using country sources), Brent crude oil price (OIL) and the trade-weighted euro exchange rate (EUR). The data are monthly in frequency, beginning in January 1990 and are collected using Thomson Reuters Datastream. 

-------------------------------For the more technical reader--------------------------------

To analyse PT, I run two autoregressions, similar to those published in Gopinath & Burstein (2013) and Campa and Goldberg (2005). For imports, I regress import prices at time t on its own 6 lags, 6 lags of EUR and 6 lags of OIL. Similarly, for export prices, I regress export prices at time t on its own 6 lags, 6 lags of EUR and 6 lags of OIL. I then sum across the betas of 6 lagged EUR variables in both regressions (a common technique in PT empirical studies) to get sensitivities over a 6 months time frame.

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The charts above show the sensitivities (or ‘betas’) of the IPI and EPI in the 6 months following a change in the exchange rate. For illustrative purposes, France’s import price PT is -0.85, meaning that a 10% depreciation in the EUR would, on average, lead to a 8.5% rise in import prices over the next 6 months.

A few observations:

1) Export prices (in Euros) rise when the currency falls. This means that exporters raise the local currency price of their goods as the Euro depreciates. 

This is not what the theory says, and hence is a failing of the simple theory - export prices do to not show full PT. A simple example to drive this point home: Say Euros depreciated by 5%. Goods that would be normally 5% cheaper for foreign buyers are now only 1% or 2% cheaper because producers raise their price in Euros. This therefore means that import price PT is much higher than export price PT. 

2) The change in import prices is higher than export prices for each country. 

3) There are significant differences in the price sensitivities across the 4 countries.

Implications on the euro area:

Note that the ECB’s inflation mandate says that consumer price inflation (CPI) should be close to, but below 2% and that changes in the CPI can be broken down in domestic producer prices + import prices - export prices.

Assuming the change in exchange rate does not change domestic producer prices much, import prices will rise by more than export prices (observations 1 and 2) following a depreciation. This means that the change in import prices minus the change in export prices is positive, and so inflation rises. In other words: a euro depreciation should raise inflation across the Euro area.  

From observations 1 and 2, producers raise their export prices to offset the effective reduction in prices for foreign buyers arising from a currency depreciation. Consequently, demand will not increase as much as it would have done if they didn't raise the price (as the theory assumes). 

The end result?  The potential growth kicker from higher export volumes is dampened by firms’ pricing decisions. Moreover, even though import prices rise and hence domestic consumers buy more domestic goods, the boost to growth is likely to be lower than what people expect from a currency depreciation because of this dampened export PT.

Implications for country growth and inflation:

Now let’s combine this with observation 3. Import PT is the highest in Spain and France, while lowest in Germany and Italy. The mirror opposite applies to export PT. Let us take the two extremes, Germany and Spain, for illustration purposes.

On imports:

By only looking at PT rates, we can infer that a given depreciation in the Euro means higher growth in Spain than Germany - Spanish import are prices rise more than in Germany, so Spanish consumers switch to buying more domestic goods than German consumers, spurring growth.

Remember though, that Germany has the largest proportion of its trade with non-euro area members out of the big 4 countries. Interestingly, Germany seems well placed to take advantage of a depreciation from a trade perspective, but its poor import price PT means that it can’t. 

Conversely, Spain has the smallest proportion of its trade with non-euro area members, but has the largest PT. Though its import prices move a lot following a deprecation, it doesn’t actually matter for the economy because Spain predominantly trades with countries whose currency is also denominated in Euros.

On exports: 

Here, the story is the other way around. German firms’ decisions not to raise prices following a depreciation does mean cheaper goods for foreign buyers. Germany’s major trade links with non-euro area countries ends up being a major boon for its economy.

Spanish producers on the other hand choose to raise prices following a depreciation (more than Germany). In other words, the effective price of a good for a foreign consumer doesn’t change much even following a depreciation as Spanish producers raise its prices. Therefore, a depreciation doesn’t end up being a big deal for Spanish export growth.

The bottom line: 

There are two aspects that are required for a currency depreciation to have a meaningful effect. The first is a high pass through. The second is that the country must do a lot of trade with countries who have a different currency.

Draghi's message of a lower Euro has been a persistent narrative over the past few years and with more monetary easing on the horizon, a depreciating Euro is likely to continue for some time. When we take into account both trade links and the pass-through story, the analysis suggests a euro depreciation predominantly pushes German exports higher with little effect on much else. There are very little (first-round) effects on either the Spanish economy or German imports. It also follows that German growth is likely to be the major beneficiary of a euro depreciation, compared to Spain or France. 

In a world where euro-area growth has historically been very uneven as the Euro depreciates, this pass-through angle suggests that expecting anything different going forward would be nothing short of insane.

Changing market dynamics

“Noticing small changes early helps you adapt to the bigger changes that are to come.” Spencer Johnson

The Federal Reserve chose to keep interest rates on hold on their 18th September committee meeting. Despite improving household spending, business investment and labour market, the committee judged (correctly, in my opinion) to pay heed to economic and financial developments abroad. In response to the announcement, world equity markets fell. The S&P fell 1.6% on the day of the announcement and other equity markets followed suit.

Those who believe in market efficiency (i.e. that markets price in the ‘true value’ of the stocks at any point in time) would conclude that investors believed that the Fed made a mistake in its decision, and that the US economy was in fact strong enough to withstand a rate hike. In doing so, they would argue, the Fed has introduced more uncertainty into the economy, thereby warranting lower equity prices. The policy implication from this is that the Fed should ‘just get on with it’ and hike rates, as it should not cause too much of a disruption to the markets. A very simple bit of analysis by looking at what I call the ‘market reaction function’ to economic data suggests this isn’t quite the case.

First, a word on the data: I use the Citi US Economic Surprise index to represent ‘economic data’. It looks at every single US economic data release and compares it to what was forecasted by economists (the assumption to make it meaningful is that the economists’ forecasts closely represent what is expected by investors). Essentially, if the data release is better than expected, then a positive number is registered in the index. Likewise, if data is worse than expected, a negative number is registered. Using these elements, a cumulative index is created. The chart below shows the average (mean) return of the S&P on days when economic data releases ‘beat’ expectations (i.e. positive surprises), and days when it ‘missed’ expectations (i.e. negative surprises).

The period from 2005 onwards (which I think is a long enough sample set to think of as the long run/normality) shows how equities should react to economic surprises. Theoretically, equities should go up on days with positive releases as it signals to the market that the economy is healthier than people believe, which should translate to higher profits for companies (and therefore higher stock prices). Conversely, equities should go down on days with negative releases for exactly the opposite reason. 

Convention was turned on its head in the second half of 2013. With the Fed still conducting its QE programme and signs of its upcoming termination emerging, markets became jittery and appeared hooked on QE. Any piece of negative news that suggested the Fed would delay the ending of its QE programme was met with jubilation by the markets.  This is shown on the chart by S&P returns significantly higher on days where data ‘missed’ expectations than those where they ‘beat’. This was the very much a characteristic of the ‘taper tantrum’ that many commentators and media outlets continue to speak of. Essentially, the market would only go up if there were signs of a prolonging of QE, as there was little faith in the strength of the US recovery. The Fed subsequently ended its QE purchases in October 2014, and the market dynamics eventually returned to normal (the third pair of bars - Jan 2015 to August 2015). Until recently. 

Since the FOMC announcement in September, it seems the market has begun to be jittery again. Now, negative news is being met, on average, with positive returns in the S&P, and certainly much higher than the corresponding returns on a day with positive economic news. (Note that I have used mean returns here, but using medians produce the same results). From this, it doesn’t seem as if the market is sure about the strength of the economy at all - somewhat similar to the second half of 2013.

So what caused the S&P to fall after the announcement? Surely if the market wasn’t sure about US economic prospects, a delay of the rate hike should be push equities higher? In theory yes. In practice though, what I believe happened is that those investors who thought the Fed would not raise rates bet on this by buying equities BEFORE the announcement. The more and more people did this, the higher the price got. Once the announcement came out in favour of those investors, they cashed in and sold their stocks, having already made a profit running up to the event. And if a lot of people do this, the price falls. This is what, in ‘trader-talk’, is called ‘an unwinding of heavy positioning’. If we look at the price data, this is exactly what we see. From the 1st September to the 18th, the S&P went up 4%, as investors bought equities in anticipation of the Fed not hiking rates. Indeed this is corroborated with a various articles citing that the Fed funds rate rise expectations was being pushed out towards December/January 2016.  And then low and behold, as soon as the announcement was made, the S&P was down 1.6% the following day as those who made money on the way up sold their equities. 

The bottom line

The implication from all this is that the market reaction function has changed, and shows characteristics similar to that of H2 2013. Now, to be clear, I do not believe that we will get a ‘taper tantrum’-style scenario, with violent swings in all asset-classes, if the Fed does raise rates - the economy is certainly a lot healthier than it was back then, and I think everyone is aware of that. The point is that there again seem to be doubts creeping into markets as to how strong this recovery is. If the FOMC care at all about the market reaction to its decisions, it may well benefit from not normalising policy just yet. Indeed, noting this small change early on could save the Fed from a disastrous normalisation of policy that is to come.

Free money?

“There's No Such Thing as a Free Lunch.” Milton Friedman

My last post, ‘Too good to be true’, looked at Jeremy Corbyn’s most contentious economic proposal, People’s QE. I highlighted two issues: the threat to the BoE’s independence and the belief that the debt can be cancelled and then proceeded to discuss the first. In this post, I deal with the second.

Recapping from last week: 

"So what is People’s QE? Well, it begins the same as QE, with the BoE creating money. But this money is then only allowed to be used “under government direction and subject to government guarantees” to buy bonds of a new institution set up to promote investment and innovation the UK, called the National Investment Bank (NIB). Moreover, it is believed that the debt created by the NIB can be subsequently cancelled on a technical detail."

Earlier this year, Richard Murphy put forward his proposal for Green QE (the policy idea that spawned People’s QE). In his post, he writes that Government debt bought by the BoE as part of a QE programme is cancellable. This in and of itself, he argues, is no different to conventional QE:

"The government no longer pays interest on this £375 billion of its borrowing, because to do so would mean that it would simply be paying interest to itself since the government gilts now belong to the Bank of England, which is in turn owned by the Government. That’s one clear indication that the debt no longer existed, because if it did the interest would have been due. And that is quite obviously true: whilst one part of government can obviously owe money to another part, if no one outside government is due money as a result there can be no government debt owing, and that has been the consequence of QE."

He explains again, in another post:

"If the government buys its own debt then it cancels it. This, as  a matter of fact, is true. It is, of course, technically legally possible to argue that the debt still exists, but if I create a loan to myself, even if it is legally recorded, it has no economic consequence:  my repayments of my loan from me to me means that no money actually in net terms leaves my own pocket and that is exactly what  happens when, as a consequence of any form of quantitative easing, the government owns its own debt.   So, quantitative easing actually cancels government debt and does not increase it."

Now, this might not sound like a big deal but it has enormous ramifications for economic policy. First, it means that the motivation for embarking on a QE programme could have nothing to do with monetary policy, but rather fiscal issues (which bring us down the route of questioning central bank independence). Second, it means that the government could essentially be getting free money. 

So, it makes sense to figure out what is actually happening. In the rest of this post, I’ll explain why I think government debt bought in a QE programme CANNOT be cancelled under the current framework.

The evidence

A look at the correspondence between the BoE and the Treasury gives us a fair idea of the financial agreements in place between them. The first thing to remember though, is that the Government is indemnified to the Bank of England (BoE) and its subsidiaries, i.e. the Government covers losses as well as receives profits arising from the BoE’s activities. 

In the Monetary Policy Committee (MPC) meeting of 7-8 November 2012, committee members were briefed on (and subsequently agreed to) the Government’s request to receive excess cash, on a quarterly basis, from the entity set up to carry the QE transactions (the Asset Purchase Facility - APF). This excess cash was defined as the interest paid by the Government on the bonds the APF held as part of their QE programme, minus operating and other costs. 

When the APF was initially set up, it was agreed that the total profit/loss for the APF would be settled with the Government when QE was finished and the APF was closed. During that time, the Government would borrow money to finance the interest payments on the bonds that the APF owned (just as if the bonds were owned by private investors). 

George Osborne, in his letter correspondence with Sir Mervyn King (former Governor of the BoE), argued that with the UK recovery sluggish, it was apparent that the APF would be around for a while longer. This then meant that the APF’s cash balances from received interest payments (a sizeable £35 billion at the time) would continue to grow. Osborne (correctly) argued that the Government was borrowing too much to fund these payments, and the set-up was economically inefficient. Therefore, he said, it made sense to transfer the cash back on a quarterly basis.

Essentially, the Treasury believed that as the APF was just another governmental department, it made little sense for one part of the government borrowing to fund another, and so the interest payments were economically moot. So far, so good for Murphy and his theory.

The letters though, made clear that these payment will likely be reversed in the future (due to the Government’s indemnity to the BoE) as the APF incurs losses on its bond positions when the MPC decides to sell their bond holdings and increase the Bank rate in response to a strengthening economy.

What does this mean?

The OBR noted in its press notice that the fiscal effect of this transfer would be two fold. In the short term, Government net borrowing would be lower than it would have been - so QE provides a helping hand to the government finances. In the longer term, the OBR said, it is likely to be higher than it would have been as the Government has to borrow to fund any losses the APF incurs, just as the letters noted. It's critical to realise that these losses could amount to MORE than what the Treasury saved from the APF’s quarterly transfers to it (depending on how violently the UK bond market reacts to the MPC deciding to raise the Bank rate). In this case, QE doesn’t cancel any debt, but in fact raises it. This is where Murphy's theory breaks down.  

What’s more, Mervyn King was sure to spell out that principal (cash) received from the maturing bonds would not be transferred to the Treasury, and would  be used at the discretion of the MPC. In an example: if the APF bought £100 billion of government debt as part of QE at an interest rate of 3%, though government would get a £3 billion windfall from this transfer set up, it would still have to pay £100 billion back to the APF (and hence the BoE) once the bonds mature. 

Also bear in mind that once the MPC normalises monetary policy by selling its government bond holdings back to the market and raising the Bank rate, the APF will no longer be the owner of Government bonds - private investors will. The Government will then have no choice but to resume making interest payments and the interest costs become, in some sense, ‘live’ again. 

So, government debt cannot be cancelled; only interest payments can be cancelled (and that, only for a short period of time). But as I explained above, if the APF incurs substantial losses as part of the MPC raising rates, this doesn’t mean that QE will necessarily reduce government borrowing.

The bottom line

For People’s QE to be fiscally neutral (i.e. have no effect on government debt), the debt must be cancellable. This is, in my view, impossible under the current set up of QE. One way it could be done, is if the MPC is instructed to buy and hold government debt until maturity, and then create more money to finance any losses it might incur. The outcome? The loss of central bank independence.

In my first ever economics lesson, we were taught that economics is the theory of allocating finite resources to satisfy infinite wants. Richard Murphy seems to have forgotten the fundamental principle of economics; and in doing so has forgotten that there’s no such thing as a free lunch.

Too good to be true

“If it seems too good to be true…read the fine print to see what it will cost you.” Anonymous.

New leader of the UK Labour party, Jeremy Corbyn’s economic policies, dubbed “Corbynomics” by the media, have been a big talking point in UK policy-making circles over the past few weeks. The proposal causing the biggest stir, certainly within economics arena, is “People’s QE”. A variant on the ‘conventional’ Quantitative Easing that the Bank of England (BoE) undertook between 2009 and 2012, Corbyn and his advisers believe People’s QE is a sure-fire solution to the UK’s economic woes.

For those who aren’t familiar with the working of conventional QE, it works as follows: The Bank electronically creates money (by basically increasing the number of 0s in their bank account) and uses it to buy UK government bonds from private investors. This leaves these investors with unwanted cash which they then invest in other assets (because holding cash gives you 0% return). This then lowers longer-term borrowing costs, which should act as a stimulant for borrowing and spending which, in turn, stimulates growth and inflation.

So what is People’s QE? Well, it begins the same as QE, with the BoE creating money. But this money is then only allowed to be used “under government direction and subject to government guarantees” to buy bonds of a new institution set up to promote investment and innovation the UK, called the National Investment Bank (NIB). Moreover, it is believed that the debt created by the NIB can be subsequently cancelled on a technical detail.

I believe there are two big issues with this policy: 1) the threat to the BoE’s independence and 2) the belief that the debt can be cancelled. I will deal with the first in this post.

What is Central Bank Independence?

Gordon Brown, as Chancellor of the Exchequer, made the BoE independent from the Treasury in 1997. But what does independence mean? Broadly, it can split be into two parts - goal independence and instrument independence. Goal independence is when a central bank is free to set its own targets and mandates, absent of government involvement, whereas instrumental independence is when a central bank is free to choose the means by which to meet their targets or goals (with the instruments assigned to them).

As the Treasury sets the BoE’s mandate - to deliver price stability (low inflation at 2%) and support the Government’s economic objectives including those for growth and employment - it is clear that the BoE is not goal independent. But, it can choose how and when it changes interest rates to try to meet this target, and hence can be considered to enjoy instrument independence. 

Interestingly, a survey of central bankers around the world conducted by the Centre of Central Bank Studies at the BoE, showed that members didn’t consider goal independence high up on their list of determinants for central bank independence as a whole. Instead, they focussed on instrument independence and not having to finance the government deficit (i.e. not printing money for the government to spend) as two cornerstones of central bank independence. 

Worryingly enough, these are exactly the two attributes of central bank independence that People’s QE threatens. Under this new regime the Bank of England will take policy orders from the Treasury on how much, and when to create money for NIB purposes.

Richard Murphy, the economist whose ideas Corbyonmics is born from, is ‘quite sure’ that the BoE is not actually independent anyway, and hence the loss of independence doesn't matter:

"… If those who do really think that such decisions are wholly uninfluenced by the Chancellor of the day then I very politely suggest that they have suspended their disbelief in ways that our counter to sound analysis. I am quite sure that it does not happen like that, whatever the rules might say. The fact that the OBR is forecasting rate rises at the end of the year is, for example, the surest indication from the Chancellor to the BoE as to what they might do. Let’s not pretend otherwise."

Though he doesn’t give any sound evidence for his case, the fact that the OBR is forecasting rate rises at the end of the year, he says, is the Chancellor signalling to the BoE of what they should do. The BoE’s formal forecast of the Bank rate is just above 1% in 2016 Q3, so could it be that the OBR is merely following the Bank’s guidance? Moreover, given most economists are also expecting a rate rise towards the end of this year/early next year, the OBR’s forecast of the same really tells us nothing at all. Having spent an enormous amount of time at the Treasury and Bank of England as a consultant, Simon Wren-Lewis argues against Murphy on this point from an anecdotal standpoint. Granted, the legislation does say that the Treasury can “give instructions to the Bank on interest rates for a limited period”, in extreme circumstances. Given the financial crisis in 2008 was not considered an ‘extreme circumstance’ for the Government to direct the BoE, I can’t imagine anything aside from a World War that would be. So for the purposes of the near future, we can assume this is irrelevant.

The implications of the loss of central bank independence

A wealth of academic research stands behind the decision for BoE's independence. Empirical evidence suggests that central bank independence, on average, leads to low inflation (see here and here for good summaries of the literature). Independence increases the central bank's credibility insofar as it can't be swayed by political agendas. For example, around election time, governments are well-known to increase spending to stimulate economic growth to show the electorate what a great job they’ve done. If the central bank is sucked into these illusory political manipulations, its credibility for price-stability will be lost. Every election year, governments will likely force the BoE to loosen policy even  if it may actually need tightening. The loss of credibility of the BoE in and of itself will lead to unstable inflation and growth as businesses and consumers struggle to plan for a future with too much uncertainty. 

This loss of independence likely also reduces the BoE’s effectiveness in managing the economy. Consider the following scenario: Inflation has been rising for some time and the BoE wants to raise rates. At the same time, the Treasury believes that there is not enough investment in the UK and commissions the BoE to create £50 billion to buy NIB bonds. In effect, we have the BoE tightening policy by raising interest rates, while at the same time loosening policy by injecting £50 billion into the economy. The BoE would be fighting against itself in its entire existence. In short, the loss of independence could very easily lead to a neutralisation of the BoE’s ability to meet its inflation target.

Secondly, every piece of academic literature that I have read on this issue has encouraged precluding central banks from funding the fiscal deficit (i.e. creating money for the government to spend; see here and here for examples). In this case, with essentially unlimited money at their disposal, the government has a free-pass. The issue here is one of precedent. Even if the current government emphatically argues that People’s QE will be only used to fund investment projects, what is stopping another government from using it for another purpose in the future?  All it takes is one crossing of the line and a slippery slope awaits. Though a very different time and circumstance, given the right (or wrong!) unfolding of events, we could find ourselves in a 1920s Germany under Hjalmar Schacht, where the cost of living goes up by an order of 15x in 6 months, and where workers carry wheelbarrows of cash to the shops on payday to buy groceries before prices go up again. (OK, this is clearly an exaggeration, but you get the point!)

The Bottom Line

To be clear, I am in support of a National Investment Bank, which I think will help with the UK recovery enormously. Business investment has been seriously lacking in the UK since 2009 and it is no doubt the time, just as it has been over the past 6 years, for the government to fill the gap. Unfortunately, the costs in the fine print of "People’s QE" are just too high for it to be the panacea that Corbynomics makes out.

Decisions, decisions...

“We all make choices, but in the end our choices make us.” Ken Levine.

The Federal Reserve will, by the end of this week, have made one of the most important decisions in its 102-year history in deciding whether or not to raise the fed funds rate (the overnight inter-bank lending rate, used as a monetary policy tool) from its 0% floor. The consequences of its decisions will reverberate all across the world and may well affect future generations. The aim of this post is to discuss whether or not the correct timing of the rate-rise is now.

Economists are divided as to whether the Federal Open Market Committee (FOMC) meeting on Thursday and Friday will conclude with a decision to hike rates. Financial markets have priced in a probability of 20% for a September rate hike, but 60% for December. 

I am in support of a delay to the first rate hike for four reasons: 

1) The labour market is not as strong as people think
2) A broad range of inflation indicators continue to show weakness
3) We have already had some financial tightening via the market
4) The risks towards halting the recovery with a rate-hike are still too high.

The economy

The US economy in one word? Mediocre - that is, when compared to pre-crisis levels of growth. Compared to post-2007 though, a quick glance at the recent economic numbers in the US suggest an economy that is chugging along quite nicely. GDP growth was at 3.7% last quarter, far above the 5-year average. Importantly here, nearly every component of GDP contributed to growth, showing how broad-based the recovery really is. The US ISM (a survey asking corporate executives about their current business situation) remains above the 50% expansion-contraction line.

So far, the case for a rate-hike is somewhat powerful. But these are all indicators of what has already happened in the economy. Leading indicators, such as the Federal Reserve of Atlanta Now Indicator are showing signs of weakness, and the uncertainty of the global outlook (especially China) demands more caution from policy makers. 

From the domestic side however, the majority of the debate is in the labour market and inflation indicators. Though headline unemployment has halved since 2009 to 5.1% now, this masks a large divergence in both demographics and type of unemployment in the US. For example, underemployment (i.e. those who are working part-time or with zero-contract hours but want to work more) is still high, at 10%. This number was 9.5% at the beginning of the last Fed tightening cycle. 

The more underemployment falls, the more likely we will get the wage growth that Janet Yellen is so keen to see. And once wage growth picks up (so the theory goes) inflation is just around the corner. But so far, wage growth has been subdued. True, real wage growth (wage growth adjusted for changes in prices) has increased, meaning higher purchasing power for workers, but that is predominantly because of the transitory effects of low inflation - a cursory glance at the nominal wage growth indicators confirms this. 

Inflation

A large range of inflation indicators (including those that strip out effects from food and energy prices, which is believed to look past ‘noisy’ inflation) currently sit below 2%. Indeed CPI (the measure that is explicitly part of the Fed’s legal mandate) currently sits at 0.2%. With half of the Fed’s legal mandate so far away from its 2% target, what rationale is there to suggest that it is time for a tightening? 

The argument sympathises with the lagging effect of monetary policy. Much has been made of trying to estimate the lag with which monetary policy affects the economy, and results vary. What is clear though is that there is a substantial lag and in general, as Bernanke mentioned in 2003, accounting for this by being proactive and raising rates earlier than later is preferable. 

But this time isn’t ‘in general’. The US economy is on a straight but fragile path, where any sudden adverse movements will surely tip the US economy back in the recession. Even if inflation did rise rapidly, I would rather have a few quarters of above average inflation and be sure that the recovery was strong and healthy than try to curb mild inflation and risk another spiralling downturn.

Financial conditions

Central bank tightening policy is aimed at ensuring the economy doesn’t overheat. Tightening financial conditions via raising the rate for borrowers should dampen demand for debt, as well as raising the required rate of return for investment projects causing consumption and investment to moderate. Haven’t we just had a natural tightening of financial conditions courtesy of the markets? Summer 2015 was one of the most painful summers for financial markets since 2012, with the S&P 500 and Chinese stock markets down 7% and 40% from their peaks respectively. 

In 2013, around 50% of all US adults owned stocks, and if today’s number is anywhere near that, then the negative wealth effect stemming from the fall of stock prices may well be large enough to pare business and consumer confidence and keep a lid on the economy.

Raising rates risks damaging a fragile recovery

Finally, with interest rates at their effective lower bound - 0%, hawks argue that were the US to fall into recession, there would be no room for policy accommodation. To prevent this, the Fed should raise rates to allow room for cutting rates if need-be later. I’m sorry, what?! True, there is no conventional policy left, but all that will be achieved by raising rates is increasing the chance that the US will fall into recession again. Surely the more important thing is to ensure that the US economy DOESN’T plunge back into recession?!

The bottom line

So, this week is a very important week in the Fed’s existence - more important than almost any other rate rise in the past. A good decision, I believe, will be to delay the rate rise until at least the December FOMC meeting.

The above Ken Levine quotation is very befitting of Yellen's job at hand as she arrives at the Federal Reserve's two-story chandeliered Board Room on Wednesday. She and her colleagues are at a crossroads, and their choices will not only make them, but the rest of the world as well.

Welcome!

“You don’t write because you want to say something, you write because you have something to say.” F. Scott Fitzgerald.

Dear Reader,

Welcome to my blog! My name is Yad Selvakumar and I am currently a post-graduate economics student at the London School of Economics. As a former macro-research analyst at a large investment bank, my main focus (and interests) naturally involved macroeconomics and financial markets.
Pre-2007, financial markets were more or less considered by central bankers as a consequence of, rather than a input into, macroeconomic policy decision making. That is, the belief of efficient markets ran through the psyche of the Federal Reserve, causing large imbalances stemming from financial markets to be somewhat ignored. The Great Recession though, has taught us that the constant feedback loop between the economy and financial markets is incredibly important and requires very close attention. It is within this context that I hope to provide, in this blog, some insight into the world of economics and financial markets through the lens of economic history, theory and thought. Specifically, the majority of posts will discuss monetary policy issues - an area of special interest to me.

I hope to make this blog accessible to readers with a general interest in economics as well as economic students like myself. With this in mind, I will endeavour not to use economic jargon that so many commentators  love dearly. But when the situation leaves me no choice, I will try to explain them in layman’s terms. Finally in a nod to the Scott Fitzgerald quotation above, I pledge not to write for the sake of writing, but to write only when I feel I have something useful to contribute. For that reason I choose not to predetermine the frequency of my posts, instead defining them as “periodical”.

So, with the admin stuff done - here we go. Thank you for joining me on this journey, let’s make it a good one!