Savings Glut, Secular Stagnation, Demographic Reversal, and Inequality: Beyond Conventional Explanations of Lower Interest Rates

 

New Working Paper published by the Political Economy Research Institute (PERI). From the abstract:

Interest rates have declined over the last 40 years, a period of increasing inequality. The steady decline in interest rates has been interpreted by and large as resulting from a decline of the natural rate of interest. This paper surveys the main explanations associated with the notion of a decline in the natural rate of interest, including the savings glut and the secular stagnation hypothesis. It analyzes the views according to which demographic forces were behind the decline, and might perhaps be associated to a future rise of the same natural rate. It also discusses the view according to which the role of inequality has been also to affect the natural rate of interest. Finally, views that discuss the role of monetary and financial factors, including the so-called global financial cycle literature, are discussed. It is argued that the conventional view suffers from logical and empirical problems that are ultimately insurmountable. A brief critique of the notion of a natural rate of interest, and alternative monetary theory of the decline of interest rates, as determined exogenously by the monetary authority of the hegemonic country, the United States, is proposed.

Read paper here.

Capital Flows to the Periphery: Still ‘push’, but with significantly lower risk spreads

Gabriel Aidar and Julia Braga (Guest Bloggers)

We have, in our new paper, gone back to the old pull-push debate on determinants of capital inflows to emerging markets, to look at the behavior of country risk premium spreads. Our Principal Component Analysis of the country-risk spread series of ten emerging economies from 1999 to 2019 revealed that 86% of the total volatility of the original series can be represented by only two components, suggesting the prevalence of common factors in determining country risk. This evidence, reinforced by the correlation of the first major component with global liquidity indicators, corroborates our hypothesis that the sovereign risk trend is driven by external factors, in line with the push literature. This is clearly shown in the graph below that shows the Evolution of the EMBI+ emerging market risk spreads against EMBI Brazil over time.

Our contribution strengthens the thesis, stressed by Medeiros (2008), about the subordination of economic cycles in developing economies to global financial cycles. This in effect imposes an (asymmetric) constraint for the management of domestic monetary policy. To avoid capital outflows and/or successive exchange rate devaluations, the domestic interest rate should not remain lower than the international reference interest rate added to its country risk premium (Serrano and Summa, 2015). This constraint has changed significantly in the 2000s.

In the recent expansionary cycle of global liquidity, many developing economies seems to have taken advantage of this window of opportunity to simultaneously grow more and reduce their external vulnerability. These two movements ended up having the combined effect of lowering the collective external fragility of the developing economies (Freitas et al., 2016; Serrano, 2013). As a result of this change, developing economies experienced a virtually unprecedented period of reduction of Balance of payments crises. As we show in the paper, and can also be clearly seen in the graph, these favorable developments led to a once for all structural break at the level of sovereign risk spreads, that have fallen significantly after 2002. This seems to be the reason why the risk spreads have not risen again to the levels prevailing in the 1990s. Although the risk spreads continued to respond to international financial indicators and have risen both during the 2008/2009 world financial crisis and also in 2014/15, when the FED threatened to raise the interest rate and began to phase down nonconventional monetary policies, developing economies are now in a much better position to deal with those changes. This is what we can read in current pattern of risk premium spreads that, although still vary in response to changes of the relevant international financial indicators, do it around a significantly lower average.

References:

Freitas, F., de Medeiros, C. A., and Serrano, F. 2016. Regimes de política econômica e o descolamento da tendência de crescimento dos países em desenvolvimento nos anos 2000, in “Dimensões estratégicas do desenvolvimento brasileiro. Continuidade e mudança no cenário global: desafios à inserção do Brasil”, 17–46

Medeiros, C. A. de. 2008. Financial dependency and growth cycles in Latin American countries, Journal of Post Keynesian Economics, vol. 31, no. 1, 79–99

Serrano, F. 2013. Continuity and Change in the International Economic Order: Towards a Sraffian Interpretation of the Changing Trend of Commodity Prices in the 2000s, pp. 195–222, in Sraffa and the Reconstruction of Economic Theory: Volume Two, UK, Springer

Serrano, F. and Summa, R. 2015. Mundell–Fleming without the LM curve: the exogenous interest rate in an open economy, Review of Keynesian Economics, vol. 3, no. 2, 248–68

A predator–prey model to explain cycles in credit-led economies

A paper in the new issue of ROKE by Óscar Dejuan and co-author. From the abstract:

This paper develops a predator–prey model to explain cycles in credit-led economies. The predator is the part of the financial sector that issues credit money for non-output transactions. It increases the indebtedness ratio and inflates bubbles that eventually have a negative impact on the real rate of growth (the prey). From this basis, we build a couple of models that may lead to self-contained or explosive cycles. Even in the first case, there is a risk of a financial collapse when certain variables move far away from their long-term equilibrium positions. In order to tame the cycle and avoid extreme positions, governments should ban the expansion of credit money for the purchase of assets and introduce permanent checks to risky credit.

You can read the whole paper here. 

Latin America's growth

From the presentation with Esteban Pérez. The graph shows that growth in the region is increasingly tied to terms of trade changes and financial flows.

This was something we discussed a few years ago here.

New Book: Private Equity at Work, When Wall Street Manages Main Street

By Eileen Appelbaum and Rosemary Batt

Prior research on private equity has focused almost exclusively on the financial performance of private equity funds and the returns to their investors. Private Equity at Work provides a new roadmap to the largely hidden internal operations of these firms, showing how their business strategies disproportionately benefit the partners in private equity firms at the expense of other stakeholders and taxpayers. In the 1980s, leveraged buyouts by private equity firms saw high returns and were widely considered the solution to corporate wastefulness and mismanagement. And since 2000, nearly 11,500 companies—representing almost 8 million employees—have been purchased by private equity firms. As their role in the economy has increased, they have come under fire from labor unions and community advocates who argue that the proliferation of leveraged buyouts destroys jobs, causes wages to stagnate, saddles otherwise healthy companies with debt, and leads to subsidies from taxpayers. Appelbaum and Batt show that private equity firms’ financial strategies are designed to extract maximum value from the companies they buy and sell, often to the detriment of those companies and their employees and suppliers. Their risky decisions include buying companies and extracting dividends by loading them with high levels of debt and selling assets. These actions often lead to financial distress and a disproportionate focus on cost-cutting, outsourcing, and wage and benefit losses for workers, especially if they are unionized.

See here.

Dean Baker: Bond Bubbles? Silly Season at the Fed

By Dean Baker

Throughout this [so-called] 'recovery' there have been a number of economists and policy types expressing concern about a “bond bubble.” This is the idea that bonds are overpriced and could take a sudden tumble giving financial markets and the economy the same sort of hits we saw from the collapse of the housing and stock bubbles. This is seriously misguided thinking from any conceivable perspective. At the most basic level the concern is misplaced because there is nowhere near as much money at stake. Former Fed economist Andrew Flowers put the amount of money at stake in the bond market as $40 trillion in a recent FiveThirtyEight column. This compares to a stock market valued at around $28 trillion and housing market at a bit over $20 trillion. While that may make the bond market seem more important, the $40 trillion number is hugely misleading. The $40 trillion figure refers to total debt, much of which is short-term. This is important because short-term debt doesn’t lose much value when interest rates rise. If we restrict our focus to debt that stands to lose substantial value when interest rates rise – remaining duration of five years or more – the volume of debt would be well under $20 trillion.

Read rest here.

Tokunaga & Epstein - Endogenous Finance of a Dollar-Based World-System: A Minskian Approach

Junji Tokunaga & Gerald Epstein 

From the Abstract:

Global financing patterns have been at the center of debates on the global financial crisis in recent years. The global imbalance view, a prominent hypothesis, attributes the financial crisis to excess saving over investment in emerging market countries which have run current account surplus since the end of the 1990s. The excess saving flowed into advanced countries running current account deficits, particularly the U.S., thus depressing long-term interest rates and fuelling a credit boom there in the 2000s. According to this view, the financial crisis was triggered by an external and exogenous shock that resulted from excess saving in emerging market countries, not the shadow banking system in advanced countries which was the epicenter of the financial crisis. Instead, we argue that a key cause of the global financial crisis was the dynamic expansion of balance sheets at large complex financial institutions (LCFIs)(Borio and Disyatat [2011] and Shin [2012]), driven by the endogenously elastic finance of global dollar funding in the global shadow banking system. The endogenously elastic finance of the global dollar contributed to the buildup of global financial fragility that led to the global financial crisis. Importantly, the supreme position of U.S. dollar as debt- financing currency, underpinned by the dominant role of the dollar in the development of new financial innovations and instruments, and was a driving force in this endogenously dynamic and ultimately destructive process.

Read rest here 

New Working Paper By Passarella & Sawyer: Financialisation in the circuit

From The Abstract:

The relationships between financial systems and the macro-economy with emphasis on the saving-investment relationships and the nature of money are set out. A circuitist framework is extended to reflect some major features of the era of financialisation circa 1980.

Read the rest here.

* FESSUD is a multidisciplinary, pluralistic project which aims to forge alliances across the social sciences, so as to understand how finance can better serve economic, social and environmental needs. For more on the project, see here.

Sunanda Sen on financial integration and national autonomy in China and India

Also in the new issue of ROKE. From the abstract:

The narrative as well as the analysis of deregulated finance in the global economy remain incomplete unless one relates to the surges as well as volatility in capital flows which are experienced by the emerging economies. An analysis as above needs to consider the implications of capital flows in those economies, especially in terms of the ‘impossibility’ of adopting monetary policies which benefit growth in the national economy. There is also a need to recognise the role of uncertainty and the related changes in market expectations in the (precautionary) accumulations of the large official reserves as are held by these countries. The consequences are found to affect the fabric of growth and distribution in these economies. Recent experiences of China and India, with their deregulated financial sectors, bear this out. 

Financial integration and free capital mobility, which are supposed to generate growth with stability in terms of the ‘efficient markets’ hypothesis, have failed, and not only in the advanced economies but also in the high-growth developing economies like India and China. Deregulated finance has led these countries to a state of compliance, where domestic goals of stability and development are sacrificed to make way for the globally sanctioned norms relating to free capital flows. 

With the global financial crisis and the spectre of recession haunting most advanced economies, issues as above in the high-growth economies in Asia have drawn much less attention than they deserve. This oversight leaves the analysis incomplete by ignoring the structural changes that result in these developing economies — which are of much relevance to the pattern of financialisation and turbulence in the global economy as a whole.

 Whole paper available here.

Bernard, Gervorkyan, Palley, Semmler: A Review & Critique of Long Wave Theories

In a previous post (see here), I had argued that the capitalist world economy can be conceived as resting on the dependence of historically-specific hegemonic institutions, whose rise and fall follow the trajectory of long waves, what Giovanni Arrighi defined as systemic cycles of accumulation (SCA's), periods of approximately 40-60 years, separated by A phases and B phases (see here). Lucas Bernard, Aleksandr V. Gervorkyan, Thomas I. Palley, and Willi Semmler, however, offer a penetrating critique of this central tenant of the world-systems tradition.

From the abstract:

This paper explores long wave theory, including Kondratieff’s theory of cycles in
production and relative prices; Kuznets’ theory of cycles arising from
infrastructure investments; Schumpeter`s theory of cycles due to waves of
technological innovation; Goodwin`s theory of cyclical growth based on
employment and wage share dynamics; Keynes – Kaldor – Kalecki demand and
investment oriented theories of cycles; and Minsky’s financial instability
hypothesis whereby capitalist economies show a genetic propensity to boom-bust
cycles. This literature has been out of favor for many years but recent
developments suggest a reexamination is warranted and timely. 

Read rest here.

Lars P. Syll: Shiller & Roubini's Fears of Swedish Housing Bubble Justified

By Lars P. Syll

The Swedish Riksbank has according to Lars E.O. Svensson been pursuing a policy during the last fifteen years that in reality has made inflation on average more than half a percentage units lower than the goal set by the Riksbank. The Phillips Curve he estimates shows that unemployment as a result of this overly “austere” inflation level has been almost 1% higher than if one had stuck to the set inflation goal of 2%. What Svensson is saying, without so many words, is that the Swedish Fed for no reason at all has made people unemployed. As a consequence of a faulty monetary policy the unemployment is considerably higher than it would have been if the Swedish Fed had done its job adequately. So far, so good — I have no problem with Svensson’s argument about the inadequacy of the Swedish inflation targeting policies. However, what makes the picture more complicated is that we do have a housing bubble in Sweden — it’s not just a figment of imagination the “bad guys” use to intimidate us with. [That said, I, of course, in no way want to imply that central bank interest rate targeting (and/or accommodations) is the best way to counteract housing bubbles. Far from it.]

Read the rest here.

Macroeconomics and the financial cycle

Claudio Borio from the BIS has written a widely cited paper. The Economist has linked to it and suggested that so far his advice for including the financial cycle into macroeconomics has only been followed by a few. Besides Borio, Minsky, Godley and Lavoie and Keene are also cited by The Economist. The paper by Borio (he only cites Minsky), which has been a very influential voice suggesting that capital flows were pro-cyclical and more regulation was needed before the financial crisis, is somewhat underwhelming though.

For starters the definition of the financial cycle is based on individual perceptions. In his view, financial cycles result from "self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts." Then there is the question of the theoretical features for modeling the financial cycle according to Borio. There are three that are essential according to him. First, that financial cycles have endogenous causes, second, that debt must be present, and last but not least a different measure of the output gap. The last one is really the central theoretical modification in his scheme [note that heterodox models, like Kaldor's 1940 cycle model were endogenous, and Keynes had debt in the General Theory, in chapter 19 it is central, in fact].

The new output gap measure would include financial variables. He correctly notes that output gap measures take into consideration only inflation, when ascertaining whether the economy is above the potential or not, and that "it is quite possible for inflation to remain stable while output is on an unsustainable path" [and you can have inflation without being at full employment too, I would add]. His measure of the output gap would include information about asset price inflation too (property prices and measures of credit booms) and is shown for the US and Spain as the red line below.

Note that the new output gap shows the economy growing way beyond its potential in both the US and Spain before the crisis, more than in the alternative measures using a Hodrick-Prescott filter (green) and a conventional production function (blue). He concludes that: "potential output and growth tend to be overestimated" by conventional methods. Further, his point when arguing that the cycle is endogenous is that excessive booms are the cause of the collapse, so what is needed is to smooth out the boom. The prescription is to grow less and avoid to surpass the potential level, which is supply determined and exogenous presumably (since no word on this is uttered).*

He wants then to constrain booms, and macroprudential policies should be used for that aim. Further, while noting that in balance sheet recessions (following Koo) it is important to deal with agents losses head on, he suggests that "fiscal policy is less effective than in normal recessions" and that as a result of excessive monetary expansion after the bust "the central bank’s autonomy and, eventually, credibility may come under threat." So one really needs to kill booms, since nothing much beyond re-writing debt down and acting as lender of last resort with moderation can be done after.

I have several problems with these views, even if there are some good things, beyond good intentions, in Borio's paper. In fact, I think that there is significant evidence for the notion that potential output varies with demand expansion (Kaldor-Verdoorn Law), so that if a revision of the way potential output is measured it would be in the opposite direction. Mind you, if you check the chart above it means that Spain now is close to its potential level. I guess the natural rate of unemployment in Spain is around 20% or so (slightly below the current level). Note, also, that in Latin America we have been smoothing the boom with the consequence that our crises are not milder than Asia, but we end up growing less (see the paper by Pérez and Pineda linked here).

However, in my view the biggest flaw in the approach to financial cycles proposed by Borio is the absence of any discussion of how debt-deflation (the balance sheet recessions) affect and are affected by income distribution. There is no understanding of how wage stagnation in the center was as instrumental as financial de-regulation for the collapse, as noted by Barba and Pivetti (link here) or Jamie Galbraith's last book, not by chance called Inequality and Instability. This is again something that heterodox economists have known for a while and that the mainstream still has to learn.

* The reasons for the excess in the boom are associated to excessive finance [which he calls excess elasticity of the system], as in Shin's (2011) global banking glut, and not excessive savings, since he correctly points out that "expenditures require financing, not saving."