Saturday, March 16, 2019

On the future supremacy of the US dollar

The “flight-to-safety” describes the tendency to hold a assets denominated in a robust currency. This has been true for the US dollar during the post-war period. Ilzetzki, Reinhart, and Rogoff (2018) studied the issue and found that the US dollar remains the preferred anchor and reference currency despite the introduction of the Euro and the rise of the Chinese currency.[1]

Recently, a number of an online journalistic articles argued that there have been some underlying political-economy sort of events that might undermine the dominance of the US dollar.

One of these events is the financial money-transfer system, e.g., SWIFT - the Society for Worldwide Interbank Financial Telecommunication. Clearly, this system is highly influenced, or even dominated, by the United States, is it not? The trouble might stem from the US decision, for whatever reason, maybe political, to cut off countries such as Russia or China, or Iran, etc. from that system. There has been a strong push against Russia and China in the US recently.

That led Russia and China to creating an alternative system.

Moreover, the EU decided, including the UK, to continue to trade with Iran in defiance of the US. The EU announced that it had created a new system, INSTEX - Instrument in Support of Trade Exchange - to bypass the international system, which is under the control of the US, in order to facilitate payments with Iran, and other countries that have bad relationships with the US. This must be an important development in the international monetary arrangement, and must have some implication for the US dollar domination, now and in the future.

There is no doubt that there is a rising tension between the US and the EU regarding the latter's economic ties with Iran, Russia, and China. Trump has a very different stance on globalization and international trade from previous governments. INSTEX could be used in case the US decided to punish the EU for importing gas from Russia, for example, could it not.

The market value of the US dollar, and a lot more currencies, are highly affected by trade, i.e. the price of a currency in terms of another (exchange rate) is a function of trade issues.

The tariff war on China may not be benign, or a bluff. It does affect the exchange rates among other things. It increased uncertainty. Uncertainty is not something one could insure against; it would distort prices and affect the volume of trade. What if no deal is reached and tariffs increased by 25 percent?

So the straightforward implication of the break of the US dollar dominated international monetary arrangement, which has been in place since 1945, may be at the end of the day only a declining global demand for the USD, thus, a depreciated currency.

A depreciation of the USD itself is not a major cause of a concern for economists.

Countries with fixed exchange rate such as China and Russia and most of the oil-producing rich countries hold a huge amount of US dollar debt and reserves. Although the interest rate paid on US debt is low, these countries would also lose a great deal if they undermine the US dollar, don’t they? In other words, dumping the US dollar is costly.

However, something else could jeopardize the supremacy of the US dollar.

Modern Monetary Theory, which is advocated by some Democrats in the U.S. today, proposes to use the Fed balance sheet to, permanently, finance social programs. The issuing of more debt would put upward pressure on interest rate. If the debt issuing is persistent or permanent, it might have some damaging effect to the US dollar.

In my paper with Moosa (here) “Monetary Policy, Corporate Profit, and House Prices,” we show, using US data, that there is a strong relationship between corporate profit and asset prices such as housing prices and stock prices. Monetary policy drives all these variables. The increase in interest rate and / or the reduction of the money stock reduce both corporate profits and asset prices (different magnitudes).

A permanent change to monetary policy along the lines suggested by the Modern Monetary Theory would induce a secular decline in corporate profits, and asset and share prices that could cause a permanent decline in the demand for US dollars and setup the way to ending its dominance at some future point.

That is a testable scenario.

[1] Ethan Ilzetzki, Carmen M. Reinhart, Kenneth S. Rogoff, February 2017, Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold? NBER Woking Paper No. 23134.

Thursday, December 6, 2018

The Economics Analysis of Wellbeing in New Zealand

I read about “wellbeing” in 2014 when the Chief Economist of the Treasury sent me his paper on this issue for comments. He had a economic model, which included a variables called social cohesion and environmental indicator, as I recall. Wellbeing is something, probably, about higher employment rate, decent wages, better education and health care, cleaner environment, and gender and race equality…etc. Essentially, his key objective was to maximize GDP growth.

The Treasury still adopts the same wellbeing program, but this time without a macroeconomic model, analysis, or anything formal. It is unclear how the Treasury advises the government about this issue. I learned that the Treasury uses the large micro data (100 variables), which are produced by Stat NZ to shed light on these issues.

It is unclear how the Treasury advises the government using these data!

Undoubtedly, formal macro analysis is required for the Treasury’s work to be credible.

There is something about utility maximization, perhaps. To begin with, it is very difficult to design a social welfare function although some economists are still trying.

You can imagine that many economists have been trying to understand how this works! I think that it is still incomplete.

A simple approach most economists know well is to begin with a small general equilibrium model, whereby the average household maximizes an expected utility function, which is a function of a consumption bundle (all goods and services), and leisure subject to a budget constraint. The budget constraint is where after-tax income from work and other assets is equal to expenditures on consumption and investment. The government budget constraint remains unchanged. Later, one could vary the analysis with sex, age groups, race, etc., or find a way to deal with heterogeneity.

For completeness, there must be also a production function of the goods and services. Optimal growth is a key. Output is produced by choosing (and substituting) inputs such as physical capital, labor and maybe human capital and other inputs… This process is also subject to a resource and other constraints, and needs optimization.

Combining these consumer / producer optimal solutions yield a consistent optimal outcome, say for example, the consumption to output ratio. The ratio combines optimal consumption and output, which may convey useful information about the wellbeing of the average household.

What could affect the optimal the consumption – output ratio?

Actual hours – worked is a key variable – the supply of labor. The share of capital (or labor) in the production of output matters too. Many policies affect these decisions. A tax on capital and labor might reduce these shares because they affect the prices of capital and labor, which induce substitutions. Savings matter too because savings are capital, eventually investments, which determine the output of goods and services, and eventually the consumption-output ratio. Finally, within this simple structure, the relative value of leisure matters a great deal for the optimal consumption – output ratio. Would this model explain the actual consumption-output ratio?

This simple model can generate dynamic stochastic projections for the future of optimal consumption and output. Such a humble beginning would lend some credibility to this program.

Thursday, October 18, 2018

The New Zealand Dollar

In 1991 I was an intern at the IMF. Robert Flood asked what am I writing about and I said the exchange rate. He said, I advise you to look at something else because explaining the exchange rate is hopeless. That was 27 years ago and nothing has changed. 

Since the Meese and Rogoff finding many decades ago that the no model's forecast could beat the forecast of the random walk model, nothing much has happened on that front. 

A couple of years ago I wrote a paper where I showed that commodity prices for commodity-exporting countries (New Zealand, Australia, Canada) explain their exchange rates. Here is a graph of monthly data for NZ.

The high NZD/USD and low productivity might be puzzling. However, NZ might be a small country, but it is not small when we talk about milk. It is a major player in the global milk market. The higher the demand for milk the more the demand for the NZD. 

The NZD/USD has been falling in the past few weeks, which motivated me to produce some dynamic stochastic projections.I use three models: a random walk model (i.e., the NZD / USD depends on its last period value only); an unrestricted VAR with the NZD/USD, the ANZ NZ commodity price index, and the ANZ world commodity price index; and an SVAR, whereby I have PPP imposed, and PPP is basically the commodity price indexes ratio. I estimate these VARs with and without, a constant term because the constant affects the forecasts as we know (The VARs have 12 lags). The sample is Jan 1999 to Sep 2018. Then for every month from October 2018 to June 2019, I report the average projection of 10,000 iterations (I use bootstrapping to generate the innovations).    

There are small differences between the models' projections. VARs with a constant term have higher projections on average. The minimum across all five models over the projection periods, is 0.6483 (Nov 2018) and the maximum is 0.6742 (Jun 2019).

I could not tell which model is better because these are out-of-sample projections. We have to wait and see if they have better information than the Random Walk. 

Thursday, October 11, 2018

Petrol Prices in New Zealand

 There has been talk about the recent increase in petrol prices. The PM also spoke about it.

I do not have access to all data from where I am, but I could access Stats NZ petrol prices from the Consumer Price Index (CPI). The plot shows the petrol price index in the CPI, the CPI, and two measures of crude prices: West Texas Intermediate (WTI), and European Brent (seasonally unadjusted). All indexes have base 2007 Q2 =1000. The second plot, which is more relevant to any analysis, is for the inflation rates of petrol and crude prices.

What do we see?

First, the price of petrol has been increasing lately. The average quarter-on-quarter growth rate over the period from 2006 Q2 to 2018 Q2 is 0.44 percent. The growth rate in 2017 Q4 was 5.9 percent. Since then it fell to 2.5 percent in 2018 Q1 and picked up a little to 3.1 percent in 2018 Q2. The data show that the price of NZ petrol did not fall as much as crude did after the collapse of the oil market in 2014.

Second, petrol prices in New Zealand are associated with crude oil prices. The simple correlation between crude prices and our petrol prices inflation rates is 82 and 84 percent and highly statistically significant for the WIT and Brent respectively.

High petrol price could be explained by (1) high tax on petrol at the pump; (2) excess demand for petrol; (3) higher international crude prices; (4) lower NZ dollar; (5) higher company profit margins; (6) higher cost of production such as unit labor cost; and (7) noncompetitive market (i.e., the marginal cost > the price). There could be an omitted variable, but I would say these are the important ones to start with.

I believe that New Zealanders have the right to complain about the tax rate on petrol, but not  about the companies profit margins.Company profit is taxable.

The profit margin declines as competition increases because new entrants in the market would chew bits of the market profit. Hence, prices should fall as competition increases.

Unlike countries like Singapore, for example, we have no restrictions on the number of cars in the streets. Petrol is a normal good. We buy less of it when the price goes up. And, we buy more when  income and population increase. If the supply of petrol is a little bit inelastic, an upward shift in demand raises the price considerably. The government should have an idea about the elasticities of supply and demand of fuel.

From the above, the only assured measure to reduce petrol price in the hand of the government is the tax on petrol (it's been a long time since I checked, but I assume we don't have import duties on crude!).

The government has no control over international crude prices, domestic excess demand for petrol, the value of the Kiwi dollar, the company profit margin, and the cost of labor.

Re competition, if petrol companies have been making large profits and the market is competitive we would have expected new entrants in the market, which should have resulted in lower petrol prices over time. That did not seem to have happened. Why? Is it because companies have not been making extraordinarily high profit as some might suggest? Or because there is a lack of competition?

Could the government promote more competition in the NZ petrol market? I don't know much about this, but maybe there are "restrictions to entry," which the government could remove.

Also, the higher the tax on petrol the higher the price. If the price of petrol is higher than the marginal cost then the tax reduces competitiveness. 


Tuesday, August 14, 2018

Remembering Iraq's Wars

August and September of every year remind me of Iraq wars.

The Iraqi economy was growing quite nicely in the 1970s. Surely high oil prices helped, but there was a promising development plan in place, industrialization was taking shape, and human capital investments were up. A growing middle – income class began to flourish. Real GDP per working-age person (15-64 year) grew from USD 5000 in 1970s to a nearly USD 12,000 in 1980.[1]

Then 25 years of wars. The first war is the Iraq-Iran war (September 22 1980 to August 20 1988); proven oil reserves were of about 30 billion barrels and a large budget surplus of nearly 40 billion dollars. The second war is the Iraqi invasion of Kuwait in August 2, 1990, which led to the American-led war that saw the destruction of Iraq by February 1991. Nothing survived. Real income per working-age person was as low as USD 2,000 in 1991. Third, the 15-year crippling economic sanctions followed, which I believe had more negative effects than the wars. Half million children died. Iraq was deprived from the basics (e.g., hospitals didn’t have bandages and students didn’t have pencils). People paid the heavy price. Fourth, the American-led ground invasion and occupation of the country began March 20, 2003.

Real income per working-age person USD 4,600 in 2003 is lower than the 1970 level.  
Now imagine that Iraq had continued to develop without the wars and ask what would have been its GDP per working-age person. Figure (1) plots my projection of real GDP per working-age person for the period 1981 to 2002 based on baseline period from 1970 to 1979.[2]

Figure (1)

Everything else remained unchanged, I estimate that real income per working-age person could have increased to be somewhere between a low of USD 12,000 and a high of USD 15,500 in 2002. The projections are affected by the small sample and other measurement and estimation problems and should be taken with a grain of salt. However, it is not unreasonable to imagine Iraq’s real GDP per person around USD 20,000 in 2002 had it continued with its development plans of human capital and accelerated its manufacturing production that began in the 1970s. Who knows what Iraq would have looked like today had it not suffered all that destruction?

Mesopotamia  is very old. Twenty or thirty years of wars is relatively short relative to a long history. The people who built the ‘cradle of civilization’ can, at some point and under certain helpful conditions, rebuild again.   

[1] I am using real GDP in chained PPP and capital stock from the Penn World table 9.0.

[2] I estimate a VAR, which included real GDP per working-age person (15-64), capital – output ratio, and working-age population. The price of oil is a proxy for Terms of Trade shocks. The model was estimated over the short period 1970 to 1980, then dynamic stochastic projections from 1981 to 2002 were computed. I use bootstrapping and solve the model 10,000 times. The mean of the dynamic stochastic projections is plotted.

Wednesday, August 8, 2018

Trump's Tariffs

One of the problems with policy, in general, is that more policies are not evidence-based. Nobel laureate Edmund Phelps emphasized that. I have seen that during my long career in every country I worked in. They are more sever in some places than others, of course, but it remains astonishing that advanced nations like the US still suffers. In my view, the problem is not in the researchers, but more in policymakers, and more in ignorant politicians.

Policy errors are persistent. They cause lots of damages over time. This is true whether we are talking about economics, science, or politics, or any other filed. In politics, people suffer for decades or more because one politician's error, or bad policy. In economics, the damages could be externally high. Above-all, it is very costly to undo the errors.

But there is a still some puzzling aspects to economic policy errors and that is why economic advisers to the policymaker, Trump in this case, do not explain to him that his tariff policy violates 101 economic principles? 

In economics 101, net exports (exports less imports) = net foreign investments (US investments abroad less foreign investments in the US). Period. So if his policy reduces imports, it must reduce foreign investments in the US too. That would reduce employment in the US and cause more suffering to American workers.

Trade economists know more about the dynamics, but I would say eventually that must happen. There is no free lunch. 

Wednesday, April 11, 2018

Graeme Wheeler and the RBNZ: Policy Errors or Bad Luck?

Many people criticized the RBNZ ex-governor Graeme Wheeler for not bringing the CPI inflation “up” to hit the target. In other words reducing the OCR. Some went further to call for a negative OCR! 

Two things influence moving the CPI inflation to meet the target, policy and luck. By luck I mean the randomness of the shocks. Shocks are very difficult to identify ex-ante. I don’t know Graeme Wheeler, but examining the data indicate that perhaps he was mostly unlucky. 

The main job of the central bankers is to analyze the data, as they arrive, and try to identify the nature and the permanency of the shocks in order to make forward looking policies to offset their effects, which is a very difficult job. Failing to identify the shocks gives rise to ‘gut feelings’ and backward looking policies. Clearly luck plays a big role.

Soon after signing the first Policy Target Agreement (PTA) in 1990, inflation came down to hit the target much sooner that it was anticipated by anyone (back then the RBNZ experimented with instruments other than the setting the Official Cash Rate - OCR). One arguments could be that the inflation expectations adjusted downward quickly. Perhaps it was believed that the RBNZ was committed to achieving the job.[1] Once inflation expectations were anchored and the RBNZ held inflation around the target successfully it gained reputation.[2] These are valid arguments. Don Brash was a credible inflation fighter. He was fortunate too. No significant shocks occurred until 1997.[3] Even Milton Friedman told him that he is a fortunate man.

Regardless of its reputation and known commitment to keeping the CPI inflation on target, the RBNZ messed up a big deal in 1997, the Asian Financial Crisis. Of course no one saw the shock coming; the RBNZ reacted to it; and made a costly policy error (around 3 billion dollars of losses in GDP initially if I recall correctly, but I could be wrong). The year 1997 was both bad luck and bad policy.

In 1999 the RBNZ began setting the short-term interest rate (OCR) as a policy instrument. The next big shock was the 2007-2008 Global Financial Crisis (GFC). Monetary policy, which uses the interest rate (price) rather than money (quantity) has different dynamics. Quantitative Easing as a policy response in the US, the EU and elsewhere did not generate inflation. A successful anchoring of inflation expectations removes the positive correlation between CPI inflation and the growth rate of money. I illustrated that in an RBNZ discussion paper (Money in the Era of Inflation Targeting, 2001).[4] 

Simply modeled, the CPI is a weighted average of the domestic and foreign prices. Let the d Log CPI = a d Log P + (1-a) (d Log P*+d Log S), where (d) is the annual difference, P is the GDP implicit price deflator, P* is the US CPI, S is the exchange rate and (a) is a weight.[5] The RBNZ has no control over the exchange rate. Macroeconomic fundamentals cannot forecast the exchange rate because its fluctuations are dominated by randomness rather.[6] Therefore, any governor would find it difficult to push the CPI inflation up/down during times of extraordinary appreciation/depreciation of the currency.

Let’s look at the data. Unfortunately I do not have real-time data as Athanasios Orphanides taught us to do, but I do not think the exchange rate is subject to revisions anyways (price might be revised).

Figure (1) plots the actual d Log CPI (inflation) on the vertical axis and d Log P + (d Log P*+d Log S) rates of change on the horizontal axis.  The weight could be estimated, but it does not matter in this case.

The association between the CPI inflation, and the domestic and foreign prices is evident in the data until the end of 2009, then a clean break in the correlation occurred and remained until the end of the ex-Governor’s tenure.

I separate the variables to shed more light on the components.

Figure (2) plot the CPI inflation and NZ price of foreign exchange rate depreciation (P*+S). The picture is similar to figure (1). There is a break in the correlation in 2009. 

Figure (3) plots the CPI inflation and P, the domestic price inflation. There is a spike  in domestic price inflation in 2014. 

Figure (4) plots the CPI inflation rate and the US CPI inflation rate, and they seem to be correlated except for the period of the Great Recession in the US.

So it is the exchange rate! 

Given these large, unpredictable, and persistent foreign exchange rate shocks, I imagine that it was very hard to hit the CPI inflation target during that period even if the OCR was set to zero or even negative.

CPI inflation reached 1.9 in September and fell to 1.6 percent in December 2017 and these fluctuations are associated with highly unpredictable random changes in the exchange rate.

Some may argue that Graeme Wheeler could have done something about domestic price shocks, but I find it difficult to believe that he or anyone else could do anything about the exchange rate appreciation, which makes it very difficult to inflate and hit the CPI target. He (and the RBNZ) was more unlucky than anything else.

[1] There is a large literature on commitment.

[2] There is a large literature on reputation.

[3] Senior colleagues at the RBNZ told me that they (the RB) were targeting lower inflation a long time before the signing of the PTA in 1990.
[5] The variables are logs. I use the resorcinol of the exchange rate posted on the RBNZ webpage.

[6] The variance of the exchange rate depreciation rate is several folds larger than the variance of macroeconomic fundamentals.