The zero lower bound in our minds

PRIOR to the crisis, there was a general (if tenuous) accord among macroeconomists of many different stripes, that the Federal Reserve could and would act to stabilise the economy when necessary. Then, in December of 2008, the Fed hit the zero lower bound, when it dropped its target for the federal funds rate to between 0% and 0.25%, where it has sat ever since. At the time, the unemployment rate was 7.3%. It eventually peaked at 10% about a year later, and it has come down, very slowly and fitfully, to just 8.5% since then. For fully three years, America has been a zero lower bound world.

During that time, economists have been working very hard to figure out what the implications of the zero lower bound are for macroeconomic policy and unemployment. Are we stuck, or what? 

At a session this morning, I saw a few presentations on the topic. There was a general agreement among them on the nature of the zero lower bound problem and the liquidity trap. There are two different kinds of people in the economy: savers and borrowers. The borrowers borrowed heavily until the shock of the crisis changed the nature of their borrowing constraint and forced them to rapidly deleverage. Without an increase in demand elsewhere, the high rates of saving of the borrowers will plunge the economy into a deep recession. Normally, the real rate of interest should adjust downward until the savers cut their desired saving enough to offset the increase in desired saving of the borrowers; that is, they spend more to make up for the others furiously trying to pay off their bills. But in some cases, the extent of the deleveraging by borrowers may be great enough to drive the market-clearing real interest rate into negative territory. Since the Fed can't cut rates below zero, savers don't spend enough, there is excess saving, and the economy is stuck with high unemployment.

What then? Paul Krugman, who presented a paper in the session with Gauti Eggertsson, noted that fiscal policy was likely to prove effective in such a situation. The government could borrow from those wishing to save more and provide the economy with needed additional demand. At the zero lower bound, government spending doesn't generate crowding out of other investment activities via higher interest rates, so policy is even more effective than usual. And so on. There are other potential solutions, as well; one presenter noted that "unconventional fiscal policy" could replicate an ideal monetary policy through a combination of tax changes—a consumption tax scheduled to rise over time alongside a tax on labour that would decline over time.

But Stanford economist Robert Hall really nailed the crux of the question, so far as I was concerned. At the AEA meetings a year ago in Denver, I listened to Mr Hall speak a few times on this issue and point out that with the market-clearing interest rate below zero the economy was stuck with high unemployment. At the time, I wondered why, if that were true, that the answer wasn't simply a higher rate of inflation, which could combine with a zero nominal interest rate to move the real interest rate below zero.

This time around, Mr Hall addressed the point head on. He noted that in a liquidity trap, the real rate of interest was simply equal to the negative inflation rate. In other words, if the Fed's nominal rate is at 0% and the inflation rate is 2%, then the real rate of interest is -2%. If a -3% real interest rate is necessary to clear the economy, then all that's needed is a higher rate of inflation—3% rather than 2%. Mr Hall noted that this was an important point because potentially the Fed could have an enormously helpful impact on the economy simply by raising inflation just a little. And here's where things got topsy-turvy. Mr Hall argued that:

1. A little more inflation would have a hugely beneficial impact on labour markets,
2. And a reasonable central bank would therefore generate more inflation,
3. And the Federal Reserve as currently constituted is, in his estimation, very reasonable; therefore
4. The Federal Reserve must not be able to influence the inflation rate.

Now, perhaps there was a political economy subtext to this argument; if so, I missed it. Rather, he seemed to be saying (as others, like Peter Diamond, have intimated) that at the zero lower bound it is simply beyond the Fed's capacity to raise inflation expectations. Now admittedly I haven't done a rigorous analysis, but it seems clear to me that the Fed has been successful at using unconventional policies to reverse falling inflation expectations. Why is Mr Hall—why are so many economists—willing to conclude that the Fed is helpless rather than just excessively cautious? I don't get it; it seems to me that very smart economists have all but concluded that the Fed's unwillingness to allow inflation to rise is the primary cause of sustained, high unemployment. And yet...this is not the message resounding through macro sessions. Instead, there are interesting but perhaps irrelevant attempts to model the funny dynamics of a macro challenge that actually boils down to the political economy constraints (or intellectual constraints) facing the central bank. Let's focus our attention on that, for heaven's sake.

Is the liquidity trap almost over?

LIQUIDITY traps: we can't stop talking about them. Since late 2008, the nominal interest rate target suggested by most standard monetary policy rules has been negative, leaving the American economy in a liquidity trap. Eddy Elfenbein recently ran a monetary policy rule devised by Greg Mankiw through the data and found that an exit from the trap might be closer than many think. The rule is:

Federal funds rate = 8.5 + 1.4 (Core inflation – Unemployment)

And when run against the data it produces:

At this rate, it seems, the recommended policy rate will be positive in no time. Maybe. The recent, steep increase is unlikely to continue. Core inflation is expected to level off and might well decline in 2012. The recent decline in unemployment is also unlikely to continue. Labour force departures have overstated the health of the labour market as captured in the unemployment rate, and if the job market continues to strengthen, then rising labour force participation will prevent a too-rapid drop in the unemployment rate. The rule might recommend a positive rate by the end of the year (2% core inflation and an 8% unemployment rate would just about do it), but it's far from certain that it will.

Neither should the Fed follow the rule right away when it begins recommending rate increases. Monetary policy gains traction in a liquidity trap by raising expected inflation. To achieve that, the Fed has to promise to let inflation rise above what the rule might normally recommend; it needs to credibly signal that there will be some catch-up inflation.

That's a tough thing for a central bank to do, and it gives rise to a time inconsistency problem in liquidity-trap monetary policy. The Fed can promise to behave "irresponsibly" in the future, but if most people think that no matter what Ben Bernanke says now he'll keep inflation at 2% later on, then the Fed will struggle to spark a recovery. A policy that explicitly allows for catch-up inflation, as through a level target, would make liquidity-trap fighting more credible. The Fed is none too anxious to head in that direction, however, lest it "lost credibility" as an inflation fighter. Which, of course, is precisely what's needed.

Cautious on the economy, happy with liquidity

THE European Central Bank (ECB) kept its main interest rate at 1% following its meeting on January 11th. Speaking after the decision, the bank’s president, Mario Draghi, was cautious in his assessment of the economy. There were tentative signs of stabilisation in activity but only at weak levels and the downside risks to the economy from financial-market tensions remained “substantial”, he said. The latest money-supply figures, though weak, do not suggest that there is a credit crunch. But such problems can take a while to emerge so credit supply will need to be monitored.

Mr Draghi was more positive about the effects of ECB’s long-term refinancing operation (LTRO), carried out on December 21st, at which commercial banks were able to borrow €498 billion for three years at a low interest rate. The scheme had been effective, said Mr Draghi. Some markets for unsecured bank lending had reopened. The banks that bid hardest for the three-year ECB loans were often those that had debts maturing in the present quarter, when some €200 of bank bonds are falling due. The operation may thus have prevented a bank-funding crisis.

What is more, there are signs that the borrowed money is flowing around the economy. The ECB’s balance-sheet shows a big rise in deposits held by commercial banks as excess reserves alongside the increase in ECB lending to banks. But Mr Draghi cautioned against a judgment that banks had borrowed money only to hoard it. The more liquidity the ECB provides, the larger the liabilities side of the ECB’s balance-sheet (which includes deposits) must become. By and large the banks that have borrowed from ECB are not the same as those depositing with it, he said. This suggests that much of the borrowed money had first washed through the financial system before being parked at the ECB.

The flood of liquidity may have helped lower government borrowing costs. Yields on long-dated bonds for Italy and Spain fell sharply today, after successful auctions of bond and bills in both countries. But there was yet not enough evidence to link the fall in long-term rates to buying by banks flush with ECB cash, said Mr Draghi. 

Mr Draghi did nothing to suggest that the ECB is ready to cut interest rates again in February. Monetary policy is already accommodative, he said, but the ECB would respond to worsening conditions. The vote to keep rates steady was unanimous, in contrast to the one on the cut in December. One of the likelier dissenters, Germany’s Jürgen Stark, has departed to be replaced on the bank’s executive board by Jörg Asmussen, previously Germany’s deputy finance minister. The other new face around the table was Benoît Coeuré, formerly a senior official at the French Treasury. Their arrival has not obviously shifted the ECB’s stance towards greater activism. But after a hyper-active meeting in December (when rates were cut and the three-year LTRO was announced) that was not a huge surprise.

The Big Mac index

THE ECONOMIST's Big Mac index is based on the theory of purchasing-power parity: in the long run, exchange rates should adjust to equal the price of a basket of goods and services in different countries. This particular basket holds a McDonald's Big Mac, whose price around the world we compared with its American average of $4.20. According to burgernomics the Swiss franc is a meaty 62% overvalued. The exchange rate that would equalise the price of a Swiss Big Mac with an American one is SFr1.55 to the dollar; the actual exchange rate is only 0.96. The cheapest burger is found in India, costing just $1.62. Though because Big Macs are not sold in India, we take the price of a Maharaja Mac, which is made with chicken instead of beef. Nonetheless, our index suggests the rupee is 60% undercooked. The euro, which recently fell to a 16-month low against the dollar, is now trading at less than €1.30 to the greenback. The last time we served up our index in July 2011, the euro was 21% overvalued against the dollar, but it is now just 6% overvalued. Other European currencies have also weakened against the dollar since our previous index, notably the Hungarian forint and Czech koruna, which have fallen by 23% and 16% respectively. Six months ago both currencies were close to fair value, but they are now undervalued by 37% and 18%.

For the full data set see here.

Prada is not Walmart

INDIA, if you believe the government, will be a land in which Starbucks and Prada thrive but where foreign firms will be prohibited from selling onions. It does not seem like much of a cause for celebration, but the announcement on January 11th that foreign “single brand” retailers could own 100% of their operations in India was meant to show the reform process was on track. It followed a debacle late last year when the government first announced that not only would single brand retailing be opened up, but foreign supermarkets would be allowed to operate in India too—and then was quickly forced into a U-turn on the latter promise after facing a rebellion within its own ranks and from the coalition parties it relies on in parliament.

By emphasising that at least the single brand bit of retail reform is still on track, the government hopes to show the world that India is still open for business. But this is a meek change indeed. Single brand retailers, such as fashion chains, were already allowed to own 51% of their operations. And the political stink of last month is likely to scare those who are not already present because swathes of the political class have been shown to be populist and hostile for foreign firms. Individual states may still choose to override the central government’s rules. Lastly, the reform comes with a large catch: 30% of what is sold must be supplied from cottage industries in India. If you are selling a uniform product worldwide—a sofa or handbag made in China—that is a major hassle.

The hope must be that India is on a journey to the right place, stumbling along the way. Perhaps the supplier rule will eventually be dropped, the argument goes. Maybe reluctant states will learn the error of their ways and open up too, after seeing the success of single brand retailers in other states. And maybe, after seeing an influx of investment from single brand retailers, the political climate will change and it will be easier to pass a reform that lets in supermarkets in too.
Interviewed in Delhi earlier in January a government mandarin insisted that the supermarket reform was not dead. Yet all of this seems half hearted. India is a hard enough place as it is for foreign firms to make profits. Adding in a fickle polity just makes things worse. And it is a rather sorry day for progress when a rule tweak to allow Starbucks or Prada to own not 51%, but 100%, of their shops is presented as a meaningful economic reform.

America’s next CEO?

Paint it grey
Start with the advantages. The most important fact about Mr Romney is that he is a non-ideological man who did something that America needs a lot more of. In 2002 he was elected to govern Massachusetts, normally a Democratic stronghold. He passed a version of health-care reform that is at once his proudest achievement and his biggest liability. Back then a system based on obliging everyone to buy private health insurance was a conservative idea, and Mr Romney did a good job of working with a hostile legislature to get it passed. (Today, his party viscerally opposes Mr Obama’s health reforms, which are closely modelled on Mr Romney’s; such are the twists of politics.) He also turned round Massachusetts’s finances, just as he had earlier righted the Salt Lake City Winter Olympics. Mr Romney needs to make these successes count for more than they have so far. Once the primaries are over, and America’s independents rather than the Republican Party faithful become the electorate to win over, he may be able to.
Second, Mr Romney has something that the president and his Republican rivals sorely lack: business experience. For 25 years he made himself and the management consultancies BCG and Bain a lot of money by making companies more efficient which, yes, sometimes means firing people, but also drives economic growth (see article). So far, Mr Romney has done a poor job of defending himself against attacks which are really aimed at the creative destruction which is the essence of capitalism itself. He says he created a net 100,000 jobs during his time at Bain. That figure is impossible to prove, but he could do more to argue that the benefits outweigh the costs. His task has not been helped by disgraceful attacks from fellow-Republicans on corporate restructuring.
Third, Mr Romney seems sure-footed. It is hard to think of a single misstep in this campaign. He may be wooden, but no scandal has ever attached to him. His family life is impeccably monogamous and progenitive. Those who have worked closely with him tend to admire him. On both the economic and the foreign-policy sides, he has already put together impressive and above all sensibly moderate teams.
The debit side of the ledger
A useful list, to be sure: but can it outweigh the negatives? Mr Romney’s pragmatism has an inconvenient flip side: no one is quite sure where he stands. The Republican base does not think he is reliable on such things as gay rights and abortion. That will not matter so much to independents (who will probably also accept that any Republican has to say a few mad things to win a nomination). But people have to trust a president on the main issues, and, despite publishing a long economic manifesto, Mr Romney remains vague over how a lot of it is to be accomplished.

Explore our interactive map and guide to the race for the Republican candidacy

It is not at all clear how he would reform America’s ruinously expensive health-care and pensions systems. His views on what he wants to do about America’s 12m illegal immigrants are also unsettlingly gnomic. And where he has been clear, he has sometimes been wrong: his insistence that, on day one of his presidency, he will brand China as a currency manipulator represents dangerous pandering to populists. His pledge to cut federal spending to no more than 20% of GDP, a sop to his party’s fiscal extremists, would also be dangerous if applied as quickly as he implies.
Mr Romney will have other problems in wooing the electorate. He would be the richest candidate ever to win a big-party nomination and he reeks of privilege. His father was a governor as well, and he himself studied law at Harvard. On the other hand, Mr Obama is a millionaire several times over, can give a fair impression of having come from the planet Vulcan, and also studied law at Harvard. Mr Romney’s lack of charisma is a problem; but perhaps America wants fewer soaring speeches and more pragmatic restructuring plans.
Mr Romney’s last difficulty is one that should not be a problem at all. He is a Mormon and, despite Mormons’ protestations to the contrary, a third of Americans do not consider them to be Christians. There is not much Mr Romney can do about this. He could explain the Mormons’ extraordinary missionary work, but he can hardly risk saying that it is not really any more incredible that God communicated His plans to man in upstate New York in 1820 than He did in Palestine in 0AD. We recall, however, that America was for decades “not ready” for a Catholic president, or for a black one. Eventually, Americans thought better of those attitudes. Prejudice would be a silly reason for the Republicans to reject a man who offers their best chance of beating Mr Obama.

Gold, God and forgiveness

 Gold, God and forgiveness

DO BANKERS inevitably go to hell? What many people today merely hope will come to pass was for Christians in the early 1400s a matter of faith. After all, the Bible, like the Koran, was explicit in its condemnation of lending money at interest, the basis of most banking operations. So in many parts of Christendom moneylending was left to Jews. In several northern cities of medieval Italy, however, ingenious Christians started to find ways round the banking ban. Their contrivances, though legal, were not popular with the church, which held that usurers, by charging for the duration of a loan, were not trading in goods but in time, and this was God’s.
The prospect of an eternity of hellfire was particularly acute in Florence, since it was here that the foundations of modern banking were being laid. As it happened, Florence was also witnessing the first stirrings of an extraordinary flowering of the arts. Before long guilt-ridden bankers were commissioning great works of religious art in the hope that they might after death escape the damnation that the scriptures foretold. In this way were the birth of the international financial industry and that of the Renaissance intimately connected.

 

The connection might perhaps be reduced to a single word, whether patronage, or atonement, or Medici. A
longer, and far more pleasurable, elaboration can be found in text, pictures and objects at the Palazzo Strozzi in Florence, where an exhibition devoted to “Money and Beauty” continues into 2012. Subtitled “Bankers, Botticelli and the Bonfire of the Vanities”, it explores the motives of Florence’s bankers in their artistic commissions; the reactions of churchmen to rich Florentines’ displays of luxury and wealth; and the effects of both penitential patronage and ecclesiastical reproach on the works of art that, throughout the 1400s, or Quattrocento, tumbled forth from Florence like coins from a slot machine.
In the background of the exhibition are the Medici, the wool-traders turned bankers who held sway over the Florentine republic in its golden age under Lorenzo the Magnificent, and who produced popes and queens and Tuscan grand dukes until the last of the dynasty died in 1737. Their grip was interrupted by the invasion of Charles VIII of France in 1494, which brought in its wake the brief rule of Girolamo Savonarola, the austere Dominican friar from Ferrara who berated the Florentines for their luxuries, gambling, carnivals, and particularly their wanton paintings, which made “the Virgin Mary look like a harlot”. He called for children to spy upon their parents, prostitutes to be chastised, sodomites burned alive and irreligious frivolities prohibited. Hence the great Bonfires of the Vanities in the Piazza della Signoria in 1497 and 1498, when countless works of art, as well as cards, books and dresses, went up in flames.
Sandro Botticelli, a central figure, was not one of the artists who flung their paintings onto the fires, but he nevertheless fell under Savonarola’s spell, as his later works clearly show. Gone, in these, were the sensuous depictions of idealised beauty seen in his early paintings, such as the “Birth of Venus”. Now Botticelli’s figures were more likely to bear agonised expressions of intense piety, as in “Madonna and Child with the Young St John”.
In between came works like “The Calumny” (pictured above). This shows Midas on his throne, receiving the counsels of Ignorance and Suspicion, with a hooded Envy clasping the hand of Calumny, who in turn, with Deception and Fraud attending, is dragging the unidentified victim by the hair, while Penitence turns hopefully towards stark-naked Truth. Though not overtly religious, the sentiment is morally correct and therefore Savonarola-suitable, as is the turbulent mood, so far removed from the sumptuous lyricism of Botticelli’s earlier, mythological works. When those were made, as the chronicler Giorgio Vasari noted over half a century later, he worked happily for many Florentine families painting “very nude women”.
“Money and Beauty” was proposed in 2006, just after the birth of the foundation that runs the Palazzo Strozzi, a 15th-century building in the middle of Florence built by mercantile rivals of the Medici. Five years of incubation, however, have only improved the show’s timeliness, allowing reflections not just on the role of bankers in general but even on some familiar banking terms whose origins are Tuscan. The most notable may be “risk”, which derives from Tuscan rischio, the amount considered necessary to cover costs when lending money, ie, a euphemism for interest. Another is “florin”. First coined in Florence, florins circulated widely in Europe for centuries—in Britain until 1971—and may yet perhaps make a post-euro return.
It is not just its timing, though, that makes this show so successful. Its themes, and the abundance of artefacts and paintings on which the curators could draw, allow every point to be illustrated with a wonderful work of art: a panel commissioned by the mint; an altar painting showing Filippo Strozzi, who paid for it, almost as prominently as the entire Holy Family; keys, locks, letters of exchange; an account book pointing to the perils of sovereign default (three banks had gone bust when Edward III of England reneged on large loans); a codex containing the sumptuary laws that forbade flashy clothes and ostentatious funerals. (Even Fra Angelico—see next story—so pious he could not paint a crucifix without tears running down his cheeks, chose to depict the Virgin’s obsequies in the manner of an unashamedly opulent 15th-century Florentine funeral.)
The images are merciless. Miserly bishops are shown being whipped with their own moneybags; St Anthony causes a usurer’s heart to be found in a strongbox; a moneylender meets the figure of Death. Balancing these are numberless images of devotional scenes, the Nativity, the Madonna and other religious figures. And also shown are the events with which Lorenzo’s magnificent era ended: Charles VIII’s entry into Florence, Savonarola preaching against luxuries in a city that derived so much wealth from making them, and the fundamentalist friar’s own execution in the very square in which the Bonfires of the Vanities had been held. This is the visual telling of a tale of beauty and bloodshed, lucre and licentiousness, morality, hypocrisy and propitiation.
The telling is not all the work of the Quattrocento. The exhibits benefit enormously from the commentaries of two curators, Ludovica Sebregondi, a specialist in the religious art of the Renaissance, and Tim Parks, a British novelist and author of “Medici Money” (2005). While one puts the exhibits in their art-historical context, the other explains the social and wider significance. With different styles, and sometimes conflicting views, they add considerably to the pleasure of the show.
And should today’s bankers take heed? Though usury has long since lost its power to inspire any penitential effort among Christians, modern moneylenders are accused of other sins: Pope Benedict calls for “moral renewal” in Italy and the Church of England agonises about the godlessness of the City of London. Yet most bankers seem to dread damnation in the hereafter as little as censure in the here and now. Too bad. Without the fear of God, they are unlikely to pay for a new Renaissance.