What is a log point? 100*ln(new/old).

 Nerdy. Often when doing growth in Economics, we use change in natural logs.  For a change to y from x, the log point change = 100*ln(y/x).   So a change of 1 in the natural logs, which we often call "1%" is 100 log points.  

If a dataseries rises from 100 to 100.5, then: 

a. the % change is 0.5%

b. the change in the natural log is 0.0049875

c. the change in log points is 0.49875

If a dataseries rises from 100 to 101, then: 

a. the % change is 1%

b. the change in the natural log is 0.00995

c. the change in log points is 0.995

A basis point is defined as: 1bp is 0.0001 = 1/100th of 1%.  Or 100bps are 0.01 = 1%.  One might be tempted to say 0.995 log points are 99.5 basis points, but that's not often done.

Defence spending: getting a sense of the numbers

 1. If we have to spend more on defence, what is the scale of those numbers?

2. The ever brilliant IFS have a "what does the government spend money on" guide. 

3. The picture is this: 

4. and the (round) numbers are this. 

5. Total spending 22-23 is £1,200bn.  We have (again in round numbers)

   a. NHS spending: 200bn = 20% of total

b. Education: 100bn = 10%

c. Defence 50bn = 5% 

d. Public order = 40bn, 4%

e. Transport 40bn = 4%

f. net debt interest 100bn, = 10%.

6. Total GDP in 22-23 was 2.6tr. So 1% of GDP is 26bn, 0.1% of GDP is 2.6bn (a basis point of GDP is 260m).  If we currently spend 2.3% of GDP on defence and want to increase that to 2.5% of GDP, that is a rise of 0.2 pp of GDP whiich is about 5bn.  That's about 12% of transport or public order, or 5% of Education. 

India's growth success: log scales in action

 In class we have spent a lot of time saying how informative log scales are. Here's a perfect illustration from Martin Wolf in the FT. 

1. The main story is : An economically dynamic India is Manmohan Singh’s greatest legacy. He drove radical reform of an anti-market policy regime that was strangling growth. Link. 

2. "Singh’s most important achievements as a policymaker were made during his years as finance minister from 1991 to 1996. "

2. How do we see that in the data?  Notice the log scale allows us to read off the growth rate break from just that time.

4. and here by contrast is the data on a non-log scale: which fools you into thinking it's a post-2000 effect.

Addition: applying the rule of 72 to the growth rates in the FT graph, we have that before Singh it takes 72/1.6=45 years to double GDP per head, after 72/5.2=14 years. 

Visual summary of our work on intangibles

If you'd like a beautiful visual summary of some of our work on intangibles, do look at this amazing graphic storyboard from The Beautiful Truth. 

The magazine is at this link. The graphics are fantastic.

Adjustments along many margins

We have spent time in class reviewing how firms can adjust to prices by changing no only quantities, but other margins as well.  Here's an example from the Next case 

Para 396: "in the early 2000s paid rest breaks which sales consultants had received were removed following the introduction of the national minimum wage".

What is economics about, really?

Everybody knows the answer to this. Economics is about economic forecasting. Since much of economic forecasting is wrong, economics must be wrong. Or, economics is about the stock market and money. Since the stock market and money are by definition tasteless and immoral, economics must be tasteless and immoral too. Or, economics is about shifting a load of curves here and there in order to pass an exam, to be forgotten about once one is exited the exam room.

Getting a sound answer to this question is increasingly important as many other subjects touch on Economics. For example, much of human geography is concerned about economic questions: Cities, prosperity between countries, inequality. Much of management is also about economic questions, and if anything seems less abstract and more relevant: managing R&D projects, accounting, business strategy.

This is so ingrained there are now two famous jokes that everyone knows about economics.  The first is that a physicist, a chemist, and an economist are stranded on a desert island with a can of food but no can opener.  The physicist and the chemist devise a clever mechanism for opening the can: the economist says “assume we have a can opener".   The second is that a £50 note is lying on the street.  “Did you see that?” says the non-economist.  “No need to look” says the economist, “if it was really there someone would have picked it up”.

This is typically ignored when you start an economics course. You are told that the great benefit of economics is it helps you think about the big questions in the world. But many students , when they come out of an economics class, often jettison everything they've learned, regarding it as too abstract, and worth understanding just for the purpose of passing in the exam.  So it's worth asking again; what is economics about, really?

Let me suggest the study of economics can be summarised as asking a really good question: Is there a better alternative? That may not sound like something very profound, and economics is undoubtedly broader than this (the study of econometrics and associated statistical techniques for example), but as a pithy summary I think this carries the essence of economics and why it is actually very helpful in helping you think about the world.

Why is this a good question?  It’s worth stating first off that it’s a broad-based question.  That “better alternative” might be within the context of a market like a stock market for example. Or it might be in the context of a non-market transaction like a business hierarchy. Or a school or even a household.

Let’s take an example.  Geography has much to say about countries.  International business, a important subdivision of business studies and business strategy, has much to say about the arrangement and conduct of business across borders.  International relations, has much to say about the political and economic arrangements between nations.

In a 1997 article in the Quarterly Journal of Economics, the economists Alberto Alesina and Enrico Spolaore asked a different question: what’s the optimal number of countries?  Using an economic model, they argued the democracies would produce too many countries, that is, there would be too many nations, relative to a socially optimal benchmark.  Now whether you agree or disagree with their analysis is beside the point. My only point is that this is a nice example of the question that economists ask when they see a particular arrangement, in this case, a set of countries; is there a better alternative?

Likewise, the Canadian economist Robert Mundell asked in the 1960s how many nations should share currencies? This was viewed as an absurdity at the time but of course turned out to be an incredibly important question when it came to the design of the euro ( and indeed many have argued the design of the euro is flawed precisely because the designers ignored the principles that Mundell enunciated over half a century ago).

The next issue then is to ask whether economists have a comparative advantage in asking and answering this question? Surely other subjects have not only asked this question but perhaps answered it better? What do economists have to offer?

Herein I believe lies the true power of economics as a way of thinking relative to other subjects. I think that economists have two very important comparative advantages.

The first is that economics defines and understands very clearly the definition of “better”.  What are called, perhaps rather unapproachably, the fundamental theorems of welfare economics, describe the exact conditions under which a particular economic arrangement tends towards the most efficient allocation of resources. That is to say, that economics has a precise statement under which Adam Smith’s description of the “invisible hand”, namely interactions in markets , lead to the “best” outcome.  That means that in economics we are able to precisely compare a certain economic arrangement (the number of countries, the price of sugary food, the trade arrangements of a
country, your employment contract) with the “best” arrangement.  In turn, we can therefore answer precisely the question “Is there a better alternative?”. 

The second source of comparative advantage comes from the observation by Smith that the natural propensity of humans is “to truck and barter”.  Economists understand is that if there is a better alternative, unless there is some blockage, human beings are probably going to try to get towards it. Neither dogs nor human beings can fly naturally.  But human beings created a machine to help them fly because they saw a better alternative to walking.  The incentive to trade, means this is a good question to ask and an understanding that incentive makes economists in a good position to answer it.

Asking the question also provides a couple of helpful insights.  First, when presented with some fact of social interaction many subjects would explain it by social norms.  Where you shop, what newspapers you read, what phone you buy might be plausibly explained, at first pass, by what your parents did or peer groups do.  Economics tends to regard this as a last resort.  If there is a cheaper shop, a livelier newspaper, a zippier phone, the question of “is there a better alternative” and understand why people don’t get to that improvement is the first question to ask.

Of course, the relentless pursuit of even a very good question can get the Economist into hot water.  When presented with the public provision of a service (say health or education in many countries), the “is there a better alternative” question makes you ask if, for example, a private providers could do it much better.  Economists are, as said, well placed to ask this question because we have a strong theory about the optimality of a market economy.  But one has to remember that markets are in practice underpinned by a whole series of non-market factors such as trust.  Indeed there is a literature which suggests that financial incentives might drive out these non-market incentives.

Finally, the describing of economics in this way helps understand the two famous jokes set out above. The point of the “assume a can opener” story, is that economists start by thinking about the the best outcome, as a way of reasoning whether the current situation can be made better.  The point about the money on the street is to ask why human beings , with the Smithian propensity to track and barter, would not reach a better outcome. It does not say they would reach a better outcome, but it forces the analyst to set out exactly why not.

Teaching Note: Bank of England Monetary Policy Report May 2020

Here are some notes on this report.

The information content of prices

We spend a lot of time in class looking at prices as a discovery mechanism and as an information indicator of unknown consumer attributes.  Here's a summary on their use from p.5 of

https://laweconcenter.org/wp-content/uploads/2019/07/Concluding-Comments-The-Weaknesses-of-Interventionist-Claims-FTC-Hearings-ICLE-Comment-11.pdf

Price and output are metrics (and relatively easily identifiable ones, at that) that aggregate the decisions of countless individuals who are performing their own hedonic calculations, using all their own subjective values, with respect to the conduct of firms in the economy. The price and level of output that arise from those individual calculations necessarily takes account of the various preferences—albeit relatively imprecisely—of all those subjective, multidimensional calculations. Importantly, price and output offer the best means available to evaluate the effects of many non-price factors, including innovation. In other words, although imperfect, measurements of market price and market output are (generally) reliably informative, at the very least of the direction of likely changes in consumer welfare along all dimensions in response to changes in firm conduct

BTW, later in the report they say

Many ...voiced concerns about the potential for data to enable more price discrimination. Perplexingly, this issue was largely discussed as a presumptively harmful outcome. On the contrary, in industries with high fixed costs, price discrimination can increase total output and produce benefits for previously unserved segments of the market. 

We shall cover this last point in class next week.

Economics and Biology

With COVID modelling in the news the relation between the two is interesting.  in this post, Peter Klein, argues

    "To understand why people shoot guns, on purpose or accidentally, we need to focus on their preferences, beliefs, and actions."

He further links to Edith Penrose warned more than sixty years ago about the limits of biological analogies in understanding social issues. “The chief danger of carrying sweeping analogies very far is that the problems they are designed to illuminate become framed in such a special way that significant matters are frequently inadvertently obscured. Biological analogies contribute little either to the theory of price or to the theory of growth and development of firms and in general tend to confuse the nature of the important issues."

And the Penrose article is interesting.  What is the relation between market competition and natural selection?  Penrose discusses Alchian:

" To survive firms must make positive profits. Hence positive profits can be treated as the criterion of natural selection-the firms that make profits are selected or "adopted" by the environment, others are rejected and disappear. "  Thus he argues also that even non-profit maximising firms will be forced to profit maximise.


I suspect this is an argument that a lot of economists will recognize and would relate to biology.  But Penrose has read Darwin. 

" Darwin deduced the struggle for existence from two empirical propositions:
    a. all organisms tend to increase in a geometrical ratio, and
    b. the numbers of any species remain more or less constant.
From this it follows that a struggle for existence must take place"

She relates that to economics

" Translated into economic terminology, the explanation of competition in nature is found in the rate of entry. The "excessive entry" is due to the nature of biological reproduction."

That is, in biology, the assumption of geometric increase means the entry of new "competitors".   She continues:


" But how shall we explain competition in economic affairs where there is no biological reproduction? The psychological assumption of the traditional economic theory that businessmen like to make money and strive to make as much as is practicable performs a function in economic analysis similar to that of the physiological assumption in the biological theory of natural selection that the reproduction of organisms is of a geometric type-it provides the explanation of competition (and in economics, incidentally, also of monopoly). To be sure, the two assumptions rest on vastly different factual foundations and should not be treated as analogous. We can only say that there is some evidence that such a psychological motivation is widely prevalent and that we have found we can obtain useful results by assuming it. If we abandon this assumption, and particularly if we assume that men act randomly, we cannot explain competition, for there is nothing in the reproductive processes of firms that would ensure that more firms would constantly be created than can survive; and certainly from observations of the real world we can hardly assume that competition is so intense that zero profits will result in the long run or that only the best adapted firms can survive."

asks Is Terrorism a Disease?

Teaching note: QE FAQs from Ben Bernanke

Ben Bernanke has a very interesting review paper on QE.  Here are some excerpts.

1.       He focusses on large-scale asset purchases when the Central Bank (CB) has got to the effective lower bound.

2.       The Fed focus was “former emphasized the effects of buying longer-term assets on longer-term interest rates”

3.       To know if QE will work we have to know what determines long term yields.  “Longer-term yields can be conceptually divided into (1) the average expected short rate over the life of the security, and (2) the difference between the total yield and the average expected short rate, known as the term premium.”

4.       He then splits the effects into two

a.       “To a first approximation, portfolio balance effects work by affecting the term premium, while the signaling effect works by influencing expectations of future short rates.”

5.       These effects are:

a.       “portfolio balance effect.  if investors have “preferred habitats” because of specialized expertise, transaction costs, regulations, liquidity preference, or other factors, then changing the net supplies of different securities or classes of securities should 6 affect their relative prices.

b.       signaling effect.  if QE serves as a commitment mechanism, or perhaps as a signal of seriousness, leading investors to believe that policymakers intend to keep short-term policy rates low for an extended period….market participants are typically confident that central banks will not raise shortterm interest rates so long as asset purchases are continuing. Since QE announcements typically include information about the likely duration of purchases, which may be measured in quarters or years, and since QE programs are rarely terminated prematurely (because of the likely costs to policymakers’ credibility), the initiation or extension of a QE program often pushes out the expected date of the first short-term rate increase. Observing this signal that short rates will be kept low, investors bid down longer-term rates as well.”

6.       He then goes onto the evidence.

a.       The early data were on event studies and appeared to show important effects. “Evidently, QE1 had powerful announcement effects, including a full percentage point decline in the yield on 10-year Treasuries and more than a percentage point decline in the yields on mortgage-backed securities. Qualitatively, these results hold up well for different choices of event days or for shorter or longer event windows.”

Table 1. Responses of asset prices and yields to QE1 announcements

2-year Treasuries -57

10-year Treasuries -100

30-year Treasuries -58

Mortgage-backed securities -129

AAA corporate bonds -89

SP500 index 2.32

b.       But is this evidence clear?  He continues

                                                               i.      “First, in contrast to the results shown in Table 1 for QE1, event studies of later rounds of quantitative easing have tended to find much less dramatic effects. …. A possible interpretation is that the initial rounds of QE were particularly effective because they were introduced… in a period of exceptional dysfunction in financial markets.

                                                             ii.      “second point raised by critics is that event studies, by their nature, capture asset market reactions over only a short period. ... A variant of this objection, which takes a slightly longer-term perspective, begins by pointing out that longer-term Treasury yields did not consistently decline during periods in which asset purchases were being carried out. For example, the 10-year yield at the termination of QE1 purchases was actually higher than it was before QE1 was announced…Using time series methods, Wright (2011) argues that the effects of post-crisis policy announcements died off fairly quickly.”

c.       However, he believes these criticisms are overblown.

                                                               i.      “If later QE rounds were largely anticipated, then their effects would have been incorporated into asset prices in advance of formal announcements, accounting for the event-study results (Gagnon, 2018).”

                                                             ii.      “the prices of assets not subject to Fed purchases—including corporate bonds, equities, 13 the dollar, and a variety of foreign assets—moved substantially following announcements of asset purchase programs…QE also appeared to stimulate the global issuance of corporate bonds... The cross-asset impacts seem inconsistent with the view that the event-study findings reflect only asset-specific liquidity effects.” (longer-term yields did not reliably decline…in part, this pattern can be explained by the confounding influences on yields of other factors, including fiscal policy, global etc.)

d.       This relates to stocks and flows “The portfolio balance channel of QE, recall, holds that policymakers can affect longer-term yields by changing the relative supplies…a stock view of QE…The alternative flow view holds that the current pace of purchases is the critical determinant of asset prices and yields…The flow view would be correct if QE affected asset prices and yields primarily through short-run liquidity effects”.

He then talks about other policies

1.       forward guidance. “.

a.       Forward guidance takes many forms (such as the specification of policy targets, economic and policy projections) and occurs in many venues (speeches and testimonies, monetary policy reports).”

b.       “Delphic guidance is intended only to be informative, to help the public and market participants understand policymakers’ economic outlook and policy plans. In contrast, Odyssean guidance…. incorporating a promise or commitment …to conduct policy in a specified, possibly state-contingent way in the future “.

c.       He remarks that guidance has worked, but is hard to disentanglbe from QE.

2.       Other New Monetary Policy Tools. Various forms

a.       central banks also purchased a range of private assets, including corporate debt, commercial paper, covered bonds.  These have greater effect on private yields, (but there are general equilbirm effects )credit risk and political controversy.

b.       “subsidized bank lending through cheap long-term funding”.  “these lending programs were aimed at broader economic stabilization… offering bank-dependent borrowers the same access to credit as borrowers with access to securities markets... Most …evidence on these programs suggests that they lowered bank funding costs, promoted lending, and improved monetary policy passthrough…However, the efficacy of these programs seems likely to depend in a complicated way on the health of the banking system: If banks are well-capitalized, then their need for cheap liquidity from the central bank may be limited. Conversely, if banks are short of capital, their lending may be constrained or their incentives to make good loans distorted, notwithstanding the availability of low-cost funding”.

c.       Negative rates.  He says they might cause switching into cash and affect Bank’s profits, but aginst that help overall economic conditions.

d.       Yield curve control. He believes this works in Japan, but might not in the US. “…if long-term yields were pegged, and market participants came to believe that the future path of policy rates was likely higher than the targeted yield, the Fed might need to buy a large share of the outstanding bonds to try to enforce the peg. Those purchases in turn would flood the banking system with reserves and expose the central bank to large capital losses.  However, pegging Treasury yields at a shorter horizon, say two years, would likely be feasible”.

3.       What are the costs of risks of these various tools?  He believes all, bar the last, on financial instability, are small

a.       “Impairment of market functioning….Asset purchases likely improved market functioning “

b.       “High inflation. … Fed policymakers and staff understood that, with short-term interest rates near zero, the demand for bank reserves would be highly elastic and the velocity of base money could be expected to fall sharply  [i.e. that money and bonds would be near perfect substitutes]…. However, some FOMC participants did express concern about the possibility that [QE] could un-anchor inflationary expectations”

c.       Managing exit

d.       Distribution “the research literature is close to unanimous in its finding that the distributional effects of expansionary monetary policies… may even work in a progressive direction, for example by promoting a “hot” labor market”.

e.       Capital losses “The large, unhedged holdings of longer-term securities associated with asset purchase programs risked substantial capital losses if interest rates had risen unexpectedly, losses which in turn could have ultimately reduced the Federal Reserve’s remittances of profits to the Treasury”. 

Finally he discusses “. Financial instability….including but not limited to the creation of asset bubbles; incentivizing “reach for yield” and excessive risk-taking by investors; the promotion of excessive leverage or maturity transformation; and the destabilization of the business models of insurance companies and pension funds, which rely on receiving adequate long-run returns, and of banks, whose profits depend in part on their ability to earn positive net interest margins. U.S. central bankers also heard frequently from their foreign counterparts, especially in emerging markets, about the “spillover effects” of Fed policies on financial conditions abroad (Rey, 2013).”  He makes a number of points.

                                                               i.      “Increased risk-taking is by no means always a bad thing, of course: Encouraging banks, borrowers, and investors to take reasonable risks, rather than hoarding cash and hunkering down, is a desirable goal for policies aimed at ending a recession or crisis and restoring normal growth. However, risk-taking may become excessive…”

                                                             ii.      “Most participants in that debate agree that that the first line of defense against financial instability risks should be targeted regulatory and macroprudential policies..”

                                                           iii.      “…the portfolio balance effect of QE involves pushing some investors out of longer-term Treasuries into other, possibly riskier assets; but in general equilibrium, by removing duration risk from the system, QE reduces the riskiness of private-sector portfolios in aggregate, increases the supply of safe and liquid assets, and helps compensate for reduced private risk-bearing capacity during periods of high uncertainty”. 

Teaching Link: Imperial college student webinar, Current economic prospects, 12 May 2020

Imperial college student webinar, Current economic prospects, 12 May 2020

Some of our Imperial College students organised a webinar last night on our current economic prospects. They kindly invited David Shepherd, David Miles, James Sefton and me to participate. Here are some notes on the questions that they set us in advance and a few notes on what was said. Thanks to our talented and interested students for organising this and participating.

Q. How does the current climate compare to previous periods of economic turbulence e.g. Spanish flu of 1918, WW I&II, the great depression? In your opinion what is the optimal fiscal/monetary policy mix to confront the liquidity crunch due to COVID? 

The BBC showed on its website the following graph saying that this was the sharpest annual downturn since 1706. So this is clearly an gigantic recession; historically unparalleled, at least since 1706m and rolling together The Great Depression, the 2008 Financial Crisis and the flu pandemic all in one go. 

Optimal mix.

The optimal mix of money in fiscal policy is a nice question. Perhaps the best way to think about it is the benchmark economics competitive model. In that model economic systems are self-correcting. If there’s a shock to a market, say to the demand for PPE, it becomes more expensive: demand is choked off and supply is increased, as firms rush to enter a more lucrative market. The two forces of falling demand and rising supply raise prices and bring the market back to equilibrium.

The second feature of the benchmark competitive economics model, is that markets are not only self correcting, but they are what economists call complete. By complete this means that goods can be transacted for. And, in particular, future goods can be transacted for via future contracts.  Of course that's exactly what we see in the real world if we're thinking about let us say oil or aluminium. Airlines buy the oil forward . And that's part of prudent business management. But when economists think of a complete market they mean that all items can be traded forward. As John Kay is pointed out, in his book “The Truth About Markets” that would mean that you could buy a futures contract in let us say 1960 for the appearance of an iPad in 1990. The fact is of course that nobody even knew what an iPad was in 1960, let alone were able to sign a contract for it. But had they done so, it would have meant that the contract could have been traded and the forces of supply and demand mentioned above would have equilibrated the market.

Now in an economy where neither of those two conditions hold then we potentially have a room for policy. Let's take the first one. Many markets especially financial markets, seemed to be complete opposite of self equilibrating, especially in periods when market participants are panicking. That is to say uncertainty over the future, which induces panic, often makes sellers of financial assets sell, without demanders coming in to pull up the price (Think of somebody who are forced into crisis to sell some asset, a so called fire sale , even when the market is very depressed). The price of the asset falls and falls, thereby amplifying the original shock.

As for the second condition, nobody knew what COVID19 was and nobody signed a contract on it: in this case nobody insured themselves against its possibility. So we've had a very large adverse shock against which nobody took out insurance.

So the role of the state in this case , is to (1) step in if the market is in chaos and (2) to provide insurance because of the incompleteness in that market.

One important role for monetary policy is to step in when financial markets are in chaos and are dysfunctional. The Monetary Policy Committee did this in the financial crisis.

As for insurance, that is commonly the right role for fiscal policy. The benefit system ensures that workers have unemployment benefits if they were unlucky enough to be unemployed, and the progressivity of the tax system is such that when incomes go down taxes are effectively cut, so-called automatic stabilisers. That provisioning of insurance of course involves borrowing and involves perhaps paying out large amounts of unemployment benefit now, to be funded by the state, but then paid back by future taxing and borrowing once the economy has been restored.  

The right mix of monetary and fiscal policy depends upon institutions that we currently have in place.  The burden of insurance provision should lie with the fiscal authorities. Note however that as part of inflation targeting an independent central bank might want to undertake more expansionary monetary policy than would otherwise be the case if it wanted to avoid scarring; that is to say, if its inflation target would be imperilled if a prolonged recession lowered the potential output in the economy.   See Powell’s speech today (https://www.federalreserve.gov/newsevents/pressreleases/other20200228a.htm).

·         Do you expect a mild recession with a V shape recovery, a greater recession with a U shaped recovery or an L shaped deep depression? What are 'the city' thinking and how are they modelling excess risk/uncertainty into long-term economic models/predictions?

In our most recent monthly policy report The Bank of England have felt that the situation is so uncertain, and the historical parallels so difficult to discern, that it is unable to have a definitive forecast . Instead it produced a scenario, being an outlook based on the series of what at the time seem reasonable judgments. That scenario in Chart 1.3 below has a very sharp fall in GDP and then a slow recovery.  So overall UK GDP falls by 14% in 2020. Activity then picks up in the latter part of 2020 and into 2021 as social distancing measures are relaxed. That said GDP doesn't reach the pre covid level until the second half of 2021. So in 2020 GDP falls by 14%, in 2021 it rises by 15% and in 2022 it rises by 3%.

. 

The chart below shows what other forecasters expect for 2020 Q 2. The bank is somewhere in the middle of these averages. 

The report notes a number of downside risks to this scenario. One of course is the position of the world which is currently extremely difficult. A second which other commentators have looked at is the possibility of further waves of the pandemic. This is obviously a matter for epidemiologists but it is of interest to look at the chart below, put together by some London Business School economists pointing out that belief the death rate from Spanish flu came in three waves.  It is perhaps also worth pointing out do we don't yet have a vaccine for AIDS, thus the question of whether we will eventually have a vaccine is still open one .  Still another important point came out in the discussion last night. It is that it's very difficult to know how to interpret the recent fall and death rates because we are so uncertain as to what the level of infection in the community might be. The range of estimates seems to be from 5 to 65%. Of course, if the level of infection is very high, this is potentially extremely good and important news, because it means that the lockdown can be released. We urgently need to know what this number is. Perhaps the proliferation of tracing apps, the national launch of the NHS app, and Professor Tim Spector’s app from Kings College might help us.

Finally, the other sets of sensitivities would be around scarring. As mentioned above this is the possibility that the long-term supply potential of the economy is so damaged that it is difficult for the economy to come back again consistent with low inflation.  A number of scarring mechanisms exist. One is obviously the idea that if there was an extended period of unemployment workers would lose their skills and motivation. The second is that there may be a permanent structural change in the economy such that a number of capital assets (think airports) are simply as not usable and productive in the current economy as before. Of course capital can be reallocated but if that takes a time then the supplies potentially the economy can potentially be disrupted.  And of course it does look like they're going to be need to be some capital assets which will have to be increased: say, hospitals, delivery equipment and social distancing infrastructure.

·         What will be the long term impact of QE/Debt monetisation on interest rates and inflation post-COVID?  How will we pay-off the debt: taxation, austerity, growth, or a combination of the three? How does this marry-up with political decision-making and public opinion?

This raises a number of key questions. Let's go through them one by one .

The first point is what will happen to R*. To recap R*is the neutral rate of interest , that is to say the rate of interest at which resources completely utilised, and  unemployment and inflation are stable. It is indeed the case that central banks can influence short term interest rates but the long term interest rate is something typically beyond their control. So for example the large increase in demographic ageing in the last 30 years and the associated high demand for savings for a longer old age, is widely held to have depressed the equilibrium interest rate. Equally there appears to have been a fall in the demand for capital, perhaps caused by the increase of use of intangible assets which likewise pressed down on the equilibrium long term interest rate. So the key question is what happens to that future interest rate after this crisis?

One possibility is that it will increase as the demand for capital and demand for debt rises in the face of large borrowing by central banks and governments. Against that if there were an outbreak of precautionary savings in the face of the uncertainty around this shock , then there will be strong pressure for the rate to fall even further. We don't know what the balance of these forces is going to be. At least in the short run the amount of saving is strongly correlated with unemployment and the fear of unemployment. If unemployment rises and stays high that would typically drive saving up comma and if that were, common throughout the world that would drive the equilibrium real rate of return down.

So if the equilibrium interest rate falls further or at least stays low, that of course is very good news for what will of course be highly indebted governments. That said, we will need to boost growth in order that even at very low interest rates the economy can grow sufficiently to pay off what will be almost certainly a greatly increased debt burden.  And indeed was a bit of discussion at the session as to what his oral experience can tell us. The debt to GDP ratio was extremely high After World War One World War Two and rather earlier the Napoleonic wars. In the case of the Napoleonic wars in World War One the debt was reduced essentially via growth and low interest rates. That was also the case after World War 2, although inflation did play a role. So there is historical precedent for having high debt burdens and there is historical precedent for their being reduced by the joint forces of economic growth and interest rates.

In that respect QE is a minor player.  

Q. The Fed was quick and effective to launch stimulus programmes to contain the freefall in markets by providing mass scale liquidity. Warren Buffet recently commented that due to Fed intervention asset prices haven't bottomed out, making investment opportunities less attractive. Do you think the market has bottomed out? What are the asset price implications if lockdowns continue, albeit intermittently, until 2021? i.e. returns on stocks, bond yields, ETFs, safe haven assets such as gold.  Given the flight to safety we're seeing in capital outflows, what are the implications for FX rates between strong currencies (e.g. dollar, euro) and EM currencies? Could the massive scale QE cause the dollar to depreciate?

The session finished with some discussion of the above couple of questions. The difficulty of forecasting interest rates exchange rates made most people rather non-committal, beyond the observation that the US dollar always seems to stay strong in periods of panic , as people seek refuge in the world’s reserve currency. Finally, the future of the housing market. The interesting issue here is whether our experience of working from home, and the possible worries about taking public transport , might get us to a situation in which there is simply much less demand for both offices in general, but also office space,. That fall in demand may well have important effects reducing prices and rendering housing more affordable.  Another example of an equilibrating market? 

Various teaching links

We discussed the role of the state in the last section of class on Wednesday. Here is a typically insightful essay by Tim Taylor on what the state can and cannot do.

Various teaching links: broadband and innovation

1. Broadband raises productivity and demand for the skilled, lowers for the unskilled (Quarterly Journal of Economics (2015), 1781–1824).

This is an interesting paper that uses matched employee and employer data for Norway, using variation in Broadband availability across regions to measure the broadband effects on various meaures, including skilled and unskilled output elasticities.   Broadband lowers (raises) the output elasticity of the unskilled (skilled) with an overall effect on total factor productivity of (p.1809) a 10 point rise in availability of 0.4%.  The overall change in availability is a bit hard to see, but figure 1 suggests that most areas of Norway had zero availability in 2001 but 75% or above in 2005.  So if availability rose by, say 80 percentage points in 4 years, roughly TFP rose by 0.8% per year.


Update.
A new paper by Rosa Sanchis and co-authors does not however find such good results for Broadband speed on learning by kids.(summary here)

The abstract

Governments are making it a priority to upgrade information and communication technologies (ICT) with the aim to increase available internet connection speeds. This paper presents a new empirical strategy to estimate the causal effects of these policies, and applies it to the questions of whether and how ICT upgrades affect educational attainment. We draw on a rich collection of microdata that allows us to link administrative test score records for the population of English primary and secondary school students to the available ICT at their home addresses. To base estimations on exogenous variation in ICT, we notice that the boundaries of usually invisible telephone exchange station catchment areas give rise to substantial and es-

sentially randomly placed jumps in the available ICT across neighboring residences. Using this design across more than 20,000 boundaries in England, we find that even very large changes in available broadband connection speeds have a precisely estimated zero effect on educational attainment. Guided by a simple model we then bring to bear additional microdata on student time and internet use to quantify the potentially opposing mechanisms underlying the zero re-duced form effect. While jumps in the available ICT appear to increase student consumption of online content, we find no significant effects on student time spent studying online or offline, or on their learning productivity.

2. McKinsey have a new report on China Innovation.  They focus on innovation, measured by TFP growth, this from the Executive Summary.

Without labor force expansion and investment to propel growth, China must rely more
heavily on innovation that can improve productivity. We use multifactor productivity—growth that does not come from factors of production such as labor and capital investment—as a proxy for the macroeconomic impact of innovation broadly defined (including productivity gain from catch-up). The contribution to GDP of multifactor productivity has been falling in China, from nearly half of yearly GDP growth in the 1990 to 2000 decade to 30 percent in the past five years. To reach the growth target of 5.5 to 6.5 percent per year (the current consensus view from five leading economic institutions), multifactor productivity growth will need to contribute 35 to 50 percent of GDP growth, or two to three percentage points per year of GDP (Exhibit E1).