Anjulie-Rusius_100

A shifting Beveridge Curve – Does the US have a long term structural unemployment problem?

I am sure that many of us are familiar with some of the better known economic theories concerning unemployment which have previously been discussed or alluded to on this blog e.g. Okun’s Law and the Taylor Rule, but perhaps a lesser known theory (which has been receiving growing attention from economists in recent times), is the Beveridge Curve.

Using data on job vacancies and unemployment, the Beveridge Curve indicates how efficient an economy is at matching unemployed workers to job vacancies and can indicate where in the business cycle an economy sits. Looking specifically at data for the US from December 2000 onwards, the jobs market behaved as you’d expect; changes in the supply or demand for labour causes movement along the curve (this is particularly apparent during the highlighted recessionary periods). But what is particularly interesting – and glaringly obvious – is the shift which occurred post June 2009. The looping movement “back up the curve” is less surprising as after an economic contraction, this would be precisely what you would expect during a recovery period (i.e. falling unemployment teamed with an increase in the job vacancy rate as firms start to hire again).

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But what could have caused this shift in the Beveridge curve, which if it remains, could imply a long term increase in structural unemployment?

1) Inefficiency. The shift is essentially indicative of an increase in the job vacancy rate. So perhaps we could argue that there has been a short-term reduction in the efficiency of job matching due to labour market conditions. Indeed, this inefficiency could in part have arisen from a decrease in labour mobility, linked to the US housing market. Since home prices are still below the pre-crisis peak, this could result in reluctance from jobseekers to sell their homes, which could in turn geographically limit their search. If this were true, in time the curve would be expected to shift back in line as the housing market recovers and jobs and workers get matched more quickly.

2) The labour force participation rate. Perhaps the shift has been caused by the post-crisis increase in unemployment. As the theory would have it, as the number of job seekers increases relative to the population, this would cause an outward shift of the Beveridge Curve. The US has however witnessed the exact opposite since 2009 – a fall in both the unemployment and labour force participation rates. On this point, research from Unicredit suggests that the fall in the latter is causing the unemployment rate to be understated were it not for the decline in the labour force participation rate, unemployment would stand at 11.5%. This signifies that the US may well have an underlying structural unemployment problem that is currently being ignored.

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3) Long term unemployment. If caused by a fundamental mismatch between an employer’s requirements and an employee’s skill set (which deteriorates as more and more time is spent out of work), long term unemployment could cause the Beveridge Curve to shift outwards. Indeed, the proportion of unemployed workers who have been without work for 27 weeks upwards has increased since June 2009 and remains high, suggesting that a long term structural shift may have occurred in the US.

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4) Increasing frictional unemployment. To cause an outward shift of the Beveridge Curve, frictional unemployment – the time period between jobs, caused by redundancies and resignations – would have to increase. Although this could have caused the initial shift, to my mind, this argument is inconsistent with longevity of the shift. If the shift were solely due to frictional unemployment, this impact should have been eroded since 2009 as labour market performance gained some ground.

5) Economic and policy uncertainty. I think it’s fair to say that the US has seen its fair share of economic uncertainty since 2009 and significant political headwinds in 2013 alone. Firstly, with regards to the sequestration earlier this year which saw fiscal contraction manifest most notably via the expiration of the temporary payroll tax and budget caps. Secondly (although more recently so this will not yet be reflected in the data), political headwinds have continued in the form of the prolonged Government shutdown. As such, these headwinds could potentially explain the lasting effect of the shift, in 2013 at least.

On the whole, the outward shift of the Beveridge Curve indicates that there has been a significant change in the US labour market. The key question however is whether or not this shift will prove to be a short term phenomenon that will erode over time as the US recovery strengthens. If we suppose that the shift is temporary and that the US will revert to norm, reading off the graph, this suggests that unemployment for August 2013 should have been in the region of 5.5%, which is well below the Fed’s trigger level to raise interest rates. On the other hand, is this too optimistic and have we instead witnessed a long term shift that is here to stay? The Beveridge Curve is one to watch.

richard_woolnough_100

Full time, not part time, economic recovery

When meeting UK clients we obviously spend a lot of time discussing employment and the relative strength of the UK economy. The chart below from the Bank of England shows the recovery in employment in comparison to previous recessions. It actually looks quite good versus the other mega recessions.

UK employment is well above previous recession levels

One very good common question we often get is along the lines that the employment number is “not real” as part time employment has gone through the roof.

The chart below shows part time employment as a percentage of the total number of workers in the UK. There is obviously an ongoing trend to part time employment that has continued from the peak of the crisis. It appears that part time employment increased relatively rapidly through the recession. However, since 2010 the ratio has been declining. Therefore the recent recovery in employment appears genuine and not flattered by part time workers.

Part time employment has moved sideways since 2010

The UK economic recovery is real, and thankfully fiscal deficits, and interest rate policy have worked. The market’s fears of permanent recession are diminishing as reflected in the current bear market for UK gilts. The economic panic illustrated by very low yields where gilts became very dear (see this blog from January 2012), is over. The gilt market yield is returning towards better value, with ten year yields once again around three percent, as the UK economic recovery remains firmly on track.

richard_woolnough_100

Jobless claims and Fed policy

Today’s release of jobless claims shows that the US economy is continuing its healthy response to the stimulus provided by the Fed. Momentum in the US labour force remains in a positive direction.

The very long term chart below shows today’s headline number of 331,000 to be relatively low historically. However, this is actually understating the current strength of the labour market.

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In order to interpret the jobless rate more effectively we need to look at it as a percentage of the ever increasing labour force, and not just the headline number. We have made those adjustments in the chart below.

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The fact that the economy has thankfully responded to low rates is good, though not new, news. However, the one thing that is very different this time is where we are in the interest rate cycle. At previous lows in jobless claims the Fed has typically been tightening to slow the market down. This time they are still in full easing mode with conventional and unconventional policy measures. This contrasts dramatically with the lows in jobless claims in the late ’80s and the beginning and the middle of the last decade, when the Fed was already in full tightening mode. This is highlighted in the chart below.

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As you would expect to see, interest rate policy works with a lag. Given that we are unlikely to see conventional tightening for a while, one would expect the US economy to remain in decent shape.

A bear market in bonds can be seen as predicting a future normalisation of rates. If, like the Fed, you recognise that this time around things are not all normal, then you could expect short rates to stay low and employment growth to continue. The extent of the current bear market in bonds is therefore limited by the new environment we are in, where conventional economic systems have been amended and changed by the financial crisis.

jim_leaviss_100

It’s a knockout – why the gilt and currency markets have no love for Carney’s forward guidance

Millwall FC wasn’t the only team to trek up to Nottingham yesterday from London and to come back empty handed (at the hands of the mighty, mighty Forest).  Team Carney from the Bank of England also had an unproductive time of it in the East Midlands as the new Governor gave his first speech in the role to the CBI, Chamber of Commerce and the Institute of Directors.  Since the publication of the August Inflation Report, in which the Monetary Policy Committee delivered its framework for forward guidance, the markets have done the opposite of what the Bank had hoped for.  The gilt market has sold off – not just at medium and long maturities, which are largely outside of direct Bank control and are more dependent on global bond market trends, but also at the short end, where 5-year gilt yields have risen by 20 bps in under a month.  There has also been a de facto tightening of UK monetary conditions through the currency.  Trade weighted sterling is 1% higher than it was before forward guidance came in.  Both the gilt market and the pound went the “wrong” way as Carney discussed forward guidance yesterday afternoon.  The Overnight Index Swaps market (OIS), which prices expectations of future official rate moves, fully prices a 25 bps Bank rate hike between 2 and 3 years’ time.

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So why don’t markets believe Mark Carney?  In yesterday’s speech he was clear that the UK’s economic recovery was “fledgling”, and weaker than recoveries elsewhere in the world.  He spent some time discussing how a fall in unemployment to the 7% threshold would mean 750,000 new jobs having to be created, which would take some time, possibly three years or longer.  And even if growth picked up, it didn’t necessarily follow that jobs growth would be strong.  But two things led gilts lower yesterday afternoon.  Firstly there was the announcement that UK banks would be able to reduce the amount of government bonds that they hold as a liquidity buffer so long as their capital base is over 7% risk-weighted assets – potentially triggering sales of tens of billions of gilts over the next couple of years.  But more importantly, Carney’s attempted rollback from the “knockouts” stated in the Inflation Report was not strong enough.

On page 7 of the Inflation Report, after detailing the forward guidance linking rates and asset purchases to the 7% unemployment rate, there are three “knockouts” which would cause the guidance to “cease to hold”.  The first knockout is the most important.  If CPI inflation is, in the Bank’s view, likely to be 2.5% or higher in 1 1/2 to 2 years’ time then the unemployment trigger becomes irrelevant.  The other two knockouts were that medium term inflation expectations become unanchored, and that the Financial Policy Committee judges that the monetary policy stance is a significant threat to financial stability.

So for all the talk of the UK’s weak economy, and the accommodative stance that the Bank will take to allow the unemployment rate to fall to 7%, perhaps over many years, don’t forget that if CPI inflation looks likely to be at 2.5% or higher, the MPC will ignore the jobs market promise.  Since the middle of 2005, UK CPI has been at or above 2.5% most of the time, through a strong economy and (for longer) the weak economy.  Since the start of 2010 there have only been 3 months of sub 2.5% year-on-year CPI.  And in 2008 and 2011 the year-on-year rates exceeded 5%.

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Of course, the Bank of England can forecast inflation to be whatever it likes over the next 1 1/2 to 2 years.  Its inflation forecasts have famously been awful for years, always predicting inflation would return to 2% when it always was much higher than that.  But it will be important for Carney to earn some credibility here in the UK, and the days of the Inflation Report’s “delta of blood” inflation forecast always showing a mid point for future inflation of 2% must surely have ended when Mervyn King left.  What does the outside world think about the prospects of UK inflation being below 2.5% in the future?  Here the news is better – the consensus broker economic forecast is for CPI to fall to 2.4% in 2014 and 2.1% in 2015.  And the implied inflation rate from the UK index-linked gilt market is for an average of 2.8% per year over the next five years on an RPI basis, which given the structural wedge between RPI and CPI suggests that the market’s CPI forecast is somewhere below 2.5%.  M&G has launched a new Inflation Expectations Survey, together with YouGov.  We should have August results shortly, but in our last release we saw that 1 year ahead UK consumer expectations of inflation ran at 2.7% (a fall from 3% a quarter earlier) and 5 year ahead expectations were at 3%.  Higher than the 2.5% target, but consumer expectations are often higher than the market, and the 3% level has been stable (well “anchored”).

But as we have seen, UK inflation has been notoriously sticky.  Not because consumers are demanding more goods than the shops can supply (although there has been some long awaited good news from the retail sector lately, with sales stronger), as in general real incomes have been squeezed and discretionary spending has been hit.  But because non-discretionary items, like food and energy costs, have substantially exceeded the inflation rates of consumer goods.  Add to this administered prices relating to public transport costs or university tuition fees and we can see that the UK’s “inflation problem” is potentially something that a monetary policymaker can only influence by forcing discretionary spending into deflation.  The chart below shows that so long as the non-discretionary basket of goods keeps inflating at around 5% per year, there must be virtually no inflation in discretionary goods in order to get below Carney’s 2.5% knockout.

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So it is going to be tough for the market to believe that the CPI inflation “knockout” won’t have a decent chance of coming into play well before the 7% unemployment threshold is reached.  I think Carney missed an opportunity to move away from the knockouts yesterday – he certainly didn’t use the term again, and implied that the gilt market’s move lower was driven by international developments and over-optimism about the prospects for a quick fall in UK unemployment.  But the three knockouts were almost dismissed in the sentence “provided there are no material threats to either price or financial stability” rather than given the prominence that they were in the Inflation Report.  But it looks as if the gilt and currency markets need something stronger if they are to produce the monetary easing that, from Carney’s bearish analysis of the UK economy, it still needs.

richard_woolnough_100

Mr 7 percent – exploring unemployment in the UK

The governor at the Bank of England stepped forward last week with guidance about its future plans and conditions regarding the tightening of monetary policy. Ben gave his views on the announcement here last week, but what I am going to focus on is the 7 percent unemployment rate ‘knockout’.

Firstly, why has the Bank of England decided to use the unemployment rate as an indicator of inflationary pressures? Well, in the press conference they expressed that this is a good indicator of excess capacity. This has some obvious logic to it, so let’s explore this knockout level in an historical context.

Below is a chart of UK unemployment going back 20 years. As you can see, the rate was below 7 percent from 1997 to 2009 – a period of good economic growth where the bank acted regularly to tighten policy to keep inflation under control. In fact this new knockout does not appear to be new news, as the bank rate has rarely increased when unemployment exceeded 7 percent over this period.

Rates have rarely been hiked with unemployment above 7%

Looking at the next chart you can see the regions that currently have unemployment at 7 percent or below and the ones that do not. This regional disparity is not as strong as in Europe, but is something one should take into account.

UK unemployment by region

Mobility of labour is needed for the rate to fall below 7 percent, with work relocated to labour and labour relocated to work. This is beyond the Bank of England’s remit, and is more of a central government economic project. The better regional labour mobility is, the quicker the UK can get unemployment below 7 percent. So, the easier it is to move house, or the quicker transport links are, the quicker unemployment can get below 7 percent. If regional labour mobility in the UK is very rigid then getting below 7 percent may not occur for years.

One new factor that we should take into account is the developing context of the wider European labour market. The UK workforce is not only competing as a whole internationally, but within the domestic economy it now also competes with international labour. The free movement of labour in the European Union combined with high rates of unemployment on the continent means that UK unemployment (spare labour capacity) can no longer be set with reference to our domestic borders. The huge pool of available labour could well dampen reductions in UK measured unemployment, aided by the UK’s tradition of welcoming foreign labour, its diversity of population (especially in areas seeking workers), and the fact that English is a well taught second language abroad. This could well act to reduce the ability of unemployment to fall in the UK despite low policy rates.

Even if the UK economy does respond to monetary policy and we reach escape velocity, labour immobility in the UK and or the supply of continental labour will have a baring on when the 7 percent unemployment rate is knocked out. Using this as a signal to raise rates could well mean that rates stay low for a long time even as the economy recovers.

jim_leaviss_100

Video: whilst the market gets excited about unemployment falling to 6.5%, the Fed’s attention is turning to falling inflation

I spent a couple of days in New York last week seeing economists and academics. The US Treasury market had just seen a significant sell-off, with 10 year yields rising from 1.63% at the start of May, to over 2.2%, with much of the damage done by Bernanke’s surprise talk of QE tapering during the Q&A following his address to Congress’s Joint Economic Committee. US 30 year mortgage rates sold off in parallel, and are now around 4%, potentially damaging the housing recovery.

I came away with two main conclusions. Firstly, given the stuttering nature of the US growth recovery (and the second half of this year could be mediocre, thanks to some back-loading of fiscal cliff tightening) the case for a slowing of QE in the next few months is not at all strong. Economists point out that Bernanke’s prepared testimony to the JEC was very dovish and in no way suggested that tapering might happen this year. His Q&A response appears to have been a communication error, as evidenced by some rolling back over the last couple of days via well connected journalist Jon Hilsenrath in the Wall Street Journal. And secondly, whilst we all focus on the jobs data in the States and try to forecast the timing of hitting the 6.5% unemployment rate threshold, we might be taking our eyes off the Fed’s other concern, inflation. Having spiked higher in 2011/2012, thanks largely to higher commodity prices (cotton, oil), core inflation measures, and particularly the Fed’s preferred Core PCE Deflator statistic, are falling to around 1%. Wage growth is also weak. With inflation 1% below the target level, a Taylor Rule approach would see the Fed easing interest rates by 1.5%, not hiking or withdrawing monetary stimulus! And with rates at the zero bound and a cut impossible, unconventional monetary policy would have to take the strain. More, not less, QE might be more likely than any tapering.


Wolfgang Bauer

Should we worry about recent rises in capacity utilisation?

In recent years the use of capacity utilisation (CU) as a leading indicator for inflation, and hence for interest rates, has fallen somewhat out of favour. The large amount of spare capacity in the developed world in 2009-10 failed to translate into the substantial deflation that many had anticipated. Most economists and investors are eagerly focussing on U.S. labour market data instead, given that the Federal Reserve has tied its interest rate policy to an unemployment rate threshold of 6.5%. So, is it time to throw CU into the dustbin of economic history once and for all? This might be premature; ignore CU at your own peril.

Every month the Federal Reserve Board produces a CU percentage figure for industries in manufacturing, mining and utilities by essentially dividing actual output by capacity, i.e. a maximum sustainable output level. In general, capacity figures are derived from physical product data from government and trade sources or, if actual product data is unavailable, from responses to the Bureau of the Census’s Quarterly Survey of Plant Capacity. The basic rationale behind using CU figures as a leading inflation indicator reads as follows: in economic boom times factories tend to bring their output closer to full capacity, which places growing strains on their goods-producing capital. Excess demand and lack of supply, in combination with failure of stressed equipment, can lead to product shortages, sparking price increases and inflationary pressures. A more detailed explanation can be found in chapter 4 of Richard Yamarone’s book “The Trader’s Guide to Key Economic Indicators” from 2012.

Prior to the financial crisis in the late 2000s, the Fed apparently followed this line of argumentation. As the first chart shows, major hikes in the Federal Funds Rate, e.g. the January 1994 and July 2005 rate hiking cycles, marked by white dotted lines, followed periods of rising CU numbers. However, from 2008 onwards this relationship has clearly broken down. Although CU has risen by more than 11 percentage points from 66.9% in June 2009 to 78.3% in February 2013, the Fed Funds Rate has been kept close to zero. One could argue that despite this remarkable CU growth, i.e. reduction in spare capacity, in recent years the absolute CU level is still below the psychologically significant 80% threshold. For instance, the 1994 rate hike, and the subsequent “death of the bond market”, began at a considerably higher CU level of 82.4% (January 1994). However, I do not find this argument particularly convincing, considering that the Fed’s most recent major rate hiking cycle started at a CU level of only 77.9% (July 2004), 0.4% below the current figure.

And then came the crisis...

Another aspect worth exploring is the relationship between CU and business investment spending. Maybe U.S. companies have simply slashed their investment plans and decided to run down their plants and equipment after the financial crisis, scared to invest their cash safety blankets. In this case, rising CU numbers would merely be an artefact and no indicator for economic recovery and inflationary pressure. The second chart shows both CU and quarter-on-quarter (qoq) changes in non-residential fixed investment for 2009 onwards. With increasing CU figures, investment changes get less negative in 2009 before they enter positive territory in Q1 2010. Throughout the following three years, business investment has grown in 10 out of 12 quarters. Slightly negative qoq changes of -1.3% and -1.8% were recorded in Q1 2011 and Q3 2012, respectively. It should also be noted that the decline in qoq investment changes from Q3 2011 to Q3 2012, which was addressed in a Wall Street Journal article from November 2012, has come to an end by jumping to +8.4% in Q4 2012. Considering this pattern of investment spending, recent CU increases cannot be explained by cut backs in business investment. Therefore, I believe that the rise of CU is indeed a strong sign for an ongoing recovery of the U.S. economy.

Can rising CU be explained by cut backs in investment?

In conclusion, although at the moment the Fed seems to be preoccupied with the unemployment rate, I believe it is worthwhile keeping an eye on CU. If CU continues to rise, while being backed up by growing business investments, this would indicate inflationary pressures too strong to be forever ignored by the Fed.

markus_peters_100

Wage inflation: Upward pressure on German labour costs in 2013

When I left Germany more than three and a half years ago, it was a good place to live. Germany’s polarising football superpower Bayern Munich had just failed to win the Bundesliga, horse meat was deliberately eaten in form of “Rheinischer Sauerbraten” and circa 40 million Germans were in employment. Despite all the bad news today – Bayern Munich has a strong lead in the Bundesliga table and horse meat is a basic ingredient in nearly every ready-to-eat meal available – Germany has not become a worse place to live. Employment is at record highs in absolute terms and the unemployment rate stands steady at 6.9%.

Although some of the peripheral countries have made some progress to lower their unit labour costs through harsh austerity measures (as projected by the Organisation for Economic Co-operation and Development (OECD)), Germany’s competitiveness still stands out as exceptionally high within Europe. Austerity is a tough medicine to take, so I doubt that the Greeks, Spanish and especially Italians (as the recent electoral outcome confirmed) are willing to take their prescribed doses all the way through until they reach a similar level of competitiveness to Germany.

Germany’s economy is highly competitive

For this reason, it is generally argued that the Eurozone rebalancing has to come not only through structural reforms in the periphery, but also through internal devaluation in the core of Europe. Unlike peripheral Europe which is attempting to reduce labour costs, in 2012, Germany’s economy saw annual real wage growth for the third consecutive year. Employees keep demanding higher salaries after cutting back for years. Hiring intentions and business confidence have not even dropped considerably after the economy’s slowdown in the last quarter. But most importantly, it’s electoral season in Germany.

At the start of March, the SPD, Greens and “Die Linke” (The Left) officially kick-started their electoral campaign around the topic ‘social justice’ (Soziale Gerechtigkeit). In Germany’s upper chamber (Bundesrat), where they now hold the majority of the votes, the three parties voted in favour of a statutory minimum wage of EUR 8.50/hour (or circa EUR 1,300 per month if we assume an average weekly working time of 35 hours for full-time workers).

Germany is one of the few countries in Europe which has not got a statutory minimum wage. The proposed minimum wage would roughly equal the minimum wage level of the United Kingdom and would be below the minimum wage of France, the Netherlands – and Ireland (looking at the below chart, I have been wondering if this is one of the reasons why we have not seen as many Irish people on the streets as Spaniards or Greeks). The proposed law is still subject to the approval by the CDU/FDP-led German Parliament though. It is very unlikely that it will be approved in its current form, but it puts considerable pressure on Angela Merkel to make concessions on this topic and to somehow set a floor level to German wages.

The proposed statutory minimum wage level is not excessive in comparison to other major European economies

The main source for wage pressure in Germany though stems from expiring labour agreements between the powerful trade unions and industrial employers. It is estimated that labour agreements concerning up to 12.5 million workers, or around 30% of the German labour force, are subject to re-negotiation in 2013. Trade unions Ver.di and IG Metall represent the interests of around 9 million German workers alone this year. The wage negotiations with the biggest impact take place for compensation in the metal and electronics industries (concerning circa 3.4 million employees), in the retail industry (1.3 million), in the wholesale commerce sector (780,000), and in the main construction sector (650,000).

So what are they asking for? One of the very first renewed agreements was concluded last weekend. Labour union Ver.di and the public sector representatives agreed on a 5.6% wage rise throughout 2013 (+2.65%) and 2014 (+2.95%) for around 800,000 public sector employees. Furthermore, job guarantees were granted for all public sector trainees and a uniform holiday allowance of 30 days per year was agreed. Elsewhere, IG Metall currently aims at a nominal wage growth in the metal and electronics industries of 5.5% and IG Bau has demanded wage growth of 6.6% for workers in the construction sector. Beyond doubt, this could mean significant real wage growth for a considerable part of Germany’s 41.7 million labour force.

The power of German trade unions, particularly in electoral times, must not be underestimated. The German “blue collar” workers are the traditional voters of the left parties, so the social democrats will do everything to support the trade union efforts. Angela Merkel has to find a way to accommodate the unions’ demand for higher wages because she will not be able to afford an outright electoral recommendation for her competitors to 12.5 million blue collar workers.

German wage inflation is on its way – labour agreements for more than 12m German employees are subject to renegotiation in 2013

Wage inflation is certainly on its way in Germany. And it might come at exactly the right time for the German economy. In an environment in which we can’t see Eurozone demand for German goods picking up and Chinese demand for German goods is increasingly likely to slow down, it strikes me as a positive development that German workers have more money in their pockets and can stimulate domestic consumption, making the German economy less dependent on the export sector. But the German economy clearly walks a fine line here. Excessive wage growth might decrease German competitiveness too much. We don’t see this danger stemming from the suggested minimum wage which seems to be too low to have a significant immediate negative impact. In the longer run, there is the risk though that the minimum wage level could prove to be an enticing lever for governments to please the electorate ahead of general elections.

In the shorter run, the impact on overall wage levels from labour union agreements might prove to be more considerable. The rigid Bundesbank models suggest that a 2% increase in real wages in the German economy would translate into a ¾% decline in the rate of GDP growth and a 1% increase in unemployment. The same models say that the effect for the peripheral nations from the decreased competitiveness of the German economy would be close to zero because of the structure of trade flows. So the net negative effect to European trade overall is attributable to what Bundesbank president Jens Weidmann phrases as the realisation that “Europe is not an island, but part of a globalised world”. In our opinion, it would be interesting to see what the models say when you feed them with a 30% Yen depreciation and 20% sterling depreciation against the euro and what the Bundesbank’s suggested reaction to such a scenario might be.

 

richard_woolnough_100

Climate change – bzirc monetary policy

As investors we get used to living within certain recognised bounds. For example, it has been commonly assumed that interest rates cannot be sub-zero. There has been the odd historical quirk when we’ve seen negative rates (Switzerland in the 1970s), but that’s more for amusement than general investment consumption. However, there now appears to be the potential for a major investment climate change.

There are already plenty of bond markets now living in the sub zero ice age, such as Switzerland, Denmark, Germany, Finland and the Netherlands. In these cases, the existence of negative rates could be down to the desire to express a currency or re-denomination view (as Mike previously wrote), so may be seen as a by-product of external factors and not of domestic monetary policy. However, there is now the potential for G7 monetary policy to enter the previously unbelievable reality of official sub-zero rates.

Many G7 economies have implemented very low rates and quantitative easing for a number of years, yet still appear to be in the economic doldrums with high unemployment, low growth and limited fiscal room. It could now be time for a significant change in the investment text book as central banks experiment with rates below zero.

Theoretically, a negative interest rate sounds simple – you put £100 in the bank and you get £99 back a year later if the rate is -1%. A  rational investor would of course have the alternative of simply keeping their cash under the mattress and not suffering the negative rate, although the incentive to behave rationally would be limited by the administrative burden and security risk of holding cash.  The central bank could simply limit this activity by basically not printing enough cash. Therefore the vast majority of money would have to be held electronically and could therefore suffer a penal negative rate. Implementation of sub zero rates is possible.

From a central bank’s point of view this should be stimulative, as it would discourage saving and encourage consumption like any traditional interest rate cut. At the extreme you could create exceptionally low, zero, or even negative borrowing rates.

The challenges faced by central banks and governments are still there despite traditional and unconventional policy action. Maybe it will soon be time to use the conventional tool of cutting interest rates in an unconventional way by making them negative. The next step to be taken by the authorities might mean economies working in a below zero interest rate climate (bzirc monetary policy).

matt_russell_100

From The Politics Of Economics To The Politics Of Society

As we had a three day weekend last week I used the opportunity of an extra day off to catch up on some reading. One of the pieces I read struck me as particularly pertinent given the elections on the continent last weekend. Woody Brock, the founder of the economic advisory service Strategic Economic Decisions (SED), regularly puts out thought provoking research reports discussing various topics encompassing economics, politics and philosophy. In his latest piece he has pulled all three strands together to discuss the conditions that are necessary for an ideal society.

The report is a fairly long piece but I will do my best to summarise. Dr Brock argues, and I tend to agree, that much of the debate about the current state of the world is too focused on creating an ideal economy. From the relative merits of western capitalism vs Chinese state capitalism to austerity vs growth policies in Europe the arguments are regularly hammered out in economic terms – potential GDP growth, inflation outcomes, effects on bond yields and so on. Whilst all these factors are important to our well-being they are not the entire story, one must also look to other elements that make up a society – politics and philosophy.

While Dr Brock feels that the optimal economy is one which essentially displays the characteristics of perfect competition he also accepts that government intervention is required to provide public goods (say the police) and to correct for negative externalities (e.g. pollution). Brock believes that the level of government involvement should be determined by the checks and balances written into a nation’s constitution/fundamental laws, or the collective philosophy of the people of the nation. In short, the constitution/courts are there to limit politicians’ powers to those that the people want to grant them, and politics is there to regulate the economy based on those parameters.

The conclusion that Brock comes to is that the optimal society is one in which these various spheres overlap as little as possible – politicians should leave the economy to its own devices as much as they can and not amend the constitution/laws that govern their own behaviour unless with good (social) cause. I’ve lifted the below diagram straight from the report to demonstrate this more clearly.

SED – The Ideal SocietyIt struck me as I was reading the report that if SED’s analysis is correct France has taken a step away from becoming an ideal society after electing Francois Hollande. He ran with a brazenly socialist platform – lowering the retirement age, creating subsidised jobs for the unemployed and creating 60,000 new teaching jobs.

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