Parity and Stimulus

The ongoing appreciation of the Australian dollar could mute the impact of the current fiscal stimulus working its way through the system.

A recent paper released by the Centre for Economic Policy Research in London sheds light on the ongoing debate of whether fiscal stimulus being coordinated currently by the G20 nations would have a significant effect on the long run growth of their economies. The problem essentially has to do with estimating the size of the government multipliers of the nations involved.

As highlighted by its authors, on one side of the fence are the likes of Robert Barro who argues that the peace-time multiplier has essentially been zero. On the other side sit equally learned people like Christina Romer, Chair of the US Council of Economic Advisers, who uses a figure as high as 1.6. The difference between these two views is 3.7 million US jobs by 2010.

The paper in analysing the multiplier effect of government spending distinguishes between developed and developing nations, those with open and closed economies, those with fixed and flexible exchange rates and those with and without large external debts.

The findings which I quote below show a stark contrast:

In developing countries, the response of output to increases in government spending is smaller on impact and considerably less persistent than in high income countries.

The degree of exchange rate flexibility is a critical determinant of the size of fiscal multipliers. Economies operating under predetermined exchange rate regimes have long-run multipliers of around 1.5, but economies with flexible exchange rate regimes have essentially zero multipliers.

The degree of openness to trade (measured as exports plus imports as a proportion of GDP) is another critical determinant. Relatively closed economies have long-run multipliers of around 1.6, but relatively open economies have very small or zero multipliers.

In highly-indebted countries, the output response to increases in government spending is short-lived and much less persistent than in countries with a low debt to GDP ratio.

The picture this paints is quite clear. Since most advanced economies have successfully floated their currencies and have maintained relatively open economies, their ability to benefit from their spending will be limited in the long run. While it is true that in the short-run, fiscal stimulus does provide a “quick hit” to the system, the problem in the medium term is that as the stimulus diminishes (assuming it is temporary in nature), it creates a "fiscal drag" (the opposite of the multiplier effect). As per the US stimulus, this drag will detract from its GDP by as much as 2.5% in 2011.

China, an emerging economy which does not have external debts to speak of and which has a pre-determined exchange rate, will be able to benefit much more from its stimulus without threatening its exports. Australia on the other hand has seen its dollar approach parity with the greenback and may even see it reach $1.1, as the banner story of the Australian today declared, which would be an appreciation of about 70% from its lows this past year. This will lead to the stimulus leaking out of the country in the form of higher imports and weaker exports).

Unfortunately, the criteria laid out for spending, that it be targeted, temporary and timely may have been too difficult to adhere to. The cocktail of spending measures that resulted to address both short-run and long-run growth needs might have already been countered by monetary and exchange rate policy with the effects of a rising dollar soon to take hold.

Shiller on Animal Spirits

Robert Shiller in his address to the RSA notes that the use of the term animal spirits or spiritus animales referring to animating feelings that drive our thoughts and actions has had a 2000 year history. Keynes used this term in the 1930s to portray the motives that lie behind the market and to explain the occurrence of depressions. He used this to argue for macro fiscal stabilisation policy to be used in conjunction with monetary policy in undermining fear that was gripping agents in the economy.

Thirty years later, the efficient markets revolution of the 1960s as espoused by scholars Modigliani and Miller converted many to the perfect markets hypothesis. This theory eventually gained ascendancy to thwart Keynesian macroeconomics and led to Thatcherism and Reaganism in the 1980s. Ultimately, faith in the assumption of perfect information that markets embody may have left markets exposed to extreme cycles of bubbles and busts, shocks which gradually have eroded confidence in the theory itself.

He speaks of his long association with George Akerlof the former president of the American Economics Association spanning over twenty years in developing behavioural macroeconomics and with Richard Thaler in developing behavioural finance. Over fifty years of research since Keynes has contributed to some extensions of animal spirits. The book uses the constructs so often ignored in the economic literature relating to:

• Empathy: a modern term that is distinguished from sympathy, relating to the way we are able to experience something that is happening to someone else, e.g. we feel left out, sad during an expansionary bubble if we are not invested in the market and are not profiting from it unlike those around us,
• Fairness: people are very alert to being slighted, i.e. sticky wage theory which is based on rigidities found in labour markets arises because people react negatively towards wage reductions,
• Corruption/bad faith: comes as a result of a lowering of standards (due to greed for example) i.e. the sub-prime mortgage meltdown has led to distrust towards the banks and legal contracts in general and leads to an unwillingness to transact,
• Money illusion: the way individuals react to inflation and deflation is based on the illusory effects of the value of money,
• Stories: social psychology tells us that the mind is organised around stories or narratives; people relate to stories rather than dry statistics.

Overall, these insights tell us that people are proximately rational. It is only under stressful conditions when undertaking decisions of significant emotional content that the animal spirits take over the rational mind. A memorable moment came when he quoted Larry Summers, chief economic advisor to Pres Obama who said that on the crucial policy issues of the day, none were being informed by economists.

In responding to the possible collapse of the banking system, governments in Britain and the US acted swiftly in order to cut off the oxygen from the narratives that were building to prevent stories that were proliferating of individuals affected by the possible bank collapses. Their accurate reading of the stiuation did not come from an understanding of behavioural economics but from their survival instincts.

When a member of the audience challenged his view that the crisis was driven not by these “panic” attacks but by the accumulation of reserves in China that supplied cheap money to US housing markets, Shiller pointed out that China’s massive savings rate developed over time. It came as a result firstly of the One Child Policy which was the Communist Politburo’s response to the narrative built up in the ‘70s by Club of Rome about the “limits to growth”; and secondly, by the story woven today of China’s resurgence in the global scene. The result of this has been the sense of nationalism and self-sacrifice that is justifying this need for savings. Fascinating stuff!

China and the Long March to (Global) Recovery

The unfolding bi-polar global economy emerged this week with talk of “green shoots” in the US being mimicked by “bamboo shoots” in China. Several leading indicators from stocks, housing and credit markets had some hoping that these were early signs of recovery. This was then dashed with reports of poorer than expected retail spending in the US and weaker GDP growth in China later in the week. Closer inspection of China's data however show that there were genuine signs of recovery burried in the figures.

The Economist rightly points out that the slowdown in China is a result of purposeful policy back in 2007 when authorities were worried of overheating and restricted the flow of credit. The recent data shows that lending and investments have been restored, and that consumer spending has remained robust (read Jim O'Neill from Goldman Sachs referring to China as the new shopping superpower here). What has been impeding growth overall is the slowdown in exports resulting from weak demand from abroad. Contrary to perception though, employment in the tradable sectors accounts for only 10% of the labour force and much of the content of their exports is imported from abroad (only about 18% is locally value added, which translates to 7.2% of GDP).

Andrew Peaple of Dow Jones writes in the Wall Street Journal that:

the debate among economists is becoming more alphabetical. Is this recovery V-shaped, with China set to return quickly to the high-level growth of recent years? Or is it more W-shaped, as a government spending-led recovery this year peters out and China's longer term structural issues resurface?

Manoj Pradhan of Morgan Stanley forecasts that:

(G)lobal output will probably start growing in 3Q09 (3rd quarter of 2009), with G10 output growth turning positive in 4Q (4th quarter). However, growth for 2009 as a whole will stay firmly in negative territory for all regions except AXJ (Asia excluding Japan) ... We expect AXJ’s outperformance to be sustained next year with a 6.4% increase in output, compared to 2.1% for CEEMEA (Central and Eastern Europe and Middle East and Africa), 1.1% for the G10 and 0.3% for Latam (Latin America).

That developing Asia will lead the world to recovery is evident from this forecast as well as by consulting this year-to-date chart of stock market performance around the world assembled by Bespoke Investments. Apparently, there could still be something to the BRICs and decoupling argument after all.

The Impact of China's Stimulus

Markets cheered when the leaders of the G20 emerged from their summit in London with little more than an agreement to infuse the IMF with additional capital through issuing SDRs (special drawing rights) intended for distribution among member countries. Dani Rodrik points out the significance of these measures.

To produce greater bang for each buck from a fiscal stimulus plan, countries have to increase their Keynesian multiplier. One of the things that reduces the multiplier effect is the marginal propensity to import. To prevent leakage of such spending on foreign goods (the effect of the marginal propensity to import), it is essential for other countries to "pull their weight" and engage in similar levels of spending. In developing markets, credit and liquidity was drying up, limiting their capacity for fiscal spending .

This is why the Chinese fiscal stimulus which is roughly equivalent to 90% of Australia's entire GDP was significant for advanced economies. Some estimates put the multiplier in China at 1.1, meaning $1 spent by the government leads to $1.1 of additional spending elsewhere. Picture the output of Australia for two years being disbursed in less than a year. Much of this multiplier is due to the public investment nature of the spending on roads and basic infrastructure. For this reason, resource rich countries like Australia will have much to cheer about in the coming months.