It’s hard to make sense of all the various economic data that we are seeing in recent weeks:
1. A red-hot labor market, perhaps the strongest since the 1960s.
2. Rapidly falling equity prices.
3. Plunging interest rates, both fed funds futures and longer-term bond yields.
4. Reports that the Chinese economy may be back to normal by April.
Of course the backdrop to all of this is the coronavirus epidemic. (Thankfully, we don’t have to hear any more about Bernie Sanders causing the stock crash, as Biden seems to be firmly in the drivers seat. Sanders had an impact, but it was small.)
The simplest explanation is that the coronavirus epidemic may cause a recession. But that doesn’t fully explain the decline in bond yields, especially the real yield on long-term inflation indexed bonds. The impact of the coronavirus is expected to be relatively short-term. In another 12 to 18 months we may have a vaccine. Some even believe that the epidemic will moderate as soon as it warms up this summer.
Another possibility is that the coronavirus is expected to cause a radical change in lifestyle, one that involves a much higher savings rate. Thus people will be less interested in going on vacations, to the movies, or eating out. You might argue that in that case they’d simply switch consumption to other goods, buying more washing machines and automobiles. But we live in such a service-oriented economy that it’s hard for people to quickly adjust their lifestyle in such a way as to move consumption from one sector to another. Thus saving increases, depressing interest rates.
I do find it plausible that the bond market is being hit by an unusually sudden and unusually large savings shock. This theory has the same drawback as the previous theory, however, as the coronavirus epidemic is expected to be temporary. Indeed in places like China it appears the worst is already over. Perhaps the markets are signaling that the epidemic will last longer than expected, and/or that it will trigger fear of future epidemics, and that this will permanently change lifestyles.
You could argue that financial markets aren’t actually measuring “expectations” anymore, and that the enormous uncertainty about the epidemic has created a high demand for safe assets, which is boosting bond prices and reducing stock prices. According to this view, the low interest rates on long-term bond don’t actually reflect expectations that future interest rate will be extremely low. Perhaps, but we’ve been hearing that argument for 12 years, and it hasn’t panned out so far. The markets have been broadly correct on low rates being the “new normal”.
Some claim that at least 3 billion people will eventually contract the illness. If we assume a mortality rate of 0.5% to 1.0%, then this implies 15 – 30 million deaths, making it the greatest disaster since the Great Leap Forward. Perhaps wars and plagues move societies in an illiberal direction, which would be bad for long run economic growth. But this all seems highly speculative at the moment, and is unlikely to account for day-to-day moves in the financial markets. Furthermore, those mortality estimates assume another upward surge in deaths in China (reported at roughly 3000 so far, and slowing, although the actual numbers are somewhat higher). I have no idea whether there will be a secondary and far worse outbreak in China; this claim seems highly speculative.
What are the policy implications? Even with all the uncertainty, several points seem clear.
1. Equilibrium nominal interest rates are declining.
2. Equilibrium real interest rates are declining.
3. Expected inflation and expected NGDP growth are very likely declining.
The first point suggests that the Fed should cut its nominal interest rate target. The third point suggests the Fed should ease monetary policy. (And no, that’s not saying the same thing in two different ways, as NeoFisherians are fond of pointing out.). The second point might imply that we would benefit from building more infrastructure, but it most certainly does not imply that the government should be building that infrastructure.
READER COMMENTS
Loquitur Veritatem
Mar 6 2020 at 3:08pm
I suggest that the fatality rate won’t exceed 0.2 percent, which is the rate (so far) for the passengers and crew of the Diamond Princess — an especially unrepresentative group. See https://politicsandprosperity.com/2020/03/06/lesson-from-the-diamond-princess-panic-is-unwarranted/.
Scott Sumner
Mar 6 2020 at 3:27pm
I don’t disagree with you claim that far fewer than 15-30 million will die, but you are mixing up two unrelated issues, the mortality rate of those who get the disease with the number who will get it. The mortality rate of those who get the disease is probably 0.5% to 1%. I do agree than many fewer than 3 billion are likely to get the disease, as you imply. But I think it’s important to keep those two ratios separate. Keep in mind that the infection rate on the ship might have been higher if the cruise had lasted longer.
Alan Goldhammer
Mar 6 2020 at 4:24pm
Scott – This is off topic but can you post a couple of good references on NGDP targeting for those of us who are non-economists. I would like a better understanding but haven’t really found much out there.
On topic – I serve on the investment committee that is responsible for a sizable portfolio. We are trying to figure out what to recommend to the fund manager in terms of shifting allocations. It’s a tough call right now and so far we are staying the course. I suspect that in the next 4-6 weeks we will start getting data from the US and other countries that will allow some better predictions. The outbreaks are still weird from an epidemiological point of view.
With respect to your third point, what should the policy of the Fed be? Should they even consider going into negative interest rate categories?
Scott Sumner
Mar 7 2020 at 12:27pm
Read this:
https://www.mercatus.org/system/files/beckworth-ngdp-targeting-mercatus-special-study-v1.pdf
The Fed should shift to level targeting, stop paying IOR, and buy as many assets as necessary to get inflation expectations up to 2%
Alan Goldhammer
Mar 7 2020 at 5:51pm
Thanks!!!
Michael Sandfer
Mar 6 2020 at 4:38pm
Just as I’ve suspected that the risk of less effective monetary policy at the ZLB has been a drag on growth for years, I think it’s even more of a drag now, as risks of reaching the ZLB have increased and the effects of the real shock are expected to drag on. This is mostly nominal.
I don’t think the ZLB inherently matters, but it does matter in the context of likely Fed policy.
Few economists agree, but I don’t think the US ever recovered from the depression after the Great Recession. After all, consider the yield curve even shortly after the Recession ended. Wouldn’t they have taken so much secular stagnation into account? Otherwise, we must have had some other real shocks along the way.
Matthias Görgens
Mar 6 2020 at 10:52pm
Unemployment rate is down, employment is up. What more could you ask for?
(There’s more to be asked for on the supply side. But that’s a different issue.)
Michael Sandifer
Mar 7 2020 at 2:20am
I would want higher investment, productivity, consumption, and even a bit higher population growth rate now, and since 2004, at least. Also, I would have wanted unemployment to fall much more quickly than it has.
Michael Sandifer
Mar 7 2020 at 2:32am
Also, in general I don’t think a flow of savings into the developed world is bad for the developed world, even if the result of distortion by some developing country governments. I think it can only be positive on net for recipients, if monetary policy is handled properly.
Ahmed Fares
Mar 6 2020 at 8:36pm
“Another possibility is that the coronavirus is expected to cause a radical change in lifestyle, one that involves a much higher savings rate.”
Saving is non-volitional. The amount of saving in a community is exactly equal to the amount of investment, to the penny. (S = I). This is an accounting identity, true by definition.
If people attempt to save en masse, the attempt to save will drive investment down as the capacity utilization rate falls and businesses see no need to add additional capacity, thus dragging the saving rate lower, not higher, as saving falls with investment in what is a moving equilibrium.
We saw this in the Great Depression. In 1933 in the the midst of the Great Depression, the saving rate hit -1.5% (yes, that’s a minus sign). People were in fact dis-saving. Here in Canada and in the same year, the saving rate hit -8%, again, Canadians were dis-saving.
Investment is the excess of income over consumption. Investment is also the excess of production over consumption. While unemployed people do not produce, they continue to consume, in fact dis-saving, and the saving rate falls that way.
This is Keynes’ Paradox of Thrift writ large.
Ahmed Fares
Mar 6 2020 at 8:47pm
“Investment is the excess of income over consumption. Investment is also the excess of production over consumption.”
Correction: it should be this:
“Saving is the excess of income over consumption. Saving is also the excess of production over consumption.”
Matthias Görgens
Mar 6 2020 at 10:53pm
Community would have to be the whole globe these days, wouldn’t it?
Ahmed Fares
Mar 7 2020 at 1:03am
Yes, the accounting identities hold true at the global level. For the private domestic sector to net save, i.e., (S > I), then one of the other two sectors has to be in deficit. Here is the accounting identity:
(S – I) = (G – T) + (X – M)
Since the US almost always runs a trade deficit in order to export US dollars in its role as the global reserve currency, then the US government will almost always run a budget deficit. If it chooses not to run a deficit, then the economy contracts, tax revenues fall and welfare payments rise, and the government deficit rises in that way.
Either way, the government does not control the fiscal balance. That is determined by the other two sectors. Here is the accounting identity from the government’s perspective:
(G – T) = (S – I) – (X-M)
Excluding the external sector, the only way for the private domestic sector to net save, i.e., (S > I), is for the government to be in deficit, i.e., (G > T).
Christophe Biocca
Mar 7 2020 at 10:12am
That seems like the weakest part of the argument. Not every investment results in merely increased capacity. Re-tooling to cut costs makes sense even in a shrinking market. Substituting capital for labor makes more sense when capital is cheaper.
Ahmed Fares
Mar 7 2020 at 11:39am
While it’s true that investment continues for the reasons you describe, the net effect is that investment does fall in recessions. We can see that in the data (note the especially huge drop in investment in the 2008 recession, this despite the low interest rates):
https://fred.stlouisfed.org/series/USAGFCFQDSMEI
Scott Sumner
Mar 7 2020 at 12:28pm
The paradox of thrift was discredited long ago.
Ahmed Fares
Mar 8 2020 at 11:52pm
Most of that discrediting was done by those who believed in the fallacy of loanable funds theory which said that excess saving would lead to lower interest rates and thus higher investment. Except that investment is not funded by saving but rather by credit creation and brings forth its own saving.
In other words, the ones that did the discrediting have themselves been discredited.
Fred_in_PA
Mar 8 2020 at 8:44pm
I’m going to reveal my ignorance here, but if I’ve misunderstood what’s happening, I would appreciate some illumination on my error.
You repeat the old equation between Savings & Investment. But I wonder if there isn’t a split between “live” and “dead” investment. If I squirrel my savings away in capital equipment which then finds employment, then I’d call that “live” investment and I suspect it’s what you, too, mean by investment. But suppose I simply stuff it under the mattress. (Or, more realistically in a time of the corona virus, I squirrel it away in several hundred dollars of canned goods that sit in my basement unopened.) This is what I conceptualized as “dead” investment. Except for buying me some peace of mind, it’s a subtraction from the economy’s productive output which doesn’t materialize as new productive capacity.
I am obviously groping here, but isn’t there — at least conceptually — some parallel to Hernando DeSoto’s Dead Capital held by the peasantry but without any legal documentation?
It seems to me to be quite possible to have Savings not equal to (“live”) Investment.
Where have I gone wrong?
Ahmed Fares
Mar 8 2020 at 11:44pm
Inventories are counted as part of investment.
However, you raise an interesting question about “live” versus “dead” investment. So I came up with an example that hopefully illustrates that there is no difference between the two.
Say you have a machine such that if you put a lump of metal in it, produces 100 widgets in its useful life. It is now year one. We have a choice of producing 100 widgets in year two, or producing 100 widgets now and carrying them over as inventory into year two.
Now from the perspective of year two, the two options appear the same, whether you produce now or in the next year. Either way, there are 100 widgets in year two, and no machine at the end of year two, having had it’s useful life exhausted before then (either in year one or in year two).
Or say you produce 10 widgets now as future inventory, and 90 widgets in year two which is the remaining life of the machine. Or some variation like that. In any event, any combination of production leaves 100 widgets in year two, and no machine.
As I see it, a firm would be indifferent to having the machine versus having the inventory that the machine would produce in its useful life.
Thaomas
Mar 7 2020 at 7:59am
#1 has no policy implication
#2 suggests it is a good time to invest in log-lived infrastructure. Probably even the new NYC subway makes economic sense at near zero real rates not to mention all those nuclear power generation facilities we will need when we finally get a tax on net CO2 missions.
#3 means the Fed needs to do more (lower the IOR? reduce ST nominal rates still more, QE or whatever it takes) When /if employment starts being affected, a FICA holiday should be declared.
Scott Sumner
Mar 7 2020 at 12:30pm
I don’t think that NYC knows how to build subways at an acceptable cost. Come back to me with a plan when they figure out how to do so.
Mark Z
Mar 7 2020 at 3:44pm
I don’t fully buy the argument made in #2, that low interest rates make the case for more government investment. If interest rates are low because the market sees few opportunities for new productive investments down the road, why wouldn’t that apply to investments by the government as well? If there are fewer future opportunities for innovation or new forms of commerce in the private sector, then this should also lower our expectation of returns on public investment, since it means there’ll be lower returns to investing in human capital (e.g. education) or infrastructure. The returns to public investment are, IOW, largely dependent on the private sector; we might build more roads to facilitate more commerce, but if there’s not going to be more commerce, then the returns to building more roads is pretty low. Low returns to private investment therefore may also suggest low returns to public investment.
Mark Z
Mar 7 2020 at 3:50pm
I should clarify: I mean regarding what your saying with respect to #2, not that this is what Scott is arguing there.
Thaomas
Mar 9 2020 at 8:48am
That real borrowing rates for the government have declined because private sector actors have for the moment decided to save more does not imply that building long lived infrastructure cannot still have positive NPV. If NYC subways do not pass the NPV test even at the lower rate, then don’t build it: build something else that does. And of course I do mean term adjusted borrowing rates.
Steve
Mar 7 2020 at 1:48pm
Let’s go back to first principles. The Fed doesn’t target 2% inflation (its job), and economists still speak in confusing terms about what the Fed does and what the Fed can do (out of ammo, interest rates, etc.).
Hopefully, the Fed won’t create a new recession this time.
Michael Pettengill
Mar 7 2020 at 6:44pm
You confuse finance with building. The Saudi wealth funds certainly finance building energy infrastructure in the US, eg, Saudi investments in Exxon which builds assets in Saudi Arabia is effectively building Exxon infrastructure in the US because a dollar paid too buy bonds in a firm building in both the US and SA is financing both, making the US assets Saudi government built infrastructure.
The only government built infrastructure is limited to parks and recreation which involved lots of unskilled hand labor with the goal to both provide the dignity of work, but also provide the skills employers seek. The. CCC in the 30s, and the military for much of the 50s and 60s, employed millions of people who had little opportunity for lack of skills or the poverty of their home, but only for a few years, when they went to work in the private sector, often as preferred workers.
Not even NASA built the space infrastructure, though it did oversee much of the design, so the current “privatized” space industry is hardly a big change. The Boeing of today which is dozens of government contractors from the 50s and 60s, is operating pretty much the same today as its parts did did in the 60s.
The private sector had very little faith in Elon Musk’s plan for private space infrastructure so it took government funding for SpaceX to get over the hump and revolutionize both the building, and finance, of space infrastructure construction.
The same is true for cars and solar power, which were really about building batteries. The GM press releases show GM is stuck in 2000 when it abandoned electric vehicles because it saw building battery infrastructure as too costly. Yes, Tesla has gotten substantial government finance to build battery infrastructure, the debt to buy and rebuild NUMMI abandoned by GM, the finance for infrastructure in Nevada for the Gigafactory. But GM, and other automakers have gotten government finance over the decades, including in 2009.
Almost all infrastructure is built privately, not by government. The electric and telephone grid was build almost entirely privately, but in many cases with government finance, especially for infrastructure the private sector refuses to finance. Since 1980, the policy has leaned toward no public finance, claiming the public will be better served, yet most of the the public is denied access to high speed Internet.
The FCC is doling out finance to build high speed Internet, mostly to serve the former Bell companies that would have been forced to build it by “big government” regulations issued by PUCs.
Note, in the 70s AT&T started looking beyond copper and by the 80s had a plan to replace all copper with fiber optics to every home. But the claim was made that something better and cheaper would be built privately if the government “got out of the way”. The US could have had fiber to virtually every home address by 2000, 2010 at the latest.
Not even close, thanks to depending on private finance. Plenty of cash, but the private sector wants more, bigge,r government, because that’s what the private sector is financing.
Scott Sumner
Mar 9 2020 at 12:24pm
I don’t even want the government to pay for the infrastructure.
Michael Sandifer
Mar 8 2020 at 1:07pm
Scott,
What is wrong with this model? Risk of less effective policy at ZLB saps AD since the early-2000s. 2004 also saw beginning of growing commodity price shocks.
With ZLB risk sapping AD, consumption and investment are depressed in favor of savings, with investment more depressed than consumption as the math inherently suggests. Disproportionately depressed investment depressed productivity growth. This even exacerbates slowdown in population growth.
Is there something wrong with modeling “secular stagnation” as a mostly AD problem, acknowledging that there are also supply-side factors such as changing demographics?
I’m referring to the US here. In the EU and Japan, there is a negative nominal lower bound problem.
Thaomas
Mar 9 2020 at 9:27am
The task of fiscal-monetary policy makers is to enforce Say’s Law: if some people want’s to save more/invest less (a possible but not a necessary consequence of a supply shock), then other people should be incentivized to save less/invest more. Figuring out just what the incentives should be is their job.
Alexander Turok
Mar 10 2020 at 8:29pm
What problem is this trying to solve? The standard story is that intervention is necessary to “prime the pump” when resources are being misallocated due to market failures, when factories are closed and workers and unemployed. In this case if factories are closing down it’s for a good reason and unemployment is still at record lows.
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