Photo: Goldman Sachs
In a recent report, Goldman’s top economist Jan Hatzius predicted that finally, the US would see a real growth acceleration in the second half of 2013.There are three great reasons to listen to Hatzius:
1. He’s the top economist at Goldman Sachs. That alone is a reason to take him seriously.
2. He called the economic downturn. Remember, he got pilloried in 2007 by Ben Stein for saying that housing was going down, and that the economic ramifications would be significant.
3. He has a framework for analysing the economy that’s rare among Wall Street economists.
At the core of his call — which was made in a note titled The US Economy in 2013-2016: Moving Over the Hump — was this simple chart:
Photo: Goldman Sachs
The chart demonstrates a critical economic concept: Government deficits (the grey line) are essentially the mirror image of private sector savings (the dark black line). When the private sector tries to save money aggressively (as happened during the crisis) the government deficit will inevitably explode (as happened). Periods associated with small government deficits (such as the late ’90s) are associated with extreme private sector leveraging.
The key to understanding the economy, and forecasting growth, is to think about which sectors are increasing and decreasing their savings.
In a 30-minute conversation with Business Insider conducted last Friday, Hatzius explained:
“…every dollar of government deficits has to be offset with private sector surpluses purely from an accounting standpoint, because one sector’s income is another sector’s spending, so it all has to add up to zero. That’s the starting point. It’s a truism, basically. Where it goes from being a truism and an accounting identity to an economic relationship is once you recognise that cyclical impulses to the economy depend on desired changes in these sector’s financial balances.”
Hatzius is bullish on the U.S. economy starting in the second half of 2013, because finally he expects private releveraging to occur at a nice clip, and to not be counteracted by a fiscal drag. Says Hatzius:
“If the business sector is basically trying to reduce its financial surplus at a more rapid pace than the government is trying to reduce its deficit then you’re getting a net positive impulse to spending which then translates into stronger, higher, more income, and ultimately feeds back into spending.”
He has a specific explanation and numbers in mind, to explain the private sector’s inclination to reduce its savings, and spend more.
“Since mid-2009, that surplus has gradually come down as businesses and households have gotten closer to where they need to be from a long-term balance sheet perspective. They’ve paid down debt, they’ve eliminated the excess supply of housing, and that’s basically allowed them to reduce the financial surpluses that they run. They’re still running large surpluses – still 5.5 to 7 per cent of GDP, but they’re no longer as large. We expect those figures to come down as the balance sheet adjustment process makes further strides and that’s an underlying source of boost to the economy that’s happening on the one side.”
Of course, Hatzius’s bullishness on the private sector’s impulse to spend more is tempered by the fact that we’re going to see some form of austerity early in 2013, even if there’s a deal on the fiscal cliff.
And if there’s no deal on the fiscal cliff, then there is major cause for worry. While things might be OK if a deal is agreed to early in January, the ongoing confidence shock as the fight wore longer into the year, would be a problem. If we go into February without a deal?
“…I think the economy will be contracting, and potentially contracting pretty rapidly. It’d be a very unpleasant environment.”
Suffice it to say, Hatzius is not to keen on the push to rename the “Fiscal Cliff” the “Fiscal Slope” in order to take the urgency out of getting a deal by the end of the year.
Among other topics in our discussion: The future of Fed policy (he thinks there’s a high probability, but no guarantee, that the Fed will adopt an “Evan’s Rule” early in 2013), why business investment has slowed down dramatically, when interest rates will finally rise (probably the end of 2013), when the Fed will tighten policy (no sooner than 2016!), and whether monetary policy regime change will work in Japan.
The full transcript of our discussion is below the dotted line. Thanks to Lucas Kawa for the transcription.
BI: In your recent note you said that starting last year, you introduced your clients to the notion of “financial balances model,” that private sector surpluses were offset by government sector deficits, and that they mirrored one another. Explain this chart and how you came to recognise the importance of it.
HATZIUS: There is an accounting identity which is issued, if you start with the global economy, to simplify it, that every dollar of government deficits has to be offset with private sector surpluses purely from an accounting standpoint, because one sector’s income is another sector’s spending, so it all has to add up to zero.That’s the starting point. It’s a truism, basically.
Where it goes from being a truism and an accounting identity to an economic relationship is once you recognise that cyclical impulses to the economy depend on desired changes in these sector financial balances.
If the business sector is basically trying to reduce its financial surplus at a more rapid pace than the government is trying to reduce its deficit then you’re getting a net positive impulse to spending which then translates into stronger, higher, more income, and ultimately feeds back into spending.
Conversely, if the business sector reduces its desired surplus by less than the government sector tries to reduce the budget deficit, then you end up with cyclical weakness. It’s a little heavy-going, to put this into words, and can be challenging.
There’s a reasonable amount of jargon involved (ex post, ex ante type of stuff), and I generally try to avoid having too much jargon and too much heavy going in the sort of things that we write, but in this particular case it is useful and worthwhile to wade through this a little bit. It’s an exception, but I think it is useful in this case.
BI: In your recent note, “Moving Over The Hump” you say that in the second half of 2013, we’re going to switch over to a level of above-trend growth that we haven’t seen since the financial crisis hit. What’s the switch, and how does it relate to this chart?HATZIUS: The main thing is that there’s a sort of continued improvement in the private sector, in the sense that the private sector went to running extremely large financial surpluses during the crisis. In the middle of 2009, households and businesses spent 9 per cent of GDP less than they earned, meaning they were running a 9 per cent of GDP financial surplus.
Since mid-2009, that surplus has gradually come down as businesses and households have gotten closer to where they need to be from a long-term balance sheet perspective. They’ve paid down debt, they’ve eliminated the excess supply of housing, and that’s basically allowed them to reduce the financial surpluses that they run. They’re still running large surpluses – still 5.5 to 7 per cent of GDP, but they’re no longer as large. We expect those figures to come down as the balance sheet adjustment process makes further strides and that’s an underlying source of boost to the economy that’s happening on the one side.
On the other hand though, the government has moved to increasing the fiscal drag. The pace of fiscal consolidation has picked up. Most of the fiscal consolidation that we’ve seen so far has been in the state and local sector.
As we move into 2013, we’ll see a big pickup in fiscal consolidation, probably, in the federal sector, and early 2013 we’re going to be at 1.5 per cent of GDP of fiscal drag and I think that is going to make the economy quite weak.
Our baseline is not recessionary weak but nevertheless, it is going to look quite weak. Beyond that though, to get to answering the question, beyond the first half of 2013, we would expect the pace of fiscal drag to diminish, and as it diminishes that should lead to some acceleration in models over the next couple of quarters here.
BI: Speaking about the private sector specifically – I understand the argument that households are repairing their balance sheets for various reasons (ex. the housing bust is over) – but what’s your take on the corporate side of the private sector? What will prompt the corporate sector to spend more money and reduce its surpluses?
HATZIUS: There’s been some of that already. Over the last couple of years, the corporate sector – outside the financial sector – didn’t go into the crisis with big, heavy, over-leveraged balance sheets, but there’s been sort of improvement in the quality of balance sheets, earnings have been strong, and so the corporate sector has reduced its surpluses a bit as well. There has been, more recently, greater weakness in corporate spending over the past 6 months.
We would attribute some of that to fears about the fiscal cliff and fears of policy uncertainty shock in late 2012 – early 2013. I think if that’s the right diagnosis and you do get some kind of a deal and some resolution to the uncertainty, then that might also mean that you get some pent-up demand being released in the for profit sector. My expectation would be that you get a recovery, provided you do get the deal.
BI: Do you think there are any other factors contributing to the hesitancy in corporate spending, or do you think it’s mostly related to policy uncertainty and the fiscal cliff?HATZIUS: I think the short-run weakness that we’ve seen over the past few months is related to policy developments. Other than that, if you exclude the last 3-6 months, business investment actually hasn’t performed all that badly in the recovery so far.
I think the growth rates haven’t been spectacular, but you really wouldn’t expect spectacular growth rates given how muted things have been elsewhere, but you’ve seen decent growth rates in business investment. So I think the weakness we’ve seen recently does suggest there’s been a policy impact here.
BI: Back to the balance sheet, multi-sectoral framework of looking at the economy. How did you come to this view? On Wall Street this is still very rare. I don’t see many economists talk about the economy this way, recognising this identity and making projections based on it. How did you come to see this as the framework by which we should be looking at the economy right now?
HATZIUS: I’ve long been fascinated with looking at private sector financial balances in particular. There was an economics professor at Cambridge University called Wynne Godley who passed away a couple of years ago, who basically used this type of framework to look at business cycles in the U.K. and also in the U.S. for many, many years, so we just started reading some of his material in the late 1990s, and I found it to be a pretty useful way of thinking about the world.
It’s usually not something that gives you the secret sauce at getting it all right, because there are a lot of uncertain inputs that go into this analytical framework, but I do think it’s a reasonable organising framework for thinking about the short to medium term ups and downs of the business cycle.
Basically, in order to have above-trend growth – a cyclically strong economy – you need to have some sector that wants to reduce its financial surplus or run a larger deficit in order to provide that sort of cyclical boost, most of the time.
“Basically, in order to have above trend growth, a cyclically strong economy, you need to have some sector that wants to reduce its financial surplus or run a larger deficit in order to provide that sort of cyclical boost, most of the time.”
There are other factors at play in the business cycle – I’m certainly not claiming that ‘this is it!’ – but I have found it to be pretty useful.
BI: Do you have any explanation or thoughts about why this framework hasn’t broken through more on Wall Street? It still seems pretty rare.
HATZIUS: I’m not sure. I think there are actually a lot of people who think about the world in terms of this chart a little more implicitly. I think if you talk about the need to have stronger demand growth somewhere in order to get acceleration, in those charts it becomes kind of a truism. But if you put it in financial balances terms, you’re not really saying anything dramatically different. It’s just perhaps a little more semantics even. I just find it a reasonable discipline to think about.
BI: Let’s go back to the current state of the economy. One of your colleagues put out a note, sort of keying off your research, saying that real interest rates are finally going to rise and that this could break the back of the gold bull market. What will cause real interest rates to rise? Despite the stronger economy, we still haven’t seen that happen. Long-term and short-term real interest rates have been stuck at incredibly low levels.
“I mean, we don’t have any increase in real rates at the short-end of the yield curve in our forecasts until 2016”
HATZIUS: I mean, we don’t have any increase in real rates at the short-end of the yield curve in our forecasts until 2016, those are policy instruments, purely policy instruments, and we would expect the Fed to keep the funds rate at zero even beyond the current 2015 guidance, so we’ve got them hiking sometime after that, in 2016.
At the longer end, nominal rates or real rates are partially policy instruments these days, but they’re partially also responses to changes in the economy and changes in expectations of future short rates, so as you approach the period when you have more lift-off, you would expect some upward pressure on long-term yields relative to the extremely low levels that we’re at, at the moment.
In 2013, our expectation is that on average, growth is still going to be pretty slow – 2 per cent annual average, roughly – but in the second half of the year and in 2014 things get a bit better. And if it’s true that the degree of fiscal drag diminishes and the private sector boost stays with us, I think you can ultimately expect a little bit of upward pressure on long-term yields.
But we still have long-term yields in nominal terms – pretty close to 2 per cent by the end of 2013. In subsequent years, I would expect a little more upward pressure if the lift-off date for the funds rate stays in 2015 and doesn’t get pushed through due to additional bad news about the economy.
BI: Why is it that you don’t think we’ve seen that yet on the long end. It appears there’s been a turn (based on the stock market and some labour market indicators). More people are talking about the economy getting closer to liftoff. And yet, if you were just looking at long-term rates you wouldn’t see that at all.HATZIUS: It’s been a little surprising to us that we’re quite as low as we are. Having said that, we’ve not seen a sustained return to above trend growth, maybe in some of the labour market indicators you could sort of infer above-trend growth, but in other GDP-type indicators, broad indicators, like our current activity indicator, which measures a wide variety of different signals for the economy, certainly is not sending a message of above-trend growth.
You’ve seen an additional move from the Fed in the direction of more aggressive unconventional easing. Unconventional easing is partly more aggressive guidance about the short term rates and partly more aggressive asset purchases than what the market was building in a year ago, and so that’s offset whatever improvement in the economy and the stock market you might have gotten.
BI: You bring up the Fed and the direction it’s going in. There’s been a growing buzz that the ultimate endgame for the Fed is some sort of Nominal GDP targeting regime. What do you think about that concept, and what do you think the prospects are that the Fed will end up going in that direction?
HATZIUS: I think it has quite a lot of attraction in the sense that it’s forward guidance about the economic conditions that the Fed is trying to achieve and it’s a very clear forward guidance about the Fed’s desire to bring spending in the economy back to something closer to pre-crisis trends.
I think at least in economic models, very simplified economic models admittedly, but economic models in which firms and consumers are forward looking and build even relatively long-term expectations about monetary policy into their current decisions, policy like Nominal GDP targeting can be pretty expansionary, can shift expectations about the economy in a way that already delivers a boost at this point in time. So there are some significant attractions about it.
Of course, there are also some risks. I don’t think it’s a likely switch for the Federal Reserve in the near term. I think the risks and the drawbacks are that the Fed is somewhat uncomfortable with the message that catch-up growth could be achieved regardless whether it comes through higher inflation or higher real growth.
That is, of course, part of the logic of the framework – we’re going to focus on nominal growth and aren’t going to respond the same way to changes in inflation. That stands in the way of them adopting a framework like this any time soon despite the fact that it’s become talked about more, it’s gained quite a bit of respectability, Woodford presented his long Jackson Hole paper, basically endorsing NGDP targeting this summer, but I don’t think that they’re so close yet.
BI: So in the meantime do you expect the Fed to adopt something close to an Evans Rule, where it’s not necessarily NGDP targeting, but where they’d get rid of the date-based targets and come up with some other threshold?
HATZIUS: That’s very much the signal that I would take away from what we’ve heard over the past couple of months. In particular, the speech by Janet Yellin the day before the last set of FOMC minutes – and it’s very much for the reasons that Woodford made out in his Jackson Hole paper – which is that they’re conceptually much happier with forward guidance that specifies how the economy performs as opposed to forward guidance that’s specified in the calendar.
So my expectation is that they will adopt an Evans-style rule or threshold guidance, probably not at the meeting next week, but I would expect it for sometime in the first quarter.
“…my expectation is that they will adopt an Evans-style rule or threshold guidance, probably not at the meeting next week, but I would expect it for sometime in the first quarter.”
One thing I would say is I don’t think it’s a done deal yet.
While I expect it, I don’t think it’s a 90 or 95 per cent probability.
It’s still an ongoing discussion and there are a number of practical issues that have to be sorted out, one of which was illustrated in (Friday’s) employment report, namely the fact that the unemployment rate can fall for reasons that don’t really indicate a stronger labour market because of declines in labour force participation, which basically means the unemployment rate may not be such a good indicator of how the broad labour market is performing or how the overall economy is performing.
The less direct correspondence we have between where the unemployment rate is, ,what the overall economy is doing and what the overall labour market is doing, it gets trickier to adopt this sort of threshold guidance. Another issue is that I don’t think it’s clear how you would define the threshold guidance in terms of inflation. You don’t want to use headline inflation because it can move for spurious reasons like commodity shocks, which don’t really tell you what monetary policy should do.
On the other hand, the Fed has basically said in the minutes, that they don’t want to talk about core inflation anymore. They don’t want to talk about core inflation or even underlying inflation, and it’s sort of put a little bit of a shift in their position if they now specify the inflation threshold for tightening in terms of the core measure of inflation.
BI: Let’s talk about Fed efficacy. There’s this idea in the popular press that after multiple rounds of QE, there’s only so much more the Fed can do. On the other hand, there’s this argument that now, for the first time since the crisis, that Fed policy is actually loose, and that with housing coming back a bit, that monetary policy can find some teeth and help boost the economy. Where do you fall in that debate?
HATZIUS: I think that their policy has been effective up to a point. I do think that unconventional policy, both in terms of forward guidance and in terms of reduction in the term premium have eased financial conditions, and that has translated into stronger growth than what you otherwise would have seen. But at the same time I don’t think it’s particularly powerful.
So one of the big lessons that we’ve taken away from the past few years is that the zero lower bound on nominal short-term rates is a really big deal because it does get quite a bit more difficult for central banks to provide stimulus once you’ve hit that zero bound.
“So one of the big lessons that we’ve taken away from the past few years is that the zero lower bound on nominal short-term rates is a really big deal.”
The last chapter hasn’t been written yet. What you say is certainly possible. It would be a good outcome, it’d be nice to see. If we found that we haven’t gotten that much traction yet with unconventional policy but the real beauty of it will become apparent when there is a bit of natural velocity in the economy and the Fed has, by that time, put in place a framework where they’re committed not tightening policy for an extended period of time even in a more rapidly-improving economy and labour market. It’s possible.
I wouldn’t put really huge stakes on the idea that we’re going to get much bigger effects from monetary policy than we’ve had so far, but it certainly would be nice to see.
JW: When I think of the balance sheet approach to analysing about the economy, one of the economists I think about is the work of Richard Koo, who has argued that in a balance sheet recession, that monetary policy just doesn’t work, and that clearly the answer is more fiscal policy. Do you see it quite that strongly or do you see that it’s more of a balance?
HATZIUS: No, I would say I see a little more shades of grey. I think a lot of the points that he makes are well taken, but I think at the moment fiscal policy is likely to have bigger effects on growth than monetary policy.
I think fiscal policy surprises, certainly in the run-up to the fiscal cliff, are measured in percentage points, whereas monetary policy surprises are measured in tenths of a percentage point in terms of potential impact.
Clearly fiscal policy is the more important driver and the bigger source of uncertainty about the growth environment than monetary policy at the moment. But I wouldn’t be so extreme as to say that monetary policy has no role to play.
BI: On the matter of the fiscal cliff, there’s this idea that “fiscal cliff” is the wrong term; that it’s a fiscal slope – that we can go into January, and as long as we get a deal fairly soon that it’s not too big of a problem. How far can we go into next year without a deal and still feel comfortable that we’re not going to go into a recession?
HATZIUS: I think there’s probably something to that. Purely from the perspective of fiscal policy itself, you can reverse some of these effects, for example, essentially restoring tax rates to where they were a couple weeks after the end of the year.
The problem with the argument, though, is the uncertainty effects and the potential impact on financial conditions – if you went into the first week, second week of January or longer without a sense of how this is going to be resolved, I think the impact on financial conditions would be much more negative.
So I think even though you can reverse the dollars and cents on fiscal issues, I think you could do quite a lot of damage to the economy and I would get worried about a return to recession pretty quickly.
“So I think even though you can reverse the dollars on cents on fiscal issues, I think you could do quite a lot of damage to the economy and I would get worried about a return to recession pretty quickly.”
BI: So if we don’t have a deal by the end of January, would we go into a recession?
HATZIUS: I think that would make it pretty likely that you get a contraction in the economy. I mean, how long-lasting will that be, whether it’s that long-lasting enough to be classified as an NBER recession, an officially defined recession, that’s harder to say.
But I do think the economy will be contracting, and potentially contracting pretty rapidly. It’d be a very unpleasant environment.
BI: One last topic, because it’s been the subject of fascination lately, but what do you make of the current debate that’s going on in Japan, and the idea that perhaps Japan could try a much more aggressive inflationary regime. How beneficial do you think that would be?
HATZIUS: I do think that somewhat higher inflation target in Japan than 1 per cent would be helpful. 1 per cent inflation target is very low, by the standards of what monetary policy experts say. How big of an effect it would have is hard to know. If you look at the sort of models that economists like to look at and evaluate, based on monetary policy frameworks, it should be pretty beneficial. The same is true with respect to the earlier question about NGDP targeting.
We do think a switch to NGDP targeting could be very expansionary, the problem is that we have very little actual experience with central banks actually making these regime shifts. There are some that come somewhat close, but typically you have to go back to the Great Depression of the 1930s, FDR-induced policy changes, there were some regime shifts in Europe – Sweden is an example – but you don’t have the same kind of systematic data about monetary policy regimes to make a very confident prediction.
BI: Thank you.
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