Category Archives: Business Cycle

12/9/16: Fiscal Policy in the Age of Debt


In recent years, there has been lots and lots of debates, discussions, arguments and research papers on the perennial topic of fiscal stimulus (aka Keynesian economics) on the recovery. The key concept in all these debates is that of a fiscal multipliers: by how much does an economy expand it the Government spending rises by EUR1 or a given % of GDP.

Surprisingly, little of the debate has focused on a simple set of environmental factors: fiscal stimulus takes place not in a vacuum of environmental conditions, but is coincident with: (a) economies in different stages of fiscal health (high / low deficits, high/low debt levels etc) and (b) economies in different stages of business cycle (expansion or contraction). One recent paper from the World Bank decided to correct for this glaring omission.

“Do Fiscal Multipliers Depend on Fiscal Positions?” by Raju Huidrom, M. Ayhan Kose, Jamus J. Lim and Franziska L. Ohnsorge (Policy Research Working Paper 7724, World Bank) looked at “the relationship between fiscal multipliers and fiscal positions of governments” based on a “large data-set of advanced and developing economies.” The authors deployed methodology that “permits tracing the endogenous relationship between fiscal multipliers and fiscal positions while maintaining enough degrees of freedom to draw sharp inferences.”

The authors report three key findings:

First, the fiscal multipliers depend on fiscal positions: the multipliers tend to be larger when fiscal positions are strong (i.e. when government debt and deficits are low) than weak.” In other words, fiscal expansions work better in case where sovereigns are in better health.

“For instance, our estimates suggest that the long run multiplier can be as big as unity when the  fiscal position is strong but it can turn negative when the fiscal position is weak. A weak fiscal position can undermine fiscal multipliers even during recessions. Consistent with theoretical predictions, we provide empirical evidence suggesting that weak  fiscal positions are associated with smaller multipliers through both a Ricardian channel and an interest rate channel.”

By strong/weak fiscal position, the authors mean low/high sovereign debt to GDP ratio. And they show that fiscal expenditure uplift for higher debt ratio states results in economic waste (negative multipliers) in pro-cyclical spending cases (when fiscal expansion is undertaken at the times of growing economy). Which is important, because most of the ‘stimuli’ take place in such conditions and majority of the arguments in favour of fiscal spending increases happen on foot of rising economic growth (‘spend/invest while you have it’).

Second, these effects are separate and distinct from the impact of the business cycle on
the fiscal multiplier.” Which means that debt/GDP ratio has an impact in terms of strengthening or weakening fiscal policy impact also regardless of the business cycle. Even if fiscal expansion is counter-cyclical (Keynesian in nature, or deployed at the time of a recession), fiscal multipliers (effectiveness of fiscal policy) are weaker whenever the debt/GDP ratio is higher. In a way, this is consistent with the issues arising in the literature examining effects of debt overhang on growth.

Third, the state-dependent effects of the fiscal position on multipliers is attributable to two factors: an interest rate channel through which higher borrowing costs, due to investors’ increased perception of credit risks when stimulus is implemented from a weak initial fiscal position, crowd out private investment; and a Ricardian channel through which households reduce consumption in anticipation of future fiscal adjustments.”

What this means is that low interest rates (accommodative monetary policy) may be supporting positive effects of fiscal expansion, but at a cost of reducing private investment. In a sense, public investment, requiring lower interest rates, crowds out private investment. Now, no medals for guessing which environment we are witnessing today.

Some charts

First, median responses to increased Government spending


Once you control for debt/GDP position with stimulus taking place during recessions:



“Note: The graphs show the conditional fiscal multipliers during recessions for different levels of fiscal position at select horizons… Government debt as a percentage of GDP is the measure of fiscal position and the values shown on the x-axis correspond to the 5th to 95th percentiles from the sample. …Fiscal position is strong (weak) when government debt is low (high). Solid lines represent the median, and dotted bands are the 16-84 percent confidence bands.”

In the two charts above, notice that the range of public debt/GDP ratios for positive growth effect (multiplier > 1) of fiscal policy is effectively at or below 25%. At debt levels around 67%, fiscal expansion turns really costly (negative multipliers) in the long run. How many advanced economies have debt levels below 67%? How many below 25%? Care to count? Five  economies have debt levels below 25% (Estonia, Hong Kong, Macao, Luxembourg and San Marino). For 67% - nineteen out of 39 have debt levels above this threshold. Not exactly promising for fiscal expansions...

Overall, the paper is important in: (1) charting the relationship between fiscal policy effectiveness, and debt position of the sovereign; (2) linking coincident fiscal and monetary expansions to weaker private investment; and (3) showing that in the long run, fiscal expansion has serious costs in terms of growth and these costs are more pronounced for countries with higher debt levels. Now, about that idea that Greece, or the rest of PIGS, should run up public investment to combat growth crisis…

2/9/16: Interest Rates, Financial Cycles and the Real Economy


Claudio Borio and his team at the Bank for International Settlements have just published another interesting working paper, titled “Monetary policy, the financial cycle and ultra-low interest rates” (BIS Working Papers No 569 by Mikael Juselius, Claudio Borio, Piti Disyatat and Mathias Drehmann Monetary and Economic Department July 2016).


In the paper, the authors ask whether “the prevailing unusually and persistently low real interest rates reflect a decline in the natural rate of interest as commonly thought?”

The authors “argue that this is only part of the story. The critical role of financial factors in influencing medium-term economic fluctuations must also be taken into account.” In other words, the authors attempt to control for purely financial factors driving interest rates first, and then consider predominantly real economic variables-determined rates (natural rates).

You might think that the currently low rates are facilitating the real economy, right? If so, then actual observed (already low) rates today should be coincident with even lower ‘natural’ rates (if real economy drags down the financial economy). Alas, as the authors find: accounting for the different sources of pressure on the interest rates (financial vs natural), in the case of the United States, “yields estimates of the natural rate that are higher and, at least since 2000, decline by less.”

Oops… so persistently low interest rates today are below natural rates and reflect the needs of the financial intermediation sector.


Notice the difference between the observed rates (yellow) and the ‘natural rates’ (red). Or as the lads from BIS put it: “As a result, policy rates have been persistently and systematically below this measure.”

But never mind. With time, things should get rebalanced, as the authors also find that “monetary policy, through the financial cycle, has a long-lasting impact on output and, by implication, on real interest rates. Therefore, a narrative that attributes the decline in real rates primarily to an exogenous fall in the natural rate is incomplete. The influence of monetary and financial factors should not be ignored. Exploiting these results, an illustrative counterfactual experiment suggests that a monetary policy rule that takes financial developments systematically into account during both good and bad times could help dampen the financial cycle, leading to higher output even in the long run.”

Yah, yah… lots of talk. What’s the meaning? Ok, the authors take two drivers of financial sector impact on the real economy: leverage and credit.


Leverage gap is defined as basically a credit to assets ratio for the economy - or how much credit does economy create per each unit of assets. Meanwhile debt service gap is the ratio of debt service payment, or more precisely, “the ratio of interest payments plus amortisations to income”.

To understand the dynamics of the monetary (interest rates) policy impact, the authors do a couple of experiments. The main one is worth discussing. The authors start with a leverage gap of -10%, so there is an excess of assets over credit in the economy and hence there is room to borrow, driving leverage gap up. Note: as the authors point out, the -10% leverage gap assumption is consistent with historical reality: in the late 80s and mid-2000s, “at their trough”, leverage gaps were -11% in 1987 and -20% in 2006 respectively.

So, as I noted above, “a negative leverage gap initially induces a credit boom that then turns into a bust… Initially, the negative leverage gap is followed by rapid credit growth, which in turn feeds into a positive, albeit small, increase in private sector expenditure. But as credit outgrows output, the credit-to-GDP ratio and with it the debt service gap start to rise, putting an increasing drag on output and asset prices. A severe and drawn-out recession follows.”

The dynamics match the Great Recession: “…at the start of 2005, the real-time estimate of the leverage gap was significantly negative while the debt-service gap was positive. Given this starting point, the adjustment dynamics of the system would have predicted much of the subsequent output decline during the Great Recession. This suggests that the recession was not a “black swan” caused by an exogenous shock but, rather, the outcome of the endogenous dynamics of the system – a reflection of the interaction between the financial factors and the
real economy.”

And here is the actual run of annual estimates of the two gaps:


Remember, the cyclicality? Negative leverage gap —> credit boom —> positive leverage gap and positive debt service gap —> bust.

Good thing we are not going to repeat THAT cycle this time around, right?.. Not with all the low interest rates not being lower than ‘natural’ rate… right?



17/6/16: Credit markets on the ropes?


In their research note, titled aptly “Credit Metrics Bode 1ll”, Moody’s Analytics produced a rather strong warning to the corporate credit markets, a warning that investors should not ignore.

Per Moody’s: “The current business cycle upturn is in its latter stage, aggregate measures of corporate credit quality suggest. The outlook for the credit cycle is likely to deteriorate, barring improved showings by cash flows and profits, where enhanced prospects for the latter two metrics depend largely on a sufficient rejuvenation of business sales.”

In other words, unless corporate performance trends break to the upside, credit markets will push into a recessionary territory.

Recessions materialized within 12 months of the year-long ratio of internal funds to corporate debt descending to 19.1% i n Ql -2008, Ql-2000, and Q4-1989. As derived from the Federal Reserve's Financial Accounts of the United States, or the Flow of Funds, the moving year long ratio of internal funds to corporate debt for US non-financial corporations has eased from Q2-2011's current cycle high of 25.4% to the 19.1% of Ql-2016.

Moody’s illustrate:


Now, observe the ratio over the current cycle: the peak around the end of 2011-start of 2012 has now been fully and firmly exhausted. Current ratios sit dangerously at 4Q 2007 and close to 1-3 quarters distance from each previous recession troughs.

The safety cushion available to the U.S. corporates when it comes to avoiding a profit recession is thin. Per Moody’s: “The prospective slide by the ratio of internal funds to corporate debt underscores how very critical rejuvenations of profits and cash flows are to the outlooks for business activity and credit quality. Getting profits up to a speed that will keep the US safely distanced from a recession has been rendered more difficult by the current pace of employment costs."


Here’s the problem. Employment costs can be cut back to improve profitability in a normal cycle. The bigger the cut back, the more cushion it provides. But in the current cycle, employment costs are subdued (do notice that this environment - of slower wages and costs inflation - is the same as in 2004-2007 period). Which means two things:

  1. U.S. corporates have little room to cut employment costs except by a massive wave of layoffs (which can trigger a recession on its own); and
  2. U.S. corporates have already front-loaded most of the risk onto employment costs during the Great Recession. Which means any new adjustment is going to be even more painful as it will come against already severe cuts inherited from the Great Recession and only partially corrected for during the relatively weak costs recovery period since then. 


Moody’s are pretty somber on the prospect: "As inferred from the historical record, restoring profits through reduced labor costs is all but impossible without the pain of a recessionary surge in layoffs. Thus, barring a recession, employment costs should continue to expand by at least 5% annually."

That’s the proverbial the rock and the hard place, between which the credit markets are wedged, as evidenced by the recent dynamics for both Corporate Gross Value Added (the GDP contribution from the corporate sector) and the nominal GDP:


Again, the two lines show steady downward trend in corporate performance (Corporate GVA) and slight downward trend in nominal GDP. In terms of previous recessions, sharp acceleration in both trends since the end of 4Q 2014 is now long enough and strong enough to put the U.S. onto recessionary alert.

Per Moody’s: "As of early June, the Blue Chip consensus projected a 3.2% annual rise by 2016's nominal GDP that, …signals a less than 3% increase by corporate gross value added. [This]... implies a drop by 2016's profits from current production that is considerably deeper than the - 2.5% dip predicted by early June's consensus. Moreover, as inferred from the consensus forecast of a 4.4% increase by 2017's nominal GDP, net revenue growth may not be rapid enough to stabilize profits until the second-half of 2017, which may prove to be too late for the purpose of avoid ing a cyclical downturn."

In other words, there is a storm brewing in the U.S. economy and the credit markets are exhibiting stress consistent with normal pre-recessionary risks. Which is, of course, somewhat ironic, given that debt issuance is still booming, both in the USD and Euro (a new market of choice for a number of U.S. companies issuance in response to the ECB corporate debt purchasing programme):




Just as the corporate credit quality is deteriorating rapidly:


You really can’t make this up: the debt cornucopia is rolling on just as the debt market is flashing red.