Population Ageing and Global Externalities - What if QE is not temporary?

This post first appeared on Alpha.Sources, but given the arrival of Ben Bernanke to the world of econ blogging and the interaction between him, Krugman and Summers, I would it would be interesting to highlight it to DM's readers too.

This discussion of market failures and externalities is mostly a microeconomic discussion. Students will tend to encounter it, in the context of the classic case of the polluting industrial company whose marginal private cost, or supply, curve is not the same as the marginal social cost curve. A firm which dumps toxic waste in a river does not bear the full cost of such actions; society also faces a costs even if this is not taken into account in the firm's profit maximization problem. The solution according to the welfare theorems is for the social planner, the government, to tax the company forcing the firm to produce at a lower output relative to what would have been optimal according to its own marginal revenue and marginal cost curves. Profit maximization on the firm level must, in this case, give way to a socially more optimal outcome only achievable through government intervention.

Back in November 2013, as the Summers' and Krugman's notion of a secular stagnation was garnering attention in policy circles, I introduced the concept of a global paradox of thrift and adverse externalities from living in ZIRP world. More specifically, I asked: What happens to global asset markets when large open economies either deliberately (beggar-thy-neighbour) or rationally increase their precautionary savings?

The beginning and end of Bretton Woods II

In the years following the EM currency crisis in 1998 current account surpluses in the developing world surged giving rise to the discourse of global imbalances and Bretton Woods II [1]. The flow of savings due to rising external surpluses in EM has become one of the main arguments to explain the Great Moderation and also led former Fed chairman Ben Bernanke to formulate the concept of the global savings glut. Bernanke's speech in 2005, and those who agree with it, have generally been maligned for underwriting the attempt by policy makers to exonerate themselves for any culpability in sowing the seeds of the crisis in 2008. But as usual in the ongoing tedious slug-fest between Neo-Austrians and Keynesians/the establishment, this debate completely misses the point.

Anyone trying to understand what is going in the global economy at the moment should read the speech, and pay especial attention to the following.

In response to these crises, emerging-market nations either chose or were forced into new strategies for managing international capital flows. In general, these strategies involved shifting from being net importers of financial capital to being net exporters, in some cases very large net exporters.

(...) 

According to the story I have sketched thus far, events outside U.S. borders--such as the financial crises that induced emerging-market countries to switch from being international borrowers to international lenders--have played an important role in the evolution of the U.S. current account deficit, with transmission occurring primarily through endogenous changes in equity values, house prices, real interest rates, and the exchange value of the dollar.

Ben S. Bernanke, March 10th 2005

Significant blood has been spilled in academic and policy circles over whether the policy pursued by emerging markets was a rational response or a simply a function of bad policy in pegging to the US dollar, essentially relying on the US economy as the consumer of last resort. Let us assume for a moment that building up buffers of reserves was partly rational. Faced with the prospect of a repeat of 1998, the decision to accumulate reserves in dollar assets, in part to counter rising dollar liabilities in the domestic economy, can be seen, in part, from the point of view of precautionary savings.

But in a global economy with free capital mobility, a coordinated increase in savings across such a large swathe of economies has costs, and it is exactly such costs that were partly counted during the crisis in 2008. The bust of the subprime bubble in the U.S. in 2007, and associated devastation on the global economy, could then be seen as partly driven by the negative externality of too much capital searching chasing little yield [2]. What was "rational" from the point of view of open economy in the developing world was not optimal from the point of view of the global economy due to the boom/bust effects of too much excess liquidity. In the language of negative externalities, the marginal global cost of rising surpluses exceeded the marginal cost of additional savings in EM economies.

Today, accelerating capital outflows in China and collapsing oil prices offer evidence that the key drivers of Bretton Woods II, the global liquidity pump so crucial in driving low global interest rates from 1999 to 2008, are waning. Looking at the current plight of some EM economies, however, I cannot help but feel that we are potentially headed for a repeat of the aftermath to 1998. Booms and busts are a natural part of international capital flows, but if the global economy cannot sustainably accommodate external deficits in countries such as Brazil, Turkey, South Africa, India etc, without instability it stands to reason that these economies will ramp up savings to avoid becoming external borrowers. And who prey tell, will run the deficits then if these economies aren't going to. EM currencies have plunged since 2011, and if the bust worsens this year, the inevitable result will be a knee-jerk reaction to once again enter a cycle where external savings become the key objective for economic policy in these economies.

But even before we write the obituary on Bretton Woods II, or grant it an extension, another process is waiting in the wings to take over, a force that could make EM FX reserve accumulation and recycling of petrodollars look like chump change.

Population ageing and QE: A permanent externality to global asset markets? 

In theory, a rapidly ageing economy should dissave and become net a importer of capital through a current account deficit. But the aggregation of microeconomic life cycle dynamics to macroeconomic capital flow dynamics is, in my view, flawed. Indeed, in practice it appears that rapidly ageing economies act exactly opposite to what theory predicts. Japan was the first example of a major economy getting stuck in ZIRP and QE, and the Eurozone is arguably the second. These economies are not characterised by dissaving, but rather by their desperate fight against it.

Is it rational for a mature market economy with a large level of public debt and an expensive transfer state to dissave into old age? Is it conceivable that foreigners would finance deficit spending, and investment, in such an economy at yields at or below steadily weakening nominal GDP growth? I don't think it is, and the response by Japan to fight dissaving by attempting to maintain an external surplus and keep a positive net foreign asset position is an important case in point. Abenomics might yet fail, but it was the risk of Japan slipping into a sustained current account deficit and depleting domestic resources to buy enough JGBs that ultimately forced the BOJ to throw caution to the wind and start annexing the bond market and debase the currency. The Eurozone is earlier in the process, but the principle is the same. A weak euro, a rising current account surplus, and a dramatic acceleration of portfolio outflows in search for yield abroad, all with an eye to bolster the economy's net foreign asset position. The combination of current account surpluses in the periphery and a benevolent ECB has, effectively, defused the sovereign debt crisis despite notional debt levels growing larger since 2012.

As older workers nearing retirement, these two economies are simply trying to build a portfolio of assets off of which to earn income to pay the bills. For large open economies such as Japan and the Eurozone with access to consumption smoothing through their balance of payments, this response is, I would argue, perfectly rational. The alternative, prescribed by theory, would seem completely at odds with a stable macroeconomic situation. A rapidly ageing economy running a current account deficit is a recipe for disaster; ask governments in the Eurozone periphery if you do not believe me.

But just as the marginal global cost of EM's rapid reserve accumulation from 1999 to 2010 was higher than the cost facing the accumulators themselves, so do the costs of persistent and large capital outflows from ageing economies likely represent a negative externality that is not adequately accounted for in hypothetical "optimal" growth strategy for the Eurozone and Japan.

The current debate on the need, or otherwise, for the Fed to raise rates is a classic case in point. The dollar is surging, and the Fed faces the prospect of raising rates in a world where the two other major economies are likely permanently stuck in ZIRP. This need not deter the Fed from pulling the trigger; indeed I think it is very likely that Yellen will do just that this year.

But even the Fed does not set its policy in a vacuum. One of the key drivers of low long-rates in the U.S. is that money from Japan and the Eurozone are chasing yield, and a 10-year yield in the U.S. at 1.9% is suddenly a very good prospect with sub-zero rates in the other major currency areas. It is very likely that the Fed might not get "traction" on long rates even if they push up the funds rate. What is a poor central bank to do? As the Fed moves to increase short rates the capital inflows intensify potentially stoking the very excess and boom that it is trying to manage. Emerging markets of course have been here before, lowering interest rate in an attempt to ward off hot money coming in. This is an endemic part of global capital flows, and we will see more of this in the future.

In a world where it is rational from a domestic point of view for major economies to rapidly expand their money supply, monetary tightening elsewhere becomes very tricky. If excess savings become the chosen growth strategy for more and more economies it is also possible to speak of a global paradox of thrift. I have previously described this as follows:

If more and more economies are now faced with a negative natural rate of interest it means that (desired) savings will exceed investment even with ZIRP. This has crucial implications for global capital flows. You only need rudimentary algebra to see this in the context of basic national accounting. If S>I it can only mean that the current account is positive in an open economy and this is difficult to prescribe a universal growth strategy since you need someone to run the deficits.

The costs, or negative externalities, are financial instability. Volatility will remain very low for extended periods, only to rise rapidly as capital flows back to the savers in times of crisis. Global carry trade flows and the associated booms and busts provide ample evidence of this.  

The next obvious question is what to do about it? We don't have a global social planner to mitigate the costs of excess savings but discussions about whether China is a "currency manipulator" and G7 push, in 2006, for the BOJ to join Trichet and Bernanke in the "great interest rate normalisation" are both examples of how this externality can lead to conflict. How long will it take now, for example, before the U.S., the U.K. etc start probing the Eurozone about whether QE and ZIRP are a necessary combination in a world where the German economy are accelerating rapidly with a labor market that has never been tighter? It won't be tomorrow, but towards the end year is a good bet for when questions will start start emerging around the viability of QE at the ECB.

At the end of the day, my message is fairly straight forward. Investors need to move on from a situation where central bankers are blamed for blowing bubbles and creating financial stability to an understanding of the reality they operate in. Super easy money and QE are sowing the seeds for financial instability and we are inevitably getting closer to the next denouement. But central bank involvement as some of the world's largest asset managers is likely here to stay. This is an objective fact, best kept separate from a discussion of whether it is a good thing or not.

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[1] - In fairness to the sources referenced above, especially Setser, the recycling of oil surpluses in the Middle East into USD was assets was equally important as EM surpluses.

[2] - I can already hear the cries of protest. Clearly, the subprime crisis of excess in the U.S. financial system had deep domestic behavioural and structural roots too. I am not trying to fit a mono-causal explanation to any one boom/bust cycle here. But simply noting that easy money flowing from EM surpluses was part of the explanation.

On cat islands and the wider potential of rewilding

I'm still fond of a old post of mine that I had made back in January 2011, "What the cats of Houtong say about the population of Taiwan". That post, drawing on a September 2010 post I made at my blog, examined how the Taiwanese village of Houtong, located just outside the capital of Taipei, has managed to find new life after its coal mining economy went under thanks to its large feral cat community.

Visitors' raves on local blogs have helped draw cat lovers to fondle, frolic and photograph the 100 or so resident felines in Houtong, one of several industrial communities in decline since Taiwan's railroads electrified and oil grew as a power source.

Most towns have never recovered, but this tiny community of 200 is fast reinventing itself as a cat lover's paradise.

"It was more fun than I imagined," said 31-year-old administrative assistant Yu Li-hsin, who visited from Taipei. "The cats were clean and totally unafraid of people. I'll definitely return."

On a recent weekday afternoon, dozens of white, black, grey and calico-coloured cats wandered freely amid Houtong's craggy byways, while visitors captured the scene with cellphone cameras and tickled the creatures silly with feather-tipped sticks.

I went on to connect this with a variety of phenomena, including the decline of peripheral communities, the rise of international migration and tourism in Taiwan, even the demographic regime of the cats themselves. I had fun.

Last Saturday, I reported on another cat community, this one an entire island, in Japan. Early in March, The Atlantic featured a Reuters photo essay by Thomas Peter depicting the cats of the Japanese island of Aoshima. As one source describes it, Aoshima--located off of the coast of the major Japanese island of Shikoku--is an island with an aging human population and a rapidly growing cat population. This latter gives it some economic heft that it would otherwise ave lacked.

A remote island in southern Japan is home to 22 people and more than 120 cats.

Aoshima is a dwindling fishing community of elderly people who live mainly off retirement benefits. The cats were originally brought over to the island to deal with mice plaguing fishing boats. But they've since multiplied as there are no natural predators.

Tourists have been flocking to the island off Ehime prefecture on a ferry that runs twice twice a day. Cat lover Makiko Yamasaki, 27, said: "I came here looking to relax. And as for how is it? Well there is a ton of cats here, then there was this sort of cat witch, who came out to feed the cats, which was quite fun. So I'd want to come again."

Many more photos are available at the links, if you are curious.

The specific phenomenon of the "cat island" or "cat village" seems to be relatively common in East Asia. I have also read of the Pacific-coast cat island of Tashirohima received attention after being spared by the 2011 tsunami. What these communities, in Japan and Taiwan and perhaps elsewhere, all seem to share in common is a recent sharp decline in human populations, coupled with a growth of cat populations. It's reasonable to imagine that, in decaying human settlements, cats might do reasonably well, taking shelter in human constructions and feeding off of prey. The extent to which this is sustainable may be another question entirely. The cats of Aoshima, at least, seem to depend on regular feedings. Can they count on these indefinitely into the future, as Aoshima further depopulates? Will cat tourism bring in enough income to keep the whole cycle going? Will it lways do so?

This specific phenomenon fits within a broader context of rewilding, of the return of wild animals and ultimately wilderness to peripheral areas experiencing depopulation. One example of this is the return of wolves to East Germany in the past decades, aided in part by the depopulation of much of rural East Germany. Another example I'm personally familiar with is the gradual return of woodland to Prince Edward Island over the past century, as subsistence agriculture has disappeared and marginal lands fallen out of production.

It is estimated that in the early 1800s, forests would have covered some 95 per cent of this province; the average age of these trees would have been in the hundreds of years.

[. . .]

According to the State of the Island’s Forests report in 2002, only 9,000 hectares of this hardwood dominant shade tolerant forest remains in scattered patches throughout the island. By 1900, the population of PEI had drastically increased to 100,000 and only about 30% of the land was left in forests. During those 100 years, much of the best forested land went under the axe or was burned to make room for agriculture. Many species of mammals were extripated from the island forests, such as bears, fisher, marten, and piliated woodpeckers. Of those remaining forests, many had been disturbed by cuttings, fires, and cattle grazing. Another big problem was the introduction of diseases that has devastated the American Beech and American Elm on PEI as well as other areas.

[. . .]

According to the State of the Forest report in 2002, only 9,000 ha of forested area on PEI is in a late sussessional shade dominant forest state, typical of the Acadian Forest. That accounts for less than 2% of the entire island, that at one time, was entirely covered in trees. Since 1900, there was a gradual increase in forest coverage, mostly due to farm abandonment. Today, approximately 50% of the island’s land mass of 560,000 hectares is forested, but much of it is in poor condition, growing on poor worn-out agricultural fields. Much of the this has grown up into what’s termed old-field white spruce. This is an even aged stand of poor quality trees, growing on poor quality soils.

In the decline of the human population of many regions lies the potential for a managed return of wilderness. The Rewilding Europe website goes into great detail about the potential for rewilding projects around Europe. The Landscape Institute's James Richardson looked at eastern Portugal, suggesting that rural depopulation could be environmentally advantageous. (Perhaps also economically, if eco-tourism becomes popular?)

We arranged to meet with Pedro Prata, the lead advisor of the Western Iberia locality of Rewilding Europe in the Coa valley around 3 hours north of Idanha-a-Nova. Rewilding Europe is an organisation that aims to ‘rewild’ areas of Europe undergoing land abandonment. RE see it as an opportunity for the regeneration of land that has been misused for hundreds if not thousands of years and their ideas support many of our own. The Mediterranean climate and soils are actually ill-suited to the kind of agriculture practiced north of the Pyrenees and Alps.

Pedro showed us around their reserve which they have purchased from local landowners, and through planting native trees, grazing by native breeds of horse and cattle (in association with the Tauros Project), as well as reducing fire, are beginning to establish a regenerating ecosystem in the Coa valley. Although Rewilding Europe is mainly focused on nature conservation, its rewilding projects have important associated effects such as local employment in ecotourism, helping to balance the water table through vegetation as well as having a positive effect on game species such as partridge and rabbits which spill over from the reserve; hunting is a very important activity in Iberia.

We were able to learn many things from the visit including the vulnerability of traditional and sustainable cork-oak forests when too high a percentage of trees are harvested, removing their natural fireproofing. We learned that the area generally receives a good deal of water, but that this water falls seasonally and is often stored centrally and not distributed, or is lost to evaporation or surface run-off before it can be captured by the soil. We learned that despite appearances, the local areas do not provide the amenities such as reliable transport, education, employment and health care that would otherwise keep young people in the area.

A key thing that we have come to appreciate is that there are reasons that people have abandoned the land, and that we should not be trying to address the issue by forcing people, through our strategies, back into agriculture in inherently difficult areas. The abandonment will be used in our respective projects as an opportunity to encourage ecological regeneration, and the boost in productivity and economic activity that this can bring through a reconsideration of the value of nature and through outdoor pursuits.

The project prompts questions about areas of the UK that, were it not for subsidies, would also be undergoing abandonment, such as our sheep-grazed uplands and intensively managed grouse moors. In the UK, the positive effects of rewilding on these bleak areas would be easy to appreciate – native reforestation and the benefits to flood reduction, water quality, carbon storage, biodiversity, diverse and increased economic activity, recreational activity to name but a few.

Can we take, from the growth of the cat island phenomenon and the wider context of rewilding, clues as to how we should react to the future of rural depopulation? I am actually being serious when I say that we can and we should.

On the transformation of Canada's temporary foreign worker program

Today in Canada is a notable day in Canada's immigration history, for today is the day that changes in the Temporary Foreign Worker program are going to have a significant but as yet uncertain effect on the lives of people in the Canadian labour market. David P. Ball's article in British Columbian newsmagazine The Tyee, "Foreign Worker Exodus Expected as New Rules Kick in" outlines the situation.

Changes to the Temporary Foreign Worker Program will force the removal of tens of thousands of workers from the country starting today.
This will have an immediate impact not only on workers who have been in the country for more than four years, but also on industries that use foreign workers such as restaurants, construction and the agricultural sector.

The new rules will apply to an estimated 70,000 temporary workers, migrant advocates claim, but the exact number is not known and has not been revealed by Citizenship and Immigration Canada. Under the rules, workers who have been in the country longer than four years must leave. Once out of the country, they can't re-apply for another work permit to enter Canada for another four years, hence the "four-in, four-out" description.

There are more than 300,000 temporary foreign workers in Canada.

The "four-in-four-out" policy was announced in 2011 amid public debate over whether the program was replacing Canadians' jobs and exploiting non-Canadian labourers at the same time.

Last year, as a consequence of media reports that a significant number Canadian employers were bringing in temporary foreign workers in circumstances where there was no need--not only bringing in skilled labour, but bringing in unskilled labourers at a time of high domestic unemployment, the federal government clamped down significantly on the program. This extended analysis by the CBC's Tracy Johnson makes the point that, even now, basic information about the numbers of workers who will be affected remains vague. Betting on tens of thousands of people, perhaps--I speculate--as many as a hundred thousand--seems safe..

Here's what we don't know — how many are set to leave April 1. Temporary workers who have been working in Canada since April 1, 2011, will see their visas expire, unless they were given the one-year reprieve.

Migrante Canada says that based on the number of people asking for help in Alberta, 16,000 are vulnerable. But that doesn't mean they all have to leave April 1.

"Well it's a rolling number," says Gil McGowan, president of the Alberta Federation of Labour. "Because it depends on when their employers got their approval and the workers got their visa."

In June, the federal government made changes to the temporary foreign worker program after numerous abuses were reported by CBC
News.
The changes included a ban on low-wage temporary foreign workers in regions where the unemployment rate is higher than six per cent and ultimately a 10 per cent cap in areas where unemployment is lower. Low-wage temporary foreign workers are defined as workers who earn less than the median income of approximately $20 per hour, depending on your province.

The consequences for the workers themselves will be severe: Without any chance to return to Canada for four years, these workers and their dependents will face significant issues. As reported by Torontoist' Desmond Cole, this could well lead to many of the former temporary foreign workers overstaying their visas, perhaps giving Canada a significant problem with overstaying--illegal--migrants. At the same time, the impact on the Canadian labour market could be significant. Will Canadians take up the newly-available jobs in substantial numbers? Do the demographics of the Canadian labour force, with a diminishing number of young people able and willing to fill these "starter" jobs, support this? Will employers improve the working conditions they offer so as to be more competitive?

More will come later. I'm still thinking through the consequences of this. I would be interested to hear from our readers about what they think of all this. Is this a good strategy to increase levels of unemployment? Is this a fair strategy, for Canadians and for foreign workers alike? Will it work?