Developed Market Privilege

With Boris Johnson proroguing parliament the chat has turned again to whether UK is becoming an Emerging Market (EM). Sure – suspending democracy to avoid losing power is a bold move for any British government/ monarch. But what does it actually mean to go full-EM?

The IMF definition of an Emerging Market studiously avoids words like dictatorship and democracy, focusing instead on income per capita and export diversification, but leaving plenty of wiggle room to change minds if an upstart somehow qualified as Developed. The World Bank scrapped the definition completely in 2016. MSCI and JP Morgan have their own convoluted definitions that control the entry into their widely followed equity and bond indices, respectively. Under any of these definitions the UK is miles away from going EM. But it’s a conversation with a very smart tweep about a year ago that really sticks in my mind.

If you live in a Developed Market it means that you are pretty likely to be well-off individually (when measured on a global scale). But it also means that you benefit from Developed Market Privilege: your government can run counter-cyclical monetary and fiscal policy.

Reducing (rather than raising) interest rates, and loosening (rather than tightening) government purse strings when an economic downturn comes might sound like common sense. And for Developed Market economies it is. But if you are an Emerging Market (EM) economy, things aren’t quite as simple. For EM economies, rate cuts and easier fiscal policy (that might help cushion the blow of a slowing or shrinking economy) might well be met by currency weakness, rising inflation, and a higher risk premium applied to the country’s debt and financial instruments by foreign (and domestic) investors, all of which might be somewhat counterproductive to the happiness of EM citizens. Bottom line, in the words of my interlocutor “at the risk of provoking the fixed-income goblins, the shibboleth is ‘in risk-off, am I buying or selling your debt?’”.

So being EM sounds not exactly brilliant, but also actually something that has a concrete definition relating to how credibility issues lead directly to currency weakness and financing issues. Given that pretty much everyone knows that a central bank can control the level of bond yields (if it is willing to pay a high enough price) this sounds like a story of Exchange Rate Pass Through (EPRT). A high EPRT should indicate EM-hood. A low ERPT might deliver DM-privilege. It’s actually a bit tricksy to calculate ERPT. Professor Kirsten Forbes is pretty awesome on this whole EPRT issue, and has the benefit (from my perspective) of having served on the MPC and looked at where the UK sits in all of this.

Taking both Forbes’ EPRT data, and looking also at what happens in risk-off situation, we get chart 1. The dark blue blobs are considered Developed Markets in bond indices, the blue diamonds are considered Emerging Markets. Higher ERPT are higher in the chart, and lower ERPT are lower in the chart. The average EPRT for his small sample of Developed Markets is lower than the average EPRT for this small sample of Emerging Markets, but there is not really much in it.

Chart 1: Exchange-Rate Pass-Through coefficient, vs Local bond-equity correlation coefficient 2004-15

erpt

One reason why ERPT differences might be so slight is precisely the different reaction functions of the central banks in EM and DM respectively. And this could be the thing that is informing the real distinction shown on the horizontal axis of the chart and observed by my clever friend: in risk-off I buy your sovereign debt if you’re DM and sell your debt if you’re EM. (Eg, perhaps Turkey’s ERPT was contained in 2004-15 precisely because every time there was a downturn that caused its local equity market to weaken, fiscal and monetary policy-makers may have collectively tightened sufficiently to push bond yields higher but protect the currency from moves that delivered higher inflation pass-through.)

So I think that the chart tells a story, and it’s one of control. Being rich, diversified, and having strong institutions has put a bunch of countries’ sovereign debt into that bracket labelled ‘safe assets’. These assets are bought by investors when things get hairy, bestowing upon respective governments the ability to deliver counter-cyclical policy (cutting rates and boosting government borrowing and spending when things get tough). This Developed Market Privilege is something that countries around the world have sought. Developed Market Privilege delivers enhanced control over your destiny – a form of economic sovereignty that is far from universal.

So is the UK going full-EM? It doesn’t seem that investors have yet given up on Gilts, although long Gilts look as though they have underperformed Bunds and Treasuries as the risk of a disorderly Brexit have increased. UK inflation isn’t soaring despite extended currency weakness. These things tend not to be linear, but I think it’s too early to declare the UK a banana republic quite yet. That said, the institutions on which the UK’s Developed Market Privilege depend appear to me to being eroded by the day.

 

 

Doing stuff for free

As I occasionally muse on Twitter, Diane Coyle’s stuff is fascinating and wonderful. If you’ve read her GDP book or any of her papers (and you ought to) I’ve nothing really to add.

But I have made a cut-out-and-keep picture of my understanding of some of the issues raised in trying to capture changes to GDP and productivity (with apologies to Diane). This is for me rather than you. It’s a bit messy, but here it is. And I like it enough to share, because prosthletise as I do, not everyone is familiar with the basic outline of these ideas.

If you’ve read this far, I expect you have one of 3 thoughts: 1) I already know this; 2) you’ve taken something simple and made it look complex, kthxbye; 3) can you explain? The rest of this blog helps people with thought number 3.

The big black line is the Production Boundary: a threshold between stuff that happens when you Do Stuff For Money (ie, captured in GDP), and when you Do Stuff For Free (ie, everything else).

Breaking the diagram into smaller pieces, let’s start with the up arrows:

When you find a new and better way to Do Stuff For Money (DSFM), this tends to be good for GDP growth and is good for the growth of GDP/ hour worked (generally thought of as productivity growth). On the diagram, this is #1 arrow on the left and captures all sorts of things from the invention of the harvester-reaper, to the roll-out of basic management training. Many if not most of the things we *all* agree about as boosting productivity do so through this arrow.

When you find a new and better way to Do Stuff For Free (DSFF), this doesn’t *directly* touch GDP growth or productivity growth. On the diagram, this is the #2 arrow on the right and captures things like the first order effects of the invention of Wikipedia or the computer language Python, learning how to cook better food, writing a blog etc. This saves us time and/ or is an improvement on what came before. It is good stuff that increases what economists would call the consumer surplus, but won’t deliver a first order boost to GDP.

There are a lot of other lines on this chart. All the other lines cross the black Production Boundary line.

When a red line crosses the production boundary from right to left it boosts GDP. When a red line goes from left to right it reduces GDP.

Famously, marrying your housekeeper reduces GDP as they pass from DSFM to DSFF (#3), even if the stuff they do doesn’t change (although in fairness it might). Divorcing your spouse and paying them to do stuff they would otherwise do for free (#4) strikes me as less conventional, but would deliver a GDP boost. What either means for aggregate GDP/ hour I guess depends upon how much you pay them per hour (as a monetary measure of their value) versus how the output per hour of the rest of the population is valued.

And now we come to some interesting bits.

Inventing and manufacturing something like a washing machine that saves us time and improves our non-market lives boosts GDP and consumer surplus (so arrow #5 is upward sloping). That is, if people generally do their own washing rather than pay someone else to so do. And so the activity of washing clothes shifts from the DSFF to the DSFM side of the Production Boundary.

And there have been some innovations like the self-scan checkout that move tasks from the DSFM side of the Production Boundary to the DSFF side (#6). Here, firms boost output/ profit per employee by substituting a combination of capital and customer labour for their own low skill labour. Unlike the washing machine, this is a slight hit to consumer surplus, getting shoppers to do the work that firms had previously paid staff to do (although maybe reduced queue-times make up for the hit; also, maybe some people enjoy scanning). So the end result is a slight decrease in consumer surplus and higher firm profit.

Online travel agents – like self-scan check outs – boost measured output per employee by shifting some of the work to the customer. But I reckon that the proposition is a cheaper outcome for the customer (#7). So GDP takes a first order hit as offline travel agencies shrink.

And lastly there is the case that Tim Harford wrote up about Microsoft Office. Tim’s mischievously makes the case that having office workers all writing their own PowerPoint presentations, doing their own expenses, etc, rather than what they are presumably experts in doing is an insult to the principle of division of labour, and a negative drag on productivity. I’ve popped this one in at #8 sloping down from DSFF to DSFM rather than just being an arrow of questionable direction sitting on the left hand of the production boundary. The logic is built on Tim’s blog: that having to do stuff in which you are not expert but which is not very taxing (ie, make bad PowerPoint presentations) may be a welcome relief from your actual work. It might even be thought of as a pretty rubbish, but fully-paid, work break. I don’t think I agree with Tim, but I 1) can’t think of another good example off the top of my head, 2) am keen to get symmetry in the diagram, 3) love Tim’s stuff.

Who cares?

Well, I think everyone actually cares about each of GDP, GDP/ hour and general welfare. But I also think that different people are incentivised to really care a lot about one angle more than another.

Government treasury departments care a lot about raising and spending money. For this, GDP is the most immediate concern. It is hard to tax stuff that is neither money flow or money stock, and GDP is money flow. Wikipedia may be awesome, but it is hard to get a cut of the welfare they deliver in order to pay nurses’ and teachers’ salaries. Things that boost GDP in some taxable way are good for governments that seek to resource spending decisions with tax.

Financial analysts and investors care about revenue, profitability, and spare capacity. For this, GDP is important, but output per employee is – I reckon – even more so. Changes in output per hour inform at the macro level the amount of spare capacity there is in an economy, and a boost in output/ hour can boost on a sustainable basis the ultimate level of GDP in a non-inflationary manner (keeping central banks away from the brake pedal). Output/ hour is also important for understanding how corporate profit margins will change. For example, if firms automate, they can produce more revenue per employee; if the cost of automation is not high this will boost profitability, helping boost firm values. And firms and investors will care a lot if some innovation (that they don’t own) shifts stuff across the production boundary. It could maybe wipe out an industry’s viability.

Citizens care about welfare improvement. We shouldn’t obsess over GDP growth if it is associated with reduced consumer surplus. That said, the correlation between measured GDP per capita and different measures of welfare is strong (maybe related to governments’ ability to intervene to raise outcomes being contingent on taxing GDP, don’t know). Have a follow of the brilliant @MaxCRoser https://twitter.com/MaxCRoser for a plethora of great charts, many of which show that places with plenty of GDP tend to get better health outcomes. Like this chart of maternal mortality and GDP/ capita, reproduced here from https://ourworldindata.org/

There is sooo much more to write on this, but frankly, I am poorly qualified to write it and Diane Coyle’s stuff reads much better. Also, check out the Bean Review.