No, I’m not a scholar of Sufism. I came across the quote in Kim Stanley Robinson’s Mars trilogy years ago, and it spoke to me in a certain way — not as a moral or religious principle per se so much as a practical . . . → Read More: Possess nothing and be possessed by nothing]]> The saying is attributed to Ahmed Ibn Abu al-Hassan al-Nuri.

No, I’m not a scholar of Sufism. I came across the quote in Kim Stanley Robinson’s Mars trilogy years ago, and it spoke to me in a certain way — not as a moral or religious principle per se so much as a practical strategy for avoiding undesired entanglements, particularly vis a vis the state.

The jury’s still out on how well that works, by the way.

Anyway, I thought I’d throw it out there for discussion.

As such, you might be surprised to learn that in . . . → Read More: Modeling the Role of Money]]>

If you ask the layman about what economics is the answer you get is likely to contain the notion of money. This is understandable. After all, if economists do not study money in some form or the other what are we doing then?

As such, you might be surprised to learn that in the grand sweep of the economic literature, economists have often found it very difficult to explicitly model the role of money and indeed to incorporate this role into the overall model framework. Put very generally, graduate econ students will see two types of models which incorporate money. The first is the money in utility model (MIU) where money is simply added, alongside consumption, to the utility of the representative individual and where some form of monetary instrument (e.g. bonds) are added to the wealth and thus inter the problem through the budget constraint. The other is the cash in advance model (CIA) where we essentially assume that consumers must hold cash solely for the purpose of buying the goods that they want. Or in more convuluted terms; to facilitate the exchange of goods and services.

If the story above is the one that trickles down into the the university classroom the real world is of course more complicated and any student who starts to dig deeper will find a diverse literature which, notably, have been greatly enriched on the back of the financial crisis.

A paper from the Chicago Fed by Ed Nosal, Christopher Waller, and Randall Wright takes a look at recent endeavors in this field.

The first question which you would probably like to ask is; why the neglect by economists of money and the explicit modelling of something so important? Well, in the word of the authors, blame it on the general equilibriumnistas;

The reason many economists either ignore institutions like money, or slip them in with short cuts, is this: they do not take seriously the nature of the process of exchange. Following classical general equilibrium theory, agents do not trade with each other, but trade only against their budget constraints. Any bundle that is worth no more than the value of one’s endowment is available, with no discussion of how it is to be acquired. Everyone worth his salt understands that there is no role in Debreu’s frictionless paradigm for money, intermediation, or anything else that facilitates the process of exchange since this process is not part of model.

But this is not the whole explanation (fortunately). As the authors go on to explain, many economists sees the working of money as the plumbing behind the scene and thus that it should be assumed to simple do its work (i.e. facilitate the exchanges in a Arrow-Debreu GE world). However, as the authors point out; what happens when the plumbing goes wrong? Indeed, what happens when liquidity, credit and ultimately money transmission mechanisms breaks down?

Some have argued that modeling the details of exchange and intermediation is nothing more than studying the “plumbing”of the economy –it all works well behind the scenes and so we do not need to pay attention to it. This seems wrong. How do we know it is working well if we do not pay attention to it? What happens if the “plumbing”goes bad? We know what this entails, and it is not pretty. We believe that it is dangerous to ignore the details of “plumbing”and that the recent …nancial crisis makes this obvious. We therefore think that it is important to study institutions that help to facilitate exchange, and the papers in this special issue do just that.

And here then is the cue to go read the paper or at least to bookmark it. Note in particular how the authors group recent contributions in the context of money, credit and liquidity and thus what was originally simply a facilitator of exchange has now become a much broader concept.

Naturally, economists of an Austrian pedigree have known this for a while and one decidedly fruitful consequence of the financial crisis is the nascent incorporation of their thoughts into the mainstream economic methodology [1].

—

A lot has been written about Japanese savings and especially about when they would run out so as to make the country dependent on foreigners for the financing for the ever growing mountain of public debt. I have written extensively about this basically arguing that while the flow of savings in Japan is indeed inadequate for the ongoing financing of the debt, Japan has two things in their favor. The first is a large stock of domestic savings of which not everything, yet, is parked in government bonds and secondly, central bank which will be forced into taking up any bid that would otherwise have gone to yield hungry bond vigilantes.

A recent working paper by Tokuo Iwaisakoy and Keiko Okadaz from the Japan Ministry of Finance Policy Research Institute (PRI) looks to be well worth reading; (my emphasis);

The decline in Japan’s household saving rate accelerated sharply after 1998, but then decelerated again from 2003. Such nonlinear movement in the sav- ing rate cannot be explained by the monotonic trend of population aging alone. According to the life cycle model of consumption and saving, popu- lation aging will increase short-run ‡uctuations in the saving rate, because the consumption of older households is less sensitive to income shocks. Ana- lyzing income and spending data for di¤erent age groups, we argue that this is exactly what happened during the recession following the banking panic of 1997/98. Two important changes in income distribution are associated with this mechanism. First, the negative labor income shock, which in the initial stages of the “lost decade”was mostly borne by the younger genera- tion, spread to older working households in the late 1990s and early 2000s. Second, there was a signi…cant income shift from labor to shareholders asso- ciated with the corporate restructuring being undertaken during this time. This resulted in a decline in the wage share, so that the increase in corporate saving o¤set the decline in household saving.

An important aspect of Japan’s economy is the ongoing increase in corporate savings which is just about the only chart on the Japanse economy (apart from the public debt to GDP one) going up. Indeed, it may just be one of the most important charts to understand Japan’s economy;

(click for larger image)

Retained earnings have grown at an average of 4% since 2000 and has thus offset, to a large extent, the decline in private household savings.

—

[1] – Indeed Austrians seem have become more mainstream in the aftermath of the financial crisis as a whole. This is no doubt to their great lament since it means you actually have to provide policy advice and not just advocate eternal damnation and bloodletting. ]]> http://www.citizeneconomists.com/blogs/2011/01/11/modeling-the-role-of-money/feed/ 0 http://www.citizeneconomists.com/blogs/2010/06/28/demographics-and-macroeconomics-part-1/ http://www.citizeneconomists.com/blogs/2010/06/28/demographics-and-macroeconomics-part-1/#comments Mon, 28 Jun 2010 18:50:58 +0000 Claus Vistesen http://www.citizeneconomists.com/blogs/?p=4250 Blog post series, like the vuvuzela, is the new bacon; it works with everything and with John Hempton’s recent excellent series on the economics of default in the Eurozone and Edward’s recent postings on AFOE in which he pulls out some of our old paper abstracts has inspired me to a series in which . . . → Read More: Demographics and Macroeconomics – Part 1]]> Blog post series, like the vuvuzela, is the new bacon; it works with everything and with John Hempton’s recent excellent series on the economics of default in the Eurozone and Edward’s recent postings on AFOE in which he pulls out some of our old paper abstracts has inspired me to a series in which I try to pin point exactly how demographics and macroeconomics interact and where I believe we need more focus and work.

When it comes to the overall link between demographics and macroeconomics we already have a number of core workhorse models in the form of the life cycle and life course framework where the former deals with consumption and savings decisions as a function of age and the latter deals, broadly, with life time events and their individual and aggregate importance on economic dynamics. The adequate impact on the macro economy from the dynamics of demographics must then be developed as a function of the attempt to do two things; firstly, to continuously develop the life cycle and life course theories themselves and secondly to seek out new ways to apply life cycle and life course theory to existing macroeconomic problems and themes.

In the first series, I will begin with the latter.  Overall, I will highlight 6 areas where demographics enter  macroeconomic theory  and research as an important variable and I will try to offer my view on where to progress further. I will begin with two classics in the form of growth theory and open economy dynamics.

Growth Theory

Firstly, I need to say that I am not an expert on growth theory and this represents somewhat of a problem since growth theory although somewhat out of vogue at the moment has grown to become an extremely diverse field with a wide number of different schools and discourses. For the purpose here it will suffice to note that most economists today still use some form of the classic production function framework which has its roots in the work by Charles Cobb and Paul Douglas in 1928 and was popularized in 1958 by Solow’s famous article. This is what it looks like;

Where Y is output, K is physical capital, A is the illusive residual or more specifically technology/production function, L is the size of the labour force and H is a measure of human capital. Now, I certainly won’t do any math at this point and it is important to note that the functional form may take many exotic forms (which are not necessarily Cobb-Douglas), but just to give you one example the following is a Cobb-Douglas production function which incorporates human capital as above (here with constant returns to scale);

The key point I want to emphasize here is simply that we have output as a function of some input and that we would like to account for and explain the dynamics and behaviour of this input. How might we imbue this model with reasonable characteristics that reflect demographic dynamics?  As it turns out, we already have some pretty solid frameworks to deal with this questions and we can see this by looking at the inputs one at a time.

The evolution of capital (K) – In most traditional models the evolution of capital is simply expressed as the fraction of income save minus any depreciation of the capital stock in the last period and here of course we have several workhorse models to show demographic dynamics that are all wrapped up in the form of the life cycle hypothesis of savings and consumption. Usually and since most of these models are constructed on the basis of Walrasian microfoundations, we have some form of intertemporal optimization problem ticking away in the background which assumes an OLG (overlapping generations) form. The classic model here is the Diamond model who is based on Diamond (1965) which is the father of all OLG models, but over time a plethora of different OLG models have been developed with differing degree of analytical complexity.

The basic problem here though remains the concept of the steady state which means that we must construct model such as to allow the change of capital through time (or its derivative with time) to be 0 in the long run. Please note here that this condition is not imposed on the basis of empirical behaviour but on the basis of (mathematical) analytical tractability. So, apart from the uncertainty surrounding exactly what this ”long run” is it also locks in the analysis and assumes away a large part of the important aspects of even basic life cycle behavior. Specifically, the idea that once reaching a steady state any change in the savings/consumption rate will one have transitory effect and that the economy will automatically (and always) converge to the same growth rate/state as before is a problem. Essentially, the whole idea of a steady state whether be it in the form of an exogenous or endogenous growth theory framework is a huge problem since it is evident that such a thing does not exist. And even if we could establish over a very long run horizon that such an average/constant path is a good approximation we would be ironing out all the interesting and important questions in the process.

The evolution of human capital (H) – The adoption of human capital into the growth theory framework is famously due to a paper by Mankiw, Romer and Weil in 1992 in which human capital is proxied by rates of schooling and thus the perspective becomes one of the quality of human capital and to the extent that the formation of human capital also includes the evolution of the population (or perhaps working age population) we can say that this is a direct way in which demographics enter the framework. Again, we might simply ask here; to what extent does the aggregate quality of human capital in an economy depend on the age structure of its population and here I am not only talking about the level of education but much more broadly about the idea of innovative capacity as a function of population structure.

The evolution of technology (A) – Technology and productivity are famously assumed exogenous in the Neo-Classical tradition while New Growth theory as it was developed in the 1980s and 1990s emphasised the need to specifically account for the evolution of technology. Today, I would venture the claim that there is a consensus that productivity and technology is a function of what we could call, broadly, institutional quality which encompass almost anything imaginable from basic property rights to the level of entrepreneurship. Indeed, a large part of research is still devoted to pinning down exactly which determinants that are most important here both across countries and through time. Now, I would argue that, in the context of standard growth theory, this is where the scope for the study of the effect of population dynamics is largest. Thus I don’t think it is unreasonable to expect the level and evolution of productivity growth and technological development to be a function of the current population structure but also its velocity which is a function of e.g. migration (new inputs?), future working age size etc. Also, this is also where human capital and the evolution of technology is joined at the hip through the idea of innovative capacity and readiness.

As you might have inferred from the exposition above, I have some difficulties with growth theory. I can admire the framework for its internal logic and I can see why it is an important part of a macroeconomist’s toolkit, but I also think that growth theory (as I describe it above) has outlived itself. In this sense, most of the questions that we have as economists when it comes to the evolution of growth and welfare of our economies both individually and through their interaction is not addressed by growth theory. Especially the effect of an ongoing and ruthless process of ageing is completely impossible to analyse in the standard framework. Naturally, I am also being a bit unfair here since the kind of growth theory I am describing above is also too simple to give adequate credit to where the field is today. For example in relation to demographics, I am grossly overlooking important strides in the development of OLG models which have been perfected continuously so that we today have a very large battery of very complex models. But also more generally, growth theory is being used today to produce a lot of useful research. As I say, it remains a key tool in our toolbox.

Yet, the basic growth theoretical setup remains flawed in key a number of un-salvagable ways. Concretely, specifying a production function and specifying the underlying inputs as differential equations through whose solution we reach a steady state equilibrium is not, in my opinion, the way to go. Thus and in an intuitive sense I feel much more at home, for example, in the company of evolutionary growth theorists [2] whose argument and methodology is more agile. In summary then and as I try my utmost not to become a hostage of the notion of a steady state I will simply make the following observations in the context of what we macroeconomists consider the main inputs to growth where the ”age” is simply an unspecified collection/function of variables that pertains to fertility, age structure, mortality etc (and of course a whole slew of other factors, but for the sake of argument let us keep it monocausal here).

Where age in the context of the capital stock relates to the size and evolution of the capital stock as well as savings and investment dynamics, in the context of human capital it may be argued to enter directly, but may also affect the quality of human capital. Finally, I think that the impact of demographics on innovation and especially the idea of velocity of innovation and innovative capacity represents an area which is not well understood. In general though and short of letting some variant of demographics enter directly, I think an important research program would be to examine the effect from demographics on the inputs to growth which we traditionally operate with. Especially, the process unprecedented process of ageing is a completely new phenomenon here in the context of traditional growth theoretical analysis.

Open Economy Dynamics

An enduring feature of macroeconomics is that the entities we study are not black boxes but interdependent entities who interact in very complex ways in the global economy. This statement was true 40-50 years ago and today it is almost a cliché. In fact, for non-macroeconomists it must seem very strange that we still distinguish so strongly between closed and open economy analysis as the use of studying the former must surely be almost nill. I would agree with this statement but simply note that important things do actually happen when we go from a closed to an open economy and the way this transition is operationalised is important in itself.

Now, I could write a lot about this (in fact, I have penned a whole thesis about it), but I will only cover the essentials. What you need to know upfront are two things. The first is that the economic theory used to handle the effect of age structure/demographics on open economy dynamics is again the life cycle framework and, in most cases, we still have a OLG representative agent model taking care of the microfoundations. Secondly, it is important to be aware of the concrete specifics of the transition from a closed to an open economy. Luckily, this can be handled by some very simple algebra from macroeconomics 1-0-1.

The whole point is to find an expression for savings, so for the closed economy we have;

By definition every unit of output has to equal a unit of income, and national income in any given period can either be saved or consumed. This means that national income can either be put aside for saving or consumed through government (G) or private consumption (C). In this way, we define national saving in any given period as;

This is a fundamental result in basic macroeconomics and what is equally fundamental is why this changes in one key aspect when we move into an open economy setting. We then have;

With (x-m) equal to the trade balance and by doing the same exercise above we get;

In this context and remembering that the life cycle hypothesis tries to map consumption and saving as a function of age, the transition from a closed to an open economy becomes crucial in order to see how demographics may affect open economy dynamics. As such, allow me to quote the following passage of my thesis which I find myself coming back to when thinking about this topic;

The best way to think about this [3] is to imagine that savings and investment are in a race governed and controlled, as it were, by the transition in age structure that occurs as a result of the demographic transition. Initially, as the transition sets in with a decline in mortality and where fertility only follows with a lag, investment demand outruns the supply of savings and the economy is running an external deficit. Steadily however, the supply of saving catches up with investment demand which itself begins to decline and thus the external balance moves into a surplus. Finally, the pace of savings accumulation is replaced by outright decumulation (dissaving) and the external balance moves into deficit as savings decline faster than domestic investment demand

This is stylized of course, but especially the idea of the race between savings and investment is a very helpful metaphor. Consider then a closed economy; in such a setting there can be no race as described above since savings and investment will be tied together at all points in time, but in an open economy savings and investment dynamics are exactly what provokes relations between economies and more specifically, the fact that the economies have different preferences for savings and investment at different points in time. This gives a very strong foundation for thinking about how demographics affect open economy dynamics.

Concretely, and in order to tie the argument up on the underlying theory capital flows occur precisely because economies have different intertemporal preferences for consumption and saving and since this intertemporal preference itself is a function of age (through the life cycle/OLG framework) demographics become a driving force for international capital flows.

This as it were is also where the fun begins since exactly how this process should be understood both from the point of view of the individual economy, but also in a global context remains, for all intent and purposes, an unresolved question. Surely, we have studies that use basic life cycle frameworks to simulate capital flows between economies and they do have some intuitive appeal and explanatory power, but they are hampered by, in my opinion, by an inadequate understanding of the life cycle thesis and how exactly it manifests itself. As I noted in the beginning, part of all this also requires a continuous development of the life cycle hypothesis itself and here this becomes important. Personally, I have cast my eyes on two areas of research where I believe that the influence of demographics on open economy dynamics is important.

1 – Global Imbalances

This represents an enduring feature of the global economic system and while everyone can agree that they need to be resolved some way or the other I think that the proper understanding of demographics shows us that they are essentially structural. Especially on the side of surplus economies I have argued (both in my thesis and in genera) why we cannot suddenly expect economies such as Germany and Japan to do their part and crucially, why we should expect more economies to venture down the same path as they are also ageing rapidly. Importantly, this provides a concrete theoretical spin to the question everyone seems to be asking at the moment of who exactly is going to run the deficits? The pessimistic answer here is no-one and herein lies the rub.

2 – Export dependency

This one is essentially the concrete theoretical proposition used to make the argument above on global imbalances. Ageing leads to a decline in domestic demand and in a closed economy there is really not a lot you can do; savings/investment will fall and consumption will be lacklustre since there is no underlying dynamic to feed it other than dissaving. However, in an open economy you can fight this through claims on other economies or put in another way, you can save more than merited by domestic demand and thus you can invest your savings abroad. Note here that technically this is exactly what e.g. Germany and Japan are doing in the sense that their excess savings have to be matched by excess borrowing/investment demand elsewhere.

I am still developing these two areas, but there are plenty of meat on this topic I think. One crucial task is to develop the life cycle hypothesis on the basis of observed behavior of economies as they age and another is to.

Stay tuned for the next post in this series which looks at the influence from demographics on asset prices, demand, and return and composition of consumption. Suggestions and comments on potential omissions on my part are welcome.

—

[1] -  Most often operationalized through an OLG framework.

[2] – Evolutionary Growth goes back to this one “Nelson, R.R., Winter, S.G., 1982. An Evolutionary Theory of Economic Change. Harvard University Press, Cambridge, MA” and is a must read I think. The work by Jan Fagerberg is a good place to begin as well as for a more modern exposition.

[3] – I.e. demographics and savings and investment behavior in an open vs closed economy

It is actually a horror that the level of private debt peaked last year at about $36 trillion, which is . . . → Read More: Private Debt Decline: Good For US, Bad for the Economy]]> I got a disturbing email from Bianco Research which showed a chart of “Private Credit Market Debt” which they say shows “Total credit market creation not including Treasury Debt, Municipal Debt and Agency Debt”.

It is actually a horror that the level of private debt peaked last year at about $36 trillion, which is certainly a lot of money, especially since total GDP of the Whole Freaking Country (WFC) is only $14 trillion (and falling!).

In some kind of bizarre “good news/bad news” joke, total private debt has now actually fallen by a couple of trillion dollars to $34 trillion, which is bad news for an economy that depends on consumption, but is good news in that people have lighter debt burdens.

David Stevenson of the Money Morning newsletter at moneyweek.com notes that it’s not just us, but “private borrowing is slowing everywhere” and that “US consumer credit has shrunk for a record 11 months in a row.”

The interesting thing is that the Bianco chart goes back to 1952, and there has never, ever been a time when private credit market debt fell by as much as a dime! Although it, sometimes, did not go up for short periods, nevertheless, it has never gone down. Never!

Until now. Oops!

Note that the soundtrack has gotten all gloomy, which makes sense, because if total private debt has – gasp! – gone down, then the money supply is not expanding because people are not borrowing to buy and invest. Oops!

Parenthetically, the money supply is not actually shrinking that much, as you would expect, because the asinine neo-Keynesian theory says that the government should replace private spending with deficit-spending, which they do, thanks to the Federal Reserve creating the money, which is another whole subject about which usually results in a loud Mogambo Scream Of Outrage (MSOO), which is, I think, more of a wail of anguish and crushing despair than a scream, although it usually concludes with me howling, wolf-like, “We’re freaking doooooooooommmmed!”

That’s, unfortunately, the bad thing that happens at the end of long booms produced by constant monetary stupidity, especially of the kind of stupidity found at the Federal Reserve, which explains why I say, with a loud, irritating repetitiveness that makes people run screaming from the room every time I open my mouth, to buy gold, silver and oil as your only defense against rampant government stupidity and insane levels of monetary over-creation of money and credit, as redundant as that actually is because of how incestuous they are.

I assume that you now understand the depth of the ignorance, stupidity and depravity of the government and the Federal Reserve (and, indeed, all the central governments and central banks of the world), and you are saying to yourself, “Hey! The Loud Mogambo Idiot (LMI) is right! Maybe he is not as stupid as everyone says!”

Fortunately, that knowledge is all that is required to be a Junior Mogambo Ranger (JMR), and now that you have begun on your path to economic enlightenment, I can let you in on a little secret; it’s going to get worse. Much worse. Much, much worse. Worse than anything, even that time when your First True Love (FTL) dumped you and started going out with that jerk from the baseball team, and how you still hate him for it, even after all this time, and you still love her in spite of it, even after all this time.

But you are not here to listen to my tale of love gone wrong, desperately loving someone who doesn’t love you, and rejects your aching heart over and over, and when you call her on the phone, her father answers and says, “My daughter says you are a creepy little rat-faced creep, so why don’t you just give up, kid?”

And so I did, on the spot, saying a final goodbye to her, through him, and with a tearful, heart-broken voice, and I told him to tell that scheming little lying two-faced cheating slut he calls his daughter, as a parting gift of wisdom from me, to “Buy gold, silver and oil when your idiotic government allows unrestrained creating of money and credit, and especially when the government deficit-spends said money to expand itself”, thinking, you know, that I would leave her with a fabulous piece of advice by which she could always remember me fondly.

Instead of him saying, “Well said, intelligent young man! I shall be honored to relay your wise advice to my daughter, and I shall act upon it at once myself!” he said, “What in the hell is that supposed to mean, you little punk?”

So I told him that he was obviously a moron about monetary policy, fiscal policy and raising demonic daughters and, judging by his reaction, burned another bridge behind me.

But I won’t need it! Hahaha! I have gold, silver and oil, and with them I can build all the new bridges I want, with riches untold, when his precious dollars and dollar-denominated assets turn into the crap that fiat currencies always become.

And his daughter, the tramp Carol? Now it shall be I who says, “Scram! Ya creep me out, loser weirdo!” Hahahaha!

Private Debt Decline: Good For US Bad for the Economy originally appeared in the Daily Reckoning.

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Ideally, stabilisation using monetary and fiscal policy, alongside actions by the private sector, should restrain the decline in consumption, and yield conditions which are not too harsh . . . → Read More: Protectionism, Recession, Recovery: Looking Back and Looking Forward]]> In thinking of protectionism, the Great Depression, the Great Recession, and what might come next, here are two interesting angles.

Governments with their backs against the wall

Ideally, stabilisation using monetary and fiscal policy, alongside actions by the private sector, should restrain the decline in consumption, and yield conditions which are not too harsh for households. At the time of the Great Depression, much less was known of economics. Pegging the currency to gold meant giving up monetary policy autonomy; the US Fed succumbed to contractionary monetary policy once you take into account the closure of banks; the fiscal policy response at the time was miniscule.

It has been argued that the the Smoot-Hawley Tariff Act came about in the US in June 1930, at a point in time where the politicians were coming under enormous pressure to do something. After seven months of inaction by macro policy, with mounting difficulties in the economy, the politicians succumbed to protectionism. This appears to have been of decisive importance in sending the world down the destructive path of competitive trade barriers and cometitive devaluation. In the graph made famous by Barry Eichengreen and Kevin H. O’Rourke, at month 7 there was almost no decline in world trade. Douglas A. Irwin is worth reading on this.

Protectionism adversely impacts the recovery

Greg Mankiw and Scott Sumner point out one more channel through which Smoot-Hawley damaged prospects for the recovery was through the impact of protectionism on confidence.

The private sector saw protectionism as symbolising government backing away from responsible thinking in economics, and responded with a weakening of investment demand. This served to exacerbate the downturn.

Will this time be different?

The bulk of world GDP is now endowed with inflation targeting central banks. This ensures that monetary policy will be counter-cyclical: under bad business cycle conditions, inflation forecasts will drop below targets, and central banks will use every trick in their book to push inflation back up to target.

Fiscal policy has responded well this time around, thanks to better understanding of business cycles when compared with 1929. But there is little headroom to go further.

The world has as little ability to rein in some players engaging in competitive devaluation (e.g. China) today, as was the case in 1930. But with the bulk of world GDP being placed with inflation targeting central banks, the extent to which such tactics will be used will be relatively limited.

So far, we have had an upsurge of protectionism, but nothing on the scale of that seen from 1930 onwards. This could partly reflect the dramatic actions which governments have undertaken through monetary and fiscal policy, through which politicians have been able to reduce the domestic political difficulties that go along with business cycle downturns. But if, in coming months, the world economy remains mired in recession, then we could get fresh pressure to do something. In a recent voxEU post, Jeffrey Frieden points out that the path of adjustment of macroeconomic imbalances and currency distortions will involve political pain along the way, which could spillover into protectionism.

Some protectionist decisions could reflect bargaining tactics aimed at getting China to reduce or end their market manipulation of the currency market. But if there is an upsurge of protectionism beyond this, it will further damage the recovery by hurting investment, giving a spiral of bad economy -> protectionism -> reduced investment demand -> worse economy.

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