Category Archives: Interesting papers

2020

It’s this time of the year. This post recalls events of 2020. It has been such an unusual year, so different from what we expected. Luckily, there seems to be light at the end of the very long and dark tunnel, and – I hope – that 2021 will be considerably more joyful than 2020.

2020 started out so well. The roaring twenties and all that. Wuhan was a city I had not heard of, corona a beer people tell me is best served ice-cold with a slice of lime (I do not drink beer, tough I do enjoy wine), and social distancing words we would only get to know too well. Today, we know that Wuhan is a Chinese city with more than eleven million inhabitants and a marketplace where it presumably all started, corona also means something terrible, and social interaction is an activity we have come to miss so dearly.

At the time of writing, app. 75 million cases of corona/COVID-19/SARS-CoV-2 have been confirmed globally and app. 1.7 million people have passed away because of corona. Most countries have been in lockdowns, many still are (again), and the social and economic costs of the crisis have been enormous.

I started this blog in April 2020. This had nothing to do with corona. I had wanted to set up a blog for some years (people ask me where I find time for this, and I really do not know, but seemingly I simply like writing economic stories and analyses). Starting the blog in April this year, however, naturally implied that many of the blog posts have dealt with various economic and financial aspects of the pandemic. In this post, I will review some of the learnings from 2020.

The worst recession on record. With the highest growth rate on record

The recession started in February 2020 in, e.g., the US. Initially, it was caused by a supply shock: lockdowns were imposed and firms could not sell their goods and services and households could not go shopping. In April, when the IMF released their Spring Outlook, they labelled it “The Great Lockdown”. This was a suitable label. The IMF also noted that “This is a crisis like no other” and that “many countries now face multiple crises—a health crisis, a financial crisis, and a collapse in commodity prices, which interact in complex ways”. As unemployment and bankruptcies increased, households and firm got nervous, and demand suffered, too.

The path of economic activity has been highly unusual. This graph shows the quarterly percentage changes in US real GDP since 1947:

Quarterly percentage changes in US real Gross Domestic Product. 2020 encircled.
Source: Fed St. Louis Database

2020 is very much an outlier. On average, from 1947 through 2020, real GDP has grown by 0.8% per quarter. Until 2020, quarterly growth had never exceeded 4%. Economic activity had never contracted by more than 2.6%. Then came the Great Lockdown. During the second quarter of this year, economic activity contracted by 9%. This is almost four times more than the otherwise worst contraction on record. In this sense, it was the worst recession ever.

It has also been the weirdest recession ever. During this recession, we have also witnessed the highest growth rate on record: economic activity expanded by 7.4% during Q3. This is twice as much as the otherwise highest growth rate on record.

This puzzling feature of the recession led me wondering what a recession really is (link). I expressed sympathy with members of the NBER Recession Dating Committee. They face a particularly difficult task this year. Should they conclude that we had one V in spring, with the recession ending in late April, and then a new V now, i.e. two separate Vs (VV), or that we have had one long recession with a double dip, i.e. a double-V (W)? Does it make sense to call it a recession when we experienced the fastest rate of growth in economic activity on record? If you conclude that the economy cannot be in recession when it expands at its fastest growth rate ever, then you must conclude that the recession ended during Q2. But, the NBER Recession Dating Committee has not called the end of the recession yet, i.e., officially, the recession is still ongoing.

You may ask why it is important to know whether the recession ended in April or whether it is still ongoing. The development in economic activity is what it is, whether we call it recession or not. It is important because a “recession” is such an important concept in economics. We inform the public, business leaders, students, and others about the characteristics and consequences of recessions. If a recession can contain the by-far strongest expansion of economic activity on record, we need to change our understanding of recessions.

The very unusual behavior of economic activity during Q2 and Q3 caused very unusual, and scary, developments in unemployment and related aspects of economic activity. This graph shows the monthly change in the number of unemployed in the US:

Monthly changes in the number of unemployed in the US. Millions. 2020 encircled.
Source: Fed St. Louis Database

During March, unemployment in the US increased by 16 million. Again, this was beyond comparison. Until March 2020, the number of unemployed had never increased by more than one million over one month. In March 2020, it increased by 16 million.

As the virus contracted during summer, unemployment fell. There has never been as fast a reduction in the number of unemployed as the one occurring during this summer. In May, the number of unemployed dropped by more than three million. Until May 2020, the number of unemployed had never fallen by more than one million over one month. In May 2020, it fell by more than 3 million. So, within a year, we have had the strongest-ever increase in unemployment, but also the largest-ever fall in unemployment. By far.

Such dramatic events happened all around the world. I documented this here (link) and here (link).

Inspired by these events, I did something admittedly nerdy. I calculated the probability that we would experience events such as these, given the historical data (link). I found the unconditional likelihood that we could see the increase in newly registered unemployed that we saw in spring to be 0.97 x 10^(-841). This is a zero followed by 841 zeroes and then 97. For all practical purposes, this is a zero-probability event. But it did happen. It was just very, very unusual.

The stock market

I use some of my time (a significant part, by the way) to try to understand the stock market. This has not been a straightforward task this year.

Today, the global stock market is 13% percent above its January 1 value, the US stock market is 18% higher, and the Danish stock market 29% higher (MSCI country indices). Given that we have been through the worst recession ever, and that the recession is not officially over yet, this is not what one would have expected prior to the events.

Then, on the other hand, in hindsight it is perhaps not so strange. The recession has been the worst on record, yes. But, we have also had the fastest growth in economic activity on record. I argued (link) that if we imagine that the recession ended in late April, when economic activity bottomed out, the behavior of the stock market fits perfectly well with the historical evidence on the behavior of the stock market.

Central banks have certainly played their role, too. When markets melted down in March, central banks intervened heavily. In contrast to the financial crisis of 2008, it was not banks that were in trouble this time, but firms. Firms could not sell their goods and services due to the lockdown. The limitless purchases of government bonds that central banks have become used to during and after crises thus probably did not do much good (evidence came out that central bank purchases of government bonds are less effective than we are often told, link ). What turned things around, instead, was the announcement on March 23 that the Fed would facilitate credit to firms (link). This was a new policy tool. It led to a complete turnaround of events. I produced this graph (I still think it is a supercool graph): 

Difference between yields on ICE BofA AAA US Corporate Index and 3-month Treasuries (Left hand axis) as well as the SP500 inverted (Right hand axis). Both series normalized to one on January 2, 2020. Vertical line indicates March 23.
Source: Fed St. Louis Database

The graph shows how the stock market lined up with credit spreads. Firms were suffering, and their credit spreads started widening, in late February. The stock market suffered. The Fed announced it would provide credit to firms on March 23. Credit spreads tightened. The stock market cheered. The graph summarizes how the Fed saved credit and equity markets. And, strikingly, the Fed did so by merely announcing they would intervene. Up until today, the Fed has not intervened a lot. In this sense, it was a “Whatever it takes moment of the Fed”.

It should be mentioned that the Fed announced other initiatives on March 23, too, such as the Main Street Lending Program (link) and the Term Asset-Backed Securities Loan Facility (link). The Corporate Credit Facilities were the ones that directly targeted corporate bonds, though. Due to the nature of this crisis, the stock market lined up with credit spreads during this crisis, as the above graph reveals, emphasizing the importance of the announcement of the Corporate Credit Facilities.

Eurozone troubles, or rather no Eurozone troubles

The fact that we have not had to talk a lot about the risk of a Eurozone breakup since summer has been a positive surprise. In spring, there was talk about the risk of a Eurozone crisis. Like so often before, Italian sovereign yields rose relative to German sovereign yields. There was reason to be anxious. I argued that “Some kind of political solution at the EU level would be needed” (link).

This we got. The European Union agreed on a “Recovery and Resilience Facility” (link) that includes both loans and grants. EU has moved one inch closer towards a common fiscal policy. Who will pay is not clear, but EU has shown solidarity. I believe this is positive. At the same time, the European Central Bank continued its interventions and bought a lot of Italian debt. This has kept yields on sovereign bonds low. Here is the Italian-German yield spread during 2020:

Italian yield spread towards Germany. Ten-year government bonds. Daily data: January 2, 2020 – December 21, 2020.
Data source: Thomson Reuter Datastream via Eikon.

Italian yields have been falling continuously since summer, when the EU agreed on its recovery plan. It is positive that we have not had to discuss Eurozone troubles. We have had so many other troubles. Whether this means that we do not have to discuss Eurozone troubles again at some point, I am less sure. But, that is for another day.

Banks have been doing OK

The risk of a Eurozone breakup did not materialize. Another risk that did not materialize was the risk of systemic bank failures. This is positive as well, as economic activity suffers so much more when banks run into trouble and credit consequently does not flow to its productive uses.

During the worst days in March, stress in the banking system intensified. For instance, the spread on unsecure interbank lending increased relative to secure lending:

The TED spread. Difference between 3-Month USD LIBOR and 3-Month US Treasury Bills. Daily data: January 2, 2000 – December 14, 2020. 2020 encircled.
Data source: Fed St. Louis Database.

Stresses lasted only a few days, though. During the financial crisis in 2008, on the other hand, spreads remained elevated for much longer. This time, trust in the banking system was quickly reestablished.

I think I am allowed to claim that this was one of the predictions I got reasonably right. In autumn 2019, when nobody knew about the upcoming crisis, I wrote a policy paper on the Nordic financial sector. It was presented in December 2019 and finally published in June this year (link). I argued that banks are safer today, compared to 2008. Some doubted my conclusion and said, “just wait until the next crisis, then you will see that banks are not safer today”. Well, few months later we had the worst recession ever. Luckily, though, we have not had bank-rescue packages and we have not had to bail out banks. Banks have been withering the storm. In some instances, banks have even been part of the solution by showing flexibility towards troubled firms. I am not saying everything is perfect, but I am saying that the situation has been very different from the situation in 2008. On a personal note, this made me happy, too, as it would have been somewhat embarrassing if banks had failed at the same time I published an analysis arguing that the banking sector is safer. This, luckily, did not happen. Instead, the banking system turned out to be far more resilient than in 2008, as I predicted.

You may add that the Fed rescued markets during spring, as mentioned above, and thereby rescued firms and subsequently banks. True, but there was certainly also tons of rescue packages in autumn 2008. Banks nevertheless failed in large numbers in 2008. They did not this time around. Perhaps, thus, we did learn something from the financial crisis of 2008, and have gotten some things right. This would be no small achievement.

US election and Brexit

There have been other events, for instance the US election and Brexit negotiations. In normal years, such events would potentially have been among the most important events for markets and the economy. This year, the pandemic has certainly been more important. I did manage to write a post on the US election and the stock market, though (link). I discussed evidence that stock markets perform better under Democratic presidents. Only time will tell whether the same will happen under Biden.  

I did not manage to find space to discuss Brexit, but we got a trade agreement on Dec. 24 (link). Hopefully, the EU and UK can now move on.

The cost of the crisis

It is impossible to summarize the pandemic in one number or one word. Hence, I will not attempt to do so. But, I did present a calculation of the expected cost of the crisis in Denmark (link). I arrived at DKK 336bn, or app. USD 10,000 per Dane. This calculation generated some attention in Denmark.

One can discuss every single assumption one needs to make when calculating the expected cost of a crisis: What is the value of a statistical life? What is the value of a statistical life of those who pass away due to COVID-19, i.e. who are typically above 80? What is the past loss as well as the expected future loss in economic activity due to the crisis? Does it make sense to present one number when there is so much uncertainty? And so on. These are all fair points, but if we want to have a meaningful discussion of the impact of the crisis, we have to start somewhere.

In my calculation, I closely followed the assumptions of Cutler & Summers, such that US numbers and Danish numbers can be compared. This allowed me, for instance, to conclude that the cost of the crisis in Denmark, most likely, will be much lower than the cost of the crisis in the US.

Conclusion

I must admit I find it difficult to end this last post of 2020 on a happy note. Right now, at the time of writing, the situation is bad in the country I live, Denmark, and in many other countries in Europe and around the world. Numbers of new cases and deaths have been rising recently, or are on the rise again, and more and more restrictions and lockdowns are being imposed. Days are grey and short. The crisis has already been tremendously costly and it is clearly not over yet.

Nevertheless, I will try to end the post on a positive note. It gives me hope that several countries have started vaccinating people, and it seems to be working well. Finally, the EU also starts vaccinating people now. This has taken way too long, however, given the severity of the crisis and the fact that other countries started weeks ago. And, yes, every day counts. If it is correct, though, and I deliberately write if, that the EU has failed when it comes to the approval process and purchase of vaccines, as the normally well-informed and serious magazine Der Spiegel claims (link), it is a scandal. Biden aims to vaccinate 100m Americans within his first 100 days in office (link), close to a third of the US population. As things look now, it seems unlikely that we will be able to achieve the same in Europe. Christmas is all around us, though, so let us hope that somehow things will develop in the right direction.

Therefore, let me focus on the bright side. With the jabs, the situation will most likely start to improve within a not too distant future. I will try to convince myself that I see weak light at the end of the long and dark tunnel, even when we probably have to wait many months before things really calm down. Days are at least getting longer. I will focus on this, then.

With this, which is meant to be a positive message, let me thank you all for reading this blog and for sending me many encouraging mails with feedback. Please keep on doing so – it is highly appreciated.

I conclude by expressing hope that next year will be considerably more joyful than the one we leave behind.

Happy New Year!

If Biden wins

If history is any guide, it will be four good years on the stock market if Biden wins on November 3. Historically, stocks have performed so much better under Democratic presidents. The question is whether history will be a guide also this time around.

Are Democratic or Republican presidents better for the stock market? To evaluate, let us recall the performance of the US stock market under Trump – a Republican – and compare it to its performance under Obama – a Democrat and Trump’s predecessor. Afterwards, let us look at the full history of the stock market under Democratic and Republican presidents. Finally, let us discuss what it implies for this election and the next four years on the US stock market.

Obama vs. Trump

This graphs shows the cumulative return to USD 1 invested in respective January 2009 (Obama 1st term), January 2013 (Obama 2nd term), and January 2017 (Trump). I show real returns, i.e. returns after inflation:

Cumulative real returns to US large-cap stocks under Obama and Trump. Own calculations.
Data source: http://www.econ.yale.edu/~shiller/data.htm

A couple of months remain, but during most of Trump’s presidency, the stock market has performed worse than under Obama. The exceptions are the first few months of Obama’s first term and the beginning of this year, right before the corona crisis.

In numbers, one US dollar invested in the US stock market in January 2009, when Barack Obama – a Democratic president – was inaugurated, had turned into 2.68 USD in December 2016 (when Obama’s second term ended) in real terms, given reinvestments of dividends. This is a total accumulated real return of 168 percent over eight years, or an average annual return of 13%.

One US dollar invested in the US stock market in January 2017, when Donald Trump – a Republican president – was inaugurated, had turned into 1.46 USD in September this year (in real terms). This is a total accumulated return of 46 percent over four years, or an annual average real return of 10% (there are still three months to go of Trump’s presidency, so the numbers might change a little in the end).

Some extraordinary events influenced the stock market under both Obama and Trump.

Early 2009, the stock market was still suffering from the financial crisis of 2008. Obama was inaugurated in January 2009. A few months later (in March 2009), the stock market turned around. Following March 2009, many great years on the stock market followed.

This year, 2020, has seen the fastest bear market in history (in March; link), caused by the corona crisis, hurting the stock market’s performance during Trump’s presidency.

The financial crisis of 2009 and the corona crisis were very unusual events. Perhaps the stock market’s performance under Trump and Obama was unusual.

It turns out that the picture painted above – that the stock market performs better under Democratic presidents – is robust. In fact, the US stock market has historically performed much better under Democrats.

The Presidential Puzzle

Pedro Santa-Clara and Rossen Valkanov published in 2003 a paper (link) entitled ”The Presidential Puzzle”. They documented an intriguing stylized fact: Over the 1927-1999 period, the excess return on the US stock market has been nine percentage points higher under Democratic than Republican presidencies. The average excess returns under Democratic presidencies, they showed, was 11 percent versus 2 percent only under Republican presidents. A nine-percentage point difference is enormous. For instance, it exceeds the excess return on the stock market in general, i.e. the return stocks provide over and above the return on risk-free assets.

Santa-Clara and Valkanov took great care in investigating potential reasons for this stylized fact. The most obvious explanation, financial economists would suggest, is that this is simply a compensation for risk, i.e. that risks have been higher under Democratic presidents. It turns out that this is not the case. In the end, their conclusion was:

”There is no difference in the riskiness of the stock market across presidencies that could justify a risk premium. The difference in returns through the political cycle is therefore a puzzle. ”

Pastor and Veronesi (link) update the results of Santa-Clara and Valkanov. They add app. twenty years of data (until 2015, i.e. their sample runs from 1927 through 2015). Pastor and Veronesi find even stronger results. In their extended sample, they find that the average return under Democratic presidents is eleven percentage points higher than the average return under Republican presidents.

Pastor and Veronesi have this figure with average annual excess returns under each president:

Average excess returns during individual presidencies.
Source: Pastor and Veronesi (2020).

The figure shows that the only Democratic presidency that delivered returns significantly below the average return over the whole period (the dotted line) was Roosevelt’s second term (1937-41). In contrast, a number of Republican presidents have delivered subpar returns (Nixon, first Reagan term, Bush Jr.). My small calculation in the beginning of this post, that returns have been higher under Obama than Trump, strengthens this conclusion.

Pastor and Veronesi show that this finding is robust during subsamples, for instance if excluding the large negative and positive returns during the 1930s. They also show that it is particularly the first year of the presidency that drives these differences. During the first year in office, Democrat presidents have experienced a 37%-points (!) larger return than Republican presidents have:

Difference between average excess returns in the returns during the presidents’ early years in office.
Source: Pastor and Veronesi (2020).

(If you are interested, here is a detailed account of the stock market’s performance under every single president since Truman: link).

There is some discussion whether this finding (that the stock market does better under leftwing presidents) holds internationally. Pastor and Veronesi show in the (114 pages…) appendix to their article that it holds internationally while others claim that it does not (link). We leave this aside here.

Democratic presidents are elected when times are bad

Pastor and Veronesi develop an interesting explanation of this intriguing pattern of the data. They argue that the reason for the difference between the stock market’s performance under Democratic and Republican presidents has nothing to do with economic policies during presidencies but everything to do with the economic situation when new presidents are elected.

Pastor and Veronesi argue that Democratic presidents are elected at points in time when risk aversion is high. Remember, for instance, the election of Obama in autumn 2008. This was right in the middle of the financial crisis. The worst financial and economic crisis since the 1930s. Everybody was afraid and uncertain how things would evolve. Risk aversion was high. When risk aversion is high, investors demand high compensation for taking on risks in the stock market. Subsequently, investors get compensated by high average returns.

So, the story of Pastor and Veronesi is that Democratic presidents get elected when times are bad. When times are bad, voters have a tendency to vote for left-wing candidates, as voters demand more social insurance during hard times. An important implication of this theory is that Democrat presidents do not cause higher stock returns (and Republican presidents do not cause lower stock returns). Instead, Democratic presidents are elected when the economy is suffering and risk aversion is high, causing high expected returns and subsequent high average returns.

Implications for this election

If (and I write if) it is correct that Democratic presidents get elected when risk aversion is high, and that good returns subsequently follow, what does this imply for this election and the next four years on the stock market?

Pastor and Veronesi suggest a number of proxies for risk aversion. To illustrate, let us look at two of them. The first is unemployment. The idea is straightforward: when unemployment is high, people are afraid of taking on risk on the stock market. Risk aversion is high and so are expected returns.

Here is unemployment in the US since 1947:

US unemployment rate.
Source: FRED.

Unemployment is currently high, at 7.9% in September (latest figure at the time of writing). This is more than two percentage points above the historical average rate of unemployment of 5.8%. Unemployment is coming down, though, and fast. Also, there are still two weeks to go until the election. Nothing is for sure. But, as it looks now, this indicates high risk aversion, and thus high expected returns.

Another measure of risk aversion is the habit-persistence idea of Campbell and Cochrane (link). If your consumption is low today, in relation to your past consumption, you feel that times are bad. If you are used to go on holiday a couple of times per year, but now you don’t dare because you are afraid of losing your job, you also become afraid of taking on risk in the stock market. Your risk aversion is high. You require high expected returns if you should be convinced to nevertheless invest in stocks.

Let me present a simple illustration here, inspired by Atanasov, Moeller, and Priestley: link. I take consumption (real per capita) and divide by habit. I approximate habit by the average of the past three years of consumption (this is a blog, so this should be OK), i.e. the habit ratio is here: C(t)/(AVG[C(t-1)+(C(t-2)+…..+C(t-12]), where C(t) is consumption in period t and AVG is the average. I do this calculation for every quarter since 1950. The result is the following time series:

Consumption habit ratio. Own calculations.
Data source: FRED.

When an entry in the figure is above one, consumption during that quarter is higher than its past three-year average, and times are good. When the habit-ratio is low, times are bad. The habit ratio (current consumption to habit) thus has a tendency to drop around recessions (1980, 2008, etc.), as, during recessions, people cut consumption in relation to past their consumption.

The lower is the habit ratio, the higher is risk aversion and thus expected returns. Currently, due to the enormous drop in consumption resulting from the corona-crisis, the habit-ratio is historically low. Times are bad. Consumption is low. Biden should win (according to this theory). Risk aversion is high. Expected returns should be high. The next four years on the stock market should be good.

There is uncertainty, of course

Many things can happen until November 3 and the next four years. And, for sure, this has been a really weird campaign. Nothing is for sure.

Some reservations:

My figure with the habit-ratio is based on quarterly data (consumption is quarterly). The last entry is Q2 2020. Since Q2, the stock market has been sprinting ahead, implying that the potential for future returns is, all else equal, lower now than in Q2.

Also, financial markets have been pricing in an enormous amount of event risk surrounding this election. The uncertainty surrounding this election is high. Protection against event risk is expensive (link, link, and link).

At the same time, the stock market has been doing really well since March 23 (link). This is unlike recessions in general. During normal recessions, the stock market tanks. This stock market rebound since spring, everything else equal, reduces the potential for future returns as of now.

On the other hand, at least right now, the polls seem to offer some support for the story. We are in a big downturn (corona crisis). In downturns, people have a tendency to vote left-wing. As we all know, Biden leads the polls at the time of writing:

Poll average. October 16, 2020.
Source: www.realclearpolitics.com.

Conclusion

The stock market has performed worse under Trump than under Obama. This is not an outlier. Historically, the US stock market has performed much better under Democratic presidents.

One explanation why the stock market performs well under Democratic presidents is that Democratic presidents get elected during bad times, when risk aversion is high.

Currently, we are in the midst of a terrible situation (corona crisis). Supporting this theory, Biden leads the polls. If history is any guide, this indicates good years ahead on the stock market. Not necessarily because Biden – if he wins – implements policies that support the stock market (perhaps he does, but this is not the point of the theory), but because risk aversion is high right now, at the time of the election.

Of course, so many things can happen. This certainly has been a strange (and, at least for many Europeans, myself included, a very weird and scary) campaign to follow from the sideline. The performance of the stock market during this recession has also been weird. It is important to recognize that the stock market rebound since March reduces the potential for future returns as of now. And, in general, so many things can happen during the next four years. Perhaps the situation will thus play out differently this time around. We will know how the election turns out in two weeks, and we will know how the stock market performs during the next presidency in four years and three months. It will be interesting to follow.

Quantitative Easing (QE) and biases in research

Do asset purchases by central banks raise economic output and inflation? An interesting new paper finds an affirmative answer, but also – and this is the main point – that the size of the effect depends on whom you ask. If you ask central bankers, they will tell you that the effect of QE is large. If you ask independent academic researchers, they will tell you it is considerably smaller. This difference indicates that central-bank research on this topic might be biased. It also indicates that Quantitative Easing is probably not as effective as we are told.

One of the defining characteristics of financial markets since the financial crisis in 2008 is the use and influence of “unconventional policy tools” by central banks. As monetary policy rates have been close to zero, central banks have been unable to stimulate the economy via even lower interest rates. Instead, central banks have started purchasing financial assets, mainly government bonds. These alternative policy tools are labelled “asset purchases by central banks”, or simply “Quantitative Easing (QE)”.

Quantitative Easing increases the demand for government bonds, thereby raising their price and bringing down their yields. When yields on government bonds fall, other yields in the economy, such as yields on mortgage bonds, fall, too. This should promote economic activity and raise inflation, central banks argue.

Quantitative Easing is not uncontroversial, though. In several of my posts (link, link, and link), I have argued that it raises other asset prices in the economy, such as stock prices. Some fear that this induces bubble-like behavior in asset prices. Also, QE might distort signals from asset prices, causing unclear signals from prices about the underlying state of the economy and financial markets. In addition, by raising other asset prices, Quantitative Easing might contribute to increasing inequality, as financial assets are typically held by the already wealthy. On the other hand, if QE helps promoting economic activity, it helps reducing unemployment among low-income groups, which should reduce inequality, central banks argue in return (link). In the end, then, to justify Quantitative Easing, it should have a sizeable impact on inflation and output, outweighing the potentially negative effects on other parts of the economy.

Many papers have analyzed the effects of quantitative easing. A brand-new paper (link) summarizes these analyses and asks the question whether results are more positive when central bank economists analyze QE. Given that central banks influence public opinion, the latter question is important when we evaluate the most significant policy intervention during the last decade.

There are two reasons why I think this paper is particularly interesting. First, it summarizes research on QE in a neat way. It concludes that QE is effective, but not as effective as we are often told. Second, it emphasizes the importance of independent academic research. As the faculty representative on the Board of Directors at Copenhagen Business School, stressing the importance of academic research, I find this to be an important conclusion, too.

To avoid any misunderstandings about my own view, let me stress two things before getting to the results.

First, I believe that targeted central bank intervention can be useful. In my last post, I describe one monetary policy intervention that clearly fulfilled its goal (link). During a crisis, if markets are malfunctioning, there can be good reasons for policy interventions. On the other hand, I am skeptical towards the view that the advantages of endless asset purchases by central banks outside crisis periods outweigh their disadvantages. This paper indicates that QE is less powerful than central bankers tell us, lending some support to this view.

Second, my point here is not to say that central bank research is suspicious in general. On the contrary, I strongly recommend central banks to invest in economic research. I believe that better decisions are taken when based on solid academic analyses. So, central banks should be encouraged to invest in research, but their own evaluations of their own actions are probably not unbiased.

The study

Brian Fabo, Martina Jancokova, Elisabeth Kempf, and Lubos Pastor (link) study 54 analyses, written/published between 2010 and 2018, of the effects of quantitative easing in the US, the UK, and the Eurozone. 57% of the papers have been published in peer-reviewed journals. 60% of the authors are affiliated with central banks.

Lubos Pastor and co-authors collect estimates of the effect of QE on economic output and inflation across the 54 studies and report the average (and median) effects. They also investigate whether the reported effects are different if a study is conducted by central bank researchers.

Bias in central bank research

Pastor et al. list five reasons why central bank research might be biased (directly taken from the paper, page 2, here):

  • ”First, the economist may worry that the nature of her findings could affect her employment status or rank. Is she less likely to get promoted if her findings dent the bank’s reputation? Could she get fired?”
  • ”Second, the economist may be unsure whether her research will see the light of day. Bank management could in principle block the release of studies that find the bank’s own policy to be ineffective, or to have undesirable side effects.”
  • ”Third, the economist may suffer from a confirmation bias (Nickerson (1998)). A central bank employee may believe a priori that the bank’s policies are effective, and she may select evidence supporting her prior.”
  • ”Fourth, the economist may care about the bank’s reputation.”
  • ”Finally, the economist may care about her own reputation if she is senior enough to have participated in the formation of the bank’s policy.”

The findings

The main findings of the paper are collected in this graph:

Source: Fabo, Jancokova, Kempf, and Pastor (2020)

Pastor et al. report that a QE-program at its peak, i.e. when a QE program has its maximum effect, on average (across the 54 studies) raises GDP by 1.57% and the price level in the economy by 1.42%, as indicated by the blue columns in the graph (”Average all studies”). This seems to be relatively large effects, I would say.

Do these effects depend on the affiliations of researchers? Pastor and co-authors find that central-bank affiliated researchers report significantly larger effects. If counterfactually changing the share of central bank researchers in a study from 0% to 100%, the peak effect on output is estimated to be 0.723%-points larger and the peak effect on the price level 1.279%-points larger. I illustrate this in the figure above as the “Effect of CB authors”. Compared to the overall average effect, the effect of central-bank authorship is large. For the price level, going from 0% to 100% central-bank authorship almost corresponds to the total average estimated effect of QE on price levels across all 54 papers . In other words, if you think central bank estimates might be biased, the ”true” average effect of QE programs is considerably smaller than the estimated overall average effect.

Pastor and coauthors report the average point estimate of all papers and the additional effect of central bank affiliation, as indicated in the figure above. They do not report the average estimate from papers written by central bank authors, respectively written by academic authors. I asked Lubos Pastor about this. In private email correspondence with Lubos and Elisabeth Kempf, they inform me that papers written by central bank authors (defined as papers with at least one central bank author) estimate a 1.752% peak effect on output. Papers written by academics (defined as papers with zero central bank authors) find a considerably smaller effect, 0.996%. For inflation, the peak effect on output is 1.791% for papers written by central bank affiliated authors. Academics estimate a much smaller effect, only 0.545%. In spite of massive asset purchases (we are literally talking trillions of dollars, euros, and yen), the average effect on inflation is small, at 0.5%, academics report. Less than a third of what central bank affiliated researchers report.

As academics, we are not only interested in the size of the coefficients/effects, but also whether effects are statistically different from zero. Pastor and coauthors report a striking finding here. While all papers written by central bank researchers find that QE has a statistically significant effect on output/inflation, only 50% of papers written by independent academics find significant effects.

Finally, Pastor and co-authors note that the German central bank (the Bundesbank) has been particularly skeptical towards ECB QE. So, what happens if you look at researchers affiliated with the German central bank? Bundesbank researchers find much smaller effects of QE. In fact, Bundesbank researchers find an even smaller effect of QE on economic output than independent academics. Again, this indicates that the preferences of an institution seem to influence the conclusions of its researchers.

The paper presents additional analyses, such as looking more closely at the mechanisms at play, i.e. career concerns, involvement of management in research, and so on. Read the paper if you want to know more about this.

Conclusion

I think the paper by Brian Fabo, Martina Jancokova, Elisabeth Kempf, and Lubos Pastor is interesting also because it summarizes what the average effect of QE is, based on a large number of studies. Across more than 50 papers, the average maximum effect of QE on GDP and the price level is around 1.5%. This is useful information in itself.

Some papers are written by central bank researchers and some by independent academics. It seems reasonable to hypothesize that central bankers might have a tendency to view their own policies in a more favorable light. This is what Lubos and co-authors find. They report that the effect of having central bankers as authors of an analysis is almost as large as the average reported effect of QE on the price level itself. In private email correspondence, they also tell me that the average effect, estimated in academic papers, of QE on the price level is only 0.5%, i.e. very small, almost negligible. This is of course a controversial result. I predict it will generate intensive debate.

The fact that I discuss this paper here should not be taken to imply that I am skeptical towards central bank research in general. In fact, I am sure the quality of monetary policy decisions is improved when central bankers have access to the latest research. Also, I have no reason to believe that central bank research on other topics than monetary policy should be biased. But, when it comes to assessing their own actions, researchers in central banks might be subject to certain biases. It requires some guts to tell senior management that the trillions they have spent on quantitative easing probably has not been very effective. Instead, it might further your career if you paint a rosier picture. This is important to recognize.

I view the bottom line as follows: QE probably has some effect, but its effect is considerably smaller than we are told by central banks.

Is the stock market too optimistic? Or, is the market always right?

The rebound in stock markets has been spectacular. One may wonder whether it is sustainable.

What does it actually mean that the stock market is “too optimistic”? Doesn’t the stock price always reflect the average expectation of all investors? True, and, in this sense, the market cannot be “too optimistic”. On the one hand, the market is always right.

On the other hand, the legendary economist Paul Samuelson famously noticed that the “stock market has predicted nine of the last five recessions”. Stock markets also appear “excessively volatile”, as Shiller showed already in 1981. I.e., the stock market might always be right, but perhaps we are going through a period of excessive volatility where markets were overly pessimistic in March and are overly optimistic now.

In any case, if the stock market is always right, so is the futures market. Investors in the futures market expect huge drops in dividends over the next year. If stock prices behave as they usually do during recessions, stock prices should drop even more, that is dropping even more than dividends.

Market developments

Before we start this attempt to explain things and look ahead, let us review the facts. This graph shows developments in the Danish, the US, the world (MSCI All countries), and the emerging stock markets since the start of the year, all MSCI indices (Danish index is in Danish kroner, the rest in USD):

Stock markets since January 1, 2020. MSCI indices.
Data source: Theomson Reuter Datastream via Eikon.

Stock markets did well in the beginning of the year, fell dramatically from mid-February through mid-March, and have rebounded spectacularly since then. Today, the Danish stock market is above its January 1 value, the US market is 10% down, the world market is 15% down, and emerging markets are 20% down.

What could explain current stock prices?

Stock prices are by definition discounted future cash-flows. That is easy to say. The difficult part is to find the expected future cash-flows and the appropriate discount rate.

Let us start with a positive view on markets and see what is needed to support this.

To begin with, let us keep the discount rate fixed. Let us also, as a starter, assume that valuation ratios are constant. For instance, let us assume that stock prices closely follow developments in real economic activity. Under these assumptions, we would, largely, be able to understand recent market movements. These assumptions would also support a rosy view of the future. Afterwards, we discuss if this is a likely scenario.

Forecasts for economic activity in light of the corona crisis start coming in. Late April, we got the WEO from the IMF and forecasts for the US from the CBO, and this week we got forecasts for Europe from the EU-commission. This figure shows the expected path of real GDP in the US and EU:

Expected developments in EU and US real GDP. The CBO does not provide quarterly growth rates for 2021, so I assume linear growth during 2021, accumulating to the CBO forecast of 2.8% for 2021 .
Data source: EU commission and CBO.

This recession is enormous. GDP is expected to fall by 15% in Q2 this year, compared to late 2019. Luckily, economies are expected to rebound sharply after this quarter, too. The EU commission expects a strong recovery in the EU in 2021, with 6.1% growth in 2021. The CBO expects 2.8% growth in 2021 in the US. Whether this difference is realistic, I do not want to discuss here.

The economy drops by 15% in Q2. If stock prices follow GDP, as we assume for now, stock prices should have dropped by 15% in Q2. This is almost spot-on.

This theory would also predict that we have a great year in front of us. Economic activity should improve by something like 15-20% until late 2021. If stock prices follow, stock prices should also increase with something like 15-20% from here.

What about the huge drop in March? This we can also explain, I think. Basically, it had little to do with underlying economic fundamentals. Some leveraged hedge funds got squeezed, they received margin calls, they dumped everything to raise cash, there was panic, spreads widened, and markets feared a replay of 2008 (I comment on it here and John Cochrane has a nice and more detailed explanation here). Stress on markets almost reached 2008 levels, as, for instance, the St. Louis Fed Financial Stress index indicates:

St Louis Fed Financial Stress Index.
Data source: St. Louis Fed.

Central banks intervened and provided liquidity. Markets calmed down. The stress index is still somewhat elevated, but much lower than in March. Markets started looking at economic fundamentals again. With lots of liquidity around, and low yields, investors bought stocks. This was a temporary crash.

The intermediate conclusion is that if stock prices follow GDP, stock prices should drop by something like 15% during Q2, only to rebound afterwards. And, as of today, stock prices have in fact fallen by something like 15% since the start of the year, with a bumper on the road in March. If we stop here, everything would be fine and we should expect substantial stock market gains going forward. Under these assumptions, markets are expected to rebound by something like 15-20% until late 2021.

Cash-flows do not always follow economic activity

Unfortunately, we cannot stop here. We need to go back to the definition of stock prices: Discounted cash-flows. I truly believe that cash-flows relate to economic activity in the long run (I have research demonstrating this), but I also believe that there are temporary business-cycle deviations between cash-flows and economic activity. And these deviations can be substantial.

We have expectations to economic activity from IMF, CBO, EU, and so on, but how do we find expectations to cash-flows? Niels Joachim Gormsen from the University of Chicago, a smart former Ph.D. student at Copenhagen Business School, has, together with Chicago Professor Ralph Koijen, developed a method that can be used to back out expected changes in dividends from dividend futures. They also estimate a relation between dividend growth and GDP growth, such that they can back out expected GDP growth, too.

Their latest estimates are from April 20. Compared to January 1, 2020, Gormsen and Koijen estimate that US GDP will be 3.8% lower over the next year (precisely, Niels tells me, they compare expected growth from April 1, 2020 through April 1, 2021, to expected growth from January 1, 2020 through January 1, 2021). This is not far from what the CBO expects (the figure above shows that GDP will be something like 5% lower ultimo 2020 compared to primo 2020).

The scary thing is that Gormsen and Koijen show that markets expect dividends to be 18% lower over the next 12 months, i.e. drop by 13%-points more than GDP. An 18% drop in dividends is a very large drop in historical terms.

This graph shows how investors update their expectations to future dividend growth rates during the corona crisis:

Data source: Gormsen and Koijen (2020).

For the EU, Gormsen and Koijen expect GDP, respectively dividends, to drop by 6.3%, respectively 28%. The market is always right, right?

Unfortunately, we cannot stop here either.

Stock prices react excessively to cash-flows during recessions

We need to talk about the last part of the definition of stock prices: discount rates. Research shows that discount rates move counter-cyclically, increasing in bad times and dropping in good. From our definition of stock prices, this means that stock prices should fall by more than dividends in bad times, if discount rates increase in bad times.

Tim Kroencke from the Univeristy of Neuchatel has an interesting paper that studies how stock prices move in relation to dividends during recessions. The central graph in the paper is this one:

Data source: Kroencke (2020)

The graphs shows how dividends (and earnings) fall during recessions and how stock prices fall even more (there are two stock price indices. Read Tim’s paper to get the explanation for the difference. The point is that stock prices fall more than dividends.)

The figure shows that US dividends drop by 10% and US stock prices drop by ten percentage-points more, i.e. 20%, on average during US recessions. It also shows that stock prices do not drop ahead of the drop in dividends, but alongside. This is not good news.

Gormsen and Koijen’s estimates say that we should expect dividends to drop by 18% for the US and 28% for the EU over the next year. Kroencke says that on average stock prices drop by 10%-points more. This means that stock prices should drop by close to 30% in the US. If we use the 10% drop in the price-dividend ratio for EU data, EU stock prices should drop by close to 40%. Today, stock prices are down 15% globally.

Conclusion

We might hope that this recession plays out in a different way than recessions usually do. We might also hope that stock markets react in a different way than they usually do. We might hope that everybody starts spending when economies open up, companies start producing, and earnings and dividends do not suffer. In this case, the drop in dividends might not be that large. And, we might hope that stock markets do not fall by more than dividends, in contrast to what they normally do. This could for instance be because central banks are marginal investors in many markets now, driving asset prices away from what they would have been if prices were solely determined by private market participants. This is what markets hope. And, of course, this might turn out to be the case.

We might also fear, however, that companies will start facing problems given the severity of the crisis, i.e. this turns from a liquidity crisis to a solvency crisis. Should this happen, earnings and dividends will drop. The market is always right. The futures market expects dividends to drop by something like 20% for the US and 30% for Europe. If stock prices react as they normally do during recessions, stock prices should drop even more. The 15% drop since early 2020 seems small in this light.

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PS. Did you by the way notice the German Constitutional Court ruling this week? Given last week’s post on the Italian situation, I might just inform you that the Italian yield spread to Germany widened as a consequence. Not a lot – 15 basis points or so – but in the wrong direction.