The Unassuming Economist

From a new ECB working paper:

“The international finance literature has documented two important regularities in foreign exchange markets. First, there is ample evidence that, for developed countries, real exchange rates are reverting to the level implied by the Purchasing Power Parity (PPP) theory. Second, for flexible currency regimes the adjustment process is mainly driven by the nominal exchange rate. At the same time most of the recent articles remain skeptical that one can outperform the random walk (RW) in nominal exchange rate forecasting.

In this paper we claim that the two above in-sample regularities of foreign exchange markets can be exploited to infer out-of-sample movements of major currency pairs. To prove this thesis we proceed as follows:

1. We begin by presenting robust (in-sample) evidence that, for major currency pairs, long-run PPP holds and that the nominal exchange rate is the main driver of this adjustment process.
2. We then evaluate a battery of models that aim to exploit these in-sample regularities for forecasting purposes. The winner of the forecasting race is a calibrated PPP model, which just assumes that the real exchange rate gradually returns to its sample mean, completing half of the adjustment in 3 years, and that the adjustment is only driven by the nominal exchange rate. This approach is so simple that it can be implemented even on the back of a napkin in two steps. Step 1 consists in calculating the initial real exchange rate misalignment with an eyeball estimate of what is the distance from the sample mean. Step 2 consists in recalling that, according to this model, one tenth of the required adjustment is achieved by the nominal exchange rate in the first 6 months, one fifth in one year, just over a third in two years and exactly half after 3 years.
3. We highlight that severe problems arise when attempting to carry out more sophisticated approaches, such as estimating the pace of mean reversion of the real exchange rate or forecasting relative inflation. Among the estimated approaches, we find that it is strongly preferable to rely on direct rather than multi-step iterative forecasting methods. We also find that models estimated with panel data techniques perform only marginally better than those based on individual currency pairs. This finding has bittersweet implications. On the negative side, estimated models encounter a second formidable competitor that, like the RW, bypasses the estimation error problem. On the positive side, the HL model is more acceptable than the RW from the perspective of economic theory.
4. This analysis highlights also that equilibrium exchange rate analysis matters. Simple measures of exchange rate disequilibria, not only signal economic imbalances, but also provide hints in which direction the exchange rate will go.

Our paper has an important message for policymakers. For advanced countries, it is better to rely on the concept of long-run PPP rather than on the RW.”

A new VOXEU post by Paul Schmelzing says that “Trends over recent decades are generally in line with a long-term ‘suprasecular’ trend of declining real rates.”

“[…] even if cyclical forces could now stabilise nominal Treasury rates beyond 3%, central bankers may find that before they have fully returned to normalised balance sheets, ‘suprasecular’ real rate trends will have caught up to them once more. Negative real rates could become a more frequent phenomenon, and indeed constitute a ‘new normal’. Absent geopolitical or natural disaster shocks – which in the past at least temporarily ‘broke’ the trend – unconventional monetary tools may (under this scenario) mature into more permanent features of the international financial system.”

From a new post by Timothy Taylor:

“I was hired back in 1986 to be the Managing Editor for a new academic economics journal, at the time unnamed, but which soon launched as the Journal of Economic Perspectives. The JEP is published by the American Economic Association, which back in 2011 decided–to my delight–that it would be freely available on-line, from the current issue back to the first issue. Here, I’ll start with Table of Contents for the just-released Spring 2018 issue, which in the Taylor household is known as issue #124. Below that are abstracts and direct links for all of the papers. I will blog more specifically about some of the papers in the next week or two, as well.”

A new post by Peter Dizikes summarizing David Donaldson’s new paper on how railroads helped India trade and grow: “railroads fostered commerce that raised real agricultural income by 16 percent.”

“Donaldson’s paper on the subject, “Railroads of the Raj: Estimating the Impact of Transportation Infrastructure,” just published in the American Economic Review, may also speak to the importance of infrastructure more broadly. After all, as he notes in the paper, about 20 percent of World Bank lending in the developing world goes to infrastructure projects. And in the United States, debate rolls on about the value of building and refurbishing America’s roads, bridges, railroads, ports, and airports.”

“And while every country is different, and circumstances change over time, Donaldson’s research suggests that the growth India experienced as its railroads grew was specifically the result of increased trade, a general finding that could be applied to other countries and other eras.”

From a new post by Mohamed A. El-Erian:

“[…] the reputation of mainstream economists has taken a beating in the last 10 years. The bulk of them failed to predict the 2008 crisis that almost tipped the global economy into a multiyear depression. They also didn’t foresee the aftermath.

Most made the mistake of treating the crisis as a cyclical shock and forecast a V-type growth snapback. They were prisoners of an excessive mean-reversion mindset: They acknowledged that growth was taking a huge hit due to severe financial dislocations, but they forecast that economic activity would bounce back strongly and inclusively.

Instead, the experience of advanced economies more closely resembled an “L,” in which they got stuck in a “new normal” characterized by a prolonged period of low and insufficiently inclusive growth.

The damage goes well beyond lost output, diminished consumer welfare, widespread economic insecurity and a worsening of the inequality of income, wealth and opportunity. The shortfalls fueled the politics of anger, along with a heightened mistrust of the establishment, institutions and expert opinion.

This, in turn, has diminished the credibility of economics. Meanwhile, many students have complained to me that the mainstream economics they are taught is divorced from real-world relevance. It is only a matter of time before the funding for economic research risks becoming a casualty.

Yet this huge failure has not been the result of ignorance about the limitations of the discipline, nor is it the consequence of a lack of new, disruptive ideas.

Here are some reasons for the erosion of the insights and predictive powers of mainstream economics:

• The proliferation of oversimplifying assumptions, including those that sideline many elements of real-world behaviors and interactions, in an effort to make models seem more “scientific.” This leads to overreliance on excessively abstract estimation techniques and approaches.
• Insufficient consideration of financial linkages and little allowance, if any, for the possibility that financial dislocations can disrupt the economy.
• Poor and grudging adoption of important insights from behavioral science, along with excessive hesitation to develop multidisciplinary approaches.
• An oversimplification of uncertainty and the ways it influences economic interactions.
• Overemphasis of equilibrium conditions and mean reversion, a trend that reduces the understanding of transitions, structural changes and tipping points.”