Macro Roundup

Evidence from France suggests public research spending spills over to the private sector. Firms in the top 25% of exposure to academic funding increase their R&D effort by 20% relative to firms with the lowest exposure. "...Firms in the top quartile of exposure to increase their R&D effort by 20% compared to the bottom quartile. We exploit reports produced by funded clusters, complemented by data on labor mobility and R&D public-private partnerships, to provide evidence on the channels for these spillovers. We show that spillovers are driven by outsourcing of R&D activities by the private to the public sectors and, to a lesser extent, by labor mobility from one to the other and by informal contacts. A few years after the treatment, industry-location pairs exposed more to the local public research funding shock witnessed increased spending on R&D labor. Five years after treatment, we observe an increase of around 1.5% in R&D wage bill when the exposure of an industry in a commuting zone is doubled...."
“..We first propose a new measure of scientific proximity between public research groups and industrial sectors, allowing us to measure the exposure of private firms to the program. Based on this measure, we use the funding shock to estimate the causal impact of public research on private sector outcomes. We find that firms spatially and scientifically “close” to funded research groups increase their spending on R&D inputs and achieve higher levels of R&D outputs compared to less exposed firms…”

Three Primary Findings

“…Our first contribution is to construct a new measure of proximity. The key idea is to use the distance between the science used by firms and the science produced by research groups, as a proxy for the share of ideas produced by the research group which are relevant for a firm in a given industry.2 Importantly, this measure assigns a scientific position to firms rather than using the typical approach in the literature that attempts to assign a technological position to an academic group. An academic group and an industry can be close according to our measure, even if the papers published by the group are not yet cited in patents, and would thus be categorized as distant with the traditional approach. We then test and exploit this measure in the context of the LabEx program that selected 170 academic clusters in 2010 and 2011. These clusters bring together public researchers from different research units, not necessarily from the same institution, planning to work together on a common theme. The funding was run as a competition, with an international jury evaluating 436 proposals. We obtained a number of key pieces of data from the agency organizing the competition, for both accepted and rejected projects, in particular the full bibliography of the proposals and the grades awarded by the jury. The articles listed in the bibliography of the proposal are used to construct the proximity between LabEx projects and industrial sectors through the above procedure, while the identity and grades of rejected projects are the basis for various robustness checks.

“…Our second contribution is to use this natural experiment to estimate the causal effect of a positive shock in funding of public sector research on private sector R&D. For a given pair of commuting zone (henceforth “CZ”) and industry, we calculate exposure as the sum of funding obtained by the LabEx proposals in the CZ, weighted by the proximity of the LabEx to this industry. We then implement a difference-in-differences estimation that exploits the fact that a given industry in a given commuting zone will be more exposed to the shock if it is close technologically and geographically to a funded LabEx. We show that firms in high exposure pairs of CZ and sector significantly increase their employment in R&D after the start of the program, controlling for CZ specific time effects. The magnitude is large: a firm in the top quartile of exposure increases total spending on wages of R&D workers by more than 20% compared to the bottom quartile. We also find significant impacts on outputs of the R&D process in the more exposed sectors, in particular on the creation of new plants and on the production of new patents….”

“…Our third main contribution is to shed light on the channels through which the important spillovers from public to private research occur. There are three main candidates. First, spillovers could be due to direct collaboration between researchers in the academic cluster and the exposed firms (see e.g. Fernandes and Ferreira, 2013). Second, they could result from mobility of researchers from the public to the private sector or creation by these researchers of startups (see e.g. Agrawal and Henderson, 2002). Third, spillovers could simply be due to informal contacts between researchers from the public and the private sectors, for instance during events organized by the LabEx…”

The Evidence

R&D efforts

“..We first study how the financing of public research affects private R&D efforts. Figure 1 presents the results of the estimation of the dynamic model (equation (4)) using as outcome variable the total R&D wage bill (in log

"… We present the results using the continuous measure of exposure in Figure 1(a) and we show the effect by quartile of exposure in Figure 1(b). The results show that a few years after the treatment, industry-location pairs that were more exposed to the local public research funding shock witnessed an increase in spending on R&D labor. 5 years after treatment, we observe an increase of around 1.5% in R&D wage bill when the exposure of an industry in an commuting zone is doubled. This Figure also shows the absence of differential pre-trends in the years building up to the financing, which is evidence in support of our identification strategy. Figure 1(b) shows that the effect is mostly driven by pairs of industry-location that are in the top quartile of exposure. On average, these pairs increase their spending on employment in R&D by 20% compared to the least exposed units (which received no funding)...."

R&D outputs

“..The impact on patenting is explored in the second part of Table 3….To measure the effect of the LabEx program on the creation of new plants, we use the registry of plants administrated by the Insee and calculate the number of new establishments in each CZ and each sector. Table 3 shows a positive effect of LabEx exposure on the probability of creation of a new plant in an industry-CZ pair, corresponding to an increase of 0.2 percentage points when exposure doubles. Decomposing this effect between plant creation from new and incumbent firms shows that it stems almost entirely from new firms. The impact on patenting is explored in the second part of Table 3. As is standard in the literature, we use a Poisson regression to estimate the coefficient, which takes into account the very large number of observations with no patent. The baseline model yields an insignificant static coefficient along with non zero pre-trend. However, when sector-year fixed effects are added to the model, the coefficient becomes positive and significant and the pre-trends are no longer significant…”

Spillovers By Sector

“…. While an empirical comparison of the relative impact of these two instruments on private sector innovation is beyond the scope of this paper, we can shed light on the question of what sectors are more affected by these two instruments. To perform this comparison, we allocate the total funding of the two instruments by industry: the LabEx funding is allocated using the sum of exposures over all labs, while the research tax credit is using the claims made by firms. The results are presented in Figure 3. We see that the distribution of exposure to the LabEx program is much more skewed towards a few sectors. The two sectors that benefit the most are the scientific R&D (almost 30%) and the pharmaceutical sector (more than 20%).On the contrary the benefits of the CIR are much more evenly distributed across sectors, including in sectors where innovation should not be central, such as computer consultancy. This evidence is coherent with the idea that financing public research to spur private sector innovation might be a better instrument to target truly innovative firms than more direct tools such as tax credit programs. Comparing these instruments and understanding their complementarities is an important avenue for future research….”

Antonin Bergeaud, Arthur Guillouzouic, Emiric Henry and Clément Malgouyres, "From public labs to private firms: magnitude and channels of R&D spillovers,"London School Of Economics, October 2022, https://poid.lse.ac.uk/textonly/publications/downloads/poidwp041.pdf

Brad Plumer, Lisa Friedman and Somini Sengupta, "Developing Nations Have a Message at Global Climate Talks: Polluters, Pay Up,"New York Times, November 6, 2022, https://www.nytimes.com/2022/11/06/climate/loss-and-damage-climate-cop27.html

Developing Nations Have a Message at Global Climate Talks: Polluters, Pay Up

In Pakistan, flooding this summer killed 1,700 people and left one-third of the country underwater. In Fiji, entire villages are retreating inland to escape rising seas. In Kenya, persistent drought has killed livestock and devastated livelihoods.

They are among scores of developing countries that face irreversible damage from climate change but have done little to cause the crisis. And they are demanding compensation from the parties they see as responsible: wealthier nations that have burned oil, gas and coal for decades and created pollution that is dangerously heating the planet.

Across cultures and centuries, the idea that if you harm your neighbor’s property, you owe restitution is a commonly held notion, found even in the Bible.

But as a legal and practical matter, it has been extraordinarily difficult to apply that principle to climate change. Rich nations and blocs like the United States and the European Union have opposed the idea of explicitly compensating poorer countries for climate disasters already underway, fearing it could open them to unlimited liability.

As United Nations climate talks open Sunday in Sharm el Sheikh, Egypt, the debate over loss and damage will be front and center. Egypt, the host country and Pakistan, which is leading a group of 77 developing nations, succeeded in placing the issue on the formal agenda for the first time.

Simon Stiell, the U.N. climate chief, said the decision to include it on the agenda “bodes well” for a compromise by the end of the summit.

The issue is unavoidable this year, with leaders from nearly 200 nations gathering on the African continent, where millions are at risk of famine because of drought intensified by climate change. And developments in science have allowed researchers to quantify the role global warming plays in disasters, bolstering the argument that rich nations, which have emitted half of all heat-trapping gases since 1850, bear heavy responsibility.

“What we seek is not charity, not alms, not aid — but justice,” Bilawal Bhutto Zardari, Pakistan’s foreign minister, said in September, discussing the country’s devastating floods that scientists say were worsened by global warming. “Thirty three million Pakistanis today are paying in the form of their lives and their livelihoods for the industrialization of bigger countries.”

Last year, wealthy nations vowed to provide $40 billion per year by 2025 to help poorer countries with climate adaptation measures such as building flood defenses. But a United Nations report estimates this is less than one-fifth of what developing nations need. That has fueled calls for separate loss and damage funding to deal with the aftermath of climate disasters that nations can’t protect themselves against.

Facing growing pressure, John Kerry, President Biden’s climate envoy, has agreed to discuss the idea of financing for loss and damage — a move that helped avoid a bitter fight over the summit’s agenda.

But that’s a far cry from agreeing to a new fund. The United States is already behind on previous promises to help poorer countries shift to cleaner energy or adapt to climate threats by building sea walls, for example. Last year, Senate Democrats sought $3.1 billion in climate finance for 2022 but secured just $1 billion. With Republicans, who largely oppose climate aid, poised to make gains in Tuesday’s midterm elections, the prospects of new funds appear dim.

“The political foundation is simply not there,” said Senator Jeff Merkley, Democrat of Oregon, adding that he believes the United States has a “moral responsibility” to address loss and damage.

Europeans worry that if they agree to a fund, they could be left holding the bag if the next U.S. president repudiates the idea.

In Turkana, a semiarid region in northwest Kenya that is among the nation’s poorest, loss and damage is far from abstract.

The region is now suffering its fourth straight year of extreme drought, and some scientists see a long-term drying trend. Most of Turkana’s 900,000 people are pastoralists who make a living raising livestock, and they have watched herds perish for lack of water. Half the population faces starvation. Some herders have crossed into Uganda or South Sudan in search of greener pastures, triggering violent conflicts.

Local officials have drawn up urgent plans to adapt: drill more wells to tap aquifers, build dams to store water when rain does come and help people shift to more resilient forms of agriculture. But money is a hurdle. The full plan could cost roughly $200 million per year, double the county’s annual budget, said Clement Nadio, Turkana County’s director for climate change.

That has left Turkana acutely vulnerable in the current crisis. Officials are struggling to provide emergency food aid this year, leaving fewer resources to adapt to future droughts.

“Right now we need to focus on saving lives, dealing with malnutrition,” Mr. Nadio said. “But we also need to focus on making people resilient to future climate shocks. We are trying our best. But we can’t do it all with the funding we have available.”

While the United Nations hasn’t formally defined loss and damage, it could include destruction caused by extreme weather exacerbated by global warming. In 2019, Hurricane Dorian overwhelmed the Bahamas, bringing winds up to 185 miles per hour and 23-foot storm surges that destroyed homes, roads and an airport. The damage: $3.4 billion, one-quarter of the nation’s economy.

It might also include slower-moving losses that are harder to quantify, as in the case of salt farmers in Bangladesh who lose their jobs because tidal surges and heavy rainfall have hindered production, or communities in Micronesia that have watched ancient burial grounds tumble into the encroaching oceans.

“If we had cut emissions early enough, we wouldn’t have to adapt, and if we had adapted early enough, we wouldn’t have loss and damage,” said Avinash Persaud, an adviser to the prime minister of Barbados. “But we didn’t act early enough, so now we have to do all three.”

Because the definitions are broad, it’s hard to calculate exactly how much money loss and damage would entail. One frequently cited study estimated that developing countries could suffer $290 billion to $580 billion in annual climate damages by 2030, even after efforts to adapt. That could rise to $1.7 trillion by 2050.

In the past, wealthy countries have suggested that such disasters could be alleviated by existing humanitarian aid or insurance.

Developing countries say that’s unacceptable. By some estimates, over half of U.N. appeals for donations after weather disasters already go unfilled. And insurance doesn’t work for homes that will soon be swallowed by rising seas. Instead, poorer nations have been forced to take on debt to rebuild.

Without dedicated loss and damage funding, said Lia Nicholson, a senior adviser for the Alliance of Small Island States, climate impacts will force island nations “into unsustainable debt, arresting development and holding us hostage to random acts of charity.”

With so much money at stake, discussions of loss and damage in Egypt are certain to prove contentious.

Behind the scenes, U.S. officials say they’re concerned a new fund could be poorly defined and unwieldy.

Some wealthy countries also say China, currently the world’s largest emitter, as well as fossil fuel exporters like Qatar and Saudi Arabia, should contribute. That could spur a major fight, since those countries have not traditionally been held responsible for climate aid.

Perhaps the biggest challenge is that each side is dug in: Developing countries and activists view loss and damage as a matter of justice while wealthy nations blanch at the idea of accepting blame.

Mr. Kerry acknowledged the United States, which has burned coal for electricity since the 1880s and is the biggest historical emitter, bears responsibility for climate change. But he also argued that by the 1980s, when governments widely agreed that carbon dioxide emissions from oil, gas and coal were warming the planet, emerging nations were burning fossil fuels, too.

“If you want to measure from there, at the rate we’re going, a couple of countries have the ability to eclipse our historical emissions,” Mr. Kerry said. “So yeah, we burned coal and we did this. But guess who else burned coal? Every single one of those other countries. Are they absolved?”

Difficult issues ahead

If nations agree, at least in principle, to create a loss and damage fund, they will have to wade through difficult issues: Who deserves help and how much? How to guarantee money is spent in ways to benefit people who most need it?

David Michael Terungwa is the president of Global Initiative for Food Security and Ecosystem Preservation in Nigeria. He recently learned a friend’s home had been submerged in Benue state in floods that displaced more than 100,000 people and destroyed 140,000 hectares of farmland.

“I spoke with a young man who lost all his chickens in the floods,” Mr. Terungwa said. “If there was something, climate insurance, it could be recovered and he could start life again or start a business. When we discuss loss and damage, this is what I think of, the local farmers.”

But he also said he worries that governments will use the money to simply rebuild in vulnerable areas that will be washed away in future disasters.

Developing countries say questions like these are no reason for inaction. The first step is agreeing that loss and damage funding should exist; details can be resolved later.

For now, the losses continue.

Hassan Abou Bakr, an agriculture professor at Cairo University who owns an olive grove outside the city, said he has sunk into depression as repeated heat waves have ravaged his crops by depriving them of the winter “chilling hours” they need to flourish. This year, his olives were smaller than ever, and most were rejected in the market.

“Climate change is not something that will happen in the future,” he said. “It is here and now and it is hitting us.”

Restitution would help, but Mr. Abou Bakr’s worries extend beyond that.

“You can give money, but what about the olive trees?” he said. “We need to save the trees.”

"... It is not just that volatility is driving illiquidity. Illiquidity is beginning to cause volatility. If both effects operate simultaneously, they form a vicious spiral in which volatility surges and liquidity collapses. The terrifying thing about a run is that it operates by itself. If you hold treasuries for liquidity and a surge of panic-selling causes the market to seize up, then on precautionary grounds, you must try to sell too so as not to miss your chance. Given the scale of foreign involvement, shocks emanating from anywhere worldwide will reverberate in the market. Foreign sales were an important part of the shock in 2020 when significant emerging market reserve sales occurred. In 2022, given the savage devaluation of the yen and the prospect of a major course correction by the Bank of Japan, the main worry is sales by Japanese investors...."

The housing market may be the biggest single macroeconomic force. US residential real estate alone is worth $53 trillion. But it is illiquid. US equities are valued at $46 trillion. They can be easily bought and sold, but no two equities are alike. You have to pick and choose. The $23 trillion market for US government debt offers a relatively smooth spectrum of homogenous assets that differ only in terms of their duration, ranging from a few weeks to 30 years. They trade on a curve defined in terms of maturity. They are safe assets with no serious default risk offering an extremely liquid market, which provides the ideal platform for financial engineering supercharged with algorithmic high frequency trading. As the largest pool of fixed-income, safe assets, the Treasury market registers vibrations from every piece of economic and policy news in a matter of millisecond. Every day hundreds of billions of Treasuries change hands in hundreds of thousands of trades.

The prices and yields that result from these trades set the benchmark for all other borrowing and lending. The question that haunts the markets right now is what happens when the entire structure of interest rates lurches violently upwards in response to a sudden surge in inflation and the promise of severe central bank action?

The risk is not that Treasuries suddenly become worthless, as a result of US government default or hyperinflation. Nor is there much prospect of a geopolitically motivated bear raid on the US by its foreign enemies. The risk is more mundane, the risk is that the market, driven by greed and fear, will stop working, that prices and yields will become anomalous and upset trillions of dollars in portfolio allocations unleashing a landslide, as hedge funds, banks and other investors scramble for cash.

So large a shock would this be that there is little prospect that it would be allowed to play out to its full catastrophic extent. We dont live in the 1930s anymore. There is an answer to such a crisis - the central bank. But if the Fed were forced to step in, it would imply a shuddering reversal of policy. The shock would move from the markets to the institutions. Credibility would be in tatters. It would amount to a severe intra-elite crisis. Something like the UK suffering but at the heart of the world’s financial hegemony.

You might counter that in 2020 the Fed dealt with a crisis in the US Treasury market and emerged with its reputation for competent crisis-management enhanced. But that malfunction was triggered by a pandemic, a shock that, as far as the financial system was concerned, was exogenous. If something similar were to occur in 2022/23 there would be no excuse. Of course, the inflationary surge that began in 2021 is itself attributable, whether demand- or supply-induced, to COVID. But today what is causing the stress in financial markets is not inflation as such but the policy response of the central banks. They are raising rates as the macroeconomic situation demands. If they cannot do so without triggering a malfunction in the world’s most important financial market, then, “Houston”, we have a problem.

***

For many readers of this newsletter, the 2008 banking crisis will be the benchmark of financial terror. But in 2008 the American government balance sheets was the platform from which the rescue of the banks was mounted. The Treasury market remained solid. Indeed, investors ran to safety in Treasuries. Only in weaker members of Eurozone - Ireland was the prototype - did we see a full doom-loop develop in which a banking crisis overloaded the public balance sheet, precipitating a public debt crisis, which in turn destabilized the private financial system.

The US Treasury market is not immune to shocks. It wobbled badly in September 2019 in the so-called repo market crash. But the real scare came in March 2020 when the Treasury market stopped working for several weeks. This precipitated a panic even more acute than in 2008 and a truly gigantic intervention by the Fed. On several days in late March 2020 the Fed bought more bonds than Ben Bernanke’s Fed’s bought in an entire month at the highpoint of the first round of Quantitative Easing. This story is at the heart of Shutdown, my book about 2020.

It is important to emphasize, in light of the comparison with the Eurozone, that what caused the panic in March 2020 was not concern about the solvency of the US government. The volume of Treasuries has continuously increased because of the deficits run over the last quarter century. And ahead of 2020 the balance sheets of the main actors in the Treasury market were stuffed full by the large deficits run by the Trump administration. In relation to GDP, US government debt was rising and it surged at a wartime rate due to the COVID stimulus. But that was not what the panic of March 2020 was about. Nor is the deficit and new public debt issuance the main worry in 2022. What matters is what private financial actors - banks, investment funds, hedge funds - do with Treasuries and their constant need to churn them through a liquid market. What concerns us is not a crisis of public finances, but a crisis triggered by the private use of public debt.

For all that public debt is a liability of the taxpayer, it is also an asset. You buy assets to benefit from appreciation and their yield. You can use them as collateral for further borrowing. Crucially, you need to be able to sell them in an emergency. That is what US Treasuries normally offer you. But in March 2020 the market stopped working. There were too many sellers and not enough buyers, so the price of highly rated entirely safe securities suddenly plunged and yields surged. To avoid disaster the Fed stepped in as the buyer of last resort. It also offered repo facilities, i.e. loans against Treasury collateral, in the hope that if they could be used to raise funds by way of the Fed, private investors would have less reason to sell their holdings. The combined effect was to flush trillions of dollars of liquidity into the system and to stop the run.

In 2020 inflation was not a concern. Prices were falling. Today, with prices rising the Fed is trying to reverse course. It is trying to tighten monetary conditions. It is raising interest rates and rather than buying Treasuries to provide liquidity, it is selling them, draining reserves out of the financial system. Between September and November the Fed planned a $95 billion tightening. The question is whether the Treasury markets can take it. Without the Fed as the buyer of last resort, will private investors still be able to buy and sell Treasuries smoothly or will the market again become dysfunctional?

***

The signs of stress are clearly there. Both anecdotal evidence and some quantitative indicators suggest a worsening liquidity situation.

The market depth for US Treasuries varies by duration. It collapsed entirely in March 2020, but though it has recovered, it remains well below 2019 levels.

Bid-to-ask ratios that measure how difficult it is to sell Treasuries are at uncomfortably high levels. And, at the primary Treasury auctions, when fresh Treasuries are sold, there is a noticeable weakness of new demand.

Clearly, market conditions are not easy. But the difficulty is to decide how serious these signs are. There are technical reasons discussed in the Fed’s latest Financial Stability Report why some of the commonly cited indicators may exaggerate the liquidity squeeze. Furthermore, as market participants point out, it is not surprising that liquidity should be somewhat tight right now. As we move from one level of interest rates to another, you would expect more volatility and with more volatility you should expect less liquidity. This is a normal market adjustment.

The worry expressed by several market participants to the FT is that causality is also beginning to run the other way around. It is not just that volatility is driving illiquidity. Illiquidity is beginning to cause volatility. If both effects operate at the same time they form a vicious spiral in which volatility surges and liquidity collapses. Given this possibility the question of what is the precipitating factor may become moot. The terrifying thing about a run is that it operates by itself. If you hold treasuries for liquidity and a surge of panic-selling causes the market to seize up, then on precautionary grounds you must try to sell too, so as not to miss your chance. Whatever your underlying long-term motivation, you must join the crowd.

As a recent paper from the New York Fed by Thomas Eisenbach and Gregory Phelan shows, this kind of run dynamic with “precautionary selling” appears to have built up in Treasury markets in 2020. It would be disastrous if it were to recur.

***

At this point you might wonder why this vital market is so opaque. If this is the most important financial market, if this is the sovereign debt of the most powerful state, why is there so much uncertainty and volatility?

Part of the problem is that the range of investors holding treasuries is huge. The largest single group of Treasury investors are reserve managers from across the entire world.

Given the scale of foreign involvement, shocks emanating from anywhere in the world will reverberate in the market. Foreign sales were an important part of the shock in 2020, when there were significant emerging market reserve sales. In 2022, given the savage devaluation of the yen and the prospect of a major course correction by the Bank of Japan, the main worry are sales by Japanese investors. We will return to that in a future installment of this series.

But pointing finger at foreign investors can be a way of diverting from the main problem. Japanese pension funds and banks are just one part of the giant transnational system of shadow banking for which US Treasury bonds are the rocket fuel. The main hub of this system is not in Tokyo but in New York.

The emergence of this system from the 1950s onwards is beautifully chronicled by Tracy Alloway in an extraordinary essay for Bloomberg which draws heavily on the work of the brilliant Josh Younger. As Younger put it: “In the early 1950s, the Federal Reserve and Treasury leaned heavily on dealers to jump start a ‘free’ Treasury market — one where prices were set by investors not the government,” explains Younger. “In many ways, we’re still living with the legacy of those policy decisions. The Treasury market today is arguably only as healthy as the shadow banking system on which those dealers depend.”

The system that has emerged is fragmented and unstable. The Financial Stability Board provides the following map for the secondary market, with further complexity added by repo and futures markets.

As Vanderbilt Law Professor Yesha Yadav points out, it is not just the markets themselves, but the regulators of the markets that are fragmented. "Whereas equities or corporate bonds are overseen by a primary regulator (the SEC), Treasuries are supervised by five or more major agencies, none of which has lead status. The Treasury writes the rules, the Federal Reserve Bank of New York (N.Y. Fed) facilitates debt auctions, the SEC and the Financial Industry Regulatory Authority (FINRA) supervise securities firms that trade Treasuries, the Fed monitors banks, and the Commodity Futures Trading Commission (CFTC) oversees the derivatives markets linked to Treasuries."

Though this kind of fragmentation is typical of the US administrative state, it is highly dysfunctional in the case of a market as large, dynamic and essential as the Treasury market. Yadav joins other academics, notably Darrell Duffie of Stanford, in calling for central clearing to achieve greater transparency and security in trading. Her conversation with David Beckworth on his Mercatus podcast makes for great listening.

As The Economist neatly summarized the options, reform entails one of three options: "allowing the banks to trade more bonds with investors (by loosening reserve requirements on the banks - their preferred option;) ), let investors trade more bonds with each other (with some kind of clearing or improved trading mechanism), or let investors trade or swap more bonds with the Federal Reserve (by way of a widened repo facility)."

So important is the US Treasury market that it has attracted the attention of the G30 and the Financial Stability Board that advises the G20 and the IMF has also chimed in (as linked above).

***

The US authorities are not oblivious to the need for reform. The 2020 crisis was serious.

The Inter-Agency Working Group for Treasury Market Surveillance (IAWG), which was formed in 1992 after the Salmon brothers auction bidding scandal convenes staff from the U.S. Department of the Treasury, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York (FRBNY), the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC), has taken on task of coordinating reform discussions across the different branches of government.

The most consequential recommendations to date have come from Gary Gensler and the SEC. The SEC is pushing for an extension of central clearing both in Treasury Trading and in repo. It also wants to have more oversight over the firms involved in the market. Earlier this year it proposed that all firms that trade more than $25bn in Treasuries per month to, in future, be registered and regulated as dealers. This has triggered furious blowback back from market makers, investment funds and other firms — almost everyone but the primary dealers, who are already heavily regulated - who all denounced the suggestions as dangerous. They will cause key actors to limit their involvement thus deepening the liquidity problems.

Given the asymmetry of information between market participants, regulators and journalists, and given the lack of overall information, the Treasury market is one in which forming an independent judgement is truly difficult.

And in any case as Alexandra Scaggs of FT Aphaville has noted, tinkering with regulations affecting one group of market participants alone is a partial fix at best. "There isn’t much the SEC can do about high levels of Treasury issuance and economic uncertainty (that’s the job of Treasury, Congress and the Fed). But it can expand its surveillance into Treasury markets to get a better idea of who these price-sensitive traders are, and put de facto limits on leverage. If the goal were solely to create a robust Treasury market structure independent of political pressures, which is surely a fantasy in the US, regulators could be focusing on systemic solutions to deal with funding costs in times of crisis. They could look into clearing solutions, or make more policy about countercyclical changes in dealer regulations. But if regulators are instead using the Pottery Barn rule, the hedge-fund focus makes perfect sense."

A conference will be held on November 16th (tomorrow) with industry players and experts at New York Fed to address the issues.

***

Will there be a market incident before new regulations come in place? It cannot be ruled out. But if it were to occur, we already know how it would be contained. The Fed would buy assets and offer expanded repo facilities to all comers. That is what all the central banks did in 2020. It is what the Bank of England briefly did after the nasty incident with Trussonomics. But if this is the future, it raises the question: are we on a ratchet in which macroeconomic shocks and weak market structure force central banks repeatedly to intervene? Each time they expand their balance sheets and flush liquidity into the system, expanding commercial bank reservers. Then, when they seek to reverse course and “normalize”, they unleash market stress, which causes them to intervene again.

That appeared to be the case in 2019, when Jerome Powell’s first attempt at tightening ended in the repo market shock of September. If we are repeating that cycle now, it forces us to ask: why is it so hard to normalize? Why is it so hard to reverse QE with QT? The answer provided by Raghuram G. Rajan and Viral Acharya in a project syndicate column, and with co-authors in several other papers, is that expanding and shrinking reserves is not symmetrical. It is not symmetrical because of the way that commercial banks respond to the increase in their reserves during the expansionary phase of QE.

When the Fed buys bonds, it does so in exchange for reserves. The bonds that the banks sell to the Fed come from customers who end up with deposits at the banks. The banks make a small interest margin on this trade. But as highly incentivized profit-driven businesses they cannot be satisfied with these slim pickings so they go in search of bigger business. "commercial banks have created additional revenue streams by offering reserve-backed liquidity insurance to others. This generally takes the form of higher credit card limits for households, contingent credit lines to asset managers and non-financial corporations, and broker-dealer relationships that promise to help speculators meet margin calls (demands for additional cash collateral)"

And that is what creates the ratchet effect. The commercial banks become more vulnerable to shocks due to their exposure to contingent credit lines. But when the central banks wants to carry out normalization and shrink reserve, the banks are slow to reel in their profitable lines of new business, putting further stress on their balance sheets. If things get rough they can, after all, rely on being able to sell more Treasuries and if that market freezes up, they will count on the Fed to ride to the rescue.

As Rajan and his colleagues point out, normalization after post-2008 QE may never have happened. But history is moving fast. In the wake of second round of gigantic balance sheet expansion we are now embarked on serious monetary tightening, and not just in the US. The stakes are high. A UK-style “incident” played out in the US Treasury market would rock the global financial system.

Adam Tooze, "Chartbook #172: Finance and the Polycrisis (3) US Treasuries - how fragile is the world's most important market?,"Chartbook, November 15, 2022, https://adamtooze.substack.com/p/chartbook-172-finance-and-the-polycrisis

Chartbook #172: Finance and the Polycrisis (3) US Treasuries - how fragile is the world's most important market?

If there is one financial market that could put in doubt the stability of the entire global financial system it is the $23 trillion US Treasury market.

"...Housing wealth increased by nearly $9 trillion between the first quarter of 2020 and the second quarter of 2022, more than 82 percent through price gains rather than an increase in the housing stock. Plausible estimates of the direct impact on housing wealth suggest that a pessimistic scenario—with a real price correction of 15-20 percent—could shave as much as 0.5-0.7 percentage points from real personal consumption expenditures...."

Skimming U.S. Housing Froth a Delicate, Daunting Task

U.S. house prices appreciated a remarkable 94.5 percent from first quarter 2013 to second quarter 2022—a 60.8 percent rise after adjusting for inflation. The magnitude of the increase is even larger than that of the preceding housing boom, from first quarter 1998 to second quarter 2007.

House prices have risen especially rapidly since the pandemic began—from first quarter 2020 to second quarter 2022—accounting for roughly 40 percent of the decade-long appreciation. Measures of profitability (price to rent) and affordability (price to income) have also jumped in the past two years, past historic highs dating back to first quarter 1975.

This unprecedented pandemic boom poses an outsized risk for the U.S. economy, pressuring housing rents and, consequently inflation, higher. The possibility of a sharp price correction leading to an economic contraction—were one to materialize—would further complicate Federal Reserve inflation-fighting efforts.

Housing Demand Outstripped Supply During Pandemic

Fundamental forces—whether temporary or more persistent—spurred the initial house price surge. Robust disposable income supported by pandemic-related fiscal stimulus and cheap credit boosted consumer demand, while supply-chain disruptions, COVID-19-related lockdowns, and rising labor and raw construction materials costs pushed supply lower.

Pandemic-induced lifestyle changes—work-from-home arrangements and internal migration—also help explain why demand so outpaced housing supply early on.

A housing boom—such as the pandemic-era run-up—becomes frothy when the belief becomes widespread that today’s robust price increases will continue unabated. If many buyers and investors share this belief, purchases arising from a “fear of missing out” (FOMO) further drive up prices and reinforce expectations of strong (and accelerating) future gains beyond what fundamentals could justify.

This self-fulfilling mechanism leads to exponential price growth until a price correction inevitably occurs.

COVID-Era Boom Became Bubbly

Economists often disagree on the fundamental value of housing and what causes expectation-driven bubbles. There is greater agreement on how to identify unsustainable exponential growth—a symptom of a bubble—in the data.

A novel empirical approach is based on so-called exuberance statistics. These measures can help detect if and when housing market indicators—quarterly real house prices, the house price-to-rent ratio and the house price-to-income ratio—start growing exponentially (Chart 1). An exuberance statistic above the 95 percent threshold signifies 95 percent confidence of abnormal unsustainable behavior in the underlying data series. Such episodes are identified in all charts with varying grades of shaded bars.

Moreover, the latest statistics from second quarter 2022 closely parallel the preceding housing bubble, with the data once again showing evidence of explosive behavior in the price-to-rent and price-to-income ratios as well. Accordingly, the pandemic surge before summer 2022 exhibited widening symptoms of a FOMO-driven bubble, one that extends beyond the U.S.

Monetary Policy’s Role Easing Housing Booms

The relatively high number of new houses currently under construction can be a silver lining since supply catching up with demand can take some air out of the market and curb housing affordability woes. However, completions continue to lag. Recent data also show slowing housing sales and softening prices as borrowing costs surge, easing market pressure and, perhaps, enabling builders to chip away on order backlogs.

The share of mortgage debt service payments as a percent of personal disposable income stood at a historically low 3.9 percent in second quarter 2022. This remains well below the unsustainably high range of 6-7 percent reached at the peak of the last housing boom during 2005-07 (Chart 2). The mortgage share of income is poised to rise given the rapid increase of the 30-year mortgage rate―from 3 percent to above 6 percent at the end of third quarter 2022―induced by Fed monetary policy tightening since March 17, 2022. Rapidly rising mortgage rates have contributed to plummeting mortgage loan applications and declining housing sales.

Housing Poses Vulnerability for the U.S. Economy

The red-hot pandemic-era housing market poses significant risks to the Fed’s dual mandate of price stability and maximum sustainable employment.

On the inflation side, the four-quarter change in asking rents climbed to 16 percent in second quarter 2022, modestly slowing to 12.2 percent in the third quarter, reflecting house price increases, according to Zillow data. The Bureau of Labor Statistics’ rent of shelter—a broad measure of household rental costs and a component of the Consumer Price Index (CPI)—reacts with a lag given that landlords’ asking rents are increased gradually as leases turn over. Even so, rent of shelter climbed to 6.2 percent in third quarter 2022—the sharpest rent increase since at least the early 1990s—and pushing overall CPI inflation higher (Chart 3).

Housing wealth increased by nearly $9 trillion between first quarter 2020 and second quarter 2022, more than 82 percent through price gains rather than from an increase in the stock of housing (Chart 4).

To complicate matters, the pandemic price boom has also widened wealth inequality since homeownership is the primary driver of household wealth

Is a Major Housing Correction Unavoidable?

In the current environment, when housing demand is showing signs of softening, monetary policy needs to carefully thread the needle of bringing inflation down without setting off a downward house-price spiral—a significant housing sell-off—that could aggravate an economic downturn. Increasing mortgage rates, which follow from higher Fed policy rates, reduce the risk of prolonging the house price boom.

A gradual unwinding of the pandemic housing excesses can occur if policymakers can quell inflation without putting buyers under too much stress and can slow house price and rent increases while keeping underwater mortgages (housing worth less than what is owed) from rising.

Households and financial institutions are in better shape than during the housing boom and bust in the mid-2000s, likely providing more of a cushion to withstand some of the consequences of a negative wealth effect, were one to materialize.

However, after a housing boom partly driven by pandemic-era FOMO beliefs, cooling market participants’ expectations is key to shifting house prices toward a more sustainable path and avoiding the peril of a disorderly market correction.

A severe housing bust from the frothy pandemic run-up isn’t inevitable. Although the situation is challenging, there remains a window of opportunity to deflate the housing bubble while achieving the Fed’s preferred outcome of a soft landing. This is more likely to happen if the worst-case scenario of a price-correction-induced economic downturn can be avoided.

“…Most of this decline is attributable to the aging of the population and a reduction in part-time employment among workers aged 70 and older. The decline in the overall employment rate was 0.89pp. Of this decline, the aging effect accounts for 0.58pp, about two-thirds of the total decline. The “failure” of employment to rebound to pre-pandemic levels is not primarily explained by some decreased “willingness to work”, but rather by the steady aging of the population….”

Preston Mui, “Who is Driving the Labor Shortage? Part-time Over-70 Workers,”Employ America, November 4, 2022, https://www.employamerica.org/blog/who-is-driving-the-labor-shortage/

Who is Driving the Labor Shortage? Part-time Over-70 Workers

A Labor Supply Shock?

Much ado has been made about the shortfall in the headline employment-to-population ratio and the headline labor force participation rate of late. Many have claimed that recent wage and price pressures trace back to a “labor supply shock”. Some have even tried to make the more nuanced claim that this disappointment holds even after controlling for demographic effects, with specific attention given to workers aged 55 and older. The employment rate of this group in October was 37.9%, compared to its pre pandemic high of 40.5% in July 2019.

This morning, the Bureau of Labor Statistics released the new Employment Situation Report. As was true in previous months, the data show a strong recovery since the pandemic recession, although there are signs of weakening in the household survey. The prime-age (25-54) employment-to-population ratio fell from 80.2% to 79.8%, slightly lower than its pre-pandemic high of 80.5%. The all-age employment-to-population, however, has not seen the same recovery since the pandemic started. The labor force participation data shows the same pattern.

Some have pointed to stagnant employment rates among older workers as evidence of a labor supply issue. However, in reality, most of this decline is attributable to the aging of the population and a reduction in part-time employment among workers aged 70 and older. In the context of what counts as a strong employment recovery from a pandemic with disparate impacts on the elderly, it is not apparent that there has been critically “missing labor supply” from those older workers that can—or should—be brought back.

“Early retirements” in this older population have been explained in various ways: concerns over COVID, strong balance sheets after a strong fiscal response and stock market returns, or a reevaluation of work-life balance preferences. At the same time, there are concerns that early retirements in this group are presenting a significant drag on labor supply. In a speech last month, Lisa Cook cited early retirements as a cause of stagnant labor supply. Jay Powell has cited “subdued” labor supply as one source of labor market tightness (and implicitly, inflation) in both his May and June FOMC statements.

Labor demand is very strong, and, while labor force participation has increased somewhat, labor supply remains subdued.
– Jay Powell, May 4, 2022 FOMC press conference

In the post, I explain why concerns over these so-called “lost workers” as a source of labor supply issues are overblown. The predominant explanation for the employment shortfall is the aging of the workforce, not lower employment rates within age groups. The shortfall of older workers is primarily concentrated among workers over the age of 70, and specifically those who were working part-time. While there have been economically consequential acute labor shortages in particular sectors—like trucking, construction, and oilfield services—any wage, price, and bottleneck pressures in these sectors cannot be credibly attributed to the shortfall in employment and participation among these elderly cohorts.

Decomposing the Shortfall in Employment

What then accounts for the overall shortfall in employment? To answer this question, I decompose the change in the overall employment rate between before the pandemic and now into an “aging effect” and an “employment effect.” The aging effect is the change in the overall employment rate that is attributable to the changing age composition of the population, holding the employment rates of age groups constant. Conversely, the employment effect measures the effect of changes in the employment rates of age groups, holding the age composition constant.

The chart below shows the decomposition of the employment shortfall into these aging and employment effects. Importantly, I use narrow age bands to calculate the aging and employment effects, which allows me to distinguish between older working-age workers (55-64) and the 65+ population. Since the narrower employment rate data is only available on a non-seasonally adjusted basis, I compare the average of the three months ending October, 2019 to the three months ending October, 2022.

The decline in the overall employment rate was 0.89pp. Of this decline, the aging effect accounts for 0.58pp, about two-thirds of the total decline. The “failure” of employment to rebound to pre-pandemic levels is not primarily explained by some decreased “willingness to work”, but rather the steady aging of the population.

The remainder of the decline in employment, 0.30pp, is accounted for by the employment effect. This employment effect is in turn mostly explained by a decline in the employment rate of the 65+ population. The decline in the employment of workers between the ages of 55 and 64 (workers who would potentially be taking “early retirement”) accounts for only a minimal part of the overall decline.

When one takes a closer look at the decline in employment rates in older cohorts, the proposition that the sidelining of these workers is a significant source of “labor shortages” becomes even more strained. In the chart below, I repeat the decomposition exercise for the decline in 55+ employment rates.

As with the overall population, the fall in employment rates among the 55+ population is mostly due to aging within this population. The contribution of the employment effects is concentrated mostly among the oldest among the older workers, those above the age of 70, not the workers between 55 and 69 mostly characterized in the media as affected by “early retirements.” If employment rates of workers aged 55-69 returned to pre-pandemic levels, the overall employment-to-population ratio would only increase by 0.075pp, less than one-tenth of the overall shortfall.

Full-time Employment Shows a Strong Recovery

Another reason the labor supply shortage story is overstated is that full-time work (35 or more hours a week) has now nearly fully recovered, and the shortfall in employment is predominantly due to lower rates of part-time work (less than 35 hours). The proportion of the population (3-month moving average) working full-time is only 0.4pp lower than three years ago, while part-time work is 0.6pp lower.

Data on part-time vs. full-time work for older workers is not as disaggregated or frequent as the overall data, but what is available suggests that the decline in employment among older workers is also mostly due to declines in part-time, not full-time, work. The proportion of Americans 65 and older usually working full-time actually increased between 2019 and 2021 (annual averages) by 3.3%, from 6.42 million to 6.63 million. Meanwhile, the number of part-time workers in this age range fell by 11.0% in the same period, from 3.93 million to 3.49 million.

To sum up: the all-age employment-to-population ratio has not caught up to pre-pandemic levels for reasons not primarily due to work disincentives, fiscal support, or nebulous “quiet quitting” phenomena. Rather, the bulk of the fall in employment is attributable simply to the aging of the workforce. The remainder of the shortfall is better characterized by a reduction in septuagenarians working part-time jobs, not early retirement of the working-age.

While there might be acute labor shortages in particular areas, such as pilots or construction workers, these are probably not shortages that are likely to be resolved by “bringing back” part-time elderly workers. In short, it does not appear that there is a substantial labor supply issue in an aggregate sense.

Moreover, this decomposition exercise clearly shows just how successful the labor market recovery has been over the last two years. The sluggish labor market recovery following the Great Recession left many workers on the sidelines for years. Thankfully, the COVID recovery has been much more rapid, due in large part to the strong fiscal and monetary policy response.

However, the October jobs report shows worrying signs of a deteriorating labor market. The prime-age employment-to-population ratio continued to fall from 80.2% to 79.8%. Unemployment ticked up to 3.7%, and full-time employment fell. If trends continue, we risk giving back the gains from the strong labor market recovery. Policymakers need to take this risk seriously.

Jay Powell (and others) have framed the labor shortfall in terms of labor force participation, rather than employment. A similar exercise decomposing the shortfall in labor force participation shows the same story as this decomposition for employment.