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Modelling Challenges for the Near Future: Income Inequality, Financial Systems, and Exhaustible Resources Michael Kumhof, International Monetary Fund April 30, 2012 Disclaimer The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management. 1 Introduction • My background: I design the theoretical foundations of the IMF’s global DSGE model, GIMF (Global Integrated Monetary and Fiscal Model), an optimizing model of the global economy frequently used at the IMF for policy and scenario analysis. • My view: The 3 most important challenges for contemporary policy are all being modeled inadequately by the current generation of DSGE models. • We need to make more progress here. • The 3 most important challenges (in DECREASING order of importance): 1. Exhaustible resources (especially oil): — The fact that oil is exhaustible, and could peak by 2020, is not even taken seriously: UKERC (2009), Benes et al. (2012). — The contribution of oil to economic activity may be underestimated (by focusing on low cost share): IMF WEO April 2011. — The substitutability between oil and other factors is likely to be highly overestimated (e.g. no easy substitutes, on the required scale, for the transportation sector in the short term and medium term). 2. Monetary/financial systems design: — Existing models are based on banks intermediating funds between savers and investors. This function of banks is secondary and coincidental. In other words, I could have a model of the economy completely without intermediation, and I would still need banks. — New generation of models will focus on the ability of banks to create and destroy money. — Without recognizing this, the contribution of banks to business cycles must be underestimated. — Without recognizing this, the possibilities for policy to deal with this problem are not properly understood. — The fact that different financial arrangements could reduce both private and public debt levels is therefore also not understood. 3. Inequality: — Greater inequality is partly a consequence of financial systems design, which has created a lot of our inequality (Phillippon and Reshef (2008)). — The insistence on representative agent models (or patient-impatient agent models) has completely obscured the importance of inequality. — Greater income inequality can be a fundamental cause of financial crises: Kumhof and Ranciere (2010). — It can also cause current account imbalances: Kumhof et al. (2012). 2 Exhaustible Resources 2.1 The Future of Oil - Geology versus Technology • Conventional models — Have great difficulty predicting future oil prices. — Official institutions have had to dramatically revise oil output forecasts downward. • Alternative approach is to take geological limits to oil supply seriously. • Our empirical model combines both approaches. We find: — Geological limits are key for the upward trend in oil prices. — But demand shocks, through higher prices, can increase production. • Model Performance: — History: Decomposition into trends and shocks is very plausible. — Forecasting: Far better performance than competing models. • What Do The Current Forecasts Say? — EIA’s latest forecasts of 0.8% annual supply growth may be feasible. — But real oil prices would have to nearly double over the next decade. — World growth could be significantly lower, even without capturing a nonlinear relationship between GDP and oil prices at very high prices. 1 Horizon 1 year 2 years 3 years 4 years 5 years Root Mean-Squared Errors Real Price of Oil Oil Production Our Model Random Walk Our Model 14.7 27.7 1.69 17.6 47.4 1.97 19.9 57.9 2.31 22.4 79.0 2.41 25.1 100.0 2.69 EIA 1.59 2.57 3.51 4.66 5.72 https://editorialexpress.com/c.cgi?i=fe8a458c1c408dbff33e2e3221d1345d Interpretations of History Next pages: Model estimated until 2002. Then allow the model to forecast out to 2010 assuming no shocks (dashed red line). Then add back the estimated shocks, one by one and overall, to see how they affect deviations from the red dashed line (shown as blue lines). The "All Shocks" line is by construction equal to the data, while the three other lines show the contributions of three main shocks. Oil demand explains early 2000s deviations from trend. This is the trend line without any shock realizations after 2002: Points upward because of Hubbert feature. Contributions of Different Shocks to Oil Prices All Shocks Oil Demand Shocks 120 120 100 100 80 80 60 60 40 40 2002 2005 2008 2011 2002 Oil Supply Shocks 120 100 100 80 80 60 60 40 40 2005 2008 2008 2011 Output Gap Shocks 120 2002 2005 2011 2002 2005 2008 2011 8 Oil supply explains 2005-2008 and recent deviations from trend: Effects of the plateau. Output gaps explain price collapse in 2008/9. https://editorialexpress.com/c.cgi?i=fe8a458c1c408dbff33e2e3221d1345d Forecasts Next pages: Model estimated until 2011. Then produce a point forecast and confidence bands for oil production and prices. Point forecast has real oil price nearly doubling over next decade. Oil Price Forecast with Error Bands (in real 2011 U.S. dollars) 220 200 Point forecast 90 pct interval 70 pct interval 50 pct interval 180 160 140 120 100 80 60 40 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 11 2.2 GIMF Simulations • Assumptions: — Oil supply = mostly exogenous endowment. — Very low price elasticities of supply and demand, around 0.05. • Results: — Oil price effect in the benchmark is similar to our empirical paper. — Peak oil, low substitutability and high output contribution could lead to larger output effects, but they are not enormous. — But the oil price effects are enormous. — Key question: At what level does output response to higher oil prices become nonlinear in the real world? Elasticity of substitution following an oil supply shock 0.3 Economists’ View 0.2 Physicists’ View: Entropy 0.1 Time ___ Baseline = -1% oil output growth _ _ Alt1 = higher oil output share ... Alt2 = -3.8% oil output growth _ _ Alt3 = Alt1 + Alt2 ... Alt4 = Alt3 + zero substitutability Oil Supply 20 20 0 0 -20 -20 -40 -40 -60 -60 -80 -80 0 5 10 15 40 20 20 20 0 0 0 -20 -20 -20 -40 -40 -40 -60 -20 -40 0 1500 Rest of the World Real GDP 40 20 USD Price of Oil 1500 Oil Exporters Real GDP Output effects range from 0.2% p.a. to well over 1% p.a. 5 10 15 20 Real Absorption 300 0 -60 0 300 20 5 10 15 20 Real Absorption 20 20 0 1000 500 0 1000 200 200 500 100 100 0 0 5 10 15 Real Interest Rate 5 5 0 -5 -5 -10 -10 5 10 15 20 0 0 0 0 0 20 5 10 15 100 80 60 60 40 40 20 20 0 0 5 10 15 -20 -40 -40 -60 -60 -80 20 -80 0 80 0 -20 20 Current Account/GDP 100 0 5 10 15 20 Current Account/GDP 5 5 0 0 -5 -5 -10 -10 0 5 10 15 20 The oil price effects in the ___ Baseline = -1% oil output growth baseline are very large, but in _ _ Alt1 = higher oil output share ... Alt2 = -3.8% oil output growth the alternatives they are _ _ Alt3 = Alt1 + Alt2 enormous. ... Alt4 = Alt3 + zero substitutability Oil Supply 20 20 0 0 -20 -20 -40 -40 -60 -60 -80 -80 0 5 10 15 40 20 20 20 0 0 0 -20 -20 -20 -40 -40 -40 -60 -20 -40 0 1500 Rest of the World Real GDP 40 20 USD Price of Oil 1500 Oil Exporters Real GDP 5 10 15 20 Real Absorption 300 0 -60 0 300 20 5 10 15 20 Real Absorption 20 20 0 1000 500 0 1000 200 200 500 100 100 0 0 5 10 15 Real Interest Rate 5 5 0 -5 -5 -10 -10 5 10 15 20 0 0 0 0 0 20 5 10 15 100 80 60 60 40 40 20 20 0 0 5 10 15 -20 -40 -40 -60 -60 -80 20 -80 0 80 0 -20 20 Current Account/GDP 100 0 5 10 15 20 Current Account/GDP 5 5 0 0 -5 -5 -10 -10 0 5 10 15 20 2.3 Exhaustible Resources and Climate Change • The work of David Rutledge at Caltech shows that virtually all climate change projections assume rates of fossil fuel consumption that are very unlikely to happen. • In other words, nature may be about to do a lot of the abatement for us. • Furthermore, resource limits are going to hit the economy a lot earlier than climate change (UKERC (2009)). Oil Production in the IPCC Scenarios • Gb = billions of barrels, historical production from the BP Statistical Review • Range for production from 2010 to 2100 is 1446Gb to 8278Gb — still growing in 13 scenarios in 2100 2 Carbon-Dioxide Emissions • Carbon coefficients for oil, gas, and coal from the BP Statistical Review • Projection is less than any of the 40 IPCC scenarios (Deffeyes’ Law?) • For next assessment report, representative concentration pathways (RCPs) are planned — RCP8.5 is the business-as-usual one, with long-term emissions of 6TtC (7x larger than curve fits) 3 3 Financial Systems • Important work is close to completion. • The next generation of models will have the following features: — The primary function of banks is not intermediation of savings (which is incidental), but the creation and destruction of money through credit. — Cash outside banks (0.25% of GDP) is empirically irrelevant compared to bank + shadow bank liabilities (200% of GDP). — Central bank reserves are empirically and conceptually virtually irrelevant (Kydland and Prescott (1990)). The deposit multiplier is nonsense, it gets the transmission mechanism between money and reserves backwards (Carpenter and Demiralp (2010)). — Banks can create huge and instantaneous booms and busts that would be impossible if they were just intermediating savings. In fact, by creating money, banks create savings. — But banks also create huge debts that exist for the sole purpose of creating enough money to service transactions needs. This is not necessary. • Reform proposals like the 1930s Chicago Plan (Henry Simons, Irving Fisher) can be analyzed in such models. Lending Boom and Bust in the New Model GDP 2 (% Difference) Consumption 2 1 1 0 0 -1 -1 -2 -2 -3 -3 -4 -4 5 0 0 -5 -10 -10 60 (pp Difference) 40 20 20 20 20 0 0 0 0 -20 -20 4 2 0 -20 6 4 4 2 (pp Difference) 2 -20 6 (pp Difference) 6 4 4 2 2 0 0 -2 -2 -4 -4 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 Nominal Deposit Rate 6 -10 -20 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 Nominal Bond Rate (pp Difference) 10 0 Bank Basel Ratio 60 40 6 10 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 40 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 30 20 Bank Deposits/GDP 60 (% Difference) 20 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 40 -20 30 -10 Bank Loans/GDP (pp Difference) Investment 5 -5 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 60 (% Difference) Nominal Treasury Funding Rate 6 4 4 2 (pp Difference) 4 2 0 0 -2 -2 2 0 0 0 0 -4 -4 -2 -2 -2 -2 -6 -6 -4 -4 -4 -4 -8 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 Real Bond Rate 6 (pp Difference) Real Deposit Rate (pp Difference) Real Treasury Funding Rate 6 6 4 4 4 4 2 2 2 2 0 0 0 0 -2 -2 -2 -2 -4 -4 -4 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 (pp Difference) 5 0 0 -5 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 -4 4 20 (pp Difference) (pp Difference) 4 2 2 0 0 -2 -2 -4 -4 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 Real Average Retail Rate 10 5 -5 6 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 Real Wholesale Rate 10 -8 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 Inflation (pp Difference) 20 4 15 15 2 2 10 10 0 0 5 5 -2 -2 0 0 -4 -4 -5 -5 -6 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 -6 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 Figure 3: Business Cycle Properties Pre- versus Post-Transition 50 4 4 Inequality, Debt and Crises 4.1 The Evidence • Inequality has increased dramatically in most developed economies. • Domestic debt-to-income ratios have increased simultaneously, but only for the bottom 95%. • This is lending from the top 5% to the bottom 95% due to inequality. • It creates financial fragility and makes crises much more likely. • Countries with the highest increase in inequality have also experienced the worst deterioration in current accounts. So foreign debt levels increase along with domestic debt levels. Percentage Points 130 Bottom 95% of the Income Distribution Top 5% of the Income Distribution Aggregate Economy 150 130 110 110 90 90 70 70 50 50 30 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Percentage Points 150 30 Source: Survey of Consumer Finance (triennal), 1983-2007. Debt corresponds to the stock of all outstanding household debt liabilities. Income corresponds to annual income before taxes, including capital gains and transfers, in the year preceding the survey. 10 Switzerland (79−95) 8 2 Change in Current Account Balance R : 0.62305 6 Sweden (79−00) 4 Netherlands (81−99) France (79−00) Japan (79−00) Italy (79−00) 2 0 Canada (79−00) Germany (80−98) Spain (79−00) Australia (79−00) New Zealand (79−00) −2 UK (79−00) US (79−00) −4 −6 Portugal (79−00) 0 2 4 6 8 Change in Top 5% Income Share 10 12 14 4.2 How to Model This • Neither a representative agent model nor a “heterogeneous agents” model. • Rather, 2-agent models: The rich (investors) and everybody else (workers). • Income shares determined by bargaining. • Wealth in investors’ utility function. • When investors gain income: — Credit Demand ↑: Workers want to borrow to maintain living standards. — Credit Supply ↑ (more important): Investors want to lend to acquire more (financial) wealth. — In open economy, they also intermediate foreign savings: CA deficits. • As a result, debt and crisis probability go up. - Real wage drops persistently. - Return to capital increases persistently. Baseline Scenario • Highly persistent decrease in workers’ bargaining power. • Financial and real crisis in year 30. Real Wage −2 0 −4 −6 −8 Return to Capital −2 −4 −6 0 10 20 30 40 50 10 20 30 40 0 Investors‘ Physical Investment 10 20 30 40 5 50 level in % % deviation −2 −4 −6 0 10 20 30 40 50 10 20 30 40 20 50 120 100 80 60 50 40 0 Workers‘ Debt−to−Income Ratio 140 0 40 0 0 Workers‘ Consumption 30 60 level in % 10 20 80 15 0 0 10 Investors‘ Loans % deviation % deviation % deviation 0 0 50 20 10 1 −1 0 Investors‘ Consumption 2 pp deviation 2 % deviation % deviation Bargaining Power 0 0 10 20 30 40 50 10 20 30 40 50 Crisis Probability 3 2 1 0 0 10 20 30 40 50 - Investors consume more. - Investors invest more in equity. - Investors make more loans. Baseline Scenario • Highly persistent decrease in workers’ bargaining power. • Financial and real crisis in year 30. Real Wage −2 0 −4 −6 −8 Return to Capital −2 −4 −6 0 10 20 30 40 50 10 20 30 40 0 Investors‘ Physical Investment 10 20 30 40 5 50 level in % % deviation −2 −4 −6 0 10 20 30 40 50 10 20 30 40 20 50 120 100 80 60 50 40 0 Workers‘ Debt−to−Income Ratio 140 0 40 0 0 Workers‘ Consumption 30 60 level in % 10 20 80 15 0 0 10 Investors‘ Loans % deviation % deviation % deviation 0 0 50 20 10 1 −1 0 Investors‘ Consumption 2 pp deviation 2 % deviation % deviation Bargaining Power 0 0 10 20 30 40 50 10 20 30 40 50 Crisis Probability 3 2 1 0 0 10 20 30 40 50 Baseline Scenario • Highly persistent decrease in workers’ bargaining power. • Financial and real crisis in year 30. Real Wage −2 0 −4 −6 −8 Return to Capital −2 −4 −6 0 10 20 30 40 50 10 20 30 40 0 Investors‘ Physical Investment 40 −4 −6 20 30 40 50 10 20 30 40 40 20 50 120 100 80 60 40 60 0 Workers‘ Debt−to−Income Ratio 140 level in % % deviation −2 30 0 0 0 10 5 50 Workers‘ Consumption 0 10 level in % 30 20 80 15 0 20 10 0 10 20 30 40 50 50 Investors‘ Loans % deviation % deviation % deviation Workers 0 reduce 0 10 consumption. 0 50 20 10 1 −1 0 Investors‘ Consumption 2 pp deviation 2 % deviation % deviation Bargaining Power 0 10 20 30 40 Crisis Probability 3 2 - Workers' leverage increases. - This 50 increases the probability of crises. 1 0 0 10 20 30 40 50 A Much More Sustainable Scenario: Restoration of Workers’ Bargaining Power Investors‘ Consumption Investors‘ Physical Investment 20 Investors‘ Loans 15 10 0 80 % deviation % deviation % deviation pp deviation % deviation % deviation • Highly persistent decrease in workers’ bargaining power, as before. • But in year 30 workers’ bargaining power is restored to its original level. • Financial and real crisis is thereby avoided. Recovery in Bargaining Power Real Wage Return to Capital 4 0 real wage 2 2 −2 gives workers 1 0 −4 −2 0 the means to −6 −4 −1 service their −6 −8 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 debts. 10 5 60 40 20 0 10 20 30 40 50 0 −4 0 10 20 30 40 50 10 20 30 40 50 0 Workers‘ Debt−to−Income Ratio 140 level in % % deviation Workers‘ Consumption −2 0 0 120 level in % 0 100 80 60 0 10 20 30 40 50 10 20 30 40 Crisis Probability 3 Leverage therefore goes on a sustained 50 downward path. 2 1 0 0 10 20 30 40 50 5 Summary • In my view, the 3 most important challenges for contemporary policy are all being modeled inadequately by the current generation of DSGE models. • What are they? 1. Oil: Most important. 2. Monetary/financial systems design: Almost as important. But this can be fixed. 1 is hard to fix. 3. Inequality: Very important. But there are many ways of fixing it: — Monetary/financial reform. — Tax changes: Progressive income taxes, taxes on rents. — Strengthening the bargaining powers of workers.