Download Modelling Challenges for the Near Future

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.