Last year some economists caused a minor stir by suggesting the concept of something they called R**. It looks pretty prescient in light of the recent US banking mess, and they’ve now updated their paper with more detail.
First, some background. In economic equations, R stands for interest rates, and stars are used to denote long-term variables. So R* has become shorthand for the idea of a long-term “neutral” interest rate that neither slows nor quickens economic growth and inflation.
It’s theoretical unknowable number until you really know you’ve jacked rates up beyond it, but R* has become such a eco-nerd meme that Alphaville even used it for our own line of swag.
Anyway, at a conference at the NY Federal Reserve last autumn, economists Ozge Akinci, Gianluca Benigno, Marco Del Negro and Albert Queralto presented a paper on what they dubbed R**, or R-double star (yes, really).
The idea is that there is also a neutral level of interest rates for financial stability, and, crucially, it is not the same as R*. Basically, R** is a measure of an economy’s financial sturdiness. When it’s low, a country is vulnerable to financial shocks from rate increases, and when it is high it can more easily shrug them off without major mishaps.
Crucially, if R** drifts lower than R* — for example, if prolonged low interest rates encourages leverage, risk-taking and general stupidity — a central bank’s rate increases can cause financial calamities long before it gets to the point where rates really start to contain inflation.
That the Fed’s rate increases precipitated a banking crisis before they got inflation down to even vaguely near their target looks like a good example of what Akinci et al were arguing last year.
They’ve now revised the paper to flesh out some details and models of R**. You can also read a summary of at the NY Fed’s Liberty Street Economics blog.
Since R**, like R*, cannot be directly observed, the economists have tried to model of what it probably is, constructed out of other measures of financial instability and using machine learning (naturally). The basic question they wanted to answer is: How large a shock to real interest rates can the financial system take before entering a crisis?
Here’s what some R** variants look like over the past 50 years:
You can probably spot some issues just eyeballing this chart.
The problem is that R** cannot in practice actually be used as a way to predict financial disasters. So unless we’re missing something it’s of questionable practical use, beyond as a new conceptual take on an ancient realisation: rate shocks often reveal financial faultlines.
As the paper points out, the modelled R** readings looked comfortably high in the late 1990s — until LTCM suddenly blew up. It was similarly sanguine in the noughties — right up until the global financial crisis erupted.
Still, it’s a pretty fascinating paper that the researchers promise they will follow up with more work. And the fact that financial and economic stability are multi-faceted, dynamic and sometimes at odds deserves more attention.
Further reading
— The fault in R-stars
Source: Economy - ft.com
