Sunday, January 25, 2015

Grexit: it is not the debt, it is the future.

A follow up to my previous post now that we know that the Syriza party has won the election. What comes next will not be easy. And it is not because the policies proposed by Syriza are that radical or unreasonable and certainly they are not worse that what has been done in Greece since the crisis started. The real issue is that this is a wake up call for the Euro area (and possibly the European Union). A wake up call that without a consensus on what is the purpose and processes of a monetary union, this will be a failed project. The reality is that so far EMU has been built in an asymmetric way: the ECB was designed as a strong anti-inflation central bank with the Bundesbank in mind and that served a purpose (for everyone including Greece). The strict criteria to enter into EMU (low inflation, low budget deficits) were a great excuse for politicians in some countries to do policies that otherwise they could not have done internally. There was no doubt who was in charge and what was the ideology that prevail when it came to define policies. And that model worked well in times of economic growth when everyone, including Greece, enjoyed the benefits of stability and growth.

But the crisis made everyone realized that the model was not perfect, that there was no consensus around economic policy and, more fundamentally, that for monetary policy to function properly we needed some amount of risk sharing, something that no one had been willing to discuss before.

And the elections in Greece yesterday have made it even more clear that the consensus is gone. That the model that worked well until 2008 is being challenged by several countries. And without a minimum level of consensus, EMU cannot work. The problem is not that anti-austerity policies might stop in some countries. This is likely to benefit everyone in the short run including Germany. The problem is not that we might need to restructure Greek debt again, that is feasible from an economic and political point of view. The real issue is how to move forward, what will be the way in which the European Commission will deal with future budgetary plans of Euro members, how will the ECB treat sovereign debt in the future, how will markets perceive the risk of future default.

From the perspective of Germany (and other countries that share the same view and economic situation), any agreement with Greece that signals to the market that this would be the solution for any future crisis, would be a disaster. Germany needs a strong commitment from Greece and others that this would be the last time that this happens. But that is unlikely to happen. There could be promises but I cannot imagine how to make those promises credible.

So either Germany gives up and runs the risk of having similar negotiations later in the year with Ireland, Portugal, Cyprus, Spain and Italy. And it accepts the fact that we will be starting a new cycle of accumulation of government debt until the next crisis. Or it throws the towel. And I see this happening in two ways, either it refuses to be flexible in the negotiations with Greece and the ECB holds its promises that liquidity will stop unless there is an agreement, which will push Greece out of the Euro. Or Germany decides to leave the Euro and leaves the other countries to manage what is left. Both of these scenarios are likely to cause a crisis. The first one could potentially be more contained assuming the other Euro countries support Germany. The second one would be a major economic disaster for Europe and the world.

No, Syriza's policies are not that radical, crazy or absurd but the negotiation that starts today is between parties that are either scared by what has happened so far or are not willing to be members of a club that cannot commit to not doing this again. I still do not see how they will agree on a model to move forward.

Antonio Fatás

Monday, January 5, 2015

And this is how Greece might leave the Euro

An interesting month lies ahead for the Euro area. On January 22 the ECB will meet and they will either announce a QE-style monetary policy action, as most expect by now, or they will disappoint markets with yet another statement suggesting the need to wait for more data and the effects of what has been done so far. On January 25, three days later, elections in Greece will decide whether the first political party with strong views against austerity and with an explicit proposal for a serious haircut on its government debt reaches power in the Euro area.

No doubt that the outcome of these two developments will determine the fate of the Euro economy over the coming years but it is also possible that it determines the fate of the Euro area -- at least the current membership.

Rumors have started reaching the press that the Germans will not negotiate with Syriza and that they are ready to let Greece leave the Euro.  We have seen this before and we know the outcome: Back in 2011 and 2012 when the fear of Greece leaving the Euro was at its peak (and the threat of Syriza winning the elections was also real), the contagion to other countries, in particular Italy and Spain, forced the Germans (and the ECB) to come to the rescue. A haircut on Greek debt plus the "whatever it takes" statement from Draghi saved the day and ensured that no country left the Euro area.

But the situation is very different now for many reasons. So far, contagion has not spread to other Euro countries, possibly because the other countries are seen as having stronger fundamentals. But what really matters might not be economics but politics. In some of the other Euro countries we have political parties with platforms that are very similar to the Syriza party in Greece (for example, Podemos in Spain). They (and the citizens of these countries) will be looking very carefully at what is happening in Greece. If Syriza wins and their negotiating strategy is successful, it is likely that we will see similar political changes in other Euro countries and a revolt against the current Euro economic policy. This is the last thing that Germany wants.

How does Germany avoid this outcome? Let me be cynical and argue that they only have one potential strategy, a very risky one. Let the ECB be nice on January 22 and let them go ahead with a full-blown QE policy involving government bonds. Let the Greek decide on January 25 if they want to be part of this. If they Greeks vote for Syriza then the Germans will not negotiate and will only leave Greece with one alternative, to leave the Euro. If that happens, the financial system in Greece is likely to be under enormous pressure with a high chance of bank runs. While the risk might spread to other countries, the ECB could be very aggressive to avoid contagion. If a bank run happens in Greece and the ECB refuses to provide liquidity, Greece will default and be out of the Euro. This will lead, at least in the short run, to a deeper crisis in Greece with strong disturbances to the banking sector and businesses. This is exactly what the Germans need to scare the other countries in the Euro area not to follow the same path and stay in the Euro. The cost are the potential losses on Greek debt but at this point very few people believe that Greece will be able to pay its debt.

This is a serious gamble. It requires that the German voters accept the new ECB aggressive policies. That the potential losses associated to a Greek default and exit from the Euro are contained and that the other Euro countries play along with this strategy. Very risky.

But maybe I am wrong and the Europeans will find once again a way to kick the can further down the road without neither a proper solution nor a final crisis but I feel that this time is different and the possibility of a serious political challenge to the status quo is too high to ignore the possibility of a very volatile period ahead.

Antonio Fatás

Tuesday, December 2, 2014

The logic behind the German Euro gamble.

In the current economic policy debate in Europe there seems to be an increasing polarization between the German view and the view of the other countries. How did we end up with such polarized views of the world? What is the basis for the apparent German stubbornness to change their mind about what are the right economic policies for the Euro area? Here is my best attempt to explain the economic logic behind that side of the debate, including a critical view of the arguments whenever is needed.

1. Europe needs structural reforms. Correct, this has always been true and it will be true in the coming years or decades.

2. Some countries/governments will find any excuses they can to avoid reforms. Correct. Without external pressure or a crisis, change will not happen. This was also true for Germany in the post-2000 reforms.

3. Imbalances of spending and debt (and asset price bubbles) were a fundamental cause of the crisis. Correct.

4. The pre-crisis imbalances requires post-crisis sacrifices. Correct but only up to a point. We understand that deleveraging can slow down growth but this does not justify the extent of the Euro crisis. For example, the fact that pre-crisis growth was not balanced and required an adjustment does not justify the post-crisis downward revisions that we have seen of potential output in many Euro members.

5. Competitiveness and low wages are the key to growth. Wrong. Prices need to reflect the balance of supply and demand and while it is possible that in some cases some prices or wages are above their optimal levels the idea that reduction in nominal wages leads to growth is wrong. It just leads to deflation. And the idea that reduction in real wages is always good makes no sense. If this was true, let's all work for free to be more competitive. In addition, reduction in wages look a lot like competitive devaluations that we know are not possible everywhere.

6. Good behavior, high saving and a surplus in the current account are a sign of strength. Wrong. Not every country can run a current account surplus. The world cannot save (net of investment).

7. Inflation is always bad. Wrong. Even the Bundesbank always understood that 0% inflation was not optimal. All central banks around the world set inflation targets above 0% for a reason. Questioning 2% as a target and arguing for 3% or 4% (permanently or temporarily) is consistent with the framework central banks use to think about inflation.

8. Germany can live without the Euro, it has only been a source of costs for the economy. Germany will certainly be a successful economy without the Euro but so far Germany is one of the countries that has benefitted the most from the creation of the Euro.

9. Demand does not matter, the only thing that matters is supply and structural reforms. Wrong. Recessions are a reality and some of them are driven by a deficiency in demand. While it will still be true that reforms are needed (see point #1), in the short-term policy should be focused on demand. And what matters for the short run (spending) might be different than what matters for the long run (saving and investment).

So that's how we ended up with a policy that is based on the idea that pre-crisis excesses justify any post-crisis suffering. That assumes that whatever output drops we see are the consequence of the imbalances that led to the crisis and the absence of reforms. That refuses to debate about inflation despite the agreement among central banks that 0% inflation is never optimal. That is willing to gamble with the political consequences of discontent in some Euro countries even if they lead to yet another crisis and possibly a break up of the Euro zone.

Antonio Fatás

Monday, November 24, 2014

Is 0% growth for 90% a successful economic model?

Via Greg Mankiw I read the review of Piketty's book by Deirdre McCloskey. The review reminds me of the conversations I have in my class when I bring up the issue of income inequality. While most people express initial concerns about recent trends of increasing inequality, there tends to be a negative reaction about accepting that this is indeed a failure of our current economic model and most become very defensive when that argument is being made.

I do not want to discuss the details of the review but more the overall message. The review presents a strong defense of capitalism relative to alternative economic models potentially proposed by the "left". Very few, including Piketty, would disagree with the merits of capitalism. The fact that all advanced and prosperous economies have reached their current level of income by relying on markets, the fact that the fastest growing emerging markets are those that move closer to that model and by doing so are able to lift a large percentage of their population from below poverty levels, all speak up in favor of the power of markets and incentives to unleash growth.

But the debate cannot end up there. The success of capitalism as an economic model does not imply that we should accept current outcomes and that we should not discuss alternative models that, in comparison to other economic paradigms, might all look very similar but they could produce very different distributions of income. What Piketty and others have done is to raise awareness that since the early 80s, the economic model that we call capitalism has generated an outcome that is different from the one we had seen in the previous decades and that this outcome, in some countries, resemble what we saw before the Great Depression.

While we can debate the exact magnitude of these changes, it is clear that the strong correlation between productivity and wages has weakened over these decades. It is also clear that income growth has been going to a small part of the population, those with the highest earnings. And for a large majority of the population, income stopped growing (or started growing at a much slower rate). [On a technical matter: yes, we can discuss whether national income or GDP are capturing all the increases in welfare of the average citizen, but that discussion can go in both directions and to be fair we should also apply it to the earlier decades (if we believe that GDP growth underestimates welfare growth)].

Here is how I try to challenge the thinking of my students when I discuss income inequality. We all agree that the current economic model has allowed the income of many Americans to increase at a rate close to 2% for more than a century based on continuous productive accumulation of capital and innovation, an amazing success. But how would we think about the same economic model if this rate of growth slowed down and was very close to 0%? This would represent a big change in the economic outcome and would, for sure, raise concerns about why the model is failing to deliver relative to our expectations (that is the argument we use to call alternative models, like those of planned economies, a failure).

While it is true that GDP per capita growth has remained in line with historical experience over the last decades, the income of a large % of US households has either stopped growing or is growing at a rate much closer to 0% than to 2%. So if 0% growth for 100% of the population would represent a failure, what about 0% growth for 90% of the population? Regardless of how well capitalism has performed in the past, we need to open for a debate on the merits and outcomes of such a model that takes into account how the income and wealth that it generates gets distributed. There is no just one form of capitalism, there are many. Current tax rates, regulations are not set in stone and they are very different from what they were during many periods of the recent economic history so a debate on how inequality trends reflect on the successes and potential weaknesses of the current model is not only a healthy one but one that is needed.

One more comment regarding McCloskey's review. While I said I did not want to go into the details of the review, there was one that I found very surprising. The review argues that while income inequality might have increased, consumption inequality is a lot lower. One of the reasons is that the actual consumption of those who own six houses is not that different from those who own one as you can only live in one house at a time. That's an odd argument. If taken seriously it provides support from those on the "left" who argue for very high levels of taxation for the rich. Let's tax 100% of the value of those 5 extra houses given that they are not providing any consumption or welfare to those who own them.

Antonio Fatás

Thursday, November 20, 2014

Macroprudential policy and distribution of risk

There is very little doubt that housing prices and leverage played a strong role in the global financial crisis that started in 2008. As the effects of the crisis disappear many countries still struggle with the fear that the dynamics of household debt and leverage resemble those of the pre-crisis period (e.g. Sweden).

While I am sympathetic to the idea that increased leverage and debt increases risk, I am less convinced by the theoretical justifications that are commonly used. Typically, there is an assumption that leverage and debt are associated to the notion of "living beyond our means", which makes this behavior and unsustainable. This is not correct and there are plenty of subtleties that should not be ignored that are related to distributional issues.

Let's keep things simple. Imagine a world where the stock of housing is not going to change (we have enough houses for everyone). And imagine no population growth either (we do not need more houses). In this world, someone needs to own the assets, either those who live there or those who rent them to others. Imagine there is some utility that we all derive from owning our place. So if you ask me to choose between owning and renting assuming the financial cost of both is the same, I would rather own a place.

Initially, there are some people who rent their house because they do not have access to enough credit to buy a property. This requires that someone out there owns property and is happy renting it to others. Let's now change the access to credit of some of the constrained households. Either because changes in financial regulation, interest rates or simply because of economic growth, more households have access to mortgage financing. We expect to see an increase in the purchases of houses by tenants, an increase in the price of housing and an increase in the amount of leverage. Realize that the households that are buying houses are not living beyond their means. They are simply buying a good (the ownership of the house) that they did not have access to before. Their wealth (i.e. "equity") has not gone down, only their leverage has increased. So they are not living beyond their means, they simply hold more wealth in assets that is backed by the debt they now have access to. [There will be as well other general equilibrium effects that I am ignoring it].

How much macroeconomic risk does it represent the increase in debt and leverage? It all depends on how close these new households are to being financially constrained. If now there is a shock that reduces their income and housing prices, they might find themselves financially constrained and possibly bankrupt. This risk could be related to the increase in the level of debt prior to the shock but it does not need to be. What really matters is not the aggregate level of debt but the % of households that are now in a riskier position because they hold an illiquid asset whose price might change. To assess this risk we need to know something about the distribution of income, wealth and risk. In the aggregate, if there is a shock, the change in wealth associated to a decrease in housing prices is always the same. But what matters is who owns those assets. Is it those who have access to funding or those who are at the edge of being financially constrained? It might not be unreasonable to assume that as debt and leverage increase, it is mostly due to increases happening at the margin (those with lower financial resources) but it does not always need to be the case.

There are plenty of other examples one could make to reach a similar conclusion (housing prices grow because of changes in population, move to cities, increases in ownership of a second house, reduction in the size of household,...).

In summary, this is what I learn from this and other similar examples;

1. Debt should not always be equated to living beyond our means. It could be if the borrowing goes straight to consumption spending but when it goes to purchases of assets, in particular housing, the real issue is one of leverage and potential risk.

2. Leverage through acquisitions of assets can add risk to a household as long as we believe that the prices behind those assets are risky (and more so if we already know they overvalued). Understanding the fundamental driving forces behind the changes in asset prices is a must.

3. While leverage can increase macroeconomic risk, it can also be a sign of economic development. As countries develop leverage tends to increase because of increased sophistication and size of financial markets (this is what economists called financial deepening). This is normally seen as a positive development.

4. The macroeconomic risk of increased debt and leverage depends on the distribution of income, wealth and asset purchases. While the overall risk could be related to the aggregate amount of debt and leverage, the relationship is a lot more complex than that. Macro prudential policies need to be sophisticated and incorporate distributional issues in their assessments. One more reason why understanding the distribution of income and wealth is important.

Antonio Fatás

Sunday, November 16, 2014

German economic policy and chameleons

Wolfgang Munchau's FT article today is one of the most complete explanations I have seen about the origin and contradictions of the German economic orthodox dogma. The only issue that he does not address is how these economic views have survived over time despite the increasing evidence that their advice does not deliver the expected results.

Here is my guess from what I have learned from many heated discussions over the last years about economic policy in Europe: the resilience (stubbornness) of this view on economic policy comes from a combination of faith and the inability of the economic profession to apply enough real world filters to models.

Faith in a certain economic model comes from many years of being trained about the beauty of markets and all the inefficiencies that governments generate. But faith also comes from the belief that only through (individual) hard work and sacrifice (saving) one can achieve any economic progress. In this world (what Wolfgang Munchau refers to as Germany's parallel universe) there is no room for an economic crisis caused by lack of demand. Recessions only take place as a result of misbehavior, debt and lack of willingness to work hard (and reform). The only way to get out is to behave.

But faith alone might not be enough, policy makers and their advisors are required to look at the data and check how their priors allow them to understand economic outcomes. Here is where the economics profession and its ability to hide under economic models that have little empirical relevance provide the necessary support. A recent paper by Paul Pfleiderer about the misuse of theoretical models in finance and economics explains this logic very well. Many economic models are used in ways that make them "chameleons", they do not go through any real world filter and they fight back their criticisms with the argument that "the empirical-test jury is still out". In other words, we start with unrealistic assumptions, we generate a result that fits what we are looking for, we do not find evidence to support it but we can always claim that the evidence cannot conclusively reject the model either and we continue using the model for our economic policy advice.

So it is faith and the use of "chameleon" models that keeps the stubbornness of the German economic policy advice alive in Europe. And while this is going on, the Euro fatigue and discontent in many European countries keeps growing and polarizing the political landscape. The next round of elections will be an interesting test for the Euro/EU project.

Antonio Fatás

Sunday, November 9, 2014

The false rhetoric of (Euro) victims and offenders

Hans-Werner Sinn has written a new book with an analysis of the causes and potential solutions of the Euro crisis: "The Euro Trap: on Bursting Bubbles, Budgets and Beliefs". I have not read the book yet but I just went through a video of the presentation he made about a month ago at the Peterson Institute for International Economics. The video of the presentation as well as a transcript are available at the PIIE web site.

For those who have followed the writings of Hans-Werner Sinn there should be no surprise in the presentation. His views are very consistent and they put most of the emphasis on the price imbalances that were built prior to the crisis (the periphery becoming uncompetitive, interest rates being too low). These imbalances partly supported unsustainable growth that hid the need for structural reforms that were badly needed. His analysis of the crisis years is very similar: bailouts from the ECB and others, not enough austerity have also supported governments in their actions to avoid  reform.

After Sinn's presentation, Fred Bergsten provides some insightful comments. He gives credit to the book as it highlights some of the weaknesses among Euro countries (it is hard to disagree with the view that reforms move very slow in Europe and that government will find any excuse to slow them even further). But Bergsten also provides very critical comments about Sinn's view of the crisis and its solutions. I like in particular Bergsten's emphasis on the economic benefits that Germany has derived of the creation of the Euro area. He goes as far as saying that Germany is possibly the only country that has so far benefitted from the Euro (going against the German conventional wisdom of who are the winners and the losers of EMU).

One of the issues that Bergsten does not bring up enough is the misplaced (in my view) emphasis that Sinn puts on relative prices and competitiveness. The idea that in periphery countries the cost of production became too high and unsustainable and that it now requires deflation in the periphery (and some inflation in Germany) is a constant argument in Sinn's presentations. But the data does not fully support his views. It is not that relative prices do not matter, but they do not matter as much as he claims and I would go as far as saying that they are not a central part of the pre-crisis or post-crisis experience of Euro members.

Here is a quick chart to support my views. This is the value of goods exports (data originally in in billions of US dollars, from the OECD) for Germany, France and Spain since the Euro was launched. Data is rebased so that it equals 100 in 1999Q1.

















It is hard to see in this chart the story of the periphery (Spain) high prices reducing growth via lack of competitiveness (before or after the crisis). Even compared to Germany where we know that there was a significant internal devaluation via very low nominal wage growth, exports in Spain grew at a similar speed before the crisis and faster than in Germany. Yes, the current account in Spain was on an unsustainable trajectory but it was caused by capital flows supporting excessive imports.

Then, why the insistence on prices? Because it fits well the rhetoric of misbehavior that led to the crisis. Under this view, countries belong to one of two groups: the victims and the offenders. And it explains everything: the differences between the savers and the borrowers, the ones who reform and the ones who never do, the ones who control debt and the ones that just let it increase, the ones where workers are reasonable and they accept lower living standards and the ones where they are not and want to live beyond its means. Reality is more complex than that, countries do not always belong to the same side of these imbalances, some imbalances are not central to explain the crisis and all imbalances have two sides to them.

Antonio Fatás