Running out of words?

The Euro crisis is stretching for such a long period of time that it is difficult to know what is news and what is not. Yields go up and then they go down. The ECB is buying bonds or maybe they are not.

Today there was yet another auction of Spanish government bonds and CNBC must have run out of words to describe what happened. See below the description of the news as it appeared on their web site (should we interpret the fact that there was no second paragraph planned as good news?)

Antonio Fatás

The discipline of Financial Markets

John Kay writes an interesting article on the FT today about the limited effect of fiscal rules on fiscal discipline. This is related to out last blog entry and I agree with most of his arguments although I am less pessimistic, there are some fiscal rules that work better than others. What I found surprising is one of the last sentences in his article (a sentence that was highlighted in the title of the article):

Financial markets are an effective discipline on profligate individuals and states because markets cannot easily be bullied or lobbied, and their threat to make the cost of funds prohibitive is effective. 

Financial markets are NOT effective when it comes to providing discipline to governments. Yes, occassionally they do bring governments down and they push governments that misbehave towards default, but they do so in the last minute. They are completely absent in the years where discipline could really matter, when things go well and governments should work hard at generating a large surplus. This is the experience of European countries since the launch of the Euro when all governments were seen as identical and their bonds were priced as risk-free assets. Where was the discipline of financial markets then?

Antonio Fatás

The European Instability and Stagnation Pact

There is a story in the movie "The Inside Job" about a paper that Fred Mishkin (a Professor at Columbia University and former member of the Board of Governors of the US Federal Reserve) had written on the Icelandic banking system before the crisis. The original title of the paper was "Financial Stability in Iceland" but the paper appeared in his CV as "Financial Instability in Iceland" after the crisis had taken place (and after the movie was released the title was changed back to the original one -- here is a clip of the interview). This clip made me think of the European Stability and Growth Pact that seems to be delivering exactly the opposite of what the name of the title suggests: Instability and lack of growth.

European countries agreed to limit their government deficits and government debt (to 3% and 60% respectively) as part of the Maastricht Treaty that led to the creation of the Euro. The limits were not strictly enforced when the membership decision was made. Some countries (Belgium or Italy) were allowed to be members of EMU with debt levels that were double the established limit (the way this worked was through a loose interpretation of a footnote in the Treaty that allowed countries to be accepted even if their debt was above 60% if the level was close to 60% and there was enough progress in the prior years -- how is 120% close to 60%???).

The constraints on fiscal policy were made more explicit through the Stability and Growth Pact that took the numerical limits one step further and developed a set of more specific interpretations of the limits as well as a process to deal with deviations from the rule. The Pact was a failure with many countries (including Germany) going above the deficit and debt limits. The rules were then rewritten once and just las weekend, during the European summit, there has been a proposal to rewrite them once again. This is what some have referred to as a proposal to create a fiscal union, which is clearly not the case. The proposal is simply about changing the enforcement rules of the Pact.

Academics have written extensively on how the Stability and Growth Pact was poorly designed and could not work (my own work can be found here, here or here. The criticisms can be summarized by the following three points:
- simple numerical limits are "too simple" to deal with fiscal policy. Applying the same rules to every country and every year makes no sense. And the moment you open the door for exceptions then the rules lose their meaning.
- enforcement of the Stability and Growth Pact does not work because the enforcers is the same group as the sinners. The ones imposing fines are the ones who pay for them and collect them. As it has been the case before when many countries are above the limit, fines should be paid by all and collected by all. There is no real sanction here.
- but even if fines are applied, what would happen to a country in trouble (Italy today) if the other European countries imposed a fine on the Italian government? That their deficit would be even larger and it would simply make things worse.

The decision over the weekend was to improve the enforcement of the Stability and Growth Pact and it tries to address the second issue while it ignores the other two. What is worst is that it might not even addressed that issue. The proposal (to be approved) makes the fines automatic. They can only be overturned if a qualified majority of countries agree to it. This is a marginal change that is unlikely to work if many (more so the large) countries are the ones violating the rules. And the proposal ignores the fundamental problems of the Pact.

What is more concerning is that there is still no clarity on the goals of the Pact. The Pact and more so its implementation has always mixed goals such as sustainability with other goals such as coordination of fiscal policy and growth-oriented reforms. But there is no clarity on how these things mix together, and some times they do not. Long-term sustainability is a valid goal, more so given what we are seeing these days. But this does not imply that all countries should have the same fiscal policy all the time. In fact, we want fiscal policy in the short run to be different across countries. Coordination of fiscal policy (understood as one policy stance for all all the time) makes no sense in a monetary union.

And here is where we are today: starting with the concern about long-term sustainability we conclude that short-term austerity is the right policy for all European countries. But imposing coordination combined with a short-term focus on what should be a long-term goal will not deliver stability or growth. It will lead to stagnation in the region and instability in some countries as fiscal policy is not allowed to play a proper countercyclical role.

Antonio Fatás

What can the ECB do?

It seems that many economists agree that the ECB has to get more involved in dealing with the current crisis in the Euro area. Politicians (at least some of them) disagree. They cite fear of inflation, take moral stance on past recklessness, argue that sinners have to repent and repay, etc. By now, hundreds of articles have been written on the potential damages from the collapse of the euro area, so I am not going to repeat them here. I want to focus on what the ECB can do to stop the self-fulfilling collapse of several European economies.

The standard view on ECB is that they have to print money in order to buy bonds of governments in trouble like Greece, Italy, Portugal, etc. But there is another thing that they can do. About 18 months ago, the chief economist of Citigroup, Willem Buiter, wrote an article in which he noted that the ECB can use its future profits to stop the acceleration of these negative dynamics on the bonds market. According to his estimates, the ECB has a “non-inflationary loss absorption capacity of … at least €2.4trn and more likely over €3.4trn.” In other words, the ECB can put credibly on the market a firewall of over €2.4 trillion. Certainly this ought to stop the ever-increasing yields on Spanish and Italian debt from rising further.

How does this work? Central banks run very profitable operations – they issue pieces of paper that we call money on which they pay us no interest. With the printed money they buy interest-bearing securities like government bonds. Because of the interest rate differential between the 0% rate on currency and the yield on bonds, central banks generate profits every year. Well, the actual calculation of the profit (seigniorage) is a bit more complicated (see Buiter’s article), but the mechanics are not changed much. This profit is generated even if inflation is 2% (ECB’s mandate).

One way to imagine Buiter’s proposal is the following: Suppose that the ECB issues bonds worth €2.4 trillion (note that they do NOT print money equal to €2.4 trillion). These bonds would most likely have a yield close to the yield on German bonds (2.6% for 30-year bonds) because one can expect that if the euro is alive, the ECB will be mechanically generating this revenue from their activities. After issuing these bonds, the ECB can make an announcement that for countries which are solvent when the yield is 5%, they will not allow these yields to go above 5% (one can adjust the numbers for the state of the cycle, but the idea is that they restrict the yields from increasing due to the lack of confidence). If yields are above 5%, they buy the bonds with the revenue generated through their own issue. If this announcement happens, and if the ECB just starts with some symbolic purchases, yields will go down quite rapidly and yields on Italian debt for example will return to sustainable levels.

Notice that if the ECB has to buy the bonds, then they will be generating yet another profit stream from the difference between their 30-year bond (at 2.6%) and the Italian yield (currently at 6.5%). But even if Italy fails and does not repay the bonds bought by the ECB, the ECB can fully absorb the loss. This is why Buiter calls this quantity the “non-inflationary loss-absorbing capacity” of the ECB.

Is there any magic or a free lunch here? Not really. The seigniorage of central banks has to be transferred by law to the governments of the euro zone. So, effectively what the ECB does is that it takes future government revenues and puts them today to create a firewall. They can commit to having this revenue in the future because of the nature of their operations. Governments – even though they are the eventual recipients of this flow – cannot commit today because the markets do not trust them anymore. The essential role played by the ECB in this case is to put the certain revenue stream on the table and to tell the markets – this future revenues will be used to absorb losses or to repay debt and not for other spending. It is quite likely that they will never have to buy even one government bond out of this facility.

Will the ECB do it? I am somewhat skeptical. It does require a bit of resolve to go beyond the standard thinking.

Ilian Mihov

P.S. On November 16, 2011 Willem Buiter also gave an interview on Bloomberg TV where he talks again about this proposal.

Competitiveness inside and outside of the Euro area

The story of how the creation of the Euro has led to a large discrepancy in unit labor costs among members of the Euro area is often used to explain the large current account imbalances in these countries, which are partly responsible for the current crisis. These imbalances cannot be easily addressed because of the absence of national currencies. It all starts with a chart that looks like this one:

Data is from the OECD and it shows how Greece, Ireland, Italy, Portugal and Spain saw their labor costs increase relative to Germany since the creation of the Euro. This eroded their competitiveness and it is one of the reasons why we find ourselves in a crisis. I wrote last week about how including France in this picture would challenge the conclusion that it is all a problem of the club-med countries (plus Ireland). As I argued there, France looks a lot like all of those countries, Germany is the outlier.

I was curious to see what other countries looked like during those years. So I added the Netherlands and this what I now had:

There are some differences and the increase in unit labor cost was lower in the Netherlands and France than in the other two countries but the real message is the same as before: Germany is the outlier in this story.

So I was now curious to include other countries, those that are not part of the Euro area. Here is what happens if we now include Sweden, the UK and the US.

It is becoming very difficult to see which country is which with the exception of Germany! This picture makes it even more evident that the Euro effect on unit labor costs is very much driven by one country. And that comparing Germany to countries outside of the Euro area leads to the same conclusion.

The picture above is missing something: it is not correcting for movements in exchange rates, it is just looking at unit labor costs from a domestic perspective (measured in local currency). What happens if we convert the numbers for the US and the UK into Euros?

Now the story is very different for the UK and the US. In both cases their exchange rate has depreciated significantly. In the case of the US it is a trend that started in 2000 when he Euro reached its minimum (about 83 cents of a dollar). In the case of the UK, the pound retained its value relative to the Euro until the recent crisis when it collapsed. By 2009, and measured in Euros, the unit labor costs of the UK look similar to that of Germany. In the case of the US they look even lower because of the large depreciation of the dollar relative to the Euro since 2000. Let's not forget that despite the fall in the US dollar, the current account of the US still had significant deficits during all those years.

What I learn from this analysis is that from a domestic point of view, ignoring exchange rates, what happened in Germany in terms of labor costs was very unique. No other country looks like Germany and whether we look at Southern Europe or Northern Europe or we go to the UK or the US we get a similar evolution of labor costs. When you add the exchange rate we find that in the case of the UK and the US, during these years the depreciation of their currencies have made the labor costs fall when measured in foreign currency. How sustainable is this trend is unclear. We have already seen the Euro falling relative to its peak but about 20% which has undone some of what we see in the picture above (the picture above finishes in 2009 when the Euro was higher in value than today).

Antonio Fatás

S&P warning or warning about S&P analysis?

The fact that S&P is now issuing a warning to all Euro countries regarding their sovereign ratings is not a surprise. All these governments are facing difficulty managing their fiscal policy so there is a potential risk in government bonds, a risk that maybe we have been ignoring for too long. And the behavior of S&P is consistent with their earlier practices: Japan or the US are not AAA in their ratings and they seem to like to make announcements around specific events so that people listen to what they have to say.

What is more surprising is that their announcement made it to the front page in all newspapers and seemed to be moving markets. I did not learn much from their announcement except that I confirmed my earlier impression that rating agencies have very little to say when it comes to sovereign debt. Their analysis is shallow and in many cases misleading or even wrong (e.g. in their recent calculations regarding the US fiscal outlook). They are also the same agency that was mispricing risk in the years previous to the crisis. I did a random search of their assessment of the mortgage risk market in 2006 and I found the following document regarding GMAC mortgage corporation:

The rankings for GMACM as a Residential Special Servicer and a Residential Subprime Servicer are affirmed at ABOVE AVERAGE. The rankings reflect the company's experienced management team and staff, comprehensive and effective policies and procedures, pervasive internal control environment, sophisticated technology platform, and comprehensive standards for monitoring key performance metrics. GMACM continues to be a highly efficient loan servicer for a wide variety of residential mortgage loan products and investors. GMACM's management team effectively minimizes portfolio risk through strong internal controls, well-defined risk management methodologies, proactive default management policies and practices, substantial technology enhancements, and effective business strategies. Management continues to execute its business paradigm of strategically aligning various servicing functions with its human capital resources to maximize servicing performance, develop platform-wide best practices, enhance technology, and minimize employee turnover through enhanced career-pathing opportunities. (January 2006)

Sounds good. Too bad that they had to be bailed out by the US government a couple of years later.

And S&P was also the same rating agency that was very pleased with fiscal policy in advanced economies during the years when it was really badly run (during the good years when we should have seen s healthy surplus).

And do not panic if they downgrade all the Euro government bonds, we still have Liechtenstein rated AAA. And if you get tired of government bonds you can invest in the gold market. Visit the S&P web site today and right there were they have their announcement on the warnings to Euro governments you can also find a great video explaining how Gold has dropped to a strong support area, picture below for your entertainment - I wondered if they used a similar graphical analysis to calculate the probability that the German government will default on its debt obligations.

Antonio Fatás

Internal Devaluation German Style

When countries are members of a single currency are, such as the Euro, they cannot depreciate their currencies to boost their exports. The only way to produce the equivalent of a depreciation is to keep costs growing at a lower rate than other countries. This can only be achieved through wage moderation - not in absolute terms but relative to productivity growth. This is sometimes called an internal devaluation and it is normally thought as being more difficult to achieve than a straight devaluation or depreciation of the currency because it involves changes in wages.  Many see this today as a challenge for Souther European countries as they might have been losing competitiveness relative to the other Euro countries and now they cannot just use their exchange rate to gain it back.

The recent OECD economic outlook talked about all this and had a chart that I am reprinting below.

The chart shows unit labor costs of selected Euro countries. The striking pattern of the chart comes from Germany. Germany managed to keep unit labor costs constant while all other countries in the chart saw increasing labor costs since the creation of the Euro. It is important to notice that this is not just about the usual suspects, France looks very similar to all the "club med" Euro countries. What is really remarkable is the behavior of Germany!

What I find interesting in this chart is that with the creation of the Euro, Germany managed to "engineer" such an increase in competitiveness while it did not manage to do it when it had its own currency. The German Mark, as any of the other large currencies in the world (the US dollar) fluctuated in directions that might not always have been in the interest of the country. In that sense, one could argue that Germany had a stronger control of its real exchange rate post-1999 than before. Of course we are talking about the intra-Euro exchange rate. Relative to the US, there is still an exchange rate that Germany cannot control: the Euro/Dollar. And this runs contrary to the way we normally think about exchange rates. It is when you control your own currency that we assume that you can better to influence your real exchange rate.

Just to complement the chart above, I produced two additional charts with the behavior of exports and GDP (both in real terms) during the same period. There are, of course, many other factors that affect these two variables but it is interesting to check what happened to both during the same years. Did Germany benefit from the behavior in unit labor costs?

When we look at exports we see that Germany did better than any of the other countries, although the behavior is not as extreme as one would expect from the behavior of unit labor costs. When we look at GDP then Germany is not an outlier at all and in fact it is one of the countries with the lowest performance during these years (only Portugal and Italy performed worse). There are reasons why we do not expect Germany to grow faster than the other countries (Germany has a higher GDP per capita than all of them) so the absolute comparison might be misleading but it still provides a sense on how the behavior of unit labor costs was reflected in economic activity and exports.

Antonio Fatás

No bailout, just monetary policy: ECB versus US Fed

We enter yet another interesting week in Europe with the same discussions on how high interest rates will be in Italy or Spain, rumors on a possible IMF program for Italy (doubtful) and pressures on the ECB to do more. So far ECB officials argue that "bailing out" Euro governments will violate their legal framework and it is a bad idea. Without going again into the arguments of whether the ECB can and should buy Euro government debt, here is a quick comparison between the US Fed and the ECB in terms of holdings of government debt.

The chart below measures the holding of US government debt at the US Fed and Euro government debt at the ECB. They are measured in billions of local currency (USD for the US, EUR for the ECB).

If you look carefully at the last months you see a small increase in the ECB holdings that reflect their recent  attempts to bring some stability to financial markets and keep bond yields under control. But how does it compare to the US Fed actions over the last two years?

Let's first compare the end point. Today the US Fed holds about 1.7 trillion of US government debt. This represents about 11% of the 15 trillion of outstanding US government debt. For the ECB, the holdings of government debt are about 550 billion (EUR), which is less than 7% of the total outstanding debt of Euro governments (around 8.3 Trillion).

If we look at the evolution over the last years we can see that from mid-2009 the US Fed has doubled the holdings of government debt. If we use 2008 as the starting point then we are looking at an increase of more than 300%. The decrease in holdings of government debt in the years 2008-09 corresponds to the period when the Fed was exchanging treasury bills against other assets such as MBS.

The ECB has also been increasing its holdings of government debt. From 2008 to today it has increased its holdings by about 66%. But this increase is not that different from the previous trend and there seems to be very little change during the crisis except in the last months.

The actions of the Federal Reserve are part of its monetary policy strategy and not an attempt to provide a hidden bailout to the US government (not everyone agrees on this but let's leave that discussion for the future). The comparison between the two central banks and the fact that the ECB is so reluctant to consider a similar action in the current environment where financial and macroeconomic stability are at risk makes the ECB decision even more difficult to understand.

Antonio Fatás

Ratings deflation: a world without AAA bonds?

First it was Greece, then Portugal, Ireland, Spain, Italy and France and Germany are maybe coming next. It seems that soon there will be no Euro countries left with AAA rating. Japan lost it a while ago and the US could follow when the next super-committee does not agree on what to cut or which taxes to increase. What happens if all countries lose their AAA-rating?

We know that in some cases we know that the impact of going down in the ratings is minimal - as it has been in the case of Japan where the government keeps funding very large deficits at low interest rates.

But what is more interesting, given current circumstances, is whether the rating can be seen as an absolute measure of the probability of default or a relative one. If you check what agencies say, they will not give you a definite answer to this question.

To the question "Are Credit Ratings absolute measures of default probability?", Standard and Poor's answers:

"Since there are future events and developments that cannot be foreseen, the assignment of credit ratings is not an exact science. For this reason, Standard & Poor’s ratings opinions are not intended as guarantees of credit quality or as exact measures of the probability that a particular issuer or particular debt issue will default."

Which is not too informative. And then they add:

"For example, a corporate bond that is rated ‘AA’ is viewed by Standard & Poor’s as having a higher credit quality than a corporate bond with a ‘BBB’ rating. But the ‘AA’ rating isn’t a guarantee that it will not default, only that, in our opinion, it is less likely to default than the ‘BBB’ bond." 

This is more informative but not much of a surprise: One would hope that at least the relative ranking of ratings says something about the relative default risk.

So if ratings are relative and they are all going down (deflation has also reached rating agencies), it might not matter much for investors. This might be a signal that the world is more volatile than what we thought, and this is not good news, but as long as nothing else look safer than these bonds, it might not change much the portfolio strategy of investors.

There is however a risk: that investors seek safe returns somewhere else. This happened to some extent in the period 2003-2007 where investors looked for returns in assets other than government bonds because of their low yields. And financial markets were very good at creating assets that offered higher returns and that apparently where as safe as government bonds. But we know that this story did not end very well.

We can imagine going forward a world where investors move away from government bonds not so much because of low yields but because of the perception of risk, and theysearch for yield in assets that appear less volatile or where the expected return more than compensates for the potential risk. We have seen this behavior in the gold market, the exchange rate market (with the Swiss Franc until the central bank said enough). But if deflation in ratings continues it is very likely that we will see similar phenomena in many other markets.

Antonio Fatás

Solvency or Liquidity? (r-g)

As we continue seeing interest rate spreads increasing in the Euro area, we keep asking the question of whether this is a crisis of solvency or liquidity. The fact that interest rates keep increasing makes it more difficult for governments to meet interest payments, and solvency becomes more likely. If default happens we might never find out what type of crisis we had. Were governments insolvent? Or did the high interest rates and lack of funding pushed them into default? And if we cannot tell ex-post, how can we tell ex-ante (now!)?

Let me look at some historical facts to understand the potential scenarios these countries are facing. After my previous post on Italy, let me look at Spain today, one of the countries that is also seeing spreads rapidly increasing.

The way we normally look at the question of solvency is by asking what type of effort the government needs to do to keep the debt under control. The typical benchmark is to look at the current ratio of government debt to GDP and think of scenarios where this ratio remains constant. In the case of Spain, this ratio is 60-67% measured in gross terms and 48-56% in net terms. The range corresponds to the number for 2010 and the forecast by the end of 2011. Let's just use 65% as the relevant ratio.

To keep this ratio constant, the Spanish government has to deliver a primary balance which is equal to the difference between the interest rate it pays on the debt (r) and the growth rate of GDP (g) multiplied by the debt to GDP ratio [Note: the primary balance is the difference between revenues and spending excluding interest payment on the debt].

With a simple formula: to maintain a stable debt-to-GDP ratio you need a primary surplus of

(r-g)  Debt/GDP

Interest rates and growth rates have to be measured in the same units so we either measure them in nominal or real terms. Let me choose nominal rates. 

Some facts: In the period 2000-2011, average nominal growth in Spain has been equal to 5.23% (out of which 2.17% was real growth). If we exclude the crisis years (2008-2001), average nominal growth was as high as 7.46%. 

I am focusing at the post-Euro years as we want to avoid looking at a different monetary policy framework, but just for the sake of understanding history, in the previous decade (1988-99) Spain grew at a rate of 7.73 in nominal terms and 3.11 in real terms.

What about interest rates? Currently the Spanish government is paying about 4% on average (even if on the margin they are facing rates closer to 6%). If Spain managed to maintain rates at 4%, the required primary balance is

(4% - 5.23%) x 65% = -0.74%

So a deficit of 0.74% will do it. This does not look that different from actual numbers. Over the period 1999-2011, the government primary balance in Spain was -0.57%. If we exclude the years of the crisis and focus on the expansion 1999-2007, the primary balance was +2.24%, a significant surplus. 

In other words, if Spain faced an interest rate of 4%, and even if within the next decade they experienced another massive crisis with four really bad years (as bad as 2008-2011) in terms of low growth and large deficits, the debt to GDP ratio would still remain at 65% ten years from now. "Business as usual" would do it. This is a very conservative scenario where we are asking no change in policies to the Spanish government.

Is 4% a reasonable interest rate? No if you look at markets today. But here is where the self-fulfilling nature of the crisis comes in. The relevant question to me is whether can we build a scenario for Spain that is conservative in terms of growth and fiscal efforts coupled with rates which are not too far to a risk-free rate, and where we feel that we can guarantee with almost 100% confidence that the debt will remain stable. If this scenario is possible, then the interest rate of 4% is justified because we are looking at a world of no default. 

Of course, if we start with an interest rate of 15%, then all the calculations above will send you in the direction of default, which would justify the high interest rate we started with. 

But if both scenarios seem plausible then we are facing multiple equilibria and we need to find a way to coordinate to the good one, the one without default. Looking at last week, it seems that we are going in the opposite direction. So it looks like the only way out is for all of us suddenly become optimistic, or the ECB steps in and helps us coordinate to the good equilibrium.

Antonio Fatás


Update: And Paul Krugman is also puzzled about interest rates in Euro countries when you compare them with fiscal policy outcomes in those countries. He cannot understand how interest rates for Austrian government debt remain so high giving its low debt, low unemployment and a current account surplus.

The not-so-original sin of finding others to pay for it.

Paul Krugman talks about the causes of the current sovereign default crisis in terms of what economists call "the original sin". The concept was developed to describe situations in which a country borrows in someone else's currency. When faced with a crisis, large devaluations of their exchange rates make the value of debt increase, which leads to default and possibly a deeper crisis. Krugman argues that a similar logic applies to Euro countries today: Italy has borrowed in a currency (Euro) that they do not control and this is a problem. If Italy had borrowed in their own currency they will always be a way out of a high debt situation: printing more Italian Liras.

Let me take a step back before I comment on how the "original sin" applies to Europe. What is a government default? Government debt is a result of spending decisions that have not been financed with tax revenues. If government debt is to be paid back it simply means that some future tax payers will pay for the spending done in previous years. If debt is not paid back and government defaults, it is simply a shift in the burden of paying for the debt from current and future tax payers to someone else (bond holders). In that sense, default of a government has nothing to do with default of a company where we tend to think about a failure of a business model. It is simply about finding someone else to pay for our spending, not tax payers.

But who else will pay for it? In a closed economy (no international trade or capital flows, think about the world), it is not obvious to find "others" who will pay for our spending. You can shift the burden from tax payers to bond holders but in a closed economy both are citizens of your country, in some cases they are the same individuals. No economy is closed but some do not look far from this example. Below is a chart comparing Greece and Japan in terms of who holds their government debt (domestic versus foreign investors).

In the case of Japan, most of the Japanese government debt is held by Japanese citizens. If the government of Japan defaults it is equivalent to sending a tax bill to only bond holders. But they are Japanese tax payers so there is very little difference between default and taxes, there is no choice! I am, of course, simplifying what is a more complex situation: not every tax payer in Japan has an amount of government bonds which is proportional to their income and Japan is an open economy but to a large extent we are talking about a redistribution decision. The comparison to Greece is a good way to understand that the trade offs and consequences of a decision to default are not the same for Greece. Greece can potentially pass the burden to others (foreigners) who are currently holding its debt.

Back to the "original sin" discussion. When a government borrows in its own currency, there is a third alternative to taxes and default: printing money. Conceptually, it not different from the other two: you need to grab someone else's resources. Printing money leads to seignorage via inflation and  this is an alternative source of income that can be seen as a tax on those whose assets are denominated in nominal terms. Some of these individuals are also tax payers, some are the ones who are currently holding your bonds, so you might be passing the bill to the same people but in different proportions (as in the Japanese example).

At the end of the day, default, taxes or seignorage are three ways to pay for the spending governments have already done. They are not that different conceptually. In a closed system there is no way to avoid grabbing resources from your own citizens - in some sense deciding between the three choices is simply a redistribution decision. In an open economy you might be able to grab resources from other countries by defaulting on debt held by foreigners. Although conceptually similar, each of the three methods differ in terms of the political consequences or even feasibility. Passing the bill to foreigners will tend to be easier from a political point of view although it will have more damaging effects in terms of credibility. In some countries raising taxes is more feasible than creating inflation. In other cases it will be the other way around. From an economic point of view it might be that the same individuals end up paying the bill but sending them a bill in a different format or color just happens to be easier.

Antonio Fatás

Italy: not good but we have seen this before

It is hard to find much optimism by looking at the Italian economy today: Low growth, high government debt, limited confidence of financial markets and no government. Pick a random newspaper or economics blog today and the tone will be on a range from mildly pessimistic to catastrophic. I will not repeat their arguments and instead I will do my best to be a contrarian and argue that maybe it is not as bad as it looks. Or maybe it is, but Italy has managed to live with such a bad situation for years so there is some hope. This might not be enough to turn you into an optimistic but at least it provides a perspective to how similar episodes ended.

Below is the Italian government debt expressed as % of GDP. There are two lines, the gross and net values of government debt. Net debt is a more appropriate measure as it takes into account some of the financial assets that the Italian government owns and it is equivalent to what is referred to in the US as "government debt held by the public". I include gross debt as well because the "net" measure is noisy and some times unreliable so some prefer to focus on gross debt. 

When we look at gross debt we see that Italy is now back to where it was in 1994. If we focus on net debt the current level of debt is significantly below what it was in 1994. So Italy has seen similar or higher levels of debt before.

We can then argue that those times were different, that Italy had its own currency (although it was heading towards the Euro) and that a combination of high inflation and fast growth allowed them to stabilize that high level of debt.

Certainly it was not growth what saved them. GDP growth in Italy has been low during this period of time: the average growth rate for the period 1994-2007 was 1.6%, clearly below the growth in other Euro countries (France grew at 2.6% and Spain at 3.6% during the same period of time).

What about interest rates? Maybe the government of Italy did not face the high interest rates that they face today? Below is a chart of the 10-year interest rate for Italian government bonds.

As it is clear from the chart, financial conditions back in 1994-1995 were extremely difficult for the Italian government with nominal interest rates as high as 12%. Much higher than the current levels of 6-7% that look as unsustainable. Of course, what matters is not nominal rates but real rates (what really matters is the difference between interest rates and growth but I do not have that chart ready in my computer). Below is a chart with real rates that confirms that interest rates today remain low compared to the ones faced by Italy in 1994-95.

Here is what I learn from the previous three charts. To my surprise, and the surprise of many, Italy has managed to sustain a very high level of debt even when facing high interest rates by generating large enough primary surpluses. And it has done so with a political environment that has been volatile and in some cases driven by very poor choices. Does it mean that they can keep going like this forever? No, there might be a sense of fatigue and maybe the end of what it looks like an unstable model. But, at the same time, it is interesting to see when we look back at history that a similar episode did not automatically  lead to default even with poor economic policy choices. And if you want to be even more optimistic, there is some hope that this crisis is not wasted and the future Italian government finds an even better way to manage a very difficult situation.

Antonio Fatás

Europe versus the US: Fight!

Comparing economic performance in Europe and the US is always interesting and in some cases controversial, especially when politics enters the debate. European politicians blamed the US for causing the 2008-09 crisis and now it is the turn of the US politicians to blame the Europeans for their inability to handle the sovereign crisis.

Jeff Frankel has a nice blog entry comparing the performance of Europe and the US today under the title "Who is screwing up more: Europe or the US?". Not easy to make that call.

Some of the European economic problems come from the bad performance of politicians. Given that Italy is at the center of the crisis today, one wonders how a former G7 member and an economy of around 2 trillion dollars has been under the direction of Silvio Berlusconi for so many years...

But given that this post is about the competition between Europe and the US, we can check how some of the large US states (similar in size to Italy) compare in this respect: California (about 2 trillion dollars) has been led by Arnold Schwarzenegger for years; and the current governor of Texas (an economy of about 1.3 trillion dollars) is Rick Perry - the one who cannot remember the three government agencies that he plans to close if he becomes president. In case you have not seen the video, here it is:



But there is hope: Berlusconi is on his way out and it looks as if Rick Perry will not be the next US president.

Antonio Fatás

Plan B for Europe: Do not Stare Into the Abyss.

Everyone is running out of hope regarding a solution for the economic problems in Europe. A change in government in Greece, the possibility of Berlusconi stepping down are not enough to bring confidence to markets or the public. In the Econ Blogosphere we only see increasing pessimism: Mark Thoma, Barry Eichengreen, Paul Krugman, and many others.

Tim Duy makes the point that so far stock markets, in particular, Wall Street is ignoring the risks that are building in Europe. He draws an analogy to what was going on in 2007 when stock markets were still booming and ignoring the fact that we were literally looking into the abyss but we could not see it. He believes that today Europe is unable to see the abyss ahead of them and Wall Street is ignoring the problem assuming that it will not hit the US.

But what does the abyss looked like in 2007? In 2007 we had built a set of imbalances on asset prices, in particular housing prices that had supported a different imbalance, on spending and debt (private and or public). While some did not want to see the abyss, those who saw it were looking into a fall in asset prices, financial disruption and a sharp fall in economic activity. 

What does the abyss look like today for Europe? We know with certainty that there will be partial default in Greece, but as I have argued before this does not qualify as an abyss (for Europe). It is a bump on the road, maybe a big one but not large enough to justify a deep recession in the Euro area. The fear is about others following, in particular Italy and Spain. But here is where the 2011 abyss looks very different from the 2007 one: this time the crisis is much more linked to confidence. In 2007 the adjustment in asset prices was unavoidable. Today, we debate about whether the Italian government or the Spanish government are solvent and the answer is much less clear. Why? Because solvency depends on confidence and confidence depends on how we see solvency. If Italy keep losing the confidence of markets, as it is happening today, then they are insolvent, too big to fail but too big to be rescued. 

So if we keep staring at the abyss, we are just making it deeper. And the deeper the abyss is, the more we want to stare into it. 

So the solution is to stop staring into the abyss. Given where we are today there is only one way to do that, to have the ECB taking a very aggressive stance on how they are willing to support the governments of Italy or Spain if their interest rates keep increasing. Communication from European governments, over stretching the EFSF is not going to be enough anymore, you need the ECB to stand between us and the abyss so that we stop staring into it.

Antonio Fatás

It is not Greece, it is Fear.

I made this point before when I discussed the exposure of a French bank (Societe Generale) to Greek debt  in comparison to other losses such as the loss that a single trader (Jerome Kerviel) caused to that bank back in January 2008.

Today I see that Societe Generale released the results of the third quarter of 2011 and that comparison has become even more interesting. In a balance sheet of about EUR 650 bn, exposure to Greek government debt is as low as EUR 575m. Exposure to the government debt of Ireland, Portugal, Spain, Greece and Italy combined is "only" EUR 3.4bn. This combined amount remains below the loss caused by Kerviel back in 2008 (about EUR 4.9 bn).

(Note: there is nothing specific about Societe Generale in this analysis. I just picked it up as an example of a large French bank. I assume that others look similar.)

Antonio Fatás

Politics: the beginning and the end of the Euro

As much as economists have been wondering for years about the economic benefits and costs of sharing a currency, such as the Euro, the decision to create the Euro area and to be one of its members has always been a political one. As an academic, I have written about the costs and benefits of sharing a currency and my work has led me to the belief that, in the case of the Euro, the benefits outweigh the costs. When I have had an occasion to present my work in this area to those in charge of making the decision (politicians) I always realized that economic arguments matter very little when there are political constraints.

As an anecdote, back in January 2010 I wrote a chapter for a book about the 10 year anniversary of the Euro and the lessons for countries such as Sweden that stayed out of the Euro area. Anders Borg (Swedish Finance Minister) was in charge of commenting on our book and he made it very clear that from the point of view of economics there was no doubt that Sweden belongs in the Euro area but that we need to wait for the "right timing" (a similar position, although less explicit, is held by the UK government with their entry tests). And the right timing is decided on political grounds and not so much on economics. Given the current Euro crisis, it is likely that the timing of entry of any of these countries has just moved into the very distant future...

The countries that are part of the Euro area joined under different political agendas. There is the core (France, Germany) who has been driving European integration through the years (for reasons linked to the end of WWII). There is the periphery (Greece, Spain) who wanted to be like the core. With relatively low income per capita, their societies aspired to converge not only in terms of development but also from an institutional point of view to the levels of the rich Euro partners. And this was the reason why these countries supported every step of European integration, including membership to the Euro area.

And now are looking at the possibility of exit. In the last months, when I have been asked whether Euro exit was a possibility I have always said that it would be economic suicide for any country to leave the Euro area. But economic and political incentives are not always aligned and I have also argued that I could imagine a country leaving the Euro area if the political dynamics of the country produce a potential referendum where the question of Euro membership is simply read as "us versus them". In that environment you could imagine a country leaving the Euro area simply because its citizens have lost faith in the European project and the other countries are seen as enemies not allies. This has happened in recent times in Europe, where a referendum (about the Maastricht Treaty or the European constitution) was turned down in several countries and the only thing the European politicians could do is to repeat the referendum over and over again until it was approved...

Today the Greek government has surprised other Euro members and financial markets announcing a referendum on the last Euro bailout plan. This can be the end of the Euro, at least in some countries. Given the difficult economic situation in Greece and Europe, a "No" vote is not just possible but very likely. And while the vote will be just on the details of the plan, it will be seen as a referendum on the Euro. And this time there will be no second chance to repeat the vote if we do not like the outcome. And my fear is that just the announcement of a vote and the anticipation of that scenario might lead to a crisis months before the referendum takes place.

Antonio Fatás

Being pessimistic to build optimism

The new European plan to deal with the potential of sovereign default and the increasing doubts about solvency of financial institutions was announced two days ago. Financial markets so far seem to like the plan. The plan did not provide many surprises, it was very much what was expected. Maybe the surprise, to some, is that there was an agreement on the plan.

One issue that was debated in the preparation of the plan is how to account for potential losses derived from default on sovereign debt when doing stress tests on banks.

But here is a problem: European governments want to send two messages:

1. No default will ever take place in Italy or Spain.

2. Financial institutions are safe, they have enough capital.

But how do you build a capital buffer for banks that convinces markets? By being pessimistic and consider scenarios where things really go wrong. When doing this exercise there is a big difference between losses on sovereign debt and losses on other loans. For other loans one can imagine different macroeconomic scenarios where housing prices or GDP are more or less affected and this leads to a certain % of loans going bad. The disagreement can be on how pessimistic you want to be but conceptually we all understand how the different scenarios are being built.

When it comes to sovereign debt, there is something much more problematic. Will governments default? According to market prices there is a significant probability of default by several European governments. According to European governments this will never happen. But we heard that before about Greece...

In the current situation, whom you believe is going to determine the fate of some of these governments. If market participants believe Italy or Spain will default then their interest rates will keep increasing and those two governments will not be able to sustain their current debt levels. But if there is trust and interest rates remain low, they have a higher chance of surviving. Expectations are key and both outcomes are possible. If we all become pessimistic we end up in a self-fulfilling crisis.

Being pessimistic when doing stress tests on financial institutions is a way to generate confidence. We build a capital buffer that is large enough to deal with any possible crisis. But if you send a pessimistic message about sovereign debt then you cannot achieve the first goal! How do you strike a balance?  This is what the Europeans have done: they have built a capital buffer to deal with potential loses derived from default by Spain or Italy. But then they turn around and they tell us that this buffer should not be seen as a validation of the assumption that these countries will default because they will not!

In the words of the EBA (European Banking Authority):

"The objective of the capital exercise is to create an exceptional and temporary capital buffer to address current market concerns over sovereign risk. This buffer would explicitly not be designed to cover losses in sovereigns but to provide a reassurance to markets about banks’ ability to withstand a range of shocks and still maintain adequate capital."

So this buffer is not designed to cover losses in sovereigns but to provide reassurance to markets. This is a explicit statement that we are dealing with a crisis of confidence and we are trying to combine both optimism (about sovereign debt) with pessimism (when it comes to building a large enough capital buffer) in order to improve the confidence of markets. Not an easy exercise.

Antonio Fatás

Spot the Euro effect

The role that the Euro plays in the current crisis in European countries is a source of debate. Some see the Euro as the main reason why we find ourselves talking about sovereign default in Europe. Brad DeLong goes as far as saying that "A Greece can only happen to a country that does not control its own currency" (although he knows well that history is full of sovereign defaults of countries that controlled their own currency). Paul Krugman mentions the experiences of Iceland or the UK as examples to Ireland or Greece or Spain where a currency that is allowed to devalue can help GDP grow, which will help making debt sustainable.

I will not dispute the theoretical argument that a flexible exchange rate can be a tool to smooth business cycle fluctuations but I fail to see that the data speaks so much against the Euro experience. I can entertain the argument that some of the constraints of the Euro are not helping Europeans to find a solution, but when I look at the data, it is not easy to see a dramatic effect coming from the fact that the exchange rate is not allowed to move.

We could compare GDP growth rates but there are too many factors that affect GDP. What if we simple focus on the contribution of exports to GDP? Why exports? Because we normally think about exports as being affected by foreign conditions (which are similar for all these countries) and the real exchange rate. If we were to look at imports then domestic conditions would matter as well and we would have to control for other factors. If the exchange rate is a significant part of the crisis we should expect countries that are constrained by Euro membership to show a worse exports performance than those that let their currencies depreciate.

The first chart below plots growth of exports (volume) for Portugal, Greece, Ireland and Spain (countries that are part of the Euro) as well as Sweden and the UK (countries that decided to stay out of the Euro and saw their currencies depreciate during the crisis). The second one simply aggregates growth rates over time to compare levels of exports where 2005 is equal to 100.

It is not easy to see the Euro effect in these pictures. While it is true that Greece is the worst performer and Sweden one of the best in this sample, the same is not true for the other Euro countries. In comparison to the UK, exports growth in Portugal or Spain or Ireland are similar. In addition, if we were to choose 2008 as the starting date, there will be even more similarities in the sample. To transform these charts into a proper test I would like to control for the mix of exports of each of these countries but I do not have a strong prior why this should bias the picture in our or another direction.

So I remain less pessimistic about the Euro than other econ-bloggers out there. Not that I deny the constraints that a fixed exchange rate introduces but I cannot see as clearly as they do that the Euro is largely to blame for the European crisis.

Antonio Fatás

Calvin might not get a bailout next time.

Via James Furbush I see an old cartoon (ten years, some things do not change) from Calvin and Hobbes that explains how bailouts work (click on the picture below for a larger image).

This reminds me of the panel discussion at the Boston Fed conference I attended this week with the title "Will the Federal Reserve be able to serve as a lender of last resort in the next financial crisis". In the panel, Martin Feldstein, Simon Johnson, James Segel and Donald Kohn shared their views on the issue. The unanimous answer to the question was "no". With the introduction of the Dodd-Frank reform and the current political climate, it is impossible to imagine the Federal Reserve doing what they did in 2008 and 2009.

From a legal point of view, the Dodd-Frank reform modified the Federal Reserve Act in several ways. In particular, there was section 13(3) that allowed the Federal Reserve to do emergency lending to "individuals or corporations" other than banks. This was the section used for the money that went, for example, to AIG. That section has been modified and now there is no direct lending to an individual or a corporation other than a bank. It has to be part of a program or facility where the individual or corporation participates. So the flexibility is now more limited and it might take time to put such a program in place. In addition, credit cannot be extended to an organization that is failing, only to those that are short of liquidity. This is a good point but how can you tell whether it is a failure or shortage of liquidity. And, finally, many of these steps will require congressional approval. This is a key issue. Given the current political climate, it means that things will have to get much worse than last time before the congress ever approves any necessary funding.

Ideally you want to set conditions for crisis and bailouts never to happen. And part of what the Dodd-Frank legislation is doing goes in that direction. But you still need to think about events that will require the central bank to act as lender of last resort. And these events require flexibility but they also require transparency and accountability (in a democracy). But finding the balance between the two is not easy. The discussion in the panel gave me a clear impression that in the US the balance has now tilted too much in the other direction. By reducing the power of the federal reserve to act as a lender of last resort, we do not have the same ammunition as before to handle these crisis. I am all for avoiding bailouts that allow institutions and their managers to benefit from any upside and pass the downside loses to the taxpayers, but we need to be realistic and understand that in some occasions saving failing or illiquid institutions might be necessary.

Antonio Fatás

Ben Bernanke and Headlines

I am spending two days at the Boston Federal Reserve Bank for their annual conference (schedule and papers can be found here). Chairman Ben Bernanke stopped by today and gave a speech to participants about recent monetary policy issues. The press was around so his speech was scripted with very few surprises. It was a nice summary of what we have learned about monetary policy over the last decades: the importance of flexible inflation targeting, the use of balance sheet measures when interest rates are zero, etc Very pedagogical as you would expect from an academic.

At the end of the speech I wondered how the press would summarize what he said and, more importantly, how they would choose a headline for the news. He made the job of the press very difficult by giving a very clear and balanced view on monetary policy, no surprises, no shocks. But you need a headline so here is the one from CNBC: "Fed may need to halt future asset bubbles: Bernanke". I am not sure he said that. He did talk about asset bubbles and, to be honest, he did not say anything that was that different from before: monetary policy is not the right tool to deal with asset bubbles but if the other tools do not work, it might be that the central bank has a role to play. Other central bankers probably share the same views (Jean Claude Trichet made similar remarks about a year ago), although there will always be some resistance to use interest rates to stop asset price bubbles -- as a reminder here is a post I wrote about two years ago in response to a paper by Adam Posen, a member of the Monetary Policy Committee of the Bank of England.

By the way, here is the video of the speech in case you want to hear his words.



Antonio Fatás

Minimum Wage and Unemployment

As I am reading the most recent post in Greg Mankiw's Blog, I find the data he presents intriguing. He is comparing two years (2007 and 2010) to show that workers being paid the minimum wage has increased, measured as a % of all workers, from 2.3% to 6%. In those years the federal minimum wage increased from $5.15 to $7.25 in nominal terms. Greg is asking his students to evaluate the link between the two. As one of his former students I feel obliged to look at the data in more detailed to see what I can say.

My quick reaction is that there is an automatic relation between increasing the minimum wage and the % of individuals who are paid that wage. If we assume that firms keep employment constant and simply pay the higher wage, this increase will simply be those who were paid in between the old minimum wage and the new minimum wage. There is the possibility that some workers are fired, in which case the increase would be smaller.

My second reaction was about the fact that the period 2007-10 is special. Not only we have seen an increase in the minimum wage but also a deep recession. It is possible that some wages have fallen and old employees have been replaced by new ones who are now paid a lower wage - right at the level of the minimum wage. This would also cause an increase in the number of workers paid the minimum wage. But, of course, there is a potential second effect of a recession going in the opposite direction: it can be that during recessions those who lose their jobs are workers that are being paid lower wages and, as a result, you might see the percentage then decreasing as opposed to increasing.

So I was curious to see how this figure - the % of workers being paid the minimum wage- has changed over the last business cycles and whether this could also be behind its recent increase.

So I plotted three variables from 1979-2010. In blue you see the % of workers paid minimum wage (Greg's variable). As we can see this percentage has been decreasing since 1979. In that downward trend we also see three spikes: around 1991, around 1997 and 2008-10. The shape of this line, including the spikes correlate very well with the minimum wage (in green). It is measured in real terms (1996 dollars) and the scale is on the right hand side of my chart (the scale does not start at zero to see some meaningful variation). The real minimum wage has also been decreasing since 1979. A decrease that has been interrupted with increases in 1991, 1997 and 2007-09. These three increases coincide with the spikes in the blue line, the % of workers being paid the minimum wage. So the mechanical explanation is very visible in the chart, as you raise the minimum wage you see more workers being paid that rate.

What about the business cycle or labor market conditions in general? The unemployment rate is in red (left hand side axis). Interestingly, the unemployment rate, or the business cycle more generally, is also correlated with the blue line. Recessions are period where we generally see spikes in the blue line. Although there is an exception, the recession of 2001 saw unemployment increase without any change in the % of workers that were paid the minimum wage.

The difficulty in the figure above is that there is a correlation between the three variables and it is difficult to establish causality or assess the strength of each of the two effects. Two of the last three increases in minimum wages are not far from recessionary episodes which makes it very difficult to understand the potential role of the business cycle [Yes, there is a possible reading of those episodes as an increase in the minimum wage causing the recessions, but as we know well this is not what led to the 1990 or 2007 recessions].

One thing that might tell the two factors apart is to realize that we have an episode of increasing the minimum wage without a recession (1997) and we still see the mechanical effect very clearly; and we also have a recession (2001) without and increase in the minimum wage and the blue line does not change much. So based on that evidence it seems that the business cycle effect is not as visible as the simple mechanical effect of raising the minimum wage.

[For those who like econometrics: A more formal, but still very weak, test is to run a regression to see which of the two variables is more significant when put in a regression. The race is won by the minimum wage. Both the minimum wage and unemployment are significant when used in a regression by themselves. When you include them together only the minimum wage is. This regression is, of course, full of econometric problems because everything is endogenous, so still no causality inference can be made.]

Antonio Fatás

Who pays for the debt overhang?

High levels of debt by governments and households are a constraint on how fast demand can grow today. Even if the economic fundamentals (productivity, labor market) were unaffected by the crisis, an environment where everyone wants to save cannot be conducive to growth. Production needs to be sold and for that you need customers. Even those who are not very sympathetic to economic models where demand drives growth understand the difficulties of growing in an environment of debt overhang (here is Martin Feldstein today on the New York Times).

Default, reduction in mortgage payments are all proposals to alleviate the problem but they come at a cost: your debt is someone else's asset. There are, of course, circumstances where debt reduction is not a zero-sum game, where this is the only way to avoid a spiral of less spending, lower income and even higher debt as a percentage of income. This is what is called the paradox of thrift. There are other circumstances where everyone can benefit from debt reductions. As Martin Feldstein argues, reducing the value of a mortgage can be beneficial to both the individual and the bank:

This plan is fair because both borrowers and creditors would make sacrifices. The bank would accept the cost of the principal write-down because the resulting loan — with its lower loan-to-value ratio and its full recourse feature — would be much less likely to result in default. The borrowers would accept full recourse to get the mortgage reduction.

Of course, the bank would love to get back the full amount of the loan but given that in many cases individuals can walk away from an underwater home, a reduction in debt is the best the bank can get. In this case we can argue that it is even in the interest of the individual bank to strike this deal, so there is no need for co-ordination.

A similar story applies to the debate about default in Greece but the solution is less obvious. Banks do not like the idea of default; they want to be paid back but they also understand that a compromise might be better than fighting to a point where default is even bigger. This is the logic behind the current negotiations between the Greek government, the holders of the bonds and governments (who are behind the potential tax payer money that could go into the deal). And this becomes a very difficult discussion where co-ordination is key. As an example, European banks are likely to find themselves under pressure to raise more capital to absorb potential losses from an orderly default of the Greek debt. But it is costly to raise capital. The negotiations start and you need to get enough public support for your position. Josef Ackermann is quoted today as saying that recapitalization is a bad idea because the cost will ultimately be paid by customers (those asking for a loan). Or worse, the capital will not come from private investors but from public sources, making the government debt problem even worse. Here is the quote from the Financial Times:

On the one hand it [the debate] sends the signal that a [debt] haircut is more likely, and on the other because the resources for recapitalisation will surely not come from private investors, but rather states would ultimately have to raise the funds themselves, thereby worsening their debt levels.

So here we are, in the middle of the negotiation phase. I am sure there is some consensus on why dealing with the debt overhang is good for the economy, now the question is who pays for it. And no one wants to pay for it, so unfortunately there is no consensus there.

Antonio Fatás

The Lost Decade

Will the US economy go through a "lost decade" like Japan went after the burst of the bubble in the mid 90s? This is a question that gets often asked when comparing the current economic environment in the US to the one in Japan in those years. Lots of similarities: a bubble that burst, the fear (or reality) of deflation, a central bank with limited tools at its disposal, etc

But if you want to be really pessimistic, you can also look backwards to the previous decade, a decade that along some dimensions has also been lost. Here are three variables that show a downward (or flat) trend starting abut 10 years ago. No clear link between the three but interestingly a very similar pattern. The US economy showed weaknesses starting 10 years ago. They were not generalized and some measures of economic activity were doing ok, but it is interesting to see how others were not progressing anymore or even heading in the wrong direction starting around 2000.

                        US Stock Market (Dow Jones Index)

Antonio Fatás

Fear (of another recession), not uncertainty.

What is keeping growth in advanced economies from recovering at a speed similar from previous recessions? There are several explanations and which one you prefer might depend on your political taste (see an example of this debate in the US here).

There is one potential explanation that I find is being overemphasized: "it is all about uncertainty". And some make it more explicit and talk about regulatory uncertainty, uncertainty about taxes, about a sovereign default in Europe, etc.

No doubt that uncertainty plays a role in explaining macroeconomic fluctuations and I am a big fan of Nick Bloom's work, an economist at Stanford, who has provided strong evidence that uncertain raises around some of the most recent recessionary episodes.

But what do we mean when we use the word uncertainty to describe the current environment? I believe we are mixing two things: one is that the future is more difficult to predict (and this truly matches the notion of uncertainty) but the second one is that future scenarios are simply worse than what we thought before. This is not uncertainty, this is just bad news.

Here is an example: five years ago most investors would not consider the possibility of sovereign default in Europe. Today there is a chance that it might happen. Has uncertainty increased? Yes. There are now two scenarios (default and no default) and we are not certain about which one will happen. But the real problem is that on average the future looks much worse than it used to! So all the uncertainty comes from the left side of the distribution. This is mainly bad news combined with some increase in uncertainty.

Same applies to other issues where we currently use the word uncertainty: business face uncertain demand but the real problem is that in the scenarios they are considering, most look bad and they have recently gotten worse; there is increased uncertainty about public finances but the problem is not that we do not know how governments will resolve this challenge, the real problem is that governments have a challenge to resolve!

My preference would be to use the word fear rather that the word uncertainty to describe what we are seeing these days. What is really damaging is the possibility of a new recession, the possibility of sovereign default. These are all bad news. On average the future does not look great and this is the real problem.

Antonio Fatás

Kerviel versus Greek government debt

It is all a matter of several billions but as I am reading two articles from the business press today I thought it is nice to compare the numbers on both articles. One is about the exposure of European banks to Greek debt. The other one is the history or recent episodes of individual traders causing massive losses on banks because of unauthorized trading. Here are the two numbers that I find interesting to compare:

1. Loss of Societe Generale as a result of unauthorized trades by Jerome Kerviel back in January 2008: 4.9 Billion Euros.

2. Exposure of Societe Generale to Greek government debt today: 2.9 Billion Euros (this is the total amount of Greek debt they hold).

This is not to minimize the risk of holding Greek government debt but it is useful to keep things in perspective. The real danger in Europe would be one of contagion and the most important task for European authorities is to avoid it. Default in Greece will be painful, but the costs could be contained if it does not spill over to other countries which are substantially larger. George Soros makes this point today in an FT article.

Antonio Fatás

Sovereign default: panic versus fundamentals

There is a growing concern that we are approaching a wave of sovereign defaults in Europe. And if there is default on government debt, it will have an effect on the balance sheets of Euroepan financial institutions and this is the source of the recent concerns about the solvency of some of these institutions.

Stress tests are designed to look at "pessimistic" scenarios to see whether financial institutions have enough capital to deal with them. But stress tests will always have an element of subjectivity. How pessimistic should we be in these scenarios? The IMF has recently expressed their concerns about the need for capital of some European banks because of the possibility of sovereign defaults not priced into some of the stress tests that European regulators have produced. This is a source of debate between European officials, the ECB and the IMF. But what is a good assumption about sovereign default in Europe? How do we measure the probability of default? Should we look at CDS (credit default swaps or should we use interest rates as a measure of default probabilities?

Both of these measures capture the "market" view on default probabilities. A completely different approach is too look at the fundamentals of fiscal policy sustainability (yes, it requires more work but it is always a productive exercise to look at the numbers and not just at how others read those numbers!).

The IMF fiscal monitor (last issue is just out) provides a very detailed analysis of the fundamentals behind fiscal policy. They look at several indicators or fiscal policy risk:

- gross debt as % of GDP (Debt)
- gross financing needs as % of GDP (GFN)
- short-term debt (as % of total)
- the currency deficit (adjusted for the cycle) (CAPD)
- Expected increase in pension spending over the coming years
- Expected increase in healthcare spending over the coming years
- Difference between interest rates paid on debt and the growth rate of output (r-g)

All indicators are straightforward, they look at the past (debt), the present (deficit) and the future (pensions, healthcare) taking into account the cost of borrowing (interest rate) and the ability of the economy to generate growth to keep the debt to gap ratio under a reasonable number. You want all these indicators to be as low as possible.

I am copying below the indicators for some of the countries they analyze (indicators are in the same order as in my list above)

Comparing France and the  US we can see that both countries look risky along several dimensions. Overall, the US seem to score worse than France in several dimensions. Higher level of debt, deficits and more importantly, a larger future burden in terms of pensions and healthcare spending. The only indicator where the US does better is the low interest rates that the US government faces when borrowing in financial markets.

Here are the data from Germany and Spain

They do not look good either although the risks are similar or slightly lower than the ones in the US or France. Levels of debt are lower in Spain, current deficit is lower in Germany. Short-term pressures are similar to other countries and long-term pressures (pensions and healthcare) look better both in Spain and Germany than in the US. The only dimension where both of these countries do worse is when it comes to the difference between interest rates and growth.

In the case of Spain, the issue of credibility is key. If credibility is lost, the average interest rate paid on government debt will increase and will make more difficult to set a sustainable path for fiscal policy (in the chart above the indicator of the right will get higher). But the credibility of a government must be a function of the other indicators. The trust in a government's ability to repay should be a function of the level of debt, future spending, etc. Looking at those first six indicators above for Spain explains why the Spanish government insists that their fiscal position is not as bad as what "the market' believes. If you remove the last column, Spain could be seen as the strongest of the four countries.

But expectations and credibility matter and criticizing speculators might not be enough. What is needed is clarity in communications coming from the European authorities in order to rebuild the faith in the system. And this requires a combination of not denying bad news while at the same time restoring credibility where is needed. They need to try harder.

Antonio Fatás