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

Macroeconomics: Evidence or Ideology

The Wall Street Journal had a weekend interview with Robert Lucas, Nobel-winning economist and Professor of economics at the University of Chicago. He is asked about the economic situation in the US and Europe. When asked about the US he talks about the cost of uncertainty about future taxes. When he is asked about Europe, he talks about the cost of high taxes. From the interview:

For the best explanation of what happened in Europe and Japan, he points to research by fellow Nobelist Ed Prescott. In Europe, governments typically commandeer 50% of GDP. The burden to pay for all this largess falls on workers in the form of high marginal tax rates, and in particular on married women who might otherwise think of going to work as second earners in their households. "The welfare state is so expensive, it just breaks the link between work effort and what you get out of it, your living standard," says Mr. Lucas. "And it's really hurting them."

No doubt that (theoretically) high taxes could discourage effort but is this statement empirically relevant? Below is a chart of marginal tax rates (as estimated by the OECD) and the female employment to population ratio for the age range (25-54) for 2010. I have chosen that particular employment to population ratio because it matches the statement in the quote above (the chart looks similar if we look at a different age range or male participation rates).

Do we see more or less effort in countries with high tax rates? Not obvious. In fact, in the sample I have selected there seems to be a positive correlation, not a negative one. Countries with strong welfare state, high taxes (both average and marginal) show higher level of efforts as measured by employment to population ratios. The US appears as a country with low taxes but also low levels of effort.

The chart above is, of course, not the final answer to the question of how taxes affect labor market outcomes but at least it gives as good argument to dispute the claim that all European problems are about high taxes.

Antonio Fatás

Slowing Growth and Rising Risks

Slowing Growth, Rising Risks is the title of the World Economic Outlook that the IMF just released. All the chapters can now be accessed via the IMF web site. Growth forecasts are being reduced, more so in advanced economies where growth is forecasted at a rate of 1.5% this year and just 2% in 2012. If you were planning for the next recession this might not sound that bad. But hold on, you just need to read the next sentence in their report: These forecasts assume that

"European policymakers contain the crisis in the euro area periphery, that U.S. policymakers strike a judicious balance between support for the economy and medium-term fiscal consolidation, and that volatility in global financial markets does not escalate"

So not a lot of upside potential and a great deal of downside risk.

Antonio Fatás

The American and European jobs machines

Via Mark Thoma I read about the recent failure of the American jobs machine, unable to keep up with the strong dynamics it displayed during the 80s and 90s. After the 2001 recession the performance of the labor market as measured by the number of jobs or the employment rate (employment relative to population) has been much weaker than in the previous two decades. And it is a combination of very limited job creation during the 2001-2007 period and an extremely high rate of destruction during the last recession.

To add an international perspective, here is a comparison between the American, European and German job machines for the last 18 years.

The variable plotted is the employment rate for individuals in the 15-64 age group. During the 90s the US employment rate increased, at a time where the European (and German) employment rate was declining. This was a period where the US economy, in particular its labor market, was used as an embarrassing example for the Europeans. A lot of talk about how high taxes, regulation, lack of mobility in Europe were hurting the European job machine.

But starting with the late 90s we see a reversal of this trend. While the US employment rate flattens and then drops, the European rate, more so the German one, increases and by 2009/10, the German employment rate is above that of the US. Of course, this is just a partial view of the labor market (there are other age groups, there is the issue of number of hours worked), but it illustrates well the change in the performance of the US labor market, not just in isolation, but in comparison with similar economies. And what it is interesting is that this is not just the outcome of the great recession, it is a trend that had started more than a decade ago.

Antonio Fatás

The IMF WEO is out

The new IMF World Economic Outlook (WEO) is out with its two analytical chapters. Next week they release the other two chapters that present an overview of the current state of the world economy. I am quite sure they have been doing a lot of rewriting in the last days trying to cope with the constant changes in economic scenarios.

The two analytical chapters for this September 2011 edition are about monetary policy when commodity prices are volatile and an event study on the relationship between fiscal policy and current account imbalances. Both chapters are very interesting and can be accessed at the IMF web site.

The chapter on fiscal policy and current account imbalances is close to a recent paper I wrote with a group of economists at the IMF fiscal affairs department. We presented our work at a recent IMF conference on fiscal policy issues (schedule and papers at the conference web site). Our results are not far from those discussed in the IMF WEO this month: there is a strong empirical connection between fiscal policy changes and current account imbalances. This is a relevant topic for policy makers as they are trying to correct imbalances on both the fiscal policy side and the current account side - so we need to know if the efforts are complementary (i.e. does a reduction in the government deficit help reduce current account deficits and by how much?).

Antonio Fatás

Waiting for bad news on the edge of another crisis

Not a great beginning of the week for the world economy. The week has started with more rumors about a Greek default, doubts on the French banks, weakness of the Euro and sharp falls in European stock markets during the first half of the day. Another recession? The beginning of a depression? We are going through a period of fatigue as markets, investors, companies seem to be waiting for good news coming from any of the advanced economies. But we only get bad news. Governments and central banks try to cheer us up: President Obama with a plan to create jobs, the ECB buying government bonds from Spain and Italy and keeping their rates under control, but none of this is enough, we need much more to reverse the current decline in confidence. 

We have lived under the hope that as long as the news were not too bad, that we would over time build the necessary confidence to generate healthy growth. As long as we can keep going without Greece defaulting, with US fiscal policy on automatic pilot even if there is no exit plan, with unemployment rate not going up in the US (even if it stayed high), we could find the necessary arguments to start spending and investing again. Now we know that this is not going to work. As time passes confidence gets weaker and we enter a vicious cycle of expectations causing behavior that feeds into our pessimism. Fundamentals have not changed much but we are waiting for a signal that although things are not that great but they are not that bad either and in the absence of that signal, we assume the worst.

It is not easy to see what positive signal we will get over the next weeks. I cannot imagine any GDP, unemployment, consumption, earnings release that will be good enough to reverse the current mood. Will the approval of the Obama jobs plan by congress be good enough? I doubt it. Will a new statement by the Euro countries that no government will be allowed to default do the trick? I do not think so. We need a surprise, something that is not part of any of the current scenarios we are contemplating. And whatever that surprise is, it needs to do something substantial to stimulate demand in the short term. Yes, structural reforms will always be welcome but there is the need for actions in the short term and promises of a better distant future will not be enough. What I would like to see is a strong statement by economic authorities among all advanced economies that they understand the situation, that they clearly share the same priorities, that they all see that we are in the same boat and that austerity for the sake of austerity is not the solution to the current crisis. 

But such an announcement requires a lot of political consensus within countries and internationally, which is not what we have seen in the last days. And it also requires more clarity from central banks in their communications. While Bernanke and Trichet have done lots of great things to avoid a deeper recession, their most recent communications (e.g. Trichet responding to a question about the ECB and Germany) reveals too much the tension in their decision making process and not enough their commitment to find a solution.

Antonio Fatás

Interest rates should go up... or maybe down (OECD)

April 5 2011:

The OECD said central bankers increasingly need to focus on tackling inflation as the economic recovery takes root in major economies, adding that some of its members faced the risk of inflation becoming "un-anchored." 

"We see inflationary expectations creeping upwards a bit everywhere, I would say, in Europe, in the United States, in the UK," OECD chief economist Pier Carlo Padoan said in an interview with Reuters. 

"Central banks should keep inflation expectations under control," he said.

Today (September 8, 2011):

“Growth is turning out to be much slower than we thought three months ago, and the risk of hitting patches of negative growth going forward has gone up,” OECD Chief Economist Pier Carlo Padoan said during a presentation of the OECD’s latest Interim Economic Assessment.

The OECD recommends that central banks keep policy rates at present levels, and barring signs of recovery, consider lowering rates when there is scope.

Maybe we were too optimistic about the strength of the recovery few months ago... (Brad DeLong makes a similar point in this post).

Antonio Fatás

Let's increase interest rates to encourage credit growth

Since I read this article in yesterday's Financial Times from Bill Gross I have been searching all my macroeconomics books for a model that explain the logic of the article. I have not found it yet. I am glad that I am not teaching a macroeconomics course now because I do not know what I would answer if my students asked me to explain the logic of the article...

The argument is that Ben Bernanke has destroyed credit creation in the US by making the yield curve flatter in the 0-2 years horizon (and he did this with his statement that Federal Funds rate will be zero for the next two years). According to the article, the flattening of the yield curve reduces lending by banks because it reduces the potential return to banks of borrowing short term and lending at a two year horizon.

I understand that a strong recovery is normally associated with an upward slopping yield curve and the fact that we have a flat curve is bad news. But by committing to keep short term interest rates low for an extended period of time, the Fed is providing incentives for banks and investors to move into riskier assets (lending to companies, consumers) within that horizon. This should create lending, nor destroy it. This is what a macroeconomics textbook says (including the one written by Ben Bernanke). Reducing Fed rates does not change per se the returns of investment in other assets, it just makes the differential with the riskless asset even larger and creates an incentive to borrow/lend. There are many yield curves, one for each class of asset and the Fed policy can only influence (directly) the one associated to riskless assets.

Of course, it can be that Ben Bernanke's action changed our expectations of the future and we are now more pessimistic than before so lending will be destroyed after all, but this is not a direct consequence of lower interest rates but of the management of expectations.

Antonio Fatás

Two examples of gaps in Macroeconomics

Much has been said about the failure of Macroeconomics (and macroeconomists) to explain, predict or find solutions for the last financial crisis and its aftermath. The topic came back to my mind after reading two recent articles about current macroeconomic events, articles that capture well some of the gaps of the academic economics literature. 

The first article is by Robert Shiller in The New York Times. Robert Shiller is well known for his work around excesses in financial markets. He has produced many interesting pieces of academic work on this subject but he is better known to the public for his book Irrational Exuberance about the asset price bubble during the 90s as well as his warnings on the real estate bubble prior to the collapse in 2007. His article discusses recent volatility in the stock market in terms of the "beauty contest" analogy suggested by Keynes. His view of markets is one of volatility and behavior which is more about predicting what others do than understanding the fundamental value of assets. The article presents a view of stock markets which might not be far from what many (investors, those involved in financial markets, the general public) believe about those markets. But it is not the view that most macroeconomic or financial models have of how investors behave. Yes, we have models that try to capture some of the anomalies and volatile behavior described by Robert Shiller, but these models have very limited influence when it comes to macroeconomic analysis or advise for policy makers. Erratic and volatile behavior in financial markets and asset prices can be a source of volatility for the economy, lead to unsustainable behavior (bubbles) and make the recovery from those events much harder because of how pessimism spreads through trade and interactions among investors. Ignoring this behavior makes it impossible to talk about the most recent business cycles.

The second article is from Brad DeLong and it talks about what to do with the US labor market. This is another area where macroeconomic models struggle to deal with current events, in particular the very negative labor market that the US economy has had for the last three years. And in this case it is not because the labor market was not part of macroeconomic models. All macroeconomic models include a labor market and they discuss the issue of unemployment. But their discussions are not too helpful in understanding the current US environment. Most macroeconomic models have a view of labor markets clearing around a certain unemployment rate (structural unemployment, natural rate of unemployment,...). Some models only generate movements in unemployment when the equilibrium level changes - but it is hard to argue that this is what we have witnessed since 2007. Other talk about cyclical unemployment caused by frictions. But there is no agreement on the origin of these frictions. In the standard New-Keynesian model, frictions come mostly from price rigidity. These frictions are temporary and as time passes unemployment returns to its natural value. But as Brad DeLong correctly argues:

"Excess supply on the labor market not is registering at all, is not leading to any upward pressure on the rate of matching workers who want jobs with jobs that want workers. We have an awful lot of people who are answering the CPS survey by saying; "No, I don’t have a job, and yes, I have done something to look for one over the past four weeks". Your most basic economic matching model says: multiply the fraction of workers looking for jobs by the fraction of jobs looking for workers and that will b proportional to your job-finding rate. It isn't. The equilibrium-restoring forces in the labor market at the macro level appear to be much much weaker than I thought they were in 2007, appear much weaker than I would have believed back in 2007 that they possibly could be."

As a final point, and to be fair to the academic literature, there are plenty of models that incorporate volatile or irrational behavior in financial markets and there are many models that include a variety of frictions in the labor market that could account for some of what we see today. But these features are not at the core of the standard analysis of the current macroeconomic environment and they are not articulated in a way that allows for concrete and specific policy advise. And those who dare using some of these features in their analysis and policy recommendations seem to do it mostly when talking to "outsiders" and less so in conversations with other academics. 

Antonio Fatás