Antonio Fatas and Ilian Mihov on the Global Economy

New treaty, same old flaws.

2012-01-31T08:38:00.000-05:00

The European Union member states (with the exception of the UK and the Czech Republic) agreed yesterday to a new Treaty on "Stability, Coordination and Governance". The text of the agreement can be found in the web site of the European Council. My first reaction after reading the document was that I must have made a mistake and clicked on the wrong (old) document. It is very difficult to see the differences with the current economic policy framework. And, unfortunately, all the flaws of the previous system are still there.

Here is my list of concerns about the agreement.

1. Wrong title. The agreement is mostly about fiscal sustainability not about stability, coordination and governance. The assumption is that anything that produces lower deficits and debt is good for stability. And that if all countries do it together, even better (this is the coordination part). Fiscal sustainability is necessary but putting all the emphasis on it can be counterproductive.

2. Numerical limits at the center of the fiscal policy framework. The agreement relies again on strict numerical limits to enforce fiscal discipline. So far this has not worked and it is difficult to imagine why it would work going forward. The agreement says that countries cannot have deficits that are larger than 0.5% of GDP. The number is defined as "structural" meaning that they allow the budget to be adjusted for the business cycle. This is, obviously, a good idea, but its implementation is full of technical complications that the agreement ignores. Why 0.5% of GDP is the right number for all countries? It makes no sense to impose the same number to all countries except that is makes things easier to remember.. The agreement allows countries to run larger deficits when their debt is low, which makes some sense. But what about other circumstances? There is the room for exceptions, which sounds very reasonable but it goes against the notion that we are producing a simple set of numerical rules (now it is not so easy to remember anymore).

3. Not enough stress on good years. The main failure of fiscal policy in European countries in the last decade has been not to generate large enough surpluses in good years. By focusing so much on the deficit limit of 0.5% we simply ignore that the real issue is on how to generate those surpluses and we put all the emphasis on the bad economic years where getting thins right is so much harder. We have not learned much from the last 10 years.

4. Limited focus on governance. Despite the fact that the word governance appears in the title of the agreement, there is very little change in terms of governance and enforcement. The agreement will be enforced by the governments of the member countries. These are the same actors that can potentially be the sinners. There will be times (as in the years around the 2002/2003 recession) when most countries will violate the agreement (including Germany and France). What happens then? The agreement talks about automatic fines. Fines that are paid to whom? To the potential group of offenders? Do we really believe that if we had had in place an automatic fine imposed on Greece for having violated the deficit limit we would not be in a crisis today?

Providing an economic policy framework to manage the Euro area is not an easy task and I am glad that I was not part of the negotiations that have taken place over the last days. But the agreement shows that we have learned very little from the previous experience. We insist on maintaining a system that does not work and that only provides a distraction to other economic policy issues that, if we try hard enough, we might be able to solve.

Antonio Fatás

A matter of faith (in markets)

2012-01-27T09:24:00.002-05:00

Alan Greenspan contributed yesterday to the Financial Times debate about Capitalism in Crisis. The title of his article was "Meddle with the market at your peril". Not surprisignly Greenspan presents a strong defense of capitalism and market economies by comparing its success to the failures of other systems (such as planned economies).

I do not think that many disagree with that conclusion. But where the article surprised me is when he talks about the potential failure of markets:

Anti-capitalist virulence appears strongest from those who confuse “crony capitalism” with free markets. Crony capitalism abounds when government leaders, usually in exchange for political support, routinely bestow favours on private-sector individuals or businesses. That is not capitalism. It is called corruption.

This is the only sentence in the article where Greenspan admits that there could be some failure in a market economy. But that failure is driven by bad government behavior! Other than that, markets work fine. I hope his views are not really that extreme and that he is willing to accept some of the market failures that economists have identified in the past and that are taken care of by different forms of regulation. This is to me the interesting debate, the one that identifies market failures and then tries to address them via intervention or regulation. In that debate we might find that government intervention is not always possible or efficient. And I am sure we will find disagreement on the domains where government intervention is necessary or optimal. The other debate, the one that compares "capitalism" with the economic system of the former Soviet Union does not sound too interesting or useful at this stage. And it only leads to statements like the one above that seem to be driven by faith in one of the two systems.

Antonio Fatás

The Big Day for the Fed

2012-01-26T04:34:00.000-05:00

On January 25th, 2012, in addition to its regular statement from the Federal Open Market Committee, the Federal Reserve published for the first time two additional documents: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents and a Statement of Longer-run Goals and Policy Strategy. The media and the markets reacted positively to the statement. The most quoted phrase was:

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

Stock markets gained close to 1%, while yields for bonds with various maturities dropped by about 2 basis points.

The two new documents represent a historical shift in the monetary policy of the US. Put together with the standard FOMC statement, they offer much deeper insights into the way that policy makers think about the state of the economy. There are at least a dozen of points worth discussing: The explicit statement of a self-imposed inflation target; the expectations for future interest rates; the projections for GDP; their views on the natural rate of unemployment, etc. I want to focus only on two topics, which in my view are somewhat missing from the popular discussions: the consistency of the statement with the projections and policy-makers’ views on potential growth.

Economic Projections, January 2012 (excerpt)

Variable	Central tendency
Variable	2012	2013	2014	Longer run
Change in real GDP (%)	2.2 to 2.7	2.8 to 3.2	3.3 to 4.0	2.3 to 2.6
Unemployment rate (%)	8.2 to 8.5	7.4 to 8.1	6.7 to 7.6	5.2 to 6.0

First, if we look at the projections for real GDP growth and for unemployment, it is clear that by 2014 the output gap in the US is not going to close. Hence, it is quite possible that 2014 is even an early date for tightening according to the Fed. It does not necessarily mean that the statement is inconsistent with the projections. As indicated above, low interest rates are expected to be in place “at least” through late 2014. But it is worth pointing out that their “average” belief is that the economy will be still below potential at the end of 2014.

Second, and more worrisome, is the projection of long-term growth rates for the US economy. According to the Fed, the central tendency will be for long-term growth rates to be between 2.3% and 2.6% p.a. This is a significant departure from the historical record. In the post-WWII period, real growth in the US has been at about 3%. Fed’s projections suggest that this may not be the case anymore – indeed this implies a significant slowdown in the potential growth of the US economy. Just to illustrate the implications of cutting off 0.5 percentage points from the growth rate, let’s look at GDP per person in 2010 if the economy between 1950 and 2010 grew by 0.5% less. A simple calculation shows that instead of its current level of $46,844, US GDP per capita would be 26% lower at $34,530.

The dire projections of the slow cyclical recovery expected by the Fed and the downward shift in the potential growth rate have serious negative implications about the US economy. Is the Fed deliberately over-pessimistic, or do they believe indeed that we are getting into the “New Normal”?

Ilian Mihov

P.S. Below is a recent interview on CNBC discussing some of the issues related to Fed’s new communication strategy.

INSEAD blogs

2012-01-25T12:26:00.000-05:00

We just launched the new INSEAD blog with articles from INSEAD faculty and other members of the INSEAD community. The blog covers a broad range of topics coming from all the disciplines you find in a business school. It is great to see a large number of my colleagues writing now for our blog! If you want to follow up on the newest research ideas in business, this is the place to go: http://blog.insead.edu

Antonio Fatás

What we do with the debt matters

2012-01-25T04:10:00.000-05:00

Here is a follow up to my previous blog entry on the meaning of gross debt. Paul Krugman thinks that I went too far when I argued that there is no need to worry about gross debt. Correct. But my goal was not to argue that gross debt is completely irrelevant but to raise my concerns about those who only look at the liability side of a balance sheet or ignore the fact that what constitute a liability for some it is an asset for someone else (a point that Paul Krugman has made earlier when referring to government debt).

This does not mean that gross debt does not contain any important information. For example, if we think about the world, a consolidation of all balance sheets leads to an always perfectly match between revenues and spending, the world cannot accumulate any debt. But when we look at a disaggregated level, individual countries run deficits and this can be a source of concern and instability. Same is true for a country. Japan runs a surplus on the current account (accumulates assets, not debt) but its government keeps increasing its debt. The country as a whole does not need to deleverage and looking at the gross debt of the country is a meaningless exercise (the point I made in my previous entry). But the government needs to find a way to reduce or stabilize their debt so looking a disaggregated data is necessary as well.

Back to the US, Paul Krugman has a new post on the behavior of debt over the last two bubbles. Comparing the Clinton years where there was a stock bubble and the Bush years where there was a real estate bubble he concludes that there are large differences between the two. Not only the economy did much better during the Clinton years, but also the accumulation of debt was much worse during the Bush years. He is completely right on his assessment. But just to understand better what happened during those years, what was the behavior of net wealth (and not just debt) during each of the two episodes?

Using data from the Flow of Funds accounts (US Federal Reserve) I have plotted below the liabilities of US households as a % of their personal disposable income. I went back to 1960 to get a better historical perspective.

This first chart confirms Krugman's assessment that the increase in debt was significantly faster during the second bubble (post 2001). But what was going on at the same time with the value of the assets that the households were buying? The value of assets increased during those episodes and it increased much faster during the second bubble.

This is not a surprise given how widespread the bubble in housing prices was and how relevant housing is in terms of the wealth of US households.

Here comes the most interesting chart (from my point of view), the one that combines assets and liabilities and looks at the net wealth (again measured as % of personal disposable income).

First lessons is how remarkably stable this ratio has been over the last 50 years. It was around 500% in the 60s, was depressed during the 70s (around 450%) as these were years with very weak stock and housing markets. It went back to 500% during the 80s and then we see very clearly the two bubbles bringing this ratio to 600 or 650% before it collapses back to 500%.

When we look at the two bubbles from this lens we see that in both cases the accumulation of debt during the good years of the bubble was happening while the balance sheets of households were getting stronger and stronger. The valuation of assets always grew faster than the accumulation of debt (and this made the bubble look "reasonable" to some). When the bubble bursts, assets go back to normal but what it is interesting is that net wealth does not collapse; it simply returns to the pre-bubble levels. This means that despite the increase in debt if you compare post- to pre-bubble years (first chart), households are back to the level of wealth they had before the bubble started. Yes, my mortgage is much bigger than it used to be but I also own my house and stocks that are worth more than they use to. To be clear, relative to the peak of the bubble I am of course much worse off, but relative to the day the bubble started, I am in a similar position.

If we look at the balance sheet of households in the US through this lens we might reach the conclusion that there is not much need to deleverage. The consolidated balance sheet looks the same as it looked during early decades (the 60s or the 80s). Higher debt simply matches the assets the have been bought with it. We can think of scenarios where the health of the balance sheet looked much worse than before: Supposed all the borrowing during the boom years had used to pay for additional vacations or expensive meals. Then the picture today would look very different, net wealth would look so much lower than in the pre-bubble years and we would be talking about a much weaker situation as seen by the balance sheet of households.

Some caveats to what it might sound like a too optimistic look at the financial health of US households. The 500% ratio that has been stable over time might not be the right level. I am just claiming that we are at a level that is similar to what we have seen in "normal" years. I cannot claim that this is good or optimal or that there should not be a positive trend in this ratio. The second caveat is that the picture above ignores distributional issues. The fact that the aggregate looks good does no mean that we do not have a significant proportion of the population with balance sheets that look much weaker and this is a concern. Finally, the valuation of assets might still fall further (housing prices) and could send net wealth to lower levels.

Antonio Fatás

No need to deleverage gross debt

2012-01-20T07:48:00.000-05:00

The McKinsey Global Institute has produced a new report with the title "Debt and deleveraging: Uneven progress on the path to growth". The report discusses the challenge for advanced economies to reduce high level of debt and the potential consequences for growth. It is an interesting topic and, as it always the case with the MGI reports, it produces a detailed analysis of international data.

There is, however, an methodological approach in the report that I do not share and that can be misleading. The report starts with a few charts of debt trends in the last decades. As an example, here is exhibit 1 from their report.

Among all economies we see an upward trend with increasing levels of debt, measured as % of GDP. The reading of this chart tends to be one of economies "living beyond their means", where spending outpaces income and where an adjustment is needed (deleveraging). This is not correct. As I discussed in an earlier post about government debt, the debt of one individual (or government) is the asset of someone else. Looking at gross debt (as done in the chart above), can be very misleading. What matters for countries is their net wealth and not their level of gross debt.

Let's think first about a closed economy. In a closed economy liabilities (debt) have to be equal to assets. What we know from the data is that as a country develops, the ratio of assets to GDP tend to increase. This is some times called "financial deepening" and it is measured as the ratio of money supply to GDP but where the money supply is a broad measure including a large number of asset classes. Higher levels of this ratio are seen as a positive development (larger financial markets). But in a closed economy, this ratio is identical to the Debt/GDP ratio. So a more leveraged economy is one where financial markets are simply more developed. Concluding automatically that this is bad or that an adjustment is required is not correct.

When an economy is open then the right concept to measure is the net wealth of a country relative to the rest of the world. And this is the difference between foreign assets and foreign liabilities after consolidation of all internal debt. If we do not consolidate internal debt we are making the wrong assessment. As an example, in the McKinsey report, the country with the larges debt to GDP ratio is Japan (see chart below, also from the report).

But Japan does not need to deleverage! Japan has consistently had large current surpluses and accumulated a large amount of foreign assets (it is in the same situation as China). The country does not need to reduce its debt. What is going on is that the government has a large amount of debt (226% of GDP), but this debt is held by Japanese citizens. But these private assets do not show up in the above calculations as only debt is included. The government of Japan needs to reduce its debt but not the country.

Similarly, if one looks at the Euro countries with difficulties these days, their debt levels are not that high. Correct, but if one were to look at their net foreign asset position (how much they owe to the rest of the world), in some cases we would see very large numbers (Greece, Spain) because of the large current account deficits they were running in the past. So while internal debt is not that high, external debt is and that is where we see their economic problems.

Antonio Fatás

ECB: Assets=Liabilities

2012-01-17T09:35:00.001-05:00

Statistics released today about the ECB balance sheet show that Euro banks have a record level of deposits at the ECB (about €500 billion). The press tends to misrepresents the meaning of these deposits. From CNBC today:

"the recent giant injection of ECB cash left banks awash with money but too scared to lend it."

and

"With total ECB lending at 664 billion euros, banks are now storing over three-quarters of money lent by the ECB at the central bank, compared to around a third after the collapse of Lehman Brothers back in late 2008."

Both statements give the impression that the size of the balance sheet of the central bank is driven by the actions of commercial banks. This is misleading. The size of the central bank balance sheet is determined by monetary policy. Monetary policy will react to economic developments, including actions of commercial banks, but at the end of the day the size of their balance sheet is mainly a decision of the central bank.

Towards the second week of December the ECB decided to increase lending to commercial banks (by making it attractive, of course). This led to an increase in the ECB balance sheet of about €250 billion between December 16 and December 23. This is associated with an increase in assets (lending to euro area credit institutions) as well as an increase in liabilities (accounting still works!). There are potentially two liabilities that could change: Banknotes in circulation (this is printing money) and deposits of commercial banks at the central bank. Currency in circulation barely changed that week, but deposits of commercial banks changed by about €200 Billion (the rest comes from other liabilities). As banks get loans from the central bank, their accounts at the central bank get credited.

Since then, not much has changed. Loans to banks remain high as well as deposits from banks. What if commercial banks start lending to the private sector, will the level of deposits at the central bank go down? Not necessarily. The only way for the level of deposits to go down is if commercial banks start paying back the loans they took from the central bank. And the central bank could always resist this move by making these loans even more attractive (this is standard monetary policy).

So it should be no surprise that deposits of commercial banks at the ECB are at a record high when the balance sheet of the ECB is at a record high (we observe the same phenomenon in the US or England). When monetary policy decides to increase its balance sheet, both the liabilities and assets have to increase. Given that central banks are not massively increasing notes in circulations, it must be the case that it is the deposits of commercial banks at the central bank the ones that are increasing.

Antonio Fatás

Bazookas, Bailouts and Fiscal Policy

2012-01-11T07:37:00.002-05:00

As a result of the financial crisis, economic policy both in Europe and the US has been driven by announcements of plans that involved large sums of funding provided by governments to support the economy (the "bazooka" approach). It was first in the US with TARP (Troubled asset relief program) and in Europe with the EFSF (European Financial Stability Facility). In both cases we are talking about plans that amount to hundreds of billions of dollars (or euros). These large figures are seen large enough to provide support for any possible future risk, in order to provide credibility.

There is, however, a downside to this approach. Many will only remember the headline figure and will associate the number to the actual cost paid by the government (and ultimately by the tax payer). For some there is a direct association between bailout funds and taxpayer costs. And the feeling that the cost to the tax payer has been so large was partly behind the resistance to addition fiscal policy stimulus and the support that austerity received during the year 2011.

But what are the facts? Regarding TARP, the CBO (congressional budget office) regularly updates on their estimated cost to the US tax payers. Their last figures suggest that out of the original $700 billion, only $428 billion were disbursed. Most of these funds took the form of loans or investments, some of which have been paid back with a profit for the government. The estimated cost for the tax payer today is about $34 billion, a large number but far from the $700 billion that made the headlines. Most of the losses come from AIG and funds given to car manufacturers. A precise picture of the losses is below. Click on it for a larger image or you can also go directly to the source.

The same is true for the EFSF. The EFSF was established with guarantees of €780 billion and a lending capacity of €440 billion. So far it has only lent €13.5 billion and the expectation (so far) is that all this money will be paid back. But the public perception is one of large sums of transfers across Euro countries (interestingly, EU structural funds account for more than €40billion on an annual basis and agricultural funds account to €50 billion -- and these are real transfers, not loans) .

There might be some benefits to the bazooka approach to economic policy announcements in times of crisis. But there is also a need to go back ex-post and assess the actual cost of these policies. Otherwise, the headline figure is the only one that sticks in the public debate and some will equate this figure to the cost to the tax payer in an attempt to scare individuals about large governments and the use of fiscal policy.

Antonio Fatás

Financial repression German style

2012-01-09T11:33:00.001-05:00

Last weekend I attended the American Economic Association meetings in Chicago where I had been asked to discuss a paper on historical lessons lessons on government debt reduction. The paper is written by Carmen Reinhart and Belén Sbrancia and the title is "The Liquidation of Government Debt". The paper presents a historical review of episodes where governments paid interest rates on their debt below market rates. This reduction in financial expenses can be seen as a source of revenue that can keep the debt under control or reduce it.

The paper focuses on periods where real interest rates on government debt were negative which were common in the pre-1980 period. Here is a chart from their paper

They refer to the pre-1980 period as the era of "financial repression" because on average real interest rates were negative driven by the behavior during the 1945-1955 period and the early 70s. Financial repression comes from two sources: financial market regulation (e.g. ceilings on interest rates, legal conditions that favor government debt holdings by institutional investors) and surprises in inflation. The early years of the sample are characterized by capital controls and strong regulations on interest rates. The real negative interest rates of the early 70's are more driven by inflation being higher than expectations (although controls on capital flows and distortions on interest rates were also present).

A quick calculation shows the importance of this channel during the 1945-1980 period. For example, for the US and UK economies, negative real interest rates allowed a reduction of government debt equivalent to about 2-3% of GDP per year. This is a large amount compared to their ratios of taxes to GDP (this amounts to 14% of the average tax revenues for the US during these years). What this suggests is that the reduction in government debt that advanced economies witnessed in the post-second world war period was partly driven by unusually low (even negative) real interest rates.

The authors argue that we might see something similar going forward. A combination of financial repression (regulation, moral suasion) and inflation could produce negative real interest rates.

Today, the German government issued for the first time debt with a negative (nominal!) yield. This is not financial repression as the authors of the paper describe it. It is more about risk aversion, flight to quality and a reaction of what is happening in other Euro countries, but it has the same effect on the German government. It finances its debt at negative real interest rate (this is one of the benefits of the Euro for the German economy...). Same is true for the US government where over the last years nominal yields have been close to zero while inflation remained positive. Of course, not all governments (Greece, Italy or Spain) are as lucky and can benefit from fear and perceptions of risk, their real interest rates remain positive and high.

Antonio Fatás

Learning from 2011, hoping for a better 2012.

2012-01-04T11:29:00.002-05:00

Here is a summary of two very interesting articles that look back at the economic developments in 2011, what we have learned and what to look forward in 2012.

Charles Wyplosz looks at the Eurozone crisis and how it deepened during the second half of 2011. He asks the question of why governments, the European Commission and the ECB do not seem to learn from their mistakes. He suggests several hypothesis:

1. ignorance and lack of understanding
2. the obsession of the French President and the German Chancellor to find a political solution
3. the "quasi-religious" beliefs at the ECB on economic policy options
4. the crisis as a strategic option chosen by the ECB and some countries to teach a lesson to those who misbehave

Number 4 is what Charles Wyplosz calls the "kind interpretation" of the crisis. I am afraid that the other explanations matter as well. Lack of understanding of the economics behind the crisis. an obsession with certain standard recipes (austerity and confidence) as well as the belief that it is all about politics were behind the lack of a proper response to the events in the second half of the year.

Olivier Blanchard, Economic Counsellor at the IMF, summarizes four lessons ("hard truths") from 2011. The article not only provides some great insights about the year but it also offers a very honest and fresh view on some of the hard lessons that policy makers and academics have learned. He stresses something that rarely gets attention in academic research: the importance of multiple equilibria and self-fulfilling crises of confidence. Quoting from the article:

Multiple equilibria are not new. We have known for a long time about self-fulfilling bank runs; this is why deposit insurance was created... And we learned early on in the crisis that wholesale funding could have the same effects, and that runs could affect banks and non-banks alike. This is what led central banks to provide liquidity to a much larger set of financial institutions.

What has become clearer this year is that liquidity problems, and associated runs, can also affect governments.

Right or wrong, conceptual frames change with events. And once they have changed, there is no going back. For example, nothing much happened in Italy over the summer. But, once Italy was perceived as at risk, this perception did not go away. And perceptions matter: once the “real money’’ investors have left a market, they do not come back overnight.
A further example: not much happened to change the economic situation in the Euro zone in the second half of the year. But once markets and commentators started to mention the possible breakup of Euro, the perception remained and it also will not easily go away. Many financial investors are busy constructing strategies in case it happens.

Perceptions matter and, what it worse, once they are formed, it is hard to influenced them.

Olivier Blanchard also discusses what he calls the "schizophrenic" reaction of financial markets towards fiscal policy. In his words:

They (financial markets) react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.

This was one of the most interesting developments during the second half of 2011. The notion that austerity was going to help governments address their imbalances lost support during the sumer (because of the evidence) and led to a situation where governments had no good options. If they promised a quick adjustment they would be penalized for the negative growth consequences that they would cause; but if they did not adjust they would be penalized because of their lack of discipline.

So now it is time to digest all the 2011 lessons and have a better 2012. As Olivier Blanchard says in his last comment "The alternative is just too unattractive".

Antonio Fatás

Debt does not matter. Spending and taxes do.

2012-01-02T13:41:00.001-05:00

Paul Krugman makes the point that government debt matters less than most people think because in some cases we simply owe money to ourselves. He is right and what he has in mind is the notion that government debt is (in many countries) mostly held domestically. Japan is an extreme case where more than 90% of the government debt is held by its nationals but even in the US the majority of government debt is held by US citizens or institutions. For some it is debt but for others it is an asset, they cancel out from a national point of view.

We can think of an extreme case where government bonds are held by all taxpayers in proportion to their income - in a way that mimics tax rates. In that case, government debt is not imposing a future burden on anyone, it simply cancels out with the assets that all investors/taxpayers have.

How do future generations enter into this analysis? What if we try to pass the bill to future generations? Let's start with the case of a closed economy/system. In a closed system (the world, no international trade or capital flows) the debt that the current generation has will end up in the hands of the future generation in one of two ways: either it gets simply passed to the next generation as a bequest or, alternatively, the current generation could try to sell their assets and spend all their wealth if they do not want to leave a bequest to their children. But the debt must be bought by someone. And given that this is a closed economy, it can only be bought by the future generations. In both cases the bond holders are also the taxpayers.

If we bring other countries into the picture then the analysis is different. The government debt that other countries hold is a claim on our current and future income and as such it is a financial burden that either the current generation or the future one will have to pay for. But Krugman's point, which is correct, is that many make the mistake of assuming that government debt is equivalent to external debt and they overestimate the burden that it imposes on a country.

Let's go back to the case of a closed economy: is it really true that debt does not matter? Not quite, because there are distributional issues of two types: first there is no perfect match between bond holders and taxpayers so it is not quite true that we owe money to ourselves. Some citizens owe money to others. The second distributional issue is about generations and here we need to go back to the example above to understand how difficult the analysis can get. The best way to understand the argument is to stop talking about debt and talk about spending and taxes, which is what really matters. A government spends some income today (builds a road, provides health services to the population). It decides not to tax anyone but instead it issues debt bought by the current generation. The government decides that it will only pay back the debt in the future when it raise taxes on the next generation, not the current one. Are we passing a burden to the next generation? It all depends on what the current generation does. If they decide to spend all their income and leave no bequests for their children then the answer is a clear yes. The current generation enjoyed services that they did not pay for themselves and did not compensate the next generation in any way for the future taxes they will have to pay. Just to be clear, the future generation will be holding the debt that the previous generation sold to them when they were spending their inheritance, but this is not a transfer of resources, the asset was sold at market price. So the fact that in the future bondholders are also the taxpayers does not mean that we are not passing a burden to the next generation.

There is a second scenario where there is no burden passed to the next generation. It can be that the current generation is responsible, understands that the government is asking future generations to pay for the goods and services that they enjoyed and they decide to leave a larger-than-planned bequest to their children so that they have resources to pay for all the taxes (you can think about the bequest being the government debt itself). In this case no burden is passed to the next generation.

This simple example (*) makes it clear that answering the question of what distributional impact government debt has across generations requires an understanding of the patterns of spending, taxes and saving of different generations. What matters is not debt but who enjoys the spending that the government does and who pays for it. Debt is just a vehicle that can be used to transfer resources across different individuals or generations. Debt is not a problem, the problem, from a generational point of view, is the potential mismatch between spending and taxes (even if future taxpayers are also the holders of government bonds when they are paid back).

Antonio Fatás

(*) The example ignores many issues: the type of goods government buy, the possibility of default, the possibility of crowding out (government bonds displacing other forms of saving),...

Running out of words?

2011-12-15T05:26:00.002-05:00

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

2011-12-14T12:49:00.002-05:00

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

2011-12-12T12:23:00.005-05:00

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?

2011-12-09T06:36:00.001-05:00

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

2011-12-07T15:16:00.001-05:00

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?

2011-12-06T04:47:00.001-05:00

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

2011-12-01T12:02:00.001-05:00

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

2011-11-28T03:12:00.001-05:00

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?

2011-11-25T07:01:00.001-05:00

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)

2011-11-21T09:27:00.001-05:00

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.

2011-11-16T04:26:00.001-05:00

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

2011-11-14T05:45:00.001-05:00

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!

2011-11-11T11:51:00.001-05:00

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.

2011-11-09T08:35:00.000-05:00

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.

2011-11-08T07:44:00.000-05:00

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

2011-11-01T13:02:00.001-04:00

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

2011-10-28T07:49:00.000-04:00

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

2011-10-25T04:22:00.000-04:00

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.

2011-10-21T08:08:00.001-04:00

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

2011-10-18T20:52:00.001-04:00

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

2011-10-16T16:44:00.001-04:00

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?

2011-10-13T07:18:00.000-04:00

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

2011-10-10T15:52:00.000-04:00

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.

2011-10-03T03:37:00.001-04:00

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

2011-09-30T03:02:00.001-04:00

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

2011-09-28T07:10:00.000-04:00

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

2011-09-26T03:26:00.000-04:00

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

2011-09-20T10:31:00.002-04:00

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

2011-09-15T10:16:00.000-04:00

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

2011-09-15T02:53:00.005-04:00

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

2011-09-12T10:42:00.001-04:00

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)

2011-09-08T05:50:00.001-04:00

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

2011-09-07T07:27:00.000-04:00

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

2011-09-05T08:11:00.000-04:00

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

News or Noise?

2011-08-31T05:48:00.000-04:00

I always find it amusing to read headlines from the business press (and their web sites) regarding macroeconomic news. In particular, headlines about exchange rates many times refer to dramatic movements in currency prices. No doubt that some currencies are very volatile and there is room to talk about interesting changes affecting exchange rates, but it also seems the case that most of these headlines do not correspond to what one sees in the data. Days were there is very little movements in exchange rates produce headlines such as "Dollar tumbles" or "Euro falls sharply".

As an illustration, I have collected headlines regarding the US dollar / Euro exchange rate for the last thirteen days (source CNBC.com). What we see is a succession of headlines (and stories) that talk about dramatic upward and downward movements of this exchange rate. There are days where one can even get three headlines on this subject, each of them pointing in a different direction. The list of headlines is below, together with a plot of what the Euro/Dollar exchange rate did during those days. Interestingly, despite the dramatic tone of the headlines the exchange rate was very stable moving in a range 1.4350 to 1.4500 (which is a fairly narrow range for this exchange rate).

List of headlines (CNBC.com)

Fears of weak global economy helps support dollar
Thursday, 18 August 2011 10:51 PM ET

FOREX OUTLOOK-Dollar drops but respite in sight if economy dims

Friday, 19 August 2011 11:25 PM ET

FOREX-Fed speculation hurts dollar vs high-yielders, euro

Monday, 22 August 2011 3:32 PM ET

Dollar wavers as stocks jump on lack of bad news

Monday, 22 August 2011 5:32 PM ET

FOREX-Euro edges up on German data, hopes for Fed easing

Tuesday, 23 August 2011 5:57 PM ET

Dollar Slides as Investors Look to Fed Move

Tuesday, 23 August 2011 10:26 PM ET

Dollar Gains on Stock Selloff, Bets on Bernanke Speech

Thursday, 25 August 2011 10:31 PM ET

FOREX-Dollar slips vs euro, yen ahead of Bernanke speech

Friday, 26 August 2011 3:30 PM ET

Dollar gains strength after Bernanke speech

Friday, 26 August 2011 4:50 PM ET

FX OUTLOOK-Dollar tumbles after Bernanke; U.S. jobs data ahead

Friday, 26 August 2011 11:30 PM ET

Euro Held Up by Asian Banks

Monday, 29 August 2011 1:30 AM ET

Dollar Slips, Poland Talks Tough

Monday, 29 August 2011 3:21 PM ET

FOREX-Dollar rises vs franc, yen as US recession fears fall

Monday, 29 August 2011 6:56 PM ET

Bernanke speech weighs on dollar in thin trading

Monday, 29 August 2011 7:41 PM ET

Dollar Rises vs Franc, Yen and Franc Fall on US Data

Monday, 29 August 2011 8:37 PM ET

Dollar to Hit $1.50 to Euro?

Monday, 29 August 2011 10:17 PM ET

Euro Falls Sharply on Euro Zone Debt Worries

Tuesday, 30 August 2011 2:47 PM ET

Source: Oanda.com

Antonio Fatás

Yields for some Euro government bonds falling fast

2011-08-30T07:29:00.000-04:00

A move in the opposite direction would have made it to the headlines of all financial newspapers but, just in case you missed it, here are the yields on 10-year government bonds for Ireland and Spain. They are still high relative to where they were before the crisis but they have been falling very fast over the last weeks. Some of this fall has to do with lower interest rates everywhere else (so the spread with the German yields has not fallen as much as what you see in these figures), but from the perspective of sustainability of government debt what matters is the interest rate you pay on your bonds and not the differential with a safe asset.

Spain 10-Year Government Bonds

Ireland 10-Year Government Bonds

Antonio Fatás

Mind the ($5.1 Trillion) Gap

2011-08-29T08:36:00.002-04:00

The debate between whether governments should focus on helping the economy grow faster or imposing discipline and austerity in their budgets is not going away. No one disagrees with the statement that governments needs to find ways to bring discipline to fiscal policy. Given current policies, governments are on an unsustainable path and there is a need for reform that will require a combination of lower spending and additional source of revenues.

The debate is on whether there is also a need to increase economic activity via expansionary fiscal policy (which in the short run is likely to make the deficit bigger). Not every country is in the same situation so it is difficult to provide an answer that is valid for every economy, but here are the two principles that should not be forgotten in this debate:

1. Bringing sustainability to public finances is about ensuring sound fiscal policy over the coming decades, not months. For many of the advanced economies, the future deficits look worse than the accumulated debt. Putting fiscal policy on a sustainable path requires reforms that should be long lasting, and we are talking about decades, not quarters. The difference between implementing these reforms in 2011 or 2013 is insignificant compared to the challenge that governments face. What matters is the commitment to get it right in the long run, not now. Yes, what governments do today could be a signal of what they will do over the coming decades, but this is only true up to a point. There will be new governments in the coming years and what is really required is not a contractionary budget one year but a structure and a set of constraints that ensures discipline for future governments.

2. The need for additional fiscal stimulus is based on the assumption that we are not in a normal year. If unemployment was at a normal level, if the output gap was zero (output was equal to potential), then there is no reason to postpone the necessary adjustment. But there is a dimension of economic policy (both monetary and fiscal) that works towards the stabilization of the business cycle. We do not expect monetary policy or fiscal policy to be the same in a recession than in an expansion. And while fiscal policy might require to show discipline over the coming decades, the amount of discipline should be different depending on the phase of the business cycle. Letting the economy be producing below potential for a long number of years is not only socially costly but it leads to a permanent loss in output which is a potential source of tax revenues. And the most recent projections from the CBO (Congressional Budget Office) in the US show that GDP will be significantly below potential output for about 8 years, from 2008 to 2015 (see image below, source).

If we accumulate the output gap for all these years we are talking about a $5.1 Trillion gap that represents a permanent loss in output (and income, and tax revenues). Some might see this as a natural and unavoidable adjustment which almost amounts to claim that GDP and potential output are identical, the output gap is zero, unemployment is all structural. But given that the US economy has a strong tendency to return to its trend regardless of economic shocks, it is difficult to argue that there is no output gap to be filled in 2011 (or any other year before we get to 2015).

Antonio Fatás

Eurobonds or Political Union are not the solution

2011-08-25T08:25:00.000-04:00

I agree with Daniel Gros that Eurobonds are not the solution to the current European crisis. I also do not understand the argument that economic and monetary integration in Europe is failing because of the lack of political integration.

The only possible argument in favor of the idea that Eurobonds (or more political integration) would have solved the current crisis is that Greece, Portugal, Ireland, Italy or Spain are all doing fine and their only problem is that they are being attacked by speculators in such a way that the (high) market interest rate makes them insolvent. By attaching a different label to the bonds of these countries, the speculators will not be able to attack them anymore. There will be no PIIGS bonds out there, only Euro bonds.

This is a possible story and if indeed speculation is the only source of all of Europe problems, this might work. There are, of course, other solutions to the problem: a guarantee by the German or French government or by the IMF or the EFSF or any other credible institution that the bonds will be repaid and the interest rates will adjust to a level that makes those governments insolvent -- this is to some extent the solution being adopted.

The idea that having German tax payers being responsible for the debt that all Euro governments issue sounds not only politically unfeasible but also, from an economic point of view, it could have made matters worse instead of better. What is needed is a credible and transparent fiscal framework that ensures sustainability of public finances. Hiding the "country label" when issuing bonds or pooling all the risk together and making all taxpayers responsible for the misbehavior of any government does not seem to be setting the right type of incentives.

One could argue that the same argument applies to the Euro as a common currency that replaced the national currencies of countries with limited credibility. Does this mean that the creation of the Euro is also a bad idea? No. Sharing a currency is very different from sharing a label (and the risk) when issuing bonds. Sharing a currency does not imply sharing the risk of unexpected changes in income or the cost of the mistakes that national governments or central banks might do.

Antonio Fatás

Dow Jones at 11,000 might not be that low.

2011-08-24T03:29:00.000-04:00

Here is an interesting article from the Federal Reserve Bank of San Francisco on the potential effects that demographic changes could have on the stock market in the US over the coming decades. As baby boomers retire and sell their assets, including stocks, their prices are likely to go down. The issue is not new and has been debated before but what is novel in their research is the correlation between a standard measure of the demographic composition of the population and the price-earnings ratio in the stock market.

The image below shows the price earnings ration (P/E) and the ratio of the middle-age cohort (age 40-49) to the ok-age cohort (age 60-69). This is labelled as M/O in the chart. There is a clear correlation between the two series.

And if we look forward, this is what their paper predicts:

Their model generates a return of the P/E ratio to the low levels of the late 70's early 80's.

There remains, of course, uncertainty about this prediction given that it relies on many factors (such as demand coming from other countries, changes in retirement age), but the correlation of the first figure provides a strong enough argument so that the issue cannot be ignored.

Antonio Fatás

Financial markets and professional cycling

2011-03-23T07:12:00.008-04:00

Luig Zingales writes a very interesting article about some of the new scandals in financial markets (the insider-trading trial of Raj Rajaratnam). While we have seen similar scandals in financial markets before, he argues that this time the methods used to investigate the case and the involvement at the prosecution level are unusual. In addition, the fact that others like Raja Gupta (former worldwide managing director at McKinsey) or a managing director at Intel (Rajiv Goel) are involved, could make this case an important one that will create an even deeper dissatisfaction among the general public about what is going on in financial markets and institutions.

From the article you can see that there is a sense of disbelief about what is happening:

"It is so difficult to imagine that successful executives would jeopardize their careers and reputations in this way that many of us probably hope that the accusations turn out to be without merit."

This quote reminds me of a recent one by Alan Greenspan regarding the behavior of financial institutions prior to the crisis (from October 2008):

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity – myself especially – are in a state of shocked disbelief."

Despite his disbelief, Zingales admits that there is some recent evidence that supports the idea that personal networks can be a source of excess returns in financial markets. But he remains positive when he looks at the industry as a whole:

"After ten weeks of a trial like this, it will be easy for the public to conclude that all hedge funds are crooked, and that the system is rigged against the outsiders. Fortunately, this is not the case. While there are certainly some rotten apples in the hedge-fund industry, the majority of traders behave properly, and their legitimate research contributes to making the market more efficient."

This debate reminds me of what has happened in the sport of professional cycling (apologies to those who are not familiar with the sport and might not understand the analogy). In recent years, there have been a large number of cases of professional cyclists testing positive for performance-enhancing drugs. When the first cases came out there were two reactions:

1. Those who assumed that this was a generalized phenomenon and concluded that most cyclists were guilty.

2. Those who had the belief that this was just a few riders violating the rules but, overall, this was a clean sport. Their logic was that if doping was so generalized, how is it that we have not heard about it before?

Over the last years, we have witnessed an increasing number of scandals in this sport and what is worse is that the riders accused were some of those who had won the major races in the world (Tour de France, Giro d'Italia or Vuelta de España). The fact that most of the riders who finished in the top spots of these races in the last years have been associated to these scandals has shifted public opinion towards the belief that doping was (and might still be) a generalized practice in this sport.

I see a parallel with what we are seeing in financial markets as a result of the more recent scandals. Yes our prior is to believe that generalized corruption will be eliminated by market forces and regulation. But when we think about all the evidence that has surfaced during the last years regarding the behavior of financial institutions and those who lead them, our beliefs start shifting and at some point it is not simply a matter of questioning individuals. We start questioning the whole system, the incentives and the ways in which some become winners in this very competitive market (as competitive as the world of professional cycling).

The difference between cycling and finance is that while we can choose not to watch the next Tour de France but we cannot choose to live in a world where the behavior of financial institutions does not affect our society.

Antonio Fatás

Enforcing the unenforceable

2011-03-16T10:29:00.002-04:00

European Union countries are coming up with new proposals to provide a stricter framework for fiscal policy. EU members have lived for more than a decade under the rules of the Maastricht Treaty and the Stability and Growth pact that set numerical limits on government deficits (3%) and debt (60%). While numerical rules are attractive (they are simple and transparent) the experience of EU countries has shown that, by themselves, they are not very good at providing fiscal policy discipline.

There are many reasons why these rules have not worked as well as expected: they do not provide enough discipline when it is most needed (during economic booms), the enforcement mechanism is decided by the offenders (ministers of finance), etc. In addition, even if the rules are supposed to be objective and transparent, they have always been subject to different interpretations. In particular, the limit on government debt (60%) has been consistently violated by many countries - today most countries are above this limit. They have all used as an excuse a clause that allowed deviations if the ratio was sufficiently diminishing toward the 60% level. But what does it mean to "sufficiently diminish toward the 60% level"?

The current proposal by the European Commission (you can read it here) attempts to make the 60% limit more operational and enforceable. Here is the summary of the new proposed guidelines:

"The debt criterion of the EDP is to be made operational, notably through the adoption of a numerical benchmark to gauge whether the debt ratio is sufficiently diminishing toward the 60% of GDP threshold. Specifically, a debt-to-GDP ratio above 60% is to be considered sufficiently diminishing if its distance with respect to the 60% of GDP reference value has reduced over the previous three years at a rate of the order of one-twentieth per year. Non- compliance with this numerical benchmark is not, however, necessarily expected to result in the country concerned being placed in excessive deficit, as this decision would need to take into account all the factors that are relevant, in particular for the assessment of debt developments, such as whether very low nominal growth is hampering debt reduction, together with risk factors linked to the debt structure, private sector indebtedness and implicit liabilities related to ageing. In line with the greater emphasis on debt, more consideration should be given to relevant factors in the event of non-compliance with the deficit criterion, if a country has a debt below the 60% of GDP threshold."

Maybe I am too pessimistic but the number of potential excuses that are being introduced in this paragraph makes me think that this is not going to work either. I have written a few papers on this issue, the difficulty of enforcing strict numerical fiscal policy rules and the failure of the Euro experience (Here is one example, and here is another oner). Some of the other proposed changes (e.g. establishing national fiscal frameworks of quality) are more promising, but if they keep relying on strict and asymmetric numerical targets, I doubt they will achieve the necessary level of fiscal policy discipline.

Finally, here is a very interesting presentation on this issue from the perspective of the Chile experience by Andres Velasco, former finance minister ( via Phil Lane and the Irish Economy Blog).

Antonio Fatás

More on Ricardian Equivalence

2011-03-13T04:14:00.006-04:00

Our last post led to reactions from Mark Thoma, Nick Rowe, Paul Krugman and Brad DeLong. And, as some of the posts make clear, there is not always agreement about about how to think about the effects of fiscal policy on GDP. The debate has centered around what economists call Ricardian Equivalence a result that one can find on any macroeconomics textbook and shows that under some circumstances changes in fiscal policy have no effect on GDP and employment.

My reading of the above posts is that there are two separate issues being debated:

1. Should government spending be counted as GDP? If governments end up hiring workers to dig holes and them fill them up again, why is this considered as valuable production? This is a valid point but much broader than the current debate. I do not have strong views with respect to this point, I can imagine questioning the way we measure GDP on several grounds but this was not the main point I was trying to make. My assumption is that the government was buying goods that are valuable and therefore should be counted as GDP. But were I have strong views is that we should not confuse this argument with the one that separates the effects of changes in government consumption versus investment. Government consumption can be valuable (provision of healthcare, education and other public services) as much as government investment. It is not only government investment that should be counted as GDP. And this is where I felt that the original statement from the World Bank chief economist was not clear enough. That he seemed it imply the need to look for expenditures that raise the productivity of the economy.

2. The second debate is about the validity of the Ricardian Equivalence proposition. This proposition says something very simple: if the governments cut taxes today and does not change the path of spending, then the private sector should anticipate the future taxes required to pay for government spending and decrease consumption by exactly the same amount as the increase in government spending. In this case GDP does not change. Realize that here we are ignoring the first point and counting government spending as GDP (otherwise GDP will be falling). This result (Ricardian equivalence) does not apply to cases when government spending changes. To be more precise, depending on whether the change in government spending is transitory or permanent we get some or no effects.

The Ricardian Equivalence proposition requires many assumptions (perfect foresight, no financial constraints in the private sector, all taxes are lump sum, etc). Some believe that these assumptions are unrealistic and that is why they believe in a world where Ricardian equivalence does not apply. The assumption that I was questioning in my post was the fact that models where Ricardian Equivalence applies are models where the economy is in equilibrium. For simplicity you can think about it as the economy always being in full employment. But this is not a good characterization of many economies today. Why does it make a difference? Because with full employment, the only way to grow output and income is by increasing productivity (or by changes in the labor force participation).

What happens in a world where unemployment is high and there is a large output gap? Depending at which speed the economy returns to potential, we have a different path for income and potentially for private spending. If fiscal policy raises employment and income by closing the output gap faster, private spending will increase even if the other assumptions are still valid. Of course, this does not mean that any fiscal policy measure will do the job (if the government increases the purchases of foreign luxury cars, it will not do the trick...), but there is a potential to increase income and therefore move away from the Ricardian equivalence proposition.

Antonio Fatás

The resistance to being labelled a Keynesian economist

2011-03-09T17:13:00.002-05:00

Here is an example of the resistance that professional economists show to adhere to the standard keynesian prescriptions for an economy with ample spare capacity (and high unemployment). Justin Yifu Lin, Chief Economist of the World Bank, writes in an article entitled "Beyond Keynesianism and the New Normal":

"The above risks to a sustained recovery are directly or indirectly related to the simultaneous existence of large excess capacity in the high-income countries. In my view, a global push for investment along the line of Keynesian stimulus is the key for a sustained global recovery; however, the stimulus needs to go beyond the traditional Keynesian investment...But how can the Ricardian trap be avoided, i.e. an outcome where the government stimulus fails to boost aggregate demand because economic agents expect future tax increases to pay for larger deficits and thereby increase savings? To avoid the Ricardian trap, it is important to go beyond conventional Keynesian stimulus of “digging a hole and paving a hole” by investing in projects which increase future productivity."

So in the presence of large excess capacity he is in favor of policies intended to increase demand. But he is concerned that the standard policies (e.g. increase government spending) will not work this time. And this is because the private sector might undo the actions of the government by saving more (to pay for future taxes). The proposed solution is to direct government spending to activities that increase productivity so that output and incomes grow (and this helps keeping private spending up and tax revenues).

No one can disagree with the statement that if the government can choose between different spending projects, they should select the one with the highest return (in terms of productivity and income). But we need to understand that the advise for the government to invest in productive investment applies at all times (good and bad). What is different when there is spare capacity is that "pure demand" policies can bring the economy closer to potential in a shorter period of time. By doing so they will be increasing the overall output and income of the country. And this additional income is the source of potential increases in private spending and tax revenues. This is the intuition behind the Keynesian recipe for times of high unemployment, which is consistent with the concerns of Justin Yifu Lin. Of course, if in addition we find projects that improve productivity, innovation, human capital, even better. But there is no need to keep searching for such projects when we are producing below our potential.

Antonio Fatás

Errors in macroeconomic forecasts or in politics?

2011-03-07T12:19:00.008-05:00

In December 2000, Bill Clinton announced that the "The United States is on course to eliminate its public debt within the next decade." According to the 2001 budget presented by his administration (during the year 2000), the government debt held by the public would decrease from about 3.7 trillion at the end of 1998 (42% of GDP) to 377 billion by 2013 (around 3% of GDP).

This prediction turned out to be highly inaccurate as today (2010) government debt in the US has reached close to 9 trillion (60% of GDP).

What went wrong? Did the New Economy led to unrealistic macroeconomics assumptions or did the next administration(s) behave differently from what the Clinton administration had predicted?

The next two figures helps us understand the source of this forecasting error. Let's start with the GDP forecast. The macroeconomic assumptions in the 2001 budget were quite reasonable. The path for GDP as predicted by the 2001 budget has been very close to the actual numbers. In fact, by 2008 the actual GDP was slightly higher than what was anticipated in 2001 (Note: The 2009 forecast was, of course, off by a large amount because of the depth of the recession. I stop the series in 2008 because I want to focus on the pre-crisis period. Notice that there was a recession in 2001 that was also unexpected but it did not significantly affect the path of GDP.)

Figure 1. GDP Forecast from 2001 budget compared to actual GDP.

In contrast, the debt held by the public grew at a much faster rate than it was anticipated. Starting with the 2001 year, government debt accelerated and deviated from the optimistic assumption that the government would keep taxes and spending at levels that allowed for a continuous reduction of debt levels towards zero. Taxes were cut and without a restrain on spending, deficits and debt grew.

Figure 2. Government debt held by the public as forecasted in the 2001 budget

compared to the actual figure.

In the figure below I extend the series to 2012 by comparing the forecast made in the 2001 budget as well as the forecast made in the current 2012 budget. After 2008 the two series keep deviating from each other and this time is not all about political decisions, we also have the effect of a worse-than-expected growth performance in the 2008-2010 period.

Figure 3. Government debt held by the public

as forecasted in the 2001 and 2011 budgets.

Ensuring long-term stability in public finances is not easy. Governments face uncertainty about macroeconomic conditions and their political choices need to be consistent with their macroeconomic forecasts. What the example above illustrates is that the macroeconomic uncertainty was not responsible at all by the deviation in fiscal policy outcomes from their forecasts in the 2001-2008 period. It was a set of different policy choices after 2001 that sent the budget into larger deficits and the debt levels towards an unsustainable path.

Antonio Fatás

Global inflation and US monetary policy

2011-02-28T12:29:00.003-05:00

I was planning to write a short note on the (lack of a) link between US monetary policy and global inflation but David Altig (from the Atlanta Fed) says is as well as I can:

"If the United States unwisely floods the world with dollars, driving down the international value of the dollar, countries with flexible exchange rates would see the value of their currencies rise—making food grains and oils denominated in dollars more affordable, not less. The only way inflation gets exported to these other countries is if they attempt to maintain the values of their currencies below the levels that markets would otherwise take them. That inflation is purely homegrown."

The full article can be found here.

Antonio Fatás

The US 2012 budget (CNBC Interview with Ilian)

2011-02-18T01:56:00.000-05:00

Supply or Demand? Beyond the labels.

2011-02-17T17:45:00.002-05:00

Philadelphia Federal Reserve President Charles Plosser has questioned the usefulness of using monetary policy as a stimulus tool by saying “monetary policy cannot retrain people”. This statement is the result of his belief that the current problem with unemployment in the US is mainly structural. The only way to reduce it is by retraining workers from industries in decline (construction workers) to industries that are supposed to grow faster (nurses).

This is not a new debate and others have already replied to Plosser’s comments by showing strong evidence that the high unemployment rate in the US economy is present in practically every sector, every group or every region, so it is difficult to see how the data supports Plosser’s statements (see for example Paul Krugman making this point).

The debate about what causes business cycles: changes in demand or changes in supply is certainly not new to academics and it is normally seen as a differentiating point between groups of economists (Keynesians versus neoclassical). From the perspective of non-academics the debate is not always clear partly because of the way economists use the words demand and supply at the aggregate level and how it relates to the concepts of demand and supply in the market for a single good.

When you look at one market, demand and supply are always equal. One can explain fluctuations in prices or quantities by referring to movements in supply or demand but we normally do not think about periods where demand is too low or supply is too high (unless the market is not clearing).

When it comes to aggregate output, recessions are understood as periods where there is slack in the economy: unemployment is high, capacity utilization low. Some immediately associate these periods with the notion that demand is low. We have enough supply (workers, factories) to produce more but companies do not have enough demand to operate at full capacity. If we ask someone who has not studied economics before it is likely that they will find this story intuitive (and this is probably the reason why most people tend to have a “Keynesian” view of the world event if they have not been taught economics before). But I could also refer to recessions as a period where employment and output are low and this is about production, not just demand. So can we talk about recessions as periods where aggregate supply is also low?

Let’s ignore the supply and demand labels for the moment and separate the issue in several questions and see when there is agreement and when there is not.

Q1. Are there periods where the economy is producing below potential as measured by full utilization of all our resources? I am sure everyone agrees that this is the case. High unemployment represents a use of our labor resources below potential.

Q2. Why aren’t we using all of our productive resources during recessions? While most will agree that recessions are temporary, they disagree on what causes the friction that keeps employment temporarily below the level that ensures “full employment”. Charles Plosser's statement indicates that the friction (today) is mostly about a mismatch of skills (construction workers need to train themselves to become nurses). Keynesians believe that a low level of “aggregate demand” is keeping output low. But what type of friction explains the low level of aggregate demand? A textbook Keynesian model will talk about price rigidity as the main mechanism for such a friction. Price rigidity leads to changes in some key relative prices (such as the real wage) that generate a low level of production. Price rigidities are not that intuitive for those who have not studied economics. Does this really mean that if we let the price level drop we will go back to full employment? How fast?

What the traditional Keynesian model is probably missing is a more realistic friction that explains why “aggregate demand” remains low for such a long period of time. This mechanism cannot be a friction a la Plosser (mismatch of skills or sectors or regions) otherwise the Keynesian prescriptions do not work. If you ask someone who has not studied economics before they will probably tell you a story of companies getting stuck (at least temporarily) in a low output equilibrium. If I do not hire more workers then there is not demand for your goods and the reason why I do not hire more workers is that you do not hire them either. This is what economist refer to as models with multiple equilbria, which have been proposed by academics often but they tend not to be too popular because they are almost impossible to test and some see as an ad-hoc explanation of cycles. Notice that, strictly speaking, in those stories or models the problem is one of demand as much as supply (the coordination failure is as much at the production level as it is at the demand level).

Q3. Should fiscal policy and monetary policy be used to stimulate an economy during a recession? The answer depends on how we answered the previous question. If the friction is a mismatch of skills in the labor market, it is difficult to imagine how monetary or fiscal policy can speed up the adjustment. But if we believe that:

a) Companies are ready to hire workers who happen to be unemployed and waiting to be hired.

b) They do not do so because they do not see enough demand for their products.

Then there is room for monetary fiscal policy to increase the demand and the output (supply) of the economy. Whether one believes that the friction is just price rigidity or simply a failure to coordinate to a quick return to full employment, traditional “aggregate demand” policies such as monetary and fiscal policy will do the job (even if one could call them aggregate supply policies as well).

Antonio Fatás

Looking ahead: US and Europe

2010-12-19T10:51:00.003-05:00

Here is a recent CNBC interview where I discuss the economic situation of the U.S. and European economies.

Ilian Mihov

The future of the Euro

2010-12-17T03:50:00.004-05:00

Here is an interview published by INSEAD knowledge where together with one of my colleagues (Douglas Webber, a political scientist) we answer questions regarding the future of the Euro both from a political and an economic angle.

Antonio Fatás

Accumulating foreign reserves: private or public?

2010-12-15T07:45:00.004-05:00

The global imbalances that we have witnessed over the last years have led to significant changes in the net investment position of some countries. Those with persistent current account deficits (e.g. the US) have seen their net investment position deteriorate, while those with persistent current account surpluses have seen their net investment position improve (such as China). An improvement in the net position represents an increase in the foreign assets held by that country relative to its liabilities (domestic assets held by foreigners).

In some of the surplus countries (certainly in China), the majority of the accumulation of foreign assets has resulted in large increases in the amount of foreign assets held by the public sector (government or central bank), what is known as foreign reserves. Have they gone too far? Is there an optimal amount of foreign reserves for a country such as China?

SAFE (the State Administration of Foreign Exchange in China) provides on its web site an interesting list of FAQs regarding the current level of foreign reserves in China. To the question "What is the appropriate scale for China's foreign reserves?" they provide an intriguing answer. They start with the assertion that "Too much foreign exchange reserves can be bad." and then they follow with the paragraph:

"In terms of aggregate foreign exchange assets, in a broad sense, at year-end 2009,

China

held USD 3.46 trillion in foreign financial assets, far lower than the developed countries in North America and Europe. The main problem at present is that most of

China

's foreign exchange assets are controlled by the government, leaving only a small proportion in private hands. Specifically, foreign exchange reserves held by the Chinese government account for two-thirds of all foreign assets in China, compared with only one-sixth in Japan. Therefore, we encourage businesses and individuals to hold and invest in foreign exchange so as to diversify the mix and to distribute foreign exchange within the private sector. This, of course, takes time. With the development of our national economy and the increase in income, enterprises and individuals will have greater demands for diversification of asset allocations. If more foreign exchange investment channels and products are provided for the public to reap concrete benefits from the foreign exchange, then the foreign exchange pressures on the government will be greatly relieved."

The opening sentence is a claim that the overall level of foreign assets in China is not that high if you consolidate the public and private sector. Is this true?

The table above summarizes the gross international investment position for the US and China in 2009. By looking at the first row we can see that the claim by SAFE is correct. The overall level of foreign assets (public and private) held by domestic individuals, companies or institutions in the US is more than 130% of GDP, significantly higher than in China (around 58%). However, in the case of China the majority of these assets are held as foreign reserves, i.e. they are in the hands of the government or central bank; foreign reserves in China represent more than two thirds of all the foreign assets. It is this unusual volume of foreign reserves what drives the headlines about excessive foreign reserves accumulation in China. But the SAFE claim is correct: if one is willing to consolidate the public and private holdings of foreign assets China is still far from the levels of the advanced economies.

But is the public/private composition relevant to understand these numbers? Let's first understand the comparison between China and the US. No doubt that as a country opens up to international capital flows and individuals and companies diversify their portfolio of assets, we expect to see an increase in the amount of foreign assets (as % of GDP); that's why the US (or advanced economies) have a much higher ratio of these assets relative to GDP.

In the case of China, the flow of foreign assets (a result of exports and capital inflows) ends up in the hands of the government because of restrictions on capital flows (domestic agents see no value in holding foreign assets or are not allowed to invest in the assets they might want to hold), which is unusual.

But if we take the view that what matters is the aggregate (public + private), does this mean that the level of foreign reserves in China is too low? No, this would be the wrong reading of the numbers or the debate. What matters in this debate is the net investment position which keeps improving (+30.5% in 2009) and it is the outcome of current account surpluses that reflect an imbalance which is not sustainable (or, possibly, optimal). It is true that if capital markets in China were more integrated with the rest of the world and more individuals and companies diversified their portfolios by holding foreign assets, we would not see such a high level of official foreign reserves in China. But this would not change the diagnosis of the situation. As long as the exchange rate remains undervalued and the current account in surplus, we would still see a continuous improvement in the net investment position as a sign of unsustainable global imbalances, regardless of the ownership composition of the foreign assets.

Antonio Fatás

One lesson from the tax cuts deal in the U.S.

2010-12-08T07:06:00.004-05:00

The recent agreement on tax cuts in the U.S. has generated a heated reaction. There are different readings about the economic and political consequences of the agreement (Mark Thoma provides a nice summary of some of the reactions).

The deal represents a very interesting political agreement between the Obama administration and the Republicans. Obama concedes by maintaining all the "temporary" tax cuts of the Bush administration, even for individuals earning above $250,000 and the Republicans decide to ignore their campaign statements that reducing the deficit should be a priority.

The outcome becomes an additional fiscal policy stimulus in the form of tax cuts and, obviously, a higher projected deficit for the coming years. I am very sympathetic to the idea of using again fiscal policy as much as possible to bring the economy back to potential, so there is an element of good news in the announcement (although maybe the agreed policies are not the best, spending might still be a more powerful fiscal policy tool to deal with the current circumstances).

But beyond the economic consequences of the announced tax cuts, there is one clear lesson from this experience: reducing budget deficits in the U.S. will be a challenging task. And if the plan requires increasing taxes then you need to wait until there is a real crisis of confidence and this crisis leads serves as a wake up call to politicians. Given what we have seen this week, finding a balance between short-term goals and long-term sustainability and making difficult decisions to reduce budget deficits will require substantial changes in the way politics and policy are done in the U.S.

Antonio Fatás

The Irish bailout: Barry Eichengreen is mad (and he is right)

2010-12-02T07:44:00.003-05:00

Barry Eichengreen has written a great piece for the blog The Irish Economy. He is known (as he states himself in the introduction) as being one of the most pro-Euro(pean) of the U.S. academics but he feels that the handling of the Irish situation is a disaster. The fact that the Irish government that had a very healthy fiscal position before the crisis ends up with an exploding debt because of the bailout that it provided to private banks, does not sound right to him. Why were holders of Irish bank bonds protected from the failure of these banks? This is not a new question, it has also been raised in other countries where governments have stepped in to ensure the viability of the financial system. But the magnitude of the debt burden that the government is passing to tax payers in Ireland is such that is potentially making the Irish government insolvent.

Eichengreen is pessimistic and he thinks that the provision of the liquidity that the Irish government will receive is simply postponing the inevitable. And the only reason why the other countries agreed is because they are trying to protect their own banks who hold the debt of the Irish banks.

So Barry Eichengreen sees debt restructuring happening soon and he is probably right. And his prediction is not about the economics of debt and deficits; in principle, governments could pay a very large amount of debt with future tax revenues. The real question is whether this is politically feasible. Will Irish tax payers be willing to pay for the failures of these banks? Not obvious when you look at the potential payments associated with current debt levels.

Antonio Fatás

The European crisis = the Euro crisis?

2010-11-30T05:01:00.007-05:00

"The Euro is to blame for the current crisis in Europe". I am sure this sentence sounds familiar to many. The argument is simple: as Euro members cannot devalue their currencies anymore, they do not have an option to improve their economic conditions (by favoring exports), growth suffers and their high levels of debt become unmanageable. The Euro area is not an optimum currency area (it lacks labor mobility, fiscal transfers, etc.) so this was a crisis waiting to happen. Paul Krugman says it here, Simon Johnson says it here and you can find many more articles in the business press repeating these arguments.

Let me (partially) disagree with that statement and just bring an alternative view to this issue. It is not a view that denies the importance of exchange rates or the fact that the constraints of the Euro area (one monetary policy might not fit all) might be hurting Euro economies but I think that it is healthy to question our priors on the importance of the exchange rate in explaining some of the empirical phenomena we observe these days in Europe.

A couple of disclaimers before I present my arguments: these are difficult questions to answer. When looking at historical episodes, one needs to control for all variables and their behavior during that time. I will not do that here. Partly because those arguing about the costs of the Euro do not do it either, partly because it will involve heavy statistical analysis which might not be suitable for a blog.

A second disclaimer: I will use Spain as an example because it tends to be used as an example of the problems faced by Euro members and because it is seen as the next in line to ask for funding (it is not related to my nationality...).

Spanish unemployment has reached 20% during the current crisis and there is a sense that unemployment will remain very high for the foreseeable future. The logic says that if Spain could devalue, unemployment would fall very fast. How fast? Let's go back in time to when Spain could and did devalue. The previous recession in Spain (if we do not count the slowdown in 2002 as a recession) was in 1992/1993. At that point Spain had a fixed exchange rate relative to other European currencies. Prior to the crisis it had gone through a period of real exchange rate appreciation (because of high inflation) that had eroded its competitiveness. Very similar to what we saw before the current crisis. The difference is that in 1993 Spain decided to devalue its currency (three times between June 1992 and September 1993). What happened to unemployment during the years that followed?

Below is the picture of the unemployment rate before and after the devaluation. We cannot compare with the current crisis yet, we will need to wait a few years before we see how fast or slow unemployment comes back to a "normal" level, but as we can see in the chart below, unemployment remained extremely high in the years that followed the devaluation of the peseta. Growth picked up but not fast enough to generate employment at a fast enough rate.

Second observation: if staying outside of the Euro area produces significant benefits, a quick comparison between the UK and Spain should be very revealing. The UK has seen a large devaluation of the Pound during the crisis while Spain had no option to devalue its currency.

Below are two charts that summarize the fiscal tensions that each of these two countries are witnessing in terms of fiscal policy as well as the overall economic growth before and after the crisis. There are many ways to read these charts and I am aware that I am abstracting from many other variables but keep in mind that they could make the argument stronger or weaker depending on how you read those other variables. For example, one could argue that the real estate bubble in Spain was more significant than the one in the UK (which is true if one looks at activity in the construction sector as a measure of the bubble) so it is likely that the crisis had a much larger effect on Spain than the UK. One could argue, on the contrary, that the crisis of the financial sector had a larger impact on the UK than in Spain so it should be the UK economy that had a sharper downturn. I ignore all these arguments and simply compare a couple of variables during these years (by the way, data coming from the World Economic Outlook Database, IMF).

My reading of these two charts is that differences so far are small. The best argument one could use to highlight the costs of the Euro for Spain would be the forecasted growth for 2010, below that of the UK (but this ignores a better performance during the previous two years as well as possibly the positive effects of the Euro in the years that preceded the crisis). Apart from this, the rest looks very similar. In fact it looks as similar as if I were to compare a pair of two random European countries (within or outside of the Euro area).

A more direct comparison of the effects of the Euro could potentially be seen below in a chart of the relative performance of Spanish and UK exports since 1995. Despite the deterioration of competitiveness of Spain because of the Euro (and higher inflation), exports grew at a faster rate than in the UK (data is from WDI, World Bank, exports measured in current USD, last available year 2008).

So if the Euro is not to blame what do we make out of all the efforts of countries like Germany or France to try to save the offenders (Greece, Ireland, Portugal and Spain) from default? Isn't this linked to the Euro project and a potential failure of this project? Maybe, but there is something which is at least as important: in an integrated area (the European Union not to be confused with the Euro area), there are so many economic linkages, both in trade and capital flows, so that the performance of each individual economy is strongly linked to the performance of others. This is not because they share a currency but because they are highly integrated. Sweden has announced that they will provide funding to Ireland - this is not because they share a currency (they do not), but because there are strong links (e.g. financial links) that makes it in its best interest to do so. The Mexican bailout after the 1994/95 crisis had nothing to do with the sharing of a currency but with the economic interests of the US (and the IMF) in not seeing Mexico go into an even deeper crisis. And in that case, as it would happen with Spain or Ireland today, the existence of a currency in Mexico made matters worse as the devaluation sent all the USD liabilities of the Mexican economy to an unsustainable level.

Sharing a currency has its costs and benefits. The costs are mostly about losing the ability to manage monetary policy as a stabilizing tool. These costs tend to be more visible during times of crisis when we are asking monetary policy to act strongly. So no surprise that this is a good time to ask ourselves whether the Euro is working and whether it was a good idea in the first place. But to reach a conclusion we need to look a broader set of issues that go beyond sharing a currency and a central bank. If we simply stick to the textbook conclusion of why fixed exchange rates are bad, we might miss the bigger picture.

Antonio Fatás

Two percent or a bit below

2010-11-23T07:48:00.004-05:00

In recent speeches, Ben Bernanke has referred to a(n) (implicit) target of around 2% for inflation in the US. The U.S. Federal Reserve, together with the Bank of Japan, is one of the few central banks in advanced economies without an explicit inflation target.

Bernanke’s reference to this number is in the context of concerns that QE2 (second round of quantitative easing) will increase inflation in the US and with this message he wants to reassure the public that inflation will remain low. The exact words that he is using are

“FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below.”

It is interesting that the expression “2 percent or a bit below” happens to be almost identical to the way the ECB currently refers to its mandate for price stability.

Some history about the ECB mandate: Originally, the ECB was given the mandate of maintaining “price stability”. This mandate was later (October 1998) made precise by the governing council of the ECB as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%”. At that point there was also a reference to this target, or to price stability more generally, a a mandate “to be maintained over the medium term”.

This initial definition of price stability by the ECB received some criticism because it was leaving too much room for interpretation: Is any inflation rate below 2% consistent with price stability? Is deflation consistent with price stability or even desirable? This led to a redefinition of “price stability" by the governing council of the ECB in May 2003. At that point, the mandate of price stability was defined as “maintaining inflation rates below but close to 2% over the medium term”. So 2% becomes a ceiling (for the medium term) and the goal is to be close enough to the ceiling. Clearly, in this definition there is a sense of asymmetry: 2.1% inflation is worse than 1.9%.

The words chosen by Ben Bernanke are almost identical to the words chosen by the governing council of the ECB where “below but close” has been replaced by “or a bit below”.

What is the record of the ECB? Clearly the ECB has managed to keep inflation very close to 2% and as such we could call it a success. However, given the definition of price stability, it seems that inflation has remained many more months above than below 2%. Below is a picture of Euro inflation from the launch of the ECB until the recession of 2007/2008. Inflation is close to 2% but it would be more accurate to describe it as “above but close to 2% than “below but close to 2%”. Or using Bernanke’s words “2% or a bit above”.

If we add the last two and a half years of data (picture below), towards the end of 2007 inflation increased substantially and then it fell during the recession, below the 2% target. Today, inflation is once again approaching the 2% target.

Antonio Fatás

Not-so-balanced risks when it comes to inflation

2010-11-18T02:51:00.004-05:00

One more posts on the inflation outlook in the US related to our earlier post. With the release of the last CPI data from BLS, we continue to see a downward trend in inflation. In particular, we have seen the smallest annual change in core inflation since 1957. This is a good opportunity to reproduce the chart below (via Mark Thoma, original source San Francisco Fed).

It compares the evolution of core inflation in the US until September 2010 with the evolution of core inflation in Japan in the months that preceded deflation.

Quite similar so far. The US is today where Japan was in mid 1995. Let's hope that the months ahead show a divergent path between the two lines.

Antonio Fatás

How negative should real interest rates be?

2010-11-16T03:46:00.003-05:00

Standard monetary policy is about setting short-term nominal interest rates. Most macroeconomic models assume that inflation is sticky (constant) in the short run and by moving nominal interest rate the central bank is actually setting the real interest rate and by doing so influencing spending (consumption and investment) decisions. Of course, these spending decisions might depend on long-term interest rates and therefore we also need to understand how short-term interest rates affect both nominal long-term rates and inflation over a longer horizon (where we cannot assume that inflation is constant).

We can use this logic to think about the most recent quantitative easing policies announced by the Fed. That's what Mark Thoma does very well today in his blog. One issue that I am missing in his analysis is how we think about real interest rates (not just nominal) in the current context. This is very much related to the defense that some Fed officials have done over the last hours of their policies. For example, in his interview with the WSJ, Janet Yellen argues that QEII (the next round of quantitative easing) is not intended to raise inflation. That the Fed is happy with an inflation rate below but close to 2%.

I understand the importance of having a "low and stable" inflation target but we need to keep in mind that these targets should be interpreted in a medium-term framework, we are not asking the central bank to deliver a constant 2% inflation every month, quarter or year. And given that the Fed has refused to adopt a formal inflation target to keep its flexibility to set inflation on a short-term basis, why do they seem so obsessed with ensuring that inflation always stays at or below 2%? Even the ECB that is some times seen as putting too much emphasis on inflation has let the Euro inflation rate go above 2% during many of the months it has been in existence, so a little flexibility above 2% in the communications of the Fed might not hurt.

We can also think about what all this implies for real interest rates, by asking: what should the level for real interest rates be given current economic conditions? We know that with short-term rates at zero (and they cannot go lower)sending a strong message about inflation being below 2% sets a floor for how low real interest rates can go (the floor is -2%). Estimates of what the appropriate real interest rate is in the current situation (which tend to be made within the context of a Taylor rule) vary but some suggest that real interest rates might need to be even lower than that [By the way, I find this related post by Krugman very useful to understand the logic behind negative real interest rates].

In addition, we have the issue of the dynamics of expectations and actual inflation. It might be that Fed officials by sending a very strong message about not wanting to increase the inflation rate above 2% will keep inflation expectations low and actual inflation remains significantly lower than the 2% "target". My guess is that their conservatism when it comes to inflation is the results of the strong criticisms that they have received (both at home and abroad), which has sent them into a defensive position where they need to reassure everyone that their current policies are not about raising inflation. But this might not be optimal, while anchoring long-term expectations of inflation around a low target is reasonable, there is nothing wrong in admitting that one of the goals of the current policy is to ensure that inflation stops falling and that we go back towards 2% or even higher in the short-term.

Antonio Fatás

Maybe economists should only have one hand

2010-11-10T08:01:00.002-05:00

We have all heard many jokes about economists and how difficult it is to get them to agree on anything. Most economists always answer a question starting with the words "it depends" and then follow with the expression "on one hand...". I am not here to defend (or criticize) my profession but to point out how difficult it is these days to get a consensus among some basic macroeconomic issues.

As an example, the debate about whether inflation or deflation is more likely, and about whether the aggressive response of central banks is appropriate today is at the heart of some of the most basic issues in macroeconomics. The disagreement could potentially be the outcome of a more uncertain world but seeing how strong are the beliefs of those who express a view on this subject, it seems that we do not have that much uncertainty at the individual level (those who believe that there will be inflation seem quite sure about, same for those who are concerned about deflation) but rather a polarization of views.

One example that I always find interesting is the debate that one finds in the minutes of the monetary policy meetings at the Bank of Japan. When discussing the inflation outlook in Japan in recent yeras, you can always find views on both sides, those who are concerned with deflation and those who are concerned with inflation picking up. Here is a paragraph from the meeting back in April 2010.

"Regarding risks to prices, some members said that attention should continue to be paid to a possible decline in medium- to long-term inflation expectations. One member expressed the view that attention should also be paid to the upside risk that a surge in commodity prices due to an overheating of emerging and commodity-exporting economies could lead to a higher-than-expected rate of change in Japan's CPI."

Of course, given the last 10 years of data in Japan, it seems awkward that some are concerned with the upside risk to inflation. While one cannot completely rule out this possibility maybe erring on the other side, making the mistake of letting inflation be "too high", for a few years would be good for the Japanese economy.

Clearly the US or Europe are not in the same situation as Japan but given some of the recent commentary about inflation I wonder whether we are getting close to a debate with too many hands and too many scenarios that leads to a lack of strong actions in the right direction. One can make mistakes in both directions (too much or too little inflation) and only time will tell in which direction our mistakes go, but given what we know about inflation, inflation expectations and long-term interest rates (all of them are low, stable or falling), it seems that we are worrying too much about the potential mistake of being too aggressive when it comes to monetary policy.

Antonio Fatás

Gold Standard?

2010-11-08T06:00:00.002-05:00

Robert Zoellick, president of the World Bank, has an interesting piece on today's Financial Times about the need for a new mechanism for currency co-ordination. I like the idea of stronger co-ordination but I was surprised to read about the potential role of gold:

"The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today."

In this case I have to agree with the textbook view of gold as the "old money". The best argument in favor of using gold as a reference for currencies or central bank policies is to provide a nominal anchor in order to avoid inflationary policies (i.e. constraining central bank policies). The debate today about currency values/manipulation is about the relative price of different currencies and not about irresponsible monetary policy that might lead to inflation (to be more precise, some are afraid that the current monetary policy stance of many central banks will lead to high inflation but so far there is no evidence of high inflation and some countries are still facing the risk of deflation).

So I am all in favor of debating the need to come back to a system of fixed exchange rates (or even a one-currency world) but I cannot see how gold could play a role in that system.

Antonio Fatás

Inflation or Deflation (CNBC Interview with Ilian)

2010-11-04T11:06:00.000-04:00

Filling the Gap

2010-10-25T11:57:00.003-04:00

What do you do when you find out that the house that you live in is not worth as much as you thought? Or you realize your salary will not increase at the speed you anticipated? Or you simply realize that your debt levels are higher than what you had assumed? The recipe is likely to be a combination of reducing spending and coming out with some good ideas to increase your income.

Many advanced economies face a situation of excessive debt (public, private or both) that resembles one of the examples above. As a result, we talk about the need for fiscal adjustment, deleveraging in the private sector, increased saving, etc. But all these adjustments are required at a time when the economy is suffering from the consequences of a very deep recession. While those adjustments are necessary, they can have negative consequences on the economy (i.e. lower growth) which will make the adjustment more painful. As an example, it might be necessary to lower the consumption to income ratio, but the pain that the consumers will feel depends on what happens to the denominator (income); it is easier to reduce the consumption to income ratio when income is growing than when income is stagnant or even decreasing.

I do not think that many disagree with this logic but there are two aspects where I find some confusion in the discussion: they are about the speed (how fast to go?) and timing (when to start?) of the adjustment.

On the speed of adjustment, we read many times the argument that the adjustment needs to be fast. We hear, for example, the need for ambitious targets for government debt reduction or how we have to ensure that households’ or companies’ balance sheets become healthy as soon as possible. There are some merits to these arguments. Governments need to show commitment to sustainability and consumers or companies need to be in a financial position to be able to do business as usual. But there is also an argument that says that we need to go slowly. The argument comes from what economists call “consumption smoothing” that refers to the principle that most individuals prefer a stable consumption pattern to a volatile one. If you win the lottery, it makes sense to spread the new income across many years. If, on the contrary, you realize that your wealth is smaller than what you thought, it also makes sense to spread the pain over many years. This logic applies to individuals as well as to governments, as discussed in our previous blog entry.

The second issue is timing. How to you achieve the necessary adjustment without hurting growth and income? Here the analogy of an individual fails to capture the complexity of this issue for a whole economy. As an individual I can reduce my consumption as much as I want without affecting my income. As a country, this is not true, as my consumption is linked to somebody else’s income. Of course, there is the rest of the world and a country could potentially reduce its consumption if the rest of the world replaced the demand for the locally produced goods but this is unlikely. This issue of timing is even more important in the current environment because we just went through a very deep recession. Should the adjustment towards reduced spending start now? When should governments start reducing budget deficits? The answer depends on our assessment of the output gap (the difference between potential and actual output). While there might be some questions about the size of the output gap, there is no doubt that it is significant. If this is the case, even if our main objective is to bring the necessary adjustment to the economy by reducing spending the best way to do this is by reducing the output gap first.

Many times, reducing the output gap is portrayed as getting out of the crisis by spending more (which some see as a contradiction because excessive spending is seen as the cause of the crisis). This is not correct, reducing the output gap requires both spending and production. It is about ensuring that the economy produces as much as it can, generates the maximum (potential) amount of income so that the adjustment towards lower spending is done in the least painful manner.

Discussions on the size of the output gap are always subject to uncertainty and today we witness a debate about the extent to which structural issues, not just cyclical, are behind the current low level of output in advanced economies. I am willing to admit that we need a combination of policies to reduce the output gap and some might be seen as “supply-side” policies. But it is difficult to believe that a large and quick adjustment towards a path of lower spending will bring the economy closer towards potential in the short term; it is likely to make matters worse. And whether excess spending is responsible for the crisis we just went through is irrelevant. Regardless of how we got here, we need to figure out a way to reduce the output gap by ensuring that the level of income, spending, production are all as close as possible to potential and this means more of all of them, not less.

Antonio Fatás

Fiscal adjustment: fast or slow?

2010-07-15T04:53:00.002-04:00

As growth slowly comes back governments in advanced economies are facing the question of when they should start reducing their deficit and address the growing debt problems. While there is no question about the need for an adjustment, there is a debate about its timing and speed. These are the two sides of the debate:

1. Go slow: given that growth is still not strong enough and unemployment remains high, adjustment should be postponed as much as possible. A cut in government spending or an increase in taxes will decrease aggregate demand and growth. The costs of keeping the debt high are small compared to the costs of high unemployment.

2. Governments need to act fast because their high level of deficits and debt are creating too much uncertainty and fear of a crisis. In some cases this is showing up as higher interest rates (which can harm growth). In others, interest rates remain low but the fear of an unsustainable path for fiscal policy can lead to low investment and growth. A quick fiscal consolidation (reduction in deficits) is what the economy needs now.

Both sides of the argument have merits and it is not a question of which one is right and which one is wrong. Circumstances are different in each country and it is likely that the optimal speed of adjustment is different for each economy. What I would like to highlight in this post is an area where I feel there is some misperception: the burden that interest payments on the debt impose on taxpayers, an argument that is used in favor or speeding up the fiscal adjustment.

It is possible, although empirically it is not that obvious, that a high level of government debt has negative consequences on investment or economic growth. The high level of government debt can be seen as an accumulation of previous errors or misbehavior: governments spent too much or did not have the political willingness to collect enough taxes. But the past cannot be changed and the question we face now is how to pay for our previous “mistakes”: Do we do go for a quick payment of our debt or do we spread the pain over a long number of years? This is an economic decision that depends on many parameters but mainly on the relative value of current versus future income and the interest rate that we are charged on the debt (which in general equilibrium they have to be related). What we need to understand is that the cost of the debt will be there whether we pay now or we pay later. We might find good reasons why we should pay earlier but there might also be reasons why we want to postpone the payment (spread the pain over several years).

Think about an individual who inherits some debt or that realizes that the total value of his debt is higher than what he initially thought. Is there an economic argument that he should cut his consumption as much as possible to avoid the higher interest payments on the debt? Not clear. This decision is about the trade off between consuming today and tomorrow and the price at which this trade off takes place. In most economic models, we assume utility functions for individuals that generate a preference for consumption smoothing, so we normally think about an optimal solution that requires slow payment of the debt. Same for governments, we normally think about tax decisions as being driven by a “tax smoothing” argument, which suggests that spreading the burden of high debt over many years or decades, is optimal. In addition, if we think about the present as a period where income is unusually low (because of the recession), this might not be the right time to start paying off our debts by cutting our consumption even more.

In summary, one needs to be careful using the argument of the high burden of the debt to push for a quick reduction in government debt levels. The level of government debt is what it is and the burden will have to be paid in some form over the future. The question on how fast we reduce the debt is about the timing of those payments and not so much about the total cost of the debt. Paying earlier has to be a statement about how we are willing to cover the cost of debt with reduced current spending as opposed to reduced future spending.

Of course, if financial markets are not willing to fund our debt anymore, we will be obliged to pay the debt faster. Or, in a milder scenario, if the interest rate we face is “unreasonably” high because of the fear of default, we might find it optimal to pay the debt now to calm that fear and reduce the overall burden of the debt – this might apply to Greece but it clearly does not apply to the US.

Antonio Fatás

Completing the Eurozone rescue

2010-06-17T03:35:00.003-04:00

VoxEU has published a new eBook on the current economic situation in Europe. The book is called "Completing the Eurozone rescue: What more needs to be done?". The book contains 13 short articles with an analysis of what went wrong and some concrete policy proposals to ensure a successful recovery and avoid similar crisis in the future.

Here is a summary of some of the findings:

"Although the essays were largely uncoordinated – and the authors hark from diverse backgrounds – a remarkably coherent message emerges. The authors unanimously believe that the crisis is not over, and that the Eurozone rescue is not finished. More needs to be done.

As Charles Wyplosz puts it, the Eurozone is levitating on the hope that European leaders will find a way to end the crisis and take steps to avoid future ones. Unless more is done, however, this levitation magic will wear off and the Eurozone crisis will resume its destructive, unpredictable path.

The crisis, in our view, is a thorny tangle of incipient debt and banking crises. Until this tangle is sorted out, any further shock could threaten the Eurozone as we know it. After all, Eurozone bank systems remain in a parlous state. Confidence in the financial system has not been restored. The losses from the Spanish real estate binge have only partially emerged. Greek public finances have still not been stabilised. Large competitiveness imbalances persist.
In short, none of the underlying causes of the crisis have been addressed.

Massive shocks could come from any number of sources ranging from the Spanish banking sector to political crisis in member countries facing fiscal austerity. Indeed, we already see ominous signs. Risk premiums on some Eurozone government debt have resumed their upwards trend despite the two May packages.

We also know that even small shocks can lead to a major crisis given the interconnected fragility of the Eurozone. Remember that it started with fiscal problems in a country which accounts for only 2.5 % of Eurozone GDP. Banking crises in a number of European countries could cause sovereign debt crises – a la Reinhart and Rogoff (2009) – which could spark contagion, thus triggering more bank crises. Trying to muddle through would be like sleepwalking through a minefield.

The time for action is now, for, as Barry Eichengreen puts it, “financial crises feed on uncertainty. The longer uncertainty is allowed to linger, the greater the damage to confidence…”.

Ilian and I wrote on of the essays where we are argue in favor of an institutional solution to the fiscal problems of the Eurozone. Our essay can be found here. The full set of essays can be found on this link.

Antonio Fatás

The Architecture of the new Global Economy

2010-05-18T12:22:00.002-04:00

Last Friday INSEAD hosted its 4th Leadership Summit in its Fontainebleau campus. I participated in a debate on the architecture of the new global economy. The other members of the panel were Shanti L. Poesposoetjipto (Chief Executive Officer, PT Ngrumat Bondo Utomo), Ernest-Antoine Seillière (Chairman of the Supervisory Board, Wendel Group), Lord Simon of Highbury (Director GDF Suez, Former British Minister for Trade and Competitiveness in Europe, Former Chairman of British Petroleum) and it was moderated by Geoff Cutmore (CNBC).

A video with a summary of the session is below. Other videos from the event can be found in the INSEAD YouTube channel.

Antonio Fatás

We are not Greece

2010-05-17T04:06:00.003-04:00

"We are not Greece". Many government officials from different countries have been claiming that their fiscal problems are not as bad as those of Greece: Portugal, Spain, Ireland or the U.S.

Given the importance of credibility and "labels" in financial markets, many government are trying to distance themselves form the "Greek" label to ensure that their interest rate spreads remain under control.

It is hard to deny that the situation of the Greek government is one of the most difficult ones among advanced economies, but how bad is it compared to other countries? The most recent IMF analysis of fiscal policy provides a nice summary of the difficulties ahead.

One way to summarize the many tables that the report contains is to look at Figure 14 (below). This figure looks at two dimensions of the necessary adjustment in economies around the world:

1. The effort in terms of adjustment to the government primary balance to maintain government debt levels at 60% of GDP in 2030. (see the full report for details, there are some technical assumptions that matter). This is measured in the horizontal axis.

2. The expected increase in Age-Related Spending during the 2011-2030 period. This is an important number because it informs us about the need to increase taxes (or reduce other components of spending) in order to achieve the necessary adjustment as calculated above in point #1. This is measured in the vertical axis.

The best place to be is on the bottom/left quadrant where the adjustment is small and the projected increased in spending is small. The worst place to be is the top/right quadrant where there is a need for a large adjustment and where age-related spending is likely to increase fast.

One clarification about this picture: Greece is not included in the IMF chart. The reason is that you need to use a starting point as a reference to calculate the necessary adjustment. Given the current turmoil and the constant change in budgetary plans, it is difficult to establish such a reference point in Greece. I have added Greece in the picture by using the information on the note that comes with the chart which states that Greece needs to adjust the budget balance by 9.2% after measures of 7.6% undertaken in 2010.

Greece is the country that requires the largest adjustment in the (primary) budget balance, even after the proposed adjustment for this year. Greece also expects a significant increase in age-related spending over the next two decades. although others are in a worse situation.

There is no country that looks exactly like Greece but there are a few that face a significant fiscal policy challenge.

The United States combines the need for a very large short-term adjustment with an increase in age-related spending that is only second to Japan. Spain and Ireland are also in need of large adjustment although they face significantly lower pressure when it comes to age-related spending.

There are many ways to look at fiscal policy statistics and future scenarios and there are some key assumptions that can dramatically change the position of each economy in this chart (assumptions on growth, interest rates,..). But looking at numbers rather than "labels" is always a good starting point.

Antonio Fatás

$700 Billion, $1 Trillion,...

2010-05-12T15:21:00.007-04:00

It seems that large bailouts are becoming the norm these days. TARP was 700 Billion, the recent agreement to support European governments is larger than $1 Trillion. Are these reasonable numbers? How large will the next one be?

There is still some confusion about what these bailouts do. In their design, they deal with a situation of financial distress that some see as a problem of liquidity (short-term financing) but others see as a problem of solvency (the business or the government will never be able to generate enough funds to pay for the current debt). Policy makers are uncertain about whether liquidity or solvency is the true problem but they might see reasons under both scenarios to still go for the bailout. If it is liquidity, the reasons are clear, you do not want a large institution, a large government or the whole financial system collapse and drag others into financial distress. In the case of solvency, it is less obvious but there are still economic (or political) reasons to keep some companies or governments alive (as in the case of the car industry in the US).

If liquidity is the real problem, the cost to taxpayers should be minimal or one could even imagine a profit from the lending. If solvency is the problem, there will have to be a transfer from taxpayers to the company or government in trouble.

In the case of TARP, the plan to buy toxic assets in the US, there was always an understanding that some of the purchases would constitute a transfer to the financial institutions holding those assets but there was a lot of uncertainty about its financial amount. Today's estimates are more optimistic than some of the earlier ones with a total cost somewhere around $90 billion.

In the case of Greece, we are talking about loans that do not imply a direct transfer to the Greek government. It could, of course, be that the interest rate charged to the Greek government is seen as below market and this could be considered a transfer -- but if the final goal is achieved and the Greek government does not default, then the market interest rates were simply overestimating the true risk and there is no transfer implied in the interest rate set by the loans. If Greece defaults and this default affects the bonds purchased by this rescue plan then there is a cost to the taxpayer.

The reaction of financial markets (both the stock and bond market) to the plan is difficult to understand. The plan does not involve a direct transfer to the Greek government (or any of the other European governments that might need the funds). If the reaction was so positive it must either mean that the market believes that this was a liquidity problem that was just solved or the market reads more into the plan than what you see in the statement by the ECOFIN. Maybe they see the promise of a future transfer if liquidity problems turn into insolvency for the Greek government.

My interpretation is that a direct transfer (not a loan) to the Greek government from other European countries is unlikely to happen. So the $1 Trillion plan looks more like a way to send a strong message (a number that was much higher than what most expected) and, at the same time, ensure liquidity over the months to come. It seems that the number matters more to the markets than the details. In practice, not much has changed. The government of Greece still needs to find the necessary revenues (taxes) to cover their spending and service the debt. They have bought themselves some time but the fundamental imbalance remains and it needs to be addressed.

There will be other crisis and I wonder if this is a trend of designing larger and larger bailouts to make sure that they provide the necessary reassurance to financial markets.

And if you want to look at the less serious side of bailouts, you can always play the bailout game (click here to access the game).

Antonio Fatás

Current account imbalances and fiscal policy

2010-05-12T04:27:00.004-04:00

Current account imbalances and sustainability of fiscal policy are two of the most important challenges that the world economy has to deal with in the coming years. They are both linked by the national account identity that states that the current account balance of a country is the sum of the private balance between saving and investment and the government balance.

I spent some time at the IMF Fiscal Affairs department last year and as a result we produced an analysis of the empirical link between fiscal policy and the current account. Our goal was to analyze a broader sample of countries and to look at episodes of large changes, two issues that had not been studied before in this literature.

The copy of the working paper can be found at the IMF web site.

Antonio Fatás

The visual display of (politically-loaded) information

2010-05-02T02:56:00.003-04:00

I have always been a fan of Edward Tufte and his work on the visual display of information (I am borrowing one of the titles of his books for the title of this blog entry). Below is a chart that I found via Brad DeLong on the path of job creation (or destruction) around the time of the change in the US administration. The original source of the data is the blog/web site of Nancy Pelosi (speaker of the US House of Representatives). Nice contrast between the Bush and Obama administration.

There are, of course, different ways of looking at the labor market performance during the Obama administration as Greg Mankiw has pointed out in his blog. Below is a picture that he updates often on the difference between what the administration had forecasted as a result of the recovery plan and the actual unemployment rates.

Same labor market, same data, but two very different messages depending on how we look at it.

Antonio Fatás

The Euro crisis

2010-04-30T03:35:00.004-04:00

According to Paul Krugman, the Euro is one of the main factors behind the crisis in Greece and other European countries. The fact that Greece (and Portugal, and Spain and Ireland) cannot devalue their currencies is having a negative impact on their growth which lowers tax revenues, increases government deficits and raises the possibility of default. Martin Feldstein goes one step further and argues that if Greece could devalue, they would easily avoid default.

I understand their argument, that exchange rate misalignments can have negative economic consequences but I think that blaming the Euro for the imbalances in government accounts is misleading.

The work of Reinhart and Rogoff, summarizing eight centuries of financial crises is full of examples of countries with flexible exchange rates where governments default. There are also plenty of cases of countries with fixed exchange rates and large devaluations that not only do not avoid default but might be responsible for it (as liabilities where denominated in a foreign currency).

Anyone who looks at the history of Greece (or any of the other Souther European countries) knows that crises come in variety of forms and the anchor of the European Union and the Euro has led to additional constraints on the government that have probably avoided crises, rather than creating them. This is what Reinhart and Rogoff conclude:

"Interesting recent cases include Greece and Spain, countries that appear to have escaped a severe history of serial default not only by reforming institutions, but by benefiting from the anchor of the European Union."

One thing that I am missing in the arguments of those who blame the single currency for the current European "crisis" (at least of confidence) is their recipe for the US in terms of exchange rate policy. The US government has debt levels that are likely to grow faster over the coming years (and decades) than in the case of Ireland or Spain (if we believe the OECD). The current US government deficit is similar and the projected US budgets for the next years in the US do not show a strong sense of restraint. There is no doubt that US fiscal policy is on an unsustainable path and there is a need to cut spending or raise taxes substantially over the coming years. In addition, the US has also displayed very large current account deficits in the last decades a sign (according to them) of the lack of competitiveness of an economy. How will the flexibility of the US exchange rate help the US going forward? If their recipes for Southern Europe are applied to the US, what should the US dollar do over the coming years? Depreciate? Relative to which currencies? Who will engineer that depreciation?

As an academic, it is easy to find arguments against a certain exchange rate system (flexible or fixed). But we need to go one step further and suggest an alternative taking into account the empirical evidence we have accumulated over the last decades or even centuries. In my view, arguing that the Euro is one of the key factors behind the Greek crisis ignores the economic history of these countries and the true trade offs that they face between different exchange rate systems.

Antonio Fatás

Bringing government debt under control: how painful will it be?

2010-04-14T06:09:00.002-04:00

Last week I participated in an academics consultant meeting at the Board of Governors of the Federal Reserve to discuss the question of achieving fiscal sustainability. I have posted the note I wrote for the meeting on my web site, but here is a quick summary of some of the points I made:

1. There is no doubt that governments in advanced economies will have to go through major fiscal policy changes in the coming years to keep the debt-to-GDP ratio under control. Given current policies, debt-to-GDP ratios are likely to explode in some cases to 300 or 400% of GDP over the next decades.

2. The required changes are large. The recovery will bring deficits somehow under control but this goes nowhere in terms of achieving sustainability. Most advanced economies need to find additional revenues (or cut spending) by a large amount, somewhere in between 4 and 10 percentage points of GDP depending on the country -- and this has to happen every year for the foreseeable future (we are talking about many decades here).

3. There is no mystery to what needs to happen: governments need to increase taxes and reduce spending. Both have economic and political consequences and we need to be as smart as we can to choose changes that are efficient and have limited negative consequences on the economy (and growth).

4. Good news: We have seen large adjustments in government debt before so this adjustment is feasible. No need to go to the post-WWII decades, in the 80s and 90s we saw very large reductions in government debt in many advanced economies. We are talking about reducing the debt to GDP ratio by up to 40 percentage points in a short period of time, such as 10 years.

5. Good news (2): Some of these prior adjustments had limited consequences on growth. We normally tend to think about reductions in government spending and increases in taxes as having negative effects on growth but in several of these adjustments, growth accelerated rather than decreased (we refer to these events as "expansionary fiscal consolidations"). And when growth accelerates, this becomes a virtuous cycle as faster GDP growth reduces the debt-to-GDP ratio, generates tax revenues, etc.

6. Expansionary (growth promoting) fiscal consolidations tend to be associated to decreases in spending rather than increases in taxes and they tend to come together with a series of pro-growth reforms in other areas of the economy (Ireland post-1985 is a perfect example of this).

7. So can we hope for a nice, painless, expansionary fiscal consolidation over the next decades? Not obvious. There are several reasons why those experiences might not be easily replicated this time:

- In some countries, government spending levels have come down relative to where they were in the 80s or 90s. It is not easy to produce a significant decrease in government spending without affecting some basic services provided by the government. More so in the US where government spending is low relative to other (European) advanced economies.

- Some of the expansionary fiscal consolidations benefited from falling interest rates. As an example, Belgium reduced government debt by close to 40 percentage points in between 1996 and 2006 but most if not all of the decrease was linked to falling interest rates on government debt. Currently, there is no room for interest rates to go down. If any, they might go up.

- This time, the consolidation needs to take care of the past (the accumulated level of debt) and the future (the fact that projected deficits given current policies will be very large). The adjustment is larger than what was needed in some of those previous expansion.

8. So my guess is that a "painless" fiscal adjustment is unlikely this time. Taxes will have to play a stronger role and governments will need to strike a balance between the need for additional revenues and the potential negative growth effects that higher taxes might have. This balance will require a strong amount of political leadership and consensus.

Antonio Fatás

Health Care and Macroeconomics

2010-04-12T07:53:00.003-04:00

Here are three charts that show the importance of the health care sector in some of the key present and future macroeconomic challenges for the US economy:

1. Health care expenditures and GDP per capita.

As a starting point, below is the correlation between per-capita expenditures on health care and GDP per capita. The US stands as an outlier. (Source: OECD)

2. Health care expenditures and imbalances prior to the current crisis. In the years prior to the crisis the US economy run large current account deficits, a sign of excess spending relative to income for the whole country. One of the components of spending that grew the fastest was private consumption. As a % of GDP it grew by about 4-5% of GDP. All of it can be accounted for by increases in health care and education as shown in the chart below (we have blogged about this before).

3. Health care and government debt. The projections for US government debt is that it will explode to a level of about 300% of GDP in the coming decades (assuming no change in policy). The biggest source of this explosion is health care costs. Yes, there are some other costs associated to aging (more need for healthcare and pension) but most of the increases in government spending comes from the assumption that health care costs will keep growing faster than GDP, as reflected in the chart below - where the units are % of GDP (Source: CBO).

So maybe health care reform was a political distraction from other issues that required the attention of US policy makers, but there is no doubt that getting health care right is a key ingredient for many of the challenges that the US will face in the years to come.

Antonio Fatás

Current account imbalances and exchange rates

2010-04-07T05:17:00.003-04:00

The debate on the possible undervaluation of the Chinese Renminbi is in full force among politicians and academics. Most agree that the Renminbi is undervalued but there are disagreements on the effects of exchange rate misalignments (are they they ultimate cause of current account imbalances?).

Are exchange rate misalignments the main cause of current account imbalances? Here are two Nobel prize winners who disagree: Stiglitz says no and Krugman says yes. I will not resolve the debate here but there is something that I cannot understand in Krugman's argument. His argument is that current account imbalances cannot be corrected without an exchange rate change. While he does not say so, he almost implies that current account imbalances are always the result of exchange rate misalignments. This position is too extreme. The current account is the difference between national saving and investment. It is true that saving and investment will react to relative prices (which are determined by the exchange rate). But we can observe changes in saving and investment that are driven by many other factors and that have minimal impact on relative prices. Krugman's argument is that an increase in Chinese consumption will not reduce its current account surplus unless this consumption will translate into imports, and for this to happen we need a relative price change.

Krugman is right in the sense that if an increase in Chinese consumption is directed towards local goods, their price will increase, which amounts to an exchange rate appreciation. But the fundamental question is what needs to happen for the imbalance to be corrected. His view is that we first need to get prices right and then the adjustment will happen. The alternative view is that Chinese will have to get used to consume more, Americans will need to understand that they need to save more and this will be the main factor that will drive the current account adjustment. Relative prices are likely to adjust and therefore the (real) exchange rate will have to change. How much? It will all depend on how easy we can find substitutes for the goods currently produced in China. It might be that it will not take much of an increase to find an alternative location for production (with cheaper labor) and prices will change very little.

By the way, here is an interesting piece of data: while both the US and the Euro area have a large bilateral trade deficit with China (which can be interpreted as a signal of the undervaluation of the Renminbi), the Euro area has an overall current account surplus while the US has a current account deficit. You can argue that for the Euro area, an undervalued Renminbi shifts demand from other countries goods to Chinese goods. But this does not get reflected in the overall current account balance. Clearly there is more than an undervalued Renminbi in the dynamics of the current account in the US and the Euro area. And, yes, I am aware that we can argue that the Euro is undervalued relative to other currencies, as Martin Fedstein does, but then the argument becomes a tautology, every time we see a current account imbalance we conclude that it is because exchange rates are not right.

The debate has extended to the broader issue of current account imbalances and the potential blame that the countries with current account surpluses (China or Germany) have on the weakness of the economic recovery. As an example, here is Martin Wolf (FT) arguing that Germany cannot be a model for the Eurozone because of its current account surplus. Germany is accused of having kept wage growth too low and therefore forcing a "depreciation" to be more competitive. I am not sure what Martin Wolf proposes as a solution. Charles Wyplosz gets it right in his article: Germany should be running a current account surplus to save for the future and this is what many other advanced economies should be doing.

Antonio Fatás

Gross Debt, Net Debt (and future debt)

2010-03-29T16:17:00.006-04:00

Many governments of advanced economies are struggling with large deficits and increasing debt. When the crisis is over some of these countries will find themselves with levels of government debt that we have not seen since the end of World War II and, in many cases, close to double the amount before the crisis started. Some European countries, Greece in particular, but also Portugal, Spain or Ireland are under enormous pressure to control their deficits as they see their interest rate spreads grow.

Who is in more trouble? Why is it that some of the countries that were used as models of fiscal discipline (Ireland or Spain) are now under attack? A quick look at government debt (as a % of GDP) reveals very high levels for may advanced economies. The first question is which measure of debt to use: gross or net. Gross debt is simply the stock of outstanding government debt. Net debt is the difference between gross debt and the financial assets that government holds (Note: the definition of net debt is not identical for all countries. Not all governments include the same type of financial assets).

The table below shows gross and debt levels for a group of advanced economies (this is a forecast for 2011 done by the OECD).

Government Debt as % of GDO in 2011

(source: OECD Economic Outlook)

It is clear that the difference between gross and net debt is very large for some countries. While Japan looks like an outlier in terms of gross debt, it is close to Italy and Greece when it comes to net debt. In principle, net debt is a more appropriate measure of government indebtedness. If governments have a significant amount of assets, they need to be considered when thinking about the solvency of their accounts. In some cases the government (at large) holds some of its own debt in pension funds for public employees or the social security fund (this is why in the US the most common measure of government debt is "debt held by the public" which is a measure very similar to the concept of net debt), this debt is not a liability for the government.

There are, however, some concerns with the concept of net debt. In addition to some measurement question (which assets to include, at which value), the government needs to refinance all its gross debt and not only the net part, so in terms of flows, it is the gross debt that matters. Also, while it makes sense to exclude government debt held by the government, some of this debt is part of a fund that covers future pension liabilities that are unaccounted for in the budget. And here is where the assessment of government solvency gets more difficult: what you really want to do is not just to look at government debt but also at future revenues and liabilities.

Doing these calculations requires many assumption about the future so there is always uncertainty about these assessments. Below is a chart from an article by C.Hagist, Stefan Moog, Bernd Raffelhuschen and Johannes Vatter that calculates what they call "implicit government debt" as the net present value of future liabilities minus future revenues.

The numbers are dramatic for some countries and there are are large difference between some of them. While Spain or Switzerland have levels of implicit debt that are "low", the US or the UK have levels of implicit debt that make the total debt four or five times higher than the current level of debt (total indebtedness of the UK government is 547% of GDP). This does not mean that the US and UK government are broke (or more likely to default than Switzerland). What it says is that relative to current policies, the US and the UK require larger increases in taxes or decreases in spending to stabilize their debt.

A similar analysis of the fiscal gap for the US has been done by Auerbach and Gale and they reach similar conclusions. The fiscal gap for the US government today is between 5% and 7% of GDP. Meaning that if the government wants to stabilize the debt at current levels over the next 8 decades, they need to increase taxes or cut spending by five percentage points of GDP (every year for the next eight decades). This is a very large number given that total federal tax revenues stand today at 15% of GDP (so 5 extra points amounts to a 1/3 increase in taxes!).

Given these numbers, why is it that Southern European countries are under more pressure than the US or the UK? It is all a matter of credibility and the trust in the ability of these governments to get their budget under control. It might be that the UK needs a larger effort than Ireland but the question is which one is more likely to deliver on this effort. And the moment credibility is low, interest rate spreads increase and the fiscal gap increases as well as you need to generate more revenues to simply cover the interest payment on the debt.

Credibility will always be a subjective assessment and it is always easy to argue that markets are getting it wrong (or right) for a given country. What is important is to understand the numbers, not just the current ones but the future ones as well, before making that assessment, otherwise we are only seeing the tip of the iceberg and ignoring the true size of the problem.

Antonio Fatás

The apparent weakness of the Euro (please define "weak")

2010-03-08T08:52:00.004-05:00

In today's Financial Times, Wolfgang Munchau writes about "Why the Euro will continue to weaken". He makes an argument that we have heard before: the political tensions, the economic tensions created by the Greek debt problem make it clear that a monetary union without a political union cannot be successful.

I will ignore the general question on whether a monetary union can succeed without a political union so that I keep this entry short, but I want to challenge his reading of exchange rates.

Let me start with the areas where I agree with the FT article: Is the Euro getting weaker? Yes, relative to the US dollar. Is this caused by the perception that some of the economic troubles in Greece and other European countries could cause instability in the Euro area? Yes.

Here is where I disagree: Is the Euro a weak currency? To be honest, I cannot answer this question unless we agree on a definition of "weak". If by "weak" we mean that its current value is low relative to some benchmark (and we also need to agree to a benchmark), the answer is NO. The Euro remains overvalued according to purchasing power parity (PPP), which is the most fundamental theory we have about exchange rates (I am aware that there are more sophisticated models to think about over/undervaluation of currencies but at some point they need to rely on some notion of purchasing power parity as a long-term anchor).

The current value of the Euro (about 1.36 USD/EUR) is higher than what most PPP estimates indicate. Those tend to be in the range 1-1.2, depending on the basket of goods that you use. If any, the Euro remains overvalued. We reach a similar conclusion is we look at the historical evolution of the USD/EUR exchange rate (see chart below) where the German Mark is being used as the Euro in the pre-1999 period.

My second disagreement with the article is about the connection between political and economic turmoil and exchange rates. Why should the current European environment lead to a depreciation of the currency? The informal argument is that the currency reflects the "strength" of an economy. This sounds ok but it is not right - you first need to define "strength" and then be clear about the exact economic mechanisms through which the exchange rate is affected. Wolfgang Munchau argues that Europe needs to go through a major fiscal adjustment and this implies an increase in public saving. Given that the sum of public and private (net) saving have to be equal to the current account, and assuming that we do not want private saving to fall, we need to see the current account going up (exports growing faster than imports). For this to happen, you need to see a depreciating Euro. This logic is not right either. If we apply the same logic to the US or the UK we will reach the same conclusion: we need a depreciating US dollar and a depreciating UK Pound. But this is impossible! We cannot have the three currencies depreciating at the same time (at least relative to each other).

The argument that the political tensions in the Euro area will lead to a weaker Euro are not new. They were in fashion during the early years of the Euro when the Euro was getting weaker (as low as 0.85 USD/EUR). Funny enough, those theories became irrelevant in the period 2003-2007 when the Euro appreciated by close to 100% relative to the dollar. And this was at the time when the political and institutional weaknesses of the Euro area became really apparent. It was during the 2003-07 period when the stability and growth pact collapsed, it was during that period when several countries did not live by the deficit and debt limits that they had agreed to and the confidence in the Euro-institutions was seriously damaged. But during those years the Euro got stronger, not weaker.

Theories about why exchange rates move need to be tested over several episodes. Otherwise we are simply looking for an ex-post rationalization of the changes we see.

Antonio Fatás

Greek debt woes will remain (CNBC interview with Ilian)

2010-03-05T08:09:00.002-05:00

Maybe the Euro was not such a bad idea.

2010-03-02T17:28:00.007-05:00

The current budgetary crisis in Greece has led to concerns about the stability of the Euro zone as a single currency area. There have been talks about the possibility of some countries leaving the Euro area and some see this as a clear signal that having a single currency among such a diverse group of countries was a bad idea. A few academics in the US have reopened the debate on whether the Euro zone is indeed “an optimal currency area” and their conclusion tends to be that it is not and the crisis with Greece is a proof of that analysis.

Their logic of those who believe that the Euro was a bad idea is the following: if today countries such as Spain, Greece or Portugal (or Italy) had their currency, they could have devalued it (or depreciated it) and this would have helped them to get out of the crisis because of the positive effect on exports. They point out to the fact that in recent years some of these countries have lost competitiveness through high inflation and this could be easily corrected with a devaluation while the alternative of deflation (or lower inflation) is more painful.

Their argument is a standard textbook analysis of the costs and benefits of keeping your own currency (where we are looking at just the benefits). This is an argument that I bring up regularly in class when I teach macroeconomics and it is easy to explain to my students. However, one needs to go beyond the theory and what is difficult is to assess whether the logic applies to this case and indeed these benefits outweigh the costs of having your own currency and exchange rate.

My reading of the current situation is that it does not reflect at all on the weaknesses of the Euro zone as a currency area and that if any of those countries had kept their currencies they would be in much more trouble today.

Here is a long list of arguments of why the textbook argument does not apply to this case:

1. This is a global crisis. The current recession is global in nature. While some countries are hurting more than others, this is not an asymmetric shock that is affecting just one country. While the exports of Greece could benefit from devaluation, this would hurt the exports of other countries. While it is true that some countries like Germany have kept a surplus in their current account, it is also true that their exports have collapsed and their GDP has been affected as much or even more than some of those other countries. Why shouldn’t be Germany the one who devalues?

2. Is competitiveness a problem? A potential answer to the question in point #1 above is that Germany does not have the same problems of competitiveness than the Southern European countries. It is Spain, Portugal, Greece the countries that have seen their real exchange rate appreciating because of higher inflation than in Germany. They are the ones that need the correction. This is true but we have to be careful not to use Germany as an example of all other countries. The chart below (from a presentation by Jose Manuel Campa, from the Ministry of Economy and Finance in Spain), Spain has not seen a deterioration of competitiveness relative to France, the second largest economy in the Euro area. It is Germany the one that looks like an outlier.

In addition, inflation was higher in Spain mainly because of the evolution of prices in the non-tradable sector (the one where competitiveness is not an issue). Below is another picture from the same presentation by Jose Manuel Campa where we see that the evolution of unit labor cost in manufacturing in Spain (relative to Germany) are much more moderate.

If this is not reassuring enough we can look at the evolution of Spanish exports (as a share of world exports) during these years, Spain has done better than countries like France or the US and its performance is similar to that of Germany.

Yes, Spain had a large current account deficit during these years but it was mainly the result of increasing imports due to the strong expansion in the economy. A phenomenon that we observed in other countries (such as the US) that have a flexible exchange rate.

3. Exchange rates are not a magical tool. If having your own currency is such a powerful tool to deal with crisis like the current one, why is it that countries such as the UK, Sweden or the US are suffering through very deep recessions? Both the UK and Sweden, despite having witnessed a depreciation of their currencies, are also struggling with a deep recession that seems to be lasting as long as in some of the Euro countries. In the case of the US, the currency has moved in the “opposite” direction and appreciated since the beginning of the crisis. The current account has been reduced but mainly because of the collapse in demand that comes from the recession.

4. We cannot forget the costs of having your own currency. While the idea of manipulating the exchange rate to increase exports might seem at times attractive, there is no doubt that if any of the Southern European countries had their own currency today, they would be in a much deeper recession (we can go back to the early 80s in Spain when there was also a banking crisis to see how much the Spanish peseta helped). It would be very likely that these countries had accumulated during the boom years liabilities in foreign currency that now, with a devaluation, they would not be able to pay back. The government of Greece would be facing a much higher interest rate because of exchange rate risk, which would make the probability of default even higher.

Finally, a reminder that one needs a longer perspective to assess the benefits and costs of a monetary union. Yes, countries like Spain are going through a deep recession with very high unemployment rate but partly this is the result of the “excesses” of the previous years. Below is a picture of real GDP that shows the very-high growth rates that Spain enjoyed during the previous years. While it might be the case that there was some loss of competitiveness relative to Germany, the growth rate of Spain remained very high, higher than that of Germany or the UK who had the flexible exchange rate to adjust (if needed). Yes, the current recession will erase some of these gains, but not all of them.

So maybe the Euro was not such a bad idea after all and it deserved a less dramatic 10^th anniversary.

Antonio Fatás

An insider's view on the financial crisis (Interview with Sir Win Bischoff)

2010-03-01T04:40:00.008-05:00

Here is a video of an interview I conducted recently at INSEAD with Sir Win Bischoff. He is the current chairman of Lloyds Banking Group and was the chairman of Citigroup in the Fall of 2008, during the worst of the financial crisis. We talked about the days around the fall of Lehman Brothers and his views on the current debate on financial regulation.

Click on this link to access the video (which is hosted at the INSEAD YouTube channel).

Antonio Fatás

Labor markets and the current cycle (and the death of Okun's Law)

2010-02-25T05:39:00.007-05:00

There are growing concerns about the labor market performance in the US during the current crisis, concerns that might extend to the recovery phase. Unemployment has risen faster than in any previous recession, even taking into account the depth of the recession. As Brad DeLong, Robert Gordon and many others have pointed out, 2009 is a clear outlier in the relationship between unemployment (changes) and output growth, known as Okun's Law. See chart below borrowed from Brad DeLong's blog.

Here is an alternat

ive view of the labor market dynamics during this time but focusing on employment growth rather than unemployment rate changes, which are affected by decisions regarding labor market participation (this is also the US economy).

The year 2009 remains an outlier in this chart: employment growth was much lower than what GDP growth would suggest, based on the historical relationship captured by the red (regression) line. Of course, this means that productivity was growing faster than normal that year, at least as measured as GDP per employee.

It is also interesting to see that 2007 and 2008 were normal years - so it cannot be an argument that prior to 2009 companies were hiring "too many" workers.

The chart also shows how the last recovery (2002 and 2003) are also outlier years where employment growth was below what was suggested by GDP Growth.

Why is employment growth being so weak in these years? Are there significant structural changes in terms of sectoral composition that can explain the weak behavior of employment growth? For 2009, did restrictions on access to credit cause an abnormal behavior by companies when it comes to hiring and firing? If we are talking about structural changes, we cannot expect a fast recovery in the labor market. If it is all a matter of credit availability then there is some hope that as the economy recovers we see a quick recovery in employment that will feed into faster GDP growth.

Antonio Fatás

Using a hammer or a wrench to pop asset price bubbles?

2009-12-14T03:48:00.003-05:00

In a recent speech Adam Posen (recently appointed a member of the Bank of England's Monetary Policy Committee) argues that monetary policy should not be used to deal with asset price bubbles. His main argument, which has been expressed before by different central bankers, is that monetary policy is the tool to deal with price stability and it is not appropriate to deal with asset price bubbles. Quoting from his speech:

"Just because we want there to be a policy response to a problem does not mean that the problem can be solved with the tools at hand. Again, if I have a hammer, it can be useful for all sorts of household tasks, but useless for repairing a leaky shower head – in fact, if I take the hammer to the shower head, I will probably make matters worse. I need a wrench to fix a pipe leak, and no amount of wishing will make a hammer a wrench. This is the essential reason why central bankers are now looking around for what has been called a ‘macroprudential instrument’, that is a tool suited to the job – and a tool additional to the one that we already have in our toolkit."

I am very sympathetic to this argument, interest rate is probably not the right tool to deal with asset price bubbles and using regulation or a 'macroprudential instrument' is the right thing to do.

However, we still need to ask the question: What if those instruments are not available or are simply failing to do their job? Is there a role for monetary policy? He cites the example of Spain as a country where the central bank was stressing the importance of dynamic provisioning for banks and still went through a real estate bubble. It might be that the Bank of Spain was not aggressive enough, but how do we know that the systems that we are setting in place now will take care of the next bubble or financial imbalance?

One can argue that interest rates should not be used to deal with an imbalance in financial markets, because this is not part of their mandate, but I think this is a very narrow view of the role of central banks. There is no doubt that imbalances in financial markets spread to the real economy. In fact, there were many signs of a macroeconomic imbalance prior to the crisis such as excessive consumption, current account imbalances. Aren't interest rates the tool to deal with macroeconomic imbalances?

If we apply Adam Posen's logic to some of the previous recessions, we could come up with the conclusion that central banks should never use the interest rate as a stabilizing tool. We could always claim that previous recessions originated in a specific sector of the economy and it would be better to deal with these developments using 'sector-specific' tools. Adam Posen uses as an example a procyclical tax on real estate that might avoid real estate bubbles like the one we just went through. We could apply the same logic to the internet bubble of the 90s and argue that a tax on internet-related companies would have avoided that bubble. This might be true but how do we know where the next bubble will come from so that we set up the right 'procyclical tax' to avoid it? In my view, if the next bubble generates a macroeconomic imbalance, then it is the role of monetary and fiscal policy to deal with it. The next business cycle, the next bubble is likely to be different from the current one and we will learn from it and set up additional policies to make sure that it does not happen again, but until we figure out policies to avoid any potential bubble or imbalance that can cause a recession, monetary policy still has a role to play. And yes, using a hammer to fix a pipe leak will be a challenge...

Antonio Fatás

Central Bank Transparency

2009-12-10T03:18:00.002-05:00

Here is an excerpt from an interview by Jean-Claude Trichet, President of the ECB with De Tijd and L'Echo (the full interview can be found at the ECB web site).

Q. For some financial assets, such as gold, we are seeing a return to risk-taking on the part of investors. Is this a parameter that the ECB takes into account in its strategy?

A. I will not make any specific comments regarding gold.

Generally speaking, one of the fundamental lessons of the crisis is that when we underestimate financial risks and focus only on the short term, we set the stage for a future catastrophe. The new principles for bank remuneration, which the international community have agreed within the framework of the Financial Stability Board, were established precisely in order to ensure that there is no incentive for operators and traders in particular to favour the most risky attitudes and decisions, leading to illusory profits in the short term at the expense of the long-term interests of the financial enterprises concerned and the stability of the financial system as a whole.

It is always interesting to see how central bankers tend to start their answers by saying that they will not make any specific comment on a market or an asset price and then make a broad statement about how financial markets need to be careful and not create bubbles. This reminds me of the famous question by Alan Greenspan back in December 1996: "How do we know when irrational exuberance has unduly escalated asset values?" Great question and I would like to know the answer!

Should central banks provide more guidance to help us answer our questions and doubts about asset prices (or other financial market developments)? Should they share their views and forecasts on the evolution of asset prices as they do for other financial variables, such as interest rates? I do not know what the right answer to these question is but I find the current communication style from central banks ("no specific comment on that question but...") unsatisfactory.

Antonio Fatás

The "investmentless" recovery

2009-11-25T07:55:00.006-05:00

The behavior of U.S. employment at the end of the last two recessions (1991 and 2001) was different than in previous recessions. Employment did not grow fast and it took several years to reach the pre-recession levels. Because of this, the recovery years that followed both of these two recessions have been labelled "jobless recoveries". Below is a chart from Brad de Long that compares them to two other previous recessions (original posting is here).

Employment was flat in 1991 and 2001 instead of increasing fast as in 1975 and 1982. Because of the current high level of unemployment combined with what might be weak growth there is a fear that the current recovery will also be a jobless one and that the unemployment rate will take a long time to reach a normal level (here is Krugman on this issue).

The behavior of employment will depend on many factors (amount of labor hoarding, productivity) but at the end of the day, the major factor be remain the strength of the recovery and how fast GDP and demand can grow. If we look at different components of demand (or GDP) there is an interesting factor about the last two recessions: In both of them, investment played a weaker role during the recovery phase. Below is a chart comparing the behavior of investment (measured as a % of GDP) around the recovery time (0 is the quarter when the recovery started according to the NBER).

What is interesting in this chart is that the last two recoveries were also special when it comes to the behavior of investment. In fact, the behavior of investment seems to mimic what we see above in the employment chart. While during the 1975 and 1982 recoveries investment grew faster than GDP (so the ratio increased), during the 1991 and 2001 recessions, investment grew at the same pace as GDP (so the ratio is flat). And this is more of a surprise if we take into account the fact that real interest rates remained very low during these two recoveries (more so in 2001).

We know that investment is the most volatile component of GDP so the V-shape that we see in 1975 and 1982 is what we would normally expect. By definition, it has to be that other components of GDP played a stronger role (relative to previous recessions) in 1991 and 2001 (consumption, exports). What was the exact role of those components will (hopefully) be the subject of a future post in this blog. What is interesting so far is the similarity in the behavior of employment and investment across the most recent recessions.

Antonio Fatás

Inflation or Deflation?

2009-11-23T08:19:00.004-05:00

There is an ongoing debate on whether we will see inflation or deflation during the coming years. Inflation could be a result of the expansionary monetary policies we have witnessed in many countries around the world. Deflation could be caused by the effects of the economic slowdown (asset price deflation, deleveraging, low growth) and its global nature.

Despite these concerns, inflation indicators remain very stable. After a period where they were pointing in the direction of deflation, they are now back to levels which are fairly consistent with inflation in recent years. The stability of inflation forecasts and how they seem to be ignoring some of the theories that suggest more radical changes ahead are a reflection of the strong anchoring of inflation expectations that has been achieved in recent decades. This anchoring of expectations is the result of very low and stable inflation in most economies since the mid 90s. Here is the evolution of World inflation since 1980 (source: IMF World Economic Outlook database October 2009).

It is remarkable how after 1996 inflation has remained almost constant. While it is true that this was a stable period of time from an economic point of view, there were several episodes (the Asian crisis, the recession in 2001/2002) that could have had an effect in inflation. The fact that inflation did not react and remained in a very narrow range (between 4-5%) is behind the strong anchoring of inflation expectations. And this is a virtuous cycle: the more anchored inflation expectations are, the more stable inflation will be.

What is also interesting is to see that the behavior of inflation has been very similar across developed and developing countries. In the case of advanced economies, inflation decreased very fast in the early 80s and came down even more in the mid-90s. In the case of emerging markets we witnessed a period of high inflation during the early 90s but after 1995 inflation has come down and remained stable for 13 years.

While 13 years of stable inflation cannot guarantee that we will not see large changes in the inflation rate in the coming years, there is no doubt that this is a reflection of the strong anchoring of inflation expectations, more so than in any other period in recent history and this stability is likely to keep inflation volatility low even in the presence of many uncertainties.

Antonio Fatás

It will continue to go up until it stops.

2009-11-17T07:27:00.002-05:00

One of the best quotes I have recently seen in financial news sites. This is from CNBC Monday November 16th (link to the article and video here):

Dennis Gartman, founder of The Gartman Letter told CNBC Monday that the price of precious metal will "continue go go up until it stops." "It is a gold bubble, Gartman told CNBC. He called the trade on gold "mind boggling," but also said that he is currently long - or betting gold will go higher.

Well, I am sure he is right, the price of gold will continue to go up until it stops...

By the way, Willem Buiter has an interesting blog entry on the market for gold.

Antonio Fatas

The definition of strong (dollar)

2009-11-13T04:11:00.002-05:00

Timothy Geithner said this week "I believe deeply that it is very important to the United States, to the economic health of the United States, that we maintain a strong dollar." It would be interesting to know what his definition of "strong" dollar is.

When John Snow was asked the same question back in 2003 (May 18) when he was Secretary of the Treasury he said: "You want people to have confidence in your currency (...) You want it hard to counterfeit, like our new $20 bill."

Antonio Fatás

9.5% productivity growth. How unusual?

2009-11-06T03:45:00.004-05:00

As reported by the Bureau of Labor and Statistics yesterday, US labor productivity grew at a 9.5% in the third quarter of 2009. Fast productivity growth is normally a sign of economic strength, but in this case because it is the result of a combination of GDP growth and destruction in employment, this has raised further concerns about the possibility of a jobless recovery (see Brad DeLong, among others).

How unusual is to see productivity growing that fast during a recovery phase? No doubt that 9.5% is a very large number but we have seen similar patterns before. For example, the 1981Q3 recession showed a very similar pattern of productivity growth as seen in the picture below.

Six or seven quarters after the recession had started, productivity was growing at rates which are very similar to what we are seeing now. Interestingly, the 1981 recession was also a long recession, it lasted 16 months. It is possible that the current recession ended in the summer of 2009 which would make it very similar in length to the 1981 recession.

There is, however, a big difference between the two: in the 1981Q3 recession, we saw GDP growth rates close to 10% (quarter to quarter) seven quarters after the recession started - i.e. the last observation in the above chart. This time GDP is only growing at 3.5% and it is only because of the large decrease in employment that productivity growth is so high. This is not good news (unless we believe that this trend is about to reverse).

What did productivity growth look like in shorter recessions?

This second chart shows productivity growth in the previous two recessions (1990 and 2001). Both of these recessions were short, about 8 months. Productivity also increased in the quarters after the recession started. It started growing earlier (this is probably related to the short nature of the recession) and it did so in a smoother manner with peaks below the current levels.

Antonio Fatás

Reality check (fiscal policy)

2009-11-04T03:15:00.002-05:00

The IMF has just published their November 2009 edition of "The State of Public Finances Cross-Country Fiscal Policy Monitor". It is a great analysis of the current state of public finances and the risks ahead.

Some good news: if one looks carefully at the numbers, while deficits and debt levels are high, they are manageable. They require an effort in the years (decades?) ahead but we have seen large fiscal consolidations in the past of a size which is similar to what is required from today's perspective. This seems to be the perspective of financial markets as interest rates on government bonds remain low and there is no obvious pricing of a default risk.

The arithmetics of fiscal discipline are simple and the future effort will depend on the difference between the interest rate that governments will face and the growth rate of their economy. In emerging markets, we have seen rapid changes in this difference (interest rate getting very high as growth rates slow down) leading to crisis as the burden becomes unmanageable. While this is not the scenario that one might expect for advanced economies, it all depends on the credibility that governments established. And theoretically one could imagine a self-fulfilling prophecy where a crisis starts with a small change in the perceived credibility of governments which increases interest rates and leads to unsustainable interest payments.

The bad news is that there is no guarantee that governments will behave better going forward. Yes, we know the effort that is needed to stabilize debt-to-GDP ratios but history is full of examples where once the crisis is over we forget about fiscal policy discipline. And here is where we need an exit strategy. It is not about about announcing a short-term schedule to remove the current fiscal stimulus is about giving reassurances that in the next decade or decades we will look at sustainability of government finances in a different way. I have argued in some of my academic research (together with my co-blogger Ilian Mihov) that there is a need to think about institutional reforms that change the way we think about fiscal policy and budgets. Other academics have presented similar proposals, all of them implying the creation of some constraints around the power of governments to decide on all aspects of fiscal policy. While numerical rules are the simplest way to think about constraints (budget balance rules, stability and growth pact), the empirical evidence is that implicit constraints - such as those created by the political process through which budgets are decided- can be as powerful and less rigid. A change in this direction would be a good "exit strategy" for governments. Without the need to harm the current recovery, it would provide the necessary foundations for a credible fiscal policy in the years ahead.

Antonio Fatás

Extending the (EMU) Stability and Growth Pact to take care of global imbalances

2009-10-22T08:33:00.003-04:00

Last week Eswar Prasad had an interesting article in the Financial Times on how to deal with global imabalances. As the G-20 seems to be taken the issue of global imbalances seriously, there is the question of how to make their commitment operational.

Reducing global imbalances requires a reductio in national imbalances between income and spending or, in other words, between saving and investment. The difficulty is that this imbalance is the result of both government and private sector imbalances. Because it is difficult to think about how to effectively impose a balance on private income and spending, the only valid alternative seems to be addressing large imbalances in government spending.

This is the suggestion of Eswar Prasad:

"The scheme would work as follows. The G20, in consultation with the IMF, develops a simple and transparent set of rules for governments on policies that could contribute to global imbalances - for instance, that government budget deficits and current account balances (deficits or surpluses) should be kept below 3 per cent of national GDP"

If deficits go beyond 3% there is a financial penalty (implemented through the SDR holdings of the IMF). If we focus on budget deficits, this looks like the Stability and Growth Pact under which EMU governments have lived for several years. There is a limit on budget deficits (3%) and a set of mechanisms to enforce this limit.

The history of the Stability and Growth Pact has shown us that it does not work. While it provided some discipline in the earlier years, we soon realized that there were many issues associated to its implementation that have led to failures to comply with the limits and a revision of the Pact that has left very little power over national government balances. The issues were many:

- What do you mean by 3%? You probably want to adjust this by the cycle, but then how do you adjust it by the cycle? Do you allow for exceptional circumstances?

- How do you punish government? Who decides that governments should be punished? (in the case of EMU, it was the council of finance ministers who had to punish some of its own members, not very effective).

In practice, many countries ended up with deficits above 3% without significant consequences. There were also periods where the government deficit was below 3% but the government was clearly helping create a current account imbalance (i.e. the government should have had a large surplus as opposed to let's say a 2% deficit).

The G-20 commitment to address global imbalances is no doubt a good step in the right direction but it is unclear how this commitment will translate into specific outcomes or actions.

Antonio Fatás

Content of economic blogs

2009-10-22T04:17:00.007-04:00

Here is a snapshot of recent content of some economic blogs (thanks to Wordle).

Greg Mankiw

Mark Thoma

Brad de Long

Casey Mulligan

Antonio Fatás

How low is 1.48 (USD/EUR)?

2009-10-13T03:22:00.004-04:00

As we witness increasing signs of economic optimism about the recovery, the focus of the analysis turns into the exact form that the recovery will take and how to ensure that it is as fast and smooth as possible. One of the areas that has received recent attention is the evolution of the US dollar. In recent months the US dollar has gotten weaker and there are many questions about whether this is a trend that will continue and how far the US dollar will fall.

In an FT article yesterday Wolfgan Munchau made the case for a weaker dollar. Many of the arguments are not new and we had heard them before the crisis when global imbalances were on their way up. As the US current account deficit got larger and larger there was the question of how those deficits would be reduced. Given that (US) consumption rates looked unsustainable, it seemed that a price adjustment (through a change in the exchange rate) was the only way to produce that adjustment. In addition, now that the crisis has started, and if one takes the perspective of the US economy, a depreciating currency can help with the economic recovery, an argument made by Wolfgan Munchau in yesterday's article

"A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ."

This argument is similar to the one made by Krugman to oppose those who are voicing concerns about the fall in the value of the US dollar.

I will not argue here with this textbook logic of how currency movements can help address current account imbalances and business cycles (although I must admit that I find the empirical evidence much weaker than most people). But I have some concerns about blank statements that argue that the US dollar has to get weaker:

1. It is not enough to say that the US dollar has to get weaker you need to say how weak it should get, we need a number, there is a need for a medium/long-run anchor. As the chart below shows, the US dollar is already weak by historical standards. Sure, it has room to get to the historical low of 2008 but was is the right reference value?

As a technical and historical explanation of the chart: this is the nominal exchange rate between the US dollar and the Euro (before 1999 the German Mark is used as the Euro) and the upward trend is a reflection of the differences in inflation between Europe/Germany and the US. But even if we were to correct for inflation differences, the US dollar is still weak by historical standards. Also notice that some of the waves that we see were reversed by some statement coming from central banks and government officials, such as the September 1985 Plaza Accord, the February 1987 Louvre Accord and the interventions of November 2000. By historical standards, we would have expected similar statements in 2008 when the US dollar reached the 1.60 USD/EUR level. We did hear some comments about "excessive volatility" but not about the actual value of the currency.

2. Related to the point above, but more from a theoretical point of view: how much do we want to introduce price distortions (changes in relative prices via changes in the exchange rate) to ensure that the spending patterns of different countries are sustainable? The textbook logic of currency depreciations to smooth recessions is one that applies to countries that are suffering an asymmetric shock. Today we face a global recession, so according to the textbook, most advanced economies need an exchange rate depreciation. We might argue that all these currencies need to depreciate relative to countries that are doing well (China and other emerging markets) but we cannot simply argue that the US dollar has to get weaker. It is interesting how many criticisms China has gotten for "manipulating" the value of its currency to affect economic outcomes and now we are willing to argue that the US should be doing something similar. Just to be clear, I am not arguing that currencies cannot be a good adjustment mechanism, but the context matters and one needs to be explicit about the difference between an asymmetric recession and a global recession and the difference between smoothing business cycles and addressing structural imbalances.

3. The perspective of the other countries. A weak dollar can help the US increase its exports, which goes in the direction of reducing the current account deficit, but why would other countries see this as a "return to equilibrium"? Wolfgang Munchau argues that "A strong Euro would nicely take care of of Germany's persistent current account surplus". I am not sure all the Germans agree with this statement. I am also not sure that a fall in revenues (i.e. fall in German exports) would lead to a decrease in the saving rates in Germany. It might lead to the opposite behavior - an increase in saving rates because the decrease in income leads to more uncertainty and precautionary savings (which will make the current account surplus even larger not smaller).

Antonio Fatás