Fear (of another recession), not uncertainty.

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

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

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

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

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

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

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

Antonio Fatás

Kerviel versus Greek government debt

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

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

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

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

Antonio Fatás

Sovereign default: panic versus fundamentals

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

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

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

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

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

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

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

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

Here are the data from Germany and Spain

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

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

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

Antonio Fatás

Macroeconomics: Evidence or Ideology

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

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

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

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

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

Antonio Fatás

Slowing Growth and Rising Risks

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

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

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

Antonio Fatás

The American and European jobs machines

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

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

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

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

Antonio Fatás

The IMF WEO is out

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

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

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

Antonio Fatás