No wonder why we see bubbles in financial markets.

Here is an article written  about 18 months ago that was justifying the low personal saving rate in the US using the argument that the standard national accounts' measure of the saving rate did not take into account the increases in wealth associated to rising asset prices. The article was written in September 2007 right before the crisis started. It was written by David Malpass, who was at that point chief global economist for Bear Sterns. That increase in wealth is gone (and so is Bear Stearns).

Antonio Fatás

The end of the Overworked Americans? (and the end of the 35-hour week)

The decade of the 80s was characterized by a continuous increase in the number of hours worked in the US. It was a combination of an increase in the number of individuals who were part of the labor force and an increase in the average number of hours worked by a typical worker. This increase in number of hours represented a break in the historical trend were productivity gains led to an decrease in the number of average hours worked in favor of additional leisure. This trend led to the label of "overworked Americans" for US workers. It did not help that the Europeans were following the opposite trend by accelerating the historical trend of decreasing hours per worker (as in the 35-hour week in France) and by increasingly generous early retirement programs, which were a political response to the high unemployment rates of previous decades.

This divergent trend between the US and European economies continued during the 90s. This was a decade where the US outperformed Europe in terms of GDP growth. While some of this was due to larger increases in productivity (the "new economy"), the majority of it was due to an increase in the employment to population ratio as seen in the chart below. 

The story has changed since the end of the 90s. The Europeans realized that there was a need to reverse the trend of recent years, which led to labor market reforms and increases in employment. The US labor market suffered large employment losses during the 2001 recession and the recovery that followed was unusual in terms of low employment growth. And before the employment to population ratio could reach the pre-recession level, the current recession started. The US is now at a level which is below the one in 1992. The Euro economies did not suffer much through the 2002/03 crisis and so far the fall in employment in the current crisis has not been as dramatic as in the US.

There is no easy explanation for why the US labor market has not performed better since the end of the 90s. It is true that it had reached a level of employment from where it was difficult to continue growing so maybe there was some truth to the expression "overworked America" (be careful reading the chart above as both series are normalized to 100 in 1992, the employment to population ratio in the US remains substantially higher than in Euro countries). Going forward, it is possible that we see employment growing fast again in the US. With the large destruction of wealth in the US because of the collapse of housing and stock prices, the only way to keep up with the previous living standards is by working longer hours and having more than one income in every household. And those who had planned to retire soon, might be required to work some extra years to compensate for the loss of their pension plans. 

Antonio Fatás

Zombies. Banks or corporations?

The results from the Stress Tests were released yesterday and there were very few surprises. The numbers matched the predictions (which were coming from leaks), the reaction of stock markets were positive and the reaction of many commentators was very critical, because of the methodology and what some see as an attempt to avoid difficult political decisions by hoping that an economic recovery helps banks get out of trouble. 

There is no doubt that a healthy financial system is key for a strong economic recovery. There is also little doubt that many banks will still see large amount of losses in some of the assets they hold (although there are disagreements about the exact amount). And it also seems clear that the amount of expected losses might be larger than the capital that banks hold today, thus the need for some of them to raise additional capital. 

The FT reports in today's edition that banks negotiated with regulators to reduce the amount of equity that would be required after the stress test (the Wall Street Journal run a similar story yesterday). One of the arguments the banks used is that they would be able to generate some of this capital by earning profits over the coming quarters. How realistic this is? If some of these banks are 'zombies' (technically insolvent), how will they generate profits? Wasn't this the purpose of the stress tests, to identify these banks now, make sure that their balance sheet is healthy rather than letting them stick around hoping that the economy improves? But if the banks are not healthy and cannot lend, how can the economy improve?

An interesting argument is made by James Surowiecki, citing research from Joe Peek and Eric Rosengreen. When looking at the Japanese experience, the slow recovery was not only due to the presence of 'zombie banks' but also to the presence of 'zombie corporations' which were supported by these banks. In fact, a lot of the credit given by Japanese banks to companies was given to companies who could not repay their previous debts (by keeping these companies alive the banks did not need to record the losses). According to Peek and Rosengreen, the government and regulators also encouraged banks to give credit to those companies. If banks had better allocated their credit, we would have seen the necessary renewal at the corporate level and an earlier exit from the recession. 

How do we know that banks in the US and other advanced economies will not engage in the same behavior than banks in Japan in the decade of the 90s? If you want to be optimistic you might argue that the strong ties between Japanese banks and corporations and are not present in advanced economies (although one can easily argue that this might not apply to all countries). You can also be hopeful that governments do not put too much pressure on banks to lend without the proper lending standards (although we have already seen enormous pressure on banks to lend). Finally, you can also hope that the banks are not given incentives to create short-term profits at the expense of their long-term survival (although it might be that the november deadline for US banks to raise the needed equity could indeed provide the wrong short-term incentives). 

And if all this is not enough to make you feel optimistic, you can always start a cartoon series about zombie banks (see the video below).

Antonio Fatás

Stressed?

The Stress Tests Results for the largest U.S. banks will be released today at 5pm (ET, US). While the results were supposed to remain confidential until this afternoon, there have been a good number of leaks regarding the needs of each of the individual banks. The blog Calculated Risk has posted a table with estimates of the capital needs of each of the banks. While the numbers are large for some of the banks (Bank of America tops the list with 34 billion), it seems that a combination of raising capital in private markets and public funding might provide the necessary additional capital. However, uncertainty will remain even after the results are presented this afternoon. Some will question the methodology (Are we really looking at the worst case scenario? How were the legacy assets valued?) but the debate is likely to be around how some of the banks in need of capital will raise new funds. The government would like to avoid providing new funds. One quick solution is to convert previous public funds into common stock. This solution has been criticized by Paul Krugman on the grounds that is simply an accounting trick (although it all depends on the methodology that the stress tests used, more this afternoon). In addition, such a conversion is moving us in a direction of slow partial nationalization, with the problems that Nouriel Roubini highlights in this FT article.

On the other side of the Atlantic, the ECB has decided to cut its interest rate to 1% and start purchasing Euro-denominated covered bonds. Not a big surprise. Here is the press release.

Antonio Fatás

No news is good news

Back in the Fall of 2008 the spreads between standard interbank lending rates (such as LIBOR) and central bank interest rates made the headlines of all major newspapers because their levels were at record highs (even compared to times of crises). Slowly but consistently, these rates have come down and are at now at levels which are the lowest historical level since those markets exist (as reported by the Financial Times today). The spread relative to central bank interest rates remains above what could be considered normal but very far from what we saw back in November 2008.

A signal that financial markets are slowly returning to normality. Of course, uncertainty still remains - including the outcome of the stress tests on US financial institutions that will be released this week.

Antonio Fatás

Obama's achievements (Ilian on CNBC)

Changes in the funding of the U.S. current account deficit

Since the mid 80's (and with the exception of a small pause in the early 90's) the U.S. has run a current account deficit, which means that domestic spending has been larger than domestic income/production. This deficit was growing in the period leading to the current crisis and it led to concerns about global imbalances and how countries would adjust to them. Here are a couple of charts that show some of this evolution as well as some recent changes that point to adjustments in the way the current account deficit is being financed.

The first chart shows the evolution of the U.S. current account balance. We clearly see the downward trend during the 1995-2007 period and then a reversal during the last year, 2008. This reversal is very much driven by a large drop in imports. Exports have also decreased (as world trade has collapsed), but imports have fallen by a much larger amount. Some of this fall is related to the decrease in the price of oil during 2008 relative to 2007.

U.S. Current Account Balance (Billion USD)

A second interesting fact in the chart above is the behavior of net investment income. Net investment income remains positive during all the years. This means that the US receives more investment income from investments abroad than what it pays to foreigners for the capital that it has borrowed from them. If you take into account the fact that the US has become a large debtor to the world (i.e. that the foreign liabilities are substantially higher than the foreign assets) this is a surprise. One would expect a debtor to be paying interest on the debt. What we see below is that in net terms the U.S. is receiving interest payments on a negative net asset position. In other words, the U.S. benefits from lending at very low rates while it earns substantially higher rates on the capital it sends abroad. Financing a current account deficit under this conditions is much easier!

This investment income has more than compensated the income sent abroad in the form of "Net Transfers". This income include worker's remittances to their countries of origin. The fact that these two variables have been very close to each other means that the current accounts is very close to net exports (the balance on goods and services) [A reminder on balance of payments accounting: Current Account = Net exports on goods and Services + Net Investment Income + Net Transfers].

How was the current account financed during these years? The U.S. was borrowing from other countries (those with current account surpluses looking for investment opportunities). Of course, we observe capital flows in both directions and what matters is the difference between the two. Interestingly, during these years, capital flows in both directions grew. The chart below shows these flows. The current account deficit needs to be financed by foreign lending to the US (labelled below as "changes in foreign assets in U.S." which by convention are positive if there is a flow) in excess of US lending to other countries (labelled below as "changes in US assets abroad" which by convention are negative if there is a flow). 

Funding of U.S. Current Account (Billion USD)

Up to 2007 we see both flows increasing but the size of foreign lending to the US is always larger than the flow in the opposite direction, and this difference funds the current account deficit. 

In 2008 we see a collapse of both flows. The flow of lending to the U.S. goes from around 2 trillion to 600 billion. This collapse is matched by a decrease of capital flows from the U.S. to foreign countries from 1.3 trillion to almost zero. What is even more interesting is that if we split this flow into private and official (government and central bank related) flows, we see that private flows from the U.S. to other countries changed from an outflow of about 1.3 billion in 2007 to an inflow of 480 billion - this represents a change of close to 1.8 trillion. In other words, a large part of the current account deficit in 2008 was financed by U.S. nationals selling their assets abroad and repatriating the funds to the U.S. The change in these private flows more than compensate the drop in capital flows from other countries. [At the same time, official flows from the U.S. to other countries increased to reach almost 500 billion. Most of this lending is likely to be associated to the lending facilities that the Federal Reserve has made available to European central banks]

A final comment on the chart: the "statistical discrepancy" also helped funding the U.S. current account deficit in 2008. The swing from negative to positive from 2007 to 2008 indicates that while in 2007 there were some "missing" capital outflows, in 2008 we are missing some of the capital that flew into the U.S. by an amount that is large (about 130 billion). 

It will be very interesting to see how these numbers change during 2009 and 2010. The selling of U.S. assets is not a sustainable source of funding. It is likely that the current account deficit will become smaller but not by much (given the limited growth that we are seeing in other countries) so there will be a need for capital inflows to the U.S. to be larger than what we have seen during 2008.

By the way, if you are interested in this topic, I recommend the excellent blog of Brad Setser.

Antonio Fatás