Growth Forecasts Revised Upwards

For the last year and a half we have seen a worsening of forecasts of growth for most countries around the world. As we discussed in an earlier post, forecasts for GDP growth for 2009 had been revised downwards every single quarter starting in 2007Q4 until 2009Q1. Since then we have seen that these forecasts are becoming more stable and in the recent update by the OECD of their economic outlook we now see forecasts for the third quarter of 2009 being revised upwards - in some cases significantly. For example, the forecast for Germany was close to zero in June and it is now being revised to more than 4% (this are annualized growth rates). Below is a picture from this report.

Antonio Fatás

Government Debt. Going up (and then down?).

There is a growing debate about the increasing burden of government debt in advanced economies. As a result of the recession and the large stimulus packages, government debt is likely to increase over the coming years to levels that we have not seen in many decades. In the case of the US, the Congressional Budget Office expects government debt to go from 40.8% in 2008 to 68% of GDP in 2019 (more details here, this figure corresponds to the debt held by the public which is lower than the overall level of debt, as some of it is held by public institutions).

Is 68% too high? The debate is open and some think that while high debt in itself is not desirable, this is a number that we have seen before (Krugman has made this argument here). Others disagree and believe that this level of debt will impose a large burden on the economy (Hamilton makes the argument here).

Many countries (including the US after the second World War) have dealt with levels of debt as high or even higher than what we are likely to see over the coming years. In the US debate, there is a reference to the case of European countries that in the 90s saw levels of debt above 100% of GDP and "survive". What was their experience? Here is the picture from two of the "worst offenders": Belgium and Italy.

In both cases, the debt to GDP ratio increased above 110% of GDP. What did we learn from that experience? The good news is that countries can "survive" with such levels of debt. In fact, we need to realize that the burden that this debt imposed on the Italian or Belgian government budget was substantial because the interest rates were much higher than the rates that governments in advanced economies face today (more so the US government). Even with those high rates, levels of debt above 100% did not lead to insolvency and what we saw over the years that followed was a gradual reduction of those levels as a result of increased fiscal discipline and GDP growth.

The first piece of bad news is that the economic performance of these two countries was not great but it is hard to argue that government debt was the main reason for such a low performance. The second piece of bad news is that while the levels have been coming down, they have done so at a very low rate. The slope going up seems to be much faster than when it goes down.

Here are two other European countries that might provide a more optimistic perspective: Ireland and Sweden.

In both cases we see a much faster decline in the debt-to-GDP ratio. In Ireland, the ratio went from 105% to 25% over two decades. In the case of Sweden, the ratio decreased from 75% to 35% in about ten years. We know that high growth played a role, much more so in Ireland than in Sweden, but the trend is also a reflection of the efforts to bring discipline to the budget. The bad news is that these figures are likely to explode in the years ahead because of the current recession, a reminder once again, that the effect of the discipline of the last year might vanish quite soon.

Here is my reading of these experiences:

1. Advanced economies can live with high levels of debt-to-GDP ratios. The levels that European countries or the US are likely to see over the coming decades are manageable.

2. How easy will it be to manage the burden of the debt depends on interest rates and growth. An environment of low interest rates (the one we have seen so far) and healthy growth (to be seen) will make the lives of governments much easier.

3. There is no need to pay back the debt within the next "x" years. What matters is to keep the level of debt-to-GDP ratio under control. [Of course, there is an issue of fairness that I am ignoring, about which generation should pay for the current expenditure]

4. Having said that, we need to plan for the next crisis, even if we are still trying the get out of the current one. The real fiscal discipline shows up during good times when government manage to save the necessary resources to pay for the extra spending and the reduced taxes that the next recession will bring. In many countries, including the US, the high projected levels of debt are a result of the consequences of the current recession but also the inability of previous administrations to bring the level of debt down when growth was high.

Antonio Fatás.

Fed’s Exit Strategy

After the reappointment of Ben Bernanke, discussions about the exit strategy from the massive increase in liquidity intensified again. On Squawk Box of the CNBC Asia channel one guest expressed his doubt that the Fed will be able to withdraw the liquidity because they are holding a lot of illiquid assets.

The Fed has more levers to control money supply than just open market operations and I will discuss them below, but let’s focus first on the balance sheet.

The inflationary danger arises from the fact that banks (depository institutions) hold over 819bln in deposits at the Fed (the second line in the liabilities side). If these institutions withdraw their deposits at the Fed and start lending out, there will be inflation. In order to reduce inflationary pressures, the Fed should be able to withdraw money from circulation. In normal times, the operation is very simple – the Fed officials sell some of Fed’s assets on the open market. By doing this, the Fed gets back cash and thus money supply in the economy goes down. To be able to perform this operation, however, the Fed must have liquid assets.

If we look at the asset side, we will see that the Fed has over 600bln in mortgage backed securities. Clearly, these are not good candidates for an open market operation. But in addition, there are at least three items that can be quickly sold or cancelled – US Treasury securities ($736bln), Term Auction Credit (credit with short maturity of about $220bln), and Commercial Paper facility of about $50bln. The last two items are part of credit facilities that the Fed can cancel easily once commercial banks start lending. The total amount is above 1trillion. In short, the Fed has enough balance sheet instruments to counteract the potential conversion of bank deposits into money.

Consolidated Balance Sheet of All Federal Reserve Banks (August 20, 2009) (Billions of USD)

Assets		Liabilities and capital
Gold US Treasury Securities Mortgage-backed Securities Term Auction Credit Commercial paper Other portfolio holdings Liquidity swaps Other assets	11 736 609 221 53 61 69 304	Banknotes Deposits of deposit. institutions US Treasury Other Capital	871 819 240 83 51
Total	2064	Total	2064

But these balance sheet tools do not exhaust the ammunition of the Fed to counteract any raise in inflation. Let me enumerate here some of the possible actions:

1. Open market operations (as described above).

2. Closing down of lending facilities (as described above)

3. Change in reserve requirements. What matters for inflation is the increase in broad measures of money. The Fed can raise required reserves ratios and by doing this they can reduce dramatically the speed at which money enters the economy. Required reserve ratios are used rarely because they are a very powerful tool (too powerful, one might say) in the control of money supply.

4. Change in the interest rate paid on the deposits of commercial banks. The Fed currently pays interest to banks that deposit their money in the Fed. If they increase this rate, the process of conversion of deposits into currency will slow down.

5. Issuance of central bank bonds. Currently the Fed does not have the authority to issue bonds (why would they borrow money, if they can print money?). But for the purposes of controlling money supply, they may ask the Congress to authorize them to issue bonds if they run out of Treasury bonds (i.e. they use all of them in open market operations) and they still need to reduce money supply further. This is a less conventional tool, but it has been used in China since 2003. Indeed this is how the People’s Bank of China sterilizes the effect of capital inflows and trade surpluses on money supply.

Armed with all these instruments, it is clear that, technically at least, the Fed possesses the levers to control the supply of money, so that rate of inflation does not increase above their (implicit) target persistently.

If you want to monitor the balance sheet of the Fed, it is published weekly on the following site: http://www.federalreserve.gov/releases/h41/Current/ (scroll down to where you see “Consolidated Statement of Condition of All Federal Reserve Banks”.)

Below is my interview for CNBC Asia from August 26, 2009, about the reappointment of Ben Bernanke as the chairman of the Fed (I know that I am biased). I also discuss Fed’s exit strategy briefly.

Ilian Mihov

More stimulus?

The debate about the need for a new stimulus package in the US is becoming more prominent among economists (see what Krugman or De Long have to say about it) and news web sites (the WSJ or CNBC are just an example).

What I find interesting is that this debate is taking place when most of the first stimulus package has not been implemented. In a recent conference at the IMF, Doug Elmendorf director of the US Congressional Budget Office, presented a summary of the progress of the first stimulus package. I was surprised to hear that at that point (a month ago), only 6% of the allocated money had been spent. By the end of September, it is likely that this figure will only be 25%.

Some of this delay was expected but it raises questions about what a second stimulus package would do to these figures. Even if we reach the conclusion that the US economy is in a weaker state than what was forecasted when the first stimulus package was approved (and this is probably true), how long will it take to implement a second stimulus package? Will new projects simply be added to the list of the current ones and be implemented a couple of years from now? This is a very important issue that needs to be resolved before we can start thinking about how many more billions of dollars we need to add to the first stimulus package.

As a side note, I find this related article by Paul Krugman very interesting. When it comes to fiscal policy, the burden of proof to show that it is an effective tool is so much higher than when it comes to monetary policy. And I agree with his reading that this is probably because ideologically, more government spending is a much more difficult proposition than lower interest rates.

Antonio Fatás

Stimulus money and the Chateau of Fontainebleau

Here is an interesting article from the New York Times about how fast France is spending the approved "stimulus money" relative to the US. The reason is that in a country with a large and more centralized system of public investment, there are many more "shovel ready" projects. The project they refer to is the renovation of the Chateau of Fontainebleau (home of one of the two INSEAD campuses). France is hoping to spend 75% of the stimulus money this year, a figure that is much larger than what is currently forecasted for the US. Here is an interesting chart with the evolution of money spent in the American Recovery and Reinvestment Funds. Numbers remain very low from the overall size of the program. The fact that we might see faster implementation of stimulus packages in countries with large governments (such as France) means that these countries not only benefit from strong automatic stabilizers, but they might also be able to be more effective when it comes to the implementation of discretionary fiscal policy measures.

Antonio Fatás

Ups and downs of fiscal policy

The large increase in government debt that we are witnessing across many countries have raised questions about the adjustment that will be necessary to bring those levels back to normal.

As much as the projected increases in debt are large for many governments, we have seen these high levels in the past and in some cases adjustments towards lower levels of debt have been fairly smooth and have taken place over a relatively short period of time. One of these examples is Ireland in the 1996 to 2006 period. During those years government debt was reduced from over 100% of GDP to about 20%. Fiscal discipline during those years helped, but what was more important was to have a fast-growing economy that made the level of debt shrink in relation to GDP. None of the advanced economies (the US, the Euro area) will be able to replicate the growth rates of Ireland in those 10 years but the message is clear: without healthy growth, bringing down debt to GDP ratios will be impossible (and Japan is a good example of what to expect if growth does not return).

The Irish example is also a reminder of how important is to have a proper framework for long-term sustainability of public finances. While the reduction of the debt levels was very impressive, some of the contributing factors were of a cyclical nature but they were judged to be structural by the policy makers. Once the cycle changed and the surpluses turned into large deficits, debt levels increased and, in the case of Ireland, we are witnessing a return to the high levels of the early 90s.

As an example of how cyclical factors helped during those years, the chart below - from the Public Finances 2009 publication of the European Commission - shows how dependent the increase in taxes was on the boom in property taxes. At the peak in the real estate boom, property-related taxes accounted for close to 20% of all tax revenues. In 2008 they have gone down to 10%, a loss of about 3 percentage points of GDP. Ireland is not the only country that is suffering from this problem. Overoptimistic scenarios used during the expansion phase did not produce the necessary fiscal discipline that could have created the necessary space for the current fiscal expansion. Let's hope we get this right in the next expansion (whenever it starts).

Antonio Fatás

Update on the difficulty of building counterfactuals

An update to our previous post. Below is a chart from the blog Calculated Risk that makes clear how difficult is to judge the effectiveness of economic policies. The two blue lines show the projections made by the Obama administration on January 10th for the evolution of the unemployment rate with and without the implementation of the recover plan. The difference between the two was a measure of the expected positive effects of such a plan. The red line shows the actual behavior of unemployment, much worse than any of the two predictions. A failure of the recovery plan or the fact that things have gotten much worse than what we expected in January?

Antonio Fatás