Inflation or Deflation (CNBC Interview with Ilian)

Filling the Gap

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?

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

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

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

"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,...

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