The future of the Euro

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?

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.

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)

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?

"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

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

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