News or Noise?

I always find it amusing to read headlines from the business press (and their web sites) regarding macroeconomic news. In particular, headlines about exchange rates many times refer to dramatic movements in currency prices. No doubt that some currencies are very volatile and there is room to talk about interesting changes affecting exchange rates, but it also seems the case that most of these headlines do not correspond to what one sees in the data. Days were there is very little movements in exchange rates produce headlines such as "Dollar tumbles" or "Euro falls sharply".

As an illustration, I have collected headlines regarding the US dollar / Euro exchange rate for the last thirteen days (source CNBC.com). What we see is a succession of headlines (and stories) that talk about dramatic upward and downward movements of this exchange rate. There are days where one can even get three headlines on this subject, each of them pointing in a different direction. The list of headlines is below, together with a plot of what the Euro/Dollar exchange rate did during those days. Interestingly, despite the dramatic tone of the headlines the exchange rate was very stable moving in a range 1.4350 to 1.4500 (which is a fairly narrow range for this exchange rate).

List of headlines (CNBC.com)



Fears of weak global economy helps support dollar 
Thursday, 18 August 2011 10:51 PM ET

FOREX OUTLOOK-Dollar drops but respite in sight if economy dims 

Friday, 19 August 2011 11:25 PM ET

FOREX-Fed speculation hurts dollar vs high-yielders, euro 

Monday, 22 August 2011 3:32 PM ET 

Dollar wavers as stocks jump on lack of bad news 

Monday, 22 August 2011 5:32 PM ET

FOREX-Euro edges up on German data, hopes for Fed easing 

Tuesday, 23 August 2011 5:57 PM ET

Dollar Slides as Investors Look to Fed Move 

Tuesday, 23 August 2011 10:26 PM ET

Dollar Gains on Stock Selloff, Bets on Bernanke Speech 

Thursday, 25 August 2011 10:31 PM ET 

FOREX-Dollar slips vs euro, yen ahead of Bernanke speech 

Friday, 26 August 2011 3:30 PM ET

Dollar gains strength after Bernanke speech 

Friday, 26 August 2011 4:50 PM ET

FX OUTLOOK-Dollar tumbles after Bernanke; U.S. jobs data ahead 

Friday, 26 August 2011 11:30 PM ET

Euro Held Up by Asian Banks 

Monday, 29 August 2011 1:30 AM ET

Dollar Slips, Poland Talks Tough 

Monday, 29 August 2011 3:21 PM ET 

FOREX-Dollar rises vs franc, yen as US recession fears fall 

Monday, 29 August 2011 6:56 PM ET

Bernanke speech weighs on dollar in thin trading 

Monday, 29 August 2011 7:41 PM ET 

Dollar Rises vs Franc, Yen and Franc Fall on US Data 

Monday, 29 August 2011 8:37 PM ET

Dollar to Hit $1.50 to Euro? 

Monday, 29 August 2011 10:17 PM ET

Euro Falls Sharply on Euro Zone Debt Worries 

Tuesday, 30 August 2011 2:47 PM ET

Source: Oanda.com

Antonio Fatás

Yields for some Euro government bonds falling fast

A move in the opposite direction would have made it to the headlines of all financial newspapers but, just in case you missed it, here are the yields on 10-year government bonds for Ireland and Spain. They are still high relative to where they were before the crisis but they have been falling very fast over the last weeks. Some of this fall has to do with lower interest rates everywhere else (so the spread with the German yields has not fallen as much as what you see in these figures), but from the perspective of sustainability of government debt what matters is the interest rate you pay on your bonds and not the differential with a safe asset. 

Spain 10-Year Government Bonds

Ireland 10-Year Government Bonds

Antonio Fatás

Mind the ($5.1 Trillion) Gap

The debate between whether governments should focus on helping the economy grow faster or imposing discipline and austerity in their budgets is not going away. No one disagrees with the statement that governments needs to find ways to bring discipline to fiscal policy. Given current policies, governments are on an unsustainable path and there is a need for reform that will require a combination of lower spending and additional source of revenues.

The debate is on whether there is also a need to increase economic activity via expansionary fiscal policy (which in the short run is likely to make the deficit bigger). Not every country is in the same situation so it is difficult to provide an answer that is valid for every economy, but here are the two principles that should not be forgotten in this debate:

1. Bringing sustainability to public finances is about ensuring sound fiscal policy over the coming decades, not months. For many of the advanced economies, the future deficits look worse than the accumulated debt. Putting fiscal policy on a sustainable path requires reforms that should be long lasting, and we are talking about decades, not quarters. The difference between implementing these reforms in 2011 or 2013 is insignificant compared to the challenge that governments face. What matters is the commitment to get it right in the long run, not now. Yes, what governments do today could be a signal of what they will do over the coming decades, but this is only true up to a point. There will be new governments in the coming years and what is really required is not a contractionary budget one year but a structure and a set of constraints that ensures discipline for future governments.

2. The need for additional fiscal stimulus is based on the assumption that we are not in a normal year. If unemployment was at a normal level, if the output gap was zero (output was equal to potential), then there is no reason to postpone the necessary adjustment. But there is a dimension of economic policy (both monetary and fiscal) that works towards the stabilization of the business cycle. We do not expect monetary policy or fiscal policy to be the same in a recession than in an expansion. And while fiscal policy might require to show discipline over the coming decades, the amount of discipline should be different depending on the phase of the business cycle. Letting the economy be producing below potential for a long number of years is not only socially costly but it leads to a permanent loss in output which is a potential source of tax revenues.  And the most recent projections from the CBO (Congressional Budget Office) in the US show that GDP will be significantly below potential output for about 8 years, from 2008 to 2015 (see image below, source).

If we accumulate the output gap for all these years we are talking about a $5.1 Trillion gap that represents a permanent loss in output (and income, and tax revenues). Some might see this as a natural and unavoidable adjustment which almost amounts to claim that GDP and potential output are identical, the output gap is zero, unemployment is all structural. But given that the US economy has a strong tendency to return to its trend regardless of economic shocks, it is difficult to argue that there is no output gap to be filled in 2011 (or any other year before we get to 2015). 

Antonio Fatás

Eurobonds or Political Union are not the solution

I agree with Daniel Gros that Eurobonds are not the solution to the current European crisis. I also do not understand the argument that economic and monetary integration in Europe is failing because of the lack of political integration.

The only possible argument in favor of the idea that Eurobonds (or more political integration) would have solved the current crisis is that Greece, Portugal, Ireland, Italy or Spain are all doing fine and their only problem is that they are being attacked by speculators in such a way that the (high) market interest rate makes them insolvent. By attaching a different label to the bonds of these countries, the speculators will not be able to attack them anymore. There will be no PIIGS bonds out there, only Euro bonds.

This is a possible story and if indeed speculation is the only source of all of Europe problems, this might work. There are, of course, other solutions to the problem: a guarantee by the German or French government or by the IMF or the EFSF or any other credible institution that the bonds will be repaid and the interest rates will adjust to a level that makes those governments insolvent -- this is to some extent the solution being adopted.

The idea that having German tax payers being responsible for the debt that all Euro governments issue sounds not only politically unfeasible but also, from an economic point of view, it could have made matters worse instead of better. What is needed is a credible and transparent fiscal framework that ensures sustainability of public finances. Hiding the "country label" when issuing bonds or pooling all the risk together and making all taxpayers responsible for the misbehavior of any government does not seem to be setting the right type of incentives.

One could argue that the same argument applies to the Euro as a common currency that replaced the national currencies of countries with limited credibility. Does this mean that the creation of the Euro is also a bad idea? No. Sharing a currency is very different from sharing a label (and the risk) when issuing bonds.  Sharing a currency does not imply sharing the risk of unexpected changes in income or the cost of the mistakes that national governments or central banks might do.

Antonio Fatás

Dow Jones at 11,000 might not be that low.

Here is an interesting article from the Federal Reserve Bank of San Francisco on the potential effects that demographic changes could have on the stock market in the US over the coming decades. As baby boomers retire and sell their assets, including stocks, their prices are likely to go down. The issue is not new and has been debated before but what is novel in their research is the correlation between a standard measure of the demographic composition of the population and the price-earnings ratio in the stock market.

The image below shows the price earnings ration (P/E) and the ratio of the middle-age cohort (age 40-49) to the ok-age cohort (age 60-69). This is labelled as M/O in the chart. There is a clear correlation between the two series.

And if we look forward, this is what their paper predicts:

Their model generates a return of the P/E ratio to the low levels of the late 70's early 80's. 

There remains, of course, uncertainty about this prediction given that it relies on many factors (such as demand coming from other countries, changes in retirement age), but the correlation of the first figure provides a strong enough argument so that the issue cannot be ignored.

Antonio Fatás

Financial markets and professional cycling

Luig Zingales writes a very interesting article about some of the new scandals in financial markets (the insider-trading trial of Raj Rajaratnam). While we have seen similar scandals in financial markets before, he argues that this time the methods used to investigate the case and the involvement at the prosecution level are unusual. In addition, the fact that others like Raja Gupta (former worldwide managing director at McKinsey) or a managing director at Intel (Rajiv Goel) are involved, could make this case an important one that will create an even deeper dissatisfaction among the general public about what is going on in financial markets and institutions.

From the article you can see that there is a sense of disbelief about what is happening:

"It is so difficult to imagine that successful executives would jeopardize their careers and reputations in this way that many of us probably hope that the accusations turn out to be without merit."

This quote reminds me of a recent one by Alan Greenspan regarding the behavior of financial institutions prior to the crisis (from October 2008):

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity – myself especially – are in a state of shocked disbelief."

Despite his disbelief, Zingales admits that there is some recent evidence that supports the idea that personal networks can be a source of excess returns in financial markets. But he remains positive when he looks at the industry as a whole:

"After ten weeks of a trial like this, it will be easy for the public to conclude that all hedge funds are crooked, and that the system is rigged against the outsiders. Fortunately, this is not the case. While there are certainly some rotten apples in the hedge-fund industry, the majority of traders behave properly, and their legitimate research contributes to making the market more efficient."

This debate reminds me of what has happened in the sport of professional cycling (apologies to those who are not familiar with the sport and might not understand the analogy). In recent years, there have been a large number of cases of professional cyclists testing positive for performance-enhancing drugs. When the first cases came out there were two reactions:

1. Those who assumed that this was a generalized phenomenon and concluded that most cyclists were guilty.

2. Those who had the belief that this was just a few riders violating the rules but, overall, this was a clean sport. Their logic was that if doping was so generalized, how is it that we have not heard about it before?

Over the last years, we have witnessed an increasing number of scandals in this sport and what is worse is that the riders accused were some of those who had won the major races in the world (Tour de France, Giro d'Italia or Vuelta de España). The fact that most of the riders who finished in the top spots of these races in the last years have been associated to these scandals has shifted public opinion towards the belief that doping was (and might still be) a generalized practice in this sport.

I see a parallel with what we are seeing in financial markets as a result of the more recent scandals. Yes our prior is to believe that generalized corruption will be eliminated by market forces and regulation. But when we think about all the evidence that has surfaced during the last years regarding the behavior of financial institutions and those who lead them, our beliefs start shifting and at some point it is not simply a matter of questioning individuals. We start questioning the whole system, the incentives and the ways in which some become winners in this very competitive market (as competitive as the world of professional cycling).

The difference between cycling and finance is that while we can choose not to watch the next Tour de France but we cannot choose to live in a world where the behavior of financial institutions does not affect our society.

Antonio Fatás

Enforcing the unenforceable

European Union countries are coming up with new proposals to provide a stricter framework for fiscal policy. EU members have lived for more than a decade under the rules of the Maastricht Treaty and the Stability and Growth pact that set numerical limits on government deficits (3%) and debt (60%). While numerical rules are attractive (they are simple and transparent) the experience of EU countries has shown that, by themselves, they are not very good at providing fiscal policy discipline.

There are many reasons why these rules have not worked as well as expected: they do not provide enough discipline when it is most needed (during economic booms), the enforcement mechanism is decided by the offenders (ministers of finance), etc. In addition, even if the rules are supposed to be objective and transparent, they have always been subject to different interpretations. In particular, the limit on government debt (60%) has been consistently violated by many countries - today most countries are above this limit. They have all used as an excuse a clause that allowed deviations if the ratio was sufficiently diminishing toward the 60% level. But what does it mean to "sufficiently diminish toward the 60% level"?

The current proposal by the European Commission (you can read it here) attempts to make the 60% limit more operational and enforceable. Here is the summary of the new proposed guidelines:

"The debt criterion of the EDP is to be made operational, notably through the adoption of a numerical benchmark to gauge whether the debt ratio is sufficiently diminishing toward the 60% of GDP threshold. Specifically, a debt-to-GDP ratio above 60% is to be considered sufficiently diminishing if its distance with respect to the 60% of GDP reference value has reduced over the previous three years at a rate of the order of one-twentieth per year. Non- compliance with this numerical benchmark is not, however, necessarily expected to result in the country concerned being placed in excessive deficit, as this decision would need to take into account all the factors that are relevant, in particular for the assessment of debt developments, such as whether very low nominal growth is hampering debt reduction, together with risk factors linked to the debt structure, private sector indebtedness and implicit liabilities related to ageing. In line with the greater emphasis on debt, more consideration should be given to relevant factors in the event of non-compliance with the deficit criterion, if a country has a debt below the 60% of GDP threshold."

Maybe I am too pessimistic but the number of potential excuses that are being introduced in this paragraph makes me think that this is not going to work either. I have written a few papers on this issue, the difficulty of enforcing strict numerical fiscal policy rules and the failure of the Euro experience (Here is one example, and here is another oner). Some of the other proposed changes (e.g. establishing national fiscal frameworks of quality) are more promising, but if they keep relying on strict and asymmetric numerical targets, I doubt they will achieve the necessary level of fiscal policy discipline.

Finally, here is a very interesting presentation on this issue from the perspective of the Chile experience by Andres Velasco, former finance minister ( via Phil Lane and the Irish Economy Blog).

Antonio Fatás