New treaty, same old flaws.

The European Union member states (with the exception of the UK and the Czech Republic) agreed yesterday to a new Treaty on "Stability, Coordination and Governance". The text of the agreement can be found in the web site of the European Council. My first reaction after reading the document was that I must have made a mistake and clicked on the wrong (old) document. It is very difficult to see the differences with the current economic policy framework. And, unfortunately, all the flaws of the previous system are still there.

Here is my list of concerns about the agreement.

1. Wrong title. The agreement is mostly about fiscal sustainability not about stability, coordination and governance. The assumption is that anything that produces lower deficits and debt is good for stability. And that if all countries do it together, even better (this is the coordination part). Fiscal sustainability is necessary but putting all the emphasis on it can be counterproductive.

2. Numerical limits at the center of the fiscal policy framework. The agreement relies again on strict numerical limits to enforce fiscal discipline. So far this has not worked and it is difficult to imagine why it would work going forward. The agreement says that countries cannot have deficits that are larger than 0.5% of GDP. The number is defined as "structural" meaning that they allow the budget to be adjusted for the business cycle. This is, obviously, a good idea, but its implementation is full of technical complications that the agreement ignores. Why 0.5% of GDP is the right number for all countries? It makes no sense to impose the same number to all countries except that is makes things easier to remember.. The agreement allows countries to run larger deficits when their debt is low, which makes some sense. But what about other circumstances? There is the room for exceptions, which sounds very reasonable but it goes against the notion that we are producing a simple set of numerical rules (now it is not so easy to remember anymore).

3. Not enough stress on good years. The main failure of fiscal policy in European countries in the last decade has been not to generate large enough surpluses in good years. By focusing so much on the deficit limit of 0.5% we simply ignore that the real issue is on how to generate those surpluses and we put all the emphasis on the bad economic years where getting thins right is so much harder. We have not learned much from the last 10 years.

4. Limited focus on governance. Despite the fact that the word governance appears in the title of the agreement, there is very little change in terms of governance and enforcement. The agreement will be enforced by the governments of the member countries. These are the same actors that can potentially be the sinners. There will be times (as in the years around the 2002/2003 recession) when most countries will violate the agreement (including Germany and France). What happens then? The agreement talks about automatic fines. Fines that are paid to whom? To the potential group of offenders? Do we really believe that if we had had in place an automatic fine imposed on Greece for having violated the deficit limit we would not be in a crisis today?

Providing an economic policy framework to manage the Euro area is not an easy task and I am glad that I was not part of the negotiations that have taken place over the last days. But the agreement shows that we have learned very little from the previous experience. We insist on maintaining a system that does not work and that only provides a distraction to other economic policy issues that, if we try hard enough, we might be able to solve.

Antonio Fatás

A matter of faith (in markets)

Alan Greenspan contributed yesterday to the Financial Times debate about Capitalism in Crisis. The title of his article was "Meddle with the market at your peril". Not surprisignly Greenspan presents a strong defense of capitalism and market economies by comparing its success to the failures of other systems (such as planned economies).

I do not think that many disagree with that conclusion. But where the article surprised me is when he talks about the potential failure of markets:

Anti-capitalist virulence appears strongest from those who confuse “crony capitalism” with free markets. Crony capitalism abounds when government leaders, usually in exchange for political support, routinely bestow favours on private-sector individuals or businesses. That is not capitalism. It is called corruption.

This is the only sentence in the article where Greenspan admits that there could be some failure in a market economy. But that failure is driven by bad government behavior! Other than that, markets work fine. I hope his views are not really that extreme and that he is willing to accept some of the market failures that economists have identified in the past and that are taken care of by different forms of regulation. This is to me the interesting debate, the one that identifies market failures and then tries to address them via intervention or regulation. In that debate we might find that government intervention is not always possible or efficient. And I am sure we will find disagreement on the domains where government intervention is necessary or optimal. The other debate, the one that compares "capitalism" with the economic system of the former Soviet Union does not sound too interesting or useful at this stage. And it only leads to statements like the one above that seem to be driven by faith in one of the two systems.

Antonio Fatás

The Big Day for the Fed

On January 25th, 2012, in addition to its regular statement from the Federal Open Market Committee, the Federal Reserve published for the first time two additional documents: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents and a Statement of Longer-run Goals and Policy Strategy. The media and the markets reacted positively to the statement. The most quoted phrase was:

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

Stock markets gained close to 1%, while yields for bonds with various maturities dropped by about 2 basis points.

The two new documents represent a historical shift in the monetary policy of the US. Put together with the standard FOMC statement, they offer much deeper insights into the way that policy makers think about the state of the economy. There are at least a dozen of points worth discussing: The explicit statement of a self-imposed inflation target; the expectations for future interest rates; the projections for GDP; their views on the natural rate of unemployment, etc. I want to focus only on two topics, which in my view are somewhat missing from the popular discussions: the consistency of the statement with the projections and policy-makers’ views on potential growth.

Economic Projections, January 2012 (excerpt)

Variable	Central tendency
	2012	2013	2014	Longer run
Change in real GDP (%)	2.2 to 2.7	2.8 to 3.2	3.3 to 4.0	2.3 to 2.6
Unemployment rate (%)	8.2 to 8.5	7.4 to 8.1	6.7 to 7.6	5.2 to 6.0

First, if we look at the projections for real GDP growth and for unemployment, it is clear that by 2014 the output gap in the US is not going to close. Hence, it is quite possible that 2014 is even an early date for tightening according to the Fed. It does not necessarily mean that the statement is inconsistent with the projections. As indicated above, low interest rates are expected to be in place “at least” through late 2014. But it is worth pointing out that their “average” belief is that the economy will be still below potential at the end of 2014.

Second, and more worrisome, is the projection of long-term growth rates for the US economy. According to the Fed, the central tendency will be for long-term growth rates to be between 2.3% and 2.6% p.a. This is a significant departure from the historical record. In the post-WWII period, real growth in the US has been at about 3%. Fed’s projections suggest that this may not be the case anymore – indeed this implies a significant slowdown in the potential growth of the US economy. Just to illustrate the implications of cutting off 0.5 percentage points from the growth rate, let’s look at GDP per person in 2010 if the economy between 1950 and 2010 grew by 0.5% less. A simple calculation shows that instead of its current level of $46,844, US GDP per capita would be 26% lower at $34,530.

The dire projections of the slow cyclical recovery expected by the Fed and the downward shift in the potential growth rate have serious negative implications about the US economy. Is the Fed deliberately over-pessimistic, or do they believe indeed that we are getting into the “New Normal”?

Ilian Mihov



P.S. Below is a recent interview on CNBC discussing some of the issues related to Fed’s new communication strategy.

INSEAD blogs

We just launched the new INSEAD blog with articles from INSEAD faculty and other members of the INSEAD community. The blog covers a broad range of topics coming from all the disciplines you find in a business school. It is great to see a large number of my colleagues writing now for our blog! If you want to follow up on the newest research ideas in business, this is the place to go: http://blog.insead.edu

Antonio Fatás

What we do with the debt matters

Here is a follow up to my previous blog entry on the meaning of gross debt. Paul Krugman thinks that I went too far when I argued that there is no need to worry about gross debt. Correct. But my goal was not to argue that gross debt is completely irrelevant but to raise my concerns about those who only look at the liability side of a balance sheet or ignore the fact that what constitute a liability for some it is an asset for someone else (a point that Paul Krugman has made earlier when referring to government debt).

This does not mean that gross debt does not contain any important information. For example, if we think about the world, a consolidation of all balance sheets leads to an always perfectly match between revenues and spending, the world cannot accumulate any debt. But when we look at a disaggregated level, individual countries run deficits and this can be a source of concern and instability. Same is true for a country. Japan runs a surplus on the current account (accumulates assets, not debt) but its government keeps increasing its debt. The country as a whole does not need to deleverage and looking at the gross debt of the country is a meaningless exercise (the point I made in my previous entry). But the government needs to find a way to reduce or stabilize their debt so looking a disaggregated data is necessary as well.

Back to the US, Paul Krugman has a new post on the behavior of debt over the last two bubbles. Comparing the Clinton years where there was a stock bubble and the Bush years where there was a real estate bubble he concludes that there are large differences between the two. Not only the economy did much better during the Clinton years, but also the accumulation of debt was much worse during the Bush years. He is completely right on his assessment. But just to understand better what happened during those years, what was the behavior of net wealth (and not just debt) during each of the two episodes?

Using data from the Flow of Funds accounts (US Federal Reserve) I have plotted below the liabilities of US households as a % of their personal disposable income. I went back to 1960 to get a better historical perspective.

This first chart confirms Krugman's assessment that the increase in debt was significantly faster during the second bubble (post 2001). But what was going on at the same time with the value of the assets that the households were buying? The value of assets increased during those episodes and it increased much faster during the second bubble.

This is not a surprise given how widespread the bubble in housing prices was and how relevant housing is in terms of the wealth of US households.

Here comes the most interesting chart (from my point of view), the one that combines assets and liabilities and looks at the net wealth (again measured as % of personal disposable income).

First lessons is how remarkably stable this ratio has been over the last 50 years. It was around 500% in the 60s, was depressed during the 70s (around 450%) as these were years with very weak stock and housing markets. It went back to 500% during the 80s and then we see very clearly the two bubbles bringing this ratio to 600 or 650% before it collapses back to 500%.

When we look at the two bubbles from this lens we see that in both cases the accumulation of debt during the good years of the bubble was happening while the balance sheets of households were getting stronger and stronger. The valuation of assets always grew faster than the accumulation of debt (and this made the bubble look "reasonable" to some). When the bubble bursts, assets go back to normal but what it is interesting is that net wealth does not collapse; it simply returns to the pre-bubble levels. This means that despite the increase in debt if you compare post- to pre-bubble years (first chart), households are back to the level of wealth they had before the bubble started. Yes, my mortgage is much bigger than it used to be but I also own my house and stocks that are worth more than they use to. To be clear, relative to the peak of the bubble I am of course much worse off, but relative to the day the bubble started, I am in a similar position.

If we look at the balance sheet of households in the US through this lens we might reach the conclusion that there is not much need to deleverage. The consolidated balance sheet looks the same as it looked during early decades (the 60s or the 80s). Higher debt simply matches the assets the have been bought with it. We can think of scenarios where the health of the balance sheet looked much worse than before: Supposed all the borrowing during the boom years had used to pay for additional vacations or expensive meals. Then the picture today would look very different, net wealth would look so much lower than in the pre-bubble years and we would be talking about a much weaker situation as seen by the balance sheet of households.

Some caveats to what it might sound like a too optimistic look at the financial health of US households. The 500% ratio that has been stable over time might not be the right level. I am just claiming that we are at a level that is similar to what we have seen in "normal" years. I cannot claim that this is good or optimal or that there should not be a positive trend in this ratio. The second caveat is that the picture above ignores distributional issues. The fact that the aggregate looks good does no mean that we do not have a significant proportion of the population with balance sheets that look much weaker and this is a concern. Finally, the valuation of assets might still fall further (housing prices) and could send net wealth to lower levels.

Antonio Fatás

No need to deleverage gross debt

The McKinsey Global Institute has produced a new report with the title "Debt and deleveraging: Uneven progress on the path to growth". The report discusses the challenge for advanced economies to reduce high level of debt and the potential consequences for growth. It is an interesting topic and, as it always the case with the MGI reports, it produces a detailed analysis of international data.

There is, however, an methodological approach in the report that I do not share and that can be misleading. The report starts with a few charts of debt trends in the last decades. As an example, here is exhibit 1 from their report.

Among all economies we see an upward trend with increasing levels of debt, measured as % of GDP. The reading of this chart tends to be one of economies "living beyond their means", where spending outpaces income and where an adjustment is needed (deleveraging). This is not correct. As I discussed in an earlier post about government debt, the debt of one individual (or government) is the asset of someone else. Looking at gross debt (as done in the chart above), can be very misleading. What matters for countries is their net wealth and not their level of gross debt.

Let's think first about a closed economy. In a closed economy liabilities (debt) have to be equal to assets. What we know from the data is that as a country develops, the ratio of assets to GDP tend to increase. This is some times called "financial deepening" and it is measured as the ratio of money supply to GDP but where the money supply is a broad measure including a large number of asset classes. Higher levels of this ratio are seen as a positive development (larger financial markets). But in a closed economy, this ratio is identical to the Debt/GDP ratio. So a more leveraged economy is one where financial markets are simply more developed. Concluding automatically that this is bad or that an adjustment is required is not correct.

When an economy is open then the right concept to measure is the net wealth of a country relative to the rest of the world. And this is the difference between foreign assets and foreign liabilities after consolidation of all internal debt. If we do not consolidate internal debt we are making the wrong assessment. As an example, in the McKinsey report, the country with the larges debt to GDP ratio is Japan (see chart below, also from the report).

But Japan does not need to deleverage! Japan has consistently had large current surpluses and accumulated a large amount of foreign assets (it is in the same situation as China). The country does not need to reduce its debt. What is going on is that the government has a large amount of debt (226% of GDP), but this debt is held by Japanese citizens. But these private assets do not show up in the above calculations as only debt is included. The government of Japan needs to reduce its debt but not the country.

Similarly, if one looks at the Euro countries with difficulties these days, their debt levels are not that high. Correct, but if one were to look at their net foreign asset position (how much they owe to the rest of the world), in some cases we would see very large numbers (Greece, Spain) because of the large current account deficits they were running in the past. So while internal debt is not that high, external debt is and that is where we see their economic problems.

Antonio Fatás

ECB: Assets=Liabilities

Statistics released today about the ECB balance sheet show that Euro banks have a record level of deposits at the ECB (about €500 billion). The press tends to misrepresents the meaning of these deposits. From CNBC today:

"the recent giant injection of ECB cash left banks awash with money but too scared to lend it."

and

"With total ECB lending at 664 billion euros, banks are now storing over three-quarters of money lent by the ECB at the central bank, compared to around a third after the collapse of Lehman Brothers back in late 2008."

Both statements give the impression that the size of the balance sheet of the central bank is driven by the actions of commercial banks. This is misleading. The size of the central bank balance sheet is determined by monetary policy. Monetary policy will react to economic developments, including actions of commercial banks, but at the end of the day the size of their balance sheet is mainly a decision of the central bank.

Towards the second week of December the ECB decided to increase lending to commercial banks (by making it attractive, of course). This led to an increase in the ECB balance sheet of about €250 billion between December 16 and December 23. This is associated with an increase in assets (lending to euro area credit institutions) as well as an increase in liabilities (accounting still works!). There are potentially two liabilities that could change: Banknotes in circulation (this is printing money) and deposits of commercial banks at the central bank. Currency in circulation barely changed that week, but deposits of commercial banks changed by about €200 Billion (the rest comes from other liabilities). As banks get loans from the central bank, their accounts at the central bank get credited.

Since then, not much has changed. Loans to banks remain high as well as deposits from banks. What if commercial banks start lending to the private sector, will the level of deposits at the central bank go down? Not necessarily. The only way for the level of deposits to go down is if commercial banks start paying back the loans they took from the central bank. And the central bank could always resist this move by making these loans even more attractive (this is standard monetary policy).

So it should be no surprise that deposits of commercial banks at the ECB are at a record high when the balance sheet of the ECB is at a record high (we observe the same phenomenon in the US or England). When monetary policy decides to increase its balance sheet, both the liabilities and assets have to increase. Given that central banks are not massively increasing notes in circulations, it must be the case that it is the deposits of commercial banks at the central bank the ones that are increasing.

Antonio Fatás