Gross Mistake

In a couple of recent posts Paul Krugman reminds us that interpreting data on debt as a sign of excessive spending and living beyond our means is incorrect. I have made this point before when looking at government debt.

The first flaw in the logic is that while it is correct to argue that if someone lives beyond his or her means we will see their debt increasing, it is not correct to argue that every time we see debt increasing it means that someone is living beyond his or her means. The reason is that we need to consider assets and not just liabilities. This argument becomes even more relevant when you go from an individual to a country as what is debt for a person is likely to be an asset for someone else. In other words, for an individual you want to look at the balance sheet (and not just debt), for a country we need to look at the consolidated balance sheets of all economic actors.

As Krugman argues in his blog post, the main reason why we see debt increasing in the US (and other advanced economies) during the years that preceded the global financial crisis was an increase in leverage and not overspending. I borrow to invest in someone else's business or idea who is borrowing from me to invest in someone else's asset, etc. In this scenario, the collective level of debt keeps increasing even if no one is living beyond their means; our balance sheets look fine with assets matching liabilities. It can, of course, be the case that we are creating a risk in the system by this increasing lending with leverage that could itself become an amplification mechanism to any future disturbance to the economy (so maybe increasing debt as a result of increasing leverage is bad after all) but this has nothing to do with the level of spending (no spending spree here).

One way to provide an additional perspective on this issue is to realize that as countries develop we expect their level of debt to increase relative to their GDP. There is a measure that economists use all the time called financial deepeness that captures the development of financial markets which is directly related to the size of the balance sheet of financial institutions. In advanced economies these balance sheets are bigger in size so any measure of the liabilities as a % of GDP will be higher than in developing countries. So higher debt is a sign of development in this context.

There are indicators that aggregate all the balance sheets of all economic actors that give us the true measure of imbalances in spending and income. We can do it by sectors (the government, the private sector, households,..) or we can do it for the whole country. When we do it for the whole country what we measure is the Net International Investment Position (NIIP). This is the difference between all foreign assets and foreign liabilities. This is the true measure of how much the country is borrowing from the rest of the world (in net terms). How does it compare to measure of gross debt? For a start it is smaller for most countries but, more interestingly, it can give you a very different perspective on a country if you just compare it to a partial measure of indebtedness.

As an example, let's compare government debt with the NIIP for some selected countries.

The figure above shows the (gross) government debt as % of GDP and it compares it to the NIIP (also as a % of GDP). In the case of the US, gross government debt is around 100% but the NIIP position is much smaller (around 25%). In other words, some of the debt that the US government issues is held by US citizens, we owe money to ourselves and it is wrong to think that we are passing all the government debt to the next generation because we are also passing the asset that goes with it (a point made many times by Paul Krugman).

In the case of Japan or Germany, government debt is high (very high in the case of Japan). But that debt is more than compensated by the assets that both the government and the private sector hold so both countries have large net international investment positions.

We have other countries like Australia where the government debt is small relative to the NIIP. This is a sign that the private sector has been borrowing (in net terms).

There are lots of interesting questions about the meaning and risk of gross versus net debt but answering those questions requires an understanding of how gross positions create risk to the financial system and more generally to the macroeconomy. Simple and misleading statements that link debt to overspending are not helpful in understanding the potential risks and can be completely off when it comes to suggesting solutions for the economic crisis.

Antonio Fatás

Cyprus: between hope and panic

The Eurogroup announcement on Saturday of an agreement with the Cypriot authorities for a macroeconomic adjustment program came with a big surprise. The agreement involves a controversial "one-time-tax" on bank deposits. The tax is progressive starting with a lower level for bank deposits below 100k Euros. While the authorities are trying to sell this measure as a tax, it is clearly going to be read as a statement that regardless of any deposit insurance mechanism (which is in place in Cyprus for deposits below 100k), bank deposits might now be considered risky. As much as the Eurogroup and the Cypriot authorities will do their best to minimize this interpretation, there is the possibility that it spreads to other countries and that we see bank runs at a significant scale in some of them.

The reaction to the announcement has either been of hope or panic. My reaction is somewhere in between the two.

When it comes to the government of Cyprus, they are hopeful that everyone will understand that this was a one-time event and that the country can now move forward. From CNBC here is a quote from the Cyprus finance minister Michael Sarris:

"Absolutely, there is no capital restrictions, people can move. We hope people will believe us, believe the collective leadership of the European Union, that this was a necessary step, but a single shot at the problem, and that from now on they can be very confident that nothing will happen to their savings."

This will not happen, people will not believe them (not to mention the fact that the parliament has postponed the approval of the agreement that was scheduled to happen on Sunday). Prepared for several rounds of panic. I doubt the banking system will be able to operate without some capital restrictions over the coming days.

On the other side, there are those who panic that this is the prelude of bank runs in Greece, Spain, Portugal or Italy. This is certainly a possibility and we have already seen withdrawals of deposits in some of these countries during this crisis, but it will take a lot of panic to produce a significant bank run. The reason is that there are still costs or barriers to produce a widespread bank run in these countries. The assumption that all the depositors in these banks will immediately open an account in Germany and transfer all their funds is (fortunately) not obvious. There are significant restrictions in opening of bank accounts even within the Euro area if depositors do not have residence in the country where the bank is established. Of course, there is always the option of hiding all your deposits under your mattress (or a cash vault) but both they represent a risk or they simply are not practical enough. Having said that, in the event where there is a strong perception that a similar "one-time-tax" is about to happen in other countries, these barriers will not be enough, so a bank run cannot be ruled out either.

The next days are going to test the ability of European authorities to convince the public that what has happened in Cyprus will not happen in other countries. Is it possible? Yes, this is what to some extent happened after the agreed default on Greek government debt. The fact that interest rates on government debt of other countries in the periphery has come down significantly over the last months is a proof that you can credibly claim that certain events are exceptional and will not spread. Contagion is always possible when we see default but it is not always necessary. Let's see how good European authorities are this time to ensure that hope defeats panic.

Antonio Fatás

Bill Gross on the Big Mac and QE

These are good days for someone who teaches macroeconomics, because it is easy to find articles that misrepresent the basic concepts we teach in class - this always motivates our students who now feel that they can make better arguments than those writing in the financial press.

Bill Gross, founder and co-chief investment of Pimco is back in the Financial Times. This time he is not trying to explain why higher interest rates are good for investment and growth, but instead he is trying to help investors make decisions on foreign exchange markets. His argument is that the traditional theories of exchange rates (Purchasing Power Parity = Big Mac Index) do not matter much today, what matters is the behavior of central banks when it comes to quantitative easing.

The first thing that is odd in the article is that he misses the connection between the different theories he discusses. Someone making an argument that quantitative easing leads to inflation and a depreciation of a currency is implicitly using Purchasing Power Parity as an argument to talk about exchange rates. That argument is standard in any macroeconomics textbook.

What is not standard and where, in my view, he is not being accurate is the way he describes quantitative easing and its implications on exchange rates. First, there is the constant reference to "money being printed". This is wrong. Most of the increases in the monetary base (the size of the balance sheet of central banks) do not correspond to increases in the amount of currency in circulation but to increases in the deposits that commercial banks hold at the central bank (reserves). This increase in the monetary base do not always lead to an increase in the money supply or inflation. Or you can put it in a different way: the increase in liquidity is matching the demand for liquidity by the financial system. If demand and supply are balanced, prices do not change (exchange rates do not change).

When it comes to the exchange rate he cites Japan as an example where his theory is working (the Yen has depreciated because of quantitative easing). Correct, but only up to a point: it is not because the balance sheet of the central bank is increasing, it is because there is the perception that the central bank is finally committed to deliver high inflation and if this is the case, PPP tells us that a currency will get weaker.

His advice: to pick winners and losers (in terms of currencies) by looking at the size of the central bank balance sheet. Way too simplistic and possibly wrong. It sounds more as one additional attempt to criticize central banks for what they have been doing (QE). If anyone had followed that advice during the crisis years, they would have gotten their bets on currencies wrong several times (same for those who followed his earlier advice that inflation was around the corner and interest rates would increase fast).

Yes, monetary policy matters for the exchange rate because it affects all nominal variables: prices, inflation and the nominal exchange rate. But mislabeling quantitative easing as "printing money" and call it a sure bet to increase inflation in future years has proven to be wrong enough times in the last years that one would think that the argument would not be repeated again. But I should not complain, I have to teach a few more sessions on monetary policy in about three weeks, so these articles are making my search for interesting readings much easier.

Antonio Fatás

Dove or Hawk? Bernanke's record

In yesterday's testimony at the U.S. Senate Ben Bernanke was accused of policies that could potentially generate high inflation. Senator Corker accused the Fed Chairman of nor being concerned enough about inflation by saying "I don't think there's any question that you would be the biggest dove since World War II". The term "dove" in the context of central banks is used to describe policies that put more weight on unemployment and less on inflation (as opposed to "hawks" who do the opposite). Ben Bernanke defended himself by mentioning that he has one of the strongest records in terms of inflation of any previous Chairman.

Below is a quick check on both the inflation as well as the unemployment record of the last six chairmen of the US Fed. Ben Bernanke has so far produced one of the lowest inflation rates since the 1950s. When it comes to unemployment, his record is not that positive, only second to Paul Volcker in terms of high unemployment rates.

Comparing performance of central banks without controlling for other factors (such as the depth and frequency of economic crisis or shocks during their mandates) is not fair but at a minimum it provides some basic facts to back the statement by Ben Bernanke that it is difficult to see his record as someone who put too much weight on unemployment and too little on inflation.

Antonio Fatás

The Euro depression

As we wait for the results of the Italian election, Europe is heading for yet another period of uncertainty. Governments in key countries (Italy, Spain, Greece, France,...) do not have the support to continue the path that has been followed so far but there is still no real alternative and a strong sense of complacency: we will continue the same policies that we have followed so far.

According to the European commission recent forecasts, the Euro area will see negative growth rates again in 2013 and growth rates as low as 1.4 in 2014. This means an average growth of 0.16% in the period 2012-2014, assuming we do not end up revising downwards our views on 2014 - which is very likely. And this comes after Europe has gone through its worst recorded recession during the 2008-2010 years.

This is now worse than a double-dip (great) recession. What is really frustrating (maybe we should call it depressing, to match the economic situation) is the complacency with which some European politicians look at what is happening. When Olli Rehn (EU commissioner for economic and monetary affairs) commented on these negative forecasts produced by the EU commission, he called them disappointing but then he just said that current policies are finally paying off. The introduction letter to those forecasts, produce by Marco Buti, the Director General responsible for the forecasts, talks about several factors that are contributing to weak growth: the negative feedback between public finances, banks and the weak macroeconomy, lack of credit growth, uncertainty about policies,... These are all external factors (austerity is not even mentioned as a possible factor), so the best we can do is to continue the policy agenda "to ensure the sustainability of public finances". There is no learning here, it does not matter how strong the facts are (I will not present again the facts here, see Krugman or De Grauwe for a recent analysis and a reaction to these forecasts).

But let me look at some (depressing) data from Italy, where election results are expected by the end of the day. Below is the evolution of the Italian economy compared to the US and South Korea since 1980. Data is GDP per capita (in logs) from the IMF World Economic Outlook, including their forecast for 2013 and 2014.

After the Italian "miracle" of the 1960s and 1970s where Italy was growing fast and converging towards the other rich countries, the economy stagnated in the 80s and then started falling apart in the years that follow. Since 1990, not only Italy has stopped converging towards the US levels, it is now drifting down and away from the US level. If this trend continues, Italy will follow the path of Argentina in the 20th century when it went from one of the richest countries in the world to a middle-income country. As a comparison we see how South Korea continues its path of convergence towards the US and has recently passed Italy in terms of GDP per capita.

We talk a lot about the lost decade for Japan, but if there is an advanced country where the label lost decade applies is Italy during the last 10 (or 15) years. But, of course, we can always be optimistic (as Olli Rehn seems to be is), Italy still exists as a country, it is still a member of the Euro area and bond yields are not as high as the ones in Greece - although all this can change in a few hours if the election results end up being a (bad) surprise!

Europe can and should do much better than zero growth over a decade. If this is not understood by political leaders then the downward drift that some countries started 10 or 15 years ago will continue or even accelerate and this might drag all the other European countries with them.

Antonio Fatás

Celebrating negative growth

GDP growth during the last quarter of 2012 turned negative in the US (-0.1%) and this came as a surprise to many.  Looking at the different components of GDP, the biggest decline happened in government spending and in net exports (due to the weakness in other economies). This is just one quarter and the data is likely to be revised later in the year, but what is to be learned from the data? The answer is whatever justifies your priors. Here is the interpretation that Larry Kudlow does in CNBC, which is a good example of how statistics can be interpreted in so many different ways.

He makes the claim that this is indeed a good quarter because private spending (consumption and investment) grew at about 3.4% - after removing inventories that fell significantly. From here he concludes:

"Even with the fourth-quarter contraction, the latest GDP report shows that falling government spending can coexist with rising private economic activity. This is an important point in terms of the upcoming spending sequester. Lower federal spending, limited government, and a smaller spending-to-GDP ratio will be good for growth. The military spending plunge will not likely be repeated. But by keeping resources in private hands, rather than transferring them to the inefficient government sector, the spending sequester is actually pro-growth."

So this is an interesting test that he is using to prove that decreasing government spending is good for growth. As long as we see any growth in private spending it means that the decrease in government spending is helping the private sector grow. Of course, the real test is to compare the -0.1% to what would have happened to GDP growth if government spending had not decreased. Reading Larry Kudlow's article it sounds as if GDP growth would have been even lower (although his statement is not as precise as this). Yes, consumption grew and investment (once we exclude inventories) grew as well, but how much? Not enough to compensate the decrease in government spending so the final outcome is a negative (literally negative) performance for GDP growth.

So if we were to use just this observation to understand the fiscal policy multiplier, what would we learn? [Just to be clear, we should not be doing this, to understand fiscal multipliers we need more than one quarter of data, but I am just trying to follow his logic] I see that GDP growth is low and certainly much lower than what anyone would expect taking into account that the US economy is still below potential. We see that government spending fell and this is a component of GDP. A natural reaction might be to argue that the fall in government spending had a negative effect on GDP. Given that the GDP growth number is so low (and lower than expected), this is a reason to believe that the multiplier is positive and possibly large. But, as Larry Kudlow shows, there are always other interpretations.

Antonio Fatás 

Doomsday, gold and the Bundesbank

Noah Smith has a great blog post on the obsession with gold as a store of value or as an investment strategy. I fully share his views on gold and in particular about the arguments made by those who see gold at the center of the world economy and the best investment one can do these days.

Interestingly, his blog post comes the same day that all business media report on the announcement of the Bundesbank that they are moving some of the gold reserves back to Germany. The move of these gold reserves is partly seen as a response to an earlier report by the German court of auditors that was concerned with the lack of checks on the gold reserves held abroad.

The story not only made up the headlines but it also came with a quote from Mr Thiele, Bundesbank board member who commented on the purpose of the reserves and the move by saying

"To hold gold as a central bank creates confidence. We build trust at home and have the possibility to exchange gold at short notice into foreign currency abroad."

I am really curious about what (doomsday) scenarios he has in mind where the gold reserves of the Bundesbank would become crucial to restore confidence. By the way, the gold reserves of the Bundesbank which at 130 Billion Euros are large compared to other central banks seem small compared to many other magnitudes that matter in financial markets, more so during crisis time. And I am assuming that these scenarios are catastrophic, otherwise why would gold be needed to buy foreign currency. And given that they are thinking that those scenarios are likely, is there anything that they are planning to deal with them?

There is, however, one positive outcome out of this news and Mr Thiele's quote. I need to teach my students tomorrow about central banks and the history of the monetary system (including the gold standard) so I know have some good material to motivate my lecture.

Antonio Fatás