Tuesday, May 18, 2010

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

Monday, May 17, 2010

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

Wednesday, May 12, 2010

$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

Current account imbalances and fiscal policy

Current account imbalances and sustainability of fiscal policy are two of the most important challenges that the world economy has to deal with in the coming years. They are both linked by the national account identity that states that the current account balance of a country is the sum of the private balance between saving and investment and the government balance.

I spent some time at the IMF Fiscal Affairs department last year and as a result we produced an analysis of the empirical link between fiscal policy and the current account. Our goal was to analyze a broader sample of countries and to look at episodes of large changes, two issues that had not been studied before in this literature.

The copy of the working paper can be found at the IMF web site.

Antonio Fatás

Sunday, May 2, 2010

The visual display of (politically-loaded) information

I have always been a fan of Edward Tufte and his work on the visual display of information (I am borrowing one of the titles of his books for the title of this blog entry). Below is a chart that I found via Brad DeLong on the path of job creation (or destruction) around the time of the change in the US administration. The original source of the data is the blog/web site of Nancy Pelosi (speaker of the US House of Representatives). Nice contrast between the Bush and Obama administration.

There are, of course, different ways of looking at the labor market performance during the Obama administration as Greg Mankiw has pointed out in his blog. Below is a picture that he updates often on the difference between what the administration had forecasted as a result of the recovery plan and the actual unemployment rates.

Same labor market, same data, but two very different messages depending on how we look at it.

Antonio Fatás