Completing the Eurozone rescue

VoxEU has published a new eBook on the current economic situation in Europe. The book is called "Completing the Eurozone rescue: What more needs to be done?". The book contains 13 short articles with an analysis of what went wrong and some concrete policy proposals to ensure a successful recovery and avoid similar crisis in the future.

Here is a summary of some of the findings:

"Although the essays were largely uncoordinated – and the authors hark from diverse backgrounds – a remarkably coherent message emerges. The authors unanimously believe that the crisis is not over, and that the Eurozone rescue is not finished. More needs to be done.

As Charles Wyplosz puts it, the Eurozone is levitating on the hope that European leaders will find a way to end the crisis and take steps to avoid future ones. Unless more is done, however, this levitation magic will wear off and the Eurozone crisis will resume its destructive, unpredictable path.

The crisis, in our view, is a thorny tangle of incipient debt and banking crises. Until this tangle is sorted out, any further shock could threaten the Eurozone as we know it. After all, Eurozone bank systems remain in a parlous state. Confidence in the financial system has not been restored. The losses from the Spanish real estate binge have only partially emerged. Greek public finances have still not been stabilised. Large competitiveness imbalances persist.
In short, none of the underlying causes of the crisis have been addressed.

Massive shocks could come from any number of sources ranging from the Spanish banking sector to political crisis in member countries facing fiscal austerity. Indeed, we already see ominous signs. Risk premiums on some Eurozone government debt have resumed their upwards trend despite the two May packages.

We also know that even small shocks can lead to a major crisis given the interconnected fragility of the Eurozone. Remember that it started with fiscal problems in a country which accounts for only 2.5 % of Eurozone GDP. Banking crises in a number of European countries could cause sovereign debt crises – a la Reinhart and Rogoff (2009) – which could spark contagion, thus triggering more bank crises. Trying to muddle through would be like sleepwalking through a minefield.

The time for action is now, for, as Barry Eichengreen puts it, “financial crises feed on uncertainty. The longer uncertainty is allowed to linger, the greater the damage to confidence…”.

Ilian and I wrote on of the essays where we are argue in favor of an institutional solution to the fiscal problems of the Eurozone. Our essay can be found here. The full set of essays can be found on this link.

Antonio Fatás

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

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

$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

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

The Euro crisis

According to Paul Krugman, the Euro is one of the main factors behind the crisis in Greece and other European countries. The fact that Greece (and Portugal, and Spain and Ireland) cannot devalue their currencies is having a negative impact on their growth which lowers tax revenues, increases government deficits and raises the possibility of default. Martin Feldstein goes one step further and argues that if Greece could devalue, they would easily avoid default.

I understand their argument, that exchange rate misalignments can have negative economic consequences but I think that blaming the Euro for the imbalances in government accounts is misleading.

The work of Reinhart and Rogoff, summarizing eight centuries of financial crises is full of examples of countries with flexible exchange rates where governments default. There are also plenty of cases of countries with fixed exchange rates and large devaluations that not only do not avoid default but might be responsible for it (as liabilities where denominated in a foreign currency).

Anyone who looks at the history of Greece (or any of the other Souther European countries) knows that crises come in variety of forms and the anchor of the European Union and the Euro has led to additional constraints on the government that have probably avoided crises, rather than creating them. This is what Reinhart and Rogoff conclude:

"Interesting recent cases include Greece and Spain, countries that appear to have escaped a severe history of serial default not only by reforming institutions, but by benefiting from the anchor of the European Union."

One thing that I am missing in the arguments of those who blame the single currency for the current European "crisis" (at least of confidence) is their recipe for the US in terms of exchange rate policy. The US government has debt levels that are likely to grow faster over the coming years (and decades) than in the case of Ireland or Spain (if we believe the OECD). The current US government deficit is similar and the projected US budgets for the next years in the US do not show a strong sense of restraint. There is no doubt that US fiscal policy is on an unsustainable path and there is a need to cut spending or raise taxes substantially over the coming years. In addition, the US has also displayed very large current account deficits in the last decades a sign (according to them) of the lack of competitiveness of an economy. How will the flexibility of the US exchange rate help the US going forward? If their recipes for Southern Europe are applied to the US, what should the US dollar do over the coming years? Depreciate? Relative to which currencies? Who will engineer that depreciation?

As an academic, it is easy to find arguments against a certain exchange rate system (flexible or fixed). But we need to go one step further and suggest an alternative taking into account the empirical evidence we have accumulated over the last decades or even centuries. In my view, arguing that the Euro is one of the key factors behind the Greek crisis ignores the economic history of these countries and the true trade offs that they face between different exchange rate systems.

Antonio Fatás