Sovereign default: panic versus fundamentals

There is a growing concern that we are approaching a wave of sovereign defaults in Europe. And if there is default on government debt, it will have an effect on the balance sheets of Euroepan financial institutions and this is the source of the recent concerns about the solvency of some of these institutions.

Stress tests are designed to look at "pessimistic" scenarios to see whether financial institutions have enough capital to deal with them. But stress tests will always have an element of subjectivity. How pessimistic should we be in these scenarios? The IMF has recently expressed their concerns about the need for capital of some European banks because of the possibility of sovereign defaults not priced into some of the stress tests that European regulators have produced. This is a source of debate between European officials, the ECB and the IMF. But what is a good assumption about sovereign default in Europe? How do we measure the probability of default? Should we look at CDS (credit default swaps or should we use interest rates as a measure of default probabilities?

Both of these measures capture the "market" view on default probabilities. A completely different approach is too look at the fundamentals of fiscal policy sustainability (yes, it requires more work but it is always a productive exercise to look at the numbers and not just at how others read those numbers!).

The IMF fiscal monitor (last issue is just out) provides a very detailed analysis of the fundamentals behind fiscal policy. They look at several indicators or fiscal policy risk:

- gross debt as % of GDP (Debt)
- gross financing needs as % of GDP (GFN)
- short-term debt (as % of total)
- the currency deficit (adjusted for the cycle) (CAPD)
- Expected increase in pension spending over the coming years
- Expected increase in healthcare spending over the coming years
- Difference between interest rates paid on debt and the growth rate of output (r-g)

All indicators are straightforward, they look at the past (debt), the present (deficit) and the future (pensions, healthcare) taking into account the cost of borrowing (interest rate) and the ability of the economy to generate growth to keep the debt to gap ratio under a reasonable number. You want all these indicators to be as low as possible.

I am copying below the indicators for some of the countries they analyze (indicators are in the same order as in my list above)

Comparing France and the  US we can see that both countries look risky along several dimensions. Overall, the US seem to score worse than France in several dimensions. Higher level of debt, deficits and more importantly, a larger future burden in terms of pensions and healthcare spending. The only indicator where the US does better is the low interest rates that the US government faces when borrowing in financial markets.

Here are the data from Germany and Spain

They do not look good either although the risks are similar or slightly lower than the ones in the US or France. Levels of debt are lower in Spain, current deficit is lower in Germany. Short-term pressures are similar to other countries and long-term pressures (pensions and healthcare) look better both in Spain and Germany than in the US. The only dimension where both of these countries do worse is when it comes to the difference between interest rates and growth.

In the case of Spain, the issue of credibility is key. If credibility is lost, the average interest rate paid on government debt will increase and will make more difficult to set a sustainable path for fiscal policy (in the chart above the indicator of the right will get higher). But the credibility of a government must be a function of the other indicators. The trust in a government's ability to repay should be a function of the level of debt, future spending, etc. Looking at those first six indicators above for Spain explains why the Spanish government insists that their fiscal position is not as bad as what "the market' believes. If you remove the last column, Spain could be seen as the strongest of the four countries.

But expectations and credibility matter and criticizing speculators might not be enough. What is needed is clarity in communications coming from the European authorities in order to rebuild the faith in the system. And this requires a combination of not denying bad news while at the same time restoring credibility where is needed. They need to try harder.

Antonio Fatás

Macroeconomics: Evidence or Ideology

The Wall Street Journal had a weekend interview with Robert Lucas, Nobel-winning economist and Professor of economics at the University of Chicago. He is asked about the economic situation in the US and Europe. When asked about the US he talks about the cost of uncertainty about future taxes. When he is asked about Europe, he talks about the cost of high taxes. From the interview:

For the best explanation of what happened in Europe and Japan, he points to research by fellow Nobelist Ed Prescott. In Europe, governments typically commandeer 50% of GDP. The burden to pay for all this largess falls on workers in the form of high marginal tax rates, and in particular on married women who might otherwise think of going to work as second earners in their households. "The welfare state is so expensive, it just breaks the link between work effort and what you get out of it, your living standard," says Mr. Lucas. "And it's really hurting them."

No doubt that (theoretically) high taxes could discourage effort but is this statement empirically relevant? Below is a chart of marginal tax rates (as estimated by the OECD) and the female employment to population ratio for the age range (25-54) for 2010. I have chosen that particular employment to population ratio because it matches the statement in the quote above (the chart looks similar if we look at a different age range or male participation rates).

Do we see more or less effort in countries with high tax rates? Not obvious. In fact, in the sample I have selected there seems to be a positive correlation, not a negative one. Countries with strong welfare state, high taxes (both average and marginal) show higher level of efforts as measured by employment to population ratios. The US appears as a country with low taxes but also low levels of effort.

The chart above is, of course, not the final answer to the question of how taxes affect labor market outcomes but at least it gives as good argument to dispute the claim that all European problems are about high taxes.

Antonio Fatás

Slowing Growth and Rising Risks

Slowing Growth, Rising Risks is the title of the World Economic Outlook that the IMF just released. All the chapters can now be accessed via the IMF web site. Growth forecasts are being reduced, more so in advanced economies where growth is forecasted at a rate of 1.5% this year and just 2% in 2012. If you were planning for the next recession this might not sound that bad. But hold on, you just need to read the next sentence in their report: These forecasts assume that

"European policymakers contain the crisis in the euro area periphery, that U.S. policymakers strike a judicious balance between support for the economy and medium-term fiscal consolidation, and that volatility in global financial markets does not escalate"

So not a lot of upside potential and a great deal of downside risk.

Antonio Fatás

The American and European jobs machines

Via Mark Thoma I read about the recent failure of the American jobs machine, unable to keep up with the strong dynamics it displayed during the 80s and 90s. After the 2001 recession the performance of the labor market as measured by the number of jobs or the employment rate (employment relative to population) has been much weaker than in the previous two decades. And it is a combination of very limited job creation during the 2001-2007 period and an extremely high rate of destruction during the last recession.

To add an international perspective, here is a comparison between the American, European and German job machines for the last 18 years.

The variable plotted is the employment rate for individuals in the 15-64 age group. During the 90s the US employment rate increased, at a time where the European (and German) employment rate was declining. This was a period where the US economy, in particular its labor market, was used as an embarrassing example for the Europeans. A lot of talk about how high taxes, regulation, lack of mobility in Europe were hurting the European job machine.

But starting with the late 90s we see a reversal of this trend. While the US employment rate flattens and then drops, the European rate, more so the German one, increases and by 2009/10, the German employment rate is above that of the US. Of course, this is just a partial view of the labor market (there are other age groups, there is the issue of number of hours worked), but it illustrates well the change in the performance of the US labor market, not just in isolation, but in comparison with similar economies. And what it is interesting is that this is not just the outcome of the great recession, it is a trend that had started more than a decade ago.

Antonio Fatás

The IMF WEO is out

The new IMF World Economic Outlook (WEO) is out with its two analytical chapters. Next week they release the other two chapters that present an overview of the current state of the world economy. I am quite sure they have been doing a lot of rewriting in the last days trying to cope with the constant changes in economic scenarios.

The two analytical chapters for this September 2011 edition are about monetary policy when commodity prices are volatile and an event study on the relationship between fiscal policy and current account imbalances. Both chapters are very interesting and can be accessed at the IMF web site.

The chapter on fiscal policy and current account imbalances is close to a recent paper I wrote with a group of economists at the IMF fiscal affairs department. We presented our work at a recent IMF conference on fiscal policy issues (schedule and papers at the conference web site). Our results are not far from those discussed in the IMF WEO this month: there is a strong empirical connection between fiscal policy changes and current account imbalances. This is a relevant topic for policy makers as they are trying to correct imbalances on both the fiscal policy side and the current account side - so we need to know if the efforts are complementary (i.e. does a reduction in the government deficit help reduce current account deficits and by how much?).

Antonio Fatás

Waiting for bad news on the edge of another crisis

Not a great beginning of the week for the world economy. The week has started with more rumors about a Greek default, doubts on the French banks, weakness of the Euro and sharp falls in European stock markets during the first half of the day. Another recession? The beginning of a depression? We are going through a period of fatigue as markets, investors, companies seem to be waiting for good news coming from any of the advanced economies. But we only get bad news. Governments and central banks try to cheer us up: President Obama with a plan to create jobs, the ECB buying government bonds from Spain and Italy and keeping their rates under control, but none of this is enough, we need much more to reverse the current decline in confidence. 

We have lived under the hope that as long as the news were not too bad, that we would over time build the necessary confidence to generate healthy growth. As long as we can keep going without Greece defaulting, with US fiscal policy on automatic pilot even if there is no exit plan, with unemployment rate not going up in the US (even if it stayed high), we could find the necessary arguments to start spending and investing again. Now we know that this is not going to work. As time passes confidence gets weaker and we enter a vicious cycle of expectations causing behavior that feeds into our pessimism. Fundamentals have not changed much but we are waiting for a signal that although things are not that great but they are not that bad either and in the absence of that signal, we assume the worst.

It is not easy to see what positive signal we will get over the next weeks. I cannot imagine any GDP, unemployment, consumption, earnings release that will be good enough to reverse the current mood. Will the approval of the Obama jobs plan by congress be good enough? I doubt it. Will a new statement by the Euro countries that no government will be allowed to default do the trick? I do not think so. We need a surprise, something that is not part of any of the current scenarios we are contemplating. And whatever that surprise is, it needs to do something substantial to stimulate demand in the short term. Yes, structural reforms will always be welcome but there is the need for actions in the short term and promises of a better distant future will not be enough. What I would like to see is a strong statement by economic authorities among all advanced economies that they understand the situation, that they clearly share the same priorities, that they all see that we are in the same boat and that austerity for the sake of austerity is not the solution to the current crisis. 

But such an announcement requires a lot of political consensus within countries and internationally, which is not what we have seen in the last days. And it also requires more clarity from central banks in their communications. While Bernanke and Trichet have done lots of great things to avoid a deeper recession, their most recent communications (e.g. Trichet responding to a question about the ECB and Germany) reveals too much the tension in their decision making process and not enough their commitment to find a solution.

Antonio Fatás

Interest rates should go up... or maybe down (OECD)

April 5 2011:

The OECD said central bankers increasingly need to focus on tackling inflation as the economic recovery takes root in major economies, adding that some of its members faced the risk of inflation becoming "un-anchored." 

"We see inflationary expectations creeping upwards a bit everywhere, I would say, in Europe, in the United States, in the UK," OECD chief economist Pier Carlo Padoan said in an interview with Reuters. 

"Central banks should keep inflation expectations under control," he said.

Today (September 8, 2011):

“Growth is turning out to be much slower than we thought three months ago, and the risk of hitting patches of negative growth going forward has gone up,” OECD Chief Economist Pier Carlo Padoan said during a presentation of the OECD’s latest Interim Economic Assessment.

The OECD recommends that central banks keep policy rates at present levels, and barring signs of recovery, consider lowering rates when there is scope.

Maybe we were too optimistic about the strength of the recovery few months ago... (Brad DeLong makes a similar point in this post).

Antonio Fatás