Friday, September 30, 2011

Closing Up Shop

The America of today: optimistic, proud, at the forefront of technology, and determined to lead the way into the future. Or something.
Tevatron atom smasher shuts after more than 25 years

One of the world's most powerful "atom smashers", at the leading edge of scientific discovery for a quarter of a century, is about to shut down. The Tevatron facility near Chicago will fire its last particle beams on Friday after federal funding ran out.

...A bid to extend the Tevatron's lifetime by three years was denied in January 2011 because the US Department of Energy could not come up with the extra $35m per year required to keep the machine running. An expert panel recommended the extension but its advice was not followed, turning the quest for the Higgs into a one-horse race.
I'm not qualified to give an opinion about whether it was worth $35 million per year to keep this facility in operation; the Large Hadron Collider in France has superseded the US facility in terms of size and power, and I don't know what the continued research potential of the US installation is.

But this story seems so symptomatic of the United States of today: the militantly dogmatic opposition to taxes by some Americans is increasingly registering its effects in any number of ways, from embarrassingly decrepit infrastructure, to run-down and understaffed schools, to lagging technological capability in all sorts of things from transportation to wireless communication to energy efficiency. It just feels increasingly like the US has given up.

I suppose we in the US can feel pride in the fact that we pay extremely low taxes. But it's awfully hard to be proud of the smaller, meeker future that comes with it.

Thursday, September 29, 2011

Moral Judgment and Bad Economics from the ECB

It seems that the ECB's policy prescriptions are being guided more by ideology and moral judgment than by sound economics. A very revealing letter from the ECB to the Italian government from August has just been published in the Italian press. The BBC reports:
ECB told Italy to make budget cuts

The European Central Bank told Italy to make sweeping changes to its labour laws and take tough action to cut the deficit, a leaked letter has shown. In the letter, sent to prime minister Silvio Berlusconi in August, the ECB said the severity of Italy's economic situation made "bold and immediate" action "essential".

...In unusually clear language, the signatories told Mr Berlusconi to make deep reforms, including opening up public services and overhauling pay bargaining and hiring and firing rules.

...The letter, published in Corriere della Sera, said Italy should aim to bring the deficit down to 1% of gross domestic product by 2012 and balance the budget by 2013, a year ahead of schedule, "mainly via expenditure cuts".
This is troubling in several ways. First, as the article points out, the timing of things certainly makes it appear as if there was a quid pro quo: the ECB would help only if the Italian government took certain policy steps that the ECB wanted. The ECB has continuously denied that there was any such condition attached to ECB assistance, however -- which is a relief, because otherwise this would look awfully like an instance where a central bank was blackmailing a democratically elected government.

Second, the ECB was apparently expressing a purely ideological preference for Italy to reduce its budget deficit through spending cuts. But shouldn't the size of a country's government, and decisions about whether to use tax increases or spending cuts to reduce a deficit, be determined by the country's democratic process? When Alan Greenspan disguised his opinion that the US budget deficit should be primarily reduced through spending cuts rather than tax increases as the official advice of the Federal Reserve back in 2005, many (including me) where dismayed by this conflation of economic policy advice with ideological preference. (Bernanke has done a much better job of keeping those two separate, by contrast.) So it's disturbing to find the ECB leadership now directly trying to impose its own apparent small-government inclination on democracies in the eurozone.

But third and most distressing to me is how a central element of the policy prescription that the ECB made to Italy was completely wrong. Italy's problem is not annual budget deficits; yes, Italy had chronically large budget deficits during the decades leading up to euro adoption in 1999, but Italy actually ran smaller budget deficits than France, Belgium, or even the Netherlands over the past couple of years (see chart below).

Italy's problem right now is low growth, and the fact that such low growth makes it more difficult for Italy to service the massive debt is has left over from 20 or 30 years ago. The recession hit Italy very hard, and the country has been slow to recover (which makes Italy's relatively low budget deficits even more impressive, by the way). The last thing Italy needs at this point is a sharp fiscal contraction.

So why would the ECB have asked Italy's government to apply contractionary policy when Italy is struggling to emerge from a very deep recession? Why would they point the finger at Italy's budget deficits as the problem, when Italy has been better than many of the core euro countries at keeping them under control? The economics of this policy advice is all wrong.

I fear that this is yet another sign of how the eurozone crisis has undammed a reservoir of cultural and moral judgment of southern Europe by some in the north. The north-south cultural divide in Europe has always been significant, but it was easy to overlook during the prosperous years leading up to the recession of 2008. Now, it seems, all of those old prejudices are coming out again, and a surprisingly large number of people are falling back on the simplistic sterotypes that southern Europeans are lazy and irresponsible, have jeapordized the euro through their moral failings, and need to be given a punishingly large dose of austerity - whether it makes economic sense or not. Unfortunately, it's beginning to seem like some at the ECB agree.

Martin Wolf and Paul Krugman eloquently point out that morality-based policy has triumphed over economics-based policy much more widely than just in this specific example.

Wednesday, September 28, 2011

Estimating the Cost of the Eurozone Crisis

I tend to think about it like this. The eurozone crisis imposes costs on the periphery countries (Greece, Ireland, Portugal, Spain) through the austerity and resulting recessions they have been forced to impose upon themselves. And the crisis imposes costs on the core countries (France, Germany, Benelux, Austria, Finland) through the rescue packages that they have been forced to cobble together.

I've argued before that I think that since the benefits of the euro have been enjoyed by all memebers of the eurozone (EZ), the costs of the crisis should also be shared among the members of the EZ. To what degree has that happened? Let's see if we can come up with some sort of rough estimate.

To figure the costs to the periphery countries, I measure the GDP shortfall between those countries and the rest of the EZ during the years 2010-12 using data from Eurostat. (But note that the 2012 GDP growth rate is a forecast, and as such is nothing more than an educated guess on my part.) So for example, over those three years Greece will have had approximately €42 billion less income than it would have had without the crisis, i.e. if it had enjoyed the same economic growth as the EZ core. Dividing this by the Greek population yields a cost of about €3,700 per person, or about 18% of annual income.

To estimate the costs to the core EZ countries, I add up the various rescue packages agreed to so far, including the most recent (July 2011) €110 billion plan for Greece. (Though it's worth noting that the July 2011 plan has not actually been approved by all EZ member countries, and final details are yet to be worked out, so I'm not sure that it's quite a done deal.) Most of this assistance is in the form of loans; after all, the idea was that these rescue packages were primarily supposed to just see the periphery countries through a liquidity crisis. As such, much of this assistance is due to be repaid. But to be as generous as possible to the EZ core countries in this reckoning, let's assume that such repayments never amount to more than 50% of the package totals.

The following table summarizes these very rough estimates of the burden that the crisis has imposed on the members of the EZ so far.

Assuming that the July 2011 agreement is indeed approved and the money is actually handed over to Greece, then the crisis will have cost about €740 per capita in the EZ core, or about 2.5% of annual income in 2010. For the periphery countries, the cost of the crisis ranges between about €1,300 and €3,700, depending on the country, or between 6% and 18% of one year of average income.

If you believe that solving the EZ crisis is a matter of shared responsibility -- and since the crisis was largely the result of forces beyond the control of the EZ periphery, that seems a reasonable conclusion -- then then these figures are badly askew. At the very least, they suggest that any additional costs imposed by this crisis should henceforward be paid for primarily by the EZ core. The periphery has already paid its dues, and then some.

Tuesday, September 27, 2011

Causes of the Eurozone Crisis (Part 2): Policy Implications

In the previous post I sketched out the origins of the eurozone crisis, and argued that powerful systemic forces, not irresponsible behavior, pushed the periphery countries toward crisis – and may well have done so no matter what the peripheral eurozone countries had done. The common currency encouraged (in fact, was designed to encourage) large-scale capital flows from the eurozone (EZ) core to periphery. We know from experience that such “capital flow bonanzas” are susceptible to sudden changes in investor sentiment, and very often come to a sudden stop. The sudden stop in this case happened in 2009 (exploring the specific reasons for that stop is interesting, but will have to wait for another day), made it difficult for the periphery countries to roll over their debt, and thus caused a crisis.

But note that other aspects of the common currency meant that the odds were stacked even more heavily against the peripheral EZ countries. Euro-adoption not only set the stage for the crisis by encouraging a capital flow bonanza to the EZ periphery; it also made it impossible for the periphery countries to deal with the sudden stop to those capital flows if and when it came. In his excellent recent paper (pdf), Paul De Grauwe has pointed out that the adoption of the euro by Europe’s periphery effectively caused them to be “downgraded to the status of emerging countries”, in the sense that they could no longer issue sovereign debt in their own currency. This made those countries peculiarly vulnerable to changes in investor sentiment. As Paul Krugman recently put it, thanks to the common currency, the periphery countries lacked the tools to manage their balance of payments.

Given that, the heavy firepower for dealing with the crisis necessarily had to come from the rest of the EZ, i.e. the core (by which I generally mean Germany, France, Benelux, Austria, and maybe Finland). But does this understanding of the origins of the crisis tell us anything else about proper policy responses?

Immediate Implications

1. Being judgmental is not helpful.
One of the objections raised by some who oppose support from the EZ core to the periphery is that such a bailout of the periphery countries may just encourage future irresponsible behavior. The periphery behaved badly, according to that argument, must pay the price, and clean up its own mess.

But if the very structure of the common currency area contained the essential ingredients for this crisis, and if the easy answer (namely, that the crisis is due to the irresponsible behavior of the periphery countries) is not the right answer, then such an argument no longer works. Since the crisis was largely the result of forces outside the control of the EZ periphery countries, it’s not appropriate to try to punish those countries through the bitter medicine of insufficient assistance. In other words, this crisis should not be turned into a morality story.

2. Austerity is not helpful.
Severe fiscal austerity by the periphery EZ countries has been the condition attached to assistance from the core EZ. But that austerity requirement brings with it several problems.

First, it is largely counterproductive with respect to reducing annual deficits; a simple textbook example illustrates how fiscal contraction during a recession will typically fail to meet deficit reduction goals, because the austerity itself makes the recession worse. That’s exactly why Greece keeps missing its deficit reduction goals: not because they aren’t trying hard enough, but because it’s inherently unrealistic and unreasonable to try to balance a budget through austerity during a recession.

Second, austerity is completely counterproductive with respect to reducing debt burdens. As the economy shrinks thanks to austerity, the debt burden skyrockets relative to the country's income. Just look at the debt, GDP, and debt-to-GDP ratios for Greece to see how that works. It's no wonder that it has recently become crystal clear that Greece will never have enough income to repay this level of debt. (Note: data from Eurostat; 2011 figures are forecast.)

But finally, and most importantly in the context of this analysis, austerity shifts most of the burden of dealing with the crisis onto the EZ periphery countries. And that means that citizens of the core EZ countries like Germany, France, and Benelux are essentially getting a free ride.

All of the members of the EZ have enjoyed the benefits of the common currency; that's apparent simply from the fact that they have worked so hard to construct and maintain it (recent evidence notwithstanding). Many of those benefits are political, but some are baldly financial as well: the large capital flows from the EZ core to the periphery during the years 1999-2007 are evidence that investors in the core EZ countries enjoyed and took full advantage of the high returns they could get on new investment opportunities in the periphery. Furthermore, the capital outflows from the core meant that the core EZ countries had to run current account surpluses; they have been able to enjoy significantly stronger exports for the past 10 years thanks to the euro.

But there is a fundamental asymmetry that goes along with international capital flows: the country on the receiving end risks a serious financial crisis when that flow stops, while the country that is the source of the capital bears no similar risk. In other words, the periphery of the EZ bore the bulk of the systemic risks inherent to the common currency area, while the benefits were shared by both the core and the periphery. In a sense, the periphery countries “took one for the team” when they allowed themselves to be placed at risk for the greater good of the entire eurozone. Given that, it doesn’t seem appropriate that the burden of solving the crisis should be placed so overwhelmingly on the periphery countries that had such little control over the crisis to begin with. Trying to solve the crisis primarily through austerity is thus just plain unfair. (For reference, I provide an estimate of the cost of the eurozone crisis to its members.)

3. Shared responsibility is very helpful.
The opposite of trying to solve the crisis through austerity – which places the burden of escaping from the crisis on the periphery countries themselves – is for the core EZ countries to substantially share the cost of getting out of this mess. Once it is clear that the systemic risk of crisis that came along with the creation of the euro was borne disproportionately by the EZ periphery, while the benefits of the common currency were enjoyed by both core and periphery, the calculus of how to respond to the crisis changes. In that context, substantial assistance from the core to the periphery in response to the crisis is not only helpful, but can in fact be viewed as the responsibility of the core EZ countries. The degree to which they choose to accept that responsibility – and pay for it – will determine how the crisis is resolved.

And let’s not kid ourselves about something: policy-makers in Europe know exactly how the crisis can be solved. It’s not a mystery that if the core EZ countries contribute sufficient funds to finance Greece’s debts for the foreseeable future, accept a substantial write-down on the amount owed by Greece, and provide funds to recapitalize banks in Greece and elsewhere in the EZ, then the crisis will be over. So the question is simply whether the core EZ countries are willing to pay that required price. If they are, then the EZ will remain intact. If not, it will not. The current debate going on among European policy-makers is simply the unpretty process of figuring out the answer to that question.

After the Crisis

Suppose that at some point the EZ emerges from this crisis. And let’s be as hopeful as possible, and further suppose that the EZ emerges more-or-less intact, i.e. with most or all of its member countries still exclusively using the euro. What then?

The problem is that the logic that led to this crisis will not have changed. At some point, if financial integration and convergence between the core and periphery is to resume, there will once again be capital flows from the EZ core to the periphery. It might take 10 or 15 years, but investors at some point will regain confidence and once more try to seek out the higher returns that are available in the periphery countries. And the recipients of the resulting capital flows will once again be vulnerable to a sudden stop. And they will once again lack any policy tools to deal with it when it happens. So can anything be done to fundamentally make the eurozone system more stable?

A few thoughts come to mind.

1. Impose policies to reduce capital flows.
Every financial crisis seems to generate renewed suggestions from economists that it might make sense to use policy to slow down international capital mobility, and this one should do the same. The most famous incarnation of this idea is the Tobin Tax, the suggestion put forward by Nobel prize-winning economist James Tobin in the early 1970s that each international transaction (in his case he was specifically talking about currency transactions) be subject to a small transaction tax. This would make investors think more carefully and move more slowly both into and out of international capital markets.

2. Make explicit institutional changes to explicitly support the EZ periphery countries ahead of time.
One of the reasons that this crisis has gotten so bad is that the EZ periphery countries lacked any tools to deal with it, largely because in a common currency area they have no central bank to fall back on in the event of a liquidity crunch. This problem can be solved, however, through a number of steps. For example, if the ECB promises to provide unlimited liquidity to any EZ country that needs it. Yes, the Maastricht treaty would probably have to be amended. And yes, such a policy could potentially be expensive for the core EZ countries. But crucially, it would be a mechanism for the EZ core to carry its share of the burdens that come with the currency union. Paul De Grauwe's paper suggests other institutional changes that would help. But details aside, the point is basically quite simple: one way or another, if the eurozone is going to survive in the long run, there needs to be a recognition that since all members benefit from the common currency, all will have to pay the price of dealing with its vulnerabilities when they arise.

3. Restrict the eurozone to the core.
If the core EZ countries are simply not willing to accept the burden of substantially footing the bill to clean up the mess left by a capital markets crisis, then the only real remaining solution will be to make sure that all of the countries using the euro are similar enough that there won’t be any large-scale capital flows from one to another. If there are no significant and systematic capital flows within the EZ, then the likelihood of crisis goes away. The remaining eurozone would probably be half of its current size; but it would be stable.

The basic choice that policy-makers face is therefore fundamentally the same in both the short-run and the long-run: the core EZ countries need to be willing to pay a substantial portion of the cost of fixing the current mess, and they need to be willing to remain on the hook for any similar future events. In return, they will be able to continue enjoying the substantial political and economic benefits that the euro has brought them. If they decide that it’s not worth the price, then the eurozone will not continue to exist in its current form for much longer.

Thursday, September 22, 2011

What Really Caused the Eurozone Crisis? (Part 1)

I've been doing some work on gaining a better understanding of the root causes of eurozone (EZ) debt crisis. As a point of departure, let's take a couple of dueling quotes. First, Wolfgang Schäuble, Germany’s finance minister, from his recent piece in the Financial Times:
Whatever role the markets have played in catalysing the sovereign debt crisis, it is an undisputable fact that excessive state spending has led to unsustainable levels of debt and deficits that now threaten our economic welfare.
Next, here's an excerpt from a statement recently made by Greece's Deputy Prime Minister and Minister of Finance, Evangelos Venizelos:
We should not be the scapegoat or the easy excuse that will be used by European and international institutions in order to hide their own lack of competence to manage the crisis and give a definitive and complete answer to the attacks against euro, the world’s strongest currency.
These two statements capture the essence of two radically different views about the origins of the EZ debt crisis. Which one is right?

Local Causes or Systemic Causes?

Some believe that the crisis was fundamentally caused by profligate, irresponsible behavior by governments and individuals in the EZ periphery. (Note: by the "EZ periphery" I mean Greece, Portugal, Ireland, and maybe Spain. Italy has not really been accused of such behavior, to my knowledge, and it seems generally accepted that it is much more the victim of contagion rather than the cause of the crisis.) Let's call this the local causes point of view: government deficits and debt in the periphery were so large that once the Great Recession of 2008-09 hit, investors lost confidence in the ability of those countries to remain solvent. So they tried to dump the bonds from those countries, triggering the crisis.

An alternative point of view is that, while the crisis may have had some peculiarly local triggers (the Greek government's admission that it fudged some official statistics certainly didn't help), much of the current mess is the result of forces and decisions outside the control of peripheral Europe's governments. In other words, the crisis could have non-local, systemic causes.

For example, suppose that the adoption of the euro suddenly made it more attractive for investors in the rest of Europe to buy assets in the periphery. This could have caused a large, exuberant capital flow from Europe's core to periphery, much like NAFTA helped to spark a surge in capital flows from the US to Mexico in the early 1990s. In theory, that's a good thing, and should help the process of economic convergence. But we know that such "capital flow bonanzas" (so named by Reinhart and Reinhart) are notoriously susceptible to changes in investor attitudes, and can come to an abrupt halt. These sudden stops in capital flows, as they are referred to in the literature, typically trigger a financial crisis. (See this paper by Calvo, Izquierdo, and Mejia for much more about sudden stops.) As noted by Rudi Dornbusch in the context of the Mexico crisis of 1994, it's not speed that kills; it's the sudden stop.

Crucially, sudden stops may happen even when a country is following all the right macroeconomic policies. As a result, financial crisis may be largely outside the control of a country that's on the receiving end of a capital flow bonanza. Mexico in 1994 is a good example of that, I think. And it could be that some of the peripheral EZ countries also fit this characterization. If so, then it's not appropriate to lay the blame for the crisis entirely at the doorstep of the peripheral EZ's governments; while they may have done some things that contributed to the crisis, the odds were significantly stacked against them to begin with.


Which view of the EZ crisis - the local causes view or the systemic causes view - better matches the evidence? There are a few different types of clues we can look for.

1. Which deficit predicted the crisis?
If the crisis is due primarily to local causes, then we would expect the best predictor of crisis to be government deficits and debt. On the other hand, if the systemic causes view is correct, then a better predictor of the crisis would be large current account deficits, which necessarily happen when there's a capital flow bonanza.

The following table shows both fiscal (i.e. national government) budget balances and current account balances during the period after the adoption of the euro and before the worldwide financial crisis and recession struck in 2008. All figures are from the OECD and expressed as a % of GDP.

The factor that crisis countries have in common is that, without exception, they ran the largest current account deficits in the EZ during the period 2000-2007. The relationship between budget deficits and crisis is much weaker; some of the crisis countries had significant average surpluses during the years leading up to the crisis, while some of the EZ countries with large fiscal deficits did not experience crisis. This is one piece of evidence that a surge in capital flows, not budget deficits, may have been what laid the groundwork for the crisis.

2. Which deficit grew after euro adoption?
If the crisis is due to the profligacy of governments in the peripheral EZ that took advantage of EZ membership to increase spending, we would expect to see budget deficits grow in the periphery after the common currency was introduced in 1999. But if the crisis was really the result of a post-euro adoption surge in capital flows from the EZ core that then came to a sudden stop, we would expect current account deficits (i.e. capital flows) to have grown more after adoption of the euro.

The following charts show the path of both types of deficits during the years before and after adoption of the euro. (Data from the OECD, expressed as % of GDP.)

Note: minor data discrepancies in the fiscal balance series above have been corrected.

Capital flows (i.e. current account deficits) increased substantially in all the EZ periphery countries in the period after adoption of the euro. Meanwhile, the peripheral countries generally tended to have tighter fiscal policies after adopting the euro than before euro adoption.

Note that the capital flow bonanzas in evidence in these charts were directly the result of the adoption of the euro by the peripheral EZ countries, which made it easier for capital in the core EZ countries to find investment opportunities in the periphery. In fact, this was exactly what the advocates of the common currency intended and expected, and has always been touted as a selling point for the euro project - it's called "financial integration". The problem is the sudden stop that frequently follows such a capital flow bonanza.

3. What did the periphery countries spend their money on?
If the crisis is due to irresponsible behavior by governments and individuals in the EZ periphery, then one indicator of that would be a rise in government spending and/or personal consumption after euro adoption. On the other hand, the systemic causes view would suggest that crisis could strike even if a country is behaving 'responsibly' (in a macroeconomic sense) by spending more on investment goods (i.e. capital formation) and less on personal consumption.

The next table shows the fraction of domestic purchases spent on consumption and investment goods in each of the EZ periphery countries. Germany is included in the table for comparison.

There is a clear tendency for investment spending to rise in the periphery countries (with the exception of Portugal), and for consumption to fall. This is consistent with the convergence story; capital flowed from the core to the periphery to take advantage of and fund investment opportunities there. Meanwhile, with the periphery countries experiencing fiscal contraction, a smaller share of purchases going to personal consumption, and a higher share of purchases going to investment goods, it is hard to see evidence for the story that the capital inflows were simply frittered away on a spending binge either by individuals or governments.

So... What Really Caused the Crisis?

Putting it all together, it seems that the EZ crisis is more consistent with the systemic causes view than the local causes view. In other words, while they didn’t necessarily make the right decision every time, the peripheral EZ countries were up against powerful exogenous forces - capital flow bonanzas and sudden stops - that tended to push them toward financial crisis. They were playing against a stacked deck.

It’s useful to reevaluate the macroeconomic history of peripheral Europe in light of this interpretation. Rather than large current account deficits being the result of fiscal mismanagement or excessive consumption, the current account deficits were the necessary and unavoidable counterpart to the surge in capital flows from the EZ core. Rather than above-average inflation rates and deteriorating competitiveness being signs of labor market inefficiencies or lax fiscal policies in the peripheral countries, appreciating real exchange rates were inevitable as the mechanism by which those current account deficits were effected.

The eurozone debt crisis is big enough that there's plenty of blame to go around, and some of it certainly should go to the crisis countries themselves. But it must also be recognized that as soon as those countries adopted the euro, powerful forces were set in motion that made a financial crisis likely, and very possibly unavoidable, no matter what the governments of the peripheral euro countries did. Irresponsible behavior by the periphery countries did not set the stage for the eurozone crisis; the common currency itself did.

Coming soon: Part 2 of this series, in which I examine some policy implications of this analysis.

Germany is a Credit Risk?

Maybe this will spur politicians in Germany to take more decisive steps to deal with the eurozone debt crisis: today the spreads on credit default swaps (CDS) - those derivatives that effectively provide insurance against default - rose by 8% today on German government bonds. Anyone who wanted to insure their German bonds against default today had to pay over 100 basis points for the first time ever. That's the same as it cost to insure French government bonds less than 3 months ago, or Italian government bonds about 6 months ago. This week marks the first time that such insurance costs signifcantly more for German bonds than for those of the UK.

But the principal lesson that I draw from this is not that the risk of Germany defaulting on its debt has risen recently. Is Germany really that much more likely that the US or the UK to default? If we take a deep breath and think clearly about things, I doubt that many people would answer yes to that question.

Rather, I take this as a sign that investors are panicking, and panicking specifically about anything having to do with the eurozone. It may not be rational, but a pervasive and ill-defined fear is gripping the financial markets right now. In the current context, that is what contagion is all about.

There are certainly plenty of things for people to worry about right now, of course: stagnating recoveries in the developed world; political brinksmanship and paralysis in the US; endless indecision in Europe regarding how to help the struggling periphery economies; financial institutions that seem weak, opaque, and untrustworthy; slowing growth in China.

All of these factors are certainly contributing to the deep anxiety that currently grips financial markets. But I think that this is evidence that of all of these, the fear of what will happen in Europe looms largest. Which brings me to my own fear: that time is running out for the eurozone to take steps to get the market's fear under control and avert catastrophe.

Wednesday, September 21, 2011

The Twist

Today the Fed announced that it would embark on 'Operation Twist', as the business press has dubbed it. To be a bit more precise, here's the actual text from the FOMC press release:
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
What does this mean? Basically, it's an effort by the Fed to bring down long term interest rates. Typically the Fed moves interest rates by changing the intercept of the yield curve, i.e. by shifting the entire curve up or down. It can do this because it has control over short term interest rates, and that anchor can shift the rest of the yield curve up or down.

But one of the many odd things about being at the zero lower bound on interest rates, as we have been in the US for a couple of years now, is that the Fed no longer has the ability to shift the yield curve down. So the 'Twist' is an effort to bring down long term interest rates despite this handicap. As shown in the picture below (which is meant to be schematic, not exactly accurate), by selling short-term bonds and buying long-term bonds, the idea is to change the slope of the yield curve instead of its intercept.

Some observers, like Mark Thoma, have suggested that while laudable, this effort won't actually accomplish very much. And I'm sympathetic to that point of view, because I agree that in an ideal world, the Fed would be doing much more than this to try to help spark an economic recovery in the US.

But as I've argued before, I do think that any reduction in long-term interest rates can only help -- and the US can use all the help it can get right now. But more importantly, we have to recognize the fact that the Fed is now operating under the cloud of very real and very dangerous political threats.

Those threats are now being made, contrary to all historical precedent in the US, because of the way the American public has voted over the past few elections. And those threats impose real constraints on the Fed's ability to act.

Given those constraints, this is a pretty good response, I think: it embodies a balance between doing something that would actually help the economy (which is, I'm convinced, what the FOMC would do much more of if politically unconstrained), and not doing so much that it creates a political backlash that would have serious negative consequences for the Fed's long-run independence.

So if we are unhappy that this is the extent of the Fed's efforts -- and I think we have every right to feel that these efforts are inadequate -- then I think it is important to explicitly recognize that these actions by the Fed are insufficient due to political constraints. The conduct of monetary policy should clearly be added to the list of victims of the current toxic political environment in the US.

Is There Enough Income at the Top to Make a Difference to the Deficit?

In response to Obama's proposal (pdf) to let the Bush tax cuts expire for high-income households as one of the ways to close the budget deficit in future years, I've heard and seen a number of commenters assert that there simply aren't enough people at high levels of income for that particular idea to make much difference to the federal budget deficit. Are they right?

Here's a table that I constructed using data from the CBO on income and taxes paid by income group. (The data goes up through 2007.) I divide US households into three categories. The first includes all households making under approximately $75,000 per year -- that's the bottom 80% of the income distribution, and includes about 93 million households. The second category includes all households that make between approximately $75,000 and $350,000 -- that's the 80th to the 99th percentile of the income distribution, and includes about 22 million households. The final category is the top 1% of the income distribution -- those households earning over about $350,000 per year.

To get an idea of whether there's enough income at the very top of the income distribution to make a serious dent in the US's long-run budget problems (note that I firmly believe that the US does not need to worry about its budget deficit in the short run -- we have much more pressing problems to deal with first), I estimate what would happen if effective tax rates (ETRs) for each group reverted to the average of the period 1993-2000. I selected that timeframe as the point of comparison simply because that was the only brief period in recent history when the US had clearly beaten its chronic budget deficit problem.

If all tax rates went back to their 1993-2000 averages, approximately $350 billion in additional taxes would have been collected in 2007.* Of this total, roughly one-third would come from each of the three categories delineated above. So the 1.2 million households in the top 1% of the income distribution can certainly not close the budget deficit by themselves. But they could get the US about one-third of the way there.

Put another way, if the US is only willing to raise taxes on the very top of the income distribution, the US's medium-term budget problems can not be solved through additional revenue alone. However, tax increases that are limited to just the very top of the income distribution, while not sufficient by themselves, would actually probably get us about one-third of the way toward fixing the US's medium-term deficit problems. So while not a cure, it would make a significant dent in the problem.

* This would clearly not be enough revenue to close the US's current budget deficit; however, most of the remainder of the US's budget problems over the short and medium-run is simply due to the bad economy. If revenue collections were back at 1993-2000 levels and the economy recovered, I think our medium-term (i.e. over the next 10 or 15 years) budget deficit problems would be gone. As far as the long-run (i.e. more than 15 years from now) budget picture goes: it's all about rising health care costs, and the only solution will be something that addresses that. Which is really another topic.

Thursday, September 15, 2011

The End of an Era in China

It looks like most of the $100 bills lying on the sidewalks of China have been picked up already.

That's how I tend to think about a tremendously important phenomenon that is the subject of a KPMG study released today:
Consumer Companies Look Beyond China for Sourcing as China’s Low-cost Advantage Diminishes

With increasing labor costs and an aging workforce, China is losing its foothold as the world’s lowest cost manufacturer of consumer goods. Rising costs are forcing companies to take a closer look at new sourcing locations across Asia, according to a new report from KPMG International.

A number of countries in South and Southeast Asia are set to benefit from this recent shift, the report notes. While hard goods ranging from consumer electronics to furniture are still being sourced from China, apparel and footwear production is widely dispersed and more mobile across the Asia Pacific region (ASPAC). Clusters of specialized production are emerging, such as footwear in Indonesia and Vietnam and hand stitched fabrics and metalware in India.

“Sourcing goods in China purely because of ultra-low costs is a thing of the past,” said Nick Debnam, KPMG’s Asia Pacific chair, Consumer Markets and a partner in the China firm. “With demand still soft in many Western consumer markets, it is also proving difficult for companies to pass on higher costs to consumers. This changing environment is forcing companies to reassess sourcing strategies.”
For almost 20 years, manufacturing firms have been able to move production to China, employ low-cost but productive labor there, and earn unusual profits. Those were the proverbial $100 bills lying on the sidewalk, which is simply a poetic (at least to economists, who are not known for their poetry) way of saying that there have been arbitrage opportunities available in China to firms that could move production there. Specifically, the opportunitity for arbitrage was the result of a difference between the cost of labor in China (relatively low) and its productivity (relatively high).

Note that such gaps are quite rare in a development context; when countries have cheap labor, they typically have relatively unproductive labor as well. (For further explication and illustration of this point take a look at this classic paper by Stephen Golub (pdf), which provides some international evidence.) Why that gap between compensation and productivity was so large in China prior to the 1990s is an interesting subject to think about, and I suspect it has to do with China's institutions and pre-1990s communist system.

At any rate, as we well know, all arbitrage opportunities are eventually arbitraged away. And that's what's happened in China. The employment of tens (hundreds?) of millions of workers in China's factories over the past two decades has driven up wages -- and, crucially, driven up wages by more than labor productivity has grown. So while it's still possible to find low-cost labor in China, and it's certainly possible to find productive labor there, it's no longer easy to find labor that is low-cost relative to its productivity.

But I disagree with the conclusion of the KPMG study, which was that multinationals will now start moving their production to other Asian countries. They will certainly do so here and there, of course, but production will only start moving to another country in a large-scale and systematic fashion if that country has a similar gap between labor costs and productivity. And I just don't see such arbitrage opportunities in any other major countries in Asia. Maybe Vietnam has some, but I'm doubtful that they exist in Bangladesh, Indonesia, or India, in other than isolated industries or locations.

That's why I'm inclined to think that the massive and rapid development of manufacturing in China over the past two decades was really a once-in-a-lifetime event. It's impossible to understate the importance of that event -- I can't think of many economic changes that have similarly altered the lives of hundreds of millions of people in such a profound and rapid manner -- but a once-in-a-lifetime event it probably was. After all, you really shouldn't expect to find $100 bills lying on the sidewalk every day.

Central Banks Riding to the Rescue

Naturally, the ECB and the Fed have been perfectly aware of the recent signs of stress in Europe's financial markets as dollars have been withdrawn, moved, and otherwise made increasingly unavailable to European financial institutions. Today they decided that they had to take action:
ECB to Lend Dollars to Euro-Area Banks

The European Central Bank said it will lend euro-area banks dollars in three separate three-month loans to ensure they have enough of the U.S. currency through the end of the year. The European Central Bank said it will lend dollars to euro-area banks in a series of three-month loans as the region’s debt crisis limits market access to the U.S. currency.

The Frankfurt-based ECB said it will coordinate with the Federal Reserve and other central banks to conduct three separate dollar liquidity operations to ensure banks have enough of the currency through the end of the year. The three-month loans are in addition to the bank’s regular seven-day dollar offerings and will be fixed-rate tenders with full allotment, the ECB said in a statement today. They will be offered on Oct. 12, Nov. 9 and Dec. 7.

The euro jumped more than a cent against dollar after the announcement and traded at 1.3865 at 4:13 p.m. in Frankfurt. Treasuries fell, pushing 10-year yields up the most in more than three weeks, as demand for the safest assets eased.

“This tackles one small problem in the market at the moment,” said Chris Scicluna, deputy head of economic research at Daiwa Capital Markets Europe in London. “Ultimately, until there’s a more comprehensive response to the sovereign debt crisis, which has been feeding into concerns about the health of European banks, the strains in Europe’s banking sector will continue.”
And this is exactly how the world's central bankers will be earning every penny of their salaries over the coming months, I think: by doing everything they can to keep the gears of the financial markets running as smoothly as possible in the face of enormous risk and uncertainty. They can't make risk and uncertainty disappear, but they can do a lot to prevent them from causing unnecessary damage.

Tuesday, September 13, 2011

The World's Safest Bank

Where do you put your money when you fear the worst? Why, in the world's safest bank, of course: the Federal Reserve System.*

That's what the rest of the world has been doing in recent months, in massive quantities. And it makes perfect sense. After all, it's hard to think of any asset that is more safe and more liquid than dollar deposits kept in a bank account with the Fed, i.e. "reserves". And right now, banks -- especially European banks -- are clearly desperate for additional safe, liquid dollar assets.

So that's why this time around, unlike during the banking crisis of late 2008, when the deposits of US banks with the Fed increased dramatically, it's now primarily non-US banks that have been pouring the most money into their accounts with the Fed. The following graph and table tell the story.

Foreign-related banks in the US have doubled their deposits with the Fed in 2011, while US banks have increased their reserve holdings relatively little compared to 2008.

(Note that the Fed does not publish data on reserves owned by type or geography of bank, so the series shown here were constructed using a combination of tables H.3 and H.8 from the FRB.)

I've made this point in a couple of different ways over the past two weeks, but this data makes it more explicit. And the story it tells is a relatively simple one: banks around the world -- and specifically financial institutions in Europe, it seems -- have taken hundreds of billions of dollars out of Europe and moved them to the world's safest bank.


So what's so attractive to non-US banks about keeping cash with the Fed right now? There are a couple of possible reasons, which are familiar to us from late 2008 when banks desperately sought to obtain reserve assets in the wake of Lehman's collapse.

1. Liquidity hoarding: if you're worried that you may need some dollars and won't be able to borrow them at a reasonable price from another bank -- perhaps because you think you might be deemed to be a credit risk -- then it makes sense to have your own stockpile of liquid dollar resources.

2. Counterparty risk: if you're worried that any dollars that you lend to another bank won't get repaid -- which might happen if the borrower goes under while they still have the dollars you loaned to them -- then you will be reluctant to lend out your dollars, and instead will just keep them yourself.

Note that there's no reason that both effects can't be present at the same time. There's some evidence that during the 2008 banking crisis the hoarding of Fed reserves by financial institutions was primarily due to counterparty risk, not liquidity concerns. (See for example the NY Fed staff paper "Stressed, Not Frozen: The Federal Funds Market in the Financial Crisis" by Afonso, Kovner, and Schoar (pdf).) But with respect to European banks today, I have the sense (admittedly unsupported by any concrete data) that liquidity concerns are paramount.


What are the implications of this phenomenon? I can think of a couple. First, one might think that this would have contributed toward a strengthening of the dollar in 2011. But keep in mind that much of the cash being transferred to the US may have been in dollar form to begin with (i.e. eurodollar assets), in which case the impact on the exchange rate would be limited, which may explain why the dollar has remained roughly unchanged against the euro (within +/- 5% of 1.40 USD/euro) over the past year (see chart). In addition, other forces affect the exchange rate as well, such as the weak and slowing US recovery, which has probably tended to push the dollar down.

Second, this suggests that the dfficulties that some European banks may be having in obtaining dollars are not simply due to the retreat of US money market funds from Europe -- the actions of European banks themselves are also contributing to the shortage of dollars in Europe. This raises the likelihood that, so long as fear and uncertainty reign in Europe's financial markets, we'll probably hear more about the dollar shortage on the eastern shores of the Atlantic.

Finally, it's worth considering what a continuation of this phenomenon could mean for the US. Over the past 8 months we've been in the unusual situation where the increased demand for dollar reserves by non-US banks has coincided with an increase in the overall quantity of reserves in the US banking system, thanks to QE2. That has made it relatively easy for European banks to increase their dollar reserves. But the quantity of bank reserves (i.e. deposits) with the Fed is now essentially fixed, and unless QE3 is permitted, will not be allowed to grow again any time soon.

Given that, if European banks continue to try to acquire additional dollar reserves, then it's conceivable that the stresses showing up in the market for dollars in Europe could cross the Atlantic. Because if European banks continue to seek a safe haven in the US for their cash, they are now going to have to start persuading domestic US banks to part with some of their own limited dollar reserves, driving their price up. There have been no signs of such spillovers yet (as far as I am aware), but it is something that bears watching. Because due to the peculiar nature of bank reserves, even if everyone wants to keep their cash in the world's safest bank, not everyone can.

*And not, despite my daughter's suggestion, at Gringotts. Of course if Ron Paul gets his way and we go back to using gold as currency...

Monday, September 12, 2011

The Hunt for Dollars by Europe's Banks

This is another sign of the stresses -- due to uncertainty, fear, and lack of trust -- that seem to be growing within the European banking system, and it's also an important clue as to why European banks have been shifting cash to the US and building up their dollar reserve assets:
Dollar borrowing costs add to strain on European banks

European banks are facing increasing strains on their balance sheets because of the dramatic jump in the cost to borrow dollars, essential for some institutions as they need to repay loans in US currency.

The cost for European banks to swap euros into dollars has jumped fivefold since June, hitting the highest levels since December 2008, and raising the risk of insolvency in the region’s financial sector.

...The main reason for the spike in the cost of swapping euros for dollars is the overwhelming demand for the US currency due to its growing status as a haven in the face of rising worries of an imminent Greek default that could spark a deeper sovereign debt crisis.

European banks, which need to borrow dollars to repay loans, face an extra premium of 103 basis points to swap euros into dollars for three-month loans – a dramatic jump since June when they only had to pay an extra 20bp.

Don Smith, economist at Icap, said: “More and more banks want dollars because of worries about the debt crisis in Europe. This leads to a vicious circle where the cost to swap dollars for euros rises and creates even more strains and potentially deeper problems for the financial sector.”
Since dollars are growing more scarce and more expensive for European banks as they seek safety from possible fallout of the eurozone debt crisis, it makes all kinds of sense for them to try to increase their dollar reserves. Which may explain why it is foreign-owned banks that have acquired nearly all of the ~$600 billion in new reserves created by the Fed over the past 8 months.

Friday, September 09, 2011

When Fear Dominates

Today's twin pieces of news out of Germany - that the ECB's most prominent German, Juergen Stark, is resigning, and the unconfirmed report that the German government is preparing a contingency plan to support its banks in the event of a Greek default - had the effect of fanning the flames of fear running through world financial markets. How should we interpret this?

I'm not sure about how sensible it was, but I'm quite sure that today's reaction was completely unsurprising. Because market participants are afraid right now, and so any news has to be viewed through the lens of that uncertainty and fear.

The Stark Resignation

Europe has a couple of major problems right now. As we all know, there's the seemingly never-ending concern that Greece (and possibly other countries) may be insolvent and have to default on its government debt. But an equally serious problem, I think, is the widespread perception that there is no convincing leadership in Europe. European leaders just can't seem to agree on the big decisions that would have to be taken to firmly resolve the crisis one way or another, and so the policy responses have been seen to be nothing more than a series of delaying tactics. When you then get news about members of the ECB leadership resigning (note that Stark was the second to do so in recent months), the policy disarray looks even worse.

Stark was the most prominent German in the ECB’s leadership, and probably also one of the most hawkish of them. The Germans, and Stark in particular, were quite unhappy with the ECB’s decision to start buying the government bonds from Italy and Spain. They simply do not want to put the German taxpayers on the hook for any of that debt, even indirectly.

But the question now is what to make of this news, because you can really have two completely opposite interpretations about what this will mean for ECB policy going forward. Since the ECB leadership is losing one of the fiercest opponents of assistance to the weaker euro countries, maybe this means that the ECB will now actually provide more of it. On the other hand, it's equally possible to think that German cooperation with the ECB's policies has now been pushed to the limit, so this will mean the end of support for the eurozone periphery.

The point is that no one really knows... and when fear is the dominant emotion, people just imagine the worst, even if they don’t know quite what that is.

It reminds me a little of Kremlin-watching back during the Cold War, when people were trying to figure out what Soviet policy was going to be based on who appeared in the photos. It’s just that this time the Kremlin is in Frankfurt.

The German Contingency Plan

The other news today was that the German government may be preparing to recapitalize their banks in the event of a Greek debt default. I've argued before that there are numerous signs that people are losing confidence in the European banking system, and this news strikes right at the heart of that concern.

For months and months European governments have been working hard to reassure people that the European banking system is sound. And then comes this news that Germany is already working on figuring out how to strengthen their banks. Once again, you can read that two completely different ways.

You could take heart from this news, and take it as a sign that the German government has a plan, and will step in if things go wrong to make sure that their banks are safe. It was only two weeks ago that Christine Lagarde, head of the IMF, was urging Europe to take concrete action to strengthen the European banking sytem. Maybe this simply means that the Germans were listening, and are being prudent. If so, it's entirely reasonable to read this as good news.

But on the other hand, you could hear this news and think that maybe it means that the German government knows something we don’t know. Maybe it suggests that the German government thinks that Greece really is about to default. Or worse: maybe it suggests that the German government believes that the European banking system really is weak and vulnerable. In that case, this could be a very, very bad sign.

Given today's climate of fear in the financial markets, and given that no one really knows what’s going on behind the scenes, it shouldn't come as a shock that lots of people are going to jump to the scariest possible interpretation of the news. When fear dominates, the worst case scenario suddenly becomes the one everyone thinks about.

Thursday, September 08, 2011

The 2011 Stimulus Proposal

A few thoughts about the $450 billion stimulus proposal that Obama presented tonight...

This is a big proposal, composed of a lot of very effective ingredients. If enacted (which it won't be, but that's another issue), this would make a noticeable difference to the recovery -- I would expect the number of jobs it would create to be in the millions, not thousands.

The good:

1. Unemployment benefits: The biggest bang for the buck would be the extension of unemployment benefits. Numerous studies show that this provides a large and direct boost to the economy.

2. Infrastructure: The proposal includes a large amount of spending on infrastructure (schools, parks, roads, bridges, mass transit), which also provides a very large bang for the buck. Furthermore, greater infrastructure spending has the tremendous advantage of yielding benefits far into the future by generally increasing the productivity of the US economy. The US's infrastructure is dreadfully underfunded and out-of-date; since we know we need to spend huge amounts of money over the next 10-20 years to fix it, why not do it now when we have lots of unemployed labor (especially construction workers) and rock-bottom interest rates?

3. Payroll tax cuts: I also like the proposal's tax cuts that go directly into the pockets of middle-income consumers, namely the extended reduction in payroll taxes for workers. Such tax cuts are almost completely spent (middle-class consumers save very little of their take-home pay), and would therefore have a very direct impact on the economy.

4. State and local government jobs: The proposal would include funding to be passed along to state and local governments so that they could avoid laying off teachers. Again, good in the short run for the US economy, and very good in the long run.

5. Mortgage refinancing: this has been covered in some detail by others, and it would have the potential to provide some real stimulus to the economy.

The not-so good:

There are a few tax cuts, credits, and so forth that I think would be of dubious value...

1. Cut payroll tax for employers: This provides little incentive to firms to hire more workers. The primary effect, I suspect, would be to increase corporate profits. Some studies assert that such employer payroll tax cuts can induce firms to reduce prices (thereby raising sales and production); but if the tax cuts are targeted only at small and medium-sized businesses, as in the Obama proposal, then that mechanism probably won't work because small and medium-sized businesses are generally price-takers, with little scope to change their prices by a significant amount.

2. Tax credits for hiring unemployed veterans: The main impact of this provision, I think, would be to inspire firms to look specifically for veterans when hiring: any firm that is going to hire someone anyway will now simply look for a veteran. But it's doubtful that many firms would create entirely new job openings just because of this provision. In other words, I would expect the main effect of this to be that firms would change the type of job candidates they are looking for, not the number of them. Good for veterans, but bad for non-veterans, with little net impact on the economy.

3. Extend 100% expensing for businesses: I'm not sure how this is supposed to help. In theory, allowing 100% expensing (i.e. deducting the full amount in year 1 of an investment that has a multiple-year useful life span) should persuade firms to move planned investments from the future into the present. But since this provision is already in place, firms have already been pushing forward whatever investments they could. I suppose that it could provide some benefit in the second half of 2012... but little to no benefit for the next 12 months.

Nevertheless, as I said, taken as a whole this was a big and ambitious proposal. And it would really help. The fact that it has no chance of passing tells us something about the US's political system right now... but I do think that Obama should get full marks for at least trying.

UPDATE: For Mark Thoma's initial reaction (which I also agree with), see here.

Tuesday, September 06, 2011

Swiss FAQs

In proper analogy format, today's news that the Swiss National Bank (SNB) is going to buy "unlimited quantities" of foreign currency in order to keep the Swiss Franc (CHF) from appreciating beyond 1.20 CHF/euro can be expressed as follows:

China:US :: Switzerland:Eurozone

Just as China has for years steadily purchased US dollars in order to keep its currency from appreciating, Switzerland has now promised to buy euros in order to keep the CHF from appreciating. To help understand what that means, here are some FAQs:

1. Why did the SNB decide to do this?
The SNB had to act because the strong CHF had basically been strangling the Swiss economy by making Switzerland a horrendously expensive place to manufacture or buy things. So it's not surprising that the SNB decided it was time to take steps to prevent a dangerous deflationary spiral from taking hold.

2. Is the SNB's new exchange rate policy credible?
Yes, it is absolutely credible. There's no technical or economic limit to the ability of the SNB to sell CHF and buy euro to keep the exchange rate above 1.20, simply because the SNB can create as many CHF as it wants. So the exchange rate will only go below 1.20 if and when the SNB decides to allow that to happen.

3. What will this do to the Swiss money supply?
Chances are high that Switzerland's money supply will explode. There's probably no getting around this one; the only way the SNB can keep its exchange rate at the desired level is to offer unlimited CHF at an exchange rate of 1.20 CHF/euro to anyone who wants to use Switzerland as a safe haven for their money. Given that lots of people are seeking safe havens for their money right now, it's likely that there will be a lot of takers, which means that the SNB will have to create lots and lots of new CHF.

However: please remember that this doesn't matter. I know, I know, lots of people are going to immediately jump to the possibility that this will cause rampant inflation in Switzerland. But it won't. Inflation is not determined by the amount of money in the economy -- it's determined by the amount of demand. That's why gigantic increases in the US money supply in recent years have had no effect on US inflation. The same will be true for Switzerland.

4. But what if (just for the sake of argument) inflation did start to pick up in Switzerland?
In that case -- which could happen if demand for Swiss goods and services picks up in a serious way -- then investors will begin to realize that all those CHF they accumulated are losing purchasing power, and they will start to sell them. And the process of the SNB creating CHF to buy euros can simply be reversed. Furthermore, in that case the SNB will be perfectly content to let the CHF appreciate again, if there's still a tendency for it to do so.

5. Will this stem the flow of cash into Switzerland? At the announced exchange rate floor of 1.20, I doubt it. Banks and other financial institutions are still seeking refuge from perceived risks in Europe, and they seem to be moving their money out of other European countries at a rapid clip. Much of that is going to the US, but not all of it, so investors will continue to seek other safe places to park their funds. Switzerland's attractiveness as a safe haven will not be diminished just because the SNB is enforcing what will effectively be a fixed exchange rate. However, there is one possible additional step that the SNB could take to help stem the tide of cash...

6. Will the announced exchange rate floor of 1.20 CHF/euro be modified?
It's possible, and in fact, the announcement by the SNB indicated that they would like the CHF to weaken further over time. This is a very sensible strategy by the SNB, and I wouldn't be surprised if they soon make an explicit promise to gradually ratchet up the exchange rate from 1.20. The reason is because only by promising investors that their CHF portfolio will suffer exchange rate losses over time can the SNB really do something to staunch the flow of funds into Switzerland -- a fixed exchange rate of 1.20 won't do it. The SNB will probably give it a little time to see if the flow of funds into Switzerland slows as a result of today's action, but if it doesn't, then look for the SNB to set a gradually rising target exchange rate going forward.

7. How will this affect the eurozone?
That depends in part on what the SNB decides to do with all of those euro it will be accumulating. Some reports suggest that the SNB (typically cautious) had decided to only buy German and French government bonds with those euro, and not bonds from other eurozone countries. That will have the effect of exacerbating the interest rate differentials between the eurozone core and periphery, potentially making things worse. It would be reasonable to interpret this as indicating that the SNB believes that there's a good chance that eurozone is going to lose the periphery countries.

Alternatively, the SNB could decide to place a bet on the survival of the eurozone, or at least on continued Spanish and Italian inclusion. If so, then it could help to make that positive outcome happen by using some of its growing stash of euros to buy Spanish and Italian government bonds. Not only would this directly help to narrow interest rate spreads between the core and periphery, but it would be interpreted by the markets as a major vote of confidence.

Either way, Switzerland's fate is now substantially tied to the eurozone. This was always true to some degree, of course, but the linkages will now be even deeper and more explicit, as the SNB begins rapidly accumulating a big pile of eurozone bonds. It's yet another example of how the eurozone debt crisis has had, and will continue to have, effects far beyond the eurozone itself.

More on Transatlantic Cash Flows

Last week I noted the recent buildup of cash assets by foreign banks in the US. I suggested that, when paired with ECB data showing that European monetary financial institutions (MFIs) have been drawing down their deposits in Europe, this provides circumstantial evidence that European institutions are reducing their exposure to Europe in part by moving cash to the US. (Note that most of that cash is being deposited with the Fed in the form of reserves.) But as noted by some commenters, it's worth considering a couple of other possible explanations.

For example, Kate Mackenzie at Alphaville draws our attention to commentary by Lars Pedersen at Alliance Bernstein. In June Pedersen noted the substantial buildup of cash assets by foreign banks in the US, and suggested that "building up dollar balances at the Federal Reserve might be viewed as insurance by these foreign banks." But he also noted that there may be something else going on (pdf):
There may be other motivations beyond safety. Deposits at the Fed are unusually attractive for foreign banks because of the regulatory landscape. Borrowing money via deposits that don’t exact an FDIC surcharge, and depositing them at the Federal Reserve, earning 25 basis points, is much more attractive to a foreign bank with a US branch than it is to a US bank. That regulatory gap also provides insight into why foreign-related banks have maintained sizable deposits at the Fed.
Could recent rule changes at the FDIC explain the recent buildup in cash reserves by non-US banks? Unless I'm missing something, this seems an insufficient explanation. Because if I understand the FDIC assessment scheme correctly, the FDIC charges don't seem to depend on whether bank assets take the form of deposits with the Fed or some other sort of asset. So it's not clear how this would specifically affect Fed reserves and not other asset classes.

But what about a second possibility raised by Pedersen and others: perhaps the rise in Fed reserves of foreign-owned banks is simply an artifact of QE2. Though this was not the program's primary goal, QE2 had the unavoidable side-effect of increasing the total quantity of reserves owned by the US banking system. And after all, someone has to hold all of the reserves created by QE2.

But while this may be a part of what's going on, this explanation again seems insufficient by itself. First, there's no obvious reason why the reserves created by QE2 should have gone so overwhelmingly to foreign-owned banks. QE2 created new bank reserves, but the Fed has no say in who actually holds those reserves. There must be some force at work that has made foreign-owned banks in the US more eager to increase their holdings of Fed reserves than domestic US banks. A greater fear of unexpected losses by non-US banks would do it.

Second, if the funds that foreign-owned banks in the US are stashing with the Fed were simply coming from QE2, then we would expect the rise in reserves held with the Fed to be matched by a decrease in those banks' other domestic US assets; the story would be one of foreign-owned banks in the US effectively trading one type of US asset (such as US Treasuries) for another (deposits with the Fed).

But foreign-owned banks in the US have been getting the funds to deposit with the Fed from their foreign parents, not from their base of existing US assets. The following chart shows FRB data detailing the amount owed by the US branches of banks in the US to their overseas affiliates, broken down by whether the banks are domestic or foreign-owned. (A negative number means that the foreign office owes the US office.)

One year ago the US branches of foreign-owned banks were effectively "owed" about $400 billion by their non-US parents. Then, beginning around the end of last year, foreign banks began a large net transfer of funds to their US branches. At first this transfer of cash had the effect of essentially "repaying" the net obligations that existed in 2010, and then from June 2011 onward those continued cash transfers from overseas offices to affiliated US branches meant that the US branches of foreign banks became net borrowers from their parents. The total cash transfer to US branches of foreign-owned banks over the past 8 months, according to these figures, was around $600 billion. And what happened to the cash received by US branches of foreign-owned banks in the US? They deposited almost all of it with the Fed.

Meanwhile, it's interesting to note that over the past 2 months, domestic banks in the US have been paying down the debts of their overseas affiliates to their US parents. While this has been a much smaller and more recent phenomenon than the cash movements of foreign-owned banks, I would be eager to hear some theories as to what's behind this. (I have a couple of thoughts about it, but no story that I find convincing yet.)

Note the one other time in the recent past when non-US banks shifted large amounts of cash to the US: during October and November of 2008, during the height of the (first?) worldwide financial crisis. Then as now, foreign banks were eager to accumulate the safest form of cash there is: dollar deposits with the Fed. This may be yet another sign that we are currently in the midst of a time of financial stress similar to that at the end of 2008. And that probably explains this queasy feeling I have...

UPDATE:For another alternative interpretation of this data, see this post by Rebecca Wilder.

Friday, September 02, 2011

Europe's Banking System: The Transatlantic Cash Flow

And now, the flip side of the story presented yesterday, in which ECB data seems to indicate that monetary financial institutions (MFIs) in Europe have been moving their deposits out of European banks. Where is that money going?

It looks like much of it is being placed with US banks instead. The following chart shows the total deposits at domestically chartered commercial banks in the US. (All data is from the Federal Reserve Board, through August 17, 2011.)

Clearly, something is going on -- the recent rise in deposits with US banks has been dramatic, with an above-trend increase in deposits of approximately $500 billion over the past 6 months.

Who is responsible for this sudden inflow of deposits into the US banking system? The answer is non-US banks, as illustrated in the following picture, which shows the cash assets of domestically chartered banks alongside the cash assets of foreign-owned banks in the US.

The cash assets (i.e. bank deposits) that foreign banks are keeping in the US banking system has risen sharply over the past 6 months -- not coincidentally, by about $500 billion. Meanwhile, domestic US banks have started showing some similar tendency toward accumulating cash, but only to the tune of approximately $150 billion, and only over the past 2 months.

Recall from yesterday's post that MFIs in Europe have drained their bank accounts at European banks by about €700 billion over the past year and half, which at current exchange rates is approximately $1 trillion. It seems that much of that money has recently found its way into the bank accounts that European MFIs keep in US banks. And conversely, it seems likely that the large inflow of cash deposits held at US banks this year is largely from European banks.

Putting it all together yields a compelling story: European banks are shifting their cash assets out of European banks and putting much of them into US banks. (An interesting question is what European MFIs have done with the remaining money they've withdrawn from the European banking system... but that's a story for another day.) This has happened at a significant rate, with a net transatlantic flow from European to US banks that probably totals close to half a trillion dollars in just six months.

If you're wondering exactly who has been the first to lose confidence in the European banking system, look no further. It seems that at the forefront is the European banking system itself.

Thursday, September 01, 2011

Europe's Banking System: A Slow-Motion Bank Run in Progress?

Last week The Economist described what it called a "slow-motion run in the funding markets" in Europe -- in other words, a gradual but steady run on European banks, as depositors remove their money from European banks and put it in places that are seen to be safer. It's worth taking a look at some data to see how significant this phenomenon is.

First, let's look at the troubled euro-zone perihpery countries. The following chart shows the total level of deposits with monetary financial institutions ("MFIs", which basically means banks and money market accounts) in Greece, Ireland and Portugal. For comparison, the total level of deposits within the entire euro-zone is also presented. (All data is from the ECB and is through the end of July 2011 unless otherwise noted.)

Ireland clearly stands out as having experienced a large net withdrawal of deposits over the past year. Perhaps surprisingly, banks in Greece have seen their deposits fall by only a relatively modest amount (about 10%) since the summer of 2010. And for the euro-zone as a whole, total deposits have been essentially flat.

But this hides some important details. If we compare the three most troubled periphery countries with other euro-zone countries, we find that Cyprus has actually seen the greatest percentage decrease in deposits since the start of 2010. But Germany has also seen total deposits shrink by a bit, and, perhaps alarmingly, even though it is not in the euro-zone, the UK has experienced a very significant fall in total deposits with its MFIs. (Note: UK data is through June 2011.)

This still doesn't tell the whole story, however. To really understand what's going on it's useful to break the change in deposits held with European MFIs into two pieces: deposits owned by other MFIs, and deposits owned by non-MFI entities such as households and non-financial corporations. That story is told in the following table.

Now we can understand why Greece, for example, doesn't show a bigger fall in bank deposits in the aggregate statistics: households and corporations have indeed removed money from Greek banks at a substantial rate over the past 18 months (withdrawing about 15% of their deposits), but much of this has been replaced by increased deposits by other MFIs, reflecting the inflow of funds into the Greek banking system resulting from the various international measures to support it.

The truly troubling thing to note in the table, however, is the rate at which financial institutions have been withdrawing money from European banks. This has particularly affected those countries that have traditionally been large international money centers, such as Germany, the UK, and to a lesser degree, Ireland, but it has affected all of the major European economies to some extent. To varying degrees these withdrawals by financial institutions have been offset in the large euro-zone countries by steady increases in the deposits made by domestic residents and corporations (i.e. non-MFI deposits), leaving the overall level of deposits in the euro-zone roughly unchanged. But it seems very clear that the world's big banks and other financial institutions are indeed moving their funds out of Europe at a significant rate.

Fortunately for them, the big euro-zone countries all have a large domestic base of depositors that has continued to deposit a portion of their earnings into their own banks, so alarm bells have not yet been sounded. But the fall in deposits by MFIs indicates that international money managers are nervous about keeping their money in European banks. And if their nervousness begins to spread to households and non-financial corporations (the way that it clearly has in Ireland and Greece, for example), this hidden slow-motion bank run will suddenly become very visible, and very dangerous.

One last note: according to this ECB data, MFIs in the UK have seen by far the largest falls in deposits over the past year and a half in absolute terms. But keep in mind that the UK does not even use the euro. That's a potentially chilling reminder that if Europe's debt crisis worsens and spreads, there's every reason to believe that its effects will be felt well beyond the euro-zone.

UPDATE: See the following post, the Transatlantic Cash Flow, for some evidence about where European MFIs have been putting the funds they've withdrawn from the European banking system.