The Street Light

International Capital Flows, House Prices, and the Euro

2012-01-27T07:56:00.000-05:00

Free Exchange’s weekly reading list includes an excellent recent paper by Jack Favilukis, David Kohn, Sydney C. Ludvigson, and Stijn Van Nieuwerburgh: “International Capital Flows and House Prices.” Lots of observers (including me) have noted the suspicious correlation between surges in international capital flows into certain countries in the early 2000s (e.g. the US, Ireland, Spain, Greece, Iceland, Australia) and simultaneous or near-simultaneous surges in house prices in those countries. This paper addresses the question of whether there is in fact a systematic relationship between capital flows into a country and house prices. Were the house price booms of the 2000s caused by international financial flows?

The answer provided by this paper is no, or at least not directly. When different possible macroeconomic explanations for changes in average national house prices are considered, it turns out that by far the most important factor is the ease of bank credit. In other words, rising house prices in the 2000s (as well as their subsequent fall) probably had much more to do with the willingness of banks to lend than any other factor. When banks are happy to lend money and they relax lending standards, house prices go up. When banks reverse course, house prices go down.

The importance of bank lending standards to the US housing bubble has been well documented and discussed, but this data suggests that the same may be true for a number of other countries as well. On the other hand, countries that did not experience a general relaxation in lending standards in the early 2000s did not experience house price booms. Once changing lending standards are taken into consideration, changes in international capital flows seem to have little additional explanatory power for house price changes.

This raises an obvious question: why did credit standards change in certain countries in the early 2000s? Bank lending standards are surely partly endogenous (as the paper discusses) – when banks expect house prices to continue rising, they are more willing to lend, which helps to push house prices higher. That sort of self-fulfilling logic is exactly why changes in house prices (first up and then down) were so extreme in the boom countries between 2002 and 2009. But this story doesn’t explain how the cycle got started in the first place in those countries.

For that, we need to look for some factors that can affect bank lending standards that are external to the housing market. Surely, general prospects for macroeconomic growth must play a role there, as well as overall risk tolerance. When a country seems to be headed for better economic times and risk tolerance grows, banks become generally more willing to lend. And that is where we come to the euro. (Were you wondering when I would bring that into the story?)

The peripheral euro countries benefited in specific tangible ways from adoption of the euro in 1999, not least from surges in international capital flows that reduced interest rates. Yet this research demonstrates that there is no direct connection between those capital flows and house price booms. So how is the euro involved?

This paper provides some evidence that in addition to truly exogenous changes in the supply of bank loans, expectations about future economic growth also have an impact on house prices: all else being equal, when growth prospects improve house prices go up. And more generally, bank lending standards depend heavily on their perception and tolerance of risk.

Now consider the likelihood that the adoption of the euro by the peripheral European countries (e.g. Spain, Ireland, and Greece) created expectations for higher growth (and lower interest rates) in those countries, and helped persuade banks to become less risk averse. House prices start to rise and banks become more willing to lend. House prices rise more. Banks respond by relaxing credit standards further. And the bubble begins to inflate.

Surges in capital flows don’t directly create house price bubbles. But this paper does help us understand a mechanism by which the adoption of the euro could have indirectly caused house price booms: by changing expectations and altering the perception of risk in the eurozone periphery, a self-reinforcing cycle of easier credit was sparked in those countries. That’s not all there is to it, of course – other factors surely must have also caused changes in risk aversion and bank lending standards in the housing bubble countries – but it does seem to be a likely piece of the puzzle for the peripheral eurozone.

Putting it all together, we now have a plausible contributing explanation for why almost all of peripheral Europe experienced a house price boom following the adoption of the euro, while the euro core (Germany, Austria, Benelux) missed it. It’s yet another way in which adoption of a common currency by economically dissimilar countries may have vastly important but completely unforeseen consequences.

China in the News

2012-01-06T08:12:00.000-05:00

While 2011 was a busy year for Europe-watchers, I suspect that 2012 is going to be a big year for China-watchers, at least when it comes to developments that will have the potential to dramatically affect the world's financial system and economy. And as has been the case with the eurozone debt crisis, the most significant developments will probably be purely internal. (Note that I don't mean to suggest that we're done with the euro crisis, by any stretch of the imagination.)

After years of seemingly unstoppable growth, China's economy has shown some sign of cooling off in recent months. But as always, the sharpest dangers to China's and the world's economy are fundamentally financial. China's property boom seems to be coming to a sputtering halt, and the big question is whether this will turn into a full-blown bubble-burst. But in China such things have an additional layer of significance, because in addition to potentially causing financial disruptions, falling property values could create political disruptions as well. From Marketwatch:

China faces social unrest from housing woes

HONG KONG (MarketWatch) — Irate Chinese homeowners are among the top policy concerns for Beijing this year, according to analysts who say weakening house prices are stoking serious tensions.

...City University’s Cheng says tensions over the housing market are emerging, even as authorities are proving more adept at defusing conflict in other areas. He points to December’s protest in the southern costal community of Wukan as one example.

Frustrations in Wukan over corrupt land deals by the village elite — and the death of a protester there — boiled over when 13,000 Chinese citizens took to the streets, sending the local Communist Party officials fleeing and beating back attempts by police to retake the town.

Not exactly the reaction we would expect in the US or Europe to events in local property markets. So while the Chinese government has substantial resources (both financial and adminstrative) that it can throw at this issue if it becomes a serious problem, this is something that we'll have to keep an eye on.

Note that one important way that events in China impact the rest of the world is through its exchange rate, which is substantially controlled by China's central bank. With that in mind, Caixin Online recently published an interesting interview with the governor of China's central bank (the People's Bank of China), Zhou Xiaochuan. I admittedly know relatively little about him, but based on what I do know about him Zhou strikes me as a relatively thoughtful policy-maker who has softly but consistently pushed for market-oriented reforms. I encourage you to read the whole thing, but here are a couple of interesting tidbits:

Regarding prospects for China's economy in 2012:

Caixin: China's macro-economic policies were adapted to fit changing economic situations in 2011. How do you see the economic situation in 2012 and corresponding policy options?

Zhou Xiaochuan: The Central Economic Work Conference clearly articulated macro-economic policy, taking into account two considerations: Efforts to prevent an economic downturn, and efforts to restrain inflation.

First, we are encountering concurrent issues in the international arena, including an evolving European debt crisis, U.S. economic uncertainty, and slowing growth in emerging economies. More importantly, the international economy is changing rapidly, and its outlook remains uncertain. Thus, we must be prepared to respond to new situations.

On the other hand, looking at China's domestic economy, local governments will have leadership reshuffles in 2012 and the capacity for growth in the Chinese economy is still great. At the same time, the consumer price situation has changed for the better, and the need to control inflation is not as pressing as it was in early 2011. Of course, there are still uncertain factors, such as the impact that the real estate market will have on the national economy.

And regarding continued yuan appreciation against the dollar:

Caixin: Is the current two-way volatility of the yuan a temporary phenomenon, or does it fundamentally indicate that the yuan exchange rate has already been overshot?

Zhou Xiaochuan: In the past, people said expectations for the yuan were one-way appreciation. Until close to the equilibrium level, it would experience two-way expectations and two-way volatility. This sort of natural, bi-directional floating state is the goal that reform has pursued. But to truly reach this state may take more time. The movement in the current foreign exchange market is still mainly related to the external environment.

That's as close to an explicit statement as you could expect from the PBOC's governor that the yuan has quite a bit further to go in its appreciation against the dollar. I'll have more to come soon regarding recent developments in the yuan-dollar exchange rate.

More House Prices and Current Account Deficits

2011-12-08T16:41:00.003-05:00

Continuing to think about the relationship between house prices and the current account deficit, I put together the following chart showing house price changes in the US (measured by the FHFA's house price index) alongside the US's current account deficit over the past 30 years. Even though I was expecting them to be somewhat correlated, I am still surprised by how incredibly closely the two track each other...

...And given the relatively close coincidence of the two series, the idea that the causation runs both ways between them seems quite plausible to me.

House Prices and Current Account Deficits

2011-12-07T07:58:00.000-05:00

A new Economic Letter put out by the Federal Reserve Bank of San Francisco, "Asset Price Booms and Current Account Deficits", by Paul Bergin, addresses a subject that I've been thinking a lot about lately. The question is this: is there a systematic relationship between current account deficits and booms in housing prices, and if so, why?

The picture to the right (from Bergin's paper) summarizes why many people think that the answer to the first part of that question is yes. There are exceptions, of course, such as the recent boom in property prices in China (which has been running current account surpluses), but looking across countries there's clearly a significant correlation between the house price appreciation and current account deficits. And looking across time within a single country, the relationship is also easy to see -- for example, the biggest boom years in the US housing market (2002-06) coincided perfectly with the largest current account deficits in modern US history. Many European countries experienced the same coincidence in timing.

So if we believe that there is indeed a causal relationship between house price appreciation and current account deficits, what's the explanation? Bergin mentions a couple of possibilities:

1. Rising house prices make consumers wealthier, so they spend more, which causes an increase in imports.

2. Rising house prices give consumers more collateral against which to borrow, easing credit constraints and allowing more consumption, which causes an increase in imports.

A third possibility, discussed in a paper by Pedro Gete, is this:

3. Rising house prices cause a reallocation of an economy's productive resources away from manufacturing and into construction. The country must therefore source more manufactured goods from elsewhere, leading to an increase in imports.

All of these mechanisms are probably at least part of the story. But notice that these explanations all assign the role of cause to the house price boom, and leave the widening current account deficit as an effect. But in some cases at least, it is entirely possible that the causality could go in the opposite direction.

When a country experiences a surge in capital inflows -- and yes, I'm thinking particularly about the periphery eurozone countries during the years after euro adoption -- that capital flow itself may have a substantial impact on house prices, for a couple of reasons:

4. Capital inflows reduce interest rates, which has the effect of driving up the value of long-lived assets like houses.

5. Capital inflows require offsetting current account deficits, which imply a real exchange rate appreciation. With fixed exchange rates (e.g. within the eurozone) this will typically happen through a rise in price levels in the recipients of the capital inflows, and such price increases will disproportionately affect non-traded goods like real estate.

This is certainly not an exhaustive list; I think that this is an important area for additional research, both to explore other possible mechanisms as well as to better understand the relative importance of each. Just as importantly, better insight into how capital flows can affect asset prices will be crucial to understanding how policies that affect capital flows might impact house prices, or might even be used to dampen real estate bubbles. And as a bonus, this line of research will also help shed crucial light on how the flow of capital from the core to the periphery in the eurozone, by contributing to real estate booms in the periphery countries, may have done much more to sow the seeds for the eurozone crisis than commonly believed.

Keeping an Eye on Banks

2011-12-02T07:53:00.002-05:00

Banks. They're so easy to hate. And yet they're so important to the functioning of the economy. If the euro crisis is going to have a significant impact on the US, the channel through which it will do so is the banking sector. We're not in a full-fledged banking crisis, but the signs of stress are real, and growing.

Return of the credit crunch: caught in the grip

Banks are the traditional suppliers of credit – to governments whose debt they hoover up; to rivals through interbank lending; to companies, from sole traders to corporate behemoths; and to individuals. Banks provide the oil needed to run the economic machine; without that lubrication the machine seizes up. But to carry out that role, the banks themselves need money. And that is where the whole model is breaking down.

...As fears over the integrity of the eurozone have deepened, European banks have found it expensive, difficult or in some cases impossible to raise funding in the bond markets. So far they have covered barely two-thirds of the amount of outstanding funding that falls due in 2011. For most banks, the bond markets have been closed for months.

...The few banks that have plenty of money are holding on to it, or depositing it with super-safe institutions such as the US Federal Reserve or the ECB. That means the third key mechanism for bank funding – interbank lending – is also drying up.

...The nervousness surrounding many European banks is rooted in fears about losses they face, particularly on their sovereign debt holdings. Bankers recognise the concerns but complain that the effect is being compounded by regulators’ insistence that the banks should meet tough new capital ratios. The European Banking Authority, which oversees bank regulators across the continent, has identified a total €106bn ($143bn) gap at 70 banks that it stress-tested for their exposure to eurozone sovereign debt. Rather than raise fresh capital in turbulent equity markets to bridge that gap, many are opting instead to shrink their balance sheets and comply with the capital ratios that way.

Regulators, policy-makers, and most observers agree that in order to boost confidence in the banking system (as well as to reduce the odds of a major bank going bust), many of Europe's banks need to increase their capital ratios, which is the amount of core capital they have to work with divided by the amount of loans they have made. But there are two ways to get to a higher capital ratio: by increasing the numerator, or by decreasing the denominator. Bankers argue that given the amount of capital they currently have, calls to increase their capital ratios force them to reduce their lending activities and shrink their loan portfolios. But that is exactly the opposite of what policy-makers intended, of course: the hope was that banks would maintain their portfolios of loans while raising more capital.

In the absence of specific, enforceable requirements that banks meet capital ratio requirements by raising more capital, there's no reason to expect Europe's banks to reverse the current tendency to try to meet capital ratio targets by reducing the size of their loan portfolios. After all, it's expensive to raise capital, and the current ethos of risk-aversion means that extending new loans is not at the top of the list of things that banks want to do. The depressing similarities with the events of 2008 continue...

When the Euro Was Good for Germany

2011-11-30T07:22:00.002-05:00

During the good years, the economic benefits of the common currency in Europe were fairly easy to recognize. The countries on the eurozone's periphery -- Spain, Portugal, Greece, and to a lesser degree Italy -- had improved access to international capital markets, enjoyed lower borrowing costs, and experienced substantial investment booms as a result. Meanwhile, the countries in the eurozone core such as Germany, France, and the Benelux countries enjoyed a surge in exports to the rapidly-growing periphery. Importantly, they also enjoyed the higher returns that they could earn by investing in companies, assets, and projects in southern Europe. The gains from the common currency were shared by north and south.

Now, of course, Germany is pondering just how much it is willing to pay to keep the currency union intact. An important part of that calculation is an understanding of what the benefits to Germany were during the good years. There's been some debate about that in recent weeks, for the most part focusing on whether and how much Germans benefited from the export boom of 2004-08. But another element of the calculation should be the higher investment income that German individuals and corporations earned from the new investment opportunities afforded by the common currency.

The following charts illustrate the surge in investment income earned by the core eurozone countries during the 2000s. The first expresses foreign investment income in billions of euro, while the second shows that income relative to GDP. (Data is from Eurostat.)

A couple of important caveats. First, this data is from national balance of payments statistics, which measures foreign income earned by each country from the entire rest of the world. We don't have an easy way to directly measure how much of the increased investment income earned by these countries was specifically from the eurozone periphery. However, given everything else we know about the pattern of capital flows within Europe during that time, and the timing of the surge in investment income (the euro was adopted in 1999, and the boom really happened right after the economic slowdown of 2001-02 ended), it seems a safe bet that the much or most of this increased investment income was from southern Europe.

Second, we don't know what the pattern of investment income earned by the core eurozone countries would have looked like in the absence of the common currency. In the absence of the counterfactual, we can only make an educated guess about the impact of the euro. In this case, however, I think there's every reason to believe that the massive capital flows from core to periphery, the associated investment boom in the periphery, and the surge in investment income enjoyed by the core during the years leading up to the crisis would not have happened without the euro. I would therefore attribute the vast majority of the increased investment income earned by the core from the periphery during the 2000s to the euro.

Given that, this data suggests that the euro enabled Germany to enjoy increased investment income of perhaps €30 to €40 billion per year, or between 1% and 2% of GDP. The Netherlands also enjoyed an income boost of up to 2% of GDP during the best years of the 2000s, while the euro helped France to earn higher investment income equal to perhaps 1% per year.

Are these figures large enough to justify substantial additional spending by Germany to keep the eurozone intact? I have no idea. Keep in mind that this does not tell us anything about the economic benefits that the core eurozone countries enjoyed thanks to their increased exports to the periphery. And most importantly, the benfits of the common currency have always been perceived to be at least as much about politics as economics, and I'm not sure how we would go about quantifying those political benefits. But this sort of analysis does at least give us some rough sense about the magnitude of one specific type of benefit that countries like Germany and France enjoyed from the euro during the good years, and therefore puts a floor on our estimate of the overall benefits of the euro to those countries that are now considering whether to save it.

Italy and Japan

2011-11-29T08:03:00.002-05:00

Consider the following differences between Italy and Japan. Italy has a history of lower budget deficits, as well as forecast budget deficits for the next few years that are dramatically lower than those forecast for Japan:

(All data is from the OECD; figures for 2011 and 2012 are forecasts.)

Italy's debt to GDP ratio has remained roughly constant over the past 15 years, while Japan's has climbed steadily higher:

Both countries have had relatively poor economic growth over the past decade, with little difference between them:

And yet, despite all of this, yields on Japanese 10-year government bonds hover around 1.0%, while yesterday the Italian government was forced to pay nearly 8.0% to borrow money for 10 years. Given how much worse Japan's public finances look when compared to Italy's, it seems unlikely to me that investors are demanding higher interest rates from Italy simply because they are worried about excessive budget deficits or debt.

So what explains the dramatic disparity in investor willingness to lend to Italy compared to Japan? There are three crucial differences between Italy and Japan that, when put together, create a coherent story about what lies at the heart of this crisis:

1. Japan has the ability to create its own currency, while Italy does not.
2. Japan has been running current account surpluses, while Italy has had a current account deficit for the past several years.
3. Japan can borrow at 1.0% while Italy must pay much more to borrow.

Item #1 on this list has helped to cause the crisis for the reasons noted by Paul DeGrauwe: by giving up its own currency, Italy lost the important backstop on its government borrowing costs that countries that can borrow in their own currency have. This was a key prerequisite for this crisis to take hold.

Item #2 on this list is important because at its heart, this crisis can be seen as a balance of payments problem. Italy (along with the rest of southern Europe) has been dependent on capital flows from northern Europe to meet its borrowing needs, as reflected by the large current account deficits Italy has experienced in recent years. But private capital flows are notoriously fickle, and when they stop, a balance of payments crisis can ensue. What we're seeing in southern Europe right now is a variation of that.

Item #3, you'll notice, is simultaneously cause and effect. This is the self-fulfilling downward spiral that Italy has become trapped in. Once the necessary conditions were established by item #1, and once Italy became vulnerable to a stop in private capital flows thanks to item #2, the dynamics inherent to self-fulfilling crises took hold -- and events have mercilessly followed that unforgiving logic to the point in which Italy finds itself today.

On the other hand, government deficits in Italy had little to do with getting it into this mess. Which is why all of the stern talk in Europe about setting up firm and credible ways to discipline countries into being fiscally responsible will do nothing to end the crisis in the short run, and nothing to prevent it from happening again in the long run.

UPDATE: I should have mentioned that item #1 goes hand-in-hand with one additional ingredient to Italy's current predicament: the lack of a flexible exchange rate that could adjust in response to the stop in private capital flows. Such an exchange rate adjustment would improve Italy's external competitiveness and reduce its relative income, which in turn would help Italy bring its current account back toward balance. Again, the point is that this crisis is primarily a balance of payments problem, not a budget deficit problem.

Programming Note

2011-11-14T21:10:00.002-05:00

My apologies for the light posting lately -- other commitments are keeping me busy right now, but I should be able to get back to more regular posting next week. (I'm going to trust that the eurozone will hold itself together for another week at least.)

In the mean time and apropos of nothing, I'll simply take this chance to refer you to an astronomical applet that I find unreasonably entertaining: Galaxy Crash.

Scarce Job Openings in the US

2011-11-10T20:31:00.005-05:00

Earlier this week the BLS released new data on the number of job openings, hires, and separations in the US labor market for September 2011. The headline story from that news release was that the number of job openings in the US continued what has been a pretty solid and steady rise over the past year.

Some have interpreted this news as possible evidence that the US labor market is beset with structural unemployment problems; if the number of job openings is increasing so strongly, then the relatively slow increase in the level of employment must be due to the fact that unemployed workers are mismatched to the types of jobs that are available, right? The unemployment problem in the US, the reasoning goes, must be significantly the result of this worker-job mismatch -- which is a "structural" problem -- rather than low demand. From the FT:

High US joblessness puzzles economists

The stubbornness of high unemployment despite a steady rise in the number of job openings in the US since the end of the recession is posing a puzzle to economists as they try to understand the troubled labour market.

New data released this week show that the number of vacant jobs in the US rose to 3.4m in September – the highest in more than two years – even as the unemployment rate remains mired at 9 per cent.

The question is whether the rising rate of job openings, derived from the Job Openings and Labour Turnover Survey, is the better indicator of a steady recovery in the labour market or whether the fact that vacancies are being advertised but not filled points to an underlying malaise...

But I don't actually think that this data actually provides any support for the structural explanation of the US's stubbornly high unemployment rate. While the number of job openings has indeed risen substantially over the past year or two, that was from an abysmally low level in 2009. Even now, the total number of private sector job openings is just barely back to the level of jobs available at the worst of the 2001-03 employment recession in the US, as shown below.

The fact is that there are still terribly few jobs available relative to what is normal for the US economy. Meanwhile, the number of net new hires (i.e. total new hires minus the number of worker separations due to both voluntary quitting and involuntary layoffs) has been averaging about 100 thousand people per month recently, which is disappointingly small. But compared to the relatively small number of job openings, this is actually fairly decent performance. Dividing the number of net new hires by the number of available job openings we find that jobs are actually being filled at a decent rate -- more or less at the same rate as during the relatively good labor market years of 2004-07.

This suggests that it is not any more difficult to match people with positions today than usual. The dominant feature of today's job market is simply that there are still very few job openings; companies in the US remain reluctant to hire more people. That is not the result of any structural, skills-mismatch sort of problem. That is simply the result of firms feeling that they do not yet need to hire more workers. It's yet more evidence (see here for another type of evidence) that the US's unemployment problem is the result of plain old insufficient demand.

Italy: Illiquid-but-Solvent

2011-11-09T08:11:00.000-05:00

Evidence for the argument that Italy is having a liquidity crisis, not a solvency crisis:

Italian Yields Top 7%

Italian bonds slumped, driving two- five-, 10- and 30-year yields to euro-era records, after LCH Clearnet SA raised the deposit it demands for trading the nation’s securities.

Two-year note yields rose above 10-year rates, with five- year debt climbing above 7.5 percent as Prime Minister Silvio Berlusconi’s offer to resign left his weakened government struggling to implement austerity measures to reduce borrowing costs.

...The yield on Italy’s five-year notes jumped 82 basis points, or 0.82 percentage point, to 7.70 percent at 11:56 a.m. London time.

The rate on Italy's ten-year bonds are currently at about 7.25%, creating a fairly sharp inversion over the 2-to-10 year portion of the yield curve. In other words, while investors are demanding a risk premium on all maturities of Italian bonds, they are now demanding a higher risk premium on shorter maturity bonds than on longer maturity bonds. This implies that market participants believe that Italy's potential difficulties in repaying its bonds are concentrated in the next couple of years, and that if Italy can get through that stretch then the risk of default diminishes.

This is not to say that there couldn't also be some concerns about Italy's long-term solvency; but those concerns are clearly being overshadowed by worries that Italy may not make it through its current liquidity crisis. Which means that no matter what steps are taken to change Italy's long-term budget picture, if Italy isn't provided with the liquidity it needs to get through the next couple of years, then long-run solutions are really rather irrelevant.

Liquidity, liquidity, liquidity.

Days, Not Weeks

2011-11-09T07:55:00.000-05:00

Today Ryan Avent wrote the post that I had been intending to write myself. So I will simply turn things over to him (though please click through to read his entire comments):

Finito?

SILVIO BERLUSCONI'S promise to resign has done nothing to calm European bond markets. Italian bond yields are soaring today; both the 2-year and the 10-year are above 7%. There are rumours that the ECB is in the market and buying heavily. If so, it's not having the desired effect. The ECB can't hope to keep yields reasonable through brute force. It will need to make an expectations-changing announcement. Will it? Italy's yields aren't the only ones rising. Markets are ditching Irish, Spanish, Belgian, and French debt too.

...I have been examining and re-examining the situation, trying to find the potential happy ending. It isn't there. The euro zone is in a death spiral. Markets are abandoning the periphery, including Italy, which is the world's 8th largest economy and 3rd largest bond market. This is triggering margin calls and leading banks to pull credit from the European market... The cycle will continue until something breaks. Eventually, one economy or another will face a true bank run and severe capital flight and will be forced to adopt capital controls. At that point, it will effectively be out of the euro area. What happens next isn't clear, but it's unlikely to be pretty.

...I hate to get this pessimistic about the situation. It feels panicky and overwrought. I can't believe that Europe would allow so damaging an outcome as a financial collapse and break-up to occur.

I wish I didn't agree so completely with Ryan's assessment. The ECB is the only institution that can put a stop to this. And they have days, not weeks, in which to decide if they are going to do so.

Those Awful Banks

2011-11-05T15:45:00.003-04:00

It's remarkable the degree to which so many people from vastly different countries, backgrounds, and political inclinations all share a bitter and seething rage against the world's big financial institutions. Everyone hates big banks, and today's Bank Dumping Day is only one of many signs of that deep loathing.

Given this near-universal hatred of banks and bankers, the idea of providing them with taxpayer support is pretty much intolerable to most people. The widespread disgust felt about the US's TARP bailout of banks in 2008 provided fuel for both the Tea Party movement's popularity in 2010 and the Occupy Wall Street movement of this fall. In the eurozone, banks are reviled in the troubled periphery countries, where austerity measures are seen in part as a mechanism devised to shift the pain of the eurozone debt crisis from banks to the people. And in the core eurozone countries like the Germany, the public is understandably angry at the idea of having to provide funds to restore European banks to financial health thanks to the crisis.

The Financial Sector and the 1%

There are plenty of reasons for these intensely negative feelings about financial institutions. One of the most important may be the extraordinary concentration of wealth and power that has accumulated among the world's financiers over the past couple of decades. Income inequality in the US, for example, is almost entirely a story about the richest 1% pulling away from everyone else -- and a substantial portion of that richest 1% have the financial industry to thank for it.

In the US, the compensation paid to employees in finance, together with financial sector corporate profits, added up to close to $200,000 (in constant 2005 dollars) per each person working in the finance industry in 2010, according to BEA data (NIPA, section 6). In real terms this figure has almost doubled since the early 1990s, and more than tripled since 1980. By contrast, inflation-adjusted median household income in the US is unchanged over the past 20 years.

This remarkable rise in the fortunes of people working in the US's financial industry almost perfectly matches the rise in the income share going to the richest 1% of Americans. It's certainly possible that this correlation is spurious. But it's also natural to consider that perhaps this is not just a coincidence.

(Note: data on top 1% from Emmanuel Saez.)

The Story Behind the Numbers

What has driven this impressive concentration of power and wealth into the few hands that control the world's financial system? It's hard to escape being drawn toward the conclusion that the rules of the system have indeed been subtly, slowly changed over the last 30 years, simply because no alternative explanations seem to fit.

To see this, let me make four uncontroversial (I hope) observations:

The US's political system is far more dependent on financial contributions from super-wealthy contributors than it used to be.
Contributors tend to give more money to political actors that will do things that they like.
Since the US is a democracy, the US's political system establishes the rules of the game by which individuals and corporations must play.
Super-wealthy individuals in the US have grown even more super-wealthy over the past ~~two~~ three decades, and thus more able to fund the US's political system. (See point 1.)

Of course, there could be more than one possible explanation for this series of observations; they could be completely unrelated phenomena, for example. However, it's also possible that these phenomena do indeed have something to do with each other. All we need to do is posit some mechanism by which #3 above could have led to #4, and the logical loop is complete. My candidate would be this:

3.5: The rules pertaining to the financial system have been modified over the past two decades in such a way that it has facilitated the concentration of wealth and power in the financial sector.

And now we have a complete and consistent logical story of a self-sustaining cycle in which greater concentration of wealth leads to more political influence by the super-wealthy, which leads to rule-changes to their benefit, which leads to greater concentration of wealth. And the financial sector is the arena in which this cycle has largely been played out.

Whether or not you believe this story, it is a plausible one, and it should not come as a surprise that many people believe it. And I think this is exactly what lies at the heart of the anger and frustration felt by so many toward the finance industry.

Bailouts

And now we get to the fuel that has been repeatedly added to this already hot fire in recent years: the repeated use of taxpayer money to rescue big banks, both in the US and Europe. The latest plan to end the eurozone debt crisis has, as one of its core elements, a commitment of additional taxpayer money to help keep Europe's banks afloat; the string of bank bailouts continues.

The whole idea of using taxpayer funds to support the financial system is justifiably difficult to digest. Weren't the world's biggest financial institutions exactly the cause of the financial meltdown in late 2008? Aren't they also substantially responsible for the eurozone debt crisis through their unwise lending? And in between these various crises, haven't they been earning obscene amounts of money while crying foul any time they are asked to share it through higher upper-income tax rates? So why should taxpayers lift a finger to help the world's bankers in those instances when they've bet the wrong way?

The problem is that banks are absolutely essential to our economic system. Like it or not, they are special. This is largely the result of their unique ability to make loans, create money, and direct capital toward sectors of the economy that need it. Without financial intermediation, today's economy would immediately grind to a halt. The health of the world's economy is, without exaggeration, completely at the mercy of the banking sector.

And that is the icing on the cake. It's awful to contemplate that our basic economic system, and the very livelihood of most of us who participate in world's modern market economy, are crucially dependent on institutions that are so hard to understand, have done so much to concentrate wealth and power among the privileged few, and are directly responsible for financial chaos and crisis. But it's doubly awful to be forced to repeatedly bail them out under threat of widespread economic catastrophe, which is exactly what would happen in the absence of those bailouts. It really violates every fundamental notion of fairness.

The remedies for this situation are precisely those policies that the financial industry hates the most: significantly more government oversight, and/or mechanisms through which taxpayers can share in the benefits the financial sector brings during the good times. In the absence of such measures to rectify the basic unfairness of the current system, antipathy toward the world's financial industry will only grow. And with good reason.

Italy's Future

2011-11-02T07:52:00.001-04:00

Italy's Prime Minister, Silvio Berlusconi, is apparently going to propose some "shocking measures" in an attempt to get control of the downward spiral that the market for Italian government debt is currently experiencing. Most likely (thanks to the urging of Germany and France) these shocking measures will be composed primarily of sharp cuts in government spending.

This will fail to help. The market is not worried about Italian debt dynamics because of excessive government spending. It is not worried about Italian debt dynamics because of an excessive primary (i.e. excluding interest payments) budget deficit in Italy. It is worried about Italian debt dynamics simply and purely because of skyrocketing interest rate expenses that the Italian government is now facing thanks to the eurozone debt crisis.

In the table below I present three scenarios for the path of Italy's budget deficits and gross government debt (both as a % of GDP). Scenario 1 is the OECD's most recent forecast for 2012. To extend that baseline a bit, let's say that 2013 would look like 2012 in the absence of other changes. Note that the OECD's forecast is for Italy's debt/GDP ratio to remain roughly constant. Until very recently, there was no particular worry about the Italian debt burden getting out of hand. It is not at all obvious that under the baseline OECD forecast there is any particular urgency for Italy to reduce its budget deficit.

Scenario 2 illustrates why, even though the market is not worried about Italy's primary budget deficit (since Italy actually runs a primary surplus), it has good reason to be VERY worried about the recent rise in Italian borrowing costs. Suppose that in 2012 and 2013 Italy has to pay 250 basis points (i.e. 2.5%) higher interest rates than assumed in the OECD forecast. Suddenly Italian debt dynamics look very scary -- Italy's debt/GDP ratio, instead of remaining flat, will take off on a frighteningly familiar upward trajectory. (Hello Greece, here we come...)

Scenario 3 then supposes that the Italian government enacts dramatic cuts in government spending - let's say, cuts equal to 2% of GDP in both 2012 and 2013. Will that fix the problem?

The answer is clear: no. If anything, it will make the problem worse.

Cuts in government spending will be overwhelmed by Italy's higher borrowing costs, which are far, far greater in euro terms than any cuts in government spending that could realistically be acheived. And so Italy's budget deficit will still rise sharply. And if we assume that severe austerity will likely lead to a contraction in Italian GDP, as it has done in the UK, Greece, and elsewhere, then the trajectory of Italy's debt looks even worse with the cuts in government spending than it did without them. (I assume a government spending multiplier of 1.0 in this scenario.)

Austerity as a response to the recent rise in Italy's borrowing costs is exactly the wrong policy prescription. It misdirects attention from the real problem here, which is the self-fulfilling doom spiral in the debt market that Italy has gotten trapped in. The only way to break out of this cycle is to do something radical to change market expectations.

The ECB is the only institution that has such power right now. And yet it seems likely that they will sit on the sidelines, or even applaud Italy's austerity proposals -- the very proposals that are almost certain to make things worse rather than better.

Swiss Magic and Central Bank Price-Targeting

2011-10-31T19:30:00.002-04:00

You may recall that in September the Swiss National Bank (SNB) announced that it was going to intervene as necessary in the currency markets to ensure that the Swiss Franc (CHF) stayed above a minimum exchange rate with the euro of 1.20 CHF/EUR. How has that been working out for them?

It turns out that it has been working extremely well. Today the SNB released data on its balance sheet for the end of September. During the month of August the SNB had to spend almost CHF 100 billion to buy foreign currency assets to keep the exchange rate at a reasonable level. But in September -- most of which was after the announcement of the exchange rate minimum -- the SNB's foreign currency assets only grew by about CHF 25 billion. Furthermore, this increase in the CHF value of the SNB's foreign currency assets likely includes substantial capital gains that the SNB reaped on its euro portfolio (which was valued at about €130 bn at the end of September), as the CHF was almost 10% weaker against the euro in September than in August. Given that, it seems likely that the SNB's purchases of new euro assets in September after the announcement of the exchange rate floor almost completely stopped.

But why would the SNB's promise of unlimited intervention in currency markets have led to a near total cessation of those interventions? Didn't they say they would intervene more, not less?

This is a beautiful demonstration of the almost magical power that central banks can sometimes have when they target prices instead of specifying a certain quantity of intervention. Market participants correctly believed that the SNB's promise to keep the CHF/EUR rate above 1.20 was perfectly credible. As such, no one was willing to try to accumulate CHF at a price inconsistent with that floor. In fact, there has been some sense in the market that this 1.20 rate was going to be increased, which would guarantee losses for anyone holding CHF assets. As a result, market demand for CHF has fallen dramatically and the exchange rate has drifted up above the 1.20 floor set by the SNB -- all with little or no actual intervention required by the central bank.

This should be a reminder to other central banks that when they target prices by promising unlimited intervention, the market will often do most of the work for them and respect that price target out of its own self-interest.

So let's apply this lesson to another situation: the doom loop that the market for Italian debt seems to have entered. Imagine that the ECB declared an interest rate ceiling and stated that it would not allow the rate on Italian bonds rise above some clearly specified spread over German interest rates. (Obviously this should be at an interest rate consistent with long-run Italian solvency.) And imagine that the ECB backed up that interest rate ceiling by promising unlimited intervention to support it. Since the ECB can make good on that promise by simply creating more euro -- which it can do in unlimited quantities -- market participants would understand that there is no way they could break the interest rate ceiling set by the ECB. And as a result, it is entirely possible that the ECB could achieve its price target on Italian debt with minimal intervention, just as the SNB achieved with its exchange rate floor.

What's preventing the ECB from doing that? Caution, conservatism, and politics, of course. But the Swiss Franc experience reminds us that, from an economic perspective, price targeting by a central bank can sometimes make very good sense.

Worrying Signs

2011-10-28T07:39:00.001-04:00

I don't like seeing stories like this just a day after the eurozone's latest and greatest rescue plan was announced:

Italian borrowing costs surge in lacklustre auction

Italy issued 10-year debt on Friday but paid the highest price since joining the euro as investors demonstrated scepticism over the centre-right government’s economic reform programme in the first bond auction in the region since new steps were agreed to tackle the eurozone debt crisis.

...The yield on Italy’s March 2022 bond rose to 6.06 per cent from 5.86 per cent a month ago. The sale of the 10-year bonds was covered less than 1.3 times, but demand for the total sale of medium and long-term paper was sufficient for the Treasury to raise €7.94bn – at the top end of its target range. The yield on a three-year debt maturing in July 2014 rose to 4.93 per cent, at its highest since November 2000, compared to 4.68 per cent at an end-September sale.

“All in all, today’s auction was not very satisfying,” said Annalisa Piazza at Newedge Strategy. “Although the EU summit welcomed the new measures the Italian government is planning to implement in the next eight months to ‘change’ the economy, markets remain sceptical about the outcome.”

Officials recognise that yields at this level are unsustainable in the long term with Italy needing to roll over more than €250bn next year to finance its €1,900bn debt burden amounting to 120 per cent of gross domestic product...

Meanwhile, the ECB has apparently been forced to buy up more Italian debt on the secondary market since the new eurozone rescue plan was announced. But because of the ECB's obvious reluctance and the backwards way that they've structured their bond-buying program, such purchases probably have very little effect, other than to reinforce market skepticism about Italian debt.

I've argued repeatedly that the ECB can and should assume full responsibility for ending this crisis, and that it should be targeting interest rates on the secondary markets for Spanish and Italian debts. Paul De Grauwe articulates this reasoning perfectly in a column this week, and more generally expresses how painful it is to watch the ECB make mistake after mistake:

There is no sillier way to implement a bond purchase programme than the ECB way. By making it clear from the beginning that it does not trust its own programme, the ECB guaranteed its failure. By signalling that it distrusted the bonds it was buying, it also signalled to investors that they should distrust these too.

Surely once the ECB decided to buy government bonds, there was a better way to run the programme. The ECB should have announced that it was fully committed to using all its firepower to buy government bonds and that it would not allow the bond prices to drop below a given level. In doing so, it would create confidence. Investors know that the ECB has superior firepower, and when they get convinced that the ECB will not hesitate to use it, they will be holding on to their bonds. The beauty of this result is that the ECB won’t have to buy many bonds.

I am not impressed by the direction in which things have been heading in Europe this week. My sense is that, like me, many financial market participants have been suffering from so much 'crisis exhaustion' that they were willing to give this week's rescue package the benefit of the doubt and believe that it was in fact sufficient to permanently put things on a stable footing. Everyone wants this crisis to be over. But the inadequacies of the plan are real, and will only become more apparent over time. I hate to say it, but I fear that we haven't reached the final fix yet.

Liquidity, Solvency, and Competitiveness

2011-10-25T18:27:00.000-04:00

Kantoos considers whether it is obvious that the eurozone debt crisis is, at least with respect to Spain and Italy, merely a liquidity crisis and not an issue of fundamental insolvency:

The problem is how to distinguish a multiple-equilibria situation from cases of genuine one-equilibrium insolvency – especially for countries as the future capacity to repay is not based on assets in a narrow sense but on the expectation of future economic growth.

...For Italy and Spain, there is a reasonable chance that it is in fact a self-fulfilling liquidity problem, but – and that was my main point – it is by no means certain. A backward-looking remark about Italy having a primary surplus is just not enough to make your case and Henry’s analysis is not encouraging.

A few points. First, take a look at the following chart that shows the debt/GDP ratios for a number of major European economies. See if you can tell which country is Spain. (All data is from Eurostat.)

If the markets believed that Spain (the blue line) is fundamentally insolvent -- or even at risk of becoming fundamentally insolvent in the foreseeable future -- then wouldn't such solvency concerns have also hit the debt of Germany, France, and the UK? (Those are the other three lines in the chart.) Given this, it seems overwhelmingly likely to me that the market's nervousness about Spanish debt is of the nature of a self-fulfilling "illiquid-but-solvent" crisis.

And what about Italy? Italy's debt/GDP ratio is indeed high -- over 100%. But that ratio has been over 100 percent for the past 20 years, so that's nothing new. And in recent years, Italy's budget deficit has been relatively small, as seen below.

Again, it seems far from obvious from this why market participants would have become worried about Italy's insolvency but not that of France or the UK.

There are two factors that Spain and Italy do have in common, however, that sharply distinguish them from France, Germany, and the UK. The first is that they do not have a central bank to provide unlimited liquidity to the government if necessary. The UK clearly does, by contrast, and I think most people would expect that the ECB would also perform that function for Germany if necessary. France is in a bit of a grey area there, which is exactly why the markets have inserted some additional risk premium into French government bond yields in recent months.

The second factor is the long run issue that Kantoos draws attention to: the competitiveness problem. The UK has no such problem, because its flexible exchange rate will automatically adjust its competitiveness to match the amount of financing it is able to attract; if investors become less willing to finance the UK's debt, the pound will lose value and the UK will start to gain competitiveness. Germany has no such problem, because it has undergone a steady improvement in its relative competitiveness ever since the adoption of the euro. And France is much closer to Germany than to Italy as far as competitiveness goes.

But where I would disagree with Kantoos is his assessment that Germany's improvement in competitiveness during the euro period was policy-driven, and that Italy and Spain's competitiveness problems are the result of their unwillingness to tackle the problem.

The changes in competitiveness in each of the eurozone countries during the years leading up to this crisis were driven by capital flows within the eurozone. Countries that received large capital inflows saw their prices rise in relative terms and their competitiveness worsen, which in turn helped to bring about the current account deficits that are the counterpart to those capital inflows. Conversely, countries that sent capital abroad saw their relative prices fall and competitiveness improve, for the same reason. Policy had little to do with competitiveness changes; they were a macroeconomic necessity entailed by the flow of capital from capital-rich countries like Germany to capital-poor countries like Spain.

The following table ranks the major eurozone countries in order of their current account balances between the adoption of the euro in 1999 and the onset of the financial crisis in 2008. Using total changes in the price level to provide a quick-and-dirty estimate of changes in competitiveness, it's clear that the relationship between the two is very strong -- countries that experienced capital inflows saw their price levels rise and their competitiveness worsen. The implication is that in the absence of policies to stem the inflow of capital, there was probably nothing they could have done to prevent that.

To summarize: Spain and Italy seem quite clearly to be the victims of a self-fulfilling illiquid-not-insolvent sort of crisis. They are in this situation because the markets have doubts about the willingness of a central bank to provide unlimited liquidity, unlike the case with Germany or the UK. And in addition they face a competitiveness gap with Germany that has arisen not out of any specific policies in Germany, Spain, or Italy, but that instead is the direct result of the massive capital flows from the northern eurozone to the southern eurozone that took place during the 2000s.

The eurozone therefore faces both a short run problem (the self-fulfilling liquidity crisis) and a long run problem (the competitiveness issue). There are fairly clear policy prescriptions for both. The primary question at this point is whether Europe's policy-makers will act on them.

The ECB: Unwilling Saviour

2011-10-25T07:33:00.002-04:00

Joseph Cotterill at FT Alphaville reiterates an important theme today: the solution to the eurozone crisis really rests with the ECB.

The ECB is not here to save the world

...You might quibble with some parts of the plan [for much greater ECB support to eurozone sovereigns] but at least it is very clear about its starting point, the ECB. And of course many analysts have been calling for crisis solutions to move on from the EFSF’s finite balance sheet, to making use of the ECB’s omnipotent, effectively limitless balance sheet. Think of all the deep pockets of seigniorage, oodles of liquidity, et cetera. Only the ECB can absorb the quantum of sovereign losses, other analysts argue.

We definitely wouldn’t say this argument is wrong, or unworkable...

However... What we will say is that the ECB would never go along with it – based upon what the ECB has been doing so far.

...Frankly, at this point we’re open to theories on why the ECB has resisted the calls to provide sovereign liquidity.

The ECB is really the only institution that can establish a backstop in eurozone sovereign debt markets that is completely credible. This would be especially effective if the ECB targeted an interest rate for Spanish and Italian bonds rather than a quantity of intervention, as I've suggested previously.

But there's another reason that it would be appropriate for the ECB to be at the heart of the solution. In a recent paper (pdf) Paul DeGrauwe points out that an essential ingredient to the crisis is the fact that the adoption of the euro meant that sovereign nations in the eurozone could no longer borrow in their own currency. As he puts it, "in this sense member countries of a monetary union are downgraded to the status of emerging economies." The difficulty this creates is that since the central banks of these countries can no longer provide unlimited domestic currency liquidity to the government, default becomes a possibility in a way that it was not before euro adoption.

The solution to this flaw in the system is to have the new, joint central bank -- the ECB -- take up the role that individual central banks previously had of ensuring that their own government would never have to default on domestic currency debt simply due to liquidity problems. If the ECB were to assume that role today, default would be completely taken off the table as an option for investors to worry about in the markets for Spanish and Italian debt, which would guarantee that this crisis could no longer spin out of control as it is currently threatening to do.

Regardless of whether European leaders agree use the ECB as the immediate solution to the crisis, I would argue that if the eurozone is to survive in the long run, the ECB is going to have to be explicitly granted the authority -- and indeed the responsibility -- for doing just that. If they want to have a common currency and all of its benefits, the eurozone countries need to accept the drawbacks that come with it. And one of those drawbacks is that the ECB will have to not just be the guardian of the eurozone's inflation rate, but will also have to be an effective guardian of Europe's financial system, even at the potential cost of slightly higher inflation during certain limited episodes.

But as Cotterill points out, there is very little chance that the ECB will actually agree to take on this role. So do not expect this crisis to come to a neat conclusion this week.

Hoping that the Minimum is Enough in Europe

2011-10-24T07:57:00.003-04:00

The headline of this New York Times story is somewhat at odds with the substance of what happened this weekend in Brussels regarding the eurozone debt crisis:

European Leaders Deal Directly With Debt Dilemma

BRUSSELS — With a new sense of urgency, the leaders of the 27 European Union nations grappled directly on Sunday with their thorniest financial and economic problems, and made progress that they promised could yield a complete package of measures within days.

The hope is that the seriousness of the leaders’ effort to finally solve the interrelated problems of Greek debt, weakened banks and a bailout fund in need of reinforcement will keep speculators at bay when the financial markets open on Monday morning. But now there is heavy pressure on the leaders to deliver the goods at their next meeting, set for Wednesday.

There are three reasons that I've gotten a slightly sinking feeling as I've been reading news reports about the progress that was made this weekend.

1. The EFSF. The heart of the matter to be decided is how to increase the resources available within the EFSF to support the sovereign debt markets for Spanish and Italian debt. That has always been the most difficult part of the puzzle to build, and based on reports from this weekend, we still seem to be no closer to knowing what approach they will agree on, or even if they will be able to agree in the first place. At least eurozone leaders did use impressively vigorous language to reiterate that they are indeed determined to reach an agreement. So that's something.

2. Bank recapitalization. Eurozone leaders have decided that EU banks will need a capital injection of €108bn:

Banks must find €108bn in new capital

Europe’s big banks will be forced to find €108bn of fresh capital over the next six to nine months under a deal to strengthen the banking system that is to be unveiled by European Union leaders.

This seems low to me. The IMF has estimated that the EU's banking system will take a hit of closer to €200bn as a result of the debt crisis, and I would have been somewhat relieved if the EU had agreed on a number closer to that. €108bn may be enough money, particularly if there's a robust and significantly large mechanism put in place to defend the Spanish and Italian sovereign debt markets, because in that case banks may actually realize relatively few losses on those bonds. But a larger bank recapitalization promise would have provided reassurance that eurozone policy-makers understand the scope of the problem and are willing to get ahead of it, rather than simply trying to fix things as cheaply as possible.

3. Common purpose. Or more accurately, the lack of it. Everything I've read about the forthright but also acrimonious debate this weekend suggests to me that European leaders continue to be focused primarily on making sure that their own country pays the smallest share of the costs possible. No one has stepped up as an advocate for the common project of the euro. No country has taken on the leadership role of being willing to accept a higher burden of the costs for the common good. And now it is clear that no one is going to. Without any sign that the eurozone's political leaders are going to change their mindset and think first about the collective good and second about their own country, I am left with the feeling that the delays and inadequate responses to the crisis will continue. With each country narrowly focused on its own parochial interests, a resolution to the crisis is still certainly possible; but the brinksmanship that it will involve will make it difficult for financial markets to feel soothed by the process.

A crisis of confidence such as this can be resolved when financial markets are persuaded that policy-makers will do absolutely everything necessary to ensure that worst-case scenarios never come to pass. Unfortunately, this weekend's Brussels summit provides us with more evidence that instead of being willing to do whatever is necessary to avert catastrophe, Europe's political leaders are going to continue to try to do the minimum possible to contain the crisis.

So now we wait for their next meeting on Wednesday. And hope that their estimate of the mimimum possible will be enough.

Greece at its Limit

2011-10-20T18:34:00.000-04:00

It seems that the ECB's thirst for austerity-punishment for Greece has not yet been fully slaked. From the FT:

Troika warns time running out for Greece

Greece should get its next €8bn in international aid, but its economic outlook is deteriorating so rapidly that the second bail-out plan, agreed just three months ago, is no longer adequate to keep Athens afloat, international lenders have determined.

The findings are part of a highly anticipated report by the so-called troika of Greek lenders – the European Commission, International Monetary Fund, and European Central Bank – and sent to eurozone countries on Thursday morning. The Financial Times obtained a copy of the report.

...Part of the reason for the delay is a standoff between two of the members of the troika – the IMF and ECB – over whether Greece can keep paying its debts without taking more stringent austerity measures. The ECB has taken a tougher line, while the IMF has urged more leniency.

The Greek parliament just passed the previously agreed-to package of tax increases and spending cuts. But I am willing to bet that it is the very last round of austerity measures that Greece will be able to enact. Here are excerpts from Gavin Hewitt's gripping column from yesterday:

Athens erupts over austerity cuts

Athens was expecting violence. The expectation of it hung in the air. It is all people have spoken of in recent days. Even tourist hotels some distance from the parliament were boarding up. As a 48-hour general strike took hold shopkeepers were hammering in place steel shutters. The fear that emerged in hushed conversations was that there could be serious casualties. Such is the rage, the frustration that has built over months.

...I joined some students heading for the parliament. They are outraged that schools have a shortage of books. One young man said to me that he was not prepared to see decades of social progress sacrificed to satisfy the European Union and the IMF. Some waved banners with Che Guevara's picture. Then the column stopped, and from the left marched builders, arms linked, carrying poles with red flags on top. They walked with purpose. They have seen the construction industry collapse.

Then metal workers and teachers. It seemed at times as if the whole city was on the move. ...Marches and skirmishes soon became running battles across the capital But the numbers kept coming; great rivers of protesters.

...And with the marchers came young men and women in black hoods and masks. They began tearing at a wire fence that the police had slung across the road at the side of the parliament.

When eventually the police lost patience and fired the first tear gas grenade, the sound echoed across Syntagma Square and the crowd cheered.

There is a sense here that this is the key battle if spending cuts and wage increases are to be defeated.

Then skirmishes became running battles. Some of the anarchists had petrol bombs that snaked through the air falling around the riot police. They replied with volleys of tear gas and stun grenades.

...Europe's leaders had insisted that in exchange for bailing Greece out, it had to slash its deficit. The Greek foreign minister told me on Tuesday that no European country had ever tried such cuts in such a short space of time.

But seeing the vast numbers on the street, the government ministries occupied, the violence, it has to be asked whether Greece can impose these new austerity measures.

And if it can't, will the EU and IMF go ahead with the next tranche of bailout money. The so-called troika (the EU, IMF, the ECB) is delivering its report this week. Without the next 8bn euros ($11bn; £7bn) Greece will be unable to pay its bills within weeks.

But the mood has hardened here. There is less fear of default.

The finance minister said on Wednesday that "what the country is going through is really tragic".

Greece will continue to miss the deficit targets set by the troika. The ECB can continue to demand that Greece raise taxes and cut spending by even more, but further austerity-punishment will not help. At some point very soon Germany is going to have to make a simple decision: does it, for its own self-interest, come up with the money needed to fix this crisis, irrespective of what's happening in Greece; or does it say no, and elevate the crisis by an order of magnitude. I wish I had confidence in the answer.

UPDATE: Lifted from the comments:

petercorner: I can't help but notice the parallels between the Versailles treaty reparations, and what the [ECB] wants from Greece - to quote Keynes:
"The policy of reducing Germany to servitude for a generation, of degrading the lives of millions of human beings, and of depriving a whole nation of happiness should be abhorrent and detestable -- abhorrent and detestable, even if it were possible, even if it enriched ourselves, even if it did not sow the decay of the whole civilised life of Europe."

Where Exactly Are Those Lazy Southern Europeans, Anyway?

2011-10-20T08:00:00.006-04:00

The northern eurozone countries are facing the prospect of coming up with massive amounts of additional funds to avert the collapse of Europe's financial sector. There have been some hints from various sources that a major and decisive agreement will be reached this weekend... though if the eurozone crisis has taught us anything, it is that one should never underestimate the power of European policy-makers to dither and delay beyond all reasonable expectations.

At any rate, lots of people (primarily but not exclusively in northern Europe) are very angry about the massive cost of fixing the eurozone mess. Understandably so. But unfortunately, much of that anger has been specifically directed at those lazy, shiftless, irresponsible southern Europeans that are seen to have gotten the eurozone into this mess to begin with. It's not difficult to find such finger-pointing expressed in the statements of prominent European officials, or in commentary on blogs and news sites.

I've repeatedly argued that I strongly disagree with this placement of blame; the eurozone crisis was fundamentally caused by the massive flow of capital from the north to the south of Europe that was bound to happen once the euro was adopted, and the specific behavior of individual governments in southern Europe had little to do with it. But I realize that this is a relatively abstract economic argument -- albeit one with substantial theoretical and empirical support. Stories of impersonal capital flows somehow don't address the gut feeling that lots of people have that southern Europeans really are less hard-working and responsible than northern Europeans, and that those laid-back southern attitudes must have caused the crisis.

I understand that gut feeling. That's part of what people like about southern Europe, after all -- things there do tend to move more slowly than in the north. But sometimes that gets confused with inefficiency and laziness, and turned into a moral judgment.

For some people, such judgments can be traced back to their own experiences... such as that day on vacation somewhere in southern Europe when they suffered through terrible service at a restaurant, got food poisoning, found that every pharmacy was closed for an extended lunch break in the middle of the afternoon, and then attempted navigate an incredible amount of paperwork and government bureaucracy to register a simple complaint. (No, I'm not speaking from personal experience at all. Why do you ask?)

In other cases the moral judgment of the south is probably more abstract and theoretical, and is simply following in the tradition of Weber's Protestant Ethic and the Spirit of Capitalism. Suspicion of the character of southern Europeans is not at all new.

But either way, being the economist that I am, I've been looking for some data to provide more insight into what lies behind this notion that southern Europeans are indeed a bunch of lazy free-loaders. Here's what I've found so far. Note that each table shows four northern eurozone countries and then four southern eurozone countries. Data is from the OECD.

Southern Europeans tend to work more hours each year than northern Europeans. But perhaps this is made up for in the north by greater participation in the labor force...

No, with the exception of Italy, it appears that the percentage of the population that is an active part of the labor force is generally similar to labor force participation rates in northern Europe. Germany appears to compensate for the few hours that its people work by having more people working in the first place.

So let's turn to the productivity of that labor. We know that labor in southern Europe has always been less productive than in northern Europe (for the past few centuries, anyway)... but have they been falling even further behind?

Labor productivity grew incredibly rapidly in Greece in the years leading up to the crisis. Even much-maligned Portugal enjoyed improvements in labor productivity roughly equal to northern Europe. Interestingly, it was Spain and Italy -- two southern European countries that did not run particularly large budget deficits (Spain even ran a budget surplus), and for which capital flows from northern Europe financed private investment rather than government spending -- that lagged in productivity growth. This again calls into question the common notion that large budget deficits in southern Europe are to blame for the crisis.

Now let's look at the social welfare system. In addition to being lazy, southern Europeans are accused of simply living off the state. So here's the amount of social welfare spending per capita:

Northern European countries give their people considerably more state assistance than do southern European countries. Greece and Portugal give by far the least, though we must recognize that incomes in those countries are much lower in general. But even Italy provides less social support to its citizens on a per capita basis than any of the northern European countries, and in 2007 Italy's per capita GDP was about the same as France's.

Just to be sure, though, let's take a look at a specific kind of public assistance expressed as a percentage of GDP: state pensions.

With this measure Italy does indeed appear to spend more on pensions than northern European countries. Of course, Italy also has one of the oldest populations in the world on average, which might explain that difference. Regardless, pensions in the rest of southern Europe are not particularly generous, even relative to income, when compared to northern Europe.

Putting it all together, it's hard to see much empirical support in this data for the notion that southern Europeans are a bunch of lazy free-loaders. That's not to say that there aren't obvious cases of gross inefficiencies in southern European countries -- of course there are. And there are probably other types of data that I haven't thought of that should be examined as well. Feel free to offer suggestions. I've focused on the types of data that, to me, most obviously and directly speak to the common criticisms of southern Europeans, but perhaps I've missed something.

Alternatively, maybe there really isn't a systematic difference in how hard-working, responsible, or self-reliant southern and northern Europeans are. After all, it is also possible to find plenty of examples of opaque government bureaucracies, entrenched unions, and extremely generous state assistance in the northern eurozone countries. So the next time someone asserts that southern European irresponsibility is what lead to this crisis, I would simply ask to see the data they have to support that claim.

China's Inflation Rates: Signs of Market Imperfections

2011-10-18T06:40:00.013-04:00

Ryan Avent points out that if one uses a different measure of inflation in China to convert its nominal exchange rate into a real exchange rate, the Chinese yuan (CNY) has actually appreciated quite a bit in real terms in recent years. Using China's GDP deflator instead of the CPI, in fact, the CNY has appreciated in real terms by close to 50% since 2005. Using the CPI the other day I had calculated the real appreciation to be much smaller.

The larger figure obtained using the GPD deflator provides a reassuring confirmation of our priors, but it raises a very interesting question: why are the two measures of China's inflation rate so different? As seen in the chart to the right, the GDP deflator has been consistently rising much faster than the CPI in China. Why?

While there are many differences in how the two measures of inflation are calculated, the biggest and most relevant distinction in this case is that the CPI only measures the prices of things that consumers buy, while the GDP deflator also measures the prices of things that non-consumers -- i.e. businesses, the government, and the foreign sector -- buy.

Let's make the (reasonable, I hope) assumption that consumers buy more services than goods, while non-consumers buy far more goods than services. Combining this assumption with the distinction noted above tells us that the prices of tradable goods have been rising much faster than the prices of locally-provided services in China. And this has three important implications.

1. Manufacturing wage growth in China outpaces productivity growth.
For simplicity, let's think of China's economy as producing two types of goods: tradables (i.e. manufactured products) and non-tradables (i.e. services). We typically think of wages as being equal to the marginal revenue provided by labor, that is:

(1) w^t = p^t * MPL^t

where 'w' stands for wages, 'p' is the price level, 'MPL' stands for the marginal product of labor, and the 't' superscripts indicate that variables pertain to the 'tradable' sector of the economy. If w and MPL in the tradable sector both rise at the same rate, then p^t should remain constant. The fact that p^t has been rising indicates that wages are rising faster than productivity in this sector of the economy.

This in turn raises its own interesting question: why are wages rising faster than productivity in China's manufacturing sector? This apparently violates classical labor market assumptions. While I don't pretend to be an expert in China's labor market, I suspect that this is a form of catch-up. Prior to China's great economic growth of the past 15-20 years, wages in the manufacturing sector were far below what worker productivity would normally have warranted in the absence of market imperfections. (My guess is that this was due to the communist, command-economy system that dominated in China prior to the 1990s, which kept wages artificially depressed.) And what we've been seeing over the past 10-15 years is the process of that discrepancy being corrected.

This ties back to an argument I have previously made that the incredible movement of manufacturing to China that has happened over the past two decades was a once-in-a-lifetime event, in which multinational firms could essentially take advantage of an arbitrage opportunity in China that existed because labor in China was cheaper than its marginal product. That difference between wages and productivity in China is now rapidly being arbitraged away.

2. There is poor intersectoral labor mobility in China.
The fact that the prices of manufactured goods in China are rising faster than the prices of services also tells us that there must be poor labor mobility between China's manufacturing sector and its services sector. How can we infer that? Take a look at an equation similar to (1) above, but for the non-tradables sector of the economy:

(2) wⁿ = pⁿ * MPLⁿ

We know that pⁿ is rising more slowly than p^t. There's a mountain of empirical evidence that tells us that MPLⁿ almost always rises more slowly than MPL^t, i.e. that labor productivity grows faster in manufacturing than in services. Putting those together, it must be the case that wⁿ is growing more slowly -- much more slowly, in fact -- than w^t.

But if workers could move between the tradable and non-tradable sectors of the economy, they would equalize wages between them. So we can reasonably conclude that workers can NOT move between the two sectors of the economy. This corresponds with casual observation in China (manufacturing jobs are highly prized in China, but not available to everyone), but it is a sign of an important labor market imperfection that we must keep in mind.

3. The real appreciation of the CNY may be near an end.
We've now established that wages are growing faster than productivity in the manufacturing sector in China, and that workers can not easily move between the manufacturing and service sectors of China's economy. This has an important implication for China's real exchange rate.

Developing countries typically experience trend appreciations in their currencies as they become more developed. This is explained by what's widely referred to as the Harrod-Balassa-Samuelson (HBS) effect. The HBS effect can be summed up like this: relatively low productivity gains in the services sector compared to the manufacturing sector means that the relative price of services in the developing economy rises. This raises the overall price level in the developing economy relative to where it used to be (and relative to its trading partners), causing a real appreciation of the currency. The Economist article that Ryan refers to in yesterday's post cites the HBS effect as one reason why inflation in China has been and should be higher than inflation in other countries.

But inferences #1 and #2 above directly contradict the underpinnings of the HBS effect. Instead of experiencing faster inflation in the services sector as the HBS story predicts, China is experiencing faster inflation in the manufacturing sector. And instead of labor mobility equalizing wages between the two sectors of the economy, there are clearly barriers that prevent that in China.

This means that the HBS effect does not apply to China, and can not be expected to drive a continued real appreciation of the CNY. China's currency has indeed undergone a real appreciation in recent years, though as Ryan correctly pointed out, exactly how much depends greatly on which inflation measure you use. (Please see this paper by Menzie Chinn for an excellent primer on which inflation rate to use when calculating real exchange rates. In short: there's no single right answer.)

But the real appreciation of the CNY over the past several years seems to have been driven by the catch-up of manufacturing wages with manufacturing productivity. And that means that once that catch-up process is complete -- i.e. once the difference between labor's productivity and wages has been arbitraged away -- this mechanism for real appreciation will go away. Given the various distortions and imperfections in China's labor markets that this simple analysis can illuminate, I hesitate to have faith that market forces will solve the problems of China's massive imbalances, either internal or external.

Does the euro need Greece more than Greece needs the euro?

2011-10-15T10:18:00.007-04:00

Gavin Hewitt puts it another way in his most recent column, but that's basically the question he's asking:

Eurozone debt crisis: Greece's wild card

When the G20 finance ministers gather in Paris they face a stark fact: that nearly a year and a half since Greece received its first bailout, the crisis remains unresolved. Europe's leaders will be asked yet again what they are going to do with Greece.

...But there is another factor in all this, a wild card: the Greek people. It is just possible that the Greek people will have their say, that they will simply refuse to go along with austerity plans demanded by outsiders, their creditors.

What happens if a people simply says "no"? What happens if, through many small and not-so-small actions, they sabotage the plan?

I think of it like this: Greece and the core eurozone countries (Germany, France, etc.) are in the process of trying to apportion the additional costs of fixing the crisis. Is local austerity ("punishment" is a more accurate term in my opinion) going to be the main mechanism to pay for the solution, or will the crisis mainly be solved through direct assistance from Germany and France? So far the costs of this crisis have been mainly borne by the Greeks through austerity-punishment, but there's a limit to how much of that can be imposed. To better understand who will pay the additional costs of resolving this crisis, it's helpful to think about the incentives each side has to voluntarily shoulder the burden.

Greece

Yes, of course Greece has some awfully compelling reasons to try to avoid a unilateral default on its debt, and to shoulder some of the cost of avoiding that outcome. If at some point Greece is forced into unilateral default, it will face the prospect of losing all further financial assistance from the rest of the EU, a run on domestic banks and complete shutdown of its financial system, an immediate inability for the Greek government to pay all of its bills (even excluding interest payments), and a wave of Greek corporate bankruptcies. As I've argued before, I think that this would very quickly lead to Greece issuing its own domestic currency (which would probably operate in parallel with the euro rather than replacing it). And that would lead to rapid inflation, depreciation, and a drop in Greece's purchasing power. In a nutshell, the outcome for Greece would be very bad. So Greece undeniably has a strong incentive to comply with Germany's demands for continued austerity-punishment.

But keep in mind that once the trauma of unilateral default and the introduction of a new local currency has faded a bit, Greece could be in a very good position to stage a strong economic recovery. Argentina has pointed the way as far as that goes. So while that prospect doesn't mean that unilateral default would be a good outcome for Greece, it does mean that it's a dark cloud with a silver lining, and therefore a slightly less-bad option than it would otherwise be.

The Eurozone

But the outcome for the rest of the eurozone countries could be equally devastating. The main problem they face is that markets are looking to Greece for information about what the core eurozone countries are willing to do to keep the eurozone together. If Greece is allowed to unilaterally default, the markets will have their worst fears confirmed -- that the core countries are willing to allow other eurozone countries default and effectively exit. European financial markets will immediately be devastated by contagion as a massive selloff in Spanish and Italian debt quickly pushes weak eurozone banks to the brink of collapse. The eurozone will face the prospect of having to come up with perhaps in excess of a trillion euro to support the Spanish and Italian government debt markets and to rescue the entire European banking system from collapse.

It is difficult to overstate the seriousness of the crisis that would hit European financial markets in the wake of a unilateral Greek default, I think. This gives France and Germany an enormous incentive to bail out Greece -- for their own pure self interest.

If on the other hand the core eurozone countries actually do come through with sufficient funds to finally resolve the Greece issue, then all of a sudden markets will have important evidence that the core countries are indeed determined to do whatever is necessary to keep the eurozone whole. Put simply: if Germany is willing to pay up to keep Greece in the system, then it's pretty likely that it will also do what is necessary to keep Spain and Italy in the system. Investors' fears are soothed, and contagion largely goes away.

When Greece Hits its Limit

Given this, I would actually argue that the eurozone needs a Greek rescue more than Greece does. At some point soon -- if it hasn't already -- Greece is going to reach its limit regarding the austerity-punishment it is willing to accept. The Greek government will continue to miss deficit reduction goals set by the ECB and Germany, and will be unable to raise additional taxes or cut government spending further without the Greek people triggering the government's complete collapse. And given that this crisis is largely the result of forces beyond Greece's control, I wouldn't really blame them.

When that happens, Germany and France are going to have to think very, very carefully about their response. The immediate reaction of a lot of people at that point will be to throw Greece to the wolves. But if more sober heads prevail, the sort of reasoning I've outlined here suggests that it will be in the eurozone's own interest to swallow its pride and hand over whatever amount of money it takes to keep Greece in the system.

Inflation and Real Exchange Rates in China

2011-10-14T08:00:00.004-04:00

China's exchange rate policy has been in the news quite a bit recently, thanks to the US Senate's action this week to try to punish China for it. Putting aside the legal issues for a moment, it has been noted by various observers (e.g. Matt Yglesias) that the problem of China's undervalued exchange rate is at least partially resolving itself over time. This week's Economist picks up this theme:

And now, protectionism
America’s latest anti-China bill tackles a problem already being solved

...The problems this bill purports to address are already being resolved. The Economist has long argued that a flexible yuan is in the interests of both China and its trading partners. It would hasten the reorientation of China’s economy from exports to consumer spending, give its central bank more freedom to fight inflation, and divert demand to depressed Europe and America, catalysing an essential rebalancing of the global economy.

Belatedly, China recognises this. Since June last year the yuan has appreciated 7% against the dollar. The rise in China’s relative costs has been even greater given its higher inflation rate. With stimulative fiscal and monetary policy bolstering domestic demand, China’s current-account surplus has shrunk by two-thirds, from 10% of GDP in 2007. Meanwhile America’s trade deficit has narrowed, and manufacturing employment has stopped falling. All this means the yuan is far less undervalued than it was a few years ago—if at all.

If you had asked me yesterday how much the yuan (CNY) had appreciated against the dollar since China released the yuan from its long-standing peg of 8.28 CNY/USD back in 2005, I could have told you that the CNY is now about 20% stronger in nominal terms. But then I would have been quick to add that since inflation in China has been considerably higher than in the US, in real terms -- i.e., in terms of actual purchasing power once inflation is accounted for -- the CNY has probably appreciated by more like 30% to 40%.

It turns out I would have been pretty badly wrong. Last night I pulled data from Principal Global Indicators (an excellent multi-country data site, by the way) on actual inflation in China and the US over the past few years, and this is what the consumer price index looks like in each country (try to look past the terrible seasonal fluctuations in the Chinese data):

It turns out that, at least according to official statistics (and yes, we probably need to take them with a large grain of salt), consumer prices in China have risen only by a total of only 6.7% more than prices in the US since 2005. The inflation differential that had loomed large in my mind is not so great after all.

In addition to the possible unreliability of Chinese inflation statistics, there may be a second explanation for the fact that Chinese inflation has been less different from US inflation than I imagined: changes in consumer prices in both countries since 2005 have been largely driven by changing energy prices. So for example, the US CPI is currently up almost 4% over a year ago thanks to higher energy prices (excluding energy prices, US inflation remains very modest) -- and China has experienced a bulge in its own inflation rate at the same time, in part for exactly the same reason. Similarly, the collapse in energy prices in late 2008 and early 2009 caused inflation rates in both countries to plummet at the same time. In short, the role that energy costs play in consumer price inflation in both countries may explain why inflation rates in the US and China have tracked each other surprisingly closely in recent years, as shown below.

The result is that when the consumer price index is used to measure inflation differentials between China and the US (and yes, I know that the CPI is not the ideal inflation measure to use for that, but Chinese inflation data is woefully limited, and as economists we're forced to look where there's light), the Chinese currency's real exchange rate has only appreciated a little bit more than the nominal exchange rate. The final picture below shows both series, setting January 2007 = 100.

So clearly my guess that China's currency has appreciated against the dollar in real terms by 30% to 40% would have been pretty far off. The real answer is that the real appreciation of the yuan is only a few percent more than the nominal appreciation. Put another way, almost all of the movement in China's real exchange rate has been due to movements in the nominal exchange rate.

So if you're looking for China's undervalued yuan to correct itself over time, you can't count on inflation differentials to do much of the work, at least based on the experience of the past few years. Any significant changes in China's real exchange rate are probably going to have to come from further changes in the nominal CNY/USD rate.

Europe's Farm Subsidies

2011-10-12T07:54:00.005-04:00

It seems that the European Commission wants to change how its Common Agricultural Policy (CAP) is run. Or at least how it's marketed. From the BBC:

EU plans CAP reforms for 'greener' farm subsidies

The European Union has announced plans to reform its Common Agricultural Policy - its most expensive scheme, and one of the most controversial. The CAP cost 58bn euros (£51bn; $80bn) last year - 47% of the whole EU budget.

The European Commission does not want to cut the budget, but change its priorities - including linking direct payments to environmental measures.

I find this fascinating, for a couple of reasons. First, amidst all of the current discussion about the merits of additional fiscal federalism in the EU -- i.e. whether increasing the independent taxation and spending power of the EU might be the best way to deal with the ongoing eurozone crisis -- this serves as an important reminder of the current state of affairs in that regard. The EU does have its own budget, and does get to spend money on EU-wide priorities. The problem is that its budget is very small: only about €140 billion in 2011 for the entire 500 million people in the EU -- roughly the same as government spending in Denmark alone (population 5 million). And of that tiny budget, almost half is devoted to agricultural subsidies.

Given such a small budget to begin with, it has always seemed very odd that so much of it is consumed by subsidies to farmers. And the EU is apparently a bit self-conscious about that fact: farm subsidies are described as spending for the "preservation and management of natural resources" in the EU's budget planning documents. (Note the reassuring green color on the pie chart.) And they rather defensively note in their FAQs that the share of the EU's budget that has been devoted to farm subsidies has been steadily falling.

Why have such large agricultural subsidies, then? There are several possible explanations, but I think that there are two that are the most important. First, they served as an important lubricant in the political process of getting everyone on board with the EU project. As economists say, they were an important side-payment made from some members of the EU to others to faciliate other agreements.

Second, I think it's reasonable to believe that there's a genuine value placed by many Europeans and their governments on farming villages, lifestyles, and countrysides. In other words, I think that many non-farmers in Europe reap positive externalities from the existence of their farming communities. So for better or worse, they're willing to pay subsidies to maintain them.

But that doesn't mean that the EU can't try to do a better job of marketing them. And I think that's what's going on here; the EU realizes that if it more explicitly ties these farm subsidies to environmental protection, they will be more defensible. And they're probably right. So whether you like this idea or not will probably depend largely on what you think "environmental protection" is really all about.

What Smaller Government Looks Like in the US

2011-10-11T07:52:00.011-04:00

Last week's employment report in the US contained a familiar story: the private sector continues to add jobs, albeit at a modest pace, while government layoffs continue to undo a portion of those job gains. In the absence of the current mania to reduce the size of government, the US labor market would have gained closer to 2 million jobs instead of the roughly 1.5 million actually created over the past year.

But it's informative to take a look at exactly which sort of government jobs are being cut. The following table tells the story.

Over the past two years, government employment in the US at all levels (federal, state, and local) has fallen by a bit over half a million. Total federal employment has remained roughly constant (increased defense department jobs have made up for job losses elsewhere in the federal government), and employment by state governments has fallen by a bit. But local government employment has seen by far the largest change over the past two years, with local governments alone accounting for about 90% of all government job losses in the US. And of that, the majority of job losses are education jobs.

The US (along with many countries around the world right now) is currently going through a deeply unfortunate and harmful bout of fiscal contraction, right when it should be doing exactly the opposite. And by acheiving that fiscal contraction primarily by laying off teachers, it appears to have decided to do so on the backs of its schoolchildren.

Drawing the Line for Italy and Spain

2011-10-10T07:31:00.006-04:00

Greg Ip at Free Exchange directs us to a very helpful graph (helpful to those who think about the world in terms of supply and demand curves, anyway) that illustrates how the current situation with eurozone debt can benefit from some non-traditional thinking.

The idea is that the fear currently endemic in eurozone sovereign debt markets means that investors look to the price of bonds for two very different pieces of information. First, as is always the case, the price of bonds tells investors what return they will earn from holding those bonds. So when the price of bonds falls, they look like a better deal and investors can expect to earn a correspondingly higher rate of return, which tends to make the demand for those bonds goes up. That's the normal, downward-sloping demand curve at the top of the graph.

But right now investors also extract a second piece of information from the price of those bonds: they see it as a signal about how worried the rest of the bond market is about the probability of default. So once the price gets too low, then even though investors know they will get a good rate of return, they also start to worry that they'll never get repaid, so a lower price can actually cause demand to fall. That's the backward bending part of the demand curve noted in the graph as the "zone of vulnerability". (There are other mechanisms at work to reinforce this negative feedback loop as well, but you get the idea.) The result is that once the price of bonds falls too far, this vicious cycle takes over until a new equilibrium is reached at a very, very low price - the "distressed" price.

This is a helpful way to look at what's happening in the eurozone bond markets right now, I think. (Note that while this illustration uses Italy as an example, the logic applies equally well to Spain, which is also fundamentally solvent.) But there's a very clear policy prescription that follows from this analysis, as noted by BCA Research: The ECB has the ability to influence which equilibrium the market settles on.

How can the ECB make sure that the "good" equilibrium is the one that actually pertains? They somehow need to change this picture so the price can never drop below a certain level -- the level I've added to the picture in red. If the ECB can credibly establish that red line and restrict the market to the upper portion of the graph, then the only possible equilibrium will be the good one. Interest rates stay low, panic is avoided, and minimal additional intervention is required.

So how can the area below the red line be rendered off-limits? There are a couple of ways. First, policy-makers could simply state, repeatedly and loudly, that there is absolutely no possibility of Italy defaulting. If market participants are convinced, then they will no longer look at the price of the bonds as providing information about the probability of default. That's basically the approach that has been followed by European policy-makers (both within and outside the ECB) to date.

If that doesn't work, though (and clearly it hasn't worked very well so far, as investors seem unimpressed by such statements), then more credible statements are needed. The simplest would be for the ECB to make a formal promise that it will simply never let the price fall below the red line. In other words, they could commit to always buying Italian bonds at a price equal to the red line.

Note that this would be very much like an exchange rate floor, in which a central bank states that it will not let a currency fall below a certain limit. That's exactly what the Swiss central bank promised last month with regard to the euro vis-à-vis the Swiss Franc, for example. Only in this case instead of making a commitment to buy currency at a certain price, the promise would be to buy bonds at a certain price.

For this to work, the ECB's promise would have to be credible, of course - investors would have to believe that the ECB will actually put its money where its mouth is. But if it is indeed credible, and if the red line (i.e. the bond price floor) is below the good equilibrium price, then it's very possible that the ECB would not actually have to buy many Italian bonds. The bond market would do most of the work for it, and keep the price of Italian bonds at the good equilibrium. It's a perfect example of how targeting a price can be a far more effective -- and less costly -- for a central bank than targeting a certain quantity of intervention.

Of course, it's unlikely that the ECB would ever follow this economic logic and actually commit to supporting such a bond price floor. The fear among European policy-makers would be that the ECB would have to buy an uncomfortably large amount of Spanish and Italian bonds before the market became convinced that the price floor was indeed binding.

But if the ECB were able to take a deep breath and take this step, it would almost certainly bring about a quick end to the contagion of the eurozone crisis to Italy and Spain. I think it's a good example of how bold and unconventional economic policy actions could go a long way toward resolving the crisis. And since actual policy responses to the eurozone crisis have been neither bold nor unconventional, it also illustrates why the crisis never seems to end.

Retaliating Against Currency Manipulation: A Primer

2011-10-05T07:48:00.013-04:00

You've probably heard that this week the US Congress has been addressing the issue of how China controls its exchange rate with the US dollar. In particular, many have argued that China's policy of only allowing the yuan (CNY) to appreciate very gradually against the dollar has kept Chinese products unreasonably cheap to American consumers, and American products unreasonably expensive to Chinese consumers. (See for example Paul Krugman's column on Monday.)

So this week the US Senate voted to consider a bill that would impose tariffs on countries that are judged to have misaligned exchange rates. But China has reacted by very explicitly threatening to retaliate against the US. And now Boehner and other Republicans in Washington seem to be ready to stop this bill, so it's unclear to me whether it actually has a realistic chance of becoming law.

But this is an issue that is not going away any time soon, so it bears thinking about. In general I tend to focus much more on the economics than the legal aspects of international trade and financial issues, but in this case the legal implications could have some important economic effects that we need to consider.

The WTO

The first thing to recognize is that the WTO has a substantial amount of jurisdiction over the tariffs that the US can impose. Why is that? Think of the WTO as a club. Like all clubs, it has certain rules that members must adhere to, and in exchange the members get certain benefits. For the WTO, the primary benefit is that all other members of the club must be nice to you when it comes to trade, meaning that they can not arbitrarily impose tariffs on your products. On the flip side, the rules of the club (naturally) include a prohibition against arbitrarily imposing tariffs on your fellow club members.

So if the US unilaterally imposes tariffs on China, then the US may be breaking club rules. This would mean that the injured party (in this case China) would probably receive official WTO sanction to retaliate. And that is exactly what China has promised to do.

Such a 'trade war' (I've seen the term in the business press a lot this week) could possibly have some negative implications for the US economy. But it's hard to quantify how much China's retaliation would hurt the US, because I suspect that it would be much more informal than formal. For example, I would guess that China will start selecting Airbus over Boeing airplanes for a while. US multinationals could be shut out of lucrative joint ventures in China. And it wouldn't surprise me if China takes a bit of a breather on trying to enforce copyrights and patents owned by US companies. In addition, China might impose some tariffs on US products, but those would almost be secondary to the informal measures that China could take.

None of these steps would be disastrous to the US, but they might be enough to undo some of the benefit that the US could gain through a stronger CNY. Of course, the US could complain to the WTO about any informal retaliation -- the WTO would only sanction formal, tariff-based retaliation. But if the US has unilaterally imposed tariffs on China itself and been found to be in violation of WTO rules, it will not be in a particularly good position (legal or moral) to act as the injured party.

Options

Given this, what are the US's options for retaliating against China's weak-CNY policy?

1. Ignore the WTO. First of all, the US could simply go ahead and break the club's rules, allow the WTO to sanction retaliation by China, and take a chance that China either can't or won't punish the US severely enough to make a difference. There are plenty of cases where the WTO has determined that a member has violated the rules, sanctioned retaliation, and the violator has just ignored or put up with the consequences. It's arguably not very good for the health of the club, but it's an option.

Note that this is effectively what the legislation currently being considered by the US Congress would do - it would unilaterally impose tariffs on China without trying to get official WTO sanction. And while I'm not entirely clear on all of the reasons for Republican opposition to the bill, this does seem to be one of their concerns; Orrin Hatch has proposed an amendment that would have the US work with the WTO rather than take unilateral action. (Of course, this does then raise the question of why Republicans, who generally despise most international institutions, are more interested than Democrats in respecting them on this issue...)

2. Use the IMF. Another option would be for the US to try to get the IMF on its side. The IMF (another club, with different membership rules and benefits that relate to financial matters rather than tariffs and trade) has rules that specifically prohibit its members from manipulating currencies to gain unfair competitive advantage. And it doesn't hurt that voting shares in the IMF, unlike with the WTO, depend on how much money each country contributes. Needless to say, this means that the US has a lot more influence there.

The problem is that the IMF rules don't contain any enforcement or retaliation mechanism. So tariffs by the US would not be sanctioned by the IMF even if the US argues that China is breaking IMF rules.

3. Work the System. But what if the US can make the argument that China is actually the party that first violated WTO rules, so that the US's tariffs are actually a justified retaliation? Then the WTO would have to sanction the US's tariffs, and China would be breaking the club rules if it tried to retaliate. Everything would be flipped on its head.

As part of this strategy, the US could cite IMF rules, along with reference to an agreement that the IMF and WTO have signed in which they promised to help each other, respect each other, and coordinate as much as possible. With that legal foundation the US could, through the WTO's adjudication process, ask the WTO to sanction tariffs on China. If the US wins the adjudication then China must allow its currency to appreciate or face retaliatory US tariffs -- which China would then be disallowed from retaliating against. But if China wins the adjudication, then the US must go back to option #1. The primary disadvantage of this strategy, however, is that it's very, very slow; even if the process started today, it would probably take a year or more before a decision was made. That's a long time to wait if you think that this policy is important to helping the US out of its current economic slump.

What About the Economics?

I realize that I haven't yet provided any insight here into what I think should happen from an economic perspective. The short answer on that is that I do think that international clubs like the IMF and WTO serve very useful functions, and that the US generally should avoid undermining them whenever possible. It's really in the US's own long-term interest for those institutions to be robust and respected.

But the China issue is a real one. I'm doubtful that a stronger CNY would make a noticeable difference to the US economy over the next year or two -- I think the trade effects of exchange rate movements are simply too slow for that -- but there's pretty convincing evidence (see Menzie Chinn, for example) that it would slowly push things in the right direction. So while we shouldn't think that a different CNY/USD exchange rate would suddenly pull the US out of its economic slump, it might help a bit over time. And that's worth something.

Additional reading: if you're interested in more details regarding the legal options and implications of possible US retaliation against Chinese currency manipulation, you can't do better than this paper by Jonathan Sanford of the Congressional Research Service: "Currency Manipulation: The IMF and WTO".

Magical Thinking

2011-10-04T07:55:00.002-04:00

This is what policy paralysis looks like. From the FT's ongoing coverage of the eurozone crisis:

8.40: Another day, another fudge. Or so cynics might think following the latest eurozone finance ministers’ decision on Greece. After meeting until late into the night, ministers from the 17-member common currency area agreed to – yup you guessed it – wait a bit longer before deciding what to do.

Sometimes bad policy-making takes the form of enacting bad policies. But sometimes it takes the form of doing nothing.

What do the EU's finance ministers think will be different one month from now? Do they expect that between now and then Greece will find a secret treasure chest that will enable the Greeks to miraculously reduce their budget deficit? Or that investors will just get bored of the whole eurozone debt crisis, go on a nice holiday for the rest of the year, and stop applying pressure to fix anything?

I realize that this will probably sound like a truly horrible insult (particularly to European policy-makers themselves) but I can't help but be reminded of the magical thinking that characterized so much of George W. Bush's policy-making, who regularly avoided making difficult policy choices due to the apparent belief that things would just get better on their own. It seems that many European policy-makers are hoping for such a similar magical resolution to the eurozone debt crisis.

Either that, or it's nothing more than simple procrastination.

UPDATE: Oops, I hadn't remembered that Paul Krugman had used the term magical thinking in the context of European policy-making more than a year ago. Sorry for missing the citation, Paul.

Macro 101 Validated Yet Again

2011-10-02T20:20:00.004-04:00

I wish I could take more comfort in the fact that we are regularly provided with evidence that the macroeconomics of fiscal policy that we teach first-year university students is a pretty good guide to the real world. Here's the Macro 101 lesson:

Suppose we are in a country that is running a large budget deficit but, for whatever reason, decides that it needs to dramatically reduce it. Take your pick of examples, because there are plenty to choose from: Greece, the UK, the US...

Suppose that the country – let’s call it Austerityland – has a GDP of $100/year, and a budget deficit of $10/yr, or 10% of GDP. And suppose that the government decides it wants to get the deficit down to 5% of GDP. How can it get there?

No, the answer is not “cut spending by $5/yr”. Nor is it “raise taxes by $5/yr”. And last but not least, it is also not “enact a combination of tax increases and spending cuts that total $5/yr”. To see why, let’s do just a bit of arithmetic...

...[With a $5 cut in spending] the new deficit is now $6.875, which is 7.4% of the new level of GDP. Wait, I thought we were trying to get the deficit down to 5% of GDP? What happened?

What happened is that we’ve missed our target, by quite a bit, due to the multiplier effect and the fall in tax revenues that resulted from the shrinking economy. In fact, just a bit of simple algebra allows us to figure out that government spending in Austerityland will have to be cut by about $9 in order to reach a budget deficit target of 5% of GDP. In other words, the government will have to cut spending by almost twice as much as it initially thought it would in order to reach its deficit target.

(When that happens, by the way, GDP will fall from $100 to around $86. Yes, that’s a 14% drop in output. But hey, at least we’ve hit our deficit reduction target!)

And here's today's news out of Greece:

Greece to miss budget deficit targets in 2011 and 2012

Greece has said its budget deficit will be cut in 2011 and 2012 but will still miss targets set by the EU and IMF. The 2011 deficit is projected to be 8.5% of GDP, down from 10.5% in 2010 but short of the 7.6% target.

The government, which on Sunday adopted its 2012 draft budget, blamed the shortfall on deepening recession... It blamed an economic contraction this year of 5.5% - rather than May's 3.8% estimate - for the failure to meet deficit targets.

Closing Up Shop

2011-09-30T18:30:00.001-04:00

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.

Moral Judgment and Bad Economics from the ECB

2011-09-29T07:58:00.004-04:00

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.

UPDATE: 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.

Estimating the Cost of the Eurozone Crisis

2011-09-28T08:00:00.008-04:00

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.

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

2011-09-27T08:00:00.006-04:00

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.

What Really Caused the Eurozone Crisis? (Part 1)

2011-09-22T22:10:00.002-04:00

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.

Evidence

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?

2011-09-22T21:15:00.000-04:00

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.

The Twist

2011-09-21T20:28:00.004-04:00

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?

2011-09-21T07:37:00.002-04:00

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.

The End of an Era in China

2011-09-15T19:40:00.000-04:00

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

2011-09-15T18:28:00.000-04:00

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.

The World's Safest Bank

2011-09-13T18:59:00.000-04:00

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.

Why?

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.

Implications

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...

The Hunt for Dollars by Europe's Banks

2011-09-12T07:38:00.000-04:00

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.

When Fear Dominates

2011-09-09T18:08:00.006-04:00

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.

The 2011 Stimulus Proposal

2011-09-08T20:53:00.003-04:00

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.

Swiss FAQs

2011-09-06T18:46:00.003-04:00

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

2011-09-06T07:26:00.006-04:00

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.

Europe's Banking System: The Transatlantic Cash Flow

2011-09-02T07:31:00.000-04:00

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.

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

2011-09-01T07:56:00.006-04:00

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.

How to Read Consumer Survey Data

2011-08-31T07:44:00.002-04:00

Yesterday it was reported that US consumer confidence has plunged recently:

Consumer confidence plunges as hope dims
Expectations at the lowest level in two years

WASHINGTON (MarketWatch) — Consumer confidence plunged in August as expectations dived, with worsening views on future business conditions, jobs and income, the Conference Board reported Tuesday.

The nonprofit organization said its consumer-confidence index fell to 44.5 in August, the lowest level since April 2009, from a slightly downwardly revised 59.2 in July. It was the sixth-largest one-month decline in the past 21 years. Economists surveyed by MarketWatch had expected an August reading of 51.9.

When news headlines breathlessly announce breaking news about consumer expectations, it's worth taking a step back and remembering what these surveys actually tell us.

Consumers expectations typically are much more reflective of the past than the future. Put another way, they're backward looking. And that makes perfect sense, since if you don't really know how to reliably forecast the future (and let's be honest, none of us are particularly good at that) then it's usually a very reasonable strategy to assume that the future, at least in the near term, will look a lot like the recent past.

To see how this works regarding these consumer surveys, I pulled the data on consumer inflation expectations and overall consumer sentiment in the US since 1978, and compared it with actual inflation and consumer spending. The first chart illustrates that consumer inflation expectations (measured by the University of Michigan's monthly survey) match up almost perfectly with actual inflation -- over the previous 12 months. Inflation expectations do not match future inflation nearly so well. (If you can imagine shifting the red line to the left by 12 months, you can see what I mean.)

The next chart shows "consumer sentiment" (the name used in the University of Michigan's monthly survey) plotted against the 12-month change in real consumer spending -- again over the previous 12 months. The series match extremely well, but would not match nearly so well if we tried to compare sentiment with future spending changes instead.

To be slightly more rigorous, the following table shows correlation coefficients between consumer expectations, the past, and the future. The first column shows the correlation between consumer inflation expectations, inflation over the previous 12 months, and inflation over the subsequent 12 months. The second column shows the correlation between consumer sentiment, changes in real consumer spending over the previous 12 months, and spending growth over the subsequent 12 months. A zero would indicate no correlation, while a score of 1.00 would indicate perfect correlation.

Consumer expectations regarding inflation are almost perfectly correlated (the correlation coefficient = 0.94) with actual inflation over the previous 12 months, but significantly less so with future inflation. And on the spending side, consumer sentiment is also much more correlated with the change in real spending that took place over the past 12 months (coef = 0.76) than over the coming 12 months (coef = 0.42). So for both inflation and spending, the consumer survey data tells us much more about the past than the future. Something that's important to keep in mind when trying to read the economic tea leaves.

Europe's Banking System: How Weak Is It?

2011-08-30T18:37:00.000-04:00

To be diplomatic, let's simply say that opions differ over how weak Europe's banking system really is. Over the weekend Christine Lagarde, former Finance Minister of France and now the head of the IMF, said that a significant amount of new capital should be provided to European banks in order to help contain contagion:

A Call to Arms

The world economy, [Lagarde] said, was entering a “dangerous new phase” driven by a sense that “policymakers do not have the conviction” to take decisions that are needed. That must change, and now. Ms Lagarde laid out a bold to-do list to support growth, including a forced capital injection into Europe’s banks, aggressive new action to deal with America’s foreclosure crisis, and a broad rebalancing of fiscal priorities.

The most headline-grabbing prescription was for Europe’s banks. More capital, Ms Lagarde argued, was essential to “cutting the chains of contagion” in the euro crisis. Without it there could easily be “the further spread of economic weakness to core countries, or even a debilitating liquidity crisis”. She called for what would essentially be a European version of America’s policy for its biggest banks in 2008—a mandatory capital increase using public funds if necessary. Those funds could come from the European Financial Stability Facility.

But this suggestion was rebuffed by many political and financial leaders in Europe:

Europe officials defend banking systems

MADRID — Top European officials defended the health of the continent’s financial system Monday, trying to stem concerns that Europe’s slowing economy and high levels of government debt may cause some of its banks to fail.

In separate statements European Central Bank President Jean-Claude Trichet and European Economic and Monetary Affairs Commissioner Olli Rehn said banks within the 17-nation euro currency zone have been steadily raising the amount of capital set aside as a cushion against losses and will not face the sort of cash crunch that helped trigger the recession in 2008.

Meanwhile, ground zero for possible banking crisis contagion (Greece) had its own set of developments. For one, the second and third largest banks in Greece announced plans to merge, along with, crucially, an injection of fresh capital from Middle East investors:

Alpha to Acquire EFG Eurobank to Create Biggest Greek Lender

Aug. 29 (Bloomberg) -- Alpha Bank SA, Greece’s third- largest lender, will buy EFG Eurobank Ergasias SA and increase capital by as much as 3.9 billion euros ($5.7 billion) to ride out a deepening recession and the country’s sovereign debt crisis.

...Following the merger, the bank plans to strengthen its finances with a 1.25 billion-euro rights offer, a 500 million- euro convertible note to be taken up by Qatari-backed Paramount Services Holding Ltd., and more than 2.1 billion euros of internal measures, the statement said. That will help give the lender a core Tier 1 capital ratio of 14 percent, even after accounting for writedowns of Greek government bonds, the companies said.

Meanwhile, the National Bank of Greece (NBG), the largest bank in that country (18% owned by the Greek government), reported a large loss due to a writedown of part of its stock of Greek government bonds:

National Bank of Greece Posts EU1.31 Billion Loss on Bonds

Aug. 30 (Bloomberg) -- National Bank of Greece SA, the country’s biggest bank, reported a first-half loss after writing down its holdings of Greek government bonds.

The net loss was 1.31 billion euros ($1.89 billion), compared with a profit in the year earlier period of 146 million euros, according to a faxed statement from the Athens-based lender today. National wrote down the value of its bonds by 1.645 billion euros, according to the statement. Stripping out that figure, profit was 29 million euros.

One worrying statistic reported along with this news about the write-down was the continued shrinkage in deposits kept with NBG. In fact, deposits with the Greek banking system as a whole have fallen by almost 10% so far this year. And that's why Lagarde's suggestion was rejected so forcefully by leaders in Europe. Because if people start calling into question the viability of the big European banks and start withdrawing money from them as a result, the euro-zone debt crisis will take on a whole new dimension of horribleness.

Doing More with Less Driving

2011-08-30T07:56:00.009-04:00

While Americans will probably end up driving slightly more miles in 2011 than last year, they do appear to be getting more done per mile of driving. That's the story told by the statistics recently released by the Federal Highway Administration describing the amount of driving done in the US. Plotting the total miles driven in each 12-month period ending in June (the most recent period being up through June 2011), we see that total vehicle miles has basically leveled off over the past few years, after approximately ten decades of continuous growth.

The End of an Era?

Is this the end to the heretofore endless rise in the amount of driving done in the US? Or is this just a temporary pause in the upward trajectory?

As much as I'd like to be able to conclude that we've already seen the all-time high for the amount of driving done in the US, that's probably not the case. There are a few important drivers (ahem) of the current pause in the growth in total vehicle miles. The first is the Great Recession. When fewer people are working, and when businesses are selling less output, some cars and trucks that would otherwise be on the road stay home. As economic activity picks up, those idle cars and trucks will increasingly be back on the road.

Second, there's population growth. More people in the US means more driving, of course. And population growth in the US slowed in response to the recession (the US naturally attracts fewer immigrants during recession), though only by a bit -- in 2010 the US resident population grew by about 0.85%, compared to an annual average of about 0.95% during the years 2001-2008. Once the economy strengthens, the US population will likely resume its ~1% annual average growth rate, once again putting a larger increment of new drivers on the road every year.

Improved Driving Efficiency

But then there's the most interesting force affecting the amount of driving in the US: the secular trend toward doing less of it. A combination of factors has contributed toward a steady increase in what I call "driving efficiency": the number of miles driven for each dollar of economic activity.

This has fallen quite steadily since the early 1990s. In 1992 approximately 0.27 miles were driven for each dollar of economic activity in the US, but so far this year that figure is down to about 0.225 -- a 17% improvement. (Note that recessions clearly have an impact on driving efficiency as well, as can be seen in 1991, 2001, and 2009.)

There are a number of possible explanations for this 20-year trend in improved driving efficiency. Of course higher gas prices have played a role. The last chart plots the spot wholesale price of a gallon of gas (petrol) in constant 2005 dollars against driving efficiency in the US.

The chart confirms what we already know: gas has gotten more expensive in recent years (with the exception of the recession year of 2009), and that has surely been a catalyst for some improvements in driving efficiency recently. But it's important to note that the secular trend toward increased driving efficiency was well underway before the high gas prices of the last several years, so clearly there are other forces at work as well.

Widespread changes in behavior unrelated to the price of gas must be a part of the story. People (and presumably businesses as well) have obviously been choosing to do more with less driving, whether out of environmental concerns or simply because they're sick of sitting in traffic.

Driving Efficiency: Better, but Not Better Enough

But the secular trend towards improved driving efficiency that the US has enjoyed over the past 20 years is not going to be enough to keep the overall total miles driven in the US from rising again. To see why, we simply need to compare increases in driving efficiency with the forces that tend to cause more driving, such as population and economic growth.

Since 1992 driving efficiency in the US has improved by an average of about 1% per year. Efficiency improvements at that rate were more than enough to keep up with the growth of economic activity in the US recently, since GDP growth has averaged only 0.2% per year over the past 4 years. But once real GDP grows at more normal (faster) rates, driving effiency is going to have to improve by faster rates as well, or we'll see the total miles driven in the US start to rise again. So for example, if real GDP grows at 3% in 2012 while driving efficiency only grows by 1.5%, the total miles driven in the US will reach record levels by the end of 2012.

More generally, in order for the total number of miles driven in the US to level off permanently, the US is going to have to experience improvements in driving efficiency that are at least as large (in % terms) as GDP growth. Note that the biggest gains in driving efficiency happened in 1999, 2006, and 2011, when Americans were able to cut the driving needed for each dollar of economic activity by about 2.3%. The US is going to need to improve its driving effiency by that much or more every year, on a sustained basis, before the total amount of driving done in the US peaks.

The World in the Hands of City Planners

Perhaps such sustained rates of improvement in driving efficiency in the US -- more than double the rates we've seen over the past 20 years -- are simply not possible, and the amount of miles driven in the US (and the amount of greenhouse gases emitted in the process) is destined to continue rising inexorably. But who's to say we couldn't do better? There's no theoretical reason that driving efficiency couldn't improve by 3 or 4 or 5% per year. But if such faster rates of driving efficiency are going to materialize, it seems likely that the only way to acheive them will be by making gradual but significant changes to the economic geography of the US.

Geography is not fixed, of course. Most of the geographic features that matter to us in our day-to-day lives were designed and built by humans: neighborhoods, roads, bridges, cities. And seemingly innocent and well-meaning ideas for how to structure our physical surroundings can have pernicious unintended consequences, particularly on the amount of driving that is done.

Take, for example, the parking lot. (Really, please take it. I don't want it near me.) We're all familiar with how a few large, badly-placed parking lots can destroy a neighborhood or a city center. But in a recent post about parking lots (yes, it is possible to write a post just about parking lots), a friend who's a city planner points out that there's a flip side to that: small changes in zoning requirements can potentially have big effects on the geography of cities, very possibly for the better.

The science of urban planning has evolved significantly over the past 20 years, and we have a much more sophisticated understanding of the unintended consequences (what economists generally refer to as externalities) of specific, local decisions made about our economic geography. If we want to permanently break the trend of ever-increasing driving in the US, that understanding, and how we apply it to our economic geography, is going to be crucial. So if it's going to happen, it will be up to the city planners to show us the way.

How QE3 Could Help

2011-08-26T08:13:00.006-04:00

With Bernanke's speech today at Jackson Hole, QE3 is in the news. Yesterday Izabella Kaminska at Alphaville wrote about the Fed's use of Jedi mindtricks -- its influence on market expectations -- and rightly noted that one of the important impacts of any additional QE would be its effect on market expectations. Agreed.

But a couple of times now she has made reference to her belief that QE3 "might only prolong the liquidity trap or make it worse." I'm trying to understand the argument, and I'm not sure that I get it. When I hear the term "liquidity trap", I think about a situation (like the present) in which nominal short-term rates have been pushed down to zero, so conventional monetary policy has no impact on the economy. By selling short-term assets and buying long-term assets, how exactly would a new round of LSAPs by the Fed make the liquidity trap worse?

More generally, I have yet to see a convincing argument for why QE3 would be a bad idea (in the previous post I explained why I find Woodford's arguments unconvincing, for example), and I can see a couple of ways in which it might help.

1. Market expectations. First, as Kaminska and others have pointed out, additional QE (or LSAP, which is the more accurate name) could have an impact on market expectations. But that's a good thing. Anything the Fed can do right now to communicate that it will do work hard to avoid further disinflation, and that in fact it is willing to tolerate a bit of inflation, will help to spur new spending.

But I think it's just as important to remember the rather prosaic but very real impact that further QE would have on long-term interest rates. As I've summarized before, there are a number of rigorous empirical studies that show that the Fed's QE programs had a significant impact on long-term interest rates. And if QE can push long-term interest rates down, it can have additional positive impacts on the economy through a couple of channels.

2. Help push investors out of US Treasuries. For one, driving down long-term Treasury rates will, at the margin, push some investors who have been parking their cash in government bonds to move their wealth into other assets. Anything that persuades investors to take on a bit more risk, undertake new investments, and lend money to businesses and individuals has to be a good thing. (Yes, this is another way of saying that QE pushes down interest rates throughout the economy, not just in the market for US Treasuries.)

3. The housing market. Perhaps more importantly, lower long-term interest rates lead directly to lower mortgage rates. And mortgage rates have a well-established and signficant impact on the housing market. (See, for example, this 2008 paper by Clayton, Miller, and Peng (pdf) for some recent empirical estimates of the impact of mortgage rates on house prices and transaction volumes.) Since the housing market is probably the sickest part of the US economy right now, and is certainly a serious drag on economic growth (as highlighted by Bernanke in today's speech), there's every reason to think that pushing down long-term interest rates could have some real positive effects on the economy.

So yes, Jedi mindtricks are important, but there are other mechanisms through which QE3 could have a real, positive impact on the US economy. It would not be a miracle cure, of course, but it would have a positive impact at the margin. And at this point, we should be happy to take whatever we can get.

QE Confusion

2011-08-26T07:33:00.000-04:00

Michael Woodford has a piece in today's FT warning against QE3 today in the FT. There are a few problems with it, however.

Woodford's arguments are:
1. QE and QE2 were supposed to work by raising the price level, which is theoretically unlikely. Agreed -- and the Fed specifically said that the LSAP was intended to be different from QE^(*) precisely because it was not going to lead to a permanent expansion of the money supply. So an impact on the actual price level was never intended to be the mechanism through which QE helped the economy. Note that Woodford's argument here is exactly at odds with the primary criticism of QE2 that we were hearing a couple of months ago, when the inflationistas were breathlessly proclaiming that the US was entering a period of runaway inflation.

2. QE and QE2 were supposed to work by flattening the yield curve and reducing long-term interest rates... but while QE1 accomplished this, QE2 did not. Woodford does not explain why he thinks the first round of QE worked but the second round didn't. Furthermore, there are a number of empirical studies that provide consistent estimates that QE2 did in fact have a significant impact on long-term interest rates. (See here for a summary of some of them.)

3. QE2's main impact was through altering the market's expectations about future policy... but this is a bad way for the Fed to communicate with the markets. I agree that probably the most powerful single weapon left at the Fed's disposal right now is its ability to change market expectations. But now that the Fed has explicitly described its intended policy with respect to short-term interest rates (i.e. zero for the next two years), why discount the possibility that QE3 could change expectations regarding long-term interest rates?

In fact, QE2 did reduce long-term interest rates, and there's no reason to think that QE3 wouldn't do the same. How much of a boost this would provide to the economy is another matter, and if you want to argue against QE3 because you think that lower long-term interest rates won't do much for the economy, then we can probably have a reasonable discussion. But to say that it won't work because it won't work (which is the best summary I can come up with for Woodford's piece) does not seem a helpful way to advance the debate.

^(*)Note that, as I've written before, "quantitative easing" is a bad name for the Fed's program of Large Scale Asset Purchases (LSAP), because the program is not really intended to increase the money supply in the way that, say, Japan's QE program did in the early 2000s. But I'll use the common shorthand for convenience.

Stimulating the Economy for Free (Almost)

2011-08-25T07:52:00.010-04:00

Yesterday the CBO released new figures describing both its projections for the US federal budget deficit, and its estimate of the impact on the economy of the 2009 stimulus package (the ARRA). The budget forecast is grim, of course, and the CBO attributes much of the bad budget outlook to the bad economy.

But while there's a lot of good stuff in both documents, I was particularly intrigued by a rather remarkable sidenote included in the budget forecast document. The CBO explained that they believe that the Great Recession will have very persistent effects on long-run economic growth in the US. From yesterday's CBO budget update, p. 54 (pdf):

The financial crisis that began in 2007 had a sharp impact on the U.S. economy, nearly freezing credit markets and pushing the economy into the most severe recession since World War II. International experience shows that downturns following financial crises tend to be more prolonged than other downturns, and the return to high employment tends to be slower. In addition, because such recessions—more so than typical recessions—raise the level and duration of unemployment, reduce the number of hours that employees work, and dampen investment, they are more likely to reduce potential output for some time.

...Combining estimates of the effects on capital accumulation, potential hours worked, and potential total factor productivity, CBO projects that potential output will be about 2 percent lower, on average, between 2017 and 2021 than it would have been without the financial crisis and the recession.

This is a point that Brad DeLong has particularly emphasized (see for example here and here); it's good to see the CBO incorporating the recession's "shadow", as Brad calls it, into their forecasts.

But this has important implications for projections regarding the costs and effects of stimulus spending right now. If a new stimulus plan had been implemented at the start of 2011, for example, the economy would be significantly stronger this year and the long-run effects mentioned by the CBO would be smaller going forward. And this in turn means that stimulus spending right now would, according to the CBO, significantly improve long-run growth prospects, and hence the budget outlook for the federal government.

In the other document put out by CBO yesterday there are estimates of the economic impact of the ARRA (pdf). And in the CBO's January 2011 budget outlook (pdf) the CBO provides, in table B-1, some "rules of thumb" to translate changes in forecast economic growth into changes in the forecast budget deficit.

This gives us all the ingredients we need to create a back-of-the-envelope estimate of the long-run budgetary impact of new stimulus spending. Suppose that a new stimulus package of $800 billion (about the size of the ARRA) had been enacted early in 2011. Suppose that its impact on economic growth was half way between the CBO's high and low estimates of the impact of the ARRA. And suppose, finally, that the resulting return to strong economic growth in 2011 and 2012 allowed the US economy to reduce by half the long-run, persistent impacts of the Great Recession highlighted by the CBO above (i.e. the recession's "shadow"). Using the CBO's rules of thumb for how this would impact the budget deficit, we get the following:

Using the CBO's estimates, the additional economic growth that such a stimulus package would cause -- particularly over the second half of the decade -- would mean that the $800 billion stimulus would indirectly reduce the budget deficit by $634 over ten years. So the net deficit impact of such stimulus spending would only be $166 billion, or about 20% of the initial outlay. And of course, if we extended the time horizon beyond just the next ten years, the payback would be even greater.

Note that this is not a normal result for additional government spending. The beneficial effects on the budget deficit over the long run would disappear if the US weren't trapped in this ongoing debilitating recession. But given our current situation, the US can actually get a remarkably good deal on new stimulus spending: for every dollar the US government spends to stimulate the economy and create jobs, the economy will pay back 80 cents as a way of saying thanks...

A Silver Lining to the Italian Debt Cloud

2011-08-22T18:38:00.005-04:00

Okay, I admit it: I'm so depressed by the unrelentingly bad state of the world right now -- particularly but not exclusively in the realm of economics and finance -- that it's an ongoing struggle for me to make myself read through the news in the morning. And providing commentary about each day's Awful News often just seems simultaneously obvious and pointless. The fact that much of the news concerns Self-Inflicted Awfulness makes it even more depressing than it otherwise would be.

But I found a glimmer of light shining from Europe this morning as I was reading today's installment of Awful News. Okay, you have to squint really hard to see it, and it will probably be extinguished by more self-inflicted, intentionally generated black smoke. But for today, I saw a small hint of a possible beneficial side effect of the Euro debt crisis spreading to Italy.

The news item that gave me pause this morning was this:

ECB settled 14.3 bln euros of bond buys last week

FRANKFURT (MarketWatch) -- The European Central Bank on Monday said it settled 14.3 billion euros ($20.6 billion) in purchases of government bonds last week as part of its Securities Market Program. The ECB settled purchases totaling 22 billion euros the previous week. The purchases come as the ECB was seen stepping back into bond markets this month to push down yields on Italian and Spanish government debt in an effort to halt the spread of the euro-zone sovereign debt crisis... The ECB, which sterilizes purchases under the SMP, announced it would drain 110.5 billion euros from the system on Tuesday through a one-week deposit auction.

What does that mean? As you probably know, the ECB is buying Italian and Spanish government bonds to try to reassure investors that those bonds are safe, and will be defended vigorously by the ECB (and presumably other European institutions). But there's a curious technical side-effect of this action: these purchases of Italian debt end up boosting the eurozone's base money supply (i.e. bank reserves) by an equal amount, since that is essentially how the ECB pays for those Italian bonds.

Now, the ECB is widely recognized as the most hawkish central bank on the planet. (Obsessively so, in fact.) And one facet of that hawkishness is that the ECB is adamant that all such operations will be "sterilized", i.e. neutralized by countervailing operations. In essence, the ECB has said it will always and completely mop up any increase in the eurozone's base money supply that results from its efforts to support the Italian bond market. So that's why this week (tomorrow, in fact), the ECB will try to remove about 110 billion euros from the banking system.

But what happens when they are no longer able to do that? 110 billion euros is a LOT of money to vacuum out of the European banking system in one go. Even if the operation goes off without a hitch tomorrow, the ECB is now in the position of having to do that every couple of weeks. At some point the European banks may not be in a position to cooperate voluntarily. Already earlier in the summer the ECB was having difficulty with such vacuuming operations, and the quantities of euros to be soaked up were much smaller back then.

If the ECB is no longer able to completely sterilize the large-scale purchases of Italian bonds needed to keep the bond market stable (and thus to keep a potentially self-fulfilling euro crisis from becoming inevitable), the ECB will face a stark choice:

1. Cease purchases of Italian bonds in sufficient quantities to avert the crisis.
2. Give up on the commitment to always and completely sterilize.

It's quite simple: there are no other options. And the participants in the bond market know this as well as I do, which means that they will start selling off Italian bonds, forcing the issue to come to a head, the moment there is a sign that the ECB can not easily sterilize.

So what will the ECB do? If it chooses option 1, then there will probably be a rout in the Italian bond market, leading to all sorts of Awful Things, possibly and eventually including the crumbling of the eurozone to just a few core member countries. The ECB might decide that its reputation for utter and absolute inflexibility is more important than keeping the eurozone from falling apart, so it might choose option 1.

But maybe, just maybe, the ECB will choose option 2. And if it does so, the result could be a deep and lasting shift in the market's perceptions of the ECB. For the better.

Choosing option 2 will signal that the ECB is willing to allow bank liquidity to rise enormously in order to defend Italy and Spain's participation in the eurozone. And that, in turn, could cause inflation expectations in Europe to start rising, for the first time in many years, which could provide an important boost to the European economy. (Mark Thoma today provides a handy review of Krugman's explanation of that point.)

Note that I am not arguing that a massive expansion of the European monetary base would actually cause inflation; it almost certainly would not, just as such an expansion of the US monetary base has had no inflationary effects in the US. But I do think that it would have a dramatic effect on market perceptions and expectations, which in this case could be just as good, if not better.

And so we finally arrive at the promised silver lining to this massively dark cloud: At some point the ECB may find it difficult to soak up the excess liquidity it creates by supporting the Italian bond market. In which case, it might stop trying to do so.

It's not much of a hope, but it's better than nothing.

Backwards Priorities

2011-08-12T07:52:00.003-04:00

This point can not be repeated often enough right now. I direct you to the excellent Ryan Avent:

I trust the analyses showing that a long-term fiscal crisis looms, and I note that America's gross debt-to-gdp ratio is uncomfortably high. It's not obviously too high to sustain, however. It's far from obvious that swingeing cuts are necessary to right the fiscal ship—as opposed to, say, moderate increases in revenues combined with a meaningful slowing of the projected rate of growth of health spending. And markets, which should be heeded, could not be shouting any more forcefully that whatever cuts need to be made certainly don't need to be made now.

...I see Americans as distressed by a dismal economy, frustrated at years of stagnant pay amid rising costs, and outraged by a system of government institutionally incapable of addressing basic concerns. Europe hasn't proceeded with dramatic austerity because austerity is popular in Europe. Oh no. Europe has proceeded with austerity because markets posed a real threat, because European parliamentary systems lack the anti-majoritarian bottlenecks that constrain America's government, and because European electorates accepted that policies they dislike were necessary to avoid potential outcomes they dislike even more.

Lampooning American voters as idiots living fat off the government teat obscures the reality of the present situation. Fiscal issues are not and should not be the principal worry in an America with high unemployment and rock-bottom sovereign-debt costs.

This is going to be my new mantra.

Fiscal issues are not and should not be the principal worry in an America with high unemployment and rock-bottom sovereign-debt costs.

Fiscal issues are not and should not be the principal worry in an America with high unemployment and rock-bottom sovereign-debt costs.

(By the way, life has almost finished with its current bout of overwhelming interference with my blogging. More regular posting to resume in the next few days.)

Cutting Our Way to a Smaller Future

2011-08-02T10:32:00.005-04:00

I'm not generally very interested in lionizing specific companies. But in this piece, David Weidner makes what I think is a very good analogy:

How Apple would solve the debt crisis

NEW YORK (MarketWatch) — Spending is good. Borrowing is better. Washington is doing neither. It’s liquidating.

I’ve been covering Wall Street and corporate America for going on two decades, and if there’s anything I’ve learned it’s that there are really only two kinds of companies: those growing and those shrinking.

The U.S. government today has officially become the latter.

The difference between a growing business like Apple Inc. and a shrinking one such as Eastman Kodak has less to do with spending and revenue and than with psychology. Growing companies go through tough times. They adapt, and they’re poised to strike when conditions are right. They don’t stop innovating.

Defeated companies may be producing steady profits. But they lose their entrepreneurial spirit. They stop looking at the future. They get intimidated. They quit fighting. They look for a sale. They try to buy growth. They play not to lose — and end up losing anyway.

Which of those does Washington sound like?

...Ultimately, what’s happened to our government, lawmakers, elected officials and ourselves is that we’ve have taken on a mind-set of defeat. It doesn’t seem to matter that the business model — taxing for revenue, spending for growth — isn’t broken. After all, it’s working in Germany, Canada, India and China.

We’ve given up on the model because of our debt situation. It’s a problem, and a pressing one. A default or lower credit rating would cause further damage to our credit picture.

But there are really two ways to handle it. We could take a balanced approach of reining in spending and increasing revenue (cutting costs, raising taxes), or we could simply cut, slashing incomes (Medicare, Social Security, the military). These drastic cuts, which will balance annual budgets, are in effect a surrender.

The very basic and (I thought) uncontroversial notion that the government can make useful investments in the nation, that it can do things to help make the economy stronger and more productive, has been thrown out the window in the US recently. And the result, I fear, will be a decidedly smaller, meeker, and poorer future for this country.

Feel the Austerity

2011-07-26T07:20:00.004-04:00

The Cameron government's austerity plan in the UK is near its one-year anniversary, and its effects continue to exactly match the prediction that any decent Macro 101 student could provide as the correct answer to a final exam question:

UK GDP figures show slower growth of 0.2%

Growth in the UK economy slowed in the three months to 30 June, partly because of the extra bank holiday in April. Gross Domestic Product (GDP) grew by 0.2% in the second quarter, according to the Office for National Statistics, down from 0.5% in the previous quarter.

...Chancellor George Osborne said the growth was good news, but Ed Balls accused him of choking the recovery. "The positive news is that the British economy is continuing to grow and is creating jobs," said Mr Osborne.

...But shadow chancellor Ed Balls said that the slowdown was a serious problem for the government and it should take steps to boost growth.

"These figures show that last year's recovery has been recklessly choked off by George Osborne's VAT rise and spending review," he said. "The economy has effectively flat-lined for nine months and this is very bad news for jobs, living standards, business investment and for getting the deficit down."

...The think tank the Institute for Public Policy Research (IPPR) was also critical of the level of growth. "Last June, the OBR [Office for Budget Responsibility] predicted GDP would grow by 2.6% in 2011, but even if the economy gets back on track in quarters three and four this year, it will barely reach 1.2%," said IPPR director Nick Pearce.

It's not mysterious: when you raise taxes and cut government spending, growth slows. And when you do that during a very fragile and weak recovery, you can push your economy back into recession, or at best, choke off growth almonst completely. That's exactly why, as has been extensively written about both here and elsewhere, austerity during a time of economic weakness is not a good way to beat a budget deficit, and will be largely self-defeating.

And NO, in answer to the various comments and emails that follow every time I make this point: this doesn't mean that I think we should always and endlessly expand government spending. It just means we should expand government spending when economic growth is weak and unemployment is a problem. And that appropriate expansionary policies will reduce unemployment, improve income, and also effectively reduce the deficit in the long run.

Gross Domestic Happiness

2011-07-25T08:55:00.005-04:00

Excuse the light posting these days; I'm in the process of selling my house and moving, and so lots of non-blogging-type things keep absorbing what I have for spare time.

At any rate, over the weekend I came across this interesting tidbit from the BBC:

Bhutan spreads happiness to UN

Bhutan has put the politics of happiness on the UN's agenda.

This week the General Assembly adopted a non-binding resolution that aims to make happiness a "development indicator". Bhutan's ambassador Lhatu Wangchuk told the BBC the next step was to help UN members better understand the concept.

He admitted some were sceptical when Bhutan started lobbying for the resolution 10 months ago. But ultimately it won 66 co-sponsors, including the UK.

The idea is based on Bhutan's model of GNH, or Gross National Happiness, which measures quality of life by trying to strike a balance between the material and the spiritual.

The resolution invites member states to draw up their own measures of happiness and contribute them to the UN's development agenda.

"It's basically an approach," said Mr Wangchuk. "Our initial idea was to bring the concept of happiness to the consciousness of the UN membership… because we know that GDP indicators are inadequate to address human needs."

People who are interested in the macroeconomy (including me) spend lots of time focused on GDP, also known as national output. (And which in theory should also equal national income.) In fact, GDP is typically considered to be the single best descriptor of a country's economic conditions. And there's good reason for that: if what you want to measure is the total amount of stuff (i.e. goods and services) produced by the millions of individual actors in an economy over a given period of time, then GDP is your indicator.

But remember that GDP only tells you about how much stuff the economy produced -- not whether that stuff was useful, whether it actually made people better off, or how it was distributed. What if you don't care so much about the amount of stuff produced by an economy, and instead care about the well-being of the individuals in that economy?

If you're more interested in the well-being of individuals, then GDP is lacking when used by itself. It's a helpful indicator, because it gives you an idea of the amount of resources available to be consumed by the individuals in the economy over a given people of time, and it's reasonable to think that to some degree and in some situations, having more resources at your disposal allows you to possibly be better off. But if you believe that having more stuff available to consume is only one of many ingredients to happiness, then GDP shouldn't be taken as the final word in the welfare of a country's citizens.

For whatever historical reason (Eric Weiner, in his funny and well-written book The Geography of Bliss, argues that it has a lot to do with the deep influence of Bhuddism on the country's culture), Bhutan's government has long championed the use of more direct measurements of welfare. Its king has stated that his goal for his country is not to just increase his country's GDP, but rather to improve Bhutan's Gross Domestic Happiness, or GDH, which is an official indicator calculated by the government statistics office.

Note that while Bhutan is at the forefront of this movement, other countries are slowly taking interest, such as the UK. In fact, The Guardian is reporting today that the Office of National Statistics has just released its preliminary thinking about how it would develop a national happiness indicator. (Read the Guardian article if you're curious to learn more about how such an indicator would be calculated.)

But it is little Bhutan that has finally been able to push this idea of the GDH statistic into the UN for discussion. And I think it's an important discussion to have. Because if you start thinking about the economic indicators you're using, what you're really doing is thinking about what matters to you in life and what your goals are. If the best goal we can come up with is the maximization of the amount of stuff available for consumption, then I guess we should just stick with GDP as the best measure of how we're doing. But doesn't that feel like a pretty small goal for our society?

Greece Update

2011-07-19T15:46:00.003-04:00

For those of you who are keeping up with the euro-zone debt crisis, I strongly recommend reading this piece by the BBC's Gavin Hewitt:

The euro and the endgame

It has not taken long, but increasingly attention is turning to the endgame of the eurozone crisis.

Everyone seems to accept that "the centre cannot hold, things fall apart". So every idea is in play: a break-up of the eurozone, Greece leaving, fiscal and political union, European bonds, a European treasury etc. It is at last being recognised that papering over and pretending cannot continue.

...What has changed is a recognition that Greece needs some debt relief. Almost every economist believes that at some stage Greece will default. It can be now or later. The debt-to-GDP ratio is heading for 170%. There is no way a country can escape that trap, particularly with an economy in recession. So a way has to be found to write off part of the value of the debts.

So a dozen schemes have been on the table... [and if] a solution is found a second Greek bail-out will be launched at a eurozone summit on Thursday. Of course the question will be asked: if Greece gets debt relief why shouldn't other countries? Steps may well be taken to extend the period of the bail-out loans already given to Portugal and the Republic of Ireland - as well as Greece - and reduce the interest rates.

...All of this may buy some time, some relief, but it won't address the wider issue: how to convince markets and investors that Europe has a plan to address its debt mountains at a time of low growth.

Take Italy. How will it find the growth to reduce its debt-to-GDP, which currently stands at 120%? Italy stands perilously close to the edge. All it takes is a 2% rise in its borrowing costs for it to struggle to pay its way.

Which is why so many people leap forward to the endgame.

Some say there is a choice. Europe could take a giant leap towards integration and so all debt would become European debt. It could only do this with fiscal union - and that almost certainly would need the backing of political union.

...Or: Greece is shown the door, offering it a sabbatical from the eurozone, allowing it the flexibility to default and devalue. A couple of other countries may have to follow too, but the core of the eurozone would be protected, and ringfenced. All of these countries could rejoin the single currency later. Nobody pretends it would be easy, but it might be preferable to risking the single currency.

Read the whole thing.

Should We Care About the Price of Gold?

2011-07-18T08:05:00.003-04:00

Last week gold hit a new record high, and the business press is now breathlessly reporting that gold futures broke $1,600 per ounce for the first time. Should we care?

There are a couple of reasons why we might care about the price of gold: if it tended to make other things more expensive, as oil does; if it told us something about market psychology, e.g. inflation expectations; if it was a good leading indicator for something. While some or all of these may have been true at times in the past, I don't think that any of them hold today, so the short answer to my question is no, I don't see any reason to care about the price of gold.

Wait a minute, you're thinking: gold is a classic hedge against inflation, and so the price of gold has always been viewed as a good indicator about where market participants think inflation is going. It turns out that the relationship between gold and inflation expectations is rather out-of-date; as shown in the chart below, the price of gold has not shown any correlation with inflation for the past 15 years or so. (Note that the green line shows one explicit measure of inflation expectations, by measuring the interest rate difference between bonds that are indexed against inflation compared to those that aren't.)

So the dramatic rise in the price of gold over the past couple of years does not seem to tell us anything about average market inflation expectations. Then what has caused that amazing price rise?

In looking at the data I was struck by how small (relatively) the worldwide market for gold really is. That means that relatively small inflows of funds into the market for gold could potentially have very large effects on the price of gold. And that in turn means that the price of gold could be very sensitive to a number of factors that have nothing to do with economic conditions or inflation.

The table below shows how much gold exists in the world, and its distribution. (Data is from the World Gold Council.) Most gold that has been brought above ground on Earth has been turned into jewelery. And even over the past couple of years, roughly 2,000 tons per year of new gold jewelery is produced. (Though keep in mind that a certain amount of gold jewelery is also recycled each year, so the net increase of gold that is in jewelery form is smaller than that.)

Surprisingly, over the past couple of years investment holdings of gold have risen by only about 3,500 tons. Comparing the total value of all investment holdings of gold at the end of 2007 with the end of 2010, we find that such holdings have risen by about $600 billion in value over that time, about $150 billion of which was due to a rise in the actual quantity of gold held for investment purposes, and the remaining effect due to the rise in the price of gold.

How much of a net inflow of money into the market for investment gold would have been necessary to cause the rise in the price of gold that we've witnessed recently? We can't say for sure without having a lot more specific data about supply and demand with which to estimate how sensitive the price of gold is to various factors. But we can put an upper limit on it: at most, the net influx of funds into the market for investment gold that lead to a near-doubling of the price of gold since 2007 was $600 billion (since that was the total increase in the value of investment gold).

In reality, it was almost certainly far, far less than that. If it takes an inflow significantly less than $600 bn to double the price of gold, it's reasonable to guess that a net influx of $100 bn, or probably even $50 bn per year into the market for gold investments would be enough to push the price of gold significantly and steadily higher. This is a small number, compared to the tens of trillions of dollars worth of other sorts of financial assets owned by households. See the table below for a summary of the financial assets owned by US households in recent years. (Source: Federal Reserve Board Flow of Funds data: pdf.)

So moving just 0.1% of the financial wealth of US households into gold could be enough to have a substantial impact on the price of gold. Note that the same can not be said of other asset prices that we care about; it would be difficult to discern any price effects whatsoever of a move of $50 billion more or less per year flowing into the stock market (valued at over $50 trillion around the world), the bond market (also with a total value in the tens of trillions of dollars), or real estate.

Given all this, what can we say about the steady rise in the price of gold in recent years? This analysis suggests that seemingly small phenomena could have big effects on the price of gold. For example, the increased demand for gold jewelery among millions of newly well-to-do households in China and India could be enough to do it -- if 5 million families per year each acquire a couple of pieces of gold jewelery (say perhaps 3 oz of gold), that would represent an increase in the demand for gold of $25 bn per year.

It's also conceivable that a good advertising campaign by gold producers could be enough to move the price of gold. Imagine that an effective, sustained advertising campaign, targeted at wealthy, conservative individuals in the US, is able to persuade 25,000 of them per month to switch a portion of their financial assets into gold. (Note that the target audience would be those roughly 3 million US households that have over $1 million in financial assets.) Suppose for the sake of argument that each of them is persuaded to shift just 5%, or $50,000, of their portfolio into gold. Such an advertising campaign would have the effect of pushing $15 bn per year into the market for investment gold -- very possibly enough to have a significant impact on the price of gold, given how small the overall market for gold is.

Note that a very similar thing happened to the market for diamonds in the middle of the 20th century. The DeBeers diamond cartel used an incredibly successful advertising campaign in the 1950s to cement the idea of the diamond as the premier gemstone, and in so doing permanently changed the value of diamonds.

Whether or not you like that analogy, the central point here is a very simple one. Since the market for gold is so small, its price may be strongly affected by things that have nothing to do with the economy. And since the price of gold tells us nothing about the state of the economy, it should no longer be considered to be a meaningful economic indicator. So I think that it's time to drop the price of gold from our daily headlines.

Italy's Catch-up with Spain

2011-07-16T15:57:00.005-04:00

The biggest news from the past couple of weeks regarding the euro-zone debt crisis has been the way that investors have added Italy to the list of countries that they are worried about. From this week's Economist:

The road to Rome

EVER since Europe’s sovereign-debt saga began, euro-area policymakers have feared that the turmoil afflicting first Greece, and then Ireland and Portugal, would engulf larger economies. Most attention had focused on Spain, a country that remains in peril. This week, however, contagion spread to another and even more alarming place: Italy.

Starting on July 8th bond markets staged an unexpected buyers’ strike, driving yields on Italian debt to their highest levels in a decade. These violent moves were mirrored by sharp falls in the shares of Italian banks. Markets calmed in mid-week amid talk that the European Central Bank had started buying peripheral debt. But the psychological damage has been done. The possibility that Italy, the euro area’s third-largest economy and the world’s third-biggest issuer of government bonds, might be sucked into the debt crisis cannot now be denied.

But actually, in some ways the sudden involvement (albeit in a very limited way so far) of Italy in the crisis could be seen more as a reversion to a more normal state of affairs. Until 2010 Italian bonds were judged by the markets to be a more risky investment than Spanish bonds, as illustrated by the spreads over equivalent German bonds displayed in the first column in the table below. The substantially lower level of Spanish government debt (again, see below) was certainly the reason for this. And in fact, it wasn't until May of 2010 that yields on Spanish bonds surpassed those of Italian debt.

The perceived riskiness of the sovereign debt of any particular euro country is the product of multiple factors, the most significant of which are probably the size of the outstanding stock of government debt (which, at around 150% of GDP, is what has convinced most observers that Greece is now insolvent) and the size of the current budget deficit. Spain has recently had a larger budget deficit than Italy (about 9.2% of GDP compared to 4.6% for Italy in 2010), and has added about nine percentage points more to its stock of debt than Italy over the past few years, but Italy's stock of debt is still far, far higher.

Clearly investors have begun reevaluating the relative importance of these two factors when assessing the riskiness of sovereign euro debt. And in so doing, they may be starting to revert to the sentiment that the overall size of the stock of debt is just as important as the size of present budget deficits. So rather than be surprised at the recent reconsideration of the riskiness of Italian government debt, perhaps we should be surprised that it took so long.

Great Depressions

2011-07-13T07:55:00.000-04:00

Coming across stuff like this is exactly why I've been reluctant to even pick up the newspaper (metaphorically) in recent weeks:

The U.S. Treasury will not default.

Despite all the rhetoric and posturing we see in the media and in Washington D.C., it is safe to say categorically that the U.S. Treasury will not default on its debt after August 2nd, even if the debt ceiling is not raised. Not only will the Treasury be able to pay interest on U.S. debt obligations, but there is money for other essential programs as well. However, there will be some serious cutting that has to happen because spending clearly exceeds revenues.

Yes, quite. In fact, some specific numbers are provided in this column: federal spending would instantly have to be reduced by about $100bn per month. By the end of 2011 federal spending would be about $500 bn lower for the year than it would have been otherwise.

I've made this point before, but for numbers that large, anyone who wants to pretend to have some understanding about the economy has to think about macroeconomic effects. In particular, spending cuts of that sze would reduce the US's 2011 GDP by multiple percentage points. The Q3 and Q4 GDP growth rates wold probably be on the order of between -5% and -10%. Recall that during the recession of 2008-09, GDP only fell by about 4% in total. The unemployment rate would be likely to rise by several percentage points from its current level of 9.2%, to perhaps 15% or more of the US population. Recall that at its worst, the unemployment rate during the Great Recession only reached 10%.

So when you read someone blithely writing that the federal government will not default in the absence of a debt ceiling deal, and instead will merely have to trim excess spending, remember that what they're really advocating is a new and deliberately caused Great Depression. And not just in economists like me.

Contagion: Looking Ahead to Spain and Italy

2011-07-13T07:24:00.001-04:00

The past week has been a busy one for people worried that the Greek debt crisis will soon spread to other countries. Ireland and Portugal have long been seen as susceptible to going the same way as Greece, but recently Italy has joined the group of countries seen to be potentially vulnerable.

So like many, I’ve been thinking a lot about contagion this week. But even though it seems to be common knowledge in the business press that if and when Greece defaults the crisis will immediately deepen for other countries, cogent explanations for why that might happen have been scarce. So I think it’s helpful to try to get more specific about why we think the crisis might or might not spread further to Spain or Italy. That will help us better understand whether those fears are real or overblown.

Most of the economic literature about contagion has focused on its applicability to currency crises, such as the EMU crisis of 1992-3 or the “Asian Flu” of 1998. However, the logic is similar when applied to sovereign debt crises. As a reminder, here’s a list of some of the explanations that have been put forward to explain previous episodes where financial crises spread from country X to nearby and similar country Y:

a common external shock: whatever factor originally tipped country X into crisis has the same effect on country Y, so it will also push Y into crisis.
the “wake up call”: when country X enters a crisis investors suddenly reevaluate their portfolios for risk, and sell off assets related to any country similar to X, thereby precipitating a crisis for country Y.
liquidity concerns among common creditors: crisis in country X causes creditors (e.g. banks) to suffer losses that force them to sell off assets in country Y, precipitating a crisis in Y.
cross-market hedging among common creditors: crisis in country X means that the portfolio of creditors (e.g. banks) has suddenly become more risky on average, so they respond by reducing their risk exposure elsewhere in their portfolio, in part by selling off the assets of any similar country also seen as risky, such as Y.
political contagion: the actions taken to deal with the crisis in country X (e.g. dropping a fixed exchange rate, or in this case, default) make it less costly for country Y to do the same thing, and investors realize this, sell off the assets of country Y, and thus precipitate a crisis for country Y as well.

The thing that these mechanisms have in common is that they all create a process of self-fulfilling expectations, where a loss of investor demand or confidence causes a sell-off of assets, which causes a crisis, which validates the original loss of confidence.

But in the case of Greece, I don’t think that most of these sources of contagion are of real concern, simply because the crisis has been drawn out over such a long period of time now that investors and creditors have all had plenty of time to expect and plan for a Greek default. So I think that the only one of these possible sources of contagion that might apply in this case is the last one, which for convenience I’ve labeled “political contagion”.

If Greece is seen to default (and it seems likely that however the EU chooses to package and label the terms of the new Greek bailout, it will involve some sort of "soft default"), then investors will have been provided a demonstration of how a limited default could work for other euro countries. This poses an enormous problem for European policymakers. Whatever new bailout and debt restructuring they agree to for Greece -- especially if it substantially reduces the Greek debt burden going forward -- could prompt Ireland and Portugal to ask for the same terms. On the other hand, if the terms of the Greek deal do not sufficiently reduce Greece’s debt burden then the deal will have done nothing to resolve the fundamental issue of insolvency, and policymakers will be right back where they started at some point down the road.

But developments in the financial markets over the past week have reminded everyone that policymakers may need to worry less about Ireland and Portugal, and instead be more far-sighted and consider first and foremost the impact on Spain and Italy. Because when it comes to those two countries, it is clear to everyone that if the debt crisis takes serious hold on them then a financial crisis will become a financial catastrophe.

Paradoxically, one way to help cut off the speculation in the financial markets that Spain and Italy could at some point be candidates for bailouts and/or debt restructuring would be for the EU and ECB to be relatively generous with Greece. If the transfers to Greece from the core euro countries are large – so large that they are difficult for France and Germany to agree to – then investors will have to draw the conclusion that such a deal could never, ever be applicable to Spain and Italy. Spain and Italy are just too big, and the aid packages that worked for Greece would never be feasible for them. While that wouldn’t necessarily stop speculation that Spain and/or Italy might someday be unable to service their debts, it would definitely stop speculation that they would ever be candidates for a Greek-style managed default. And that might be enough to help.

Slow Return

2011-07-08T12:24:00.002-04:00

A quick update: I'm back from summer travels, and slowly emerging from under the pile of back-to-reality make-up work. I should be able to spare some time to get back to posting in the next few days.

Summer Vacation!

2011-06-17T15:30:00.002-04:00

I'm leaving today for two weeks of (mostly) vacation with the kids, visiting family and friends in Europe. I will probably not be able to avoid keeping up with major developments in the Greek Debt Drama -- next week promises to be an eventful one -- so I may do a bit of posting here and there... but hopefully there won't be too much of that. (For both Greece's sake as well as, very selfishly, my own...) At any rate, more frequent posting will resume in July.

Superfood

2011-06-17T15:00:00.001-04:00

Is there anything olive oil can't do?

Olive oil 'helps prevent stroke'

Olive oil can help prevent strokes in people over 65, a study suggests. Researchers followed around 7,000 people aged 65 and over living in three French cities, for at least five years.

They found those who used a lot of olive oil in cooking or as a dressing or dip had a lower risk of stroke than those who never used it.

...Commenting on the study, published in Neurology, Sharlin Ahmed of the Stroke Association, said: "Olive oil has long been known to have potential health benefits.

"It is believed that it could protect against conditions such as high cholesterol, high blood pressure and heart disease and so it's promising to see that it could have a similar protective function against stroke.

US Bank Exposure to Greece, part 3

2011-06-17T09:25:00.004-04:00

Tracy Alloway at the FT summarizes some of the push-back against the idea that US banks have substantial exposure to Greece:

Who’s selling Greek CDS, again

There appears to have been a massive amount of misunderstanding about recently published BIS statistics regarding US banks’ Greek exposures. The idea that US banks are on the hook for $32.7bn of CDS written on Greece was first expounded by the Street Light blog, then picked up by us (unfortunately), then spread to Fortune and onwards to markets. This week US bank stocks moved on the concern, apparently.

Anyway, the BIS statistics do not clearly lay out the amount of US banks’ Greek CDS exposure. Anyway, the BIS statistics do not clearly lay out the amount of US banks’ Greek CDS exposure...

If you want a summary version, here’s Nomura’s new banking analyst Glenn Schorr:

The U.S. banks and brokers sold off yesterday [Wednesday] over concerns around exposure to a potential Greek debt restructuring or default. The concern was driven by a BIS report published this month that shows that U.S. banks and brokers have written $32.7bn of credit guarantees (most likely CDS protection) on Greece. Unfortunately, this number is only half the story, as it shows gross protection written but does not show the net exposure of U.S. banks, meaning that any hedges or collateral that the U.S. banks may have in place is not being captured in this number. While there is definitely some Greek exposure in the U.S. system, we think net exposure at the large U.S. banks and brokers is a whole lot less than the $32.7bn.

While I agree that the BIS data does not tell us how much of the exposure is due to CDS contracts, I disagree that it can't be used to tell us the size of the US banking system's exposure to Greek debt. The whole point of the BIS statistics is to measure the ultimate risks that banks face, after all, and so they take great pains to ensure that the statistics reflect the net effective exposure faced by banks. As explained by the BIS in their guide to the international statistics (pdf):

The statistics mainly provide information on international financial claims of domestic bank head offices on a worldwide consolidated basis, ie including the exposures of own foreign offices but excluding inter-office positions. Currently they indicate the nature and extent of foreign claims of banks headquartered in 30 major financial centres. In contrast to the residence or balance of payments principle of the locational statistics, the reporting of consolidated positions offers a more useful measure of the total risk exposure of a reporting country’s banking system.

...Consolidated data based on the residence of the party ultimately responsible for the repayment of an obligation (ultimate risk basis) in addition to total claims based on the residence of the immediate borrower (contractual claims) are more compatible with information produced by banks’ own internal risk measurement systems and are considered a more appropriate measure of country risk exposure.

Regarding the specific question of whether the "guarantees" listed in the BIS data are net or gross exposures, the answer is more complicated than the one provided by the Nomura analyst above. This week I asked BIS for clarification on how they handle CDS data. The BIS has told me that when a bank writes a CDS contract selling default protection, the gross amount appears in the line "guarantees". So Schorr has that part of the story correct -- the guarantees are, in a sense, gross CDS exposures, because they are not offset by the protection purchased (if any) by the bank to hedge the risk it took by selling the protection.

However, that doesn't mean that the offsetting protection purchased by the bank is simply not counted. It will be counted either in the "derivatives contracts" line of the BIS statistics, or the "foreign claims" line of the BIS data. In either case, the protection purchased through ofsetting CDS contracts are counted in the BIS data, so that when you add together the direct + indirect exposures, you have netted out all countervailing CDS positions and have the final, true, net exposure faced by banks.

In other words, the BIS data does indeed represent true net exposure, and in the case of US banks that exposure is about $40 billion to Greece, on par with the exposure faced by banks in France and Germany. No, we don't know exactly how much of that takes the form of CDS contracts, but we do know that the exposure is there.

Recent Exchange Rate Trends

2011-06-17T06:56:00.004-04:00

Exchange rates are on my mind this morning. Perhaps surprisingly, the euro has not been devastated recently by the high level of uncertainty regarding Greece. As evident in the chart below, the euro's value against the dollar has fluctuated rather choppily over the past two months in response to developments in the Greek Debt Drama... but there has been no sustained loss in value. In fact, it's not at all clear that a Greek default would devastate the euro; a high probability of default is already priced into exchange rates by now, so depending on how things happen (i.e. if it turns out not to be a complete disaster for the core European banks), it's possible to imagine currency investors feeling relieved that the event is finally over, causing the euro to strengthen.

Meanwhile, the picture also illustrates that the Japanese yen recovered very quickly from a short drop in March in the wake of the earthquake disaster, and since then has trended slowly higher (unsurprisingly). Disasters for an economy -- either real or financial -- are not always disasters for the economy's currency.

By the way, it turns out that the currency that wins the award for gaining the most strength so far this year is the Swiss Franc. I hope you haven't put off buying that watch you've been wanting, because if you get paid in dollars, it has already gotten 10% more expensive this year for you...

Greece at its Limit

2011-06-15T19:50:00.000-04:00

Ryan Avent provides an excellent summary of recent developments in the Greek debt drama:

Unpleasant Greek options

TODAY has been nasty day for markets, those in Europe especially. Equities are off. The euro is falling against the dollar. And yields on the debt of euro-zone periphery governments are rising to new heights. The yield on 3-month Greek securities is now over 12%. Markets want nothing to do with Greece if they can help it.

European yields have spiked many times before, and each time European leaders have responded with a new bail-out package or other reassurances to prevent Greek panic from fueling a broader contagion... So where's this go-round's intervention? Well the trouble at the moment is that Europe's leaders can't agree on one...

...It's not an insoluble set of problems. But given the euro-zone's institutional weaknesses, it's not a walk in the park, either.

I would have used stronger language than Ryan did in that last sentence, but I agree with the sentiment: the EU has demonstrated that it simply does not have the necessary mechanisms and institutions to deal with a deeply difficult problem like this.

Meanwhile, the Greek economy has been shut down by a general strike, the government is scrambling to avoid a collapse in the face of possible revolt by its own members of parliament, and protesters have been fighting "running battles with the police" today in the streets of Athens. All of that means that it seems increasingly improbable that the Greek government will be able to actually implement the new austerity package that was forced upon it by the "Troika" (the EU, IMF, and ECB).

If the agreed-to austerity measures are not passed into law by the Greek government, what happens? That would essentially mean the end of Greece's voluntary cooperation with the "kicking the can down the road" strategy. And if Greece isn't cooperating, then it's really hard to see how the Troika will agree to extend additional loans to Greece. This act in the drama may finally, finally be drawing to a close.

Has the Bad Housing Market Reduced Labor Mobility?

2011-06-14T18:38:00.000-04:00

Economists Colleen Donovan and Calvin Schnure have written an interesting new paper examining whether the fall in house prices since 2007 in the US -- which has left many home-owners owing more on their house than it is worth -- created a lock-in effect that depressed labor mobility.

This question has significance far beyond either the real estate market or the labor market, because there has been a persistent line of argument from some that the US's current unemployment problem is not the result of insufficient demand, but is instead a "structural" problem resulting from the inability of the US economy to properly match people with available jobs. A frequent explanation for why it suddenly became difficult to match people with jobs in 2008 is that underwater mortgages have locked people in to their houses, reducing labor mobility and making job-matching more difficult.

The evidence presented in this paper indicates that the fall in house prices has indeed caused a "lock-in" effect, but has not significantly impacted labor market efficiency. Here's the abstract:

LOCKED IN THE HOUSE: DO UNDERWATER MORTGAGES REDUCE LABOR MARKET MOBILITY?

The collapse of the housing boom led to an unprecedented number of homeowners who are “underwater”, that is, owe more on their mortgage than their homes are worth. These homeowners cannot move without incurring significant losses on their homes, possibly causing a “lock-in” effect reducing geographic mobility. This raises concerns that a reduction in labor market mobility may hamper the ability to move to accept employment in another geographic market, degrading labor market efficiency and contributing to higher structural unemployment.

This paper examines housing market turnover and finds significant evidence of a lock-in effect. The lock-in, however, results almost entirely from a decline in within-county moves. As local moves are generally within the same geographic job market, this decline is not likely to affect labor market matching. In contrast, moves out-of-state, which are more likely to be in response to new employment opportunities, show no decline, and in fact are higher in counties with greater house price declines. Housing market lock-in does not appear to have degraded the efficiency of the labor market and does not appear to have contributed to a higher unemployment rate.

This is a significant piece of evidence against the "structural unemployment" explanation for the US's high and persistent unemployment rate. Yes, labor market inefficiencies do certainly exist, and there are a variety of reasons why economies don't always perfectly match unemployed people with available jobs. But the underwater mortgage "lock-in" phenomenon that has been cited as the primary reason why the US's labor market suddenly got so much worse starting in 2008 simply does not match the evidence.

As a result, if we want to understand why unemployment has been so persistently high in the US since 2008, we have to look beyond "structural" or supply-side explanations. Once again, the far simpler explanation seems to better match the evidence: there's just not enough demand, so businesses aren't hiring, and people remain unemployed.

A New Era for the US-China Trade Deficit?

2011-06-14T07:56:00.002-04:00

Inflation in China is, if not quite galloping, at least trotting along at a decent clip:

Inflation quickens in China, India; Beijing raises reserve ratios

BEIJING/MUMBAI, June 14 (Reuters) - Inflation in China and India accelerated in May, prompting Beijing to lift bank reserve requirements on Tuesday and keeping pressure on India to raise interest rates later this week even as Asia's two big growth engines show signs of slowing and recovery stalls elsewhere.

China's consumer price inflation hit a 34-month high of 5.5 percent, keeping inflation-fighting at the top of the agenda for Beijing, which sees little chance of the current slowdown from last year's 10 percent-plus growth turning into a hard landing.

Inflation in China has been an important contributor to the subtle but very significant change in the pattern of trade that we've seen between the US and China. For nearly 20 years, the story of the US's trade with China was a simple and predictable one: month after month, year after year, the US imported more from China. US exports to China also grew, but at a slower rate, and so the US's trade deficit with China grew steadily. That story had grown so monotonous that by the mid-2000s many people had stopped paying attention to it.

But over the past couple of years that pattern has been broken. The big difference is that now, US exports to China are starting to grow rapidly, while US imports from China are growing slowly at best. Since the start of 2008, US exports to China have risen by about 40%, while US imports have risen by only about 10%. Granted, US exports are rising from a much lower base than imports, so it will be a while before we see that change actually start to reduce the US's overall trade balance with China... but even so, the bilateral trade deficit (goods + services) has been roughly constant for almost four years now, as shown in the chart below.

This striking change is the result of two related forces: the strong growth of the Chinese economy (particularly relative to the anemic US economy), and the rise in Chinese prices. Higher inflation in China means that Chinese-made products are now less competitive than they were a few years ago, inhibiting US imports. And at the same time, Chinese inflation makes US-made goods and services look somewhat cheaper to Chinese consumers than they used to.

Since there's probably no reason to expect either the growth differential or the inflation differential between the US and China to reverse course any time soon, it's reasonable to expect these recent trends in US-China trade to continue. And if so, then I wouldn't be surprised if we may be near the all-time peak of the US-China trade deficit. Within a year or two the US-China trade balance could actually begin to show sustained (and not recession-driven) improvement. And wouldn't that be a striking change from what we're used to? We could be near the end of an era...

Indirect US Exposure to the Euro Debt Crisis, part 2

2011-06-13T19:18:00.000-04:00

As last week's new BIS data showed, it appears that US banks indirectly have substantial exposure to the peripheral Euro-zone countries that are teetering on the edge of bankruptcy. Exactly what form that exposure takes is a bit uncertain, though it seems likely that much of it is in the form of credit default swaps (CDS) written by the US banks to provide insurance against default to the holders of bonds from Greece, Ireland, and Portugal.

But it's a bit frustrating not to have a clearer understanding of exactly what form this exposure takes. So I've been trying to see if there is any public information that can give us a hint about exactly how the big US banks have incurred such exposure.

Unfortunately, it's very difficult to get any good information about banks' derivatives exposures. The major US banks tend to downplay their exposure to the Euro debt crisis in their SEC filings. For example, in their 2010 10-K filing Bank of America wrote:

Certain European countries, including Greece, Ireland, Italy, Portugal and Spain, are currently experiencing varying degrees of financial stress. These countries have had certain credit ratings lowered by ratings services during 2010. Risks from the debt crisis in Europe could result in a disruption of the financial markets which could have a detrimental impact on the global economic recovery and sovereign and non-sovereign debt in these countries. The table below shows our direct sovereign and non-sovereign exposures, excluding consumer credit card exposure, in these countries at December 31, 2010. The total exposure to these countries was $15.8 billion at December 31, 2010 compared to $25.5 billion at December 31, 2009.

In fact, B of A's direct exposure to Greece is listed at only about $500 million. But note that that is their direct exposure. What we learned from the BIS data is that they also have indirect exposures, which probably arise primarily through their credit derivatives purchases and sales.

The following table summarizes all of the useful information I could gather about credit default derivative activities from the 2010 annual SEC filings of the six largest banks in the US. It's not much, and doesn't really answer our original question, so mainly this just confirms what we have no way of knowing which US banks are exposed to the Euro debt crisis or why.

Let me walk you through the figures in this table. The first line shows CDS contracts sold by each bank -- essentially how much insurance against default each bank sold to third parties. Note that some of that insurance was on non-investment grade assets (which would include Greece, of course). That's the second line.

Now, it's often the case that a bank doesn't want to have an open position on that contract -- in other words, it doesn't really want to make the bet that the underlying asset will remain sound. In those cases the banks purchase default insurance themselves on the same asset. The effect is that the bank is then just making money on the spreads and fees, but has nothing to gain or lose based on whether the underlying asset defaults.

If you subtract line 3 from line 1, then you have the net open positions taken by each bank on the credit default insurance it has written. That line is highlighted in the table above, because that tells us how active each bank has been in actually placing bets on default outcomes. No details are provided by the banks about where those exposures are, however, either geographically or by type of underlying asset.

Finally, the last line is also somewhat interesting, because it tells us how much income each bank earned from their trading in CDS as well as their betting (taking open positions) on default events. Obviously, if you do it right you can really make some good money in the CDS market -- over $9 billion in 2010 for B of A. Note that every month that goes by without a Greek default is great for the sellers of default insurance on Greek assets, so it could well be that some of these banks are making a killing right now on the default insurance they've sold.

What can we conclude from this? I can think of a few things.

1. Bank of America, Morgan Stanley, and Goldman Sachs are the most aggressive in terms of taking open positions on default outcomes. But we have absolutely no idea how much of those positions (if any) were with peripheral Euro assets. Also, while the last two firms don't break out income attributable to CDS activities (at least not that I could find), B of A made a huge portion of their profits in 2010 from them. (Note that Citi did not indicate how much of the CDS protection that they sold was covered by purchases of CDS insurance, so they may or may not be in that list as well.)

2. The aggregate CDS exposures of the big US banks are certainly large enough to be plausibly consistent with the BIS estimate of about $100 bn in indirect exposures to peripheral Europe. If you add up the highlighted numbers (and make a guess at Citi's position), it seems reasonable to guess that the total net open positions on CDS protection sold to third parties by the big US banks is between $1,500 and $2,000billion. Attributing $35 bn of that (about 2%) to Greece, which has certainly had one of the most active markets (proportionally) for CDS contracts over the past year, doesn't seem to be a stretch.

3. Banks do not have to provide much detail about the indirect credit exposures that they take on when they sell default insurance through the CDS market. We have incredibly scant information about the positions that US banks take through default insurance, and therefore no idea about how any individual bank will be affected by a Greek default.

4. It's hard to find any other potential exposures to Greece, Ireland, and Portugal in the banks' public filings, other than through CDS contracts. Combined with points 2 and 3 above, the process of elimination suggests to me that CDS contracts are indeed likely to be the source of the bulk of US banks' indirect exposures to a Euro-zone default.

Finally, a note about the risk this poses to the US banking system. The big US banks are well-capitalized now, and can fairly easily absorb losses of several billions of dollars in the event of a Greek default. But two serious concerns remain. First, I fear that this may have the potential consequence of exacerbating the flight to safety that will happen in the event of Greece's default; if you have no idea who is really going to be on the hook and ultimately liable for CDS payments, your best strategy may be to trust no one. I don't think that triggering post-traumatic flashbacks of the fall of 2008 is going to do good things to the market or the economy. Second, I wonder if there's a public relations disaster just lying in wait for the big US banks. After all, how will you feel (assuming you don't work on Wall Street) when you read the headline that Big Bank X lost money because it sold billions of dollars of credit default insurance while it was on taxpayer life-support? Rightly or wrongly, I'm guessing that Big Bank X will not be very popular for a while.

Greece Endgame, pt. 2

2011-06-11T21:43:00.005-04:00

Dear Troika,

It seems that you're starting to agree with me: it's probably inevitable at this point. There will be some sort of restructuring (i.e. default) on Greek debt. It may be "voluntary" (Vienna-style) at first, but at best the voluntary-ness of it won't last past the present (June) agreement, so in a few months we'll be facing the same situation except with the "voluntary" option no longer on the table.

If you're a member of the "Troika" and you accept that, then it's time to change your goals. Perhaps until now you've been mainly working to try to avoid Greek default. (Though that has not been entirely clear.) And since the possibility of default grew and we began entering the endgame, it certainly seems like your objective shifted to trying to get a relatively good bargaining position for the negotiations about how default would happen. But now it's probably time to focus on something else.

That 'something else' is the precedent that you will be setting for Portugal and Ireland. They are carefully and critically watching your actions vis-à-vis Greece, and will take their cues from what you decide there -- as will investors around the world. In other words, while Greece is probably lost, the details of exactly how you decide to retreat will have a big impact on how investors and governments in Portugal and Ireland act. Time to move on to the next battle.

Put another way: if you do this right, the crisis could end here. If you do it wrong, you can multiply the crisis by three.

Yours sincerely,

Kash

Contractionary Mania

2011-06-10T06:17:00.005-04:00

The current bizaare mania for contractionary policies during a time of low inflation and economic weakness is not confined to the US, or to fiscal policy:

ECB signals eurozone interest rates are set to rise

The European Central Bank (ECB) has signalled that it will raise interest rates next month, from 1.25%.

Earlier on Thursday, the ECB kept rates unchanged for the second month in a row, after increasing them in April for the first time in almost two years. The central bank wants to raise rates again in July to curb inflation in some of the eurozone's 17 member states.

However, one really has to squint to see any signs of an inflation problem in Europe. Commodity prices around the world (particularly oil and some raw agricultural products) experienced a bump in prices between the fall of 2010 and spring of 2011. But that is really the only source of inflation the Euro area has experienced recently, as the ECB itself admits, writing in their most recent Monthly Bulletin (pdf):

The increase in inflation rates during the first four months of 2011 largely reflects higher commodity prices.

Excluding energy and raw food prices, the core rate of inflation remains in the neighborhood of 1.5% over the past 12 month, well below the Euro-zone's average inflation rate over the past decade. The following chart shows core inflation separately in Germany and in the rest of the core Euro-zone over the past decade.

Yet despite its acknowledgement that the recent rise in inflation is almost completely due to transitory factors (which began to reverse themselves in May), and without providing any reasoning for this statement, the ECB continued its discussion of inflation in the latest Monthly Bulletin by adding:

Looking ahead, inflation rates are likely to stay clearly above 2% over the coming months.

It's hard to see how this will happen, when core inflation is well under 2% (which is by far the better predictor of future inflation -- see this post by Paul Krugman for further details on that), this winter's rise in commodity prices (that the ECB itself admits is the primary cause of the current bulge in headline inflation) is over, and in fact commodity prices have recently begun experiencing deflation as their prices fall back somewhat.

It's mystifying.

Greek Endgame?

2011-06-08T08:25:00.007-04:00

The key players in this drama are making it embarrassingly easy to imagine exactly how a Greek default could happen this summer.

The immediate concern has been whether and under what conditions the "Troika" -- the IMF, the ECB, and the EU Commission -- would agree to give the Greek government another dollop of money (€12 bn) in July. Last Friday, the Troika seemed to indicate that they had agreed in principle to go ahead and disburse the July tranche of funds. But nothing has been finalized yet (and probably won't be until EU finance ministers meet on June 20), and public disagreements within the Troika are growing louder every day.

Consider the current state of affairs, and what we know about the members of the Troika:

1. The IMF. They have a policy of not disbursing additional funds unless they are assured that the recipient country has solid prospects of being fully funded for at least 12 months. Greece does not have such prospects. Note that the IMF takes great institutional pride in the fact that its loans always get repaid, in part because it is willing to be hard-nosed enough to stop throwing good money after bad. So even though the IMF seemed to agree to the July tranche with last week's announcement, it seems quite possible that the IMF could still back out if the other two legs of the Troika don't come to a realistic agreement covering the next 12 months. And then, of course, they'll have another chance to play coy again in three months...

2. The ECB. They have threatened sturm und drang if there is any Greek restructuring (i.e. default). They've made it quite clear that they will allow the Greek banking system to collapse if restructuring happens -- which, I've argued previously, essentially means that they are saying that they will force Greece out of the eurozone if there's a restructuring. With that threat in hand, they have placed themselves squarely in the camp of the large banks and other creditors, which may not be surprising since the ECB is in fact Greece's largest creditor.

3. The EU. Naturally, the governments of the EU are worried about the political consequences of events in Greece. That explains this week's letter to the ECB from the German finance minister, Wolfgang Schaeuble, who wrote that the German government won't support the disbursement of additional funds for Greece without some restructuring. In essence, the German government has placed itself squarely in the camp of European taxpayers, who naturally don't want to have to bear the cost of the Greek default single-handedly (i.e. without getting the banks and other creditors to share in the pain). What leverage do they have? They can refuse to contribute more money to Greece, and that is the threat contained in Schaeuble's letter.

Given this information, I encourage you to take a short multiple choice quiz.

Question 1: Are the public positions of the members of the Troika more consistent with:
(a) Three parties trying to come to an agreement on how best to prevent Greece from defaulting.
(b) Three parties each looking out for their own interests, arguing over who is going to bear the costs of the Greek default, and using whatever leverage they have to improve their own outcome in the event of default.

I think you could make an argument that either answer could still (possibly) be the right one. However, the current situation does feel very much like a typical endgame in any bankruptcy, whether personal, corporate, or sovereign: at a certain point, the arguments stop being about how to prevent the bankruptcy, and start to be about how the pain will be distributed. To me, it's beginning to feel like we've reached that point.

Betting On the PIGs

2011-06-06T08:34:00.012-04:00

The BIS today released some very interesting new data (pdf) on the exposure of various parties to debt issued by the PIGs (Portugal, Ireland, and Greece). There is a lot of good stuff in this data -- particularly what it tells us about who is betting which way on a default by one of the PIGs. Let me first make three observations.

Observation #1. Default Insurance Matters.
First, the BIS data very helpfully breaks exposures into two pieces: direct exposures, which basically means creditors who own bonds issued by one of the PIGs; and indirect exposures, which for the most part means agents who sold default insurance to creditors, primarily through credit default swaps. As summarized in the following table, it seems that approximately 30% of total potential exposures to debt from the PIGs are covered by default insurance (see the figures in red). Put another way, if one of the PIGs defaults, creditors who actually hold bonds from that country will absorb about 70% of the losses, while agents (primarily banks and insurance companies) that sold insurance against the possibility of default will have to cover the remaining 30%. That's not a trivial amount. (All figures below are in billions of USD, as of the end of 2010.)

Observation #2. Direct Exposure in Europe, Indirect in the US.
The table above also hints at striking differences between how European and US creditors would be hit in the case of default by one of the PIGs. If Greece were to default, for example, approximately 94% of the direct losses would fall on European creditors, and only 5% would fall on US creditors. However, US banks and insurance companies would have to make about 56% of the default insurance payouts triggered by such an event, while European agents would make only 43% of those payouts.

The next table illustrates this difference even more starkly. In the case of Greece and Portugal, the vast majority of the losses that would be borne by creditors in Europe would be direct losses. In fact, French and German creditors would almost certainly be substantial net recipients of default insurance payments. (That's less clear in the case of Ireland.) Meanwhile, US financial institutions would have to make substantial net default insurance payments, which would account for between 80% and 90% of all losses borne by the US in the case of default (see the figures in red below).

Observation #3. Similar Overall Exposures in Europe and the US.
Finally, it's worth noting that once you account for the substantial payouts that US agents will have to make to European creditors in the case of a default by one of the PIGs, financial institutions in the US have roughly as much to lose from default as those in France and Germany. (See the figures in blue in the table above.) The apparent eagerness of US banks and insurance companies to sell default insurance to European creditors means that they will now have to substantially share in the pain inflicted by a PIG default.

Implications
This has some important implications. First, US and European financial institutions are likely to have very different incentives as negotiations regarding debt restructuring and reprofiling proceed. US banks and insurance companies are surely delighted with the "soft restructuring" that is currently being discussed. Such a partial default would probably not trigger default insurance payments, and so the pain would be borne almost exclusively by European institutions. On the other hand, some time soon it seems likely that European creditors will begin to prefer a "hard restructuring" that would require default insurance payouts from the US institutions that sold such insurance. Given how strikingly one-sided the net default insurance payments will be (from the US to Europe), it's easy to imagine how that could shape future negotiations over debt relief for the PIGs.

Second, there's an interesting puzzle here. Why have European and American financial institutions behaved so differently when it comes to the PIGs? Specifically, why have American firms been so willing to sell default insurance to the Europeans, though they have not bought much PIG debt? And conversely, why have the Europeans systematically been so eager to buy insurance for their PIG debt, even at the very high price such insurance now commands? In essence, European firms have been betting that a PIG default will happen sooner rather than later, while US firms have been betting that default would happen later or not at all.

There may be some subtle institutional reason for the dramatic difference in behavior between US and European financial institutions; I would welcome any insights or suggestions. An alternative explanation could be that there are informational differences, and/or that European financial institutions have a systematically different view of the PIGs than US financial institutions do. Could the Europeans know something that the Americans don't about the likelihood or timing of eventual default? I hesitate to believe that, but I don't have another good explanation for the one-sidedness of the betting on a PIG default...

UPDATE (June 13): In response to questions from a number of readers, here are some details about BIS definitions.

First note that these exposures are net, not gross exposures. Here's the BIS definition of exposures on a consolidated basis as reported in this data: "The consolidated banking statistics report banks’ on-balance sheet financial claims (ie contractual lending) vis-à-vis the rest of the world and provide a measure of the risk exposures of lenders’ national banking systems. The data cover contractual (immediate borrower) and ultimate risk lending by the head office and all its branches and subsidiaries on a worldwide consolidated basis, net of inter-office accounts... [T]o reflect the fact that banks’ country risk exposure can differ substantially from that of contractual lending due to the use of risk mitigants such as guarantees and collateral, reporting countries provide information on claims on an ultimate risk basis (i.e. contractual claims net of guarantees and collateral) since June 1999." (BIS Quarterly Review, Statistical Annex (pdf), p. A4.)

Second, there's some confusion about whether what I've labeled "indirect exposures" are really comprised significantly of credit default swaps (CDS). The confusion arises from the fact that the BIS data contains a line entry for "credit derivatives" which is very small for US banks (a net exposure of about $1bn for US banks with respect to Greece in that category), but then also has an entry call "guarantees" that is much larger (about $33bn for US banks with respect to Greece). It turns out that most CDS contracts are actually probably included in the "guarantees" line of the BIS data, not the "credit derivatives" line.

Here's the explanation from the BIS guide to their international statistics (pdf, p.14):

[C]redit derivatives, such as credit default swaps and total return swaps, are only reported under the item 'Derivative contracts' if they are held for trading by a protection-buying reporting bank. Credit derivatives that are not held for trading are reported as 'Risk transfers' by the protection buyer and all credit derivatives should be reported as 'Guarantees' by the protection seller.

'Guarantees' are contingent liabilities arising from an irrevocable obligation to pay a third-party beneficiary when a client fails to perform some contractual obligation. They include secured, bid and performance bonds, warranties and indemnities, confirmed documentary credits, irrevocable and standby letters of credit, acceptances and endorsements. Guarantees also include the contingent liabilities of the protection seller of credit derivative contracts.

While we can't say for certain how much of US banks' indirect exposures to Greece are the result of CDS protection written on Greek bonds, we can say that any time a bank uses a CDS to take an open position rather than strictly for trading purposes (in which case we wouldn't expect the bank to have a significant open position by the end of the year anyway, which explains why the BIS entry for "credit derivatives" is so small), then that amount will show up in the BIS line called "guarantees". Given my suspicion that US banks are not writing a lot of letters of credit or otherwise directly issuing warranties and endoresements to Greek institutions, it seems likely that the bulk of the indirect exposure reported by the BIS for US banks to Greece is in fact in the form of CDS contracts.

UPDATE #2 (June 13): For more on this, see the new post Indirect US Exposure to the Euro Debt Crisis, part 2.

QE2: What it Did, and What it Didn't Do

2011-06-05T09:56:00.005-04:00

QE2 is winding down, and will be completely finished sometime around the end of this month. And as I mentioned yesterday, I think that the chances for a new round of expansionary action by the Fed this year are very small. Despite what some think, however, the reason for that is not because the Fed's last effort -- what is usually, if inaccurately, referred to as "QE2" -- was a failure. In fact, the research indicates that QE2 worked as intended, and had positive, if modest, effects on the US economy.

What's in a name

Let's start by clearing up an oft-misunderstood point. The Fed did not actually engage in what we typically think of as "quantitative easing", the way that the Bank of Japan did during the early 2000s. The goal of the Large Scale Asset Purchase ("LSAP") program (the more accurate term for QE2) was never to "create money". As illustrated in the chart to the right, none of the reserves given by the Fed to banks under LSAP were actually lent out -- they were all simply held by banks as additional excess reserves, exactly as the Fed expected and intended. Since "money" is only created when banks lend out their reserves, this means that the LSAP program didn't cause any money to be created, which is why the supply of money didn't budge.(1)

So "QE2" (I'll revert to the common shorthand for convenience) was not intended to create money, and did not create money. Instead, the program was intended to help the recovery by reducing long-term interest rates. The Fed did that by selling short-term assets and buying long-term bonds -- that's really the essence of LSAP. (Since the Fed doesn't normally buy a lot of long-term bonds, this program was new and got a special name, but it's fundamentally quite a simple idea.) And the hope was that by buying some long-term bonds and thereby lowering long term interest rates, QE2 would help stimulate demand.(2)

What QE2 didn't do

Before we examine what QE2 did do, it's helpful to understand what it didn't do. A lot of the evils of the world have been wrongly attributed to QE2 in recent months. Here are some frequent criticisms:

QE2 has caused rampant inflation.
QE2 has artificially inflated asset prices such as the stock market.
QE2 has devalued the dollar.
QE2 simply didn't work.

Let's take these in turn.

1. Inflation: Critics say that all of the money pumped into the economy by QE2 has caused a surge in prices. Yet we know that QE2 has actually not created any additional money. So it's hard to see how QE2 has caused inflation. Furthermore, it's quite straightforward to trace the recent rise in global food and commodity prices to certain specific factors such as turmoil in the Middle East and several bad harvests for grains and vegetables (Russia, Argentina, Australia, Mexico).

2. Asset prices: Critics say that by purchasing long-term assets, the Fed has flooded the financial markets with cash, causing all asset prices to rise. A more sophisticated variant of this criticism is that by driving long-term interest rates down, QE2 has forced investors to seek higher returns in other types of assets, driving their prices up. But there are several problems with this theory. First, QE2 created no money (not to beat a dead horse or anything), so any notion that there was a broad injection of liquidity that caused commodity price inflation is wrong. Second, many of these same critics say that QE2 hasn't worked (point 4), and they point to the fact that long-term interest rates are no lower now than they were in the fall of 2010. But if interest rates weren't driven down, how could QE2 have caused asset prices to rise? (As shown below, the evidence is that interest rates actually did go down in response to QE2, but that is not generally recognized by QE2's critics.) Finally, the Fed has only purchased $600bn in long-term US government bonds. That's less than 5% of the US government bonds in existence, and probably well under 1% of the value of all types of traded assets (stocks, bonds, commodities, real estate). Even though the evidence (see below) is that QE2 was able to push down interest rates a bit, it doesn't seem likely that such a relatively tiny influx of demand into bond markets could cause a dramatic change in overall asset prices outside of the bond market.

3. The value of the dollar: Critics say that QE2 weakened the dollar by causing inflation and/or by causing a loss of confidence in the dollar. But the dollar is just as strong as it was in the middle of 2008, and only about 3% weaker than it was in Oct 2010 when QE2 started. So no systematic weakening of the dollar is apparent, which makes it unclear why the critics of QE2 raise this complaint, since they do not typically make the correct comparison against what the dollar exchange rate would have been in the absence of QE2. But more importantly, even if QE2 has caused the dollar to be weaker than it would otherwise have been, we should be thankful for that -- a weaker dollar is exactly what the US economy needs right now to help stimulate demand. It would be a good thing right now, not a bad thing.

4. QE2 simply didn't work: Some critics say that it was a waste of money -- it cost $600 billion but the economy is still lousy. First of all, QE2 didn't actually cost anything -- the Fed still has that $600bn, it's just now in the form of US government bonds. But second, yes, I agree, the economy IS still lousy... but that doesn't tell us anything about whether QE2 worked. Without QE2, it's entirely possible that the economy could have been in even worse shape. So the correct comparison to understand the effects of QE2 is to try to understand what would have happened in the absence of QE2. This, the critics of QE2 do not do. (Plus, if you think that QE2 didn't have any effects, then you should really drop criticisms 1-3, which rely on the premise that QE2 was effective.)

In short, it's pretty unlikely that QE2 caused any of the terrible things its critics attribute to it. So did QE2 actually accomplish anything?

What QE2 did do

The correct way to figure out what QE2 did is to first try to estimate what would have happened without QE2, and then compare that with what actually did happen. And while that can be a tricky exercise, that's what economic research is all about, so let's see what the research has found.

Krishnamurthy and Vissing-Jorgensen (Kellogg Northwestern): "The Effects of QE2 on Long-term Interest Rates" (pdf). They find that QE2 was likely to reduce interest rate on long-term AAA bonds by about 30 basis points, and rates on average long-term corporate bonds and mortgage loans by about 10 basis points, compared to what they would otherwise have been. They do not estimate what impact, if any, those interest changes had on real economic activity.
Gagnon, Raskin, Remache, and Sack (New York Fed): "Large-Scale Asset Purchases by the Federal Reserve: Did They Work?" (pdf). Using two completely different methodologies they find that QE1 (which was about 3 times the size of QE2) reduced long-term interest rates by between 50 and 80 basis points. Based on that estimate, the implied effect of QE2 would be to reduce long-term interest rates by between roughly 15 and 30 basis points.
Hamilton and Wu (UCSD / Chicago): "The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment" (pdf). They estimate that a $400bn LSAP by the Fed would reduce long-term interest rates by about 13 basis points; a simple linear extrapolation of this result implies that QE2 would have reduced interest rates by about 20 basis points.
D'Amico and King (FRB): "Flow and Stock Effects of Large-Scale Treasury Purchases" (pdf). They look at the stock and flow effects of the Fed's purchases of Treasury securities in 2009 to estimate their impact on interest rates. Their estimates imply that QE2 would have had a total impact on long-term interest rates of between 15 and 30 basis points.
Chung, Laforte, Reifschneider, and Williams (FRB / SF Fed): "Estimating the Macroeconomic Effects of the Fed's Asset Purchases". Using the Fed's own large-scale model of the US economy (FRB/US), they estimate that QE2 pushed down long-term interest rates by about 25 basis points. They also use the FRB/US model to estimate the impact that this had on unemployment and output, and find that QE2 raised GDP by about 0.75%, and employment by about 700,000.

While this is not an exhaustive compilation of the research, it's striking that the estimates are all remarkably similar, despite very different methodologies: QE2 reduced long-term interest rates by 20 to 30 basis points compared to what they would otherwise have been, and this in turn almost certainly had some positive impact on employment and output in the US.

So... Was QE2 a good idea?

Unfortunately, QE2 is not the only thing that has affected the US economy over the past 6 months, and many of the other forces at work have negatively impacted the economy. So the small but positive effects of QE2 were swamped by the other things going on such as supply-side shocks, contractionary fiscal policies, the US Treasury's program of large scale asset sales (i.e. bond sales to finance the deficit) that directly undid much of the effect of QE2 on interest rates (see Jim Hamilton for more on that), and a discouraging lack of private demand.

So yes, I would say that QE2 was probably a good idea, but it was simply not a sufficiently powerful tool to be able to single-handedly ensure a good recovery in the face of all of these headwinds. It helped a bit at the margin, and may have played a crucial role in helping the US step away from a dangerous flirtation with deflation in 2010... but the problems facing the US economy are just too numerous and substantial. My conclusion is that the only policy tool powerful enough to really help the US economy right now would be a new round of expansionary fiscal policy. Unfortunately, that's about as likely as me winning an Oscar this year.

That doesn't mean that QE3 would be a bad idea. In fact, given the new and alarming weakness in the US recovery, I think that further expansionary monetary policy would be very much worth trying. I wouldn't expect a dramatic impact, but right now the US could use every little bit of help it could get. Unfortunately, QE3 is only slightly less unlikely than a new round of expansionary fiscal policy (maybe on par with the likelihood of me winning a Grammy). And that's too bad, because every month that goes by with current levels of unemployment causes permanent long-term damage to countless individual lives, as well as to the US economy as a whole.

UPDATE: text edited slightly for clarity.

(1) For more on the distinction between what the Fed actually did and "quantitative easing", take a look at this speech by Ben Bernanke from January 2009, especially the part about halfway through.
(2) There are a number of channels through which lower long-term interest rates could possibly stimulate demand, including wealth or portfolio effects, exchange rate effects, and direct interest rate effects.

Missing the Will to Fight

2011-06-03T20:10:00.000-04:00

Gavyn Davies wonders where we can look for help as the US economy struggles to regain some forward momentum:

US economy: out of ammo?

The US employment numbers for May seemed to surprise the markets, but in fact they confirmed what we already knew from a string of earlier data releases, which is that the economy has slowed very markedly in recent months. The debate now is whether this slowdown has been triggered mainly by transitory factors – the fallout from the Japanese earthquake, stormy weather, and a spike in gasoline prices above $4/gallon – or whether it reflects a more fundamental malaise in the economic recovery.

...I am not usually disposed towards pessimistic nightmares about the US economy, but I am worried about the all-too-easy assumption, which is often heard from investors, that the Fed will automatically ride to the rescue if there are signs of a double dip recession. In fact, I have been told several times this week that QE3 is already a “done deal”...

...The Fed itself has done many studies which show that QE has had very similar effects to more conventional forms of monetary easing, but the evidence of the past 6 months has made many people sceptical about this comforting conclusion. Since QE2 was launched, real GDP growth has slowed markedly, while inflation and commodity prices have risen. Rightly or wrongly, another dose of the same medicine would certainly be a hard political sell.

And that is the source of my nightmare. If the present downward momentum in the economy were (unexpectedly) to continue, where would the rescue come from? With the Republicans in charge of the House, another fiscal stimulus seems improbable, to say the least. And even Mr Bernanke, who is clearly able to read the political tea leaves, has said that the hurdle to more Fed easing is “very high”. In these circumstances, the markets might suddenly conclude that the US cavalry is “out of ammo”.

Davies is right to worry. While transitory factors have played a role in the spring slowdown in the US economy, they only account for a portion of the problem. And unfortunately, I really don't think we can expect any new expansionary fiscal or monetary policy this year.

I would disagree with him about one crucial point, however: the reason that QE3 won't be tried this year is not, as Davies suggests, because QE2 proved ineffective. Rather, QE3 is simply not politically feasible for the Fed under present circumstances. Conservatives have attacked the Fed's program of Large Scale Asset Purchases (LSAP) not because they have actual evidence about its effects -- they don't -- but rather because they find it a convenient shorthand for criticising current macroeconomic policy in the US. Given fierce Republican opposition to expansionary policies, and in the context of the various threats they have made to curb the Fed's independence, Bernanke's hands are effectively tied this year.

So let's be perfectly clear about why policy-makers aren't fighting to save the recovery. It's not because they are out of ammo, or because the remaining rounds in their holster are defective. It's because the political will to fight for the US economy is simply not there.

Contractionary Fiscal Policy and the US Job Market

2011-06-03T08:44:00.001-04:00

The BLS released its estimates of employment and the unemployment rate for May. Unsurprisingly, it was a weak report, showing a marked slowdown in the US's net job creation in the private sector in May compared to preceding months.

The government sector of the economy continued to make the jobs picture worse. May was the seventh month in a row during which government layoffs undid some of the work of the private sector in creating jobs. Since January 2009, government employment has shrunk in 21 of 29 months -- and without temporary hiring for the Census, it would probably have shrunk in 25 of the last 29 months.

This steady reduction in government employment is a form of contractionary fiscal policy. (Note that most of the layoffs are at the state and local level, and thus are primarily composed of teachers and public safety personnel.) If government employment were simply keeping up with population growth in the US, we would expect to see about 17 to 18 thousand more state and local government jobs each month. Instead employment has shrunk by an average of 15 thousand jobs per month since the start of 2009.

The following chart shows what the monthly employment report would have looked like over the past 8 months (i.e. since the one-time effects of the Census that skewed employment from March-Sept of 2010) if government employment had simply kept up with the rate of population growth:

And total employment in the US would have followed the blue line in the chart below, rather than the red line:

In other words, in the absence of the sharp cutbacks in government spending that have been prevalent in the US over the past year or two, about 1.3 million additional people would be working now compared to 8 months ago, rather than the actual job growth we've experienced over that time of about 1 million - a 30% difference. That's a pretty tough headwind to fight, especially for an economy that's already struggling.

The Beatings Will Continue Until Morale Improves*

2011-06-02T07:33:00.003-04:00

Greece readies itself for a new round at the whipping post:

Greece to present new austerity plan

(Reuters) - Greece intends to present a fresh austerity plan on Friday, a government official said, after Moody's cut its credit rating deep into junk territory and said there was an even chance of eventual default.

The budget plan will include a faster pace of privatisation and 6.4 billion euros ($9.2 billion) of new savings, including some tax rises, to eat into Greece's debt mountain, the senior official told Reuters.

As Joseph Cotterill points out at Alphaville, the problem is that Greece continues to miss targets set last year for raising additional revenue. And so the vicious cycle of contractionary fiscal policies leading to lower income leading to lower tax revenues leading to additional contractionary measures continues...

* For those that are curious, the original source for this oft-repeated quip is not known, though some attribute it to facetious elements in the Japanese Imperial Navy during the Second World War.