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Tuesday, May 18, 2010

Much Ado About (Some Of) The Wrong Things

by Edward Hugh: Barcelona

German Finance Minister Wolfgang Schaeuble told reporters in Brussels yesterday (Monday) that getting their deficits down was "the only task that everyone has to fulfill for himself and for the common good." Meanwhile, over in New York, Paul Krugman was busy writing on his blog that "the most startling and frustrating thing about the debate over the fate of the euro is the way almost everyone avoids confronting the core issue" - which is, according to Krugman, that "wages in Greece/Spain/Portugal/Latvia/Estonia etc. need to fall something like 20-30 percent relative to wages in Germany". So at one extreme the Eurozone's problems are seen as being almost exclusively fiscal ones, while at the other the principal problem is thought to be one of restoring lost competitiveness.

The difference in perceptions couldn't be clearer at this point, now could it?

And if all of this is causing so much confusion among reasonably well informed economic observers, then what chance is the layperson likely to have? As it happens, reading through this piece by PIMCO's Mohamed El-Erian this morning a number of thoughts started to come together in my head. Essentially what we have on our hands are a number of distinct (yet inter-related) problems, but few studies seem to go to the trouble to differentiate these analytically, and the end result is often a hotch-potch, which given the seriousness of the European situation is an outcome which is a long long way from being satisfactory.

One point that is often not stressed hard enough and long enough is that the backdrop to this whole debt issue is the underlying problem of rapidly rising elderly-dependency ratios (and increasing population median ages) across the entire developed-economy world. Normally this implies the imminent arrival of a wave of heavily underaccounted-for-liabilities which will simply increase the pressure on the underlying structural (rather than cyclical) deficits in the worst affected economies. The strange thing is that this development had in principle been long foreseen, and indeed formed part of the underlying raison d'être for drawing the 3% deficit/60% debt Maastricht line-in-the-sand. The other part was, of course, an attempt to stop spendthrift governments being spendthrift. As is now abundantly clear, in neither case can the Maastricht package be said to have worked, but the unfortunate historical accident is that we have come to realise this in the midst of the worst global economic crisis in over half a century (indeed arguably the second worst one ever, and - disturbingly - it is still far from being over).

So one part of the sovereign debt concerns which are currently so preoccupying the financial markets is associated with the containability of state debt in the context of ageing societies, and this issue is further complicated by the fact that different developed societies are ageing at different rates. This underlying uneveness is leading some people to draw some surprising conclusions. For example, according to a Financial Times/Harris opinion poll published this morning, the French turn out to be the most nervous of developed economy citizens when it comes to thinking about the sustainability of their country’s public finances.

Some 53 per cent of those polled in France thought it was likely that their government would be unable to meet its financial commitments within 10 years, while only 27 per cent thought this outcome was unlikely. Americans were only slightly less worried, with 46 per cent saying default was likely, against 33 per cent who saw it as unlikely. Curiously, only a third of the British people polled thought a government default was likely in the next 10 years, and I say curiously since on many counts the UK economic position is far more critical than the French one is. In fact, I am inclined to think that the British here are being reasonably realistic, while the French and the Americans are not, and I say this for one simple reason: all these countries have had substantial immigration in recent years, while the fertility levels in each case are quite near population replacement level. And this means that their population pyramids are much more stable, and if what is worrying you is rising elderly dependency ratios, then this is important. Let's put it this way, if you assume (a big assumption I know) that underlying GDP growth rates are similar, and that the level of pension entitlement is the same, then the more rapidly the elderly dependency ratio rises the greater the pressure on deficits and accumulated debt.

On the other hand, the Spanish respondents were remarkably more positive about their situation, with only about 35 per cent of Spaniards questioned saying they considered default to be a likely eventuality over the next decade. Which is strange, not because I have any special insight into whether or not Spain will default, but Spain's problems are clearly worse than any of the other three aforementioned countries (in part, as Krugman stresses because they lack some key economic policy tools which could help them correct the distortions in their economy) and, even more to the point, Spain's citizens are showing very little appetite at this point for making the changes which will be needed to stave off the worst case scenario.

Without reform in the labour market, and in the health and pension systems, France's finances are just as capable as going careering off a cliff as anyone else's, but the French do have a little more time, and this, at the end of the day, could be critical. Also the French (like the Swedes) have done their homework in one department - the demographic one - so their population pyramid is inherently much more stable than the Spanish one. Indeed the Spanish government clearly indicated last week just how little they understand the importance of this question, since rather than facing up to the wrath of the Spanish pensioners (who of course vote) by cutting back on pension payments, they took the easy route (since babies don't vote, and those who never get to be born even less so) and slashed the so called "baby cheque" (which may well not be the best of pro natality policy tools, but still). Basically cutting the baby cheque instead of cutting back on pensions has to be the next best thing to slitting your own throat, just to see what happens. Societies need to invest in their future, not in their past, and having children is an investment, indeed in the age of the predominance of human capital it is one of the most important ones there is.

Basically this whole area (of the impact of ageing populations on GDP growth performance and with this the consequent debt dynamics) remains largely underexplored by most mainstream analysts, but for now I will simply state that those "doctors" who wish to offer cures for our collective ills yet fail to mention the underlying dynamics of the demographic transition all our societies are passing through (even in a footnote) have missed one very important dimension of the overall picture, and their analyses and remedies are likely to be correspondingly deficient as a result. The musings of Mohamed El-Erian, interesting as they are, would fall into this category, since I fear he is missing the biggest part of the big picture.

Secondly, there is the issue of the financial rescue which has been carried out during the crisis itself. Something strange seems to have happened to the discourse over the last three years, since a problem which originated in the financial sector has now metamorphised into a fiscal crisis for almost all modern democratic states. Indeed, such is the sense of panic being generated out there on this issue that I am already starting to see articles from investor circles asking whether or not democracy is compatible with fiscal rectitude. This is rather putting the cart before the horse, I feel.

So having identified an underlying structural issue with government spending in the previous (demographic) argument, we should not fail to notice the fact that another significant part of rising state indebtedness comes from having recently bailed out a significant chunk of the private sector. Look at Latvia for example, and the Parex bank bailout, as the extreme case, since government debt to GDP was something like 12% before the crisis, while it is now heading up to near 80%, or Ireland, where debt was around 35% of GDP before the crisis but will probably rise above 70% this year.

In fact, a rather weird circle has been created. The private sector (possibly as a result of the absence of adequate public vigilance) got itself into a huge mess of its own making. Governments all over the globe (understandably and correctly) rushed in to put the fire out, and in the process transferred the problem over to their own balance sheets. But what is most interesting to note about what happened next is how, given that the crisis itself means there are few positive investment outlets in the first world, the money generated by the bailouts is increasingly being used to encircle those very governments who initially made them. Basically a massive moral hazard conundrum has been created, as markets leverage a discourse which pressures governments for fiscal rectitude (which is contractionary - given the depth of the crisis - as far as aggregate demand is concerned), in the process creating the need for yet more bailouts, and so on (the possibility of ultimate Greek default being perhaps the clearest example here).

Actually, while the initial "fire prevention" intervention was evidently necessary, people may have been mislead into thinking that action, in and of itself, would do the trick (see Bernanke's speech on Milton Friedman's 90th birthday - with its this time we got it right theme - also see note at the foot of this post) due to a slightly faulty diagnosis of what happened during the great crash. There was, of course, a bank run: but this was by no means the whole picture, and in any event doesn't explain why the whole global economic system took so long to recover, even back then in the 1930s.

So something decisive needs to be done to break the circle which currently binds us, although at this point I am not exactly sure what. If we could agree that Mohamed El-Erian's most striking insight is that: "Industrial countries are running out of balance sheets that can be levered safely in order to minimize the disruptive impact of past excesses. ... The balance sheets that are left -which reside essentially in central banks - are not made (and, I would argue, should not be forced) to assume permanent ownership of dubious assets." then the logic would seem to be that the dubious assets need to be put back where they belong - on the balance sheets of the private sector in general (including households) and the likes of AIG, Goldman Sachs, UBS, and naturally PIMCO.

But we should be clear: any such move to do this would also be significantly growth "unfriendly" across the first world.

And thirdly, and certainly not least importantly, as Paul Krugman is constantly pointing out, here in Europe we have an additional complicating factor: the euro experiment. Whatever the pros and cons of all the various arguments here, one thing seems evident: under the existing set-up the 16 economies are not converging. Exactly why this is would take us into areas which lie far beyond the objectives of this short post, but I would say that, personally, I feel the different demographic trajectories of the countries concerned must form part of the picture. As Angela Merkel is stressing, even in the best of cases (the euro holds) the bailouts which are being prepared can only buy time in which to carry out the much needed adjustments, which in countries like Spain/Portugal/Ireland are as much to do with restoring competitiveness to an extremely distorted private sector as they are to do with applying fiscal correction measures.

As far as I can see, measures like collectively financing state debt via EU bonds and bilateral loans - plus operating some variant of Quantitative Easing at the ECB (if this can all credibly be made to stick, and the vicious circle meltdown mentioned in the second point be avoided) - could temporarily stabilise the patient while the much needed surgical intervention is carried out. But my guess is that one by-product of doing things this way would be that a lot of the toxic stuff would then work its way onto the ECB balance sheet. Thus, instead of recapitalising Spanish Cajas, what we would then be collectively into would be recapitalising the central bank, which would be just another form of fiscal sharing through the back door (with the result that, following a good Brussels tradition, what you can't explain to people directly and from centre stage, you explain to them in footnotes and in the small print). The latest data from the ECB (see this useful post from FT Alphaville), suggest that the bank is not only busy buying peripheral bonds, it is also buying private paper from countries like Spain and Portugal (although there is no breakdown available on this point).

The measures which need to be applied on Europe's periphery are all more or less obvious at the micro level - labour market reform, pension reform, reform of the public administration - but (and assuming we have at most three years to see all this though before the respective populations get very, very restless), on the macro economic side it is very doubtful such measures will have the impact which is expected for them in terms of restoring competitiveness and growth, and fiscal order can only be restored by restoring competitiveness and growth.

Given this I can see only two plausible alternatives:

a) Either the peripheral economies undertake a sizeable internal devaluation (say 20%, but this is just a rule of thumb estimate). The snag here is that at the present time most EU policymakers remain unconvinced that we need a shift of this magnitude. Yet there is surprisingly little detailed study of how the economies concerned are going to get back to growth without this price correction. Indeed the EU Commission itself has strongly pointed out that the rates of domestic private consumption growth being assumed for these economies by the respective national governments in their Stability Programme estimates are highly optimistic. What would be nice would be for someone to set up a small model to try to examine just how much ongoing growth in the combined goods and services trade surplus countries like Spain now need to achieve to get positive growth in headline GDP under a variety of different assumptions, including low or negative inflation, stagnant domestic consumption and reduced fiscal spending.

This should enable people to calculate just how much of a drop in unit costs (from a combination of productivity growth and price adjustment) you need to have to get the kind of surplus you need given the relevant elasticities (etc). In particular one of the problems I see in basing too much hope on using productivity improvements to do the heavy lifting in the correction is that while you can surely get significant efficiencies at the micro level (though not by a long way enough to do the whole job), you can in fact only achieve the result in the short term by slowing a recovery in the labour market (since you will be going for more output with less people), which means aggregate productivity (say GDP per capita as a proxy) doesn't improve that much, given that there is a huge fiscal burden and continuing stress on the financial sector as a result of all those long term unemployed. Alternatively we have another possibility;

b) Germany (and possibly one or two other smaller economies) temporarily leaves the eurozone and revalues.

Now, since option (a) looks very, very difficult to implement (especially since virtually no one apart from people like me and Krugman apparently wants to even hear of it),to which problem we could add the fact that German politicians are having increasing difficulties convincing their citizens that the "qualitative transformation" of the ECB is what is really in their best interests, then on a purely pragmatic level (b) may well end up being what happens in the end (and we had better just hope any eventual German exit is only temporary).

Having Germany temporarily separate from the Eurozone would, in fact, have a number of evident advantages. The first of these would be that citizens in the South would not need to see their wages slashed, while those in Germany would not be asked to pay for bailouts via their tax bill, or lead to blame Greeks or Spaniards for having their hospitals closed or their pensions reduced: ie it would all be politically much easier to handle at this point.

Evidentally German banks would have to swallow a write-down, as loans paid back in Euros would not be worth the same in (new)marks, but 70% of something (say) is better than zero or 20%, and the big plus would be that as the Euro devalued sharply the peripheral economies could rapidly return to growth, and government finances could be quickly turned round as exports grew, tourists returned, and (in addition) many of those coastal properties that currently stand empty could be sold. At the end of the day, what would be left would be a private sector, and not a public sector, problem, and it was (in part) the private sector who got us all into this mess (wasn't it?).

Indeed this solution does to some extent coincide with what could be termed the new economic reality, since economic growth in emerging markets mean that these are fast becoming key trading targets for German industry, as consumption in Southern and Eastern Europe looks to be increasingly "maxed out". In fact, according to the recent March trade report from the German Federal Statistics Office, the rate of interannual growth in exports to ex-EU "third" countries (34.7%, as compared with 15.1% for the euro area) was significant, while the volume of trade (34.2 billion euros as opposed to 35.2 billion euros for the Euro Area) is roughly comparable, and indeed at this rate countries outside the EU will soon replace the Eurozone group as destinations for German exports.

I say I hope this move (if undertaken) would be temporary, since I think in the mid term the German economy is neither so strong, nor the peripheral countries so weak, as many commentators assume. But being out of the zone would give the Germans the opportunity to see this for themselves.

The important point to emphasise, I feel, is what we now need is an orderly and credible solution to our problems. Simply standing back and watching things deteriorate, and keeping our fingers crossed that what won't work will, is not going to produce an orderly outcome. Au contraire! Even those precious exports we are winning as a result of the falling Euro are being put in doubt, try these headlines from Bloomberg: Mexico’s Peso Falls Third Day on European Fiscal Deficits, Yuan Appreciation Unlikely This Year Due to Europe Debt Crisis, Emerging-Market Stocks Drop Most in Six Days, Russian Stocks Slide Most in Week on Oil, Europe Debt Concern. And this is just a quick selection.

The problem is that any gain to exports outside the EU can be offset by falling risk sentiment as the currency slide continues, and markets which were previously being funded lose the ability to attract money. What we need are some serious measures which can turn the tide, and restore confidence that we are applying measures which will work.

Actually, the argument I am presenting here was first put to me by a young Barcelona IT engineer - David González - and you can find his argument in this blog post (below the Spanish introduction). As David says:

In conclusion, at the moment the EMU lacks the necessary economic long term policies to become a stable monetary zone. Obviously, we lack the free currency exchange rate needed in any free trade zone, which would work as an automatic stabilizer between different countries. But we also don’t have enough automatic stabilizers (only the exception of cohesion funds) needed in any monetary zone. First we need to recover the balance, and then we have to make sure it is a stable balance implementing measures that keep it. Otherwise the EU construction process will fail, and the hopes it has bring to so many people and countries will be forgotten. The implications this failure would have for democracy and peace in Europe should not be underestimated.

Or as Krugman puts it: "If the euro isn’t workable without highly flexible nominal wages, well, it isn’t workable". It's a sad conclusion, but that would seem to be where we are at this point. Basically, it is obvious that any road forward is now fraught with difficulty, but a situation where none other than the head of Deutsche Bank is saying that in all probability Greece will not be able to pay, and where an ECB which badly needs to operate a policy of Quantitative Easing but is at desperate pains to try to show that it isn't, is evidently not sustainable for long. Money has been put on offer, and the financial markets are now chafing at the bit to try to force it up and onto the table as quickly as possible. July promises to be another sweltering month here in Spain. Maybe it's time for a rethink.


Note: At the end of his "On Milton Friedman's Ninetieth Birthday" speech Ben Bernanke arrived at what now looks like a rather hasty conclusion: - "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again". In fact, what is at issue here is a question of causality, whether the real economy problems are ultimately caused by the absence of a "stable monetary background", or whether in fact, the demand shock unleashed by the unwinding of a highly leveraged economic boom may not be the main factor in preventing the recovery of a "stable monetary background", as we have already seen in the Japanese case. The critical question facing all developed economies in addressing their fiscal sustainability problems is where the aggregate demand is going to come from to make the adjustment both viable and socially palatable.