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Sunday, May 30, 2010

Random Shots on Global Monetary Policy, Martin Wolf and Small Business Lending

By Claus Vistesen: Copenhagen

With Edward busy mingling with the economic elite and literally saving Spain one step at the time I thought that it would be time for some random shots here at GEM. Enjoy


Turning back the Clock on Global Monetary Policy

Sovereign risk and debt continues to mark the fault lines in the global macro landscape and thus the main discourse. In this context and although the technical recovery is still a reality the discourse has started to move into a decidedly bearish mood. I find this interesting since while financial markets, in traditional fashion, have reacted strongly and early on the sovereign debt crisis in Europe it is only now that we are about to close the book on H01-2010 that we are seeing significant and lingering worries from all sides that the we are headed straight into a double-dip recession.

To put it differently. My call, a week ago, concerning short term belief in a technical recovery may now return to haunt me. Of course, in that specific note I did talk about divergence and I think this is really important to factor in when talking about the global economy. Consequently, and even in the context of developed economies alone there will sharp divergence between economies that will return to some form of growth and others who will linger in depression. Conversely, in relation to the emerging economy edifice I am largely constructive and indeed, the problem here is how to deal with the volume and volatility of yield chasing inflows as a result of super abundant liquidity provided by the G3 central banks. As I keep on emphasizing the idea of a global monetary transmission mechanism (and subsequent carry trades) and how they interact with domestic monetary policy decisions and objectives is very important to factor in to your analysis.

In that respect, Morgan Stanley's Manoj Pradhan had a very good birds eye view of global monetary policy last week and specifically, the following point is a good way to conceptualize some of the costs and challenges associated with being the first to raise interest rates while G3 liquidity is provided in ample quantities.

Thanks to the Great Recession and the synchronised policy response to it, central banks find themselves riding in a monetary peloton. Central banks like the Bank of Israel, the Norges Bank and the RBA that started hiking rates early (the front-riders) faced dual headwinds. First, the widening interest rate differential and abundant liquidity drove their currencies' values higher. Second, higher policy rates failed to translate into tighter financial conditions due to low bond yields and buoyant equity markets in the major economies to which most financial markets around the world remain linked.

This is very close to my own viewing of the current setup in the global economy and also a setup which links in with the discourse on global imbalances. Concretely, you only need to add Pradhan's first and second point above to see how it may effectively make higher interest rates counter productive relative to the aim of cooling domestic overheating and bubbles in the making. In fact, by raising interest rates while the G3 are in QE may lead to an exacerbation of the very boom in domestic inflation/assets that the tightening bias was meant to secure against in the first place.

Apart from chapter 4 of the recently published Global Financial Stability Report by the IMF (which is really a must read), a new paper from the Asian Development Bank also discusses this issue with specific focus on Asia and the distinction between floaters and non-floaters relative to the USD.

Turning to the immediate economic cycle Pradhan notes the fact that hitherto hawkish central banks (e.g. Israel, Norway, and Korea) have recently backtracked on their interest rate increasing credentials.

Just a few months ago, most central banks were likely deciding how soon they would have to begin their hiking process. It was too early then for most G10 central banks to start raising rates (with the notable exceptions of Norges Bank and the RBA) but markets mostly saw risks that would tempt monetary policymakers to hike sooner rather than later. That was then. Now, the risk of a spillover of euro area problems into global growth and commodity prices and a subsequent dampening of inflation expectations have shifted risks the other way. Our US and euro area teams have pushed back the first rate hikes from the Fed and the ECB to 1Q11 and 3Q11, respectively. In addition, the ECB's asset purchase programme (and, to a much lesser extent, the reinitiating of FX swap lines between the Fed and major central banks) has been a step in a direction directly opposite to an exit from QE. In other G10 economies too, central bank statements show increasing concerns about global growth and funding market stress.

In its recent monetary policy report, Norway's central bank played down the expected increase in interest rates (although I expect them to resume hiking in due course), the central bank of Korea also opted to leave interest rates on hold and so did the Bank of Israel. More importantly and contrary to earlier expectations the first half of 2010 has not seen the reduction of QE wielding central banks, but actually added one to the fold in the form of the ECB biting the bullet and engaging in outright purchases of Eurozone government paper. And thus as Mr. Pradhan points out, the day when excess liquidity is going to be mopped up has been postponed yet again. If, as I expect, the Reserve Bank of Australia also opts to shelve an otherwise planned (or earlier expected) interest rate hike this Tuesday, a clear picture of monetary backpedaling is emerging.


Bugs in the System ...

To be perfectly honest, Martin Wolf does not really put anything new to the table in his latest column which paints the global economic system as one being populated by grasshoppers (the importers/deficit nations) and ants (the exporters/surplus nations). Still, his allegory is interesting and useful in terms of pinpointing the current setup of the global economy characterised, as it were, by macroeconomic imbalances and no real way to resolve them since there are simply too many would-be ants and not enough grasshoppers. But wait a minute, this is my spin on the story and not quite, I think, how Mr. Wolf sees it;

Today, the ants are Germans, Chinese and Japanese, while the grasshoppers are American, British, Greek, Irish and Spanish. Ants produce enticing goods grasshoppers want to buy. The latter ask whether the former want something in return. “No,” reply the ants. “You do not have anything we want, except, maybe, a spot by the sea. We will lend you the money. That way, you enjoy our goods and we accumulate stores.”

(...)

What is the moral of this fable? If you want to accumulate enduring wealth, do not lend to grasshoppers.

Now, let me reciprocate Martin Wolf in his analysis by also bringing nothing new to the table in my continuing emphasis on demographics and specifically how demographics ultimately determine whether you turn up being an ant or a grasshopper or perhaps even how and why you merge from the latter into the former. My small niggle with Mr. Wolf's argument is thus the implicit assumption, as I see it, that you can actually choose to be either an ant or a grasshopper. Naturally, to some extent you can, but I would qualify the argument in a very important way. In this way, demographics and specifically an economy's median age is a good yardstick through which to determine whether it will act more as an ant or a grasshopper. In a nutshell, as the median age increase you become more and more like an ant with the subsequent desire and need to accumulate liabilities on others in order to achieve economic growth and preserve wealth. And this brings us to Wolf's final point and the alleged moral which I believe is false, indeed almost non sequitur. In this way, we need the grasshoppers just as well as we need the ants and specifically if ageing (which is a convergent global phenomenon), as I argue, leads to an increasing prevalence of ant like behavior the scare resource becomes the grasshopper who are willing and able to borrow.

Small business, big effect

One of the great unsung stories of this "crisis" (at least seen from my perch) has been conditions for small business and especially credit and lending conditions. This is odd since in terms of the real economy these companies are far more important than their bigger listed brethrens; or at least as important. Consequently and while the post March-09 rally has seen many a big listed company head back to the trough in the form of issuing stock or debt (as well as the odd IPO and M&A) the conditions for small business have in many respects remained lackluster. Or have they?

Well, I have not done the analysis myself and any analysis on this subject is bound to be very sensitive not only to the country in question, but indeed also the region/state and industry.

This makes it inherently difficult to generalize but I still found this report by the Atlanta Fed about the credit conditions for small businesses in Alabama, Florida, Georgia, Louisiana, Mississippi and Tennessee (using a survey sample of 311 companies) an interesting read. What I especially like was really the introduction in which Paula Tkac (assistant vice president and senior economist at the Atlanta Fed) touches on the very important issue of disentangling supply and demand drivers in the context of assessing the impact of "tighter" credit conditions. In this sense, deleveraging which has now become one of the main underlying structural forces that drive real economic activity essentially may be propelled by both demand and supply factors.

On the demand side, simple changes in preference may lead to a lower demand for debt or more precisely, the correct discounting, by the individual or the company, of her economic situation may lead to less demand for debt. In addition (and very relevant for the analysis by the Atlanta Fed) demand may go down because some would-be borrowers are "discouraged" from applying for credit as they anticipate a negative outcome of their application. On the supply side and beyond the obvious effect of raising price/the interest rate (in a wide discretionary move) credit may simply not be available in the same quantities or some economic agents may be precluded entirely from having access to credit.

As Paula Tkac notes, it is difficult to say when one ends and the other begins and ultimately, supply and demand effects will be interrelated. The concrete results from the Atlanta Fed survey, while difficult to general, suggest that the traditional discourse of blaming conservative or frightened banks (or perhaps even capital requirements and thus regulation) is essentially a pot shot;

Indeed, the results of our April 2010 survey suggest that demand-side factors may be the driving force behind lower levels of small business credit. To be sure, when asked about the recent obstacles to accessing credit, some firms (34 firms, or 11 percent of our sample) cited banks' unwillingness to lend, but many more firms cited factors that may reflect low credit quality on the part of prospective borrowers. For example, 32 percent of firms cited a decline in sales over the past two years as an obstacle, 19 percent cited a high level of outstanding business or personal debt, 10 percent cited a less than stellar credit score, and 112 firms (32 percent) report no recent obstacles to credit. Perhaps not surprisingly, outside of the troubled construction and real estate industries, close to half the firms polled (46 percent) do not believe there are any obstacles while only 9 percent report unwillingness on the part of banks.

In many ways, the idea that demand side factors are just as prevalent in the process of deleveraging as are supply side conditions is an important entry point to understand the real economic dynamics from the crisis on, in this case, the US economy. In this sense and if you will allow me to briefly expand the perspective it means that there is no switch that can be turned on which will bring us back to normal once funding conditions in the bank sector returns to normal. Indeed, during the initial phases of the crisis in which the seizure of the wholesale money market was the talk of the town a widespread assumption emerged, almost by definition, that once central banks had restored confidence the supply of credit/funding could return to normal and we could be back on our merry way. We know now of course that this was not the case and while the huge back draft of turd assets and the concrete need to rebuild balance sheets still acts as an important supply side constraint I take the Atlanta Fed's analysis as a small and local evidence for the notion that a more profound structural change has taken place.

Well, I may be taken it too far of course and I certainly would not want to make Altig et al. at the Atlanta Fed straw (wo)men for my musings, but I still hold this to be significant. The report by Paula Tkac is worth reading in its entirety as it also goes into the obvious point that the impact on small business credit conditions from the crisis is strongly industry biased (basically, construction and real estate companies face much tougher credit conditions).

Tuesday, May 18, 2010

No Recession in the Global Economy, but Divergence Aplenty

By Claus Vistesen: Copenhagen

Yours truly is actually a macroeconomist, indeed with a knack for financial markets, but still; a macroeconomist nonetheless. However, you would not have gotten that impression from the writings here end last week where I worried a lot about the worry of financial markets. I still do, worry that is, mostly because we are in a very delicate situation where a severe shock in financial markets can easily and quickly be transmitted into the real economy. Moreover and as Edward eloquently conveys in his recent post the structural challenges we face are complex and difficult.

Yet, in terms of the immediate evolution in the real economy, and in case you had not noticed, the recovery is coming along just fine.

(click on pictures for better viewing)

If ever there was a clearer sign of a v-shaped recovery I'd like to see it. On an annual basis the EMU industrial production index rose 11.6% in Q1 2010 and on the quarter the increase was 4%. Despite the emerging crisis in the Eurozone and with reservations for the final number of Q2-10, this suggests that the turnaround is intact so far. Naturally, the level of industrial production is still very low compared to before the crisis and, as I have argued, this is an important gauge in terms of the overall strength of the momentum. But, the recovery remains real at this point

Of course, it is not difficult to pick the positive discourse apart and this applies especially to the Eurozone there is a bound to be notable divergence between the growth rate of economies. In particular, it does not take much Roubinesque imagination to see what awaits the famed Eurozone periphery (Spain, Portugal and Greece) who are now about to embark on a very brutal spell of internal devaluation; kind of like in the Baltics who are undergoing the same [1].

This comparison may of course be inappropriate for a number of reasons, but it provides a good yardstick with which to look ahead into especially 2011 where the first part of austerity measures will really start to bite. Whether the Eurozone "core" remains enough momentum to pull the Eurozone forward is really not the important issue here. The real problem here is that from here on imbalances (not just external) will compound. In the lingo of development economics the convergence which was thought inevitable and on track is now about to unravel. In this respect, the comparison with key parts of Eastern Europe is well chosen I think.

And not just Europe...

Yet, if the outlook for Europe is still very uncertain the global outlook is positive for the remainder of 2010 even if the momentum appears to be flattening out;

On an annual basis leading indicators for the major emerging economies as well as the OECD are coming in very strongly for Q1-10 and also over the quarter (i.e. from Q4-10) do we observe growth with the notable exception of China where activity seems to levelling off a tad going into 2010 on the back of continuing measures by the government to restrain the economy.

It is difficult to deny that the leading indicators tracked by the OECD seems to be flattening moving into Q2-10 and it will naturally be interesting to see whether momentum will be sustained. As ever, divergence both in levels and actual growth rates will be paramount to factor in, but I am very confident that we are not going to see a double dip recession in for example the US let alone the emerging market edifice in 2010. In Europe, the tug-of-war will between growth in France and Germany (with the latter exporting to EMs as the only real source of growth) and a continuing slump in Southern Europe. However, since 2010 budgets are already passed to indicate very stimulative policies throughout Europe the growth momentum will be strong in 2010 although the medium to long term look decidedly awful.

Event Risk still High

As a natural finishing point it should not escape market participants and analysts alike that event risk is currently at a very high level. In many ways, we already have an event in so far as goes the crisis in Europe but I can think of plenty of more sources of potential market destabilisers. The point here is then that at the current juncture the transmission between market distress and the real economy is likely to be strong and relatively quick. In this sense, the recent news that the interbank market is freezing over once again is indicative that not all is well and I am watching this very closely.

As such I maintain my somewhat bearish inclination and deep skepticism for where aggregate demand is actually going to come from in the medium to long term; this especially the case in Europe whereas I am much more constructive on emerging economies who are, for all intent and purposes, doing well (indeed almost too well in some cases).

A number of well known proverbs spring to mind here; is the glass half full or half empty? Is this the end of the beginning or the beginning of the end? Whatever methaphor you prefer forward looking indicators point to strong growth in the first half of 2010 (at least). The key message on the real economy will thus be one of divergence and especially how some economies are doomed to deflation and negative growth in nominal GDP (in the context of internal devaluation) while others will fly on the back of excess global liquidity. For me, this is the main meta-discourse currently describing the global economy.

---

[1] - Q1-10 GDP is only available for Lithuania so for the two others the calculations ends with Q4-09.

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.

Sunday, May 9, 2010

Spain Emerges From Recession?

by Edward Hugh: Barcelona

Well it is now official - or at least as official as it is going to get: the Spanish economy sneaked back into growth by a short head during the first three months of this year. According to data published in the Bank of Spain's quarterly report on the Spanish economy, Spain's GDP grew by 0.1% in the first quarter. Interannually output was still down by 1.3%, but this is evidently a considerable improvement on the 4.2% annual drop registered in the second quarter of last year, and much better than the 3.1% fall seen in the last three months of 2009.






So that's it. Spain is out of the woods, the worst is now over, and the Spanish economy can now get back to the agreeable business of growing, and putting people back to work? Or can it? We don't have all the details yet, but from the information the Bank of Spain does provide we already have a sufficient information base to start asking ourselves just how sustainable this quarter's numbers actually are. In the present case it is the how, just as much as the what, that matters.

Obviously, and as everyone by now surely knows only too well, what little growth Spain is able to eke out at this point takes place on the back of massive government deficit spending (estimated at 11.2% of GDP in 2009), but even this is only one part of the picture, since we need to ask ourselves, outside the government contribution, what is actually driving the growth at this point?

Here the bank of Spain is reasonably helpful, since they tell us that, on the demand side, the decline in domestic demand eased (on an interannual basis) to a 2.6% fall (from a 5% one in Q4 2009), while the positive contribution from net external demand weakened to 1.4 percentage points (from 2.2 percentage points in the three previous months).

The net external demand component is simply the difference between the rates of change in exports and imports. These are year on year numbers, but we can deduce what the situation must have been (more or less) on a quarter by quarter basis: domestic demand (which includes government consumption, as well as private consumption and investment) grew on the quarter, while the net trade contribution was negative, since while both exports and imports increased, imports increased more than exports, and as a result the trade deficit deteriorated, which is, of course, for a country with a heavily indebted external position, not good news at all.

So basically the situation is simply an extension of the one described in the following chart (produced by the Spanish statistics office to accompany the Q4 2009 data), where as can be seen the roles have reversed rather, with domestic demand ceasing to be such a drag on the economy, and net external demand having an increasingly negative impact.



As we will see in the analysis which follows, there is plenty of evidence to support the idea that domestic demand has been stabilised (with a huge injection of demand from the government), but the external position is rather more confused, and doubly so given the existence of a slight discrepancy between trade data published by the Bank of Spain (in their monthly report on the Balance of Payments position) and that sent by the government department of trade to Eurostat, and hence to the World Trade Organisation. In fact the export data published by the two organisations more or less coincide, since the WTO report February exports as 20.522 million USD (or about 15.8 million euros), while the Bank of Spain reports 14.196 million euros (or about 18.5 million USD using the same exchange conversion rate). When it comes to imports, however, the discrepancy is rather more important, since the WTO (via, I emphasise Eurostat) offers us a February volume of 27.727 millones USD (or around 21.3 million euros) while the Bank of Spain records 17.251 million euros (or about 22.42 million dollars).

Now all of this may seem like nit-picking, but let's look at the two charts for the trade deficit that we get as a result of applying the respective figures. If we take the first (Bank of Spain data) chart, we can see that there is a slight improvement in the deficit in February (and this, let us remember, is GDP positive):



On the other hand, the chart I made using WTO data (below) gives a rather different impression: the deficit clearly deteriorated even further in February (this is the latest month we have). Now none of this would really matter, if it weren't for the fact that the level of GDP growth being estimated is only 0.1%, and thus a small variation in the trade deficit could easily make the difference between zero and slight positive growth, and given the propaganda emphasis being placed by the Spanish government on the return to growth we need to be rather careful at this point before drawing too many conclusions.



To be very clear: I am not in the least suggesting that there is any kind of "black hand" at work manipulating the data here, I am simply pointing out that due to whatever reason (the respective reporting period in question, earlier and later estimates, or whatever) this discrepancy exists, and it does seem to me to be significant. The real problem here, as in the case of the unemployment data which was the subject of another recent post, Spain's reporting agencies are quick to point out any item in the data which shows the Spanish economy in a positive light, while they have the frustrating custom of passing over in silence any inconvenience.

Another good example of this was the claim made in the Kingdom of Spain February roadshow in London, that between 2000 and 2009 Spain's share in world exports actually increased (implying that, there you see, Spain is not so uncompetitive after all), without mentioning that over the same period the trade deficit worsened considerably, which means that Spain's share in world imports increased even more, or if you like that Spain became a major global imports powerhouse - there, that didn't sound so impressive, now did it?




The Patient's Condition Is Stable

As I say, a combination of strong fiscal support from the Spanish government and ample supplies of liquidity from the ECB to the banking system have managed to stabilise the patient. Perhaps the best example of this are the latest PMI readings. According to the monthly report from Markit Economics in April Spanish industry saw the fastest rise in manufacturing new orders since April 2007, while for the second consecutive month, operating conditions improved throughout the manufacturing sector. The seasonally adjusted Markit Purchasing Managers’ Index – which is a composite indicator designed to measure the performance of the manufacturing economy – rose to 53.3 in April giving its highest reading since June 2007.



Positive as this news is, we should not forget that there is currently a government car purchase programme in place, and that many purchasers may buy now to beat the forthcoming July VAT hike. In fact Spanish car sales were up by 39.3 percent year-on-year in April compared with the same month of last year with 93,637 units sold. To get some sort of comparison, in France, where scrapping incentives were reduced to a lower rate at the start of 2010, passenger car registrations rose an annual 1.9 percent in April to 191,000 units, compared with 13 percent growth in March, while in Italy, where the stimulus measures have now beem withdrawn completely, the car market fell an annual 15.65 percent in April to 159,971 units. Developments in France and Italy should give us some indication of what to expect in Spain as stimulus measures are withdrawn and taxes rise.

As Andrew Harker, the Markit economist who prepared the monthly report, said:

“A further strengthening of the Spanish manufacturing PMI data at the start of Q2 is a welcome follow-up to the rises in production and new business seen in March. The fastest rise in new export orders for a decade suggests that Spanish firms are beginning to benefit from improving global demand. However, with employment continuing to fall, and manufacturers unable to pass on record input cost inflation to customers because of the fragility of demand, there remain doubts as to whether the sector is really out of the woods yet.”


If we look at the actual industrial output chart (below) we can see clearly that although there is ample evidence to justify the thesis of stabilistation over the last twelve months (and even a slight rebound in March), the medicine applied has simply stopped the collapse, and not (in any meaningful sense) restored growth.



A similar picture emerges for Spain's hard pressed services sector from the April services PMI: the rate of activity growth actually slowed slightly during the month and demand remained fragile, and growth in both activity and new orders was described by the report as "anaemic". The headline seasonally adjusted Business Activity Index – which is based on a single question asking respondents to report on the actual change in business activity at their companies compared to one month ago – dipped slightly to 50.9 in April, from 51.3 in the previous month, to indicate a marginal increase in activity for the second month running. According to survey respondents continued weakness in the wider Spanish economy prevented a stronger rise in activity during the month.



To quote Andrew Harker again:

“The Spanish service sector failed to gain momentum moving into the second quarter of 2010, with serious concerns remaining as to whether a broader economic recovery will get underway in the near-term. Panel members indicate that they are experiencing reductions in profit margins caused by a combination of weak pricing power and rising costs.”


As noted above, a rather more positive picture emerges when it comes to retail sales, since they have rebounded somewhat since the turn of the year, and are now only down by just over 7% from their November 2007 peak (see chart below). The question is whether the demand injection from the government which is supporting this (with unemployment running around 20%, and banks short of liquidity) remains sustainable - especially given recent events in the financial markets.



Spain's previously bloated construction industry continues to "downsize", and a further sharp drop in activity was registered in February (see chart below), but this is hardly surprising, since the Spanish economy will now inevitably have to move from being a construction and tourism driven one to having a more broadly based profile. So the continuing demise in construction is a logical and inevitable part of the ongoing adjustment.

House prices continue to fall, and are now down 16.2% from their December 2007 peak (according to the TINSA index, see chart below). There is obviously still a long way to go in the house price adjustment process, and it remains to be seen for how much longer Spain's more stressed banks can continue to increase their already extensive property portfolios in their attempt to cushion the fall.



Both house sales and mortgages have risen slightly during the last quarter, but the picture (see charts below) remains one of stabilisation rther than rebound.





The Patient Is Stable Thanks To Massive Life Support

So Spain's economic collapse has been stabilised, but in order to grasp what may happen next we need to understand how it has been stabilised. In the first place Spain's banks have been in receipt of a massive liquidity injection from the ECB (see chart below), and it was the imminent likelihood that these would be withdrawn in the coming months that created much of the market panic which was seen at the end of last week.



Spain's banks increased their reliance on the ECB's longer term financing operations from 47 billion euros to 79 billion euros between June and July last year, and much of the increase will be need to find alternative sources of funding if the ECB holds to its current exit strategy agenda (which, of course, it now may not do). In fact, during the fisrt decade of euro membership, the dependence of Spain's banks on inter-bank funding became huge (see chart), and it is the uncertainty about whether markets are willing to sustain this that is causing the whole Eurozone edifice to tremble at this point.



The other part of the life support system that is currently keeping Spain's vastly over-leveraged economy afloat, is the ongoing fiscal support from the Spanish government. The fiscal deficit last year was officially 11.2%, and it looks like this year it won't be too far short of double digits. But, as the Spanish administration constantly stress, Spain's basic problem is not a fiscal one, Spain's problem is the rapid ballooning of the fiscal deficit in the context of a heavily indebted private sector.

Spanish households, for example, have around 900 billion euros (or around 90% of GDP) in debts. In fact, during the boom years Spain's economy was running on steroids, with household debt increasing at a rate of around 20% a year. Then along came the financial crisis, and all that came to a halt, with household debt remaining virtually stationary (see charts below). As a result, Spain's economy screeched to a halt, and from that time onwards has simply been able to stagger throught from one day to the next.





And it isn't only Spanish households who have gotten themselves excessively into debt, Spain's corporate sector also has some 1.3 trillion euros in debt (or 125% of GDP), and again a similar picture is observed (see charts) since the financial crisis set in, the rate of new debt generation has steadily ground to a halt.






The response of the Spanish administration to this fairly dramatic state of affairs has not been to make the kind of changes we have seen in Ireland (creation of the bad bank NAMA, serious efforts at a competitiveness adjustment), rather the Spanish government has simply tried to spend its way out of the problem (see chart) in the hope that better days will return.



Spain's official outsanding government debt is only around 55% of GDP, but the markets seem increasingly less willing to finance more of it without being presented with some sort of credible strategy for really reviving the economy on a sustainable basis.

The key to the problem is competitiveness. This issue has caused an uncountable number of arguments between "Anglo Saxon" economists, and their continental counterparts. I sometimes feel the issue is almost being taken as a personal one, a question of "honour". Indeed I often find company executives here in Catalonia extremely sensitive on this issue. So let us be clear, the issue is not that Spain's leading global companies and exporters are not competitive in the markets in which they operate. These companies have survived, and to survive they have become competitive. In true Darwainian fashion the fittest have survived. But what about thosxe who were less "fit", what happened to they? Of course, they died, they are no longer with us. And herein lies the problem, since to provide work for the 3 to 4 million people who are steadily being displaced from the construction sector (and the industrial ones closely associated with it) the dead will need to be reborn, and needs which are currently satisfied with imports will need to be met locally. Here is the challenge, and here is the reason many analysts have suggested that what Spain most urgently needs is a wage and price (downward) adjustment.

And how do I know this? Well just look at the trade deficit above. As Spain's economy has steadily "recovered" this has only deteriorated. Far from a deteriorating goods trade deficit, what Spain badly needs is a goods trade surplus. Exports have revived somewhat (especially following the recent drop in the value fo the Euro), but this improvement is far from sufficient, and indeed we are still well below pre-crisis levels (see chart).



So month by month, Spain's aggregate national accounts are steadily deteriorating. Every month the trade deficit needs to be financed, and the interest on the growing external debt needs to be financed. This is why Spain's current account has once more deteriorated, and is currently stuck around 7.5% of GDP.



And as a consequence of the continuing current account deficit the level of external indebtedness simply rises and rises.



The big danger at this point in Spain is that growing market uneasiness about Spain's external position creates a "debt snowball" not on government debt, but on the ability to finance the country's external liabilities, as lenders demand higher risk premia on interest rates charged, which produces a further deterioration in the current account, which lead the ratings agencies to make further downgrades which only feed market nervousness, and so on, in what could easily become a very vicious spiral.



Putting Spain's Economy Straight A Priority For All Europeans

So the point here is not to pour cold water on recent improvements in the state of the Spanish economy. Rather it is to point out that such improvements are really only rather superficial ones, and the underlying problem - the inability to generate a sufficient trade surplus to start paying down the debt - not only isn't resolved, it is getting worse. The principal reason why Spanish debt is steadily moving into high risk territory is not the absence of an adequate EU ratings agency, but rather is to be found in the impact on investor confidence of the perceived state of denial over the magnitude of the problem which which is to be found at the highest levels of the Spanish administration, and consequently the absence of any credible plan to address the situation. Confidence has now become the main problem, but not the confidence of those consumers who rationally decide to keep their money in the bank (to earn those very attractive 4 percent interest rates) rather than going out and spending it. Consumers in fact - at least according to the official ICO confidence index - has been becoming more confident of late (yes, this is what the reading tells us, although it would help observer confidence in what they were seeing if the agency who published the survey were not a government one):



Even more incredibly the expectations sub component surged back up again in April, and is now very close to series historic highs. I couldn't say I don't believe this, but I could say that living in Spain and talking to people on a daily basis I do find the result very hard to believe: either Spanish citizens are extraordinarily unrealistic about where extactly their country is at this point in time (which in itself would be hardly reassuring as far as the future of the Eurozone goes), or there is something wrong with the data.



The real issue, however, is to be found in the confidence (or lack of it) of those who lend money to Spain's citizens that they will be able to pay it all back. The confidence issue now revolves around whether Spain and its banks now owe more than the country is going to be able to pay back in the longer run. And remember, that even as GDP apparently grew in the short term, the level of external debt to GDP has simply continued to rise and rise. So while there may well be grounds for questioning the rational basis for the opinions reportedly expressed in the ICO confidence reading, there are far fewer grounds for imagining that those investors who are nervous about buying debt with the "Made in Spain" trademark are being other than very realistic.



As I say in this post, if the Spanish economy is really to be put straight, and not simply go straight back and do the same again, then surely one major priority must be for public opinion leaders to find the ability and the courage to speak openly and clearly about the Spanish economy's "inner secrets", and the strength of character needed to address the country’s problems in a proactive way - to be out there in front of the curve, and not constantly trailing behind it. If you want to stop a forest fire you put down aggressive faire breaks, you don't run behind it with a garden hosepipe.

The problem is - as I say here - with Mr Zapatero constantly denying that Spain has a public debt problem while at the same time persistently failing to address the evident private debt issue, there is a real danger that confidence deteriorates even further, and especially in the month of July, when a large quantity of both public and private debt is due for renewal. “We can’t spend all day paying attention to speculation,” Mr Zapatero said to journalists in Brussels last week. Exactly. Then don’t do it. What Spain’s Prime Minister needs to learn to do is stop answering questions people aren’t asking.

The principal reforms that Spain currently needs have been made abundantly clear by both the IMF and the EU Commission, so now is the time to implement them. Only this week the IMF urged the Spanish government to be more vigourous in implementing its fiscal correction programme, so why not spell out line by line where the cuts will come? It is no longer sufficient, as Miguel-Anxo Murado so ironically puts it in the Guardian newspaper, to simply say time and time again "all repeat after me, ‘Spain is not Greece’". This is clear to all. What is worrying people is whether or not Spain could become another Greece in the future, and whether or not the country’s present leaders have the determination needed to take the steps to ensure it won’t. Confidence in Spain’s economy is at a low level, and confidence in Mr Zapatero’s ability to do what is needed is at an even lower one. If Spain’s Prime Minister finds he is no longer able to convince external observers that he can do the job which needs to be done, then in the interest of all Spaniards and all Europeans he should offer to stand down at the and of the European Presidency in July and pass the rudder over to someone who can.

Like A Dog Guarding His Bone

by Edward Hugh: Barcelona

Presidents and Prime Ministers have to be careful with their choice of words. Especially in times of crisis and difficulty for their country. Former Mexican President José López Portillo will be remembered by history, not for his turbulent relations with his beautiful mistress Sasha Montenegro, but for the fact that one day after he appeared on national television stating "I will defend the Peso like a dog after its bone" the Peso was massively devalued. In similar fashion, when the Greek Prime Minister declares "Our national red line is to avoid bankruptcy," the markets do not know how to interpret him. Does this mean, they ask, the some form of debt restructuring is imminent? So the intervention this week of Spain's Prime Minister Jose Luis Rodriguez Zapatero, in a rather clumsy attempt to calm financial markets, could not have been more unfortunate. It is “absolute madness.” he told journalists in Brussels, to think Spain will need the kind of aid package debt-laden Greece is receiving from the European Union and the International Monetary Fund.

Of course it is, at least at this point in time. So why mention such a possibility? Right now what Spain needs is determination, leadership and serious reform. Mr Zapatero was reacting to market rumours that Spain was next in line for a rescue loan and was in the process of negotiating a €280bn bail-out package. The International Monetary Fund in Washington, for their part, confirmed that they will indeed be visiting Spain next week, but clarified that this simply formed part of a rountine annual consultation. There was no question of any rescue plan, and there the matter should have rested.

But something, somewhere had touched a raw nerve in the Spanish administration. Mr Zapatero said it was “simply intolerable” that such rumours were damaging Spain’s interests and could increase the cost to the state of raising money through bond issues. But his statement did little to improve things, since the country had to pay an average yield of 3.53 per cent on the sale of €2.35bn of five-year bonds later in the week. This was 72 basis points more than at the last five-year bond auction only a month ago, and the highest yield for the sale of new Spanish bonds over this maturity since May 2008. To put this in perspective, if matters continue in this way, the additional revenue anticipated from July’s VAT increase will soon be eaten up in added interest payments.

The root of the problem here does not lie in rumours, or inadequate perceptions of Spain’s situation among investors or “speculators”. The real problem is to be found in the levels of debt, whether public and private, which are to be found in many countries on Europe’s periphery, and in the ability of Europe’s existing institutions to handle the problems which have arisen.

And all of these concerns made themselves evident again on Friday, since despite the fact that many Eurozone countries have been busy getting parliamentary approval for the loans to Greece, the markets remain unconvinced that the rescue will work. Greek government bond prices fell sharply on Friday amid investor flight due to concerns the country might be forced to restructure its bonds in the coming days and weeks because of the deterioration in sentiment that was only made worse by the sharp fall in US stocks on Thursday.

As the Greek emergency has grown into a wider European sovereign debt crisis, so eurozone governments seem to have arrived at the conclusion that changes to the design of European monetary union can no longer be postponed, and this topic will surely be the main item at their Brussels meeting this Friday evening. Details of the kind of changes which may be under consideration remain scant, and it is still far from clear that Europe's leaders are ready to accept just how thoroughgoing the institutional changes may need to be if they are to be capable of putting the common currency on a sound and sustainable footing.

Greek 10-year bond yields rose to a record 12.287 per cent on Friday, while the cost to insure the country’s bonds against default rose close to 1,000 points, a level widely considered to be an indicator that a country or institution is in danger of default. Portuguese 10-year bond yields also rose to 6.18 per cent, another record, while the cost of protect Portuguese debt jumped to over 500 points. This situation is already causing all sorts of anomalies, with Portugal, for example, facing the problem of having to lend Greece emergency loans at rates (5%) which are lower than what it would have to pay to borrow the money in the capital markets itself.

So confused was the situation on Friday afternoon that even the European Central Bank found itself repeatedly pressed on rumors that it was considering a special credit line for European banks. The focus of attention was a suggestion that the ECB might announce a special 12-month loan facility amounting to as much as EUR 600 billion over the weekend. This speculation followed strong market disappointment that no clear strategy had emerged from the monthly meeting of the central bank on Thursday. The news that three-month U.S. dollar Libor rates jumped 0.05 percentage point to 0.428% on the day simply added to concerns, since it suggests that demand for dollars in the European banking system is on the rise.

The report comes amid growing concerns that European banks face another liquidity crisis due to the widening sovereign debt crisis. Tension may well come to a head in July after the ECB's 12-month money tender expires, when banks will be expected to return to the interbank market for funding.

But in what is begining to look horribly like a repitition of what happened in the autumn of 2008 Europe's wholesale money market is starting to show signs of increasing stress, relieved only by the fact that European Central Bank is still offering unlimited liquidity to the system, if only for one week at a time. One small datapoint attracted a lot of attention among market participants on Wednesday: the 2 year German bund spreads was trading below the 3 month euribor. The last time that happened was right before Lehman Brothers went down in October 2008. No wonder everyone was so jittery on Thursday when someone made a trading error. And use of the ECB deposit facility to store cash has been rising. It rose to 290.01 billion euros on Thursday, up from 1.99 billion euros on Wednesday, according to ECB data, offering us an indication of the extent to which banks prefer to bolt-hole their money over at the ECB rather than lend to each other.

So the real confidence issue at the moment does in fact revolve around Spain. But not around Spain’s public debt, which is still small by European standards. Rather the crisis of confidence turns on whether or not Spain’s banking system will be able to find sufficient funding in the interbank market to satisfy its liquidity needs according to the exit schedule (still formally in place) laid down initially by the ECB.

In Spain itself the problem is that with the country’s’ leaders constantly denying there is a public debt problem while avoiding addressing the private debt issue, there is a real danger that confidence deteriorates even further, especially given the large quantity of public and private debt due for renewal in July. “We can’t spend all day paying attention to speculation,” Mr Zapatero said in Brussels. Exactly. Then don’t do it. What Spain’s Prime Minister needs to learn to do is stop answering questions people aren’t asking.

As for Europe’s leaders, the time for talking and the time for waiting is now over. What Europe needs is action. Action to convince the markets that they have the policies and they have the will to make the institutional changes that are needed to make the common currency work effectively. Since if they don’t, or if they can’t, then like President José López Portillo before them they may find the dog that can only bark and never bite very rapidly loses possesion of his bone.

Sunday, May 2, 2010

The Catch 22 of Eurozone Imbalances - Fighting the Debt Snowball

By Claus Vistesen: Copenhagen

Edward does a nice job to sum up the flurry of the past week which saw the ongoing problems in Greece elevated to a full fledged systemic crisis in the Eurozone economy which, if it ultimately blows, will have ramnifications far beyond the borders of the European continent. Being a firm believer in the notion of markets as conversation it is funny to see that although Lehmann Brothers is dead and buried, people are talking an awful lot about it.

Consequently, the official figure for a Greek bailout has now risen to EUR120-130bn and with S&P downgrading Spain on Wednesday it suggests that the ultimate cost of this mess may exceed the already dizzying number note above many times over. As the Economist neatly puts it this week;

THERE comes a moment in many debt crises when events spiral out of control. As panic sets in, bond yields lurch sickeningly upwards and fear spreads to shares and currencies. In September 2008 the failure of once-stellar Lehman Brothers almost brought down the world’s banking system. A decade earlier, Russia’s chaotic default on its sovereign debt rocked the credit markets, felling Long Term Capital Management, a hugely profitable American hedge fund. When the unthinkable suddenly becomes the inevitable, without pausing in the realm of the improbable, then you have contagion.

As the Economist goes on to argue events are indeed spiralling out of control, a statement with which I concur in full. One question then which, at the moment, may not seem particularly important is how we managed to get ourselves into this mess.

In my most recent working paper entitled Quantifying and Correcting Eurozone Imbalances - Fighting the Debt Snowball I try to provide an intial answer to this question. Well actually, I don't set out to address this question specifically. But, I do think that if you want to understand why the Eurozone has ended up where it is today and why it is essentially threatened as an economic entity you need to take a long hard look at the issue of intra-Eurozone imbalances and why correcting them from within the Eurozone is almost impossible without some form of disruptive sovereign default in key member economies.

As an introduction, here is the abstract:

This paper quantifies and discusses the concept of Eurozone current account imbalances. Using panel data estimations, the analysis shows how the external positions of the Eurozone economies can be modelled as a function of divergences in unit labour costs. Specifically, the results indicate that the formation of EMU has exacerbated the extent to which even relatively small divergences in unit labour costs may materialize in large current account imbalances. These results are framed in the context of the idea of a debt snowball effect and why the idea of an internal devaluation as a tool to correct external imbalances is inconsistent with the current setup of the Eurozone.

So, do I bring anything new to the table in terms of the overall discourse on the Eurozone's economic problems? Not really. The story I tell is pretty well known but I still see the main contribution of the paper as the attempt to give a concrete quantitative perspective on the effect of divergent inflation rates (in my case unit labour costs) in an economic setting where countries are grouped together with seperate control over fiscal policy and no sovereign monetary policy and exchange rate.

Crucially, I argue that the forces which have lead to the build-up of imbalances are joined at the hip with the same forces which make it almost impossible to correct from within the Eurozone. Specifically the idea of a debt snowball effect is a good way to show why it will be almost impossible for some economies to correct their external imbalances without an explosive evolution in government debt and since they need to correct external competitiveness issues in order to achieve economic growth, the whole thing turns into a vice and essentially a catch 22.

Please note that this is a first draft only and still subject to several re-reads and editing (especially the tables) before I send it off for hopeful approval somewhere. However, for now your comments are welcome both on the paper itself as well as the topic.

What A Difference A Day Made!

by Edward Hugh: Barcelona

According to a once famous statement by the British Prime Minister Harold Wilson, a week is often a long time in politics. But when it comes to financial market crises we seem to follow a pattern more reminiscent of a line from the Dinah Washington version of an old María Méndez Grever song: "What a difference a day made". The day in this case was last Wednesday, at least for those of us here in Spain, since it was on Wednesday that the ratings agency Standard & Poor's downgraded Spanish Sovereign debt to AA from AA+. As a result the cost of insuring such debt using credit default swaps (CDS) surged at one point to a record 211 basis points according to CMA DataVision prices. Contracts on Greece and Portugal also rose sharply, with Greece climbing 42 basis points to hit 865.5, while Portugal jumped 20 to 406.

Standard & Poor's justified their Spain downward revision by referring to their medium-term macroeconomic projections. In particular the agency cited heavy private sector indebtedness (of around 178% of GDP), an inflexible labor market (they expect unemployment to remain around 21% throughout 2010, but then continue at a very high level for half a decade or so), the country's fairly low export capacity (Spain's exports only amount to around 25% of GDP) and the general lack of external price competitiveness. All these factors they feel are likely to mean that Spain will have low growth between at least now and 2016, a factor which will make the combined burden of private and public indebtedness much harder to service.

And despite the fact that Spanish Deputy Finance Minister Jose Manuel Campa stepped forward to say he was “surprised” by the move, arguing they are based on overly pessimistic growth forecasts, the fact is it is very hard to disagree with the S&P conclusions, as investors across the globe well understand. Even the EU Commission recently responded to Spain’s Stability Programme by stating that the growth forecast it contained was far too optimistic, and the IMF are even more pessimistic than the Commission.

In fact, it now seems that the present Spanish government seems to be becoming more and more isolated from Spain's financial and corporate establishment with every passing day. As Victor Mallet points out in today's Financial Times, "it cannot be often that academic economists use pictures of Omaha Beach, site of the bloodiest fighting in the 1944 Normandy D-Day landings, to illustrate their conclusions about one of the world’s medium-sized industrial economies", but this is precisely what the prestigous Barcelona-based Esade business school's latest economic bulletin did in their “H-Hour for the Spanish economy” editorial. “The diagnosis is very serious,” they said. “This is a highly indebted country with a damaged income-generating mechanism.”

Now even if one does not entirely go along with the whole analysis they offer of the roots and remedies for Spain's malaise, there can be no doubt that they now take the situation very seriously, even if one could lament that they did not begin to do so starting in August 2007, when the wholesale money markets first closed their doors to the increasingly toxic products that were being issued from within the Spanish banking system. The warning signs were already there, and were plain to see, although, unfortunately few inside Spain were able to do so. As a result, nearly three critical years have been lost, dithering around, large quantities of public money have been wasted, and what was a private sector external indebtedness problem has now been transformed, little by little, into a fiscal crisis of the state.

If the Spanish economy is really to be put straight, and not simply go straigh back and recidivise (after whoever it is who will do the "bailing out" finally does it), then surely one major priority during the coming national soul-searching process must be for public opinion leaders to find the ability and the courage to speak openly and clearly about the Spanish economy's "inner secrets", and the strength of character needed to publicly recognise problems in order to be seen to address them in a proactive and not a reactive fashion - to be out there in front of the curve, and not constantly trailing behind it. Put another way, it's high time Spain's bank and financial analyst community finally came out of the closet.

And if that all important international investor confidence is to be once more regained then it is important that those in the Economy Ministry are seen to be aware of the problems they face, and not simply reduced to the role of "marketing department" for a government which finds itself in ever deeper difficulty, caught between the rock of its own voters, and the hard place of the international financial markets. If you don't like having rating agency downgrades, then do something to avoid them before they inevitably come. But what was it Mr Zapatero was saying only yesterday, oh yes, he personally can see "signs" the Spain's economy Spain is at long last "improving", that the "worst is now behind us", or as Miguel-Anxo Murado so ironically puts it in the Guardian's Comment Is Free: "all repeat after me, "Spain is not Greece"". I'm not sure who it is the Spanish Prime Minister currently has interpreting the signs for him - it is certainly not Perdro Solbes, or David Vergara, or Jordi Sevilla, or indeed Carlos Solchaga - but it seems far more likely to me to be one of Spain's renowned Gypsy palm-readers than any reputable and internationally recognised macro economist.

In fact, as I have often stressed (and as Paul Krugman makes plain yet again here) Spain's problem is not essentially a fiscal one. Spain's problem is one of very high levels of corporate and household debt, and how Spain's banking system is going to support these during the long economic downturn and the ultra-high unemployment the country now faces, especially as a growing number of unemployed steadily lose their entitlement to unemployment benefit. The problem is not only that unemployment is currently running at 20%, but that benefits only last two years (plus an emergency six month flat rate 426 euro monthly payment extension), while many forecasts are now showing unemployment in the 16% to 20% range in 2013 or 2014. Just how are all these people going to continue to pay all those mortgages?

So it is not simply that "public sector borrowing is aggravating external debt and leading Spain towards high-risk territory". This is happening, as Spain's most high profile and most strategic export increasingly becomes government and bank paper, but this is the aggravating factor, and not the root cause. The principal reason why Spanish debt is steadily moving into high risk territory is the continuing state of denial to be found among the Spanish decision making elite, and the absence of any credible plan that is up to the magnitude of the challenge ahead. Confidence has now become the main problem, but not the confidence of those consumers who rationally decide to keep their money in the bank (to earn those very attractive 4 percent interest rates those banks who now anticipate having difficulty funding themselves in the wholesale money markets are offering) rather than going out and spending it.

The real issue is to be found in the confidence (or lack of it) those who Spain and its banks owe money to that the country (as a whole and not just the government) is going to be able to pay it all back. And in this context the sea change in mentality that Victor Mallet describes - assuming it is maintained - will be crucial. Those of us with rather longer memories - ones that stretch back to January for example - may wonder whether, once the immediate pressure is off, all that new found national resolve may not simply drift back into the mists from which it emerged, as has happened only too often in the past. Maybe the simplest and quickest way to help everyone feel comfortable that this was not going to happen would be to call in the IMF now, not becuase a bailout loan is needed yet, but as David Cameron is suggesting in the UK case, to carry out a "no holes barred" policy audit, so that everything which should be transparent actually is.

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Of course the problems which became all too apparent on Wednesday went well beyond Spain. Along with the CDS prices, bond spreads widened all across the European periphery - with Spanish, Greek, Portuguese, Italian, and Irish yields all widening in tandem. Yields on Greece's two-year bonds briefly even hit an incredible 21%, following Standard & Poor's downgrade of the country's sovereign debt to junk status the day before.

All of this and more finally forced the EU’s hand, and officials had to go rushing to the microphone to reassure investors that Greece would soon be able to access an aid package, with German Chancellor Angela Merkel going so far as to state that talks about providing aid should now be accelerated.

Then the numbers started to be filtered out, and evidently they were much larger than many had been expecting. According to press reports IMF chief Dominique Strauss-Kahn told German policymakers that Greece might need EUR120-130bn over three years, a number which the German press quickly calculated would mean that the German contribution might then go up to EUR25bn.

Certainly, at the point of writing we still don’t know what the exact number will be - and it is not even sure they have decided yet - but the reality is that once the EUR120-130bn number is out there from an authoritative source, it will be hard not to hit it, if not exceed it.

Then followed the announcement that IMF staff have reached an agreement with the Greek authorities on a 3-year program that will include draconian fiscal cuts (of the order of 10pc of GDP) and a series of structural measures aimed at driving nominal wages lower, reforming the pension system and building better institutions. Thus, the message this weekend to investors is: stop worrying about Greece for the next three years; you can continue to speculate in the secondary market, but the Greek government will be fine. And debt restructuring with the private sector now seems to be off the table for, at least for as long as the Greek government stick with the conditions – which will obviously be the aspect to watch carefully going forward. And even if there is an eventual default, the main counterparty will be other European governments (and the taxpayers who back them) and not private bondholders.

On the other hand, Europe’s institutions have, at a stroke, opened themselves up to a large slice of what is known as “moral hazard”, since the implicit message is : what we are doing for Greece we'll do for any other Euro-zone country, if needed. So from this moment on, we are all in up to our necks, if not beyond.

This "historic moment" point-of-no-return dimension did not escaped the notice of Dominique Strauss-Kahn either, since following his meeting with German politicians he was at pains to stress the potential contagion affect lack of backing Greece to the hilt would have had on the euro and the rest of Europe in the days to come. “I don't want to hide behind a rosy picture. It's not easy,” he said. All this “ can also have consequences far away. We have to face a difficult situation. We are confident we can fix it... But if we don't fix it in Greece, it may have a lot of consequences on the EU.”

Highly respected US economist and Harvard University Professor Martin Feldstein went even further, saying that in his opinion Greece will eventually default on its bonds and he feared other euro-area nations may follow, most probably Portugal. “Greece is going to default despite all the talk, despite the liquidity package,” he said. Portugal's name is mentioned frequently these days, since although the government deficit and debt levels are lower in Portugal than in Greece and the Portuguese government has much more fiscal credibility than its Greek counterpart, when you add private sector debt to the public part the number is not far short of 300% of GDP, and in fact the underlying problems are very similar to those which are to be found in Greece.

But it isn’t only in the South the the EU has to worry, since probems in the East continue to fester. The Hungarian forint had a fairly hard time of it over the past few days, and had a two-day intraday loss 3.6 percent on Tuesday and Wednesday, its biggest such fall since March last year. At the same time the cost of credit default swaps on Hungarian debt rose 23.5 basis points to 240. The drop followed revelations from Hungary’s incoming Prime Minister Viktor Orban that the country’s underlying fiscal deficit had in fact been rather higher than the previous government had acknowledged. So contagion may now be also moving Eastwards, meaning that EU institutions may now increasingly face a battle on two fronts, since the wobbling won’t simply stop with Hungary, there is Latvia, Bulgaria and Romania to also think about (just to name the first three that come to mind).

As Angel Gurria, OECD Secretary General, said this week: “This is like Ebola. When you realise you have it you have to cut your leg off in order to survive...... it is contaminating all the spreads and distorting all the risk assessment measures. It is also threatening the stability of the entire financial system.”