Sunday, May 3, 2015

The Greek Dra(ch)ma is back?

One more round of negotiations between Greece and the rest of is European partners to seek a last-minute solution before the Greek government runs out of money. Negotiations could end up going in any direction. Greece is unlikely to score a massive win but it could buy itself some time if there is agreement around a reasonable set of reforms that are to be implemented over the coming months. Reforms that could be sold domestically very differently from the way they are presented in Brussels.

What Greece really wants out of these negotiations is straightforward: a restructuring/reduction of its current debt that allows them to survive over the coming years with a primary balance in (small) surplus. This would mean that their pressure is gone and and that they can implement any policies they want without worrying about new loans as long as they can keep a primary surplus, which might be feasible given the current state of the budget. In return it will be easy to promise reforms that can have enough support at home (removing bureaucratic barriers, broadening the tax base, improve government efficiency). Of course, when it come to the actual implementation of those reforms, the support could turn into strong opposition. Greece also does not want to leave the Euro. Support among Greek voters is very high and the government understands the uncertainty and likely downside risk that they would face if Greece has exit the Euro area.

What the European partners want is much less clear. They would love to get paid back on all the current Greek government debt that they hold but that's unlikely to happen. Some would love to see Greece outside of the Euro area so that they do not have to deal with this again. There is a sense that whatever agreement is found now will not be the last one. The lack of trust has reached levels that has made it clear to some that Grexit is the best long-term outcome. But they are afraid of the consequences, both in the short run and in the long run in terms of credibility of the membership that would be left after Greece was gone. What no one wants is an agreement that does not offer a permanent solution to the problem. But is this possible? You need a credible commitment from Greece on implementing reforms in a way that can guarantee a large enough primary balance so that the possibility of future crisis goes down significantly. But credible commitment on reforms is not feasible. Reforms take time to be designed and implemented and there is enough uncertainty about growth and interest rates to ensure that a future crisis can be ruled out.

The intersection between what the Greek government wants and what the European partners want is an empty set today (once we remove all the unfeasible solutions). And that's why a risk of collapse in the negotiations is real. The only thing that can stop the collapse is the willingness by Germany (and the others) to compromise out of the fear that a default by Greece and the possibility of an exit from the Euro area can generate a crisis of unknown consequences. No doubt that this fear has decreased over the last years as markets are happy with low rates on Spanish, Italian debt while these negotiations are going on. But maybe they are happy because they assume a last-minute compromise will be reached (a good prediction given what we have seen in the past) or maybe because they believe the ECB could protect the other periphery countries from contagion with yet another 'whatever it takes' statement.

But the power of the ECB to contain a potential exit from from Euro is not infinite. It will depend on how the exit is played. Maybe they can contain some of the economic risk but what about the political risk?  With coming elections in key EU countries (UK, Spain) with interesting political dynamics when it comes to EU membership or policies, the range of political outcomes remains very wide to feel comfortable about an exit from the Euro area.

Antonio Fatás

Monday, March 2, 2015

Missing the anti-inflation central bankers.

In two recent posts, Martin Feldstein and Andrew Sentance (former member of the Bank of England monetary policy committee) criticize the recent actions of central banks to bring inflation back to its 2% target.

Andrew Sentance clearly misses the central bankers of the 1980s, the fighters against high inflation. He has an interesting definition of a central banker job:

"The job of a central banker is to make unpopular decisions when politicians will not. We saw that in the 1970s and 1980s from the Bundesbank and the US Federal Reserve."

And, unfortunately, central bankers are not fighting inflation anymore (maybe because inflation is too low?):

"It is a measure of how much has changed in the world of central banking that the very institutions that won their credibility by keeping a lid on prices now seem to be trying to create inflation, not subdue it."

And it gets even worse when he looks back at 2011:

"Central banks now seem ready to do whatever it takes to sustain growth — to a degree that casts doubt on the genuineness of their commitment to price stability. Monetary policy deliberately turned a blind eye to relatively high inflation in 2011-12."

There are two central banks that were worried about inflation in those years: the ECB and the Swedish central bank. Not sure they are the example to follow.

What both articles share is an asymmetric view of inflation. In some sense inflation can only be too high. High inflation represents a real risk with significant costs while inflation below target might just be ok (despite all the evidence to the contrary of the recent crisis).

Their criticisms would have a lot more power if inflation was going up anywhere in the world, but it is isn't. So they need to find another cost of this unreasonable policy of trying to raise inflation back to its target. And what Martin Feldstein finds is the financial instability that "low interest rates" create (a point also made by many other critics of current central bank actions).

But, as Paul Krugman points out, it is really odd to hear these arguments coming from those who tend to believe in the power and efficiency of markets (relative to government policies). How can it be that financial markets are so easily fooled by monetary policy and end up mispricing assets in such a bad way as to create a bubble that will have large and negative consequences on the economy? Because we are not just talking about asset prices going up as interest rates are low, we are talking about bubbles and instability. If this is really what we believe, wouldn't this be an argument to enforce some strong regulation on markets that are unable understand how interest rates and other macroeconomic trends affect asset prices?

This is not to deny that periods of unusually low interest rates can indeed create confusion in investors and markets (what some call "search for yield"). But to make this argument one needs to first understand the global nature of this phenomenon that suggests that the reasons for low interest rates extend beyond the particular actions of a central bank. And then we need a theory of financial markets, their irrational behavior and how the central bank can influence this behavior. It is unclear to me that the history of financial market bubbles teaches us much about the ability of central banks to stop excessive optimism. Real interest rates in the 1990s were high and they did not stop the largest stock market bubble the US stock market has ever seen.

Antonio Fatás

Thursday, February 26, 2015

The Taylor rule conundrum

Back in February 2005 Alan Greenspan referred to the abnormal (low) level of US long-term interest rates as a conundrum:

"For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience."

A month later, Ben Bernanke, proposed the idea of a global saving glut as the main reason for low long-term real interest rates. In a world where capital markets are global, interest are determined by global forces and not by domestic macroeconomic conditions.

This behavior is also very much related to the discussion around "global liquidity" and the potential influence of monetary policy in the US on monetary policy conditions in emerging markets. The difference is that in this case we are talking about short-term rates where we typically expect more control by the central bank and a stronger correlation domestic conditions.

To illustrate this point let me use a slide from a presentation two days ago by Hyun Song Shin (BIS) at the Bank of England discussing the future agenda of central banks. The slide includes the following chart (click on it for a larger image).

The chart shows the behavior of emerging markets central bank interest rates in comparison with a standard Taylor rule. The chart shows that since 2000, central banks have set interest rates significantly below the level implied by the Taylor rule (the same behavior is also true among advanced economies although not to the same extent). If one looks carefully at the scale, interest rates are 6 to 8 percentage points lower than those implied by a Taylor rule. This would imply an incredibly expansionary monetary policy. The chart comes from a paper by researchers at BIS (Hofmann and Bogdanov) who on their discussion of this result they argue that

"This finding suggests that monetary policy has probably been systematically accommodative for most of the past decade. The deviation may, however, in part also reflect lower levels of equilibrium real interest rates that might introduce an upward bias in the traditional Taylor rule."

Monetary policy can be too accommodative when central banks follow US interest rates to avoid appreciations of their currencies. But if monetary policy was that accommodative for more than a decade we should have seen increasing inflation rates during those years. That was not what we saw, inflation rates remain stable (and even decreasing) in most of these markets. Today, where interest rates remain very low compared to those implied by the Taylor rule, we talk about global deflation, not global inflation.

So it must be that the fundamental cause must be related to lower levels of equilibrium real interest rates and these are determined by global forces (otherwise why would all countries behave in the same way). Interestingly, the deviations from the Taylor rule coincide with the period where global imbalances started.

So here is yet another interest rate conundrum, this time related to short-term interest rates. How much do central banks control short-term rates in a world where capital markets are global? How relevant is a Taylor-rule approach to analyze the appropriateness of central bank interest rates?

Antonio Fatás

Monday, February 23, 2015

Financial crisis, the Euro and the need for political union.

In today's Financial Times, Gideon Rachman discusses the flaws of the Euro and the possibility of failure. He admits that from the beginning he believed that the Euro project would eventually collapsed because

"First, a currency union cannot ultimately survive unless it is backed by a political union. Second, there will be no political union in Europe because there is no common political identity to underpin it. And so, third — the euro will collapse."

I have always been very skeptical about statements arguing that a currency union needs a political union. The political consequences of sharing a currency (the Euro area) are in many ways much smaller than the political consequences of being part of the European Union, why don't we make the same argument about the European Union? (just to be clear, some make the same argument but clearly it is much less common, as can be seen in the article by Rachman).

There are plenty of example where the European Union (EU) requires some serious political consensus: the EU requires partial transfers of sovereignty to a supranational authority when it comes to legislation, the EU has economic mechanisms that imply a significant transfer of income across countries (via its budget, the structural and cohesion funds). Then why is it that the EU does not require to be backed by a political union in the same way the Euro project does?

My view is that the request for more political union in the Euro area is not so much the result of sharing monetary policy and a currency, I think that the answer comes much more from the power and size of financial flows and how these flows create a risk that is centralized and needs to be managed through the ECB.

The current debate between Greece and others in the Euro area is not about monetary policy. While there have been disagreements about the best course for monetary policy during the crisis, the fact is that the ECB has not been "too far" from what other central banks have done, interest rates have been close to zero for years and while QE has been different from that of other central banks, it is unlikely that a US-style QE would have made that much of a difference (we are still debating how effective QE was in the US or the UK).

The real debate in the Euro area today is about dealing with a debt crisis. The real issue is that the financial flows in the period 2000-2007 established links between countries and spread a risk across all Euro members, in a way that other countries (including EU members) not part of the Euro did not see. And the creation of the Euro was instrumental for this.

The role of the Euro was twofold. First it facilitated flows across countries as exchange rate risks had disappeared and provided the illusion of no risk. Second, once the flows had taken place it created financial links between banks and governments across countries that made them exposed to the same risk. In addition, the ECB because its connections with banks became a central repository of that risk and a solution for some of the countries facing a credit crunch -- the ECB acted like the IMF in many ways.

None of this is exactly about monetary policy, even if the ECB is involved. This is about financial risk and how financial crises have painful economic consequences. When sharing a currency the risk of financial crisis and its potential solutions bring countries and governments together in a way that a political consensus seems to be necessary because transfers might be involved and because common political solutions need to be found. And while these transfers might be smaller than the ones agreed as part of the Social and Cohesion Funds of the European Union, they come as a surprise and they are uncertain (we cannot agree ex-ante on their final size). This is what makes the Euro project a much more difficult one to manage without a sense that we all belong to the same group and are willing to work on this together.

For many, the Euro was one of the projects within the much bigger ambition behind the European Union (which came with the idea of a partial political union). But the recent financial crisis has shown that the risks associated to sharing a currency when financial and sovereign crises are possible, are a lot larger than what we thought. And these risks are much larger than the risks associated to simply sharing the same currency and the same monetary policy (yes, one interest rate does not fit all but this is not the real issue this time).

If there was a way to avoid the next financial crisis I would go back to my original idea that a currency union can survive without a political union. But as long as financial flows (and sovereign debt) can potentially generate the same type of risk as in this crisis, then the Euro might not survive the next one without stronger political ties between all its members.

Antonio Fatás

Thursday, February 5, 2015

Those mountains of debt (and assets)

A recent report by the McKinsey Global Institute on the increasing amount of debt among advanced and emerging markets made it to the front page of many financial newspapers yesterday (e.g. the FT). The report reminds us that in many countries debt is still going up as a % of GDP, that there is limited deleveraging. The Financial Times offers an interesting graphical tool to compare debt evolution for different countries.

The data is interesting and it highlights the difficulties in deleveraging but, in my mind, it might lead to readers to reach a simplistic conclusion that is not correct: that everyone is living beyond its means, that we are not learning and that this will not end up well.

Let me start with the obvious point: your debt is someone else's assets. The increase in debt as a % of GDP can be rephrased as an increase in assets as a % of GDP. It implies that the size of financial assets and liabilities is growing relative to GDP. That is not always bad. In many cases we think the opposite: the ratio of assets (or liabilities) to GDP is referred to as financial deepening and there is plenty of empirical evidence that it is positively correlated with growth and GDP per capita.

To illustrate why only looking at debt can give you a very distorted picture of economic fundamentals  let me choose a country that best illustrates this point: Singapore. In the graphical tool developed by the Financial Times one can see that government debt in Singapore has increased over the last years. Here is a longer time series from the World Economic Outlook (IMF) going back to 1990.

The current level of government debt is above a 100% (much higher than in 1990) and it puts Singapore in the same league as Spain or Ireland. But here is the problem: the government of Singapore has been running a budget surplus since 1990 (and many times a very large budget surplus).

What is going on? As the government of Singapore explains here, debt is not issued to deal with funding needs but to generate a set of Singapore government securities in order to develop a safe asset for the Singapore financial markets as well as for the compulsory national savings system called the Central Provident Fund. So while debt is very high, the value of assets is even higher and the balance sheet of the government of Singapore looks very healthy.

This is admittedly an outlier among governments, most governments do not have assets that equal in value their liabilities. But even in those cases someone is holding government debt. And it might be that government debt is held by its own citizens that are in many ways the shareholders of the government. So the consolidated balance sheet of the country might still look great (e.g. Japan). 

This argument does not deny that the actual composition and ownership of assets and liabilities matters (even if by definition they always have to match). We know well that certain credit booms are indeed associated with crisis so worrying about debt is a good idea. But one has to be very careful interpreting analysis (and newspaper headlines) that only refer to the debt side of the balance sheet. A richer analysis that understand where the assets are and how they relate to issuance of debt is necessary.

Antonio Fatás 

Sunday, February 1, 2015

Which countries managed the Great Recession better?

As we compare countries' performance since the beginning of the global financial crisis we try to look for patterns that explain differences in behavior and lessons on how to handle the next crisis. When doing that comparison we some times forget that looking at GDP growth does not always give us all the information we need to understand cross-country variation in performance. This variation can be due to demographic, labor market, productivity factors and while these three might be correlated over time, this is not always the case.

Here is a quick look at the years 2007-2013 for a group of advanced economies. The charts below plot the level of activity in 2013 measured as a ratio to the level in 2007.

We start with GDP.

We see the usual suspects at the bottom of the list and we also see on the right hand side the ones that have managed to do better during the crisis years. Japan and the UK sit in the middle of the table. 

We now correct for the potential effect of changes in demographics in particular working-age population (defined as 16-64 years old).

Not many changes except for Japan where the performance looks a lot better as it ranks #2 in this list.   [A caveat: any definition of working-age population is likely to be problematic. In many countries (in particular the US) activity rates above 64 years old and significant and increasing so this statistic might be giving us a distorted pictures of the true level of potentially-active population.]

Finally, what about if we look at GDP per worker? This will give us a sense on performance on productivity of those working, abstracting from the labor market performance (ability to employ the working age population). 

While this is a rough measure of productivity it is affected by many factors including the possibility of sectoral shifts as least productive sectors see a bigger downturn.

Some things do not change, Italy and Greece remain at the bottom of the list. But more movements on the other side. In particular, the UK is now the third-worst country and Japan goes back to the middle of the table. In the Euro area the biggest change happens in Ireland and Spain, both made it to the top 3. This means that for these two countries the labor market performance is the main drag on their GDP performance. Germany falls to the bottom half of the table suggesting that the strong German labor market performance has compensated a not too stellar growth rate of GDP per worker.

Antonio Fatás

Wednesday, January 28, 2015

Greece, EMU and democracy

One more post on Greece, possibly not the last one.

Markets are more worried about what is going on and there is more and more talk about the possibility of and exit of Greece from the Euro area. As I have argued in my previous posts, exit will not be the choice of the Greek government, it will be the only solution for Greece as the ECB refuses to provide liquidity to Greek banks as depositors run to avoid capital losses on their Euro deposits in the scenario of Greece leaving the Euro.

Let me start by repeating (as I have expressed many times in this blog) that I find that the economic policies followed in Europe have been a disaster, that the suffering that countries such as Greece had to go through during the last years should not have taken place. And I am convinced that in many of these countries, austerity has produced higher debt-to-GDP ratios, as opposed to lower ones. A real disaster.

But this is not what this negotiation is going to be about. The reality is that the crisis has had an impact on the way we all see the experiment of sharing a single currency, the experiment of EMU. While in the early days we all talked about optimum currency areas, the synchronicity of business cycles, the absence of a fiscal transfer mechanism, what we now realize is that the real issue is how to handle a full-blown crisis that puts governments at the edge of default and creates bank runs among Euro countries (something that many l thought it was impossible). The role that the ECB plays in those circumstances is not the typical role a central bank plays and one cannot ignore the political aspects associated to the difficult decisions they face.

And while it is true that Syriza has been chosen by the Greek voters and as such it is a victory of democracy, there are also voters in other countries that also feel they want their say heard by their governments.

And here is the question that I think is fundamental: if voters had a choice now, would they choose to join the Euro area given its current membership? What if they were allowed to change some of the members? There is no doubt that in some countries voters would like a different configuration of the Euro area. No doubt that Germany would be happier with fewer countries, in particular the "trouble makers".

And this decision will not be just based on economic arguments, some of it will be about the emotions generated by the crisis and some of it will be generated by the first statements of the Syriza government (and proposing a rethinking of the sanctions to Russia does not help).

So if the current membership does not work anymore, what do we do? There is no explicit process for this. Countries can opt out of the Euro if they do not like what they see. But the current negotiations with Greece will be seen by some as an opportunity to change who is in and who is out of the Euro.

If (big if) contagion can be avoided, Germany and Brussels have all the power in these negotiations. Greece does not want to leave the Euro.

Can contagion be avoided? The answer to this question three years ago was a clear no. And that's why this was not an option. Today I am not so sure. Three years ago Spain or Ireland or Italy were facing very difficult economic conditions that looked similar to Greece. Today that's not the case. Growth is very low but deficits are under control, debt to GDP ratios decreasing in some countries and interest rates are low and not reacting much to the Greek elections. The possibility of contagion today could come more from the political side. If voters in other countries decide to elect similar parties, we might repeat the same scenario in a few months in Spain or Italy. But will voters do this if they see that exit from the Euro is a possibility? Remember these political parties do not want to leave the Euro. Most citizens even if they are critical with European policies do not want to leave the Euro. My guess is that an exit of Greece from the Euro area will change political outcomes in European countries relative to what we see in the polls today. And this will limit the possibility of "political contagion".

Interesting times. More to come.

Antonio Fatás