Sunday, 25 December 2011

Merry Christmas and a Happy New 2012!

The new 2012 bears a lot of questions on the eurozone, UK, US, China and so on, but lacks to provide many answers. Unemployment is still at high levels and is likely only to rise. Output on the other hand, as well as investments, are likely to fall. Stagnation is upon us. The reports of the most prominent world institutions predict this, but they also predict a bounce back in 2013. This is a bias their models hold, since no one takes into account the possible reactions if the euro falls, or if the Chinese bubble finally bursts. The picture is gloomy and the politicians are realizing this more quickly than before as their election dates are closer. The current situation of postponing the necessary solutions is only pilling up the pressure on them and is increasing the dissatisfaction and antagonism among voters. Sooner or later, we will all have to face the necessary consequences and accept painful solutions. Balanced budgets and increased bailout funds will result only in more debt accumulation and won’t create a favourable environment for private sector growth. It may temporary restore investor confidence but the banks will still be reluctant to lend and the regulatory requirements will still raise costs for private sector enterprises. The upcoming year will eventually give us the answers on why the recovery is taking so long and why worldwide investor and consumer confidence is experiencing its longest low streak since the 1930s. We already know the welfare state is unsustainable in a productive-less and freedom lacking economy. Now we must find out how to fix it and find the proper remedy for an overblown and overdependent system. 

In the mean time, in these festive times let us enjoy the moment and celebrate the holidays, fearfully looking forward to the new 2012.

Thursday, 22 December 2011

The Great Mismatch between the labour market and universities

The ever high unemployment levels worldwide and particularly the upsurge of youth unemployment is getting more and more people worrying. The hardship of finding a proper job for a recent graduate has become next to impossible in 45%-youth-unemployed Spain or 42%-youth-unemployed Greece. Other countries aren’t far behind. Europe’s youth is locked in an unemployment trap and some go so far to call it a ‘lost generation’. I refuse to be that pessimistic as the amount of brilliant young minds created is increasing with the technological development, student ‘migration’ and widening exposure to new ideas and ways of thinking. However, the fact that they remain unemployed stands and the solutions are lacking. Although I won’t go in much detail on how to fix youth unemployment here (as I see the problem of unemployment being solved through restoring confidence and removing uncertainty in the economy in order to increase private sector investment and eventually hiring) I will touch upon the mismatch that has risen between universities and the labour market. 


Certain claims suggest that universities are not preparing the graduates good enough for jobs in the private sector, particularly for small and medium sized businesses. All those taking on apprenticeships are deemed too inexperienced and are turned down at job interviews. Unfortunately this is normal during a crisis. More experienced workers who lost their jobs will pick up the available ones. How can a graduate, no matter how impressive his CV is, compete with someone with 10 or more years of experience in the desired sector of work? This is why I find it strange why some advocate for government intervention in encouraging the employers to hire more young people, or better yet to encourage universities to offer a better skill-oriented program to graduates making them more competitive.

There are suggestions that universities should be encouraged by the government to provide more employability skills in order for the companies to be likely to hire and be more open to graduate students. This would be a wrong approach. Providing incentives to the education system to change will be costly and could produce unwanted results such as many below average schools taking in taxpayer’s money without using it in the right direction. Besides, how can the government verify whether the programs offered are any good, or helpful at all? The universities can always defend themselves that the program is new and it needs time for it to improve. By that time a lot of money will be spent and nothing will be gained in return. As a consequence the policy will result in squandering resources and without any real effect on employment or enhanced skills for that matter.

A much better approach would be to let the universities decide on their own whether or not to introduce such a program based on the experience of their students and the type of students they wish to attract. By offering a unique program a university will be able to distinct itself from others and attract more students. They will form their programs based on the demand signals they receive from the students. If there is a higher demand for more employment skills related programs, the universities who supply it will see an upsurge of applications and revenue. By offering what the students want they can charge higher prices and seize the rising demand, if there indeed is any. Today most students choose finance and economics programs hoping for a high return on their invested tuition. The majority of space and programs at the universities for those types of students simply shows that the universities are adopting the supply of their services. And it’s not that the universities don’t offer other, less attractive programs as well. They do, but since the demand for these is much lower, so is the supply.

The incentive for more hiring must go the opposite way. The businesses who wish to take on more apprenticeships or more graduate level students should advocate a need for more skills based programs. When the students notice this is important for them to get a job at a certain company they will look for universities which offer such a skill-oriented program. Upon observing an increase in demand for such programs the universities themselves will decide whether or not to engage in it and offer it to the students. It would be wrong to demand from the government to impose more skill-oriented programs onto universities so that we could increase the graduate hiring rate. There is no guarantee the businesses will react in the right direction and indeed start hiring more graduates. If they rather take in an experienced hire, no university program will make them change their minds. A government subsidy could change their mind, but then the problem is shifted towards a different angle – age discrimination and diversion of the firms’ resources towards a political market. The problem wouldn’t be solved, it would, much like in most government intervention programs, only be shifted away from one group to another.

The only thing the government could do in terms of incentives is to reduce regulatory requirements and employment taxes that discourage businesses from hiring. The issue isn’t the lack of skills handed to the graduates, it’s the lack of motivation for hiring by the employers.

Friday, 16 December 2011

Graph of the week

This week we take a look at an interesting figure showing the target levels of the new eurozone treaty (signed last week).

Source: The Economist, Daily chart

As the Economist says, "this time we really mean it!" The level of insubordination of the eurozone countries is astonishing. While some were balancing around the target in pre-crisis times, trying to cope with it, others were outright irresponsible, particularly right about after the credit squeeze in 2009, when the debt levels and the deficits soared.
The debt levels are at an even worse state, knowing that the Maastricht target was 60% of GDP. How will the automatic punishments suppose to handle all of this and prevent further political mischief is still rather puzzling to me.

Monday, 12 December 2011

The path towards a fiscal union

One part of this post was published at the ASI blog, titled "Europe's road to serfdom"


The deal was struck. The EU and the eurozone are on a new path toward a more strict fiscal union. And with the deal, it is very likely a move towards a double speed Europe, or a union within a Union. Britain has isolated itself from the new treaty by a veto from its PM David Cameron. Whether such a move is good or not for the UK, only time will tell. It would be frivolous to make predictions now, as it is very likely that Britain will remain a part of the EU, only now left out of some main decision making and possibly regulatory standards. This isn’t necessarily bad, as Britain mostly suffered under various EU labour and financial market restrictions, but it is a question on how Britain might suffer politically. Loss of power and influence within the EU is certain, and it is left to see how this will impact Britain’s future motivation and public opinion regarding the EU.
The break-up of the Union, at least at the moment, isn’t likely, despite all the negative predictions. Neither will Britain exit, nor will the euro fall. The two-paced union was an unavoidable outcome ever since the euro introduction. The currency itself offered better economic conditions initially to all those who embraced it. It was the reason behind imbalances and it will be the reason for fiscal unity. All those who refuse to enter it, will remain outside like they did before. The UK can still benefit from trade treaties and a more open and flexible labour market (still only a theoretical assumption in most of Europe). It will enjoy less regulations and less fiscal constraint. It will remain to be independent and different than continental Europe, as it was before. I see no big differences in this apparent ‘break-up’ apart from the administrational ones. The euro needed a fiscal union, perhaps not in this form, but it nonetheless needed it. The loss of national sovereignty to the EU is the unfortunate but necessary outcome. It was never going to be the other way around.
The UK mostly did this to protect its money-maker – the City of London. It is encouraging they have finally remembered its importance, and they are finally showing support for once. They also realize that the FTT will present a huge negative impact on the City of London and the UK GDP in times of recovery. Britain finally got fed up with all the unnecessary regulation coming from the EU that was undermining its competitiveness. Introducing the FTT was the final drop, as London would lose its battle over the financial influence against Hong Kong, New York or Singapore. The “big bang” made London into the global financial centre it is today. The FTT would undo all that change and in return offer bigger equality in Europe? No thank you, say the Brits and who could blame them?
I don’t see a decrease of trade levels with the UK either. The EU does a lot of trading with the US, China, Japan and even Switzerland, and the fact that they are out of the single trade zone (well apart from the Swiss) didn’t result in negative outcomes for these countries, quite the opposite – it resulted in more specialization and more gains from trade worldwide.

The treaty agreement itself is much more a plea towards fiscal discipline and austerity. It lacks a long term strategy apart from hope that within a fiscal union there will be less scopes for irresponsible behaviour and everyone will have to act as Germans. If they were treated as Germans by the bond markets before, now they will finally have a chance to act like ones. 
The budgets of eurozone members need to be balanced or in a surplus. This will be introduced in each country’s legal system and possibly be overseen by the European Court of Justice. If any country breaches the 3% deficit ceiling (which was the initial requirement for the euro introduction; if only they had listened before) it will suffer automatic consequences and possible sanctions unless the majority of other nations oppose. I see room for political games once more.
The financial measures in place were designed to increase the firepower of the eurozone institutions to rescue the currency and its most endangered member states. There is a new rescue mechanism, the European Stability Mechanism which is to hold €500bn, and there is an additional €200bn to arrive through the IMF. According to some high numbers being called out before, it isn’t certain whether this will be enough.
The problem with the current plan is that it requires more and more bailouts, which essentially implies more and more debt accumulation. The socialist foundations of Europe are falling apart simply because they refuse to realize (or are unable to realize) that socialism and the welfare state are unsustainable, once you run out of other people’s money, that is. The dependency of peripheral nations is causing the highest burden on the eurozone. Its core members don’t have sympathy towards these countries, they require bailouts to save their own countries’ banks who plied up on peripheral debt due to Basel capital requirements – another example of European regulatory oversight that ended up increasing systemic risk of the financial sector rather than decreasing it. 
As long as the EU officials close their eyes on the only plausible solutions left – defaults that will end further bailouts and dependency (excellently summarized by Dan Mitchell of the Cato Institute), Europe will remain in dire straits. More socialism and more faulty policies that caused the current situation cannot be the answer to its problems. The response must come from a different perspective – just like it did in the 1980s. The question is how much longer will it take for the policymakers to realize they are on the road to serfdom. 

Wednesday, 7 December 2011

Graph of the week

Here's a figure depicting the history of eurozone sovereign bond spreads vs. 10-year German Bunds, from 1990 to 2011. 


Source: FT Alphaville, original source: Pictet

It is an interesting proof to the propositions made here that the introduction of the euro equalized the risks across eurozone which gave the peripheral countries an opportunity to borrow cheaply. This opened the scope for excess borrowing and fueling domestic growth with consumption and government expenditure. As an effect all the peripheral countries experienced severe current account deficits

What is interesting in the figure is how the spreads were much more volatile before the euro and the rapid decrease of volatility (and hence risk) once the euro was introduced. It appeared that every eurozone country could borrow as if it were Germany. It is obvious that this was fiscally unsustainable. The US spillover effect can be seen in 2008, but the credit squeeze that came about in 2009 fully uncovered the eurozone's instabilities and led the bond markets to react the way they did - rapidly adjusting the risks of the eurozone sovereigns. 

Tuesday, 6 December 2011

Never fear, the Supercommittee is here?

Did anyone really believe that after the August US credit rating downgrade caused by political quarrels, stubbornness and instinctive self-preservation, a committee made of an equal number of Democrats and Republicans would actually reach a favourable conclusion? I didn’t think so.

After all the pleas for the Supercommittee to go big and seize the chance to create an impact and make a credible reform, in more than three months work, last week they’ve announced the inevitable failure.

I admit, on first sight it seemed like a good idea. Any form of political indulgence of the deal was removed. The Senate couldn’t use its filibuster power, there was going to be no amendments in the Congress; it was supposed to be a simple yes or no policy effective immediately. However, then I remembered that the topic was the US deficit and the actors were US politicians, the same ones responsible for the US debt downgrade and market panic in August this year, and I quickly came to realize any hopes of them coming up with a compromise solution was in vain.

The failure of the Supercommittee in the US results in several disappointing consequences. The first one is complete disgust of American voters over their politicians. I wouldn’t be surprised to see a record low turnout at the next Presidential elections. It is amazing to see that even when all obstacles are removed and when everyone is hoping for a credible solution, the nation’s politicians are unable to provide one. One signal is clearly sent to the voters – “remove us out of office”. 

Apparently the Republicans were reluctant to accept any tax rise (at least for the rich), while the Democrats refused to make cuts on various entitlement programmes (Social Security and Medicare). Once can see why each party was holding on stubbornly to its proposals as admitting defeat on one of the issues would automatically mean loss of reputation and voter support. But ironically, the inability to reach consensus is hurting them both even more. I would blame the two protest movements for this – the Tea Party and the Occupy movement are holding both parties to stick to their agenda and not let the other one get away with anything. The Republicans will not allow any taxation of the rich, something that the Democrats are very strongly in favour for. One couldn’t say the protest movements were a direct cause of the political lock down, but they definitely played a big role in shaping the opinions of each party’s representatives in Congress.

The second consequence is an inevitable fiscal contraction (Bush tax cuts will expire, so will the temporary cut in payroll taxes and unemployment benefits). The US will see an automatic $1,2 trillion deficit cut with half of that amount taken away from military spending and the other half from other areas such as education, housing, environment protection etc. It is questionable how the markets will react, since the ratings agencies welcomed the Supercommittee idea as a way for the US to prove its credibility for the AAA rating. Its failure increases uncertainty and prolongs any chance for a faster future recovery. Confidence in the economy cannot be increased under uncertainty. Next year will be particularly dramatic for Europe and more uncertainty coming from the US will only add to the gloomy picture the world economy is finding itself in. The political lock-down will last until the presidential elections in November 2012, which means that we can all anticipate a turbulent  2012, to put it mildly. 

The moral hazard of having two strong parties deciding the fate of the country is showing its most adverse effects. A political lock-down is causing an economic lock-down. It is striking how the US politicians, on one hand calling European leaders irresponsible for not being able to tackle the crisis, and on the other hand causing the same contraction to their own economy, cannot see the irony in all of this. The double-dip, both in Europe and in the US, will be caused by political incompetence and their lack of perception of reality. Is there anyone to put the politicians down to earth? The voters can, but they, just like the politicians, are seriously lacking options. 

Saturday, 3 December 2011

Investment should be left to the private sector not the government

This blog post was also published at the Adam Smith Institute blog

Regarding the UK Chancellor’s last week’s autumn statement, if anyone had any doubts, one thing was made clear – the UK, much like the US, is embracing fully on a Keynesian path to recovery.  

The government took the plunge to direct private sector investment decisions. It is calling on pension funds to invest into infrastructure projects and even putting in some money by itself, it is calling on businesses to hire more young people (introducing an age boundary and a waiting list boundary) and offering them money to do so, it is calling on banks to lend more money to businesses by offering guarantees for these loans thereby setting a stage for another asset bubble, it is underwriting mortgages and driving the housing supply and finally it is doing all this in hope of satisfying narrow interests and in hope of ensuring political success.

The government is centrally planning the country’s development. And they are doing so through populist policies, higher spending and more borrowing, despite all the warnings from the Office for Budget Responsibility (OBR) on the adverse effect this will have on output. The call for cuts is still strong but so is the call for more spending and more borrowing. The deficit and debt goals are prolonged another 2 years than initially planned. No wonder, since the policies the Chancellor came up with will only widen the national debt and increase the budget deficit. What is the point of calling plan A (or plan A plus) austerity, when it is clear that the UK is using a fiscal stimulus.

It is worrying that the current government would rather resort to populism and cronyism to create a seemingly good picture of the economy then to keep its long term goals. The bond markets aren't punishing the UK yet, but they will do so soon enough. The policies imposed by the Chancellor resemble all those policies that led the peripheral eurozone nations into severe debt troubles. The UK is nothing like these economies some would say and would be right. But it is only a matter of time before it becomes like them if allowed to continue with a centrally planned investment and ‘growth’ scheme.

The worst outcome will be in the perception the UK government will create. Once it fails in its policies to restore growth, the Keynesian response will be it was because it crippled the recovery by cuts and that the plea towards austerity didn’t boost spending or the aggregate demand. The fiscal austerity aimed to reduce the national debt and budget deficit will be blamed for UK’s failure and a lost decade or two. But it will be exactly the opposite. Reckless spending in the Brown period and incompetence and lack of courage to change the public’s opinion on the welfare state and continuance with populist policies during the current government will mark the reasons of a lost decade in Britain. 

The lessons of the financial crisis in 2008 and the current eurozone sovereign debt crisis haven’t been learnt. The fallacy that a centrally planned economy can lead to prosperity and creating value still persists in the minds of the decision makers. Government steering of private sector investment leads to the creation of artificial demand and it leads to the creation of asset bubbles. The solution to these previously created problems cannot be applying the same policy as before, it must rest on other virtues, it must focus on creating value. And only the private sector can create value. Therefore, the government must do everything to clear the path for the private sector and remove any burdensome regulation and taxes in order to encourage the private sector to do so. Confidence in the economy is best restored if it’s a healthy, private sector led economy, not a government run behemoth. If the UK policymakers are unable to see this, they should resign with immediate effect before they poison an entire generation with dogmatic thinking.  

Thursday, 1 December 2011

Graph of the week

I will be introducing a new category on the blog, inspired by the economist's daily chart, I will randomly select and/or make interesting charts and comment them briefly. If it turns out to be popular, maybe I'll turn the category into 'graph of the day'. 

The first one is taken from the Economist's daily chart:
Source: The Economist, Nov 28th 2011.

It is the OECD GDP growth forecasts for the year(s) to come. It appears that 2012 will be the year of the double-dip recession. This will be particularly emphasized in case of a euro break-up. The European countries in the figure reflect this the most. On the other hand the US economy is expected to slightly increase growth to a steady 2%, while Japan is expected to rebound from its earthquake tragedy earlier this year. The developing economies will also be affected by the european slowdown as their exports are expected to fall. 
It is worth noting that the OECD have made the predictions based on the fact that the current status quo situation persists throughout the following year. Due to the dynamics of bond market reactions and political responses I believe that the road ahead will be rough and the growth forecasts will have to be revised a couple of times. Let's all hope they will be revised upwards if/when the credible solution to the sovereign debt crisis is found. If not, we're in for a depression rather than a recession. 

Tuesday, 29 November 2011

Subsidizing youth hiring is wasteful and will yield no positive long-term effects

This post was also published on the Adam Smith Institute blog

The UK Chancellor George Osborne announced his Autumn Statement today, and here are some immediate UK think tank reactions. In summary, the Autumn Statement wasn't surprising; it seems that the taxpayers were bearing the burden of the crisis in order for the government to spend that money on wasteful infrastructural projects, mortgage guarantees (see here), loans to businesses (see credit easing) and essentially is trying to guide (dare I say centrally plan) investment incentives in the economy. 

Within the Autumn statement one proposal in particular caught attention, and it was a policy earlier announced by the LibDem Deputy PM Nick Clegg. The UK government wants to subsidize businesses in hiring young unemployed workers, precisely from the ages of 16 to 24, by offering £1bn to the private sector to take young workers into apprentice schemes. 

Under a typically political decision and explanation, youth unemployment is supposed to be tackled by offering money to private sector firms to take on temporary workers so that the young might get more experience. How this is supposed to create value for the private sector and how is such a policy sustainable in the long run, no one in the government knows or cares about.

The coalition is obviously desperate to cut youth unemployment as it fails to see the paradox in its claim that a subsidy to employ a young person is a way to create “lasting” jobs in the private sector. A temporary subsidy will be of just that effect – it will be temporary. Even if it does produce some youth jobs this won’t be due to an increase in real demand for workers, but due to an artificial increase in demand for workers. 

A private sector business will be able to assess by itself the best whom to hire and how long to keep them. By creating a distorted incentive the government is directing the firms’ employment policies. In a crisis of confidence with many lay-offs it is natural that the young suffer the most. They lack the experience older laid-off workers possess and cannot compete with them. By creating a subsidy to employ only the youth, the government discourages hiring of older workers and distorts the labour market against them (discriminates against them). These are not just too old workers, but all those older than 24, meaning that younger workers, university graduates, still may get discriminated against. A subsidy, wherever it is enforced, will always yield similar effects – it will distort the market in favour of the subsidized and against every other market participant. In addition, the effect is always temporary and works only if the subsidies carry on indefinitely, which is of course extremely costly.

A private business owner will have better knowledge of what kind of worker to employ, whether a young or more experienced one, the choice is always his to begin with. A government subsidy can only help him make the wrong decision and chose a young worker, not necessary a worse decision but also not necessarily a better one either.

Subsidies create a political market for the companies to compete on. The difference is they don’t compete for customers, they compete for bureaucrats, or more precisely the favourability to bureaucrats in extorting funds. 

A far better idea would be to create incentives for hiring temporary workers, not via subsidies but via decreased taxes (removing the NIC for employers) and cutting employment regulations to encourage businesses to start hiring again. An NIC holiday for small businesses (actually proposed by the Chancellor) or removing it altogether, lower income taxes for the young, removing any regulatory confinements for hiring temporary workers and those on zero based contracts, reducing the rigidity of dismissal rules, removing financial repercussions for employers and further reform of the employment law. These are just some of the policies that would work much better than a subsidy. First of all, it will cost less to implement. There will be no need to increase public spending and waste resources. Second, a tax cut creates a completely different incentive to the private sector business. Instead of competing for public money, it will decrease its costs by hiring another worker. It will lead to lowering of the entire unemployment rate and create more scope for businesses to make higher revenue. This will eventually decrease youth employment as well, as it will go down once the economy starts recovering with a higher pace.

In addition, if they really want to help the young get more working experience there is a particular policy decision preventing the young to do so – minimum wage. By removing the minimum wage for young workers the government will make it much more affordable for the private sector to offer them temporary jobs and work placements. The young are willing to work for a lower rate than the market rate to get some work experience. This is why they engage into internships and volunteering, hoping to get more experience and be more competitive on the market. Removing the minimum wage would yield exactly the effect Nick Clegg is hoping for – it will offer more jobs to more young people and help them get more experience. The subsidy, on the other hand, will fail to result in the same effect and is a prime example of wastefulness of the taxpayers’ money. 

Besides I again fail to see how is spending £1bn going to cut the deficit and lower the national debt. The more serious the threat of recession in Europe, the further away the UK government is from obtaining its long term stabilization of the debt and deficit policy. If you already design a credible plan, I expect you stick to it. Every policy proposal the government made after its plan A seems to undermine it.

Furthermore, a similar policy was in power during the Labour government, worth about £1,3bn only to be removed by the Conservatives once they came to power. Regarding such a U-turn, I would like to remind them of a certain Conservative leader and her opinion on the subject: 

Monday, 28 November 2011

Long live the technocrats!?

Plato would be proud. His idea that philosophers should govern is coming true in Italy and his very own Greece. Even though economists rather than philosophers are in power, economists are today most closely to being the ancient philosophers Plato had in mind. This isn’t at all a biased statement.

The idea itself has its benefits and its flaws. As a non-elected entity, how does this government serve the people? Is the very foundation of democracy at stake if we allow for legitimately elected governments to be replaced by parachuted technocrats? Even if the people have an utmost confidence in these new ‘rulers’ and consider them much more capable of handling the crisis situation, isn’t this necessary an attack on democracy and free choice of the voters? Not necessary.   

The technocratic governments were given legitimacy once approved by Italian and Greek parliaments. The elected members of parliament in both countries agreed upon that a new technocratic leader should step in instead of the current government and resolve the issues facing both countries. The opposition didn’t acclaim themselves as the saviours, rather they were bold enough to offer a third choice, as long as the current government, incapable of reform, is removed from office.

Picture the current technocratic government as a central bank committee. It has the legitimacy given to them by the parliament and yet it has the independence it needs to run the monetary policy (or in this case the economy) without fulfilling political goals such as debt monetization (no matter how strong the political establishment is advocating this goal currently in the eurozone). If the system allows the technocrat experts to handle a delicate and complex issue such as the monetary system, who is to say they wouldn’t do a good job in handling a much less complex issue such as the budget allocation and distribution.

There is danger to the technocratic government. Even an economist fully aware of all the negative effects of resource wastefulness cannot escape the influence of lobbyists and traps set by lawmakers. Sometimes political sense and deep understanding and knowledge of the political process are needed to avoid negative influence of outsiders. And who is to say the technocrats themselves won’t become prone to corruption and overcome with power at one point during their reign? 

There is a reason why this is unlikely to happen. The parliament is supposed to keep an eye on the technocrats therefore creating an incentive for them to do a good job in office. If Monti or Papademos start behaving badly and misusing their influence they will lose the support of all the parties in parliament needed to keep them in office. Politicians are able get away with this since they do tend to have a majority in parliament that enables them to very often misuse their power and act pompously. A technocrat has too much constrains to do so. However, these constraints might encourage him to do a good job once in office.

Italy 10-year bond yield. Source: Bloomberg
Greece 10-year bond yield. Source: Bloomberg
The markets are still sceptical though, and after an initial positive reaction the uncertainty remains rather high, which is pretty much expected. The situation in these countries is still the same and due to the fact that the new PMs are relatively unknown outside their nations, confidence will increase only after they start fulfilling their programs and ideas on how to save their respectful economies. This is when the markets will react, either positively or negatively, depending on how successful the technocrats turn out to be. Let’s just hope it’s not all in vein and that the euro stays together long enough to give them a chance to succeed. Personally, I am very much interested in how this experiment turns out.

I support the technocratic governments, and despite all the issues such a move might raise for civil liberties and the democratic process, unless such a government turns into an authoritarian regime (which is highly unlikely as technocrats are not capable to uphold such authority), it might well turn out to be better than anything experienced so far, at least in Italy and Greece. 

Saturday, 26 November 2011

Reusing chewed-up ideas on the housing market

Note: this post was first published on the Adam Smith Institute blog, on Wednesday 23rd November 2011

On Monday, the UK Prime Minister David Cameron announced a new policy on housing designed to partially underwrite mortgage loans for first time buyers in order to make it easier for them to buy and own a house. The idea is to make new buyers provide only a 5% deposit for buying a new home, instead of up to 20% which the banks are demanding now. It is supposed to make the “ home-ownership dream” a reality for young people. The government and the construction firms will together underwrite a part of the loan creating an incentive to the banks to relax lending standards. This is aimed to help 100,000 new possible home-buyers who are excluded from the market due to high loan-to-value ratio’s.

The PM cleverly offered a caveat to potential critics by saying this policy won’t result in another asset bubble like it did in the US, since it is only focused on people buying new houses. It is supposed to create jobs in the construction industry as well as making it easier to own a home.

This essentially means that no matter what the current supply of housing is in the UK, because the government is worried with low rates in housing construction, it is willing to distort the housing market by increasing the supply of new homes.

The policy such as this one comes closest to the Community Reinvestment Act (CRA) instituted in the US, more particularly its amendment in 1995. For those unfamiliar with the CRA, it forced the banks to offer more loans and weaker lending standards to underprivileged groups in the society (minorities for example). It was a popular political move that was guided under the idea that everyone is entitled to a home, and if they can’t provide it by themselves, the government should do it instead.

As an effect, encouraging homeownership added to an artificial created demand for housing in the US which combined with a few other presumptions led to the boom and bust of the housing market. Houses became available to many of whom were unable to afford them, underwritten by the government controlled enterprises. Lending standards were decreasing due to short run interests of the politicians to remain in power. A populist policy such as “let’s make more people own a home” sounds good to the median voter, and may even win some favours for the politician in power, but its effect can only be an artificial demand and suboptimal provision of an asset.

I do understand the difficult situation the PM and his Chancellor are finding themselves in as their growth strategy isn’t delivering any results. I understand the need for a politically motivated act that will create a (temporary) artificial boost in housing and build some new homes for the people. However, it seems that every move they make to boost short-run growth further undermines their long-run growth path. Every new populist policy will simply detach them from their fiscal stabilization goal and make the UK more vulnerable to outside shocks of investor sentiment. I fail to see how increasing spending via credit easing programs or subsidizing homeownership can overturn a deficit. There will be no aggregate demand created either, since household incomes are locked-in and it is unlikely for the people to start spending on houses all of a sudden. The effects cannot be immediate, they can only distort the economy in the long run. It all sounds more like an expensive political trick used to buy votes.

Haven’t they learned anything from the eurozone sovereign debt crisis? A welfare state used to fund populist policies to finance political self-preservation leads to disaster. 

Friday, 25 November 2011

Eurozone crisis – analysis of causes and consequences (part 4)

The final part of the eurozone causes and consequences analysis deals with the outcomes of the sovereign debt crisis and how it now threatens to spread contagion back to the rest of Western world and undermine the current sluggish recovery. 

The summary and suggestions on the eurozone sovereign crisis and the critique of the policymakers responses were analyzed on this blog previously and can be found here and here

What were the outcomes?

Italian bond yields. Source: Bloomberg 
In the last year every peripheral eurozone government was kicked out of office. Portugal and Ireland changed governments earlier in the year, Italy and Greece most recently got technocratic governments, while Spain held elections this Sunday and saw the victory of the conservatives announcing cuts and fiscal responsibility. The political implication of the crisis was huge, and naturally the politicians needed to pay the price. Governments such as Italy’s Silvio Berlusconi who managed to avoid being removed from office for a decade (apart from a brief 2 year period) has finally seen his political career finished. It wasn’t the corruption or reckless behaviour, it was the European bond markets that brought down the peripheral governments. And the very same bond markets are threatening future recovery and the  existence of the eurozone and its currency. 

The bond yield spreads in the eurozone have been relentless in punishing incompetent governments and they were right to do so. The governments failed to adopt necessary reforms and were thus removed from office. They were supposed to restore investor confidence and set a stage for economic growth. In stead they lacked a proper soulution and were avoiding the necessary reforms afraid of losing popular support. On the other hand, The ECB refused to act as lender of last resort as it insists it cannot replace the governments in restoring investor confidence. The markets reacted as they should have - via rising bond yields. 

Higher bond yields (or spreads over the German bonds) simply reflect unsustainable public finances of its issuers. Investors don’t believe that the issuer will be able to service its liabilities in the short run and the costs of borrowing rises. The real danger is when the bond yield spread rises above 500 basis points. This implies higher costs for debt holders in the form of margin requirements (collateral payments made when bond prices fall) and could lead to a further cycle of higher and higher yields. This is what happened to Ireland before its bonds were given a “junk” investment grade.

Italy has already jumped through that spread and Spain is close enough. The danger is higher and higher costs of borrowing and more illiquidity for these countries that will inevitably lead to their insolvency. 



Double dip?

According to the latest data on economic growth and forecasts of future growth the double dip recession has arrived. Even though the data for October and November haven’t been taken into account (months that showed largest instabilities), there were signs of decreasing growth, probably due to expectations of future instabilities. One can rightfully conclude that another recession is here, and this time the cause is political. The inability of the politicians to reach a plausible conclusion on how to resolve the crisis of confidence in Europe is appalling. The rise of bond yields in Italy, Spain and France, and the lack of liquidity for German bonds is a natural reaction of the markets to political incompetence. Rather than focusing on policies to restore growth and stick to a credible debt and deficit reduction strategy, the politicians continuously choose temporary short-term fixes. The markets can only bear these to a certain extent. The best proof is the signals after the Berlusconi exit in Italy – even though most of the politicians expected a stabilization on the debt market, it surprised everyone by having Italian bond yields jump above the “unsustainable” 7% boundary. It shouldn’t have come as a surprise, though. There is nothing the investors can think of that will make them feel safe. Higher bond yields for Italian debt is an effect of no recovery. Things are still too uncertain, despite the technocratic government. When they devise a credible plan on how to reduce Italy’s huge debt burden and how to restore economic growth, which might take years, then Italy can finally see a decrease of its yields and easier financing. Italy is on a brink of another recession the former government drove them into, and investors are hence losing confidence. The more time it takes PM Monti to design a credible growth strategy and to resolve Italy’s high corruption and public sector problems, the harder will it be for them to borrow on the international markets. 

Concluding words on the eurozone debt crisis

The eurozone debt crisis was triggered by misusing the welfare state to fund electoral victories by advocating populist policies under the idea of social justice. Populism, described by white elephant projects and pork-barrel spending, can never create sustainable wealth. It can only lead to an inevitable disaster and higher social injustice which can trigger social turmoil.

The political economy implication in the eurozone debt crisis is huge. The causes lie within several factors; large CA deficits due to the introduction of the euro and a misguided idea on how it was supposed to work, internal instabilities that used cheap borrowing to fund populist policies, a US crisis that lead to a sudden credit stop which emphasised the domestic instabilities, and finally a regulatory system that steered banks' investments into sovereign debt which caused the threat of default to be far greater than it usually is.

Two solutions are available; either the ECB enters the market a lender of last resort and monetizes debt, which might lead to hyperinflation – a strategy Germany strongly opposes, and rightly so, or we might see serial defaults of certain eurozone countries. This was obvious three months ago and it is obvious now. However, during all this time no credible solution was proposed and the position of all these countries and the eurozone itself became unbearable. Unlike the recession in 2008 triggered by Lehman, this one will be triggered by the severe loss of confidence in the bond markets caused by political incompetence.

The analysis is presented in full on a separate page on the blog

Wednesday, 23 November 2011

Eurozone crisis - Intermezzo (2)

Just a quick look at the daily chart from the Economist.




























Source: The Economist, 22nd November 2011

Observe the obvious differences between the North (Gernmany, France, Netherlands, Belgium, Austria, Ireland) and the South (Greece, Italy, Portugal, Spain) in the eurozone. The set of graphs itself don't necessarily prove any causal relationship (that geography or a relaxed southern lifestyle has something to do with it for example), but they can provide an interesting comparison. They can also provide support for the claim on too large differences between these countries to have a single currency, or the net borrowing effect on the international markets that led to high current account deficits of the 'South'.

The graphs can make an inference on one thing emphasised in the last three posts on the eurozone debt crisis - a welfare state used to fund populist policies cannot lead to a sustainable growth path, only a temporary boom; it will result in increasing existing domestic instabilities, loss of confidence in the bond market and a deteriorating economic performance. The 'South' experienced crony capitalism and increased political rent-seeking. Any wealth that was supposedly created proved to be artificial. The unfortunate thing now is that we all need to pay the price.


The final part of the eurozone debt analysis concerning total outcomes and possible remedies will be published tomorrow. 

Friday, 18 November 2011

Eurozone crisis – analysis of causes and consequences (part 3)

After the initial identification of the causes of eurozone contagion in domestic and foreign instabilities, having in mind the current debt situation we now look at how and why the banks got incorporated into the peripheral contagion, which led to further systemic risk, and finally, how did the collapse take place after a sudden credit stop.

How the banks got caught up buying peripheral debt?

As was already noted in this blog, eurozone banks were buying the peripheral debt as part of their zero risk-weighted assets. While the regulatory requirement on holding a corporate loan was 8%, the capital requirement for holding sovereign debt was just 1,6% (sovereign debt, considered to be a zero risk asset was given a 20% risk-weight, resulting in the total 1,6% of capital requirement for sovereign bond holdings). This meant that if a bank was to lend to sovereigns instead of businesses it could make much more money (leverage on sovereign bonds was 62.5 to one compared to leverage on business loans of only 12.5 to one). This created a huge incentive for the banks to increase profitability. It opened a whole new area of investment, similar to what the recourse rule did for the mortgage market in the US. 

Accusing the bankers of being greedy based on their huge holdings of MBSs and/or peripheral sovereign debt can only be done by someone who doesn’t understand the elementary principle of business economics (or microeconomics) – businesses use scarce resources to maximize their wealth, i.e. their profitability. Companies are motivated by profits, it is what drives them forward, it is what drives economic growth and it is what drives capitalism to succeed as a system.

Banks, just like any other private business, will always look for ways to increase its revenues and minimize its costs and risks. By investing into sovereign debt they were doing just that, reducing their exposure to risks, minimizing costs of lending and maximizing their profits. They were following the Basel accords whose initial idea was to make banks safer and more prudent, but through guiding their investments and creating new demand for assets they yielded the exact opposite result of what they were aiming at. The regulatory paradox is once again evident. By recognizing Greek debt (for example) as a safe asset, they artificially increased demand for this asset. An artificial increase of demand resulted in too high exposure of EU banks to Greek debt, which is the reason behind a particularly delicate situation regarding the Greek default, as most private Greek debt holders are EU banks. It is their bancrupcy and/or nationalization, not the default itself that may prove to be the trigger for another depression

What was the end outcome of an artificially created demand for peripheral debt? It made it easy for the governments of these countries to borrow to fund their populist, electoral winning policies. It worsened domestic fiscal balances of these countries and worked towards increasing their debt levels. Higher debts in Italy and Greece were evident even before the crisis. The Basel accords only further endangered the fiscal positions of these countries and haven’t worked at all towards decreasing the systemic risks for their banks. 


The collapse 

Source: IMF, World Economic Outlook, September 2011. The data for 2012 are estimates. 
The sudden credit stop was a result of a recession spreading from the US. As was described previously, a banking crisis in the centres of world finance (New York, London) yields a credit squeeze on the international market, and a severe decrease of investor confidence. As a result emerging market economies and economies dependent on foreign lending to finance its consumption find it much harder to borrow on the international market and see their bond yields rise and their debt harder and harder to service. 

This was an inevitable scenario for the eurozone peripheral countries. A stop of borrowing from the core eurozone countries such as Germany, triggered by the US financial crisis, exposed the depended peripheral countries to the threat of default. Fiscal deficits and rising public debts acted as a signal to investors to exit from eurozone peripheral debt and the yields started rising. Even though the current account deficit proved to be the leading reason behind the countries respective bubbles, investors usually make the decision to buy government bonds based on whether the government will be capable to service its debt obligations and pay out interest, i.e. to stay solvent in the future. As soon as they see a rising fiscal deficit and more and more debt pilling up the probability of staying solvent decreases and the country's debt becomes a more risky investment.

However, the cases of Ireland and Spain were somewhat different. As stated previously they were running a real estate boom, much like the one in the US, and suffered an immediate impact of deteriorating housing prices and loss of construction jobs. The construction and housing industries carried a lot of employment so when the building boom stopped and turned into a bust, employment soared down in both countries (see the second figure and observe the rapid increase of unemployment for both these countries in particular). 

In his text in the New York Times in January 2010, Paul Krugman recognizes the start of troubles for Spain and Ireland through a large fiscal deficit that arose due to a severe decrease of revenues since tax receipts were mostly depended on real estate transactions. As was shown previously, the government debt levels of Spain and Ireland rose particularly high after the bubble burst on their housing markets. Furthermore, as unemployment rose, so did the costs of unemployment benefits, which led both Ireland and Spain from a budget surplus into a huge budget deficit. 

In addition, Krugman adds, guarantee on bank debts by the Irish government increased the Irish debt substantially and brought its own solvency into question. All this worked further in decreasing investor confidence regarding the eurozone situation and the result was even more short-selling of peripheral government debt and higher yields and spreads over the German Bund.

Loss of confidence further crippled any Keynesian solution of spurring big money into the economy. No matter how much liquidity was being pumped in the system, no one would use it to increase lending and businesses lost support. As opposed to American companies eurozone companies are much more dependent on bank loans to fund their business (80% of EU companies compared to only 30% of US, accordingto the FT). It is obvious how a lending freeze and reluctance of banks to lend further due to their increased contagion from enforced exposure to peripheral debt resulted in severe consequences for the real eurozone economy. 


Next post will conclude the analysis by observing the outcomes and indications of solutions. 

Tuesday, 15 November 2011

Eurozone crisis - Intermezzo

Here's something to keep it interesting while waiting for the next few posts on consequences and the remedies of the eurozone crisis. 

I 'borrow' this figure from the Economist, depicting debt burdens of eurozone economies:

Source: The Economist

The graph serves as a good reminder on importance of debt levels and the sustainability of these debt levels on investor confidence and country bond yields. Greece, Italy, Portugal and Ireland (4 out of 5 countries analyzed previously) are countries with the highest debt burdens in the eurozone and are the countries most exposed to the threat of default. 

In addition to this I would like to stress out the mechanism of outside contagion described excelently by Reinhart and Rogoff (2009) (I summarize their main findings on the spread of contagion throughout the world financial system):
  • "Banking crises in advanced economies decrease growth of these economies. This slowing of growth and economic activity will hit exports thus eliminating availability of hard currency to emerging market countries, making it more difficult for them to service their debts.
  • Weakening global growth will decrease commodity prices which will reduce export earnings to primary commodity producers – the emerging market countries, making it even more difficult for them to service their debt
  • Banking crises in global financial centers will yield a credit squeeze on the international lending market. Since it will become harder for the emerging market economies to obtain credit, their economic activity will contract and the burden of the debt will be harder to service
  • Banking crises will decrease investor confidence and make them withdraw from risk taking and move their money into safe assets (such as low-yield government securities). Again, emerging markets will find it much harder to borrow on the international market as the yields on their bonds will rise and they will become less attractive to investors." 
Reinhart, Rogoff (2009): "This Time is Different: Eight Centuries of Financial Folly" Princeton University Press

There are striking similarities with the case of the eurozone economies described previously. The only difference is that they didn't depend on commodity prices to drive their exports, but the credit squeeze and the dependence on credit from net lenders forced them into a situation where they were unable to service their debts anymore, and their economies contracted. Now, due to a severe decrease in confidence they find it hard to borrow on international markets and are entering into an even higher dependency on foreign aid from either Germany, the ECB or eventually the IMF (in the emerging markets case, it's usually only the IMF who comes to the rescue). 

Saturday, 12 November 2011

Eurozone crisis – analysis of causes and consequences (part 2)

The second part observes problems inflicted to the eurozone economies from abroad. It then looks at how foreign capital inflows (due to large CA deficits shown in part 1) were used in domestic economies. 

(Regarding the current affairs, the economist offers its own short history of the eurozone crisis, worth reading. In addition, its Free Exchange blog offers two good texts on the current eurozone affairs, one on Spain, the other on ItalyTyler Cowen offers an interesting summary on what we learned from the euro crisis on his blog Marginal Revolution.)


Instabilities from abroad

Problems with a CA deficit and the common currency

When one country runs a current account deficit, this implies that it runs a surplus in its capital account. A capital account surplus means an inflow of foreign capital (investments) into a country, which is essentially a good thing since money will always flow to where it expects the highest and safest returns. However, the question is where is the money from abroad being transferred to domestically? If it is used to finance investment (into manufacturing or any other wealth creating activity) instead of consumption, then the deficit can carry on rising as the country is using the inflow of capital to boost its production facilities and increase growth. If it is used to finance consumption and government expenditures focused on politically popular policies, then the outcome might be an asset price boom or an unsustainable fiscal position of the government who is becoming dependent on foreign capital to finance its over-exaggerated expenditures. Ireland, Spain and to some extent the US suffered from the first, while Greece, Portugal and Italy suffered from the former. 

Foreigners with high savings rates (China, Japan, Germany) choose where to invest their savings, and they usually choose the US, considered to be a safe haven for investments due to many factors. In Europe, savings from the core eurozone countries was channelled to the peripheral countries after introducing the euro, which explains the high CA deficits experienced by all the peripheral countries, pointed out in the previous post.

Before the euro unification Greece had a history of debt defaults, financial contagion, inflation crises and banking crises (see Reinhart and Roggof). This was usually reflected in its higher bond yields, a sort of a risk premium for investing in its debt. The spread between Greek and German bonds was always high. However, once the euro was introduced, its yields and the spread started decreasing making the Greek debt as safe an investment (financially) as the German debt. The reasoning behind it was that the ECB would make sure inflation will never again be the problem of Greece or any other peripheral country. Soon enough, every eurozone peripheral bond on the market traded as the German Bund – the spreads were smaller and the risks were perceived as non-existent (Basel I and II recognized their debt as zero risk-weighted assets).  

This meant one thing; all these countries could borrow at cheap rates, while the politicians had no need to be fiscally responsible and could resort to populist policies that would keep them in power. Borrowing cheaply meant that credit from abroad was used to fuel domestic consumption which led to a rapid increase in GDP above its potential levels (see graph from last post). The bubbles did not affect the same markets – Ireland (like the US) experienced a housing bubble (180% increase since 1998), Greece’s government increased its debt in order to support its public sector and win elections by populist policies, Spain in addition to the housing bubble had a construction bubble and so on. 

The following graphs observe how the inflow of capital was used in the peripheral economies. It compares growth of consumption and investment and government expenditures and investment for all the peripheral economies to see what really drove the GDP far above its potential level, and whether the CA deficit was unsustainable. 





Source: St Louis Fed, FRED economic data. (Note: consumption is everywhere depicted by the blue line, while fixed capital formation is the red line)

From the graphs it can be inferred that in all these countries, except Ireland, consumption was growing much faster than fixed capital formation (investments). In Ireland they grew simultaneously right about two years before the crisis, when the housing prices started to fall and the construction industry started deteriorating - the same effect can be noticed in Spain. 
Greece, Italy and Portugal saw particularly rising gaps between consumption and investment, implying that much more funds were guided into consumption than into investment. 

The next set of graphs shows the relationship between government expenditures and fixed capital formation. 





Source: St Louis Fed, FRED economic data. (Note: government expenditures are everywhere depicted by the blue line, while fixed capital formation is the red line)

Even thought the relationship isn't as straightforward as it is in the previous graphs, it does show a rising trend in each country's government expenditures (represented by the blue line). Even for Greece, government expenditure doubled over the past 10 years, while its investments rose by a third before the crisis, and are now approaching the level they were at 10 years ago. Italy saw its government expenditures rise the same level as investments, while Portugal experienced a significant decrease of the gap between investments and government expenditures after the introduction of the euro. 
Observe also the two spikes of investments in Ireland and Spain which show even better on the new set of graphs, pointing out to an asset price bubble and burst of the bubble. 

Summary of outside contagion 

Interest rates were low across the eurozone, and investors in the core countries seized this opportunity to invest in periphery countries. In Germany lack of domestic demand was suppressed by a rise of foreign investments. It became more attractive for investors to invest in the periphery as the risk of default was diminished by the fact that euro was backed up by all eurozone nations, including the most important ones like Germany and France. Capital outflows came mainly from the core as it was available now for German and French investors to broaden their portfolio onto new, and yet stable markets. The system of borrowing to fuel domestic asset bubbles worked as long as the asset prices kept rising. Borrowers could pay off their loans simply by borrowing more even cheaper. However, the sudden stop in credit flows put an end to this mechanism and made room for the recession.

In essence the idea of euro was to increase and smoothen convergence in the eurozone. Adoption of the euro made it easier for capital to flow into the peripheral countries. Their CA deficits prove this. However, this was an anticipated reaction and a welcomed move from the eurozone policymakers. It indeed helped fuel and sustain economic growth way above its potential level for some of these countries. The problem arose when the inflow of capital suddenly stopped due a spread of financial contagion across the globe spilled-over from the US. Investor confidence rapidly declined worldwide and the peripheral eurozone countries faced the same fate of the Latin American countries in the 90s. They were given the status of emerging market economies since they were no longer able to issue debt in their own currency. Investors didn’t react well to this. The sudden stop in 2009 made it difficult for these countries to roll over their debts which increased the European crisis of confidence and led the peripheral economies into recession. 

The underlying graphs show what was the driver of high growth above its potential level explained in the previous post. Consumption and government expenditures (and an asset price bubble in Ireland and Spain), rather than investments, were fueling growth creating dependency on foreign capital to service current liabilities. Local instabilities combined with an increase of systemic risk and outside shock that led to a stop of credit exaggerated the existing instabilities in the peripheral eurozone countries.


The next post looks at how the collapse came about and how the banks got involved and increased their risk exposure to peripheral debt.