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. 

Thursday, 10 November 2011

Eurozone crisis – analysis of causes and consequences (part 1)

In the next few days I will publish a series of blog posts about the causes and consequences of the eurozone crisis. I will cover the potential reasons why the peripheral eurozone economies suffered a particularly hard hit. The political responses and potential remedies to the eurozone crisis have been published in two previous posts. After publishing all the blog posts, I intend to make a separate page on the eurozone crisis. The topic itself will probably continue for some time as the situation around eurozone currently carries the highest risk for another recession, and so will the page on the crisis be updated. 

Causes of the eurozone contagion

The focus of the first few blog posts will be on the spread of financial contagion onto the peripheral eurozone economies, which include Greece, Portugal, Ireland, Italy and Spain. The reasons why these countries in particular found themselves in such troubles can be separated into three features which they all share. The first are specific local instabilities and the way these peripheral countries ran their economies in the wake of the crisis. Even though each of them was characterized by specific conditions and some are more different than others (for example Ireland and Spain experienced a housing and construction boom, while other countries were exposed to different, more structural imbalances), there are certain similarities that drove to instabilities.

The second common characteristic was the introduction of the euro. With all its benefits, the common currency brought with itself some negative characteristics that became visible once the crisis fully sprung. In particular, due to a common currency it became cheaper for the peripheral economies to borrow on the international market which induced large current account deficits. They became dependent on credit from abroad and once this credit flow stopped the stage was set for the spread of the crisis. They found themselves in a typical sudden credit stop, usually a characteristic of emerging economies, which is partially why the phrase ‘peripheral eurozone economies’ was coined.

And third, what brought to the sudden stop of credit worsening their fiscal balances was the spread of outside contagion, particularly from the US. The financial crisis that started in the US quickly spread worldwide through decreasing trade, loss of investor and consumer confidence and a credit squeeze. All this made it harder for the peripheral economies to borrow on the international markets, and since their economies became dependent on cheap capital abroad to finance its consumption and government expenditures, the credit squeeze proved to be particularly painful. Outside contagion brought the instabilities of the eurozone economies onto the surface. 

Apart from these in common to all of them, Greece and Italy had an additional constraint – corrupt politicians which cared more of self-preservation than the well-being of their country (needless to say all politicians are rent-seekers, but some tend to misuse their power much more than the others). Their politicians used expensive populist policies to remain in power. They used cheep borrowing on the international market to “fund” their electoral victories by broadening its welfare states and offering concessions to particular electoral groups. They “bought” votes by increasing pensions, hiring more public sector workers and increasing their wages in order to create a perception of high employment. Their governments were perfect examples of how the inflow of foreign capital was used inefficiently to finance consumption and maintain power.

Foreign instabilities vs. domestic instabilities

Regarding the first cause there is a prevailing opinion that all these countries acted recklessly and fiscally irresponsible so they must now pay the price of austerity in order to set their economies straight again. The main argument is that these countries ran large fiscal deficits and large government expenditures. They were borrowing cheep and used this money to live above their means. The inflow of foreign capital fueled the economies beyond what they were capable of.

Here is a graph that looks at the output gap as a percentage of potential GDP for the five peripheral nations.

Source: IMF Economic Outlook, September 2011 (note: data for 2012 are predictions)

The graph shows that Greece for example had a GDP growth substantially above its potential level previous to the crisis. This is a good indication that the Greece economy was in fact overheating. Its rapid growth rise was fueled mostly by large capital inflows (which will be show later).
Ireland and Spain experienced a similar output gap well beyond its potential level. Unlike Greece, the driving force of their high growth were the asset price booms in housing and construction.
But the other two countries, Portugal and Italy grew within their potential levels, and weren't overheating as much. Nevertheless, they found themselves in similar structural problems as the three countries above.

The following graphs look at each country's CA deficit compared with the level of gross government debt.

Source: IMF Economic Outlook, September 2011 (note: data for 2012 are predictions)

Even from a brief look at the graphs it is obvious what all the countries have in common: right before the start of the crisis, and mostly from the introduction of the euro, they have all experienced rising current account deficits. Even though Greece didn't have a CA surplus for over 30 years, Portugal, Spain, Ireland and Italy in particular all experienced CA surpluses at some point prior to the euro. Ever since the introduction of the euro, the CA balances started to decrease.

Government debt increase, on the other hand, fails to give such strong implications.  Spain and Italy were actually decreasing their government debts and improving their fiscal positions, while Greece kept it steady. They all only saw an upsurge of debt once the crisis started due to bailouts (Ireland) and a decrease of revenues (in Spain and Ireland the construction industry was a significant contributor to revenues; their losses and bankruptcies reflected severely on the countries' budgets).

Therefore, domestic imbalances weren't as crucial as imagined. Some instabilities certainly did exist, but they couldn't have caused a crisis so severe. It is more likely that outside contagion combined with dependence on foreign capital outflows exaggerated the systemic risk of each country. Domestic imbalances became more visible once the foreign inflow of credit stopped.

Next post will cover current account deficits and instabilities brought about by the euro as the common currency.

Monday, 7 November 2011

NGDP targeting – a licence for inflation

Last week saw a new idea sprung into economic discussion focused on restoring economic growth – it was proposed that the US Fed should adopt a target growth rate of nominal GDP to 4,5%, or in short NGDP targeting. Nominal GDP is GDP measured with current prices (in a given year). Since it is hard to compare market values of GDP in current prices from one year to another as the value of money changes, economists adjust this nominal value of GDP by including inflation. Therefore, real GDP is nominal adjusted for inflation (or simply GDP measured with constant prices in a given year). 

On the given graph I compare US nominal and real GDP from 1948 to 2011, using quarterly data, base year 2005. The difference between the two should be obvious from the graph – dollar value of goods and services in the 60s or the 70s isn’t the same as the dollar value today (i.e. in 2005). It is much less and hence nominal GDP has lower values than real GDP. Also, every nominal GDP after 2005 shows a higher value than real GDP because prices rose making the total value of goods and services bigger in terms of current prices.

The following graph looks at the difference between the two in terms of inflation.

 Source: Data360, http://www.data360.org/index.aspx

Notice how nominal GDP growth is usually higher than real GDP growth – this is because inflation is usually positive. During the current recession, for example, there was a rising threat of deflation and inflation rates were close to zero (having the nominal and real GDP growth almost equated). Therefore, nominal GDP growth is real GDP growth plus inflation.

This is important to know when evaluating the NGDP targeting policy proposal. The idea itself came from Goldman Sachs earlier last month (and even before that from Scott Sumner, who calls himself the biggest advocate for it on his blog), and again last week from Christina Romer to Fed Chairmen Ben Bernanke. The idea calls for a rule that should allow the Fed to target the 4,5% nominal GDP growth rate - so if the normal real growth rate of the economy is around 2,5%, the Fed inflation target is 2%. The problem is, currently the US isn’t growing at 2,5%, and it isn’t likely to reach this via NGDP targeting either. Essentially it is a licence to the Fed not to worry about inflation, thereby completely ignoring its main task of achieving price stability. 

The idea can literary translate to the following: If the Fed prints more money, this drives up prices (the classical causal relation in monetary economics where more money in the economy makes it lose its value and triggers an increase in prices as people now need more currency to buy the same goods as before). Higher prices of goods and services will increase the GDP measured in current prices (nominal GDP). This is an easy way to reach the target without increasing real growth at all. For the current 1% rate of real growth the Fed may pump up inflation to 3,5% in order to reach its target. But this doesn't mean the economy grew at 4,5% - it's real growth is still weak. 

If this is indeed made the rule, the Congress will expect the Fed to follow it closely. However, due to an inability to start up economic growth with current methods, the Fed will have no option but to raise current prices in order for the nominal GDP to reach its target level. Not to mention that by doing so the Fed will have an excuse to use more quantitative easing which will further devalue the dollar. This is one of the arguments in favour of NGDP targeting as the Fed will now claim it is using quantitative easing to reach its target NGDP growth rate, and it is assumed expectations will translate from high inflation expectations to higher growth expectations (nominal at least). Most people stand firmly against QE as they see it as an unnecessary inflation boost or a way to ‘monetize the national debt’, however, now this will be ‘adjusted’ as expectations will be focused on NGDP growth instead of inflation. Since now the reasoning is that this might be the policy needed to bring back confidence in the economy. Also, proponents of NGDP targeting point out how such a policy is very effective during a liquidity trap, which the economy is in currently.

Some proponents of NGDP targeting say that it could be a better policy than inflation targeting as this way we will “kill two birds with one stone”. If real growth is say 2,5%, the Fed would only have to keep inflation at 2% (which is coincidentally a long term inflation target). If there is an increase in food or energy prices (such as the one we’re experiencing now) that will drive up inflation and under an inflation target other prices will have to fall. Under sticky wages this would decrease employment and decrease demand. However, under a NGDP target, the Fed could allow for a temporary inflation increase above 2%, and thus eliminate the necessary negative consequences on demand and output. But inflation is already well above 2%, reaching 3,8% in September, and since growth is expected to be 1,6 % this year, isn't the target already reached? Even overshoot perhaps. 

Inflation targeting has its flaws but at least it sends a credible signal of future inflationary expectations to consumers and businesses. It makes a central bank credible in the eyes of the nation which is an important condition to achieve price stability.

The Volcker moment? Not quite

Romer’s comparison of NGDP targeting to the Volcker moment is somewhat paradoxical since it is well known that by slashing interest rates Paul Volcker reduced inflationary expectations severely and set stage for the Fed to be considered a highly credible institution in keeping inflation low. Some claim the Great Moderation to be a partial consequence of the Volcker move to cut interest rates and control inflation, even for the temporary price of the loss of employment. In the long run employment, of course, recovered.

Sending a signal to expect higher inflation due to the nominal GDP targeting is exactly the opposite of the Volcker moment.

The main issue behind Volcker’s inflation targeting was credibility of the Fed that it will reach its target. If this would be the case with NGDP targeting Mr Bernanke will have to strive to keep the target by increasing inflation due to low growth rates in the economy currently. Expectations of higher growth could arise but so will expectations of higher inflation. This might annihilate everything done by Mr Volcker to establish the Fed as a credible inflation-hawk institution and return the US in the volatile 70s inflation (see the second graph – notice high levels of inflation in the 70s, up until the Volcker moment in 1981 when inflation targets took place. It had a significant effect on the decreasing demand and GDP growth but its end result was easing inflation volatility and credible expectations of future inflation).

Ultimately, the Fed should only be left to worry on the stock of money in the economy and setting interest rates through which it is able to curtail inflation and impose price and long-term interest rate stability. Any goal exceeding this main goal will provide a trade off to the Fed where more money in the economy and higher inflation would trigger nominal GDP growth, without a necessary increase in real GDP growth. Furthermore, I can’t see the causal relationship of why a NGDP target will increase real GDP growth. Expectations are not going to be enough to start it up. Restoring confidence will.

Update (21/04/2012): I stumbled upon this interesting webpage called NGDP.info summarizing all you need to know about this increasingly popular monetary policy. I still think it won't do any good in the current recovery and that it's final effect will only be higher inflation and a reversal of everything Volcker did in the 80s. 

Thursday, 3 November 2011

Political economy of eurozone crisis

This is just a short look at how the bond markets reacted on political negotiations and meetings over the eurozone crisis (inspired by the latest reaction on the markets after the call for referendum by the Greek PM, Mr Papandreou):

The Economist brings this interesting graph:

For the full text in the Economist click here.

Observe how the Greek yields in particular reacted to positive or negative reinforcements coming from the politicians. It's not proof but it's a good indication of how markets react to political decisions. For Italy, however, the yield was mostly depended on the ECB buying its bonds earlier this year, but now, after the latest referendum call, even the ECB's actions remained without effect.

Wednesday, 2 November 2011

Currency devaluation – why is it useless in some cases?

Due to the Tuesday call for referendum by the Greek Prime Minister, George Papandreou, it is becoming more and more likely that Greece will chose its own path out of further bailouts and enforced austerity and into default and exit from the euro. I have covered a more negative scenario (full euro break up), and today I will touch upon the effects of currency devaluation. 

The devaluation of a currency will yield two immediate effects: an increase of exports (since domestic goods are now cheaper for foreigners so they will want to buy more of them) and a decrease of the value of domestic wages in terms of the foreign currency, making domestic workers more competitive on the international markets.

However, there are many other indirect effects that are likely to completely crowd out any positive effects of currency devaluation. Since Greece is the first most likely to exit the euro and devalue its currency, I will look at the effects from a Greek perspective. The Greek people and businesses were, just like the Greek government, running high debts and used them to fuel their consumption previous to the crisis. An increase of the exchange rate would imply higher interest payments in drachmas for all those with outstanding loans with the banks, leaving the households and businesses with less disposable income. As a response to this effect the labour unions may negotiate higher domestic wages in terms of foreign currency (the euro) which will crowd out the devaluation effect and yield an inflationary effect of roughly the same size as the devaluation, thereby undermining the increase in competitiveness. Besides, Greece needs to completely change and restructure its labour market and labour market conditions if it wants to make its workers more competitive on the international market. No currency devaluation will resolve the deep structural problems of the labour market, no matter how competitive they may seem to appear due to cheaper currency.

Concerning the export increase (due to lower export prices), if the labour unions do increase the wages and spur an inflationary effect over the economy, this will increase the prices of domestic goods further offsetting positive devaluation effects. Besides, currency depreciation can work only in countries which have high production levels and a huge industry such as Japan or China. Greece isn’t like that as it runs mostly a service based economy. 

In short, devaluation of a currency doesn’t have to be the right answer and can very likely yield no particular positive effects, only inflation in the long run. One should think about the specific country conditions when deciding to impose currency devaluation and how it might react. The textbook cause and effect relations don’t work for all countries the same way, and policymakers and economist who propose such ideas should keep that in mind.