Friday, 31 August 2012

On central planning

Note: This article was also published on the Adam Smith Institute blog, on 3rd September 2012. For all my other ASI writings see here.

My two favourite political economists, Daron Acemoglu and James Robinson, have started (and ended with) a series of blogs on the topic of central planning. Their angle is that central planning in practice doesn’t originate from Marxist ideology, but from the inherent desire of an extractive state to exert full control over its people.

They were motivated to engage into the subject in order to disprove the idea that ideology is what causes economic inefficiency (they spend a lot of time in their book tackling this subject – the book is reviewed here). 

This is similar to another argument they aim to disprove, which claims that poor countries are poor because their leaders are ignorant and chose inefficient systems since they either don’t know better, or are blinded by ideology. And while a lack of knowledge and/or ideology is an attractive way of explaining some of the persistently bad equilibria in certain dictatorships, it is more realistic to believe that dictators choose bad policies because they want to preserve the rent-extracting system under their command. They are smart enough to know that preserving the status quo, no matter how poor the country is, allows them to keep hold of their power (just think of North Korea).*

That’s where central planning kicks in:
“Essentially central planning is not about the efficient allocation of economic resources, it is about control. 
Central planning maximizes the extent of control that the state, and the people running the state, exercise. The desire to control others is a constant in history and is part and parcel of the construction of states. If the state can grab all the land and resources and control who and on what terms people get access to them, then this maximizes control, even if it sacrifices economic efficiency. 
This sort of economic and political control — not Marxist ideology — is what central planning is all about. This is not to deny that Marxist ideology supported and legitimized central planning in several 20th-century societies. But it is to emphasize that the emergence and persistence of central planning is often a solution to the central economic and political problem of many elites: to control and extract resources from society.”
This is the concluding point they make after examining historical cases of central planning which have originated as far as ancient Greece or even among the Incas. The Soviet example, certainly the most popular one, used ideological motives to overshadow the true reason behind having a command economy.

Have in mind that central planning of the Soviet economy didn’t take place until after Stalin took over (the authors remind us of that) whose ideological views were fully subordinated to his lust for power and self-preservation.

The conventional explanation of using ideology to preserve one’s power (or the whole system) is wrong if one thinks of what methods most dictators use to silence their political opponents thereby eliminating any possible threat to power. When things escalate out of control even more brutal methods are used (as in the case of Syria). In that perspective Stalin’s central planning does come as a good example of a dictator’s choice to what is more important – having an efficient and productive economy (to a certain extent), or having the power to control and extract everything the economy creates, even if it’s well below full efficiency. This dilemma certainly isn’t limited to Stalin alone. 

Achieving absolute control and preservation of power is a strong incentive to maintain an inefficient system, especially if such conditions are supported by ideology and submissive, subliminal brainwashing of the population. 

Realizing this argument, a logical inference emerges in which the only way to achieving a prosperous society can come from attaining individual freedom.

*Update (04/09/12): Some have pointed out correctly that events such as the Arab Spring showed how a full control isn’t permanent. I most certainly agree. However, in that particular example it is left to see how the revolutions will unfold. Will it be a continuation of a vicious cycle where new dictators come in place of the former ones (Egypt seems to be heading down that unfortunate road), or will it be an opportunity to carry on a virtuous cycle and 'break the mould' of underdevelopment? 

Have in mind also that Libya, for example, experienced the first scenario re-occurring upon the arrival of Gadafi – one dictator overpowered another under the ideological call for equality and socialism. Almost the exact same thing happened in Ethiopia (Mengistu), Iraq (Saddam), or even Egypt back in the 80-ies when Mubarak took power, and many, many more.

Monday, 27 August 2012

Is there such a thing as an Austro-Keynesian?

Arnold Kling has ended his blogging days recently, and from now on he will just be writing in essay format. Too bad, cause I really enjoyed his wit and brilliance at EconLog. We will still have a chance to read his intuitive pieces, best of which in my opinion are his articles on the "Patterns of Sustainable Trade and Specialization", and his inspiring book on Economics 2.0, entitled "From Poverty to Prosperity" (co authored with Nick Schulz). All of his research can be found here.

In light of this news, I bring forward a following quote from Prof. Kling, from a couple of weeks ago, referring to his long sought idea of calling himself an Austro-Keynesian:
"About four years ago, I described myself as an Austro-Keynesian. Recently, I have been asked about that concept.

One way to put it is that I accept and reject some major tenets of each camp.

From the Keynes camp, I accept the view that financial market psychology is variable (animal spirits and all that) and that market economies are unstable. I am comfortable with a Minsky-Kindleberger view. Thus, I reject what I see as the common Austrian view that the only source of instability in the economy is central bank money-printing.

From the Austrian camp, I accept the view that there is not much that government can do about downturns. I view a downturn as a sudden, widespread realization that certain patterns of specialization and trade are unsustainable. We just have to wait for entrepreneurs to sort things out. Thus, I reject the Keynesian view that deficit spending by the government provides a cure for unemployment. Another way of describing what I have in common with Austrians is that I do not subscribe to the aggregate demand/aggregate supply paradigm.

Because I do not subscribe to AS-AD, I am skeptical of the monetarist (or basic macro textbook) view that a downturn is almost entirely due to a misalignment between the supply of money and nominal wages. Similarly, I am skeptical of the "New Keynesian" view that a downturn is almost entirely due to a misalignment between the money supply and aggregate prices."
I have to say I completely agree, although I wouldn't necessarily call that Austro-Keynesian. Perhaps New Austrian? Since it's popular nowadays to call everything "New", even when it significantly differs with the old philosophy (not to say that New Austiran would differ that much, but it does to some extent). 

Starting from the top, I too believe markets are unstable and are not always efficient, in which psychology plays an important role. But as Kling and Schulz would say: "Markets often fail, that's why we need markets!" I too am growing less fond of the idea that interest rate manipulation of the central bank is the primary cause of business cycle booms and busts. The central bank can certainly distort market signals and to a large extent, but other things have to collide with it to initiate a business cycle bust. I give the role of politics a much stronger emphasis on that point. I guess on that perspective I would put myself somewhere between public choice theory and new institutional economics. New institutional economics can explain the persistence of bad equilibria within an economy, while public choice theory can, in my opinion, offer a good explanation of how good equilibiria can be distorted (this is something I'm currently working on, and was the topic of my Master's thesis, available here as a working paper). 

On central banks, I feel they have moved a long way from the times of von Mises, and have became much more stable. Or to put it in better words, the system became much more dependent on them to create and sustain financial and macroeconomic stability within an economy. In that sense I can see central banks, particularly in some countries, doing more good than bad for the economy. In some developing nations, central bank independence is often the only thing holding the system together (i.e. removing the influence of corrupt, rent-extracting politicians). In The Constitution of Liberty, F.A. Hayek clarifies the point on how we're stuck with central banks, so we might as well keep them as an element of stability: 
"Perhaps, if governments had never interfered, a kind of monetary arrangement might have evolved which would not have required deliberate control; in particular, if men had not come extensively to use credit instruments as money or close substitutes for money, we might have been able to rely on a self-regulating mechanism. This choice, however, is now closed to us. We know of no substantially different alternatives to the credit institutions on which the organization of modern business has come largely to rely; and historical developments have created conditions in which the existence of these institutions makes necessary some degree of deliberate control of the interacting money and credit systems. Moreover, other circumstances which we certainly could not hope to change by merely altering our monetary arrangements make it, for the time being, inevitable that this control should be largely exercised by governments."
Back to marco, I support the Austrian view and reject the Keynesian view of how to respond to recessions, in addition to rejecting the AS-AD paradigm. Here is where I find Kling's PSST theory extremely useful in its groundbreaking assumptions on how occupational heterogeneity eliminates the necessity of an aggregate supply of labour, or how constant reconfiguration of trade and production make the concept of potential output meaningless (basically, the process of constant reconfiguration of new patterns of specialization and trade make all aggregate values useless in the real world - which is a pretty strong and realistic assumption). I also like the idea that production techniques are not known, but that they should be rediscovered by entrepreneurs in a trial and error process. Modeling all these assumptions is extremely hard, which is why Kling states that "the economy is too complex to be solved by equations". Now there's a truly Austrian perspective, isn't it?

I would like to see more research and more effort done in the direction of this theory. Perhaps it's not the best one out there, but it could be well on its way. Calling it New Austrian or Austro-Keyensian - does it really matter? 

Friday, 24 August 2012

Graph of the week: who really gained from the euro?

Back to the Eurozone briefly with the following graph found on FT's Alphaville last week, taken from a recent study done by the UBS. They try to find out who has benefited the most over the past decade from the euro, and a unlikely conclusion emerges – the peripheral economies experienced (in most cases) rapid increases in personal incomes, while the so-called core countries mostly lost out. (Click on graph to enlarge)

Source: FT Alphavile (taken from a report by the UBS)

Each country’s individual graph depicts income distribution within a country based on 10 grades of disposable income, aligned from left (the bottom decile) to right (the highest income decile). 

Several interesting conclusions arise. First the authors point out that in the "core" countries the poor got poorer while the rich got richer. This is evident in the cases Germany, Austria, Holland, and significantly in Belgium (a close to 50% drop in income in a decade!). In France it was the middle class who lost out the most. 

On the other hand, in "peripheral" economies like Greece, Portugal and Spain, it’s the poorest decile which benefited the most, even though noticeable growth in incomes was experienced across all income groups. 

Italy and Ireland, were the only two "peripheral" economies which have lost out, having disposable income decrease across income groups (apart for Italy's bottom 10% which have experienced a slight increase in income over the decade). 

However, the rise in "peripheral" economies' incomes has to be observed in relative terms, i.e. compared to much higher levels of income in "core" countries. In that perspective it is natural to notice a “catching up” of the periphery. After all, that was the point of the Eurozone convergence. 

On that point the authors of the study have an interesting conclusion on the burdens which are left once again on the "core" to bear:
"While the authors point to the move toward greater income equality between nations during this period as a positive trend, they also cautiously argue that their findings suggest that the core countries should not be expected to continue financing the rise in peripheral living standards:
Looking at the growth of real incomes over the first few years of the Euro’s existence, it is hard to argue against the idea that the peripheral countries should be taking more pain now. Core countries have had to accept a decline in real living standards, and it seems unrealistic to expect them to finance an increase in living standards for others."

Tuesday, 21 August 2012

On budget plans

I already covered the Ryan budget proposal back in March, calling it hypocritical and in certain parts unrealistic. I praised some aspects of his taxation reform proposals, but I didn’t approve of his expenditure side reforms, particularly concerning defence spending, and have fully aligned with what Ron Paul had to say on the Ryan budget, calling it disappointing in which it continues to assume that “the federal government should [more or less] continue to do everything it is currently doing”, and that Congress should learn to “stop trying to run the world, run the economy and run our lives”. Five months later the Ryan budget is again the focal point of attention due to Paul Ryan's nomination for Vice President by Mitt Romney, the Republican challenger to President Obama in the 2012 US Presidential elections. This resulted in many economists and political commentators having once again repeated their main points from five months ago on what this budget can and cannot do. And so will I. 

The most recent well devised summary of the Ryan proposal compared to other available budget plans is offered by the Bipartisan Policy Center (BPC). They came up with the following graph comparing the debt and deficit reduction plan of 5 different budgetary scenarios. However, the expected results at the end of the decade are based purely on the given calculations. Meaning that it doesn't take into account whether or not the proposals are realistic in their assumptions, nor can the graph show if any cuts or revenues raised are actually attainable. In that sense I favour the Bowles-Simpson proposal (it’s not perfect but it goes a long way in realistically resolving some of the country's crucial issues – I covered their proposal briefly earlier in February).

In a nutshell, what Ryan is trying to do is the following; 

Ryan's proposal, noted simply as "Proposal", compared to CBO's extended-baseline scenario and the alternative fiscal scenario, would increase debt after the first decade reducing the deficit down to 2%, but real benefits wouldn't be visible for another 30 or 40 years, no matter how unrealistic this sounds (there is a number of unforeseen issues and circumstances that may arise until then. Even 10-year forecasts sometimes sound too implausible to be taken seriously).  
His budget includes a couple of laudable proposals such as the government-funded voucher system that incentivises buying private health insurance for over 65-year olds (even though this still doesn’t solve the problem, it’s a step in the right direction), or his tax system overhaul. In the previous blog I praised the idea to reduce marginal tax rates for US companies, which are currently the highest in the world. In the same time an emphasis must be to exclude all the existing exemptions, giveaways, and rebates which only create jobs for accountants and lawyers. These ultimately only benefit the big corporations who are able to find an exemption, while small businesses almost never do and will end up paying the full burden. Not to mention the amount of revenues which is lost this way. Indeed, Mr Ryan proposed to scrap six different rates of income tax and replace them with only two bands. This is one of the centrepieces of his proposal – by doing away with exemptions and closing loopholes he plans to pay for the tax cuts he wishes to move forward on US companies and high income earners.

Here’s the tricky part. His critics claim that he never states which specific exemptions he would get rid of, nor how he plans to offset the reduced revenue from tax cuts by broadening the tax base. A lot of politicians use the term “broadening of the base” as a favourable economic policy but none of them really know what this means and even less how to do it in the right way. The best way would be via a flat tax rate, which would close any possibility of a loophole and make the tax easily collectible and easily enforceable. The broadening of the base comes along gradually as less and less businesses find it profitable to deviate on paying taxes. Along with this effect, a flat tax creates a simple and competitive tax system which attracts foreign investments and initiates the creation of more businesses in the economy. Another important step in that direction is increasing political stability, economic freedom, and doing away with any constraining regulation (the US is strong in the first condition, weakening in the second, and severely disrupted in the third). Then the base can be called broadened and the stream of revenues is increased. However I doubt this is what the Ryan budget proposal would achieve even if his idea is, broadly speaking, similar.

The Economist makes a good point on that perspective: 
"Until he is more specific, the fear must remain that the Republicans will deliver the spoonful of sugar but not the medicine, as they did under George W. Bush. If that happened, the deficit would balloon, just as it did under Mr Bush. And, with the top rate of income tax falling from 35% to 25%, the rich would benefit while spending cuts hit the poor disproportionately." 
This is what gives the Democrats the biggest edge in that debate; the Ryan plan is unrealistic, and would only benefit the rich. They do have a point there. 
"Mr Ryan was also wrong to vote against the proposals of the Bowles-Simpson deficit commission, which he did on the grounds that it wanted to close the deficit partly through an increase in tax revenues. He believes that the gap should be closed wholly through spending cuts. Because Mr Ryan, in true Republican fashion, wants to increase spending on defence, everything else—poverty relief, transport infrastructure, environmental protection and education, for instance—will have to be squeezed intolerably." 
Cutting all discretionary spending (food stamps, environmental protection, infrastructure and education) apart from defence will give President Obama a lot of easy targets. Especially on one particular point in which after the first decade the Ryan budget would continue into cutting discretionary spending relative to GDP down to 3.5%, which does sound implausible since only defence spending (something in which no Republican dares to touch), is currently at 4% of GDP. 

Serious institutional and structural reforms require hard, well-defined solutions and a broad-based, nation-wide support. Because of political stubbornness, the US lost that chance last August after the debt ceiling debate. Now everyone is just waiting for the November elections, but the country cannot afford to be in a standstill that long. Ideology is playing too high a role in US economic policy which is producing a grim outlook for the country. US is the perfect example of how good politics doesn’t necessarily translate into good policies.

Sunday, 19 August 2012

Social transfers and the welfare state

The points made in the previous post on net contributions paid and entitlements received got me thinking on the whole debate regarding transfers and their outburst during the recent crisis. As the quote from Makiw has shown, accounting for net transfers while calculating the progressiveness of the tax system paints a more precise picture of the US redistribution of income (amid all the controversies over how those numbers were calculated). Even though the number for transfers to the bottom quintile group is biased upwards, it is still nonetheless true that on average lowest quintile groups receive more from the government than what they contribute to. And this is fair in some instances where people are disabled or for other reasons unable to work (retired or children). But the escalation of transfer payments towards a rising 'army' of unemployed can have negative long-term consequences as well. 

The following graph shows an expected inverted relationship between rising unemployment (i.e. at declining employment population ratio - red line) and increasing transfers (blue line). An obvious interpretation would be that as more people lose their jobs, the state has to divert more resources to unemployment benefits and other welfare programs which is increasing the pressure on the budget (engage into counter-cyclical policies). 

Source: St. Louis Fed, FRED Database

Short-term spikes in transfers (such as the 2008 tax rebate) didn't do much to stop rising unemployment (or in the case of the E-P ratio, to stop the increase of discouraged workers), a point that was proven earlier on this blog by comparing spikes in temporary income and its effects on consumption. 

Looking at the graph, one can't help at wonder does the argument go the other way since the E-P ratio puts a stronger emphasis on people leaving the workforce. In particular, did the people quite the workforce to live off entitlements? In this case, certainly not. In a crisis people don't typically chose to quit their jobs to end up on social benefits. But the problem starts to arise if this increase in social transfers becomes permanent. From the looks of the graph, this is becoming more and more likely as both variables, transfers and discouraged workers, seem to be stabilizing. 

The graph further shows that (1) the employment-population ratio is a much better labour market indicator than the unemployment rate (a point made on this blog many times before) since it perfectly depicts the strength of the labour force, and (2) the gap between those who work and those who receive transfers (not in scale) is far too unsustainable at the moment. This draws implications on another important debate - the fiscal deficit and public debt unsustainability. With a severely distorted labour market, lack of incentives, and  ageing baby-boomers, the deficit will become unsustainable even in the short run.

Does this mean that the US is turning into a European-style welfare state? It is true that a lot of blame for an escalating budget deficit is due to the crisis, but large entitlement programs and war spending started way before the crisis and the current administration. The accumulation of Medicare, Medicaid and Social Security programs inspired Alex Tabarrok from George Mason University to call the US a Warfare-Welfare state (he adds to the three biggest spending programs expenditures on defence, the second largest budget outflow), in opposed to what it used to be - an innovation state.

Source: Alex Tabarrok, "The Innovation Nation vs. the
Warfare-Welfare State", The Atlantic , January 26th 2012
The following graph shows what he aims at. He compares the warfare-welfare expenditures to those on innovation (science and medical research for example). Even though some funds in defence spending are allocated towards R&D, this is highly unlikely to have spillovers beneficial to the rest of the economy. The urban myth that the internet was created by a state funded defence agency is proved to be untrue. On the other hand, innovation and research in fields like health care can go a long way into solving the US health care issues. Tabarrok makes a clear case: 
"From an innovation perspective, two facts about health care are of importance. First, a huge amount of health care spending is wasted. A strong consensus exists on this point from health care researchers along the political spectrum. Hundreds of billions of dollars are spent on health care today with little or nothing to show for it in terms of improved health. Second, although spending more on health care today doesn't get you much, spending more on health care research gets you a lot. The increases in life expectancy from fewer deaths brought on by cardiovascular disease over the 1970-1990 period, for example, were worth over $30 trillion... In other words, the gains from better health over the period 1970-1990 were comparable to all the gains in material wealth over the same period."
The essential point from creating a welfare-warfare state is constant fighting over how the pie should be divided. But the true challenge is to try and make the pie bigger - that's the point of innovation. And that's the real issue average Americans should think about - why is the US becoming less and less competitive and less and less innovative. The substantial increase in transfer payments during the current crisis certainly didn't help. And while the argument that transfer payments caused the people to drop work is certainly false, it may keep them out of work for much longer. As soon as they get used to living off the state, a lot will "become discouraged" and continue to do so, which will seriously undermine the country's competitiveness, not to mention what it will do to the budget deficit. In short, they will turn into a European-style welfare state, very vulnerable to outside shocks and very far away from the innovative forces that drove the US forward all these centuries.

Thursday, 16 August 2012

Two points on taxes

They’re not all that recent but can come in handy any time. The first one is on the progressivity of taxes and transfers, while the second one is on the morality of tax evasion. A well informed reader would probably guess instantly (based on the vividness of the ongoing debates) that the first one is concerning the US, while the second one is concerning the UK. And he or she would be right. 

A post by Gerg Mankiw a month ago introduced a different perspective on the unfair income tax debate. It shifted the attention from low taxes on the 1% of high income earners to the high transfers received by the rest of the public. He got the numbers from a recent CBO report on the distribution of income and taxes. 
"Because transfer payments are...the opposite of taxes, it makes sense to look not just at taxes paid, but at taxes paid minus transfers received. For are taxes less transfers as a percentage of market income (income that households earned from their work and savings): 
Bottom quintile: -301 percent
Second quintile: -42 percent
Middle quintile: -5 percent
Fourth quintile: 10 percent
Highest quintile: 22 percent
Top one percent: 28 percent 
The negative 301 percent means that a typical family in the bottom quintile receives about $3 in transfer payments for every dollar earned.  
The most surprising fact to me was that the effective tax rate is negative for the middle quintile. According to the CBO data, this number was +14 percent in 1979 (when the data begin) and remained positive through 2007. It was negative 0.5 percent in 2008, and negative 5 percent in 2009. That is, the middle class, having long been a net contributor to the funding of government, is now a net recipient of government largess."
However such a brief overview has its flaws as Nancy Folbre notices on Economix. She stresses that the lowest quintile's numbers are biased since they contain the most numbers of retirees, young children and the disabled, which explains why they receive really high net government transfers. Also many retirees that are receiving Social Security or Medicare now were net contributers before, distorting further the temporary numbers. She also points out that the value of net transfers is measured inaccurately, since total transfers include both state and local govenment transfers, while taxes are only federal taxes. Taking this into account the middle quintil would surely be positive, which Mankiw also notes in his update to the post.  

The post nonetheless diverts the reader's attention into taking a different approach in thinking about the progressivity of the tax system in the US. One should also look at the transfer side, which will show a net value of contributions given and entitlements received from the federal (and state and local) government offering a more precise inquiry into the US (re)distribution of income. 

The second point comes from Tim Harford in the FT, a couple of weeks ago, and is regarding the morality of tax evasion. Harford reacted to the following statement from a UK Treasury Minister David Gauke: "Getting a discount with your plumber by paying cash in hand is something that is a big cost to the Revenue and means others have to pay more in tax. I think it is morally wrong."
"And if I agree to pay cash in hand, am I helping the plumber to evade tax?

Economically speaking, the plumber is helping you to evade tax. Lawyers and accountants look at the legal responsibility for paying tax and that lies with the plumber. But economists look at something called “tax incidence”, which is who ultimately bears the cost of the tax. A tax on plumbing might well increase the post tax cost of plumbing far more than it lowers the post-tax wages of plumbers.
...Assume that most plumbing work is not price sensitive: if the lavatory is leaking, you pay to have it fixed, whatever the cost; at the same time, nobody has cheap plumbing work done for the joy of a bargain. Assume also that the supply of plumbing services is quite elastic; if plumbing becomes more profitable, more plumbers will arrive from Poland and prices will fall; if plumbing becomes less profitable the Polish plumbers will ply their trade elsewhere...If these assumptions are broadly true then any tax on plumbing would ultimately be paid by consumers, not by plumbers. Tax evasion would help consumers themselves, not the plumbers.
....So tax evasion is really a blue-collar crime, then?  
No, I think that is wildly over-interpreting. But it is certainly not the exclusive preserve of the Monaco set. One important thing is missing from the HMRC definition of “tax gap”, however. It’s an estimate of how much tax is demanded yet not paid. But remember that how much tax is demanded is itself a function of opportunities to evade tax. If multinational companies are footloose, for instance, governments may offer low rates and generous tax breaks. The tax gap would then be small on paper but large relative to the taxes the Treasury might fantasise about levying."
Read the whole text, it's really interesting.

In terms of liquidity and access to finance problems surrounding UK businesses, prompt cash payments can prove to be very helpful. So I don't see any issue of morality in offering discounts to pay in cash, particularly in uncertain times of today. It helps the small and medium-sized businesses access money faster and adjust to the market conditions quicker. If invoice payments are late, liquidity is low, and bank loans are scarce and /or impossible to get, it is only normal for a small business to ask for cash to survive. In fact, it would be immoral from the government to force them to do otherwise, especially in a situation where they are ones increasing uncertainty and making the situation harder. 

Wednesday, 8 August 2012

Tracking the recovery (2) – business and consumer confidence

Continuing with the Recovery Tracking series after a brief graph of the week pause, we look at business and consumer confidence in the US, UK and Eurozone, comparing them to the situation from 6 months ago. The OECD once again offers a good database of tracking these indicators, in particular the Business Confidence Indicator (BCI) and the Consumer Confidence Indicator (CCI). 

Business confidence

Source: OECD Standardized Confidence Indicators. Latest data available
for June 2012. Click on graph to enlarge. 

I've limited the data to start from May 2010 to focus only on the recent shock in confidence experienced in 2011. Looking at the US and the UK in the first graph, a shy recovery from January onwards was soon brought to an abrupt end around April. This is something that the leading indicators failed to take account of. The reason is the faster reaction rate of business (and consumer) confidence indicators to a series of bad news that surrounds the business-owners.

And while the US and the UK saw the first quarter of 2012 as a move in a positive direction that was soon interrupted, the European periphery (lower right graph) experienced no such thing. Even in France, Germany or the Netherlands, the increase of confidence was only half a basis point. In the end, the brief increase of business confidence in the first few months of 2012 was soon interrupted by signals sent from the periphery. And again, as the European LEI showed previously, we are back to where we were in December. One ECB push was enough for only a few months. Good thing Draghi just announced another one. We'll see where this will take us

Consumer confidence 
Source: OECD Standardized Confidence Indicators. Latest data available
for June 2012. Click on graph to enlarge. 
Consumer confidence was much shier than business confidence. Neither European nor the UK consumers were showing any signs of optimism. US consumers apparently did until May, but this has recently also started to descend down a declining path. As for the rest of Europe, the increase of optimism in France and Greece can best be explained by their elections where the people saw new hope of upcoming political solutions. If you compare this to the business confidence at the same period you can notice an inverse trend. It seems that the election uncertainty was bad for business but good for the people. However, the outcome of the elections so far wasn't beneficial to either of the two groups.

In comparison to the situation from 6 months ago, the conclusion is similar to the previous two posts. Things are back to where they were, with 6 more months spent on not reforming and  scraping through with half-baked solutions. This only made things worse for governments and its voters. Instead of following positive examples of reforms, Europe collectively descended into maintaining the status quo, hoping that the ECB will somehow step in and save the day. That's what everyone is putting their money on at the moment. It will be interesting to see what will happen in the second half of 2012 as a response to this reverse of fortunes. Last year around this time troubles re-emerged. Let's just hope this time such a scenario will be prevented, since neither Europe nor the US have the strength to bear that again.

Update (15/08): The Gallup pool shows a US nationwide drop in economic confidence (tracking from January to June), however, they notice an improvement of confidence from 2011 to 2012, which can be interpreted as positive news. An interesting detail is that Washington DC is the only state showing a strong increase in economic confidence in the first half of 2012. Maybe they really are living in their own world. 

Thursday, 2 August 2012

Graph of the week: 150 years of bond yields

This week's graph offers several interesting facts to ponder upon: (click to enlarge)

Source: The Economist, July 2012
It seems that high spikes in bond yields were a natural occurrence in the 70s and the 80s during times of high inflation. Even in the 90s, average US and German bond yields were still higher than what Spain and Italy have today. And it was interestingly in the beginning of the 90s that Spain and Italy started to diverge against US and German yields just as they are doing today. The convergence came soon enough, or to be more precise, a bit before adopting the euro and agreeing to the necessary convergence conditions

However, the divergence of today is really simple to explain. It’s all a question of risk perception of investors where bonds of countries like USA, Germany or the UK (not pictured), no matter how bad their fiscal position is and no matter what the rating agencies say, are still regarded as ultra safe investments. On the other hand, this is due to the relatively high risk exposure of all other Eurozone countries. It appears that investors think that the US or the UK still aren't as bad as Greece or Spain, so they buy into their bonds. The real panic and downturn on the markets will begin when the previous statement will cease to be true.  

Another interesting fact is the question of when exactly did the idea of bond yields being considered the safest assets commence? It probably came about quite recently, following a steady 30-year decrease of US and German bond yields (a consequence of the “Great Moderation”), with all other yields converging to similar low rates. 

If you look at this in retrospect, something artificial had to have happened to keep all these yields exactly the same for 10 years (end of 90s to the end of the 2000s). Looking at the series historically, there was never a time when these yields were moving so closely together, not even in the beginning of the century in the prelude of the Great Depression. The artificial aligning of the yields had nothing to do with the Great Moderation. The culprit was the idea that all countries should bear no risks of borrowing within a highly controlled monetary union accompanied with a regulatory paradox that made all this possible. The aim was to eliminate risk for all countries within the Eurozone, a venture that has failed hopelessly. History teaches us that some difference between countries in their relative exposure to risk has to exist. An attempt to prove otherwise results in disaster.