In a development that I definitely didn't expect, Germany had a disastrous debt auction today, driving its borrowing costs up over 2% for its 10-year notes. I think this reflects, above all else, an extreme vote of no confidence in the European Central Bank by the market. My mode of thinking about the European crisis had been of the ECB as an extremely deficit hawkish appendage of the Bundesbank. That is, it set monetary policy based exclusively on developments in Europe's biggest economy, Germany. I saw the crisis driven, in large part, by the ECB's stubborn refusal to accept marginally higher inflation in Germany in order to ease the burdens of deflation in the peripheral countries. In the case of an asymmetrical shock, like the one that struck when Greece went bust and Spain and Ireland's property bubbles burst, those countries needed wages and prices to fall relative to the rest of Europe's in order to restore export competitiveness and allow them to essentially export their way out of trouble. But, absent higher inflation in the core countries like Germany, this would mean lower nominal wages and prices in the periphery, which in turn would make those countries' real debt burdens higher (not to mention bring on a massive deflationary recession that would cause huge suffering).
In this model, I expected spreads between German and peripheral sovereign debt to widen until those countries were forced out of the Euro. The widening spreads make sense because, in the case of a Euro collapse, the new drachma and new peso would be revalued at substantially less than the deutschemark. However, that development in turn means that Germany's borrowing costs shouldn't rise, since investors would see their bonds appreciate rather than depreciate if they were revalued in deutschemarks, provided Germany doesn't default.
I think what the failed auction reflects, though, is one of two things. The first is the possibility that Germany might opt to take on the liabilities of the peripheral countries, which would put substantial fiscal pressure on the Germans. However, I think that's unlikely-- with a cooperative central bank, a one-time addition of debt could be alleviated with steady growth, provided it wasn't choked off by the central bank. Which is, I think where the heart of the problem lies. The ECB is hawkish to the extreme on inflation; if it sees a possibility of inflation, it raises rates. Which is a huge problem when economic growth Euro-wide is stagnant and there's mass unemployment. I think the fear is even contraction in Germany wouldn't lead the ECB to raise rates, out of its misguided inflationary fears. Then, in a collapse, their further misguided fear of inflation would keep them from acting. This still doesn't explain the German borrowing problem-- even in a Euro collapse, their debts would get paid off-- but I think it may just be markets' fear of anything having to do with the Euro that's driving them away from German bunds.
To use a metaphor I really like, the ECB is the fireman who shows up to Noah's flood with his fire extinguisher and gets swept away. To use Paul Krugman's (probably superior) characterization, the ECB is determined to cast itself as the highly credible defender of the value of a currency that no longer exists.
Showing posts with label Europe. Show all posts
Showing posts with label Europe. Show all posts
Wednesday, November 23, 2011
Sunday, November 6, 2011
How much longer for the Euro?
Looks like Greece's prime minister has to resign in order for them to accept the latest package. I still don't think it's going to make a difference. Sure, it includes some debt write-downs (definitely a good thing), but it also includes a bunch of immediate austerity (short-term, definitely not a good thing). For me, the key would be a commitment on the ECB's part to support the Euro-periphery's funding needs until their economies recover (an indefinite bond-buying program, for example). But, while Mario Draghi is infinitely more competent than Jean-Claude Trichet, he still doesn't seem to be willing to give the peripheral countries the kind of commitment they need to get them through the crisis.
While it's kind of hard to see the Europeans letting the Euro go, they are also committed to not doing enough to keep the Euro-zone together. Eventually, this will come to a head-- Greeks will get tired of counterproductive austerity, and the Euro will reach a point of crisis. Either the ECB will have to provide open-ended financing and delay austerity until the economy can recover, or Greece will have to shut down its banking sector, default on its debts, and exit the Euro-zone. That will inevitably cause massive bank runs-- assets on Greek banks' books are Euro-denominated, while the drachma would inevitably be worth substantially less than the Euro. Depending on the global financial system's exposure to Greek (and other peripheral European) debt, it could also have knock-on effects whose scale could range anywhere from seriously disruptive to catastrophic.
I tend to think that a Greek default would cause a cascading effect, at the least to Spain, Italy, and Portugal, but potentially even further. In that case, I think we'd be facing a global Lehman moment. Lehman's disorderly collapse in 2008 shook global financial markets so much that the Congress was immediately scared into passing TARP and bailing out the rest of the big American banks, while the Fed flooded the US financial system with trillions of dollars of emergency liquidity to prevent an imminent failure. A failure of any one of Greece, Spain, Italy or Portugal, never mind all four, would be a few orders of magnitude worse. And the US alone probably wouldn't be equipped to rescue them. I think at that point we'd need a concentrated global effort to avert global economic collapse, with not just Germany and France, but also China and the US pitching in funds to stabilize the global financial system. Now, the ECB could choke off that kind of disaster by taking aggressive steps to create higher inflation in the Euro-zone and buy up peripheral Euro-zone debt, but it's looking more and more like the ECB is a useless institution, which in turn could well mean that the global economy would have to be on the verge of collapse before it was induced to act.
While it's kind of hard to see the Europeans letting the Euro go, they are also committed to not doing enough to keep the Euro-zone together. Eventually, this will come to a head-- Greeks will get tired of counterproductive austerity, and the Euro will reach a point of crisis. Either the ECB will have to provide open-ended financing and delay austerity until the economy can recover, or Greece will have to shut down its banking sector, default on its debts, and exit the Euro-zone. That will inevitably cause massive bank runs-- assets on Greek banks' books are Euro-denominated, while the drachma would inevitably be worth substantially less than the Euro. Depending on the global financial system's exposure to Greek (and other peripheral European) debt, it could also have knock-on effects whose scale could range anywhere from seriously disruptive to catastrophic.
I tend to think that a Greek default would cause a cascading effect, at the least to Spain, Italy, and Portugal, but potentially even further. In that case, I think we'd be facing a global Lehman moment. Lehman's disorderly collapse in 2008 shook global financial markets so much that the Congress was immediately scared into passing TARP and bailing out the rest of the big American banks, while the Fed flooded the US financial system with trillions of dollars of emergency liquidity to prevent an imminent failure. A failure of any one of Greece, Spain, Italy or Portugal, never mind all four, would be a few orders of magnitude worse. And the US alone probably wouldn't be equipped to rescue them. I think at that point we'd need a concentrated global effort to avert global economic collapse, with not just Germany and France, but also China and the US pitching in funds to stabilize the global financial system. Now, the ECB could choke off that kind of disaster by taking aggressive steps to create higher inflation in the Euro-zone and buy up peripheral Euro-zone debt, but it's looking more and more like the ECB is a useless institution, which in turn could well mean that the global economy would have to be on the verge of collapse before it was induced to act.
Monday, September 26, 2011
The Next Big Crisis
Even though the market meltdown in the aftermath of Lehman's collapse came after about a year of slow boiling in financial markets (beginning with BNP Paribas suspending redemptions on its subprime-invested hedge funds in 2007 and continuing with Bear Stearns's acquisition by JPMorgan and the government's placement of Fannie Mae and Freddie Mac into conservatorship), relatively few people expected the housing crisis to have as profound an effect on the global economy as it did. But now, barely 4 years after Lehman, we're seeing the same kind of build-up coming in slow motion. Except this time, the problem isn't just housing in the US and parts of Europe-- it's European sovereigns.
Now, there's a conventional story people (read: American conservatives, and, on some issues, the Germans) like to tell about why Europe's in trouble, and it's important to know that, for the most part, that story is BS. It's not "massive welfare states" and "irresponsible government spending" that have Europe on the edge of collapse-- that's a major part of the story for Greece, but if that were the story, Spain and Ireland would be fine (they had little debt and budget surpluses in 2007), and Italy would be humming along (it's got a heavy debt burden, but the budget is more or less balanced). The problem, really, is that the Eurozone is fundamentally a problem-- there's a massive mismatch between what the Germans want (low inflation) and what the peripheral countries need (monetary easing combined with fiscal stimulus). To be able to pay off their debt loads, what the peripheral countries need is devaluation-- they need their wages and prices to fall relative to Germany and France's. That would allow them to export more goods to the Germans, boost their employment, and begin to pay off their debts. But the Germans won't play along. While the press focuses on the subsidy the Euro provided to countries like Greece and Ireland (which borrowed at German rates until they didn't), there's a subsidy that Germany gets that is overlooked by the financial press. A huge chunk of Germany's economic success has come from the strength of its export sector. And that export sector has been fueled in large part by the fact that the Euro is (and has long been) valued lower than the Deutschemark would be were it still in existence. That is, while German workers are substantially more productive than Greek or Italian workers on balance, their labor is valued in the same currency units, which allows Germany to export a ton of goods and keeps its economy buzzing along. And the Germans won't readily accept higher inflation that would allow the peripheral countries to revalue because it would mean giving up some of their export advantages in the process. And internal deflation by the peripheral economies without German inflation won't work either because that would boost the real value of those countries' debts and make repayment even harder than it already is.
So Europe is stuck between a rock and a hard place-- its solution so far has been to kick the can down the road, providing loan subsidies tied to austerity demands in hopes that somehow the Greek, Spanish, Irish, Italian and Portuguese economies will magically start growing and will allow them to start making progress on repaying their debts. But that's a fool's hope. It might happen someday, but for now, there's no light at the end of the tunnel-- it looks like Europe is looking at the comatose patient and hoping the feeding tube will be enough to pull him out of his coma.
What Europe actually needs is systemic rebalancing-- it needs substantiallly higher (maybe 4%) inflation in the core countries that will make it relatively less painful for the peripheral countries to devalue compared to the core. It needs significant fiscal transfers from the core to the periphery to jump-start demand, and a Eurobond program that makes individual countries' obligations collective "European" obligations. It also needs looser monetary policy from the ECB-- hyperinflation is bad and all, but worrying about it in the current climate is absurd-- it's like agonizing over heatstroke on the North Pole. Collectively, those steps might make Europe less likely to blow up fast. But even then, it would take quite a bit of luck to diffuse the ticking time bomb on the continent.
While Europe might spend the next few months kicking the can down the road, the reality is that the continent is under speculative attack. And the attackers know that, economically, the rebalancing they're betting on needs to happen, so they'll press their advantage. That means half-measures won't go far: there are two ways to halt a speculative attack-- by definitively resolving the problem, or by caving in. In 1992, when the British pound's peg to the deutschemark was under speculative attack from George Soros and a bunch of other hedge fund giants, the attack ended when Britain had to abandon the peg and leave the exchange-rate mechanism (almost certainly for its own good). In 2008, when the stocks of the stand-alone investment banks came under speculative attack after Lehman collapsed and Merrill Lynch was acquired by Bank of America, Morgan Stanley and Goldman halted the attack by becoming bank holding companies and getting permanent access to the Fed's discount window, instantly allaying concerns about their liquidity. To resolve the issue in Europe, half-measures won't do: to avoid defaults and a rapid, disorderly blowup of the Eurozone, similarly decisive steps are essential. But right now, it doesn't look like we'll get them.
Tuesday, August 9, 2011
Tuesday Musings
Looks like the ECB's effort to stop the fire in Europe is actually working. Italian 10-year bond yields dropped significantly today after the ECB's bond-buying program, meaning there's a bit less fear of contagion. Some might claim that this is obvious-- if the ECB is buying bonds, of course the yield will go down. But the alternate scenario would be bondholders revolting at holding bonds they see as risky that don't yield enough to compensate them for the risk. Luckily, they aren't. And, on the fundamentals, I think they're right. Italy is running a primary budget surplus, so as long as the interest payments on their large debt burden stay manageable, they should be able to tread water and avoid contagion from the Greek travesty.
In other news, since S&P "downgraded" the US, yields on 10-year Treasuries have fallen by 38 basis points, and rates on 30-year Treasuries have fallen by 26 basis points. And real yields (which take into account inflation expectations are at 0 for 10-year Treasuries and about 1% for 30-year Treasuries. The real yields are actually NEGATIVE for 5- and 7-year bonds, meaning that you're essentially paying to lend the government money for that length of time (people still lend to the government at negative real rates because nominal rates are positive, so holding cash always has a negative real return over time unlses inflation is negative). The point to take from this is: so much for S&P's downgrade throwing the US's solvency into question.
In other news, since S&P "downgraded" the US, yields on 10-year Treasuries have fallen by 38 basis points, and rates on 30-year Treasuries have fallen by 26 basis points. And real yields (which take into account inflation expectations are at 0 for 10-year Treasuries and about 1% for 30-year Treasuries. The real yields are actually NEGATIVE for 5- and 7-year bonds, meaning that you're essentially paying to lend the government money for that length of time (people still lend to the government at negative real rates because nominal rates are positive, so holding cash always has a negative real return over time unlses inflation is negative). The point to take from this is: so much for S&P's downgrade throwing the US's solvency into question.
Sunday, August 7, 2011
Europe: A BIG Problem
Lost in the pointless S&P downgrade debate is the fact that Europe is a HUGE problem. And it's getting bigger. For proof, take a look at what Italian 10-year bond yields are doing. Also, Spanish 10-year bond yields. In response, the European Central Bank has apparently decided to "intervene decisively on markets" once trading open tomorrow. What that means, it's not fully clear. If I had to guess, the European Central Bank is going to start buying up Spanish and Italian bonds. Maybe both. Why now? Well, the Eurozone can afford to bail out Greece, Ireland and Portugal indefinitely. Greece's GDP is about $330 billion. Ireland's and Portugal's are about $230 billion each. Spain's is almost double those 3 combined. Italy's is almost triple Greece, Ireland and Portugal combined. The EU can't afford to bail either of them out. Contagion to Spain or Italy would spell big trouble for the EU and the world economy. In all likelihood, it would mean collapse of the Euro. And that would be a massive problem. Think Lehman Brothers times 1000.
So what will buying up Italy and Spain's bonds do? Well, for one, it will allow them to borrow. And neither of their problems look anything like Greece's. Whereas Greece had a massively distorted economy with a bloated public sector, along with a massive debt burden and a huge primary budget deficit, Italy has a big debt burden, but a primary budget surplus (meaning that, debt interest payments aside, its government actually takes in more than it pays out), while Spain had a fairly small debt burden and a primary budget surplus when its real estate bubble collapsed in 2008. Capital market access would buy them time to improve their outlook while Greece gets its act together (and Ireland tries to pay down the debt the EU has shoved down their throats by forcing them to bail out their wildly irresponsible banks). Realistically, it's not a way out as much as a stabilization mechanism meant to avert disaster. But that disaster is scary enough that the ECB taking this action is without a doubt the right move.
The final question, I guess, is what contagion would mean. My guess is a spiral in which Spain and Italy lose capital market access would end in a forced exit from the Euro for a number of countries (that or the ECB loosening monetary policy in a way that would be highly inflationary for Germany, which seems pretty unlikely...)-- Spain, Italy, Ireland, Greece, and Portugal are the obvious candidates. Places like Estonia (which, Robert Samuelson nonsense pieces aside, is still suffering enormously; yes, 14% unemployment is down from 19% unemployment, which is better in the same way that losing a leg is worse than losing your head) would also probably have to go, and each of those places would suffer, as Barry Eichengreen detailed, the mother of all bank runs. Confused? Well, here are the mechanics, as I understand them (as always, bear in mind that I'm no economist, so I'm probably prone to some misinterpretation). An exit from the Eurozone would mean a massive global financial crisis. The instant investors were told that the Eurozone would fall apart (or that a country was leaving the Eurozone), it would start a MASSIVE run on all of the country's banks. The reason is that an exit from the Euro would mean redenominating the bank's assets in the new (old) domestic currency. So instead of holding Euro-denominated assets, Italian banks would hold lira-denominated assets. But remember that the lira would be revalued against the Euro, and this revaluation would mean the real value of the assets would fall. So investors would scramble to transfer their assets from lira-denominated assets into Euro-denominated assets, and the Italian banking sector would collapse. But the Italian banking sector has a HUGE number of counterparties, which in turn would see their assets and contracts evaporate. As a result, the global financial system would seize up in a way that makes the crash after the Lehman collapse look like small potatoes. And even a coordinated effort by global central banks might not be enough to push back against that kind of event. Which is a scary, scary proposition.
(As a side note, the two best pieces I've read about this kind of problem, for anyone interested, are the Eichengreen piece I linked above and this paper by Maurice Obstfeld which talks specifically about devaluations in fixed-exchange rate regimes (like the ones in Argentina and Mexico), but default within a unified currency follows the same basic pattern.
So what will buying up Italy and Spain's bonds do? Well, for one, it will allow them to borrow. And neither of their problems look anything like Greece's. Whereas Greece had a massively distorted economy with a bloated public sector, along with a massive debt burden and a huge primary budget deficit, Italy has a big debt burden, but a primary budget surplus (meaning that, debt interest payments aside, its government actually takes in more than it pays out), while Spain had a fairly small debt burden and a primary budget surplus when its real estate bubble collapsed in 2008. Capital market access would buy them time to improve their outlook while Greece gets its act together (and Ireland tries to pay down the debt the EU has shoved down their throats by forcing them to bail out their wildly irresponsible banks). Realistically, it's not a way out as much as a stabilization mechanism meant to avert disaster. But that disaster is scary enough that the ECB taking this action is without a doubt the right move.
The final question, I guess, is what contagion would mean. My guess is a spiral in which Spain and Italy lose capital market access would end in a forced exit from the Euro for a number of countries (that or the ECB loosening monetary policy in a way that would be highly inflationary for Germany, which seems pretty unlikely...)-- Spain, Italy, Ireland, Greece, and Portugal are the obvious candidates. Places like Estonia (which, Robert Samuelson nonsense pieces aside, is still suffering enormously; yes, 14% unemployment is down from 19% unemployment, which is better in the same way that losing a leg is worse than losing your head) would also probably have to go, and each of those places would suffer, as Barry Eichengreen detailed, the mother of all bank runs. Confused? Well, here are the mechanics, as I understand them (as always, bear in mind that I'm no economist, so I'm probably prone to some misinterpretation). An exit from the Eurozone would mean a massive global financial crisis. The instant investors were told that the Eurozone would fall apart (or that a country was leaving the Eurozone), it would start a MASSIVE run on all of the country's banks. The reason is that an exit from the Euro would mean redenominating the bank's assets in the new (old) domestic currency. So instead of holding Euro-denominated assets, Italian banks would hold lira-denominated assets. But remember that the lira would be revalued against the Euro, and this revaluation would mean the real value of the assets would fall. So investors would scramble to transfer their assets from lira-denominated assets into Euro-denominated assets, and the Italian banking sector would collapse. But the Italian banking sector has a HUGE number of counterparties, which in turn would see their assets and contracts evaporate. As a result, the global financial system would seize up in a way that makes the crash after the Lehman collapse look like small potatoes. And even a coordinated effort by global central banks might not be enough to push back against that kind of event. Which is a scary, scary proposition.
(As a side note, the two best pieces I've read about this kind of problem, for anyone interested, are the Eichengreen piece I linked above and this paper by Maurice Obstfeld which talks specifically about devaluations in fixed-exchange rate regimes (like the ones in Argentina and Mexico), but default within a unified currency follows the same basic pattern.
Thursday, August 4, 2011
What Economic Indicators Mean, OR Who You Should Listen to On Economics
Today, financial markets had a bit of an off day... Alright, maybe a rough stretch... Alright, so I guess calling it a rough stretch is a bit of an understatement. The Dow had its worst day today since we all thought the world was going to end in 2008, dropping 512 points (over 4%), and the index itself has dropped over 10% over the last 10 days (as has the S&P, which is a better measure of broader market attitudes than the Dow; and the Nasdaq). The first thing to note is that the stock market is a really terrible measure of the country's economic health. It dominates the news and the talking heads spend a lot of time on it, but, if anyone reads this, relax, the stock market is NOT in any way a measure of how the broader economy is doing. All a stock price reflects is people's attitudes about companies' future prospects. In other words, it's a lagging rather than a leading indicator, and it's often wrong: Paul Samuelson, pretty universally regarded as the greatest economist of the second half of the 20th century, famously noted that the stock market had predicted nine of the last five recessions. That was true, and also prescient. Sometimes, a dip in the market signals the start of a recession (the burst of the tech bubble in 1999/2000, the stock crash that sparked the Great Depression). Other times it follows a move back into recession. Other times, it doesn't mean much of anything at all (in 1987, the major global indices dropped over 20% in a single day, followed by... nothing; last May, the Dow lost 600 points in 5 minutes), besides that trading algorithms were selling off stocks rapidly. So there's no need to panic because the stock market had a crummy day.
What the lagging stock market recently DOES mean is that investors by and large aren't optimistic about the growth and profitability prospects of listed companies in the near future. And that has a lot to do with expectations centered around the lagging economy, and Congress and President Obama's inexplicable and inexcusable decision to ignore the job and growth crisis and focus on... the deficit. A major culprit here is the mainstream press. The first "expert" CNN quotes in the story I linked is Peter Schiff. Peter Schiff is an ignoramus. He's an expert in the economy in the same way I'm an expert at speaking Mandarin Chinese (one of my college friends taught me to say "Hello pretty girl", and spent the next hour making fun of me for speaking Chinese with a French accent). He has an eminent record of being wrong about everything. Schiff's incoherent claim is that the stock market tanked because now, all of a sudden, markets realized that "stimulus didn't work." He'd have you believe that traders woke up one morning in late July and decided, "Gee, that stimulus passed in 2009 really didn't get the job done; I'm selling NOW." If that sounds stupid to you, that's because it is.
In this case, though, the economy is certainly struggling, and markets clearly don't think the deficit reduction deal is going to do anything to stimulate growth (that much was obvious to anyone with a brain) or even address the deficit (as Herbert Hoover demonstrated). What we'll most likely end up with is possibly a shrinking nominal deficit (if Republicans get their way and gut everything), but a rising debt burden, as GDP craters (debt only matters as a proportion of GDP; to put it in practical terms, a person making $160,000 a year with $10,000 of debt has a much smaller debt burden than a person making $16,000 a year with $5,000 of debt). And the US's economy isn't the only one struggling; borrowing costs for Greece have long been skyrocketing, but the spread between Italy and Germany's 10-year rates is spiking. Now, at this point, I look like I'm being inconsistent: how can I say that it's bad that interest rates on 10-year Treasuries are low (3.125%), but it's also bad that interest rates on Italian bonds of the same maturity are high?
The answer to that is nuanced. For one thing, a yield by itself doesn't tell you much. Yield prices in inflation (if the real value of the currency it references is lower, the yield is higher), likelihood of repayment (if a country has a history of fiscal irresponsibility, yields on its debt are higher), and the broader state of the economy (if companies are doing well, investors are more likely to move money out of safe-haven government bonds (specifically, US Treasuries) and into riskier stocks and corporate bonds, which drives demand for Treasuries down, and thereby increases their yield.
So what's the story? Well, to anyone looking at it with a clear head, it's pretty straightforward. In the US, low stock prices reflect investor pessimism about the state of the economy and the recovery; they're moving their money out of stocks and corporate bonds and into what is still the ultimate safe haven investment (Congress's shenanigans aside): US Treasuries. Which explains why Treasury yields are so low. Those yields would be rising significantly if investors expected the hyperinflation Peter Schiff has spent the last 2 years hysterically railing about. Unfortunately for him, no one is and he comes across looking like the buffoon that he is (no one would take the 4% coupon on 30-year Treasuries that is currently being paid if they thought that hyperinflation was right around the corner). So in the US, we've got investors who are pessimistic about the recovery but believe that the government will continue to be good for the money it is lent, and won't inflate away its debts.
In Italy, coupons on debt are soaring, but stocks are down. If investors thought Italy was at risk of high inflation, that inflation would also be reflected in stock prices (explaining the mechanics of inflation will take another post, but basically if prices and wages are spiraling, stock prices will spiral, too). Very clearly, those same investors aren't bullish on Italy's recovery. Essentially, they're increasingly worried that Italy will default. This is made even more acute by the European Central Bank's obsession with inflation, which is driving it to raise rates even as its peripheral countries need looser monetary policy to help them address their massive debt overhangs. But, day by day, I think the Eurozone is coming apart at the seams (and Gillian Tett, my second-favorite English financial journalist, agrees), as the peripheral countries with big debt burdens are swamped by an inability to service their debt. I think the story will go something like this. Greece has literally no growth prospects in the medium- or even the long-term without a default. Their debt overhang is massive, the bailouts they're getting are essentially pushing payment on that debt overhang into the future in the hope that growth will somehow restart, but, without the ability to conduct expansionary monetary policy (since they're in the Euro) or expansionary fiscal policy (because they're locked out of capital markets), there's really no way to see Greece restarting growth. Eventually, the rest of the Eurozone will lose the political appetite to keep throwing money at Greece, and will decide to draw the line. At which point bond markets in the other peripheral economies will begin crumbling too. At that point, we have a repeat of the Lehman Brothers crisis, only way bigger.
Now, I'm not claiming that will definitively happen, but I think it's a semi-plausible scenario. And that kind of scenario being semi-plausible is a pretty scary prospect.
What the lagging stock market recently DOES mean is that investors by and large aren't optimistic about the growth and profitability prospects of listed companies in the near future. And that has a lot to do with expectations centered around the lagging economy, and Congress and President Obama's inexplicable and inexcusable decision to ignore the job and growth crisis and focus on... the deficit. A major culprit here is the mainstream press. The first "expert" CNN quotes in the story I linked is Peter Schiff. Peter Schiff is an ignoramus. He's an expert in the economy in the same way I'm an expert at speaking Mandarin Chinese (one of my college friends taught me to say "Hello pretty girl", and spent the next hour making fun of me for speaking Chinese with a French accent). He has an eminent record of being wrong about everything. Schiff's incoherent claim is that the stock market tanked because now, all of a sudden, markets realized that "stimulus didn't work." He'd have you believe that traders woke up one morning in late July and decided, "Gee, that stimulus passed in 2009 really didn't get the job done; I'm selling NOW." If that sounds stupid to you, that's because it is.
In this case, though, the economy is certainly struggling, and markets clearly don't think the deficit reduction deal is going to do anything to stimulate growth (that much was obvious to anyone with a brain) or even address the deficit (as Herbert Hoover demonstrated). What we'll most likely end up with is possibly a shrinking nominal deficit (if Republicans get their way and gut everything), but a rising debt burden, as GDP craters (debt only matters as a proportion of GDP; to put it in practical terms, a person making $160,000 a year with $10,000 of debt has a much smaller debt burden than a person making $16,000 a year with $5,000 of debt). And the US's economy isn't the only one struggling; borrowing costs for Greece have long been skyrocketing, but the spread between Italy and Germany's 10-year rates is spiking. Now, at this point, I look like I'm being inconsistent: how can I say that it's bad that interest rates on 10-year Treasuries are low (3.125%), but it's also bad that interest rates on Italian bonds of the same maturity are high?
The answer to that is nuanced. For one thing, a yield by itself doesn't tell you much. Yield prices in inflation (if the real value of the currency it references is lower, the yield is higher), likelihood of repayment (if a country has a history of fiscal irresponsibility, yields on its debt are higher), and the broader state of the economy (if companies are doing well, investors are more likely to move money out of safe-haven government bonds (specifically, US Treasuries) and into riskier stocks and corporate bonds, which drives demand for Treasuries down, and thereby increases their yield.
So what's the story? Well, to anyone looking at it with a clear head, it's pretty straightforward. In the US, low stock prices reflect investor pessimism about the state of the economy and the recovery; they're moving their money out of stocks and corporate bonds and into what is still the ultimate safe haven investment (Congress's shenanigans aside): US Treasuries. Which explains why Treasury yields are so low. Those yields would be rising significantly if investors expected the hyperinflation Peter Schiff has spent the last 2 years hysterically railing about. Unfortunately for him, no one is and he comes across looking like the buffoon that he is (no one would take the 4% coupon on 30-year Treasuries that is currently being paid if they thought that hyperinflation was right around the corner). So in the US, we've got investors who are pessimistic about the recovery but believe that the government will continue to be good for the money it is lent, and won't inflate away its debts.
In Italy, coupons on debt are soaring, but stocks are down. If investors thought Italy was at risk of high inflation, that inflation would also be reflected in stock prices (explaining the mechanics of inflation will take another post, but basically if prices and wages are spiraling, stock prices will spiral, too). Very clearly, those same investors aren't bullish on Italy's recovery. Essentially, they're increasingly worried that Italy will default. This is made even more acute by the European Central Bank's obsession with inflation, which is driving it to raise rates even as its peripheral countries need looser monetary policy to help them address their massive debt overhangs. But, day by day, I think the Eurozone is coming apart at the seams (and Gillian Tett, my second-favorite English financial journalist, agrees), as the peripheral countries with big debt burdens are swamped by an inability to service their debt. I think the story will go something like this. Greece has literally no growth prospects in the medium- or even the long-term without a default. Their debt overhang is massive, the bailouts they're getting are essentially pushing payment on that debt overhang into the future in the hope that growth will somehow restart, but, without the ability to conduct expansionary monetary policy (since they're in the Euro) or expansionary fiscal policy (because they're locked out of capital markets), there's really no way to see Greece restarting growth. Eventually, the rest of the Eurozone will lose the political appetite to keep throwing money at Greece, and will decide to draw the line. At which point bond markets in the other peripheral economies will begin crumbling too. At that point, we have a repeat of the Lehman Brothers crisis, only way bigger.
Now, I'm not claiming that will definitively happen, but I think it's a semi-plausible scenario. And that kind of scenario being semi-plausible is a pretty scary prospect.
Thursday, July 28, 2011
USA vs. Europe: Who's Worse?
Simon Johnson, who used to be chief economist at the IMF and now teaches at MIT and has a pretty good blog, has a good post comparing the US's problems to Europe's. I agree with the crux of his argument: that Europe has a near-term problem rooted in its disaster of a common currency which both keeps the afflicted countries from growing their way out of trouble, and leave the core economies with the tab for either their fiscal profligacy (Greece) or their disastrous, deregulated banking sector (Ireland). The worst part of their problem is the contagion-- Greece's growth AND fiscal problems are so bad that it needs regular bailouts just to stay above ground, and the jitters that the market feels about Greece are bleeding over into Italy and Spain, both of which have their own problems (albeit nowhere near as bad as Greece's), but whose collapse would be disastrous not just for Europe but for the whole world.
The US's problems, on paper, are nowhere near as bad. Contrary to what scaremongers in Washington might say, the US's budget picture isn't particularly bad. In other words, we look NOTHING like Greece-- we're more like Ireland. We had a fairly small debt load and manageable deficits (Ireland actually ran a surplus in the mid-2000's...), but our runaway deregulated financial sectors and subsequent housing bubbles caused big economic problems that depressed revenues, necessitated bigger government expenditures, and made our finances look much, much worse than they really are, at least in the short term. To be sure, we do have a significant health care cost problem (as I've acknowledged in this post, we need to deal with health care cost), but that's a problem for the long run, not right now.
So why is the US in crisis? Well, the answer is bad politics. We've got scaremongers who insist that we have to cut spending NOW NOW NOW (but, funny enough, won't say the same about raising taxes because, well, we can't afford to raise taxes modestly "in this economic climate", though apparently we can afford to cut spending by a whole lot more), and are willing to risk a default on the government's obligations to get their draconian cuts. In a way, the problem we have may be worse. Europe does have flexible politicians doing their best to get out from a policy straitjacket caused by a terrible decision to adopt a common currency. The US has a bunch of crayz politicians who don't understand the consequences of their actions. To put the analogy another way, if the US and Europe are cars driving along a highway to a destination, Europe has a broken car that it can't control, while the US has a functioning car, but a crazy drunk in the passenger seat grabbing at the steering wheel and doing his best to run the car over a cliff. That crazy drunk is the Tea Party nonsense that's taken over the Republican Party and is threatening to destroy the country's fiscal situation.
The US's problems, on paper, are nowhere near as bad. Contrary to what scaremongers in Washington might say, the US's budget picture isn't particularly bad. In other words, we look NOTHING like Greece-- we're more like Ireland. We had a fairly small debt load and manageable deficits (Ireland actually ran a surplus in the mid-2000's...), but our runaway deregulated financial sectors and subsequent housing bubbles caused big economic problems that depressed revenues, necessitated bigger government expenditures, and made our finances look much, much worse than they really are, at least in the short term. To be sure, we do have a significant health care cost problem (as I've acknowledged in this post, we need to deal with health care cost), but that's a problem for the long run, not right now.
So why is the US in crisis? Well, the answer is bad politics. We've got scaremongers who insist that we have to cut spending NOW NOW NOW (but, funny enough, won't say the same about raising taxes because, well, we can't afford to raise taxes modestly "in this economic climate", though apparently we can afford to cut spending by a whole lot more), and are willing to risk a default on the government's obligations to get their draconian cuts. In a way, the problem we have may be worse. Europe does have flexible politicians doing their best to get out from a policy straitjacket caused by a terrible decision to adopt a common currency. The US has a bunch of crayz politicians who don't understand the consequences of their actions. To put the analogy another way, if the US and Europe are cars driving along a highway to a destination, Europe has a broken car that it can't control, while the US has a functioning car, but a crazy drunk in the passenger seat grabbing at the steering wheel and doing his best to run the car over a cliff. That crazy drunk is the Tea Party nonsense that's taken over the Republican Party and is threatening to destroy the country's fiscal situation.
The Financial Times Asks for Bad Policy
Yesterday, I wrote a post about what a failure Britain's effort to expand its economy through contractionary deficit reduction was. Shockingly, cutting demand by limiting government spending, and cutting demand again by hiking taxes, isn't exactly a formula for gettin out of a mess that's caused by... lack of demand. Realizing that contraction wasn't expansionary, Conservative London Mayor Boris Johnson and Ed Balls, Labour's Shadow Chancellor, proposed a cut in the Value Added Tax (VAT) to stimulate demand and get their economy off its knees.
In an opinion piece published last night in the Financial Times, Chris Giles writes a criticism of the policy, claiming that Britain's caught the voodoo economic bug conservatives in the US have. Giles is completely off base. First, there's a big difference between American Republicans, who have a fetish for tax cuts, and will reach for any justification for why cutting taxes is necessary, never mind that those reasons don't follow any reality or coherent logic (I can't tell you how many times I've heard, "We can't afford to raise taxes in this economy! But we have to cut spending... in this economy. Nonsense."), and Tories in the UK, who have a coherent (if very misguided) belief in the need for fiscal rectitude, even in a severely depressed economy. Giles is wrong because the justification for the tax cut is NOT the Reagan-era supply-side claim (thoroughly debunked by the data over and over) that tax cuts increase revenue. Rather, it's based on the very reasonable claim that policies that stimulate demand in the short run can alleviate short-run demand problems, and allow for fiscal adjustment in normal times. Giles, on the other hand, is invoking the confidence fairy. Britain HAS to show the world that it's serious about deficit reduction NOW, he claims, and that will spur credibility. Never mind that his serious deficit reduction has, predictably, stalled the recovery ("It was the Royal Wedding! I swear! And the Olympics!" he says), all while the UK continues to borrow at extremely low rates.
Now, do I think a cut in the VAT is the most efficient way to stimulate demand? Honestly, probably not. Giles IS right that a significant chunk of that will be saved, which helps the saver at the expense of everyone else. But it IS a form of stimulus that the depressed UK economy could definitely use. Obviously, I'm no proponent of the tax cut fetish in the US. But Giles is using it as a boogeyman to promote the nonsensical confidence fairy idea (the idea that consolidating the budget will somehow magically improve confidence enough to spur recovery, never mind that there's still a demand shortfall), a policy that isn't quite equally bad, but is close.
It's ridiculous how bad ideas have somehow taken hold on both sides of the Atlantic. Different species of bad policies, to be sure, but still bad policies. It's depressing, really, how we go through crises exacerbated by bad policies, write a bunch of books about those bad policies, and then, the next time a similar crisis hits, dig them up, reuse them, and expect different results.
In an opinion piece published last night in the Financial Times, Chris Giles writes a criticism of the policy, claiming that Britain's caught the voodoo economic bug conservatives in the US have. Giles is completely off base. First, there's a big difference between American Republicans, who have a fetish for tax cuts, and will reach for any justification for why cutting taxes is necessary, never mind that those reasons don't follow any reality or coherent logic (I can't tell you how many times I've heard, "We can't afford to raise taxes in this economy! But we have to cut spending... in this economy. Nonsense."), and Tories in the UK, who have a coherent (if very misguided) belief in the need for fiscal rectitude, even in a severely depressed economy. Giles is wrong because the justification for the tax cut is NOT the Reagan-era supply-side claim (thoroughly debunked by the data over and over) that tax cuts increase revenue. Rather, it's based on the very reasonable claim that policies that stimulate demand in the short run can alleviate short-run demand problems, and allow for fiscal adjustment in normal times. Giles, on the other hand, is invoking the confidence fairy. Britain HAS to show the world that it's serious about deficit reduction NOW, he claims, and that will spur credibility. Never mind that his serious deficit reduction has, predictably, stalled the recovery ("It was the Royal Wedding! I swear! And the Olympics!" he says), all while the UK continues to borrow at extremely low rates.
Now, do I think a cut in the VAT is the most efficient way to stimulate demand? Honestly, probably not. Giles IS right that a significant chunk of that will be saved, which helps the saver at the expense of everyone else. But it IS a form of stimulus that the depressed UK economy could definitely use. Obviously, I'm no proponent of the tax cut fetish in the US. But Giles is using it as a boogeyman to promote the nonsensical confidence fairy idea (the idea that consolidating the budget will somehow magically improve confidence enough to spur recovery, never mind that there's still a demand shortfall), a policy that isn't quite equally bad, but is close.
It's ridiculous how bad ideas have somehow taken hold on both sides of the Atlantic. Different species of bad policies, to be sure, but still bad policies. It's depressing, really, how we go through crises exacerbated by bad policies, write a bunch of books about those bad policies, and then, the next time a similar crisis hits, dig them up, reuse them, and expect different results.
Wednesday, July 27, 2011
Taking Another Look at the US-Europe Gap
Conventional wisdom has long been that the US and the advanced European economies represented different models of capitalism. Not better or worse, necessarily, but divergent in the choices they made about how to construct their society. America had higher wages, lower unemployment, and more jobs. It was easier to start a career after college, and easier to make enough money at a young age to move out of the parents' house. Europe had better job security, a stronger social safety net, and better benefits. Unions protected workers, which had the effect of making companies more cautious in hiring. Older workers weren't unceremoniously dumped out of work, but young workers had trouble getting into the labor market, and unemployment was naturally higher. Each side was convinced its model was better: American politicians warned about European "big government", high taxes, and "Eurosclerosis". Europeans equally warned about the dismal American safety net, unceremonious dumping of workers, and meager support for the poor. Ultimately, both sides' claims were rooted in a reality-- to get the benefits of job security, a high minimum wage, and a strong safety net, you sacrifice take-home pay, ease in getting hired, and social services.
The New York Fed's Liberty Street blog, though, has an interesting post about that phenomenon. Namely, it's been closing. Europeans decided that rigid labor markets weren't all that great after all, and started loosening labor market restrictions and weakening their unions. The US, meanwhile, went even further in the deregulatory direction. As a result, Europe has closed the gap in employment-population ratio pretty dramatically. While the gap hovered right around 10% between 1980 and 2000, it spent the last decade converging, and has almost closed entirely. It was over 10% in 2000, under 5% by 2007, and under 2% now. The trend has been pretty clear-- Europe's employment to population ratio has been on an upward trajectory since about 1992 (likely a rsesult of them loosening their labor market), while the US's has been falling since 2000 (I don't really have a hypothesis for why it's happened here; poring through those statistics is above my pay grade..), but either way the ratio has more or less converged at this point.
The piece of the puzzle I'm trying to piece together is why the US employment to population ratio started dropping in 2000.
The New York Fed's Liberty Street blog, though, has an interesting post about that phenomenon. Namely, it's been closing. Europeans decided that rigid labor markets weren't all that great after all, and started loosening labor market restrictions and weakening their unions. The US, meanwhile, went even further in the deregulatory direction. As a result, Europe has closed the gap in employment-population ratio pretty dramatically. While the gap hovered right around 10% between 1980 and 2000, it spent the last decade converging, and has almost closed entirely. It was over 10% in 2000, under 5% by 2007, and under 2% now. The trend has been pretty clear-- Europe's employment to population ratio has been on an upward trajectory since about 1992 (likely a rsesult of them loosening their labor market), while the US's has been falling since 2000 (I don't really have a hypothesis for why it's happened here; poring through those statistics is above my pay grade..), but either way the ratio has more or less converged at this point.
The piece of the puzzle I'm trying to piece together is why the US employment to population ratio started dropping in 2000.
Experiments in Austerity
The big economic policy debate over the last couple of years has been the proper way to respond to the recession, and the budget issues that it has created in advanced economies. On the one hand, the New Keynesians have argued that, if the country entered the crisis with a relatively low debt burden, could borrow at reasonable rates because of that, and could conduct its own monetary policy, the best way out of recession AND the best fix for its fiscal issues was to use fiscal policy to stimulate growth in the economy. The other view, which isn't really built on any coherent model that I've seen, is that the government should seek to get its fiscal house in order in the middle of a depressed economy because... that would somehow boost "confidence" so much that the newfound confidence would overwhelm the contractionary effects of cutting demand in a downturn. It's also worth noting that these same people make the intellectually incoherent argument that we can't afford to raise taxes in a recession... but we can afford to cut spending (really, if anything, we can afford to raise taxes but NOT cut spending, though it's also coherent to say that we can't afford either).
In our case, the US has been following a policy of muddling along. The Fed was properly aggressive in cutting rates at the outset of the crisis, did another round of monetary expansion (QE2), and since then has been standing pat. The government passed a small (relative to the size of the economy) dose of stimulus (the net effect wasn't stimulative at all, as much of it went to provide relief for cash-strapped states and a further chunk was tax cuts that weren't spent) and has done a bit of fiscal contraction (contrary to nonsense spouted by a lot of Tea Party people, the number of federal workers has actually SHRANK in the downturn), but nothing dramatic was done.
The best test of the austerity hypothesis came in the UK. Their situation was quite similar to ours- relatively low debt, their own monetary policy, and low interest rates being demanded by investors to hold their debt. But when the recession came and administered a shock to their public finances, the Conservative government under David Cameron was elected on a mandate to fix the budget picture. The Tories have been way more sensible than the American GOP (which is completely nuts at this point). They were consistent, in the sense that their deficit hawks were actual deficit hawks and not anti-government crusaders. So they approached the issue by raising some revenue and cutting some spending. If the New Keynesian view is correct, this would not only harm the economy, but also do nothing at all for the fiscal picture. If the austerity view is correct, this would have restored "confidence" to the English economy and spurred growth. So what happened?
Well, Berkeley economist Brad DeLong directs us to David Dayen's post, which reveals that, surprise, England's recovery has stalled. Less than 1% annualized GDP growth since the year started. Even worse than the US's performance, and our initial shock was way bigger than theirs. This should put the silly view that budget consolidation in a downturn is a good idea. Unfortunately, it won't. Instead, we'll here a new reason why austerity is good, it will be proved wrong again, and the cycle will start over.
In our case, the US has been following a policy of muddling along. The Fed was properly aggressive in cutting rates at the outset of the crisis, did another round of monetary expansion (QE2), and since then has been standing pat. The government passed a small (relative to the size of the economy) dose of stimulus (the net effect wasn't stimulative at all, as much of it went to provide relief for cash-strapped states and a further chunk was tax cuts that weren't spent) and has done a bit of fiscal contraction (contrary to nonsense spouted by a lot of Tea Party people, the number of federal workers has actually SHRANK in the downturn), but nothing dramatic was done.
The best test of the austerity hypothesis came in the UK. Their situation was quite similar to ours- relatively low debt, their own monetary policy, and low interest rates being demanded by investors to hold their debt. But when the recession came and administered a shock to their public finances, the Conservative government under David Cameron was elected on a mandate to fix the budget picture. The Tories have been way more sensible than the American GOP (which is completely nuts at this point). They were consistent, in the sense that their deficit hawks were actual deficit hawks and not anti-government crusaders. So they approached the issue by raising some revenue and cutting some spending. If the New Keynesian view is correct, this would not only harm the economy, but also do nothing at all for the fiscal picture. If the austerity view is correct, this would have restored "confidence" to the English economy and spurred growth. So what happened?
Well, Berkeley economist Brad DeLong directs us to David Dayen's post, which reveals that, surprise, England's recovery has stalled. Less than 1% annualized GDP growth since the year started. Even worse than the US's performance, and our initial shock was way bigger than theirs. This should put the silly view that budget consolidation in a downturn is a good idea. Unfortunately, it won't. Instead, we'll here a new reason why austerity is good, it will be proved wrong again, and the cycle will start over.
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