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Updated: 2017-10-07T10:39:47.253-04:00

 



Transfer Pricing Economics

2014-10-29T10:48:08.344-04:00

I'd like to announce that after a long hiatus from blogging, I'm taking it up again in a new forum.  The new blog, Transfer Pricing Economics, is primarily devoted to exploring my particular area of professional specialty, namely "transfer pricing".  If that term doesn't mean anything to you, then feel free to check out my brief explanation of transfer pricing.

My aim is to expose and analyze the connections between the arcane world of transfer pricing and broader developments in the economic and financial world. And the connections are significant: the rules and economic logic of transfer pricing have a direct impact on trillions of dollars of international trade every year. So please feel free to check in on and contribute to the discussions about these issues that governments, tax authorities, economists, and transfer pricing professionals wrestle with every day. 



Cyprus and Eurozone Bank Deposits

2013-03-24T13:22:42.704-04:00

To me, the central issue raised by this week's Cyprus debacle is how it has affected confidence across the eurozone.  To what degree has the possibility of insured depositors at a eurozone bank losing a portion of their deposits affected the mindset of depositors?  To what degree has ECB acquiescence to this possibility undermined the notion that deposit insurance in the eurozone means the same thing in all countries?  And to what degree has the ECB's direct threat to end support for Cyprus's banking system in the event that the government of Cyprus can not arrange sufficient funds to meet its conditions made a farce of its earlier promise to "do whatever it takes to preserve the euro"?

These, to me, are the interesting questions prompted by this week's events.  And while no one can definitively say that they know the answers to these questions, the answers will likely have a very direct bearing on the future of the eurozone.  It's a pity that we need to ask them at all -- if things had been handled better in Brussels, Frankfurt, and Nicosia last weekend then we wouldn't even be thinking about these questions right now.  But they weren't, and we are.

While I don't know how significantly confidence in the eurozone periphery's banks have been shaken by this week's events, I do have an idea of what I will be keeping an eye on over the coming weeks and months: deposits in banks in Greece and Spain.

Perhaps depositors will shrug off this week's events as being particular to Cyprus, with no broader ramifications.  In that case, the eurozone may be able to get back to business as usual.  (Cyprus excepted, of course.)

But if people around Europe's periphery start questioning the commitment of the ECB to banks in the periphery countries, and start considering that insured banking deposits are not actually risk-free if they happen to be in a bank in a southern European country, then it's possible that depositors may start moving their assets out of those banks.

Deposits in the already weak banking systems of Spain and Greece seem to me the most likely to be at risk.  While there's no reason to expect a sudden rush for the exits in those countries, it may not be unreasonable for people to believe that a €100.000 deposit in Deutsche Bank or ING might be a bit safer than the same deposit in Banco Popular or Pireaus Bank.  So why not shift some of that money, just to be on the safe side, before the next crisis hits the eurozone?



A gradual shift of deposits out of Spain and Greece could spell trouble for those banks, even if the shift is well short of what could be called a bank run.  As the chart above illustrates, Spain and Greece s saw their banks' deposits steadily leaving town during 2011 and the first half of 2012.  However, bank deposits in both countries stabilized in recent months, ever since the ECB's unequivocal statement in July 2012.  If people interpret this week's events as undermining that crucial statement by the ECB last July -- an interpretation that I certainly wouldn't argue with -- then we may expect to see the negative trend in peripheral bank deposits resume.  And with it the periphery's banking problems may resume as well.



When the Fed Chair is an Academic

2012-09-15T10:43:07.958-04:00

The big economic news of the week was, in fact, big economic news: the Fed's announcement of significant changes from past practice in the the quantity of its next round of large scale asset purchases ("unlimited"), and in the timing of any future reversal of this expansionary policy ("a considerable time after the economic recovery strengthens").

I view this as a pretty fundamental shift in how the Fed hopes to affect the economy.  Rather than trying to push economic activity one way or the other through its management of interest rates (which can alter economic activity through its portfolio-rebalancing and wealth effects, for example), the Fed is now quite explicitly trying to affect economic activity by altering interest rate and inflation expectations.  As Krugman has put it, the crux of the matter here is that this is pretty close to a "credible promise to be irresponsible".

This is ground-breaking stuff for a central bank.  This type of expectations-management hasn't really been done before -- at least not as an expansionary policy in a zero-lower-bound environment.  And that is why I think that this could only have happened with an academic as Fed chair.  There's a vast academic literature on the channels of monetary policy transmission (important bits of it written by Ben Bernanke himself), and a growing body of academic evidence that suggests that monetary policy's biggest impacts may often be through changing expectations.  Woodford's already-famous August 2012 paper summarizes and crystalizes much of the current thinking on this subject, but the evidence and literature on the expectations channel has been steadily building for more than a decade.

But despite this, it's hard for me to imagine Alan Greenspan, or any Greenspan-like Fed Chair who has primarily a Wall Street background, enacting such significant changes in how monetary policy is conducted purely on the basis of a body of academic research, without prior experience or Wall Street conventional wisdom to fall back on for support.  The academic literature is often theoretically and mathematically complex, and employs statistical techniques that are pretty opaque to most people -- sometimes even to other economists. So unless you're immersed in the field yourself, it would take a pretty big leap of faith to set a new course for monetary policy based solely on the arguments and evidence in such papers.

But Bernanke is immersed in the field.  And so he is in a position to fully understand -- and perhaps more importantly, to really believe -- the conclusions of the academic literature, and therefore to allow that literature to guide the Fed's actions, even though its conclusions have not yet had time to become received wisdom in the financial world more broadly.  And in the current situation, that may make all the difference.

Sometimes a deep understanding of markets and institutions -- such as what one might gain from working on Wall Street -- is probably most helpful to running a central bank.(Think 2008, for example.) But at other times, an academic background can give a Fed Chair profound advantages.  I do not think we would have seen this relatively rapid and remarkably direct implementation of the policy recommendations of academic papers if the Fed Chair had been anyone other than an academic himself.  And with just a little bit of luck, we'll soon have more evidence about whether the academic literature was right.



Government Job Destruction

2012-05-04T09:52:41.151-04:00

Another jobs report in the US, another month where part of the private sector's job creation was undone by continued job destruction by the government sector.


The 15,000 additional jobs lost in April brings total job losses in the government sector since January 2010 to over 500,000. While the US has not quite been experiencing European-style austerity over the past two years, that's still a pretty tough headwind to fight as it emerges from recession.



Eurozone Unemployment and the Recession of 2012

2012-05-03T14:18:41.475-04:00

Europe is on its way back into recession. During the second half of 2011 several EU countries already met the most common definition of recession, namely two consecutive quarters of falling output, including Spain, Italy, the Netherlands, Denmark, Ireland, Greece, Cyprus, Czech Republic, Portugal, Slovenia, and the UK. Correspondingly, European unemployment rates began rising again during 2011, more than undoing the modest recovery they enjoyed in 2010. But while the prospect of a European recession in 2012 is quite bad enough, this understates the scope of the problem. Because not only will this year's recession directly impact millions of unemployed and soon-to-be unemployed EU workers, as well as (for those more fiscally minded) seriously damaging this year's government budget balances, it will have lingering effects on Europe's economies for many years to come. Hysterisis is the notion that the state of the world today has lingering effects on the future. In the context of labor markets this primarily arises because the state of being unemployed tends to make it harder for workers to find a new job, and the longer someone is unemployed the harder it becomes. Unemployment -- especially long term unemployment -- therefore has permanent negative effects on an economy even after economic growth has resumed. Unemployment today damages the economy's potential tomorrow. This should be of particular concern for European policy makers, because the European labor markets have proven to be particularly slow to recover from recessions. To get a rough sense of this, I calculated the weighted-average annual unemployment rate of what I call the "EZ6" -- the six largest eurozone economies, i.e. Germany, France, Italy, Spain, Netherlands, and Belgium -- over the past 20 years. If we compare the EZ6 unemployment rate with real GDP growth over those years, we find that every percentage point of real GDP growth reduces the unemployment rate by about 0.33 percentage points. In other words, for every percentage point that the unemployment rate goes up in the EZ6 this year, those economies will need three years of real GDP growth 1.0% above trend to undo the damage. This is significantly longer than in the US. For the US, every percentage point of real GDP growth causes the unemployment rate to fall by almost 0.5 percentage points, meaning that it takes about two years of growth that is 1.0% above trend to undo a one point rise in the unemployment rate, rather than three. The following chart shows the fall in unemployment rates after the past three recessions in the US. Unemployment rates have been normalized in each case so that the peak rate of unemployment is set equal to 100. Somewhat surprisingly (at least to me), the current unemployment recovery in the US is roughly on par with the previous two recessions. Granted, those previous two recessions were also characterized by frustratingly slow improvements in the labor markets (so presumably we should still hope to do better), but it's nice to be able to place our unhappiness with the present labor market recovery in some context. The next picture shows the same thing for the EZ6, and makes clear that unemployment increases in the eurozone tend to be considerably more sticky. Sometimes, it appears, what goes up comes down only very, very slowly. Even during the relatively successful recovery of 2005-2008 the EZ6 unemployment rate only dropped to about 81% of its peak.To be fair, it's important to recognize that unemployment rates also tend to rise more slowly in Europe than in the US. In 2009, for example, the unemployment rate in the US rose by 3.5 percentage points, while in the EZ6 the unemployment rate only rose by 1.6 pp. However, this doesn't take the sting out of the fact that when unemployment rates do rise in the eurozone -- as they are doing now -- their negative repercussions last considerably longer than in the US. European policy-makers need to r[...]



Turning the Tide on Austerity

2012-04-28T14:16:00.557-04:00

This week the Economist places François Hollande, the socialist presidential candidate who is likely to win the election in France on May 6, on its cover with the headline "The rather dangerous Monsieur Hollande". A socialist in charge of Europe's second-largest economy is apparently cause for serious concern. But why? France is overburdened with a massive welfare state and needs to make changes, argues the Economist: "Public debt is high and rising, the government has not run a surplus in over 35 years, the banks are undercapitalised, unemployment is persistent and corrosive and, at 56% of GDP, the French state is the biggest of any euro country." But looking at the data, France actually does not seem to be doing particularly badly. A look at a few basic economic indicators over the past ten years fails to reveal any obvious signs of an economy that has been oppressed by an oversized government sector, as seen below. Yes, the French have chosen to allow the government to perform more functions than in many other countries, but economic growth has not been notably worse than its neighbors, and its public debt burden is on par with Germany and the United Kingdom. Despite ideological wishes to the contrary, there is little evidence that countries that choose to have a larger government (within a reasonable range) perform worse economically.Hollande's chief sins are, according to the Economist, that he advocates a very high top income tax rate, that he supports a suspension of a planned increase in the retirement age for those who have contributed the longest to the nation's pension fund, and that he has a generally "anti-business attitude". But it's hard for me to see how any of this could spell doom for the French economy. And on the other side of the ledger, Hollande has something extremely important to recommend him to those who care about European economic performance: a potentially strong voice against the counterproductive austerity madness that has dominated eurozone politics for the past couple of years. The tide may be turning more widely in the battle for the eurozone's macroeconomic sensibilities; perhaps the steady repetition by certain prominent voices of the simple truth that austerity is counterproductive under current circumstances may finally be bearing some fruit. But if Hollande becomes France's president, the relative weight of the anti-austerity camp will grow considerably in the eurozone. And that can only mean good news for the future of the eurozone. Won't eurozone bond markets be spooked by Hollande's softness on deficits, though? I doubt it. I tend to think that bond market participants are, on average, quite savvy. And they fully understand (probably quite a bit better than a lot of politicians do) the arguments for why pro-growth policies are the best ways to restore long run fiscal health to eurozone (and other) economies. Instead of causing fiscal armageddon, expansionary fiscal policies could actually reduce national debt burdens in most eurozone countries, given present circumstances. So rather than be afraid of things like a possible Hollande victory, or the collapse of the conservative, austerity-promoting government of the Netherlands, I actually see such developments as reason for the slightest bit of (cautious) optimism. The eurozone crisis is and always has been primarily a balance of payments crisis, not a fiscal crisis. So if we are finally nearing the end of the disasterous blanket prescription for austerity as the solution to the eurozone's financial market crisis, that can only be a good thing.[...]



Eurozone Austerity by the Numbers

2012-04-23T13:02:36.196-04:00

Today Eurostat released its official tally of the budget deficits recorded by the EU and eurozone countries during 2011:

In 2011, the government deficit of both the euro area2 (EA17) and the EU27 decreased in absolute terms compared with 2010, while the government debt rose in both zones. In the euro area the government deficit to GDP ratio decreased from 6.2% in 20103 to 4.1% in 2011, and in the EU27 from 6.5% to 4.5%. In the euro area the government debt to GDP ratio increased from 85.3% at the end of 2010 to 87.2% at the end of 2011, and in the EU27 from 80.0% to 82.5%.

During 2011 the borrowing requirements of the eurozone's governments fell by about €180bn, of which nearly 60% was accounted for by the two largest economies, France and Germany.  But expressed as percent of GDP, it was the countries that have been forced to implement tough austerity measures that were at the top of the deficit reduction list between 2009 and 2011.  The following table illustrates.


Greece, Portugal, and Spain have substantially reduced their deficits over the past two years, despite the fact that their economies were stagnant or contracting. And of course, their terrible economic performance can be attributed in large part precisely to those very same austerity measures, as contractionary fiscal policy in each country has depressed their economies.  Yet eurozone politicians' obsession with deficit reduction continues -- and continues to have new repercussions every day on the eurozone's economies and governments. 



False Starts

2012-02-29T08:56:50.945-05:00

This recovery has taken us on several emotional ups and downs. After a truly horrifying 2008-09, when the financial crisis and plunging real economic activity threw the US economy into the deepest recession since the 1930s, there were glimmers of optimism in 2010. But that proved to be a false start, and by late 2010 the economy was doing little better than during the darkest days of the recession. Again in early 2011 things seemed to be getting decidedly better... only to turn worse again and remain pretty lousy through most of last year.

But over the past couple of months we have now been experiencing a third round of positive signs on the recovery in the US. Is this spring likely to reveal yet another false start for the US economy?

I don't think so. I think this time the improvements are for real, and more sustainable. There are two primary reasons that I say this (putting aside the obvious one, which is "third time's the charm"). First, the housing market finally appears to be well and truly near its cyclical bottom. Yes, house price indexes are still showing some declines, but there is good reason to think that there's very little further for house prices to fall. House price-to-rent ratios and real housing prices are just about where they were in the late 1990s, before the housing bubble was even a glimmer in any home-owner's eye. It's not likely that prices will fall much further. And construction activity has already bottomed out, with changes in real estate construction now adding to economic growth rather than subtracting from it.

The second reason is that the process of debt deleveraging by American households is further along than it was during the false economic starts of 2010 and 2011.

(image) Note: debt figures are from the Fed's Flow of Funds data; figures for 2011 Q4 are forecast.

This debt overhang has been a stubborn impediment to consistent growth in spending activity -- US households have been quite busy paying down the debts they racked up during the 2000s -- but over the past couple of years it has been eroded to a significant degree. This will make it easier for any gains in income to be translated into sustainable increases in spending, supporting the recovery in a way that didn't happen a year or two ago.

No one sensible is likely to be carried away by their excitement about this recovery. It will probably continue to be frustratingly slow in many ways, particularly with the relatively slow pace of job growth. But I do think that the recovery is likely to at least remain a real recovery through the rest of this year, which will be a welcome change from the past few years.



International Capital Flows, House Prices, and the Euro

2012-01-27T10:03:02.605-05:00

Free Exchange’s weekly reading list includes an excellent recent paper by Jack Favilukis, David Kohn, Sydney C. Ludvigson, and Stijn Van Nieuwerburgh: “International Capital Flows and House Prices.” Lots of observers (including me) have noted the suspicious correlation between surges in international capital flows into certain countries in the early 2000s (e.g. the US, Ireland, Spain, Greece, Iceland, Australia) and simultaneous or near-simultaneous surges in house prices in those countries. This paper addresses the question of whether there is in fact a systematic relationship between capital flows into a country and house prices. Were the house price booms of the 2000s caused by international financial flows?The answer provided by this paper is no, or at least not directly. When different possible macroeconomic explanations for changes in average national house prices are considered, it turns out that by far the most important factor is the ease of bank credit. In other words, rising house prices in the 2000s (as well as their subsequent fall) probably had much more to do with the willingness of banks to lend than any other factor. When banks are happy to lend money and they relax lending standards, house prices go up. When banks reverse course, house prices go down. The importance of bank lending standards to the US housing bubble has been well documented and discussed, but this data suggests that the same may be true for a number of other countries as well. On the other hand, countries that did not experience a general relaxation in lending standards in the early 2000s did not experience house price booms. Once changing lending standards are taken into consideration, changes in international capital flows seem to have little additional explanatory power for house price changes.This raises an obvious question: why did credit standards change in certain countries in the early 2000s? Bank lending standards are surely partly endogenous (as the paper discusses) – when banks expect house prices to continue rising, they are more willing to lend, which helps to push house prices higher. That sort of self-fulfilling logic is exactly why changes in house prices (first up and then down) were so extreme in the boom countries between 2002 and 2009. But this story doesn’t explain how the cycle got started in the first place in those countries.For that, we need to look for some factors that can affect bank lending standards that are external to the housing market. Surely, general prospects for macroeconomic growth must play a role there, as well as overall risk tolerance. When a country seems to be headed for better economic times and risk tolerance grows, banks become generally more willing to lend. And that is where we come to the euro. (Were you wondering when I would bring that into the story?)The peripheral euro countries benefited in specific tangible ways from adoption of the euro in 1999, not least from surges in international capital flows that reduced interest rates. Yet this research demonstrates that there is no direct connection between those capital flows and house price booms. So how is the euro involved?This paper provides some evidence that in addition to truly exogenous changes in the supply of bank loans, expectations about future economic growth also have an impact on house prices: all else being equal, when growth prospects improve house prices go up. And more generally, bank lending standards depend heavily on their perception and tolerance of risk.Now consider the likelihood that the adoption of the euro by the peripheral European countries (e.g. Spain, Ireland, and Greece) created expectations for higher growth (and lower interest rates) in those countries, and helped persuade banks to become less risk averse. House prices start to rise and banks become more willing [...]



China in the News

2012-01-06T09:56:38.031-05:00

While 2011 was a busy year for Europe-watchers, I suspect that 2012 is going to be a big year for China-watchers, at least when it comes to developments that will have the potential to dramatically affect the world's financial system and economy. And as has been the case with the eurozone debt crisis, the most significant developments will probably be purely internal. (Note that I don't mean to suggest that we're done with the euro crisis, by any stretch of the imagination.)After years of seemingly unstoppable growth, China's economy has shown some sign of cooling off in recent months. But as always, the sharpest dangers to China's and the world's economy are fundamentally financial. China's property boom seems to be coming to a sputtering halt, and the big question is whether this will turn into a full-blown bubble-burst. But in China such things have an additional layer of significance, because in addition to potentially causing financial disruptions, falling property values could create political disruptions as well. From Marketwatch:China faces social unrest from housing woesHONG KONG (MarketWatch) — Irate Chinese homeowners are among the top policy concerns for Beijing this year, according to analysts who say weakening house prices are stoking serious tensions. ...City University’s Cheng says tensions over the housing market are emerging, even as authorities are proving more adept at defusing conflict in other areas. He points to December’s protest in the southern costal community of Wukan as one example.Frustrations in Wukan over corrupt land deals by the village elite — and the death of a protester there — boiled over when 13,000 Chinese citizens took to the streets, sending the local Communist Party officials fleeing and beating back attempts by police to retake the town. Not exactly the reaction we would expect in the US or Europe to events in local property markets. So while the Chinese government has substantial resources (both financial and adminstrative) that it can throw at this issue if it becomes a serious problem, this is something that we'll have to keep an eye on.Note that one important way that events in China impact the rest of the world is through its exchange rate, which is substantially controlled by China's central bank. With that in mind, Caixin Online recently published an interesting interview with the governor of China's central bank (the People's Bank of China), Zhou Xiaochuan. I admittedly know relatively little about him, but based on what I do know about him Zhou strikes me as a relatively thoughtful policy-maker who has softly but consistently pushed for market-oriented reforms. I encourage you to read the whole thing, but here are a couple of interesting tidbits:Regarding prospects for China's economy in 2012:Caixin: China's macro-economic policies were adapted to fit changing economic situations in 2011. How do you see the economic situation in 2012 and corresponding policy options?Zhou Xiaochuan: The Central Economic Work Conference clearly articulated macro-economic policy, taking into account two considerations: Efforts to prevent an economic downturn, and efforts to restrain inflation.First, we are encountering concurrent issues in the international arena, including an evolving European debt crisis, U.S. economic uncertainty, and slowing growth in emerging economies. More importantly, the international economy is changing rapidly, and its outlook remains uncertain. Thus, we must be prepared to respond to new situations.On the other hand, looking at China's domestic economy, local governments will have leadership reshuffles in 2012 and the capacity for growth in the Chinese economy is still great. At the same time, the consumer price situation has changed for the better, and the need to control inflation is not as pressing as [...]



More House Prices and Current Account Deficits

2011-12-08T16:51:06.234-05:00

Continuing to think about the relationship between house prices and the current account deficit, I put together the following chart showing house price changes in the US (measured by the FHFA's house price index) alongside the US's current account deficit over the past 30 years. Even though I was expecting them to be somewhat correlated, I am still surprised by how incredibly closely the two track each other...

(image)

...And given the relatively close coincidence of the two series, the idea that the causation runs both ways between them seems quite plausible to me.



House Prices and Current Account Deficits

2011-12-07T12:59:18.005-05:00

A new Economic Letter put out by the Federal Reserve Bank of San Francisco, "Asset Price Booms and Current Account Deficits", by Paul Bergin, addresses a subject that I've been thinking a lot about lately. The question is this: is there a systematic relationship between current account deficits and booms in housing prices, and if so, why?The picture to the right (from Bergin's paper) summarizes why many people think that the answer to the first part of that question is yes. There are exceptions, of course, such as the recent boom in property prices in China (which has been running current account surpluses), but looking across countries there's clearly a significant correlation between the house price appreciation and current account deficits. And looking across time within a single country, the relationship is also easy to see -- for example, the biggest boom years in the US housing market (2002-06) coincided perfectly with the largest current account deficits in modern US history. Many European countries experienced the same coincidence in timing.So if we believe that there is indeed a causal relationship between house price appreciation and current account deficits, what's the explanation? Bergin mentions a couple of possibilities:1. Rising house prices make consumers wealthier, so they spend more, which causes an increase in imports.2. Rising house prices give consumers more collateral against which to borrow, easing credit constraints and allowing more consumption, which causes an increase in imports.A third possibility, discussed in a paper by Pedro Gete, is this:3. Rising house prices cause a reallocation of an economy's productive resources away from manufacturing and into construction. The country must therefore source more manufactured goods from elsewhere, leading to an increase in imports.All of these mechanisms are probably at least part of the story. But notice that these explanations all assign the role of cause to the house price boom, and leave the widening current account deficit as an effect. But in some cases at least, it is entirely possible that the causality could go in the opposite direction.When a country experiences a surge in capital inflows -- and yes, I'm thinking particularly about the periphery eurozone countries during the years after euro adoption -- that capital flow itself may have a substantial impact on house prices, for a couple of reasons:4. Capital inflows reduce interest rates, which has the effect of driving up the value of long-lived assets like houses.5. Capital inflows require offsetting current account deficits, which imply a real exchange rate appreciation. With fixed exchange rates (e.g. within the eurozone) this will typically happen through a rise in price levels in the recipients of the capital inflows, and such price increases will disproportionately affect non-traded goods like real estate.This is certainly not an exhaustive list; I think that this is an important area for additional research, both to explore other possible mechanisms as well as to better understand the relative importance of each. Just as importantly, better insight into how capital flows can affect asset prices will be crucial to understanding how policies that affect capital flows might impact house prices, or might even be used to dampen real estate bubbles. And as a bonus, this line of research will also help shed crucial light on how the flow of capital from the core to the periphery in the eurozone, by contributing to real estate booms in the periphery countries, may have done much more to sow the seeds for the eurozone crisis than commonly believed.[...]



Keeping an Eye on Banks

2011-12-02T09:33:35.990-05:00

Banks. They're so easy to hate. And yet they're so important to the functioning of the economy. If the euro crisis is going to have a significant impact on the US, the channel through which it will do so is the banking sector. We're not in a full-fledged banking crisis, but the signs of stress are real, and growing.

Return of the credit crunch: caught in the grip

Banks are the traditional suppliers of credit – to governments whose debt they hoover up; to rivals through interbank lending; to companies, from sole traders to corporate behemoths; and to individuals. Banks provide the oil needed to run the economic machine; without that lubrication the machine seizes up. But to carry out that role, the banks themselves need money. And that is where the whole model is breaking down.

...As fears over the integrity of the eurozone have deepened, European banks have found it expensive, difficult or in some cases impossible to raise funding in the bond markets. So far they have covered barely two-thirds of the amount of outstanding funding that falls due in 2011. For most banks, the bond markets have been closed for months.

...The few banks that have plenty of money are holding on to it, or depositing it with super-safe institutions such as the US Federal Reserve or the ECB. That means the third key mechanism for bank funding – interbank lending – is also drying up.

...The nervousness surrounding many European banks is rooted in fears about losses they face, particularly on their sovereign debt holdings. Bankers recognise the concerns but complain that the effect is being compounded by regulators’ insistence that the banks should meet tough new capital ratios. The European Banking Authority, which oversees bank regulators across the continent, has identified a total €106bn ($143bn) gap at 70 banks that it stress-tested for their exposure to eurozone sovereign debt. Rather than raise fresh capital in turbulent equity markets to bridge that gap, many are opting instead to shrink their balance sheets and comply with the capital ratios that way.
Regulators, policy-makers, and most observers agree that in order to boost confidence in the banking system (as well as to reduce the odds of a major bank going bust), many of Europe's banks need to increase their capital ratios, which is the amount of core capital they have to work with divided by the amount of loans they have made. But there are two ways to get to a higher capital ratio: by increasing the numerator, or by decreasing the denominator. Bankers argue that given the amount of capital they currently have, calls to increase their capital ratios force them to reduce their lending activities and shrink their loan portfolios. But that is exactly the opposite of what policy-makers intended, of course: the hope was that banks would maintain their portfolios of loans while raising more capital.

In the absence of specific, enforceable requirements that banks meet capital ratio requirements by raising more capital, there's no reason to expect Europe's banks to reverse the current tendency to try to meet capital ratio targets by reducing the size of their loan portfolios. After all, it's expensive to raise capital, and the current ethos of risk-aversion means that extending new loans is not at the top of the list of things that banks want to do. The depressing similarities with the events of 2008 continue...



When the Euro Was Good for Germany

2011-11-30T10:49:19.257-05:00

During the good years, the economic benefits of the common currency in Europe were fairly easy to recognize. The countries on the eurozone's periphery -- Spain, Portugal, Greece, and to a lesser degree Italy -- had improved access to international capital markets, enjoyed lower borrowing costs, and experienced substantial investment booms as a result. Meanwhile, the countries in the eurozone core such as Germany, France, and the Benelux countries enjoyed a surge in exports to the rapidly-growing periphery. Importantly, they also enjoyed the higher returns that they could earn by investing in companies, assets, and projects in southern Europe. The gains from the common currency were shared by north and south.Now, of course, Germany is pondering just how much it is willing to pay to keep the currency union intact. An important part of that calculation is an understanding of what the benefits to Germany were during the good years. There's been some debate about that in recent weeks, for the most part focusing on whether and how much Germans benefited from the export boom of 2004-08. But another element of the calculation should be the higher investment income that German individuals and corporations earned from the new investment opportunities afforded by the common currency.The following charts illustrate the surge in investment income earned by the core eurozone countries during the 2000s. The first expresses foreign investment income in billions of euro, while the second shows that income relative to GDP. (Data is from Eurostat.)A couple of important caveats. First, this data is from national balance of payments statistics, which measures foreign income earned by each country from the entire rest of the world. We don't have an easy way to directly measure how much of the increased investment income earned by these countries was specifically from the eurozone periphery. However, given everything else we know about the pattern of capital flows within Europe during that time, and the timing of the surge in investment income (the euro was adopted in 1999, and the boom really happened right after the economic slowdown of 2001-02 ended), it seems a safe bet that the much or most of this increased investment income was from southern Europe.Second, we don't know what the pattern of investment income earned by the core eurozone countries would have looked like in the absence of the common currency. In the absence of the counterfactual, we can only make an educated guess about the impact of the euro. In this case, however, I think there's every reason to believe that the massive capital flows from core to periphery, the associated investment boom in the periphery, and the surge in investment income enjoyed by the core during the years leading up to the crisis would not have happened without the euro. I would therefore attribute the vast majority of the increased investment income earned by the core from the periphery during the 2000s to the euro. Given that, this data suggests that the euro enabled Germany to enjoy increased investment income of perhaps €30 to €40 billion per year, or between 1% and 2% of GDP. The Netherlands also enjoyed an income boost of up to 2% of GDP during the best years of the 2000s, while the euro helped France to earn higher investment income equal to perhaps 1% per year. Are these figures large enough to justify substantial additional spending by Germany to keep the eurozone intact? I have no idea. Keep in mind that this does not tell us anything about the economic benefits that the core eurozone countries enjoyed thanks to their increased exports to the periphery. And most importantly, the benfits of the common currency have always been[...]



Italy and Japan

2011-11-29T16:02:58.334-05:00

Consider the following differences between Italy and Japan. Italy has a history of lower budget deficits, as well as forecast budget deficits for the next few years that are dramatically lower than those forecast for Japan:(All data is from the OECD; figures for 2011 and 2012 are forecasts.)Italy's debt to GDP ratio has remained roughly constant over the past 15 years, while Japan's has climbed steadily higher:Both countries have had relatively poor economic growth over the past decade, with little difference between them:And yet, despite all of this, yields on Japanese 10-year government bonds hover around 1.0%, while yesterday the Italian government was forced to pay nearly 8.0% to borrow money for 10 years. Given how much worse Japan's public finances look when compared to Italy's, it seems unlikely to me that investors are demanding higher interest rates from Italy simply because they are worried about excessive budget deficits or debt. So what explains the dramatic disparity in investor willingness to lend to Italy compared to Japan? There are three crucial differences between Italy and Japan that, when put together, create a coherent story about what lies at the heart of this crisis:1. Japan has the ability to create its own currency, while Italy does not.2. Japan has been running current account surpluses, while Italy has had a current account deficit for the past several years.3. Japan can borrow at 1.0% while Italy must pay much more to borrow.Item #1 on this list has helped to cause the crisis for the reasons noted by Paul DeGrauwe: by giving up its own currency, Italy lost the important backstop on its government borrowing costs that countries that can borrow in their own currency have. This was a key prerequisite for this crisis to take hold.Item #2 on this list is important because at its heart, this crisis can be seen as a balance of payments problem. Italy (along with the rest of southern Europe) has been dependent on capital flows from northern Europe to meet its borrowing needs, as reflected by the large current account deficits Italy has experienced in recent years. But private capital flows are notoriously fickle, and when they stop, a balance of payments crisis can ensue. What we're seeing in southern Europe right now is a variation of that.Item #3, you'll notice, is simultaneously cause and effect. This is the self-fulfilling downward spiral that Italy has become trapped in. Once the necessary conditions were established by item #1, and once Italy became vulnerable to a stop in private capital flows thanks to item #2, the dynamics inherent to self-fulfilling crises took hold -- and events have mercilessly followed that unforgiving logic to the point in which Italy finds itself today.On the other hand, government deficits in Italy had little to do with getting it into this mess. Which is why all of the stern talk in Europe about setting up firm and credible ways to discipline countries into being fiscally responsible will do nothing to end the crisis in the short run, and nothing to prevent it from happening again in the long run.UPDATE: I should have mentioned that item #1 goes hand-in-hand with one additional ingredient to Italy's current predicament: the lack of a flexible exchange rate that could adjust in response to the stop in private capital flows. Such an exchange rate adjustment would improve Italy's external competitiveness and reduce its relative income, which in turn would help Italy bring its current account back toward balance. Again, the point is that this crisis is primarily a balance of payments problem, not a budget deficit problem.[...]



Programming Note

2011-11-14T21:24:08.696-05:00

My apologies for the light posting lately -- other commitments are keeping me busy right now, but I should be able to get back to more regular posting next week. (I'm going to trust that the eurozone will hold itself together for another week at least.)

In the mean time and apropos of nothing, I'll simply take this chance to refer you to an astronomical applet that I find unreasonably entertaining: Galaxy Crash.



Scarce Job Openings in the US

2011-11-10T21:05:06.456-05:00

Earlier this week the BLS released new data on the number of job openings, hires, and separations in the US labor market for September 2011. The headline story from that news release was that the number of job openings in the US continued what has been a pretty solid and steady rise over the past year.Some have interpreted this news as possible evidence that the US labor market is beset with structural unemployment problems; if the number of job openings is increasing so strongly, then the relatively slow increase in the level of employment must be due to the fact that unemployed workers are mismatched to the types of jobs that are available, right? The unemployment problem in the US, the reasoning goes, must be significantly the result of this worker-job mismatch -- which is a "structural" problem -- rather than low demand. From the FT:High US joblessness puzzles economistsThe stubbornness of high unemployment despite a steady rise in the number of job openings in the US since the end of the recession is posing a puzzle to economists as they try to understand the troubled labour market.New data released this week show that the number of vacant jobs in the US rose to 3.4m in September – the highest in more than two years – even as the unemployment rate remains mired at 9 per cent.The question is whether the rising rate of job openings, derived from the Job Openings and Labour Turnover Survey, is the better indicator of a steady recovery in the labour market or whether the fact that vacancies are being advertised but not filled points to an underlying malaise...But I don't actually think that this data actually provides any support for the structural explanation of the US's stubbornly high unemployment rate. While the number of job openings has indeed risen substantially over the past year or two, that was from an abysmally low level in 2009. Even now, the total number of private sector job openings is just barely back to the level of jobs available at the worst of the 2001-03 employment recession in the US, as shown below.The fact is that there are still terribly few jobs available relative to what is normal for the US economy. Meanwhile, the number of net new hires (i.e. total new hires minus the number of worker separations due to both voluntary quitting and involuntary layoffs) has been averaging about 100 thousand people per month recently, which is disappointingly small. But compared to the relatively small number of job openings, this is actually fairly decent performance. Dividing the number of net new hires by the number of available job openings we find that jobs are actually being filled at a decent rate -- more or less at the same rate as during the relatively good labor market years of 2004-07.This suggests that it is not any more difficult to match people with positions today than usual. The dominant feature of today's job market is simply that there are still very few job openings; companies in the US remain reluctant to hire more people. That is not the result of any structural, skills-mismatch sort of problem. That is simply the result of firms feeling that they do not yet need to hire more workers. It's yet more evidence (see here for another type of evidence) that the US's unemployment problem is the result of plain old insufficient demand.[...]



Italy: Illiquid-but-Solvent

2011-11-09T17:07:52.703-05:00

Evidence for the argument that Italy is having a liquidity crisis, not a solvency crisis:
Italian Yields Top 7%

Italian bonds slumped, driving two- five-, 10- and 30-year yields to euro-era records, after LCH Clearnet SA raised the deposit it demands for trading the nation’s securities.

Two-year note yields rose above 10-year rates, with five- year debt climbing above 7.5 percent as Prime Minister Silvio Berlusconi’s offer to resign left his weakened government struggling to implement austerity measures to reduce borrowing costs.

...The yield on Italy’s five-year notes jumped 82 basis points, or 0.82 percentage point, to 7.70 percent at 11:56 a.m. London time.
The rate on Italy's ten-year bonds are currently at about 7.25%, creating a fairly sharp inversion over the 2-to-10 year portion of the yield curve. In other words, while investors are demanding a risk premium on all maturities of Italian bonds, they are now demanding a higher risk premium on shorter maturity bonds than on longer maturity bonds. This implies that market participants believe that Italy's potential difficulties in repaying its bonds are concentrated in the next couple of years, and that if Italy can get through that stretch then the risk of default diminishes.

This is not to say that there couldn't also be some concerns about Italy's long-term solvency; but those concerns are clearly being overshadowed by worries that Italy may not make it through its current liquidity crisis. Which means that no matter what steps are taken to change Italy's long-term budget picture, if Italy isn't provided with the liquidity it needs to get through the next couple of years, then long-run solutions are really rather irrelevant.

Liquidity, liquidity, liquidity.



Days, Not Weeks

2011-11-09T17:08:12.181-05:00

Today Ryan Avent wrote the post that I had been intending to write myself. So I will simply turn things over to him (though please click through to read his entire comments):
Finito?

SILVIO BERLUSCONI'S promise to resign has done nothing to calm European bond markets. Italian bond yields are soaring today; both the 2-year and the 10-year are above 7%. There are rumours that the ECB is in the market and buying heavily. If so, it's not having the desired effect. The ECB can't hope to keep yields reasonable through brute force. It will need to make an expectations-changing announcement. Will it? Italy's yields aren't the only ones rising. Markets are ditching Irish, Spanish, Belgian, and French debt too.

...I have been examining and re-examining the situation, trying to find the potential happy ending. It isn't there. The euro zone is in a death spiral. Markets are abandoning the periphery, including Italy, which is the world's 8th largest economy and 3rd largest bond market. This is triggering margin calls and leading banks to pull credit from the European market... The cycle will continue until something breaks. Eventually, one economy or another will face a true bank run and severe capital flight and will be forced to adopt capital controls. At that point, it will effectively be out of the euro area. What happens next isn't clear, but it's unlikely to be pretty.

...I hate to get this pessimistic about the situation. It feels panicky and overwrought. I can't believe that Europe would allow so damaging an outcome as a financial collapse and break-up to occur.
I wish I didn't agree so completely with Ryan's assessment. The ECB is the only institution that can put a stop to this. And they have days, not weeks, in which to decide if they are going to do so.



Those Awful Banks

2011-11-06T09:31:14.770-05:00

It's remarkable the degree to which so many people from vastly different countries, backgrounds, and political inclinations all share a bitter and seething rage against the world's big financial institutions. Everyone hates big banks, and today's Bank Dumping Day is only one of many signs of that deep loathing.Given this near-universal hatred of banks and bankers, the idea of providing them with taxpayer support is pretty much intolerable to most people. The widespread disgust felt about the US's TARP bailout of banks in 2008 provided fuel for both the Tea Party movement's popularity in 2010 and the Occupy Wall Street movement of this fall. In the eurozone, banks are reviled in the troubled periphery countries, where austerity measures are seen in part as a mechanism devised to shift the pain of the eurozone debt crisis from banks to the people. And in the core eurozone countries like the Germany, the public is understandably angry at the idea of having to provide funds to restore European banks to financial health thanks to the crisis.The Financial Sector and the 1%There are plenty of reasons for these intensely negative feelings about financial institutions. One of the most important may be the extraordinary concentration of wealth and power that has accumulated among the world's financiers over the past couple of decades. Income inequality in the US, for example, is almost entirely a story about the richest 1% pulling away from everyone else -- and a substantial portion of that richest 1% have the financial industry to thank for it. In the US, the compensation paid to employees in finance, together with financial sector corporate profits, added up to close to $200,000 (in constant 2005 dollars) per each person working in the finance industry in 2010, according to BEA data (NIPA, section 6). In real terms this figure has almost doubled since the early 1990s, and more than tripled since 1980. By contrast, inflation-adjusted median household income in the US is unchanged over the past 20 years. This remarkable rise in the fortunes of people working in the US's financial industry almost perfectly matches the rise in the income share going to the richest 1% of Americans. It's certainly possible that this correlation is spurious. But it's also natural to consider that perhaps this is not just a coincidence.(Note: data on top 1% from Emmanuel Saez.)The Story Behind the NumbersWhat has driven this impressive concentration of power and wealth into the few hands that control the world's financial system? It's hard to escape being drawn toward the conclusion that the rules of the system have indeed been subtly, slowly changed over the last 30 years, simply because no alternative explanations seem to fit. To see this, let me make four uncontroversial (I hope) observations:The US's political system is far more dependent on financial contributions from super-wealthy contributors than it used to be.Contributors tend to give more money to political actors that will do things that they like.Since the US is a democracy, the US's political system establishes the rules of the game by which individuals and corporations must play.Super-wealthy individuals in the US have grown even more super-wealthy over the past two three decades, and thus more able to fund the US's political system. (See point 1.)Of course, there could be more than one possible explanation for this series of observations; they could be completely unrelated phenomena, for example. However, it's also possible that these phenomena do indeed have something [...]



Italy's Future

2011-11-02T10:54:13.395-04:00

Italy's Prime Minister, Silvio Berlusconi, is apparently going to propose some "shocking measures" in an attempt to get control of the downward spiral that the market for Italian government debt is currently experiencing. Most likely (thanks to the urging of Germany and France) these shocking measures will be composed primarily of sharp cuts in government spending.This will fail to help. The market is not worried about Italian debt dynamics because of excessive government spending. It is not worried about Italian debt dynamics because of an excessive primary (i.e. excluding interest payments) budget deficit in Italy. It is worried about Italian debt dynamics simply and purely because of skyrocketing interest rate expenses that the Italian government is now facing thanks to the eurozone debt crisis.In the table below I present three scenarios for the path of Italy's budget deficits and gross government debt (both as a % of GDP). Scenario 1 is the OECD's most recent forecast for 2012. To extend that baseline a bit, let's say that 2013 would look like 2012 in the absence of other changes. Note that the OECD's forecast is for Italy's debt/GDP ratio to remain roughly constant. Until very recently, there was no particular worry about the Italian debt burden getting out of hand. It is not at all obvious that under the baseline OECD forecast there is any particular urgency for Italy to reduce its budget deficit.Scenario 2 illustrates why, even though the market is not worried about Italy's primary budget deficit (since Italy actually runs a primary surplus), it has good reason to be VERY worried about the recent rise in Italian borrowing costs. Suppose that in 2012 and 2013 Italy has to pay 250 basis points (i.e. 2.5%) higher interest rates than assumed in the OECD forecast. Suddenly Italian debt dynamics look very scary -- Italy's debt/GDP ratio, instead of remaining flat, will take off on a frighteningly familiar upward trajectory. (Hello Greece, here we come...)Scenario 3 then supposes that the Italian government enacts dramatic cuts in government spending - let's say, cuts equal to 2% of GDP in both 2012 and 2013. Will that fix the problem?The answer is clear: no. If anything, it will make the problem worse.Cuts in government spending will be overwhelmed by Italy's higher borrowing costs, which are far, far greater in euro terms than any cuts in government spending that could realistically be acheived. And so Italy's budget deficit will still rise sharply. And if we assume that severe austerity will likely lead to a contraction in Italian GDP, as it has done in the UK, Greece, and elsewhere, then the trajectory of Italy's debt looks even worse with the cuts in government spending than it did without them. (I assume a government spending multiplier of 1.0 in this scenario.)Austerity as a response to the recent rise in Italy's borrowing costs is exactly the wrong policy prescription. It misdirects attention from the real problem here, which is the self-fulfilling doom spiral in the debt market that Italy has gotten trapped in. The only way to break out of this cycle is to do something radical to change market expectations. The ECB is the only institution that has such power right now. And yet it seems likely that they will sit on the sidelines, or even applaud Italy's austerity proposals -- the very proposals that are almost certain to make things worse rather than better.[...]



Swiss Magic and Central Bank Price-Targeting

2011-10-31T21:24:10.839-04:00

You may recall that in September the Swiss National Bank (SNB) announced that it was going to intervene as necessary in the currency markets to ensure that the Swiss Franc (CHF) stayed above a minimum exchange rate with the euro of 1.20 CHF/EUR. How has that been working out for them?It turns out that it has been working extremely well. Today the SNB released data on its balance sheet for the end of September. During the month of August the SNB had to spend almost CHF 100 billion to buy foreign currency assets to keep the exchange rate at a reasonable level. But in September -- most of which was after the announcement of the exchange rate minimum -- the SNB's foreign currency assets only grew by about CHF 25 billion. Furthermore, this increase in the CHF value of the SNB's foreign currency assets likely includes substantial capital gains that the SNB reaped on its euro portfolio (which was valued at about €130 bn at the end of September), as the CHF was almost 10% weaker against the euro in September than in August. Given that, it seems likely that the SNB's purchases of new euro assets in September after the announcement of the exchange rate floor almost completely stopped.But why would the SNB's promise of unlimited intervention in currency markets have led to a near total cessation of those interventions? Didn't they say they would intervene more, not less? This is a beautiful demonstration of the almost magical power that central banks can sometimes have when they target prices instead of specifying a certain quantity of intervention. Market participants correctly believed that the SNB's promise to keep the CHF/EUR rate above 1.20 was perfectly credible. As such, no one was willing to try to accumulate CHF at a price inconsistent with that floor. In fact, there has been some sense in the market that this 1.20 rate was going to be increased, which would guarantee losses for anyone holding CHF assets. As a result, market demand for CHF has fallen dramatically and the exchange rate has drifted up above the 1.20 floor set by the SNB -- all with little or no actual intervention required by the central bank.This should be a reminder to other central banks that when they target prices by promising unlimited intervention, the market will often do most of the work for them and respect that price target out of its own self-interest. So let's apply this lesson to another situation: the doom loop that the market for Italian debt seems to have entered. Imagine that the ECB declared an interest rate ceiling and stated that it would not allow the rate on Italian bonds rise above some clearly specified spread over German interest rates. (Obviously this should be at an interest rate consistent with long-run Italian solvency.) And imagine that the ECB backed up that interest rate ceiling by promising unlimited intervention to support it. Since the ECB can make good on that promise by simply creating more euro -- which it can do in unlimited quantities -- market participants would understand that there is no way they could break the interest rate ceiling set by the ECB. And as a result, it is entirely possible that the ECB could achieve its price target on Italian debt with minimal intervention, just as the SNB achieved with its exchange rate floor.What's preventing the ECB from doing that? Caution, conservatism, and politics, of course. But the Swiss Franc experience reminds us that, from an economic perspective, price targeting by a central bank can sometimes make very[...]



Worrying Signs

2011-10-28T08:59:34.678-04:00

I don't like seeing stories like this just a day after the eurozone's latest and greatest rescue plan was announced:Italian borrowing costs surge in lacklustre auctionItaly issued 10-year debt on Friday but paid the highest price since joining the euro as investors demonstrated scepticism over the centre-right government’s economic reform programme in the first bond auction in the region since new steps were agreed to tackle the eurozone debt crisis....The yield on Italy’s March 2022 bond rose to 6.06 per cent from 5.86 per cent a month ago. The sale of the 10-year bonds was covered less than 1.3 times, but demand for the total sale of medium and long-term paper was sufficient for the Treasury to raise €7.94bn – at the top end of its target range. The yield on a three-year debt maturing in July 2014 rose to 4.93 per cent, at its highest since November 2000, compared to 4.68 per cent at an end-September sale.“All in all, today’s auction was not very satisfying,” said Annalisa Piazza at Newedge Strategy. “Although the EU summit welcomed the new measures the Italian government is planning to implement in the next eight months to ‘change’ the economy, markets remain sceptical about the outcome.”Officials recognise that yields at this level are unsustainable in the long term with Italy needing to roll over more than €250bn next year to finance its €1,900bn debt burden amounting to 120 per cent of gross domestic product...Meanwhile, the ECB has apparently been forced to buy up more Italian debt on the secondary market since the new eurozone rescue plan was announced. But because of the ECB's obvious reluctance and the backwards way that they've structured their bond-buying program, such purchases probably have very little effect, other than to reinforce market skepticism about Italian debt.I've argued repeatedly that the ECB can and should assume full responsibility for ending this crisis, and that it should be targeting interest rates on the secondary markets for Spanish and Italian debts. Paul De Grauwe articulates this reasoning perfectly in a column this week, and more generally expresses how painful it is to watch the ECB make mistake after mistake:There is no sillier way to implement a bond purchase programme than the ECB way. By making it clear from the beginning that it does not trust its own programme, the ECB guaranteed its failure. By signalling that it distrusted the bonds it was buying, it also signalled to investors that they should distrust these too.Surely once the ECB decided to buy government bonds, there was a better way to run the programme. The ECB should have announced that it was fully committed to using all its firepower to buy government bonds and that it would not allow the bond prices to drop below a given level. In doing so, it would create confidence. Investors know that the ECB has superior firepower, and when they get convinced that the ECB will not hesitate to use it, they will be holding on to their bonds. The beauty of this result is that the ECB won’t have to buy many bonds.I am not impressed by the direction in which things have been heading in Europe this week. My sense is that, like me, many financial market participants have been suffering from so much 'crisis exhaustion' that they were willing to give this week's rescue package the benefit of the doubt and believe that it was in fact sufficient to permanently put things on a stable footing. Everyone wants this crisis[...]



Liquidity, Solvency, and Competitiveness

2011-10-25T19:11:35.121-04:00

Kantoos considers whether it is obvious that the eurozone debt crisis is, at least with respect to Spain and Italy, merely a liquidity crisis and not an issue of fundamental insolvency:The problem is how to distinguish a multiple-equilibria situation from cases of genuine one-equilibrium insolvency – especially for countries as the future capacity to repay is not based on assets in a narrow sense but on the expectation of future economic growth. ...For Italy and Spain, there is a reasonable chance that it is in fact a self-fulfilling liquidity problem, but – and that was my main point – it is by no means certain. A backward-looking remark about Italy having a primary surplus is just not enough to make your case and Henry’s analysis is not encouraging.A few points. First, take a look at the following chart that shows the debt/GDP ratios for a number of major European economies. See if you can tell which country is Spain. (All data is from Eurostat.)If the markets believed that Spain (the blue line) is fundamentally insolvent -- or even at risk of becoming fundamentally insolvent in the foreseeable future -- then wouldn't such solvency concerns have also hit the debt of Germany, France, and the UK? (Those are the other three lines in the chart.) Given this, it seems overwhelmingly likely to me that the market's nervousness about Spanish debt is of the nature of a self-fulfilling "illiquid-but-solvent" crisis.And what about Italy? Italy's debt/GDP ratio is indeed high -- over 100%. But that ratio has been over 100 percent for the past 20 years, so that's nothing new. And in recent years, Italy's budget deficit has been relatively small, as seen below.Again, it seems far from obvious from this why market participants would have become worried about Italy's insolvency but not that of France or the UK.There are two factors that Spain and Italy do have in common, however, that sharply distinguish them from France, Germany, and the UK. The first is that they do not have a central bank to provide unlimited liquidity to the government if necessary. The UK clearly does, by contrast, and I think most people would expect that the ECB would also perform that function for Germany if necessary. France is in a bit of a grey area there, which is exactly why the markets have inserted some additional risk premium into French government bond yields in recent months.The second factor is the long run issue that Kantoos draws attention to: the competitiveness problem. The UK has no such problem, because its flexible exchange rate will automatically adjust its competitiveness to match the amount of financing it is able to attract; if investors become less willing to finance the UK's debt, the pound will lose value and the UK will start to gain competitiveness. Germany has no such problem, because it has undergone a steady improvement in its relative competitiveness ever since the adoption of the euro. And France is much closer to Germany than to Italy as far as competitiveness goes.But where I would disagree with Kantoos is his assessment that Germany's improvement in competitiveness during the euro period was policy-driven, and that Italy and Spain's competitiveness problems are the result of their unwillingness to tackle the problem.The changes in competitiveness in each of the eurozone countries during the years leading up to this crisis were driven by capital flows within the eurozone. Countries that receiv[...]



The ECB: Unwilling Saviour

2011-10-25T09:56:43.281-04:00

Joseph Cotterill at FT Alphaville reiterates an important theme today: the solution to the eurozone crisis really rests with the ECB.The ECB is not here to save the world...You might quibble with some parts of the plan [for much greater ECB support to eurozone sovereigns] but at least it is very clear about its starting point, the ECB. And of course many analysts have been calling for crisis solutions to move on from the EFSF’s finite balance sheet, to making use of the ECB’s omnipotent, effectively limitless balance sheet. Think of all the deep pockets of seigniorage, oodles of liquidity, et cetera. Only the ECB can absorb the quantum of sovereign losses, other analysts argue.We definitely wouldn’t say this argument is wrong, or unworkable... However... What we will say is that the ECB would never go along with it – based upon what the ECB has been doing so far. ...Frankly, at this point we’re open to theories on why the ECB has resisted the calls to provide sovereign liquidity.The ECB is really the only institution that can establish a backstop in eurozone sovereign debt markets that is completely credible. This would be especially effective if the ECB targeted an interest rate for Spanish and Italian bonds rather than a quantity of intervention, as I've suggested previously.But there's another reason that it would be appropriate for the ECB to be at the heart of the solution. In a recent paper (pdf) Paul DeGrauwe points out that an essential ingredient to the crisis is the fact that the adoption of the euro meant that sovereign nations in the eurozone could no longer borrow in their own currency. As he puts it, "in this sense member countries of a monetary union are downgraded to the status of emerging economies." The difficulty this creates is that since the central banks of these countries can no longer provide unlimited domestic currency liquidity to the government, default becomes a possibility in a way that it was not before euro adoption.The solution to this flaw in the system is to have the new, joint central bank -- the ECB -- take up the role that individual central banks previously had of ensuring that their own government would never have to default on domestic currency debt simply due to liquidity problems. If the ECB were to assume that role today, default would be completely taken off the table as an option for investors to worry about in the markets for Spanish and Italian debt, which would guarantee that this crisis could no longer spin out of control as it is currently threatening to do. Regardless of whether European leaders agree use the ECB as the immediate solution to the crisis, I would argue that if the eurozone is to survive in the long run, the ECB is going to have to be explicitly granted the authority -- and indeed the responsibility -- for doing just that. If they want to have a common currency and all of its benefits, the eurozone countries need to accept the drawbacks that come with it. And one of those drawbacks is that the ECB will have to not just be the guardian of the eurozone's inflation rate, but will also have to be an effective guardian of Europe's financial system, even at the potential cost of slightly higher inflation during certain limited episodes.But as Cotterill points out, there is very little chance that the ECB will actually agree to take on this role. So do not expect this crisis to come to a neat conclusion t[...]