Thursday, December 08, 2011

More House Prices and Current Account Deficits

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...

...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.

Wednesday, December 07, 2011

House Prices and Current Account Deficits

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.

Friday, December 02, 2011

Keeping an Eye on Banks

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...

Wednesday, November 30, 2011

When the Euro Was Good for Germany

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 perceived to be at least as much about politics as economics, and I'm not sure how we would go about quantifying those political benefits. But this sort of analysis does at least give us some rough sense about the magnitude of one specific type of benefit that countries like Germany and France enjoyed from the euro during the good years, and therefore puts a floor on our estimate of the overall benefits of the euro to those countries that are now considering whether to save it.

Tuesday, November 29, 2011

Italy and Japan

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.

Monday, November 14, 2011

Programming Note

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.

Thursday, November 10, 2011

Scarce Job Openings in the US

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 economists

The 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.

Wednesday, November 09, 2011

Italy: Illiquid-but-Solvent

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

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):

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.

Saturday, November 05, 2011

Those Awful Banks

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 Numbers

What 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:
  1. The US's political system is far more dependent on financial contributions from super-wealthy contributors than it used to be.
  2. Contributors tend to give more money to political actors that will do things that they like.
  3. Since the US is a democracy, the US's political system establishes the rules of the game by which individuals and corporations must play.
  4. 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 to do with each other. All we need to do is posit some mechanism by which #3 above could have led to #4, and the logical loop is complete. My candidate would be this:

3.5: The rules pertaining to the financial system have been modified over the past two decades in such a way that it has facilitated the concentration of wealth and power in the financial sector.

And now we have a complete and consistent logical story of a self-sustaining cycle in which greater concentration of wealth leads to more political influence by the super-wealthy, which leads to rule-changes to their benefit, which leads to greater concentration of wealth. And the financial sector is the arena in which this cycle has largely been played out.

Whether or not you believe this story, it is a plausible one, and it should not come as a surprise that many people believe it. And I think this is exactly what lies at the heart of the anger and frustration felt by so many toward the finance industry.


And now we get to the fuel that has been repeatedly added to this already hot fire in recent years: the repeated use of taxpayer money to rescue big banks, both in the US and Europe. The latest plan to end the eurozone debt crisis has, as one of its core elements, a commitment of additional taxpayer money to help keep Europe's banks afloat; the string of bank bailouts continues.

The whole idea of using taxpayer funds to support the financial system is justifiably difficult to digest. Weren't the world's biggest financial institutions exactly the cause of the financial meltdown in late 2008? Aren't they also substantially responsible for the eurozone debt crisis through their unwise lending? And in between these various crises, haven't they been earning obscene amounts of money while crying foul any time they are asked to share it through higher upper-income tax rates? So why should taxpayers lift a finger to help the world's bankers in those instances when they've bet the wrong way?

The problem is that banks are absolutely essential to our economic system. Like it or not, they are special. This is largely the result of their unique ability to make loans, create money, and direct capital toward sectors of the economy that need it. Without financial intermediation, today's economy would immediately grind to a halt. The health of the world's economy is, without exaggeration, completely at the mercy of the banking sector.

And that is the icing on the cake. It's awful to contemplate that our basic economic system, and the very livelihood of most of us who participate in world's modern market economy, are crucially dependent on institutions that are so hard to understand, have done so much to concentrate wealth and power among the privileged few, and are directly responsible for financial chaos and crisis. But it's doubly awful to be forced to repeatedly bail them out under threat of widespread economic catastrophe, which is exactly what would happen in the absence of those bailouts. It really violates every fundamental notion of fairness.

The remedies for this situation are precisely those policies that the financial industry hates the most: significantly more government oversight, and/or mechanisms through which taxpayers can share in the benefits the financial sector brings during the good times. In the absence of such measures to rectify the basic unfairness of the current system, antipathy toward the world's financial industry will only grow. And with good reason.

Wednesday, November 02, 2011

Italy's Future

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.

Monday, October 31, 2011

Swiss Magic and Central Bank Price-Targeting

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 good sense.

Friday, October 28, 2011

Worrying Signs

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 auction

Italy 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 to be over. But the inadequacies of the plan are real, and will only become more apparent over time. I hate to say it, but I fear that we haven't reached the final fix yet.

Tuesday, October 25, 2011

Liquidity, Solvency, and Competitiveness

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 received large capital inflows saw their prices rise in relative terms and their competitiveness worsen, which in turn helped to bring about the current account deficits that are the counterpart to those capital inflows. Conversely, countries that sent capital abroad saw their relative prices fall and competitiveness improve, for the same reason. Policy had little to do with competitiveness changes; they were a macroeconomic necessity entailed by the flow of capital from capital-rich countries like Germany to capital-poor countries like Spain.

The following table ranks the major eurozone countries in order of their current account balances between the adoption of the euro in 1999 and the onset of the financial crisis in 2008. Using total changes in the price level to provide a quick-and-dirty estimate of changes in competitiveness, it's clear that the relationship between the two is very strong -- countries that experienced capital inflows saw their price levels rise and their competitiveness worsen. The implication is that in the absence of policies to stem the inflow of capital, there was probably nothing they could have done to prevent that.

To summarize: Spain and Italy seem quite clearly to be the victims of a self-fulfilling illiquid-not-insolvent sort of crisis. They are in this situation because the markets have doubts about the willingness of a central bank to provide unlimited liquidity, unlike the case with Germany or the UK. And in addition they face a competitiveness gap with Germany that has arisen not out of any specific policies in Germany, Spain, or Italy, but that instead is the direct result of the massive capital flows from the northern eurozone to the southern eurozone that took place during the 2000s.

The eurozone therefore faces both a short run problem (the self-fulfilling liquidity crisis) and a long run problem (the competitiveness issue). There are fairly clear policy prescriptions for both. The primary question at this point is whether Europe's policy-makers will act on them.

The ECB: Unwilling Saviour

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 this week.

Monday, October 24, 2011

Hoping that the Minimum is Enough in Europe

The headline of this New York Times story is somewhat at odds with the substance of what happened this weekend in Brussels regarding the eurozone debt crisis:

European Leaders Deal Directly With Debt Dilemma

BRUSSELS — With a new sense of urgency, the leaders of the 27 European Union nations grappled directly on Sunday with their thorniest financial and economic problems, and made progress that they promised could yield a complete package of measures within days.

The hope is that the seriousness of the leaders’ effort to finally solve the interrelated problems of Greek debt, weakened banks and a bailout fund in need of reinforcement will keep speculators at bay when the financial markets open on Monday morning. But now there is heavy pressure on the leaders to deliver the goods at their next meeting, set for Wednesday.
There are three reasons that I've gotten a slightly sinking feeling as I've been reading news reports about the progress that was made this weekend.

1. The EFSF. The heart of the matter to be decided is how to increase the resources available within the EFSF to support the sovereign debt markets for Spanish and Italian debt. That has always been the most difficult part of the puzzle to build, and based on reports from this weekend, we still seem to be no closer to knowing what approach they will agree on, or even if they will be able to agree in the first place. At least eurozone leaders did use impressively vigorous language to reiterate that they are indeed determined to reach an agreement. So that's something.

2. Bank recapitalization. Eurozone leaders have decided that EU banks will need a capital injection of €108bn:

Banks must find €108bn in new capital

Europe’s big banks will be forced to find €108bn of fresh capital over the next six to nine months under a deal to strengthen the banking system that is to be unveiled by European Union leaders.
This seems low to me. The IMF has estimated that the EU's banking system will take a hit of closer to €200bn as a result of the debt crisis, and I would have been somewhat relieved if the EU had agreed on a number closer to that. €108bn may be enough money, particularly if there's a robust and significantly large mechanism put in place to defend the Spanish and Italian sovereign debt markets, because in that case banks may actually realize relatively few losses on those bonds. But a larger bank recapitalization promise would have provided reassurance that eurozone policy-makers understand the scope of the problem and are willing to get ahead of it, rather than simply trying to fix things as cheaply as possible.

3. Common purpose. Or more accurately, the lack of it. Everything I've read about the forthright but also acrimonious debate this weekend suggests to me that European leaders continue to be focused primarily on making sure that their own country pays the smallest share of the costs possible. No one has stepped up as an advocate for the common project of the euro. No country has taken on the leadership role of being willing to accept a higher burden of the costs for the common good. And now it is clear that no one is going to. Without any sign that the eurozone's political leaders are going to change their mindset and think first about the collective good and second about their own country, I am left with the feeling that the delays and inadequate responses to the crisis will continue. With each country narrowly focused on its own parochial interests, a resolution to the crisis is still certainly possible; but the brinksmanship that it will involve will make it difficult for financial markets to feel soothed by the process.

A crisis of confidence such as this can be resolved when financial markets are persuaded that policy-makers will do absolutely everything necessary to ensure that worst-case scenarios never come to pass. Unfortunately, this weekend's Brussels summit provides us with more evidence that instead of being willing to do whatever is necessary to avert catastrophe, Europe's political leaders are going to continue to try to do the minimum possible to contain the crisis.

So now we wait for their next meeting on Wednesday. And hope that their estimate of the mimimum possible will be enough.

Thursday, October 20, 2011

Greece at its Limit

It seems that the ECB's thirst for austerity-punishment for Greece has not yet been fully slaked. From the FT:

Troika warns time running out for Greece

Greece should get its next €8bn in international aid, but its economic outlook is deteriorating so rapidly that the second bail-out plan, agreed just three months ago, is no longer adequate to keep Athens afloat, international lenders have determined.

The findings are part of a highly anticipated report by the so-called troika of Greek lenders – the European Commission, International Monetary Fund, and European Central Bank – and sent to eurozone countries on Thursday morning. The Financial Times obtained a copy of the report.

...Part of the reason for the delay is a standoff between two of the members of the troika – the IMF and ECB – over whether Greece can keep paying its debts without taking more stringent austerity measures. The ECB has taken a tougher line, while the IMF has urged more leniency.
The Greek parliament just passed the previously agreed-to package of tax increases and spending cuts. But I am willing to bet that it is the very last round of austerity measures that Greece will be able to enact. Here are excerpts from Gavin Hewitt's gripping column from yesterday:

Athens erupts over austerity cuts

Athens was expecting violence. The expectation of it hung in the air. It is all people have spoken of in recent days. Even tourist hotels some distance from the parliament were boarding up. As a 48-hour general strike took hold shopkeepers were hammering in place steel shutters. The fear that emerged in hushed conversations was that there could be serious casualties. Such is the rage, the frustration that has built over months.

...I joined some students heading for the parliament. They are outraged that schools have a shortage of books. One young man said to me that he was not prepared to see decades of social progress sacrificed to satisfy the European Union and the IMF. Some waved banners with Che Guevara's picture. Then the column stopped, and from the left marched builders, arms linked, carrying poles with red flags on top. They walked with purpose. They have seen the construction industry collapse.

Then metal workers and teachers. It seemed at times as if the whole city was on the move. ...Marches and skirmishes soon became running battles across the capital But the numbers kept coming; great rivers of protesters.

...And with the marchers came young men and women in black hoods and masks. They began tearing at a wire fence that the police had slung across the road at the side of the parliament.

When eventually the police lost patience and fired the first tear gas grenade, the sound echoed across Syntagma Square and the crowd cheered.

There is a sense here that this is the key battle if spending cuts and wage increases are to be defeated.

Then skirmishes became running battles. Some of the anarchists had petrol bombs that snaked through the air falling around the riot police. They replied with volleys of tear gas and stun grenades.

...Europe's leaders had insisted that in exchange for bailing Greece out, it had to slash its deficit. The Greek foreign minister told me on Tuesday that no European country had ever tried such cuts in such a short space of time.

But seeing the vast numbers on the street, the government ministries occupied, the violence, it has to be asked whether Greece can impose these new austerity measures.

And if it can't, will the EU and IMF go ahead with the next tranche of bailout money. The so-called troika (the EU, IMF, the ECB) is delivering its report this week. Without the next 8bn euros ($11bn; £7bn) Greece will be unable to pay its bills within weeks.

But the mood has hardened here. There is less fear of default.

The finance minister said on Wednesday that "what the country is going through is really tragic".
Greece will continue to miss the deficit targets set by the troika. The ECB can continue to demand that Greece raise taxes and cut spending by even more, but further austerity-punishment will not help. At some point very soon Germany is going to have to make a simple decision: does it, for its own self-interest, come up with the money needed to fix this crisis, irrespective of what's happening in Greece; or does it say no, and elevate the crisis by an order of magnitude. I wish I had confidence in the answer.

UPDATE: Lifted from the comments:

petercorner: I can't help but notice the parallels between the Versailles treaty reparations, and what the [ECB] wants from Greece - to quote Keynes:
"The policy of reducing Germany to servitude for a generation, of degrading the lives of millions of human beings, and of depriving a whole nation of happiness should be abhorrent and detestable -- abhorrent and detestable, even if it were possible, even if it enriched ourselves, even if it did not sow the decay of the whole civilised life of Europe."

Where Exactly Are Those Lazy Southern Europeans, Anyway?

The northern eurozone countries are facing the prospect of coming up with massive amounts of additional funds to avert the collapse of Europe's financial sector. There have been some hints from various sources that a major and decisive agreement will be reached this weekend... though if the eurozone crisis has taught us anything, it is that one should never underestimate the power of European policy-makers to dither and delay beyond all reasonable expectations.

At any rate, lots of people (primarily but not exclusively in northern Europe) are very angry about the massive cost of fixing the eurozone mess. Understandably so. But unfortunately, much of that anger has been specifically directed at those lazy, shiftless, irresponsible southern Europeans that are seen to have gotten the eurozone into this mess to begin with. It's not difficult to find such finger-pointing expressed in the statements of prominent European officials, or in commentary on blogs and news sites.

I've repeatedly argued that I strongly disagree with this placement of blame; the eurozone crisis was fundamentally caused by the massive flow of capital from the north to the south of Europe that was bound to happen once the euro was adopted, and the specific behavior of individual governments in southern Europe had little to do with it. But I realize that this is a relatively abstract economic argument -- albeit one with substantial theoretical and empirical support. Stories of impersonal capital flows somehow don't address the gut feeling that lots of people have that southern Europeans really are less hard-working and responsible than northern Europeans, and that those laid-back southern attitudes must have caused the crisis.

I understand that gut feeling. That's part of what people like about southern Europe, after all -- things there do tend to move more slowly than in the north. But sometimes that gets confused with inefficiency and laziness, and turned into a moral judgment.

For some people, such judgments can be traced back to their own experiences... such as that day on vacation somewhere in southern Europe when they suffered through terrible service at a restaurant, got food poisoning, found that every pharmacy was closed for an extended lunch break in the middle of the afternoon, and then attempted navigate an incredible amount of paperwork and government bureaucracy to register a simple complaint. (No, I'm not speaking from personal experience at all. Why do you ask?)

In other cases the moral judgment of the south is probably more abstract and theoretical, and is simply following in the tradition of Weber's Protestant Ethic and the Spirit of Capitalism. Suspicion of the character of southern Europeans is not at all new.

But either way, being the economist that I am, I've been looking for some data to provide more insight into what lies behind this notion that southern Europeans are indeed a bunch of lazy free-loaders. Here's what I've found so far. Note that each table shows four northern eurozone countries and then four southern eurozone countries. Data is from the OECD.

Southern Europeans tend to work more hours each year than northern Europeans. But perhaps this is made up for in the north by greater participation in the labor force...

No, with the exception of Italy, it appears that the percentage of the population that is an active part of the labor force is generally similar to labor force participation rates in northern Europe. Germany appears to compensate for the few hours that its people work by having more people working in the first place.

So let's turn to the productivity of that labor. We know that labor in southern Europe has always been less productive than in northern Europe (for the past few centuries, anyway)... but have they been falling even further behind?

Labor productivity grew incredibly rapidly in Greece in the years leading up to the crisis. Even much-maligned Portugal enjoyed improvements in labor productivity roughly equal to northern Europe. Interestingly, it was Spain and Italy -- two southern European countries that did not run particularly large budget deficits (Spain even ran a budget surplus), and for which capital flows from northern Europe financed private investment rather than government spending -- that lagged in productivity growth. This again calls into question the common notion that large budget deficits in southern Europe are to blame for the crisis.

Now let's look at the social welfare system. In addition to being lazy, southern Europeans are accused of simply living off the state. So here's the amount of social welfare spending per capita:

Northern European countries give their people considerably more state assistance than do southern European countries. Greece and Portugal give by far the least, though we must recognize that incomes in those countries are much lower in general. But even Italy provides less social support to its citizens on a per capita basis than any of the northern European countries, and in 2007 Italy's per capita GDP was about the same as France's.

Just to be sure, though, let's take a look at a specific kind of public assistance expressed as a percentage of GDP: state pensions.

With this measure Italy does indeed appear to spend more on pensions than northern European countries. Of course, Italy also has one of the oldest populations in the world on average, which might explain that difference. Regardless, pensions in the rest of southern Europe are not particularly generous, even relative to income, when compared to northern Europe.

Putting it all together, it's hard to see much empirical support in this data for the notion that southern Europeans are a bunch of lazy free-loaders. That's not to say that there aren't obvious cases of gross inefficiencies in southern European countries -- of course there are. And there are probably other types of data that I haven't thought of that should be examined as well. Feel free to offer suggestions. I've focused on the types of data that, to me, most obviously and directly speak to the common criticisms of southern Europeans, but perhaps I've missed something.

Alternatively, maybe there really isn't a systematic difference in how hard-working, responsible, or self-reliant southern and northern Europeans are. After all, it is also possible to find plenty of examples of opaque government bureaucracies, entrenched unions, and extremely generous state assistance in the northern eurozone countries. So the next time someone asserts that southern European irresponsibility is what lead to this crisis, I would simply ask to see the data they have to support that claim.

Tuesday, October 18, 2011

China's Inflation Rates: Signs of Market Imperfections

Ryan Avent points out that if one uses a different measure of inflation in China to convert its nominal exchange rate into a real exchange rate, the Chinese yuan (CNY) has actually appreciated quite a bit in real terms in recent years. Using China's GDP deflator instead of the CPI, in fact, the CNY has appreciated in real terms by close to 50% since 2005. Using the CPI the other day I had calculated the real appreciation to be much smaller.

The larger figure obtained using the GPD deflator provides a reassuring confirmation of our priors, but it raises a very interesting question: why are the two measures of China's inflation rate so different? As seen in the chart to the right, the GDP deflator has been consistently rising much faster than the CPI in China. Why?

While there are many differences in how the two measures of inflation are calculated, the biggest and most relevant distinction in this case is that the CPI only measures the prices of things that consumers buy, while the GDP deflator also measures the prices of things that non-consumers -- i.e. businesses, the government, and the foreign sector -- buy.

Let's make the (reasonable, I hope) assumption that consumers buy more services than goods, while non-consumers buy far more goods than services. Combining this assumption with the distinction noted above tells us that the prices of tradable goods have been rising much faster than the prices of locally-provided services in China. And this has three important implications.

1. Manufacturing wage growth in China outpaces productivity growth.
For simplicity, let's think of China's economy as producing two types of goods: tradables (i.e. manufactured products) and non-tradables (i.e. services). We typically think of wages as being equal to the marginal revenue provided by labor, that is:

(1) wt = pt * MPLt

where 'w' stands for wages, 'p' is the price level, 'MPL' stands for the marginal product of labor, and the 't' superscripts indicate that variables pertain to the 'tradable' sector of the economy. If w and MPL in the tradable sector both rise at the same rate, then pt should remain constant. The fact that pt has been rising indicates that wages are rising faster than productivity in this sector of the economy.

This in turn raises its own interesting question: why are wages rising faster than productivity in China's manufacturing sector? This apparently violates classical labor market assumptions. While I don't pretend to be an expert in China's labor market, I suspect that this is a form of catch-up. Prior to China's great economic growth of the past 15-20 years, wages in the manufacturing sector were far below what worker productivity would normally have warranted in the absence of market imperfections. (My guess is that this was due to the communist, command-economy system that dominated in China prior to the 1990s, which kept wages artificially depressed.) And what we've been seeing over the past 10-15 years is the process of that discrepancy being corrected.

This ties back to an argument I have previously made that the incredible movement of manufacturing to China that has happened over the past two decades was a once-in-a-lifetime event, in which multinational firms could essentially take advantage of an arbitrage opportunity in China that existed because labor in China was cheaper than its marginal product. That difference between wages and productivity in China is now rapidly being arbitraged away.

2. There is poor intersectoral labor mobility in China.
The fact that the prices of manufactured goods in China are rising faster than the prices of services also tells us that there must be poor labor mobility between China's manufacturing sector and its services sector. How can we infer that? Take a look at an equation similar to (1) above, but for the non-tradables sector of the economy:

(2) wn = pn * MPLn

We know that pn is rising more slowly than pt. There's a mountain of empirical evidence that tells us that MPLn almost always rises more slowly than MPLt, i.e. that labor productivity grows faster in manufacturing than in services. Putting those together, it must be the case that wn is growing more slowly -- much more slowly, in fact -- than wt.

But if workers could move between the tradable and non-tradable sectors of the economy, they would equalize wages between them. So we can reasonably conclude that workers can NOT move between the two sectors of the economy. This corresponds with casual observation in China (manufacturing jobs are highly prized in China, but not available to everyone), but it is a sign of an important labor market imperfection that we must keep in mind.

3. The real appreciation of the CNY may be near an end.
We've now established that wages are growing faster than productivity in the manufacturing sector in China, and that workers can not easily move between the manufacturing and service sectors of China's economy. This has an important implication for China's real exchange rate.

Developing countries typically experience trend appreciations in their currencies as they become more developed. This is explained by what's widely referred to as the Harrod-Balassa-Samuelson (HBS) effect. The HBS effect can be summed up like this: relatively low productivity gains in the services sector compared to the manufacturing sector means that the relative price of services in the developing economy rises. This raises the overall price level in the developing economy relative to where it used to be (and relative to its trading partners), causing a real appreciation of the currency. The Economist article that Ryan refers to in yesterday's post cites the HBS effect as one reason why inflation in China has been and should be higher than inflation in other countries.

But inferences #1 and #2 above directly contradict the underpinnings of the HBS effect. Instead of experiencing faster inflation in the services sector as the HBS story predicts, China is experiencing faster inflation in the manufacturing sector. And instead of labor mobility equalizing wages between the two sectors of the economy, there are clearly barriers that prevent that in China.

This means that the HBS effect does not apply to China, and can not be expected to drive a continued real appreciation of the CNY. China's currency has indeed undergone a real appreciation in recent years, though as Ryan correctly pointed out, exactly how much depends greatly on which inflation measure you use. (Please see this paper by Menzie Chinn for an excellent primer on which inflation rate to use when calculating real exchange rates. In short: there's no single right answer.)

But the real appreciation of the CNY over the past several years seems to have been driven by the catch-up of manufacturing wages with manufacturing productivity. And that means that once that catch-up process is complete -- i.e. once the difference between labor's productivity and wages has been arbitraged away -- this mechanism for real appreciation will go away. Given the various distortions and imperfections in China's labor markets that this simple analysis can illuminate, I hesitate to have faith that market forces will solve the problems of China's massive imbalances, either internal or external.

Saturday, October 15, 2011

Does the euro need Greece more than Greece needs the euro?

Gavin Hewitt puts it another way in his most recent column, but that's basically the question he's asking:
Eurozone debt crisis: Greece's wild card

When the G20 finance ministers gather in Paris they face a stark fact: that nearly a year and a half since Greece received its first bailout, the crisis remains unresolved. Europe's leaders will be asked yet again what they are going to do with Greece.

...But there is another factor in all this, a wild card: the Greek people. It is just possible that the Greek people will have their say, that they will simply refuse to go along with austerity plans demanded by outsiders, their creditors.

What happens if a people simply says "no"? What happens if, through many small and not-so-small actions, they sabotage the plan?
I think of it like this: Greece and the core eurozone countries (Germany, France, etc.) are in the process of trying to apportion the additional costs of fixing the crisis. Is local austerity ("punishment" is a more accurate term in my opinion) going to be the main mechanism to pay for the solution, or will the crisis mainly be solved through direct assistance from Germany and France? So far the costs of this crisis have been mainly borne by the Greeks through austerity-punishment, but there's a limit to how much of that can be imposed. To better understand who will pay the additional costs of resolving this crisis, it's helpful to think about the incentives each side has to voluntarily shoulder the burden.


Yes, of course Greece has some awfully compelling reasons to try to avoid a unilateral default on its debt, and to shoulder some of the cost of avoiding that outcome. If at some point Greece is forced into unilateral default, it will face the prospect of losing all further financial assistance from the rest of the EU, a run on domestic banks and complete shutdown of its financial system, an immediate inability for the Greek government to pay all of its bills (even excluding interest payments), and a wave of Greek corporate bankruptcies. As I've argued before, I think that this would very quickly lead to Greece issuing its own domestic currency (which would probably operate in parallel with the euro rather than replacing it). And that would lead to rapid inflation, depreciation, and a drop in Greece's purchasing power. In a nutshell, the outcome for Greece would be very bad. So Greece undeniably has a strong incentive to comply with Germany's demands for continued austerity-punishment.

But keep in mind that once the trauma of unilateral default and the introduction of a new local currency has faded a bit, Greece could be in a very good position to stage a strong economic recovery. Argentina has pointed the way as far as that goes. So while that prospect doesn't mean that unilateral default would be a good outcome for Greece, it does mean that it's a dark cloud with a silver lining, and therefore a slightly less-bad option than it would otherwise be.

The Eurozone

But the outcome for the rest of the eurozone countries could be equally devastating. The main problem they face is that markets are looking to Greece for information about what the core eurozone countries are willing to do to keep the eurozone together. If Greece is allowed to unilaterally default, the markets will have their worst fears confirmed -- that the core countries are willing to allow other eurozone countries default and effectively exit. European financial markets will immediately be devastated by contagion as a massive selloff in Spanish and Italian debt quickly pushes weak eurozone banks to the brink of collapse. The eurozone will face the prospect of having to come up with perhaps in excess of a trillion euro to support the Spanish and Italian government debt markets and to rescue the entire European banking system from collapse.

It is difficult to overstate the seriousness of the crisis that would hit European financial markets in the wake of a unilateral Greek default, I think. This gives France and Germany an enormous incentive to bail out Greece -- for their own pure self interest.

If on the other hand the core eurozone countries actually do come through with sufficient funds to finally resolve the Greece issue, then all of a sudden markets will have important evidence that the core countries are indeed determined to do whatever is necessary to keep the eurozone whole. Put simply: if Germany is willing to pay up to keep Greece in the system, then it's pretty likely that it will also do what is necessary to keep Spain and Italy in the system. Investors' fears are soothed, and contagion largely goes away.

When Greece Hits its Limit

Given this, I would actually argue that the eurozone needs a Greek rescue more than Greece does. At some point soon -- if it hasn't already -- Greece is going to reach its limit regarding the austerity-punishment it is willing to accept. The Greek government will continue to miss deficit reduction goals set by the ECB and Germany, and will be unable to raise additional taxes or cut government spending further without the Greek people triggering the government's complete collapse. And given that this crisis is largely the result of forces beyond Greece's control, I wouldn't really blame them.

When that happens, Germany and France are going to have to think very, very carefully about their response. The immediate reaction of a lot of people at that point will be to throw Greece to the wolves. But if more sober heads prevail, the sort of reasoning I've outlined here suggests that it will be in the eurozone's own interest to swallow its pride and hand over whatever amount of money it takes to keep Greece in the system.

Friday, October 14, 2011

Inflation and Real Exchange Rates in China

China's exchange rate policy has been in the news quite a bit recently, thanks to the US Senate's action this week to try to punish China for it. Putting aside the legal issues for a moment, it has been noted by various observers (e.g. Matt Yglesias) that the problem of China's undervalued exchange rate is at least partially resolving itself over time. This week's Economist picks up this theme:
And now, protectionism
America’s latest anti-China bill tackles a problem already being solved

...The problems this bill purports to address are already being resolved. The Economist has long argued that a flexible yuan is in the interests of both China and its trading partners. It would hasten the reorientation of China’s economy from exports to consumer spending, give its central bank more freedom to fight inflation, and divert demand to depressed Europe and America, catalysing an essential rebalancing of the global economy.

Belatedly, China recognises this. Since June last year the yuan has appreciated 7% against the dollar. The rise in China’s relative costs has been even greater given its higher inflation rate. With stimulative fiscal and monetary policy bolstering domestic demand, China’s current-account surplus has shrunk by two-thirds, from 10% of GDP in 2007. Meanwhile America’s trade deficit has narrowed, and manufacturing employment has stopped falling. All this means the yuan is far less undervalued than it was a few years ago—if at all.
If you had asked me yesterday how much the yuan (CNY) had appreciated against the dollar since China released the yuan from its long-standing peg of 8.28 CNY/USD back in 2005, I could have told you that the CNY is now about 20% stronger in nominal terms. But then I would have been quick to add that since inflation in China has been considerably higher than in the US, in real terms -- i.e., in terms of actual purchasing power once inflation is accounted for -- the CNY has probably appreciated by more like 30% to 40%.

It turns out I would have been pretty badly wrong. Last night I pulled data from Principal Global Indicators (an excellent multi-country data site, by the way) on actual inflation in China and the US over the past few years, and this is what the consumer price index looks like in each country (try to look past the terrible seasonal fluctuations in the Chinese data):

It turns out that, at least according to official statistics (and yes, we probably need to take them with a large grain of salt), consumer prices in China have risen only by a total of only 6.7% more than prices in the US since 2005. The inflation differential that had loomed large in my mind is not so great after all.

In addition to the possible unreliability of Chinese inflation statistics, there may be a second explanation for the fact that Chinese inflation has been less different from US inflation than I imagined: changes in consumer prices in both countries since 2005 have been largely driven by changing energy prices. So for example, the US CPI is currently up almost 4% over a year ago thanks to higher energy prices (excluding energy prices, US inflation remains very modest) -- and China has experienced a bulge in its own inflation rate at the same time, in part for exactly the same reason. Similarly, the collapse in energy prices in late 2008 and early 2009 caused inflation rates in both countries to plummet at the same time. In short, the role that energy costs play in consumer price inflation in both countries may explain why inflation rates in the US and China have tracked each other surprisingly closely in recent years, as shown below.

The result is that when the consumer price index is used to measure inflation differentials between China and the US (and yes, I know that the CPI is not the ideal inflation measure to use for that, but Chinese inflation data is woefully limited, and as economists we're forced to look where there's light), the Chinese currency's real exchange rate has only appreciated a little bit more than the nominal exchange rate. The final picture below shows both series, setting January 2007 = 100.

So clearly my guess that China's currency has appreciated against the dollar in real terms by 30% to 40% would have been pretty far off. The real answer is that the real appreciation of the yuan is only a few percent more than the nominal appreciation. Put another way, almost all of the movement in China's real exchange rate has been due to movements in the nominal exchange rate.

So if you're looking for China's undervalued yuan to correct itself over time, you can't count on inflation differentials to do much of the work, at least based on the experience of the past few years. Any significant changes in China's real exchange rate are probably going to have to come from further changes in the nominal CNY/USD rate.