Monthly Archives: November 2010

Economics

Cloud cuckoo land

Eurozone politicians are looking more and more out of touch. Like King Canute commanding the sea, they are helpless against the incoming tide of inevitable default and restructuring. The markets are not irrational, despite the fulminations of the politicos. What bond investors are keenly sensitive to is the likliehood (or otherwise) of the payment of principal. Not surprisingly, bond investors are sceptical that Ireland is really willing to devote 25% of its total revenues to interest payments in 2014. I’m not surprised that there is a growing resentment in Ireland, which may produce a move towards default and restructuring after the forthcoming elections. Italy is beginning to feel contagion. Spain might just be manageable, but Italy, with €2 trillion of public debt (the third largest public sector debt in the world) would decisively blow the euro out of the water.

The politicians and policymakers have ignored some basic flaws in the euro construct, namely that competitiveness can only be adjusted by internal devaluation and crushing deflation, which becomes self-defeating as it sets in train a debt default spiral. The eurozone has very limited fiscal transfers to offset individual country fiscal squeezes. The ECB’s sphere of action is more limited than national central banks like the Fed because it can’t monetise government debt. The ECB has also exposed itself to credit risk through its liquidity operations in a way that it couldn’t have envisaged when the crisis started. No wonder the focus has been propping up Ireland’s bust banking system. If the ECB had to start recognising impairments, it would have to be recapitalised. What fun! There are other flaws but you get the picture.

So what can be done to save the euro? Understandably, the Germans don’t want to underwrite the euro with their taxes. Why not look at a transfer the other way around? Give every German household a fistful of free euros to spend. This would boost German domestic consumption, hopefully reducing the trade surplus and starting a virtuous circle.

You might go one stage further and issue vouchers to Germans that can only be spent in Greece, Ireland, Spain, Portugal and Italy to induce Germans to go on holiday to ClubMed (the tiny flaw is that many Germans may not want to go to Ireland on holiday!).  The quickest way to help reduce the imbalances would be through tourism. Unlike just issuing euros to the German populace, a tourist voucher scheme would mean that the stimulus would be targeted at the countries that most need it and not leak out of the eurozone on Chinese imports.

One subtext, which I’m sure would be unacceptable to the Germans, is that German inflation will need to be higher than ClubMed to help reduce the competitiveness gap. I’m not sure how to get around this stumbling block.

It is slightly bizarre that the Germans have been so vociferous in wanting to impose haircuts on periphery debt when their financial system has the second largest exposure to Ireland. Given the parlous capital position of many German banks, you would have thought the last thing they wanted was yet more asset write-downs. It seems likely that their exposure is more in bonds than loans.

Although the UK has the largest exposure to Irleand ($224bn, source: BIS, March 2010), the majority is concentrated in RBS and Lloyds. Together they account for $122bn in loans (55% of the total exposure). According to Morgan Stanley (gleaned from the FT), a substantial proportion of these have already been recognised as impaired and meaningful provisions have been made. Undoubtedly more provisions will need to be made, but if exposure is direct loans rather than sovereign bonds, then the impairment process is already under way. One small crumb of comfort is that sterling’s decline against the euro may have made the write-offs larger in sterling terms, but the rump value of the loan is also higher. I imagine that the remainder of the UK exposure is relatively diffused and probably includes the exposure of foreign banks, with operations in London.

I’ll bet you that the exposure of the German banks (ex Hypo Real Estate) and the French banks has a high proportion of sovereign debt which is in the held to maturity bucket with minimal provisioning. This yield pick up game between the core and the periphery, it seems to me, is at the centre of the worries of the bankers and policymakers. These banks have been at it for ten years and until recently, it was money for old rope. Now it’s potentially looking like the mother of all asset/liability mismatches. If any of these countries exit the eurozone, it will cause a major headache for the eurozone banking system. Presumably, eurozone banks have a greater amount of domestic liabilities compared with assets, as they have been picking up yield in the periphery. Perhaps that’s the bomb ticking away in the basement of the whole eurozone construct.

 

 

Economics

Useful economics: MV = PQ

4 Comments

This is part of a series of three which will look at some useful economic frameworks for thinking about the current crisis. Today, I’ll look at MV = PQ and why it is useful in thinking about quantitative easing and the future course of inflation.

MV = PQ

M= money supply, V= the velocity of money, P=prices, Q=quantity of production or activity. PQ = nominal GDP

I don’t want to get into any theoretical arguments about this one, but it helps to explain the actions of central banks and why, eventually, they will end in inflation. The response of the Fed (and other central banks) to the seizing up of the banking system has been a rapid increase in money supply (and bank reserves) because they were worried about the velocity of money falling precipitately. They were correct about the velocity of money, which has collapsed. In essence this is QE, although the Fed has done its best to deny it.

However, no one really knows what would have happened had the money supply not been increased. The velocity of money, at least in the short run, appears to be inversely correlated with the supply of money. Despite this, it’s probably fair to say that the actions of the Fed and friends prevented nominal GDP (PQ) from falling more dramatically and that it stopped a debt liquidation spiral.

The problem now faced by the Fed is gauging when the velocity of money might increase. The first sign will be when banks are willing to resume lending and when the real economy shows some appetite to borrow. This is going to be difficult to judge and it is very likley that the Fed will get behind the curve, since it will want concrete evidence that animal spirits have returned to the economy. It won’t want to be accused of strangling a recovery, so it will be late to take action. Given the huge increase in monetary base, it won’t take much of an increase in the velocity of money to produce a significant dose of inflation.

The tools that the Fed can use to head this off are:

  1. Increase bank reserve requirements.
  2. Raise interest rates (including interest paid on bank reserves).
  3. Sell assets from its balance sheet.

All of these pose problems. Bank reserves are very high at the moment because of risk aversion. The Fed controls reserves through open market operations and payment of interest on reserves rather than direct mandate. The Fed might want to think about following the Chinese example of a direct reserve requirement, which would be easier to implement than through market operations. The Fed will also be wary of a re-run of 1936/37, when it raised bank reserve requirments and caused a recession.

Raising interest rates again is not going to be an easy operation and you could see the potential for some (many) borrowers to get in trouble (again) and for those leveraged in some way to capital markets, playing the yield curve or carry trade, to hit the buffers quickly.

Selling assets from its balance sheet could cause significant dislocation and panic in bond markets. The Fed is now so heavily enmeshed in the private credit sector, that the exit strategy could be very difficult both logistically and politically.

So my feeling is that the Fed will be too late and too feeble with its actions to stem an increase in the velocity of money. I don’t know when this will happen. It is possible that, either through a trade war or risk aversion because the eurozone falls apart that there could be a period of deflation before inflation. If we saw a further deflationary pulse, then I think the Fed will pump up the money supply even more creating an even greater inflationary threat in the future.

Returning to MV=PQ, this little formula is not much use as a forecasting tool in terms of the exact level of each of the terms, but it is very useful in thinking how the variables interact and what might be the outcome of changes in the variables. For me, it makes me feel that at some stage we will get a significant pulse of inflation. Indeed, inflation is the only way that the overindebted West will be able to reduce its liabilities in real terms without a default. It also explains why I think deflation is highly likely in the short term in the eurozone periphery as the ECB refuses to act like the Fed.

 

 

 

Economics

When to tighten monetary policy?

The resilience of equity markets despite the eurozone crisis, the continuing catastrophe of the US housing market and the North Korean shelling is a testament to the excess liquidity around the globe.  While the Fed has undertaken a fresh round of QE, in my view, it won’t do much for the economy because banks won’t lend and the private sector is deleveraging. When liquidity is not used by the real economy it goes into financial markets and pushes up asset prices.

The UK is not indulging in more QE (yet), but Mervyn King made clear in the Treasury committee hearing that the BoE would if needed. Pushing up asset prices is part of QE, but it also maintains a high level of bank reserves which helps to underpin a financial system under stress. Like the US, the private sector is deleveraging so there’s little demand for borrowing in the real economy so it ends up in financial markets.

However, in the eurozone, the picture is starting to change. Axel Weber and Jeurgen Stark are both sounding more hawkish, warning that excessive accommodation could be harmful. This is strange when the eurozone is convulsed with a crisis. However, it’s not so strange from a German perspective. Germany’s economy minister Rainer Bruederle has suggested that Germany is nearing full employment.

Could the Germans be getting twitchy about inflation? Seared into the memory of German policymakers is the experience of hyperinflation of the Weimar Republic. The ECB is already gently winding down liquidity support for the eurozone banking sector, shortening the term of liquidity support.

The Germans may start to pressure the ECB to put up interest rates and the Germans are calling the shots at the moment. If the ECB acquiesces, it will be the final nail in the coffin of the eurozone. Greece, Ireland, Portugal and Spain are all going to suffer deflation and a horrible debt deflation spiral. If the ECB puts up rates they will just implode. It will be very negative for asset markets, for obvious reasons.

It’s not just the Germans who want to tighten monetary policy. The Chinese are getting very concerned about rising inflation and are tightening policy through rises interest rates and reserve requirements. However, monetary policy produces perverse effects in China because of its unsophisticated financial system.

Michael Pettis argues in his latest post that raising rates may have the opposite effect and further fuel the asset bubble. Presumably, at some stage, the Chinese may have to stomp hard on the brakes. The rest of Asia also, probably, needs to tighten monetary policy. If that occurs at the same time as the ECB tightening it spells trouble for asset markets. It’s probably not going to happen until the middle of 2011, but there are signs that the pressure is building.

Economics

Nice try, but no cigar!

1 Comment

The FT ran a very positive article on German consumption yesterday. A positive Ifo number also prompted a commentator to talk about the German locomotive pulling Europe along.

Let’s take a quick look at German consumption and see what it might mean for Eurozone growth. Eurostat is forecasting that the eurozone economy will be about €9,135bn in 2010 and Germany will be €2,451bn (26.8% of eurozone GDP). German consumption is forecast to be €1,384bn or 15.2% of eurozone GDP. Forecast consumption growth for Germany is 0.9%, slightly lower than the whole eurozone at 1.0% (2011 compared with 2010). Wage growth for Germany is forecast to be 1.1% for 2011.

At least from the official forecasts, it doesn’t seem that German consumers are going to be driving eurozone growth. However, Germans have a high savings rate at 17.7% of gross disposable income. If we assume that in 2011, German consumers run a zero savings rate, then it would be worth 3.2% to eurozone GDP. However, German trade with the eurozone accounts for about 67% of German trade, so it would only be worth 2.1% of eurozone GDP, assuming the current ratios remain constant.

Of course this is complete fantasy because German consumers are not going to run down their savings rate aggressively partly because the population is aging and partly because access to credit is tight, particularly mortgage borrowing. So let’s say that they run down the savings rate by 2 percentage points in 2011. This would equate to around €33.6bn or 0.37% of eurozone GDP, but this needs to be reduced because of the trade factor mentioned above, so it becomes 0.25% of eurozone GDP.

This is almost the same as the fiscal tightening for Germany, Spain, Ireland, Greece and Portugal forecast by Eurostat in their spring 2010 publication. After recent events, the fiscal tightening is likely to be even more aggressive, overwhelming any rise in German consumption. A background of a squeeze on government expenditure and rising taxes hardly seems like a recipe for a consumer boom.

While a rise in German consumption would be useful, it is hardly transformational. However, it is even more optimistic when you consider that the euro has been strong relative to Asian currencies. If there were to be a consumer boom in Germany, it would probably suck in more imports from Asia, rather than benefiting the eurozone proportionately.

Furthermore, Eurostat is forecasting that the German trade surplus is likely to stay at current levels, suggesting that Germany is not going to be a net contributor to growth through a change in trade balance. It may grow slightly faster than the eurozone, but not enough to make any real difference. The real beneficiaries of German growth, anyway, are likely to be CEE rather than the struggling periphery.

The German consumption story is a nice idea, but doesn’t really stand up to scrutiny. The German locomotive story also looks a bit over done. As one of my friends used to say, “nice try, but no cigar”!

Economics

Don’t be like the Germans

Martin Wolf’s excellent column in today’s FT explains why the periphery can’t be like the Germans, dooming the eurozone to failure (my view, not his). It is strange how such a sophisticated nation and one so technically competent in many areas, just can’t understand simple economics. It’s also worth taking a look at the two discussion papers mentioned.

Economics, Geopolitics

More on China

4 Comments

I have a very simple view on China. At some stage, it will suffer a catastrophic bust. Economies that have high credit growth and fixed exchange rates always do. It’s only a question of time. China also has probably the most unbalanced economic growth in history with 45% of GDP going on investment. It is still a command economy, so the chances of malinvestment are high. Real estate booms are also a red flag and China has seen a huge one. Hubris is another warning sign. China has sailed through the credit crunch better than most economies, thanks to a huge stimulus policy and a surge in bank lending. This seems to have created an aura of invincibility and complacency. The timing of a bust is always difficult because the trend goes on longer than seems possible.

I came across this interesting piece on China, which goes into some more detail. It also has some observations on Japan and how Japan could flip from deflation to inflation.

Economics

Fixing the euro

This is an interesting article: http://www.voxeu.org/ . I’ve not come across the idea of the ECB setting different interest rates for different countries before. It seems like an interesting idea to pursue. This is the first solution I’ve seen that might actually work. It still doesn’t overcome the present problem of acute deflation to overcome competitiveness problems. I can’t see an easy way out of that conundrum.

Economics

Déjà vu

It’s difficult to know what to add on the Eurozone crisis. It seems the market is doubting the efficacy of the Irish bailout. In a banking crisis, which is the problem for Ireland, the only way out is to ‘fess up the losses and recapitalise the banks. There are no details yet on how the rescue package might address this issue, although I’m sure the IMF, if not the EU are well aware of this. I do have some hope that Ireland can trade its way out of its problems eventually as it has a viable export sector (unlike Portugal and Spain, but that’s another story).

Apart from the obvious problems, a further issue facing Ireland is emigration. If you don’t have to, why would you want to stay in Ireland and suffer probably a decade of hard times? Ireland may see a drain of talent over the next few years and a narrowing of the tax base. In a small country this can be a serious problem.

The UK faces some of the problems that Ireland has, namely a property bubble and overextended banks (still). Clearly a flexible currency regime and control over monetary policy have been an enormous help. However, size and diversity are also positive attributes. As I’ve said before, larger economies benefit from diversity, which is a significant cushion to cope with exogenous shocks.

For Ireland the decisions of individual companies and people have a much greater impact than in the UK. It also means that shifts in employment patterns can be handled more easily. The UK has significant immigration pressures, which actually help the economy and support the housing market, although you wouldn’t realise that from some of the hysterical commentary from the likes of the Daily Mail.

A further feature that has helped the UK enormously has been the London property market. The devaluation of sterling has meant the London property looks cheap in an international context and this has drawn a lot of high-profile buyers. The latest is the sale of 50% of the Westfield shopping centre in Stratford to Dutch and Canadian pension funds. Again, size matters as it creates diversity and liquidity.

It would be nice to think that the UK can sail through this crisis without too much further trouble, but a deepening in the Eurozone crisis would be highly problematic for the UK. I am dismayed at some of the parochial comment on the UK’s offer of help to Ireland. Ireland is one of the UK’s largest trading partners and the UK banks have about £140bn of exposure to Ireland. The largest being the two biggest culprits in the credit crunch RBS and HBOS (now Lloyds). Thanks a bunch!

George Osborne is absolutely correct in suggesting that it is in the national interests of the UK to help Ireland, even though we are not in an exactly healthy position ourselves. I have to say, I’m deeply worried about the growth prospects (or lack of them) in the Eurozone next year. It’s going to be very difficult for the UK to rebalance the economy against a background of a weak Eurozone, especially with a rolling crisis. My biggest worry is that the banking sector gets hit again, weakening growth and that the housing market cracks, producing a negative feedback loop for the UK economy. Policymakers would do well to make some contingency plans.

You didn’t have to be a genius to know that this would all end in tears. All you needed to do was to read a couple of books: “Globalizing Capital: A History of the International Monetary System” by Barry Eichengreen and “Manias, Panics, and Crashes: A History of Financial Crises” by Charles Kindelberger. Even idiots like me wrote well ahead of time that financial sector profits were unsustainably high, that economic volatility must rise and that the Eurozone was like the gold standard. The two biggest indicators of an incipient bubble and crash are 1) a property boom and 2) a fixed currency regime. China anyone?

This is depressing me too much, so next I’ll write a bit on some useful economic formulae that can help to interpret what is going on at the moment and give some insight into what may happen in the future.