Thursday, February 26, 2015

The Taylor rule conundrum

Back in February 2005 Alan Greenspan referred to the abnormal (low) level of US long-term interest rates as a conundrum:

"For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience."

A month later, Ben Bernanke, proposed the idea of a global saving glut as the main reason for low long-term real interest rates. In a world where capital markets are global, interest are determined by global forces and not by domestic macroeconomic conditions.

This behavior is also very much related to the discussion around "global liquidity" and the potential influence of monetary policy in the US on monetary policy conditions in emerging markets. The difference is that in this case we are talking about short-term rates where we typically expect more control by the central bank and a stronger correlation domestic conditions.

To illustrate this point let me use a slide from a presentation two days ago by Hyun Song Shin (BIS) at the Bank of England discussing the future agenda of central banks. The slide includes the following chart (click on it for a larger image).

The chart shows the behavior of emerging markets central bank interest rates in comparison with a standard Taylor rule. The chart shows that since 2000, central banks have set interest rates significantly below the level implied by the Taylor rule (the same behavior is also true among advanced economies although not to the same extent). If one looks carefully at the scale, interest rates are 6 to 8 percentage points lower than those implied by a Taylor rule. This would imply an incredibly expansionary monetary policy. The chart comes from a paper by researchers at BIS (Hofmann and Bogdanov) who on their discussion of this result they argue that

"This finding suggests that monetary policy has probably been systematically accommodative for most of the past decade. The deviation may, however, in part also reflect lower levels of equilibrium real interest rates that might introduce an upward bias in the traditional Taylor rule."

Monetary policy can be too accommodative when central banks follow US interest rates to avoid appreciations of their currencies. But if monetary policy was that accommodative for more than a decade we should have seen increasing inflation rates during those years. That was not what we saw, inflation rates remain stable (and even decreasing) in most of these markets. Today, where interest rates remain very low compared to those implied by the Taylor rule, we talk about global deflation, not global inflation.

So it must be that the fundamental cause must be related to lower levels of equilibrium real interest rates and these are determined by global forces (otherwise why would all countries behave in the same way). Interestingly, the deviations from the Taylor rule coincide with the period where global imbalances started.

So here is yet another interest rate conundrum, this time related to short-term interest rates. How much do central banks control short-term rates in a world where capital markets are global? How relevant is a Taylor-rule approach to analyze the appropriateness of central bank interest rates?

Antonio Fatás

Monday, February 23, 2015

Financial crisis, the Euro and the need for political union.

In today's Financial Times, Gideon Rachman discusses the flaws of the Euro and the possibility of failure. He admits that from the beginning he believed that the Euro project would eventually collapsed because

"First, a currency union cannot ultimately survive unless it is backed by a political union. Second, there will be no political union in Europe because there is no common political identity to underpin it. And so, third — the euro will collapse."

I have always been very skeptical about statements arguing that a currency union needs a political union. The political consequences of sharing a currency (the Euro area) are in many ways much smaller than the political consequences of being part of the European Union, why don't we make the same argument about the European Union? (just to be clear, some make the same argument but clearly it is much less common, as can be seen in the article by Rachman).

There are plenty of example where the European Union (EU) requires some serious political consensus: the EU requires partial transfers of sovereignty to a supranational authority when it comes to legislation, the EU has economic mechanisms that imply a significant transfer of income across countries (via its budget, the structural and cohesion funds). Then why is it that the EU does not require to be backed by a political union in the same way the Euro project does?

My view is that the request for more political union in the Euro area is not so much the result of sharing monetary policy and a currency, I think that the answer comes much more from the power and size of financial flows and how these flows create a risk that is centralized and needs to be managed through the ECB.

The current debate between Greece and others in the Euro area is not about monetary policy. While there have been disagreements about the best course for monetary policy during the crisis, the fact is that the ECB has not been "too far" from what other central banks have done, interest rates have been close to zero for years and while QE has been different from that of other central banks, it is unlikely that a US-style QE would have made that much of a difference (we are still debating how effective QE was in the US or the UK).

The real debate in the Euro area today is about dealing with a debt crisis. The real issue is that the financial flows in the period 2000-2007 established links between countries and spread a risk across all Euro members, in a way that other countries (including EU members) not part of the Euro did not see. And the creation of the Euro was instrumental for this.

The role of the Euro was twofold. First it facilitated flows across countries as exchange rate risks had disappeared and provided the illusion of no risk. Second, once the flows had taken place it created financial links between banks and governments across countries that made them exposed to the same risk. In addition, the ECB because its connections with banks became a central repository of that risk and a solution for some of the countries facing a credit crunch -- the ECB acted like the IMF in many ways.

None of this is exactly about monetary policy, even if the ECB is involved. This is about financial risk and how financial crises have painful economic consequences. When sharing a currency the risk of financial crisis and its potential solutions bring countries and governments together in a way that a political consensus seems to be necessary because transfers might be involved and because common political solutions need to be found. And while these transfers might be smaller than the ones agreed as part of the Social and Cohesion Funds of the European Union, they come as a surprise and they are uncertain (we cannot agree ex-ante on their final size). This is what makes the Euro project a much more difficult one to manage without a sense that we all belong to the same group and are willing to work on this together.

For many, the Euro was one of the projects within the much bigger ambition behind the European Union (which came with the idea of a partial political union). But the recent financial crisis has shown that the risks associated to sharing a currency when financial and sovereign crises are possible, are a lot larger than what we thought. And these risks are much larger than the risks associated to simply sharing the same currency and the same monetary policy (yes, one interest rate does not fit all but this is not the real issue this time).

If there was a way to avoid the next financial crisis I would go back to my original idea that a currency union can survive without a political union. But as long as financial flows (and sovereign debt) can potentially generate the same type of risk as in this crisis, then the Euro might not survive the next one without stronger political ties between all its members.

Antonio Fatás

Thursday, February 5, 2015

Those mountains of debt (and assets)

A recent report by the McKinsey Global Institute on the increasing amount of debt among advanced and emerging markets made it to the front page of many financial newspapers yesterday (e.g. the FT). The report reminds us that in many countries debt is still going up as a % of GDP, that there is limited deleveraging. The Financial Times offers an interesting graphical tool to compare debt evolution for different countries.

The data is interesting and it highlights the difficulties in deleveraging but, in my mind, it might lead to readers to reach a simplistic conclusion that is not correct: that everyone is living beyond its means, that we are not learning and that this will not end up well.

Let me start with the obvious point: your debt is someone else's assets. The increase in debt as a % of GDP can be rephrased as an increase in assets as a % of GDP. It implies that the size of financial assets and liabilities is growing relative to GDP. That is not always bad. In many cases we think the opposite: the ratio of assets (or liabilities) to GDP is referred to as financial deepening and there is plenty of empirical evidence that it is positively correlated with growth and GDP per capita.

To illustrate why only looking at debt can give you a very distorted picture of economic fundamentals  let me choose a country that best illustrates this point: Singapore. In the graphical tool developed by the Financial Times one can see that government debt in Singapore has increased over the last years. Here is a longer time series from the World Economic Outlook (IMF) going back to 1990.

The current level of government debt is above a 100% (much higher than in 1990) and it puts Singapore in the same league as Spain or Ireland. But here is the problem: the government of Singapore has been running a budget surplus since 1990 (and many times a very large budget surplus).

What is going on? As the government of Singapore explains here, debt is not issued to deal with funding needs but to generate a set of Singapore government securities in order to develop a safe asset for the Singapore financial markets as well as for the compulsory national savings system called the Central Provident Fund. So while debt is very high, the value of assets is even higher and the balance sheet of the government of Singapore looks very healthy.

This is admittedly an outlier among governments, most governments do not have assets that equal in value their liabilities. But even in those cases someone is holding government debt. And it might be that government debt is held by its own citizens that are in many ways the shareholders of the government. So the consolidated balance sheet of the country might still look great (e.g. Japan). 

This argument does not deny that the actual composition and ownership of assets and liabilities matters (even if by definition they always have to match). We know well that certain credit booms are indeed associated with crisis so worrying about debt is a good idea. But one has to be very careful interpreting analysis (and newspaper headlines) that only refer to the debt side of the balance sheet. A richer analysis that understand where the assets are and how they relate to issuance of debt is necessary.

Antonio Fatás 

Sunday, February 1, 2015

Which countries managed the Great Recession better?

As we compare countries' performance since the beginning of the global financial crisis we try to look for patterns that explain differences in behavior and lessons on how to handle the next crisis. When doing that comparison we some times forget that looking at GDP growth does not always give us all the information we need to understand cross-country variation in performance. This variation can be due to demographic, labor market, productivity factors and while these three might be correlated over time, this is not always the case.

Here is a quick look at the years 2007-2013 for a group of advanced economies. The charts below plot the level of activity in 2013 measured as a ratio to the level in 2007.

We start with GDP.

We see the usual suspects at the bottom of the list and we also see on the right hand side the ones that have managed to do better during the crisis years. Japan and the UK sit in the middle of the table. 

We now correct for the potential effect of changes in demographics in particular working-age population (defined as 16-64 years old).

Not many changes except for Japan where the performance looks a lot better as it ranks #2 in this list.   [A caveat: any definition of working-age population is likely to be problematic. In many countries (in particular the US) activity rates above 64 years old and significant and increasing so this statistic might be giving us a distorted pictures of the true level of potentially-active population.]

Finally, what about if we look at GDP per worker? This will give us a sense on performance on productivity of those working, abstracting from the labor market performance (ability to employ the working age population). 

While this is a rough measure of productivity it is affected by many factors including the possibility of sectoral shifts as least productive sectors see a bigger downturn.

Some things do not change, Italy and Greece remain at the bottom of the list. But more movements on the other side. In particular, the UK is now the third-worst country and Japan goes back to the middle of the table. In the Euro area the biggest change happens in Ireland and Spain, both made it to the top 3. This means that for these two countries the labor market performance is the main drag on their GDP performance. Germany falls to the bottom half of the table suggesting that the strong German labor market performance has compensated a not too stellar growth rate of GDP per worker.

Antonio Fatás

Wednesday, January 28, 2015

Greece, EMU and democracy

One more post on Greece, possibly not the last one.

Markets are more worried about what is going on and there is more and more talk about the possibility of and exit of Greece from the Euro area. As I have argued in my previous posts, exit will not be the choice of the Greek government, it will be the only solution for Greece as the ECB refuses to provide liquidity to Greek banks as depositors run to avoid capital losses on their Euro deposits in the scenario of Greece leaving the Euro.

Let me start by repeating (as I have expressed many times in this blog) that I find that the economic policies followed in Europe have been a disaster, that the suffering that countries such as Greece had to go through during the last years should not have taken place. And I am convinced that in many of these countries, austerity has produced higher debt-to-GDP ratios, as opposed to lower ones. A real disaster.

But this is not what this negotiation is going to be about. The reality is that the crisis has had an impact on the way we all see the experiment of sharing a single currency, the experiment of EMU. While in the early days we all talked about optimum currency areas, the synchronicity of business cycles, the absence of a fiscal transfer mechanism, what we now realize is that the real issue is how to handle a full-blown crisis that puts governments at the edge of default and creates bank runs among Euro countries (something that many l thought it was impossible). The role that the ECB plays in those circumstances is not the typical role a central bank plays and one cannot ignore the political aspects associated to the difficult decisions they face.

And while it is true that Syriza has been chosen by the Greek voters and as such it is a victory of democracy, there are also voters in other countries that also feel they want their say heard by their governments.

And here is the question that I think is fundamental: if voters had a choice now, would they choose to join the Euro area given its current membership? What if they were allowed to change some of the members? There is no doubt that in some countries voters would like a different configuration of the Euro area. No doubt that Germany would be happier with fewer countries, in particular the "trouble makers".

And this decision will not be just based on economic arguments, some of it will be about the emotions generated by the crisis and some of it will be generated by the first statements of the Syriza government (and proposing a rethinking of the sanctions to Russia does not help).

So if the current membership does not work anymore, what do we do? There is no explicit process for this. Countries can opt out of the Euro if they do not like what they see. But the current negotiations with Greece will be seen by some as an opportunity to change who is in and who is out of the Euro.

If (big if) contagion can be avoided, Germany and Brussels have all the power in these negotiations. Greece does not want to leave the Euro.

Can contagion be avoided? The answer to this question three years ago was a clear no. And that's why this was not an option. Today I am not so sure. Three years ago Spain or Ireland or Italy were facing very difficult economic conditions that looked similar to Greece. Today that's not the case. Growth is very low but deficits are under control, debt to GDP ratios decreasing in some countries and interest rates are low and not reacting much to the Greek elections. The possibility of contagion today could come more from the political side. If voters in other countries decide to elect similar parties, we might repeat the same scenario in a few months in Spain or Italy. But will voters do this if they see that exit from the Euro is a possibility? Remember these political parties do not want to leave the Euro. Most citizens even if they are critical with European policies do not want to leave the Euro. My guess is that an exit of Greece from the Euro area will change political outcomes in European countries relative to what we see in the polls today. And this will limit the possibility of "political contagion".

Interesting times. More to come.

Antonio Fatás

Sunday, January 25, 2015

Grexit: it is not the debt, it is the future.

A follow up to my previous post now that we know that the Syriza party has won the election. What comes next will not be easy. And it is not because the policies proposed by Syriza are that radical or unreasonable and certainly they are not worse that what has been done in Greece since the crisis started. The real issue is that this is a wake up call for the Euro area (and possibly the European Union). A wake up call that without a consensus on what is the purpose and processes of a monetary union, this will be a failed project. The reality is that so far EMU has been built in an asymmetric way: the ECB was designed as a strong anti-inflation central bank with the Bundesbank in mind and that served a purpose (for everyone including Greece). The strict criteria to enter into EMU (low inflation, low budget deficits) were a great excuse for politicians in some countries to do policies that otherwise they could not have done internally. There was no doubt who was in charge and what was the ideology that prevail when it came to define policies. And that model worked well in times of economic growth when everyone, including Greece, enjoyed the benefits of stability and growth.

But the crisis made everyone realized that the model was not perfect, that there was no consensus around economic policy and, more fundamentally, that for monetary policy to function properly we needed some amount of risk sharing, something that no one had been willing to discuss before.

And the elections in Greece yesterday have made it even more clear that the consensus is gone. That the model that worked well until 2008 is being challenged by several countries. And without a minimum level of consensus, EMU cannot work. The problem is not that anti-austerity policies might stop in some countries. This is likely to benefit everyone in the short run including Germany. The problem is not that we might need to restructure Greek debt again, that is feasible from an economic and political point of view. The real issue is how to move forward, what will be the way in which the European Commission will deal with future budgetary plans of Euro members, how will the ECB treat sovereign debt in the future, how will markets perceive the risk of future default.

From the perspective of Germany (and other countries that share the same view and economic situation), any agreement with Greece that signals to the market that this would be the solution for any future crisis, would be a disaster. Germany needs a strong commitment from Greece and others that this would be the last time that this happens. But that is unlikely to happen. There could be promises but I cannot imagine how to make those promises credible.

So either Germany gives up and runs the risk of having similar negotiations later in the year with Ireland, Portugal, Cyprus, Spain and Italy. And it accepts the fact that we will be starting a new cycle of accumulation of government debt until the next crisis. Or it throws the towel. And I see this happening in two ways, either it refuses to be flexible in the negotiations with Greece and the ECB holds its promises that liquidity will stop unless there is an agreement, which will push Greece out of the Euro. Or Germany decides to leave the Euro and leaves the other countries to manage what is left. Both of these scenarios are likely to cause a crisis. The first one could potentially be more contained assuming the other Euro countries support Germany. The second one would be a major economic disaster for Europe and the world.

No, Syriza's policies are not that radical, crazy or absurd but the negotiation that starts today is between parties that are either scared by what has happened so far or are not willing to be members of a club that cannot commit to not doing this again. I still do not see how they will agree on a model to move forward.

Antonio Fatás

Monday, January 5, 2015

And this is how Greece might leave the Euro

An interesting month lies ahead for the Euro area. On January 22 the ECB will meet and they will either announce a QE-style monetary policy action, as most expect by now, or they will disappoint markets with yet another statement suggesting the need to wait for more data and the effects of what has been done so far. On January 25, three days later, elections in Greece will decide whether the first political party with strong views against austerity and with an explicit proposal for a serious haircut on its government debt reaches power in the Euro area.

No doubt that the outcome of these two developments will determine the fate of the Euro economy over the coming years but it is also possible that it determines the fate of the Euro area -- at least the current membership.

Rumors have started reaching the press that the Germans will not negotiate with Syriza and that they are ready to let Greece leave the Euro.  We have seen this before and we know the outcome: Back in 2011 and 2012 when the fear of Greece leaving the Euro was at its peak (and the threat of Syriza winning the elections was also real), the contagion to other countries, in particular Italy and Spain, forced the Germans (and the ECB) to come to the rescue. A haircut on Greek debt plus the "whatever it takes" statement from Draghi saved the day and ensured that no country left the Euro area.

But the situation is very different now for many reasons. So far, contagion has not spread to other Euro countries, possibly because the other countries are seen as having stronger fundamentals. But what really matters might not be economics but politics. In some of the other Euro countries we have political parties with platforms that are very similar to the Syriza party in Greece (for example, Podemos in Spain). They (and the citizens of these countries) will be looking very carefully at what is happening in Greece. If Syriza wins and their negotiating strategy is successful, it is likely that we will see similar political changes in other Euro countries and a revolt against the current Euro economic policy. This is the last thing that Germany wants.

How does Germany avoid this outcome? Let me be cynical and argue that they only have one potential strategy, a very risky one. Let the ECB be nice on January 22 and let them go ahead with a full-blown QE policy involving government bonds. Let the Greek decide on January 25 if they want to be part of this. If they Greeks vote for Syriza then the Germans will not negotiate and will only leave Greece with one alternative, to leave the Euro. If that happens, the financial system in Greece is likely to be under enormous pressure with a high chance of bank runs. While the risk might spread to other countries, the ECB could be very aggressive to avoid contagion. If a bank run happens in Greece and the ECB refuses to provide liquidity, Greece will default and be out of the Euro. This will lead, at least in the short run, to a deeper crisis in Greece with strong disturbances to the banking sector and businesses. This is exactly what the Germans need to scare the other countries in the Euro area not to follow the same path and stay in the Euro. The cost are the potential losses on Greek debt but at this point very few people believe that Greece will be able to pay its debt.

This is a serious gamble. It requires that the German voters accept the new ECB aggressive policies. That the potential losses associated to a Greek default and exit from the Euro are contained and that the other Euro countries play along with this strategy. Very risky.

But maybe I am wrong and the Europeans will find once again a way to kick the can further down the road without neither a proper solution nor a final crisis but I feel that this time is different and the possibility of a serious political challenge to the status quo is too high to ignore the possibility of a very volatile period ahead.

Antonio Fatás