Reasons To Be Cheerful

I finaly noticed the new zeitgeist. It was an article in yesterday's FT that brought it home to me, but more of that later.

Four years on from the start of the crisis, a new common sense is emerging and it is roted in ideas of equality. The first idea is a rejection of the gross inequality that has grown over recent decades. The super rich are revealed as undeserving. They did not acsend to the heights of wealth on merit - through education, talent, innovation or risk-taking. Much of the wealth comes from the extraction of economic rent combined with a redirection of the spoils to the agents rather than the owners of firms. Some time ago I described this as agency capitalism.

Meriit is a key part of the new zeitgeist. The good society needs not just a concern for the weakest but it demands a contribution from each of its members. This is the idea of fairness as decribed in Will Hutton's book Them and Us. To anyone who read Hutton's latest work, Ed Miliband's conference speech made perfect sense. It only seemed odd to a commentariat who did not yet see how the times are changing.

Then yesterday, in the FT, Martin Wolf wrote a column on rising inequality and identified the demand for a huge agenda, covering education, employment, corporate governance, finacial reform and "elements of redistribution".

For me the idea that a mainstream commentator has seen the importance of tackling inequality means that the zeitgeist is taking root.

I will have more to say on this. It is afterall the soul of this blog. Merry Christmas.

To update: I will add the links and correct the typos when I get to my desktop.

Austerity Can Drive Up Interest Rates

Chancellor Osborne boasts continually that his austerity programme has reduced British interest rates compared to our European neighbours. (He means the rate at which government can borrow not the rate you pay on your mortgage but he doesn't always make that clear.)

Via Krugman, we have this from Olivier Blanchard, the Chief Economist at the IMF:

... it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. 

In other words austerity programmes can push up the interest rate on government borrowing as a result of the slower growth which they cause and which bond markets are beginning to price in.

To be clear Blanchard's claim is hedged with caveats. This is based on estimates which the IMF is still working on. We already know that austerity can fail to reduce the government debt ratio when it slows economic growth. Now it seems it it might increase the cost of government borrowing making reducing the deficit more difficult.

It's Not Fair!

My seven year old was very upset the other day. My better half had just told her off for some minor misdemeanour. She was inconsolable and  the reason was not the telling off so much as that her older brother had done it first and not been seen.

It's not fair , he did it first and he didn't get into trouble!

It sort of reminds me of France reacting to the threat of a downgrade of its credit rating.

Update: I explained to my daughter that my son didn't get into trouble because he has his own currency which can devalue to stimulate net exports, that he has his own central bank which can act as a lender of last resort and that he only needs to refinance half as much of his debt each year.

ECB's Dangerous Game?

Here is an odd thing. The EU summit failed to produce a credible plan for fiscal union. The ECB did not become the "lender of last resort" as economist's believe is necessary to end the crisis. Yet, the roof did not fall in and the panic has ebbed. With no political or monetary intervention to calm the markets, the Euro has muddled on through another week.

What has happened? Perhaps Mr Draghi has not been as invisible as I previously thought. The ECB did inject liquidity into Europe's struggling banks. That seemed to be a response to the freezing up of interbank lending which could have led to a new credit crunch. It seems to have done something else. The liquidity has found its way to the bond markets easing the pressure on Italy and other peripheral governments.

Coincidence? Or conspiracy? There is a fascinating analysis of ECB policy on Vox, published before the summit. It claims that, far from being a weak central bank unable to do what its peers can by guaranteeing government debt, the ECB is using its political independence to play a very political game.

The ECB is a full-blooded political actor engaging in a strategy aimed at forcing EU political leaders to embrace fiscal rectitude and a quantum leap forward in European integration.

The allegation is that Mario Draghi is using the crisis to force reform on reluctant governments. The ECB is doing just enough to keep their economies from collapse but not enough to get the market off their backs. In fact it wants the markets to keep the pressure on. Comparing the ECB approach to military strategy the article claims:

Its philosophy is that you never offer your opponent certainty (by pre-committing to buy all Italian debt at 5% yields, for example). Rather, you constantly seek the dislocation of your opponent’s mind until this dislocation (10-year interest rates above 6-7%) renders the delivery of a decisive blow practicable.

Indeed the article alleges that the ECB played a part in the ejection of Mr Berlusconi from office.

The implications of this analysis are profound. Are democratic governments being undermined? What legitimacy has the ECB for acting as a political player? Who decides on the policy agenda of the ECB and who can hold it to account?

Apart from legitimacy, is its policy correct? By backing a particular theory which puts supply side reform above addressing the deficiency in demand, is the ECB pursuing the wrong policy? That is one danger if the ECB is playing a political game: that it may be pursuing a disastrous policy.

Another danger of the ECB's alleged political role lies in the implementation of the policy. Could the ECB make the fine judgements necessary to keep the bond markets on edge without starting a bank run that would ruin us all?

Source: Jacob Funk Kirkegaard, The next strategic target: De Gaulle’s EU legacy, Vox, 30/11/2011

ECB to the Rescue, Not

Last week's excitement about a summit to save the Euro was all based on the idea that once a "fiscal compact" was agreed the ECB would act. I was sceptical, and even before the summit reached agreement on the pact Mario Draghi was explaining why he could not do what was expected.

So why did everyone get so excited? The problem is that ECB political independence means that there can be no explicit deal between the Bank and governments. Yet markets and commentators alike thought there was some kind of a deal.

I know I've said this before but I think the logic went like this:
1 - A deal between Angela Merkel and the ECB could not be announced publicly.
2 - No deal was announced publicly.
3 - Therefore there they have done a deal.

Getting Fiscal

Flash, I love you but we only have three days to save the Euro.

The depressing part of this week's narrative is that fiscal union is completely irrelevant to resolving the Euro crisis.

Would fiscal union have prevented the current crisis? A moment's recollection is enough to see that it wouldn't. Spain ran a budget surplus in the three years before the crisis and brought its debt ratio down to 32%. Ireland too ran a surplus and at 25% was well below the Maastricht limits until it took on the debt of its failing banks. Even Italy had its debt on a declining path from around 120% in 1996 to 103% before the crisis.

OK there was Greece, but Greece was prepared to lie and cheat on its national accounts. Ordinary rules cannot catch a determined cheat.

There are two aspects of a fiscal union which could help. One is transfers from stronger countries to weaker ones. The second is a common treasury issuing common bonds. That is why fiscal union works in the US; but both are off the table in the Eurozone.

So why is there a buzz of hope around the Merkozy proposal? The answer is that Signor Draghi dropped a hint that, with a fiscal compact agreed, the ECB might do something. What the ECB needs to do is massive. It has to underwrite the bonds of all Eurozone governments without limit. A suggestion of a possible undefined move doesn't quite fill me with confidence.

Isn't it ironic?

Has anyone else noticed the glaring contradiction in Osborne's speech to the Conservative party conference? (I admit I was distracted by the bare-faced fibbing.) Chancellor Osborne has become the champion of credit easing, which if it means anything, means making credit easier.

…borrowing too much is the cause of Britain’s problems, not the solution. …You can’t borrow your way out of debt.

So too much borrowing is the problem, and making it easier to get credit is the solution.

Keep Telling Those...

Behind the little fib about the worst debt crisis in British history, lurks the real whopper - the claim that when Labour left office Britain faced a debt crisis. This has been Chancellor Osborne's consistent narrative for the last two years. A debt crisis happens when a government can borrow only at ruinously high interest rates.

So here is the recent history of the interest rates paid by the British government:

Can you see the surge in interest rates during the "debt crisis"? Nor me.

Little White Lies

George Osborne,yesterday:

First, the last government borrowed too much money... They saddled the country with the worst debt crisis in our history.

The real history of British debt:

Update: I've replaced the broken link with a chart using the same data from http://www.ukpublicspending.co.uk/

Fix the Banks to Fix the Crisis

While conventional wisdom says that Europe is embroiled in a debt crisis, I keep pointing out that it is still a financial crisis. The problem is not government debt; it is the solvency of the banks. Fixing the crisis should start with fixing the banks.

Martin Wolf in the FT has a nice illustration of the problem. He shows a chart of the exposure of banks to debt of Greece, Ireland and Portugal. German banks holding such debt  could lose as much as 60% of their capital. France is a little better with exposure worth a bit more than 30%. Even British banks are as risk to around 20% of their capital. Add in Spain and the picture is much worse. German banks' exposure is almost 100% of their capital and French banks have risks up to 60%.

This explains why Eurozone governments are so keen to avoid a default. If soverign debt had to be writen down, bank losses would push them to the brink of bankruptcy, meaning new bail outs. If Greece defaulted on its debt, German banks would need to be rescued by German taxpayers, in effect turning Greek government debt into German government debt.

This also explains why there is now talk of "reprofiling" rather than "restructuring" Greek debt. Which means simply extending the payback period of loans rather than cutting the face value of debt.

The truth almost came out in yesterday's Today programme. A Greek economist explained that the difference is  one of accounting. Reprofiling means that the loan remains unchanged as an asset on a bank's balance sheet. Restructuring forces a bank to regonise the loss and so face up to its solvency problem. ( Adam Shaw jumped in before he could complete the point to press his own view that the language was just "politics".)

Of course, reprofiling doesn't make the banks any more solvent. It just delays the day of reckoning.

Does Government Debt Reduce Growth?

Kenneth Rogoff, a very respected economist, repeated in the FT his claim that there is a threshold for government debt above which growth begins to slow.

According to my recent research with Carmen Reinhart, debt-to-income ratios are already at, or near, postwar highs across advanced economies. Many are close to the roughly 90 per cent debt-to-income threshold which, historically, begins to be associated with lower growth.

This claim has been questioned by others who point out that the result does not come from the well researched book This Time Is Different, but from another short paper. Paul Krugman in his blog has made some good points challenging the research. (link added) In particular Krugman questions the direction of causality. Does low growth increase debt, not just becase of automatic stabilisers but also because the numerator in the debt ratio is lower?

I am also concerned at how the idea of a threshold is arrived at. The paper simply slices the data into four sets where the debt ratio is below 30%, 30%-60%, 60%-90% and above 90% and then compares median and mean growth rates. So the 90% "threshold" is manufactured by the methodology. It does not emerge from the data.

I don't have access to the dataset they used and so I decided to find an easy to assemble dataset which could be used to test for a threshold around 90% debt to GDP ratio. The main criterion would be a set of data including a number of countries and periods when government debt was high.

Looking into Eurostat I was able to find the data for the 15 countries which were already members of the EU in 1996 and looked at the numbers for general government gross debt and growth rates in each year between 1996 and 2007 inclusive. I thought it reasonable to cut off the data in 2007 which is both before the disruptions of the Great Recession, and also because the data is less likely to be revised in future.

This gave me 180 data points which I put on a scatter chart. Here is the result, click on the chart for a closer look:

I see no sign of a threshold at or near the 90% debt ratio. You might see a slight correlation between high debt and low growth, but there is not much. Trying a linear regression gives an R2  of 0.09 which is not significant and so I haven't added a trendline.

I don't know how to show the median lines using Excell, but I did calculate that the median growth rate in the dataset is 3.05%. Of the 34 data points which lie above the 90% debt ratio there are 15 above and 19 below this median. So this data does not support Reinhart and Rogoff's claim.

Of course other data sets should be used, say EU 27 plus Switzerland and the non EU Nordic countries, and over a longer period. I look forward to seeing the results of such research.

Feint Praise

Gavin Davies has a strange piece in today's FT; he rejects all George Osborne's argument for austerity but urges him to stick with Plan A.

Mr Osborne likes to claim (falsely) that Britain had a fiscal crisis or was on the brink of a crisis like Greece or Ireland and so his cuts were unavoidable.

Gavin owns up that this is nonsense:

Admittedly, the public debt ratio is lower than in other economies, and a large proportion of UK debt is funded on a long-term basis. There has also been no sign whatsoever of any funding problems in the gilts market.

So, this is austerity of choice not necessity:

The new government chose to reduce the risks of a sovereign debt crisis at the expense of taking somewhat greater risks with near term economic growth.

Mr Davies thinks that the rationale is wrong but the policy correct. He does argue that the deficits was high and that it could not go on at 11% of GDP for long. Who disagrees with that?

There is a but: stick with Plan A but if the economy dips be ready with Plan B and the bank needs to keep interest rates down.

It is absurd to argue that fiscal policy tightening of 2 per cent of GDP will not depress economic growth. Of course it will, and the Bank should be extremely wary of adding to this tightening by raising interest rates.

Could it be that the praise for George is just a feint?

Competitiveness Pitch

So the Franco-German plan for a "competitiveness pact" ran into opposition at the summit last week. The plan which is meant to cover the eurozone, includes ideas like harmonising corporate tax rates and pushing up retirement ages, which do not seem to me to have much to do with competitiveness.

Leaving aside the issue of how meaningful it is to focus on competitiveness. I thought to check whether there is any evidence that the Eurozone is failing in international competition.

The latest figures show a current accout deficit of 0.4% of GDP. Over the last 4 quarters the current account has varied between a surplus of 0.5% and a deficit of 0.9%. In other words the Eurozone is selling pretty well as much as it buys.

Countries Do Compete

Ireland for example has a low rate of corporation tax in order to attract firms to set up there. Countries and regions compete for inward investment.

Imagine a Japanese car company wanted to set up a new factory to produce luxury cars for the European market. It choice of location might come down to Belgium or Slovakia. Both countries would court the Japanese investor. One of them wins and X billion Yen are invested in the lucky nation.

That is not the end of the story. Net trade is equal to the difference between domestic savings and investment:
X-M = S-I
(exports minus imports = savings minus investment)

So all else being equal, the winning country would find its trade balance falling by X billion Yen. In other words the more successful a country is in attracting inward investment, the bigger its current account deficit gets.

That is one reason why the current account does not tell you whether a country is economically successful or not. There are many reasons why the current account might be in surplus or in deficit. Conversely, being competitive in export markets need not equate to economic success.

The idea for this post arose from a discussion I had while on my quest for enlightenment on the issue of competitiveness

Competitiveness Patch

According to press reports, tomorrow's EU summit will discuss a "competitiveness pact".

My questions remains: is competitiveness Europe's problem?

I don't mean: is Europe uncompetitive? As Paul Krugman argued a long time ago, countries and major economic blocs do not compete economically with each other. Companies seek competitive advantage, countries seek comparative advantage.

My question means: is chasing competitiveness the problem? Pursuing the wrong goal will lead to adopting the wrong policies, and allocating funds to the wrong places. Which is why Krugman described "competitiveness" as a dangerous obsession.