Lately there has been a lot of media coverage about an Excel error by academics Ken Rogoff and Carmen Reinhart – co-authors of ‘This Time is Different’ – 2009. A student from University of Massachusetts tried to replicate one their models regarding growth rates when a country has a public debt of greater than 90% of GDP. Rogoff and Carmen stated that with this level of public debt growth in a country falls to a mean of -0.1%. However using the same data the student found that a figure of 2.2% was applicable in this context.
However Rogoff and Reinhart have been cautious about saying that high debt causes slower growth rates but it does highlight the validity of analysis connecting debt and austerity to growth rates. Adam Posen in the FT stated that the claim of a clear tipping point for the ratio of Government Debt to GDP past which an economy starts to collapse doesn’t hold. Following the second world war the US, UK, Belgium, Italy and Japan had public debt greater than 90% of GDP but there was not much of an effect on their economies. In Italy and of late in Japan stagnation in economies led to slowly rising debt levels. In the UK and US in the 1950’s growth returned and debt levels declined. What this is suggesting is
Slow growth is at least as much the cause of high debt as high debt causes growth to slow.
But a certain amount public debt is necessary for future development of any economy especially when you think about the construction of infrastructure and government spending on education. Both of which contribute to future growth and in theoretical terms move the production possibility curve outwards. This in turn creates growth and subsequently income for a government.
USA – Mad Spending v EU – Nervous Austerity
With one side of the Atlantic – USA – involved in quantitive easing (printing money) and the other – EU – with severe austerity, maybe somewhere in between would be a logical way to go about things. But is moderation a choice for policy makers when they have already gone so far down the track of their respective plans?
What can be concluded is that too much debt has costs for growth but the degree of those costs is dependent on the reasons for debt accumulated and what path the economy is actually taking.
Another satirical clip from Clarke and Dawe of ABC in Australia, this time on the crisis in Cyprus. I like the idea of the spin cycle with this new model and the impact the crisis is having on Russian investment. Well worth a look
If you look at the labour market in Spain you would think that it resembles the German economy 10 years ago when Gerhard Schroder was its leader. Schroder was responsible for labour reforms that ignited the German economy into one of the strongest in Europe.
Spain is relaxing labour laws and cutting public spending and there are some positive signs here in that labour unit costs are falling as result of greater productivity. However German’s vocational education sector was a significant factor in its improved performance as the education and training system is more job orientated. Furthermore, with austerity measures in place and more to follow – pressure from the EU to introduce yet another sales-tax rise – Spain will find it hard to generate any sort of growth. But if it does grow will it generate any reduction in unemployment? Because of labour reforms some economists now believe that only 1.5% growth is required to bring about net job creation rather than 2.5% as previous.
The 10bn-euro (US$13bn) bailout of Cyprus’ economy, agreed by the EU and IMF, demands that all bank customers pay a one-off levy and has led to heavy cash withdrawals.
Under the currently agreed terms, depositors with:
* Less than 100,000 euros in Cyprus accounts would have to pay a one-time tax of 6.75%.
* More than 100,000 euros would pay 9.9%.
The BBC says the president may want to lower the former rate to 3%, while raising the levy on the larger depositors to 12.5%. Some EU source told Agence France-Presse there could be a three-way split on the level of levy, grouped into accounts holding less than 100,000 euros, between 100,000 and 500,000 and more than 500,000. The clip below is from Al Jazeera – it shows at one bank in the Limassol district, a frustrated man parked his bulldozer outside and threatened to break in.
2008 – 2010 – approx 10-14 new cases of HIV infections per year among drug users.
2011 – 206 new cases
2012 Jan – Oct – 487 new cases
With the current state of the Greek economy there are more people who are vulnerable and use drugs. Some turn to cheaper drugs and inject them instead of smoking in order to get the same high from a smaller quantity. One of the main methods of controlling the spread of the virus is by the distribution of free, clean needles but the demand for more needles has increased from 50 per addict to approximately 200. However the spending cuts by the Greek government has meant that there is a shortage of basic materials.
With the US debt currently standing at 16 billion dollars and the prospect of a fiscal cliff – slashed spending and higher taxes – is it sustainable to keep on borrowing money? Historically Americans have preferred debt to taxes – you could say that it all started with the Boston Tea Party where they disposed of tea in the harbour because of the tax policy of the British government and the East India Company that controlled all the tea imported into the colonies. The video clip below from PBS News has MIT economist Simon Johnson talking about his recent book “White House Burning” which discusses the history of US debt – 225 years of it. He states that if we want to keep Social Security and Medicare we need to think how you are going to pay for it. The answer is NOT selling more debt to the Chinese but to pay the taxes to support social insurance programmes. He also mentions that if you go over the fiscal cliff in a disorganised way, with significant political confrontation, it will be a disaster. Quite simply the US government needs to acquire more tax revenue and bring its spending under control.
Another really good video from Paul Solman of PBS, this time he talks with Wall Street Journal journalist David Wessel about America’s debt. Some noteworthy facts include:
* 63 percent the government spent went out the door without a vote of Congress
* 20 percent of the federal budget is spent on defense – $700 billion last year, more than the combined defense budgets of the next 17 largest defense budgets of other countries
* Each aircraft carrier is $11 billion. This is enough to replace 750,000 shoulder, knee, and hip joints for people on Medicare.
* In 2011 the government took in $1.3 trillion in tax revenue, but the Treasury adds up the value of all the loopholes, deductions and credits, and they amounted to $1.1 trillion.
Since the start of the global financial crisis in 2008 and with the exception of Germany, none of Europe’s biggest economies have returned to the level of economic output they had in the pre GFC days. In Japan in the 1990’s there was the need for the central bank to aggressively fight deflation, and let banks take credit losses quickly, suggesting that expansionary fiscal policy did not offer a way out of low economic growth.
According to the New York Times – economic growth not realised represents investments in education that were never made, research was never financed, businesses that failed and careers that ended too early or never got off the ground.
Economists warn that the euro zone is on the same path as Japan was in the 1990’s, when failure to deal with weak banks led to a decade of stagnation. The Japanese never fixed their banks and as banks in Europe have limited cash reserves they are reluctant to take the risk of lending money. Although the ECB has supplied banks with significant amounts of cash they cannot force them to lend the money out to investors which ultimately creates growth and jobs. Below are some statistics which allude to this.
Demand for housing loans in Q1 2012
Italy – business loans 38%↓
Recessions can be beneficial as they can improve efficiency and reduce risky lending. However for the eurozone this is no normal recession in that its duration will be significantly longer than the norm. See the interview below with investor George Soros.
From Felix Salmon of Reuters – this astonishing GIF comes from Nanex, what we see here is relatively low levels of high-frequency trading through all of 2007. Then, in 2008, a pattern starts to emerge: a big spike right at the close, at 4pm, which is soon mirrored by another spike at the open. This is the era of traders going off to play golf in the middle of the day, because nothing interesting happens except at the beginning and the end of the trading day. But it doesn’t last long.
By the end of 2008, odd spikes in trading activity show up in the middle of the day, and of course there’s a huge flurry of activity around the time of the financial crisis. And then, after that, things just become completely unpredictable. There’s still a morning spike for most of 2009, but even that goes away eventually, to be replaced with sheer noise. Sometimes, like at the end of 2010, high-frequency trading activity is very low. At other times, like at the end of 2011, it’s incredibly high. Intraday spikes can happen at any time of day, and volumes can surge and fall back in pretty much random fashion.
The recent LIBOR crisis that hit the headlines last week has shown that once again banks which were once reknowed for their prudence and considered boring have now been replaced by greed and reckless risk-taking. According to the WSJ, in the early years of banking an institution needed to attract deposits from the public and therefore cultivated prudence and integrity and publicised this to potential investors. Lets face it being boring was potentially a selling point for bankers. During the 20th century this changed and you only need to look no further than the pre-crisis advertising in which the rhetoric wasn’t one of care and honesty but a willingness to lend to anyone.
However in today’s environment do depositors care so much about the prudent and trustworthiness of banks? Do they actually benefit from this? When you have a situation that the banks become “too big to fail” and are bailed out by the government there seems to be nonchalant attitude amongst depositors to the integrity of banks. This then means that the banks have little incentive to care either. It seem that banks gain little advantage over their competitors from being prudent. In fact depositors can gain from the banks making risky uses of their money. As the government will guarantee their money they then can profit from higher rates of interest by the banks being prepared to make riskier investments. This has encouraged investors to favour risk-taking banks.
Another interview with Paul Krugman this time with Paul Solman of PBS. Krugman describes the events in 2008 as the Wile E. Coyote moment – a character in the Road Runner cartoons. That is, according to the law of cartoon physics, it is only when you look down that you realise that there is nothing below. Krugman likens this to the situation where housing bubble had started to burst and banks called in loans to be repaid.
But when everyone everybody tries to pay down debt at the same time what happens is the economy shrinks, prices of assets fall and people lose their jobs, people lose their income, profits crash, and everybody ends up being in a worse financial position than they were before because they’re, they’re… When everyone tries to do it at the same time, the result is mutual destruction.
Here is the first half of an interview on Hardtalk. Nobel economist Paul Krugman continues to see that the way out of the economic crisis is to spend more. He says that Greece will have to leave the euro as there is no alternative but whoever makes the decision for Greece to go would simultaneously be ending their own political career. He does state at the end of this clip that somebody who tries to bring in Weimar German and Zimbabwe as examples of hyper-inflation with further spending should be ‘ejected from the conversation’. Well worth a look.
Here are some interesting thoughts from the ASB bank with regard to the eurozone crisis situation. Predicted market outcomes as participants become concerned over potential contagion:
* The USD is likely to strengthen further.
* European Central Bank to cut interest rates 50 basis points to 0.50%.
* Bank of England to undertake further Quantitative Easing.
* Federal Reserve to undertake a third round of Quantitative Easing.
* Reserve Bank of Australia cuts rates 100 basis points to 2.75%.
* Reserve Bank of New Zealand cuts rates by up to 50bp to 2%,
Also look at the graphs below especially the one showing the withdrawal of money from trading banks.
In the book “This Time is Different” by Carmen Reinhart and Ken Rogoff (2009), they have studied a number of different types of financial crisis including:
• Sovereign debt defaults, which occur when a government fails to meet payments on its external and domestic debt obligations, and
• Banking crises, when a country finds that a large part of the banking sector has become insolvent and there is a loss of confidence by the consumer which can often lead to a run on the bank
A high occurrence of global banking crises has historically been linked with a high frequency of sovereign defaults of external debt. The graph below plots the share of countries that have gone through a banking crisis against the comparably calculated share of countries experiencing a default or restructuring in their external debt.
The data suggest that if there is a surge in a banking crisis there is the strong likelihood that this will be accompanied by sovereign debt defaults. Research has shown that real central government debt typically increases by about 86 percent on average (in real terms) during the three years following the crisis. It is therefore hardly surprising that there has been a sharp increase in sovereign defaults in the current global financial environment.
The above is a brief extract from an article published in this month’s econoMAX – click below to subscribe to econoMAX the online magazine of Tutor2u. Each month there are 8 articles of around 600 words on current economic issues.
With 24% unemployment and approximately 50% of those under 25 without a job, can it get much worse for the Spanish economy. Well it just has – Standard & Poors have downgraded Spain by two levels to BBB+ from A, with a negative outlook and this has “direct negative rating implications”. However the latest trend is for public-sector workers to lose their jobs with 32,000 government employees being made redundant in the first quarter of this year. When they lose their jobs they receive unemployment benefit for up to two years. When that runs out, the central government has been giving for the past several years a monthly subsidy of €400 ($530) to people who still haven’t found jobs. Most laid-off workers cut down on consumption, so they aren’t spending on goods and services to help stimulate the economy or fill tax coffers. But the dilemma is if they don’t bring in austerity measures they won’t get bailed out by their European colleagues – balanced budget v growth in the economy.
With the stagnating growth levels in the developed world – USA, Europe, etc – the emerging economies are not immune from this environment. Lower export demand for goods and services impacts on average growth levels in those emerging countries. In order to get out this sluggish condition economies can employ both monetary and fiscal policy. However richer nations have tended to exhaust both these policy options by dropping interest rates to exteremely low levels (see interest rates below) and in their inability to exapand their borrowing because of the size of governmets deficits. Emerging economies average budget deficit 2% of GDP, against 8% in the G7 economies. And their general-government debt amounts on average to only 36% of GDP, compared with 119% of GDP in the rich world.
The Economist ranked 27 emerging economies according to their ability to utilise expansionary fiscal and monetary policy. They used 6 indicators to assess a country’s ability to use these policies. The first 1-5 focus on the ease of which countries can manipulate monetary policy interest rates. 6 concerns Fiscal Policy flexibility
1. Inflation – 2% in Taiwan to 20% or more in Argentina and Venezuela.
2. Excess Credit – measures the gap growth rate in bank credit and nominal GDP. Argentina, Brazil, Hong Kong and Turkey have seen credit grow vastly beyond GDP whilst Chinese bank lending is now rising mor slowly than GDP.
3. Real Interest Rates (interest rate – CPI) – tends to be negative in most economies. Over 2% in Brazil and China
4. Currency Movements (against US$ since mid-2011) – Nine countries, including Brazil, Hungary, India and Poland, have seen double-digit depreciations, with the risk that higher import prices could push up inflation.
5. Current-Account Balance – If global financial conditions tighten, it would be harder to finance a large current-account deficit, and so harder to cut interest rates.
6. Fiscal-Flexibility Index – combining government debt and the structural (ie, cyclically adjusted) budget deficit as a percentage of GDP.
From The Economist
The average of these monetary and fiscal measures produces our overall “wiggle-room index”. Countries are coloured in the chart according to our assessment of their ability to ease: “green” means it is safe to let out the throttle; “red” means the brakes need to stay on. The index offers a rough ranking of which economies are best placed to withstand another global downturn. It suggests that China, Indonesia and Saudi Arabia have the greatest capacity to use monetary and fiscal policies to support growth. Chile, Peru, Russia, Singapore and South Korea also get the green light.
At the other extreme, Egypt, India and Poland have the least room for a stimulus. Argentina, Brazil, Hungary, Turkey, Pakistan and Vietnam are also in the red zone. Unfortunately, this suggests a mismatch. Some of the really big economies where growth has slowed quite sharply, such as Brazil and India, have less monetary and fiscal firepower than China, say, which has less urgent need to bolster growth. India’s Achilles heel is an overly lax fiscal policy and an uncomfortably high rate of inflation. The Reserve Bank of India has sensibly not yet reduced interest rates despite a weakening economy. In contrast, Brazil’s central bank has ignored the red light and reduced interest rates four times since last August. In its latest move on January 18th, the bank signalled more cuts ahead. That will support growth this year but at the risk of reigniting inflation in 2013. Desirable as it is to keep moving, ignoring red lights is risky.
In spite of the fact that Hungary is not part of the eurozone, and although its problems differ from that of Greece, there are concerns that its banking problems could still have a damaging impact on the european economy. Austrian banks alone are on the hook for liabilities of US$40bn. The anxiety originates from the amount of public and private sector debt that is held in foreign currencies.
When the Hunagarian currency – the forint (ft) – was strong it was okay to have liabilities in euros and Swiss francs. This is because there are less Fts required to buy a euro or Swiss franc in order to pay the interest on the debt. However the rapidly falling Ft has made it more expensive to pay back the interest on loans which in turn has led to increasing bad debts. The Ft, sank to a record low against the euro a month ago (see graph), and its government bond yields rose above 11 percent on concerns that amid the euro zone crisis it may not be able to fund its increasing debt with projected weak economic growth.
Although it has recently increased against the euro (see graph), Hungary is still seeking an international credit line of 15 to 20 billion euros.
Below is a flow chart which explains the problem that indebted eurozone countries have in trying to improve their fiscal position – it becomes a self-fulfilling cycle. Higher interest rates are needed to attract investors but this puts more pressure on government fiscal stability which leads to greater unease amongst investors.
Although investors focused on small countries like Ireland and Portugal, Italy and Spain were experiencing significant problems with regard to fiscal discipline. These two economies are among the biggest in the eurozone and a default by one of them will have serious consequences – Spanish and Italian government debt is held worldwide. However the belief that the crisis was initiated by fiscal neglect is not totally correct. Before the financial crisis of 2008/09 Italy’s debt had been falling as proportion of GDP. Furthermore Ireland and Spain were being used as model countries with their low debt and low government deficits.
Problems of one currency in getting out of the mess
With all Eurozone countries sharing the same currency (the Euro) one of the main instruments in the pre-eurozone environment has become invalid. When a country has their own currency imbalances such as differing labour costs between countries would be offset by a typical revaluation of their respective currencies. In pre-eurozone, if there was a rise in labour costs in Italy this would lead to a fall in the Italian currency (the Lira) and thereby restoring some of Italy’s lost competitiveness against other trading nations. However under the euro these balances cannot be corrected by currency revaluation. Therefore the result for Italy is that the euro is too strong (strong currency makes exports less competitive) and too weak for exporting countries like Germany. Therefore, strong increases in the unit labour costs of the peripheral European nations have left them burdened with significant competitive disadvantages.
What does this mean for New Zealand?
European policymakers will do enough to avert disorderly financial disruption – though it could be that only a dramatic turn for the worse prompts decisive rather than
incremental action. So what are the implications for New Zealand?
- The likelihood is we will have another year of volatility in global financial markets.
- ‘What if’ risks to the downside will linger, so scenario planning may be beneficial for businesses.
- The crisis emphasises that New Zealand needs to work hard to integrate into Asia and
focus strongly on the trade opportunities there.
Source: ASB Bank
Paul Krugman wrote an interesting piece on his blog (New York Times) about how those in Washington DC have no idea what they are talking about when in comes to debt. Although the US economy was technically going through a recovery last year, the levels of unemployment have been worringly high – 9%. However there is concern in Congress about the rising budget deficit and the need to reign in government spending.
Krugman explains that Washington isn’t just confused about the short run; it’s also confused about the long run. Those concerned about deficits portray a future where we have to pay back what we have borrowed – it is not like taking out a mortgage and struggling to paying it back. Krugman looks at government debt in two ways:
1. Although households have to pay back debt governments don’t – all they need to do is ensure that debt grows more slowly than their tax base. As the US economy grew (and the tax revenue for the government) the debt from WW II became immaterial and was never repaid – see graph below.
2. What is unique with regard to US debt is that it is not like an individual who owes debt to a bank. Essentially the US debt is money that is owed to the US themselves. Foreigners do hold a significant amount of government debt in teasury bonds but every dollar’s worth of foreign claims on the US is matched by 89 cents’ worth of US claims on foreigners. Furthermore because foreigners tend to put their assets into safe US investments, the US actually earns more from its assets abroad than it pays to foreign investors.
Nations with responsible governments willing to impose modestly higher tax rates when the situation warrants it have historically been able to live with much higher levels of debt than today’s conventional wisdom would lead you to believe. The UK has had debt exceeding 100% of GDP for 81 of the last 170 years. Keynes suggested of the need to spend your way out of recession when the UK was deeper in debt than any other adanced nation today, with the exception of Japan. Krugman states that the US doesn’t have a government that is responsible ie. willing to impose higher taxes. Debt matters BUT more government spending is needed to reduce unemployment.
Here is an informative graphic with explanations for the decline/rise in the NZ$ – source BNZ.
The key points from the BNZ Financial Market Wrap are:
• Risk aversion relating to the EU debt crisis dominated markets until a late month rally.
• The tone of US data continues to improve. Suggesting the US economy has averted recession.
• In NZ, RBNZ rate cuts were priced. Declining interest rate differentials, commodity prices and risk sentiment undermined the NZD.
• The NZD’s end of month rally was driven by improving global risk appetite.
• We see further upside to NZD on improving interest rate differentials. Next week’s RBNZ meeting is a potential catalyst.