“There’s a 60 percent probability that most advanced economies will fall into a recession, while authorities are running out of options to provide emergency support.” — Bloomberg News today, describing the views of Nouriel Roubini

This forecast from a sometimes-prescient and widely quoted economist brings to mind a question that many people now find irrelevant.

Which should we policymakers choose, option A or option B? How about doing whatever is necessary to balance the government’s budget? Increasingly, policymakers believe that is their only option. In some countries, these policymakers may be right. For them, options A through Z are to raise taxes or cut spending. This is what happens when (1) tax revenues are weak, (2) money is needed to make payments on government debt, and (3) the country in question does not or cannot print its own currency and cannot make reserves for its own banks.

Here in the United States, point (3) above does not apply. Hence, the federal government can issue any amount of securities, with the Fed purchasing them if necessary, as long as Congress is willing to keep increasing the debt limit. Unfortunately, however, the stimulus package of 2009 is wearing off, and Congress and the President have not acted quickly enough to increase spending or reduce taxes. As a result, combined government employment at the local, state, and federal levels has been falling. Unemployment remains ultra-high. Hence, we look forward with great concern to President Obama’s upcoming address on jobs creation. Many constructive proposals are likely to be on offer.

On the other hand, all three points in the third paragraph of this post seem to apply to most of the countries in the Eurozone. They are in some kind of a trap, perhaps a debt trap. continue reading…

Conversations surrounding eurozone disintegration have largely focused on the prospect of Greece making its exit, but the publication of this Hans-Olaf Henkel op-ed in the Financial Times puts the possibility of a German departure front and center.  For an analysis of the consequences should Germany revert to a national currency, see this Levy Institute policy note put together by Marshall Auerback.

You might wonder if this question is a misguided satire of Keynesian proposals like the ones in this Institute one-pager for boosting employment in a time of weak economic growth. The question is not meant as a satire, though. In a time of increasing recession fears, policies specifically aimed at reducing the value of the dollar have gained some supporters. Many scholars see a deliberate weakening of the U.S. dollar and/or a moderate increase in the U.S. inflation rate as something to be sought after in itself, not just as an unfortunate side effect of monetary or fiscal stimulus.

Kenneth Rogoff, for example, recently reprised the classic argument that the burden of debt falls when prices rise across all industries. (Rogoff’s Financial Times article is here. The New York Times discusses his views here.)  To wit, moderately higher prices obviously allow firms that have debt in dollars to more easily meet their debt-service obligations. Furthermore, increases in prices often bring higher wages, albeit with a time lag, making it easier for consumers to pay off their debts on time. In the United States, this is a very salient point, in light of high debt levels in nonfinancial business and the household sector, which we documented in this recent post.

Meanwhile, on the other hand, John Plender skeptically reminds Financial Times readers (and perhaps proponents of modern monetary theory [MMT]) of the possible dangers associated with policies that intentionally or unintentionally invite a spurt of inflation. continue reading…

(Clicking on picture will make it larger.)

Floyd Norris has an interesting column in this morning’s New York Times. Earlier this week, I was getting ready with some observations similar to his, though I am sure I could not have done as good a job as he has in getting across the gist of the problem and presenting some evidence. Essentially, Norris shows that since the introduction of the euro in 2000, products from the countries now in fiscal crisis have lost competitiveness relative to German products in international markets. Norris presents data on competitiveness. His data is similar to the series depicted in the chart at the top of this post, but the data above are real exchange-rate indexes. The lines in my chart compare the competitiveness of various economies’ exports, taking into account not only differences in unit labor costs but also the values of their currencies relative to those of their trading partners. Norris’s graph and my own feature data from different economies.

Norris’s point is that Germany is an big exporter partly because it has reduced labor costs relative to its competitors. Meanwhile, according to Norris’s theory, the peripheral countries of Europe, such as Greece, Ireland, and Portugal, have become less competitive, as their labor costs have risen relative to those in Germany and other “core” European nations. And because of the common currency, these higher-cost countries cannot use a devaluation to regain competitiveness.

As all acknowledge, the issues involved are complex. One key critique of the current approach to policy embodied by the European Central Bank and European Union rules is that this game clearly has winners and losers, mostly the latter. Norris’s graphs show increasing trade deficits in Italy, France, Spain, as well as the aforementioned troubled economies. While there is no reason that all countries must lead at once, someone, in either government or in industry, must hire workers to produce goods or services if employment is to be increased. Current bailout agreements and big debts are leading to drastic cuts in government employment and wages, even as they bring protests from opposition parties in countries called upon to help fund bailouts. This has contributed to a situation in which unemployment is extremely high in much of Europe, while all are focusing on the need to cut government spending, seemingly ruling out new or enlarged Keynesian public works programs.

However, it must also be said that the notion of cutting wages and benefits is also hard to swallow for most Europeans. The countries currently in deep crisis are not known as having high real wages for rank-and-file workers. Also, wage cuts have a tendency to undermine domestic demand for consumer goods, but cannot accomplish the complex task of making a country’s exports competitive in foreign markets. This is doubly true at a time when so many countries are attempting to cut production costs at the same time. Wage cuts do not reduce standards of living if they are accompanied by cuts in domestic prices. However, deflations have a tendency to make it more difficult for consumers and governments to pay off debts, which are mostly for a fixed amount of euros. Also, most deflationary policies tend to reduce economic growth and are appropriate only when the economy is booming and inflation is high. This is one of the key problems with the “new Keynesian” view—held by many economists—that rigid or “sticky” wages set in union contracts, etc., are a key cause of unemployment during business-cycle downturns.

There is much discussion of these issues on the web these days. Jeffrey Sommers and Michael Hudson, who holds an appointment at the Institute, have pointed out in a number of articles this year (such as this one) that the Latvian economic-policy model, which involved spending cuts and other efforts to regain competitiveness, has not been as popular in Latvia itself as some commentators have implied. Moreover, recent policies in Latvia have led to large-scale emigration, while failing to bring strong economic growth, in the aftermath of a 25 percent fall in output. (Latvia’s real exchange rate is among those shown in the chart above.) Charles Wyplosz analyzes data similar to those shown above and in Norris’s New York Times column and comes to the conclusion that differences in labor costs are fairly small—especially considering the likely accuracy of the data—and are not crucial to current problems in Europe. Last month, Alejandro Foxley of the Carnegie Endowment offered a more sanguine view than Sommers and Hudson of events in Latvia, while attributing many European problems to the rapid deregulation of financial markets and the rush to the adoption of the euro. He sees the latter process as having brought about an unsustainable boom in financial investment, property values, and consumption spending in many currently struggling economies.

We disagree with many of the arguments in these articles. They describe a situation that differs in many ways from the current one here in the United States. But the authors’ analyses are helpful to economists like me who lack intimate knowledge of the countries involved and their economic issues. While European countries should certainly not attempt to reduce wages across the board, policymakers there are in a position in which issues of excessive public debt are very real. Hence, the lessons for the United States, with its dollar-printing machine, are not always straightforward. But also, as the figure above suggests, the United States also has little reason to worry about excessive wages relative to those in the average industrialized country.

Update, April 25, approximately 8:10 am: I have revised the chart to include Canada, a major trading partner of the United States. Also, I made minor clarifying edits to the text used in the post and figure.

(Click picture to enlarge.)

Readers may have seen two charts that are part of a column by David Wessel published last week. For five European countries, they compare actual interest rates with those prescribed by a standard policy rule. Wessel’s charts provide some interesting evidence that European Central Bank monetary policy has been either too loose or too tight most of the time for several currently ailing European economies, given these countries’ inflation rates and gaps between actual and potential output.  Wessel’s charts support the article’s theme, which is that severe economic problems in some Eurozone countries result in part from the “one-size-fits-all” interest rate policies of the ECB.

Along the same lines, at the top of this entry is a chart of short-term “real interest rates” faced by business borrowers who use overdraft loans in a group of European countries, which are mostly members of the euro area. I have used data on interest rates for this common type of loan, adjusting each month’s observation to reflect the same month’s measured consumer price inflation, so that the resulting “real rates” take into account inflation’s effects on the burden of loan payments. Inflation is helpful to debtors because it has the effect of reducing the amount of goods and services represented by each dollar owed under the terms of a loan. Of course, I have used only one of many possible methods that one could employ to approximate real interest rates.  Moreover, to construct a true real interest rate data series, one would need to know borrowers’ forecasts of the inflation rate, which is an impossible requirement in most circumstances. Hence, these series and others like them usually need to be taken with a grain of salt.

As theory would have it, real interest rates in different countries tend over the long run to converge on a common value, a result known as “real interest rate parity.” This convergence is assured only under certain exacting conditions that are clearly not met in the case of the numbers depicted in the chart. Nonetheless, the degree to which the rates differ may provide another indication of the disparities in credit costs that are imposed by a unified central banking system. Moreover, the chart shows that some of the countries now experiencing fiscal crises have been suffering the effects of particularly tight credit conditions. For example, Greece’s real interest rate was 20.49 percent in January, as indicated next to the green line representing the Greek data. Real rates for Ireland and Portugal, two other countries whose governments’ financial problems have recently been in the news, are also shown in the figure.

My next chart shows lines for all of the aforementioned countries, plus 7 others, containing points that are constructed by averaging the last 12 months’ observations from the first chart.  This removes most of the effects of regular seasonal patterns and helps to highlight longer-run trends, which would otherwise be obscured by the extreme volatility of these series. As a result, we are able to include data for 10 European nations in this figure.

(Click picture to enlarge.)

The data underlying the figures are harmonized European statistics, which are meant to be somewhat comparable across national boundaries. Nevertheless, the ten series in the figure seem to show no signs of converging, though their movements appear to be highly correlated over the past three years. According to the averaged data, Irish real interest rates have been the highest among the 10 European economies represented in the graph since approximately spring 2009. In January, the unaveraged real rate in Ireland exceeded 9 percent.

Like Wessel’s diagrams, the ones above show that despite centralized interest-rate setting, one measure of the tightness of policy for actual retail borrowers varies greatly across eurozone economies.

Notes:

continue reading…

(Click on graph to enlarge.)

Some interesting information on the federal government’s balance sheet can be gleaned from the fourth-quarter flow-of-funds report, which was released by the Federal Reserve Board on the 10th of this month. The total amount of all federal liabilities, as reported by the Fed last week, is shown as the sum of the red and blue areas in the figure above. The blue portion of the graph represents net liabilities owed by the federal government to the Federal Reserve System, while the red portion shows the rest of the federal government’s liabilities. The blue portion is best netted out of the total debt when one is calculating a figure to be used for policy purposes, as it essentially represents a sum of money that one part of the federal government owes to another. (The Fed describes itself in its educational literature as “independent within the government,” though it is shown in flow-of-funds reports as a separate entity with a separate balance sheet from that of the federal government.)

As noted in the figure above, total federal liabilities, according to the new data, rose in the fourth quarter of 2010 to 75.0 percent of seasonally adjusted U.S. GDP from 72.6 percent the previous quarter. Of this 2.4 percentage-point increase, 1.6 percentage points were accounted for by an increase in net Fed holdings of federal government liabilities, while all other entities increased their combined holdings of these liabilities by only about nine-tenths of a percentage point. Hence, ignoring the more-of-less irrelevant holdings of the Fed, the federal debt stood at approximately 65.5 percent of GDP as of the end of last quarter.

When the Fed purchases federal government liabilities using its open market account, it is swapping money for debt securities, so that economic sectors other than the Fed and the federal government wind up holding more U.S. currency and/or reserve deposits and fewer interest-bearing U.S. liabilities than before. This helps the Fed keep interest rates lower than they otherwise would have been as the total debt rises. Dimitri Papadimitriou and I discuss the increased use of this “financing” strategy in a recent working paper.

A couple of minor technical points: These figures are approximate and do add up in some cases because of rounding. Also, the Fed liabilities data are not seasonally adjusted, though, as noted above, I have divided them by seasonally adjusted GDP figures from the FRED database at the St. Louis Fed website.

Revised to improve clarity by G. Hannsgen on March 17, 2011 at approximately 8:20 am. Specifically, I have clarified the point that the blue portion of the figure, representing federal government liabilities to the Fed, is a net amount. In other words, it shows the amount of federal liabilities to the Federal Reserve System minus the amount of liabilities that the Fed owes to the federal government, all divided by GDP and expressed in percentage terms. Some discussion of this point might have been helpful. To wit: most of the federal government’s liabilities to the Fed are Treasury securities; an example of the opposite variety would be one or another of the several “bank accounts” that the government holds at its central bank. To determine how much the federal government owes the Fed, one must subtract the balance in these bank accounts and the like from the government’s gross liabilities to the Fed. It is only such net amounts that are shown in the blue portion of the figure above. Those figures are in turn subtracted from total federal liabilities as reported in quarterly flow-of-funds data to yield approximations of the quarterly “true” federal debt, which are, of course, depicted by the red area in the picture.

Suggestions a few months back by Germany’s chancellor that countries running consistently high deficits be expelled from the Euro zone evidently haven’t fallen on deaf ears. Even though almost everyone thinks of expulsion as a remote possibility, the notion does get factored into the thinking of bankers and investors in a way that may ultimately become a self-fulfilling prophesy. Fears of sovereign-debt debt default are not about to go away anytime soon.

But there is an alternative for dealing with public debt that may help achieve a more perfect union. The European Central Bank should create a large sum of money—say, a trillion Euros—and distribute it across the Euro zone on a per capita basis. Each country could use this emergency relief as it sees fit. Greece might purchase some of its outstanding public debt; others might spend it on fiscal stimulus.

If you think this idea will force every European household to purchase a wheelbarrow with which to transport its soon-to-be-worthless currency, consider the case of Japan. With a 227 percent sovereign debt to GDP ratio, Japan is the world’s most indebted nation. But close to half of this debt is held by the country’s central bank, and interest payments on this half are returned to the Japanese government, making it in effect interest-free. Basically, the central bank printed the money to acquire this debt. To inflation hawks, the creation of trillions of yen to finance government deficits raises the terrifying specter of runaway inflation. Yet prices in Japan over the last two decades have risen by a mere 6 percent—not annually, but for the entire period. The only problem with the yen, meanwhile, is that it’s too strong.

The ECB should do the same thing. It holds sovereign bonds, and it should refund the interest payments on this debt to the issuing countries just as the Japanese central bank has done. The Federal Reserve does the same thing when it returns all net earnings from its securities holdings to the U.S. Treasury.

Modern money economists would argue that over the longer term for the Euro zone countries it may be necessary to put in place a permanent fiscal arrangement through which the central authorities distribute funds to be used by member nations. Ideally this should be in the hands of the equivalent to a national treasury responsible to an elected body of representatives—in this case, the European Parliament. This would parallel the U.S. Treasury’s relationship with the American states. Perhaps an amount equal to 10 percent of Euro zone GDP would be distributed each year on a per capita basis to member nations. This would relieve pressure to adopt austerity and reduce the need to keep borrowing from financial markets. To be sure, the European Parliament has long engaged in transfers to its poorer nations—but its total budget has been below 1 percent of GDP, which is clearly too small to allow economies to operate near full employment even in the best of times. In a deep recession, even 10% of GDP might not be enough, in which case the EU can provide more funding.

A second option for over-indebted Euro zone states that has been put forward is to include a covenant in their debt instruments stating that in the event of default the bearer can use those securities to pay taxes. This would make it obvious to investors that these new securities are as good as cash, and would allow countries to finance deficits at low interest rates. This option may suffer from a “moral hazard” problem—it could lead governments to continue with business as usual, spending too much and generating inflation. And it does not resolve the fundamental problem with the euro—the absence of a supra-national fiscal authority that can generate an alternative to the “beggar thy neighbor” export-led growth strategy that the current arrangement promotes.

The sudden turn in the mood in Europe regarding the prospects of the global economy needs commenting. In this context, most European governments announced drastic cuts in government expenses in an effort to avoid following Greece to the precipice of default. It coincides with the outcome of the G20 deliberations a few days ago that dropped support for fiscal stimulus and emphasized the risk of having sovereign debts getting out of control. This turn is happening in an environment where the politicians seem to be incapable of directing stimulus to productive directions, while at the same time, the public continues to reject any tax increases to cover the future deficits that today’s stimuli may create.

The critical issue is whether we need more and cautiously directed stimulus to enable the global economy to retain current economic activity, or whether we need a fiscal exit. Nobody would disagree with safety nets or government support to post-secondary education, investment in clean energy and new transport infrastructure. After all, these are all Keynesian measures indeed. Keynes never claimed either that his proposed policies can provide deleveraging overnight, or that they can correct the excesses that “Madoff economics” and unregulated markets usually bring about. But Keynes’s way might make deleveraging smoother and with the least possible negative repercussions, especially if appropriate monetary accommodation complements systematic spending.

As for Greece, the main problem is the absence of an appropriate domestic monetary and exchange rate policy combined with an extremely hard euro, which eroded domestic competitiveness and increased demand for imports. The result was a ballooning current account deficit that reached 14% of GDP in Greece (2008), a deficit that requires corresponding capital inflows. These inflows could not be foreign direct investment in the context of falling domestic competitiveness. The government, thus, had to take over and sell bonds to finance a fast-deteriorating current account as the hard currency was fueling domestic consumption by making imports cheaper and more competitive.

In sum, if a contractionary, “post-Great Recession” era policy finally prevails globally and especially around Europe, Greece and similar countries might find it even harder to drive their economies through an export-led recovery. It would then be easy to predict what will happen to those banks keeping toxic skeletons in their closets.

A Wall Street Journal “Heard on the Street” item plays up the early good news from Greece’s austerity program:

In the first half, Greece’s budget deficit came in at €9.6 billion, down 46% from the same period of 2009, the Finance Ministry said this week. Revenues rose 7.2%, while spending fell by 12.8%. Revenue growth remains below target, but not all of the revenue measures have come into effect yet and spending cuts are well ahead. That continues the positive trend identified by the European Commission, IMF and European Central Bank in June’s interim review, and makes this year’s deficit target of 8.1% achievable.

The writer’s conclusion is that perhaps a Greek tragedy can be averted after all. This assumes, of course, that the numbers can be believed.

People often say that the problem in Greece is profligacy. Greece, the story goes, is a nation living beyond its means. Reading the press, in fact, one gets the impression that Greeks must enjoy one of the highest standards of living in Europe while making the frugal Germans pick up the tab.

In reality, Greece has one of the lowest per capita incomes in Europe, much lower than the Eurozone 12 or the German level. Furthermore, the country’s social safety net might seem generous by US standards but is truly modest compared to the rest of Europe. As to borrowing, Greece is far from unique in its level of overall indebtedness as a percentage of gross domestic product.

So what’s the real problem? It all started when Greece embraced the Euro, which some saw as the country’s salvation. But as is so often the case, what once seemed a strength turns out to be weakness. The same might be said of Greek social programs; once seen as a pillar of the state, in hard times they automatically swell government deficits.

Remember that as Europe slid into recession, tax revenue fell and social transfer payments (such as unemployment benefits) rose, opening a larger gap between tax receipts and spending. The same thing happened in the United States. But the United States controls its own monetary policy. In Greece, which is stuck with the Euro, yawning deficits began to worry investors. With borrowing costs soaring, the country has embarked on an austerity program. Unfortunately, If the government lowers its deficit during a recession through spending cuts or tax increases, the strategy is destined to fail.

Cutting wages and pensions, as the recent presidential decree declared, which is a large part of the imposed EU/IMF plan, or raising taxes for that matter, will only make budget deficits bigger by lowering national income and tax revenue. This will mean lower effective demand, which will exacerbate the already bad unemployment situation and potentially lead to more civil disturbances. Some analysts estimate that unemployment will increase by 6 percentage points as a result of the austerity package.

More importantly, Greece continually imports more than it exports, and its firms and individuals spend more than they save (much like some large countries in North America that I can think of). Now, any country’s current account deficit plus its private sector deficit equals its government deficit. During recessions the private sector cuts spending and tries to save more. This automatically takes the government further into deficit territory as social programs grow and taxes fall. Bear in mind that when the current account goes into a deficit, which is a leakage out of private sector income, it means that unless the government deficit rises by the same amount, the private sector’s saving will fall. In the context of Greece’s high current account deficit, its private sector has been running a deficit for the past decade.

Even though the macroeconomic accounting identity linking the sectoral balances is not a theory, it is a good way to analyze policy proposals. When some analyst says that Greece needs to lower its budget deficit to 3% of GDP, then looking at the sectoral balances one must ask, what will need to happen to the balances of the other sectors for this to take place? For example, in 2009, the Greek current account deficit was about 10 percent of GDP. The budget deficit including swaps was about 13 percent of GDP allowing the private sector to save at 3 percent of GDP. Without the option of currency depreciation, it is hard to imagine that Greece can boost its exports (and/or reduce imports) to the point of a balanced or surplus trade account—a swing of 10 percent of GDP. If the budget deficit is to be lowered to 3 percent of GDP to comply with the Eurozone’s Stability and Growth Pact limit, firms and households will need to run a deficit of 7% if there is no change to the current account balance.

In other words, without a massive adjustment of its current account balance, the austerity plan can succeed only if the country replace public deficits with private deficits, and private debt buildup at this rate would certainly be unsustainable. It looks like Germany’s disciplined fiscal policy has been able to accomplish precisely this. Low levels of German government debt have been offset by high levels of private debt—arguably, more unsustainable than public debt. Ireland, Spain and Portugal are in a similar situation. Greece, on the other hand, has allowed its private sector to operate with somewhat lower levels of debt as the government’s deficit has risen relatively more. Indeed, the “profligate” Greeks have less private debt than that of their neighbors—which could place them in a better situation to withstand this crisis.

Still, financial crises and recessions inevitably lead to larger public deficits and debts. The private sector deleveraging that occurs in recession must be accompanied by public sector leveraging unless the current account moves to the surplus side.

Most developed countries, including the United States, United Kingdom and Japan, are in a similar situation in terms of their deficit and debt positions. But they have their own currencies. In the Eurozone, the issue is that the Stability and Growth Pact requirements are not rooted in any sensible theoretical arguments or empirical evidence. Countries have different export profiles and private-sector saving rates, and these influence the public sector’s balance. For European governments to be able to comply with the Stability and Growth Pact requirements at all times, they would need to abandon most of their social protection policies so that spending on the safety net does not rise in recessions. This would be counterproductive, to say the least. The bottom line is that the non-discretionary nature of Greece’s deficit does not leave many options for the government during bad times.