Germany doesn’t like its own fiscal union, so why would it ever agree upon a European one?

Posted on 26 March 2013 by Markus Peters

If I asked you how the structural problems of the Eurozone may be resolved, I am sure that the suggestion of a fiscal union in which transfer payments will be made by the “rich” Northern member states to the “poor” ones in the South of Europe would rank amongst the top answers. I’ve been wondering for a while if the member states could ever agree upon major fiscal transfer payments and if it would indeed lead to greater degree of convergence within the Eurozone. I feel that we have come closer to an answer to my questions this week. And I am not referring to the issues around Cyprus.

Yesterday the German federal states Hesse and Bavaria filed a lawsuit against the existing mechanism of fiscal transfer between the federal states of Germany, the so-called “Länderfinanzausgleich”. The German constitution states that the objective of this fiscal transfer mechanism is the convergence of the financial power across its federal states. The current system consists of vertical payments between the German state (“Bund”) and the federal states (“Länder”) as well as horizontal payments from federal state to federal state. The eligibility for transfer payment receipts is determined by an index (“Finanzkraftmesszahl”) which indicates the relative financial power of the federal states. Bavaria, Baden-Württemberg and Hesse are currently the only net contributors, while Berlin is the biggest net recipient of these fiscal transfers.

Bavaria and Hesse argue that the current mechanism does not create any incentives for the net recipients to improve their financial position. It is said that sanctions for fiscal mismanagement are missing, while the net contributors are discouraged to consolidate their finances further as long as they have to redistribute their wealth. Basically, one rich German state is arguing why it should transfer its fiscal revenues to a poor (and arguably irresponsible) German federal state. If you already see significant opposition against a redistribution mechanism of wealth within a country, how is it possible to picture Germany, the Netherlands or Finland agreeing on major fiscal transfer payments to Southern Europe? Furthermore, the implication here is that the German Constitutional Court will have to decide if a stricter central enforcement of fiscal discipline has to be institutionalised and which set of sanctions can possibly be introduced to do so. Could you see anything like this to be enacted in the Eurozone in the near future, including lawsuit files from Germany, the Netherlands and Finland in response to any agreement as well as the subsequent court rulings on national and European level? In this context, it might be worth noting that the German Constitutional Court indicated last year that any further European integration, e.g. fiscal union, would require a referendum. Ultimately, German taxpayers might get to decide whether they want their tax payments to be transferred to other parts of Europe.

There remains the question about the potential long-term effect of a fiscal union. Would fiscal transfer payments from the North to the South lead to economic and social convergence in Europe? In Germany, fiscal transfers from the South to the North-East have certainly helped these federal states to converge in terms of their financial power and standard of living since the German unification in 1990. Nevertheless, after 23 years of fiscal transfer payments, the economic situation in these states remains highly unequal. For instance, the German unemployment rate varies significantly across federal states. While the unemployment rate in Mecklenburg-West Pomerania stands at around 14%, it is nearly as low as 4% in Bavaria and Baden-Württemberg. And the historic ties of companies, the geographical location and different geostructural fundamentals, infrastructure disparities, qualitative differences between educational and research institutions and many other factors might prevent them to ever fully converge.

This is the crux of the Eurozone matter for me. Only if we accept the fact that full convergence and homogeneity in Europe will not be achievable – even within a fiscal union – we may become sufficiently pragmatic to deal with the Eurozone issues. We might finally arrive at the conclusion that we could be able to improve the economic prosperity and dismantle some social stress in the periphery, but that we will not make these economies as competitive and prosperous as Northern Europe as a whole. Take the US as an example. No one expects the standard of living, the average income level and economic competitiveness to be anyhow equal or homogenous across the country. Despite a long established currency and fiscal union, the economic situation and opportunity set still varies enormously depending on whether you live in New York, Detroit, Kentucky or Las Vegas. But you can reasonably move from Detroit to Kentucky if you want or have to because the same language is spoken and partly similar traditions are followed. You certainly won’t be able to say that about your move from Athens to Munich. It has been taken as a given in the US that some degree of inequality and heterogeneity is the function of a free market economy (the rest is a function of bad policy-making), and that might be one of the reasons why the US model, including monetary and fiscal union, has managed to succeed.

This would be an inconvenient and unpopular insight in Europe which would fundamentally question the current ambitions of the European convergence project. If you discount the possible long-term return of the Eurozone to its member states because of a lack of German support for a fiscal union, you might want to ask where the Euro project is heading.

I predict a CypRIOT: Three major implications for the European and UK banking systems

Posted on 20 March 2013 by Ben Lord

Stefan blogged earlier this week about the landmark sovereign bailout occurring in Cyprus, and about some of the interesting issues this raises. Sure enough, the parliament did not approve the package in the form talked about at the weekend. The reason? The taxes were felt too painful for the poor and too lenient for the more wealthy. This harks back to a blog I wrote about a couple of years ago, and goes to reiterate the issues we discussed then. However, for now I wanted to highlight some of the issues that this raises more specifically for the European banking system at large.

Firstly, depositors were presumed to be guaranteed by governments up to at least €100,000 in Europe. Last weekend, that notion was dealt a brutal blow by the Cypriot situation. However, it feels to us as though the main reason for the parliamentary delays is that deposit guarantees could and should remain in place – or at least to a greater extent than was implied in the original bailout package. This package stated that those people with deposits of less than €100,000 would pay a 6.75% tax, whilst those with more than this amount would be taxed 9.9%. The politicians that have delayed the approval of the rescue package want to see greater amounts of the burden borne by the wealthier (those with more than €100,000, and perhaps an even higher rate borne by those with greater amounts than, say, €500,000 in deposits), and so lesser amounts of the burden borne by those with small amounts of deposits.

My guess is that this is the key issue here. If the tax rates are not changed, then I would expect to see some significant moves in Spanish, Italian and other peripheral deposit flows and movements. As a risk, this must not be underestimated by the Troika. Why not maintain the deposit guarantee and generate the amount raised by the taxes, through taxing more on those with more than €100,000, more still on those with more than €250,000, and more still on those with more than €500,000?

Secondly, subordinated debt bail-in is a key part of the package, and without it one senses the Troika will not part with the bailout funds needed. We have expected weaker banks in weaker regions to have to use this as a necessary tool to break the sovereign-bank link for some time now. It is now official, and being used. I would expect more of these to come.

Thirdly and finally, sovereign bailouts of banking systems where the sovereign is already in an over-levered position will no longer be tolerated. It is time to break the sovereign-bank feedback loop (as we previously wrote about here). This has to be through bail-in and burden-sharing. However, the most unpalatable part of the proposed package to us (and I guess to many riotous Cypriots) is this: up until 2007 it was believed that senior bank bondholders ranked pari passu with depositors in the event of a bank failure. And now in 2013 we learn quite vividly that in actual fact in Cyprus depositors are likely to be subordinated to a bunch of wholesale and institutional (ie banks and insurance companies) investors?

The capital stack has been turned on its head in this regard. No one used to buy senior unsecured bank debt because they thought that depositors would take losses before them. Rather, it was because the markets believed 100% in the government guarantee of depositors. The pari passu relationship of depositors and bondholders supported high valuations on senior bank bonds. Thus to be pari passu with depositors, senior bank bonds need to take the same losses as depositors are. In my opinion, this part of the proposed deal is the most disgraceful.

So, I find myself wondering how on earth a deposit tax found its way into the package. The answer to me seems to be quite simple: contagion, or the avoidance thereof. We all know that in Europe and the UK in the future (as in the US already), senior bank bonds will be bail-in-able or writedownable if a bank fails or gets into difficulty. We were originally told that the date for senior bank bond bail-in in Europe would be 2018, although there has recently been much talk about bringing this forward to the beginning of 2015. It has long struck me that this should be the favoured route out of the bank-sovereign interconnectedness problem in Europe: continue to promote and enable senior issuance in Europe by banks, and then implement a higher level piece of legislation that at some date in the future makes all debt in the Eurozone and UK writedownable.

No matter how small Cyprus is relative to the rest of the Eurozone, if the Troika had forced senior bank bondholders to accept losses before 2018 – or is it 2015? – senior bank debt spreads would have suffered significantly across Europe. Given that this is the most attractive funding market for banks at the moment, as it is still cheap to issue from a bank’s perspective, and as sovereigns do not want to have to (or cannot, in the Cyprus case) step in to take on more liabilities on behalf of their banks, the Troika has ripped up the rule book and done the insane.

I think parliamentarians in Cyprus should force a rethink on the sovereign-bank feedback loop, as well as forcing a more palatable (ie Robin Hood) sharing of the burden between smaller and larger depositors. After all, can anyone truly imagine the French, German or any core European government accepting losses for their depositors whilst a bunch of international senior bank bondholders get made whole? Our view is that depositors should be protected (at least to the guaranteed amount) over and above all wholesale creditors, whether senior or subordinated. This is the first step to break the sovereign-bank loop. The second step, only to be used in cases where there is not enough senior and subordinated debt to prevent the sovereign, and so tax-payers, from having to bail out the failed institutions, is to look at forcing losses on depositors, but with preserving the preceding guaranteed amounts of deposits. The final, most radical, and rarest, step is to have to renege on that deposit guarantee amount, so as to avoid tax-payer bailouts and increased probability of sovereign default.

Depositors across Europe are already watching Cyprus carefully. My guess is that many are starting to check the amounts they keep with any one institution or in any region. Subordinated bondholders are already aware of the risks if those banks get into difficulty, but senior bondholders in my opinion are not. These investors must ask whether the Cyprus package is likely to be copied in future cases. And they must also start to wonder if they still have until 2018 before senior bonds can be bailed in, or if it is significantly sooner.

Irish eyes are crying when they look at the economy

Posted on 13 March 2013 by Anthony Doyle

With St. Patrick’s Day around the corner, we thought there would be no better time to do an economic update on Ireland.

In November 2010, Ireland found itself bankrupt. Dublin’s promise to keep bank creditors whole resulted in a massive increase in its debt obligations – too big for the government to remain solvent; especially after yields on 8 year government bonds rose to over 7% (they would later increase to over 15%). In desperation, Ireland turned to the European Commission, the European Union and the International Monetary Fund (the so-called “Troika”) for assistance.

After lengthy negotiations, Ireland received a €67.5bn international bail-out from the Troika, after yields on Irish government bonds rose to record levels. In return, the Irish government agreed to downsize and reorganise the banking sector so that it became proportionate to the size of the economy. The government also agreed to significant fiscal and structural reform, including austerity measures of €15bn over four years. This adjustment was to be made up of €10 billion in expenditure savings and €5 billion in taxes. This three year assistance programme is due to conclude at the end of 2013.

It was hoped that by implementing these reforms that Ireland would be able to return to the international capital markets and that investors would again lend to the Irish government. And that is indeed what has happened. As recently as January, Ireland issued €2.5bn of bonds maturing in 2017 at 3.32%. There are now hopes to issue a benchmark 10-year bond and possibly a linker in 2013.

Ireland cannot use the billions of euros it received from the Troika to embark on stimulatory policies for the economy. The money loaned to Ireland is sent to Dublin by the Troika, pumped into the Irish banks, and then channelled to Irish bank bondholders. The man on the street doesn’t see a cent. It was hoped that the bailout would benefit the Irish taxpayer by preventing even harsher austerity.

With that in mind, how has the real economy performed?

As would be expected, the evidence suggests a weak recovery at best. Ireland expanded at a pace of 0.8% over the year to September 2012 despite an environment of high unemployment and fiscal austerity. Looking at the sectors that contribute to GDP, we can see some improvement in the combined distribution, transport, software and communication sectors. At around 25% of the economy the Irish government is hoping that an increase in demand for Irish goods, particularly within the pharmaceuticals and information technology sectors, will support growth over the medium term. A weaker euro will help, particularly against the US dollar (the US is a big market for Irish exports – around 24%), but it is not weak enough.

Given that many of Ireland’s major industries – like pharmaceuticals – are highly capital-intensive they tend to employ few people. Additionally, the capital used in these industries is largely owned by foreigners and hence the benefits of profits are repatriated out of Ireland. Thus gross national product, which deducts income paid to foreigners, is a more relevant gauge of how the economy is performing. And on this measure, the Irish economy isn’t too cash hot, remaining significantly below the pre-crisis trend.

The above chart is a good illustration of the housing and construction boom that occurred in the run-up to the financial crisis of 2008. Housing and construction peaked in March 2007 and has since contracted by 65% in real terms. Despite only being around 7.5% of the economy at its peak in 2006, the boom and subsequent bust in this sector highlights the significant multiplier effects that the housing market can have on an economy (and is something we have highlighted here).

Turning to the labour market, it is true that the deterioration in labour market has stopped over the past year. The unemployment rate peaked at 15.0% and has now fallen to 14.2%. Many are pointing to the improvement in the labour market as a sign that the Irish economy is healing. We are less sure.

Holding the participation rate steady at September 2008 levels, the unemployment rate is closer to 19.5%, a full 5.3% higher than the current unemployment number of 14.2% suggests. This equates to around 140 thousand people. Where have they gone?

Net migration figures show that between the years of 2009-2012, a total of 87 thousand people left Ireland and predominantly between the ages of 15-44. Net migration, a declining participation rate and an increase in discouraged workers goes some way to explain the reduction in the Irish unemployment rate. The labour market isn’t healing; in fact the number of employed people in Ireland has fallen from a peak of 2.16 million in the third quarter of 2007 to 1.85 million at the end of 2012.

We have heard much about the internal devaluation going on in Ireland, which has been seen as a sign that Ireland is becoming more competitive in the global economy. True, unit labour costs (ULC) fell by 16% from the peak in Q4 2008 to Q3 2012. But this is misleading of the more recent trend. From Q1 2010 to Q3 2012, unit labour costs fell by only 3.4% and from Q1 2011 to Q3 2012 unit labour costs have actually been flat. This very slow reduction in unit labour costs in recent years suggests that it will be a decade or more before it is competitive. Ireland is seen as a nation with one of the more flexible labour markets in the Eurozone. What hope is there for Italy, Greece, Spain or Portugal with their relatively inflexible labour markets?

We fear for the Irish economy. What is required is stimulus, not austerity. Without some form of stimulus package, the Irish economy will experience sub-trend growth for the foreseeable future (in contradiction to the IMF’s forecasts – see here). A good place to start would be to use using some of the proceeds from borrowing at record low interest rates in the capital markets to stimulate the economy. The €2.25bn stimulus package was a good start last July but much, much more is needed. For example, how about a helicopter drop of cash into the economy Bernanke style? Give the estimated 4.5 million inhabitants of Ireland €200 each? It would only cost €900 million. Cut income tax. Encourage investment and lending. Build infrastructure. Create jobs. Reverse austerity.

Or how about using the money raised to embark on a programme of debt forgiveness in order to provide homeowner relief. Find a way for homeowners to take advantage of low interest rates and refinance despite having limited/negative equity in their homes. Allow refinancing to occur on a mass scale.

I know, I know. What about the loss of faith in Ireland’s credit rating? What about the spike in government bond yields? Well hopefully the stimulus package would work. Besides, ECB President Mario Draghi will do “whatever it takes”. And we believe him when he said “And believe me, it will be enough”.

If Ireland continues to tie its flag to the austerity mast, it is difficult to see a time in the next decade when the economy will cause Irish eyes to smile again.

The chart annoying every Aussie consumer

Posted on 21 January 2013 by Anthony Doyle

In 2012, the Reserve Bank of Australia cut its cash rate five times and by a total of 1.25%. That is a big move in interest rates for an economy growing at 3.1%, an unemployment rate of 5.4% and inflation sitting bang-on target at 2.0%. The RBA cash rate is now equal to the 50-year low seen during the 2009 recession. So what has got the RBA so nervous?

One word: consumption. Around 54% of Australian GDP is household consumption. But the household saving rate, at 10.6%, is more than double the average of the past decade. Aussies are deleveraging. Consumption, for so long the driver of growth in the boom years, has stumbled.

And unfortunately for the RBA, the latest GDP statistics showed limited sign of investment outside the mining sector. Certainly the appreciation of the Australian Dollar – once known as the “Aussie Battler” or “Pacific Peso” – has not helped things. On a trade-weighted basis, the Australian Dollar has risen by 45% since January 2009, leading to calls from industry for the RBA to intervene in currency markets. The strong dollar is a huge headwind for the Australian manufacturing sector in an increasingly globalised world. The RBA is hoping that a reduction in interest rates will a) spur household consumption and b) have some impact on the strength of the currency.

On the currency front, the RBA rate cuts have had minimal impact. The trade weighted index rose over the course of 2012 by 1.7%. Ouch. On the consumption front, unfortunately for the RBA and the heavily indebted Aussie consumer, the banks haven’t been playing ball. The chart below highlights the spread differential between variable mortgages, variable term loans, and the standard credit card rate over the RBA’s cash rate.

Despite a record low cash rate of only 3.0%, the spread between the rate charged on personal loans and credit cards is at a record highs. Banks aren’t passing on the full cuts in the official rate. In the variable home loan space, the spread has been steadily rising since October 2007. It is particularly important to have a look at the variable mortgage rate as around 80% of home loans in Australia are variable rate mortgages. Overall, the chart shows that the transmission mechanism of monetary policy in Australia is becoming increasingly muted, presenting greater challenges for the RBA.

Central banking isn’t the easiest job in the world at the best of times. Due to high rates of indebtedness and home ownership, the RBA has previously found that moving interest rates could quickly stimulate the economy if needed. The last thing that central bankers need is a further handicap on their ability to deliver their inflation targets. But that is exactly what is going on in Australia right now and the RBA should be concerned.

Should the people of Middle Earth have done Quantitative Easing to mitigate against Smaug’s tight monetary policy?

Posted on 2 January 2013 by Jim Leaviss

Any blog that begins with the words “Smaug the dragon is typically viewed as a fiscal phenomenon…” has immediately got my attention. Please read The Macroeconomics of Middle Earth by Frances Woolley. Woolley compares the size of the dragon’s hoard with a picture of the gold reserves at the Bank of England – although it is likely that Smaug is the beneficial owner of his gold, rather than a custodian of gold for richer dragons elsewhere in Middle Earth. He concludes by suggesting that the peoples of Middle Earth should have abandoned the gold specie standard and adopted paper currency to reduce the deflationary drag that Smaug’s monetary tightness produced. Unfortunately though “the lack of a central bank, or indeed any but the most rudimentary monetary institutions, was a major obstacle to currency reform”. The comments are worth reading too – was Middle Earth an Optimal Currency Area? Before Smaug arrived, were the the Dwarves running Middle Earth like a petro-state?

*SPOILER ALERT* So Smaug dies in the end, and the gold was released into Middle Earth’s money supply. Was there hyper-inflation as a result? Or did Nominal GDP return to trend (i.e. the “catching up” theory that has been talked about by Central Bankers like Mark Carney lately) without longer term inflation problems? If there was hyper-inflation perhaps the political instability that resulted allowed the rise of Sauron as a leader, and the subsequent world war between Men and Elves, and Orcs?

Stress in the Eurozone – Day of action, years of reaction

Posted on 14 November 2012 by Richard Woolnough

Today in Europe we have a day of action. The day of action means in reality a day of inaction, as the active protesting on the streets is outweighed by the inactive sectors such as transportation hit by the strike. Why are workers and, increasingly importantly, non workers undertaking such protests?

Firstly let’s look at the evidence. Below is a chart of unemployment in the Eurozone split by country. The chart shows who is protesting and why. The higher the unemployment the more concern there is in that nation’s population over the current economic situation. Germany is not protesting; southern Europe is.

It can be seen from the chart that at various times over the last 10 years the sick and healthy economies of Europe have alternated, the strong core and the weak periphery were the weak core and the booming periphery in the middle of the last decade. Industry, labour skills, and structural shifts do not occur that quickly so what is causing this volatility in national economic outcomes?

We have commented before on the travails of the single currency concept. This is an economic construct, which has been constructed for the good of Europe. Let’s look at how this current economic policy affects the Eurozone, and how the divergence in economic outcomes can be solved using economic theory.

The first economic lesson I learned from my excellent economics teacher, was the concept of the invisible hand (quite ironic as he had the biggest hands I’ve ever seen!). The introduction of a single currency causes the invisible hand as expressed via exchange rates to be metaphorically tied behind your back. Given the single currency is the root of the dislocation, disbanding it is an obvious solution. However the other ramifications of doing this are potentially large, and it is not an option European leaders are prepared to take. This is not because it is an ineffective policy option, but they are wedded to the political concept as well as the economic concept that comes with a single currency. The weak economies are therefore stuck with too high an exchange rate and the strong economies are left with too low an exchange rate. The economics of the invisible hand in foreign exchange markets is not allowed to work and therefore economic divergence not convergence becomes a more likely event.

Being educated in Britain, the next main economic lessons we learned were around the work of John Maynard Keynes. The principle point drummed into us being that governments should run counter cyclical budget deficits. Unfortunately in Europe the response that the weaker economies are being forced to take is more fiscal discipline through budget deficit reductions. The strong have room to undertake fiscal stimulus, the weak are being told to run pro cyclical fiscal policy. So from this economic perspective the weak will get weaker and the strong stronger…..

The third basic lesson of economics was monetary policy. Lower interest rates stimulate consumption and growth. If you’re the German state, a German company, or a German individual the transmission mechanism of borrowing substantial amounts of money at low rates is available and is working. Sadly if you’re the state, a company, or an individual in the weaker economies the cost of borrowing is high and the physical quantity you can borrow is limited. The transmission mechanism is not working equally across Europe. The strong will get stronger the weak will get weaker.

The single currency is an economic construct that has come about through a political process. If that economic construct does not cause many economic ripples then politically it is relatively easy to take the political decisions to make the concept work. However if the economic construct becomes very destabilising as it appears to be doing then the political skills and policy options have to increase in size to offset its destabilising effects. The political day of action of launching a single currency was simple, the actions required to make it work long term are not.

Happy birthday to the credit crunch

Posted on 12 August 2010 by Richard Woolnough

We first started writing about the credit crunch 3 years ago (see August 2007). Since then, short-term interest rates in the USA, Europe and the UK have collapsed to near zero. Ten year government bond yields across the respective economies have fallen by around two percent. Whilst the fall in interest rates and yields has been a great present for government bond investors, the global economy has been suffering one of its worst recessions since World War II. But enough history. What about the future?

Financial market values at a simple level are driven by two basic themes – long term trend following and shorter term mean-reverting price action. This is also generally true of economies. Looking back over the past 50 years, we have seen a period of strongly upward trending economic growth within which there has been cyclical up and downturns. It has been the job of the modern fund manager from a stock selection point of view to identify if individual stocks and sectors are in a long term trend or mean reverting mode, whilst from the macro point of view they have just had to focus on where the economic cycle is within its permanent uptrend.

The challenge investors now face is to add another dimension to this traditional thinking. What if economic growth is no longer permanently upward trending? What if the trend of growing economies in the developed world is coming to an end?

The credit crunch is now three years old. Where is the upturn in economic growth? On Tuesday the US Federal Open Market Committee (FOMC) acknowledged that we were not there yet and have decided to reinvest the assets they purchased through quantitative easing. This is an acknowledgement that it is still not time to start tightening monetary policy. The FOMC have used up all their bullets in the interest rate armoury by reducing interest rates to near zero percent, encouraged the huge fiscal pump priming undertaken by government (Republicans and Democrats alike), and used unconventional measures of quantitative easing. These policies have been replicated to a lesser or greater degree within the G7 and beyond. And despite all of these extraordinary measures, the global economic recovery remains in doubt. It is fair to say that those central banks around the world that are currently running ultra-easy monetary policy will continue to do so for some time to come.

The interesting question now is whether we are in a long term structural change in economic growth prospects. Maybe we are no longer just in a cyclical downturn. It has been 3 years since the credit crunch began, and the arguments that this is not a normal economic cycle are becoming more compelling. If this is the case, it will be a long term growth environment that the Western world governments, central bankers, and fund managers have never seen before in their working lives. A challenge indeed.

Some thoughts from the Barclays Capital Inflation Conference

Posted on 30 June 2010 by Jim Leaviss

I went to the excellent Barclays Capital Inflation Conference a couple of weeks ago – although titled “inflation”, a lot of the conference’s content concerned the growing fears about the solvency of western governments. In particular, whilst the US Treasury market is currently seeing a massive flight-to-quality bid (10 year yields are now down below 3%) I came away worrying that it’s difficult to see that the US has any plan to avoid medium term bankruptcy other than some hopeful reliance on the American Dream to magic it all better.

Ken Rogoff (Professor of Economics at Harvard, and co-author of This Time Is Different) accused the US Treasury of “playing the yield curve”. With yield curves still extremely steep by historical standards, the authorities have skewed issuance to short maturities with the lowest interest rates (even though long dated maturity bonds would have historically low coupons despite the steep yield curve). Around half of all US debt will mature in the next three years – a tactic which keeps the US’s interest payment burden down in the short term, but which is a “classic way” of triggering a financial crisis when rates start to rise. This is the shortest debt maturity profile for the US since the 1960s. A huge burden of debt refinancing, coupled with higher interest payments was the trigger for Greece’s recent debt crisis. It’s another reason why we disagreed with Bill Gross’s “nitroglycerin” comments regarding the UK – the average maturity of the gilt market is around 14 years, compared with under 5 years for the US and 6 and 7 years for Germany and France. A “buyers’ strike” should be a little less problematic for the UK than it would be for the other nations.

Rogoff also talked about the prospects for financial repression as a method for governments to create a buyer for their debt when the natural, economically motivated, buyer has disappeared. Financial repression is the process of making people own assets they don’t want to hold – and the financial regulator is the important driver of this. In particular banks are encouraged (or forced) to hold more of their assets in less risky assets – i.e. government bonds – but also pension funds and individuals might find themselves being nudged into government bonds (in Japan individuals have most of their savings in the Japanese Post Office, which invests those savings in JGBs). Once domestic buyers are handcuffed, it becomes much easier to use inflation as a tool to reduce the real debt burden, especially in an economy like the US which has been steadily reducing the amount of inflation-linked debt it has outstanding as a percentage of the overall debt mix (although see comments below about the other inflation-linked government liabilities which stop inflation being the magic bullet policy tool).

Finally Rogoff said he’d be astounded if many Eastern European governments (and Greece) did not default, even with the IMF helping them. He pointed out that an IMF rescue package doesn’t always mean an economy is saved; in fact in 1/3rd of the IMF programmes since the 1970s default has ensued (including Argentina, Indonesia, the Dominican Republic and Turkey).

If you were nervous about the US keeping its creditworthiness after Ken Rogoff, a speech by Ajay Rajadhyaksha (Barclays Capital’s Head of US Fixed Income Research) piled on the anxiety. First the good news – the role of the US dollar as the primary reserve currency allows it to run excessive deficits far in excess of its economic rivals. Barclays have modelled the US’s AAA credit rating with an overlay based on the percentage of the world’s reserves kept in US dollars. On a stand alone basis, the US should have a AA credit rating, like Spain – but currently the US$ makes up 60% of global currency reserves, and this would allow them to run a 200% Debt/GDP ratio without losing their AAA rating, compared with the estimated 90% Debt/GDP level now. If the US$ became a bigger portion of global reserves (65%) then a 250% Debt/GDP ratio could be sustainable. Under current projections, only a fall in the dollar’s share of reserves to 50% would trigger the downgrade to AA. Even with continued diversification away from the dollar by foreign investors, this looks a long way off. However, once it happens the acceleration is severe – when Japan lost its AAA rating the yen fell significantly as a percentage of foreign portfolios, perhaps helping to trigger Japan’s further ratings downgrades.

That was pretty much it for the good news. Even at current low levels of interest rates, the US’s debt servicing costs take a step upwards in coming years, as the Debt/GDP ratio rises to 95% by 2020. If yields were to rise by 2% across the yield curve the percentage of US government revenues spent on debt service would rise from a troubling 17% now to around 33%! And inflating away that debt burden doesn’t work very well, as so much of the government’s outlays are indexed to inflation (although I guess you can always do what George Osborne did in last week’s UK Budget and change the inflation measure used to index benefits to one that is structurally lower, CPI rather than RPI). Radadhyaksha was also nervous about the US government’s contingent liabilities – losses on mortgages held by the GSEs (e.g. Freddie and Fannie) could be in the realms of $300 bn+. But the biggest contingent liabilities are the entitlements due to the US populations – and predominantly Medicare costs. After 2020, for every $2 trillion of taxes raised, spending will be $3.5 trillion. How do you close that gap without triggering a popular revolt, especially in an economy where median household incomes are only at the same level that they were back in 1998/99? Senator Judd Gregg, who some expect will run for the Republican Vice Presidential nomination next time round and sits on the Senate Budget Committee, suggested that the answer was to slash entitlements and cut taxes – this combination will encourage entrepreneurial spirits and reduce the deficit. It’s one possible outcome I suppose. (Earlier Ken Rogoff suggested that the Federal tax take needs to go up by a massive 25% to put a dent in the deficit.)

A panel session with Adam Posen of the UK’s MPC, and Former Fed Governor Larry Meyer asked whether Central Banks’ independence is under threat from concepts like Quantitative Easing (buying government bonds as part of the monetary policy, but also incidently (?) keeping yields down at times of budgetary pressure – not unlike the trigger for the Weimar Germany inflation experience), and some increasing commentary about Central Bank inflation targets being too low (including from the IMF’s research director Olivier Blanchard who thinks that 4% would be more like it). Posen believed that as long as a government is unable to fire the Central Bank Governor, and that the Bank is not made to buy government bonds in the primary market then independence is safe (although I didn’t get why there should be a difference between the primary market and secondary market). Most importantly, independence is not about legislation, but about a “buy in” from society – for example, the Bank of England was able to be made independent in 1997 because it had gained anti-inflation credibility in the preceeding years, rather than prices subsequently falling because it was made independent. Meyer did, however, worry that the US Federal Reserve was more vulnerable to political interference than in the past – there was currently extraordinary hostility to the Fed from Congress as the result of the Fed’s bailout of the banking sector, and its new lending powers. Further more as fiscal deficits become unsustainable, could the Fed really hike rates in a world where the US needs to rollover half its debt every three years without triggering a downgrade or default?

Now for a word on the inflation measures that we use. I’ve lost track of the times that people have told me that the RPI, CPI or some other measure systematically under-report inflation – or that these measures are useless for pensioners, who don’t buy iPads, Blue Ray discs and SuperDry T-Shirts (sub-editors – please check that these things exist). Dean Maki (Barclays Chief US economist) and John Greenlees of the US Bureau of Labor Statistics put paid to a few of these inflation myths, and in particular pointed to the famous Boskin Commission Report of 1996 which concluded that in fact the US CPI measure was actually overstating inflation by something like 1.1% to 1.3%. The reasons why inflation measures tend to overstate actual inflation include substitution bias (the basket of goods doesn’t change to reflect the fact that if the price of something rises, consumers will switch to a cheaper alternative), outlet substitution (not capturing the lower prices charged by a new Aldi store in the data for example), quality change (more reliable goods with higher specifications) and new product bias (price deflation is often seen in new technology for example, but it may take a while for that new technology to enter the inflation basket). Another big complaint people have about CPI measures is the treatment of housing, and especially the US concept of Owners’ Equivalent Rent (OER), which is supposed to reflect the implicit costs of owner occupancy (“if someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”). Recently OER has depressed inflation, causing critics to claim that this is somehow fiddling people with incomes linked to CPI. However, over the past 20 years or so, OER has actually boosted the CPI in most periods. The US does have an experimental measure of inflation supposed to better reflect the basket of goods for a pensioner (CPI-E), but it is only very marginally higher than the ordinary CPI. In fact there are no serious studies to show that western governments have suppressed the inflation measure to save money on inflation linked outlays (Argentina is a very different story however!) – the widely used inflation measures usually overstate inflation, which means both that inflation-linked bonds are good hedges for experienced inflation, and that there is a bias towards pensioners and other recipients of inflation-linked incomes being overcompensated.

If the CPI measure is so robust why does the Federal Reserve like to use the PCE deflator (personal consumption expenditures price index) as its preferred measure of inflation? Firstly it is chain-weighted, so it’s more flexible in changing its composition weights to reflect cost-conscious goods substitutions, and secondly, unlike the CPI measure the PCE deflator can be revised historically along with the GDP numbers as fuller data is received. Because the CPI is used to calculate things like bond coupon payments, once released it never changes. The real cynic would additionally say that it is because the PCE deflator is usually lower than the CPI!

Finally, a senior sovereign analyst from one of the major ratings agencies was asked whether there has been any pressure on him from AAA sovereign issuers imploring him to leave their ratings unchanged. The terse reply was “There has been absolutely no pressure from the US or UK authorities”. I wonder who has been calling?

Lessons from Argentina

Posted on 9 April 2010 by Stefan Isaacs

The past couple of days have seen Greek debt take a bit of a battering. Spreads on Greek government bonds are the widest they have been since the inception of the Euro, and Greek 5yr CDS is wider by 100bps+ versus the beginning of the week. This seems to have been driven initially by nervousness around the anticipated bailout, with rumours that the Greeks are trying to renegotiate the deal that was announced on 26th March. More seriously though, Greek banks, who ironically were the ones responsible for buying a lot of recent sovereign issuance, have now asked for Eur14bn in loan guarantees from the government, perhaps due to recent numbers that showed as EUR10bn drop in deposits (4.5% of Greek GDP!). This could be the start of a bank run.

Looking to the relatively recent past one will find that Argentina underwent something similar. They went through their debt fuelled crisis in the ‘90’s, with a bank run in 2001 as Argentines withdrew money from banks and converted into US dollars, culminating in sovereign default in late 2001.

The parallels between the two countries are quite striking. Argentina used to operate a currency peg to the US Dollar (abandoned in early 2002), effectively the same as having a common currency, in order to keep a lid on inflation. Argentina therefore imported US monetary policy, resulting in an artificially strong currency, and this resulted in artificially high imports (which meant a steady outflow of US dollars from the economy). The currency peg also gave the Argentinian public access to cheap US credit, which they were less than reluctant to use. Greece too has spent the past decade or so borrowing at artificially low rates of interest.

Corruption and tax evasion in both countries exacerbated their problems. Admittedly appointing political supporters to Argentina’s Supreme Court and an (alleged) illegal arms deals could be seen as more morally questionable than cooking the books, but where markets are concerned dishonesty on any level is a serious offence.

The levels of debt of the two however are not comparable. Unfortunately for Greece, they are starting from a considerably worse position than the Argentinians. In 2001 Argentina’s debt/GDP ratio and deficit as a percentage of GDP were 62% and 6.4% respectively. At the end of 2009, Greece’s debt to GDP was 114% and the deficit 12.7%

After the Argentinian crisis, the IMF, who repeatedly lent cash to Argentina in the 90’s, produced an evaluation report entitled The IMF and Argentina 1991-2001. It’s quite a hefty piece but on pages 6 and 7 there is a list of lessons learned and recommendations on how to avoid mistakes in the future. To me, the most interesting lessons are lesson 9 ‘Delaying the action required to resolve a crisis can significantly raise its eventual cost…..’ and recommendation 4 ‘The IMF should refrain from entering or maintaining a program relationship with a member country when there is no immediate balance of payments need and there are serious political obstacles to needed policy adjustment or structural reform’. Recommendation 4 must be a particular worry to the Greeks. This crises has been dragging on for a few months now without any decisive action having been taken and disagreements between Germany and the rest of the Eurozone over whether/how to lend a hand could be viewed as a ‘serious political obstacle’. Clearly the disagreement is what has caused the delay in a resolution but the longer the policy makers procrastinate the more expensive an eventual bailout will get.

When Argentina defaulted, the government offered a debt swap valuing existing bonds at only 35% of face value, the worst recovery rate in sovereign debt history. 76% accepted these terms, but the rest didn’t (and the holdouts are still fighting with the government today, which has locked Argentina out of international capital markets since it defaulted). With over half of outstanding Greek bonds still trading with a cash price in the 90s, if Greece does default (implied risk from CDS market is over 30% in the next five years) then investors potentially still stand to lose over half of their money.

A further worry is that when Argentina defaulted, the consensus (seemingly as now) seemed to be that there wouldn’t be contagion (see here). True, initial contagion at the end of 2001 was limited, but contagion increased through the second half of 2002. Only a $30bn IMF loan prevented a Brazilian default in 2002, and Uruguay experienced a banking crisis and defaulted in 2003. Argentina’s default resulted in borrowing costs increasing significantly in the region, and growth for all countries stagnated. What is particularly worrying is that, unlike with Greece now, Lat Am banks didn’t actually have that much exposure to their neighbour’s debt.

Could a Fiscal Policy Committee do for UK creditworthiness what the Monetary Policy Committee did to inflation expectations?

Posted on 1 April 2010 by Jim Leaviss

The granting of independence to the Bank of England following Labour’s victory in the 1997 UK General Election caused a collapse in inflation expectations. Whilst inflation expectations had been drifting down anyway, thanks mainly to globalisation and a demographic productivity boost, after independence was announced the 10 year breakeven inflation rate fell from 4% to 3.4% in just a couple of weeks. A year after independence, inflation expectations were down to 2.9%. See chart. With monetary policy out of the hands of politicians the long held view that the UK was a bit flakey on inflation faded away, and nominal bonds dramatically outperformed index-linked gilts.

Nowadays of course the UK has decent reserves of anti-inflation credibility (although funnily enough 30 year breakeven rates at 3.82% are nearly back at pre-independence levels), but we are definitely regarded as being a bit flakey on the fiscal side – just ask Bill Gross. At a gilt market lunch yesterday (hosted by BNP Paribas) former MPC member Tim Besley discussed his ideas for a fiscal policy committee (FPC) – “a politically neutral, expert body…that would assess the UK’s fiscal position”. As Besley’s blog states, other countries with similar fiscal councils “have reinforced government’s responsibility by raising the political costs of deviation”. After a post-election kitchen sink audit of the UK’s finances which finds that growth will be lower than forecast, off-balance sheet debt higher than declared and the cupboards bare, an incoming Conservative government can implement a VAT hike (which could take the annual RPI rate to 3.6% by the end of 2010) and buy fiscal credibility for the future by announcing the creation of a body like the FPC. Perhaps then we’d see a collapse in the UK’s CDS spread from its current level of 77 bps to something similar to France or Sweden (46 bps and 35 bps respectively)?

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