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Economist May 20th 2010

Watch it snap… 

IT HASN'T been the best couple of weeks for the global economy. China is officially in a bear equity market. Europe appears to be headed toward financial crisis or years of sluggish growth, or possibly both. America's housing market stalled out right through the first quarter, despite substantial government support (most of which has now been withdrawn). Leading economic indicators in America unexpectedly faltered in April. American stock markets have dropped over 10% in the space of just a few weeks. (On Thursday alone, the Dow fell nearly 4%.) Commodity prices are flashing a growth warning; oil prices have fallen nearly 20% over the last month. And America's labour market stubbornly refuses to right itself. Initial jobless claims rose by 25,000 last week, leaving the picture of filings looking like this:

Meanwhile, we get statements like this from European Central Bank president Jean-Claude Trichet:

The European Central Bank’s present monetary policy stance remains “appropriate” after the ECB’s decision to purchase debt issued by governments in the euro zone, ECB President Jean-Claude Trichet said Thursday.

“Our decisions on May 9 have confirmed it: We are not engaging in any form of quantitative easing,” Trichet said at an event in honor of ECB Vice President Lucas Papademos, who will leave the central bank at the end of May.

This despite the fact that annual core euro zone inflation (excluding energy) was just 0.7% in April, down from 0.8% in March and 1.7% the previous April. And despite the fact that the euro zone is forecast to see growth of just 1% in 2010, and just 1.5% in 2011. And despite the looming catastrophe in southern Europe. One doesn't want to get gloomier than the facts warrant. But the outlook for the economy looks materially worse today than it did just a few weeks ago. Markets seem quite convinced that events in Europe are likely to have a negative effect on global economic activity. It's debatable whether policy positions in Europe and America were appropriate back in April, given persistent signs of weakness. But if they were appropriate then, they're certainly too tight now. Europe has no fiscal room to boost the economy. America has some, but no appetite for new stimulus. The burden of action falls to central bankers. Unfortunately, central bankers seem to be too busy guarding their independence to handle their missions. 

Every crisis has its heroes: the economists who "correctly" forecast the crash.

Since there are a few economists who forecasts financial armageddon at any given time, the simple test whether the heroes of the last crash were lucky or omniscient is to see if they can repeat. 

Dr. Doom, the hero of the last crash is trying to step into the spotlight again (here).  Not to remind us that he predicted the current crisis, but to announce his book. Crisis Economics, "which covers not only the recent crisis, but also dozens of others throughout history and across both advanced economies and emerging markets – I show that financial crises are, instead, predictable “white swan” events." 

Aside from tall claims of prescience, the articles is a tour de force. It as an excellent working definition to identify a financial crisis:

"An event that forces policy officials to spend a long weekend trying desperately to announce a new bailout package in order to avoid national and global panic before the markets open on Monday. In the past years, such weekend all-nighters dealt with the needed bailouts of private firms – Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, AIG, bank rescues, etc."

and it reminds us of the scale of the "new normal" 

The scale of these bailouts is mushrooming. During the Asian financial crisis of 1997-1998, South Korea – a relatively large emerging-market economy – received what was then considered a very large IMF rescue package – $10 billion. But, after the rescues of Bear Sterns ($40 billion), Fannie Mae and Freddie Mac ($200 billion), AIG (up to $250 billion), the Troubled Asset Relief Program for banks ($700 billion), we now have the mother of all bailouts: the $1 trillion European Union-International Monetary Fund rescue of troubled eurozone members. A billion dollars used to be a lot of money; now one trillion is the “new normal”… Governments that bailed out private firms now are in need of bailouts themselves. But what happens when the political willingness of Germany and other disciplined creditors – many now in emerging markets – to fund such bailouts fizzles? Who will then bail out governments that bailed out private banks and financial institutions? Our global debt mechanics are looking increasingly like a Ponzi scheme.

Absent is, however, a simple, lucid analysis of what we can expect in the future as the Eurozone crisis unfolds. Paul Krugman and Milton Friedman provide that insight succinctly.   

Dani Rodrik's fascinating hypothesis:  “the political trilemma of the world economy”: economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time. Democracy is compatible with national sovereignty only if we restrict globalization. If we push for globalization while retaining the nation-state, we must jettison democracy. And if we want democracy along with globalization, we must shove the nation-state aside and strive for greater international governance. 

I am amazed how optimistic markets have been as to the success of the EU rescue package. And sure enough the first reports are coming in that "Euphoria ends as investors suspect another shameless EU confidence trick."

This time around the creative accounting is that Less than 10% of the funds actually existed and the rest were plans to establish facilities to raise the rest of the money. Those are a lot of hoops and ifs… Here is the rescue rackage (in euros) in a snapshot (via Econbrowser): 

Graphic from Thomas and Ewing, NYT, May 11, 2010; link here. 

Note: Jean Claude Trichet clarified yesterday how the bond purchasing programme is likely to work. To sterilise the bond purchase, the ECB is considering term deposit, compulsory deposits banks would have to hold at the ECB, which has the effect of withdrawing liquidity from the system. 

Economists aren't political scientists, but they aren't stupid. They learn quickly from their mistakes. 

The $150 billion program was economically sufficient, but politically untenable.  Now that this is understood, there is talk is of "restructuring" Greek debt, which is nothing other than to say that the Eurozone will allow Greece to default on part of its debt (to reduce the pain of the austerity measures over the next 10 years). The question is, what comes first: the German elections (next week) or the Greek implosion. It's tough for German Chancellor Merkel to "restructure" Greek debt since Germans aren't inclined to pay for Greek transgressions. 

And that is exactly the problem with the Euro, no fiscal mechanism to buffer ideosyncratic shocks, as Joe Stiglitz forcefully explains.

In this instance I have always been with Joe Stiglitz (aka, the Euro was ill designed to work only in good times), and I am with Paul Krugman who highlights that there is really no way around Greece exiting the Euro. What I cannot figure out right now (since I am not a political scientist) is how important it is for EU politicians (especially those in France and Germany) to maintain the Eurozone status quo and how disasterous it will be for Greece to exit the EU in terms of contagion for Portugal and Spain. 

While the economics of the Greek bailout may be sound, political economy realities seem to have been entirely forgotten in the design of the package. Jean-Paul Fitoussi (via the New York times) reminds us of the obvious: Greece is a democracy and the economic policies to not square with political realities. More to the point, Fitoussi said “unfortunately for economists, there is democracy,” Mr. Fitoussi said. “If you impose too strict a program, the population will refuse.”

Our book introduces a parallel example, when England tried to return to the gold standard in the mid 1920s. It is instructive to work out the similarities in the situations that Greece and the UK (then) faced. Maybe the Greek economy survives the austerity measures in the Eurozone, but its government likely won't. 

Cool visual – but who's going to draw this for us with "normalized" figures that represent "% of GDP" ?  

Source 

The next few days will tell if the contagion was averted with the Greek package, or if it was simply the start of a speculative attack on the other PIGS.  

Source  

Greece agreed on a rescue package, and it is now clear why the IMF needed to be involved. The previous, 25 billion ($40 billion) line of credit just wasn't near enough. What's worse, already the day after, it is becoming clear that the bailout may not be large enough, as it is based on the crucial assumption that starting next (!!!) year Greece will be able to borrow again from international capital markets. That may be too optimistic, say bond-market specialists. 

The Wall Street Journal reports that with the aid come the austerity measures:

The Greek government has promised to slash and then freeze public-sector wages, raise sin taxes, increase value-added taxes, impose a new levy on businesses, cut pension payments and raise retirement ages for some public-sector workers. Greece also promised to meet budget and debt goals:

• Cut budget deficit by 11% of GDP by 2013, through spending cuts valued at 7% of GDP and revenue increases valued at 4% of GDP.
• Reduce budget deficit to 'well below' 3% of GDP by 2014.
• Reduce debt-to-GDP ratio from 2013, with primary budget surpluses of at least 5% of GDP up to 2020.
• Cut public-sector pay and pensions.
• Raise average retirement age.
• Increase value-added taxes and excise duties.
• Deregulate the labor market and industries.
• Privatize some state industries.
• Cut public investment.
• Crack down on tax evasion.

But even these high drama austerity measures will only save about €30 billion through 2013, meaning the Greek public debt will rise from  115% of GDP to more than  140% by 2014. Part of that is due to the predicted decline in output of – 4% this year. 

Actually these numbers are no surprise, as I (via The Economist) already laid out these figures 6 weeks ago.