Wednesday, June 30, 2010

Eating Sugar and Being Taxed

Greg Mankiw wrote a New York Times article a few weeks ago about the relevance of taxing sugar eaters. The piece was followed up by a blog as the article illicited some reaction from David Leonhardt also in the New York Times.

In the end, these folks were arguing that maybe taxing sugar might not be such a good idea after all because it postponed death and people (obese people in their articles) cost more money when they are alive than when are dead. Although all these people's arguments are logical they do not pass my "reality check" test and I wrote Greg Mankiw to tell him the following:

I am sending you a chart (above) depicting the health care cost per capita per age category for Canada. The chart seems to be strongly making the point that dying young could indeed save a lot of money to society and taxpayers.

But this is the fallacy of the average. Nothing says that the chart is identical for everyone.

In fact, it is very likely that the "cost chart of an obese person" is similar to a that of a healthy individual but that that all the health costs of the obese people are incurred early and skewed into the 0-65 years range time frame.

This would mean that because the cost would be incurred earlier we would have to discount the health costs of an obese person versus that of a healthy one living longer in order to truly compare them.

Short term interest rates might be close to zero but long term interest rates are not (especially real interest rates) and there is a significant risk of getting much higher rates in the future.

In other words, it might be more expensive to die early.

I am not saying that I have the definite answer. I do not.

I think that a more rigorous cost-benefit analysis should be done before we pronounce ourselves one way or another.

You claim that there is evidence of lower health care costs for smokers. It is possible. I have not seen the study.

But before claiming that the death of obese people is an attractive proposition (and we are strictly talking finance here), I would study the phenomenon a little more.

The fallacy of the average often plays tricks on our mind.

I will grant you that a healthy citizen who dies instantly in a car accident upon retirement at age 65 is probably providing benefits to society (again strictly from a financial point of view).

Yet, nobody is advocating that we should not be wearing our seat belt for financial reasons and we never see headlines such as "Seat belt laws are costing tax payers a bundle".



Sunday, June 27, 2010

Two Fat Tails: Inflation and Deflation

We Simply Do Not Know

Keynes pointed out that in times of societal stress, we realize that, in looking into the future, we are looking into an abyss.

The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-paneled Board Room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface”.

More recently, Nicolas Nassim Taleb has discoursed on our “pretty, polite technique” of assuming that random processes are tightly distributed around a mean value. Our economists create probability distributions for future outcomes by fitting measurements of past realizations of financial variables into a Gaussian ‘normal’ distribution. In the language of statistics, they impose a ‘prior’ belief that events occur around some discernable mean; the further from the mean, the lower the probability of occurrence. This paradigm has held sway, in part, because most events do occur around a mean. Taleb has built a successful investment career by betting that the Gaussian assumption is wrong, that there are non-trivial possibilities of extreme events-so called ‘fat tails’ - which implies that, over time, such events will almost certainly occur.

Keynes was not so strident. He allowed a class of ‘well behaved’ phenomena who’s outcomes can be described by a Gaussian distribution. But there are important things that cannot be so described. They are subject to Knightian uncertainty.

By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know."

There’s Something Weird About Inflation Forecasts

Today, something weird is going on in the field of inflation forecasting. All the metrics of future US inflation expectations imply that people expect future inflation to be near the informal 2% target of the Fed. Indeed, Fed Chairman Bernanke assured some years ago that the Fed could counter deflation with a ‘helicopter’ drop of high powered money (and he’s made a creditable show of his prowess with the Fed’s unconventional monetary policy these past two years), and more recently he’s explained that the Fed can counter inflation by draining reserves from the economy with use of its new powers to pay interest on bank deposits at the Fed.

But people are worried. They feel that they “simply do not know” what is going to happen to prices over time. Few are soothed by Chairman Bernanke’s assurances. Why, then, is not a bias away from the benign forecast showing up in the inflation expectation metrics? It is because the uncertainty is so radical that we do not know which way the needle might move. But, unlike Keynes and Knight, we can place some bounds on possible outcomes. The distribution –if it is appropriate to describe it as such – is two tailed, with ‘fat tails’ for extreme inflationary and deflationary outcomes. Our predictions are like Buridan’s ass; we cannot choose so we are paralyzed in-between.

Two Fat Tails

Our uncertainty is well justified and simply explained. Inflation, for a given level of economic activity, is determined by three factors: (1) positively by the growth in base money – currency and central bank deposits in commercial banks- (2) positively by the increase in leverage among financial intermediaries and private parties and (3) negatively by the demand by the public to hold cash balances. Since the autumn of 2008, base money growth has exploded but has been offset by de-leveraging by banks and private agents, while the demand to hold dollars has fluctuated; increasing during crisis, when the dollar is perceived as a ‘safe haven’, and declining otherwise. The Fed has so far done a masterful job of manipulating its balance sheet so as to inject the right amount of base money to keep prices stable.

But we don’t know very much about how these variables will evolve over time, nor how effectively the Fed might counter their effects. One central concern over deflation is the continued need for banks and private agents to de-leverage. The danger here is that central banks have had great difficulty countering deflation when it sets in. The US was mired in a deflationary episode from the early 1930’s until WWII and Japan has net yet extricated itself from deflation, in spite of the most aggressive expansion in base money supply of any developed country in half a century.

The risk of inflation is all too apparent. If de-leveraging stops, if foreign investors begin to lose confidence in the solvency of the US government or the stability of the dollar exchange value in light of the unsustainable US trade deficit, there could be a flight from the dollar that would trigger a huge spike in inflation. Hovering above all this is the explosive growth in health related entitlements that could undermine the credibility of deficit reduction efforts in the US, increase US government borrowing requirements and, in a ‘flight from the dollar’ scenario, force the Fed to monetize US debt.

So here we are, stuck, like Buridan’s ass, between the two fat tails of inflation and deflation.

Wednesday, June 23, 2010

Tax Cuts Versus Government Spendings

The debate between the proponents of reducing taxes and those preferring to boost spending to stimulate the economy is one that spans decades. It often pits Republicans versus Democrats. The following article, Crisis Economics, written by Gregory Mankiw and published in National Affairs sheds a pretty good light on the issue.

Tuesday, June 22, 2010

Two Sceptical Officials

I recently attended speeches from both Christian Noyer, the Governor of the Bank of France and Angel Gurria, the Secretary-General of the OECD. Both were very candid about the economic situation in Europe and laid out the conditions for growth friendly policies to work. They both said that unless a serious "fiscal consolidation" effort was credibly put in place, any additional stimulus would be be wasted.Here are my notes from the speeches:

Christian Noyer,
Governor of the Bank of France

The Governor certainly showed that he understands the dynamics of what is happening now. After the typical warning that his words could not be interpreted in any ways as an indication on the next move by the European Central Bank, he was quick to ask the right question: in the face of persistent global imbalances, can Europe’s fragile recovery be sustained? He answered yes if it is accompanied by structural reforms. The Greek crisis illustrates the risk associated with postponing adjustments as well as the political difficulties that governments have in adopting austerity measures and their limited capacity of implementing cooperative solutions to address such issue.

What is needed, according to Christian Noyer, is to send clear signals of budget cuts without compromising growth. This is the essence of the fiscal consolidation story. The central banker is lucky in the sense he does not have to implement this policy. Once stability is back, it is the government’s role to restore credibility by convincing investors that they deserve their confidence. The wish list of the Central Banker is quite long: improving the flexibility of the labour market, bringing regulation reforms to the goods and services markets, stimulating innovation by adopting structural measures. In theory there are not obstacles to growth if we do all the right things.

Angel Gurria (pictured above),
Secretary-General of the OECD

The OECD Secretary General went even further than the Governor. The world is growing at 3 speeds: Europe is stagnant, North America is OK and emerging economies are still on fast track. Because of growing fiscal imbalances in developed countries, these nations are going to have to pull their biggest balancing act in a long time. The story has to be one where industrialised nations will convince the public of the necessity of a belt tightening exercise by increasing the fear and the danger of not doing anything. It is a legitimate strategy because the danger is real. Otherwise, markets will create rampage and dictate the rules in a disorderly manner. Take the case of Spain. It had five years of surplus but we are now putting it in the same basket as Greece. There is a real danger that if we let financial markets dictate the pace of reforms we will be in real trouble.

Growth friendly policy is the new catchy phrase. A new balance has emerged:Keep the stimulus, keep zero interest rates for a while but also make sure that you sent clear signals about "fiscal consolidation". Don't start cutting government deficits now but don't start spending before you come up with specific announcements about what you intend to do to in order to reign in futures expenses with specific deadlines and measures. Are there some exceptions to this? Yes, because it is already too late for some countries like Greece.

Growth will not happen without fiscal adjustments or consolidation. We will need to put fiscal rules in place first. Exchange rate adjustments should come in second. And structural adjustments and reforms should complement these measures (competition, education, R&D, more flexible markets, more flexible labour markets, etc.)

Should we bail out Greece? It's too late to ask this question, we already did. We can do a lot of things with the $ 110 billion that we provided to Greece, a relatively small country. Now we have time to restructure the debt and implement the needed reforms.

But Greece is not really the problem; the question of Europe's fiscal outlook is the issue. Europe put $ 1 trillion to address the problem and it's not working. Fiscal consolidation needs to be articulated through fiscal rules in order to be made credible.

Hungary was an unfortunate translation problem. But it underscores the problem of lack of credibility that Europe has: Everyone is asking: "Can these people put something together and get something done?"

We were first worried about financial instability. We took care of that with the G-20. The new debate is very different from what it was a year ago. Now it is about coming up with a credible fiscal consolidation strategy with clear fiscal rules.

How do we do this?

First, we need to finish cleaning the banks balance sheets (we have barely started to address this issue as a lot of write downs still have to be taken before we are done). Second, we need to create the proper regulatory environment (this is still under heavy discussion) for credit to grow. For now, we don't know if there really is a credit crunch because the demand for credit is still very weak. But it is going to be interesting when demand comes back and picks up some momentum. We will have to have the framework to make it work. But we don't yet have a consensus on what we should do. Tax the banks, tax their capital, tax their loan portfolio, tax assets, tax profits, etc. How should we regulate? It is still very much in the making.

But we won't be able to address the issues and come up with a credible fiscal consolidation strategy if we don't address the roots of the problem. The problem is that there was a major failure in governance: Failure of the regulators, failure of corporate governance and failure in risk management. We will need to solve these issues. These imbalances ultimately occurred because of these failures and they are going to remain (in fact in the short run the imbalances are all worse than they were at the beginning of the crisis) until we solve the governance issue.

A word on Canada: Canada has to remain aware that there is a problem out there. Also the good times in Canada may be hiding deeper structural issues. Canada started off in a better position. Maybe Canada does not need a fiscal rule because it has credibility after 10 years of surplus. Yet, even the most credible countries are putting fiscal rules in place. This will be a credibility game.


Now this is me, Luc, talking. It certainly sounds that entrenched interests or insiders were able to grab some of the political power, influence regulators and then gradually rigged the initially levelled playing field in their favour. This led to the build up over a few years of greater and greater imbalances which were able to grow unchecked precisely because of the influence insiders had on the policy-makers who designed the economic and financial system and on the regulators who were supposed to be supervising their activities. Obviously, the benefits of these imbalances fell mostly on the insiders whereas most of their potential, yet unavoidable eventual negative consequences fell on us, the taxpayers.

When Angel Gurria talked about a failure of governance that's what he meant.We did not remain alert enough to the potential failures of the system. Not necessarily that policy-makers and regulators “were in on it” but that we all drank the insiders’ kool-aid about how little risk was falling on us while insiders were drawing huge benefits from the system. When the system imploded, it was too late. The privatisation of the gains had taken place and the socialisation of the losses ensued to prevent the entire economy from collapsing. That it could happen as a result of letting the power of insiders grow without checks and balances should have been a history lesson. We might be somewhat responsible for forgetting it but this should not be preventing us from taking the proper measures to ensure it does not happen again.

Saturday, June 19, 2010


In my last post I stated the paradox that the growth of the Welfare State, so closely related to the spread of the Keynes’ ideas, has sapped the potency of Keynesian fiscal stimulus. Keynesian economics can more readily stabilize the classical night watchman state than reverse a downward spiral of the mixed economy.

In this post, I examine the dilemma of using policy to stimulate our (US and European) economy. Private spending has declined and private saving has increased dramatically since the financial meltdown of 2008. In order to counteract its contractionary force, Keynes prescribed that government dis-save and spend more, which increases government debt. The probability of default rises with the size of debt and recedes with economic growth.

The Dilemma

The dilemma is this: Fiscal stimulus spurs growth, which improves the capacity of government to service debt, but also increases debt, which in extremis can push up default risk to a point where private agents will not lend to government. At that point fiscal policy breaks down. The higher the initial debt, the more dominant will be the latter effect. So, push on the fiscal lever and risk a government debt crisis or lay off it and risk stagnation, and the possibility of a government debt crisis. Greece has passed the tipping point. Much of the rest of Europe is near and nobody can be sure how far away is the US.

Keynes famously satirized the British government in depression: “They say they cannot spend because they do not have the money, but they have not the money because they will not spend”. But the UK did not face a borrowing constraint in the 1930’s. It may be near one today.

As I pointed out in my last post, this argument is not founded on any notion that government debt ‘crowds out’ private investment when the economy is in a slump. It accepts the idea that a market economy can be stuck in a position of low capacity utilization. Even so, people will not lend to a sovereign they fear will default.

Some commentators, notably Paul Krugman, will not countenance that we may be near the practical limits of government debt capacity. His sanguinity is contradicted by the historical record of sovereign default in the wake of financial crises.

A Solution?

Martin Wolf has laid out, in a series of essays in the FT, a persuasive case for threading the needle by pursuing fiscal stimulus now, with the promise of austerity once the economy has recovered. This ‘jam today’ policy would calm the bond market fears of government insolvency and thereby enable sovereigns the unimpeded access to private savings required for fiscal stimulus. It is an elegant solution to our dilemma: Borrow to meet the short term emergency and wind down the bloated public sector after the storm has passed, when far fewer people are reliant on public support.

A Fatal Flaw

For Wolf’s idea to work, however, investors would have to be convinced that Europe and the US will roll back the Welfare State. Is that a reasonable prospect? The social compact of the urbanized/industrialized world since the Great Depression and WWII has been founded on a growth in social insurance. To reverse that will require a tectonic shift of a type that usually follows a social and economic crisis, but Wolf’s idea is intended to avert such a crisis; Another dilemma.

Naturally, today’s government leaders will promise future austerity if that will gain them access to funding, but they cannot bind what tomorrow’s leaders might do. That is the rub that makes rubes out of investors who believe it.

We are adrift.

Wednesday, June 16, 2010

G20 - The Big Mistake (Part III)

For this last installment, let me lay down the four necessary conditions for a sustainable recovery:

1. Increase the stimulus now

The economy is on an artificial respirator. I would be faltering without government support. It’s no time to stop taking the medicine.

2. Cut future fiscal outlays in an unmistaken and credible way

The "budget curve" needs to be flatten: more spending in the present and significantly less in the future, post-recovery.

Yes, Krugman is right. He likes to pick up fights, especially against Republican leaning economists. Again, recently, he was on Rajan's case after Rajan published a piece about his distaste for the zero-interest rate policy of the Fed. Mark Thoma started the fight and Paul was happy to put more salt on Rajan's opened wounds to prove his point that now is not the time to reign in the stimulus. It seems that since Rajan started his blog a few weeks ago, he has been on the defensive. Don't pity the guy: he is able to defend himself and it gave his blog instant visibility. Yet the debate rages on between the three.

I nevertheless read Rajan's piece (and his subsequent blogs on the topic) and I thought that some of the arguments were pretty insightful. Rajan is actually not calling directly for an increase in interest rates as both Thoma and Krugman claim that he is. I believe that he is mainly questioning the efficiency of a zero-interest rate policy. And he has a point. Unfortunately, the point is being lost in the debate; probably partly because of politics: the other side would hate that there might be some rational for increasing rates right now. It does not mean that rates should increase but it seems appropriate to point out that there are also negative consequences to the zero-rate policy of the Fed.

Here is the argument expressed in my terms which I think make the point clearer. Since investment decisions usually have long term consequences and since interest rates in part determine investment decisions, interest rate policies will ultimately determine resource allocation. Thus, if low interest rate policies are leading investors to allocate resources inefficiently, a low interest rate policy could have negative long term consequences for growth. This of course should be weighed against the benefits of lower rates. When the level of investment is insufficient, low interest rates should help. But low rates can also lead to investment that won't be sustainable when interest rates will be higher. A lot of home owners apparently made that mistake when they decided to take advantage of low rates to invest in real estate. I am not sure how significant empirically this misallocation of resources effect actually is. But, in principle, it potentially could be very important if the people allocating the capital in the economy are incompetent, biased or subject to influence. In developing countries where bankers are though not be that competent and easily corruptible, it is a widespread concern. After the recent performance of our bankers maybe we should worry to about their ability to allocate capital for the purpose of investment.

I made this long point just to argue that the same logic applies to fiscal policies. Yes, Paul Krugman is right: it is not time to reduce the stimulus now; at least, not for the wrong reasons which are currently being invoked by both sides in Congress. However, the inefficiency and wasted funds associated with the fiscal stimulus should be of concern. Also the danger that some programs meant to be temporary become permanent and eventually crowds out private investment is another valid concern. There are ways to stimulate the economy in the short term using fiscal policies but it is important to try minimising the negative impact of such policies on long term growth and the trajectory of future government expenditures.

For that, the most important measure is to drastically reduce actuarial deficits. If Greece did this if would get out of trouble fast. France just announced that it is increasing the retirement age as proof that they understand the importance of projecting fiscal discipline in building credibility.

This brings me to where and how the money should be spent and the third condition to create the environment for a sustained recovery:

3. Deleverage the economy

We have to deal with the leverage in the economy. We hear all the right stuff. For instance the G20 recognizes in their last communiqué that “further progress on financial repair is critical to global economic recovery. This requires greater transparency and further strengthening of banks’ balance sheets and better corporate governance of financial firms.”

But it seems that one ingredient is missing. Beyond tighter regulation, better governance and stronger recapitalisation, it is still not a clear how we are going to get there and deleverage the economy. The path to point B from point A is the missing link of this recovery. The current efforts are all focused on the banks themselves; in large part because banks hold the political power and lobby hard to get our (taxpayer) cash and to keep a tight control over the new rules that are going to govern them in the future. All the official talk form the G20 or other policy makers "sounds" good but it's being carefully drafted by bankers themselves through the influence of their lobbyists on our policy-makers. Because of the crisis, bankers are careful not to offend us too much and now agree to some restrictions that they would never have agreed to before the crisis. But bankers have just become more subtle than they were pre-crisis. They have adapted to a more hostile and alert public. And as result the policy environment is still very much banker friendly and the concerns remain deeply bank centered.

But it is not the bank that should be at the center of our effort. It is the leveraged consumer. Deleverage the consumer and the bad assets of banks are going to shrink like snow banks in the spring. Yes, without a doubt, eventually do put in place all the proper rules to regulate banks but this is not what is going to kick start the system for now. It might help prevent the next crisis but we need to deal with the current crisis first as it is not over yet. What good does it do to prepare ourselves to fight the next war if we lose this one? And, at the risk of repeating myself, I (and others) have made proposals to achieve the objective of deleveraging the consumer. Unfortunately, this will take money. But it will be money well spent. In fact, I will go further, any other money that will not address this problem of consumer leverage will be money wasted.

Something will also need to be done to reduce consumer’s incentives to leverage themselves. In Canada, the financial system was not so much saved by better bank capital ratio and regulation but by the fact that consumers did not have the same advantage or capabilities to use leverage (no interest rate deductibility, a requirement that you must have a minimum of capital in your house and the existence of less gimmicks to fool consumers into thinking that debt is good for them). Such measures are needed as well. But, again, because they have the power, banks are able to push these kinds of proposals away as they would hate it if consumers had fewer incentives to borrow (see Rajan’s book on this): It would cut into one of their most profitable business lines.

Which brings me to the last conditions:

4. Find a way to hit the reset button on the allocation of power.
Bankers are obviously in a conflict of interest when it comes time to designing rules and regulation not only for the financial system but for the whole economy. They need to be kept at bay. This may be the most difficult conditions to implement. I think that it will take another deeper crisis to convince politicians and policy-makers to free themselves from their influence. Unfortunately, we may be closer to that crisis than we think.

China and Brazil boosts trade ties

In April, China and Brazil signed various trade agreements with the objective of boosting two-way trade between the two countries. In particular Presidents Hu and Da Silva signed a 5-year action plan to increase trade and energy cooperation.

Since China joined the World Trade Organization (WTO) in 2002, Brazil’s exports to China have grown at 23% per annum, faster than during the 1989-2009 period at 18%. Brazilian imports from China have grown at 26% per annum since 1989. Recently China overtook the USA to become Brazil’s number one trading partner. As of May 2010 exports to China accounted for 14% of its total exports, from 4% in 2002. Imports from China, the world’s largest goods exporter, represented 13% of its total imports versus around 3% in 2002.

Just from looking at these numbers it is difficult to determine causality: is the fact that by joining the WTO, China had any significant impact on trade between the two countries? Or is this just growth-driven? More probably, simultaneous events are responsible for the surge in the amount of trade between the two. Theory suggests that trade liberalization induced by tariffs reductions has a positive impact on trade between two countries. Lee and Shin confirmed that Regional Trade Agreements (RTA) increase bilateral trade between members. Although in this case China and Brazil are not in a RTA, it is somewhat comparable because the identity of products traded between the two is historically the same. Over 85% of Brazil’s total merchandise exports to China are fuels and mineral products and agricultural products. About 95% of its imports are manufactured goods.

During the global expansion of the past decade, the net impact of trade on employment and poverty in Brazil was positive but modest, according to research from the Carnegie Endowment for International Peace . However it is quite likely that as the value of trade reaches a critical level, gains created in part by economies of scale and the multiplier effect will spread out to a larger share of the population.

In the long term Brazilian exports growth to China should sustain the pace of the past few years as it is obvious that the Asian giant is on sound footing. Chinese wages have started rising and will probably outpace the economy’s top line growth. This trend should bear rich secular fruits in the long-term by boosting consumption and accelerating industrial upgrades.

The question for Brazilian exporters is this: can they climb up the value added chain? Although exports to China of high-end telecom equipment, integrated circuits and electronic components, chemical and pharmaceutical products have been rising, it is still insignificant on total merchandise exports.

In 2008 the WTO warned that the global financial crisis would affect trade flows globally by reducing access to trade financing. It appears however that the fear was misplaced as Chinese exports have already rebounded – up 48% y/y in May. Brazil’s exports to the middle kingdom, already surpassing US$10 bn for 2010 as of May, should make this a record year.

In conclusion, recent measures adopted in April by both countries suggest that two-way trade will remain healthy for the next few years.

Saturday, June 12, 2010

The Welfare State at the Brink and the Limits of Keynesian Economics

The Welfare State at the Brink

The economies of the industrialized world have grown phenomenally since the end of the Second World War; the size of government in those countries has grown even more. Is this a good thing?

Proponents of the welfare state think it is. According to them, as societies become wealthier, people prefer the wealth to be spent on increased social insurance, infrastructure and education, and the mitigation of market externalities like pollution. To opponents who worry that the increased incursion of government will slow growth, welfare state proponents point out that the increased size of the public sector has coincided with growth. Reagan and Thatcher merely slowed the growth of government – while stoking private sector growth – they did not repeal the welfare state. The ‘third way’ of Clinton and Blair provided a first best optimization by marrying welfare state goals with market incentives. Until 2008, it seemed to work.

There is a problem. It might be seen as a Black Swan problem, but it is really not. A government whose largess places it near the limit of what the private sector can support – through taxes and debt – lacks the resources to respond to economic, natural and military emergencies. 9/11 may have been a Black Swan, the financial meltdown of 2008 may have been a Black Swan and Deepwater may have been a Black Swan. But that emergencies requiring large government action arise every decade or two is to be expected – it is a White Swan.

The problem with the Welfare State, we are now learning, is that it depletes government of the juice to take on the big challenges when they arise. Thus, the US finds itself forced to shrink from military confrontation with enemies like Iran, al Qaeda and North Korea, independently of the strategic merits of such action. It is always dangerous when your enemies know you cannot fight. Likewise, should another financial storm hit, the governments of the US, Europe and Japan will not be able to provide fiscal stimulus to counter concretionary forces as the recent fiscal stimulus has caused them to take on debt that will become increasingly difficult to finance. This too, is a very dangerous place to be.

The Limits of Keynesian Economics

The central tenant of Keynesian economics – and the premise of the fiscal stimulus enacted in 2009 by all developed countries – is that if people become fearful about the future, they will pull in their horns; investment and consumption will decline. The fall in aggregate demand is reflected in an excess of desired savings over desired investment at the prevailing interest rate. Since realized savings must equal realized investment, as a matter of accounting identity, it follows that output will decline until it reaches a point at which funds available for saving contract and desired savings equal desired investment. When interest rates decline to a level from which they can decline no further, conventional monetary policy exhausts itself; there is no further ‘down’ to push interest rates (which presumably increase investment and reduce saving) and the private sector is locked in a high unemployment ‘liquidity trap’. In that position, only government stimulus, according to Keynes, can push up demand and set the process in reverse, reducing savings, increasing investment and propelling the economy back towards full employment.

Fiscal stimulus is defined as deficit spending, whether through tax cuts or spending increases. Either way, the government ‘soaks up’ a portion of the excess private sector savings by issuing debt to the private sector. The transfer of savings from the private sector to government is transmuted into spending –either directly by government, or indirectly through tax cuts that lead private actors to increase their spending. Thus does the fiscal stimulus increase aggregate demand.

For this process to occur, private actors must be willing to lend their savings to government. For Keynes, who addressed a 1930’s Britain and US with a far smaller government sector than today, this was a given. Government debt was ‘riskless’. That is no longer the case. In the aftermath of the recent Greek debt crisis, investors and ratings agencies are beginning to question the solvency of developed countries with unprecedented debt levels and unsustainable future social spending commitments. This is not exactly a matter of “Ricardian Equivalence”, the idea that government deficits lead private actors to increase savings to offset anticipated future tax increases to cover the deficit. It is a questioning of whether the size of a government’s debt – and underneath it, the size of that government itself- has become so bloated as to render the government unable to meet its debt obligations.

There is good reason for investors to question the solvency of developed country governments. In their recent seminal work on the history of financial crises, Carmen Reinhart and Kenneth Rogoff show a pattern of slow economic growth and increased probability of government debt default once the debt exceeds 90% of GDP. Japan, Britain and the US all exceed, or are near, that mark. What is worse, is that social spending commitments will propel these countries well beyond fiscal solvency in the coming decades.

There is a possibility that, in response to a funding crisis, governments may impose capital controls on foreign investment and require domestic institutions to invest in home government debt. This may direct more investment toward individual government debt, but it would reduce saving (because it would reduce the expected return on investment), it would reduce private investment and, if undertaken by several large countries, it would probably cause a deep worldwide recession.

The End of American Exceptionalism?

Some commentators, like Martin Wolf of the FT, point to the status of the dollar as a world currency as an assurance that the dollar, and the government that issues it, will be viewed as a ‘safe haven’ for some time. So long as the dollar maintains its privileged status, Wolf rightly points out, the US can borrow at low cost and conduct effective fiscal stimulus. But if the US government is fundamentally insolvent, this equilibrium is unstable. Any number of ‘Black Swans’ can unravel it, in which event the dollar will face collapse and render the US government unable to conduct fiscal policy. Do a large number of ‘Black Swans’ constitute a ‘White Swan’?

Can Unconventional Monetary Policy Save the Day?

Martin Wolf has been arguing, and Ben Bernanke has been acting, the premise that a Central Bank can engineer a stimulus in any event by purchasing the debt of government and private actors, both of which activities drain debt out the economy and flood it with money, which increases spending. Skeptics, who have warned that such monetary expansion will ignite inflation and increase interest rates - which would offset the stimulative effect of the monetary expansion – so far appear to be Cassandra’s; prices are declining and interest rates are low. Moreover, as Ben Bernanke has explained, Central Banks have tools to offset inflation if it were to emerge.

What has happened so far is that the massive increase in high powered US currency since the fall of 2008 has not translated into an increase in broad money, as banks, foreign governments and investors have increased their ‘safe haven’ dollar holdings. But a loss of the dollar’s ‘safe haven’ status would cause banks, governments and investors to unload their dollar assets, triggering a collapse in the foreign exchange value of the dollar, a massive inflation in the US and a funding crisis for the US government. Again, any event that might trigger this financial Armageddon is a “Black Swan”. But how many ‘Black Swans’ are out there and when does thier aggregation constutute a “White Swan”?

Whither the Welfare State?

The Welfare State, as it has developed since the Second World War, is not financially sustainable. We are entering a very dangerous period that will pit the old, to whom too much has been promised, against the young, of whom too much is asked. A struggle to relieve the young from obligations to subsidize the old will take place in all developed countries. There will likely be a compromise in which the life plans of the old are frustrated and the ability of the young to bear the fruits of their labor are restricted. That is if we are lucky. Along the way, a new “Black Swan” might threaten the social stability and economic solvency of the western world.

Friday, June 11, 2010

The Power of Technology is Rewiring our Brain

And our time perspective. In a fascinating short animated video, The Secret Powers of Time by RSA Animate "Professor Philip Zimbardo conveys how our individual perspectives of time affect our work, health and well-being. Time influences who we are as a person, how we view relationships and how we act in the world." You can also watch another recent longer video, featuring a conference given by Professor Zimbardo on the topic.

The content of the videos is partly based on a book, The Geography of Time (I'll have to read it) by social psychologist Robert Levine (it's him on the picture) of CSU- Fresno, CA. It actually is not a new book. It was published in 1998 (here is a review). Although I have yet to get more familiar with the concept, it seems that it contains promising clues to understand and to deal with the complex geopolitical issues of our time, an essential skill to better understand the dynamics of financial markets. Thanks to Freakonomics to have pointed out the existence of the video.

Wednesday, June 9, 2010

G20 - The Big Mistake (Part II)

I was at the Conference of Montreal on Monday (and watching the game tonight). The conference this year is sort of a post G-20 finance minister event sandwiched between last week-end G-20 meeting in Korea and the upcoming G-20 summit in Canada next month. The Conference of Montreal is often used as a venue for such officials to exchange views in a more discreet and informal fashion; away from the big media things are said that would not normally be said. It is also a way for officials to test their narrative and to practice their speeches. Present among the speakers were the Governors of the Bank of France and the Bank of Canada, the Secretary-General of the OECD, the Minister of Finance of Canada, the heads of the Asian Development Bank as well as a plethora of other “big” guests and VIPs.

The new buzz word in town is officially “Fiscal Consolidation”; a euphemism for cutting government expenses. It also is often combined with the expression “Growth Friendly Policies” to convey the message that the cuts will be surgical, not to upset the fragile recovery. Prepare yourself to hear these two expressions until you get sick during the next few months. The finance officials are now in need of a good story to convince the markets that they know what they are doing. And, as you might suspect, they talk a pretty good game. But the pitch still shows a few obvious cracks.

The first vulnerability of their story is a lack of consistency. A mere few weeks after promising to keep the spigot going, the Greek tragedy instilled the fear of God in these guys. Europeans were very worried that Greece would become another Lehman; another climactic event that could have totally spooked the markets. They acted swiftly but it did not quite work. The disease spread to the PIIGS, then to Hungary last week and suddenly panic really set in. You can read in the last communiqué from the G-20 finance ministers meeting “The recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, growth-friendly measures, to deliver fiscal sustainability, differentiated for and tailored to national circumstances. Those countries with serious fiscal challenges need to accelerate the pace of consolidation.” Thus, it is clear to me that they are reacting to events rather than taking the lead and control over this crisis.

The second problem is an increasing lack of credibility. The lack of consistency mentioned above is creating a credibility vacuum. If, one month after you strongly affirmed that you are firmly in favour of maintaining the stimulus, you change your mind for no other reasons than that the markets don’t like the turn of events in Greece, it becomes quite evident that whatever you say should be discounted as you may change your mind again quite soon.

The third issue is the lack of rational for the change in policy. These very well informed officials did not learn last month that Greece was in trouble and that eventually, sooner rather than later, Europe would have serious fiscal issues to deal with. They knew about this for a long time. And they also knew that the more they were going to spend in the short term, the bigger the issue of fiscal sustainability would be and the sooner it would matter. Unfortunately, the financial markets started to notice, or care about it, in May. But, if last month’s events had any impact on the real economy, it is that European growth could potentially, in the short run at least, be lower and more fragile than previously anticipated. Obviously, with more uncertainty and a higher risk premium, the private sector is going to have an even harder time to “take over” and growth targets are therefore going to be even more difficult to reach. This should have reinforced the expansionary fiscal bias, not tame it.

Fourth there is the lack of clarity in the statement. “Growth Friendly Policies” and “Fiscal Consolidation” are a big contradiction. You can say them in the same sentence if you want but it still does not make sense. Officials need to explain that the fiscal consolidation they are talking about is something that is going to reign in budget deficits only beyond the current crisis, once the recovery is firmly established. Only if you can commit to do this credibly will you improve the long term fiscal outlook.

Fifth, in spite of all the talk about international cooperation, there is a lack of consensus on the issue. The dissension comes mainly from the US which fiscal situation is not as critical as that of Europe. Tim Geithner wrote a letter to his finance minister colleagues urging them to maintain the stimulus. Today, Ben Bernanke also testified in front of the House Senate Committee. Although he warned of unsustainable deficits, he said “This very moment is not the time to radically reduce our spending or raise our taxes, because the economy is still in a recovery mode and needs that support.”

Sixth, there is a total lack of credible commitment to return to a balance budget down the road. It is a neglected issue because we are all short-term driven. Now that the market is bringing the long-term issue in the fore front and in the face of officials, they are forced to publicly acknowledge it. Yet, nothing concrete is being done about it and if history is any guide, it will not happen until it is too late.

Finally and most important, there is still a lack of understanding regarding the roots of this crisis and hence about what needs to be done to resolve it once and for all. I talked about this on Monday in part I of this series and will be back on this topic soon in the third and last installment early next week.
Go Hawks Go!

Monday, June 7, 2010

G20 - The Big Mistake (Part I)

In the thirties, it had been a monetary policy blunder by the Fed which prematurely tightened the money supply that threw the economy into the abyss and unnecessarily prolonged the Great Depression. It forced a brilliant but ineffective Hoover out of power and brought in a new president, Roosevelt, who finally introduced sweeping and radical changes to jump start the economy by breaking the status quo and untying system-entrenched interests.

It did not help that, in a prisoner dilemma type-situation, the dynamics of protectionism were set in motion by short-sighted countries which unilaterally resorted to old mercantilist policies to try pulling themselves out of misery; only to aggravated the situation as others did the same.

This time, it will be a global fiscal policy error that will ensure that the Great Recession is indeed worthy of its label. And although the sinister and dark forces of protectionism are still only in the shadow for now, it would not take much to bring them back to the front stage. Already China and Congress are engaged in a confrontation rather than a dialogue. Add a nervous Europe into the mix and there is a significant potential that the defenders of free trade easily fall victims to the cacophony of nations' infighting; all unilaterally trying to “protect” their domestic economy from falling apart while all the same contributing to the collapse of the whole system.

The G-20 finance ministers met this week-end and it seems that the recent fiscal crisis in Europe has sent many of them into panic mode. Case in point, it was decided this week-end to reign in the fiscal stimulus and the lax fiscal policies of the last two years to appease the mobs on the financial markets. It appeared to be a consensus. Even Strauss-Kahn of the IMF was in agreement. Zeus and the Greek Gods sent from haven have spoken! Actually their position is quite a lot more subtle and sophisticated and I'll come back to this later this week.

What a monumental mistake! Last week, the bailout of Greece and today nothing! Is this 100% turnabout, policy remorse? I strongly suspect, in fact I know, that it is rather the sudden fear that Europe won't be able to afford the bailouts of other members of the PIIGS alliance; which now seems to be stretching all the way to Hungary!

Yes, bailing out Greece was a huge mistake in that it sent the signal that, by extrapolation, Europe could be in need of the mother of all bailouts! Of course, nothing was done to deal with the root of the problem. The short-sighted idea of the bailout was to discreetly plug the hole made by Greece in an already leaking system. But the move was obviously done in plain sight and it inadvertedly became the focus and obsession of the financial markets (the mob) for the last few weeks. What the bailout accomplished is to open the eyes of investors to the reality that Europe could indeed be bankrupt if it does not change its ways soon. we are not talking about now but financial markets have a way of pressing the issues.

The facts are the following. The population of Europe is stagnant at best and it is slowly getting older (yet the future is at its dooor steps!). Globalisation is also eating away at its competitive edge in the many areas where it is still a leader (for how long?). Finally, because it is already highly indebted and has heavy financial commitments (pensions, public health care and other costly social programs), the debt tipping point on the horizon is getting closer. In other words, investors suddenly realized that the day of reckoning is steadily approaching and are forcing the issue using Greece as an excuse. It was a question a time before investors were going to notice or, rather, worry about the perverse European debt dynamics. In fact, the story is always the same: nobody wants to be the first to worry until others start worrying and suddenly (sometimes irrationaly) everything unravels at once and it is too late. It’s unfortunate but it is the reality of today’s short-termism on the financial markets: It is costly to be the lone worrier waiting to be right. As they say: you could be broke before you are right! But once the chips start flowing in, they poor in and you can't stop them. You can reason with the markets once they have reached that point. It is the tyranny of the markets at work and I have seen it so many times.

So Europe is bankrupt and we are finally realizing it. Thus, what is wrong with the week-end G20 announcement?

As much as I hate to admit it, Paul Krugman is right: This is absolutely not the right time to cut the deficit! I know that Paul likes picking up fights (his last one with Raghu Rajan) with everyone and he has become sort of the John McEnroe of Economics. This feeling does not only emanate from the people who do not know him. Like Rajan, I also had Paul Krugman in International Trade at MIT and I know the guy. But he writes on sand paper and as a reader it hurts beyond the surface to read his columns and blogs. He is the Nobel prize winner who everybody loves to hate but we’ve got to look beyond our emotions here and recognize that his argument make complete sense even if it is incomplete (and I’ll explain why further) and if it is stated in a way as to provoke an allergic reaction in any common sense individual.

Yes, we should be worried about the deterioration of the national debts of the industrialised country. But shattering the recovery’s hopes while it has not yet taken hold is simply incomprehensible and irresponsible. It is as short-sighted a move as imposing protectionist measures to stimulate our individual domestic economies. And, horror, it is the best way to insure that protectionism follows to put the last nail in our coffin.

Yes, optimism has been in the air for a while and it has been the justification to start cutting back on the stimulus. But this is like cutting medicine to the sick patient claiming that he is getting better without strong evidence; whereas our real selfish concern appears to be that we are afraid of running out of money to pay for the medication. This surely sounds to me as the best way to kill the patient! That is not going to be save us any money at all in the end, is it?

We have been hearing about green shoots for more than a year now (feels like two) but we have not seen much of a harvest yet. It is important that the private sector takes over in a sustainable manner but that has not happened yet. All we are seeing for the moment is the effect of the steroidal medication of the government on the sick patient. We still have no proof that the patient is cured and can live without life support. The stimulus cortisone is only hiding the source of the problem which is an inability of the financial system to get the private flow of credit going again. The cold blooded animal has not woken up from winter and we want it to run on its own!

Global credit creation (the life blood of our economy) is still anaemic and, historically, at the lowest level in more than three decades. In fact, it is experiencing negative growth in spite of zero interest rate policies around the world. Global money supply is not growing either which means that the patient is still being feed intravenously and unable to take care of himself yet.

The only thing that taking the patient off life support is going to be achieved by cutting back on government expenses is kill growth while the deficit will keep growing as a result of the lower growth. This is the spiral of death. I know that that the G-20 officials know this and, as such their narrative is more complex. As I mentioned above, I'll come back to their discourse later this week.

Our economies have two illnesses at the moment. The first one is a cyclical short-term inability to have the system generate self-sustaining credit growth. The second one is a long-term structural public debt problem. The more public money we throw at the first problem, the worse we seem to be making the second. The solution however is not to stop supporting the patient. It may die before the second problem becomes relevant. The solution is to address the source of the first problem which is the over-indebtedness of the private sector, namely the indebtedness of the consumers. In a giant debt restructuring scheme, we need to move the debt of the private sector into the public balance sheet to give room to the private sector to grow. In other words, we need to accelerate the deleveraging process and this process needs government assistance.

The first big mistake we did in saving the banks last year was to save the banks directly rather than save the mortgage owners themselves. These are at the bottom of the borrowing edifice. The bank bailout only succeeded in giving us back useless banks that are over-capitalized but who refuse to lend. Strong of their new found taxpayer-funded capital, banks are actually ready to lend .., but only in a world where the rest of the economy would be deleveraged. The problem is obviously that the deleveraging process is far from being over. In the meantime, the big lending machines are sitting in a wait and see position, fully loaded but gun shy. Far better would have been to relieve mortgage owners directly and have them use the government money to privately bailout banks. We would have automatically deleveraged the whole system for the same amount of money.

How do we engineer such a deleveraging? I wrote a very simple proposal in the early fall of 2008 (yes, already almost two years ago) and I published it on this blog as well as some private research piece last summer/fall. I even had the opportunity to send it to the Chief Economist of the Council of Economic Advisers, a former MIT Economics Ph.D. graduate like me, whom I had met during an official visit a the White House last summer. Finally, I also had a series of e-mail exchanges with Robert Shiller and other academics who recognised that the idea had some potential to deal with the crisis. Yet, the proposal was often deemed to be too complicated politically at the time; compared to the mess we are in today it now sounds like plain pasta. Others, such as Martin Feldstein and Luigi Zingales, have also come up with similar proposals which recognised the importance of untying the vicious circle of debt at its roots, starting with the people who borrowed the money at the bottom of the pyramid. But they too met with the same scepticism from policy makers.

The fact that such proposals did not make it pass the idea stage is unfortunate because in the meantime we prolonged the crisis for nothing, we squandered public funds and we truly exposed ourselves to the second illness, the structural debt issue which was a minimal issue back then. Although it was always present, pre-bail out, the structural fiscal problem did not appear to be too preoccupying at the time and was a distant enough issue. Fast forward two years and trillions of dollars later and we are in a strange predicament. Even the simplest remedies, such as a fiscal stimulus, now appear to be politically difficult to sell to the market. Part of it is, without a doubt, posturing on the part of politicians in order not to squander all that is left of the ammunitions before we find a viable solution. But most of it is the tyranny of the markets dictating that governments around the world stop spendingor else; it is the return of the bond market vigilantes. And it is hardly good news when you need room to think and act rationally.

Whereas, in 2008, we had only one imminent and visible problem, a stalled deleveraging process, now we have two: the deleveraging and the long-term debt issues. Now that the second issue is with us, it makes it less easy for governments to borrow in order to deleverage the private sector by unclogging the financial system at its roots; that is by starting to deleverage the balance sheet of the mortgage owners.

Yet, it is the only solution. Yes, I admit that in five years, deleveraging will have been processed. But waiting five more years is not an option. We have to address this issue now and because of the second structural illness that we contracted (I should say aggravated) along the way, we are now in a much more difficult situation to act. In other words, it probably would not be sufficient today to temporarily transfer the mortgage debt of home owners into the public balance sheet to solve our problems. There would probably need to be a plan to credibly demonstrate that this measure is only temporary and that governments are going to seriously address their long-term debt problems. Such proposals have been made by Alan Blinder in a recent article published in the Wall Street Journal and which I covered in this blog a few weeks ago.

To be continued later this week.

Friday, June 4, 2010

Bill Gross on Why Debt Will Get You in Trouble

Bill Gross learned not to play with fire when he was young. His June Investment Outlook, “Three Will Get You Two (or) Two Will Get You Three” is a cautionary tale of what can go wrong with debt. It’s a perfect Black Swan narrative: You toy with debt thinking that you know what you are doing ... until an unforeseen event changes the premises of your world completely. And suddenly, you are out of luck!

That’s the story behind a lot of other well known tragedies: LTCM, the last financial crisis, Greece, etc.

You load sixteen tons, what do you get?
Another day older and deeper in debt.
Saint Peter, don’t you call me ‘cause I can’t go;
I owe my soul to the company store.

– Tennessee Ernie Ford

“Debt will get you in trouble – on both sides of the dollar bill as Shakespeare wisely counseled long ago: Neither a lender nor a borrower be. That probably seems like a strange admonition coming from a guy who helps to lend $1 trillion of it – and I suppose it is. But there was a time back in 1968 when lending got me in lots of trouble – deep doo-doo, to tell you the truth – and I’ve regretted it ever since. I was a Naval officer back then, sailing between the Mekong Delta and Manila Bay. Strangely enough, it was in the Philippines, not Vietnam, where I lost my moral compass and ran aground. I started a shipboard replica of a “payday” lending company operating under the principle of “two will get you three.” Sailors in port were always short of cash and yours truly – engaged to be married and operating under a self-imposed one-beer, nine-o’clock curfew – was more than willing to extend them a hand. The “two gets you three” scheme sounded harmless enough, because, heck, what’s a buck between friends when you’re about to hit the beach and party hearty! Still, as the “payday” characterization connotes, the money was due only a few weeks down the road when we were back at sea and receivables could easily be collected. And the annualized yield, as most of us investor types can easily calculate, was well in excess of 1,000% annualized. Well, there’s usury and there’s grand larceny, and my payday-hayday scheme was clearly in the latter category. The amounts were small – paychecks were only a few hundred dollars – but 200 compounded into 300, which turned into 450, 675, 1,000 – well, you get the picture. It didn’t take too many ports of call before Uncle Sam’s next payday became the property of Uncle Bill, and I became the financial godfather of the USS Wish I’d Never Enlisted. Oh but loose lips sink ships, and it wasn’t too long before the authentic godfather – El Capitan – got wind of Ensign Gross’s growing fortune. Rather than cut himself in on the scheme, he did what every good captain would do. He made me give it all back and confined me to the ship for the rest of my tour. No beer, no sightseeing in Tokyo on the way back home. No nothing. Two got me three for awhile, but it eventually got me into a heap of trouble. Well deserved, I’d say, and I’ve learned my lesson. Never made a 1,000% loan since!

“Another lesson I’ve learned over these last 40 years is that while “two gets you three,” it’s also true that “three gets you two.” Sometimes it gets you zero, as in “default” – a big goose egg. That’s why lenders demand a premium for “riskier” loans, a subjective judgment to be sure, like when J.P. Morgan long ago described the most fundamental principle of lending as one based on “character” as opposed to “property or collateral.” Still, character will get you only so far if initial conditions are sufficiently onerous that they resemble the “sixteen tons” coal miners’ lament that leads off this month’s Investment Outlook. Owing your soul to the company store is more than descriptive of not only today’s households, but of sovereign nations as well. The burden of debt can take decades to accumulate, but only a few short months to change course into crisis. Many investors, economists and politicians alike have little understanding of why attitudes and lending standards can reverse so quickly – how a seemingly innocuous “two will get you three” build-up of debt will suddenly produce a crisis like it did aboard my ship in 1968. They operate with the mindset that markets, jobs and economies will “come back.” “I’ll just wait ‘till it comes back” is the common saw amongst underwater investors, just as “something will turn up” is a sad refrain of many unemployed or underemployed workers. Sometimes it doesn’t come back. Sometimes nothing turns up. Sometimes “three gets you two” in the real, as well as the financial, economy.

“Those times are best characterized by a borrower’s amount of debt and their ability to grow out of their burden. How much debt is too much? How little growth is too little? No one knows for sure. Economic historians such as Kenneth Rogoff point out that at debt levels of 80-90% of GDP, a country’s real growth becomes stunted, and the sixteen tons become more and more difficult to bear. Greece is well past that standard, which is one of the reasons why lenders are balking at extending a private-market helping hand. When not only government but corporate and household debt is included, the waters become murkier, because historical statistics are less available, and corporations are more multinational than ever before. Common sense observation tells you, though, that the debt super cycle trend in the U.S. shown in the following chart is reaching unsustainable proportions and that the “growth” required to service it if real interest rates were ever to go up instead of down would be insufficient. That is why lenders balked 18 months ago during events surrounding the Lehman liquidity crisis and why they’re beginning to balk once again. Too much debt/too little growth makes for a “three will get you two” moment, and they refuse to extend credit under those circumstances.

“Granted, sovereign debtor nations are now saying all the right things and in some cases enacting legislation that promises to halt growing debt burdens. Not only Greece and the southern European peripherals, but France, the U.K., Japan, and even the U.S. are sounding alarms that might eventually move them towards less imbalanced budgets and lower deficits as a percentage of GDP. Still, credit and equity market vigilantes are wondering if in many cases sovereigns haven’t already gone too far and that the only way out might be via default or the more politely used phrase of “restructuring.” At the now restrictive yields of LIBOR+ 300-350 basis points being imposed by the EU and the IMF alike, there is no reasonable scenario which would allow Greece to “grow” its way out of its sixteen tons. Fiscal tightening, while conservative in intent, leads to lower and lower growth in the short run. Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator. In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits!

“Several months ago I rhetorically asked whether it was possible to get out of debt crisis by increasing debt. Yes – was the answer, but it was a qualified yes. Given that initial conditions were favorable – relative low debt as a % of GDP, with the ability to produce low/negative short-term policy rates and constructively direct fiscal deficit spending towards growth positive investments – a country could escape a debt deflation by creating more debt. But those countries are few – the U.S. among perhaps a handful that have that privilege, and investors, including PIMCO, have strong doubts about U.S. fiscal deficits leading to strong future growth rates.

“So the developing predicament is becoming more obvious to Shakespeare’s “lenders and borrowers be.” Fiscal tightening and budget conservatism may have come too late for Greece and its global lookalikes. Continued deficit spending may be an exorbitant privilege extended to only a few. Caught in the middle are many developed countries that likely face New Normal growth rates and a continued bumpy journey toward that destination.

“Investors must respect this rather tortuous journey in the months and years ahead for what it is: A deleveraging process based upon too much debt and too little growth to service it. No longer will “two get you three” in the investment world. Not 1,000%, but 4-6% annualized returns for a diversified portfolio of stocks and bonds is the likely outcome. And be careful – sometimes “three gets you two."

Wednesday, June 2, 2010

China: labor strikes ?

Workers at several of Honda's auto factories in Guangdong province staged a strike last week demanding higher wages and better benefits. Websites such as also reported that a strike by 1,000 workers took place at Xingyu Auto Tech, a component manufacturer for Beijing Hyundai Motor. A wave of recent suicides or attempted suicides at Foxconn in China also highlights the 'malaise' affecting a large segment of the labor force.

Broader implications for policymakers?
- Labor actions may spread out to other parts of China. A large section of the population is unhappy about rising income inequality, unaffordable housing and corruption. Recent studies show that the income gap between the richest 10% and the poorest 10% of the population was 23 times in 2007, versus 10 times in 1988 - Professor Li Shi, Beijing Normal University.
- Low-end manufacturers could see their profit margins squeezed by having to increase wages in order to retain workers. Many local governments will be forced to raise minimum wages in the near future. In labor intensive industries such as garments, shoes, auto parts, labor costs account for around 30 to 35% of value added.
- Consumer prices may rise.
- A rapid increase in labor costs, reducing competitiveness, may reduce the chance of a Renminbi revaluation.

These events reveal the urgency for the Chinese government to significantly reform and upgrade the economy.