Zombies causing havoc (with monetary policy)

Halloween has come and gone this year but stories of zombies are still haunting the dreams of some.  One person in particular is Mervyn King who is the governor of the Bank of England (the central bank in the United Kingdom) and the walking dead are making the difficult job of guiding the economy through a weak recovery into something even more treacherous.

Nothing is ever too exciting in economies so rather than brain-munching corpses, zombies instead refers to companies who are saddled with excessive levels of debt which should drive them into bankruptcy but who are artificially kept alive by lower interest rates.  But firms closing down is a necessary part of the functioning of an economy and here’s why. 

During periods of growth, an economy can expand so rapidly that not all funds are put to good use – too many firms may be making too much of the same products.  So, a recession is normally a time where the less successful are weeded out.  As part of a process which is referred to as creative destruction, some firms go bust and this frees up money and workers that can be put to better use elsewhere.  While it sounds a nasty prospect, it is crucial to the vitality of an economy.  Think of a jungle where no animal would die - eventually the jungle would be overrun and even the strong would struggle.

The Bank of England (BoE) released data last week showing that, while three out of ten firms in the UK are losing money, the number of firms going under is low compared to other recessions.  This could be seen as a good thing in the short term – fewer workers out of jobs mean that the slump in the economy is milder than it might have been.  It also means that companies which have viable businesses but are going through a rough patch can stay in business and go on to prosper in the future. 

However, the effects over the long term are less benign.  Zombie firms take business away from better run companies which hampers the expansion of successful businesses and hurts investment which is already sluggish as firms try to navigate a high degree of uncertainty (for more details, Tale of Two Recessions).  The rise of the walking dead has been given as a reason why the BoE now predicts that economic growth in the United Kingdom over the next few years will be slower than predicted with the economy not expected to reach the same levels as before the global financial crisis until 2015.

Like in the movies, zombie companies also have a weak spot – interest rates.  Because the zombies typically have large amounts of debt, higher interest rates increase the costs for these companies and act as magic bullet that will send them to their graves.  But increasing interest rates also makes everyone else suffer and hurts the economy in the short term.  This leaves Mervyn King and the BoE with a dilemma.  The current low interest rates are prolonging the lives of businesses that need to be put down but the harsh measures required to do this could kill off hopes for a recovery.  Such a conundrum and talk of zombies would be enough to keep Your Neighbourhood Economist awake at night.

Winning the election was the easy part…

In a presidential election which was more notably for the money spent (an estimated US$6 billion) than any notion of what each candidate would do in power, Barack Obama managed to pull off a relatively easy (but not emphatic) victory.  But now Obama faces a bigger challenge - the fiscal cliff.  The fiscal cliff refers to painful measures which will be implemented if Democrats and Republicans are unable to come up with a solution on how to deal with high government spending and low taxes.  But the political stalemate looks set to continue in the United States following an election which was supposed to help provide impetus for new policies but may instead result in further gridlock.

Improving the government finances was increasingly becoming a concern in the United States due to a large budget deficit of 7.8% of GDP in 2011 and rising government debt topping 100% of GDP in the same year.  Investors are still happy to buy government bonds as the United States is seen to have a more viable economy whereas similar levels of debt would cause panic among investors in Europe.  Yet, it is unclear how much longer investors will tolerate rising debt.  Politicians realise the necessity for action but are ideologically opposed to how to go about it – the Democrats want to see spending cuts accompanied with higher taxes on the wealthy whereas Republicans flatly refuse to even consider higher taxes. 

The origin of the fiscal cliff is an attempt by the two parties to force themselves into a compromise by upping the stakes.   Politicians passed the Budget Control Act of 2011 whereby, if an agreement on how to cut the deficit was not reached by the end of 2012, a range of deficit-reducing policies which are painful for both Democrats and Republicans (and the economy) would automatically kick in from the start of 2013.  Politicians have been too consumed with electioneering up until now for a deal to be struck and only have a short time left to figure out a compromise before US$600 billion of spending cuts and tax rises come into effect - the consequences of which is expected to push the United States economy into recession in 2013.

Just the possibility of recession as a result of these measures is already having an adverse effect on the economy.  The uncertainty created by the lack of a deal means that businesses are holding off from making new investments and hiring extra workers at a time when the economy should be on a path to recovery.  The election should have been a great chance for each party to convince the voters that they had a plausible solution but the outcome has only seen minor changes to the political landscape and the status quo has been maintained so that continued gridlock is a real possibility. 

Life would have been difficult for whoever won the election.  With the Republicans controlling the House of Representatives and the Democrats holding sway over the Senate, agreement between both parties is needed to pass any new laws.  But neither Obama nor Romney put themselves in a strong position due to the bulk of the campaigning being negative rather than providing any ideas on new policy direction (see An election with no winners).  As such, despite winning, Obama does not have much of a mandate - an entitlement to implement policies due to the perceived backing of a substantive majority of voters following an election.  The going will be made tougher with Obama having failed to exhibit much leadership in his first term as president.  Yet, Obama has come out of the blocks strongly with a bold statement that any new measures must include higher taxes for the rich.  On the other hand, Republicans are still not convinced that Obama has much support from voters and are likely to stand firm for now with regard to their demands for no tax hikes.

This sets the scene for last minute dramas and for uncertainty to continue to plague the economy.  The extent to which politicians can be trusted to make pragmatic decisions is unclear and Your Neighbourhood Economist is unsure of what will ensue.  Even Greek voters showed a considerable degree of pragmatism in backing pro-bailout parties in elections in June 2012 (Back from vacation in Greece).  Yet, like the situation in Greece, any possible solutions regarding the fiscal cliff are likely to be drawn out with stopgap measures likely before the end of the year (if at all) and more long-term policies discussed in 2013.  The prolonged uncertainty and political sideshows could have not come at a worse time but it is even more frightening to think that the worst may not be over. 

An Election with No Winners

Any crisis should be seen as a boon by politicians.  Problems become evident during times of turmoil and voters are more open to the prospects of sweeping change.  This gives opportunities for leaders to implement a raft of new policies and stamp their mark on the pages of history.  Yet, the opposite seems to be true with regard to the current presidential election in the United States.  The candidates have provided few details of what changes they would implement and how to better position the United States to face a rising number of challenges which stem from both internal problems and external threats.  The election has instead concentrated on the flaws of the candidates themselves rather than the ideas they espouse.  The United States looks likely to be bogged down for at least another four years until the next presidential election which may offer up a chance for decisive leadership.

The presidential election comes at a time when the country is in desperate need of leadership.  Obama has failed to deliver on his promises from the election four years ago.  It has been ironic than a presidential candidate that has given rise to so much hope among disparaged Americans has been so underwhelming even by normal standards to which presidents aspire.  In an election which should have been easy for any politician to beat Obama, Romney ended up the Republican candidate by default as other challengers each had their moment in the spotlight but all were deemed to be flawed.  But as the default candidate, Romney has struggled to even animate Republicans.  As such, the United States has been left without a genuine choice and campaigning has focused on the negatives of each candidates’ character due to a lack of new ideas. 

In an uninspiring election, Obama may be the lesser of two evils.  Obama has done a reasonable job of fixing the way in which the United States is seen by other countries in the world.  The Democrats as a party are also less entrapped by ideologues on the left and have been more pragmatic at a time when action is necessary.  On the other hand, the Republican Party has fallen under the sway of the Tea Party movement which has a virile hatred of government and taxes based primarily on ideological grounds.  The stubbornness of Republicans has stopped progress being made on dealing with the government budget deficit.  The party refuses to consider any tax increases to be implemented alongside cuts to government spending when this mix of more taxes and less spending is seen as optimal policy by many.  Instead, Republicans choose to squabble while Rome burns which may see the fall of another “empire”. 

There are signs that the United States may be heading into a period of gradual decline which its leaders refuse to confront.  Along with the rise of China and other emerging economies which is destined to reshape the global economy, the United States is also being challenged internally by problems such as a lack of investment in infrastructure and education, growing inequality and falling social mobility, and unsustainable levels of pensions and health care.  Obama has done little to solve these problems.  But there is a fear that a Republican president could make the problems worse.  Ballooning government debt in the United States during the Regan and Bush junior administrations has already shown Republicans to act more on ideology and less on economic realities.  Your Neighbourhood Economist would (if possible) vote for Obama - better the devil you know - but would rather fast forward four years in the hope for real leadership.

“It’s the economy, stupid” – or is it?

The phrase “it’s the economy, stupid” encapsulates the strategy used by Bill Clinton in his election battle with George Bush senior in 1992.  The blame for the recession at the time was attributed Bush senior and this helped Clinton to victory.  Twenty years later, Mitt Romney may have thought that a similar message would aid him in his bid to become president.  The four years that Barack Obama has been in power has coincided with the harshest economic downturn in living memory and a surprisingly weak recovery such that GDP has only edged up 0.7% between 2009 and 2011.  But the outlook for the economy has brightened a tad recently following the release of upbeat data on GDP and jobs in the United States.  Anecdotal evidence would suggest that this would be a boost to Obama but this may not hold true in an election where the candidates have sidestepped the big issues.

Economists like to point out that the state of the economy is a good guide to the plight of an incumbent in a presidential election.  Voters everywhere tend to hold politicians accountable for economic growth even though there is little that politicians can do to in this regard.  Obama was unlucky to have been voted in while the global financial crisis was still wreaking havoc.  The record of Obama’s management of the economy is hard to asses given the unique circumstances – Obama has been criticised for the assistance given to the finance sector and for the bailing out of firms such as the car maker GM but no one can know whether these actions actually staved off more wide spread disaster.

But it is economic welfare of the voters and their beliefs on how the future will pan out which is the crucial factor.  And in this regard, Obama has been getting small bits of good news among all of the doom and gloom.  In GDP figures for the third quarter (July to September) of 2012 released in late October, the economy was shown to have grown by 2.0% which is slightly faster than was expected.  Job data published one week later also exceeded expectations with 171,000 jobs being created in the US economy in October and unemployment below 8%.  Neither bit of news permits much optimism about the end of tough times and businesses will have to hire significantly more workers to make a significant dent in the unemployment rate (for more, see US Jobs Data).  But the signs of improvement may be enough to some to have hope.

But it is still unclear whether the slightly brighter outlook will be much of a boost to Obama.  Your Neighbourhood Economist would argue that news on the economy will only sway those who were undecided but these voters have been side-lined by campaigning which has vilified the personalities of the candidates rather than proposed solutions to the problems plaguing the United States.  So the election results are more likely to depend on how many Democrats and Republican can be bothered to vote for their respective candidates as both Obama and Romney have been underwhelming and failed to inspire a following from anyone else but their core supports.  Not the best way to decide who will be leading the country for the next four years and something that is likely to result in further disappointment (but more on that coming soon).

The European Union - Worth fighting for!

The recent announcement that the European Union (EU) would be awarded the Nobel Peace Prize may seem strange – the Prize typically goes to an individual whereas the EU is an organization which governs relationships between countries in Europe.  And why now?  The EU has done nothing of late that was worthy of the Prize and is on the verge of irrelevance due to political infighting.  But the Norwegians who dish out the Nobel Prizes are not shy of making a statement and Your Neighbourhood Economist supports their stance which can be seen as a timely reminder of what the EU has achieved and what the governing body of Europe still has to offer.

The reason behind why the EU has been awarded the Nobel Prize is its role in promoting peace and reconciliation.  The origins of the EU stem from the aftermath of WWII when leaders in Europe looked to increase the ties that bind the former foes of Europe as a counterweight against the feverish nationalism that brought about the War.  The political impetus behind the growing notion of community in Europe also took on economic ramifications with the European common market.  The EU itself was formed in 1993 out of the precursor organizations and this was followed by the launch of the euro in 2002.  The size of the membership has increased from an original six back in the first agreements in 1951 to 27 with Romania and Bulgaria as the last to join and Croatia set to join in July 2013.  The Eurozone countries make up a smaller subset of these countries and currently number 17.

Much has been made of the cooperation between France and Germany along with the United Kingdom as one of the profound benefits stemming from the EU.  Yet, it is unclear the extent to which the EU has contributed in getting the major powers of Europe to work together rather than fight among themselves.  Your Neighbourhood Economist would argue that it is the outward spread of democracy and the rule of law and order to the growing number of countries which have joined the EU which has provided a greater bounty. 

To be accepted into the EU, candidate countries must meet certain standards which include institutions to guarantee democracy and the protection of human rights as well as a functioning market economy.  Many of the countries have been pushed to apply these rules to a greater extent than would have happened otherwise and this has brought political emancipation and economic prosperity to many that would have otherwise remained side-lined.  Entry into the EU also comes with funds to be spent on infrastructure which helps the newer members to economically integrate to the good of all.

But the expansion of the EU is not over.  The EU has already absorbed a large portion of the old Soviet bloc but there are still countries such as Ukraine which would benefit from the carrot of entry into the EU to reform their political system.  But bigger challenges and benefits wait in the prospect of membership for countries which made up part of the old Yugoslavia in the Balkans.  Many of these countries are still mired in conflict and need the prospects of EU membership for politicians to help the region to shape up.  And then there is Turkey whose entry is controversial in the EU but who would also add a growing economy and a link to the Muslim world.

What should be clear from the above paragraph is that there is still considerable scope for the EU to do good things in the periphery of Europe even disregarding its work elsewhere in the global.  And it is for this reason that Your Neighbourhood Economist believes that the EU is worth fighting for.  Yet it is euro that could be the key.  If the current members are not willing to make the sacrifices to hold together the Eurozone, the outlook for the inclusion of new countries would be bleak.  Furthermore, a squabbling and inward looking Europe would unravel much of the good work from the past sixty years and would signal an end to the principles that earned the EU its well-deserved Nobel Prize as well as its hopes for a role as a dominant player on the world stage – if only the politicians in Europe could look further than their front door steps.  

Tale of two recessions

Imagine (again) the outbreak of a common disease but as a new strain and on a scale not yet seen before.  What makes diagnosis even more difficult is that not only to the symptoms change over time but the disease itself mutates.  What started as a banking crisis in 2008 has morphed into a crisis of confidence in capitalism.  The world is awash with cash as central banks pump money into the economy but firms and banks prefer to hoard their funds than put it to use.  Yet the global financial crisis is not the whole story and is different to the problems that are plaguing the global economy recently.  And that is why Your Neighbourhood Economist is going to tell the tale of two recessions.

The story starts what seems like a long time ago with the boom period before the banking crisis.  Rising house prices and stock markets seemed to be ushering in a new era of prosperity and more and more investors followed the mirage of easy money.  Deregulation in the finance sector allowed for more creative ways to make money which made banks so complicated that the banks themselves did not understand their inner workings and which exacerbated the problem by increasing the amount of debt held by firms and households. 

But with the gains in asset prices based on an increasing amount of debt, all it would take was the slightest bit of trouble and the house of cards would come tumbling down.  The trigger seems to have been excessive mortgage lending in the United States where banks competed to push mortgages to individuals with low credit ratings.  The new creative streak among banks means that this dubious debt could be passed on to others by being turned into bonds which was supposed to spread the risk but also diluted lending standards.  Cracks started to appear in banks across the globe and the arteries of global finance began to clog up as banks did not lend even to each other due to the possibility of problems luring in their complex structures.  The crucial role of lending by banks as the life blood of any economy mean that it was like the global economy suffering a heart attack.

Governments everywhere were jolted into action – billions were thrown at banks to stop them going bust and the US government even had to save the country’s largest car maker.  Countries even banded together for a global fiscal stimulus in 2009.  But governments in Western countries had also been found wanting – politicians too had believed the good times would last and had been reckless in their spending. 

Economies rebounded in 2010 with help from the limited stimulus packages that governments could manage but a bigger boost came from continued growth in emerging markets which had not been caught up in the same hubris as the West.  But the hangover from the previous debt-fuelled party still lingered as excessive amounts of borrowing prompted firms to go bust and consumers to be weighed down by mortgages worth more than their homes.  And the situation was made worse as bankers were targeted as the bad guys of the crisis and the banking sector were hit with a battery of new regulation which further restricted its ability to lend (refer to Another reason not to bank on Europe). 

The weak recovery has been like an infection which has sapped the willingness of firms to invest and to take on new workers.  Investment in particular is typically the driving force of economic growth (for more detail on investment in the economy - Investment in China) but companies need to be confident of a return on their investment.  Problems such as the sovereign debt crisis in Europe and the lack of a plan to deal with growing government debt in the US have added to the debilitating degree of uncertainty which is plaguing firms.  The lack of confidence in future growth is creating the circumstance for a downward spiral where hoarding of cash by firms further drags on growth and brings down confidence.

Governments are also limited in their ability to act by the overload of debt.  Austerity seemed to offer up a cure through easing concerns in the bond market but cuts to government spending seem to be more like a treatment of leeches – a bit out-of-date and likely to do more harm than good.  But the belief in austerity still holds sway despite the IMF suggesting it may not be the best course of action (see Time for Plan B?).  Without a clear consensus on the need for an alternative, decisive action such as another global stimulus package looks unlikely.  No happy ending is likely any time soon.

Time for Plan B?

Imagine the outbreak of a common disease but as a new strain and on a scale not yet seen before.  Symptoms vary depending on the patient which makes it difficult for even the best doctors across the world who are unsure of the cure.  The patients are treated in different ways in different countries but nothing seems to be working.  There does however seem to be a consensus that one form of treatment is causing unnecessary harm to the patients.  This could be an analogy for the global economy with austerity being the treatment that has fallen out of favour.  But, while the appetite for more painful government cuts may be on the wane among some policy makers, other policy options are limited.

The biggest sign of the shift in views was the head of the IMF, Christine Lagarde, making a call for austerity measures to be eased if growth continues to remain weak.  The IMF is an international body which has funds to help bail countries out if their governments cannot get access to cash from elsewhere.  The change in stance by the IMF has all the more meaning because the IMF itself has a reputation for imposing harsh measures on countries which require help such as in the Asian crisis in 1997. 

The change in opinion follows new research which brought into question the effects of austerity measures.  It was previously thought that austerity through cuts to government spending (or higher taxes) would reduce GDP by less than the actual measures themselves but the IMF research suggests that this may be too optimistic and such policies may reduce GDP by more than the amount the government benefits from austerity.  This could create a downward spiral in the economy - lower government spending resulting in a bigger fall in GDP which in turns means that further government cuts are necessary to reach targets for budget deficits and so on. 

The most interesting case with regard to austerity is the United Kingdom where the government has adopted austerity policies of their own volition while other countries in the midst of government spending cuts have been forced into such measures due to high interest rates on their government debt.  The coalition government in the UK headed by the Conservative party has advocated the need to reign in government spending using the debt crisis in places like Greece and Spain as examples of what could happen otherwise and emphasizing the need to maintain a good credit rating as justification for cuts.  Yet, the interest rate on government debt in the UK is near a record low which means that there is less of a need for urgency in dealing with the government budget deficit which is expected to be 5.5% of GDP in 2012 with government debt at 89% of GDP.

The rightward bent of the Conservatives means that the party has an ideological inclination toward wanting to reduce the size of government.  The debt crisis in Europe has provided a useful tool for the Conservatives to convince voters that this is the right course of action.  But Your Neighbourhood Economist would argue that fervour with regard to austerity in the UK is based more on right wing ideology of the government than on economic practicalities.  And the repercussions of austerity on the economy have become evident in the change in stance by the IMF and a further 10 billion pounds in cuts which were announced by the Conservatives in early October. 

The worst may not yet be over with the IMF becoming more pessimistic with regard to the outlook for the UK economy with a 0.4% fall in GDP predicted for 2012 compared to a 0.2% rise forecast in April.  Growth of 1.1% is predicted for 2013 which is lower than the 1.4% estimate in April.  A further deterioration in the economic outlook for the UK is a real possibility if austerity measures continue to do more hindrance than help. 

Yet, while less austerity would help to ease the burden on many, it is more depressing to consider that a change in tact by the UK government may have only a minimal effect.  The malaise of the UK economy is due to not only the government cuts but also a sluggish global economy and a high degree of uncertainty which limits the appetites of companies to invest.  So the effects of measures implemented in individual countries may be limited unless there is a certain degree of coordination between governments in the larger economies.  But this seemly unlikely – more on that in my next posting (but mostly bad news sorry).

The end of the end of the world

For manufacturing firms in developed countries such as the United States and the United Kingdom, the rise of China as a manufacturing base was seen as the end of the world.  With a seemingly endless supply of low-wage and diligent Chinese workers, manufactures elsewhere have been forced out of business and those that survived retreated to more high-tech products which were still beyond the reach of Chinese firms.  But the end is no longer nigh.  The bountiful supply of cheap labour has dried up and wages in China are rising along with demands for better working conditions.  Not only does this suggest the end of Armageddon for manufactures in developed countries but may also open up new business opportunities.

The industrialization of any economy whether it be Britain during the industrial revolution in the eighteenth century or modern day China involves the mass migration of workers from the agricultural sector into manufacturing.  The increase in productivity (the ability for workers to produce more in the same amount of time) generates a surge in wealth which typically first goes mostly to the owners of factories employing the cheap labour.  But there comes a point in time when the supply of workers from the countryside starts to fall off and firms have to compete more to keep workers which results in wages starting to rise.  This is crucial for the formation of a consumer society as workers gain spare cash to spend.  This is where China is positioned at the moment and it is a trend that is likely to pick up in the future. 

Along with the typical momentum involved with industrialization, demography is another factor that is adding to the upward pressure on wages.  Population growth is slow due to China’s one-child policy which limits the available pool of labour.  With most families only having the one child, parents are investing more in the education of their single progeny and this combined with the bright prospects for the Chinese economy mean that younger workers are aspiring to more than menial factory jobs.  The trade-off is that higher wages are required to attract and maintain employees.  

Rising wages are a boon for China as its new-found wealth begins to be dispersed to its citizens to a greater degree.  And higher pay for Chinese workers also offers some respite for competing firms - both in other low-wage countries and in developed economies.  Wages are now lower in other countries in Asia such as Vietnam and Cambodia.  This will attract factories to move there and help spread the benefits of industrialization. 

But a mass exodus from China is not expected.  China provides not only cheap labour but excellent transport links and suppliers of various components required for manufacturing which have been developed as China has become a key cog in the global supply chain.  Instead, China is expected to increasing replace workers with machines as pay rates increase further.  This will also be accompanied with a shift toward more high-tech products.  But this opens up the chance for big pay-offs for Western firms that can supply the machinery to Chinese factories as well as companies that can tap into the growing consumer market as employees get paid more. 

Doing business in China will still continue to present difficulties.  The Chinese government is doing its best to control the economy during this unprecedented surge in growth (for details, see Why China needs a slowdown) but that is like trying to steer the proverbial bull through a china shop.  The politics generated by a rise of China as a new power can also be problematic such as in the case of Japanese firms struggling with a nationalistic backlash over issues dating from over 60 years ago.  The growing pains involved in the coming of age of a country of 1.3 billion were never going to be easy but changes in the economy in China are offering up a new wealth of opportunities.

Where is all the money going?

Central banks in the world’s largest economies, the European Central Bank and the Federal Reserve in the United States, have recently announced plans for creating an unlimited amount of money.  A third central bank, the Bank of Japan, also has announced its intent to pump even more cash into the Japanese economy.  The funds from the central banks are used to buy bonds with the goal of pushing down interest rates (for details – see The Demand and Supply of Money).  The money received by those selling the bonds has to go somewhere.  But it is not always clear where the money will go.  Image pumping more and more jam into a donut – some of the jam will go where it is supposed to but the jam will at some point spurt out in unintended directions and make a bit of a mess.

The buying of bonds by the central banks will increase the prices of bonds and decrease the interest rates which mean that bonds will be a less attractive investment.  The shift of funds away from the bonds being brought by the central banks to other sectors of the economy is seen as an added benefit along with the lower interest rates.  It will help to reduce the borrowing costs of companies which would make them more likely to invest.  But the anaemic state of the economy suggests that such investment is still muted. 

Money has also moved from the bond market into shares.  This also has an upside due to what is known as the wealth effect – consumers will spend more when they perceive themselves to be wealthier (when their shares are worth more).  But any gains in the stock market due to this can only be temporary as the underlying value of the shares which depends on the profitability of the companies can only improve along with the economy.  This had not stopped the stock markets reacting vigorously to the perceived intentions of the central banks.

Considering the global nature of finance, the money does not only stay within the same country but spans the globe looking for the highest return.  However, the bond buying policies add to the colossal amount of funds that can potentially cause havoc in the economies which are their final destinations.  A flood of money surging into a country will increase the value of its currency while putting downward pressure on the currency in the country where the bond buying is taking place.  This dents the exports of the former while boosting the exports of the latter and the bond buying has been labelled as a protectionist policy at a time when sluggish economies make most countries desperate to boost exports.

A previous victim has been Brazil where the value of its currency, the real, climbed to above R$1.6 against the US dollar in July 2011 after having dropped briefly to below R$2.4 against the US dollar at the end of 2008.  The volume of its exports has suffered as a result and the Brazilian economy has slowed.  A strong currency is also a problem in Japan where the central bank followed the lead of central banks in Europe and the United States with its own bond buying plans with one eye on its currency.  The Japanese yen is still close to its record high of around Y76 against the US dollar which was reached in October 2011. 

In the old economic textbooks, the value of currencies would be dictated by the relative competitiveness of different economies.  More competitive economies would be able to export more and the funds drawn in from overseas as a result would increase the value of the currency.  The opposite would hold true for less competitive economies and the system of global trade would trend toward equilibrium as a higher currency would make more competitive economies less so and vice versa.  However, the flow of money across borders now overwhelms the flow of goods and it is the cash that is sloshing around in the global financial system which dictates movements in the currency markets. 

These funds are often completely separated from the reality of the underlying economy and the same forces that push the overall system to equilibrium are not at work as would be the case when trade in goods dominates.  This combined with the ability for cash to be moved almost instantaneously has profound and often chaotic effects on the global economy and our understanding of the economy still lags behind these new circumstances – a humbling reality for any economist.

The Demand and Supply of Money

Economists love the idea of demand and supply.  It is one of the basic concepts we use to describe almost everything.  Yet, thinking about demand and supply with regard to money may seem strange.  Money is something that everyone wants more of and there is never enough of the stuff.  But with central banks across the globe printing more money but banks and companies being cautious about using the bundles of money they have, there is plenty of it around but no one wants to spend it.

The supply of money has been on the rise due to the policies of quantitative easing which central banks have used to try to revive sluggish economies.  The central banks have been creating money from nothing to buy bonds in an attempt to push down interest rates so as to prompt firms and households to borrow more. 

Typically, an increase in the money supply will result in inflation as more money chasing the same number of goods pushes up prices.  But much of the extra cash is being hoarded by banks and companies who are too scared to put it to use.  On the other hand, consumers are being squeezed with downward pressure on wages for those that manage to hold onto their jobs.  Any extra money for households is typically being used to pay off debt after a borrowing binge in the build up to the global financial crisis. 

Central banks have tried to boost the demand for money by lowering interest rates.  It may sound like a bizarre concept but the interest rate is the price of money as it is the cost involved in obtaining cash that is not yours.  The interest rate is determined by the demand and supply for money in a market environment.  That is, an abundance of savings (excess supply) will push down the interest rate while lots of borrowing (excess demand) will have the opposite effect.  In practice, interest rates are also influenced by central banks that set the interest rate, which acts as a base rate for the interest rates on different types of debt, to keep inflation within a target range – typically inflation of around 2.0%. 

The global financial crisis in 2008 and 2009 can be seen as the result of interest rates deviating from what would have been appropriate.  There were massive inflows of savings from China in the banking system in the United States as the Chinese government built up foreign currency reserves which were in US dollars and invested in US government bonds.  This kept interest rates artificially low and resulted in increasing levels of debt as companies, households, and even the government took advantage of cheap borrowing.  Fingers have also been pointed at the US central bank, the Federal Reserve, for not acting faster to clamp down on the excessive borrowing by increasing the interest rate.  But it proved difficult for even the Federal Reserve to end the debt fuelled party – the results of which have only become obvious with hindsight. 

But now interest rates cannot be low enough.  The central banks have set the interest rate close to zero but this is still too high to prompt companies to borrow considering that it is unclear whether investments will generate profits given the uncertainty that clouds the global economy.  Central banks have tried printing more money through quantitative easing which is another way of pushing down interest rates which firms actually pay when borrowing.  While this new cash has helped somewhat in this regard, much of the money has gone elsewhere – some to stocks which has helped to boost the share market but some of the funds have headed overseas with undesirable effects (but more on this in my next posting).

The nitty gritty of economic is not for everyone, and while it may not be that interesting (Your Neighbourhood Economist cannot work miracles), hopefully the workings of the economy will make a little bit more sense (and please comment or email if you would like to know more).

Why China needs a slowdown

The rise of China will be the most momentous shift in economic power of a generation and it is only a matter of time until China will be the largest economy in the world.  For a long time, the concerns regarding China have been over its relentless rise and how its insatiable appetite for raw materials has pushed up commodity prices.  But the world economy has become dependent on China as an engine of growth as economies in Europe and elsewhere stumble.  So the worry now is not about China expanding too fast but China not expanding fast enough as sluggish global demand begins to hurt China’s economy and the Chinese government is not acting to maintain the previous hectic rate of economic growth.

As a capitalist economy with a communist government, China has the best of both worlds.  Rampant entrepreneurism, which Your Neighbourhood Economist has always associated with Chinese people (positive racial stereotyping?), has resulted in wealth creation on a massive scale and dragged millions out of poverty.  Yet, the communist government maintains a level of control over the economy to help the country through a period of unprecedented growth.  As such, the government stepped in when the global financial crisis hit in 2008 with a colossal economic stimulus worth 16% of GDP over two years.  It may seem a strange notion for a communist government to be propping up a capitalist economy but it is the best way for the communists to provide higher income for its citizens and maintain their grip on power.  And a strong central government helps to keep much of the messy politics out of the way (for an example of politics getting in the way - One step forward and two steps backwards)

Yet, as the global economy weakens, China itself is in the midst of a significant economic slowdown but the government has held back from throwing its full weight behind another economic rescue mission.  The Chinese government has the capacity for further action as it does not have the debt of governments in other large economies.  Punters in the media have suggested that it is the change of the top government posts that has resulted in the leaders in China being distracted.  Others have pointed to the possibility that more of a stimulus would not have any further effect.  But Your Neighbourhood Economist would argue that the Chinese government is smarter than that and still has the capacity to generate growth in the economy.

It is not that the Chinese economy wouldn't get a boost from more stimulus but that such measures would create more problems than it would solve.  The economy in China is like a weightlifter on steroids – more steroids would typically help to lift heavier weights but too much can cause severe damage.  Investment is the steroids that have been driving the Chinese economy.  Investment is typically what fuels any economic expansion.  Companies build factories and shops if there are products to make and sell but this will only happen if consumers have enough money to buy the goods.  So investment surges when an economy is booming but companies will stop investing if times turn bad.

Companies in China not only provide goods and services for the 1 billion people that live in China but also export products for retailers across the globe.  As such, investment in China has reached unprecedented levels - around 50% of GDP compared to around 15% in the United States.   Much of the stimulus package in 2008 went toward spending on infrastructure and was combined with lower interest rates and increased lending by state-owned banks.  A bit more of the same has been tried in 2012 but without the same fervour. 

The leaders in China could try more of the same but a further boost to investment may result in one shot of steroids too many.  That is not to say that it would not have an effect but rather than the effect would be to exacerbate imbalances in the Chinese economy.  Investment that outpaces growth in the economy risks not only being a waste of money but distorting the development of the economy.  Excessive spending to build factories which end up producing goods that no one wants will result in bad debts.  Spending on infrastructure is another possible form of investing but this also needs to expand along with a growing economy so as to go to areas where it is actually required rather than roads to nowhere.

Considering that global banking system got in trouble following a period of debt fuelled expansion, Your Neighbourhood Economist hopes that lessons have been learnt and that the Chinese economy is not pushed to expand too rapidly.  But only time will tell – stay posted.

One step forward and two steps backwards?

Economics can often provide solutions to problems while the study of politics can be about why the solutions are not always easy to implement.  This could be seen as a bias interpretation but the changes in the fate of Spain over the past month could possibility be an example.

The interest rates on Spanish government debt tumbled at the beginning of September following the announcement of plans by the European Central Bank (ECB) to buy an unlimited amount of bonds of indebted countries in Europe (refer to “Whatever it takes”).  This should have been the beginning of the end of the debt crisis in Europe.  But the mood turned sour as Spain once again hit the front pages of the papers as politicians in Madrid and in the region of Catalonia positioned themselves amidst the changing political landscape.  As a result, the Spanish government is having to fight to stay in the Eurozone as well as trying to hold the country together. 

The ECB made a bold stand in its willingness to stand behind countries like Spain who suffer from excessively high interest rates as a result of concerns over a possible breakup of the Eurozone.  If the ECB makes good on its pledge to do “whatever it takes” to save the euro, investors have less to worry about and renewed buying of Spanish bonds should help bring down the interest rates on the government debt.  But in practice, the best laid plans do not always work out.

The backing of the ECB required countries to submit to supervision from the EU and the IMF which makes the help offered by the ECB less attractive.  Losing control of their own affairs is a fate that those in power do not welcome and the Spanish government is holding off on asking for help from the ECB.  But the daunting nature of the economic problems in Spain suggests that help from outside is inevitable.  Real GDP in Spain is expected to shrink by 1.5% in 2012 and 0.7% in 2013 according to the IMF while the government debt continues to increase.  The Spanish government is expecting to borrow 207.2 billion euros in 2013 which is more than its plans for 186 billion euros in new debt in 2012.  An examination of Spanish banks this week suggests that a further 60 billion euros are needed to stabilize the banking sector and some of these funds may have to come from the government.

However, help from the ECB may be on the way as the Spanish government is making moves in the right direction and is in the process of implementing many of the policies that would be required of it if the country needed assistance from the ECB.  This may be crucial as the Spanish prime minister Mariano Rajoy has remained firm in his stance that he will not accept conditions being imposed from outside.  Yet, if the prescribed policies had already been put in place, the outside help need not require any further harsh measures.  But the policies of austerity have resulted in protests in Spain so the government is treading a fine line and the possibility of turmoil is never far away but at least efforts towards a solution are in the process of being made. 

The political difficulties of cutting government spending and raising taxes would be more than enough to deal with.  But the tough measures taken by the government have triggered another crisis – the perennial issue of secession in Spain.  Catalonia which is centred on Barcelona is both the wealthiest region in Spain as well as the region which has the most debt.  Its prosperity means that Catalonia provides more tax revenue to the central government in Madrid than it receives in government spending.  But, at the same time, the regional government in Catalonia has had to ask Madrid for just over 5 billion euros as investors will no longer lend the region any money.  This contraction has been jumped on by politicians in Catalonia who want to push for independence for the region and a snap election for the regional government in Catalonia has been called for November which is being seen as a proxy referendum on the possibility of secession.   A crisis is always a good opportunity for politicians to push for change even if it adds to the mayhem.

But such is politics.  Politicians must keep voters happy to stay in their jobs while others will take their opportunity to grab for power.  But this is not always conducive to action.  It is no coincidence that the ECB has been able to make bold policy shifts while governments in the various countries in Europe (including Germany) have been squabbling on the sidelines.  The messy politics in democracies can get in the way of doing what is required.  If only economists ruled the world!

“Whatever it takes”

This is the bold pledge made by the governor of the European Central Bank (ECB), Mario Draghi, in reference to what the Europe’s central bank is willing to do to help stop countries leaving the euro.  This statement of intent was made at the end of July but investors had to wait until the beginning of September for the details of how far the ECB was willing to go.  And the ECB has brought out the big guns to prove its resolution but it remains to be seen whether the full might of the ECB will be enough.

The central part of the new policy was that the ECB would purchase an unlimited amount of bonds of indebted countries suffering from high interest rates.  The fact that the ECB has set no limit on funds available for bond purchases is meant to stop investors selling bonds of European governments in the expectation that the interest rates will rise (interest rates get higher if bonds are sold off and their price falls).  If the ECB is always ready to buy bonds, the price of bonds is less likely to fall and this will create an environment where other investors will be motivated to also buy. 

And in theory, it is a good time to buy.  The worries that a breakup of the Eurozone will prompt governments to default on their debt have prompted investors to sell off the bonds of countries such as Spain who are expected to have difficulties in paying their bills.  If the fears of default can be soothed, the prices of bonds will seem cheap.  So, the ECB is betting on its ability to calm the nerves in the market and could actually make a profit on its buying of bonds.

This new stance is not without its problems.  The help for troubled countries from the ECB is not unconditional and governments must agree to reforms to the economy which would be supervised by the EU and the IMF for the ECB to buy their bonds.  Spain is seen as a prime candidate for this support but the harsh reality of having to submit to orders from others has made the government reluctant to seek assistance. 

 

The ECB could be caught in a dilemma if a country does not toe the line after having their bonds propped up by the ECB despite having signed on for reforms.  If the ECB stops its bond purchases for such a country, default would be highly likely and this is exactly the result that the policy is intended to stop.  There are concerns with the ECB along with the EU and the IMF having control over governments which have been democratically elected by their citizens.  While an undesirable outcome of the sovereign debt crisis, the greater power of these unelected bodies is the result of governments being unable to sort out the problems themselves. 

But perhaps the biggest concern is the slim possibility that that the unlimited firepower of the ECB will not have enough punch.  Pessimists may bet against the ECB to test its resolve.  There are numerous parties which are unhappy with the new position taken by the ECB.  In particular, policies makers in Germany have made public their displeasure and this will grow with the amount of funds which the ECB uses to buy up bonds increases.  Investors will also second-guess the efforts of countries receiving support as to whether they will stick to what is expected of them by the ECB.  The policy of the ECB has been compared to a bazooka – if you have a big enough gun, no one will mess with you.  But there is the smallest chance that even a bazooka may not be big enough faced with an army of doubters.  

Another dose of medicine but will it help…

Vital signs suggest that the global economy in 2012 is not healthy.  Europe is the main cause of concern as politicians argue about the right course of action with regard to the sovereign debt crisis.  But problems in other major economies such as the United States and China are also adding to the ailments of the global economy.  This deteriorating outlook for the global economy has also sapped the willingness of many firms who operate on a global level to spend and invest.  The typical economic prescription in cases where a lack of optimism dents spending by firms and consumers is Keynesian – the government is to step in and increase spending to cover the drop in demand from elsewhere.

But governments in many countries such as the United States have their hands tied due to large amounts of government debt which limits further spending.  Central banks have also tried the textbook response to a weak economy by cutting interest rates to close to zero.  But this has had little effect as business will not borrow even at low interest rates if the prospects for the economy are dim. 

So central banks have been pushed to try less conventional medicine.  The new prescription is referred to as quantitative easing and involves the central banks printing money and using this to buy bonds issued by their government or by businesses.  This acts to further lower interest rates on the bonds and the lower return for investors in bonds prompts some of them to move their money to other investments such as shares which acts as a shot in the arm for the stock market.

Growing concerns that the global economy is on its sick bed have jolted the central banks in the United States, Europe, and Japan into ordering a further dose of medicine.  The European Central Bank released plans to buy as many bonds of indebted countries as necessary to help out the sick patients of Europe after its pledge to do “whatever it takes” to support the euro (more on this in a future posting).  The Federal Reserve in the United States followed suited and announced it would buy an unlimited amount of bonds until unemployment began to come down.  The Bank of Japan also jumped on the bandwagon with its own plans to buy up bonds.

 

This new consensus among central banks has not pleased everyone.  There are concerns over the new roles for central banks who have traditionally been bastions against inflation.  Inflation is seen as a negative influence as it reduces the value of money which hurts savers.  Central banks have killed off inflation by increasing interest rates but this has been possible due to the targeting of inflation by central banks.  But attempts by central banks to revive flagging demand through quantitative easing also could result in the resurrection of inflation.  As quantitative easing also involves central banks creating money for nothing, it also acts to drive down the value of the currency (as will be described in a future posting) and this is controversial as a weaker currency boosts exports at the expense of other countries. 

Even if the quantitative easing by central banks is seen as a necessary evil, there are further fears about whether the policies themselves are having the desired effect.  Because quantitative easing involves buying bonds in the hope of influencing investment decisions of other buyers of assets for investment, the effects are not clear and the continuation or even worsening of economic problems suggests that the policies are not a cure-all.  This is reinforced by the fact that, for example, this will be the third round of quantitative easing in the United States (hence the abbreviation “QE3” in the newspapers). 

In effect, there are few differences from when Your Neighbourhood Economist first started this blog in November 2011 (So what is going on…???).  The problems that central banks are grappling with are beyond the scope of the current understanding and available tools.  It remains to be seen if the unlimited resources now being tapped by the central banks will in fact be enough to resuscitate the major economies.  There is not much else that can be done.  Even Your Neighbourhood Economist does not know what to expect in twelve months’ time.

Back from Vacation in Greece

Upon returning from holidaying in Greece, Your Neighbourhood Economist typically has gotten a quizzical look from people when the choice of holiday destination comes up in conversation.  “How was it?” would be a standard response with the expectation of tales of squalor coupled with rebellion being rampant amongst the locals.  But except for stories of idyllic islands and endless sunshine, there was nothing much else to tell.

While there are stories of hardship coming out of Greece, for many life goes on.  While 17.7% of the working population are unemployed, there are still 4.1 million workers in jobs who generate GDP worth 215 billion euros giving Greece a per capita income which is higher than Portugal, Croatia, and the Czech Republic.  Much of the hurt that the country is experiencing comes not from absolute poverty which does exist as it does in many other richer countries.  The real pain comes from what has been lost due to the debt crisis and from a future that looks considerably different now than would have been the case five years ago when the entry to the euro had seemingly ushered in a new era of prosperity.

Some readers with a sympathetic disposition toward the people of Greece may consider the stance of Your Neighbourhood Economist to be harsh.  But the trouble that Greece is in will require pain to be inflicted on someone and it is essentially the Greek people that ran up the bill.  Blaming an irresponsible and unrepresentative government only goes so far when considering that the Greeks have left these politicians in power.  Investors who hold Greek debt have endured a portion of the pain in the form of the debt write-off that was part of the previous bailout (see Another Bailout for Greece).  But the Greek people are even now living beyond their means considering the small primary budget deficit in 2011 which means that government spending still exceeds its income even when interest payments on its debt are excluded despite the austerity measures already implemented. 

The cash and the solutions are available to solve the debt problems in Greece and elsewhere but sharing out the pain is the issue that politicians are negotiating.  To let Greece off the hook too easily would create a moral hazard – setting a precedent whereby costs of bad decisions are borne by others.  Despite the rioting and protests, Greeks have shown a willingness to accept a considerable share of the burden after a small majority voted for parties which supported the bailout and the accompanying austerity in elections in June 2012 (which was a bit of a surprise to Your Neighbour Economist - Greece Set to Rebel and Dump the Euro).  And even Angela Merkel has shown some flexibility in allowing the European Union to move toward a banking union whereby funds will be available to prop up the banks in the different countries.  But taxpayers in Germany are still loath to stump up cash for the Greeks who are seen as proliferate when German workers have made do with limited wage increases to maintain competitiveness. 

But these negotiations have dragged on for too long as the leaders in Europe hope that minimal measures will suffice.  The trials and tribulations that Greece is being put through to ensure that it bears its share of the pain are causing the problems to fester such as delays in a possible bailout to Spain as well as sluggish economic growth in the Eurozone acting as a drag on the global economy.  Europe’s leading politicians and its central bank have been more proactive of late (more on that in a future posting) and hopefully the end of austerity is not too far away with the Greek government hoping that cuts to spending in 2013 and 2014 will be the last of it.  If the country pulls through without much more turmoil, it will be the Greeks that will have earned themselves a holiday.  

Bracing for Impact!

The ongoing sagas in Europe can seem at times like a multi-car pile-up.  It begins with just a car or two spinning in circles after having been swiped but soon escalates as drivers are surprised by what they encounter.  Onlookers try to warn the oncoming traffic but the drivers are distracted and everything seems to happen in slow motion.  Just as people wince as they wait for what seems to be a major collision (fresh elections in Greece on July 17^th), eyes are averted to the potential for even more carnage – a banking crisis in Spain.

The turmoil in Greece and Spain appear similar but stem from different causes.  The government in Greece had too much debt before the global financial crisis came crashing into our living rooms.  The Greek government had borrowings of more than 100% of GDP in 2007 and this quickly rose to over 160% of GDP in the four years as tax revenues plummeted and government spending proved difficult to trim.  The government in Spain, on the other hand, was comparatively a model of virtue with debt of than less 40% of GDP in 2007.  Even as worries mounted, the level of government debt in Spain was still less than 70% in 2011. 

Yet Spain has been shunned by investors due to concerns over its banking sector.  Spain has fallen victim to a property bubble and it is typically in banks where the first symptoms show.  People or companies take out a mortgage using their new real estate purchase as collateral, and when prices are rising, everyone is happy.  However, when the market turns sour, property prices drop and prospective sales are not enough for the banks to recover the value of the debt. 

Dealing with a banking crisis like this is tough enough as it is.  The government needs to shovel money into the banks to stop them from collapsing under the weight of all the bad debts.  Write-offs are required for money that won’t be recovered and considerable time and effort is necessary before banks can get back to operating as per normal.  Typically, the government would just step in and put up the money to bolster the banks.  Bankia, Spain’s four largest bank, was recently bailed out by the government at a cost of 19 billion euros with the rest of the banking section expected to need around another 45 billion euros.  Compared to the level of government debt in 2011 of over 700 billion euros, putting up the cash is manageable and the debt to GDP ratio would still be less than 100%. 

Yet, Spain has more obstacles in the road in front of it than just a banking crisis.  The high interest rates on Spanish government debt (around 7%) means that the government doesn’t have the access to the funds it would normally have.  And the government is short on cash as it cuts spending to lower the government deficit.  To add to this, the economy is in recession with real GDP expected to fall by 1.5% in 2012 and 0.1% in 2013 with the austerity measures and banking crisis likely to make things worse.  The deteriorating economy also hits property prices, exacerbating the problems at the banks.  And on top of all this, the possibility of Greece dumping the euro means that Spaniards are taking their savings out of the banks and putting it under their mattresses due to worries about a return to the peseta.

As well as being short on funds, the Spanish government has lacked the creditability in dealing with its banks after having underestimated that cash that would be needed to bolster Bankia.  Help is on offer via a bailout for its banks from Europe and the IMF but Spain is wary.  While the money would be welcome, the conditions would not be and the saga in Greece are a reminder of this.  There have been some positive moves such as deliberation over whether Spain should be given an extra year to reduce its deficit to 3% which would help (as suggested previously – Spain and the Long Hard Slog).  But with both Spain and Greece now playing chicken with the leaders of Europe to try and ease their share of the burden, expect the carnage to mount.

A Letter to Angela Merkel

Dear Mrs Merkel

I know that you have a lot to deal with at the moment so I thought I would send you some ideas on how you could manage the problems in Europe to do with Greece.

I understand that you are in a difficult position as the chancellor in Germany and a leader in Europe.  Of course, your first responsibility lies with the German people and you must defend their interests first and foremost.  But as the leader of Germany, you also have a crucial role to play in Europe.   And leadership in Europe is needed now more than ever.  Do you want to be remembered in history as the German Chancellor that let Europe crumble or as the saviour of 60 years’ worth of post-war integration in Europe? 

I can understand your stance up until now.  To forgive countries that have spent too much during the boom and have been caught out when the economic tide turns is to make the same behaviour likely the next time around.  It is not easy to be the stern taskmaster in a time of crisis but you have made a stand on principles that in many respects deserves to be applauded.  

However, I would argue that circumstances require a change of tact.  Greece is on the verge of jumping ship and exiting the euro.  While Greece has some responsibility for the mismanagement of their economy, even you must realise that the measures that have been imposed as the conditions for the last bailout package have left the Greek people with a bitter taste in their mouths.  The popularity of the anti-bailout political parties in the election this month is a reflection of this, and if this mood prevails, Greece is sure to depart the Eurozone. 

We both know that, while tough on the Greeks, Greece leaving the euro in itself will have only a minimal impact on Europe.  But it is what may follow that is the real concern.  Once one country leaves, fears that others may follow will wreak havoc in Europe.  Investors will dump the government bonds and savers will race to grab cash from the banks of any country that is seen to be in trouble and one country to the next - Ireland, Portugal, Spain, Italy, and maybe even France – could be targeted.  The domino effect would see the country fall one by one while the pressure builds up on the next in line. 

Only the solidary of Europe as a whole can stop this from happening.  The indebted countries need to be backed by an overwhelmingly large reserve of funds (much more so that what has currently been made available) and by unwavering support from yourself and the other leaders in Europe.  While I would not like to see Greece exiting the euro as I believe the consequences would be too great, I would not begrudge a decision where Greece is left to its own devices.  If an example is to be made of at least one country, then it is the misfortune of the Greeks to have been the worst of a bad bunch.  But it must stop there or worries will only mount up and panic will ensue.

Now is the time for concessions.  You must consider implementing Eurobonds even as just a temporary measure.  Eurobonds will ease the pressure on the struggling countries by lowering their debt payments, and by making concessions with regard to this, you will be able to get other countries to agree to new fiscal rules which will stop excessive government spending in the future.  The recent change in focus toward growth following the election of the new French president François Hollande should help provide you cover for the change of stance. 

To stay with the current framework is courting with disaster.  Germany’s tough stance will leave it isolated in Europe.  The process which has brought about the integration of Europe may not recover and the single market may disintegrate.  Germans will lose out – they just don’t know it yet.  It is time to use your popularity in Germany and make a case for a softer approach toward Greece and others before it is too late for them and for Europe.

With my best wishes

Your Neighbourhood Economist

“Should I ask to be paid in pounds?”

A friend who had recently moved from the UK to a new job in Europe recently asked the question which is the title of this posting.  While the question may have been half in jest, it did reflect concerns about what will happen to the euro if Greece was to leave.  The reply was that there was not much to be worried about and here’s why.

For starters, Greece is very small in comparison with the rest of the Eurozone.  The GDP of Greece is only just over 2% of the GDP of the Eurozone.  A larger currency union means that people would have more reason to hold money in that currency and this would increase demand and the value of the currency.  But because Greece is so tiny and not central to business in Europe, the effects on the value of the euro from its exit would be minimal. 

Forgetting about other factors, the departure of Greece may even be a boost to the euro as it would end a saga that has brought a cloud over the euro.  However, it is the possible follow-on effects more than the actions of Greece itself that are the real concern.  If one country leaves the euro, it sets a precedent and makes it easier for others to follow.  Investors then begin to worry about this and move their money out of any struggling country which in turn makes it tougher for these countries and increases the likelihood that they also may have to leave the euro.  People in those countries would start withdrawing money from banks due to fears about losing out with the change to a new and weaker currency. 

The fears about other countries leaving the euro then become a self-fulfilling prophecy and one country after the next may become the target of this.  In this manner, first, the smaller countries of Portugal and Ireland, then probably Spain, followed by Italy, and even maybe France could fall like dominos.  If such a chain of events begins, it is difficult to know where it might end. 

What would be required to stop this would be the leaders in Europe drawing a metaphorical line in the sand to state that Europe stands behind a certain group of countries.  The leaders in Europe need to show conviction in standing behind the struggling countries and earn the trust of investors who will not bring their money back until they think it is safe.  As obvious as this sounds, it is not something that Europe has managed so far and still may be beyond their leaders.

Despite all the turmoil, the euro as a currency has held up surprising well.  Demand for the euro has stayed strong due to the size of the Eurozone which makes the euro a useful currency to have.  Even though there has been lots of selling of bonds issued by Greece and others, German bonds have been popular.  Big investors and others with lots of cash such as reserve banks in Asia like to spread their investments over many different regions and will always hold a large portion in euros.  Investors who want to make money from the troubles in Europe have done so by selling bonds of particular countries rather than selling euros.

So the euro has stayed around 1.30 vs the US dollar so far this year which is similar to where the euro was trading at the beginning of 2011.  A weak patch this week prompted the euro to drop to near 1.25 vs the US dollar and hit a two year low (or a three year low of 0.80 vs the UK pound).  It remains to be seen whether this is just a blip or whether investors have become fed-up with politicians and are moving money elsewhere.  Either way, my friend may lose a bit of money if he wants to convert it back to pounds but that all depends on the timing of the change as the euro is likely to recover at some stage.  However, it is not something to lose sleep over (yet).

Greece Set to Rebel and Dump the Euro

One of the reasons why Your Neighbourhood Economist has taken to blogging is because the media often hype up a story in order to entice readers.  Since the beginning of the crisis in Europe, headline everywhere have played up that Greece has been on the verge of collapse and the breakup of the euro has been just around the corner.  Yet politicians in Europe always seem to find a compromise.  However, the current situation in Greece means that the potential for a big bust-up this time is a real possibility.

Your Neighbourhood Economist had previously considered the chances of Greece ditching the euro to be small at best.  The reasons for this is are the massive costs involved.  Just switching from one currency to another is costly enough.  But in the case of Greece, its new currency would have a lower value than that of the euro as it would be money that no one outside of Greece would want.  But much of the debt of businesses and consumers is denominated in euros and this debt would balloon in size when changed into the new currency.  Banks would also have to deal with the likelihood of people wanting to get cash out before the switch to the new currency as the value of their savings would plunge.  And it would be tough for banks and other businesses as well as the government to get money again from foreigners due to the belief that Greece would take the easy way out and default again if times got tough again in the future.

A change in currency implemented in a rapid manner is therefore a recipe for chaos.  And that is just inside Greece.  Investors would panic and withdraw their money from any other struggling countries in Europe such as Portugal or Spain and people in these countries would be lining up at banks in a rush to take out money.  European banks would lose out from Greece defaulting on more debt and tax payers in Europe would lose the funds that have already invested to stabilise the situation in Greece.  So the potential consequences have been enough so far to prompt politicians in Greece and the leaders of Europe to do enough (barely) to stop this from happening.

But it has been the people of Greece that have had to bear the burden due to the mismanagement of their economy and it is a burden that many do not feel is justified.  And this frustration manifested itself in recent election results where voters punished the established political parties who backed austerity measures imposed as part of the latest bailout package.  The parties that did do well where those keen on dumping the euro and any measures imposed from the outside.  The outcome was that the mishmash of parties that did get into government were unable to form a coalition that could govern the country and so Greece will be voting again in the middle of next month.

An argument can be made for Greece leaving the euro.  There would be benefits in terms of its exports regaining competitiveness due to the weaker currency.  Other countries such as Argentina have combined a change in currency and a large scale default on debts and managed to soldier through.  But Argentina has a large export industry and abundant resources while the opposite could be said of Greece. 

However, most of all, Greece would gain a greater degree of control over its own destiny.  Germans have been adamant in their stance of not footing the bill for wayward countries in Europe.  But the harsh treatment of Greece has pushed the country and its people into a corner.  Likely to lose out whether staying in or leaving the euro, voters are likely to lash out again at those that they deem responsible – the leaders of Europe and the politicians in Greece that backed the bailout.  The resulting carnage of an exit from the euro may be seen as the Greeks being short-sighted.  However, it is the equally narrow-minded tax payers in Germany and their politicians who flinched at standing behind Greece and left the Greeks with few options.  Flexibility and perseverance is required on both sides with other measures such as Eurobonds needed (see previous blog - Conspiracy Theory for your Greek Holiday) amid growing disquiet to harsh austerity across Europe.  Or else, irrationality may be the only winner.

Another Reason not to Bank on Europe

There is a saying that “when it rains, it pours”.  And for Europe, there is a flood of doom and gloom.  A further concern that has not been dealt with yet in this blog is the state of the banks.  Life is not easy for bankers everywhere but the prospects for banks in Europe are a worry not only for the banks themselves but the economy in Europe as a whole. 

One reason behind the financial crisis was the excessive leveraging which involved banks lending too much with too little collateral.  But now the opposite process, deleveraging, has gripped Europe and the banks are scaling back their operations.  Part of this is a natural adjustment to having previously been too generous in their lending.  But there is a concern that the banks will go overboard and deny funds to companies that need to borrow money to expand or to get them through a rough patch.

The situation has been made worse by new regulations that have come into force since the financial crisis that aim to make banks less likely to get into trouble.  The revised rules make it necessary for banks to hold more capital reverses in case borrowers can’t pay back their loans.  Typically, banks would raise capital by issuing shares or bonds but this is difficult as investors have been scared away due to lots of dud loans at many banks.  So banks are tackling the new capital requirements by cutting back on lending.  Thus results in capital reserves increasing relative to its lending without the banks actually having to raise more capital.  But this has not been enough for some banks with Spain having recently nationalised Bankia, its largest property lender, due to bad debts. 

The European Bank has tried to help out by providing the banks with cheap loans (such mentioned in a previous posting - Economists save world for now).  While providing some relief, it also heightened the risks posed by banks and raised the stakes if anything is to go wrong.  This is because many banks in such places as Italy and Spain brought the bond issued by their own countries.  While the high interest rates on these bonds will boost revenues at the banks, the high level of government bonds at the banks increased the links between governments and banks in each country so that if either stumbles, both are likely to fall.  As a result, the size of any bailout will be substantially large.  And even if a bailout is not necessary, the funding from the European Central Bank needs to be paid back in three years which will likely involve a lot of selling of government bonds as the deadline for debt repayment draws near if the problems have not been sorted out by then.

And the deleveraging is not a process which will end anytime soon.  The IMF expects banks in Europe to reduce their lending by 2 trillion euros over the next 18 months.  But with that estimate only amounting to around 7% of the debt of banks, many expect that the IMF is being too optimistic.  Either way, the actions of banks, which typical boost growth by funnelling funds to where cash is need, will act as a drag on the economy of Europe for the next few years at least.  It is almost enough to make you feel sorry for bankers (but not quite).

Conspiracy Theory for your Greek Holiday

Much of the topics dealt with in this blog over its first six months were to do with the Eurozone crisis.  Looking forward, the next six months may be the same.  Strange as it may sound, one of the reasons for this is that many of Europe’s politicians want the turmoil to continue.  There are solutions that would considerably ease the burden of many countries in the grip of austerity measures but politics in Europe prevent their implementation.  To prove that this is not a weird conspiracy theory hatched by Your Neighbourhood Economist, let me explain.

One possible saviour for those in the midst of cutbacks would be something called Eurobonds.  Currently, all of the government bonds are issued by individual countries while, on the other hand, Eurobonds would be joinly back by all of the members in the Eurozone.  The benefit of this would be significantly lower interest rates on these bonds compared to those from individual countries as the Eurobonds would be backed by the whole of the Eurozone including the stronger countries such as Europe. 

The issuing of Eurobonds could be used to replace a large portion of government debt in such countries as Greece, Portugal, and Spain who are suffering under the burden of high interest rates, and as a result, are having to savagely slash their government spending.  But the stern Germans (and some other countries) are having none of it.  Their steadfast leader, Angela Merkel, is not keen on providing relief to the indebted countries in the hope that the pain will help the politicians there push through reforms that will make their economies more productive.  Such reforms are typically neglected when times are good and only get implemented during times of hardship and when politicians have someone else to blame.

It is like holding back food from someone who has grown flabby and pushing them toward starvation with the intention that this will make them change their ways and slim down.  But it is not something just for this dieter at this point in time.  Being tough on indebted countries now will make them and other countries in the Eurozone think before they build up debt again in the future.  This is also true of other pain relief measures such as the central bank in Europe taking a more active role in prompting direct or indirect buying of government bonds in Europe (as discussed in a previous posting - Economists save world (for now)). 

So it is a trade-off between short-term pain and long-term gain.  But that is not much comfort for the destitute who are bearing the brunt of the pain.  Needless to say, Germans are not popular among their fellow Europeans and the Greeks in particular.  Germans tend to flock to the beaches in Greece for their summer holidays but Your Neighbourhood Economist is planning to spend some vacation time in Greece on the assumption that it may not be so busy this year if many of the tourists from Germany stay away this year.  And it may even help a little.  I don’t need much more of an excuse to go back to the beautiful beaches in Greece.  Feel free to come along and spend a bit of cash as well.