Greek Data Updates

Edward Hugh is only able to update this blog from time to time, but he does run a lively Twitter account with plenty of Greece related comment. He also maintains a collection of constantly updated Greece data charts with short updates on a Storify dedicated page Is Greece's Economic Recovery Now in Ruins?

Sunday, November 28, 2010

Greece Is Almost Certainly "On Track" - But Towards Which Destination Is It Headed?

"There is a difficulty that is widely recognized that the amount [of debt] to be repaid is high in 2014 and 2015," Giorgios Papaconstantinou (the Greek Finance Minister).

"We are confident that Greece will be able to return to the markets. But whether it will be able to return to the markets on a scale that allows Greece to pay off its European partners and the IMF, that is a question."..."We have a number of options. If paying off the €110 billion loan proves to be a question, we stand ready to exercise some of those options" - Poul Thomsen, head of the IMF team in the ECB-EU-IMF troika delegation.

"In the rushed last-minute deal to forestall certain bankruptcy, everyone missed one very important fact. That the memorandum created an unrealistic and immense borrowing squeeze on the feckless Greek state for the next five years."
Nick Skrekas - Refusing Greek Loan Extensions Defies Financial Reality, Wall Street Journal

Get On The Right Track Baby!

According to the latest IMF-EU report Greece’s reform programme remians “broadly on track” even if the international lenders do acknowledge that this years fiscal deficit target will now not be met and that a fresh round of structural measures is needed if the country is to generate a sustained recovery. My difficulty here must be with my understanding of the English lexemes "remains" and "sustainable", since for something to remain on track it should have been running along it previously (rather than never having gotten on it), and for something - in this case a recovery - to be sustained, it first needs to get started, and with an economy looking set to contract by nearly 4% this year, and the IMF forecasting a further shrinkage of 2.6% next year, many Greeks could be forgiven for thinking that talk of recovery at this point is, at the very least, premature. A more useful question might be "what kind of medicine is this that we are being given", and "what are the realistic chances that it actually works". Unfortunately, in the weird and wonderful world of Macro Economics, witch doctors are not in short supply.

As the representatives of the so-called `troika`mission (the IMF, the ECB, and the EU) told the assembled journalists in last Tuesday's press conference “The programme has reached a critical juncture." Critical certainly (as in, in danger of going critical - just look at the 1,000 basis point spread between Greek and German 10 year bond yields, or the 4% contraction in GDP we look set to see this year), but the question we might really like to ask ourselves is what are the chances of the patient surviving the operation in one piece?

The statement came at the end of a 10-day mission visit to Athens to review the extent to which the country was complying with the terms of the country’s €110bn bail-out package and take a decision on whether or not to authorise the release of the third tranche of the agreed loan.

In the event the decision was a foregone conclusion, with the rekindling of the European Sovereign Debt Crisis as a background, and the very survival of the common currency in the longer term in question, this was no time to tell the markets the tranche was not being forwarded. But still, the expression "on track" continues to fall somewhat short of expectation with the lingered issues like the recent upward revision of the Greek deficit numbers (up to 15.4% for 2009), the failure to increase revenue as much as anticipated, and the need for a further round of “belt tightening” measures in 2011 to try to attain the agreed objective of a 7.4% deficit as a backdrop. The upward revision in the deficit numbers only added to all the doubts many economists have about the long term payability of the Greek debt, which the IMF now expect to peak at around 145% of GDP in 2013, although again, many analysts put the number much higher.

Independent analyst Philip Ammerman who is based in Greece, and whose expectations about the evolution of Greek debt have proved to be reasonably realistic, now expects debt to GDP to come in much higher than anticipated in 2010, due largely to 10 billion euros in debt from the train company OSE being added to the total and downward revisions in 2009 GDP from the Greek statistics office.

The key to payability is of course a resumption of economic growth, which at the present time looks even more distant than ever. The IMF is arguing for another round of structural reforms – like opening up “closed-shop” professions, or simplifying administrative procedures and modernising collective wage bargaining, and while many of these are necessary, none of these are sufficiently “short sharp shock” like to restart the economy, and in general don’t target the main issue which is how to restore competitiveness to the country’s struggling export sector.

Just One More Moment In Time!

Doubts about how Greece was going to start financing its debts in the market after the expiry of the loan programme in 2013 had only been adding to market nervousness in recent days, since in addition to the fact that loan repayments to the EU and the IMF would need to start in 2014. Most critical are the first two years, when the bulk of the debt to the EU and IMF falls due. Under current repayment schedules, In fact, as things stand now, Greece's gross borrowing needs for 2014 and 2015 (when most of the EU-IMF debt falls due) will balloon to over 70 billion euros a year from around 55 billion euros a year in 2011-2013. This represents having to finance about 40% of GDP each year. Not an easy task. The difficulty presented by this looming repayment mountain lead the FT’s John Dizard to speculate that the Greek parliament might be tempted to go for the rapid passage of a law allowing for the application of “aggregate collective action” on bondholders – using the reasoning that, since the money being borrowed at the moment is basically being used to pay off existing bondholders (who are relatively easy to haircut) while the new lenders (the IMF and the EU) are (at least on paper) not. As John says, “Greece is exchanging outstanding debt that is legally and logistically easy to restructure on favourable terms with debt that is difficult or impossible to restructure. It’s as if they were borrowing from a Mafia loan shark to repay an advance from their grandmother”.

What a (retroactive) aggregate collective action clause would mean is that if a specific fraction, say 80 per cent or 90 per cent, of existing Greek bondholders agree to a restructuring that lowers the net present value of Greek debt by, say, half, then the remaining “holdout” bondholders would be forced into accepting the same terms. It is the consideration that the Greek Parliament might be tempted to go down just such a road that possibly lies behind this weekends Reuters report that The EU and the IMF could extend the period in which Greece must repay its bailout loans by five years, to make it easier for it to service its debt. According hot the agency Poul Thomsen, the IMF official in charge of the Greek bailout, stated in an interview with the Greek newspaper Realnews "We have the possibility to extend the repayment period ... from about six years to around 11," This follows earlier reported statements from Mr Thomsen the the IMF “could provide part of the funding on a longer repayment period, or give a follow-up loan.” Indeed the announcement of the Irish Bailout details seems to suggest there has been a general change of position here, since the Irish loan is initially to be for seven and a half years (which certainly does suggest we are all trying hard to kick the can further and further down the road), while - in what you might think was a token nod in the direction of John Dizard's argument, aggregate collective action clauses are now to be written into all bond agreements after 2013. It will be interesting to see how the existing bondholders themselves respond to this proposal when the markets open tomorrow (Monday) morning.

So now we know that in fact Greece is likely to be able to extend its dependence on the IMF all the way through to 2020, the only really major question facing us all is: just how small will the Greek economy have become by the time we reach that point.

To start to answer that question, let’s take a look at some of the macro economic realities which lie behind the “impressive start” the Mr Thomsen tells us the Greek economy has made.

Austerity Measures Provoke Sharp Economic Contraction

The IMF-EU-ECB austerity measures have - predictably - generated a sharp contraction in Greek GDP, with falling industrial output, falling investment, falling incomes, falling retail sales, and rising inflation and unemployment. The big issue dividing Macro Economists at this point is whether countries forming part of a currency union which have a competitiveness problem are best served by their fiscal difficulties being addressed first.

Arguably countries which do not have the luxury of implementing a swift and decisive devaluation to restore their competitiveness would be best served by receiving fiscal support from other part of the monetary unionion to soften the blow as they implement a comprehensive programme of internal devaluation to reduce their price and wage levels. That is to say the current approach has the issue back to front, and will undoubtedly lead the countries concerned into even more problems as slashing government spending at a time when no other sector is able to grow is only likely to create a vicious spiral which leads nowhere except towards eventual and inevitable default. To date Greek GDP has fallen some 6.8% from its highest point in Q1 2008, yet far from bottoming out, the contraction seems to be accelerating under the hammer blows of ever stronger fiscal adjustments, and the downard slump still has a long way to go.

The Greek economy contracted by 1.1% quarter-on-quarter in the third quarter of 2010, making for the eighth consecutive quarter of contraction. And evidently there are still have several more quarters of GDP contraction lying out there in front of us.

Year on year the Greek economy was down by 4.5% on the third quarter of 2009. This is the fastest rate of interannual contraction so far. Far from slowing the contraction seems to be accelerating at this point.

Domestic Consumption In Full Retreat

Looking at the chart below, it is clear that Greece enjoyed quite a consumption boom in the first years of the Euro's existence, a boom which is in some ways reminiscent of those other booms in Ireland and Spain, and a boom which came roundly to an end when the credit markets started to shut down. As in other countries, the government stepped in with borrowing to try to keep the boom going, with the major difference that deficitfinance went to levels well beyond those seen in other European countries in 2009, as did the efforts the Greek government went to to try to cover its tracks.

One of the clearest indications that the party is now well and truly over is the way in which the level of new car registrations is slumping.

Retail sales have now fallen by something over 15%.

And With It The End Of The Credit Boom

The Greek consumption boom came to an end, just as it did in Spain and Ireland, when the credit crunch started to bite in 2008. Pre-crisis household borrowing was increasing at the rate of around 20%, the interannual rate of change has now fallen more or less to zero, and will stay there for some time to come. Since in a mature modern economy aggregate demand (whatever you do in the way of supply side reforms) can only grow in a sustained way as a result of either credit expansion or exports, export growth is going to have to give the Greek economy what little demand growth it can eventually get.

Along with the general stagnation in household credit, lending for mortgage borrowing has also ground to a sharp halt.

And credit to companies has also become pretty tight if we look at the next chart.

Asin many other heavily indebted countries (the US, the UK, Spain) the only sector which is still able to leverage itself is the public one, or at least which was still able to drive demand by leveraging itself, but now, with the IMF EU adjustment programme, increases in government borrowing are also going to suddenly come to an end, with the evident consequencethat the economy goes into reverse gear. I can't help feeling that people aren't using enough emotional intelligence here. Obviously people are outraged by the level of fiscal fraud that was going on in Greece. But outrage and demogogic press headlines seldom form the basis of sound policy. Arguably the competitiveness issue is more important at this point than the fiscal deficit one, since the position is asymmetric - solving the competitiveness issue will automatically open the door to solving the fiscal deficit one, while addressing the fiscal deficit does not necessarily resolve the competitiveness problem, and does not return the country to growth - only a strong supply side dose of ideology can lead you to (mistakenly) think that.

The Best Way Not To Restore Competitiveness: Raise VAT

In fact, the fiscal adjustment programme contains two components, reducing spending, and increasing taxes. Of these the most damaging measure as far as growth and competitiveness goes is without doubt the decision to raise VAT by 5%. Not only (as we shall see) does this increase not raise the extra money anticipated (in an economy which is increasingly export dependent the tax base for a consumption tax weakens by-the-quarter in relative terms), it also sharply raises the domestic inflation rate, effectively ADDING to the competitiveness problem. I would say this obsession of the IMF with raising VAT in these economies which are effectively unable to devalue is just plain daft, frankly. And it doesn't impress me how many times respected micro economists describe raising VAT as the most benign of measures: all this does is convince me that they don't really have an adequate understanding of how economies work from a macro point of view, and especially not export dependent economies.

As we can see in the chart below, the VAT rise not only adds to the consumer price index, it also affects producer prices, and even export sector producer prices, which are sharply up.

I would say that policymakers have fallen into two "Econ 101 simpleton" type errors here. The first is to think that since part of the objective is to raise nominal GDP to reduce debt to GDP, and since GDP is falling, raising the price level might help (I would call this the "fools gold" discovery), and the second is to imagine that since exports don't attract VAT, the impact is relatively benign, without stopping to think the the VAT hike also acts on inputs, and especially in an economy which suffers from chronic price and wage rigidity issues like the Greek one.

If a first year student had sent me these kind of arguments in a term essay, aside form awarding a "fail", I think would recommend to the person that they would perhaps be better off studying another topic, physics maybe, since the demonstrated aptitude for applied macro economics would be very low indeed. Could it be that bondholders who normally understand quite a lot more than many imagine about how economies work are also noticing this, hence their growing nervousness.

The incredible result of the application of this very short sighted policy is that in addition to the fact that Greece started out with a serious competitiveness issue with its most competitive EuroArea peers, like Germany.....

it has even hadits virtual currency revalued against the EuroArea average since entering the IMF sponsored programme, which is the exact opposite of what we need to see.

Export Lethargy Feeds The Industrial Output Slump

As a result we are seeing no evidence of a Germany-type resurgence in export activity.

And in fact even though the trade deficit has reduced somewhat, it still remains a trade deficit.

Given the fact that domestic demand is falling, while exports stagnate, Greece's industrial sector is still in a sharp and continuing contraction.

A contraction which continued and even accelerated slightly in October, according to the most recent PMI reading.

Construction activity is in "freefall", as can be seen from the drop in cement output.

and the decline will surely continue, as new building permits continue to fall.

And private construction activity continues to drop.

The net result of the economic contraction and a credit crunch is, of course, that while other consumer prices rise, house prices are now falling, giving us just one more reason why Greeks are starting to feel a lot less wealthy than they used to feel. Evidently, to kick start the economy again the fall in land and property prices needs to be brought to a halt. This is where the traditional devaluation strategy helped a lot, since you could stop the fall in nominal prices at a stroke, but the Greeks are helpless in this case, and it is rather alarming to find that there is no discussion of this key issue at the policy level, and just talk about how structural reforms will put everything right.

Employment Falls And Unemployment Surges

The man and woman power is there to rebuild the economy, as ageing hasn't yet reached the point where the labour force will start to shrink. Indeed at this point it is still rising.

But, of course, employment is now falling.

And thus, logically, unemployment is rising, and is currently something over 12%.

And With The Fall In Employment Revenue Comes Under Pressure

And with the rise in unemployment, there is a fall in incomes, and thus income tax revenue is falling, putting yet more pressure on the deficit.

At the same time, and despite a 5% increase in VAT rates, returns on the tax are also not rising as hoped.

A Contraction Which Feeds On Itself?

The Greek fiscal deficit is now falling, but after the huge upward revision in the 2009 figure, getting it down towards this years 9.4% target is a more or less Herculean task, which will involve far more fiscal effort than was previously anticipated, and with the fiscal effort more economic contraction. In addition, the finance ministry recently reported that while Greece's central-government deficit narrowed by 30% in the first 10 months of this year, this still fell short of the targeted narrowing of 32% due to lower than anticipated revenue returns.

Finance ministry data show that the Greek central government took in 41.0 billion euros in revenue in the first 10 months of 2010, just 3.7% more than it did in the same period of 2009. The deficit-reduction plan hammered out with the EU and the IMF in May called for 13.7% growth in such revenues for 2010 as a whole. This implies that to meet the target, Greece must receive 14.1 euros billion in November and December, which is highly improbable given that to date this year the Greek government has only once had monthly revenue above €5 billion, and that was in January.

On the spending side things have gone better, and targets are being met. Indeed over the summer the Greek government put forward a revised plan that compensates for the lower revenue with deeper spending cuts. But even meeting the lowered target of €52.7 billion would require a 30% jump over last year's revenue for the last two months of the year, and this is well nigh impossible.

As a result of the revenue shortfalls and the revision in the 2009 deficit, Greece still looks to be well short of the 7.8% of GDP deficit originally aimed for. Current estimates are for a shortfall this year of something like 9.4% of GDP. In order to try to soothe market fears in this unsettled environment the Greek government last week unveiled a further austerity plan for 2011 involving an addition 5 billion euros in cuts, with the objective of cutting public deficit to 7.4% of GDP by the end of next year. Apart from the fiscal effort involved the new budget will almost certainly involve a stronger economic contraction than previously anticipated - and indeed the Greek government have already revised their forecast to 3% from the previous expectation of a 2.6% shrinkage.

The problem is, that Greece is in danger of a counterproductive downward spiral here, since the revenue shortfall is at least partially the result of the existing budget austerity, which has simply helped to squeeze an already weak economy. The expected sharp contractions in GDP this year and next, will weighing heavily on revenue from income and sales taxes. Cuts to public-sector paychecks that went into affect this summer, for instance, have certainly helped contribute to a fall of about 10% in retail sales in August and September, and continuing unemployment rising above 12% will only add to the banking sectors bad debt problems.

You Need To Attack The Competitiveness Issue, And Not Just The Fiscal Deficit One

In my opinion the IMF are making a fundamental mistake in relying almost exclusively on structural reforms. "It has to come through structural reforms," Mr. Thomsen said, adding that he expected those reforms to be discussed at the next visit by the delegation early next year. "It cannot come through higher tax rates, that's not good for the economy, and it cannot come from more wage cuts because that is not fair."

The are right that more taxes and less salaries without corresponding price reductions don't solve the problem, but Greece needs to do something radical (like a sharp internal devaluation) to restore competitiveness rapidly. Pushing the issues out to 2020 is no solution, and it is hard to imagine Greek civil society will accept the levels of unemployment and social dislocation that are being produced for such a lengthy period of time.

Estimates of the future path of Greek debt vary a lot, and their is considerable uncertainty involved in any estimate. The IMF currently forecast that the debt will peak at just under 145% of GDP in 2013, but I think we can regard that as an estimate at the lower end of the range.

Despite the fact that George Papandreou's government has been widely praised for enforcing draconian austerity measures, the country still has the largest debt-to-GDP ratio in the EU, which involves a debt mountain of something like 330 billion euros - only 110 billion of which will be funded by the EU-IMF rescue programme. That is to say, private sector bondholders will still have something like (at least) 220 billion euros of exposure to Greek debt come 2013.

Greece's whopping current account deficit has reduced to some extent since the 2008 15% of GDP high, but the level is still quite large.

More importantly the IMF do not forsee Greece running a current account surplus at least before 2015. Indeed they imagine that Greece will still have a current account deficit of 4% of GDP come 2015. Which means that far from paying down their external debt, Greek indebtedness (absent restructuring) will continue to rise over the whole period. According to Greek central bank data, the country had a net external investment position of 199 billion euros in 2009, or put another way, net external debt was something like 110% of GDP.

At the end of last week, risk premiums on 10-year Greek bonds over their German equivalents were still timidly nosing above 1,000 basis points, a level many consider to be the market signal that default is likely. And this despite the International Monetary Fund having announced the same day that the Greek reform programme is “broadly on track”.

And then there is the return to the financial markets issue. Finance Minister George Papaconstantinou has repeatedly said the country would return to bond markets when the time was right sometime in 2011. This looks increasingly like wishful thinking, especially since the 2009 deficit revision by Eurostat, while the less than anticipated revenue performance means that Greece has already missed its first fiscal consolidation target. Such a lapse may convince inspectors from the EU and the IMF, but it is unlikely to cut too much ice with ultra conservative fixed income market participants.

And, as Nick Skrekas points out in the Wall Street Journal, the numbers simply don’t add up. Greece has to raise €84 billion to repay interest and principle over the next three years, even assuming the force of the economic contraction doesn't mean even more missed deficit targets . Add to that an additional €70 billion for each of 2014 and 2015 in repayment of EU-IMF loans, and the calculation equals an unavoidable default, which is what the markets are signalling with there 1,000 to the sky is the limit spread on Greek 10 year bonds over bunds.

Even in the pre-crisis days, Greece couldn’t realistically raise more than about €50 billion a year from markets that trusted it. And market participants know the ‘troika’ is being unrealistic in its expectations. Lack of conviction in the bond markets that Greece can survive without a default is creating a vicious cycle that keeps prospective borrowing costs elevated and thus makes eventual repayment even more unlikely. And round and round and round and round we go.

In this sense the troika’s earlier inflexibility over the repayment postponement issue has been entirely self-defeating. The delay in letting the markets know that extension was a possibility is rumored to have been in part due to the German government's worries about what the reaction inside Germany would be to the news. Evidently borrowers are going to be able to kick the can a lot harder and a lot further down the road than previously imagined. Indeed only today Ireland is seemingly to get money over a nine year term, which makes it hard to see how exactly the European Financial Stability Facility can be wound up in 2013 as previously planned - indeed the way things are shaping up it looks like 2013 could be the year when it really gets going.

Which, as John Dizzard notes in the Financial Times, would seem to create a new potential moral hazard problem, which is that if the funds in the pot are going to be limited, and if potential costs going forward are likely to be high, then we could see a rush to get in (before the funds are all used) with few in any hurry at all to leave. Giving Spain the prospect of 350 billion euros (or thereabouts) over seven and a half years mights seem very tempting, but it is unlikely that those in Rome would be happy to pay rather than join the queue standing next to the soup pot.

So, what this all boils down to is, that along with the EU and IMF we can be in no doubt: the reform programme evidently is on track. The only issue which seems to divide everyone - and especially those office-bound Fund employees from their more financially savvy market-participant peers - concerns the exact name of the station towards which the train in question is heading.

Saturday, October 16, 2010

An Unusual But Interesting Argument Which May Help To Understand Why QE2 Is Now Almost Inevitable

For reasons which aren't worth going into now, I'm reading through a recent report by Deutsche Bank Global Markets Research entitled "From The Golden To The Grey Age" this afternoon. The report (all 100 pages of it, many thanks to researchers Jim Reid and Nick Burns who produced the thing) looks at the extent to which a variety of macro indicators - like GDP growth, inflation rate, equity yields, etc - may have been influenced by demographic forces over the last 100 years or so. It is certainly one of the most systematic reports of its kind I have seen, and well worth losing a Saturday afternoon to read.

But in the middle, there is an argument which caught my eye, and I thought it worth reproducing. Basically the starting point is this chart, which if you haven't seen by now (or something like it) I'm not sure where exactly you've been during the last 2 or 3 years.

Obviously, just the most cursory of glances at the thing should lead even the most untrained of eyes to get the point that what is going on around us is not some passing phenomenon, and that there are deep structural factors at work.

As our Deutsche Bank researchers put it:
As can be seen (from the above chart) there was a step change in the US economy’s indebtedness from the early 1980s onwards and then an additional one in the late 1990s/early 2000s. A similar picture is apparent across most of the Western World.

Basically from the early 1980s to the onset of the Global Financial Crisis the economy added on more debt every year and business cycles were extended as a result. Indeed the Fed and Central Banks around the world were afforded the luxury of operating in a secular falling inflation regime (globalisation) that allowed them to cut rates, further allowing the accumulation of debt, every time the economy may have naturally been rolling over into a normal recession consistent with those seen through history. This debt accumulation undoubtedly helped smooth the business cycle and contributed to the period being known as the ‘Great Moderation’. This period came to a spectacular end with the onset of the crisis and it is possible that going forward we will revert to seeing business/credit cycles more like they were prior to the ‘Great Moderation’.

Now here comes the clever part. Our researchers then go on to take a look at the the average and median length of the 33 business cycles the US economy has seen since 1854. For the overall period they found the average cycle from peak to peak (or trough to trough) lasted 56 months (or 4.7 years). However, the averages are boosted by an occasional elongated "superbusiness cycle", and thus the median length is a much smaller 44 months (3.7 years). As they comment, such numbers must look very strange to those who have only ever analysed business cycles over the last 25-30 years. Within these 33 cycles the contraction period lasted 18 months on average or 14 months in terms of median length. This equated to the economy being in recession 31% or 32% of the time depending on whether you look at the averages or the median numbers. Taking just the period before the “Great Moderation” the average US cycle lasted 5 months less at 51 months (or 4.3 years) with the median at 42 months (3.5 years). Over this period the US economy was in recession 35% and 36% of the time respectively depending on whether you look at averages or the median.

Now we used to think that all of that was behind us, but then we used to think that the "Great Moderation" had gotten things under control, and not simply temporarily extended the cycle length by facilitating long-term-unsustainable levels of indebtedness. So in fact, given that, as they say some sort of cycle or other has been with us since at least biblical time, what we might now expect are more "normal" cycles (in historical terms), which put a little better means shorter ones with more frequent recessions.

"Given all we know about the ‘debt supercycle’, it is likely that the onset of the Global Financial Crisis ended the “Great Moderation” period. Unless we find a way of continually adding more debt at an aggregate level in the Developed World it is likely that we will see much more macro volatility and more frequent business cycles going forward. Given the fact that Developed World Government balance sheets are under pressure, and given that interest rates around the Western World are close to zero, the post-crisis ability to fine tune the business cycle is extremely limited. We may need to put an immense amount of faith in the experimental force of Quantitative Easing to deliver economic stability. This will be an experiment with little empirical evidence as to how it will turn out. For now the base case must be that we revert more towards business cycles more consistent with the long-term historical data".

So then our authors do their calculations concerning the average length of US cycles since 1854 in order to make a rough estimate of when the next few US downturns will start, as illustrated in the following chart.

Now, without dwelling on the gory details, if we look at the spread between the upside, median, and downside cases, we could pretty rapidly come to the conclusion that the next US recession has a high probability of starting sometime between next summer, and the summer of 2012 - which, as you will appreciate, isn't that far away. I am also pretty damn sure that Ben Bernanke and his colleagues over at the Federal Reserve appreciate this point only too well, and hence their imminent decision on more easing, since a recession hitting the US anytime from next summer will really come like a jug of very icy water on that very fragile US labour market, not to mention the ugly way in which it might interact with the US political cycle.

I think the mistake many analysts are making at this point is basing themselves on some sort of assumption like, "if the recession was deep and long, then surely the recovery should be just as pronounced and equally long", but, as the DeutscheBank authors bring to our attention, business cycles just don't work like that.

Now, why I think this is an interesting argument is that the starting point for looking at the recovery is rather different from the norm, in that instead of peering assiduously at the latest leading indicator reading, they do a structural thought experiment, and work backwards from the result. Now, one thing I'm sure Ben Bernanke isn't is stupid, so it does just occur to me that either he, or someone on is team, is well able to carry out a similar kind of reasoning process.

Watch Out, Here Comes The QE2

In fact, it would be an understatement to say that the forthcoming QE2 launch is causing a great deal of excitement in the financial markets. As the news reverberates around the world, it seems more like people are getting themselves ready for some kind of "second coming". Right in the front line of course are the Europeans and the Japanese, and the yen hit yet another 15 year high (this time of 81.11 to the dollar) during the week, while the euro was up at 1.4122 at one point. Greeks, where are you! Can't you engineer another crisis? We need help from someone or we will all capsize in the backwash created by this great ocean liner as it passes.

But joking aside, a weaker USD is going to be both the natural and the intended consequence of the coming bout of additional QE by the Fed, and it will have a strong collateral effect on the already weaked and export dependent economies of the EuroArea and Japan.

With this prospect as the background, it should not come as a surprise that talk of currency wars and competitive devaluations is rising by the day. Japan only last week threatened "resolute action" against China and South Korea, Thailand has placed a 15% tax on bond purchases by non resident investors, and central banks from Brazil to India are either intervening to try and keep their currency from rising too fast, or threatening to do so.

And the seriousness of the situation should not be underestimated. Many have expressed disappointment that the recent IMF meeting couldn't reach agreement, and hope the forthcoming G20 can do so. But really what kind of agreement can there be at this point, if the real problem is the existence of the ongoing imbalances, and the inability or unwillingness of the Japan's, Germany's and China's of this world to run deficits to add some demand to the global pool. Push to shove time has come, I fear, and if this reading is right then it is no exaggeration to say that a protracted and rigourously implemented round of QE2 in the United States could put so much pressure on the euro that the common currency would be put in danger of shattering under the pressure. Japan is already heading back into recession, as the yen is pushed to ever higher levels, and Germany, where the economy has been slowing since its June high, could easily follow Japan into recession as the fourth quarter advances.

Indeed, I think we can begin to discern the initial impact of the QE2 induced surge in the value of the euro in the August goods trade data. The EuroArea 16 have been running a small external trade surplus in recent months, and to some extent the surplus has bolstered the region's growth. It is this surplus that is now threatened by the arrival of the QE2. The first flashing red light should have been the news that German exports were down for the second month running in August, but now we learn from Eurostat that the Euro Area ran a trade deficit during the month.

"The first estimate for the euro area1 (EA16) trade balance with the rest of the world in August 2010 gave a 4.3 bn euro deficit, compared with -2.8 bn in August 2009. The July 20102 balance was +6.2 bn, compared with +11.9 bn in July 2009. In August 2010 compared with July 2010, seasonally adjusted exports rose by 1.0% and imports by 1.8%".

Basically the eurozone countries had been managing to run a timid trade surplus (see chart below, which is a three month moving average to try and iron out some of the seasonal fluctuation) and this had been underpinning growth to some extent. Now this surplus is disappearing, and with it, in all probability, the growth. Maybe we won't get a fully fledged "double dip" in the short term, but surely we will see a renewed recession (and deepening pain) on the periphery and at the very least a marked slowdown in the core.

In fact the current situation is extraordinarily preoccupying. We are now in the fourth year of the present crisis (however you choose to term it, the second great depression, the very long recession, or whatever) and there seems to be no sustainable solution in sight. The underlying problems which gave birth to the crisis are excessive debt (both private and public) and large global imbalances between lender and borrower countries, and neither of these issues has so far been resolved, nor are there proposals on the table which look capable of resolving them.

And unemployment in the United States (which is currently at 9.6%, and may reach 10% by the end of the year) is causing enormous problems for the Obama administration. The US labour market and welfare system are simply not designed to run with these levels of unemployment for any length of time. In Japan the unemployment rate is 5.1%, and in Germany it is under 8%. So people in Washington, not unreasonably ask themselves why the US should shoulder so much extra unemployment and run a current account deficit just to maintain the Bretton Woods system and the reserve currency status of the US Dollar.

My feeling is that the US administration have decided to reduce the unemployment rate, and close the current account deficit, and that the only way to achieve this is to force the value of the dollar down. That way it will be US factories rather than German or Japanese ones that are humming to the sound of the new orders which come in from all that flourishing emerging market demand.

I think it is as simple and as difficult as that.

The problems created by the way the crisis has been addressed now exist on a number of levels. In emerging economies like Brazil, India, Turkey and Thailand, ultra low interest rates in the developed world are creating large inward fund flows which are making the implementation of domestic monetary policy extremely difficult, and creating sizeable distortions in their economies.

At the same time, a number of developed economies like Spain, the United States, the United Kingdom became completely distorted during the years preceding the crisis. Their private sectors got heavily into debt, their industrial sectors became too small, and basically the only sustainable way out for them is to run current account surpluses to burn down some of the accumulated external debt. Traditionally the solution to this kind of problem would be to induce a devaluation in the respective currencies to restore competitiveness, but in the midst of an effectively global crisis doing this is very difficult, and only serves to produce all sorts of tensions. As Krugman once said, "to which planet are we all going to export".

At the same time, two of the world's largest economies - Germany and Japan - have very old populations, which effectively means (to cut a long story short) they suffer from weak domestic demand, and need (need, not feel like) to generate significant export surpluses to get GDP growth and meet their commitments to their elderly population. The very existence of these surpluses also produces tensions, and demands for them to be reduced. But this is just not possible for them, and Japan is the clearest case. For several years Japan benefited from having near zero interest rates and becoming the centre of the so-called global "carry trade", which drove down the currency to puzzling low levels, and made exporting much easier. Large Japanese companies were even expanding domestic production and building new factories in Japan during this period (a development which had Brad Setser scratching his head at the time, trying to work out how the yen could have become so cheap).

Then the crisis broke out, the Federal Reserve took interest rates near to zero, and the United States became the centre of the carry trade. The result is that every time the Fed threatens to do more Quantitative Easing the yen hits new 15 year highs, even while the dollar continues its decline, with the result that Toyota are having a change of heart, and are now thinking of closing a plant in Japan to move it to Mexico. The present situation is just not sustainable for Japan, which is basically being driven back into what could turn out to be quite a deep recession.

Unfortunately I think there is no obvious and simple solution to these problems. As we saw in the 1930s, once you fall into a debt trap, it can take quite a long time to come out again. You need sustained GDP growth and moderate inflation to reduce the burden of the debt, and at the present time in the developed world we are likely to get neither. In the longer term, the only way to handle the presence of some large economies which structurally need surpluses is to find others who are capable of running deficits, but this is a complex problem, since as we have seen in the US case, if the deficit is too large, and runs for too long, the end result is very undesireable. Basically the key has to lie in reducing the wealth imbalance which exists between the developed and the developing world, but this is likely to prove to be a rather painful adjustment process for citizens in the planet's richer countries, so policy makers are somewhat relectuntant to accept its inevitability.

Basically, the structural difficulty we face is that all four major currencies need to lose value - the yen, the US dollar, the pound sterling and the euro - and of course this basically is impossible without a major restructuring of what has become known as Bretton Woods II. The currencies which need to rise are basically the yuan, the rupee, the real, the Turkish lira etc. But any such collective revaluation to be sustainable will need to be tied to a major expansion in the productive capacity of the economies which lie behind those currencies.

In fact, the failure to find solutions is increasingly leading to calls for protectionism and protectionist measures. The steady disintegration of consensus into what some are calling a "currency war" is, as I said above, another sign of this pressure. On one level, the move to protectionism would be the worst of all worlds, so I really hope we will not see this, but if collective solutions are not found, then I think we need to understand that national politicians will come under unabating pressure from their citizens to take just these kind of measures. The likely consequence of them succumbing to this pressure, which I hope we will avoid, would be another deep recession, possibly significantly deeper than the one we have just experienced. And, not least of the worries, the future of the euro is in the balance at the present time.

The structural imbalances which we see at the global level, between say China and the United States, also exist inside the eurozone, between Germany and the economies on the periphery (Ireland, Portugal, Spain, Italy, Greece). These latter countries failed to take advantage of the opportunities offered by the common currency to carry out the kinds of structural reform needed to raise their long run growth potential, and instead they simply used to cheap money available to get themselves hopelessly in debt. At the same time the crisis has revealed significant weaknesses in the institutional structures which lie behind the monetary union, weaknesses which go way beyond the ability of some members to fail to play by the rules when it comes to their fiscal deficits. Steps are now being taken in a night-and-day non-stop effort to try to put the necessary mechanisms in place, but it is a race against the clock, and it is not at all guaranteed that the attempt will be succesful, especially if the volume of liquidity about to hit the global financial system drives the euro onwards and upwards beyond supportable limits.

Monday, September 27, 2010

And Then There Were None

According to Spanish Prime Minister José Luis Rodríguez Zapatero speaking in an interview with the Wall Street Journal last Tuesday the European sovereign debt crisis is over. "I believe that the debt crisis affecting Spain, and the euro zone in general, has passed," Mr. Zapatero said.

This is excellent news, but it comes with just one proviso, and that is that despite all such reassurances most financial market participants seem to be far from convinced that he is right. True Spain recently raised nearly €4bn in a successful government bond sale, with some observers suggesting the sale constituted but one more sign that what is still the eurozone’s fourth-largest economy had finally broken free from the group of “peripheral” European economies who have severe economic problems and whose debt is viewed by investors as especially risky.

In fact Spain managed to sell €2.7bn of 10-year bonds and almost €1.3bn of 30-year bonds while at the same time bringing yields down noticeably from their earlier highs - to 4.144 percent in the case of the 10-year issue ( from 4.864 percent in June), and to 5.077 percent for the 30 year issue (from 5.908 percent in June). But, at the same time, in the background the extra yield that investors demand to hold Spanish 10-year bonds over German bunds has been steadily creeping back up again, and as of last Friday (24 September) it stood at 183 basis points, below the 220 level being asked in June but still more than double what it was at this point last year.

Yet, despite all those nice words we hear from him, one of the things that is worrying investors right now is the real depth of Mr Zapatero’s commitment to reducing the deficit as planned, especially after he unexpectedly stated on August 10 that in his opinion some of the planned infrastructure spending cuts could be reversed, while on September 10 he reiterated the point, saying that lower borrowing costs may enable the government to "ease up" on some of the projected spending cuts. In fact the extra yield offered on Spanish debt has risen 33 basis points over the period since he started to mention the possibility.

On top of which all the short term indicators we have been seeing suggest that the Spanish economy started to contract again in the third quarter.

Spreads Rising Across The Periphery

Of course it isn't only Spanish bond yields which have been sneaking back up of late. Greek 10-year bonds as compared with equivalent German bunds still offer around 950 basis points (or 9.5 percent) of additional yield, only around 20 points below the all time record they hit on May 7, at the height of the Sovereign Debt Crisis

Indeed spreads on government bonds all along Europe's periphery have been rising steadily back towards (and even in some cases beyond) their May levels in recent weeks. Most notably the last week has seen both the Irish and Portuguese government 10-year bond yields surge to euro era records levels, in a way which could lead us to ask whether, rather than Spain snuggling back into the main group the big picture story at this point might not be that it is Irish and Portuguese sovereign debt that is being prised apart from the rest.

So rather than being over, what the debt crisis now may be entering is a new stage, where one sovereign bond after another is being chisled out and sent off to join their Greek counterpart in the isolation ward. Actually, in this sense the present European Sovereign Debt situation does rather resemble the plot of the well known Agatha Christie detective novel "And Then There Were None". As told by M. Christie a group of ten people, all of whom have in one way or another been previously complicit in an earlier death, are somehow tricked into travelling together for what was intended to be a short stay on a secluded island. Once there, and even though the guests are apparently the only people on the island, they are - somehow, and one after another - systematically murdered. So, in a way which may eventually come to foreshadow scenes from the forthcoming meetings of the European Financial Stability Facility management board, each morning one guest less shows up for breakfast. One by one, and little by little, each participant becomes mysteriously overcome by a seemingly inexplicable bout of some fatal variant of what could be termed "systemic instability syndrome".

As I say, Irish and Portuguese yield spreads are significantly wider than they were May 7, the last trading day before Greece finally agreed to go for their €110 billion bailout package and the European Central Bank announced the initiation of its ongoing program of purchasing EuroArea government bonds in the secondary markets.

And despite holding what was considered to be a "succesful" bond auction at the start of last week Irish 10-year bond yields, shot up`once more during the remainder of the week, hitting a new record high of 6.34 per cent (see Bloomberg chart below), while yield spreads over benchmark 10 year German Bunds spiked to 416bp, euro era another record. At the same time Ireland 5 year CDS shot up to 461 bps, which meant the cost of insuring Irish debt was $461,000 for $10m of debt annually over five years.

At the same time yields on Portuguese 10-year bonds over comparable German bonds hit a record of near 4.25 percentage points Friday, while the Portuguese debt agency paid a euro era record of 6.24 percent to holders of its 10-year bonds and 4.69 per cent to holders of the four year-bonds in its own bond auction this week. In last equivalent auction, Portugal had paid 5.32 percent on 10-year bonds and 3.62 percent on four-year bonds. Portugal’s budget gap widened in the first eight months of the year, indicating the government may struggle to rein in the euro-region’s fourth-largest deficit as its borrowing costs surged to a record.

Portugal and Ireland "Decoupling"?

In each case the issue is different, since in the Irish case it was a sharp and unexpected contraction in the economy which became the major concern while in Portugal's case it was an apparent inability to reach the political agreement necessary to get the budget deficit under control.

Data out during the week for second-quarter gross domestic product showed the Irish economy has never really left recession, since GDP contracted by 1.2% compared to the first three months of the year, following a downwardly revised 2.2% expansion in the first quarter. Irish GDP has now contracted on a quarterly basis for 9 out of the past 10 quarters, and there is no evident end in sight.

In addition Ireland’s central bank governor Patrick Honohan saw fit to give a rather ill-timed press conference (unless he objective really was to force the country's government into the arms of the EFSF) where he urged the government to implement even deeper fiscal cuts to restore balance to the budget in what seems at this point to be a virtually unrealisable bid to regain investor confidence. All of which left many observers wondering just what the country can do in the present situation, since the budget is evidently deteriorating due to the severity of the economic contraction, and further cuts in spending by anyone (households, companies, government) are only likely to feed the contraction even more, in their turn making even more cuts necessary.

Obviously Ireland is rapidly approaching a situation where it cannot move the situation forward based on its own resources. This feeling is only added to by the persistent rumours that subordinated bond holders to Anglo Irish bank may well not get re-imbursed in full. These rumours have found some confirmation in a report which appeared in the Irish Examiner suggesting that the Irish Finance Minister Brian Lenihan had given a strong hint that the riskiest lenders to nationalized Anglo Irish Bank may not get all their money back.

Mr Lenihan apparently explained to the paper that the bank guarantee program which will be extended once it runs out at the end of September may only cover deposits and not subordinated debt. And if the interpretation put on events by the FTs John Dizard's is correct Mr Lenihan's delay in clarifying the situation is due to the fact that the Irish government is awaiting an EU Commission ruling on exactly this issue. His most recent official statement on the topic was that the Aglo Irish wind-up plan “is being prepared for submission to the [European] Commission for approval”.

At the same time the EU’s Competition Commissioner, Joaquin Almunia, issued a statement that “a number of important aspects need to be clarified, and a new notification received, before the Commission is in a position to finalise its assessment and to take a decision”. Which Dizard interprets as meaning that while Anglo Irish might propose a buy-back of its subordinated bonds, and that buy-back might be included in an Irish government proposal, Brussels might, in the end, not approve the plan. Since this would effectively the first time in the current crisis that a significant group of investors did not have their losses underwritten (apart, of course, from the rather unfortunate Lehman incident), decision makers may be rather apprehensive, since no one really knows how the financial markets would react. Yet speculation some such decision will be taken remains rife, as witnessed by the decision by Moody's rating agency to downgrade Allied Irish ratings. Moody's cut Anglo Irish's senior bonds by three notches to Baa3, the last level before junk, but the markets' main focus was on the deep, six-notch cut in the bank's subordinated debt, to Caa1, which indicates that bondholders will be forced to pay for some of the expected bailout.

Deficit Worries In Portugal

In the Portuguese case it is the budget deficit issue which is unsettling the markets, with the spread widening sharply following the revelation that far from the deficit being reduced is was actually increasing. According to the latest data from the Finance Ministry the central government’s shortfall during the first eight months of the year rose to 9.19 billion euros from 8.74 billion euros over the equivalent period in 2009. Previously the 2010 deficit had been almost exactly tracking the 2009 one (see chart from Societe Generale below).

Portugal’s borrowing costs surged to record levels on the news, and while the spread subsequently eased back to 388 basis points, the level is still close to the zone in which Greek bonds were trading in April just before the EU offered the country emergency loans to avoid default (see Greek 10 year spread chart below).

What this means is that this year's overall public deficit could well come in at around 9 percent of gross domestic product unless there is a radical change in policy during the last few months of the year.

According to its commitments to the EU Stability Programme, the Portuguese government should be aiming to reduce the overall deficit to 7.3 percent of GDP in 2010 from last year’s 9.3 percent. The government has pledged to reach the target, with Finance Minister Fernando Teixeira dos Santos saying that the country “can’t afford” not to, but so far there is little evidence that it will be able to do so, and especially with all the political bickering that is now going on in the background.

In all these cases, including the Greek and Spanish ones, this issue is not simply one of stimulus versus austerity (always a false polarity when it comes to the situation on the Euro periphery). The real issue is how to restore growth to highly-indebted and structurally-distorted economies, since without growth the debt to GDP ratios will not come down, and the burden of the debt will not be reduced.

So more borrowing is not what these countries need right now (other than to aid short term liquidity). What the countries involved all need is more exports and larger industrial sectors, and no one seems to be very clear how they are to achieve them. Simply running a double digit deficit to generate less that 1% (in the best of cases) GDP growth is not exactly a "wise" use of resources. Evidently using deficit spending to cushion programmes which would lead to a surge in exports would make sense, but in no case is this really being done, and all the emphasis is simply going on what may turn out to be a rather fruitless and self-defeating programme of achieving fiscal rectitude.

The result is that the peripheral countries are one by one being steadily "decoupled", with Portugal and Ireland now moving up towards Greece, as the following two charts from Citi Research clearly show.

For quite a long time the Irish and Portuguese spreads simply moved in harmony with the Greek ones, widening as the Greek spread surged upwards. But now it is Greek debt which can be adversly affected by sentiment over the situation in Ireland or Portugal, and not the other way round, and meanwhile the other two countries slowly but surely are moving on up there to join their Greek counterparts as the second of the two charts (which show the recent relative movements in Greek and Irish spreads) seems to demonstrate.

Vigourous Action Needed

Naturally the ongoing deterioration in the situation requires bold and far reaching action from the Commission and the ECB. Obviously we should expect to see renewed activity on the part of the ECB, buying an increasing number of eurozone periphery government bonds. Their activity on this front has been increasing of late, but weekly bond purchases are still well below 1 billion euros a week level seen at the height of the crisis in May and June. Evidently we will see calls for more of these purchases in the days and weeks to come, but what is striking at the present time is just how ineffective they have been in containing the damage.

The ECB’s bond buying program is effectively the second pillar in the EU crisis containment mechanism established in May. The other one is the Luxembourg-based 440 billion-euro European Financial Stability Facility, headed by former European Commission official Klaus Regling. Mr Regling has also been actively campaigning to calm markets in recent days. "It would be preferable if we didn't even have to intervene," he told the German magazine Der Spiegel in an interview, "In fact, I believe that's the most likely scenario." His hope then is that the very existence of his organization will bring calm to investors and deter speculators. "If that's the case, we'll close up shop here on June 30, 2013," he said.

Morgan Stanley’s Chief Global Economist, Joachim Fels remains pretty unconvinced by all of this. “Strains,” he wrote in a recent research report, have now reached a point where "one or several governments" may soon have to resort to the rescue mechanism. "Neither the European sovereign debt crisis nor the banking sector crisis has been resolved and both continue to mutually reinforce each other," he said, adding that the EU's stress tests for banks had manifestly failed to restore the necessary confidence. Fels's conjecture didn't need that long to get some confirmation, since according to the German newspaper Handelsblatt the ECB was last week actively considering recommending that Ireland avail itself of the fund. The Central Bank declined to comment on the story, and simply pointed out that any decision on the matter was a question for national governments, which is formally correct (and obvious) but doesn't mean that they wouldn't in fact have recommend such a move if asked.

So, like former US Treasury Secretary Hank Paulson before them, Europe’s leaders, having armed their bazooka may soon need to fire it. Indeed Mr Regling’s optimism that his organization may quietly disappear from the scene is not generally shared by investors, who as we are seeing seem to be continuously pricing in an ever greater likelihood of intervention.

Meantime, according to a report in the Financial Times over the weekend, Europe's leaders are once more at odds among themselves about just how much carrot and how much stick the various national governments need to get their economies back into line. Predictably it is Paris talking about carrots, and Berlin who is talking about sticks.

But all this talk of what to do about those countries who in the future fail to stick to the new set of rules which are apparently being prepared monumentally misses the point: what we need are some policies which help the most affected economies get out of the mess they have found themselves in following the way the monetary and fiscal policy rules were implemented last time round.

According to one popular analogy currently circulating , the EuroArea countries could be likened to a group of 16 Alpine climbers scaling the Matterhorn who find themselves tightly roped together in appalling weather conditions. One of the climbers - Greece – has lost his footing and slipped over the edge of a dangerous precipice. As things stand, the other 15 can easily take the strain of holding him dangling there, however uncomfortable it may be for them, but they cannot quite manage to pull their colleague back up again. So, as the day advances, others, wearied by all the effort required, start themselves to slide. First it is Ireland who moves closest to the edge, getting nearer and nearer to the abysss with each passing moment. And just behind Ireland comes Portugal, while some way further back Spain lies Spain, busily consoling itself that it is in no way as badly off as the others who have already lost there footing. But if Spain cannot hold out, and all four finally go over, each dragged down by the weight of those who preceded them, then this will leave some 12 countries supporting four, something that the May bailout package only anticipated as a worst-case scenario. In the event that this is finally what happens, Mr Reglin will certainly find that the quiet life has come to an end for him, and that he has plenty of work to do, as will Mr Trichet’s successor at the ECB. In the meantime all the rest of us can do is wait and hope, firm in the knowledge that having come this far, we can only go forward, since there is no easy way back down to the point from which we started. But for heavens sake, the only thing we don't need while we sit here biting our nails is to be told by someone who manifestly has no idea what he is talking about that the danger has already past, even as we slide, inch by inch, onwards and downwards towards the chasm that gapes beneath.

Tuesday, May 18, 2010

Much Ado About (Some Of) The Wrong Things

German Finance Minister Wolfgang Schaeuble told reporters in Brussels yesterday (Monday) that getting their deficits down was "the only task that everyone has to fulfill for himself and for the common good." Meanwhile, over in New York, Paul Krugman was busy writing on his blog that "the most startling and frustrating thing about the debate over the fate of the euro is the way almost everyone avoids confronting the core issue" - which is, according to Krugman, that "wages in Greece/Spain/Portugal/Latvia/Estonia etc. need to fall something like 20-30 percent relative to wages in Germany". So at one extreme the Eurozone's problems are seen as being almost exclusively fiscal ones, while at the other the principal problem is thought to be one of restoring lost competitiveness.

The difference in perceptions couldn't be clearer at this point, now could it?

And if all of this is causing so much confusion among reasonably well informed economic observers, then what chance is the layperson likely to have? As it happens, reading through this piece by PIMCO's Mohamed El-Erian this morning a number of thoughts started to come together in my head. Essentially what we have on our hands are a number of distinct (yet inter-related) problems, but few studies seem to go to the trouble to differentiate these analytically, and the end result is often a hotch-potch, which given the seriousness of the European situation is an outcome which is a long long way from being satisfactory.

One point that is often not stressed hard enough and long enough is that the backdrop to this whole debt issue is the underlying problem of rapidly rising elderly-dependency ratios (and increasing population median ages) across the entire developed-economy world. Normally this implies the imminent arrival of a wave of heavily underaccounted-for-liabilities which will simply increase the pressure on the underlying structural (rather than cyclical) deficits in the worst affected economies. The strange thing is that this development had in principle been long foreseen, and indeed formed part of the underlying raison d'être for drawing the 3% deficit/60% debt Maastricht line-in-the-sand. The other part was, of course, an attempt to stop spendthrift governments being spendthrift. As is now abundantly clear, in neither case can the Maastricht package be said to have worked, but the unfortunate historical accident is that we have come to realise this in the midst of the worst global economic crisis in over half a century (indeed arguably the second worst one ever, and - disturbingly - it is still far from being over).

So one part of the sovereign debt concerns which are currently so preoccupying the financial markets is associated with the containability of state debt in the context of ageing societies, and this issue is further complicated by the fact that different developed societies are ageing at different rates. This underlying uneveness is leading some people to draw some surprising conclusions. For example, according to a Financial Times/Harris opinion poll published this morning, the French turn out to be the most nervous of developed economy citizens when it comes to thinking about the sustainability of their country’s public finances.

Some 53 per cent of those polled in France thought it was likely that their government would be unable to meet its financial commitments within 10 years, while only 27 per cent thought this outcome was unlikely. Americans were only slightly less worried, with 46 per cent saying default was likely, against 33 per cent who saw it as unlikely. Curiously, only a third of the British people polled thought a government default was likely in the next 10 years, and I say curiously since on many counts the UK economic position is far more critical than the French one is. In fact, I am inclined to think that the British here are being reasonably realistic, while the French and the Americans are not, and I say this for one simple reason: all these countries have had substantial immigration in recent years, while the fertility levels in each case are quite near population replacement level. And this means that their population pyramids are much more stable, and if what is worrying you is rising elderly dependency ratios, then this is important. Let's put it this way, if you assume (a big assumption I know) that underlying GDP growth rates are similar, and that the level of pension entitlement is the same, then the more rapidly the elderly dependency ratio rises the greater the pressure on deficits and accumulated debt.

On the other hand, the Spanish respondents were remarkably more positive about their situation, with only about 35 per cent of Spaniards questioned saying they considered default to be a likely eventuality over the next decade. Which is strange, not because I have any special insight into whether or not Spain will default, but Spain's problems are clearly worse than any of the other three aforementioned countries (in part, as Krugman stresses because they lack some key economic policy tools which could help them correct the distortions in their economy) and, even more to the point, Spain's citizens are showing very little appetite at this point for making the changes which will be needed to stave off the worst case scenario.

Without reform in the labour market, and in the health and pension systems, France's finances are just as capable as going careering off a cliff as anyone else's, but the French do have a little more time, and this, at the end of the day, could be critical. Also the French (like the Swedes) have done their homework in one department - the demographic one - so their population pyramid is inherently much more stable than the Spanish one. Indeed the Spanish government clearly indicated last week just how little they understand the importance of this question, since rather than facing up to the wrath of the Spanish pensioners (who of course vote) by cutting back on pension payments, they took the easy route (since babies don't vote, and those who never get to be born even less so) and slashed the so called "baby cheque" (which may well not be the best of pro natality policy tools, but still). Basically cutting the baby cheque instead of cutting back on pensions has to be the next best thing to slitting your own throat, just to see what happens. Societies need to invest in their future, not in their past, and having children is an investment, indeed in the age of the predominance of human capital it is one of the most important ones there is.

Basically this whole area (of the impact of ageing populations on GDP growth performance and with this the consequent debt dynamics) remains largely underexplored by most mainstream analysts, but for now I will simply state that those "doctors" who wish to offer cures for our collective ills yet fail to mention the underlying dynamics of the demographic transition all our societies are passing through (even in a footnote) have missed one very important dimension of the overall picture, and their analyses and remedies are likely to be correspondingly deficient as a result. The musings of Mohamed El-Erian, interesting as they are, would fall into this category, since I fear he is missing the biggest part of the big picture.

Secondly, there is the issue of the financial rescue which has been carried out during the crisis itself. Something strange seems to have happened to the discourse over the last three years, since a problem which originated in the financial sector has now metamorphised into a fiscal crisis for almost all modern democratic states. Indeed, such is the sense of panic being generated out there on this issue that I am already starting to see articles from investor circles asking whether or not democracy is compatible with fiscal rectitude. This is rather putting the cart before the horse, I feel.

So having identified an underlying structural issue with government spending in the previous (demographic) argument, we should not fail to notice the fact that another significant part of rising state indebtedness comes from having recently bailed out a significant chunk of the private sector. Look at Latvia for example, and the Parex bank bailout, as the extreme case, since government debt to GDP was something like 12% before the crisis, while it is now heading up to near 80%, or Ireland, where debt was around 35% of GDP before the crisis but will probably rise above 70% this year.

In fact, a rather weird circle has been created. The private sector (possibly as a result of the absence of adequate public vigilance) got itself into a huge mess of its own making. Governments all over the globe (understandably and correctly) rushed in to put the fire out, and in the process transferred the problem over to their own balance sheets. But what is most interesting to note about what happened next is how, given that the crisis itself means there are few positive investment outlets in the first world, the money generated by the bailouts is increasingly being used to encircle those very governments who initially made them. Basically a massive moral hazard conundrum has been created, as markets leverage a discourse which pressures governments for fiscal rectitude (which is contractionary - given the depth of the crisis - as far as aggregate demand is concerned), in the process creating the need for yet more bailouts, and so on (the possibility of ultimate Greek default being perhaps the clearest example here).

Actually, while the initial "fire prevention" intervention was evidently necessary, people may have been mislead into thinking that action, in and of itself, would do the trick (see Bernanke's speech on Milton Friedman's 90th birthday - with its this time we got it right theme - also see note at the foot of this post) due to a slightly faulty diagnosis of what happened during the great crash. There was, of course, a bank run: but this was by no means the whole picture, and in any event doesn't explain why the whole global economic system took so long to recover, even back then in the 1930s.

So something decisive needs to be done to break the circle which currently binds us, although at this point I am not exactly sure what. If we could agree that Mohamed El-Erian's most striking insight is that: "Industrial countries are running out of balance sheets that can be levered safely in order to minimize the disruptive impact of past excesses. ... The balance sheets that are left -which reside essentially in central banks - are not made (and, I would argue, should not be forced) to assume permanent ownership of dubious assets." then the logic would seem to be that the dubious assets need to be put back where they belong - on the balance sheets of the private sector in general (including households) and the likes of AIG, Goldman Sachs, UBS, and naturally PIMCO.

But we should be clear: any such move to do this would also be significantly growth "unfriendly" across the first world.

And thirdly, and certainly not least importantly, as Paul Krugman is constantly pointing out, here in Europe we have an additional complicating factor: the euro experiment. Whatever the pros and cons of all the various arguments here, one thing seems evident: under the existing set-up the 16 economies are not converging. Exactly why this is would take us into areas which lie far beyond the objectives of this short post, but I would say that, personally, I feel the different demographic trajectories of the countries concerned must form part of the picture. As Angela Merkel is stressing, even in the best of cases (the euro holds) the bailouts which are being prepared can only buy time in which to carry out the much needed adjustments, which in countries like Spain/Portugal/Ireland are as much to do with restoring competitiveness to an extremely distorted private sector as they are to do with applying fiscal correction measures.

As far as I can see, measures like collectively financing state debt via EU bonds and bilateral loans - plus operating some variant of Quantitative Easing at the ECB (if this can all credibly be made to stick, and the vicious circle meltdown mentioned in the second point be avoided) - could temporarily stabilise the patient while the much needed surgical intervention is carried out. But my guess is that one by-product of doing things this way would be that a lot of the toxic stuff would then work its way onto the ECB balance sheet. Thus, instead of recapitalising Spanish Cajas, what we would then be collectively into would be recapitalising the central bank, which would be just another form of fiscal sharing through the back door (with the result that, following a good Brussels tradition, what you can't explain to people directly and from centre stage, you explain to them in footnotes and in the small print). The latest data from the ECB (see this useful post from FT Alphaville), suggest that the bank is not only busy buying peripheral bonds, it is also buying private paper from countries like Spain and Portugal (although there is no breakdown available on this point).

The measures which need to be applied on Europe's periphery are all more or less obvious at the micro level - labour market reform, pension reform, reform of the public administration - but (and assuming we have at most three years to see all this though before the respective populations get very, very restless), on the macro economic side it is very doubtful such measures will have the impact which is expected for them in terms of restoring competitiveness and growth, and fiscal order can only be restored by restoring competitiveness and growth.

Given this I can see only two plausible alternatives:

a) Either the peripheral economies undertake a sizeable internal devaluation (say 20%, but this is just a rule of thumb estimate). The snag here is that at the present time most EU policymakers remain unconvinced that we need a shift of this magnitude. Yet there is surprisingly little detailed study of how the economies concerned are going to get back to growth without this price correction. Indeed the EU Commission itself has strongly pointed out that the rates of domestic private consumption growth being assumed for these economies by the respective national governments in their Stability Programme estimates are highly optimistic. What would be nice would be for someone to set up a small model to try to examine just how much ongoing growth in the combined goods and services trade surplus countries like Spain now need to achieve to get positive growth in headline GDP under a variety of different assumptions, including low or negative inflation, stagnant domestic consumption and reduced fiscal spending.

This should enable people to calculate just how much of a drop in unit costs (from a combination of productivity growth and price adjustment) you need to have to get the kind of surplus you need given the relevant elasticities (etc). In particular one of the problems I see in basing too much hope on using productivity improvements to do the heavy lifting in the correction is that while you can surely get significant efficiencies at the micro level (though not by a long way enough to do the whole job), you can in fact only achieve the result in the short term by slowing a recovery in the labour market (since you will be going for more output with less people), which means aggregate productivity (say GDP per capita as a proxy) doesn't improve that much, given that there is a huge fiscal burden and continuing stress on the financial sector as a result of all those long term unemployed. Alternatively we have another possibility;

b) Germany (and possibly one or two other smaller economies) temporarily leaves the eurozone and revalues.

Now, since option (a) looks very, very difficult to implement (especially since virtually no one apart from people like me and Krugman apparently wants to even hear of it),to which problem we could add the fact that German politicians are having increasing difficulties convincing their citizens that the "qualitative transformation" of the ECB is what is really in their best interests, then on a purely pragmatic level (b) may well end up being what happens in the end (and we had better just hope any eventual German exit is only temporary).

Having Germany temporarily separate from the Eurozone would, in fact, have a number of evident advantages. The first of these would be that citizens in the South would not need to see their wages slashed, while those in Germany would not be asked to pay for bailouts via their tax bill, or lead to blame Greeks or Spaniards for having their hospitals closed or their pensions reduced: ie it would all be politically much easier to handle at this point.

Evidentally German banks would have to swallow a write-down, as loans paid back in Euros would not be worth the same in (new)marks, but 70% of something (say) is better than zero or 20%, and the big plus would be that as the Euro devalued sharply the peripheral economies could rapidly return to growth, and government finances could be quickly turned round as exports grew, tourists returned, and (in addition) many of those coastal properties that currently stand empty could be sold. At the end of the day, what would be left would be a private sector, and not a public sector, problem, and it was (in part) the private sector who got us all into this mess (wasn't it?).

Indeed this solution does to some extent coincide with what could be termed the new economic reality, since economic growth in emerging markets mean that these are fast becoming key trading targets for German industry, as consumption in Southern and Eastern Europe looks to be increasingly "maxed out". In fact, according to the recent March trade report from the German Federal Statistics Office, the rate of interannual growth in exports to ex-EU "third" countries (34.7%, as compared with 15.1% for the euro area) was significant, while the volume of trade (34.2 billion euros as opposed to 35.2 billion euros for the Euro Area) is roughly comparable, and indeed at this rate countries outside the EU will soon replace the Eurozone group as destinations for German exports.

I say I hope this move (if undertaken) would be temporary, since I think in the mid term the German economy is neither so strong, nor the peripheral countries so weak, as many commentators assume. But being out of the zone would give the Germans the opportunity to see this for themselves.

The important point to emphasise, I feel, is what we now need is an orderly and credible solution to our problems. Simply standing back and watching things deteriorate, and keeping our fingers crossed that what won't work will, is not going to produce an orderly outcome. Au contraire! Even those precious exports we are winning as a result of the falling Euro are being put in doubt, try these headlines from Bloomberg: Mexico’s Peso Falls Third Day on European Fiscal Deficits, Yuan Appreciation Unlikely This Year Due to Europe Debt Crisis, Emerging-Market Stocks Drop Most in Six Days, Russian Stocks Slide Most in Week on Oil, Europe Debt Concern. And this is just a quick selection.

The problem is that any gain to exports outside the EU can be offset by falling risk sentiment as the currency slide continues, and markets which were previously being funded lose the ability to attract money. What we need are some serious measures which can turn the tide, and restore confidence that we are applying measures which will work.

Actually, the argument I am presenting here was first put to me by a young Barcelona IT engineer - David González - and you can find his argument in this blog post (below the Spanish introduction). As David says:

In conclusion, at the moment the EMU lacks the necessary economic long term policies to become a stable monetary zone. Obviously, we lack the free currency exchange rate needed in any free trade zone, which would work as an automatic stabilizer between different countries. But we also don’t have enough automatic stabilizers (only the exception of cohesion funds) needed in any monetary zone. First we need to recover the balance, and then we have to make sure it is a stable balance implementing measures that keep it. Otherwise the EU construction process will fail, and the hopes it has bring to so many people and countries will be forgotten. The implications this failure would have for democracy and peace in Europe should not be underestimated.

Or as Krugman puts it: "If the euro isn’t workable without highly flexible nominal wages, well, it isn’t workable". It's a sad conclusion, but that would seem to be where we are at this point. Basically, it is obvious that any road forward is now fraught with difficulty, but a situation where none other than the head of Deutsche Bank is saying that in all probability Greece will not be able to pay, and where an ECB which badly needs to operate a policy of Quantitative Easing but is at desperate pains to try to show that it isn't, is evidently not sustainable for long. Money has been put on offer, and the financial markets are now chafing at the bit to try to force it up and onto the table as quickly as possible. July promises to be another sweltering month here in Spain. Maybe it's time for a rethink.


Note: At the end of his "On Milton Friedman's Ninetieth Birthday" speech Ben Bernanke arrived at what now looks like a rather hasty conclusion: - "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again". In fact, what is at issue here is a question of causality, whether the real economy problems are ultimately caused by the absence of a "stable monetary background", or whether in fact, the demand shock unleashed by the unwinding of a highly leveraged economic boom may not be the main factor in preventing the recovery of a "stable monetary background", as we have already seen in the Japanese case. The critical question facing all developed economies in addressing their fiscal sustainability problems is where the aggregate demand is going to come from to make the adjustment both viable and socially palatable.