Facebook Blogging

Edward Hugh is only able to update this blog about once a month at the moment, but he does have a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Sunday, October 31, 2010

Spain's Troubling Unemployment Statistics

Spain's statistics office continue to issue worryingly confusing press releases. The latest example is one published in connection with the quarterly labour force survey which came out last Friday.

Now the data the INE assemble in their report is very interesting, and as many observe, the complete survey gives far more reliable data about the state of the labour market than the monthly labour office signings do.

But the way they present the data isn't interesting, in fact its downright misleading. In particular they chose not to seasonally adjust the data - which in a seasonally driven economy like the Spanish one with significant ups and downs in tourist activity doesn't make much sense - and this omission is not only lazy, it is negligent. As I say, it is misleading, in the same way the information on VAT returns and deficit reduction progress issued by the Ministerio de Economía y Hacienda is misleading (they do not, for example, clarifying the changed VAT refunds procedure), or in the same way the notarial contracts data gives a completely topsy turvy view of movements in Spanish house prices. At best such data gives completely meaningless information, and at worst it leads reporters who cover the Spanish economy hopelessly astray.

Thus Reuters:

"Spain's unemployment rate fell to 19.79 percent in the third quarter, the first drop since the second quarter of 2007, the National Statistics Institute said on Friday".

In fact Spain's seasonally adjusted unemployment (and this is the relevant number, as explained to everyone who ever attended a class in Econ 101) did not fall to 19.79 at the end of the third quarter (ie by September), but rose from 20.5% in August to 20.8% in September, the highest rate in the European Union, and probably in the developed world (you can check the complete Eurostat report on the September Labour Force Survey results here - the numbers are provided by the INE, even if they do not see fit to publish them in their own report).



And in fact, far from creating jobs during the quarter, and as can be seen in the Ministry's own data if you look hard enough, seasonally adjusted the economy lost 30,000 jobs, and the number of unemployed grew by 65,000 (the apparent discrepancy between these two numbers is accounted for by movements in the size of the economically active population).

Even more importantly, and as reported by the Spanish website Cotizalia, of the 92,900 increase in salaried employment reported in the unadjusted data, 90,300 jobs were supplied by the public sector (and this during a deficit reduction exercise where staff contracts are in principal frozen), and only 2,600 came from the private sector.



Indeed, when we take into account the seasonal increase in tourist related employment during the summer, underlying employment in the private sector evidently shrank significantly, as suggested by the fact that (on an unadjusted basis) Spanish industry employed 18,300 people less at the end of the quarter than it did in June, and this is the sector which has to lead - through exports - the Spanish recovery.





Now let's go back for a minute to something Monsieur Trichet said in a recent speech on Euro Area statistics. Reliability, clarity and ease of interpretation have to be key cornerstones of national statistics office policy. As he says:

"First, the reliability of the general government statistics underlying the Excessive Deficit Procedure and the Stability and Growth Pact must be guaranteed when they come out. While the government finance statistics of the overwhelming majority of the Member States is reliable, this does not yet apply to all of them. Yet as we are in a highly integrated union, we need reliable statistics not just from the majority of Member States we need it from each and everyone, no matter how large or how small the country is. We have seen that the potential for loss of credibility affects the entire union."

and then

"we must have full assurance that the statistical indicators supporting enhanced macroeconomic surveillance are robust and timely available. We must have assurance that indicators – such as international indebtedness, unit labour costs and other indicators of competitiveness – are firmly based on accepted statistical methodologies, ideally already legislated, and that the degree of estimation in compiling them is limited".

Essentially, the point I am making here is not that Spanish statistics are simply "falsified" in the way many argue that Greek ones are, but that insufficient effort is put into producing high quality and reliable data which helps investors, analysts and policy makers to measure what is going on, and take the appropriate decisions. Economic statistic production is not a game where you attempt to fool as many people as you can as often as you can. Nor is good statistical work a question of simply mechanically churning out reports to comply with legal requirements, without consideration of what use the end product will be - the INE's monthly retail sales and industrial output reports come into this category, since without seasonal adjustment (which again they do not publish even though again they provide the relevant corrected numbers to Eurostat) it is impossible to tell what is happening on a month by month basis. Indeed one cannot escape getting the impression that, when we are talking about Spanish statistics, where the opportunity arises to send journalists heading off on an informational wild goose chase, this opportunity is rarely missed.

Data needs to be credible, informative, and helpful to outsiders who wish to evaluate, and take decisions. As Monsieur Trichet says, if this is not the case, the consequences can affect all members of the monetary union. Unfortunately, all too often, Spanish statistical presentations fall woefully short of these required standards.

Those wishing to read the original INE press release on the Q3 employment data, and see for themselves just how uncritically that drop in unemployment to 19.79% was reported, can find it here. Enjoy the read.

What Goes Up....

Spain's troubled banking sector is back in the news again. Despite the apparently succesful stress tests carried out over the summer problems persist, and don't seem likely to go away soon. Foremost among these is the steady rise in problem loans which have now risen to an all-time high, potentially endangering the credit rating of the country's financial institutions, according to a recent report from the credit ratings agency Moody's.

In fact distressed loans in Spain's banking system reached 102.5 billion euros as of August, according to the latest Bank of Spain data. At 5.6% of the total this is the highest proportion of overall loans since 1996. "The performance of the commercial real estate sector has been the main driver of overall asset quality deterioration," Moody's said in their report. Evidently asset quality deterioration in Spain's banking system is likely to continue both this year and next, driven by oversupply in the property market, the impact of the real estate crisis on the larger economy, and the continuing high unemployment levels.

The warning about the potential impact of the continuing rise of so called “non-performing” loans has also been reiterated by the Bank of Spain itself, who draw attention, in their latest Financial Stability Report, to the fact that the banking system is very likely to face a further increase in problem loan ratios in coming quarters, an admission which effectively constitutes a revision of last April’s IMF forecast that such loans would peak in the third quarter of 2010. Unfortunately the number of distressed loans continues to rise, and the end of the problem is not yet in sight.

Indeed the latest Moody’s report comes at a time of growing uncertainty for the sector, with Spain's two largest banks - Banco Santander and Banco Bilbao Vizcaya Argentaria - both releasing earnings results which disappointed the markets and gave evidence of the significant pressure they have on their margins. A further indication of the pressure they are under can be found in the fact that they have publicly attacked the slow pace of reform among the savings banks, arguing that these are using the billions of euros from the public restructuring funds to compete unfairly by offering uncompetitive rates to attract deposits. Cajas are offering rates of up to 4.75% in order to build their deposit base, which they urgently need to do given the difficulties they have attracting finance in the wholesale money markets. The large banks argue that such campaigns are bound to generate losses in the longer term and that such behaviour is unacceptable for institutions receiving public aid.

Emilio Botín, Santander's chairman, was first out of the box with a speech to business leaders which criticised the “inadequate” speed of restructuring at the cajas and called for more concrete plans to cut capacity and improve margins. Then Angel Cano, chief executive of BBVA, added his voice calling for a speedy completion of the restructuring process so that bankers could begin 2011 “with equal conditions and on a level playing field”.

In another sign of the pressure they are under Spain's banks are starting to sell-off some off their most valuable branches. One popular way of doing this is to sell them and then lease them back again, a move which allows them to record a short-term transaction gain, one which can then be used to absorb and conceal losses sustained in their mortgage loan book.

According to an analysis carried out by the Wall Street Journal BBVA is about to register a gain of €233 million on a sale and leaseback of offices and buildings to a real-estate investment consortium led by Deutsche Bank AG's RREEF. The proceeds will then surely go directly toward into the bank's provisions against bad loans. Banco Sabadell also completed a similar €403 million deal in May, in which it sold and rented back 378 offices and other properties. And Caja Madrid, one of the country's largest savings banks, is reportedly looking at similar deals, following its own branch sales last year and a separate €108 million, 30-year sale-and-leaseback agreement with a unit of the German fund S.E.B. Asset Management AG in May. According to the WSJ Caja Madrid is currently in talks with investors to sell a somewhat larger package of branches, valued at €300 million, according to a spokesman for the savings bank.

And a further sign that all is not well - the banks are still having difficulty issuing covered bonds, with Spain's domestic banks currently paying a full two percentage points above the bank borrowing benchmark, as compared with a mere 0.20 percentage points before the European sovereign debt crisis erupted, according to Barclays Capital analysts Carlos Cobo Catena and Tom Rayner.

This difficulty is underlined by the evident fact that Spanish banks are falling behind their counterparts across Europe in reducing their dependence on emergency central bank funding. While Euro Area banks cut their collective borrowing in September to 514.1 billion euros, the least since the Lehman Brothers collapse in September 2008, Spain’s banks continued to borrow 97.7 billion euros, still well above the 85.6 billion euros they borrowed in May this year, just before the debt crisis broke out.



With the Bank of Spain pressuring them to increase their provisioning for properties held on their books, the banks have been vigorously attempting to move it off them, often promoting attractive property deals on their websites, and in some cases even offering 100% financing and other deals on mortgages in an effort to sell their growing mountain of real estate, which normally comes to them through debt for asset swaps or foreclosure. But, with the sales market sluggish to virtually non-existent, banks are increasingly looking towards renting a part of their empty stock, on occassion transferring the targeted property directly from the developer to one of their off-balance-sheet subsidiaries. Banks aren't required to set aside as many provisions for assets which carry a rental stream, and none at all for assets they do not formally own.

The absence of a liquid market in Spanish housing is causing more and more problems. Before the crisis set in, homeowners who found themselves in financial difficulties had, for example, been able to sell their houses relatively easily, repay their outstanding debts, and start all over again. However, times have now changed, selling the property at a price which lets them clear the mortgage is increasingly difficult, and the banks, under pressure from their bottom line, are increasingly resorting to mortgage foreclosure. "Although lenders have historically not particularly liked extra judicial enforcement, it has become a solution among Spanish lenders in areas where the courts are saturated by cases and the foreclosure of a property may prove more speedy than the traditional enforcement procedure" says Alberto Barbachano, a Moody's Vice President and author of a recent report on the subject.

The volume of Spanish foreclosed mortgages that were taken to court grew by 126% in 2008 and 59% in 2009 on a year-on-year basis. In the first three months of 2010, 27,561 mortgages were foreclosed, a record since the economic downturn started in 2007.

In fact Moody's argue that the very high reported number of foreclosed mortgages that have been taken to court in Spain since 2007 underestimates the actual number of properties that have been repossessed by Spanish financial entities for two reasons. First, because more than one property may have been involved per individual foreclosure process. And second, because Spanish mortgage lenders have generally become more willing to sign up to voluntary agreements, accepting the property as payment in kind and then releasing the debtor from the debt.

At the present time the consumer protection organisation Adicae estimate that 1.4 million Spaniards are facing potential foreclosure proceedings, and the number is likely to continue to rise in the months to come. A recent Standard & Poor’s report found that 8 percent of Spain’s housing is now worth less than the value of the mortgage, and with prices continuing to fall, and some experts believe that figure could rise to 20 percent before the price contraction is over. So with unemployment, problem loans, and property foreclosures all rising, the only thing that seems to be falling steadily towards earth is the level of bank profitability. It is only to be hoped that with their untimely descent Spain's banks don’t bring the whole edifice of Spanish economic activity (and with it the institutional structure of the Eurozone) crashing down behind them.

Sunday, October 17, 2010

Mr Zapatero Said What..........?

Spain's Tinsa Price Index was out last week, and showed Spanish property prices fell again in September, and at an accelerating rate. As Tinsa point out in their report, both "Metropolitan Areas and municipalities on the Mediterranean Coast," whose rates experienced a significant drop from the previous month, have contributed decisively to this steep decline".



In fact, looking at the chart the other way round, prices have now fallen some 18% from their December 2007 peak.



The strange thing is that the latest Tinsa data contrast sharply with the most recent finding of Spain's National Institute of Statistics (INE) on the subject, since they suggest in their latest report that Spanish property prices actually rose in the second quarter (quarter-on-quarter) (and for the first time in the best part of 3 years), but this finding rather than reassure us that all is well (and as it should be) only serves to cast further doubt on the ability of the INE to maintain adequate statistics on the state of the Spanish economy, or at least to interpret the data they collect. This latest piece of statistical wizzardry lead Spanish property expert (and author of Spain Property Insight blog) Mark Stucklin to say "If you believe that, you’ll believe anything". Frankly, I'm inclined to agree with him.

Of course, it has become rather fashionable to question INE data interpretation of late (and I personally have had my problems with the seasonally adjusted employment numbers - in fact see these collected screenshots of the the backward revisions that were going on in the data as evidenced by Eurostat monthly reports) but this latest "faux pas" does make you want to ask "can't they get anything right"? In fact the Statistics Office house-price-data, is full of incredible and eye catching details, like the suggestion that new build sale prices only peaked in the third quarter of 2008, following which they only fell back 7.77% from peak, before taking off again, if we are to accept the official data version of things. So this must have been the "bottom" that Mr Zapatero refered to in his CNBC interview (see below). And this, as Mark Stucklin notes "despite a glut of up to 1 million newly-built homes, and discounts of up to 20pc or more on any developer’s price list you care to look at". So is this how one of the greatest housing busts in living history ends, with a whimper and not a bang? Somehow I doubt it.





Naturally, I'm sure its a pure coincidence that this latest "surprise price reversal" data came out just before Jose Luis Rodriguez Zapatero went to New York to kindly inform all concerned that the Spanish property market is now on the mend. In an interview with CNBC (see this official Moncloa transcription of the interview if you have any doubt), Prime Minister Zapatero repeated the INE claim, stating that house prices are beginning to rise in some areas, though not, he admitted, in the case of holiday homes. “In fact, in the last 2 to 3 months, we have seen that prices are not only not falling, but even rising in certain parts of Spain, where people buy their first home,” he told CNBC's Maria Bartiromo. This, he argued, shows that “demand appears to be on the rise.”

MS. BARTIROMO: Are you expecting real-estate prices to continue coming down? Have they hit the bottom or not yet?

PRIME MIN. ZAPATERO: I think that the price of housing has hit the bottom. It won't go down any more. For the past two or three months, what we see is that not only has it not dropped. But in certain parts of Spain, the price of housing has gone up. This is especially the case in those areas of -- not where people are buying their second house, if you like, with the prices there have still gone down a bit, but rather where they're buying their first, there the prices have gone down in the housing sector. So in general the prices have been stable recently, and they've even been increasing. So demand seems to be ticking up again.


Now, as that posse of irate INE defence vigilantes who may come chasing after me on this will no doubt tell you, the methodology they use is different from the Tinsa one, since it based on registered Notarial transaction prices, while the Tinsa index is based on asking prices, but come on, house prices rising again in Spain? Which world are we living in?

Of course, there could be another explanation for this seeming discrepancy (apart from fudging the numbers that is) and that would be that many of the actually new build transactions are not real transactions at all, but rather paperwork ones, as the banks move over the developers unsold property onto the books of their special purpose subsidiaries, and don't mark down the price since they prefer not to show losses. Then, of course, the very same subsidiary offers the property for sale at a sizeable discount (and it shows up with the Tinsa index as an asking price), but since there are very few real new-build sales at the moment, these number never show up back in the notaries office, where all is quiet and orderly.

Sure, the data show that new house sales "seem" to have bottomed, and even picked up a bit (see chart below), but talking to developers and estate agents out on the street, this doesn't seem to be the result of any real pick up in end user demand. It is more a question of banks responding to pressures from the Bank of Spain by moving their properties "out of sight" (if not out of mind). Meanwhile, the typical Spanish buyer is adopting a watch-and-wait approach, and will need a lot of convincing that they really have stopped falling before they move back in. Even the "experts" employed by the EU Commission are not convinced either, since they just published a report stating that Spanish property prices were still 17% too high.


But if you want one, there is something more like a smokin gun out there which should tell us that this whole Spain property market recovery story is a bit strange, and that is the Bank of Spain data for total mortgage lending. This has hardly moved since the start of 2009 (see chart below) so it is far more easily reconcilable with the properties being transfered over to bank subsidiaries (complete with their "developer" mortgages) story, than it is with one of rising sales and rising prices.



More than the house price story itself, which is hardly pleasing to the eyes, what I find most worrying is the way the Spanish administration seems to be boxing itself into a corner with its use of data. During the interview. Mr Zapatero also said the following in a response to a question about the outlook for the Spanish economy: "Well, our estimate is that we won't have any more quarters where growth will go down. We think that growth will continue to improve, and this will also improve confidence in the Spanish economy". But none other than Bank of Spain Governor Miguel Angel Fernandez Ordoñez recently asserted that the Spanish economy had visibly weakened in the third quarter, and the data we have certainly seem to back him up. And the fourth quarter outlook looks even worse. So which is it, will Mr Zapatero be able to eat humble pie, or will an army of bank analysts and hedge fund investors end up spending the whole xmas period going through all the Spanish data with a fine toothcomb? Mr Zapatero also says: "What's happening is that our plans are being fulfilled to the letter". This reminds me of other statements from other national leaders in other times. Would that those beyond the confines of his own small closed inner circle could find themselves able to agree with him when he makes such an assertion!

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.

Saturday, October 02, 2010

All For One And One For All - "We AreThe Eurozone"

One of the worrying things about the handling of the current European crisis is how many of those responsible for taking the decisions seem to view the Eurozone in a way which is every bit as rigid, timeless and dogmatic as the thinking of those old school scholastics whom Galileo, in his time, found himself battling against. Rather than facilitating a dialogue, and a free and open discussion, the guardians of fortress euro seem to want to keep the doors slammed tight shut, just in case any strange and unwanted ideas should inadvertantly slip in without them noticing.

Take the issue of Eurozone aggregate data. Treating the countries that constitute the bloc as one homogenous entity seems to have become a sort of shibboleth which it is impossible to question, even though it is patently evident to all concerned that there are often enormous differences between the economy of one member country and another. Inflation is the prime example. What seems to interest members of the ECB Governing Council when they have their monthly meeting is that somewhat abstract entity, the average EU16 inflation rate, while what is obviously interesting to follow from a policy point of view (just look what happened to Ireland, Spain and Greece in the years before the crisis - see Spain chart below), is the degree to which inflation rates in individual countries diverge from the mean.



Another example would be current account balances (see chart below). Eurostat publishes data for the EuroArea 16 on a monthly basis, but I think I am right in saying they never publish the national-level breakdown (certainly I have never seen it, and that hasn't been for want of trying). But, of course, now we find ourselves with a whopping set of internal imbalances between those countries running large surpluses and those with large deficits - which the financial markets are becoming less and less willing to fund - and no one seems any too clear about what to do to restore the balance. But how were the imbalances allowed to build up in the first place? Did they creep up on us by stealth, or was no one really looking?



Exactly the same issue arises with the national breakdown of bank borrowing from the ECB. As if living in a theoretical cocoon, decision makers at the ECB move forward in way which makes them seem completely impervious to the problems posed by the way banks in one country are more dependent on funding than are those in others (M Trichet repeatedly refuses to answer questions on this kind of issue at the monthly press conference) and hence remain walled-in from the issues which actually exist in the real world which surrounds them. When pressed they simply state that there is no problem since an EU country is in principle just like a US state - try telling that to Ireland or Greece. Or try telling it to German voters when they are asked to contribute to bailouts.



The issue is of course a very telling one, since basically the whole present Eurozone debt crisis has the inter-country imbalances as its backdrop, hard as the members of the ECB Governing Council may try to avoid admitting it, prefering instead to focus attention on the fiscal profligacy (of which, naturally, there has been a good deal) of the national members state governments. In other words, the problem is not of their making, oh deary me no!

Rivers Of Liquidity Here, Credit Drought There

National divergences in bank lending constitute another very good case in point. Despite the fact that the current crisis has become known as a Sovereign Debt One, it isn't always fiscal spending and public sector debt which lies at the heart of the problem. In fact, private sector debt is often as much of an issue, and the private sector in some EuroArea countries is heavily indebted, while that in others is not. It is important to discover who is who here, and to distinguish between them, since if you don't it will be impossible to decide prescisely which kind of policy mix is appropriate in each and every case (but, of course, our modern scholastic dogmatists will tell us there are no such things as "cases" here, and continue to insist there should be no distinction between countries at the level of policy). Yet just when you need the fine grained detail, what you get are more aggregate numbers and a bunch of platitudes which really tell you very little.

Thus, in the August edition of their publication "Monetary Developments In The Euro Area" we learn from the ECB that bank lending to euro-zone businesses increased in August by €17 billion as compared with July, a rise which more than reversed the €11 billion decline in July over June. What this increase meant was that the annual rate of decline in corporate borrowing was only 1.1% in August versus a 1.4% annual drop in July. That lending to corporates is falling less rapidly is good news, but it is still falling on an annual basis.

Aggregate lending to households also picked up, rising €14 billion during August compared with a €5 billion monthly increase in July. This lead the annual rate of growth to rise to 2.9% from 2.7% in the previous month, which produced a lot of "at last" type comments in the press. And putting the two numbers together, we find the annual rate of growth in loans to the entire private sector was up at 1.2% in August from 0.8% in July. Relief all round, surely, since we are going the right way.

Unfortunately nothing is ever so simple, and once we start to dig down we find large and significant disparities - disparities which may well produce monetary policy decision conflicts for the ECB in the months to come - hidden away in the aggregates. In France, for example, lending for house purchases was up an annual 6.5% in August, and indeed over the last three months such lending rose at a 7.9% annualised rate (ie lending growth for housing is accelerating), while in Spain total house lending was only up 0.6% on the year (in July, we don't have the August data from the bank of Spain yet, but it won't be very different).






When we come to total lending to households we find the pattern repeated, since this was up 5.4% in France in August, and only 0.5% (in July) in Spain.





And when we come to corporate borrowing, this was up an annual 0.4% in France in August, while it was down 1.9% in Spain (in July).





But then, you may want to ask, at the end of the day just why would anyone in Spain want to take on more debt? Since the Spanish stock of corporate debt is around 1,300 billion euros, while the French equivalent is only 771 billion euros (and the country is about half as big again as Spain), French corporates could certainly take on some more debt (if circumstances like market and investment needs warranted) but Spain's heavily over-indebted corporates simply need to pay their debt down. In the context of Spain's shrinking economy, more credit for Spanish corporates simply means more indebtedness and more interest-roll-up loans of the kind that "gather no loss" (at least at the balance sheet level), hardly a desireable development at this point.

Evidently I have taken the two polar cases here, borrowing in Italy and Germany is much weaker than in France, while the situation in Ireland, Greece and Portugal will look more like Spain. But this is part of the point, France is the one large EuroArea country where domestic demand still has real life to it (for a variety of reasons it wasn't blown out by a bubble during the last round) but for just that very reason it would be absolute madness to turn the goose that can still lay golden eggs into some kind of "foie gras" by feeding it up with massive doses of liquidity it evidently doesn't need.

Looking at the inflation differential between France and the Eurozone average matters aren't getting out of hand yet, although French inflation is above the average in a way in which it has not been before, and the situation now requires careful monitoring.



Forward looking inflation expectations have risen in France in recent months, but they seem to a stagnated of late, so again, at this point there is no need to panic.



But the situation is one where - now what is the expression - "extreme vigilance" needs to be exercised, since naturally there is no reason why a country that didn't have a bubble last time round won't develop one next time. So perhaps one of you journalists who attend the post-meeting press conference might like to ask M Trichet whether this is the kind of approach he has in mind, and what policy options are open to him should the worst case scenario (on the upside) really start to materialise. In the meantime, all I can do is shrug my shoulders and mutter under my breath "ma eppur si muove".