Monday, 11 October 2010

Financial Markets Finally Awake to Eurozone Risk

This year the Eurozone has suffered its first existential crisis. Ongoing turmoil in financial markets has exposed the vulnerability of the public debt position in several Eurozone member states. The financial spreads amongst Eurozone countries against the benchmark (10-year German bond) Bund, which gauge the medium-term risk in the Eurozone, have not only escalated to historic highs but also have displayed increasing tendency to be skewed (roughly measured by the gap between median and average), as a group of countries are finally perceived as increasingly risky by financial market participants. A typical response to this crisis has been to ask for a Stabilisation Fund to support distressed Eurozone (EZ) economies and for meaningful restrictions to be placed on public debt levels for EZ member states. This may not be where to begin.

Two obvious factors explain the widening of these spreads, which in a credible monetary union ought to be negligible (as they should reflect mostly some small liquidity preferences for holding one country's public debt over another, with currency risk not really a concern). One of the consequences of the financial crisis is that financial markets are more willing to price risk into financial contracts and so a given quantity of risk, will wish to be paid a greater excess return than in the period prior to the crisis. The second reason is that the perceived quantity of risk has risen on average but also for some states in particular, as the first round response to tightening credit conditions and a contraction of world demand has been a large one-off increase in the level of public indebtedness.

The OCED report that that the level of outstanding government debt for advanced economies in 2009 was around 50% higher than its 2006 level (, p. 19) but this alone seems unlikely to be able to explain the overall and specific increase in sovereign spreads. Part of the reason for the increase in spreads is their ‘compression’ to very low levels in the period leading up to 2007, which exaggerated the apparent change pre- and post-crisis. The question then is why did financial market prices, traded by highly intelligent and resourced investment bankers, for Eurozone sovereign debt display such insouciance to both the construction of a “non-optimal currency area” EMU and to the ongoing implication that public debt levels would have to rise as countries increasingly turned to fiscal policy to stabilise their domestic economies? What were the impediments to use of all available information? It is surely not that much news that certain Mediterranean states have public debt overhangs and were not especially well synchronised to the German economic cycle?

The favourite set of theories may be that there is a tendency for financial prices to herd, in the absence of full information. Some story involving the end of the business cycle, the longevity of the Euro, and belief in an implicit bail-out encouraged some herding which promoted a compression trade – buying higher yield sovereign debt funded in the currency of a lower yield sovereign. But a little more transparency on fundamental debt positions in the event of a prolonged asymmetric shock might have scared the markets into demanding country-level risk premia somewhat earlier. And so I can't help thinking that this kind of information and scrutiny on an on-going basis, alongside assessment of debt positions, may be of more value than a currency stabilisation fund.

Saturday, 2 October 2010

How much growth divergence will spit the Eurozone?

The main economic criterion for a monetary union across a set of economies is that they should be sufficiently synchronised so that the a single interest rate does a reasonably job in stabilising each economy in response to shocks. For this observation, Robert Mundell was awarded a Nobel prize in 1999. But even in any one long established nation state, this criterion often seems be a major challenge. In the UK, for instance as the story goes, the industrial north in the 1980s suffered a depression while south the benefited from a boom – on average there may have been some form of balance but perhaps not one that was ideal. This kind of schism also seems to have inflicted itself on the Eurozone.

A recession is a particular test of a monetary union, as it seems likely that the patience to accept slightly awry monetary policy from the perspective of any individual state may be more severely tested in a recession rather than boom. In this case, the credit shock that triggered the economic bust may have impacted in a different manner on the individual members of the monetary union and it seems likely that different countries may pull out of the recession more quickly than others, which implies a persistent divergence in growth rates. So has recession been associated with a wider distribution of growth rates in the Eurozone wider? Has it been associated with increased national differences in economic growth?

Let’s take a peek. The chart above gives the median year on year growth rate of members of the Eurozone (I exclude Slovakia, Malta and Luxembourg) and the inter-quartile range of annual growth rates, which acts to trim any extremes. Median year on year growth in the Eurozone was negative in the final quarter of 2008. The average inter-quartile range of growth rates was 2.4% prior to that quarter and it has been just over 3% subsequently. So there has been some increase in the dispersion of growth rates and in the first quarter of 2009, the inter-quartile range of growth was over 4%. So in principle, the one interest rate does not fit as well as it did.

But to me the increase is dispersion does not seem that great, I leave as an exercise the calculation of whether the differences in dispersion of growth rates are significant. Part of the reason here is that countries have been able to resort to an increase in public indebtedness to deal with their domestic output gaps. This response may well be a once-and-for all increase so could be replicated in the event of another downturn. But I do not know, and neither does anyone else know what the trigger point would be for a collapse in monetary union.

What is more important than the unconditional dispersion in growth rates in any one quarter across the countries, is the persistence of the deviation in any individual country from the median and what we can observe, even for Greece, is that sometimes it has been a winner and sometimes a loser so if the state can be patient enough EMU may even work for them, financial markets willing. (The chart below simply plots the inter-quartile range of growth rates and as red blobs year on year Greek economic growth.) We will return to that question next time.

Monday, 20 September 2010

Getting to Grip with a Double Dip

All I seemed to get asked at the moment is whether there will be a double dip. By which, I think, people mean whether the economy will experience another sustained period of negative growth. The UK recession started in 2008Q1 and continued until 2009Q3, which was relatively prolonged by the 'normal' standards of industrialised nations. Since then we have benefitted somewhat from three positive quarters of growth. As to whether we will have more quarters of negative growth, unfortunately I do not have the answer – and we shall simply have to wait. The typical forecast error of one-year ahead GDP growth is well over 1% and probably nearer to 2% of GDP warns me to be careful in making predictions. So much so that I would have be forecasting strong GDP growth of well over 2% in order to be reasonably sure that growth would be positive in the year ahead.

As with many question of economic policy, this one is badly formulated. It may matter, to some extent whether we think the economy is going to grow at +0.1% or -0.1%, with zero demarcating the difference between a happy and unhappy future for all. And some people do believe in some notion of a stalling speed for an economy, under which low or negative growth rates are more likely to lead to sustained lower and more negative growth rates in future: such a view might be based on the conjecture on confidence-based feedback loops from growth to employment prospects and vice versa. But ultimately more or less growth over a short period is less important than the extent of spare capacity.

And so the questions about which we ought to be thinking hardest, are not only about the extent of spare capacity but whether it will ultimately be dissipated by strong positive growth in demand or the scrapping of output potential. If the former, the long-lived consequences of the financial crisis and subsequent economic recession would be minimal but if the latter then we may have to learn some very hard but also permanent lessons about relative impoverishment. The chart above shows real GDP in the UK, Euroland, Japan and the US relative to their level at the end of the second quarter of 2007, which you will recall was a month or so before the financial crisis took its grip and I have arbitrarily normalised that quarter’s GDP level to 100. I also draw a simple trend line (dotted line) from 2001 to 2010, which shows where we might have expected the income to be this year if we had been foolish enough to believe a straight-line forecast in 2007. Even though the various recessions seem to have ended, the gap between expected income and actual income remains very large. In general, we can see, there is a shortfall of around 5-10% between the expected level of GDP and current income. A double dip or not, what matters is the persistence of this gap, which can be only be eroded quickly by some combination of fast growth and supply side scrapping. When we consider the indebtedness of household balance sheets, a nervous corporate sector and a trickle of bank lending – it is difficult to see how demand will quickly erode the gap. And if the decision-makers on the supply side then think that the gap must be closed by scrapping output, then we will all be permanently worse-off. Double dip or not that is the real question.