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.

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.

Is a Love of Finance the Root of All Evil?

There is a syllogism that has gained currency just as financial markets have been devalued. And it goes something like: (i) finance is dangerous (ii) the economy is in danger (iii) finance must therefore be constrained. I regularly attend conferences and hear a panoply of dirigiste sentiment directed against the financial sector, arguing that not only that financial markets and banks been the root cause of the final crisis but that they must now be bound like Prometheus to a stone. Though such a conclusion is tempting, it may not be quite right.

The critiques are well known: financial markets underpriced risk, created excessive liquidity and leverage, unbundled exotic near-worthless debt instruments and at the limit, often via hedge funds, promised semi-permanent excess returns. All activities that rewarded participants on the upside and ended up having government support on the downside. The argument then is that faced with such a skew in returns, too many resources have been devoted to financial activity. It is said that banks and financial institutions have become too large both in absolute size because they cannot then be allowed to fail without creating systemic risk and relative to the size of the economies they service. Maybe.

Let us rehearse the arguments about why finance matters. Finance allows individuals and firms to disconnect in time and space their abilities to earn and their abilities to spend and hence concentrate on one or other at any particular moment. The advantages of specialisation are clear – everyone can benefit from the greater production of goods and services by allowing agents inter-temporal as well as geographical options to share resources. But we do know that the efficient allocation of funds from savers to borrowers is subject to severe informational constraints and also various temptations to renege: the avoidance of these problems requires significant regulation, institutional capability and investment in reputation-building. These kind of first order problems do not in general sort themselves out and it is possible even to write about the vast sweep of economic development itself in terms of the history of solutions, failed or otherwise, to these types of problems.

So we can expect that alongside the development of financial instruments we will have to re-write the book of rules and regulations every generation or so, as we moved from heavyweight capital controls in the immediate post-war era under Bretton Woods to an era of neo-liberalism running from the late 1970s to about now and hopefully beyond. And so let us not take the initial premise too far in that the problems with the global financial system are best solved by reducing the size of that system because it seems likely that at least some of the problems stem from its incompleteness rather than its dominance. Let me illustrate: it is entirely proper that capital flows from “impatient” countries to “patient” countries and at some real interest rate the deficits of the impatient must equal the surpluses of the patient. Over time the patient countries will then build up claims or assets against the debts of the impatient countries. Now let us suppose that the patient countries become wealthier, say as their productivity levels catch-up, and all this extra wealth is saved, global savings will then initially exceed investment and interest rates will have to fall to clear the global market for savings, encouraging the impatient to become more impatient and increase their overall level of indebtedness.

For impatient read the US and for patient read China. Under this equilibrium real rates are low and capital flows uphill from fast growing to mature economy. The problem here is that the extra savings are all being sent to the impatient, as there are limited vehicles for the patient to invest in their own economy. In a closed economy, the extra income would have to be channelled domestically and domestic growth would be stimulated in order to use the savings. And so by the same token, if there is an inadequate development of savings vehicles in the patient economies then these savings will tend to drive up the prices of existing assets, for example, US Treasuries which will be in short supply. This global excess demand for assets hence drives down real interest rates raising other asset prices in turn, for example housing, equity or real commodities.

It is thus the lack of financial development in emerging economies which arguably lies at the heart of the problem of this financial crisis and not, perversely, the excess of financial development. An example from the most recent IMF Article IV report from October 2006 for China suffices to illustrate the point, which reports that the foreign exchange rate market remains tightly managed, there seems to be little development of bond markets even at maturities of less than one-year and little or now availability of bonds in the 1-10 year maturity range and equity markets seem not to allow firms to access the market. Overall the IMF view was that the “limited role of capital markets in China…reflects the dominance of state banks in intermediation, but these markets are plagued with regulatory and governance problems”. Obviously a report form late 2006 may well be rather out of date but it does clearly illustrate the point about a lack of liquid assets in newly emerging economies at the high watermark period of so-called financial excesses.

So rather than shunning financial market development, global policies ought also to think more about deepening capital markets and encouraging the development of assets across the risk spectrum, particularly in parts of the world where surpluses are being generated. By helping the development of such assets, policy makers will help raise global real rates, help prevent the conditions under which asset price bubbles will develop and also help get various parts of the world onto more sustainable growth paths that are not reliant on the capacious appetites of Western-style consumption alone. And if as a consequence, we become a little more patient and they become a little more impatient, then we have all become a lot closer to each other, which is a rather pleasant thought.

Those Can't Get Enough of Them Fiscal Blues

In a recession it is easy to motivate some form of discretionary fiscal policy. Let us rehearse the arguments: aggregate demand is shocked downwards as real and financial wealth falls; under heightened uncertainty, consumption and investment plans are delayed; and the ongoing difficulties in obtaining (bank and other financial) credit seem likely to amplify the impact of these effects on the economy. Furthermore we can point to a co-ordinated international downturn, which not only is likely to increase the size of the initial shock but also limit individual country responses with no individual option available to increase external demand. Furthermore it has become clear that monetary policy has reached its limits, with the zero bound and resort to quantitative easing, which means that there is an "interest rate gap" to be mopped up by fiscal policy expansion.

So if we can agree that there is a demand gap going forward and fiscal policy is part of the answer, what form should the fiscal stimulus take? One background point first - there has been an upward shock to the level of public debt in all economies with substitution of private claims for public claims on banks and this means that all economies are nearer some notion of the threshold of public solvency than they were prior to the crisis. And implies that the overall room for manoeuvre is somewhat limited. The IMF use a number of key phrases in thinking about the fiscal response. That it should be timely (now); large (expensive); contingent (could be end up being even larger); collective (all join hands) and diversified (to deal with the uncertainty of multipliers in any one sector). What really worries me is that large is no substitute for well directed and that for any discretionary fiscal policy to work what it must put spending into the economy in exactly those areas where demand has been weakest during contraction, which implies to my mind that it is temporary in nature and well targeted rather than scattergun. For example, a scheme to help the recently unemployed maintain consumption or for idle construction projects to go ahead is preferable to one that raises the wages of public sector workers, even academics.

The temporary nature of the fiscal expansion is also key. If treated as permanent, the fiscal expansion is more likely to lead to higher nominal interest rates at term and hence crowd out private sector investment or expenditure as it will be perceived to reflect more probability of default or inflation risk. Obviously this kind of concern will limit the accommodative stance of monetary policy at zero nominal rates. Think flat LM curve with IS shocks and upward sloping LM curve with the same shocks - in the latter case with higher interest rates, output (and the multiplier) is lower. In this respect funding choices also matter - a government that raises discretionary expenditure with index-linked bonds may be treated as more credible than one that does so with nominal bonds and hence may be able to reduce the crowding out. It also likely to be the case that a more permanent increase in expenditure is one which people will save against. The Ricardian equivalence hypothesis may not work when there are liquidity constraints and when the government can borrow more cheaply than the private sector but if government behavior more clearly starts to resemble the private sector and of more equal risk, any advantage will be watered down.

So how should fiscal policy state what is does during a deep recession in order to maximise its effectiveness? It helps to start with monetary policy as an example. The solution to the zero bound problem for monetary policy involves some kind of commitment to inflate. Which is a long run commitment to do what is necessary to drive inflation up. This is possible because monetary policy ultimately controls the price level. But fiscal policy cannot promise to spend, spend and spend again to save the country it loves (passim Gaitskell) because that raises the spectre of fiscal solvency and increases the present value of the burden on tax payers, reducing their marginal propensity to consume. Ultimately we believe that income is supply side determined. In this sense fiscal policy is more like a one-off expansion of a deflated tyre - some air should go into the gap but not too much. The expansion should be just enough to offset deflation and leakages ought be minimised. And when the tyre gets back to the correct pressure all expansion must be turned off immediately.

So how can we answer the key question on fiscal policy? How vocal should fiscal authorities be about the exit strategy, by which we mean the relaxation of high levels of discretionary expenditure? The key is to ensure some belief in the government's present value budget constraint. That spending will be undertaken to the extent that it does not threaten fiscal solvency. But who should judge whether a government's spending is solvent? Certainly not the government itself or the(ir) IMF (representatives) and probably the financial markets should play a role, which they will do in the pricing of nominal and real government liabilities at term. But while QE continues it will be very hard to treat market prices as telling as much about the financial markets' views. And so under uncertainty about the preferences or ability of the government to cut back on fiscal expenditure, there needs to be some conditional plans about the path of real expenditure and revenue which are measurable. Which sounds very complicated and rather difficult to convey and so what so the danger is that we might end up with is something more of a random walk, which seems to increase uncertainty.

If we want to keep the public sector as large as it is now, there will have to be increases in expenditure and tax increases over the longer run. But some serious discussion about the appropriate size and role of the public sector is also required, which does seem somewhat bloated. So as well as plotting a course out of the current sequences of deficits, responsible government would also call for a debate on the appropriate size and government involvement in the economy, as well as the magnitude of both public and private indebtedness.

The Party's Over...

...and here’s the bill. So now we know more clearly the cost of this bust (in which GDP is now forecast to fall some 3.5% this year) and it is shocking. Public sector net debt was 36.5% of GDP in the fiscal year 2007/8 and today the Chancellor has projected public debt to rise to just a shade under 80% of GDP by 2013/14. Public debt was previously as large as 80% of GDP in 1968 when the trajectory was still gradually adjusting downwards after WWII. This government’s self-imposed Golden Rule, or threshold, for public debt of 40% of GDP has been shattered with some £790Bn of borrowing planned over years from 2008/9 to 2013/14.

Admittedly, accompanying this debt projection are some plans for taxes to rise and for the growth in government spending to fall somewhat more than earlier plans. But these new plans represent second order modifications around a potentially explosive path. The risks to the path for debt to GDP seem to lie on the upside should the economy continue to remain longer in the doldrums and, which may follow, should there be further calls on the public purse to bail out financial institutions.

The big picture is that a large quantity of debt, created during the long 1990s expansion which ended in 2008, has now been transferred from the private sector to the public sector. And the trick that the public sector is trying to pull off is to smooth the increase in taxes that need to be levied on the private sector to pay-off these debts. But the danger is that financial markets will see through this trick and start to treat the public sector as more risky, like the hapless private sector, and that is why the initial reaction has been for bond yields to rise some 8-10bp. Now where’s that aspirin?

Are we in another Great Depression?

Too early to tell. The chart below shows data from the Angus Maddison’s well known dataset on long run growth in world economies (the data can be downloaded from http://www.ggdc.net/maddison/), which compiles national data sources into a comprehensive annual dataset. The data was mostly constructed postwar by various academics and research institutes in the countries concerned, that is after the fact, and is probably subject to some huge measurement errors but I found the chart highly instructive when thinking about the scale of the recessionary problems we might face in comparison to the so-called Great Depression.

Before discussing the chart, let me point to an old debate that seems to have been re-ignited between those who judge business cycle phenomena such as a possible Depression to be the result of shifts in productive potential or whether such phenomena are always the result of demand deficiency. Peter Temin (MIT, JEL, September 2008) recently reviewed work by Tim Kehoe and Ed Prescott (Minnesota School, Response FRB Minneapolis, December 2008) on the causes of Great Depressions and severely questioned the basic hypothesis that it was possible to think of the Great Depression as resulting from the former rather than the latter. In recent work, Kehoe and Prescott point to a sharp fall in US productivity in 1929-33, which was associated with a sharp fall in labour hours which did not recover even when productivity recovered later in the 1930s. Temin argues that: “(a)ny description of sort run macro events needs to pay attention to the effects of monetary and fiscal policy”. I am very sympathetic to the Minnesota School but when I start to think about the current debate and possible causes of this downturn, in a world of immense and prolonged analysis, I have seen little or no reference to a productivity slowdown as a cause of the financial crisis. Maybe it will come.

Turning to the data. The data gives us 1990 US$ price GDP in a variety of countries and I simply normalise the GDP at 100 for 1929 and see when output returned back to its previous level for a few countries. The results surprised me. The UK seemed to have a relatively mild output recession following its exit from the Gold Standard in 1931. Following my previous blog, it is remarkable how often the exchange rate helps adjustment in the UK. The US did not return to its previous output level until 1936/7 but that masks positive growth from as early as 1933.

In some senses the US path is probably the worst we might expect given an absence of effective countercyclical monetary (Friedman and Schwartz, 1963) and fiscal policy and the adoption of protectionism, which exacerbated negative trade multipliers. The stylised fact for the Great Depression is that world trade (exports plus imports) in 1913 US$ constant prices was around US$36bn in 1929 and fell to $25bn in 1938 i.e. around 33% and world output over the same period moved from US$241bn to US$270bn, which meant that the fraction of trade to GDP fell from around 15% in 1929 to 9% by 1938 (Estevadeordal, et al, QJE, 2003).

For obvious reason, we may not want to dwell on the militaristic solutions in Japan and Germany but, at a stretch, these might be analogous to making some kind of point that with the right kind of demand management, economic growth might return quickly and rapidly. So the question then is whether extreme monetary and fiscal policy stimuli currently being developed are sufficient to drive demand in the absence of much global demand (recent market inflation expectations data suggests this might be the case)? And under what circumstances will the saving nations (e.g. China) shift their investment functions outwards – as this will probably require some reform of their financial institutions it will probably not happen anytime soon? A financial crisis is difficult as it impacts on demand, as agents’ wealth and ability to smooth consumption evaporates, and it impacts on supply, with capital and labour shedding resulting. So we know that output will fall and demand management can have, at best, a temporary impact. So in the end the authorities simply do what they can, given tremendous uncertainties, and hope that confidence returns.

Whither Sterling?

Much ink has recently been split on the causes and consequences of the sharp decline in UK exchange rate. The bare facts look to be a concern, since mid-September 2008 sterling has fallen by 14% against the Euro and some 25% against the US dollar. In combination with the confirmation of a deep recession, it seems that the world is shunning the UK. The speed and extent of the decline is remarkable and is not dissimilar to that which occurred in the days and weeks following ERM exit in September 1992. It is even argued that if Sterling is to lose its role as an international store of value then far better to consider joining a large currency zone where the external unit of value cannot be so easily buffeted around by gales blowing though the world of international finance.

So just how much of a problem is the depreciation of Sterling and does the scale of the decline provide a potential cure or kill for the UK economy? The Chart (below) shows a weighted average of the UK exchange rate versus the US$ and the Euro on a daily basis since 1985, with down signalling a depreciation in Sterling. The red-line shows the ratio of share prices in banks relative to those of the FT All-Share Index and is a measure of the news on banking profits relative to the whole economy. We can see that ERM exit was broadly a good thing for bank shares, most probably signalling that UK policy rates were more likely in future to reflect domestic growth prospects – implying that the bank profitability would benefit from such a re-direction. Furthermore, in the mid-1990s, once growth had been re-established Sterling did recover its previous level. On the other hand, we can see that the more recent fall in the exchange rate after the start of the Credit Crunch in 2007 (vertical line), seems to have been driven (at least in part) by the relative downgrading of bank profitability compared to the rest of the economy. In other words rather than being an exogenous cause of bank profitability and recovery, the widespread perception that this crisis will continue to constrain financial intermediation for some time to come may have led to a fundamental re-assessment of the Sterling’s fair value.



So where is the gain from the fall in the currency? Those involved in international trade will not be pleased, importers of goods and services will face higher bills and yet because of weak UK demand may find that it is not possible to pass on these higher costs and their profits will be directly reduced. Exporters may superficially benefit but much of UK exports are simply added value to imported raw materials or component manufacture and so the direct gain will be somewhat militated. It also seems likely that international corporations may dislike to notion of being sited in an economy where the exchange rate fluctuates widely as this will tend to disrupt profit forecasts and the lead to volatile remittances priced in foreign currencies.

But even if the exchange rate channel offers a rather weak form of direct support, it might be that every little bit helps. And so to the extent that the fall in sterling simply reflects an anticipated reduction in interest rates in the UK relative to those overseas, then exchange rate adjustment may help the economy adjust to its new equilibrium following a constellation of shocks. For the UK economy a list of these shocks might include: (i) a persistent downward shock to the value of financial intermediation; (ii) a downward shock to asset prices and hence net wealth; (iii) a realisation that the household balance sheet was becoming too heavily indebted and (iv) a global reduction in overall demand for UK goods and services.

As well as the possible impetus to net exports there are two further ways that the exchange rate depreciation may help the UK economy. First in the midst of mounting deflation pressures, a large exchange rate depreciation offers a one-off increase in the UK price level that will hold those pressures in abeyance for some time. The depreciation will increase the price of traded goods and lead to a temporary inflation as the increased costs of imported goods feeds though the economic pipeline as typically it is still the case that there is a large pass through from a nominal exchange rate change into the domestic price level. By keeping inflation temporarily higher than it would otherwise be, the economy may avoid some of the problems brought about by too rapid a disinflation. Secondly, the reduction in the foreign currency price of UK assets means that they may now offer a good prospective return in foreign currency terms and lead to some support for both the domestic housing market and equities from foreign capital, which may be looking for a place to park itself.

The danger really is that the depreciation in Sterling hinders in some way the government’s ongoing ability to deal with the financial crisis. By which I mean that we can characterise the policy response to the crisis as a transfer of risk from the private to the public sector, as we are using public debt to hoover up private debt contracts. If the decline in the exchange rate becomes widely thought of as a reflecting risk in the UK, rather than an adjustment associated with economic fundamentals, then the upper bound on the government’s ability to sell its debt will bite somewhat earlier than would otherwise be the case. And that in the end is the real risk from a Sterling sell-off – that it somehow signals looming fiscal insolvency.