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Thoughts on EM conference in NY

Yesterday I attended the 6th Annual Goldman Sachs Emerging Markets conference in New York. My takeaway from the conference overall was that the risk-on sentiment that is driving massive inflows into EM funds is still very much present. Going forward, the conference participants generally see emerging markets as “different” from those ten years ago, and will no doubt remain resilient to the sovereign stress that is emanating from the developed world.

China. Goldman Sachs views the recent property boom as limited to that sector – the Chinese authorities are currently clamping down via administrative tightening measures – and that a broader “asset bubble” is not present. China was deleveraging going into the crisis, so its starting point was on a very different level than that of other “frothy” economies, like the US or UK.

On the outlook for China, Goldman sees 13% growth this year, followed by a remarkable 12.4% next. The inflation outlook, although tame, depends very much on Asia continuing as front-runner of the policy tightening cycle.

Jan Hatzius presented his outlook on the US economy – he sees the Fed hiking rates in 2011, as monetary policy accommodates the massive labor underutilization. I could not disagree with this assessment.

Rebecca: I would add that I see a positive probability attached to further Fed QE measures, as the fiscal stimulus inevitably drags the economy – without further stimulus growth will turn negative and drag GDP. In lieu of a heroic surge in private sector demand, which is currently driven almost solely by the upswing on a massive inventory cycle, the Fed will have no choice but to continue to “pushing on a string”. The fiscal impetus is driving this recovery.

Actually I was truly shocked that the merits of the fiscal stimulus were not mentioned more directly in his outlook. He spent (roughly) 7 slides comparing this recession to previous post-war recessions, and not once did fiscal policy come up – just Fed policy. Several slides after that, we finally get a chart illustrating the contribution to GDP from government spending. And then, I knew it was coming, a chart about the US public debt to GDP. It’s just a scare tactic, I assure you; these charts should not be taken seriously. As long as the US issues debt in its own currency, and that currency is not fully convertible (into anything), the US government does not face solvency risk!

Unlike Greece….

Erik Nielsen proffered his outlook for the Eurozone. Currently, Goldman Sachs is more bullish on Eurozone growth than is the consensus. Their baseline case is that Greece’s liquidity crisis is mitigated through IMF/EU support, and that the solvency issues are repaired in a timely manner through restructuring and austerity measures. Overall, the economic impact remains mostly contained in Greece.

Of course, the risk in the interim is that the EU/IMF is too slow in approving the aid package, and a mass run on the banks ripples throughout the Eurozone (currently there is no deposit-insurance mechanism across the members of the “zone”). I queried Marshall Auerback regarding the banking sector in the Eurozone:

Rebecca: “In the “zone”, is there an FDIC-style insurance mechanism in place to shore up the banking system across the member countries?”

Marshall: “No. The deposit guarantee is handled on a national scale, which is why Ireland is basically insolvent. The deposit liabilities of its banking system are about 600% of GDP. Ireland can “write the cheque” to cover this, so it’s doomed. “

Rebecca: “Great, thx! This is not good…”

Marshall: “No, it’s a disaster. In many respects, Ireland’s problems are even worse than Greece. It truly is insolvent. Greece has problems because of self-imposed constraints, nothing more.”

Rebecca again: I still don’t see it: how “internal devaluation”, i.e., falling prices and massive wage cuts, is to drive export growth for all debtor across the Eurozone. It’s a fallacy of composition: if every country in the Eurozone deflated in order to improve competitiveness, then demand on the aggregate falls. Therefore, the Eurozone sees less rather than more export income generation.

The average country in the Eurozone earns over 60% of its export income via inter-European Union trade. Likewise, and this is why Nielsen’s base case is no contagion: the GIIPS countries (Greece, Italy, Ireland, Portugal, and Spain) account for 35% of GDP in Q4 2009. Contagion is assured if the GIIPS jointly face a liquidity crisis.

Ahmet Akarli is very positive on the outlook for Turkey. He is likewise bullish on Russia, which is consistent with the Goldman Sachs outlook for oil: $90/barrel in 2010 and $110/barrel in 2011. Finally, Hungary appears to be the apple of the investment banking eye. Hungary’s austerity measures have been very effective, and the economy gained momentum on improved competitiveness.

Rebecca: I should note that my feeling about Hungary’s bullish export outlook is consistent with that of the Eurozone overall: the forint is pegged to the Euro (within a band, that is), so its true competitive advantage can only be sustained by persistent productivity gains and wage declines.

Paulo Leme covered Latin America. For Brazil, their outlook on the BRL and its economy more generally is consistent with my own: hot! Week after week, the inflation numbers are “higher than expected”, the current account balance “surprises to the downside”, and domestic demand is outpacing GDP by leaps and bounds.

That’s all for now.

Rebecca Wilder

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Marshall Auerback: "Troubles in the EuroZone: Will the Contagion affect the U.S.?"

Roosevelt Institute Senior Fellow Marshall Auerback and Braintruster at the New Deal 2.0 explores the possibility, and what it means if deficit hysteria continues unchecked:

A recent poll by Douglas Schoen and Patrick Caddell suggests that swing voters in the US, who are key to the fate of the Democratic Party, care most about three things: reigniting the economy, reducing the deficit and creating jobs.

But the latter two goals are generally incompatible, especially during major recessions.

In times of high unemployment, government deficits are required to underwrite growth, given that the private sector shift to non-government surpluses has left a huge spending gap and firms responded to the failing sales by cutting back production. Employment falls and unemployment rises. Then investment growth declines because the pessimism spreads. Before too long you have a recession. Without any discretionary change in fiscal policy (now referred to in the public media as “stimulus packages”) the government balance will head towards and typically into deficit, unless the US miraculously becomes an export powerhouse along emerging Asia lines, and runs persistent current account surpluses, to a degree which allows the governments to run budget surpluses.

This is not going to happen, particularly when the largest current account surplus nations, notably Germany, cling to a mercantilist export led growth model, an inevitable consequence of that country’s aversion to increased government deficit spending. The German government’s reticence to counter any kind of shift in regard to its current account surplus is particularly significant in light of the ongoing and intensifying strains developing in the EMU nations (see here) . Last week’s Greek “rescue” is Europe’s “Bear Stearns event”. The Lehman moment has yet to come. One possible outcome of this could well be significantly larger budget deficits in the US and a substantial increase in America’s external deficit, given the unlikelihood of America becoming an export super power again. Let me elaborate below.

In the euro zone, I now see one of two possible outcomes. Scenario 1: the problem of Greece is not contained, and the contagion effect extends to the other “PIIGS” countries, leading to a cascade of defaults and corresponding devaluations as countries exit the EMU. Interestingly enough, the country which could well be affected most adversely in this situation is France, as the country’s industrial base competes largely against countries like Italy and the corresponding competitive devaluation of the Italian currency in the event of a euro zone break-up could well destroy the French economy (by contrast, as a capital goods exporter with few euro zone competitors, Germany’s industrial base will be less adversely affected in our view).

In Scenario 2 (more likely in my opinion) we get some greater fears about other PIIGS nations (discussion is now turning to Spain, Portugal and Ireland). The EMU might well hold together but the corresponding fear of contagion might well provoke capital flight and drive the euro down to parity (or lower) with the dollar. Of course, the euro’s weakness creates other problems: when the euro was strengthening last year due to portfolio shifts out of the dollar, many of those buyers of euro bought euro denominated national government paper (including Greece). The resultant portfolio shifts helped fund the national EMU governments at lower rates during that period. That portfolio shifting has largely come to an end, making national government funding within the euro zone more problematic, as the Greek situation now illustrates.

The weakening euro and rising oil prices raises the risk of ‘inflation’ flooding in through the import and export channels. With a weak economy and national government credit worthiness particularly sensitive to rising interest rates, the European Central Bank (ECB) may find itself in a bind, as it will tend to favor rate hikes as prices firm, yet recognize rate hikes could cause a financial collapse. And should a government like Greece be allowed to default, the next realization could be that Greek depositors will take losses, and, therefore, the entire euro deposit insurance lose credibility, causing depositors to take their funds elsewhere.

It all could get very ugly for the ECB. The only scenario that theoretically helps the value of the euro is a national government default, which does eliminate the euro denominated financial assets of that nation, but of course can trigger a euro wide deflationary debt collapse. The ’support’ scenarios all weaken the euro as they support the expansion of euro denominated financial assets, to the point of triggering the inflationary ‘race to the bottom’ of accelerating debt expansion.

So timing is very problematic. A rapid decline of the euro would facilitate a competitive advantage in the euro zone’s external sector, but it could also set alarm bells off at the ECB if such a rapid devaluation creates perceived incipient inflationary strains within the euro zone.

What about the US? In the latter scenario, we can envisage a situation in which the combination of panic and corresponding flight to safety to the dollar and US Treasuries, concomitant with the increased accumulation of US financial assets (which arises as the inevitable accounting correlative of increased Euro zone exports) means that America’s external deficits inexorably increase. There will almost certainly be increased protectionist strains, a possible backlash against both Europe and Asia, especially if the deficit hawks begin sounding the alarm on the inexorable rise of the US government deficit (which will almost certainly rise in the scenario we have sketched out).

Assuming that the US does not wish to sustain further job losses, the budget deficit will inevitably deteriorate further, either “virtuously” (via proactive government spending which promotes a full employment policy), or in a bad way , whereby a contracting economy and rising unemployment, produce larger deficits via the automatic stabilisers moving to shore up demand as the economy falters.

How big can these deficits go? Easily to around 10-12% of GDP or higher (versus the current 8% of GDP) should a euro devaluation be of a sufficient magnitude to induce a sharp deterioration of America’s trade deficit. Possibly even higher.

What will be the response of the Obama Administration? America can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus. But this becomes virtually impossible if the euro zone’s problems continue, as we suspect that they will.

President Obama, however, has long decried our “out of control” government spending. He clearly gets this nonsense from the manic deficit terrorists who do not understand these accounting relationships that we’ve sketched out. As a result he continues to advocate that the government leads the charge by introducing austerity packages – just when the state of private demand is still stagnant or fragile. By perpetuating these myths, then, the President himself becomes part of the problem. He should be using his position of influence, and his considerable powers of oratory, to change public perceptions and explain why these deficits are not only necessary, but highly desirable in terms of sustaining a full employment economy.

Governments that issue debt in their own currency and do not promise to convert their currency into anything else can always “afford” to run deficits. Indeed, in this context government spending financially helps the private sector by injecting cash flows, providing liquid assets and raising the net worth of some or all private economic agents. In contrast to today’s budget deficit “Chicken Littles”, we maintain that speaking of government budget deficits as far as the eye can see is ludicrous for the simple reason that as the economy recovers, tax revenue rises, the deficit automatically reduces. That’s the whole reason for engaging in deficit spending in the first place. Any projections that show the deficit continuing to climb without limit is misguided — the Pete Peterson projections, for example, will never come to pass. As we near and exceed full employment, inflation will pick-up, which reduces transfer payments and increases tax revenues, automatically pushing the budget toward surpluses.

In the 220 year experience of the United States there have only been a few years when we’ve not had deficits and each time the surpluses were immediately followed by a depression or a recession. History shows that we can run nearly permanent deficits and that when we do, it’s better for the economy. The challenge for our side of the debate is to expose these voluntary constraints for what they are and explain why the US is not a Weimar Germany waiting to happen.

This article was originally published at the New Deal 2.0 and reproduced with author’s permission.

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An auspicious sign: the consumer (for now) is back

I remain very skeptical about the sustainability of the recovery, as the labor market is in shambles and nominal wage growth is unlikely to facilitate “healthy” deleveraging – please see this recent post “Reducing household financial leverage: the easy way and the hard way”. I digress; because you can’t fight the data. And for now, the consumer is back.

The latest retail sales figures reveal two bits of information worth noting. First, autos were a big factor in the March 2010 surge. Second, even though the large contribution from motor vehicles and parts compromises my enthusiasm somewhat, the underlying trend has emerged: consumers are less frugal in spite of income constraints.

The March advanced retail sales report was genuinely strong, 7.6% annual pace since March of last year or 1.6% over the month and seasonally adjusted. At first I thought that this heroic sales growth was just a scam. March auto sales were unusually large in response to the competitive pricing during the peak of the Toyota scandal. See Edmunds.com’s preview of the March light weight vehicle sales that registered a large 11.75mn gain.

And in reality, the March number was driven largely by auto sales, contributing 1.1% to the 1.6% monthly growth in retail sales. Furthermore, 36% of the total sales bill drove 5.7% of the 7.6% annual gain: nonstore retailers, motor vehicles and parts, and gasoline stations.

One could stop there (which I almost did); but upon further examination, a real trend is breaking out: the growth is broadening across categories with each month that passes. Just look at the evolution since January 2010 (after revisions, of course).



The charts illustrate the sequential contributions to growth from each major category in the advanced retail sales report from left (January 2010) to right (February 2010) to lower left (March 2010). The number next to the date for each chart (title) is the annual total retail sales growth, and you can find the data at the census website here.

You might ask yourself now, what do retail sales look like when conditioning for the robust growth in nonstore retailers, motor vehicles and parts, and gasoline stations? What’s happening to the other 64% of sales? Here’s where the green shoots become even more evident.

The trajectory of retail sales ex nonstore retailers, motor vehicles and parts, and gasoline stations is more of the 60-degree type, an auspicious sign for the near-term recovery.

However, as I have stated time and time again, further deleveraging is imminent. Whether that happens through default or through income growth is all the same in the aggregate – that is, until default causes further macroeconomic instability. Until the economy generates income enough to pay down leverage, the risk of a double dip remains as the inventory cycle is laid to rest. Economic momentum is gaining; let’s just hope that policymakers don’t screw it up.

Here’s something of interest: our friend rjs is looking at a sales tax conundrum….

Rebecca Wilder

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Final destination “rising public deficits” with a stopover in “falling public deficits”

Brad DeLong and Mark Thoma posit that a falling US public deficit is bad news – they are right!

Deficit hysteria is now mainstream thinking, while the more appropriate hysteria should be “jobs hysteria”. How in the world is nominal income growth expected to finance a drop in consumer debt leverage if the government supports a smaller deficit? TARP costs less and tax receipt growth is beating expectations. But that’s all it is, beating expectations.

This only proves the endogeneity of the deficit: the sole reason that the private sector is producing stronger-than-expected growth in tax receipts is BECAUSE the government ran large deficits.

Put it this way: as long as the US is running current account deficits, then a shrinking government deficit will, by definition, squeeze liquidity from the private sector. During a “balance sheet recession”, the government should be growing its balance sheet not shrinking it.

An excerpt from the Japan’s Quarterly Economic Outlook (Summary*) (Summer 1997):

“Thus, recovery in personal consumption is expected to continue after the reaction to the rise in demand ahead of the consumption tax hike subsides in the near future. However, the pace of recovery is likely to be moderate considering the increases in the tax burden, such as the rise in the consumption tax.”

RW: Boy were they wrong – moderate?

GDP fell 2.0% in 1998 (from +1.6% growth in 1997) and consumption growth turned negative over the year, -1.1% (from +0.8% in 1997). Please see slide 9 from one of Richard Koo’s presentation in 2008; he highlights the policy-mistake-induced “unnecessary government deficits”. The point is: the government deficit is not some exogenous “thing” that the government controls; it’s very much endogenous and a function of private demand.

We’re on this road now: squeezing liquidity out of the private sector; supporting minimal wage growth; and imminent deleveraging is on the horizon(more likely the default route). And Congress is happy that they are squeezing private sector liquidity? I guess so, as reported by the Wall Street Journal yesterday:

“Like a number of Democrats, Mr. Blumenauer said he’s “intrigued” with the consumption-tax idea. Tax experts say consumption taxes are regressive, because lower-income people tend to spend more of their income. But a consumption tax could be designed with offsetting breaks for lower-income Americans, to shield them from its impacts.”

Rebecca Wilder

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Macroeconomics: en route

The Institute for New Economic Thinking (INET) hosted its inaugural conference this weekend at King’s College Cambridge, an experiment of sorts. I had the pleasure of attending the conference, my first time to Cambridge. John Maynard Keynes wrote his *General Theory* at King’s College. And as if that wasn’t enough, I dined with blogging legends, Mark Thoma and Yves Smith! The photo was taken at the conference by another attendee, Pierpaolo Barbieri: “Lord Skideslky, easily Keynes’ finest biographer”.

The conference was a spectacular fireworks display of economic panels, featuring experts across a broad spectrum of applied macroeconomic theory and policy, including banking and development. (You can see the speaker list, presentations, and video here). Definitely read other conference pieces by Marshall Auerback, Mark Thoma, and Yves Smith.

Through INET, George Soros is funding a vision: that new and innovative macroeconomic theory prevent, rather than fuel, future “Superbubbles”. INET’s goal is the following:

“to create an environment nourished by open discourse and critical thinking where the next generation of scholars has the support to go beyond our prevailing economic paradigms and advance our understanding of the economic system as a tool to meet social objectives.”

That’s a tall order, and likely not the intended output from the inaugural conference. But what Rob Johnson, Executive Director of INET, probably did have in mind was something of a declaration of war against outdated, disproved, or even deleterious macroeconomic policy and research. And there, I believe that he succeeded.

There was no shortage of criticism at the INET conference.

  • Joseph Stiglitz reiterated the sharp divergence between representative agent models and reality.
  • James Galbraith went the even more aggressive route by suggesting that REH (rational expectations hypothesis), EMH (efficient markets hypothesis), RAM (representative agent models), and DSGE (dynamic stochastic general equilibrium models) be buried beneath a bed of garlic below Keynes’ quarters with guards standing atop the burial site. (This was not a direct quote but very close.)
  • Simon Johnson pressed the need for more action to relieve the systemic pressures coming from the still top-heavy US banking system.
  • Dominique Strauss-Kahn charged global policymakers of being complacent with monetary and fiscal policy over the last decade. They were lured in by ostensibly stable growth, when in fact the financial foundation was crumbling below (after, of course, he was disrupted by a globalization protest with the catch phrase “the IMF is the Problem not the solution”).

In my view, the fact that economists were in some sense accepting blame for policy ignorance is a step in the right direction. So what’s the next step? What will it take to move macroeconomic theory and policy in a truly innovative and novel direction? I don’t know; but I do see two issues that will likely drag the process.

Problem #1: the financial crisis has rendered much empirical and theoretical research obsolete; clearly, this is a solid chunk of what I refer to as the “aggregate Curriculum Vitae”. There’s a host of refereed and published literature with now documented spurious results, or entire literature reviews citing papers with theses that tread water at best.

It’s going to take time to break through the concrete wall of neo-classical macroeconomic denial (among other types of denials). This is the “old boys club”, where careers and prestige are on the line. It’s the true sense of economics as a falsifiable science: some disproved and obsolete macro theory remains ingrained in the profession as some academics, some policymakers, and some politicians cling to their reputations. This “enables” bad economic policy.

The good thing, though, is with funding and support from Institutes like INET, this enabling behavior cannot last forever. The aggregate may enable the profession now; but if the foundation starts to crack, i.e., the next wave of graduate students and new tenure track researchers break the mold, the profession will rebuild. I hope.

Problem #2. Talented researchers, early in their tenure careers or currently registered in Ph.D. programs, need incentives and professional support to publish alternative views in top journals. It’s so easy to be shunned from the academic community; just take on an unorthodox research agenda, and bang, you’re bright and shiny career may be over before you know it. So what’s the incentive to rock the boat before establishing tenure? If tenure, by definition, is conditional on top-journal peer-refereed publications?

The new thinking must come from within the Ph.D programs. Building a base of new and sometimes controversial macroeconomic research that is accepted within the top academic community requires funding, but more importantly, a shift in the construct of the labor force. Macro Ph.D. programs across the world need restructuring and innovative teaching that includes an even stronger collaboration between student and adviser than existed before.

They say that lightning never strikes twice. Let’s hope that the economics profession avoids the second strike…this time around.

Rebecca Wilder

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Reducing household financial leverage: the easy way and the hard way

In case you haven’t noticed, I have become slightly less “optimistic” about the prospects of a sustainable U.S. recovery. I used to think that the household deleveraging story was more of a decade-long project, and the economy would cycle throughout. But recent deficit hysteria has me worried; income growth might lapse.

What differentiates this recovery from every other cycle since 1929 is the lingering debt deflationary pressures. There is a very large overhang of U.S. household financial leverage that’s going down one of two ways: the easy way, through nominal income growth, or the hard way, by default. Unfortunately, the hard way is rearing its ugly head.

The chart above illustrates private-sector financial leverage (debt burden). Not a surprise; but, the real leverage problem is in the household sector, and to a much lesser degree, the non-financial business sector. Household debt burden is the ratio of the debt stock (generally mortgages outstanding plus consumer credit) to income flow (personal disposable income), while “de-leveraging” is reducing this debt burden.

Given that the burden has a numerator (debt stock) and a denominator (income), de-leveraging can occur through either variable. As such, I see three (general) de-leveraging scenarios (See an earlier McKinsey study on the consumer for a broader discussion):

1. If there is no income growth, then households must manually pay down debt at the cost of current consumption. The consumption decline drags the economy, and some default results.

2. If income growth is positive, then the degree to which households must pay down debt at the cost of current consumption will depend on the pace of income generation. This is the most macroeconomically-benign scenario.

3. If income growth is negative, i.e., deflation, then real debt burden rises. 30-yr mortgage payments, for example, are fixed in nominal terms and become more difficult to meet as income declines. In this case, widespread default is likely.

Of course, these are just three broad categories, but I believe that my point has been made. Clearly, choice 2. is optimal. However, evidence is pointing to a de-leveraging process that is more of the 1. and/or 3. type, especially as the federal stimulus effects run dry (although I have noted before that there is room for error in the measurement of the income data).

The chart illustrates annual growth of disposable personal income minus annual growth of disposable personal income less government transfer receipts (DPI – DPIexT). The variable DPIexT proxies the personal income growth currently generated by the private sector only. Note: this is a calculated number, based on the BEA’s monthly personal income report (Excel data here). The spread has never been wider, 2.1% Y/Y DPI growth over DPIexT growth in February, spanning every recession since 1980.

The government is propping up income (as it should be). Spanning February 2009 to February 2010, DPI averaged 1.2% Y/Y growth per month, while DPIexT averaged -1.1% Y/Y per month. Further, since the onset of the recession DPIexT fell an average 0.03% M/M (over the previous month), while DPI grew 0.18% M/M.

The economy has crossed the threshold and is expanding – phew! However, without a burst of export income, it’s going to take a lot more than 123,000 private payroll jobs per month to free the economy of its fiscal crutch. (I debated whether or not to use the term “crutch” when applying it to fiscal policy because fiscal policy is not a crutch; but the metaphor works.)

Households WILL drop leverage further; it’s just a matter of how smoothly.

Rebecca Wilder

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Thoughts on the Eurozone, Greece, and the EMF

I was asked by Periódico Diagonal to answer a few questions related to the Eurozone, based on several articles that I wrote (here, here, and here). I don’t know if these will be published, but “enquiring minds want to know”. Here we go:

1. In a recent article you announced that the next cycle of crisis in Europe will be determined by the struggle for exports. Does that mean that the country which lags behind in this struggle for exports will suffer from falling wages?

Rebecca: What I meant was that the Eurozone might find itself in a “race to the bottom”. The prescript coming out of the IMF and the European Union is one of harsh and deep reductions in nominal income (wages) and prices in order to reduce relative prices enough to drive export income. Normally, downward pressure on internal prices via recession occurs alongside a sharp devaluation in the currency, where external demand pulls the economy back onto its feet. But the main problem across the Eurozone IS ITS CONSTRUCT, one currency “to rule them all”. Greece, nor any of the other GIIPS countries – Greece, Italy, Ireland, Portugal, and Spain – can devalue the currency in order to drive export growth.

The problem is that without proper export growth, the internal devaluation would more accurately take the form of “infernal devaluation”. Cuts to nominal income, wealth (via pensions), and other labor variables will restrict current consumption and aggregate spending to a point where such measures then pressure government deficits. It’s a vicious circle, not to mention a fallacy of composition to think that the aggregate can export its way out recession if wages are falling – spending, by definition, must be falling, too.

2. In this sense, the IMF´s advice is to decrease wages and promote privatization of common services. Are we facing the first IMF´s serious intervention in (¿most developed?) the North countries? In that case, what is the aim of these adjustment policies? Do you think they will benefit countries like Greece or Iceland? Or is it just a matter of financial balance and euro´s credibility?

Rebecca: The Iceland economy received IMF support in November 2008, but IMF lending comes at the cost of conditional fiscal austerity programs and macroeconomic measures, including trimming the government-funded pension system, reduced wages, and other related budget cuts. Iceland has muddled through, though, because it has something that Greece (nor any other Eurozone country) doesn’t have: a free-floating, non-convertible currency.

The Iceland case is very different from Greece (or any of the GIIPS), though, because it issued a lot of debt that is denominated in foreign currency. But nevertheless, the Iceland krona depreciated around 50% against the US dollar between July 2008 and December 2009, driving exports and reducing imports. In 2009, real GDP in Iceland fell 6.5%, the biggest drag came from government spending that shaved 12.2% off of GDP growth. However, the contribution coming from exports and imports was +14.2%, which more than offset the drag from the IMF’s “austerity measures”.

Greece doesn’t have this option, since it cannot devalue its currency. Greece can only reduce wages and prices enough to generate internal devaluation resulting in the prescribed export growth. That’s just not going to fly when the Eurozone as a whole is fighting for export income.

But worse yet, there’s a positive feedback loop here that will likely result in a debt deflation scenario, normally resulting in private-sector default. Let’s use Iceland, again, as an example. In 2009, private consumption dragged GDP growth a large 7.8%. In Greece’s case, the effect on consumption would be magnified, since without the benefit of external income generation the private sector must take a larger hit. As consumption falls, so too do tax receipts and the primary deficit rises once more – the positive feedback loop.

3. You say it is impossible for all European countries to decrease wages in order to increase exports because –we suppose- this would reduce, in some way, domestic demand and, therefore, trade within the European Union, seeming to be no other way out. How can we get out of this situation? Could it be the end of the monetary union -so that some countries prefer currency devaluation in order to gain competitiveness?

Rebecca: It probably won’t be the end of the EMU, but I wouldn’t be surprised if some countries defaulted, which then increases the likelihood of the “end of the EMU”. What we have is an unsustainable situation in the Eurozone, as key countries face “infernal devaluation”. Without an epic surge in export growth, the government austerity programs called upon by the E.U. (or the IMF) will force the private sector to accumulate debt in order to balance out the aggregate forces of income and spending. That’s just fact.

The Eurozone was built upon the premise that there would be a unified currency and an un-unified fiscal system. In order to balance the inherent fiscal challenges that come along with inherently different saving motives across the 16 EMU countries, strict rules were set in place: no government is “allowed” to run fiscal deficits in excess of 3% nor accumulate debt in excess of 60% of GDP. Countries are fined, but that didn’t stop them from hiding government obligations from the European Union via sophisticated derivative securities. In the end, you have a band-aid plan to satisfy markets so that Greece can attempt to rollover its near-term debt. This “bailout” comes with no specifics as to threshold levels that must be crossed in order to get the central E.U. players to offer support, which is no doubt by design. Nothing has changed here; no lessons learned; the Eurozone is still just as flawed as it was ten years ago.

What has now become obvious to those who did not see this coming, is that the Eurozone, in its construct, was never meant to withstand the financial contagion and ensuing global recession of 2007-2009.

4. The European media are suggesting this week that the European Union should “let Greece fall” as a sign of credibility. What do you think of this issue?

Rebecca: Unless the structure of the EMU was changed for the better, meaning fiscal consolidation, the Eurozone would be no more “credible” after the default of Greece.

5. What is your opinion concerning the possibility of creating a European Monetary Fund, which has recently come up in the news?

Rebecca: It is an awful idea and ridden with disruptive side effects. In essence, the EMF would be established to prevent sovereign default from causing contagion throughout the Eurozone. If funds are dispersed immediately, the obvious result is the lop-sided power engendered to those countries that contribute, rather than borrow, from the fund. From the get-go, the EMF would generate political pressures from the creditor countries to the unduly strained debtor countries.

With such power comes abuse, as illustrated by the International Monetary Fund’s involvement during the Asian Financial Crisis. The IMF proved itself to be highly intrusive into local sovereignty and adopted a one-size-fits-all policy to its conditional lending programs. There is a reason that capital controls are the policy du jour in Asia, and consequently not part of the IMF’s “prescription”.

It is NOT unlikely that the same [abuse] would happen under the EMF.

Rebecca Wilder

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O.K., let’s just think about this budget thing for a while, Part I

To be sure, the U.S. government deficit is shocking; but it’s not anymore shocking than the recession through which we have all lived. Tax receipts plummeted (see the second chart from this post) and spending on cyclical social programs (like unemployment benefits) is surging. This adds up to an exponentially rising budget deficit, and thus an increasing debt burden.

The resulting hysteria leads to headlines like that from Reuters on March 11, 2010: “Fed’s Dudley: Waiting to fix fiscal problems risky”.

Be very careful when reading these articles, as the title implies that William Dudley, president of the New York Federal Reserve Bank, is advocating “fixing fiscal problems” right now – cutting spending and/or raising taxes now – while that is not the case at all. According to Reuters, Dudley says:

The issue, Dudley said, is not fiscal stimulus, which he noted had been necessary in the United States to stabilize the economy, even though it drove up the deficit. That spending is temporary, he added. The bigger long-term problem for the United States and other advanced economies is structural deficits — those likely to persist absent changes in tax and spending policies.

A link to Dudley’s speech. He does refer to structural deficits that may result from recent countercyclical policy. However, these long-term structural deficits have essentially nothing to do with the current downturn, in my view. In fact the effects of the current deficits are simply a speed bump on the road to structural indebtedness.

Just look at the CBO’s extended-baseline projection for the long-term budget published in June 2009.

This above scenario projects the spending share on social security, Medicare and Medicaid, and Other Federal Noninterest Spending through the medium and long term under current law. Notice the blip that is 2009 and 2010?

What is key to this outlook is the assumption on economic growth and productivity trends (among others, of course!). GDP is assumed to grow an average 2.2% per year. I didn’t delve into this full report and conduct a full alternative scenario test. But it is pretty clear that GDP growth of anything less than 2.2% (on average) – holding all else equal, of course – would have a deleterious impact on the outlook for government financing.

Japan provides a perfect case study of what not to do when the economy is recovering from a financial crisis: raise taxes too soon. You do that, and the probability of a “lost decade” rises quickly. You suffer a lost decade, and the outlook on the structural budget looks a lot worse than that illustrated above.

Marshall Auerback has argued time and time again that the government should run deficits until private saving adjusts so that the economy can stand on its own two feet, i.e., grow. As long as the currency floats and is fully non-convertible, the government’s debt burden will not become a solvency issue. Hence, his interview titled fighting deficit hysteria.

I would say, rather, that the deficit hysteria is appropriate, but very much misallocated intertemporally toward the short-term outlook.

Part II coming to a post near you!

This article is crossposted with News N Economics

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