Relevant and even prescient commentary on news, politics and the economy.

The hourless recovery

There was an interesting blog post over at the Macroblog (Atlanta Fed) regarding productivity. John Robertson and Pedro Silos highlight the contributions to GDP growth from various factors, including productivity and employment. One of their findings:

As this chart shows, relatively high labor productivity growth during a recession is not a phenomenon isolated to the 2007–09 and 2001 recessions (for present purposes, the end of the most recent recession is identified with the trough in GDP in the second quarter of 2009). All recessions from WWII through 1970 also featured sizable growth in labor productivity.

The article focuses on the contribution of productivity gains to GDP growth during a recession and the early stages of the recovery. The authors do not comment on, however, a very interesting bit of their story: the “hourless” recovery. Lockhart speaks of this curtly in his speech – the focus of the macroblog article:

Current data on the use of part-time workers suggest that businesses have some scope to increase hours without hiring new full-time employees.

The precipitous drop in hours worked has differentiated this labor downturn from previous cycles (papers here and here). According to the BLS Q1 2010 productivity report, the recovery of the 2007-2009 recession has so far been “hourless”, which is consistent with the previous two cycles.

The chart illustrates the contributions to output growth from hours and productivity for the the first three quarters of recovery spanning the last six recessions. Note: the current recession has not officially been dated as having ended, but June or July 2009 is the “whisper” talk for now. I will simply call Q3 2009 as the onset of the recovery, since GDP grew that quarter.

The “hourless recovery” is underway: a cumulative 3.3% of output has been generated over the last three quarters (using the BLS productivity report) via a 0.9% drop in aggregate hours. I argued last year that adding back hours cannot generate sufficient output growth for sustainable “recovery”; however, productivity growth has been strong enough that the productive hours cycle has not even begun.

It’s likely that the large service sector is the drag that is driving the “hourless” recovery because manufacturing hours are red hot.

(The weekly hours series are indexed to 100 for comparison.)

The chart illustrates average weekly hours of production and nonsupervisory workers in manufacturing and private industry payroll. Manufacturing weekly hours, 41.5 hours per week in May 2010, recovered 5% off the low of 39.4 hours in March 2009. Furthermore, May 2010 set a ten year record, breaking past levels not seen since July 2000 (not shown in chart but you can see it here). In contrast, total private weekly hours remain below pre-recession levels, just 1.5% off of the June 2009 low, 33.0 hours.

The BLS breaks down average weekly hours for all workers by industry since 2006. The service sector is the lion’s share of the private payroll (~85%). Of the service sector payroll, 68% remains short of pre-recession weekly hours worked: trade, transportation, and utilities, professional and business services, and education and health services.

Adding hours still won’t provide a large growth impetus, as I argued here; however, the service industry has yet to see the burst in hours like in manufacturing. As such, I agree with the overall conclusions of the Robertson and Silos article:

Hence, it will probably take awhile to see how President Lockhart’s forecast of continued modest employment growth pans out.

Rebecca Wilder

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It’s not hard to understand why Asia’s worried about Europe

On the forefront of the Chinese economic releases this week was the trade data, where headlines shouted +48.5% Y/Y export growth in May. This report didn’t go unnoticed in Washington, as renewed obsessions with the Chinese peg against the US dollar fired up again.

But the Chinese release overshadowed the Philippines April trade report, which in my view, illustrates more transparently the slowdown in external demand that is likely underway across the region. In the Philippines merchandise exports increased 27.4% over the year in April, which was half the rate of the Bloomberg consensus and that in March, 42.7% and 43.8%, respectively.

A negative export growth trend has been established – explicitly in the Philippines and likely going forward in China (see Goldman Sachs report below). And these countries have strong trade ties with Europe – the Eurozone was 15% of 2009 world GDP (PPP value) according to the IMF.

Therefore, recent nominal appreciation of the Philippine peso and Chinese yuan against the euro, and expected real appreciation – Europe’s self-imposed economic contraction stemming from harsh fiscal austerity measures will drag prices downward – may very well hamper the economic recovery for key Asian economies via the export channel.

Export growth in the Philippines has been slowing to top trading partners.

The chart illustrates the contribution to overall export growth from the Philippines six largest trading partners – together these countries account for roughly 50% of total exports. The contributions to the Philippines export income growth has been slowing or flat for some time to China, Singapore, and Germany. Slightly more worrisome is the Netherlands contribution having turned negative for two consecutive months.

The Netherlands and Germany account for roughly 13% of total export demand from the Philippines. The euro has depreciated 8% against the Philippine peso since April 2010 (through June 11 and see chart below), and the lagged effects of the nominal depreciation will continue to pass through to exports.

In China, though, a resurgence of export growth among its top trading partners bucks the trend seen in the Philippines.

The chart illustrates the contribution to overall export growth from China’s six largest trading partners – again, these countries jointly demand roughly 50% of total Chinese exports. China’s May report was indeed strong: the US added a large +8.3pps to overall Chinese export growth in May, and Hong Kong contributed another robust +6.2pps of growth. In contrast to the Philippines April numbers, The Netherlands contribution to Chinese export growth remained strong, contributing 1.5pps in May.

Chinese exports are quite volatile in the beginning of the year. I suspect that Yu Song and Helen Qiao at Goldman Sachs are right, that export growth will initiate its trend downward starting in June:

“We believe the very strong exports growth in May is likely to be a temporary phenomenon, much like the very weak exports data recorded in March, and expect June data to show a visible normalisation,” said Yu Song and Helen Qiao at Goldman Sachs.

In their Goldman report (no link) Yu Song and Helen Qiao argued that the Chinese numbers remain clouded by the following distortions:

  • “The exports acceleration was likely to be partially induced by a potential cut to the export VAT rebate for some commodity exports: There have been a number of domestic news reports that this might happen soon as a part of the broader policy package to reduce pollution and energy consumption.
  • But it probably also reflected changes in the domestic economy: Our proprietary GS Commodity Price Index (GSPCC) (Bloomberg ticker: ALLX GSCP) suggest that the domestic prices of main commodities have been mostly trending down in May which might have encouraged more exports in this area.
  • Strong export activities might also be impacted by the Lunar New Year effects as many exporters resumed production after taking time off during the holiday season which often last for weeks. [although they say this cannot be validated until a further breakdown becomes available later this month].”

The recent nominal depreciation of the euro against the Chinese yuan and the Philippine peso, 11% and 8%, respectively, since April 1 2010, will pass through to both Chinese and Philippine exports at a lag. And further real depreciation – the nominal exchange rate adjusted for relative prices of goods and services – of the euro against the yuan and the peso is almost certain. Europe’s self-imposed fiscal austerity measures will crimp economic growth and deflation is bound to take over across Europe and relative to Asia.

As such, recent external shocks from Europe will likely show up Chinese and Philippine trade data in coming months. Doesn’t look good for Asia, especially for those economies like the Philippines and China for which exports provide a robust growth impetus.

We’re nowhere NEAR out of the woods yet.

Rebecca Wilder

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The United Kingdom Draws the Wrong Lessons from Canada

by Roosevelt Institute Senior Fellow and Braintruster Marshall Auerback at the New Deal 2.0

For once, Canada is making the news for the wrong reasons. The United Kingdom has braced the country for cuts in government spending up to 20 percent as the new Conservative-Liberal Democrat coalition lays the groundwork for an austerity program to last the whole parliament. Their inspiration? According to The Telegraph, Prime Minister David Cameron’s administration hopes to draw lessons from the experiences of the Canadian Government of the 1990s. Before too much damage is done, we suggest they’d better re-read the history books a bit more closely.

The standard narrative of the Canadian experience in the 1990s is this: in 1993, Canada’s budget deficit and debt-to-GDP ratios were the second highest amongst the G7 countries, after Italy’s, and the US financial press was unfavorably comparing Canada to Mexico. That year, with the IMF supposedly lurking at the door, the Liberal Government of Prime Minister Jean Chretien, and his Finance Minister, Paul Martin, laid out a goal to halve the budget deficit to three percent by 1998, with an unannounced goal of a zero deficit by 2000. Martin began cutting costs significantly in 1994, chopping 10 percent from department budgets and converting a deficit equal to nearly 7 percent of gross domestic product into a surplus by 1997. By 1998, the deficit was eliminated and overall debt was dropping quickly, amidst a rapidly growing economy.

Success, correct? Certainly, this narrative has largely gone unchallenged (even in Canada). It has metamorphosed into received wisdom and has been used by many to justify a renewed assault on the welfare state. It is argued that the impact of Chretien government’s cuts in public spending allowed Canada to get through the Asian crisis with little damage and to go on to become one of the strongest Western economies.

And this is the lesson drawn by the British government. Hence, the remarks of the Chancellor of the Exchequer, George Osborne, who yesterday announced an unprecedented four-year spending review. According to Osborne, every Cabinet minister will have to justify, in front of a panel of colleagues, every pound they spend. He said the task ahead represented “the great national challenge of our generation” and that after years of waste, debt and irresponsibility it was time to bring public spending under control, guided by the principle that people should ask “what needs to be done by government and what we can afford to do”.

The Canadian experience certainly makes for an interesting story, although we suspect that the IMF threat was significantly overstated. In 1995, Canada had a debt to GDP ratio that was around half of that of Italy and Belgium. Yet curiously, those countries were never deemed to be ready-made victims for the Fund’s Little Shop of Horrors, even as Canada was supposedly threatened with the prospect of becoming a ward of the IMF a la the United Kingdom in 1976. In truth, the IMF threat represented yet another in a series of manufactured crises that enabled longstanding opponents of government spending to muscle through budget cuts in vital and politically popular social programs.

The reality is somewhat more complex, as Professor Mario Seccareccia of the University of Ottawa has noted in a paper entitled, Whose Canada? Continental Integration, Fortress North America, and the Corporate Agenda (pp. 234-58). In the paper, Seccareccia noted the real reasons for the “success” of the Chretien/Martin austerity programs:

1. High growth in the US, Canada’s largest trading partner, a sharply declining Canadian dollar (which fell as low as .62 cents against the greenback), and the implementation of the North American Free Trade Agreement (NAFTA), all of which combined to push the export sector’s share of Canadian GDP to 45% by 2000 (now about 33%), and
2. An expansionary monetary policy which did significantly stimulate consumer spending, and which was sustained until the financial crisis.

The turnaround emerged despite the fact that investment remained weak relative to historic economic recoveries. But the massive turn in the country’s external sector was largely made possible through a revival of growth in the US (Canada’s largest trading partner). The stock market boom in the US, the high tech bubble, and the beginnings of the American real estate boom created huge demand for Canadian exports, which largely drove Canada’s recovery. (All of which were fueled by huge increases in US private debt growth, another malign effect of the Clinton budget surpluses.) If anything, this vast improvement in Canada’s external account largely offset the deflationary impact of the fiscal austerity which, in any case, likely impeded, rather than facilitated, economic recovery, given the slashing of employment insurance and social welfare benefits.

The other byproduct of this Canadian “budget miracle” was the increasing indebtedness of the Canadian private sector, a phenomenon mirrored in the US by the Clinton Administration, which repeatedly recorded budget surpluses in the late 1990s. Again, this is no surprise to those of us who adopt the financial balances approach, but it does give a fuller (and less flattering) picture of the ultimate impacts of eliminating Canadian “fiscal profligacy”.

The chart above highlights the importance of Canada’s restrictive fiscal policy in pushing the household sector balances increasingly into the red until the financial crisis of 2008 (also accompanied by a massive increase in the Canadian budget deficit, which almost certainly cushioned the impact of the crisis in Canada).

In any event, Canada’s export boom of the 1990s is a miracle that could certainly not be repeated today, given the decline in global economic growth, and the extent to which the ailing manufacturing exports sector is now being hammered by the so-called “Dutch disease” as a consequence of the Canadian dollar’s relative strength.

By the same token, the United Kingdom would hardly do any better today, given global recessionary pressures and the corresponding implosion of its largest export markets in Europe and the US. If Prime Minister David Cameron is indeed preparing Britons for a Canadian-style attack on the deficit, he is acting on the basis of profoundly misguided historical information. Canada’s growth was largely stock market bubble-driven, so both the US budget surpluses and the Canadian miracle were based on a one-off fluke. From the sector balances approach, we know that unless you get something like one of the biggest bubbles of all time in your own economy or in a major trading partner’s, don’t count on recovery in the face of fiscal retrenchment. The UK government’s current monomaniacal fixation on deficits and its simplistic reading of Canadian history will do nothing more than cut back on vital stimulus that has cushioned the UK from a far greater disaster, all to satisfy the loons in the conservative press and some threatening types in ratings agencies . Not only would a Canadian-style fiscal assault be a nonsensical short-run strategy, given the debt levels the UK private sector is carrying at present, it would not be a sustainable growth policy in the medium-term. Eventually, the private balance sheets would become too fragile and households would attempt to increase saving even further. This would reduce aggregate demand further and income adjustments would force the public balance into an even larger deficit and set the deficit hawks toward cutting government spending with an even greater sense of urgency. The Canadian experience teaches us very little. There is never a case for fiscal austerity in periods of cyclical weakness unless you can recreate the conditions of a financial bubble. But aren’t we paying the price for that today?

Posted with author’s permission from the New Deal 2.0.

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China’s not the answer for the Eurozone

by Rebecca

“Go long whatever Chinese consumers buy and go short Chinese capital spending (construction) plays. Consistently, go long tech/short material stocks.”

That is the first sentence of a BCA Research report’s executive summary on China equity strategy (link not available). Rather than a global equity strategy, I’d like to put this into an economic growth context via trade…and with Europe.

Go long Eurozone economies selling to China? Is China the panacea for Eurozone growth? Short answer is no, but we’ll attend to that later. Even if the euro wasn’t selling off against the majors, China’s domestic demand is robust and export income is flowing into the Eurozone – but to where?

The chart below illustrates the dynamics of annual export growth to China for the top 6 countries of the Eurozone measured by GDP in 2009: Germany, France, Italy, Spain, Netherlands, and Belgium. Presumably, the bulk of China’s export demand would flow to these countries.

Since the Eurozone’s annual export growth to China bottomed out in May 2009, many of the Eurozone economies (some not shown in chart) have registered, on average, double-digit monthly export growth to China: Belgium 49% Y/Y, Germany 25%, Spain 16%, Greece 19%, Ireland 22%, Netherlands 39%, and Portugal 49%. Only Finland saw its monthly average export income drop over the same period, -10% Y/Y.

(A note of clarification: the statistics in the chart are monthly Y/Y growth rates, while the statistics in the paragraph above represent the average monthly Y/Y growth rate spanning the period May 2009 to March 2010. All of this data can be downloaded from Eurostat, EU27 Trade since 1995 by CN8).

But 75% of the Eurozone’s exports to China flow from just three countries: Germany, 54%, France, 11%, and Italy 10% (average Jan 2009 – Feb 2010 and see table below). This makes sense, given that Germany, France, and Italy are the three largest countries in the Eurozone.

However, compared to the size of their economies, Belgium and Germany are the true beneficiaries of China’s external demand, not Spain, France, nor Italy. And this trade data is truncated before the record decline of the euro.

The table above relates each country’s share of total Eurozone exports to China to its share of Eurozone GDP. I’d say that Belgium is doing quite well compared to its larger neighbors, +2.5% spread on a 3.8% share base. But Germany’s out of this world, 26.9% spread on a 26.8% share base. Spain, France, and Italy are faring poorly, as their spreads are wide and negative.

China appears to be the panacea for just a handful of countries, most notably Germany and Belgium. But alas, it’s no panacea for the Eurozone, not even for Germany. Unfortunately, the Eurozone’s fragile developed colleagues, the US and UK, are.

The shares illustrated in the chart are calculated for year 2009.

Markets anxiously await China’s every move; but according to the April 2010 IMF World Economic Outlook, China ran the largest current account surplus across the IMF member countries – $284 bn in 2008 – the 20th largest as a share of GDP. That kind of saving is NOT going to get the global economy back on its feet in full very quickly. China is not the answer for Europe.

The Eurozone, in particular, is paying close attention to non-Eurozone (16 countries adopted the euro as their currency) growth alternatives. I leave you with an excerpt from a nice FT article on Europe’s true woes – fiscal austerity measures – featuring the research of Wynne Godley and Rob Parenteau:

Many years ago, he [Wynne Godley] also criticised the institutional arrangements of the European Monetary Union. Writing in The Observer in August 1997, he noted that members of the eurozone were not only giving up their currencies but also their fiscal freedom. Within the union, a government could no longer draw cheques on its own central bank but must borrow in the open market. “This may prove excessively expensive or even impossible,” he warned.

He went on to caution that without a common European budget, there was a danger that “the budgetary restraint to which governments are individually committed will impart a disinflationary bias that locks Europe as a whole into a depression that it is powerless to lift”.

China is not the answer: not for Europe; not for the US; and not for the UK.

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Marshall Auerback is a Roosevelt Institute Senior Fellow and Braintruster at the New Deal 2.0.

By Marshall Auerback

To paraphrase Shakespeare, things are indeed rotten in the State of Denmark (and Germany, France, Italy, Greece, Spain, Portugal, and almost everywhere else in the euro zone). An entire continent appears determined to commit collective hara kiri, whilst the rest of the world is encouraged to draw precisely the wrong kinds of lessons from Europe’s self-imposed economic meltdown. So-called respectable policy makers continue to legitimize the continent’s fully-fledged embrace of austerity on the allegedly respectable grounds of “fiscal sustainability”.

The latest to pronounce on this matter is the Governor of the Bank of England, Mervyn King. This is a particularly sad, as the BOE – the Old Lady of Threadneedle Street – has actually played a uniquely constructive role amongst central banks in the area of financial services reform proposals. King, and his associate, Andrew Haldane, Executive Director for Financial Stability at the Bank of England, have been outspoken critics of “too big to fail” banks, and the asymmetric nature of banker compensation (“heads I win, tails the taxpayer loses”). This stands in marked contrast to America’s feckless triumvirate of Tim Geithner, Lawrence Summers, and Ben Bernanke, none of whom appears to have encountered a banker’s bonus that they didn’t like.

But when it comes to matters of “fiscal sustainability” King sounds no better than a court jester (or, at the very least, a member of President Obama’s National Commission on Fiscal Responsibility and Reform). In an interview with The Telegraph, the Bank of England Governor suggests that the US and UK – both sovereign issuers of their own currency – must deal with the challenges posed by their own fiscal deficits, lest a Greece scenario be far behind:

“It is absolutely vital, absolutely vital, for governments to get on top of this problem. We cannot afford to allow concerns about sovereign debt to spread into a wider crisis dealing with sovereign debt. Dealing with a banking crisis was bad enough. This would be worse.”

“A wider crisis dealing with sovereign debt”? Anybody’s internal BS detector ought to be flashing red when a policy maker makes sweeping statements like this. The Bank of England Governor substantially undermines his own credibility by failing to make 3 key distinctions:

  1. There is a fundamental difference between debt held by the government and debt held in the non-government sector. All debt is not created equal. Private debt has to be serviced using the currency that the state issues.
  2. Likewise, deficit critics, such as King, obfuscate reality when they fail to highlight the differences between the monetary arrangements of sovereign and non-sovereign nations, the latter facing a constraint comparable to private debt.
  3. Related to point 2, there is a fundamental difference between public debt held in the currency of the sovereign government holding the debt and public debt held in a foreign currency. A government can never go insolvent in its own currency. If it is insolvent as a consequence of holdings of foreign debt then it should default and renegotiate the debt in its own currency. In those cases, the debtor has the power not the creditor.

Functionally, the euro dilemma is somewhat akin to the Latin American dilemma, such as countries like Argentina regularly experienced. The nations of the European Monetary Union have given up their monetary sovereignty by giving up their national currencies, and adopting a supranational one. By divorcing fiscal and monetary authorities, they have relinquished their public sector’s capacity to provide high levels of employment and output. Non-sovereign countries are limited in their ability to spend by taxation and bond revenues and this applies perfectly well to Greece, Portugal and even countries like Germany and France. Deficit spending in effect requires borrowing in a “foreign currency”, according to the dictates of private markets and the nation states are externally constrained.

King implicitly recognizes this fact, as he acknowledges the central design flaw at the heart of the European Monetary Union – “within the Euro Area it’s become very clear that there is a need for a fiscal union to make the Monetary Union work.”

This is undoubtedly correct: To eliminate this structural problem, the countries of the EMU must either leave the euro zone, or establish a supranational fiscal entity which can fulfill the role of a sovereign government to deficit spend and fill a declining private sector output gap. Otherwise, the euro zone nations remain trapped – forced to forgo spending to repay debt and service their interest payments via a market based system of finance.

But King then inexplicably extrapolates the problems of the euro zone which stem from this uniquely Euro design flaw and exploits it to support a neo-liberal philosophy fundamentally antithetical to fiscal freedom and full employment.

The Bank of England Governor – and others of his ilk – are misguided and disingenuous when they seek to draw broader conclusions from this uniquely euro zone related crisis. Think about Japan – they have had years of deflationary environments with rising public debt obligations and relatively large deficits to GDP. Have they defaulted? Have they even once struggled to pay the interest and settlement on maturity? Of course not, even when they experienced debt downgrades from the major ratings agencies throughout the 1990s.

Retaining the current bifurcated monetary/fiscal structure of the euro zone does leave the individual countries within the EMU in the death throes of debt deflation, barring a relaxation of the self-imposed fiscal constraints, or a substantial fall in the value of the euro (which will facilitate growth via the export sector, at the cost of significantly damaging America’s own export sector). This week’s €750bn rescue package will buy time, but will not address the insolvency at the core of the problem, and may well exacerbate it, given that the funding is predicated on the maintenance of a harsh austerity regime.

José Luis Rodríguez Zapatero, Spain’s Socialist prime minister, angered his trade union allies but cheered financial markets on Wednesday when he announced a surprise 5 per cent cut in civil service pay to accelerate cuts to the budget deficit.

The austerity drive – echoing moves by Ireland and Greece – followed intense pressure from Spain’s European neighbors, the International Monetary Fund on the spurious grounds that such cuts would establish “credibility” with the markets. Well, that wasn’t exactly a winning formula for success when tried before in East Asia during the 1997/98 financial crisis, and it is unlikely to be so again this time.

Indeed, in the current context, the European authorities are simply trying to localize the income deflation in the “PIIGS” through strong orchestrated IMF-style fiscal austerity, while seeking to prevent a strong downward spiral of the euro. But the contradiction in this policy is that a deflation in the “PIIGS” will simply spread to the other members of the euro zone with an effect essentially analogous to that of a competitive devaluation internationally.

The European Union is the largest economic bloc in the world right now. This is why it is so critical that Europeans get out of the EMU straightjacket and allow government deficit spending to do its job. Anything else will entail a deflationary trap, no matter how the euro zone’s policy makers initially try to localize the deflation. And the deflation is almost certain to spread outward, if sovereign states such as the US or UK absorb the wrong lessons from Greece, as Mr., King and his fellow deficit-phobes in the US are aggressively advocating.

There are two direct contagion vectors off the fiscal retrenchment being imposed on the periphery countries of the euro zone.

First, to the banking systems of the periphery and the core nations, as private loan defaults spread on domestic private income deflation induced by the fiscal retrenchment. Second, to the core nations that export to the PIIGS and run export led growth strategies. So 30-40% of Germany’s exports go to Greece, Italy, Ireland, Portugal and Spain directly, another 30% to the rest of Europe.

These are far from trivial feedback loops, and of course, the third contagion vector is to rest of world growth as domestic private income deflation combined with a maxi euro devaluation means exporters to the euro zone, and competitors with euro zone firms in global tradable product markets, are going to see top line revenue growth dry up before year end.

Let’s repeat this for the 100th time: the US government, the Japanese Government, or the UK government, amongst others, do NOT face a Greek style constraint – they can just credit bank accounts for interest and repayment in the same fashion as if they were buying some helmets for the military or some pencils for a government school. True, individual American states do face a fiscal crisis (much like the EMU nations) as users of the dollar, which is why some 48 out of 50 now face fiscal crises (a problem that could easily be alleviated were the US Federal Government to undertake a comprehensive system of revenue sharing on a per capita basis with the various individual states). But, if any “lesson” is to be learned from Greece, Ireland, or any other euro zone nation, it is not the one that Mr. King is seeking to impart. Rather, it is the futility of imposing arbitrary limits on fiscal policy devoid of economic context. Unfortunately, few are recognizing the latter point. The prevailing “lesson” being drawn from the Greek experience, therefore, will almost certainly lead the US, and the UK, to the same miserable economic outcome along with higher deficits in the process. As they say in Europe, “Finanzkapital uber alles”.

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Greece – GIIPS – Eurozone – Big Problem

O.K., Greece is now “high yield”, “junk”, “below investment grade”, at least according to S&P. What I mean by that is S&P now rates Greece’s foreign and local currency sovereign debt at the BB+ level (with a negative outlook), below the sometimes-coveted investment grade status, BBB- is the minimum. Why did S&P feel the need to do this now? Just covering its _ss – Greek debt was rated A- as recently as December 2009.

On to the Germans. What they are doing is actually quite striking: offering a bailout in order to appease markets so that international investors will pick up the Greek bill (never was going to happen anyway); and then telling markets that bond investors in Europe will take a haircut so that international investors won’t pick up the Greek bill. I guess the light-bulb finally went on that there is a contagion brewing here because bunds are tight, while all Peripheries are wide.

The original bailout will likely be offered to satisfy Greece’s near-term obligations. However, in the meantime the probability that the liquidity crisis spreads across the GIIPS (Greece, Italy, Ireland, Portugal, and Spain) – especially Portugal with a 2009 current account deficit equal to 10.3% of GDP, making it shockingly susceptible to capital outflows – is rising.

We’re in crisis mode – the calm before the storm. I see the Eurozone disaster happening in three waves:

First, there is a liquidity crisis in Greece (already underway).

Second, it turns into a full-fledged financial crisis for the GIIPS. The capital account drops precipitously with investor confidence in GIIPS markets, leaving the very vulnerable countries, like Portugal and Spain with current accounts very much in the red, seriously short of cash.

What Germany wants out of Greece (and any bailout thereafter) is the equivalent of an economic anaconda. It will force Greece to meet the limits of the EMU Stability and Growth Pact (3% of GDP) by some period, let’s say 2012.

Of course that cannot happen without an epic surge in exports. Here’s the death spiral: sharp austerity measures translate into unemployment, economic contraction, deflation, and yes, higher deficits. There’s just no way out of it.

So what is the be all and end all policy script? Regain competitiveness in world markets, no less. The Economist on Portugal:

Low growth reflects a disastrous loss of competitiveness since the country joined the euro. Portugal has lost export-market share to emerging economies (including those of eastern Europe) that churn out similar low-value products. This is largely due to a steady rise in unit labour costs, as wage increases outstripped productivity growth (see chart).

The IMF’s consultation on Italy, as per its latest Article IV report:

Economic rigidities, along with Italy’s specialization in products with relatively low value added, have also been contributing to a steady erosion of competitiveness. Consequently, Italy has been losing its market share of world trade.

And my favorite part of the Italy Article IV:

In the past, other countries have overcome similar challenges from very difficult starting positions with comprehensive policy packages.

Note the very incriminating term, “comprehensive”. That usually includes expansionary monetary policy and the depreciation of a currency to drive export income, both of which elude any of the GIIPS countries.

The Economist portrays Portugal’s path away from depression-land via export income by lowering ridiculously high labor costs (i.e., productive labor as measured by the unit labor cost index) relative to those in Germany. As such, Portugal should be able to pick up exports while the government drops the deficit and constricts domestic demand. Notice the catchy title!

But what they fail to illustrate is the fact that all of the GIIPS are in EXACTLY THE SAME UNCOMPETITIVE BOAT!

So we get to the final stage, GIIPS go depressionary, and the economic contagion spreads across the Eurozone, hitting yes, Germany. Notice that Ireland is the only GIIPS with a fighting chance, according to the Eurostat’s forecast.

I’m married to a German – I understand stubbornness. But this time, being stubborn is just going to get the Germans in trouble.

The GIIPS are 34% of Eurozone GDP – try to export your way out of that one when 1/3 of the “Zone” is reducing costs and cutting wages. It’s a fallacy of composition to assume that the GIIPS are cutting spending while the aggregate remains intact. Furthermore, each EU country exports an average of 68.6% within Europe, so Germany’s clearly going to feel this, too – at least if the “Zone” gets past the immediate liquidity crisis.

Nobody talks about this – but Greece can secede from the Eurozone as per the Lisbon Treaty.

Rebecca Wilder

Update: It should be noted that Lisbon allows a country to leave the EU, of which the Eurozone is (effectively) a subset.

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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’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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