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

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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Get ready for a little EM inflation

Today I was thinking about tightening cycles in emerging markets; and more specifically, about that in China. Because let’s face it, China matters. China matters to the rest of Asia via competition for export income. China matters to Europe via competition for jobs. China matters to Brazil via domestic production via imports. China matters.

The inflation pressures are building in key emerging economies, especially in the BIICs (Brazil, India, Indonesia, and China) – see this previous post regarding my new acronym, and this article at the Curious Capitalist (curiously posted just shortly after my post), which leaves my omitted “R” but relays the intuition behind the second “I”.

Although the inflation is not prevalent in any BIIC except India, really, I wanted to comment about why it will build…quickly.

First round, the construction of consumer prices is heavily weighted toward food and energy costs across the BIICs. Indonesia, India, and China are highly susceptible to food price shocks (either driven by shortages or demand growth). Expect this as a first-round driver of inflation as the global economy recovers further. It’s already happening.

Second round, the BIICs are growing quickly and nearing, or are already at, potential. Annual industrial production growth has recovered or surpassed its pre-crisis rate in China, Brazil, and India, 19%, 16%, and 17%, respectively. This is expected, given the drop-off in world trade (an illustration can be found from this May 2009 pos), but unsustainable as the output gap closes.

Third round, interest rate differentials. This year, the BIICs’ central banks are expected to raise policy rates. In fact, Brazil, China, and India have already boosted reserve requirements. But with US rates expected to stay low for an “extended period”, international interest rate differentials will change and monetary flows will shift. Capital inflows can lead to inflation if not properly sterilized.

To date, inflows are not properly sterilized, as evidenced by the ongoing accumulation of reserves and rising money supply growth (again, I refer you to my previous post on M1 growth rates.

The chart above illustrates the one-year-ahead nominal interest-rate differential between the 2yr forward government rate for each respective BIIC country versus the 2 yr forward US Treasury rate. The forward differentials for China and India are on a steady upward trajectory, while those for Brazil and Indonesia are simply steady. I believe that this appropriately represents the sterilization efforts and monetary policy management on the part of the BIICs’ central banks: more managed in Brazil and Indonesia, not as much in China and India.

So where does this analysis leave us? With a very interesting policy mix in the emerging market space. In fact, in my view this is the riskiest part of the emerging market cycle: the recovery. If policymakers get this wrong, we could see a lot of price action, final goods and assets alike, on the horizon.

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It Takes Two to Tango: A Look at the Numerator AND Denominator

This is a guest contribution by Marshall Auerback, Braintruster at the New Deal 2.0

by Marshall Auerback

A new book by Kenneth Rogoff and Carmen Reinhart, “This Time It’s Different: Eight Centuries of Financial Follies”, has occasioned much comment in the press and blogosphere (see here and here)

The book purports to show that once the gross debt to GDP ratio crosses the threshold of 90%, economic growth slows dramatically.

But that’s too simplistic: a ratio is just a number. Debt to GDP is a ratio and the ratio value is a function of both the numerator and denominator. The ratio can rise as a function of either an increase in debt or a decrease in GDP. So to blindly take a number, say, 90% debt to GDP as Rogoff and Reinhart have done in their recent work, is unduly simplistic. It appears that they looked at the ratio, assumed that its rise was due to an increase in debt, and then looked at GDP growth from that period forward assuming that weakness was caused by debt instead of that the rise in the ratio was caused by economic weakness. In other words, they have the causation backwards: Deficits go up as growth slows due to the automatic countercyclical stabilizers.They don’t cause the slow down, etc.

After the Second World War, the debt ratio came down rather rapidly—mostly not due to budget surpluses and debt retirement but rather due to rapid growth that raised the denominator of the debt ratio. By contrast, slower economic growth post 1973, accompanied by budget deficits, led to slow growth of the debt ratio until the Clinton boom (that saw growth return nearly to golden age rates) and budget surpluses lowered the ratio.

From 1991 through 2001 the growth of government debt had been falling and since then rising most recently at a faster pace. The raw data comes courtesy of the St. Louis Fed (and attached spreadsheet).

The Ratio of the rates of change of Debt / GDP is rising faster than the change in Debt indicating that both the increase in Debt and the fall in GDP are contributing to a rising Debt / GDP ratio. For policy makers who obsess about a rising Debt / GDP ratio, they fail to understand that austerity measures that cut GDP growth will cause a rise in the Debt to GDP ratio. Basically, it boils down to this simple observation: it is foolish, dangerous, and thoroughly counterproductive to treat fiscal balances in isolation. In particular, setting a fiscal deficit to GDP target equal to expected long run real GDP growth in order to hold public debt/GDP ratios at a completely arbitrary (indeed, literally pulled out of thin air) public debt to GDP ratio without for a moment considering what the means for the feasible range of current account and domestic private sector financial balance is utterly nonsensensical.

It is crucial that investors and policy makers recognize and learn to think coherently about the connectedness of the financial balances before they demand what is being currently called fiscal sustainability. As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further private sector debt destabilization. To put it bluntly, if the private sector continues to pursue a high net saving/financial surplus position while fiscal retrenchment is attempted, unless some other bloc of nations becomes large net importers (and the BRICs are surely not there yet), nominal GDP will fall in the fiscally “sound” nations, the designated fiscal deficit targets WILL NEVER BE ACHIEVED (there can also be a paradox of public thrift), and private debt distress will simply escalate.

In fact, if austerity measures are based on measures of debt relative to economic growth there is a very real risk of a downward spiral where economic growth declines at a faster pace than government debt and the rising Debt / GDP ratio leads to ever greater austerity measures. At a minimum, focusing only on the debt side of the equation risks increasing the Debt / GDP ratio that is the object of purported concern is likely to lead to policy incoherence and HIGHER levels of debt as GDP plunges. The solution is to recognize that the increase in the ratio is in some fair measure the result of declining economic growth and that only by increasing economic growth will the ratio be brought down. This may cause an initial rise in the ratio because of debt financing of fiscal stimulus but if positive economic growth is achieved the problem should be temporary. The alternative is to risk a debt deflationary spiral that will be much more difficult (and costly) to reverse.

This article is crossposted with News N Economics

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The endgame for Europe: wage cutting and the battle for exports

Yesterday I argued that Latvia’s cost-cutting efforts are evident compared to a cross-section of European Union countries. Latvia’s efforts, while commendable, were very much a function of the emergency IMF loan in December 2008 and the ensuing recession in 2009.

After an email exchange with Marshall Auerback, and thinking more about the cross-section of Europe, I now see a very scary trend emerging across Europe: the fight for exports.

To be sure, Latvia’s efforts are of note, as the acceleration in hourly labor costs dropped from a 22% pace spanning 2007-2008 to just 2.8% in the first three quarters of 2009 compared to the same period in 2008 (the Eurostat data are truncated at Q3 2009).

But look at the similar wage-cutting behavior occurring across the European Union, especially in the Eurozone hopefuls (Latvia, Lithuania, and Estonia are preparing to adopt the euro in coming years).

The battle for exports has begun. Compared to the same period in 2008, Q1-Q3 2009 annual hourly labor costs growth are down 4.9% in Lithuania, 0.8% in the U.K., and 0.5% in Estonia. In fact, every country across the 26 countries listed except Belgium, Germany, Greece, and Spain, saw the rate of hourly wage growth decrease since 2008. The currency is pegged, so the only mechanism to increase external competitiveness is through price (wages) declines. To be sure, this growth model cannot work for the Eurozone as a whole.

Latvia’s model: drop wages to increase export income. Greece: drop wages to increase export income. France, Germany, Spain, Portugal, etc., etc. It’s impossible that the whole of the Eurozone will drop wages to increase export income. It’s especially bad for countries like Latvia or Hungary, where the lion’s-share of trade occurs withing the boundaries of Europe.

And what happens when export income does not provide the impetus for aggregate demand growth? Well, there’s not much left. Can’t devalue the currency (via printing money), and tax revenues will fall faster than a ten-pound weight: rising deficits; rising debt; rising debt service (via surging credit spreads). Sovereign default seems like a near-certainty somewhere in the Eurozone!

This article is crossposted at News N Economics

Rebecca Wilder

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