The Lost De(bt)cade

The IMF released the analytical segment of its latest WEO (the full release occurs in the second week of October before the IMF-WB meetings). Two chapters (3&4), one focussing on the debt-overhang in advanced economies, the other on the 'resilience' of emerging markets and the link to economic policies. Chapter 3 offers a country-specific analysis of debt dynamics at certain threshold levels and is historically focussed (in line with the FAD's data compilation of over a century's worth of debt data). It deals with 'episodes' as related to the sustainability factor upon crossing thresholds. Naturally, the 100% mark is frequently used as:

"First, it is most relevant today given the number of countries currently close to or above that threshold. Second, 100 percent is high relative to historical experience: only 15 percent of the observations in our advanced economy database are above 100 percent. Third, our analysis suggests that political and economic forces do not tend to exert downward pressure on debt on average until public debt reaches this level." 

Before picking on a few charts and conclusions, the basic framework of course is this:
Five variables - the stock of debt, the interest paid on this stock of debt, the inflation rate for the deflator, the real growth rate and the primary balance (ratio of GDP). So essentially - 

d(t)= ((1+i)/(1+pi)(1+g) )*d(t-1) + pb + e

where d(t) and d(t-1) is the stock of debt at time t. i is the interest paid on the stock of debt. pi is the inflation rate for the deflator, g is the real growth rate, pb is the primary balance ratio and e is the residual which accounts for accounting valuation differences and adjustments. 

For Japan, I'll try and incorporate the fiscal balance, debt, real growth and inflation into one and the bond yields and policy rate into another. Here's what they look like:

Good historical perspective on the 'liquidity trap'. The second graph shows the low borrowing costs the government has had for over a decade. This 'over-a-decade' time frame is also one characterized by the zero-bound. Japan's debt progression has been steady and unhindered (most of the debt is public). You can see two episodes of the deflationary spiral in the 90's as well as a steady stream of persistently higher fiscal deficits. What's interesting is the brief period pre-crisis when the debt dynamics stabilize accompanied by consistent 2% growth and a much-needed increase in price levels as well as a severe reduction in the deficit before slipping into recession again. 

The most interesting data comes from the actual decomposition of the debt dynamics. That is, categorizing by time-period. what percent of GDP each debt-dynamic factor contributed to the change in debt. This is what it looks like: 

Only in the '02-'07 period does growth contribute significantly to the change in debt whereas inflation has a minimal contribution during the same time frame. The consistency in the interest rates across such a long period of time is reflected in the lack of change in contribution. The '02-'07 period incidentally, is the period characterized by literally zero interest rates and low borrowing costs.

I suppose 1997 could be somewhat of a midpoint for the 'lost decade'. It's the point where Japan's debt-to-GDP ratio touched the 100% threshold and the country found itself mired in a mild deflation trap with stagnant output levels - significant repercussions of the devastating aftermath of the real estate and stock market bubble bursts. What followed immediately was near-panic monetary policy and fiscal stimulus, evidenced by a severe deterioration in the fiscal balance. The problem was that the slashing of interest rates was overshadowed by the accompanying drastically low levels of inflation and inflation expectations (The Japanese REER appreciated 60% in the early 90's!), that gives you a  sense of what happened to the nominal effective rate at those inflation levels!

The WEO says that "This episode highlights the need to deal with banking sector weakness and ensure a supportive monetary environment before fiscal consolidation can succeed."

Furthermore, "When structural weakness in the financial system prevents the normal transmission of monetary stimulus and when policy rates are constrained by the zero lower bound, the risk of anemic and fragile growth is high regardless of the fiscal setting."

There's a lot of truth, intuition as well as evidence behind that supposition. 

Despedida Espana

What's certain is that this is the last thing Spain needs right now. What's less certain is whether it can survive.

A couple of weeks ago, Catalonia's President Arturo Mas stated, "If we cannot reach a financial agreement, the road to freedom for Catalonia is open," which naturally invited a backlash from Rajoy's conservative political allies.

The Rajoy argument is essentially the issue of infighting. That during a time of serious crisis, this separatist surge is a major fundamental distraction when compared to Spain's grave needs as a sovereign. Catalan autonomy, since the '78 adoption of the constitution has after all, been a part of Spain. That may not be what Rajoy is hostile to.

The Catalan argument is simple in the short term and more abstruse over the long. During a period of prolonged austerity and sacrifice, Catalonia is disproportionately suffering far more, because the richness of Catalan as a region, requires it "to transfer up to 9% of its GDP " each year to Madrid. The autonomy issue arises over fiscal authority. They quite simply want a greater say in taxation policy.

Catalonia for the record, represents about a fifth of Spain's GDP, is the nation's most heavily indebted region and like all others, is suffering under exhaustive austerity measures forcing it to request a fresh five billion euro credit line to cover its existing maturities. Stung by a fiscal refusal from the centre, it seems to want out

Believe me, no matter how this plays out, it will be a crisis. A crisis on top of a crisis? Yes, very much so.

As it stands, Rajoy has hordes of Catch-22's on his hands. While Europe waits for him to request assistance (ECB bond-buying), he has to contend with sovereignty issues and bail-out conditions. On top of that he has angry protesters and the pressure to announce a "credible" budget which would imply...more protests!

But wait, there's more! November 25th will see snap elections where the ballot will be "seen as a de facto referendum on President Arturo Mas's demands for greater independence". 

Mas was naturally emboldened by the protests and surge in sentiment while obviously stinging from the refusal of Madrid to negotiate a change in the fiscal pact. Sounds like a risky but popular gamble to me - the vote was, after all called  two years ahead of time! 

Meanwhile, as Peter Spiegel reports from Brussels, the political eruption was amidst signs that Germany, Holland and Finland were trying to back-track on an agreement in June that would relieve Spanish bank-debt to the tune of tens of billions of euros. The statement said that "the plan to move bad bank assets would not apply to 'legacy assets' (a reference to wound-down banks under the Irish bailout program)". 

Wait. There's more. Next week, the budget will be announced and likely to have overshot budget deficit estimates in the agreement with Brussels. 

Ambrose Evans-Pritchard has a moving and sentimental piece in the Telegraph where he remembers how two weeks before he told a Catalonia newspaper how it "would be unthinkable for the Spanish state to stop Catalan secession by military force". That doing so would lead to a violation of EU treaties and thus Spain being suspended from the EU. 

Now he's not so sure. 

Colonel Francisco Alaman compared the crisis to 1936 (yes,  1936!) and stated, "Independence for Catalonia? Over my dead body". 

Hyperbole indeed, but an accurate indicator of the dangerous sentiment descending over Spain's populace. 

As the crisis digs deeper and becomes more entrenched, the focus shifts rapidly away from economics into politics and then into people. The horrible realization of the powerlessness of the government. The permanent scarring of austerity, a compounding of the debt-deflation nightmare and the reluctance to accept a fate dictated by a centre that lacks confidence. 

As I wrote earlier, on Friday Madrid will reveal its funding needs for its broken domestic banking sector. This will kick off negotiations (a euphemism for arguments!) as to how much of the ESM pledged funds will be used and where the responsibility would lie. 

Meanwhile, the sentiment and actions in the north nudge Spain towards a constitutional crisis, buoyed by a vocal and unrepentant leader. When you have approximately a million people marching for a common cause (Catalonia's population is 7.5 million), voices will be raised and anger will be directed. 

Nothing encapsulates this best (not the blame, but the sentiment!), of the Popular party's Catalan leader Alicia Sanchez-Comacho who lashed out in reply to Mas stating that he was "leading us into a very dangerous process in which civic and social co-existence will be ruptured". 

It seems like a perfect storm.

What Am I Reading?

1) In the mood for a history lesson? Noah Smith has an interesting take on Mankiw's Scientists vs Engineers macro paradigm.

2) David Glasner has a quick (sure!) response to QE bashers specifically detailing the misconception of Bernanke targeting asset prices rather than arguing that there was some correlation between the movement in stock prices and the expectations of future performance.

3) Gideon Rachman has a stern piece in today's FT on the Indian spectrum. There's an irony that while funding IMF bailouts to troubled EU economies, India's own living standards pale in comparison to Greece/Ireland etc.  "You stay sane in India by looking at the medium-term". Don't ask me who said this!

4) The best social policy is full employment? Jack Ewing has a piece in the NYT on Germany and Jobs.

5) The Big Picture has a link to charts I've been wanting to look at. Global growth rates and Equity market returns (through JPAM). A noticeable difference in the weighting pie. 

6) ...and....HARRY POTTER's BACK!! Or atleast Rowling is...

Cut That Rate!

More on the grand Indian attempt to rekindle those "animal spirits". Here are some views held by economists monitoring the RBI's monetary policy stance (which incidentally looks like this):

M3 is the y-o-y growth percentage of broad money. Both the rates are on the right axis while the WPI % yoy (This is because WPI inflation (and non-food manufactured goods component) is significantly more sensitive to international commodity prices than the typical consumer price index (CPI)-based inflation)  and M3 are on the left axis.

RGE analysis and forecasts "does not see the RBI cutting rates again until Q1 2013". Furthermore, "the decision by the RBI to go for a 50 bps rate cut in April was in anticipation of an imminent correction in diesel prices" that is only coming along now. Changes in the external scenario (impact of QE3 on commodity prices etc.) further contribute to the RBI's hawkish stance whilst simultaneously being mindful of over-tight liquidity conditions. 

Rajiv Malik, of CLSA thinks that, "the RBI was correct in leaving the repo rate unchanged, as it had already anticipated some action from the government ...A rate cut today would have made the RBI a laughing stock..."

Victor Mallet reported for the FT a week ago that the diesel price increase will ultimately not reduce the fuel bill all that much and he quotes a senior government official as saying, "what's creating the space for doing these things is a growing sense of crisis. The crisis helps you override gridlock, vested interests...there's a sense of urgency." 

That's good news, but we've known that all along!  How many crises must we learn from in hindsight? The Indian parliament may be a mess but that's no excuse to divert attention from it! This is evidenced by two officials from the FICCI who felt that the central bank, in restricting M3, would be constraining economic activity and thereby indirectly nudge the rate up while trying to prevent a depreciation of the rupee.

Meanwhile, outgoing CEA Mr. Basu believes that the right stance has been taken with inflation being "uncomfortably high". As growth can be expected to be feeble at best, "the onus is on the government to bring about changes."

DBS Group research a few months ago opined that, "rate cuts are premature and (we) have pencilled in cuts only because the central bank and the government appear to worry more about slowing growth than about inflation." It goes on further to state that while conventionally a central bank plays ahead of the curve by easing conditions on the back of under-potential growth, India's economy is "undergoing structural changes", making it harder to "judge with reasonable confidence that the output gap is negative".

Lastly, Saajid Chinoy (a JP Morgan economist) stated that by sticking to their stance, the RBI had "increased the sense of urgency in Delhi". He cited scant evidence that "a small cut in interest rates would stimulate economic demand". 

My sense is that any loosening may well be too premature and a bit too arrogant. Hoping that lowering rates will brighten business sentiment and investment without adversely affecting price levels goes beyond being optimistic. The bottom line is that the RBI has a paramount duty of maintaining price stability and ensuring an adequate flow of credit to productive sectors as evidenced and restated in the Mid-Quarter Monetary Policy Review. 

No one's denying that monetary policy has a crucial role in reviving growth but it must be used judiciously and not as a tool to try and account (read: cover up) for the paralysis in the centre and the structural deficiencies in areas of the real economy. 

There's a consensus that, the RBI needs to be internally consistent, credible (like any central bank) and above all, immune to immense market pressure. India's growth has suffered, its currency taken a beating and there are glaring weaknesses in some broader underlying macro fundamentals. 

Global headwinds and downside risks disrupt the scope of policy change but the direction must be made clear - the RBI cannot and must not underestimate the inflationary effects on a fragile economy suspect to external developments. 

What Am I Reading?

What Am I Reading?

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- Wolfgang Munchau has a hard-hitting metaphorical diatribe on Weidmann, Merkel, Draghi and the German public (your usual players). You have to read this to believe it

" It should be clear by now what game Mr Weidmann is playing. He is sabotaging the euro through the most effective means he has at his disposal – by reinforcing people’s innate fears about the common currency. He cannot outvote the governing council of the ECB. He is in a minority of one. He also knows that he cannot overturn the ECB’s policy through the legal route. Anybody who decided to drag Mario Draghi in front of the European Court of Justice would lose. Mr Weidmann no longer has any pull over Angela Merkel, the German chancellor he once advised.

But make no mistake: he is very effective in encouraging a creeping euroscepticism among Germans. In doing so, he may well succeed in undermining the chance of the euro’s survival because euroscepticism limits the German government’s political room for manoeuvre."

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- Ed Luce has a kind of confusing indictment on the current state of politics in the US and the outlook for the economy in terms of productivity, competitiveness and the coming "energy boom" (Really?)

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- John Taylor has a blog blurb on the impact of negative regulatory policy contributing to the dampened recovery of the US economy. In fact, he compares it to the early 80's and cites data of federal workers in regulatory activities. What's funny is that he states, "While correlation does not prove causation..." and then proceeds to forget all about it!

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Brad DeLong has a take down of a ridiculous (yes ridiculous!) article in the WSJ by Taylor and the high-priest of regulation Phil Gramm regarding the QE3 impact. You think what bothers Krugman is that they claim the impending required contraction to today's expansionary monetary policy is a downside?? 

Nope. It's that they rolled out Mr. "Mental Recession" to validate such claims.

The absurd part (and there are many) is the refusal to acknowledge that no matter who owns the treasuries, the stock remains the same. Then again, Phil Gramm isn't exactly world famous for calling a recession when he sees one. 

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Here's an interesting read on the WSJ's reporting, the "fat-finger" error and of course (where would we be without this!), the price of oil. 

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The Indian Deficit

Manmohan may have got his mojo back and India may have hit a homer with all bases loaded but the stark reality hasn't changed all that much. Andy Mukherjee has a succinct piece on the twin-deficit issue in a BreakingViews column where he points out politely that fiscal profligacy (more like idiocy), took off in February 2008, when the government irresponsibly announced a $15 billion "farm-debt waiver". 

What he goes on to state is that the current account must be viewed from the savings-investment dynamic. (Note that if a nation earns more than it spends the overall effect will be to build up savings, unless those savings are being used for investment. If consumers can be encouraged to spend more instead of saving; or if the government runs a fiscal deficit to offset private savings; or if the corporate sector divert more of their profits to investment, then any surplus will tend to disappear).

Look at this from the Indian view - the corporate sector diverting profits towards investment? Consumers spending more? Government running a fiscal deficit thus offsetting private savings? Check

Mukherjee then says that households, seeking cover as an inflation-hedge to this fiscal profligacy turned to imported gold and the household investment in 'valuables' increased 5 times over the past five years! Hence, the domestic corporate sector couldn't maintain the pace at which they were issuing debt and equity securities which further led to an increased reliance on external financing. 
Current account deficit - up. Stock of foreign debt - up. Reserves - down.

I never thought (and still don't think) we're close to a BOP crisis a la 1991 but significant and persistently high deficits feeding off each other tend to lead to a sense of drag and extremely negative sentiment in the broader economy adversely affecting investment and consumer behaviour. 

Anyway, here's the interlinked and tricky solution!

1) Competitive exchange rate - The rupee has taken blow after blow of late, unable to sustain itself due to (among numerous other factors), persistent dollar demand and India's import composition, but what's happened to the REER?

Nomura's Sonal Varma says this year there's been a real depreciation of only 3% last FY (i don't get that - looks more like 10-11% to me), and 7.7% YTD which should narrow the CA gap by about 0.8% subject to the price of crude oil. The problem is that this is an unfavourable scenario for competitiveness because global demand is damp and tepid and on the domestic front, higher inflation leads to less of a 'real' adjustment.

2) Further Reductions in Subsidies - The issues here are more than a few. Further reductions in subsidies could lead to a bullish sentiment in equities and thereby put pressure on the rupee to appreciate. The counter-move would be for the RBI to snap up dollars and maintain the level of liquidity in the economy which leads to a dilemma on the direction of monetary policy during a period of relatively stagnant growth. 

3) Inflation - This would certainly be the most worrisome and sensitive issue. As experienced over the past year, any depreciation of the rupee coupled with a jump in the price of crude oil could have a significant negative effect in the form of imported inflation. Poor infrastructural bottlenecks and negative sentiment make the issues of supply-side solutions that much harder. 
The whole FDI-reform saga could encourage more private investment but this is far from a short-term effect. Fiscal reform in the form of a disinflationary GST tax for example can be thrown out of the window as a result of parliamentary legislative gridlock.  
Mukherjee concludes that the whole inflation nightmare is why the RBI has to tread extremely cautiously and remain hawkish to "control aggregate demand" even though it might not be the popular move to make. Those expecting and demanding a further rate cut must be postponed for later, only after the government has demonstrated some semblance of fiscal resolve.

Which means, that in the face of volatile headwinds further exacerbated by the moves of the Fed and the ECB's fluctuating sentiments, India would do well to leave the "growth-fixation" aside very temporarily and attend to far more difficult matters at hand. 

A prolonged sense of malaise and despair is the last thing that any economy needs and neither is a more austere agenda. What can push it along in a favourable direction is accepting that there are serious structural flaws and constraints and that most of the time, good economics must trump good politics.

Inconclusively Iberian

Tony Barber paints a melancholic picture of Spain's waltz towards aid although the results of a relatively successful auction may beg to differ. Spain's 859 million euro 10 year auction drew an average yield of 5.66% - almost a 100 basis points less than last month. The 3.9 billion offering on 3 year notes drew 3.845%.

That's the Draghi effect for you. The ECB's OMT pledge bought Spain an almost unimaginable amount of relative time to resist a bail-out. The problem is that Spain sits on the junk-bond cusp for Moody's and while safe from an S&P downgrade, is also on the investment-grade cusp at Fitch. A slash here or a slash there could sharply precipitate bond-yields and throw Rajoy's government into an immediate quandary. 

Come on, let's face it. No on really believes that Rajoy can defy fate for much longer when the heavy burden of under-capitalized banks, unfavourable debt dynamics, no growth and almost mass unemployment weighs heavy on his crown. Skip the talk of banks and bonds and you arrive at the more serious matter of regional friction, political disarray and social discontent. 

A large factor is the national pride and perception of sovereignty yet Rajoy has all but admitted to resisting aid unless borrowing costs increase again. 

If I was the ECB, it would make sense that the OMT pledge succeeded in one short-term respect. It bought Spain enough time to figure out what kind of aid they could use without seemingly compromising all and sundry. It doesn't have to be a strict, comprehensive package, maybe a flexible credit line. The important aspect is the relative ebb of the current waters. Should the tides rise again, stiffer consequences will naturally accompany stiffer conditions.

As the IBT reports,

"Critical to Spain's ability to use the time bought by the Draghi Effect to avoid a bailout will be its plans for the funding and budget needs of its 17 semi-autonomous regions, which collectively contribute to nearly a fifth of Spain's overall debts and more than a third of its annual deficit.

Spain's federal government has set up a domestic rescue fund of around €18bn to help the regions refinance maturing debt, but a good portion of that funding comes from Spain's troubled banking sector, whose debts are among the highest - at 340 percent of GDP - in the whole of the Eurozone."

And there's the matter of regional impasse with Catalan requesting a few billion in assistance as well as more fiscal self-authority which poses a heads-on conundrum to an equitable distribution of any potential aid. 

Spain's socialists, in power when the bubbles began to burst, are naturally vehemently opposed to any sort of a rescue, which they say would "affect the Spain brand" and force citizens to make further incomprehensible sacrifices thus placing additional pressure on the Rajoy government that quite frankly, they could do without. 

On September 28th, a stress-testing for Spain's banks will be complete and their capital deficiencies and requirements will be further brought to light. This fleeting warmth is uncomfortable at present but if the majority of factors start trending in unfavourable directions, they may well give rise to a scalding heatwave from which escape without serious repercussion may be too difficult.

(40.2, 53.9, 61.2 and 68.5 are Spain's General Govt Debt as a % of GDP for '08-'11. g is the year on year growth rate for real GDP while r is the interest rate on a 10 year Spanish bond discounted by the average inflation rate.)

Mitt Gaffeney

A faux pas.

A blunder.

A mistake.

An unintentional act or remark causing embarrassment to its originator

You know, when politicians dare to speak the truth - a moment when they slip up, when they let the guard down perhaps taken in by the comfort of their surroundings. Of course, the great thing about gaffes is that it's the easiest thing in the world to misconstrue them. Take a candy from a kid, take a gaffe and put a spin on it. 

Obama's guns-and-religion clinging remark was preceded by a commentary on the sad economic affairs caused by previous administrations. In reality, he was sympathizing with them. 

You didn't build that? Nope. Not the business, stupid! The roads and bridges that help your business. 

And to be fair to Romney, he didn't mean that he doesn't have to worry about that "47%". Just for the purposes of votes, of course he'll care about them after he's elected.

Yes, Mitt Romney's made lots of gaffes. Commenting on the London Games from his high vantage point of rescuer-in-chief of Salt Lake City, accusing his country's administration of apologizing on a day when a US Foreign Ambassador was killed.

This one's going to turn the election. Josh Barro thinks so too. 

You see, it's not fair to say that 47% of the American populace don't pay taxes and then imply that they're entitled, depend on government for everything etc.

Firstly, they DO PAY TAXES. The high number is the product of a depressed economy and a horrible financial crisis with mass unemployment. Before the crisis struck, this number was about 40%. 

Secondly, and this relates to the first point, THEY DO PAY TAXES, just not federal income tax. Not because they're tax evaders or tax avoiders (ahem!), but because they're simply under the bracket. What THEY DO PAY, is the payroll tax (which means they're employed) among others.

The people who don't pay the payroll tax too are, for the majority the elderly, especially those with disabilities. Students fall in this bracket too, but most go on to start contributing. 

CBO data in fact, estimates that low-income households (the poorest fifth), paid about 4% of income in 2007, a significant proportion when the average income was $18,400. The next fifth paid about 10.6% (avg income: $20k-$34k)

Best of all, when all federal, state and local taxes are taken into account, the poorest fifth pays about 16%! Here's the data for your own eyes (courtesy Center on Budget and Policy Priorities and Krugman).

It's not that this release flipped the election around. There's still no guarantee of an Obama victory. But I would like to believe that what this does, is guarantee Obama the popular vote victory (meaningless). 

And if it doesn't? 

That would say a lot about the American 'majority'.

The Lucky Sperm Club

Straight from the mouth of a Job Creator comes Gina Rinehart's diatribe bemoaning the difficulties her business has to face. David Lazarus in the LA Times has this piece where Rinehart, who struggled from the depths of poverty to hit the capitalist jackpot (the same way I was born the King of England only to be dethroned), railed against the high minimum wage laws. 

She could have made her case if she talked about the economics of it all. All said and done, she's lamenting an increased lack of competitiveness. It's obvious the pie isn't big enough and she wants a bigger slice. But one of the problems is in the jargon used. To quote, she feels that 

"There is no monopoly on becoming a millionaire. If you're jealous of those with more money don't just sit there and complain, do something to make more money yourself. Spend less time drinking, smoking and socializing and more time working."

Yup. This coming from a mining tycoon.

The usual rebuttal from Australian parliament members, while swift, may not have been harsh enough. Gillard obviously reiterated support for a "decent" minimum wage and how it wasn't the "Australian Way" to toss people $2. Perhaps she should have come out more strongly against the tone Rinehart used. For heavens sake, "Butt out the fag, put down your beer and start bloody working!" isn't exactly a polite way of saying something!

Contrast this with Buffett who found himself in a political uproar the right caused over the "Buffett Rule" where he wondered how it could be 'fair' for his secretary to be paying a higher tax rate than him. Someone who could have never done what he did in any other country, perhaps at any other time yet who's still aware that 

"the market economy creates some lopsided payoffs to participants … who may lack the right endowment of vocal chords, anatomical structure, physical strength, mental powers or inherited wealth to hit the capitalist jackpot themselves''

And yeah, according to him, Rinehart would be a star member of the "lucky sperm club" -  someone who chose her ancestors wisely.

The bottom line is that this is disgusting. There's nothing wrong in wanting to collectively lift people higher but the way to do it is by offering a hand, not a swift kick. 

Logical Traps

With Bernanke's $40 billion a month promise...and the famous Woodford paper on which much has been written about, I was left wondering when i glanced at an article by Blackrock's Peter Fisher which is based on the threat of a liquidity trap, you know, the one that Keynes conceptualized. Fisher's point can be found in the first line itself.

The. Federal. Reserve. Should. Stop. Trying. To. Engineer. Lower. Long-Term. Interest. Rates

The reasoning is straightforward, i.e: that the lower long-term rates go, the more lending would be discouraged. That basically, there "would be no reward for those willing to give up current consumption or liquidity" - cash becomes attractive and rates this low would not positively impact credit creation but rather, have a perverse effect on lending and investment.

But the US economy IS in a liquidity trap. Conventionally, a liquidity trap would occur when increased money supply would fail to lower interest rates. On the ground, people would hoard cash based on expectations of deflation, depressed demand, war etc. Mathematically, it refers to a state in which the nominal interest rate is close or equal to zero effectively "zero-binding" conventional monetary policy. As it goes, a deflationary environment can arise thus creating a vicious cycle of output stagnation and further deflationary expectations. Furthermore, in a leveraged sector, the real value of debt rises leading to more balance sheet pain. 

Using a Taylor Rule, like most before me I'll use the Mankiw version with an indicator at -8.5, i could run the numbers using BLS data and here's my chart with the Mankiw rule and the actual fed funds rate:

2009 is where the disparity starts. It's also interesting to note that sometime back in January, the economist ran an article in Free Exchange which claimed that the Mankiw rate would be positive in no time but that this steep is unlikely to continue. Here's a graph of the same data only from 2009 onwards (the effective fed funds rate is the right scale):

The problem is that Krugman re-estimates the coefficients (it's still a linear combination of 
the unemployment/inflation differential), but his data is fresher and the results makes these look significantly overestimated. Hmmm. Four more years of zero-bound flirtation if you extrapolate using conservative CBO projections. 

It's easy to hear the chorus singing the "unintended consequences" of the easing. By driving down long-term rates and easing mortgage pressure among others, the Fed, all said and done is making clever use of its balance sheet. In Bernanke's defense, it's hard to predict investment behavior in the absence of any easing. The zero bound constrains options because quite simply, when banks lend money to one another in the fed funds market, lenders simply don't pay for the "lending privilege". Hence, the fed is definitely not going to raise rates anytime soon. Mathematically, you would need (ballpark estimates) a percentage point drop in the unemployment rate coupled with near 1% inflation and even with a 2% inflation rate, there would ened to be a drop to 8% in the unemployment rate. Not happening. Zero-rate environment where conventional monetary policy will have minimal stimulatory effect. 

Also, from an IS-LM view, expansionary fiscal policy would shift the conventional IS to the right thus putting upward pressure on interest rates - the 'crowding out' effect. But in a liquidity trap, the LM curve is flat and only curves towards the end of the output gap (full employment cuts through the LM curve but the economy isn't there). So a shift in IS has its effect on output but no push on interest rates. 

The relationship between long-term yields and short-term interest rates brings out critics in full force. Fisher argues that lower yields forces investors to notice the smaller opportunity cost of holding cash. Simply put, if the Fed continues to hoard securities, investors might be forced to replace such assets with comparable risk leading to a further lowering of rates, easier lending conditions etc. What Fisher says is that portfolio shifts are far more ambiguous, i.e: it could spark a chase for yield and a path of increased  (and perhaps abrupt) expected reversal in trend. 

By the way, this is what the long-term US government bond yield and the Fed Funds rate differential looks like historically. I vaguely attempted to shade in recessionary periods but they're not perfectly accurate:

A more exact approximation would be helpful but at a glance, it seems better to focus on the pre-recession periods which seem to be associated with a kind of convergence or a downward trend. A convergence would imply either a drop in long-term treasuries or a rise in the fed funds rate (tighter monetary policy). What's interesting is that from 2009 onwards the significant movement in the differential can be broadly attributed to what's happening with the long term treasuries, the effects of easing. 

It seems, from an aesthetic perspective, that most times there's a convergence to zero, a grey area follows but in a depressed economy with near-zero rates, the differential is simply the long-term treasury yield assuming no increases in the fed funds rate for the next couple of years at least. 

EU stuff

Martin Wolf's piece in today's FT is coherent, predictable and above all - true. While he is quick to dole out credit to Draghi for taking such a step against the "sole, albeit significant" opposition of Weidmann, he is equally quick to point out that not only could this be too late a step but that still, it is too little. It is here that he makes the distinction of the monetary responsibility of the ECB and the political responsibility of keeping the eurozone intact.

The ECB's rationale may very well be to affect the transmission mechanism of policy through "Outright Monetary Transactions (OMTs)" and ensure that the heavy penalty of a "fear-of-break-up" premium is reduced. As obvious, this might turn out to be as far a conditional program as there can be which leads us to an eventual double-edged sword of an outcome post-program - Either the ECB stops buying sending markets into panic, or the ECB continues, which could lead to paralysis and disagreement in the union. Aggressive monetary policy is a no-go and German discontent is gathering intractable momentum. In layman's terms, the bottom line is:

ECB conditional bond buying with German opposition leads to eurozone forever.
This statement is false.

Here are a few charts on the EU mostly courtesy Eurostat over the past decade. Data is yearly.

1) This is the outstanding Money Supply (EUR trillions) tracked with the ECB main refinancing rate (currently at 0.75%). I've included M1, M2 and M3. For the euro area, the ECB's 
M1 is basically all currency in circulation and overnight deposits. 
M2 is M1 + Deposits upto 2 years maturity and those redeemable at a notice period of upto 3 months. 
M3 is M2 + repos, MMFs and debt securities upto 2 years.

2) Here's World Bank data to compare (as a % of GDP), Capital formation and Household & General Govt. Consumption:

3) This, for the EU, is the unemployment rate with the trend in wage index (2005=100):

4) Here's what happened to the CPI-based Real Effective Exchange Rate and the % of GDP levels for trade. Note the significant appreciation for the first four years:

5) Finally, this is the common deficit level [RHS] (i've used absolute numbers so positive is basically negative) and the Maastricht debt levels for the euro area:

The problem is that EU faults are best observed either individual or grouped (core-peripheral etc.) countries. Even so, there are still some almost glaring trends in principal variables. More on this later.

Win for Weidmann

The passage of time changes people. The advent of even foreseen circumstances can affect behaviour. NOTHING however, works better than fear. 

Here's Mario Draghi at his first press conference taking over from JCT in November:

“What makes you think that the ECB becoming the lender of last resort for governments is what is needed to keep the euro area together?” he said then. “No, I do not think that this is really within the remit of the ECB.”

Eight months later in July he unequivocally pledged to do whatever it took to save the Euro. 

Has Spain been saved? Is Italy sitting pretty? Is the worst over? No, no and NO. Forget the plunging yields and soaring shares for a moment and think of consequences. Possible, Impossible, Unlikely, Unintended, doesn't matter.

1)  Unlimited fire power is a good thing. It means you never run out of ammo. You could keep shooting all night long without worry. Of course, there's no guarantee that you'd hit the target and there's just no free lunch anywhere in the world, least of all in the ECB. There's going to be a heavy-duty bailout attached to every inch of the ECB's bond-buyin' assistance. Strict austerity and unpopular reform is going to be the carrot at the end of every stick and in fragile political climates, popular vote most often will determine the attractiveness of such packages. 

2) There are no specifics as to what extent the program would be implemented; no numerical cap on borrowing costs for Spain or Italy at which point the ECB decides it has done enough. Furthermore, even if the fire power is unlimited, there's a maturity cap that stands at one to three years which doesn't necessarily mean that long-term markets will suddenly have a change of heart based solely on lessening risk. A lack of access to the long-term market could signal the entrance of the EU's bailout funds which most certainly is nowhere close to covering what is required.

3) When has a loss ever been a win? Here's the most important part of the whole exercise. The President of the Bundesbank was the lone dissenting voice! Think about that for a minute. 

4) The ECB justification may be the "convertibility risk" but the difference in peripheral borrowing costs compared to Germany cannot be wholly attributed to a fear-of-break up attitude in investors. There's a lot of underlying macroeconomic fundamentals at play here.

5) Weidmann is now a hero back home. A loser in the ECB decision, his underlying view that bond purchases by a central bank are eerily parallel to debt monetization is the consensus in German academia. When the time comes to look at cutting the refinancing rate or perhaps raising them at the first sign of recovery, Draghi will run into Weidmann again, this time perhaps with a lot less leverage.

6) The instant euphoria of investors cannot be looked at as a barometer of dampening risk sentiment. A promise to stave off a break up is not the same as actually doing so and furthermore, a big play in-game does not guarantee a win when the clock runs out. Each second that passes will have an incremental effect on the old fear returning. Every moment of hesitation by Spain to be sold on the deal, every minor disagreement over the program to be implemented will stoke panic and raise fundamental fears of blatant moral hazard in the EU. 

7) Ironically, as Louis Bacon of Moore Capital states, there's been a market rally because a central bank violated its golden rule, using it's balance sheet to finance a deficit. Envision a scenario on the other side of the double-edged sword where targets are missed and forecasts are deemed unachievable. Do further rules and cuts kick in and send the country in question into a deep recession? Does the ECB stay quiet and continue buying bonds, risk losing the complete backing of Germany and destroying its own credibility? 

The Eurozone is an intricate maze of difficulty, its foundation long a quagmire. In the absence of unity, it will break apart but in the absence of decisiveness it will not survive either. Markets may react rationally or not but irrespective of the merits and advantages of the ECB program, what is most important is that a certain consensus seems to be taking a more opaque form, gathering shape and stature with every passing day. The German consensus, political and public, will ultimately decide the fate of the EU, just like it always has. 

Made in the USA, financed by China

“China manipulates its currency giving it an unfair trade advantage. So why doesn’t the president do something about it?” Portman asked. “I’ll tell you one reason – President Obama could not run up his record trillion dollar deficits if the Chinese did not buy our bonds to finance them…This will end under Mitt Romney.”

One would like to think that a high-school student with basic macro-knowledge or even someone who just reads the newspaper would laugh at the absurdity of such a statement. But here's what's intriguing: there are a whole host of respected economists supporting the GOP agenda this election - Mankiw, Taylor, Hubbard, Feldstein, Lazear

As DeLong angrily states, what on earth [in more polite language] do they think they are doing? Why won't a single one of them have the temerity to say, "Portman's statement was flavorful and hyped rhetoric and not based on fact by any stretch of imagination?"

Krugman is a lot more methodical, preferring to focus on what's behind the financing and concluding kindly that Portman is simply misinformed.

Here's why they should do it. First, recall the current account-capital flows relationship and then look at the consequence of financing the deficit. 

This, according to MGI research sourced from the Federal Reserve flow of funds, is the private sector deleveraging post 2008:

And here's the current account deficit, as a percentage of nominal GDP (adjusted seasonally) which peaked in 2006:

Corporations stop investing + consumers stop spending and start paying of debt = massive private sector surplus. 

The US could still run up record deficits even if China did not "buy bonds to finance them". It just wouldn't be an exciting story to hear if you narrated it that way.