Humiliation and Hubris

Just a quick take on Gillian Tett's article a while ago on the psychology of the eurozone crisis as it applies to distressed nations. It's obviously paramount to get a comprehensive historical understanding of the european political psyche post WWII to analyze how people and politicians have been reacting and why they do so but Tett makes an important, if not exact point. 

The background is that (as British sociologist Dennis Smith puts is) - the post-war european experience has been self-characterized and presented as a post-humiliation regime constructed to heal the wounds of the second world war and foster liberty, equality, (and more tellingly), fraternity. Post-crisis, it is humiliation that has returned, drawing stark, naked and divisive lines among nations in the union. 

Conventional psychologists differentiate between shame and humiliation through the source - one is internally driven while the other is external, characterized by "a loss of autonomy, demotion of status and finally exclusion of the group". 

What's important is the response, which Tett says can be short-term (flight, rebellion or disassociation) and long-term (acceptance, challenge etc.)

But such thinking is commonplace. Investors often attempt to get a sense of state when analyzing market sentiment or crises by looking at position on the cycle of denial-anger-bargaining-depression-acceptance. And it is here where the contrast is drawn between Ireland and Greece, with Spain open for debate. 

According to Smith, Ireland, having lived in British dominance has innate "cultural coping mechanisms" to deal with this and the response to crisis has been escape (emigration), pragmatic conciliation (reform) and defiant compliance. 

Naturally Greece looks nothing like this. Perhaps it is due to the high level of national pride and fervour - that during the prosperity years when millions were rescued by public sector expansion, the past was conveniently forgotten and the present (recent past) was embraced. This could explain the state of shock and reaction from Greece compared to Ireland, where "politicians are physically attacked in the streets...public buildings are set on fire...german politicians are caricatured as Nazis".

But what about Spain? 

I would presume that Spain has an added state of confusion, with a lot of each thrown in - enough denial, dollops of anger, attempts at bargaining, an uncertain sense of depression and perhaps a latent form of acceptance. 

Spain is not Greece, and to generalize sovereign nations under basic psychological reaction would be foolish but it seems the key here is pragmatic conciliation - something Greece has not and perhaps cannot adhere to. For all the pragmatism in the world will not ease the pain of conciliation and that is something Greece continues to learn in the worst of ways. 

Tett shifts the focus of Spanish pride in requesting assistance to the 'strong eurozone leaders' (cue: Merkel). It should serve as a plea: to be mindful of the state of national psyche when attempting to enforce a solution.

Rmb Musings

I don't understand the Renminbi. I don't understand how and when China plans to 'internationalize' the Rmb. I don't understand how much capital really moves in and out of the economy. I don't understand why the yuan has been hitting multiple highs against the dollar since July...but of course, I could always try and shed some light. Let me start with some facts, some old, some new:

1) At the turn of the century, the US accounted for a quarter of China's exports, now it accounts for just a  sixth. LatAm+SE Asia account for the same proportion.

2) In the past five years, the Rmb has appreciated by a fifth against the dollar but only a tenth on a trade-weighted basis. 

3) On two consecutive days last week, the Rmb almost hit the upper limit of its daily trading band against the dollar. 

4) Over the past 12 months, China's trade surplus is up nearly USD 200 billion and net foreign direct investment has been about USD 30 billion. 

Here's what has happened to the Real and Nominal trade weighted exchange rates over the same time period as well as the bilateral rate, which hit a 19 year high of 6.2530! (the NEER-REER is Left Scale, USDCNY is right)

Which obviously begs the question, what is the PBOC doing?

Ok, let me rewind. Essentially, an economy with a controlled exchange rate and the ability to set its own monetary policy should have a direct trade-off between its legal capital flows and its official reserves. If there's an imbalance between recorded and reported flows and the change in reserves, one immediately should smell hot money. In China's case, the status quo, loosely speaking - is ever increasing reserves above expectations, which suggests inward/onshore speculative flows. 

As it turns out, quite the opposite as happened. Look at 4) above - according to general estimates and basic calculations (factoring the returns on existing reserves plus currency changes) - you get another USD 50-100 billion which is a huge margin by all means. If you add all that up, there's a bandwidth of USD 280 - 330 billion, as Simon Rabinovitch estimates over at beyondbrics. 

But this is what happened to forex reserves (USD billion). 

Does that look like a few hundred billion? Nope, 88.32 to be precise and that's a USD 200-250 billion short fall there. Is it really possible that all that has been moved ashore? As it turns out, there's a more than partial explanation - the majority of which has to do with the central bank and the rest of the banks. 

Essentially, if Chinese company X were to receive a payment in dollars for its goods, it could/would officially convert them into Rmb (at a fixed beneficial rate) and the dollars would end up in the central bank as official reserves. The company would use the Rmb to produce/manufacture/pay wages etc. This leads to the simple explanation that if company X stops doing this as much then the dollars end up in commercial banks rather than in the official reserves. So what's happened to foreign currency deposits at Chinese banks? They's increased by 60% yoy, a good USD 158 billion that gets offset with our initial 200-240 bandwidth. 

What about the remaining USD 40-80 billion?

An increase in Rmb payments to settle invoices and trades. This is where the 'internationalization' issue sets in. At least, for such kinds of settlements, there's not much doubt that China has been pushing for a more active Rmb role. Hong Kong, though an SAR, operates under a free capital, currency board framework thus being positioned as a prime offshore market. If the Rmb doesn't appreciate in line with expectations, a foreign company Y would send Rmb back to pay for a Chinese export. This is measurable stuff through the HKMA - Rmb deposits in Hong Kong have fallen by approx USD 9 billion (currency converted). 

That's still another USD 30-70 billion which is a far cry from the initial starting point, but it still merits enough thought and almost inevitable conclusions. China suffers from significant capital movement (significant could be a misnomer, because it's less than a percentage point of GDP) but that's Chinese output! 

Unleashed on smaller markets such as Hong Kong, Sydney, Singapore, Cyprus it could have significant impacts on asset prices. 

If there's a change in perception of Rmb appreciation, investors naturally start opting for dollars - but there comes a point when the PBOC has to say enough before a more dangerous trend is set. 

I think, but don't remember for sure, that I read an excerpt of a note somewhere from a Credit Agricole analyst that dwelled on the impact of US politics on China's Rmb policy but it's impossible for anyone to measure something like that. 

Over at Alphaville, David Keohane uses similar estimates concluding naturally that an estimate the size of the initial outflow runs opposite to the recent new found strength of the Rmb. It wasn't too long ago (May-July), that the Rmb depreciated sharply on the back of outflows and China's first BOP deficit in 14 years.

Josh Noble, at beyondbrics, points to the seemingly depressing macro-fundamentals that might be a bit too dooms-dayish, a reversal of outflows, Obama over Romney and QE3 leading to higher import costs. 

Meanwhile, BNY Mellon's Neil Mellor wrote about the long-term fortune of the euro and its role as a reserve currency, the logic being that USD accumulation (via sterilized intervention to check local currency appreciation) have led to a diversification into the euro as well as other currencies. Using China's reserves as a proxy, it means there is little doubt that fundamental support for the euro has weakened over the past year (less USD accumulation implies less reserves for euro-swaps). 

The WSJ has an interesting report on the draining of the Chinese money-basin, so to speak. It uses similar outflow estimates among stories of citizens finding ways to circumvent the capital restrictions. Moreover, it has a couple significant statements - one by Michael Pettis stating that if local businessmen take money offshore in such a fragile global environment, it can't be a good sign. The other is by the well-known Eswar Prasad who reiterates what everyone assumes and realizes, "The wealthy in China have always had an open capital account". 

The general consensus is obviously to wait a little longer for more data. But this is a really really interesting spell for the Rmb and China's policy makers. There's a lot going on.

What Am I Reading?

-   Raghuram Rajan has this refreshing piece on democracy and free enterprise.

-   Free exchange has an internally inconsistent but broad analysis on the Bush deficits.

-   Anne Lowrey has this piece in the NYT citing a study on inequality's effect on growth by Jonathan Ostry     and Andrew Berg among other ideas.

-   Mark Thoma has a response to James Kwak who had a response to Richard Posner's much debated post on the role of luck and hard work in...you guessed...making money.

-   Menzie Chinn has a compact analysis of gasoline prices and Romney's boasting and blaming. Don't miss the correlation between Brent in the US and Europe.

-  Noah Smith has an interesting read on the age-old math-in-economics debate in the wake of the Nobel awarded to Roth and Shapley.

-  And here's something for me, so I don't know why I'm posting this. Also from Noah Smith

AWOL

Sifting through the data coming out of the financial world, it's easy to feel like the calm has come and the sun is about to rise. Every chart that's depicted has something nice to say, every new number points to increased confidence. 

I've still felt like a sceptic more than once. And I've got Clive Crook in my corner! In a sort-of reality-check piece on Bloomberg, Crook says that, "The condition of the world economy, you might think, is serious but stable. Actually, it continues to deteriorate."

He's right. Look at the numbers all you want but just imagine how little has been done anywhere save monetary policy. Imagine what the global economic outlook would be without "reckless" QEs. It's not a great situation, to be stuck between the devil and the deep sea but that's where we are.

Monetary policy is the domain of independent technocrats - distinguished academics (in most cases) - who function without the horrible burden of being answerable to voters. Fiscal policy is entirely the realm of people who are elected by us. Crook gets it spot on when he judiciously states that, "Compare this with fiscal policy, the realm of elected leaders. It’s in shambles both in the U.S. and Europe, albeit in different ways. What governments ought to do is conceptually simple: Maintain fiscal support for lower-than-normal economic activity in the short term, while announcing plans -- detailed, credible plans -- to strengthen public finances over the longer term. It hasn’t happened."

Europe's political structure is incapable but it's also predictable. After all, these are sovereign nations bound by a monetary union, not a fiscal one. What's been the most shocking to see over the past few years is the extreme polarization of the American polity. The divisiveness, derision and lack of respect shown by both parties has hurt the average citizen the most and will continue to do so in the future.

The patient may be showing signs of recovery but it's more likely that the internal sickness is worsening. As long as the politics is dysfunctional, nothing will ever get accomplished. Leaders are failing everywhere and I don't think the reaction to this void is strong enough. To be honest, it is a pretty bleak scenario after all. 

Mittthesmallbusinessguy

This is more of a scrap, but I think it is worthy of solitary mention. I push myself to steer clear of politics because it's sometimes too frustrating and furthermore, I'd never stop typing/talking. This, though, really does warrant its own mention.

From Romney's acceptance speech in Tampa, 

"I learned the real lessons about how America works from experience. When I was 37, I helped start a small company. My partners and I had been working for a company that was in the business of helping other businesses. So some of us had this idea that if we really believed our advice was helping companies, we should invest in companies. We should bet on ourselves and on our advice. So we started a new business called Bain Capital. The only problem was, while WE believed in ourselves, nobody else did. We were young ...That business we started with 10 people has now grown into a great American success story."

It's amazing what words can do - it really is. You could easily get the impression that Romney started a little corner-shop book store or a fence-painting service for his neighbourhood. Who would realize he started a private-equity spin-off from an elite management consulting firm! Krugman has a blurb today on "Itsy-Bitsy-Bain" too!

Poor Mitt, it's the only way a governor's son-harvard educated-multi-millionaire-million-times-over can try and connect with 'ordinary' voters - with the actual small business owners - a lot of whom, unfortunately actually think that he "came through small business". 

Of course this is all irrelevant if he doesn't win. But just saying...stranger things have happened. 

Noble Nobel

I don't quite understand how one predicts the Economics Nobel but I'm pretty sure it's easy to figure out who's not getting it. Just do the usual rounds of the internet during the lead up and you'll be able to cross out a few very well known names. 

So of course I was surprised when the announcement was made. Nash, Harsani and Selten got it in 1994, while Aumann and Schelling got it in 2005 and now Roth and Shapley. The official announcement states that it was for, "the theory of stable allocations and practice of market design" but it's a lot more than that. 

Shapley reminds me, in a way of Nash (they both overlapped at Princeton). I read somewhere that when informed of the decision, he stated that he had never taken an economics course in his lifetime. Pure mathematics, nothing more powerful and perceptive. 

Along with the Shapley value, the Bondareva-Shapley theorem , the Shapley–Shubik power index, the Gale–Shapley algorithm (for the stable marriage problem), the concept of a potential game, the Aumann–Shapley pricing, the Harsanyi–Shapley solution, and the Shapley–Folkman lemma & theorem bear his name

Aumann, in his 2005 lecture, considered Shapley to be "the greatest game theorist of all time". In 1995, Albert Tucker said that he felt Shapley was only second to Neumann in game theory research. 

Essentially, when I think of Shapley, I think of the Shapley value which is the foundation for determining gains in cooperative games. In a set of players (where some may have greater control over an outcome/gain or some may contribute more to the overall outcome), you can assign a unique distribution to each element. i.e: how important is each player in the game and what pay-off can he/she expect based on his/her contribution/power etc. 

Shapley offered decades of fascinating research in analyzing outcomes. The area in relevance due to the Nobel in fact, is the Gale-Shapley theorem or the Stable Marriage Problem. Simply put, it ensures pair-wise matching between a man and a woman such that no pairing is unstable (there are no two people of opposite sex who would rather have each other over their current partners). You can see how it works in practice here.

Think about the implication of such a system. You could match employees into departments based on the preferences of either side. You could match children choosing schools if you navigated or equalized the entry-process. What if you could match kidneys between donors and recipients?

That's where Alvin Roth comes in. Steven Levitt stated that, "When I talk about economists, one of the greatest compliments I give is to say that they changed the way people think about the world." 

Thanks to Roth, if John needs a kidney but his sister Jill is incompatible - they could find Molly, a willing donor who matches with John, and whose brother Mike is compatible with Jill. Which makes you immediately think about a three way swap, or a multi-swap, could you design this for n-participants?

Anyway, there are A LOT of tributes, accolades and information on the both of them.

1)  Ben Walsh over at Counterparties has this short piece which is nicely titled "Economists who did good".

2)  Josh Keating at Foreign Policy further explores Roth's paper on Repugnance and why it could be a constraint on markets. Think of it this way, as Roth provides an example. In California, it's illegal to eat horses but it's not illegal to kill them - just not to eat them. Yet, some people in California are from societies where eating horse meat is normal...

3)  Matthew Yglesias at Slate has a more focused piece on the matching issues, and why the lack of money and prices is why it works. 

4)  Alex Tabarrok at Marginal Revolution has perhaps the most succinct yet informative piece on the two. He focuses on the stable marriage issue, it's weaknesses, how they can be overcome and why the future is open to more wonders. 

5)  Joshua Gans at Digitopoly says, "Here is an economic theorist who hasn’t just made things more efficient. He has actually saved lives. It is unclear whether it is the economics Nobel he deserved or the Nobel prize for medicine." Strong praise indeed. 

6)  Mark Thoma has an agglomeration of the above as well as a very brief summary of the two. He concludes by saying that, "Even though these two researchers worked independently of one another, the combination of Shapley's basic theory and Roth's empirical investigations, experiments and practical design has generated a flourishing field of research and improved the performance of many markets. This year's prize is awarded for an outstanding example of economic engineering."

7)  Dylan Matthews at EK's Wonkblog has more detail, especially on Shapley but also on Roth.

8)  Susan Adams had this well written piece on Roth back in 2010 that focuses more on the school-matching issue.

9)  Leon Neyfakh has a detailed story back in 2011 on how Roth fixed a breaking process of matching young doctors with hospitals (the NRMP program). 

I think I'd like to conclude with the fact that we get so caught up in terms of what is relevant with respect to the world we live in, what can or cannot be applied today and all those if-and-but questions that it's easy to forget the power of an intuitively brilliant theory and the impact that its practical application may have. 

To Shapley and Roth.

Easing on EMs

Bernanke's making tidal waves and garnering support as well as opposition for his defence against the Fed's easing policies on emerging market economies. 

On the surface, it seems genuine enough (the argument, that is!) - in a capital-mobile network of economies, the zero-boundedness and short/medium-term promise of zero rates in advanced economies tend to cause a "search-for-yield" thus possibly leading to hot money flows into EMs and in the process, creating all sorts of unwanted troubles such as currency appreciation, asset bubbles, volatility and stoking inflation fears at a sensitive time. 

Now firstly, this is a sensitive issue that needs  a good bit of further empirical study. A couple of weeks ago, Jose-Antonio Campo had a piece on this where he essentially went down the middle path. He gives the Fed credit for acting boldly given that the recovery was sluggish, there was no fiscal manoeuvre left and the gridlock in DC was too strong. Here's the problem though (and this comes back to Triffin once again) - The dollar is the international reserve currency of the world. And such expansionary monetary measures are bound to create significant externalities and imbalances in the rest of the world, effects that (as Campo says), "the Fed is clearly not taking into account". 

I'd summarize Bernanke's defence but Weisenthal at Business Insider has a short and sweet round-up of the rebuttal:

a) Interest rate differentials aren't the only determinant of private inflows, growth differentials for example, also play a role.

b) Data shows that since the advent of ultra-easy monetary policy, flows have actually eased. (I'll get some data on this)

c) Emerging Market economies aren't exactly powerless and helpless to do anything

d) Stronger currency = greater ability to buy imports, woohoo! to domestic demand (and to hell with all exporters!)

There's a dilemma when EM economies have to calm speculation and cool the economy. Raising rates to adopt even a strict anti-inflationary stance could end up attracting more short-term funds and hot, volatile money. The problem is the alternative. A US recession and inaction from the Fed could be extremely painful for the global economy, already facing a bleak and sluggish outlook. I don't think anyone denies this and desires this above all.

Andy Mukherjee over at BreakingViews mentions an IMF study (I haven't read it), that concludes a 3% reduction in probability of an EM surge for every 1% rise in US interest rates. Yet, he also agrees with the premise that the ups and downs of the EZ crisis over recent times have caused sometimes implausible shifts in investor sentiment. To him though, what Bernanke failed to mention is an economy without QE which might have led to lower oil and commodity prices, something of great importance to EM policy makers. 

But in a world without QE, to revisit the earlier point, the impact on the global economy of a US slowdown might be far worse. Bernanke raised valid points, some of which were indisputable, but he also left a few openings in his analysis which will undoubtedly be questioned in the very-near future.

What Am I Reading?

1)   A last (I hope!) follow-up of the highly discussed and debated IMF-morph into pragmatism and shying away from austerity, i.e: that the impact of fiscal consolidation on growth has been understimated. Wolfgang Munchau says something quite simple and what I think is most important to remember,

"The IMF does not say that austerity is too hard, too unfair, causes too much pain in the short term or hits the poor more than the rich. It says simply that austerity may not achieve its goal of reducing debt within a reasonable amount of time."

Brad Plumer at the WaPo has a succinct summary on why the change in stance is unexpected, creditable and what it actually implies for policy in the short-term future. 

Meanwhile, Chris Giles had a write-up on the susceptibility of the robustness in the results. That Greece and Germany data might be skewing the conclusions.

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2)   Roubini has the latest take on what QE3 means to the US economy - how the usual transmission channels are still severely impaired (bonds, credit, currency, stock markets). What's interesting here (to me of course!), is the impact on the dollar. Firstly, the Fed isn't the only central bank indulging in easing. Furthermore, (similar to what India went through recently), the US is a net-importer of commodities so a weaker dollar will create a drag on the trade balance in this respect. There's a bit more on the equity-market "wealth-effect" but I won't get into detail. 

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3)   Jacob Kirkegaard at the PIIE has brief analysis out at voxeu on the contrasts between youth unemployment in the US and the EZ where he concludes with:
"American youth is today idler and worse affected by the crisis than their EZ and UK counterparts. This result probably reflects both the depth of the labour market contraction in the US (which has been worse than the EZ and UK aggregate) and the fact that many American youth have fewer education and training opportunities than in Europe – especially following the dramatic cuts to US state and local government education budgets during the crisis."

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4)   Simon Johnson and Peter Boone had this piece in The Atlantic on Japan's doomsday scenario fuelled by rising debt and a shrinking tax base (When will the Bond Vigilante's demand a higher risk premium!). There are eerie parallels in some minor ways between the US and Japan, namely the fiscal gridlock and the inability of tax increases. Does inflation need to be 'created'? Is some outright monetization required? Read on, along with this take from Noah Smith who argues that Japan's euro-style social spending and american levels of taxation is unsustainable. And Tim Duy waxes eloquent about the trappings of the zero bound and why we need to return to the 'normal' (not the 'new normal') as soon as possible.

Maradona's Monetary Policy

There's a really nice read in the FT by Claire Jones on the parallels between Central Bank monetary policy and football. Back in 2005, Sir Mervyn King, the outgoing BoE governor, gave a monetary policy speech in London in which he stated the following, 

"This is what I call the Maradona theory of interest rates....Maradona’s first “hand of God” goal  was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates....The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do.  Because they expected Maradona to move either left or right, he was able to go straight on."

Essentially, the premise is this - how people perceive the central bank will react is what determines market interest rates. Which means, according to Jones, that Draghi might have to morph into Cruyff if his OMT is to work contrary to market sentiment. 

In any case, I'm not the greatest-of-greatest-fans of the goal. It's because I wasn't there, I'm not a Maradona fan, and I'm really really surprised no English defender took him down. Maybe investors will be nice enough to central banks too. If they are perceived to be moving in a credible direction, they might not have to actually be snapping up all those mortgages/bonds etc. 

Fiscally Flat

The October Fiscal Monitor from the IMF is out and it provides ample analysis on fiscal adjustments and their impacts. It also has a few graphs and charts on fiscal adjustment in relation to Gini measures. 

I'll try and limit myself 9 countries (for 2012) and incorporate the main constituents of the equation - namely the interest rate, the growth (differential between the two) and the primary balance contrasted with the overall balance. This provides a broader status update kind of glance at the economies in question.

Just a quick reminder that assuming the time period as fixed (so that i can get the 't' out of the equation), then:

If the primary balance is p, and the real interest rate is r, where (1+i) = (1+r)(1+pi) and 
suppose x = (i-n)/(1+n) therefore x = (r-g)/(1+g) therefore 1+x = (1+r)/(1+g) 
then my stock of debt at t time period is given by :
d(t) = (1+x)d(t-1) - p

where 
n is my nominal growth rate between t and t-1
pi is my change in the GDP deflator between t and t-1
g is my real growth rate between t and t-1
i is my nominal interest rate in period t, paid in t, on debt stock outstanding of t-1

This is why the interest rate-growth differential matters, because holding p constant with an existing debt stock, we depend on the value of (1+x) which is essentially (1+r)/(1+g). Alternatively, the value of x is (r-g)/(1+g) and therefore, for x or 1+x to be smaller, g has to be greater than r. If the reverse is true then you have a multiplier > 1.

Some observations on the graph:

 - Greece is the outlier as far as the differential is concerned. Think of high borrowing costs (high nominal i not offset by pi) and no growth (g). Japan, the US and Germany have a differential close to zero even though growth is minimal because of the safe have haven of the treasuries, bunds and jgbs. 

 - Italy, predictably is the only country (apart from Germany) with a positive primary balance yet negative overall balance, it's borrowing costs at the mercy of investors and it's current gross debt level being about 126% of GDP.

 - The UK too, is running a primary deficit of over 5% and doesn't have a favourable differential. It hasn't suffered at the hands of investors (the BoE has control over its printing press) and its borrowing costs aren't out of control but growth is anemic at best debt levels are uncomfortably high.

 - Lastly, China's gross debt stands at about 20% of GDP with a minor primary and overall deficit. Both India and China have their own internal macroeconomic imbalances and causes for concern but they still have emerging market growth rates. India's fiscal deficit is uncomfortably high which is why the government has been trying to take steps towards subsidy reform among other policy measures. 

Recovery has suffered yet again and the outlook seems bleaker than it did earlier in the year. Synchronized fiscal consolidation has clearly made growth stall more than expected and external situations/scenarios (EZ crisis, China's hard/soft landing, US fiscal impasse) have left so many interconnected economies at the mercy of shockingly bad policy. 

It was Dickens who wrote and Pip who said, "Whitewash on the forehead hardens the brain into a state of obstinacy". Perhaps it's time for more than a few policy makers and politicians to reflect, change direction, and ditch a dogma that does more harm than good.

A for Austerity, B for Bye-Bye

More than a few words on that little box from the WEO that's set off the econosphere. Before I get to it, there are some bits from DeLong and Krugman that should be thrown in for perspective. Before I get to them, here's an excerpt from the Summers-DeLong paper back in March, "Fiscal Policy in a Depressed Economy":


"Unless the real interest rate at which the government borrows on the left-hand side is greater than the right-hand side of (2.9)*, fiscal expansion now improves the government’s budget balance later. Arguments that economies cannot afford expansionary fiscal policy now because they should not raise their future debt financing burdens then have little purchase."

*2.9 is the equation that relates the real interest rate to the sum of the growth rate of the tax base and the short-term multiplier, the fraction of the depth by which the economy is depressed and the marginal tax-and-transfer rate. 

Essentially, if the fiscal multiplier is larger than 1, suppose 1.5, and the marginal tax share is 0.33, and the economy can borrow at zero in real terms, then in the medium term, there's is no long-run cost to the budget. The thing here, as DeLong re-emphasizes, is that there is no short-term exit from the ZLB, which means that there is still time for governments to act. 

Krugman makes it simpler to explain this "multiplier-mea-culpa". To him, it's the asymmetry in the effects of leveraging as opposed to deleveraging. Essentially:

1) Leveraging = higher AD, but this can be offset by tighter monetary policy
2) Deleveraging = lower AD, but the offset isn't as easy because of the ZLB and the uncertain impact of unconventional monetary policy measures. 

This deleveraging constraint is responsible for the liquidity trap and hence the larger (>1) multiplier. 

Kate Mackenzie has this to say about how the consensus was built over the range of the multiplier and how it gradually shifted and shifted further perhaps.

And finally, this is what the actual box in the WEO (written by Blanchard (Director) and Leigh (Senior Economist) of the Research department)) had to say:

"Based on data for 28 economies...the multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2...

...Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7."

Think about that for a moment. It's big.

And this is based on hard data. Austerity is damaging, now more than ever. How else could you explain (for example) UK growth over the past few years? Look at the numbers:

The estimated equation is y = a + bx + e where:
y is the forecast growth of error = difference in actual cumulative real GDP growth ('10-'11) and the April 2010 WEO forecast.
x is the forecast of fiscal consolidation = forecast of the change in the structural fiscal balance ('10-'11) as of 
the April 2010 WEO

Mathematically, if the multipliers used in the forecasting have been accurate in retrospect, then the equation should be y = a + e and we should get a zero coefficient. 

Of course that's not the case. 

Instead, the co-efficient is found to be "large, negative, and significant. The baseline estimate suggests that a planned fiscal consolidation of 1% (of GDP) is associated with a growth forecast error of about 1%...indicates that the multipliers underlying growth projections have been too low by about 1."

Furthermore, naturally other variables are analysed as possible triggers to consolidation and weaker-than-expected growth. Among these are the debt-to-GDP ratio, the sovereign CDS spreads, the impact of banking crises, the consolidation of trading partners, the external balance.

They conclude by commenting that more work is warranted yet unequivocally, "in today's environment of substantial economic slack, monetary policy constrained by the ZLB, and synchronized fiscal adjustment across numerous economies, multipliers may be well above 1".

As a Bloomberg editorial justifiably says, "...the new pragmatic IMF is the voice of reason. It’s impressive to see such a culturally conservative institution leading this change, rather than being reluctantly dragged along. We’ll be even more impressed when governments start acting on its advice"

About time. It's about time.

Eurominbi

With reference to the global role of the dollar, I decided to go through reading the Eichengreen white paper, the remainder of which focused on the sorry state of the euro and the rapid yet confusing rise of the renminbi.

The euro-matter is predictable enough, for what can be said about the euro that hasn't already been said enough? Essentially, when the very existence of a currency is oft called into question, what hope can there be for a more 'global' role? 

But Eichengreen is wise about this and instead of dwelling on the myriad of problems plaguing the euro, he looks to the future. 

If anything, the EZ crisis illustrated the difference between the US and the Euro bond markets. When european governments at one point looked to the east for funds, there was naturally a sense of indifference and lack of desire from most central banks and sovereign funds. 

In fact, Li Diaoku a Chinese monetary policy committee member in the PBC stated, "The last thing China wants is to throw away the country's wealth and be seen as just a source of dumb money". 
Words indeed!

But what if the Euro survives and emerges with reparable scars? What if public finances stabilize, economies start growing and labour conditions improve? What if Germany takes the high road because:

1) For every inept borrower (south), there is an inept lender (north)
2) German exports (automobiles, machinery etc.) have benefited enormously from sharing the same currency as other Southern countries - a competitive exchange rate has been an integral factor in their economic renaissance
3) The shock of a euro abandonment - bond dumping, capital flight, bank runs etc and the accompanying contagion effect that could knock over economies like dominos (think east-asia '97)
4) The ideal of European integration would be severely undermined if the euro doesn't survive.

If the euro's flaws are fixed and tough decisions are made, we might have some essential systems in play such as centralized regulation, a common deposit-insurance scheme - i.e: a legitimate banking union. Perhaps if debts are partially guaranteed there might be some semblance of a pseudo yet effective fiscal union. 

Eichengreen quotes Jean Monet, who famously stated that, "Europe is forged in crises, and will be the sum of the solutions adopted for those crises". 

And while historically that may be true it doesn't change one crucial part - There are solutions, the challenge is to apply them. 

Everyone would love to cling to the safe knowledge that Europe will do what is necessary to save the union but the longer the delay, the lesser the chances. It's a long, dreary road ahead.

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The renminbi, on the other hand, has been on an opposite trajectory. China's implementation of the trilemma is simple - independent monetary policy and a severely restricted capital account by which they can keep the renminbi pegged to the dollar. While that does wonders for export-driven growth it cannot be a model for a reserve currency. And this leads us to its internationalization. Invariably, minor measures to liberalize capital flows cannot lead to a coherent globalization of the currency. Barriers have to be broken and flexibility needs to be induced. Eichengreen mentions a few instances from policy makers in China:

 - In August 2010, a pilot scheme was introduced that allowed select offshore FI's to invest in China's bond market using renminbi funds
- In 2011, regulators permitted offshore renminbi to be used by investors i the Chinese stock market. 
- In early 2012, HM Treasury and the Hong Kong MA agreed to permit the trading of offshore renminbi in London.

The key, as he argues, is the private financial market and their adoption of the renminbi. This will lead to central banks diversifying their reserves and participating in bilateral swap agreements (eg. the Chiang Mai initiative). And so there exists a broad step-by-step framework from China's perspective:

Use in invoices and trade transactions -> facilitate use in a range of international financial transactions -> encourage its adoption as a reserve currency.

The problem is this (both charts are for China): 

The trading volume has grown extremely fast but the size has stabilized and is in slight decline. Moreover, if the outstanding stock is rapidly growing, the trading volume fails to provide a good enough measure of liquidity. A more relevant metric is the turnover ratio, which is basically the ratio of the value of the bonds traded and the average outstanding amount of bonds; and China's bond turnover ratio for government debt is extremely low. 

The Chinese economy is enormous, but it's bond market isn't. Even without comparison to the US, it is neither deep enough nor liquid enough to complement a global role of the renminbi. Moreover, most of the bonds of the government and corporations are held to maturity (hence not actively traded) which leads to an extremely low turn-over and the fact that it won't take a large transaction to affect prices. 

Inevitably, China cannot proceed without real reform. If the renminbi has to be accepted in a more international role, these are a few steps that must be implemented:

1) Capital account liberalization and hence the halt of dollar-pegging - a willingness to accept the inability to keep the renminbi artificially low and provide an export boost.
2) Bank reform, so that foreign investors can place deposits freely in Chinese banks and banks are no longer directed towards lending to local governments for projects, or to property developers in order to achieve construction objectives. 
3) A more liberal corporate environment and strict implementation of law and property rights. 

Point 1) is the anti-thesis to the Chinese growth-model. Dependence on exports, a monitored and pegged renminbi, and bank lending that can be adjusted and directed to whims and wills all have to be eroded and erased for the currency to be accepted. 

Essentially, as Chinese policy makers have often claimed, the economy needs to be rebalanced. In a fragile, post-crisis world characterized by dampened external demand, this could be much required by removing significant vulnerabilities of the export sector to global shocks and externalities.

Eichengreen's view is that such a monumental paradigm shift in theory, even if accepted, will not happen overnight - which is why the dollar is the only alternative on the table even though the renminbi is fast catching up and the US fiscal doldrums might exacerbate such a process.

Even if those statements hold some truth, it is still immensely difficult to dislodge an incumbent for poor performance when the alternative either isn't ready or isn't up to the mark - just look to the US presidential race!

The Exorbitant Dollar

Barry Eichengreen has a white paper out at the DWS Global Financial Institute. I thought it would be somewhat of an epilogue, or just some minor reflections on his book "Exorbitant Privilege". And in some ways, it is. By the way, you can't not have read the book - it's just a fascinating read infused with historical perspective, reality checks and substantive solutions.

A few facts beforehand, lifted from the paper:

1) 85% of all foreign exchange trades worldwide are "dollar-trades".
2) The dollar accounts for 60% of the reported foreign exchange reserves of central banks and governments around the world.
3) The dollar also accounts for 45% of all international debt securities.

There aren't just two sides to this debate (What are we debating?). It's a multi-faceted and multi-polar issue with no visible solutions. Is there a problem? No, but there might be. Are there solutions? Yes, but there are problems with the solutions. It's not as easy as it seems.

One would think that in the long run (in which we're all dead), this would make sense. The US economy is relatively nowhere near the behemoth it was post World War II. Naturally, this relative decline in output (to the world) would lessen the global 'need' and 'convenience' of the dollar. In fact, today most estimates put the US economy as accounting for about a quarter of the global economy and a lesser fraction of global trade.

Eichengreen mentions two other points of note that could lead one to question the role of the dollar and the first is far more obvious than the second. He says that the depth and liquidity of the US financial markets are simply no longer a hallmark of the US alone. I think this is debatable because while true, it still doesn't change the fact that there is simply no comparable alternative to the US financial market especially in terms of liquidity. But more on this later.

Furthermore, the first-mover advantage, the incumbency factor or changing the status quo (whatever you call it), is less of a hindrance now than it ever has been. This refers to the convenience of the dollar - that everyone uses it - so everyone will continue to use it. The ease of transaction is immense but newer technology, systems and frameworks could lead to a scenario where multiple operating systems could exist.

Lastly, a less intrinsic factor and something that has gained rapid traction recently, is the US fiscal situation. This brings the Triffin dilemma into play - that just as the expanding global economy needs a growing supply of dollars, we mustn't forget that the liquidity of the 'international reserve asset', i.e: the US treasury bill, is backed by the full faith of the United States government. Cue fiscal impasse.

If the world economy is expanding faster than the US economy, logically the capacity of the US government to keep providing safe assets will, at some point, be "overwhelmed by the scale" of this expansion. The key point here, is that the full faith of the government simply refers to its "power to tax". This thought gathers even more steam when the polarity of the American political situation comes into light.

The bottom line is that one could envision multiple scenarios but these are the ones that stand out:

a) The US gets it fiscal house in order and the exorbitant privilege continues though gradually losing its monopoly and sharing international space with the euro (yes, it will survive! or wait...no it won't!) and the renminbi. This perhaps, is the essence of the book - that inevitably, China and Europe will catch up through their financial markets' own depth and liquidity.

b) The adverse scenario, which is undoubtedly one which anyone and everyone has replayed in their mind and thought of - is that the US indulges in major fiscal folly and general confidence in the dollar is severely undermined and tested. While this is adverse, it's something that no one could risk writing off. The amount of political drama between the left and the right is at times suffocating, and their paths are theoretically polar. The last thing one would want is a looming fiscal cliff but that's exactly what's around the corner...

Anyways, the paper also has a section on international hostility to the Fed's unconventional and easy monetary policies. In accordance with the trilemma, and in a world of free capital flows, the near-zero interest rate environment in many advanced economies, coupled with higher interest rates in emerging markets forces capital out and into markets that may not be well equipped enough to handle such a 'tsunami of capital'. Unchecked capital flows of course, can rapidly create asset bubbles, stoke inflation fears and put immense pressure on a float. While true, I'm not quite sure what the viable alternative is. If domestic monetary policy is of paramount importance (and naturally it is!), then the Fed obviously cannot sit still or in reverse gear while the domestic economy suffers from no growth and severe unemployment. Zero sum game indeed!

I don't have any charts but i'll try and create one with events, of the dollar's reaction to the downgrade and the central bank announcements etc. but it's clear that the 'safe-haven' tag has never been questioned as investors have time and time again sought comfort in treasuries. Eichengreen provides three reasons for this:

1) The US financial markets are simply way, way, way more liquid than any other market anywhere, ever. In an uncertain environment, naturally investors crave liquidity the most.

2) There has been no attempt at debt monetization, no attempt to inflate away the debt. Monetization occurs when the treasury issues debt to finance spending, and the central bank purchases it thereby increasing base money. While cash and credit in circulation must have gone up, inflation has not reared its head one bit. But that's because of the liquidity trap and the depressed economy and not because monetizing debt is a "bad thing" necessarily!

3) Lastly, and most funnily as well as obviously, in an environment like the one we live in today, Eichengreen states that "despite its warts", the dollar "is still the least unattractive belle at the ball".
Bill Gross has stated that it's the "least dirty shit in the pile". You get the point. It's the outright lack of viable alternatives.

Of course this leads us to a discussion on the alternatives which is, I suppose the crux of the paper. What comes next? Essentially, what is the fate of the euro and what exactly is the status of the internationalization of the renminbi? And thus, what is the fate of the dollar?

More on that later, maybe.

What Am I Reading?

The effervescent Wolfgang Munchau emphasizes, as so many millions have again and again and again. That the 'solutions' are proving to be worse than the problems. He has a bit for a third of the troika too, 
"One wonders sometimes whether this is the same IMF that in its latest World Economic Outlook produced a very thoughtful analysis of past debt crises. It came to the conclusion that deficit reduction programmes can function only under certain auspicious conditions and must not be pursued in a blind, mechanistic sort of way."


Interested in how the US Senate and Congress handles their wealth? Are they suffering? Nope. Here's the WP with  Capitol Assets.

James Surowiecki has a short piece in the New Yorker on the looming fiscal cliff that ends with this gem of a line, 

"The fact that Congress was foolish enough to create the fiscal cliff doesn’t mean it also has to be foolish enough to drive us off it."

The narrative Robert Shiller has a piece in the NYT on the double-edged nature of the housing fever - the booms and the busts, and the seemingly extravagant expectations people had of the market.

Keeping in line with a favourite Republican nominee pastime of euro-bashing, here's a piece focusing on Romney playing to his base by attempting to distinguish America from...well....the rest of them (in this case, Spain). Funny thing is anyone can tell you that Europe did not spend its way into this crisis - that's not the cause. But obviously Romney knows that. Which means - that this is yet another case of intentional dishonesty. 

And finally, here's Mankiw's thoughts on the whole BLS 'truther' controversy (controversy?? really?). And Krugman's blurb on constant-demography based unemployment data. What it's all trying to come down to is of course, is this a real recovery or not. Election year you see...

And finally finally, Acemoglu, Robinson and Verdier came out with a paper on different forms of capitalism. This, from the abstract - "some countries will opt for a type of cut-throat capitalism that generates greater inequality and more innovation and will become the technology leaders, while others will free-ride on the cut throat incentives of the leaders and choose a more cuddly form of capitalism. Paradoxically, those with cuddly reward structures, though poorer, may have higher welfare than cut-throat capitalists but in the world equilibrium, it is not a best response for the cut-throat capitalists to switch to a more cuddly form of capitalism."

I'm going to read it and get back on this. 

Technically...

The Singapore numbers don't look good. A bit surprising perhaps and no reason to panic, but definitely a cause for concern in the short-term future. Some highlights:

- The PMI (Purchasing Managers' Index) was down about 0.8%, that's contraction for 3 consecutive months
- Industrial Production down by 2.2% yoy in August surprisingly?
- Exports for August plunged 10.7%.

Although Singapore's economy is not over-exposed to electronics demand and the sector as a whole should see a slight boost ahead of the holiday season, the electronics PMI still fell by 0.7 points.

The problem is the not-so-short-term. Three bogeymen of varying impact - 

The ever-faithful eurozone crisis, 
A potential fiscal cliff in the US 
The should-be-considered-more slowdown (slowdown?) in China. 

Q3 for Singapore is definitely not good but it's possible that global easing measures have somewhat of an impact on the real economy thereby helping slowing economic activity a fair bit. More importantly, the MAS's focus on inflation is likely to ease and result in an easing of monetary policy. It's a bit confusing from what I've been reading. For the most part, it seems everyone thinks it likely but I've heard a few say it's almost a coin-flip. I don't think there's any question. Firstly, inflation data looks more promising which it most certainly didn't not too long ago:

Clearly, the divergence has held back (July '11 and Feb '12), perhaps reflecting accommodation cost changes. 

Secondly, exports have clearly been suffering and the effective exchange rate, it seems, has appreciated a bit too rapidly:

It's not the differential that's worrying, but rather the rapid pace of appreciation since the start of the year. Which leads me to believe that it's still very possible that the MAS goes with what they decided in their last review. 

The general talk seems a bit morose, to be honest. Generally, the SGD should act as somewhat of a safe-haven currency with international investors, more-so given the global easing announcements from the three major central banks. 

External demand conditions are damp and strengthening global headwinds (declining PMI's in key export markets), as DBS pointed out, are relatively strong indicators for the manufacturing sector. There's no need to use the 'R' word at all no matter how probable it technically is. 

The next two or three months seem pretty important. And the next week or so will be quite important for the MAS which seems to be stuck in a conundrum because it could seem a bit too soon to ease off under a false sense of bringing inflation under check. According to an economist at Mitzuho, "there is no easy policy response to fragile demand conditions with supply side inflation risks". 

I think a policy redress might be a bit premature. A slight easing might help but it might also help in undoing the hard work been put in to tackle a stubborn inflationary trend. The greater issue is the vulnerability and downside risks in major global economies and that's something that domestic monetary policy cannot account for. 

It's just a bit too soon for some easing, but most may not quite see it that way.