ExRussian

Today I digress from my recent Eurozone obsessions to compare the U.S. Consumer Confidence report (released today) to the PMI production surveys, a “soft” comparison of supply and demand. According to the Conference Board today:

The Conference Board Consumer Confidence Index, which had decreased in February, rebounded in March. The Index now stands at 52.5 (1985=100), up from 46.4 in February. The Present Situation Index increased to 26.0 from 21.7. The Expectations Index improved to 70.2 from 62.9 last month.
…
Consumers’ assessment of current-day conditions was less negative in March. Those claiming conditions are “bad” decreased to 42.8 percent from 45.1 percent, while those claiming business conditions are “good” increased to 8.6 percent from 6.8 percent. Consumers’ assessment of the labor market was also less pessimistic. Those saying jobs are “hard to get” declined to 45.8 percent from 47.3 percent, while those saying jobs are “plentiful” increased to 4.4 percent from 4.0 percent.

This report is nothing to write home about. Consumer confidence remains at excruciatingly low levels.

In a post back in September, I argued that the expectations index is a better indicator of consumer spending. As such, the expectations component remains stronger than the composite, having rebounded to its level at the onset of the recession. However, like the composite index, the expectations index is moving rather laterally since May 2009.

Notice the bigger picture, with the Confidence survey illustrated alongside the ISM manufacturing and non-manufacturing surveys. The story remains to be very one-sided on the production side, which is more likely to drop back to meet weak consumer demand UNLESS THE JOBS MARKET IMPROVES…FOR REAL. See my previous post on the temporary effects of the Census hirings.

The underlying demand for goods and services, as determined by the 70% of the economy that is the Consumer, is weak, especially at this stage of the recovery (having already posted a positive quarter of economic growth). (By the way, if you want National Income data, the BEA offers an exceedingly easy way to download it here.)

These numbers challenge even the most optimistic of us all (that used to be yours truly).

ExRussian

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

ExRussian

VIDEO: CLICK ON PICTURE TO PLAY!

by Marshall Auerback

As before, this is in fact another statement that indicates no checks are to be written.

The purpose is probably the hope that it be read as a statement of support which will facilitate continued funding of Greek debt.

It is a clear statement that no funding is available until Greece fails to find funding elsewhere. However, understood but unstated, is that the process of finding funding is necessarily that of price discovery. Greece, like all borrowers, simply offers securities at ever higher rates until it finds the needed buyers. Failure, in theory, is defined as the rate reaching infinity with no buyers. At that time, the euro members would step in with a loan offer at a non concessional rate which would then presumably be infinity.

This makes no sense at all, of course. The statement is in fact a statement that Greece must first drive rates to infinity before euro zone member loans are available. In other words, it’s a statement that says Greece is on its own, and that they will stand by without taking action as observers of the standard market default process of Greek funding rates going into double and then triple digits as happens to all failed borrowers of externally managed currencies, including nations with fixed exchange rates.

“In this context, Euro area member states reaffirm their

willingness to take determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole, as decided the 11th of February.

As part of a package involving substantial International Monetary Fund financing and a majority of European financing, Euro area member states, are ready to contribute to coordinated bilateral loans.

This mechanism, complementing International Monetary Fund financing, has to be considered ultima ratio, meaning in particular that market financing is insufficient. Any disbursement on the bilateral loans would be decided by the euro area member states by unanimity subject to strong conditionality and based on an assessment by the European Commission and the European Central Bank. We expect Euro-Member states to participate on the basis of their respective ECB capital key.

The objective of this mechanism will not be to provide financing at average euroVarea interest rates, but to set incentives to return to market financing as soon as possible by risk adequate pricing. Interest rates will be non-concessional, i.e. not contain any subsidy element. Decisions under this mechanism will be taken in full consistency with the Treaty framework and national laws.”

The problematic institutional structures for the euro zone have been present since inception. But it’s always been unclear as to what triggered the crisis at this particular time. ECB President Trichet gives a clue:

ECB President Jean-Claude Trichet took some pressure off Greece today by extending emergency lending rules, saying its bonds won’t be cut off from ECB refinancing operations next year in case Moody’s Investors Service lowers its rating to a level comparable with other companies.

Trichet’s remarks marked a reversal for the ECB, which said in January that it wouldn’t soften its collateral policy for the sake of a single country. The bank was scheduled to reintroduce pre-crisis rules at the end of 2010.

This basically confirmed my earlier suspicions that this whole crisis was triggered by the ECB. They closed the window, which placed attention on the perverse institutional structures at the heart of the EMU. The markets began to query the solvency of Greece as a consequence.

The problems of the EMU have been in existence since inception (Jan, you’ve written about this for over a decade). But it’s always been curious to me that the crisis came when it did. I always thought that the ECB was responsible. But at whose behest did they unilaterally change the rules of the game on Greece? I suspect Germany was responsible here.

Early Feb ECB decided to unwind QE. Remember, Greek banks were doing backdoor monetization: buying Greek government debt, reporting it to ECB, and then taking the reserves from that and buying more government debt. Germans surely took offense to that, since it is Weimar 2.0 from their paranoid perspective. Irish have also been using this loophole. In Randy’s book, turn to the page with the vertical and horizontal money diagram: this was the only way to get vertical money into Greece, once ECB stopped expanding its balance sheet as the crisis died down. So they start mentioning in front of microphones that ECB rule waiver will be up at year end, the one that lets ECB hold and repo low quality rated eurozone government debt, and away we go.”

Though China has not and is not about to save the world from economic turmoil, business leaders, captains of industry and government leaders think and read of China more regularly than ever before. The Chinese government may have imposed clear limits to what it will do globally, but this does not stop the rest of the world getting excited about China. The People’s Republic is simply “hot” at the moment. But can we rely on books written by instant China experts after one or a few visits to truly understand the governance culture of this new land of hope?
Posted December 4, 2009

In E.M Forster’s A Passage to India, a novel set in the late years of the British Raj, a liberal-minded Englishman offers to hold a “bridge party” for a newly arrived Englishwoman who longs for something of the real India. “Not the game,” explains the well-intentioned host, “but a party to bridge the gulf between East and West.” Meeting real Indians, it turned out, hardly facilitated understanding between the two cultures. When rubbing elbows, Indians and Britons only stoked each other’s resentments and prejudices. By the end of the novel, Forster indicates that a true meeting of these different cultures could exist only in the abstract-in the humanist aspirations for a shared dignity based on political equality.
Posted December 4, 2009

Most books on North Korea focus on the nuclear issue, that never-ending soap opera of the international diplomacy. In the rare cases when North Korean domestic dynamics are taken into account, the authors (most of whom do not speak or read Korean) concentrate on the official pronouncements of the regime.
Posted December 4, 2009

In February 2007 Niall Ferguson and Moritz Schularick coined the term “Chimerica” in an opinion piece published in The Wall Street Journal. The article addressed the economic paradox of the time: how interest rates managed to remain doggedly low in the face of bubbling asset prices and fast-growing corporate earnings around the globe.
Posted December 4, 2009

According to Paul French, however important and exciting the “China story” is today, a century ago it was much more so. Foreign-media coverage of pre-1949 China, he argues in his new book, was greater in scope than in recent years. Mr. French reminds us, for instance, that in the latter half of the 20th century there were more publications dedicated to China issues than there are today, as well as a number of locally edited papers that no longer exist. China was a sought-after assignment for foreign journalists, drawing in the likes of Jack London and Ernest Hemingway.
Posted July 10, 2009

This is a post about my confusion, rather than my reporting, of the Eurozone saga. Here are some pieces worth reading if you want to catch up:

The NY Times (the basics); Ed Harrison (via Naked Capitalism); From the billy blog; The Financial Times (Martin Wolf, a must read); The Economist (will reference below).

Okay, a conditional guarantee for possible lending, maybe, only with consultation from the IMF has been agreed upon by the Eurozone countries (Germany and France, really). But what I don’t understand is pretty well stated in the Economist article:

The Greek government has somehow to keep its economy on an even keel while pushing through a huge fiscal tightening. Countries that seek IMF help generally have to endure brutal cuts in public spending, which deepen recessions. To counter that effect, the IMF typically counsels a weaker currency. Sadly, this is not an option for Greece. Stuck in the euro, its exchange rate with its main trading partners is fixed. Greece cannot devalue, so it needs more time to adjust than the three years it has agreed with its EU partners—and a bigger safety net while it does.

Sadly? This is not an option? The Economist completely skips over the VERY LARGE issue of a currency peg in order to focus on the increased competitiveness that must be derived through internal devaluation, i.e., dropping wages and other nominal variables.

Financial crises, especially those in small-open economies (Sweden, for example), generally end with a massive currency devaluation that drives export growth (provided there is external demand to suffice). I honestly don’t see how a sufficient export-generated rebound is even a possibility, given that the rest of the Eurozone is essentially trying the “internal devaluation” bit simultaneously (chart above).

And who’s going to pick up the slack? In 2008, 64% of Greece’s export income was derived by the EU 27 countries, 70% for Spain, and 74% for Portugal. If the Eurozone as a whole is using this same internal deflation mechanism to spur export growth, only the “zone” as a whole really benefits, not any one country.

WIHTOUT a massive surge in export-driven GDP growth no “zone” country can drop its financial deficit without incurring behemoth debt burden growth (in the case of the Eurozone, the term “burden” actually applies since Greece, nor any one economy, can print its own money).

Look at the government’s period budget constraint (left), where the lower-case letters “d” and “p” stand for the debt and primary deficit as a share of GDP, respectively. r is the nominal interest rate, and (1+g) is the rate of NOMINAL GDP growth (including price appreciation). (Email me if you want the algebra.)

When Greece starts dropping p (the primary deficit), the fundamentals of the economy (i.e., nominal gdp growth (1+g)) must be robust enough to prevent a surging debt burden. And here’s the cycle: to drop the primary deficit, it does so by reducing G and raising T, which drags Y (as of Y = C + I + G + Ex – Im) and growth of Y, (1+g), since export growth is unlikely to be there to offset the decline in private spending; these effects then flow back to the primary deficit to raise p.

And likewise, only under the circumstances of heroic export growth can the government reduce its fiscal deficit to 3% WITHOUT the private sector levering up their balance sheets and contributing to a larger default risk (of the depressionary type). I’m confused.

All I’m saying is that this plan, in its current form, is really not much of a plan at all. The export competitiveness story is getting old, let’s think of something new.

ExRussian

This morning there was an abundance of links evidencing the building anxiety over U.S.-China relations. Edward Harrison at Credit Writedowns links to a Reuters article, China vows to hit back if targeted by U.S. on yuan. Calculated Risk refers to commentary at the Financial Times and the Washington Post referencing China Losing Support of American Business Community.

Let’s think about the currency from a U.S. auto exporter’s viewpoint. The China Daily looks at China’s relatively “young” automotive market compared to its developed U.S. counterpart. But what if the yuan appreciates more than expected against the U.S. dollar? This market would develop much quicker than the article portends, and the room for revenue growth is vast.

Deutsche Welle also reports the benefits that Europe would incur from a stronger yuan compared to the U.S. dollar, which gives me pause: why exactly would Europe profit from an appreciation of the Chinese yuan against the U.S. dollar? The U.S. export industry, yes, but Europe? Deutsche Welle tells us:

“But Europe stands to benefit a lot, because with a revaluation, European products would become more affordable for Chinese consumers and companies alike and we would definitely feel the benefits in terms of better exports,” said Schularick.

This is an entirely one-sided argument: if the Chinese yuan appreciates, then export income would be diverted away from Chinese exports and toward Chinese imports, paving the way for Europe to reap the benefits. Same story as in the U.S. auto maker case, but with a twist: China has options.

First, China drops the currency peg, allowing its exchange rate to float (appreciate) against the U.S. dollar (USD). In this situation, the USD will depreciate not only against the Chinese yuan (CNY), but more likely against all currencies to which the USD is implicitly pegged via the yuan.

It’s pretty simple, really, if you think about cross rates: USD:CNY / EUR:CNY = USD:EUR. If USD:CNY falls (i.e., the U.S. dollar depreciates against the Chinese yuan), and that depreciation is not matched by an equal increase of the EUR:CNY (appreciation of the Eurozone euro against the Chinese yuan), then you get a depreciation of the U.S. dollar against the euro (the USD:EUR falls).

Point 1: as the Chinese yuan floats, it’s very likely that all else equal, the U.S. dollar depreciates against the euro. This improves the near-term prospects for U.S. exports to Europe, and reduces those for European exports to the U.S. (given sticky prices). Therefore, the increased demand for European exports to China will be offset somewhat by the decline in demand for those to the U.S.

Second, given that the Chinese do not allow the yuan to float (much more likely), who’s to say that the Chinese will not simply substitute one peg for another, i.e., target the euro to a larger degree? This would be very simple; and frankly, a euro peg would make more sense, given the trade flows between Europe and China.

Europe is a natural market for Chinese exports: in 2007, 24% of China’s exports landed in Europe, while 21% shipped to North America. All else equal, a euro peg would be quite an effective “export growth tool” if the Chinese shifted their asset base from U.S.-denominated assets toward Euro-denominated assets.

Point to 2: Europe would be very much worse off if China simply increased the weight of the euro in its currency target basket. The biggest economy in the Eurozone, Germany, is an “exporter” itself. Talk about trade wars!

U.S.-China bi-lateral relations SHOULD BE TREATED as a multi-lateral story; they’re interconnected.

ExRussian
ExRussian