Thursday, 31 March 2016

A plan to turn the Euro from zero to hero

Guest post by Ari Andricopoulos

It is difficult to read the history of inter-war Europe and the US without feeling a deep sense of foreboding about the future of the Eurozone. What is the Eurozone if not a new gold standard, lacking even the flexibility to readjust the peg? For the war reparations demanded at Versailles, or the war debts owed by France and the UK to the US, we see the huge debts owed by the South of Europe to the North, particularly Germany.

The growth model of the Eurozone now appears to be based largely on running a current account surplus. Competitive devaluation is required to make exports relatively cheap. While this may have been a very successful policy for Germany during a period of high economic growth in the rest of the world, it cannot work in the beggar-thy-neighbour demand-starved world economy of today.

As I've explained elsewhere, reasonably large government deficits are very important for sustainable economic growth. However, in the Eurozone this is prohibited both by the Stability and Growth Pact (SGP) and by the fear of losing market confidence in the national debt. At the same time credit growth for productive investment is constrained by weak banks and Basel regulation. And the Eurozone as a whole is already running a large current account surplus; the rest of the world will not allow much more export-led growth. Helicopter money would be a solution, but politically this is a long way away. Summing up, if economic growth cannot be funded by government deficits, private sector debt, export growth or helicopter money it is very difficult to see where nominal GDP growth can come from.

In a way, this can be seen as a Prisoner’s Dilemma. Every country knows (or should know) that if all states provided fiscal stimulus, the Eurozone would benefit from more economic growth. However, for any individual state, a unilateral fiscal boost would increase their own government debt whilst giving a fair amount of the GDP growth to other states (because some of the stimulus would go to increasing imports from the other nations). And if all others provide stimulus, then it is in an individual state’s interest to take the benefit of the other states’ stimulus, and become more competitive versus the rest.

The huge imbalances created by the fixed exchange rate system, described in this great piece by Michael Pettis, are still there. The enormous current account surplus built up by Germany makes it extremely difficult for the less competitive countries to run a current account surplus. The only way for this to happen, without German inflation, is by internal devaluation; a long and painful process to lower wages, which may succeed in achieving a current account surplus, but only at the expense of shrinking the economy. The debt owed to the creditor nations therefore gets larger in real terms. In the end, the debts owed by the South to  the North are unpayable without the Northern countries running a current account deficit and using the savings built up during the amassing of the surplus to buy goods from the South. But the Northern surpluses are only getting bigger.

On top of this, all countries in the Eurozone are committing the "original sin" of borrowing in a foreign currency. This can only be a time bomb, waiting to devastate Europe. 

The effect of all of this becomes clear when comparing GDP growth in the Eurozone to that of the USA. In the period up to 2008, before the problems of the Eurozone structure became apparent, the growth was pretty comparable. This is to be expected with two similarly developed large blocs. The trend growth is driven by innovation and there is enough money flowing through the system to support it. After 2008, however, is a different story.  The growing gap between the two economies is largely due, in my opinion, to the existence of the Euro.

My prediction, as things stand at the moment, is that the ECB will never be able to have positive interest rates again. Growth will only deteriorate from here and eventually the currency union will have to break up. I do hope that I am wrong on this and that a political solution can be found.

Having said all of this, I believe that there is a solution that, given the political will (admittedly this is a big caveat) could make the Euro a workable currency. It consists of three parts, and the idea came from a Twitter discussion with Frances Coppola a few months ago, following this post by Simon Wren-Lewis on using inflation as a metric for determining how large the government deficit/surplus should be.

A three-point plan

1) The ECB should make an implicit guarantee of all Eurozone government debt, just as the Bank of England, the BoJ or the Federal Reserve do. 
They should state that all interest payments by all states will be approximately the same, ie. no member state has credit risk. This interest rate is thus a reflection of nominal growth rates across the Eurozone, and not of the individual default risk of any member state.
This is important because otherwise countries with default risk must borrow at higher rates, thus worsening their already (by definition) bad situation. This avoids the potential death spiral that hit Greece when the market lost confidence.
It also removes the risk to the banking system caused by holding national debt with default risk. Currently a teetering bank and teetering government could pull each other over the edge of the cliff.

2) The stability and growth pact should be scrapped and replaced with a new one that is fit for purpose. In a more appropriate stability and growth pact, the fiscal mandate of all member states is purely to target inflation. It does not matter if a government has a budget surplus of 5% or a budget deficit of 5%; all that matters is that it hits the inflation target.
Punishments, in the form of large fines, should be given to any government that strays too far from its cumulative target, on either side of the target, as it is a crucial part of maintaining growth and balance in the economy. Any state running too high a deficit will get higher growth rates, but they will add to the inflation of the Eurozone and thus devalue the currency for everyone else. Any state running too low a deficit will get a competitive advantage that takes demand from the other states and gives them a current account surplus at the expense of the others.

3) Although the average inflation across the Eurozone can remain at 2%, this inflation target should be different for different members. A country running a large relative current account surplus with a large accumulation of net foreign assets needs to run a higher inflation rate, say 3%. This would be set each year in advance by an independent formula. A country with large debts should run a lower inflation rate, say 1%.
The targets would be cumulative. So if a country needed to run 3% a year for 3 years and in the first two they only hit a 2% inflation target, then the target in the third year would be just over 5%. Likewise if they were getting 4% inflation for the first two years the target would be just over 1% in the third year.
This would mean that over the years, the (long under-rewarded) workers in the creditor countries would get wage rises and have more and more buying power, enabling them to buy more goods from the debtor countries. The increase of buying power means the previously accumulated savings by people in the creditor countries now flow back the other way. This makes it possible for debtor countries to be able to repay the creditor countries. Balance is restored.

In the past, the South consumed more than they produced, using money borrowed from the North to fund their consumption. In this new regime, the South would be effectively be working their debt off for the North.

This is far better than the current situation where the South is not working and the North is not getting paid.

This does not preclude the running of a current account surplus. If this is to be the desired policy, then (probably through currency manipulation) it could still be achieved. The difference would be that the surplus would be balanced across the whole Eurozone, and achieved at the expense of the rest of the world rather than other Eurozone members.


This three-point plan would address all of the main structural problems of the Eurozone.

It addresses the imbalances between nations by using inflation to force nations to equalise their competitiveness. This balance is important because it allows money to flow both ways, meaning that debts are less likely to arise and, if they do, can be repaid without creating hardship. These imbalances are the cause of the previous Eurozone crises and are responsible for Greece’s current predicament. Point 3 of the plan prevents them from building up.

It solves the Prisoner’s Dilemma problem above because it forces coordination of fiscal stimulus – it does not allow one country to take advantage of the others to boost its own competitiveness.  It means that Eurozone nations would no longer be undercutting each other for competitiveness.

It removes default risk, allowing governments to run large enough deficits to allow nominal GDP growth. It removes fear of borrowing so that governments can invest in projects that will improve future growth. It means that governments would no longer need to pay credit spreads to bond-holders; a cost no sovereign currency government normally has to pay. And it removes the sword of Damocles from above the head of every debtor nation. No longer would economic survival be a case of "there but for the grace of the bond markets go I".

It does so without allowing any country a free pass.  One nation may have larger debt than another, but not enough to cause the inflation so feared by Germany in particular. And because of the differential inflation rule, higher debt countries will naturally be able to pay off that increased debt.
And there are no fiscal transfers between countries. These, for obvious reasons, are very unpopular between nations and can cause a lot of resentment. Every time a country defaults in the current system, transfers are made and rifts between nations are built up. This is very damaging to European unity and can be avoided.

But the biggest benefit of all is that it would mean higher economic growth for every nation in the Eurozone.

It is my wish that we can find the political will for this type of solution. Surely this is the true meaning and spirit of European cooperation; working together to have a better outcome for all.


Ari Andricopoulos is a principal at Dacharan Advisory AG, an investment manager. He has a Ph.D in Financial Mathematics from Manchester University and has published in various academic finance journals. His personal blog is Notes On The Next Bust. Follow him on Twitter @ari1601.

Image from Carlos Latoff via, with thanks. 

Related reading:

Tuesday, 29 March 2016

The unaffordable George

On March 16th, George Osborne unveiled his shiny new Budget. Full of populist tax giveaways to help "hard working people", it was the sort of budget that we might expect from a Chancellor riding the crest of an economic recovery. UK plc is growing well, profits are rising and the Board can afford to increase the dividend.

But this is not the current economic situation. Far from an economic recovery gathering pace, the latest figures from the OBR show that UK plc is slowing. In its March 2016 Economic & Fiscal Outlook, the OBR trimmed its GDP growth forecast for the next few years:

Not only has it trimmed its forecast down to 2% pa, it has also indicated considerable uncertainty. There is even a not-insignificant chance of a recession in the Chancellor's Fiscal Mandate year of 2019-20.

From the Chancellor's perspective, growth below 1% - or even a recession - might be welcome, since it would enable him to justify breaching his fiscal surplus target. The biggest risk for the Chancellor is that growth comes in just above 1% of GDP, which would make delivering a fiscal surplus by 2019-20 all but impossible. Unfortunately for George, this is rather likely.

The Chancellor is already failing on his other self-imposed targets: the welfare cap will now be breached in every year of this parliament, and the target for debt to fall every year as a percentage of GDP will be breached at the end of this month. If he is to succeed Cameron as PM, he must deliver that fiscal surplus. Failing to do so without economic justification would leave his credibility in tatters. The OBR's growth forecasts are bad news.

Nor is potential GDP (output) growth the only factor affecting the Chancellor's prospect of delivering his fiscal mandate. Inflation, interest rates and fiscal changes also have an impact:
The surplus in 2019-20 could fall to zero due to relatively small differences in the output gap (if it were -0.7 per cent in that year, not zero), potential output (if it were 1.0 per cent lower), whole economy prices (1.2 per cent lower), debt interest spending (due to interest rates 1.2 percentage points higher than market expectations or a 2.2 percentage point upside surprise in RPI inflation), effective tax rates (a 0.5 percentage point lower tax-to-GDP ratio, due to the composition of GDP, distribution of incomes or movements in asset prices), or the delivery of public spending cuts (a quarter less than planned)...
The OBR's forecasts show that the fiscal finances are considerably weaker than they were even last November. The planned surplus is highly sensitive even to small changes in economic conditions. Far from the Board being able to afford a generous dividend, it should be retaining earnings to build up buffers. From this perspective, the Chancellor's largesse appears foolhardy.

But never underestimate George's determination to do whatever it takes to achieve his ambitions. The OBR still forecasts a fiscal surplus of £10bn in 2019-20:

 This is achieved by means of an additional fiscal squeeze in that year ONLY:

I think they call this "boomerang economics".

This remarkable fiscal spike will be achieved by:
  • bringing forward capital expenditure to 2017-18
  • delaying to 2019-20 the implementation of changes to business taxation that would force some groups to pay tax early - thus generating additional revenue for that year
  • pencilling in £3.5bn of unspecified further cuts to departmental spending in 2018-19, apparently to be achieved through "efficiency savings", though no-one has any idea what these might be. 
So this fiscal spike is actually a fiscal fudge. Forestalling of business taxation changes, reverse forestalling of capital expenditure, probably pushing a whole load of departmental spending below the line....anyone would think Osborne learned his job from a dodgy tax accountant. Of course, Osborne has always been more concerned about the politics of government financial management than the economics, but this could hardly be more blatant. All the smoothing of fiscal consolidation introduced in November has been removed so he can pretend he has hit his fiscal surplus targets, nicely in time for the 2020 election campaign. The rollercoaster is back with a vengeance.

But since the UK economy is slowing and the fiscal outlook worsening, how are the tax cuts in this Budget to be achieved while still putting downwards pressure on the debt/gdp ratio and aiming for a fiscal surplus? Well, by cutting spending, of course.

Not that this is proving at all easy for our George. Among other things, he thought he could fund his higher rate income tax and capital gains tax increases by cutting personal independence payments (PIP) to the disabled. Even before the Budget there were discomfited rumblings about this: the BBC's Andrew Marr, for example, described it as a "very callous set of priorities". But worse was to come.

Two days after the Budget, the Work & Pensions Secretary, Iain Duncan Smith, resigned. His resignation letter pointed the finger directly at Osborne's decision to cut welfare spending in order to fund tax cuts for the better-off:
I have for some time and rather reluctantly come to believe that the latest changes to benefits to the disabled and the context in which they've been made are, a compromise too far. While they are defensible in narrow terms, given the continuing deficit, they are not defensible in the way they were placed within a Budget that benefits higher earning taxpayers. They should have instead been part of a wider process to engage others in finding the best way to better focus resources on those most in need.
And he complained about manipulation of fiscal strategy for political ends:
I am unable to watch passively whilst certain policies are enacted in order to meet the fiscal self-imposed restraints that I believe are more and more perceived as distinctly political rather than in the national economic interest. Too often my team and I have been pressured in the immediate run up to a budget or fiscal event to deliver yet more reductions to the working age benefit bill. 
Sound economics and concern for the poor taking second place to Osborne's ambition. Well I never.

Perhaps predictably, Duncan Smith's resignation forced what was described as a "screeching U-turn" from the government on PIP cuts. In fact it went even further. The new Work & Pensions Secretary, Stephen Crabb, has now announced that there will be no further "planned" welfare cuts" - though that doesn't mean there couldn't be ad-hoc ones if the fiscal finances deteriorate further, and it doesn't mean that the government is backing down on £12bn of welfare cuts already announced.

But the Government's U-turn over PIP cuts has unfortunately distracted attention from the real issue. This was by no means the only cut which would disproportionately affect poorer people. In fact as this chart from the Resolution Foundation shows, the distributional effect of successive Budget changes in this parliament significantly penalises the poor and benefits the better off:

And these charts from the IFS show that the biggest cuts will be borne not by the disabled, but by low-income families with children:

George's claim that this was a "Budget for the next generation" looks very thin in the light of such a hit to "hard-working families", doesn't it?

In fact the Budget was universally panned. The highly respected IFS, in the most negative review I have ever heard it give, criticised just about every key policy proposal in the Budget for regressiveness, pointlessness or political scheming.

Paul Johnson complained about the "disingenousness" of Osborne's claim that the personal allowance rise “means another 1.3 million of the lowest paid workers taken out of tax altogether”:
No it does not mean that. Taken out of income tax, yes. But not taken out of direct taxes on income. It remains the case that National Insurance Contributions, which are just another tax on earnings, start to be paid once earnings rise above about £8,000. Low paid workers are not taken out of tax by raising the personal allowance. 
The people who really benefit from the tax allowance rises are middle-class couples where one pays higher rate tax and the other is a low-income earner, perhaps working part-time. These people also benefit most from the new Living Wage. Since their household income can be quite high, and they are therefore likely to have assets, they also stand to benefit from the capital gains tax cuts. As the charts show, all of this more than offsets the losses they suffered in previous Budgets. It would be ungrateful of them not to vote Conservative after this, wouldn't it?

The IFS questioned whether the new saving schemes would help anyone to save who was not already saving. The severe cuts to Universal Credit make it unlikely that the "Help to Save" scheme would have much effect - after all, if people are not saving now, they are hardly more likely to do so after experiencing double-digit cuts in their net income, whatever tax breaks the government offers. And the Lifetime ISA merely encourages young people to save from taxed rather than untaxed income. This has an interesting fiscal effect, as Johnson points out:
Of course if people respond by saving less in pensions and more in ISAs Mr Osborne will get more tax revenues today, his successors will get less tomorrow.
More fiscal fudge. Remarkable. In fact as Jolyon Maugham shows, George relies extensively on various flavours of fudge to make his sums add up, mostly at the expense of future generations. A "budget for the next generation" this is not. Anything but.

But the U-turn on PIP has now rendered a finely balanced Budget all but impossible to deliver. George now has a £4.4bn hole to fill, and not much to fill it with. He has committed to tax cuts he can't afford, and now that the welfare budget is effectively ring-fenced alongside the NHS, education, pensions, overseas aid and defence, it is hard to see where he is going to find sufficient cuts in the remaining unprotected departments to deliver his prized fiscal surplus.

How he deals with this depends on where George thinks his interests lie. This Budget - like all of his previous ones - has little to do with economics and much to do with securing a Conservative victory at the next election (and his own place in No.10). Will he resort to further bloodletting - perhaps in local authority budgets - and hope the restive Conservative backbench MPs accept it? Or will he quietly change the mandate and hope no-one notices?

The attitude of Conservative backbenchers is key to Osborne's survival. Duncan Smith's motives may be questionable, but his analysis hit hard. The Government's fiscal strategy, of which this Budget is the latest instalment, places an unacceptable burden on the poorest and most vulnerable people in the country while giving unjustified handouts to the well-off. Some Conservative MPs already find this hard to stomach. Further fiscal transfers from poorer to richer may be more than they will tolerate. Duncan Smith's resignation exposed a deep rift in the Conservative party, not only over Europe but also over domestic fiscal policy. Far from creating "one nation", dear to the hearts of many Tories, Osborne's regressive policies deepen the rich-poor divide. The Conservative party may not be able to afford George's ambition.

More importantly, this Budget is unaffordable under the Chancellor's own rules, themselves only set for political reasons. He has sacrificed sound economic management on the altar of political ambition. The price for this will be paid by us all.

I don't think the country can afford him.

Wednesday, 16 March 2016

Understanding balance of payments crises in a fiat currency system

It's weird. Whenever I say that floating exchange rates can't absorb all shocks and that balance of payments crises can happen even in fiat currency systems, I am accused of gold standard thinking. Gold standard? Me? Perish the thought. I am the world's biggest fan of fiat currencies. And of floating exchange rates, too. But that doesn't mean I regard them as a panacea.

Firstly, about gold standards. Under a strict gold standard, the quantity of money circulating in the economy is effectively set externally. The domestic money supply can only grow through foreign earnings, which bring gold into the country. I have said a "gold standard", but the same is true of any FX reserve-backed fixed exchange rate system such as a currency board: gold is really only a universal FX reserve. The domestic money supply grows as the supply of FX reserves rises, and falls as the FX reserve supply falls. It isn't strictly true to say that a trade surplus is necessary for the economy to grow, but if the economy grows without a corresponding increase in net exports, the result is deflation.

This is evident from the quantity theory of money equation MV = PQ, which is fundamentally flawed in a fiat currency fractional reserve system but works admirably under a strict gold standard or equivalent. When the supply of goods & services (Q) rises but the quantity of money in circulation (M) remains fixed (and assuming that V also remains constant), consumer prices (P) fall. Some people regard this type of deflation as benign, though it is worth remembering that even in a naturally deflationary system, expectations of future price falls can dampen aggregate demand. A little bit of inflation can be a good thing. Nonetheless, this sort of deflation is far removed from the vicious deflationary spiral described by Irving Fisher in his Theory of Debt Deflation.

So under a gold standard or equivalent, it is much easier for countries to grow if they run trade surpluses. This is not because exports create growth, but because inflows of FX reserves act as a monetary stimulus: the risk, of course, is inflation. Conversely, trade deficits involve a net outflow of FX reserves, which is monetary tightening. There is thus a direct relationship between domestic growth, domestic inflation and the external balance.

More seriously, FX reserve outflows in a fixed exchange rate system can result in a balance of payments crisis. Because central banks can't print foreign currencies or gold, a country running a persistent trade deficit* can literally run out of money. The IMF's original role was to provide emergency funding to countries facing such a disaster and help them implement policies to restore the trade balance. Those policies typically involved depressing domestic demand to curb imports and reduce inflation, putting downwards pressure on business costs in order to improve external competitiveness, reducing external debt, and devaluing the currency relative to its anchor. This last was key. In a fixed exchange rate system, devaluation is domestic monetary stimulus, because it allows more money to be created relative to the anchor. Thus the IMF's standard solution to a balance of payments crisis was austerity offset by monetary stimulus in order to generate export-led growth. Does this sound familiar?

The era of gold standards ended in 1971 when President Nixon suspended the convertibility of the US dollar to gold. We now supposedly have a universal system of fiat currencies managed by inflation-targeting central banks.

In a fiat currency system with floating exchange rates, the quantity of money in circulation is determined by the central bank**. The country is not reliant on FX or gold inflows for domestic money growth, and FX or gold outflows do not threaten the country's solvency. All the central bank needs to do is create (or destroy) the amount of money needed to maintain a target inflation level and allow the external value of the currency to adjust. The external balance is not directly linked to growth or inflation, and trade deficits do not cause crises.

In such a system, a trade deficit is a monetary drain which must be offset by money creation. Central banks can create unlimited quantities of their own currency: if the currency is flowing out of the country via a trade deficit or capital flight, the central bank can simply create more of it.  Note that in a floating-rate fiat currency system - unlike the gold standard and its relatives - it is not necessary to devalue the currency deliberately to enable more money to be created. Creating money for domestic monetary stimulus may devalue the currency, of course, but that is a side effect.

Equally, the inflationary effect of a trade surplus can be offset by a monetary drain (raising interest rates). This tends to raise the exchange rate, discouraging exports and encouraging imports. In a floating exchange rate system where central banks are targeting inflation, trade imbalances should in theory be benign and short-lived.

However, this is not what we have. True, we have fiat currencies and inflation-targeting central banks. But we don't have universal floating exchange rates. The ghost of the gold standard still haunts the world monetary system, living on in the proliferation of currency boards, crawling pegs and other, more subtle versions of currency fixing. And there remains an enduring belief that depressing domestic demand and improving external competitiveness is necessary to restore growth. This is gold standard thinking, and it is not appropriate in fiat currency systems.

But even if every country had a floating exchange rate, balance of payments crisis would remain a risk for many countries.

The idea that currency depreciation will absorb all shocks rests on the assumption that there is infinite demand for all currencies. The balance of trade therefore simply reflects the movement of the domestic currency in and out of the country. Since there will always be some price at which the currency is exchangeable, the country can always pay for everything in its own currency and has no need for FX reserves. If an exporter doesn't want to accept the currency of a particular country, the country can refuse to trade with him, to his detriment.

Sadly, it is not that simple. All currencies are not equal. Just as the price of government debt depends on market views of future economic performance and government trustworthiness, so too does the exchange rate of a sovereign currency. There is a hierarchy of currencies. Currencies at the top of the hierarchy - the "reserve currencies" and a few other advanced-economy currencies - are highly liquid: they are readily exchangeable for almost any other currency and welcomed in most countries. The introduction of central bank swap lines also means that these countries can effectively treat certain other "premier" currencies as their own, further reducing their need for FX reserves. The chances of a genuine balance of payments crisis in these countries are very low.

But this is not true of other countries. Currencies at the bottom of the heap are not welcomed externally: there may be no market for them, and all trade with the country may be conducted in foreign currencies. The worst currencies may not even be particularly welcomed domestically: widespread use of "hard currency" is a feature of basket case economies. Most emerging market currencies are welcomed domestically but have only a qualified welcome externally.

Clearly, a country whose currency is not widely accepted externally must trade in foreign currencies. It will have to pay for imports in foreign currencies, and since it cannot print foreign currencies and there is a limit to FX borrowing, it will look to balance this with foreign currency income from exports. If the country's FX income from exports exceeds its FX obligations, it can meet those obligations from current FX income regardless of the external value of its own currency. In fact, when the currency depreciates, improved terms of trade would mean an increased inflow of FX reserves. This looks very much like the gold standard, doesn't it?

Of course, if the country is dependent on imports for essential goods - foodstuffs, medical supplies, energy - then a rapidly depreciating currency would be likely to result in rising demand for FX as exporters to the country demand payment in other currencies. But terms of trade improvement could offset rising FX demand. Alternatively, the country can run a persistent trade surplus in order to build up FX reserves, creating a buffer to protect itself from short-term trade fluctuations. This is what many emerging market countries learned to do after the 1997 Asian crisis. Better beggar-my-neighbour competition and depressed global trade than a repeat of 1997 - or 1931.

Clearly, therefore, countries dependent on foreign currency for external trade are operating on something akin to a gold standard internationally, even if their own fiat currency is floating. And it is a fallacy to suggest that the value of the domestic currency has no bearing on this.  The value of the domestic currency crucially affects the country's ability to attract the FX it needs for external trade. Indeed FX reserves may fall disastrously when a domestic currency depreciates rapidly.

When a fiat currency is not welcomed externally, its exchange rate falls regardless of the country's external balance. We see this at present with Venezuela: the real exchange rate (not the government fix) of the bolivar is falling catastrophically despite Venezuela's trade surplus. Venezuela is an oil producer, so the (real) exchange rate of its currency to the US dollar naturally tracks the price of oil. But the bolivar's value is falling far more than that. Such rapid falls set up a feedback loop, whereby those holding bolivars exchange them for hard currency, gold and other non-perishables as fast as they can, causing the exchange rate to fall even faster. This is how hyperinflations develop. Venezuela's inflation rate is currently thought to be over 750% and rising fast. Hyperinflationary capital flight causes FX and gold reserves to leave the country at a rate of knots. No improvement in terms of trade can possibly keep up with this. Severe balance of payments crisis is characteristic of hyperinflations.

Even without hyperinflation, balance of payments crisis in an FX-dependent economy with a local floating-rate fiat currency has widespread and damaging effects on private and public sector balance sheets. Most countries that run persistent trade deficits have to import FX. The central bank does this by selling its own currency, causing it to devalue, which in normal times helps to rebalance the trade position: the central bank then provides FX liquidity to banks for them to support FX demand from households and corporations. It is normal for banks to have currency mismatches on their balance sheets, and it is also normal for many exporters and importers: these mismatches may take the form of FX debt and local currency assets, or vice versa. Households, too, may have currency mismatches if they take on foreign currency debt, for example FX mortgages (Poland please note).

These currency mismatches are toxic. A balance of payments crisis is fundamentally a solvency crisis. A sovereign currency issuer can't run out of its own money, but it can run out of other people's. And if it does, then neither the private sector nor the sovereign can service foreign currency debts. If the currency is already depreciating rapidly, the central bank selling the currency to buy FX simply worsens its collapse: monetizing sovereign deficits has a similar effect. Since the private and public sector cannot service their existing debts, they cannot borrow to meet their obligations. The result is sudden, widespread and very damaging debt default among banks, corporations and households, along with severe cutbacks in consumption. Even the sovereign can be involved, if it has high levels of FX debt. Currency mismatches on corporate, sovereign, household and bank balance sheets are the blue touchpaper that is lit when a balance of payments imbalance becomes a crisis.

It is thus quite wrong to suggest that in our fiat currency system, balance of payments crises cannot happen. They can, and they do. And this, I think, partly explains the prevalence of export-led growth models, particularly in emerging market economies. The protection offered by a sustained trade surplus from the long-lasting and horrible effects of balance of payments (FX) crisis more than compensates for reduced living standards arising from repressed domestic demand.


* For the purposes of this post, "trade" includes services.
** As I don't wish to get caught up in arguments about whether governments do or don't create money when they spend, I am preserving the fiction of central bank and government separation. This means that the language in this post is that of monetarism, rather than MMT. I do not apologise for this: it is my firm belief that MMT and market monetarism are brothers under the skin, and the differences between them are largely semantic. Though there might be a difference in political ideology too.
UPDATE TO FOOTNOTE: This post is NOT about "who creates money". I'm well aware of the limitations of the monetarist framing I have chosen, and I did say that the quantity theory of money is fundamentally flawed in a fiat currency system. However, I've used a monetarist framing to enable a direct comparison of gold standard and fiat currency systems from a trade perspective. For the purposes of this post it does not matter whether the CB creates money, commercial banks do so when they lend or the government does when it spends. I'm not going to host a debate here about the effectiveness of monetary policy versus fiscal policy. Comments about the creation of money are therefore off topic for the purposes of this post.

Related reading:

Rethinking government debt
Competitive devaluation is not a free lunch
Competitive devaluation plus monetary expansion does create a free lunch - David Glasner
The limits of understanding of MMT - Neil Wilson
How to think about the balance of payments - JW Mason

Image from The Sunday Times. 

Tuesday, 8 March 2016

A German spring

The sun is shining, the daffodils are flowering. Blossom is on the trees. The dark days of winter are behind us: in front of us lies a bright, glowing spring. Black zeros reap golden rewards, it seems.

What is all this about? German industrial production has suddenly bounced back from recent falls, rising by 3.3% month-on-month in January 2016. The German statistical agency DEStatis reports that there are particularly strong performances in construction, capital and consumer goods production:
In January 2016, production in industry excluding energy and construction was up by 3.2%. Within industry, the production of capital goods increased by 5.3% and the production of consumer goods by 3.7%. The production of intermediate goods showed an increase of 0.4%. Energy production was up by 0.1% in January 2016 and the production in construction increased by 7.0%.
According to Dominic Bryant of BNP Paribas (quoted in the FT), Germany is "booming". And in the same FT piece, Pantheon Macroeconomics describes the report as "extraordinary" - a "very strong report with a surging headline". Wow.

But hang on. This chart from DEStatis shows German industrial production since 2008:

Forgive me, but I am struggling to see any boom here. As far as I can see, German industrial production (blue lines) has been essentially flat since 2011. Taking out energy and construction makes little difference: the red line is flat too. To be sure, there is a tiny uptick in both lines at the far right of the chart, but this could simply be a statistical blip. And that wonderful rise in construction (orange line) is merely recovering the ground that has been lost since 2014. Really, there is nothing to look at here.

In fact it is worse than that. This chart from Capital Economics tells of the dangers of premature rejoicing:

The glowing figures in DEStatis's report come from the point circled on the chart. But industrial orders tell a different story. On Twitter, Capital Economics explained that this high point reflects the spike in industrial orders two months earlier - the normal lag - which has since been reversed. We might see industrial production figures rise a little higher yet, but they will then fall back.

To be sure, Dominic Bryant and Pantheon Macroeconomics both express some caution over DEStatis's figures. But both seem to think the figures say more than they actually do. There is no reason whatsoever to suppose that they presage a lasting recovery. To the contrary, Capital Economics's chart suggests that the underlying trend is actually downwards.

Spring is very short-lived in Germany.

Friday, 4 March 2016

The Great Scandinavian Divergence

From @MineforNothing on Twitter comes this chart:

Now, we know Finland is in a bit of a mess. A series of nasty supply-side shocks has devastated the economy. When Nokia collapsed in the wake of the 2007-8 financial crisis, ripping a huge hole in the country's GDP, the government responded with substantial fiscal support. This wrecked its formerly virtuous fiscal position: it switched from a 6% budget surplus to a 4% deficit in one year, and although its deficit has improved slightly since, it is still outside Maastricht limits. Because of this, the current government - under pressure from the insane Eurocrats - is implementing fiscal austerity to bring the budget deficit back below 3% of GDP. For an economy which has suffered a serious reduction in its productive capacity, this is disastrous. The austerity measures will neither reduce the deficit nor restore the economy. On the contrary, they will cause the economy to shrink and consequently - through simple arithmetic - increase the deficit as a proportion of GDP. Finland has been in recession for just about all of the last four years: what it needs is expansionary fiscal policy, not bloodletting. Austerity is an utterly self-defeating policy for an economy which has a damaged supply side due to exogenous shocks.

The one thing that is keeping the Finnish economy from imploding is the ECB's expansionary monetary policy. Negative rates and QE may be a weak stimulus, but they are better than nothing. Finland has been masquerading as a prosperous core country, but the truth is that it is much more like the weak Southern European states:

(US GDP is included for comparison)

Without ECB support, Finland would be in deep trouble.

But what on earth has gone wrong with Denmark? Like Finland and Sweden - and interestingly, NOT like Norway (more on that shortly) - Denmark suffered a deep recession after the financial crisis, hitting bottom in the second quarter of 2010. But unlike Sweden, it did not recover. The pattern of its GDP growth is much more like Finland's. Yet it did not have the supply-side shocks that Finland suffered. Why has it stagnated for most of the last seven years?

Every man and his dog has a theory about this. Most of them focus on Denmark's generous welfare state and relatively high taxation. High taxation stifles enterprise, while the welfare state discourages productive work, apparently. So what Denmark should do is cut taxes and shrink its welfare state. That will make it much more prosperous - though probably no happier.

But hang on. Sweden also has a generous welfare state and relatively high taxation. So does Norway. Indeed, so does Finland. All the Nordic states do. And all of them have made serious attempts in recent years to improve the efficiency of their welfare systems and reduce their cost. Denmark, in fact, ranks higher up the OECD's list of countries by reform effort than any other Scandinavian country. Yet their economic performance differs enormously. Finland and Denmark are performing poorly. Norway and Sweden are performing well - and Norway did not suffer the deep recession of the post-crisis years, either. It is hard to see that Scandinavian welfare and taxation causes this. No, there is some exogenous reason.

The reason is not difficult to find. Finland, the worst-performing of these countries, is a member of the Euro. Not only does this prevent it from managing its own monetary policy, including devaluing to protect its economy from exogenous shocks, but it also chains its fiscal policy to the provisions of the Stability and Growth Pact. Finland is in the Excessive Deficit Procedure, and as a Euro member, that means it must comply with the actions required under that procedure or face sanctions - even if those actions are directly harmful to its economy.

None of the others is a Euro member. But Denmark is a member of the Exchange Rate Mechanism (ERM II) which is a precursor to Euro member. It is obliged to maintain the value of its currency within agreed bands around the Euro. Its monetary policy is therefore determined to a large extent not by local conditions, but by the decisions of the ECB - whether or not they are appropriate for the Danish economy. Denmark has also agreed to be bound by the stricter form of the Stability and Growth Pact known as the Fiscal Compact, which means it is subject to the same fiscal rules and penalties as if it were a member of the Eurozone.

In contrast, Sweden is not a member of ERM II. It is supposed to join the Euro at some point, but - mysteriously - persistently fails to meet convergence criteria. The Swedish krona floats against world currencies including the Euro, giving Sweden much greater control of its monetary policy than Denmark or Finland. On the fiscal side, although Sweden ratified the Fiscal Compact, it refused to allow itself to be bound by its provisions while it remains outside the Euro. So although it is supposed to keep within Maastricht fiscal limits, it does not face penalties for failing to do so.

Norway, of course, is not a member of the EU. Since Norway is an oil exporter, the Norwegian krone is a petrocurrency. Norway has used its sovereign wealth fund effectively to mop up the income from oil production and prevent its currency appreciating excessively. Recent oil price falls nevertheless have hit it hard: January's GDP growth was negative, and it is currently drawing on its sovereign wealth fund to maintain fiscal programmes. It remains to be seen whether Norway's previous responsible management will be sufficient to prevent it slipping into outright recession. But Norway's current difficulties are principally due to global conditions, not because of ties to a depressed and austerity-obsessed Eurozone.

The ability to manage monetary and fiscal policy is precious. Eurozone central banks, locked into a one-size-fits-all monetary policy, have little ability to protect their economies from local shocks; with the centralisation of bank supervision, they have even largely lost control of macroprudential policy. Eurozone fiscal authorities, too, have little autonomy once the country is in the Excessive Deficit procedure; for those outside it, avoiding Brussels supervision can become an overriding concern. For Eurozone countries, the real monetary target is not inflation but deficit/GDP. The ECB is fighting a losing battle trying to raise inflation against the determination of the Brussels bureaucracy to force 19 fiscal authorities to depress demand in the name of balancing the books.

So Finland's economic disaster is at least partly a consequence of its Euro membership. And Denmark suffers from loss of monetary autonomy due to its membership of ERM II, and loss of fiscal autonomy because it chooses to be bound by the Fiscal Compact. Conversely, Sweden has control of both monetary and fiscal policy, while Norway not only has control of monetary and fiscal policy but is further buffered by its large sovereign wealth fund.

The final evidence is provided by this chart:

There seems little doubt. Welfare states, taxation and structural reforms, pfft. The Great Scandinavian Divergence is principally caused by the Euro.

Related reading:

A Finnish cautionary tale
An unjustified rating
Reforms, bloody reforms

Charts 2 and 3 from Arne Petimezas (@APetimezas on Twitter)