The World Bank suggests 3 policy options during currency wars: a country could 

1) Use its own monetary policy. But then the WB observes "appropriate monetary policy in many developing economies at present would likely be to tighten, which will however attract even more capital inflows and further appreciate exchange rates."  

2) Fixed exchange rates, which would require the country to "ceding control of monetary policy as an independent policy instrument." This would imply "importing loose U.S. monetary policy to stimulate excessive domestic money growth, inflation in the goods market, and speculative bubbles in asset markets. In this case, adjustment will occur through high inflation (with its attendant efficiency and equity costs) and appreciation of the real exchange rate." 

3) "combine an independent monetary policy with a fixed exchange rate by closing the capital account through capital controls." This will lead in inefficient allocation of capital and a destortion in the longer maturities.  Argentina seems to have used the latter path - but life without captial flows is not all that easy (see link). As the Argentiniean "government’s economic model is based on aggressive monetary expansion to support swelling budget deficits, currency and capital controls" the MF model tells us that the duration of these policies is limited by Argentina's foreign currency reserves. 

The Lollipop war goes back to 1789! But it did not start in earnest until the great depression.  Here is the most recent installment (mp3 and transcript):

Soros and Sinn weigh in on European Policy Options.

It all seems so black and white: Germany shoulders a greater share of the adjustment, and/or a price adjustment in crisis countries is inevitable. Note that the adjustment will either be an internal devaluation (reduction of prices/wages without a change in the exchange rate) or through an external devaluation (countries exiting the Euro, effectively leaving a fixed exchange rate regime, and depreciate their (new domestic) currencies).

There is also an interesting historical parallel. In The Economic Consequences of the Peace (1919), Keynes argued that Germany's war debt should be largely forgiven. He thought the absence of a German recovery would stifle the economic (and political) recovery of all of Europe. As an advisor to the British Government at the Verailles Conference he argued that German reparations should be limited to £2,000 million. This was less than what Britain owed the US in war loans! Nevertheless he had the audacity to suggest that a general forgiveness of war debts would benefit Britain. Certainly the German transgressions had been more objectionable than the Greek, Cypriot, Irish, Portuguise goverments in the early 2000s.

The term "competitive devaluations" or "beggar-thy-neighbor" policies refer to monetary policy designed to lower the exchange rate to increase exports and growth (see IE CH 19). More recently these policies have also been referred to as "currency wars" and even financial "weapons of mass destruction." A recent working paper by the World Bank now equates failures of the gold standard in the 1930s to competitive devaluations. Instead of unilateral devaluations, the World Bank document suggests 

The optimal policy response to the Great Depression, in this view, should have been a coordinated, unsterilized devaluation against gold by all countries suffering deflation. In effect, this would have been a coordinated global monetary easing, but without the beggar-thy-neighbor effects on trade.

- How would "coordinated devaluations" across countries have avoided the beggar-thy-neighbor effects

- Can you see any problems with the World Bank's policy prescription?  

Its impossible to argue with the numbers; and few can slice and dice numbers like Ed Leamer, who provides his is take on the sources of the 2008- recession. He focusses on an important factoid: The most recent recession is not different: because its similar to the two previous recessions (1990 &2001). And these last three recessions collectively behaved very different from the previous 9 recession.

Is it robots / microprocessors / trade? Some would add a possible liquity trap as the source of the 2008 crisis (but we all agree 1990 & 2001 were no Liquidity Trap efflictions). Personally, for me no story of the 2008- crisis is complete without an explanation of the encredible Excess Reserves: the money banks are depositing with the Federal Reserve for meager interest rate of 0.25% rather than lend it out to business investments for substantially higher rates.   

Is projected to be 700,000 jobs, due to a temporary reduction in economic growth. As forecast by the nations most respected Macroeconomic Modelers:

An Extenal Devaluation is simply lowering the value of a currency. An Internal Devaluation is trickier, it implies that domestic prices fall (and hence exports become more competitive abroad). Hailed as the the new form of expenditure switching and reducing, we now also have Fiscal Devaluations if internal devaluations are not feasible. Use the TB/Y diagram to outline how a fiscal devaluation would work (assume lower prices shift the x-m curve only). 

source 

Barry Eichengreen and Paul Krugman take down the Currency War Mirage

 Use the Large Open Economy Mundell Fleming Model to show how Currency Wars

a) may have no effect on either country in terms of competitiveness

b) show how two countries - (and hence the world) might benefit from a currency and give the conditions under which this must be true.  

Through humor, you can soften some of the worst blows that life delivers. And once you find laughter, no matter how painful your situation might be, you can survive it. (Bill Cosby)
 

Enjoy:  Here you go

 Its unclear how much hair is actually left in Greece, but its debt has gone from "Haircut" (here and here) to firesale. The first haircut was 50% in October 2011, but by early 2012 more haircuts were on the docket. This is not all that surprising since few economists thought a credible plan for Greek debt management has been presented. So the term "haircut" is actually quite fitting in the context, since regular trips to the barber are the status quo (unless you are bald).

Back to the news, today Greece managed a more permanent solution to its debt troubles: it bought back its own debt (for pennies on the dollar, or better $0.32 - $0,40 cents per dollar of debt) using other peoples' money (the European Financial Stability Facility (EFSF)). Interesting transactions: Europeans paying Greece to buy back Greek debt that is (mostly) held by Europeans. Why?

Haircut or firesale, Greek debt is still forecast rise to a whopping 188% of Greek GDP. Definitely default range. 

The East Grows only because the West Consumes. Bitch Please.

An abiding belief held by many about the global economy is that the East is one gigantic Foxconn-shaped, steroid-boosted manufacturing facility, pumping out iPhones, shoes, clothing, refrigerators, air-conditioners, and defective toys that its own people could never afford. In this narrative, the only reason that measured Eastern GDP shows any kind of life is because the Western consumer steps into the breach to buy up these manufactures.

The confirming natural experiment would then be what was sure to occur post-2008, when Western imports collapsed. Here is what actually happened:

China became the single largest contributor to world economic growth, adding to the global economy 3 times what the US did. Since this chart shows GDP at market exchange rates, those who have long argued China’s RMB is undervalued must be standing up now to say that China’s real contribution is likely even larger. Sure, China undertook a massive fiscal expansion beginning November 2008. But, hey, everyone fiscal-expanded.

In number two position among the contributors to global growth is Japan. Yes, “Lost Decades” Japan helped stabilize the global economy more than did the US. Among the other top 10 contributors are the other BRIC economies, and Indonesia.

How is East Asian or emerging economy growth merely derivative when they had nothing among Western economies from which to derive?

Here’s the other interesting fact:

(German exports to the rest of the world. Source: IMF Direction of Trade Statistics, 2011)

This chart addresses the question: How has Germany remained a successful export-oriented growing economy when its domestic demand is weak, the Eurozone is buying hardly anything these days, and German exports to the US have collapsed in the wake of the 2008 Global Financial Crisis? The chart shows that today Germany exports 30% more to Developing Asia than it does to the US. And this is not just a China effect: German exports to China account for just two-thirds of exports to Developing Asia overall. Also notice how as late as 2005, German exports to the US were still double those to Developing Asia.

The East grows only because the West consumes. Bitch please.

Menzie Chinn is reviewing recent developments. Here are the pertinent aspects (October 25, 2012)

(1) the Chinese currency has appreciated considerably since 2005 to arguably near equilibrium levels, and

(2) Chinese reserve accumulation has tailed off; in particular accumulation of USD has stabilized. 

First, to the point of Chinese currency appreciation. Figure 1 shows the nominal bilateral USD/CNY exchange rate, with Deutsche Bank forecasts, and the trade weighted real CNY exchange rate.

Figure 1: Log trade weighted real (CPI deflated, broad basket, 2010=0) CNY index (blue, left scale), nominal USD/CNY exchange rate (dark red), as of 10/24 (dark red triangle), and forecasts from Deutsche Bank (Oct. 3) (red +). Sources: BIS, St. Louis Fed FRED, and Deutsche Bank, Exchange Rate Perspectives(October 3, 2012).
Figure 4. Source: “Capital Inflows Become Outflows in China, WSJ Analysis Shows,” WSJ Real Time Economics (October 16, 2012).

In general, the trade weighted real exchange rate (blue line) is the most relevant one for assessing China’s role in the world economy; it has appreciated substantially since the end of the Great Recession. The BIS (and IMF) trade weighted exchange rates are CPI-deflated. One might reasonably argue that this measure of competitiveness (see Chinn (2006)for definitions) is not the most appropriate. It turns out that using unit labor costs does not change the conclusion considerably. Figure 2 shows that the IMF CPI deflated measure and the unit labor cost deflated to do not differ substantially (and in fact has exhibited greater appreciation since 2009Q2). 

Figure 2: Excerpt from Figure 4 of IMF, Staff Report for Article IV Consultation: People’s Report of China (July 2012).

[Some argue] China is keeping the exchange rate weak in order to gain competitive advantage, presumably by intervening in foreign exchange markets. However, the evidence for massive intervention is quite limited, insofar as we can infer from the data. 

Figure 16 from Deutsche Bank, Exchange Rate Perspectives (October 3, 2012).

Total reserves are barely rising, while the share of reserves held in US dollar assets is estimated by DB to be declining over time. Moreover, it is not quite right to equate reserve accumulation with the trade surplus, as shown in the below figure from the Wall Street Journal Real Time Economics: 

Would it be better for the U.S. and world economy if the Chinese allowed the currency to appreciate more rapidly? Most likely; as I’ve argued, this would help re-allocate aggregate demand away from China and to the rest-of-the-world. 

There are a number of ways to think about Europe's troubles

a) An irresponsible buying spree by the GIPS countries, induced by lower interest rates, due to the Euro was financed by Germany (Sinn)

b) Germany's excess savings sloshed into GIPS countries who were now flush and of course started buying 

c) It's the balance of payments, stupid! (also known as doctrine of immaculate transfer, see Davis)  

Paul Krugman provides the Davis quote and the data. 

It is normal to discuss the sovereign debt problem by focusing on the sustainability of public debt in the peripheral economies. But it can be more informative to view it as a balance of payments problem. Taken together, the four most troubled nations (Italy, Spain, Portugal and Greece) have a combined current account deficit of $183 billion. Most of this deficit is accounted for by the public sector deficits of these countries, since their private sectors are now roughly in financial balance. Offsetting these deficits, Germany has a current account surplus of $182 billion, or about 5 per cent of its GDP.

It’s also worth noting that we’re not talking about imbalances that have been going on forever.The internal imbalances of Europe are a recent development, coinciding with and almost surely caused in large part by the creation of the euro itself (GIPS is Greece, Italy, Portugal, Spain):

And what Davies’s post drives home is that implicitly at least European leaders went in for the doctrine of immaculate transfer — in effect, they wanted to believe that the huge payments imbalances could be ended without major changes in relative prices.

110 Billion to rescue Greece in 2010 seemed like a lot. Politicians underestimated the power of capital flows. To counterbalance international capital markets, which can trade $2.6 trillion on a quiet day, the size of the fund has progressively grown.  

The fund is still miniscule compared to the approximately $2 trillion China has in reserves to stablilize its currency. Curious also that Italy and Spain are in it for about a quarter when both countries may soon be in dire need of the funds assests. In the next month economists will learn how the inevitable (the end of the Euro as we know it) can play out politically.  

Another great way to visualize data

From Paul Krugman's "All Banked Up With Nowhere to Go"

First, I really, really don’t understand people who deny that we’re in a liquidity trap. As I’ve tried to explain in various ways, the hallmark of such a trap is that at the margin people hold money not for its moneyness but simply as a store of value, and that therefore conventional monetary policy — which involves swapping money for non-money assets like Treasury bills — has no effect, because it’s just replacing one zero-interest asset with another.

As confirmation, consider this LA Times report on surging bank deposits; basically, people are holding monetary assets simply as a safe place to park their wealth, and the banks have no desire to put those funds to work.

You can also see this in the data. Look at the velocity of M2 — the ratio of nominal GDP to Milton Friedman’s preferred measure of the money supply. Monetarism rested on the assumption that there was a reasonably stable relationship between M2 and GDP; what’s happening now is that deposits are piling up but going nowhere, so velocity (which rose in the 90s thanks to the rise of shadow banking) has plunged:

What about inflation? First of all, the inflation question is to some extent separate from the liquidity trap issue: you can be in a liquidity trap, with conventional monetary policy ineffective, while still having some inflation due to cost pressures.

That said, is inflation running higher than I expected? Yes. Am I worried that this might be the beginning of a runaway inflation process? No. Do I sound like Donald Rumsfeld? Yes.

The IMF study of PLOGs — prolonged large output gaps — pretty much summarizes my own views. You expect a persistently depressed economy to have falling inflation, although it tends to level out at a small positive number. There can be episodes of rising inflation along the way, however, but these normally reflect special and temporary factors, usually oil prices and/or currency devaluation.

US experience mostly fits this pattern, although I now believe that there’s an additional special factor that isn’t typical: the prolonged slump in home construction has now created a bit of a shortage, so rents are rising — and since implicit owners’ rent is a major part of core inflation, that’s causing a pickup over and above the effects of oil prices.

But there remains no sign of a wage-price spiral — wages remain very weak:

I expect inflation to subside; so do investors.

However, fear of inflation remains a powerful factor among people with a strong influence on policy — as witness Paul Volcker’s op-ed today, which is a clear demonstration of just how hard it is to break out of this trap.

In principle, monetary policy can still be effective even in a liquidity trap — hey, I sort of wrote the book on that back in 1998. But that effectiveness depends on expectations, on credibly promising higher inflation over the medium term, so that sitting on cash becomes less attractive. And that credibility is hard to achieve when even good guys — and they don’t come much better than Volcker — insist on partying like it’s 1979; not to mention the likes of Rick Perry threatening the Fed with mob justice.

The belief that it would be hard to gain the kind of credibility we need for monetary effectiveness is why I and others, notably Mike Woodford, believed that a strong fiscal stimulus was the option most likely to work in clawing our way out of a liquidity trap.

Of course, that didn’t happen either. So now people are once again hoping that the Fed will save the day — even as it’s more likely, as Tim Duy says, that we’ll get some deck-chair rearrangement.

A fascinating paper by Anthony Atkinson, Thomas Piketty and Emmanuel Saez in the Journal of Economic Literature, condensed and interpreted by Uwe E. Reinhardt @ the NYT Economix:

its a good exercise to figure out why median and mean income diverged so dramatically while per capital GDP kept growing. The answer is on Reinhardt's blog, and its depressing.

From Stuart Rojstaczer and Christopher Healy, grade inflation chroniclers extraordinaire (via Economix):

Here is   historical data on letter grades awarded by more than 200 four-year colleges and universities, confirming that the share of A grades awarded has skyrocketed over the years: 

Stuart Rojstaczer and Christopher Healy Note: 1940 and 1950 (nonconnected data points in figure) represent averages from 1935 to 1944 and 1945 to 1954, respectively. Data from 1960 onward represent annual averages in their database, smoothed with a three-year centered moving average.

Most recently, about 43 percent of all letter grades given were A’s, an increase of 28 percentage points since 1960 and 12 percentage points since 1988. The distribution of B’s has stayed relatively constant; the growing share of A’s instead comes at the expense of a shrinking share of C’s, D’s and F’s. In fact, only about 10 percent of grades awarded are D’s and F’s.

Private colleges and universities are by far the biggest offenders on grade inflation, even when you compare private schools to equally selective public schools. Here’s another chart showing the grading curves for public versus private schools in the years 1960, 1980 and 2007:

Stuart Rojstaczer and Christopher Healy Note: 1960 and 1980 data represent averages from 1959–1961 and 1979–1981, respectively.

As you can see, public and private school grading curves started out as relatively similar, and gradually pulled further apart. Both types of institutions made their curves easier over time, but private schools made their grades much easier.

What accounts for the higher G.P.A.’s over the last few decades?

The authors don’t attribute steep grade inflation to higher-quality or harder-working students. In fact, one recent study found that students spend significantly less time studying today than they did in the past. In the last couple of decades to a more “consumer-based approach” to education may be to blame, which they say “has created both external and internal incentives for the faculty to grade more generously.” More generous grading can produce better instructor reviews, for example, and can help students be more competitive candidates for graduate schools and the job market.

More disturbing, they argue, are the potential effects on educational outcomes. “When college students perceive that the average grade in a class will be an A, they do not try to excel,” they write. “It is likely that the decline in student study hours, student engagement, and literacy are partly the result of diminished academic expectations.”

All this jives with Cliff Mass's report that the University of Washington simply watered down its math assessment for Freshmen to reverse the trend of falling math scores in the 1990s.  

 

Here is a nice summary of the contagion factors in Europe. 

Contagion: Looking Ahead to Spain and Italy

... Mike Shedlock redirects our attention to the fact that only US income but not employment is rising. Not only is the change in income quite diverse and concentrated across the US population but it is also geographically diverse. Some areas gain while others loose (you guessed it largely the geographic gains/losses are correlated with the changes in inequality in the population as a whole)... Here is the sad case of Detroit - unlike Greece it does not have the option to exit a currency union and devalue...:

Please take a look at this link of a 360 degree photo tour of several spots in or around Detroit, including the abandoned Michigan Central Train station. Then there are the images of the Michigan Central Train depot courtesy of the Wall Street Journal article Less Than a Full-Service City



Shedlock has written about Detroit on several occasions:

• Detroit Mayor Plans to Halt Garbage Pickup, Police Patrols in 20% of City


• Detroit Bankruptcy Looms with Deficit of $446 Million in Budget of $1.6 Billion


• Detroit Heads For Bankruptcy; 50 Cities Must "Shrink to Survive"
  

How much longer will politicians pretend there is a way around restructuring? Mish has the round up:

80 Percent of Greeks Oppose More Austerity; Tens of Thousands Defy Spain's Protest Ban; Greece, ECB Deny the Obvious; IMF in Denial Regarding Portugal

The words for today are the same as the words for last week and last month: defy and denial. Let's consider a few examples.

Campers in Spain Defy Protest Ban

The New York Times reports Tens of Thousands in Spain Defy Protest Ban

Tens of thousands of demonstrators across Spain continued sit-ins and other protests against the established political parties on Saturday. They did so in defiance of a ban against such protests and ahead of regional and municipal elections on Sunday.



About 28,000 people, most of them young, spent Friday night in Puerta del Sol, a main square in downtown Madrid, the police said. They stayed even as the protest ban went into effect at midnight under rules that bring an official end to campaigning before the election in 13 of Spain’s 17 regions and in more than 8,000 municipalities.

Fueling the demonstrators’ anger is the perceived failure by politicians to alleviate the hardships imposed on a struggling population. The unemployment rate in Spain is 21 percent.

Beyond economic complaints, the protesters’ demands include improving the judiciary, ending political corruption and overhauling Spain’s electoral structure, notably by ending the system in which candidates are selected internally by the parties before an election rather than chosen directly by voters.

As the campaign ban came into force at midnight, many of the Madrid protesters stuck tape across their mouths to signal that they would continue the demonstration, even if ordered to be silent. “The voice of the people can never be illegal,” read some of the banners, while others argued, “We are not against the system but the system is against us.”

"Debt restructuring is not under discussion," Papandreou said in an interview in Sunday newspaper Ethnos.

Greece has no other option but to follow through its fiscal plan, ECB governing council member Ewald Nowotny told Greek newspaper To Vima Saturday. "For the ECB, the line is one and clear: you have to implement the commitments you have made."

Greece is considering deeper cuts in public sector wages and further tax increases on a range of products and professions to qualify for more aid, Greek newspapers said Saturday.

The plan may include scrapping bonuses to civil servants and employees in state-run companies, newspapers Ta Nea and Isotimia reported, without citing any sources.

The government may also lower or scrap tax-free thresholds on property holdings and the self-employed, raise consumption taxes on soft drinks and certain fuel types or shift a range of products to a higher VAT-bracket, other newspapers said.

Papandreou vowed Saturday to take any measure necessary to secure more funding for his country. "Greece must convince everyone of its determination," he said.

Eighty percent of respondents told pollster MRB they refused to make any further sacrifices to get more EU/IMF aid, an MRB poll for paper Realnews showed.

The same poll shows Papandreou's ruling Socialist PASOK neck-and-neck with the opposition conservatives, with both parties scoring 21.5 percent each. In the previous MRB poll in April, PASOK had an 1.8 point-lead.

But Papandreou warned that any failure to push through the plan might lead the country straight to default. "At the moment, it does not seem as if Greece can cover its 2012 borrowing needs... from the market," he said in the interview.

1. Higher property taxes
2. Higher value-added (consumption) taxes
3. Higher taxes on self-employed
4. Still lower government spending
5. Still lower wages
6. Still lower benefits
7. Selling Greek assets

The crisis has arrived in Italy. Anyone surprised by the S&P Downgrade? Even the IMF is speaking now using the "D" word.

The hope for a quick recovery are muted. State revenues are recovered strongly - but only in some states. Slow revenue growth foreshadowed the recent downgrade in GDP... Policy makers celebrated the end of the contraction, but the absence of a recovery that returns us back to trend growth is worrysome. 

The significant event would not be a Greek exit. The significance of a Greek exit is that Germany's bailout stance would thus have changed and Chancellor Merkel closed the Tap probably not only for Greece, but also for Ireland (whose deficit is trice that of Greece), Spain and all other PIIGS

Euro falls on rumours Greece is to quit the eurozone Greece has vigorously denied rumours that it is has raised the idea of quitting the euro. The euro has fallen by more than 1% against the dollar, following a report that Greece had raised the possibility of leaving the single currency. German magazine Der Spiegel said eurozone finance ministers were holding a crisis meeting in Luxembourg. The report has been denied vigorously by eurozone countries, including Greece and Germany. However, the BBC has learned that ministers from four eurozone countries are indeed meeting in Luxembourg. The countries - France, Germany, Finland and Netherlands - are said to be discussing EU issues, including the financial situation of Portugal, Ireland and Greece. "The report about Greece leaving the eurozone is untrue," the Greek deputy finance minister Filippos Sachinidis told Reuters. "Such reports undermine Greece and the euro and serve market speculation games. "For (Greece) to leave the euro is very complicated. It's not like they can just wake up tomorrow and say we're not in the euro anymore”Ron Leven Currency strategist said

Denials

A source told Reuters that some EU ministers were meeting in Luxembourg on Friday to review issues such as Portugal, Greece and European Central Bank leadership, "but nothing more".German Finance Minister Wolfgang Schaeuble and his deputy Joerg Asmussen were at the meeting, according to Reuters.But the head of the Eurogroup, Luxembourg Prime Minister Jean-Claude Juncker, has denied that crisis eurozone talks were being staged that could see Greece exit the euro, his spokesman told AFP. "This information is totally false," his spokesman Guy Schueller told AFP. "There is no Eurogroup meeting taking place or planned this weekend," Mr Schueller underlined.Despite dismissals from officials, the story "does seem to be having a market effect," said Ron Leven, a currency strategist at Morgan Stanley in New York. But he played down the significance of the report. "For (Greece) to leave the euro is very complicated. It's not like they can just wake up tomorrow and say we're not in the euro anymore."

Protesters demonstrated in Athens in December 2010 against government austerity measures. 

 

Bailout

Greece became the twelfth country to join the single currency, when it ditched its own currency, the drachma, in 2002. Over the past decade the Greek government borrowed heavily - public spending soared and money flowed out of the government's coffers. However, the revenues the government generated through tax were not enough to counterbalance this, mainly as a result of widespread income tax evasion. The result was a bulging budget deficit, more than four times the limit under eurozone rules. In the end, almost twelve months to the day, Greece was forced to accept a multi-billion euro bailout, by the EU and the IMF, to finance its huge deficit. The 110bn-euro ($136bn; £94bn) loan was designed to prevent Greece from defaulting on its massive debt. But despite a programme of government spending cuts and other reforms, its economy has struggled to keep its head above water. In recent weeks, there has been increased speculation that Athens could default and will need to restructure its debts. Yields on Greek government 10-year bonds have leapt to over 15 percent, a sign that investors are becoming increasingly sceptical that they will be repaid.

The Greek rescue package that the EU provided last year required massive cuts, which led many economists to doubt whether the package would actually cure the patient or induce a coma. Coma it is. This years budget shows the effects of the large austerity measures (afterall G is part of Y!), so the fall in Greek national income depressed goverment revenues to jack up the deficit. The ill designed package from a year ago, now leaves Europe where exactly in the same spot it was in last year: negotiating either a Greek exit, or more cash infusions to keep the patient alive. The BBC has the story

Greece budget deficit worse than thought

Greece's austerity measures have sparked anger in the country. 

 

Greece's budget deficit for 2010 has been revised up to 10.5% of its annual economic output. The figure is even worse than a previous estimate of 9.6%, and far above the 8% target agreed by Athens as part of the country's financial rescue. The data comes as Eurostat unveils official debt statistics for the EU. In Greece, debt levels jumped to 142.8% of the country's gross domestic product from 127.1% previously.

 

Select counties' debt statistics

Country	Deficit	Debt
Rep of Ireland	32.4%	96%
Greece	10.5%	143%
UK	10.4%	80%
Spain	9.2%	60%
Portugal	9.1%	93%
France	7.0%	82%
Italy	4.6%	119%
Germany	3.3%	83%
Estonia	surplus: 0.1%	7%
Eurozone	6.0%	85%
EU	6.4%	80%

Data for 2010. Source: Eurostat

The Greek government has brought in a string of draconian spending cuts and tax rises demanded by European peers and the International Monetary Fund as part of its bail-out last year. The measures succeeded in bringing the government's deficit down from 15.4% of GDP in 2009, but still fell well short of what was hoped. Greece's two-year cost of borrowing rose further in bond markets to more than 23% per annum following the data release. The level indicates that markets believe the country's debts are unmanageable and Athens is very likely to impose losses on bondholders when its existing bail-out loans expire in 2013. The Greek government blamed the excess borrowing on the country's recession, which has proved deeper than expected. "The Greek government remains committed to achieving its deficit targets," said the finance ministry in a statement. "All necessary measures in that direction are accounted for in the context of the medium-term fiscal strategy which will be submitted to parliament by 15 May." Many economists point to the vicious circle Greece is caught in, whereby government austerity is worsening the recession, which in turn is increasing the government deficit.

Meanwhile, Eurostat data also painted a bleak picture at the Irish Republic, whose 2010 deficit was confirmed at an unprecedented 32.4% of GDP. The level of new borrowing - double what was recorded the year before - was largely due losses at the nationalised Irish banks. Like Greece, Portugal - which is set to become the third eurozone member to receive a bail-out - also overshot its 7.3% target, with a 2010 deficit of 9.1%. Also like Greece, both Portugal and the Irish Republic saw their borrowing costs increase after deficit data was announced, each seeing yields on five-year bonds increase to about 11.5%. However, there was good news for Spain, which many see as next in line to become stuck in the eurozone debt quagmire. Madrid succeeded in cutting its deficit to 9.2% of GDP, beating the 9.3% target it had set itself.

The migration discussion in industrialized countries (aka, the discuss of how to keep immigrants out to protect domestic wages) often forgets to notice that capital is mobile. The WSJ reports how US firms respond to employment cost differentials at home and abroad. Examining capital and labor flows in isolation is not helpful as the two are intimately linked.

Use the Heckscher Ohlin model, making use of the Rybczynski Theorem to analyze the effect of such captial flows on domestic and foreign wages.

As the IMF finally comes around to realize that unfettered capital flows may not be optimal policy for all countries at all times, not all countries agree that the new IMF stance is appropriate. Brazil has long imposed capital controls (see also here) and comes out as one of the harshest critics of the new IMF stance.

At the same time, China is moving in to the opposite direction - well somewhat. The Chinese capital account has been one of the most tightly regulated, which is about to change - slightly, as the WSJ reports. This is a good exercise to see how policy effectiveness in China are going to change in the Mundell Fleming model with fixed exchange rates! 

Ok, Portugal is a done deal, now people start hand wringing whether Spain is next. Bob Mundell, "Father of the Euro" or better known as the creater of the "Mundell Fleming Model" has been warning for a while that Greece, Ireland, Portugal, and Spain are trivial compared to a potential crisis in Italy. Let's start watching the risk premium on Italian goverment debt. It sounded far out in 2010, today it is an uncomfortable reality.

As expected (but long virgerously denied by the Portuguese government), Portugal needs a bailout from the EU to maintain its fixed exchange ratet.  As usual, the past estimates were low: currently the current package has risen to $113 billion... The WSJ reports a few hours later that its closer to $126 billion...Things are starting to get interesting. Some has noticed that Spain will be next - recall that most of Portuguese debt is held by Spain...)

From Bloomberg: Portugal Said to Need as Much as $99 Billion in Bailout

A bailout for Portugal may total as much as 70 billion euros ($99 billion), said two European officials with direct knowledge of the matter. A financial lifeline would be between 50 billion euros and 70 billion euros ... Portugal has not yet asked for a bailout.

It appears a bailout is inevitable and imminent. Here are the 2 year (6.7%), 5 year (8.2%) and 10 year (7.7%) yields on Portuguese government debt - all at new highs.

Watch Ireland too - the Irish ten year yield is near 10%.

Same discussion, same situation, issues, just 80 years ago

The Pain Caucus of 1932

Here is a good discussion about the proposal to cut the massive US government deficit. In a nutshell, its about inequity aversion: spend now to reduce unemployment, or start saving now to reduce the largest fiscal deficit in US history. The below is all from Mark Thoma, who provides the readers digest version (read the links if you want the full load)

Former CEA Chairs and the Unsustainable Budget Deficit

Unsustainable budget threatens U.S., by 10 ex-chairs of the president's Council of Economic Advisers, Politico: ... As former chairmen and chairwomen of the Council of Economic Advisers, who have served in Republican and Democratic administrations, we urge that the Bowles-Simpson report, “The Moment of Truth,” be the starting point of an active legislative process that involves intense negotiations between both parties.

There are many issues on which we don’t agree. Yet we find ourselves in remarkable unanimity about the long-run federal budget deficit: It is a severe threat that calls for serious and prompt attention. ...

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http://www.census.gov/foreign-trade/statistics/state/data/

As expected, the BBC reports that Portugal is next, its just a matter of time - or should I say: its just a matter of election time...

Portugal bail-out looms as government nears collapse

Portugal's austerity measures have sparked widespread opposition

Portugal's opposition parties have withdrawn their support for austerity policies that may lead to the Lisbon government's collapse on Wednesday.

The government's expected defeat in a parliamentary vote is likely to trigger an international financial rescue.

The vote comes on the eve of a European Union summit where leaders hope to finalise a eurozone debt crisis plan.

Kevin Dunning, analyst at the Economist Intelligence Unit, told the BBC that this is "crunch time" for Portugal.

"This could be the week when they have to activate the bail-out fund," he said.

Last year Greece and the Republic of Ireland had to accept massive rescue packages after markets lost faith in their governments' efforts to deal with their debt burdens.

Portugal's financial collapse would likely spark another round of nervousness in financial markets and may revive concerns about the larger Spanish economy.

Opposition parties say the austerity plan - cuts in welfare, tax rises, and increases in public transport costs - go too far.

Prime Minister Jose Socrates has said he will no longer be able to run the country if the package is rejected.

Major international lenders have been wary of Portugal's attempts to avoid tapping eurozone bail-out funds by raising money in the debt markets.

The yield on Portugal's 10-year bond was at 7.4% Tuesday, close to recent records, an indication of investors' concerns about the country's ability to pay back its debts.

On Thursday eurozone leaders begin a two-day summit at which they hope to finalise details of a "grand bargain" to deal with the 17-nation group's debt burden. 

China is learning about the basic principles of open economy macro: Sterilize the balance of payments surplus or experience increases in output that eventually lead to inflation. Use the TB/Y diagram or the Fixed Exchange Rate MF model to show how the undervaluation of a currency leads to massive reserve accumulations that must, eventually, be sterilized. It will be an interesting case study to count the ways in which China will try to maintain control of its money supply, and how follow effective each measure is going to be.   

The New York Times reports that Mexican exports are hurting, because the peso is appreciating. With industrialized countries in crises, and the US in a liquidity trap, Mexico has become a high yielding currency - ripe for carry trade.... But then again, in the big picture, the peso may simply be returning to its pre-crisis value.

By ELISABETH MALKIN, NYT, February 8, 2011

MEXICO CITY— Six years ago, Benjamín Hernández turned his family’s small metal-stampingcompany into an exporter. Although the firm barely survived the global economiccrisis, it bounced back last year. But now he has a new worry. Mexico’s peso is rapidly rising against the United States dollar, which means that the costof producing in Mexicofor the American market is climbing in dollar terms. But because Mr. Hernandezfaces global competition for his plant’s fire extinguisher brackets,“increasing our price isn’t an option,” he said. So Mr. Hernández keepsreinvesting in the company, called Bicar, and praying for the United States economic recovery tocontinue, to stimulate his sales. “We just have to make a better effort to bemore efficient,” he said.

That seems to be the business attitude of Mexico rightnow, as the rising peso puts pressure on its exports even as Mexican policymakers are reluctant to intervene. “We decided many years ago to bet on a free-floating peso,”the Mexican finance minister, Ernesto Cordero, said in a radio interview lastweek. “It has given us good results, and we are convinced of this.”

As the exchange rate has dipped below 12 pesos to thedollar, the local press is full of speculation over what it calls “thesuperpeso.” The reasons behind the increase are the same as those pushing upcurrencies in other emerging markets. Facing low yields in developed countries,investors have bought securities in Latin America and Asiawhere returns are higher. “To any foreign investor in securities, thisgovernment is signaling that it is going to hang on to a very strong currency,”said Rogelio Ramírez de la O, an economist, who argues that the governmentprefers a strong peso because it brings stability. “It is a no-brainer to buythe peso.”

But the risk, he said, is that “you are inviting speculatorsto give you a capital outflow whenever something changes in the United States, particularly if U.S. interestrates rise.” Export figures suggest that the strong peso has not caused anyharm yet. Although the currency is now at its strongest level since October2008, Mexicoregistered blistering growth in exports, which drove an economic expansionabove 5 percent last year. Mexican exports rose almost 30 percent in 2010. Thestandout was the auto industry, where exports grew 52 percent to a record. Inpart the export boom is a rebound from a disastrous 2009, when the economyshrank by 6 percent as the recession caused demand in the United Statesfor Mexican products to dry up.

Nicolas M. Guillet, the president of Salzgitter MannesmannPrecisión, the Mexican subsidiary of a German supplier, said the steel tubeshis plants produced for the auto industry were priced in dollars. But thestronger peso means that his costs for labor, gas and electricity are allrising in dollar terms. Since he cannot pass the increases on to his customers,the impact is on the bottom line. “It has eaten a significant chunk of mymargin,” he said. The company, which set up production in 2007 outside Guadalajara, has beenstudying how to hedge against the stronger peso. “This creates an extra layerof complexity,” Mr. Guillet said. “Our strength and skills are in producinggood parts at a competitive cost, not in managing currencies.” Still, even withthe pressure from the rising peso, he expects sales to increase 60 percent thisyear, on top of a 100 percent increase in 2010.

The US trade pattern in two pictures, curtesy of the WSJ

From the NY: Students Covering Bigger Share of Costs of College or 

Public Universities Relying More on Tuition Than State Money

Here is the full report onTrends in College Spending 1998-2008

A great survey of the History of OCA Theory. Here is the Readers Digest version. Barry Eichengreen applies it to the Euro.

The Wall Street Journal is very funny:

Portugal Bailout Denial: Sure Sign One Is Coming Soon?

Portugal’s prime minister said Tuesday that the country won’t need a bailout. If history does in fact repeat itself, this means Portugal’s probably going to be asking for help in a matter of days.

During the debt crisis that’s plagued Europe for nearly a year, government leaders have made a habit of publicly declaring that their countries can fight their own battles shortly before asking for help.

A look at what happened when Ireland and Greece officials made similar statements last year shows that when those two European sovereigns declared they were fine on their own, it took less than a week for them to start sounding a different tune. Within a month of their statements, both had done full about-faces and sought financial aid from the European Union and International Monetary Fund.

Ireland’s minister for European affairs, Dick Roche, said Nov. 15 that “there is no need for us to trigger any [financial support] mechanism; we haven’t triggered any mechanism; there’s been no political discussions about triggering a mechanism.”

It was exactly six days later that Irish Prime Minister Brian Cowen formally applied for aid from the EU and IMF bailout fund.

Greece set the trend eight months earlier, when Greek Prime Minister George Papandreou said March 18 that “we want to do it ourselves and, for that reason, we are not seeking financial help.” Five days later, Finance Minister George Papkonstantinou said, “There must be some sort of mechanism to ensure stability,” a statement that some saw as an about-face. By mid-April, Greece had formally requested the European Union-IMF bailout.

So, don’t be surprised if Portugal is asking for help next week, even as Portuguese Prime Minister Jose Socrates said Tuesday that the country “won’t ask for any financial help because it’s not necessary.” Indeed, spreads on Portuguese sovereign debt swaps reached record-wide levels Tuesday — an indication that fears about the country’s fiscal health were running high — before bond-buying by the European Central Bank helped calm down the market.

Just don’t assume that these sudden stance shifts are unique to Europe. Remember how many U.S. financial institutions proudly said they didn’t need help from the U.S. government in 2008? We all know how that ended.

The yield on the Portugal 10-year bond is at 7.1%...

From Marcus Walker at the WSJ: Portugal's Test of Debt Market Looms This Week

Portugal hopes to raise new funds in a bond auction on Wednesday ... European Union governments including Germany and France have for weeks been urging Portugal to apply for rescue loans from the joint EU-International Monetary Fund bailout facility ...

the EU's deliberations over Portugal haven't reached the intensity seen ahead of the Greek and Irish rescues ... That could change quickly, however, should Portugal's borrowing costs continue to rise. Euro-zone finance ministers are set to meet Jan. 17, by which time the market's appetite for Portuguese debt should be clear.

Portugal and the EFSF: déjà vu all over again

Reuters reports this morning that discussions have started for Portugal to seek fund under the EFSF/IMF scheme, as pressure on Portuguese and other eurozone peripheral bonds increased on Friday. According to the Reuters report, preliminary discussions have taken place since July about a scheme totalling between €50bn and €100bn, according to an unnamed source. Merkel’s spokesman officially denies that any pressure has been brought on Portugal (which is obviously not true). The article also said the EU was expecting a “battle of Spain”, which would be the real test of the system.

The official Portuguese reaction continues to be one of denial. Portuguese Prime Minister José Socrates reiterated that the government is doing its homework and that his government will meet its 2010 budget target. Jornal de Negocios quotes Socrates saying: “We have better results in terms of receipts, better results in terms of expenses and this provides the strongest signal of confidence to the international markets that we can provide”.  We heard the same messages before Greece and Ireland were bailed out. Pedro Passos Coelho, the leader of the opposition, is quoted by Reuters as saying with that, with an EU bailout, the government would not be in a position to continue ruling as its policies would have failed. In Portugal, the opposition is obviously using the threat of a bailout for political point scoring.

In its attempt to alleviate the pressure of the markets, the Portuguese government is looking into alternatives to debt auctions. Diario Publico (hat tip El Pais) reported that the Finance Ministry will proceed with a direct sales operation, possibly towards with China.

Spanish newspapers reported that Portugal would inevitably have to seek international financial help. (To contain contagion, Spain wants Portugal to tap the funds sooner rather than later.)

Spain is nervously awaiting its first bond issue of 5 year bonds, El Pais reports. Italy will also launch a bond that same day.

Bloomberg cites an article in today’s Handelsblatt saying that Germany might be ready to discuss expanding the €750bn rescue facility at the next EU summit. Der Spiegel reported that this could coincide with an agreement on aid for Portgual. “No decision has been taken about widening the rescue fund,” Steffen Seibert, Merkel’s chief spokesman told.

Willem Buiter is provocative, but he may be correct. Any country other than the US or Japan would have seen capital flight in response to their economic crises. But in a world of risk, both countries experienced capital inflows because they were seen as the sovereign of last resort, or, the least risky of all risky assets. If Buiter is right, what will be the new save asset?

Sovereign Debt Unsafe, Default Concern Spreads to U.S., Japan, Buiter Says

Bloomberg, By Simon Kennedy - Jan 7, 2011

“Despite the recent drama, we believe we have only seen the opening and second act, with the rest of the plot still evolving,” London-based Buiter and colleagues wrote in a research note published today. “There is absolutely no safe” sovereign.

The warning comes after the threat of default forced Greece and Ireland to seek bailouts and as borrowing costs for Portugal this week surged at a six-month bill sale as investors speculate it will be next to seek aid. Elsewhere, U.S. lawmakers last month extended tax cuts and are now wrangling over whether to raise the nation’s debt limit, while Japan’s public debt is set to exceed twice the size of the economy this year.

“The U.S. and Japan likely cannot continue to ignore the issues of fiscal sustainability,” said the Citigroup economists, who added that it’s “only a matter of time” before the U.S. government can only fund itself through debt issuance at “significantly higher interest rates.”

Concern of default will spread especially if the definition is extended beyond violating legal contracts to include the infliction of losses on bondholders by deliberately engineering inflation or currency depreciation, the economists said.

Several debt restructurings will occur in the euro area in the next few years and the current system of providing liquidity won’t be enough to prevent them, the economists said. Greece’s government is “manifestly insolvent,” they said.

European Debts

Western European government bonds are now riskier than emerging-market debt for the first time as investors brace for $1.1 trillion of borrowing from euro-region nations this year.

For a lasting solution, the sovereign-debt crisis must be addressed at the same time as weaknesses in the region’s banking system, the report said. In Ireland, for example, the recent aid package will “buy time,” yet fails to address fault lines in the country’s banking system and highlights the need for a continent-wide regime to deal with them, it said.

Portugal is likely to be the next country to access the regional rescue fund soon, yet the almost $1 trillion system of support “looks insufficient” to prevent a speculative attack on Spain or to fund it completely for three years, the economists said.

Spain Contingency

In a separate report also published today, JPMorgan Chase & Co. economist David Mackie said there is concern that if Spain seeks help “the current arrangements will not be able to contain the crisis” and that doubts about whether debt sustainability can be achieved without restructuring would linger and contagion could spread to Italy and Belgium.

“If that were to happen, euro-area policy makers would need to enlarge the current facilities,” said Mackie, noting that could involve moving to a system of debt guarantees and reducing the borrowing costs on the emergency cash.

The chance of the 17-nation euro area breaking up is nevertheless “extremely unlikely and would be an economic disaster,” said Buiter’s team, adding that exiting the region would be “irrational” for fiscally weak countries such as Greece.

We've had part I of the saga, and now - like night follows day - we have the Portuguise version (via Reuters):

Germany and France want Portugal to accept aid

Reuters, (by Brian Rohan; Editing by Alison Birrane)

Fri, Jan 7 2011

BERLIN (Reuters) - Germany and France want Portugal to accept an international bailout as soon as possible in order to prevent its debt crisis spreading to other countries, German magazine Der Spiegel reported on Saturday.

Without citing its sources, the magazine said government experts from both European heavyweights were concerned Lisbon will soon not be able to finance its debt at reasonable rates, after its borrowing costs rose at the end of last year. Berlin and Paris also want euro zone countries to publicly commit to do whatever it takes to protect the bloc's single currency, including topping up a 750 billion euro ($968 billion) rescue fund if necessary. Portugal is viewed by many economists as the peripheral euro zone country that is most likely to follow Ireland and Greece to seek an international bailout as it grapples to cut its debts and borrowing costs. It holds its first bond auction of the year next week.

Why rely on Purchasing Power Parity adjusted GDP to assess development. Here are much more convicing measures:

Light

  Locations of Friends

  Air Traffice

Looks like the coming year is going to be a tough one for the Euro...

A Tactical Short is, of course, not to be confused with my favorite book of the years: The Big Short

Of course, if you like this one, you will also enjoy his eclectic collection on the crisis:

A scary reminder how little the 2008 US banking crisis taught Europe:

This is not, in fact, an Irish bailout. It's a bailout of the European (including British) banks that lent a lot of money to the Irish government and Irish banks. If European governments want to bail out their banks, let them do so directly and openly—not via the subterfuge of country bailouts. Then they should face the music: How is it that two years after the great financial crisis, European banks make so-called systemically dangerous sovereign bets, earn nice yields, and then get bailed out again and again? Source

Japanese farmers enjoy a 777.7% tariff on imported rice. Some say its a matter of national security. The new Trans Pacific Partnership would unhinge these tariffs in exchange for unfettered Japanese car and television exports... They should talk to the Indonesian farmers, Korean farmers, or even those European farmers whose livelihoods are protected by subsidies...

WTO Rules U.S.Tariffs on Chinese Tire Imports Legal (Businessweek)

Dec. 13 (Bloomberg) -- World Trade Organization judgesrejected China’s complaintthat U.S.tariffs on Chinese car and light-truck tires violate global trade rules, sayingthe Obama administration “did not fail to comply with its obligations.”

President Barack Obama announced the three-year dutieson $1.8 billion of tires from Chinain September 2009, acting on a complaint by the United Steelworkers union,which represents 15,000 employees at 13 tire plants in the U.S. The unionsaid Chinese tire exports to the U.S. tripled from 2001 to 2004 to41 million and called for a cap on annual imports of 21 million.

The case was the largest so-called safeguard petitionfiled to protect U.S.producers from growing imports from China. Union leaders and Democraticlawmakers said at the time the decision was proof of Obama’s commitment tosafeguarding domestic workers and jobs.

The Chinese government said the tariffs broke WTOrules and were a “serious case of trade protectionism, which Chinaresolutely opposes.” It lodged a complaint at the Geneva-based WTO against theduties just three days after Obama announced them.

‘Major Victory’

“This is a major victory for the United States and particularly for Americanworkers and businesses,” U.S. Trade Representative Ron Kirk said in a statementfrom Washingtontoday. “This outcome demonstrates that the Obama administration is stronglycommitted to using and defending our trade remedy laws to address harm to ourworkers and industries.”

Trade complaints against China have surged since Obamabecame president -- as have retaliatory steps by the Chinese government. China calls U.S.complaints against its exporters signs of protectionism while the U.S. says it’senforcing trade rules.

The two countries, the world’s largest andsecond-largest economies with $366 billion in annual two-way goods trade in2009, have clashed over access to each others’ markets for products includingsteel pipes, auto parts, poultry, movies and music. Chinaran up a $201 billion trade surplus with the U.S.in the first nine months of this year, more than the U.S. deficit with the nextseven-largest trading partners combined, according to Commerce Department data.

That gap, together with the drop in Americanmanufacturing employment and the U.S.contention that the yuan -- which has gained 2.4 percent since a two-year pegto the dollar ended on June 19 -- is undervalued, has made China a targetfor Congress and voter anger.

Opposition

The Tire Industry Association opposed the tariffs,saying they would create shortages and hardships for tire retailers withouthelping domestic manufacturers. Findlay, Ohio-based Cooper Tire & RubberCo., the second-biggest U.S.tiremaker, and the U.S. unitof Osaka, Japan-based Toyo Tire & Rubber Co., which has a plant in Atlanta, were alsoagainst the tariffs.

One year after the duties kicked in, they have“reversed a massive decline in domestic production and provided much-neededrelief to workers, their employers and communities from a flood of Chinesetires,” according to Leo Gerard, president of the Pittsburgh-based UnitedSteelworkers.

The tariffs are calculated as a percentage of tires’value. Obama imposed a levy of 35 percent in the first year, 30 percent in thesecond year and 25 percent in the third year, on top of the 4 percent dutyapplied to all passenger-vehicle and light-truck tires imported into the U.S. market.

 Samuelson provides a dissenting opinion. 

Turns out the iPhone is not really "Made in China." Interestingly China produces none (!) of the components, it only provides the assembly. Here is an update of Table 1.1 in Eicher Turnovsky and Mutti:

(source Rassweiler, 2009) 

which was then used by Xing and Detert to show that the iPhone addes a whopping $1.9 Billion to the US trade deficit with China. 

First it was panic, then hype, and now it is conventional wisdom: Portugal & Spain will have to restructure and its just a question when. How these packages turn out politically and economically will likely determine if the Euro will go into "over time" - a package for Italy... 

Here is Ken Rogoff:

Now that the European Union and the International Monetary Fund have committed €67.5 billion to rescue Ireland’s troubled banks, is the eurozone’s debt crisis finally nearing a conclusion?

Unfortunately, no. In fact, we are probably only at the mid-point of the crisis. To be sure, a huge, sustained burst of growth could still cure all of Europe’s debt problems – as it would anyone’s. But that halcyon scenario looks increasingly improbable. The endgame is far more likely to entail a wave of debt write-downs, similar to the one that finally wound up the Latin American debt crisis of the 1980’s.

For starters, there are more bailouts to come, with Portugal at the top of the list. With an average growth rate of less than 1% over the past decade, and arguably the most sclerotic labor market in Europe, it is hard to see how Portugal can grow out of its massive debt burden...

Paul Krugman provides the pertinent data...

Italian 10 Year bond rates 

Here is the story in an interactive chart and video from the WSJ 

The EU/IMF program stole Ireland's Christmas. Just like in Greece, the people are on the streets to protest. Paul Krugman outlines nicely how the Irish Crisis is - just like the Greek Crisis - a botched goverment action that citizens now have to finance with dramatic spending cuts (and tax increases). 

Just like in Greece, the simple solution would be to give up on the Euro, devalue dramatically and bring back the old Irish currency, the Punt. The costs keeping the Euro a clear - they are outlined in the new EU/IMF package. What are the costs of bringing back the Punt? 

The economic effects of NAFTA are still being examined in the US

 - John McLaren & Shushanik Hakobyan

- Council on Foreign Relations

- Peterson Institute for International Economics

- Congressional Budget Office

- Office of the United States Trade Representative

- Economic Policy Institute

- US State Department 

While gains from trade usually generate increases in national incomes, they do produce winners and loosers. Most countries have government programs that are supposed to address this redistribution of income. In the US President Kennedy introduced the Trade Adjustment Assistance Program administered by the US department of labor.

The DOL's national statistics highlight that currently 280,000 US workers benefit from the program, at a cost of $575 million. That is about $2000 per worker - probably not enough to pay for retraining or any meaningful compensation for job losses. The state data is even more fascinating. 

The Irish Times reports that the EU and IMF have approved the Irish rescue package. Irish Prime Minister Cowen confirmed the European Union has agreed to Irish Government's request for financial aid package from the European Union and the International Monetary Fund. While the package is approved, its size is still undetermined (although the Financial Times thinks its around $100-$120 bn). Even Prime Minister Cowan does not seem to know how large the program will be - but he does know it will be smaller than the Greek bailout package. 

As predicted the arrival of the IMF team and the resulting austerity measures are no marriage made in heaven (see here)  

·        The EU/IMF program calls for

                 - corporation tax rate to remain unchanged at 12.5%

·                                 - 10bn euros (£8.5bn) of spending cuts between 2011-2014, and 5bneuros in tax rises

·                                 - minimum wage to be cut by one euro to 7.65 euros per hour

·                                 - 3bn euros of cuts in public investment by 2014

·                                 - 2.8bn euros of welfare cuts by 2014, returning spending to 2007levels

·                                 - reduction of public sector pay bill by 1.2bn euros by 2014

·                                 - the reform of public sector pensions for new entrants with paycut by 10%

·                                 - 24,750 public sector jobs to be cut, back to 2005 level

·                                 - VAT up from 21% to 22% in 2013, then 23% in 2014

·                                 - raise an extra 1.9bn euros from income tax

·                                 - abolition of some tax reliefs worth 755m euros

·                                 - real GDP to grow by an average of 2.75% from 2011 to 2014

            -  unemployment to fall from 13.5% to below 10% in 2014 

Bank Run In Ireland

The Irish government is still playing hard to get. Until yesterday, it  refused to concede that a bail out was needed - and that's remarkable given that the EU/ECB/IMF delegations were already on their way to Dublin. 

This morning the FT reports that that corporate customers have been pulling out their deposits from Irish banks, amid signs of fading confidence in the banking system. Irish Life & Permanent said corporate customers had withdrawn €600m, more than 11% of total deposits, during August and September. The FT report says there is evidence that another deposit crunch is happening right now, as confidence faded that the Irish banking sector is able to fund itself if, and when the ECB scales backs its emergency funding.  But even the  ECB funding had not been sufficient as Irish central bank had to provide €20bn in exceptional liquidity assistance outside the ECB programme. And, wait for it, Brian Lenihan, the Irish finance ministers, tells the world that the Irish banks had no funding difficulties.

Floyd Norris of the New York Times outlines (in two parts) the US/Chinese Dilemma:

In the long run, China may have to choose. Its currency can become more reasonably valued by rising against the dollar (and the euro, and the yen, andthe pound, and the won and so on and on) or it can become more reasonably valued through inflation and rising costs that reduce China’s competitiveness. 

and 

Who's in Charge of Determining U.S. Interest Rates? It May Be Beijing

May 19, 2005 | May 13, 2005

IN Washington these days, complaining about China has become standard operating procedure. The Bush administration calls on China to allow its currency to rise and Congress talks of punishment if China does not do so.

Be careful what you wish for.

As speeches of low-level Chinese bureaucrats are read with care for hints as to just when China will allow its currency to rise, perhaps it would be better for Americans to ponder the impact of China's current policies. Some might wonder just why the American politicians are upset. The way things work now, China sells to the world most everything the world wants and then buys United States Treasury securities. That helps hold down interest rates and stimulates consumer spending.

You can understand why China might not like to keep doing that forever. Those Treasury securities do not pay much interest, and they are sure to decline in value, measured in Chinese yuan, when that currency rises. But the largest vendor financing program ever has stimulated both the Chinese and American economies. In Washington, the theory is that China's keeping the yuan low increases America's trade deficit. But the benefits to United States exporters from a modest rise in the Chinese currency would most likely be small, while the effect of higher interest rates could be larger if China cut back on its purchases, particularly if other Asian central banks decided that they, too, wanted to sell dollars.

If that were to happen, the impact could be acute in the housing market. Investors in housing stocks have been nervous for some time, happy to see ever-higher profits but worried that the good times must end someday and fearful that they could be left holding the bag when that happens. One stock where those conflicting emotions have played out is Pulte Homes, a home builder active in 27 states. Last fall, its share price fell when it reported problems in Las Vegas, which was perhaps the most overheated market in America. But price cuts there got homes selling again, and the stock has resumed its ascent. Pulte filed its quarterly report with the Securities and Exchange Commission last week, disclosing that its inventory of land continues to grow. Some of that land is owned, while the rest is controlled via purchase options that give Pulte the right to walk away - forfeiting what it paid for the option - if home sales soften.

Kathleen Shanley, a bond analyst at Gimme Credit, points out that Pulte's inventory of land is concentrated in areas where home prices have been rising rapidly and that the company's cash flow is negative, even as profits soar, because of all the land it is buying. Pulte has been borrowing money even as it buys back stock at high prices. When things were at their worst in Las Vegas, Pulte was seeing cancellations of home purchases that amounted to 75 percent of new sales. "The risk of similar, and perhaps more prolonged, regional downturns should not be ignored," Ms. Shanley wrote in a note to clients. Rising interest rates could be a cause of such downturns. Homeowners with fixed-rate mortgages would be relatively immune, although they could find it harder to sell if they needed to, and the flow of cash from mortgage refinancings would dry up.

But many buyers, particularly in some of the hottest markets, have resorted to floating-rate mortgages, some of them paying only interest. Alan Greenspan, the Federal Reserve chairman, has less power over interest rates than he once did. Perhaps the real decision maker will be Hu Jintao, the Chinese president, as he weighs the pressures to free his currency and stop accumulating Treasury securities. In the words of Robert J. Barbera, the chief economist of ITG/Hoenig, "Hu's in charge here."

Analysis provided by Menzie Chinn on the occasion of China's last rate hike, March 18, 2007.

Attaining Internal and External Equilibrium in China

China raises rates again. What will higher rates do?

From Bloomberg:

China Cools Investment, Fails to Tame Trade Surplus (Update1)

By Nipa Piboontanasawat

March 19 (Bloomberg) -- China, which raised interest rates for a third time in 11 months this weekend, is discovering that solving one of its two main economic problems makes the other one worse.

The interest rate increases and other measures are cooling investment in factories, real estate and other fixed assets, allowing Premier Wen Jiabao to claim partial victory in a fight against wasteful spending. At the same time, the trade surplus -- which has pumped cash into the economy, fueling inflation and asset bubbles -- is ballooning.

The People's Bank of China raised interest rates to the highest in almost eight years on March 17. By curbing investment, Wen has reduced demand for imported steel and cement for factories, exacerbating the trade imbalance and straining ties with the U.S.

"It's difficult to reduce both investment and the trade surplus," said Huang Yiping, chief Asia economist at Citigroup Inc. in Hong Kong. "You can do one but you'll see a rebound in the other."

Wen is concerned that building too many factories will leave the world's fastest-growing major economy vulnerable in a slowdown. The central bank has increased the amount of money lenders must set aside as reserves five times in eight months, sold bills to soak up cash, and restricted property investment.

See also coverage here: FT, WSJ, and Macroblog.

Interestingly, the increase in the nominal interest rate is only offsetting, to a certain degree, accelerating inflation. This point is made in Figure 1.

 
Figure 1: Nominal (blue) and real one year lending rates (green). Real rates calculated by subtracting off lagged one year CPI inflation rates (quarterly averages of monthly year-on-year inflation rates). Source: IMF, International Financial Statistics, and author's calculations.

I find it interesting to think about this issue in the context of the Mundell-Fleming model with low capital mobility. "Low capital mobility" is modeled as a small value for the parameter linking capital flows to interest differentials vis a vis developed market economies. I'll depict this characterization as a "BP=0 schedule" steeper than the LM curve.

 
Figure 2: Tightening of monetary policy.

Just to review, this is an demand side model, with prices assumed fixed (or sticky) for the period of analysis. The IS curve summarizes the relationship between interest rates and income for which income equals aggregate demand, for a given level of autonomous spending and real exchange rate. The LM curves summarizes the combinations of interest rates and incomes for which a given money supply equals money demand. The BP=0 curve includes all combinations of interest rates and income for which the current account and private capital account sum to zero, for a given real exchange rate. Y^FE is full employment output. As drawn, under quasi-pegged exchange rates, the country experiences a substantial balance of payments surplus; the LM is held in place by sterilization of reserve accumulation through the sales of monetary stabilization bonds.

The increase in the domestic interest rate (and the imposition of restrictive administrative measures) could be interpreted as a shift inward of the LM schedule. This leads to a reduced GDP at Y₁ (or in dynamic terms, a slower growth rate), as desired by the authorities. But at the same time, the combination of reduced output and higher interest rates (now at i₁) leads to an exacerbation of the external disequilibrium (a bigger balance of payments surplus, through an increase in the trade balance, and higher capital inflows), thereby illustrating Huang Yiping's assertion.

As many observers have noted, a more rapid appreciation of Chinese yuan -- as shown in Figure 3 -- could accomplish both aims of slower growth and less external imbalance more efficaciously.

 
Figure 3: Accelerated real exchange rate appreciation.

A stronger yuan shifts up the BP=0 schedule and shifts in the IS schedule due to expenditure switching toward foreign goods (although the strength of this effect is subject to great uncertainty -- see Marquez and Schindler, Thorbecke and Chinn). Output is reduced down to full employment levels, while equilibrium interest rates fall to i₂.

This then poses an interesting question: Why is it the Chinese authorities choose this route? The exchange rate route leads to a larger investment expenditure share, and smaller export sector, while the monetary tightening route leads to a smaller investment share and larger export base. It therefore appears that they value the export sector more than domestic investment. To the extent that Chinese authorities are wary about the quality Chinese capital investment, this might make sense. However, to justify the current (costly) approach, Chinese investment must be very low productivity indeed (which may be true -- see Dollar and Wei). Or alternatively a yuan's worth of foreign demand might be perceived as inducing more employment than a yuan's worth of domestic investment.

On the other hand, maybe Chinese authorities are coming around to the need for more drastic appreciation. From Daily News and Analysis:

HONG KONG: Economic policy circles in China and Hong Kong are abuzz with speculation that Chinese authorities are preparing for a one-off 10% appreciation of the renminbi later this year as a "shock treatment" procedure to rein in the country’s soaring trade surplus and beat back currency speculators.

...

"The intriguing possibility that the authorities might be preparing for a second renminbi revaluation in the 10% range is gaining traction in policy circles," notes UBS chief Asia economist Jonathan Anderson.

How realistic, though?

"In the current environment, it's a small but rising possibility," notes Anderson. However, he acknowledges, this is an "unlikely scenario" - not only because there isn't sufficient political support for such a large discrete move but also because it's not clear that carrying out another revaluation would solve China's trade problem or end the currency speculation. ...

So perhaps we may still have to wait a while more for "rebalancing".

China raises interest rates; world shudders

TUESDAY, OCT 19, 2010 13:48 ET BY ANDREW LEONARD

Reuters

A U.S. dollar bill and a Chinese yuan banknote

China's "shock" decision to raise interest rates by a quarter of a percentage point on Tuesday jolted world financial markets. Oil prices and stock markets fell, on the expectation that China's move would impede domestic economic growth, thus decreasing that nation's demand for commodities and possibly placing a drag on the larger global economy.

China's reasons for the move are clear: After successfully emerging from the global recession through the combined powers of a huge stimulus and an artificially weak currency, China's economy has been growing like gangbusters, and inflation is on the rise. U.S. and European central bankers would likely do the exact same thing if faced with a similar inflationary push. But China is also determined to be aggressively proactive in avoiding a potential crash. In recent months, China's leaders taken strong measures to quash the kind of disastrous property bubble that blew up the U.S. economy

From Bloomberg:

 

Officials raised the reserve requirements for six banks for a two-month period, three people with knowledge of the matter said last week ... China will speed up the introduction of a trial property tax in some cities and then expand the levy to the whole country, the government said Sept. 29, without giving a timetable. The state also told commercial banks to stop offering loans to buyers of third homes and extended a 30 percent down payment requirement to all first-home buyers.

 

Considering the effect a mere interest rate hike in China has on financial markets worldwide, it doesn't seem like a stretch to think that an actual Chinese economic crash would be bad news for the entire world. If U.S. government leaders had been able and willing to slam on the brakes when the U.S. property bubble was accelerating, perhaps the Great Recession could have been averted.

But that's not how some critics see the move. Paul Krugman, who has been doubling down in recent days on his assertion that China is a "rogue economic nation," argued immediately that China's interest rate hike is more evidence of the country's "beggar-thy-neighbors" policy.

 

So, the United States is pursuing an expansionary domestic monetary policy, which increases overall world demand; however, a side consequence of this policy is a weaker dollar. China is pursuing a weak-yuan policy; to counter the inflationary domestic effects of that policy, it's pursuing a contractionary domestic monetary policy, reducing overall world demand.

We're doing the right thing; they're making the world as a whole worse off.

 

The whole world? I wonder whether Australia, and other commodity exporting nations in Africa and South America, would support that thesis. Chinese economic growth has been very good for their economies over the last ten years. Africa has enjoyed the best overall growth in many decades, in large part due to China. Yes, emerging markets, as reported by the Wall Street Journal, were hammered by the interest rate move.

But how much worse would they be hurt if China's economy crashed altogether?

Nonetheless, it's also true that China's move, in the short run, hurts the U.S. Higher interest rates in China will attract foreign capital, thus having the perverse effect of strengthening the dollar at exactly the time when a low dollar is most in the interest of the U.S. So in a zero-sum game between the U.S. and China, the U.S. loses ... unless China matches its interest rate hikes with policy moves favoring a stronger yuan. (SEE UPDATE BELOW.)

At the very end of a Financial Times article on the rate hike, Nick Chamie, head of emerging markets research at RBC Capital Markets, is quoted as saying that the hike "was the start of a cycle of rate rises in China to be accompanied by further appreciation in the Chinese currency against the US dollar."

That would be a good thing indeed, but it will have to be seen to be believed. But it is fundamentally inevitable. China's primary goal is stable, strong economic growth. A trade war with the U.S. would endanger that. But so too would the kind of drastic, immediate revaluation that Krugman and others demand. Some sort of gradual, mutual accommodation has to happen. If today's rate hike is a first step in that direction, that would be exactly the kind of shock the world needs.

"We [Ireland[ are no longer a sovereign nation in any meaningful sense of that term" says Morgan Kelly, professor of economics at University College Dublin "From here on, for better or worse, we can only rely on the kindness of strangers." Kelly is known as Ireland's "Doctor Doom." He's got a long (depressing) piece on Irelands (mis)fortune entitled If you thought the bank bailout was bad, wait until the mortgage defaults hit home. 

George Bush's much hated but much needed TARP program (these days mysteriously attributed to Democrats) resulted in an 8.2% return... Check out (here) if your bank got some - the odds are it did, the list is long.

The Bank of International Settlements reports that the DAILY foreign exchange volume has just about cracked the $4 trillion mark. Up from $3.3 trillion in 2007. To get an idea of the unbelievable scale of these flows, the DAILY turnover is thus larger than the total ANNUAL income of any European economy (for example, FX turnover is twice the size of the UK's ANNUAL income) and DAILY FX flows are about 1/3 of the ANNUAL income in the US. Or, to ballpark it, ANNUAL FX flows are about 70 times larger than ANNUAL US GDP...

Interestingly, the dollar maintains its status as the worlds reserve currency, despite the subprime crisis, despite quantitative easing (rounds I and II), despite record fiscal deficits, and despite the zero interest rates policy of the Fed.   

A WSJ/NBC poll shows that most Americans now think free trade agreements hurt the US.

Forbes thinks it is simply the media bias. But USA Today makes a good point, From 2000 to 2009, America’s trade deficit with China surged nearly 300%. During that same time, 5.4 million American jobs in manufacturing were eliminated. It’s tough for U.S. manufacturers to compete against China’s lower wages, looser regulations and cheaper currency.

In a way the public sentiment is understandable. Nobel laureate Paul Samuelson (1969) was once challenged by the mathematician Stanislaw Ulam to "name me one proposition in all of the social sciences which is both true and non-trivial." It was several years later than he thought of the correct response: comparative advantage. "That it is logically true need not be argued before a mathematician; that is is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them." 

Austerity protests are growing violent in Europe, and we are not just talking about Greece. Here is a summary of Austerity measures that European countries have instituted to avoid debt crises (spiraling public deficits that increase country risk). Its the cost of maintaining membership in the Eurozone. Other countries "simply" devalue - not that devaluation is without costs, they are just not that obvious. Here is a good exercise: lists the costs and benefits of staying in the Eurozone, and the costs and benefits of a devaluation. 

The world at war; the weapon: depreciation. Brazilian Finance Minister Guido Mantega has warned in remarks reported from Sao Paulo. "We're in the midst of an international currency war, a general weakening of currency," he said in remarks reported by the Financial Times newspaper. "This threatens us because it takes away our competitiveness." Japan, South Korea and Taiwan have intervened recently to pull down the value of their currencies, the newspaper noted, and the dollar has fallen by about 25 percent so far this year against the Brazilian real. Such a decline increases the price of Brazilian exports on the US market.

Barry Eichengreen provides a summary of the economic implications of currency wars. Here are a few study questions

Why is China keeping its exchange rate artifically low?

Why are the US and Europe contemplating weaker currencies?

How are these policies related to beggar-thy-neighbor effects?

What are the alternatives to beggar-thy-neighbor policies?

Who is the winner in this war? 

Why do countries tailspin into economic crises?

Source: Frankel

That's how long it took for a the NBER Eggheads to locate the bottom of the recent economic downturn - which is also associated with the end of the recession. As we know by now, the patient is recovering but much slower than we have seen after previous recessions. That's because this is the only recession that involved (or indeed was started by) a banking crisis -- other than the great depression. In "Diminished expectations, double dips, and external shocks: The decade after the fall," Reinhart and Reinhart outline why the 2008 collapse of the US banking sector makes this recovery special.

Credit Suisse tells us in a few pictures why the the past year since the end of the recession is still not feeling like a "Recovery."  

There is a lot of hype that the Chinese are manipulating their exchange rate. Unfortunately the discussion usually involves the nominal exchange rate - which does not indicate the real value of the currency. Nor does it indicate the actual competitive edge that the Chinese exchange rate policy is actually creating. Menzie Chinn has the whole story, here are his is his post:

The debate over the yuan's value is heating up again. [Free Exchange/RA] [WSJ RTE/Talley] [WSJ RTE]. Here is a plot of two relevant time series.

 

Figure 1: Real trade-weighted value of CNY from BIS (blue, left axis), and nominal CNY/USD exchange rate (monthly average of daily rates). + denotes 9/15/2010 observation. Dashed line at de-pegging in July 2005. Source: BIS, and St. Louis Fed FREDII.

Two quick observations. First, the Chinese trade weighted real exchange rate is the relevant one for the world economy; the USD/CNY nominal exchange rate has some importance for the US-China trade balance, but less so for the US overall trade balance -- which is the relevant aggregate.

Second, the trade weighted CNY was appreciating before the crisis, and the CNY has largely reverted to that trend over the past few months, after a detour associated with the dollar appreciation during the financial crisis and flight to safety. This observation, however, does not speak to whether the level of the rate is appropriate for moving the Chinese current account to a sustainable level. Additional (relevant) graphs in this post. 

The divide between political rhetoric and economic reality in Europe is growing. Former IMF chief economist Simon Johnson along with Peter Boone have the summary:

As usual, Nouriel Roubini tells us how deep Europe could side in all different dimensions. (Remember, Roubini earned only hearty laughs when he predicted the 2008 financial crisis in 12 easy steps too scary for anyone to take seriously - then it all came true, just worse than even he had predicted...

Here is the update on Euro Bond Spreads. Looks like markets are getting quite confident about default - then why is the Euro so strong? - Because US interest rates are zero... Try Interest Parity...

The newswires are abuzz with the news of the Japanese Central Bank intervention.  Some commentators realize that the ancient term for "dollar mercantilism", "neo-mercantilism", or "competitive depreciation" is simply "beggar thy neighbor" (see Chapters 19). The Economist Magazine has an interesting take on the issue. IF the Japanese intervention floods the market with dollars and IF this would lead to inflation in Japan - the effect might actually be positive for all!

Extra Credit: How would you use the large open economy Mundell Fleming Model (Chapter 19) to explain how the massive sale of yen by the Japanese Central Bank could benefit not only Japan but also the US (and other countries).  Hint: Think Liquidity Trap, and The Paradox of Thrift...

Solution: Combine 1, 2, for an alternative view (see 3, which is the "great vacation" view of the great recession. I contrasted these views before...).

Time for a short list of links to Chinese Mercantilism, which is blamed for an annual loss of 1.4 million jobs in the US.

The mechanics of "Dollar Mercantilism" - why China is buying $ 

Effects of Dollar Mercantilism on the US  

Krugman's back of the envelope US job-loss calculation  

Krugman's "Taking On China", calling for a 25% tariff against Chinese goods

Ralph Gomeroy "Jobs, Trade, Mercantilism" Part 1 & Part 2 

Peter Morici's Currency Conversion Tax to End Mercantilism 

Today the Japanese Central Bank intervened (for the first time in 6 years in international currency markets). BBC has the story:

Japan moves to combat rising yen 

The Japanese central bank stepped in to sell yen and buy dollars, a day after the yen hit a 15-year high against the dollar.

It is the first time in six years that the Bank of Japan has intervened, and further action has not been ruled out. A strong yen makes Japanese exports more expensive, and reduces profits when earnings are repatriated.

In early trading on Wednesday, the dollar rose to 85 yen, after hitting 83.09 yen on Tuesday. Investors welcomed the intervention, sending Japan's Nikkei share index up by 2.9% at first, with the index eventually closing 2.34%higher at 9,516.56.

Economic harm

But in a brief news conference, Finance Minister Yoshihiko Noda said: "We have conducted an intervention in order to suppress excessive fluctuations in the currency market. "We will closely monitor currency developments, and take firm action including intervention… The yen's rapid appreciation "harms the stability of the economy and finances. We cannot tolerate it."

Japanese exporters praised the intervention. "From the standpoint of aiding the competitiveness of Japan's manufacturing industry, we applaud the move by the government and the Bank of Japan to correct the yen's strength," carmaker Honda said in a statement. Honda's shares closed up4%, while Sony, another big exporter, ended 4.2% higher…  A recent government survey suggested many companies were considering moving production overseas if the yen stayed high.

The record low for the dollar is 79.75 yen, reached in April 1995. Mr Noda did not reveal the size of the intervention, although the Dow Jones news agency reported that Japan's Ministry of Finance had initially sold between 200bn and 300bn yen ($2.4bn-$3.6bn).

But who is buying the Yen? The Japanese economy has been anemic since the early 1990s (the Japanese stock index has fallen by roughly 66% in the last 20 years).

Source 

Ok, so the Chinese government has been buying Japanese bonds, but their $20 billion purchases this year, cannot be the whole story.  Reuter's makes an attempt to explain the recent movements using interest parity (yield spreads) and sterilization - none of it convincing.  The one interesting piece is that the REER has actually not moved much less than the nominal exchange rate because of Japanese deflation.

Here is a final thought: when will we hear about Japanese "Mercantilism?" 

The Wall Street Journal spells out the Love (Hate) triangle all its juicy details:

Japan is not alone in this phenomenon. China has also bought South Korea’s currency, the won. And South Korea routinely intervenes in currency markets, buying dollars to keep its currency from rising too quickly, again offsetting China’s move out of the dollar. 

Dani Rodrik expounds the virtues and pitfalls of the Chinese exchange rate manipulation. For a change, he does not focus on US-Chinese economics, but on the impact of the undervalued Yuan on poor countries. 

a) use the large open economy diagram to show how a one time reduction in the exchange rate affects China and poor countries

b) explain why the artificially weak Yuan is equivalent to Mercantilism (see page 630) and explain the exact dynamics.

Cartoonist E.W. Clay published this 1831 cartoon lampooning the "American System" as the Monkey System with this caption "Every one for himself at the expense of his neighbor!" (Source) Senator Henry Clay of Kentucky is considered the architect of the “American System,” the first US government-sponsored attempt to invigorate the national economy.  The Systemn included:

The system was an attempt to bring Alexander Hamilton’s proposals to fruition, as outlined in his 1792 “Report on Manufacturers.” As proposed under the American System, a protective tariff of 20 to 25 percent on imported goods—such as woolens, cottons, leather, fur, hats, paper, sugar and candy—would protect the nation’s fledgling industries from foreign competition.  Congress passed a tariff in 1816 that increased the price of European goods, which encouraged consumers to buy less expensive American-made goods. (Here is also the Wiki brief on Mercantilism).

This graph from Paul Swartz at the Council of Foreign Relations shows the time structure of Greek default probabilities for three different dates: The market oracles thus that default will occur sometime around 24 months from now... 

These probabilities are based on risk spreads between German (aka "risk free") and Greek bonds. The IMF, does not seem to have a subscription to the same data. Greek debt default is unlikely according to IMF... Debt default by an advanced economy such as Greece is “unnecessary, undesirable and unlikely”, according to an IMF paper released yesterday.

This runs against market sentiment according to which  Greece will eventually restructure its debts, writes the FT. I guess the story is that "once Greece has cut its deficit to zero, it will not need any new borrowing to finance its budget. Examples in the past 20 years, like Belgium in 1984 or Italy in 1991,showed that when these advanced economies cut their deficit none of went on to default."  Time will tell...

 A comparison of real time yields for European Country Debt is now available from Bloomberg. Calculated Risk has the instructions:

One line of reasoning holds that Fannie Mae and Freddie Mac - the two quasi governmental agencies that are now in receivership and fully owned by the tax payer - caused the housing bubble. It took until now to inform this discussion with actual data. The NYT has the abstract and the entire report can be found here.

Interestingly, the Federal Housing Finance Agency suggests Fannie and Freddie did not cause the housing bubble, since one can think of the money that poured into the housing market as cash that was piled on on top of Fannie and Freddie's regular annual mortgage financing (in blue below). This reduced Fannie and Freddie's share of the US housing finance by about 50% in 4 years. 

Source: Inside Mortgage Finance

Right now it seems pointless to assign blame, the housing market is getting downright scary. New mortgage delinquencies are still increasing in the US and the decline in overall delinquency (still near all time highs) came only because of some loan modifications that targeted 90+ day delinquent loans.

See Calculated Risk Post: MBA Q2 2010: 14.42% of Mortgage Loans Delinquent or in Foreclosure

These delinquencies are partly explained by the high unemployment, but also by the negative equity that so many Americans now hold:

My plumber in Seattle (making $90/hour) proudly told he stopped paying his mortgage, since he is 20% under water. Scarily, the above chart suggests this level of negative equity is about average for the state.  

Time to check in with the PIIGS and take the Euro pulse again. Ireland's debt has been downgraded (again) on the eve of a massive government bond sale, and the end of the tourist season now signals the Greek decline in earnest. Not surprising, the risk premia for the PIIGS are up, nearing their May 2010 highs, while the Euro is in free fall again, after it peaked at just above 1.30. 

In 1979, Professor Vogel shocked the world with the bold title of his book: 

It was a shock, because Japan was exporting cars like this at the time: 

A few years later, the Japanese car makers brought US car makers to their knees - to the degree that Chrysler received its first government bailout in the early 1980s. When the US car industry was threatened by the popularity of cheaper more fuel efficient Japanese cars, the US government threatened car tariffs in 1981. As Japanese manufacturing productivity exploded across all manufacturing sectors, so did its exports, and soon Ezra Vogel's book became the book to read in the 1980s. 

Alas, Japan never became number 1 - and just a few days ago it lost its number 2 status, as China advanced to become the second largest global economy. The Economist points out, however, that the Chinese rise is less about China than about the Japanese decline: 

WHEN China's economy was announced as the world's second-largest earlier this week, the news was spun as a China story, or occasionally as a story about the Chinese challenge to America. But the data that triggered the announcement were Japanese, and China's rapid catch-up to the Japan says as much about the latter economy as the former. 

Five years ago China’s economy was half as big as Japan’s. This year it will probably be bigger (see chart 1). Quarterly figures announced this week showed that China had overtaken its ancient rival. It had previously done so only in the quarter before Christmas, when Chinese GDP is always seasonally high. Since China’s population is ten times greater than Japan’s, this moment always seemed destined to arrive. But it is surprising how quickly it came. For Japan, which only two decades ago aspired to be number one, the slip to third place is a gloomy milestone. Yet worse may follow. Many of the features of Japanese capitalism that contributed to its long malaise still persist: the country is lucky if its economy grows by 1% a year. Although Japan has made substantial reforms in corporate governance, financial openness and deregulation, they are far from enough. Unless dramatic changes take place, Japan may suffer a third lost decade.

Read the entire piece. It's largely about the structural problems in the Japanese economy, and especially in Japan's corporate sector. But one shouldn't overlook the chilling effect of years of deflation.

Pictures of the Great Recession brought to you by the Center for Budget and Policy Prioritiesnter on Budget and Policy Priorities

In 1998, the financial times reported that the Argentinian finance minister compared the country's peg to the dollar with a marriage to a pretty Hollywood actress:  Foreign investors often ask Argentine officials if they have an exit route from convertibility, the currency board system that links the peso at par to the dollar. "When you are married to Sharon Stone, you do not require an exit route."

"Plan B" does turn out to be important, in the world of Hollywood divorces as well as in currency markets.  These are important lessons for European nations that are currently contemplating to drop the euro to depreciate (and probably also) deflate their way out of the massive country debt. Bleyer and Levy Yeyati have the story.

A fantastic, dynamic graph of the Fed's Balance Sheet, by credit facility

Joe Stiglitz says it all in a nutshell: The Federal Reserve Board is no longer the lender of last resort, but the lender of first resort. Credit risk in the mortgage market is being assumed by the government, and market risk by the Fed. No one should be surprised at what has now happened: the private market has essentially disappeared.  

The only way you can get behind the massive government stimulus is if you believe that a one-time defibrillation is needed to resuscitate the economy from its liquidity trap. If you do not believe that we are in a liquidity trap, there is no need for stimulus and all the money spent is simply wasted without effect (other than increasing the public debt). 

There is now ample evidence that the stimulus was large enough to stop the economy from going over the cliff - economic growth has recovered. However, at the same time, the stimulus was not large enough to result in large scale hiring or investment. That's a major problem. The defibrillation returned a heart beat, but the patient is still in a coma. 

Many had argued that the stimulus was too small at the time. I didn't do the math at the time whether the size was right, but was astonished how unproductive much of the spending actually was. Unproductive in actually putting people to work. Of course,  in his General Theory, Keynes wrote, “To dig holes in the ground, paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.” So the take-away was "it does not really matter what the stimulus is being spent on, as long as its spent. But it turns out that out insufficient size or productivity in terms of the # of people put to work matter for a stimulus. Here is how the unusually creative and brilliant Robert Schiller puts it in the NYT (via Mark Thoma). 

This would take care of the necessary income effect to exit the liquidity trap. Appropriately targeted tax cuts could stimulate investment. But a basic result in economic theory is that temporary tax cuts have very limited effects, and the debate about the semi-permanent Bush tax cuts is still raging (see here and here and here)...

Including Central Bank Reserves can be found at the Center for Financial Stability.

Deficits, Elections & The IMF 

Why have Hungary and the IMF been chatting in the first place? A previous post highlights Hungary's fiscal deficit problem, which led to increased country risk and foreign reluctance to finance the Hungarian external deficit.   As Chapter 15 and this post by Simon Johnson outline, this is a classic case for the IMF -- especially if elections are coming up. Here is the story from the Financial Times:

IMF breaks off talks with Hungary

This is a story we used to see a lot more ten or twenty years ago. Hungary and IMF have  broken off talks, as the new Hungarian government refuses to accept further austerity measures. The FT reports that the message is not entirely clear, as the economy minister later accepted that Hungary would cut its budget deficit to 3% of GDP by 2011. It looks as though the government is mindful of the local elections, which could see the rise of a far-right party that opposes foreign capital. The election are held in October. The EU also criticised the Hungarian policies, as well as attempt to undermine the independence of the central bank. Hungary currently does not need to draw on the €20bn standby facility, but the article says the country’s financial position remains precarious. The forint fell by over 3% against the euro after the news of the breakdown of talks came out. 

Update 7/23/2010: When It Rains, It Pours

Hans Rosling believes that making information more visually accessible has the potential to change the quality of the information itself. His website Gapminder allows data to be displayed to experience development in motion. He also has a great TED talk. Here is one of his pictures:

Output has recovered in the US

but employment is still absolutely dismal

And there is little evidence for an imminent hiring spree.

New evidence that economists had the entire stimulus vs. no stimulus debate 80 years ago. Damning evidence against economics as a science. What is the definition of progress/consensus if 80 years of theories and data do not produce insights into such fundamental events as great depressions/recessions. This tête-à-tête between Keynes et al. and Hayek et al. can actually be judged with the beautiful hindsight of history. On one side in the ring areJohn Cochrane and Luigi Zingales. On the other side are Paul Krugman and Brad DeLong. Here is Chochrane:

Nobody is Keynesian now, really... Now, we all understand that growth, fuelled by higher productivity, is the key to prosperity... We now understand the links between money and inflation, and the natural rate of unemployment below which inflation will rise... We all now understand the inescapable need for markets and price signals, and the sclerosis induced by high marginal tax rates, especially on investment...

Most of all, modern economics gives very little reason to believe that fiscal stimulus will do much to raise output or lower unemployment. How can borrowing money from A and giving it to B do anything? Every dollar that B spends is a dollar that A does not spend. The basic Keynesian analysis of this question is simply wrong. Professional economists abandoned it 30 years ago...

The government can also help by not causing more harm. The credit markets are partly paralysed by the fear of what great plan will come next. Why buy bank stock knowing that the next rescue plan will surely wipe you out, and all the legal rights that defend the value of your investment could easily be trampled on? And the government needs to keep its fiscal powder dry. When the crisis passes, our governments will have to try to soak up vast quantities of debt without causing inflation. The more debt there is, the harder that will be. 

And in the other side of the ring is Paul Krugman, who can hardly contain himself after reading the Keynes/Hayek debate from 1932:  

First, Hayek was as bad on the Depression as I thought. The claim that “many of the troubles of the world at the present time are due to imprudent borrowing and spending on the part of the public authorities” — in 1932! — is bizarre. The claim that barriers to trade and capital movement were what was preventing recovery is as crazy as … as .. claiming that we’re in a slump because workers decided to take a break in the face of prospective Obama tax hikes.

Second, Keynes pretty much had the policy implications of the General Theory down long before he actually worked out the detailed analysis. I’m especially struck by the way he grasped, right from the start, the point that if higher private spending expands employment in a slump, so does higher public spending.

Third, it’s deeply tragic that we’re having to have this debate all over again, as the world economy slides into deflation and stagnation. 

It may be time to buy Gold. While the precious metal is at all time highs, some highly intelligent commentators see us staring at the abyss:

Willem Buiter, a highly distinguished economists (now chief economist at Citi) believes Europe need not Euro 1 trillion, but Euro 2 trillion in tarp money. Here is his line of reasoning.  I thought it was fitting when I heard the Euro 1 trillion package referred to as "Wundertuete" or "Grab Bag" since no one has any idea if/when/how or how much a country in need could procure from that fund. Paul Krugman thinks Obama's TARP 1 was too small a similar line of reasoning has been proposed byBrad DeLong. If all that money is indeed needed at some point to pull the economy out of the ditch, government debt is going to skyrocket. If these commentators are correct, we're between a rock and a hard place: debt or depression.

On the lighter side, the alternative is to listen to Ed Prescott (also a very intelligent economist, in fact, a Nobel Laureate). He proposes the view (called Real Business Cycles) that business cycles and indeed great recessions or depressions can be modeled as technological retrogression (people forget technology). Sounds strange, I know, but that's just the beginning (via Stephen Williamson):

"Ed Prescott did pathbreaking work in the economics profession, and his Nobel prize is well-deserved. However, I doubt that there were any people in the room yesterday who took Ed seriously. Ed's key points were: 1. Monetary policy does not matter. 2. Financial factors are the symptoms, not the causes, of the recent downturn. 3. The recession was due to an Obama shock, i.e. labor supply fell because US workers anticipate higher future taxes."

Chapter 15 outlines Expenditure Switching and Expenditure Reducing Policies. None one could have described the heart ache better than former IMF chief economist Simon Johnson. After using either the IS/LM or the TB/Y model to indicate how a country can end up with a balance of payments crisis, it may be interesting to read Johnson's account of the IMF's image problem. He highlights that no matter how different countries are the sources of the problems are almost always similar (as the models in Chapter 15 confirm...). His descriptive also highlights why the political powerless almost are always the losers when  in the harsh austerity measures kick in, and that this hardly makes the IMF radar :

A historical treasure trove (mostly US/UK data, some Chinese/Japanese data

• • Annualized Growth Rates
  • Relative Values - US $
  • Relative Values - UK £
  • Relative Values - China 
  • Relative Values - Japan ¥
  • Conversion ($ and £)
  • Purchasing Power - US $
  • Purchasing Power - UK £
  • Savings Growth - US $
  • Inflation Rates
  • Stock Growth Rates (DJIA, SP500, & NASDAQ)
• GRAPHS
• DATA SETS
  • GDP - US
  • GDP - UK
  • CPI - US
  • Wage - US
  • RPI & Earnings- UK
  • Consumer Bundle - US
  • GDP, & Prices- China
  • GDP, Prices, & Wages - Japan
  • SAP - US
  • Daily DJA
  • Price of Gold
  • Interest Rates - US & UK
  • Dollar Exchange Rates
  • Dollar-Pound Exchange Rate

Here is the notion of Optimal Currency Areas in two pictures 

The eurozone pain is mainly in Spain, by Stephen Gordon:

...I charted the employment losses for the G7 countries and noted that while the US was still bouncing along the trough of of a deep recession, the other countries were less badly-hit. But there was an important country missing from that graph - and it wouldn't have been included in a chart for the G20, either.

It turns out that even though only 14% of the people who use the euro live in Spain, the fall in Spanish employment accounts for 41.5% of the total eurozone losses since the peak in 2008Q3:

The picture from the WSJ below looks dramatic. That's when people say lies, damn lies and statistics...

What looks like a massive appreciation is really only a 0.4% move against the dollar. 

From the WSJ Journal in Education:

SUMMARY: China's central bank allowed the yuan to appreciate to its highest level ever versus the dollar, possibly signaling a new era of exchange rate liberalization in global markets.

CLASSROOM APPLICATION: Student learn how central banks impact a country's currency in a fixed exchange rate regime. They also learn how market forces may affect the value of a country's currency. Finally, they discover how changes in a currency's value affects exports and economic growth.

QUESTIONS:

1. What are two factors that caused the value of the yuan to appreciate to 6.798 yuan per dollar on Monday? Check today's dollar/yuan exchange rate and comment on the size of the appreciation to date

2. What will the effect of the central bank letting the yuan appreciate versus the dollar be on China's exports? On American imports? Why? Use information in the article, and recall the Marshall Lerner condition and the J curve.

3. How does the People's Bank of China (China's central bank) intervene in foreign exchange markets to keep the yuan from fluctuating? 

4. Does the U.S. government want the yuan to appreciate versus the dollar? Why or why not? Do American consumers want the yuan to appreciate versus the dollar? 

Reviewed By: Marc Tomljanovich, Drew University

Chapter 15 outlines why and when a Central Bank might want to Sterilize the effects of Balance of Payments imbalances.

The case seldom considered is that such sterilization might actually fail, because the public is simply not willing to lend to the central bank at the prevailing interest rates. This just happened in Europe at a grand scale. Perhaps that is not surprising, the markets are clearly predicting an imminent Greek default (aka "restructuring" or "haircut").

CRISIS IS BACK WITH A VENGEANCE AS ECB’S STERILISATION AUCTION FLOPS

After a brief lull, during which the crisis seemed almost forgotten, the financial market reverted to crisis...

One of the reasons for the panic was concern about the state of the European banking system, and the surprising news was that the ECB’s €55bn fixed-term deposit flopped spectacularly, as it managed to managed to raise only €31.866bn at an average interest rate of 0.54%. This means that financial institutions continue to hog liquidity.

The  FT reports on new turbulences in financial markets, as the ECB’s decision not to renew one-year loans to financial institutions spooked investors and prompted concerns about the ability of some eurozone banks to access interbank borrowing markets for funding.  Financial shares dropped 4.5%, European interbank borrowing rates jumped to the highest level for nine months and the euro reached lowest exchange rate level against the yen for the last eight years.

The cost of insuring Greek government debt is now second only to that of Venezuela,Bloomberg reports. Credit swaps signal there’s a more than 67 percent chance Greece won’t meet its commitments within the next five years. Greek government bonds have now overtaken Argentina. Greek debt was 115% of GDP last year, compared to 60% for Argentina when it defaulted. 

Europe widens stress tests

The Wall Street Journal’s Brussels blog reports that some more details on the stress tests for European banks have now been settled. The scope of the tests will be widened from 26 banks to 60-120 banks, including Landesbanken and Cajas. The tests will incorporate banks in all countries. The results will be released on a bank-by-bank basis. The banks will be tested for sovereign default. All tests to be completed by mid-July. Last year’s forecast mistakes will be taken into account.

Output is turning around, employment has high rock bottom, some think the economy is on an inevitable path to recovery.

The anatomy of the fiscal crises in the US (as told by the SF Fed) predicts a different future. Two pictures peak a 1000 words...

As GDP fell, revenue plummeted 

 Spending adjustments failed to match revenue losses

The result?  "Aid to states in the federal economic program is winding down next year and the situation is likely to get worse before it gets better..."

Data Sets and visualization tools (check out the data visualizer and interactive maps)

Debt Sustainability Model Plus 

WorldDevelopment Indicators

GlobalDevelopment Finance

AfricanDevelopment Indicators

MillenniumDevelopment Indicators

GlobalEconomic Monitor (GEM)

ActionableGovernance Indicators

BulletinBoard on Statistical Capacity (BBSC)

DoingBusiness Database

EducationStatistics

Enterprise Surveys

GenderStatistics

HealthNutrition and Population Statistics

InternationalComparison Program

JointExternal Debt Hub (JEDH)

LogisticsPerformance Index (LPI)

PrivateParticipation in Infrastructure (PPI) database 

QuarterlyExternal Debt Statistics (QEDS/SDDS)

QuarterlyExternal Debt Statistics (QEDS/GDDS)

WorldwideGovernance Indicators (WGI)

Climate Data 

Environment Data

Rural and Urban Development Datasets

Country Environmental Factsheets

Little Green Data Book

World Development Indicators

Indicator 

Yesterday China announced it would move to a more flexible exchange rate regime. The move was hailed by those who didn't notice that the statement lacked any details. Sure enough, Monday morning the yuan was unchanged in value. Below are estimates of how much the yuan is undervalued, and Mark Thoma provides a roundup of the responses:

 Is China's announcement that it intends to increase the RMB exchange rate flexibility "more smoke than fire"?:

International Feedback Mechanisms are detailed in Chapter 15. Except here, the locomotive effect is going the wrong direction... 

Extra EU 27 Trade Falls by 20 % In 2009 - and that is before the upcoming EU austerity measures

Source: WSJ

To round out the balance of payment information, here is the news on EU financial flows:

EU Foreign Direct Investment (FDI) flows have been severely affected by the global economic and financial crisis. They ...dropped sharply in 2008, for both inward and outward FDI flows (34 % for outflows, 52 % for inflows). 

That has been the fancy catch phrase which describes central banks printing money and using it to purchase government bonds. Just about every text book states that Monetizing Debt will lead to inflationary disaster. 

As the global financial crisis caught the US in a liquidity trap, Ben Bernanke decided to fight it by monetizing debt in astonishingly creative fashion. He instructed the US Central Bank not only to monetize the government's debt (to the tune of $1.2 trillion, but also to purchase another $1.25 trillion of toxic mortgage backed securities that where sloshing in the bond market without any buyers in sight. 

Those unfamiliar with liquidity traps saw the writing on the wall: After deciding to Monetize Debt at a gigantic scale, the US was in for hyperinflation: an "Inflation Bomb". It turns out that these predictions were not true. Prices are still falling in the US.

Now the same discussion is taking place, since the European Central Bank was forced to buy up toxic Greek Government Debt. The WSJ captures the discussion (from the Journal In Education):

QUESTIONS:

1. What is the main reason that the European Central Bank (ECB) is choosing to purchase Greek bonds in the secondary bond markets?

2. Why are critics opposing the ECB's purchase of Greek bonds in secondary bond markets?

3. By buying Greek bonds, how is the ECB influencing the yields on Greek bonds? How in turn does this affect other countries' bond yields (e.g. Spain's)?

4. Explain how the ECB's decision to keep purchasing bonds of distressed European countries can or cannot lead to a) inflation, and b) perpetual fiscal deficits in the long run. 

5. What is the effect of these purchases on the Euro? 

Adam Posen, an external member of the Monetary Policy Committee of the Bank of England,  has a blunt and impatient piece that counters those worrying about "inflation bombs." He does not mince words... Actually, mincing words would be an understatement. This speech must rank high up among the shrillest speeches anyone associated with a central bank has ever given:

When the instrument nominal interest rate is already at de facto zero bound, and the financial transmission mechanism is damaged, buying bonds is the only means central banks have of trying to deliver price stability against deflationary pressures – some form of quantitative or credit easing is the right thing to do. Getting unduly caught up in protecting the appearance of central bank independence is doubly mistaken: first, it will not do any good because it is not that appearance which delivers desirable results; second, it will prevent pursuing the right policy option.

As I indicated at the start, much of the hue and cry about central bank independence in response to the various sorts of bond purchases is awfully shallow. It is adolescent or worse to be so preoccupied with how someone looks, and her supposed reputation among the self-appointed conformists, than with the substance of her actions and values. This holds true whether that someone is a high school student or a monetary policy committee. That has not stopped such preoccupations and nasty name calling from spreading of late regarding central banks. In imagery typical of the preening machismo of financial markets participants and those who report on them, a number of people of late have spoken about the ECB losing its ‘political virginity’ or purity last month.

One is tempted to ignore or dismiss such idle chatter, but let us take it at its vulgar face value to show just how empty these characterizations are. Cultures which make a public fixation of virginal purity, of a stylized maiden’s reputation, tend to be backward superstitious cultures that impede people exercising autonomy and making responsible choices. For society, and arguably for the young persons themselves, what matters is not a young person’s ‘virtue,’ let alone any  reputation for such. What matters for society and for the young person is whether they are promiscuous, engaging in unsafe behavior, or getting pregnant casually, that is whether they behave responsibly.  

It is just uncanny how financial crises always evolve much like soap operas. At each stage you think "who's lying" and "you cannot make this one up." Here is today's news...

Spain angrily denies rumors of a bailout

The Spanish government was yesterday trying to deny German media reports according to which the EU was getting ready to finalize another bailout plan. [Prime Minister] Zapatero was yesterday busying trying to establish the facts behind the story in Berlin and Brussels, but nobody seems to have claimed responsibility. El Pais quoted the spokesman for economic affairs, Amadeu Altafaj, not only as denying that the Commission was negotiating a bailout, but also blaming Germany for inciting the rumors.

and the... in the same edition of the same Spain's national news paper, on the same day, we find:

Spain cut off from international financial markets

The crisis has now reached a new dramatic momentum, as Spain is now effectively cut off from international capital markets. El Pais has some interesting statistics showing the reliance of the Spanish banking system on the ECB. While Spain’s share in the ECB is 9%, Spanish banks now accounts for 16.5% of direct ECB borrowing. The amounts borrowed represent a 26.5% increase over May. The paper quotes the chairman of BBVA Bank as saying that for the majority of companies and financial firms, the international capital market was closed. He said that the country urgently needed to tackle three issues simultaneously: sustainability of public finances, growth, and financial sector reform.

Some German economists think that bailing out foreign countries is not good policy. I wish they'd check the Bank of International Settlements' report on foreign exposures to the contagion countries. Below is the graph. Germany and France have two options: bail out another sovereign country, or bail out their own banks. It is either or -all else is empty rhetoric.

Source BIS and Calculated Risk 

The previous post  suggested a leak in the EU containment system. That is, the announcement of a $ trillion bailout fund did not stop interest rates from rising in possible contagion countries. 

Today German papers report that Spain's bail out is imminent.  Here is the scoop via Euro Intelligence 

This post is not about the Gulf of Mexico. Calculated Risk alerts us the the Euro crisis is far from over. Something seems to be brewing in the financial markets... Quote of the day via Bloomberg (ht Bob_in_MA):

Uh oh, not another problem "contained"! This just in from the Atlanta Fed:

The Bank for International Settlements maintains a rich time series on real effective exchange rates; The Bundesbank keeps wonderful historical data. Interestingly, Econbrowser uses the data to show that the appreciation of the dollar against the euro is much less pronounced when we look at the broadest exchange rate measure. The answer is of course China holding its exchange rate with the US fixed. 

 Despite the euro's depreciation, the dollar has exhibited much less movement on a real, trade-weighted, basis.

Real Effective Exchange Rates 

Figure 2: Log broad trade weighted real USD (blue bold), CNY (red) and EUR (green). Source: BIS and author's calculations. 

Bloomberg breaks the sad news: Hungary also deceived the capital markets: 

June 4 (Bloomberg) -- Credit-default swaps on sovereign bonds surged to a record on speculation Europe’s debt crisis is worsening after Hungary said it’s in a “very grave situation” because a previous government lied about the economy.

The cost of insuring against losses on Hungarian sovereign debt rose 63 basis points to 371, according to CMA DataVision at 3:30 p.m. in London, after earlier reaching 416 basis points. Swaps on France, Austria, Belgium and Germany also rose, sending the Markit iTraxx SovX Western Europe Index of contracts on 15 governments as high as a record 174.4 basis points.

Hungary’s bonds fell after a spokesman for Prime Minister Viktor Orban said talk of a default is “not an exaggeration” because a previous administration “manipulated” figures. The country was bailed out with a 20 billion-euro ($24 billion) aid package from the European Union and International Monetary Fund in 2008.

The euro dropped below $1.21 for the first time since April 2006, stocks tumbled and the cost of insuring against corporate default rose on speculation Hungary will weaken the EU’s willingness to rescue the region’s indebted nations.

Swaps on Spanish government debt were up 22 basis points at 278, after earlier reaching a record 295.5, according to CMA. Contracts on Portugal were 26 basis points wider at 364.8, while Ireland was up 32 basis points at 292, and Italy climbed 30 basis points to an all-time high of 264, before retreating to 253. Contracts on Greece were 57 basis points higher at 783, down from 798 earlier.

“Are we on the brink of something more serious?” Deutsche Bank AG strategist Jim Reid wrote in a note to clients today. “We’ve little doubt that the authorities have no appetite for imminent peripheral defaults but we do see the situation getting worse before it gets better. This leaves markets vulnerable until there is more certainty surrounding the structure of the peripheral funding bail-out.”

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A basis point on a contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Ominous signs of weakening Eurozone foundations via Eurointelligence:

The report alleges that French banks, the largest holders of Greek debt, have been dumping their Greek bonds at the ECB, while the German banks have agreed with the finance ministry to hang on to their bonds until 2013.  The article, whose sources are anonymous central bankers in Germany, says the Bundesbank wonders why the ECB was still buying Greek paper at a time when the financial shield is already in place.

The answer is that they [the German Bankers] suspect a French conspiracy, according to the article, a presumption that French banks are using the ECB purchase programme to clean their balance sheet. The article then takes to the thought to its logical conclusion, and calls the ECB a “bad bank” [a term used for a financial institution whose purpose it is to buy toxic assets]. The article goes on to ask, whether and how the ECB can get out of this, because stopping the purchase programme would lead to a collapse in prices – as the ESCB is the only buyer. And if Greece were to restructure (which is what everybody who has looked into the numbers in some detail) knows, then the ECB itself would need to be bailed by the German taxpayer.

We assume that this article is unlikely to win a Franco-German friendship prize. French newspapers have picked up on it, including Le Monde, which said yesterday that “a perfume of divorce floats between the Germans and the ECB” (i.e. Trichet). Please also note that the source of Der Spiegel’s information do not hail from France. They are German central bankers, who voice their suspicions. So do not treat it as fact that French banks are selling, and German banks are not selling. But the article raises an interesting question: how to prevent moral hazard arising in this situation? And if the ECB were to reveal what it bought in its open market operation, we would know a lot more. At present, the only information ordinary Germans have is the Spiegel report.

The euro already faces a sea of troubles, but it could confront one more: It is becoming a favorite funding currency of the "carry trade."   The Wall Street Journal details the recent euro arbitrage opportunities.

At times I read economic material that is off topic (in terms of the actual International Economics textbook), but I cannot help but share. So I am starting a new category, titbits, referencing the dictionary definition of the term: a tasty small piece of food for thought...

Who'd have thought it (from the New York Times):

Conservative states tend to employ larger shares of state and local government workers in the US

Source: Report on public sector wages, Center for Economic and Policy Research, using Labor Department data; U.S. National Archives and Records Administration

The more dominated a state is by public-sector workers, the less likely that state was to vote for the Democratic presidential candidate. Any theories? Catherine Campell suggests two potential explanation:

1) Liberal states tend to be more urban, and big cities have a lot of private industry that can dwarf the size of state and local governments.

2) Maybe this is not “big government” versus “small government,” but federal vs local government - since these data refer to a very specific segment of the government: non-federal workers. Maybe, Jeffersonian-style, it’s not such a big contradiction for states to be hostile to candidates perceived to be expanding the size of the federal government, and to still employ lots of workers at the state and local levels.

The Economist Magazine has create a whole industry devoted to sizzling the Big Mac Index. Its unhealthy, as the concept has very little to do with the law of one price or purchasing power parity (see chapter 20). Bloomberg's Billy Bookshelf Index is more informative, but it also lacks a crucial arbitrage component, since the item is not freely traded, but only available from one supplier, who might still price discriminate in different markets. A good visualization of the failure of the law of one price is given by a recent Wall Street Journal article that  highlights how the change in the value of the Loonie (the Canadian dollar) is simply not reflected in US/Canadian prices of goods such as DVD players or fridges, causing major headaches for multinational retailers. 

MegaMac. Source 

Applications of Expenditure Switching and the Real Effective Exchange Rate changes, via Menzie Chinn

The euro has been depreciating against the dollar over the past few weeks. The implications of this development for the US depend critically on (1) the extent of the depreciation, (2) the duration, and (3) the source of the depreciation. (See Jim's post for other links.)

 
Figure 1: EUR/USD exchange rate, monthly averages (blue line), and value as of 5/14; and trade weighted value of USD against broad basket of currencies (red line), and value as of 5/14. NBER defined recessions shaded gray. Source: Federal Reserve Board via FRED II, NBER.

The euro has depreciated since the 2009M11 average, by about 10.5% in log terms, and about 16.1% versus 2008M07, just before the Lehman bankruptcy. What the graph makes clear is that the first flight-to-safety induced dollar appreciation faded after about a year. This second dollar appreciation might be construed as another flight-to-safety. How lasting will this appreciation be? Much depends upon how and whether the euro area governments resolve the current crisis. It also depends upon the desirability of US dollar denominated assets, including Federal government debt.

Since I am less pessimistic than some others regarding the short to medium term deficit outlook for the US [0], I think that the upward appreciation of the dollar against the euro might be fairly persistent. That being said, Figure 1 also highlights the fact that euro movements do not translate one-for-one into dollar value movements. At the monthly to annual frequency, the elasticity is about 0.4 to 0.45 (calculated as log-changes on log-changes).

It's difficult to evaluate the impact of exchange rate depreciation on GDP, and other variables, without taking a stand on what causes the exchange rate movements. The OECD has recently released documentation on their new macroeconometric model. One of the experiments implemented involves a 10% euro depreciation against a basket of currencies. From Karine Hervé, Nigel Pain, Pete Richardson, Franck Sédillot and Pierre-Olivier Beffy, The OECD's New Global Model, Economics Department Working Papers No. 768 (May 2010) (h/t Torsten Slok):

The simulations are conducted in the following fashion:

The exchange rate simulations assume sustained 10% nominal effective depreciations, individually for US dollar, yen and euro rates, against all other currencies, assuming that monetary policy follows a standard Taylor rule and that fiscal policy is set by endogenous rule. Following depreciation in the first quarter, the exchange rate is assumed to remain at the new level throughout the simulation period with the sustained shift assumed to be exogenous, coming from unexplained movements in markets expectations, rather than being policy induced or reflecting an identifiable change in economic fundamentals. The possible endogenous influence of simulated changes in interest rates on exchange rates, which might tend to offset the original shock, is therefore not taken into account. For this reason, these shocks are not particularly realistic, but serve rather to illustrate the role and transmission channels of exchange rates in the model.

The key channel is expenditure switching; a depreciation induces more spending on euro area goods, and less on those of the RoW. However, the table indicates the effect of a 10% euro depreciation would only have a modest impact on US GDP -- a 0.2 percentage point deviation relative to baseline two years out, if sustained. The historical correlation between the euro/dollar rate and the BIS trade weighted value of the euro is about 0.5 (that is, the elasticity is about 0.5), so the euro depreciation since the April average is only about 5%, and hence the negative impact about half that indicated in the table.

There are other channels incorporated in the model, including valuation effects from exchange rate changes (see this post for discussion).

Part of the reason that the effect on the US is modest is that changes in the euro/dollar exchange rate are not the same as changes in the USD value. This is illustrated in Figure 1. The short run elasticity of (broad) trade weighted exchange rate with respect to the euro/dollar exchange rate is about 0.4-0.45 (at the one month to one year horizon).

The model is fairly conventional in terms of macroeconomics -- in the short run output is largely demand determined, while in the long run it is supply determined (in other words, pretty much like in most standard macro textbooks). The key distinction is econometric; the key macro relationships are estimated using error correction models.

One channel that is not included (and would not be included in a open economy RBC [1] or a standardDSGE) is the effect coming from cross-border propagation of equity price declines. For that, one might need to appeal to financial stress indicators, as discussed in this post.

Interesting side point: the government spending multipliers are substantially greater than unity.

The multiplier, defined as the five year cumulative deviation from baseline for a one percentage point of GDP increase in government spending is 2.0; this multiplier assumes a Taylor rule for monetary policy. Presumably, with interest rates set at zero, the multiplier would be bigger. 

Is there a problem?

Economist May 20th 2010

Watch it snap... 

 

IT HASN'T been the best couple of weeks for the global economy. China is officially in a bear equity market. Europe appears to be headed toward financial crisis or years of sluggish growth, or possibly both. America's housing market stalled out right through the first quarter, despite substantial government support (most of which has now been withdrawn). Leading economic indicators in America unexpectedly faltered in April. American stock markets have dropped over 10% in the space of just a few weeks. (On Thursday alone, the Dow fell nearly 4%.) Commodity prices are flashing a growth warning; oil prices have fallen nearly 20% over the last month. And America's labour market stubbornly refuses to right itself. Initial jobless claims rose by 25,000 last week, leaving the picture of filings looking like this:

Meanwhile, we get statements like this from European Central Bank president Jean-Claude Trichet:

The European Central Bank’s present monetary policy stance remains “appropriate” after the ECB’s decision to purchase debt issued by governments in the euro zone, ECB President Jean-Claude Trichet said Thursday.

“Our decisions on May 9 have confirmed it: We are not engaging in any form of quantitative easing,” Trichet said at an event in honor of ECB Vice President Lucas Papademos, who will leave the central bank at the end of May.

This despite the fact that annual core euro zone inflation (excluding energy) was just 0.7% in April, down from 0.8% in March and 1.7% the previous April. And despite the fact that the euro zone is forecast to see growth of just 1% in 2010, and just 1.5% in 2011. And despite the looming catastrophe in southern Europe. One doesn't want to get gloomier than the facts warrant. But the outlook for the economy looks materially worse today than it did just a few weeks ago. Markets seem quite convinced that events in Europe are likely to have a negative effect on global economic activity. It's debatable whether policy positions in Europe and America were appropriate back in April, given persistent signs of weakness. But if they were appropriate then, they're certainly too tight now. Europe has no fiscal room to boost the economy. America has some, but no appetite for new stimulus. The burden of action falls to central bankers. Unfortunately, central bankers seem to be too busy guarding their independence to handle their missions. 

That is the question. Here are two views from the opposite ends of the spectrum. Avinash Persaud thinks its good policy to bail out banks and bond holders. In the other corner of the ring is John Cochrane, free market gladiator extraordinaire, who tells us of the virtues of inflicting severe pain upon those who speculated. The interesting detail here is that Greece lied about its deficit, so one cannot really talk about fair play, or rational expectations on the part of investors... So punishing those who believed the Greek government seems to be counterproductive to me. 

Here is the bottom line on the Eurozone crisis. Is it massive government deficits, debt,  political economy of austerity, default risk, or the absence of the promised $ trillion rescue package?

The answer is neither. The scariest prospect of all is that even if none of these issues existed, the crisis countries would have to work their way out of their crisis of competitiveness. Essentially they spent more than they produced, and to align their spending with their income, not only spending has to drop, but income has to rise. This can only happen if goods in crisis countries become more competitive. Here "competitive is simply an euphemism for "lower prices and lower wages." Krugman calls it the Elephant in the Euro and puts concrete numbers to it: wages in crisis countries need to fall 20 to 30 percent relative to Germany.

What does that really mean? Well, no none can really conjure up images of such a wage decline. But we do know that the country with the most draconian austerity adjustments, Latvia, saw its unemployment rise from 6 to 22 percent, causing a decline a meager decline in labor costs of 5.4 percent. One can only hope that European labor markets are more flexible and prices and wages adjust faster than in Latvia - but this is obviously wishful thinking.  

Every crisis has its heroes: the economists who "correctly" forecast the crash.

Since there are a few economists who forecasts financial armageddon at any given time, the simple test whether the heroes of the last crash were lucky or omniscient is to see if they can repeat. 

Dr. Doom, the hero of the last crash is trying to step into the spotlight again (here).  Not to remind us that he predicted the current crisis, but to announce his book. Crisis Economics, "which covers not only the recent crisis, but also dozens of others throughout history and across both advanced economies and emerging markets – I show that financial crises are, instead, predictable “white swan” events." 

Aside from tall claims of prescience, the articles is a tour de force. It as an excellent working definition to identify a financial crisis:

"An event that forces policy officials to spend a long weekend trying desperately to announce a new bailout package in order to avoid national and global panic before the markets open on Monday. In the past years, such weekend all-nighters dealt with the needed bailouts of private firms – Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, AIG, bank rescues, etc."

and it reminds us of the scale of the "new normal" 

The scale of these bailouts is mushrooming. During the Asian financial crisis of 1997-1998, South Korea – a relatively large emerging-market economy – received what was then considered a very large IMF rescue package – $10 billion. But, after the rescues of Bear Sterns ($40 billion), Fannie Mae and Freddie Mac ($200 billion), AIG (up to $250 billion), the Troubled Asset Relief Program for banks ($700 billion), we now have the mother of all bailouts: the $1 trillion European Union-International Monetary Fund rescue of troubled eurozone members. A billion dollars used to be a lot of money; now one trillion is the “new normal”... Governments that bailed out private firms now are in need of bailouts themselves. But what happens when the political willingness of Germany and other disciplined creditors – many now in emerging markets – to fund such bailouts fizzles? Who will then bail out governments that bailed out private banks and financial institutions? Our global debt mechanics are looking increasingly like a Ponzi scheme.

Absent is, however, a simple, lucid analysis of what we can expect in the future as the Eurozone crisis unfolds. Paul Krugman and Milton Friedman provide that insight succinctly.   

Dani Rodrik's fascinating hypothesis:  “the political trilemma of the world economy”: economic globalization, political democracy, and the nation-state are mutually irreconcilable. We can have at most two at one time. Democracy is compatible with national sovereignty only if we restrict globalization. If we push for globalization while retaining the nation-state, we must jettison democracy. And if we want democracy along with globalization, we must shove the nation-state aside and strive for greater international governance. 

I am amazed how optimistic markets have been as to the success of the EU rescue package. And sure enough the first reports are coming in that "Euphoria ends as investors suspect another shameless EU confidence trick."

This time around the creative accounting is that Less than 10% of the funds actually existed and the rest were plans to establish facilities to raise the rest of the money. Those are a lot of hoops and ifs... Here is the rescue rackage (in euros) in a snapshot (via Econbrowser): 

Graphic from Thomas and Ewing, NYT, May 11, 2010; link here. 

Note: Jean Claude Trichet clarified yesterday how the bond purchasing programme is likely to work. To sterilise the bond purchase, the ECB is considering term deposit, compulsory deposits banks would have to hold at the ECB, which has the effect of withdrawing liquidity from the system.