Sunday, January 22, 2006

Who Will Be The First To Blink?

Methinks the first serious test of the eurosystem is now looming on the horizon. The title of this post refers to an earlier point made by Nouriel Roubini. The FT this morning is reporting that:

"The German cabinet will on Wednesday endorse a 2006 budget that breaks the European Union's fiscal rules for the fifth year in a row, amid criticism that Angela Merkel’s coalition government is failing to meet its own target to cut spending."

If this is confirmed the EU Commission and the ECB will then have to respond. One of these fine days all hell is going to break loose in the financial markets. Will that be sooner or later? We await developments.

Friday, January 13, 2006

Is The ECB Measured-Pace Cycle Over?

Well, not unexpectedly, the ECB decided to leave its main refinancing rate unchanged at 2.25% yesterday. Rather more surprisingly (for some at least) the German Federal Statistical agency reported that German economic growth ground to a halt at the end of 2005.

According to the Financial Times:

Johann Hahlen, president of the federal statistics office, said that growth last year had been based largely on exports, with domestic demand remaining weak. “Broad and self-supporting growth is still not being observed”.

Again according to the FT, Herr Hahlen's comments "surprised economists, who had expected growth to continue and have become increasingly upbeat about the outlook in 2006". I'm surpised the FT can be so blazé in saying 'economists': they certainly didn't surprise me. I think it was reasonably clear that this was coming. If I am surprised by anything it is that it has come so quickly.

So where do we go from here? Well Jean-Claude Trichet, the ECB president, has been trotting out the party line to the effect “we have to be vigilant as regards inflation”, but with inflation now falling back (in December the harmonised rate slipped back a fraction to 2.2% from the 2.3% in the year to November) and with virtually no 'second round oil rise' effects in evidence this argument is going to sound increasingly hollow. Couple this with the ongoing 'low- growth' environment in the Eurozone (we're still awaiting the sort of news from Italy which will again I imagine surprise 'economists') and you can see that there will be few reasons to justify any serious interest rate rises. At the limit we may just see one more quarter point rise squeezed-in before year's end. Aside from that the ECB tightening cycle is, as I suggest, just about done.

Since it has recently become fashionableto try to predict the future, here are my 2006 forecasts.

In first, and most prominent, place: the dollar will not decline sharply in 2006. Change on the margin is a much harder call, but, on balance, I expect the euro to nudge down during 2006. The principal factors here will be the interest-rate and growth differential with the US.

Global growth will be a touch slower than in 2005.

Germany and Japan will not have sustained, internal-demand driven, recoveries.

Japan will not 'break-lose-decsively from the chains of deflation.

China and India will continue to grow pretty much as they are currently doing.

Turkey will continue to be the principal growth tiger in the EU orbit.

Ireland and Spain will continue to have property bubbles.

The US will grow a tad more slowly in 2006. It will not enter recession. The CA deficit problem may well grow.

There will be time enough to forecast 2007 when we have had time to see just how near the mark our 2006 forecasts are.

Wednesday, January 11, 2006

The Perrenial Euro Story (or lack of it)

Brad Setser has a post, the perrenial dollar story, which IMHO, has one large and significant ommission: it doesn't really mention the euro. Personally I don't really see how you can consider the future evolution of the dollar without taking the euro into account. This realisation provoked a rather long comment from me on Brad's blog, and it is this comment, in a slightly modifed form, that I am now posting here. (Update: incidentally, I notice that Claus Vistessen has two highly relevant summaries of the great greenback debate (here, and here) which. among other things, serve as an excellent introdiction to the issues involved).

In reponse to a Bloggin Wall Street post which suggests that "folks who worry about the trade deficit are in denial", Brad hits back with:

"My answer: trade deficits can be a signal of future trouble. Can be. This is different than always are. "

I think Brad is, as they say 'flexibilising his argument'. I welcome this and absolutely agree with him.

In fact I would put it this way: imbalances, including trade imbalances, which have no obvious and direct automatic stabilisers to put to work to resolve them, are *normally* a sign of trouble to come in the future. It's just that, following Keynes, the term structure is the key: we need to distinguish here between the long and the short run.

Now according to Brad those who are not in 'the US trade deficit matters' camp tend to argue:

Either "the trade deficit is a sign of US strength, so it doesn't matter"

Or "the trade deficit is not as bad as it seems".

Well I can think of a third option (at least), and this would be:

The US trade deficit is in fact worse than it seems, but there is no easy way to correct it, and any significant attempt to correct it from inside the US would cause a lot more pain ex-US than it would cause inside, ie the correction would be, global speaking, non-optimal.

That is, more or less, what I feel. But then I am not in the US :).

I think the comparisons of individual and collective indebtedness (which Brad examines at some length) do have a certain validity, but, as in any debt calculation, it all depends what multiples of present GDP per capita you estimate for the US 20-30 years from now, and what multiples you expect for the 'rest of the world'. If the US values exceed the 'rest of the world' ones, then the indebtedness could indeed be a rational response, if you don't (and I'm inclined not to, especially with big players like China and India around) then of course........

The problem here is that it is the Bretton Woods system itself (either in its version 1.0 or its version 2.0) which is a little short of the necessary automatic stabilisers. The natural support points should be the euro or the Japanese yen, but for other reasons, both of these are currently 'missing', and so the system itself cannot correct.

Something similar is actually happening inside the euro system itself: let me explain.

Let's take Spain as a good mini example. Spain has a shocking housing bubble. Arguably the worst on the planet. Spain also has a whopping trade deficit, and extraoradinarily high (and rapidly rising) rates of private indebtedness coupled with very little saving.

The reason is obvious: Spain has a circa 4% inflation rate, and a 2.25% ECB-set base interest rate. This means that people can contract 40 to 50 year mortgages, on an initial interest-only basis, for anything from 3%.

Now not borrowing at 3% when inflation is at 4% just doesn't seem rational, so most people do.

Thanks to the euro system Spain is effectively spending German savings (in the same way the US is spending Chinese savings).

Can Spain correct? Well it has no control over its virtual exchange rate (the virtual pesseta) since it is pegged to the euro, so it can't do much about the trade deficit, and it has no control over the interest rate since this is set in Frankfurt, so it can't do much about the housing bubble.

How long will this ridiculous situation continue? I really don't know. There is no obvious reason why it needs to end anytime soon. What will happen when it does all come to an end? Again I don't know, but one can imagine it won't be anything too nice.

Now really I think this analogy can be applied directly to the US and its role in the global currency markets (via Bretton Woods I and II) and its limited control over its own interest rates (read here the yield inversion) which is at least in part a consequence of globalisation and the financial 'big bang' of the late 80s.

So what can't be happening in fact is, and continues, and will continue until it really can't any more. I imagine that this end-state will be reached when India and China are fit-enough and strong-enough to take the strain.

Finally a quick word in closing on a recent argument from Marty Feldstein. (New Economist also covers it here).

Brad understandably says:

"It is nice to have some of the arguments I have made backed by someone on the short-list to replace Alan Greenspan."

Well I could also say the same about my arguments about the euro (or rather Marty Feldstein's arguments about the euro - and here, and here). Indeed, I could go further, and say (if you look carefully at the arguments Bernanke actually puts in euro at five ) "It is nice to have some of the arguments I have made backed by someone on the short-list to replace Alan Greenspan, and by the person who has actually replaced him".

Feldstein's view in the linked article is puzzling, since, regardless of whether or not you think the dollar is about to fall, one of the considerations in your judgement should also be your appreciation of whether the euro is up to the task which would fall to it, and indeed whether euro denominated government paper is any way an attractive alternative to US government paper. Since Feldstein has perhaps been one of the most outspoken critics of the euro, you can certainly accuse him of not being exactly 'consequentialist' here.

Bernanke is much more 'subtle' in his 'euro at five' article than he was on the global savings glut issue (where again, of course, he agrees with me, whoops, I agree with him).

Bernanke is the art of diplomacy, calling the introduction of the Euro a 'remarkable technical achievement'. But if you read the fine print, he more or less agrees with Feldstein:

"Rather than pursuing the question of whether Europe is in fact an optimal currency area in Mundell’s sense, I think it is useful simply to recognize that the European experiment in economic and monetary union has not been motivated primarily by Mundellian factors. .........Political factors, rather than economic ones, have played the dominant role. "

So, in any event, both Brad and I can have recourse to arguments from 'authority' here. Of course non of this makes any of these arguments right. Personally, rather than the US dollar, I would be watching Italian public debt.