Wednesday, September 30, 2009

Germany - The Bitter-Sweet Tears Of Angela von Merkel

German voters gave Chancellor Angela Merkel the green light for a second term on Sunday, along with a clear mandate to form a new government with the liberal Free Democrat Party (FDP). But just what exactly is the new government likely to do? Merlek has been quick to pour cold water on any idea of early tax cuts, “I expect we’ll agree very quickly on tax policy, especially when you look at the leeway we have with the budget," she is quoted as saying.

Angela Merkel's room for maneuver is limited by the fact that Germany has been steadily racking up debt to tackle the crisis. Only today the Federal Statistical Office have said that the deficit in the overall public budget increased to euro 57.2 billion in the first six months of this year from euro 6.9 billion a year earlier as spending rose sharply (8.1%) and revenue declined (1.7%). No figure was given as a proportion of gross domestic product, but it seems to be around 4.89% of the GDP registered in the first six months (unadjusted GDP was reported by the Federal Statistics Office as €1,168 billion over the same period).

So, while the mood in Merkel's Berlin headquarters was naturally jubilant, the euphoria will not last too long, especially since things are not going to be anything like as simple as they may seem at first sight. The problem, of course, is an economic and not a political one. Simply put, Germany’s apparent recovery from recession may have come "just in time" to see Angela re- elected, but the good economic news may not last much longer than today.

Europe's Economies Buoyant But Not Ebullient?

While talk of a Eurozone recovery continues unabated following a recent heavy slew of data, including the business surveys for September and the summer consumer spending numbers from France, which tend to suggest upside momentum. The data continue to support the idea of continuing recovery in the third quarter of 2009 but a more careful examination suggests that the German economy is not building up as much underlying momentum as was prviously hoped, and that sustaining this timid growth into 2010, especially as government stimulus programmes are pulled back, may prove to be hard work.

In France, the latest household consumer data pointed to 1% monthly falls in spending in both July and August as a rebound in inflation and further job losses continued to weigh on consumption. The untick in French inflation while price index numbers remain lodged in negative territory in Spain, Ireland, Finland and even Germany, constitutes just one of the rapidly looming headaches for the ECB.

The weaker French consumption trend was, however, offset by a fairly solid performance in both the industrial and service sectors, with the PMIs powering above the critical 50 level. Similar improvements were not, however, matched in Germany, where both the IFO survey, the Retail PMI and the Manufacruring and Serivices PMIs came in below expectations. So France, far from being a harbinger of things to come, may well turn out to be an exception in a region characterised by stagnation (at best) or continuing sharp contraction (Ireland, Finland, Spain).

Just this cautiousness about the fagility of the recent stabilisation in the Eurozone was underlined by Bundesbank President, Axel Weber in an interview with Market News. Mr Weber was at pains to stress that he still considers the current level of interest rates to be appropriate and that it is still far too early “to exit the currently extremely loose monetary policy.” He also warned that the recovery will be “very sluggish”. Mr Weber placed considerable emphaisis on the behaviour of bank credit, stating he did not expect any turnround in the present decline before mid-2010. Clearly this is likely to be the decisive indicator for the ECB to begin withdrawing liquidity. “As we come out of this crisis and as the economy recovers and as the credit cycle turns, I think we do have an obligation to decisively counter long term inflation risks,” he said.

Germans Get Ready To Tighten Your Seatbelts

If we come to examine the German situation in more detail, then we can see that M. Merkel's room for manoeuvre is going to be extremely limited indeed. Economic growth managed to scrape together a 0.3% increase in the second quarter, but this was driven by exceptional measures of 85 billion euros to lift spending and subsidize jobs, measures which surely helped keep unemployment below levels in many other OECD economies, even while the economy suffered the hammer blows of its worst post-World War II recession. However, the positive feedback impact from so much government spending can't continue like this, and Angela Merkel knows it, and she she also knows that it is either pain now or pain later, then my bet is she will use the political capital accruing from the first post election year to put the German house in order, in the hope of being able to offer some tax-cut based upside in the second half of her mandate.

That is to say, if you are hoping for some more German consumer expansion tow to help pull your own local economy out of the mire, then I suggest you forget about it right now.

Q2 GDP Growth A Statistical Quirk?

First off, the 0.3% growth obtained in the second quarter was actually the outcome of quite a complicated statistical balancing act. As is illustrated in the chart below the small final balance is actually obtained after cancelling out two much larger elements, the inventory run down (which subtracted 1.9 percentage points from the final total) and net exports which (which added 1.6 percentage points, where the positive balance was produced by a much larger drop in imports than the drop in exports).

So while it may not be absolutely correct to talk about a statistical "quirk", and while it is obviously true that there was some real growth, there was so much noise going on in the background that it is hard to know what importance to put on the headline numbers. As should be obvious it is very hard to attach too much importance to the ideat that houshold consumption added 0.4 percentage points when there are such large percentage swings impacting other items, and the fact that the trade impact was achieved by having exports down 1.2% on the quarter while imports were down 5.1% only adds to the lack of conviction which can be attached to the idea that "Germany has now returned to growth", even though this headline perhaps has sold more papers in recent weeks than virtually any other.

In fact as should also be abundantly clear from the two charts below, the sharp fall in exports was largely halted in the second quarter, while the fall in imports continued, but again, it really is stretching the point a bit to call this a solid return to growth.

So with the stimulus programme now steadily set to come off from this point on, and unemployment looking certain to jump and consumer spending to drop as we enter 2010, and with many companies continuing to warn of a credit crunch, while debt remains at very high levels, policy makers would seem to be left with few options to counter any eventual double dip should there be no sharp upturn in world trade. In fact the German economy will never recover on the back of domestic demand, which is weak, and tends to lag behind movements in exports and in GDP. So really a full fledged German recovery must await recovery elsewhere, and in the meantime we are left with simply marking time.

Germany's Economy "Returns To Growth" in the Second Quarter

German second-quarter real gross domestic product rose 0.3% from the first quarter, when it fell back 3.5% from the previous one.

Year on year the economy was down 5.9% in the second quarter. Exceptional stimulus measures amounting to some 85 billion euros have so far helped spending hold up and made it possible to keep people on short time working, but this situation obviously cannot continue much longer and even Germany’s 5 billion-euro “cash-for- clunkers” program has now come to an end. The premium led to a 23 percent increase on spending on vehicles during the first six months of 2009, spending which evidently had a lot to do with the second-quarter rebound. The unemployment rate is set to jump to 10.3 percent in 2010 from 8.1 percent this year, according to the latest IWH institute forecast. The also predict that consumer spending will drop 0.7 percent in 2010 after growing 0.5 percent this year.

And the most recent data results are only likely to add to policymakers’ concerns about the sustainability of Germany’s recovery. The country’s economy is still expected to shrink by about 5 per cent this year, with the under-utilisation of capacity bound to feed through into higher unemployment – which in turn will act as a further constraint on growth.

And as if to offer yet more evidence that the crisis is far over, the VDMA industry group said this week that orders for German machinery and factory equipment were down 43 percent on the year in August.

Export Dependent For Growth

Domestic demand is congenitally weak, and lags behind export and headline GDP gowth. As a result it is not especially surprising to find that retail sales fell for a the third consecutive month in July. Sales, adjusted for inflation and seasonal factors, decreased 0.8 percent from June when they fell 1.8 percent from May. From a year earlier, sales fell 0.7 percent, but this number is not especially significant, since, as can be seen in the chart, German retail sales have now been in decline since 2006.

Spain's retail sales fell again in September, according to the Markit Retail PMI which came in at 47.9, disappointingly weaker that the 49.5 reading registered in August. The index has been below the neutral 50.0 value during every month since June 2008, and the latest reading pointed to the sharpest rate of contraction for three months. Anecdotal evidence attributed the drop in like-for-like sales to weak economic conditions and subdued willingness to spend among consumers. There were also a number of reports in the autos sector that the end of the government’s ‘cash for clunkers’ scheme had contributed to lower sales compared with the previous month.

Despite some slight uptick in houshold consumption, overall domestic demand, which includes both final consumption expenditure and gross capital formation (including changes in inventories), was down by 2.5% in Q2 over the same period in 2008. A large part of this decrease was due to the performance of gross capital formation, which was down by 16.0% year on year. The massive slump in real capital formation in machinery and equipment therefore continued and even accelerated in Q2, with German enterprises reducing their capital formation in machinery, equipment and vehicles by 23.4% compared with the second quarter of 2008. And the trend looks set to continue, if the latest report from the Frankfurt-based VDMA machine makers associationis anything to go by. VDMA said German plant and machinery orders declined 43 percent in August from a year earlier. Export orders slumped 41 percent and domestic orders dropped 45 percent.

Looking into the third quarter German exports rose for a third month in July as global trade picked up generally. German sales abroad, adjusted for working days and seasonal changes, increased 2.3 percent from June, when they jumped 6.1 percent. Exports were still down 18.7 percent from a year earlier.

Imports remained unchanged from June, when they increased 5.9 percent. As a result the trade surplus increased to 13.9 billion euros from 12.1 billion euros in June. The surplus in the current account, the measure of all trade including services, was 11 billion euros, down from 13.5 billion euros in June. But all in all, the balance during the first moth of the third quarter was positive, even if only marginally so.

On the other hand, industrial production output numbers for Junly tempered hopes for a further rebound, since they fell back a seasonally asjusted 0.76 per cent compared with June’s figures, according to Eurostat. According to the German Technology Ministry the strongest performing sectors in recent months have been those producing investment goods and “intermediate” products, shipped for completion elsewhere.

PMIs Suggest Germany Pulled Back In September

Eurozone Flash PMIs generally showed a continued improvement in operating conditions in September, although the rate of improvement slowed somewhat, and indeed the German private sector slipped back even if it continue to maintain a general expansion. France did generally rather better. However, this does start to suggest that the easy part - stopping the slide - may now be over. We have stopped the fall, but restoring growth may well prove to be a very tough nut to crack indeed.

The Markit Flash Eurozone Composite Output Index - based on a sample of around 85% of the normal monthly survey - edged up from 50.4 in August to 50.8 in September, signalling a marginal increase in private sector output for the second successive month. The flash German Composite Output Index stood at 52.2 ( following 54.0 in August), a 2-month low.

Manufacturing new export orders weakened slightly in September, but growth on average in the third was the most pronounced since the first quarter of 2008. Anecdotal evidence suggested that overall demand had improved as a result of more favourable economic conditions and a corresponding rise in confidence among clients. Moreover, a number of investment goods producers pointed to increased exports to emerging markets in Asia.

The German flash Manufacturing PMI came in at 49.6 (49.2 in August), a 13-month high, but still just shy of the critical frontier separating overall expansion from contraction.

Commenting on the Markit Flash Germany PMI survey data, Tim Moore, economist at Markit said:

“The German economy ended the third quarter with output levels still moving in the right direction, supported by the fastest rise in new business since June 2008 and a rebound in business sentiment. PMI data suggest that the economy continued to expand in Q3, but the latest figures point to below-trend growth and only a gradual recovery. Job shedding and cost cutting measures were prevalent in September, while firms were forced to reduce their charges further, suggesting that the outlook for private sector demand remains subdued.”

The German Flash Services Activity Index came in at 52.2 (53.8 in August), again a 2-month low. And the weakening in German activity seems to have been concentrated in the services sector. Service providers were again upbeat about the outlook for the next twelve months. The balance of firms expecting a rise in business activity was the highest since January 2006, largely reflecting optimism that economic conditions will gradually improve in the year ahead.

Nonetheless, private sector companies remained cautious in their staff hiring decisions in September. Overall employment levels fell for the twelfth successive month, largely reflecting a marked decline in the manufacturing sector. Job cuts were linked to output and demand remaining at relatively low levels, with the recent change of direction not yet sufficient to prevent staff restructuring. Furthermore, backlogs of work decreased for the seventeenth month running, suggesting that firms had adequate staffing levels for existing workloads.

Plenty Of Confidence Around Though

German investor confidence jumped again in September,to hit yet another three year high as stocks surged and election day approached. The ZEW Center for European Economic Research said its index of investor and analyst expectations rose to 57.7 from 56.1 in August. The benchmark DAX index has now rebounded 52 percent from its March trough and reached the highest level in almost a year last week. At roughly the same moment the survey result was released the European Commission forecast that the German economy woul barely grow in the fourth quarter after expanding an anticipated 0.7 percent in the third one. My feeling is the Q3 estimate is too high, but the fourth quarter prognosis seems very realistic.

German consumer confidence rose to a 16-month high as the economic recovery boosted households’ income expectations and willingness to spend. GfK AG’s sentiment index for October, based on a survey of about 2,000 people, increased to 4.3 from a revised 3.8 in September, the Nuremberg-based market-research company said in a statement today. That’s the highest reading since June 2008. GfK’s measure of economic expectations turned positive for the first time since June 2008 and jumped to 3.4 from minus 7.5. A gauge of income expectations rose to 16 from 8.8 and an index of consumers’ propensity to spend increased to 36.5 from 31.1.

However it is possible to detect signals thatGermany’s economic recovery is losing momentum to some extent since business confidence rose less than expected in September, and this on the back of the weaker than expected PMI readings certainly serves to highlight the fragility of the growth recovery in Europe’s largest economy.

The Munich-based Ifo institute reported its business climate index rose from 90.5 in August to 91.3 in September. That was the highest reading since September last year, when Lehman Brothers collapsed in the US. But it fell short of many economists’ expectations, suggesting that at least some of the recent optimism about Europe’s largest economy may have been overdone.

The rate of increase in the Ifo index certainly slowed markedly in September. Hans Werner Sinn, Ifo president, pointed out that most companies still regarded current business conditions as poor, and that the rise in the index had been driven largely by the component covering businesses’ expectations for the next six months – which has risen for nine consecutive months to the highest level since May 2008.

Employment Falling As Unemployment Slowly Ticks Up

German unemployment declined in September, but the fall was due to a seasonal upturn and statistical effects rather than any fundamental economic improvement.

The unadjusted jobless rate was 8 percent, down from 8.3 percent in August.

A total of 3.346 million people were registered as unemployed — 125,000 fewer than the previous month but 266,000 more than in September 2008.

In seasonally adjusted terms, the unemployment rate dipped to 8.2 percent from 8.3 percent, with 12,000 fewer people out of work than in August. Economists had forecast an increase of 20,000. The labor agency drew attention to the fact that the number would have risen by 10,000 but for a change made earlier this year under which those being trained by private job agencies were removed from the jobless figures.

At the same time the number of those employed is falling, and there were 40.01 million people in employment in Germany in August 2009. Compared with the previous year, this was a decrease of 216,000, or 0.5%. In fact the German job machine ran out of steam last autumn, and since that time has been adding jobs at an ever slower pace. Now it has turned negative, and less Germans are employed every month than they were a year earlier.

Jobs have been subsidized by the Federal Labor Agency, which pays 60 percent of the net wage that’s lost due to reduced working hours. The program, extended to 24 months in May from 18 months, supported about 1.4 million employees at some 50,000 companies as of June.

As compared with July 2009, there was hardly any change, with the number in employment even rising slightly - by 11,000 (0.0%). But after seasonal adjustment the number in employment dropped by 57,000 (–0.1%) from July to August 2009. In July 2009, the seasonally adjusted number of persons in employment declined by 30,000 (–0.1%) on June.

Given the scale of the current economic crisis, the decline in the employment observed in Germany over the last year has been quite moderate. As the statistics office point out the fact that many employees were placed on short-time working significantly reduced the negative effects of the fall in output on employment.

So far, unemployment has been kept in check because many employers have used government-supported short-time working arrangements - Kurzarbeit - rather than laying off workers. However, this is now widely expected to be gradually wound down and hence the number of unemployed will rise significantly over the next year.

So How Long Can Kurzarbeit Continue To Run?

Well the good news, at least according to analysts at Societe Generale is a good deal longer than many seem to think. The analysts examined the working of the German employment protection programme, and show clearly that while official unemployment in Germany has in fact only risen moderately in the current recession the underlying real effective rate is much higher. The unemployment rate (using the ILO measure) has risen by just 0.6ppt - to 7.7% from its 7.1% low in Q4 2008, while in the euro area as a whole, the rate is up by 2.4ppt to 9.6% from its March 2008 low of 7.2%. As they say, it is also quite clear that this relative stability owes much to the widely-used practice of so called short-time working (Kurzarbeit).

As the SocGen analysts point out, this relatively benign situation could easily turn nasty if company employment intentions deteriorate significantly and growth expectations get revised down. However they are not that convinced by this line of argument, since they think that since German legislation has already extended the period for which companies can run short-time working from 18 to 24 months the programme is pretty firmly supported.

Examining in detail the evolution of the numbers on short-time working they find that the vast majority of companies only resorted to the programme in the spring, so that the 24 month limit will not bite until late-2010. Until the turn of the year 2008/09, the recourse to short-time working was very small indeed. Aside from the seasonal increases in the first quarters of 2007 and 2008, the numbers were small at around 50,000. To put the number in context, they point out that this represents 0.1% of the labour force and is equivalent to the monthly gains in unemployment that were recorded this year. Since then, the numbers resorting to the programme have indeed exploded and by March of this year (the latest available data), there were 1.3 million workers with shortened hours, and this number has probably now risen to around 1.4 million. These are clearly big numbers, amounting to about 3% of the labour force. If they were added to unemployment figures, total unemployment would rise to the previous historic peaks of around 5 million.

Deflationary Winds Blowing?

The German consumer price index declined by 0.4% in September 2009 over september 2008, maintaining pressure on existing deflation concerns. Germany as a whole has never seen such a low inflation rate since German reunification.

The harmonised consumer price index for Germany, which is calculated for European purposes, is expected to decrease by 0.4% in September 2009 on September 2008 (August 2009 on August 2008: –0.1%). Compared with the Augus the index is expected to be down by 0.4% in September.

And producer prices are also falling, with the index of producer prices for industrial products falling by 6.9% in August from August 2008. In July 2009, the annual rate of change was –7.8%. Compared with the preceding month, the index rose by 0.5% (as compared with –1.5% in July 2009).

Meantime the ECB continues to try to offer abundant liquidity to get credit and economic activity moving again, though there seem to be few takers.

The European Central Bank is lending banks less money than economists forecast in its second 12-month auction of unlimited funds, held on September 30, suggesting banks’ need for cash has eased for now.

Banks bid for 75.2 billion euros at the current benchmark interest rate of 1 percent. The ECB loaned a record 442 billion euros at the first auction in June and economists had forecast demand for 137.5 billion euros this month.

The ECB, which will offer banks 12-month loans for a third time on Dec. 15, is trying to flood the system with money in the hope it will be lent on to companies and households. Liquidity, liquidity everywhere, but not a drop of inflation in sight.

In A Tight, And Embarassing Corner?

Angela Merkel did not mince words at last weekends G20, warning fellow world leaders not to make the fight against global imbalances the central issue of the meeting. With Sunday's election looming she came close to accusing the US and Britain of backtracking on the issues of financial market regulation and global limits on bonuses for bankers by shining the spotlight on the export-oriented economic policies of Germany and China.

“We should not start looking for ersatz issues and forget the topic of financial market regulation,” she said in one of her speeches, “We cannot afford to neglect this issue now....Imbalances are an issue, but we must look at all the factors . . . We must talk about imbalances and name the reasons why they came into being.”

“We should also look at imbalances between currency regions and not pick on specific countries within the eurozone,” she added, referring to criticism from the US that Germany is not doing enough to support its domestic demand.”

"In terms of handling the aftermath effects of the financial crisis, the biggest problems and the deepest pitfalls are yet to materialize," according to Munich-based Unicredit economists Alexander Koch and Andreas Rees "It is very likely that typical lagging indicators like the labor market and the public deficit will still deteriorate markedly next year," and "big question marks" remain over the sustainability of the recent upswing.

A fiscal "exit strategy" is needed to avoid ballooning public debt, set to pass 5% of GDP this year, and even more during 2010. At the same time Merkel want to create a growth-friendly environment for consumers and companies by lowering the tax and social security burden. This balancing act is going to be hard, very hard, in a worl dwhich may just not allow Germany to run up the sort of trade surpluses she has been living from.

The German deficit is forecast to rise to 6% of gross domestic product next year, double the amount allowed under normal circumstances under European Union rules. Germany is still expected to see full-year gross domestic product shrink by around 5% in 2009.

One of the main acts of the outgoing government was the introduction of a debt ceiling, under which the German constitution now limits federal government borrowing to 0.35% of GDP by the time we reach 2016. What this means is that the new government will really have its work cut out if it wants to reduce the budget deficit and cut taxes at the same time. The only way will likely be via serious spending cuts. Some of these cuts may well come in the area of social benefits, possibly in health care, where the FDP is proposing a basic private insurance, with subsidies for those who cannot meet the costs. On the other hand, the CDU/CSU is essentially committed to maintaining the status quo, having already abandoned its more radical health care reform ideas. This more or less guarantess that a sizeable chunk in savings will have to come in the area of pension benefits, where the CDU/CSU is committed to the planned gradual increase in the pension age to 67.

Angela Merkel faces no easy task. She has to manage the exit from the massive fiscal stimulus and financial rescue packages,she has to ensure that the post-crisis economy is a more resilient and more balanced one, she has to address the long-standing issue of an ageing German society where generational inequality is on the rise and where younger generations are now burdened with an even higher debt level. And she has to do all this while keeping alive a coalition with a Free Democrat Party whose proposals on pension reform while certainly far reaching, still raise serious doubts about whether they will be sufficient to address the pension time bomb that is ticking away under an elderly export dependent society whose generous entitlements to pension benefits, healthcare and long-term care are becoming harder and harder to square with the long run growth performance of the German economy.

Sunday, September 27, 2009

The G20 and Why Export Dependency And Global Imbalances Matter

With the timing of the latest G20 meeting set to coincide with the run-in to the German elections acrimonious debate has not been absent, but even as the passions generated by the arrival of voting day subside, it is clear that just beneath the surface their lie some simmering problems which simply will not go away. Despite the fact that nothing is really on the table that will make that much difference in the short run, I think the structural transformation that they are carrying out at G20 level is going to be very important in the longer term in finding eventual solutions.

According to Bertrand Benoit in the Financial Times the G20: "will endorse a report from the Financial Stability Board that calls for bonuses to be linked to the long-term success of financial companies and not excessive risk taking." Well this of course sounds absolutely fine. I have absolutely no objection, but we need to understand that from a macro economic point of view it is virtually irrelevant, with the added detail that the implications are that a recovery in growth will be slower yet less risky. Evidently the issue of why there has been so much liquidity floating around (and this has been the heart of the problem) has little to do with bank bonuses and salaries.

Having interest rates near zero in a significant part of the developed world for an extended period of time - the inevitable consequence of having such a huge excess in global savings - means the the money will still be there, very cheaply, for people to do just whatever they want with it. They might, for example, like to buy Hungarian forint denominated assets, as Deutsche Bank analysts have been advising them to do, and try to find out just how long it takes them to push the economy of that small country right off the edge of the precipice on which it is presently so perilously perched. Or they might like to do something similar with the Russian Ruble, and see if they can block Bank Rossii from being able to move towards a floating currency. Or, if they are really short of interesting ideas, they might like to buy the South African Rand to see just how far out of line you can push the currency in a country which is suffering its worst recession in a couple of decades. Of course, all of this is not that risky for those who understand the finer arts of Forex trading, and the banks who lend them the money will run little risk. The risk here is for the poor people who live in Hungary's and South Africa's of this world. Risk in these cases is, of course, massive.

The banks are also being pressurised to raise their capital ratios. While this is always well-advised in the boom times, it only makes matters worse in a downturn. The current drive to make banks less leveraged and safer may well have the perverse consequence of reducing money balances in the short term. At least this is what Tim Congdon from International Monetary Research argues. This process simply "strengthens the deflationary forces in the world economy, and that increases the risks of a double-dip recession in 2010," he says.

Meanwhile everyone will continue to drive full speed ahead on open ended stimulus programmes, without being altogether clear what it is they are trying to stimulate (see the Spanish case if you don't believe me). "The G20 will call for extraordinary fiscal and monetary stimulus to be continued until “a durable recovery is secured”". But, and here comes the rub, it will also call on countries to act together to ensure more balanced economic growth in future, with surplus countries – China, Germany, Japan and oil exporters – urged to raise domestic demand and deficit countries asked to reduce budget and trade deficits once the world has secured a recovery.

This is evidently the sensitive point which has had everyone from Peer Steinbrück and Angela Merkel, to the newly elected members of the DJP in Japan and the governing elite in China twitching away furiously in recent days. The leaders of these countries have become nervous, since they feel they are being blamed for something they haven't done, and naturally they are lashing back.

They need not worry so much, these exhortations will also be to no real avail. In order to see why, let's take a quick tour through the real heart of the problem.

Who Runs The Current Account Deficits

According to the current director of the US president’s National Economic Council, Larry Summers, writing in an academic paper published in 1990, the United States economy was set to run current account deficits for a period of 15 years, with the consequence that more than 6 percent of U.S. assets would be owned by foreigners by 2010. However, as he saw it, high saving during the subsequent 15 years would result in the generation of current account surpluses and a reduction in foreign capital ownership to 3.5 percent. After 2025, or so the analysis ran, the rapid increase in the number of elderly, would once again lead the United States to run current account deficits.

Since this forecast seems to come so near to describing a process we are now seeing unfolding before our very eyes – in a world where many hold economists can see nothing at all coming – we might like to ask ourselves how anyone could have known so much so far in advance? The answer to this strange questioin is Larry Summers used a very simple model to arrive at his “predictions”, a model based on the life cycle saving and borrowing mechanism, the description of which was to lead Italian economist Franco Modigliani to win a Nobel in 1995. Summers and his co-authors simply applied the individual Life Cycle model to a whole population, and as it appears came up with a fairly plausible outcome.

Everyone is evidently only too well aware that all developed societies are ageing (some, of course, more rapidly than others), but what many observers do not seem to grasp is that this ageing process has very concrete and forseeable economic consequences, consequences which have now been captured in a whole generation of economic models, and which are described in the accompanying chart prepared by my colleague Claus Vistesen.

As can be seen from the chart, as the demographic transition – identified in age bands following the nomenclature of the Swedish demographer Bo Malmberg - advances median population ages move steadily upwards, producing in their wake a whole series of economic phenomena, phenomena which tend to impact directly on the domestic consumption and the current account balance of a national economy. The thick blue line shows what happens to the current account as a given country moves through the age bands. Initially there is a tendency to sharp deficits and severe economic crises, such as are very characteristic of low income, high fertility, developing economies like Ecuador or Pakistan. Then, as societies develop socially and economically the tendency toward deficit remains, only this time on a more mature, and seemingly more stable, basis as seen most evidently in recent years in countries like the United States, the United Kingdom, Spain and France, who all have population median ages in the 35 to 40 range.

But then something strange happens as population median ages rise past the 40 mark, and especially as they age past 42. The current account suddenly swings into the positive zone, and this can be seen in the real world in countries like Germany, Japan and Sweden, where the ageing population effect means that domestic consumption becomes steadily weaker, and if we look at the second (purple) line in the chart, which illustrates the level of export dependency, we can see that while this is weak at the lower median age ranges (due to the momentum derived from stronger domestic-credit boom dynamics), it steadily grows at the higher median ages.

So, is there any empirical evidence for this phenomenon you may ask? Well just look at Germany, Japan and Sweden, and how the recent collapse in demand for their exports produced by the global crisis sent the economies in these countries spiralling downwards. On the other hand, during periods of economic boom, strong surplus countries need to find an outlet for the savings they accumulate. Hence the large current account deficit countries in the East of Europe, for example, were funded by Austrian, Swedish and German banks. The question we should be asking is not why banks in these countries were so stupid as to lose so much money, rather it is why they had so much money to lose in the first place. That is, why were their populations saving so much, and why were profitable domestic outlets for such savings insufficient? Once we can get hold of this, we can start to see one of the reasons why there have been such large global imbalances in the first place.

One of the problematic aspects of this situation, looking at the chart, is there there is no steady state (or cyclical correction) mechanism at work here, since there is not, to use the jargon, homeostatis, and the need to export (the export dependency purple line) simple heads off exponentially towards infinity, while the level of deficit does the same in the opposite direction. The reason that the need to export moves exponentially upwards is that median age doesn’t just move up from one level to another, and sit there, but keeps climbing steadily upwards, and the more it rises, the less “bang for the buck” in GDP growth you get from any given level of exports. This is the situation we are seeing now in Germany and Japan, and this is why they will struggle mightily to pull themselves out of the present recession, and why the whole situation is evidently not sustainable. So, if the countries in question don’t do something, and do something now, to stop median ages rising too rapidly, more crises like the one we are presently living through are evidently guaranteed.

This way of thinking about things is sure to form, in my opinion, one piece in the new, post-crisis, macro mindset that will emerge. Of this I have no doubt, since the present crisis is all about imbalances, and this is one simple and straightforward model for thinking about and understanding them. Basically one group of people - the current account surplus countries (China, Japan, Germany, Sweden) - were afloat with money, and spent their time rather recklessly lending it to another group of people - the current account deficit crowd ( the United States, Iceland, Ireland, the UK, Spain, Portugal, Greece, Romania, Bulgaria, the Baltics, Hungary and New Zealand etc, etc) - who needed to fund their deficit habit, and who did so by equally recklessly borrowing the money. So if you want to understand the banking crisis, you need, as the US economist Brad Setser would say, to follow the money and find source of all those surpluses and deficits.

And all of this helps us understand not only the crisis, but also the problems we are going to have getting out of it, since as Larry Summers noted over lunch with the FT’s Chrystia Freeland “‘The global imbalances have to add up to zero and so, if the US is going to be less the consumer importer of last resort, then other countries are going to need to be in different positions as well.’

As Freeland highlighted, on this possibility, Summers was absolutely bullish, and understandably so. “The very great enthusiasm for accumulating reserves that one saw globally is likely to be a smaller factor over the next decade than it has been in recent years” he predicts this time. And so too is economic growth (going to be a smaller factor over the next decade), Edward Hugh rapidly adds, since with everyone looking to export their way out of trouble, we have to ask, as Nobel Economist Paul Krugman pointed out, the tricky question about just who the customers with the current account deficits are now going to be to enable all those much needed exports. The current talk of a simple and straightforward recovery for the global economy is misleading, and a long hard road lies ahead for all of us.

And the first evidence of this can be found in the latest quarterly US current account data. The deficit narrowed in the second quarter to $98.8 billion, the lowest level since 2001, reflecting a smaller shortfall in trade of goods as imports and exports both decreased. This is far from being a linear process, and the U.S. trade deficit was up again in July, rising 16.3% over June to hit $32.0 billion, according to Commerce Department data. Despite the fact that imports rose sharply in July on the back of the stimulus programme, total trade activity is still well below last year's level, and the trade deficit with China was $20.42 billion compared with $25.01 billion in July 2008.

In addition US bank loans have been falling fast, and were down at an annual pace of almost 14% in the three months to August (from $7,147bn to $6,886bn). The M3 "broad" money supply, watched as an early warning signal of where the economy will be a year or so later, has been falling at a 5% annual rate. There is absolutely no sign of an imminent sharp rebound in US domestic demand, and little likelihood of a continuing strong current account deficit. The most likely path is for the deficit to steadily close of its own accord as the stimulus programem which is still supporting it is steadily withdrawn. Well, this is what the world wanted, and this is what it is now going to get. So everyone should be happy, I guess.

And while the deficit countries close them down, there is little liklihood of the surplus countries taking their place. It is like telling these countries, you know, you really should have had more children 30 years ago. Do people really think these countries can simply invent policies at the snap of a finger and convince citizens who are worried about the stability of their pension system to spend more now, just because it is in the interest of the global economic system? And what policies exactly. Buy one and get another one for free from the central bank?

But coming back to the G20, as I said at the outset, what I think really matters at this point is that our policymakers have set up a problem for themselves to solve, and they have also set up a structure through which they may solve it. And that is something. Now in all likelihood we will continue to thrash around trying-out false solutions for the next two or three years, but then maybe, just maybe, they will all be ready to talk about what we really might do. And here's the good news, there is another planet out there waiting to be exported to. And the planet has a name - the Emerging Economies. So all we have to do now is work out is a sensible and responsible framework (the so called "supportive environment") through which cheap credit can be channeled into these countries, without that is producing the kind of boom-busts we just saw in the Baltics, Romania and Bulgaria. Not a little task, but not an impossible one either.

(1) An Aging Society: Opportunityor Challenge? - written with David M. Cutler (Massachusetts Institute of Technology), James M. Poterba (Massachusetts Institute of Technology), and Loise M. Sheiner (Harvard University) and published in Brookings Papers On Economic Activity, 1990.

Wednesday, September 16, 2009

How Will The ECB Ever Manage To Stop Funding Spanish Government Debt?

The looming problem of what will happen as and when some of the other Eurozone economies eventually start to recover while the Spanish one languishes in decline is finally starting to make the columns of the global financial press. Yesterday Thomas Catan had an article in the Wall Street Journal entitled Spain's Struggles Illustrate Pitfalls of Europe's Common Currency while Emma Ross-Thomas and Gabi Thesing also had a similar sort of piece in Bloomberg, under the heading Europe’s Two-Speed Economy Complicates ECB Rate Plans.

So the difficulty Spain could represent for the rest of the Eurozone is now it seems becoming the "Topic du Jour".

As Thomas Catan says:

Even as France and Germany begin to show signs of economic recovery, weaker members of the European common-currency union remain mired in recession. Without painful overhauls, euro-zone countries such as Spain, Italy, Greece and Portugal seem set for years of meager growth, making their debts harder to pay. That raises the question: Could the divergent economic fortunes of euro-zone countries pose a problem for the currency union itself?
Or, as the Bloomberg columnists say:

Europe’s economies are rebounding at different speeds, complicating the European Central Bank’s efforts to put the region back on a more stable footing.

Even as the global economy recovers and Germany and France return to growth, the European Commission yesterday cut its forecasts for Spain and Italy. Deutsche Bank AG says some of the economies that were once motors of growth and job creation across the 16-nation bloc may stay mired in recession next year.
So what is the background here? Let's look at what has happened in Spain. The Spanish property bubble started to slowly puncture throughout 2006 (well before the outbreak of the Sub Prime crisis) as the ECB steadily started to tight monetary policy and raised interest rates - the biggest weakness, and greatest vulnerability in the Spanish domestic economy is the way Spanish mortgages are overwhelmingly (85% plus) of the variable interest rate variety. That makes Spanish consumption exceptionally dependent on ECB interest rates. Thus, when these are lowered, as has happened over the last nine months, the relief is virtually instantaneous (as can be seen in the recent surge in the consumer confidence index) but when they are raised the squeeze on spending power is acute.

Spain's construction industry was the first to notice the change, and activity slowed as the prospect of higher interest rates loomed. In fact by the time we reached last July the construction industry had already been contracting for three years, and from the July 2006 peak activity was down by 30.5% - that is it is the industry had shrunk to 70% of what it used to be.

The decline in construction was followed by a decline in industrial output and job creation, which both peaked in June/July 2007 - with production having fallen by 33.45% from the peak by last July. That is industrial output has now been falling for over two years. Then, as the economy slowed domestic demand started to fall, and retail sales are now down a little over 10% from their November 2007 peak. So, as we can see, the whole economy is steadily sliding down, as first the builders, then households, and then finally companies steadily reduce their spending, and the drift is relentless.

And so things continue, and we hit the next stage, and in comes the government to support the economy, which is now extraordinarily indebted and at the same time extremely demand deficient. It is demand deficient because all the main groups of domestic economic agents are steadily trying to cut back on spending and debt, and the export oriented sector, after years of neglect and internal price inflation is now just not competitive enough to make up for the gap. So there is simply a huge sucking sound and the economy folds in on itself, and it is just this implosion force that the rise in government activity attempts to cushion.

So far, so good. This is the stuff burt bubbles are made of. But this respite offered by the rise in government indebtedness is only viable and worthwhile (after all, you are only creating even more debt, which at some point needs to be paid) if it serves to facilitate the kind of economic correction Spain most urgently needs, which involves inevitably and inexorably transforming itself into an export driven economy. But what happens as the government starts to take on all the debt, well, as we saw last year, the interest differential, or "spread", that the Spanish government has to pay on its debt suddenly starts to surge, as investors begin to worry about the sustainability of all the new debt.

So what happens next? Well, as Claus Vistesen points out in his recent analysis, the ECB needs to step in with a massive one year liquidity injection, and this effectively enables the Spanish banks to borrow the money they need to buy the bonds directly from the government, and then deposit the bonds purchased over at the ECB (with a haircut - or discount) to serve as collateral for their borrowing, earning on the way a minimal interest differential, or "carry" for their labours. Thus the ECB does indeed indirectly slightly improve the liquidity position of Spain's banks, even if the big news here is really that the ECB is - wittingly or unwittingly - indirectly funding Spain's fiscal deficit. Let's take a look at the spreads for a moment. The first chart shows a comparison of the "usual suspects" club - Spain, Ireland, Greece, Italy, Portugal and Austria. As can be seen, these spreads widened notably last winter, on the back of the Lehman collapse inspired financial crisis. They have subsequently narrowed again although notably we are still not were we were before conditions deteriorated, and especially the Greek and Irish spreads remain worryingly high.

Of course, part of the explanation for the improvement is the return of risk appetite, but there is also another factor, an institutional one, which I hope in the course of the coming paragraphs I will be able to demonstrate, since it is my contention that, in at least the Spanish case, the tightening of the spreads has been (an intended or unintended) direct consequence of ECB liquidity provision. And if the spread has only come down (see the chart below for the Spanish case on its own), then the reasonable question to start thinking about is what might happen to the spread once this support is withdrawn.

As we can see in the accompanying chart below, the issuance of short term debt (the maroon line, the one which spikes dramatically) has grown at very high year on year rates this year, yet despite all the talk of governments ahving difficulty placing debt, the spread on Spanish debt has softened. Now why might that be?

The ECB Furnishes The Proof

Well, quite conveniently for our present needs, the ECB, in its June Monthly Bulletin, supplied some useful details about the level of government debt purchases made by the various financial institutions. Basically what can be seen from the data is the way in which Monetary and Financial Institutions (MFIs) have been steadily moving away from riskier assets into the relatively safer area of government debt as the force of the financial crisis blast hit them head on.

The ECB estimates that the Eurozone banks really started seriously acquiring government debt in the first quarter of 2008, building up their stocks at an average rate of about €30bn a quarter. But then, in the first quarter of 2009, there was a sudden surge to a rate of around €90b.

During the last part of 2008 and early 2009 many of these purchases were in fact made by what are called money market funds which, as Barclays Capital analyst Laurent Fransolet points out in a June research note (to which I am indebted for this part of my analysis), is not entirely surprising since at the end of last year a lot of the buying originated from French, Luxembourg and Irish MFIs, the three countries which are host to biggest slice of the money market fund industry in Europe. Since the beginning of 2009, however, things have changed, and it is clear that the banks have actually been responsible for most of the buying. Based on the ECB estimates, it seems that something like 75% of the Q1 buying was conducted by banks. The ECB explanation is that a lot of this buying is more or less normal at this stage in the credit and business cycle, when risk sentiment is low. In fact Fransolet points out, and illustrates with a chart (below), how historically there has been a reasonably good relationship between the steepness of the yield curve and the buying of government debt by banks (and indeed MFIs in general).

Basically all of this is a reflection of the sort of "carry" positions banks find it convenient to take on board when yield curves are steep, since they can normally fund themselves at a pretty low rate, it is then quite interesting for them to buy near 0% risk-weighted assets that are yielding a few percentages points over their funding costs, and in this way they both make money and rebuild their capital base and de-risk their balance sheets at one and the same time.

As Fransolet notes the ECB does not offer a direct breakdown of such purchases by country. However the ECB database does contain a breakdown by country at the MFI level. What we find here is that the purchasing of government debts by MFIs has been far from uniform across countries. In fact the largest purchaser has been, guess who, the Spanish financial system who have bought about €9bn a month over the past six months - strange how that number just nicely covers what is needed for the current account deficit, isn't it .

Relative to the other countries and the size of the Spanish banking sector, this is, as Fransolet states, pretty big beer indeed. Buying of government securities was also brisk in several of the other usual suspects - Italy, Greece and Ireland (+€22bn, €13bn and €1 bn over the six months to April). Hence, we find, surprise surprise, that banks in countries that have experienced large rises in government debt issuance (and which previously had wide spreads versus Germany) have been quite active in supporting their own domestic debt markets this year. Not a smoking gun, but........

As Fransolet concludes: "Obviously, this bank buying is not the only reason why cross-market spreads have retightened recently, but it has definitely been a big factor."

To this I would add another piece of circumstantial evidence, one that hasn't been widely reported in the press, and that is that Spain's share of the 442 billion euro June 24 one year tender represented something over 15% of the total, when the share of the Bank of Spain in the Eurosystem is just over 8%. Not only that, as can be seen in the chart below, the level funding injection into the Spanish banking system (net of Spanish bank reserve deposits with the ECB) has continued to shoot up all year.

So let's retrace our steps now and ask ourselves the same question the other way round; just where is all this money going? Well if we go back to some charts I posted yesterday, the answer isn't hard to see. Lending to households has been flat:

and lending to corporates ditto:

while lending to government has, of course, and as we have been noting, been shooting up.

So while it is surely true that we can't say simply say outright and categorically that the ECB is carrying out indirect intentional debt monetisation and thus engaging in Quantitative Easing stricto sensu, we can say, and without a shadow of a doubt, the ECB one year liquidity injection has, in the Spanish case, largely served to help monetise Spanish government debt. And this is where the problems and all the exit related issues start.

As Claus Vistesen puts it in his excellent summary of the current battery of ECB measures:

"The ECB is not actively pursuing a policy of funding the growing pile of government debt in Austria, Ireland and Southern Europe, but it is in fact doing so as an indirect consequence of its actions. Thus, given that I think we can all assume that any eventual recovery will be uneven, unwinding liquidity provision in the aforementioned countries is going to involve very special problems, since evidently, if these governments seek to substitute free market funding for the current institutional one the spreads will evidently balloon again. And here is the dilemma, for those who can recover will, while the rest may be simply sent straight to hell."

Basically the current ECB approach raises the following issues and problems:

i) it is a quite common and normal process for central banks to facilitate the monetization of government debt, allowing the high street banks to earn some liquidity from "carry" in the process";
ii) this process can later lead to difficulties in the banking sector if there are differing maturities on the debt in question, that is, if the banks borrow short to lend to governments who needs are over the much longer term, this leads to a problem when the central bank withdraws funding if ready support is not available for the government debt in the private market. This would be the position in Spain if the ECB go for exit in July, and the Spanish government needs to rollover its 2009 debt at the same time as funding its 2010 deficit.
iii) the central bank also runs the risk of financing excessive deficits, if it has no political control over the actions of the government in question (which in the ECB case it manifestly doesn't) then funding supplied for one purpose can easily be used for another, and this is exactly what is happening now in Spain, as funding made available to ease Spain through a much needed correction is quite simply being wasted. This situation can create "grave dilemmas" for the central bank. This is where the ECB is at now with Spain.
iv) all of this is one of the reasons why the Maastricht Treaty tried to tie the ECB's hands quite strongly, but well....
v) and the worst of all this is that not having carried out the correction, the most serious problems will face Spain should the rest of Europe begin to recover before Spain does.

And this takes this whole post back to just where it started. The reason for (v) should be obvious, since if we think about the fact that most Spanish mortages are variable, then the ECB will not only be withdrawing the credit enhancement liquidity support from the banks, it will also be raising rates, indirectly tightening the noose even more strongly around the neck of the unfortunate Spanish, most of whom actually have no idea at all of what is to come next.

So in closing I will go back to Thomas Catan in the Wall Street Journal. As he sees it, when faced with a debt crisis the ECB and the EU Commission have essentially three ways out, and it is now up to history (and hopefully a few strokes of good fortune) to decide which of the alternatives he outlines will actually carry the day.

In the case of a debt crisis, there would be three main ways out -- all of them painful. Faced with a debt crisis in weaker members, the euro zone could eliminate the problem by moving to full political union. Government bonds would be issued centrally, with the funds doled out to member nations. But that seems like an awfully hard sell at a time when there is scant enthusiasm for further integration in many European countries.

The second is the so-called nuclear option. Tired of paltry growth and spiraling debts, a country such as Spain or Italy could decide to scrap the euro. That would almost certainly mean defaulting on its national debt, which is denominated in euros. Investors would pile pressure on the next weak link, possibly leading to a chain reaction and a collapse of the currency.

Given how damaging the nuclear option would be to everyone involved, one has to imagine that Europe would opt for the third option -- bailout -- no matter how unpalatable.

Such a bailout would be hugely controversial. Germany and France would find it hard to justify it to their own taxpayers. And they would most likely have to impose unpopular, International Monetary Fund-style austerity plans on the other countries, stoking tensions within the EU.

The euro zone still has time to kick-start growth by taking concerted action. Unfortunately, it may need the threat of a debt crisis to begin doing so.

Tuesday, September 15, 2009

The ECB's Balance Sheet At A Glance

by Claus Vistesen

What follows is essentially the fruit of the last week's labour. It is a detailed look at the ECB's balance and the related question of whether we can call, what it is that ECB the is doing quantiative easing or not?

Needless to say, I think that this question is an important one in a general context since if my intuition that the epicentre of the global financial and economic crisis has now migrated from the shores of the United States to the periphery of Europe is right, then a detailed look at the ECB's policies and arsenal is not only merited, it is essential reading.

With the distinct risk of turning this into a cheesy copy of the Oscars show I should thank Edward Hugh for his patient and thorough back-editing of my English language blunders and for his seemingly unlimited availability when I needed someone to sound out about the arguments themselves. All mistakes and mishaps naturally fall on my shoulders and criticism should be directed accordingly. Here I simply reproduce the executive summary but you can download the full report - which is currently in the form of a working paper online here. The analysis includes data up to week 35 (and up to July in the case of monthly data). If you want a copy of the spread sheet, I will willingly provide if you simply let me know.

Executive Summary

Is the ECB deploying a variant of Quantitative Easing in any fashion, way, shape or form?

If you are talking about Quantitative Easing senso strictu then my answer has to be a simple and straightforward no. However, if we stop being quite so by the letter of the book, and broaden our definition slightly, then I would strongly suggest that the battery of credit enhancing measures put in place by the ECB when taken together with the steady increase in securities accepted onto the balance sheet as collateral, do make it evident that the ECB - whether wittingly or unwittingly - has moved into some form of what we could at least call "quasi" Quantitative Easing.

Is the ECB indirectly monetizing the debt issuance of Eurozone governments?

If my initial answer to this question - before actually going through the books - would have been an outright yes, I now feel the need to tread much more carefully on this point, since I have most definitely not been able to conjure up that proverbial smoking gun. In fact, it has proved very difficult to establish any kind of direct link between the amount of funding drawn from the ECB refinancing operations and the purchase of government bonds by the MFIs at the national level.

This is not to say, however, that circumstantial evidence is not available that this process is taking place to some extent, and in some countries. I do believe, for example, that the massive purchase by Spanish MFIs of government bonds in that country does offer prima facie evidence that some such connection may well exist, and thus all I can say at this point is that further research is called for, and especially a much more detailed and discriminating data-mining dig-down.

What are the prospects and possibilities for a viable exit strategy for the ECB from its non-standard monetary policy measures?

The measures collectively known as Enhanced Credit Support are by their very nature flexible. However, if there is anything we have learnt from the operation of monetary policy in Japan over the last twenty years it is that premature exit from the sort of substantial support the ECB is offering only makes matters worse, and in addition this kind of massive liquidity easing is a lot easier to get into than it is to get out of.

A true economic recovery will inevitably be somewhat selective, and it is at this point that the ECB's problems will really start, since the recovery will begin in some countries and not in others. To take the extreme case: it will be awfully hard to maintain massive monetary easing for a Spanish economy which remains stuck in an "L" shaped non-recovery if in France headline GDP growth were to start to tick back again towards - say - 2%. Then the real dilemmas which face the ECB will begin in earnest. As such, it is going to be much more difficult for the ECB to instigate that dearly beloved exit strategy than many currently like to believe.

Monday, September 07, 2009

There Is Another Shoe To Drop In The Global Economic and Financial Crisis - And The Focus Will Be On Europe's Perifery

'As far as I am concerned, this is ... the most complex crisis we've ever seen due to the number of factors in play'
Spanish Economy Minister Pedro Solbes speaking to the Spanish radio station Punto Radio September 2008

“‘The global imbalances have to add up to zero and so, if the US is going to be less the consumer importer of last resort, then other countries are going to need to be in different positions as well."
Director of the US president’s National Economic Council Larry Summers, speaking over lunch with the FT’s Chrystia Freeland.

Basically what we now have before us - as Pedro Solbes pointed out before being uncerimoniously defenestrated from the inner circle of the Spanish government - is an extremely complex situation and problem set. The background has evidentally been an unprecedented global financial and economic crisis, but this crisis has affected countries unequally, and it is noteworthy just how many people in what could be called the "weaker" countries have often sought refuge in the global nature of the crisis, rather than asking themselves just what it is exactly about their own particular economy that makes them "weaker", and more vulnerable, and why the crisis has struck more severely "here" rather than "there". Thus there is a great danger that people take refuge in the fact that the crisis is global in order to avoid thinking about the actual reality that faces them. This danger becomes even more of an issue as some countries begin timidly to return to growth, leaving others stuck in the mire - and possibly in danger of bringing the whole pack of cards tumbling down on top of them again. One such danger is evident in China (for which see the numerous warnings from Andy Xie) but others are for me somewhat nearer home, on Europe's periphery. A number of countries in Eastern Europe immediately come to mind - not only the Baltics, but also Russia, Ukraine, Bulgaria, Romania, Hungary, Serbia and Croatia. And in Southern Europe Spain and Greece stand out as in particular need of what Jean Claude Trichet would undoubtedly call "extreme vigilance".

If we leave out Russia (which is arguably a rather special case due to its dependence on energy revenue), then the simple fact of the matter is that what all of these countries had in common during the bubble years was that they were all running large (unrealistically large) current account deficits, which were produced to fuel strong credit driven housing and consumption booms. The crisis has struck all these countries like a shot of lightening for the simple reason that under present conditions such current account deficits are now no longer sustainable.

Now, the only way forward for such countries, as Paul Krugman points out (citing Reinhardt and Rogoff) is to export their way back to growth, and to demonstrate how this might work Krugman produced a simple chart in his Lionel Robbins lectures, which although rather rough and ready does serve the purpose adequately well.

So the central point I wish to make is that all these countries now need to run current account and trade surpluses to generate headline economic growth and to start paying down the external debt they accumulated during the heady years of the boom. Countries are no different to households in this sense. And the wider the current account deficit at the height of the boom, the bigger the correction needed. Without the much needed correction these countries simply will not recover, and we will see the famous "L" shaped recovery. If people think otherwise they are simply deluding themselves.

The situation in the US and the UK is, of course, not that different structurally from that which is to be found in some parts of Eastern and Southern Europe, but it is less extreme, in that the Current Account deficit peaked at between 5% & 6% of GDP. This is still large, and correcting it is going to be one of the very good reasons that the global economiy ISN'T going to return to any kind of strong growth anytime soon, given the strategic importance of the economies concerned.

The UK and the US do, however, have one large and significant advantage over the worst affected countries in South and East of Europe, and this lies in the fact they can issue debt in their own currency, and they can allow that currency to devalue, and that in fact is the road that both these countries are now going down. But remember, the result of this is that US and UK consumers will now play little part in facilitating headline growth in the global economy, since they themselves will now be net savers. But most of the worst affected East European economies are either locked-into currency pegs with the euro (the Baltics and Bulgaria), or cannot devalue very far due to the strong dependence on forex loans (Romania and Hungary) or both. Nor can these countries realistically expect to issue debt in their own currencies. So they are in effect in a very parlous situation, on financial life support from the EU and the IMF, while unable to make sufficient adjustments sufficiently quickly to stop unemployment rising out of hand, and non performing loans piling up in the banking sector.

Which brings us to Southern Europe. Italy is a case apart - since it is "simply" suffering from a kind of ageing-related terminal slow death "Venice style", and thus has a different problem set - in particular, while the Italian government is heavily in debt, Italian households are strong net savers, and thus any eventual default would be largely a "home team" issue. Portugal, Greece and Spain, on the other hand, were all running large CA deficits between 2000 and 2008, and these are deficits are now being forceably closed. But of course, and here comes the rub, these countries don't have their own currency - they have to issue debt in euros, and they can't simply fuel inflation (like they did in the past) since they can't print money, only the ECB can do that, and the ECB is a multi-national not a national institution.

Now people over at the ECB are well aware of this problem, and the bank is facilitating all the liquidity these countries need in the short term, but it is so very important important to understand this only aids liquidity, it does not resolve the solvency-related issues (which the individulal countries have to sort out for themselves) and in fact the short term palliative only adds to long term accumulated debt problem if the breathing space offered is not taken advantage of. And, here comes the problem, since all the available evidence suggests that the correction the ECB would like to be funding is either not taking place, or is taking place too slowly to be of much use. That is, the ECB has the funding capacity, but it does not have the necessary political clout.

Take Spain for example - Spain's external debt is continuing to rising even as I write, while at the same time GDP is falling, and will continue to fall untill we get back to export competitiveness. Worse, nominal GDP (that is current price GDP) is now falling faster than real (inflation-adjusted) GDP, so the value of the debt remains - in money terms - where it is, while GDP shrinks in relation to this absolute reference point - both in real terms, and even more so in nominal terms. I have been following this problem in Japan for the best part of a decade now, and the solution is evidently not an easy one, since - if you take the core core price index - Japan never really came out of deflation after 1998, and land prices are now back at the levels of somewhere in the early 1980s. Needless to say, if this repeats itself in Spain, the mess will not be a pretty one, and the problem for the ENTIRE global financial system will be substantial, due to the counterparty risk element.

So we are really caught on the horns of a dilema here, Spain and other EU periphery countries have to deflate (willingly or unwillingly, they need to carry out what has now come to be known as "internal devaluation") but so long as they fail to do this and to attract sufficient investment for new export industries to turn the economic dynamic around AND as long the rest of the global economy doesn't recover strongly enough with some countries starting to shoulder significant deficits again, then we are all only going to plumb the bottom. Worse, unemployment will continue to mount, and bad debts pressurise the banking system, which is where the next shoe might then not only drop, but be forced right off the foot first.

The only way in which it would be possible for these countries to attract the necessary investment to be able to start to create employment employment again would be to restore competitiveness, and over the time horizon we should be thinking about this is impossible for them to do via productivity improvements alone: hence the pressing urgency for the "internal devaluation" solution.

And let's not be fooling ourselves here - the main reason those famous government bond "spreads" have all tightened so impressively recently has been the willingness of the ECB to discount the national government bonds which are first purchased by local financial entities and then passed on for discounting at the ECB - a practice one of my Spanish friends calls the "truco del almendruco" (that is, you sell the 10,000 euro new car for 9,995 euros thus changing the key headline digit, giving everyone the impression there has been a large and significant discount, and, oh yes, first of all you need to dump a wheelbarrow load of cash on the banks - in this case on a one year financing basis).

"Between October 2008 and April 2009 MFIs’ net purchases of debt securities issued by the euro area general government sector totalled €217 billion in the context of rapidly declining short-term interest rates. This entirely reversed the net sales of €191 billion observed between December 2005 and September 2008 in the context of rising short-term interest rates."
ECB Monthly Bulletin, June 2009

So what I am saying is that the ECB is effectively conducting expansionary fiscal policy in the Eurozone countries - by buying a large part of the new government debt, a state of affairs which is in fact equivalent to conducting Quantitative Easing via the back door, while the EU/IMF tandem is offering similar support to the key countries in the East. Anatole Kaletsky made a similar point in the Times back in June, when the ECB announced its €442 billion of new cash into the euro money markets in what was the biggest long-term lending operation in the history of central banking and roughly equivalent to half the Fed’s entire monetary expansion in the past 18 months.

The Fed has “monetised” roughly $1 trillion of US Government debt since 2007, if we combine its Treasury and agency bond buying. Meanwhile, the ECB has lent $1.5 trillion to the euro-area banks. But what have the euroland banks done with this new money? They have lent most of it straight to their governments. Indeed, the governments in Ireland, Greece, Portugal, Spain and Austria would long-since have gone bust had it not been for the willingness of the commercial banks in these struggling economies to buy unlimited quantities of government bonds with money borrowed from the ECB. And these bond purchases have, in turn, been used as collateral for more ECB borrowings, which could be used to buy more government bonds.

In effect, therefore, the ECB has been lending money by the shed-load to governments, with commercial banks acting merely as a fig leaf for what would otherwise be seen as a blatant monetisation of the most insolvent European countries’ public debt.

Now Anatole only has it half right here, the objective is not to finance dubious government debt in semi-bankrupt countries (Italy, for example), but to enbale those countries who had been running extraordinarily large current account deficits (Spain, Greece and Portugal) to close the deficits gradually (ie without precipitating a dramatic implosion in their economies) by facilitating government borrowing to fill the gap left by domestic and corporate deleveraging. The situation I am trying to describe is perhaps best illustrated by the following chart on Financial Balances prepared by PNB Paribas Chief European Economist Dominic Bryant for a recent research report on Spain.

As households and companies desperately try to save, to put some sort of order back into their balance sheets, government steps in (Krugman's push button "G") to help ease the transition. Such a policy is, of course, all well and good and totally justified (since there is effectively no alternative), so long as the structural transition which such support is meant to facilitate is actually carried through. And this is a big if, especially since most of the evidence we have seen to date suggests it isn't.

And then there is the Irish case, and the proposal to create a "bad bank" (NAMA). According to Minister of Finance Brian Lenihan the Irish State plan to buy up toxic property loans with a current face value of €60 billion and investment property loans with a book value of €30 billion, all in exchange for Government bonds. And how will the Irish government finance a possible €90 billion (or two thirds of 2008 GDP) in bonds? We the government plans to pay the banks in bonds which they can then redeem for cash over at the ECB. Obviosuly there is little other way, with such a high proportion of GDP, but has anyone started to think what will happen if the Spanish exchequer is faced with an equivalent proportional sum to clean up bad loans in Spanish banks. Spain, remember is the only major country where there was a property bubble where the banks have not had a substantial capital injection.

And in my humble opinion the ECB will only be willing and able to continue with this kind of policy for a limited period of time, since they will not be in a position to keep accumulating Irish, Austrian and Southern European bonds ad infinitum, and the sovereign governments won't be able to keep increasing their debt load for ever. Just look, for example at the kind of dynamic Spanish public finances have entered in 2009 (see the acceleration in the cash basis deficit shown for 2009 in the chart below - the evolution is almost exponential, and it still hasn't stopped the haemorrage of jobs out of the economy).

We also need to think about the risk the ECB is running of accumulating substantial capital losses if there is a sovereign debt problem (which there most likely will be at some point if the correction is not carried out) in one of the member states as the size of the ECB position simply grows by the day, and ultimately the German and French taxpayers will have to pay the losses being steadily accumulated, something I feel they will be very reluctant if those in the worst case scenario countries continue to harp on about a global economic and financial crisis whilst effectively doing nothing to put their own house in order.

Precisely this point was raised a while back by Willem Buiter on his Mavercon Blog:

The first vacuum is that there is no single fiscal authority, facility or arrangement which can re-capitalise the ECB/Eurosystem when the Eurosystem makes capital losses that threaten its capacity to implement its price stability and financial stability mandates.

The second related vacuum is that there is no single fiscal authority, facility or arrangement which can re-capitalise systemically important border-crossing financial institutions in the EU or the Euro Area, or provide them with other forms of financial support.

When the Bank of England develops an unsustainable hole in its balance sheet, Mervyn King knows he only needs to call one person: Alistair Darling, the UK Chancellor of the Exchequer. If the Fed were to become dangerously decapitalised, Ben Bernanke also needs to call just one person: Tim Geithner , the US Secretary of the Treasury. It is possible that no-one in the US Treasury will pick up the phone, as none of the senior political appointments below Geithner are in place yet, but Geithner clearly would be the man to call.

Whom does Jean-Claude Trichet call if the Eurosystem experiences a mission-threatening and mandate-threatening capital loss? Does he have to make 16 phone calls, one to each of the ministers of finance of the 16 Euro Area member states? Or 27 phone calls, one to each of the ministers of finance of the 27 EU member states whose NCBs are the shareholders of the ECB? I don’t know the answer, and I doubt whether Mr. Trichet does.

Maybe one day all those phones will be ringing, only for the caller to hear that old Elvis automated operator resonse - "no such number, no such zone".

The G20 Needs A Real Rethink And A New Plan

So, coming back to where we started, growth in Germany and France. Such growth is unlikely to be anything like as strong as most commentators and analysts seem to be expecting. France will most likely do rather better than Germany, given that the German economy can't really move forward till other key economies move, due to export dependence. The German economy may well even ultimately contract over 2009 as a whole by more than the Spanish economy, and I expect Germany's problems (like Japan's) to continue well into 2010, simply because both these countries are now very high median age societies which are completely dependent on exports to grow - which means that now that the UK, US, Eastern and Southern Europe are no longer running current account deficits, Germany and Japan are very hard pressed to get the level of trade surplus they so badly need for achieving sustainable headling GDP growth, which brings us back to Krugman's joke about which planet is going to do the importing?

Structurally the previous drivers of growth will now fail to work, since as Krugman suggests, all the former CA deficit countries now need to export and run trade surpluses to grow and straighten out their financial imbalances , and it is not clear which countries can buy all the added output, especially when countries in general are still reducing imports, and certainly not about to open up deficits which would soak up all those new surpluses.

Essentially, I would close by emphasising that I am not a complete catastrophist, since I think there is a mid term solution out there - and that the answer lies in steadily unwinding the global demographic and wealth imbalances, through the economic development of a number of key emerging economies - in a way which would perhaps be similar to the implementation of the Marshall Plan which is what really brought the first great global depression to an end.

The problem is that I think we are still some years away from being able to get any sort of agreement on such a programme - as everyone will have noted the G20 isn't really talking about this yet, although I think they eventually will. In the meantime we all have to stagger forward. And it is the risk of further "events" occuring in countries like Latvia and Spain that make all this staggering onwards and downwards ever so dangerous. In all the key countries involved - the Baltics, Bulgaria, Romania and Hungary in the East, and Portugal, Greece and Spain in the South - government support is simply not sufficient to arrest the contraction in Krugman terminology simply hitting the "G" button will not work, and these economies are steadily "imploding" in on themselves, with the result, as I keep stressing, that unemployment inexorably rises, and bad debts simply mount up in the banking system, and if nothing is done to change course the outcome is surely a foregone conclusion.

The principal difference between the East and the South is that in the East governments no longer have the capacity to continue to sustain large deficits, while in the South they continue to be able to do so, though even here they cannot hold out indefinitely. Sometime in late 2010 or early 2011 all of this will, with a horrid and almost deterministic inevitability, all come to a head.

And this is why, I personally take the view that the global financial and economic crisis is far from over. There is another stage yet to come, and the focus of the problem will be Southern and Eastern Europe.