5/5/2012: Can austerity work as default probability evaluation aid?

Usual argument in favor of a fiscal contraction in response to an adverse fiscal shock goes along the lines of the Expansionary Fiscal Contraction - or structural - argument. There are many who agree/disagree with this proposition, but there's plenty of literature covering it.

A new argument in favour of 'austerity' response to a fiscal shock is presented in the recent paper from the Bank of Italy.

Optimal Fiscal Policy When Agents Fear Government Default, by Francesco Caprioli, Pietro Rizza and Pietro Tommasino (March 2012), link here, argues that under optimal fiscal policy, when a government is facing with investors who fear a sovereign default, and assuming investors learn over time so as to gradually correct from the initially over-pessimistic view of the default probability, "a frontloaded fiscal consolidation after an adverse fiscal shock is optimal". In other words, 'austerity' can work when it facilitates learning process to support investors' discovery of the 'true' lower probability of default.

In a summary, the findings are:

• When agents fear government default, a fiscal consolidation after an adverse fiscal shock becomes optimal. The intuition is that the interest rate on government debt is too high due to distorted expectations about government default; therefore the marginal cost of higher distortionary taxes today is more than compensated by the expected future marginal benefits of lower distortionary taxes tomorrow. 
• The incentive to reduce debt is stronger: a) the more pessimistic agents are about government solvency and b) for a given degree of pessimism, the higher the post-crisis debt level. 
• The state of agents initial beliefs has an effect on the long-run mean value of the tax rate and debt. In particular, the more pessimistic agents initial beliefs, the lower the long-run mean value of debt. The intuition is that the more pessimistic the agents are, the stronger the incentive to change their expectations.

12/09/2011: IMF admits failures in debt risk forecasting frameworks

In the analysis published just minutes ago, the IMF ("Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis" by the Fiscal Affairs Department and the Strategy, Policy, and Review Department, dated for internal use from August 5, 2011) implicitly admits deep errors in the methodology for analyzing public debt dynamics. Given the magnitude of errors reported by the IMF (see table summary below), the entire exercise puts the boot into the EU-led attacks on the Big 3 ratings agencies - it turns out that the wise and uncompromisable IMF was not much good at dealing with fiscal sustainability risks either.

Here are the core conclusions: "Modernizing the framework for fiscal policy and public debt sustainability analysis (DSA) has become necessary... [This paper] proposes to move to a risk-based approach to DSAs for all market-access countries, where the depth and extent of analysis would be commensurate with concerns regarding sustainability..."

DSA could be improved, according to the IMF report, through a greater focus on:

• Realism of baseline assumptions: "Close scrutiny of assumptions underlying the baseline scenario (primary fiscal balance, interest rate, and growth rate) would be expected particularly if a large fiscal adjustment is required to ensure sustainability. This analysis should be based on a combination of country-specific information and cross-country experience." (Note that in Ireland's case such analysis would probably require, in my view, using GNP metrics in place of GDP).
• Level of public debt as one of the triggers for further analysis: "Although a DSA is a multifaceted exercise, the paper emphasizes that not only the trend but also the level of the debt-to-GDP ratio is a key indicator in this framework. [Apparently, before the level of debt didn't matter much, just the rate of growth in debt - the deficit - was deemed to be important] The paper does not find a sound basis for integrating specific sustainability thresholds into the DSA framework. However, based on recent empirical evidence, it suggests that a reference point for public debt of 60 percent of GDP be used flexibly to trigger deeper analysis for market-access countries: the presence of other vulnerabilities (see below) would call for in-depth analysis even for countries where debt is below the reference point." [So, now, folks, no formal debt bounds, but 60% is the point of concern. Of course, by that metric, IMF would have to do country-specific analysis for ALL euro area states]
• Analysis of fiscal risks: "Sensitivity analysis in DSAs should be primarily based on country-specific risks and vulnerabilities. The assessment of the impact of shocks could be improved by developing full-fledged alternative scenarios, allowing for interaction among key variables..." [Another interesting point, apparently the existent frameworks fail to consider interacting risks and second order effects. That is like doing earthquake loss projections without considering possibility of a tsunami.]
• Vulnerabilities associated with the debt profile: IMF proposes "to integrate the assessment of debt structure and liquidity issues into the DSA." [Again, apparently, no liquidity risk other than maturity profile analysis is built into current frameworks]
• Coverage of fiscal balance and public debt: "It should be as broad as possible, with particular attention to entities that present significant fiscal risks, including state owned enterprises, public-private partnerships, and pension and health care programs." [It appears that the IMF is gearing toward more in-depth analysis of the unfunded state liabilities, such as longer-term liabilities relating to pensions and health expenditure, as well as more explicitly focusing on unfunded contractual liabilities, such as specific contractual exposures on state pensions. If that is indeed the case, then there is some hope we will see more light shed on the murky waters of forthcoming sovereign exposures that are currently outside the realm of exposures priced in the market.]

Now, several interesting factoids on sovereign debt forecasts and sustainability as per IMF paper.

Here's the summary of IMF own assessment of its forecasting powers when it comes to Ireland: "The 2007 Article IV staff report included a public DSA, which showed that government net debt (defined as gross debt minus the assets of the National Pensions Reserve Fund and the Social Insurance Fund) was low and declining. In the baseline scenario, net debt was projected to fall from 12 percent of GDP in 2006 to 6 percent of GDP by 2012. The medium-term debt position was judged to be resilient to a variety of shocks. The worst outcome-a rise in net debt to 16 percent of GDP in 2012-occurred in a growth shock scenario. Staff identified age-related spending pressures as the most significant threat to the long-run debt outlook. The report noted that, although banks had large exposures to the property market, stress tests suggested that cushions were adequate to cover a range of shocks. Net debt to GDP subsequently increased nearly fivefold from 2007 to 2010, owing to a sharp GDP contraction and large fiscal deficits linked mainly to bank recapitalization costs."

No comment needed on the above. The IMF has clearly missed all possible macroeconomic risks faced by the Irish economy back in 2007.

On Greece: "In the 2007 Article IV staff report, staff indicated that fiscal consolidation should be sustained over the medium term given a high level of public debt and projected increases in pension and health care costs related to population aging. ...In the baseline scenario, public debt to GDP was projected to fall from 93 percent in 2007 to 72 percent in 2013. All but one bound test showed debt on a declining path over the medium term. In the growth shock scenario, debt was projected to rise to 98 percent of GDP by 2013. Two years later, staff warned that public debt could rise to 115 percent of GDP by 2010-even after factoring in fiscal consolidation measures implemented by the authorities-and recommended further adjustment to place public debt on a declining path."

So another miss, then, for IMF.

Here's the summary table on these and other forecast errors:

Next, take a look at a handy summary of debt sustainability thresholds literature surveyed by the IMF (largely - sourced from IMF own work):
So for the Advanced Economies (AE), debt thresholds range from 80-150 percent of GDP, the range so wide, it make absolutely no sense. Nor does it present any applicable information. By the lower bound, every euro area country is in trouble, by the upper bound, Greece is the only one that is facing the music. Longer term sustainability bound is a bit narrower - from 50% to 75%, with maximum sustainable debt levels of 183-192%.

And, for the last bit, off-balance sheet unfunded liabilities and actual debt levels chart:
Here's an interesting thing. Consider NPV of pension and health spending that Ireland is at - in excess of aging economies of Italy, Japan and close to shrinking in population Germany. One does have to ask the question: why the hell does the younger economy of Ireland spend so much on age-linked services and funds?

Another thing to notice in the above is that there appears to be virtually no identifiable strong statistical relationship between debt levels and pensions & health expenditures. This clearly suggests that the bulk of age-related spending looking forward is yet to be factored into deficits and debt levels. Good luck with getting that financed through the bond markets, I would add.

Economics 1/8/10: California's lesson for IRL?

Last week the State of California declared official emergency in relation to its fiscal shortfall. The problem, you see, is that torn between various vested interests, California's legislature is unable to approve a new budget for 2011. The State deficit is currently running at $19bn, which represents 22% of the general budget fund. As a part of emergency declaration, Governor Schwarzenegger ordered three days off without pay per month beginning in August for tens of thousands of state employees to preserve the state's cash to pay its debt, and for essential services. Now, 3 days out of each month represents roughly speaking a 14% straight cut across all lines of wages, pensions liabilities, overtime etc. A bit more dramatic than Irish Government 2-year old programme of cutting PS pay by an average of 5-7%.

May be the depth of California's crisis is that much (say 2.5 times?) deeper than the fiscal crisis in Ireland?

Well, let's compare, shall we? To do so, I took budgetary projections (latest available) for California and Ireland and put them side by side. I computed the extent of expected and planned deficits in both locations as a share of the net Government expenditure.
It turns out that in its state of emergency, 'insolvent' California is not 2-3 times worse off than Ireland. It is the 'turning the corner' Ireland that looks 1.5 times worse off than California. And not just now - all the way through the next 4 years.

So California - its Governor and Legislature - are at the very least trying to work through the summer to hammer out some sort of a resolution. Our own legislators and Government are out to enjoy a spot of recreation. And why not, you may ask, if the economy has finally turned the corner... err... sort of... for the 15th time since May 2009 that is...

Economics 22/7/10: EU stress tests - what do they tell us, really?

The EU stress tests of the banks confirm the worst fears of all analysts – including myself. The tests were simply a PR exercise, so poorly conducted that no one can have any credibility in their outcomes. Worse than that, the whole circus:

• The difficulty with which the EU member states appeared to be willing to release information about the tests;
• The way in which information is being released (via a drip feed – bit by bit over time, with massive leaks beforehand);
• The struggle through which member states have gone in order to even agree to carry out the tests in the first place;
• The rhetoric from the EU regulators assigning an almost heroic quality to its efforts to test the banks in the face of a clear shambolic nature of the whole exercise.
  

All of these things provide for a strong suspicion that the EU will not be able to undertake robust regulation and monitoring of the euro zone banking system in the future, plus a clear cut realization that the entire idea of the euro member states coming together to police their own fiscal behaviour will be even less honest, transparent or robust. In other words, how can we expect the EU to act as a functional policeman of its members fiscal policies if:

1. It failed to do so over years past, even armed with already robust and automatic regime of the Stability & Growth Pact, and
2. It failed to properly stress test its own banks?
   

In the nutshell: German banks, including Landesbanken, have already privately leaked the ‘news’ that they all had passed the test. Ditto for banks in France, Ireland and Italy. Only one German bank – already failed HRE – has failed the test from among 91 institutions.

In the case of AIB – the sick puppy was ‘passed’ by allowing to include into regulators’ calculations the €7.4 billion the bank plans to raise by the end of 2010. Good intentions count for hard evidence, then, per EU regulators. And Bank of Ireland passed - along with all the rest of the PIIGS banks is by the test excluding any possibility of twin shocks - simultaneous continued deterioration in quality of loans and a sovereign debt crisis. Now, in all likelihood, if the sovereign debt crisis continues to rage, does anyone in their right mind thinks that housing and other asset markets in the likes of Ireland and Spain are going to improve to alleviate the loans book pressures?

Farcical!

What the 91 tested banks did ‘pass’ was not a stress test, but a joke, concocted either by those with no understanding of banking (Eurocrats?) or created specifically with an ex ante intent of passing them all. The French and Greek banks privately said that the haircut applied to their holdings of Greek government debt were about 23%. Markets are factoring in 50-70% haircuts, so the EU stress test was less than half as severe as what is being priced already. Worse than that – the sovereign debt haircuts were applied only to bonds held in banks’ trading books. That accounts for just 10% of all Greek bonds held by the euro area banks, as 90% of Greek sovereign debt has been already moved to ‘held to maturity’ parts of banks assets portoflia, not reflected on trading books.

In other words, when it comes to Greek sovereign debt exposure, the EU tests were capturing no more than 5% of the total risk of such exposure for the banks. Like a doctor, looking at the brain activity chart of the patient and saying: ‘Look, there’s no activity at all. But 95% of all other vital signs are performing just fine. Indeed, no worries old man, the patient is still looking 95% alive then…’

And there's more. Per media reports, a memo from Germany's Financial regulator BaFin earlier this year said the real concern should be contagion from "collective difficulties" across the PIIGS, not an isolated default of Greece.

All of this did not prevent Irish stockbrokers from issuing upbeat reports about 'the good news' for BofI and AIB. What good news? The shares in two banks rallied today because someone, somewhere, allegedly decided that if Greece softly defaults, Irish banks will survive? Did that someone actually paused for a second to think, before placing a 'buy' order if Irish banks can survive their own home-made disasters? Or whether they can survive a meltdown of Greek debt default as priced by the markets? Or whether they can survive both happening at the same time?

Irish analysts, who issue these forecasts should be required to read Taleb's 'Fooled by randomness', though one wonders if they will understand much of what Taleb is saying for years now. Investors who chose to belive that AIB and BofI passing of the 'test' this week is some sort of a 'good news' are simply fooling themselves by ignoring a simple fact of life - misdiagnosing a patient with heart attack as being free of an Avian flu is not going to improving the patient's chances of survival. It actually reduces them.

Shamed by this absolutely incompetent, if not outright markets manipulating ‘testing’, you’d think the EU leaders would step back and start an earnest conversation between themselves as to what has gone wrong here. Nope. They are hell bent on creating more Napoleonic sounding, but utterly unrealistic and even disastrously risky plans. This time around – for fiscal harmonization. France and Germany – the two countries that have been clearly at odds with each other in responses to the current crisis have decided that a bout of amicable activism is long overdue. So behold the latest Franco-German alliance on a list of fiscal policy co-ordination proposals.

Per reports in today’s media: a French cabinet meeting took place with German presence, during which Sarkozy called for a complete harmonisation of European tax systems. ‘He did whaaat?!’ I hear you cry… yeah, he did call for that which was explicitly denied by him and the entire EU leadership core as ever having a chance of happening in the run up to the Lisbon II referendum in Ireland.

Now, don’t take me wrong here – this is not a voluntary call for individual states cooperative action – it is a call for an EU-wide ‘reform’. And if you don’t think so, the same meeting called, once again, for member states with excessive deficits to be punished by withdrawal of voting rights in the Council of Ministers, plus a fine and the compulsory imposition of an interest-bearing deposit for member states.

Eurointelligence blog has put it succinctly: “In other words, France and Germany [have called] to continue the same dysfunction regime, except that they strengthen those parts that have prove the most dysfunctional.”

Let me be a tad controversial here - wasn't all of this predicted to happen by Declan Ganley, Anthony Coughlan, Mary Ellen Synon and others who argue in favour of democratic reforms in the EU? Weren't they 'refuted' on exactly these predictions by the entire 'establishment' in Brussels and the all-knowing dons of the Upper Merrion Street? You don't have to agree with their points of view. You might as well agree that the idea of fiscal harmonization is a great thing. But what cannot be denied is that:

1. Any policies absent meaningful ability to honestly, transparently and effectively enforce them (and EU has shown none of these in its stress tests of the banks - the easiest area to deliver them in current political and economic environment) is destined to be nothing more than a bullying pit for some states to arbitrarily control others; and
2. Given grave doubts about EU's capabilities to provide for (a), the automatic default option of any new policies should be to scale opportunism and adopt pragmatic, cautious, incremental reforms approach - when in doubt, measure and caution must be the prevalent guide.
   

After all, if I were a person with the power to shape EU principles, I would adopt the milenia-old medical code of ethics, that is based on the fundamental axiom of morality: Primum non nocere, or First, do no harm.

Then again, adopting such a principle would have meant not conducting these 'stress tests'.

Economics 27/06/2010: G20 - real stats and real issues

As G20 leaders undertake another attempt at injecting some balance into global economic order - with last meeting in Pittsburgh focused on stimulus strategies, while the current one in Toronto focusing on austerity - it is worth taking a look at the stakes.

Bank of Canada estimates that disorderly (or uncoordinated) exit from global stimulus phase of the recession can lead to a loss of up to USD7 trillion worth of output, primarily concentrated in the advanced economies.

However, the story is more complex than the simple issue of whether G20 nations should opt for a fiscal solvency or for a continued monetary and fiscal priming of the pump. Here are the key stats on the leading global economic blocks, revealing the structural imbalances that suggest the real problem faced by the advanced economies is the debt-driven nature of their fiscal and private sector financing.
First chart above shows Current Accounts for the main blocks, including the G20. Two things are self-evident from the chart. Firstly, the crises had a crippling effect on the overall trade flows from the emerging economies to the advanced economies, though this came about mostly at the expense of countries outside Asia Pacific. Second, crisis notwithstanding, IMF forecasts (data is from IMF April 2010 update to WEO database) the trend remains for unsustainable trade deficits for the Advanced Economies. European (read: German) surpluses of the last two decades are going to be wiped out in the post-crisis scenario, but it is clear that the US, as well as other advanced economies, will have to face a much more severe adjustment toward more balanced current account policies in years to come.

These adjustments will have to involve government finances:
Chart above shows government deficits, highlighting the gargantuan size of the fiscal measures deployed by the US and European countries, as well as a massive stimuli used in some 'Tiger' economies and China, over the latest crisis. This puts into perspective the size of the austerity effort that has to be undertaken to bring fiscal policies back to their more sustainable path. You can also see the relative distribution of these adjustments - the gap between the red line and the blue line. This gap is accounted for, primarily, by the UK, Japan and US and is much smaller than the overall Euro area contribution to G7 deficits.

But there is more to the deficits picture than what is shown above. Expressed in terms of percentages of GDP, the figure above obscures the true extent of the problem. So let's look at it in absolute dollar terms:
Now you can clearly see the mountain of debt (deficit financing) deployed in the crisis. Someone, someday will have to pay for this. It will be you, me, our children and grandchildren. Can anyone imagine that things will get back to pre-crisis 'normal' any time soon with this level of deficit overhang on the side of Governments alone?

What is even more disturbing in the picture is the position of Advanced Economies in the period between the two recessions. It is absolutely clear that Advanced Economies have lived beyond their fiscal means, even at the times of plenty, running up massive deficits in the years of the boom.

This puts to the test our leaders (EU and US) claims that the banking system reckless lending was a problem. The banks were not shoving cash at the Clinton-Bush-Obama administrations, or at European Governments. Instead, just as the banks were hosing their domestic economies down with cheap cash, courtesy of low interest rates, Western governments were hosing down their friends and cronies with deficit financing. The two crises might have been inter-related, but both fiscal profligacy and banks reckless risk-taking are to be blamed for our current woes.

Irony has it, neither the banks, nor the political profligates have paid the price for this recklessness.
Hence, the dire state of the governments' structural balances. As chart above shows, in the entire period of 20 years there was not a single year in which advanced economies (G7 or G20 or the Euro zone) have managed to post a structural surplus. Living beyond ones means is the real modus operandi for the advanced economies' sovereigns. Expressed in pure dollar terms:

Now, on to the levels of economic activity:
As I remarked on a number of occasions before, the whole idea of the Advanced Economies decoupling from the world is really a problem for the Euro area first and foremost. want to see this a bit more clearly?
Look at G7 plotted above against the Euro area and ask yourself the following question. G7 includes Japan - a country that is shrinking in its overall importance in the global economy. This contributes significantly to the widening gap between the world income and G7 income. But the region in real trouble is the Euro zone. Again, this puts Euro area problems into perspective:

• Anemic growth
• Poor relative performance in terms of absolute levels of activity

In short - decay? or put more mildly - Japanese-styled obsolescence? Whatever you might call it, the likelihood of the Euro area being able to cover its debts and reduce its deficits is low. Much lower than that for the US and the rest of G7 (ex-Japan).

Some revealing stats on savings and investment:
Clearly, chart above shows the opening of the gap between the need for demographically-driven savings growth in the advanced economies, where ageing population is desperately trying to secure some sort of living for the future, and the lack of real savings achieved. It also shows the downward convergence trend in rapidly developing economies, where younger population is finally starting to demand better standard of living in exchange for years of breaking their backs in exports-focused factories.

Yet, as savings rose during the peak in advanced economies (pre-crisis), investment was much less robust and it even declined in rapidly developing economies:
Why? Because of two things: much of domestic savings in Advanced Economies, especially in Europe, was nothing more than the Government revenue uplift during the boom. In other words, instead of European citizens keeping their cash to finance future pensions, Governments were able to increase expenditure out of booming tax revenues and borrowing against the booming savings rates. Ditto in the USofA (although to a smaller extent). In the mean time, Asia Pacific Tigers started to finance increasingly larger proportion of fiscal imbalances in Advanced Economies, driving down their domestic investment pools and shifting their domestic savings into foreign assets. Which, of course, is an exact replica of the Japanese global investment shopping spree of the 1980s - and we know where that has led Japan in the end...

So the scary chart for the last:
The big question for G20 this time around will be not the stated in official press conferences and statements - but will remain unspoken, although evident to all involved: Given that over the last 20 years, advanced economies financed their purchases of exports from the rapidly developing countries by issuing debt monetized through savings of the developing countries, what can be done about the current twin threat of excessive debt burdens in advanced economies and the shrinking savings in emerging economies?

This is a far bigger question that the USD7 trillion one posited by the Bank of Canada. It is a question that will either see some drastic changes in the ways world economy develops into the next 20 years, or the permanent decline of the advanced economies into Japan-styled economic and geo-political obsolescence.

What if? - When the IMF knocks on neighbours' doors

In light of the IMF rescue packages for Latvia, Iceland and Hungary, it is worth looking at the conditions imposed under these loan contracts. While Ireland has not requested IMF assistance, yet, as probability of such a request rises (due to the deepening mismatch between Exchequer receipts and outlays), what austerity measures can the Irish Government count on should our rescue be structured along the lines similar to the above three states?

In answering this question (table below), I use the following comparatives:
(1) Current and forecast GDP and GDP per capita levels and growth rates;
(2) 2008 and 2009 budget deficits; and
(3) Relative extent of committed liabilities under various national rescue plans.

The estimates are presented under two scenarios for Ireland:

• 'Benign' scenario implying IMF/external funding of 10% of the 2008 GDP which will cover ca 30% of committed state liabilities for 2009; and
• 'Average' scenario consistent with 25% of GDP borrowing covering ca 75% of liabilities).

A third scenario - consistent with relative liabilities in line with those in Iceland would imply an improbable, but not an impossible demand for external funding of up to 58% of GDP. To err on the conservative side, I omit this scenario in the current post.

Finally, it is worth noting that I do not 'price-in'

• the effect of deeper economic contraction in Ireland than in some of the reference countries;
  
• the effects of higher public spending as a share of the domestic economy in this country relative to the reference countries; and
• factors relating to inflation differentials and currency adjustments (note that all countries in receipt of IMF loans have had significant currency devaluations, while Ireland had a significant currency appreciation).

Thus, these estimates should be viewed as lower bounds.


To date, the only sign of any 'austerity' measures coming from the Department of Finance is a vague rumor that Brian Cowen is looking for a 5% wage bill cut in the public sector. Whether or not this figure is gross of the wage increases granted in the latest Partnership agreement is a moot point, given the austerity measures of 15-20% estimated above.