12/2/2012: A road map to a cooperative solution for Greek crisis

Papandreou: 'this is a battle between the markets and democracy'.

Greek political discourse - mirroring the received wisdom of the crowds has been reduced to a blatant, and populist lie.

The battles in Greece today are between democracy and European/ECB dogma of preserving the status quo of existent statist system, of which patronage by the State of some markets participants is just an element. Here's why:

1. The markets did not impose ANY conditions on Greece - EU/ECB did. The markets simply refuse to be conned any longer into subsidizing the Greek state through cheap credit. This is the basic right of any participant in the markets - to refuse investing or lending to anyone, just as it is the right of any baker to refuse selling bread to someone with no money and no desire to pay on credit.
2. The markets investors are the injured party - excluding the bottom-fishing hedge funds who bought Greek bonds very recently at hefty discounts. The investors are the only ones who were first deceived by the Greek Governments cooking books and fudging numbers in official statistics. The investors should have known better, but that is not a valid defense of the case against them - they were deceived by fraudulent data reporting by the Greek State (yes, right - politicians, Governments, civil servants). The markets/investors are also the only ones who have to take any writedowns. The ECB and the European Union are taking no writedowns on Greek bonds, and are, in fact, lending Greece 'rescue funds' at a profit. 

I am pointing this not to prevent imposition of losses on Greek bonds investors. They deserve to lose and they should lose more than 70-75% of the face value of their investments in Greek bonds.

I am writing this to point that the battle we are facing in Athens today is between people pushed to a breaking point by the policies of the Governments past, and the EU/ECB.

And there is a way out, folks. Here's what should be done:

1. Impose full losses on Greek bondholders to bring debt/GDP ratio in Greece to 75%. Do same for banks bondholders in Ireland and Spain, and combine these sovereign and banking measures to achieve the same in Portugal and Belgium. Seniority under these arrangements should be as follows: private sector debt holders take the first hit, followed by the public debt holders.
2. All PIIGS bonds held by the ECB are to be transferred into a separate holding fund. This fund is to run between 2012 and 2021. Bonds are to be held in the fund not at face value, but at purchase value to instantaneously reduce debt overhang in these countries. Note: this imposes no loss on ECB until the fund is wound up.
3. The ECB Special Fund (outlined in (2) above) is to monitor the conditions of compliance with real (not the currently identified) reforms aiming to restructure PIIGS economies to put them on the path of private sector-driven growth and fiscal sustainability over 10 years horizon.
4. No coupon payments or principal repayments to be accepted by the ECB on these bonds between 2012 and 2021 to reduce debt overhang drag on the participating economies and improving their fiscal capacity to implement reforms.
5. The bonds held in the ECB fund are to be automatically written down to zero face value in 2021 as long as the participating country meets conditions of implementing the reforms.

The above proposal will eliminate or severely restrict the problem of moral hazard, as countries participating in the programme will be subject to strict reforms programme implementation. The plan will also reduce the burden of repayment of debt on the countries that do stick to the conditions of the reforms. The plan will also bring, gradually, these countries economies to more competitive institutional, fiscal and regulatory environment. In other words, the proposal contains both the sticks (under items (2), (3) and conditionality) and the carrots (items (4) and (5)).

In other words, the fund, as outlined above, would satisfy core objectives of the crisis resolution framework:

• Allow for meaningful change and reforms
• Create an incentive to participate actively in reforms for the countries engaged with the fund
• Reduce moral hazard problem
• Help to establish popular support for reforms by providing real, tangible improvement in the economies ability to sustain reforms

We can't keep fighting battles driven by noble objectives, but based on faulty logic that simply serves the very same elites that have created this crisis. We need to find a cooperative solution to the problems we face.

11/02/2012: Labor Productivity - some cross-EU comparatives

There has been much of talk about Euro area (and EU27) competitiveness trends recently in the media. Some of the commentary I've seen references the issue of decoupling in competitiveness across EU states. In light of this, I decided to take a look at productivity trends. Using eurostat data, I was able to:

1. Take eurostat main series for per person aggregate (total) productivity index that sets 2005=100
2. Rebase the index to Q1 2000=100 and recompute entire set of EU27 countries, plus EA17 and EU27 aggregates
3. Obtain via (1) and (2) above new set of productivity indices that reflect dynamics in per person productivity since Q1 2000 through Q3 2011
4. Note: data is seasonally adjusted and I am only reporting countries where data is hours adjusted as well.

Here are the core charts (I added Ireland and EU 27 average in every chart):

So few trends are apparent:

• Ireland performs - since the beginning of the crisis extremely well in terms of productivity improvements and levels - much due to the massive destruction of its employment base (I commented on this effect a number of times before). Overall - this is remarkable performance albeit at huge cost.
• Spain has posted some significant increases as well, mostly due to destruction of employment - much more so than Ireland.
• Italy is performing poorly as does Greece. In fact, Greece is the third worst performer in the entire EU27 in terms of productivity growth since the beginning of the crisis (Q1 2008).
• Portugal improvements appear to be largely consistent with the pattern for Spain.
• Finland clearly leads the pack (after Ireland) in the group of Small Open Economies (SOEs)
• Strong trends in growth in East-Central Europe (ex Hungary and Slovenia) 

Now, let's take a look at cumulative growth in productivity since the beginning of the crisis - note: green boxes mark countries that outperform EU27 average by more than 1/2 STDEV, while red boxes mark those countries that underperform the EU27 average by more than 1/2 STDEV:

And similar analysis for cumulative growth in productivity since Q1 2000:

 So is there 'decoupling' going on in terms of labor productivity? Not really. Here's what's happening:

• Spain shows highest gains in total productivity since Q1 2008 but weak (roughly average) gains since Q1 2000
• Ireland shows second highest gains since Q1 2008 and above average (6th highest in EU27) gain since Q1 2000
• Slovakia doing spectacularly well, albeit, of course, from low levels, as is Estonia (though not too great during the crisis period)
• During the crisis, Belgium, UK, Greece, Hungary, Italy, lux & Sweden all posted below average (more than 1/2 STDEVs) performance
• Since Q1 2000, Italy and Lux were the only two statistical underperformers.

So unless we go beyond Q1 2000 (the period for which we don't really have coherent comparable data) there is no 'decoupling' going on in labor productivity. There is shallow growth in it on average, but no dramatic 'decoupling'. In other words, much of core Europe is pretty poor in terms of labor productivity growth, while East-Central Europe and Ireland are performing pretty well.

11/02/2012: Globe & Mail 9/02/2012

Here's the link to my latest article for Economy Lab with Canada's Globe & Mail.

10/2/2012: Two charts for a Friday night pint

Two charts for some Friday night thinking instead of (or even while) drinking. One courtesy of Lorcan Roche Kelly flagging it on twitter (link here):

No, it's not Nouriel Roubini references that are of import in the above - entertaining as they might be - it's the likely pending reversal in the series that some techies have noticed. Hope you are not too long into the weekend...

Second chart is my own. I took a simple ratio (expressed in %) of General Government Deficit to Structural Deficit to highlight the extent of the spending related to excess over structural imbalances, in other words - to show some pro- and counter-cyclicality. Underlying data came from IMF WEO.

Some points worth noting: US has been running expansionary (in excess of structural) deficits since 2007 and these have peaked in 2009. UK started slightly later - in 2009 and will be running these through the entire forecast period. Here's an interesting thing - for all the austerity claims in the UK, ordinary deficits are expected to run above structural deficits all the way through 2016. 

10/2/2012: Few thoughts on the global policy crisis

What makes me really concerned nowdays is not the ongoing crisis, but the logical and numeric impossibility of the mounting policy "solutions' to the crisis. Here's a quick synopsis. Take a look around the world:

• Bank of England repeated QE rounds in the face of £1 trillion+ debt pile is a strategy for growth via debasement of the currency
• Fed's continued unrelenting QE is much the same
• ECB has been debasing any real connection between banks, real economy and banks profits via uninterrupted injection of cash into banks - giving a license to earn free profits on interest margins while monetizing already excessive Government debts. Real economy, of course, gets hammered by sterilization via reduced real credit flows. The end game - moral hazard of massive proportions in the financial sector across Europe
• EU itself is hell-bent on debasing real incomes and wealth of its citizens by implementing the Fiscal Compact as the sole policy tool for dealing with the crisis
• Obama Administration is debasing, in contrast with EU, the future generations' wealth and income by continuing to spend Federal dollars like a drunken sailor arriving in a casino
• Ireland's Government is actively debasing the entire domestic economy, oblivious to the reality that households and businesses deleveraging is being prevented by banks and Government deleveraging - all for the sake of grand posturing of "We will pay all our debts" variety
• Japan is engaged in an active pursuit of debasing Government balancesheet as the debt bubble spreads to Japanese Government bonds - now in negative yields
• China is debasing its monetary and fiscal policies to deliver a 'soft landing' to the massive train wreck of its vastly bubble-like property and banking sectors

Close your eyes and think - how will the world be able to reverse out of these disastrous desperate policies in years ahead without completely shutting off growth via high interest rates, destabilized savings-investment links and in the presence of ever-rising public, private and corporate debts? What levels of inflation will be required to 'inflate' out of this mess? What degree of real wealth destruction has to be imposed on the ordinary people to sustain these gambles without a structured, orderly and coordinated restructuring of debts? What asset class and geography hedge can protect you from this avalanche of disastrous policy choices by the Western leaders?

9/2/2012: Interesting chart on Euro area deposits

Here's an interesting chart from Credit Suisse via zerohedge:

Now, it's not the blue line that worries me and the others (EAP5=Euro Area Periphery states or PIIGS). It's the massive dip in the grey line. Given there's little deleveraging of consumers and corporates in France and Germany and that there is little it terms of concerns for stability of German banks (whether or not this sense of security is justified or not), the chart suggests that deposits are flying out not just in fear of local banks risks, but in fear of the euro risks.

The link to zerohedge post is here.

9/2/2012: What can ECB do?

In relation to the recent statements from Minister Noonan and Taoiseach Kenny on their expectations that ECB involvement in Greece should be matched by ECB extending assistance to Ireland:

What can ECB provide in relief for Ireland:

1) ECB can do a swap of Irish higher coupon bonds for cheaper EFSF/ESM bonds at current or even reduced (via suitable averaging) market value, saving interest charges and reducing outstanding principal of Irish debt. This will not be a credit event, as the transaction will be purely contained within ECB balancesheet.

2) ECB can give a green light to the Central bank of Ireland not to sterilize ELA returns under the promisory notes, effectively rebating the funds back to the Exchequer.

3) ECB can also consent to restructuring of ELA (partial form of (2) above)

So there are a few things ECB can do, but all will de facto open ECB to a major risk of other countries coming to it with similar demands.

Regardless of the outcome, the Taoiseach and Minister Noonan are correct in demanding ECB step forward with solutions to the problems in Ireland that have been created in the first place by ECB policies of the past.

9/2/2012: Few bothers

Today's mid-day CDS spreads (courtesy of CMA):

This should bother few sovereigns:

 and few banks:

And is likely linked to Greek bailout costs falling on: France, Netherlands, and Finland while doing nothing good to over-indebted Belgium and Italy and leading to a slowdown in Norway and Denmark... while taking a bite out of the balancesheets of few big banks. And that comes on top of markets already expecting the fallout from the Greek deal...

9/2/2012: ECB rate decision

So we have ECB keeping rates at 1%... which relates to:

1) growth:

So with growth leading indicator stuck for the 4th month in a contraction territory, 1% repo rate is a bit too high, given we are now into the second leg of recession judging by leading indicators.

2) inflation:

So with inflation still anchored well ahead of 2% bound, that 1% repo rate is a bit too low for the ECB mandate, unless the ECB expects rapid de-acceleration of prices.

And in case you wonder, the pull on policy side comes from divergent growth/inflation dynamics:

And thus we have: ECB latest decision is inconsistent with either inflationary or growth signals. You might say that on average, that makes ECB policy balanced. Or you might want to say that this mismatch reflects monetary union internal inconsistency. Or both... take your pick.

8/2/2012: A more pleasant Sovereign arithmetic

And for a rather more pleasant sovereign arithmetic, here's an interesting table from the Global Macro Monitor (link here) summarizing yoy movements in 5 year CDS:

Frankly speaking, all of this suggest some severe overshooting in CDS and bonds markets on upward yield adjustments over time followed by repricing toward longer term equilibrium. What this doesn't tell us whether we have overshot equilibrium or not... Time will tell.

7/2/2012: An unpleasant risk arithmetic

Here's the guys Irish authorities trust so much on risk assessment, they contracted them to do banks stress tests - PCARs - back in 2010-2011. Note: this is a statement of fact, not an endorsement by me. The Blackrock folks produce quarterly report on sovereign risks and this the summary chart from the latest one - Q1 2012. Negative numbers refer to higher risks:

So Greece leads, Portugal follows, Egypt and Venezuela are in 3rd and 4th place worldwide of the riskiest nations league and then, in the fifth place is Ireland, followed by Italy. And here's the summary of the euro area ratings:

Yes, bond yields have been improving significantly, including due to both fundamentals and banks liquidity steroids, which is a good news. The bad news, yields have been declining for other countries as well and investors' relative sentiment is not improving as much as the absolute levels of yields declines suggest.

Today, one of the Irish Stuffbrokerages claimed in a note that: "The country’s success in meeting its targets under an EU/IMF bailout without social or political unrest and its export-focused economy has enabled it to dodge the recent Eurozone downgrades by S&P and Fitch and distance itself from fellow bailout recipients Greece and Portugal. " Distancing we might be, but the neighborhood we are lumped into is not changing as the result of this distancing. At least not for now.

Please note, the assessments above are consistent with CMA analysis based on CDS spreads, covered here.

6/2/2012: Fiscal Compact Treaty - Sunday Times 05/02/2012

This is an unedited version of my Sunday Times article from February 5, 2012.

In medical analogy terms, this week’s Fiscal Pact signed by the 25 EU Member States, is equivalent to a misdiagnosed patient (the euro area economy) receiving a potent cocktail of misprescribed medicines.

In other words, the Fiscal Pact is neither a necessary, nor a sufficient solution to the ongoing crisis of the euro area insolvency. Moreover, it saddles the euro area with a choice of only two equally unpalatable alternatives. The first choice is compliance with the Pact that will lead to a situation whereby a one-policy-fits-all monetary framework will be coupled with an equally mismatched one-policy-fits-all fiscal framework. The second choice is business as usual, with continued reckless borrowing, internal and external imbalances and ever deepening links between the sovereign finances, the ECB and the banking sector balancesheets. In other words, there is a choice of either pushing Euro area down the deflationary, stagnation-inducing deleveraging spiral, or leaving it in the current modus operandi of reckless borrowing.

Both alternatives are internecine for Ireland, and both increase the probability of an eventual collapse of the euro over the next 5-10 years.

Suppose the EU member states, opt for the first alternative. As a whole, to comply with the Pact parameters, the Euro area economy will have to shrink by some €535-540 billion every year between now and 2020 – an equivalent of reducing euro area growth by a massive 3.9% annually. Just for the purpose of comparison, during the 2009 recession, Euro area experienced a real decline of overall income of 4.25%.

Ireland will be one of the worst impacted economies in the group courtesy of our excessively high structural deficits, debt to GDP ratio and cyclical deficits. In 2012, Ireland is forecast to post a structural deficit in excess of 5.5% of potential GDP – the highest structural deficit in the entire Euro area. To cut our structural deficit to 0.5% will require reducing annual aggregate demand in the economy by some  €7-8 billion in today’s terms. Debt reductions over the period envisioned within the pact will take an additional €12 billion annually. For an economy with huge private sector debt overhang, paying some 12% of its GDP annually to adhere to the Fiscal Pact is a hefty bill on top of the already massive interest bill on public debt.

Ireland’s fiscal performance under the Fiscal pact constraints, 2012

Sources: author estimates based on the combination of data from the Department of Finance, Budget 2012, IMF World Economic Outlook database, and author own forecasts

Crucially, the idea of the Fiscal Pact as a tool for resolving the structural crisis faced by the Euro area is equivalent to doing more of the same and expecting a different outcome.

The crisis arose because the Euro area combined vastly heterogeneous and complex economies under a one-policy-fits-all monetary umbrella. This has meant that no matter what policy the ECB pursued, interest rates and money supply will never be in synch with all economies within the Euro. The modern economic theory suggests that fiscal transfers can act as automatic stabilizers, correcting for monetary policy disequilibrium.

In European case, this theory is a pipe dream. Firstly, fiscal transfers cannot happen with the same timing as monetary policy changes, especially given the bureaucratic nature of the EU and its institutions’ detachment from the member states’ realities. Take one example – Ireland and other euro areas have been experiencing severe unemployment problems since 2009. Yet, only this week did the EU wake up to the problem and thus far, there are no tangible plans for dealing with it. Automatic stabilizer of fiscal policy will never be timely and responsive enough to undo damages caused by the unsuitable monetary policy. Secondly, fiscal transfers are an imperfect substitute for private sector adjustments to dislocations that monetary policy generates. No need to go beyond the current crisis to see this with aggressive monetary policy interventions since 2008 yielding not an ounce of real economic impact on the ground. Which means that the theoretical stabilizers are not really that effective in stabilizing the economic disruptions caused by monetary policy misfiring. Lastly, neither the current Pact, nor any other institutional arrangements within the Union provide for any automatic fiscal transfers.

Yet, when it comes to the penalties that apply to member states breaching the Pact conditions the new agreement are automatic and very tangible. This imbalance – with the Pact being all stick and no carrot – risks destabilizing economic systems struggling with shocks.

Take for example a country like Ireland. Suppose ECB policy in the future leads to high interest rates – a scenario consistent with the current monetary policy developments. This would imply that our terms of trade will deteriorate, reducing our exports and driving our economy into an external deficit. Simultaneously, slowdown in the economy will put pressures on our fiscal balance. This deterioration will not be consistent with a cyclical recession, implying that we are likely to simultaneously breach the twin deficits targets under the Fiscal Pact, triggering automatic penalties. Economy brought to its knees by the monetary policy mismatch will be forced to pay additional price through fiscal penalties.

In other words, the Pact is now attempting to create another policy system that will risk further detaching fiscal policies within the Euro area from the monetary policy.

When it comes to dealing with the current crisis, the new Pact contains no tools for achieving structural reforms required to arrive at sustainable public finances. Paying down the debts and cutting back deficits requires simultaneously running surpluses on the Exchequer side and the current account side. In other words, both external and internal surpluses must be achieved simultaneously. As international research shows, the likelihood of any state moving from long-term external imbalances to a sustainable current account surplus is extremely low.

Matters are worse when it comes to both fiscal and external balances. My own research based on the Euro area data shows that during 1990-2008, only two euro countries – Finland and Malta – have complied with the Fiscal pact criteria more than 50% of the time. The rest of the member states, including Germany and France, have run sustained deficits more than 60% of the time. Once a euro state found itself stuck in twin current and fiscal deficits in one decade (the 1990s), transitioning to a twin current account and fiscal surplus in the next decade (the 2000s) was virtually impossible. For example of all states in EA17 who were in current account deficit throughout the 1990s, only 2 have managed to achieve current account surpluses during the following decade. Only one country that experienced fiscal deficits in the 1990s has managed to generate fiscal surpluses over the following decade. No country has been successful in restoring fiscal and external balances after a decade of twin deficits.

The Fiscal Pact implies even less flexibility in adopting structural reforms necessary to achieve an already highly unlikely economic transition to the long-term sustainability path for many euro area states, including Ireland.

Consider for example two economies currently in a crisis – Ireland and Portugal. Portugal requires severe and substantial cuts in all public spending and then deep reforms in the private sectors of its economy. The country does not need a debt restructuring, but it needs huge capital injections to put it onto the path of capital investment convergence with the euro area average.

In contrast, Ireland needs restructuring of the private sector debts, deep reforms on the current expenditure side of the Irish exchequer, and more gradual reforms in the private sectors. Ireland has a functional exports generating economy, it has achieved current account surpluses on external side and balance on its Government spending side in the past. During the adjustment, Ireland needs structural reductions in the current spending best timed to start concurrently with the pick up in private sector jobs creation to offset adverse effects of these reforms on the most vulnerable – the unemployed. Ireland also needs to boost its after tax returns to human capital in the medium term – something that Portugal has no need for at this point in time.

There is nothing within the Pact that would facilitate either Portuguese or Irish economic stabilization and recovery. Neither will the Pact improve the chances of Spain, Belgium and Italy ever reaching real growth paths that imply sustainability of fiscal and external balances. In short, the Pact our Government so eagerly subscribed to is at the very best a continuation of the status quo. At its worst, Ireland and other member states of the Euro are now participants to a fiscal suicide pact, having previously signed up to a monetary straightjacket as well.

Box-out:

Last two weeks marked two significant milestones on Ireland’s economic performance front. Despite the adverse newsflow on the real economy side, Irish bond yields for 5 year bonds have dipped below 6% mark last week for the first time since the beginning of the crisis. This week, spreads on the 5 year Credit Default Swaps (the cost of insuring Irish bonds) also fell below 6% mark. For the first time since the crisis began our implied cumulative probability of default (CPD) – the probability that the Irish Government will default on its debt at some point over the next 5 years has touched 40%, down from over 46% at the end of 2011. Although the CPD is a mechanical function of CDS yields and not a statistical estimate of the true risk of the Government default, the CPD is an important metric for the markets. The significant decline in our CDS spreads this week, was prompted by the Irish banks buying into longer maturity bonds in the recent NTMA-led bond swap, plus the overall improving sentiment for sovereign debt in the euro area markets. The later itself was driven by the artificial forces, such as the ECB extending €497 billion to the banks in 3 year money. Nonetheless, our bond yields and CDS spreads declines are starting to show some improvement in overall markets risk-pricing for the Irish Government debt – a much needed stabilization and a moment of respite from the relentless crisis dynamics of the recent past.