Friday, January 9, 2009

Unemployment and more

As was widely predicted, December implied unemployment rate (based on Live Register figures) came in at 8.3%. According to CSO:
"The seasonally adjusted Live Register total increased from 277,200 in November to 293,500 in December, an increase of 16,300."

The unadjusted LR came in with a much higher increase of 22,777 - a number that might be actually closer to the reality on the ground, as seasonality adjustments are likely to underestimate the extent of actual jobs destruction in the recessionary economy.

For persons of 25 years of age and over (the prime earners' category), newly unemployed males outnumbered females almost 2:1 - a trend that underpins unemployment growth throughout the year.
Overall, there are now 293,500 seasonally adjusted individuals on the unemployment assistance in Ireland, implying the unemployment rate of 8.3%. However, this assumes static population figures. In reality, it is highly likely that net outward migration from Ireland has actually reduced the size of the available labour force in the country. If so, the actual unemployment rate should be higher than 8.3%.

Whether the actual unemployment rate is 8.3% or 8.5% is a moot point when one considers that we started 2008 with an implied unemployment rate of 4.9%. It is now clear that we are on-trend to reach 12% unemployment mark by the end of 2009 - so much for yet another childishly inaccurate DofFinance forecast of 7.3% unemployment for 2009!

On a bit more encouraging side

Yesterday's CSO data on industrial production has shown some positive signs of life in, it is worth saying, extremely volatile series. Here are some charts:
First chart above shows a robust pick up across the entire manufacturing sector in November. So much for 'uncompetitive' manufacturing story, but do not a massive overall increase in the range of volatility last year compared to 2007.
The second chart shows that most of the November increase can be accounted for by the 'Modern' sectors - aka US multinationals. This is quite interesting as December Exchequer returns have shown a massive (20%) drop in corporate tax receipts, suggesting that increased multinationals' activity was associated with increased transfer pricing. Exchange rate movements - stronger Euro - did not help either, exacerbating the impact of transfer pricing.
Really positive piece of news in on expectations front, with all but two sub-sectors (Basic Chemicals and Office Machinery & Computers) shown upward trending new orders for 2008.

These charts re-enforce the argument that I have been making for years now - Ireland Inc's productivity is wholly dependent on one source for growth: foreign firms. Forget the talk about somehow intrinsically better quality of our labour force and regulatory regimes. The formula for any real success in 1990-2007 in this country is: get them in with low taxes, for there is no other reason for them to be here.

Competition II

More of the Hitchhiker's quotes to depict our leadership team:

(5) On Government's modus operandi:
"They obstinately persisted in their absence."

(6) On Government plans for economic 'revival' through windmills, banning of 100 Watt lightbulbs, investing in 'tech' start-ups and the rest:
"It is a mistake to think you can solve any major problems just with potatoes."

(7) On the Budget 2009 - and more specifically on the idea of raising taxes in a recession in order to pay for public sector pay stability:
"The Hitchhiker's Guide to the Galaxy [...] says of the Sirius Cybernetics Corporation products that 'it is very easy to be blinded to the essential uselessness of them by the sense of achievement you get from getting them to work at all. In other words - and this is the rock solid principle on which the whole of the Corporation's Galaxy-wide success is founded - their fundamental design flaws are completely hidden by their superficial design flaws.' "

(8) On Government's ability to manage the reform of its own finances:
"It wasn't merely that their left hand didn't always know what their right hand was doing, so to speak; quite often their right hand had a pretty hazy notion as well."

(9) Brian Cowen's way of getting policy debate going:
"Why do you need to think? Can't we just sit and go budumbudumbudum with our lips for a bit?"
Preferably with a PINT!..

Thursday, January 8, 2009

Competition: Win a Pint!

I am opening a competition for the richest pickings of the quotes descriptive of our brilliant Leaders! Send them on to me for posting here. Winner (quality, not quantity matters) gets a pint with True Economics!

Forgive me, but I could not resist a handful of quotes from that literature of absurd masterpiece - the
Hitchhiker's Guide to the Galaxy - that aptly describe our state of governance.

(1) Last Sunday, in a well-publicised interview with RTE, Mr Cowen - Ireland's Taoiseach/PM - has evaded the only straight question asked - the question of whether he was ready, as a leader of the country facing an unprecedented economic crisis to do what it takes to get the job done. Instead of a straight 'Yes, I am', our nation's leader mumbled something along the lines that the whole thingy of governing in a crisis is a matter of reaching a consensus. Now, recall the following:

"My doctor says that I have a malformed public-duty gland and a natural deficiency in moral fibre and that I am therefore excused from saving universes."

Close enough...

"The mere thought," Mr Prosser said "hadn't even begun to speculate about the slightest possibility of crossing my mind."

Neither did a mere thought of standing his ground against the narrow political interest groups tearing into the fabric of our economy cross Mr Cowen's mind, despite the fact that as last week's Exchequer figures for 2008 revealed, he is now facing a fiscal crisis of unprecedented (by our historical record and relative to any other OECD country) proportions. To remind you, the General Government Deficit of 2008 was a cumulative 17.3 billion Euro relative to 2006, marking a second year of deficit financing and a 22% fall in revenue in Q4 2008 compared to Q4 2007!

"Curiously enough, the only thing that went through the mind of the bowl of petunias as it fell was: Oh no, not again!"

The current Cabinet is, like that bowl of petunias, seemingly incapable of assessing the simple cause-effect chain of logic that links planned over-commitment of public funds to fiscal deficits. Over the last 8 years, Irish Government, effectively the same Government we have today, has presided over public spending boom that outpaced private economy growth 2:1. And yet, curiously enough, neither our Department of Finance, nor its Ministers (including Mr Cowen), nor the rest of the Government have seen anything wrong with this dynamic.

Or to quote the Guide again:
"You know," said Arthur, "it's at times like this, when I'm trapped in a Vogon airlock with a man from Betelgeuse, and about to die of asphyxiation in deep space that I really wish I'd listened to what my mother told me when I was young."
"Why, what did she tell you?"
"I don't know, I didn't listen."

Oh, dear...

(4) With Irish tax revenues now at 2005 levels and public spending commitments at their height, Government's silence on the issue of public sector reforms is an equivalent to the Hitchhiker's description of the inner workings of the '(im)probability drive' engine:

"Please do not be alarmed," it said, "by anything you see or hear around you. You are bound to feel some initial ill effects as you have been rescued from certain death at an improbability level of two to the power two hundred and seventy-six thousand to one against – possibly much higher. We are now cruising at a level of two to the power of twenty-five thousand to one against and falling, and we will be restoring normality just as soon as we are sure of what is normal anyway."

If only our Two Brians & Mary can get an economic concept of 'normality'...

(5) Irish Government plan for economic revival is a direct reference to the following quote:
"Please relax," said the voice pleasantly, like a stewardess in an airliner with only one wing and two engines, one of which is on fire, "you are perfectly safe."

BofE Rate Cut

In a historic move today, Bank of England cut interest rates below 2% for the first time in its 314 year history. This took the UK benchmark rate to 1.5% with the statement issued by the Board referring to the emergence of a deepening synchronized global economic crisis.

As a continuation of the theme we've picked up earlier (see here, and here), the statement also confirmed that credit availability for UK households and corporates continues to tighten, despite historically low interest rates, "pointing to the need for further measures to increase the flow of lending to the non-financial sector".

Unless the ECB carries out a matching 50bps cut in its benchmark rate, expect renewed devaluation of GBP vis-a-vis Euro (see figure below) with last year's highs in the range of EUR/GBP0.93-0.95 back in sight.The latest strengthening in GBP, just as in the case of US financial markets, is likely to remain in a classic bear rally until there is a pronounced change in underlying economic fundamentals, possibly around Q3 2009. Before then, however, there is more room for downward corrections than for an upward momentum implying that GBP will remain weak and volatile against the Euro in the interim, with GBP/EUR parity remaining a distinct possibility. The picture is only marginally better for the USD...

Such a prospect would be of serious concern to Irish exporters, to the economic theory buffs with a (healthy) obsession with stability of the GBP, and to those, planning an escape route out of Ireland Inc and into 'dollarized' world...

Monday, January 5, 2009

10 years of the Euro: Part III. Two notes

In two footnotes to these two posts on the Euro (Post I and Post II),

(1) A recent article by Maurice J.G. Bun and Franc J.G.M. Klaassen, titled "The Euro Effect on Trade is not as Large as Commonly Thought", published in the Oxford Bulletin of Economics and Statistics, Vol. 69, Issue 4, pp. 473-496, August 2007 provides an even more damming estimate of the poor Euro performance as trade-facilitation currency union:
"Existing studies on the impact of the euro on goods trade report increments between 5% and 40%. These estimates are based on standard panel gravity models for the level of trade. We show that the residuals from these models exhibit upwards trends over time for the euro countries, and that this leads to an upward bias in the estimated euro effect. To correct for that, we extend the standard model by including a time trend that may have different effects across country-pairs. This shrinks the estimated euro impact to 3%."
... and this is from two Dutch academics, not some 'Euro-skeptic' Americans or Brits... Ouch...

(2) The same issue of the Oxford Bulletin of Economics contained another article - previously published by the Austrian Central Bank - by Harald Badinger from the Europainstitut/ Department of Economics of Wirtschaftsuniversität Wien, titled "Has the EU’s Single Market Programme fostered competition? Testing for a decrease in markup ratios in EU industries". This research showed that using panel data covering 10 EU Member States over the period 1981 to 1999, for manufacturing, construction, and services, as well as for 18 detailed industries, the EU’s Single Market Programme has led to:
  • an increase in competition in the aggregate manufacturing, and – less robustly – for construction;
  • a decrease in competition in most service industries since the early 1990s.
This, also, is a discouraging sign for the Euro, especially as services account for more than half of the entire economic activity (and trade) within the Eurozone...
Once again, Ouch!..

Sunday, January 4, 2009

2009: A Brave New World of Brian, Brian & Mary

A couple of days ago, a friend dispensed with the usual ‘all the best’ seasonal greetings formulae by saying ‘This New Year, remember: what doesn’t kill you makes you stronger’. An apt seasonal greeting for the Brave New World awaiting us!

Triumvirates of Government and Punditry

First, for the establishment, expect more unconvincing and clichéd emergency announcements punctuating lengthy stretches of deafening silence. This is the modus operandi our Brian, Brian & Mary (BB&M) triumvirate prefer to active policy engagements.

The economy will wobble through the mud of international recession and domestic problems at an even slower speed than in 2008.

By March, this will trigger a fresh round of forecast downgrades editorialising calling for higher taxes to pay for public services from another triumvirate - the ESRI, Irish Times and RTE. Just in time for an emergency mini-Budget that will see more pain doled out to the embattled households. Last Fall, months after many economists warned about it, our official policy pundits agreed that massive household debt and falling incomes are the central drivers of this recession. Both have managed to suggest, however, that taking more money away from the households in higher taxes is a good thing. Forgive me for stating the obvious, but this is a sign of policy psychosis gripping Ireland’s intellectual elites.

The commentariate will be upstaged by occasional outbursts by our honorary President and her endless entourage of NGOs singing the end of the Age of Prosperity and the dawn of Enlightened Poverty. What kills our economy will make our chattering classes louder.

Elections and Opposition
Second, the opposition will go on scoring talking points, but no one will honestly challenge the status quo in fear of actually winning the poison chalice of running this economy.

Labour, the kingmaker-in-waiting, will play a safety strategy of catering to everyone: ‘No cuts, no taxes, no borrowing’. Fine Gael, forced to counter this will subscribe to equally contradictory ideas that, mixing in real economic incentives for growth with the programmes for stamping out more PhD graduates, building windmills and squeezing more knowledge economy ‘investments’ out of the already impoverished households.

This state of paralysis will take us into European and local elections, when a token lashing of the Soldiers of Destiny by the electorate will take place. But, what doesn’t kill the Government will leave it more resilient to change.

An IMF Bailout
By late Summer, collapsing state revenue will spell another set of emergency measures that may result in the state asking for an external bailout. By that time, a second round of income tax hikes (most likely to be passed in April) would have induced an even more severe contraction in tax revenues. With a rising army of self-employed fuelled by ‘shadow’ layoffs, tax evasion and cash economy will lay claim to a greater share of our GNP. What doesn’t kill our entrepreneurs and displaced workers will make them less visible to the taxman.

Things will become even less palatable after the new issue of state bonds fails to find willing buyers. By mid 2009, sovereign debt markets worldwide will be feeling the heat. Irish debt, that is becoming progressively costlier to place than that of many developing countries, will most likely be out of favour with international investors.

External donors – the ECB and European Commission – will be likely to respond positively to a request, especially if it is filed before the Lisbon II referendum. But an IMF loan will come with some austerity measures attached. By my estimates, based on the conditions imposed on other European borrowers, the IMF will require the Government to cut 15-20% of the entire budgeted expenditure.

Before that, following a mildly critical report by the An Bord Snip, BB&M will do some magic with public sector figures. Pushing ahead with a reduced raise in public wages (my guess would be a deferred hike of 2%), the Taoiseach will boldly ‘cut’ the bill by ca 3% in 2010, implying a real reduction of only 1.1%. Thus, the Government will issue yet another IOU to the State employees adding to banks’ guarantees and recapitalization, green and techy ‘investments’, and credit injections into some semi-states which might see cash drying out by mid 2009.

With this Enronesque fixing of the books, BB&M triumvirate will secure an IMF-led injection of some €5-7.5bn. They will blow through this sum 2 or 3 months later.

Down the economy’s slope
By the time our civil servants ‘tighten’ their belts, private sector workers will see their incomes shrink by up to 15% due to a combination of cost cuts by the employers and layoffs. The retail sector will face a wave of bankruptcies that will eat even deeper into VAT returns adding to a run away train of welfare costs.

By next year’s Budget day, we might see real per capita income shrinking almost to 2005 level, inflation at near zero and public sector inflation at around 3-4%, as semi-state companies in electricity and gas, transport, health and aviation sectors pass the Exchequer dividend demands onto ordinary consumers. Unemployment could be reaching above 11-12%.

Net emigration will be taking our guest-workers and educated young Irish out of this country. At a recent conference attended by Ireland’s top 2009 graduates, over half expressed their intention to get the hell out of Brian Cowen’s ‘paradise’ of competitiveness. In the last two months of 2008, I wrote a dozen recommendation letters to some of the best of my former students seeking jobs outside Ireland. All of them held very good jobs here before the current crisis.

Industrial and Social Strife
And this brings us to two most recent worries that, in my view, will form the backdrop of 2009.

The first one is a concern that Ireland might see a wave of industrial unrest in 2009 expressed by many between the Budget day and the publication of the Finance Bill II. While some strikes are inevitable in a recession, industrial strife in Ireland is exclusively the domain of unionised public sectors. They will have little reason to worry in the New Year. No one will seriously ask of them to raise their productivity (on average about 30% below that in the private sectors) or to take a significant cut in their pay (on average about 40% above private sector). Overpaid and under-performing, they will see their incomes rise relative to the rest of the country. For them, what might be killing the rest of us is of little concern, but they will fight tooth and nail for their position of privilege should the Exchequer cuts be contemplated.

On the other hand, public unease that swept across several EU countries in December may become a reality here. The December unrest was led by educated youth – dubbed the ‘€600 generation’ because of their low pay and poor jobs prospects. Few days before Christmas one of my students in Trinity summed up the feeling many of her classmates are harbouring: “Let’s hope that tens of thousands of Euros we spent on tuition will not be wasted in this knowledge economy of ours”. Given the prospects for 2009, she is right to be worried. Given the state of our Government’s capacity to manage this economy, she is right to be sarcastic. And so are all of us.

May we all spend this year getting stronger!

An edited version of this article appeared in the Irish Mail on Sunday, January 4, 2009.

10 years of the Euro: Part II. Mid-term Euro trend

See a disclosure here

It is this (see Part I) political motivation for the Euro that now threatens to undermine the main reasons for arguing that the Euro is a success story. European elites see the strengthening of the Euro against the US dollar as a sign that the new currency is gaining the market share as a global reserve currency.

But the problem for the Euro is that gaining a market share in a largely symbolic market for reserve currency at the expense of losing a market share in the real trade markets is a Phyrric victory.

NBER paper by Michael Bordo and Harold James (NBER Working Paper 13815, February 2008) makes similar point in devoting quite a bit of space to the discussion of the Euro as an international currency. They identify the precise mechanics for politically motivated international demand for the Euro as an alternative to the US dollar.

Because of the demand for Euro as an international reserve vehicle is politically motivated, argue Bordo and James,
“It is – projecting into the future – quite conceivable that there will be moments at which massive political pressure, built up by underlying anti-globalization concerns and focused on the technical necessities of dealing with major international crises, leads to a serious onslaught against the ECB and against the euro.”

From politics to economic fundamentals
Furthermore, the strengthening of the Euro throughout 2008 has been largely driven not by the underlying strengths of the Eurozone economies, but by the interest rates differentials between the ECB, BofE and the US Fed.

Chart 1 shows the link between the FX market and the policy gap – the gap between the cost of central banks funding as determined by the difference between the actual (realised) monthly Federal Funds Rates and the minimum benchmark ECB Deposit Facility rate from August 2000 through December 2008 (the entire historical data available to us).
As this figure highlights, the current Euro crisis is a lagged aftermath of the policy crisis that saw the medium-run directionality of the Federal Reserve policy becoming the exact opposite of the ECB’s policy stance around November 2005. By July 2007, as the credit crisis first manifested itself, the ECB’s suicidal denial of the problem became even more clear as the Eurozone rates have actually risen in the face of collapsing credit markets, just as the Fed aggressively pursued rates cuts.

Of course, many other variables help driving the exchange rates especially in the long run (more on this in the next post). However, the link between the Euro value and the interest rates mismatch between the ECB and the Fed is a historical regularity, as shown in Figures 2 and 3 below.
Figure 2 above plots the relationship between the monetary policy gap and the Euro/USD exchange rate. This relationship is causal, strong (with 63% of variation in the FX exchange rate captured by variation in the policy gap) and robust over time. It is also economically significant, with every +25bps change in the gap between the US Fed rates and the ECB rates inducing a ca Euro 0.021 strengthening in the dollar. This assumes parity at USD1.43 per 1 Euro for the period selected.

Figure 3 shows a similar relationship between the synthetic Euro/Dollar rate (linked to the traded index designed to replicate the returns on holding Euro). In fact, both the synthetic index and the actual exchange rates reaction to the monetary policy gap are virtually identical at -8.2 points for the former and -8.5 for the latter.
So where do we go next?
Figure 4 shows the actual movements in the monthly EUR/USD exchange rate and its 6-months and 12-months moving averages.

The relationship between the three lines indicates that in Q3 2008 we have entered a new trend of strengthening dollar that, so far, has taken us back to the levels closer to the resistance levels of the early 2007. The fact that we have, since, returned back to the levels consistent with Q3 2007 is a worrying point, as it suggests that November-December correction in the extremely high valuations of the Euro is not likely to persist in time.

However, there is little certainty as to the near-term direction in the EUR/USD rate. Several forces are currently pulling the FX markets demand for both currencies in different directions:
(1) The monetary policy gap is set to close in the next few months as the ECB loosens the key rates more dramatically than the already bootstrapped Fed;
(2) The liquidity policy gap (not plotted in this post) is also set to narrow as the ECB will be playing catch up with the Fed on injecting liquidity into the markets. Note: ECB’s liquidity creation is likely to support sovereign bond markets across Europe’s weaker economies (Ireland, Greece, Italy, Spain, etc), while the US liquidity creation is going primarily into banking and financial sectors;
(3) Financial markets demand for Euro is likely to weaken relative to the US dollar around Q2 2009 as US stock markets and bond markets will strengthen relative to the Eurozone;
(4) Both the US and the Eurozone’s imports will stagnate as the US consumers continue to de-leverage and the Eurozone consumers suffer significant personal disposable income shocks. However, while the US consumers de-leveraging has been pretty much fully priced in the current valuations, the slowdown in the Eurozone’s consumer demand is yet to be reflected in the FX valuations;
(5) US exports will remain relatively more robust than those in the Eurozone;
(6) A relative strengthening of the US economy vis-à-vis that of the Eurozone countries starting with Q2 2009 is likely to further improve demand for dollars;
(7) Relatively more dynamic prices contraction in the real estate coupled with the falling cost of mortgages financing in the US as compared to the Eurozone will continue to push the dollar down against the Euro;
(8) Stronger fiscal stimuli in the US than in the Eurozone will tend to favour relative increases in demand for dollar.
(1)-(3), (5)-(6) and (8) will all tend to support relative devaluation of the Euro. (4) and (7) will imply stronger decline in foreign exchange demand in the Eurozone than in the US – a force that will tend to support further devaluation of the dollar.

On the net, the preponderance of fundamentals suggests strengthening of the dollar relative to Euro in the next 3-6 months into $1.30/€1-$1.35/€1 range, but the key to this process will be increased volatility of the 3-months and 6-month MA trends (as opposed to the volatility in the daily series). The signs of this process taking hold should be traceable by the 3-way crossovers in the actual monthly series (led by weekly series) and the 6- and 12-months MA lines, as shown in the historical plot in Figure 4 above.

10 years of the Euro: Part I. Economic Dividend

Following one of the reader's suggestions, I decided to post some of my thoughts on the Euro and the direction of the EUR/USD and EUR/BPS exchange rates. This is the first blog post dealing with these issues.

A prior disclosure (see below)...

On December 29, 2008 Harvard’s Jeffrey Frankel – one of the world’s leading international macroeconomics experts wrote:
“By roughly the five-year mark after the launch of the euro in 1999, enough data had accumulated to allow an analysis of the early effects of the euro on European trade patterns. Studies include Micco, Ordoñez and Stein (2003), Bun and Klaassen (2002), Flam and Nordström (2006), Berger and Nitsch (2005), De Nardis and Vicarelli (2003, 2008), and Chintrakarn (2008)… Overall, the central tendency of these estimates seems to be a trade effect in the first few years on the order of 10-15%. None came anywhere near the tripling estimates of Rose (2000), or the doubling estimates (in a time series context) of Glick and Rose (2002).”

Reasons for relatively poor performance
In his 2008 paper, Frankel looks at the possible reasons for this poor (relative to the original expectations) performance of the common currency:
(1): It takes time for the effects on trade to reach full potential;
(2): Monetary unions have smaller effects on large countries than small countries, and
(3): The original estimates were spuriously high because bilateral currency links have historically been the result of bilateral trade links rather than the cause (the so-called endogeneity problem).

What Frankel found was that correcting for the first argument does not change the rate of underperformance of the Euro relative to the original expectations. In other words, “at the moment there is little evidence to support the lags explanation”. With respect to the second argument, Frankel established that “There is no tendency, overall, for currency unions to have larger effects on the trade of small countries than large.” Finally, testing the third explanation also shows that it fails “to explain the gap between the recent euro estimates and the historical estimates”.

What all of this suggests is that the original justification for the existence of the Euro – the idea that it will boos significantly economic competitiveness of the exports-driven Euro block of countries – is yet to be confirmed. Neither on its 5th birthday, nor on its 10th anniversary did the Euro show a significant (economically) prowess to drive economic development of the Eurozone.

Even more egregious is the fact that the estimated effectiveness of the Euro to generate exports growth did not appear to move up between January 1, 2004 and the end of 2008.

A handful of strengths
This is not to say that the Euro has been a failure. Frankel – long-time champion of the common currency – states in another article that: “Looking back, the euro has in many ways been more successful than predicted by the sceptics — many of them American economists.” The list of such successes that he provides relates only to the metrics which reflect the positive reception of the Euro and the ECB amongst the world economies.

More trouble ahead
However, as Frankel puts it:
“…some of the sceptics' warnings have come to pass: shocks have hit members asymmetrically; cushions such as US-type labour mobility have remained thin; and the Stability and Growth Pact has proven unenforceable. Furthermore, the popularity of the project with the elites does not extend to the public, many of whom are convinced that when the euro came to their country, higher prices came with it.”

The latter point is now being reinforced by the former across all European economies. In fact, popular decline of the Euro has been so steep in 2007-2008 that the Eurobarometer gauge of public opinion has shown declining willingness of the electorates in Germany, France, Italy and pretty much the rest of the Eurozone, to remain a part of the ECB-run common currency area in contrast to the upward support trend recorded in 2002-2006.

What is more problematic for the, still, relatively young currency is that the cost of the ‘one monetary policy – different economies’ strategy for the Euro might be a long-term suppression of growth across the entire Eurozone. If monetary policy were to become a tool for delivering European convergence, it might lead to the convergence benchmark being set at an anaemic growth trend of Germany, France and Italy. In other words, rather than pushing the slow growth larger Eurozone economies up, the Euro might be pushing faster growth ‘fringe’ economies (Ireland, Austria, Sweden and Finland, alongside the Accession 10 states that care to join common currency or peg to it) down.

Nobel Prize winning economist, Robert Fogel in a 2007 paper suggested that a rate of real GDP growth for the period 2000-2040 of 1.2 percent for the industrialized EU-15 will be only slightly higher than the 1.1 percent for Japan, but a “much lower than the 3.8 percent for the United states or 7.1 percent for India or 8.4 percent for China.”

A recent NBER paper by Michael Bordo and Harold James (NBER Working Paper 13815, February 2008) makes very similar point by stating that:
“In particular, there is the possibility for the EMU that low rates of growth will produce direct challenges to the management of the currency, and a demand for a more politically controlled and for a more expansive monetary policy. Such demands might arise in some parts or regions or countries of the euro area, but not in others and would lead to a politically highly difficult discussion of monetary governance.”

A litany of challenges
Bordo and James look into asymmetric regional shocks impact, labour mobility effects, wage and price flexibility conditions, and risk sharing mechanisms implicit under the Euro as discussed in the existent literature and find that in all of these issues, the Eurozone monetary policy institutions are inferior to the arrangements in the US.

“The most obvious threat to the single currency is usually held to arise out of the imperfect control and coordination of national fiscal policies,” say Bordo and James, going on to conclude, contrary to the pundits of greater federalism at the EU level that:
“A formalized system of fiscal federalism would however not necessarily deal with the problems of fiscal indiscipline on the part of member states. Indeed, the expectation of institutionalized transfers or bailouts following fiscal problems might well be expected to increase the incentives for bad behavior. Stricter observance of the existing system and its rules, on the other hand, might lead to pressure to reform. Fiscal reforms would in the longer run be expected to raise the rate of growth.”

Of course, to date, the EU has failed to enforce the code of fiscal discipline among its members. In fact, 2004-2005 saw a set of reforms aimed at diluting the Stability & Growth Pact criteria for fiscal performance.

Financial stability of the system is another area of challenge for the Euro, where the lack of coherent regulatory structure is the mirror image of the overly centralized monetary policy. Again, Bordo and Lames sum this up by saying that:
“The difficulty of an effective Europe-wide response to financial sector problems thus reflects a more general problem with respect to the making of monetary policy: there may be a different political economy of money in regions of the Euro-zone and EU member countries, leading to contradictory pressures on policy.”

All of this implies greater volatility around the trend for smaller and more open economies, so occasionally countries like Ireland will be going through more pronounced boom-and-bust cycles, but in the end, average (or potential) long-run growth will remain below that in the US, Canada, and the rest of the developed world.

Disclosure: I would like to explicitly state that I do not share in some analysts' view that Ireland would fare better outside the Eurozone, nor do I believe that the Euro has been a sort of a disaster. I see the Euro as a challenging and generally positive element of the European integration project. This view motivates my analysis of the weaknesses in the common monetary and currency policy to date. It is my desire to see a gradual strengthening of the European democracy and markets that inform my analysis. Sadly, I feel that this disclaimer is a necessity in the current climate of attacks on the freedom of thought and expression that characterise our (European) political and economic policy debates.

Friday, January 2, 2009

Can lower interest rates spur housing market growth?

In an earlier post I wrote:
Elsewhere in Europe and the US, similar [to the Irish banks] capitalization schemes have failed to reduce the cost of corporate borrowing or to restart lending to the households. In the UK, a £43 billion capital injection scheme has been in place for almost two months and the supply of consumer and business credit continues to fall - whether due to demand slowdown, lenders withdrawal from the market or both. In the US, massive banks’ capital supports have lowered the mortgage rates, but there is no meaningful increase in new mortgages uptake.

Here is more evidence that lower rates and re-capitalizations of banks are not driving new mortgages applications up:
"British interest rates have already been slashed to 2%, their lowest level since 1951. ...Amit Kara, an economist at UBS ...expects rates to be cut to just 1% next week and to 0.5% by March. British interest rates have never gone below 2% since the central bank was created in 1694,"
"Mortgage approvals for house purchase ...fell to just 27,000 in November, the lowest level since the series began in January 1999 and a third of its level a year ago."

Ditto in the US, where (Marketwatch): "The average rate on 30-year fixed-rate mortgages fell for the ninth week in a row this week, setting another record low". The 5.1% mortgage rate recorded last week is the lowest since the data started in 1971.

Another report by the Mortgage Bankers Association (see details here) showed that the resurgence in the US mortgages issuance (155% year-on-year) on the foot of dramatic interest rates declines is accounted for by re-financing applications (83%). Of the remainder, some 2/3 of mortgages growth was due to the Federal Government purchases.

In short, the answer to the question in the title is NO.

Lower interest rates are only a part of the solution, but the paramount condition for rekindling the markets is that households must de-leverage significantly enough to bring their debt in line with their after-tax incomes. This is a lengthy and painful process that can be aided only by
  • income tax cuts or rebates (US);
  • consumption tax cuts (UK); and
  • liberal personal bankruptcy laws (US).
Even with these in place it has taken US households 6 months of straight contraction in indebtedness to start (cautiously) testing the re-mortgage market waters again.

None of these policies are even being tried in Ireland!

Thursday, January 1, 2009

Government Plan: VC investments Redux

See the latest on VC investments here, but my favourite bit of this exceptionally well researched and written article is towards the end:

"Illiquid investments like venture-backed startups don’t look so hot. VCs 'have been living off fumes for a long time now,' says one prominent Silicon Valley investor. 'If you have any money, the last thing you’re going to do is put it into an asset class that hasn’t generated a return for ten years.'"

Well, apparently Irish Government knows something that Harvard economists, Forbes journalists, global 'smart' money and this humble blogspot (here) all have missed - an alchemist's formula for turning taxpayers' cash into Exchequer Gold via VC investments in 'greenish and techy things'...

What can possibly go wrong now?

Volatility falling?

In a rare piece of good news VIX index measuring (albeit imperfectly) revealed risk assessments in the US markets, has fallen below 40 on the final trading day of the year, for the first time since October 1. The VIX is the Chicago Board Options Exchange Volatility Index shows the market's expectations for volatility over a 30-day period.

As my students in Investment Theory course would know, only human imagination is a limit to the number of ways one can think about (and depict) market volatility. Here are three simple (my favourite criteria for empirical validity) ways of doing this.

Chart 1 plots VIX data since January 1990. This shows a dramatic fall in VIX reading since November highs. But, it also shows the cyclicality of VIX – an approximate 3:5:3 cycle of 3 years rising volatility trend, followed by 4-5 years of elevated ‘flat’ trend, concluding with a 3 years of falling trend. By this pattern, we are not out of the woods. Indeed, we have just finished the 3-year rising trend bit around mid 2008, implying that a long-term elevated volatility period may be still ahead for us.
Chart 2 plots intra-day variation in VIX (High-to-Close, alongside the same logic as semi-variance models of risk pricing). Note the unusually elevated red peaks since ca July 2007. This disputes the common claim that it took some time for credit markets troubles (starting in mid-Summer 2007) to feed through into the markets for real claims (assets with fundamental underpinnings). Once again, the latest moderation in VIX reading may be simply concealing the historically high volatilities in risk perceptions that drive daily markets.

Chart 3 shows three alternative, albeit slightly similar, measures of risk dynamics. Note that up until around mid February 2007, daily deviations in VIX readings measured as ‘High’-to-‘Low’ and ‘High-to-Close’ tracked one another and were roughly in line with the weekly Moving Average in the standard deviation. In other words, while risk itself might have been rising or falling over time, the uncertainty about the future risk levels was much lower and more static prior to the beginning of 2007.
This ‘calm’ was first challenged in February and then finally shattered in late September 2007. Once again, no matter how positive the latest decline in VIX to below 40 may sound, we are not of the woods yet.

• More intra-day and intra-week volatility, and
• Less predictability in volatility trend.
2009 seas of financial market are going to be no less choppy than the ‘Perfect Storm’-torn 2008.

Happy New Year 2009

Happy New Year to all reading this blog!

Here is a quick thought on the year ahead:

This will be a year of inversion of the traditional dictum: "What doesn't kill you, makes you stronger". Instead, the 2009 motto will be "What doesn't make you stronger will kill you".

This implies that in 2009 every one of us will need:

(1) a healthy dose of reality - may the battles you chose be only the ones that, if unwaged, have a potential of bringing disaster to your employment, business, investment, wealth. 2009 is going to be a year of fighting;

(2) a massive dose of brave thinking - 2009 is going to be a year when our weaknesses are going to be costlier than our usual mistakes. 2009 will be year to invest in your employment, business, investment portfolio, wealth - it is a year to take (calculated) risks;

(3) a potent dose of independent criticism - in 2009 you should seek anyone willing to tell you an uncomfortable truth. The opportunity cost of being complacent today is finding yourself in a Bear Stern's-like predicament tomorrow.

The new dictum, therefore, is about seeking new risks, new ways to make you stronger, for at the times like these, weaknesses multiply like fractal patterns - ad infinitum!

May you avoid all things that can't make you stronger!