Will Greece Pay Its Debts Via The Agamemnon Option?

June 17th, 2015

Legend has it that, at the onset of the Trojan war, the Mycenaen king Agamemnon sacrificed his daughter Iphigenia to Artemis, the goddess of (amongst other things) wildness, in order to obtain favorable winds for the Hellenic fleet’s crossing of the Aegean.

Some three millennia after the events that inspired this story, the government in Athens finds itself again attempting to appease greater powers in the face of an increasingly wild regional conflict. And yet again, perhaps Greek leaders have already made a terrible sacrifice of youth which could go some distance to calming the seas their beleaguered nation must navigate, if those greater powers view the offering with favor.

Standing in for Artemis are the so-called “Troika” of Greece’s institutional creditors, the International Monetary Fund (IMF), the European Central Bank (ECB) and the eurozone countries. In the role of poor Iphigenia we have a generation of young, educated, professional and entrepreneurial Greeks. In these more civilized times, however, the sacrificial instruments are not altar and dagger but an airline ticket and an EU passport.

At least two hundred thousand Greeks have emigrated since the financial crisis began, the vast majority of whom are youthful, skilled and facing bleak prospects in their home country. They are the next generation of Greece’s experts in medicine, the sciences, engineering, finance and academia. Their primary destinations are other EU nations – for example, the UK’s Guardian reports Germany alone has received 35,000 Greek physicians.

While many of these émigrés might prefer to return to their native land someday, Greece’s stifling regime of regulation and taxation, its bloated welfare state and rampant corruption are likely to continue to render that nation far too uncompetitive to accommodate their ambitions. The 2014-15 World Economic Forum competitiveness ranking places Greece eight-first, just behind Uruguay (but, in fairness, one ahead of Moldova). By contrast, the U.S is third, while Germany ranks fifth. Rather than implement meaningful additional legal, pension and labor market reforms, Athens proposes to roll back many of those the Troika has already imposed, thus ensuring this unfortunate state of affairs is likely to continue for some time.

Yet there is a kind of tragic silver lining in all this, both for Greece’s creditors and its government’s apparent vision. Consider the value of Greece’s professional diaspora in Europe to its recipient nations. Let’s do an admittedly “back of the envelope” calculation. First, a few compensation figures. For German engineers the average is around $57,000, for bankers around $55,000. The average physician in Germany made $155,000 in 2010, in France a bit lower at $131,000. So for the sake of argument, let’s assume a $50,000 per capita income for two hundred thousand Greek professional émigrés (a number which could rise if Greece continues on its current trajectory) and an average working lifetime of thirty years. Discounting by the current German thirty year bund rate of 1.5% over that time frame (a not unreasonable proxy given integration into largely northern European economies) yields an expected present value of $240 billion. Assuming a 50% rate of total taxation (income,VAT, property etc.) yields $120 billion, or approximately 44% of the $273 billion Greece owes the Troika creditors and the central banks of the eurozone. In particular, this is $30 billion more than the $90 billion the ECB has extended to Greek banks under the former’s Emergency Liquidity Assistance (ELA) program*.

Thus, if the Troika and the eurozone’s central banks are to take a hit on Greece, the transfer of that country’s human capital to the rest of Europe and other IMF members should provide the creditors with some recompense (in an ideal world some inter-creditor transfer system would be implemented to make things fair, given that many Greek expats may head to the non-eurozone UK and the non-EU United States, and that poorer creditors like Portugal may not get a pari passu share of Greek emigration). A full realization of the value of this emigration might ameliorate the Troika’s reticence concerning whatever restructuring, discount, or other euphemism for a Greek default ensues, perhaps to the point of extending the ELA to prevent bank runs, with a bit left over for some form of humanitarian aid.

To be sure, some of the Troika’s actions and proposals have been neither helpful nor realistic, especially as regards overly aggressive near-term primary surplus targets (1% for the next couple of years would be in the outer realm of the possible). Yet the irony here is that, absent very necessary reforms to the welfare state that Athens is loath to agree to, the conditions in Greece are likely to persist, such that young, talented Greeks will remain in diaspora, lending their abilities and energy to the economies of Greece’s creditors. Effectively, Athens will have guaranteed at least a partial repayment of its debts, albeit at the cost of its nations’ youth.

Of course, the Greek polis may not be entirely pleased with its government’s sacrificial policy. After all, in Pindar’s poetic telling, certain members of Agamemnon’s constituency, notably Clytemnestra, mother of Iphigenia and his queen, registered displeasure with the monarch in the manner of a time before the invention of the parliamentary no-confidence vote, making for arguably the most notorious bathing scenes in literature. With polls consistently showing a majority of Greeks in favor of remaining in the eurozone even if that means agreeing to painful reform, Greece’s leadership may yet choose to compromise. Otherwise, they could find themselves grateful that the democratic process allows them to lose power without taking a bath considerably less pleasant than even the one they would impose on their creditors.

Then again, in some old versions of the tale, at the last moment Artemis rescues Iphigenia and replaces her with a stag, so hey, there’s always the chance of a deal, though bailing out Greece will take a lot more than a single buck.

*Of course this analysis neglects the social welfare cost of the émigrés to their adopted countries; this may be justified to the extent that these young people are already educated and that much of the other expenses will be incurred in old age and thus are to be heavily discounted in terms of present value. Such costs would also be partially offset by revenue from assets transferred out of Greece by the expats and other Greeks, and also by revenue from enterprises founded by disproportionately entrepreneurial immigrants, at least if one goes by the American experience.

U6 Stalks The Hawk

August 21st, 2014

Put an “HMS” in front of the word “Hawk” in the title of this post and one might think it describes some World War II duel between a German U-boat and a British destroyer, but in fact the “Hawk” in question is any Federal Reserve official inclined to tighten monetary policy, and the “U6” lurks not beneath the frigid waters of the North Atlantic but rather in the data of the Bureau of Labor Statistics, though it’s certain to surface at this week’s Jackson Hole conference on central bank policy.

A broader measure of distress in the labor market than the U3 statistic generally referred to as the unemployment rate, U6 reflects not only unemployed workers but those who are “marginally attached,” including those with part-time jobs wishing for fuller employment as well as potential workers discouraged or otherwise incentivized to cease looking for work. Thus, U6 represents hidden slack in the labor market, a reserve of individuals whose potential reentry into the workforce could help contain wage inflation even as the Fed maintains unusually accommodative monetary policy.

The reality is that even as an inflation-wary FOMC tapers its quantitative easing program and looks to the day it can raise short-term interest rates from essentially zero, Janet Yellen and her colleagues confront an extraordinarily high number of underemployed and discouraged workers, especially as compared to the number of “conventionally” unemployed measured by U3. One can get a sense of this by comparing the ratio of marginally attached workers included in U6 to the unemployed as measured in U3*. The result can be seen in the chart below:

Marginally Attached-Unemployed RatioThe data goes back to the beginning of 1994, when the BLS began tracking marginally attached workers and computing U6. As the chart shows, for most of the last twenty years the ratio has floated around .8, falling at times to a bit above .6 and rising to a little below .9 on occasion. Yet, in the current recovery, the ratio has risen to unprecedented heights (especially in the last few months) rising above 1 for the first time in June even as U3 itself declined (in July the ratio eased slightly to just above .99). This reflects the fact that even as U3 unemployment has fallen, a large pool of jobless or underemployed have remained in that unhappy position and uncounted in the generally reported unemployment figure.

The bottom line is that for every person officially unemployed there is another either not looking for a job or desiring more work than they have been able to attain. That spells enough hidden supply in the labor market to potentially discourage accelerated tightening, even as just released Fed minutes indicate increased hiring has made some FOMC members hopeful of a chance to raise rates sooner rather than later.

Unless U6 dives a fair bit deeper, it remains poised to torpedo the hawk’s plans for an early return to more “normal” monetary policy.

*Since the BLS uses the civilian labor force alone for the base in calculating U3 and adds marginally attached workers in figuring U6, the ratio here is computed by taking the ratio of the difference between U6 and an “adjusted” U3 to that same adjusted U3, the adjustment consisting of multiplying U3 by the sum of the civilian labor force and marginally attached workers, then dividing by the civilian labor force. All figures are seasonally adjusted except attached workers, which the BLS does are not seasonally adjust though it uses that series in calculating seasonally adjusted U6.

 

Does “Helicopter Ben’s” Napalm Drop Smell Like Victory?

August 22nd, 2013

Those who’ve seen Francis Ford Coppola’s “Apocalypse Now” will recall Robert Duvall’s air-cavalry colonel (and surfing enthusiast) by his declaration of love for “the smell of napalm in the morning….smelled like…victory.” Since then, few people have been similarly associated with the power of things dropped from the sky (metaphoric or not) so much as Fed Chairman Bernanke, whose famous remark referencing Milton Freidman’s concept of countering deflation via a “helicopter drop” of money earned him the nickname “Helicopter Ben.” That moniker has only been reinforced by the money creation and Fed balance sheet expansions of the central bank’s Quantitative Easing programs.

However, back on May 22, when Bernanke didn’t rule out some so-called “tapering” (he didn’t actually use that term) of the Fed’s asset purchases as early as this coming September, the fixed-income market has behaved as if he’d called in an airstrike. Indeed, the sell-off seemed to motivate some of Bernanke’s colleagues on the FOMC (as well as the big man himself) to at least project the appearance of walking back the incendiary comments, emphasizing that the decision process on tapering would be data driven and even implying that weak numbers might move the central bank to increase purchases. Case in point: the equivocation evinced in the July Fed minutes released yesterday.

This uncertainty is understandable in the face of less than robust indications of economic expansion, e.g., second-quarter GDP growth of 1.7%. Moreover, inflation continues to be subdued, begging the question of why Bernanke & Co. would choose to discuss reining in bond buying now.

Perhaps one hint is to be found in the yield spread between Treasuries and the inflation-indexed variety known as TIPs. An indicator of market expectations of future inflation, the ten-year TIP spread has widened from near zero in late November 2009 to around 2.15% as of this writing. While in excess of the 2% rate the FOMC has generally acknowledged to be their current target (though some have indicated a willingness to consider a range about this figure), the problem is that as the taper rhetoric has increased, the TIP spread has been contracting. As can be seen from the accompanying graph (with Fed assets expressed as a fraction of their 1/2/2008 value), even as Fed asset growth accelerated in 2013, the central bank has struggled to increase inflation expectations, with the TIP spread maxing out at 2.59 this past February before beginning its fall to current levels. To be sure, by many measures actual inflation has increased since its post-crisis lows, but with the Core Personal Consumption Expenditure price index (the Fed’s preferred measure of inflation) still running at only 1.22%, neither current inflation nor expectations give the Fed vast breathing room.

 

 

Meanwhile, recent job creation figures have been only modestly solicitous, with a stubbornly low participation rate even as employers confront incentives to move full-time workers to part-time status under health care reform. The prospect of coming quarters is also haunted by the specters of fiscal drags from the delayed effects of sequestration and increased taxes.

Of course, regardless of the economic statistics, the Chairman could be forgiven for wanting to put in train at least a reduction in the rate of Fed asset purchases so as to indicate the will to deal with the central bank’s massive and growing balance sheet before leaving office, let alone prior to a more meaningful increase in inflation or fall in the value of the dollar. After all, the Fed’s assets now stand at over 20% of the national debt, and the central bank current bond purchase rate has it pretty much buying up the entire Federal deficit this year, raising fears of monetization (see “Uncle Ben’s Reverted Price”). Yet with unemployment still high, corporate profits decelerating and even the hint of tapering having caused mortgage rates to spike, there is a serious potential for taper-induced economic deceleration. Given that inflation is at best just nudging up into its perceived target range, if any Fed taper is followed by a fall in growth it may be difficult for Bernanke or his successor to justify meaningfully dialing back quantitative easing. Even as far from the ocean as Jackson Hole, FOMC members gathered without their leader must feel the alternatives are a bit like the choice Duvall’s colonel gave his men: engage in a firefight or attempt to surf under an artillery barrage.

“You Can’t Handle The Truth!”- The Craven Logic Of Stealth-Bipartisan Budget Deals

April 4th, 2013

What if Democrats and Republicans came together on a deficit-reduction program of tax hikes and spending cuts, yet neither side admitted it, even to themselves, lest their compromise offend both their respective bases and their own partisan sensibilities? For all the sturm und drang that attended the last few months of so-called fiscal brinksmanship, when one looks at the mathematics behind the recent legislation (or lack thereof) that’s exactly what has transpired.

The completion of this effective compromise came at the start of this year, though the wheels were set in motion through the sunset provisions of Bush and Obama-era tax cuts and the budget deal of 2011.

First, January saw tax hikes imposed at the conclusion of the “fiscal cliff” negotiations totaling $600 billion over the next decade, including the rollback of the payroll tax holiday and income and capital gains tax increases for individuals and couples earning over $400K and $450K, respectively (this is on top of similar, previously budgeted Obamacare capital gains tax increases at $200K and $250K income thresholds). This basically represented a partial rollback of the Bush cuts, all of which would have expired without legislative intervention, as well as the scheduled termination of the 2010 Obama payroll tax measure.

A few weeks later, the so-called “sequestration” kicked in, which if allowed to continue cuts $1.2 trillion over the next nine fiscal years, with an $85 billion reduction in the present one (the “cuts” are of course decreases in the growth of spending rather than absolute declines). These are across-the-board reductions, excepting most entitlements, notably Social Security and Medicaid (Medicare provider reimbursements get cut by 2%), and are actually a second installment of $2.4 trillion in cuts agreed to under the 2011 budget pact (see “Downgrading Democracy”).

So the first quarter of 2013 witnessed a set of significant tax hikes and spending cuts, all the result of bills passed by a Congress with a GOP-controlled House and signed by a Democratic president. The wording of those bills allows each side to blame the other for not doing enough to either prevent or go beyond “automatic” tax code sunsets, and for not increasing, decreasing or otherwise re-allocating the “automatic” sequestration cuts. It was, however, this Congress and this President who passed and signed those “automatic” tax hikes and spending cuts into law in the first place, thus effectively prepackaging a tax and spending cut trade-off using the language of sunsets and sequestration to re-frame as a crisis what in another age might have been hailed as a compromise. Subjective partisan judgment may find that compromise imperfect, but that’s the nature of compromise itself.

This is not to say the criticisms are vacuous: all things being equal, increased taxes on all income brackets will reduce consumption and hinder investment; the latter effect will attend the hike in capital gains taxes as well. As for making the spending cuts more rational, reasonable people could argue until the end of time the virtues of funding medical research versus student aid, defense versus space exploration and so forth. It is unlikely that debate would produce a result more universally satisfying then the rough justice of the sequester. Yet absent serious reform of Social Security and Medicare (e.g., some combination of means testing, increased eligibility age and chain-weighted adjustments for inflation – see “The “Pained” Consumer Price Index”) these recent measures are only a modest down-payment on bringing the rate of US debt expansion in line with economic growth. Indeed, viewed in this light the budget compromise of 2013 is just an opportunity for Americans, especially younger ones, to begin to become accustomed to the sacrifices that will be required of them in order to pay for benefits their elders have voted for themselves but did not adequately fund (see “Generation Hexed: The Curse of Inter-Generational Taxation Without Representation”). Thanks to this new, sound-bite-friendly, “blame the other guy” structure of budget deals, leaders of both parties will be able to attribute those hardships to the intransigence of their opponents and “dysfunctional Washington,” as opposed to acknowledging them as predictable results of policy choices made over the last four decades without regard to the well-being of future generations.

It appears that, as regards deficit reduction in the face of exploding entitlements, the answer to the age-old question “who will tell the people” is, in fact, no one. Not to worry, though. As younger generations pay their taxes, try to start businesses, apply for scholarships, research grants or just a mortgage, I have a feeling they’ll get the message.

N.B. For the cinematically disinclined, the phrase “You can’t handle the truth!” was made famous as the volcanic courtroom outburst of Jack Nicholson’s Marine colonel in “A Few Good Men.” Though it’s hard to imagine the President and the Speaker of the House roaring those words in unison before a stunned Washington press core, perhaps their actions and those of their colleagues convey the same sentiment, albeit in more muted tones.



Currency War Is The Continuation Of Stimulative Policy – And Politics – By Other Means

February 20th, 2013

One does not generally think of G20 communiques as hilarious, but Carl von Clausewitz might have been amused by the one put out over the weekend (Prussian military theorists are known for their sense of humor) and perhaps honored its comic genius with the above corollary to his famous maxim*. The document essentially re-classified recent competitive currency devaluation, without even calling out the tactic by name, as one of a variety of “policies implemented for domestic purposes,” on the part of G20 members seeking to “minimize” “negative spillovers” on other countries.

Got that? So when the Fed prints money to fund QE “infinity and beyond” and the dollar slides against the euro it’s just a “spillover,” as is apparently the effect of Japanese Prime Minister Shinzo Abe’s call for a weaker yen (precipitating a 20% dive) since he’s just trying to stimulate his “domestic” economy. Indeed, as market commentators seized on the G20 statement as a ratification of Japan’s devaluation policy, the point of the group’s statement became clear; one might paraphrase it as “hey, big advanced economies, we’re cool with you devaluing – just call it quantitative easing or monetary stimulus and try not to be too obvious in stating how low you want your currency to go.”

The problem, of course, is that for any nation that trades with the world, there really is no such thing as a purely “domestic” economic policy. For example, when a nation’s central bank creates currency to buy financial assets in quantitative easing, all that money printing can drive down the value of the currency versus that of the country’s trading partners, giving the QE the added stimulative kick of improving balances of trade and payments. The US may well be enjoying this effect, while Japan, facing monstrous energy-driven trade deficits in the wake of its post-Fukushima near-total nuclear shutdown, desperately wants to increase exports. Indeed, the newly-elected LDP government has entertained purchasing foreign bonds to flood the world with cheapening yen, though Abe downplayed the need for going this far following both the yen’s plunge and the G20 summit, perhaps fearing the optics at the moment.

The fall guys in a currency war tend to be the countries that don’t devalue, a point not lost on ECB president Mario Draghi, who only a few months ago stated his intention to “fully sterilize” Outright Monetary Transactions – his own quantitative easing – and prevent a decline in the euro, presumably by using foreign currency reserves to mop up the excess euros used to buy Eurozone bonds. That was a nod to inflation hawks like Bundesbank president Jens Weidmann, who fear currency debasement may lead to higher prices, but it was also before the G20 devaluation love-fest. Right after the summit, Draghi made clear that while he was not targeting a specific exchange rate (of course not – after all, he read the communique) he was cognizant of the “deflationary” effects of too strong a euro. Translation: “Hey folks – I’ve got a printing press, too!”

Of course, in a policy free-for-all like the one the G20 just had, there has to be something in it for everyone, including emergent economic powerhouses like the BRICs. Thus the comment about the need to “minimize” “spillovers,” including measures to prevent all that newly-created, developed-world “hot money” bidding up and crashing developing nations’ domestic markets as it roars in and out of their economies. In other words, the new kids on the block get a green light for currency controls.

Beggar thy neighbor devaluations, protectionist currency controls…this kind of thing can get very out of hand, with bad consequences, economic and otherwise. As the G20 expands the scope of this game, its members had better learn to play nice. After all, past competitions of this kind have preceded events which prove the veracity of von Clausewitz’s observation.

*“War is the continuation of politik by other means.” Then as now, the shadings of the translation of politik (policy or politics, depending on the translator) are both intriguing and ominous.

Generation Hexed: The Curse of Inter-Generational Taxation Without Representation

October 16th, 2012

In a political season of putative class warfare, with accusations of who didn’t build what and which percent isn’t paying its fair whatever, it’s worth considering that the true critical divide in early 21st century America, the one driving everything from entitlement spending to the tax debate, is that between generations as opposed to classes.

To understand this, one must first grasp the underlying demographic realities. The Baby Boom generation, comprised of the approximately 78 million people born between 1946 and 1964, are just now beginning to reach the age of retirement, with the eldest of this cohort now turning 66. They precede, and, as we shall see, intend to be supported by, Generation X, the approximately 46 million Americans born between 1965 and 1980. This “baby bust” is reflective of a parentage produced by low reproduction levels associated with the Great Depression and the Second World War, just as the 80-95 million members of Generation Y born between 1980 and the early 2000’s -the so-called “Millennials” – are an echo of the post-war Baby Boom.

Meanwhile, the life expectancy of Americans has increased sharply since the establishment of the entitlement programs the Boomers will avail themselves of in their golden years. For example, in 1935, the year Social Security was established, the average life expectancy was 61.7 years, significantly less than the full benefit eligibility age range of 65-67 years under current law. Even in 1970, five years after the establishment of Medicare with its eligibility age of 65, life expectancy had risen to only 70.8 years. By contrast, in 2008, U.S. life expectancy stood at 78 years, and, more to the point, the life expectancy of a 65 year old was a further 18.7 years, which is to say an average lifespan of 86.7 years.

One does not have to be an actuary to guess that if you have any kind of insurance and don’t increase eligibility age in line with an explosion in life expectancy, eventually the program is going to go broke. Over their working and voting lives the Baby Boomers neither meaningfully raised their own eligibility age nor sufficiently increased their contributions paid through taxes to fund future disbursements. As a result, under the current structure both Social Security and Medicare will be unable to pay out full benefits within coming decades. Specifically, Social Security would have to start reducing benefits between 2033 and 2036, while Medicare would need to do the same around 2024 (this despite the 2% reduction in Medicare spending promised under the recent reform). Past these dates it might still be possible to pay out reduced benefits for some added years (say at a 75% level) or alternatively to fund the shortfall from higher taxes paid now and in the future by the young, i.e. Gen X, and older members of Gen Y.

Of course, even a significantly higher tax burden may be merely sufficient to allow the younger generations to take care of the aging Boomers at the level that the latter, with their overwhelming numbers, have voted to become accustomed to. It would not fund the retirement and health care of the current young themselves. Gen X in particular will likely be faced with the choice of truly onerous, growth-killing taxes (these could include ruinous inflation to extinguish the national debt built up in funding the Boomers’ benefits) or a very sharp rise in their eligibility age, to a point much closer to their life expectancy. To borrow a term the current administration said was a criterion for some projects provided stimulus funding, Gen X may not get Federal retirement aid until it’s close to being “shovel-ready.”

In a very real sense, the nearly eight to five ratio of Boomers to Gen X has served to exaggerate a sort of inter-generational taxation without representation which may occur in a democracy, a form of moral hazard in which an older generation may vote obligations upon a succeeding one not yet fully enfranchised. In the present example, a ray of hope in the young’s otherwise dim prospects might be found in the economic opportunities afforded by serving a larger aging population. However the greater voting power of the Boomers could well limit this potential upside, through legislated effective price controls for critical goods and services Gens X and Y might sell to the Boomers, and indeed from health care to energy to finance, there are already a variety of proposals which could effectively constitute such controls.*

Patriotism and concern for the young could lead the Boomers to moderate their demands, perhaps through some combination of slowly raising their own eligibility age, means-testing entitlements, and limiting the growth of benefits. One could be forgiven for questioning the likelihood of such a shift in behavior on the part of what by the ’70’s came to be known as the “Me” generation, or was termed by Hunter S. Thompson a “Generation of Swine.” Perhaps more probable is the eventual emergence of some kind of voting block composed not only of Gen X but of older Gen Y and some younger Boomers (perhaps those under the 55 limit above which both parties hold no entitlements may be reduced) allied in realization that they are being assigned the very short end of the inter-generational stick.

To be fair, the young could have it worse. In his novel “Never Let Me Go,” Kazou Ishiguro imagined a dystopoia in which the young are produced via cloning for the sole purpose of providing successive and eventually fatal “donations” of their vital organs to the aging individuals in whose image they have been created. The Boomers are unlikely to impose a similar levy on Gens X and Y; after all, the technology just isn’t really there yet. Yet barring their elders acquiring some heretofore not evinced inter-generational empathy, X and Y will have to stand up for themselves politically lest they find Ishiguro’s lethal tax one of the few they have do not have to pay. As observed in another time in which one might be born into unbearable obligation, serfs own nothing save their own bellies. Let us hope the young are not on a road to a similar condition.

*N.B. For my mathematical economist friends, consider the future “Harberger’s triangle” dead weight costs to the economy Gens X and Y will experience as a result of effective rationing of these goods and services under those implicit or explicit price controls.

Aware of Greeks Tearing Rifts, Germany May Have To Let The ECB Do More Than Twist

June 28th, 2012

As the prospect of Brussels hosting yet another euro-summit showcase of intransigence and impotence looms before us, even the redoubtable Angela Merkel may be forced to contemplate allowing the European Central Bank to become quite a bit more like the US Federal Reserve. Otherwise, European divisions made obvious during the latest Greek elections may become irresistible tidal forces as the crisis reaches Spain and Italy, opening an economic chasm into which even Germany could fall.

In the wake of two rounds of “quantitative easing” that have left the Fed owning about 12% of US Treasury debt, the Fed has announced its intention to continue attempting to stimulate the economy by extending “Operation Twist,” selling shorter dated Treasuries and buying longer maturity T-bonds in order to bring down long-term borrowing costs (see “Uncle Ben’s Reverted Price”). But US long rates are already quite low, indicating that, at least for the moment and despite past and potentially future fiscal fireworks on Capitol Hill, the bond markets remain rather unconcerned about US credit quality. This may be in no small measure due to the Fed’s demonstrated willingness to purchase massive amounts of Treasuries.

By contrast, as euro-crisis contagion spread from Greece to the rest of the periphery, the sharp rise in the yields of Spanish, Italian and of course Greek debt speak to markets’ deteriorating faith in these credits. For a time these rate hikes were held in some check by ECB sovereign debt purchases; since 2010 the central bank has bought some 200 billion euros of Portuguese, Irish, Italian, Greek and Spanish (PIIGS) paper, creating a degree of precedent for this kind of strategy. However, unlike the Fed, the ECB’s constitution does not include a mandate to pursue full employment in addition to maintaining price stability, so the euro’s central bank was forced to act in the name of maintaining the integrity of the banking system, whose collapse could be deflationary. Two German ECB members took such exception to this rationale that they resigned in succession, reflecting Germany’s traditional post-war concern regarding inflation. For Mario Draghi, the ECB president who recently highlighted the limits to what the central bank can do absent fiscal and structural reform in Europe, much more substantial action would likely require German support, and the quid pro quo of at least a somewhat credible promise of that reform.

Like their American counterparts, the yields on German bunds are quite low. And for Germany as for the US, these low yields are not due to low debt to GDP ratios, as the German figure is now near 90% and likely to rise significantly higher with the announced issuance of Deutschland bonds through which the central government will back borrowing by German states. Rather, both the US and Germany are in some sense in command of the mechanism for creating the currency in which they borrow; for the US this power is unambiguously invested in the Fed, while Germany enjoys a kind of negative control of the ECB, since with the exception of Finland and the Netherlands, the rest of the eurozone seems to have little objection to money creation through policies such as sovereign debt purchases.

A crucial point here, and one readers of this blog will be familiar with, is the difference between real default on sovereign debt caused by inflation and nominal default, in which the bonds do not fully pay off, even in a depreciated and inflated currency (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility”). Because the latter does not result in an inability of banks and other holders of bonds to meet their obligations (like deposits) payable in the same currency as the bonds, the real default of inflation, though potentially quite pernicious, may not precipitate acute systemic financial crises, and thus institutions may be willing to hold debt at risk of inflation but not nominal default. So at least until the inflationary crows hatched by monetization come home to roost, a central bank’s buying of its currency’s sovereign debt may lower yields on that debt, as may even the possibility of such buying, based on the central banks’ ability to make such purchases.

Germany is understandably wary of letting profligate states borrow on its credit card. If it’s serious about not allowing eurozone-wide “Eurobonds” to refinance peripheral debt, and with the necessarily limited firepower of bailout funds like the European Financial Stability Facility (EFSF) and its successor, the European Stability Facility (ESM) limiting their credibility, an ECB with the theoretically unlimited power of the monetary printing press may have to be the buyer of last resort for the debt of the PIIGS, effectively creating euros to re-liquify the banking system, preventing runs and reflating the eurozone’s economy. For Germany, staying in the euro absent such an action could mean the loss of its periphery export markets while its own bank exposure to those countries drags the German economy down (see “It’s Hard To Make That German Export Wiener Without PIIGS – And That Goes For Chinese Dumplings, Too.”). Alternatively, a report from Merkel’s own government puts the cost of an exit from the common currency at 500 billion euros, with a 10% GDP drop and five million Germans unemployed.

Ah, but there’s the matter of those inflationary blackbirds I mentioned, and an old Spanish saying – if you raise crows they will peck out your eyes. With eurozone inflation running at 2.4% in May and the German rate even lower (1.7% in June), the ECB has some inflationary breathing room, ironically due to a global economy weakened by the euro crisis itself. Yet Germany’s concerns are well founded, and in exchange for a more Fed-like ECB it could and should insist on rapid reforms in Europe. These would have to go beyond austerity and the purely fiscal, embracing structural changes addressing woefully low competitiveness in much of the eurozone. Only then can there be confidence in a limit to monetization and any hope of peripheral countries paying debts current and future. Clear milestones and a commitment to a time scale much faster than the ten years contemplated in European Council President Van Rompuy’s plan would be essential. Unfortunately, the most serious opposition to such reform is likely to come from the new French government, which would have to reverse the newly elected François Hollande’s support of earlier retirement benefits and restrictions on layoffs even as French competitiveness dives.

But hey, what in the last two hundred years of Franco-German relations would cause one to doubt that France and Germany can’t work things out?

Uncle Ben’s Reverted Price

April 19th, 2012

The price of financing the U.S. debt is the interest paid to America’s creditors, but to whom does America pay that interest? Who owns the biggest slice of the U.S. debt? If you’re thinking China or Japan, those trade deficit bogeymen of the East, you’d be wrong and by quite some distance: those relative pikers are in a close battle for second, with the PRC slightly edging out Nippon but each holding about a trillion dollars worth, good for 7% apiece. The reigning champ out-distances both by 70%, holding $1.7 trillion dollars or nearly 12% of America’s $14.28 trillion national debt. Fortunately for Uncle Sam, however, that top lender is like no other, for this is a creditor from whom all interest paid on the debt it holds is “reverted” straight back to the borrower, which is to say the U.S. Treasury. I refer, of course, to the Federal Reserve.

With the Fed funds rate hovering near zero, the Fed resorted to massive Treasury purchases in an effort to drive down interest rates and stimulate the economy, a policy which has made the central bank Washington’s largest creditor. Because all Fed profits are rebated back to the Treasury, the interest on the 12% of U.S. debt held by the Fed is being returned directly to the Federal government’s coffers and, by extension, to American taxpayers, since every dollar of interest the Treasury receives back from the Fed is a dollar it does not have to collect from taxpayers in order to finance the debt. Given that 20% of tax revenue goes to servicing this debt, that’s quite a break we’re receiving from Bernanke & Company.

Yet it gets better. Like disk jockeys programming an oldies station, the FOMC’s members recently brought back a blast from the past, the 1961 monetary policy sensation known as “Operation Twist.” In the September 2011 remix of this interest rate two-step, the Fed announced it would sell $400 billion of Treasuries with maturities of no more than three years, using the proceeds to purchase an equal amount of 6- to 30-year T-bonds. Given how low short rates already are, the idea is to lower rates at the long end of the yield curve by pushing out the maturity of the central bank’s holdings and taking longer-dated T-bonds out of the market. The theoretical argument is that lowering the long rates should stimulate the economy, while the counter-balancing short-maturity sales hold the size of the Fed’s balance sheet constant. A side effect of this kind of maneuver is that, as it skews the Fed’s holdings toward higher-yielding long Treasuries, the fraction of total interest on U.S. debt rebated to the Treasury by the Fed will increase even though the value of the Fed’s Treasury holdings are held constant. As an added bonus, those lower long-term rates mean reduced long term costs of further borrowing by the Treasury as it finances that ever-increasing U.S. debt.

All this may sound suspiciously like the free lunch your economics professors told you was but a culinary myth. But the tab’s arrival may be delayed while markets extract a higher price for the fiscal over-consumption of other nations. The Fed’s epic Treasury purchases are funded by money the central bank creates and injects into the markets, which, ceteris paribus, might be expected to depress the value of the dollar and increase inflation. However, ceteris hasn’t been particularly paribus lately; ongoing Euro-antics continue to place a safe haven premium on both the currency and debt of the United States (see “Send Treasury Your Retired, Your Not-So-Poor, Your Befuddled Classes Yearning To Invest Risk-Free…”) while, in the wake of the financial crisis, sluggish global growth has restrained increases in both labor and commodity costs. This trend has been reinforced of late by recent slowdowns in China and India, engineered by those countries’ central banks in the hopes of restraining their own domestic price pressures.

Nevertheless, the nascent recovery in the U.S. has been attended by a run-up in the price of oil and, recently, rising unit labor costs, causing the TIP spread between regular and and inflation-protected Treasury bonds to widen, albeit modestly. If, as some recent data from Beijing indicate, China’s landing proves to be more of a brief layover, and should concern over a full-blown Euro implosion continue its recent ebbing, then the U.S. may learn a truth diners at complimentary buffets generally discover: sooner or later, gorging on a seemingly free lunch is paid for with inflation, be it in your waistline or your currency. But for a Fed faced with the alternative of stalled growth, increased inflation risk may be, as the old saying goes, just the price of rice, converted or not.

“Send Treasury Your Retired, Your Not-So-Poor, Your Befuddled Classes Yearning To Invest Risk-Free…”

February 9th, 2012

If they continue on their current course, the architects of America’s fiscal and monetary policies might want to consider the above revision to Emma Lazarus’ great exhortation on the pedestal of the Statue of Liberty. For it is in no small measure the flight of capital from investment on other shores that’s has been driving down yields on United States Treasuries, allowing the US to borrow with remarkable abandon despite ratings downgrades and Washington’s ongoing budget follies. As forbidding as the US debt and deficit might be, last year investors continued to bid up America’s debt, lowering the interest cost to finance economic stimulus programs while keeping tax rates unchanged. This injection of capital has almost certainly helped to spur the nascent US recovery, just as some economists argue pre-war European flight capital helped lift America out of the Depression in the later 1930’s.

Washington has had various factors to thank for the easy credit terms the world continues to offer. From Iranian saber-rattling to Japanese earthquakes, many forces served to drive frightened capital into the arms of the US Treasury market. However, at the top of the list is surely the political leadership of the Eurozone. The Obama-Boehner show has nothing on the extravaganza headlined by Merkel and Sarkozy, with a supporting cast of various and changing guest stars governing the solvency-challenged PIIGS (Portugal, Ireland, Italy, Greece and Spain) and of course the folks at the IMF and ECB (every comedy needs a few straight men and women, after all). This noisome cavalcade had provided a continuous flow of confidence-shaking news, keeping sovereign default risk and systemic shock ever present in investors’ minds. Meanwhile, the US has muddled through a budget deal which, while insufficient in the long run, indicated some capacity for concord even in the current poisonous political atmosphere. Similarly, the Fed, aided by TARP financing, seemed to succeed in stabilizing the American financial system. Through late in 2011, the result was an increase in the cost of euro-denominated borrowing for key large Euro sovereigns with the exception of Germany, the yield on whose bunds declined almost in lockstep with a simultaneous drop in US Treasury bond yields.

At the time of this writing, with the “voluntary” Greek debt restructuring talks dragging on, observers may understandably have a difficult time conceiving of an end to “Euro-fear.” Nevertheless, it is precisely the possibility that, with or without Greece in it, the Eurozone will find a way to get its house in some kind of order that threatens America’s ultra-low borrowing costs. We are in fact seeing some tentative signs of, as Churchill put it, not the end or even the beginning of the end, but perhaps the end of the beginning.

New ECB president Mario Draghi’s Long Term Refinancing Operation ostensibly provides a three-year, multi-hundred-billion euro stabilization line of credit to European commercial banks, but as the ECB is “allowing” (read: encouraging) those banks to use this credit to buy better European sovereign bonds (and avoid having to dump weaker Euro nation credits in bulk) what we’re really seeing is a back-door program to lower European states’ borrowing costs. Because the ECB loans represent money created by the central bank, this is a form of bailout that does not require direct taxation of “core” European nations citizens (e.g. Germans), though to be sure, they may end up paying the price through inflation (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility”) and devaluation, though export-driven economies like Germany actually need a weaker currency more than they might like to admit (“It’s Hard To Make That German Export Wiener Without PIIGS – And That Goes For Chinese Dumplings, Too”).

Second, whether or not the Greek debt restructuring talks result in a formal default or an effective one (and the contemplated 70% write-down will surely be a default in fact if not in name) is not so important as whether the process is orderly. So long as any any write-offs and triggered credit default swaps are handled in a way that does not lead to bank runs and frozen markets, such an event could be kept contagion free. There is no guarantee such a systemically benign scenario will play out, but the aforementioned willingness of the ECB to inject liquidity on a massive scale does provide reason for optimism.

And therein lies the rub for US government borrowing costs: as the Eurozone crisis subsides, so may the safe haven “panic bid” on US Treasuries, causing the yields on those bond to rise and further increasing the burden on American taxpayers of financing the deficit. Indeed, the 10 year US Treasury yield has crept up from below 1.87% in late November of last year to over 2.02%, while conversely (and despite it’s own rating downgrade), France’s ten year debt yield declined to below 2.90% since spiking above 3.73% during the same period. Similarly, the Italian 10 year yield dropped from over 7.36% to less than 5.49%.

To be sure, there are significant benefits to the US economy in this “risk-on” shift; the reduction in Eurofear has bolstered equity markets with a knock-on wealth effect boosting consumption and, yes, tax-revenue even in the absence of a rate hike. Even so, higher T-bond rates translate into an increased cost of servicing America’s heavy debt, so even if the core Euro countries seem to be picking up the tab, their Greek holiday may not come without cost for Uncle Sam.

N.B.: One advantage of a weakened euro – cheaper French wines (in dollar terms), and in particularly that said-to-be-excellent 2009 Bordeaux vintage; for insight into this and all things vino, check wine expert (and Duke econ grad) Jessica Bell’s very excellent webcasts at MyWineSchool.com.

It’s Hard To Make That German Export Wiener Without PIIGS — And That Goes For Chinese Dumplings, Too.

October 27th, 2011

With all the flack Angela Merkel has taken at home for agreeing to help bail out Greece, one could be forgiven for wondering why the Chancellor would want to yolk Germany’s seeming paragon of export-driven economic strength to the Hellenic basket case, let alone to the fortunes of those other peripheral euro states that, with Greece, are collectively known as PIIGS (Portugal, Ireland, Italy, Greece and Spain). Perhaps counter-intuitively, part of the answer lies in the fact that German exports are actually made more competitive because of the weakening of the euro caused by the participation of the PIIGS in that currency.

A weaker euro means relatively cheaper prices for German goods in the currency of non-Eurozone trading partners, giving German exporters an edge in world markets. To understand this effect, one must first consider two histories: that of the euro since its birth, and of German exports prior and subsequent to that introduction.

For all its troubles, the euro has strengthened considerably since its first day of trading, January 5, 1999. It hit $1.19 that day, but by December 3 of the same year it fell below parity with the dollar. The currency has since risen over 40% to $1.4172 as of this writing (it hit a high of $1.5892 on July 7, 2008). Now this appreciation versus the greenback has occurred despite the presence of the PIIIGS in the eurozone, with all the systemic risk that their potential sovereign defaults pose to European banking and economic growth. Imagine how much higher the euro might trade were the PIIGS to exit Euroland’s pen, remaking the euro into something more in the image of the old German mark!

So how did German exports fare before and after it traded marks for euros? From January 1991 to January 1999, under the old mark (1991 being the first full year following reunification) German monthly exports rose from around 30 to 40 billion euros, an increase of about 4% per year. By contrast, in the euro period from January 1999 to January 2011 Germany’s exports rose to over 80 billion euros per month, an increase of over 6% per year (German exports dropped sharply during the ’08-’09 financial crisis but have subsequently more than rebounded, hitting 97 billion euros in April 2011 before easing to 85 billion in September).

Would German exports have risen as sharply were the nation still using a mark, reflecting solely that nation’s monetary policy, as opposed to a euro in whose valuation German export strength, traditionally tight postwar German monetary policy and relatively conservative German fiscal policy are diluted by the PIIGS’ trade weakness and profligate budget policy, not to mention power sharing in the European Central Bank? I strongly doubt it.

To be sure, 60% of German exports still go to the EU, where the euro’s exchange strength would be irrelevant. But it is trade with China that is providing the growth in German exports, having risen four fold over the last ten years to rival the US as Germany’s largest single national market at 5.6% of the nation’s foreign sales, a figure that may triple by the end of this decade. This ballooning China trade is in turn driving German economic growth. Without the squealing PIIGS of the Eurozone’s periphery, a stronger euro could make German goods less competitive and have serious consequences for continued China-trade driven economic expansion.

There is perhaps some irony that, in addition to a “voluntary” 50% markdown in Greek bank debt, Europe is turning to China in hopes of having that nation finance some of the expanded $1.4 trillion European Financial Stabilization Fund, perhaps directly or through the IMF. Like Germany, China’s expansion is dependent on exports, and the global slowdown that could come in the wake of a euro collapse would threaten those sales. Meanwhile, Chinese inflation is still running high, driven by an undervalued yuan and tight commodity markets, so Beijing may also find continued euro-discounted German manufactured imports not unwelcome. And investment in euro assets provides China with some diversification from its substantial dollar holdings.

Chinese investment could at least lessen the need for debt monetization (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility”) and/or the issuance of Eurobonds directly backed by German taxpayers, perhaps under some kind of Eurozone fiscal union. That would be welcome news for Merkel. The former is anathema to a nation whose prewar experience with inflation had the darkest of consequences. As to the latter, Germany’s 83% debt-to-GDP ratio (it may hit 87% in short order, jumping from approximately 67% in 2007) is not at Greek or even American levels, but still speaks to Germany’s own bloated welfare state, which combined with past and potential bank bailouts, stimulus and Eurobond exposure to the PIIGS could yet make even German borrowing unsustainable, bringing us back to monetization and inflation.

So fortunately for Merkel, China seems to realize PIIGS are a desirable ingredient in dumplings as well as wieners. It remains to be seen if Beijing’s investments will eliminate or merely forestall the need for stronger measures. The Chancellor recently warned that the issuance of Eurozone debt and fiscal union would lead to “solidarity in mediocrity.” Yet when your export-led economy is partially built on the weakness of your currency partners, some economic convergence may be inevitable; a cruel truth, perhaps, but  then they don’t call it reversion to the “mean” for nothing.