Friday, February 27, 2015

Sundry links

No time for writing this week, so I'm listing blog posts and articles that caught my eye recently:

1. Liftoff levers. John Cochrane is doing a fantastic job explaining how the Fed's reverse repo operations are supposed to work. Start with this post, and then read this other one.

2. A "new" working paper, by Katharina Knoll, Mortiz Schularick, and Thomas Steger, looks at global house prices in the really long run (1870-2012). From the abstract:
...house prices in most industrial economies stayed constant in real terms from the 19th to the mid-20th century, but rose sharply in recent decades. Land prices, not construction costs, hold the key to understanding the trajectory of house prices in the long-run. Residential land prices have surged in the second half of the 20th century, but did not increase meaningfully before. We argue that before World War II dramatic reductions in transport costs expanded the supply of land and suppressed land prices. Since the mid-20th century, comparably large land-augmenting reductions in transport costs no longer occurred. Increased regulations on land use further inhibited the utilization of additional land...
3. An Icelander goes to Cyprus and tells us why Cypriots keep cash worth 6% of GDP under the mattress.--Sigrún Davíðsdótti at A Fistful of Euros.

4. China's monetary and exchange rate framework under pressure.

           4.1 Huge FX inflows turn into small outflows, and the PBoC switches from draining renminbis to injecting them. To keep base money growing, the central bank has introduced new tools. By Gabriel Wildau for the Financial Times.

           4.2 Time to ditch the renminbi-dollar peg? The Chinese currency has depreciated and is hitting the central bank's target band.

           4.3 On the internationalization of the RMB, a colleague forwards several papers and reports
                 Paths to a reserve currency, at the Asian Development Bank Institute.
                 The rise of the redback, by HSBC.
                 Yuan is fifth world's payments currency, at the WSJ.
               
An important event to keep in mind is that the IMF is reviewing the SDR basket in 2015. China is under pressure to step up the internationalization of the renminbi, ahead of the basket review.

5. Dani Rodrik summarizes the results of his latest paper on de-industrialization.

Premature deindustrialization is not good news for developing nations. It blocks off the main avenue of rapid economic convergence in low‐income settings, the shift of workers from the countryside to urban factories where their productivity tends to be much higher.
Industrialization contributes to growth both because of this reallocation effect and because manufacturing tends to experience relatively stronger productivity growth over the medium to longer term. In fact, organized, formal manufacturing appears to exhibit unconditional convergence (Rodrik 2013), which makes it special and an engine of growth. Since low‐income countries tend to start with small manufacturing sectors, the dynamic within manufacturing initially plays a small role, overshadowed by the reallocation effect. But over time, the within‐manufacturing effect becomes a more potent force as the manufacturing sector becomes larger.Premature deindustrialization throws sand in the wheels of both engines (Rodrik 2013, 2014).
The consequences are already visible in the developing world. In Latin America, as manufacturing has shrunk informality has grown and economy‐wide productivity has suffered. In Africa, urban migrants are crowding into petty services instead of manufacturing, and despite growing Chinese investment there are as yet few signs of a real resurgence in industry. Where growth occurs, it is driven largely by capital inflows, transfers, or commodity booms, raising questions about its sustainability.  
In the absence of sizable manufacturing industries, these economies will need to discover new growth models. One possibility is services‐led growth. Many services, such as IT and finance, are high productivity and tradable, and could play the escalator role that manufacturing has traditionally played. However, these service industries are typically highly skill‐intensive, and do not have the capacity to absorb – as manufacturing did – the type of labor that low‐ and middle‐income economies have in abundance. The bulk of other services suffer from two shortcomings. Either they are technologically not very dynamic. Or they are non‐tradable, which means that their ability to expand rapidly is constrained by incomes (and hence productivity) in the rest of the economy.

I couldn't help but tie Rodrik's paper to that other paper by Pritchett and Summers, the one about regression to the mean of long-term growth rates. Growth is far from a uniform process. It tends to happen in fits and starts. Those who are projecting high growth rates of developing economies, based on past high growth rates, which in turn hinged on industralization, are probably going to be disappointed.

6. The translation industry.The Economist opines that translation is very hard for machines. Humans will need to stay involved, but technology will improve productivity.

A different question: Do improvements in translation bode well for language diversity in the world? How about the language learning industry? I see this as a race between technologies that allow machines to translate better, and technologies that allow humans to learn languages faster. The machines are winning, by a long shot. We're clearly on a path to better simultaneous translation capabilities. Soon we'll be able to listen to anything, anywhere in our native tongue, in real time. That means humans won't have to know more than one language. Learning languages will become a hobby, like dancing. (Sorry, parents, but you're wasting your money on Mandarin lessons.)

As for language diversity, I think a more important force than technology is urbanization. The lion's share of the world's languages are spoken by small, rural communities in developing countries. Urbanization increases the usefulness of majority languages, killing the minority languages. And urbanization will happen faster than the spread of cheap, simultaneous translation technology. At some point, however, the trend towards fewer and fewer languages will slow down, as simultaneous translation becomes pervasive.

Friday, February 20, 2015

Is aging deflationary?

Hideki Konishi, Kozo Ueda, and Mitsuru Katagiri presented a few months ago a paper titled "Aging and deflation from a fiscal perspective." Here are the slides.

The authors build a model that combines overlapping generations, the fiscal theory of price determination, and political considerations to analyze how the price level changes with fertility and longevity.

The simplified version of the model, in section two of the paper, assumes that taxes are exogenous. This simple version, nevertheless, is enough to produce a key result:
"Aging is deflationary when caused by an increase in longevity, but inflationary when caused by a decline in birth rate." 
The reason is political considerations:
"If the birth rate declines, the resultant contraction in the tax base reduces the fiscal surplus. The government is then inclined to maintain its solvency partly by generating inflation at the cost of the older generation's well-being and partly by making the younger generation pay more taxes. In contrast, if the life expectancy increases and older persons survive longer than expected, they might face a shortage of savings for their retirement period. The government then, led by the strengthened political influence of the older generation, attempts to suppress inflation and increase the real value of the government bonds held by the older generation."
Japan has experienced both unexpected declines in fertility and unexpected increases in longevity. The deflationary effect of higher longevity, however, dominated. The authors' simulations of the model show that Japan's aging depressed inflation by 0.6 percentage points annually.

Another key result, which comes from the fiscal theory of price determination, is that our children don't pay for our deficits. The government debt at the beginning of each period is fixed in nominal terms. Today's price level changes to equate the real value of today's debt with the present value of future deficits.

A corollary of this result is that tomorrow's fiscal policy is not constrained by today's level of debt or fiscal policy. Governments are unencumbered by the deficits of their predecessors in office.

A second corollary of the fiscal independence result is that governments don't have an incentive to strategically accumulate debt. In some political economy models of fiscal policy, a government can tie the hands of a successor it dislikes, by raising debt. If the price level, however, adjusts every year to fulfill the government's inter-temporal budget constraint, strategic debt accumulation doesn't happen.

I thought this paper was a refreshing way of looking at the link between deflation and aging.

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

Other recent papers (post 2000) about this topic, in chronological order:

Lindh, T. and B. Malmberg (2000) “Can age structure forecast inflation trends?”, Journal of Economics and Business, 52, pp 31–49.

The demographic age structure influences the aggregate of individual economic decisions. Standard macroeconomic models imply that inflation pressure will covary with the age distribution unless accommodated by monetary policy. We estimate the relation between inflation and age structure on annual OECD data 1960–1994 for 20 countries. The result is an age pattern of inflation effects consistent with the hypothesis that increases in the population of net savers dampen inflation, whereas especially the younger retirees fan inflation as they start consuming out of accumulated pension claims. This can be explained, for example, with life-cycle saving behavior combined with a cumulative process of inflation, but other mechanisms are also consistent with the results. In any case, the results suggest that demographic projections may be useful for long- and medium-term inflation forecasts. Forecasts from our panel model catch the general downward trend in OECD inflation in the 1990s. However, useful forecasts for individual countries need to incorporate more country-specific information.


Bullard J., C. Garriga and C. J. Walker (2012) “Demographics, Redistribution, and Optimal Inflation” Federal Reserve Bank of St. Louis Review, November/December 2012, 94(6), pp. 419–39.

The authors study the interaction among population demographics, the desire for intergenerational redistribution of resources in the economy, and the optimal inflation rate in a deterministic life cycle economy with capital. Young cohorts initially have no assets and wages are the main source of income; these cohorts prefer relatively low real interest rates, relatively high wages, and relatively high rates of inflation. Older cohorts work less and prefer higher rates of return from their savings, relatively low wages, and relatively low inflation. In the absence of intergenerational redistribution through lump-sum taxes and transfers, the constrained efficient competitive equilibrium requires optimal distortions on relative prices. The authors’ model allows the social planner to use inflation/deflation to try to achieve the optimal distortions. In the model economy, changes in the population structure are interpreted as the ability of a particular cohort to influence the redistributive policy. When older cohorts have more influence on the redistributive policy, the economy has a relatively low steady-state level of capital and a relatively low steady-state rate of inflation. The opposite happens when young cohorts have more control of policy. These results suggest that aging population structures, such as those in Japan, may contribute to observed low rates of inflation or even deflation.


Anderson, D., D. Botman and B. Hunt (2014) ”Is Japan’s Population Aging Deflationary?” IMF Working Paper 14/139, August.

Japan has the most rapidly aging population in the world. This affects growth and fiscal sustainability, but the potential impact on inflation has been studied less. We use the IMF’s Global Integrated Fiscal and Monetary Model (GIMF) and find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly makes matters worse as it leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need. Many of these factors will beset other advanced countries as well, but we find that deflation risk from aging is not inevitable as ambitious structural reforms and an aggressive monetary policy reaction can provide the offset.


Yoon, J.-W., J. Kim and J. Lee (2014) “Impact of Demographic Changes on Inflation and the Macroeconomy” IMF Working Paper 14/210 November.

The ongoing demographic changes will bring about a substantial shift in the size and the age composition of the population, which will have significant impact on the global economy. Despite potentially grave consequences, demographic changes usually do not take center stage in many macroeconomic policy discussions or debates. This paper illustrates how demographic variables move over time and analyzes how they influence macroeconomic variables such as economic growth, inflation, savings and investment, and fiscal balances, from an empirical perspective. Based on empirical findings—particularly regarding inflation—we discuss their implications on macroeconomic policies, including monetary policy. We also highlight the need to consider the interactions between population dynamics and macroeconomic variables in macroeconomic policy decisions.


Juselius, M. and Takáts, E. (2015) “Can Demography Affect Inflation and Monetary Policy?” BIS Working Paper 485, February.

Several countries are concurrently experiencing historically low inflation rates and ageing populations. Is there a connection, as recently suggested by some senior central bankers? We undertake a comprehensive test of this hypothesis in a panel of 22 countries over the 1955-2010 period. We find a stable and significant correlation between demography and low-frequency inflation. In particular, a larger share of dependents (ie young and old) is correlated with higher inflation, while a larger share of working age cohorts is correlated with lower inflation. The results are robust to different country samples, time periods, control variables and estimation techniques. We also find a significant, albeit unstable, relationship between demography and monetary policy.

Friday, February 13, 2015

Leveraging, deleveraging, and assets

The world might not be "deleveraging," but I wouldn't know just by looking at the debt-to-GDP ratio.

The latest update to the McKinsey Global Institute's "Debt and deleveraging" report says that
...debt continues to grow. In fact, rather than reducing indebtedness, or deleveraging, all major economies today have higher levels of borrowing relative to GDP than they did in 2007. Global debt in these years has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points.
What does a debt-to-GDP ratio of, say, 286% mean? It means that if a country devoted all its income to paying down debt, it would take 2.86 years, at today's income level, to pay it all off. And if the ratio rises to 300% next year, it means the country's debts grew faster than its income.

At first consideration it makes sense to normalize debt levels across countries and over time using GDP. Bigger and wealthier nations should be able to support more debt than smaller or poorer ones. And if income grows over time, a country should have the capacity to borrow more.

The proceeds from borrowing, however, are (often) not consumed, but rather used to buy assets. And if you have more assets you should be able to bear more debt too.

Suppose you make $200k this year. You buy a house that costs $500k, making a $100k downpayment, and getting a $400k mortgage. You have no other assets or debt. Your debt-to-income ratio in year 1 is 2 ($400k / $200k).

Next year you make $200k again, save $100k, and buy another $500k house, with a $400k mortgage and $100 downpayment. The principal on the first mortgage is still $400k. Now your debt-to-income ratio is 4 ($800k / $200k). Your "leverage" is going up fast!

If you measure leverage a different way, however, you will see that debt is not going up at all. Continuing with the example above, the debt-to-equity ratio is 4 at the end of year 1 ($400 / $100), and still 4 at the end of year 2 ($800 / $200). Leverage is stable.

You could question whether servicing an $800k debt is a sane financial decision for somebody with a stagnant $200k income. But a broad discussion about "leverage" shouldn't leave the two houses out of the equation.

"Leverage," measured by the conventional debt-to-GDP ratio, has been going up in a number of countries for decades:








Other than Japan, debt-to-GDP has been generally going up in the long run.

You might think that the world has been on a multi-decade borrowing binge that will be, eventually, corrected. But while we wait for the Big Crash, we could entertain another possibility: the economy's balance sheet is just growing faster than income is.

I don't mean to say there's nothing to worry about. I have no clue whether national assets or equity have gone up in most countries, or whether the increase in the value of assets or equity matches the rise in debt. Besides, asset values can fall just as quickly as they rise. And, crucially, one needs to consider the distribution of assets and debt within the economy to make any assessment of "stability," "risk," or "sustainability."

Nonetheless, looking at rising debt-to-GDP ratios and concluding, as McKinsey does, that leverage is going up, which "poses new risks to financial stability and may undermine global economic growth," is quite a leap, to the say the least. A more complete assessment of "leverage" would be welcome.

P.S. Antonio Fatás has similar concerns about the McKinsey report.

Friday, February 6, 2015

Growth and productivity in developed countries: the 2007-13 record

A recent post by Antonio Fatás got me curious about the composition of growth between 2007 and 2013. (Beware, however, that the period doesn't comprise a full business cycle, and that some European economies suffered two recessions during that period.)

Antonio shows that, between 2007 and 2013, the growth of productivity -measured as GDP per worker- was strongest in Spain, U.S., and Ireland. (I don't know where his data come from, so I make no attempt to replicate, correct, or comment on his findings.)

I look at data on the decomposition of growth from the Conference Board's Total Economy Database (TED). I start with the (geometric) average growth rate of GDP:


Australia, Switzerland, Canada, and the U.S. posted the fastest growth, whereas the GIPS were the weakest.

How was growth split between the increases in labor quantity and labor productivity?



Once again, the GIPS shed the most labor, whereas Australia, Switzerland, Norway, and Canada added the most. (Notice that three of the top four are commodity economies.) In the U.S. total labor input decreased between 2007 and 2013 (although much less than in the GIPS).

On productivity, Australia is still among the top performers, and so is Canada. But here the news is that two of the GIPS (Ireland and Spain) are near the top, along with the U.S. In Italy and Greece productivity declines sharply, and so does in the U.K. This feature of the U.K. recovery (relatively small job loss, and massive declines in productivity) has been covered several times by the FT.


Productivity growth can further be decomposed into the contributions of: changes in labor composition (essentially, changes in the education of the employed), capital additions, and "dark matter" (also known as total factor productivity).

Starting with labor composition:


Portugal, Greece, and Spain improved the quality of their employed the most, whereas Italy did so the least. The labor composition didn't make a negative contribution to growth anywhere.

The contribution of capital (the sum of ICT and non-ICT capital) was also positive in every country, and was largest among commodity economies, as well as Ireland. Greece here is number six. Italy is once again last.


Finally, and strikingly, total factor productivity growth was negative almost everywhere:


TFP contributed the most to growth in some of the richest economies (U.S., Japan, Germany, Switzerland) and the least in Greece, Norway, U.K., and Portugal.

To sum up:

1) Output growth was fastest among commodity economies (Australia and Canada), as well as the U.S. and Switzerland, thanks to generally growing labor input (or a small loss, in the U.S.), fast growth of capital, and some growth of TFP in the U.S.

2) Labor composition (the "quality" of labor) added to growth everywhere, whereas total factor productivity was negative everywhere except in the U.S. and Japan.

3) Southern European countries lost the most employment.

4) Productivity shrunk by a massive amount in Greece. Italy, the U.K., and the Netherlands also saw their productivity decline.


Friday, January 30, 2015

Those shifty inflation expectations

Market-based measures of U.S. inflation expectations plummeted over the last quarter of 2014--which is a concern now that inflation is so low. In particular, two market-based gauges are often quoted: the break-even rate from 5- and 10-year bond yields, and rates from inflation swaps.

Janet Yellen thinks that factors other than inflation expectations may be moving these "inflation compensation" rates (emphasis mine):
There are a number of different factors that are bearing on the path of market interest rates, I think, including global economic developments. It is often the case that when oil prices move down and the dollar appreciates, that that tends to put downward pressure on inflation compensation and on longer-term rates. We also have safe-haven flows that may be affecting longer-term Treasury yields. So I can’t tell you exactly what is driving market developments. But what I can say is that we are trying to communicate our thoughts as clearly as we can.
[...] 
Oh, and longer-dated expectations. Well, what I would say, we refer to this in the statement as “inflation compensation” rather than “inflation expectations.” The gap between the nominal yields on 10-year Treasuries, for example, and TIPS have declined—that’s inflation compensation. And five-year, five-year-forwards, as you’ve said, have also declined. That could reflect a change in inflation expectations, but it could also reflect changes in assessment of inflation risks. The risk premium that’s necessary to compensate for inflation, that might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets. And, for example, it’s sometimes the case that— when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries and could also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation. And we indicated that we are monitoring inflation developments carefully.
Summarizing, Yellen mentions four things that, together or individually, compress "inflation compensation" (the yield charged by investors for bearing both inflation and inflation risk):

1. Oil prices
2. Exchange rate
3. Safe-haven flows
4. Dispersion of inflation expectations

As I said, there might be correlation among those four factors. I would add a fifth item, which is perhaps correlated to "safe-haven" flows: liquidity. As the market in nominal treasuries is deeper than that in TIPS, and investors have a preference for liquidity, a surge of inflows to the dollar may increase the liquidity premium that TIPS must offer, reducing the break-even inflation rate. I wrote about this a long time ago.

Recent developments offer a glaring example of how "inflation compensation" measures can be a noisy gauge of true inflation expectations. See, for instance, these charts:

Source: FRED.

Source: Capital Economics, Global Economic Update, Jan. 27.

Notice the co-movement of the short-term changes of long-term "inflation expectations" and the price of oil. I can't think of a reason why today's changes in the price of oil should affect so much the market's assessment of inflation five years from now, over the following five years. Neither break-even rates nor inflation swap rates seem, then, reliable gauges of inflation expectations.

The Federal Reserve Bank of Cleveland has published for quite some time an estimate of inflation expectations that combines surveys of forecasts with market prices to come up with a (better?) measure of inflation expectations. (The methodology paper is here.)

Below is a chart of the price of Brent, the 5y-5y expected inflation measure from break-even rates, and a 5y-5y estimate from the Cleveland Fed's time series. The Cleveland Fed doesn't give you the 5y-5y forward rate, so I computed the latter with the usual spot-forward formula:

$$(1+\pi _{0,10}^{e})^{10}=(1+\pi _{0,5}^{e})^{5} (1+\pi _{5,5}^{e})^{5}, $$ where \({\pi}_{n,m}^{e}\) is the annual rate of inflation expected \(n\) years from now, over the next \(m\) years. The forward inflation rate we're interested in is the second term on the right-hand side.


Up until 2008, the gap between market-based and Cleveland Fed estimates was small and transitory. Then the two diverged, especially after 2010. For a while I was suspicious: the Cleveland Fed's estimates had become more than one percentage point lower than the estimates from break-evens, and the level was persistently close to 1.5%--too low, from a(n admittedly subjective) point of view.

Of late this has changed, as the 5y-5y breakeven has plummeted, but the Cleveland Fed's estimate has not. More importantly, the Cleveland Fed's measure continues to be much less sensitive to the price of oil than the market-based estimate, which is a desirable feature for an estimate of long-term inflation expectations.

Two important questions: Did the market-based estimate of expected inflation become more sensitive to the price of oil after 2008, as the chart suggests? (Beware, the price of oil might be a proxy for something else.) Why?

Friday, January 23, 2015

Fear depression, not deflation

Following up on a blog post by David Andolfatto, I checked on the deflationary experiences of seven countries during the 19th and 20th centuries.

The mainstream commentary these days is that deflation causes (or at least is associated with) declining real economic activity. Here's an example of this type of narrative:
Plenty of people are alarmed by the prospect of deflation, which can snuff out growth by making consumers reluctant to spend and companies unwilling to invest.
David's main point is that that's not always the case. Both the U.S. after the Civil War, and Japan since 2009, experienced declining price levels, but real GDP per capita rose.

I have put together a dataset of price indexes and growth between 1828 and 2006 for Australia, France, Netherlands, Spain, Sweden, U.S., and U.K. (Many thanks to the sources, especially measuringworth.com, and the International Institute of Social History, for distributing the data for free!)

It's relatively well known that prices were roughly steady in the 19th century, although income per capita rose quite a lot. The inflection point seems to be the Great War, but that's something I learned only after looking at the data.

See these charts and table:






This seems hard to reconcile with the conventional association between "lack of inflation" and "lack of growth."

Taking five-year growth rates, the association between inflation and real growth is hard to spot (the picture is very similar with one-year growth rates):





Finding "big" deflations

Ok, maybe you're thinking: 19th-century deflation was slow and steady. Under that type of deflation, declining prices are presumably expected, which should be less damaging than rapid, unexpected deflation.

To which I reply: But slow-and-steady is the kind of deflation that we're contemplating these days, right?

How about abrupt, big deflations? I don't know of a definition of "big" deflation, but I think most people have the American Great Depression in mind.

The U.S. price index bottomed in 1933, at which time the five-year, annualized inflation rate was -5.4%. So I have looked for deflations of this size across countries. When I find one, for a given country, I rule that a "big" deflation episode occurred, starting with the first year in which one-year inflation was negative, and ending with the first year in which prices rose (even if the five-year inflation rate was no longer below -5%). If the string of price declines is interrupted for only one year, I consider the episode of deflation was unbroken; if the string stops for two or more years (and five-year inflation eventually falls below -5%), then a new episode begins.

Using this admittedly ad hoc process, I find the following episodes of "big" deflation:


The table shows that, for example, Australian prices fell at a compounded rate of 3.6% a year between 1836 and 1851, for a total decline of 43%. Real GDP per capita went up by 5% a year.

Except for the deflations in the late 1920/early 1930s, output per capita didn't fall during deflations! It has been possible, and in fact frequent, to have rising real economic activity and falling prices, even with rapid deflation.

At the very least, I think we should agree that not all deflations are created equal. Only a small minority is associated with persistently declining real activity. And those experiences, over the last two centuries, have all happened during a peculiar period (the Great Depression).

What really hurts, then, is not deflation, but a depression, which is not what most people expect for the years ahead.

Data sources:

Real GDP per capita growth:

Maddison Project Database.

Inflation:

Australia: Diane Hutchinson
France: CGEDD
Netherlands: International Institute of Social History
Spain: Rafael Barquín Gil, Esmeralda Ballesteros, and Jordi Maluquer de Motes.
Sweden: Riksbank
United States: Lawrence H. Officer and Samuel H. Williamson
United Kingdom: Gregory Clark

+++++++++++++++++++++++++++++++++++++
UPDATE (2/15/2015): I just came across this paper, which does the empirical analysis I had in mind:

Atkeson, Andrew, and Patrick J. Kehoe. 2004. "Deflation and Depression: Is There an Empirical Link?" American Economic Review, 94(2): 99-103. Ungated version here.

And here's another paper, by Jess Benhabib and Mark Spiegel, with different conclusions.
+++++++++++++++++++++++++++++++++++++

Thursday, January 15, 2015

Is Greece's debt really so unsustainable? Yes, it is.

Lorenzo Bini Smaghi, former member of the executive board of the ECB, writes for the Financial Times that Greece's debt might be sustainable.

One of the points he makes is
...the sustainability of the debt depends on the dynamics over time rather than on the overall level. A high debt-to-GDP ratio can be more sustainable than a lower one, if the former component is expected to stabilise and fall over time, while the latter continues to grow unabated. In fact, the sustainability of the debt is inversely related with the level of interest rate paid on the debt, and positively related to the expected growth rate of the economy and the primary budget balance which has been achieved.
I can't argue with that.

He makes assumptions for the four variables that pin down the dynamics of the debt-to-GDP ratio, and concludes that Greece could reduce its debt burden by 40% of GDP by 2019.

I am shocked. If there was one thing I thought I knew about the Greek crisis, it's that Greece's debt is on an explosive path, under any realistic scenario for the relevant variables. But since a simple computation, in this case, can clarify a lot, I decided to check.

The sovereign debt-to-GDP ratio is governed by the familiar GIDDY equation:

$$D_t =  (1+y-g-i) D_{t-1} + d_t $$
where \(g\) is the growth rate of real GDP; \(i\) is the inflation rate; \(D_t\) is the debt ratio at time \(t\); \(d_t\) is the deficit, as a ratio to GDP; and \(y\) is the average interest rate on the debt (yield).

(I'm assuming all debt is in denominated in domestic currency,  in this case euros, so I can ignore changes in the exchange rate.)

Bini Smaghi draws his debt projections out to 2019, although he's not explicit about his assumptions year by year. Suppose, he says, that Greece grows 3% a year through 2019; it runs a primary fiscal surplus of 4.1% of GDP every year (as Bini Smaghi says Greece will do in 2015); and the average interest rate on debt is 4% (Bini Smaghi assumes 4%, because "official creditors have accepted a reduction of the interest rate on their loans to levels comparable to those of the best eurozone borrowers").

It's not clear whether his growth assumption is real or nominal. However, the debt reduction is way too small if his assumption is for nominal GDP. Let's be generous, then, and suppose he's talking about real GDP, and add an inflation rate of 3% a year through 2019.

With all that in place, I get numbers close to Bini Smaghi's. The debt ratio goes down about seven points in 2015, just like he says, and we get to a level of 138.5%, not too far from his claim of 135%.

(You can plug in your own assumptions in this tool by the Financial Times and the IMF. Beware, though, that this calculator assumes the starting debt ratio, in 2014, is 164%, whereas I started with 175%.)

I checked the IMF's projections, as a benchmark, and it turns out he may have been using the IMF's projections all along! The WEO database shows a debt ratio of 174% in 2014, which goes down to 135% by 2019, just like Bini Smaghi says. The primary balance is 3.5% in 2015, and north of 4% after that. Real GDP growth never falls under 3% after 2015, and inflation gradually soars from 0.4% this year, to 1.75% in 2019.

IMF's projections (WEO Oct. 2014)
2015 2016 2017 2018 2019
Real GDP growth, % 2.9 3.7 3.5 3.3 3.6
Inflation (GDP deflator), % 0.4 1.1 1.3 1.4 1.8
Primary fiscal balance (% of GDP) 3.0 4.5 4.5 4.2 4.2
Debt (% of GDP) 171 161 152 145 135


Lo and behold, however, the heroic assumptions. Three to three-and-a-half percent real growth, year in year out, through 2019? Primary surpluses above 3% for five years in a row? Are we talking about a fiscally hyper-disciplined, pro growth economy? Or are we talking about Greece?

I'm sorry, Mr. Bini Smaghi and economists at the IMF, but these are science-fiction numbers.

Suppose instead that nominal growth (real growth + inflation) is 3%, primary surpluses average 2%, and the cost of debt stays at 4%. (Still generous projections for a country with Greece's situation and track record.) The debt ratio then declines by a modest 1.3% of GDP over five years, to 173.7%.

Bini Smaghi makes a second point in his column: Greece is unlikely to default because its debt is largely held by the EFSF and it has a long average maturity. Refinancing risk, he says, is much lower than for other eurozone countries that borrow in the market.

But he's addressing two different questions here. One is whether Greece's debt is sustainable. The most likely answer is "no," based on realistic assumptions. The other question is whether Greece will default in the short term. Not necessarily (assuming there were no elections soon). A country can be insolvent in the long term and, yet, thanks to temporary arrangements, be able to service its debt in the short term. There is no doubt that Greece's cost of debt would not be 4% today, if it weren't for the EFSF. And Greece's fiscal balance would not be a surplus of 4% if it weren't for pressure from the troika. Greece is on life support, and current conditions will not, and should not, apply in the long term.

Wednesday, January 7, 2015

Dominant and contrarian visions of 2015

It's that time of the year when seemingly every economist in the private sector puts together an economic outlook for the year ahead. I'm not foolhardy enough to make predictions, or even to pretend my crystal ball is less cloudy than others'. I'm writing this post because I am bothered by the extreme prevalence of some "consensus views." For example: the narrative of divergence between the U.S. and the eurozone. Or the widely shared belief that Syriza will lead Greece out of the eurozone. 

I have put together a list of (what I see as) dominant views--it's not fair to call them "consensus"--, as well as possible alternative scenarios that don't get as much attention as they should. Time will tell.


Dominant view Contrarian view Dark-horse view
U.S. dollar Fed raises rates, and the U.S. economy outperforms that of the eurozone, Japan, and emerging markets, leading to a big appreciation of the U.S. dollar relative to most currencies. Grexit and the failure of Abenomics add more fuel to the run-up of the dollar. The eurozone's economy performs better in 2015 than in 2014, the ECB delivers little or no QE, and Japan's growth and inflation turn out higher than expected. The dollar depreciates from the level of late 2014.
Monetary policy Divergence between Fed, on one side, and BoJ and ECB on the other. Tightening begins in the U.S., whereas ECB and BoJ commit to zero interest rates for the foreseeable future. Rapid disinflation lifts real interest rates. The Fed turns more dovish, and policy rates rise less than anticipated, supporting asset prices. Faster-than-expected growth, and recovering oil prices change the Fed's inflation outlook, prompting aggressive tightening.
Inflation Inflation stays low in most countries. In the U.S., core inflation remains stable, then rises, as labor market tightens. Eurozone enters deflation, briefly, before base effect of low oil prices is phased out. U.S. core inflation falls, scaring the Fed into postponing interest rate hikes. Eurozone falls into deflation, which proves to be more persistent than anticipated. "Japanization" narrative becomes mainstream. Oil price rebound puts disinflation behind, at least for now.
U.S. bonds Long-term interest rates rise, in anticipation of the Fed's tightening "in mid-2015". The yield curve flattens, due to low expectations for medium-term growth and inflation. Slow growth and ultra-low inflation push long-term yields even lower. Monetary policy tightening happens faster than expected. Growth surprises on the upside. Long-term yields rise sharply. The yield curve steepens despite Fed's tightening.
U.S. equities Gradual withdrawal of Fed support + Pick-up in economic growth = Elevated profits and valuations persist --> Positive returns, but lower than in 2014. The Fed is even more cautious than expected, and puts off interest rate hikes, perhaps due to ultra-low inflation. Investor enthusiasm turns into mania. IPOs and M&A activity bubble up. Valuations approach those of the late 1990s, raising the risk of a crash in the short term. Fundamentals of 2009-2014 bull market prove fragile. Faster-than-expected monetary tightening crushes equities.
Oil Plentiful supply and sluggish demand keep prices in $50-$80 range. Disruptions to supply in MENA push prices back up to the $90-$120 range. Recession in China pushes price under $50 for several months.
China Soft landing, with bumps. "Lowflation" persists, pernicious deflation is avoided. Excess capacity is worked out slowly; government doesn't need to officially bail out the financial sector. Slowdown escapes Beijing's control. Sharp recession and deflation set in, but government steps in to save the day, nationalizing several financial entities. Commodities plunge, several countries in Latin America enter recession, financial crises engulf a few EMs. Volatility spikes in all the world's main financial centers. China's slowdown proves temporary. GDP growth rebounds north of 8%. Commodity prices rebound.
Japan Fresh monetary stimulus succeeds at first. Yen depreciates, Japanese firms gain market share and increase profits. Core inflation remains positive, but eventually starts falling again, prompting the gov't to provide, eventually, more stimulus. New round of monetary stimulus fails to keep inflation up. Deflation returns, spurring the gov't to provide new stimulus, soon. Domestic demand, inflation expectations, inflation grow faster, setting off a "virtuous cycle" that leaves deflation behind forever. Abe's third arrow gets implemented, raising potential growth.
India Lower commodity prices boost economy and improve fiscal position. Modi pushes through reforms, lifting potential growth and dampening core inflation. Equity bull market continues. Global environment supports Indian growth, but Modi can't push reform as quickly as expected, due to internal political obstacles. Equities lose some steam, but there is no collapse. Rupee sell-off triggered by rising U.S. interest rates, contagion from Russian crisis to other EMs, etc. Foreign exchange reserves shrink precipitously, financial crisis looms.
Russia Recession deepens. External debt crisis looms, but is narrowly avoided. Short-lived dip. Growth resumes thanks to rebound of oil price. Persistently lower oil prices push Russia into full-blown external debt crisis. Banks fail. IMF comes to the rescue.
Greece Syriza wins the Jan. 25 elections, or gets enough seats to form a coalition led by Syriza. Greece requests a debt restructuring (i.e. partial default), which the troika rejects. Grexit. Syriza wins the Jan. 25 elections, but doesn't obtain majority. They call new elections. By then (March), Greeks get scared out of leaving the euro. Syriza loses votes in the second election. A coalition of moderate parties forms, and in the nick of time Greece commits to reform in exchange for more time and money from troika. Greece stays in. Syriza gets crushed in the polls, and stays out of gov't. ND forms a coalition. Stability returns, for now.