Inflation round-up

The Reserve Bank of India is officially an inflation targeter. The agreement between the Ministry of Finance and the RBI was signed on February 20, and published a few days ago. The target is to "bring inflation below 6 per cent" by January 2016. For financial year 2016-17 and subsequent years the target will be 4±2%, so the acceptable inflation band will be 2%-6%. That would represent a significant reduction from the typical inflation rates in India since 2008.

RBI governor Raghuram Rajan has de facto followed an inflation target since the start of 2014, but the monetary policy framework was not official. Prior to inflation targeting, the RBI's policy target can be described as flexible, as it included, besides inflation, the rupee exchange rate and banking sector stability.

Amol Agrawal, at Mostly Economics, doesn't like the agreement.

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Eurozone inflation expectations are sinking, say researchers at the New York Fed. Survey-based inflation expectations have been falling at the one, two, and five-year horizons. They're particularly worried that the whole distribution of inflation expectations is shifting down, not just the median, or the lower percentiles.

A report by Generali, however, shows that inflation expectations measured by inflation swaps have picked up during 2015.

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Inflation, relatively: The following map shows inflation relative to each country's own history (the 10-year z-score), as of 2014-Q4. Despite abundant talk of Russian inflation, prices are increasing slightly more than they have, on average, over the past ten years, adjusted for standard deviation (z score of 0.13).

The highest inflation rates, relative to their own medium-term experiences, are for Argentina, Bolivia, Venezuela, Japan, and Gabon. The lowest inflation rates, relative to their own experiences, are in Greece, United Kingdom, Hungary, and Poland, in that order.

The eurozone is pretty green (meaning low inflation), but if you squint you'll notice that Sweden and Switzerland are experiencing relatively less deflation than their European neighbors. Even the U.S. is deviating more from its own history than Switzerland.

One-year inflation rate, 2014-Q4, 10-year z-score, relative to own country's history. Source: FactSet data, gunnmap.herokuapp.com, author's elaboration.

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.

The (surprising?) resilience of inflation expectations in the eurozone

One way for central banks to gauge long-term inflation expectations is to look at the \(n\)-year-forward, \(m\)-year-ahead expected inflation rate. For instance, the two-year-forward, three-year-ahead expected inflation is the expected change of prices two years from now, over the following three years. As of December 2014, that would be the inflation rate expected in Dec. 2016, over the 2017-2019 period.

Central banks like these forward measures because they eliminate--or at least diminish--the influence of short-term inflation inflation expectations.

One data source for the construction of such forward measures are surveys of forecasters. The ECB Survey of Professional Forecasters asks participants for their inflation outlook over the next year, the next two years, and the next five years. Using those overlapping horizons one can infer the forward expected inflation rate from this equation:

$$(1+\pi _{0,5}^{e})^{5}=(1+\pi _{0,2}^{e})^{2} (1+\pi _{2,3}^{e})^{3}, $$ 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.

Likewise,
$$(1+\pi _{0,2}^{e})^{2}=(1+\pi _{0,1}^{e}) (1+\pi _{1,1}^{e}), $$ So $$(1+\pi _{0,5}^{e})^{5}=(1+\pi _{0,1}^{e}) (1+\pi _{1,1}^{e}) (1+\pi _{2,3}^{e})^{3} $$ If you estimate the forward expected inflation rates this way and plot the time series, this is what you get:

I am surprised to see that, despite much talk of deflation and falling inflation expectations, the inflation expectations that matter most (the long-run, forward rate, in green) is firmly glued slightly above 2%. The intermediate forward rate (i.e. one-year-forward, one-year-ahead) has declined moderately over the past year from 2% to 1.7%. The only inflation expectation that has dropped dramatically is the short-term rate (inflation expected over the next year), which is now close to 1%, down from 1.5% a year ago, and 1.9% two years ago.

This undermines the case for quantitative easing in Europe. Granted, the ECB might be looking at other measures of inflation expectations (i.e. inflation compensation from nominal and inflation-linked bonds, inflation swap rates, consumer surveys of inflation expectations, etc.) And the ECB might also be worried, besides inflation expectations, about credit growth, output growth, etc.

P.S. By the way, the formulas above were written thanks to the Mathjax tool for Blogger. With Mathjax added to your blog, you can type formulas as you would with LaTex. And if you are not fluent in LaTex, this website is helpful. You just type in your formulas, with the help of some buttons, and it produces the LaTex code for you.

Italian banks: ownership structure, corporate governance, and asset quality

Nadege Jassaud, economist at the IMF, writes an entry on Vox about Italian banks: ownership structure, corporate governance, and asset quality. Her main points:

1. The recently released ECB balance sheet assessment highlighted nine Italian banks that failed the asset quality review (AQR) and stress tests – before 2014 recapitalisation. Eight of them fall into the categories described in this article (and 14 out of the 15 Italian banks participating in the assessment).

2. In Italy, bank ownership through foundations and bank cooperatives raises specific challenges for corporate governance.

3. Italian foundations have played a critical role in the privatisation of community-owned banks.

4. Foundations still remain in control of the largest Italian banks.

5. Foundations suffer from an opaque and weak governance structure.

6. The financial position of several foundations has weakened, raising concerns about their capacity to provide further bank support.

7. Banks with foundation ownership tend to feature weaker asset quality than other Italian banks.

8. Cooperative structures are widespread in Europe and have been an important source of credit to local businesses.

9. The cooperative model raises governance issues when banks grow above a certain size.

10. Like foundation-owned banks, bank cooperatives have weaker asset quality compared to other banks and are less resilient to shocks.

This reminds of the Spanish cajas de ahorros, bank-like institutions with no shareholders and effectively under the control of local governments. The cajas were poorly managed, and highly vulnerable to the real estate crash. Regulators forced them to merge, and restructure into proper banks, after the financial crisis.

New paper on the mechanisms behind the eurozone crisis

Philippe Martin and Thomas Philippon have written a new paper about the mechanisms of private leverage and fiscal policy within the eurozone, from its creation through the Great Recession. (NBER link, ungated version).

From the introduction (emphasis mine):

There is wide disagreement about the nature of the eurozone crisis. Some see the crisis as driven by fiscal indiscipline and some by fiscal austerity, some emphasize excessive private leverage, while others focus on external imbalances, sudden stops or competitiveness divergence due to fixed exchange rates. Most observers understand that all these “usual suspects” have played a role, but do not offer a way to quantify their respective importance. In this context it is difficult to frame policy prescriptions on macroeconomic policies and on reforms of the eurozone.

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...we propose a simple model that focuses on three types of shocks: household leverage, fiscal policy, interest rate spreads and exports. A key challenge is then to empirically identify private leverage shocks that are orthogonal to shocks on fiscal policy and shocks on spreads. To help us identify the eurozone shocks, we use the US as a control.

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The key difference between the US and the eurozone experience is the sudden stop in capital flows starting in 2010 in the later.

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Contrary to the eurozone, the US states did not experience any shock on spreads in borrowing costs and no fear an a potential exit of the dollar zone. This allows us, for the eurozone, to identify the part of the private deleverage dynamics that is not due to the spreads shocks by the private deleveraging predicted in the US on the period 2008-2012. We call this the “structural” private leverage shock.

[...]

Starting in the Spring of 2010, sovereign spreads widen and several European countries find it difficult to borrow on financial markets. The US and EZ experiences then start to diverge. While US states grow (slowly) together, eurozone countries experience drastically different growth rates and employment. A state variable that correlates well with labor markets performance in 2010-2011 in the Eurozone is the change in social transfers during the boom. Eurozone countries where spending on transfers (and also government expenditures) increased the most from 2003 to 2008 are those that are now experiencing severe recessions in the later stage. This suggests that in the second stage past fiscal policy, because of its effect on accumulated debt, had an impact on the economy through spreads and the constraint on fiscal policy it generated after 2010.

[...]

In this paper, we analyze a model where borrowing limits on “impatient” agents drive consumption, income, the saving decisions of “patient” agents and employment in small open economies belonging to a monetary union. We introduce nominal wage rigidities which translate the change of nominal expenditures into employment. We first consider the predictions of the model taking as given the observed series for private debt, fiscal policy and interest rate spreads between 2000 and 2012.

Maybe I don't understand the paper, but it seems to me that using U.S. states to identify the causal mechanisms is crucial. It also seems (and I might be wrong) that the identifying vehicle are the spread shocks. Now, there exist important differences between U.S. states and eurozone countries: fiscal, political, labor markets, cultural, etc. Insofar as those differences are not reflected in spreads or spread shocks, but played a role in determining the path of unemployment, deficits, etc., the identification strategy is flawed. Comments?

Putting those doubts aside, I love this paper.

Summary of main findings, from the conclusion:

1. The private leverage boom (in 2000-2008) was the key igniting element of the crisis, especially in Spain and Ireland.

2. Pro cyclical fiscal policy during the boom worsened the situation, especially in Greece.

3. In Ireland and Spain, a more conservative fiscal policy during the boom would have helped, but would have entailed an implausibly large fall of public debt.

4. A macro-prudential fiscal policy to limit private leverage during the boom would have stabilized employment in all countries. However, in the absence of more prudent fiscal policy, this would have induced a larger buildup in public debt.

5. Fiscal and macro-prudential policies are thus complements, not substitutes, in order to stabilize the economy.

6. The sudden stop in the eurozone worsened the crisis by further constraining fiscal policy. If the ECB's "whatever it takes" line had come earlier (and had been successful at that earlier time), Ireland, Spain, Greece and Portugal would have been able to avoid the latest part of the slump.

What caught my eye

1. Labor under-utilization: We keep thinking, long and hard, about how much slack there is in the job market. Gavyn Davies brings our attention to a timely conference put on by the Peterson Institute. The "consensus" --at least as gauged by Davies-- is that the unemployment rate in the U.S. under-represents the true amount of slack, due to the effect of the participation gap and involuntary part-time employment. Moreover, because of long-term unemployment and the potential rise of productivity growth, a decline of labor slack need not be as inflationary as it normally would. Everybody, however, acknowledges the "great uncertainty" around these assessments.

The Peterson Institute has posted the videos and ppt files of all the conference presentations here.

2. "Grapho-tainment": Twenty-two maps and charts that will surprise you, by Vox.com. I love these: #1, #3, #7, #10, #15, #17, and #19.

3. Speech by Vítor Constâncio, vice-president of the ECB, on "understanding the yield curve." I liked this [emphasis mine]:

Moreover, high sovereign spreads in the euro area have raised the question of what is the appropriate yield curve to monitor. In an article in the July Monthly Bulletin we discussed this issue in the context of measuring the euro area risk-free rate. Should we use Bund yields, euro area average AAA rates or OIS rates, or does it depend on the matter at hand?

Incidentally, an intriguing question in a currency union is the following: if it is difficult to identify a risk-free rate in a currency union, this means that there is no risk-free asset either, besides the central bank's own liabilities, the currency. 

4. David Keohane at FTAlphaville shares a report by HSBC, on the uneven conditions for growth across states in India.

5. From this week's batch of NBER working papers [emphasis mine]:

We employ a model of precautionary saving to study why household saving rates are so high in China and so low in the US. The use of recursive preferences gives a convenient decomposition of saving into precautionary and non precautionary components. This decomposition indicates that over 80 percent of China’s saving rate and nearly all of the US saving arises from the precautionary motive. The difference in the income growth rate between China and the US is vastly more important for explaining saving rate differences than differences in income risk. We estimate the preference parameters and find that Chinese and US households are more similar in their attitude toward risk than in their intertemporal substitutability of consumption.

I find the statement in bold very, very hard to believe, given this.

The paper is by Horag Choi, Steven Lugauer, and Nelson Mark, and here's an ungated version.

Inflation in the eurozone: goods versus services

Giulio Zanella (hat tip to John Cochrane) writes a post suggesting that Italy’s deflation is mostly imported. He supports his idea with two observations. First, the price index of goods has declined, but the price index of services has increased (coincidentally, by the same percentage). Second, among goods, those whose price has declined are: unprocessed food, energy, tobacco, and consumer durables. The first three have in common, Zanella says, that they’re traded in global commodity markets.

Assume that goods are tradable in international markets, whereas services are non-tradable—a good approximation for a country like Italy, Zanella says. Then, he concludes, the origin of Italy’s deflation is international and on the supply side, whereas the contribution of weak domestic demand is “modest.”

In this post I look at the questions of whether eurozone deflation is really “imported,” and of how big the deflation threat is.

For the currency area as a whole, disinflation is a lot faster for energy and unprocessed food than for the other components of the HICP:

Within the “core” inflation rate, durable and semi-durable non-energy goods are in outright deflation, whereas non-durable goods are not:

The identification of the tradable component of the HICP with goods, and the non-tradable component with services is not accurate, but I’ll accept it for the sake of simplicity. (After all, the main drivers of services inflation should be domestic factors.) Extending this simplification to prices, goods deflation is “imported,” whereas services deflation is “homegrown.”

The distinction is important, among other things, because the optimal monetary policy response depends on the type of deflation. If deflation is imported, the ECB should do nothing, because commodity prices and the exchange rate are outside the set of things it can (or wants to) control. Let’s look, then, at the split of the HICP between goods and services.

The sub-index for all goods was falling at an annual rate of 0.3% as of July, whereas the price index of the basket of services was increasing 1.2%:

(Goods account for about 57.2% of the eurozone-wide HICP, and services for 42.8%.) 

Services inflation appeared to be declining from 2011 up until April 2013, and since then it’s been more or less flat around 1.2% (to zoom in, adjust the dates on the chart above).

It appears, then, that a large part of the eurozone’s current disinflation might be “imported.” Another, smaller part of this disinflation is “homegrown,” but it doesn’t seem to be getting worse.

What’s the evidence across countries?

Goods inflation has declined in every single of the 15 countries I consider*. In all but two countries, prices are falling outright.

Services inflation has declined overall, but slightly (from 1.4% in July 2013 to 1.2% one year later). In five countries services inflation rose: Belgium, Ireland, France, Portugal, and Finland. In one country, Greece, deflation became less pronounced. In two countries, Germany and Austria, the services inflation rate didn’t change. And in the remaining six countries inflation declined: Estonia, Spain, Netherlands, Italy, Slovakia, and Slovenia.

So far, then, I’d say the jury is still out on whether disinflation, for services, is continuing.

Clemente De Lucia, economist at BNP Paribas, just published a research note taking a deep look at services inflation. This is what I see, from the first section of his note (“Inflation decomposition”):

1. Services inflation in core countries (Netherlands, Austria, Luxembourg, Belgium, Finland, Germany, France) is higher than in periphery countries (Greece, Spain, Portugal, Ireland, Italy). In the “core” region, services inflation shows no apparent trend since early 2011, whereas in the “periphery” services inflation has been roughly flat since late 2013:

Source: Clemente De Lucia (BNP Paribas), July-August 2014.

De Lucia mentions how, in the core, the current inflation rate is “slightly below its historical average,” and that in Germany and the Netherlands the services inflation rate is below the eurozone aggregate (although barely so):

Source: Clemente De Lucia (BNP Paribas), July-August 2014.

2. "Lowflation” is spreading across services sub-categories, but deflation is less pervasive. To gauge the diffusion of disinflation and deflation, De Lucia looks at the percentage of the 39 sub-components of the services HICP that had an inflation rate between 1% and 2%, between 0% and 1%, and below 0%.

For the eurozone as a whole, the share of services sub-categories with inflation between 1% and 2% has shot up, but the share of services in deflation has declined (from a percentage that was never higher than 20%):

Source: Clemente De Lucia (BNP Paribas), July-August 2014.

The evidence by country varies. De Lucia focuses on the total proportion of services sub-categories with inflation below 2%. That statistic is rising, De Lucia notes, in Spain, Portugal, Greece, Netherlands, and France. From that he concludes that deflationary pressure is mounting in those countries.

(Beware that, in those charts, the three categories are nested. That is, the category of "below 2% inflation" includes the category of "below 1%" inflation, and so forth. I checked.) 

De Lucia's data end in May 2014. I gathered my own data to see what's happened over the past 12 months, for the eurozone aggregate. The proportion of service categories with inflation below 2% reached a maximum in February (70%), and has declined since then. The diffusion of deflation reached 18% in December 2013, and has fallen to about 5% in July.

It will be interesting to see a breakdown by country. So far, though, I'm not convinced that "domestic deflationary pressures" are mounting.

One interpretation of the ECB’s recent policies is that the bank is not reacting to today’s decline in the price of goods. Most of that is due to past declines in commodity prices—which the ECB has no control over— and to the past rise of the exchange rate—which the ECB doesn’t target. The ECB, instead, is reacting to the disinflation of services, and the risk (or expectation?) that it might turn into outright deflation. How serious is that threat?

Based on the (admittedly backward-looking) evidence surveyed here, the risk of "homegrown" deflation is there, but it's not increasing, imminent, or pervasive across countries. (De Lucia’s note continues with a promising, long section on inflation expectations, which I haven’t had time to read yet.)

A different interpretation is that the ECB sees deflation in goods as a problem it can solve—through the exchange rate. The euro appreciated steeply, through May, and that has driven the euro price of commodities lower. The new policies might be aimed at depreciation.

But that will have to wait for another blog.

*For visual clarity, I removed from the chart the three smallest members of the eurozone: Cyprus, Malta, and Luxembourg.

Why QE might be a bad idea for the eurozone

Michael Heise, chief economist at Allianz, is against (FT) quantitative easing by the ECB. He thinks the ECB shouldn't go down the QE route, because:

First, the recent low inflation rates are in part a result of the decline in oil and other commodity prices. They also reflect necessary adjustments in the eurozone periphery. [...] There is no sign of a vicious circle of falling inflation expectations and consumer restraint. Inflation rates will gradually climb again as the economy recovers.

Second, although the ECB has several options when it comes to implementing QE, there are serious objections to all of them. Buying asset-backed securities or corporate bonds would expose the European taxpayer to credit risk.

[...]

Third, the impact of further monetary easing on output and price levels would be negligible. That is because the recession in many parts of the eurozone is caused by the hobbling effect of the unsustainable amounts of debt that were built up by public and private actors during the boom years. Over-indebted households and companies are unlikely to pile up more debt; on the contrary, they are trying to pay it down. This makes monetary policy ineffective.

Fourth, the collateral damage from ultra-loose monetary policy is accumulating. Risks to financial stability are growing as investors are piling into riskier assets in search of higher returns. Already, some assets such as junk bonds are trading at what look like inflated prices.

Fifth, further monetary easing would delay the much-needed adjustments in the balance sheets of European banks and companies. An abundance of cost-free liquidity from the central bank enables commercial lenders to continue propping up weak creditors.

Of those, I agree most with #1. A breakdown of the eurozone's consumer price index suggests that a good chunk of Europe's deflationary pressure is "imported," showing up in the price index of goods with a high component of commodities. The price index of services, on the other hand, many of which are non-tradable, doesn't indicate deflation. (More on this soon.) Yes, demand is weak, and the private sector is deleveraging, but a lot of the "deflation" problem has to do with declining prices of globally traded goods, and the appreciation of the euro between 2012 and 2014, which only started to reverse itself in May.

Of the other reasons offered by Heise, I agree with #4. I'm sympathetic with #3 (further easing will be ineffective), but I stress a different obstacle: banks are under pressure to clean up their balance sheets. In that sense, European policy is schizophrenic. On one hand, the ECB is trying to encourage more lending; on the other, regulators tell banks to improve their equity ratios.

What caught my eye

1. Recessions according to Hayek and Keynes;
2. Network neutrality;
3. Vaccines and autism;
4. Spain issues inflation-linked bonds;
5. The Fed was way off.

1. Reconciling Hayek's and Keynes' views on recessions (NBER working paper). I can't find an ungated version. Please email me if you do.

Abstract: Recessions often happen after periods of rapid accumulation of houses, consumer durables and business capital. This observation has led some economists, most notably Friedrich Hayek, to conclude that recessions mainly reflect periods of needed liquidation resulting from past over-investment. According to the main proponents of this view, government spending should not be used to mitigate such a liquidation process, as doing so would simply result in a needed adjustment being postponed. In contrast, ever since the work of Keynes, many economists have viewed recessions as periods of deficient demand that should be countered by activist fiscal policy. In this paper we reexamine the liquidation perspective of recessions in a setup where prices are flexible but where not all trades are coordinated by centralized markets. We show why and how liquidations can produce periods where the economy functions particularly inefficiently, with many socially desirable trades between individuals remaining unexploited when the economy inherits too many capital goods. In this sense, our model illustrates how liquidations can cause recessions characterized by deficient aggregate demand and accordingly suggests that Keynes' and Hayek's views of recessions may be much more closely linked than previously recognized. In our framework, interventions aimed at stimulating aggregate demand face the trade-off emphasized by Hayek whereby current stimulus mainly postpones the adjustment process and therefore prolongs the recessions. However, when examining this trade-off, we find that some stimulative policies may nevertheless remain desirable even if they postpone a recovery.

2. Everything you need to know about network neutrality, applied to the internet, in 17 easy-to-read cards, from vox.com.

3. Clear, eight-minute review of the evidence (or lack thereof) on the link between autism and vaccines. Thanks to audible.com and upworthy.com.


4. Spain is issuing bonds linked to eurozone inflation, for the first time ever (link to El País article in Spanish, article in English from Bloomberg). A couple of years ago PIMCO published a viewpoint on the eurozone inflation-linked bond market. Market conditions have changed dramatically since then, but it's worth keeping some of PIMCO's concerns in the backs of our minds.

5. John Cochrane re-posts a chart of the Fed's forecasts vs actual growth, by Torsten Slok at Deutsche Bank. If the Fed, employing a flock of highly qualified economists, gets the forecasts so wrong, what's the hope for any individual, somewhat-less-qualified private forecaster?

Political credit cycles (JEP paper by Fernández-Villaverde, Garicano, and Santos)

This just-published JEP paper explains where the troubles of the eurozone periphery come from. Basically, the gist of the paper (as I understand it) is that the single currency imposed monetary constraints (no more devaluations), but relaxed others (capital flows). The constraints that were lifted allowed for abnormally high growth, consumption, and employment, while hiding the pitfalls of the new economic model of growth and removing incentives for structural reform. Economic constraints before and after the euro were radically different, but the result was the same: absence of real reform.

I would say the insights are not new, but they are wonderfully articulated:

The elimination of exchange rate risk, an accommodative monetary policy, and the worldwide ease in financial conditions resulted in a large drop in interest rates and a rush of financing into the peripheral countries, which traditionally deprived of capital. Figure 1 shows the convergence in interest rates,which resulted in much lower interest rates for Ireland, Greece, Spain, and Portugal—indeed, they became able to borrow at German-level interest rates. This paper argues that, as the euro facilitated large flows of capital and a financial bubble in peripheral countries, economic reforms were abandoned, institutions deteriorated, the response to the credit bubble was delayed, and the growth prospects of these countries declined.  

In the next section, we explore the two main channels through which these n the next section, we explore the two main channels through which these large inflows of capital led to the abandonment of economic reforms. First, these capital inflows relaxed the economic constraints under which agents were acting, thus reducing the pressure for reforms. Second, they made it harder for principals to extract signals about who was performing well or poorly. When all banks are delivering great profits, all managers look competent; when all countries are delivering the public goods demanded by voters, all governments look efficient. As a result, bad agents are not fired, incompetent managers keep their jobs, and inefficient governments are reelected.The efforts to reform key institutions that burden long-run growth, such as rigid labor markets, monopolized product markets, failed educational systems, or hugely distortionary tax systems plagued by tax evasion, were abandoned or even reversed. It is often argued that the inflow of capital to the peripheral countries led to a number of difficulties, such as a debt overhang from excessive borrowing. But in our view, the reform reversal and institutional deterioration suffered by these countries are likely to have the largest negative consequences for growth.

Links 20130624: Eurozone's banks, Norway

1. How much capital do European banks need? A sobering quantification by Wolfgang Münchau at the FT.

The reason I believe the amount of hidden losses in bank balance sheets is ultimately quite large is the sheer number and scale of the accumulated crises during which European banks managed to lose money in recent years: the US subprime crisis, a eurozone housing bubble, the Greek debt restructuring, the Cypriot bank failures and the short and sharp 2009 recession followed by the Great Recession of 2011-13, with no end in sight for southern Europe. 

One would hope that an asset quality review by the European Central Bank, envisaged for next year, would provide clarity. But I am doubtful. In the past, bank transparency exercises were undertaken with the intention of hiding the truth. Remember the stress tests of 2011? Or the apparently independent audit of the Spanish banking system, which concluded that Spanish banks only needed a teeny weeny bit in new capital? 

... 

Assume now that my estimate is wildly wrong, and deduct the size of the Italian economy from that back-of-the-envelope number. You still end up with €1tn. With this order of magnitude it mattered relatively little whether the ESM could contribute €60bn, €80bn or zero. Europe’s national governments are clearly incapable and unwilling to fill the gap. And without the money for bank resolution, it barely matters whether the European Commission will become the resolution authority that does not do the job or whether someone else does not do it.
That leaves a long period of regulatory forbearance as the most likely outcome – a policy version of pretend and extend. They pretend not to see the losses, and extend the crisis.

2. Norway's military to conscript women:

Norway will soon become the only country in Europe to extend its military conscription to women in peacetime, after parliament reached agreement on the issue. All of the parties represented in parliament, with the exception of the small Christian Democrat party, agreed on Friday to back a proposal by the centre-left government for a "gender neutral" military conscription. In practice, that means Norway's mandatory one-year military service will be extended to women, probably as of 2015, according to the defence ministry's proposal."Norway will be the first European country to draft women in peacetime," a defence ministry spokesman, Lars Gjemble, said. 

A number of other European countries have gone in the opposite direction in recent years, moving away from conscription towards professional armies. 

Norway's parliament is expected to adopt the bill by a broad majority, but a date has yet to be set for the vote.

On a related note, former Norwegian Defense Chief today said that Norway's military lacks preparedness needed to meet the threats that the country faces. Here's the link, and here's the original article on the Aftenposten.

My interview with Edward Hugh

Last March I had the privilege to meet and interview Edward Hugh at a conference in Vienna. I have pasted (an edited-down version of) our interview below, originally published on the Morningstar Advisor magazine (p.49). In case you don't know anything about Edward, he's an extremely knowledgeable and insightful economist, who has written a lot about Europe and about the implications of the demographic transition on the macroeconomic outlook. He contributes to a large number of blogs.



Edward Hugh is a Catalan economist of British extraction who lives near Barcelona. As a macroeconomist, he specializes on demographic processes, migration flows, and growth and productivity theory. Although recently he has done a lot of work on the economic troubles of the eurozone (for obvious reasons), his curiosity has taken him far away from his home continent, and he has written about the economies of India, Eastern Europe, and Japan. Hugh is a regular contributor to a number of economics blogs, including “A Fistful of Euros,” “Global Economy Matters” and “Demography Matters.”

I spoke with Hugh on March 14 at the Morningstar Investment Conference in Vienna, where he delivered a presentation titled “What Do Aging Populations Have to Do With the Sovereign Debt Crisis?” We started our conversation with a discussion of the demographic problem of the developed world, but ended up visiting topics as diverse as how the United States’ national identity has helped it through the financial crisis and how Italy might be the greatest threat to the eurozone’s stability. Our conversation has been edited for clarity and length.

Francisco Torralba: You argue that the demographic situation in Western Europe, Japan, and the UK implies that sovereign finances are going to be in a very sticky situation within 10 to 20 years. The populations of these countries are aging rapidly and will need help funding their retirements. But fewer younger people are working and paying into the system. What will be the ramifications of these trends for sovereign finances?

Edward Hugh: What this means for sovereign finances in Europe is that there is increasing pressure on the level of sovereign debt and increasing pressure from markets on sovereign bonds simply because of political risk. It’s going to be very difficult, as years go by, for the politicians to keep convincing voters that the necessary sacrifices have to be made to help an aging population. So, we’re in a complex situation.

But if I can broaden this a bit, it’s not simply a question of the demographic change in Europe, the United States, or Japan. What we’re facing at the moment is a paradigm shift in the way markets, investors, economists, and everybody are thinking about economic processes, debts, and sovereign risk. Somebody told me about a recent pensions meeting where a presenter said, “It’s the population, stupid.”

This idea is very simple, and it’s just surprising that it went out of people’s heads for so long. In fact, traditionally, economists were always interested in population dynamics and demographic processes. But there were some famous studies in the 1970s and 1980s by the Nobel Economist Simon Kuznets, who found that size of population was not a factor in economic growth. That was the necessary catalyst that caused people to think, “Well, then, population doesn’t matter.” But Kuznets’ research was very specific: the size of a population didn’t matter. Iceland is no different from China in this sense. 

Later, as we got into the 21st century, with the growth of emerging markets, people started discovering again that population structure does matter. It’s not the size; it’s the population structure, stupid. 

So from the end of the 20th century, there was increasing interest among development economists in the way in which the drop in fertility rates in the emerging economies could help those economies get up to speed, if they made the necessary institutional reforms to accompany these changes.

The first warning signal came from countries like the Asian Tigers—Singapore, South Korea, Taiwan, and Hong Kong. Then, Goldman Sachs got the idea of BRICs, as China started to come online, and suddenly, we were talking about countries like Brazil, India, Indonesia, and the Philippines.

There’s been a definite before and after to the global crisis, with the emerging markets assuming a far greater importance. The valuation of the outlook for both growth and sovereign risk in the developed economies has shifted into another gear, as has the perception of growth possibilities, and therefore, sovereign risk in the emerging markets.

That’s why I call this a paradigm shift. Some of these debates which we have between Schumpeter and Keynes about how to handle the current crisis are out of date in light of that paradigm shift, I would argue.

Torralba: You argue that there's a ratio called the dependency ratio: the number of older, retired people relative to working-age people....

Hugh: If I can interrupt, actually, there are two dependency ratios. There’s a child dependency ratio and an elderly dependency ratio. The problem with the super-underdeveloped economies is that they have a massive child dependency ratio, which means they have very little in the way of saving, because they have large numbers of children.My father was one of a family of 14 and started work at 12 in the Liverpool of the United Kingdom, which was the richest country on the planet at that time. As my father told me, having lots of children means poverty. Having a lot of old people, if we’re not very careful, could also mean poverty, too.

We’re making an inversion from having too many children in proportion to the rest of the population to having too many old people. For developing economies, the news that fertility is dropping is good. In developed societies where the key ratio to watch is the elderly dependency ratio, then a continuing fall can become a malor issue. Having let the developed world population pyramid get to the stage it’s now in, trying to address the problem is going to be difficult. Giving more facilities to working mothers who want to have children, for example, or some kind of family support system, or paying to subsidize school textbooks so that having a child is not such a direct economic burden on a family—all these are going to be very, very difficult in a situation where resources are so strained, because of the demands on the pension and health systems due to the large proportions of elderly people.

Torralba: The problem is that we used to have a demographic dividend, where we always had an adequate ratio of retired people to working people. It’s what we call a pay-as-you-go system. Each year’s taxes are used to pay the pensions for that year. That model will be inadequate for the next two or three decades. How are we going to transition to a new form of financing retirement?

Hugh: Well, the transition will be turbulent. That’s the only clear thing we can say. Our societies just aren’t prepared for this transition. People in many countries—and it’s not just Southern Europe, because I think the United Kingdom could soon be in the same situation—don’t understand that you need to make systematic cuts—in health systems, for example. One of the reasons why the proportions of elderly dependents are rising is simply because of advances in medical technology. It’s getting easier to extend people’s lives, but we achieve this end by using more and more expensive medication and technology for increasingly lower  additions to quality of life. It’s a very expensive process, but it’s going to be very hard to explain to people that that’s the case.

What do see in the future? In the first place, I see a lot of turbulence in the political systems. Second place, I see a process of realignment in the global markets. Every company needs growth. Companies need markets to grow for their products to justify the next generations of investment. For corporations, the expansion in emerging markets is a godsend. Even though the majority of the population can’t buy Italian luxury products or expensive German cars, the volume of the population is so large that even with only a small percentage of that population being rather rich, you’ve got quite a big market.

So, at the moment, the corporate sector is reorienting and reinventing itself. This is being reflected in the U.S. equity markets; companies are reorienting production toward these new, growing areas. But it’s going to be quite difficult for the populations in the developed countries to come to terms with the fact that their status in the world is changing.

What Can We Learn From Japan?

Torralba: Japan is a little bit further along in the demographic transition than Western Europe. Is there anything we can learn from Japan’s situation that is applicable to Western Europe?

Hugh: The thing that’s distinguished Japan the most has been its ongoing deflation. Up to now, no other countries have had this kind of deflation. So, at the moment, this is a unique Japanese feature. We need more time to see whether it’s going to typify other countries or not.

What we can say, though, is that Germany, which has a similar aging profile as Japan’s, has had a very strong disinflationary tendency over the past few years. The Germans have patted themselves on the back about this and said how good they’ve been in comparison with their European peers. But to some extent, this could simply be a product of the internal demand dynamic. Because I think the lesson that we can get from Japan is that with populations aging beyond certain thresholds, the structure of production changes. Investment oriented toward domestic consumption, and domestic consumption itself, tends to become more and more lackluster, while the country comes to depend increasingly on having a super-efficient tradable sector and ramping up the level of export production. 

We do see a rather similar pattern in Germany. Why is it the case that domestic demand starts to weaken? Because most of the actual economic growth that we get comes from taking demand from the future in terms of credit. In this sense, rather than a credit cycle, what we see is a structural shift in the role of credit. Where we do get strong consumer demand growth in countries like Spain or Ireland or the United Kingdom during the first decade of the century, the driving force was a very large increase in private domestic credit. Once that comes to an end, you seem to notice that consumer demand doesn’t have anything like the same dynamic, because a higher proportion of the population is just buying out of current earnings and current income.

There is a certain age profile associated with patterns of spending and borrowing. Nobel economist Franco Modigliani noticed this in formulating his lifecyle model. It was indeed a pattern that had already been identified by the British social philanthropist Joseph Rowntree at the start of the 20th century. There are different stages in life. And these stages are successively either ones of increasing borrowing or ones of increasing saving for the future.

When we extend these stages to a whole population, we can see that the domestic demand dynamic isn’t what it was as countries get older. So, that’s one of the points that we can get from Japan.

The other point is this increasing dependency on exports and external saving. One way of making the  situation easier was always the idea that during the good years, when you are having higher levels of economic growth, savings could be diverted out of the country into overseas investments—and to some extent, the population can live off of these overseas investments.

Indeed, this is what we’re seeing in Japan at the moment, because Japan’s got a 50% of GDP net national investment position, which helps the current account, but the country can’t live forever off this. little by little, we can see the surplus weaken as people draw down on their savings. So, there’s then a big theoretical argument among economists about how long this will last. But if we look at not only Southern Europe but also Eastern Europe—these are all countries that are about to enter this important aging period, and they’ve got strong negative external investment positions. This is a great concern. How are they going to manage the aging process? They haven’t got the external savings to draw down, and they have external debts to pay.

Torralba: Exactly. Not only do they have current account deficits, but on top of that, they owe money to the external sector.

Hugh: Every month, just to cover the current outflows on the equities and on the debt obligations these countries have, they have to do an extra dose of exporting to be able to earn the money to pay it down. That exporting doesn’t help compensate for deficient internal demand. So, it’s going to become an increasing headache.

Labor Mobility

Torralba: I’d like to discuss the relationship between migration and fiscal policy. In an economic area like the eurozone, where in theory you have a tree labor market—people are free to work and live wherever they choose—you have the possibility that people will move from the least-productive, lowest-wage parts of the eurozone to the most-productive, highest-wage areas. That leaves behind retirees, or people with very low earnings, who make small fiscal contributions to the state. What does the free labor market in the eurozone imply for fiscal solidarity in the eurozone?

Hugh: This is a very important point. The euro was set up with major institutional deficiencies. Some of  these had to do with the fiscal coordination and product market integration, services integration, or whatever. One of the deficiencies was the absence of widespread labor mobility. For some reason or another, people were not moving from one country to another. Or even within countries. Take the example of Spain; even when the economy was growing at 4% a year and 750,000 migrants were entering the country every year,
there was double-digit unemployment in the southern parts of Spain. There was no movement from these areas towards richer regions like Madrid, Valencia, or Barcelona, where the economies were booming, and there was plenty of opportunity for work.

Spain is quite a nice microcosm of the problems that the euro area has as a whole. If this mobility wasn’t evident, or wasn’t evident in Italy from the south to the north in the first decade of this century, how much less wasn’t it there in the euro area as a whole. I mean, there was a migration from Eastern Europe into the euro area, but not from one eurozone country to another, except at the most highly qualified level.

What we are seeing now is something new, and something that in principle is very welcome—people are moving from countries which are stuck in deep recession to areas where there is economic growth, where there is demand for labor.

But, as you’re suggesting, this basically good news also presents us with a problem, as it highlights yet another institutional deficiency in the design of the euro area. Basically, those who are moving have been brought up, educated, and prepared for life by one society but they then go and work in another one. Instead of paying contributions through the pay-go system of their own country, they contribute to the pay-go system of another one, and there’s no evident mechanism whereby any of this money gets recycled back to meet the old-age needs of the parents who raised them. 

The issue then is, is the euro area going to set up some kind of equivalent arrangement to the one that’s been set up in the Federal Republic of Germany, or the autonomous communities of Spain, and make some kind of allowance for the sharing of the benefits of this migration? Because if it isn’t, then what you are left with is what the old East Germany would be like, if it wasn’t part of the Federal Republic, a country with a very large number of old people, quite a high unemployment rate, and insufficient growth to support the basic welfare system.

Torralba: From a political point of view, it’s going to be extremely complicated, It creates tensions between regions, and it creates resentment. In Spain, people in Catalonia think they’re paying too much to Madrid. How is that going to work in Europe when Germany is told that they’re going to have to send checks every month to pay for the Spanish retirees? I don’t see that going down very well.

Hugh: No, and I don’t think that’s going to happen, either. Japan has these problems, not at the regional level, but the problem simply of sustaining the health and pension system, given the lackluster nature of the economy and now the declining workforce and problems of productivity that they’re having, associated with its aging. How Japan is handling this is just by boosting debt. Japan’s gross sovereign debt last year was  around 235% of GDP, and they were running a fiscal deficit of around 10%. The prime minister, Shinzo  Abe, is talking about doing even more of the same this year, so we can imagine they could go up through the 250% of GDP and onwards to upwards to more than 300% over the next few years. 

These are unheard of proportions in any modern society. We don’t know where this leads. But I would suggest that the most likely tendency that we can see in Europe at the moment is a tendency for some kind of mechanism to be devised, yet to be specified, which allows these countries to continue spending without all the weight of this falling on Germany. 

Torralba: We’ve been talking about the implications of demographics for fiscal solidarity. Another implication that we read about is that having a single financial system eventually leads to some sort of burden-shedding in the end, because eventually, the state is the guarantor of the financial system’s liabilities. You wrote recently that what Ireland did may be a peek into the future of the eurozone. First, the Irish Central Bank bought promissory notes that were meant to recapitalize the financial system, and then those promissory notes were actually later swapped for Irish government debt. In the end, what this means basically is that the Irish Central Bank is financing the deficit, even though it completely goes against the European Union Treaty—that the central banks are not supposed to finance deficits. The European Central Bank is against it, the Bundesbank is against it, and nonetheless, it seems to be happening in Ireland. Is this where we’re headed in Europe?

Hugh: Something is going to have to happen, isn’t it? The market’s assuming as well that something is going to happen, because otherwise, you can’t make sense of the pricing of European sovereign bonds at the moment, unless you think that’s the case. 

The premise would be what you said in the earlier question, and that is that it’s going to be very, very difficult for the Europeans collectively to agree to have the kind of fiscal arrangement they have in the United States, where there are automatic stabilizers from one state to another, which operate immediately. If there is some kind of economic slowdown in one part, that doesn’t affect another. People can go and live in Florida and have pensions paid, just the same as if they were living at home.

It’s going to be very difficult to convince German voters to accept that, so some other way has to be found. What’s concentrated everybody’s mind recently is the outcome of the Italian election, because it’s clear in Italy that people are not voting at the moment and are unlikely to vote in the foreseeable future for a government that is strongly committed to the kind of reforms that will be needed in order to apply to Mario Draghi to implement an Outright Monetary Transactions bond-buying program. Yet, the whole market current position is based on the idea that ultimately these countries, Italy and Spain in particular, will, if need be, apply to Mario Draghi.

So, everyone is skating on thin ice at the moment. What happened in Italy could easily happen in Greece in the next elections. You could get another party which is not favorable to continuing with the Troika  programs, with a majority, because Greece has this first-past-the-post party system, winner takes nearly all. So, if it was Syriza instead of New Democracy that came first by a short head in the next elections, this would cause all  kinds of problems. Portugal is going to have elections one day or another and has a similar
situation pending. You don’t have to be a genius to see that there’s a limited lifespan to the unpopular austerity measures, necessary as many of them may be.

Strength of the U.S. Federal System

Torralba: This reminds us that monetary policy and fiscal policy are not independent. They’re kind of two sides of the same coin. In Europe, it’s difficult within the short time horizons to have responsible fiscal policies, so we’re going to resort to monetary policy to finance deficits. In the United States, you don’t have that fiscal constraint. Why has the U.S. embarked on this monetary expansion policy that seems to be turning into “QE infinity”?

Hugh: I think there are two questions here. One is, why has the United States gone for quantitative easing? And the other one is, why is it possible for the United States to do certain things where they don’t mind who’s paying—whether it’s somebody in Alabama who’s paying or in California?

Most people I talk to from the United States say that the United States can have this federal system—where people maybe moan a little bit, but nobody really seriously takes issue with who’s paying for what. They had a Civil War, and the Civil War settled this question. 

Now, that’s not an argument for having a civil war in Europe, but we’ve never settled the question, despite all these wars we’ve had. It’s quite interesting that the whole idea of the European Union, the traditional argument for it, is that because we were always at war. But in fact, war didn’t settle this issue, because we are still a continent of bigger and smaller nations, where the national identity is something that’s important to us.

Yet, the whole idea of a working European Union, and especially the euro, depends on everybody feeling part of the same entity. They obviously don’t. Therefore, it’s dysfunctional. That’s why the United States can do something that Europe can’t, and I don’t see any short-term or easy solution to this question. 

Why do they keep doing QE even when there’s no evidence it works? Again, we can go back to Japan. It’s curious that people say that the Bank of Japan hasn’t ramped up its balance sheet as much as anybody else. In fact, it did ramp up its balance sheet quite a lot before the crisis started, so the baseline is a bit different there.

But it was quite obvious that in fact QE didn’t work the first time it was tried in Japan. There was this critical moment in 2005 when the G20 had decided that everybody was going to go back home and try to start raising interest rates, because the environment was perceived as being excessively risky with people extending too much credit, etc. People were anticipating, a little bit, the crisis.

Japan got as far as putting the rate up a quarter percentage point and then stopped the whole tightening cycle, because it couldn’t go any further without imploding the economy.

So, on the one hand, it wasn’t working, but on the other hand, Japan wasn’t able to apply a more hawkish monetary policy without really putting the economy itself at risk. 

This is the whole point. It’s working in that it’s boosting the equity markets and boosting carry trades across the planet, but this way may be indirectly creating a little bit of inflation. But it’s not meeting its primary objectives of restarting credit flows and generating a slightly higher inflation rate to aid deleveraging. Fine, but what would?

So, if you haven’t got an answer to “what would?” then you stay where you are. I think that’s why we are where we are. There are people in the United States who would argue that QE is doing certain things,  achieving some of its objectives. That’s a huge debate that I don’t really want to go into because it isn’t really within the bounds of my expertise.

But we are locked into these kinds of situations because nobody’s come up with a better idea. The alternative to this is not to raise interest rates. So, what do we do? 

Torralba: Speaking about inflation, a prediction that you hear about sometime is that the monetization of government debt in the long run will imply much higher rates of inflation. In tact, this is one way how governments are going to deal with their fiscal problems: just wipe away the real value of their debt by letting inflation run higher. Do you think this eventually is an outcome that we should be worried about?

Hugh: Well, it’s not a concern that I have at the moment, because there seems to be a structural deficiency in domestic demand in many of the economies where they’re applying this technique. So, it’s hard to see how you can get domestically driven inflation. How you could get troubling inflation is if you provoke a collapse in the currency. This is a risk Japan is running, as George Soros is pointing out.

So, in the long run, you could have hyperinflation, let’s say, in Japan, if the yen really collapsed—not if it went from JPY8O to JPY100 to JPY12O, but went from JPY12O to JPY300. If there was a dramatic collapse in the yen, because there was a dramatic flight of funds out of Japan at some moment, because people anticipating continuing falls in the yen started really panicking, then, this could precipitate a very strong inflationary dynamic. 

This creates a peculiar position, then, for the countries in Southern Europe, because the only way you can avoid breakup risk coming back again is to let some economies spend more money. The advantage of doing it through the national central banks is that it doesn’t all fall back onto Target2 balances and generate additional liabilities for the Germans. If this is shown to be the case, then maybe the Germans will become more relaxed about the situation.

But the interesting thing is that these countries with large net-negative external investment positions and high levels of sovereign debt normally would experience a big run on their currency. What the euro does is stop the big run on the currency, because they’re in a common currency—although it isn’t a national level currency.

But what Willem Buiter, the chief Citigroup economist, has spoken about over the past months, and it’s becoming increasingly relevant, is the possible ruble-ization of the euro, making a comparison with the old USSR, when the ruble was retained as a common currency for a number of increasingly independent states. In fact, 5 euros in Germany may already effectively have a different value, even though we’re talking about the same banknote, to 5 euros in Greece.

Torralba: Just to make sure I understand what you’re saying. Right now, the value of the euro is in a sense anchored by Germany. Germany is seen as a responsible country with a current account surplus.

Hugh: Yes, and as a result of that perception Germans get all kinds of financial perks, like cheaper interest rates when they want credit. But it’s interesting, the Germans and the French are increasingly arguing now
about this point that you’ve drawn attention to. It was interesting to hear Jens Weidmann, the president of the German central bank, recently raising doubts about the French will to implement major structural reforms and
to bring the fiscal deficits under control. If the tensions grow on the German/French axis, we’re going to be in even more trouble. But, yes, Germany is seen at the moment as the heart. 

20130610 Links: Malaysia, eurozone banks, Venezuela

1. Is Malaysia "overheating"? 

Even in countries such as Malaysia where growth has been fuelled by pro-business policy measures, easy lending conditions have also played an important role in supporting economic activities, in particular for private consumption and investment.

... 

The point was underscored by IMF managing director Christine Lagarde, who, in a speech delivered during a meeting of the Economic Club of New York on April 10, cautioned that although it made sense for monetary policy in the emerging and developing countries to do the “heavy lifting” by remaining accommodative during the recovery period and in a low-inflation environment, there were unintended consequences. 

She points out that “low interest rates push people to take on more risk – some of which justified, some of which not”. 

Standard & Poors Rating Services analyst Ivan Tan says low mortgage rates is one of the reasons that have spurred demand for residential property in Malaysia. 

He says in a report titled “Rising property prices could expose vulnerabilities in the Malaysian banking system” that a resilient economy has also spurred demand, which in turn has driven up prices since there is also a lack of supply. 

Tan says borrower repayment ability will be supported so long as the economy remains resilient, unemployment stays low and interest rates remain low but notes that price increases have also placed the credit quality of some home loans in the spot light.

2.  Eurozone bank stress test: Plug in your own assumptions on capital ratios and haircuts, and see what's the estimated capital shortfall and how many banks would fail the test.

3. Hyperinflation in Venezuela.