Thrift's Paradox or how economics can be made simple

We are all slaves to dead economists, the (late) British economist JM Keynes famously stated. A lot of politicians on both sides of the Atlantic have committed mistakes that indicate that they could need a hefty dose of pre-Keynes thinking. I am talking of the Thrift’s Paradox, first formulated by Mandeville in 1714. Put briefly, it states that if we all save to become richer, we all end up poorer.

It is a brief statement, and to most people without understanding of economics, it seems like simple nonsense. If something works for me (saving to improve my financial situation) it must also work for the government.

It sounds obvious. But it does not make it any more correct. If I save, it means that somebody else’s business will suffer a lack of demand. And if a lot of consumers decide to hold back on consumption, it will mean that a lot of demand disappears. In the end it is felt all the way down to the producers and they will respond by reducing output and laying off staff.

This simple mechanism is one of the most misunderstood issues in economics. It is also one of the most misused. It is easy to make political soundbites by comparing the public sector to a household. It is difficult to catch voters’ attention while trying to explain why it is wrong.

In the current situation, households on both sides of the Atlantic are saving in order to improve their balance sheets. That leads to lower demand. It would only be normal if the government sectors would do the opposite, spend in excess of the revenue, in order to keep the economy going during the transition. The public sectors can then – later – concentrate on improving its balance sheet. Usually, the governments are then also helped by a sprinkling of inflation reducing the real value of the debt.

Because of the suddenness and the depth of the economic setback in 2008/2009, many governments are running sizeable deficits – induced by lower tax revenue and increased spending related to unemployment. Since late 2010 significant efforts have been made to reduce government deficits. That austerity hits us now.

In the US, a weak president has left the field open to voodoo economics espoused by an uncompromising Tea Party. In Europe, the strongest economy, Germany, is also the one least inclined to add stimulus. And Germany will not “save Europe” until Europe’s institutions have been reformed – which is being blocked by France.

Central banks are the only ones left holding the rope. They do not have an awful lot of rope to give. Economic growth estimates will be adjusted downwards in the near future. A period of slow growth seemingly lies ahead. A lot of it caused by a wrong policy reaction, caused by the wrong political philosophy at the wrong time.

For once I will quote from the Economist's Free Exchange Blog. (Article from 28 July 2011). It reads:

“The challenges facing Europe and America are big, but they're not mysterious. In Europe, the issues are sovereign debt, vulnerable banks, and a poorly designed currency area. It's not tricky to see what must be done. Peripheral debts should be addressed through austerity, sure. But unsustainable debt loads need to be written down. Banks should be recapitalised to prevent trouble in financial markets. Emergency funds should be bolstered to fight sovereign and banking contagion. And substantial fiscal integration must take place, including fiscal transfers to support peripheral economies while they get their budgets in order. The central bank should also stop fighting the phantom of accelerating inflation.(...) “Again, it's not like the correct policy path is incredibly complicated. Here, I'll sum it up in three quick steps:

Don't cause a major crisis.
Do spend more and tax less for the next year or so.
Do spend less and tax more after that.”

Wonder how far stock markets will have to fall and unemployment will have to increase before politicians get it. If they don’t, well...

It's the debt, stupid

Stock markets are plunging on an unappealing cocktail of worries about economic growth, the handling of sovereign debt problems, the apparent inability of politicians to bail out the markets when the markets really want it, and a handful of other assorted ailments. 

Given that analysts now realise that growth in 2H of 2011 is going to be slower, they are working overtime to adjust earnings estimates. Those estimates will invariably be lower than the pie-in-the-sky estimates of just two weeks ago, and the assumed valuations of the stock markets may take a serious blow.

How come that the adjustment to slower growth has come so quickly? At my company, Origo, we have warned about the “soft patch” ahead since late March, when early indicators showed that the US economy was in for a slowdown. European indicators have been unequivocal since April. That was also the month when commodities took notice.

On the other hand, bond markets have been right on the ball this time. Bond yields of high quality sovereign debt have fallen in the past months, giving another clear indication that something was afoot.

However, indicators of (stock) market euphoria have shown the increasing divergence between the optimism in the stock markets and the increasingly gloomy economic background. The speed of adjustment indicates what has been obvious for some time: stock markets have been living in their own little bubble for a while, and that bubble has now burst.

Summing up all these indicators, we arrive at a picture of the best announced stock market correction for a decade. The stock markets have yet again failed to predict important economic trends. Now they are rapidly adjusting and “Double-dip Recession” is now a favourite buzzword.

Which brings me to my point. For those who believe that the decline in the stock market reliably predicts a new recession, remember the famous dictum of the late economist Paul Samuelson: “The stock market has predicted nine of the last five recessions.”

I do not think we are heading into a global recession, i.e. a new period of negative growth. But I do believe that we are heading into a period of growth below trend. Remember that this economic crisis is not your standard run-of-the-mill recession. We are cleaning up after a major debt-fuelled party. It means that households, particularly in the US and the UK have to redress their balance sheets. It takes time to bring down debt, and in that period consumption has to be lower. Obviously it also hurts the banks that have financed the party.

It would not have taken more than a few years if the public sectors were in a position to let their balance sheets deteriorate for a period. That has historically been the role of the public sector in smoothing out economic cycles. But many countries were not in that position when the downturn started in 2008. Public sector finances in USA, UK, and some smaller European countries were hit full force.

At the same time the countries that could have afforded to expand their balance sheets were gripped by fiscal conservatism. The results have not been encouraging. We now have a situation where both private and public sectors are working to consolidate their balance sheets. That leaves the monetary policy to do the job of getting the economy moving.

It can’t. Monetary policy can only create the conditions for growth, and central banks have certainly done so. But when the consumers and business leaders are more focused on reducing debt than increasing loans, adaptive monetary policy won’t work. In such a liquidity trap, the money created by central banks in all likelihood fuels speculation in financial assets instead.

Oh, and in the longer term, it may be inflationary. Some voices are already afraid of an impending hyperinflation. In the big picture, however, such fears are pushed aside as asset reflation is supposed to make consumers feel better and hence more prone to consumption.

Central banks can reliably be counted upon to support the stock market this time around, too. It does not change the fact that we probably are heading into that period of below-par growth that may last for quite a while. It may not be a recession, but growth will be slow enough that it feels like one. I don’t know who came up with the expression “the new normal”.  But I do think that it is what we are looking at now. 

Will China speed up a floating of the CNY?

It is interesting to observe China’s government join the chorus in demanding that the US government clean house and get back to a situation where economic policy is based on facts rather than woodoo and political blackmailing.

I could not agree more, but it is fascinating to hear China indicate that unless something happens, the country will have to reconsider its position as the world’s largest holder of US treasury bonds. Either it is complete nonsense, or else the Chinese authorities are telling us something. The timing is impeccable.

With everybody being busy panicking it is a good time to make important political statements that will not be seized upon by protectionist US politicians.

To repeat the obvious: as long as the Chinese current account is in surplus AND as long as the Chinese government opts for a (very) slow appreciation of the CNY against USD, China has no choice. The Central Bank is forced to purchase USD denominated assets in order to avoid an appreciation of the CNY. As long as the currency peg is maintained, Chinese worries about the value of the dollar are just theatrics.

China has no effective mechanism for absorbing the boost to domestic liquidity that comes when Chinese exporters exchange their dollars for CNY. This huge boost to the domestic liquidity is easily the most difficult issue for Chinese policy makers to control as it drives domestic inflation upwards. It forces the central bank to increase interest rates, when in fact the correct thing to do would be to sell CNY-denominated government bonds to the public.

As long as China does not change her currency policy, the harsh words about the US government and the need to replace to dollar with another reserve currency are simply noise, aimed at positioning China favourably towards their own constituency, a large number of developing countries. But the words will not be followed by actions.

However, something else may be brewing. In a series of articles, Yu Yongding, currently President of the China Society of World Economics, and a former member of the monetary policy committee of the Peoples' Bank of China as well as Director of the Chinese Academy of Sciences Institute of World Economics and Politics has indicated that the Chinese government is ready to move a bit faster towards letting the CNY free itself from the peg to the USD.

There is no doubt that the Chinese leadership finds itself in a dilemma. The USD peg has been instrumental in building up Chinese exports and has created a huge flow of investments into China. But now that policy creates other, insidious domestic problems. Yu Yongding’s articles indicate that a serious discussion is going on inside the corridors of power in China.

Yu Yongding is adamant that a currency reform must happen on “market terms”. Translated to plain talk it means: We will not do it if it can be seen as a result of American pressure.

While this kind of exegesis may seem irrelevant as the stock markets are taking a pounding, it is worth noticing that the symbiosis between US deficits, Chinese surplus and a CNY-USD peg has allowed us all to have lower interest rates than we have really needed. It has been one of the important elements in creating the debt-fuelled boom that burst in 2008 (of course, bad regulation and plain greed were other important drivers).

So if China is now signalling a further, more significant step away from the need to buy USD treasury bonds, the world better sit up and listen. The impact would be far bigger than further downgrades of US debt. The ensuing increase in bond yields would be sufficient to actually force the savings balance of the USA towards an improvement. Not a bad idea. But it would help to keep US growth below trend growth for a decade or so. And the rest of us certainly would not like that.

S&P downgrades the US and their own importance

So Standard and Poor’s has stripped the USA of the AAA rating for its federal debt. A lot of media attention is paid to this fact and legions of experts are being asked by serious-looking news presenters: Is this really the end of the world?

Fortunately it is not.

My initial reaction was that if Standard and Poor’s put the same good analysis into the US government debt as they put into the analysis of Sub-Prime Mortgages, we are probably fine. Readers are reminded that Standard and Poor’s together with Moody’s and Fitch were caught pants down having essentially eschewed even a minimal research effort in order to maximise revenue when CDO’s were all the rage at 5 years ago.

Since then, the three US government chartered ratings institutions have done quite some work to re-establish their tarnished image and - one presumes – their revenue. They have not really succeeded.

It is a fact that the ratings institutions are home to a series of conflicts of interest that would have clients run away screaming. Their business model is that they are paid by the issuers of the bonds to be rated. They cannot be sued for damages in case they are mistaken, since they simply get away with invoking the First Amendment to the US Constitution: Their expensive analyses are simply expressions of the right to free speech. They have a government-approved monopoly on the rating of nearly anything. Like auditing companies it is considered suspicious if an issuer terminates the contract with them. They do not shy away from rating a whole “production chain” of derivative products, including the insurance companies.

Despite an appalling track record, these institutions still hold considerable power. It is because pension funds and other institutional investors across the globe have given themselves internal guidelines that essentially dictate the portfolio composition on the basis of the ratings of the bonds.

Doing so of course frees the institutions of the responsibility for having an informed opinion about the assets they hold. That reduces the cost of running an investment department considerably.

It is not because of the quality of their analysis that ratings matter. They matter because they have become a convenient replacement for independent thinking. And because of the way huge amounts of money may move as a result.

The US government and congress of course now protest: S&P are wrong. So did the Greek government and parliament as the ratings downgrades fell thick and fast over Greece the past 15 months. They know very well that money may move out of their assets as a result, pushing up interest rates in the process.

Fortunately there are signs that the financial markets have learnt to take the ratings with a pinch of salt. After some noise, investors probably will conclude that there are no compelling reasons to reshape portfolios on the basis of the downgrade alone.

The only alternative is of course to modernise the ratings institutions. They should be made liable for their own mistakes (well, not exactly in fashion in the financial sector these days). More ratings agencies should be established. Government licensing should be withdrawn and new entrants should be given easier access. Government or supranational institutions should get involved. That would be the only way of putting an end to the political meddling and abuse of monopoly powers so blatantly displayed by the ratings institutions.

Greece vs. Lehman? Look for the next AIG instead

Much of the discussion about how to restructure Greece’s debt has focused on the banks and other institutions that will take a hit when the unavoidable happens. It is in fact pretty simple. As a sovereign issuer, Greece of course knows precisely how much debt is outstanding. Regulators in other countries have a pretty good idea who own the debt, since they can force the banks to disclose their holdings. So when politicians are negotiating, they know who will lose. It is just not good style to tell.

The fact that 100’s of banks would take a hit has led to comparisons with Lehman. That is a wrong comparison. When Lehman blew up as a direct result of their own incompetence, the real surprise was that AIG blew up as well. The culprits were of course CDS’s.

Buyers of CDS’s buy insurance against a credit default – lyrically referred to as “protection”.  One does not need to have given credit, i.e. to hold bonds in order to buy CDS’s. Buying or selling CDS’s has become a simple speculation in a default with volumes of "protection" traded often massively exceeding the volume of underlying bonds. As the Lehman/AIG debacle showed, if too many have speculated in a default happening and on the other side we find only one major seller of CDS’s, the situation can become unmanageable.

A combination of gaping holes in the accounting rules, a complete lack of transparency, and plain incompetence and greed created a situation where the US government chose to simply pour billions of dollars into AIG. The purpose was to make sure that the buyers of CDS’s on Lehman debt did not end up in a situation where the “protection” they had bought did not vanish. It is by now a well-known story that a bank like Goldman Sachs received cash compensation to the tune of USD 14bn directly from the US government via AIG’s accounts.

Back to Greece. It is obvious that a debt restructuring is necessary, and Germany has suggested a voluntary maturity extension. It had to be “voluntary”, i.e. the holders of Greek debt would have to accept swapping short term debt for long term debt without saying: “hey, you are forcing me to do this, it means Greece has defaulted on the short term debt. That is a credit event”.

The important term here is “credit event”.  What constitutes a credit event is not defined by politicians but by ISDA, the International Swaps and Derivatives Association. It is a private organisation which serves as the financial market’s own watchdog over OTC transactions. In other words, even if European politicians were hoping to construe a maturity extension as voluntary, ISDA could simply say that they were having none of it and define it as a credit event.

In that case, all the CDS’s bought and sold on Greek government debt would have to be settled, the credit default protection would be activated. And here lies the rub.

Despite several well-meaning political efforts to force open the CDS market, it is still largely unknown how many CDS’s have been established on Greek debt. Nor do we know for certain who are the holders and who are the issuers.

Whereas holders of Greek government debt are relatively simple to identify, it is close enough to impossible to find out who is sitting with the CDS risk. It may be banks. It may be commercial companies. In other words, there is a sizeable risk that the holders of Greek debt will not be alone in taking a loss. Issuers of default protection will also take a hit, and they may or may not have enough capital to survive a credit event. This uncertainty could indeed create a new freeze in the money markets. We know what that leads to.

If that were to happen, it would be the second time in three years that the CDS market proved dysfunctional. Which leads me to my real point.

Since 2001 corporate bonds and particularly junk bonds (conveniently renamed “High yield bonds”) have been very strong performers across the world. This is partly due to the existence of CDS’s , which have allowed the treasurers of the corporate world to have the illusion of being able to manage the default risk on the issuer of the corporate bonds.

If Greece fails (as I believe it will), it could lead to a major blowout of CDS’s, where nobody would know who would be hit. And in the after math, it could lead to a major loss of confidence in a system which has blown itself up twice. The effect could very well be a visible widening of credit spreads worldwide.

I have earlier written that I believe risk is priced way too cheaply. It has become cheaper since back then. A “credit event” on Greece could be one step in the direction of normalising the price of risk. But it would not be pretty.

The value of implicit bank guarantees

In an event little noticed outside of Denmark, the Danish FSA and the finance ministry let the country’s former fifth largest bank, Amagerbanken, go bust . This happened after a couple of attempts at recapitalising the bank. Remarkably, the holders of Amagerbankens’s bond debt were told that they could line up with other creditors to get their money back.

It has created quite uproar in Denmark’s financial sector, where previous bank collapses had been handled with “due respect” for the interest of bond holders. 

As a direct consequence, the international (read: the US) rating agencies have downgraded Danish banks several times since then, most recently at the end of May.

Predictably, Danish banks are lamenting the fact that the government has shown its willingness NOT to compensate bond holders.

Their spin is that the lower ratings mean higher funding costs and thereby a competitive disadvantage for Danish banks. So we are to believe that the FSA and the finance ministry willingly have weakened the position of the country’s own banks?

One could look at it differently. I have several times wondered why simple capitalist principles were not applied when it came to the banking sector. The answer is that a) the banks were much weaker than anybody outside the sector had expected and b) the banks have been very good at making politicians believe that it would be the end of civilisation as we know it if banks and their owners/creditors were to shoulder the burden of their own greed and recklessness.

If we look at it this way, Denmark is the first country that has shown the way forward (well, Iceland sort of did, too). If banks cannot survive with the capital they have, they go under. Those who had lent them money should take the losses, since money lending inherently is a risky business. That seems a very healthy principle for “bank resolution”, i.e. dealing with dead banks. And by the way, it was exactly what Sweden did during its systemic banking crisis in the early ‘90s.

But what about the increased funding costs, stemming from the absence of a government guarantee to the lenders?? 

The right way to look at this is not to bemoan the situation of the Danish banks, but instead look at the difference in funding costs as the market value of the implicit government guarantees. We are in a situation where banks in other European countries have higher ratings than Danish banks, simply because the governments are expected to pick up the pieces if another bank blows up. It could hardly be unhealthier.

I quote former US Secretary of the Treasury and Chief Economic Advisor to President Obama, Larry Summers, who in 2000 said:

“While conditioned, precautionary financial support is constructive in some cases, the risk inherent in systematic availability of unconditional credit to countries can be summarized in two words: moral hazard. ... It is certain that a healthy financial system cannot be built on the expectation of bailouts.”

Summers later minced his words in a quite spectacular way and helped engineering the biggest giveaway of taxpayer money in modern history. But that does not make his statement of 11 years ago wrong.

Banks’ funding costs should not be based on implicit guarantees. They should be based on the availability of a capital base sufficient for their activities. Incredible that it is so difficult to get this simple message across to the banks.

Well, an implicit guarantee does not weigh on the balance. It allows a higher financial leverage. And it creates the possibility of higher return to the shareholders and fatter bonuses to the bank management. Go figure.

Post-restructuring, which future for Greece?

The events around Greece and its government debt are taking new turns every day. It understandably has the financial markets on tenterhooks. A good deal of the commotion comes from the fact that more and more economists and market participants are trying to do the math, and they end up with more or less the same conclusion: No austerity policy will make it possible for Greece to repay its debt. In particular not when the austerity measures are meeting increasing resistance from the voters.

Some of the more sanguine observers have begun to make – not entirely unfounded – comparisons between Greece and Argentina. Two decades ago Argentina introduced a “currency board” whereby the currency was pegged to the USD in an attempt to control inflation. After an initial period where exports picked up strongly, the domestic economy floundered, unemployment increased, government deficits exploded, and the current account worsened. The government debt was largely sold abroad, where investors believed in the strength of the currency board.

However, in absence of serious reform, the government deficit continued growing, and servicing the debt meant a serious further strain on public finances, and even a wave of privatisations was insufficient. In 2001 the currency board evaporated, the currency depreciated by a whopping 70%, and in 2002 Argentina defaulted on the debt. It has taken nearly a decade of economic hardship to rebuild the economy and in 2010 Argentina offered to resume paying back the debt.  

There are some eerie similarities between Greece and Argentina. Most significantly, both entered into a very rigid currency regime with an economy that was clearly not ready for such a move. The ensuing drop in interest rates mainly led to an increase in property prices and consumption. The economy did not in any way undergo a development whereby investments were made in sectors that would increase the export competitiveness.

That is the main problem with Greece. No matter what happens to the Greek government debt (my guess: debt rescheduling, followed by a small haircut, eventually default), or Euro membership (my guess: will be maintained for now), in order for Greece to move forward, some serious structural reform is necessary.

The problem here is that “serious structural reform” has a meaning that not everybody likes. I may mean that established power concentrations will have to be dissolved, labour market conditions may have to be liberalised, public sector reformed, a serious privatisation programme will have to be introduced.

All of that will upset the existing status quo and that is usually not wanted. But since Greece’s exit from the
Euro is far away, such reforms will have to be more profound, since no currency devaluation will help the adjustment. I am afraid that the full weight of the necessary changes in the aftermath of a restructuring has not yet dawned on all parties.

It is interesting to see that the European consensus of “extending and pretending” is beginning to unravel. Whereas Germany is beginning to see the advantage in restructuring Greece’s debt while Spain and Italy have strongly denied that such a thing could happen. They are obviously afraid that they will stay out of the limelight as long as EU covers up for Greece. That position becomes increasingly untenable as time passes.