Why Increasing China’s Labor Costs Is Good For Everyone (Almost)

The featured article on Economist is about the rising power of the Chinese worker. Indeed. A long waited increase in Chinese workers salaries will have many good implications for China itself and the rest of the world. This article analyzes some of these benefits. In addition to the mentioned benefits in the article, which I summarize briefly bellow, there is one more.

This is that an increase in Chinese workers salaries will improve the competitiveness of other countries, like the Europe’s south, who now suffer, from the abundance of cheap labor in motherland China. In sort, the benefits from increasing China’s labor costs are:

1. Increase the ability for the Chinese workers to enjoy the fruits of their labor.
2. Balance the Chinese economy which is currently heavily depended upon investment.
3. Boost the world economy, by increasing consumption.
4. Balance the China’s trade imbalances with the rest of the world.
5. Adjustment in the Juan’s exchange rate.
6. Increase the employment in the rest of the world, as less jobs from the other countries are going to be lost to China.
7. Improve the competitiveness of other countries.

The main cost from this increase, will be the increase in the price of Chinese products, but this is counterbalanced with all the above benefits, especially that of increasing employment in other countries, and also the fact that at this time a little inflation is not bad.  The ones who may lose more form this rise, is going to be the shareholders of the big corporations who have factories in China.

Citi’s Stress Tests Results

The picture bellow shows the results of the failed European banks – those with stressed tier 1 capital ratio of less than 6 percent – Citi worked out, given more stringent scenarios and the debt portfolios that were revealed from the European stress tests last week. There is a clear difference between Europe’s results – 6 failed banks out of 91 – and Citi’s results – 24 failed banks out of 91. This is attributed to the more stringent scenarios tested by Citi. Note, how much damaged the Greek banking sector is as 5 of the 6 Greek banks that took part in the tests failed, and the last four positions in the list are occupied by Greek banks. For the details of the exercise run by Citi, click here.

More on Debt-To-GDP Measures

Here, I would like to come back to a topic also raised in a previous article, the debt-to-GDP measures, and their use as indicators of the fiscal state. That article was devoted to the different debt-to-GDP measures that can be constructed by using different measures of debt (external, internal, public, private, net or gross). At that article I focused on the numerator of these measures. Here, I will question the plausibility of even using any of the debt-to-GDP measures. Hence, I am focusing on the denominator of such measures.

The debt-to-GDP measure is a number that reveals how much bigger is the debt relative to the country’s GDP, or how many years of output are required to payoff all the debt. But, the assumption itself that the country’s output is used in order to payoff all the public debt is impractical. This assumption could be implemented only if the government confiscated all the private sector.

In less extreme periods, though, we expect the government to pay back its liabilities with less dramatic measures. Notably, by using the revenues. Therefore, a natural measure of the fiscal state is the ratio of debt-to-revenues or debt-to-tax collections, and it shows how many years are needed in order to be paid back all the debt by giving all the revenues in retiring the debt. This is, also, something that governments never do, as they always face, even minimal, spending needs. 

Another measure that have been constructed by Auerbach and Kotlikoff is the fiscal gap. This is measured as the difference between the present value of all the receipts minus the present value of all the obligations for a long period in the future. Both numbers are measured as percentage of GDP, thus, their difference is a percentage of GDP. The fiscal gap can be interpreted as the percentage increase in revenues or reduction of expenditures necessary to balance spending and revenues in the long run.

These two measures, the debt-to-revenues ratio and the fiscal gap are much better measures of measuring the fiscal state than the debt-to-GDP measure, for which a lot of confusion exists, and it also corresponds to an implausible scenario.

How Stringent The European Banks’ Stress Tests Were?

Here are some some details on the stress tests European officials considered.

1. Tests did not consider a sovereign default.

2. They considered what is called “sovereign shock” which means a fall in bond prices. They only considered the impact of this price fall in trading portfolios, but they did not consider their impact on the banks’ books – in which they keep the long term bonds.

3. The worst case scenario called for only a mild decline in GDP growth by 0.4% next year, and a increase in unemployment from 9.6% to 11%.

4. The price declines considered were from the price levels prior to the crisis, which makes very little sense, as these prices have already declined.

5. The drop in the 5-year Greek bonds considered  assumed to yield 13.64%. Yet Greek 5-year bond yields hit 14% at the height of the sovereign crisis in April.

6. The hurdle rate was 6% Tier 1 ratio, while the U.S. stress tests in 2009 required banks to exceed 4% core Tier 1, under stressed conditions. 

Comparing the results with those in the U.S., we find that: 10 out of the 19 U.S. lenders were found to have insufficient capital. In Europe, only 7 out of the 91 banks needed additional capital.

These tests still do not answer the question whether the banks could withstand a sovereign default, which fears created the European debt crisis, or a significant downturn. 

European Banks’ Stress Tests

  Watching the Greek news over the weekend, I witnessed feverish broadcasters, almost panicked, emphasizing as strongly as they could that the Greek banks are safe and that all, yes they were saying all, even though one failed, had passed the tests with great success and that no risk existed for the banks. It was so clear that the whole thing was orchestrated. They even were slowing down their speeches, almost spelling the letters, when they would say how A L L  the  B A N K S    H A V E   P A S S E D   T H E    W O R S T   C A S E   S C E N A R I O     T E S T S.

And, of course, these were hardly the worst case scenarios. They weren’t even the most possible scenarios.  Apart from their profound eagerness to emphasize the result, which shows that there is something there, there were other reasons to not take what they said at face value. For example, the Greek media trumpeted how much more the capital requirements were for the Greek banks, 15 percent, in comparison to the requirements of let’s say Spanish banks, which was only 6 percent.  They failed to mention, though, what counted as capital and what prices they used in order to value the bonds and the other assets the banks hold. Reading in the press, my suspicions that there has to be something fishy here were validated, as I realized that they used the before the crisis asset prices. But those prices have already declined in some cases more than 15 percent.

If we also remind ourselves that European banks have already received billions of tax-payer’s money in order to stay “well” capitalized, these phony tests clearly fail to calm the worries of investors. After all this infusion of capital, they still cannot pass serious tests, or at least the European officials seem afraid to consider them. If nothing else, this behavior, doubled up with the   a p p a r e n t   eagerness of European politicians to draw a different picture,  make us reach a different conclusion than the one they want us to reach.

Past Performance, Future Forecasts, And Taxes

Not surprisingly, the central piece in the talk continues to be the mounting debt and policies that could address that, and more specifically the taxes. The Bush tax-cuts are perhaps going to be the coming election’s campaign theme.

Related to the talk on taxes, WSJ today publishes an article “The Democratic Fisc” which uses the White House’s budget office numbers, published on Friday last week, to have a look at the past performance and future outlook of the U.S. economy. WSJ says “the main message is that tax revenues are smaller, spending is greater, and the deficits are thus larger than the White House has been saying”.

The article compares the current period with the 1981-82 recession which is similar in its severity with the one the current administration inherited. What strikes me are the following differences between these two periods:

	1981-1987	2009-20012
Budget Deficit:	less than 6% of GDP	current 9.9% of GDP, it is expected to rise to 10%, before it declines to 5.6% of GDP
Revenues:	17.3% of GDP, despite pro-growth tax cuts	14.5% of GDP, expected to increase to 15.8% in 2011 when big tax increases hit
Policy:	tax cuts across-the-board	spending, temporary tax rebates, jobless benefits

The findings, from the above table, clearly raise the long debated question about the effectiveness of spending and tax cuts. I will return to this later.

Some other factors that enhance the bleak future economic outlook are described by (1) the expectation that deficits will not shrink bellow 3.4% of GDP over the next ten years, (2) the ratio of debt-to-GDP will continue to increase over the same period, (3) there is no plan yet to fight debt, (4) spending is expected to increase and (5) taxes are increasing -- this is not a request of the fiscal commission, which means that perhaps more taxes are coming.

A Great Movie! “Inception”

Yes, there is activity outside of offices, and some people make great things. One of them is the new Movie “Inception”. It is a great movie. Highly recommended.

Austerity vs Stimulation: The Questionable Effectiveness Of Spending

Austerity measures are usually combinations of government spending cuts and increased taxes. Stimulating practices, on the other hand, are consisted of combinations of the exact opposite actions, increasing government spending and/or reducing taxation. Therefore, it is clear that perhaps one has to choose one or the other, austerity or stimulation.

The above premise is based on the belief that one can create stimulation in the economy by increasing government spending or reducing taxes, and that one can save money by cutting spending or increasing taxes. But how much of it is true? Are the policies that help the country’s balance sheet hurt the economy’s growth? This article attempts to answer both questions.

It is always the case in economics, that an action generates more than one effect and often times these effects move in opposite directions. This is the case also here. Let us start with the alleged austerity measures and their effects.

Austerity Measures

1. Spending Cuts
   1. Effect on Output: Output may decline.
   2. Effect on Balance Sheet: Interest rates may decline.
2. Tax Hikes
   1. Effect on Output: It may decline.
   2. Effect on Revenues: Collected taxes may go up or down.

Spending Effect on Output

In what follows I will discuss the consequences of spending cuts, or increasing spending, on output. I focus on this because this is the most relevant topic these days. The current economic situation is described by anemic growth and high debts. In order to address one we may deteriorate the other and vice versa. Currently the discussion has focused on whether one, for example the U.S., should engage in tight fiscal policy, and more specifically, in cutting spending. This week FT hosts a debate on the same topic inviting articles from renowned economists.

Whether spending has an effect on output is summarized by the value of the spending multiplier. This is a number that stands for the number of dollars is generated in output by one dollar spent by the government. Advocates of spending policies justify their opinions on spending multiplier greater than 1.0. How much of it is true?  

The answer is that, at best, the academic community has been inconclusive about the effectiveness of spending on stimulating output. This means that there is a lot of doubt, in the academic community, that spending works, i.e. that spending has a multiplier value greater than one.

For example, Barro and Redlick (paper link, WSJ article) find that defense spending has a multiplier of 0.6-0.7 at the median unemployment rate – while holding fixed average marginal income-tax rates – and there is some evidence that the spending multiplier rises with the extent of economic slack and reaches 1.0 when the unemployment rate is 12%. Estimating spending multipliers for non-defense spending is problematic as the nondefense government purchases are positively correlated with the business cycle and it is difficult to establish causality. Is it the spending that created growth or the growth that spurred government into spending? Barro and Redlick think the latter.

The same ideas are reiterated also in Wednesday’s FT article by Kenneth Rogoff. He believes that:

“At the same time, the stimulus benefits of massive fiscal deficits are not nearly so certain as proponents of a new surge of spending maintain. The academic evidence on Keynesian growth effects of fiscal deficits is thoroughly inconclusive. Ironically, a lot of the newfound conviction comes from the casual empiricism on the growth effects of the Bush tax cuts, evidence that few academics consider sufficient to outweigh the mass of previous results. Indeed, it will take researchers many years, perhaps decades, to sort out the effects of the massive fiscal stimulus that many countries undertook during the crisis. My guess is that scholars will ultimately decide that fiscal policy was far less important than monetary policy and measures to stabilize the banking system.”

In addition, a rough method I employ gives me a spending multiplier of 0.6, less than 1.0, rendering spending an ineffective policy. Finally, there are people who argue that the multiplier is negative, in which case, spending by the government decreases the output. This is also called crowding out.

There are however economists who argue that the multiplier is greater than one. Christina Romer, head of the President Obama’s Council of Economic Advisers, and Mark Zandi, from Moody’s, claim that the multiplier is 1.6. Note that, Keynes believed that the U.S. multiplier in the 1930s was 2.5.

Policy Implications

It is clear, now, that if the value of the multiplier is what the consensus has it in the academic community, around 0.6 or lower, cutting spending will have a small effect on output, as it is also the case that giving another stimulus package will generate little additional growth in the economy. Clearly, the opposite is true if the multiplier is 1.6 or higher, like some people advocate. However, the benefits of any policy have to be weighed with the benefits or costs of contingency scenarios. A policy creates repercussions that also need to be evaluated. For example, spending cuts may or may not decline the economy’s output, but it also has an effect on the country’s balance sheet, the expectations of both the bond investors and the consumers. A policy decision is an act of balancing the fears of all the groups that are involved in a given situation. (For more, read on the big number of factors that affect the value of debt.)

Not Exactly, Mr Krugman.

Paul Krugman expressed his view against austerity measures at this time. Even though I also think that we should not take austerity measures right now, I have to disagree with the argument he gives in his posting entitled “Self-defeating Austerity”. The point of the article is that austerity measures have a toll on output which will decrease the government revenues (taxes). Therefore a tight fiscal policy, at this time, will be detrimental for the economy as well as the budget deficit.

Is this right? The devil lies in the details and indeed this is where it again lies in the argument Krugman gives. The key assumption to his argument is the spending multiplier, which is assumed to be 1.4. This means that every dollar spent by the government generates 1.4 dollars in the economy. It is not difficult to understand that if such a multiplier is really at works, then cutting spending really hurts the economy, while pilling up debt “pays for itself”.

Spending Multiplier Debate

So the question is whether the spending multiplier is as high as 1.4. The answer is that, at best, the academic community has been inconclusive about the effectiveness of spending on stimulating output. This means that there is a lot of doubt, in the academic community, that spending works, i.e. that spending has a multiplier value greater than one. There are also people who argue that the multiplier is negative, in which case, spending by the government reduces output. For a more complete discussion of this debate, click here.

In addition, a rough estimate I come up with by reversing Krugman’s argument I find that the spending multiplier is 0.6, much less than the 1.4 used in his article, rendering spending an ineffective policy.

Back to Krugman’s Argument

The whole argument is that since 1% of GDP spending could produce 1.4% GDP growth, cutting it, shrinks the economy by 1.4%, while the savings amount to only 0.65% of GDP, since a 0.25 marginal tax effect implies that the government losses 0.35% of GDP in taxes.

Now, using an arguably more accurate multiplier estimate of 0.6, we have that a 1% of GDP cut in spending, shrinks the economy by 0.6% and results to savings of 0.85% of GDP. These numbers describe a much more appealing picture in favor of fiscal tightening.

Evaluating the Benefits of Spending Cuts

In addition, Krugman calculates the current benefits of not getting additional debt. Assuming that an increase in spending is coming from borrowing at a real interest rate of 3%, the government by not borrowing saves the expense of 3%*1% of GDP or 0.03% of GDP. This amount, using the same marginal tax rate as above, implies that the government does not have to generate an additional 0.03%/0.25 of GDP or 0.12% of GDP. Given that the current interest rates are way lower than 3%; this number is actually an overstatement of the current debt benefits from cutting spending.

Even though the current interest rates are not high, so perhaps this exercise may not be relevant now, I would like to calculate the general benefits of spending cuts, i.e. the maximum benefits, by considering a case in which the interest rate constraint is binding, i.e, when debt reaches its ceiling, so that the reader gets a feeling of the benefits of these policies in extreme cases, when they are really needed. In those days interest rates increase rapidly to very high values, like 10%-20%. With a 10% real rate, the same computation done above implies that, the savings from servicing the new debt amount to 0.4% of GDP.

However, measuring the benefits of spending cuts just by looking at how much less debt we need to service, in a strictly output-measure sense, is not complete. There are other benefits which are difficult to quantify,[1] like the increased confidence of the bond community on the sovereign entity’s bonds and the benefits from escaping default. Alleviating fears and escaping from the worst, which are worthy way more than 0.4% of GDP.

Parameters as Functions of the State of the Economy

My next comment has to do with the partial approach that we usually employ in economics.[2] The costs calculated above are marginal costs when all the other parameters are fixed to the assumed values. However, these parameters are not constant in the economy. They too change with the state of the economy. For example, the marginal tax rate changes; it increases (or decreases) if taxes are increased and it declines if output declines. The same is true about the spending multiplier; it can increase if the government becomes more efficient, if the economy improves, or if the quality of projects increases. Also, it decreases as it crowds out private sector’s investments and it perhaps increases as the private sector holds on on investing, anticipating high taxes in the future. The same, at last, is true about the interest rate; it is considered to be procyclical, it increases as the credit quality of the country deteriorates, and it increases as fears or expectations about inflation increase.  

Acknowledging this fact but also ignoring to some extent, for now, and taking his argument to the extreme can reveal some of its weaknesses, which I have already mentioned. Assuming that the marginal tax effect and the multiplier are as above, the new revenue is always 0.35% of the previous period’s GDP. What is the interest rate that would make taking additional debt impossible to service? This rate would be such that r%*1% = 0.35%, hence r=35%! This means that this scheme could be played as long as real long interest rates are less than 35%. Of course, we all know that a scheme like this would have stopped way earlier, most probably at rates around 15% (this is itself arbitrary but historically justifiable).

A Spending Multiplier Estimate

Reversing the above exercise, we can estimate maximum multiplier that can sustain the above pilling up debt scheme. As the country’s balance sheet deteriorates, both the marginal tax effect and the multiplier change. Assuming that the tax effect is less volatile than the spending multiplier, we can estimate the maximum value the multiplier can get in order to facilitate servicing debt at 15%. Multiplier = 15%/0.25 = 0.15/0.25 = 0.15*4 = 0.6. So, an estimate for the spending multiplier we get by reversing Krugman’s argument is 0.6. This means that for each dollar spent in the economy by the government, the economy increases its output by 0.6 dollars, revealing that government spending is not a very efficient use of the public money.

A More Robust Answer Why We Do not Need Austerity Measures

Instead of going on and giving examples that are based on questionable estimates, a much more direct and unquestionable approach is to look at what the markets say. Interest rates are bottom low. For more, read on my answer to this question.

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[1] Putting a number on these benefits depends on the level of interest rates, the amount of debt, the growth rate of debt, the state of the economy and other factors.

[2] This is a general comment, not necessarily against Krugman’s argument, of course. After all, he warns against generalizations of his argument and taking it to the extreme.

Do The U.S. Need Austerity Measures?

The current state of the U.S. economy is described by an anemic growth and a huge debt that is increasing in a fast rate. This situation has led economists and policy makers to debate on the necessity of taking austerity measures, especially in light of countries like Germany and U.K. who proactively and willfully have taken tough austerity measures.

But do we really have two hot potatoes in our hands? My short answer is no. We definitely have one, the anemic economic growth, and, at least until now, we do not really have a U.S. debt problem, if the U.S. debt holders would require higher interest rates or if the CDSs on U.S. debt would start to get dangerously high. However, the last months we have seen the exact opposite. If nothing else, the last debt crisis in the eurozone has helped the U.S. by bringing the long term yields down to extremely low levels. Let me remind you that a few months ago long term yields touched, and even exceeded, the psychological threshold of 4%. At the time, everybody was nervous about it and people started circulating stories about the unattractiveness of the U.S. debt.

The flight to quality (quality meant in relative sense) that started with the resurgence of the eurozone debt fears reversed that trend and since then the long term interest rates have been constantly declining. Today the 10-year yield is a stunning 2.89%. Really, how bad can the outlook out there be so that there are people willing to get a 2.89% for the next 10 years?

At the same time the supposingly inflation protected assets, like gold, silver and other commodities, have not increased in value during this last period. Gold reached a new high at almost $1257.2 per pound and since then it has declined to 1191.6 today. This tells us that the markets do not fear inflation as much, which would be the case if they anticipated that the U.S. would not be able to tackle its debt and resort to printing money.[1] In addition the yield on TIPS is 1.29% for a 10-year security and 1.95% for a 30-year security. If anything else, the markets are telling us that there are big problems out there, but the U.S. pilling debt is not one of them. At least not for now.

Three Schools of Action

And the question is: should we wait until it really becomes a problem? Should we wait until the bond vigilantes take notice of the bad debt outlook of the U.S. and start requiring higher rates? There are three schools of thought about it.

The first wants everybody who even silently thinks on the issue to stop thinking! This is the most extreme view and the loudest of the three schools out there. There are people who get annoyed by even thinking or talking about it, which is incomprehensible to me.

Some of the people in the first group argue that we have time in the following grounds. For the U.S. to start having problems investors have to dislike the U.S. debt and to also like other securities, like other countries’ debt, stocks, commodities, cash and TIPS. Since this is not on the horizon right now we can wait.

This approach is risky. It basically relies on optimally timing the behavior of the investors, something that it is not very easy to do. Also, it requires we know and monitor the return behavior and flows to all the assets that could be substitutes to U.S. bonds.

The second line of thought is consisted of people who stand on the other extreme, demanding measures on fighting the mounting debt. According to my understanding, they are not so many or forceful about their views.

And the third school is consisted of people who want to start thinking and discussing the policies that eventually we will need to take at some point, sooner or later. These people encourage a healthy dialogue that will get us prepared and ready to face the Armageddon that is coming. There is a consensus among the people in this school that the mounting debt is an issue that we cannot ignore. On the contrary, it is an issue we need to start addressing right now.

The last group advocates that deciding on and laying out the policies that we will have to take when time comes, has many benefits. By having the policy makers committing on a set of policies to fight debt, will (a) alleviate the fears of bond vigilantes, therefore interest rates will not skyrocket, (b) calm the central bankers that the government will not go on with an inflationary policy, and (c) will alleviate the concerns of the public sector and hopefully they will not hold on on consumption and investment more than it is necessary based on the plan to fight debt. The performance of the economy is based on expectations. Therefore, laying out the plan, showing sternness and sturdiness in solving the problem, is as important as actually fighting it.

My view is closer to the one described by the third group. It is more prudent to, at least, start thinking about the problem, even though we may not have a problem right here right now. Since the problem is lurking, growing at a fast pace, and since we do not know how far from today the problem is going to arise, therefore how much time we have, it is sounder to decide on the policies and actions to be taken when time comes. The benefits from doing it are great, the risks from not doing it are even greater and there is no reason not to decide on policies now.

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[1] I do not include the strengthening of the dollar during this period in my calculations which could explain some of the decline in the price of gold in dollars.

Trade Can Be A Non-Zero-Sum Game

I, like John Kay, think that reiterating what seems to be obvious to economists, has value, as it may not, and in this case it is not, at all obvious to non-economists. There are people, in some cases populations, who still think that engaging in commerce is a zero-sum game. One benefits only in the loss of the other. The benefit of one is due to tricking the other counterparty to accept a not good deal for him. In order to change this fundamental misconception, that still exists after centuries since it was proved wrong; I started this blog with an article on mercantilism. Today, John Kay on “It may be a Rembrandt to you, but markets can beg to differ” writes about the same subject providing examples where trade is not a zero sum game. It is a good read for everybody.

Jacques Attali Admits Problems With The Euro's Construct And Reluctance By Eurpoean Politicians To Address Them

Mr. Jacques Attali, counsel of president François Mitterrand, admits in an interview given to greek journalists that the deficiencies of the Euro project were known at the time of EMU's creation. Mr. Attali says that they knew that Euro and eurozone economies would have problems if the creation of the Euro was not associated with centralized eurozone fiscal policy. He emphasizes that EU decided to move towards greater expansion rather than deeper expansion which would have strengthened European economies. Another important comment he makes is that Europe has been reactive rather than proactive. In addition, he finds that the reflexes of European leaders have declined significantly and currently the responses are very much delayed. Currently, the developments are dictated by the markets, rather than by the politicians. Politicians follow with great delay, something that was not the case during the years of François Mitterrand, as he says. To listen to the interview, which is in Greek click here.

A Conversation Between Two Scientists

An interesting interview of Christos Papadimitriou, professor of computer science at U.C. Berkeley, by George Grammatikakis, professor of Physics at the University of Crete. The interview is all in Greek. Click here.

Greece, A Country That Never Graduated From The Group Of Emerging Countries

Perhaps it has become clearer now, after the crisis in Greece’s debt has become a headline in all the news media, that Greece never graduated from the group of emerging economies. Nevertheless, Greece was treated as a country belonging to the group of developed countries for nearly a decade, contributing to the developing economic woes throughout this period.

First let us start with the definition of emerging markets, and then it may become clearer why confusion about Greece’s quality may have occurred. And, yes now it is clear. There is no such definition!

Different organizations use different criteria and this results to grouping the countries in different ways. Not only, though, different institutions categorize differently the same countries, but also within the same institution’s reports the same country may appear to belong in different categories. This is shown very eloquently in Kvint’s article in which he shows the confusion that exists between the classification of the emerging and the developing economies. There is, however, one thing that different sources seem to agree upon and this is the names of the different classes, which are: developed economies, emerging, developing, and under-developed economies.

Greece on the other hand is an example of an emerging country that was mistakenly taken as a developed one. By entering in the club of the Euro area countries but also during the 1990s still in the process of entering the union, it received the benefits of the monetary union like decreasing interest rates. At the time of the entrance in the monetary union Greece’s interest rates collapsed to the rates Germany was paying at 2% allowing the imprudent Greeks to borrow and spend beyond their means.

Partly, the misconception was that Greece will converge to the other countries, and especially those of the north, but without strict monitoring from the monetary union this could never happen. This is exactly what distinguishes a developed from an emerging market: the discipline. The discipline to implement measures that will shield the economy for years to come and will not just focus on the ephemeral today. In my view, this also shows that Greece could also not be considered emerging as it was not and still is not decisively on the path of reforming and modernizing the economy. The tendency is towards the past, towards more nationalization and controls.

Still, the public as well as the authorities are very reluctant of taking new measures. Their movements are very slow and the people’s attitude is that in short time, when things improve, they will be able to go back to business as usual. The government also does not want to disturb the establishment as this is the establishment the governments of the last 30 years created. The corruption is sky high and there are a lot of people who benefit from it, including the policy makers. For this reason the government does not put effort to fight tax evasion but it raises the taxes for the middle and lower class. It does not want to break the monopolies and open the labor markets, but it wants to maintain the distorted benefits of the few privileged. All these things make real changes all the more difficult. If this is not an emerging or even a developing country’s behavior then what is?[1]

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[1] For a definition of emerging markets look here and also here.

Making Comparisons? Be Aware! Factors That Affect The Value Of Sovereign Debt

In this article, I will outline the different factors that affect the value of sovereign debt. In general, the valuation of defaultable debt depends mainly on interest rate risk, inflation risk and credit risk. However, these days the main influence – concern – of debt valuations is the credit risk or solvency of the organization. In the rest of the article I focus on the factors that determine the credit quality of firms or sovereign entities.

The goal of summarizing the factors that determine the quality of debt is to highlight the complexity of debt valuations and that the comparative approach people employ due to its simplicity, can give misleading conclusions. This is for the simple reason that it is very hard to find two sovereign entities with exactly the same factor loadings. The factors I am going to give bellow can be separated in many groups.

One separation is between factors that describe the state of the domestic economy and the state of the foreign or world's economy. Clearly, open economies are affected by the foreign or global environment as much as they are affected by their local conditions.

Another separation is between factors whose values are currently known, which describe the current state of the economy, and factors whose values are forecasted based on assumptions, which describe the future path of the economy, the evolution of the insolvency measures or the (in)ability of the organization to repay its debts. The current state of credit quality is measured by variables like the Debt-to-GDP ratios and variants of it. The future evolution of the credit quality of the organization depends on estimates (forecasts) of the growth prospects in the immediate as well as longer term future. The main statistic of this sort is the growth rate. Therefore, in total there are four groups of factors – domestic-current, domestic-future, foreign-current, foreign-future.

One more important factor people look at, that is closely connected with the future estimates of factors, is the velocity or rate-of-change with which these numbers are expected to change in the future. For example, a bad current state which is expected to deteriorate fast is different from a current bad state which is expected to deteriorate slowly; therefore there is time for the policy makers to act.

Bellow I separate the factors only in local and foreign, but one should always have in mind that there are two estimates associated with them; the current, and the future.

Domestic Economy's Factors

Let me start with the factors that describe the state of the domestic economy.

1. Debt Statistics: This includes measures like[1]
   1. Debt-to-GDP ratios
   2. Aggregates of public debt (net, or gross)
   3. Aggregates of private debt

1. Growth estimates: Growth is the single most important factor in determining the quality and value of sovereign debt. Estimates of it though depend on a number of other factors and conditions like the type of growth:
   1. Stimulus packages vs healthy growth: Growth rates can be similar in value between two economies but there can be big qualitative differences between them. For example a debt driven growth is very different from a non-debt driven growth. Also, a growth fuelled by monetary easing, like in our days, is very different from a growth driven by a healthy private sector. For one reason, the government cannot keep injecting money into the economy indefinitely. There is an upper limit in this kind of activity.
   2. Types of projects: In addition what matters for the long term growth of a country is the type of projects that the public and private sector in this country is undertaking. Here comes the ingenuity of the businessmen and that of the policy makers -- are very important factors in determining the value and quality of the debt. The competence of these two groups of people is reflected in the valuations.

1. Government Spending & Government Investments: Government spending has proven to be one of the most important factors that resulted to overblown debts across all countries. This is shown by the actions many countries take to reduce their government spending in order to bring down their balance sheets.

1. Competitiveness: Competitiveness is an extremely important factor that determines the growth rate that certain projects can deliver. This measure describes the ability of the labor force. The more competitive the labor force of a country the higher the growth rate as lower cost per unit of production implies higher output.

1. Legislation: The current and expected laws of a country constitute a first order determinant of future growth. The clarity, simplicity and stability of the Laws that have to do with the labor, pensions, and taxes encourages foreign and domestic investments, hence promote output.

1. Ethics: Alternative this factor could be called corruption. The business ethics of both the labor force and businessmen is another factor that influences investments. By ethics we mean all the unwritten cultural influences that affect the behavior and attitude of a country’s citizens. Here I also include the tendency to pay or avoid paying taxes, as well as the tendency to conduct business in the underground economy, to collude, and to manipulate the markets. For example, there are clear differences between the ethical standards between Japanese and Greeks, or between Germans and Italians.

1. Size: The size of the economy and the history of the country clearly affect the investors’ perspective. U.S. is different from Holland, Belgium and Luxemburg. Even if the fundamentals of these two groups of countries are not very different, the U.S. is considered more stable since its fate depends on the success of many more projects than the success of any of the other countries. In other words, U.S. is a more diversified “corporation”. The same is shown by comparing Japan with Greece. Japan may actually have more debt than Greece relative to GDP, nevertheless, forgetting other factors that are different between the two countries, Japan has way more projects active than Greece. The history finally of the economy is important.

1. Emerging or developed: A clear distinction between the world’s economies is between those who are developed or matured countries, meaning countries that have been experiencing a stable economic environment for the last 60 years at least, and developing or emerging markets which have been facing currency and debt crises periodically and still work towards industrialization and greater economic reforms (openness). Emerging markets are associated with greater risk in reversing the growing path they have embarked upon, therefore undermining investments and output.

1. People’s psychology: This category wants to differentiate between optimism and pessimism of country’s citizens as well as their attitude towards saving and consuming.

1. Exchange Rate Mechanism: An extremely important determinant of future growth and investments is the exchange rate mechanism of the domestic country. Monetary policy is one of the policy tools (the other being fiscal policy) that each sovereign entity has in order to control and navigate the economy. In times of crises, when the country wants to improve its competitiveness, one possible action is to devalue its currency. This is what all the Euro Area countries cannot do now, even though they would like to be able to, like Greece, Italy, Spain and Portugal. Having stable and credible monetary authorities that can act decisively in helping the local economy is a first order factor in determining the quality of a country’s credit.

1. Business Cycle Phase: The current phase of the business cycle describes the prospects of the local economy. A booming economy is treated differently than a collapsing economy. The real (fundamental) prospects are different, and also the investors’ psychology is different, between these two cases, blinding them sometimes from easily forecastable problems.
   

World Economy's Factors

The world economy’s factors are consisted of all the above mentioned factors for all the foreign countries. For example, the other countries’ Debt-to-GDP ratios, the world economy’s GDP growth, the consumers’ sentiment in these other markets, the exchange rate mechanisms in the rest of the world, and the phase of the global market’s business cycle. It is very important for any country what happens in the world economy, as any shock or event taking place abroad can have strong repercussions in the domestic economy. In the current environment of strong links across all countries, no events can go unnoticed. The attractiveness of one country’s debt depends on the relative attractiveness of all foreign countries’ debts.

In the scale of the world’s economy what matters is everything that describes the structure of the global economy. Like, who are the consumers and who are the producers in the world economy; what the phase of different countries’ business cycles are; foreign countries’ balance sheets; foreign fiscal and monetary policies; foreign savings and investments decisions. In addition to the already mentioned factors I would like to highlight the following:

1. Correlation of business cycles: The more the local business cycle is correlated with the global business cycle the higher the risks to be priced. In general investors seek positions that can deliver returns as well as to reduce the overall riskiness of their portfolio.

1. Correlation of shocks: The higher the magnitude of the correlation among shocks in different markets the higher the priced risk.

1. Trade imbalances: Clearly trade imbalances affect the balance sheets of foreign countries and the relative attractiveness of foreign debt to domestic debt. There is a lot of discussion the last months regarding the imbalances between China, Germany, U.S., U.K. and the other countries.

 

To conclude, as it is evident by the long list of factors that affect the attractiveness of sovereign debt, it is very difficult to make comparisons between the debts of different sovereign entities both today and across time. This also raises a lot of questions about the studies who claim that they have studied phenomena in the past and attempt to draw conclusions about the current time. It is always challenging to account for all the possible different factors that do affect sovereign debt’s attractiveness. Something to always have in mind.

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[1] As I describe in Economic Data and Manufactured Confusion there are many seemingly similar measures of debt one can look at. One has to be careful and consistent with the measures he uses.

Bleak Prospects For The World Economy

The infamous Nouriel Roubini and his collaborator Ian Bremmer published an article in FT describing the grey picture of the world economy. The main tenet is that with the until recently "world's consumers" -- U.S., U.K., Spain, Greece, and others -- that now need to deleverage, and with the hesitation of the "world's savers" to spend more, the world economy is heading for a double dip, or another financial crisis.

"... These steps will take time. Even if all are undertaken properly, global growth will recover only slowly. But if they are not undertaken at all, the risk of a global double dip, and a new financial crisis, will grow sharply. Policymakers cannot keep kicking the can down the road for much longer."

Economic Data And Manufactured Confusion

The first step an economist has to take in order to analyze a situation is to decide what data is more relevant. These days, the talk is on the debt burdens of sovereign countries and where these will lead. In short, after Greece, who is next? Are we going to see a similar debt crisis for the U.K. and U.S. debt?

It is natural in this environment for people to try to understand the situation. Especially, if the snowstorm catches them unguarded, like in Greece. People there wonder what hit them and why they are going through what they are going through. Ignorance makes them blame the markets, the bad speculators, their bad luck, and some even attribute their debt crisis to a plan of superior centers of power for extinction of the Greek people. Others, more calmly, try to find a rational explanation and there the confusion begins. What numbers to look at?

This confusion is fed by the media, who in their own ignorance pick any set of numbers that support one or the other story, depending on the conclusion they want to make. Sometimes though, even the specialized economists do not unanimously agree on the measures that best describe a situation. One reason for this potential disagreement can be that there is more than one proposed story/explanation which are based on looking at different variables.

In our case the question is, what debt measures are relevant? For example, some think that figures on private debt are important to bond vigilantes and perhaps in an environment were money markets are in stalemate the potential inability of firms to rollover their debt may make them turn into the governments for help, like many banks have already done, whereas others strongly feel that using figures of aggregate external debt is misleading, feeding into a doom-mania. This disagreement would not exist if the numbers in public debt and external debt were the same. However, they are very different with each other, (compare estimates of 2009 public debt by country with 2009 estimates of external debt by country). The short answer to the posed question in the beginning of the paragraph is that all measures can be important, which is determined by the proposed explanation. But let's analyze the possible scenarios and the complexity of making comparisons between one country's current crisis with another country's current or older crisis.

Positive Analysis of Sovereign Debt

Choosing between these two approaches is not straightforward. First, it requires a detailed knowledge of the specific country's economic structure. Second, and most importantly, it depends on the tastes, in each specific period and case, of the bondholders. Understanding what matters in the bond markets entails guessing the behavior of the bondholders and how they perceive the economic outlook of the country under consideration. Each of the two components by itself is an aggregate of other forces or pieces of information which can be categorized into fundamental or psychological factors.

1. Debt Outlook

Let us start with the first by saying that there are four possible combinations of the debt outlook of each country: The best scenario is that both the public and private debt are small, the worst scenario is that both the public and private debt for a country are big, and in between situations that one of two is big and the other small. In the first scenario it is clear that the country has a big problem. Perhaps the crisis is very near and the authorities should take immediate abrupt steps to bypass it if they can, or choose to default. In the second scenario there is really no problem. A lot of debate though exists about the two in-between cases.

If the public debt is small and the private debt big, it could pose a problem for the country. In this case it all depends on whether the debt markets function, on the state of the world economy, on the size of the sovereign economy, and on the phase of the business cycle we are in, which largely dictates the economic soundness of the firms themselves. This is the case about Spain, which has a low public debt of 53% of Spain's GDP and a relatively high private debt resulting to an external debt of 165% of Spain's GDP.

Greece, on the other hand is an example of a country with high public debt, estimated at 113% of GDP for 2009, and a relatively low private debt, given that its external debt is estimated at 167% of GDP for 2009. However, in the current state of the world economy the relatively low private debt cannot help insight of the ballooned public debt, the lack of entrepreneurship, the lack of profitable projects, the tax evasion, and the corruption in the public and private sector. These examples highlight the importance of differences in the structure of economy.

2. Bondholders' Identity

Finally, we turn our attention in the identity and tastes of the bondholders which is a component of equal if not bigger importance than the economic outlook of each country. A clear contrast of the different impact different groups of investors can have is provided by comparing Greece and Japan. Japan's public debt is the second in the world estimated to be 189% of GDP for 2009, whereas its external debt of both the private and public sector is estimated to be just 42% of GDP for 2009. This means that all Japanese debt is held by Japanese hands, whereas most of Greece's debt is held by foreign investors, mainly European banks. Given that Japanese have no interest in bringing down their own country, as well as their known habits for saving, which makes them very patient, clearly contrasts this group of investors with the foreign investors who invest in Greek debt.

Different Debt Measures

Even though the logic of analyzing each case -- positive economics -- used above is sound, the data used are not exactly comparable. This does not mean that the conclusions are not valid, as the correct data may be very close to the ones available. But the point I want to make is that there are a lot of different ways one can construct data numbers that measure quantities that sound almost the same but they are not and that the specific construction can be very important in determining the conclusions we reach.

For example, apart from the crude distinction I used above, between public and private debt, which people these days use freely and sometimes interchangeably, there are other more subtle separations of debt. In this fashion, we have Gross Public debt[1] and Net Public debt[2] here. In addition, there is Internal debt (the total public and private debt owed to residents) and External debt (the total public and private debt owed to nonresidents repayable in estimates for which one can find foreign currency, goods, or services).

The bottom line of all this is that which measure one uses is extremely important as different measures have very different values. So one has to first decide which measure is most relevant, and then in order to make comparisons between two countries, one has to make sure that the structures of the two economies are similar in a huge array of other dimensions, that we analyzed above. In short, making comparisons is extremely tricky, but at least we should be aware of the complexity of the problem and the differences of the existed measures.

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BACK TO POST1. Gross debt consists of all liabilities that require payment or payments of interest and/or principal by the debtor to the creditor at a date or dates in the future. This includes debt liabilities in the form of SDRs, currency and deposits, debt securities, loans, insurance, pensions and standardized guarantee schemes, and other accounts payable. Thus, all liabilities in the GFSM 2001 system are debt, except for equity and investment fund shares and financial derivatives and employee stock options. Debt can be valued at current market, nominal, or face values (GFSM 2001, paragraph 7.110).

BACK TO POST2. Net debt is calculated as gross debt minus financial assets corresponding to debt instruments. These financial assets are: monetary gold and SDRs, currency and deposits, debt securities, loans, insurance, pension, and standardized guarantee schemes, and other accounts receivable.

Rogoff's Testimony In 2007; Turns Out His Fears Were Right

Only two months before the turbulent August of 2007, Rogoff expressed in his 2007 testimony in the House of Representatives view that U.S. financial system is healthy and strong. Even though the bad timing of this statement, Rogoff has been right in almost all of his other views mentioned in the testimony (as of now), even being prophetic warning against exactly the shock that was to come, i.e. a shock in the debt markets.

Why It Is Right For Central Banks To Keep Printing

Martin Wolf from Financial Times wrote a thought provoking article with title "Why it is right for Central Banks to keep printing". The article speaks directly on the hot topic of the right balance of monetary and fiscal policy. Wolf is against fiscal tightening right now and in favor of a continuing monetary easing, To support his belief he sites a paper that refers to Milton Friedman's ideas. It is a paper by Randall Wray which according to Wolf it proposes a harmonized coordination of Fiscal and Monetary policy so that none of the two does the heavy lifting alone. Even though I have not read Wray's paper and I cannot comment on it, I promise to comment on it in due time.

Back on Wolf's article, it sparked a lot of discussion, as evidenced by the long list of comments following the article. Questions begging for an answer: What is the right balance between fiscal and monetary policy? Quantitative easing or not? Do Debt-to-GDP measures matter and when are they "too" high?

On the quantitative easing front Wolf cites Charles Bean's, Governor at the Bank of England, talk on the subject.

Mercantilism And Closing Ports In Greece

Recently a certain one labor union in Greece closed the Ports of Piraeus and Corinth. Piraeus closed for two days. In Corinth two European Union owned ships were blocked for more than fifteen days. Surprisingly, though, and even though courts decided against the blocking of both ports and in favor of free trade and free transportation, the government took the side of the minority-representing union, by not imposing the law-and-order that by the constitution is supposed to maintain. These are clear signs of mercantilism and agreements under the table between the government and the union. For this reason and in order to provide some evidence of the bad consequences of these practices in the economy, I cite two articles on mercantilism. The first one is borrowed from the Library of Economics and Liberty and the second one from Wikipedia. Hopefully, the general public in Greece will become more aware of the welfare implications of mercantilism.