By Claus Vistesen, on April 18th, 2011
In a seminal paper [1] from 1958 Franco Modigliani and Merton H Miller showed why investors should not care about whether firms were financed with debt or equity. This led to the idea of the the debt irrelevance proposition and although the DIP is a theoretical benchmark rather than a real world rule the 1958 paper by Modigliani and Miller remains a key contribution to the finance literature. We should not however extend the same role to the recent attempt by researchers [2] to re-invent the DIP in a new guise replacing “debt” by “demographics”. Allow me to explain why.
Demographics, Just Forget About It …
My point of departure is Edward Chancellor’s recent GMO letter in which he tackles what he considers to be the non-issue of Japan’s dire demographics. He emphasizes two things; firstly, that economists are notoriously poor at predicting demographic variables and secondly he notes that whatever relevance demographics might have for macroeconomic analysis at large (of which Mr Chancellor appears skeptical) it is irrelevant for the investor;
Besides, long-term demographic forecasts aren’t particularly relevant for equity investors. It’s true that changes in the population have a sizable impact on GDP growth. But stock market returns are not positively correlated with economic growth. Returns from equities are a function of valuation and future returns on capital – a subject to which I will return later – rather than changes in GDP. Nor is there a positive correlation between population growth and stock market returns. In short, investors should not get too hung up on inherently unreliable long-term demographic projections for Japan.
It is important to underline, in fairness to Chancellor, that the points are made with specific focus on Japan but the the argument seems to have a more general hue. This is even more obvious in relation to one of Chancellor’s main references in the form of Morgan Stanley analyst Alexander Kinmont’s note entitled The Irrelevance of “Demographics”? Kinmont puts up the following four points which I will use as my points of reference;
1. It is not clear that demographic estimates are accurate over long time frames. In fact, while spurious specificity is one of the attractions of demographics as a talking point, the fact that neither death rates nor birth rates have proven predictable should caution one against accepting any assertion about demographics.
2. It is not clear that demographics are the critical variable in determining the level of economic growth. That role falls to the growth rate of TFP.
3. It is not clear that equity returns are related to absolute levels of growth. Equity returns are an issue of valuation. Nominal returns are greatly affected by inflation too.
4. It is not clear that demographic change, even if it is allowed as a negative for economic growth, is necessarily negative for stocks, as certain forms of demographic change may be associated with a rising equity market multiple. Demographic change could in fact represent a benign environment for stocks.
On the first point Kinmont makes points to the irony in that the worry about Japanese demographics seems to be peaking just as Japanese fertility is on the mend. This is a cheap shot though and not one which stands up to scrutiny. First of all on the fertility trend itself I get the same chart as Kinmont’s below using data from the World Bank showing a rebound in Japan from a low point of 1.29 in 2003 and 2004 to 1.37 in 2009. However, Indexmundi which takes its data from the CIA World Factbook has fertility much lower and actually declining in Japan. The latest data point from the CIA World Factbook reports an estimate of TFR in 2011 is 1.21. This is a pretty steep difference and I invite comments as to suggest the right number or at least the right trend.
(click on picture for better viewing)
All this is of course underlines Kinmont’s point that we don’t know the future and that economists have a proven track record for abysmal forecast performance. Still, we should get our concepts right at the offset. Long term projections in age structures are likely to be robust as they are a function of people already being born and while migration may change the course of ageing in any given country the fact that we are all ageing at one at the same time means that there are fewer migrants to go around. I would then claim that ageing does matter and that understanding how an economy such as Japan adapts to the ageing of its population remains one of the most vexing and important issues for social scientists and investors alike.
So when Kinmont implies that low fertility in Japan is a non-issue I have to strongly oppose. Just take a look at the chart above Kinmont himself uses. Fertility has been below replacement levels in Japan since 1970 and on current growth rates (assuming a constant growth rate of fertility which in itself is dubious to the extreme) fertility levels would reach replacement levels some time in 2030-40. So, that would be 60 years with below replacement fertility. Even if fertility in Japan (and again in most of the OECD) took a discrete jump to replacement levels it would do very little to change the outlook for ageing in the immediate future.
In claiming that demographics do not matter Chancellor are Kinmont are taking a very wide brush over the general recognition in the academic literature that our economic systems tend to hit a snag once fertility falls below a certain level (a TFR of 1.5). This is also called a fertility trap and what it means is that it becomes very difficult to escape negative population dynamics once they set in. I emphasize this since it highlights that we are not, as a friend of mine likes to point, simply shooting arrows into the void when we point to the importance of these issues. I recommend the following presentation by Wolfgang Lutz et al and the paper that goes with it or this old post at AFOE by Edward if you are still not convinced.
In terms of the postulated increase in Japanese fertility since the mid 2000 it is a positive development, but as is evident from the data this rebound is extremely uncertain. In addition, we need to know whether this is just an echo of the tempo effect (and thus how large the rebound is likely to be) or whether it reflects a real change in attitudes on quantity. I am open to contributions here but the only thing we can for certain is that ageing, in Japan and the rest of the OECD, will continue its march onwards. Here I also feel that Kinmont puts up a straw man when he invokes the idea of Japan’s population going to zero;
The unrevealed assumption, then, behind the mathematics used to arrive at widely-used population estimates is that the Japanese population will drop to zero. One cannot help but suggest that the logic of demographic pessimism is circular.
I want to re-emphasize that the issue here is not predicting fertility and death rates but recognizing the effect that the current and past trends have on ageing today and tomorrow. Try the recent work by Wolfgang Lutz, Warren C. Sanderson, and Sergei Scherbov if you want to see the cutting edge here and while uncertainty is still a key variable ageing remains a tangible reality. The main question issue I would like to get across is then that the demographic transition manifests itself in a transition of ageing and that this essentially becomes our main unit of analysis.
Growth and Demographics, No Connection?
Kinmont and Chancellor argue that demographics are likely to be less important for growth over time as total factor productivity (TFP) growth tends to be the main driver of growth.
Japan could quite easily grow at a good rate, especially in per capita terms, for a high-income developed country even in the face of a falling population (or more precisely a falling working age population). All that is required is for TFP growth to accelerate back to the level of growth enjoyed by Japan prior to the bursting of the Bubble in 1989. TFP slowdown preceded the population peak. Variation in TFP performance not in labour input growth is likely to be larger than the negative effects of population change.
This is an important point and more importantly, Kinmont offers an argument to explain the declining labour input in Japan’s economy which links in with the fact that Japan has been stuck in deflation and at the zero lower bound for the best part of two decades (my emphasis).
Labour input has in fact fallen at an accelerating pace over the past 20 years. It is clear that the fall is principally a decline in man-hours. This cannot be simply a function of a decline in the working age population because that decline only began in 2000. Instead, its origins must lie in rising unemployment and under-employment. A persuasive new paper, The Paradox of Toil, by a researcher at the NY Fed [3] argues that a decline in labour input is a natural consequence of a deflationary economy with zero (or effectively zero) interest rates.
In short, the declining labor input in Japan is a function of deflation and being stuck at the zero lower bound. In addition, this Fed Researcher Kinmont refers to is Gauti Eggertson who studied under Krugman at Princeton and did most of his initial work on the liquidity trap and the zero lower bound. So, I would be careful getting in his way without a strong look at the argument.
I think however that we might be dealing with the problem of a missing link in the sense that demographics may be one of the primary sources of deflation and the liquidity trap in the first place. This is an argument that has been pushed in Japan’s case in the sense that it was a lack of pent up demand that held Japan back in the 1990s as well as deleveraging. Indeed, Japan may hold a cautionary tale on the effects of a balance sheet recession in an economy where fertility has been below the replacement level for an extended period. The Eurozone periphery (ex Ireland) who have even ceded monetary policy to Frankfurt are case studies to this theory I think.
I would also emphasize that as labour input declines so does, obviously, consumption (aggregate demand) input which again feeds into the the paradox of thrift in the closed economy (or perhaps even a realisation crisis?). In an open economy it leads to export dependency as domestic investment actvity responds to foreign demand as well as the excess income you earn from a positive net foreign asset position (if you are so lucky as to have one) becomes a crucial source of growth.
Another more fundamental point is that if the total factor productivity growth (TFP) is a residual what is actually hidden in this residual? Well, I had a wack at the whole argument a while ago from the perspective of the academic armchair.
Technology and productivity are famously assumed exogenous in the Neo-Classical tradition while New Growth theory as it was developed in the 1980s and 1990s emphasised the need to specifically account for the evolution of technology. Today, I would venture the claim that there is a consensus that productivity and technology is a function of what we could call, broadly, institutional quality which encompass almost anything imaginable from basic property rights to the level of entrepreneurship. Indeed, a large part of research is still devoted to pinning down exactly which determinants that are most important here both across countries and through time. Now, I would argue that, in the context of standard growth theory, this is where the scope for the study of the effect of population dynamics is largest. Thus I don’t think it is unreasonable to expect the level and evolution of productivity growth and technological development to be a function of the current population structure but also its velocity which is a function of e.g. migration (new inputs?), future working age size etc. Also, this is also where human capital and the evolution of technology is joined at the hip through the idea of innovative capacity and readiness.
Once we venture into the notion of endogenous growth theory and thus the attempt to directly explain the sources and components of total factor productivity growth there is growing evidence that age structure/demographics alongside a host of other variables are important. Try this one for a recent literature review, and for the general link between growth and demographics the list of contributions is long. You just need to read around a bit.
I would argue then that growth and prosperity of the modern capitalist welfare state is highly conditional on some form of demographic balance and Japan has long since moved beyond into unbalanced territory. Basically, Japan is stuck in a liquidity trap as well as a fertility trap. The latter works along the lines of depressing consumption demand and making it very difficult to maintain key economic structures such as e.g pension systems. In addition, ageing affect the growth path of an economy and leads to export dependency, this last point however which I concede is not yet an established fact in the literature.
What about stocks then?
We seem to have two intertwined arguments here. Firstly, the extent to which demographics may have an influence on growth it is irrelevant for the investor since you can’t buy GDP growth anyway. Secondly, the evidence of a correlation between demographics and equity prices is weak and indeed, if anything, should be bullish for Japan (this last point is made by Kinmont).
Thus the FT summarized the latest findings of the London Business School team of Dimson, Marsh and Staunton, as published in the Credit Suisse Global Investment Returns Yearbook, 2010. The LBS academics examined all the available data (83 markets), and concluded that “99 per cent of the changes in equity returns could be attributed to factors other than changes in GDP”. (…) Growth is not all that it is cracked up to be. This analysis underscores previous academic findings showing that growth
per se to be of only small importance to stocks.
It would be unwise to disagree with the gist of this point. Even if I can make a connection between demographics, growth and investor performance it is very likely that buying into such a story at too high a valuation will lead to poor returns. Buying at the right value is the most important aspect of any investment decision.
This however is not the same thing as saying that just as you make sure to “buy cheap” poor demographics, low growth etc are completely irrelevant. Rather, I think that the extent to which the modern investor needs to understand a decidedly more complex macro picture with lingering deflation, heightened risk of sovereign defaults and zero lower bounds the understanding of demographic dynamics is key. We are then again discussing the question of deflation and low interest rates in Japan;
The origin of Japan’s problems is falling valuation when compared with the rest of the world. When we note in addition that it is excesses of inflation or the arrival of deflation (that is, monetary phenomena reflecting policy errors) which tend to reduce market average valuations, we feel it safe to conclude that demography will have next to nothing to do with the longer-term return profile of the Japanese market either in nominal or real terms.
I feel this is a very dangerous claim to make because it assumes that the deflation dynamics of Japan and indeed the problems facing the Bank of Japan in reviving credit growth are unrelated to demographics. In addition there is the unintended consequence of BOJ having to monetize an ever greater amount of JGB issuance in the future which in itself becomes more paramount as Japan ages.
On the second point regarding a direct relationship between demographics and stock prices (asset prices in general if you will) I think Kinmont does better especially because he does not fall into the asset meltdown hypothesis trap. In short the asset meltdown hypothesis states, in a US context, that as the baby boomers retire they will dissave and thus need to sell off their financial assets to a market which cannot support the flow, because the generation in the working age years is smaller, and that this will lead to an “asset meltdown”. Generalized, this is then the classic (and naive) nexus between life cycle economics and financial markets which postulate that dissaving into old age is rapid and imminent.
There are two problems here. Firstly, the empirical (and indeed theoretical literature) has found it very difficult to verify that dissaving occur among elderly cohorts to the extent postulated by the standard life cycle theory. Secondly, the relationship between asset prices and broad demographic aggregates appear weak. Results differ from country to country and most studies take place in a US and Anglo-Saxon setting which tend to bias the results further.
Kinmont does however point to a study by Geanakoplos, Magill and Quinzili [4] which show how the ratio of the 45-54 age group to the 25-34 age group is closely related to P/E ratios. As this ratio is set to increase in Japan, Kinmont ventures the idea that, if anything, perhaps you would want to buy Japan on the basis of demographics.
I have read the research by Geanakoplos et al and I find it intriguing, but my problem is that it does not control for the old age dependency ratio which suggests that the key ratio will be correlated with ageing in general. But I should be hesitant disregarding it on the basis of this hunch. I am preparing a large panel data set at the moment on demographics and stock prices with the aim to essentially rejuvenate a literature which seems too focused on the asset meltdown hypothesis noted above.
On a more general level, demographics and investment has been a core theme in the post crisis flow into emerging markets which, by and large, share the characteristics of being in the middle or at the end of their demographic dividend. Again, this does not nullify the importance of valuation and certainly, the recent soft patch notwithstanding, many emerging markets are still looking expensive.
Where goes the DIP then?
If you build your story up around the notion that investors buy value and not GDP growth you can easily come to the conclusion that demographics are irrelevant for the investor at large. This however would be a mistake.
I would be the first to wish for a return to a state of affairs in which investors needed only to look at valuation and firm fundamentals to make their decisions. Today however, you need to understand the macro backdrop and in order to do that you need a firm grip on how demographics affect macroeconomics. Pointing out that we are poor at predicting birth and death rates as well as pointing to weak evidence between growth and demographics do not cut it. We need not predict fertility and mortality but instead we need to understand the effects of ageing already present and there is plenty of evidence that demographics affect the growth rate and growth path of the economy.
I am more sympathetic to the strict relationship between stocks and demographics which is fickle and not well understood. Clearly, there is not presently any convincing model or framework which suggests how and why you might be able to buy sound demographics on a beta level. My main bet is that demographics should, at least, be used to qualify the notion of the global market portfolio and especially that demographics be used to re-balance such a portfolio over time.
In conclusion, Kinmont and Chancellor bring up some valid and good points in their attempt to brush away demographics as an important input variable to investment and macroeconomic analysis but you shouldn’t be fooled. Just as was the case with the original DIP you accept this new version at your peril.
—
[1] – Franco Modigliani and Merton H Miller (1958) – The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review 48 (June 1958) pp. 261-297.
[2] – GMO White Paper – After Tohoku: Do Investors Face Another Lost Decade from Japan?, Edward Chancellor and Morgan Stanley Japan Strategy – The Irrelevance of “Demographics”?, Alexander Kinmont. I realise that I have lately been referring to sources and pieces of research which by nature of their origin (banks, research firms etc) are behind subscription walls. I am sorry, but I will make sure to produce relevant quotes so that my readers can follow the issues and arguments. I cannot upload full PDF versions of the reports for obvious reasons and I hope my readers will understand.
[3] – The Paradox of Toil, Gauti Eggertsson, Federal Reserve Bank of New York Staff Reports, no. 433, February 2010
[4] – Demography and the Long-run Predictability of the Stock Market. John Geanakoplos, Michael Magill, and Martine Quinzili; August 2002, Revised: April 2004. Cowles Foundation Discussion Paper No. 1380
By Claus Vistesen, on March 11th, 2011
I recently asked the opnion of my readers regarding the question of whether the global economy is in for inflation, deflation, or stagflation. Given the obvious issue that it may be all three at different points in time it seems as if recent market action suggests that we should be looking at the d-word.
QE1 + QE2 +…+QEn = Deflation?
Even if macro soothsayer’s favorite comparison between Japan and the US is misleading because the former has decidedly more miserable demographics than the former, it is clear that US policy makers are steering into largely uncharted waters.
Consider then Atlanta Fed President Dennis Lockhart’s recent comments before the National Association of Business Economics that the Fed would contemplate cueing in QE3 in the event that the current oil price shock proved to be more severe. On the face of it this makes sense in so far as goes the idea that the main effect from sharply rising oil price is a relapse into recession and thus deflation. Indeed, the Fed can hardly be blamed for acting in the context of events which are essentially geo-political in nature.
Yet, it is much more complicated than that.
It then stands to reason that while the Fed should certainly be forward looking in conducting policy the primary effect of ongoing measures of quantitative easing is exactly to put pressures on headline inflation and commodities in general. As I noted recently at this space;
Given that we seem to be looking at a re-run of 2008 it must be factored in that the volatility and speed (and subsequent decline) of commodity prices are a problem in itself. The famous loss function which must then be metaphorically minimised is the one which plots the trade-off between the cost of recurrent flares of commodity prices and the need to act as a counter trend to the destructive forces of a balance sheet recession. Here, it becomes a rather serious issue if one of the main collateral effects of providing buckets of liquidity is to engender strong commodity melt-ups with a subsequent deflationary outcome.
And perhaps this is what is running through the mind of Dallas Fed President Richard Fisher who, in the same picece as linked above, is quoted of voicing oppositon towards QE3 and indeed that he would like QE2 to be phased out sooner rather than later.
Which way the tide will turn at the Fed is not a trivial question. There are plenty of signs that after the SP500 having tested the 1350 level, and failed, the market is running on the evaporating fumes of QE2. As one of my many market spies noted today:
(…) it is definitely possible that the market will discount the end of QE2 ahead of time this time around. This is what happened in Japan too – the market began to rally as soon as their QE2 was announced (since it had rallied smartly on QE1) , but halfway through the implementation the Nikkei began to fall, ultimately losing 45% from the interim peak and ending below the level of the day QE2 was announced. Mind, I’m not saying it will play out in the exact same manner, this is just to point out that there can be leads and lags between QE and its effect on the stock market – the QE1 experience is not necessarily a road map that needs to be repeated.
Again, we have that comparison with Japan which is then only to say that repetitions in the market rarely occur the way you expect them to, but there is definitely an unwinding narrative emerging. Team Macro Man gives their list of bearish omens today and I find it difficult disagreeing with them on the general idea that the reflation trade might be in for a stutter; at least until the next round of QE.
To their list I would add that another favorite punt of the reflationistas, gold, is finding it mightly difficult to reach new highs above the 1420s (today, Thursday, getting a right beating back to 1405ish). Now, we should always remember that the market can move three ways, where sideways is the third. Yet, the fundamentals of the gold trade kind of black or write so the ongoing difficulty reaching new highs will be rightly worrying the g-bugs.
More generally however the SP500 is only now coming down to the 50dma (at pixel time) and I would wait to see whether it forcefully breaches that level before putting on the tin foil hat.
(click image for better viewing)
As you can see dear reader, the chart is telling you to buy the dip, but chartism on such short time scales can make plenty of widows too, so be careful out there.
Looking into the rearview mirror at the ECB
I wasn’t really sure whether to cry or laugh last week when Trichet mounted himself in front of the microphones to deliver an almost sure signal of future rate increases by invoking the idea of strong vigilance. Indeed, the ECB let it be known that it was perfectly possible that their April meeting would be accompanied by a rate increase. Game set and match then!
As I have noted before at this space, stranger things have happened than the ECB raising rates just before a global slowdown. I even ventured to call it a leading indicator. Soc Gen’s always enjoyable Albert Edwards dryly noted recently (HT: FT Alphaville); “all we need now to push the world back into the recession is an ECB rate rise.”
This seems an apt take on the situation and my good friend Edward Hugh similarly notes that all this has an alltogether well expected outcome invoking the idea of the Chronicle of a Policy Error Foretold.
Now the problem with this latest policy initiative is not only that it represents something akin to the chronicle of an early death foretold for a much troubled and highly fragile Spanish economy, where around 90 percent of mortgages are variable rate ones.
It also draws attention to an area which it would be much better for the ECB not to draw attention to at this delicate moment in its history: the convenience of having a single-size monetary policy applied to such a diverse group of economies.
I heartily agree that it is due time that we, yet again, try to evaluate what it means to have a single interest policy in the eurozone. More specifically, there is the question of divergence of fortunes when it comes to deflation and inflation;
Inflation on the periphery has much more to do with rising commodity prices and the application of a misguided policy of consumption tax increases as a way of reducing fiscal deficits than ever it has to do with economic overheating.
I think it is pretty obvious that there will be no second round effects in the eurozone periphery and if the ECB is seriously suggesting this to be the case, I would dearly like to see the empirical evidence for such a claim (even a theoretical would do actually!).
Finally, we should never neglect to mention that all this might be a bluff and that the ECB like most other rational institutions can change direction based on the evidence before them. Yet, herein also lies the rub because the current vigilance comes on a backdrop which smells a lot like the last time the ECB raised only to see the deck of cards fold before their eyes. Perhaps they ought to look closer into the rear view mirror.
Random Shots indeed
The immediate conclusion here would seem to be that Trichet should get on a plane and relieve Bernanke of his post in Washington and leave the tower of Frankfurt to Benny. As FT Alphaville (see link above) quotes from Gavekal;
Since its inception, the ECB has typically been slow to cut rates (famously rising them in July 2008!) and slow to raise them. So is the fact that the ECB is now considering a tighter monetary policy before the Fed a sign that the ECB is making a mistake? Or a sign that the Fed is starting to really fall behind the curve?
I am not sure that it is either really. Core inflation in the US is still nudging down but I think that ongoing loose monetary policy will run the risk of replicating the UK more than Japan. Put differently, I think the US economy is in a position where inflation expectations might take hold which is not the case in the Eurozone periphery at large.
At the time of writing it seems an awful lot as it the deflation trade is back and thus that the market has already sucked QE2 dry and now awaits the third version. A spike in oil prices helps no-one too, but oil at current levels is not the problem, but a quick zoom to 150ish and we would have grave problems. This would then be ample catalyst for QE3 and even if this would not prevent the correction which seems evident now, it would setup another meltup in all things unprintable and risky.
We can only hope then that central banks, on either side of the pond, are taking more than random shots at our current problems.
By Claus Vistesen, on February 28th, 2011
 As the debate between inflationistas and deflationistas appear about to rev up again, I thought that I would try to pen to virtual paper and sketch my thoughts on the matter.
The specific catalyst for looking into this is naturally in part the fact that oil looks set to do a round of catch-up with the rest of the frothy commodity space but also this piece by the Pragmatic Capitalist citing David Rosenberg on the coming deflationary shock;
David Rosenberg makes some interesting comments in his morning note regarding the price action in US Treasuries. He cites the rally as a sign that the world is concerned about the deflationary shocks from rising oil prices:
“It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock.”
I think Rosey has this one spot on. The risk of rising oil is not a hyper inflationary spiral, but rather a deflationary spiral. Oil price increases are cost push inflation of the worst kind and for a country still mired in a balance sheet recession that means spending gets diverted which only gives the appearance of inflation in (highly visible) gas prices while creating deflationary trends in most (less visible) other assets (have a look at today’s Case Shiller housing report for instance).
Hang on for minute then. Do you mean to tell me that we have been running around worrying about QE2 leading to bubbles all over the place while the real danger is continuing and entrenched deflation? Well, yes this exactly what this means, but note the important distinction between the US (and the OECD) and emerging markets. Greed and Fear kicks off this week with the following point [1];
(…) an oil-led commodity spike would clearly cause an intensification of the current inflation scare which has been hitting Asia of late with India the most vulnerable market. Still, as occurred in 2008, such a spike is likely to have the perverse effect of short circuiting the inflation scare in terms of duration. This is because sharply higher oil and food prices will hit current growing optimism on the US recovery. For ordinary Americans are not seeing the income growth to offset such prices increases.
This point is echoed in BCA’s chief economist Martin Barnes’ recent mischief which exactly sets out to clear up the (non)-threat of inflation in the global economy.
Despite investor angst, the above analysis paints a relatively benign inflation picture for the developed countries. The policy mix of large fiscal deficits and highly stimulative monetary policies certainly appears inflationary. However, there currently is no excess monetary growth, and the pass-through from higher commodity prices is weak given ongoing slack in the economy.
(…)
The emerging economies are in a very different position [from the OECD]. All three approaches to inflation are telling the same story: There is excess money growth and the absence of slack implies that higher commodity and energy costs will push up wages and the overall prices of goods and services. Thus far, inflation is edging higher, not spiraling out of control. Nevertheless, policymakers need to get ahead of the curve by raising rates and, where necessary, allowing exchange rates to appreciate.
A large part of Barnes’ analysis is based on the notion of slack and thus the most illusive of all macroeconomic concepts, the output gap. But the argument is really quite simple. For cost push inflation to lead to higher overall inflation there must be an inbuilt tightness in the economy for this to happen. This is to say that workers must be able to pass on rising prices to larger than expected increases in wages and firms must observe strong final demand in order to be able to pass on the increase in prices to consumers. Barnes’ argument in nutshell is then that while capacity constraints might be an issue in the emerging world it isn’t in the OECD still mired by a balance sheet/deleveraging recession.
This argument is interesting in relation to the notion of unintended consequences from low interest rates in the developed world and just what output gap central bankers should look at then. Enter James Bullard, president for the St Louis Fed and the discussion (hat tip FT Alphaville) of the global output gap vis a vis the US output gap.
The argument here combines the two point made by Barnes in the sense that while the analysis of the US economy might certainly merit low interest rates for a long time given the excess slack of the economy, Bullard explicitly mentions the potential of adverse effects from ZIRP at the Fed due to an increasingly neutral to positive global output gap. Here is the FT’s John Kemp with the gist of Bullard’s speech as he sees it;
It is the first time a senior official at the U.S. central bank has acknowledged global capacity issues rather than a narrow focus on U.S. unemployment and capacity utilisation might give a better indication of where inflation is headed.
The obvious question here is whether the US should care at all here about global capacity issues, but given my endorsement of Rosenberg’s point noted above I obviously think they should. A central bank can argue up to a point that rising headline inflation should not be a reason for assuming a rise in underlying inflation pressures, but it is evidently obvious that as if an oil price rising to 120-150 USD (even for a short while) becomes a trigger for an even strong deflationary shock, then the original argument for low interest rates become very difficult to make.
And finally, just to make sure we get all sides of the argument we should never forget that stagflation is also looming as an increasingly likely outcome in parts of the global economy (hat tip: Global Macro Monitor).
(quote from the Economist)
Historically, the margins of retailers and manufacturers have been remarkably stable, says Carsten Stendevad of Citigroup’s corporate-advisory arm. If commodity prices continue to rise, they will eventually be passed on to consumers one way or another. After years of goods getting cheaper, consumers may have to start getting used to everyday higher prices.
This highlights a crucially important issue namely, the underlying trend of inflation in the global economy. It stands to reason that if the trend of global headline inflation is up due to structural capacity issues, an increased prevalence of adverse supply shocks and low interest rates, then bouts of headline price volatility may incrementally find its way into core prices and in a deleveraging world facing the effects of a balance sheet recession it is tantamount to stagflation.
What is the take then?
If the small tour above of the informed punditry serves to set the stage for general argument what is then the important points to take away? Below I offer my suggestions.
- The stronger the meltup the stronger the correction. This is a classic dictum in the world of finance and translated into the inflation v deflation debate it means that the stronger and longer the outbreak in commodity prices last, the larger is the risk of a deflationary correction and we are then talking about a re-run of 2008. It also raises important questions regarding the policy tools used by global central banks. Bernanke and co can hardly claim, ex post after the crash, that they were right not to react to rising headline inflation when it stands to reason that the low interest rates were the main source of the commodity melt-up in the first place (and indeed will also be the source of the next meltup a couple of years from now). In this sense, it almost amounts to a self-fulfilling prophecy that as the wall of lingering inflation and stagflation rise to a zenith you also know that the time is nigh for the correction.
- Where is the capacity? Bloomberg recently ran a number of stories pushing the story that while emerging markets were the strong performers in the immediate wake of the crisis, the fortunes were now turning to the US and developed markets. On the surface, this is undoubtedly true and a rotation out of emerging markets into developed markets remain the main consensus trade at the moment. Structurally however this masks a more fundamental question of the so-called emerging economies’ ability to sustainably absorb all the excess liquidity and savings which is trying to find an outlet. The evidence from 2008 and the current melt-up suggests that while the long term story of emerging markets as the new drivers of global growth remains intact, this is not a linear process. Indeed, we are presented with some grave questions as to the collateral damage from the process of global rebalancing that is bound to take place. Some part of the immediate inflation issues could perhaps be solved by allowing a more gradual appreciation of a broad basket of EM currencies to the USD, but this then pushes the problem further towards the question of just what magnitude of external borrowing the emerging world can be expected to do to transfer growth to ailing economies in the OECD. In addition, there is a real risk that higher interest rates coupled with an open capital account would lead to an exacerbation of hot money inflows.
- Volatility around a Trend? One of the most crucial questions to answer in this debate is whether the underlying trend of prices is one of inflation or deflation in the developed world. Based on the reaction by monetary and fiscal policy makers they squarely believe in the former. But volatility has a cost independent of the trend around which it operations. Given that we seem to be looking at a re-run of 2008 it must be factored in that the volatility and speed (and subsequent decline) of commodity prices are a problem in itself. The famous loss function which must then be metaphorically minimised is the one which plots the trade-off between the cost of recurrent flares of commodity prices and the need to act as a counter trend to the destructive forces of a balance sheet recession. Here, it becomes a rather serious issue if one of the main collateral effects of providing buckets of liquidity is to engender strong commodity melt-ups with a subsequent deflationary outcome. Could it be that we are then talking about two trends here? One which is the underlying structural forces of deleveraging and the second is the structural issue of too much capital chasing too little yield proxied by the fact the growth to fight deleveraging must largely come from external sources.
- Stagflation coming to a town near you? As I am currently living in the UK I think I am as good as any to talk about the spectre of stagflation. Whether or not you agree with the BOE in its rather complacent view of inflation (given its own inflation target policy mandate) it seems to me that the UK citizens may be the first in the OECD to really experience what a hike in indirect taxes as well as rising global commodity prices mean. Again, you could of course note that if this all ends in a deflationary implosion in the end it is a matter of semantics, but these are then semantics which matter. More generally and going back to the point made by the Economist, if the general trend in global headline inflation for structural reasons is up then one would find it hard to believe how this would not act as a stagflationary trend in a world where demand pull inflation and growth are kept at bay by deleveraging. I want to see entrenched prices before I believe it and I still concur that this is playing out largely as in 2008 (with a deflationary outcome), but in some economies it might be different and the UK is a good candidate.
- Inflation today, deflation tomorrow? The extent to which we are watching a rerun of 2008 this is what we are going to see but I also think that the further we get down towards the path where low interest rates become structural parts of the macro picture the risk is that inflation expectations get entrenched. I am not talking in the global economy as such, but perhaps in individual economies and this divergence between those still stuck in deflation and those experiencing stagflation is a dangerous cocktail.
- Kill the speculators!? I remember during the heaty days of 2008 how a large part of the observed punditry slowly but surely came to the uniform opinion that high commodity prices were here to stay and that obviously speculation had no hand at all in this. Apparently, if oil prices went up 100% over the course of 6 months, then it was all a question of fundamental supply and demand. Like Fischer and his famous remark on US stocks reaching a permanent plateau it lasted until it didn’t. In short; obviously speculation plays a part. I would have thought this to be blatantly clear. Commodities of all forms and kinds have been thoroughly securitised which is exactly what allows such a melt-up in the first place. But this does not mean that the speculators should be lined up and shot let alone that they are a force of evil. I any case, what speculators are you talking about here? What about China (and other sovereigns) stockpiling commodities in turn bidding up prices? Should these be regulated and how? And if you really want to have a go at the masters of the universe of Wall Street and the City, would that really change a bit? Speculation in the form of what Sarkozy et al waffle about is a phantom menace and the real issue here is more structural. But speculation … indeed, lots of it! Finally, I should note that this time around we have had a number of concurrent and severe supply shocks to especially soft commodities which clearly have exacerbated the melt-up. Further, the extent to which adverse weather phenomenon become more prevalent it will add volatility to the commodity edifice regardless of what markets and regulators do.
Which door should you pick then to get it right on the global economy? You would not be surprised if my answer here is ambiguous. At the moment, I am leaning towards a 2008 re-run but precisely because it appears to be a re-run it raises some additional important questions. Consider then the following form one of my friends;
The underlying problem is that the Emerging Markets as a group (while many of them are long term growth positives) simply cannot withstand the short term massive funding injection without food prices getting out of control. Food prices getting out of control produces, as we are seeing, political instability, and this leads investors to withdraw.
As noted above, this is then a issue of short term capacity to add as magnets of yield as well as long term capacity to rebalance the global economy. But this is the trend then, the speed and volatility matters too as another of my friends pointed out;
I think rates of change in oil price matter a lot more than the level. People adapt, but they can’t adapt quickly. We need to watch the speed of the oil price move. If it moves quickly, that could be a huge drag on growth like 1980, 1991, 2008.
I think these two arguments combined are very, very important. I would hold lingering deflation to be a near certainty in the European periphery and Japan where it never left. I also see many of the worst affected economies in Eastern Europe suffering a deflationary outcome. In the US, we will see and in the UK stagflation is a real threat if only because inflation may soon feed into expectations on a sustained basis. For the emerging economies as a whole they will be fighting inflation for a long time to come especially as the hunt for yield continues. In the end then, picking the door may depend as much of your time frame and unit of analysis as anything else.
—
[1] – I get G&F and a few selected of BCA’s publications through a well connected network of analysts and economists, but I cannot (obviously) reprint the whole editions here for copyright reasons.
By Claus Vistesen, on February 3rd, 2011
As the proverbial line seems to be running out for Greece, I thought that I would look at a slightly longer, although no less important, issue in the context of Spain; more specifically the trend in net migration. While much of the focus on Spain’s membership of the Eurozone has been (rightly) centered on the effect of interest rates that were too low, for too long another important aspect is the boom in immigration that followed at the turn of the 21st century.
Indeed, when we today speak of Japan (and Germany) as the oldest economies of the world Spain was, by 2000), destined to become just this but an impressive net migration rate from 2001 to 2007 managed to buck the trend;
(click on pictures for better viewing)
The decline in net migration is naturally a by-product of the crisis especially as immigrants (and especially those who are more or less sans papiers) are in the front line when recession strikes.
(quote Time)
The wave of immigrants into Spain has been fast and furious. The nation’s foreign-born population shot up from little more than 2% in 2000 to more than 12% in 2010. “The process was so quick and so intense that Spaniards and politicians had a hard time understanding what was happening,” says Josep Oliver, an applied-economics professor in the Universidad Autónoma de Barcelona and one of the lead authors of the Yearbook of Immigration in Spain 2009.
Then came the credit crunch, with its mass layoffs, stagnant growth and fiscal austerity. More than a million migrants have lost their jobs, homes and small businesses in a boom-to-bust cycle not seen since the Great Depression in the U.S. To be sure, migrants around the world are feeling the pain of the recession. But Spain’s massive and recent immigrant influx, compounded by economic restructuring beyond the construction industry, has taken a particularly high toll on foreigners, magnifying the crisis for the country as a whole.
With the unemployment rate almost surely on the wrong side of 20% you could be excused for arguing what exactly the problem is here. Surely with this kind of excess capacity in the labour market the last thing Spain needs is for the migrants to stay competing for already incredibly scarce jobs. Indeed, the Spanish government has tried to create incentives for unemployed migrants to leave in order to free up the mismatch between supply and demand for labour.
This approach however does not hold up to basic economic intuition even if it is an understandable move from a political point of view. First of all, there is likely to be a low value added skill bias in the kind of jobs migrants are taking. This is then an often misunderstood point in the context of western societies’ attempt to cherry pick the brightest graduates and lure highly skilled foreign labour to the country with lucrative tax breaks. As such, low value added labour (relative to the average level of value added in the receiving country) can provide a crucial labour input to the labour market in the form of filling up vacancies that domestic labor seekers would otherwise shy away from.
Now, you might again protest that in a severe crisis and as desperation among job seekers kick in, the matching for vacancies become subject to a general process of trading down as people accept jobs they are not qualified for simply in order to make ends meet. This is undoubtedly true but this is also the difference between a win-win and lose-lose situation then.
Migrants are ultimately attracted by work opportunities and the sharp decline in migration rates in Spain can be seen as migrants voting with their feet. In this sense, net outward migration of relatively low value added labour only to let domestic workers compete for these same jobs is not a sign of virtue let alone a recovery. I would hold this to be one of the most important structural issues to look out even if the long run effect of an economic crisis on migration is difficult to predict. In addition, and this is evident in Eastern Europe, there may be a strong (and worrying) me too effect from foreign immigrants leaving as it migh even incite Spanish young people to contemplate leaving as well especially as the labour market continues to look dire.
Finally, the obvious question is whether Spain needs immigration? Indeed it does;
As such and strong immigration notwithstanding Spain is still ageing and, rapidly so! Note especially, the twin peaks of first the 20-39 age group in 2002/03 and then the 35-54 age group in 2011/2013. This is then the great tragedy of the peripheral economies in the Eurozone in the sense that whatever last ounce of demographically induced momentum they had will likely be completely erased by the demands for fiscal austerity and internal devaluation. And once this process has run its course (whatever that means) their population pyramids will be beyond repair.
Looking at age specific migration in Spain and considering that by definition migration occurs among the most mobile part of the population (i.e. the working age population), the trend has reversed. This is also why migration flows are an important input to the analysis of global population ageing even if immigration, in no country, would be able to completely nullify the wave of ageing (indeed in some economies such as China and Russia immigration will be almost impossible to achieve in sufficient scale to dent the force of ageing).
The influx of migrants to Spain in the age group 20-39 has consequently steadily declined in the past 4 years.
The article above by Time personifies the Spanish migrant in the form of 35-year-old Colombian construction worker Doney Ramírez who used to police one of the many, now idle, construction cranes in in and around the building sites of Madrid. You could then note that Spain certainly does not need Mr Ramírez anymore as the future of Spain is not built on construction of empty houses. Indeed I would agree, Spain now needs to export. But neglecting the importance of Ramírez would be poor economics since quite possibly he could do a different job (if the economy could create one for him) and more importantly the fact that he is now more likely to leave than stay says a whole lot on the effect of ongoing deflation and deleveraging faced by Spain.
By Emmanuel Tabones, on November 22nd, 2010
In his New York Times article (October 17, 2010) on the general impact of deflation on Japan, Martin Flacker spoke of “economists who portend that this represents a dark vision of the future.” Indeed, in a speech back in August 27, 2010, America’s most powerful economist, Ben Bernanke forcefully said that “The Federal Open Market Committee will strongly resist deviations from price stability in the downward direction,” as noted by Greg Robb, at the WSJ’s marketwatch.com.
In fact, just last month, Chairman Ben made noises about the Consumer Price Index being too low, and getting considerable flack for that, what with reports of rising commodity prices, which are normally associated with inflation. Bill Bonner at DailyReckoning.com, sarcastically noted that “Bernanke is ‘right’….Prices for people who neither eat, nor travel, nor heat their houses, are flat.” Adding further fuel to the fire, Bonner’s colleague Chris Mayer recently reeled off some revealing inflationary statistics courtesy of the Wall Street Journal:
“Corn is up 44 percent, milk is up 6.5 percent, hot rolled coiled steel is up 4 percent, copper is up 29 percent, and oil is up 14 percent from a year ago.”
And we are also back to paying over three dollars a gallon for gas, and gold is way above USD $1,300 an ounce. To quote Mayer, “One day, the Fed will wish inflation were only 2 percent,”
Other economic indicators reflect this dire picture, according to Eric Fry, also at DailyReckoning.com, who came up with U.S. inflation numbers way above 8 percent (courtesy of ShadowStats.com). In other words, the “monster” has already entered the building.
Bernanke instituted QE2 in part to curb the likelihood of deflation, even though to critics, it is becoming increasing clear that he may be preparing for the wrong battle. For many, it might look like the “barbarians of inflation” are inside the castle walls, but Emperor Ben has his back turned, fending off the “imaginary dragon of deflation.”
Now, perhaps that is a little bit of an exaggeration, for deflation remains a possibility, although a remote one, a fact which even Bernanke had acknowledged, before. Echoing that view, Jens Christensen, a senior economist at the Federal Reserve Bank in San Francisco, wrote in a FRBSF economic letter published in October 25, 2010:
“The recent economic slowdown has raised concerns about the possibility of sustained deflation in the years ahead. However, a refined model of inflation-indexed and non-indexed Treasury bond yields, which captures accurately the possible inflation outcomes perceived by bond investors, suggests that the probability of sustained deflation is just 5.3%. The model accounts accurately for the behavior of inflation-protected Treasury bond yields during the financial crisis and could prove reliable in evaluating deflation risk.”
So according to another leading Fed economist, the chance of sustained deflation is under six percent. I’m very sure most folks can live with that.
Meanwhile, on the other side of the world, the Chinese are grappling with the “beast” of inflation (NY Times, November 10, 2010), and that, my friends, is what Americans should really be concerned about, for it is already here, among us, regardless of the Fed’s CPI figures. And for those still wondering, QE2 should NOT be the weapon of choice.
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By Rok Spruk, on October 28th, 2010
The economic and financial crisis of 2008/2009 hit Ireland heavily. The asset price bubble and the subsequent deflation have added to the uncertain macroeconomic outlook. How did the country went from the times of the “Irish miracle” to the prolonged economic slowdown? Following the beginning of the 2008/2009 economic and financial crisis, Ireland was hit by an unprecedented economic slowdown. In 2008, the GDP declined by 3.0 percent on the annual basis. In 2009, the GDP further declined by 7.1 percent in real terms. The unemployment rate increased to almost 12 percent.
Prior to the outburst of the economic crisis, Ireland enjoyed stable and predictable levels of public debt. In 2007, the country was known for having stabilised the public debt at 25 percent of the GDP – the lowest level of any Western European country. In 2009, the debt-to-GDP ratio increased to 64 percent of the GDP. Once known as the sick man of Europe, Ireland’s economic policymakers have implemented a set of fiscal policy measures aimed to boost the long-term economic growth and abolish the economic policy based on the state intervention, high tax rates on labor and capital and export-led growth.
Ever since the 1960s, Ireland pursued a soft version of industrial policy targeted at the promotion of inward foreign direct investment and the education of highly skilled workers. In addition, Ireland reduced the corporate income tax rate to 12.5 percent and provided a thorough technical assistance and to multinational companies located in Ireland. Indeed, U.S. multinationals such as Microsoft, Dell and Intel were encouraged to locate in Ireland mainly because of its geographic proximity to key European markets, skilled English-speaking workforce, membership in the EU, relative low wage level and favorable corporate taxation.
In early 1990s, the results of a precise set of economic policies were spectacular. By the end of 2006, the unemployment rate dropped to 4.6 percent from 18 percent in early 1980s. Between 1992 and 2005, Irish GDP increased by an average of 6.9 percent while the investment grew by 8.6 percent on the annual basis. The largest contribution to GDP growth was domestic demand (5.3 percentage point). Hence, Ireland’s public finance enjoyed a favorable outlook mainly due to the rapid decline of debt-to-GDP ratio from 1980s onwards, and from a relatively low demographic pressure on the budgetary entitlements.
During the Irish boom, Irish banking and financial sector were highly dependent on the wholesale funding. Due to largely positive macroeconomic outlook from 1990 onwards, Irish banking sector received high and consistent credit ratings from agencies such as Moody, S&P and Fitch. In turn, the reliance on fragile wholesale funding resulted in overleveraged balance sheets. After the failure of Lehman Brothers in September 2008, the short-term outlook on Irish banking sector signaled a significant rise in credit-default swaps which raised concerns over the ability of banks to provide the wholesale funding for a mountain of short-term debt liabilities. And since the overleveraged balance sheets downgraded the outlook on Irish banking sector, the institutional investors demanded higher risk premium to extend the funding channel to the Irish banks.
The Directorate Generale for Economic and Financial Affairs of the European Commission downgraded the macroeconomic forecast of Irish GDP growth. By the end of 2009, the economic activity plummeted by 7.1 percent. The housing market crash was largely a result of the asset price bubble channeled through the overinvestment in the construction sector which represented 12 percent of the GDP. Nothing could explain the deflationary pressures in the aftermath of the financial crisis than excessive housing prices during the pre-crisis Irish economic boom. After 2008, Ireland’s household savings rate increased to the level above 10 percent which is a result of the adjustment in the household balance sheet. In fact, between 2001 and 2007, the share of household debt in the GDP nearly doubled.
Meanwhile, the mountain of liabilities in the Irish banking and financial sector raised the concern over its solvency. The Irish Government immediately facilitated a bailout plan for the troubled banking sector. Consequently, the large budget deficit resulted in excessive debt-to-GDP ratio which grew by 39 percentage points between 2007 and 2009. In the annual European Economic Forecast (Spring, 2010), the European Commission estimated that by the end of 2011, the debt-to-GDP ratio could reach as high as 87.3 percent. while the cyclically-adjusted government balance is estimated to increase up to -10.2 percent of the GDP. The contraction of domestic demand which, by all measures, is the main engine of Ireland’s economic growth led to a rapid increase in the unemployment rate which increase from 6.3 percent in 2008 to 11.9 percent in 2009. By 2011, the European Commission forecast that the unemployment rate is expected to further increase by 1.5 percentage point compared to 2009. In World Economic Outlook, the IMF estimated that the unemployment rate in Ireland would increase by 1.1 percentage point by the end of 2011. In 2009, Ireland experienced net outward migration for the first time since 1960s in the wake of expected 13.8 percent unemployment rate in 2010.
The macroeconomic forecast for 2011 is favorable. The European Commission upgraded GDP growth estimate to 3 percent. Meanwhile, the investment is expected to increase for the first time since the 60 percent cumulative decline of the construction sector. The positive contribution of net exports to the gradual narrowing of the current account deficit could be an important measure to alleviate the rising pressure over debt-to-GDP ratio. On the other hand, Ireland’s Department of Finance revised the macroeconomic forecasts and estimated that by the end of this year, the GDP would grow by 1 percent on the annual basis.
The essential measure of Irish economic recovery is the retrenchment of wage rates in the public sector and the adjustment of public sector wages to the cyclical dynamics of economic activity to prevent the possibility of excessive inflationary pressures in the course of economic recovery. Current measures of retrenching public sector wages successfully anchored the inflationary expectations. According to the IMF, the annual inflation rate is estimated to peak at nearly 2 percent by the end of 2015. The falling wage rates in the private sector could induce the reallocation of resources in the tradeable sector, further adding to the contribution of net external trade to the GDP growth.
The key measures to alleviate the consequences of economic and financial crisis in both real and financial sector are the immediate narrowing of Ireland’s excessive budget deficit and public debt in the share of GDP. High public debt is mainly the result of government capital injection into Anglo-Irish Bank which represents about 2 percentage points of net deficit increase in 2010. The entire consolidation package represents 2.5 percent of the GDP.
Deutsche Bank recently published Public Debt in 2020 and estimated the levels of public debt by the end of that year for both advanced and emerging-market economies. The analysis by Deutsche Bank predicted the effect of a combined negative shock in real interest rate, primary government balance and real GDP growth. If the combined shock of all three variables were to change by about one-fourth standard deviation from the estimated growth rate, the public debt in 2020 would reach 154 percent of the GDP. If the combined shock of all three variables increased by one-half standard deviation from the baseline estimates, the public debt in 2020 would increase to 197 percent of the GDP. The difference in the estimated increase is due to higher intensity of the combined shock. In addition, to restore the debt-to-GDP ratio to pre-crisis level, Ireland would be required to increase the primary government balance to 6 percent of the GDP.
Given the enormous magnitude and burden of public debt and overleveraged corporate and financial sector, the immediate facilitation of measures to alleviate the public indebtedness is necessary. Ireland’s economic future is constrained by the persistence of budget deficit which adds to the future burden of public debt. Prudent efforts to reduce the burden of both debt and deficit are of the essential importance. Nevertheless, Irish policymakers should not neglect the economic policies that created the Irish miracle as well as the policy errors that caused the deepest economic decline in Western Europe during the 2008/2009 economic crisis.
By Claus Vistesen, on October 27th, 2010
Popular wisdom has it that markets are always right or, more appropriately; that if you find your self on the wrong side of the market consensus the best cause of action is to join the ranks less you want to be rolled over by a steamroller. However, it may take some time before the market corrects to the underlying fundamentals or so, at least, I will argue.
Last time I wrote on Ireland I noted how the country’s latest move to emphasize its strong cash position (as well as the fact that it announced the intention not to go to market to seek financing) was a wink to EU policy makers that either the current plan works or Ireland will need funding help. Private market funding at current and future expected rates is not an option and the really important question is whether the interest rates charge by some form of European SPV would also be consistent with a recovery or simply another debt spiral. I have my doubts here.
Indeed; with a the running deficit to GDP of 32% in 2010 it is absolutely necessary that Ireland addresses this as a first priority. No matter how much cash you have lying around or how much you expect to be able to get from a coordinated relief program (essentially borrowing with low rates and long maturity), the failure to react now would mean that the time path of public debt would prove instantly unsustainable as we moved into 2011 and 2012
However, markets don’t seem to be very comfortable with the prospects of very strong austerity measures in Ireland.
Quote Bloomberg
Bond investors are losing faith in Ireland’s plan to lower the deficit as spending cuts threaten to undermine economic growth, reducing government revenue. Irish 10-year bond yields climbed within 50 basis points of the 454 basis-point record spread, set Sept. 29, relative to similar-maturity German bunds. Portugal’s spread fell about 1 percentage point against the German benchmark in the past month, the Greek-German yield gap narrowed 102 basis points and the Spanish spread was close to the lowest level since Aug. 10.
It is important to understand the underlying message here. What drives the worry is not so much the debt and deficit itself, but more so that the severe austerity measures needed to restore the evolution of debt will derail the economy and thus become counterproductive. Indeed, this is the main issue which most OECD economies grapple with at the moment.
But surely, it is not easy being Ireland at the moment. On one day, spreads climb because you are trying to plug the hole in the budget as you try to salvage a broken financial sector and the next spreads climb on growth fears as you introduce austerity measures in an attempt to correct the deficit incured in the first place.Look up the old proverb of being stuck between a rock and a hard place and you will find the European Periphery as a chief example.
What is interesting in particular are the comments extracted by Bloomberg from various fixed income portfolio managers across Europe. They seem to me to be getting closer to a does not compute moment of their own (all quotes are gathered by Bloomberg). Firstly, Dermot O’Leary, chief economist at Goodbody Stockbrokers simply turns the focus upside down and argues that now, surely, growth is the most important goal for Ireland.
“With the scale of consolidation now known, the department’s strategy for returning the economy to growth” could “now be described as more important than the consolidation measures,”
I wonder whether he would change his mind if the black hole of Anglo Irish takes the 2010 deficit/GDP figure to 40% (or perhaps 50%?). But there are other much more fundamental issues being raised; for example by John Fitzgerald a member of the central bank board.
The risk is “the medicine is too severe so that, like chemotherapy, it puts the patient into decline,”
Indeed, this is a risk and one which I (and others) have been banging on about the last 2 years, but the one I really liked was the comment by Ralf Ahrens from Frankfurt Trust and the simple yet crucial question;
“There is this central question of where does growth come from.”
Well, well. Aren’t we coming full circle here?
Allow me to repeat three questions I posed recently in relation to the ongoing efforts to solve the the crisis in many European economies.
- How do you correct external competitiveness deficiency from within a currency union at the same time as implementing fiscal austerity without risking debt levels to spin out of control?
- How long should Southern Europe and Ireland endure deflation relative to the core to restore external competitiveness (will Germany accept a lower external surplus as result)?
- How might a sovereign restructuring in a Eurozone economy play out?
The first question is really the main issue at hand. In the absence of nominal currency devaluation you need to impose wage restraint and deflation in order to correct a large external balance. As this large external imbalance is reflected in a large domestic debt level there is a real risk that if the entire correction must come from the domestic price level, the level of debt in itself will spin out of control which then manifests itself in either large scale private sector defaults or default on the sovereign level.
The main message here is simple macroeconomics. If you combine deflation and negative nominal growth rates over a prolonged period of time and given an already elevated debt level; your overall level of debt relative to the value of your activities (GDP) quickly become unsustainable.
So how do correct then? Well, not without a little help from your friends which brings us to the second question.
Consequently, this is not only about the European periphery suffering, it is about them suffering more than everyone else. Indeed, the recent ascent of the Euro is no good for them in so far as goes competitiveness outside the Eurozone and even inside Europe, it is starting to look like everybody’s race to the bottom in terms of on whose back intra-Eurozone imbalances are supposed to correct. Naturally, a steady depreciation of the Euro would, strictu sensu, be welcome news for Greece, Ireland et al. Yet, this seems far off at the moment with the Fed doing the printing and the ECB reluctant to add further stimulus. On the concrete question of time, you just need to slice up the effects of say, a 30 % nominal devaluation (e.g. against the Euro or USD) which is the likely alternative scenario, I think, if any of the most troubled Eurozone economy had their own currencies. It then means that we would need to see a prolonged period of relative deflation to Core Europe.
This however would in itself be problematic since 5-10 years of slow pain would almost certainly result in a Japan type lost decade, but also be almost impossible from within the Eurozone (i.e. politically). So by proof of elimination we reach question three. Indeed, PIMCO’s El-Erian recently argued that Greece is likely to default within 3 years and that this need not be cataclysmic. I fully agree.
It is impossible to do any form of calculation here since we don’t have any numbers that are coherent, but surely I would think that something along the lines of a 30% haircut on the principal and a notable extension of maturity is a likely result (but really, I have no idea!). The alternative would be that the rest of the periphery follows Ireland’s example and simply leave the private market (although China et al. have indeed been fishing lately) and thus, they would have to be capitalised slowly from within an intra Eurozone structural fund (or through outrigth monetization by the ECB, but this is not going to happen I think).
In the event of restructuring, big the question of the hole left on the balance sheet of Eurozone debt holders of peripheral bonds (let us think about foreign holders later). A couple of potential solutions have already been put forward.
Leaving aside the Structural Fund which is not supposed to recapitalise private entities (at least not yet) it would mean that those banks either would have to enter the market to recapitalise, be recapitalised by their domestic governments (a deal which could form part of the default), or simply transfers bonds at par to the ECB which tend would have to take the hair cut on its balance sheet.
At the end of the day, this kind of rhetoric is still seen as fearmongering and disruptive in the Eurozone collective since there is still a strong sense of resolve around the fact that no sovereign in the Eurozone may be allowed to default/restructure on its debt. As such, you could argue that one glaring omission in my analysis is that I don’t consider the costs of default. Well, they would naturally be substantial not only for the individual economies but for the Eurozone itself. However, when you run even a rudimentary simulation of the likely numbers it is pretty easy to see how this cannot go on. There is no exogenous source of economic growth that will help the periphery move in to a virtuous circle, there is only one big vicious one in which more austerity brings lower growth and deflation which in turn affects the level of debt to GDP.
I admire resolve and I even believe that it is merited, but this is only to the extent that Germany (and France) are willing to assume their part of the bill (which will be very big) or to the extent that the ECB decides to employ wholly new and Fed-like policy tools.
Absent this and leaving aside the question of whether Germany and France realistically would be able to foot the bill at all, the only question is if the markets are starting to get it, when will the shoe drop on the level of macroeconomic policy making?
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By Claus Vistesen, on October 8th, 2010
I have just been listening to Ben Davies’ podcast (see also FT Alphaville here) from Hinde Capital about the funding issues of the Japanese government and the points he makes are important. I have used the metaphor of Japan as a bumblebee before and while I believe that the story on Japanese savings may just be a little more complicated than many believe I think Ben points his finger at two very important points. One is how Japan has difficulty with both deflation and potential inflation (higher yields) at the same time which not only puts the economy in a very tight spot, but also locks in Japan towards a balance between veering to far in either direction, a balance which can be difficult to strike. The second is that while Ben believes that Japan will ultimately pop, the central bank (and indeed Japan itself) will try to do everything it can before that happens. Especially the last point is very important. Coupled with the need for Japan to attempt to maintain a structural external surplus it brings me back to a point I have made before (and which I will continue to make again and again).
Ageing societies are not, in the main, characterised by aggregate dissaving but rather by the fight against it.
So, Japan will fight and the central bank will do the government’s dirty work and the most intriguing question here is how long it will take of unsterilised hyper-QE before an economy such as Japan stuck in both a fertility and liquidity trap [1] implodes in hyperinflation; will it happen at all(?) and what can the country do to balance the trade-off between deflation and inflation.
Finally, on Ben, he is bullish on gold but then again, he would be wouldn’t he as runs a gold fund. But there is a subtler point underneath the reaffirmation of the bull market in gold since Hinde is also, following Ben’s comments, long volatility, a bet which has not, yet, paid off (and one would assume the “position” has some carrying/opportunity costs even if volatility is flat). Or put differently, gold (precious metals) have performed strongly alongside risky assets as liquidity has been plenty but what has not happened yet is the ultimate shakeout in which volatility spikes and investors buy gold and not the dollar. I think that you need to fit two stories in your head. One is why gold might move alongside risky assets as fiat currencies are slowly debased as well as how gold should do also do well in a situation where volatility suddenly increases quickly and abruptly although I suspect this last situation is the ultimate endgame with the interim mainly being one of dollar strength in times of sudden reversals in market fortune.
But even gold can’t be a free lunch, right? Perhaps, this is one way to rationalize that fact that investor performance currently seem to be demarcated by those who climbed on the gold train a year ago (or 2-3 years ago if you will) and those who didn’t. When times are tough and volatility spikes, the USD rallies but as such events almost inevitably carries an immediate response of more liquidity so will gold (and other non-printable assets) do well. But then as liquidity manages to smooth over markets and as the SP500 starts to tick back up this should again be constructive for gold since after all; the whole precondition for low volatility at the moment is the promise of more QE from the Fed (well not quite, but still very close I think). This is then good for a long gold position but not a long volatility position although I am intrigued by the ultimate punt on the final coup de grace in which gold and volatility becomes the only place to be. Still you got to have that acking feeling on gold, I mean; either it trades as a risky asset or becomes the safe haven of choice in times of volatility. So, which is it? I don’t know, but perhaps we are going to find out very soon.
The Punchbowl
Indeed, I suspect that many readers would have counted on me pointing to gold as the ultimate punchbowl and while I can certainly envision a situation is which gold takes a 10-15% correction (or even more) the point is that this would not counter the trend (not even close). This brings me to the real punchbowl at the moment; equities, emerging markets and high beta EM currencies (Asia and Latam). I am largely indifferent to the first in the long run, long term bullish on the second, and by consequence pretty constructive on the latter as well in the long run [2].
However, in the short run I think that while the punchbowl never left the table, talks about a new round of QE and how Japan’s intervention might actually be a leading indicator of more to come from OECD central banks all at the same time as the SP500 breaks 1160 is extraordinary.
(quote Bloomberg)
The Bank of Japan may have acted first in a new round of central bank action to prop up the global economy as recoveries in industrial nations falter.
The unexpected decision by the Japanese central bank yesterday to drop its interest rate to “virtually zero” and expand its balance sheet follows the U.S. Federal Reserve’s move toward more unconventional easing. Bank of England officials will consider further stimulus tomorrow, while the central banks of Australia, Canada and New Zealand are among those now holding fire on further interest-rate increases.
It reminds me of a point made recently [3] that the marginal returns of additional QE measures (Q1, Q2, Q3 … QN) are declining rapidly. I mean, how much QE do we need before the SP500 hits 1200 or 1250 perhaps? Certainly, I think this is a worthwhile consideration when talking about the effects of QE even if the ultimate policy rationale for additional measures has intensified with the macro environment definitely turning darker in the OECD.
Actually, if you will allow me a mathematical description of this.
The first derivative of QE with respect to the macroeconomy and risky assets are positive but the second derivative appears to be negative for the macroeconomy. More and more is needed to have a smaller and smaller effect. But it is more complicated than that and some asset classes clearly have a very positive second derivative (gold for instance) and look at those poor emerging markets as well. More and more liquidity chasing relatively few assets and high yield opportunities are relatively scarce. This is then a positive second derivative and a clear risk of a bubble.
Quote Bloomberg
Emerging-market borrowers are on course to sell more bonds than ever this year after yields hit record lows and developing economies rebounded faster from the credit crisis than advanced nations. Governments and companies in developing countries including Vale SA, the world’s biggest iron-ore exporter, and Korea Electric Power Corp., South Korea’s largest electricity producer, borrowed $196 billion from July to September, the most for any quarter, according to data compiled by Bloomberg. Bond sales surged from $157 billion in the second quarter of 2010 as yields in developing countries slid to an all-time low of 5.4 percent on Aug. 23 from as high as 6.8 percent in February, JPMorgan Chase & Co.’s EMBI+ index shows.
(…)
Brazil doubled the tax yesterday on foreign investment to 4 percent on fixed-income securities to stem the currency’s two- year rally and help shore up exports. The move coincided with the Bank of Japan’s reduction of the overnight call rate target to a range of zero to 0.1 percent, the lowest since 2006, and said it would set up a fund to buy bonds. Brazil’s benchmark interest rate, at 10.75 percent, is the second-highest among the Group of 20 nations after Argentina’s and is luring demand for local-currency debt. “The IOF tax isn’t enough to contain the flows coming from the liquidity injection by the Japanese central bank and global dollar weakening,” said Luis Otavio Souza Leal, chief economist with Banco ABC Brasil SA in Sao Paulo.
(…)
Governments from South Korea to Brazil are stepping up attempts to control their currencies as investors pour a record amount of money into emerging markets.
Regulators in Seoul will start an audit of lenders handling foreign-currency derivatives on Oct. 19 to curb volatility caused by capital flows, the finance ministry said today. Brazil doubled a tax it charges foreigners on investments in fixed- income securities to 4 percent yesterday. The yen fell the most in three weeks after the Bank of Japan cut benchmark interest rates and pledged 5 trillion yen ($60 billion) to buy bonds and other assets, having sold $25 billion worth of its own currency last month in the first intervention since 2004.
This is just a small smørrebrødsbord then of the effects this is having in emerging markets where more and more creative policy measures are being tried to keep the money out. This is then a strongly positive second derivative effect and one which is a key mechanism to be aware of in the global economy.
The point here is of course that there is a lack of stability. It is fairly well established from Japan’s experience that once caught in a liquidity trap and with a rapidly ageing society the extra effect of more liquidity is almost 0 with respect to the macroeconomy (until of course the balance tilts, but sufficient unto that day and all). Yet, there is always a bubble waiting to inflate elsewhere as such the Japans of the world create a huge externality in the global economic system by filling the proverbial punchbowl for risky assets.
Yet for now and as markets seem to be wanting more and more QE to push forward it appears that investors should be careful diving too deep into the punchbowl even if it currently might appear as a golden opportunity.
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[1] – For more on the fertility trap, look no further.
[2] – Although an AUD/USD at 0.97 is unbelievable to me. I think this is one of the brightest stars high their looking for a strong correction.
[3] – I can’t for the life of me remember who it was.
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By Bron Suchecki, on September 3rd, 2010
The Gold Symposium, Tuesday 9th and Wednesday 10th November 2010
Symposium announces the launch of The Gold Symposium being hosted at the Amora Jamison Hotel in Sydney, Australia on Tuesday 9th and Wednesday 10th November 2010.
Featuring highly respected speakers from Canada, Australia and the USA, this event will approach topics such as the current state of the global markets; why gold is important as an investment; and, gold versus paper as currency.
Amongst many renowned speakers, hear from the internationally respected gold analyst and author, Mr James Dines. Even now many do not believe Mr. Dines’ longstanding prediction of “The Coming Great Deflation” internationally, but what’s next? Boom or Bust, inflation or deflation, or even a hyperinflation?
Other speakers are:
Mr Dan Denning, Editor, The Daily Reckoning
Mr Louis Boulanger, CFA, Founder and Director, LB Now Ltd
Dr David Evans, mathematician and founder of GoldNerds
Mr Robert Lambourne, Chairman, Penox SA
Mr Rudy Fritsch, President, Allsteel
Mr Richard Karn, Managing Editor, The Emerging Trends Report
Mr Gavin Thomas, Managing Director and CEO, Kingsgate Consolidated
Mr Barry Dawes, Managing Director, Martin Place Securities
Prof Steve Keen, Associate Professor of Economics and Finance at the Uni of Western Sydney
And ME!
My presentation is: Paper gold – will it “crack-up”?
• You only protect your wealth by knowing when (or when not) to sell your gold
• To do this you need a real understanding of the risks inherent in the operation and interaction of the physical and paper gold markets, not the hyped-up commentary designed to increase the commentator’s Google ranking rather than your wealth
• Otherwise you may find yourself holding worthless cash after what you thought was a bubble in gold was really a collapse of paper assets
By Claus Vistesen, on August 6th, 2010
Team Macro Man has a nice perspective on what deflation might mean in the OECD context and it is difficult to disagree with the underlying rationale.
One sector that is glaringly not singing to the Deflationistas’ hymn sheet is commodities. While a rapidly-growing global population continues to compete, like bacteria on a Petri dish, for the basic resources of food and energy, the input component to basic living will keep local prices firm even in an environment of other localised deflationary pressures.
The world is still steadily competing for raw materials, so any slow down in the West can only express deflation through lower wages as competition for jobs tightens and hence labour cost inputs fall. So whilst service sector (higher labour component) may see a higher relative price deflation, the basic cost of survival, food and energy to the individual stays the same, or rises as we are now seeing.
That isn’t an individual enjoying deflation, that’s an individual suffering poverty.
I remain inclined to believe that the biggest problem for most OECD economies in the coming decades will be deflation (and the subsequent increase in the value of real debt) rather than inflation. But there is a world outside OECD too and especially commodities could very well be a source of inflation and thus in some sense stagflation (with the added spice that our relative wage in the West may fall at the same time)
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If you like me are prone to the occasional what the h’ck is going here mantle; this rap up by Gwen Robinson at FT Alphaville provides a good overview of the recent flurry. Highly recommended as the first read this Friday morning or as weekend lecture.
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Jean Tirole is professor in Economics at Toulouse University and back in September 2009 he penned a very interesting article on illiquidity and what it means for a balance sheet (of a bank) to be liquid and illiquid.
The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don’t know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment. Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macroprudential
policies.
The best academic read I have a had in a long time.
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Eliana Marino takes a look a migration in the Baltics and tells one of the great unsung stories of this crisis and what it means when you lose your working age people to net migration;
- emigration of working age population makes the demographic burden increase: the number of inactive people (children and retired people) exceeds the number of active people, creating serious challenges for the sustainability of the welfare system;
- the most part of the outflows consists of working age population (from 15 to 65 years old) that includes people in reproductive age (from 15 to 49 years old). A huge number of emigrants in this particular age group means a further reduction of the natural increase of the population. In fact, they will probably have their children abroad or the migration decision itself will discourage the creation of numerous families.
I need to write a paper on this!
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