By Ajay Shah, on November 18th, 2011
How did it happen?
The worst financial crisis in the western world for nearly 80 years broke in September 2008.
It required banking/financial systems to be supported and recapitalised by governments across the EU and in the US.
In June 2009 it became apparent that the peripheral countries of the Eurozone (Greece, Portugal, Spain and Ireland) were grossly over-indebted.
Yet in some instances (Spain) their public debt to GDP ratios happened to be lower than those of the US, France, the UK and Germany.
The continued viability of their public finances depended entirely on markets being willing to refinance them with cheap money.
But, when markets scrutinised the sustainability of their fiscal positions, they baulked from refinancing except at punitive rates.
CDS spreads (against Germany as a benchmark) of peripheral Eurozone countries (PIGS or Club Med) debt began widening relentlessly.
Global financial markets began to price in an escalating risk of partial/full voluntary/involuntary default on PIGS bonds since December 2009.
Contrary to first impressions, except for Ireland, that was a result not just of the financial crisis and bank recapitalisation demands on the fiscus.
It became apparent instead that bank recapitalisation demands on public finance were only the last straws that broke the camel’s back.
Greece, Portugal, Spain and Italy, as a direct consequence of joining the Eurozone, had been running up unsustainable fiscal deficits since 2000.
Ireland had not. It suffered because the bailout of its disproportionately large banking system caused its public debt to rise astronomically.
PIGS became over-indebted despite the supposed self-imposed discipline adopted by the Eurozone of prohibiting fiscal deficits >3% of GDP.
That discipline was violated by almost all Eurozone members, beginning with France and Germany, but more egregiously by the PIGS.
To make matters worse, however, the PIGS were also running increasingly large current account deficits (with Germany, France, China).
Though countries like France (and to a lesser extent) Germany were fiscal sinners, they were at least running current account surpluses.
PIGS had access to excessively cheap public and private money available on terms totally inappropriate to their economic circumstances.
Given their inherent risks, which markets mispriced completely, their borrowing costs should have been 300-500 bp higher than Germany’s.
Instead, they were virtually the same for nearly a decade. That relieved market-induced pressure on PIGS’ governments to behave responsibly.
Consequently, their public expenditures after 2000 ballooned out of all proportion to their intrinsic capacity to fund them from tax revenues.
Such expenditures became almost wholly dependent on access to increasing amounts of cheap public borrowing from capital markets.
In response to access to excessively cheap money, wages in the PIGS rose across the board as did growth in public sector employment.
With the financial crisis triggering bank recapitalisation needs, on top of this unsustainable structure, the edifice began to crumble.
The first early warning signals became apparent in December 2009 but the dam broke in mid-2010 with the first Greek bailout.
How has the Eurozone crisis been handled?
Extremely ineptly; indeed very foolishly, by sophisticated Eurozone authorities (political, fiscal and monetary) that should have known better.
Eurozone leaders learned nothing from the preceding debt crises in Latin America (1982-87, 1994-95) and Asia (1997-2000).
They went through avoidable phases of serial denial that there was a structural debt (solvency) crisis that could spread via contagion.
They treated it as a liquidity crisis that could be dealt with by temporary patch-ups of additional money combined with fiscal restraint.
They reiterated their commitment to ensuring there would be no default – partial or full, voluntary or involuntary – by any Eurozone member.
They believed that their remedial measures would stop the crisis from ballooning beyond the first bailout package for Greece.
They were totally wrong. That package did nothing to convince markets that Eurozone leaders understood the nature/severity of the problem.
In fact, the inadequacy of that first bailout package — which did not provide enough money for sufficiently long – became quickly apparent.
Eurozone leaders were fixated on debt-affected PIGS being forced to live within their means through indefinite austerity without end.
Debt recovery/sustainability models did not provide sufficient new money, or permit debt restructuring, in ways that would restore stability.
Least of all were bailout packages designed to restore growth in a conscionable period of time that would be socially/politically acceptable.
Without financial system (and borrowing cost) stability, and absent growth, debt problems can never become better. They can only worsen.
Instead, as a result of poor design, all the bailouts did (except for Ireland) was to add new debt to bad debt and reduce growth prospects.
To exemplify: In mid-2009 the debt/GDP ratio for Greece was 115% of GDP and the debt service ratio about 11% of GDP.
But, by October 2011 the debt/GDP ratio for Greece was 161% of GDP and the debt service ratio nearly 20% of GDP.
It is projected with the third bailout to rise to 185% of GDP (although debt service will be lowered to 16%) before it comes down again.
In the meantime, over the last 32 months, the Greek economy has shrunk in size by almost 17% in nominal terms. It will be 1/5 th less in 2012.
Such inane ‘remedies’ do not solve debt problems. They only aggravate and exacerbate them.
While behaving in this absurd fashion Eurozone leaders repeatedly asserted for two years that they would do everything in their power to:
- Maintain the credibility of the Euro while ensuring that every member stayed in the Eurozone
- Not allow any default of publicly issued bonds to occur; and
- Do everything possible to avoid contagion spreading beyond PIGS (even as it became clear that markets were worried about Italy.
Instead they achieved the exact opposite of all three objectives through their inability to understand the implications of what they were doing.
Though now contrite and claiming to have learnt a few lessons from their serial bungling over 30 months Eurozone leaders have no solution.
The EFSF facility they created is woefully underfunded. It can barely deal with financing the third Greek bailout.
The idea of leveraging it or using it as a partial guarantee facility is absurd since it would add to risk and uncertainty not resolve them.
Yet over-indebted governments (including France and Germany) would have to issue more public debt in order to fund the EFSF properly.
That would simply mean requiring their fragile, near-bankrupt, banking systems (or the ECB) or global markets to buy more Eurozone debt.
Except for Germany (and even that will be in doubt soon) the market has no appetite for taking on more Eurozone debt given its risks.
Contagion has spread from the periphery and now lodges at the core of the Eurozone economy in which Italy is the third largest member.
What could have been resolved with about 300 billion euro in additional financing in mid-2010 is now a problem that may require 2 trillion euro.
Where are we now?
Over 35 EU/Eurozone summits in 30 months have resolved nothing. They have made matters worse; despite Herculean exertions!
Right now Greece is in ‘effective’ default; though markets are overlooking that because of the implications of CDS contracts being triggered.
Its borrowing costs for refinancing its debt would exceed 30% if it had any access to private markets; which it does not.
Any refinancing of, or addition to, Greek debt can now only be financed by the ECB; which the Germans will not permit the ECB to do.
Meanwhile the Greek banking system is bankrupt. Indeed the entire Eurozone banking system’s credibility/stability/solvency is in doubt.
Today an outstanding portfolio of about 11-12 trillion euro in Eurozone debt – of which about 80% is held by EU firms – is souring relentlessly.
About 7 trillion euro of that portfolio is sufficiently affected by contagion to require provisioning (France and Belgium may soon be added).
About 5 trillion euro of Eurozone high-risk-debt is currently held by EU banks, insurance companies, pension funds and individuals.
That sovereign debt, which is supposed to constitute the ’safest’ component of any asset portfolio, now constitutes perhaps the riskiest element.
That reality inverts the whole basis of banking/financial system soundness and stability across Europe (including the UK).
It compounds the problem of calculating capital adequacy requirements for these banking systems and puts regulators in a quandary.
Ireland’s bailout programme is working but could be derailed by what is happening in the rest of Europe.
Portugal’s programme is not working as intended. But nobody is talking about it because it pales in comparison with Italy and Greece.
Italy’s outstanding public debt will soon cross 2 trillion euro (120% of GDP) and its debt service payments amount to around 300 billion euro per year.
That is made up of about 120 billion euro in interest payments and 180 billion euro in principal repayments. Average duration is 5 years.
Public debt service in Italy now amounts to around 17% of GDP and will rise to 20% unless Italy’s debt is dramatically restructured.
Italy now needs to borrow about 40 billion a month euro (gross) and about 28 billion euro a month net in private markets to refinance its debt.
The world is holding its breath with every auction of Italian public debt (3-8 billion euro per week) any of which could trigger accidental default.
The cost of refinancing Italy’s public debt has risen from around 4% a year ago to around 7% now. That adds 20 billion euro a year to
its debt.
Meantime the Italian economy is flat-lining and its capacity to service additional debt is diminishing despite its running a primary balance.
Banks around the world are dumping their holdings of Italian public debt but there is no buyer other than the ECB because of the risk.
The ECB’s capacity to refinance Greek, Italian and Portuguese debt is limited and constrained by Germany’s unwillingness to consider
that.
Contagion from Italy is now beginning to affect Spain and France which is supposed to be a bulwark for the EFSF’s borrowing capacity.
The resulting gridlock is pushing the entire Eurozone system toward a catastrophic denouement with a binary outcome. Either:
- Crisis-induced progress toward fiscal union with national sovereign bonds being replaced by a single Eurozone bond with a joint/several guarantee, or
- Sudden disorderly collapse of the Eurozone with unimaginable fallout and consequences that would trigger a global double-dip
recession.
Such a recession would last for a minimum of 2-3 years and would probably be quickly followed by a similar debt crisis in the US.
The resulting fallout of disorderly Eurozone break-up could trigger a break-up or restructuring of the larger EU as well.
So where do we go from here?
With the foregoing in mind it seems absurd that the world is waiting with bated breath to see what the new technocratic governments
in Greece (Papademos) and Italy (Monti) will actually achieve by way of structural reform and increased debt servicing capability in coming months.
These technocratic governments inject new credibility but lack political and social legitimacy. They have been appointed not elected.
It remains to be seen how long their technocratic legitimacy holds out without the backing of gradually earned political/social legitimacy.
The risk is that if the ministrations of these technocratic governments (which their societies believe have been imposed on them
from the EU above) do not work and bear fruit relatively soon (the probability is that they won’t), public patience with them will melt.
Will they be able to convince electorates to accept the inevitability of austerity without growth for the indefinite future?
The next Greek crisis is perhaps 10-12 weeks away.
The next Italian crisis could be triggered by any one of the upcoming weekly auctions of Italian government debt.
Despite these rather obvious realities, global markets deem to be reacting in dream-like hope and optimism that all will be well.
There is of course a solution at hand; and the only one that will work because all the other options seem to have been exhausted.
That option requires Germany to reconsider its refusal to bear its large share of the fiscal burden that will come with Eurozone fiscal
union.
It requires political/social willingness on the part of rich northern Eurozone members to finance fiscal transfers to poorer
southern members through an exponential expansion of structural funds, currently applied to help develop more rapidly the poorer regions of the EU.
Reciprocally, it requires other Eurozone countries to relinquish fiscal, and a great deal of political, sovereignty immediately; in
order to assure global markets of their commitment to structural reform, restoration of competitiveness, and relentless pursuit of fiscal/monetary discipline.
It requires all unwanted national sovereign bonds of Eurozone members to be replaced by a single Eurobond that is jointly and
severally guaranteed and underpinned by the weight and ability of the ECB behind it to print money if necessary to ensure that such bonds are honoured.
This solution would resolve both the over-indebtness problem of the Eurozone and the problem of banking system collapse at a single stroke.
If it were adopted the need to provide for risky Eurozone debt and recapitalise (yet again) the EU banking system would disappear.
Yet, this is the one solution that keeps being discarded because of legitimate German constitutional, judicial and political constraints.
They inhibit movement in such a direction regardless of the consequences for the Eurozone, the EU, and mostly Germany itself.
It is like witnessing a repeat of 1939; not of conquest but of mindless destruction. But, this time with money rather than tanks being involved.
If that only workable solution continues to be discarded, the other possibility that will manifest itself is the disorderly break-up of
the Eurozone; simply because its orderly break-up defies contemplation and imagination.
Talk of Greece being ejected from the Eurozone, or of Germany departing from it voluntarily, is fanciful simply because neither can
afford to bear the costs of the consequences that will follow, regardless of what their populations and political leaders may believe
or think (though ‘thought’ seems to be conspicuously absent from the process just now). Neither can their neighbours, regardless of what they may think.
Yet it is not unimaginable that a break-up will be forced on Eurozone members by global markets if the only workable solution
continues to be ruled out as it seems to be repeatedly by the German Chancellor. But she has changed her mind so often the hope is she will yet again.
A disorderly break-up may result in a reversion to national currencies; which would be better than members trying to retain some
semblance of the Euro through separate residual monetary unions of more compatible economies.
That would probably require four different Euros (for the super-efficient Northern economies a Baltic Euro, for the relatively efficient middling economies a Franco-Euro; for the newly acceding countries an Eastern-Euro and for the inefficient, uncompetitive Club-Med economies, a PIGS-Euro). Other than the first, none of the others would be credible for holding as reserves, or for trading significantly in global currency markets.
Finally, bear in mind that we have spoken of only the public debt problem in the Eurozone.
Should the unthinkable (but increasingly likely) disorderly break-up happen, the public debt problem will be accompanied by an unresolved private debt problem throughout the Eurozone of equally monumental proportions! That really will break the system and the banks!
By Rok Spruk, on December 27th, 2010
The ongoing difficulties in overcoming the persistence of debt-to-GDP ratio in EU countries highlight the question whether the European Monetary Union can survive the set of shocks which prevailed since the 2008/2009 economic and financial crisis. Recently, European Commission has presented the 2010 review of public finances in EMU (link), suggesting that macroeconomic outlook for Eurozone economies has deteriorated in the light of a growing debt-to-GDP ratio.
The launch of government bailouts in various European countries has added considerable amount to the stock of public debt across the Eurozone. Since 2008/2009, general government balance in Eurozone countries has continually resulted in persistent government deficits which further added to the stock of debt. Since public debt is by definition the sum of previous deficits, the European macroeconomic outlook suffers significantly from downgraded stability of public debt.
The anatomy of sluggish economic recovery in Eurozone consists of different set of economic policies. Countries at the European periphery (Portugal, Ireland, Greece, Italy, Spain) seem to be hit most by the sluggish economic recovery. From the viewpoint of macreconomic stability, the economic policymakers in these countries have pursued the most discretionary economic policies to mitigate the effects of decline in GDP on employment, earnings and tax revenues. In addition, highly expansionary monetary policy by the European Central Bank provided a bulk of quantitative easing, resulting flooding liquidity to supplement the interbank lending and, hence, to contain the effect of overleveraged financial sector on macroeconomic stability. In Ireland, income per capita in 2010 notably decline back to 2004 level (link). As I previously emphasized in one of my previous posts (link), the depth of the economic crisis in Ireland is largely attributed to the overleveraged banking sector, vulnerable to the interbank interest rate increases. Since the sovereign CDS spread on Ireland exceeded 500 basis points in late September this year, the Irish public finance outlook deteriorated significantly in the light of the innate ability of the Irish government to bailout Anglo-Irish Bank. Recently, the IMF estimated (link) that by 2012, Irish debt-to-GDP ratio would reach 67 percent, up from 12 percent in 2005.
A prudent reduction in debt-to-GDP would be accomplished only under restrictive fiscal policy based on the reduction in government spending and a permanent fiscal rule on budget surplus at a given target level. If Irish government set the surplus target at 3 percent of GDP in the next ten years, debt-to-GDP ratio could be considerably reduced within the range of Maastricht fiscal criteria.
The macroeconomic outlook in peripheral countries suffers from high fiscal expenditures and rigid labor market institutions. By 2012, Portugal’s debt-to-GDP ratio is expected to reach nearly 85 percent of GDP. In addition to soaring public debt, the Mediterranean part of the EMU suffers heavily from high unemployment rate. Eurostat recently reported that, by October 2010, the unemployment rate in Spain reached an astonishing 20.7 percent. Double-digit unemployment rate in Spain, Greece (12.2 percent) and Portugal (11 percent) hamper the economic recovery since, in the past, these countries exercised expansionary fiscal policy and the policy of automatic stabilizers to mitigate the effects of high unemployment on aggregate consumption decline. In the aftermath of financial crisis, these countries experienced recessionary output gap in which economic contraction is marred by unchanged inflationary pressures.
Since EMU countries withheld domestic currencies and adhered the adoption of the Euro, the macroeconomic adjustment to the recovery is possible only by a prudent fiscal policy. High unemployment rates and a persistent divergence of economic policies in EMU countries could substantially increase discretionary fiscal policies that would eventually result in the serious possibility of country default. The economic crisis in Greece resulted in 11 percent cumulative GDP decline between 2010 and 2012. In the same period, government net debt is expected to reach the 120 percent of GDP thresold. A divergence between Member States towards highly discretionary fiscal policy would probably alleviate the persistence of high unemployment but at the expense of bold increase in the rate of inflation as well as in the persistence of debt-to-GDP ratio and large government imbalances. Hence, the survival of the Eurozone would depend on the ability of EU Member States to adjust government balance by reducing fiscal expenditure and adopt the fiscal rule to pursue fiscal surplus in the coming years as to reduce the stock of public debt.
Even though a common fiscal policy could accomplish the goals of stabilization policy, the mitigation of fiscal asymmetries would be easily accomplished by labor market integration. A currency union between different countries implies integrated and assimilated labor markets under relatively homogenous preferences. It would be nearly impossible to envision the European Monetary Union without these key macroeconomic features.
 Join the forum discussion on this post - (1) Posts
By Rok Spruk, on November 1st, 2010
The central aim of my bachelor’s thesis is to demonstrate the unsustainability of public pension system in OECD countries in the longer run through the lens of a rigorous theoretical and empirical analysis.
The origins of contemporary public pension schemes date back to 19th century when Bismarck Germany in 1881 first adopted a universal old-age public pension system based on pay-as-you-go (PAYG) funding principle. The principle itself captures full advantages of high (stationary) population growth rate. In the simplest form, PAYG pension scheme is based on the notion of generational solidarity upon which current generations pay mandatory social security contribution into the public scheme. Aggregate contributions are then paid out to current retirees. The cycle is then expanded through generations. However, PAYG funding scheme is sustainable as long as the population growth is high and above the marginal productivity of the capital. Back in 19th century, public pension schemes were adopted under unrealistic assumptions about future population prospects. In 19th century, advanced countries experienced high population growth rate, high fertility rate and an extremely low share of dependent old population that was receiving universal old-age support from PAYG pension schemes. These set of assumptions was crucial to the stability of government-provided old-age support embodied in the public pension schemes.
The sustainability of PAYG pension system requires the equivalence of population growth rate and real interest rate. In the early 20th century, the advanced world shifted towards aging population, declining fertility rates and lower labor market entry rate. In broad terms, a growing old-age dependency ratio led to the pure disequilbrium effects. In a theoretical framework, I re-examined the neoclassical framework of lifecycle hypotheses embodied in Samuelson and Cass-Yaari models of life-cycle utility maximization. The lifecycle hypothesis is based upon the assumption of the three-period model where individuals maximize the consumption in the course of a lifetime. In the first period, individuals do not discount the future consumption since, in this period, individuals acquire the human capital. In the second period individuals enter the working age and discount the future consumption. Hence, in the third period, individuals retire consume the output produced in the working-age period. Since future discounting is compounded, the lifetime consumption increases geometrically. In purely analytical terms, the individuals maximize the utility of consumption through time preference rate.
Considering the abovementioned equivalence between population growth rate and real interest rate, the stability of the equilibria requires the period discount rate to equal the population growth rate. If population growth rate decreases, the stability of the equilibria requires that individuals decrease the future discount rate by the same rate to keep the PAYG pension system within the theoretical limit. The rigorous theoretical formulation of the neoclassical model of lifetime consumption, which essentially captures the necessary conditions for equilibrium stability of public pension schemes, had been put forth by Paul A. Samuelson in his seminal contribution to the theoretical foundations of stationary “PAYG” public pension scheme .
In the course of the last decades, OECD countries have experienced a significant drop in fertility rates, population growth and, under the political climate of social democracy, a widespread adoption of early retirement schemes and generous social security benefits. In addition, labor market exit age dropped significantly, initiating a trend towards the unprecendent growth of generational indebtedness.
The OECD estimated that between 2000 and 2050, old-age dependency ratio is forecast to increase to the largest extent in Japan (193 percent), Spain (136 percent), Portugal and Greece (135 percent). The astonishing increase in the estimated old-age dependency ratio directly reflects the declining fertility rate in OECD countries from 1960s onwards. I estimated the ratio of fertility rate between 1960-1970 and 2000-2006 for OECD countries at around 2, which means that average fertility rate between 1960-1970 was twice the fertility rate between 2000-2006. The highest fertility ratios were found in Spain (2.23), Italy (1.96), Ireland (2.00) while the lowest ratios were found in Denmark (1.37), Netherlands (1.72) and the United States (1.46).
High and stable effective retirement age is the main assumption underlying the stationary stability of PAYG pension system. In the 20th and 21st century, OECD countries have experienced an unprecendent decline in effective retirement age. Blöndal and Scarpetta (2002) estimated the decline in labor market exit age for OECD countries between 1960 and 1995. The female labor market exit age had declined significantly in Ireland (10.7 years), Spain (9.1 years) and Norway (8.8 years). Male labor market exit age exerted persistent decline in all developed OECD countries except for Iceland. The exit age declined significantly in the Netherlands (7.3 years) and Spain (6.5 years).
In a large part, declining labor market exit age has confluenced the rapid growth of unemployment and disability benefits and early retirement incentives from the second half of the 20th century onwards. As the OECD correctly contemplated, in a number of countries, disability pensions and unemployment benefits can be used as de facto early retirement schemes. In a large part, widespread growth of early retirement schemes and implicit incentives for moral hazard in retiring too early via unemployment and disability schemes is held responsible by generous welfare states in the aftermath of the World War II.
When I examined various features affecting early retirement choices, I came across an interesting finding. I regressed labor market exit age and marginal tax rate in a cross section of 23 OECD countries in 2007. I estimated the relationship between exit age and marginal tax rate using a classical OLS linear regression model. The estimate suggests that, holding all other factors constant, if marginal tax rate increases by 1 percentage point, average labor market exit age decreases by 1.88 months. Surprisingly, 51.74 percent of sample variation is explained by marginal tax rate alone. The sample constant is statistically significant, suggesting that if the hypothetical marginal tax rate were zero, the average labor market exit age in randomly chosen country from OECD sample would be 69.65 years. The sample constant is consistent with a prior theoretical expectations since it concurs with the “substitution effect” hypothesis that higher marginal tax rate leads to lower labor supply and fewer working hours.
The cost of early retirement in OECD countries
Source: T.T. Herbertsson & J.M. Orszag, The Cost of Early Retirement in OECD, 2001. OECD, Pensions at Glance, 2009.
Fiscal imbalances arising from unsustainable PAYG public pension systems in OECD countries cannot be assessed without a sufficient estimate of economic costs of unfunded pension liabilities. I approximated the cost of early retirement using Auerbach-Kotlikoff-Gokhale (1999) methodology that directly estimates the size of generational imbalances created by public social security systems. Large and rapidly unsustainable net pension liabilities occured in late 1980s. Van den Noord and Herd (1993) estimated the size of net pension liabilities in seven major OECD countries. The results suggest that continental European countries have had the largest net pension liabilities in terms of GDP. The size of pension liabilities in France and Italy had been about 2.5 times the size of their respective GDPs and twice the stock of the public debt.
Gokhale (2008) directly estimated fiscal imbalances arising from unfunded pension liabilities to current and prospective generations. The size of generational fiscal imbalance, as a share of the GDP, is extremely large and rapidly unsustainable in all OECD countries. In fact, the size of the imbalance is the most severe in Greece (875 percent of the GDP), France, Finland and the Netherlands (500 percent of the GDP) while it is more than twice the size of the GDP in all OECD countries except for the United States, Canada, Australia and New Zealand.
Fiscal imbalance in OECD countries
Source: J. Gokhale, Measuring Unfunded Obligations of European Countries, 2009.
I built the econometric model of public pension expenditure for a cross section of 23 OECD countries in 2007 to assess which variables might explained the cross-country variation in public pension expenditures. I’ve been aware of the possible drawbacks of choosing a cross-section model since it might be vulnerable to specification errors and the unbiasedness of regression coefficients. To account for possible specification bias, I conducted Kolmogorov-Smirnov, Shapiro-Wilk and Jarque-Bera normality tests. By performing normality tests, I have examined whether the normality assumption of normally distributed error terms is valid in the studied sample of 23 OECD countries considering error terms as identically and independently distributed.
In the set of explanatory variables that might yield consistent and robust estimates of regression coefficients I chose 10 various demographic, economic and institutional independent variables. Apart from demographic and economic variables, institutional variables are dichotomous since the institutional features can be captured by binary modes of choice. The dependent variable is the size of public pension expenditures in the share of the GDP.
The results suggest that public pension expenditures are positively correlated with the share of population aged 65 and older (0.746**), difference in life expectancy after age 65 between 1960 and 2005 (0.477*) and dichotomous variable for continental European countries (0.697**) where * and ** indicate the statistical significant of the sample correlation coefficient at the 5% and 1% level. The estimates suggests that the probability of higher pension expenditures in the share of the GDP is likely to occur in a continental European country known for a relatively large share of older population and a high difference in life expectancy after age 65 between 1960 and the present. On the other hand, public pension expenditures are negatively correlated with average effective retirement age (-0.475**), private pension funds as a share of GDP (-0.658**), labor market exit age (-0.523**), dichotmous variable for Anglo-Saxon countries (-0.544**) and a dichotomous variable for private pension system (-0.672**), where ** denotes the statistical significant of the sample correlation coefficient at the 1% level. Again, the estimates suggest that the probability of lower pension expenditure is likely to occur if a randomly chosen country from the OECD sample is Anglo-Saxon and has a high effective retirement age, large private pension funds as a share of the GDP, high labor market exit age and a mandatory private pension system. The coefficients suggest that in repeated sampling, the estimated sample correlation coefficient will include the true or correct population value in 99 percent of cases.
I conducted the econometric model which consisted of 8 regression specifications. I chose double-logarithmic model which yields direct elasticities as regression coefficients. However, I added two exceptions. In regression specifications 5 and 6, I chose a mixed specification mostly due to the inclusion of private pension funds (assets) variable in the regression specification. Unfortunately, but the share of private pension funds in Greece in 2007 equals 0 percent of the GDP which does not enable the researcher to apply double-logarithmic model as the basis of regression specification.
The estimates suggest that the share of population aged 65 and older is statistically singificantly positively related to the share of public pension expenditures in the GDP. Hence, the elasticity of public pension expenditures with respect to effective retirement age ranges from -1.465 to -4.935, suggesting that an increase in effective retirement age by an additional year leads to per unit increase in public pension expenditures by more than a unit increase in the share of the GDP. The coefficient of private pension funds is highly statistically significant. The elasticity of public pension expenditures with respect to private pension funds (as a share of the GDP) ranges from -0.34 to -0.38 and is statistically significant at the 1% level. The elasticity suggests that a 10 percentage point increase in the share of private pension funds reduces the share of public pension expenditures in the GDP, on impact, by 3.4-3.8 percent, holding all other factors constant. In addition, the estimates of coefficients for dichotomous variables suggest the following: the probability of higher public pension expenditures (as a share of GDP) is likely to occur in continental European countries with mandatory private pension system. Five estimates of dichotomous coefficients are statistically significant at the less than 10% level.
The significance of dichotomous (dummy) coefficients has been tested by beta coefficient analysis to rank the magnitudes of separate effects of explanatory variables on public pension expenditures as dependent variable. The results suggest that continental European countries are significantly more likely to face higher public pension spending in the share of GDP compared to Anglo-Saxon countries.
Earlier I mentioned the necessity of normality assumption in yielding robust, consistent and unbiased estimates of regression coefficients. The assumption has been questioned by conducting Kolmogorov-Smirnov test (K-S), Jarque-Bera test (J-B) and Shapiro-Wilk (S-W) normality test. The aim of the testing the normality assumption is to observe whether error terms distribute normally so that estimated test statistics, standard errors and confidence intervals are reliable. In setting test statistic, I set the normality assumption as null hypothesis. The results from K-S, J-B and S-W tests show that the null hypothesis cannot be rejected at 5% level, suggesting that the normality assumption is valid in the studied sample. Hence, test statistics, standard errors and confidence intervals are both valid and reliable.
The meaningful question to evaluate the prospects of the coming public pension crisis is how to reverse the growth of fiscal imbalances and reform public pension system as to avoid erratic generational indebtedness. Aging population and the growth of old-age dependency ratio trigger an enormous future burden on public finances in OECD countries. Lower fertility rate and population growth shall place an incurable burden on the stability of PAYG public pension systems. The estimates suggest that life-expectancy after the age of 65 is likely to increase by 2050 and gradually approach the age of 90 for both male and female. Assuming the effective retirement age is 65, the remaining life expectancy is 25 years or almost one-third of the average lifetime. As Alemayehu and Warner (2004) suggest: “Old-age health care costs thus will impose increasingly severe pressure on private finances and government coffers. Indeed, applying our age-specific estimates to the age distribution anticipated for the year 2030, we find that if nothing is done to alter current patterns of health care, per capita health care expenditures will rise by one-fifth due to population aging alone.”
The long-term pension reform that aging societies of the West should undertake is a complementary measures of three key policy features of the reform.
First, the transition to fully-funded retirement savings accounts is the only viable and sound pension reform that can alleviate the damage generated by the growing fiscal imbalances. The theoretical foundation of the transition from public pension systems to fully-funded pension system has been laid down by Feldstein and Liebman (2001). The authors derived an algebraic solution which suggests that keeping a PAYG public pension system does not attenuate the persistence of a growing demographic pressure on the stability of public pension system. As I discussed earlier, PAYG system crucially depends on three key assumptions: high fertility rate, very low share of population older 65+ and high population growth. These assumptions are incompatible with actual demographic parameters and, hence, OECD countries should undertake a drastic transition towards fully-funded pension systems based on individual savings accounts. Otherwise, the growing demographic pressure will inevitably result in the exponential growth of generational debt, creating an enormous deadweight loss for current and prospective generations.
Fully-funded pension system is based on the premise of investing pension contributions into the capital market, earning a compound interest over time. The stock of individual’s lifetime earnings is paid in the form of annuities upon individual’s withdrawal from the labor market. In addition, there is a growing disparity between the implicit return of PAYG public pension system and real rate of return in the capital market. Under realistic assumptions, such as that the marginal product of capital (MPK) is below the welfare-maximizing level and the real rate of return exceeds the implicit return from PAYG system, fully-funded pension system would not create a deadweight consumption loss to the working-age population. In fact, Feldstein and Liebman (2001) derived an analytic solution for the transition to fully-funded pension system in which the transition induces a short-term consumption loss in the next period while, at the same time, it creates a geometrically-growing future consumption for both retired and working-age population.
The only remaining question is whether the real rate of return would compensate the consumption loss of working-age population and, hence, increase the stock of future consumption to all generations. According to Feldstein and Liebman (2001), assuming 6.5 percent inflation-adjusted rate of return, the payroll cost of fully-funded pension system would represent only 27 percent of the payroll cost incured under PAYG public pension system. Tax rate, required to bear the cost of current stock of pension liabilities is 12.4 percent respectively.
According to Congressional Budget Office, the average real rate of return for large-company stocks between 1926 and 2000 is 7.7 percent, 9.0 percent of small-company stocks and 2.2 percent for long-term Treasury bonds. Feldstein (1997) estimated that PAYG implicit rate of return is 2.6 percent.
Assume an individual wants to maximize the lifetime earnings in the capital market. An individual is offered 2.6 percent implicit return from PAYG system. The individual enters the labor market at certain age, say 25, and intends to retire upon the age of 65. Assume he invests $10.000 annually in the capital market to create retirement annuities upon labor market withdrawal. Assuming the implicit rate of return (2.6 percent), the stock of overall annuity would be 10 times the initial investment in 90 years. Assuming the average long-run real rate of return from large-company stocks (7.7 percent), the the overall annuity would be 10 times the initial stock of investment in 31 years. Therefore, the individual would reach the desired level of lifetime earnings at the age of 56 or 9 years before the targeted retirement age.
I assumed the distribution of lifetime investment portfolio is weighted average of availible asset types: large-company stocks (33 percent), small-company stocks (19 percent), long-term corporate bonds (20 percent), long-term Treasury bonds (20 percent) and 3-month Treasury bills (8 percent). According to the average annual real rates of return in the United States (1926-2000), I calculated the weighted average real rate of return (5.247 percent). Investing $10.000 annually at the age of 25 would buy $100.000 annuity at 5.247 real rate of return in 45 years (the age of 70) compared to 90 years (the age of 115) under the PAYG implicit rate of return (2.6 percent). Of course, the time to buy the annuity would shift alongside the changing composition of portfolio.
In addition, OECD countries should immediately increase the effective retirement age. I believe the solution suggested by Gary Becker is both meaningful but sustainable in reversing the growth of generational debt. Becker (2010) suggested “One simple and attractive rule would be to raise retirement age by an amount that makes the ratio of years spent in retirement to years spent working equal to the ratio that existed at the beginning of the social security system.”
When President Roosevelt signed the notorious Social Security Act in 1935, the normal retirement age was 65. However, life expectancy after the age of 65 was significantly lower than is today. In 1940, average life expectancy after 65 in the U.S was 13.7 years. In 2006, it stood at 18.6 years, according to OECD. In 1935, the average life expectancy at birth in the United States was 61.7 years. We assume that individuals in 1935 worked for 35 years and spent 12 years in retirement. The ratio is thus 0.4 (12/ 35=0.34). Today, if individuals retire at the age of 65, they can expect further 18.6 years in retirement. To equalize the ratio to the 1935 level, (18.6/x=0.34), individuals should spend 54.7 years working. The estimate time is an equivalent measure of years required to spend working if PAYG public pension system is left intact. Assuming the individuals enter the labor market at the age of 25, then the expected effective retirement age is the age of 80.
In the long run, PAYG public pension system is unsustainable since demographic parameters do not suffice the assumptions under which the PAYG system is possible without distortions of labor supply incentives. The future of OECD countries will be marked by aging population, lower fertility rates and a growing demographic pressure on public finances. Without bold and decisive pension reform, OECD countries will experience increasing pension deficits and, hence, an explosive growth of generational indebtedness.
Parametric pension reforms are not a substitute for the postponement of paradigmatic pension reform. Thus, implementing the transition to fully-funded pension system essentially requires higher effective retirement age. A comprehensive pension reform cannot be made possible without these measures. At last, but not least, the major challenge in the systematic pension reform in OECD countries to address the burden of global aging, is whether political courage will withstand the pressure of interest groups to maintain the status quo of early retirement incentives. Nonetheless, eliminating early retirement incentives is the essential step towards creating retirement system without perverse incentives to retire too early. Unless political leaders encourage a transition to fully-funded pension system, OECD countries will be unable to withstand the deadly consequences of an enormous generational indebtedness.
By Claus Vistesen, on September 23rd, 2010
Unlike Mr. Market who seem to be in full risk-on mode at the moment I am a bit handicapped on account of an awfully slow internet connection which is why posting is unusually slim at the moment. Another part of the market which seems to be a bit handicapped is the usual suspects in the form of the European periphery which seems to be ever so slowly creeping its way back to the front line of the discourse after having stirred in the background. Perhaps this is a sign of the the market attention-deficit-disorder which follows naturally from the inability of anyone to keep track of all discourses at the same time [1], a point which Team Macro Man described recently described quite elegantly;
It’s a right old mess out there at the moment. There are so many broad macro themes all colliding at the moment it looks like a slow motion replay of a motorway pile up. Deflation meets printing presses, meets commodities, meets politics, meets intervention, meets civil unrest, meets desperation, meets Voldemort.
Perhaps, this was also why the FT’s Ralph Atkins felt that he had to remind us of something we already knew this morning but which is still at the crux of the economic issues in the Eurozone. Basically, the ECB would like to think that everything is fast returning to normal and that, by consequence, monetary conditions should follow suit. Apart from the obvious in the form of a gradual increase in the main refinancing rate (currently at 1%) this would also mean a gradual withdrawal of liquidity support to the European banking system and a dismantling of the possibility to post collateral to obtain liquidity.
Mais, plus ca change in Frankfurt as the same problem which has been nagging the past 2-3 years is still, well, nagging;
Overall lending by the ECB has fallen to about €600bn ($780bn) compared with peaks of up to €900bn. But the amounts have stabilised at high levels in those countries worst hit by this year’s crisis over public finances. Greek, Spain, Portugal and Ireland account for 61 per cent of the total, despite comprising only 18 per cent of eurozone gross domestic product.
And this is indeed a royal mess since obviously not all banks in the Eurozone are equally distressed but just as the single interest rate policy creates macroeconomic distortions so will an overall liquidity scheme create the same kinds of distortions on a market level. One would think they would have learned by now. The problem though is no laughing matter. Jacques Cailloux, European economist at the Royal Bank of Scotland makes a key point when he notes that while the ECB clearly knows which banks that are using the funding facilities because they really need and which who use it for arbitrage (borrowing at 1% from the ECB and invest in the widening periphery yields to the Bunds) it is very difficult to do anything about the latter as annoying and frustrating it might be for the ECB to be a part of. Of course, you start to make differentiated access to auctions either by positive or negative discrimination but the end result would almost surely be the downfall of a number of European banks since the market would interpret this, and rightly so, as a sign that these banks would not be able to survive as independent private entities.
Meanwhile, in market land and while the S&P500 tests new highs at around 1130ish the water is starting to boil under the Irish cooker just as you might have thought that Ireland was one of the better of the bench. Yields on 10 year Irish bonds rose to an all time high today nudging above 400 bps as worries mounted that the government would not be able to meet its otherwise fine and lauded austerity plan on account of a darkening economic outlook not to mention the odd bank bailout (this time being Anglo Irish’ turn. The problem is essentially that at some point you simply run out of line and as such, finance minister’s Brian Lenihan’s assurances over the weekend that Ireland would not only have no problem finding bid for its 1.5 billion euro bond offering today and that the market would get a final tally on the recapitalisation of Anglo Irish, the screw has so far kept turning.
On Anglo Irish, WSJ’s Market Beat raised a further concern today regarding Anlgo Irish;
In the coming days, Ireland’s central bank will also provide more clarity on the biggest bug bothering investors: The total cost to the government of winding down troubled lender Anglo Irish Bank Corp.
Investors will be watching not just the final tally, but also details on what could happen to holders of the bank’s senior bonds and roughly 2.5 billion euros worth of riskier “subordinated” bonds.
This is a point also recently made by John Dizzard in the FT and it goes to heart of uncertainty surrounding Anglo Irish and indeed the whole bailout mechanism since where it is all well and good that stockholders get buggered bondholders have, for now, in most cases been spared. The cost so far of bailing out the bank has been staggering for Ireland. To date the government has injected a full 23 billion Euros and Standard & Poor estimated back in August that this figure might rise to 35 billion Euros over time. Even at 25 billion Euros Dizzard points to the dizzying fact that this already constitutes 5600 euros for every man, woman and child in Ireland.
While all this trundles on the yields of the periphery continues to widen and apart from Ireland, Portugal has also found its spot in the market cross hair.
The real question to answer then is if and when Ireland (and Portugal) capitulates and goes to the trough of the European Stability Fund (chargin 5% for a loan) and/or the IMF. According to Goldman Sachs Erik Nielsen, anything beyond 5% (i.e. as a lingering yield on Irish bond offerings) would mean that they are cooked and this, remarkably and scarily, is even in the context of a country that is actually fully funded until mid 2011. However, with the underlying assumptions on the economic outlook almost certainly too positive and the butcher’s bill on Anglo Irish more likely to rise than fall this particular fact might mean very little. But this I reckon is already old news by now.
–
[1] I intend to present a solution for this at some point so stay tuned!
By Claus Vistesen, on June 16th, 2010
As it seems that we are finally about to get something which resembles a stable summer here in Denmark it may seem strange to suddenly start talking about snowballs. Yet, the idea of debt snowball is very relevant in the current environment as it relates to the potentially unstoppable development in public/domestic debt levels despite a country’s best efforts in the form of austerity measures. Specifically, the combination of a year long loss of competitiveness, excessive domestic debt levels (private as well as public) and being caught up in a fixed currency union means that as austerity measures enforced to rein in debt levels also push the economy into deflation and growth, by virtue of the loss of competitiveness, remains absent the debt problems essentially worsens despite efforts to the contrary. Recently, I penned a paper on, in part, this very subject and the following passage sums up the main learning point;
Thus, Greece et al are effectively caught in a catch 22. Specifically, the need to simultaneously rein in fiscal stimulus in order to preserve long term debt sustainability as well as to correct an external deficit proves a decisively unattractive macroeconomic medicine which may not only prove difficult to administer, but also effectively impossible to pull through in the current Eurozone setup. The vice which then locks in
uncompetitive economies in the Eurozone is twofold.
Firstly, the deflation in prices and wages needed to restore external competitiveness and thus growth must be relative in excess of other economies’ correction. In this sense, Greece et al are fighting a moving target in the form of relative deflation compared to other member economies and indeed other global economies facing similar pressures to deleverage. In short, the battle for relative market share on export markets will increase in conjunction with the amount of economies pursuing a deliberate export oriented growth strategy. Secondly, deflation increase the real value of overall government debt thus requires even more in the way of austerity measures to keep the debt level sustainable. Moreover and as a complicating factor; Greece, Spain, and Portugal are currently paying a large premium over the base rate (German Bunds) for lending money.
This may sound terribly complicated, but the argument is apperently not more complicated that it made it into a recent EU draft report according to Bloomberg who has obtained a copy of the report. Specifically, the report notes that while the measures already taken are the right way to go they may not prove enough;
(quote Bloomberg)
Debt levels in Spain and Portugal may “snowball” in coming years and additional budget cuts are needed to meet deficit targets announced just a month ago, according to a draft European Commission document. The deficit-reduction measures announced by the two nations as part of a European Union agreement on May 10 to create a 750 billion-euro ($920 billion) financial backstop for indebted countries aren’t sufficient, the report obtained by Bloomberg News said. Spain pledged to cut the EU’s third-highest deficit to 9.3 percent of gross domestic product this year and to 6 percent in 2011. Portugal vowed to lower its shortfall to 7.3 percent of GDP in 2010 and to 4.6 percent in 2011.
“While the newly announced measures are significant and the targets imply impressive budgetary consolidation, more measures are needed to meet those targets, in particular for 2011,” according to the draft report, which is dated May 26. The document, titled “Consolidation Requirement in Spain and Portugal,” was prepared by the European Commission, the EU’s executive arm, for the region’s finance ministers.
Really, I think it is important that you appreciate the irony and tragedy in all this. Consequently, while the process of internal devaluation (which is really what the Eurozone periphery is embarking on) is the underlying cause of the potential debt snowball in Spain, Greece and Portugal what the draft report is saying is essentially that this process should be speeded up. Now, in the internal logic of policy making in the EU it is important to understand that this is the only possible solution within the confines of the Eurozone where currency devaluation is impossible. However, in the specific context of avoiding a debt snowball the discourse falls apart since the very suggestion made by the EU here will only exacerbate the snowball.
In other words; you cannot restore growth and rein in debt levels at the same time through an internal devaluation from within a setup such as the Eurozone. At some point there will be an inflection point and short of some form of Eurozone breakup it will come with a large bout of ongoing deflation in the Eurozone periphery which, I reckon, will end with a wide private and public sector default.So, I will give a C for realizing, while belatedly, the risk of a snowball in itself, but an F for the proposal.
However, the most important thing I think is why this is in fact the only viable policy option the EU can propose to the South. Whether this be irony or tragedy I will leave to you.
By Rok Spruk, on May 13th, 2010
The $140 billion rescue package to Greece is a milestone in the European Monetary Union. A lively debate on recent macroeconomic imbalances in the weakest economies of the Euroarea – Greece, Italy, Spain and Portugal – in the Eurozone has reopened the old debate on whether the Eurozone is an optimum currency areas (here, here, here and here). The idea of optimum currency areas was first proposed by Nobel-winning economist Robert Mundell. In general, if several countries form a currency union, they should have at least four common macroeconomic features as essential framework of the currency union. In this article, I’ll review the labor market criteria and fiscal adjustment criteria in the light of a recent imbalances in the Euroarea, and leave production diversification and export criteria for future discussion.
First, there should be a high degree of labor mobility between countries in the currency union. The basic idea behind the labor mobility criteria is that the lack of labor mobility triggers divergence of productivity growth rates and asymmetric adjustment of wages. If inter-country productivity divergence persists, there is an upward pressure on wages adjustment given the lack of exchange rate adjustment since the countries share a common monetary policy. The formation of the currency union in the United States was relatively straightforward given the fact that labor mobility between the states is very high. In Europe, the level of labor mobility is relatively low. The lack of labor mobility has a lot to do with labor market institutions in European countries. Workers from the European periphery can hardly move to Germany, Netherlands or Denmark as they do not speak the same language. The lack of inter-country mobility resulted in significant wage premiums and rise in rents since European labor markets share a pretty high degree of monopoly power since European workers can’t switch easily between labor market structure. The resulting outcome of the lack of labor market competition was a significant “union capture” of the labor market, leading to rigid wage determination and high market switching costs.
Paul Krugman recently argued (link) that the major problem behind the European Monetary Union is the lack of common fiscal policy. To a very large extent, the absence of common fiscal policy seriously affects the future prospects of the European Monetary Union. Common fiscal policy could easily absorb asymmetric shocks withing the Euroarea. However, instituting the policy could not alter the trade-off between fiscal autonomy and asymmetric shock intensity. In other words, the main problem of the Euroarea right now is the free-riding of Eurozone’s most problematic countries on a common monetary policy using disrectionary fiscal policy. Before the economic crisis, Spain had a budget deficit while, at the moment, the 2010 budget deficit forecast is more than 8 percent of the GDP. The estimate Greece’s balooning public debt in 2009 ranges from 110 to 115 percent, depending on the consensus forecast. If the EMU countries unified a fiscal policy, the countries would not have an incentive to free-ride on discretionary fiscal policy and further increase the stock of public debt. The major impediment on the recovery and long-term economic outlook of Eurozone countries is largely dependent on how these countries will reform the pension systems in the light of a growing old-age dependence and a near fiscal insolvency of the pay-as-you-go (PAYG) pension schemes. It will be impossible to reverse the aging population and its persistent pressure on an increasing public debt. The integration of fiscal policy would require a sizeable harmonization of taxes given high costs of coordination and sufficient incentives for moral hazard. Without the reversion of long-term public debt pressure from aging, discretionary spending and entitlements, countries such as Greece, Spain and Portugal would leave the Eurozone.
By Rok Spruk, on April 7th, 2010
The Economist published a fascinating overview (link) of the macroeconomic indicators in Europe’s most vulnerable economies in the current debt crisis (Portugal, Italy, Ireland, Greece, Spain).
By Rok Spruk, on February 17th, 2010
Paul Krugman has blogged an interesting analysis of the anatomy of the recent economic crisis in Europe (link).
Europe’s difficult macroeconomic situation in the aftermath of the financial and economic crisis has exacerbated rising fiscal deficits and public debt alongside strong deflationary pressures. These pressures were triggered by the highly negative output gap – the difference between the economy’s potential output and the real output. In fact, a brief observation of the output gap estimates (link) shows that the sick men of Europe (Portugal, Greece, Spain, Italy, Slovenia) are likely to face negative output gaps. In 2010, Spain is likely to reach -2.12 percent output gap. Slovenia, Italy and Greece will also face a negative output gap. The negative output gap triggered strong deflationary pressures since the nominal aggregate demand is insufficient, causing a decreasing price level.
Before the financial and economic crisis of 2008/2009 evolved, Europe’s peripheral economies faced strong asset price bubble. As real estate prices were soaring, these economies attracted significant capital inflows which lead to inflationary pressures. Before the crisis, the inflationary dynamics in the peripheral countries of the Eurozone were strong. In Greece, Spain and Slovenia, consumer prices increased by more than 3 percent on the annual basis. The asset bubble was further spread by low interest rates. The asset price inflation in these countries was very high. In Slovenia, five-year asset prices increased by 500 percent (see: IMF, International Financial Statistics). As the increase in asset prices widened, Europe’s sick men were faced with rising current account deficit.
In 2007, Spain’s current account deficit amounted to more than 10 percent of the GDP. In such circumstances, a clever monetary policymaker would push up interest rates. As interest rates were at historic lows during the pre-crisis period, the real cure was on behalf of the fiscal policy. Before the crisis, Spain’s fiscal picture was very well indeed. From 2004 to 2007, Spain was running a fiscal surplus which reached the level of 2 percent of the GDP in 2006 and 2007. However, massive capital inflows were not sterilized by raising interest rates which further inflated the real estate bubble and overheating of Spain’s economy.
Independent fiscal policies and a common monetary policy – which is an economic model of the EMU – cause asymmetric shocks. During the years of high growth, these shocks are mostly neglected. However, during the crisis these shocks might cause a serious trouble in the macroeconomic adjustment. Greece, which recently declared a worrisome possibility of debt default, is a typical case of what happens when asymmetric shocks persist.
As Greece, Spain, Italy, Portugal and Slovenia now face high fiscal deficits and poor economic growth, these countries will likely face years of deflationary pressures and high unemployment. The fiscal policymakers already exhausted the ability of governments to boost spending. Further growth of government spending is impossible unless European countries want the Greek debt episode to evolve in a domino effect throughout the Eurozone. The ECB will sooner or later this year raise the baseline interest rates to avoid the inflationary swings in Germany, Austria, Netherlands and other countries with current account surplus.
The macroeconomic outlook for the Eurozone is backlashed by the debt crisis in Mediterranean countries. An economic recovery may include indepedent monetary policies to adjust interest rates and prevent another asset bubble episode as well as to target current account balance. However, European countries will have to rethink the role of indepedent and discretionary fiscal policies pursued by the sick men of the Eurozone.
Join the forum discussion on this post - (2) Posts
By Claus Vistesen, on January 14th, 2010
I shall openly admit that I have always found the exact role of the rating agencies a bit odd in the global financial system. I mean, do we really need them to tell us which bonds are good and which are not? I am not sure and what is more; rating agencies sometimes, if not all the time depending on their ability to stay in front of the curve, seem to wield a tremendously amount of power relative to their role as private actors (after all) in financial markets. For example, they may ultimately decide whether bonds of a given Eurozone economy may be eligible for collateral at the ECB or, even more importantly, they may decide which sovereign bonds that are investment grade or not and thus whether big institutional investors can allocates there or not.
Yet, this reservation notwithstanding, the rating agencies do seem to be some of the only big ticket private market actosr who are able to state the obvious. Specifically in this context, the obvious is directing our attention to the the ongoing travails of some economies in terms of figthting the current crisis with fiscal stimuli while the yoke of population ageing and its effect on public finances steadily pushes the economy’s long term prospects into the sinkhole.
In this way, I don’t think people should be, or indeed that they have a right to be outraged by the continuing comments (and inevitable) downgrades. How could they possible act otherwise given that they are here and do what they do?
In this sense, the recent messages from Moodys on Japan as well as Greece and Portugal respectively sounds extraordinarily timely to me even if it is stating the obvious;
(Quotes Bloomberg, first Japan and then Portugal/Greece (Eurozone))
The replacement of Japan’s finance minister four months into the government’s term increases concern about the commitment to contain the world’s largest public debt burden, Moody’s Investors Service said. “Japan’s fiscal strategy unknowns deepen” with the appointment of Naoto Kan last week, Thomas Byrne, senior vice president of Moody’s in Singapore, wrote in a note yesterday.
Byrne’s stance contrasts with analysts at Goldman Sachs Group Inc. and Morgan Stanley, who said Kan has indicated a willingness to repair Japan’s finances. The 63-year-old deputy prime minister last week replaced Hirohisa Fujii to become the country’s sixth finance chief in 18 months, tasked with preventing a relapse into a recession while containing the debt. “The revolving door for leadership at the Ministry of Finance does not engender confidence that Japan will put together a credible fiscal strategy to reduce deficits and stabilize the massive government debt overhang in the medium term,” Byrne said.
Kan said on Jan. 7 that it will be a “challenge” to maintain fiscal discipline this year and he will try to secure funds to fulfill the ruling Democratic Party of Japan’s pledges without exacerbating the debt burden. The role change also “raises doubts” over the administration’s commitment to a 44 trillion yen ($480 billion) cap on new Japanese government bond sales for next fiscal year, Byrne said. Kan may “seek to further boost fiscal stimulus to an economy hamstrung by renewed and stubborn deflationary pressures,” he said.
(…)
The Portuguese and Greece economies may face a “slow death” as they dedicate a higher proportion of wealth to paying off debt and investors demand a premium to hold their bonds, Moody’s Investors Service said.
While the two countries can still avoid such a scenario, their window of opportunity ”will not be open indefinitely,” Moody’s said in a report today from London. Portugal, with a negative outlook on its Aa2 rating, has more time “to reverse this trend” while Greece “has significantly less time.” Moody’s cut Greece’s rating to A2 from A1 on Dec. 22.
The premium that investors demand to hold Greek debt instead of German equivalents is six times more than it was two years ago, and the spread has doubled since 2008 in the case of Portugal. Greece had the largest budget deficit in the euro region last year, more than four times the European Union limit of 3 percent of gross domestic product. Portugal’s debt load will account for 85 percent of GDP this year, according to the European Commission.
Naturally, the case of Japan and the Eurozone periphery diverges in a number of notable ways. For starters Japan has its own central bank which will be duly deployed to provide funding for the issuance of government bonds to the extent that private (or foreign) savings are not enough to satisfy demand. Moreover, and as Moody’s point 94% of Japanese debt is held by the country’s own residents. I find this point less convincing as a mitigating factor since a country may very well go bankrupt with the majority of debt owned by domestic actors. Think about this as simply marking Japan to market given the demographic outlook and thus scything the face value of all those bonds they issue domestically. I.e.e Japan would move from the third/second biggest economy in the world to the “..th”. However, since this would ultimately occur internationally through a sharp depreciation of the JPY, it would also boost Japan’s competitiveness considerably. More importantly Japan has a large external surplus which means that she is building up claims on the rest of the world in stead of the other way around.
This is not the case for the Eurozone periphery and apart from the obvious fact that Greece, Portugal, Spain etc do not benefit from their own central bank which they could collaborate with in the context of quantitative easing or a prolonged commitment to ZIRP, they are also net external borrowers. According to the data from the IMF, the average annual current account deficit as percentage of GDP between 1999 and 2008 in Greece, Portugal, and Spain was -8.6%, -9.1% and -5.9% respectively.
On this point I agree with Moodys and others that the risk of a sudden balance of payment crisis leading into short term default is not relevant at this point. Rather, the main issue lies in how to make headway on the public debt/fiscal front at the same time as correcting the external deficit which has to correct since these economies are now effectively export dependent. It is very important to understand the very dangerous and decidedly unattractive cocktail that these economies must now swallow and why it is exactly so because of the inability to use nominal exchange rate depreciation as a tool to correct the external deficit. In this sense, what these economies now have to do is to travel the ill-wanted route of an internal devaluation in which domestic price and wage deflation are deployed in order to restore competitiveness. But this is not all. They are consequently also now effectively forced, vis-à-vis the nudge and pressure from Moodys et al, to take serious steps to rein in public deficits and put long term finances back on track. Now, the dilemma should be clear at this point since, as we know, deflation increases the real value of debt and thus it is difficult to see how these economies are exactly to pull this off. We could say, that the Eurozone does not allow them the leisure of inflation to ease their path to recovery.
Now at this point, the Austrian police aka haters of Fiat et al will probably be flashing their badges and tell me to pull over. And so, as I pull over I will tell them that anyone seriously arguing that the inability of Greece et al. to use nominal exchange depreciation to correct is not an aggravating factor simply do not have the faintest idea of what export dependency means modern growth dynamics of ageing economies stuck in a fertility trap about to become a liquidity trap. Really, it is as simple as that and while not everyone can devalue at the same time to become dependent on the same exports (i.e. the real underlying problem as we move forward) we are about to find out what happens when the entire weight of adjustment has to fall on the domestic economy.
Having said this however, I would like to emphasize that while the Eurozone, for reasons just mentioned, may be far from perfect we cannot let it fall apart and thus an internal devaluation in Greece, Spain etc it is. As with the Eurozone itself, it will be a great experiment to see how and whether it will work to salvage these economies.
|
|
Most Popular Posts