By Thomas Knapp, on January 18th, 2011
To whom it may concern:
The United States Congress is currently engaged in one of its periodic debates over raising the “debt ceiling” (the total amount of money it “allows” itself to be in debt for).
I’m nearly 100% certain that Congress will “allow” itself to borrow more money.
If you’re thinking about loaning them some of that money, though, you might want to reconsider.
The collateral underlying US government debt is the notion that I’ll pay you back the money they borrowed.
Three words: Ain’t Gonna Happen.
If 435 US Representatives, 100 US Senators and a US President borrow money from you, then so far as I’m concerned they’re the ones who get to pay you back.
Those 536 individuals are already extended to the tune of $14 trillion, or (math in my head time) somewhere in the general neighborhood of $25 billion each.
If you think that those 536 people have, on average, assets worth in excess of $25 billion to collateralize/cover their existing debt, with stuff left over to make you comfortable that they’ll pay back new debt, by all means loan them all the money you’re comfortable loaning them.
If you think I’m going to pick up their check, though, let me repeat myself, just so you can’t claim later that you were unaware of it: Ain’t Gonna Happen. I didn’t borrow the money, they did. I’m not going to pay it back, which means that either they’re going to have to pay it back themselves or that it isn’t going to be paid back (three guesses which one).
So you might want to look into legitimate investment opportunities instead of the US government’s fly-by-night scams. I’m just sayin’ …
By Claus Vistesen, on December 15th, 2010
I did have some plans to do a series of post to give a brief overview of my main macro and trade themes for 2011, but time has, not surprisingly, caught up with me. As such, you will have to make due with a special version of random shots.
Risky Assets to fly in 2011? – This one is a bit too general to answer in full of course, but one interesting discourse that has emerged lately is that as bond vigilantes are feasting on the Eurozone (and even going for an altogether larger prey in the US), investors are being pushed into equities.
Following a well worn cliché in the world of finance, equities is the least ugly alternative.
Now, this may only be a working explanation on the surface since the underlying move into equities is also part of a more structural consequence of QE2 since the Fed is not only trying to move investors around on the yield curve, they are also trying to move them out of the curve altogether and into more risky alternatives. In this sense, what appears to be a melt up in equities might just be a slow but steady excess liquidity driven grind. Surely, Bernanke is in no rush to raise interest rates in 2011 and if the US economy continues to slowly heal, there will be only speed bumps ahead of a general trend upwards. One interesting thing here will be how the market reacts to event the slightest hawkish tone from the Fed or perhaps even a downtoning of the dovish stance. I think; not all too well but precisely because of this assumption (which I think many share with me), the Fed will remain uber dovish as far ahead as the eye can see.
Technically, I think the melt up towards the end year is in for a rude stop in the beginning of the year and I have the SP500 declining to about 1180-1190 in January. This would then provide a potentially tasty entry point for a 2011 rally. Other than a veritable cataclysm in the Eurozone (which appears the main source of systemic risk at the moment) and China suddenly slamming on the breaks in an unduly harsh manner, I see little resistance for risky assets in 2011. This is especially the case as the BOJ and the ECB will likely add their interpretation of “QE2″ to the table to respond to the ongoing sluggishness of their respective economies.
We have already gotten a barrage of 2011 predictions and outlooks from research houses, banks and other financial sages and quite frankly it is quite difficult to get a bearing on it all. I did find the Barclay Macro survey quite interesting though as it shows that about 70% of all investors see risky assets in the form of commodities and equities to outperform in 2011 while US treasuries will underperform. The underlying rationale is again quite simple I think. Given the severity of the crisis, monetary policy will tend to apply the brakes with a considerable lag and if 2010 saw the first signs of the effect of such a lag, 2011 could give us the full force. Again, this is especially important to note as the ECB and the BOJ might just be about to join the party.
On the other hand, “underperforming treasuries” will also present Bernanke with a dilemma in the sense that the extent to which the infamous bond vigilantes fancy more than a pot shot on US bonds he may be forced to apply even more pressure to keep yields low.
Low Growth in the OECD – This one is hardly news and hardly one exclusively for 2011 either. However, I still think there is a lack of recognition of just how low growth in the OECD is likely to come in for the coming years. In this way and just as investors have their focus set on outperformance in Asia and Latin America, I think that the ultimate growth outcome in the OECD will be worse than the market currently expects.
The point I am basically getting at is that we need to think about the fact that the Eurozone periphery essentially are going to be hampered by negative trend growth rates and that the rest of the OECD will be dependent on exports to grow (think mainly Germany, Japan and now also the US). Apart from any productivity miracle or some other exogenous source of growth, the growth engines in the OECD are simply tapped out. Indeed, this is probably the most important structural macro theme for me at the moment.
Now as for 2011, a lot of this will also depend on whether economies really intend to walk the walk in terms of fiscal tightening or whether they are simply talking. Clearly, countries under the spotlight in the form of the Eurozone periphery will see their growth rates severely dented by the need to consolidate public finances. In the US on the other hand, I think the latest estimate for the 2011 budget deficit is 10% of GDP which is hardly tight.
According to the IMF’s latest forecasts “Advanced Economies” will be running a deficit on the structural balance to the tune of 5% in 2011 and the G7 as a whole one of 5.88%.
But all this only goes to accentuate the issue since if there is one thing we have learned by now it is that one cannot borrow ad infinitum and especially not as you are essentially borrowing against a depreciating asset in the form of future growth held down by population ageing. So the big (as in biig!) question is; if you substract the 5% government spending induced deficit from the equation what kind of trend growth rate is left in the OECD as a whole?
Clearly, we know that some economies are now basically saddled with negative trend growth rates, but I think that even the aggregate number in advanced economies would be scary reading. We could call this decoupling in reverse and thus how vulnerable we now are to the continuing growth spurt of Asia and other so called emerging economies. But in the end, it is a basic question of not having any more components of the national identity to lever up as it is obviously clear that governments are only going to find it increasingly difficult to borrow (even in the case of very generous central banks).
Indeed, as we move forward I see this low growth environment for the OECD (and actual negative trend growth in some economies) as one of the main components in my call that we are going to see some spectacular and costly sovereign defaults in the OECD edifice going forward. On this, I think the current mess in the Eurozone is only the beginning.
The Euro and the Eurozone - Actually, I have not followed FX a lot lately so I am a bit of out form here, but I still use my Old Maid metaphor when thinking about big global currency movements and intra G3 movements especially. Interestingly, 2010 saw the JPY as a looser and thus holder of Old Maid in the sense that it appreciated significantly against the USD and Euro. In essence, the USD was being held down by the Fed’s policies and the Euro actually acted as a nice buffer against the crisis in the Eurozone as it fell strongly throughout the spurts of Eurozone tension in turn providing a much needed boost to external competitiveness when it was needed the most.
In principal, these trends do not stop at year end and will continue to dominate at least part of the intra G3 movements in 2011. The main question is what kind of bazooka, if any, the BOJ will pull out to revive the ailing Japanese economy. If it becomes the kind of shock and awe many are expecting we could be into a nasty long squeeze in the JPY. This also goes for the Euro in the context of the ECB being forced, kicking and screaming, into supporting Eurozone bond markets. I hold this to be almost given since the current setup simply does not work.
Today, Trichet called for more bold action on the fiscal front and in terms of capitalising the stability front (didn’t he just tell them to tighten their belts?). This is no doubt part of a futile attempt to preempt any defacto query, to the ECB, by part of the EU on taking an active and open role in the bailout. Trichet and his compadres are not going to like it, but the alternative asking Italy and Greece to pay for the bailout of Spain who in turn helped finance Greece and Ireland is simply hogwash.
As I have noted on several occasions; should the issue turn out to be contained with Greece, Ireland and Portugal the fiscal solution/stability fund would suffice, but evidently we are looking at a much more structurally problematic issue and Spain is surely next in line and even yields on German and Belgium bonds have begun to break loose. As such, it is becoming increasingly clear that the ECB will have to take a more active part beyond “simply” supplying liquidity to the banking system and buying bonds on the drip (or covertly).
I tend to have little opinion on the EUR/USD in general, but I will timidly forward the idea that we can expect the ECB to surprise with some of open support to the periphery, it should provide some pressure on the single currency. Yet, it is also fair to assume that the extent to which risky assets fly in a bath of excess liquidity the USD will depreciate and the Eurozone will gain on carry flows as interest rates are still higher in the Eurozone (especially, if things get so calm that the ECB starts turning hawkish again, but this may be selfdefeating in itself of course).
Emerging Markets – Well, the EM story is important enough to merit its own section even if it is intimately tied to the risky asset story. Yet, there is no need to re-invent the wheel and in this sense I think that Morgan Stanley’s Manoj Pradhan’s recent note on the 2011 EM outlook is pretty much accurate in all the important areas.
Especially his first point is important on structural outperformance by the EM relative to the developed world whereas 2011 should see EM growth cooling and, hopefully, growth in the developed world nudging up. As such, 2011 will see relative outperformance by developed markets. This is a bold, but also astute, call. It is bold because I think the link between the EM and DM is still too strong to see DM growth decouple entirely for a relative slowdown in emerging markets. In this sense, how far and how fast monetary policy in emerging markets are tightened in response to fears of overheating will be key. It is astute because, all things point in the direction of a slowdown in the emerging world after a breakneck 2009 and 2010 and in this sense, on the margin, perhaps the developed world is the place to be in 2011 on a tactical basis.
I also like that he spends some time on the inevitable, but important, process of rebalancing away from a reliance of an overlevered Anglo-Saxon consumer in the OECD (and of course, a now cracked Eurozone periphery). Reverse decoupling and rebalancing towards the emerging markets are two of the main global discourses and real economic drivers at the moment.
Finally, I think it is also important to re-emphazise the basic problems emerging markets face as they try to cool their economies through higher interest rates only to allow more hot money flowing in. The policy mixture is obviously being developed as we move along with some form of capital controls being implemented across the board. In a world of structural excess liquidity this policy dilemma becomes an additional issue on top of the more traditionally discussed trilemma.
As such, I am large cautious on the emerging markets going into 2011 as I think they are overloved, but the long term bull call stands uncontested. In addition, there appears to be general acceptance and expectation that key emerging economies (China most notably) will react strongly to any lingering signs of overheating and just as Bernanke might not care that his low interest rates will fuel asset bubbles far from the shores of the US, so may Chinese policy makers care very little if they have to slam on the brakes to the detriment of global growth and OECD’s recovery.
By Doug Gentry, on December 3rd, 2010
Each year The Economist magazine publishes one of my favorite economic indicators – the Big Mac Index. This year The Economist said,
Our Big Mac index, based on the theory of purchasing-power parity, in which exchange rates should equalise the price of a basket of goods across countries, suggests that the yuan is 49% below its fair-value benchmark with the dollar.
 Here’s the background. First the theory. In a world of freely floating currency exchange rates, those rates will adjust over time so that a commodity costs the same anywhere in the world. This is called purchasing power parity. An example: Imagine that Brazil finds some way to sell sugar on the global market at a much lower price than everyone else. Right away sugar buyers can buy more sugar with their own currency from Brazil than anywhere else in the world. This will substantially increase Brazil’s exports.
Now, we also know that if a country’s exports increase significantly their currency will increase in value on the international currency market. That is because all these purchases of Brazilian sugar will increase demand for the Brazilian real. As the value of the real rises Brazilian sugar becomes more expensive to foreign buyers – their own, local currency can’t buy as many real as before. At the same time other sugar exporters may see a slight decrease in the value of their currencies, as sugar buyers switch to Brazil. Over time international currency exchange rates will adjust so that a sugar buyer will be able to buy the same amount of sugar anywhere in the world. That’s the theory of purchasing power parity. We know that currency rates don’t float perfectly, and in some cases countries seek to influence the value of their currencies. Enter the Big Mac Index.
A number of years ago staffers from The Economist decided to test purchasing power parity (PPP). Rather than using a boring commodity like sugar, they looked at Big Macs, from McDonalds. Big Macs are as close to a commodity at the definition allows – virtually identical everywhere. They recorded the price of Big Macs in scores of countries, converted those prices to dollars and tested the PPP theory. The results showed a wide range of prices for Big Macs.
Now, these results could disprove the PPP theory. Instead, The Economist staffers maintained that PPP was true, and that various countries’ currencies were either over-valued or under-valued. Let’s use China as an example. Earlier this year a Big Mac cost $3.58 in the United States, but only $1.83 in China (after converting yuan to dollars). If PPP is true, then China’s currency is under-valued by almost 50 percent. And, in fact, there is considerable angst in the international community about China’s efforts to artificially lower the value of its own currency in order to protect its huge export market and supporting industries.
Economists love to forecast, and yet have a very mixed record of success with their forecasting. The Big Mac Index can be used as a rough forecasting tool. In the March, 2010 article the Euro was 29% over-valued. Over the last six months the Euro has declined in value against the U.S. – just what the Big Mac Index would predict.
Who says economists don’t have fun?
By Emmanuel Tabones, on November 15th, 2010
There is a scene in Book XXI, Chapter IV, of Sir Thomas Mallory’s Le Morte D’Arthur,” which described how King Arthur waged his final battle with Sir Mordred, concluding with the utter destruction of both their armies, and leaving the latter surviving, alone. Meanwhile, the monarch still had two knights left, Sir Lucan and Sir Bedivere, though they were both “sorely wounded.” Sir Lucan pleaded with the king not to continue the conflict any further, reminding him that he had “won the field” that day. But Arthur would have none of that as he was determined to exact final revenge, at whatever cost. Readers all know what happened next because of his fateful decision.
This all came to mind as I read a recent question posted in the Wall Street Journal’s online “Journal Community” section:
Should the U.S. and other countries risk a trade war with China over the valuation of the yuan?
Alas, it is just another way of saying, should the U.S. and like-minded countries risk mutually assured destruction in order to fix what others refer to as a non-existent problem, or at worst, one that is overblown. We could all simply end up like King Arthur.
As economist Walter E. Williams noted in his excellent article entitled, “Our Trade Deficit (May 25, 2005):” “I buy more from my grocer than he buys from me, and I bet it’s the same with you and your grocer. That means we have a trade deficit with our grocers. Does our perpetual grocer trade deficit portend doom?”
Of course not, I say, but as Dr. Williams had observed, this example illustrates that there is more to the issue than those seemingly frightening deficit figures used by certain “pundits and politicians” to scare the general public, and there are a fair number of such fear mongers these days, both from the political right and left, whether we refer to Pat Buchanan, Lou Dobbs, as well as former congressman Richard Gephardt, current U.S. Senator Sherrod Brown (D-Ohio), and a host of others.
However, judging from the lopsided poll results and angry posts in support of trade war, these respondents and other, similarly outraged individuals, have largely ignored the thoughtful and sensible pronouncements of people like Dr. Williams. Yes, these folks have certainly worked themselves up to a similar, “to hell with the consequences” frenzy, and the U.S. Federal Reserve’s new initiative, known as QE2, is largely influenced by these same views. Fortunately, saner heads seem have to have prevailed at the recent G20 summit, with the general consensus rejecting American efforts to pressure China to relax tight controls on its currency. Yet, that hardly resolved any major issues, leaving the prospect of trade war hanging over everyone’s heads like a dreaded “Sword of Damocles.” More importantly, the United States has simply incurred the opposition of trading partners such as Germany (not to mention China) for this seemingly reckless monetary policy aimed at further bringing down the value of the U.S. currency, all in the name of “stimulating the U.S. economy and creating jobs.”
Gee, if only things were that simple and not fraught with risks, such as the likelihood of causing a dramatic rise in inflation, especially in the price of commodities like petroleum products. With the continued deterioration of the U.S. dollar, we may very well see oil prices again rise north of USD $100 per barrel, perhaps as early as 2011. The Obama administration is probably betting that many Americans (especially those who actively participate as voters) are not savvy enough to know the connection, and unfortunately, that may very well be the case. Maybe people will finally figure it out once oil hits USD $200, with inflation raging at 20 percent.
Meanwhile, I doubt President Obama fooled anyone with his insistence that QE2 was “not meant to deliberately weaken the U.S. dollar,” as reported by Ben Feller of AP and others. It also appeared that the Fed was not fully prepared for international reaction, especially with countries getting ready to, or having imposed additional financial regulations meant to blunt the intended effects of QE2. Nowadays, I am increasingly convinced that Bernanke and his people are losing their grip on economic, global reality.
With this unfortunate and largely misleading political perception that America’s high unemployment rate is directly linked to its massive U.S. trade imbalance, and with increasing demands to impose trade barriers, other nations could likely respond in kind, which could bring us to a SH2 (Smoot-Hawley 2) type scenario and an economic nightmare that could reduce global trade dramatically and bring about massive, worldwide unemployment not seen since the Great Depression. As the philosopher George Santayana was quoted as saying, “Those who do not learn from history, are doomed to repeat it.”
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 Ajay Shah, on October 15th, 2010
From the mid 1990s onwards, the US trade balance has steadily become bigger. This is a centrepiece of the problem of `global imbalances’. Starting from values of roughly zero, this got all the way to values like $70 billion a month, where the US was importing over $2 billion a day of capital to pay for the trade deficit. Here’s the picture:
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| The US trade balance (goods+services, per month, seasonally adjusted) |
This was termed as the `Bretton Woods II’ configuration, where exporting countries like China gave loans to the US, in a form of suppliers’ credit, and the US bought Chinese goods. This magnitude of capital import was unsustainable for the US. Something had to give.
Warning for Indian readers: In India, the term `trade balance’ pertains only to merchandise trade. In the US, the monthly trade data covers both goods and services. So it is a meaningful measure of what is going on in international trade, unlike the corresponding Indian data.
Bretton Woods II first broke down in the financial crisis. In the downturn, the mighty American consumer purchased fewer 50″ television sets. The US trade deficit dropped nicely all the way to $25 billion per month. Alongside a rise in the US savings rate, this looked like a world which was rebalancing. In recent months, this movement reversed itself and the US trade deficit once again started getting worse. A deterioration of $20 billion per month is visible; i.e. a deterioration of $240 billion a year. Suddenly, the story of global imbalances righting themselves came under question. The present US run rate is around $40 billion a month or $0.5 trillion a year.
Alongside this, we have news that the Chinese reserves rose by $194 billion in Q3 2010. The Chinese seem to have also passed on some of their problems of exchange rate pegging upon their neighbours by purchasing Japanese, South Korean and Indonesian assets. I am not aware of such behaviour having been observed prior to this in human history. Japan, South Korea and Indonesia have taken unkindly to this behaviour. Given the opacity of the Chinese regime, one can’t help wonder if similar things are going on through less visible channels – e.g. a Chinese sovereign wealth fund buys $10 billion of OTC derivatives on Nifty.
So we seem to be headed for quite some escalation of conflict over the Chinese exchange rate regime. Here are some interesting readings on the subject:
By Claus Vistesen, on September 8th, 2010
The financial and economic discourse is a funny beast really; it can, if harnessed properly, shed light on future investor and market performance, it can give a diversified and detailed picture of any given economic or financial topic, and it is a place where stories, no matter how counterintuitive and misplaced, can linger and grow for a long time.
I am focusing on the last aspect and in doing so moving in alongside Edward (here, here and here) as well as Wolfgang Munchau in pondering just why it is that people are so excited about the fact that Germany continues to experience stellar growth rates largely driven by exports. Moreover, in his latest piece, Edward once again opens up the discussion for just what it is that we are supposed to do with those global imbalances and it is here that I will also spend my time.
Of course, just what it is that is misplaced here is definitely a matter of opinion and not everyone seems to be content with neither Munchau’s point (comments section) nor Edward’s take on the situation. Not surprisingly, I will come out in favor of Edward’s take here but I do so arguing on the basis of fact and not on the basis of some inherent hate towards Germany, Spain or any other of European economy for that matter. I would hope that this, at least, is clear for all to see.
The Problem
The fact that Germany does well is not the issue here (indeed, in isolation this unequivocally good news), but the fact that Germany is still driven by exports and the fact that Southern Europe continue to languish in uncompetitiveness tells a cautionary tale that some of the most important prerequisites for a sustainable trajectory of the global economy have not been met. So, while Edward opted to tell the same story with a chart, I will do so in words.
Before the financial crisis, the world was characterised by structural surpluses in Japan, Germany and the rest of Asia [1] to match a growing US/Anglo Saxon current account deficit. Europe as a whole was running an overall balanced current account which, however, masked notable intra-European imbalances between Southern and Eastern Europe (with external deficits) and Germany as the main supplier of credit to this expansion[2]. So, before the crisis we had export dependent Germany and Japan coupled with USD peggers in Asia (where China will soon become export dependent herself) to match current account deficits in the US/Anglo Saxon world and Eastern/Southern Europe.
This system was clearly unsustainable, but it worked as long as it did especially because of the US economy’s remarkable resilience despite the huge load put on its shoulders offering capacity to the credit supplied by the surplus nations. The system however famously buckled as a result of the subprime mortgage debacle which had its origins, ironically enough, exactly, in the mortgage debt binge made possible by the flow of cheap credit to the US economy.
As a result (and most economists would agree here I think), the recovery that had to follow the crisis was closely tied to a resolve of global imbalances. Yet, the recent narration of the German economic performance on account of its strong export performance shows us that we have not really gotten anywhere.
This brings us to the problem.
Leading up the crisis, the global economy was populated by two outright export dependent economies in the form of Germany and Japan as well as a batch of USD peggers in form of China et al and the petro exporters. Today, as we all hope to muster some form of recovery we are in a situation where not only Japan, Germany and China rely on exports to power their economies so must now the US and, in effect, Europe as a whole since there is no more juice left in either Southern, Eastern or, for that matter, Anglo-Saxon Europe to run respectable current account deficits. Indeed, the continuing talk about how this and that country is now going to rely more on exports or is about to become an export powerhouse strikes me as extremely odd since no one seems to be asking the real question of who exactly are to run the corresponding deficits?
Economists trained in the art of general equilibrium would immediately point out that it does not matter much since if there is one thing that we can be sure off it is that at all points in time the sum of external deficits will equal the sum of external surpluses. I cannot but agree, but this also means that speaking of surplus nations as the good guys and deficit nations as the bad guys does not make sense. What we really need here is economies with ability to run sustainable external deficits; this basically means economies who need to borrow to maintain trend economic growth and a proper rate of investment given the intrinsic return of the economies investment pool. As such, if we look at the structural forces at play there is not so much that we can do in the near term about a number of key issues.
- There is nothing that we can do about the great demographic shift and the fact that we are all rapidly ageing and soon will hit the threshold where we effectively become dependent on external demand in order to achieve economic growth, pay pensions, build roads etc. Germany and Japan shows us where we are headed and while timing will differ markedly it is towards their current structural setup the entire OECD is drifting
- The US and many of the other Anglo-Saxon economies have pretty sound demographics [3], but they have overspent and over -borrowed to the extent that demographics become secondary to the massive force of deleveraging. Consequently, and while the US economy should, theoretically, be capable of providing, in a sustainable manner, some excess demand through a current account deficit the amount of private sector and, now, public sector leveraging means that they are simply tapped out. In addition, deleveraging is a slow and structural process which will take a long time and also engender behavioural changes in US consumers. In short; we cannot rely on the US consumer anymore and actually; the US economy now needs to export more than she imports in order to turn the boat around.
Old Maids who won’t play Anymore
An integral part of any discussion of global imbalances has to involve a suggestion as to on whose shoulders rebalancing is supposed to occur. In this context, the debate has focused on intra G3 rebalancing as well as the need for China to loosen the peg towards the US dollar. On the former account I have called this a game of Old Maid since the real question was never which of these economies that could contribute to global rebalancing, but to whom they were going to sell their exports and thus how they would compete with each other for export market share.
Old Maid is a card game where the simple task is to avoid holding a given card (often the queen of spades) at the end. Even in the company of good friends however, holding Old Maid at the end is not fun. Often, you have to buy the drinks, drop a piece of clothes, or endure other travails. And as it turns out, the global FX market is not unlike this good old game of cards where the Old Maid is proxied by having a strong currency on whose shoulders the correction of global macroeconomic imbalances must invariably fall.
In this context and while nominal exchange rates is not the best proxy for export market share the G3 fx edifice has been characterised by change of baton between the G3 currencies in terms of who is holding Old Maid*.
So far in 2010 there has been two stories. Initially, the main focus was one of a sharp depreciation of the Euro as the sovereign debt woes of Southern Europe sent the single currency reeling. That trend reversed in a nasty short squeeze which saw the EUR/USD bounce very quickly from 1.18 to 1.30 (still down on the year). From here it seems as if the EUR/USD has resumed its old ways of trading on the risk on/risk off themes. The second story which has recently gotten a lot of traction is that of the ascend of the JPY especially in relation to the USD/JPY which has recently been very close to the lows of 1995. These two stories are captured in the chart above where the JPY has appreciated notably against the USD and the Euro while the Euro (against the USD) has weakened considerably since the beginning of 2010. Among other things, this has spawned an almost endless stream of commentary concerning the possibility for BOJ/MOF intervention in the currency market through direct purchases of the USD.
In so far as goes the idea of an old maid, Japan seems to be holding it in the first half of 2010 (against the Euro and the USD) while the USD holds it against the Euro. Curiously, and just as to ram home the real economics behind this strange metaphor, it is worthwhile emphasizing how it was precisely Japan’s economy that seems to have hit the breaks in H01-2010 while the European economy stormed ahead aided by a very strong Q2 performance in Germany.
Ultimately however, the idea of the Old Maid remains a trading theme with one important real economic implication. Whoever holds the Old Maid among the G3 currencies is losing market share relative to the two others vis-a-vis the emerging world and others willing or able to muster a respectable external deficit. The bottom line remains however that in the context of global rebalancing it cannot occur along the G3 axis (e.g. with German and Japan providing a boost through domestic demand). In short; these Old Maid cannot and will not play anymore
The Solution
I am not a big fan of one-off solutions and especially not when it comes to complicated problems like this. However, in relation to global currency alignments I think one big issue revolves around the need for big emerging markets such as e.g. India, Brazil and China to let their currencies go, as it were, simultaneously against the G3.
The chart above needs some explanation. First of all, 1999 = 100 and up means appreciation of the emerging market currency versus the g3 basket [4] and down means depreciation. As we can see, there has been no meaningful appreciation of big emerging market currencies vs the G3 when using 1999 as the benchmark (I use nominal exchange rates). This is exactly what has to change.
Surely, pushing those lines upwards would not solve the underlying problem in the G3 but it would address on very important obstacle to global rebalancing. In essence, it would put the burden on the broadest shoulders not because of some political/economic disdain for current account deficits in the OECD or because we should “exploit” the emerging world’s increasing aggregate demand, but simply because it is what makes economic sense. In this context, I have always agreed with the now silenced blogger Brad Setser that a global currency alignment is needed. What we have debated however was rather the importance attributed to China relative to other EMs as well as the importance of demographics as an underlying driver of the shift in aggregate demand growth and/or decline.
In conclusion there are two points to take away here. Firstly, the game of old maid will continue as a trading theme and as always you want to buy whoever gets to hold it among the G3. In addition, any currency moves in an intra G3 context also constitute shifting of market share vis-a-vis global high growth economies who will, whether it be kicking and screaming or willingly, be dragged into providing more of global aggregate demand through external deficits. For this to happen sustainably however, we need to see joint appreciation of emerging market currencies against the G3 or, more intuitively, the appreciation of a basket of emerging market currencies versus the G3. Continuing to believe that domestic demand can be a growth driver in the G3 let alone the OECD is the same thing as calling on Old Maids to play a game cards which they won’t and can’t play anymore.
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[1] – For simplicity, I will leave out pegging oil exporters here, but their role in this game is not fundamentally different.
[2] – Again, considerable complexity is left out. For example, the credit expansion in Hungary originated mainly from Switzerland (and by proxy through the Austrian banking system) and in the Baltics the Scandinavian economies supplied most of the credit (Sweden in particular).
[3] – Yes, I know the baby boomers will now become a drag and this is important but that is a bulge moving through an otherwise pretty stable population pyramid as a result of healthy immigration rates and replacement level fertility. In short; demographics in Japan are deflationary (and also in Germany), but I am not sure this is the case, strictu sensu, in the US.
[4] – This basket is created using share of global GDP of the G3 which is obviously inadequate, but let us just assume that we are dealing with economies that are either already relatively open or are going to become more open as we move forward (e.g. India).
* All data is from St. Louis Fed.
By Winton Bates, on August 30th, 2010
Gary Becker has recently written an interesting article on the Becker-Posner blog about polls suggesting that the majority of parents in the United States are not confident that their children will be better off economically than they are. He suggests that the best way to counter such pessimism is to promote faster economic growth.
The article made me feel slightly uneasy because I wrote something a few months ago suggesting that the poll results actually conflict with the view that Americans are pessimistic about the future for their children. Have I mis-read the poll results? How much have the poll results changed over the last year or so?
Scott Winship has recently considered the evidence of a variety of polls on his blog: here and here. In brief, the polls indicate that the proportion of Americans who think that their children will have better standards of living than themselves consistently exceeds the proportion who think their children will have worse standards of living. The margin tends to narrow during recessions but, even this year, the polls suggest that optimism is no lower than in the mid-1990s (see Pew Research Center poll results here).
Rather than trying to explain why Americans have become more pessimistic perhaps researchers should be trying to explain why Americans are still so optimistic.
By Rok Spruk, on April 22nd, 2010
I published a brief analysis (link) for the European Enterprise Institute, discussing a pattern of a growing income differential between the EU and America. The financial crisis diminished European growth rates and further widened the economic growth between the two continents.
Given a weak economic outlook for EU countries, the gap between European Union and the United States is likely to widen in the next decade although the US economy will be restrained by high tax burden and a growing federal debt. In 2010, I estimated the gap between the US and EU15 at 35-40 years, depending on EU’s growth scenario.
By Rok Spruk, on April 21st, 2010
Gary Becker (link) and Richard Posner (link) opened an intense debate on the issue of a growing US income inequality since 1980s onwards.
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