Sunday, December 19, 2010
Friday, December 17, 2010
Wednesday, December 15, 2010
The opening sentence is a claim that the overall level of foreign assets in China is not that high if you consolidate the public and private sector. Is this true?
Wednesday, December 8, 2010
Thursday, December 2, 2010
Tuesday, November 30, 2010
Tuesday, November 23, 2010
Bernanke’s reference to this number is in the context of concerns that QE2 (second round of quantitative easing) will increase inflation in the US and with this message he wants to reassure the public that inflation will remain low. The exact words that he is using are
“FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below.”
It is interesting that the expression “2 percent or a bit below” happens to be almost identical to the way the ECB currently refers to its mandate for price stability.
Some history about the ECB mandate: Originally, the ECB was given the mandate of maintaining “price stability”. This mandate was later (October 1998) made precise by the governing council of the ECB as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%”. At that point there was also a reference to this target, or to price stability more generally, a a mandate “to be maintained over the medium term”.
This initial definition of price stability by the ECB received some criticism because it was leaving too much room for interpretation: Is any inflation rate below 2% consistent with price stability? Is deflation consistent with price stability or even desirable? This led to a redefinition of “price stability" by the governing council of the ECB in May 2003. At that point, the mandate of price stability was defined as “maintaining inflation rates below but close to 2% over the medium term”. So 2% becomes a ceiling (for the medium term) and the goal is to be close enough to the ceiling. Clearly, in this definition there is a sense of asymmetry: 2.1% inflation is worse than 1.9%.
The words chosen by Ben Bernanke are almost identical to the words chosen by the governing council of the ECB where “below but close” has been replaced by “or a bit below”.
What is the record of the ECB? Clearly the ECB has managed to keep inflation very close to 2% and as such we could call it a success. However, given the definition of price stability, it seems that inflation has remained many more months above than below 2%. Below is a picture of Euro inflation from the launch of the ECB until the recession of 2007/2008. Inflation is close to 2% but it would be more accurate to describe it as “above but close to 2% than “below but close to 2%”. Or using Bernanke’s words “2% or a bit above”.
If we add the last two and a half years of data (picture below), towards the end of 2007 inflation increased substantially and then it fell during the recession, below the 2% target. Today, inflation is once again approaching the 2% target.
Thursday, November 18, 2010
Tuesday, November 16, 2010
Wednesday, November 10, 2010
"Regarding risks to prices, some members said that attention should continue to be paid to a possible decline in medium- to long-term inflation expectations. One member expressed the view that attention should also be paid to the upside risk that a surge in commodity prices due to an overheating of emerging and commodity-exporting economies could lead to a higher-than-expected rate of change in Japan's CPI."
Monday, November 8, 2010
"The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today."
Thursday, November 4, 2010
Monday, October 25, 2010
Many advanced economies face a situation of excessive debt (public, private or both) that resembles one of the examples above. As a result, we talk about the need for fiscal adjustment, deleveraging in the private sector, increased saving, etc. But all these adjustments are required at a time when the economy is suffering from the consequences of a very deep recession. While those adjustments are necessary, they can have negative consequences on the economy (i.e. lower growth) which will make the adjustment more painful. As an example, it might be necessary to lower the consumption to income ratio, but the pain that the consumers will feel depends on what happens to the denominator (income); it is easier to reduce the consumption to income ratio when income is growing than when income is stagnant or even decreasing.
I do not think that many disagree with this logic but there are two aspects where I find some confusion in the discussion: they are about the speed (how fast to go?) and timing (when to start?) of the adjustment.
On the speed of adjustment, we read many times the argument that the adjustment needs to be fast. We hear, for example, the need for ambitious targets for government debt reduction or how we have to ensure that households’ or companies’ balance sheets become healthy as soon as possible. There are some merits to these arguments. Governments need to show commitment to sustainability and consumers or companies need to be in a financial position to be able to do business as usual. But there is also an argument that says that we need to go slowly. The argument comes from what economists call “consumption smoothing” that refers to the principle that most individuals prefer a stable consumption pattern to a volatile one. If you win the lottery, it makes sense to spread the new income across many years. If, on the contrary, you realize that your wealth is smaller than what you thought, it also makes sense to spread the pain over many years. This logic applies to individuals as well as to governments, as discussed in our previous blog entry.
The second issue is timing. How to you achieve the necessary adjustment without hurting growth and income? Here the analogy of an individual fails to capture the complexity of this issue for a whole economy. As an individual I can reduce my consumption as much as I want without affecting my income. As a country, this is not true, as my consumption is linked to somebody else’s income. Of course, there is the rest of the world and a country could potentially reduce its consumption if the rest of the world replaced the demand for the locally produced goods but this is unlikely. This issue of timing is even more important in the current environment because we just went through a very deep recession. Should the adjustment towards reduced spending start now? When should governments start reducing budget deficits? The answer depends on our assessment of the output gap (the difference between potential and actual output). While there might be some questions about the size of the output gap, there is no doubt that it is significant. If this is the case, even if our main objective is to bring the necessary adjustment to the economy by reducing spending the best way to do this is by reducing the output gap first.
Many times, reducing the output gap is portrayed as getting out of the crisis by spending more (which some see as a contradiction because excessive spending is seen as the cause of the crisis). This is not correct, reducing the output gap requires both spending and production. It is about ensuring that the economy produces as much as it can, generates the maximum (potential) amount of income so that the adjustment towards lower spending is done in the least painful manner.
Discussions on the size of the output gap are always subject to uncertainty and today we witness a debate about the extent to which structural issues, not just cyclical, are behind the current low level of output in advanced economies. I am willing to admit that we need a combination of policies to reduce the output gap and some might be seen as “supply-side” policies. But it is difficult to believe that a large and quick adjustment towards a path of lower spending will bring the economy closer towards potential in the short term; it is likely to make matters worse. And whether excess spending is responsible for the crisis we just went through is irrelevant. Regardless of how we got here, we need to figure out a way to reduce the output gap by ensuring that the level of income, spending, production are all as close as possible to potential and this means more of all of them, not less.
Thursday, July 15, 2010
As growth slowly comes back governments in advanced economies are facing the question of when they should start reducing their deficit and address the growing debt problems. While there is no question about the need for an adjustment, there is a debate about its timing and speed. These are the two sides of the debate:
2. Governments need to act fast because their high level of deficits and debt are creating too much uncertainty and fear of a crisis. In some cases this is showing up as higher interest rates (which can harm growth). In others, interest rates remain low but the fear of an unsustainable path for fiscal policy can lead to low investment and growth. A quick fiscal consolidation (reduction in deficits) is what the economy needs now.
Both sides of the argument have merits and it is not a question of which one is right and which one is wrong. Circumstances are different in each country and it is likely that the optimal speed of adjustment is different for each economy. What I would like to highlight in this post is an area where I feel there is some misperception: the burden that interest payments on the debt impose on taxpayers, an argument that is used in favor or speeding up the fiscal adjustment.
It is possible, although empirically it is not that obvious, that a high level of government debt has negative consequences on investment or economic growth. The high level of government debt can be seen as an accumulation of previous errors or misbehavior: governments spent too much or did not have the political willingness to collect enough taxes. But the past cannot be changed and the question we face now is how to pay for our previous “mistakes”: Do we do go for a quick payment of our debt or do we spread the pain over a long number of years? This is an economic decision that depends on many parameters but mainly on the relative value of current versus future income and the interest rate that we are charged on the debt (which in general equilibrium they have to be related). What we need to understand is that the cost of the debt will be there whether we pay now or we pay later. We might find good reasons why we should pay earlier but there might also be reasons why we want to postpone the payment (spread the pain over several years).
In summary, one needs to be careful using the argument of the high burden of the debt to push for a quick reduction in government debt levels. The level of government debt is what it is and the burden will have to be paid in some form over the future. The question on how fast we reduce the debt is about the timing of those payments and not so much about the total cost of the debt. Paying earlier has to be a statement about how we are willing to cover the cost of debt with reduced current spending as opposed to reduced future spending.
Of course, if financial markets are not willing to fund our debt anymore, we will be obliged to pay the debt faster. Or, in a milder scenario, if the interest rate we face is “unreasonably” high because of the fear of default, we might find it optimal to pay the debt now to calm that fear and reduce the overall burden of the debt – this might apply to Greece but it clearly does not apply to the US.
Thursday, June 17, 2010
Here is a summary of some of the findings:
"Although the essays were largely uncoordinated – and the authors hark from diverse backgrounds – a remarkably coherent message emerges. The authors unanimously believe that the crisis is not over, and that the Eurozone rescue is not finished. More needs to be done.
As Charles Wyplosz puts it, the Eurozone is levitating on the hope that European leaders will find a way to end the crisis and take steps to avoid future ones. Unless more is done, however, this levitation magic will wear off and the Eurozone crisis will resume its destructive, unpredictable path.
The crisis, in our view, is a thorny tangle of incipient debt and banking crises. Until this tangle is sorted out, any further shock could threaten the Eurozone as we know it. After all, Eurozone bank systems remain in a parlous state. Confidence in the financial system has not been restored. The losses from the Spanish real estate binge have only partially emerged. Greek public finances have still not been stabilised. Large competitiveness imbalances persist.
In short, none of the underlying causes of the crisis have been addressed.
Massive shocks could come from any number of sources ranging from the Spanish banking sector to political crisis in member countries facing fiscal austerity. Indeed, we already see ominous signs. Risk premiums on some Eurozone government debt have resumed their upwards trend despite the two May packages.
We also know that even small shocks can lead to a major crisis given the interconnected fragility of the Eurozone. Remember that it started with fiscal problems in a country which accounts for only 2.5 % of Eurozone GDP. Banking crises in a number of European countries could cause sovereign debt crises – a la Reinhart and Rogoff (2009) – which could spark contagion, thus triggering more bank crises. Trying to muddle through would be like sleepwalking through a minefield.
The time for action is now, for, as Barry Eichengreen puts it, “financial crises feed on uncertainty. The longer uncertainty is allowed to linger, the greater the damage to confidence…”.
Ilian and I wrote on of the essays where we are argue in favor of an institutional solution to the fiscal problems of the Eurozone. Our essay can be found here. The full set of essays can be found on this link.
Tuesday, May 18, 2010
Monday, May 17, 2010
Wednesday, May 12, 2010
Sunday, May 2, 2010
Friday, April 30, 2010
"Interesting recent cases include Greece and Spain, countries that appear to have escaped a severe history of serial default not only by reforming institutions, but by benefiting from the anchor of the European Union."
Wednesday, April 14, 2010
Monday, April 12, 2010
Wednesday, April 7, 2010
Monday, March 29, 2010
Monday, March 8, 2010
I will ignore the general question on whether a monetary union can succeed without a political union so that I keep this entry short, but I want to challenge his reading of exchange rates.
Let me start with the areas where I agree with the FT article: Is the Euro getting weaker? Yes, relative to the US dollar. Is this caused by the perception that some of the economic troubles in Greece and other European countries could cause instability in the Euro area? Yes.
Friday, March 5, 2010
Tuesday, March 2, 2010
Their logic of those who believe that the Euro was a bad idea is the following: if today countries such as Spain, Greece or Portugal (or Italy) had their currency, they could have devalued it (or depreciated it) and this would have helped them to get out of the crisis because of the positive effect on exports. They point out to the fact that in recent years some of these countries have lost competitiveness through high inflation and this could be easily corrected with a devaluation while the alternative of deflation (or lower inflation) is more painful.
Their argument is a standard textbook analysis of the costs and benefits of keeping your own currency (where we are looking at just the benefits). This is an argument that I bring up regularly in class when I teach macroeconomics and it is easy to explain to my students. However, one needs to go beyond the theory and what is difficult is to assess whether the logic applies to this case and indeed these benefits outweigh the costs of having your own currency and exchange rate.
My reading of the current situation is that it does not reflect at all on the weaknesses of the Euro zone as a currency area and that if any of those countries had kept their currencies they would be in much more trouble today.
Here is a long list of arguments of why the textbook argument does not apply to this case:
1. This is a global crisis. The current recession is global in nature. While some countries are hurting more than others, this is not an asymmetric shock that is affecting just one country. While the exports of Greece could benefit from devaluation, this would hurt the exports of other countries. While it is true that some countries like Germany have kept a surplus in their current account, it is also true that their exports have collapsed and their GDP has been affected as much or even more than some of those other countries. Why shouldn’t be Germany the one who devalues?
2. Is competitiveness a problem? A potential answer to the question in point #1 above is that Germany does not have the same problems of competitiveness than the Southern European countries. It is Spain, Portugal, Greece the countries that have seen their real exchange rate appreciating because of higher inflation than in Germany. They are the ones that need the correction. This is true but we have to be careful not to use Germany as an example of all other countries. The chart below (from a presentation by Jose Manuel Campa, from the Ministry of Economy and Finance in Spain), Spain has not seen a deterioration of competitiveness relative to France, the second largest economy in the Euro area. It is Germany the one that looks like an outlier.
In addition, inflation was higher in Spain mainly because of the evolution of prices in the non-tradable sector (the one where competitiveness is not an issue). Below is another picture from the same presentation by Jose Manuel Campa where we see that the evolution of unit labor cost in manufacturing in Spain (relative to Germany) are much more moderate.
If this is not reassuring enough we can look at the evolution of Spanish exports (as a share of world exports) during these years, Spain has done better than countries like France or the US and its performance is similar to that of Germany.Yes, Spain had a large current account deficit during these years but it was mainly the result of increasing imports due to the strong expansion in the economy. A phenomenon that we observed in other countries (such as the US) that have a flexible exchange rate.
3. Exchange rates are not a magical tool. If having your own currency is such a powerful tool to deal with crisis like the current one, why is it that countries such as the UK, Sweden or the US are suffering through very deep recessions? Both the UK and Sweden, despite having witnessed a depreciation of their currencies, are also struggling with a deep recession that seems to be lasting as long as in some of the Euro countries. In the case of the US, the currency has moved in the “opposite” direction and appreciated since the beginning of the crisis. The current account has been reduced but mainly because of the collapse in demand that comes from the recession.
4. We cannot forget the costs of having your own currency. While the idea of manipulating the exchange rate to increase exports might seem at times attractive, there is no doubt that if any of the Southern European countries had their own currency today, they would be in a much deeper recession (we can go back to the early 80s in Spain when there was also a banking crisis to see how much the Spanish peseta helped). It would be very likely that these countries had accumulated during the boom years liabilities in foreign currency that now, with a devaluation, they would not be able to pay back. The government of Greece would be facing a much higher interest rate because of exchange rate risk, which would make the probability of default even higher.
Finally, a reminder that one needs a longer perspective to assess the benefits and costs of a monetary union. Yes, countries like Spain are going through a deep recession with very high unemployment rate but partly this is the result of the “excesses” of the previous years. Below is a picture of real GDP that shows the very-high growth rates that Spain enjoyed during the previous years. While it might be the case that there was some loss of competitiveness relative to Germany, the growth rate of Spain remained very high, higher than that of Germany or the UK who had the flexible exchange rate to adjust (if needed). Yes, the current recession will erase some of these gains, but not all of them.