Tuesday, January 31, 2012

Today's links

1--International Capital Flows, House Prices, and the Euro, Streetlight blog

Excerpt: ...This paper addresses the question of whether there is in fact a systematic relationship between capital flows into a country and house prices. Were the house price booms of the 2000s caused by international financial flows?

The answer provided by this paper is no, or at least not directly. When different possible macroeconomic explanations for changes in average national house prices are considered, it turns out that by far the most important factor is the ease of bank credit. In other words, rising house prices in the 2000s (as well as their subsequent fall) probably had much more to do with the willingness of banks to lend than any other factor. When banks are happy to lend money and they relax lending standards, house prices go up. When banks reverse course, house prices go down.

The importance of bank lending standards to the US housing bubble has been well documented and discussed, but this data suggests that the same may be true for a number of other countries as well. On the other hand, countries that did not experience a general relaxation in lending standards in the early 2000s did not experience house price booms. Once changing lending standards are taken into consideration, changes in international capital flows seem to have little additional explanatory power for house price changes.....(BUT)

. When a country seems to be headed for better economic times and risk tolerance grows, banks become generally more willing to lend. And that is where we come to the euro......consider the likelihood that the adoption of the euro by the peripheral European countries (e.g. Spain, Ireland, and Greece) created expectations for higher growth (and lower interest rates) in those countries, and helped persuade banks to become less risk averse. House prices start to rise and banks become more willing to lend. House prices rise more. Banks respond by relaxing credit standards further. And the bubble begins to inflate.

Surges in capital flows don’t directly create house price bubbles. But this paper does help us understand a mechanism by which the adoption of the euro could have indirectly caused house price booms: by changing expectations and altering the perception of risk in the eurozone periphery, a self-reinforcing cycle of easier credit was sparked in those countries. That’s not all there is to it, of course – other factors surely must have also caused changes in risk aversion and bank lending standards in the housing bubble countries – but it does seem to be a likely piece of the puzzle for the peripheral eurozone.

2--Monti's attack on labor, Bloomberg

Excerpt: The government has also started talks with unions and employers aimed at overhauling the country’s rigid labor laws, the last pillar of Monti’s plans to remake the 1.6 trillion-euro economy. Labor Minister Elsa Fornero said this week that she hopes to have an agreement within a month.

The new plan comes as many Italians are rejecting Monti’s calls for shared sacrifices now to spur future prosperity. A wildcat strike by truck drivers this week has clogged traffic on Italian highways, forcing Fiat SpA to halt car production and leaving some cities short of gasoline and food.

Public transport workers and some airport and airline staff are striking today, disrupting travel across Italy. The 24-hour strike wrecked havoc on transport on buses and trains while Rome’s two metro lines and local commuter trains were shut down, ATAC, the company that runs them, said in a statement on its website....

While Monti’s measures may have helped shore up investor confidence in Italian debt, the budget cuts and higher taxes are deepening the economic slump in a country where growth has lagged behind the euro-region average for more than a decade. The International Monetary Fund forecast on Jan. 24 that the economy will shrink 2.2 percent this year, compared with a 0.5 percent contraction for the euro area.

3--GDP report: Austerity is stifling the recovery, moneywatch

Excerpt: Investment has two components -- business investment and the construction of new houses. Businesses are waiting for the outlook to improve before increasing investment (Business investment will follow GDP growth, not lead, and the housing market is unlikely to give us the necessary spark.) Net exports are a possibility. They were featured in President Obama's State of the Union speech as part of the path to a better economy, but problems in Europe make an export boom unlikely anytime soon. Besides, not every country can be a net exporter. Other countries will not sit idle while we try to increase our share of exports to world markets, so that even if the world economy grows robustly gaining, market share will not be easy

GDP growth in Q4: Good, not great

That leaves government spending. However, these numbers are moving in the wrong direction, and that is unlikely to change given the emphasis on reducing the long-run budget problem. In fact, premature austerity -- cutting spending before the economy is ready for it -- is taking a toll on the recovery. The fall in government spending reduced fourth-quarter growth by 0.93 percent; if government spending had remained constant, GDP growth would have been 3.7 percent, rather than 2.8 percent.

This is the opposite of what the government should be doing to support the recovery. We need a temporary increase in government spending to increase demand and employment through, for example, building infrastructure. That would help to get us out of the deep hole we are in. Instead, the government seems to be trying to make it harder to escape.

4--(From the archives) Europe’s Lehman moment, Reuters

Excerpt: Europe is in the midst of its variant of the great debt crisis that hit the United States in 2008. Fears abound that if things go wrong, the continent will face its own “Lehman moment” – a recurrence of the sheer panic that hit American and world markets after the collapse of Lehman Brothers in October 2008. How did Europe arrive at this dire strait? What are its options? What is likely to happen?

Europe is retracing steps Americans took a couple of years ago. Between 2001 and 2007 the United States went on a consumption spree, and financed it by borrowing trillions of dollars from abroad. Some of the money went to cover a Federal fiscal deficit that developed after the Bush tax cuts of 2001 and 2003; much of it went to fund a boom in the country’s housing market. Eventually the boom became a bubble and the bubble burst; when it did, it brought down the nation’s major financial institutions – and very nearly the rest of the world economy. The United States is now left to pick up the pieces in the aftermath of its own debt crisis.

Europe’s debtors went through much the same kind of borrowing cycle. For a decade, a group of countries on the edge of the Euro zone borrowed massively from Northern European banks and investors. In Spain, Portugal, and Ireland, most of the borrowed money flooded into the overheated housing market....

But as in the United States, the boom was not sustainable. When the global financial crisis began in October 2008, the European debtors were largely frozen out of financial markets. As their economies spiralled downward, they faced grave difficulties in servicing their debts.

The problems of Europe’s debtors were not just worrisome for the debtors themselves. Most of their debts were owed to Northern European banks and investors, and the crisis threatened the very solvency of major European financial systems. This – not some abstract desire to extend a hand to the Greek and Portuguese people, or to save the euro – has been the principal reason for Europe’s ongoing debt bailout:

The rationale here was like that of bailing out a bank: a collapse of Greek or Portuguese finances could harm the rest of the euro-zone financial systems. If Bank of America was too big to fail, then so was Greece. And since a deepening of the financial crisis that drew in the entire euro zone would affect the entire global financial system, the International Monetary Fund was also drawn into the rescue….And because the Greek emergency triggered a crisis of confidence in other euro-zone countries whose failure could harm the region as a whole, the European Union was driven into a massive trillion-dollar package for other troubled European debtors. (page 188)...

Some or all of these debts will have to be restructured, the interest rates reduced and maturities extended. If not, there will be a wave of defaults whose reverberations will rival those of the Lehman failure.

For two years, Europe’s governments have been grappling with how to address this continuing debt crisis. But most of the public discussions have been highly misleading. In Northern Europe, and especially Germany, the tone has been one of outraged indignation. This high moral tone is misplaced. Certainly many Southern European banks and households, and the Greek government, borrowed irresponsibly; but German and other Northern European banks and investors lent just as irresponsibly. It’s not clear that there’s any real ethical distance between irresponsible borrowers and irresponsible lenders.

And most Northern Europeans also seem to believe that the bailouts have gone to lazy Southern Europeans. In fact, their purpose has been to shore up the fragile Northern European financial systems. German banks are among the weakest in Europe; some of them (especially the state-owned landesbanks) are effectively bankrupt. If they were forced to mark down their Southern European debt, they might well collapse in a heap, and the European financial system could grind to a halt. Just as in the United States, the real impact of the European bailout has been to shore up the continent’s banks – not to help the continent’s debtors. The recent downgrading of two of France’s most important banks, due to their holdings of Greek debt, reminds us of how exposed Northern Europe’s financial systems remain. And rumors of a recent IMF report that European banks are over $270 billion short of the capital they need to confront their current problems served to drive the point home....

Eventually Europe’s creditors and its debtors will have to admit that these debts will not be serviced as contracted, and the debts will be restructured. Pretending otherwise will only prolong the agony – not just for the debtor countries imposing austerity, but also for the financial systems that are now crippled by debts that nobody believes will be repaid. When major central banks, earlier this week, threw a lifeline to the European financial markets, they undoubtedly helped avoid what appeared to be an imminent panic. However, this initiative will only postpone the final reckoning with the region’s underlying financial weaknesses.

In Europe as in America, the real question is how the costs of this devastating debt crisis will be distributed. Who will pay – creditors or debtors? Taxpayers or government employees? Germans or Greeks?

5--De-Mythologizing Fiscal Consolidation, Econbrowser

Excerpt: The September 2010 WEO cross-country analysis of fiscal contraction effects was discussed in this post (And the absence of expansionary fiscal contraction in the UK here).

Fiscal contractions raise both short-term and long-term unemployment, as shown in Chart 3, but the impact is much greater on the latter. Long-term unemployment refers to spells of unemployment lasting more than six months. Moreover, within three years the rise in short-term unemployment due to fiscal consolidation comes to an end, but long-term unemployment remains higher even after five years.

So, in addition to contracting the economy, fiscal contractions exacerbate the already daunting challenges facing the long term unemployed (keeing in mind long term unemployment is not necessarily the same as structural unemployment). [1] [2]

What about how the burden of adjustment is allocated?

How does fiscal consolidation affect the distribution of income between wage-earners and others? The research shows the pain is not borne equally. Fiscal consolidation reduces the slice of the pie going to wage-earners. For every 1 percent of GDP of fiscal consolidation, inflation-adjusted wage income typically shrinks by 0.9 percent, while inflation-adjusted profit and rents fall by only 0.3 percent. Also, while the decline in wage income persists over time, the decline in profits and rents is short-lived

The foregoing suggests that the schedule of fiscal consolidation should be such that spending cuts and tax increases are implemented when the economy has recovered. The findings also imply that fiscal consolidation should be accompanied by measures to protect low wage earners and the long term unemployed.

Hence, our fiscal policy prescriptions in Lost Decades:

...with the economy growing only modestly as recovery began, too rapid a retrenchment in spending and an increase in taxes could very well be counterproductive, throwing the economy back into recession and further accumulation of debt. However, the politics of countercyclical fiscal policy can be perverse, as the Obama administration found. Recessions hit hardest at poor and working-class families, who would benefit most from stimulative fiscal policy. But attempts to undertake these policies face opposition from upperincome taxpayers who are less affected by the recession and more concerned about the impact on their future taxes. This opposition can impede an effective fiscal response to cyclical downturns. Whatever the difficulty with devising appropriate short-term fiscal policy, government finances over the next two decades need everyone’s focused attention. The big problems are Americans’ unwillingness to tax themselves, ever since the Bush tax cuts of 2001 and 2003, and the entitlement programs—Medicare, Medicaid, and Social Security—which are going to consume ever greater shares of the budget. ...

6--Lost decades, econbrowser

Excerpt: Half of the holdings of US Treasury securities and Treasury and Agency securities were held by China and Japan. While the Chinese and Japanese holdings were about the same size, China's had caught up quickly, over the preceding five years.

..The boom in the shadow financial system, as measured by asset backed commercial paper, started taking off in 2004, and peaked in 2007. The collapse in this market began over a year before the Lehman bankruptcy.


7--What Predicts a Credit Boom Bust?", econbroswser

Excerpt: From Chapter 1 of the IMF’s recent World Economic Outlook (Box 1.2), a set of findings by Jörg Decressin and Marco Terrones:

The econometric results confirm that net capital inflows, financial sector reform, and total factor productivity are good predictors of a credit boom. Net capital inflows appear to have an important predictive edge over the other two factors....

I think this is a particularly interesting set of findings; credit boom/busts are closely associated with financial crises. As an international finance economist, my view had been that net capital inflows were particularly dangerous for the United States in that they resulted in increasing net indebtedness to foreigners that would eventually lead to foreigners dumping dollar denominated assets (see Chinn (Council on Foreign Relations, 2005)). A competing view was that the net capital inflows signaled financial excess (of course, the two are not mutually exclusive -- both forces could be in effect, but with different strength). The findings reported here are more consistent with the second view. (There is of course yet another view, that all that borrowing was justified by the high productivity and entrepreneurial energies unleashed by the tax cuts of 2001 and 2003); ‘nuff said of that.) ...

Several policy implications flow from these findings:

... Given the high costs of credit boom-bust cycles, policymakers should closely monitor the joint behavior of capital inflows and domestic lending. 6 There is also evidence that financial sector reforms are predictors of credit boom-busts. Policymakers must ensure that financial liberalization programs are designed to strengthen financial stability frameworks. Last, there is evidence that large productivity gains increase the risk of a credit boom, particularly in advanced economies, driven perhaps by exuberant optimism in new sectors. Thus, even during particularly good periods for the economy, policymakers must be on the lookout for emerging threats to financial stability stemming from credit booms.

I think this warning should be kept in mind when three years after the largest financial crisis in history, we see attempts to gut effective regulation of the U.S. financial system. From Moneyline.com:

Republicans will are likely to up attacks on the Dodd-Frank legislation that increases regulation on the financial sector as campaign season heats up, the New York Times reports.

Dodd-Frank aims to curb abusive lending practices, stop high-risk bets on complex derivative securities and protect consumers from financial fraud, among other goals.

Many of the bill's provisions haven't gone into effect, which will give Republicans new material to point out how President Barack Obama's efforts to increase regulation will continue to hamper economic recovery.

"It created such uncertainty that the bankers, instead of making loans, pulled back," says Republican presidential hopeful Mitt Romney, speaking at a South Carolina rally over Labor Day weekend where he again called for the law’s repeal, the New York Times reports.

8---Lost Decades: The Making of America's Debt Crisis and the Long Recovery, econbrowser

Excerpt: From the preface to Lost Decades, published today (9/19) by W.W. Norton:

The United States ... lost the first decade of the twenty-first century to an ill-conceived boom and a subsequent bust. It is in danger of losing another decade to an incomplete recovery and economic stagnation.

In order to not lose the decade to come, the United States will have to bring order to financial disarray, gain control of a burgeoning burden of debt, and re-create the conditions for sound economic growth and social progress. None of this will be easy. The tasks are made more difficult by the fact, which we have learned to our alarm, that all too many policymakers and observers cling to the failed notions that got the country into such trouble in the first place. If Americans do not learn from this painful episode, and from others like it, they will condemn the nation to another lost decade.. (p. xvi)....

For us, we find key blame in a toxic and synergistic mixture of ample foreign savings, a profligate fiscal policy (EGTRRA, JGTRRA, Iraq, Medicare Part D), a debt-biased tax code, and most importantly regulatory disarmament.

Government policies enabled, catalyzed, and fueled America’s crisis. The Bush administration’s tax cuts and spending splurge drove the federal budget from surplus to deficit, beginning the most recent cycle of foreign borrowing boom and bust. The Federal Reserve’s excessively loose monetary policy encouraged households to take advantage of very low real interest rates to embark on a debt-financed consumption spree, with much of the debt borrowed from abroad. Neither the government nor the households that did the borrowing used enough of the borrowed funds to increase the nation’s productive capacity and its ability to eventually service the debt without sacrifice. Lawmakers disarmed financial regulators, who in turn used few of the weapons left in their arsenals, allowing financial institutions to develop new instruments that were largely untested and wholly unsupervised. Financial institutions worked madly to increase their profits in a low-interest-rate environment by taking on ever riskier assets, insisting that they had mastered risks they barely understood.

Any one of these policies might have gotten the United States into serious trouble. Together they created a financial perfect storm, driving the American economy to the brink of financial collapse and dragging much of the rest of the world with it. (pp. 201-02)...

clearly, regulatory disarmament/nonenforcement and "criminal activity" were important. Office of Thrift Supervision under the Bush Administration "helped out" IndyMac [2] [3], and how deregulatory zeal [4] [5] metastatized over into criminal activities on the part of regulators and the regulated.

Fiscal profligacy is important because it pushed the economy more into a boom exactly at a time when not needed (i.e., near full-employment), and the tax cuts made people feel like they had more discretionary income than justified, thereby adding extra fuel to the asset boom....

Finally, tax policy clearly provided incentives to borrow and leverage. In particular, I have been thinking about the tax deductibility on second homes, a provision dating back to 1997 [6] [7] [8]. (Mortgage deductibility on a second home never made sense to me, let alone on a first home); see Capital Games and Gains, who highlighted this provision, citing a NYT article). I suspect that on its own, this provision wouldn't had a big impact, but in combination with the other forces and distortions, it might have.

Typically, for ordinary phenomena, I would think of these factors adding up in a linear fashion, so that each of the impulses would sum to the total effect. But I think it's worthwhile to think about lax monetary policy, deregulatory zeal and criminal activity/regulatory disarmament, and tax cuts and tax policy changes, all combining to lead to the "bubble" (in a nontechnical sense) or episode of Akerlof-Romer "looting", and subsequent collapse we’ve witnessed.

Consider one example of a pernicious synergy: the 2001 and 2003 tax cuts were aimed at higher income households, while the second home mortgage deductibility benefited mostly higher income households [9]; with regulatory oversight absent, and low interest rates, the stage was set.

So, despite the outward trappings that seemingly differentiated the last crisis from previous ones, we can interpret the recent episode as yet another capital flow cycle: We borrowed from overseas, not only because of ample supplies of capital, but because government profligacy and the distortions in the purportedly "deep and liquid" (but actually under-regulated) financial markets....

Second, turning to the longer horizon, we see equally daunting obstacles to preventing a replay of financial crisis. If one believes that highly leveraged and unregulated financial institutions and households were important, then one want to implement tighter standards and higher capital requirements. However, some have argued for a "just say no" approach to further bailouts. We believe that that approach will work as well in financial regulation as it did in drug policy, and really just covers for the naked self-interest. (See how finance was powerful enough to force Republicans to delete all references to Wall Street in the Financial Crisis Inquiry Commission report. [11]) As we note:

None of the changes necessary to avoid a repeat of this disaster will be easy. At every turn there are major political obstacles. Financial interests resist regulations that shift the burden of risky behavior back onto them and off of taxpayers. Beneficiaries of government programs fight against attempts to curb their benefits. Taxpayers refuse to pay the taxes needed to pay for the programs they want. Partisan politicians block reasoned discussion, suggesting absurd pseudo-solutions instead of realistic alternatives. Ideologues and political opportunists encourage Americans to cling to the childish things that have served them so poorly in the past: a mindless belief that markets are perfect, that tax cuts solve every ill, that borrowing is to be encouraged. Despite the great trouble these policies have caused, their attractions continue to be touted and spouted by unprincipled pundits. (p. 221)

Hence, the challenge of avoiding a second lost decade is still a very real one.

9--Austerity Is Not The Correct Medicine---Greek Tragedy should not set fiscal agenda for rest of world, Richard Koo, Nomura via zero hedge

Excerpt: I think it a miracle if Europe does not experience a full-blown credit contraction.

EU’s response has aggravated crisis

This 9% rule effectively prescribes the size of European banks’ balance sheets. This means banks will not be able to increase lending no matter how much liquidity the ECB supplies, effectively rendering any monetary accommodation by the ECB powerless to stimulate the economy.

The EBA’s 9% rule may help in preventing the next crisis, but it will do nothing to resolve the current one—in fact, it will make it much worse...

Apart from the problems in Europe, economic activity is decelerating in China and India, where policymakers are working to rein in inflation. Some areas of China are facing a deflation—not yet a collapse—of the real estate bubble leading to balance sheet recession-like conditions.

Economic conditions in Japan and the US are relatively stable by comparison. But the governments of both countries are moving towards fiscal consolidation at a time when the private sector is trying to clean up its own balance sheet. If the private and public sectors attempt to deleverage simultaneously at a time of zero interest rates, the risk is that the economy will fall into a deflationary spiral....

New eurozone capital rules will lead directly to credit contraction

The new international capital requirements proposed by the BIS, known as Basel III, call on banks to raise their core capital ratios to 7% by 2019. The EBA, meanwhile, has demanded another 2% on top of that while insisting that banks comply by June 2012, offering no logical basis for its position. Nor has the ongoing credit crunch in the eurozone prompted any discussion of a government recapitalization of the banking system.

Even a 7% target would have been hard for banks to meet, which is why they were given until 2019 to comply. The EBA’s demand that banks raise core capital ratios to 9% by June 2012 in the midst of a systemic crisis seems spectacularly ill-advised. I think it a miracle if Europe does not experience a full-blown credit contraction....

In Europe, however, I find few people—including the authorities—understand what a balance sheet recession is. The vast majority are unaware that such a thing even exists, and to some extent that is why the crisis continues to worsen. Since the ongoing balance sheet recession and sovereign downgrades are a first for eurozone investors, their confusion, like that of their predecessors in Japan, is understandable.

But I think it is just a matter of time before eurozone investors come to understand this concept and learn to ignore the views of rating agencies operating in ignorance of economic realities.

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