April 19, 2012
Recovery and Rebalancing
Several new items regarding assessing recoveries, here and abroad; and the prospects for rebalancing.
The IMF View, and the Recovery Compared
The IMF released its semi-annual World Economic Outlook on Tuesday, with an overview chapter reviewing the state of the world economy. One of the topics was a cross country comparison of this recovery against previous post-War recoveries. From Ayhan Kose, Prakash Loungani, and Marco Terrones, entitled "The Global Recovery: Where Do We Stand?”:
... the current recovery in advanced economies has been extremely weak, reflecting in part the legacy of the global financial crisis, particularly the ongoing need for balance sheet repair in the household and financial sectors.8
This paper analyzes the interactions between business and financial cycles using an extensive database of over 200 business and 700 financial cycles in 44 countries for the period 1960:1- 2007:4. Our results suggest that there are strong linkages between different phases of business and financial cycles. In particular, recessions associated with financial disruption episodes, notably house price busts, tend to be longer and deeper than other recessions. Conversely, recoveries associated with rapid growth in credit and house prices tend to be stronger. These findings emphasize the importance of developments in credit and housing markets for the real economy.
Then think of the results of Jordà, Schularick, and Taylor (2011), recounted in Tuesday’s post, and we see that if one wants to evaluate a recovery, one needs to condition appropriately. That is, if one is going to condition one’s expectations of a recovery on the extent of contraction during the recession, one should also condition on other factors. That lesson clearly still eludes many observers, for whatever reasons.
Prospects for Rebalancing
In a new e-book edited by Ulrich Volz, entitled Financial Stability in Emerging Markets I have an article assessing the prospects for global rebalancing. From “Global rebalancing with financial stability: possible, feasible, or unlikely?”:
The prospects for rebalancing are assessed here from the following perspective: the global economy was unbalanced before the financial crisis of 2008, with current account surpluses in China and the oil exporting countries matched by deficits primarily in the United States (US). While imbalances shrank during the period 2007–09, during the ensuing Great Recession, we can now see surpluses and deficits again expanding.
The source of these imbalances has been the topic of an extensive and heated debate that is far too complicated to recount here. I would argue that while intertemporal consumption smoothing and the dearth of profitable investment projects in East Asia are partly to blame, I think that the existence of distortions in domestic financial markets in the United States attracted excess savings from the rest of the world.3 The abdication of regulation on the part of the Bush Administration, aided and abetted by the anti-regulatory ethos of the Greenspan Fed, ensured that the capital inflows that came with the current account deficit would manifest themselves in the form of a massive boom. The resulting bust in consumption led to a short-term improvement in the current account as imports fell faster than exports. With the resumption of growth, there were hopes that global rebalancing would occur, that is, that demand in China and East Asia would reorient itself away from exports and towards domestic consumption while US aggregate demand would shift towards tradable goods. It was never clear that the first part of the equation would occur, and it’s certainly clear that the second part is not occurring with sufficient rapidity to make an impact over the next couple of years.
At this juncture, I think it is useful to recount what our models can tell us. In work with Barry Eichengreen and Hiro Ito, we have highlighted the fact that given projected growth rates, and the historical norms that have governed the behaviour of current account balances over the medium term, a persistence of current account balances can be predicted (cf. Chinn / Eichengreen / Ito 2011). On the other hand, it is also true that our models have done a poor job of predicting the level of current account balances for key countries like the US and China, especially during the 2006–08 period. That is, while budget balances explain some of the deterioration in the US current account, and the lack of both financial and institutional development explain some of the surpluses of China, movements of these factors do not enable us to track external developments in these economies.
In our forensic analysis, we found that the extent of misprediction during the 2006–08 period was well explained by housing price appreciation and private bond market growth during the preceding 5-year period. In addition, increasing leverage in the household sector was clearly associated in a subset of countries with a deterioration in current account imbalances. The unfolding of those trends – particularly in the United States, but also in the United Kingdom – may very well result in greater current account convergence than we predict with our statistical model.
For China, since our model is unable to capture the behaviour of Chinese surpluses during the 2000s, I’m particularly loathe to make predictions based solely on our statistical model. Suffice it to say that to date we have not seen evidence that the rapid internal rebalancing of China’s spending patterns is having an effect on substantial shrinkage in Chinese current account balances.
See here for the Chinn, Eichengreen and Ito paper. The policy prescriptions based upon this view of the world differ from the simplistic arguments often forwarded of deregulating the financial markets further.
The table of contents for the book:
- Introduction Ulrich Volz
- Global rebalancing with financial stability: possible, feasible, or unlikely?
Menzie D. Chinn
- US quantitative easing: spillover effects on emerging economies
- The comovement of international capital flows: evidence from a dynamic factor model
Marcel Förster / Markus Jorra / Peter Tillmann
- Global liquidity and commodity prices
- Foreign banks and financial stability: lessons from the Great Recession
Ralph de Haas
- Emerging market economies after the crisis: trapped by global liquidity?
- Capital account management: the Indian experience and its lessons
Y. Venugopal Reddy
- Avoiding capital flight to developing countries: a counter-cyclical approach
Stephany Griffith Jones / Kevin P. Gallagher
- What role for the FSB?
Jo Marie Griesgraber
- International capital flows and institutional investors
- Global liquidity and the Brazilian economy
- AMRO’s role in regional economic surveillance and promoting regional economic and financial stability
Speaking about rebalancing, how should fiscal consolidation proceed? The recently released IMF Fiscal Monitor has an interesting finding (Appendix 1):
There is an extensive and—since the economic crisis— rapidly expanding empirical literature that tries to estimate fiscal multipliers. However, only a few empirical studies have so far analyzed the links between fiscal multipliers and the underlying state of the economy. New research (Baum, Poplawski-Ribeiro, and Weber, 2012) finds that the position in the business cycle affects the impact of fiscal policy in G-7 economies: on average, government spending and revenue multipliers tend to be larger in downturns than in expansions. This asymmetry has implications for the desirability of upfront fiscal adjustment versus a more gradual approach.
Figure from IMF Fiscal Monitor, April 2012.
This suggests that even if one’s objective were to shrink government discretionary defense and nondefense spending to 4% of GDP, as in Representative Ryan's budget , it still might not make sense to front-load consolidation via government spending cuts.
Posted by Menzie Chinn at April 19, 2012 12:20 PMdigg this | reddit
Looks like even John Taylor is coming onboard with the effectiveness of fiscal multipliers in a strong economic downturn:
I guess that's progress.
Maybe this is just anecdotal, but it seems like all of the models tend to understate turning points. The models sometimes do a decent job of getting the timing right, but they seem to undershoot recoveries by half and miss contractions by an equal magnitude. Maybe it's just me.
Posted by: 2slugbaits at April 19, 2012 02:35 PM
Taylor has not changed anything. He is simply demonstrating that some of his earlier work is validated by others since his is central to the entire population.
Taylor has always been a Keynsian, but what makes him interesting is he is one of the few who actually let's a bit of the data influence his theory. Of course he will still live and die by the Taylor Rule because it is he claim to fame, the curse of academic celebrity.
Posted by: Ricardo at April 20, 2012 06:34 AM
For the United States, real rebalancing comes when enough current account deficits have been converted into industrial assets for a transformation to perpetual decline and poverty. Without positive cash flow, a nation will dilute itself.
Probably the biggest contributor to America's conundrum is the active manipulation of the dollar as an international reserve currency. Surplus dollars have to be created to support international commerce (multinational corporate activity). Those dollars eventually have to be repatriated by the sale of US assets to offshore entities. Commercial profits are rapidly sucked out of the economy, reducing money velocity and the multiplier effect.
Posted by: MarkS at April 20, 2012 07:16 AM
Menzie, on the size of the multiplier and the state of the economy, Yuriy Gorodnichenko and Alan Auerbach have done work on this and found robust evidence that multipliers are systematically larger when "slack" is high:
Posted by: oc at April 20, 2012 09:37 AM
i know how much you like to beat up Wisconsin. I thought this was interesting:
Posted by: dwb at April 20, 2012 02:41 PM
A question about the EU -
I am not sure of the exact level of participation of ECB, IMF, FED,..., but a large amount of cash has been lent to banks in Spain, Greece, Portugal, etc, to keep the banks solvent.
The banks buy government debt with the proceeds.
The effect is to sustain the market for government debt at reasonable lending rates and also to support the price of government debt on the balance sheets of the banks.
Without intervention, the banks' balance sheets would suffer as the price of soveriegn debt falls, leading to insolvency. Similarly, the respective governments would find little demand for their debt, which would lead to sovereign default.
It appears the ECB has decided to end the easy money for banks. The result is upward pressure on sovereign debt yields as the market begins to realize the consequence.
We approach the end game. It seems that either the EU/FED/IMF will have to buy the bad sovereign debt from euro banks, like the FED bought bad MBA's from US investment banks, or a large number of EU banks will fail.
The result is that Central Monetary Authorities (ECB, IMF, FED) made loans to commercial banks, then the banks bought impaired assets (soverign debt), and now it appears the only solution is for the Cental Monetary Authority to pay cash to the banks for the impaired debt. (The same debt that was purchased with loans from the Central Monetary Authority).
How does this end? These countries need growth to increase tax revenue to solve the fundamental problem of unsustainable deficit spending. However, the Central Monetary Authority requires austerity. Austerity prohibits growth. Without growth, there is only default on a massive scale in the EU.
How does this end without an EU systemic collapse?
What am I missing? What is the scenario in which the EU escapes a death spiral similar to that which occurs when a publicly held company dilutes the value of its stock by issuing billions of shares because its debt is worthless?
Posted by: tj at April 20, 2012 07:20 PM
oc: Thanks for the references. The IMF Fiscal Monitor makes reference to these papers in its discussion of the asymmetry.
dwb: Thanks! Great article. Wisconsin is almost back to where it was when Governor Walker took power, in terms of nonfarm payroll employment.
Posted by: Menzie Chinn at April 20, 2012 07:21 PM
tj: It's been my view that resolution will only occur with a commitment by the Northern eurozone countries to provide more funds for the bailout, a loosening of the austerity measures in the periphery countries, increased spending in Germany, and very importantly, a higher inflation target, as a means of eroding real debts (see this post).
Posted by: Menzie Chinn at April 20, 2012 07:27 PM
But, Menzie, if inflation becomes the means to erode real debts, will not the very creditors that are being protected by the IMF/ECB/Fed be the losers? Is this not the very death spiral that tj is talking about?
Posted by: rl love at April 21, 2012 07:37 AM
Thanks Menzie. Do you think there is time for those measures to have sufficient effect to head off default in the EU commercial banking sector?
It looks like tax revenue growth is going to fail to acheive 'escape velocity' as all or part of the EU zone falls into recession. Various countries have large debt payments coming due over the next year or 2, and without economic growth, tax revenue will not fill their treasuries to a level necessary to pay off the obligations in full. ==> soverign defaults and default at banks who hold the sovereign debt on their balance sheet.
The inlfation solution you propose might work in the medium term, but it doesn't work if countries default in the short term.
Maybe the EU will be forced to issue an EU Bond and use it to replace the impaired debt issued by individual countries. The situation would have to be dire before Germany will agree to that or the inflation solution.
Otherwise, the ECB will be left with no choice but to buy up the impaired debt with cash, similar to the way the FED traded cash for MBA's in the U.S.
The difference is that the ECB would be preventing default in both the commercial banking sector and troubled governments. Germany will have trouble swallowing this solution as well. Maybe they will agree to let the IMF do it.
Nevertheless, it's difficult to comprehend how creating money to keep insolvent banks and countries solvent does not create larger problems for the future.
Posted by: tj at April 21, 2012 08:06 AM
tj: I don't think the political leaders will allow default (of course, since I'm an economist, not a political scientist, you can take that forecast with the proper discounting); rather I think they'll muddle through from crisis to crisis, until the political consensus arises for bigger transfers, bigger haircuts, and inflation can erode the real value of debts (and along the way, erode real wages in the countries with relatively high unit labor costs).
rl love: Reducing debt via inflation is easier than reducing it by negotiation.
Posted by: Menzie Chinn at April 21, 2012 10:00 AM
tj It's also important to keep in mind that not all of the periphery countries are Greece. Greece is pretty much of a basket case. The Greeks just refuse to pay taxes for the government services they demand. And Greece is a relatively small economy, so Greece breaking away from the EU isn't unimaginable. But Spain is a big economy and Spain does have a record of being fiscally prudent. And Ireland's problems are due to the otherwise fiscally responsible government deciding to backstop the bad loans of Irish commercial banks. In those kinds of cases I can see where the ECB would allow things to just kind of muddle along for awhile until inflation eats away at the real debt and real wages. And don't forget that the tried-and-true solution to unemployment problems among Irish youth is "self-deportation." There are other possibilities. The French are likely to elect a socialist president, so that might pump up inflation. German labor costs might escalate if Turkish immigration falls off. None of those things constitute a plan, but stuff happens.
Posted by: 2slugbaits at April 21, 2012 10:48 AM
If someone can find it, I think it would be enlightening to see a table with the amount and due date of principal repayment for Spain and Portugal.
Government debt structured as interest only loans with a principal repayment at maturity leaves countries in a situation like Greece. The market sees the large principal repayment (was it 50B+ for Greece?) approaching, and the governemnt does not have the enough cash in the bank to make the payment.
I think Spain and Portugal have some large principal repayments due in Fall 2012, or is it later than that?
We see the reports in the press that these countries are making cuts to get debt/GDP to X% and it sounds believable. However, those numbers assume positive economic growth. I fear that growth will fall below forecasts and there will not be enough funds in the treasuries when the principal repayments are due.
Posted by: tj at April 21, 2012 02:35 PM
You are talking about government debt, but there is also another problem in the recovering economies. I´m Canadian and we are challenging incredible high debt-to-income ratio of our population (you can get more info in How Dangerous is High Household Debt for the Economy). In combination with overpriced housing and stagnating economy, this will likely produce a recession or in worse case even a depression.
Our current score in economic growth is not important, since we are sitting on a ticking bomb.
Posted by: John Berkowitz at April 23, 2012 03:47 AM
2slugbaits wrote "German labor costs might escalate if Turkish immigration falls off. None of those things constitute a plan, but stuff happens."
Since 2005 we observe a net emmigration of Turks from Germany to Turkey :-)
Another issue is that many Turkish highschool students still do not graduate or only graduate in the third tier highschool (Hauptschule) and therefore contribute only relatively little to the qualified workforce the German economy esp. the Mittelstand relies on.
Immigrants from eastern European countries are more important.
Posted by: ulenspiegel1965 at April 23, 2012 06:00 AM