Friday, December 21, 2012

The Election of Shinzo Abe: Voters Mull over Monetary Policy

In the world's top creditor nation, a change in policy might soon be in store. Last week, hawkish opposition leader Shinzo Abe was elected to his second term. Abe's first term in 2006-2007 collapsed in the aftermath of Agricultural Minister Toshikatsu Matsuoka's suicide. Adopting an overtly expansionist economic stance for this election, Abe called for "unlimited" monetary policy easing in order to combat deflation and higher spending on both public works and national defense last month.

Among the key issues in the election, was the general timidity on the part of the BOJ to aggressively pursue inflation targets. Japan's financial markets, as well as its overall economy has been consistently undermined by deflation over the past 15 years.  

What it comes down to is there has been a feeling among the Japanese electorate, that monetary policy should be more aggressively expansionist. So far there have been five rounds of monetary stimulus in Japan. In February of this year, the BOJ set a short-term inflation goal of 1% and a long-term inflation goal of 2%. A move referred to as "meaningless" by Abe. 

BOJ's Independence
The Bank of Japan's independence is being called into question. Although a 1997 reorganization of the BOJ granted the central bank more independence, making the BOJ one of the last central banks in the world to gain independence, this electoral cycle saw both political parties campaigning on monetary policy issues. Both parties promised to call for more monetary easing. 

The new government has the power to appoint a majority bloc to the BOJ's policy board. It is likely this will happen. Furthermore, Abe has threatened to revise the Bank of Japan Act. 

What Does this Mean for Japan's Economy?
In general, there is a consensus that Japan must combat its deflation at all costs if indeed it is going to regain its lost economic growth and dynamism. 

While some may talk of structural reforms, the fact that Japan has an extremely high median age is -and thus a high dependency ratio- is a fact that cannot easily be maneuvered around. On the other hand, three prominent features of Japan's economy are its deflation rate, its extremely high savings rate, and the fact that Japan's investors have massive amounts invested overseas, making Japan the world's largest creditor. Expansionary monetary policy might be a positive step in addressing these issues.

Monetary stimulus would also help reduce the price of export-dependent Japan's currency on international markets, providing a boon to Japanese manufacturers.  
Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Tuesday, November 13, 2012

A Thought About Greek Austerity

Time to Scrap a Failed Policy. Time for Greece to Stand up for Itself
These days, we are living in the middle ages of economics, where we still treat headaches by drilling in to the head.. and we treat flesh wounds by hack-sawing limbs.... but at least we as a profession are (hopefully) starting to realize how foolish it all is.

This story is one where austerity demands lead to a full-on dismantling of the Greek GDP.. ostensibly to help things. Of course, if the GDP gets worse, then the Debt-to-GDP ratio will also get worse.. leading to yet another round of austerity (complete with the promise that *THIS TIME* it really is the last round of austerity). Greece has seen six rounds to far, and the situation only gets worse.

When it's all said and done.. it will all seem as foolish as when the Austrians printed money in the 1920s in an attempt to alleviate hyperinflation. At the time, only Hayek saw the foolishness of it. Prescribing austerity to a country whose economy is collapsing is equally foolish.  In 20 years, we'll all look like idiots for not having known any better.

Results of Austerity
So far, Greek unemployment has tripled is this time in 2008, when the Greek crisis emerged, while interest rates on government bonds have reached 177%. If ever an economic policy failed, German-backed Greek austerity failed. To quote the BBC (a news source which is not sympathetic to any party in the eurozone crisis),

"The new Greek budget foresees a deepening of the worst recession of any country in modern history, our correspondent says.

The national economy is expected to shrink next year by 4.5% and public debt is likely to rise to 189% of GDP, almost double Greece's national output. This year, public debt stood at 175%.

The head of Syriza, a left-wing opposition party, said the latest budget cuts would leave Greeks unable to afford essential goods this winter."

Greek Left Detects the Pattern
Alexis Tsipras was quoted by NPR "I wouldn't be surprised if you were back again in a few months, asking for more cuts. Because these measures are going to bring a deeper recession and we'll have bigger debts." For some reason, this result  common to almost all austerity budgets that ever were, certainly true of Argentina, was not immediately obvious earlier.

What Should Be Done? 
As a matter of National Interest, Greece should realize the pattern being played out and act accordingly. The idea of the Greek government so beholden to foreign (German) economic interests that it is only able to survive by surrounding itself with increasingly massive security cordons is utter foolishness. The Greek government should come to its senses before it turns into the Argentine government. given both the current events, and the direction of things, that is evidently not far off. The looming threat is one of a complete loss of market confidence in Greek markets and Greek debts. But then we must ask... "Has this not already happened?" On the other hand, continuing with austerity will only exacerbate the already desperate economic situation. At this point, Greek citizens have nothing to lose but their chains.

As for economists, we should realize how ridiculous this all is.  Prescribing austerity to a country whose economy is collapsing is pure foolishness and we should see it for the quackenomics that it is.

Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Thursday, November 1, 2012

Education's Return on Investment

In this era of austerity, it must be remembered that expenditures by the state are not unilaterally expenses. Funds dispensed by the state are also investments, which yield a measurable return on investment. According to the OECD's Education at a Glance 2012 report, education-related expenses grant massive returns on investment at both public and private levels. The OECD reports that the Net Present Value of public and private premium for completing secondary and tertiary education is $388,300 for men and $250,700 for women across the 28 OECD member nations. The net public return for tertiary education is two to three times public investment level. 

Unfortunately, this is not the way that this issue has progressed. Education expenditures have recently become and issue for the wrong reasons in several places, such as the UK, Quebec and the Netherlands. 

A Question of Externalities
Another interesting aspect of the OECD report is the discussion over public and private returns to educational expenditures. Private returns on education are comprised by a measurable earnings gap as well as an unemployment gap. Public returns on education include tax revenue, an unemployment gap, and social contribution effects (which are housing benefits and social assistance that does not have to be paid by the taxpayer). In addition, higher education rates are directly causally linked to increased economic growth.

While costs are borne mostly by the individual, benefits are divided between the individual and the public. The combination of (partially) public gains and (mostly) private financing can cause a  costs-benefits mismatch which might lead to lower-than-optimal investment in education under laissez-faire, despite high returns, public benefits, and economic growth effects which education causes. 

While education is 31% privately financed in the UK, it is 97% publicly financed in Finland. In 2009, the US spent 2.6% of its GDP on tertiary education. More than half of this figure was comprised by private expenditures. 

What Should Be Done?
Expenditures of the state should be evaluated taking potential Return on Investment into consideration. For policy markers, this should mean that GDP growth, revenue growth, and growth levels in other relevant measurable metrics should be considered.  

The debate then shifts from asking "Can we afford to spend more on education?" to "How can we best spend on education in order to maximize future revenue growth?" and "How can educational expenditures help reducing other social costs, such as unemployment, housing subsidy, incarceration, and healthcare costs?"
Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Sunday, October 28, 2012

Germany Restricts High-Frequency Trading, Chicago Fed Recommends Same

WSJ Article: Germany to Tap Brakes on High Frequency Trading
NYT Article: Germany Act to Increase Limits on High Speed Trades

Late last month, New York Times and WSJ reported on Germany's intention to restrict High Frequency Trading.  High Frequency Trading is the use of proprietary algorithms to trade securities rapidly and at high speed. The idea is to capture fractions of a penny per trade. 

Chicago Fed's Concern About HFT
Earlier this month, the Chicago Fed published an essay on the risks of HFT for financial markets. Every exchange it investigated has had problems attributable to errant algorithms and software malfunctions. The worst was the 2010 Flash Crash which caused a 700 point drop in the Dow within seconds. 

At fault is insufficient risk controls, a phenomenon due to the competitive time pressures involved. The Chicago Fed found that exchanges that impose pre-trade risk checks increase latency. Furthermore, investor confidence in the markets has also been adversely affected and the markets have seen a rise in volatility. 

In order to control risks associated with HFT, the Chicago Fed has recommended:
               Limits on the number of orders that can be sent to an exchange within a specified period of time;
               A “kill switch” that could stop trading at one or more levels;
               Intraday position limits that set the maximum position a firm can take during one day; 
               Profit-and-loss limits that restrict the dollar value that can be lost.

Germany Acts to Restrict HFT
Draft legislation on the matter was approved by the German parliament. Proposed measures include requiring that all high-frequency traders be licensed, clear labeling of all financial products traded by HF algorithms without human intervention, and a limit to the number of orders that may be placed without a corresponding trade.

According to a press conference by the German Finance Ministry, as much as 40 percent of all trading sales can be attributed to HFT. Germany's goal in acting are essentially to limit the identified risks associated with HFT. If the bill becomes law, "excessive use" of trading systems would come with added fees. Traders also would have to maintain a balance between orders and executed transactions.

While France has already imposed a tax on high-frequency trades, legislation is also under consideration at the European Parliament and may become the basis for governmental legislation on HFT across the EU.
Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Thursday, October 11, 2012

Zero Lower Bound: When Interest Rates Can't Drop Any Further

Recently, a new issue has emerged in the unfolding drama of the global financial crisis. After four years of reducing interest rates and increasing money supply at central banks of virtually all of the world's major economies, both academia and the media have started to mention a new obstacle, the Zero Lower Bound.

The underlying challenge of the Zero Lower Bound is that because interest rates are at zero, they cannot usually be lowered any further. Moreover, the context is typically one in which the economy is sluggish and stimulus is needed. In such circumstances, monetary policy has to proceed by unconventional means. Otherwise, a liquidity trap might develop along the lines of the situation Japan has been stuck in for nearly two decades. The question is of particular relevance today, since both the ECB and Fed have had their policy rates hovering around zero since 2008-2009. 

The Policy Alternatives
In 2010, the ECB published a working paper outlining the two ways that ZLB can be confronted are via a change in the way monetary policy is conducted, or via stimulatory changes in fiscal policy. 

In any case, whenever ZLB has been confronted in the recent past, some unorthodox monetary measures have been tried, with varying degrees of success:

  • Quantitative Easing: This can always be done, no matter how low interest rates are. This has been recommended for the case of Japan.

  • Switching the way monetary policy is conducted. Switching to inflation targeting is the rhetoric of choice now. In the 1990s, it was exchange-rate targeting. The downfall of this approach is credibility. If markets don't buy the idea that the central bank will commit to either exchange rate targeting or inflation targeting, the plan will run into difficult terrain. Since it has taken central banks decades to build the credibility of their current low-inflation path, a change in course might be difficult to establish credibly. At least overnight. 

  • Changing the distribution mechanism. Last year, the Fed engaged in "Operation Twist", an effort to engage in quantitative easing by injecting liquidity along various points on the yield curve. 

  • Negative Interest Rates: During the Swedish crisis in 1991, the Swedish central bank forced policy rates into negative territory temporarily by charging banks a premium for storage of funds within the central bank, as well as for access to LOLR services. This encouraged banks to actually lend funds which they were being issued. 

  • Reliance on Fiscal Policy: Market confidence can also be affected by changes in revenue and expenditure. Unfortunately, during hard times, the capability of the state to credibly increase its expenditure is limited. This is especially the case where central banks have the commitment not to monetize deficits. 

During the WWI and WWII eras the British tried a somewhat different take on this approach. In 1914, for example,  Keynes recommended direct monetary intervention to compensate losses in the international trade finance sector caused by the sudden German embargo. In concept, the idea is similar to the US' Troubled Asset Relief Program, a fiscal measure to directly intervene in the failed derivative market in 2008-2009. 

Regardless of the approach (or combination of approaches) used, the issue of maintaining an expansionary stance in the face of ZLB is one of the more challenging issues in monetary economics and central banking. It may be quite some time before a policy consensus develops in this area. One thing is certain however: central banks will all need to develop adequate ZLB tactics at one point or another. 

Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Thursday, October 4, 2012

Middle-Class Squeeze: Wages are Down, but we Aren't More Competitive
American wages and labor conditions have been continuously deteriorated since the 1980s. Since the start of the 21st century however, this trend has become especially pronounced. Known as the Middle Class Squeeze, this phenomenon has been particularly pronounced in the US, while real wages expanded strongly in European OECD countries such as the UK, France, Italy and Germany, as well as in the BRIC countries since 2000. It has become a major issue in both the 2008 and 2012 presidential elections. In 2008, the House Committee on Government Reforms published a brief study which concluded that median real household income dropped by almost $1,300 while real household expenses increased by nearly $5,000 over the 2000-2008 period.

How it Happens
Essentially, the deterioration of incomes on the US labor market has emerged in two ways:

1: The large-scale loss of high-skilled, high value added mid-wage employment, to be replaced by low skilled, low value-added, and low-wage employment. According to the National Employment Law Project, 
sixty percent of of US job losses experienced during the recession, while comprising only around twenty  percent of the jobs gained during the current recovery period. Low-skilled jobs meanwhile made up only around twenty percent of the jobs lost during the recession  but nearly sixty percent of the jobs recovered thus-far in the recovery.

2: Declining real incomes: The maintenance of median wage and salary levels in the face of increased price levels and cost of living. Healthcare and energy costs have especially increased, as has education. To compound this trap, the new millennium has seen the rise of household debt to try to cover the difference. The debt-to-income ratio reached its highest level in 24 years for middle class households, while Bush-era bankruptcy reform has made the debt trap considerable more difficult to climb out of. In 2010, the Levy Institute published a study showing that both household debt and the US GINI coefficient spiked upwards since 2000.

Why This is Problematic
According to the standard ruling paradigm in labor market economics, low wages are helpful to a country's economic competitiveness. But, this only begs questions such as:

  • How much wage deterioration is enough and when will the US's wage levels become "competitive"? Do wages and labor standards have to sink to those of China? 
  • What will happen to consumer demand as a result of this trend?
  • If wages are supposed to equal the marginal productivity of labor, how can the replacement of mid-wage, high-skilled jobs with low-skilled Mcjobs possibly be a positive development for our labor market?

Setting aside the ominous ethical significance to what is perceived as the US' core traditional values posed by the progressively increasing American wealth gap, there are long term economic side-effects which we have also seen emerge. 

Among these are a weaker, more debt-dependent consumer market, lower growth in productivity levels within the American workforce. All of this will hurt the progress of the American economic recovery, and will undermine long-term economic health. 

What Can Be Done
Unfortunately, the Middle Class Squeeze has no magic overnight solutions. Addressing this issue would take a package of policy solutions. We can start by asking what the rest of the OECD countries have done in order to promote real income growth. We also take measures to counteract the primary immediate causes of the short-term squeeze.

  • More attention needs to be focused on increasing our labor force's productivity level. This means not only improving the educational level, but securing access to mid-career and between job training as well. In policy terms, it means that our school systems must perform better, university education must be cheaper, and employer training has to be incentivized. 
  • Healthcare costs have to be tamed. 
  • Consumer debt markets have to be reformed and Bush-era bankruptcy reforms need to be scrapped. The growing debt-trap is a large component of the middle class squeeze. It also undermines both short and long term consumer confidence and household savings, two key ingredients to healthy, sustainable economic growth. Climbing out of the debt trap has got to be made easier if the American economy will continue to succeed in the long-run. 
  • High-skilled employment clusters have to be constructed and defended. Essentially this means that the long-term survival of clusters such as Detroit and Silicon Valley have got to be treated as issues of national interest.
Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Monday, September 10, 2012

ECB Swings into Action - Markets Jump Accordingly

The  ECB Bond-Buying Plan
Last week, ECB chief Mario Draghi launched and ECB bond-buying plan, sparking a dramatic rally in the world's financial markets. "Economic growth in the Euro Area is expected to remain weak, with the ongoing tensions in financial markets and heightened uncertainty weighing on confidence and sentiment" said Draghi. Faced with pressure to prevent the collapse of Europe's monetary union, Draghi finally launches a monetary plan which amounts to more than merely a bandage has finally been set in place. Due to proximity of interest rates to the Zero-Lower-Bound, further reduction of interest rates would essentially be of limited effectiveness. More unorthodox monetary measures are therefore needed. Unfortunately, since this move is late in emerging, potential costs are much higher than they otherwise could have been. The bond-buying plan makes use of Outright Monetary Transactions (OMTs) and focuses on sovereign bonds maturing within three years. According to Draghi, OMTs will only be used in conjunction with the EFSF or the ESM.

Role of the Central Bank
Despite fears of inflation - and above the opposition of Bundesbank chief Jens Weidmann (who also represents the German voice in the ECB's governing council), the plan went ahead due to support from all other members of the ECB's governing council. During recessions, a focus on price stability is not only of limited relevance but also wholly insufficient as a policy response, given anemic growth prospects. Moreover, the nature of the ECB's delay to respond to turmoil in the markets had contributed greatly to the generalized lack of investor confidence and poor growth so far. A fact which will undoubtedly increase the cost of this maneuver to both the ECB and the European taxpayer. 

While there are voices that feel that the ECB should not be in the business of helping stabilize sovereign bond spreads and foster growth, one must consider exactly where the sovereign interest of the EU and that of most of the Eurozone members lies. "OMTs will enable us to address severe distortions in government bond markets, which originate from, in particular, unfounded fears on the part of investors of the reversibility of the Euro" said Draghi. It must also be remembered that this takes place against the backdrop of Germany's role in the Eurozone. While it is the single country which has benefited the most from the Euro given the currency's boost for German exports due low low currency prices which Germany could never enact on its own , it has also been the first -and most frequent- country country to violate the convergence criteria. 

The Potential Downside

With all of the bond-buying plan's upsides, and its long overdue nature, the plan does cast a dark shadow for the economic sovereignty of the Eurozone member nations, as outlined in the UK press. In a structure similar to that of the IMF, access to potentially unlimited funding is likely to be made conditional on potentially severe austerity measures which will actually be monitored by the IMF. In other words, as if it weren't bad enough that three years of austerity measures have already failed to reduce debt-to-GDP ratios in the PIIGS, the same failed model will likely be forced onto any member-nation which runs into economic trouble in the future. It paints a picture mimicking the worst days of the IMF.

Market Response
Markets responded immediately, sending the S&P 500 and the Nasdaq to multi-year highs not seen since 2008 and 2000 respectively, while the Euro climbed 0.3% against the US dollar in a matter of hours. Yields on Italian and Spanish bonds also dropped dramatically. One can only wonder what markets might look like by now had the ECB only decided act sooner. 
About the Author: 
Max Berre is a financial-regulatory economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands. 

Wednesday, August 22, 2012

Hayek vs. Hi-Tech

How Did we Actually Develop our Technology?

Evidence from the US and Israel

While the standard economic paradigm concerning innovation is based on the Schumpeterian view that technological advances are brought on by entrepreneurs and that this is best maximized by relying on the private sector for innovation as much as possible. Another aspect of the Austrian view on this issue is that the state is simply incapable of efficiently developing new technology.

The fact is, despite what established theories about technological innovation predict and recommend, several of the world's most technologically advanced countries attained their current technological level there by relying on taxpayer-funded R&D. While the role of private industry cannot be denied concerning bringing to market recently- developed technological leaps forward, nor in the micro-innovations which make said technology more flexible and user-friendly, the underlying macro-innovations, such as computers, mobile phones and the internet are based on state-discovered innovations, funded at taxpayer expense.

As for the Austrian school's views on the state, remember that Schumpeter, von Hayek, and von Mises came of age during the Austro-Hungarian monarchy. In those times the state was a bureaucratic  instrument of the monarchy. Autocratic, Arbitrary, Un-Democratic, and not a Meritocracy. It was only natural not to want to have (that particular) state involved in anyone's lives. Today however, most states have governments elected by the people on the promise to improve people's lives in a number of ways. Most of today’s leading contemporary states have a least some interest in pursuing policy which would improve R&D and technology levels.

In the US
While the role of the US government in developing the largest macro-innovations of our time, the computer and the internet are widely understood, the role of the US intelligence community in the development of Silicon Valley has just recently come to light.  The support came in the form of a public venture capital fund aimed at improving the survivability of technological start-ups. Google Earth was among the clients. NPR covered the story last month.

In Israel
The story of Israel’s role in the development of Israel’s technological level – particularly concerning the country’s booming IT sector – has been more widely reported and is more openly understood. The IDF’s role in particular has been documented as being a vitally important source of innovations for Israel’s IT startups. In particular, a disproportionately large share of Israel’s IT and communications technology industries owe their heritage to the IDF’s School for Computer Related Professions and MAMRAM, the IDF’s central computer unit.

According to the 2002 MIT study, these results have been achieved by the Israeli state primarily by providing a semi-public good in the form of a mechanism for collective learning and diffusion of IT knowledge, high-skilled training, fostering technological startups, providing a tangible link between the IT sector, policy circles, and academia, in much the same way as results achieved by the US state.

Israel’s story has nevertheless been almost wholly ignored by the economics profession in its quest to try to understand what sort of policy is needed to maximize a country’s potential for technological innovation. It’s an unfortunate case of ignoring whoever does not fit the ideological narrative. 
Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Saturday, July 7, 2012

Krugman and Layard Launch Manifesto for Economic Sense

At the end of June, 2012, Nobel Laureate Paul Krugman and Richard Layard, a distinguished British economist launched a manifesto calling for a more rational policy dialogue with respect to the economic crisis and plans for crisis recovery across the major economies. 

In the two weeks that the manifesto has been in existence, it has been endorsed by economists from across academia in the US, Europe, and Canada, and from such established institutions as Cambridge, Yale, Oxford, Columbia, LSE, Sorbonne, Dartmouth, and Harvard. Economists from the IMF, World Bank, and several of the world's stock exchanges have also signed. With over 7700 signatures spanning 180 pages thus far, a large number of ordinary citizens from various walks of life have also endorsed the Krugman-Layard Manifesto for Economic Sense. 

Let's Avoid Repeating the Mistakes of the 1930s
The Manifesto calls for an end to the focus on austerity, asserting that in the case of most countries - but not Greece- public borrowing was not at the source of the crisis, nor the subsequent ballooning of public deficits across the OECD. Rather, the source of our massive public deficits was actually the collapse of output and then revenue, which followed the onset of the crisis. It would therefore be a mistake to try to address the problem by dismantling the part of the economy that isn't broken. The manifesto calls this failed policy a repeat of the the mistakes of the 1930s, when reductions in public spending lead to economic contraction in many of the world's largest economies, thereby exacerbating the crisis. In fact, the IMF has individually studied the national-level economic effects of budget cuts in 173 cases, and found that the consistent result is economic contraction. 

What is called for according to the manifesto, is counter-cyclical fiscal policy that would dampen then economic shock rather than exacerbate it. At the moment, the private sector is simultaneously trying to cuts its spending, lower its leverage levels, and reduce its borrowing. The manifesto also calls on governments to focus more attention on unemployment figures and loss on borrowing costs. At the moment, most major economies face high unemployment levels compared to the recent past, while borrowing costs are near all time lows for most major economies. 

The Manifesto concludes by saying that in order to be able to address our economic problems correctly, correct analysis of the problems will be necessary and indispensable. 
About the Author:
Max Berre is a financial-regulatory economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) and economic correspondent for Capital-Life, who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands. 

Friday, July 6, 2012

For China, Trade is not Simply About FDI

An empirical study undertaken at the University of Hong Kong examining the phenomenon of trade and foreign direct investment in mainland China has demonstrated a key policy point of China's FDI policy. Namely, its not about how much FDI China can attract, but about maximizing productivity spillovers. Its about how much wealth actually remains in the domestic hands and how much productivity growth the domestically-owned Chinese economy experiences as a result of foreign investment.

Typically, when we talk of trade with developing countries and emerging economies, we think of a number of key concepts, all of which have their roots in western academia. Talk of trade-based economic growth and development turns to focus on Foreign Direct Investment, whose sheer volume is simply supposed to be broadly good for growth. Good policy would therefore focus on simply a maximization of FDI-lead growth. Or so we in the global north - two centuries removed from our own actual history of economic development during the industrial revolution - are told.

Necessary but not Sufficient
For China however, FDI is not universally considered as unambiguously positive. While economic growth is certainly considered to be a positive aspect of FDI, this is "necessary but not sufficient" in determining whether or not foreign investment is actually positive for the country. After all, The question then, is what precisely would be sufficient?

For China, perhaps the real question is not one of how much wealth can be generated in China with foreign investment, but rather, how much wealth actually remains in the domestic hands as a result of foreign investment. The key ingredient seems to be spillovers. That is, improving the productivity of the locally-owned economy. Presumably, this involves modernization in technological level, managerial practice, and employee know-how in the domestically-owned share of the economy.   

The Study and its Meaning
This study is an empirical examination of the productivity spillovers at the firm level. The central question it asks its quite straightforward: Are domestic Chinese firms affected by the presence of international firms in China? The study finds evidence that the technology gap leads to large productivity spillovers. In fact, the larger the technological gap, the larger the potential spillover. What this all means of course, is that FDI policy is not really a question of quantity. Sound FDI policy should revolve around bringing the most sophisticated possible firms to China, then maximizing spillover effects on domestically-owned firms by maximizing capture of technology, know-how, and managerial practices.

Foreign direct investment (FDI) is believed to bring positive spillovers to domestic firms in the host country. Empirical studies, however, have found conflicting evidence on the effects of FDI. In this study, we use a firm-level industrial census to estimate the relationship between the intensity of foreign presence and performance of domestic firms in China. More specifically, we attempt to answer the following questions. First, are Chinese domestic enterprises affected by the presence of foreign invested firms operating in the same industry which they do business in? Second, are Chinese domestic enterprises affected by the presence of foreign invested firms operating within related industries at the same locality where they conducted their businesses? It is a fact that a substantial portion of FDI in China are originated from neighboring economies, especially from the three most Chinese populated economies Hong Kong, Macao and Taiwan, that are technologically much less advanced than industrial countries. Finally, we examine whether foreign investment firms from these economies affect the Chinese domestic firms differently compared to those from other investing countries. The estimation results offer some support for the existence of positive spillovers. There seems to be stronger evidence that domestic industries benefit from foreign presence in the related industries within the province. Employment shares of foreign affiliates, especially those with investors from advanced countries, are associated with higher productivity. The impact of foreign presence within the industry is rather mixed. Employment shares of firms with investment from greater China area are negatively associated with domestic productivity while those with other foreign investment are positively associated with domestic productivity. It supports the argument that larger technology gap provides large potentials for technology spillover. For investment from greater China area, smaller technology gap present less potential gain. More over, they may be in direct competition with domestic firms and result in shrinking market share for domestic firms.

Friday, June 22, 2012

How Portugal Found Itself in Crisis

Despite Being a Well-Managed Economy
NY Times Article on Crisis in Portugal
The story of Portugal is one of how a small, soundly run economy can be battered by unstable market forces in its immediate environment. Prior to the crisis, Portugal had a well-managed economy which had low debt levels, roughly in line with the Maastricht criteria, as well as economic growth rates ranging from 3-5% per annum. As soon as the crisis emerged however, Portugal became a victim of increased borrowing costs due primarily to panic on the European markets, as well as high levels of exposure to financial sector external shocks. 

According to the New York Times, Portugal has reduced its budget deficit by more than one-third since this time last year. Furthermore, the IMF reports that contraction in output due to austerity measures has been milder than expected. Nevertheless, the IMF reports that the 2012 outlook for Europe has deteriorated substantially, affecting primarily the PIIGS economies. Essentially, Portugal's situation has been quite seriously undermined by continually deteriorating market sentiment, which is largely being driven by Eurozone stress (for which, Portugal is not responsible).

To illustrate matters further, the European national debt graph below, originally published by the NY Times last quarter, outlines that Portugal began 2009 with debt levels equal to those of Germany and have faced an increase in borrowing costs only since the Greek situation -and resulting mismanagement of the crisis- unfolded.

In other words, the IMF reports that while Portugal's fundamentals are fine in and of themselves, as is Portugal's management of the stormy economic climate thus far, Portuguese assets are being sold-off based on contagion fears stemming from the EU's (and Germany's) lethargic reaction to the crisis.

What Should Be Done?
In short, Portugal should be offered financial stabilization along the lines extended to Central and Eastern Europe under the auspices of the Vienna Initiative. In 2009, as the crisis swept through Eastern Europe, a coordinated crisis response was swiftly agreed and implemented primarily by the EIB, EBRD, The CEE region central banks, and the Austrian government. The Vienna initiative was a win-win response so effective in restoring confidence and avoiding severe economic contraction and austerity in Central and Eastern Europe that by 2010, the ECFIN Country Focus Report for Poland was titled “The Polish Banking System: hit by the crisis or merely a cool breeze?”
About the Author: 
Max Berre is a financial-regulatory economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands. 

Monday, June 18, 2012

ECB Study: Lack of Crisis Response Causing Contagion in Europe

Empirical Study on European Sovereign Spillover Risk

An empirical ECB study published in February 2012 analyzing the effects of the sovereign debt crisis found that spillover from the economic situation in Greece is affecting risk premiums across the PIIGS countries, as well as in the Eurozone at large, to a smaller degree. In other words, the European Union’s inaction with respect the European sovereign debt crisis is making the situation worse. This is happening due to investor fears of contagion. The fear is that the longer European leaders remain inactive in attempts to contain the situation in Greece, the more afraid investors become.

This was determined empirically by testing European bond yield spreads for sensitivity to general market conditions, publication of the budget-balance-to-GDP ratio, sovereign credit ratings changes, and Greek, Irish, and Portuguese sovereign credit ratings changes.The ECB study points out that a lot of the movement in the market happens automatically, as large institutional investors fulfill their fiduciary obligations to dump their riskier investments as they rebalance the risk profile of their portfolios.

The study concludes that because of economic losses caused by the simple contagion fears, the Eurozone’s highest priority should be to reduce contagion risk in Europe. It’s just a shame that Angela Merkel doesn’t see things that way.

Since the intensification of the crisis in September 2008, all euro area long term government bond yields relative to the German Bund have been characterized by highly persistent processes with upward trends for countries with weaker fiscal fundamentals. Looking at the daily period 1 September 2008 – 4 August 2011, we found that three factors can explain the recorded developments in sovereign spreads: (i) an aggregate regional risk factor, (ii) the country-specific credit risk and (iii) the spillover effect from Greece. Specifically, higher risk-aversion has increased the demand for the Bund and this is behind the pricing of all euro area spreads, including those for Austria, Finland and the Netherlands. Country-specific credit ratings have played a key role in the developments of the spreads for Greece, Ireland, Portugal and Spain. Finally, the rating downgrade in Greece has contributed to developments in spreads of countries with weaker fiscal fundamentals: Ireland, Portugal, Italy, Spain, Belgium and France.

The European Central Bank (ECB) is the institution of the European Union (EU) that administers the monetary policy of the 17 EU Eurozone member states. It was established by the treaty of Amsterdam in 1998 as the Eurozone's central bank. 

Saturday, June 9, 2012

The Economist Scolds Merkel's Obstructionism

Half-Baked Rescue Plans, Overwhelming Focus on Austerity
In mid-June of 2012, the Economist ran a piece scolding Angela Merkel for Germany’s obstructionism in the face of organized efforts to address the rapidly forming European sovereign debt crisis.  In the view of The Economist, Germany’s actions have done a great deal to turn a crisis in Greece – around 3% of the Eurozone’s economy- into a crisis of the 17-member Eurozone at large. “The overwhelming focus on austerity; the succession of half-baked rescue plans; the refusal to lay out a clear path for the fiscal and banking integration that is needed for the single currency to survive". The Economist points the finger directly at Merkel’s government over these policy failures “Since Germany has largely determined this response, most of the blame belongs in Berlin.”

The Consensus in the Rest of Europe – and World
According to the economist, the feeling in the rest of Europe, as well as in the US and China, a number of policy measures could be put in place to respond to the crisis. They proposed measures would help save southern economies as well as northern banks.

“Outside Germany, a consensus has developed on what Mrs. Merkel must do to preserve the single currency. It includes shifting from austerity to a far greater focus on economic growth; complementing the single currency with a banking union (with euro-wide deposit insurance, bank oversight and joint means for the recapitalisation or resolution of failing banks); and embracing a limited form of debt mutualisation to create a joint safe asset and allow peripheral economies the room gradually to reduce their debt burdens. This is the refrain from Washington, Beijing, London and indeed most of the capitals of the euro zone. Why hasn’t the continent’s canniest politician sprung into action?”

For their part, southern Europe’s banks have thus far proved to be considerably more resilient in the face of European volatility than their northern counterparts. So far, Spain has only seen one bank collapse… four years into the crisis at that. Compare this result with UK, Ireland, Holland or Belgium.

Why the Arrogance Then?
“She believes, first, that her demands for austerity and her refusal to bail out her peers are the only ways to bring reform in Europe; and, second, that if disaster really strikes, Germany could act quickly to save the day. The first gamble can certainly claim some successes, notably the removal of Silvio Berlusconi in Italy and the passage, across southern Europe, of reforms that would recently have seemed unthinkable.”

In other words, the Economist accuses that the action of Merkel’s government are designed to override the sovereignty of both the European Union’s 26 other member nations (and their democratically-elected governments) and the European Union itself. Berlusconi notwithstanding, the removal of foreign heads of state and the forcing of policy changes in foreign countries is a direct affront to the idea that the affairs of a country should be decided by that country’s voters: Democratic Sovereignty.

What Should be Done?
First, the proposed measures should be enacted. These are; the formation of a banking union, and the partial mutualization of debt. Second, the democratic sovereignty and national interest of the other 26 member nations should be defended as aggressively as is necessary. Germany’s austerity-demand-based obstructionism can, for example, be overcome by a series of bilateral agreements which simply exclude German participation.  
Max Berre is a financial regulatory economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

Friday, June 1, 2012

Stamp Scrip: Episodes in Economic History

On July 5th 1932, in the middle of the Great Depression, the Austrian town of Wörgl made economic history by introducing a remarkable complimentary currency. Wörgl was in trouble, and was prepared to try anything. Of its population of 4,500, a total of 1,500 people were without a job, and 200 families were destitute. The mayor, Michael Unterguggenberger, had a long list of projects he wanted to accomplish, but there was hardly any money with which to carry them out. These included repaving the roads, streetlighting, extending water distribution across the whole town, and planting trees along the streets.

Rather than spending the 40,000 Austrian schillings in the town’s coffers to start these projects off, the mayor deposited them in a local savings bank as a guarantee to back the issue of a type of complimentary currency known as 'stamp scrip'. This requires a monthly stamp to be stuck on all the circulating notes for them to remain valid, and in Wörgl, the stamp amounted 1% of the each note’s value. The money raised was used to run a soup kitchen that fed 220 families.

Because nobody wanted to pay what was effectively a hoarding fee, everyone receiving the notes would spend them as fast as possible. The 40,000 schilling deposit allowed anyone to exchange scrip for 98 per cent of its value in schillings. This offer was rarely taken up though.

Only the railway and post office refused to accept the local money. Ultimately, people paid their taxes early using scrip as well, resulting in a huge increase in town revenues. Over the 13-month period the project ran, the council not only carried out all the intended works projects, but also built new houses, a reservoir, a ski jump, and a bridge. The people also used scrip to replant forests, in anticipation of the future cash-flow they would receive from the trees. 

In other words, Stamp Scrip improved local-level C, I, and G, three of the four components of GDP.

The key to its success was the fast circulation of scrip within the local economy, 14 times higher than the schilling. This in turn increased trade, creating extra employment. At the time of the project, Wörgl was the only Austrian town to achieve full employment. Formally, it calls to mind the Quantity Theory of Money, whereby:
MV = PY and 
dM+dV = π+dY

Six neighboring villages copied the system successfully. The French Prime Minister, Eduoard Dalladier, made a special visit to see the 'miracle of Wörgl'. In January 1933, the project was replicated in the neighboring city of Kirchbuhl, and in June 1933, Unterguggenburger addressed a meeting with representatives from 170 different towns and villages. Two hundred Austrian townships were interested in adopting the idea.

At this point, the central bank panicked, and decided to assert its monopoly rights by banning complimentary currencies. Wörgl's citizens sued and lost in the Austrian Supreme Court. It then became a criminal offense to issue 'emergency currency'. The town promptly went back to 30% unemployment. In 1934, social unrest exploded across Austria, which was followed by annexation four years later. 

The 1920s had already seen a scrip currency called the 'wara' in the German town of Schwanenkirchen. This saved the town's economy and kept a coal mine operating. The wara started circulating more widely and became part of the 'Freiwirtschaft' (Free Economy) movement, based on the ideas of Silvio Gesell. Central to Gesell's ideas was the use of a hoarding fee of the kind used in Wörgl (technically known as 'demurrage'). In 1936, the soundness of the idea was affirmed by Keynes in the General Theory of Employment, Interest and Money.

The most groundbreaking feature of demurrage is that it is intrinsically anti-inflationary. Whereas conventional currencies are progressively devalued by interest, anti-inflationary money steadily increases in value. As each monthly stamp is added, the value of the note effectively increases by the stamp amount. This is technically equivalent to a negative interest rate.

The present short-term focus of investments and lack of long-term vision are exacerbated by interest-driven currency devaluation. This reduces the financial appeal of longer-timescale projects. The use of a demurrage currency gives a rate of return simply lending out money. When money is repaid (remember these are non-interest currencies), it will have increased in value owing to the money saved by having avoided paying the monthly demurrage fees. This has the potential to enable investment in highly beneficial but economically marginal activities such as earth repair.

Recently, the Federal Reserve Bank of Cleveland has launched an economic commentary brief explaining how a stamp scrip plan would work in the US. In 1933 during the great depressesion, a US plan for the issue of Stamp Scrip was drawn up by Irving Fischer.
This article is a re-posting of  of a 2002 blog article originally posted by Laboratory Readings. It has undergone minor modification to the text. 

Wednesday, May 16, 2012

National Bank of Belgium: Liquidity Doesn't Always Cause Asset Bubbles

A 2007 empirical study by the National Bank of Belgium on the effects of excess liquidity finds that only under certain conditions does excess liquidity actually lead to an asset bubble. The idea that most high-cost booms are preceded by high money growth has been well elaborated by economic theory. However, this does not necessarily imply that all periods of excess liquidity signal an imminent asset price boom. In fact only 1/3 of all periods of excess liquidity analyzed by this empirical study lead to an asset bubble. It is a warning against naive monetary analysis.

The findings of this paper are that an asset price boom arises only under a combination of events. The conditions under which excess liquidity might lead to an asset price boom (a bubble), are when the period of excess liquidity is prolonged and is accompanied by strong real GDP growth, low inflation, and credit growth.

In looking at what this means for monetary policy, it means simply that central banks can afford to act without fearing the automatic rise of inflation or asset bubbles in reaction to any effort to improve sluggish economic growth. The threat of bubbles looms large when excess liquidity persists on the market for long periods, during episodes of strong economic growth. In looking at what it means for financial regulation, it means that asset price bubbles can also be prevented or possibly even dismantled by better regulating the credit markets.

Essentially, the results of this study confirm the conclusions outlined by the Quantity Theory of Money and by the Phillips Curve, albeit on a micro scale. That is, increases in liquidity might influence prices, but only after other avenues have been exhausted. Looking at the graph above, we can say that while at point B, we should feel confident in the usefulness of monetary action, without immediately worrying about price levels. We should not pretend that we are at point A when it simply isn't the case.  

This paper analyses the relationship between the prevailing liquidity conditions (such as measures of money, credit and interest rates) and developments in asset prices from a monetary analysis perspective. After having identified periods of sustained excess liquidity, we analyse under which conditions they are more likely to be followed by an asset price boom. The results from a descriptive analysis of the developments in a number of macroeconomic and financial variables suggest that periods of sustained excess liquidity that are accompanied by strong economic activity, low interest rates, high real credit growth and low inflation have a higher likelihood of being followed by an asset price boom. This conclusion is also confirmed by a logit analysis.
The National Bank of Belgium is Belgium's central bank and lender of last resort. It is part of the European System of Central Banks 

Friday, May 11, 2012

Hollande Wins French Elections
On Sunday May 6th, 2012, French voters chose François Hollande as their president for the coming five years. Voters responded strongly to campaign promises made on transparency, proportional representation, and competence-related issues.

French Economist Francois Cocquemas comments: 
Both the left-wing favorite, François Hollande, and the right-wing incumbent, Nicolas Sarkozy, promised higher taxes and controlled public spending. Both candidates aim to bring the public deficit back to equilibrium, disagreeing only on the time-frame. Both mostly refrained from costly, last-minute promises to rally the undecided. According to the pro-business think-tank Institut de l’entreprise, both programs are underfunded by a similar amount, €11bn to €12bn.

Their difference on economic matters seems largely limited to their plans for Europe: Mr Hollande wants to renegotiate the European Fiscal Stability Treaty, so it also promotes growth and not just government austerity, which is enough to make him “rather dangerous” in the eyes of the Economist. As the Financial Times’ Chief political commentator Philip Stephens rightly puts it, there’s no reason to fret:  
The influential Economist has declared on its front cover that Mr Hollande is “dangerous” – though, being British, it did add a qualifying “rather” to this disobliging epithet. The would-be president, the magazine observed, “genuinely believes in the need to create a fairer society”. Well, what could be more dangerous than that?
The influential Economist has declared on its front cover that Mr Hollande is “dangerous” – though, being British, it did add a qualifying “rather” to this disobliging epithet. The would-be president, the magazine observed, “genuinely believes in the need to create a fairer society”. Well, what could be more dangerous than that?

Be that as it may, Mr Hollande’s campaign has been soft-spoken in therms of social and economic justice rhetoric. Mr Sarkozy, on his side, has argued about the impossibility to renegotiate a signed treaty – shortly before threatening to suspend the Schengen agreement if nothing was done to fix “leaky Europe”. Mr Hollande, on the other hand, claims that other leaders in Europe are looking forward to his election, and that lines are already moving after ECB president Mario Draghi called for a growth compact alongside the fiscal compact.

Draghi, of course, is thinking of structural reforms promoting flexibility and mobility in the labour market, where Mr Hollande’s growth plans mostly entail increased investment, financed by eurobonds.
In fact, BBC has reported that far from the being economically "rather dangerous", Hollande's policies will not make have the negative effect on growth that many in the media are trumpeting.

What the Real Story is:
What is perhaps bigger news is the ideological shift across Europe as European voters reject austerity and pro-financial sector economic agendas in favor of parties backing pro-growth  economic policies. Almost simultaneously, there have been electoral shifts in Greece, France, and Germany, while the Dutch government fell over the austerity issue.
Francois Cocquemas holds a Master degree in finance from Sciences Po Paris and a joint Master degree in economics and public policy from Ecole Polytechnique, ENSAE and Sciences Po. He is currently doing  a PhD in finance at EDHEC Business School (École des Hautes Etudes Commerciales du Nord).

Sunday, May 6, 2012

We Need to Address Student Loans & Student Debt
Today, we have reinvented debt-bondage via the university system. In the US, the OECD country where tuition rates are the highest relative to median income, the cost of decent tertiary education often exceeds $100,000 for a bachelor's degree and $150,000 for a master's. Given actual income and salary figures for Americans with a bachelor-level education, this constitutes an unsustainably high price level for education. 

Even in the best of economic times when jobs are plentiful, young people with considerable debt burdens end up delaying life-cycle events such as buying a car, purchasing a home, getting married and having children.  

The Effect on our Society
The amount of student borrowing crossed the $100 billion threshold for the first time in 2010 and total outstanding loans and exceeded $1 trillion for the first time in 2011.   Essentially, students and workers are borrowing extraordinary amounts to cover the rising cost of university education.  In fact, Americans now owe more on student loans than on credit cards. Furthermore, the National Association of Consumer Bankruptcy Attorneys reports that 25% of student loan recipients who graduated in 2005 have gone delinquent on the loans at some point, while 15% have defaulted. With rising debt comes increased risk, both to borrowers and to the economy in general. 

For the economy, higher private indebtedness levels mean less consumer confidence  (and indeed, less consumption), increased dependence on the economic cycle, and increased vulnerability to economic crises, unemployment, or anything else troublesome. It also means that people will be doing less investing in both themselves (such as by seeking more education), and in the market (which might have generated more employment).

On the personal side, high indebtedness amounts to serfdom. Ever-increasing tuition costs relative to other costs will not only lead to fewer Americans graduating from university, but also to increased mortgaging of the future for those who do. Just as the housing bubble created a mortgage debt-burden that absorbed the income of consumers and rendered them unable to afford to engage in the consumer spending that sustains a growing economy, student loans are beginning to have the same effect, which will be a drag on the economy for the foreseeable future. What’s worse, Bush-era bankruptcy law reforms make student debt completely undischargeable under bankruptcy proceedings.

Accumulating student debt in middle age is even more problematic because there is less time to earn back the money. It may also mean facing retirement years still deeply in debt.  Furthermore, parents who take out loans for children or co-sign loans will find those loans more difficult to pay as they stop working and their incomes decline.



How we Should Treat the Issue?
We need to invest properly in the productivity and competitiveness of our nation. Investing in human capital secures dividends for our nation, our economy, and our society. Like most OECD countries, the US has an economy that depends on the knowledge-base of its human capital-driven service industry in order to be competitive on an international level. OECD and US research indicate that this trend will only get deeper in the future. The more we drag our feet on this issue, the further behind the US will get compared to countries like Japan, Korea, and Germany.

In order to address the situation, a two-pronged approach is best. On one hand, tuition costs should be mostly paid by taxpayers. The argument for this can be justified by the simple fact that most of the benefits of higher education actually accrue to society at large, rather than the student. This comes in the form of increased employment levels and international competitiveness, as well as lower incarceration rates and improved health. On the other hand, currently outstanding student debt should be drawn down as efficiently and quickly as possible. This should take place by means of statutory pro-debtor statutory changes, as well as interest rate caps, and stricter application of anti-predatory-lending principles.

A 2012 study by the US National Association of Consumer Bankruptcy Attorneys found that aside from the proportions of the student debt problem and its productivity-draining effects on our economy, the stability of US student-loan debt may become the next trouble spot on the financial markets. The study recommends statutory reforms including re-instating the dischargablilty of student debt, and improved oversight of private student lenders.

About the Author:
Max Berre is a financial sector regulatory economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.