ECB Swings into Action - Markets Jump Accordingly

http://www.bbc.co.uk/news/business-19499950

http://www.nytimes.com/reuters/2012/09/06/business/06reuters-ecb-eurozone-seniority.html?_r=1&smid=re-share

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.

http://www.telegraph.co.uk/finance/comment/9531764/Carthaginian-terms-for-Italy-and-Spain-threaten-Draghi-bond-plan.html

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. 

http://www.reuters.com/article/2012/09/06/us-markets-stocks-idUSBRE88308620120906

http://www.bbc.co.uk/news/business-19516323 

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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. 

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

http://www.npr.org/blogs/alltechconsidered/2012/07/16/156839153/in-q-tel-the-cias-tax-funded-player-in-silicon-valley

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

http://web.mit.edu/ipc/publications/pdf/02-004.pdf
https://ipc.mit.edu/sites/default/files/documents/04-006.pdf
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. 

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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.

Krugman and Layard Launch Manifesto for Economic Sense

http://www.manifestoforeconomicsense.org/A-MANIFESTO-FOR-ECONOMIC-SENSE.pdf

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. 

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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. 

For China, Trade is not Simply About FDI

http://www.hiebs.hku.hk/events_updates/pdf/tongyueting.pdf

https://commons.ln.edu.hk/cgi/viewcontent.cgi?article=3522&context=sw_master 

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.

Abstract

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.

How Portugal Found Itself in Crisis

Despite Being a Well-Managed Economy
NY Times Article on Crisis in Portugal

2011 IMF Country Report 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. 

Official Government Economic Figures

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?”
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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. 

ECB Study: Lack of Crisis Response Causing Contagion in Europe

Empirical Study on European Sovereign Spillover Risk

http://www.ecb.int/pub/pdf/scpwps/ecbwp1419.pdf

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.

Abstract

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.

http://www.ecb.int/pub/pdf/scpwps/ecbwp1419.pdf

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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. 

The Economist Scolds Merkel's Obstructionism

http://www.economist.com/node/21556577

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.  

http://www.economist.com/node/21556577 

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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.