The turmoil around Greece started two weeks ago when ECB board member Juergen Stark said that Greece should not expect the EU to bail it out if its public deficit becomes unbearable. Since then even ECB President Jean Claude Trichet echoed similar comments on the public finances of Greece.
At the moment Greece is looking for a way out, either autonomously, or through help via the IMF. So far plans worked out by the Greece government to reduce the fiscal deficit from -12% back below the Maastricht level of - 3% by 2013, are received negatively.
This scepticism has to do with the fact that Eurostat, the statistical data centre of the European Commission (EC), found out that Greece has been manipulating the budget data towards the EC between 2005 and 2009. In this respect chances of reducing the budget deficit on its own strength are less credible.
This makes the exit via IMF advisors more likely. IMF officials arrived in Athens last week and are looking at the situation. Previous emerging market crises teach us that such kind of visits often precede a full IMF assistance programme. In the current environment, we think the announcement of such a programme would force Greek spreads significantly lower, even if the amounts being offered by the IMF are relatively small.
For the ECB and EC the IMF solution would be a clean one as well. It would be a strong signal towards other member states such as Spain, Portugal, Italy and Belgium to get their finances back under control. If not they would risk the loss of sovereign control over their finances towards the IMF. A non-intervention by the ECB and/or EC would avoid a moral hazard as we know it in the banking system.
If the ECB and/or EC would act as lender of last resort, it would be a signal towards countries such as Spain etc. to loosen their fiscal discipline as they would be bailed out somewhere in the future anyway.
We believe that the chances of a EUR break up are very small. For both the strong EUR-zone members as for the vulnerable ones such as Greece this would be a lose-lose situation. For the stronger members it would raise the risk of contagion towards other member states, and this would put significant pressure on the EUR.
In such a scenario a drop of the EUR of 20-30%, which is a similar drop if one compares this with other FX EM crises, would not be unrealistic. This is the type of volatility that EUR members want to avoid by any means. It would give them temporarily an export advantage over the US, but the credit spreads for the EUR members to issue sovereign credit would widen substantially as well.
Exiting the EUR for a country like Greece would be even more disastrous. The country would undergo an extreme devaluation of its new Greek Drachme. This would then give short term benefits from an export perspective. This is a technique Italy applied on various occasions during the 1980s. However Greece has less revenue coming from export activities compared to Italy. It would though have a small revival impact on export and growth, which would temporarily diminish the debt issues and raise employment, all this via tax revenues.
However, they would very quickly be faced with a spiralling of wage inflation and domestic prices as well. This is the phenomenon that we have seen in countries like Argentina at the beginning of this decade.
All this makes an IMF solution more probable. As a consequence credit spreads would come in slightly, but we will keep on seeing a substantial divergence of spreads between Greece and the core countries of the EUR-zone.
Friday 22 January 2010
Monday 11 January 2010
Bernanke playing Pontius Pillatus
Dear readers,
Fed Chairman Ben Bernanke made surprising comments during a speech at the annual meeting of the American Economic Association. He argued that the link between the aggressive monetary policy after the burst of the dotcom bubble and the 9/11 events on the one hand, and the rise of real estate prices on the other was weak to non existent.
In other words he is denying that the zero-rate policy from his predecessor, Alan Greenspan, was not the driving force behind the build up of the US real estate asset bubble. To support his thesis, he argues that there were a number of countries that had tighter monetary restrictions but still faced an even greater housing bubble compared to the US.
He continued by saying that the use of Adjustable Rate Mortgages (ARM’s) and the lack of regulation prohibiting the sale of these products that was more to blame for blowing up a housing bubble.
There are three major arguments to counter Mr. Ben Bernanke’s thesis:
• Taylor Rule
• Euro zone project
• Financial innovation versus regulation
A. The Taylor Rule
Lat year we already wrote about the Taylor rule. In the early 1970s professor John Taylor developed a model that could determine the appropriate level for (nominal) interest rates based upon the difference between real GDP and potential GDP, often called the GDP GAP.
Apart from the issues that we raised regarding the application of the Taylor rule in the current economic environment, the rule is up to a certain level a reliable tool for central banks to analyse their monetary policy.
Although a proactive/forward looking central bank will concentrate on a variety of macro economic leading indicators instead of examining the realized or expected inflation gap. Nevertheless as a back testing tool the Taylor rule gives reliable results on appropriateness of monetary policies.
Applying this over the period 2002-2005, the Taylor rule shows that the Fed’s monetary policy was too aggressive. Figure 1 shows where Fed fund rates should have been corresponding with 0,1,2,3 or 4% of inflation. Over the period Jan 2002 – Jan 2005 the average US inflation rate was 2.18%. As the chart indicates, Fed fund rates were well below the level what the Taylor rule teaches us (calculations are based upon analysis from the Fed of St. Louis).
Figure 1 Federal Fund Rates based on Taylor’s rule
Source: Federal Reserve of St. Louis
The chart also confirms the fundamental problem that central banks are coping with, i.e. the mismatch in timing of monetary policy versus economic growth. If one compares the change in federal fund rates with the average growth rate in GDP terms during the previous two years one gets a clear view of the overshooting of monetary policy of the Fed (Figure 2).
Figure 2: US 2 Year Nominal GDP Growth versus Fed Fund Rates 1960 – 2008 (1)
Source: Bloomberg Data
Figure 2 also illustrates that the Fed, but this can be generalised to any other central bank, is only catching up periods of economic recovery, but due to its slow response it is paving the way of a next crisis. In other words interventions by central banks can are akin to a pendulum swinging from one extreme to another.
The major reason forl this is because central banks focus not enough on asset price developments. Not only the Fed failed stumbled over this over the years. Another good example is the Bank of Japan that failed to acknowledge the build up of an asset bubble in its economy as well during the late eighties. This triggered the Lost Decade of Japan with deflation continually hampering a sustained economic recovery.
This is a first argument against Chairman Ben Bernanke’s effort in downplaying the role of the Federal Reserve in the US housing crisis.
B. Euro zone project
Then, there is the argument from the Fed Chairman that there were also countries that had tighter monetary restrictions but still faced an even greater housing bubble compared to the US.
It is true that in Spain and/or Ireland, two countries that suffered greatly in the housing crash, interest rates were higher than in the US. However one should not forget that these countries are part of a monetary (EUR) zone where interest rates are set for the whole region. Especially countries like Spain and Ireland were struggling right from the start with an overheating economy, as interest rates set by the ECB were far too low for their domestic economies.
This was inherent in the EUR project where the ECB had to apply a “one size fits all” monetary policy. Nevertheless it is highly unlikely that an independent central bank of Ireland would have kept interest rates that low. Bear in mind that during 2000 Irish inflation ran up to almost 7%. A lose monetary policy (for Ireland) set by the ECB led to cheap Irish credit and consequentially to a real estate bubble. A similar phenomenon was observed in Spain.
This weakens Mr. Bernanke’s thesis further.
C. Financial innovation versus regulation
Last but not least ARM’s and other inventive mortgage products are blamed for the housing bubble. It would be more correct to argue that these products contributed in part to the inflation of house prices, nevertheless the source of the problem remained too much money chasing too few goods.
Hyman Minsky already described the phenomenon of increased financial innovation and deregulation at the end of a business cycle. ARM’s and other products were simply a sign of the times. Even without these products the housing bubble would have been continuously fed via more conventional mortgage products. If money is available for free and on top of that there is the dogmatic conviction amongst house buyers that prices will only ever go up, the end result is a drop in lending standards and asset price inflation.
It is naïve to believe that regulators could have prevented the negative fall out of excess cheap credit by restricting exotic financial instruments. It is like using garden tools in the kitchen. Furthermore regulatory bodies can not regulate as fast as financial institutions innovate. Also, one should not forget that financial institutions are more pushed towards financial innovation (in creating cheap money) when rates are high. That was not the case when banks started to introduce these ARM’s. Rates were very close to zero at the time they were introduced.
In this respect the arguments Mr. Bernanke is raising in playing down the role of the Fed in the build up of this crisis are weak. Certainly there were perhaps 10.12 different key factors, all interacting together over a period of time, that created the crash. For example the role of the US government should not be forgotten. Indirectly via its government sponsored enterprises (GSE’s), Fannie Mae and Freddie Mac, it supported the mortgage-backed securities market and encouraged risk taking.
Nevertheless central banks carry a huge responsibility and as long as they will not start paying attention to asset price developments they risk staying behind the curve and fueling the flames of the next crisis.
(1) Also see Brian S Wesburry “ A US Addiction to Easy Money “, Oct 1994 Journal of Commerce and Gerald O’ Driscoll Jr. ”Asset Bubbles and their Consequences”, May 2008, Cato Institute
Fed Chairman Ben Bernanke made surprising comments during a speech at the annual meeting of the American Economic Association. He argued that the link between the aggressive monetary policy after the burst of the dotcom bubble and the 9/11 events on the one hand, and the rise of real estate prices on the other was weak to non existent.
In other words he is denying that the zero-rate policy from his predecessor, Alan Greenspan, was not the driving force behind the build up of the US real estate asset bubble. To support his thesis, he argues that there were a number of countries that had tighter monetary restrictions but still faced an even greater housing bubble compared to the US.
He continued by saying that the use of Adjustable Rate Mortgages (ARM’s) and the lack of regulation prohibiting the sale of these products that was more to blame for blowing up a housing bubble.
There are three major arguments to counter Mr. Ben Bernanke’s thesis:
• Taylor Rule
• Euro zone project
• Financial innovation versus regulation
A. The Taylor Rule
Lat year we already wrote about the Taylor rule. In the early 1970s professor John Taylor developed a model that could determine the appropriate level for (nominal) interest rates based upon the difference between real GDP and potential GDP, often called the GDP GAP.
Apart from the issues that we raised regarding the application of the Taylor rule in the current economic environment, the rule is up to a certain level a reliable tool for central banks to analyse their monetary policy.
Although a proactive/forward looking central bank will concentrate on a variety of macro economic leading indicators instead of examining the realized or expected inflation gap. Nevertheless as a back testing tool the Taylor rule gives reliable results on appropriateness of monetary policies.
Applying this over the period 2002-2005, the Taylor rule shows that the Fed’s monetary policy was too aggressive. Figure 1 shows where Fed fund rates should have been corresponding with 0,1,2,3 or 4% of inflation. Over the period Jan 2002 – Jan 2005 the average US inflation rate was 2.18%. As the chart indicates, Fed fund rates were well below the level what the Taylor rule teaches us (calculations are based upon analysis from the Fed of St. Louis).
Figure 1 Federal Fund Rates based on Taylor’s rule
Source: Federal Reserve of St. Louis
The chart also confirms the fundamental problem that central banks are coping with, i.e. the mismatch in timing of monetary policy versus economic growth. If one compares the change in federal fund rates with the average growth rate in GDP terms during the previous two years one gets a clear view of the overshooting of monetary policy of the Fed (Figure 2).
Figure 2: US 2 Year Nominal GDP Growth versus Fed Fund Rates 1960 – 2008 (1)
Source: Bloomberg Data
Figure 2 also illustrates that the Fed, but this can be generalised to any other central bank, is only catching up periods of economic recovery, but due to its slow response it is paving the way of a next crisis. In other words interventions by central banks can are akin to a pendulum swinging from one extreme to another.
The major reason forl this is because central banks focus not enough on asset price developments. Not only the Fed failed stumbled over this over the years. Another good example is the Bank of Japan that failed to acknowledge the build up of an asset bubble in its economy as well during the late eighties. This triggered the Lost Decade of Japan with deflation continually hampering a sustained economic recovery.
This is a first argument against Chairman Ben Bernanke’s effort in downplaying the role of the Federal Reserve in the US housing crisis.
B. Euro zone project
Then, there is the argument from the Fed Chairman that there were also countries that had tighter monetary restrictions but still faced an even greater housing bubble compared to the US.
It is true that in Spain and/or Ireland, two countries that suffered greatly in the housing crash, interest rates were higher than in the US. However one should not forget that these countries are part of a monetary (EUR) zone where interest rates are set for the whole region. Especially countries like Spain and Ireland were struggling right from the start with an overheating economy, as interest rates set by the ECB were far too low for their domestic economies.
This was inherent in the EUR project where the ECB had to apply a “one size fits all” monetary policy. Nevertheless it is highly unlikely that an independent central bank of Ireland would have kept interest rates that low. Bear in mind that during 2000 Irish inflation ran up to almost 7%. A lose monetary policy (for Ireland) set by the ECB led to cheap Irish credit and consequentially to a real estate bubble. A similar phenomenon was observed in Spain.
This weakens Mr. Bernanke’s thesis further.
C. Financial innovation versus regulation
Last but not least ARM’s and other inventive mortgage products are blamed for the housing bubble. It would be more correct to argue that these products contributed in part to the inflation of house prices, nevertheless the source of the problem remained too much money chasing too few goods.
Hyman Minsky already described the phenomenon of increased financial innovation and deregulation at the end of a business cycle. ARM’s and other products were simply a sign of the times. Even without these products the housing bubble would have been continuously fed via more conventional mortgage products. If money is available for free and on top of that there is the dogmatic conviction amongst house buyers that prices will only ever go up, the end result is a drop in lending standards and asset price inflation.
It is naïve to believe that regulators could have prevented the negative fall out of excess cheap credit by restricting exotic financial instruments. It is like using garden tools in the kitchen. Furthermore regulatory bodies can not regulate as fast as financial institutions innovate. Also, one should not forget that financial institutions are more pushed towards financial innovation (in creating cheap money) when rates are high. That was not the case when banks started to introduce these ARM’s. Rates were very close to zero at the time they were introduced.
In this respect the arguments Mr. Bernanke is raising in playing down the role of the Fed in the build up of this crisis are weak. Certainly there were perhaps 10.12 different key factors, all interacting together over a period of time, that created the crash. For example the role of the US government should not be forgotten. Indirectly via its government sponsored enterprises (GSE’s), Fannie Mae and Freddie Mac, it supported the mortgage-backed securities market and encouraged risk taking.
Nevertheless central banks carry a huge responsibility and as long as they will not start paying attention to asset price developments they risk staying behind the curve and fueling the flames of the next crisis.
(1) Also see Brian S Wesburry “ A US Addiction to Easy Money “, Oct 1994 Journal of Commerce and Gerald O’ Driscoll Jr. ”Asset Bubbles and their Consequences”, May 2008, Cato Institute
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