27/11/2009: The euro's strength is its weakness

Spare a thought for the late Willem Duisenberg, first President of the European Central Bank. He was mocked during his tenure not only for his spectacular hair but also for his numerous gaffes, which, given the skepticism that greeted the single European currency at its launch in 1999, did little to inspire confidence.

He surely would be proud now, because the euro is stronger than ever. Starting at around 1.18 against the dollar in 1990, the euro slid near to 0.80. But today, at over 1.50, it is roughly 20% overvalued against the greenback.

Yes, after initial doubts, the euro is a success. But let’s be honest: it is much more the child of the mighty German mark than of the jittery Italian lira. It has proven itself an anchor of stability during the financial crisis, even keeping a euro-in country, Ireland, from the bankruptcy and depression that was the fate of a euro-out country, namely Iceland. And in the aftermath of the crisis, many battered Eastern European countries seem to recognize that giving up their sovereign minted currencies is not such a bad idea. Or is it?

One doubt often expressed about the euro centers on the heterogeneous mix of countries using it. At the one extreme stands rock-solid Germany, still exporting successfully and offering real competition to the workshops of Asia on the world market. At the other end teeters profligate Greece, whose government debt, already exceeding 100% of GDP this year, is heading for very thin air at over 130% during the next two years, according to European Union estimates. Can it really make sense that such opposites coexist in one currency union?

Actually, yes. Even though Germany might consider the southern European countries a drag on overall European finances, and even though the exports of laggards like Greece are seriously impaired by the euro’s strength, we think both countries will stick to the euro.

Consider: if the Germans would opt out, their new currency would skyrocket against the euro (estimates range between 20 and 30%). This would price German exports out of the markets they have fought so hard to win, ultimately leading to an economic depression. And if Greece were to abandon the euro, its new currency would depreciate drastically versus the euro, briskly driving Greece to default on its debt, which, after all, would still be in very expensive euro.

So despite its heterogeneity, the Eurozone is what Germans would call a Schicksalsgemeinschaft, a community joined by a common fate. Hence, the risk of the Eurozone falling apart, as some investors especially from beyond its borders believe, is relatively low. However, there is a caveat: If a country like Greece were actually to default, opting-out could then become a very appealing choice, since it could reset the country’s finances.

This leads to two conclusions. First, regarding their public finances, all Eurozone governments have moral hazard. They know that the threat of exiting the euro would spur other member states to help them if they were near to default. Second, although it is probably the most independent central bank in the world, the ECB does have its limits. If its strong-euro policy threatened to bring on deflationary tendencies that moved one or more member states to default, this could well put the euro at risk. So the common currency has something in common with mythological creatures: its great strength also contains the seeds of its potential destruction.

26/11/2009: The inconvenient truth about Chinese-American trade

"Today millions of Americans are out of work because the Chinese are manipulating their currency." US Senator Charles Schumer’s blunt statement has an obvious, seductive logic. If China would let it float freely, its currency would surely appreciate sharply versus the dollar, driving down the prices of US exports to China and elsewhere. US firms would thrive and jobs would be plentiful.

What a happy ending! And hence the growing chorus in the US calling for trade sanctions on Chinese products if Beijing refuses to stop controlling the value of its currency.

But we have been down this road before and what an ugly trip it was. Raising import tariffs on over 20,000 items, the Smoot-Hawley Tariff Act of 1930 also aimed at protecting US jobs. Today, historians and economists agree that Smoot-Hawley merely amplified the Great Depression’s misery, since America’s trading partners retaliated with tariffs of their own, to everyone’s detriment.

The prospects for protectionism are even worse today. Just imagine that the Chinese authorities would agree to let their currency free-float. Yes, China’s exports to the US would grow more expensive for Americans while America’s exports to China would be cheaper. So far, so good.

Now comes the really nasty bit: the US would probably still import much the same amount of goods from China as now, but would simply have to pay a higher price. Why? Because most Chinese exports to the US are simply no longer produced in America. And, just to be clear, the Chinese didn’t "steal" US jobs. Those jobs were already long gone before the Chinese export wave landed on US shores. In this regard, China competes more with Mexico and other emerging markets than with America.

So no big job relief from updating Smoot-Hawley. But the picture grows even uglier if we contemplate what a free-float would mean for US Treasuries. Suddenly, as their relative value plummeted, one of their biggest buyers, China, would probably simply stop buying these securities. They might even opt to sell some of their two trillion US dollar reserves. Given the swelling ocean of US debt issuance thanks to growing government deficits, reduced demand for Treasuries from a primary buyer would put enormous pressure on the price of these bonds while sending interest rates skyward. Not at all a formula for a jobs recovery!

With the US economy still shaky, it could definitely not afford such a development. Echoing Senator Schumer, but with a crucial twist, we would have to say, "Tomorrow millions more Americans might be out of work if the Chinese were to stop manipulating their currency."

19/11/2009: What is money worth, if anything?

Andy Warhol’s silkscreen “200 One Dollar Bills” just sold for 43.8 million US dollars at Sotheby’s in New York. This is good news because the fact alone that people are buying again art in a big way, shows that yes, the financial crisis might be over. But it leaves also a bittersweet feeling with regards to the vanishing value of money. Accounting for the actual inflation, 200 US dollar in 1962, had the purchasing power of 1,400 US dollars of today. The US inflation multiplied prices by seven in the last forty-seven years, an average yearly inflation rate of 4.2%.

To reach 43.8 million dollars with 200 dollars of 1962, of course real one and not the ones painted by the founder of pop art, one would have needed an average yearly inflation of 29.9%. This number might seem excessive at first but it wouldn’t even qualify to be considered as “hyperinflation”. Between 1983 and 1992 Argentina, experienced a yearly inflation of 70%.

Prices for art are going up again but so do prices for every other major assets. A client asked me a couple of days ago, whether emerging market equities could be considered as the next asset bubble. Why not? But looking at the returns since March 2009 one could currently equally make this case for commodities, government bonds, global equities, or gold. Everything is just going up. The high correlation of asset prices spotted during the financial crisis and the crash last year hasn’t vanished at all.

One can find a fitting story for each asset class. Equities are up because, we ultimately didn’t experienced the end of the world as we know it. Moreover company profits have surprised and are continuing to surprise positively, and so does the economy. Government bonds are up, because actually we aren’t out of the woods when it comes to assess the credit crunch. There is still the risk of sliding in a Japanese-like lost decade, during which, Japanese Government Bonds were the only Japanese asset actually performing. Gold is up, because confronted with the huge liquidity creation of central banks and the abysmal debt creation of governments, inflation might become a serious issue going forward.

Given the multiple and contradictory stories around, paradoxically despite the extraordinarily high correlation of asset prices the best strategy remains to be broadly diversified and not necessarily only focus on one possible view of the world. What all the current stories have in common is the fact that the value of money, expressed in asset prices is shrinking. If this were to continue the next asset bubble would be plain and simple: assets.

13/11/2009: The Fed's trouble with bubbles

Not only have we suffered a grave financial crisis over the past year-and-a-half; we also have a crisis in economic theory, particularly regarding the role of central banks. Back in the simpler world of 2007, the mission statement for central banks consisted of “inflation-targeting.” Their principle tool was interest rate policy.

Ben Bernanke, the current Fed president and former Princeton economics professor, has been a very strong advocate of inflation-targeting. He edited a tome on the subject in 2001 with Columbia’s Frederic Mishkin, who was a Fed governor from 2006, when Bernanke became president, until in 2008.

But there were a few dissenting voices before the financial crisis. They came mainly from the so-called Austrian School, named in honor of economists Ludwig von Mises and Friederich Hayek. They argued that by focusing only on inflation, defined as an increase in consumer prices, central banks risked conducting overly expansive monetary policies that could easily lead to asset price bubbles. The tech and housing bubbles of the past decade did not lower the Austrian School’s credibility, it must be said.

Before the housing bubble burst, central bankers, especially those of the Fed, countered the Austrians’ critique by saying that bubbles cannot be recognized until they burst. In the words of former Fed President Alan Greenspan, “If markets can’t recognize bubbles, neither can regulators.” But were they even looking, or did they simply ignore bubbles?

Reviewing Iceland’s economy in 2006, Mishkin wrote, “The analysis in our study suggests that although Iceland’s economy does have some imbalances that will eventually be reversed, financial fragility is currently not a problem, and the likelihood of a financial meltdown is low.” Was this analysis, in the clinical, scientific sense of the word, or was it wishful thinking? Iceland made news shortly after Mishkin’s rosy prognosis, as its banking system essentially failed.

Obviously, recent financial traumas have led central bankers to review their inflation-targeting paradigm. They now acknowledge that if the US housing bubble had been on the Fed’s radar, the catastrophes of 2008 might have been avoided. This is good to hear, but we think the Fed still has some troubles with bubbles.

In an op-ed piece in the Financial Times on 10 November entitled, “Not all bubbles present a risk to the economy,” Mishkin offered a glimpse into the Fed’s mindset perhaps. He distinguishes between two sorts of bubbles, the dangerous “credit boom” types and the benign “irrational exuberance” bubbles. The former can threaten the entire banking system so they demand action by central banks. But the latter should be free to swell until they burst, in Mishkin’s view, because they “do not present the same dangers to the economy as credit boom bubbles.” Finally, he argues, bubbles of exuberance should be tolerated because bursting them early, through policy actions or publicity, would lead “to much weaker economic growth than is warranted.”

Hence, grappling with the housing bubble would have been wise, but the tech bubble should not have been impeded. Mishkin thinks the tech bubble’s harmless nature explains why, when it burst, it “was only followed by a relatively mild recession.” Right.

We think this is a rather bold, even fantastical, interpretation of recent economic history. The US recession in 2000-2001 could, and probably should, have been much worse. The Fed only contained its consequences by inflating the mother of all credit bubbles, whose puncture plagues us today.

Mishkin’s dual (or double-bubble) approach leads him to conclude that “tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture.” I once read that history was “written by the winners.” We can only hope that policymakers and central bankers now see that controlling bubbles of all sorts is indeed an important mandate.

05/11/2009: Professor Laffer goes to Germany

In 1974, on what was to become one of the most famous napkins in economic history, a young professor from Chicago, Arthur Laffer, sketched a statistical curve for Dick Cheney, then Deputy White House Chief of Staff, hoping to convince President Gerald Ford not to increase income taxes by another 5%.

The Laffer Curve, as it is now known, argues that raising taxes does not necessarily increase tax revenues. There is a tipping point in tax rates beyond which tax revenues actually diminish. Setting taxes too high creates a disincentive to earning, since the government simply takes a bigger bite of the income. Laffer’s idea was hardly new; no less than John Maynard Keynes once expressed a similar view. Indeed, the concept dates back at least to the great 14th century Arab scholar Ibn Khaldun.

While President Ford didn’t embrace the Laffer curve, it found more sympathy with advocates of what came to be known as supply-side economics or Reaganomics, after the fortieth US president. It never really went away but it was revived with gusto by the forty-third president, George W. Bush. US supply-siders argued that cutting taxes would increase tax revenues as all that untaxed income “trickled down” through the economy, raising incomes and, thus, tax revenues. But this never really happened. While the overall US economy grew robustly in the late 1980s – and some of that growth can fairly be attributed to tax cuts – it was not revenues but rather the government’s deficits that increased, and to dizzying heights.

There are several reasons why lower taxes failed to boost tax revenues. For one, the marginal tax rate in the US was already below the tipping-point tax rate. Hence, lowering it only led to lower revenues. A more subtle reason was given by another young conservative Chicago economist, Robert Barro. In an important paper, also published in 1974, he argued that people don’t see much difference between taxation and government debt because they know intuitively that today’s deficits are tomorrow’s higher taxes. When tax cuts only increase the government’s deficit, households and companies will not change their behavior. So if you want tax cuts to really have an impact, you also have to cut government expenditures.

Most economists today dismiss the Laffer Curve, and Reaganomics, given the poor results of both. Nevertheless, these ideas still resonate with many politicians. Lately, the German government has sought to justify its bold, new tax cuts along those lines. While we wish them every possible success, we are deeply skeptical. It remains to be seen whether Germany’s marginal tax rate exceeds the tipping point. Moreover, given Germany’s popular distaste for big government deficits, Barro’s argument is even more likely to apply there than in the US.