26/02/2010: Successful exporters shouldn’t be stingy

In our globalized world, the recipe for a "successful" economy is well known. If a country wants to enjoy rapid economic growth and avoid high unemployment, it has to be competitive, which is best achieved by keeping labor costs low and boosting labor productivity. If a country can do this better than its competitors, its exports will soar. The downside to this export success, however, is that it will cause the country's currency to appreciate.

To avoid this, a successful exporting country can peg its currency to the currency of one of its main trading partners, but this also has knock-on effects. It leads to trade imbalances where the "pegging country" (with an undervalued currency) enjoys a structural trade surplus while the country whose currency is pegged (and hence overvalued) is saddled with a structural trade deficit that it has to find a way to finance.

If the "pegged country" does not have sufficient domestic savings to rely on, it has to indebt itself by borrowing. But who would lend to such a country? The answer is plain and simple: the country that does not want to let its currency appreciate (the pegging country). In other words, if a country wants to prevent its currency from appreciating in order to retain its export competitiveness, it needs to buy foreign currency, usually by buying debt.

This is how the symbiosis between China and the United States has worked over the last decade: the US “living beyond its means” and indebting itself and China accumulating an immense amount of foreign exchange reserves, which is now significantly over USD 2 trillion and mainly made up of US government debt. This rise of “Chinamerica” has been widely noted, but less attention has been paid to the fact that the European Monetary Union is operating along exactly the same lines.

In Europe, one country (Germany) has been trying to maintain its competitive edge by increasing productivity and moderating labor costs. Unit labor costs (labor costs corrected for productivity increases) have barely moved in Germany since the introduction of the euro. Meanwhile, the PIIGS countries (PIIGS being the not so respectful acronym for Portugal, Ireland, Italy, Greece and Spain) have seen their unit labor costs increase quite significantly, leading to dramatic losses of competitiveness.

Before the introduction of the euro, such disequilibrium would have been corrected via exchange rates. The deutsche mark would have appreciated at the expense of the Greek drachma, the Irish punt, the Spanish peseta, the Portuguese escudo and the Italian lira.

Based on unit labor costs statistics from the Organization of Economic Cooperation and Development (OECD), one can infer that, if the euro did not exist, the PIIGS currencies would have depreciated by roughly 20% over the last ten years compared with the German currency. Even a country like France would have seen its currency depreciate 10% against the deutsche mark.

With a common European currency, of course, this is no longer possible. As a consequence, the German trade surplus increases year after year, mirroring the deepening of the trade deficits in the PIIGS countries. Therefore, we should not be surprised that the debt of a country like Greece expands. What we should wonder about, however, is the reaction of some Europeans, especially German politicians, who seem to be puzzled by the profligacy of the PIIGS countries and are now finger-pointing, delivering moralistic lessons on the virtues of austerity.

They should be careful what they wish for. German politicians cannot boast about Germany being the “Exportweltmeister” while at the same time asking their main trading partners to save money. Any imposed frugality on Greece and other profligate nations could well backfire on those countries that place so much esteem on competitiveness.

18/02/2010: Some Canadian wisdom

When assessing the dismal fiscal situations of governments around the globe, the more pessimistic among us may tend toward the view that nothing can be done and ultimately everything will end in default, debasement of currencies and inflation. We economists, being dismal scientists, tend to be particularly grim in this exercise.

Even worse, if we are trained in a Chicago or Austrian tradition, which ultimately sees all the bad things coming from the government, we will not only be grim but also very cynical. Politicians can often only be moved by self-interest and the willingness to be reelected at any cost. Hence, enforcing tough measures to preserve a country from default is not a likely scenario. However, historical precedents have shown that becoming frugal not only can be done, but can even lead to reelection of the government implementing such measures.

In 1993 the Canadian fiscal situation was hopeless. According to OECD data, the government debt to GDP ratio in Canada was at 96% (it would cross the 100% ratio two years later) while the public deficit was hovering around 9% of GDP. The newly elected government inherited basically an “all but bankrupt” country. But within five years, by systematically reducing government expenditures, it managed a spectacular turnaround from deficits to surpluses, which would actually last for almost a decade, reducing the Canadian public debt from over 100% to roughly 60% of GDP. On a side note: this Canadian government got reelected twice (in 1997 and then again in 2000).

In a recent talk reported in the UK newspaper, The Guardian, former Canadian Prime Minister Paul Martin, who was Finance Minister in the mid-1990s and hence one of the main architects of this turnaround, explained one crucial element behind its success: “Cuts in government hurt people. If they are made by a government, whose only goal is to make the bankers happy, they will never be acceptable. Deficit elimination must be seen to be essential to people’s wellbeing. It will not be supported because of arcane economic theory or simply because business calls for it. Our message was not that servicing the public debt was crowding out private sector investment; it was that the servicing of excessive public sector debt was crowding out needed social programs: health care, education and child welfare.”

No one should be so naïve to believe that the Canadian story’s happy ending is the usual outcome, but no one should be so pessimistic either to think that any effort to correct a hopeless fiscal situation is doomed to failure. What it takes is courage from politicians to do something about it, and a narrative for the broader public that not only focuses on technicalities like Maastricht criteria but also on the fact that taxes should have a better use than just servicing public debt.

12/02/2010: Fears, not fundamentals, are ruling the market

The strong correction in bonds and equities in the last two weeks has put a dampener on the spectacular rally the market had experienced since March last year. This raises the question of whether the sell-off is simply a breather from the prolonged liquidity-driven momentum, or the start of something deeper given the rise of new market concerns.

We do not deny that 2010 will be bumpy for investors, but all indicators point to the correction being driven by fears, not fundamentals. There is no evidence of major headwinds impeding the ongoing recovery as business-cycle figures point up, central banks are still providing ample liquidity, credit markets are continuing to thaw, and corporate earnings are still surprising positively.

In our view, the three major fears casting gloom on the market – tighter financial regulation, central banks’ “exit” strategies and tightening, and doubts about the fiscal sustainability of some sovereigns – are overblown. We do not view the recent sell-off as the return of the bear market that triggered the rout in 2008 and early 2009.

While we can expect some new banking regulations in the United States, the proposals under the so-called “Volcker Rule” are politically unrealistic and unlikely to pass in their present form. While China’s monetary tightening came sooner than expected, it was the right move to stabilize its long-term economic growth. Similar stimulus-exit measures by other central banks should be viewed not as outright tightening but as signs of normalcy in the economy.

To be sure, the most recent source of investor anxiety – the dismal fiscal situation in Greece and other European countries – is unsettling. But it also has to be taken in context. The small size of Greece does not justify the market’s overreaction, especially considering that Japan, the UK and the US are also confronted with massive debts and questions on their fiscal sustainability.

Amid the noise, investors need to distinguish between fundamentals and special factors as drivers of their decisions. With fundamentals still in line with market expectations, the global recovery led by the emerging markets should remain the overriding investment theme, and special factors such as what have triggered the recent correction can be viewed as a buying window for the risk-tolerant investor.

When the dust settles, the investment horizon should remain the same: floating-rate notes should be preferable to long-term government bonds, investment-grade and high-yield corporate bonds should remain attractive, the energy sector should still outperform, and European and emerging market equities should deliver solid returns. Along the way, investors can take advantage of the dollar’s strength versus the euro, but only briefly – the dollar should remain weak in the long run.

04/02/2010: Fearing the Greeks, but not only them

Having followed the ups and downs of the financial markets for over 15 years now, I have come to the sobering conclusion that, rather than reason, fad and storytelling are what really matter. The latest example is Greece and its debt, which may or may not cause government bond markets to go into a tailspin and which even calls into question the existence of the euro.

Greece, once the beacon of western civilization and founder of the Olympic Games, with a population of 11 million, and roughly the size of a city like Rio de Janeiro, will have an estimated debt-to-GDP ratio of 120% in 2010, and a public deficit of EUR 26 billion (around 10% of its GDP). EUR 26 billion, or USD 36.4 billion, is roughly the US government deficit for a week. How come therefore that many market participants echo the Roman poet Virgil: “fear the Greeks”?

The scenario goes something like this: once Greece defaults, the next shoe to drop in the so-called 'PIIGS' universe (a rather disrespectful acronym for Portugal, Ireland, Italy, Greece and Spain), will be Portugal. And once the frenzy reaches the larger countries like Spain or Italy, the days of the euro will be numbered. Although it has some appeal, and one could even draw a parallel with the 2008 situation (five Wall Street investment banks at risk then, and five European countries at risk now), there are several objections to this scenario.

Our first objection relates to the PIIGS concept itself. Currently many market participants are stressing Italy's “unbearable” debt-to-GDP ratio of over 100%. What is often forgotten though is that this has been the case for Italy for much of the last 20 years. In fact, for much of this period, Belgium had an even larger debt-to-GDP ratio, and there is currently no 'B' in the 'PIIGS'. Spain, which is another country, perceived as a major risk, has a debt-to-GDP ratio that is still far lower than that of the US or the UK; not to mention that of Japan.

Our second objection relates to the nature of the euro itself. If only market participants and economists would have had a say on the common currency, it would likely never have come into existence in the first place. However, the euro is, first and foremost, a political project, which so far has proven all its critics and doubters wrong. Although that does not in itself mean that the euro’s stability, or even its future, is assured. However, we believe that solving the Greek debt crisis is primarily a political issue. Hence, where there is a political will, there is a way.

Unless European politicians are willing to destroy, what has been painfully built in Europe over the last twenty years, they will not let Greece fail. One might argue that there is a moral hazard here and such a rescue would incentivize governments of other countries to act in a profligate way, ultimately hollowing out the European Monetary Union Stability Pact. We need to bear in mind though that even with an implicit guarantee of financial more solid European governments, the interest rates of profligate countries will remain higher. Moreover, the memory of Lehman Brothers, which was not rescued for exactly this moral hazard argument, and the costs following its bankruptcy are still vivid in Europe.

All in all, the concerns surrounding Greece and other countries' sovereign debt illustrates how odd the government bond market currently is and how artificially low interest rates are. Once the focus of market participants moves from Greece and the 'PIIGS' countries, where will it turn to next? To the UK? To Japan? Or even to the US?