30/06/2010: Taking sides

As football’s World Cup enters its decisive phase and its organizers debate whether refereeing should finally enter the twenty-first century, weightier international clashes revolve around a fundamental economic question: “What should be done to assure growth and stability roughly two years after the financial crisis?”

At the G20 in Toronto last week, the world's economic leaders were more or less split into two teams:

Team Keynes, led by the US, argues that the recovery is still fragile and that further government stimulus is needed to ensure its sustainability. Public deficits are of course a concern but as long as the recovery is only tentative, lasting improvements in government budgets are anyway a long way off.

Team Austerity, led by Germany and – newly – the UK, with France, as usual being ambiguous, are convinced that as long as public deficits remain so high, the confidence of financial markets in government credit and in a sustainable recovery cannot be restored. They believe that taming public finances should be the foremost priority of governments.

The debate itself is not new. It has haunted economists at least since Roosevelt’s New Deal and the publication of Keynes’ "General Theory." Today, once again, economists are asked to take sides.

As a policy approach aimed at softening the effects of business cycle fluctuations, Keynesianism fell out of fashion in the 1970s. But challenging times have restored Lord Keynes’ credibility as governments struggle to fend off an economic depression. Among today’s loudest Keynesians is 2008 economic Nobel Prize winner Paul Krugman. In his New York Times columns, he paints a relentlessly bleak picture of the future if governments turn stingy. He has even gone so far as to suggest that the US government retaliate with protectionist measures if Germany continues to reject fiscal profligacy and in so doing, runs the argument, harming US exporters.

Krugman won his Nobel laurels for his academic work in trade theory and he characterizes himself as an expert on the Great Depression. This makes his recent protectionist rhetoric all the more astonishing, since most economic historians agree that US protectionism in the 1930s, and the tit-for-tat responses it engendered from other countries, only served to exacerbate and prolong the Great Depression.

There is another paradox at work in the call for Eurozone countries to support US exports by issuing more debt. Given how skeptical market participants already are about the euro, more Eurozone government debt might strengthen short-term growth prospects, but it would surely weaken the euro further, ultimately supporting euro-denominated exports. Hence, the net effect of more Eurozone debt on US exporters might not be positive.

The official communiqué of the G20 summit is a masterpiece ministerial of ambivalence. On the one hand, it states, “to sustain recovery, the G20 needs to follow through on delivering existing stimulus plans;” but it also declares that its members “have committed to fiscal plans that will at least halve deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016.”

So the heads of state of the 20 largest economic powers in the world also cannot achieve consensus. Like so many games at the World Cup, the G20 ended in a draw. But the next round may demand more clarity.

18/06/2010: On the death of equities

The Dow is flat-lining at around 10,000, the S&P 500 is stalled at around 1,000. These readings were seen a decade ago. Indeed, taking inflation into account, the US stock markets is trading at 1996 levels. Are equities dying of natural causes, or will the coma pass?

So much for the old adage, "Stocks in the long run," one might say. And so much for all those who, during the Tech bubble at the beginning of this century, were forecasting that the Dow could reach 35,000, 40,000 or even 100,000 over the next decade. One of the loudest cheerleaders for the Dow to reach 40,000 was author Harry Dent, who recently published a book with the title, "The coming depression." If his new forecast is as accurate as his old one, then there is hope for the global economy.

But reborn bear Harry Dent is not alone. Ever more analysts and experts are sounding the death knell for equities as an investment. They cite several reasons for the demise of the asset class in their obituaries.

First and foremost, obviously, the performance of equities in developed economies over the past decade has frankly been dismal. While we all know that past performance is no guarantee for what comes next, history remains our key to understanding the future. Trend tracking and extrapolating are still among the most widely used analytical techniques for investing and forecasting. And by these measures the outlook for equities is unpromising.

It is also argued that equities are in fact no longer an autonomous asset class. Over the past eight years or so, they have moved in sync with the carry trade – the currency strategy that borrows in low-interest markets and invests in high-yielding ones. And equities' performance has correlated very closely with other risky investments in recent years, making them far less compelling as a diversifier in portfolios.

Then comes the charge that institutional investors are the real market makers in equities. According to Federal Reserve statistics, US households hold less than 40% of the US stock market, while institutional investors hold over 50%. Back in the 1950s, over 90% of the US stock market was in the hands of private individuals.

Finally, the high volatility of the stock market since 2007 has made equities less attractive for private investors who seek stable returns.

Interestingly, the death of equities is not at all a new thesis. In August 1979, the US magazine Business Week ran it as a cover story. The arguments in that article are not far from the ones we hear today. "Equities are more than ever the province of giant institutional investors," was one charge. Another pointed out that, "for more than 10 years the largest returns have come from taking the fewest risks." And finally, the article noted that, "Indeed, by constantly rolling over short-term paper, investors have beaten returns on stocks and bonds by a considerable margin." Sound familiar?

However, there is one big difference today: inflation. It was clearly the main concern in 1979, with US consumer prices rising a whopping 13% that year. This time around investors are still reeling from the financial crisis, but inflation is a non-issue, at least so far.

There is a silver lining to the latest "death of equities" dirge, we note. Thirty years ago, it preceded what would become the longest and strongest stock market rally in history.

"History doesn't repeat itself," starts a remark attributed to Mark Twain, "but it does rhyme." We can only hope this trenchant observation applies today.

13/06/2010: The sterile debate on sterilization

One important characteristic of the current financial crisis is that central banks have not been shy about taking stressed and underwater assets out of the system and giving fresh money to sellers of those assets in return. This has allowed financial intermediaries to clean up their balance sheets and regain a solid footing. The flipside is that those assets are now on the books of the central banks.

What the Federal Reserve did with mortgage-and asset-backed securities between 2008 and early 2009, the European Central Bank (ECB) is now doing with the sovereign debt of some countries at risk of defaulting such as Greece. But does doing so represent a risk for a central bank? That depends on what we understand “risk” to be for a policymaker.

In the sense that a central bank will always have the printing press as a financing alternative and is therefore unlikely to go broke, then it faces no credit risk. But once the central bank abuses its printing power and devalues its main asset – fiduciary money or its effective legal tender – then it creates inflation risk.

To counter the latter, central banks have the option of “sterilization”. In the past, this would have meant that a central bank buying foreign currencies to alter exchange rates, for example, could sell some of its assets to mop up the excess liquidity that comes with new-money creation. Today, arrangements such as financial intermediaries maintaining accounts with the central bank and central-bank bonds are further sterilization instruments.

In the case of the ECB, which is churning out fresh euros as it buys Greek government bonds, it can offer the bond sellers interest-bearing accounts in which to place their euros (such accounts are already in place at the Fed) or sell them its own interest-bearing bonds.

At first glance, this seems a nifty idea. The interest rate on the accounts or the bonds can stand as an added monetary policy instrument for the central bank. If it wishes to become more restrictive, it only has to lift the interest rate on those accounts or bonds. This will give financial intermediaries an incentive to pull some money out of circulation and place it at the central bank.

But there is one caveat to this thinking in the current situation. In the long run, sterilization is effective only if the central bank can resell the assets it buys from financial intermediaries for at least the same amount it paid to buy them. Looking at both the Fed’s toxic mortgages and real-estate-related debt and the ECB’s stressed sovereign debt, a good payback is far from certain.

Fast-forward to 2012. Imagine that after exhausting all help from its European neighbors, Greece decides to restructure its debt by asking bondholders including the ECB to take a 30–50% cut on the value of its outstanding debt. This means that the fresh money corresponding to the haircut the ECB will have to take will now be “forever” in the system. This would make the central bank’s job of containing inflation much harder in the future.

Crucial as sterilization might be, it leaves central banks with risks to manage.

10/06/2010: Deconstructing the euro

It all started with Greece and its flawed fiscal bookkeeping. But a deeper flaw led to Europe’s current malaise: the failure to follow-up the creation of the euro, which was meant to be a first step towards a full economic integration, with a second step of fiscal consolidation. The financial crisis of 2008 exploded the happy illusion that all was well in Euroland.

Unsustainable imbalances had developed within the EU during euro's first decade. Greece's fiscal profligacy may have triggered the run on the euro, but is not the main problem within the currency union. Rather, it is a symptom of a much deeper problem. The fundamental weakness in Eurozone countries is, in our view, waning cost competitiveness in a globalized world. We will present our case for the prime role of unit labor costs by looking at three countries.

Obviously Greece fits well in the fiscal profligacy scenario. According to the latest OECD statistics, it has a deficit-to-GDP ratio north of 12% and a debt-to-GDP ratio heading towards 120%. Its fiscal path and fiscal projections are unsustainable. Even with all the austerity measures, yet to be implemented, its debt–to-GDP ratio will reach 150% by 2012-2013, according to projections of the International Monetary Fund. The Greek government is insolvent and, technically, bankrupt.

Now look at Spain. Until the financial crisis, its government had its finances in order. The debt-to-GDP ratio declined from 70% in 1999 to 42% by 2007. True, it has surged since then and could reach over 80% by 2012, but Spain's main problem was, until recently, not with the government. Something else was at work. The whole country was actually in a spending frenzy, with a current account deficit soaring from 1.2% of GDP in 1998, the year before the introduction of the euro, to 10% by 2007.

Finally, look at Italy. Here, both the government and the population were frugal since the introduction of the euro. At 132%, Italy had a very high debt-to-GDP ratio in 1998. By 2007, it had managed to reduce this ratio to 113%. In 1998, Italy posted a current account surplus of 1.9% of GDP and managed to get its current account balance roughly in equilibrium during the period 1999-2007. However, during this period Italy was characterized by a very low growth rate – less than 1.5% on average – while the overall Eurozone was growing at 2.2%.

Large government deficits and current account deficits and low growth are all symptoms of a deeper problem: loss of international competitiveness due to the common currency. In Europe, one country – Germany – has strived to maintain its competitive edge by increasing productivity and moderating labor costs. Unit labor costs – which are labor costs corrected for productivity increases – have barely moved in Germany since the introduction of the euro. Meanwhile, Greece, Italy and Spain (as well as Ireland and Portugal) have seen their unit labor costs increase significantly, leading to dramatic reductions in their 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 OECD, if the euro did not exist, the currencies of Greece, Italy, or Spain would have depreciated by roughly 20% over the past ten years versus the German currency. Even a country like France would have seen its currency depreciate by more than 15% against the German 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 problems of Greece, Italy or Spain. In this sense, French Finance Minister Christine Lagarde’s critique of and recommendation to Germany at the end of March that, “it should raise long-stagnant domestic consumption, helping weaker Eurozone nations to boost exports and shore up their finances,” has some truth to it. However, her comment ignores the fact is that Germany – unlike France, one is tempted to say – is not a state-directed economy. You can never raise the wages centrally (and hence the unit labor costs), nor can you force the frugal Germans to consume more.

The euro today is not what it was in January

The problems stemming from differing unit costs were already known before the introduction of the euro. Many economists warned that, without further fiscal integration, the heterogeneous evolution of the Eurozone member states would lead to the very problems we face today. This warning was countered by three arguments.

First and foremost, the so-called Maastricht criteria were supposed to keep governments in the Eurozone from using the low interest environment to grow profligate. Second, despite the heterogeneity of countries, a certain form of solidarity between the different member states of the Eurozone was assumed. This suggested an implicit "Eurozone" guarantee that no country would be left to default. Finally, the European Central Bank was considered to be an independent central bank only preoccupied with inflation targeting. It was seen as even more independent and “tougher” than the Fed because it had no dual mandate (the Fed focusing on inflation and growth, the ECB only on inflation), and because to change its status required the unanimous approval of all sixteen countries.

All three arguments have been challenged lately.

When talking about the Maastricht criteria, the two fiscal criteria tend to dominate: government deficits should not exceed 3% of GDP and the government debt should remain below 60% of GDP. But there were also three monetary Maastricht criteria: the interest rate of a member country should not be more than two percentage points over the average of the three lowest interest rates in the Eurozone; the inflation rate of a member country should not be higher than 1.5% above the average of the three lowest inflation rates in the Eurozone; and each new joiner should have a track record of at least two years in a row with no major currency fluctuation against the euro. At the introduction of the euro in 1998, each member country fulfilled the monetary and the deficit criteria. Belgium and Italy did not meet the debt criteria but their debt dynamics at least suggested that they were on the right path.

Looking at the Eurozone today, we see that only two countries, Finland and Luxembourg, respect the fiscal criteria and several countries are only partially meet the monetary criteria. That said, since several countries are currently in deflation, the inflation criteria make little sense.

Again, in our view, the central problem for many countries now seen to be at risk within the Eurozone is not profligate governments but the evolution of unit labor costs. This is also reflected when looking at the Maastricht inflation criteria. During the period 2000-2008, Portugal, Spain, Ireland, Greece, as well as the Netherlands, failed to meet these criteria, especially at the beginning of the 2000s.

On 17 March, German Chancellor Angela Merkel broke a taboo by arguing in front of the German parliament that there needs to be a mechanism to expel countries from the Eurozone if they persistently break its financial rules. Rightly or wrongly, market participants concluded that this was the end of Germany’s political backing for the euro. Even though the countries of the Eurozone have pledged EUR 110bn since then to help Greece, and then another EUR 500bn as a special vehicle to help other distressed Eurozone countries, there still remains some doubts as to whether the larger European countries will ultimately bail out Greece.

On 9 May, the final taboo on the euro was broken. The European Central Bank announced that it would buy debt of distressed European governments, a course of action that its president, Jean-Claude Trichet, had denied just three days earlier. While this policy, known as quantitative easing, is not fundamentally flawed in itself – the US Federal Reserve Bank and the Bank of England have undertaken similar measures – the ECB’s abrupt reversal called into question whether inflation-fighting remained its top priority. French media picked up this change in policy by stating that, “The ECB has become more Latin.” Whether this is the case or not is debatable, but something has definitively changed in the way the ECB is perceived. Given that perceptions and symbols are as important to monetary policy as effective policy measures, this change of course has definitively left market participants puzzled about what type of currency the euro is today.

The way ahead

Despite the rhetoric of European politicians lately to heighten the sense of urgency – for example, Angela Merkel’s remark that "if the euro fails, then Europe fails and the idea of European unity fails" – it is not a given that currency unions persist forever. Nor is it a given that Europe would break apart if, for some reason, one or more countries were to leave the Eurozone. There are two extreme scenarios and one moderate scenario that we need to explore for the Eurozone: further integration, a breakup, and muddling through.

The most positive scenario takes the view that like many past crises in Europe, the current one will trigger initiatives for further integration to find a common ground for fiscal and social policy. The current austerity efforts by many southern European countries can be interpreted from this perspective, as can the EUR 500bn rescue package of 9 May. However, whether these austerity measures will really be implemented remains to be seen.

As noted, even with the severe austerity measures imposed or self-imposed upon Greece, its fiscal situation will not improve over the next three years. Quite the contrary, despite all efforts, Greece is likely to be as broke in 2012 as it is now. In fact, while current European thinking aims at reducing or at least not increasing much of the numerator of this quotient (debt) of the debt-to-GDP ratio, the very restrictive fiscal policy is likely to shrink the denominator (GDP), leading to an overall increase of the ratio. With all the sacrifices asked from the populace of the Mediterranean countries, this is not a very encouraging result.

As Ambrose Evans-Pritchard of the UK’s Daily Telegraph rightfully observed in a recent editorial, “No democracy will immolate itself on the altar of monetary union for long.” Hence, it is our view that the austerity measures will prove unsustainable and that further fiscal integration is also very unlikely.

There are several possible scenarios on how the Eurozone could break up. We see two extremes: a “bottom” or a “top” country could leave the Eurozone. By “bottom” and “top” country, we mean respectively a country with a new currency at risk of depreciating against the euro, and a country with a new currency at risk of appreciating against the euro. Greece and Germany will serve as our examples here.

To begin, we would say that it would be optimal to have one’s assets in the strong currency and the liabilities in the weak on.

Why would the Greeks want to leave the euro? At some stage, the austerity measures necessary to retain the euro could become so unbearable for the Greek population, that the alternative to switch currencies could be seen as the better choice, despite the big unknown on how the economy would ultimately react.

In the case of a Greek break-up, the remaining euro could be considered as the strong currency, while the new drachma would be the weak one. Obviously, Greece's debtors would have an incentive to switch currencies, while its asset holders would like to keep the euro. Among the debtors, there is the Greek government. Switching currencies and then announcing that the debt would be repaid in the new drachma basically means for Greek debt-holders that they would be confronted with devaluation and in a sense a debt-restructuring through the new currency.

We estimate the depreciation potential of the drachma against the euro to be today roughly 10%. However, knowing that currencies have the tendency to overshoot and also knowing that switching currencies would basically be a signal to monetize debt, we conclude that the drachma would depreciate much more if it were reintroduced.

For Greek asset-holders, obviously, this is a rather sobering prospect. They would have an incentive to reduce their Greek assets in a portfolio and switch them into other euro-denominated assets before the currency switch occurs. In fact, the announcement of a currency switch in Greece could induce a run on Greek banks. It has also a high inflation potential as the new currency will certainly not be broadly accepted as a mean of exchange and will still be substituted by the euro.

Let’s consider the other extreme scenario.

Why would the Germans want to leave the euro? On the one hand, they could become fed up by systematically have to bail out their weaker partner. On the other, they can see the new orientation of the European Central Bank as a source of inflation, which they want to avoid by any means.

In the case of a German break-up, the remaining euro would be considered as the weak currency, while the new deutschemark would be the strong one. Obviously, German debtors would have an incentive to stay in the euro, while German asset-holders would like to switch currencies. Despite switching currencies, the German government would still have an incentive to leave its debt in euros. However, especially for German government debt holders, this would feel like a debasement to the value of their holdings. Hence, it would be very difficult to implement politically.

We estimate the appreciation potential of a new deutschemark against the euro today around roughly 20%. Here again, knowing that currencies overshoot and also considering that the Bundesbank might be seen as more credible than a European Central Bank without Germany, we conclude that the new Deutschemark could appreciate much more if it were reintroduced.

A German asset-holder would profit from such an appreciation and it could mean that prior to the reintroduction of the deutschemark, German assets might experience a rally. At least two groups of Germans would be worse off, however: exporters, who would suddenly be confronted with a much higher currency, and holders of non-German assets denominated in euros.

The depreciation of the euro in this scenario doesn’t necessarily mean its demise. Actually, Mediterranean countries now confronted with a weaker euro against the deutschemark could again compete on the world markets, where their rivals would now have a much stronger currency. Moreover, the euro would still be the currency of roughly 250 million people.

Our most likely scenario remains one where the Eurozone and the euro will somewhat “muddle through.” This would mean that the sovereign debt crisis initiated by Greece is only the first of many such crises to follow. Helping Greece and other countries to get their fiscal houses into order is only solving one symptom of a much bigger problem, which is that one monetary policy will still not fit all the members of the Eurozone at the same time.

What to do

In our view, short-term and until a certain clarity on the European sovereign debt situation emerges, the euro will be subject to repeated bouts of weakness. Short-term, it could go down as far as 1.1880 or even 1.1660 against the US dollar, lows that, respectively, were last seen in 2005 and 2004. However, there are several issues one shouldn’t forget, when assessing the Euro against the US dollar, the pound Sterling or the Japanese yen, that in fact overall the Eurozone is fiscally much sounder than the US, the UK and Japan. Hence we are not bullish on the other large currencies either.

We prefer rather to diversify much more into “minor” currencies of countries, which are fiscally sounder (Canada, Australia, Sweden, Switzerland, Norway, and Singapore) and into emerging currencies from Southeast Asia. Moreover we continue to like gold as a hedge for the currency turbulences, which should continue.

05/06/2010: Mr. Keynes and the 21st century

“I am now a Keynesian in economics”

– Richard Nixon, 1971

“I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. […] This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.”

– Ben Bernanke, 2004

Those two quotes make the same implicit statement: “we know how to correctly handle the economic cycle.” Both quotes came after long periods of very low growth fluctuations in the US. Both quotes were to some extent proven wrong.

In the early 1970s everyone, even Richard Nixon, was “Keynesian”, i.e. embracing the mainstream interpretation of John Maynard Keynes’ (1883-1946) General Theory. This interpretation stated that the government could smooth business cycle fluctuations by using both fiscal and monetary tools. Whether this is what Keynes really meant, remains an open debate between the different schools that emerged after the Keynesian revolution in the 1930s. Nevertheless, what seemed to work in the 1950s and 1960s was blatantly contradicted in the 1970s with the emergence of the stagflation, i.e. a period of stagnation/recession and a high inflation rate, something not anticipated by the mainstream economic theory.

In the early 1980s, after the great US inflation ended, a new economic policy consensus emerged: “keeping inflation and budget deficits under control” and creating the right “low tax, low government, highly deregulated” environment to boost both entrepreneurship and growth. Interestingly enough, this environment was looking more and more like the one of the Roaring Twenties before the Great Depression. It now seems to have ended abruptly in the 2007-2008 financial crisis.

Keynes came back in fashion through the Minsky moment

Some economists warned that the environment we enjoyed over the last 25 years and called the Great Moderation could lead us to a similar juncture as the Great Depression, trough a “Minsky moment.” Hyman Minsky, one of the most original Keynes’ followers and interpreters, demonstrated that the existence of economic stability itself encourages excessive credit creation, leading to, first, financial instability and speculative euphoria, then credit restraint and contraction, and finally, economic contraction and volatility, i.e. the chain of events that we are currently experiencing.

Which led straight into a liquidity trap

The credit restraint went so far as completely clogging the credit channels. We are now in a situation defined as a liquidity trap. Central banks may cut interest rates close to zero (something that is currently happening around the globe), but it has no impact at all on the economy because financial intermediaries are reluctant to give credit. A more severe form of the liquidity trap would be that even if financial intermediaries were willing to lend at those interest rates, companies and/or households would be reluctant to borrow. This reluctance can have several reasons, like uncertainty and risk aversion about future prospects, already high indebtedness, and worst of all: deflationary expectations.

If you are expecting prices to come down in the future, then interest rates might be quite high even at zero because what matters in an investment/consumption decision is not the nominal, but the real interest rate, i.e., the interest rate minus the expected inflation rate (or plus the expected deflation rate). According to the traditional Keynesian theory, environments characterized by low interest rates and liquidity traps are especially favorable for the other government tool beside monetary policy: fiscal policy through deficit spending.

Does fiscal policy work?

Japan at the beginning of the 1990s was in a similar situation as the US and parts of Europe are today. The bursting of both the housing market and the equity bubbles led to a deleveraging of the Japanese banking sector, which induced a severe credit crunch and pushed the Japanese economy into a recession. Reluctant at first, the Bank of Japan slashed interest rates to zero, but Japan was caught into a liquidity trap, where this no longer had any impact at all. Fiscal policy had to take the lead. The fiscal impulses were quite impressive: between 1991, the year Japan went into recession, and 2000, the year it finally emerged, government debt increased from 70% to 140% of GDP. But in the same period, real GDP just stagnated. It was by 2000 only 10% higher than ten years before. In hindsight, this period was called the lost decade.

For many economists, this is a sign that fiscal policy is not a blank check for success. In his new book, “The Return of the Depression Economics and the Crisis of 2008,” the 2008 Economics Nobel Price winner Paul Krugman explains what happened in Japan: the fiscal impulses “didn’t get enough bang for the yen” and the policy was not a consistent one. Years with high deficits were followed by years where fiscal responsibility prevailed leaving the impression of a “stop and go” type of policy.

However, Nomura’s Chief Economist Richard C. Koo argues in his 2008 book, “The Holy Grail of Macroeconomics – Lessons from Japan’s Great Recession,” that the tremendous fiscal impulse avoided a much deeper recession for Japan, which “successfully avoided economic apocalypse for 15 years. But from the perspective of the media [...] the government spent 140 trillion yen, and nothing happened.” The debate remains open.

While fiscal policy might be a good idea in an environment, which is obviously characterized by a liquidity trap, there are several shortcomings to keep in mind and which we have learned in the experiences of the 1950s-1960s.

How to spend it

What type of expenditures should be used, i.e., where would we find the most growth bang for the government buck? Tax rebates like the ones, that were already implemented in the first half of 2008 might be the fastest way to boost the economy. However, as was experienced this year, the effects were far less conclusive than expected. Moreover, one of the main problems, which led us into the current crisis, was the over-consumption, under-saving and large indebtedness of private households in the US.

Boosting their consumption will therefore just delay an over due correction of imbalances. Infrastructure expenditures seem the next obvious choice. They have the moral advantage that while financed by debt creation, i.e., something future generations will have to pay, they will also profit future generations. However, more often, large government-sponsored infrastructure projects have lead to earmarking and bridges to nowhere.

Another lesson learned in the 1950s and 1960s was that deficits meant to be cyclical became almost always structural in the end. Once a recession was over, government expenditures didn’t come back and deficits didn’t switch into surplus. According to the US Congressional Budget Office, only five years out of 45 between 1962 and 2007 showed a fiscal surplus. The period 1998-2001 remains a striking exception in US history.

With roughly a 3.5% yield on 10-year US Treasury paper, financing its budget deficit is especially cheap for the US government. But at some stage in the future investors might suddenly become nervous about the towering deficit and the debt-to-GDP ratio accumulating in the US, and elsewhere. And this realization might lead them to exit the government bond market as fast as they entered it as a safe haven during the financial crisis. This would turn today’s favorable picture on its head and lead to sharply higher interest rates and lower bond prices. Higher interest rates in turn would be dismal for a fragile economic environment.

John Maynard Keynes is back. But let us just hope he is not back in the malfunctioning interpretation of his work in the 1950s and 1960s. Because to quote him: “The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.”

04/06/2010: The markets won't dance with TINA anymore

Margaret Thatcher called her defense of economic liberalism the TINA argument, as in "There is no alternative." This discussion-ending dictum also goes under the names "pensée unique" or Washington Consensus. These days, the TINA mantra is invoked to justify the belt-tightening exercises underway in many European countries as they confront their sovereign-debt crises. But, ironically, the more it is preached, the more TINA seems to drag on these stricken economies.

It seems clear that old truisms no longer apply. Frugality in government has always been seen as a virtue, one that investors are happy to reward. Why, then, was Spain's latest savings measures met with a downgrade to its credit rating by Fitch and renewed pressure on the euro?

To find the answer, we need to go to the one place in the world where the Washington Consensus is routinely ignored: Washington, DC. In a week that saw Germany announce new austerity measures and France declare that it would make a public-deficit cap the law of the land, Larry Summers, President Obama’s chief economic advisor, argued for further USD 200 billion in fiscal stimulus in a speech at Johns Hopkins University on 24 May. This sum would add to the already eye-watering US deficit of USD 1.5 trillion for 2010.

One of Summers’ statements must seem particularly heretical to Europeans in the midst of an austerity frenzy: "It is not possible to imagine sound budgets in the absence of economic growth and solid economic performance."

Here, we think Summers has captured how market participants are reacting to Europe's new frugality. In their efforts to save, European governments are burdening their economies with low growth rates that could threaten their recovery. Indeed, surging unemployment and falling tax revenues could well deepen their deficits. Despite the Herculean savings efforts by Greece, for example, the International Monetary Funds projects that its public debt-to-GDP ratio will increase from 115% in 2009 to 150% by 2012. In fact, Greece and other Eurozone countries could end up trapped in a Japanese-style paradox of thrift.

Although its infamous debt-to-GDP ratio is almost 200%, Japan is by far not the most profligate G7 country in terms of public debt growth over the last 20 years. That distinction goes to the birthplace of TINA, the UK.

Between 1989 and 2008, Japan's debt ratio increased from roughly 68% to over 170%. The UK, meanwhile, managed to contain its debt ratio to 60% as of 2008 (although it has since surged rapidly) despite growing its public debt by over 8% a year on average during this period. What explains this apparent anomaly? The difference in nominal growth rates: 5.5% on average for the UK and only 1.2% for Japan.

The thrift paradox refers to the Keynesian notion that when people save during a recession, demand collapses, prices and output fall and everyone suffers as incomes shrink accordingly. Ultimately the drop in income could even lead to a drop in overall savings. We think it explains why markets currently prefer the more positive growth prospects in the US over the somber deficit-reduction efforts in Europe.

Another paradox prevails today: the European Central Bank's effort to restore its inflation-fighting credentials could in fact backfire and ultimately weaken the very euro it aims to strengthen. TINA and the Washington Consensus would favor diehard monetarism – a balanced money supply aimed at price stability – but the US and the UK are running their printing presses night and day to revive their flagging economies. And this, we think, is precisely why markets are rewarding them and strengthening their currencies versus the euro, with its limited growth prospects.

While TINA may be the markets' favorite in good times, she is definitively less welcome when times are tough.