Patience warranted

It has been some time since I wrote my last blog for Economicious. Do not fear, however, as I will return within few days (at least, I hope).

A lot has happened since my November 3 post in the world of economics (not in chronological order):

• harsh criticism on QE2;
• sovereign debt concerns in the Eurozone periphery;
• Trichet under pressure and ECB bond buying;
• the rescue of Ireland (and will Portugal, Spain, Belgium, Italy and even France be next???);
• talk on the collapse of the Euro;
• emerging markets still growing strongly, just like Germany;
• the US is growing still and showing better than expected data for some time, but worse than expected unemployment data last Friday;
• some experts still believe the US will enter a second recession in 2011 although the tax cut will be extended for 2 more years for even the wealthiest Americans;
• etc.
• etc.

So I am just contemplating what my next topic will be...

QE2 could boost growth, but it will not

Below, I will spend some time explaining how the programme that the Fed will announce in a few hours could boost the U.S. economy, and why it will not do this.

With already more than two months since the Fed started talking about a new programme of money-printing (the economics word for it is quantitative easing, 2nd version, also: QE2), the list of opponents to QE2 is growing larger, and the list includes ever more renowed names. Examples: Volcker, Greenspan, Stiglitz, PIMCO's Gross, etc. All of them warn for medium- to long-term inflation dangers that will be a huge cost of the quantitative easing programme, whereas benefits are minor - that is, if they are there.

Nevertheless, the Fed will announce its QE2 programme today. Probably with monthly asset purchases of $100 billion, after each injection of cash reconsidering its next step dependent on the economy's progress. The Fed is hardly paying attention to the warnings, so it seems. Or actually, most members of the FOMC are 'not hearing evil, not seeing evil'. But yet, the Fed has never been so divided over what to do next. How come? The upcoming package of QE is unprecedented; there is no evidence of the effects of such programmes. All that Boom-Boom Bernanke is now seeing is that the Fed's dual mandate is out of sight. At least, when you look at the numbers superficially (more on that later). One mandate, an annual inflation rate between 1.7 and 2% is being missed. The other mandate, achieving close to full employment, is even further out of sight with a current unemployment rate of 9.6%, with risks of rising further as the government's austerity programme probably kicks in by 2011. Hence, the two targets are not being reached.

But there's more to this dual mandate. First of all, they are intertwined. The historically high current output gap that partly exists because firms are not hiring (thus, low employment), so capacity is not being used. This causes deflationary pressures. Get employment up, and inflation rises. Secondly, it is doubtfull that unemployment is cyclical and can be reduced by loose monetary policy (that is why it seems that the second target is being missed, but actually the mandate concerns cyclical employment as there is always some structural unemployment). As the U.S. economy is somewhat recovering, many people do not have the skills required by the sectors that are recovering, as they have been trained to work in sectors that are now declining. Looser monetary policy will do nothing to change this. Rather, retraining of workers, more flexible labour markets and changed legislation are needed. This argument has been advanced some speeches by Dallas Fed president Richard Fisher, who strongly opposes QE2.

So is the achievement of the dual mandate in the Fed's reach? Probably not, given current conditions.

However, the logic of Bernanke is the following (he, obviously, does think QE2 will help - somehwat): asset purchases lower interest rates, lower the cost of borrowing and create a wealth effect as firms and households see their balance sheets improve due to rising asset prices, whereas lower borrowing costs induce them to borrow more; hence, to spend more. This will create a domestic-demand-driven positive growth cycle. Companies will start to hire again once they see consumer spending restored.

But there are some crucial steps that need to be taken for this QE2 programme to succeed, which makes the plan weak. Some problems related to QE2:

• Interest rates are already very low. Even if the real interest rates get pushed down even lower, why would this now all of a sudden induce the consumer and business owner to start borrowing?
• Financial institutions are reluctant to lend. The normal transmission channel of monetary policy is broken. Lowering interest rates further does not automatically get credit in the economy up.
• As banks do not lend, they sit on a lot of cash that needs to go somewhere, so they invest it in higher-yielding (hence: riskier) assets. These high-risk yields get depressed as well, as can be seen already today, because of these capital flows into emerging market (EM) stocks and equities. This could lead to risks being significantly mispriced again, which was one of the causes of the recent crisis.
• It takes time to recover from a debt crisis. Consumers and firms took a blow as they saw their balance sheets destroyed. They are now reluctant to spend, and are seeking to deleverage. They just want to get rid of the debts! They do not want to invest; they want to save.
• Bernanke assumes that lower borrowing costs can get consumers/firms to borrow more (due to the substitution effect). However, lower borrowing costs imply lower returns from savings. Therefore, consumers/firms need to save even more to achieve the same return from their savings. It might well be that this income effect outweighs the substitution effect, by a lot. This is a big point. If it is true (I think it is), interest rates need to go up, not down, to get people to safe less.
• Following from the previous argument: As long as interest rates remain low, wealth gets shifted from consumers that save to financial institutions that borrow, whereas the consumers should be the ones to carry the recovery. Now they get deprived of returns to savings, whereas financial institutions that are actually doing pretty badly get to continue their operations. Higher interest rates would get less-efficient firms and financial institutions out of business. Keep borrowing costs low, and overall economic productivity stays low.
• Lastly, if the so-called 'wealth effect' is to take place, consumers/firms would have to genuinely believe in the restoration of their balance sheets from the increase in asset prices. If they think that higher asset prices are caused by the money-printing instead of asset prices rising from demand-supply forces, they will not start to borrow more againts their assets. In other words: if they think their houses etc. do not truly become worth more, they will also not lend against higher house prices, because they will foresee a new burst of the asset bubble.

And in the end, if these problems persist, and the Fed does not quickly undo the injection of money into the economy, inflation will be upon us.

This is a long list of negative effects and problems related to QE2. Monetary easing cannot lift the economy out of the doldrums. It is far too uncertain that QE2 will do any good, because of the hurdles discussed above, while the unintended consequences are possible enormous.

QE2 distracts people from the true problem, which is the unsustainable level of debts in 'advanced economies'. This problem should be recognised and attacked. However, given that the Fed proceeds with its nonsense QE2 programma, I hope the markets can get fooled. If not, QE2 will have no effect and the next (debt) crisis will be seriously damaging.

Current growth-thinking, and what is just plain wrong with it.

Alternatively, the title of this blog could be: the myth of GDP growth.

What is bothering me for some time now, is the focus on GDP growth, while often, people do not realise what this growth actually constitutes, and what the reasons for the rise in GDP are. So I have made the chart below, which should make it clear (perhaps some clarification is needed).

The light blue part of the bars is U.S. public debt. The orange part of the bars is nominal U.S. GDP excluding public (federal) debt. Strikingly, the share of nominal GDP excluding federal debt as a part of total GDP is becoming smaller and smaller.

The dark blue line indicates the percentage change (yearly) in nominal GDP excluding debt. This share is falling since somewhere halfway of 2007.

The U.S. debt as a percentage of GDP is nearly 90, but this is when you include only the general government debt. It becomes worse when you include household debt:

By the way, the picture is even bleaker when taking account of financial sector debt. Total debts are 350% of GDP!

Obviously, if one would subtract household and government debts from U.S. GDP, one should conclude that the U.S. owes far more to its creditors than it generates every year. How does it plan on paying off this debt? Question: it does not.

Now the thing is: GDP might be growing by 1.5% on a yearly basis, debts are growing even faster. Apparently, the only way the U.S. economy can sustain a growing economy is by financing this growth by taking on debt. No, actually it is worse. The statistical decline of the economy is prevented by the accumulation of debt.

It is like I would produce paintings, and every year the paintings are getting worth less and less, but I can still say that their value is increasing year on year (because I have taken on a debt that I add to the value of the paintings).

So if we were being honest, we would admit that GDP is declining. In the U.S., but in many other advanced countries as well.

And then there is the issue of all the future liabilities that are not taken into account yet.

Given all the implicit liabilities of the U.S. for healthcare, ageing, etc., it becomes very difficult to imagine how these debts are ever goint to be paid off (again, the U.S. is an example, as the same goes for other countries). Estimates of the implicit future liabilities are seriously shocking. In some estimates for the U.S., they amount to 4 times the size of the economy.

The U.S. has some options left: restructure debts/plain default, inflate debts away, and structurally reform the economy to make it efficient and flexible again in order to boost GDP. The first two options seem impossible given the size of the U.S. debt market. U.S. creditors will not like it, to say the least. But that is another issue. The last option is just insufficient. Now, this is of course a very big problem, and that is an understatement. It seems to me that there is not an easy way out for the U.S., and sooner or later, these problems will have to be recognised, preferably before the bond market recognises it and the U.S. office of debt management faces Greek-style financing conditions.

For now, the problems are being ignored and even made worse by the accumulation of deficits, in order to continue living in a myth of a growing economy.

Finance ministers and policy games

Let me start the week with a new blog. So much has been going on recently (central bank policy, financial market turbulance - or a lack of it, indicating complacency -, international policy coordination - or a lack of it, especially when looking underneath the surface -, etc.) , that it becomes increasingly difficult to choose just one topic and elaborate upon it. Especially if, like me, you just want to read and know everything. Little time left then to reflect and write down your thoughts. However, that is what I will try to do. This time it's about international policy coordination, trade, competitive currency devaluations covered up as monetary easing, and the promises made during the G20 meeting last weekend.

Some good news after the G20 meeting of central bankers and finance ministers: the IMF's legitimacy was said to be enhanced by a shift of votes and quotas from the 6% most overrepresented to the 6% most underrepresented members. Great, of course, as it is a big surprise that the members agreed, but will this really change the way China approaches its diplomatic relations? Moreover, the problem of the illegitimacy of the IMF was just a top of the iceberg of problems that the political world-stage is dealing with today.

Just underneath the surface are currency issues. Although the Brazilian finance minister even mentioned a "currency war", it has not come this far (yet). For now, countries seem willing to cooperate. The G20 communiqué mentioned that: "we [read: the G20] will, continue to resist all forms of protectionist measures and seek to make significant progress to further reduce barriers to trade.", and "... continue with monetary policy which is appropriate to achieve price stability". Okay, this sounds good. Or, does it really? Monetary policy to achieve price stability? That is what the Fed is trying to achieve. However, it requires QE2 according to the Fed, and that is exactly what more the communiqué is saying countries should NOT do: "we will [...] refrain from competitive devaluations of currencies".

Unfortunately, the G20 lacks supranational power and the apparent willingness to cooperate might go no further than the communiqué. None of these agreements are binding. Moverover, since the dispute is mainly between China and the U.S., there is no member strong enough to exert the political pressure that would force them to come to a solution.

So China and the U.S. would have to come to a solution over the currency dispute on their own. And will this dispute get settled? Not if the U.S. keeps desiring fast Yuan appreciation in order to make Chinese imports less attractive and their exports to China more attractive, and if China maintains committed to very slow appreciation of the Yuan in order not to hurt the export sector's very thin profit margins and provoke social unrest. Overall, it is very unlikely that the dispute gets settled on its own, given that neither of the two is willing to give in.

And then there is the deeper lying issue of trade imbalances. The G20 communiqué shortly addressed this, by stating that the G20 will "strengthen multilateral cooperation to promote ... reducing excessive imbalances and maintain current account imbalances at sustainable levels". But since when are imbalances not excessive, and since when can imbalances be at sustainable levels? Apparently, leaders at the G20 could not agree on when, how, and why to address these imbalances that are one of the main causes of the crisis.

The bottom line is that the deeper lying issues will not get resolved. The path of the least resistance is that countries (the U.S. first, and other countries could follow) resort to some kind of protectionism. Either in the form of trade measures or in the form of quantitative easing. The first is less likely to occur, as the biggest and most efficient U.S. companies are the ones that engage in exporting and importing, and precisely these profit-generating firms stand to loose from this. Given their large profit-making potential, it would be a very silly move. Nevertheless, it would not be the first time that politicians made silly moves (silly being a heavy understatement) .The second option, quantitative easing, is more likely, even though the G20 communiqué explicitly tells countries to refrain from competitive devaluations of currencies. The Fed, for example, can resort to its dual mandate to explain the need for further monetary easing and claim that devaluation of the U.S. dollar is just a side effect. Nobody in the real world, obviously, believes this, but it is just part of the political game.

Demand and supply forces? How the Fed tries to fool us.

These are truly very interesting times to be an economist, or an intern that is supposed to keep track of basically everything that is going on today on the financial markets. Let alone in politics. Besides interesting, it is funny as well.

The famous quote goes: you can fool some of the people all of the time, and all people some of the time, but you cannot fool all of the people all of the time.

Personally, I really like the sarcasm of this quote by Abraham Lincoln, but that's not the point I want to make.

One of the people that can be fooled all of the time is Trichet. Or does he seriously believe that in is in the US' best interest to have a strong dollar, while everything the US are doing leads me to conclude that they rather want a weak dollar?

And then there are people that try to fool all of the people, all of the time. Or they are trying to fool themselves, all of the time. Choose either one you want.

Take DeLong. I did not agree with his articles stating that US Congress should spend more, even when Obama signed the huge fiscal stimulus bill in 2009, but that was more on philosophical grounds. In a current article of him at Project Syndicate (Economics for Parrots), he argues that economics is all about supply and demand. If there is a shortfall in demand, prices will drop. A shortfall in supply? Prices will rise. Current prices for government bonds are rising, so he concludes that it must be true that there is a shortage in supply of government bonds. Thus, the government should issue more debt. This is also what people are saying when they claim that the government should engage in further fiscal stimulus, since interest rates have never been this low.

However, an utmost important fact that DeLong (and others) are ignoring, is that the Fed is intervening heavily in the market for government bonds. It is the Fed that is exerting such enormous pressure on the Treasury market, that prices remain high (and interest rates low). (Additionally there is the uncertainty about the economic outlook that leads people to look for a safe haven.) If it is the Fed itself that is creating the superfluous demand, then one cannot conclude that for demand and supply factors, there is a shortage of supply of government bonds.

The Fed is thereby also trying to fool all of the people, all of the time. They wish to keep nominal interest rates low, while striving for higher inflation. They will likely aim for inflation somewhat above the current target of 2% by creating a price target. This is a paradox. If people believe both that nominal rates will remain depressed, but that inflation will rise during the coming years, nominal rates must go up. And probably more than just by the rate of expected inflation, because the risk premium that investors demand also rises on the fear of higher inflation than expected. Overall, the Fed will probably get more inflation than it wished for.

Except, of course, when it can fool all of the people, all of the time.

Note to "Bad news is good news"

No matter how strongly I believe that further quantitative easing will not help the U.S. economy move forwards, this does not mean the Fed will not engage in QE2, unfortunately. I believe they have gone down a road and now cannot turn back, because:

• Markets have priced in a large amount of possible further easing. Announcing no or only little QE2 will shock the markets, but in the wrong direction (stocks, gold and commodities will decline);
• The first round of QE helped (although back then loose monetary policy served the completely different purpose of providing liquidity to a system in need of liquidity);
• With fiscal policy offering little help, the Fed must do (rather: try to do) something (it's in their mandate);
• Future disadvantages to QE2 are far away, and very much unknown (unknown also are the benefits, but hey...), and;
• Bernanke is in favour of QE2, and so are most Fed members (and Krugman)

With this in mind, I think it is just much more likely the Fed will announce on 2-3 November a shocking package of purchases of government bonds and private assets.

Bad news is good news

The title of one of my previous blogs was 'No news is good news' and it mentioned the market's reaction to what was actually nothing new. The blog dates 20 September: just after the Fed's remarks that the economy showed no substantial signs of improvement and they would wait and see what would happen with economic growth in the coming months. Market sentiment was positive, although there was in fact nothing to be positive about: the outlook was just as bleak as before.

Today, the outlook is just as bleak, if not worse. However, the Fed is seriously contemplating QE2. Good for the stock markets and commodities and for these markets, a substantial amount of the by-markets-desired-$1trillion-at-least-of-QE2 has been discounted in market prices. A poor nonfarm payroll number last Friday made markets more confident that the Fed will give them 'their money' and subsequently, stock markets rallied. Hence, for the markets, "bad news is good news".

However, in a speech of Dallas Fed president Fisher, Fisher hinted at markets being overly confident about Fed starting a second round of quantitative easing. Payrolls are not expanding, because businesses as unwilling to hire as they experience too much uncertainty regarding future taxes and regulation, but they are aware of the fact that some day in the future, taxes will have to be raised to finance the huge government debt. In this environment, the Fed cannot do anything to bring down unemployment. If anything, they only contribute to more uncertainty and thus higher unemployment. So far for one goal of their dual mandate. More on inflation next time.

Moreover, liquidity is abundant and more liquidity is not needed. It helped in 2008 when the financial system was experiencing a lack of liquidity and the Fed had to step in to address this market failure. But now, only a very small amount of businesses find they are credit constraint, and probably the Fed cannot overcome this. They have done whatever they have to do. Now it's time for the Fed to get their hands off of it and let Congress, now matter how divided they are there, do its job.

Will politicians be able to avert prisoners’ dilemma outcome amid pressures? Currency war debated.

During the last days, attacks on Chinese exchange rate policy (regarding the undervalued Yuan) have become more intense. After the U.S. had ignited the debate by introducing a Currency Bill that would give the U.S. the right to levy import tariffs over Chinese products that are too cheap due to the export subsidy in the form of the undervalued Yuan, other countries were asked to join the debate. Once the Currency Bill has passed Congress and Obama put its signature on it, China can take the case to the WTO. Then, it might take months before the issue is settled, and in the mean time, other countries might have followed the U.S. example, damaging Chinese exporters. Since the chances that the Currency Bill will not be condemned by the WTO are much higher if other countries follow the U.S. example, the EU has strengthened its tone vis-à-vis China to make its exchange rate regime more flexible in practice (currently, it’s only flexible in theory). (Asking the Europeans to introduce an equivalent to the U.S. Currency Bill is perhaps a bit too much.)

But the Chinese are not stupid; they offered Greece a Marshall Plan II whereby China is buying Greek bonds (while saying they strongly believe in the good economic fundamentals of the country and the Euro zone) in return for Greece buying Chinese products. By supporting the weaker countries in the Euro zone, they ensure the strength of the euro, and thereby they retain an investment alternative to the U.S. dollar and an export market. Moreover, it implicitly tells the EU that it should not complain. The EU has gotten one cookie, it should not ask for another one. So now the EU is said to back off when it started complaining about the Yuan weakness.

So this move by the Chinese was very clever, in my opinion. However, do they really have a right to ignore global complaints about the weakness of their currency? IMF studies, and other ones, agree that they Yuan is 20-40% undervalued. If that’s not an unfair export subsidy, what is?

More and more countries seek to devalue their currency by intervention and/or loose monetary policy. Research has provided ample evidence unsterilised intervention is only working when accompanied by a loose monetary policy (and sterilised intervention is actually never working, perhaps only in the short run, and it can even be counterproductive, due to signalling effects). However, it is not always possible to loosen monetary policy. Japan has loosened monetary policy for years and is at or near the zero interest rate bound for years now, without having lifted Japan out of its period of (near) deflation.

Furthermore, it just is a very bad idea to try and weaken your currency, if all your neighbour countries have the same idea. When visitors on the first row of a concert start standing on their toes to have a better view, visitors on the second row have to come up with something better. Maybe jumping does the trick for them. But the ones at the back row really have a problem. This is the outcome of the well-known prisoners’ dilemma: nobody will have an advantage from it (the ones at the first row will start experiencing aching toes after some minutes and will regret their actions).

This is obvious: if each country seeks to lower its currency, flooding the market with liquidity, no country will succeed to lower its currency relative to the other countries. Except, of course, if one country takes such extreme measures that this immediately wipes out the value of its currency. Hyperinflation will prevail. Perhaps it is good – albeit only relatively good – if one country would follow this course, just to set the (bad) example.

Luckily for us Europeans, it is unlikely that the ECB will be the first one setting the bad example; the ECB is farthest from all central banks of the weaker countries to engage in extreme further quantitative easing, although the ECB did admit banks were addicted to their liquidity provisions such that the ECB has seen its exit doors (their path to tighter policy) being blocked.

The big question is, however, how far countries will go. There is a slight chance that central bankers and politicians do not realise the game they are playing is a very nice example of this prisoner’s dilemma. One step in the wrong direction, and the prevailing outcome will not be likened. In the end, every country will be worse off. Political pressure to purposefully devalue currencies, unfortunately, is enormous. I (being an optimist) do not believe central bankers will be so naïve (read: stupig) to underestimate the dangers going “all out” and continue the road (downhill) of extreme QE and currency devaluation.

But perhaps I am just being optimistic, believing in the wisdom of politicians and central bankers. And that is perhaps not so wise.

My personal assets and liabilities

A conference this morning in Amsterdam. Interesting, a lot of macroeconomics, international economics, monetary economics, a lot of men in expensive suits. Still, something else has been playing on my mind. There is something inherently wrong in the idea of economic growth we have. This sounds a bit radical, maybe it is, but I think it is crucial for how we view the world around us.

A side note: we, economists (yes, I consider myself an economist), tend to think the whole world evolves around economics. Maybe I believe this idea is more important than it actually is, but perhaps - especially if you are also wondering what this think we call economic growth actually is - you can agree with me.

Another side note: the gut feeling I have is difficult to put in words, but I'll give it a try...

Let me start with what is going on in the markets and what a very important dilemma is that we are currently facing.

On Tuesday evening, Fed chairman Bernanke said that inflation in the US is below the Fed's target. Since the Fed has the dual mandate of keeping employment at its maximum hurry, as long as it does not hurt its other mandate of price stability, the message of Ben actually implies that the Fed will engage in another round of quantitative easing (QE II) if it sees further dangers to price stability. Hence, more liquidity injections will be advanced by the Fed to prevent deflation. When and in which way the Fed will do this is another uncertainty to which it has not given an answer (not yet at least; tonight Bernanke will give another speech with the topic what the Fed can do to stimulate the economy, speeking about which courses of action are likely and what the accompanying dangers are). However, this is outside the scope of what I'm trying to describe here.

The whole idea of the Fed is that they will provide more liquidity in order to support the economy. This money is very likely to go into assets directly, and this will unavoidably lead to increases in risky asset prices. So will this support the economy? Will this produce economic growth?

There are some conditions that have to be fulfilled, should a monetary stimulus (QE) boost economic growth, and these conditions are quite stringent:

• Liquidity should flow from the banking sector to the real economy. Hence, consumers should receive this liquidity (the banks should be willing to lend, so their prospects for receiving this money back should be sufficiently positive);
• Consumers that receive additional money should be credit constraint. That is, they have to be willing to spend this money, instead of using it to pay off debts;
• The money the central bank seeks to pump into the economy should not be directed to, for example, risky assets or commodities (gold, etc.).

If this happens, money that is created by the central bank does not stay on the balance sheets of commercial banks, but is lended to consumers, who spend this extra money. Consumers would consume, and this increase in demand would be met by additional supply.

However, increased demand for any good will certainly be accompanied by price increases. Retailers must be crazy if they would sell their products for the same price as before, while consumers received "free" money. But most importantly: there is no free lunch!

So the fourth condition for monetary stimulus stimulating growth is that prices should not rise.

Now, assume that the enormous monetary stimulus of the past two years has not created money flows into equity (increasing equity prices) or into safe havens (gold, whose price has soared, and government bonds of countries considered safe, pushing their yields to historically low levels), but consumers would have received this money, would not have consumed even more than before, and supply would have risen simultaneously. Then, we would have been back at the old situation of too much debt accumulation.

It seems that in the past, we have consumed already too much. The problem is not that now there is a lack of aggregate demand, the problem is that in the past there has been excess demand, and this was financed by borrowing, not by an increase in our own production.

So in the end, what it all comes down to, is the following:

Over our lifetime, we should contribute just as much to the economy as we take out of it. We must produce just as much as we consume. In principle (and in the long run), the balance sheet of each person, over a lifetime, should be balanced: assets equal liabilities, and there is no debt nor saving surplus at the end of a person's lifetime. Unfortunately, this is not what has been happening.

So what must be true then, is that we (us, in the West) have borrowed, from foreigners, from future generations, from the world. We are not producing in value terms as much as we are consuming.

In the train yesterday, I overheard a conversation of a woman saying that actually they were working really hard at her company. She works 36 hours a week. I am sure that she is spending more in the other 132 hours of the week than what she truly produces in value terms during the 36-hour work week.

Looking at my own balance sheet, I must admit that I have taken much. My liabilities are composed of: a laptop, a netbook, DVDs, books, a TV, CDs, my phone, the Wii, a not so small student loan, shoes, clothes, etc.. On the other hand, there is just one true asset that I have been accumulating over my lifetime: human capital.

My human capital must be truly enormous if I could have bought with it all that I own. Sure, this is called investing, and I seriously hope that I will add a lot of value to the asset side of my personal balance sheet in the future .

But still: our liabilities are huge.

No news is good news

Finally, a new blog post of mine. The last weeks have been filled with work, study, some volleyball (the preparations for the season were more than great, now let's hope our team can keep this up), and a lot of time spent on the preparations of the General Members Meeting of my volleyball club taking place in two weeks. After that: no longer Ms President of the Board for me. A short, early reflection: it has been a very good experience, but it has been a rough ride as well!

Luckily, during the past few weeks, I had some time to reflect on the economy as well.

Conclusion: nobody knows what is going on anymore! However, very few people are willing to admit this. (What makes even me so sure that nobody knows, and if that is true, I do not even know whether it really is true. Annoying.) And that makes sense. Image what would happen in Ben (Bernanke that is) would say: "Guys, I don't know whether it will help, but let's stuff another huge pile of money into the economy (or in the banks, who do not want the money anyway) and see if tomorrow or next week it can stimuate job growth, housing prices, and thereby economic confidence". Nonsense of course; this will not happen in a million years. At least, I hope it will not.

But let's assume that Ben would say this. The market's logical reaction would be to abandon the USD, and move into safe assets such as gold. The gold price will rocket, perhaps with prices of other safe assets (a more difficult question is which assets will be safe in such an event, perhaps there will not even be one considered safe). The US will face a currency crisis. Banks with substantial assets priced in USD will fail, and this will lead to contagion of other banks, with soon enough really negative consequences for the real economy. In other words: economic disaster.

However, the big question is: why is this scenario so different from what is happening today? As the Fed announced nothing new yesterday; its outlook has not changed and they are still waiting to see in what direction the US economy is heading before they decide whether or not to renew their quantitative easing efforts. Hence, no news.

The same goes for the US housing market. Figures were released on homebuilders' confidence, which remained at the same level as previous month - albeit weakest level in more than a year-. Hence, no news.

Still, market sentiment was positive today. No news is good news? At least the Fed did not announce that the overall economy was getting worse and QEII was required, and also the housing market did not become worse. And this is supposedly good news.

Right.

In some other column, I wrote that this is can be called a bias in human nature. We have seen so much bad news, and perhaps even become immune to bad news. Although bad (or mixed) signals are abound, they are not breaking news anymore. And therefore, it is easy to get optimistic when some good signals show up, which is also what everyone is hoping for.
We even perceive the not-all-too-bad news as good news nowadays. Perhaps not surprisingly, but does it really make sense? The economy is still very unstable.

Market psychology is interesting. Maybe more on this next time.

FAQs part II

In my last blog I posed some questions for which we still don’t have a (more) definitive answer, except perhaps for the first question. With the Fed taking steps to quantitative easing 2.0 (albeit baby steps, since for now it has announced only to maintain the size of its balance sheet, and not let is shrink – indicated by the FOMC’s public statement last Tuesday), the markets are certainly not responding enthusiastic. More accurately: the past week has been a very hectic week for the financial markets. Worries about the recovery in the U.S. spread to more concerns about mainly the periphery of Europe. German export-led growth for now pulls the Eurozone ahead, but how long will that last? Quarterly growth was well above expected, but if countries importing German goods see their economies weaken, German growth will be unable to sustain itself. The ECB has indicated it will slowly move to exit strategies. Although problems in the periphery are still very concerning and dependence of banks in Portugal, Spain and Greece on ECB financing is increasing steadily.

The Fed, on the other hand, is much more willing to support the economy with an even looser monetary policy. Analysts and commentators alike are very pessimistic about the effectiveness of further quantitative easing. If it has not worked in the past, why would it work next time? Is there so much more the Fed can do? Well, actually, yes. But that is just in theory. Central banks worldwide are constrained by the whims of the market. Should a sudden worry for hyperinflation pop up, better beware! If central bankers do not respond quickly taking the money out of the system within a week or so, double-digit inflation may be the result.

But for now, the Fed is walking a very thin line between high inflation and deflation. Core inflation in the U.S. (excluding food and energy prices) is already in negative territory and should economic activity not pick up, negative annual core inflation is not unlikely. Of course, for a large part this is driven by the still declining housing prices. Nevertheless, deflation is a dangerous phenomenon and Ben Bernanke will do everything in its power to prevent it, but he has not indicated directly what he will do should the economy get even worse. If such measures are taken (the measures the Fed could possibly take are in an earlier blog of mine), however, the market will interpret this as a sign that the economy is doing really, really, really, really terrible. No need to explain here what that means. But on the other hand, when signs of the economy weaken, and the Fed does not respond, the markets will also react negatively.

My overall conclusion therefore is: whatever monetary policy does, it will not improve the matter much (the matter being the U.S. economy), and it is fiscal policy that should get things going again. But please not in the way fiscal policy has been used in previous U.S. fiscal stimulus packages. Let’s look at China; they really set a good example.

More on that later.

FAQs part 1

Dear blog,

(I never had a diary, so I never could write "dear diary", but "dear blog" makes up for this loss.)

With annoying music on (why do I even have 'Air' in my iTunes library?), the clock indicating its 6.37, and the 'C' on my keyboard hardly working, why not write a little blog before I go off to Utrecht?

I have to say, I missed writing for my blog. But the past two weeks were so hectic. however, it means there's room for improvement!

What's been on my mind the past week?

- Fiscal or monetary stimulus? With the Fed hinting at further quantitative easing and trying everything in their power to get the money into the economy, the markets are not reacting too enthusiastic. Will an ever looser monetary policy get the U.S. economy going? I think not. What would help is to get the money velocity up, and this is not something the Fed could do. Giving consumers extra cash they don't want does not make them spend it right?

- Ok this sounds too simplistic, I admit. But it does come down to get the consumer spending in order for the U.S. economy to get in an upward spiral again.

- So: will tax cuts for the rich U.S. citizens have to be extended? Will it do any good (i.e. get spending up)? Maybe, maybe not. Why it could get spending up (or at least not get it down once the cuts expire): the rich are the most productive. If you get them to work, this will be very beneficial for productiveness. Lowering their marginal taxes gives them more incentive to work. Why it cannot get spending up: the rich will spend as much as they like anyhow. Even if they do not have the money to spend, they will borrow, because they believe they will have the money in the future (according to the 'lifetime spending hypothesis'). The poor, on the other hand, are credit constraint as they have no access to loans and they have also no high incomes. So: giving them more money could do a better job stimulating spending. That is, given that the poor do not foresee an even worse future and therefore safe their newly acquired credit to save. Which hypothesis is the most likely? My guess is the latter, but circumstances matter. And this is where Obama comes in...

Then the most important question: will we have a double dip?

So many are writing on this topic. I'll be joining the debate soon!

Now brush my teeth and off to Utrecht for another day as an intern.

Byebye

Monetary policy: preventing asset bubbles, leaning against the wind?

This week, I’ve done a lot of reading, in the train and during my internship (I could write a book on what I wrote as well). As I came across many (I mean seriously a lot of) interesting papers, discussions, and other pieces, one thing especially caught my attention and this is what I’ll shortly write about. At least, I’ll try to keep it short. Keeping it short is not my strongest point (in writing that is, in words I find it so much easier to be short and concise).

Anyway, the results of the stress tests were published last Friday. I hope to write more on that next week, as I’m definitely curious about how the markets analysed the results during the weekend and how investors will respond to the failure of 7 banks during the stress test. My guess in earlier blogs was that publishing the results would not cause any stress nor any relief, simply because the scenarios tested were not strict enough. On the other hand, some banks appeared to have done some (mainly accounting) tricks and thereby made the results look much nicer. Slight chance that the markets take that to be something unimportant. The fact that banks performed those tricks is a very bad signal, but I could be wrong; perhaps the markets are relieved still (hmm right, like I’m ever wrong). We’ll know more tomorrow morning.

Now what I really would like to mention is the following.

This week, the IMF in a research bulletin discussed how monetary policy could and should be used to prevent increases in asset prices that are not sustainable (asset bubbles that is). A perfect example is the housing bubble that burst in the U.S. in the summer of 2007. Common thought –and the message of an important research paper by Ben (Bernanke)- before the financial crisis took off, was that tightening monetary policy is a too rude policy tool to avoid asset bubbles. Rather, the bubble should burst and it was supposed to be the role of monetary policy to clean up the mess afterwards, using a loose monetary policy to kick start the economy again.

Some months ago, I read a paper by three famous IMF-economists: Olivier Blanchard, Giovanni Dell’Ariccia and Paolo Mauro. In “Rethinking macroeconomic policy”, they wrote that we should learn from the current crisis and that we should use more direct policy tools to fix the problems at hand. As the Jan Tinbergen-rule goes: one target, one policy tool. So: monetary policy is used to target inflation. Fiscal policy is used to make redistributions and the automatic stabilisers of fiscal policy work countercyclical. A disregarded policy that can be used well to prevent asset bubbles is regulatory policy. And this sounds so simple (although I’m sure working out the exact details takes some more time), but collateral requirements, capital and liquidity charges, and stricter lending policies make banks hold more capital and prevent credit overexpansion or give banks some leverage such that they can overcome external shocks. An example is Spanish dynamical provisioning that builds buffers in good times that can be used in bad times, to put it bluntly.

For more details, I want to refer to the paper of Blanchard, Dell’Ariccia and Mauro, which is really clear, well written, and credible. For now, I’m just wondering why the IMF wrote that monetary policy should be used (carefully, but still) to attack asset bubbles. Why is it that they disregard in some way the paper I mentioned.

I mean, if other policy tools could ‘do the trick’; why bother using such a rough measure to try to achieve the same thing, while at the same time it could seriously undermine economic growth. To me, it is like bombing the house to kill the nasty fruit flies in the kitchen, because I think it are these fruit flies that cause the rotten peaches. (Likewise, asset bubbles are hard to identify.) Definitely I’ll regret bombing the house if it turns out that the peaches will become rotten also without the nasty fruit flies in the –now bombed- kitchen.

The Federal Reserve and blood pressure

Yesterday I wrote on the U.S. economy and the Fed that will have to act someway or the other to at least try to avoid Japanese deflation scenarios. So as I promised, today you could have read the options available to the Fed. Not in my blog, but on the front page of the Wall Street Journal. Surprise!

First of all a word on my new colleagues: they are really great (they must be reading this sooner or later, so if I wanted to say something bad about them, I couldn’t anyway, for my own sake). The first day of my internship at iCC has past and I have to say that I look forward working there and doing the research for my master thesis (and for iCC, as the report is also in their interest), but more on this some other time.

Anyway, I don’t want to disappoint you already after my third blog (this will scare away the few loyal followers) so I will write here what I promised to write; let me quickly summarise what the article said (and which is, of course, exactly what I was going to write J).

So hang on: here is what the Fed could (COULD, not should) do:

1. Ideally, the Fed would strengthen its promise of keeping the fed funds rate low for an extended period of time, in order to encourage investors to borrow and take risks. Forecasts already expect the rate to stay close to zero well into 2011, so if this is not encouraging enough, what is? An yes, there is the problem of credibility. Because once investors borrowed, why not increase the rate?

2. A road the Fed could take is to push short-term rates to zero, but they are very reluctant to do so as it would disrupt the money market.

3. An attractive thing to do would be to use cash received from mortgage-backed securities or underlying loans that are paid off to invest in new mortgage-backed securities. At least, it seems to be an attractive option as it signals the Fed’s attempt to stimulate growth and so avoid deflation. A likely course of action, but the estimated impact is small, as mortgage rates are already very low so further stimulation is unnecessary.

4. Lastly, a very aggressive option would be to repurchase U.S. government bonds or mortgage-backed securities, to push down the long-term interest rate. The only problem here is that also this effect is likely to be small; the Fed would then have an even smaller portfolio to pour money from into the economy. The damage would be huge if the plan would backfire and inflation expectations rise.

So this was the theoretical part. Basically, the hands of the Fed are tightened and there are drawbacks to every option it has. Pumping money into the economy to get people to spend can stimulate growth, but whatever the Fed does, it comes at the cost of further increasing budget deficit and so it further constrains fiscal policy. What is really needed are tools to get employment up, fight falling wages and prices, but this is not the job of the Fed.

Currently the Fed is debating internally about what to do, and I think that is the best they can do; let them sit there and debate, because loosening monetary policy even more will do more harm than good. Let the U.S. government solve out how to fight unemployment and get spending and investment up.

To close with, I want to warn you. Research performed at the University of Chicago shows that loneliness can raise blood pressure. Such a relief: this holds only for those aged above 50. Don’t think: ‘time to start making friends before I’m that old’! First of all: 50 is not that old, I plan on becoming 110. Second, it’s not the amount of friends you have that determine how lonely you feel, but rather how long you can wait before someone write/calls you and how long you can stand to be alone (i.e. feelings of loneliness). Obviously perhaps, but nice that this gets confirmed by research.

The U.S. economy and the Fed

As a skip tonight’s news broadcast (just came back from a board meeting) and still have some time before I hit the bed but it’s too late to engage in some physical activity like my favourite dance game with the Wii, let me share with you my view on the U.S. economy. (That’s having your priorities straight.)

My curiosity on this topic was triggered by Paul Krugman’s blog on the Feckless Fed (btw. feckless means something like not fit to assume responsibility or being generally incompetent – nice word huh?). Paul Krugman is obviously pessimistic on the U.S. economy (rightly so), but moreover he is sceptical on how the U.S. Federal Reserve responds to the situation in the U.S., e.g. high unemployment rates, a huge government debt, too costly reform of the health system and already slow growth.

The first question that came to my mind was how it can be that the IMF in the world economic outlook predicts a growth rate for the U.S. of 3.3% in 2010 and 2.9% in 2011, while the prospects look so bleak. Of course, the states are recovering from the nadir and restoring from such a low does not require much. On the other hand, the fundamentals are really flawed and not much have been done to restore the financial system. The only good news in the last few weeks came from rallying stock indices and releases of macro-economic figures that were not too bad. However, these good figures and the following rallies again stem from increasing imbalances; too high borrowing from emerging economies and future generations. All in all, can we really believe these positive growth projections? I think we should be much more careful than taking these figures at face value.

The second question that came to my mind was when the Fed will make its move to avoid Japanese-style deflation and what move this will be. Paul Krugman’s worries about deflation are not completely ungrounded (and if they were, I wouldn’t dare to say so) and the Fed too has to confess that deflation in the near future is not completely unlikely to occur. So far, they have not taken any concrete action to do so. Even worse, the last statement of the Federal Open Market Committee suggests that economic prospects and the labour market start to improve gradually, but where does this recovery come from? There is only modest income growth and the housing market is still locked due to high unemployment. Okay, business spending is increasing, but confidence is decreasing, and many banks have not yet recognised their losses on commercial mortgage backed securities. The Eurozone economy does also not contribute positively to U.S. growth. These are the reasons for deflation not being completely unlikely.

If the Fed does not recognise this, surely they will not do anything to avoid deflation. If they would recognise it, what can they do? I range the options from hardly credible to somewhat more credible:

1. 1. ...

2. 2. ...

But this you can read tomorrow! J Sleep tight.

The criteria for stress testing

In my previous blog I have explained why publication of the stress testing results in the EU are not likely to have any effect. Below, I want to explain shortly why the criteria for the EU stress testing were set such as they were. Furthermore, I would like to add some additional comments on the stress testing criteria and its effects.

Previously, I stated that extreme scenarios were excluded from the stress tests because they would lead to too many defaults. However, there is more to it than that. First of all, including more extreme scenarios seems politically impossible; politicians do not consider sovereign defaults a likely scenario. The ECB and such will do whatever is in their power to prevent sovereign default. Market interventions play a role here: they will prevent such extreme scenarios to be tested. But the aim of stress testing is to check which banks will require capital injections should a sovereign default occur. Again, this is what makes the stress tests not credible. Another argument for not including extreme scenarios is that it is not that hard to imagine what would happen if some Southern European member states’ governments would default. But what is then the purpose of a stress test?

IMF research on stress tests, taking Iceland as an example, shows that stress tests do not have to be incredibly sophisticated, as long as the assumptions and scenarios (or the weight of the credit and market risks analysed) are appropriate. Too bad that this is ignored by the CEBS (Committee of European Banking Supervisors). Or actually the CEBS is not to blame; with its mandate being “giving advice to the EC on policy and regulatory issues related to banking supervision, promoting cooperation and convergence of supervisory practice across the EU, and contributing to consistent implementation of guidelines and recommendations” it has no regulatory power to require needed criteria for the stress tests.

My advice is to make to CEBR independent from national supervisors and Central Banks and give it the needed regulatory power to set more strict criteria for the stress tests, including:

1. Scenarios thought likely by financial markets;

2. Defining banks’ capital not as Tier I capital, but as the more stringent core equity (which would be consistent with the new Basel rules);

3. Require uniform disclosure of the results, and;

4. Require banks and governments to draw up contingency plans should markets panic after publication.

One last thing: short after release of the U.S. stress tests’ results last year, markets restored. We do not know whether this was because of the publication of the results in itself, or the required raising of additional bank capital (the U.S. contingency plan).

First blog of mine!

After being very patient while personalising the design of this blog, due to a really slow internet connection, it's time to post my first blog.

A few small things that were on my mind last week:

• Saying "With due respect, but..." shows no respect at all. So: it's better not to use this at all. Why then do we have this saying?
• Asking whether you can ask a question is not really productive.
• Neither is "to be honest...". Aren't you honest otherwise?

Apart from these language-related issues, I read some articles on the stress testing that is to be performed on 91 European banks these weeks (a list of which banks are included can be found here). A serious stress test would have been such a good idea: confidence could be restored and uncertainty lowered, thereby perhaps lowering the interest rates Southern European governments bonds pay currently. And once clear which counterparty of banks are safe, banks can finally start lending to each other again, instead of parking their money on the ECB overnight facility at a very low yield.

Results are to be published the 23rd of July. Exciting? I'm afraid not! Although it seems quite scary that the ECB refuses to set aside capital in case markets panic after release of the testing results, and also national governments have no action plan stipulated when this happens, it is actually not so scary. Why not?

After a long time of debate on what the stress testing scenarios would look like, EcoFin decided not to include the scenario of sovereign default, while this is the utmost important scenario that investors worry about. For the stress testing results to be credible, this scenario must be included, otherwise it is not the sunlight that will bring the disinfection financial markets so desperately need (because they do what outsiders cannot do on their own: assessing the health of banks). My guess on why this extreme but still likely scenario is excluded is that it would lead to too many defaults, meaning that additional capital injections will be needed, while this is not what the ECB and governments are willing to do.

Unfortunately for Spain, the country that pushed the publication of stress testing results, the effects of the publication are likely to be minor in my view; investors will not stop worrying about the creditworthiness of EU banks. On the other hand: would we have wanted such severe stress tests that may banks would have defaulted in the tested scenarios? This seems even worse, since governments refuse to have a plan B ready if markets panic.

Perhaps in the future, when other stress tests will be done on European banks, scenarios will be severe enough, and governments will have learned to draw up contingency plans in case markets panic. But: not yet... A serious stress test could have been such a good idea: once clear which counterparty of banks are safe, banks can finally start to lending to each other, instead of parking their money on the ECB overnight facility at a very low yield. Confidence could have been restored and uncertainty lowered, thereby perhaps lowering the interest rates Southern European governments bonds pay currently.

I think in the above it has become clear why I do not believe that publication of the stress testing results would lead to a required capital injection of 100 billion euro, as stated by some analysts at the Dutch Rabobank.

Now it's waiting for publication of the results on the 23rd. In the meantime, I hope to keep you updated on other interesting stuff catching my attention.

Last but not least: the website of The Economist has been renewed. Looks quite nice now!