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.