Euro: What to Do Now?

Brad de Long scratches his head and asks: what to do now:

The Euro: One Size Fits None

Marty Feldstein, back before the start of the euro, was greatly worried that a single currency would result in too much business-cycle volatility across Europe: countries would not be able to use either fiscal or monetary policies to stabilize their domestic economies because both would be fit to a common European pattern. In Business Week this week, some evidence that his fears were well-founded. Of course, that doesn't tell us what to do now...
Source Brad de Long's Semi-Daily Journal
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BW Online | January 24, 2003 | The Euro: One Size Fits None: Too much political capital is at stake -- especially in Germany and France, the euro zone's key economies -- for the euro ever to crumble. But as Germany's economy slumps into its second year of recession, the difficulties of designing a single monetary policy for 12 different countries are increasingly evident. That's worrying many of the senior businessfolk gathered in Davos, Switzerland, for this year's World Economic Forum. "The euro zone's monetary policy isn't a case of one size fitting all but of one size fitting none," says the chief financial officer of one Spanish company. "The result is that Germany is having to cope with higher interest rates than it needs, and its economy is slowing as a result. And that's affecting everyone across Europe."

SPENDING LIMITS. The problem is the Maastricht Treaty mandates that the European Central Bank maintain price stability across the entire euro zone. It can't take conditions only in Germany into account when setting rates, even though Germany is the Continent's largest economy and is a drag on growth in other countries. The ECB's key interest rate stands at 2.75%, whereas economists say Germany really needs a rate as low as 1% to stimulate demand, investment, and growth. Fiscal policymakers in Berlin are powerless to kick-start the sputtering economy because the Stability & Growth Pact puts tight limits on state spending. In particular, they may not run a budget deficit above 3% of gross domestic product. Germany's euro-zone partners have just censured it because it breached the 3% limit last year and will probably do so again this year.

Some eminent economists, such as Robert A. Mundell, professor of economics at the School of International & Public Affairs at Columbia University, argue that the Stability Pact should be scrapped and that the ECB should be given a broader mandate. Yet many European business executives take the opposite line. Gerard J. Kleisterlee, president and chief executive officer of Dutch manufacturing giant Royal Philips Electronics, says the single currency needs to be underpinned with sound state finances. Ironically, German government officials agree. Caio Koch-Weser, Germany's Secretary of State of Finance, says it would be a mistake to abolish the pact.
Source: Business Week On Line
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What to do now is an extremely moot point. I don't suppose there's much mileage in repeating the old British expression: always look before you leap.I suppose the best we can do is watch and wait since it will be some time before any of the responsible parties are likely to be prepared to admit to a mistake and start to undo the dammage. Meantime various possible scenarios do of course suggest themselves

On the one hand the inflation riddled southern fringe (Spain, Greece, Portugal) may find themselves launched into an Argentina-style rapid exit mode as rapidly rising costs make it increasingly difficult to create new jobs. On the other the German voters who are being asked time and again to foot the bill for what is at heart an unworkable system, may themsleves get so fed up that they decide they want the mark back and leave.

Either way things are still going to have to get a lot worse before anyone bites the bullet on decisions. However recent events on the Iraq front may ironically have given matters a hefty push. I don't know if anyone else is following this, or it's just me, but I can't help noticing that each time an Iraq hawk makes a strong speech the dollar drifts down a few points. Meanwhile the US treasury stays strangely silent. Reading Ben Bernanke carefully, it's clear that a weak dollar is a good hedge against perceived deflation dangers, so letting it drop without openly changing policy seems like a good move. A kind of knock-on Iraq effect. Meantime up and up goes the Euro. Since one common candidate on everyone's shortlist of potential 'Japans' is in fact Germany this could be just the shock they need (this and the firm fiscal tightening coming from the stability pact) to get them well and truly going. In which case, ZIRP will be well and truly on the order of the day, and then.......

It is interesting to note that Euro membership is not synonymous with EU membership, as with the 10 new entrants a majority of EU members (13-12) will not be in the Euro. The following link from Morgan Stanley's Global Forum might be of interest since it shows that the 4 key new Eastern entrants are all quietly dropping their currencies with the dollar to maintain competitiveness: Central Europe Currencies - The Tide Turns

Japanese Interest Rates Briefly Fall Below Zero

Japan's continuing economic problems took the world of economic data into new and previously uncharted territory on Friday as overnight call rates fell below zero for the first time in the country's history.The overnight call rate on Y15bn of funds traded between foreign banks fell to minus 0.01 per cent. Because of the negative rate, borrowers are in effect being paid for borrowing funds because they will have to pay back less than they were lent. however much of a technical one-off this may be, it does serve to attention to the copmplex character of Japan's difficulties in a particularly novel way. Of rather more significance is the continuing fall in long term interest rates. Rates up to ten years are now virtually horizontal, and the curve up to thirty years is now showing signs of flattening out. It appears the expectation of continuing deflation is really setting in long-term

With long-term interest rates already virtually nil under the Bank of Japan's "quantitative easing" policy, bankers said on Friday the move into negative territory was more a symbol of the country's decade-long economic malaise rather than an indicator of future financial chaos. Critics say that the BoJ's ongoing zero interest rate policy and it decision to flood the market with liquidity has been ineffective in stimulating the economy.

"In terms of monetary policy, the BoJ is not doing enough," said Hisashi Sitow, director at Credit Suisse First Boston in Tokyo. "It has to buy more JGBs or foreign bonds to affect the market. Monetary policy is clearly ineffective, as base money is increasing but growth in the money supply is stagnant." Current record low yields on Japanese government bonds indicate that investors are not betting on an economic rebound anytime soon. The 10-year JGB has been skirting new four-year lows for some weeks, while the yield on the five-year bond fell to a record low on Friday."This is all part and parcel of a growing loss of faith in Japan's future," said Marshall Gittler, strategist at Deutsche Bank in Tokyo. "JGB movements are telling a story that deflation is set to continue indefinitely."
Source: Financial Times
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Euro at 1.10 Dollars 'Now in Sight'

Or at least this was the sentiment expressed by one anonymous City trader in the FT yesterday. Now, as with all expressed trader opinion, this needs to be taken with a pinch of salt, but it does seem that this figure could become something of a psychological target in days to come. Certainly the Euro is going up and up - over 15% in six months now. Clearly if it does go through the $1.10 barrier this will give the ECB and European Commission something to ponder over, since a high Euro will be good for some and bad for others - another example of how difficult it is to manage monetary policy in a currency union. This is surely a falling dollar story more than it is a rising Euro one. The economic grounds for optimism on the European front are thin on the ground. So one day this will turn, but that day doesn't seem to near right now. However with Germany teetering on the brink of creeping deflation, and the ECB desperately looking for good reasons for another rate cut at a time when core inflation is still stubbornly hovering over the 2% mark, stemming the rise of the Euro could be just the excuse they need.

The euro continued to edge higher against the dollar on Wednesday amid mounting tensions between the US and Iraq.The recent bout of more aggressive rhetoric from the US administration has kept the dollar under pressure in recent days. On Wednesday, the dollar hit a fresh three-year low against the euro at $1.0744.Traders said that $1.10 now appeared in sight.

Risk reversals - an indication of the bias of the options market - provided an interesting hint into the psychology of the marketon Wednesday. Although euro calls continue to trade at a premium to euro puts - suggesting the market still expects a rising euro - this premium is at its lowest level so far this year.Marc Chandler, chief currency strategist at HSBC in New York, said this could be explained by traders long of euros trying to hedge against a fall in the currency. "This hints that many of those who hold a long euro postion do want some protection, but are not willing to sell their spot position," he said. "This is an encouraging sign for the euro," he added.
Source: Financial Times
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Incidentally, reading again the US administration hawkish rhetoric argument, it couldn't be that they are using the pre-war atmosphere to move away from the strong dollar policy, now could it. While all eyes are focused on the Bagdad/Washington axis, the dollar is quietly allowed to drop, much to the relief of a deflation worried Greenspan, and a hard pressed US manufacturing sector. Spelling this out: talking hard on Iraq is in fact talking down the dollar without saying so. Or am I being too cynical?

The Uncertain Future of the American Economy

This week it's the Economist's turn to muse over the divergent data that we keep getting for the US economy. The problem is that for each piece of good news, there seem to be two pieces of bad. As long as this ratio is maintained the downside risks only grow. First there is the news that housing starts were strongly up in December. Statistics released on January 21st and which measure new-house construction, show the level of new starts was at it's highest since mid-1986. Good news, well yes, but always bear in mind that consumption is being disproportionately driven by housing values, either through refinancing or new starts, and that this in turn is being driven by ultra-low interest rates and a higher than average rate of inflation in the property sector, which makes property an interesting assett to hold, especially when the equity market is down and out. One day or another this will come to an end, since long term growth in property prices cannot move much out of line with earnings growth. But then we had the news that fourth quarter GDP hardly moved, and may even have contracted. In addition there was December's unexpectedly large job fall-out, together with the record trade deficit, and to cap it all we discovered that US retail prices only rose 1.2% year on year to December, dead on target to enter negative values (deflation) in 12 to 18 months if all this doesn't turn itself round:

Monthly data are often unreliable, of course; there is always a plausible explanation for unexpectedly bad (or good) news. The November trade gap, for instance, reflected a big surge in imports following President George Bush’s action to halt the dockers’ strike on the country’s west coast. But nearly all recent economic statistics point to the same conclusion—that America’s recovery remains sluggish and erratic. The data on housing starts do not fundamentally alter this gloomy diagnosis. Ironically, this is likely to help Mr Bush garner political support for his latest stimulus package, unveiled on January 7th. It could also put pressure on the Fed to consider cutting interest rates again when its policymaking committee meets at the end of the month.

The biggest obstacle to healthier economic performance, though, is political. As the Fed’s chairman, Alan Greenspan, acknowledged in the closing months of 2002, uncertainty about the future is holding both investors and consumers back. The shadowy threat of international terrorism and the much more explicit prospect of a war with Iraq has made many Americans nervous about the future. For businesses still reeling from the speed at which the late-1990s boom turned to bust, the political climate is one more reason to put off investing in new plant and equipment or hiring new staff. For consumers, for so long the mainstay of the American economy, the thrill of the shopping mall seems, finally, to be on the wane. On January 17th, the respected University of Michigan survey of consumer sentiment showed an unexpected drop because of gloomier expectations of future spending.
Source: The Economist
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All of which has prompted the NBER's business cycle dating committee to withold judgement on whether the US recession is officially over:

According to the most recent data, the U.S. economy continues to experience growth in output but declines in employment. Real personal income has generally been growing over the past year, while employment fell significantly in both November and December 2002. Recent data confirm our earlier conclusion that additional time is needed to be confident about the interpretation of the movements of the economy last year and this year. The NBER's Business Cycle Dating Committee will determine the date of a trough in activity when it concludes that a hypothetical subsequent downturn would be a separate recession, not a continuation of the past one. The trough date will mark the end of the recession. The committee will not issue any judgment about whether the economy has reached a trough until it makes its formal decision on this point. The committee waits for many months after an apparent trough to make its decision, because of data revisions and the possibility that the contraction would resume. For example, the committee waited until December 1992 to announce that a trough had occurred in March 1991.
Source: National Bureau of Economic Research
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While the NBER is still trying to decide whether any return of clear recessionary indications would mean we have a prologation of the first one, or the start of a second, Morgan Stanley's Steven Roach continues to claim the arrival of the double-dip. This is a secenario wherby a demand relapse early in a recovery plunges the economy back into recession. He argues that the double dip, far from the exception, has actually been the norm in America’s recessionary experience over the past 50 years. More often that not, demand relapses have occurred just after businesses had started lifting production and rebuilding stocks. That then requires another round of output, employment, and inventory adjustments -- the second dip. In fact, he says, in five of the preceding six recessions, there was a brief interval of positive growth -- the false recovery -- that then gave way to a climactic end-of-cycle downturn, and in two of those recessions -- those of the mid-1970s and early 1980s -- there were actually not double, but triple dips. And why does he think this is happening this time round? His answer is clear: such double dips are the classic by-products of a post-bubble US business cycle. Until, he suggests, America faces up to a purging of the excesses that built up during its late-ninetees bubble, the threat of another dip remains an ever-present possibility. Unfortunately, he has a long list of such excesses -- in particular record levels of consumer indebtedness, record lows of net national saving, and a record balance-of-payments deficit. Seeing the problem isn't too hard, the trick might be in finding out how to 'purge' these excesses without sending the US hurtling down into a major depression. Raising saving and reducing indebtedness, remember, will only serve to reduce aggregate demand further absent large-scale investment hikes, but were would those investment hikes come from in an economy which already has excess capacity and where consumer demand would be falling?

It has been a year since I first came out of the closet as a double-dipper (see my 6 January 2002 dispatch, "Double-Dip Alert"). While the outcome hasn’t transpired in precise conformity with my script, the dreaded dip has been far closer to the mark than a classic cyclical recovery. And now we’re face-to-face with yet another dip alert. This is a continuation of the seesaw pattern that has been evident ever since the US economy officially stopped contracting in late 2001. The wild and frequent swings from near boom to near bust have been the rule, not the exception over the past year. The economy surged at a 5% annual rate in the first period only to sag back to an anemic 1.3% pace in the second. Then it was back up to a 4.0% clip in the third quarter before coming to a screeching standstill in the final period of the year. Morgan Stanley’s GDP "tracking model" -- which filters the GDP content of all the high-frequency data on retail sales, capital goods shipments, construction activity, exports and imports, and government spending -- is now flashing "zero growth" for 4Q02. It’s not a strict dip -- as a purist I insist on a negative sign -- but you can’t get any closer. Experience underscores the whimsy of national statistics. With a central estimate of "zero," the actual number could just as easily be in negative or positive territory. But no matter which direction government statisticians divine, the quarterly change for the period just ended now appears to have been very small. And that’s the basic point.

There is an important message to be taken from a US economy that is now back on the brink of a recessionary relapse. The repeated risks of a double dip have not come out of thin air. They are classic by-products of a post-bubble US business cycle. Until America faces up to a purging of the excesses that built up during the bubble, the threat of another dip remains an ever-present possibility. Unfortunately, there is a long list of such excesses -- namely record levels of consumer indebtedness, record lows of net national saving, and a record balance-of-payments deficit. I stress the word "record" in describing each of these attributes of a US economy that has gone to excess. It indicates how far out on a limb America remains in clinging to a growth rate it can no longer sustain. In the end, that’s what the bubble was all about -- the ultimate temptation for the world’s dominant economy to indulge in a lifestyle it could not afford. We all took a bite out of the same apple. There is no easy or painless cure for this post-bubble hangover. Lingering structural imbalances are the functional equivalent of stiff economic headwinds that have the potential to constrain the US economy to a subpar growth trajectory. With a US-centric global economy lacking any other engine of autonomous growth, a dip-prone America puts the world in a similar predicament. That’s certainly the message from near-recession-like conditions that are once again evident in Europe and Japan.
Source: Morgan Stanley Global Economic Forum
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Too Much Saving in Japan?

This piece raises a question which is very much to the point, is there too much saving in Japan? Secondly, if there is, is this structurally related to the demographics of contemporary Japan. This question is very much to the point since most of the current enthusiasm for the appointment of an 'inflation targeting' governor at the Bank of Japan results from a diagnosis that the deflationary savings excess/lack of demand growth is due to a 'bad' IS/LM equilibrium associated with the zero interest bound. Now if the problem went deeper, then logically the solution wouldn't work. Unfortunately the article ultimately backs off, concluding that: "Immigration is not a practical solution today when unemployment is high". Of course if the unemployment is high BECAUSE there has been no immigration (and consequently the slope of the labour supply curve is not steep enough in more technical terms) then we are caught in a vicious circle. Things aren't always as they appear, remember we used to think the sun went round the earth. It's my bet that the injection of a large quantity of cheap immigrant labour at the bottom end of the Japanese labour market would do a lot more to help get things going than any of the other proposals currently on the table.

Japan's economic problems have attracted a lot of attention over the years. They have also exposed a lot of erroneous thinking. Today is no exception. As politicians and academics continue to flounder, they ignore one vital fact: the Japanese economy has a structural savings surplus, and a change in economic policy is needed to deal with it.An unusually high proportion of Japan's population is in its 30s and 50s, when savings for retirement are high. There are still relatively few who are retired and spending their past savings. As a result, the national savings rate is high. At the same time, there are few people under 20, so the workforce is shrinking. This means growth is bound to be slower than in countries such as the US, which has a lot of immigrants and a growing workforce. Even if it is optimistically assumed that labour productivity will rise to US levels, the difference in demographics means Japan can only grow at half the US rate. Japan must either change its population structure by massive immigration or export its capital surplus with a much bigger current-account surplus. The trouble is that the first option is unpopular in Tokyo while the second is unpopular in Washington. Faced with unpalatable choices, the typical reaction has been denial.
Source: Financial Times
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Unfortunately apart from the connection made with demography and growth the article really has little new to offer. Even the association of saving with those in their 30's and 50's is an oversimplification of what is probably a rather complicated picture (and one which I'm still trying to sort out myself). The range of policy proposals appears to be a complete rag-bag including virtually everything except my grandad's old nightshirt, but he is surely wrong that internal monetary easing is likely to be more effective than yen value reduction in provoking short term inflation. But as I said, if the diagnosis is bad, in all probability the medicine won't work in either case.

Oh Where Has All the Traction Gone?

This effectively is the question that Morgan Stanley's Stephen Roach keeps asking himself. By policy traction, he means the ability of the authorities to jump-start the global economy with traditional fiscal and monetary stimulus actions. As he points out, in today's world, with the US (and China....?) the only visible engine of global growth, global traction means US traction. But this is just where the problem starts. The US has economy has received an unprecedented reduction in the Federal funds rate, at the same time as fiscal policy has swung violently from small surplus to sustained deficit. Normally, two years into the problem, you should be seeing daylight at the end of the tunnel, so where is it? Could it be that most analysts are missing something? Roach says its the post-bubble hangover resulting from earlier excess. Yours truly suggests that it's a change in global headwinds resulting from yet-to-be-analysed consequences of structural changes in OECD demography, and the imminent arrival of the two incipient Asian giant 'tigers', China and India. Whatever it is, something is crying out for more explanation than its getting.

Policy traction should not be taken for granted. Under normal conditions, all it takes is a dose of fiscal and/or monetary stimulus and the real economy normally responds -- albeit with a lag. However, the key in understanding the concept of policy traction lies in what constitutes "normal conditions." Insofar as my view is concerned, there is very little that is normal about America’s post-bubble workout or about the lopsided nature of this US-centric global economy. Largely for those reasons, I remain highly suspicious of the consensus presumption that policy traction can be counted on to spur a solid recovery in the US and the broader global economy.

To better understand this conclusion, I think it helps to lay out what can be called a model of policy traction -- identifying the conditions under which policy stimulus leads to an acceleration in the pace of real economic activity. In my view, this model has five key ingredients:

* First is the purging of pre-recession excesses. Typical excesses include an overhang of unutilized business capacity, unnecessary construction activity, and unwanted inventories. Of course, there can also be financial excesses, such as too much debt or too little saving. Until these imbalances are eliminated, policy stimulus is unlikely to bite. If, in fact, these excesses endure, the result would be the functional equivalent of economic "headwinds" that would restrain any recovery or subsequent expansion.

* Second is the development of pent-up demand. This involves the deferral of goods and services during a recession -- for example, the cars that aren’t bought, the homes that aren’t built, and the business investment and hiring that is deferred. Once the recession comes to an end, consumers and businesses typically unleash that pent-up demand, thereby providing a spark to the early stages of the typical cyclical recovery.

* Third is the inventory cycle. Recessions are invariably accompanied by sharp production cutbacks outright liquidation of unwanted inventories. Accordingly, it takes an increase in production to bring any such destocking to an end. To the extent that the end of the inventory run-off coincides with a policy-induced improvement in final demand, traction in the real economy is usually reinforced and often magnified.

* Fourth is the nature of the policy stimulus itself. These days, stabilization policies are normally left in the hands of the monetary authorities. Of course, that doesn’t preclude the possibility of a fiscal stimulus. Nor does it rule the possibility of a foreign-exchange-induced stimulus brought about by currency devaluation.

* Fifth are the lags -- the variable and often long response time between policy actions and their impact on the real economy. In most economies, it takes about 12-18 months for the effects of monetary stimulus to begin to show up in the credit sensitive sectors of consumer durables, residential constriction, and business capital spending. Fiscal lags tend to be shorter, depending on the nature of the stimulus.

In my view, the usefulness of this model is that it enables us to frame the debate on policy traction in a reasonably objective and coherent fashion. On that basis, the first point to make is one of global context: In a US-centric world economy, global policy traction is tantamount to US policy traction. Barring the emergence of a new engine of global growth, the rest of the world is beholden to the US for any spark of cyclical revival. And yet just as America has played a disproportionate role in driving the global economy since the mid-1990s, it is now playing an equally important leadership role in applying policy stimulus. Consequently, a US-centric global economy awaits the outcome of America’s policy-traction debate with bated breath.
Source: Morgan Stanley Global Economic Forum
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