Conjectures about the post-crisis future of the global economy are path-dependent, i.e. they necessarily depend on the course of events envisaged for getting out of the crisis.
The current global crisis was the consequence of financial de-regulation and the general dominance of hyper-liberal policies in the United States, in the UK and in the global economy. It started around August 2007 as a US banking crisis arising from toxic sub-prime assets in banks’ balance sheets; it turned into a credit crisis that depressed enterprise investment; it spread globally through the decline of foreign trade and the slowdown and often reversal of capital flows, including Foreign Direct Investment; and then - with the large scale cost of rescuing financial institutions by government budgets, the rising cost of labour unemployment and the decline in governments revenue - it grew into a fiscal crisis and, ultimately, a widespread crisis of sovereign debt, particularly in the Euro-zone.
Initially the decline in industrial output, foreign trade volume and stock exchange values replicated the scale and the pattern of the 1929-32 crisis. Soon the impact of the crisis and cross-country contagion were mitigated by simultaneous, internationally co-ordinated, monetary expansion and fiscal stimulus, introduced at the end of 2008 and early 2009. But monetary expansion failed to re-launch economic growth, while concern about fiscal sustainability soon led to a simultaneous, premature exit from fiscal stimulus in most countries. Current prospects - apart from those of BRICS (China, Russia, India, Brasil, South Africa, now accounting for 18% of world GDP and the bulk of its growth) - are of widespread stagnation and double-dip, indeed of a second and even more serious recession.
The macroeconomic policies followed appeared to have a keynesian flavour, stimulating aggregate demand via tax cuts, monetary expansion and low interest rates. But keynesian remedies would have required public investment instead, whereas tax cuts temporarily fuelled private consumption, and the effectiveness of low interest rates - which mostly were not passed on to borrowers and simply involved higher profits for financial intermediaries - was limited by liquidity preference.
The rescue of financial institutions involved a massive transfer of wealth from taxpayers to bank creditors, including depositors and shareholders. This solution was clearly inferior to any of the alternatives, whether support for bank debtors, or partial nationalization of supported financial institutions, or outright loss-taking by imprudent lenders. Income inequality, whose depressive effect on effective demand had been reduced by credit expansion - one of the contributory factors of the crisis - increased further as a result of labour unemployment and continued payment of managerial super-bonuses awarded mostly to those responsible for the financial debacle not by markets but by a semi-feudal process of self-serving decisions by a managerial caste.
The current generalized advocacy of strict fiscal discipline, demanded by international financial institutions and often enshrined in national constitutions as a balanced budget obligation, is particularly anti-keynesian, and is bound to be counter-productive in the middle of a recession.
First, a balanced budget is neither sufficient nor necessary to the sustainability of government debt, because a primary surplus (net of interest payments) may or may not be necessary to debt sustainability - depending on whether the economy grows at a rate slower or faster than the average interest paid on government debt.
Second, the keynesian lesson has been forgotten or ignored, that the balance of government expenditures minus revenues, plus the balance of private investment minus savings, plus the external balance of exports minus imports, must necessarily add up to zero as a matter not of theory but of accounting consistency. Therefore the budget balance cannot be a policy instrument, but only a target that may or may not be achievable depending heavily also on the behavior of national economic agents and of global trade partners (including the elimination or large reduction of Germany’s trade surplus vis-à-vis the rest of Europe, and China’s gigantic trade surplus). Generalized efforts by all governments to balance their budgets simultaneously might actually result in a perverse combination of budgetary (and trade) imbalances as well as a lower level of employment and income worldwide than would be the case without such efforts.
By the same token, generalized efforts to promote employment and growth via higher international competitiveness - whether achieved by external devaluations or by domestic deflation of wages and prices - can also be competitively self-defeating: another clear keynesian lesson is that lower wages can raise employment through higher exports in one country, but cannot resolve unemployment as a world problem. Nor can world unemployment necessarily be reduced by a generalized reduction of employment tenure and other labour welfare provisions, or the replacement of collective bargaining by firm-level bargaining: the only certain effect of such policies, also very popular in anti-crisis policy packages under the pretext of “structural reforms” (e.g. see the European Central Bank’s guidelines to the Italian government in their letter of 5 August 2011) is the deterioration of the quality of work and labour incentives.
Often it is believed that the impelling necessity of environmental improvements, required by the reduction of global warming and of general pollution, and the forthcoming exhaustion of natural resources, will create a new important opportunity for investment and growth. However - apart from the observably controversial nature of global warming - these are all opportunities for public or public-funded investment, desirable in itself (not absolutely but up to some point) but competing with alternative uses of scarce public funds whose expenditure today is supposed to be kept under control in the interests of fiscal sustainability.
The chances of world leaders suddenly learning keynesian lessons, and implementing them with the speed and on a scale adequate to propel the global economy out of stagnation are remote, indeed would amount to a miracle. Even those who would like to do it are prevented by the electoral challenge of populist competitors (as is Barack Obama by his Tea-Party Republican challengers). By comparison the prospect of Wealth Sovereign Funds coming to the rescue of highly indebted governments might seem a more normal occurrence, but this would be the true miracle and is simply not going to happen: it worked in 2008 to the advantage of financial stabilization, but now WSFs have run out of trust.
The fact that the US can always “print” the dollars it owns to pay its creditors does not make the US debt indefinitely sustainable: at some point the resulting dollar inflation will make dollar bonds unpalatable at less than crippling interest rates so high that they would necessarily involve eventual insolvency. Other countries face even stricter debt sustainability conditions, without the same initial room for manoeuvre. Where private wealth largely exceeds the difference between current debt and its sustainable level, it is always possible to apply a once-and-for-all or recurring wealth surcharge to achieve solvency. Italy, for instance, has a public debt of euro 1,900 bn, but in 2008 it had a household wealth of euro 8,600 bn, 45% of which was concentrated in the top 10% of households; but wealth taxation is unpopular and the political will to introduce it is scarce. Privatization of public assets is often considered as a way to reduce sovereign debt, but the potential revenue obtainable from this source is usually overstated with respect to the depressed values realizable during a crisis, when it is infelicitously timed.
An insolvent country, like Greece, has only three alternative options: 1) instant orderly default with significant “hair-cuts” negotiated with creditors; or 2) instant dis-orderly default; or 3) delayed default, whether orderly or dis-orderly, preceded by roll-over of debt with the assistance of international financial organizations (like the IMF, or the European Financial Stability Fund soon to become the European Stability Mechanism, or the European Central Bank with its controversial purchases of government bonds in secondary markets) followed eventually by actual default, as in all schemes of pyramid banking, to which such rollover of uncovered debt has been likened.
The three default options are ranked above in order of increasing cost. However it should be remembered that non-default by insolvent debtors is also very expensive, as witnessed for instance in the large scale fall (of the order of 25%-30% in just one quarter in mid-2011) in the capitalization value of stock exchanges in temporarily solvent Euro-zone countries with uncertain longer-term solvency.
Partly the probability of default, assessed by Rating Agencies (like the oligopolistic three: Standard and Poor’s, Moody’s, Fitch), reflected in the interest spreads with respect of bonds regarded as totally secure (like German Bunds) and in the price of insuring bonds against default by buying Credit Default Swaps, expresses political as well as economic judgments (as in the recent case of Italy, handicapped by a corrupt, disreputable and divided government short on credibility).
Of course Rating Agencies have proven to be highly fallible and often biased, for they have their own agendas to drive forward, have positions of conflict of interests (“issuer pays” instead of “buyer pays”) and opportunities for insider trading. Alternative, public Rating Agencies have been advocated, for instance in Europe, but such institutions could not be regarded as independent and therefore their credibility would be low. Better still, “the use of ratings in financial regulations should be significantly reduced over time” (as was suggested in the de Larosière Report of 2009 under Recommendation 3, but never acted upon by European authorities).
In order to contain the unavoidable disruption and turmoil involved by a country’s default, it would be essential to anticipate its adverse effects and counteract them beforehand, by re-capitalizing commercial banks exposed to the cross-effects of default, including central banks and above all the European Central Bank that has been acting (probably exceeding its mandate) as Lender of Last Resort to the governments of “peripheral” (meaning “high spread”) countries. An experience of default is bound to depress the price of, and thus raise yields on, old and new government bonds for the whole area; therefore contagion would worsen the sustainability conditions of debt, and therefore slow down the speed of subsequent recovery.
Furthermore, a post-crisis global economy should have renewed efforts to establish some form of global governance rather than have in place the many and inadequate ad hoc institutions cobbled together to, at present, provide some semblance of governance. But in order to be established global government now would have to be universally accepted not only in its initial form, but also in all its rules for the continuous adjustment to future, unforeseen and unforeseeable, circumstances: such acceptance now is probably out of the question. Besides, the demotion of the nation state is not necessarily desirable. For the nation state provides a layer of authority that can protect citizens from global corporations as well as from a necessarily monopolistic global governance authority that could easily misbehave out of democratic control, and without any remaining territory to which one could run for cover.
Eventually the post-crisis economy - sooner or later - will begin to recover, thanks to the profitability of production and investment being raised by depressed wages (due to mass unemployment), the accumulation of new profitable technical inventions and opportunities, the progressive depletion of existing inventories and production capacity. Once started, recovery would tend to be amplified by indirect effects, such as the usual interaction between multiplier and accelerator, until potential capacity constraints are met again and some cyclical mechanism is set in motion again in reverse. Such is the inexorable logic of the market economy. But reliance simply on market self-regulation will most probably lead to recovery much later than possible with government intervention and jump-starting. It is unfortunate that the inadequate policy responses of 2008 and their premature withdrawal should have grossly diluted their effectiveness thus making the implementation of growth policies harder today.
Changes must also be attempted in order to prevent the operation of factors that facilitated the last global crisis, or to better cope with them. The increase in banks’ capitalization, envisaged by the Basel-3 new rules, will have an initial adverse effect on the volume of lending but longer term benefits for financial stability. A new composite currency is bound to emerge, in place of the US dollar or the euro.
Regulations on the separation of credit and investment operations of banks (à la Glass-Steagall Act) are bound to be reintroduced, as already proposed in the UK by the Vickers Commission. The Over The Counter derivatives trade might be subjected to stricter regulations, such as the requirement of an underlying “insurable” interest for taking up a position in that market, or the prohibition of short-selling, temporarily introduced in the European Union on shares and government bonds. The traditional principle of Central Bank independence in the exclusive pursuit of inflation targeting - based on the now discredited theory of rational expectations and the consequent de-coupling of inflation and unemployment - is bound to change into the even more independent pursuit of multiple targets including employment and competitiveness. We might witness attempts to protect domestic industries and stop immigration - largely unsuccessful in view of the irresistible force of underlying trends.
Currently, by and large, the economic system emerging from the crisis is bound to be substantially very similar to the pre-crisis one, improved in some respects, but worsened by large scale cuts in welfare expenditure made necessary by the (debatable) purpose of achieving fiscal balance. The post-crisis system will be more conflictual and insecure, more unequal and less cohesive, less rather than more “green” - basically a more unpleasant world in which to live. It need not be so.
Showing posts with label global financial crisis. Show all posts
Showing posts with label global financial crisis. Show all posts
Monday, October 3, 2011
Thursday, February 18, 2010
The European Hermaphrodite
In an interview to Repubblica‘s financial supplement of 15 February Giuliano Amato proposes to “turn the current European crisis into an opportunity – by founding a European Monetary Fund”. Giuliano Amato was twice Italian Premier in 1992-93 and 2000-01, four times Treasury Minister, once Minister for Institutional Reform and Minister of the Interior; he is a distinguished academic, Professor of Constitutional Law, and has just been appointed Senior Advisor for Italy by Deutsche Bank. His generous proposal has vision and must be taken seriously.
Regional solutions are a step forward when global solutions are not there, but conditional financial assistance to governments experiencing imbalances in their external accounts or public finances is already being provided by the IMF. All EU and EMU members are both shareholders and clients of the IMF in any case. Giuliano Amato says “Those who are keen on the europeanisation of economies feel that something is lost if we are not capable of resolving our own problems ourselves”. Why does he endorse these views? If we set up a European Monetary Fund, should we then want to set up a European Health Organisation next to the WHO, a European Trade Organisation next to the WTO, a Bank of European Settlements next to the BIS?
Giuliano Amato does not regard the European Union as simply another regional organization, albeit of considerable scale. More than once he has defined the EU as a “hermaphrodite”, combining lasting traits of international organization with traits that used to belong exclusively to states. Therefore he believes that it was a mistake to build the single currency with a mere coordination of national economic and fiscal policy. A European Monetary Fund would give the single currency the instruments necessary to offset asymmetric shocks within the European Union. However, even someone sharing his hermaphrodite characterization of the Union might draw from it the diametrically opposite conclusion - that it should evolve more in the direction of a federal or unitary state than in that of a regional grouping (with its own regional Monetary Fund).
Apart from this, the proposal for a European Monetary Fund presumes that the operational criteria of this Fund would be different from those of the IMF, otherwise why bother? But if the EMF criteria were more severe than those of the IMF the Union cannot prevent its own members from applying for IMF assistance; if EMF conditions were less severe the Union might first try and negotiate with the IMF less stringent conditionality in general at least for its own members. It would only be worth setting up an EMF if, say, its conditions were more grounded in social and political consensus, more geared to what is left of the European Social Model, less US-centered and US-inspired.
Except that, in the financial crisis of 2008-2009 the IMF has been capable of providing the necessary leadership for implementing a global fiscal and monetary intervention against the crisis, while European institutions limped behind their various deflationary regional rules and traditional constraints.
Imagine a small group of tennis players (Giuliano Amato is a very fine tennis player), all fee-paying members and shareholders of a tennis club that works satisfactorily, who propose to found a second, exclusive club for the provision of tennis facilities identical to those already provided by the pre-existing club, simply to be able to call it their own. There would be no point - unless the game was played under different rules, but this possibility has not yet been illustrated.
Regional solutions are a step forward when global solutions are not there, but conditional financial assistance to governments experiencing imbalances in their external accounts or public finances is already being provided by the IMF. All EU and EMU members are both shareholders and clients of the IMF in any case. Giuliano Amato says “Those who are keen on the europeanisation of economies feel that something is lost if we are not capable of resolving our own problems ourselves”. Why does he endorse these views? If we set up a European Monetary Fund, should we then want to set up a European Health Organisation next to the WHO, a European Trade Organisation next to the WTO, a Bank of European Settlements next to the BIS?
Giuliano Amato does not regard the European Union as simply another regional organization, albeit of considerable scale. More than once he has defined the EU as a “hermaphrodite”, combining lasting traits of international organization with traits that used to belong exclusively to states. Therefore he believes that it was a mistake to build the single currency with a mere coordination of national economic and fiscal policy. A European Monetary Fund would give the single currency the instruments necessary to offset asymmetric shocks within the European Union. However, even someone sharing his hermaphrodite characterization of the Union might draw from it the diametrically opposite conclusion - that it should evolve more in the direction of a federal or unitary state than in that of a regional grouping (with its own regional Monetary Fund).
Apart from this, the proposal for a European Monetary Fund presumes that the operational criteria of this Fund would be different from those of the IMF, otherwise why bother? But if the EMF criteria were more severe than those of the IMF the Union cannot prevent its own members from applying for IMF assistance; if EMF conditions were less severe the Union might first try and negotiate with the IMF less stringent conditionality in general at least for its own members. It would only be worth setting up an EMF if, say, its conditions were more grounded in social and political consensus, more geared to what is left of the European Social Model, less US-centered and US-inspired.
Except that, in the financial crisis of 2008-2009 the IMF has been capable of providing the necessary leadership for implementing a global fiscal and monetary intervention against the crisis, while European institutions limped behind their various deflationary regional rules and traditional constraints.
Imagine a small group of tennis players (Giuliano Amato is a very fine tennis player), all fee-paying members and shareholders of a tennis club that works satisfactorily, who propose to found a second, exclusive club for the provision of tennis facilities identical to those already provided by the pre-existing club, simply to be able to call it their own. There would be no point - unless the game was played under different rules, but this possibility has not yet been illustrated.
Monday, July 27, 2009
“Up to a point, Your Majesty”
“No One Saw it Coming” …
When Queen Elizabeth II visited the London School of Economics in November 2008, “she asked Professor Luis Garicano, of the economics' management department, about the origins of the credit crisis, saying: "Why did nobody notice it?". Prof Garicano told the Queen: "At every stage, someone was relying on somebody else and everyone thought they were doing the right thing." The Queen described it as "awful". Prof Garicano said afterwards: "The Queen asked me: 'If these things were so large, how come everyone missed them?'". Now the Queen has been sent a letter by professor Tim Besley of LSE (a member of the Bank of England Monetary Policy Committee) and other eminent economists, explaining how "financial wizards" failed to "foresee the timing, extent and severity" of the economic crisis. The letter ends: "In summary, your Majesty, the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole." (The Observer, 26 July 2009).
“The idea that ‘no one saw this coming’... has been a common view from the very beginning of the credit crisis, shared from the upper echelons of the global financial and policy hierarchy and in academia to the general public”: Dirk J. Bezemer, of Groningen University (“No One Saw This Coming": Understanding Financial Crisis Through Accounting Models, 16 June 2009). Bezemer provides abundant examples: “Few, if any people anticipated the sort of meltdown that we are seeing in the credit markets at present” (former USA Treasury Minister Robert Rubin, at a session at the Brookings Institution in Washington, 14 March 2008). On 9 December 2008 Glenn Stevens, Governor of the Reserve Bank of Australia commented on the “international financial turmoil through which we have lived over the past almost year and a half, and the intensity of the events since mid September this year”. He went on to assert: “I do not know anyone who predicted this course of events”. On 9 April 2009 Nout Wellink – chairman of the Basel Committee that formulates banking stability rules and Dutch representative at the European Central Bank - told his audience that “[n]o one foresaw the volume of the current avalanche” (Bezemer, cited).
Predictably economists get a rough treatment, in connection with the global financial crisis, also in a major review of “The state of Economics”, published by The Economist of 18 July 2009. “There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it.”
… But Some Knew Better Than Others
Tim Besley and his colleague signatories of the letter to the Queen can speak only for themselves. Undoubtedly lots of economists in high places made utter fools of themselves for views that were so spectacularly falsified by the crisis. In February 2005 Alan Greenpan asserted to the US House Financial Services Committee that "I don't expect that we will run into anything resembling a collapsing [housing] bubble, though it is conceivable that we will get some reduction in overall prices as we've had in the past, but that is not a particular problem."(quoted by Bezemer). In its Report on “Financial Globalization: A Reappraisal” (August 2006) the IMF confirmed its established view that “there is little systematic evidence to support widely cited claims that financial globalization by itself leads to deeper and more costly crises” (p.1). Anatole Kaletsky (FT 13 November 2008) wrote of “those who failed to foresee the gravity of this crisis - a group that includes Mr King, Mr Brown, Alistair Darling, Alan Greenspan and almost every leading economist and financier in the world.”
Bezemer (who provides the above quotes and more) shows that, on the contrary, “it is not difficult to find predictions of a credit or debt crisis in the months and years leading up to it, and of the grave impact on the economy this would have - not only by pundits and bloggers [absit inIuria verbis!], but by serious analysts from the world of academia, policy institutes, think tanks and finance.” He list a dozen, for starters.
Anticipations of the Housing Crisis and Recession
Dean Baker, US co-director, Center for Economic and Policy Research. “ …plunging housing investment will likely push the economy into recession.” (2006).
Wynne Godley, US Distinguished Scholar, Levy Economics Institute of Bard College [1970–1994 Director of the Department of Applied Economics, University of Cambridge;
1956–1970 The Economic Section of the H.M. Treasury (Deputy Director from 1967): and professional oboist ]. “The small slowdown in the rate at which US ousehold debt levels are rising resulting form the house price decline, will immediately lead to a …sustained growth recession … before 2010”. (2006). “Unemployment [will] start to rise significantly and does not come down again.” (2007).
Fred Harrison, UK Economic commentator. “The next property market tipping point is due at end of 2007 or early 2008 …The only way prices can be brought back to affordable levels is a slump or recession” (2005).
Michael Hudson, US professor, University of Missouri “Debt deflation will shrink the “real” economy, drive down real wages, and push our debt-ridden economy into Japan-style stagnation or worse.” (2006).
Eric Janszen, US investor and iTulip commentator. “The US will enter a recession within years” (2006). “US stock markets are likely to begin in 2008 to experience a “Debt Deflation Bear Market” (2007).
Stephen Keen, Australia associate professor, University of Western Sydney. “Long before we manage to reverse the current rise in debt, the economy will be in a recession. On current data, we may already be in one.” (2006).
Jakob Brøchner Madsen & Jens Kjaer Sørensen, Denmark professor & graduate student, Copenhagen University. “We are seeing large bubbles and if they bust, there is no backup. The outlook is very bad” (2005)” The bursting of this housing bubble will have a severe impact on the world economy and may even result in a recession” (2006).
Kurt Richebächer, US private consultant and investment newsletter writer “The new housing bubble – together with the bond and stock bubbles – will invariably implode in the foreseeable future, plunging the U.S. economy into a protracted, deep recession” (2001). “A recession and bear market in asset prices are inevitable for the U.S. economy… All remaining questions pertain solely to speed, depth and duration of the economy’s downturn.”(2006).
Nouriel Roubini, US professor, New York University “Real home prices are likely to fall at least 30% over the next 3 years“(2005). “By itself this house price slump is enough to trigger a US recession.” (2006).
Peter Schiff , US stock broker, investment adviser and commentator “[t]he United States economy is like the Titanic ...I see a real financial crisis coming for the United States.” (2006). “There will be an economic collapse” (2007).
Robert Shiller , US professor, Yale University “There is significant risk of a very bad period, with rising default and foreclosures, serious trouble in financial markets, and a possible recession sooner than most of us expected.” (2006)
Note: for sources and more detail, please refer to the Appendix, Bezemer 2009 (cited).
No “Stopped Clock Syndrome”
Moreover Bezemer shows that his findings do not suffer from the “‘stopped clock syndrome’. A stopped clock is correct twice a day, and the mere existence of predictions is not informative on the theoretical validity of such predictions since, in financial market parlance, ‘every bear has his day’.”
He finds that accurate predictions are systematically associated with a particular type of economic model; “that ‘accounting’ (or flow-of-funds) models of the economy are the shared mindset of those analysts who worried about a credit-cum-debt crisis followed by recession, before the policy and academic establishment did. They are ‘accounting’ models in the sense that they represent households’, firms’ and governments’ balance sheets and their interrelations. If society’s wealth and debt levels reflected in balance sheets are among the determinants of its growth sustainability and its financial stability, such models are likely to timely signal threats of instability. Models that do not – such as the general equilibrium models widely used in academic and Central Bank analysis – are prone to ‘Type II errors’ of false negatives – rejecting the possibility of crisis when in reality it is just months ahead.”
Forthcoming posts will include comments on The Economist’s review of The state of Economics, and a discussion of Exit Strategies.
When Queen Elizabeth II visited the London School of Economics in November 2008, “she asked Professor Luis Garicano, of the economics' management department, about the origins of the credit crisis, saying: "Why did nobody notice it?". Prof Garicano told the Queen: "At every stage, someone was relying on somebody else and everyone thought they were doing the right thing." The Queen described it as "awful". Prof Garicano said afterwards: "The Queen asked me: 'If these things were so large, how come everyone missed them?'". Now the Queen has been sent a letter by professor Tim Besley of LSE (a member of the Bank of England Monetary Policy Committee) and other eminent economists, explaining how "financial wizards" failed to "foresee the timing, extent and severity" of the economic crisis. The letter ends: "In summary, your Majesty, the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole." (The Observer, 26 July 2009).
“The idea that ‘no one saw this coming’... has been a common view from the very beginning of the credit crisis, shared from the upper echelons of the global financial and policy hierarchy and in academia to the general public”: Dirk J. Bezemer, of Groningen University (“No One Saw This Coming": Understanding Financial Crisis Through Accounting Models, 16 June 2009). Bezemer provides abundant examples: “Few, if any people anticipated the sort of meltdown that we are seeing in the credit markets at present” (former USA Treasury Minister Robert Rubin, at a session at the Brookings Institution in Washington, 14 March 2008). On 9 December 2008 Glenn Stevens, Governor of the Reserve Bank of Australia commented on the “international financial turmoil through which we have lived over the past almost year and a half, and the intensity of the events since mid September this year”. He went on to assert: “I do not know anyone who predicted this course of events”. On 9 April 2009 Nout Wellink – chairman of the Basel Committee that formulates banking stability rules and Dutch representative at the European Central Bank - told his audience that “[n]o one foresaw the volume of the current avalanche” (Bezemer, cited).
Predictably economists get a rough treatment, in connection with the global financial crisis, also in a major review of “The state of Economics”, published by The Economist of 18 July 2009. “There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it.”
… But Some Knew Better Than Others
Tim Besley and his colleague signatories of the letter to the Queen can speak only for themselves. Undoubtedly lots of economists in high places made utter fools of themselves for views that were so spectacularly falsified by the crisis. In February 2005 Alan Greenpan asserted to the US House Financial Services Committee that "I don't expect that we will run into anything resembling a collapsing [housing] bubble, though it is conceivable that we will get some reduction in overall prices as we've had in the past, but that is not a particular problem."(quoted by Bezemer). In its Report on “Financial Globalization: A Reappraisal” (August 2006) the IMF confirmed its established view that “there is little systematic evidence to support widely cited claims that financial globalization by itself leads to deeper and more costly crises” (p.1). Anatole Kaletsky (FT 13 November 2008) wrote of “those who failed to foresee the gravity of this crisis - a group that includes Mr King, Mr Brown, Alistair Darling, Alan Greenspan and almost every leading economist and financier in the world.”
Bezemer (who provides the above quotes and more) shows that, on the contrary, “it is not difficult to find predictions of a credit or debt crisis in the months and years leading up to it, and of the grave impact on the economy this would have - not only by pundits and bloggers [absit inIuria verbis!], but by serious analysts from the world of academia, policy institutes, think tanks and finance.” He list a dozen, for starters.
Anticipations of the Housing Crisis and Recession
Dean Baker, US co-director, Center for Economic and Policy Research. “ …plunging housing investment will likely push the economy into recession.” (2006).
Wynne Godley, US Distinguished Scholar, Levy Economics Institute of Bard College [1970–1994 Director of the Department of Applied Economics, University of Cambridge;
1956–1970 The Economic Section of the H.M. Treasury (Deputy Director from 1967): and professional oboist ]. “The small slowdown in the rate at which US ousehold debt levels are rising resulting form the house price decline, will immediately lead to a …sustained growth recession … before 2010”. (2006). “Unemployment [will] start to rise significantly and does not come down again.” (2007).
Fred Harrison, UK Economic commentator. “The next property market tipping point is due at end of 2007 or early 2008 …The only way prices can be brought back to affordable levels is a slump or recession” (2005).
Michael Hudson, US professor, University of Missouri “Debt deflation will shrink the “real” economy, drive down real wages, and push our debt-ridden economy into Japan-style stagnation or worse.” (2006).
Eric Janszen, US investor and iTulip commentator. “The US will enter a recession within years” (2006). “US stock markets are likely to begin in 2008 to experience a “Debt Deflation Bear Market” (2007).
Stephen Keen, Australia associate professor, University of Western Sydney. “Long before we manage to reverse the current rise in debt, the economy will be in a recession. On current data, we may already be in one.” (2006).
Jakob Brøchner Madsen & Jens Kjaer Sørensen, Denmark professor & graduate student, Copenhagen University. “We are seeing large bubbles and if they bust, there is no backup. The outlook is very bad” (2005)” The bursting of this housing bubble will have a severe impact on the world economy and may even result in a recession” (2006).
Kurt Richebächer, US private consultant and investment newsletter writer “The new housing bubble – together with the bond and stock bubbles – will invariably implode in the foreseeable future, plunging the U.S. economy into a protracted, deep recession” (2001). “A recession and bear market in asset prices are inevitable for the U.S. economy… All remaining questions pertain solely to speed, depth and duration of the economy’s downturn.”(2006).
Nouriel Roubini, US professor, New York University “Real home prices are likely to fall at least 30% over the next 3 years“(2005). “By itself this house price slump is enough to trigger a US recession.” (2006).
Peter Schiff , US stock broker, investment adviser and commentator “[t]he United States economy is like the Titanic ...I see a real financial crisis coming for the United States.” (2006). “There will be an economic collapse” (2007).
Robert Shiller , US professor, Yale University “There is significant risk of a very bad period, with rising default and foreclosures, serious trouble in financial markets, and a possible recession sooner than most of us expected.” (2006)
Note: for sources and more detail, please refer to the Appendix, Bezemer 2009 (cited).
No “Stopped Clock Syndrome”
Moreover Bezemer shows that his findings do not suffer from the “‘stopped clock syndrome’. A stopped clock is correct twice a day, and the mere existence of predictions is not informative on the theoretical validity of such predictions since, in financial market parlance, ‘every bear has his day’.”
He finds that accurate predictions are systematically associated with a particular type of economic model; “that ‘accounting’ (or flow-of-funds) models of the economy are the shared mindset of those analysts who worried about a credit-cum-debt crisis followed by recession, before the policy and academic establishment did. They are ‘accounting’ models in the sense that they represent households’, firms’ and governments’ balance sheets and their interrelations. If society’s wealth and debt levels reflected in balance sheets are among the determinants of its growth sustainability and its financial stability, such models are likely to timely signal threats of instability. Models that do not – such as the general equilibrium models widely used in academic and Central Bank analysis – are prone to ‘Type II errors’ of false negatives – rejecting the possibility of crisis when in reality it is just months ahead.”
Forthcoming posts will include comments on The Economist’s review of The state of Economics, and a discussion of Exit Strategies.
Sunday, May 10, 2009
Eastern Europe: from Slowdown to Nosedive
On 15-16 May next the EBRD – European Bank for Reconstruction and Development, founded in 1991 to assist the post-socialist transition of Central-Eastern Europe – will hold its Annual Meeting in London. The Bank “could be set for a big increase of its €20bn capital to help deal with the economic crisis” (Stefan Wagstyl, EBRD considers big rise in capital, FT, 7 May 2009 http://www.ft.com/cms/s/0/5c560d04-3b35-11de-ba91-00144feabdc0.html). The case for capital increase is greatly strengthened by the publication, on 7 May just before the Meeting (http://www.ebrd.com/new/pressrel/2009/090507gdp.pdf), of the latest EBRD forecasts for 2009-2010 for all the 28 transition countries where it operates plus Turkey which was added in October 2008.
On average, in these 29 countries the EBRD forecasts a 5 per cent contraction in real GNP. Such nosedive comes after the growth slowdown from 6.9 per cent in 2007 to 4.2 per cent in 2008, and is followed by a modest recovery of 1.4 per cent, anticipated for the second half of 2010. The peak of unemployment is yet to come. These forecasts are much more pessimistic than the EBRD own forecast of January 2009, of imperceptible but positive growth at 0.1 per cent, itself a significant deterioration with respect to the November 2008 forecasts of 3.0 per cent growth, which in turn had been slashed from 5.7 in May 2008.
The latest EBRD figures are also – on average but not for Central Europe – worse than the most recent growth forecasts by the IMF, in the World Economic Outlook of April 2009, on Crisis and Recovery (http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/text.pdf). The European Commission Spring Forecasts 2009 (European Economy 3/2009, 4 May 2009, https://webmail.london.edu/exchweb/bin/redir.asp?URL=http://ec.europa.eu/economy_finance/publications/publication15048_en.pdf) are much more optimistic about Russia (only -3.8 per cent in 2009) but more pessimistic about Hungary and Poland, and otherwise only marginally different. The forecasts of UN/DESA Monthly Briefing on the World Economic Situation and Prospects (http://www.un.org/esa/policy/publications/wespmbn/sgnote_8.pdf), published on 7 May 2009, the same day as the EBRD forecasts, are consistently slightly more optimistic (The next set of forecasts, by the UN World Economic Situation and Prospects Update as of mid-2009, is to be released on 26 May 2009).
The EBRD is an institution suffering from three existential problems. It is supposed to lend to the private sector in transition economies, at commercial rates, but if it does this its existence does not make any difference. It is a public financial institution whose raison d’être is the inefficiency of public financial institutions. And we will know that it has fulfilled its mission only if and when it is liquidated.
In fact, before the crisis, the EBRD government-shareholders (about 60) were considering reducing the scale of its activity – perhaps also because of the EBRD own over-generous assessment of transition progress in its yearly Transition Reports. Now an expansion is being considered instead because of both the envisaged large scale of the recession in its countries of operation, and the need to fill the gap abruptly left by the drop in current capital inflows into the area.
There is no reason to believe that the pessimism of the latest EBRD forecasts has been exaggerated in order to strengthen the case for the Bank’s capital increase. EBRD Chief Economist Erik Berglof says that "There are downside risks to these predictions. But now there is also upside potential. Our underlying outlook assumes continued external engagement, particularly from the western parents of banks in the region." (http://www.ebrd.com/new/pressrel/2009/090507k.htm) Such an engagement on the part of foreign parent banks in the area is an over-optimistic assumption (see below). If anything, the withdrawal of foreign parent banks from transition economies is precisely what strengthens the case for an EBRD major capital increase in the near future, already before the review of the EBRD capital is due in 2012.
Within the aggregate forecasts given above, the heterogeneous group of 29 countries naturally exhibits a highly diversified economic performance. In Central Europe and the Baltics in 2009 Poland fares best, with zero growth. At the other end of the range, all three Baltics are contracting by more than 10 per cent: Estonia (already in recession at -3 per cent in 2008) at -10.5, Lithuania -11.8, Latvia -13.2. Hungary is doing rather poorly: after stagnation at 1.1 per cent in 2007 and 0.5 per cent in 2008, its GNP is poised to fall by 5.0 per cent, with zero growth next year. On average this area’s GDP is expected by the EBRD to decline in 2009 at 2.9 per cent, and to resume growth at only 0.2 per cent in 2010. In the April 2009 World Economic Outlook the IMF was even more pessimistic, with a 3.7 per cent GNP decline, but more optimistic for Russia and the rest of the Commonwealth of Independent States.
EBRD forecasts for South-eastern Europe show a slightly better performance: on average growth rates in 2007-2010 follow the pattern (in per cent): 6.3, 6.6, -2.2, 0.4; in 2009 Romania is worst with -4.0. Eastern Europe and the Caucasus (meaning the non Asian members of the Commonwealth of Independent States, not counting Russia) in the same years exhibit actual and predicted growth of: 9.9, 5.0, -6.2, 1.3; Ukraine is expected to contract by 10.0 per cent this year and grow at a zero rate next year. Central Asia is the least affected area, with GNP growth rates of 9.2, 5.0, 0.4, 3.0 in 2007-2010. Finally, Russia is seriously affected: 8.1 and 5.6 in 2007, 2008; - 7.5 in 2009, the result of an even deeper fall in the first quarter and an expected improvement in the rest of the year; the green shoots of recovery are forecast by the EBRD at 1.0 per cent in 2010.
All these countries have either completed their transition to the market economy and their re-integration into the world economy and especially Europe (the ten new member states of 2004 and 2007, with Slovenia and Slovakia already members of the Eurozone), or have made steady and very substantial progress in that direction. What makes them so vulnerable to the pandemic financial and real crisis?
Initially, when the global crisis involved only the financial sector, transition countries – regardless of EU membership – seemed to be fairly resilient. Then, as the crisis impacted the corporate sector, they began to slowdown, and by the end of 2008 and the first quarter of 2009, when domestic consumption began to be affected, they went from slowdown to nosedive.
In general the current financial crisis confronted all emerging and developing countries – including transition economies – with two shocks: “a ‘sudden stop’ of capital inflows driven by global deleveraging, and a collapse in export demand associated with the global slump” (Atish R. Ghosh et al., IMF 2009)[1]. But there are different aspects and intensities, specific to country groups, discussed both in the IMF Staff Position Note just quoted and in other papers[2].
1. Home made sub-primes. The USA sub-primes crisis of August 2007 touched only marginally the transition economies. But a large amount of domestic loans, mostly for house-purchase finance but also in the enterprise sector – and in the government sector – were originally denominated in foreign currency because the national currency a) involved much higher interest rates and b) had been stable or (with the exception of countries with a successful Currency Board: Bulgaria, Estonia and Lithuania) appreciating. All these loans, amounting to $250 billion in Central Eastern Europe (Auer and Wehrmuller 2009)[3] promptly became sub-prime, as soon as the domestic currency began to depreciate for the reasons indicated below. Thus Polish borrowers in Swiss Francs in the last quarter of 2008 and the first quarter of 2009 have seen their zloty liabilities rise by 31 per cent due to the revaluation of the SF with respect to the Polish zloty.
Auer and Wehrmuller estimate that in the 10 EU member states from Central Europe total losses from private and public debt re-valuation amount to about $60bn, under 5 per cent of GDP in most countries but as much as 18 per cent and 8 per cent in Hungary and Poland respectively. The expectation that the state will ultimately bear the cost of bailing out the debtors, plus the cost born by the state on its own debt, has dramatically raised the spread on Credit Default Swaps for the eight countries for which data are available out of the ten new Member States (Auer and Wehrmuller, cit.).
The problem is serious: in 2007 in eight countries the foreign currency-denominated debt in the non-financial private sector exceeded 50% of total non-financial sector debt: Ukraine, Romania, Bulgaria, Lithuania, Hungary, Georgia, Estonia, Latvia; over 60% in the last four of these, almost 90% in Latvia (Connelly, 2009, p.23).
2. External imbalances. Connelly (2009, cit.) considers twenty countries which he labels “Emerging Europe” (the EBRD 29 minus Turkey, Albania; Bosnia & Herzegovina, Macedonia, Montenegro, Serbia; Tajikistan and Turkmenistan; Mongolia). He notes that “Emerging Europe is the only emerging market region to collectively run a current account deficit”: apart from Azerbaijan, Kazakhstan and Russia in 2008 all the other countries in this group have current account deficits, of which seven over 10 per cent of GDP: Bulgaria at -21.2 per cent, Georgia -20.6, Moldova -15.3 Lithuania -13.9, Romania -13.3, Latvia -12.1, Estonia -11.2.
Sustained current account deficits lead naturally to higher external debt. But it cannot be argued that the current account deficits were the result of fiscal profligacy. Between 2000 and 2008 the number of countries running a government surplus increased from one (Russia) to five (with the addition of Azerbaijan, Belarus, Bulgaria, Kazakhstan), while the deficits of another 13 countries out of the twenty reviewed by Connelly fell below 3 per cent. Thus the growth of external debt is clearly due, on average, primarily to the private sector. Yet the expected emergence of contingent liabilities and costly bail-outs reduces governments’ credibility anyway. Darvas and Pisani-Ferry (2009)[4] establish a significant correlation between the cost of credit default swaps (CDS), the insurance against default on government debt, and current account deficits. Moreover, non-Eurozone members pay a higher insurance cost, rising very much faster over time: “the crisis management in the euro area has had the unintended consequence of putting non euro-area new member states at disadvantage”. Probably, without the credibility bestowed by the euro, floating rates lead to overshooting devaluation, while fixed rates lose competitiveness to the country that maintains them and provide adverse shocks when the peg sooner or later must be altered.
3. Primary product exporters – primarily Russia, Azerbaijan and Kazakhstan – until mid-2008 were in a position to run current account surpluses and accumulate foreign reserves. But in 2008 oil, gas, cotton and metals fell in price. Foreign reserves were used – wasted, we could say to some extent – to support overvalued exchange rates and to bail out financial institutions and productive enterprises. The Central Bank of Russia foreign reserves (including gold) fell from $476.4bn in 2007 to $427.1bn in 2008 and $383.9 at the end of April 2009, plus another $32bn lost by the Stabilisation Fund in the first quarter of 2009 (https://webmail.london.edu/exchweb/bin/redir.asp?URL=http://www.bof.fi/bofit_en/seuranta/venajatilastot/index.htm , though other sources report larger losses). The EC Spring Forecasts 2009 (cited) are more optimistic than the EBRD yet expect a Russian budget swinging sharply from a hefty surplus to large deficits, of respectively 6.5% and 2.7% of GDP in 2009, due to the reduction in commodity prices and in economic activity, plus the large fiscal stimulus packages. Russia is also forecast to see major falls in both its trade and current account surpluses, respectively to 5.1% and 6.3% of GDP in 2009, and 1.4% and 2.7% in 2010.
4. Fall or reversal of FDI and portfolio investment inflows. “With net private capital flows to emerging market (and developing) countries projected to decline from an inflow of US$600 billion in 2007 to an outflow of US$180 billion in 2009, EMEs [Emerging Market Economies] are facing a severe credit crunch. Particularly affected are the countries with large current account deficits – many of which had asset price and credit booms” (Ghosh et al., 2009, p.6). Transition economies had been able to attract large and growing capital inflows thanks to privatisations at attractive prices, high interest rates net of devaluation cover or even plus revaluations, and production de-localisation thanks to low wages. These attractions have weakened, and the recession has made inflows even less attractive.
“The region [i.e. Donnelly’s Emerging Europe defined above] faces an aggregated adjusted gross external financing requirement of approximately $460bn, or around $930bn if short-term is added… The deterioration in the outlook for private capital flows to emerging markets makes ‘roll-over’ of these loans extremely unlikely, with the Institute of International Finance (IIF) projecting a fall in private capital flows to the region from around $254bn in 2008 to only $30bn in 2009” (Connelly 2009, p.4).
In these circumstances devaluations are unavoidable but steering a course between floating and pegging is hard, as we have seen above. Higher interest rates are unlikely to bring back capital in a recession. Controls on capital flows will at best stop capital flight but not bring it back, and can be counterproductive. Official financing is therefore badly needed, by the IMF in the first instance with doubling access limits, Flexible Credit Lines, and Stand-By arrangements. With additional resources, support for debt re-structuring can come from national governments, for instance converting foreign currency loans to domestic currency and compensating banks for losses, maybe only partly.
5. Foreign Banks withdrawing funds. At the inception of the transition an under-capitalised and largely insolvent state banking system was partly cleansed of what today are labelled toxic assets, re-capitalised, privatised mostly to foreign banks, and new banks were promoted, also mostly foreign. By 2006, foreign ownership in the ten New Member States, excluding Slovenia (at 22 per cent), ranges from 74 per cent in Latvia to 98 per cent in Estonia (EBRD, Transition Report 2006). Foreign banks were to provide capital and know how, and through access to foreign parent banks provide foreign exchange and in practice access to lending of last resort in the country of origin.
Today the EBRD Chief Economist still relies on “the continued external engagement, particularly from the western parents of banks in the region” (cited above). And Darvas and Pisani-Ferry (2009, cited) still argue that “Several factors have mitigated the impact of the crisis on non euro area NMS [New Member States]: … [among other things] western European ownership of NMS banks (by indirectly stabilizing their NMS subsidiaries)…” (emphasis added).
Yet the EC Spring forecasts 2009 tell a different story: “The repatriation of capital by foreign banks has been particularly abrupt in some cases. For instance, in Ukraine real GDP growth is projected to decline by 9½% in 2009, due to a severely curtailed access to external financing, which has triggered the conclusion of a stand-by arrangement (SBA) with the IMF…”. “The significant and broad-based slowdown in the CIS could have direct growth effects in Central and Eastern Europe, and the presence of EU banks in the region creates further potential negative spill-overs via the financial channel” (p.22, emphasis added). “Paradoxically, it is precisely this characteristic – strong foreign banking presence – that renders EE countries (except for the CIS) region, much more vulnerable to the present financial turmoil” (Uvalic 2009, p.4)[5]. In turn, foreign parent banks risk downgrading as a result of the declining profitability and the losses on their operations in Eastern Europe; conversely, EE countries depend on their continued financial health.
Recently the EBRD made one of its larger investments, worth a total of €432.4 million, in UniCredit subsidiaries across eight eastern European countries, to provide medium and long-term debt and equity financing through UniCredit subsidiaries in support of SMEs, lease finance and energy efficiency projects. [6] This is precisely the kind of contribution that the EBRD can make to the region’s recovery, especially if its relatively modest resources of €20bn were to be raised by 50-100 per cent.
6. Reduction in external demand. Current projections for 2009 indicate for the first time since the last War a decline in world output (-2 per cent according to the IMF) and a much larger decline in world trade, by as much as 13% (WTO), thus reducing for the first time since the War the most common measure of globalisation, the ratio between world exports and world GNP. A sizeable de-globalisation episode is taking place. Output contraction and trade are larger in the EU, with which transition economies have grown to be increasingly integrated, with EU trade shares of the order of 60-90 per cent for the New Member States and South-Eastern Europe, all characterised by high foreign trade openness, higher than that of most old members of the EU (see the table below, penultimate column). Such openness makes the transition economies opportunities of “de-coupling” from downturns in the EU rather limited (Connelly, cit., p.5). Lower trade shares involve a slowdown in manufacturing and extractive industries, and in internal demand especially in construction and financial services.
7. Differences in initial positions and policy response. “Some [countries] were ripe for a homegrown crisis associated with the end of unsustainable credit booms or fiscal policies; others were just bystanders caught in the storm” (Ghosh et al., 2009, cit., p.3; “… the majority were just innocent bystanders”, p.2).
Uncharacteristically, the IMF has recommended, to advanced economies experiencing the global recession, easing monetary policy and lower interest rates. It has also “called for a timely, large, lasting, diversified fiscal stimulus that is coordinated across countries with a commitment to do more if the crisis deepens” (Ghosh et al., 2009, p.19-20). Naturally the IMF now is forced to recommend the same policies to transition economies in crisis, though with stronger warnings about the possible side effects: “Much of the spending and revenue policy advice for advanced economies remains relevant for EMEs [Emerging Market Economies], once scaled down for their small fiscal space” (Ibidem, emphasis added).
Thus transition economies and other EMEs are reminded that looser monetary policies involve dangers of exchange rate devaluation and consequent adverse effects on balance sheets. That it is dangerous to exceed the “policy space” and especially the “fiscal space” of a country, jeopardizing policy credibility and sustainability. Changes should be gradual (however strange this now may sound coming from the IMF) and sustainable; abrupt and non sustainable changes can be particularly costly and disruptive (see Ghosh et al., 2009).
Clearly an expansionary fiscal policy “ is likely to be more effective in stimulating aggregate demand if the economy is relatively closed to trade flows, uses monetary policy to prevent or limit the appreciation of the currency, has substantial spare capacity, has a high proportion of credit-constrained households or firms, and has a sustainable public debt position” (Ibidem, p.21). Which is fair enough, except that transition economies and other EMEs are most unlikely to satisfy these ideal preconditions.
A short digression on the euro. The question here is whether early membership of the Euroarea might assist recovery in the New Member States, of which only Slovenia and Slovakia are already members. The IMF now recommends it, speaking out of turn because it is not for the IMF to recommend anything to Europe other than possibly an application to join the Euroarea on the part of those new members that meet the Maastricht conditions for membership.
Small open economies would probably gain from being part of a large currency area in times of crisis, although Slovakia (not yet a member until 1 January 2009) and the Czech Republic have done rather well being outside it. Unilateral adoption of the euro is ruled out by the EU for both members and candidates; Currency Boards reduce the probability of a crisis at the cost of making the crisis catastrophic if and when it happens (as in Argentina); European Currency Boards are not yet out of the danger zone. The European Central Bank role as Lender of Last Resort is remarkably undetermined and left to informal arrangements with Eurozone members; non-members with hyper-fixed links to the euro (unilateral euroisation or Currency Boards) might be left high and dry in times of crisis.
The EU could have well admitted at least a few other New Member States to the Euroarea, by somewhat loosening the Maastricht criteria for fiscal and monetary convergence, and the two-year membership of the Exchange Rate Mechanism II. The Maastricht criteria for fiscal convergence are in theory looser than those of the so-called Growth and Stability Pact (GSP, which involves not only a 3% ceiling to government deficit but a stricter zero per cent over the cycle) applying to all EU members regardless of Euroarea membership. In practice however the GSP strictures and the associated penalties were considerably relaxed in March 2005, and further loosened during the current crisis, whereas Maastricht criteria for joining the euro have been very strictly enforced. It is unreasonable to subject countries that grow much faster than the Eurozone members and have relatively low ratios between public debt and GNP to the same fiscal stringency of stagnant and highly indebted Euroarea members (like Italy), moreover rigidly and inflexibly applied only to prospective members.
Lithuania was left out of the euro only because its inflation exceeded the average inflation of the three least inflationary EU members by 1.6% instead of the 1.5% prescribed by the Maastricht Treaty – not exactly an enlightened or rational behaviour, especially considering that two of those three least inflationary countries were not Euroarea members.
“The EU can certainly be criticised for clinging to criteria ill-suited to catching-up countries and the case for reforming them is strong” (Darvas and Pisani-Ferry, 2009, cited). See also Nuti 2006. [7] Be that as it may, the middle of a recession is not the best time to change or, worse, bend the rules as drastically as it would be required by early admission of all or most New Members to the Euroarea. End of digression.
The heterogeneity of country experiences is pithily and efficiently synthesised by one-liners from two sources. The first is a table on Fourteen ways to slowdown from The Economist, 26 February 2009 (http://www.economist.com/world/europe/displaystory.cfm?story_id=1318459).
Fourteen ways to slowdown (italics=pegged to euro; underlined=in euro area)
....................GDP......S&P..........financing
.....................per.....credit...requirements
Country...person*..rating#..% of GDP°..Exports§............In a nutshell
Belarus...12,344.... B+...........7.3...........62.1.Autocratic, isolated, gained surprise IMF bailout
Bulgaria..12,372.....A...........29.4...........61.0 Strong finances back currency peg; sleaze rampant
Czech R...25,757....AA.......... 9.4...........80.1 Thrifty and solid but hit by export slowdown
Estonia...20,754....AA.........20.0 ..........72.0 Star reformer squeezes spending to stay afloat
Hungary.19,830.....A ..........29.9..........80.2 Currency crush could topple debt-heavy economy
Latvia.....17,801....BBB........24.3..........46.6 Clinging to currency peg amid turmoil & downturn
Lithuania.18,855....A+ ........27.1...........59.0 Painful spending squeeze to avoid worse
Poland....17,560.....A+.........13.2..........42.3 Regional heavyweight speeds up euro bid
Romania.12,698...BBB+.......20.2.........36.4 Spendthrift policies meet solid reality
Russia....16,161....BBB..........2.2...........31.7 Energy-based kleptocracy in denial about crisis
Serbia... 10,911......BB-........23.5..........22.2 Seeking more IMF help
Slovakia.22,242....AAA......12.5...........90.5 Smugly in euro-area, hit by car-factory slowdown
Slovenia.28,894...AAA..........-.............70.5 Self-satisfied, rich and still growing
Ukraine....7,634...CCC+......16.1..........45.0 No end in sight to political and economic chaos
* PPP$, 2008 estimate. # Standard & Poor’s, latest. ° Current account balance, principal due on public and private debts plus IMF debits, 2008 estimate. § Goods and services, % of GDP, 2008 estimate. Sources: IMF; Moody’s; Economist Intelligence Unit; The Economist.
From: Sarah Hanson, The whiff of contagion, The Economist, 26 February 2009. (Corrected in the 5 March 2009 issue).
The second source is the EC Spring Forecasts 2009 (cited), whose country chapters for transition economies (EU member states, candidate states and Russia) have the enlightening subtitles listed below:
Bulgaria: Vanishing budgetary surplus, external deficit remains large.
The Czech Republic: Output falls sharply driven by collapse in external demand.
Estonia: Adjusting to face gloomier years.
Latvia: Domestic demand and trade implode.
Lithuania: Deepening recession leads to wider fiscal deficits.
Hungary: Domestic financial crisis magnifies recession.
Poland: Mild recession knocking at the door.Romania: Growth contracts sharply.
Slovenia: Sharp falls in exports and investment point to competitiveness challenges.
Slovakia: Global downturn weighs on exports.
Croatia: a declining economy creates important fiscal challenges.
The Former Yugoslav Republic of Macedonia: Joining the general trend … albeit with a delay.
Turkey: Manufacturing faltering as exports decline.
Russian Federation: The first recession in a decade.
In the 1990s an unexpected, deep and protracted recession characterised the post-socialist transition of Central-Eastern Europe and the Former Soviet Union, with GNP decline ranging from 18 per cent in Poland over three years, to 65 per cent in Moldova over ten years. The decline may be slightly exaggerated especially at the top of the range, for well known reasons, but a reliable and unbiassed observer such as Bob Mundell reckons that the transition recession was not just deeper than the 1929 crisis, it was deeper than the recession that accompanied the Black Death in the 14th century, because then income fall was matched by population fall and living standards were preserved.
By comparison the current recession must be barely perceptible to the populations of transition countries. And at least this time they are benefiting not only from more generous assistance from the international community, but from more enlightened policies of monetary easing and low interest rates, fiscal subsidies and expansion, large scale state intervention – all policies diametrically opposite to the draconian hyper-liberal policies that contributed so much to aggravate the transition recession and the other costs of transition in the 1990s. Only two things have really changed since then: today the hyper-liberalism that inspired the course of transition in the 1990s has been thoroughly discredited by the global crisis associated with it, and the predicament of transition economies is vastly improved simply because they happen to share it with the advanced countries that control international financial organisations.
[1] Atish R. Ghosh, Marcos Chamon, Christopher Crowe, Jun. I. Kim, and Johnathan D. Ostry, “Coping with the Crisis: Policy Options for Emerging Market Countries”, IMF Staff Position Note, SPN/09/08, 23 April 2009, http://www.imf.org/external/pubs/ft/spn/2009/spn0908.pdf.
[2] . See for instance Richard Connolly, “Financial vulnerabilities in Emerging Europe: An overview”, Bank of Finland Institute of Transition-BOFIT Online No. 3, 4 May 2009, http://www.bof.fi/NR/rdonlyres/BA4C9028-D69D-45CB-ABF1-140ECB129E4C/0/bon0309.pdf.
[3] Raphael Auer and Simon Wehrmuller, $60 billion and counting: Carry trade-related losses and their effect on CDS spreads in Central and Eastern Europe, 29 April 2009 http://www.voxeu.org/index.php?q=node/3467 http://www.vox.eu/.
[4] Zsolt Darvas and Jean Pisani-Ferry, The looming divide within Europe, Breugel, 18 January 2009, http://www.eurointelligence.com/article.581+M5852b1b851d.0.html
[5] Milica Uvalic, “The impact of the global financial crisis on Eastern Europe”, Conference Paper, Bol (Croatia), 21-23 May 2009.
[6] “UniCredit is the largest banking group in the central and eastern European region, with over 4,000 branches in 19 countries. The group has invested around €10 billion of equity in central and eastern Europe and has around €85 billion of total customers loans in the region. Beside its own funding programs to its subsidiaries, it cooperates with international institutions including the EBRD in order to ensure continuing support to the local economies during these challenging times.” (from the EBRD website, http://www.ebrd.com/new/pressrel/2009/090507g.htm).
[7] D. Mario Nuti, "Alternative fiscal rules for the new EU Member States", TIGER-WSPiS Discussion Papers n. 84, Warsaw, 2006, http://www.tiger.edu.pl/publikacje/TWPNo84.pdf .
On average, in these 29 countries the EBRD forecasts a 5 per cent contraction in real GNP. Such nosedive comes after the growth slowdown from 6.9 per cent in 2007 to 4.2 per cent in 2008, and is followed by a modest recovery of 1.4 per cent, anticipated for the second half of 2010. The peak of unemployment is yet to come. These forecasts are much more pessimistic than the EBRD own forecast of January 2009, of imperceptible but positive growth at 0.1 per cent, itself a significant deterioration with respect to the November 2008 forecasts of 3.0 per cent growth, which in turn had been slashed from 5.7 in May 2008.
The latest EBRD figures are also – on average but not for Central Europe – worse than the most recent growth forecasts by the IMF, in the World Economic Outlook of April 2009, on Crisis and Recovery (http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/text.pdf). The European Commission Spring Forecasts 2009 (European Economy 3/2009, 4 May 2009, https://webmail.london.edu/exchweb/bin/redir.asp?URL=http://ec.europa.eu/economy_finance/publications/publication15048_en.pdf) are much more optimistic about Russia (only -3.8 per cent in 2009) but more pessimistic about Hungary and Poland, and otherwise only marginally different. The forecasts of UN/DESA Monthly Briefing on the World Economic Situation and Prospects (http://www.un.org/esa/policy/publications/wespmbn/sgnote_8.pdf), published on 7 May 2009, the same day as the EBRD forecasts, are consistently slightly more optimistic (The next set of forecasts, by the UN World Economic Situation and Prospects Update as of mid-2009, is to be released on 26 May 2009).
The EBRD is an institution suffering from three existential problems. It is supposed to lend to the private sector in transition economies, at commercial rates, but if it does this its existence does not make any difference. It is a public financial institution whose raison d’être is the inefficiency of public financial institutions. And we will know that it has fulfilled its mission only if and when it is liquidated.
In fact, before the crisis, the EBRD government-shareholders (about 60) were considering reducing the scale of its activity – perhaps also because of the EBRD own over-generous assessment of transition progress in its yearly Transition Reports. Now an expansion is being considered instead because of both the envisaged large scale of the recession in its countries of operation, and the need to fill the gap abruptly left by the drop in current capital inflows into the area.
There is no reason to believe that the pessimism of the latest EBRD forecasts has been exaggerated in order to strengthen the case for the Bank’s capital increase. EBRD Chief Economist Erik Berglof says that "There are downside risks to these predictions. But now there is also upside potential. Our underlying outlook assumes continued external engagement, particularly from the western parents of banks in the region." (http://www.ebrd.com/new/pressrel/2009/090507k.htm) Such an engagement on the part of foreign parent banks in the area is an over-optimistic assumption (see below). If anything, the withdrawal of foreign parent banks from transition economies is precisely what strengthens the case for an EBRD major capital increase in the near future, already before the review of the EBRD capital is due in 2012.
Within the aggregate forecasts given above, the heterogeneous group of 29 countries naturally exhibits a highly diversified economic performance. In Central Europe and the Baltics in 2009 Poland fares best, with zero growth. At the other end of the range, all three Baltics are contracting by more than 10 per cent: Estonia (already in recession at -3 per cent in 2008) at -10.5, Lithuania -11.8, Latvia -13.2. Hungary is doing rather poorly: after stagnation at 1.1 per cent in 2007 and 0.5 per cent in 2008, its GNP is poised to fall by 5.0 per cent, with zero growth next year. On average this area’s GDP is expected by the EBRD to decline in 2009 at 2.9 per cent, and to resume growth at only 0.2 per cent in 2010. In the April 2009 World Economic Outlook the IMF was even more pessimistic, with a 3.7 per cent GNP decline, but more optimistic for Russia and the rest of the Commonwealth of Independent States.
EBRD forecasts for South-eastern Europe show a slightly better performance: on average growth rates in 2007-2010 follow the pattern (in per cent): 6.3, 6.6, -2.2, 0.4; in 2009 Romania is worst with -4.0. Eastern Europe and the Caucasus (meaning the non Asian members of the Commonwealth of Independent States, not counting Russia) in the same years exhibit actual and predicted growth of: 9.9, 5.0, -6.2, 1.3; Ukraine is expected to contract by 10.0 per cent this year and grow at a zero rate next year. Central Asia is the least affected area, with GNP growth rates of 9.2, 5.0, 0.4, 3.0 in 2007-2010. Finally, Russia is seriously affected: 8.1 and 5.6 in 2007, 2008; - 7.5 in 2009, the result of an even deeper fall in the first quarter and an expected improvement in the rest of the year; the green shoots of recovery are forecast by the EBRD at 1.0 per cent in 2010.
All these countries have either completed their transition to the market economy and their re-integration into the world economy and especially Europe (the ten new member states of 2004 and 2007, with Slovenia and Slovakia already members of the Eurozone), or have made steady and very substantial progress in that direction. What makes them so vulnerable to the pandemic financial and real crisis?
Initially, when the global crisis involved only the financial sector, transition countries – regardless of EU membership – seemed to be fairly resilient. Then, as the crisis impacted the corporate sector, they began to slowdown, and by the end of 2008 and the first quarter of 2009, when domestic consumption began to be affected, they went from slowdown to nosedive.
In general the current financial crisis confronted all emerging and developing countries – including transition economies – with two shocks: “a ‘sudden stop’ of capital inflows driven by global deleveraging, and a collapse in export demand associated with the global slump” (Atish R. Ghosh et al., IMF 2009)[1]. But there are different aspects and intensities, specific to country groups, discussed both in the IMF Staff Position Note just quoted and in other papers[2].
1. Home made sub-primes. The USA sub-primes crisis of August 2007 touched only marginally the transition economies. But a large amount of domestic loans, mostly for house-purchase finance but also in the enterprise sector – and in the government sector – were originally denominated in foreign currency because the national currency a) involved much higher interest rates and b) had been stable or (with the exception of countries with a successful Currency Board: Bulgaria, Estonia and Lithuania) appreciating. All these loans, amounting to $250 billion in Central Eastern Europe (Auer and Wehrmuller 2009)[3] promptly became sub-prime, as soon as the domestic currency began to depreciate for the reasons indicated below. Thus Polish borrowers in Swiss Francs in the last quarter of 2008 and the first quarter of 2009 have seen their zloty liabilities rise by 31 per cent due to the revaluation of the SF with respect to the Polish zloty.
Auer and Wehrmuller estimate that in the 10 EU member states from Central Europe total losses from private and public debt re-valuation amount to about $60bn, under 5 per cent of GDP in most countries but as much as 18 per cent and 8 per cent in Hungary and Poland respectively. The expectation that the state will ultimately bear the cost of bailing out the debtors, plus the cost born by the state on its own debt, has dramatically raised the spread on Credit Default Swaps for the eight countries for which data are available out of the ten new Member States (Auer and Wehrmuller, cit.).
The problem is serious: in 2007 in eight countries the foreign currency-denominated debt in the non-financial private sector exceeded 50% of total non-financial sector debt: Ukraine, Romania, Bulgaria, Lithuania, Hungary, Georgia, Estonia, Latvia; over 60% in the last four of these, almost 90% in Latvia (Connelly, 2009, p.23).
2. External imbalances. Connelly (2009, cit.) considers twenty countries which he labels “Emerging Europe” (the EBRD 29 minus Turkey, Albania; Bosnia & Herzegovina, Macedonia, Montenegro, Serbia; Tajikistan and Turkmenistan; Mongolia). He notes that “Emerging Europe is the only emerging market region to collectively run a current account deficit”: apart from Azerbaijan, Kazakhstan and Russia in 2008 all the other countries in this group have current account deficits, of which seven over 10 per cent of GDP: Bulgaria at -21.2 per cent, Georgia -20.6, Moldova -15.3 Lithuania -13.9, Romania -13.3, Latvia -12.1, Estonia -11.2.
Sustained current account deficits lead naturally to higher external debt. But it cannot be argued that the current account deficits were the result of fiscal profligacy. Between 2000 and 2008 the number of countries running a government surplus increased from one (Russia) to five (with the addition of Azerbaijan, Belarus, Bulgaria, Kazakhstan), while the deficits of another 13 countries out of the twenty reviewed by Connelly fell below 3 per cent. Thus the growth of external debt is clearly due, on average, primarily to the private sector. Yet the expected emergence of contingent liabilities and costly bail-outs reduces governments’ credibility anyway. Darvas and Pisani-Ferry (2009)[4] establish a significant correlation between the cost of credit default swaps (CDS), the insurance against default on government debt, and current account deficits. Moreover, non-Eurozone members pay a higher insurance cost, rising very much faster over time: “the crisis management in the euro area has had the unintended consequence of putting non euro-area new member states at disadvantage”. Probably, without the credibility bestowed by the euro, floating rates lead to overshooting devaluation, while fixed rates lose competitiveness to the country that maintains them and provide adverse shocks when the peg sooner or later must be altered.
3. Primary product exporters – primarily Russia, Azerbaijan and Kazakhstan – until mid-2008 were in a position to run current account surpluses and accumulate foreign reserves. But in 2008 oil, gas, cotton and metals fell in price. Foreign reserves were used – wasted, we could say to some extent – to support overvalued exchange rates and to bail out financial institutions and productive enterprises. The Central Bank of Russia foreign reserves (including gold) fell from $476.4bn in 2007 to $427.1bn in 2008 and $383.9 at the end of April 2009, plus another $32bn lost by the Stabilisation Fund in the first quarter of 2009 (https://webmail.london.edu/exchweb/bin/redir.asp?URL=http://www.bof.fi/bofit_en/seuranta/venajatilastot/index.htm , though other sources report larger losses). The EC Spring Forecasts 2009 (cited) are more optimistic than the EBRD yet expect a Russian budget swinging sharply from a hefty surplus to large deficits, of respectively 6.5% and 2.7% of GDP in 2009, due to the reduction in commodity prices and in economic activity, plus the large fiscal stimulus packages. Russia is also forecast to see major falls in both its trade and current account surpluses, respectively to 5.1% and 6.3% of GDP in 2009, and 1.4% and 2.7% in 2010.
4. Fall or reversal of FDI and portfolio investment inflows. “With net private capital flows to emerging market (and developing) countries projected to decline from an inflow of US$600 billion in 2007 to an outflow of US$180 billion in 2009, EMEs [Emerging Market Economies] are facing a severe credit crunch. Particularly affected are the countries with large current account deficits – many of which had asset price and credit booms” (Ghosh et al., 2009, p.6). Transition economies had been able to attract large and growing capital inflows thanks to privatisations at attractive prices, high interest rates net of devaluation cover or even plus revaluations, and production de-localisation thanks to low wages. These attractions have weakened, and the recession has made inflows even less attractive.
“The region [i.e. Donnelly’s Emerging Europe defined above] faces an aggregated adjusted gross external financing requirement of approximately $460bn, or around $930bn if short-term is added… The deterioration in the outlook for private capital flows to emerging markets makes ‘roll-over’ of these loans extremely unlikely, with the Institute of International Finance (IIF) projecting a fall in private capital flows to the region from around $254bn in 2008 to only $30bn in 2009” (Connelly 2009, p.4).
In these circumstances devaluations are unavoidable but steering a course between floating and pegging is hard, as we have seen above. Higher interest rates are unlikely to bring back capital in a recession. Controls on capital flows will at best stop capital flight but not bring it back, and can be counterproductive. Official financing is therefore badly needed, by the IMF in the first instance with doubling access limits, Flexible Credit Lines, and Stand-By arrangements. With additional resources, support for debt re-structuring can come from national governments, for instance converting foreign currency loans to domestic currency and compensating banks for losses, maybe only partly.
5. Foreign Banks withdrawing funds. At the inception of the transition an under-capitalised and largely insolvent state banking system was partly cleansed of what today are labelled toxic assets, re-capitalised, privatised mostly to foreign banks, and new banks were promoted, also mostly foreign. By 2006, foreign ownership in the ten New Member States, excluding Slovenia (at 22 per cent), ranges from 74 per cent in Latvia to 98 per cent in Estonia (EBRD, Transition Report 2006). Foreign banks were to provide capital and know how, and through access to foreign parent banks provide foreign exchange and in practice access to lending of last resort in the country of origin.
Today the EBRD Chief Economist still relies on “the continued external engagement, particularly from the western parents of banks in the region” (cited above). And Darvas and Pisani-Ferry (2009, cited) still argue that “Several factors have mitigated the impact of the crisis on non euro area NMS [New Member States]: … [among other things] western European ownership of NMS banks (by indirectly stabilizing their NMS subsidiaries)…” (emphasis added).
Yet the EC Spring forecasts 2009 tell a different story: “The repatriation of capital by foreign banks has been particularly abrupt in some cases. For instance, in Ukraine real GDP growth is projected to decline by 9½% in 2009, due to a severely curtailed access to external financing, which has triggered the conclusion of a stand-by arrangement (SBA) with the IMF…”. “The significant and broad-based slowdown in the CIS could have direct growth effects in Central and Eastern Europe, and the presence of EU banks in the region creates further potential negative spill-overs via the financial channel” (p.22, emphasis added). “Paradoxically, it is precisely this characteristic – strong foreign banking presence – that renders EE countries (except for the CIS) region, much more vulnerable to the present financial turmoil” (Uvalic 2009, p.4)[5]. In turn, foreign parent banks risk downgrading as a result of the declining profitability and the losses on their operations in Eastern Europe; conversely, EE countries depend on their continued financial health.
Recently the EBRD made one of its larger investments, worth a total of €432.4 million, in UniCredit subsidiaries across eight eastern European countries, to provide medium and long-term debt and equity financing through UniCredit subsidiaries in support of SMEs, lease finance and energy efficiency projects. [6] This is precisely the kind of contribution that the EBRD can make to the region’s recovery, especially if its relatively modest resources of €20bn were to be raised by 50-100 per cent.
6. Reduction in external demand. Current projections for 2009 indicate for the first time since the last War a decline in world output (-2 per cent according to the IMF) and a much larger decline in world trade, by as much as 13% (WTO), thus reducing for the first time since the War the most common measure of globalisation, the ratio between world exports and world GNP. A sizeable de-globalisation episode is taking place. Output contraction and trade are larger in the EU, with which transition economies have grown to be increasingly integrated, with EU trade shares of the order of 60-90 per cent for the New Member States and South-Eastern Europe, all characterised by high foreign trade openness, higher than that of most old members of the EU (see the table below, penultimate column). Such openness makes the transition economies opportunities of “de-coupling” from downturns in the EU rather limited (Connelly, cit., p.5). Lower trade shares involve a slowdown in manufacturing and extractive industries, and in internal demand especially in construction and financial services.
7. Differences in initial positions and policy response. “Some [countries] were ripe for a homegrown crisis associated with the end of unsustainable credit booms or fiscal policies; others were just bystanders caught in the storm” (Ghosh et al., 2009, cit., p.3; “… the majority were just innocent bystanders”, p.2).
Uncharacteristically, the IMF has recommended, to advanced economies experiencing the global recession, easing monetary policy and lower interest rates. It has also “called for a timely, large, lasting, diversified fiscal stimulus that is coordinated across countries with a commitment to do more if the crisis deepens” (Ghosh et al., 2009, p.19-20). Naturally the IMF now is forced to recommend the same policies to transition economies in crisis, though with stronger warnings about the possible side effects: “Much of the spending and revenue policy advice for advanced economies remains relevant for EMEs [Emerging Market Economies], once scaled down for their small fiscal space” (Ibidem, emphasis added).
Thus transition economies and other EMEs are reminded that looser monetary policies involve dangers of exchange rate devaluation and consequent adverse effects on balance sheets. That it is dangerous to exceed the “policy space” and especially the “fiscal space” of a country, jeopardizing policy credibility and sustainability. Changes should be gradual (however strange this now may sound coming from the IMF) and sustainable; abrupt and non sustainable changes can be particularly costly and disruptive (see Ghosh et al., 2009).
Clearly an expansionary fiscal policy “ is likely to be more effective in stimulating aggregate demand if the economy is relatively closed to trade flows, uses monetary policy to prevent or limit the appreciation of the currency, has substantial spare capacity, has a high proportion of credit-constrained households or firms, and has a sustainable public debt position” (Ibidem, p.21). Which is fair enough, except that transition economies and other EMEs are most unlikely to satisfy these ideal preconditions.
A short digression on the euro. The question here is whether early membership of the Euroarea might assist recovery in the New Member States, of which only Slovenia and Slovakia are already members. The IMF now recommends it, speaking out of turn because it is not for the IMF to recommend anything to Europe other than possibly an application to join the Euroarea on the part of those new members that meet the Maastricht conditions for membership.
Small open economies would probably gain from being part of a large currency area in times of crisis, although Slovakia (not yet a member until 1 January 2009) and the Czech Republic have done rather well being outside it. Unilateral adoption of the euro is ruled out by the EU for both members and candidates; Currency Boards reduce the probability of a crisis at the cost of making the crisis catastrophic if and when it happens (as in Argentina); European Currency Boards are not yet out of the danger zone. The European Central Bank role as Lender of Last Resort is remarkably undetermined and left to informal arrangements with Eurozone members; non-members with hyper-fixed links to the euro (unilateral euroisation or Currency Boards) might be left high and dry in times of crisis.
The EU could have well admitted at least a few other New Member States to the Euroarea, by somewhat loosening the Maastricht criteria for fiscal and monetary convergence, and the two-year membership of the Exchange Rate Mechanism II. The Maastricht criteria for fiscal convergence are in theory looser than those of the so-called Growth and Stability Pact (GSP, which involves not only a 3% ceiling to government deficit but a stricter zero per cent over the cycle) applying to all EU members regardless of Euroarea membership. In practice however the GSP strictures and the associated penalties were considerably relaxed in March 2005, and further loosened during the current crisis, whereas Maastricht criteria for joining the euro have been very strictly enforced. It is unreasonable to subject countries that grow much faster than the Eurozone members and have relatively low ratios between public debt and GNP to the same fiscal stringency of stagnant and highly indebted Euroarea members (like Italy), moreover rigidly and inflexibly applied only to prospective members.
Lithuania was left out of the euro only because its inflation exceeded the average inflation of the three least inflationary EU members by 1.6% instead of the 1.5% prescribed by the Maastricht Treaty – not exactly an enlightened or rational behaviour, especially considering that two of those three least inflationary countries were not Euroarea members.
“The EU can certainly be criticised for clinging to criteria ill-suited to catching-up countries and the case for reforming them is strong” (Darvas and Pisani-Ferry, 2009, cited). See also Nuti 2006. [7] Be that as it may, the middle of a recession is not the best time to change or, worse, bend the rules as drastically as it would be required by early admission of all or most New Members to the Euroarea. End of digression.
The heterogeneity of country experiences is pithily and efficiently synthesised by one-liners from two sources. The first is a table on Fourteen ways to slowdown from The Economist, 26 February 2009 (http://www.economist.com/world/europe/displaystory.cfm?story_id=1318459).
Fourteen ways to slowdown (italics=pegged to euro; underlined=in euro area)
....................GDP......S&P..........financing
.....................per.....credit...requirements
Country...person*..rating#..% of GDP°..Exports§............In a nutshell
Belarus...12,344.... B+...........7.3...........62.1.Autocratic, isolated, gained surprise IMF bailout
Bulgaria..12,372.....A...........29.4...........61.0 Strong finances back currency peg; sleaze rampant
Czech R...25,757....AA.......... 9.4...........80.1 Thrifty and solid but hit by export slowdown
Estonia...20,754....AA.........20.0 ..........72.0 Star reformer squeezes spending to stay afloat
Hungary.19,830.....A ..........29.9..........80.2 Currency crush could topple debt-heavy economy
Latvia.....17,801....BBB........24.3..........46.6 Clinging to currency peg amid turmoil & downturn
Lithuania.18,855....A+ ........27.1...........59.0 Painful spending squeeze to avoid worse
Poland....17,560.....A+.........13.2..........42.3 Regional heavyweight speeds up euro bid
Romania.12,698...BBB+.......20.2.........36.4 Spendthrift policies meet solid reality
Russia....16,161....BBB..........2.2...........31.7 Energy-based kleptocracy in denial about crisis
Serbia... 10,911......BB-........23.5..........22.2 Seeking more IMF help
Slovakia.22,242....AAA......12.5...........90.5 Smugly in euro-area, hit by car-factory slowdown
Slovenia.28,894...AAA..........-.............70.5 Self-satisfied, rich and still growing
Ukraine....7,634...CCC+......16.1..........45.0 No end in sight to political and economic chaos
* PPP$, 2008 estimate. # Standard & Poor’s, latest. ° Current account balance, principal due on public and private debts plus IMF debits, 2008 estimate. § Goods and services, % of GDP, 2008 estimate. Sources: IMF; Moody’s; Economist Intelligence Unit; The Economist.
From: Sarah Hanson, The whiff of contagion, The Economist, 26 February 2009. (Corrected in the 5 March 2009 issue).
The second source is the EC Spring Forecasts 2009 (cited), whose country chapters for transition economies (EU member states, candidate states and Russia) have the enlightening subtitles listed below:
Bulgaria: Vanishing budgetary surplus, external deficit remains large.
The Czech Republic: Output falls sharply driven by collapse in external demand.
Estonia: Adjusting to face gloomier years.
Latvia: Domestic demand and trade implode.
Lithuania: Deepening recession leads to wider fiscal deficits.
Hungary: Domestic financial crisis magnifies recession.
Poland: Mild recession knocking at the door.Romania: Growth contracts sharply.
Slovenia: Sharp falls in exports and investment point to competitiveness challenges.
Slovakia: Global downturn weighs on exports.
Croatia: a declining economy creates important fiscal challenges.
The Former Yugoslav Republic of Macedonia: Joining the general trend … albeit with a delay.
Turkey: Manufacturing faltering as exports decline.
Russian Federation: The first recession in a decade.
In the 1990s an unexpected, deep and protracted recession characterised the post-socialist transition of Central-Eastern Europe and the Former Soviet Union, with GNP decline ranging from 18 per cent in Poland over three years, to 65 per cent in Moldova over ten years. The decline may be slightly exaggerated especially at the top of the range, for well known reasons, but a reliable and unbiassed observer such as Bob Mundell reckons that the transition recession was not just deeper than the 1929 crisis, it was deeper than the recession that accompanied the Black Death in the 14th century, because then income fall was matched by population fall and living standards were preserved.
By comparison the current recession must be barely perceptible to the populations of transition countries. And at least this time they are benefiting not only from more generous assistance from the international community, but from more enlightened policies of monetary easing and low interest rates, fiscal subsidies and expansion, large scale state intervention – all policies diametrically opposite to the draconian hyper-liberal policies that contributed so much to aggravate the transition recession and the other costs of transition in the 1990s. Only two things have really changed since then: today the hyper-liberalism that inspired the course of transition in the 1990s has been thoroughly discredited by the global crisis associated with it, and the predicament of transition economies is vastly improved simply because they happen to share it with the advanced countries that control international financial organisations.
[1] Atish R. Ghosh, Marcos Chamon, Christopher Crowe, Jun. I. Kim, and Johnathan D. Ostry, “Coping with the Crisis: Policy Options for Emerging Market Countries”, IMF Staff Position Note, SPN/09/08, 23 April 2009, http://www.imf.org/external/pubs/ft/spn/2009/spn0908.pdf.
[2] . See for instance Richard Connolly, “Financial vulnerabilities in Emerging Europe: An overview”, Bank of Finland Institute of Transition-BOFIT Online No. 3, 4 May 2009, http://www.bof.fi/NR/rdonlyres/BA4C9028-D69D-45CB-ABF1-140ECB129E4C/0/bon0309.pdf.
[3] Raphael Auer and Simon Wehrmuller, $60 billion and counting: Carry trade-related losses and their effect on CDS spreads in Central and Eastern Europe, 29 April 2009 http://www.voxeu.org/index.php?q=node/3467 http://www.vox.eu/.
[4] Zsolt Darvas and Jean Pisani-Ferry, The looming divide within Europe, Breugel, 18 January 2009, http://www.eurointelligence.com/article.581+M5852b1b851d.0.html
[5] Milica Uvalic, “The impact of the global financial crisis on Eastern Europe”, Conference Paper, Bol (Croatia), 21-23 May 2009.
[6] “UniCredit is the largest banking group in the central and eastern European region, with over 4,000 branches in 19 countries. The group has invested around €10 billion of equity in central and eastern Europe and has around €85 billion of total customers loans in the region. Beside its own funding programs to its subsidiaries, it cooperates with international institutions including the EBRD in order to ensure continuing support to the local economies during these challenging times.” (from the EBRD website, http://www.ebrd.com/new/pressrel/2009/090507g.htm).
[7] D. Mario Nuti, "Alternative fiscal rules for the new EU Member States", TIGER-WSPiS Discussion Papers n. 84, Warsaw, 2006, http://www.tiger.edu.pl/publikacje/TWPNo84.pdf .
Wednesday, April 15, 2009
Bucket and Spoon
Anyone telling you when and where the next earthquake is going to happen should be disbelieved and treated with contempt. The same applies to anyone telling you when and where recovery from the current global crisis is going to happen. Maybe the green shoots are already here, in Europe and/or the US. Maybe in China end-2009 and 2010. Maybe globally in 10 years time. We are sailing in uncharted waters and nobody can speak with any acceptable degree of confidence and credibility.
The current global financial crisis is unprecedented. It is not due to an exogenous shock (like the oil shock of 1974) but it is an endogenous, systemic crisis, due to the unregulated degeneration of financial institutions, banks and non-bank intermediaries, the result of twenty years of hyper-liberalism. In August 2007 USA sub-primes acted as trigger, but the process was amplified by their securitisation and repackaging in structured bonds, as part of a much larger bubble in the derivatives market. According to the Basel-based Bank of International Settlements, the global outstanding derivatives – bets on the value of assets, and bets on those bets – have been growing exponentially and reached 1.14 quadrillion dollars. More precisely: $548 trillion in Exchange Traded Derivatives[1] plus $596 trillion in notional Over-The-Counter[2] derivatives. By comparison, the gross domestic product of all the countries in the world is only 60 trillion dollars. What was supposed to be an instrument to distribute risk has turned into a multiplication of risk.
Ultimately the problem with derivatives is that they represent bets that are only marginally covered. If those bets had to be 100% covered – and therefore losses constrained by a ceiling – at the time a transaction takes place, the size of the derivatives markets would be only a fraction of its present size, and counterparty defaults would not occur. With uncovered bets, mostly laid down on credit, when the value of underlying assets falls the whole pyramid collapses. In 2006 there were no bank failures in the USA; these were 3 in 2007, 25 in 2008, 23 in the first quarter of 2009.
The crisis is synchronised throughout the world, thus offering no geographical or sectoral shelter.
It spreads fast moving from the financial sector to the real economy, from one country to the other thanks to the globalisation of trade and capital movements, and in turn tends to de-globalise the world economy.
It is a deep crisis: for the first time since 1945 world income is falling, on average by 2% in 2009, accordingly to the IMF. World exports (obviously by definition equal to world imports), after growing steadily from 7% of world income in 1970 to 27% in 2007 are now falling, and at a rate much faster than income: minus 9% in 2009 according to the IMF, minus 13% according to the WTO. This brings down the world exports/income ratio, which is the most common and reliable index of globalisation. Labour unemployment has been growing fast. According to OECD forecasts Europe unemployment will rise by 20 million in 2009.
Such an unprecedented occurrence appears to have brought about, first, a re-thinking of the need for supervision and regulation of financial markets, and more generally for corporate governance in financial institutions and also in production, nationally and globally; second, an attempt to achieve a co-ordinated effort by at least the major countries and international financial institutions, for monetary expansion, as well as additional large scale fiscal stimulation. But there are considerable obstacles and doubts about both the actual implementation of such policies and their likely success.
The United States are unwilling to negotiate financial regulations internationally. They have injected large scale liquidity in the rescue of financial institutions, a process rightly criticised by Joseph Stiglitz as collectivisation of losses – directly, under Paulson and Bush, indirectly via government guarantees, under Geithner and Obama – after past profits have been privatised and salted away by shareholders and overpaid managers. Millionaire bonuses for managers of failing companies have been taking some cuts, through tax and ceilings, which have been criticised as improper interferences with “the market for managerial talent” – as if the medieval corporative practice of managers’ salaries being decided by other managers with a vested interest in inflationary settlements had anything to do with a competitive market. But by and large managers have kept their ill-gotten gains.
The effectiveness of monetary expansion, in any case, is limited by the current low level of interest rates, and by the liquidity preference that the public exhibits at such low rates (as we should all know very well from the experience with Japan’s monetary policy).
Fiscal expansion – Keynes resurrected and rehabilitated – on a world scale makes infinitely more sense than unilateral fiscal expansion by a single country. But many governments are already heavily indebted and feel they do not have much of what the World Bank calls “fiscal space” for sustaining larger deficits. The US have contributed fairly generously, however Gordon Brown himself, after posing as world saviour by promoting coordinated fiscal stimulation, had to trim his own sails and failed to do in the UK what he preached abroad. And there is the great temptation for governments (e.g. Italy) to benefit as free riders without contributing to the common effort.
In general, the size of the combined world-wide monetary and fiscal stimulus is at best a couple of percentage points of the size of the derivatives markets. Emptying water from the sinking ship with a spoon is not enough.
[1] ETD, traded via specialized exchanges or other exchanges acting as an intermediary, taking an initial margin from both sides of the trade to act as a guarantee.
[2] Over The Counter, privately negotiated and traded directly between two parties, without going through an exchange or other intermediary.
The current global financial crisis is unprecedented. It is not due to an exogenous shock (like the oil shock of 1974) but it is an endogenous, systemic crisis, due to the unregulated degeneration of financial institutions, banks and non-bank intermediaries, the result of twenty years of hyper-liberalism. In August 2007 USA sub-primes acted as trigger, but the process was amplified by their securitisation and repackaging in structured bonds, as part of a much larger bubble in the derivatives market. According to the Basel-based Bank of International Settlements, the global outstanding derivatives – bets on the value of assets, and bets on those bets – have been growing exponentially and reached 1.14 quadrillion dollars. More precisely: $548 trillion in Exchange Traded Derivatives[1] plus $596 trillion in notional Over-The-Counter[2] derivatives. By comparison, the gross domestic product of all the countries in the world is only 60 trillion dollars. What was supposed to be an instrument to distribute risk has turned into a multiplication of risk.
Ultimately the problem with derivatives is that they represent bets that are only marginally covered. If those bets had to be 100% covered – and therefore losses constrained by a ceiling – at the time a transaction takes place, the size of the derivatives markets would be only a fraction of its present size, and counterparty defaults would not occur. With uncovered bets, mostly laid down on credit, when the value of underlying assets falls the whole pyramid collapses. In 2006 there were no bank failures in the USA; these were 3 in 2007, 25 in 2008, 23 in the first quarter of 2009.
The crisis is synchronised throughout the world, thus offering no geographical or sectoral shelter.
It spreads fast moving from the financial sector to the real economy, from one country to the other thanks to the globalisation of trade and capital movements, and in turn tends to de-globalise the world economy.
It is a deep crisis: for the first time since 1945 world income is falling, on average by 2% in 2009, accordingly to the IMF. World exports (obviously by definition equal to world imports), after growing steadily from 7% of world income in 1970 to 27% in 2007 are now falling, and at a rate much faster than income: minus 9% in 2009 according to the IMF, minus 13% according to the WTO. This brings down the world exports/income ratio, which is the most common and reliable index of globalisation. Labour unemployment has been growing fast. According to OECD forecasts Europe unemployment will rise by 20 million in 2009.
Such an unprecedented occurrence appears to have brought about, first, a re-thinking of the need for supervision and regulation of financial markets, and more generally for corporate governance in financial institutions and also in production, nationally and globally; second, an attempt to achieve a co-ordinated effort by at least the major countries and international financial institutions, for monetary expansion, as well as additional large scale fiscal stimulation. But there are considerable obstacles and doubts about both the actual implementation of such policies and their likely success.
The United States are unwilling to negotiate financial regulations internationally. They have injected large scale liquidity in the rescue of financial institutions, a process rightly criticised by Joseph Stiglitz as collectivisation of losses – directly, under Paulson and Bush, indirectly via government guarantees, under Geithner and Obama – after past profits have been privatised and salted away by shareholders and overpaid managers. Millionaire bonuses for managers of failing companies have been taking some cuts, through tax and ceilings, which have been criticised as improper interferences with “the market for managerial talent” – as if the medieval corporative practice of managers’ salaries being decided by other managers with a vested interest in inflationary settlements had anything to do with a competitive market. But by and large managers have kept their ill-gotten gains.
The effectiveness of monetary expansion, in any case, is limited by the current low level of interest rates, and by the liquidity preference that the public exhibits at such low rates (as we should all know very well from the experience with Japan’s monetary policy).
Fiscal expansion – Keynes resurrected and rehabilitated – on a world scale makes infinitely more sense than unilateral fiscal expansion by a single country. But many governments are already heavily indebted and feel they do not have much of what the World Bank calls “fiscal space” for sustaining larger deficits. The US have contributed fairly generously, however Gordon Brown himself, after posing as world saviour by promoting coordinated fiscal stimulation, had to trim his own sails and failed to do in the UK what he preached abroad. And there is the great temptation for governments (e.g. Italy) to benefit as free riders without contributing to the common effort.
In general, the size of the combined world-wide monetary and fiscal stimulus is at best a couple of percentage points of the size of the derivatives markets. Emptying water from the sinking ship with a spoon is not enough.
[1] ETD, traded via specialized exchanges or other exchanges acting as an intermediary, taking an initial margin from both sides of the trade to act as a guarantee.
[2] Over The Counter, privately negotiated and traded directly between two parties, without going through an exchange or other intermediary.
Subscribe to:
Posts (Atom)
Posts
