US, Greece, inflation and deflation…

May 17th, 2010

First, a few words about this post. Given that I cannot post more than twice a week on my Business Standard blog and I have something to say almost every day, I believe I have found a middle path. I can write every day, but post a collection of these notes, two or possibly three combined into one, twice a week. As with any experiment, its success is uncertain, but there’s just one way to find out. On to the first topic, then…

Is the US like Greece?

This question has become one of pretty intense discussion between economists across the world recently. Paul Krugman declared that it isn’t and created some graphs to prove his point. Others declared he misinterpreted the data used for the graphs and used it to prove the opposite case. While Prof Krugman used data to try and prove that the US deficit is reducing and Greek deficit is growing in the coming years, his detractors used the same data to show that despite lower deficits, US Debt/GDP ratio in 2020 will be close to Greece’s today.
The funny thing about numbers is, if one is smart enough, one can prove almost anything with them. Sadly, the core of the problem isn’t about numbers, its about monetary theory. And by ignoring this, both sides are missing the plot completely.

When Greece adopted the Euro, it chose to give up control of its currency. The Euro is now its home currency and legal tender for all financial transactions within its borders. This includes it’s borrowings. But Greece doesn’t control the quantity of Euro in circulation and cannot create it out of thin air, a privilege reserved only for the European Central Bank. So when it comes to repaying its debt, Greece needs to ensure that it either earns the required amount or borrows it. This was not the case when Greece had its own currency when they could just create it to repay their debt.

The core differentiator between domestic and foreign currency, especially when it comes to borrowings, is the government’s control over the quantity of that currency and not its use as legal tender in the country. The test for this differentiator is simple. One only needs to ask whether the government can, even if only as a last resort, create the currency required to repay its debt. If it can, all borrowings denominated in that currency are domestic borrowings. Conversely, if it can’t, all borrowings denominated in this currency are external borrowings.

When it comes to choosing between domestic and external borrowing, if such a choice exists, government’s will try and keep external borrowings to a bare minimum to minimize their foreign exchange commitments. But there are nations which either don’t have this choice or don’t need to make it. In the former group are nations which adopted the Euro. They do not have any control over the Euro individually, but have to denominate their borrowings either in Euro or in some foreign currency. In essence. all borrowings for these nations are akin to external borrowings since they cannot unilaterally create the currency needed to repay this debt.

Membership of the latter group; nations which don’t have to make this choice, is restricted to nations having the ability to borrow in their domestic currency from foreigners. Nations like the US do not need to undertake any foreign exchange debt commitments. All their borrowings are denominated in a currency they control completely, and can create and destroy at will. For them all borrowings are akin to domestic borrowings regardless of the nationality of their lenders.

So Greece will default, either now or in some time, because it cannot create Euros out of thin air. But with a similar Debt/GDP ratio, all the US has to do is to create the money required to repay its debt. Whether that’s sensible is another discussion altogether, but in the end, the US has a choice and Greece doesn’t.

And that’s what makes them different, not their numbers.

Is the world headed for inflation or deflation?

This is a tough one. Ever since central banks started creating money from nothing, Austrian school economists have been crying themselves hoarse about potential inflation. And yet it hasn’t been that much of an issue after Paul Volcker supposedly tamed the beast. Theory supports these economists, but experience doesn’t. So what’s really going on?

For one, theory often makes assumptions which don’t hold true in reality. “Ceteris Paribus”, a Latin phrase meaning “ other things remaining constant” is often used in economic theory but doesn’t really work in real life because almost nothing remains constant.

So when central banks started conjuring money, they not only added to the amount available for consumption, but also to the amount available for lending. This in turn led to the creation of capacities, which are now far in excess of consumption demand. Consumption demand should have risen as well, and it did, but looking at the scale of unemployment in all major economies, not enough to offset increased capacity.

This should ideally result in deflation and if one were to look at core inflation numbers (excluding food & energy) across the world, it has. On the other hand, sectors in which capacities haven’t really kept pace like food-grains, and those where natural limitations exist, like minerals, oil, metals etc., prices have been rising all through this period.
Rising prices of necessities, when coupled with falling prices for almost all other items, does not impact all nations equally. This differential impact is really a function of  the consumption pattern in these nations, which in turn is a function of their average per capita income. In high income nations, a lower proportion of income is spent on necessities when compared to low income nations. So increasing prices of necessities are more than balanced by deflation in other items as far as consumers in high income nations are concerned. On the other hand, in low income nations, necessities form a large part of the consumption basket and despite deflation in other items, perceived and experienced inflation remains high.

Average global inflation is, per force, GDP weighted while actual inflation is ‘per capita GDP’ weighted. This implies that while average global inflation will remain low and inflation experienced by consumers in high income nations will be slightly below this average, inflation experienced by consumers in low income nations will be significantly higher. Looks like the rich are getting richer and the poor, poorer.

Food for thought?

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal   

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Quantitative Easing in Europe - what’s the real point?

May 14th, 2010

It seems like the European Bailout package isn’t the complete bailout that banks were hoping for. At least, not yet. But that doesn’t mean banks have given up trying to make it one.

After the ‘almost $1 trillion’ bailout package announced on Sunday, pressure is building on the European Central Bank to support it by buying government debt of the peripheral European nations. The ECB has already agreed to buy Greek, Portugese & Spanish government debt along with private sector debt but, to keep these purchases liquidity neutral, it plans to sell an equal amount of German and French government debt. But the amounts the ECB is willing to commit to this endeavor are relatively small and limited by their holdings of, and ability to sell, German and French debt. In a bid to increase this amount, financial market analysts are trying to get the ECB to delink sales from purchases. The reason being offered, of course, is very different from the real one. Analysts are trying to make the ECB believe that it needs to undertake quantitative easing to ‘unfreeze’ Europe’s slowly freezing credit market. But before we go deeper into  the real reason, let’s look at some numbers.

The EU has already pledged to set aside over $75 bln to manage balance of payment issues. In addition EU nations will set up a Special Purpose Vehicle (SPV) which will underwrite/guarantee upto $560 bln of weaker members’ Government debt. The IMF will contribute close to $320 bln to this effort through either of the channels in addition to the EU commitments bringing the total to a whopping $955 bln.

However, financial analysts will have the world believe that despite the ‘ginormous’ size, this isn’t enough and suggest the ECB step in and buy close to $400 bln of government debt issued by these close-to-failed states as well. To make their ‘unfreezing’ premise believable and to free these purchases from restrictive limits, they also suggest that the ECB should not sterilize the liquidity. They propose that since this liquidity will go to the banks already holding this government debt, this will allow them to continue functioning normally.

It seems, having analysed the bailout package, banks and financial institutions have realised that it doesn’t give them a way out of their current holdings of debt issued by these weak nations. Debt which matures in the next 3 years will be rolled over with guarantees by the SPV or underwritten by it, but banks have no way out of their holdings of longer term debt issued by these nations.

Analysis of the bailout package also suggests that it will do nothing to stop Greece from defaulting eventually. Similarly, it doesn’t really help other peripheral countries like Portugal, Spain etc. This is because the package concentrates it’s efforts on improving liquidity for their debt, but doesn’t address their solvency. This solvency issue can only be corrected by a partial default, also called debt renegotiation. But, debt renegotiation will involve writedowns in the value of this debt and a direct loss to the holders of this debt.

Worried about these losses, and not knowing which bank will suffer more, banks have virtually stopped lending to each other, preferring instead to deposit funds with the ECB. As of Monday, bank surpluses deposited with the ECB totaled just under $400 bln, the highest since July 2009. This suggests two things.

1) There is no shortage of liquidity with the banks and the demand for additional liquidity is completely unjustified.

2) Banks are seriously concerned about their own solvency if one or more of these countries were to default and don’t trust each other to survive. Hence the reluctance to lend.

But in doing so, they are also making it clear that they will continue to hold the financial markets to ransom till their demand to be insulated from these losses is met.

The ECB has called their bluff to some extent by addressing their fear of frozen markets and re-introducing a facility under which it lends to banks for slightly longer periods, similar to what it did in 2007-08. But this has only changed their argument. There are now suggestions that inflation caused by quantitative easing is desirable as it will allow the fiscally weak nations to recover easily, given that inflation reduces the real value of debt. That rising inflation would go against the only task the ECB has been entrusted with is, of 
course, of no consequence to these self serving advisors.

Hopefully, it’s still of consequence to the ECB.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal   

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The European Bailout - Shucks and Woe!

May 11th, 2010

Late Sunday night, European leaders announced they had reached an understanding on stabilizing their currency and debt markets. It was a “shock and awe” bailout package of close to $1 trillion… It is amazing how easily the number rolls off the tongue now. The trillion is now the new billion.

The markets have reacted exceedingly well for now, but who actually benefits from this bailout? Is it Greece, or are they too far gone? Is it Spain, Portugal, Ireland and Italy because they still have some time? Or is it the bankers who lent to these countries, knowing their credit quality was suspect, but secure in the belief they could coerce government(s) into underwriting their losses? Following the money is always an easy way to figure this out…

As far as Greece is concerned, very little changes. The newly created multinational agency will underwrite Greece’s future debt obligations. This will include new debt issued to finance its fiscal deficit and refinancing of old debt which is due to mature in the near future. For Greece, this means lower interest rates on their borrowings which will help. What this will not do for Greece is help reduce their debt burden. It will not penalise its lenders even though they lent to Greece knowing its fiscal position. Greece’s debt-GDP ratio will continue to remain unsustainably high in the near future. And even though it looks as if it can be reduced by going through an extremely painful deflationary process to improve its finances, it is just not that simple.

Balancing the budget is not good enough anymore. Greece has to start generating primary surpluses of a magnitude greater than the deflationary impact of the austerity required to do so AND 1.25 times its average interest rate (currently 8 per cent) for it to reduce its debt-GDP ratio. The math isn’t simple because it is iterative in nature but just as an example, Greece will have to turn from a primary deficit of 8.6 per cent of GDP to a primary surplus of 10 per cent of GDP while ensuring that its GDP does not shrink to maintain its debt-GDP ratio. It will need to do more to reduce it. So Greece will remain where it is, with default being its best option, either now or sometime in the future.

Spain, Portugal, Ireland and Italy aren’t that badly off yet. Their debt-GDP ratios are better than that of Greece and all they have to ensure is that they don’t grow. Given the above example, once again, it is not as simple as it sounds. They may not be candidates for default just yet, but one needs to bear in mind that they are just a few percentage points of GDP away.

The European Bailout package has fallen into a classic trap. It mistakes a solvency crisis to be a liquidity crisis. Yes, it can ensure that all these countries will get the funds they need to meet their debt obligations, but it doesn’t address why they couldn’t raise the money without help. While Greece is already insolvent, most of the others are on the brink and giving them access to cheap funds only delays the inevitable.

And it ensures that banks get paid in full. Since all maturing debt will either be underwritten, or provided, by the new entity created for this purpose, the burden of eventual default will be borne by those financing this entity, the European taxpayers. As far as the IMF’s contribution is concerned, the burden of its losses will be borne by each and every IMF shareholder, including India. So banks walk away unhurt while taxpayers across the world assume unnecessary risk. Doesn’t that make you wonder who we’re ruled by?

The only “hope” the package holds out is that of monetary expansion. If the ECB were to start expanding money supply by unsterilised purchases of bad Euro government debt and sparks off inflation in the process, Greece and the other countries may not have to worry about deflation as much. But if the ECB were to do so, not only would it be going against it’s anti inflation mandate, it would end up weakening the Euro. This could result in developing countries devaluing their currencies to retain competitiveness in Europe. With the US still struggling for competitiveness, prospects of a sustainable recovery would all but vanish and the world will be back to 2007.

Except, this time around, it won’t be financial sector bankruptcy we will be dealing with. It will be sovereign default.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal  

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Greece – Is it a failure of the Euro?

May 7th, 2010

With the US markets suddenly losing ground on Greek fears, and for some time now, analyses connecting Greece’s woes to its decision to join the Euro are everywhere. Some suggest that Greece may not be able to find its way out of its problems without leaving the Euro. They suggest that Greece return to a national currency system and devalue it’s way out of debt.

While it is true that for Greece to recover, leaving the Euro seems to be a solution, it is clearly not a very plausible one. Another solution is being tried out under which Greece would take the tough decisions required to improve its fiscal health, which would result in the other Euro countries and the IMF bailing it out. This solution has found support in Greek Parliament but has been greeted by riots and mayhem on the streets. The idea of living with lower government expenditure somehow seems abhorrent to the Greek as it would necessarily result in changes in Greece’s social security structure and public sector salaries.

The cause of Greece’s woes is not its membership of the Euro. Being a part of a monetary union where monetary policy is independent of the state is as close as a country can get to monetary utopia under the current system of fiat currencies and monetary monopoly. But when a nation undertakes to live with a currency outside its control, a lot of things change. For starters, all borrowings of the state and it’s citizens become the equivalent of external borrowings. This is because once the state loses its power to create currency or manipulate its price, its ability to repay becomes directly dependent on its capability to earn the currency required to repay its debt. In this situation, it is incumbent on the state not only to ensure that it’s revenues are maintained at the required level, it is also its responsibility to ensure that borrowings are made only as a last resort.

Countercyclical fiscal policy, which is recommended for all countries regardless of currency system, becomes a necessity in a currency system where the state has no control. And not only in the traditional sense of a balance being maintained in good years and deficits undertaken in bad years. When the state does not have control over currency, it is imperative that deficits of tough years are balanced by surpluses in good years to ensure that over a business cycle or two, government debt tends to zero.

Greece’s troubles today are not a result of their joining the Euro, and they will not be solved by them leaving it. Greece’s problems are fiscal in nature and have been brought upon themselves by irresponsible spending. The only sustainable course of action is to make genuine attempts to improve their fiscal position. And improvements not only to the extent of reduced fiscal deficits, which will only reduce the pace of increase in their debt burden. Greece has to chart a path towards fiscal surpluses which will result in a reduction of total debt.

Leaving the Euro now may not help them to the extent envisaged by various commentators. Yes, it will give them control over their currency which they can merrily devalue to increase exports and become more competitive. But since all their debt will still be in foreign currencies, devaluation will increase the value of their debt in terms of their new currency. With the total stock of debt exceeding GDP by 1.7 times (including private debt but not including interest payments), devaluation would only work if nominal GDP growth were to outstrip the extent of devaluation itself by a factor of 1.7. This may take some time and in the initial stages, the balance will not be in it’s favor. This will result in Greece borrowing to meet it’s obligations at an interest rate which will be worse than it’s existing rate. Since the starting point is one where bondholders are demanding over 15 per cent for two-year debt, one can only shudder to think what worsening would mean.

And interest rates add their own twist to the math. As long as average interest cost on outstanding debt remains above nominal GDP growth in the currency of obligation, the debt burden will keep on growing. Till as recently as December 2009, Greece was borrowing one year money at an interest rate lower than inflation. This has changed in 2010. Rates now are sky high pricing in a significant probability of default. To make matter worse, close to half of Greece’s outstanding debt matures in the next 5 years, which will have to be refinanced at rates which are far higher than that on the maturing debt.

All in all, Greece’s debt problems cannot be solved by either staying with or leaving the Euro. Its problems are fiscal in nature and can be solved only through fiscal measures. Given public reaction to this path, there is a distinct possibility that this will not happen.

And the only option left will be default.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal   

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