Financing of periphery external deficits

It is more than usual to read articles examining the Euro boom years which tend to suggest that capital inflows from the core funded the credit expansion in the periphery. Although that line of reasoning is not wrong when examining capital flows between countries, I do not think it is entirely correct in the case of a monetary union such as the Eurozone.

The main reason is the fact that the Eurosystem is structured in such as way that it is accommodating of capital flows between Eurozone members through overdrafts at the NCBs and unlimited Target2 credit. Banks as suppliers of credit and creators of deposits do not need a pre-existing stock of funds, nor to they need to pre-finance any outflows to other Euro members.

More specifically imagine the following example depicting the normal flow of credit and cross-border flows:

1. A bank customer in Greece applies to a Greek bank for a loan to fund a new investment project (which will require German manufactured capital goods).
2. The bank extends the loan and credits the corresponding customer’s bank account. No actual funds are needed by the bank apart from the 2% reserve requirements (which is elastically provided by the ECB).
3. The customer pays for the capital good by transferring funds to a German bank. For the transaction to take place, the  Greek bank debits its reserve account at the Bank of Greece with the corresponding amount and BoG increases its Target2 net liability position. In case the Greek bank is short of reserves (compared to average reserve requirements) it can source funds at the BoG marginal lending facility, at the weekly MRO or at the interbank (repo) market.
4. Since the interbank repo rate is quite favorable compared to the marginal facility rate, the Greek bank will use high quality bonds from its bond portfolio (mainly Greek government bonds) to source funds from the European interbank repo market using the bonds as collateral. It is clear at this point that the new bank loan remains on the Greek bank books and is never transferred outside its balance sheet, nor does it play any significant role in the cross-border flows.
5. Apart from the increase in bank liabilities to RoW (described in (4)), periphery countries also saw a large increase in the amount of government bonds held by the foreign sector. As a result, instead of (4), Greek banks could just use the flow of funds from abroad (which were used to acquire Greek government bonds) to repay their (extra) liabilities towards the BoG and maintain a stable amount of interbank funding. It should be noted at this point that any inflows of funds either from the interbank market or from foreigners for the purpose of buying government bonds will lower the net liability position of BoG to the rest of the Eurosystem (a position that actually remained quite small until the start of the 2008 crisis).

What is clear from the above is that cross border flows are accommodating (in the sense that central bank financing is always available to cover them) and that the reason of incoming flows has almost nothing to do with the original loans and transactions (in our case a bank loan to pay for an investment project ends up in a cross border liability of the government or the banking system).

Financing of cross border flows was always provided by the Eurosystem. Inflows of funds to buy government bonds and interbank loans were merely used by the banking system as a cheaper source of funds instead of large liability positions towards the corresponding NCB. Capital inflows did not ‘fund investment in the periphery’ but were the result of foreign portfolio preferences and mostly changed the composition of the net liability position in the periphery away from Target2 liabilities which were replaced by higher liabilities of the government and banking sector.

Small reminder on dependency ratios

Based mostly on this article on Japan. What is important when looking at dependency ratios is not the ratio of old persons to the working age population but rather the ratio of non-working citizens to working ones. And this includes people (usually) younger than 24, especially in developed countries (where most people attend some type of college).

When examined under this perspective the relevant picture is quite different: Non-working dependency ratios were extremely high during capitalism’s ‘Golden Age’ (1950 – 1970). Greece will hit ratios last seen in 1975 at.. 2040 (with the dependency ratio being much higher in the ’50s) while Germany will only get into trouble after 2025-2030.

As long as pensions are not a ‘defined benefits’ but rather a ‘defined contributions’ scheme and remain flexible, population aging will not lead to the ‘dooms day’ scenarios that some people fear about. We managed to take care of baby boomers just fine during capitalism’s finest hour.

Net Primary Income from RoW

Something which I think goes overlooked from time to time is the fact that what is actually available as (taxable) income within a country is not GDP but GNP (which is GDP plus net income from RoW). As a result, calculations involving maximum tax income potential and debt sustainability should take into account any income lost from GDP as income of foreigners.

This is especially true for Greece where an examination of the available data actually shows that somewhere close to its Euro entry the country moved from a positive net income balance to an increasingly negative one, both nominally and as a percentage of GDP:

At its peak (2008), Greece lost more than 3% of its GDP as income returned to RoW with dynamics that were quickly becoming unsustainable. Ever since the 2009 crisis and especially after 2012 (and the PSI exercise) that lost income was significantly reduced (and even reversed at least during 2012). Nevertheless, it seems that funds lost to the RoW are slowly increasing again with the relative balance (as %GDP) moving from -0.6% in 2012 to 0.4% during 2014:

Although the figures are still almost an order of magnitude less than during the second half of the previous decade their long-run dynamics should be modeled in any debt sustainability exercise, especially since Greece will depend on FDI for a large part of its future economic growth (which will create large flows of income for the RoW).

The same dynamics (with a peak again during 2008) are actually present in the rest of Europe as well with the periphery increasing its lost income during the Euro’s first decade and EU center (Germany, France, Netherlands) moving from a roughly balanced figure to positive net income of close to 2% GDP (which obviously increases their taxable income):

Euro area permanent economic losses

Despite the large economic losses in the Eurozone since 2008 one will hear the same constant argument: Most countries (especially those in the periphery) lived ‘beyond their means’ and the correction that followed was inevitable. Austerity might cause short-term pain but the subsequent economic recovery (however weak and thin) vindicates its use and merits.

In this short post I will take a rather simplistic approach. Since the ECB inflation target is 2% while the usual assumption about long-run growth in per capita real output is also 2% we can compare the path of NGDP per capita in European countries to a 4% trend:

What we see is quite significant. It is true that before 2008 Greece and Spain had a NGDP path that constantly diverged from the 4% long-run trend (this pattern is especially strong in the Greek case). France, Italy and Portugal roughly followed the long-run trend while Germany quickly suffered significant losses due to its stagnant domestic demand environment and low inflation.

What is especially interesting is the path of NGDP/capita since the Great Recession. All countries seem to have suffered significant and permanent losses with their expected expansion path moving to a new and lower level. This is even more visible in the case of Greece and Italy where their projected 2016 NGDP per capita level will only be 70% of the long-term trend. Interestingly, Spain seems to be the country that has suffered the least losses compared to the trend line while France, Germany and Portugal are quite far from the 4% growth path (France at 74% while Germany and Portugal are close to 78%) with France actually growing only by 1.5% since 2012.

Yes, the path of Greece and Spain up to 2008 seems to have been unsustainable (in the context of a monetary union). Yet their correction entailed significant and permanent losses while the whole of the Eurozone is now on a new growth path at least 20-25% lower than the long-term 4% trend. Austerity and tight monetary conditions result in large output losses that are lost forever. Adding a few years of income 20-25% lower than trend implies a permanent loss of more than a year’s worth of income which in the context of a person’s lifespan is more than important.

Fiscal Multipliers in recessions

Olivier Blanchard, the IMF’s Chief Economist who is stepping down from that position at the end of September gave an interesting interview on his term at the IMF which focused, among other things, on the issue of fiscal multipliers as one of the main topics where the IMF had to update its beliefs and change its assumptions on the relationship between fiscal consolidation and growth. Given this opportunity I would like to use this space as a small reference on the existing literature on the topic.

Up until the crisis, fiscal multipliers were calculated usually through an SVAR system IRFs based on a methodology pioneered by Blanchard himself (Blanchard and Perotti 2002) . Based on that research, fiscal multipliers were considered to be rather small with estimates ranging between 0.3 and 0.6 for tax multipliers and 0.3 and 1 for spending multipliers. The large (and persistent) output gaps since the crisis, the presence of the ZLB which limited monetary accommodation as well as the inability to devalue at least in the Eurozone countries changed the focus of the research away from a roughly balanced growth path where fiscal effects are only temporary (and Ricardian equivalence holds) and towards a methodology focused on regime-switching models, usually implemented through Smooth-Transition VARs. Early and significant contributions to this literature were made by Auerbach and Gorodnichenko whose work is still the primary reference on the subject.

Under this kind of framework, fiscal multipliers are different in downturns and upturns measured by a state variable such as the output gap. Moreover, in order to avoid bias problems, fiscal shocks were not specified using the cyclically adjusted primary balance approach (as originally used by Alesina in his ‘expansionary austerity’ papers) but rather using either the ‘narrative approach’ where fiscal shocks are determined based on the examination of policy documents to identify episodes of exogenous fiscal measures or where shocks are identified as forecast errors based on professional forecasts of fiscal policy.

Fiscal multipliers in the G-7

One of the earliest research notes on the subject was during 2012 by the IMF (which was also presented in the Fiscal Monitor of that year) on the fiscal multipliers in G-7 countries. The paper used a TVAR methodology to calculate spending and tax multipliers for six G7 countries.The results showed that multipliers are significantly different between regimes with spending shocks having a substantially higher effect on output:

Growth forecast errors and multipliers

Following the strong Greek disappointment the IMF and its Chief Economist published significant research on its WEO 2012 and as a separate paper on the fiscal multipliers during the fiscal consolidation period. The idea was actually rather simple and elegant:

regress forecast error for real GDP growth on forecasts of fiscal consolidation. Under rational expectations, and assuming that forecasters used the correct model for forecasting, the coefficient on the fiscal consolidation forecast should be zero. If, on the other hand, forecasters underestimated fiscal multipliers, there should be a negative relation between fiscal consolidation forecasts and subsequent growth forecast errors

The results indicated that forecasters had significantly underestimated the impact of fiscal consolidation on economic growth and especially on consumption and investment (in other words, on internal demand):

Our forecast data come from the spring 2010 IMF World Economic Outlook (IMF, 2010c), which includes forecasts of growth and fiscal consolidation—measured by the change in the structural fiscal balance—for 26 European economies. We find that a 1 percentage point of GDP rise in the fiscal consolidation forecast for 2010-11 was associated with a real GDP loss during 2010-11 of about 1 percent, relative to forecast. Figure 1 illustrates this result using a scatter plot. A natural interpretation of this finding is that multipliers implicit in the forecasts were, on average, too low by about 1.

Table 1 reports our baseline estimation results. We find a significant negative relation between fiscal consolidation forecasts made in 2010 and subsequent growth forecast errors. In the baseline specification, the estimate of β, the coefficient on the forecast of fiscal consolidation, is –1.095 (t-statistic = –4.294), implying that, for every additional percentage point of GDP of fiscal consolidation, GDP was about 1 percent lower than forecast. Figure 1 illustrates this result using a scatter plot. The coefficient is statistically significant at the 1% level, and the R² is 0.496.

As Table 1 reports, when we remove the two largest policy changes (those for Germany and Greece), the estimate of β declines to –0.776 (t-statistic = –2.249) but remains statistically significant at the 5 percent level.

As Table 6 reports, when we decompose the effect on GDP in this way, we find that planned fiscal consolidation is associated with significantly lower-than-expected consumption and investment growth. The coefficient for investment growth (–2.681) is about three times larger than that for private consumption growth (–0.816), which is consistent with research showing that investment varies relatively strongly in response to overall economic conditions.

Overall, we find that, for the baseline sample, forecasters significantly underestimated the increase in unemployment and the decline in domestic demand associated with fiscal consolidation.

Expansionary austerity? Not so fast

Another important piece of research by the IMF is a paper which focused on the ‘expansionary austerity’ narrative championed mainly by Alesina. The paper argued that using the cyclically adjusted primary balance (CAPB) suffered from serious bias problems and using instead a narrative approach (focusing on historical data of discretionary fiscal consolidation measures) changed the impact on growth significantly, especially compared to the CAPB estimation:

The conventional approach is to identify discretionary changes in fiscal policy using a statistical concept such as the change in the cyclically-adjusted primary balance (CAPB). As this paper explains, changes in cyclically-adjusted fiscal variables often include non-policy changes correlated with other developments affecting economic activity. For example, a boom in the stock market improves the CAPB by increasing capital gains and cyclically-adjusted tax revenues. It is also likely to reflect developments that will raise private consumption and investment. Such measurement error is thus likely to bias the analysis towards downplaying contractionary effects of deliberate fiscal consolidation. Moreover, a rise in the CAPB may reflect a government’s decision to raise taxes or cut spending to restrain domestic demand and reduce the risk of overheating. In this case, using the rise in the CAPB to measure the effect of fiscal consolidation on economic activity would suffer from reverse causality and bias the analysis towards supporting the expansionary fiscal contractions hypothesis.

To address these possible shortcomings, we examine the behavior of economic activity following discretionary changes in fiscal policy that historical sources suggest are not correlated with the short-term domestic economic outlook. In particular, we consult a wide range of contemporaneous policy documents to identify cases of fiscal consolidation motivated not by a desire to restrain domestic demand in an overheated economy, but instead by a desire to reduce the budget deficit.

A comparison of our measure of fiscal consolidation with the change in the CAPB reveals large differences between the two series, and suggests that, in these cases, the CAPB based approach tends to misidentify deficit-driven fiscal consolidations.

Based on our new dataset, Section III estimates the short-term effect of fiscal consolidation on economic activity. Our estimates imply that a 1 percent of GDP fiscal consolidation reduces real private consumption over the next two years by 0.75 percent, while real GDP declines by 0.62 percent. In contrast, repeating the analysis using the change in the CAPB to measure discretionary policy changes provides evidence consistent with the expansionary austerity hypothesis. On average, a rise in the CAPB-to-GDP ratio is associated with a mild expansion in private consumption and GDP. The large difference in these estimates also arises for a subset of large fiscal adjustments––those greater or equal to 1.5 percent of GDP. These results suggest that the biases associated with using cyclically-adjusted data may be substantial.

Meta-Regression: Effects on Eurozone and Greece

Apart from presenting the results of specific papers it is also interesting to note the conclusions of a large meta-regression on the available literature on the topic. This research was also used in order to determine the actual effects of fiscal consolidation within Europe and in Greece. Its main results are:

The meta-analysis finds that the fiscal multiplier estimates are significantly higher during economic downturns than in average economic circumstances or in booms.

For example, the multiplier of unspecific government expenditures on goods and services robustly rises by an average of 0.6 to 0.8 units during a downturn. And for some specific instruments, for instance fiscal transfers, the multiplier increases by much more, turning transfers from the second least effective expenditure instrument into the most effective one. Part of the strong increase of the transfer multiplier might be explained by an increase in the share of liquidity constrained private households in downturns.

Importantly, and by contrast, there does not appear to be any such regime dependence in the impacts of tax changes. In fact, the spending multipliers exceed tax multipliers by about 0.3 units across the board in normal times and even more so in recession periods. Furthermore, during average economic times and in boom periods, the fiscal multipliers are not only lower than in downturns but also tend to vary less across different fiscal instruments.

Gechert and Rannenberg (2014) find that for all expenditure categories other than increases in unspecified government spending, the cumulative multipliers robustly exceed one in the downturn regime.

Spending multipliers tend to be larger than tax multipliers,

More open economies have significantly lower multipliers than more closed economies, and

The multipliers generally vary significantly across spending and tax categories, so that studies which look at the strength of general fiscal multipliers (or deficit multipliers) on average can produce very misleading results.

Looking into the effects of Euro wide fiscal consolidation the authors find that:

the fiscal consolidation in the Eurozone reduced GDP by 4.3% relative to a no-consolidation baseline in 2011, with the deviation from the baseline increasing to 7.7% in 2013. Thus, the austerity measures came at a big cost. By far the biggest contribution to this GDP decline comes from transfer cuts

This is especially evident in Greece where austerity can explain more or less the full extent of the loss of output since 2009, as well as the return to growth during 2014 (since that was the time when fiscal consolidation was largely put on hold) :

We estimate that austerity almost entirely explains the collapse of Greek GDP after 2009. This result suggests that ceteris paribus in the absence of austerity, the Greek economy would have entered a prolonged period of stagnation, rather than a depression.

We find that the fiscal consolidation in Greece reduced GDP by more than 10% in 2010, with the cumulative GDP decline increasing to 28% in 2013, after which it decreases to about 26% in 2014, as – according to our estimates – fiscal austerity was relaxed somewhat on the expenditure side in 2014.

Fiscal multipliers: Monetary accommodation and medium-term effects

I will end this post with a look at two more papers on the subject that do not attempt to just re-estimate fiscal multipliers for specific countries but rather to answer some important policy questions. Mainly whether monetary accommodation plays a role on the impact of fiscal consolidation (economic theory and common logic suggests it does) and how fiscal consolidation affects economic growth in the medium-term (which can have negative effects on potential output through lower growth of the capital stock and hysteresis effects on the labour market).

The first paper finds that fiscal policy is much more effective when monetary policy is accommodative. This also answers the crowding-in/out question of government spending since controlling for the stance of monetary policy can determine to a large extent the effects of fiscal measures.

Clearly, the response of output is conditional on the state of monetary policy: output increases to a large extent following a federal spending shock when monetary policy accommodates, while it falls, albeit not significantly, when monetary policy does not accommodate. This result holds over time and is consistent with the findings in Auerbach and Gorodnichenko (2012). The authors find that government spending tend to be slightly recessionary during expansions when expectations are controlled for.

Estimation results suggest that output increases by 2.5 dollars within a year for a dollar increase in federal spending when monetary policy is accommodative and decreases by 1.6 dollars when monetary policy is non-accommodative. The peak multiplier when the accommodative state prevails is equal 5.5 and only equals 2.8 under non-accommodative monetary policy.

The second paper tries to study the effects of fiscal consolidation on output and employment over a 5-year period for a sample of OECD countries during periods of deep recession defined as economic contractions lasting at least two consecutive years. It  Fiscal shocks are identified using the narrative approach while separate expenditure and tax multipliers are calculated. An important contribution of this paper is the fact that it also tries to estimate employment and unemployment multipliers.

Its findings suggest that multipliers are indeed significantly larger during prolonged recessions while the asymmetry between long and ‘normal’ recessions exists mainly for expenditure based adjustments:

Our empirical findings suggest that the medium-term fiscal multiplier on output is significantly larger during PRs. Specifically, the medium-term multiplier is approximately -2 at a five-year horizon during PRs, compared to -0.6 during normal times. This means that during PR episodes a cumulative increase in the primary surplus of 1 dollar leads to a cumulative decrease in output of 2 dollars over a five-year horizon. We also find that the employment ratio persistently declines after a fiscal consolidation during periods of PR, resulting in a medium-term employment multiplier above -3 compared to -0.5 on average. The unemployment rate also persistently increases with an estimated medium-term multiplier of around 1.5, indicating that a cumulative increase in the primary surplus of 1 percent of GDP leads to a cumulative rise in the unemployment rate by 1.5 percentage points at a five-year horizon.

Our empirical results show that the asymmetry in the size of multipliers between PR and non-PR only exist for expenditure-based (EB) adjustments for which medium-term multipliers on output, employment or unemployment, are significantly higher during PR episodes compared to the average response in non-PR periods. Our results for tax-based (TB) consolidations are in line with previous literature, which finds large and symmetric effects of TB consolidations on output (Romer and Romer, 2010). These results are robust to several alternative specifications, including different definitions of the cycle, credit growth, and exclusion of countries with financial crises or with constrained monetary policy.

It is also highly significant that protracted recessions appear to have a serious impact on variables such as the capital stock, the NAIRU and (as a direct result) on potential output. Consumption, investment and private-sector employment are also seriously affected.

Conclusions

Overall I think it is quite clear that fiscal multipliers (especially expenditure multipliers) are high and significant during times of recession and negative output gap. They are able to explain the largest part of the output losses and stagnation in the Eurozone since 2010. The ‘confidence fairy’ does not seem to exist while continued consolidation during a deep and prolonged recession can have very serious effects not only on current output but also on potential output and future growth due to its impact on structural unemployment and the capital stock. Monetary policy accommodation (which is even more important in times when the ZLB has been hit or inside the Eurozone) determined to a large extent whether fiscal policy will have expansionary results or not and answers the crowding-in/out question.

Grexit, ELA and ERM II

A few days ago, this article would have started with the statement that Grexit is closer than ever. Today it seems that Grexit has been postponed for a few months. Yet I fail to understand the underlying strategy of the Greek government since the proposed austerity measures (along with capital controls and low confidence) are destined to push the economy in a deep recession. This recession will make achieving the primary surplus targets even harder and government debt clearly unsustainable (even based on the IMF’s quite optimistic projections). The current program will fail in 2016 and Grexit will come back on the table with a Greek government that enjoys a much more fragile domestic political support and an even weaker economy with a higher output gap.

Probably the biggest problem of returning to the drachma is the fact that there are certain (probable) scenarios where the economy almost collapses and others where we observe the usual path of a large devaluation following an unsustainable currency peg: A short-lived large fall in output followed by a long path of economic growth. Usually people will just choose the scenario that fits their story and ideology and not consider (or even imagine) any other possible paths. The ‘ugly scenario’ basically includes official creditors accelerating Greek debt in the form of EFSF loans and the Greek Loan Facility. That will push Greece in a permanent default state and most probably not make it able to accumulate any foreign reserves (since they would be claimed by creditors). EU structural funds will most likely be lost and Europe will not support the newly created currency exchange rate in any way. Greece will have to function in a ‘semi-pariah’ state with strict and permanent capital controls and an economy that will slowly lose most of its human capital and internationally oriented sectors (such as shipping).

In this blog post I will not analyze the above scenario any further but rather take a closer look at a controlled exit from the Eurozone which will include the help of the other Euro member countries (if not for anything else but to enhance the recovery of their official loans).

First of all let me remind people that currency movements happen mostly because of large gross capital flows and not due to the underlying real trade flows (this paper from BIS Claudio Borio is quite informative). Capital flows, at least in the short-term, will happen for only a few reasons:

• RoW liquidating domestic claims in order to transform them in foreign currency (think of other Euro banks not rolling over repos with Greek banks or equity investors exiting the Greek stock exchange).
• Domestic firms and households trying to exchange their liquid assets (mostly deposits) for foreign currency.
• Institutional players taking large currency positions. This requires being able to borrow large amounts of the currency that will be shorted at favorable terms.

In the Greek case we know that a Grexit will happen under strict capital controls (which are already present), while the terms and price (interest rate) under which the RoW will access the drachma will be determined exclusively by Bank of Greece. Since drachma does not exist in any way, a Eurodollar market is not present and cannot help anyone to circumvent capital controls. Private players outside Greece have already liquidated most of their claims (either equity or interbank loans) while the bulk of Greek liabilities are long-term official loans by other Eurozone member countries. The same is true to a large extent for Greeks themselves who have moved large amounts of liquidity outside Greece. This is the main reason why BoG has more than €120bn in liabilities towards the Eurosystem (Target2 and extra banknotes combined).

As a result, coupled with the presence of capital controls and the fact that Greece already has a strong current account surplus (on a yearly basis) there is actually small scope for strong pressure on the exchange rate of a newly introduced drachma. It is probably one of the few times that capital controls can truly be used as a policy tool and not to trap large funds looking for a way out (as was the case in Iceland). As long as outstanding Greek debt to the ECB (in the form of SMP bonds) and the IMF is rescheduled in the form of a long-term loan by the ESM, the GLF spread over Euribor is lowered to  5bps and interest payments postponed until 2020 (as has already happened with the EFSF loan) Greece will have truly minimal refinancing needs (in terms of foreign currency obligations) for the rest of the decade and be able to slowly accumulate FX reserves through its current account surpluses.

The main subject where a host of different opinions exist is what will happen with ELA financing by BoG and the corresponding liabilities towards the Eurosystem. The story usually goes that BoG will have to default on these liabilities and the Eurosystem having to perform a large capital injection. In my view any such claim is most probably false, at least in the favorable scenario. EU already has an exchange rate mechanism for EU members that do not participate in the Euro area but wish to maintain a controlled exchange rate relationship, called ERM II. This mechanism defines a ‘central exchange rate’ with the Euro, with a fluctuation band of +/- 15%. Intervention at the margins is automatic and unlimited while a short-term financing facility exists with a maturity of 3 months (which can be renewed at least once):

for the currency of each participating non-euro area Member State (hereinafter ‘participating non-euro area currency’) a central rate against the euro is defined;

there is one standard fluctuation band of ± 15 % around the central rates;

intervention at the margins is in principle automatic and unlimited, with very short-term financing available.

For the purpose of intervention in euro and in the participating non-euro area currencies, the ECB and each participating non-euro area NCB shall open for each other very short-term credit facilities. The initial maturity for a very short-term financing operation shall be three months.

The financing operations under these facilities shall take the form of spot sales and purchases of participating currencies giving rise to corresponding claims and liabilities, denominated in the creditor’s currency, between the ECB and the participating non-euro area NCBs. The value date of the financing operations shall be identical to the value date of the intervention in the market. The ECB shall keep a record of all transactions conducted in the context of these facilities.

The very short-term financing facility is in principle automatically available and unlimited in amount for the purpose of financing intervention in participating currencies at the margins.

For the purpose of intramarginal intervention, the very short-term financing facility may, with the agreement of the central bank issuing the intervention currency, be made available subject to the following conditions: (a) the cumulative amount of such financing made available to the debtor central bank shall not exceed the latter’s ceiling as laid down in Annex II; (b) the debtor central bank shall make appropriate use of its foreign reserve holdings prior to drawing on the facility.

Outstanding very short-term financing balances shall be remunerated at the representative domestic three-month money market rate of the creditor’s currency prevailing on the trade date of the initial financing operation or, in the event of a renewal pursuant to Articles 10 and 11 of this Agreement, the three-month money market rate of the creditor’s currency prevailing two business days before the date on which the initial financing operation to be renewed falls due.

My view is that in the case of a Grexit current BoG liabilities towards the Eurosystem will be transformed into a long-term financing facility, capped somewhere close to their current level. BoG will have to pay interest to the Eurosystem, either the 3-month rate applicable to ERM II financing facility or the MRO (as it happens today for Target2 liabilities) with the clear agreement that BoG will use its FX reserves in order to slowly pay back the facility (through annual current account surpluses). This will obviously mean that BoG financing towards Greek banks will remain significant, absent a domestic QE program. Short-term financing by the Eurosystem will be provided in order to facilitate temporary FX needs (the Greek current account is actually in deficit during the first months of a year) and to allow the smooth payment of government liabilities denominated in Euros. Obviously this financing facility will be capped for intramarginal interventions.

As long as the central rate is reasonable and both sides are determined to defend it through monetary policy (interest rates), capital controls and automatic interventions, confidence on the drachma will quickly be strengthened and domestic players will have little reason to try to convert their assets into foreign currency.

Obviously one important problem is the fact that creating the actual physical currency will take time. Electronic payments as well as the over €50bn in Euro banknotes circulating in Greece right now (for a GDP of less than €179bn) will help minimize the short-term impact.

Although I hope the above will remain only a scenario exercise, it is my view that, given the political climate inside Europe and the short-term economic reality, Grexit will emerge again during 2016, especially if the current package is not accompanied by serious debt restructuring.

World current account imbalances

I know that the theme of global imbalances has seen quite a bit of attention since the 2008 crisis but still I would like to stress the fact of how the Euro area is now the major contributor to current account imbalances in the world. According to the latest figures, the Euro area reported a 12-month cumulated current account of €244.5bn in March 2015 (2.4% of Euro GDP) which translates to roughly 0.40% of world GDP. This figure is substantially higher than the corresponding 2014 reading of €186.1bn (1.9% of Euro GDP).

If one takes a long-term look on country and country group current accounts a few major patterns will emerge:

1. The increase in the current account surplus for China between 2001 and 2008 and its large correction since then.
2. The corresponding increase of the German surplus which shows no signs of correcting.
3. The large surpluses of oil producing countries, dependent though on high oil prices (they are projected to be only marginally positive during 2015).
4. The US functioning as the world’s consumer up until the Great Recession and its strong correction since then (with the oil shale boom playing an important role).

One of the most important observations though is how the Euro area turned from a roughly balanced external balance (up until 2011) to a surplus larger than the combination of China and Japan for the 2013-2014 period. The result of this development, along with the US correction, is that the sum of the current account balances of this group of countries (Euro area, China+Japan, Russia + major Middle East oil producers and the USA) turned from a large negative value until 2006 to a surplus of over 0.55% of world GDP. The above are more easily illustrated in the following charts (based on the table data) for country

and country groups CA balances:

The above suggests that instead of a demand surplus in the 2001 – 2006 period (which could be tapped by the rest of the world), the world’s major countries now need the remaining (mostly emerging) part of the globe to run a current account deficit and borrow in order to maintain growth in the ‘first world’. In other words, the Euro area is now the group that fuels global imbalances and creates a ‘supply surplus’ which the world must consume if European countries will be able to emerge from their stagnation and large unemployment.

In order for the Euro area’s over -2.5% output gap to be lowered, surpluses of more than 0.4-0.5% of world GDP have to be maintained (under the current policy regime where Europe relies on external demand as a driver of its economic growth) in a world of deficient demand. Given the continuous slowdown of BRICS growth I wonder for how much longer this policy will remain successful.

Greece Net Employment inflows in 2014Q4

This will be a quick follow-up post on the 2014Q3 employment figures post. The Greek Ministry of Employment publishes monthly figures of employment announcements by employers on an online registration system called ‘Ergani’. Based on the recently announced numbers for December of 2014 (sorry the document is in Greek) I ‘d like to make a few projections on the current state of unemployment in Greece:

It is quite evident that net employment flows were negative during 2014H2 due to 2014Q4 dynamics (which are not yet reflected on the unemployment survey numbers published by ELSTAT). Compared to 2013 the total difference was 120,000 jobs (from a positive net flow of 43,000 jobs to an outflow of 77,000 employees) with the fourth quarter loosing almost 90,000 jobs, a figure close to three times that of 2013.

Since seasonal adjustment of employment is always a smoothing mechanism which requires a large number of observations my feeling is that October/November monthly employment surveys, as well as the quarterly 2014Q4 survey, will register a significant fall in employment which might result into an increase of the unemployment rate. With a labour force of 4,830 thousand people, the 88,000 jobs shortfall during 2014Q4 is equal to almost 2% which should appear in the unemployment numbers during the upcoming months. Something to definitely keep an eye on.

The math of Ricardian Equivalence and the government budget constraint

I ‘ve been bogged down with my PhD courses lately and this blog has not seen the share of posts that it was accustomed to. In any case, since I ‘m looking back into our Macro 1 course (which is based mainly on the Romer and Blanchard books, both quite informative and good to have) I ‘d like to touch on the math of the Ricardian Equivalence and the Government Budget Constraint.

As is well known, the Ricardian Equivalence (RE) states that only the quantity of government purchases, not the division of the financing of those purchases between taxes and bonds, affects the economy. This is based on the household budget constraint of a Ramsey model where the government budget constraint (with equality) is applied. What the latter suggests is that the government must run primary surpluses large enough in present value to offset its initial debt.

Usually the government budget constraint is taken at face value by most economists while Ricardian Equivalence is suggested that it might not be (completely) valid in practice due to facts such as short-term horizons, liquidity constraints, different interest rates faced by the government and households and the Zero Level Bound. Nevertheless, I ‘m not so sure that a lot of people would disagree with the RE model in its original form (a very nice reference for both issues is chapter 12 of Romer).

In this post I would like to support the proposition that mathematically both the RE and the government budget constraint require the assumption that, at the infinite horizon limit, private household net financial wealth is zero. Households only gain utility from consumption so, at the limit, they will consume all financial wealth they hold which suggests that the present value of government primary surpluses should be equal to government debt.

Obviously this only works in a world where money is neutral and ultimately is only used as a transactions medium and not as a store of value to hedge an uncertain future. The notion of «safe assets» does not really enter into the realm of the Ramsey model where the representative agent either has perfect foresight or faces stochastic risk (and not genuine uncertainty).

As Philip Arestis elegantly states, «all economic agents with their rational expectations are perfectly creditworthy. All IOUs in the economy can, and would, be accepted in exchange. There is thus not need for a specific monetary asset. All fixed-interest financial assets are identical so that there is a single rate of interest in any period.»

Once this assumption is relaxed and the private sector requires a safe store of value not only to facilitate wealth maintenance but even the daily flow of transactions (with government debt securities playing a crucial role in monetary policy operations and the repo markets), the government budget constraint breaks down while an increase in the supply of government debt can even be stabilizing (see for example the relevant Treasury programs during the 2008 credit crisis) and is required in order for the private sector to maintain its wealth in a safe store of value, free from shocks that might emerge in an uncertain world.

Further, mathematical details can be found in the attached (small) pdf document.

Government Budget Constraint – Ricardian Equivalence

Greek 2014Q3 unemployment figures

Greek ELSTAT released the unemployment figures for 2014Q3 today which marked the fall of the unemployment rate to 25.5%, down from 27.2% during the corresponding quarter of 2013. Given the positive outlook of the release I ‘d like to take a closer look at the details of Greek employment and if this drop of the unemployment rate really signifies a substantial improvement of the economy.

Based on various tables of the quarterly employment figures I have constructed the following table of certain numbers that I feel are important:

Personally I usually pass through the unemployment rate and go straight to the employment figure. As we can see, although unemployment dropped by 91 thousand people (compared to the same quarter of 2013), employment increased by 53 thousand which resulted in the labor force decreasing by 38,000. What is even more interesting is the fact that a large part of the drop in the labor force was due to a fall of the population over 15yr (-30,000). Obviously the fall in the unemployment rate becomes much less impressive if one looks only at employment while the (steady) fall in the 15+ population and the labor force are certainly not positive signs for the future.

Taking a closer look at the unemployed we see that the fall in that category was only due to people who were unemployed for less than a year while the long-term unemployed actually increased by another 10 thousand to reach close to 930,000 persons. These opposite movements are a worrying sign for the future since they might be indicators for the presence of hysteresis among the long-term unemployment. This will make reducing unemployment much more difficult (given that short-term unemployed are only 6% of the labor force with long-term unemployment reaching 19%).

Moving to employment we observe that the increase came almost entirely from part-time employment. If one also notices that under-employment was the major driver of employment (with under-employed now being close to 6.8% of employment) it is clear that employment growth is driven mainly by short-term, part-time unsecured jobs which probably pay very low salaries. The fall in the unemployment rate actually hides an increase in under-utilization of labor which finds it very hard to enter into full-time steady jobs while long-term unemployed seem to be left out of even these part-time employment opportunities.