A Picture Tells Another Story

This chart appeared in The Economist last week to show how strongly Germany has emerged from the recession.

It is clear that GDP growth in Germany has recovered ahead of the 5 other countries. Looking at the early part of the chart tells another story. In 2002 and 2003 Spain, Ireland and Greece were growing much faster than Germany, France and Italy. While Germany struggled to get growth up to 2%, the three peripheral states were touching as much as 6%.

Think about interest rates. Germany, France and Italy needed low rates to stimulate their economies. Ireland and Spain need higher rates to stop their rapid growth leading to inflation. In fact, inflation in Spain and Ireland was around 4% at the time and house price inflation even higher.

All six countries are in the Euro zone and so had the same interest rate - one more attunued to the needs of the three larger economies than the smaller ones.

Higher inflation, makes countries less "competitive". (Yes, I am still on my quest.) If costs have risen then the price of exports are higher and the price of imports lower; another meaning of the word competitivness.

So when this week's EU summit talks about the competitiveness of peripheral countries in the Euro zone, there is an explanation in terms of the problem of controling inflation when monetary policy is not available to help.

Currency Wars and Competitiveness

Today's papers are full of talk of currency wars. The US dollar has fallen. China is accused of holding down the value of the Yuan. Brazil is using taxes to limit flows of hot money pushing up the value of the Real.

Why?

It is all about competitiveness and so we enter another stage on my quest to understand what that means.

If countries can increase their competitiveness by lowering the value of the exchange rate then we are talking about increasing exports and reducing imports. There is a tendency to report countries with a trade surplus, or more broadly a current account surplus, as competitive.

The question is should a lower exchange rate be an aim of economic policy? Should we look to become more competitive by reducing the exchange rate?

The obvious objection is that everyone can not become more competitive at the same time. If everyone tried to devalue 5% then their exchange rates would stay the same.

Globally the sum of all exports equals the sum of all imports. Every trade has an importer and an exporter. Increasing exports in one country increases imports elsewhere. This is why competitive devaluation is often called a beggar-my-neighbour policy.

The danger is that this turns into protectionism, reducing global trade and the benefits which that brings. Which happens to be one of the reasons why Krugman, in the article I quoted before, calls competitiveness a dangerous obsession.

What is happening right now is that there is not enough demand and so countries try to add to demand through increasing net exports, which amounts to taking demand away from other countries. What the world really needs is an increase in demand overall.

Is Competitiveness Europe's Problem?

I have embarked upon a quest. I think this blog might be a good way of documenting my progress.

A few months ago, doing my day job, I read a very dull report on EU regional policy. Every page of this document talked of the importance of "competitiveness". The economy of the EU needs to be more competitive. Europe's member states need to be competitive. Europe's regions should be more ...
The word was repeated so often I began to wonder what it means.
I have some economics textbooks on my shelf so that is where I looked first. Competitiveness is not in the index of my macro textbook (Mankiw, 5th edition) nor of the micro (Estrin and Laidler), nor of  a couple of development economics textbooks, nor one on international political economy.
A bit more research turned up an article by Paul Krugman from 1994 where he lays into the new fashion for discussing economies in terms of competitiveness.

"So lets start telling the truth: competitiveness is a meaningless word when applied to national economies.And the obsession with competitiveness is both wrong and dangerous."

And yet, the word is found in nearly all policy documents I read on European economic policy. Sixteen years on, the obsession continues.
My quest then is to understand what national competitiveness is. Can it be measured? Is it dangerous, as Krugman says? Is Europe's economic problem a lack of competitiveness or is it a misguided search for the chimera of competitiveness?

Competitiveness for All

I saw a poster in Brussels recently with this slogan - Competitiveness, co-operation and cohesion for all regions.
I think the idea behind the slogan is that regions should be more successful in competition, not that they should be more aggressive in their attitude towards outdoing other regions.
Even that softer interpretation of the slogan makes little sense. Imagine a football league where every team was more successful in the competition. Would more goals be scored? No, the defence would also be more competitive.
Like all cliches, "competitiveness" has been drained of any meaning and so can be used inappropriately and illogically.

Don't Panic

The verdict on Sir Alan Budd's report is mostly gloomy.I can't help thinking that the report is actually quite optimistic.

The deficit falls faster on Sir Alan's calculations, as everyone has reported.

Growth is lower than the old Treasury forecast, but actually still very good. Sir Alan predicts that, after this year, growth will be above trend for the next four years.

There is some good news on public sector pensions too. Tucked away on page 59 of the report is a table on the impact on spending of an aging population. It shows that in 2009-10 public sector pensions cost 1.8% of GDP. That rises to 1.9% in 2019-20 and 2029-30, then falls back to 1.8% in 2039 and 1.7% in 2049-50. So the hysteria over public pensions is unnecessary.

The cover of the OBR report should have the words "Don't Panic" written in large friendly letters.

Spain on the Naughty Chair

Gavin Hewitt came over all censorious in his BBC blog last week:

To an extent Spain's problem is Europe's problem. For a decade many of the eurozone countries used the cover of the single currency to borrow and expand their welfare states. In fact they were living way beyond their means. Putting that right is not just a financial dilemma - it challenges what many Europeans see as their way of life.

You could forgive him for talking bollocks because
a) he is a European correspondent not an economist
b) he is just parroting the conventional wisdom.

What does it mean for a country to live beyond its means? I don't know, but did the Spanish government live beyond its means, did it borrow to expand its welfare state?

No, until the crisis struck Spain had a fiscal surplus not a deficit. Here are the figures from Eurostat for Spain's public balance (-ve means a deficit):

2001  -0.6
2002  -0.5
2003  -0.2
2004  -0.3
2005   1.0
2006   2.0
2007   1.9
2008  -4.1

In 2007, Spain's government debt was 36.2% of GDP compared with 64% in France, 65% in Germany and 66% in the eurozone as a whole. Unemployment had fallen to 8% from over 15% a decade earlier, which I suppose would make the welfare state somewhat more affordable.

Were those profligate Spaniards loading up on government handouts? Not if you look at the data instead of relying on uninformed prejudice.

What really happened in Spain is that it joined the Euro. The ECB's job is to set interest rates for the eurozone as a whole and in the naughties big eurozone economies like Germany needed low interest rates. Peripheral states like Spain and Ireland found themselves with monetary policy which was too loose. Their economies were running too hot with fast growth but rising inflation. In Spain, inflating property prices fed a construction boom. As part of the eurozone Spain could not adapt its policy to restrain the boom or choke off inflation.

When the downturn came, Spanish prices and wages had risen out of step with other eurozone economies. Higher costs put Spanish firms at a competitive disadvantage compared to other producers. So now we have a slump in which tax receipts fall and benefit claimants increase, which is why Spain now has a large government deficit.


The target here is not Gavin Hewitt, who is a competent and entertaining journalist, it is the conventional view that the Euro crisis has been brought on by feckless Mediterranean types shirking their responsibilities. Spain gives the lie to that popular narrative.

Hoodwinking

Is the UK about to star in a remake of Japan - the Lost Decade? That is the question behind a recent talk by Adam Posen, one of the team that sets interest rates at the Bank of England.

Professor Posen is an expert on the Japanese experience, so his views are worth hearing. He adds to the fun by peppering his talk with references to films by Japanese director Akira Kurosawa. Kurosawa's films, such as The Seven Samurai, have led to Hollywood remakes. Most recently one of my favourites, Rashomon was turned into a children's film, Hoodwinked (hence the frog).

After Japan's property bubble burst at the start of the 90s, the country fell into a deflationary trap. For the next decade its economy refused to recover. Could we be in for the same fate?

Prof Posen argues that Japan's continuing malaise was caused by policy mistakes. At several points the economy did pick up only to fall flat due to mistakes by policymakers. Economic growth did not flat-line; it saw-toothed. The key mistakes were withdrawing stimulus too soon and not forcing the banks to recognise bad loans and clean up their balance sheets. It was also too slow to try unconventional monetary policy once interest rates had reached zero.

In Britain and in Europe we have avoided that last mistake; but I worry about the other two. Have we done enough to fix the banks? Certainly across Europe more needs to be done - the Spanish Cajas and the German Lanesbanken need to face up to the loans they made which will never be repaid. Banks also need to take a realistic view of the sovereign debt they hold, and raise their capital accordingly. Will Greek bonds really be repaid at 100 centimes to the Euro?

On stimulus, I've already had my say - reduce the deficit over the medium term but not yet.

Deflation is too little understood concludes the good professor as he calls for more research. Inflation is a danger we know and can deal with, deflation is still mysterious. If we have to balance risk then risking inflation is the better choice.

1937 Again, Again

It is not just fiscal policy which is heading in the wrong direction, influential voices now want monetary policy to retreat from supporting the economy. The OECD wants the UK to start raising interest rates this year and to as much as 3.5% by the end of next year.
Why?
Interest rates are lifted to reduce inflation, so where does the OECD think inflation is going?

Inflation is high, but is projected to fall below the 2% target, once the temporary effects of the increase in the VAT rate wane, due to significant economic slack.

No inflation, but raise rates anyway, just in case? I think not.

Oh My Gawd, They Killed Recovery!

Not yet, perhaps but 2010 is beginning to look like 1937.

In 1937, Roosevelt cut government spending in the belief that the Great Depression was over. The result was a new recession and the Depression went on.

This week, Italy has announced cuts of €24 billion targeting pensions, public sector wages and recruitment. Spain is cutting €15 billion with public sector pay again in the firing line. Portugal announced its austerity measures back in March. Even Germany is preparing cuts - apparently to set an example for the others.

One difference between Europe today and the US in 1937 is that the Fed tightened monetary policy while European interest rates are unchanged. That is a little deceptive since interest rates are at their lower bound. It is difficult to loosen monetary policy when interest rates are almost at zero, otherwise monetary policy would be looser.

Back in January, Paul Krugman was warning of the danger that the US might replay 1937.

A Bigger Cut

On Monday the government took bold action to cut the deficit by annoucing £6.2 billion of cuts to public expenditure in this financial year. 


The previous Friday, The Office of National Statistics cut the deficit by £7.4 billion.

The Office for National Statistics (ONS) has revised down the amount borrowed by the government last year from £163.4bn to £156bn.

Euro-Brady Bonds

There is one aspect I don't get about the €110 billion Greek bailout (which is big enough to save Greece the bother of going to the bond market for a few years).

Why have the Eurozone countries agreed to lend money to Greece before it defaults? Would it not be better to have the default (or rescheduling if you prefer) first and then offer guarantees for new borrowing?

That would work a bit like the Brady bonds issued following the Latin American defaults in the 80s. The US guaranteed the Bradies which were backed by debtor country assets and IMF receipts.

See Wikipedia for more on Bradies.

Agency Capitalism

When Karl Marx defined capitalism he meant an economic and a social system in which power rested with the owners of capital. In today's capitalism the owners have been usurped by a new class of executives.
The idea that a firm might be run for the benefit of its managers rather than the owners is not new. Economist refer to this as the "agency problem". In theory, the shareholders own the firm and appoint a board of directors to ensure that the firm is run well and profitably. Yet over time the professionals running the company manage to divert the company's resources to their own benefit - a more comfortable office, a car and driver, a company plane, a bigger salary, a performance bonus and share options.

My contention is that the agency problem has grown to such a stage that it now defines the nature of the economy. The outlandish levels of remunerations which bankers and executives in the financial sector award themselves is only the most blatant example of the new agency capitalism. In some cases, as much as half a firm's net earnings are paid out as bonuses. The obvious questions are: how has this happened and what is the alternative?

In the 19th century the owners of capital were largely wealthy individuals. They could take an interest in the firms in which they invested to ensure that they continued to develop and grow and provide a good return. Now individual shareholders are a small part (10%) of the stock exchange. In 2008, 42% of shares in the London stock market were held overseas. Of the remainder 40% are owned by financial institutions - insurance companies, pension funds, mutual funds etc. (Details here) So two-thirds of UK shares held in the UK are owned, not by top hatted capitalists, but by us - people who pay into occupational pension funds, private pension funds, insurance policies and ISAs.

Strictly speaking they are owned by the insurance companies, pension funds and other institutions; but it is our money they are investing ultimately for our benefit.

With 42% of shares owned overseas and 40% owned by institutions, the company owners are no check on the executives running the companies. It is no wonder bankers can get away with daylight robbery.

The problem is compounded by the idea that a company's purpose is to provide "shareholder value"; an idea which has reduced the shareholder's interest to whether the share price is going up.

What is the alternative? I believe that there is an alternative to agency capitalism. More on that another day.

Another Euro Crisis

We may all breath easier. The crisis is over. In Brussels yesterday the leaders of the 27 agreed to save Greece from the jaws of the bond market.

On the other hand the real Euro crisis is only just beginning. Germany has signalled its price for the Greek rescue: the EU must be able to expel errant members from the Eurozone. A way is sought to revoke the irrevocable union.

A new treaty will be needed and there is little appetite for that in European capitals. Still, Ms Merkel is pushing for it and the compromise language in the summit conclusions opens the door to treaty revision.

The root of the next euro crisis lies in the change made to the German constitution last year which requires a balanced budget. While Greece and Spain and Portugal are pushed to deflate their way to German levels of competitiveness, Germany will be deflating its way to a budget balance. That is why Germany wants to make an emergency exit available.

Until now we expected the borders of the Eurozone to extend to the east. It seems more likely that the southern border will retreat northwards.

Ruskin's Critique of Capitalism

An interesting article in today's FT quotes John Ruskin on the idea that the role of a business is the provision of goods:

“it is no more [the merchant’s] function to get profit for himself out of that provision than it is a clergyman’s function to get his stipend.”

It expresses something I have been trying to say. The purpose of a business is to provide a product or a service; "to provide for the nation" in Ruskin's words. The dominant idea of our time is that the purpose of a business is to generate shareholder value. The job of an executive in any business, whether it makes software or cleans offices or whatever, is to maximise the profit returned to shareholders.

John Kay, says something along these lines in The Truth About Markets. He claims that the idea that profit is the objective and business the means is wrong; doing business is the objective and profit the motive. (I'll check the quote when I get a chance).

This is on my mind because I'm wondering about what happens when the owners of firms no longer have control of them and the only measure of a firm's behaviour is its return on equity. I'll write more on this soon.

Obama Crosses the Line

A clear dividing line: some want to reform banking regulation, others want to reform the banks.

Yesterday the US administration crossed from regulatory tinkering to real reform. In Britain it is Mervyn King and Lord Turner, rather than the government, who want banks tamed.

The "Volcker rule" means that banks which take deposits will not be allowed into the Casino - an excellent first step.

Some institutions will try to escape by giving up their status as banks. Goldman Sachs and Morgan Stanley only became bank holding companies during the crisis. It is not politically possible for them to escape government rules. Obama's goal is to cut back financial firms to a scale where they can not threaten the stability of the system. He will need some version of the quack principle- if it quacks like a duck it is a duck.

I would like to see more. The authorities - possibly the Fed - should have powers to limit leverage (that is the total amount financial firms borrow) and certain types of derivatives should be banned.

Much of the commentary will be on the politics. Is this Obama's response to the defeat in Massachusetts? I think not; look at the cover of last week's Economist when it called for Obama to come out fighting. The FT had something similar this week.

Will Britain follow suit? I think so; fear of the City of London losing out to other financial centres has held the government back. Britain can adopt the same rules as apply in New York and push them through the EU so that they apply equally in Frankfurt.

Economics or B*ll*cks?

The pound has risen to a four-month high against the euro, after higher than expected UK inflation raised the prospect of interest rate rises, says the BBC.

Is that economics or is it bollocks?

Yes you are right. In economics higher inflation pushes a currency down not up. I previously told a little story to explain why that is. So why is the BBC talking bollocks?

Well inflation figures were higher yesterday and the pound did rise against the euro so perhaps lazy journalism put the two together. Coincidence doesn't mean one thing caused the other. In fact the euro fell against the dollar as well, so maybe the pound's rise has more to do with the economic news from euroland where Greece seems to be struggling at present.

Perhaps currency traders do care more about interest rates than economic fundamentals and so they did push up the pound as the story says. It is possible; day-to-day market movements are not explicable by economists. On the other hand, the rise in inflation is a blip caused by unusually low prices a year ago. The bank is not about to raise interest rates. Surely, even currency traders can work that out.

Update 20h00

Now the BBC says:
Euro falls against dollar and pound
The euro has hit a five-month low against the dollar as continuing concerns about the Greek economy weigh heavily on the currency.

That is a little more plausible. Incidentaly the latest inflation figures for euroland are up....