Fix the Banks to Fix the Crisis

While conventional wisdom says that Europe is embroiled in a debt crisis, I keep pointing out that it is still a financial crisis. The problem is not government debt; it is the solvency of the banks. Fixing the crisis should start with fixing the banks.

Martin Wolf in the FT has a nice illustration of the problem. He shows a chart of the exposure of banks to debt of Greece, Ireland and Portugal. German banks holding such debt  could lose as much as 60% of their capital. France is a little better with exposure worth a bit more than 30%. Even British banks are as risk to around 20% of their capital. Add in Spain and the picture is much worse. German banks' exposure is almost 100% of their capital and French banks have risks up to 60%.

This explains why Eurozone governments are so keen to avoid a default. If soverign debt had to be writen down, bank losses would push them to the brink of bankruptcy, meaning new bail outs. If Greece defaulted on its debt, German banks would need to be rescued by German taxpayers, in effect turning Greek government debt into German government debt.

This also explains why there is now talk of "reprofiling" rather than "restructuring" Greek debt. Which means simply extending the payback period of loans rather than cutting the face value of debt.

The truth almost came out in yesterday's Today programme. A Greek economist explained that the difference is  one of accounting. Reprofiling means that the loan remains unchanged as an asset on a bank's balance sheet. Restructuring forces a bank to regonise the loss and so face up to its solvency problem. ( Adam Shaw jumped in before he could complete the point to press his own view that the language was just "politics".)

Of course, reprofiling doesn't make the banks any more solvent. It just delays the day of reckoning.

Does Government Debt Reduce Growth?

Kenneth Rogoff, a very respected economist, repeated in the FT his claim that there is a threshold for government debt above which growth begins to slow.

According to my recent research with Carmen Reinhart, debt-to-income ratios are already at, or near, postwar highs across advanced economies. Many are close to the roughly 90 per cent debt-to-income threshold which, historically, begins to be associated with lower growth.

This claim has been questioned by others who point out that the result does not come from the well researched book This Time Is Different, but from another short paper. Paul Krugman in his blog has made some good points challenging the research. (link added) In particular Krugman questions the direction of causality. Does low growth increase debt, not just becase of automatic stabilisers but also because the numerator in the debt ratio is lower?

I am also concerned at how the idea of a threshold is arrived at. The paper simply slices the data into four sets where the debt ratio is below 30%, 30%-60%, 60%-90% and above 90% and then compares median and mean growth rates. So the 90% "threshold" is manufactured by the methodology. It does not emerge from the data.

I don't have access to the dataset they used and so I decided to find an easy to assemble dataset which could be used to test for a threshold around 90% debt to GDP ratio. The main criterion would be a set of data including a number of countries and periods when government debt was high.

Looking into Eurostat I was able to find the data for the 15 countries which were already members of the EU in 1996 and looked at the numbers for general government gross debt and growth rates in each year between 1996 and 2007 inclusive. I thought it reasonable to cut off the data in 2007 which is both before the disruptions of the Great Recession, and also because the data is less likely to be revised in future.

This gave me 180 data points which I put on a scatter chart. Here is the result, click on the chart for a closer look:

I see no sign of a threshold at or near the 90% debt ratio. You might see a slight correlation between high debt and low growth, but there is not much. Trying a linear regression gives an R2  of 0.09 which is not significant and so I haven't added a trendline.

I don't know how to show the median lines using Excell, but I did calculate that the median growth rate in the dataset is 3.05%. Of the 34 data points which lie above the 90% debt ratio there are 15 above and 19 below this median. So this data does not support Reinhart and Rogoff's claim.

Of course other data sets should be used, say EU 27 plus Switzerland and the non EU Nordic countries, and over a longer period. I look forward to seeing the results of such research.

Feint Praise

Gavin Davies has a strange piece in today's FT; he rejects all George Osborne's argument for austerity but urges him to stick with Plan A.

Mr Osborne likes to claim (falsely) that Britain had a fiscal crisis or was on the brink of a crisis like Greece or Ireland and so his cuts were unavoidable.

Gavin owns up that this is nonsense:

Admittedly, the public debt ratio is lower than in other economies, and a large proportion of UK debt is funded on a long-term basis. There has also been no sign whatsoever of any funding problems in the gilts market.

So, this is austerity of choice not necessity:

The new government chose to reduce the risks of a sovereign debt crisis at the expense of taking somewhat greater risks with near term economic growth.

Mr Davies thinks that the rationale is wrong but the policy correct. He does argue that the deficits was high and that it could not go on at 11% of GDP for long. Who disagrees with that?

There is a but: stick with Plan A but if the economy dips be ready with Plan B and the bank needs to keep interest rates down.

It is absurd to argue that fiscal policy tightening of 2 per cent of GDP will not depress economic growth. Of course it will, and the Bank should be extremely wary of adding to this tightening by raising interest rates.

Could it be that the praise for George is just a feint?

Competitiveness Pitch

So the Franco-German plan for a "competitiveness pact" ran into opposition at the summit last week. The plan which is meant to cover the eurozone, includes ideas like harmonising corporate tax rates and pushing up retirement ages, which do not seem to me to have much to do with competitiveness.

Leaving aside the issue of how meaningful it is to focus on competitiveness. I thought to check whether there is any evidence that the Eurozone is failing in international competition.

The latest figures show a current accout deficit of 0.4% of GDP. Over the last 4 quarters the current account has varied between a surplus of 0.5% and a deficit of 0.9%. In other words the Eurozone is selling pretty well as much as it buys.

Countries Do Compete

Ireland for example has a low rate of corporation tax in order to attract firms to set up there. Countries and regions compete for inward investment.

Imagine a Japanese car company wanted to set up a new factory to produce luxury cars for the European market. It choice of location might come down to Belgium or Slovakia. Both countries would court the Japanese investor. One of them wins and X billion Yen are invested in the lucky nation.

That is not the end of the story. Net trade is equal to the difference between domestic savings and investment:
X-M = S-I
(exports minus imports = savings minus investment)

So all else being equal, the winning country would find its trade balance falling by X billion Yen. In other words the more successful a country is in attracting inward investment, the bigger its current account deficit gets.

That is one reason why the current account does not tell you whether a country is economically successful or not. There are many reasons why the current account might be in surplus or in deficit. Conversely, being competitive in export markets need not equate to economic success.

The idea for this post arose from a discussion I had while on my quest for enlightenment on the issue of competitiveness