The Great Debate UK

Germany should be happy to let Greece go

When the Greek crisis began, there was much talk of contagion as the greatest short-term risk. In my view, this worry is almost irrelevant because bondholders are in any case facing a haircut of over 70%, so the question of default or bailout is now merely a technical detail.

From a longer term perspective, there is also little reason for the Germans to panic over a Greek default, even if it ultimately leads to the disintegration of the euro zone. The line peddled by a number of commentators and politicians that Germany has “done very well out of the euro zone” begs the question of how well it would have done without the euro zone, a question to which I do not know the answer – but nor does anyone else.

The implicit or explicit claim is that, with floating exchange rates, German trade would have suffered as the DM appreciated against the currencies of its neighbours. This is nonsense, a case of how, in the world of popular economics – what one colleague famously called D-I-Y economics – exchange rates occupy a position of exaggerated importance (If those who study the subject were given the same importance, I’d have had a peerage by now).

If exchange rate appreciation were so damaging and depreciation so beneficial to a country’s trade, the Swiss would by now be the poorest country in Europe and the Italians the richest. The reality is that, while there may be short term dislocations, the effect of changes in the value of a currency are ephemeral. Devaluations are self-defeating because they push up costs until the country’s terms of trade are back where they started, and the opposite for appreciations: a rise in the value of a country’s currency makes its imports cheaper, reducing its inflation rate and restoring its competitiveness as time passes. The process of adjustment seems to take some six or seven years, which might seem a window of opportunity worth seizing for opportunistic devaluation. The fly in the ointment, however, is that the more rapidly a currency depreciates, the more agents in the economy wise up and start anticipating the next depreciation, speeding up the adjustment and thereby narrowing the window of opportunity for exporters.

In other words, exchange rate flexibility smoothes the road, but does nothing whatever to change the destination. Moreover, the effect of exchange rate changes is smallest for countries with the most efficient labour markets, which includes Germany ever since its reforms of ten years ago, so there is every reason to suppose that it would adjust quickly anyway, just as it did in the 1970’s and 1980’s when the DM rose in value almost continually without seriously damaging the country’s competitiveness.

As far as Greece is concerned, making it competitive inside the euro zone will require a so-called internal devaluation – mainly a reduction in wages – whereas outside the euro zone a relaunched drachma could be allowed to float downward. The only difference is that in the former case, Greek workers will have to get by on fewer Euros than they have been used to, whereas outside the euro zone they would be paid in devalued drachmas, which would mean a cut in their living standards of the same order of size (is there such a thing as a Hobson’s Choice between Scylla and Charybdis?).

For Germany (and for the rest of Europe, including Britain), the real danger is that euro zone disintegration might be followed by the collapse of the single market, the only truly valuable component of the EU edifice. As a nation very reliant on its external trade, Germany needs market access – no reasonable person wants to go back to a world of protectionism, quotas and  non-tariff  barriers to trade, but it is an ever-present threat as populist politics take hold in Europe. But even then, the German carmakers have demonstrated in the last couple of years how capable they are of compensating for sales lost in Europe by higher volume in the emerging markets of Asia and Latin America, and there is every reason to suppose that the formidable German capital goods sector will prove just as adaptable.

Hungary: The Greece of Eastern Europe

By Kathleen Brooks. The opinions expressed are her own.

It used to be Greece that was the canary in the coal mine, these days it’s Hungary. The new year got off to a bad start for the Eastern European nation after it experienced a failed bond auction, causing its bond yields to surge.

This caused major jitters across global financial markets and once again a small, relatively unknown economy is dominating the headlines and causing a massive headache for the European authorities.

But while there are many similarities, the reasons for the panic in Hungary’s debt markets are different from Greece’s problems. Athens borrowed too much and public spending spiralled out of control. However, Hungary’s problems were not based on the size of its budget deficit, which was a fairly manageable 4.2 percent of GDP at the end of 2010, but the amount of debt in its public and private sector that was denominated in foreign-currency.

While the post-Communist era in Hungary helped to modernise the state, its capital markets did not keep up to date. Borrowing costs were lower in the euro zone and other parts of Europe where banks were willing to lend relatively cheaply across the Eastern European bloc, especially to Hungary. While the Hungarian forint was strong it was fine to have liabilities in euro and Swiss franc, however, since the start of 2011 the forint has deteriorated at a rapid pace. Since August alone the forint has lost more than 17 percent of its value against the euro.

Here is the problem: when your liabilities are in euro but you earn forint, all of a sudden servicing your debts becomes much more expensive and bad debts start to rise.

That’s where the similarities with Greece start. If bad debts start to rise then Austria and Italy could be on the hook. Austrian banks hold a whopping $40 billion of Hungarian liabilities, while Italian banks have a slightly more manageable $20 billion.

Is there such a thing as a real safe haven?

By Kathleen Brooks. The opinions expressed are her own.

There are traditional relationships that the financial markets respect. For example, when the markets are tanking the world wants to own safe havens like the yen, the Swiss franc, U.S. debt and gold. If volatility spikes investors go into auto-mode and are almost pre-programmed to purchase these asset classes.

But just how safe are the safe havens? Both the Japanese and Swiss authorities intervened to limit the appreciation of their currencies in recent days. The Swiss National Bank (SNB) did so first by slashing interest rates and announcing a new QE program to flood the economy with money to try and put downward pressure on the franc. The Bank of Japan (BOJ) embarked on something similar, but they directly intervened and sold yen in the markets.

While some people will question the timing of the move, there can be no doubt that the Japanese and Swiss authorities don’t appreciate having currencies that are safe havens and will do all they can to try and break this association. The result has been volatility. The euro had rallied to record lows versus the Swiss franc before bouncing on news about the SNB. But once the dust settled investors went right back to doing what they have been told: buy yen and Swiss francs during market turbulence.

The essence of a safe haven should be stability. It needs to act in a predictable way during times of panic. However, the SNB and BOJ have turned this on its head. They are willing to fight the prevailing trend even if it means throwing good money after bad. But although the Swiss franc and the yen are both likely to keep their status for now, political risk for both currencies has surged higher.

So what about gold? It is considered the ultimate safe haven by some since it is not controlled by any government or central bank so there is no intervention risk. While that is technically true there are a couple of reasons why gold may not be as safe as everyone thinks it is. Firstly, it is traded on an exchange and that comes with its own set of risks. Margin calls can change if prices fall by a certain amount, also, as we saw last week, some investors are forced to sell gold and other “safe” assets to cover margin calls elsewhere, which means the price may not always react as you expect it to.

The ultimate safe haven is U.S. debt. The markets may be panicking about high levels of U.S. debt but they buy more of it. This argument is totally illogical but it is true. The reason why is that the U.S. debt market is the most liquid in the world. When investors get nervous they want something they can sell out of in an instant. Emerging markets may have stable debt levels; however their capital markets are far less developed than Treasuries. If you want to sell in a hurry you might find that there are no willing buyers and you are forced to hold on to it. This is what investors’ fear, so they flock to American markets not because they believe the U.S. debt problem is any better now than it was when the debt ceiling debate nearly caused a default, but because of its liquidity.

Why we have to support Ireland

– Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own. –

Supporting Ireland to the tune of a few billion quid must look like a no-brainer to the British Government. We should not make the same mistake as the Germans, who managed to get the worst of both worlds over Greece – forced by the scale of their bank exposure to support Greece, but providing the money with ill will, causing bitterness rather than gratitude – and now repeating the error in the Irish case.

Our wonderful British banks are more exposed than those of any euro zone member to the Irish debacle, with, at the front of the queue, the usual suspects: RBS and Lloyds-HBOS, the two big nationalised banks. So the answer to those who ask why we are contributing to the rescue package is that it is nothing more than the latest (and probably not the last) instalment of the cost of the bank bailout.

This is something to remember next time you hear one of the banking sector’s apologists crowing about how little the bailout is actually costing and how great a killing we taxpayers are ultimately going to make on our bank shares – and don’t forget to add in the cost borne by us all as bank customers, with the gap between borrowing and lending rates at their highest level in history.

There are of course other economic reasons for supporting Ireland. As we have been repeatedly reminded in recent days, Ireland is a major market for UK exports, three times as important as China and five times as important as India, so we stand to benefit considerably from a revival in its economy.

But economics is by no means the whole of this story. I have no idea what the Great British Public thinks about the support, though I suspect that, given the deep-rooted links between UK and Ireland, it is moderately sympathetic. But whatever the mood, it does no harm at all in terms of the battle for hearts and minds in Britain to see our PM playing the benefactor to a stricken neighbour, serving at one and the same time to exaggerate the difference between us and Ireland (which, as I have argued in previous blogs, is smaller than most people realise) while simultaneously warning that we ourselves would have been the ones holding out the begging bowl, if the overwhelming majority of the chattering classes, including my professional colleagues, had been able to drag us into the euro zone.

What happens next? Portugal, if it has to be taken into intensive care too, is small enough to be manageable. The nightmare is Spain, which is far too big for anything like the same treatment, or even Italy, which is not far behind and, just to make matters worse, could be facing a period of political instability over the next few months.

When is it the Fed’s cue to leave?

The Federal Reserve’s second round of quantitative easing to the tune of $600bn put a firework under a trend that started back in August when Fed Governor Ben Bernanke first touted the idea of providing more monetary policy support to the US economy. Risky assets are in demand and the market is happy to sell dollars.

After digesting the Fed’s statement released after its meeting, investors aren’t willing to stand in the Fed’s way as it keeps its hand on the monetary policy trigger: “The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.”

But should investors worry that this euphoria in asset markets will end in tears? It was, after all, William McChesney Martin Jr., the longest-serving Fed President, who said that the job of the Federal Reserve is “to take away the punch bowl just as the party gets going”. The question is, what will Ben Bernanke do with his punchbowl? This is even more in focus after a strong October payroll report.

There are a number of risks with QE2 that investors should bear in mind while they are riding the wave of Fed liquidity. Firstly, inflation. Monetary stimulus has pushed down the value of the dollar, which pushes up the price of commodities. This causes inflationary pressure to build at the start of the pipeline, which will eventually feed into consumer prices. Once inflation looks like it could exceed the Fed’s threshold (around 2 percent) it will trigger tightening by the central bank. This is when a reversal will occur in the financial markets and bond yields rise as the price of Treasuries start to tumble.

But Ben Bernanke, writing an opinion piece for the Washington Post s, argued that QE1 (at the peak of the financial crisis) didn’t cause price increases to accelerate. But QE1 was to avoid a liquidity crunch and ensure the smooth running of the financial markets. This time, financial markets aren’t in distress and the economy is growing, albeit below the rate the Fed deems acceptable. In the same piece, Bernanke said the Fed is confident that it will have the tools to unwind these policies at the appropriate time. However, he also mentioned that asset purchases are relatively “unfamiliar as a tool of monetary policy”.

The truth is that the Fed doesn’t know what its exit policy will look like since it has pledged to re-invest the proceeds of assets purchased under QE1, rather than sell them back to the market. When it finally decides the time is right, the Fed’s exit programme will need to be handled with extreme care. It has already had to relax System Open Market Account (Soma) limits, which restricts it from buying more than 35 percent of any single issue in US Treasuries. QE2 heralds the Fed as a huge force in the US Treasury market, and the prospect of price distortions are great. But the Fed will want to leave the market with as little fuss as possible so as not to cause a huge spike in bond yields. To do this it needs to ensure the timing is perfect, which may end up delaying the Fed’s eventual exit.

Lastly, it’s worth remembering that it may not be the Fed who ultimately decides the timing of its asset sales. A year ago US authorities were called to explain to China, one of the largest holders of Treasuries, how it would manage its exit strategy from QE1 and deflect any criticism that it was trying to monetize its massive debt. So far the Chinese seem more concerned that QE2 will stoke asset price bubbles in its economy, but concerns about 1, the Fed monetizing the gigantic US debt, and 2, a sharp rise in inflation eroding the value of their Treasury holdings must be keeping some officials in Beijing awake at night.

from The Great Debate:

U.S., China and eating soup with a fork

-The opinions expressed are the author's own-

Are economists the world over using an outdated tool to measure economic progress?

The question, long debated, is worth pondering again at a time when two economic giants, the United States and China, are sparring over trade, currency exchange rates and their roles in the global economy.

In the run-up to U.S. mid-term elections on November 2, politicians from both parties, for different reasons, blamed trade with China for American job losses. China responded with irritation and hit back by accusing the U.S. of "out of control" printing of dollars tantamount to an attack on China with imported inflation.

Measured by Gross Domestic Product (GDP), the United States tops the list of countries. China overtook Japan in August to become number two. Depending on whose forecasts you believe, China will overtake the United States in 2020, 2035 or 2040 and therefore turn the 21st century into the long-predicted Chinese Century. It's becoming conventional wisdom that the United States will play a reduced role on the world stage.

Crystal ball gazers might do well to remember that long-range forecasts have often been wrong in the past. At the turn of the 20th century, eminent strategists predicted that Argentina would be a world power within 20 years. In the late 1980s, Japan was seen as the next economic leader, on the strength of supposedly unstoppable progress. Forecasters extrapolated from past GDP growth rates.

They are widely used to compare standards of living in one country with those in another but critics say GDP is too narrow to be a realistic indicator. Joseph Stiglitz, the Nobel-prize winning American economist, has complained that world leaders make a fetish out of it and suffer from GDP-obsession.

Why the world needs a weaker dollar

Kathleen Brooks is research director at forex.com. The opinions expressed are her own.

Ever since the last Federal Reserve meeting when the prospect of further policy stimulus for the US gripped the market, dollar weakness has been the dominant theme in FX. The Fed action is considered in some quarters as a backdoor form of currency devaluation, and there has been talk of a global “currency war” as a result.

But is a weak dollar really that bad for the global economy? Those countries who argue yes tend to concentrate on self-preservation since a weak dollar makes higher yielding economies’ exports less competitive. Since everyone wants to be able to sell to the US – the biggest single consumer market in the world – when the dollar moves in any significant direction the world takes notice.

Already Brazil and South Korea, whose currencies have risen strongly this year, have embarked on capital constraints to try and dissuade “hot money flows”, amid fears that a strong currency will derail economic growth. Chinese premier Wen Jiabao even went so far to say that a rapid strengthening of the renminbi against the dollar would be a “disaster for the world.”

Is it really as dramatic as the Chinese premier seems to think? There is a strong case for a weaker dollar and it all has to do with the spectre of deflation that hangs over the developed world. The current average inflation rate amongst the G10 economies is on the low side at 1.5 per cent. If you strip out Australia and the UK – both economies with high levels of inflation- the rate drops to a meagre 1.2 per cent. Combined with a weak growth outlook, especially for western economies facing fiscal austerity, this keeps the threat of deflation alive and well.

The problem with deflation is that most economies are unprepared for it. It can depress demand as consumers delay purchasing in the hope of lower prices in the future, this, in turn, causes unemployment. It also depresses asset values, which weighs on investor confidence creating a negative spiral of low or anaemic growth that can last for a long time (read Japan’s lost decade).

A weaker dollar is a crude cure for deflation. Since commodity prices from food stuffs to oil and industrial metals are all priced in dollars, a weak greenback means commodity prices go higher. This puts upward pressure on inflation and, more importantly, it helps keep consumers’ price expectations in positive territory, which avoids the negative growth spiral I mentioned before. It should also eventually lead to higher stock prices, which boosts investor confidence.

What is the extent of Ireland’s crisis?

- Kathleen Brooks is research director at forex.com. The opinions expressed are her own. -

The euro’s resilience in the third quarter has been astonishing. Since reaching a low against the dollar in June, the single currency has appreciated by an impressive 14 percent. This has coincided with the Irish financial crisis reaching boiling point, culminating in the announcement on Thursday by the Irish authorities of the final bill for winding down Anglo Irish Bank.

The euro didn’t flinch, even though the sums are enormous. The Irish government estimates that it will cost 29.3 billion euros to rescue Anglo. And it doesn’t stop there. Allied Irish Bank requires more capital as does building society Irish Nationwide, which may bring the total bill for rescuing the financial sector to 50 billion euros, pushing the debt-to-GDP ratio up to 32 percent. The Irish government doesn’t even anticipate making a return on any of this money. Ireland has so far funded itself on the open market and has not had to follow Greece to the European Financial Stability Facility (EFSF). But the final bill will fall on the Irish taxpayer.

Tax receipts for 2010 are expected to be 31 billion euros, according to a forecast from the Department of Finance. That is less than the final cost of winding up Anglo. With growth weak and the possibility of another recession on the horizon, it wouldn’t take much for the markets to force Ireland to the EFSF like they did to Greece.

Is there a way out for Ireland?

Ireland does have one of the lowest tax takes in the European Union at less than 30 percent of GDP. It also has one of the lowest corporation tax rates in the world at 12.5 percent, compared with Germany where federal and national corporate taxes equate to company tax rates of more than 30 percent. So Ireland could boost tax take to help remedy its huge deficit, but at the expense of losing its reputation as a low-tax destination for global corporations.

What does it mean for the euro?

A history lesson for lenders

-Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own.-

Anyone looking for a broader perspective on the events of the last three years could hardly do better than choose for bedtime reading “This Time is Different” by Carmen Reinhart and Kenneth Rogoff.

It is nothing less than a history of financial crises through the ages, starting in late medieval England and continuing via 15th and 16th century Spain and its New World colonies on to the teething problems of Britain’s banks in the industrial revolution and the upheavals of the 20th century, ending in 2008 with the bankruptcy of Lehman Brothers.

The emphasis throughout is on sovereign default. For many politicians, bankers and economists, it ought to read not just as a lesson, but as a severe rebuke, because its basic message is that there is nothing new under the sun and that financial history reads like a long catalogue of facts we have chosen to forget.

So, as the authors show, no country’s history is free of bank collapses, sovereign defaults and currency debasement in one form or another.

Many countries have been serial defaulters, and – surprise, surprise! – the recidivists include some of today’s shakiest sovereigns, notably Greece (which went bust several times in the first decade or two after it gained its independence in 1821, and has never in its history merited a good credit rating) and Spain, which after many defaults in the pre-industrial era seemed until relatively recently to have reformed.

UK election boils down to one issue for markets

- Jane Foley is research director at Forex.com. The opinions expressed are her own. -

Whether the financial markets will view the outcome of the UK general election as a positive or negative depends almost entirely on one issue: the budget deficit.

According to The Economist, the UK’s budget deficit will balloon to 13.5 percent of GDP in 2010. To give this some perspective, The Economist estimates that the Greek deficit will be a somewhat more moderate 9.5 percent of GDP this year.

Fuelled by recession, last year’s UK government borrowing was the largest ever in peace time.  The deterioration in the budget caused S&P to warn last May that the UK’s debt rating outlook has been revised to negative from stable.

The prospect of a sovereign downgrade would seriously increase the likelihood the UK would suffer a funding crisis.

In other words a lower debt rating would reduce investor interest in UK debt auctions and send yields higher and demand for sterling lower.  In turn higher yields would increase the cost of issuing bonds and divert more taxpayer money into servicing the debt and away from public services.

While there is probably no imminent risk of a credit rating downgrade in the UK, it is clear that budget reform is necessary to kick this threat into touch.