Brad Setser

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Cross border flows, with a bit of macroeconomics

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Do Not Count (European) Fiscal Chickens Before They Hatch

by Brad Setser

The Wall Street Journal, building on a point made by Peterson’s Jacob Kirkegaard, seems convinced that the policy mood has shifted, and Europe is now poised to use fiscal policy to support its recovery.

I, of course, would welcome such a shift. The eurozone runs an external surplus, is operating below potential (in large part because of a premature turn to austerity in 2010 that led to a double-dip recession) and in aggregate has ample fiscal space.

And the public policy case for such a fiscal turn keeps getting stonger. Jan in ‘t Veld’s new paper (hat tip Paul Hannon of the WSJ) suggests that a sustained fiscal expansion in Germany and the Netherlands could have a substantial impact on the rest of the eurozone. A sustained 1 percent of GDP increase in public investment in Germany and the Netherlands helps raise output and lower debt in their eurozone partners.* in ‘t Veld writes:

“Spillovers to the rest of the eurozone are significant … GDP in the rest of the eurozone is around 0.5% higher.”

But it seems a bit too early to break out the champagne.

Actual 2017 fiscal policy has not been set in the key countries, but it is not clear to me that the sum of the fiscal decisions of the main eurozone countries will result in a significant fiscal expansion across the eurozone. Indeed, I cannot even rule out a small net consolidation.

Germany has put forward its 2017 budget. Schauble’s rhetoric has changed a bit. But Citibank estimates that it only would reduce Germany’s structural fiscal surplus by about 0.1 percent of GDP (10 basis points of GDP). It is a step in right direction, but only a baby step. Real loosening doesn’t seem on the cards before 2018.

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There Really Is No Reason for Germany Not to Do a Fiscal Stimulus Right Now

by Brad Setser

Back in May, Greg Ip of the Wall Street Journal argued that Germany didn’t need to stimulate its economy through an increase in public investment as its economy was already growing at a decent clip, and unemployment was low.

I wasn’t convinced then, and I am still not convinced.

A stimulus is needed to reorient Germany’s economy away from exports, to keep private wage growth up and to open up space for Germany’s trade partners in the euro area to adjust without falling into a deflationary trap. Adjustment doesn’t happen magically.

There is solid evidence that Germany’s level of public investment is a bit too low for its long-term health.

And now there is also a growing cyclical case for a German stimulus. German growth is projected to slow significantly in 2017. Reuters reports:

“DIW … lowered its 2017 growth forecast for Germany to 1.0 percent from 1.4 percent.”

Other forecasts are a bit more optimistic, but all expect some slowdown in growth.

And the 2016 surplus is on track to top a percentage point of German GDP. In nominal terms, the surplus should exceed last years’s €30 billion surplus. Germany is clearly not fiscally constrained.

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Imbalances Are Back, In Asia and Globally

by Brad Setser

The Economist, inspired in part by a recent paper by Caballero, Farhi and Gourinchas, highlighted two key points in its free exchange column criticizing Germany’s surplus:

a) Global imbalances have reemerged over the last few years (though this is more obvious from summing the surpluses of surplus countries than from summing the deficits of deficit countries): “… a sustained era of balanced growth failed to emerge [after the global crisis]. Instead, surpluses in China and Japan rebounded. In recent years Europe has followed, thanks to a big switch from borrowing to saving.”
b) Those imbalances are a big reason why interest rates globally are low: “Once a few economies become stuck in the zero-rate trap, their current-account surpluses exert a pull which threatens to drag in everyone else.”

I have only one small quibble. The rise in Asia’s surplus didn’t just come immediately after the crisis. There was also a significant rise in Asia’s surplus from 2013 to 2015.

Indeed, in 2015, East Asia’s combined surplus actually significantly exceeded that of Europe, adding to the world’s difficulty generating enough demand growth even with ultra-low rates.*

CA Europe and Asia

Yes, some of this is oil. But the oil exporters in aggregate aren’t running large external deficits financed by their high saving customers (Russia is in surplus; the Saudis are more an exception than the rule). The IMF puts the aggregate deficit of the main oil exporting regions of the world economy (the Middle East, North Africa, Russia and Central Asia) at $50-100 billion, substantially less than the combined surplus of Europe and Asia. So it isn’t all oil either.

China’s unloved, credit-based stimulus, together with the large reported increase in tourism spending (whether real or fake), looks set to pull China’s surplus down a bit in 2016. But China will retain a surplus of over $200 billion in 2016, and ongoing surpluses in Korea, Taiwan, Singapore and Japan will keep Asia’s aggregate surplus high. I would bet East Asia’s aggregate 2016 surplus will still exceed that of Europe.

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Germany is Running a Fiscal Surplus in 2016 After All

by Brad Setser

It turns out Germany has fiscal space even by German standards!

Germany’s federal government posted a 1.2 percent of GDP fiscal surplus in the first half of 2016. The IMF was forecasting a federal surplus of 0.3 percent (and a general government deficit of 0.1 percent of GDP—see table 2, p. 41); the Germans over-performed.*

Germany’s ongoing fiscal surplus contributes to Germany’s massive current account surplus, and the large and growing external surplus of the eurozone (the eurozone’s surplus reached €350 billion in the last four quarters of data, which now includes q2). The external surplus effectively exports Europe’s demand shortfall to the rest of the world, and puts downward pressure on global interest rates. Cue my usual links to papers warning about the risk of exporting secular stagnation.


Martin Sandbu of the Financial Times puts it well.

“The government’s surplus adds to the larger private sector surplus which means the nation as a whole consumes much less than it produces, sending the excess abroad in return for increasing financial claims on the rest of the world. German policymakers like to say that the country’s enormous trade surplus is a result of economic fundamentals, not policy—but as far as the budget goes, that claim is untenable. Even if much of the external surplus were beyond the ability of policy to influence, that would be a case to use the government budget to counteract it, not reinforce it.”

The Germans tend to see it differently. Rather than viewing budget surpluses as a beggar-thy-neighbor restraint on demand, they believe their fiscal prudence sets a good example for their neighbors.

But its neighbors need German demand for their goods and services far more than they need Germany to set an example of fiscal prudence. It is clear—given the risk of a debt-deflation trap in Germany’s eurozone partners—that successful adjustment in the eurozone can only come if German prices and wages rise faster than prices and wages in the rest of the eurozone. The alternative mechanism of adjustment—falling wages and prices in the rest of the eurozone—won’t work.

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Why Is The IMF Pushing Fiscal Consolidation in the Eurozone in 2017?

by Brad Setser

The eurozone collectively has a substantial external surplus, and its economy is operating below potential. In the framework set out in the IMF’s external balance assessment, that pretty clearly calls for fiscal expansion:

“Surplus countries that have domestic slack need to rely more on fiscal policy easing, which would address both their output gaps and their external gaps… Meanwhile, deficit countries should actively use monetary policy, where available, to close both internal and external gaps.”

But is the IMF following its own advice (for a currency union that has an external surplus and domestic slack, I am well aware of the fact that the eurozone is not a single country with a single fiscal policy) and actually recommending a fiscal expansion in the eurozone?

Best I can tell, no. Not for 2017.

The IMF of course is for more fiscal stimulus at the European level. But that is a hope, not a reality. The capacity for a common eurozone fiscal policy conducted through borrowing by the center doesn’t currently exist, and it realistically isn’t going to materialize next year.

That means the eurozone’s aggregate fiscal impulse is the sum of the fiscal impulses of each of its main economies. What does the IMF recommend there?

In Italy the IMF seems to want about a half a point of structural fiscal consolidation (see paragraph 35 of the staff report).

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Italian Banks, Pre-Stress Test

by Brad Setser

From afar, it seems like the wheels of European policy may be moving towards some kind of near-term fix for either Italy’s banks—or, more likely, for the specific problems of Monte dei Paschi di Siena.

The risk here is obvious. The intersection of Italian politics and European rules is pushing for the most narrow of solutions, one that will not recapitalize the broader Italian banking system. At least not quickly.

The recapitalization need even under pessimistic assumptions is actually fairly modest, as such things go. Less than Spain spent on the two rounds of recapitalization that were required to solve Spain’s banking crisis. Maybe less than the €30 billion Germany injected into Commerzbank and a few others in 2009, or the massive “bad” bank it set up for Hypo Real Estate (Hypo Real Estate was not retail funded, and even now, it seems like it has some performing subordinated debt—who knew). Probably less, relative to the size of Italy’s economy, than the €22 billion that the Dutch put into ABN-Amro.

But Italy’s government clearly doesn’t want to bail-in the heavily retail holders of Italian subordinated debt. Monte alone has about €5 billion in subordinated debt, and over 60 percent of that seems to be held by retail investors. A smaller subordinated debt bail-in late last year was politically controversial.

And Europe wants Italy to respect the banking and competition rules, which have been interpreted to require some form of subordinated debt bail-in. There are ways around the ”banking union” Bank Recovery and Resolution Directive (BRRD) bail-in requirement (8 percent of liabilities, a sum that implies a substantial write down of the subordinated debt). Europe’s rules already include an exemption for a precautionary recapitalization to address difficulties identified in a stress test. Getting around the state aid requirements seems harder, though perhaps not impossible if some of the flexibility used in the global financial crisis remains.*

The easiest way to protect the retail investors in the subordinated debt and to avoid violating any European rules, obviously, is for the banks to continue to carry the bad loans on their books at an inflated mark. There is a reason why nothing much has been done.

The current stress tests are rather narrow. They only will cover a subset of the Italian banks now supervised by the ECB. On their own, they will not force a broader solution.

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Can Europe Declare Fiscal Victory and Go Home?

by Brad Setser

Rules are rules and all.

But the application of poorly conceived rules is still a problem. Especially in the face of a negative external shock.

The eurozone’s fiscal policy is, more or less, the fiscal policy adopted by its constituent member states.

Wolfgang Schauble (do follow the link) should be happy: Europe’s fiscal policy is almost entirely inter-governmental.

The eurozone’s big five—Germany, France, Italy, Spain, and the Netherlands—account for over 80 percent of the eurozone GDP. Summing up their national fiscal impulses is a decent approximation of the eurozone’s aggregate fiscal policy.

And, building on the point I outlined two weeks ago (and that my colleague Rob Kahn echoed on his Macro and the Markets blog), 2017 could prove to be a real problem. Bank lending now looks poised to contract, and eurozone banks face (yet again) doubts about their capital. And the sum of national fiscal policies—best I can tell—is pointing to a fiscal consolidation.

In the face of the Brexit shock, standard (MIT?) macroeconomics says that a region that runs a current account surplus, that has a high unemployment rate, that has no inflation to speak of, that cannot easily respond to a short-fall in growth by lowering policy interest rates (policy rates are, umm, already negative, and negative rates are already, cough, adding to problems in some banks), and that can borrow for ten years at a nominal interest rate of less than one should run a modestly expansionary fiscal policy.

The eurozone as a whole clearly has fiscal space. The eurozone’s aggregate fiscal deficit is lower than that of the United States, Japan, the United Kingdom, and China. Adjusted for the cycle, the IMF puts the eurozone’s overall fiscal deficit at about 1 percent of GDP (without adjusting for the cycle, the eurozone’s overall deficit is around 2 percent of GDP). Even without any cyclical adjustments, the eurozone now runs a modest primary surplus, and simply refinancing maturing debt at current interest rates should lead to a lower headline deficit.

But the eurozone isn’t a unified fiscal actor. Right now the countries that could run a bigger fiscal deficit without violating the eurozone’s rules have said they won’t, and the countries that are already running deficits that violate the rules are facing new pressure to comply with the rules. The aggregate fiscal stance of the eurozone thus is likely to be contractionary.

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by Brad Setser

A few thoughts, focusing on narrow issues of macroeconomic management rather than the bigger political issues.

The United Kingdom has been running a sizeable current account deficit for some time now, thanks to an unusually low national savings rate. That means, on net, it has been supplying the rest of Europe with demand—something other European countries need. This isn’t likely to provide Britain the negotiating leverage the Brexiters claimed (the other European countries fear the precedent more than the loss of demand) but it will shape the economic fallout.

The fall in the pound is a necessary part of the United Kingdom’s adjustment. It will spread the pain from a downturn in British demand to the eurozone. Brexit uncertainty is thus a sizable negative shock to growth in Britian’s eurozone trading partners not just to Britain itself: relative to the pre-Brexit referendum baseline, I would guess that Brexit uncertainty will knock a cumulative half a percentage point off eurozone growth over the next two years.*

Of course, the eurozone, which runs a significant current account surplus and can borrow at low nominal rates, has the fiscal capacity to counteract this shock. Germany is being paid to borrow for ten years, and the average ten-year rate for the eurozone as a whole is around 1 percent. The eurozone could provide a fiscal offset, whether jointly, through new eurozone investment funds or simply through a shift in say German policy on public investment and other adjustments to national policy.

I say this knowing full-well the political constraints to fiscal action. The Germans do not want to run a deficit. The Dutch are committed to bringing an already low deficit down further. France, Italy, and especially Spain face pressure from the commission to tighten policy. The Juncker plan never really created the capacity for shared funding of investment. The eurozone’s aggregate fiscal stance is, more or less, the sum of national fiscal policies of the biggest eurozone economies.

If I had to bet, I would bet that the eurozone’s aggregate fiscal impulse will be negative in 2017—exactly the opposite of what it should be when a surplus region is faced with a shock to external demand. A lot depends on the fiscal path Spain negotiates once it forms a new government, given that is running the largest fiscal deficit of the eurozone’s big five economies.

Economically, the eurozone would also benefit from additional focus on the enduring overhang of private debt, and the nonperforming loans (NPLs) that continue to clog the arteries of credit. Debt overhangs in the private sector—Dutch mortgage debt, Portuguese corporate debt, Italian small-business loans—are one reason why eurozone demand growth has lagged.

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The Pain in Spain Is Easy To Explain

by Brad Setser

A few weeks back, the New York Times looked at the “mystery” of Spain’s high level of unemployment.

The article highlighted a real debate about the right level of job protection in Spain, and in Europe.

But the headline obviously stuck in my mind. I do not think there should be any significant debate over why Spain continues to have a very high level of unemployment.

Look at employment. It is down well over over 10 percent from its pre-crisis levels. Even with the current recovery, there are over 2.5 million fewer people at work in Spain today than in 2007 (18 million versus 20.7 million workers over age 15 using the harmonized EU data; the national data has a similar change but a slightly higher level)

And domestic demand is also down well over 10 percentage points.

No mystery.* If demand in the United States was 10 percent below its 2007 level, rather than roughly 10 percent above its 2007 level, I would certainly hope that there would not be much of a debate on the source of a weak labor market.

Employment vs. Demand

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The Case for More Public Investment in Germany is Strong

by Brad Setser

Last week, Greg Ip of the Wall Street Journal argued that Germany should focus on raising private wages rather than increasing public investment as part of a broader critique of Germany’s inclusion on the Treasury’s enhanced monitoring list. Ip: “Germany’s problem isn’t the public sector, it’s the private sector: Businesses need to invest more and workers need to earn more, and that can’t simply be fixed with more government spending.”

I have a somewhat different view: more public investment is a key part of the policy package needed to support German wages.

Ip is certainly right to highlight that Germany gained export competitiveness by holding down wage growth during the ‘00s. Wages and prices in Germany rose by a lot less than wages and prices in say Spain from 2000 to 2010, contributing—along with rise in global demand for the kind of high-end mechanical engineering that has long been Germany’s comparative advantage—to the development of Germany’s current account surplus. And that process now needs to run in reverse for Germany’s euro area trade partners to gain competitiveness relative to Germany. See Fransesco Saraceno, or Simon Wren-Lewis.

But the changes in German wages and consumer purchasing power needed to allow Europe to rebalance up, with shifts coming from strong wage and demand growth in Germany rather than weakness in wages and demand elsewhere, will not occur in vacuum.

To state the obvious, for Germany’s substantial external surplus to fall either exports need to fall or imports need to rise.

For Germany’s workers, many of whom work in the export sector, to have the confidence to demand higher wages while exports slump they need confidence that domestic demand growth will be there. Put differently, low nominal (Bunds out to 8 years have a negative rate) and negative real rates only will push up wages if either the private or public sector respond to low rates by borrowing more. The domestic side of Germany’s economy may need to run a bit hot to pull workers out of the export sector.

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