Brad Setser

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Cross border flows, with a bit of macroeconomics

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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 Sienna.

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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Post-Brexit

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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It Has Been a Long Time

by Brad Setser

I stopped blogging almost seven years ago.

My interests have not really changed too much since then. There was a time when I was far more focused on Europe than China. But right now, the uncertainty around China is more compelling to me than the questions that emerge from the euro area’s still-incomplete union.

Some of the crucial issues have not changed. The old imbalances are starting to reappear, at least on the manufacturing side. China’s trade surplus is big once again—even if the recent rise in the goods surplus (from less than $300 billion a couple years back to around $600 billion in 2015) has not been matched by a parallel rise in China’s current account surplus. The U.S. non-petrol deficit is also big, and rising quite fast.

But some big things have also changed.

The United States imports a lot less oil, and pays a lot less for the oil it does import. That has held down the overall U.S. trade deficit.

Oil exporters have been facing a gigantic shock over the last year and a half, one that is putting their (sometimes) considerable fiscal buffers to the test. Even if oil has rebounded a bit, at $50 a barrel the commodity exporting world is hurting.

Looking back to 2006, 2007, and 2008, one of the most surprising things is that Asia’s large surplus coincided with rising oil prices and a large surplus in the major oil exporters. High oil prices, all other things equal, should correlate with a small not a large surplus in Asia.

The global challenge now comes from the combination of large savings surpluses in both Asia and Europe rather than the combination of an Asian surplus and an oil surplus.

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Too much of a good thing? Should global capital flows be pumped back up to their boom levels?

by Brad Setser

I tend to agree with the FT’s leaders – especially their leaders on the world’s macroeconomic imbalances — more often than naught. But not always. On Friday an FT leader warned about the risk of financial deglobalization:

“Finance is deglobalising out of fear and because of national policies. Neither will be fully undone without political choices that look unlikely, at least for now …. But unless policymakers come up with better global regulation that works we may have to settle for permanently less globalised finance.”
(emphasis added)

That didn’t ring true to me. At least not fully. The tone of the leader seemed to long for a return of the pre-crisis world, one where huge quantities of funds flowed across borders, albeit one with better global regulation. Yet just as trade probably rose to a level that could only be supported if US households continued to run up an unsustainable level of debt, cross-border financial flows likely reached levels that could only be sustained if the global financial system remained over-leveraged.

The goal shouldn’t be to return the boom years, but rather to return to a more sustainable level of cross-border flows — or at least a system without the excesses that contributed to the current crisis. Remember, the rise in cross-border capital flows prior to the crisis was associated with a rise in the amount of leverage in the system, as a host of institutions tried to support bigger balance sheets without increasing their equity. That rise in leverage sustained a lot of cross border flows.

To be concrete:

US financial institutions sponsored offshore special investment vehicles (SIVs) that often borrowed short-term from American investors to buy longer-term US debt. They were offshore largely because they were off balance sheet. If the same activity had been performed on the banks domestic balance sheet – with more short-term wholesale borrowing to support a larger securities book – cross-border flows would fall. But regulators also would have had a lot more information about the build-up of risks in the global system. Taxpayers might not think that is a bad thing.

European institutions seem to have been supporting bigger dollar balance sheets than they could finance entirely in the offshore “euro-dollar” market. Some were borrowing large sums from US money market funds – and then using the proceeds to invest in longer-term US paper. Sometimes securities insured by AIG’s now notorious credit products group, a little trick that allowed the banks to minimize the amount of capital that they had to hold against their dollar book. A bit less of this wouldn’t necessarily be a bad thing. AIG hasn’t worked out so well for the US taxpayer, and the big dollar books of European banks haven’t worked out so well for European taxpayers.

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A global stimulus shortage …

by Brad Setser

China doesn’t exactly want to make it easy to evaluate the size of its stimulus. Bragging about the small size of your fiscal deficit — especially in relation to the US deficit — suggests a rather modest effort. A bigger Chinese deficit afterall would allow the US to run a smaller deficit without shortchanging global demand. The IMF’s analysis – which looks at the change in the balance of the general government – puts China’s stimulus at about 2% of its GDP in 2009 and 2010, roughly the same as the US effort in 2009 and less than the US effort in 2010.

Given China’s current account surplus, its abundant domestic liquidity (the government – per Stephen Green of Standard Chartered) had deposits at the central bank equal to 9% of its GDP, and limited government debt (at least explicit debt), China could and should do more. And maybe it is: telling the state banks to lend to support local infrastructure projects could be considered a form of stimulus (the TALF could be considered such a stimulus too; both try to keep the flow of credit going to sectors that will spend or invest). It just isn’t the kind of stimulus that looks likely to spur China to consume more. And it isn’t clear how quickly those infrastructure projects will be started, and thus provide real support for activity.

At this stage, though, I would be happy if China just did enough to keep its current account surplus from rising. That is the acid test. So long as the surplus is rising, China is subtracting from global demand growth not adding to it. China could meet its 8% growth target without any contribution from net exports if all other parts of China’s economy kept growing at their previous pace – and with private investment growth slowing, that requires a surge in public investment or a big increase in consumption. But I would note that net exports can mechanically contribute to growth if imports fall faster than exports – not just if exports grow faster than imports.

But China isn’t the only part of the world that needs to do more. Europe’s economy contracted as fast as the US economy in q4. But Europe’s combined stimulus looks to be significantly smaller than either the US or Chinese stimulus. Bruce Stokes of the National Journal/ Congress Daily did the leg work:

The International Monetary Fund has called for a global fiscal stimulus of 2 percent of GDP. In 2009, U.S. and Chinese stimulus spending is likely to match or exceed that target. European stimulus will total less than half that amount. And spending in Brazil, South Korea and South Africa will also fall below the IMF goal, according to estimates by the IMF and J.P. Morgan. …

“In proportion of GDP,” Jean Pisani-Ferry, director of the Brussels think tank Bruegel, wrote on the National Journal economics blog last week, “the size of the stimulus packages put in place in Europe [is] at best half the size of the U.S. and, unlike [the American effort] several of them are rear, rather than front-loaded.” While Germany’s spending will amount to 1.4 percent of GDP in 2009, French outlays will total only 0.8 percent, and Italy has not put forward any meaningful fiscal boost at all …

“Any way you slice the numbers,” wrote Ted Truman, a senior fellow at the Peterson Institute for International Economics, on the National Journal blog, “policymakers are falling short of real ambition in the face of the worst global downturn since the Great Depression.”

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Chieuropa?

by Brad Setser

The thesis that China and America should be viewed as a single economy – or at least as a single currency area – is due for a comeback.

After flirting with change, the RMB is once again pegged tightly to the dollar. 6.85 is the new 8.27. I would not be surprised if China’s external surplus and the United States deficit prove to be roughly equal in size in 2009 The obvious argument is that while the US runs a big deficit, Chimerica doesn’t. East Chimerica’s surplus offsets West Chimerica’s deficit. No worries. At least so long as China’s government is willing to finance the US.

The fact that the Chimerican currency union required unprecedented growth in China’s reserves was always my main objection to the Chimerica thesis. A currency union in theory shouldn’t require that kind of government intervention to keep in balance.

But Chimerica never was really financially integrated. Back when the RMB was (correctly) considered a one way bet, China erected capital controls to keep American (and other) capital from speculating on its currency. And for most of this decade, the net outflow from China to America came not from a desire on the part of Chinese savers to hold dollars but rather from a desire of China’s government to hold the Chinese currency down against the dollar. That policy required that China buy dollars in the foreign exchange market, and in the process finance the US deficit.

However, another objection may be more important. The argument that Chinese and America formed a perfect union – with US spending generating demand to offset Chinese savings, and Chinese savings financing the borrowing associated with US spending – hasn’t quite worked for the past couple of years. It leaves out Europe. And Europe, not the US, was the big spender in the world economy in 2006, 2007 and the first part of 2008.

My colleague at the Council’s Center for Geoeconomic Studies, Paul Swartz, has produced a clever graph (available on the CGS website) showing that the growth in Asian exports hinges on the growth in US and European imports. Makes sense. Paul also plotted Asian export growth against American import growth and European import growth separately — and the chart of European import growth against Asian export growth highlights just how large Europe’s contribution to Asian export growth has been recently.

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Will the US current account deficit fall faster than the IMF forecasts?

by Brad Setser

The authors of the IMF’s World Economic Outlook have a difficult job. They have to forecast the trajectory of the global economy — itself not an easy task. Their forecast will be judged and evaluated in real time. But the work according to a schedule set by the need to consult the IMF board and the demands of physical rather than virtual publication. In practice, that means that the forecast never fully reflects the most recent data. “IMF Board” time, “internet” time and “market” time are all very different things.

Sometimes that doesn’t matter. But right now is one of the times when it does. A lot happened this September. And I suspect that much of what has happened isn’t reflected in the IMF’s forecasts.

Specifically, I now expect a larger fall in US output and a larger fall in the US current account deficit — and for that matter, the combined current account deficit of the US and the EU — than the IMF currently forecasts (see the WEO’s data tables).

In the past I have argued that the IMF has had a tendency to forecast problems like the US current account deficit away, and in effect assume that the US current account deficit would tend to shrink even if neither China nor the US adjusted their policies. The IMF has also tended to downplay the role the official sector has played in financing the US.

Now I suspect that there will be more adjustment than the IMF expects.

Specifically, the IMF now forecasts that the 2009 US current account deficit will fall to $485b in 2009 (around 3% of US GDP)– well below its 2006 peak of $790b, and down from an estimated $665b in 2008. The deficit has been running at around $700b, so the IMF is forecasting a fall in the deficit in the second half of the year (see Table A10).

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