In the second part (you can read Part 1 here) of this comment on the concluding statement of the International Monetary Fund’s recent mission to the UK, I intend to address one issue:

Is it the case that greater flexibility on fiscal policy, to support demand, might destroy the UK government’s credibility, with disastrous results? Read more

“Fiscal easing and further use of the government’s balance sheet should be considered if downside risks materialize and the recovery fails to take off. In particular, if growth does not build momentum and is significantly below forecasts even after substantial additional monetary stimulus and further credit easing measures, planned fiscal adjustment would need to be reconsidered. Under these circumstances, gains from delaying fiscal consolidation could be larger as multipliers are estimated to move inversely with growth and the effectiveness of monetary policy. To preserve credibility, reconsidering the path of consolidation should be in the context of a multi-year plan focused on further reducing the UK’s large structural fiscal deficit when the economy is stronger and taking into account risks to sovereign borrowing costs. Fiscal easing measures in such a scenario should focus on temporary tax cuts and greater infrastructure spending, as these may be more credibly temporary than increases in current spending.”

The above quote is from the concluding statement of the International Monetary Fund’s mission to the UK for the so-called Article IV Consultation, released on 22 May 2012. Read more

I have noted in the first part of this blog that the debts of countries in the eurozone have suffered a very different fate from those outside the eurozone during the crisis. This is evident when one compares the yields on sovereign bonds of the UK with those of France, Italy and Spain, countries that on the face of it, have governments at least as solvent, if not more so.

So why has the experience of the eurozone members been so different and so painful and what can be done to remedy the problem?

There are two possible explanations, which are not mutually exclusive. Read more

In my most recent post, The journey towards becoming Japan, I noted the similarities between what has been happening to the US and UK and what happened earlier to Japan. But the question obviously arises: why has eurozone experience been different?

Let us start by looking at what has happened. For this purpose, I compare countries of roughly similar economic size: Germany, France, Italy and Spain, which are, of course, members of the eurozone, and the UK.

The time since the signing of the Maastricht Treaty in 1992 can be divided into three periods: 1992-98, which was when interest rate convergence was achieved among the eurozone members; 1998-2008, when all eurozone bonds were treated as being essentially identical, while UK yields diverged a little, from time to time; and, finally, 2008 to today, which has been a period of growing divergence in the eurozone, with Germany acting as safe haven and revulsion from Italian, Spanish and, more recently, even French debt.

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On May 10 2012, the yield on the German 10-year bund was 1.44 per cent, on the US 10-year Treasury was 1.85 per cent and on the UK 10-year gilt was 1.9 per cent.

These are extraordinary numbers. They are particularly striking in the cases of the US and UK, which unlike Germany, run very large fiscal deficits and are experiencing very rapid increases in public sector indebtedness.

This combination of falling government bond rates with very rapid rises in public sector indebtedness reminds us, of course, of the experience of Japan since 1990. (See charts below)

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How should the European Union regulate its banking system? What discretion should be granted to member states in deciding how safe their banking systems should be?

On these vital issues, the EU is coming to the wrong conclusions. That is the UK’s view. I agree with it. But the UK is, once again, in a minority of one. Read more

In my latest column, I discussed the state of the UK economy. Since the column does not contain charts, I have decided to post a few on the Wolf Exchange.

Let us start with gross domestic product since 1970. The chart shows quarterly GDP at constant prices and the pre-crisis trend in quarterly GDP, extrapolated up to the first quarter of 2012. Over this period the trend rate of annual economic growth was 2.5 per cent a year. It will be seen that we do see a period of above trend levels of activity in the 2000s. It will also be seen that, since the third quarter of 2008, GDP has shown a growing negative deviation from the trend. In the first quarter of 2012, the deviation was 8.9 per cent below the long-term trend.

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In my most recent post, I investigated whether fiscal contractions were expansionary. The answer seemed to be unambiguously negative: eurozone member countries that had undertaken large cyclically adjusted fiscal contractions had also experienced larger declines in gross domestic product. This being so, a question obviously follows:

Does fiscal contraction improve actual fiscal outcomes or are the effects on GDP so dire that outcomes do not improve? Read more

“The share of total income going to the top 1 per cent of income earners has increased dramatically, from 9 per cent in 1970 to 23.5 per cent in 2007, the highest level on record since 1928 and much higher than in European countries or Japan today. Meanwhile, the top tax rate has fallen by half, from 70 per cent to 35 per cent.”

In fact,

“because the top 1 per cent has captured about half of income growth since the 1970s, income growth for the bottom 99 per cent has been only about half of the macroeconomic growth we always hear about in the press.”

The second of the quotations is from an interview with Emmanuel Saez of Berkeley, winner of the John Bates Clark Medal, which goes to an outstanding economist under the age of 40. The first is from an article entitled “Taxing High Earnings” that prof Saez wrote jointly with Peter Diamond of MIT, a winner of the Nobel memorial prize in economics.

"Occupy Wall Street" protests at Zuccotti Park in New York. Getty Images

"Occupy Wall Street" protests at Zuccotti Park in New York. Getty Images

Both come from a collection of essays by well-known commentators and analysts, in response to the Occupy Wall Street movement.* The authors include, among many others, Raghuram Rajan of the University of  Chicago’s Booth School of Business, Daron Acemoglu and James Robinson, of MIT and Harvard, respectively and Michael Lewis, the well-known author. Even Gillian Tett and Martin Wolf of the Financial Times are to be found in this list. Read more

Read part I: Fiscal and monetary policy in a liquidity trap

Part II

Might fiscal expansion be a free lunch? This is the question addressed in a thought-provoking paper “Fiscal Policy in a Depressed Economy”, March 2012, by Brad DeLong and Larry Summers, the most important conclusion of which is obvious, but largely ignored: the impact of fiscal expansion depends on the context. *

In normal times, with resources close to being fully utilised, the multiplier will end up very close to zero; in unusual times, such as the present, it could be large enough and the economic benefits of such expansion significant enough to pay for itself. In a liquidity trap fiscal retrenchment is penny wise, pound foolish. Indeed, relying on monetary policy alone is the foolish policy: if it worked, which it probably will not, it does so largely by expanding stretched private balance sheets even further.

As the authors note: “This paper examines the impact of fiscal policy in the context of a protracted period of high unemployment and output short of potential like that suffered by the United States and many other countries in recent years.  We argue that, while the conventional wisdom rejecting discretionary fiscal policy is appropriate in normal times, discretionary fiscal policy where there is room to pursue it has a major role.”

There are three reasons for this. Read more

Part 1

What is the correct approach to fiscal and monetary policy when an economy is depressed and the central bank’s rate of interest is close to zero? Does the independence of the central bank make it more difficult to reach the right decisions? These are two enormously important questions raised by current circumstances in the US, the eurozone, Japan and the UK.

Broadly speaking, I can identify three macroeconomic viewpoints on these questions: Read more

Part II -The cost of equity

Read Part I: Thoughts on Peter Sands

Now, let me turn to Peter Sands’ second and most important point. He condemns the notion that the cost of equity has fallen or might fall, as a result of lower leverage.

The idea that the correct target for banks is the risk-unadjusted return on equity is as close to a religion as one can find in banking. It is always buttressed by the view, also advanced by Mr Sands, that these returns on equity somehow do not depend on risk.

Yet that is utterly at odds with everything bankers do in their daily lives.

Suppose that Mr Sands’ subordinates suggest that his bank lends $100m to a certain company. He would surely want to know how indebted the company was and where the bank’s lending would be in the order of seniority. If his colleagues responded by telling him that none of this mattered, Mr Sands would surely sack them. The riskiness of lending to a company depends, in part, on the level, cost and structure of its debt.

Now consider the position of an investor in common equity. Such an investor is, by definition, junior to all other claimants. Equity investors must be interested, therefore, in how leveraged the company is: higher leverage does, other things being equal, raise their expected returns and the expected volatility of returns. This is finance 101.

Every banker knows it. Read more

Part I

I admire Peter Sands, the group chief executive of Standard Chartered. Unlike many of his peers, he does not rely on making arguments behind closed doors. He is prepared to make arguments publicly, instead. He did this in a piece he published in the FT last week (“The dangers of our new regulation”).

The fact that I admire Mr Sands, does not mean I agree with him. On the contrary I found this article valuable, not because I thought it right, but because I found it revealingly wrong.

Mr Sands starts by saying that Standard Chartered (a bank that has, by the way, almost no business in the UK) supports the idea of macro-prudential regulation.

Nevertheless, he argues, the approach taken by the Bank of England’s interim Financial Policy Committee to which responsibility for such regulation will be transferred in forthcoming legislation is “extremely interventionist and extraordinarily blinkered”. Read more

The real interest rate on US and UK government debt is currently near to zero (see chart 1). This is a remarkable fact. True, real interest rates were negative in the 1970s. But it is extremely unlikely that anybody bought bonds expecting this to be the case.

Now, however, the position is quite different. Both of these governments sell index-linked debt that delivers zero real returns. That is a demonstration of the fact that the world has a huge “savings glut”. Indeed, since savings must equal investment at the global level, it is only by its price – the rate of interest – that one can assess whether such a glut exists. Read more

The answer to this question is an unambiguous “yes”. It is not possible, it is true, to have a currency crisis inside a currency union, provided the currency union is credible, though currency risk returns, implicitly, as soon as it is not. But balance-of-payments and currency crises are NOT the same thing. A balance-of-payments crisis can show itself in a currency union in one (or, more likely, both) of two ways: as a credit crisis or as a regional economic slump.

The fundamental point was made by the British economist, Tony Thirlwall, in a column entitled “Emu is no cure for problems with the balance of payments”, in the Financial Times of October 9 1991. In this he was responding to the then widespread argument that “we don’t talk about the balance of payments difficulties of Scotland, Wales and the North of England, or of Sicily and Apulia. But this does not mean that they don’t exist.”

Let us start at the most basic level: that of the individual. Can individuals have a balance of payments crisis? Certainly. Read more

What do eurozone leaders want most at the meeting of the World Economic Forum? To cease being viewed as the source of global economic threats and return to being a source of economic solutions. It is far more fun – let alone more dignified – to lecture others on their faults than to be lectured on one’s own. It is even more humiliating when those lectures are thoroughly deserved.

Unfortunately for the eurozone, there is no chance that its policymakers will escape blame in Davos. They will argue that they are on the way to a resolution. Alas, the more percipient of them, as well as their peers from around the world, know they are not. Their visit to the Swiss mountains will be a discomforting experience.

The eurozone is almost universally regarded as the source of the pre-eminent threat of an economic meltdown. The risk is that both banks and sovereigns could default, probably triggering – or triggered by – a partial or complete break-up of the eurozone. Such a wreck may still be regarded as unlikely, but it is no longer inconceivable.

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Capitalism in crisis

Three years ago, when the worst financial and economic crisis since the 1930s gripped the global economy, the Financial Times published a series on “the future of capitalism”. Now, after a feeble recovery in the high-income countries, it has run a series on “capitalism in crisis”. Things seem to be worse. How is this to be explained?

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What can we see in the world economy in 2012? Risks galore, is the answer.

The debt crisis of the high-income countries is already four and a half years old. Yet it shows no sign of abating, particularly in the eurozone. While emerging and developing countries are in reasonably robust condition, they would be vulnerable to an intensification of the crisis, which could hit them via several channels: trade, finance and remittances. Many countries – both high-income and developing – are in a weaker condition than they were in 2008 and would, accordingly, find it harder to respond effectively.

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AP/Bernd Kammerer

AP/Bernd Kammerer

In the most recent post, I discussed the fullest analysis yet by Hans-Werner Sinn (together with Timo Wollmershäuser), president of the Ifo Institute in Munich, of the role of the European System of Central Banks in funding the balance of payments imbalances inside the eurozone.

While this post elicited many interesting comments, none, I believe, invalidated Professor Sinn’s basic thesis, which is that monetary financing of the balance of payments (ie the current account deficit, plus net private capital flows) is large, growing and decisive in sustaining imbalances inside the eurozone.

Prof Sinn’s work has attracted much controversy. But this is not, in my view, because it is fundamentally wrong (although I think he did initially exaggerate the problems created for managing money and credit in Germany itself), but because it reveals what many policymakers and observers would like to conceal. Read more

I wrote a column on November 24 2011 entitled “Why cutting fiscal deficits is an assault on profits”. My point was summarised as follows: “If the government wishes to cut its deficits, other sectors must save less. The questions are ‘which ones’ and ‘how’. What the government has not admitted is that the only actors able to save less now are corporations. The government’s – not surprisingly, unstated – policy is to demolish corporate profits.”

This column was based on data for the sectoral financial balances in the UK and US. In this comment, I wish to elaborate on this theme, in three ways: first, I would like to show the charts from which my comments were drawn; second, I wish to describe the argument of a note by David Bowers of London’s Absolute Strategy Research (The Fiscal Risks to Corporate Free Cash Flow, November 17 2011), who has elaborated interestingly on this theme; and, finally, I want to consider the broader relevance of this way of thinking about macroeconomic adjustment. Read more