In January 2004, I attended a property conference in Switzerland, to give a talk on the European economy. I talked about the end of European catch-up on US productivity levels. But the most interesting part of the conference was a workshop in which I argued that a number of European countries, the UK being one, had dangerous property booms.

The most dangerous of all, I suggested, was Spain’s, because it is a large European country which was experiencing a huge rise in property prices and, as a result, a huge boom in property development and a correspondingly overheated construction sector. The results could be extremely painful. This remark led to a heated altercation with a Spanish property developer. I understood why he was so angry. But he was wrong, of course.

The Spanish property sector created a huge boom and a huge crash. The big question is what the Spanish authorities should (or could) have done about it. Read more

“Against the background of renewed market tensions, euro area members of the G20 will take all necessary measures to safeguard the integrity and stability of the area, improve the functioning of financial markets and break the feedback loop between sovereigns and banks. We welcome the significant actions taken since the last summit by the euro area to support growth, ensure financial stability and promote fiscal responsibility as a contribution to the G20 framework for strong, sustainable and balanced growth. In this context, we welcome Spain’s plan to recapitalize its banking system and the eurogroup’s announcement of support for Spain’s financial restructuring authority. The adoption of the fiscal compact and its ongoing implementation, together with growth-enhancing policies and structural reform and financial stability measures, are important steps towards greater fiscal and economic integration that lead to sustainable borrowing costs. The imminent establishment of the European Stability Mechanism is a substantial strengthening of the European firewalls. We fully support the actions of the euro area in moving forward with the completion of the Economic and Monetary Union. Towards that end, we support the intention to consider concrete steps towards a more integrated financial architecture, encompassing banking supervision, resolution and recapitalization, and deposit insurance. Euro area members will foster intra euro area adjustment through structural reforms to strengthen competitiveness in deficit countries and to promote demand and growth in surplus countries. The European Union members of the G20 are determined to move forward expeditiously on measures to support growth including through completing the European Single Market and making better use of European financial means, such as the European Investment Bank, pilot project bonds, and structural and cohesion funds, for more targeted investment, employment, growth and competitiveness, while maintaining the firm commitment to implement fiscal consolidation to be assessed on a structural basis. We look forward to the euro area working in partnership with the next Greek government to ensure they remain on the path to reform and sustainability within the euro area.”


This was the section of this week’s G20 communiqué that dealt with the eurozone.

Let us examine it closely.

“Euro area members of the G20 will take all necessary measures to safeguard the integrity and stability of the area, improve the functioning of financial markets and break the feedback loop between sovereigns and banks.”

The crucial word here is “necessary”. We can safely say that agreement on what this means is altogether lacking. Read more

Last week saw some important statements on UK economic policy from the chancellor of the exchequer, George Osborne, and the governor of the Bank of England, Sir Mervyn King. I considered the implications for the reform of banking and for the supply of credit and monetary policy in two columns published last week.  I failed to note important implications for fiscal policy. Happily, Jonathan Portes, director of the National Institute for Economic and Social Research did not miss them. Maybe, he noted, we are beginning to see glimmering of light in the policy darkness.

This is what Mr Portes wrote: Read more

One of the salient characteristics of Germany’s policy-making in the eurozone crisis ‑ or, more precisely, of the German chancellor, Angela Merkel ‑ has been the view that time is on its side. In a noteworthy speech delivered in Italy on June 2 2012, George Soros, the investor and philanthropist, has challenged this notion directly.

In the penultimate paragraph, Mr Soros writes:

“. . .  The German public cannot understand why a policy of structural reforms and fiscal austerity that worked for Germany a decade ago will not work for Europe today. Germany then could enjoy an export-led recovery but the eurozone today is caught in a deflationary debt trap. The German public does not see any deflation at home; on the contrary, wages are rising and there are vacancies for skilled jobs, which are eagerly snapped up by immigrants from other European countries. Reluctance to invest abroad and the influx of flight capital are fuelling a real-estate boom. Exports may be slowing but employment is still rising. In these circumstances it would require an extraordinary effort by the German government to convince the German public to embrace the extraordinary measures that would be necessary to reverse the current trend. And they have only a three months’ window in which to do it (My emphasis).”

I believe Mr Soros is right on the amount of time left. Read more

Last week I wrote a column entitled The riddle of German self-interest. To my surprise, it received a lengthy response from a senior and highly respected official of the German finance ministry. I am very grateful for this reply, because it clarifies the German finance ministry’s position and raises a number of profound issues.

In the interests of clarifying these issues further, I comment below on some of the statements made in that letter. Read more

The focus of US economic policy discussion at present is almost entirely on fiscal deficits and the level of taxes. My view is that these are second or even third order issues. What matters far more is the capacity of the economy to offer satisfactory lives for the citizenry. This depends on far more fundamental forces than deficits and taxes, such as innovation, jobs and incomes. Evidently, I am arguing that taxes and deficits do not determine these outcomes. I am suggesting this because they do not.

So I want to address two widely held, but mistaken, views. The first is that lower taxes are the principal route to better economic performance. The second is that the financial crisis is a crisis of western welfare states.

How does one measure economic performance? The most important measure is incomes per head. Employment and the distribution of income matter, too. But incomes per head are the place to start. In the long run, income per head determines the standard of living. So an obvious question is how far tax levels explain growth of income per head. Read more

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

A statue holds up a symbol of the euro in front of the European Parliament building in Brussels. Getty Images

A statue holds up a symbol of the euro in front of the European Parliament building in Brussels. Getty Images

The previous two posts Part 2 and Part 1 tried to explain why the sovereign debt of eurozone countries seem to be far more fragile than that of countries with their own central banks.

This issue is a relatively new one, so far as I know. But it is extremely important.

One of the questions raised in the subsequent discussions is why the possibility of illiquidity-induced default (as in the Spanish sovereign debt market) should be any different in impact from the possibility of a devaluation and inflation (as in the gilt market).

I have three suggested answers. 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.

 Read more

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.

 Read more

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

Paul Krugman has an interesting blog on the New York Times website on austerity and growth in the eurozone. I thought it would be interesting to examine the question, using the latest data from the International Monetary Fund’s World Economic Outlook database.

I have defined the fiscal tightening as the percentage point change in the structural (or cyclically-adjusted) general government deficit from 2008, the year of the crisis, to the forecast for 2012. The assumption is that this change represents the results of policy, rather then cyclical effects. I have taken growth as being the proportional change in GDP from 2008 to 2012. 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