Transunion has released numbers on the delinquency rate of credit card debt QTR3 2009. Ezra Becker comments:

For the first time in ten years, third quarter national delinquency rates showed a decrease from the previous quarter, indicating a departure from the usual seasonal patterns. This movement could have occurred for a number of reasons.

Well, let’s leave these reasons aside for the moment and focus on the main story. Consumers are cutting back their spending in order to repay their debt. Probably firms are doing the same thing: repairing their balance sheets, paying down debt. This, following the arguments developed by Richard Koo, is the answer to a famous question put by John Maynard Keynes in the General Theory (ch.22):

It may, of course, be the case — indeed it is likely to be — that the illusions of the boom cause particular types of capital-assets to be produced in such excessive abundance that some part of the output is, on any criterion, a waste of resources; — which sometimes happens, we may add, even when there is no boom. It leads, that is to say, to misdirected investment. But over and above this it is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent. in conditions of full employment are made in the expectation of a yield of, say, 6 per cent., and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary “error of pessimism”, with the result that the investments, which would in fact yield 2 per cent. in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent. in conditions of full employment, in fact yield less than nothing. We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are.

So the reason why there are no investments which would have yielded 2 per cent. in conditions of full employment is that instead debt is paid down that would have cost more than 2 per cent. in conditions of financial crisis – which is now. My avoiding the loss has bigger benefits than my getting the benefits. Think balance sheet – what do you prefer?

1. a higher value of assets, or
2. a lower value of debt

The International Society for Ecological Economics (ISEE) will hold its 11th biennial conference: ADVANCING SUSTAINABILITY IN A TIME OF CRISIS on 22 – 25 August 2010 at Oldenburg and Bremen, Germany. The extended deadline for abstract submission is 30th November 2009. More information here or here (pdf).

A colleague told me today that the event was to be held at Oldenburg, but with more than 1,000 attendants expected the infrastructure of the city would collapse – Oldenburg simply has no hotel rooms for 1,000 people…

In what has been a major policy shift, US president Obama declared that the rise of US government debt should be contained to stop a possible double-dip recession.

This prompted Paul Krugman to comment:

What happened? To be sure, “centrists” in the Senate have hobbled efforts to rescue the economy. But the evidence suggests that in addition to facing political opposition, President Obama and his inner circle have been intimidated by scare stories from Wall Street.

The grip of Wall Street on political power is still tight. It is unclear to me how anybody could argue that the government failed or the financial system failed in and before the crisis when it is so hard to see where one thing ends and the other begins. Think of the bail-out of AIG, for example. Geithner and Summers are so connected to Wall Street that as an academic I find it hard to see their independence.

The Fed is supposed to be independent, but it will be hard to justify this. Inflation-targeting has failed, monetary policy is helpless, the balance sheet of the Fed is full of risky assets and deflation redistributes income from debtors to creditors. While the banking system was saved, jobs were not. And during this whole decade, the Fed failed to recognize the problems in the international picture, despite warnings from the BIS, the central bank’s best friend. And all this was not caused by an endogenous shock but by failing to recognize or actively creating bad policies and bad institutions. That is a horrible record.

There must be economists with a better track record (William White, Joe Stiglitz, Paul Krugman, …). President Obama should look for these people and consult with them. A discussion that also includes Geithner, Summers and Bernanke would perhaps be really helpful.

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, written by a former manager at Wall Street named Richard Bookstaber, is an insider’s take on why Wall Street 2007 was how it was. Bookstaber switched positions every once in a while, and his biography does tell a story about the evolution as well.

The book is a good read, almost never boring, though it does not deliver a lot of new facts. Bookstaber’s talent lies at connecting things, which in hindsight sometimes is a lot easier than in realtime from within the industry. His reflections are insightful and the structure of his chapters makes sense. For example, he suggests that most definitions of hedge funds are humbug. The one willing to accept should be ‘anything else than an old investment fund’. Then, you can put hedgefunds into different categories, based on trading strategies. Also, he describes the (successful) search for a free lunch, which economic theory says should not exist. The history of LTCM is straight to the point, but it has been told before.

The best chapter of the book is number 10. Here, Bookstaber looks at theories and how they work out in reality. Hedge funds supply liquidity, but is it still there when we really need it? Complex systems arise when actions are tightly coupled, and you cannot stop the system while it’s going. Should the system be left more simple? The discussions are forming a nice overview of what might or might not work when reforming the financial sector. The main lessons is that the financial system should get simpler again: the demon of our own design should be cast away.

Originally published in 2008, the revised and updated 2009 edition features an additional chapter on the world balance sheet recession (ch. 8). Richard Koo, chief economist of the Nomura Research Institute, is the author of Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implication, which was a global success in 2003. Since I did not read that book, I will not be able to judge what exactly is new and what is old material in the Holy Grail.

The book’s main thesis is that the economy can be in two states, called yin (post-bubble) and yang (‘normal’). While in the yang state, the economy behaves just like predicted in the neo-classical models. Monetary policy works, fiscal policy is not so much effective, depending on whether it is crowding-out private investment or not. In the yin phase however, monetary policy does not work. Firms are trying to decrease debt, and the way they do that is by redirecting the cash flow from investment to repayment of debt. Therefore, investment slumps, pulling the economy downwards. Fiscal policy can and must come to the rescue and stabilize demand, never mind the fiscal costs.

The main idea is that cycles of indebtedness drive the yin and yang phases, explaining how the economy can change its behaviour as noticed by John Maynard Keynes in the General Theory and Irving Fisher in his 1933 paper on debt deflation. In Keynes phrase, the demand for liquidity depends on whether the company is doing just fine or must repay its debts. In the latter case, the preference for liquidity is quite high, leading to a fall in investment just like argued by Keynes. Richard Koo supports his theory by explaining that Japanese companies did have access to credit, so a ‘credit crunch’ was not a supply side problem but a demand side problem: nobody wanted to borrow.

When in such a situation, fiscal policy must be used to create money demand. Only then savings can be translated into investments and the economy be spared from a permanent fall. After balance sheets are repaired, which can take a decade or more as Japan’s example has shown, monetary policy will work once more. Fiscal policy as a tool for demand management can be blended out. In the real world, it will be very difficult to judge whether an economy is in a yin or yang phase. This means that the application of the theory will be very difficult and probably be dominated by the way you measure things. All serious economists have been aware of house price bubbles in the US, Ireland or Spain, but who is to decide whether this is a bubble? And if it is, should central banker try to burst it? These are old questions that can be dealt with in the clearer framework supplied by Koo.

Richard Koo claims he found the Holy Grail of Macroeconomics. It would explain why there are liquidity traps and prolonged recessions. He has achieved his goal, elegantly building on theories of giants, like Minsky, Keynes, Fisher and Leijonhufvud. The problem is two-fold. First, mainstream economists will ignore him, since he does not have a spelled-out economic model. The main issue is known since Hyman Minsky search for it: the Minsky moment. When exactly is existing debt too much? Without an answer to this question, modellers will be unable to predict the behaviour of an economy. This leads us to the second problem: without an alternative mathematical model, the financial community will ignore Koo as well. However, since he works at the investment firm Nomura, that is not so bad. Even if his Holy Grail cannot be translated into gold (and prove him right in this way), the intellectual achievement will stand for some time.

During the Great Depression deflation was transmitted via the gold standard, the international monetary system of that time. In a nutshell, it worked like this. All money had to be backed up by gold in a fixed ratio. A country that imports more than it exports than has to pay its net imports with gold. It’s central bank therefore retires some of its currency, whereas the foreign central bank expands its currency supply. Therefore, the net importer will go through a phase of deflation while the net exporter will see its economy inflate. The burden of adjustment falls 50-50 on both economies. The net exporter’s higher price level will make its products dearer, while imports are getting cheaper since the other country is seeing its price level fall. This leads to balanced trade accounts where imports are close to exports. Of course, both are highly positive.

The idea of the gold standard then is to bring about external equilibrium. Trade imbalances are not likely to persist since once the gold starts flowing, price levels are working to reverse the imbalance. Since being ‘on gold’ means that rules have to be followed by changing the monetary supply, the domestic price level is free to float. Today, we have the opposite system. Monetary policy is used to anchor the domestic price level. This strategy is called inflation-targeting. The theoretical models this strategy is based on completely ignore international imbalances, just as the gold standard ignored domestic inflation.

So we are left with a dilemma on this planet. We know that international imbalances are a bad thing, since this creates extra risk for the world economy. Capital flows have to arise to finance trade deficits, and this will have some effect on other markets. Probably the labour markets of net exporters will be doing better than those of net importers, for example. Or, the financial markets of net importers will rise in value because of capital inflows. The interdependence of markets is something that today is not understood anymore. The second part of the dilemma is inflation. We know that high and quickly growing inflation/deflation are bad as well, redistributing wealth and causing problems to transfer savings into investment. Given that the policy instrument to influence both external balance and internal price stability is the same, we have a true dilemma.

Prior to the Great Depression, neo-classical thought dominated and the gold standard ruled. Adjustment to external imbalances was hard at times, leading to severe deflation and unemployment. Recurring financial crises occurred in both industrialized and industrializing countries. Today, the Keynesian view still dominates. Therefore, unemployment has to be fought by the central bank, leaving the external situation to develop without intervention. This connects with the neo-liberal idea of ‘the market always works’, so I think we could describe today’s system as a synthesis.

During the Great Depression, countries were afraid that capital would move out of the country, thereby reducing the supply of money and creating deflation. That is why central banks entered a race to increase interest rates in order to keep the capital inside the country. On the domestic side, companies found it more and more difficult to make money with the costs of capital growing and the price level falling. All countries that played this game of keeping capital inside the country by putting up the interest rates suffered deflation. As soon as countries left the gold standard, their economies were on its way to recovery:

source: Bernanke, Ben and Harold James (1999), NBER.

The question I want to look at today is whether the euro will fulfill a similar role in today’s economic crisis for countries of the European Union. Two words of warning: this is just a scenario that I play through, and I will assume that people might be rational in the sense that they might trade-off economic well-being for getting power (back).

Recently, people with some stake in the ECB have announced that they are prepared to pull interest rates up in the near future. Some countries are still deep in recession, and it is those countries that had seen their housing bubbles burst, like Ireland and Spain. Let me focus on the latter, since I have more knowledge about Spain. Spaniards went deep into debt to buy their houses at inflated prices and spend something around 47% of their incomes on mortgages – on average (source in Spanish). The money came from Spanish banks, which they got mostly from Germany and other net exporting countries inside the EU.

So, what is the right economic policy for Spain today? Before we answer this question, let’s see how economic policy will look like if the EU does follow the rules. At some point, the ECB’s interest rate will go up. That is pure pain for Spain, which will still be shaky at that time since it’s the laggard. The notorious EURIBOR, on which interest rates in mortgage contracts are indexed will rise, leading to higher debt payments. At the same time, a rise in the interest rate will make things more difficult for the financial sector as well. More costly capital might leave some firms underwater, and without a hope of ever coming up again. This will be about expectations also. Third, the real economy is harmed since firms will invest less. This might lead to more or longer periods of deflation, which makes debt repayment for Spanish households all the more difficult. Especially so, since at the same time nominal wages will be falling and nevertheless unemployment will continue to rise.

What Spain would need is more exports in order to repay debt. Domestic demand alone is too weak to bring about something close to full employment in Spain. However, with the euro there is no monetary policy option and fiscal policy is out as well. The stability and growth pact states that fiscal deficits cannot rise above 3% of GDP a year, and also it does not apply now it will in 2012. Even if the pact is scrapped, one wonders whether Spain can increase its government debt by much. The old solution of depreciating the currency is out, too, since Spain is part of the euro zone. A different price level from the rest of the EU is also difficult to achieve since there is the common market, which should lead to arbitrage whenever price differentials in tradables show up. The whole weight of adjustment therefore lies on wages. In order for Spain to export more, wages have to come down (or productivity go up, but this is not going to happen). With wages coming down, Spain will have prolonged deflation and also very big problems with repaying its debt.

This deflation could spread through the whole euro zone. Spanish exports will pick up, putting pressure on European firms to cut costs as well. Other countries like Ireland will also be putting pressure on wages and prices to fall, perhaps leading to a race to the bottom situation where European firms let nominal wages stagnate in order to keep their level of competitiveness constant. It might be supported by politics too, since governments will fight for jobs, as we have witnessed in the case of Opel. There is a threat here that countries of the euro zone will go through a deflationary phase with low growth rates and falling purchasing power that might resemble the experience of the early 1930s. I don’t see it happen now, but sincerely I think by now economists should have warmed up to the thought of discussing worst case scenarios instead of indulging in wishful thinking.

So, what are the alternatives? Spain might consider leaving the euro zone. It would be a bold move, but Spain might be desperate. The unemployment rate stands at 20% today, and it can be expected that it gets worse. Also, Spain has a problem with its regions. While some, like the Basque country and Catalonia are industrialized and relatively rich, others are not. The dictatorship of France has led to redistribution from those rich regions to the rest, and now there is a struggle for some regions to form their own nation. While some Basques have been doing so by armed resistance, Catalans have been using political means, and that includes using the FC Barcelona as a tool for cultural identity (Xavier Sala-i-Martin plays no small part in this, by the way).

So, what will happen if Spain leaves the euro zone? The question critically hinges on whether Spaniards would have trust in a new currency. If so, the new currency could be devalued from the beginning, thereby reducing debt burden for households, firms and the government. Spain could become a net exporter, and earn its way back to economic growth. However, if some regions would not go with the new Spanish currency and instead opt for their own currency, this solution might become difficult to follow.

These are just scenarios which I think unlikely to happen, but the pressure that will be put on Spain might be real. However, it would be easier for the EU to either support Spain through a federal fiscal stimulus paid for by the net exporters or allow Spain to default on part of its debt. The political cost of Spain exiting the euro would generate quite high negative externalities for the euro zone, so some political deal is likely to go down.

I am reading Jeffry Frieden’s paper Global Imbalances, National Rebalancing, and the Political Economy of Recovery – and enjoying it:

In a 1932 presidential campaign speech, Governor Franklin D. Roosevelt emphasized the contradictions of the incumbent Republican government’s international economic policy, comparing it to the fantasy world of Alice in Wonderland:

A puzzled, somewhat skeptical Alice asked the Republican leadership some simple questions:
“Will not the printing and selling of more stocks and bonds, the building of new plants and the increase of efficiency produce more goods than we can buy?”
“No,” shouted Humpty Dumpty, “The more we produce the more we can buy.”
“What if we produce a surplus?”
“Oh, we can sell it to foreign consumers.”
“How can the foreigners pay for it?”
“Why, we will lend them the money.”
“I see,” said little Alice, “they will buy our surplus with our money.  Of course these foreigners will pay us back by selling us their goods?”
“Oh, not at all,” said Humpty Dumpty, “We set up a high wall called the tariff.”
“And,” said Alice at last, “how will the foreigners pay off these loans?”
“That is easy,” said Humpty Dumpty, “did you ever hear of a moratorium?”

During the Great Depression, banks broke down in large numbers. Afterwards, it was argued that the Fed let these banks fail by not increasing the money supply and keeping interest rates to high. Today, we can see why this argument is not valid.

This time it’s different. The ZIRP (zero interest rate policy) ensures the lowest nominal interest rate possible while quantitative easing (expanding monetary supply) ensures liquidity. However, instead of the banks getting better they seem to stabilize only, and now there are some more dark clouds on the horizon.

First let me explain that the nominal interest rate is not what all banks pay for their capital. The Fed accepts only very good assets as collateral when handing out additional money (although lending standards have been eroded there as well, with the Fed taking on troubled assets). So, if a bank with low quality assets needs to roll over debt, the interest rate it pays is probably going up, because the loan has to be coming from the financial market, and not from the central bank. At least the FT says so, reporting on an assessment by Moody’s.

This means that monetary policy is still without traction. The interest rate which banks face when rolling over debt, which is the most important one we are looking at right now, is different from the nominal interest rate set by the Fed. The only way to save banks now, should they go under water in the next months or years, is by direct transfers of capital – again. We saw this happen last year, we might see it again in 2010.

The above graph pictures not the LIBOR or any banking related interest rate but the one that matters to companies of a specific rating by Moody’s. You can see that although the nominal interest rate is near zero, relevant interest rates for firms in the real economy are not. I guess that the same goes for financial firms, since they hold a portfolio of assets stemming from exactly these real economy firms.

What has helped banks a lot is that the prices of financial assets have gone up worldwide. However, this is only because of the mother of all carry trades, as Nouriel Roubini calls it. Since you can lend at zero interest rate from the Fed, banks do that and then get out of the dollar by buying assets abroad. This is probably what drives the dollar down and global asset prices up. This takes some pressure of the balance sheets, but then: is this sustainable? Roubini says: nope.

When the dollar has declined a lot and bottomed out, the carry trades will unravel as everybody gets back into dollar. This race will drive the dollar up again and global asset prices back down. However, that also means that asset prices today are inflated, and everybody knows it. So the interest rates that banks face are probably not coming down, even though their balance sheets look nicer.

Roubini concludes:

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

I have been at an exhibition at Berlins Museum for Kommunikation two weeks ago. It’s all about money, from the beginnings via conspicuous consumption to the financial crisis. It’s very interesting for non-economists, I suppose, and it doesn’t costs much either (€3/€1,50). If you happen to spend some time in Berlin, this might be a nice idea. The museum is in the city center, metro stop Stadtmitte (U2/U6) if I remember it right. Don’t miss the robots in the entrance hall. They are always up for a game of football.