Euro area: a strained future

So here we go again – in light of the ongoing and seemingly intractable European crisis, we seem to be back looking at fiscal policy again, and from my vantage point it’s a mess.  After trying to revamp the Stability and Growth pact (SGP) in the first year of the euro area crisis, Angela Merkel and Nicholas Sarkozy (what the FT is calling the “Merkozy” factor) are now embarked on proposing a “fiscal compact” with stiff and rapidly imposed penalties on errant member states - and of course because the Stability and Growth pact had no real legal status as a series of accords ( - they merely clarified the excessive deficit procedure), it’s fines were never taken seriously.  And in any event the member states most in trouble right now would not be subject to the SGP because they are either in recession (Greece), or are running primary surpluses or close to them (Italy, Ireland and Spain). 

In one respect the prospect of a “fiscal compact” I thought would be good: it would finally get rid of the (“stupid”) SGP and move us towards something more sustainable (and hopefully properly designed) for euro area fiscal policy. How disappointing then to find that although (or perhaps because) the announcement of the new “fiscal compact” was made quickly, it’s form is little different from the original SGP except that it will now be enshrined in national laws and have more immediate and harsher consequences. This is extremely disappointing as I know that the Commission has been looking at alternative fiscal policy measures such as debt measures, and yet the Commission was obviously either reticent or was ignored by the French and the Germans when it came to drawing up the outline for a “fiscal compact”.   

In economics we distinguish between stock and flow variables – flow variables being measured over time while stock variables are measured at a point in time.  Clearly the government budget balance is a flow variable as it measures the government finances over a period of time whereas the government net debt measure is a stock variable as it measures how much is owed to non-governmental entities at a point in time. The “fiscal compact” is once again going to focus on the budget deficit, and in “structural terms” ( - that is, adjusting for the position in the business cycle, an uncertain and inaccurate adjustment given our knowledge and ability to pinpoint where an economy is in the business cycle). From an economic perspective it would have been so much more sensible to focus on net debt as this is what the market reacts to.  You cannot adjust net debt for the position of the economy in the business cycle as it is a stock variable and so one could have imagined warning limits on debt levels and then a trigger level where budget surpluses would have to be run if a specific level is breached. Moreover as economic growth affects the level of sustainable debt that could be managed ( - because it is the net debt to GDP ratio that really matters), then obviously one could also imagine a scheme whereby slow growing economies would have lower debt limits than higher growth economies in Europe.  This is an important issue as the desirability of joining the euro will be limited in Central and Eastern Europe if it limits growth prospects.

This SGP design flaw of focusing on the budget deficit is therefore going to be carried forward into the “fiscal compact”, and the only reason I can detect for doing this is the urgency of doing something quickly and also the political difficulty in coming compromising on some new economic measure which countries should focus on – a measure that would likely cause consternation in Belgium and Italy, two countries that are considered part of the “core”, but would definitely be penalized and have to embark upon more serious austerity measures.

The whole reason for this “compact” was to trigger some offset from the monetary policy side, and ultimately for the longevity of the euro area Eurobonds must be issued for the euro area as a whole but Chancellor Merkel could not allow this to be formally agreed to at the summit as this would imply that the central bank in charge of the euro is no longer independent.  Although it is unimaginable that ECB President Mario Draghi would allow the euro area to collapse ( - why would the President of an independent inter-governmental institution allow the whole reason why the bureaucracy exists to disappear?), he is going to have to make some kind of commitment in response to the fiscal rectitude about to be heaped on much of the euro area.  And that response, in my view, is key. It is likely only to be given behind closed doors, and will add an additional dimension to future horse-trading between member states.  Clearly if the ECB makes assurances now, the fiscal measures will be weaker than they otherwise would have been, so the ECB has no incentive to make any announcement until the ink dries on the new inter-governmental treaty.

Two other observations.  First, the assumption that all EU member states should be assumed to be on a track to adopt the euro should be dropped.  It is clear now that the Maastricht criteria were partly flawed (certainly the fiscal criteria are), and given the recent problems with the euro area it would make sense to allow member states to join when they are (or think themselves) ready to join.  The 60% of GDP debt and 3% deficit criteria need to taken out of the entry criteria and replaced with something more like whatever the “fiscal compact” eventually turns out to be. 

Second (and hopefully you read it here first), the UK is now widely expected to go into a second recession in 2 years.  This highlights the problem that all policymakers have (both in the US and the euro area) – that is essentially one of keeping on the right side of the financial markets while stimulating the economy, and properly coordinating both fiscal and monetary policy to ensure the best outcome.  While Cameron antagonized the Europeans, he is not exactly proving to be a good economic steward at home with the City of London likely shrinking during 2012, with a consequent drop in UK house prices.

The Mario Bros and the Euro Savings Reality

What a lot of news lately - I was thinking recently that it's almost like watching a soap opera gone badly astray from the original plot!  So in this posting I want to pull together some thoughts on the European situation.

I am doing this because I am frankly tired of reading some of the "doom and gloom" commentaries that other (mostly "glitterati") economists are producing.  Roubini's comments (see here) on Italy potentially leaving the euro area were simply over the top and illustrate that some economists simply don't understand the European project (despite the fact that Roubini is from Italy) or appreciate optimal currency area theory.  And Roubini wasn't alone - just read Krugman's (here), Martin Wolf (here) and even George Soros (here).  This alarmist reaction to what is going on in Europe is not only unhelpful but (as noted by one response to Roubini's commentary) it is alarmist and almost hysterical.  Let's not forget that Italy has a very high savings rate compared to many countries and given the economic downturn their savings rate is likely higher than where it was back in 2009 when it stood at 14% of GDP. So the run up in Italian bond yields is not something to worry about, and this was amply illustrated when the market realized this and quickly shifted it's attention over to Spain when the latest auction of Italian bonds was successful. Italy is definitely not Greece, and Italy's debt, as I recall, was 112% of GDP when they joined the euro area back in 1999, so why should there suddenly be a "crisis" when Italy's debt to GDP ratio is now 118%? 

Here are the national savings rates for various countries as of 2007:

Economics also backs this up, in the form of analysis of savings and investment, along with the funding of public sector debt. Countries that have high domestic savings rates (like Japan, for example), have no trouble funding extremely large public (and private) debts. Countries like the US with relatively low savings rates have  much more reliance on external funding of their public debt, and therefore the international bond markets. Obviously the higher the debt and the lower the national savings rate (as well as other factors such as whether the country has defaulted before, as pointed out by Rheinhart and Rogoff), the more likely it is that difficulties will occur in funding debt. So where does this put Italy? Italy's savings rate is one of the highest in Europe, and although it has been falling, it is still a sizeable chunk of GDP, so that it is unlikely that the Italian government would ever default. Add to that the fact that Burlesconi is gone and has been replaced by a "technocrat" economist (Mario Monti) who was previously an EU Commissioner, with Monti having a cabinet of no less than 7 professors, and the fact that the new ECB President is an Italian (Mario Draghi) and I think you have the recipe for losing a lot of money in the bond markets if you take a bet that interests rates on Italian bonds will stay high.  Indeed, as I didn't manage to get this post up before leaving the US for Africa I have managed to get an overnight 15% return on my bet on Italian bond yields coming down by using the ETN ITLT.

But the main message I want to get across on Europe is that the euro is NOT going away anytime soon, as some commentators seem to think. Although member states should be free to, or forced to leave, Germany, France, Austria, Italy, the Netherlands, Belgium, Luxembourg and Finland do not seem to be pulling apart economically speaking, and if push comes to shove the ECB is not going to allow bond "vigilantes" to threaten its very existence. Collapse, in my opinion, is unimaginable in the current circumstances - but crisis and default are not. The Economist's commentary on Germany's rigidity (here) in seeking solutions to the euro area's problems was instructive but failed to point out that Germany has benefitted from the euro as if it had continued to adopt the Deutschmark it's exchange rate would likely have been higher than current levels of the euro and so their economy has been given a boost through their export sector.

Next post will deal with the perhaps more severe problem of the banking liquidity issue in Europe. 

Europe, the US and a missed opportunity to initiate a EUSATA

Spencer Gore - The Cinder Path (from the Tate Collection)

Now you're probably thinking "what has happened to this Crowley dude?"  Why hasn't he been posting like crazy with all that's been going on in Europe?  Well, to be honest I've been busy - very busy as a matter of fact - setting up and then hosting a workshop in Helsinki at the Bank of Finland (see here if you don't believe me). After getting over the jetlag, then catching up on the backlog of things that needed to be done at University, I have only had a chance over the last few days to really reflect on what has been going on (and is still going on) in Europe and indeed on the world stage.

And (as they say in Texas) it ain't pretty!  But rather than dwell on events that change by the day, hour and sometimes the minute, I thought I would reflect on what could have been done and what really   matters in Europe now.

I remember when the euro was first launched that I was sceptical - I wrote a few papers using cluster analysis  (still available on my website) that showed that the peripheral EU countries did not display the same macroeconomic dynamics as the "core" countries in the centre of Europe. Underlying this view in economics is something called the optimal currency area theory which basically says that if your cycles are different from a bunch of other countries, then you shouldn't be using the same money. And just to make the point here, when I say "cycles" I mean all cycles, not just the business cycle.  Of course we all know what happened - the euro area happened and the criteria for joining the euro had virtually nothing to do with the optimal currency area criteria.  At first I thought that the euro area wouldn't last, as not only was it not an optimum currency area but also the legal underpinnings did not appear to be in place to support the single currency. Well I was proven wrong on that one and indeed the euro lasted through it's 10th birthday in 2009 to much fanfare, but after 2009 things have started to fall apart, and not at the point that you'd expect - after a severe recession. If you look at the growth dynamic of countries emerging from a recession the dynamics are usually extremely aligned - I've also done some research on this using a technique from physics called "recurrence plots". The difference though here is the debt problem that Greece faces, the fact that the debt was much higher than it should have been on entering the euro area and also their inability now to do much about it as their economy is mired in a downward growth spiral caused by the cutbacks and tax increases necessary to put them on a "sustainable path".

The problem is not just that the peripheral European countries shouldn't have been in the euro, the problem is that even with the low interest rates that the ECB is now delivering ( - now even lower after Draghi's surprise decision to lower rates last week) the peripheral euro area member states are just not growing, and the best way to get the debt to GDP ratio down is to have growth to lower the ratio as the UK is now also finding out.

So how do you stimulate growth? There are two approaches - spend and lower taxes ( - which is usually the favored route in the US) - or go for structural reforms which change the economy or its external relations in such a way that it gives businesses new incentives which jolts the economy into growth. It was heartwarming the other day to hear that that is exactly what is happening (and what I predicted) right now in Japan after the Tsunami. Just listed to this and you'll see what I mean. European member states cannot initiate more government spending or tax cuts, so structural reforms (so most economists say) are what is needed. But these are going to be hard - noone likes to lose job security in a high unemployment environment, and noone likes to have government programs reformed to give people less benefits (as has happened with teachers in the UK, Greece and it's on the tables in Italy as well).

But there is a solution that would help, and rather surprisingly the politicians who meet at the G20 summit in Cannes, France this week did not seem to get it. Indeed this was rather surprising given the motto of the summit in french read "New World, New Ideas" ( - sorry I know, I'm being sarcastic!) - in fact the lack of new ideas was enough to make anyone following all this to get out the St. John Wort tablets. This idea I had is not new, it's just that noone seems to have thought about it in the context of trying to solve the current global growth problems. At a roundtable of Consuls General from France, Germany and Italy in Houston lately, I asked it as a question and I seemed to get a bemused response from the participants. The Italian Consul General even said "it's just too complicated so it is never really considered an option", and the other Consuls General appeared to agree with this view.

So what am I talking about? In short, a TAFTA - which stands for a TransAtlantic Free Trade Agreement. Of course this is not technically correct as a TransAtlantic trade agreement should really include Canada....but wait, the Canadians are soon going to conclude their OWN trade agreement with the EU called the CETA (Comprehensive Economic and Trade Agreement) and the Mexicans already have agreements with the EU in place. I guess I would call what might emerge a EUSAFTA (- an EU-USA FTA).

But why now? First, the US Congress passed and President Obama recently signed and recently lauded new trade deals with both South Korea, Columbia and Panama. So although the US government is "broken", lawmakers on this side of the Atlantic seem to still be able to get their act together when it comes to trade deals, so there is at least a glimmer of hope there. Second, the trade flows that we're talking about are the largest in the world when you add up all the European Union member states - and yet these trade flows have not been liberalized (as anyone shopping for European cheeses knows only too well). But more to the point, the structural change (and hopefully "net boost") to the economies on both sides of the Atlantic would be significant, leading to an acceleration in growth, and indeed given how big both entities are, global growth. And third, as part of the G20 communique, leaders called for a study to be done on how to get an "early harvest" on some of the gains that could be culled from the failed "Doha round" of GATT talks which were held under the auspices of the WTO - well, hmmmm, let's think what caused the GATT talks to collapse in the first place - yes, you got it, the EU and the USA not being able to agree on agriculture! So getting them to push their heads together and negotiate something (even if you leave agriculture out) would get the diplomatic channels opened up further, and might allow a deal to also be done on agriculture which could allow the Doha round to be restarted.

Clearly getting agreement on a EUSATA would not be easy, but the potential payoff is just too great to ignore right now. We all know that just getting the trade representatives to sit down and talk will boost economic growth as businesspeople will become more optimistic about the fact that something is being done by our governments to try and boost growth. In my opinion it is the best way to get the economies on both sides of the Atlantic out of their current economic policy quagmires.

Even without a double dip, should we feel bad about the US economy?

The grim outlook outlined by Martin Wolf in his FT column this week was a stark reminder that economic measurements, while being constructs that usually measure what we want them to, can sometimes not reveal what we want them to reveal.  The example of our definition of a recession is a good example and the one used by Wolf in his column.  By the measures used by the business cycle dating committee of the National Bureau for Economic Research (NBER), the recession ended in June 2009, and yet here we are 24 months later still at real output levels that are below those of the peak of the previous cycle.  The graphic from Martin Wolf's article is reproduced on the left, and shows that US real GDP is still slightly below it's peak in late 2007 and that other countries such as Japan, Italy, the UK and France are also still languishing at output levels way below their peak in the second quarter of 2007.

The fact that the vast majority of the American general public believe that the US economy is still in recession.  According to a CNN poll (see here) only 18% of Americans believe that we are not in recession right now, so this also does not accord with the way that economists measure recessions, and suggests that we might need to review this, or at least re-categorise the phases of the business cycle!


So what should be our measure of a "recession"?  I have heard many commentators say that although we are still not officially in a recession, it sure still feels like one, particularly when unemployment is still high and there are still calls for economic stimulus like the one heard only today from Fed Chicago District President Charles Evans (see here).  But given what has happened in Japan and what appears to be happening in some other developed countries, maybe we should reconsider our definition of recession as a cyclical downturn and recovery up to the point where we surpass the level of real GDP achieved at the peak of the previous boom. In fact with a growing population even this is unsatisfactory because 4 years ago in 2007 the population was smaller than it is today in nearly all of these countries ( - the exception perhaps being Japan) so if we measure output on the basis of output per head of population (or per capita), we would take longer than indicated in the graph above to get to the same level of output per capita so we would be calling the recession over before it really ended. In fact, to be frank I am in favor of changing our definition of a recession because the current measure only focuses on the downturn and does not focus on what happens afterwards - plainly Japan's experience in the 1990s plus our own recent experience suggest that not all downturns are followed by rapid upturns.

All this is even more relevant given the release of the employment statistics on Friday - and the New York Times had a great graph in it's economics top story on the release - an update of the graph originally used by Nancy Polosi to justify the stimulus in the heady first 100 days of the Obama administration back in 2009.  The frightening thing about the graph on the left is that it most clearly shows why this current downturn has been much different from previous downturns. The previous downturn to be matched against the Great Depression was the downturn in the early 1980s where employment fell by 3% from the peak of employment. This last recession caused job losses for way longer than the other recessions ( - in the early 1980s the job losses started turning around after 15 months whereas it took 26 months in this downturn), and way bigger than other recent recessions (over a 6% fall in employment).  The big picture shows that we have only managed to claw back 1% of the loss in jobs, despite economic stimulus and the Fed pumping credit and money into the economy.

I think a much more serious problem is another quite different story that the New York Times (august newspaper though it is) does not bring out in its reporting. If you look at the recessions of the 1970s, 80s and 90s and then the 2 recessions of the 00s, it seems clear to me that the US labor market is much less able to cope with recessions than it used to be - the recovery times seem to be longer and much more drawn out than they were even 20 years ago. To me this implies that there is some very serious changes going on - some of it structural, but I think something must be also be going on in terms of reluctance to hire - for example do companies delay hiring much longer than they used to, asking their current employees to do more overtime for a longer period of time before they decide to bite the bullet?  I'm not sure we know the answers to these questions yet, but clearly things are changing for US workers, and changing fast!  A pretty grim interpretation for the reasons for this are also given today by Robert Reich in the New York Times and although I don't go along with everything he says, I do agree that we need to focus on education, but I would also add that the US really also needs to focus on marketing itself to the rest of the world - countries that sell products to the developing countries (where the economic growth is right now) is one of the best ways to help expand our economy.

So to answer the question I pose for this blog, the response is clearly a resounding "No"! But for all the problems with the labor market ( - and given that it's really no surprise that Obama recently chose a Labor economist, Alan B. Krueger, to head up his economic team), the US has a lot going for it. It has some of the most dynamic companies in the world, and it is far ahead of most countries in the area of technology - but these advantages will narrow compared to Europe and Asia if the US does not focus on what leads to these advantages - education! I think what the US is essentially finding out is that although the military gave you economic power back during the cold war, spending a lot on military does not give you that advantage now. Countries that have focused more on education over the last 20 years (e.g. Finland, Germany, South Korea etc) are now doing very well thank you - countries that have not grown as fast.

What should be done then? I think a good start would be to redefine what a recession is, re-prioritize government spending towards education and away from the military, and to set up some kind of corporate international opportunities bureau which would list foreign opportunities and so US companies would be more aware and able to more easily grasp new overseas opportunities.  

The Ladder of Escape (in US Budgetary Politics)

On Tuesday I was in London for a day of culture - something I rarely get in my current home town of Corpus Christi. So in the morning I ended up at Tate Modern to see the Joan Miró exhibition.  Miró was a staunchly nationalist Catalonian painter who lived through the upheaval of the Spanish Civil War and when he moved to France in 1938 to escape it, got caught up in the beginning of the 2nd World War as Germany planned and then enacted it's invasion of France.

That morning I had been happy to hear about the deal struck thousands of miles away in DC between the two main US parties, what I didn't realize was that the "Ladder of Escape" theme that runs through so many of Miró's paintings was really what was going on in the negotiations in DC that had just been finalized.  In Miró's paintings the "Ladder of Escape" (seen in red and black disappearing upwards) acts not only as the restlessness of a perpetual émigré but also the idea that you can escape from reality into an abstract fantasy world, as Miro did in terms of his art being a sanctuary from all the terrible things going on around him.

As the FT makes clear this morning in an excellent review of the agreement "forged of necessity" by Robin Harding, the spending cuts are post-dated to when either the current raft of politicians have been voted out of office or when economic circumstances will have changed considerably so that in a new Congress the current agreement can safely be ignored. Hence although the media stated that markets fell today because of high levels of Italian government debt, I think the truth as to why markets plunged yesterday is probably much closer to home.

Of course, the reality of dealing with budgets is not pleasant - cuts have to be made and whole sections of the population have to be asked to carry an increased burden, but ultimately at some point down the road that is what must happen.  The question is "when"?  So I can see the temptation in front of the politicians - specify that most of the cuts will happen in the future and appoint a committee to make the cuts that need to be made now, and then climb up the "Ladder of Escape".  Larry Summers (in the FT) has also noted that these spending cuts are agreed relative to a baseline, but there is no reference to any baseline in the agreement, so no doubt this can be interpreted quite a few different ways, an omission that might have been intentional to help get it passed and on President Obama's desk in time.

That is certainly not to say that I favour the UK approach of the Conservative/Lib Dem coalition.  Their policy is basically to hike sales taxes and slash government services and departments, as well as downgrading public sector pensions considerably, while also cutting the number of University places available to this year's intake and dramatically increasing tuition fees. Economic growth is almost non-existant in the UK and the country could very well slip into recession later this year. But I would say that I like the fact that there are both spending cuts and tax increases (what Obama calls a "balanced approach") despite the fact that the timing of the UK policies are just too rapid. I think what needs to be emphasised to the American people though is that new taxes will have to be raised if they are to begin to properly address the problem without gutting the welfare state or the military - that is just the reality, and even conservative economists like Robert Barro agree on this point.

Now in these blogs I have maintained all along that the US would be slowest to come out of the 2008/2009 recession because it had the catalyst for the global downturn, and would probably need most stimulus. But now that the stimulus is virtually complete it does not seem exactly the right time to enact some draconian pull-back, but obviously it does compel the administration to explain to the markets how it plans to get it's fiscal house in order down the road. And therein lies the main problem - its policies of increasing taxes on the rich to pay down some of the debt was just not grounded in political reality, given the emergence of the tea party and the pledge that the Republicans had taken to Norquist's association. So all the adjustment had to come on the spending side, and that just isn't going to happen quickly given the fact that we're still dealing with 2 wars, and a housing market that is still in decline in many parts of the nation.

There are several important questions that come out of the brinkmanship we experienced over the weekend, and one of them must be whether it would have been better not to reach an agreement that is more fantasy than reality, and then to have faced the consequences, rather than sign something that clearly lacks credibility.  No-one wanted a default, but there again running a sensible fiscal policy requires some reality checks on all fronts, not just that of taking a surgical knife to government spending.

So back to Miro again and while Miro was exiled from his beloved Catalonia to France (Paris) he painted what for me was the best picture in the Tate Modern exhibition - that of a "Still Life with Old Shoe". Here ordinary objects become fantastical - you can see the vivid colors surrounding everyday objects like an old shoe, a piece of bread, a knife in a potato and a bottle of wine. I think the point Miro was also trying to make is that when you face extreme pressure, the ordinary things in life matter a lot, and garner extra meaning. I can't imagine what analogy one might make for the budgetary mess here, but I'll be pondering that over the next few days!

Certainly though if you happen to be in London before September 11th, I would definitely recommend you take some time to see this fascinating exhibition! 

Armageddon and the US debt ceiling

Now that it is obvious that my previous post on Grover Norquist has pretty much come to pass, there are all sorts of pundits predicting what will happen if the US defaults on it's debt next week.  I saw a prediction by Credit Suisse on the CNBC website that stocks might fall by 30% and the US economy would contract by 5%.  Well frankly I think that is a bit of an over-reaction.  The US is not Greece, and although the US debt levels are high this is not a case of "can't borrow to pay", this is only potentially a case of "can't get our political act together, won't pay", which is quite a different thing.

My point is that a Greek default is now becoming a foregone conclusion and therefore causes systemic problems as people start to worry about the solvency of Greek banks if they hold Greek bonds and therefore  whether Greece can stay in the euro area with a growing economy given that it has had inflation that has been far above its partners for a significant period of time. The US is just not in that position and although some in the Tea Party and for that matter in the UK Conservative party appeal to the example of Greece as a reason why the US and the UK need to really tighten the fiscal screws, the logic frankly just doesn't carry over, and there are several reasons for this which I details below.



First, even if the political parties run out of time and cannot strike a deal, a US default is just not a foregone conclusion yet - as the FT made clear in an excellent article yesterday, the 14th Amendment of the US Constitution states that “the validity of the public debt of the United States ... shall not be questioned”. The Supreme Court, in a case back in 1933 when the US was trying to escape paying its gold obligations after it left the gold standard, stated that Congress has to honor it's own contracts, and that that means that the interest payments must be made, whatever else might happen. So that implies that, quite simply, a default cannot happen, and that cuts will have to be made to government to hold spending down so that it does not exceed revenues. If Congress is obligated to pay certain payments then presumably the President must have some role in declaring that Congress is out of order and breaking the law and can issue an executive order to raise the debt limit.

Second, there are other (rather "clever" and obscure) options, described in the excellent piece on the CNN website by Jack Balkin.  I rather like the idea of asking the Fed to issue 2 jumbo sized platinum coins worth $1 trillion each - which can then be credited to the government's account!

But let's get to the "Armageddon" option of a default - some now think that it's not such a remote possibility, and have looked at probabilities of what could happen and the implications of this.  Perhaps the most publicised analysis over the last 24hrs has been that of Willem Buiter (who used to teach me when I was a graduate student) and Ebrahim Rahbari of Citi which was neatly summarized in the FT Alphaville today.  Although a downgrade is clearly not going to be good news for future borrowing or rollover of the current stock of debt, the 2 economists do some serious "back of the envelope" calculations that make clear that GDP would not fall by a third, and that by their calculations the amount would be between 0.2 to 0.5% fall.  Now noone wants GDP to fall given the fragility of the current recovery, but that is a far cry from the 5% fall predicted by Credit Suisse.  In their research Buiter et al put weights on 5 different scenarios and they got them a little askew (in my humble opinion), as given the politics, the one now most likely is a debt default, not Scenario 1 ( - no default as a bill is passed by Congress). Plus there is another scenario which I will label Scenario 6: "The Federal debt ceiling is not raised in time and the US sovereign does not default". This might come about because of some obscure legal manoevering (see above) that the White House might be able to manage, and although it might trigger a downgrade due to the market impression that it is "kicking the can down the road", it may nevertheless be a feasible option.

So what will happen in the event that things don't go well next week? If a political deadlock with no obvious escape means that fiscal policy puts a break on US growth, the Fed is still able to swing into action with a QE3, something that might be necessary if the legality of the President's options is questioned. So I think the prospect of the US stockmarket falling by 30% is just not grounded in reality - and certainly not for any sustained period of time.

I think that a default and downgrade is now the most likely scenario, but I also think that there is an understanding in world markets that this is not a reflection of an unhealthy US economy, this is just a reflection of the dysfunctional politics that the US now finds itself in, due to the Tea Party.  There is one silver lining to all the hysteria of recent days though - at least a public debate is now starting to happen in the US as to what should be done - and that, I believe, is a positive outcome.

Norway, Texas, and Guns

OK, I have a confession to make up front - this blog posting is really not too much about economics, but having just been on a short visit to Finland I was shocked about what has gone on in Norway in the last 4 days. The Nordic countries are close neighbors ( - as anyone will know who watches the Eurovision Song Contest!) and a tragedy in one Nordic country is keenly felt in others. And I confess that although I have met some Norwegians on my travels around the Nordic countries, I haven't been there since a trip I made to Oslo many years ago. The big shock for most people from Northern Europe is where it happened - Norway is a conservative social democracy, and like most other Nordic countries has a very generous welfare system, and of course is the most oil-rich country in Europe.

What is perhaps not so shocking is that this crime took place, given the rhetoric of the right and the "bubble" a lot of the right-wing pundits appear to live in. I think it is noteworthy that most successful politically-motivated violent attacks come from right-wing or anarchist groups and they are nearly always aimed at government or prominent left-wing figures. You very rarely hear of a left-wing attack on a right-wing politician (ok I guess Reagan and Pim Fortuyn of the Netherlands are the most obvious exceptions), and I think there is good reason for this. The main reason is that the left wing are by definition a more community-oriented social party, whereas the right wing tends to believe in more individual autonomy and freedom. Most-definitely-right-of-centre Mrs. Thatcher once famously said "And, you know, there is no such thing as society. There are individual men and women, and there are families." which I think encapsulates the way in which many on the right think. So when society doesn't go their way, they sometimes seek to change it by attacking the guts of how societies operate - that is the system of government and the politics that comprise it. History is littered with examples of anarchists and righ-wingers who have done this - from Timothy McVeigh to the Unibomber, to now the Norwegian Anders Behring Breivik.

What I find stunning in all this is the reaction of some on the right - I read in the Christian Post that the attacks have exposed "European Immigration Issues", in a way trying to find a silver lining in the fact that a man killed nearly over 70 people. Surely the issue is that one man killed 76 people in a clear attempt to strike out at government and eliminate the next generation of leftist politicians who he thought of as the Labor party youth wing who had convened for a summer camp west of Oslo.

As most people who read this blog know, I live in Texas.  Texas is a state where gun ownership is very much embedded into state law and the culture of the place, and many people own guns and have concealed weapon permits so that they can carry guns pretty much anywhere if desired. The State nearly passed a law which would permit students and professors to carry guns on campus, and so I have decided that in my own interest, I should at least know how to use a gun and now have a concealed weapon license. Explaining this to Europeans is not easy - the reaction is usually extremely negative, as most Europeans are emphatically anti-gun, even though ownership of guns is quite usual in the rural areas of Europe and particularly in the Nordic countries. The justification for introducing the carrying of guns into Universities in Texas was the argument that if students or professors had been allowed to carry firearms at Virginia Tech and on other campuses where shootings have occurred, many lives could have been saved. But although this argument is in principle correct, it ignores the "unintended consequences" that may occur as perhaps student suicide rates would rise and it might lead to much higher fatalities than if guns were not allowed on campus. Gun advocates have noted that since 2007  guns are allowed on campuses in Utah, and there doesn't seem to have been any uptick in incidents. But that might have to do with the fact that many students in Utah go to Utah universities as often there is a religious affiliation, and therefore many of the students might have grown up with guns already. Also as an economist, I would argue that perhaps not enough time has passed to really evaluate the Utah campus gun laws.

We all want to be proactive to prevent the kinds of massacres that have been witnessed in Norway. But i) there are unintended consequences of allowing all students and professors to hold guns on campuses or elsewhere for that matter; ii) once a law is passed allowing people to do something it is very difficult to remove that "right", so this basically becomes a one-way street. The real question is, is  there another (better) way to allow better regulation of guns so that more of these isolated incidents can be prevented, while at the same time mitigating the unintended consequences of more widespread carrying of guns? I am not sure I know the answer to this question, but of course I have some ideas!

I would suspect that in a country like Norway, and likely now other Nordic countries, more gun controls will be put in place as despite the isolated nature of this incident, the authorities will take steps to ensure that this never happens again.  And I would also suspect that in Texas someone will have another go at introducing legislation to allow concealed weapons on campuses - this time it failed, but it only needs to pass once and then it will be the norm and we'll be experiencing any "unintended consequences"!

How one man could (at minimum) destroy the US economic recovery

The US talks on raising the debt limit now enter a critical phase as the August 2nd deadline approaches for the lifting of the ceiling on US debt issuance.  Obama's walk out and the action by Moody's which puts the US on a "downgrade watch" have heightened the alarm among political and economic pundits that there is a significant chance that the US will default on servicing its debt obligations. Some in politics make the comparison with Greece, which most observers think will soon default, but this is not a good comparison at all, as Greece's default would be an involuntary default (as they really can't borrow to pay the interest on their debt), whereas a US default would be a voluntary default (which is caused by the unwillingness to raise the debt ceiling).

As many have already commented, the raising of the current limit of $14.294 trillion, which has already effectively occurred as the Treasury has been doing by borrowing from funds in its control to keep government going (see the debt clock if you don't believe me), involves a balancing act based on commitments that both republican and democratic parties made to their electorates. Grover Norquist though, has the republican signatories to his "tax pledge" over a barrel - he made most (235 Representatives and  41 Senators) of the GOP elected representatives sign a pledge that states that "I will oppose any and all efforts to increase the marginal income tax rate for individuals and business" and "oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates". Clearly this really boxes in the GOP - it cannot vote to get rid of wasteful subsidies, nor can it vote for an increase in the taxes for the uber-rich.  So that is why this looks like it will become a full blown US crisis pretty soon.

How can you continue to support a no tax increase policy when there are obviously very good reasons to increase taxes with reduced government spending? Your hardline position does not seem to be in the best interest of this nation and the majority of its people.
(July 13, 2011 10:38 AM)
A. Grover Norquist :
Thank you for your comments.
You are wrong.
(July 13, 2011 1:13 PM )

Read more: http://www.atr.org/highlights-washington-post-chat-grover-norquist-a6337#ixzz1S4k7roZw

When asked recently whether elected representatives should continue to follow the pledge not to raise taxes if it is against the interest of the country, his response was "Thank you for your comments. You are wrong". He is basically telling elected representatives that if they vote for anything that raises taxes ( - and his interpretation of raising taxes involves even eliminating subsidies) that he will campaign against them when they are next up for election. Now, whether you think that Norquist is a lunatic or a visionary, the consequences of a default would undoubtedly raise interest rates significantly and would also likely have far-reaching consequences.

Like what?  Well as Ben Bernanke made clear on Capitol Hill yesterday, the first thing would be massive cuts in federal expenditures - military ( - although some republicans have already passed legislation detailing that troops should get paid first), social security and pretty much all federal government expenditures across the board. That would immediately cause a "Greek-style" recession as austerity reverberates through the economy with federal government workers being laid off or suffering large pay cuts. Bernanke also said a  default would "throw shock waves through the entire global financial system", meaning that US government bonds and T-bills would suddenly become much less attractive to foreign investors and would immediately be downgraded by the rating agencies. That means a large increase in interest rates as foreigners dump their holdings of US bonds and swap them for something else. That increase in interest rates would also be apparent in the US, which would automatically reverse the Federal Reserve's current monetary policy, making loans for housing and anything else much more expensive. That would hurt the housing market, and therefore consumers, and would also hurt any US business looking for a loan for business expansion.

So how bad could it get? Well the US is also the world's trading currency and most sought after currency in other parts of the world - so that would also be under threat, leading to a giant boost for the euro, perhaps a boost that it could really do with right now after all the bad news in the last few months. So the stakes are extremely high, and although there is always brinkmanship involved in cutting these political deals, in my view the chances are around 50:50 that a default will happen.

As I've already argued, apart from a few republicans who haven't signed up to Norquist's pledge, the rest are completely boxed in, and unless they all decide to go against the pledge they signed, I don't see any way out for them. The alternative is that democrats give way and agree to massive cuts - and of course that hurts their constituency the most, so they will resist this at all costs. The republicans have already suggested a short-term stop-gap, whereby "three times between now and the 2012 presidential election, the White House would send a request to Congress for a debt-limit increase of $700bn or $900bn. Congress would each time vote to reject the request and the president would then veto the denial" (see the FT on this). In other words the debt limit gets lifted by default as the proposed increase is denied and passed by the President vetoing the denial.  In other words the GOP want to be seen to vote against lifting the limit so that they don't break their pledge - but once again this is just "kicking the can down the road" as what happens after the 2012 presidential election?

How can you continue to support a no tax increase policy when there are obviously very good reasons to increase taxe reduced government spending? Your hardline position does not seem to be in the best interest of this nation and the majority of its people.
(July 13, 2011 10:38 AM)
A. Grover Norquist :
Thank you for your comments.
You are wrong.


Read more: http://www.atr.org/highlights-washington-post-chat-grover-norquist-a6337#ixzz1S4jVWvIN

How can you continue to support a no tax increase policy when there are obviously very good reasons to increase taxes with reduced government spending? Your hardline position does not seem to be in the best interest of this nation and the majority 

The Greek Solution

This is the flag that has been carried at demonstrations lately in Athens ( - see this link if you don't believe me). It is easy to see what it represents - the EU flag with a Nazi swastika inserted inside the 12 stars representing the 12 member states that originally formed the European Community. The worrying thing about the demonstrations in Athens is that they clearly represent a large portion of the Greek electorate that do not see the solutions to Greece's problems as more austerity with further bailouts coming from the European Union (through the European Financial Stability Fund of EFSF) or the IMF.  And in my opinion they have a point - we have already been through a series of bailouts and things just don't seem to be getting any better for Greece - each round of austerity measures will just make things worse for the people and the macroeconomy in general.

Today an excellent article appeared in the FT by Gideon Rachman, arguing that further European economic integration in the form of a fiscal union with a European Treasury would not solve the Greek problem, and although I am in favor of moving towards fiscal union, I buy Rachman's argument that Greece is not a compelling reason to do so. Politically speaking though, anti-EU sentiment will continue to rise though unless a "Greek  solution" is found - and this must be a lasting solution, not a patchwork solution as has been done so far. Patchwork solutions risk escalating the crisis into a full blown disaster, with the potential for a breakup of the euro, which would be in none of the participants' interest.  

Would any student of economics be surprised that we've reached this impasse regarding Greece's situation in the euro? No, as the optimal currency area theory suggests that countries whose economies move together are better suited to a single currency, and any academic paper that I've seen since the mid-1990s which tries to operationalize this shows that Greece and several other periphery countries don't have economies that move with the core member states of the euro area.

So according to the academic research, Greece should not be in the euro, but we also know that as the Greek public finances were not complete when they were assessed for membership of the euro back in the early 2000s, they really shouldn't have been allowed to join the euro in the first place. And that is the conundrum here - it is clear to me that the Greek problem is not one that should lead to contagion - it just needs to be solved once and for all - but on the other hand in a monetary union it is not possible to treat Greece as an exception as what you do for one member state you have to do for them all - hence the EFSF.

To end this continuing crisis, I think Greece should be given a choice before it shakes political confidence  in the EU and starts to destabilize the entire euro area as an entity ( - and here I'm not talking about contagion but rather that of credibility). So I would propose that Greece be given a choice - one of their choices should be to leave the euro and return to the Greek drachma so that they can effectively devalue their currency to stabilize their economy (after obviously having to default first), and all those Northern Europeans can then plan their (cheap) vacation in Greece for next summer!  The other choice would be to insist that the Greek parliament change their Constitution so that a 2% of GDP primary budget surplus becomes enshrined into law - thus leaving the decision about how the fiscal policy restraint is going to be implemented up to the Greek parliament. In return for doing this the Greeks would have to submit to scrutiny of their public finances by the European Commission but all negotiations regarding debt issuance and rollovers would be taken from the Greek finance ministry and given to the EFSF to negotiate.  In this way no new debt could be issued (by law) and all the markets would be concerned about would be the rollover of the existing debt and whether payments would be made on the debt.  The EFSF would then also be in charge of making interest payments on the debt, with a maximum of 5% of GDP allowed under normal circumstances ( - which would imply a budget deficit of 3% of GDP, just inside the Stability and Growth pact limits). The interest payments would be billed to Greece.

What are the advantages of the first "Greek solution"?  For Greece, obviously getting out of this mess - but that might be the best option if their politicians do not want to tie their hands. The real losers will undoubtedly be the bond holders, as they will have to take a big haircut given that many of the bonds that have been issued or rolled over are denominated in euros, or face almost certain default. The other big downside would be for the euro area which would have been seen to fail in its attempt to keep a wayward member in the fold.  It's credibility would be mud for a few years, but the financial markets are myopic and that would soon pass.

What are the advantages of the second "Greek solution" I propose above?  In my view it clearly leaves the decision about what to do up to the Greeks, but it also makes very clear that Greece has to pass some "retroactive" tests in order to stay in the euro area, tests that are not being imposed on other member states as they did not misrepresent their public accounts in the first place.  Secondly, the financial role of the EFSF is enhanced, and presumably rolling over/issuing the debt will be easier as it is a European institution with much better credit than the Greek finance ministry that is doing the rolling over.  Third, it also starts us on the road to further economic integration, in the sense of tying the hands of politicians at the member state level, and then allowing the EFSF to manage debt issuance.  It is not fiscal sovereignty at the EU level, but it is a move towards financing public spending at a supranational level.

Is a “Perfect Storm” heading our way?

The NYU economics professor, Nouriel Roubini just went on record in Singapore a few days ago about his long term prediction for world growth – and it wasn’t wonderful!  According to Bloomberg reporters he said that there was roughly a third chance of a perfect storm in 2013, where China slows down significantly because of lack of consumption and the unwinding of the real estate bubble there, the US also struggles to break free from its current headwinds of mounting debt and the housing malaise to return to historical levels of economic growth and the EU finds itself revisiting the PIGS (Portugal, Ireland, Greece and Spain) debt problems time and time again which slows that continent down as crowding out occurs from increases in interest rates.  According to Roubini by that time Japan would also have exhausted the extra fiscal stimulus given to the economy after the Tsunami from earlier this year, which adds the icing to a cake that clearly has refused to rise to the occasion. 

So what are the other two-thirds of Roubini's probabilities?  The second scenario with a weighting of roughly a third is a resumption to more usual levels of growth is one of them – clearly a soft landing in China, an upturn in growth in the US and better news from Europe plus a more permanent boost in growth in Japan could all combine to move things along faster than the pessimists expect.  And the third scenario with a weighting of a third again is an intermediate “anemic but OK” growth scenario where the factors in the “perfect storm” scenario are much less severe. 

Forecasting the global economy is, I would assert, harder than forecasting the weather.  At least with the weather you know there are going to be seasons – with the economy you don’t have any idea about when these “seasons” are going to occur. There is the “business cycle” of course, but the consensus for the length of the business cycle is anywhere between 3 and now 10 years.  Once you are 3 years beyond the end of the last recession (which ended in June 2009) which means we’re at June 2012, then it’s anyone’s guess when the next recession will occur. At the other extreme we’re pretty sure that something will happen by 2019, as we have never had a period of more than 10 years of uninterrupted economic growth in the US. 

If we look at the gap between recessions though, it has grown since the Second World War, and so the next recession is more likely to be later, rather than earlier. Given this, I would place less probability on Roubini’s “perfect storm” than the other two scenarios he came up with.  Also the rosy scenario is a little too “rosy” for my liking, in that not all policymakers get it right, and particularly in both China and Japan there is not much of a record of getting the correct mix of policies to really optimize economic growth, plus we now know that there is not a lot that policymakers can do once a bubble has really built up in an economy, so the Chinese might really have difficulties dealing with the aftermath of a popping of their property bubble.

So I would disagree with Professor Roubini’s main forecast, which is of a “perfect storm” brewing for 2013, and would predict that we are much more likely to see problems in one part of the world and growth in other parts over the next few years, but that the “perfect storm” in the form of the next recession is some way down the road, and rather unlikely, mainly because of business and growth cycle factors in 2013. My most likely scenario would consist of more of a divergence in growth around the world, which is not to say that I don't believe in an international business cycle, but more because each region of the world has a different focus and different views about the effectiveness of government policies. These perceptions, I believe, in and of themselves can produce different outcomes.

So a more interesting question from an investment standpoint is where there is most potential for a resumption in economic growth.  Although policymakers do not determine economic growth rates, they do, in my view, have a significant impact on setting the appropriate environment for growth to occur. The developing economies in the form of the emerging markets certainly have the most to gain, but if the US gets this mix of fiscal rectitude and continued modest monetary stimulus from the Fed right, then it too will also benefit. Non euro area European countries still have extremely bright prospects and of course the euro area, if it bites the bullet and develops a Euro area bond or decides to let Greece go, could also benefit. I, like several other commentators, am now bearish on China as their economic problems appear to presage a bursting bubble, and Japan, as I have already stated in this blog, might just be the biggest surprise of them all if they can only get their politicians to act sensibly.

The Cyclicality of Economic Growth

Courtesy: NASA / Goddard Space Flight Center

A lot of my academic research has been predicated on the basis of cycles in growth.  I realize that we talk about the "business cycle" frequently in economics and yet hardly any economists use methodological tools that assume cyclicality.  This is, I hope, about to change.  Whether we like it or not, cycles in human behaviour are everywhere, and that is partly because we live on a planet that circles around a hot molten star.  And yet economists blithely go on talking about "shocks" as though everything would always be smooth sailing but, yes, damnit, "X" (insert your own reason) got in the way and knocked us off course.

The reason why I'm going on about this today is that I recently received a rejection letter from a journal which stated "because your (cyclically based) analysis succeeds mainly in describing and summarizing the data, and does not dig deeper to identify more fundamental factors or disturbances that drive the movements in those data, the Co-editor and I also feel that the paper’s contribution, though again certainly positive, would be better-suited for a journal that specializes to a greater extent in...."  - anyway I'm sure you get the idea!!  So what I want you to note here is the word "disturbances" - this is another way of what economists term as "shocks" - what economists assume drives cycles in growth.

A lot of this methodological baggage that economists carry around with them comes from physics and indeed astrophysics - and making an analogy with both of these subjects is extremely instructive if you think about it.  The earth travels in an orbit around the sun and there is a gravitational pull which makes this happen.  Of course if the sun weren't there, the Earth would travel in a straight line, but there again none of us would be here if that happened so we are thankful for the cycles that the sun creates. Now in the case of the sun, it is gravitational pull that causes the planets to keep orbiting in an elliptical fashion (hence the seasons) and in fact we should all live in fear of "shocks" to this orbital behaviour (see Hollywood movies such as Deep Impact and Armageddon) although luckily our atmosphere protects us from most of these problems.  The point is with the economy the "shocks" are not really shocks - they are repetitive events that although are caused by different factors are much more likely to relate to cycles in human behavior rather than anything else. The idea of "bubbles" in mass human behaviour is part of this fascinating type of human behaviour because it is clearly cyclical - but there are cycles in lots of economic variables - exchange rates, investment, consumption, technology, etc. and some of the cycles are not like bubbles - so causing large falls in prices when they burst - in some variables there just appears to be undulations that seem to continue through time.  Why this is we are not sure, but certainly research appears to confirm this.

When aggregated, all these different components of the economy will lead to complex interactions which in turn  drives our GDP growth.  Sure we can get knocked off track by external "shocks" but I don't believe that is really what drives what we see in the macroeconomic aggregates.  Just look at US GDP growth below:

The chart shows the growth of GDP over time - very different from the actual trajectory of GDP which no doubt inspired the original idea of "shocks" pushing the level of real GDP around.  But what is important to a macroeconomy?  I would suggest that it's growth in real GDP, not the absolute level of real GDP. 

Looking at the chart if there were no shocks then the growth would show a consistent direction if it was converging to a "natural" growth rate. So the only way you would get a pattern like we see in the above chart is because there are shocks happening at at least a 6-monthly frequency.  So that means that the cyclical approach still has legs in my view. 

Certainly if you buy into this, the chart suggests to me a variety of cycles going on at the same time - and right now given the recent data we appear to be in one of those shorter cycle downturns which suggests that the current "deceleration" in growth that many report as driving the stockmarkets right now is only temporary.  I also hear renewed talk of double dip recessions again - but given we know that the business cycle (that causes the severe downturns) operates at a frequency of 3 to 10 years, without some massive shock to the US economy, how could this be?  Clearly these "double dippers" are fringe, but the main point here is that we should not expect the recovery to be smooth.  Looking at GDP even in good times it is extremely volatile, so why should it not be in recovery periods as well? 

The market for handheld devices

OK, this is a rarity for this blog, which generally talks about macroeconomic issues, but I've decided to do a posting about the market for handheld devices or smartphones. This is because things are getting REALLY interesting in this market with recent events in the stockmarkets for the companies that make these devices also reflecting the uncertainty about the future!

So what are these events you may ask?  First, I would say the unbridled success of the iPad has taken a lot of people by surprise. So things got even more exciting when Apple recently launched the iPad2, and announced record profits, sending its stock soaring yet again. Second, on the other side of the Atlantic in Espoo, Finland, back in February a memo leaked from Nokia's new Canadian CEO, Stephen Elop, which talked about a "burning oil rig" and making the choice to either jump into the icy waters (presumably off Newfoundland or Norway as to my knowledge, Finland has no oil rigs!) or stay on the burning deck. In other words something big was about to happen.  Nokia's stock price edged higher after it announced slightly disappointing 4th quarter results, in anticipation of Elop's announcement on February 11th of a long-term strategic alliance with Microsoft. When the announcement came it was a big surprise for Europeans: Symbian would be scrapped, Meego downgraded to "future disruptions" and Windows OS will run on Nokia hardware with new phones to be released later this year. The share price sagged by nearly 20%. The next event was the Blackberry Q2 results, which were better than expected, but the sales growth was mostly outside the US and likely would still pale in comparison to Apple's results, so Research in Motion (the Canadian manufacturers of the Blackberry) experienced nearly a 10% selloff. Apple's results were astonishing, showing that the company had now overtaken Nokia (in terms of revenue) as the biggest supplier of cellphones, with an 86% increase in units sold, taking them to 18.6m units in Q1 of 2011. And yet Nokia still manages to ship 108.5m handsets worldwide, completely eclipsing all competitors.

What is interesting about the handheld device market is that it is boiling down to 4 major competitors worldwide: Apple, Google, Blackberry, and Nokia/Microsoft. These "ecosystems" will form the basis of future developments not only of smartphones, but also of tablet devices. Apple apparently has the advantage in both handheld devices and tablets, as it's iPhone continues to fly off the shelves, a new iPhone is on the way in the fall, and it's iPad2 begins to sell in major quantities. Google's approach is a little different - it essentially licenses its flexible software platform - Android - to phone makers, and Blackberry has tremendous support in the business community and is gaining support overseas. The new alliance between Nokia and Microsoft implies that Nokia will play to its competitive strengths - hardware, and Microsoft will supply the mobile version of Windows as the OS. The big unknown is Meego - Nokia's linux-based system that is still under development with Intel, and although the previous linux-based OS called Maemo did ship in a Nokia handset (the versatile N900) it was a phone mostly sought after by developers and geeks and not particularly user friendly.

While Apple is clearly fighting for the upmarket brand-conscious developed world consumer, Nokia has clearly got a huge range of devices to support the developing world market, and unless Chinese competition knocks it off its stride, it can continue to rely on some brand loyalty in these markets. Blackberry phones have cornered the business executive market, and although they are not "fun" phones with 1000s of apps, their users are loyal, and will likelly not change handsets. This is why Nokia's Elop said recently that in fact it was Google's Android that was the main competitor to a Nokia/Microsoft handset, and not the iPhone.

So where does that leave the consumer?  Given the choice out there right now, likely dazed and confused by the options available!  The different business models will likely sell differently in different parts of the world, and so it is not clear whether further consolidation will take place quickly. Certainly Apple's growth cannot be unlimited, but at the same time Nokia was already on a second life after it's disastrous forays into TVs after it's humble beginnings as a maker of tires and business furnishings. So can its alliance with Microsoft really bring the products to market that developed and developing world consumers want? Microsoft is widely seen as a dinosaur of the computing industry but it certainly does give Nokia access to a ready made OS and the North American market. Will the Android system morph into something more flexible and will Google loosen it's control on accessing the source code? Clearly a winning OS is not enough - you have to have a certain critical mass of apps and a quality piece of hardware to make a winning phone. So far Apple has clearly won the battle, but to win the war, it will have to ensure that it's future hardware lives up to expectations - the iPhone4 reception problems luckily did not pan out into anything more serious - but clearly (and this goes for all handset makers) one bad misstep and fickle consumers could depart in droves.

Japan + the markets + higher oil prices = another (mild) recession?

OK, I know it's been a considerable amount of time since my last posting, but I've been busy interviewing and doing conference presentations, but also a little blown over by world events in the last 6 weeks.  Each time I've sat down to write about one event, another seems to happen!  The events in the Middle East, and particularly the fall of Mubarak in Egypt and the uprising in Libya, have been astonishing, while the earthquake, Tsunami and nuclear fallout in Japan have been heartwrenching to watch unfurl, and the market reaction has been knee-jerk to say the least. All these bits of the jigsaw might be relatively easy to analyze by themselves, but the interactions between them all have been difficult to piece together and understand in the context of the world economy. 

So let's start with the fallout (literally) from Japan's tsunami, earthquake and tsunami.  Japan's economy was beginning to show some feeble signs of recovery prior to the earthquake, tsunami and nuclear fallout, but this disaster changes everything.  The fall in Japanese stock prices, as Warren E. Buffett, the billionaire investor recently stated, thinks the disaster in Japan doesn’t change the economic future of the country, but with the market turmoil creates a buying opportunity for investors (see http://www.businessworld.in/bw/2011_03_21_Buffett_Japan_A_Buying_Opportunity.html).  I would go one step further, and say that it does substantially change the economic future of the country, and for one simple reason - the stimulus that the rebuilding must bring to the Japanese economy.  As any undergraduate principles of economics student knows, a disaster, as long as it happens in a country, region or state that has the resources to rebuild ( - and despite it's massive public debt, Japan certainly has the capacity to rebuild through issue of either savings bonds to the thrifty Japanese general public or by special financing bonds for public infrastructure), will lead to higher GDP than before and often higher sustainable growth rates than before if this better quality infrastructure.  Think New Orleans and contrast this with Haiti and hopefully you'll get my point.  The key here is that this rebuilding effort may begin to utilize resources that have been idle, or largely idle over the past 18 years, allowing Japan to break out of it's deflationary liquidity trap.  In economics jargon, I see the disaster in Japan as a shock that might allow Japanese GDP to start growing in a more normal way again.  That can only be good news for the rest of the world.

What about the impact on other countries and therefore the global stockmarket reaction to this?  Well Japan had a housing meltdown in the early 1990s with no apparent impact on the rest of the world, so why would the destruction of wealth this time around have a sizeable economic impact on the rest of the world?  Hence my reaction to the skittishness in the stockmarkets about the Japanese situation is that myopia will soon overcome any nervousness about the global fallout from the Japanese situation.

Now to the situation in the Middle East.  The main threat here is continuing instability and that clearly affects the oil price.  There are 2 possible scenarios that I see playing out - either a) the "low-hanging" fruit has already been picked (i.e. countries that could have a relatively stable transition of power) and populist uprisings in the "high-hanging" fruit will cause massive instability if (and that's a big "if") this wave of popular protest continues or b) the action over the Libyan situation causes a "domino" effect to occur i.e.the wave of popular protest against unpopular autocracies gathers steam and becomes unstoppable.  Clearly scenario a) is the most worrisome for the rest of the World, and would entail much higher oil prices than where we're at, whereas presumably scenario b) would imply only temporary disruptions and a much better long term future for the region.

So if much higher oil prices occur, would this give us a "double-dip" recession?  I think the risks are certainly there in certain countries, and it would be a similar set of recessions to those that occurred in the 1970s with oil prices the catalyst, but I don't think the natural international business cycle points in this direction right now.  I think though on balance this has a much lower risk than continued growth, particularly in the developed world, as countries that have significant long term stimulus efforts in place (such as the US) will not be completely knocked off course by significantly higher oil prices. The major risks are to countries such as the UK and clearly higher oil prices would cause a further slowdown in countries such as China and India.  Countries like Brazil and Canada could benefit from such a scenario though, although obviously the benefits would not be evenly spread throughout the economy.
 
Certainly, once again, we live in interesting times!!

Texas Trouble

Paul Krugman recently wrote about a “Texas Tragedy” in relation to the budget cuts that are going to have to be made in the upcoming legislative session in Austin. Certainly this last election in Texas was a farce as the true extent of the budget problems were kept from the voters (in my cynical mind) to ensure a Republican victory and of course the re-election of Governor Rick Perry. And now the alarm bells are certainly ringing loud and clear in all state-funded institutions (including my own), with virtually all planning on hold now until the extent of the cuts is made a little clearer.

But for those like Krugman who live outside of the State, I should start off by saying that there is really one group that is going to be drastically effected in Texas – the poor. For those who “have” and who are educated, the Texas budget crisis is not as bad as might be expected. Certainly at the University level, with several Universities now running early retirement programs, with some programs being abandoned and plans to combine existing programs between Universities in the same geographical proximity, this should yield some savings and so ease the pain. In general educated workers tend to be more mobile as well, so they are likely to head for other states if they are laid off in the private sector. Plus the housing market downtown hasn’t nearly been as bad in Texas as say Florida or Arizona, so there is still considerable mobility.

No, the tragedy of the cuts lies with the poorer segments of the population and the economically dislocated. But more about that in a moment. I first want to explain the way in which budgets are formulated in Texas, which is unusual, to say the least.

In Texas the legislature meets every 2 years for a short period of time in the spring and hammers out the budget as well as any new legislation. This saves money on one front, as paying annual salaries for legislators is not required as it is in most states or Canadian provinces with standing legislatives. But it leads to all sorts of problems on other fronts. First, a budget is not enacted and revised every year ( - the legislature in Texas is in essence currently making 2 budgets – one for 2011 and one for 2012). So when there is an economic downturn, the budget isn’t adjusted gradually, but on a two year basis – hence much larger cuts are likely this year in the state budget given the deficit last year, and this won’t be revised for another 2 years even though the economy could rebound In the second half of 2011, giving the State a surplus in 2012. Second, it also leads to suboptimal lawmaking as well, as laws are made during the legislative session, and then cannot be revised until 2 years later. While I support the idea of a part-time legislature as a cost-saving measure, I do think the legislature should meet at least once a year, perhaps for a short session just to revise budgets and amend existing laws, if needed.

The other thing that I think is a little crazy in Texas is that the State only has a sales tax for general tax collection purposes. Particularly during recessions like the most recent downturn, US consumers retrenched, leading to an increase in the US savings rate, which I (like most other economists) think was a good thing, as the US savings rate has been chronically low for some years and was a source of international economic imbalances. But of course, a higher savings rate really clobbers state revenues, and causes a disproportionate decline in revenues. To make things worse, the state even has a “tax free” weekend in September at the beginning of school year which caused an absolute shopping blitz in 2010 as cash-strapped parents, among others, avoided paying taxes on all clothes and school items.

Texas, like most states, has Balanced Budget legislation, and while this is all well and good, it really has a terrible impact if the recession occurs immediately after the legislature meets, as any overrun during the subsequent nearly 2 years has to be corrected with a surplus as soon as the legislature meets again two years later. That is the situation that we now find ourselves in. Here, in my opinion, Texas should really learn from Europe. The one part of the Stability and Growth pact that is, in my opinion, very sensible, is the part relating to budgetary measures during periods of recessions. The pact states that member states are exempt from abiding by the 3% of GDP limit on budget deficits in severe recessions. Of course that means that Texas would have to be able to issue bonds to cover the deficit, and that could lead to a build up of state debt that was unsustainable. I would argue that there are other options – one would be to have a temporary increase in tax (what might be called a “solidarity tax”) – another would be to build up an even bigger fund than the current “rainy day fund” ( - perhaps calling it a “recession fund”) which could be spent to offset a decline in state revenues during bad times.  Another approach would be to calculate a cyclically adjusted budget  metric that would automatically yield a surplus in the expansionary phase of the business cycle and a deficit in

the contractionary phase.

Of course the type of taxation we have in Texas is also, in my view, a problem. What Texas really needs is an income tax, and democrats have long recognized that this is also the fairest way of taxing the population given the extremely wide distribution of income in the state. But of course Democrats these days never get a majority so have never been able to enact such a change, and many Republicans don’t like the idea as it would mean greater taxes for their constituency – the rich. But apart from the politics, this tax system is a problem, as it means that the extreme poor still get taxed when they spend, even if they hardly have any income. With an income tax you could exempt all the extreme poor from paying the tax and at the same time get rid of the sales tax completely like New Hampshire has done.  I think most Texans are afraid that introducing an income tax would leave 2 taxes in place ( - that is, they don't trust their State government to repeal the sales tax), so doing this would have to be entirely contingent on removing the sales tax. 

So these are my proposals for Texas. First, set up a revenue commission at the state level to explore the implications of changing the tax system in Texas and then present this to the State politicians to start a debate on moving to a fairer tax structure. Second, get rid of the “tax free” weekend as it is a ridiculous gesture ( - why should I not pay tax just because of when I’m available to shop?). Third readjust the budget every year with a short session of the legislature. Lastly, establish a “recession fund” into which the state has to put a certain percentage of revenues during good times so as to offset any drop in revenues.