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German voters go to the polls on Sunday to determine the future leadership of their country – and perhaps the future of the Eurozone, as well.
With the continent’s largest economy, and the political clout to match, Germany is a central player in the Euro crisis.
Odds are good that Chancellor Angela Merkel, who has been criticized for pushing crisis-stricken governments to drastically curb their spending, will be reelected. However, her Christian Democratic party may have to form a coalition with parties whose fiscal stance is less hawkish.
Economists Robert Barbera, Olivier Jeanne, and Jonathan Wright and political scientist Nicolas Jabko recently outlined the challenges still facing the common currency. Speaking at a forum with graduate students at the Johns Hopkins Department of Economics, the scholars pointed out four hard truths the new German leadership – and all of Europe’s politicians – will have to confront to get Europe back on track. David Dagan, a graduate student in political science, wrote this summary of their discussion.
1) This crisis was not caused by government debt
The Euro crisis was touched off by the profligate fiscal policies of the Greek government, but focusing on this triggering event in isolation can be misleading. The majority of the debt that ended up going sour in Europe was privately held: Spain and Ireland, in particular, fell victim to housing bubbles in the American mould. What’s more, much of the problematic Spanish and Irish debt was originally issued by German banks, Barbera and Wright noted.
As in the U.S., the tailspin in the private credit markets posed a mortal threat to European banks, who had to be bailed out by their governments. It was these bailouts that then created giant public-sector liabilities.
“It’s only in Greece that it really was fundamentally a pure government fiscal problem, and yet the narrative of ‘Where the Eurozone crisis comes from’ seems to fit the Greek story and no other story,” Wright said.
2) Austerity was a political choice – and not just in Germany
Merkel has taken a lot of heat for her insistence that countries deeply slash government spending in exchange for aid packages. Berlin’s emphasis on austerity is often explained in almost psychological terms, as the product of the myopic economic views of German elites – particularly, a morbid fear of inflation.
Not so fast, Jabko said. Austerity won the day largely because it was a politically savvy choice. The austerity prescription grew directly out of the narrative that the Eurozone crisis had been the product of irresponsible government spending. And that narrative was useful to politicians of all stripes.
In Germany, this story allowed politicians to evade questions about how Berlin had contributed to the crisis. Otherwise, there could be uncomfortable questions about the lending practices of German bankers in southern Europe. Similiarly, it might be noted that Germany had spurred the southern-Europe bubble by dragging down Eurozone interest rates in the early 2000s, when its economy was hurting.
But don’t just blame the Germans, Jabko said. Many observers say that Germany forced austerity on its struggling EU partners – but that is not the whole story. The same narrative of profligate spending was adopted by many opposition politicians in the crisis-stricken countries, too. This move allowed them to score political points against ruling parties and ultimately to take over the levers of power. Once in government, these politicians brought the story to its logical conclusion by imposing austerity, and they were often able to evade responsibility for these painful policies by blaming incumbent governments as well as foreign creditors.
3) Either German workers do better, or southern workers do worse
Jeanne explained that the Euro’s financial crisis is rooted in a deep structural problem: Germany makes things more cheaply than southern Europe. The Germans hold that advantage for two reasons: first, they are more productive per labor-unit than most countries, and second, labor and business have cooperated to hold wages down over the last decade.
The imbalance in production costs leads directly to an imbalance in the terms of trade: southern European countries buy much more from Germany than they sell back to Germany. And such a trade imbalance is always accompanied by an increase in foreign indebtedness. In other words, the debt plaguing southern Europe is a logical result of underlying imbalances in the real economy.
For these imbalances to be corrected, the costs of production between Germany and its neighbors must even out. And there are two ways to make that happen: lower wages in southern Europe, or raise wages in Germany. Put simply, either German workers get paid more, or southern workers get paid less.
Of course, higher wages are not all good news for the Germans. They would produce higher inflation, which hurts savers – and Germany is a nation of savers. A recent paper estimates that Germany would need to experience an inflation rate of 4 percent annually for five years, coupled with zero inflation elsewhere for the same period, to close the gap with its neighbors.
4) A breakup leaves Germany on the hook, too
But before Germans refuse to swallow that bitter pill, they should consider something else. As Wright explained, the architecture of the European banking system leaves them extremely vulnerable in the worst-case scenario of a disorderly breakup of the Eurozone. At the moment, capital is flowing into Germany like beer at Octoberfest. The reason is that bank deposit insurance does not insure against the risk of currency breakup. If Spain leaves the Euro, then Spanish bank deposits will still be insured, but the payment will be in devalued pesetas.
The mechanics of these deposit transfers matter profoundly, however. In a single currency area, the deposits are transferred by the Bundesbank – Germany’s central bank – making a loan of equal value to the Spanish central bank. And that’s not good news for the Germans. Because the same risk that motivated the original depositors to shift their assets – the prospect of a Spanish exit from the Euro resulting in a devaluation of debt – now resides with the Bundesbank.
The Q2:2013 rise for real GDP, 1.7%, was better than expected and much better than feared. The two big misses, relative to expectations, were a contribution from inventory investment and only a modest drag from government spending. Raw data on stockpiling suggested a big drag from inventory investment. Not so. In addition, the drag from government was considerably smaller than expected—sequester notwithstanding.
More interesting, I think, was the revision to back years. The two quarter average for real GDP growth, Q4:2011-Q1:2012, was previously estimated to be 3%. Recall that during this period we now see a boomlet in payroll jobs gains—the average monthly increase is 226,000. According to this morning’s revisions, those hefty job gains now are associated with a much more substantial 4.3% annualized real GDP growth rate.
The full year growth rate for 2012 now stands at 2.8%, substantially higher than the 2.2% pace initially estimated. As it turns out the jump for both Q4:2011 and Q1:2012 real GDP overwhelms the effects of mild downward revisions for later quarters (see below):
|2011:Q4||2012:Q1||2012:Q2||2012:Q3||2012:Q4||2013:Q1||2013:Q2||Year 2011||Year 2012|
And going forward? ADP’s tally of July job growth, at 200,000, was impressive. Whatever the effects of sequester, they should be history by this year’s fourth quarter. An economy growing at near 3%, the revised full year 2012 figure, still makes sense to me.
Fed Chairman Bernanke commented on the monetary policy outlook at a speech at the NBER a couple of weeks ago, and then again in Congressional Testimony. He gave a clear signal that the current voting members of the FOMC plan to maintain a highly accommodative overall stance of monetary policy for some time. These remarks led to an unwind of some of the recent increase in longer-term interest rates.
The problem is that Fed communications reveal a clear split on the FOMC. The most glaring instance of this is that according to the FOMC minutes, about half of the participants at the last meeting expected to stop asset purchases this year, while the Chairman has presented a timeline that envisions them continuing into 2014, conditional on the economy healing as expected.
Much of this has to represent a disagreement between those who are currently voting members of the FOMC and non-voters (the term “participants” includes both). But if we want to predict what the Fed will do in 2014, it is the voters in 2014 that matter. The composition of the FOMC in 2014 will be very different from what it is today, and more hawkish.
Among the five regional Fed presidents that will be voting are Fisher, Plosser and Pianalto, all of whom have signalled in speeches that they are in a hurry to end asset purchases. Jeremy Stein will still be there, and Jerome Powell might be (his term ends at the end of January). Both of these seem to have been pushing the Fed in a hawkish direction. There’s a reference in the last minutes to two voting members wanting to curtail purchases relatively soon, and I am guessing that their names are Powell and Stein. So straight away in 2014, there could be 5 voting members who I suspect would in their heart of hearts like to stop asset purchases yesterday. Elizabeth Duke has resigned and others could leave soon. Most importantly, Bernanke himself is unlikely to be there: his successor will not be more dovish than him.
What I think it all means is that unless there is a new crisis (from Europe or China), or a sharp slowdown in the US, tapering will start in September and the asset purchase program will be wrapped up early in the new year. After that, the next move is a tightening of the federal funds rate. I woudn’t expect that to happen for quite a while. Still with a hawkish committee evidently heavily rethinking the role of asset bubbles in monetary policy, I would not be at all surprised to see a historically-normal term premium returning to interest rate futures and bond markets.
There was an article in the NY Times on July 19 by Floyd Norris that quotes CFE co-director Bob Barbera and has his fingerprints all over it.
Bob Barbera was interviewed on CNBC about monetary policy and the exit strategy. The interview is here:
Ten-year nominal Treasury yields have risen about a percentage point since the start of May. Much of this increase has come right after FOMC communications, notably the Chairman’s JEC testimony and the last FOMC press conference. The timing makes clear that the market interpretation of these communications accounts for a big chunk of the runup in yields, which is in turn large enough to potentially choke off the recovery. But these communications had both hawkish and dovish elements and the FOMC is clearly surprised by the magnitude of the reaction.
The reaction seems outlandishly large to me, but in this piece, I make an attempt to interpret what could account for recent behavior of fixed income markets.
In 2012, the FOMC stated that it would engage in asset purchases until the outlook for the labor market had improved “substantially” and “in the context of price stability”. At the last FOMC press conference, Chairman Bernanke expressed the Committee’s intention to start to taper asset purchases at a time when they project unemployment to be around 7.4 percent, and to end the purchases at a time when they project unemployment to be around 7 percent. The commitment to keep going with purchases until there was a “substantial” improvement in the labor market was first made when the unemployment rate was 8.1 percent, but was arguably reset by the expansion of the asset purchase program in December 2012, when the unemployment rate was 7.8 percent. Either way, the June press conference sets the hurdle for a “substantial” improvement in the labor market outlook surprisingly low. This is especially true since most of the decline in the unemployment rate to date has been through a falling labor force participation rate. And inflation has come in below expectations, and it isn’t reasonable to think of the “in the context of price stability” clause as being one-sided. All told, it seems to me that the FOMC is at least on the borderline of reneging on its commitment to asset purchases.
Cold Feet about LSAPs
More broadly, throughout 2013, the FOMC has given a strong impression of buyer’s remorse about asset purchases. As early as the March minutes, they were talking about stopping asset purchases entirely this year. Moreover, they have not communicated why, or even explicitly admitted that there has been a change of heart. Perhaps it is concern about the politics of the Fed making smaller payments to the Treasury as they tighten monetary policy with a big balance sheet. Or perhaps the Fed is rethinking their role in dealing with asset price bubbles. We know that there is a factor X at work, but are left guessing as to what it is.
Suppose that the Fed’s change of heart has to do with bubbles. The nature of bubbles is that they last for a while. If the Fed is rethinking how monetary policy ought to respond to bubbles, and if financial markets remain frothy after asset purchases have ended, isn’t at least possible that the Fed would respond to this by hiking the funds rate sooner than would be justified by the labor market and inflation? Investors’ desire to hedge this risk has apparently driven term premia up. Term premia are still very low—perhaps even negative—but changing signals about the exit strategy have brought term premia closer to their historic norms. I think that this accounts for much of the rise in interest rates over the last two months.
Monetary Policy Expectations and Interest Rate Futures
Money market interest rate futures contracts have moved sharply over the last two months and as FOMC members have pointed out, the magnitude of the change is very large. But what about the current level? The figure below plots the expected federal funds rate implicit in Eurodollar futures as of July 1, with the Fed’s “rule of thumb” term premium adjustment (as described in a 2008 Journal of Monetary Economics paper by Monika Piazzesi and Eric Swanson). The figure also plots the average federal funds rate prediction from the latest FOMC Summary of Economic Projections (SEP). The SEP has a slightly steeper pace of tightening. Now this is skewed by three respondents who forecast a 3 percent funds rate. On the other hand, the term premium adjustment used here has historically been too small, especially in the period before a tightening cycle begins. Overall, the current level of Eurodollar futures is quite consistent with the SEP and a very modest term premium adjustment.
By most estimates, term premia in Eurodollar futures and longer-term Treasuries have been substantially negative for the past few years. This was always likely to come to an end as the economy recovered. But the FOMC’s surprising haste to cease asset purchases seems to have accelerated the normalization of term premia.
Eurozone officials are considering a proposal to do away with one- and two-cent Euro coins, which cost more to make than they are worth. It may be a worthy cause, but amid historic levels of unemployment, grim economic forecasts, and a financial crisis that threatens the future of the currency itself, it would seem European leaders have bigger problems to talk about.
Economists Robert Barbera, Olivier Jeanne, and Jonathan Wright and political scientist Nicolas Jabko met recently to discuss some of those higher-stakes issues – and the outlook for a European course correction. David Dagan, a graduate student in political science, moderated the conversation.
How has the economic outlook for the Eurozone changed since our first conversation, last fall?
RB: The economic data has done nothing but get worse. Germany’s now deteriorating, Spain’s in a depression. And of course, Italy is having a difficult time.
OJ: I think we agree that in the best-case scenario we are looking at 10 years of slow growth in Europe. From that point of view, I don’t think that we are more optimistic now than we were last time.
If Germany really starts slowing down, would leaders there reconsider some of their policies?
JW: As Bob says, the slower growth in Germany is the most hopeful sign in the Eurozone.
RB: And quite interestingly, we’re getting help in that regard from a very odd place. Germany exports cars to the U.S. and capital goods to China. And Germany competes viciously in those two trades with Japan. Germany had a spectacular tailwind because the yen doubled in value versus the Euro from 2009 to 2011. Well, the Bank of Japan finally discovered that you don’t have to sit by and watch your country go into a depression because of your currency – and they’ve taken the yen from 75 to 100 versus the dollar. And as a consequence, now Germany is getting hit with a big trade headwind. And I think Jonathan’s exactly right – the best hope for Europe is, Germany’s about to hit the skids big time.
OJ: Right, but I am not sure that a weak German economy will move the political dynamics in a good direction in Germany. The European Central Bank can lower its interest rate a little bit more and there may be less pressure for fiscal austerity. But is Germany going to say suddenly, ‘Oh, because our economy is not doing well we are going to support a much more integrated Europe, we are going to support the banking union, we are going to support more fiscal solidarity?’ I don’t see it.
NJ: Well, that’s where the results of the German elections of September 2013 come in, because it really depends what kind of coalition (German Chancellor Angela) Merkel finds herself in. And if you look at what happened in 2008, despite the fact that German officials never talked about Keynesianism, they did quite a big stimulus in comparison to everyone else in Europe. So you could imagine a German stimulus, although they will probably resist a massive episode of deficit spending.
So what kind of political outlook are we left with?
NJ: What’s interesting on the political side is that early on there was this push for austerity. (But) there was a first inflection in the spring of last year when France changed presidents and Italian Prime Minister Mario Monti became a contributing force to the debate on what to do. Monti’s contribution at the time was to push for banking union and to sever the link between banking crisis and sovereign crisis. But there was still an agenda of austerity for at least a considerable part of Europe. And so the next step was when Monti had to step down and you had popular outbursts of anger … in Italy and increasingly in France … And so political factors that existed at the beginning only in peripheral countries are basically moving to the core, and I’m sure that the German chancellor is aware of that. So we’ve now reached a second, more serious inflection point, I think, away from austerity… Now the question is what do you do when you give up (the idea of) austerity? Is Germany going to underwrite an expansion of demand? I have my doubts.
RB: They’re going to move from bloodletting to leaches.
Are there any useful comparisons to be drawn between the European and American austerity debates?
RB: Well, we had the fiscal cliff. That was our opportunity to join Europe into diving into oblivion. And we avoided that. The sequester is nickels and dimes relative to what’s going on in Europe.
OJ: It seems to me the two systems are dysfunctional in different ways. That works to the benefit of the US – not so much by design.
NJ: In the two cases you have central banks and central bankers who are asked to come up with ways to mop up the mess on the fiscal side. And there is only so much that central banks can do. I mean, that’s part of the problem. The Fed can do all the monetary easing that it wants – it’s not going to completely change the game. Same thing for the ECB.
RB: (But) if the ECB had done everything they swore they weren’t allowed to do and then ultimately did (anyway) – if they did it all in April of 2010, Europe would not look like it does now.