Assessing the risk of a fiscal crisis

February 5, 2012 4:35 pm

by Gavyn Davies

The debate on the correct setting for fiscal policy at a time of recession is probably the oldest debate in macro-economics. One key element in the debate is the trade off between supporting output growth in the short term, versus the need to control the growth of public debt in the long term.

There are some economists who do not recognise that this trade off exists at all, because they claim that an increase in the fiscal deficit cannot impact aggregate demand, even in the short run. But this is not a view which I believe to be supported either by empirical research or by economic theory (except on some very restrictive assumptions about Ricardian Equivalence or Says Law).

I recognise that this last statement is very contentious, but it is not my subject today. Instead, I would like to take as given the assumption that a temporary easing in fiscal policy (of the type advocated last week by Martin Wolf for the UK) will increase aggregate demand in the near term. Accepting this, I would then like to ask whether the benefits of an immediate boost to aggregate demand outweigh the costs of higher public debt, and the consequent risks of a fiscal crisis. That is the nub of the issue which is, or should be, exercising policy-makers in the real world today.

How should this question be approached? Sometimes, advocates on both sides of the debate assume that the answer is obvious.
Supporters of fiscal easing tend to take it as axiomatic that higher public debt will have no effect on inflation or interest rates, and frequently quote the example of Japan in support of their argument.

Meanwhile opponents of fiscal easing (like the UK government) take it as equally axiomatic that a fiscal crisis is to be avoided at all costs, and quote the examples of Greece, Italy and Spain to support their case. They point out that public debt in some developed economies is higher than it has ever been before in peacetime (see the IMF graph below), and conclude that it simply must come down before disaster strikes.

But surely this question involves a much more delicate balance of risk and reward than is often acknowledged. The real question is how much risk a government wants to take of encountering a fiscal crisis over a given period, and how much that risk is changed by increasing the budget deficit to boost GDP. Quantifying these two steps is extremely difficult, but is essential if we want to move beyond the biases and simple assertions which so often pass for public debate on fiscal policy.

Recent publications by the Fiscal Affairs Department at the IMF enable us to make some progress. Last year, in Assessing Fiscal Stress , IMF economists estimated some new indices of fiscal stress, which are driven by 11 different economic variables, including budget deficits, debt ratios, financing needs and demographic trends. The fiscal stress index varies between zero and one, with higher numbers indicating greater concern about fiscal sustainability. The indicator has behaved as follows for the developed economies in recent years:


The most relevant line on the graph is the green one, which shows that the fiscal stress index for the developed economies, weighted by GDP, has more than doubled since the 2008 crisis. The indicator now stands at about 0.43, compared to 0.17 in 2007. The main reason for this, of course, is that budget deficits and refinancing needs have increased greatly during the recession.

We can now use this piece of information to address the questions posed above.

The IMF study also provides a chart which translates the level of the fiscal stress index into the probability that a country will enter a fiscal crisis, or remain in fiscal crisis, within one year. Obviously, the higher is the stress indicator shown on the horizontal scale, the greater the probability of fiscal crisis, shown on the vertical scale. When the stress indicator is at its present level of 0.43 for the average developed country, there is a probability of around 0.15 that there will be a fiscal crisis within one year.

Although that may be an acceptable risk in any single year, the risk does cumulate rapidly over 5 years (cumulatively 0.56) and 10 years (0.80). So the first conclusion is that something needs to be done to correct budget deficits and debt ratios over the medium term. That certainly is the case in the US today.

One rebuttal to this conclusion might be that the IMF study is based on the period from 1995-2010, when global excess savings were not as large as they are now. The increase in savings may reduce the risk of fiscal crisis today compared to the years in which the model was estimated, because there is more private money available to fund a government deficit at low interest rates. Another rebuttal could be that governments might decide that the consequences of a fiscal crisis are not necessarily fatal, and can (with difficulty) be reversed, so it might be worth running this risk anyway.

The second conclusion is somewhat different. If a country has a credible medium term commitment to reduce the fiscal stress indicator over the medium term, then it does seem that there is scope for a moderate increase in the budget deficit over a period of a couple of years to cushion a temporary period of recession in the economy. For example, a short term rise of two or three percentage points in the budget deficit would have virtually no effect on the probability of fiscal crisis in any given year (eg raising the probability of crisis from 0.15 to, say, 0.20), so it might be considered as a risk worth contemplating. That could well be the case in the UK today.

One final point. None of these conclusions is obvious, and they involve making difficult trade offs where policy makers can reasonably differ. Those who pretend otherwise are grossly over-simplifying a complex and critically important debate.

Gavyn Davies is a macroeconomist, co-founder of Prisma Capital Partners and former head of the global economics team at Goldman Sachs.


FEBRUARY 6, 2012
The Fed Votes No Confidence
The prolonged—'emergency'—near-zero interest rate policy is harming the economy.


We're now in the 37th month of central government manipulation of the free-market system through the Federal Reserve's near-zero interest rate policy. Is it working?

Business and consumer loan demand remains modest in part because there's no hurry to borrow at today's super-low rates when the Fed says rates will stay low for years to come. Why take the risk of borrowing today when low-cost money will be there tomorrow?

Federal Reserve Chairman Ben Bernanke told lawmakers last week that fiscal policy should first "do no harm." The same can be said of monetary policy. The Fed's prolonged, "emergency" near-zero interest rate policy is now harming our economy.

The Fed policy has resulted in a huge infusion of capital into the system, creating a massive rise in liquidity but negligible movement of that money. It is sitting there, in banks all across America, unused. The multiplier effect that normally comes with a boost in liquidity remains at rock bottom. Sufficient capital is in the system to spur growth—it simply isn't being put to work fast enough.

Average American savers and investors in or near retirement are being forced by the Fed's zero-rate policy to take greater investment risks. To get even modest interest or earnings on their savings, they move out of safer assets such as money markets, short-term bonds or CDs and into riskier assets such as stocks. Either that or they tie up their assets in longer-term bonds that will backfire on them if inflation returns. They're also dramatically scaling back their consumer spending and living more modestly, thus taking money out of the economy that would otherwise support growth.

We've also seen a destructive run of capital out of Europe and into safe U.S. assets such as Treasury bonds, reflecting a world-wide aversion to risk. New business formation is at record lows, according to Census Bureau data. There is still insufficient confidence among business people and consumers to spark an investment and growth boom.
Associated Press
Federal Reserve Chairman Ben Bernanke.

In short, the Fed's actions, rather than helping, are having the perverse effect of destroying the confidence of businesses and individuals to invest and the willingness of banks to loan to anyone but those whose credit is so strong they don't need loans.

The Fed's Jan. 25 statement that it would keep short-term interest rates near zero until at least late 2014 is sending a signal of crisis, not confidence. To any potential borrower, the Fed's policy is saying, in effect, the economy is still in critical condition, if not on its deathbed. You can't keep a patient on life support and expect people to believe he's gotten better.

Yet the economy doesn't need life support. Just the opposite. The patient needs to get up and start moving. We could get out of this mess, if only the Fed believed in the free-market system. In free markets, supply and demand find an equilibrium. That's true whether we're talking about the supply of grain and housing or cash and credit. But a functioning free market requires confidence that the government isn't imposing itself unnecessarily in the works, preventing supply and demand from returning to equilibrium.

All this can change with a shift in Fed policy. This is what investors, business people and everyday Americans should hope to hear from Mr. Bernanke after the next Federal Open Market Committee meeting:

"The Federal Reserve used its emergency powers effectively and appropriately when the financial crisis began, but it is very clear that the economy is on the mend and that the benefit of inserting massive liquidity into the economy has passed. We will let interest rates move where natural markets take them. Our experiment with market manipulation will stop beginning today. Effective immediately, we will begin to move Fed rate policy toward its natural longer-term equilibrium. With the extremes of the financial crisis of 2008 and 2009 long behind us, free markets are the best means to create stable growth. Our objective is now to let the system work on its own. It is now healthy enough to do just that. We hope today's announcement does two things immediately: first, that it highlights our confidencesupported by the data—that the U.S. economy is out of its emergency state and in the process of mending, and second, that it reflects our belief that the Federal Reserve's role in economic policy is limited."

There is a saying in finance: "Don't fight the Fed." It's now time for the Fed to step out of the fight. It did its job. Let's allow the free-market system to do its job. Doing so will restore business confidence and spur much needed new investment.

Mr. Schwab is founder and chairman of the Charles Schwab Corporation.
Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved



February 5, 2012

Things Are Not O.K.


In a better world — specifically, a world with a better policy elite — a good jobs report would be cause for unalloyed celebration. In the world we actually inhabit, however, every silver lining comes with a cloud. Friday’s report was, in fact, much better than expected, and has made many people, myself included, more optimistic. But there’s a real danger that this optimism will be self-defeating, because it will encourage and empower the purge-and-liquidate crowd.

So, about that jobs report: it was genuinely good, certainly compared with the dreariness that has become the norm. Notably, for once falling unemployment was the real thing, reflecting growing availability of jobs rather than workers dropping out of the labor force, and hence out of the unemployment measure.

Furthermore, it’s not hard to see how this recovery could become self-sustaining. In particular, at this point America is seriously under-housed by historical standards, because we’ve built very few houses in the six years since the housing bubble popped.

The main thing standing in the way of a housing bounce-back is a sharp fall in household formationeconospeak for lots of young adults living with their parents because they can’t afford to move out. Let enough Americans find jobs and get homes of their own, and housing, which got us into this slump, could start to power us out.

That said, our economy remains deeply depressed. As the Economic Policy Institute points out, we started 2012 with fewer workers employed than in January 2001zero growth after 11 years, even as the population, and therefore the number of jobs we needed, grew steadily. The institute estimates that even at January’s pace of job creation it would take us until 2019 to return to full employment.

And we should never forget that the persistence of high unemployment inflicts enormous, continuing damage on our economy and our society, even if the unemployment rate is gradually declining. Bear in mind, in particular, the fact that long-term unemployment — the percentage of workers who have been out of work for six months or more — remains at levels not seen since the Great Depression. And each month that this goes on means more Americans permanently alienated from the work force, more families exhausting their savings, and, not least, more of our fellow citizens losing hope.

So this encouraging employment report shouldn’t lead to any slackening in efforts to promote recovery. Full employment is still a distant dream — and that’s unacceptable. Policy makers should be doing everything they can to get us back to full employment as soon as possible.

Unfortunately, that’s not the way many people with influence on policy see it.

Very early in this slump — basically, as soon as the threat of complete financial collapse began to recede — a significant number of people within the policy community began demanding an early end to efforts to support the economy. Some of their demands focused on the fiscal side, with calls for immediate austerity despite low borrowing costs and high unemployment. But there have also been repeated demands that the Fed and its counterparts abroad tighten money and raise interest rates.

What’s the reasoning behind those demands? Well, it keeps changing. Sometimes it’s about the alleged risk of inflation: every uptick in consumer prices has been met with calls for tighter money now now now. And the inflation hawks at the Fed and elsewhere seem undeterred either by the way the predicted explosion of inflation keeps not happening, or by the disastrous results last April when the European Central Bank actually did raise rates, helping to set off the current European crisis.

But there’s also a sort of freestanding opposition to low interest rates, a sense that there’s something wrong with cheap money and easy credit even in a desperately weak economy. I think of this as the urge to purge, after Andrew Mellon, Herbert Hoover’s Treasury secretary, who urged him to let liquidation run its course, to “purge the rottenness” that he believed afflicted America.

And every time we get a bit of good news, the purge-and-liquidate types pop up, saying that it’s time to stop focusing on job creation.

Sure enough, no sooner were the new numbers out than James Bullard, the president of the St. Louis Fed, declared that the new numbers make further Fed action to promote growth unnecessary. And the sad truth is that the good jobs numbers have definitely made it less likely that the Fed will take the expansionary action it should.

So here’s what needs to be said about the latest numbers: yes, we’re doing a bit better, but no, things are not O.K.not remotely O.K. This is still a terrible economy, and policy makers should be doing much more than they are to make it better.

February 5, 2012 8:40 pm

Europe’s banks face challenge on capital

Activists of the Occupy Frankfurt movement have set up a fire place near the Euro sculpture in front of the European Central Bank

The European Banking Authority is to challenge a significant proportion of the capital restructuring plans put forward by the continent’s leading banks to meet tough new capital requirements, say three people familiar with the process.

The regulator said in December that 30 banks needed to boost capital by an aggregate €115bn to reach a 9 per cent target for core tier one capital, a key measure of financial strength.


The banks were given until January 27 to submit plans to the EBA, via national regulators, outlining how they would meet the requirement. The plans will be discussed by the EBA board next week.

According to one person close to the process, as much as half of the measures outlined in those plans do not look credible. There are two particularly contentious tactics being employedshifting the way in which a bank calculates the risk-weighting of its assets; and promising asset sales that are unlikely to attract buyers.
Projected profits for the period to June also appeared over-confident in some cases, given the worsening outlook for the eurozone economy.

Some officials said privately last month that they expected Germany’s Commerzbank, which had an EBA stress test shortfall of €5.3bn, and Italy’s Monte dei Paschi di Siena, with a €3.3bn shortfall, to find it particularly difficult to meet the requirements without state aid. Since then, Commerzbank has claimed it has already generated €3bn of fresh capital.
On Friday, German national regulator Bafin echoed that positive expectation.

Only one group, Italy’s UniCredit, has opted for a rights issue to raise capital. All other banks have come up with a combination of asset sales, risk-weighting recalculations, profit retention projections and so-called liability management exercises, involving the buying back of debt that is trading below par-values, a process that triggers an immediate capital gain.

The EBA stress tests, and the capital deficits the regulator identified, have triggered vociferous complaints from banks across the continent. Politicians, particularly in Italy and Germany, and some national regulators have also expressed doubts about the exercise and the danger that it could exacerbate a credit crunch.
Against that background, the EBA appears to have shown a growing willingness to compromise on the details of the capital restructuring process.

The regulator plans to monitor asset sales to insure they are not damaging to the economy and may allow banks some flexibility on the timing to help avoid fire sales. However, the sales cannot be put off indefinitely, people familiar with the process warned.
They also say that while some risk-weighting changes may be aggressive, many are likely to be perfectly legitimate.

As part of an effort to get banks to improve their risk management, global regulators decided that institutions that developed their own models for measuring the probability of default and the likely loss given default could use them to qualify for lower risk weights than banks which rely on the standard method, which assigns flat rates to entire classes of assets.

Many European banks currently use the model method, known as IRB for internal ratings based, for only some of their assets. Faced with a desperate need to reduce RWAs, they are now spending the money to convert to IRB for the rest. Several Spanish banks and Commerzbank are among the institutions engaged in this process.

Copyright The Financial Times Limited 2012.

February 5, 2012 7:56 pm

Germany: A Bric, or just stuck in a hard place?

Angela Merkel has just been to Beijing, in a year when China is about to displace France as Germany’s largest trading partner. When that happens, it will be a symbolic moment. It will also encourage those currently posing the following question: should Germany detach itself from the eurozone mess and become a Brica mid-sized global economic power, like Brazil, Russia, India and China, whose initials constitute the Bric acronym?

I first heard the notion of Germany as a Bric from Ulrike Guerot of the European Council on Foreign Relations, who is vehemently opposed to the separatist anti-European tendencies in Germany. Probably the clearest expression of this idea came recently from Wolfgang Reitzle. The CEO of Linde, a German industrial group, said that Germany should consider leaving the eurozone. This might bring some short term pain, he acknowledged, but it would increase Germany’s competitiveness in the long term.

I have always found Germany’s obsession with competitiveness to be one of the deep causes of the eurozone crisis. The active pursuit of large current account surpluses has contributed to the eurozone’s internal imbalances.


For a country the size of Germany, it may be feasiblealbeit misguided – to formulate policy this way. For a large economy like the eurozone, it is unsustainable.

Something which falls short of an outright endorsement of a Bric strategy is the call for Greece and other peripheral countries to leave the eurozone. Klaus-Peter Müller, chairman of the supervisory board of Commerzbank, recently advocated this. Keeping the eurozone together is clearly no longer the priority of Germany’s business and financial establishment. In the 1990s, they were the monetary union’s strongest advocates.

The establishment’s disillusion with their neighbours to the west and the south coincides with a rise in their esteem of the east. I was recently reminded of that change at a dinner in Berlin with a group of journalists, one of whom told me that young Berliners looked towards Moscow as the “coolestcity in Europe by farapart from their own, of course.

Warsaw, too, was high up in this perceived coolness scale, way ahead of London, Paris, or New York. Old Berlin was split between west and east. Young Berlin looks east. German business looks even further to the east.

The sentiment of a Germany adrift is felt elsewhere in the eurozone. After the tragic capsize of a ship off the Italian coast, an Italian newspaper published a cartoon of the German chancellor in a lifeboat rowing away from Discordia, ignoring calls to come back on board. Even I think this is unfair to Ms Merkel. She may have committed serious policy errors in her crisis management, and will no doubt commit more in future. She is not preparing for a German departure from the eurozone. But if the Germans want to reposition themselves on the global economic map, the political system will find a way to accommodate this.

We are essentially discussing a new variant of the “German question”. With unification, Germany has become too large to be an ordinary European state, yet not large enough to be a superpower. Poland’s foreign minister, Radoslaw Sikorski, recently called for more German leadership in Europe. But on the few occasions when Germany takes a lead, is met with derision.

Deep down, the Germans do not want to lead in Europe because they are not ready to pay the price for leadership. This is why it has been so important for the government to present a clearly defined upper ceiling for Germany’s maximum liability in the eurozone rescue operations. To its advocates, the Bric strategy offers a way out of this “awkward-sizedilemma.

It is not going to work, of course. Germany draws much of its current strength from a devalued real exchange rate. This, in turn, is due to a combination of wage moderation and a fall in the nominal exchange rate against the dollar and other currencies, a result of the eurozone’s crisis mismanagement. A free-floating new D-Mark would eradicate the gains of the recent decade. Germany has also been one of the main beneficiaries of the single European market.

If Germany were to follow Mr Reitzle’s into Bric-land, many companies, possibly even his own, would find it more attractive to relocate to the rump of the eurozone, which would benefit from a more attractive exchange rate. It would be the ultimate irony.

The eastward-looking bric-layers will discover that there is simply no viable political and economic alternative. Germany is a very old and rich European country with a declining population – the total opposite of a Bric.

Copyright The Financial Times Limited 2012.