Economics
Current accounts
There will be shocks
Jan 7th 2012, 19:34 by R.A. | CHICAGO
THERE has been an ongoing debate over just how profligate some euro-zone economies were prior to the present debt crisis. Some, like Greece, were obviously irresponsible. For other economies, however, the case is not so clear. Paul Krugman has repeatedly pointed out that Spain was behaving as one might hope before the crash, budgeting responsibly and cutting its debt-to-GDP ratio. Others—among them my colleague—respond that Spain's seemingly sound budget relied on unsustainable capital inflows and was therefore recklessly loose. In the future, they argue, any euro-zone fiscal rules should take into account large capital inflows and require that fiscal policy tighten in response to them in order to prevent dangerous shocks.
These commenters have a point; Spain's fiscal balance created a false sense of comfort unjustified by the gross capital flows facing its economy. But is it reasonable to ask fiscal policy to lean against these inflows? Can tight budgeting prevent the growth of the kinds of imbalances that led to the present European crisis?
In a session on the euro-zone crisis, IMF chief economist Olivier Blanchard offered some reason to be cautious in asking too much of fiscal policy. He agreed that big current-account deficits could be dangerous but pointed out that fiscal policy simply wasn't up to the challenge of controlling typical flows. Mr Blanchard presented the results of an analysis which asked what level of fiscal policy response would have been necessary to keep Spain's current-account deficit at a constant 2.7%. Using a typical estimate of the response of the current account to fiscal changes he showed that it would have taken a Spanish fiscal surplus of 20% of GDP to maintain a reasonable current-account deficit. That's an unthinkably large surplus; achieving it would, in his estimation, have resulted in a contraction of Spanish GDP of 9%. Spain's government would have had to engineer a severe depression to prevent a blow-out in its current-account gap.
That didn't suggest to him that no fiscal efforts would have been justified; a bigger surplus would likely have made sense. Other tools might also have been used; a reduction in allowable loan-to-value ratios in home purchases would have reined in the housing boom and cut capital inflows. But there is only so much a government can reasonably do to constrain these massive capital flows. If the euro zone stays together, they're going to occur again, and corresponding reversals and shocks will also occur again. The euro zone therefore needs to make sure it can handle the shocks without melting down.
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"a reduction in allowable loan-to-value ratios in home purchases would have reined in the housing boom and cut capital inflows."
So long as the ECB runs its monetary policy to suit the big countries, the little countries will have to make such adjustments, sometimes aggressively, to avoid trouble.
The peripherals would benefit from foreign investment just as developing nations have done e.g. China. Thats the point of free capital movement. Its a pity it causes imbalances when the exchange rate is fixed. What to do if you need to balance the current account but can't devalue the currency to reduce imports and increase exports?
Deflate wages?....being done to a limited extent before there is social unrest.
Get the Spanish to deregulate their labour markets and develop indigenous businesses?...being done but takes time.
Get e.g. BMW to move to Malaga?...the wages SHOULD be less but do the Spanish have the manufacturing skills...the state may need to invest?
Encourage productive investment and limit speculative investment (e.g. property buying)?..some regulations may help.
Operate a fiscal transfer union like sending money from New York to Alabama?...probably if the Europeans are serious about European Union....but when will this be palatable and politically achievable?
For a member of a single market which s therefore completely exposed to global capital flows it is ludicrous to try and rely exclusively on a fiscal lever to manage those same capital flows. Attempting a 20% fiscal surplus to reduce capital inflows is insane!
Trying to make the accelerator act as a gear box is just bonkers - Spain needs her own currency.
Blanchard got it backward. Capital inflow is the consequence of unchecked property speculation--not vice versa. Kill the profit and there would be no inflow. The example of Hong Kong shows that you can kneecap the horse before it leaves the barn.
@cheryshevsky: "Blanchard got it backward. Capital inflow is the consequence of unchecked property speculation--not vice versa. Kill the profit and there would be no inflow. The example of Hong Kong shows that you can kneecap the horse before it leaves the barn."
That doesn't affect the capital inflow at all - it simply diverts it from property to a stock market bubble, a consumer bubble or some other bubble. Spain's trade deficit was funded by foreign credit - the capital inflows were an essential feature of the sustained trade deficits they weren't an unexpected consequence.
If you choose to let a million taxes bloom in an attempt to achieve a re-balancing of trade and capital flows that could be better achieved by the simple and automatic depreciation of your currency then you are on a fools mission.
True, but at least with stock bubbles some of the money lands in useful investment as companies issue stock, and tend to stay at arms-length from Main Street.
Property bubbles are far more pernicious. They cause land to increase in value (inflation), shifts people into construction work (from which they will suddenly become unemployed later) and over-leverages local banks and citizens (big mortgages against property).
You seems to think that capital inflow is this monster with a mind of its own. There are actually minds behind investment decisions. Investors aren't going to buy stocks of Spanish companies just because they're Spanish. Spanish companies compete with German companies in the international market. Money isn't going to pile into Spanish stocks if Spanish firms aren't competitive. Bubbles in the stock market could occur, but divergence would not. Unit labor cost in Spain would never get out of line with unit labor cost in Germany because of foreign investment.
@chernyshevsky: "You seems to think that capital inflow is this monster with a mind of its own. There are actually minds behind investment decisions."
No I simply restate the economic truth that an external deficit (capital outflows) must be funded by external credit (capital inflows). These are an accounting identity.
If the inflows stop then so do the outflows.
Spain's trade deficit with Germany has averaged around 3% of Spanish GDP in the pre crisis post euro period. Capital inflows to Spain have matched (indeed exceeded) these trade outflows.
If you want to know who is holding most of this Spanish debt look at the ECB Target transfers. The Bundesbank is now holding nearly a trillion $ of peripheral assets.
Private investors and lenders may have come from all parts of the world and invested for all sorts of reasons but once the crisis set in they quickly revealed themselves to be intermediaries in what is essentially a bilateral transaction. They quickly departed the scene leaving Spanish banks to pick up their obligations and lodge them with the ECB (on very favourable terms). Via the Target system a huge share of Spain's debts are now assets on the Bundesbank balance sheet - Spanish debt has been "returned to sender"....
"Pun.gent: "True, but at least with stock bubbles some of the money lands in useful investment as companies issue stock, and tend to stay at arms-length from Main Street."
If the definition of a bubble is a massive misallocation of capital then, scale apart, I do not see how you can qualitatively assess one sort of bubble as being less economically destructive than another sort of bubble.....
If Spain is running a trade deficit with Germany, it's probably because Spanish firms are not competitive with German firms. Now why would German investors choose Spanish stocks over German ones?
@chernyshevsky: "If Spain is running a trade deficit with Germany, it's probably because Spanish firms are not competitive with German firms. Now why would German investors choose Spanish stocks over German ones?"
Well obviously the growth was better despite this competitiveness shortfall.
This merely supports what I have been saying and undermines what you have been claiming. Much of the money invested by foreigners in Spain's property bubble was reinvested by Spanish developers and banks into the Spanish stock market. The property bubble was also a stock market bubble.
It follows that a property tax would simply have pushed the money into the stock market without the intervening step of going through the hands of Spanish property developers....
If the damage is the misallocation of capital itself, then you'd be right. But that's the smaller, 'proportional' part of the damage. However, where the sudden popping of the bubble affects a lot of other, non-liquid, inelastic things (like access to secure banking services for healthy businesses, or people's choice of profession and hometown) the damage can be far out of proportion and take years to unravel.
It's that non-linear stuff that we talk about when we distinguish between "Wall Street" and "Main Street".
Mr Blanchard presented the results of an analysis which asked what level of fiscal policy response would have been necessary to keep Spain's current-account deficit at a constant 2.7%.
How about the US?
Haven't we been running a deficit of 6% per annum?
a reduction in allowable loan-to-value ratios in home purchases would have reined in the housing boom and cut capital inflows.
Would that go over well in the US?
That sounds like "regulation".
And we can't have that now, can we?
I know people that took out 125% re-fi's in the early 2000's.
So they were around before the bubble took off.
Regards
Why speaks in the abstract when there are concrete examples? One can look to Hong Kong to see how a government can deal with hot money. The HK dollar is pegged to the US dollar, so the situation is analogous to that of the euro-zone periphery. For the past couple years the territory has had to cope the Fed's zero-interest rate and quantitative easing. To combat property speculation, besides upping the loan-to-value ratio, the government also imposed a special stamp duty on housing transactions. The measures are so effective that property prices are expected to fall in 2012.
Thank you for this. As I read the linked post, it was full of blame that hadn't been thought through. It blamed governments for not understanding the danger in the capital flows, though of course private businesses with their own money on the line didn't either. I'm not surprised that the numbers would never work. There is a brand of post hoc reasoning that speaks in a language of zero risk without any thought to the consequence of that degree of holding back in the name of safety. Another example is pensions - private, public, quasi-public - are being held against absolute risk free standards as though the risk of future failure means not ever taking any risk at all. That approach replaces the foolishness of excess with the absurd foolishness of never trying anything at all.
Taken in the context of the economic history of Spain, it is not surprising the level of careless profligacy seen between 2002-2011.
With much of its history marked by bouts of Hyperinflation, economic inactivity, and for much of the twentieth century autarkic dirigiste rule, it is no surprise the carte blanche given to them with the EU resulted in a bent incentivised system characterised by explosive credit growth.