Cliff # 1

About cliffeconomics

This blog offers original economic thought and policy recommendations on Germany, the euro area, and whatever cliff has on his mind.

Cliff # 3

About cliff

The author is an economist specialized in financial and macroeconomic policy analysis. All posts present a personal opinion, and all analysis is based on publicly available information.

Cliff # 1

About cliff

The author is an economist specialized in financial and macroeconomic policy analysis. All posts present a personal opinion, and all analysis is based on publicly available information.

Saturday, November 30, 2013

Sovereign bank link? Bank sovereign link? Or linking banks to sovereigns?

The sovereign bank link and the imperative to break it is fairly ubiquitiuous in today's discussion how to improve the financial system. Like with so many overused and underthought buzz words, the sovereign bank link embeds several aspects which circumscribe different problems and solicit different solutions:

  • Banks' preference for public over private lending: Public sector loans and sovereign bonds often enjoy privileged treatment, such as zero risk weight among other. This is often thought to bias banks towards lending to the public sector. However, competition will cause this benefit to accrue to the debtor, not the creditor: all else equal, the cost of funds for the public debtor becomes cheaper than for private debtors, resulting in a lower hurdle rate for public than for private investments. This can lead to an unhealthy allocation of savings indeed. As regulatory risk weights are of relevance for banks but not other investors, this privilege has in particular distorted banks' credit allocation, and deserves to be phased out as Der Spiegel reports the ESRB had been proposed. Moreover, privileged treatment should be phased out altogether, including in pension fund regulations and tax exemption of coupons. Conversely, penalizing banks' public lending for the sake of curtailing the sovereign bank link would create new distortions.

  • Banks' exposure to the sovereign: Large exposures to the sovereign tie banks and governments together although they would better be independent. Banks' health generally depends on the business cycle, as does the public sector's which ought to smooth the cycle. If a shock adversely affects the sovereigns' creditworthiness, large sovereign exposures would drag down the banks, whose health is crucial for economic growth. In case of public overindebtedness, a situation coined as fiscal dominance could arise, in which independent monetary policy becomes an impossible preposition because banks' health hinges on the sovereign sector's, and monetary policy succumbs to the situation, e.g. by initiating inflationary policies.

  • Sovereigns' exposure to banks: As a result of bank bailouts, the public sector also holds large claims on banks. The banking crisis can thus spill into a public debt crisis, and from there spread further through the financial system, including through other banks' exposure to the sovereign as described above. Such situation can arise even before a bank intervention, when ailing banks are large and expected to receive government support. This adverse feedback loop, which previously entangled Cyprus, Greece, and Ireland, could be curtailed by a large third party backstop.

In conclusion, the discussion about curtailing the bank sovereign loop has many facettes. Ending priviliges such as zero risk weights would reduce distorted lending decisions, but need to be phased carefully. A third party backstop, such as the ESM, would strengthen the credibility of the bailout mechanisms discussed, yet ECOFIN's proposed pecking order of support mechanisms may in practice prove unworkable.

Saturday, November 16, 2013

Germany's current account surplus: Structural or cyclical?

A little discussed aspect of the recurring discussion about Germany's current account balance is the distinction between its structural versus cyclical nature, and the implications thereof. On one hand, the case for reigning in the current account surplus may not be given if it is driven by certain structural factors, such as demographics. On the other hand, it would be a grave policy mistake if structural measures were taken to moderate a cyclical current account surplus. As with policies that attempt to influence the cycle in general, applying the right dose at the right time is tricky, and has often proven ineffective.

How can the structural component of the current account be measured? Common structural determinants, i.e. factors that move slowly over time and are mostly out of the perimeter of policymakers, include:

  • Demographics. The economic lifecycle theory suggests that savings are built during the working age, and consumed at retirement (and, indirectly, also when young). German demographics exhibit a particular drop in youth dependency, while the ratio of pensioners rises more significantly only after 2020 (a constellation coined as "demografisches Zwischenhoch", demographic interim high, here), suggesting that this structural factor can justify a higher current account balance for the accumulation of (foreign) savings.
  • Past surpluses. Past surpluses have lead to the acquisition of sizable foreign assets. The investment return of those savings abroad contributes towards the current account surplus, and is thus largely irrelevant to the current discussion.
  • Low productivity growth. Productivity growth is often linked to capital intensity of production, which is already high in Germany compared to the rest of the world, thus providing a structural explanation for "downhill" capital flows from Germany to other countries, the flip side of Germany's current account surplus.
  • Oil dependency. Oil imports, while itself having a strong cyclical component, are per se a structural factor. While playing a much greater role for the current account of the United States, it is also sizable for Germany.
A paper by OECD and IMF authors provides rough estimates of these factors. While their estimation specification could be debated, results suggest that a 2 percent current account surplus could be explained by structural factors, yet recent surpluses exceed even upper estimation bands (Figure). Tweaking this structural export bias requires structural policies. Family policies and migration comes to mind with regard to demographics, as well as energy policy. In these fields, other political considerations likely outweigh this nerdy economic rationale.

Assuming the estimations are to the point, one could therefore argue that the large German current account surplus is mostly cyclical, and therefore temporary. For instance, low oil prices are keeping import values at bay and contribute to the surplus at this moment, but may bounce back as soon as global growth picks up.

Countercylical policies are always tricky, and sometimes even dangerous. If, however, policymakers decide that German or European interests justify an attempt to influence the current account cycle, it is important that measures are tailored to address cyclical effects, and thus can be phased out once the current account starts turning the other way.