Ken, what did you smoke?

It is rare for Cliff to comment on a policy proposal so absurd that no comment is needed. But Ken Rogoff, a highly respected professor at Harvard, tends to surprise.

In his article in the German Frankfurter Allgemeine Zeitung, reproduced in English here and base for his talk at INSM, a Berlin based think tank, Rogoff argues that the most efficient way to boost the euro area periphery is to forgive their debt.

Interestingly, the article does not explain why Rogoff believes this is most efficient, other than his belief that sovereign debt holders will be happy to chip in a maturity extension, as discussed recently at the IMF. But with the cost of EFSF/ESM loans minimal and market funding buoyant, the timing of Rogoff's argument is just too bizarre. Financial intermediation is just picking up again, and flush liquidity allowed Portugal to forego bailout funds and Ireland to think about their early repayment.

Why debt forgiveness now?

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No interest cut, please!

The IMF's deflation "ogre" has given way to a "lowflation" lithany in a recent IMF blog, which culminates in a call for lower ECB rates. Among other arguments, the well written post points out two key problems from low inflation:

The first problem is the presence of nominal rigidities, i.e. the difficulty of cutting wages and prices. The internal devaluation that countries in the euro periphery need to accomplish requires an inflation differential to Germany and the rest of the core.  Nominal rigidity in wages make this adjustment harder to achieve if inflation in the core is low. And where prices must fall but can’t, the adjustment falls on volumes: lower output, lower employment.

But here are some important qualifiers:

1) The nominal rigidities are the underlying problem.

The nominal rigidities are a reflection of labor market inflexibilities that remain to be addressed. Rather than a monetary quick-fix, it is finally time to correct these problems through labor and product market reforms. These would also prevent the reoccurrence of diverging price trends in the future.

2) The HICP differential does not capture the full relative price adjustment.

As pointed out here, asset prices in Germany and elsewhere are rising strongly, and—although not directly captured in the HICP—will indirectly influence relative prices. Thus, the adjustment in relative prices may be greater than the HICP differential suggests.

3) Too much fuss for too little.

The core countries have a much greater weight in the euro area HICP than the periphery, and once their inflation nears 2 percent, the ECB would have to raise interest rates consistent with its euro area-wide inflation target. Thus, the maximum inflation differential without deflation in the periphery is about 2 percentage points, and hardly ever more. 

The second problem pointed out by the IMF blog is the balance sheet effect. For a company or household with high debt, low inflation means that the same amount of nominal debt has to be serviced and repaid from lower incomes. Yet, the relevant parameter here is the real interest rate, which is record low across advanced economies. As result, indicators to gauge the debt service burden, such as the debt service to income ratio of households, have often fallen despite low inflation. The reason why this fails to be the case in periphery countries is the broken monetary channel, i.e. the failure of ultra low policy rates to feed into low interest rates in those countries. To fix this, unconventional measures are better suited than another reduction of ECB policy rates.

Dear ogre, please no interest rate cut! 

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Resolving Greece's debt overhang: swapping away

On Vox, Peter Allen, Barry Eichengreen and Gary Evans deploy acrobatic arithmetics for reducing Greece's debt through asset sales. It seems academic circles, not markets, are most hung up with Greece's debt!

The Peter-Barry-Gary proposal goes as follows:

"The ECB, ESM and EU should commit a portion of their holdings of Greek government loans and bonds to a swap facility. Private investors interested in purchasing government assets could then buy loans or bonds with a face value of €1,000 for, say, €500. The Greek government, for its part, could agree to accept those bonds as currency for, say, €750 when selling government property at auction."

Greece's EFSF debt, at long maturities and low and deferred interest rates, is nothing to give away easily. Greece should guard its official debt like a jewel! The cash savings from reducing Greece's official debt by EUR1,000 are hardly existent, as interest is deferred for 10 years, the spread is zero, and the maturities are ultra long. Greece's opportunity cost of forgoing this deal (and if needed incur additional debt) is low. The artificial price tag of EUR750 does not matter.

Further, Peter-Barry-Gary write:

"The ESM, meanwhile, will be able to liquidate some of its loans to Greece without incurring additional losses because it has already lowered interest margins and fees and extended maturities on most of them. These loans already have a low fair market value of, at most, 50 cents on the euro."

Nope. Official creditors have booked the debt at face value. They would not be happy to write down half of it. Since the loans match the funding cost, the value to the creditors is 100, and any other "fair" or "market" value does not matter to them.

Besides, there are plenty other problems with state asset sales. Land titles and legal issues seem to hinder privatization in Greece in particular. Maybe Peter, Barry, and Gary can develop a solution for that? 

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Consumer price and asset price inflation: Looking the wrong way

Recent readings of the harmonized index of consumer prices (HICP) suggest a nontrivial risk of dipping into deflation in the euro area. While ECB's Draghi sticks to his "subdued price pressures" line, the IMF's Madame Lagarde has already called central bankers to arms to fight the "ogre" of deflation.  This post argues that asset price inflation--in particular housing--is driving an overlooked wedge between the HICP and the cost of living, which ECB and commentators should take into account.

As shown below, asset prices have risen markably throughout Europe and Germany, much more than harmonized consumer prices. Stock and bond prices have advanced since 2011, albeit from depressed levels in some cases. Real estate prices are rising in Germany, among other euro area countries.

The HICP is largely aloof of asset price inflation. One perennially controversial item is the cost of housing. Currently, Eurostat's HIPC assigns small weight to housing--about 10 percent--as it excludes the implied cost of owner occupied housing given these are seen as capital expenditures. Eurostat is set to include owner-occupied housing cost in the HICP in a few years. This will significantly lift the weight of housing cost in the HICP, and lead to an increase in HICP measured inflation. Deflation no more.

House prices could and should also affect inflation expectation as the method for housing cost reflect average rather than marginal house prices. An example: Expectations of housing cost inflation of a young (and economics-literate) couple are less likely based on the constant rent they are currently paying for their current small student flat. Rather, the couple's expectations should be driven by run-away prices for family-size apartments in job-rich cities, such as Munich or Hamburg.

But there are more reasons for the ECB to take into account asset prices. Asset price inflation can stoke risks to financial stability. Juergen Stark once warned that "doing too much for too long" inhibits healthy balance sheet adjustments and leads to distortions. While financial stability is not at the core of ECB's mandate, ECB will increasingly become responsible for prudential and supervisory policies as well.

It is not deflation, it is the incapacitated transmission channels that ECB needs to fix. To achieve that, unconventional (and un-German) measures may be needed to avoid fueling unhealthy asset price inflation.

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The $9 trillion sale: Keep dreaming!

In its current edition, The Economist calls once again for privatization to help fund the high deficits of many Western governments. At first glance, this sounds reasonable given governments own indeed a lot of  assets. But that's about it. While privatization has played a significant role in the transition of Eastern Europe, in the aftermath of the Asia crisis, and in World Bank/IMF programs generally, privatization programs in the euro crisis often lagged more ambitious plans. Most notably, Greece's privatization program of EUR50 billion by 2015 has been a complete illusion. Also, sales were canceled in Spain and Ireland.

Why is that so? Key obstacles are:

• The price is too low. Buy low, sell high! Selling assets in a downturn is usually bad investment advice. It is when times are good that assets should be placed for sale.

• State companies enjoy implicit guarantees. In some cases, state owned enterprises and their staff may be understood to enjoy implicit guarantees or benefits, such as job guarantees or pensions. Withdrawing those could be costly and stir unrest. Paced reform is more appropriate, and takes longer.

• Public service must remain guaranteed. State enterprises often also serve a public good, such as servicing train lines in less densely populated regions. In many cases, private ownership makes service more efficient and customer oriented, however, at the cost of phasing out less profitable niche services. In such cases, the benefit of privatization may get offset by the loss in public good.

• Privatization may not increase net investment. Rather than increase investment, privatization may divert investive funds to the government, for instance when private assets of the same kind (such as land) are offered alongside government assets.

Privatization is not a quick snap to solve the debt issues of Western economies. Privatization is no panacea, again. Governments are better advised to ignore the wisdom of The Economist.  

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Why Germans should stop mowing their own lawn

Mowing the lawn appears to be a common pastime for Germans. Washing the car or ironing even makes it into a listing of ways to burn calories in a recent issue of the news magazine Focus. Does this make sense, economically?

Home production, i.e. productive non-market activities, are not captured in the national accounts. Time use surveys, such as the one carried out in Germany in 2001/02, show that adult Germans spend 25 hours per week on "unpaid" work, more than paid work on average.

Macroeconomic indicators may be reminiscent of the extent of home production in Germany. Labor participation, particularly among women, is low, possibly on the account of home keepers and stay-home mothers. Work hours have traditionally been lower, providing at least more opportunity to engage in home production also for those in jobs. These indicators distinguish Germany in particular from the US, where consumers are perceived to rather pay than doing stuff themselves. (For disclosure, Cliff uses dry cleaners, car washing, but doesn't have a lawn to mow.)

Home production may be a popular or cultural preference, economically sensible it is not. If home production would be outsourced and thus count as market activity, per capita GDP in Germany could be about 40 percent higher, possibly closing the gap to the US. Buying services instead of doing it yourself bears economic benefits: Mothers with higher education are more productive in paid work of their profession. Other home activities requiring low skills, such as mowing the lawn, could provide work for the less qualified. Economies of scale allow dry cleaners to be more efficient than ironing shirts at home can ever be.

Also from a policy perspective, home production is a blight. By remaining outside the "paid for" economy, home production escapes taxation. With the extent of public services and social safety net the same, higher home production means paid-for economic activities have to be taxed higher. This results in a coarse and inefficient redistributive effect and fosters black market activities, to the detriment of those seeking work in the formal economy. Also, home production largely escapes the scope of regulation, such as professional standards in home improvement. In contrast, regulations for paid-for services (such as by German's craft professions) often are excessive and deprive customers of the choice of less-quality but more affordable services. (Yet, environmental laws have put an end to Cliff's most favorite Saturday activity: washing his car on public streets.)

Overall, the mindset with regard to home production has to change. Many paid-for services that substitute home production are taxed and regulated in ways that make them unattractive alternatives. Instead, it is home production which should be viewed as an unregulated, subsidized, and usually inefficient form of economic activity, and the bar for paid-for services that replace them should be set accordingly. 

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Welfare losses for future German generations: Two interpretations

This DIW publication, which is unfortunately not available in English in full version, makes the point that Germany's foreign investments--which accumulate as flip side of the current account surplus--fared quite badly during the crisis. The report goes so far to say that "some of the net valuation losses of German firms and individuals could have been prevented if their savings had been invested in long-term assets either in Germany or abroad." Ouch! Slap in the face of the German saver! 

First a word of caution. Valuation changes are calculated as the residual between year end stocks and flows, which is a fairly coarse measure. Breaking it down even further into portfolio investments, FDI, and other makes things worse. The authors acknowledge that reading sense from the spiky charts is no fun, and error margins are large.

However, the authors' finding of large valuation losses could also be read through the lens of the IMF's publication "Towards a Fiscal Union for the Euro Area". This provides a different spin. The IMF's analysis suggests that risk sharing between countries in Europe in response to asymmetric shocks has been comparatively low (see figure). Financial linkages in Europe are found to be more limited than across US states, and cross border credit tends to freeze, which worsens crises.

This interpretation leads to the opposite conclusion: higher fiscal and financial integration in the euro area should reduce the impact of shocks on asset valuations, and thus Germany's foreign wealth. In other words, failure to provide appropriate backstops and drive deeper integration has pushed higher losses on German investors. Bang!

PS: It is unfortunate, that the publication is not available in English in full, and that the English translation of the abstract is not as punchy as its German version, which resonates well with the German press: "Wohlfahrtsverluste fuer die kuenftigen Generationen Deutschlands" (welfare losses for future German generations) got diluted to "lower future domestic welfare". Come'on, don't chicken out!

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