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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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.

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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.

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Policy responses to debt overhang: Asset price support

The role of sectoral balance sheets, and their linkages, is used oftentimes to explain the euro area crisis and the sluggish recovery. Richard Koo's holy grail narrative of balance sheet recessions experiences a post-academic renaissance. A recent Vox piece by Jorda, Schularick, and Taylor adds to the empirical analysis in this field. (Let me forgive them to cite the infamous 90 percent public debt-to-GDP threshold.)

Their research shows that in advanced economies, balance sheets of the household and financial sectors empirically play a pivotal role in explaining the outbreak of crises and the speed of recovery. Strong government balance sheets, i.e. low public debt and a healthy structural balance (also coined "fiscal space"), help to mitigate a shock.

These are all useful empirical insights, but what are the mechanics which need to be understood to develolp effective policy responses? This is yet less clear. This blog argues for the importance to prevent asset price undershooting, using the example of the recent household debt crises in Ireland, Spain, and--to a lesser degree--the UK and US.

In these countries, households thrive to deleverage, i.e., shrink and repair their balance sheets from a debt load which exceeded 100 percent of GDP. Agents save instead of spend, in turn depressing incomes and output. For instance, household savings rates since 2007 jumped by 4-5 percentage points in Ireland and the UK. House price declines of 50 percent in Ireland, 30 percent in Spain, and 20 percent in the US have spread negative equity which in turn induced mortgage default, crippling the banking system.

The usual policy response of bank stress tests, bank recapitalization and the like has ensured banks are mostly sound and well capitalized. Also, interest rates, the core monetary policy tool, has in part helped households' debt burden to become more affordable and reduce defaults. But many banks couldn't benefit from lower rates, owing to impaired monetary transmission channels.

So... what other policies are needed?

Direct debt relief would help but in many cases is unaffordable. While household debt relief following the Great Depression or in the fairly small mortgage sector in Iceland worked, the public purse is too small for such a policy response in places like Spain, Ireland, and the Netherlands where household debt is higher and public debt not low. If markets see such a policy as undermining public debt sustainability and demand higher risk premia, banks' funding conditions usually worsen as well, offsetting the benefit of such policy.

What looks more promising is a financial policy that buffers asset prices which, given the size of balance sheets, could have a very wideranging effect. Generally, market prices often get depressed amid thin trading in the aftermath of popped price bubbles, and it takes little to avoid asset prices to undershoot their fundamental levels. This will prevent damage from balance sheets of all agents holding that asset. Thus, in countries with a high degree of home ownership, a policy that carefully avoids excessive house price slumps can bring broad benefits to households' balance sheets.

In general, this line of argument supports asset purchases. Yet, not all assets can in any practical way be purchased by central banks (think houses). Thus, there is also a role for regulatory policy to be used to support asset prices. Procyclical tightening of prudential and tax rules, such as in the Netherlands, is not what I mean. 

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A second Greek debt restructuring (2): A repeat?

Public debt is very high, public and private investment has collapsed, and the economy shrinks. Official lenders provide the financing needed to service debt. This situation describes not only Greece today, but also the many developing countries in the 1980s debt crises.

This blog post applies the insights of that time provided by Krugman (1988, 1989) and Froot (1989) to the current situation in Greece.

In a situation where the future repayment capacity is exogenous yet uncertain, creditors are better off never to grant debt relief. While the expected value of the repayment may be below the nominal value of debt owed--as is surely the case for Greece--the creditors' claim has some option value. As Krugman (1988) writes, creditors would be "foreclosing the possibility of benefitting from any later good fortune on part of the country."

Creditors have thus the collective interest in postponing the day of reckoning: they keep Greece afloat to avoid an immediate default. The collective action problem arising in cases with multiple debtors is not grave: most of Greece's debt is owed to its European partners and the IMF, containing the gains from free riding that is reaped by the few private bondholders. And given Greece reaches a primary surplus next year, most of new financing needed is actually to spent to service debt! Ergo, Greece is not on the falling branch of a debt Laffer curve, unless...

...the repayment capacity is not exogenous. If the debt overhang leads to underinvestment, reducing Greece's potential output in the future, then a case could be made for forgiving debt today. In the 1980s debt crises, the debt relief in the form of debt rescheduling was found to depress future repayment capacity where there is no new, additional lending supplied. (Froot writes "if investment incentives are present… the optimal debt-relief package will include an infusion of new lending.") However, the Troika programs for Greece have determined the amounts of public investment and provide for their financing. This leaves the question whether private investment is affected by the debt overhang: Greece's low sovereign rating (a C by Moody's) may deter foreign investors, and uncertainty about a future debt restructuring may incentivize domestic savers to invest abroad. Evidence for such debt overhang effect is hard to pin down. 

How to solve this trade-off between the keeping the option of full repayment while limiting the adverse consequences of debt overhang? By committing to reduce debt to 124 percent by 2020 and substantially below 110 percent in 2022, the European partners cut this Gordian knot: They keep the option to reap any upside if Greece rebounds while trying to remove uncertainty about Greece's debt stock at the end of this decade.

Will it work? There is a sad tradition among European politicians to duck their previous  commitments. Conversely, the commitment could lead to moral hazard on Greece's behalf, which could slow the necessary adjustment or even bring forward debt creating outlays right before the 2020 cutoff.

As usual, nothing is panacea. 

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A second Greek debt restructuring (1): when and how much?

Much is being said about this, over and again.

Private bondholders have already received a haircut, and there is no rationale for official creditors (European partners and the IMF) to annul part of their claim as long as they provide for Greece's financing need in full. Financing under the current program lasts until 2016, although euro member states have pledged support longer if needed. The discussion about debt relief will only become ripe once Greece prepares for its re-entry into international financial markets. In addition to a sustainable debt ratio, investors likely require (i) solid economic growth; (ii) a revival of employment; and (iii) a healthy primary budget surplus. While the IMF projects these conditions to be in place from 2016, no market funding is penciled in at least until 2018 (the last year shown in the IMF's tables). At that point, financing requirements--at below EUR10 billion per year or around 5 percent--are small and the debt ratio declines sharply. Under such a positive scenario, official lenders may well provide a couple of years additional funding to further groom Greece's fundamentals before accessing markets--without debt relief.

However, the Eurogroup also committed to provide relief to Greece to ensure that its public debt is 124 percent of GDP in 2020 and substantially below 110 percent in 2022. This matches current long term forecasts by IMF and the European Commission. However, the IMF acknowledges that the underlying assumptions, such as a sustained primary budget surplus of 4 percent, are "ambitious". The EC's negative shock scenario (which may be more realistic than their "ambitious" baseline) estimates debt at about 140 percent of GDP in 2022, suggesting that debt would need to be reduced by some 30 percent of GDP (estimated EUR70 billion). However, while European politicians may by then have forgotten the commitment of their predecessors, markets may have grown accustomed to debt ratios well above 110 percent, such as in Ireland and Portugal.

There is no reason to expect a haircut to official creditors now. There may not be one altogether.

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Foreign Invasion in German's Housing Market: A Blessing?

The recent house price jolt in some German cities reportedly coincides with strong buying interest by foreigners (see FT weekend edition from August 3). This trend is not so different from other global cities, such as London where three quarters of buyers are reportedly from abroad (dito). Are wealthy foreign buyers causing German cities to become unaffordable to German dwellers? Here is a view that could liven up your Stammtisch debate.

First, compared to other countries, home ownership in Germany is exceptionally low and tenant regulations strong, limiting the impact of house price inflation on many German dwellers. Recent research has shown that low ownership rates are associated with lower unemployment, possibly as tenants are more mobile than home owners. This suggests that rental demand could be elastic enough to contain rent-to-income ratios, limiting the pass through of housing inflation to rents. On the flipside, buy-to-let investors will have to put up with below-cost rental yields as house prices rise. Second, if there is a bubble (and excessively low rental yields are one of its indicators), the investors affected by an eventual house price crash would largely be foreign. As foreign buyers oftentimes pay cash without the leverage of a mortgage, the repercussions of a crash on German households and banks would be less daunting than in, say, Ireland or Spain. Third, foreign buyers are more used to off plan purchases of new developments, which helps developers and could do good to German’s dated housing stock. As sad as it sounds, architectural advances are often sighted in cities with property bubbles. Foreign investors may thus bring some architectural joy to the dull look of many German cities.

With this in mind, what are appropriate policy responses to deal with the flipside of the property bubble? First, tighten prudential policies for mortgage origination. Global liquidity conditions—including an ECB policy rate that is too low for Germany—have set off a search for yield that tempts many Germans to participate in the house price rally. That is a bad idea, and debt-to-income and loan-to-value limits could ensure that those who accept this gamble maintain sufficient buffers. Second, regulation of rent increases—if designed well—could protect the large cohort of tenants who else lose amid house price inflation. While price controls are distorting and become ineffective over time, a temporary ceiling on rent increases—as often in place elsewhere—could buffer the effect of house price swings on rents. Third, a real estate transaction tax—akin to the financial transaction tax—could slow the transaction flow and discourage flipping, while revenues could be put aside as reserve or be used to help those suffering most from house price inflation, such as families with increasing housing needs.

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