Tuesday, January 27, 2015

An economic meander - Greece, debt and economic adjustment in a QE world

The election victory of Greece's far-left Syriza party under the leadership of the new prime minister Alexis Tsipras poses new challenges to the EU. The BBC News coverage is quite good - herehere, here, here and on the far right here.

I am not close enough to be able to make really sensible judgments on the implications of the win. Greece has paid a very heavy price for previous maladministration and the subsequent bail-out and associated austerity measures. Since 2008, Greek per capita GDP has fallen by 22%, while Government debt as a proportion of GDP is now higher than it was at the time of the bail-out as a consequence of the decline in GDP. The economy is now expanding, but still at a very low rate. 

It is not clear to me from this distance just how much freedom the new Syriza led coalition government has to move. My feeling is that some compromise will be worked out that will allow Greece to stay in the Euro while undertaking some adjustments at the margin, aided by the shifts that have taken place in EU thinking. 

Meantime, the ABC's business editor Ian Verrender takes a very dim view of the European Central Bank's new quantitative easing package. My previously expressed concern on QE lay in my inability to see a clear exit strategy. That remains my concern. 

In an interesting piece on his blog and one that has relevance to Greece, Michael Pettis argues that:
But when debt levels are high enough to affect credibility, or when liabilities are structured in ways that distort incentives or magnify exogenous shocks, growth can be as much a consequence of changes in the liability side of an economy as it is on changes in the asset side. At the extreme, for example when a company or a country has a debt burden that might be considered “crisis-level”, almost all growth, or lack of growth, is a consequence of changes in the liability structure. For a country facing a debt crisis, for example, policymakers may work ferociously on implementing productivity-enhancing reforms aimed at helping the country “grow” its way out of the debt crisis, but none of these reforms will succeed.
In simple terms, and this is Greece's problem, the attempts to bring about structural reform of themselves cannot deliver the desired results or cannot do so in an acceptable time frame because of the debt burden. This is particularly true where other countries are going through a similar process at the same time. The growth potential required to stabilise the position just isn't there.

In writing, Professor Pettis' primary focus is on China. Here he has been arguing for a number of years that the Chinese growth model is unsustainable and that growth must fall as the economy re-balances. Chinese growth is obviously important from an Australian perspective. Slower Chinese growth, a different composition of growth, affects Australian exports.

Here James Laurenceson .in China Spectator made a useful point.  Even though growth is slower, that growth is coming from a bigger base. Measured in absolute terms, Chinese growth is still substantial even with a decline in that rate of growth. He also points to the exchange rate effect. Because the yuan has appreciated to some degree against the US dollar, the size of the Chinese economy expressed in dollar terms has further increased. As happened in Australia when the Australian dollar appreciated, you can buy more for each yuan.

One of the interesting things at the moment is the way all these divergent trends play out against each other, For example, the application of QE by multiple countries has affected exchange rates in ways that we don't always see because so much is expressed in terms of the US dollar. In this context, I wondered about trends in the Australian Trade Weighted Index (TWI).

The TWI is a is a weighted average of a basket of currencies that reflects the importance of the sum of Australia's exports and imports of goods by country. It provides a useful gauge of the value of the Australian dollar when (as now) bilateral exchange rates exhibit diverging trends.

If you look at the graph, you can see the sharp fall at the end of the 1980s, then the rise associated with the mining boom. The Australian dollar has fallen since, but by less than you might expect based on the shift in the US/Australian dollar exchange rate. It remains quite high.         


Winton Bates said...

Jim, I don't see exit from quantitative easing as a huge problem unless the strategy succeeds too well in generating expectations of inflation. Given the reputation of the ECB for keeping inflation low, it seem likely that they will be cautious in their use of QE.

Regarding government debt, some interesting dynamics come into play when the interest rate on debt is higher than rate of growth of GDP. It becomes necessary for governments to run surpluses to pay interest and to prevent debt from rising as a percentage of GDP. Life will might get tougher in a lot more countries as interest rates on governements debt return to more normal levels.

Jim Belshaw said...

On QE Winton, you have an increase in liquidity on one side, an increase in Central Bank assets on the other. In buying, the CB keeps increases the value of the securities in question, thus keeping interest rates down.

The increase in liquidity flows over into asset prices. Surplus liquidity leaves the country. The exchange rate is kept down. The process goes into reverse as QE ends.

You might ask why any country would do this. Well, it depends on the effects of QE on the real economy. If liquidity and lower interest rates leads to more investment, if consumption goes up, if the economy expands, then unwinding becomes easier, for the negative effects of unwinding are compensated for by the need to keep activity down. To some degree, this seems to have happened in the US.

The big difficulty globally is that we are suffering from a private sector investment strike that diminished public investment cannot offset.

Of course other factors come into play as well. For example, countries including Greece may be able to refinance borrowings at lower interest rates, reducing budget demand. Still, its all a very uncertain process.

On you second point, I think that your maths is wrong, but I need to think through the reasons why.

Winton Bates said...

QE means that the government buys assets. Unwinding QE means that the government sells those assets.

It seems to me that there iwill only be a problem if we get wild swings in inflation expectations. That is unlikely if central banks give clear indications of their intention to promote a stable rate of growth in nominal GDP.

We should not get hung up on exchange rate movements. Just use monetary policy to get a stable rate of growth in aggregate demand (nominal GDP) and the exchange rate will adjust appropriately.

Anonymous said...

Well, I get hung up about the exchange rate. Devaluation of the AUD represents a reduction in real income. Prosperous countries enjoy strong currencies. All the hype about the imagined benefits of a lower exchange rate to Australia are likely to be overblown. There is just so much structural reform that is necessary before the elasticities can come into play.


Jim Belshaw said...

Winton, going back to your comment on rate of interest, I am not sure that I see the validity of:

"Regarding government debt, some interesting dynamics come into play when the interest rate on debt is higher than rate of growth of GDP. It becomes necessary for governments to run surpluses to pay interest and to prevent debt from rising as a percentage of GDP."

Interest payments are a current expenditure and just one item in the spend mix. To avoid absolute debt levels rising, Governments need balanced budgets, to reduce debt surpluses. So long as the rate of increase in debt itself is below the rate of increase in GDP, debt as a percentage of GDP will fall.

Winton Bates said...

Jim, unless I am mistaken, the rate of increase in debt is equal to the interest rate if you have to borrow more to pay the interest on debt.

Jim Belshaw said...

I see where you are coming from. Ignoring exchange rate issues, say debt is 100%of GDP and the interest rate is 4% and you are borrowing to pay that, you need GDP growth of 4% to stop debt increasing as a proportion of GDP.

Of course, if debt is only 25% of GDP, you then you need GDP growth of 1% to stop debt growing as a proportion of GDP.

Winton Bates said...

No Jim, debt will always grow as a percentage of GDP if the rate of growth of debt is higher than the rate of growth of GDP.
It might be easier to think in terms of the ratio D/Y. If D grows more rapidly than Y, then D/Y must rise.

Winton Bates said...

Jim, on reflection, my original statement was not quite right. It is the surplus of revenue over government spending other than interest payments that needs to rise to prevent debt from rising as a percentage of GDP if the interest rate exceeds the rate of economic growth.

Jim Belshaw said...

I still think that we have a maths problem, Winton. However, if we take D/Y, if D grows more in absolute terms than Y, then D increases as a proportion of Y. If D is very much smaller than Y to begin with, a larger percentage increase in D compared to Y need not lead to an increase in debt as a proportion of GDP.

Agree with your point re spending other than interest payments, but the second part of your sentence suffers from the same problem I was alluding to.