Yotta Point

Stocks and Bonds Diverge

UPDATED 2/22/12

A few people have been discussing this topic of late and it's worth a mention in the context of what to expect vis-a-vis US economic growth in the coming months.

The observation is that as market confidence in a US economic recovery has become stronger, stock markets have shot upwards but bond yields have not. One would normally expect bond yields to also go up as money moves from bonds to stocks during economic recoveries. This "anomaly" is interesting and worth watching.

Tyler Durden at Zero Hedge (1/30/12): "Yields Plunge Most In 3 Months As Equity-Debt Divergence Remains"

Joe Weisenthal at Business Insider (2/7/12): "PRESENTING: The Great Market Disconnect Seen All Around The Globe"

Joe Weisenthal at Business Insider (2/18/12): "This Is STILL The Most Glaring Anomaly In The Market"

Tyler Durden at Zero Hedge (2/20/12): "As Everything Disconnects And Everything Is Soaring, Morgan Stanley Issues A Warning"

[Also worth a look - this Aug 2011 post  by Felix Salmon at Reuters: "Chart of the day: The great earnings-yield divergence"]

It's also noteworthy that stock market trading volumes have been noticeably lower in recent times - and it's happening at a time where revenue and earnings growth has also declined (outside of Apple) and upside guidance from companies is also on the decline.

P.S. Joe Weisenthal has an observation from Doug Kass that there is also a marked divergence between the S&P 500 vs. the ratio of Dow Transports to the S&P 500. Transports, I would presume are at least in part affected by rising oil prices at a time when overall world oil consumption has been on the decline. Additionally, the potential impact of QE and liquidity type actions on stock markets and commodities like oil can't be emphasized enough.

Do Surveys of Consumer Confidence Provide Insight Into Actual Economic Activity?

Sober Look has two good, worth reading posts - "The story of two risk indices" and "The jump in U Michigan sentiment index is driven by consumer expectations". I'll try to return to the first post later but I thought I'd comment on the second one - which is about indicators tied to what we generally refer to as 'consumer sentiment' or 'consumer confidence'. SL makes some good points about these indices but he does not mention a larger point that I want to call out here - which is that these indices very clearly are not at all good gauges of absolute economic activity.

1) Let's start with SL's first point that the Thomson Reuters/University of Michigan's survey of consumer sentiment registered a reading in August 2011 that was as low as the reading in November 2008 - which, as SL says is "...a bit surprising and not at all intuitive, with anecdotal evidence suggesting that 08 felt far worse than 2011".

He's completely right about the non-intuitive nature of index values - but it is also completely non-intuitive when you look at non-anecdotal evidence. For example:

• The change in real GDP in Q4 2008 was -8.9% whereas in Q3 2011, GDP changed by +1.8%
• Retail sales changed at an annual rate of  more than -10% in Q4 2008 compared to +6 to 8% in Q3 2011
• Industrial production and capacity utilization were much lower in Q4 2008 compared to Q3 2011
• The economy was losing jobs at the average rate of ~600,000 jobs/month in Q4 2008 as opposed to gaining on average ~150,000 jobs a month in Q3 2011

So, what exactly is the Thomson Reuters/University of Michigan Consumer Sentiment measuring?

2) Second, SL adds:

What drove the sentiment index to levels comparable to 2008? The index actually has two components: the Current Conditions Index and the Consumer Expectations Index. And it was the "expectations" component that pushed the whole index to this low point. In fact according to U Michigan, when it came to consumer expectations, the "end of the world" was coming in August of 2011 - a point on the index that was in fact lower than the expectations measure in 2008 (as shown in the chart below). This is puzzling. Were consumers reacting to all the market driven media frenzy in August that wasn't as prevalent in 2008? Were consumers not as focused on the state of the financial markets in the past as they are now?

On the other hand the "current conditions" component did not dive anywhere close to its 08 lows, which is more in line with other economic indicators.

So, basically, according to this measure of consumer sentiment, in August 2011 the Consumer Expectations index fell lower than the lowest value in 2008! Yet, all the above indicators measuring the real health of the economy (see above) were much worse in Q4 2008 than in Q3 2011 and Q4 2011. How is it that, not just the overall consumer sentiment index, but also its consumer expectations component, seems so out of whack with macroeconomic conditions (current and immediate future)?

3) Third, SL discusses another indicator on consumer confidence:

Average Scaling Behavior in Biology, Cities and Corporations

I recently started reading some research from Geoffrey West, Luis Bettencourt and others on scaling phenomena relating to averages (there are always deviations). This is an incredibly rich topic and one cannot possibly do justice to it in a single post, so I'll merely highlight one or two findings from the research and provide links for further reading.

A good place to start is this article on biological organisms in Physics Today from 2004, by Geoffrey West and James Brown - "Life's Universal Scaling Laws". A couple of key passages (all bold text corresponds to my emphasis):

In marked contrast to the amazing diversity and complexity of living organisms is the remarkable simplicity of the scaling behavior of key biological processes over a broad spectrum of phenomena and an immense range of energy and mass. Scaling as a manifestation of underlying dynamics and geometry is familiar throughout physics. It has been instrumental in helping scientists gain deeper insights into problems ranging across the entire spectrum of science and technology, because scaling laws typically reflect underlying generic features and physical principles that are independent of detailed dynamics or specific characteristics of particular models. Phase transitions, chaos, the unification of the fundamental forces of nature, and the discovery of quarks are a few of the more significant examples in which scaling has illuminated important universal principles or structure.

In biology, the observed scaling is typically a simple power law: Y = Y₀M^b, where Y is some observable, Y₀ a constant, and M the mass of the organism.^1-3 Perhaps of even greater significance, the exponent b almost invariably approximates a simple multiple of 1/4. Among the many fundamental variables that obey such scaling laws - termed "allometric" by Julian Huxley⁴ - are metabolic rate, life span, growth rate, heart rate, DNA nucleotide substitution rate, lengths of aortas and genomes, tree height, mass of cerebral grey matter, density of mitochondria, and concentration of RNA.

[...]

An intriguing consequence of these "quarter-power" scaling laws is the emergence of invariant quantities,⁷ which physicists recognize as usually reflecting fundamental underlying constraints. For example, mammalian life span increases as approximately M^1/4,  whereas heart rate decreases as M^-1/4, so the number of heartbeats per lifetime is approximately invariant (about 1.5 x 10⁹), independent of size...

Bettencourt and West discussed cities and their economics and laws of scaling in their article in Scientific American last year titled "Bigger Cities Do More With Less". Here are some notable points:

By sifting through this flood of data, covering thousands of cities around the world, we have unveiled several mathematical “laws” that explain how concentrating people in one place affects economic activity, return on infrastructure investment and social vitality. Despite the rich diversity of metropolitan regions across the U.S., China, Brazil and other nations, we found a remarkable universality in the way that socioeconomic characteristics increase with a city’s population. For example, if the population of a city is doubled, whether from 40,000 to 80,000 or from four million to eight million, we systematically see an average increase of around 15 percent in measures such as wages and patents produced per capita. If eight million people all live in one city, their economic output will typically be about 15 percent greater than if the same eight million people lived in two cities of half the size. We call this effect “superlinear scaling”: the socioeconomic properties of cities increase faster than a direct (or linear) relation to their population would predict.

The data also reveal that cities’ use of resources follows a similar, though inverted, law. When the size of a city doubles, its material infrastructure—anything from the number of gas stations to the total length of its pipes, roads or electrical wires—does not. Instead these quantities rise more slowly than population size: a city of eight million typically needs 15 percent less of the same infrastructure than do two cities of four million each. This pattern is referred to as sublinear scaling. On average, the bigger the city, the more efficient its use of infrastructure, leading to important savings in materials, energy and emissions.

Our findings also show that these patterns of increased productivity and decreased costs hold true across nations with very different levels of development, technology and wealth. Although we have much more information for cities in richer parts of the world, we are beginning to obtain good data from rapidly developing countries as well, and they seem to fit the same mold. The gross domestic product for cities in Brazil and China, for instance, closely follows the same superlinear curve that western European and North American cities exhibit, though starting from a lower baseline. We believe that the pattern holds true because the same basic social and economic processes are at work, whether in São Paulo’s favelas, under Beijing’s smog-filled skies or along Copenhagen’s tidy streets.

Although urban superlinear scaling, which represents the average, idealized behavior of a city of a given size, prevails around the globe, actual cities deviate to varying degrees from the roughly 15 percent enhancements that come with size. Detailed data covering 40 years show, for example, that San Francisco and Boston are richer than their size would indicate, whereas Phoenix or Riverside, Calif., are somewhat poorer. Curiously, these deviations persist for decades: cities tend to stay remarkably close to their overperforming or underperforming histories. For example, cities that have attempted to improve their lot by creating conditions for the “next Silicon Valley” have often had disappointing results. Our research suggests that certain intangible qualities of social dynamics—more than the development of material infrastructure—hold the key to generating virtuous cycles of innovation and creation of wealth. These processes, such as the development of a spirit of local entrepreneurship, a reputation for cutting-edge novelty, and a culture of excellence and competitiveness, are difficult to design through policy because they rely on the dynamics of a city’s social fabric across many dimensions. We expect the results of this exciting area of research will lead to better “recipes” for sustainable socioeconomic development.

See the Physics Today article as well this article for some discussion of West's work, including some of the criticisms of the averages and how they miss various deviations from the averages. A recent paper that critiques the Bettencourt/West research on cities is this one by Cosma Shalizi, who says:

Reads for Jan 14

Economics & Finance

• Dean Baker at Beat The Press: How Is It Possible The Fed's Image Can Be Tarnished Further?; The Japan Story; More on the Celebration Over December's Job Report
• Gavyn Davies at FT: America’s incredible shrinking labour force (via)
• Joe Weisenthal at Business Insider: Something Has To Give Here; CHART OF THE DAY: The Final Word On ADP, The Most Controversial Economic Report There Is (also see this)
• Simon Johnson at Economix: Ron Paul and the Banks
• Kenneth Kutner: Low Interest Rates and Housing Bubbles: Still No Smoking Gun (via)
• Paul Krugman at NYT: Germans and Aliens; US Net Investment Income
• Andrew Berg and Jonathan Ostry in Foreign Policy: How Inequality Damages Economies (via)
• Alan Krueger, Chairman of the Council of Economic Advisors of the US: The Rise and Consequences of Inequality in the United States (see the accompanying slides here, via)
• An old post by Lane Kenworthy at Consider the Evidence has an interesting chart: Slow Income Growth for Middle America (via)
• Robert Greenstein at CBPP's Off The Charts Blog: Romney’s Wrong: Federal Low-Income Program Dollars Go Overwhelmingly to Beneficiaries
• Mike Konczal at Rortybomb: A Quick Note on the Distributional Consequences of a Lack of Refinancing Options
• William Black at Credit Writedowns: Real Financial Regulators Love Prosecutions of Fraudulent Bank CEOs
• Yves Smith at Naked Capitalism: Crowd-Sourcing the Revolving Door (also see here and here)
• Mark Whitehouse at Bloomberg's The Ticker: On the Capture of Economists (via)
• Simon Wren-Lewis at Mainly Macro: Mistakes and Ideology in Macroeconomics (via) - also see: Chris Dillow at Stumbling and Mumbling: Mechanisms and Models (via)
• Ejaz Ghani at Vox: Reshaping Tomorrow: What will India look like in 2025? (via)

Energy & Environment, Food Security, Climate Change

• Global Macro Monitor at Credit Writedowns: Chart of the Day: U.S. Gasoline Consumption Tanks in 2011
• James Hamilton at Econbrowser: Reducing Petroleum Consumption from Transportation - has a bunch of illuminating stats for the US v. other countries from this paper by Christopher Knittel
• Tom Smerling at Skeptical Science: U.S. 2011: The Wet Get Wetter, the Dry Get Drier [also, a useful 2005 report on Natural Disaster Hotspots is a good related reference]
• Tom Curtis at Skeptical Science: Global Warming: Trend and Variation
• Dana1981 at Skeptical Science: A Big Picture Look at Global Warming
• Stephen Lacey at Climate Progress: What Do Falling Natural Gas Prices Mean for Renewables?
• Peter Sinclair at Climate Denial Crock of the Week: Climate Change and Sea Level Rise: “An Emerging Hockey Stick”

Healthcare and Education

• Aaron Carroll at The Incidental Economist: Lots of people can’t fire their insurance companies (via)
• Kelly Kennedy at USA Today: 5% of patients account for half of health care spending [link to full study here]
• Ray Fisman at Slate: Thanks, Teach ("A new study suggests that a good grade school teacher can boost college attendance rates, reduce teenage pregnancy, and increase a student’s earning potential.")
• Catherine Rampell at Economix: Do College Grads Earn Less Now Than 40 Years Ago?; College-Educated Workers Gaining Jobs, High School Grads Losing Them

Miscellaneous

• Barry Ritholtz at The Big Picture: Internet Censorship
• Kevin Drum at Mother Jones: Less Lead, Less Crime

That's it for today.

Reads for 1 Jan 2012

A very happy new year to everyone! Here are some readings to ring in the new year...

Economics & Finance

• Bill at Calculated Risk: Private Investment and the Business Cycle; Vehicle Miles Driven Decline: A possible contributing factor; Labor Force Participation: The Kids are Alright Part 2 [Bill also provides a helpful how-to link on "How do you put recession bars on graphs using Excel?"]
• Yves Smith at Naked Capitalism: Global Savings Glut or Global Banking Glut?
• Christina Romer in the NYT: A Financial Crisis Needn’t Be a Noose
• Richard Peach, Josiah Bethards and Joseph Song at Liberty Street Economics: Labor Force Exits Are Complicating Unemployment Rate Forecasts
• David Cay Johnston at Reuters: The corporations that occupy Congress; Where's the fraud, Mr. President?
• Menzie Chinn at Econbrowser: Regulatory Uncertainty, Macro Policy Uncertainty, and Demand
• Dave Altig at Macroblog: Uncertainty about uncertainty; Maybe this time was at least a little different? (regarding the failure of economic forecasting)
• Tara Sinclar at Econbrowser: Guest Contribution: US Federal Regulatory Budget and Macroeconomic Outcomes: What Do We Know?
• Cardiff Garcia at FT Alphaville: 'Tis the Seasonality, Hold the Jolly
• Barry Ritholtz at The Big Picture: Clouded Title - The Gross Illegality of MERS
• TaxProf Blog: CRS on Income Inequality (via)
• Mark Thoma at Economist's View: Peddling a False Narrative on the Financial Crisis
• Zsolt Darvas: A Tale of Three Countries: Recovery After Banking Crisis [focus on Iceland, Ireland and Latvia, via]
• Paul Krugman ay NYT: Debt and Growth in the G7
• David Romer: What Have We Learned about Fiscal Policy from the Crisis? (via)
• Bruce Bartlett in Economix at NYT: Cutting the Corporate Tax Rate Is No Economic Panacea
• Jake at Econompicdata: Consumers Don't Care About Savings Rates
• Louis Uchitelle in the NYT: Factory Jobs Gain, But Wages Retreat (via)
• Dean Baker in CEPR's Beat The Press: Robert Samuelson, Wrong Again
• Uneasy Money: Which Fed Policy is Boosting Stocks? (includes an interesting look at the link between inflation expectations and S&P 500 returns)
• Michael Panzner at Financial Armageddon: Buzzing Again (topic: "Heightened speculation about economic recovery...doesn't mean it will happen")
• Derek Thompson in The Atlantic: It's Beginning to Look a Lot Like 2009 in India (via)

Energy & Environment, Food Security, Climate Change

Housing, Wealth and Recession

I will likely return to these papers later, but I wanted to briefly comment on the interesting research on the recession and the impact of household debt - by Atif Mian and Amir Sufi. Here are two of their recent papers:

• What Explains High Unemployment? The Aggregate Demand Channel
• Household Balance Sheets, Consumption, and the Economic Slump [with Kamalesh Rao]
• Also see this Bloomberg op-ed: How Household Debt Contributes to Unemployment: Mian and Sufi

Mike Konczal at Rortybomb interviewed Amir Sufi on the topic of balance sheet recessions and posted the transcript on his blog. The entire interview is worth reading, but I'm going to include a few excerpts on Sufi's view of the recession and its causes.

Regarding the question of which policy is likely to be more effective in addressing the aggregate demand and unemployment problem, i.e., fiscal stimulus or household debt reduction (e.g., via principal forgiveness or credit writedowns), Sufi says:

I think that right-leaning economists don’t deny that the zero lower bound could be a friction. I think the zero-lower bound does bother them, that they think it is a fundamental friction. I think where they’d disagree with Paul [Krugman], and to an extent even I disagree with Paul, is that if you look at his model, the optimal policy in those models isn’t necessarily fiscal stimulus, it is writing down the debts of borrowers. That’s the number one policy that fixes the problem.

[...]

I come from a finance micro background, so if I were to criticize the zero-lower bound literature, which I use, it is that fiscal stimulus doesn’t fall so naturally out of it. Paul goes to lengths to argue against the argument “how can more debt solve a debt problem?” and explains it is because the borrowers are constrained, and there’s some truth to that. But the fundamental problem in these models, what generates the zero-lower bound problem, is a sharp reduction in consumption by borrowers. Why not attack that problem head on? If you look at Rogoff’s opinion against Krugman’s, I think this is the main difference. They agree on the zero-lower bound nature of the problem, but have different tactics on how to fight it. I tend to agree with the view that directly targeting the household debt problem seems to make more sense than fiscal stimulus.

Here are a couple of links to Paul Krugman's views on this.

On the issue of whether the debt and demand problem is just related to regions that suffered a housing crash, Sufi says:

You are correct: if you unconditionally look at the high debt-to-income places, a lot of it is highly correlated with places that had construction booms and a lot of migration. To get rid of the construction and migration effects, we try to use exogenous variation in debt-to-income ratios that is driven by housing supply elasticity. This is a technique called “two-stage least squares.” We regress the debt-income ratio on how hard it is to build in an area. The idea is that this instrument allows us to disentangle the effect of debt levels from construction and migration. The results after doing this are very strong. Any place that had a high debt-income ratio, whether or not it had a construction boom, is suffering massively now.

On the question of whether the "wealth effect" does or does not explain the recession, as opposed to the notion of a "balance sheet recession", Konczal and Sufi had this exchange:

[Konczal] : Another response to this model is that the debt-to-income ratios don’t actually matter that much. What is really driving this is a wealth effect. People feel poorer from losing housing value, and thus they spend less. James Surowiecki just had a piece arguing against these balance sheet recession models in The New Yorker, “The Deleveraging Myth.” Dean Baker from CEPR makes this argument as well.

[Sufi]: Well obviously I disagree 100 percent with that for both theoretical and empirical reasons. The theoretical reason is that housing should not be thought of in a pure wealth sense. We all have to consume housing going forward. And the value of my house going down is also the same value of the price of housing going down. The easiest way to imagine this is to picture a young couple that currently rents and will buy a house in the future. If housing prices decline, it is good for them because they can then more easily buy a house in the future. Clearly, this is not a negative wealth effect for the young couple.

[Konczal]: But as far as I understand it there are studies that find a wealth effect in housing.

[Sufi]: This is a semantic point on what you call it. I’m saying as an economist that if you call something a wealth effect, then it has nothing to do with borrowing constraints and debt levels, and that effect in theory should be zero. To the degree that we observe that when people’s house prices go up they consume more, that’s not a wealth effect — that’s a borrowing constraint being alleviated, and people borrowing against collateral that they couldn’t before. Which is a very different thing, and it matters empirically. My own research on this topic shows definitively that people consume aggressively out of housing wealth because of borrowing constraints, not a simple wealth effect.

Here’s why I fundamentally disagree with the “wealth effect” argument. Suppose you have an economy that looks like the U.S. before the recession, where you have an extremely skewed net wealth distribution. The wealth effect argument is that the response of the economy to house price declines would have been the same if you flattened that out versus if you had the polarization that we have now. And I disagree with that fundamentally, and that’s what the research shows. The net wealth distribution matters. People who have very high debt-to-income ratios cut their spending very dramatically, and there is no way a pure wealth effect can explain the magnitude of the cut.

Also, on the topic of the wealth distribution and its impact:

The distribution of net wealth matters a lot. Let’s suppose there’s $100 of wealth in the economy and there’s a hundred people. If everybody had $1 of wealth, and then there’s a massive drop in house prices, my argument is that this recession wouldn’t have been nearly as severe. It’s because the five guys at the top have all of the $100 and are just lending to the other 95, that’s why the recession is so severe when house prices collapse. Paul said this a few times on his blog, and he’s usually very clear, but I don’t think he’s been clear enough on explaining this. These models on why deleveraging matters are all about the net wealth distribution. We shouldn’t be surprised that this recession and the Great Depression were preceded by very large increases in wealth inequality. This is well documented during the 1920s and the 2000s. This is why I get a bit annoyed at the guys who are saying it’s just a pure wealth effect, because it’s something bigger than that.

Do read the entire interview - it's worth it. Sufi also talks about savings rates and other factors.

Reads for Dec 18

Economics & Finance

• Paul Krugman at NYT: Inflating Your Way to Prosperity; Slow Learners; Lake Wobegon, Europe; No, It's Not The Welfare State; Chronic Confusion
• Brad DeLong: "Expansionary" Austerity in Europe
• Economist: Are Persistent Trade Deficits a Bad Thing?
• Paul Bergin at the SF Federal Reserve: Asset Price Booms and Current Account Deficits
• Kash Mansori at The Street Light: House Prices and Current Account Deficits; More House Prices and Current Account Deficits
• Global Macro Monitor at The Big Picture: Italy Works 20% More Hours than Germany or France
• Uneasy Money: Deutsche Bank Gets It, Why Can’t Mrs. Merkel?
• Scott Sumer at The Money Illusion: Like deer caught in headlights (talking about the Fed)
• Washingtons Blog at The Big Picture: FBI Estimates 80% of Mortgage Fraud Involved Industry Insiders
• Calculated Risk: Research: New paper on the role of investors in the housing bubble
• Michael Olenick at Naked Capitalism: NAR’s Big Miss on Home Sales Underscores Lack of Transparency and Accuracy in Mortgage/Housing Data
• Tamara Keith at NPR's It's All Politics Blog: GOP Objects To 'Millionaires Surtax'; Millionaires We Found? Not So Much [via]
• Mark Thoma at Economist's View: Percentage Growth in Annual Wages and Salaries [also see]
• Alex Tabarrok at Marginal Revolution: Roman Empire More Equal than the United States
• Brad DeLong: Why Oh Why Can't We Have a Better Press Corps? No, High Unemployment Is Not Primarily The Result of "Generous" Unemployment Insurance Benefits
• Chad Stone at CBPP's Off The Charts Blog: It’s the Great Recession, Not the Great Vacation, That’s Responsible for High Unemployment
• Mike Konczal at Rortybomb: What is the Real Unemployment Rate and How Could We Tell?
• Macromania: Beveridge Curves for 36 U.S. Cities (Updated)
• Ben Walsh at Business Insider: A Bunch Of Academics Think They've Figured Out How To Tell If A Hedge Fund Will Outperform The Market
• Barry Ritholtz at The Big Picture: Interest Rates: 1831-2011; US Housing Prices Mirror Japan's Experience; Beware The Retail Hype; Retail Sales Disappoint on False Black Friday Reports
• Cardiff Garcia at FT Alphaville: The Decline of "Safe" Assets

To wrap up this section, here's an interesting comment by William Cohan in this FDL Book Salon on his book "Money and Power: How Goldman Sachs Came to Rule the World":

Goldman actually almost went out of business many times in its history; it is very good at getting into trouble — and also very good at getting out of trouble

...and he also notes:

actually i go through chapter and verse of the many frauds that Goldman has committed or participated in over the years

Should make for some interesting reading.

Energy & Environment, Food Security, Climate Change

Eurozone Government Debt and Current Account Deficits

Background

In my previous post - The Stormy Petrel of Eurozone Budget Deficits: Current Account Deficits - I examined this question:

Do pre-crisis current account balances, as opposed to pre-crisis fiscal balances, better predict crisis-period fiscal balances (quantitatively) for countries that are part of the European currency union (EMU)?

I showed that the answer was yes and discussed the implications in the context of the recently concluded EU summit. The analysis in the post focused on current account (CA) and fiscal balances in the 7 years preceding the start of the Great Recession (pre-crisis) and fiscal balances in the 2008-2010 (crisis) time period. Countries that joined the Euro currency union in 2007 or beyond were excluded from the analysis since they were not on the Euro long enough in advance of the financial crisis. The key finding was that the average CA balance/GDP by country for 2000-2007 is a much better quantitative predictor of the average fiscal balance/GDP for the same country in 2008-2010, than is the average fiscal balance/GDP of the country in 2000-2007. The EU "fiscal union" was largely a fiscal austerity pact, with inordinate emphasis on minimizing fiscal deficits and sovereign debt levels as a % of GDP, with little or no focus on the current account. However, as I discussed in the above post, pre-crisis fiscal balances are less effective in predicting future fiscal balances than are pre-crisis CA balances. Hence, I argued that a "fiscal union" that demands fiscal austerity as a way to ensure low fiscal deficits in the future, with no attention paid to CA balances, is unlikely to consistently prevent large future fiscal deficits.

In this post, I turn my attention to government debt - the other element of the EU pact. The question I ask here is:

Do pre-crisis current account balances/GDP, as opposed to pre-crisis government debt/GDP, better predict crisis-period debt/GDP or changes in debt/GDP (quantitatively) for countries that are part of the European currency union (EMU)?

The answer is mixed as I will explain below.

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Summary

In this post, I summarize the results of a simple analysis of the average current account (CA) and government debt, as a percentage of GDP, for nearly a dozen European countries that use the Euro as their currency [Section 1]. With the usual caveat that correlation does not always imply causation, the key findings can be summarized as follows:

1. The average debt/GDP change from 2000-2007 to 2008-2010 was ~12.2 percentage points, with a standard deviation of ~11.9 percentage points. If Ireland and Luxembourg are excluded as outliers, the average is 10.0 and standard deviation is 9.8 [Section 1].

2. The % change in average debt/GDP between 2000-2007 and 2008-2010 was ~ 35.2%, with a standard deviation of 47.3%. If Ireland and Luxembourg are excluded as outliers, the average is 14.9% and the standard deviation is 13.9% [Section 1].

3. Pre-crisis average debt/GDP was a fairly good predictor of the absolute value of post-crisis average debt/GDP (slightly greater than 1X) but was poor in predicting the % change to pre-crisis average debt/GDP due to the crisis [Section 2]. The reason for this behavior is unclear.

4. Pre-crisis average current account balance/GDP is a low to moderate predictor of the absolute value of post-crisis average debt/GDP as well as the % change to pre-crisis average debt/GDP due to the crisis [Section 3].

Hence, if we were interested in knowing the likely % change to average debt/GDP [pre- to post-crisis], the pre-crisis average CA balance/GDP was more likely to give us some insight on this than the pre-crisis average debt/GDP. If, on the other hand, we were interested in knowing the likely absolute average debt/GDP [post-crisis], the pre-crisis average debt/GDP hits the mark much more effectively on this than than the pre-crisis average CA balance/GDP. In the context of the recently concluded EU "fiscal union" summit, a focus purely on nominal debt/GDP levels will likely provide less insight on the mechanisms that might allow for net debt reduction. A focus on CA balances/GDP is more likely to be useful in understanding how to shape the % change in debt/GDP in the desired direction.

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1. Eurozone Countries - Assumptions & Data

The Stormy Petrel of Eurozone Budget Deficits: Current Account Deficits

[NOTE: The second part of this analysis is posted in the next post: Eurozone Government Debt and Current Account Deficits]

Background

In my previous post discussing the recent EU "fiscal union" summit, I said:

You'll notice that Spain and Ireland were running fiscal surpluses with acceptable debt/GDP in the years immediately preceding the financial crisis - yet these countries are amongst the worst affected by the meltdown and and in the crosshairs of the ECB and austerity hawks. Slovenia had run modest deficits ahead of the financial crisis and its debt to GDP ratio was low and declining ahead of the crisis - yet, Slovenia's bond yields have been in crisis territory recently and its debt situation is worsening as the economy teeters into recession. Undoubtedly, countries like Greece made their problems much worse with very high levels of deficits and debt prior to the crisis. That said, even Germany ran significant deficits and had high debt levels prior to the crisis - yet, Germany remains relatively unscathed because it has run massive current account surpluses thanks in part to the Eurozone periphery that ran massive trade deficits that benefited countries like Germany.

This is a point that has been made by many people before: rather than fiscal profligacy, the main root cause of the current European financial crisis can be traced back to large current account deficits run by many EU members following the establishment of the Euro as a common currency, culminating in a sudden stop (in the vicinity of the Great Recession) that pummeled the economic and fiscal health of those countries. A useful chart is available from Kash Mansori at The Street Light - along with his follow-up observations...

In their book "This Time is Different: Eight Centuries of Financial Folly", Carmen Reinhart and Kenneth Rogoff point out:

An even stronger regularity found in the literature on modern financial crises is that countries experiencing sudden large capital inflows are at high risk of experiencing a debt crisis [15]. The preliminary evidence here suggests that the same is true over a much broader sweep of history, with surges in capital inflows often preceding external debt crises at the country, regional, and global levels since 1800, if not before.

[I've discussed some of these issues in more detail in a couple of other prior posts: Capital Flow Bonanzas and Their Aftermath and Q&A with President Bill Clinton at the 2011 Clinton Global Initiative, Part 2 - The Financial Crisis in Europe]

Given the known impact of large net capital inflows and current account deficits on fiscal stability, here's a natural question that came to mind in the context of the Eurozone:

Do pre-crisis current account balances, as opposed to pre-crisis fiscal balances, better predict crisis-period fiscal balances (quantitatively) for countries that are part of the European currency union (EMU)?

This post focuses on that question. The answer, as it turns out, is yes and the implications of this are obviously significant in the context of the recently concluded EU summit.

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Summary

In this post, I summarize the results of a simple analysis of the average current account (CA) and fiscal balances, as a percentage of GDP, for nearly a dozen European countries that use the Euro as their currency [Section 1]. The analysis focused on CA and fiscal balances in the 7 years preceding the start of the Great Recession (pre-crisis) and fiscal balances in the 2008-2010 (crisis) time period. Countries that joined the Euro currency union in 2007 or beyond were excluded from the analysis since they were not on the Euro long enough in advance of the financial crisis. The key finding from this analysis is that the average CA balance/GDP by country for 2000-2007 [Section 3a, 3b] is a much better quantitative predictor of the average fiscal balance/GDP for the same country in 2008-2010, than is the average fiscal balance/GDP of the country in 2000-2007 [Section 2a, 2b].

The analysis was completed with and without Ireland in the mix. Ireland is a massive outlier in the data when it comes to fiscal deficits - likely due to the fact that the main issue in Ireland was large-scale private debt rather than sovereign debt, and sovereign debt ballooned only later because of the Irish government's huge borrowing to bail out private banks during the crisis. With the exclusion of Ireland, the positive correlation between average pre-crisis CA balance/GDP to crisis-era fiscal balance/GDP is very high and even more stark [Section 3c, 3d]. It is significantly higher than the correlation between average pre-crisis fiscal balance/GDP to crisis-era fiscal balance/GDP [Section 2c, 2d]. 

The findings here raise more questions about the effectiveness of the recently touted EU "fiscal union" which was largely a fiscal austerity pact, with inordinate emphasis on fiscal balances as opposed to CA balances. Specifically, the data shown here indicate that pre-crisis fiscal balances do not effectively predict fiscal balances during downturns/crises - they are less effective in doing so than pre-crisis CA balances. Hence, a "fiscal union" that demands fiscal austerity as a way to ensure low fiscal deficits in the future, with no attention paid to CA balances, is unlikely to consistently prevent large future fiscal deficits. Further, given the limited direct correlation between CA and fiscal balances over the same period of time [see "Baseline Charts" in Section 3], it is quite possible that countries might run fiscal surpluses along with large current account deficits over the same time period, and yet have little or no protection against future fiscal deficits during downturns [as shown in Section 3a-3d]. Finally, a misguided focus on short-term fiscal deficits and debt (as opposed to longer-term fiscal health) is more likely to drive deflationary results as well in the current environment - which could be another negative consequence of the recently announced EU "fiscal union".

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1. The Eurozone Countries

The EU Brand of Hopium

It's abundantly unclear how the EU summit on Friday actually solved the foundational problems behind the financial crisis in Europe - if anything the implications for the future might be worse. Here are a few posts that get to the gist of the problem with the touted "fiscal union".

Let's start with this NPR piece by Chana Joffe-Walt which helpfully summarizes the recent historical data on Eurozone deficits and debt as a percentage of GDP. First, EU countries' deficits as a percentage of GDP compared to the threshold limit set by the pact on Friday, December 9.

Second, EU countries' debt as a percentage of GDP compared to the threshold limit set by the same pact.