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Posts Tagged ‘John Maynard Keynes’

Looks Like A Classical Pump&Dump Setup

In Financial Engeneering, Financial Markets, High Frequency Trading, International Econnomic Politics, Law & Regulations, National Economic Politics, Quantitative Finance, Technology, Views, commentaries and opinions on 14.01.11 at 22:04

The global stocks markets are reaching for new highs, sending the benchmarks to the highest level since August 2008. Once again it’s the financials that’s leading the race after Wells Fargo raised its rating for large banks on prospects for higher dividends, JPMorgan Chase says it will use some of its reserves to boost earnings and Morgan Stanley says banks and insurance companies will be winners in the stock market this year. Well, it sounds like the same old song and dance routine to me, just like we’ve seen it over and over again for the last two years – a classical pump & dump scheme.

“Companies are sitting on tons of cash. Corporate earnings are coming in very strong. I see a gain of 10 percent to 15 percent for stocks in 2011.”

Philip Dow


Personally, I don’t think there’s many investors who actually believe a word of what the bankers and their stock pushers are saying. But that’s not the point. The point is, however, that the big financials are setting up another stock market rally so they can cash in a couple of billion dollar more before the new regulations takes effect and prohibit them from trading with their own money, shutting down their most lucrative area of business.

This may very well be the biggest opportunity investors will get in 2011. The financial shares have, more or less, controlled the stock market over the last two years – pushing the average prices up, then pulling them down again.

But this is no game for amateurs. You never know when the big players turn around, stop buying and dump the load right in your face. The so-called “swing trade,” where the goal is to figure out exactly when the market turns, is one of the most difficult investment strategies there is. It can also be the most rewarding.

But remember; there is nothing – I emphasize; nothing – that indicates that the problems are over for financial firms. On the contrary; several signs points to more trouble ahead.

The greatest factor of uncertain right now is the European debt crisis. Even if it’s the national governments that is about to go bankrupt, it is the financial industry who’ll get the punch when countries starts to default.

Something the credit market investors have figured out a long time ago.

(Read also: Smart Money Is Not Stupid (Or Is It?))

The second bomb about to detonate is the dodgy foreclosure case.

At the moment, the banks are allowed to accrue interest on non-performing mortgages  until the actual foreclosure takes place, which on average takes about 16 months.

This “phantom interest” is not actually collected, but still it’s booked as income until the actual act of foreclosure.

As a resullt, many bank financial statements actually look much better than they actually are.

This means that Bank of America, Citigroup, JP Morgan and Wells Fargo, and hundreds of other smaller institutions, can report interest due to them, but not paid, on an estimated $1.4 trillion of face value mortgages on the 7 million homes that are in the process of being foreclosed, according to Forbes.

“Ultimately, these banks face a potential loss of $1 trillion on nonperforming loans,” says Madeleine Schnapp, director of macro-economic research at Trim-Tabs, an economic consulting firm 24.5% owned by Goldman Sachs.

However, the central banks, and the governments will be pumping money into the financial markets as long as they can in order to keep the financial system running. And they might be able to do that for a year or two more (maybe even longer).

“The markets can stay irrational longer than you can stay solvent.”

(John Maynard Keynes)

.


Anyway – who gives a shit?

The KBW Bank Index, which tracks 24 US financial companies, was up 13% in the four weeks through Jan. 5, three times the gains of the Standard & Poor’s 500.

And there’s also a third landmine in store for US banks.

According to Forbes, investors are now betting that the GOP-controlled Congress will water down the financial-services overhaul, and the great Wall Street reform will be just a joke, as many have feared.

On paper, the Dodd-Frank financial-services overhaul bill looks like a bank-stock killer.

It restricts how banks can trade for their own accounts, it raises capital requirements and it tightens supervision. By some estimates it will cut big bank profits by $22 billion annually—what the industry makes in a decent quarter.

Yet, bank stocks is rallying like it’s 2009.

Investors are banking that House Republicans will modify the new law, says Terry Haines, a senior analyst Potomac Research Group: “Back in July 2010, when Dodd-Frank became law, investors expected the quick imposition of rules with an immediate impact on the financial sector. But a lot of the key components of Dodd-Frank have not yet been implemented. And now there is a more favorable and moderate political environment as well.”

Note that any statement of just how much of the Dodd-Frank law will be changed by House Republicans is only speculation.

Investors may be overestimating the GOP‘s nimbleness.  The regulatory agencies could, in fact, begin to implement rules before the House Financial Services Committee holds any hearings on the matter, and the republicans may be distracted by efforts to reform the congressionally chartered mortgage giants Fannie Mae and Freddie Mac.

And some of the new regulations will simply not go away by themselves.

Banks will have to adhere to higher capital of some kind – the same goes for liquidity requirements – and the banks’ cost of deposit insurance and regulatory compliance are sure to increase significantly, regardless of what the GOP may accomplish.

“Every page of the law has something that impacts the bottom line,” banking lawyer Thomas Vartanian points out.

(The law is 848 pages long!)

Terry Haines points out that  the  regulators charged with writing regulations under the act will be scrutinized by the House Appropriations Committee as well as the Financial Services Committee.

“The Appropriations committee could limit the funding of controversial regulatory initiatives under Dodd-Frank, or even defund them entirely,” Haines says .

Perhaps. But the republicans could also easily be “Stewartized” into submission (mocked by the Daily Show’s John Stewart). And the general public is still quite upset over the fact that the hot-shots responsible for wrecking the economy still have their jobs and their bonuses, while about 8.5 million American workers lost theirs.

Something is going to hit the banking industry – whatever it will be…

“The people who took a political gamble on the sector in December most likely are traders who will take their money and run at the first sign of wavering by the House GOP,” Forbes writes.

If that’s the truth – the sector is set up for a classic pump and dump scheme.

Bank and life insurer stocks should see the biggest gains in 2011, according to a team of Morgan Stanley analysts. The team says its call is based on low valuations in the sectors, as well as increasing clarity about regulation that has weighed on the shares. An improving economy and the company’s increased capital deployment should drive return on equity.

Property and casualty insurers should also get a boost late in the underwriting cycle.

Morgan Stanley says its favorite names are Bank of America, Comerica and TD, for large cap, mid cap, and Canadian  banks, respectively.

In insurance, Prudential is the team’s pick for life insurers, with Axis Capital as a standout in P&C.

“Bank dividends and M&A activity signal the economy is transitioning from recovery to expansion,” says Philip Dow, director of equity strategy at RBC Wealth Management in a market comment at Bloomberg.com.

“Companies are sitting on tons of cash. Corporate earnings are coming in very strong. I see a gain of 10 percent to 15 percent for stocks in 2011.”

That’s right! Pump, baby. Pump!

 

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Niall Ferguson: US Economy Is Leaking

In Financial Markets, Health and Environment, International Econnomic Politics, Law & Regulations, National Economic Politics, Philosophy, Uncategorized, Views, commentaries and opinions on 25.10.10 at 02:50

Top analyst Niall Ferguson makes a powerful attack on the extreme Keynesian economic policy that’s ruling the world at the moment, and explains why quantitative easing doesn’t work.

“Remember what Keynes wrote in the 1930s about stimulus and the way in which government could get an economic going again really applied to a post-globalization world in which trade and capital flows had largely broken down, and most economies were quite isolated units. That’s something that Keynes made clear in the German edition of the General Theory when he said the theory applies better in a closed totalitarian economy.”

Niall Ferguson


“Globalization has not broken down. In fact the US economy is more open than it has ever been. That means that stimulus, both monetary and fiscal if very prone to what is called leakage. We’ve had an enormous of stimulus in the US, it’s the biggest fiscal stimulus in the world, and huge unprecedented monetary stimulus. What’s been stimulated? Not jobs in Michigan. What’s been stimulated has been commodity markets and emerging markets. Because the liquidity just leaks out, and that’s why another round of stimulus would not stimulate in the promised way. It would stimulate the wrong things. And those things, commodity markets and emerging markets, are already overstimulated to the point of being nearly bubbles.”


 

 

 

FED Adds QS To QE: Here's The Transcript of Bernanke's Testimony

In Financial Markets, International Econnomic Politics, National Economic Politics on 30.09.10 at 23:17

Appearing before the US Senate Banking Committee Thursday, FED chairman Ben Bernanke began his testimony on the recently approved US legal overhaul  – the regulation of the financial system. In a prepared speech, Bernanke praised the Dodd- Frank Act for addressing critical regulatory gaps that were revealed by the financial crisis, pointed out that the Federal Reserve was working closely with other regulators to enact the law that was approved by Congress in July. The chairman also introduced “quantitative surveillance” of the US banking system.  Read the full transcript of Mr. Bernanke’s testimony.

“The stress tests also showed how much the supervision of systemically important institutions can benefit from simultaneous horizontal evaluations of the practices and portfolios of a number of individual firms and from employment of robust quantitative assessment tools.”

Ben Bernanke


“As it was put by my former colleague, Markus Brunnermeier, a scholar affiliated with the Bendheim center who has done important research on bubbles; we do not have many convincing models that explain when and why bubbles start. I would add that we also don’t know very much about how bubbles stop either.”

The FED chief thanked the Senate for confirming two of three outstanding Federal Reserve Board governor nominees , filling key slots on the central bank’s board.

The lawmakers approved Janet Yellen as a member of the board, as well as vice chairman of the FED, and Sarah Bloom Raskin as a member of the board.

Bernanke will over the next days participate in a panel taking questions from Senators on implementation of the latest financial overhaul. The panel also includes Sheila Bair, head of the Federal Deposit Insurance,  Mary Schapiro, head of the Securities and Exchange Commission and Gary Gensler, head of the Commodity Futures Trading Commission.

Ben Bernanke started his opening statement by saying:

“In the years leading up to the recent financial crisis, the global regulatory framework did not effectively keep pace with the profound changes in the financial system. The Dodd-Frank Act addresses critical gaps and weaknesses of the US regulatory framework, many of which were revealed by the crisis. The Federal Reserve is committed to working with the other financial regulatory agencies to effectively implement and execute the act, while also developing complementary improvements to the financial regulatory framework.”

Adding:

“The act gives the Federal Reserve several crucial new responsibilities. These responsibilities include being part of the new Financial Stability Oversight Council, supervision of nonbank financial firms that are designated as systemically important by the council, supervision of thrift holding companies, and the development of enhanced prudential standards for large bank holding companies and systemically important nonbank financial firms designated by the council,  including capital, liquidity, stress test, and living will requirements.”

“In addition, the Federal Reserve has or shares important rulemaking authority for implementing the so-called Volcker Rule restrictions on proprietary trading and private fund activities of banking firms, credit risk retention requirements for securitizations, and restrictions on interchange fees for debit cards, among other provisions,” he said.

.

Introducing QS 1

According to Mr. Bernanke, a critical feature of a successful systemic or macroprudential approach to supervision is a “multidisciplinary perspective.”

“Our experience in 2009 with the Supervisory Capital Assessment Program – popularly known as the bank stress tests – demonstrated the feasibility and benefits of employing such a perspective. The stress tests also showed how much the supervision of systemically important institutions can benefit from simultaneous horizontal evaluations of the practices and portfolios of a number of individual firms and from employment of robust quantitative assessment tools,” he told the senators.

“Building on that experience, we have reoriented our supervision of the largest, most complex banking firms to include a quantitative surveillance mechanism and to make greater use of the broad range of skills of the Federal Reserve staff,” he said.

Here’s the full transcript of chairman Ben Bernanke’s testimony before Banking Committee today.

And Defending QE 2

One of the things Mr.Bernanke probably will have to explain to the senators is the – now famous – monetary policy called quantitative easing.

The policy, based on the economic theories of John Maynard Keynes,  means in practice to pour money into the the financial system in numerous ways to stimulate economic growth in times of contraction.

Many economists, commentators and other financial experts have started to question the theories, used by both central banks and governments to build their arguments and actions.

After spending unknown trillions of dollar to counter the economic downturn, without much visible results, it’s quite understandable.

However, Ben Bernanke, will defend the FED’s policy with the strongest conviction.

Speaking at a conference at Princeton last Friday, he said:

“Standard macroeconomic models, such as the workhorse new-Keynesian model, did not predict the crisis, nor did they incorporate very easily the effects of financial instability. Do these failures of standard macroeconomic models mean that they are irrelevant or at least significantly flawed? I think the answer is a qualified no.”

“Economic models are useful only in the context for which they are designed. Most of the time, including during recessions, serious financial instability is not an issue. The standard models were designed for these non-crisis periods, and they have proven quite useful in that context. Notably, they were part of the intellectual framework that helped deliver low inflation and macroeconomic stability in most industrial countries during the two decades that began in the mid-1980’s,” Ben Bernanke said at the conference, sponsored by Center for Economic Policy Studies and the Bendheim Center for Finance.

PS: Don’t Blame The Models

On the other hand, human behavior is still a big problem.

Or as the FED chief puts it: “Most economic researchers continue to work within the classical paradigm that assumes rational, self-interested behavior and the maximization of “expected utility” – a framework based on a formal description of risky situations and a theory of individual choice that has been very useful through its integration of economics, statistics, and decision theory.9 An important assumption of that framework is that, in making decisions under uncertainty, economic agents can assign meaningful probabilities to alternative outcomes. However, during the worst phase of the financial crisis, many economic actors – including investors, employers, and consumers – metaphorically threw up their hands and admitted that, given the extreme and, in some ways, unprecedented nature of the crisis, they did not know what they did not know.”

The idea that at in certain times, decisionmakers simply cannot assign meaningful probabilities to alternative outcomes –  even not think of all the possible outcomes – is known as Knightian uncertainty, after the economist Frank Knight who discussed the theory in the 1920’s.

“Research in this area could aid our understanding of crises and other extreme situations. I suspect that progress will require careful empirical research with attention to psychological as well as economic factors,” Bernanke replies.

Another issue that clearly needs more attention is the formation and propagation of asset price bubbles, the FED chairman acnowledge.

“Much of the literature at this point addresses how bubbles persist and expand in circumstances where we would generally think they should not, such as when all agents know of the existence of a bubble or when sophisticated arbitrageurs operate in a market. As it was put by my former colleague, Markus Brunnermeier, a scholar affiliated with the Bendheim center who has done important research on bubbles, “We do not have many convincing models that explain when and why bubbles start.” I would add that we also don’t know very much about how bubbles stop either.”

“The financial crisis did not discredit the usefulness of economic research and analysis by any means; indeed, both older and more recent ideas drawn from economic research have proved invaluable to policymakers attempting to diagnose and respond to the financial crisis. However, the crisis has raised some important questions that are already occupying researchers and should continue to do so. As I have discussed today, more work is needed on the behavior of economic agents in times of profound uncertainty; on asset price bubbles and the determinants of market liquidity; and on the implications of financial factors, including financial instability, for macroeconomics and monetary policy,” Ben Bernanke concludes.

*

Here’s a copy of the Princeton speech.

*

Related by the Econotwist:

Goodbye Keynes – Hello Ricardo!

US Economic growth slows to 1,6% – Does Quantitative Easing Really Matter?

US Congress Question Morals of Monetary Policy

“A Breakdown In Our Values”

Force The Rich!

Wild-West Capitalism (Don’t Blame The Baby Boomers)

Socialism For The Rich – Capitalism For The Poor?

2010 Analysis: The Road to Disaster

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Goodbye Keynes – Hello Ricardo!

In Law & Regulations, Learning, Philosophy, Quantitative Finance on 01.06.10 at 17:27

The world have been fighting the financial crisis by using every possible trick according to John Maynard Keynes‘ playbook. But, as The Great Depression taught us, extreme government spending tends to cause about as much problems as it solves. Perhaps it’s time to put Keynes back on the bookshelf, and pull out the 200 year old theories of David Ricardo.

“While budget stimulus measures are intended to boost demand from financially constrained consumers, it may for others – the majority – result in the emergence of Ricardian behavior.”

Philippe d’Arvisenet


For those not too familiar with economic theories; Ricardian behavior is basically increased  consumer savings due to expectations of higher taxes in the future. This effect has been shown to emerge more widespread in countries with large governmental debt, and lead to significant difference in the recovery process among nations.

The increase in public debt registered over the last few years is without precedent.

In each of the main OECD countries, public debt is not on a sustainable path, BNP Paribas chief economist, Philippe d’Arvisenet writes in a research paper.

This contrasts with past periods, during which emerging markets have appeared more at risk from this perspective.

The majority of developed countries will have a public debt ratio in excess of 90% in the middle of the decade, BNP Paribas estimates.

However, according to the IMF,  from 2007 to 2014, the debt ratio in these countries is expected to rise by an average of more than 30 points of GDP, reaching an average of 110% of GDP.

Philippe d’Arvisenet points out that of this increase, 3 points will be related to supporting the financial system.

* 4 points to the increased cost of debt.

* 10 points to automatic stabilizers.

* 3.5 points to budget stimulus measures.

* 9 points to losses of tax revenues relating to the decline in asset prices.

“The widening of deficits is largely structural in nature. The deficit ratio adjusted for cyclical variations is 4.4% in the euro zone out of a total deficit of 6.7 points, with 9.8 points in the UK (out of a total of 13.3 points) and 8.8 points in the US (out of a total of 10.7 points). In the past, this structural deficit has shown a strong tendency to persist,” the french chief economist writes.

For the time being, surplus production capacity limits the risk of public debt having a crowding-out effect on private investment.

Ricardo, Who?

About 200 years ago British economist David Ricardo presented his “theory of equivalence” in a newspaper essay.

In Ricardo’s view, it does not matter whether you choose debt financing or tax financing, because the outcome will be the same in either case. Flip a coin if you like, because in terms of the final results, raising taxes by $1,000 is equivalent to the government borrowing $1,000.

According to traditional economic theory, like the Keynesian, public debt has a significant effect on the overall economy because consumers regards public debt as net wealth.

The Ricardian equivalence theory, on the other hand, suggest that is has no effect so ever.

While budget stimulus measures are intended to boost demand from financially constrained consumers,  in their case  the classic system of budgetary multipliers (Keynesian style economics) takes full effect.

But for others – the majority – the result will most likely be widespread emerging of so-called Ricardian behaviour.

Ricardian behavior is a term economists use to describe growth in consumer saving to cope with the costs of expected increasing taxes in the future.

The consumers expectations are usually fulfilled, and often extended, later research have shown.

In most cases, government borrowing ends up being more expensive for the citizens when inflation, higher borrowing costs and interest rates are taken into account.

The theory of Ricardian behavior is controversial, as it assumes that people think and behave financially rationally.

We know we don’t.

But other factors can trigger similar behavior, like lack of transparency in the state finances and mistrust in the governments economic policy.

In any case; Ricardo’s main point that government borrowing is nothing more than a way of delaying tax hikes, seems to be accepted by many leading economists today.

No More Free Lunch

It should be clear by now that the public finance situation calls for credible recovery measures.

“While the conventional crowding-out effect does not have an impact, the budget situation – contrary to the situation before the financial crisis – now affects the assessment of risks and may inflate risk premiums. This results in a higher cost of debt, making adjustment even more difficult,” Mr. d’Arvisenet writes.

Adding that this situation could make an end to the until now observed developments characterized by rising debt with no impact on interest payments because of falling interest rates – a kind of “free lunch”.

“A high level of debt increases the probability of an interest rate or growth shock resulting in unsustainable debt, with higher debt ratios and a widening gap between the apparent real interest rate and the rate of growth. This configuration makes adjustment even more difficult and in any case presents a number of threats (snowball effect of debt).”

Recent data clearly call for immediate action.

BNP Paribas points to the fact that, as a direct consequence of the financial crisis – with an increase in the cost of capital and structural unemployment and a decline in economic activity – the potential level of GDP in the OECD region is around 3.5 points below the pre-crisis level.

In addition, unless there is an increase in taxation, the higher cost of debt means that some public services will have to be sacrificed.

An increase in taxation is frequently synonymous with fiscal distortions that can harm growth.

Debt then eliminates the ability to implement new support measures if needed.

A Credible Exit Strategy; Fact Or Fiction?

Ricardo’s theories might very well be correct,  but only in a perfect economy with free markets and responsible, rational people.

However, by understanding Ricardo’s line of arguments, it becomes more clear what’s wrong with the current economic policy.

BNP Paribas chief economist writes:

“In addition to purely budgetary considerations, deterioration in public finances is a potential challenge for central banks. The level of debt may result in not only increases in inflationary anticipations, but also uncertainties about the success of consolidation measures, making steering of monetary policy more complicated (what is the appropriate interest rate?). The weighting of the cost of debt may result in pressures favoring monetisation, casting doubt on the independence of central banks, not taking account of the fact that these institutions – which have increased the share of public debt securities in their balance sheets – are therefore exposed to greater interest rate risks.”

According to the IMF, a primary structural surplus of 8 points of GDP from 2011 to 2020 (from -4.3% to +3.6% of GDP) would be necessary in order to bring the debt ratio to 60 points of GDP in 2030, although with significant differences between countries: one-fifth of developed countries would have to make an adjustment of more than 10 points and two-thirds would have to make an adjustment of less than 5 points.

The adjustment would be halved for a target of stabilizing the debt ratio at the 2012 level.

The IMF estimates that over 10 years, and assuming growth of 2%, the end of stimulus measures could contribute 1.5 points of GDP.

In addition to the freeze on public spending excluding health-care, which implies priorities and efforts to improve efficiency, stabilization in expenses relating to the aging of the population proportional to GDP would provide a contribution of 3-4 points of GDP and tax deductions would provide a contribution of around 3 points.

“In the shorter term, as suggested by recent research, displaying a credible budgetary consolidation policy concerning primarily expenditure can enhance the effectiveness of support measures in place, by means of both consumer behavior (Barro-Ricardo effect) and also interest rates,” Philippe d’Arvisenet writes.

The Ricardian Union (Formerly Known As E.U.)

Research by Antonio Afonso at Universidade Tecnica de Lisboa, published in 2001, concludes that debt hardly will become neutral. And he’s probably right.

But Afonso’s finding, based on studies of 15 European countries, indicates that government debt has a considerable stronger effect on consumer spending in highly indebted countries, as compared to the less indebted nations.

There seems to be a limit around 50% of GDP; a debt-to-GDP ratio over 50 tends to make people more aware, and cautious, about their financial situation. They become Ricardian.

The prospect of a return to sustainable debt allays fears of inflation and therefore anticipations of a hike in interest rates, which helps to contain the rise in long-term rates, BNP Paribas argues.

“A budgetary exit strategy is a difficult exercise. The change in the primary balance needed to ensure a similar level of debt to that observed before the crisis – which would avoid transferring the consequences of the crisis to future generations – is considerable but not unprecedented.”

“Recourse to inflation” as dreamed of by some, does not seem to be the solution, according to BNP Paribas, refering to analysis of successful experiences of budgetary consolidation shows that a significant reduction in the debt ratio has been achieved in 10 or so countries, mainly by means of the primary balance.

The contribution of growth was negligible in this respect (apart from in Spain and Ireland), chief economist Philippe d’Arvisenet says.

“We can therefore see that consolidation measures are taken with a long-term view – one or two years has not been enough. This does not mean that it is not necessary to continue with the reforms intended to support growth,” he adds.

However, there are just too many uncertainties relating to this matter to be able to count considerably on this factor.

What About Fiscal Illusions?

Among the uncertainties are another – rarely mentioned – theory called “fiscal illusion.”

“Fiscal Illusion” is a public choice theory of government expenditure first developed by the Italian economist Amilcare Puviani in 1897.

“Fiscal Illusion” suggests that when government revenues are unobserved or not fully observed by taxpayers then the cost of government is perceived to be less expensive than it actually is.

Examples of fiscal illusion are often seen in deficit spending.

CATO Institute economist William Niskanen, has noted that the “starve the beast” strategy popular among U.S.  conservatives wherein tax cuts now force a future reduction in federal government spending is empirically false.

Instead, he has found that there is ‘a strong negative relation between the relative level of federal spending and tax revenues.

Tax cuts and deficit spending, he argues, makes the cost of government appear to be cheaper than it otherwise would be.

Paulo Reis Mourao at Australian National University presented in 2008 an empirical attempt to measure fiscal illusion for almost 70 democracies since 1960.

The results obtained reveal that Fiscal Illusion varies greatly around the world.

Countries such as Mali, Pakistan, Russia, and Sri Lanka have the highest average values over the time period considered, while Austria, Luxembourg, Netherlands, and New Zealand have the lowest.

But, as you know; some illusionists are better than others.

The French Solution

The greatest increase in public debt forecast for the next few decades relates to the aging of the population, BNP Paribas concludes.

“The matter of health-care and pension reforms is crucial (without reform, the associated cost would be 4-5 points of GDP between now and 2030,” according to the French banks research.

“Reforms in this area are even more important as their effects become more significant with time and their initial cost is limited.”

Based on lessons of other recent research, BNP Paribas notes:

“The greater effectiveness of rules that are easy to implement (public spending versus deficit), as demonstrated for example by the failure of the Gramm Rudmann Hollings Act of 1985 and the success of the Budget Enforcement Act that succeeded it;”

* The increased effectiveness of automated mechanisms, compared with discretionary practices such as those relating to sanctions for excessive deficits in the euro zone;

* The appeal of anti-cyclical measures (rainy day funds etc.).

The bank make the following suggestions:

(1) To stabilize the public debt ratio (debt to nominal GDP), it is necessary to generate a primary balance equal to the product of the debt ratio by the difference between the real rate of interest on debt and the rate of growth.

(2) Not forgetting that inflation is not manifesting itself and that inflationary fears alone are likely to provoke a rise in real interest rates.

(3) From this viewpoint, the change in retirement age has substantial effects both directly (increase in tax revenues, reduction in expenditure) and indirectly on potential growth (working-age population and participation rate).

Related by The Swapper:

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You Sue Me, I Sue You, Oh Peggy, Peggy Sue

Breeding New Watchdogs

Gerald Celente: “The Great Crash Has Occurred”

A Baltic Future For Greece?

“We Stand At The Brink Of The Next Great Crisis”

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Euro Zone: More Fiscal Integration Or Not?

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Goodbye Keynes – Hello Ricardo!

In Financial Markets, International Econnomic Politics, Views, commentaries and opinions on 30.05.10 at 04:48

The world have been fighting the financial crisis by using every possible trick according to John Maynard Keynes‘ playbook. But, as The Great Depression taught us, extreme government spending tends to cause about as much problems as it solves. Perhaps it’s time to put Keynes back on the bookshelf, and pull out the 200 year old theories of David Ricardo.

“While budget stimulus measures are intended to boost demand from financially constrained consumers, it may for others – the majority – result in the emergence of Ricardian behavior.”

Philippe d’Arvisenet

For those not too familiar with economic theories; Ricardian behavior is basically increased  consumer savings due to expectations of higher taxes in the future. This effect has been shown to emerge more widespread in countries with large governmental debt, and lead to significant difference in the recovery process among nations.


The increase in public debt registered over the last few years is without precedent.

In each of the main OECD countries, public debt is not on a sustainable path, BNP Paribas chief economist, Philippe d’Arvisenet writes in a research paper.

This contrasts with past periods, during which emerging markets have appeared more at risk from this perspective.

The majority of developed countries will have a public debt ratio in excess of 90% in the middle of the decade, BNP Paribas estimates.

However, according to the IMF,  from 2007 to 2014, the debt ratio in these countries is expected to rise by an average of more than 30 points of GDP, reaching an average of 110% of GDP.

Philippe d’Arvisenet points out that of this increase, 3 points will be related to supporting the financial system.

* 4 points to the increased cost of debt.

* 10 points to automatic stabilizers.

* 3.5 points to budget stimulus measures.

* 9 points to losses of tax revenues relating to the decline in asset prices.

“The widening of deficits is largely structural in nature. The deficit ratio adjusted for cyclical variations is 4.4% in the euro zone out of a total deficit of 6.7 points, with 9.8 points in the UK (out of a total of 13.3 points) and 8.8 points in the US (out of a total of 10.7 points). In the past, this structural deficit has shown a strong tendency to persist,” the french chief economist writes.

For the time being, surplus production capacity limits the risk of public debt having a crowding-out effect on private investment.

Ricardo, Who?

About 200 years ago British economist David Ricardo presented his “theory of equivalence” in a newspaper essay.

In Ricardo’s view, it does not matter whether you choose debt financing or tax financing, because the outcome will be the same in either case. Flip a coin if you like, because in terms of the final results, raising taxes by $1,000 is equivalent to the government borrowing $1,000.

According to traditional economic theory, like the Keynesian, public debt has a significant effect on the overall economy because consumers regards public debt as net wealth.

The Ricardian equivalence theory, on the other hand, suggest that is has no effect so ever.

While budget stimulus measures are intended to boost demand from financially constrained consumers,  in their case  the classic system of budgetary multipliers (Keynesian style economics) takes full effect.

But for others – the majority – the result will most likely be widespread emerging of so-called Ricardian behaviour.

Ricardian behavior is a term economists use to describe growth in consumer saving to cope with the costs of expected increasing taxes in the future.

The consumers expectations are usually fulfilled, and often extended, later research have shown.

In most cases, government borrowing ends up being more expensive for the citizens when inflation, higher borrowing costs and interest rates are taken into account.

The theory of Ricardian behavior is controversial, as it assumes that people think and behave financially rationally.

We know we don’t.

But other factors can trigger similar behavior, like lack of transparency in the state finances and mistrust in the governments economic policy.

In any case; Ricardo’s main point that government borrowing is nothing more than a way of delaying tax hikes, seems to be accepted by many leading economists today.

No More Free Lunch

It should be clear by now that the public finance situation calls for credible recovery measures.

“While the conventional crowding-out effect does not have an impact, the budget situation – contrary to the situation before the financial crisis – now affects the assessment of risks and may inflate risk premiums. This results in a higher cost of debt, making adjustment even more difficult,” Mr. d’Arvisenet writes.

Adding that this situation could make an end to the until now observed developments characterized by rising debt with no impact on interest payments because of falling interest rates – a kind of “free lunch”.

“A high level of debt increases the probability of an interest rate or growth shock resulting in unsustainable debt, with higher debt ratios and a widening gap between the apparent real interest rate and the rate of growth. This configuration makes adjustment even more difficult and in any case presents a number of threats (snowball effect of debt).”

Recent data clearly call for immediate action.

BNP Paribas points to the fact that, as a direct consequence of the financial crisis – with an increase in the cost of capital and structural unemployment and a decline in economic activity – the potential level of GDP in the OECD region is around 3.5 points below the pre-crisis level.

In addition, unless there is an increase in taxation, the higher cost of debt means that some public services will have to be sacrificed.

An increase in taxation is frequently synonymous with fiscal distortions that can harm growth.

Debt then eliminates the ability to implement new support measures if needed.

A Credible Exit Strategy; Fact Or Fiction?

Ricardo’s theories might very well be correct,  but only in a perfect economy with free markets and responsible, rational people.

However, by understanding Ricardo’s line of arguments, it becomes more clear what’s wrong with the current economic policy.

BNP Paribas chief economist writes:

“In addition to purely budgetary considerations, deterioration in public finances is a potential challenge for central banks. The level of debt may result in not only increases in inflationary anticipations, but also uncertainties about the success of consolidation measures, making steering of monetary policy more complicated (what is the appropriate interest rate?). The weighting of the cost of debt may result in pressures favoring monetisation, casting doubt on the independence of central banks, not taking account of the fact that these institutions – which have increased the share of public debt securities in their balance sheets – are therefore exposed to greater interest rate risks.”

According to the IMF, a primary structural surplus of 8 points of GDP from 2011 to 2020 (from -4.3% to +3.6% of GDP) would be necessary in order to bring the debt ratio to 60 points of GDP in 2030, although with significant differences between countries: one-fifth of developed countries would have to make an adjustment of more than 10 points and two-thirds would have to make an adjustment of less than 5 points.

The adjustment would be halved for a target of stabilizing the debt ratio at the 2012 level.

The IMF estimates that over 10 years, and assuming growth of 2%, the end of stimulus measures could contribute 1.5 points of GDP.

In addition to the freeze on public spending excluding health-care, which implies priorities and efforts to improve efficiency, stabilization in expenses relating to the aging of the population proportional to GDP would provide a contribution of 3-4 points of GDP and tax deductions would provide a contribution of around 3 points.

“In the shorter term, as suggested by recent research, displaying a credible budgetary consolidation policy concerning primarily expenditure can enhance the effectiveness of support measures in place, by means of both consumer behavior (Barro-Ricardo effect) and also interest rates,” Philippe d’Arvisenet writes.

The Ricardian Union (Formerly Known As E.U.)

Research by Antonio Afonso at Universidade Tecnica de Lisboa, published in 2001, concludes that debt hardly will become neutral. And he’s probably right.

But Afonso’s finding, based on studies of 15 European countries, indicates that government debt has a considerable stronger effect on consumer spending in highly indebted countries, as compared to the less indebted nations.

There seems to be a limit around 50% of GDP; a debt-to-GDP ratio over 50 tends to make people more aware, and cautious, about their financial situation. They become Ricardian.

The prospect of a return to sustainable debt allays fears of inflation and therefore anticipations of a hike in interest rates, which helps to contain the rise in long-term rates, BNP Paribas argues.

“A budgetary exit strategy is a difficult exercise. The change in the primary balance needed to ensure a similar level of debt to that observed before the crisis – which would avoid transferring the consequences of the crisis to future generations – is considerable but not unprecedented.”

“Recourse to inflation” as dreamed of by some, does not seem to be the solution, according to BNP Paribas, refering to analysis of successful experiences of budgetary consolidation shows that a significant reduction in the debt ratio has been achieved in 10 or so countries, mainly by means of the primary balance.

The contribution of growth was negligible in this respect (apart from in Spain and Ireland), chief economist Philippe d’Arvisenet says.

“We can therefore see that consolidation measures are taken with a long-term view – one or two years has not been enough. This does not mean that it is not necessary to continue with the reforms intended to support growth,” he adds.

However, there are just too many uncertainties relating to this matter to be able to count considerably on this factor.

What About Fiscal Illusions?

Among the uncertainties are another – rarely mentioned – theory called “fiscal illusion.”

“Fiscal Illusion” is a public choice theory of government expenditure first developed by the Italian economist Amilcare Puviani in 1897.

“Fiscal Illusion” suggests that when government revenues are unobserved or not fully observed by taxpayers then the cost of government is perceived to be less expensive than it actually is.

Examples of fiscal illusion are often seen in deficit spending.

CATO Institute economist William Niskanen, has noted that the “starve the beast” strategy popular among U.S.  conservatives wherein tax cuts now force a future reduction in federal government spending is empirically false.

Instead, he has found that there is ‘a strong negative relation between the relative level of federal spending and tax revenues.

Tax cuts and deficit spending, he argues, makes the cost of government appear to be cheaper than it otherwise would be.

Paulo Reis Mourao at Australian National University presented in 2008 an empirical attempt to measure fiscal illusion for almost 70 democracies since 1960.

The results obtained reveal that Fiscal Illusion varies greatly around the world.

Countries such as Mali, Pakistan, Russia, and Sri Lanka have the highest average values over the time period considered, while Austria, Luxembourg, Netherlands, and New Zealand have the lowest.

But, as you know; some illusionists are better than others.

The French Solution

The greatest increase in public debt forecast for the next few decades relates to the aging of the population, BNP Paribas concludes.

“The matter of health-care and pension reforms is crucial (without reform, the associated cost would be 4-5 points of GDP between now and 2030,” according to the French banks research.

“Reforms in this area are even more important as their effects become more significant with time and their initial cost is limited.”

Based on lessons of other recent research, BNP Paribas notes:

“The greater effectiveness of rules that are easy to implement (public spending versus deficit), as demonstrated for example by the failure of the Gramm Rudmann Hollings Act of 1985 and the success of the Budget Enforcement Act that succeeded it;”

* The increased effectiveness of automated mechanisms, compared with discretionary practices such as those relating to sanctions for excessive deficits in the euro zone;

* The appeal of anti-cyclical measures (rainy day funds etc.).

The bank make the following suggestions:

(1) To stabilize the public debt ratio (debt to nominal GDP), it is necessary to generate a primary balance equal to the product of the debt ratio by the difference between the real rate of interest on debt and the rate of growth.

(2) Not forgetting that inflation is not manifesting itself and that inflationary fears alone are likely to provoke a rise in real interest rates.

(3) From this viewpoint, the change in retirement age has substantial effects both directly (increase in tax revenues, reduction in expenditure) and indirectly on potential growth (working-age population and participation rate).

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Gerald Celente: “The Great Crash Has Occurred”

A Baltic Future For Greece?

“We Stand At The Brink Of The Next Great Crisis”

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Euro Zone: More Fiscal Integration Or Not?

Force The Rich!

Wild-West Capitalism (Don’t Blame The Baby Boomers)

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Bernanke: “We Welcome A Review Of The FED’s Management”

Final Words Of A Central Banker

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"Germany Is Unfit For The Euro"

In Financial Markets, Health and Environment, International Econnomic Politics, National Economic Politics, Views, commentaries and opinions on 21.04.10 at 11:38

According to professor Jörg Bibow a euro-country that runs up trade surpluses must, one way or the other,  either lend or grant transfers to the deficit countries that make its own surpluses possible. Today, German policymakers refuse to do either. Professor Biblow concludes that Germany is unfit for the euro, and the the European Union may need to regroup around France.

“Let the Germans have their mark back if they are so keen. Let the new euro-mark rise to US dollars 2 or 2.50, so that the joys of stability are real.”

Jörg Bibow


With unusually harsh words, professor of economics Jörg Bibow at Skidmore College, describes Germany’s role in the ongoing Greek debt crisis in a commentary published by EVROintelligence, Wednesday. Professor Bibow thinks that sooner or later Europe may have to conclude that Germany is unfit for the euro, and that the euro zone will have to regroup around France.

Jörg Bibow is a professor of economics at Skidmore College.

His research focuses on central banking and financial systems and the effects of monetary policy on economic performance, especially the monetary policies of the Bundesbank and the European Central Bank. This work builds on his earlier research on the monetary thought of John Maynard Keynes.

Bibow has lectured at the University of Cambridge, University of Hamburg, and Franklin College Switzerland on central banking and European integration and was a visiting scholar at the Levy Institute.

He received a bachelor’s degree with honors in economics from the University of the Witwatersrand, a diplom-volkswirt from the University of Hamburg, and M.A. and Ph.D. degrees in economics from the University of Cambridge.

Germany Is To Blame

In today’s blog post at the EVROintelligence.com he put the entire blame for the European debt mess on Germany.

Here’s what professor Bibow writes:

“Euroland has agreed to support Greece after all, really? Germany and its media are in uproar about Mrs. Merkel’s bowing to foreign pressures. After many years of belt-tightening, stagnant wages and fiscal austerity, it seems unfair that the spendthrift should be “bailed-out”. Germans have done everything right, they are being told by their political leaders and the media, boosting competitiveness and balancing the budget. Don’t make the Musterknabe pay for others’ sins. Instead, let Europe follow the German example. Let the Greek do their homework and get their own house in order through hard work and thrift – the German way. There is talk that Germany’s constitutional court might get busy again, providing new landmark judgments on what constitutes “stability” and what does not. For Germans have a constitutional right to stability, they are made to believe. If Europe is not ready to comply with the standards of stability, Germany will be forced to pull out. Perhaps the Bundesbank is already preparing for reissuance of marks. Germans are said to lose faith in the euro. Berlin does little to convince them otherwise. The train of European integration is rolling fast backwards.”

Misled By Their Politicians

“Not for the first time in its history the German people have been irresponsibly misled by a political leadership that seems to have lost any sense of history, any sense of order and stability in Europe, and any sense of Germany’s key contributing role to the current crisis. As ever, the mindset of lawyers frames the political debate among a political class that seems inhumanly uneducated in matters of economics. If economic voices are heard at all, it is usually the voice of the Bundesbank. It is a peculiar democracy that expects either its constitutional court or central bank to have the final word of wisdom.”

“Regarding Euro-land economic performance since 1999, three stark facts or policy blunders stand out. First, while similar in size to the US economy, Euroland is remarkably export dependent and prone to domestic demand stagnation. The world economy boomed at record rate in 2003-7. Euro-land for long was the “sick giant”. Joining late, it crashed all the harder as the global crisis hit. Second, the 2001-5 period of protracted domestic demand stagnation saw finance ministers at pains to cut budget deficits below 3 percent, as the so-called Stability and Growth Pact prescribes, and the ECB similarly at pains to squeeze headline inflation below the 2 percent mark that seems to constitute price stability. Obsession with what lawyers judge to be stability produced rather perverse results. Hiking indirect taxes and administered prices to achieve their magic number, finance ministers thereby helped to keep inflation above the ECB’s magical number. In turn, the ECB’s obstinate refusal to care about domestic demand kept budget deficits above 3 percent, triggering further indirect tax hikes, and so on. Contrary to the notorious stability-oriented gospel, it is hard to conceive of a more counterproductive macroeconomic regime than this. Third, the brief history of the euro saw the emergence of stark divergences and buildup of grave imbalances within an economic area that can no longer rely on exchange rate realignments to solve them – imbalances the implosion of which have left Euro-land stuck in the mess it is in today, once again hoping for strong global growth to pull it out.”

Sabotaging The Central Bank

“Sadly enough, Germany has been central to all of this. Germany is the biggest factor in Euroland’s export dependence, growing on exports only while domestic demand, especially private consumption, is notoriously stagnant. Among the first countries to break the Maastricht deficit limit dreamed up by its own lawyers, Germany contributed most to the ECB’s misses of its headline inflation mark by hiking indirect taxes. Worst of all, Germany reneged on the euro’s cornerstone to abstain from beggar-thy-neighbor policies.”

Jörg Bibow

“Germany likes to see its international competitiveness as the fruit of hard work and productivity. Yet, German productivity growth since 1999 does not stand out. What stands out is wage stagnation. Germany’s improved competitiveness was derived from reducing German wages relative to its European partners; the equivalent of a beggar-thy-neighbor devaluation in pre-euro times. The consequences of this strategy have proved disastrous: domestic demand stagnation in Germany, housing bubbles in partner countries with higher inflation, given that the ECB sets one rate that has to fit all. One way or another, the country that runs up trade surpluses must either lend or grant transfers to the deficit countries that make its own surpluses possible. Today, German policymakers refuse to do either. Fooled into believing that beggar-thy-neighbor was the right thing to do, popular demands appear to be just that. One cannot fail to see that insane austerity in the periphery serves to keep the euro low enough so that Germany can now grow on external exports.”

“That is neither what Europe needs nor what the world may reasonably expect from Europe. Sooner or later Europe may have to conclude that Germany is unfit for the euro. Let the Germans have their mark back if they are so keen. Let the new euro-mark rise to US dollars 2 or 2.50, so that the joys of stability are real. Euro-land may then regroup around France. With Germany once again proving immature to provide constructive rather than destructive leadership, Europe’s fate is in France’s hands.”

Original post at evrointelligence.com.

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Greek Crisis Force Germany To Put Help For Unemployed On Hold

The Great Greek Soap Opera

Markets Still Don’t Trust Europe’s Greek Aid Pledge

Greece, Lehman And Geithner

Germany Forced To Accept Greek Bailout

Greece: Here’s The Deal (Well, sort of…)

Greek Crisis: Confusion And Paranoia

Euro Zone: More Fiscal Integration Or Not?

“Greece Will Default”

G7-Countries In Deep Trouble

Merkel: Kick’em Out!

Force The Rich!

Greece: “Exploiting The Fear”

Socialism For The Rich – Capitalism For The Poor?

E.U. To Reform Economic Policy

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Bernanke Reconfirmed

In Financial Markets, International Econnomic Politics, National Economic Politics on 29.01.10 at 01:26
Official portrait of Federal Reserve Chairman ...
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Senate votes 70 to 30 to confirm Ben S. Bernanke to a second term as Federal Reserve chairman, the nation’s most powerful economic policymaker.

His nomination for four more years had become uncertain in the past week, as liberals and conservatives alike expressed new reservations about confirming a man who has presided over the worst economic downturn in generations.

Now that the Senate has confirmed him for a second term as chairman of the Federal Reserve, Ben Bernanke has, or ought to have, a very simple agenda: improve confidence. This isn’t his job alone, of course. President Obama and Treasury Secretary Timothy Geithner are hardly bit players. But what Bernanke does and says — how he projects himself and the Fed — matters a great deal, and he faces an exacting challenge.

There is a supposition among academic economists (the tribe from which Bernanke comes) that “economic policy” consists of making decisions about interest rates, taxes, government spending and regulations that translate, almost mechanically, into actions by firms and consumers to hire or fire, spend or save, invest or hoard. By now, Bernanke surely recognizes that this economic model is at best a half-truth.

The famous British economist John Maynard Keynes (1883-1946) coined the phrase “animal spirits.” Less elegantly, we say “emotions.” Whatever the vocabulary, the lesson is the same: Psychology matters. Booms proceed from overconfidence; busts inspire great fear. Recoveries require increasing optimism. Otherwise, despondent consumers confine buying to necessities, and businesses delay hiring and expansion.

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