Friday, February 19, 2010

PIIGS and a Spurious Correlation.

In this post I want to discuss some of the important issues the European Union is facing. Many of these problems have come to the surface with the mounting fiscal crisis in Greece and more broadly the PIIGS. PIIGS stand for the countries of Portugal, Italy, Ireland, Greece and Spain. The Economist magazine provides some basic facts about each countries debt and what steps have been taken to address the issues at FACTBOX-Eurozone's embattled fringe PIIGS economies which includes a link to the following chart.

It is easy to see that all the countries shown in the graph will surpass the 60% debt to GDP ratio and are fast approaching the 100% mark if they have not already surpassed it. The 60% debt ratio was a mandate for all economic and monetary union (EMU) countries and clearly no one is abiding by that rule. Whether debt levels of 60 or 100 is too much is an empirical question that I am not aware of the answer and of course based on the structure of each economy the level of debt that is sustainable might be different for each country. For example, a country with a reserve currency that is used widely to facilitate trade would theoretically have a higher potential debt ceiling limit (Hint: US).

According to Mail Online, Britain might also be vulnerable to the fiscal problems the PIIGS are experiencing at the article Britain's public finances declared 'vulnerable' thanks to bulging budget deficit. But unlike the PIIGS, UK has a flexible currency and can adjust its monetary base nearly at will. Dean Baker provides a blog post noting the differences between inside the Eurozone and outside using Hungary as the example at Hungary, Which Was Saved by Not Being in the Euro, Lectures Greece on the Virtues of the Euro, and the NYT Doesn't Notice. The ironic point is that Dean Baker did not mention George Soros from the NYT article as also being not very cognizant of the differences as Soros is a foreign currency trader {er, manipulator} he should definitely be more knowledgeable.

Graphic of sovereign risk ranking for selected countries of Europe from Mail Online.

What is the Way Forward?
Paul Krugman again provides us with some interesting insights into the problems with the PIIGS. He makes similar points as Dean Baker but uses Spain as the example. His theme was that Europe was not ready for a monetary union and was rushed into it by "policy elites" at his NYTs article The Making of a Euromess. From reading the history of the EMU, I am not sure how anyone can conclude that it was rushed in any way. Krugman supports this contention because of the problems in Spain, but he fails to show how any more time could have helped. In fact, the longer the time that the individual nation states were integrating then the more likely some unexpected event will prevent integration as happened to Britain as a result of Soros and others that broke the Bank of England.

It does not appear insurmountable the dismantling the euro or opting out of the Eurozone and would not necessarily cause "the mother of all financial crises" according to Barry Eichengreen. The process would unwind as easily as it was created and maybe a lot less painful. But that is a small possibility as most countries are enjoying the benefits of the Eurozone and many are willing to pay the the high price to join. The question forward is how to make it more beneficial to all participants-over the long term. This is where Krugman provides some useful guidance by contrasting the structural components of the USA as having a stronger central government (i.e. federal government) and the Eurozone with the nations set up as states but lacking the organization that can readily redistribute capital.

Krugman also shows the structural rigidity of the economy that is preventing the "free movement of people, goods, services, and capital" which is a tenet of the EU laws. A central government could in fact push through measures to make sure free movements occur and root out structural rigidities. In addition to this important function, it would also avoid the isolation paradox that each country is not willing to be the first to declare financial support. For example, Der Spiegel leaked a story about the German finance minister willingness to provide 20% of the bailout money. That amount of money is based on Germany being the largest economy in the EU and it provides around 20% of the European Central Banks (ECB) capital. But most recently, the EU, and Germany deny Greek bailout plans. I truly doubt that they have no plans. Only bad managers do not get contingency plans in place before crunch time.

Convergence of economies that are closely tied together economically can be another indicator of structural rigidity, that is, higher convergence (lack of divergence) indicates low levels of structural rigidity. Convergence does not mean a "race to the bottom" but by a process by which low income areas catch up to the higher income areas through higher growth rates. According to economists Sylvester Eijffinger and Edin Mujagic at The Euro’s Final Countdown?, the Eurozone is actually experiencing increasing divergence of the economies based the factors of "unit labor costs, productivity, and fiscal deficits and government debt" which in turn leads to a "convergence" of incomes if the factors are converging. Greek finance minister George Papaconstantinou summarized the situation by stating the following, "For a common currency area to work you need a convergence of economic policy ...or else you need compensation flows between member states". This again leads back to the need for a centralized government much as our Federal Government facilitates.

Andrew Willis suggests the answer may entail greater economic coordination among EU member states at Greek drama heightens debate on economic co-ordination. But coordination can only get so far in solving the structural problems. It may actually cause the problems to get worst especially concerning the debt problems. What the Eurozone has become is one big prisoner's dilemma. Everyone has a reason to "cheat" but not much incentive to make sure the other nations are following the rules, thus it has been manifested in Greece and it's falsifying and misleading its debt and deficit levels. This again points to the need for a federal bureaucracy under a representative government to insure the rules are followed and that shared resources are not unduly squandered.

For a breakdown of the concept of "coordination", I turn to Keith Pilbeam, International Finance, second edition. Pilbeam provides a "hiearchy of coordination" which he lists as: 1. exchange of information, 2. acceptance of mutually consistent policies, and 3. joint action. If the present system of coordination collapsed already due to fraudulent data about Greece's debt and deficit levels then how can the other steps be achieved? If the coordination breaks down even on the first phase, then how can it get to truly socially beneficial outcomes? For the most part, the policies have appeared to be mutually consistent as no nation has decided to severely cut back real spending but that is mostly due to ideological underpinnings of Keynesian economics. The joint action does not seem to be taking place and appears more ad hoc than a concerted effort to solve their mutually identifiable policy goals and in this case full employment is one.

What about this Spurious Correlation?
What initially got me interested in the most recent turn of events and the macroeconomic issues that went along with it came from reading a short informational report from the Center for Economic and Policy Research at An International Comparison of Small Business Employment. The graph below instantly had me thinking about the correlation between self employment rates and fiscal/financial soundness for an economy.

Of course correlation does not indicate causality, but there may be structural factors that lead to bad outcomes with excessive amounts of self-employed individuals. One aspect that might be playing out here is that the tax base might be too narrow. One of the first things that the IMF pushes for when dealing with developing countries is to try to broaden the tax base. High tax revenues that are sector specific {e.g. agriculture} can be very distorting to the market and provide suboptimal social outcomes. Self-employment incomes may be distortionary as income may be hidden or transferred and thus avoiding the full burden of the tax bite. That question along with selection bias for respondents would take more specific knowledge about each country's laws and regulations.

What does this mean?
Seeking Alpha provides three suggestions for Hedging PIIGS Risk with ETFs. The first is to directly purchase a CDS of the PIIGS. The spreads are now greater than the BRICS, which is simply amazing and maybe a signal that the market is expecting more shoes to drop. The second method is based on the assumption that the contagion effect from the PIIGS will bring down the euro and cause even slower growth in the Eurozone. The trend line for the past 3 months is showing continued strengthening of the US dollar and after February 10th has shown continuation of that trend. The third suggestion is to short ETFs for the specific PIIG countries.

Bill Ralls, CFA, Senior Vice President at Fidelity, labels the current crisis as a Greek Debt Drama, Act I. Ralls thinks the drama could result in even more weakening of the euro and no matter what happens the road to recovery will be like a Greek marathon, "stamina and grit will be required as the global economy heads down the long, bumpy path of recovery." This seems to imply that the Eurozone will continue to be a sick puppy. Whether this leads to more hot money flows into the US and increased fear of emerging markets in general is anyone's guess. The one aspect that I take exception with Ralls is he correlates Greece as similar to a US state and in this case Massachusetts. Krugman and others have provided information as how the individual states are still not like Eurozone member states. Thus the contagion effect and the lack of effective mechanisms to deal with the problems is increasing uncertainty in the markets. For example, when the rumors about Germany's willingness to bail out Greece the headline from the AP read as Optimism in Greece inspires market.

Additional links:
Can Greece Pull Out of the Euro?

America Should Pay Attention To Greece The differences between Greece's financial condition and America's are not as vast as one would wish. by Clive Crook

Stumbling and Mumbling: Trading nations

“Greek crisis over” – Our ability to delude ourselves has reached the next level

France24 - IMF aid for Greece ‘not a question of prestige’ says EU's Barroso

Game, Set and Match for Merkel – Greece will have to go to the IMF

Greece: The Curse of Three Generations of Papandreous

Fitch cuts Greece rating to BBB-, outlook negative - MarketWatch
Fitch Ratings on Friday said it downgraded Greece's credit rating to BBB- from BBB+, with a negative outlook. The agency said the move reflects intensifying fiscal challenges amid increasingly adverse prospects for economic growth and increased interest costs. The cut also reflects ongoing uncertainties about the government's financing strategy amid increased volatility in capital markets, Fitch said. Although aid for Greece is likely to be forthcoming, greater clarity regarding back-stop financial support in the form of an explicit IMF program is likely to be required to shore up market confidence in the face of substantial short-term funding needs, Fitch said

Labels: , ,

Thursday, February 04, 2010

V or W for the Recovery?

V or W for the Recovery?
In my last blog post, I quoted a section of Econoday stating that the ISM report was a sign of a V recovery and Mark Perry shows this graphically as well as other factors of these V-Signs of Economic Recovery. But we still have the housing market to deal with, and some believe that a recovery is not possible without housing at least being on stable ground, although as stated before I do not expect the construction industry to be a growth sector as Calculated Risk noted at Construction Spending Declines in December.

One of the factors that could in fact determine this outcome between a W or V recovery has to do with some moral questions. To get some thoughts on these issues, I link to The New York Times article entitled No Help in Sight, More Homeowners Walk Away where Mr. Koellmann faces these questions:
Most of all, though, he struggles with the ethical question.

“I took a loan on an asset that I didn’t see was overvalued,” he said. “As much as I would like my bank to pay for that mistake, why should it?”

Tanta at Caluculated Risk blog has a long post criticizing some of the reporting on the "walk away" home owners and provides some good insights into these concepts of home foreclosures at Let's Talk about Walking Away. Part of this moral dilemma arises from the fact that mortgages in the USA are non-recourse loans. Unlike a vehicle that you turn back the keys, where the bank can still collect from you the difference between payments in addition to selling of the asset against total owed including interest, in a housing loan they can not go after the buyer of any difference between what is owed and the selling of the assets. Morgan Housel at Motley Fool asks the question "Could This Prevent Another Housing Blowup?" His thesis is that if the USA (like most countries) reverted to "full-recourse" housing loans, then the likelihood of a bubble forming is less likely and compares changes in housing prices in the USA and Australia to illustrate the point. We would also not face the moral questions that we as a nation are discussing now.

Matt Koppenheffer also at Motley Fool provides a counter-intuitive argument that homeowners under-water should in fact make strategic defaults on their mortgages and he introduces the subject by asking tactfully "Why Are Homeowners Idiots?"
Why don't they walk away?
An interesting quirk of economics is that the dismal science generally assumes that all agents in an economy work in their own best interest. But this doesn't always happen in real life.

The mortgage crisis is a case in point. For many of the underwater homeowners in today's market, paying down their mortgage isn't really in their best financial interest. Particularly in states like Arizona -- where mortgages are nonrecourse, meaning the lender can't go after any of the homeowner's assets other than the property itself -- it makes little sense to continue paying a large mortgage on a devalued house when comparable rental rates are far below the monthly mortgage payment.

The answer to the headline question is that housing is more than just an investment and thus consumers are not "profit maximizers" and do not act always in "their best financial interest" but according to the dismal science are "utility maximizers". Thus staying in a home maybe better for the family than moving away from the familiarity of the neighborhood as well as the amenities of home ownership. This is where morality comes in that individuals also have a desire to be "good citizens" and to abide by the customs and practices of the community he/she chooses to live in. When those standards change then a vicious cycle can form as this passage from Mish's Global Economic Trend Analysis post entitled Will "Walk Aways"; Increase Discretionary Spending? shows.
After reading your work, I began to examine the attitudes of my neighborhood. The first foreclosure was one of those borderline families you often write about. They were in over their heads and couldn’t afford the house they were living in. Most likely mortgage reset. In any event, the scuttlebutt around the neighborhood was one of scorn, shame, and embarrassment. No thought was given to the negative impact to the value of all our homes in this subdivision. With each subsequent “pre-foreclosure,” people’s attitudes softened about their ex-neighbors. Gone was the Scarlet F; it was replaced with empathy, understanding, and even compassion. Maybe the attitudes have changed because people now realize that the value of their homes have fallen off a cliff. They don’t have time to shame their ex-neighbors when they are worrying about their wealth is being vaporized or a $400 natural gas bill or car payment or the kids or whatever.

Now, I understand that this is one neighborhood in one small town in the Midwest. I also know this is anecdotal evidence. But as I have learned covering retail stocks for so many years: I trust my eyes and common sense and ignore people with a vested interest in the outcome of a situation. My eyes and common sense tell me that times are changing. It has become more socially acceptable to walk away from your house. If one of my neighbors walked away today, most of the remaining neighbors would shrug their shoulders, say that’s too bad and move on. I will be looking for the next phase of this shift in attitude, when remaining homeowners think or say I wish that was me moving—getting out from this 3,000 square foot rock that has ruined me financially.

Matt Koppenheffer provides more reasons for why underwater homeowners should in fact walk away from their debts in another tactful article entitled "Why We Care About Idiot Homeowners?" After presenting a good analysis of formation of a vicious cycle in housing under the banner of "Adding fuel to the flames", he presents the counter arguments starting with the point we will just be delaying the inevitable. But, that in fact, maybe what the market needs now-a "bank holiday" or a cooling off period. Markets can overshoot the equilibrium price which some define as "animal spirits". Momentum players try to ride the wave as long as possible and even George Soros used something similar when overshooting the equilibrium exchange rate prices to make money. But the problem is that overshooting can be just as harmful for efficient allocation of resources in an economy as undershooting the equilibrium price and of course high social costs especially in the case of collapse of the British Pound.

While some homeowners do in fact need to move, but surely not all homeowners underwater need to move now. The situation that precipitated the need to move could just as easily change again for the family. Preemptively defaulting can only lead to overshooting equilibrium price and creating a vicious cycle of declining home prices.

If mortgages were not nonrecourse, then the investment decision would not be based at all on the equity of the asset but in fact would ignore sunk costs and only focus on which direction the asset is likely to follow or in other words whether it will gain in value or decrease. So I am not sure the distinction has merit when considering this as strictly as an asset under reasonable moral guidelines.

Matt does provide some guidance as to what may be the equilibrium prices of housing stock by noting average home sales as a multiple of average annual rental rates based on the historical average of 14.6. While it is true that the multiple is higher still, I think this piece of information is while interesting it does account for sufficiently for changes in how home ownership is valued. That is, the benefits from home ownership may be higher now than historically and also interest rates are bound to affect this ratio especially with the very low rates now. A better gauge, for determining if housing prices are out of normal range, is provided by Morgan Housel at This Is Killing Housing Prices. Morgan created his own index based on a price-to-income ratio. From 1987 to 2000 the index was close to the index date of 1987 at 1. But since 2000 it rose to a high of 1.64 in 2007 and now has dropped to 1.04 in 2009. I suspect even here there is some room to fall further but a lot less than the number of approximately 19% suggested by Matt's numbers.
What does this all mean?
As Calculated Risk noted, we do not have enough data to get a good enough model for understanding what is going on in the housing market, but, whatever happens, if what is acceptable changes then all bets are off on how low the housing market may go. Matt states that "homeowners living in houses that are vastly underwater is a problem for the housing market", which is not correct as these are issues dealing strictly with private consumption. The social costs come into play if all the underwater home owners {as well as the banks holding properties off the market} decide to sell in the short term and that is when we can see the animal spirits come alive...

And if all else fails there is always Uncle Sam to make everything right again. Take for example the fact that Pending home sales up 1%, recover from November plunge because of a federal tax credit was reinstated.

PS: I was going to mention Dave Ramsey in the post about debt and getting out of it for home owners but could not find the exact right place...
Dave Ramsey Featured Video

Links, and links and links...
9 Things That Could Kill a Recovery

Law Prof Says Underwater Borrowers Suffer from ‘Norm Asymmetry’

U.S. Jan. ISM factory index jumps to 58.4%
Calculated Risk: ISM Manufacturing Index Shows Expansion in January
Econoday Report: ISM Mfg Index February 1, 2010
After the Tape: ISM Suggests 2010 Momentum, Job Growth - Real Time Economics - WSJ

January 2010 Non-Manufacturing ISM Report On Business®
Econoday Report: ISM Non-Mfg Index February 3, 2010

Pfizer, ISM services disappointment drags stocks lower

Calculated Risk: Construction Spending Declines in December

Economic View - When Attitudes Are a Big Obstacle to Recovery -

Calculated Risk: December PCE and Saving Rate

Stimulus created 600,000 jobs at the end of 2009, White House says

How to Fix the Jobs Problem - Llewellyn H. Rockwell Jr. - Mises Institute
Nattering Nabobs of Economic Ignorance

The Era of Laissez-Faire? « Organizations and Markets

Economist's View: GDP Grows at an Estimated 5.7% Annual Rate in the Fourth Quarter of 2009

Wage and Benefits Grow Slower Than Inflation - Real Time Economics - WSJ

GDP Mirage - The Last Hurrah
Behind the eye-popping GDP number
Econbrowser: Strong GDP growth with weak fundamentals
Summers: GDP ‘Favorable,’ but More Effort Needed - Real Time Economics - WSJ
CARPE DIEM: V-Signs of Economic Recovery

This Is Killing Housing Prices
Why We Care About Idiot Homeowners
Calculated Risk: Is this really "Walking Away"?

No Help in Sight, More Homeowners Walk Away

Will ‘Underwater’ Homeowners Make Waves? - Economix Blog -


Monday, February 01, 2010

Manufacturing in January-State of the Economy...

The positive portent of the first day of the trading year did not hold through for the DOW as the index dropped nearly 3.5 percentage points in January. Let us just assume that Mark Hulbert is correct that it means little. Returning to one of my favorite subjects, Fox Business provides a good analysis of the January 2010 Manufacturing ISM Report On Business® at the article entitled Manufacturing Posted Another Strong Month in January. Let me quote some of the more important positive portions.
The Institute for Supply Management said Monday that its closely watched PMI rose to 58.4 from 54.9 in December, hitting its highest point since the 58.5 touched in August 2004.
Read more »

Labels: ,