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

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