Eurozone Breakup Probabilities

Quick, look at the prediction markets!

The Intrade prediction markets currently predict a 30% chance that one country will leave the Euro by the end of 2012, a 59% chance that one country will leave by the end of 2013, and 60% chance that breakup will happen by the end of 2014. Looking at the graphs for the period since June 10, one can see that the June 17th election results brought down the two nearer term probabilities by a substantial amount, while the longer term 2014 probability barely moved.

It's also helpful to look at the spreads between the 2013 and 2012 prices and between the 2014 and 2012 prices.

From the graph of the spreads, it's very obvious that the markets perceived the recent election as just "kicking the can down the road". Longer term probabilities diverged from the near term ones, but the longer term probabilities converged to each other. From this data, it seems that the markets perceive the probability of a breakup by 2014 is almost equal to the probability of a breakup by 2013. Either way, things look bleak for the Eurozone.

Friday Roundup

Some more bond vigilante-unsustainable debt commentary for the UK. The analysis is peculiar because the question is why so many people are willing to invest in UK bonds now. If expectations for the future are dour, why would investors have faith now? This may be linked to the story on a possible bubble in US government bonds. Current demand for safe assets is because of collateral needs; once the economy recovers borrowing costs are going to skyrocket.

Koo takes a close look at Eurozone fiscal and monetary union dynamics, and concludes that neither system deals with balance sheet recessions effectively, especially as they are often asymmetric shocks. An interesting point is that monetary policy, when it tries to ease the impact of these shocks for certain states (ie Germany), the cheap credit causes new problems in other countries. For as much as the ECB pursues "Deutschland über alles", there may be nothing left to be over if the monetary union doesn't develop a system of interstate transfers.

Demand for safe assets doesn't necessarily lead to a shortfall in aggregate demand...only if monetary policy can function as an offset. Is the German current account surplus sucking up your country's growth? Not if your central bank holds tight to a nominal aggregate and keeps growth on track. Just as Scott Sumner says, if your central bank is doing a good job, there are no "depression economics"; fiscal policy doesn't boost output, and current account deficits don't hurt growth. The article does outline a pretty scary chain of events for why demand shocks matter

If demand still fails to materialise, economies go on to restructure via the supply-side.
A vicious circle ensues as capacity is reduced at the expense of the least efficient businesses. Unemployment rises. The economy contracts.
All the while those who still have wealth are encouraged to hoard even more, a fact which only exentuates the contraction in broad money supply, preventing liquidity from reaching those who would most likely be prepared to spend.

Is there really that much regulation holding back the natural gas energy boom? It doesn't look like it. If anything, regulation looks to be too lax, with large scale environmental concerns just shoved under the rug. The NYT piece does bring up an interesting point. Companies, at this point, have an incentive to just get the gas out as fast as possible, before the regulations start coming into effect. Sounds like a dangerous starting point with massive first mover advantages.

Greater transparency in European repo markets would be helpful, but to what extent would it actually solve anything? No doubt more aggregate statistics would help with systemic regulation, but there's still concern that unknown unknowns could crop up. Especially since there's no legal way to force every piece of data from firms, there could always be off-sheet risks building up. And when individual transactions can lose billions of dollars, these unknown risks could break the bank.

Also on the transparency front, European governments are resisting shifts to more transparent accounting standards. It looks like many European states, especially Germany, are concerned about hidden pension debts that may rise to the surface. This does not bode well for the Eurozone in the medium-term, even if national leaders can't wade through the politics to an agreeable solution.

On the topic of the Eurozone, there's an interesting new VoxEU article on the tragedy of the commons problem with regard to the ECB and the peripheral central banks. In a nutshell, the authors argue that since national banks could determine what collateral was considered "safe", they would have an incentive to be too lenient on their own banks in order to gain an advantage in lending costs in the Eurozone. In effect, each national bank's action had a negative risk externality that would be born by the entire Eurozone. This means that fiscal solutions to the crisis are not sufficient. The problem goes deeper, starting with the conflicting incentives of sovereign central banks and the European central bank.

Chinese Labor (and Fried Chicken) Shortage

A story of China, fried chicken, and labor shortages

There's a labor shortage in China. Yes, in the land of over 1.3 billion, companies cannot find enough workers. Well, at least this is true for certain companies. While browsing a Chinese newspaper yesterday, I read an article with startling reports on labor market conditions in Guangdong, or the Hong Kong area, that talks about the exact same points as the linked article. In short, inland China is getting richer and more developed, putting upwards pressure on coastal city wages. And when those wages start becoming uncompetitive, there's growing pains as increasing amounts of migrant workers stay near their inland home provinces, working for newly constructed factories there.

Another interesting manifestation of the coastal city labor shortage in Shanghai, where I currently am, is that KFC is attempting to actively recruit workers. Yes, the fast food service industry, what is often considered to be an employer of last resort in the United States, is advertising its job offers. Below is a picture of one of these posters:

Note the happy, young, restaurant workers, who are looking forwards to a bright future. There were also other posters that declared it was time to get trained, time to get down to business, and learn the ways of working at the Chinese KFC equivalent of a West Point. On every table in the restaurant, there were little stickers listing the restaurant shifts, and of when workers would be able to get free food during their shifts.

Yet in contrast to this apparent worker "shortage", I still observe people working in extremely low productivity positions. Streets are still manually swept by workers in blue jumpsuits wielding long brooms made from thick straw. Streetside vendors pedal mobile kitchens around to serve day workers lunch and dinner. It is as if they are part of a broader labor mismatch problem in China. In the case of Shanghai, there aren't enough workers into official jobs such as fast food service, even as a large proportion of the labor force is in extremely low productivity or shadow economy jobs that they've held for a long time. I see this as another way state managed investment booms fail to effectively promote welfare. Although airplanes and train stations are fancy, there's a lot more low hanging fruit if the government could build the capital to obviate repetitive manual tasks (Street sweeping? Really?). This could allow a shift into more manufacturing or just higher end (think KFC) service work.

The fact that coastal cities are dealing with labor shortage while inland factories are blossoming strikes me as funnily ironic. While we in the U.S. complain of offshoring and outsourcing to lower wage areas, coastal China is dealing with "inshoring" as factory jobs move inland. This really strikes at the heart of why labor reallocation happens. Once the standard of living rises, it's no longer sustainable to keep people in low wage jobs. And when those wages start rising, there start to be competitiveness issues as productivity doesn't keep pace. I imagine this productivity competition is even stronger between inland and coastal China than it is between the United States and China, as the gap between production technologies employed within China is likely less than the gap between the production technologies employed by the United States and coastal China. China really is, as Chovanec says, nine nations governed under one flag. It is not a monolith, but rather a collection of subregions, each with their own markets and attending problems.

Drachmatic Monetary Policy

The trauma of drachmatazation and how monetary policy could be conducted

A recent blog post from Evan mentioned some of the problems in drachmazation, and as my list of thoughts steadily grew longer, I thought I would explicate them more fully in a blog post.

In his post, Evan mentioned that:

To get the new drachma and circulation and to phase out the euro, the government could offer a favorable initial exchange rate for depositing cash as an incentive  -- say, by establishing an initial one-to-one official convertibility rate, pledging to maintain that for a month, and then scheduling progressive official devaluations for which euro could be returned at banks for new drachma. The Bank of Greece would then exchange new drachma for euros with commercial banks at the official rate, using the euro to pay off some of the early-maturity debts partially in euro, partially in new drachma. 

I find this to be an interesting point, but I think his arguments about the legal status of the Euro are a bit more important. Without a legal mandate that the Euro can't be used in the future, there would truly be no incentive for people to go exchange their euros in the transition. If the conversion rate did not offer enough drachmas for every Euro, then not enough people would go. If too many drachmas were offered, then there would be additional inflationary pressures. Moreover, if the borders controlling capital inflow were porous, foreigners could go in and exchange their euros for drachma at the favorable rate. However, if capital controls are tight enough and the legal mandate for the use of the Euro certain, then domestic Greeks would have an incentive to exchange Euro for drachma, while foreigners would have no incentive to do so.

Evan concludes his post on possibilities for the future of Greek monetary policy. As a market monetarist is wont to do, he floats the idea of an NGDP target to limit the inflation expectations when the Greek government becomes dependent on the central bank for financing. While it sounds good in theory, this is an important example of where NGDP targeting fails in stabilizing crises. If the Greek government is going to be in such bad shape after the exit, what guarantee do we have that any of the data will be reliable? If it's not even certain who's withdrawing money and what currencies are being spent, how does one measure the net value of all the transactions to get an NGDP number? Given the turmoil, it's also unlikely that a deep NGDP futures market would be established, so there would be no way to evaluate whether NGDP is on trend or not. Once it becomes logistically impossible to maintain a credible NGDP targeting, all of the expectations-based arguments used to support NGDP level targeting start to buckle. If the public suspects that the central bank may overshoot, they can go with the momentum and send NGDP off its trend. The same would be true if there were expectations that NGDP was falling and the central bank wouldn't respond quickly enough. Although, in the end, the level target would function, the lack of true credibility would make for wild short term gyrations. In this situation, a composite inflation and rate change of employment target might function better, as quick statistical surveys could get a snapshot of these statistics. This data consideration is a very important point once NGDP targeting starts to spread to other countries. If financial markets aren't deep enough for NGDP futures targeting, and quarterly NGDP statistics are hard to verify, it may be better to work with what we have with regards to inflation and unemployment data.

Rate and Level Targeting

Evan Soltas always offers plenty of interesting topics to talk about, and his recent post on level and rate targeting is no different. Evan strikes as the fundamental problem with looking at unemployment and the rate of price growth (ie inflation) to determine monetary policy: the Fed has the rates and levels mixed up. From his post:

Third, given a mixed rate/level targeting regime, the Fed has what should be the rate and what should be the level backward. In the long run, the Fed has almost no control over the unemployment rate, yet almost total control over the price level; in the short run, it does have some control over real variables such as unemployment. Given those constraints, it makes far more sense to level-target the variable which the Fed controls in the long and short runs, i.e. the price level, and to rate-target the variable over which the Fed has some control in the short run, i.e. change in nonfarm payroll employment or quarterly real output growth.

This another example of a pragmatic near-term policy that the Fed could pursue. Instead of creating new NGDP futures markets or shifting the focus on to market forecasts, the Fed could just focus on rate changes in employment and the level of prices.

Evan, in his posts, points out an interesting mathematical discrepancy with unemployment-inflation targeting: unemployment is a level, while inflation is a rate of growth. The units don't even match up, the classic problem of physicists everywhere! His adjustment to focus on changes in employment and the level of prices has support from another empirical "rule of thumb": Okun's law. Okun's law relates the rate change in unemployment with the real GDP growth in that period. Historically, the economy needs about 3% real growth every year to maintain the unemployment rate, and every 1% increase in real growth every year can reduce the unemployment rate in that year by about 1%.

Thus, the rate change in unemployment could be used as a quick flash estimate of NGDP growth. This could then be wrapped up in a new targeting regime, as policy makers may pursue higher inflation rates or faster falls in unemployment to reach some hybrid index, which the Fed could target as if in an NGDP level tareting regime. Now that you mention it, it smells suspiciously like Evan's old H-Value proposal, just implemented with a different data source, with unemployment as a proxy for GDP growth. The data frequency argument is a pretty important one against NGDP targeting, so any alternatives for more intermediate data are always important.

1970's Sumner-time Stagnation

Recently, Scott Sumner and Karl Smith have debated to what extent was the 1970's an era characterized by "stagnation" (AS shock), or just overexpansionary monetary policy. For Scott, much this debate seemed to be about retelling the stories that we learned in introductory economics. Scott reframes the issue in terms of above trend nominal GDP growth, and, along with other data about the labor markets, argues that the decade of inflation came about not because of stagflation or supply shocks, but rather because of overly loose monetary policy.

From the most basic AS/AD perspective, robust real growth in the 1970's is no indication that there was no stagnation. Given the accelerated NGDP growth, real GDP growth should have been higher, for reasons ranging from money illusion to sticky wages to sticky prices. In other words, the higher rates of nominal change meant that a short run equilibrium with higher real growth could be maintained. Had NGDP growth been slower, then we would not have been able to squeeze 3.2% RGDP growth out of the economy. In short, I disagree with the statement that:

I think Karl and I would both agree that (whether or not there was stagflation during the 1970s) under 5% NGDP targeting there definitely would not have been any stagflation."

Is there any reason for this? Scott's argument presupposes that you can decouple nominal growth from real growth. So when he says:

Growth was normal, and inflation was very high.  Rapid growth in AD explains roughly 100% of the inflation during the 1970s.  There was no stagflation, just inflation.

He presupposes the high real growth was not explained by the higher inflation. While, in the long run, higher inflation does not lead to a permanently higher level of growth, there is still a positive relationship between inflation and output in the short run. In introductory terms, this trade-off is the aggregate supply curve, and the correlation arises from increases in aggregate demand. If the high level of aggregate demand is the reason why inflation is high, the high level of AD is also the reason output is high. I don't see how they can be separated.

There are also many places one can look for data to support this hypothesis. The first is the classic shifting of the Philips curve. If the Philips curve moved outwards in the 1970's era, that meant you needed a higher level of inflation to reach any given unemployment rate. If the unemployment rate is a proxy for real growth, then this directly leads to the conclusion that higher levels of inflation allowed higher levels of real growth.

However, Scott prefers to focus on real GDP ("I had thought the word ‘stagflation’ meant high inflation plus slow output growth (due to slow growth in AS.)"), and on this issue the data still suggests that the higher NGDP growth could not be disentangled from the higher RGDP growth. The first graph is a scatterplot of 1960's data, with NGDP YoY growth on the x-axis, and RGDP YoY growth on the y-axis.


The following grpah is a scatterplot of 1970's data, with the same x and y axis data.

Looking at these two graphs, one can see that the relationship between NGDP and RDGP was very tight in both periods. While correlation does not prove causation, it's hard to think of any theoretical mechanism that could have decoupled NGDP from RGDP in either period.. Another interesting note is that the x-intercept of the 1970's data is much larger than the 1960's data. This suggests that you needed a higher level of nominal growth to hold RGDP steady in the 1970's than you needed in the 1960's. the 1970's was suffering from an overall supply shock relative to the 1960's.

As an interesting corollary to all of this, given the lack of a long-run relationship between higher nominal and real growth, you need accelerating nominal growth to prevent real growth from falling down. In a sense, in addition to the positive relationship between the first derivatives of NGDP and RGDP, there should also be a  positive relationship between the second derivatives of NGDP and RGDP.

Notably, these correlations are even stronger than the first two graphs. This lends more evidence to the argument that, had the Fed decided to decrease YoY NGDP growth, RGDP would have taken a hit. For all the power that lies within expectations, they can't take away all of the pain away from a NGDP disinflation.

What seems unexplained is why the 1970's slope is higher (with greater than 95 confidence) than the 1960's slope. If agents adapt, the same increase in NGDP growth should result in a lower increase in RGDP growth. By that theory, the 1970's slope should be less than the 1960's slope. This will be an interesting topic for future investigation.

Over the Great Firewall

From the 17th of June until the 30th of August, I will be on the other side of the Great Firewall of China for summer vacation and language studies. While Blogger is blocked in China, I will still be able to post with the help of email and a good friend in the United States. However, this process is not perfect; I will not be able to read many important blogs (Evan Soltas, David Beckworth), research will become substantially more difficult, and the formatting through the email system may not be perfect. I just wanted to make clear why my posts may start becoming more sparse.