What Secular Stagnation?

Note: this is probably the shortest post I've ever written

According to Larry Summers, secular stagnation is supposed to be reflected in the continuous decrease of bond yields since the early 1980's (the increase before can be explained in a simple way-inflation):

Yet, we usually forge to have a look at these:

Now remember where bank capital and most of the funds of the pension funds industry are (most times forced by legislation) invested: Bonds. I'd also like to remind some of the supply and demand premise in economics: when supply of funds increases then price increases and thus the yield decreases. And we are on a continuous search for safe assets to invest in. As the safest of all are government bonds (explained here) the increase in life expectancy has forced pension funds to invest more and more assets in the bond market (for a more detailed view of pension systems and population read this).

Concluding, I do not believe that stagnation can be inferred from bond yields. Declining returns just mean that the supply of funds for bonds has been stronger than demand and this is what's driving yields down. Now if that can affect the economy is a different story (one which I do not really trust to be honest since the US has been growing steadily since the 1980's), yet it does not indicate stagnation on its own. It just shows that when times are bad, people come up with a lot of explanations about what's at fault. But then again, I might be wrong and Summers could be right; time will tell.

Pension Systems in Declining Populations

Pension Funds

The global asset management industry has been booming over the past decade. Only in 2012 assets under management were up by 9% reaching $87.2 trillion. Of that, approximately 40%, or $33.9 trillion, were held by pension funds. To get a grasp of the size these funds the graph on the right indicates their sizes relative to GDP. As one can easily observe, pension fund assets in the UK and the US exceed 110% of GDP while they account for approximately 50% of the world's GDP.

Figure 1

Although many countries (according to the OECD) are still mainly funded through public pay-as-you-go (PAYG) systems (Pillar I), a shift towards mandatory private pension funds (Pillar II) and voluntary ones (Pillar III) is observed. The increased popularity of privately-held pension funds can be attributed to a more "free-market" view of the world; the private sector can do it just as well as the public sector so why not let the former do all the job? The private sector has done its job excellently so far: pension funds usually focus on relatively conservative investment strategies (a comment from someone in the industry was "we are playing with people's retirement so we focus on low-risk products") and although their allocation has been increasingly focused on bonds and bills as the following graph shows, their returns have been relatively good for the 3-year average (see the OECD publication for details).

Figure 2

Although the fact that the private sector is doing its job very well may suffice as an excuse on the tremendous growth of  pension funds, reality offers additional justification: people are expected to live much longer than they did half a century ago thus they require more money to preserve a decent standard of living for longer (FlipChartRick has an excellent article on Pieria concerning the changes in distribution of the UK population since the 1900's). Additionally, the growing population of the elderly increases fears of PAYG systems facing trouble with funding. Compliment that with a slight need humans have to earn more and more (commonly known as greed) and the need for pension funds is increased.

Yet, what we have failed to observe is that focusing purely on the private sector to provide funding has its own issues. The PAYG system mainly took contributions from workers and passed them on to pensioners, investing the rest in government bonds. This basically means that nothing in the economy changes by much: what contributors lose, pensioners get and the remainder is returned to the people via government spending. Government spending can (and does) increase consumption, yet as David Ricardo noted "In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever, or £1,200,000 for forty-five years are precisely of the same value". In essence, although an increase in government spending can produce short-term increase in consumption, the government will eventually have to lower consumption to repay for the loan. (obviously this does not take into account multiplier effects which propagate the increased consumption shock and, with the assistance of the private sector make the shock last longer. Yet, if we strictly look at just government spending the above holds)

As Figure 2 shows, private pensions, just like PAYG, take contributions, pay out the pensioners and use the rest to invest. Yet, the investment strategy is much different: although both invest in bonds and bills, pension funds also invest in property, equity, derivatives and hold a significant amount in cash. Although funds hold about 20% of their assets in equities, the sheer number of that investment is astonishing if one remembers the total size of the market. As stated before a protracted period of increasing prices rises the money supply in the economy. In addition, as property is becoming more and more important given its "safety", more funds are allocated there, resulting in increased demand and higher prices. The following two graphs are indicative of the correlations of pension funds and housing:

Figure 3 Case-Shiller Housing Price Index

Figure 4

Although Figure 3 dates from the 1890's, the sharp drop in 2007-2008 can easily be seen, just like the one Figure 4. The drop would have been more visible in Figure 4 had I been able to find assets in dollars and not as a percentage of GDP. The reason is that US GDP also fell drastically during that period and thus although assets took a tumble the result is much less steeper than it should have been.

In general, it seems that private pension funds are actually contributing to inflation by increasing property, equity and bond prices (while reducing their yields). As the quest for safe assets becomes more and more intense, with pensioners increasing every year, the need to invest money in order to obtain a return which would make the fund sustainable makes bonds and property more valuable than ever before. This, as mentioned before, increases prices (and lowers bond yields) thus making money supply increase. 

As Charles Hugh Smith notes if yields are falling how will pension funds continue to exist, especially if the elderly population increases? The answer will most probably be through property and equity, which will create a short-term boost to their returns. Will this be permanent though?

Declining Population

Suppose that we have 100 units of currency in a population of 100 people, each person owning a unit. Suppose now that in a few year's time, the population is decreased to 80, now with each person owning 1.2 units if money is stable. Would that mean that consumption is decreased? The answer is that it depends. If people tend to spend more than before then consumption might not be reduced. Yet, even if consumption per capita increases it will occur at a diminishing rate. It has long been the case (Kuznets, 1955) that people spend less of their income as their income rises. In simple terms, even you are making a million a year you will probably not be buying a new TV every 2 months to compensate for the lack of demand. 

In this scenario, superabundance is rapidly reached: more than enough goods for every human being, yet with declining demand. Declining population will have many interesting side-effects: as already mentioned long-term rates are greatly affected by the rate of population growth. Yet, if population growth is zero or negative it will mean that these rates will also become negative or zero. My guess is that they will fluctuate on slightly positive ground if population is stable due to liquidity preferences and they will be less negative than the rate of change of the population if it is negative, for the same reason. Whether this is enough to compensate for the increased percentage of the elderly in total population and the increased need for safe assets which will make bond yields even more negative is to be seen.

Interestingly enough, in such a scenario inflation is not out of the picture. As the elderly consist of a growing part of the population and long-term bond yields tend to zero or negative, more investment in real estate and equity will occur, resulting in a rise of property and stock prices thus creating a boost in money supply. This will lead to an environment of short-term inflation due to money supply increases either through private actions like the ones described here or through public ones, i.e. printing. In such an environment banks will have a diminished role: less demand for lending will essentially mean less bank-created money.

If one thinks of a yield curve in this scenario then it would have to be an inverted, gradual-sloped one, at times resembling a fixed curve. Rates should be slightly positive in the short-run due to inflation persistence, while in the long run they should be more prone to negative values due to a decrease in population (even though the decrease in population would equal the long-run rates as already stated).

A suitable question is why shouldn't the long-run rates be positive given that we have inflation in the short run. The answer is that if population will continue to fall then the above-mentioned inflation, driven by property and equity, cannot persist for much longer. As the number of people on the planet is reduces, demand for property is also reduced and more land is available, forcing prices to fall. If this is the case, and no government intervention occurs, then the (very) long-term trend of inflation will be negative. Even at that, the short-term rates will be higher than the long-term ones. As inflation reaches approximately zero, short-term rates will reflect just that, with expectations of inflation being that the trend will stabilize. At that time, long-term rates will continue to be negative and follow the trend of population growth.

What is most likely is this environment is that markets will basically break as nobody would wish to invest in an asset which is losing its value. With working population shrinking, the only remedy I can currently think of is an increase in the retirement age, just like it is being done in most Western countries. Yet, even this has important considerations in the long-run: our bodies are not designed to work until their late 70's (unless we are talking about non-intensive work in which again productivity is reduced) and we cannot view this increase in retirement as a panacea. If abundance through automation is not achieved times might just get more difficult, with inequality rising to new heights.

Interest Rates on Sovereign Bonds: The Price of Debt

The aspect probably most sought after by the financial industry of both government and corporate bonds is yield. Yield indicates the yearly return a bond will give its owner based on the interest payments he will receive and the price the investor will acquire it for. Although at the time of issue a bond's yield equals its interest rate, the situation is soon altered as trading makes the two deviate. Yet, from the sovereign's point of view, the most important aspect of bond issuance should be the interest rate, for the simple reason that it reflects the price it has to pay for the credit received.

The rationale behind this idea is simple: when a nation has to pay more to get credit, its possibilities for growth are diminished as it is obliged to allocate more of the yearly budget to service existing debt, depriving resources from the economy both through decreased government spending as well as increased taxation or unnecessary money printing. In addition, funds employed to service the debt could have been used more effectively in promoting more growth, which in its turn would decrease the debt burden and the borrowing costs promoting a benevolent cycle. In the Eurozone, the situation is exacerbated by the fact that no nation has the liberty to use a sovereign currency, thus increased borrowing costs are a burden the taxpayer unavoidably has to assume.

On examining the current data on bond interest rates (one has to do some data mining to find what the average interest rate paid is) one of the most interesting aspects is that bond interest rates were increasing even before the crisis for some countries. The following is a graph of the interest rates on bonds of 9 Eurozone countries from 2001 to 2011 (data obtained from World Bank and Eurostat. Cyprus did not have any data at the World Bank database prior to 2007)

Not surprising, the lowest interest rate throughout the years has been the one of Germany, yet the Cyprus one is rather amazing. Historically, the island now notorious for setting a precedent on depositor bail-ins, had at a time been paying interest rates with a spread of approximately 7.5% from the German one. Yet, as it appears, the market caught up with what had been going on and in 2011 Italy, Ireland and Greece had taken her place as the leading interest payers in the region. Unfortunately, the World Bank database was not yet updated for 2012 data.

Nevertheless, although the numbers are not up-to-date, they indicate that the market has much predicting power, even in the case of sovereigns. Italy's interest rates have been on the rise since 2010 as have been Greece's and Portugal's although Italy has not yet requested any assistance, Portugal required assistance a year later and Greece did not file for help until mid-2010 and the aid received was for restructuring the debt. In addition, France has also seen interest rates rise in the last two years (2010-2011) as a result of increasing uncertainty about the state of her economy. One can safely assume that data for 2012 would indicate that interest rates in the troubled countries have further increased while in safer countries like Germany they have decreased.

This, is supposedly a problem the OMT should have addressed. When at the issuance of government bonds, the yield (which equals to the interest rate) in higher than a threshold (and importantly the country is still in the markets, i.e. not considered junk), the ECB has pledged to intervene and purchase the bonds itself. Yet, even at relatively lower interest rates than the threshold, a country's ability to service it's debt is severely affected if the interest due is high. For example, with debt at 108% of GDP in 2011, Portugal had to pay more than 5bn euros just for interest payments or approximately 10% of her revenues. The percentage for Greece was 17% of revenues while for Germany and France was just over 5%, making troubles for the Greeks even harder as they have to generate a large amount of money just to cover their interest expenses, without addressing any other problems.

Thus, if the problem of extracting large amounts of money from the population to cover increasing interest rates is not addressed, then recovery will almost certainly be delayed for even longer. As governments cannot print any new money, increased interest rates as a result of uncertainty and fear about the sovereigns' futures can only signify that more funds would be taken from the real economy and given to non-productive uses, creating a vicious cycle. This, will only add to the abundance of problems faced by the South while not promoting any solutions whatsoever.

Schäuble

I have to admit that I have not been the greatest follower of Wolfgang Schäuble. Especially when his ideas of more austerity, harsh measures and reforms are still echoing in my ears. But I have to admit that ever since he, Angela Merkel and the majority of European leaders have changed their attitude towards Greece and the austerity measures undertaken there, I have grown fonder of them. (Up to a point that is!) Nevertheless, one has to recognize that the man has some guts. In a recent trip to Singapore discussion, he has stated the following: 

"If we are not fast enough for markets, sorry, but markets have to wait"

Well, he is right on this one. As it is known, markets are handled by people who are more than eager to see action, rapid movements and fast decisions. Unfortunately, in the real world, fast decisions seldom make good decisions. This is a fact that markets have to live with. I would be much happier if it took 2 months to make a decision which would restore prosperity in the region than if a decision was agreed upon in 2 weeks and its results were mediocre. 

Wolfgang Schäuble, winner of the 2012 Charlemagne Prize. Source: Wikimedia Commons

In another interview, Schäuble has commented that "I think there will be no government bankruptcy in Greece.". I think German and (most) European politicians have come to understand that you can gain much more by supporting someone than by constantly criticizing and degrading. His recent trip to Singapore was primarily focused on convincing investors in the booming Southeast little giant to invest in European bonds. Truth be told, it will be an extremely difficult task. Investors will be hard to agree in investing at a region where fiscal stability is far from achieved. Nevertheless, if things work out in the end, returns of Greek, Spanish, Italian and Cypriot bonds will be much higher than those in most nations in the world.

Persistence of Ideologies

I have been reading Yanis Varoufakis's blog post today and what has stricken me with amazement was how much ideology is affecting economists. As you may read from his post, he is criticizing the newly developed plan for purchasing EU bonds in the secondary market, called OMT (Outright Monetary Transactions), my comments about which you may find here.

In the article, Yanis states that the EU is currently facing a battle between Bundesbank and the private German banks which want to avoid banking integration and the EU leadership
who wants to promote an EU-wide banking regulatory system. The main advantage of this proposal is that "small" countries will not be taken down as soon as their banks face disaster. What is most important is that under a common regulatory framework, all banks of the EU should (at least in theory) be treated equally without any national prejudices.

I may be too optimistic, or too pro-European in comparison to Varoufakis. Truth be told, I do not believe that Greece is innocent of all its sins and the situation there should not amaze us:
If you happened to watch any news about Greece over the last 10-20 years you would see how little trust the Greeks had in their governments, no matter what the ruling party was. Add to this an ideology proposed
by the world's leading economists (i.e. Friedman, who I am sure is laughing gaily now since he did not believe a monetary Union could be achieved in Europe) and what we get

The Effects of a Euro Collapse

Some believe that the destruction of the Eurozone, and as a consequence the collapse of the common currency, is eminent. Many actually look at this favorably as they believe that such a result would be beneficial to the world. I have read articles stating "why doesn't the Euro collapse to get over with this situation? We will deal with the consequences and then be better off". The problem is no one seems to understand what these consequences are. 

The following is an excerpt from a Financial Times article in 2011 (article can be found here):

"A euro area breakup, even a partial one involving the exit of one or more fiscally and competitively weak countries, would be chaotic. A full or comprehensive break-up, with the euro area splintering into a Greater Deutschmark zone and about 10 national currencies would create pandemonium. It would not be a planned, orderly, gradual unwinding of existing political, economic and legal commitments. Exit, partial or full, would likely be precipitated by disorderly sovereign defaults in the fiscally and competitively weak member states, whose currencies would weaken dramatically and whose banks would fail. If Spain and Italy were to exit, there would be a collapse of systemically important financial institutions throughout the European Union and North America and years of global depression."

Does this sound bad enough? The article states that a Greek exit could be manageable. It could be, only if the ECB decides to bail-out the EU countries which would be affected by that exit (That would be hmm... almost every country in the EU, even Germany). If the ECB decides that it would help the countries which would face disaster after a Grexit then why not help Greece directly and avoid such an outcome? The outcome of an Italian exit would be even worse given that it is the 8th largest economy in the world. You may only imagine what would happen if Germany were to exit.

The aftermath of an exit would occur not only to the Union but to the exiting country as well. For example, a Greek exit would mean that prices and wages in the country would fall rapidly, gaining a short-run competitive advantage which would be lost after inflationary powers settle on the country. As a result, the country would be poor, uncompetitive and with the additional disadvantage that no one would dare lend it because it that had just exited the EU. If Germany exits then the new German currency would suffer such an up-rise which would make all German products uncompetitive, leading the now booming German exports to a downward spiral.

In another article, a euro collapse is called as the "mother of all financial disaster". Robert Zoellick, the former president of the World Bank has stated that Europe may have a Lehman moment. (Just like the Lehman Brothers collapse in 2008, which triggered the worst recession in the world since the 1930's).

The worst part of all is that most of the consequences which may occur under a Euro collapse are still unknown. Germany is thought to be the state with the most sound economy in the EU now. However, German investors hold 550bn euros of sovereign bonds outside of Germany. What would happen if the euro collapsed? Most likely they would lose it all and the German government would have to bail them out. One may only imagine how many EU bonds are in the hands of non-European banks and other investors.

My simple conclusion agrees with this LSE article: It is better to do everything to save the euro than to let it fall apart.

Super Mario vs German Stubbornness

In my past articles, I have stated that the only trustworthy person in the crisis-involved countries is Mario Monti. And he proved me right! Yesterday afternoon he asked for more flexibility from Angela Merkel concerning the way the EU tackles the crisis and for "moral support not financial". While his popularity has dropped significantly from 70% to about 40%, Monti seems to be the only European leader who understands the situation more than anyone else. He introduced measures to reduce Italy's huge deficit and is going along just fine without so far any assistance from Troika or the EU.(I really hope I don't jinx the guy!)

In yesterday's statement, he stated a fact which Berlin does not want to acknowledge: there is growing resentment in the South towards the Germans and Europe. He states that if borrowing costs do not fall until next year's elections then the newly-elected government may be a Euro-sceptic one. This is not only true for Italy as most Southern countries have started viewing favorably to an exit from the Union. If exits from the Eurozone begin to occur, then Germans can be proud of producing an unprecedented collapse of the world economy, which will be far worse than the Great Depression.

Germany has become one of the greatest beneficiaries of the crisis, since it is considered a safe investment, and it has maintained an extremely low interest rate for its bonds. It is reported that for July bond issues the yield was -0.06%. Yeah, that's right. People are losing money in order to invest in Germany! Even Wolfgang has stated that interest rates are unusually low. If that wasn't enough, it seems like Germany is actually saving most of the money it has obtained from bond issued to use it as a windfall! (for details read this) These savings are about to reach three digits soon (and that's in billions). And of course, Wolfgang, a direct descendant of the German arrogance and stubbornness which led to two World Wars and an economic collapse in the first half of the previous century (and after conversations with many Germans, I thought of being extinct) states that Germany does not have to apologize for financial markets trusting them. Hmm, even if that is because you steadily hold everyone else down Wolfgang?

Paris and Berlin speak of austerity: they were the first ones to break the pact for Stability and Growth in 2005. Yet, the EU did not (and will never) fine them. It looks like laws and pacts are like spider webs; small animals get trapped in them, while larger ones break through. Both countries are in favor of a low Euro. It helps the boost their exports significantly and this is very helpful as, although their economies are stronger than all of the Southern ones, they are still weak. Meanwhile, if a country or more exits the Union, the consequences for both countries will be severe. Losses from a Greek exit could reach 66bn for France and 89bn for Germany and the global impact of it would reach 1 trillion euro. (for details on these calculation read this) You still don't care about Grexit Rösler?

You may easily imagine what will happen if Spain, Italy or both exit the Union. Germany will say goodbye to those hard gathered savings from the low interest rates. Conclusion and moral of the story above: Act to save the Union before it's too late for everyone.

German Government doesn't fear about Grexit. How about Itexit, Spexit or Cyexit?

While the Bundesbank states that a return to national currencies would not make economies better off, the German Vice Chancellor Philipp Rösler has stated earlier this week that the horror of a Greek exit has worn off I felt that he was trying to play tough cop when there was no criminal around. Otherwise, he was just really ignoring the economic reality of the EU (that is the polite way to say that he was being stupid silly).

What he seems to be forgetting here are the interconnections between the EU nations. If Greece fails and returns to drachma, then the next ones to fail will be Cyprus and Spain. And then Italy. Then maybe England if they decide not to print any more pounds. What then? Should Cyprus bring back the pound, Spain the peseta and Italy the lira just to save themselves if Germany will not is not afraid of them fleeing and will not aid them? Well then how about we just have a good north-euro? Great way to increase faith in the currency Philipp!

If Greece exits, the domino consequences will be catastrophic for the union. Euro is now the second most circulated currency in the world (after the almighty dollar of course!). 332 million people in the Eurozone use it daily and another 175 million worldwide have currencies pegged to it. Just imagine the consequences if the currency is destroyed. Great depression would seem like joyful period after such a case.

By the way Philipp I know you were only born in 1973 (errr you didn't want to say your age? Sorry!) but if you had studied German economic history you would have seen that immediately after WWI when the Allies demanded reparations paid by Germany to repay the damages and debt they had obtained during the war it was the German president of Reichsbank Hjalmar Schacht who had fought the idea most of them all. Indeed, even Maynard Keynes was against reparations as he believed that they would be a burden on the German economy which was just barely alive after the war. The allies did not want to adhere to the two economists, but the combination of a horrible inflationary period (during which Schacht was not in the Reichsbank) and the 1929 Depression made the Allies see that it would be economically irrational to pursue the policy of reparations. (which would last for more than 50 years) I do not know if Philipp can see the resemblance here which is quite obvious if you just substitute Germany with Greece and Allies with Germany. It is true that history repeats itself but I would hate for us to reach the brink of destruction just to realize that what we had been doing was wrong.

Although I am quite pro-German in several areas of the economy and society I cannot really understand this obsession with not helping the countries in need. What are they afraid of? Yesterday, Mario Draghi had an idea similar to what I had proposed here. This made me go to bed happy but today I learned that the Bundesbank has objected to such a plan. One wonders what their reasons might be! ''This seems like a good idea for the European economy so lets just say no!" While ECB seems all powerful, they will just not let it use this power. It is not acting as a real Central Bank the way the Federal Reserve acts in the US. I repeat once again: buy government bonds, expand credit in the Eurozone and let inflation rise for a year. Then go back to listening to stubborn German politics if you desire. Just do this now before it is too late.

P.S. I do not understand why we need to have IMF experts checking up economies in the Eurozone. (Well OK I do if the ECB does not want to act like a Central Bank) Don't we have enough technocrats here? Or are 4-5 troikans the only people in the world who can understand public finances?