The UK’s Referendum on the European Union: What Happens Next? [throwback from June 2016]

[Having just reviewed what I imagined to be the outcome in the event of Leave in the week before the Brexit referendum, I thought I’d drop it online for posterity. This is an abridged version (nothing added, only the scenarios that did not emerge and irrelevant details removed) from that written during the week between the devastating murder of MP Jo Cox and the referendum in 2016. With hindsight, the strength of public finances and the economy is clearly wrong and remains a puzzle to resolve; the business cycle more generally has held up–something to ponder in the period ahead; the prediction of a new PM in Bojo was also (thankfully) wrong; while I completely failed to foresee the recalcitrance of Labour to push back meaningfully against Brexit alongside a few other details… but still, our current predicament was in broad brush terms there to foresee. As to Article 50 extension, which i thought would not be granted, it now seems more a question of whether the UK asks rather if the EU grants, but let’s wait and see. I give myself 6/10, perhaps optimistically.]


June, 2016, LONDON

THE TRAGIC murder the the United Kingdom MP Jo Cox—Member of Parliament for Batley and Spen, a small consistency in West Yorkshire—has prompted welcome introspection across the political spectrum about the divisive and confrontational style of the EU referendum campaign. Whether this horrific crime will have any impact on the outcome of the referendum remains to be seen—and will no doubt be debated for years to come. And whether the tone of British politics subsequently changes for the better will take time to reveal. But still the referendum goes ahead—representing the most significant political event in the United Kingdom (and perhaps the European Union) for a generation.

… In recent weeks a string of opinion polls put Leave in the lead. Markets have since woken to the possibility of the unthinkable—the exit of a major country from the European Union. Here we speculate on the contours of global politics after the vote. How will things unfold if Remain wins? And what if the unthinkable happens: what will happen if the UK Leaves the European Union?

Two Leave Scenarios: Happy and Unhappy Divorce

First, happy divorce. Amicable divorce is difficult to foresee. But it would look something as follows. Within the UK, it is agreed PM Cameron delivered his manifesto commitment to hold a referendum and should complete his term and negotiate exit from the EU. In Brussels, it is recognized the costs of a protracted breakup negotiation for the economy and regional relations would be large, so a relatively smooth renegotiation of the UK’s relationship should occur—including continued reciprocal access to goods and service trade. While the process could take longer than 2 years, mutually beneficial agreements to avoid disruption during the transition would reassure private investors. Such a “business as usual” solution would keep disruption and uncertainty to a minimum, freeing up the private sector to undertake productive investment; the impact on the European and Global economy from the UK divorce would be relatively pain-free.

Second, unhappy divorce. We can be sure that initial noises from all sides in the aftermath of a Brexit vote will be conciliatory and kind. Separation from the EU will be unlikely smooth, however.

UK politics. A huge march on Downing Street by those in favor of remaining in the European Union—including by those, such as EU nationals, without a vote in the referendum—will be an attempt to reopen the vote. But PM Cameron will likely have to resign—his tenure entirely overshadowed by the historic withdrawal from the EU. The resulting Tory leadership contest will shift the party to the right under PM Johnson. Fearful of the economic backlash, Westminster MPs—who are in largest part in favor of Remain—could refuse to back legislation needed to withdraw the UK from the single market and deliver on the referendum outcome. Meanwhile, the negative impact on the public finances of the economic slowdown would raise concerns about growing deficits and public sector debt—and the prospect of more austerity.

Domestic politics could delay triggering Article 50 of the Lisbon Treaty—which contemplates withdrawal from the EU. A new General Election will be necessary to add legitimacy to the government—whose mandate will be dominated by the need to renegotiate EU membership and revisit the public finances. The question of what the “correct” limit for net migration into the UK should be will be become a political football. UK political parties will be asked by the electorate to set out their positions on how the accumulated influence of EU laws in UK legislation should be revisited—opening up large areas of the social compact. Such minutiae will ultimately take decades to resolve. Meanwhile, given that EU law is incorporated directly into the devolved statutes in Scotland, Wales, and Northern Ireland, the division of regional competencies within the UK will be reopened. Scotland will quickly look for another independence vote—and will likely vote to leave the UK. The free movement of people across the border in Ireland will also be in question, given the scope for migration from Europe through this route. At a time of reemerging sectarian influence, the peace process in Northern Ireland could be called into doubt. Overall, as well as relations with the EU, many aspects of domestic political order will be open to scrutiny.

EU politics. It is typically argued that since the UK runs a trade deficit with the Euroarea (exports to EUR being about GBP40 billion per year; imports nearly GBP65 billion) it is in the interests of the European Union to deliver a swift renegotiation of the UK’s trading relationship. But this overlooks the legitimate concern that smooth EU exit will facilitate additional future withdrawals—at potentially huge cost for the European core. The main pre-occupation will therefore be to prevent others contemplating leaving the club. This could be done positively through measures to solidify the Eurozone—for example, by meaningful fiscal transfers and risk sharing. But such measures remain politically unpalatable. Most likely, therefore, renegotiation with the UK will become protracted and contentious. While Article 50 of the Lisbon Treaty allows for the unanimous extension of the 2 year renegotiation period, agreement will be unlikely. The UK will fall back on WTO trade arrangements once the 2 year period expires. Negotiations could drag on for a decade or more. The possibility of retaliation against trade in services with the UK or restrictions on the movement of UK citizens cannot be ruled out—especially if the UK migration limits begin to bind. A string of important parliamentary or presidential elections (Spain next week [2016], the United States in November; France and Germany in 2017; Italy and Russia in 2018) makes the constellation of political power and influence difficult to predict.

The resulting negative macroeconomic impulse in the UK and Europe of Brexit—as investment decisions are postponed—will be folded onto the already difficult ongoing global adjustment—in particular, the slowdown and adjustment across the EM world. More precisely, the compression of the UK current account deficit—and associated GBP depreciation—and wider Eurozone current account surplus will add to global deflation pressures. Pressure will grow on Germany to use fiscal policy counter-cyclically. And if China’s current account surplus continues to widen… additional pressure will be exerted on asset prices to equilibrate global saving-investment balances. Renewed USD appreciation and commodity price deflation could follow; major central banks will seek new tools to head off deflation.

Finally, some additional complications for the EU are likely to emerge if the UK leaves. First, Schengen and free movement of people. The previously sacrosanct notion that the free movement of people should accompany the free movement of goods and capital in the European Union will be increasingly questioned. A challenge to free movement of labor could accompany the next political cycle in Europe. Second, the EU budget. If the UK leaves the EU, other member states will have to fill a roughly EUR7 billion hole in the EU budget. Interestingly, due to a special ¾ reduction for Germany, Austria, Netherlands and Sweden in financing the UK’s rebate, the largest cost from Brexit will fall on these four countries (roughly EUR4½ billion of the EUR7 billion shortfall being met by these four, EUR3 billion falling to Germany alone.) With the cost of EU budget transfers already unpalatable, the EU budget formula will likely be open to renegotiation for the next multiannual financing framework (beginning 2021) with an outcome likely be negative for the balance of payments across Eastern Europe. Third, as noted above, momentum amongst anti-establishment parties will likely deliver another EU referendum in the near future.

In summary, the result of the EU referendum is unlikely to bring an end to the challenges facing Europe and the UK. Of most concern, it is difficult to build a benign baseline. For now, the best outcome would be a decisive victory for remain. However, regardless of the outcome of this historic vote, until there is some meaningful leadership from the core, the future of Europe will continue to be in doubt.

On the prospects for global macroeconomic policy coordination

AS NEW ECONOMIC Counsellor and Director of Research Department (RES), Gita Gopinath, settles into her new role at the IMF, what might her priorities be to make an imprint on the world’s premier monetary institution? Here’s a suggestion. She might begin by taking control of the IMF’s global forecasts—and do so with a view to rekindling the prospects for global macroeconomic policy coordination.

Let me explain. Already, RES is the conduit for the IMF’s macroeconomic forecasts—by collating and aggregating country-level forecasts produced by each team within the Fund, RES publishes at least twice a year through the World Economic Outlook (WEO) a forecast for the global economy. And while this process promises something of a consistency check on country-level forecasts, in truth this is little more than an aggregation exercise. This is witnessed in the left chart below, which shows the IMF’s forecast of the global current account (discrepancy) for different vintages of the WEO from 2008. The red lines are actual data, the blue lines the forecast for each vintage. Two things stand out. First, the world in the aggregate records a current account surplus of around USD400 billion. Historically, the world recorded deficits, mainly due to supposed under-reporting of investment income amongst advanced economies undertaking tax avoidance. But since the mid-2000s this global discrepancy has turned to a surplus. And this is now due to inconsistencies in the goods and service balance—advanced economies, like the UK and euroarea, both record bilateral service surpluses, for example. And it might be linked to growing world trade and emerging market predominance in the 2000s. But who knows?

screenshot2019-01-31at19.05.38Regardless, the second thing that stands out in the data is the IMF’s forecast of this discrepancy resemble the flailing legs of a wet spider crawling out of a swimming pool. Recall, this forecast is just the aggregate of individual country current accounts. Each mission chief undertakes to forecast, together with their team, macroeconomic variables for their assigned country, including the external current account. And RES, with a tweak here or there, aggregates these. As a result, the world might be seen to have an ever-larger current account surplus discrepancy as each country-team decides to forecast export-led recovery, as in 2008/09 when the discrepancy was expected to reach USD800 billion. Alternatively, and more often, IMF teams project domestic-demand led growth, with imports being absorbed and the global discrepancy shrinking—though the imports not being drawn from elsewhere, rather from thin air. The latest WEO, from October 2018, provides a good example of this. The global current account discrepancy was expected to shrink from a USD400 billion surplus in 2017 to a deficit of about USD100 billion by 2023. See right chart. Despite being joined at the hip, with near-mirror image current accounts, both the United States and China were expected to contribute, according to the Fund, by having a shrinking surplus (China) and increasing deficit (US). Meanwhile, Germany and Japan are expected to have widening surpluses, but nowhere near enough to match adjustments in China and the US. And so there is an asymmetry in numbers (>100 countries will contribute by moving towards larger deficits) and magnitudes, such that the world as a whole is seen to be moving towards restoring the aggregate deficit discrepancy by 2023. How can the US deficit be widening by USD300 billion over 6 years without other countries providing the imports for the US? Gibberish.

The problem with this is obvious. If the global discrepancy cannot be explained, it would be best to hold it constant in any global forecast—or if it does adjust, to have a very clear explanation for why it is adjusting, something the IMF does not have. But this also reveals that each country-team within the Fund is acting with little constraint on their forecasts, meaning they bring “country-level” knowledge in their forecasting without any “global consistency” to their analysis. In an increasingly integrated global economy, the failure to contemplate global consistency is a huge blind spot which cannot be compensated for by any amount of country-specific, institutional knowledge.

A household would not budget without making sure income and spending match over time. Yet the IMF does not care for such nuance at the global level.

Global inconsistency is politically convenient, of course. It allows each mission chief to verify, or deviate minimally from, the official forecasts provided by their country authorities. But it also makes a mockery of the notion that the IMF is the institution uniquely tasked with steering the global economy and helping coordinate policies to sustain global aggregate demand. If each country’s policies are evaluated in isolation, and the global forecast merely a simple aggregation exercise, there can be no prospect for policy coordination. The IMF cannot act as guardian of the global economy if she has no clue where the global economy is headed. And the principle of effective demand, the starting point for macroeconomics as a science, is rendered irrelevant if output is simply expected to fall like manna from heaven—and not be the product of spending by someone, somewhere, at some point.

Such is the case today, however. It has been clear for some time that China has become the key driver of global aggregate demand, the investor of last resort. And it has also been clear that China cannot, and should not be expected to, sustain a credit bubble to drive global growth. Rebalancing growth is both a China problem (lowering domestic saving) and a global challenge. Yet global forecasts ignore the need for monetary-fiscal-financial balance sheets to expand in a sustainable manner to deliver reasonable growth. These forecasts do not provide any meaningful guide to future developments. And so China has been expected, and is still expected, to punch above her weight in driving global growth, while Germany continues to abrogate her responsibilities agreed at Bretton Woods. And the IMF is rendered almost irrelevant, except at the margin, in delivering balanced and stable global growth.

So there is indeed a great deal indeed Ms. Gopinath can do to improve the IMF’s work, if she is willing to challenge the stale thinking and vested interests inside the institution. Otherwise, as with her predecessor-but-one, Mr. Blanchard, she can instead expect events to catch her off guard. Indeed, in this respect we ought recall the crucial role of a “kid” in prompting the IMF’s work refuting austerity—the greatest policy mistake in a generation or more—as told by Mr. Blanchard himself:

“The honest truth is, I had not focused on the assumptions which were made in the programs [in the euroarea] … or the forecasts we were making for other countries. And then at some point in 2010 and 2011 all these economies did much worse than forecast… And so I did, as the Head of Research, what anybody should have done, [and asked] where did these forecast errors come from? …

And then at a meeting, a kid, I mean just an intern, drew a graph of fiscal consolidation… and the forecast errors for output… and there was an amazing relation between the two. And so I realised… fiscal consolidation was much worse in terms of its effect on output than had been assumed in our projections and by the Europeans. And I thought it was an important result, but I didn’t realize how important it was.”


Hidden flows: Asset prices and eurosystem balance sheets

To suppose large and successive [external] balances to be formed into a debt is to assume an accumulation of debt which is almost equally incredible.

Henry Thornton, Paper Credit, 1805

PDF: Hidden information_FINAL.

Charts: Hidden information_chartpack.

THERE WAS ONCE a time when international macroeconomics was conducted largely through the prism of the central bank’s balance sheet. Absent all but patchy data or guesswork on external current or financial transactions—such as the overall goods and service balance or net lending abroad—changes in central bank reserve assets, typically specie, served as the only real indicator of net flows against the rest of the world—if not, of course, internal drain. Thus, monitoring balance sheets became crucial for investors.


While often neglected today, the central bank balance sheet continues to prove essential for parsing private financial flows and investor sentiment. This was brought into sharp relief when the eurosystem’s TARGET2 clearing system, and network of credits and debits across national central banks (NCBs), became essential for tracking financial flows at the height of the euro area crisis.

More recently, the ECB’s asset purchase program (APP) has provided liquidity across the system that has resulted in widening TARGET2 balances once more—and ever-increasing uneven distribution of eurosystem liquidity. Figure 1.

Germany’s TARGET2 credit, at €913bn in July, has come to mirror the combined debit position of Italy and Spain—at €471bn and €403bn respectively. And at first blush, the TARGET2 debits of Italy and Spain, which have steadily increased since the inception of APP, appear of the same genus—the two giants of the periphery experiencing broadly comparable net private financing flows as expressed through their debit balance.

However, care in interpretation is needed; not all TARGET2 debits are alike. How so?

While most of the public-sector purchase program (PSPP) is undertaken according to the eurosystem capital key, there are other aspects of APP—the ABS, covered-bond, and corporate sector purchase programs—which are also important and implemented by the ECB and select NCBs. Thus, while the total stock of assets held under APP amounts to €2.5trn as of August, only 82 percent of this total related to PSPP purchases; €0.45trn relate to the smaller purchase programs. Figure 2.


Moreover, within PSPP, purchases are split between national government bonds as well as supranational debt—initially supranational purchases were 12 percent 0f total PSPP, decreased to 10 percent in April, 2016. Figure 3.

And purchase of supranationals is determined by “a specialisation approach, [whereby] only a few NCBs buy securities issued by European supranational institutions… independent of the domicile of these international or supranational institutions” (emphasis added.)


These supranational assets include the European Investment Bank (EIB), European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM), for example.

Consider the following. The ECB balance sheet component of the eurosystem is only published annually. Between end-2014 and end-2017, ECB holdings of assets for monetary policy purposes increased €211bn, the counterpart to an increase in intra-eurosystem liabilities (i.e., TARGET2 debit) of €193bn, visible in Figure 1.

However, the system-wide increase in ABS, covered-bond, and corporate sector purchases, as well as purchases of supranationals within PSPP, over the same period was €573bn. In other words, under the totality of APP there are roughly €360bn in assets held for monetary policy purposes—beyond national government bond purchased by capital key under PSPP—which show up on the asset side of NCBs of the eurosystem.

For this reason, interpretation of the evolution of TARGET2 debits becomes nuanced. Imagine a NCB buying a supranational on behalf of the system, not domiciled locally. Then there will be an automatic increase in that NCB’s assets and, mechanically through TARGET2, liabilities. But this in no way reflects net private flows to the economy in question. For example?


Begin with the case of the Banco de España (BdE) which, thanks to the continuation of historical balance sheet reporting beyond euro membership, still provides a geographical breakdown of asset holdings. Table 1 summarizes BdE stock of assets as of end-2014 and end-July 2018.

Total assets of the BdE increased €363bn over the period, as expected during APP. However, domestic asset holdings only increased €251bn—comparable with cumulative purchases, through August, of SPGBs and related local assets of €254bn under PSPP. An additional €67bn assets over this period, however, relates to claims on the rest of the world—i.e., non-euroarea assets. And ECB reporting of total Spanish asset holdings for monetary policy purposes of €328bn as of August 3rd suggests BdE has engaged in the purchase of non-domestic assets under APP.

Given that most supranational assets eligible under APP are domiciled in the EU but not euroarea, the above data would be consistent with Spain undertaking supranational purchases under the PSPP on behalf of the system, for example.

Regardless, this is also confirmed by the balance of payments (BOP) data.

Figure 4 shows the net financial flows of BdE as reported by in Spanish BOP. Witness, since 2015, the steady accumulation of portfolio investment assets by BdE alongside other investment liabilities, meaning TARGET2 debits.


Figure 5 shows BdE holdings of euro-denominated securities by non-resident geographical breakdown. The imprint of PSPP is apparent in claims on rest of the world (ROW.)

Hidden_F5Why does this matter? It means some of the “deterioration” in the Spain’s TARGET2 balance since APP-inception—perhaps €20 billion per year—does not represent net private flows, rather the mechanical accumulation by BdE of foreign assets. And just as this might mislead as to private transactions today, the necessary future financial inflows to offset APP sales later will be correspondingly reduced.

Put another way, we can adjust Spain’s TARGET2 debit over the period for the accumulation of foreign assets. And this “shadow” TARGET2 debit would be a better indicator of cumulative private flows since APP.

Next contemplate Italy, the other giant of the euroarea periphery. Banca d’Italia (BdI) does not provide a comparable decomposition of assets by geographical location, so far as I am aware. But we do know the following.

BdI holdings of securities issued by euroarea residents from end-2014 through August increased €306bn. This compares with the ECB reporting on cumulative PSPP purchases of BTPs over the same period of €356bn, although the former represents transactions beyond those only for monetary policy purposes.

Alternative reporting by BdI puts the stock of assets held for monetary policy purposes at end-July of €383bn. Since data reporting only goes back to 2017 on this measure, we cannot make a comparable assessment of the change in asset holdings since 2014. But it suggests BdI has not been engaged in comparable non-resident asset purchases under APP. And this is indeed played out in the BOP data.

Witness Figure 6. BdI has hardly engaged in the purchase of non-resident portfolio assets. Roughly speaking, in contrast to Spain, the entire accumulation of TARGET2 debits in Italy therefore represents net flows of private investors.

Hidden_F6Recall Figure 1. Indeed, Italy’s TARGET2 debit drifted below Spain’s for the first time in 2016. But this might be expected given Italy’s larger size and thus purchases under APP.

What Figure 1 hides, however, is relative purchases of external assets under APP—purchases which mechanically drives a TARGET2 debit without reflecting meaningful action on the part of private investors. Thus, APP has in some sense exaggerated Spain’s debit position relative to Italy.

Figure 7 shows Spain’s actual TARGET2 debit as well as one estimate of the adjusted, or “shadow” debit—which adjusts for euro securities held against ROW.


What does this have to do with asset prices? Consider Figure 8 which shows—from July, 2012—Spain’s adjusted TARGET2 position minus Italy’s debit (right scale, € billions) against the Italy bond yield spreads over Spain (left scale, bps).

Net private transactions against non-residents, as reflected in residual liability claim by the respective NCB on the eurosystem, have steadily deteriorated for Italy relative to Spain. From about €150bn larger debit position at the time of Draghi’s “whatever it takes” speech, Spain’s TARGET2 (a smaller economy) has improved relative to Italy such that today Italy is about €120bn worse off.

Hidden_F8And these net private flows are reflected in the yield spread of Italy over Spain. Where Italy traded through Spain in 2012, this has now reversed. Arguably, the relative TARGET2 balance is suggestive of the future yield spread.

For amusement, Figure 9 shows the BdE asset and liabilities by residency (ignoring “unclassified” items.) The increasing role of claims on ROW is evident, as is the overall impact of PSPP, reflected in liabilities to the euroarea. But a growing pocket of domestic liabilities—bank deposits—represent a relatively recent trend, suggestive of improved net private flows serving as a buffer for the local economy against future adverse flows.


Is there more to be said on the growing nuance needed when interpreting TARGET2 today? Consider another, more egregious case. It is well known that Greece does not participate in the PSPP—they are precluded from the program and it looks unlikely they will benefit from substantial purchases before the program ends. But this does not mean the Bank of Greece (BoG) is not engaged in other aspects of APP. And they have indeed been accumulating their own small share of assets held for monetary policy purposes across the eurosystem. Figure 10.



BoG assets for monetary policy purposes bear the imprint of the earlier Securities Market Program (SMP) from 2010, but these were small and were steadily rolling off. Then, in 2015 Greek holdings of assets grew sharply—from €6bn end-2014 to €64bn end-August.

Since BoG also produces a breakdown of assets by geography, Table 2 gives the decomposition previously shown for Spain.


Since end-2014 total assets held by BoG are hardly changed—up by €3bn. But domestic assets—relating to emergency liquidity assistance and repo operations by the domestic banking system—have fallen €44bn, while foreign assets have increased €47bn. These foreign assets relate, of course, to the implementation by BoG of non-PSPP aspects of the APP.

We can apply a similar adjustment to Greece’s TARGET2 (plus banknote related liabilities) to get a measure of the true “shadow” balance therefore. Figure 11 does this. And in the case of Greece this balance notionally turned positive around the turn of the year. Were it not for APP purchases, net private capital inflows to Greece (and banknotes returned from beneath the mattress) would have been enough to generate a TARGET2 credit by now. It seems likely that over the next year or so if private capital inflows remain robust, Greece will attain an actual credit balance on TARGET2—remarkable for a country that has been constantly berated for being a debtor to the eurosystem.


As a corollary of this, BoG recently attained the largest net foreign asset position since euro inception. Figure 12.

Other countries that witnessed capital inflows and a turnaround from debtor to creditor within the eurosystem—such as Cyprus, Ireland, and Slovakia—also saw a sharp compression in government bond yields. One technical constraint for Greece that prevents such compression relates to the continued limits on domestic banks from buying GGBs which remain largely in non-resident hands.


Still, growing liquidity within Greece will contribute to improved credit creation, growth, ratings upgrades, and eventually a new set of investors to drive down yields—closer to peripheral comparators. If the shadow TARGET2 position is any indicator, Greek assets remain the cheapest in the euroarea by a considerable margin.


On debt sustainability, functional finance, and the transfer problem

Here are some notes on public debt sustainability. Since WordPress apparently cannot tolerate equations I am forced to post the pdf version here and the introduction and main themes below: On debt sustainability

Anyone invested in Argentina right now will benefit from reading till the end.

More generally, feel free to dip in. Comments welcome.


HOW OUGHT sustainability of public debt be assessed? And how should this assessment inform public taxation and spending decisions now and in future?

There are few questions of greater import in macroeconomics today. Yet answers remain elusive; often, discussions of fiscal policy are anchored by the need to attain a 60 percent debt-to-GDP ratio—or, more simply, the notion that public debt is too high. But why? What grounds are there for any debt target?

More worrying, perhaps, is the fact the international community struggles to understand lessons from the past decade. What is the correct stock of public debt? Why exactly was it necessary for Greece to default, but not Portugal? Is Argentina’s public debt today sustainable? We’ll get these questions.

Yet upon the opportunity to rethink debt sustainability analysis (DSA) in 2011, IMF staff acknowledged previous analysis “often turned into a routine exercise, with mechanical implementation of the DSA template, little discussion of DSA results, and limited linkages between the DSA and discussion of macroeconomic and financial policies” (¶2). At this crucial opportunity to fundamentally challenge and rethink sustainability—including key metrics such as the 60% debt-to-GDP target, the meaning of fiscal space, and the link between fiscal and external sustainability—the Fund doubled down on the pre-existing framework. We are stuck in the same old grooves of pre-crisis thinking.

That the framing of public debt and fiscal policy has barely moved on from a decade ago is a matter of huge concern. Absent policy tools following any near-future macroeconomic malaise, we ought carefully reassess our thinking. It is crucial we do not succumb to irrational fear of public debt; we need to sustain the flow of aggregate spending in the years ahead. We ought also educate the public against the false notion that public debt is always a burden—in fact, it can be a public good.

Unfortunately, economics lacks fresh thinking—groping in understanding, deflationary in mindset, atavistic in morality-of-debt thinking.

Fortunately, a conference in Washington, DC tomorrow offers an opportunity to set the record straight. Let’s pre-empt therefore five messages on public debt that ought emerge from this conference.

First, public debt need never be repaid.

Second, a 60% debt-to-GDP target is unnecessary, and for the public misleading.

Third, public debt reflects private savings.

Fourth, the complete, consolidated state balance sheet matters.

Fifth, sometimes the balance of payments matters most.


Germany’s At Last Contributing to Global Adjustment

MATTHEW KLEIN at the FT has a nice post in Alphaville recalling the egregious adjustment in the peripheral euro area current account balances since the Great Financial Crisis (GFC)—from deficit to surplus. Indeed, “the change in the 19-member group’s current account balance can be almost entirely attributed to the crisis countries.” As he points out, similar to the experience of those hit hardest during the Asia Crisis, current account surpluses and deleveraging are forcing global adjustment elsewhere.

While true, of course, this Crisis-reaction narrative somewhat understates the contribution of flawed euro area policies—in an incomplete and disjointed monetary union—forcing adjustment entirely on domestic demand in the periphery, and therefore a compression in imports there, with little offsetting expansion in demand in the Core. This allowed the area-wide surplus to expand at the expense of the rest of the world.

Indeed, the trick for Germany at that time, in order to ride-out lower intra-euro demand, was to switch goods exports towards the rest of the world—China, the UK and US amongst others. This is shown in Figure 1 where Germany’s surplus against non-euro area rest of the world (ROW) expands throughout 2011 and 2012 (measured as percent of EA19 GDP). Meanwhile, the rest of the euro area (ROEA) balance against ROW went from deficit to surplus against ROW, as Klein points out.


Another way of seeing this is witness—and decompose—domestic demand growth in the euro area into contributions from Germany and the remaining countries. This is shown in Figure 2. Germany made a smaller contribution to overall domestic demand through 2007, after which followed a coordinated drop in domestic demand in 2008-09. After a brief recovery, led by Germany, the Crisis hit Europe and domestic demand fall sharply across the euro area once more. But rather than offset peripheral compression, German domestic demand also slowed at this crucial time—meaning there was no counter-cyclical force. Perhaps best seen in terms of the levels of domestic demand in the lower chart, this pro-cyclical intra-union policy reaction was a result of huge mistakes in monetary and fiscal policy at that time.


But this is all backwards looking. What I’d like to celebrate today is how Germany is perhaps contributing—for the first time in over a decade—to global rebalancing. This can be seen in Figure 2 by the fact that German domestic demand growth has contributed more to aggregate euro area domestic demand that the rest of the currency union members put together in the past two quarters. Moreover, the level of German domestic demand has broken the 2 percent trend time for the first time since 2000 (lower chart.)

Furthermore, seen in terms of the 12 month change in euro area aggregate current account balance, which is now compressing, most of the adjustment in the euro area current account is due to Germany. See Figure 3. Indeed, Germany’s contribution to the lower current account over the 12 months through June this year is the largest (in percent of GDP) since 2000 (consistent with domestic demand above). What we cannot be sure of is how much is due mainly to higher oil prices.

But the fact this is coincident with domestic demand picking up in Germany and a global upswing suggests this is more than simply the terms of trade. It’s also worth recalling how  many in 2010 and 2011  argued German expansion then would not help peripheral adjustment because this would not directly impact exports there. Well, so what? This missed the fact that by spurring growth outside the euro area  would spillback to support the rest of the euro area—exactly as is the case today. A rising tide really does lift all boats.


Yet we have only just begun! It is frightening to hear of Germany’s Council of Economic Experts warning about the risk of overheating. Since 2000, the German share in euro area total GDP has diverged sharply from the share in domestic demand. This gap, shown in Figure 4, is another measure of imbalances in the euro area. With continued domestic demand growth in Germany, in particular offsetting the global challenge of deleveraging in China, and continued current account compression, there is hope that the global recovery will continue. This will allow further peripheral export-led growth, the flipside of the overall rebalancing.


So let’s not cut short the encouraging recovery in German domestic demand. Indeed, fiscal expansion would do very nicely right now. And as Neil Young put it many years ago, perhaps thinking of Germany’s domestic demand expansion within the euro area today: “We’ve been through some things together, with trunks of memories still to come. We found things to do in stormy weather. Long may you run.” [END]




Germany’s Missing €500 billion

THE PERCEPTIVE Simon Tilford of the Centre for European Reform has noticed a curious feature of Germany’s external accounts: her net international investment position (NIIP) reveals net “foreign assets have risen much less rapidly than the accumulated current account surpluses, leading to … losses: around €580 billion since 1999.”

That is, the value of Germany’s stock of external financial assets minus liabilities measured at market prices is worth substantially less than implied by cumulated flow of current account surpluses. This “loss” of roughly 18 percent of GDP—a decent chunk of change—deserves attention. Why save so much abroad if it is being spilled onto the ground?

To explain this gap, Tilford suggests—contrary to the narrative of an ageing society attaining higher yields abroad—Germany’s external returns fall short of expectations. Given these losses, it would be in her interest to rein in her surplus and invest more at home.

Meanwhile, Martin Sandbu of the Financial Times’ Free Lunch column picks up on this discrepancy, arguing that since surpluses are being “diffused” by “poor … lossmaking … investments,” German savings are not the concern some suggest—if she insists on investing abroad then Germany’s steady loss represents others’ gains.

Against this, Sandbu references in passing another interpretation, due to Matthias Busse and Daniel Gros of the Centre for European Policy Studies in Brussels. They argue current account data to be more reliable; in contrast, measurement errors likely creep into Germany’s net IIP—being the difference between two large and “imperfectly measured” stocks. They therefore propose to focus on the yield on German investments abroad, observing “returns … have remained above most domestic returns” and therefore “German savers have fared quite well over the last decade in their foreign investments.” Thus, net IIP figures can be misleading; surpluses are perfectly rational given relative returns.

What’s going on?

Figure 1 uses the latest external accounts data— consistent with the IMF’s Balance of Payments Manual 6 (BPM6) methodology—for Germany, plotting from end-2003 the cumulative current account balance, financial account, and the change in net IIP. The former two series being cumulative flows, the latter a change in (net) stocks. This illuminates the gap under consideration. Germany’s current account surplus sums to about €2,310bn over the period, the change in net IIP is €1,790; sure enough, the gap is roughly €530bn.

The chart immediately points to one source of discrepancy. Germany’s financial account flows only cumulate to €2,180bn, the gap with the current account being inevitable “errors and omissions” in collection of balance of payments (BOP) data. Indeed, these sum to €130bn—per year perhaps €10bn (say ½ percent of GDP). Either the current account surplus is overstated or financial account flows understated. We cannot say which. But we have captured one-quarter of the missing €530bn already.

But what of the remaining €400bn?

Germany 1

Recall how net IIP data record the change in asset and liability stocks due to flows, recorded in BOP, plus valuation adjustments—due to exchange rate, price, or other adjustments impacting stocks. We can therefore decompose the IIP gap by contrasting the cumulative financial flows with the change in IIP stocks for each investment category—as in the table below.

The accumulation of assets since end-2003, for example, according to BOP was €4,070bn. But the change in the outstanding stock of financial assets over this time was €4,530bn—meaning assets have increased in value by roughly €460bn more than flows. The same is true of liabilities, however—for example, non-resident holders of Bunds, recorded as part of portfolio liabilities, have experienced large capital gains as yields approached zero.

Overall, the positive asset valuation adjustment (+€460bn) is more than offset by that due to liabilities (-€530bn) in net IIP; the total contribution to the IIP shortfall is exactly €66bn. This accounts for an additional 12 percent of the €530bn IIP gap. Together with errors and omissions, we have filled 37 percent of the shortfall.

Germany 2

What next? Only one item in the external accounts remains in “financial derivatives (excluding reserve assets) and employee stock options”—FDs for short.[i]

Since, per BPM6, flows due to FDs are only recorded on a net basis—not gross—it is impossible to deconstruct the stock-flow contributions exactly as in the table above. However, we can decompose Germany’s FD transactions in BOP—a measure of external gains or losses on derivatives positions—in three different ways, by: product, sector, and country, shown in the three figures that follow.

Typically, through time, Germany registers “losses” on FDs—positive flows. The total since 2003 is €305bn. But to think of these as losses is somewhat misleading. If these represent hedges—say on foreign exchange value of foreign denominated securities—then “losses” may simply offset by gains elsewhere in the net IIP, so should not be viewed in isolation.

Nevertheless, since 2010, positive FDs flows mostly reflect forward contracts. However, during GFC large losses on options were recorded. In 2007 and 2008, for example, positive options flows of €110bn (of €163bn in total options over the 14-year period) were recorded, only partially offset by gains in following years.

Employee stock options are immaterial.

Germany 3

In terms of sector, FD flows over the period mainly accrue to monetary financial intermediaries excluding the Bundesbank (€190bn) and other financial intermediaries (€92bn). Direct losses due to non-financial corporates and households are minimal (€22bn).

In 2007 and 2008, when noted losses on options positions were largest, banks (€60bn) and other financial intermediaries (€54bn) were hit roughly equally.

Germany 4

Finally, we can trace the country-counterpart to these FD flows, using the Bundesbank’s bilateral financial account flows data. Historically, Germany’s FD flows were largely recorded against the United Kingdom. For example, the correlation coefficient between total FD flows and that against the UK was more than 0.9 in the decade through 2000, while that recorded against France was less than 0.2. From the millennium—perhaps related to the inception of the euro?—the flow of FDs in Germany’s financial account has pivoted towards France. Indeed, since 2003, €138bn flows have accrued against France and only €116bn against the UK. Moreover, most of this was recorded during GFC, when FD flows against France equalled €94bn—when options losses were at a peak.

The bilateral losses against France are particularly interesting. The growing importance of derivatives trading by German banks in the period prior to GFC has been noted, as well as greater losses of Germany relative to France during GFC (see here). The BOP data appear to suggest that one reason for the high relative German losses is that French banks benefited from their derivatives positions against Germany. In other words, Germany provided the hedge for French banks during GFC, helping mitigate losses at that time. But this, like the financial positions then, is mainly speculation.

Germany 5

In any case, we have now precisely accounted for Germany’s missing €500bn, summarized in the chart below as cumulative flows since 2003. As the chart reiterates, most “losses” were incurred during two stress periods.

First, in 2007/08, during the onset and crescendo of GFC, a cumulative gap of about €200bn developed. A substantial part of this (over €100bn) reflected losses on options positions against France, noted above. But there were other valuation losses during this period on net other investment and net FDI positions.

Second, in 2010/11, during the euro area crisis, valuation on net portfolio investment assets created a further dent. Between early- and end-2011, losses on net portfolio investment asset of about €130bn were recorded. This will reflect both losses on German holdings of peripheral bonds during peak stress, but also the bund’s status as haven pushing down German yields.

            Errors and omissions, meanwhile, fill much of the remaining gap.

Germany 6

It is also noteworthy how, since 2011, the €500bn gap has levelled off. Continued flows relating to FD positions are offset by valuation adjustments elsewhere; net IIP has moved in line with the current account.

To summarize, the German data on external asset and liability stocks and flows is complete. It is not true that errors in recording IIP stocks require instead focus on the current account. While Germans make terrible macroeconomists, they make formidable accountants. There is nothing much wrong with the data. All we lack is interpretation.

But this narrative also unveils flaws in Sandbu’s sanguine interpretation of this gap. In fact, Germany’s losses occur largely during period of financial stress—revealing dangers of unchecked capital flows and external imbalances. Germany’s net IIP losses are not, therefore, a harmless means of dissipating her growing external claims. Rather external losses reflect the destabilizing influence of surplus savings and large gross capital flows across borders—leaving financial crises in their wake.

And this also refutes Tilford’s claim that Germany’s external returns have failed to deliver. Indeed, absent destabilizing financial crises, Germany’s net IIP gap would not have materialized. And it has now settled down. The gap need not grow further—and rate normalization and pull to par of bonds could see it close.

But what about the relative returns on German investments abroad? These are shown in the chart below. As Busse and Gros note, Germany has indeed generated a higher yield on external assets than non-residents have achieved from investment in Germany. But it is noteworthy that the yield gap on portfolio investments has closed in recent years, while other investment returns are more-or-less identical through time. As such, the only advantage Germany currently gains is the yield on direct investment abroad, which has generated about 1.7 percentage points more than investments in Germany on average since 2007. But this is also closing.

Germany 7

But this is not the end of the story. First, low relative returns in Germany could simply reflect the lack of domestic demand there. Any attempt to generate domestic-led growth could change this calculus. Second, in any case, inwards foreign direct investment in Germany experienced substantially larger valuation gains over the past decade (see table above). A measure of total return–that is, yield plus valuation gain or loss–on FDI (not shown) generates very similar returns on inward- as outward-FDI. In other words, the case for Germany achieving a greater return abroad is not clear-cut.

The case for continued net external asset accumulation by Germany is not clear cut.


[i] Now…   a technical note: BPM6 introduced FDs as a separate functional category in BOP reporting for the first time (see here). FDs, such as forwards and options, are used for “risk management, hedging, speculation, and arbitrage” with prices linked to some underlying financial instrument. And since employee stock options, while not derivatives, take a similar form—say, the right to purchase equity as remuneration—these are folded into this category. And it turns out that a large part of Germany’s “missing” €500bn can be traced to FDs.

BPM6 manual gives the helpful example of an exporter hedging currency risk with a forward contract (see page 163). This helps intuition. In short: at inception of the hedge, no entries in external accounts are needed—the initial forward position is zero; not true of options. As asset prices change, the value of the forward contract changes, reflected in IIP (asset or liability). Only when the contract is finally settled is the FD transaction recorded in both the BOP as financial account (flow) and net IIP (stock) as a transaction within the period and final valuation adjustment. And the FD transaction equals total net IIP valuation adjustment (but with opposite sign) returning the IIP stock position to zero.

And so, gains or losses due to FDs positions can distort changes in net IIP when compared to the cumulative current and financial account flows. Concretely, in the forward contract example, losses due to hedged exchange rate risk for an exporter imply a $1,200 goods surplus is met with an increase in “currency and deposits” on financial account of only $1,000 alongside a negative $200 FD liability flow (positive $1,200 total) because of losses on the forward contract. Net IIP only increases $1,000—and thanks to FDs, the change in net IIP deviates from the current/financial account flows. Such is the cost of hedging exchange rate risk—with the benefit that local currency value of goods is assured in advance. Technical aside over.