Why the wait?

In response to projected low growth for quite some time the federal reserve has announced they will be keeping interest rates near zero until 2013. Its European counterpart raised its benchmark interest rate last month and there is no sign of them changing their mind. This is odd seeing how the euro zone is in worse shape then America. The ECB should have to worry about high levels of inflation, especially with the German economy coming to a halt. One would expect it to step in to help the ailing economy.

One possible explanation for this is that the inflation the ECB fear is inflation of its own making. While waiting for the European bailout found to be granted the power to buy bonds in the secondary market by the member nations national parliaments, and it is not even certain that it will be, the ECB will have to fill this function. They have already bought Italian and Spanish bonds to keep down those countries borrowing costs and they might have to come to the rescue again. If these bond purchases become too expensive the ECB must pay for them with newly printed money. This will increase the money supply and lead to inflation, much the same way lowering the interest rate would. It is quite possible the ECB fears that both actions taken together would lead to excessive inflation, so they have to put off lowering the interest rate to give itself room to act in the bond market if so needed.

Blame the Euro

How did Europe burry itself in debt? It all has to do with the Euro protecting profligate southern nations from the discipline bond markets usually would have imposed.

Normally the interest rate a nation has to pay on its debt is based on two thing, expected inflation and the risk of default. In cases where a country is in control of its own currency the risk of default is pretty much zero, since they can always inflate away their debts. As debts increase so does the temptation for governments to generate higher inflation lowering that debt in real terms, to compensate for that potentiality markets will demand a higher interest rate. But for a euro country the power to print money and thereby generate inflation was taken from the individual member nations. Since inflation expectations now were the same for all euro member no matter how much they borrowed all euro members could borrow at the same low interest rate. Allowing profligate members to borrow in a manner that had previously been impossible.

Then the financial crisis hit, governments had to take on the debts of failing banks and try to compensate for drop in private sector demand all while tax revenues dried up. For those who had already borrowed excessive this added debt became too much. It rose to such levels where markets started to fear that they would simply refuse to pay back the money they owed. So they started to demand a higher interest rate to compensate for the risk of these countries actually defaulting on their loans. Interest rates they could afford to pay, making a default even more likely, leading to even higher interest rates and so on.

This whole crisis would never have arisen if it wasn't for the euro. The bond markets would not have allowed any indebted nation to borrow like in such a reckless fashion.

In order for Europe to not find itself in this situation again a variety of measures are started to be implemented. Mainly legal limits on how a member country can borrow, both in the form of treaties and national legislation. Such limits of course existed before the crisis but were simply ignored. Hopefully these will be design in such a way that they can't be. Potentially by handling the power to punish rule breakers over to the European court of justice.

No tax cuts for working Swedes

There won't be any additional cuts to the Swedish income tax as previously promise by the Reinfeldt government. The reason for this is disappointing growth figures. I would say that this is somewhat odd reasoning on the governments part since there is no better argument for lower taxes then low growth. A tax cut would boost demand in the economy, exactly what is needed when the economy is growing slowly. The main argument for cutting the income tax made by the government has been that it would increase employment. Something that surely will be more of a need for now when economy is slowing then it would have been otherwise.

If the Swedish economy's impressive growth spurt had continued this would have been a better argument against cutting taxes then in support of it. Then the danger would have been increased inflation and the creation of bubbles especially in the property market. Problems a tax cut would have made worse. If the inflation threat had been seen as serious, the Swedish Riksbank would have had to react by raising interest rates faster then it otherwise would, counteracting the positive effects of the tax cut.

These actions by the Swedish government seem to be in line with a pro-cyclical fiscal policy exacerbating the swings of the business cycle by boosting the economy in good times and strangling it in bad times.

The only defense for such a policy would be fiscal discipline, an unwillingness to spend beyond ones means. The consequences of which many of Sweden's European neighbors are suffering. But unlike them Sweden has no existing debt problem. It could easily run a budget deficit without this unnerving the markets. It does however have a budgetary rule of a 2% surplus, with the aim of continuously chipping away at Sweden's already manageable public debt. But this 2% goal is over the whole business cycle, giving the government room to help the economy during bad times given that they then show restraint during good times.

Let's do the twist!

With growth slowing markets are expecting the Federal Reserve to do something. Many is expecting another round of quantitative easing, a QE3. Meaning the Fed will start buying government bonds with freshly printed money. This has the obvious downside of pushing up prices.

There is however an alternative that won't lead to inflation. The Fed could do what is called a twist, selling its maturing bonds and using that money to buy long term debt. This should drive down the yield on long term government bonds making them less attractive as a safe hiding place when the future looks uncertain. This should force investors to return to the stock market and boost share prices. Making everyone who owns stocks a little richer, boosting demand in the economy, creating new growth. At seemingly no real cost.

The morality of central banking

Republican presidential candidate Rick Perry made the news with his comment that it would be almost treasonous for the Federal Reserve to print more money. I'm a bit unclear on what he meant by this but my guess is that what he is talking about is anther round of QE, the practice where the Central Bank buys government bonds with newly printed money in order to lower bond yields and instead channel investment in to the stock market. This has the added effect of keeping government borrowing costs low, encouraging more borrowing by the federal government. Which I'm assuming is why Mr. Perry has a problem with it.

There is also a broader mistrust of central banks in some right wing circles. Since the abandonment of the gold standard central banks have gained full control over the money supply by their control over the printing presses. This means that they can determine the value of all money. In effect they can cut all workers wages in half if they so wish, or drain all the value out of people's life time savings. Believers in limiting the power of government are understandably uncomfortable with this. Instead they want "sound money" tied to gold or some other stable asset.

I have some sympathy for this view but is satisfied by keeping the power over the printing press at an arms length from the politicians by the means of central bank independence. Something that can be seen as threatened when politicians like Mr Perry try to influence them by deeming some policy decisions treasonous.

Why?!

Stock markets are collapsing in general, bank shares are dropping even fastest. Banks are seemingly unwilling to lend to each other. Why? It all seems to have coincided quite nicely with the downgrade of Americas sovereign debt. But the likelihood of an American default is not the reason for all this. If it was investors would be unwilling to lend to the US government, instead they are falling over each other trying to get America to take their money, yields on treasury bonds are at record lows. Taking expected inflation in to account investors are actually paying for the privilege of lending money to the US government.

Why are investors desperate to lend the American government? It's for the same reason the stock market is dropping like a stone. Unexpectedly low growth in America and Europe. The economy isn't growing on its own since everyone is still buried in debt since the financial crisis and are still paying it off. In Europe spending cuts and tax increases are doing a better job then expected at killing growth. In America a newfound fixation on the debt is making any plan to spend more politically impossible. Here if anything the S&P downgrade played a part, by making any government stimulus even less likely. When it comes to monetary policy the Federal Reserve has already tried its old tricks and some new to breath new life in the the economy so more action and the effectiveness of such is questioned. On the other side of the atlantic the ECB is focused on buying up Spanish and Italian debt to keep those economies from being crushed by interest rates they can not afford to pay. So the economy is stagnating and there does not appear to be anything governments can or at least are willing to do to help. So markets are realizing that the companies they have invested in aren't going to do as well as they had expected, driving down their value making the alternative in the form of government bonds look much more attractive.

Investors are especially keen on getting rid of bank shares since banks are perceived to be especially vulnerable as the economy slows. This is partly because some of them own a large amount of government bonds of risky origin like Greek and Portuguese bonds. But also that the value of their assets in general will fall as the economy slows potentially giving them liquidity problems.

So to sum it all up, it is all to do with lower then expected economic growth.

Markets disagree

In the last few weeks we have seen a downgrade of American sovereign debt by S&P as well as all three major ratings agencies coming out in support of France's continued AAA rating. Markets seems to disagree. The people who actually invest in government bonds are rallying to American debt while selling off their French government bonds.

The interest rate on French 10 year bonds is about 3% while its American counterpart is closer to 2%. In real terms the difference is even larger since American inflation expectations are higher then expected European inflation. If markets agreed with S&P that French debt really was safer then American debt those numbers should be switched.

China has built a big boat

Historians love to tell us that we should study more history so we can learn from it. Reading about China's completion of its first aircraft carrier and the fear this has sparked in its neighbors I can help to feel that a good parallel for this is pre-WW1 Germany. China fills about the same role in the power balance in early 21 century Asia as Germany did in 20th century Europe. They both are/were large states who's rapid rise in both economic and military power is threatening the balance of power in the region which previously has constrained any one nation from dominating the continent in question.

Americas role in today's Asia is very similar to Britain's traditional role in the European power struggle. As an outsider determined to prevent any one nation from gaining control of their continental neighbors. Britain has historically faced down a series of continental powers to this end. In Americas short history they have effectively prevented both Japan and later Russia from achieving this goal, now the threat looks like it might come from China.

What is especially troubling with this comparison is what convinced Britain of the German threat in the decade leading up to WW1 was the German plan to go from a nation with very limited maritime capabilities to build a fleet to challenge the power of the Royal Navy. Today the American fleet that holds the position previously held by the British and it is China that is building up its naval capabilities.

Sovereign debt and size

There seem to be a strong correlation between the size of countries and the amount of debt they can acquire before their interest rates start spiraling out of control. Most people seem to imagine some 100% of GDP threshold after which a countries debt burden becomes unsustainable. This number seems about right for most troubled European countries. But looking at the massive Japanese economy it is completely off. Their debt to GDP ratio is closer to 200% of GDP yet their borrowing costs are the lowest of any country. This size theory helps when it comes to understanding the ease at which America can borrow. The American public debt burden is large and more importantly growing. Yet they can borrow at almost no cost.

This size debt tolerance relationship can likely be explained by a bigger bond market being less affected by a group of worried investors selling their bonds.

This relationship is also something we should keep in mind when considering the effect of the much debated euro bond. It is usually thought of as a way to drive down borrowing costs by sharing the risk with countries with less debt. Mainly benefiting from Germany's thrifty ways. But the size relationship should imply that there is also a benefit in a larger economic base. This is supposedly something that even more responsible countries like Germany could benefit from, or at least help mitigate some of the harm done by having to guarantee the debts of their less well behaved neighbors.

Europe to the rescue

The ECB has come to the rescue of Spain and Italy, by buying up their bonds after investors started to sell of the debt of the two troubled southern giants they can once again borrow at an affordable interest rate.

This is probably a good thing since the ECB prevented the sovereign debt crisis from spreading, at least for a while. But is not all good. Depending on the size of the purchases required by the ECB it might not be able to sterilize its bond purchases and be forced to pay for them with newly printed money and thereby increasing the european money supply creating inflation. Unlike a traditional change in the money supply carried out through interest rate adjustments, this increase benefits only Spain and Italy at a cost paid by all other euro members. A lowering of the prime interest rate benefits all euro member by lowering the cost of borrowing, but this bond purchase lowers the borrowing costs of Spain and Italy. Meanwhile the inflation will eat in to value of the money of all Europeans.

Then there is the long run problem, by averting this crisis the central bank might have contributed to a whole slew of future crises. Once the ECB has popped its cherry in the bond market governments will come to expect it to put out again. This takes some of the pressure off them to solve their debt problem. The markets reacted to what they saw as less then satisfactory plans by the Spanish and Italian governments to reduce their debts. By the ECB coming to the rescue they lose some of the incentive to act.

How to get rid of public debt

With most western countries buried in public debt and looking to clean up their act it might be a good to offer an overview of their options. There is basically three ways for a country to lower its debt to GDP ratio, austerity, growth and inflation.

Most debt ridden European countries are now implementing some sort of austerity plans. These basically involves raising taxes and cutting spending. The logic here is simple, turning budget deficits in to budget surpluses they can start to pay off their debt instead of adding to it.

These practices however have the downside of strangling economic growth. Since a country's ability to pay off its debt depends on it's size relative to the size of the economy, this matters. If a country's economy would simply grow by a few percentage points every year its debt to GDP ratio would in time fall to manageable levels, given that its debts aren't growing faster then the economy itself. The easiest way to manufacture growth is by increasing spending and cutting taxes, this practice would however add to the deficit, which is the opposite of what we are trying to accomplish. But there are other ways to create growth without adding to the budget deficit. A country can deregulate product and service markets in order to raise productivity. Ease labor market laws in order for the country's workforce to be better utilized. Promote competitiveness by ending government monopolies and selling off state owned firms, both in the hope of raising productivity but also to collect some much needed cash for debt payments.

Another way is to bump up inflation. Most western countries have an inflation target around 2%, if this was raised by a few percentage points this would quickly eat away at existing public debt. The downsides of inflation has previously been discussed in this blog but much of the negative sides of inflation could be remedied if the increased inflation was kept at a stable rate, let's say 6% instead of 2%. The higher inflation rate would be known in wage negotiations so that new wage increases could take it in to account. Interests rates would adjust themselves to the expected higher inflation so to not punish savers by keeping the real interest rate (interest rates minus inflation) unchanged. Of course buyers of newly issued government bonds would take the new higher inflation rate in to account too, so it would not help the indebted country here. It would only help them with bonds issued when expected inflation rates were lower, on these the cost for the state would be significantly lowered. Imagine a 10-year bond being issued before the inflation increase, the indebted country would then only need to pay back a portion of that debt in real terms. There is however a risk that once a country has bumped up its inflation target markets might come to fear another increase and demand to be compensated for this risk by a higher interest rate.

A combination of the first two somewhat contradictory measures are already being pursued to some extent in in troubled European countries. Inflation has however been kept down by successive interest rate increases by the ECB. It probably wouldn't hurt if it took a more relaxed attitude to inflation fighting and let prices rise a bit. Especially now that German growth seems to be slowing and a low euro interest rate is less likely to create bubbles in the German economy.

The future of Swedish tax cuts

The Swedish government had planed to cut taxes (mainly income taxes) sometime next year, now that looks less certain. With increasingly ruthless austerity measurers in Europe, a slowdown of the American economy and inflation fears in China, demand for Swedish exports is likely to decrease. This has brought down projections for Swedish growth. The Reinfeldt government want to run a small budget surplus, something that might be incompatible with new tax cuts. So which will the government choose, fiscal discipline or tax cuts? Both are likely to appeal to voters in the upcoming election.

Given that Swedish elections in later years have been fought over the issue of high unemployment, I would place my bets on further tax cuts. Giving Swedes a bit more spending money should increase demand in the economy helping to compensate for lost exports. Since the bulk of the tax cuts are likely to be aimed at the income tax, that could also cut unemployment by making work more rewarding. A favorite argument if the Reinfeldt government. But if the economy really is heading for more troubled times the cause of increased unemployment is likely to lie in low demand for workers, and not in the willingness of workers to seek employment. Making it harder to argue that lower income taxes would be especially effective in fighting unemployment. Rather they would simply stimulate aggregate demand leading to increased employment the same as all other tax cuts that leaves tax payers with more money in their wallet.

The inflation tax

As the world economy is slowing down governments has two categories of tools to use to help their economies, fiscal and monetary policy. One involves the state increasing spending or cutting taxes to stimulate demand while the other involves the central bank simply printing new money and injecting it in to the economy. To many monetary policy might seem preferable since you would then get something for nothing. While fiscal policy is financed by tax money either collected now or sometime in the future, monetary policy simply involves printing some new money.

But monitory policy is paid for with inflation rather then taxes, which will have a similar effect on the citizenry. As the supply of anything increases its worth falls, this is as true of money as it is of tomatoes. When more money is created the value of all other money decreases. So in order for this new printed money to come in to existence the money in everyone's bank accounts will be worth a little less and everyones salaries will decrease a little in real terms. Instead of paying a direct tax to the government (either now or sometime in the future) to finance its fiscal policy the value is directly extracted from your bank account and your salary.

The future of secular Turkey

Turkey's mildly Islamist Government has been prevented from more fully embracing an Islamist agenda by two forces. The first is the powerful and staunchly secular Turkish army, the second is the prospect of EU membership, both of these are fading.

Last week the top military brass resigned in protest over the arrests of officer charged with alleged plot making. In effect handing over power over the military to the civilian government by giving them their pick of replacement. This is hugely important since the army has seen itself as defenders of Ataturks vision of a secular Turkey and has in modern history toppled no less then four governments by the means of military coups. With them neutralized the most serious bulwark against the islamization of Turkey has been overcome.

The lure of EU membership and the massive economic gains that would entail for Turkey has helped democratize the country and preserving the countries secular attitudes have been part of this. The EU does not want any of its members practicing sharia law or any similarly undemocratic behavior. But the likelihood of EU membership is diminishing as Europeans view immigration (especially Muslim immigration) in a increasingly negative light. The French President and the German Chancellor influenced by these sentiments have made it clear that their countries oppose a Turkish membership. If Turkey's EU ambitions really are hopeless then these is no more need for them to cater to foreign audiences, the Turkish government can instead focus on domestic opinion which has a much more positive view on Islamist policies.

It is now up to the Turkish people in a truly democratic fashion to prevent the islamization of their country through the ballot box, unfortunately they are much less trustworthy in their commitment to secularism.

German power

In recent history Germany has tried and failed in their attempt to dominate the European continent twice at an enormous cost both in financial and human terms. It is ironic that they now through a process of European fiscal integration are placed in a position in many ways similar to what they tried to achieve in the two world wars they sparked.

As a response to the European sovereign debt crisis the Euro zone is moving ever closer to fiscal union, which in practice means transferring money from successful European countries (mainly Germany) to troubled European countries (most of them). In exchange for this fantastical generosity the lenders (again principally Germany) is able to force these countries to go through hugely painful and unpopular programs of austerity and economic transformation, in essence becoming more Germanic. Since Germany along with Sweden are the current prime examples of the famous Protestant work ethic and fiscal responsibility, there is likely no better example to recreate Europe’s economies in the image of. And in the long run it is likely to benefit both parties by putting Europe’s troubled economies back on track and in the process rebuilding and boosting the European market for German exports. However this is not the point, Europe could very well have thrived under the tutelage of Kaiser William and maybe even the brutal hand of the Fürer, but it meant what was then seen as an unacceptable loss of national freedom. The point is that by peaceful and benevolent means Chancellor Merkel has the potential to achieve what Germany’s militaristic leaders have failed to, power to control the domestic policies of its European neighbors and even reshape their societies to her liking.

Do we want Assad gone?

Today we can read in the paper today how Saudi Arabia has recalled its ambassador from Syria, shortly after the Arab League condemned the Syrian crackdown. The Assad family's hold on power is looking ever more fragile. This begs the question, do we want the Syrian dictator gone?

Surely he has repressed his people and by allying himself with Iran he has made himself an enemy of the West. Still the removal of dictators, however despicable is likely to cause a new set of troubles. As seen after the toppling of Saddam. Like Iraq Syria is split between several religious groups, and like Iraq it is ruled by a privileged (religious) minority. The fall of Assad could be followed by a bloody struggle and maybe even civil war. Only in this case there aren't thousands if American troops to keep the situation from exploding. If the revolution results in a power vacum Al-Qaida and other Islamists can take root, like they did in Iraq.

The fall of Assad would be a joyous event. But there is the risk that we will start missing him not soon after.