Thursday, June 24, 2010

Estonia Joins the Euro: What Can We Learn?

The economic news has been full of talk about a crisis in the euro area. Some observers are even taking bets on who will leave the euro first--Germany or Greece? Yet, in the middle of this crisis, Estonia has applied to join the euro area as its 17th member, and has been accepted, effective January 1, 2011. Why does the Estonian government think this is a good idea? What can we learn?

Start with the context. When Estonia achieved independence from the Soviet Union in 1991, it inherited the unstable Soviet ruble as its currency, and along with it, inflation of more than 1000 percent. To end the hyperinflation, in 1992 it introduced its own currency, the kroon, and pegged it firmly to the German mark using a currency board. When the euro was introduced, the peg moved from the mark to the euro. The currency board was highly successful in ending hyperinflation and restoring growth. It also helped Estonia shift its trade quickly from East to West. Today, more than 75% of its trade is with EU members.

After accession to the EU in 2004, Estonia began to see some of the drawbacks of a fixed currency. Under the currency board, it could not use interest rates or exchange rates to offset the inflationary pressures of financial inflows and a housing bubble. Similarly, when the financial crisis hit, Estonia could not use depreciation to soften the shock. Like its Baltic neighbors Latvia and Lithuania, Estonia went from boom to bust. In contrast, floating-rate countries like Poland and the Czech Republic were much less affected by the crisis. (See this previous post for more details about the impact of the crisis on fixed and floating-rate countries.)

A final lesson that can be drawn from Estonia's experience is the importance of sound fiscal policy to countries that choose a fixed exchange rate or membership in a currency block. Going into the crisis, Estonia had a solid budget surplus and the smallest debt-to-GDP ratio in the EU. In contrast to Greece, which entered the crisis in the worst fiscal position of all EU members, Estonia had much more room to maneuver. Yes, like Greece, it was forced to make some budget adjustments during the crisis, but the cuts were merely painful, not catastrophic. It appears that 2010 will see the beginning of economic recovery in Estonia, whereas Greece faces several more years of austerity and is still not certain to avoid default.

The bottom line: There are both pros and cons to fixed exchange rates and common currencies, but a small country like Estonia, with sound fiscal policy and strong trade ties to its currency partners, has the best chance that the advantages will outweigh the drawbacks.

Follow this link to download a free set of classroom-ready slides with charts, data, and lessons to be learned from Estonia's accession to the euro.

Sunday, June 20, 2010

Budget Basics (3): The Long Term, Demographics, and Entitlements

Even while the debate continues over short-term fiscal stimulus vs. austerity, it is important to look further into the future. Projections reaching 30 to 50 years into the future show that the U.S. federal debt is clearly on an unsustainable path, even given the most optimistic assumptions about legislation, demographics, and interest rates. More realistic assumptions show the debt exploding to unsustainable levels in little more than 20 years. (See the second post in this Budget Basics theories for a discussion of the meaning of debt sustainability).

According to the Congressional Budget Office (CBO), increases in entitlements, including Medicare, Medicaid, and Social Security, will be the big drivers of increases in future debts and deficits. Entitlement spending is projected to increase so rapidly that it will swamp an expected gradual increase in revenues as a percentage of GDP.

In the first 20 years, aging of the population will be the biggest force behind the growth of  entitlement spending. After that, excess growth of medical costs are the culprit. The health care legislation passed earlier this year will supposedly make a small start toward controlling medical costs, but not enough to change the long-term budget picture. All really major cost-cutting proposals proved too controversial for inclusion in the bill. If Congress waits 20 years before revisiting health care (as happened between the Clinton and Obama initiatives), the debt will have already exploded.

The really frightening thing about the CBO budget projections are the estimates of the cost of delaying fiscal consolidation. If fiscal consolidation were to begin as the current business cycle moves into expansion, an adjustment of about 8 percent of GDP (spending cuts, revenue increases, or a mix of the two) would be required to ensure sustainability. If adjustment is instead delayed until 2030, the needed correction balloons to 12 percent of GDP.

The bottom line, according to the CBO: "The choice facing policymakers is not whether to address rising deficits and debt but when and how to do so. . . . The longer that policy action on the budget is put off, the more costly and difficult it will be."

Click here to download a free set of classroom-ready slides discussing long-term projections of the U.S. federal debt.

Wednesday, June 16, 2010

Budget Basics (2): Debt Dynamics, the Primary Deficit, and Sustainability

The debate over U.S. fiscal policy is as much about the debt as it is about the deficit. The federal debt grew significantly during the early 2000s, and has risen even more sharply since the onset of the financial crisis. In 2009, it reached a post-World War II high of 53 percent of GDP, and it is expected to continue growing at least over the next 10 years.

The growth path of the debt depends on several factors. Political decisions on discretionary spending and taxes play a role, of course. So do demographic changes, which influence entitlement spending. Less well understood, there is an inherent debt arithmetic that determines the long-term economic consequences of whatever political decisions are made in the short term. This arithmetic, and the resulting debt dynamics, are the focus of this second part of the Budget Basics series.

A good starting point for understanding debt dynamics is provided by a simple formula that gives the equilibrium value of the debt. Suppose the federal deficit as a percent of GDP, the rate of real growth, and the rate of inflation are constant over time. If so, the equilibrium value of the debt will be equal to the deficit ratio divided by the sum of real growth plus inflation (that is, by the rate of nominal GDP growth).

For example, suppose we were to start from the 2009 U.S. debt ratio of 53 percent and hold the deficit constant at its 2009 cyclically adjusted value of about 6.5 percent of GDP. (See Part 1 of this series for a discussion of the cyclically adjusted deficit.) Assume 3 percent real growth and 2 percent inflation. In that case, the debt would grow to an equilibrium ratio of 130 percent of GDP over the next half-century or so.

At first glance, it seems comforting to think that even with a relatively large 6.5 percent deficit, there need not be a debt crisis--only a gradual approach to a sustainable equilibrium debt. However, there is an unpleasant assumption hidden in the equilibrium debt formula. Although it assumes a constant ratio of the total deficit to GDP, it requires big changes in the structure of the budget. Over time, as the debt approaches equilibrium, rising interest expense must squeeze out program spending on things like roads, defense, schools, and social security, or instead, there must be a steady increase in taxes, or some mix of the two.

In this sense, the equilibrium debt formula hides as much as it reveals. To get a clearer picture, we need to look at a different number--the primary budget balance. The primary balance is the deficit or surplus excluding interest expense. In order to hold the debt to a sustainable equilibrium in the long run, the primary balance must be held at or close to zero. If a primary surplus is achieved, the debt will decrease over time, as it did briefly during the 1990s in the United States. However, if the primary balance remains substantially in deficit for a prolonged period, the debt explodes, leading to a crisis of like that of Russia (1998), Argentina (2001), or Greece (2010). Such a crisis leaves the government with a choice among three very unpleasant alternatives: Outright default, indirect default via inflation, or painful austerity measures forced at a moment when the economy is already in recession.

Right now, the United States has a very large primary deficit. Adjusted for cyclical effects, the primary deficit was more than 7 percent of GDP in 2009. That was the second-largest in the OECD. It was larger even than such acknowedged fiscal basket-cases as Greece, Spain, or Japan, and was exceeded only by Ireland. This large cyclically adjusted primary deficit is the best single indicator of the fiscal policy adjustment that the U.S. government needs to make if it is to avoid a future debt crisis.

None of this means that there must be a "rush to austerity," an immediate closing of the budget gap while the recovery is still fragile. Because of a flexible exchange rate and an ability to borrow at low interest rates, the United States has more room to maneuver in the short term than a Greece or a Latvia. However, there is no escaping the need to make sufficient policy changes to close the primary budget gap over the medium term, say, by the time the economy approaches its next business cycle peak, which presumably will come less than a decade from now. If the necessary chages are not made, there will be trouble, for sure. It's a matter of simple budget arithmetic.

Follow this link to download a free set of classroom-ready slides with detailed data, charts, and analysis on the subject of debt dynamics and sustainability. Watch for further posts in this Budget Basics series, coming soon.

Thursday, June 10, 2010

Budget Basics (1): What is the Cyclically Adjusted Deficit and Why Should We Care?

A furious debate over the federal budget deficit is underway in Congress, in the press, and in the blogosphere. Is the deficit a dire threat that we need to attack with immediate austerity measures? Should we instead focus on more stimulus to create jobs, in the expectation that the deficit will take care of itself as the economy expands?

The answer to these questions depends part on how much of the deficit is caused by the recession. If most of the deficit is cyclical, we can hope that more stimulus spending now will actually shrink the deficit. If it is mostly caused by runaway spending or reckless tax cuts, it would make more sense to do something about the deficit right away.

The CBO has addressed this issue with new estimates of the cyclically adjusted budget deficit--deficit as it would look when the effects of the business cycle are stripped away. These estimates show that automatic stabilizers contributed about 1.9 percentage points of the record 9.3 percent federal deficit in 2009. The CBO numbers also show the deficit shrinking to a relatively comfortable 2.6% of GDP by 2014, when it expects the economy to be at or close to potential real output.

At first glance, these numbers are reassuring. They lend support to the argument for more stimulus and a faster return to potential real GDP, with the deficit taking care of itself. But, unfortunately, we cannot simply take the CBO projections at face value.

First of all, they are only estimates. To estimate the adjusted budget deficit, the CBO must first estimate the output gap. An interesting recent study from the Federal Reserve shows that different methods of measuring the output gap can vary by as much as 2% of GDP. So, not only can we not be sure how fast the economy will approach potential real output, we don't really know exactly where the potential is.

An even more serious problem lies in the well-known fact that the CBO, by law, makes its projections on an assumption that existing legislation will remain unchanged. Its recent rosy projections of the deficit are largely due to the assumption that the Bush tax cuts will be allowed to fully expire (even though neither Democrats nor Republicans want that to happen), and that there will be no further adjustments of the alternative minimum tax (even though Congress has repeatedly adjusted it in the past). If we strip out these assumptions, the chances that the deficit will shrink to a sustainable level by 2014 look much slimmer.

Follow this link to download a free set of slides for use in your economics course. The slides discuss the cyclically adjusted budget deficit, automatic stabilizers, the output gap, and related concepts and include relevant charts and definitions of terms. Additional posts in this Budget Basics series are planned for the near future.

Monday, June 7, 2010

What Oil Spills and Financial Crashes Have in Common: Gambling with Other Peoples Money

What do the Gulf oil spill and the recent financial crisis have in common? Both of them are the result of risk-taking gone wrong.

Gambling--more politely called risk taking--is an inherent part of business life. Entrepreneurs do not, and should not, try to avoid risk. Their job is to manage risk responsibly. Whether they do so depends on the incentives that key decision makers face.

If you are an entrepreneur risking your own money, you look for a certain type of risk. You can tolerate some uncertainty, but you want to invest in projects that have an expected value of revenue that exceeds your costs. You win some, you lose some, but on average you make a profit.

If you buy lottery tickets or otherwise gamble for fun, you often look for a different kind of risk--one that has a small chance of a huge gain, but a moderate maximum loss that is no greater than you can afford. These are called positively skewed risks. You are willing to take such risks even knowing that the expected value of your winnings is less than the cost of a ticket because you enjoy the game, and because you like to dream about the pot of gold at the end of the rainbow.

The real trouble comes when you have a chance to gamble with other people's money. Then you start looking for strategies that usually give you at least a modest payout even though they involve a small chance of catastrophic loss. These are called negatively skewed risks. You take these risks, even if you know they have a negative expected value, because you think you will pocket a gain most of the time. You expect that when disaster finally strikes, you will be able to walk away with your past winnings in the bank while sticking someone else with the loss.

Several common situations in business life give rise to the temptation to gamble with other people's money. Executive compensation plans that emphasize short-term bonuses, include golden parachutes, and lack clawback provisions are one example. Not only top executives face such incentives--mid-level traders, engineers, and analysts may also take risks in the hope of bonuses or promotions, with the expectation that the worst that can happen in case of catastrophe is that they lose their jobs. Stockholders may condone such risk taking because they are protected by limited liability.

Both the Gulf oil spill and the financial crisis had their origins in negatively skewed risks. Investigators in the Gulf disaster are looking at whether BP and its contractors underplayed downside risks when they made technical choices, ignored warning signs, and neglected preparations for dealing with a worst-case spill. In the financial crisis, negatively skewed risks involved excessive leverage, manipulation of ratings, design of complex securities, and several other factors.

What can be done? Regulations can be made stricter, but who will regulate the regulators? Who will ensure they are not captured by special interests? Compensation plans can be changed--but if shareholders do not take the initiative, can outsiders fix the system for them? Corporations can be held to strict standards of legal liability, but individuals who make bad decisions are not necessarily the ones to pay when their corporate employers are found liable.

There is no magic bullet. We can only hope that after a couple of really big disasters, people will be more alert to early warning signs the next time.

Follow this link to download a free set of slides on gambling with other people's money. If you find them useful, please post a comment to let others know how you use them in your economics courses.