Monday, March 7, 2011

Is Portugal in the Green or Red?

BRUSSELS—Portugal had about €2 billion ($2.77 billion) in cash at the end of 2010, an official of the country's debt-management office said.

Fresh borrowing and other public transactions suggest Portugal has this year likely increased that number to around €4 billion. The official said in an email that the figure had risen but didn't elaborate.

The figure underscores the urgency of Portugal's predicament: On April 15, it must spend more than €4 billion to repay one of its long-term bonds. In all, Portugal needs a total of around €20 billion this year to repay bonds and to cover its government's persistent budget deficit.

Portugal's leaders have said repeatedly that they don't need a bailout, and that a program of economic reform and austerity the country has embarked upon will convince financial markets to lend it what it needs. Portugal has been able to issue both long- and short-term debt this year, albeit at high interest rates.

The relatively small amount of cash Portugal has on hand stands in contrast with Ireland, which has roughly similar borrowing needs this year. But Ireland had about €13 billion in cash in its main accounts heading into 2011, plus tens of billions more in a pension-reserve account that has acted as a rainy-day fund.

Still, Ireland's huge exposure to government-guaranteed banking liabilities forced it into a bailout last year. Greece, which took a bailout last spring, did so because it couldn't attract enough borrowing at reasonable rates to meet two large bond redemptions.

So far this year, Portugal has raised €5 billion from selling short-term Treasury bills and spent about €7 billion redeeming them. It has raised about €4.5 billion in long-term debt, after subtracting money spent on debt buybacks. The government ran a deficit of €282 million in January; February's figures aren't yet available.

It wasn't immediately clear what Portugal has taken in through other vehicles, like retail savings bonds or private placements.

In the long term, Portugal would be justified in converting its debt to a loan with more favorable terms provided, by the ECB. Portugal has been compelled to adopt severe austerity measures as a result of being part of the EU. Many may argue that this is the cost of being part of the EU. Alternatively, it has had to sell the viability of its economy to potential bondholders, who may view austerity as a positive.

Viability of European Union Hinges on Flexibility

BRUSSELS—The European Union's [EU] executive arm is keeping pressure on Germany and others to show flexibility in support for Ireland and Greece, ahead of crucial negotiations on the euro zone's future in coming days. EU consensus in supporting this stance will be a crucial test for the inherent strength of the union.

With leaders of the 17 nations that use the euro set to meet in Brussels next Friday to hammer out the basis of a "comprehensive package" of reform measures, Olli Rehn, the European Union Commissioner for Monetary and Economic Affairs, said Ireland and Greece must not be financially overburdened.

"I see a danger that we might overburden both countries with overly strict credit conditions," Mr. Rehn told Germany's Handelsblatt newspaper, distributed ahead of publication Monday.

He added that Greece's timeline to repay aid loans should be extended to seven years from 3½, the paper said. The EU commissioner appears keen to adopt a pragmatic approach towards the loans, rather than having to face the awkward position of a default, when the facilities become due.

Mr. Rehn has consistently called for the EU to consider easing the terms of the loans to Greece and Ireland, reiterating last week that the near-6% interest rates the Irish government must pay on its €67.5 billion ($94.4 billion) package should be debated.

A spokeswoman for Mr. Rehn had no immediate comment on the commissioner's remarks. Speculation would suggest that Greece may have procured the EU for adjustments in the terms of loans, as is anticipated to be the case with Ireland.

Mr. Rehn's latest comments come at a critical moment, with euro-zone leaders committing themselves to completing the reforms by a March 24-25 summit.

Sunday morning, the leaders of Ireland's Fine Gael and Labour parties agreed on a program for coalition government. Fine Gael leader Enda Kenny, who will almost certainly be voted prime minister when the Irish parliament meets Wednesday, and Labour leader Eamon Gilmore said they had settled outstanding issues, including a timetable for introducing more austerity budgets over the next four years.

The parties have been in talks for almost a week following elections dominated by Ireland's sovereign and financial crisis. Both parties campaigned on pledges to renegotiate parts of the debt plan, including lower interest rates on the loan. Fine Gael also said senior bondholders should take a hit as part of the bailout package.

In recent days, Mr. Rehn has said forcing bondholders to take a haircut was not on the agenda. He also said Friday that European leaders must not allow the "relative calm" in financial markets "to lower the level of ambition or slow down the completion of the reforms."

However, commission officials are privately concerned about the willingness of Germany in particular to show flexibility in the face of strong domestic political pressures to take a tough line.

In the Handelsblatt interview, Mr. Rehn was quoted appealing to German lawmakers to support the package of reforms that emerge from this month's negotiations.

"I ask the Bundestag [lower house] not to ignore remaining difficulties in financial markets," he was quoted as saying.

German Chancellor Angela Merkel needs the support of the Bundestag to increase the amount of aid Germany could provide its euro-zone partners under the current European bailout mechanism and to approve any major reforms of euro-zone fiscal rules. Germany is already by far the biggest contributor to the fund.

Members of Ms. Merkel's governing coalition have at times been critical of her moves to bind Germany more tightly to its euro-zone neighbors in the wake of a debt crisis. Political considerations will probably continue to constrain practical efforts by Germany to play a more meaningful role

On Friday, Ms. Merkel met with Mr. Kenny in Helsinki during a gathering of center-right European leaders. An official said Ms. Merkel signaled her willingness to renegotiate the terms of the Irish bailout—and look again at the Greek terms—if those governments sign onto tough additional reforms.

"The German position is [that there can be] a change to the Irish program only alongside additional measures that will make the country more competitive and less debt-laden," the official said.

Greek Prime Minister George Papandreou, whose government received a €110 billion bailout from the EU and International Monetary Fund in May, has also called for the terms of that package to be eased.

On Friday, Mr. Papandreou warned his fellow Greek Socialists of a new round of market turmoil if European leaders fail to reach a satisfactory solution to the continent's debt crisis this month.

On Monday, senior officials from the euro zone will meet again to continue talks on the reform package. The economic reforms Ms. Merkel is seeking from Ireland are a nod to her proposed "competitiveness pact," an agreement she wants from euro-zone leaders to coordinate fiscal policy and undertake some painful reforms, such as raising retirement ages and synchronizing corporate tax rates.

Speaking Friday, Ms. Merkel said "agreement is building, and we've reached a new level" of understanding that such commitments are necessary. But she acknowledged that the final agreement may include only a broad agreement to pursue reforms in place of specific policies.


Austerity vs. Stimulation

By Grant de Graf
[Sourced and adapted from an article by Antonios Sangvinatsos, a professor of Finance at Stern School of Business, New York University]

Trying to Understand the Multiplier Effect

Austerity measures are usually combinations of government spending cuts and increased taxes. Stimulating practices, on the other hand, are consisted of combinations of the exact opposite actions, increasing government spending and/or reducing taxation. Therefore, it is clear that perhaps one has to choose one or the other, austerity or stimulation.

The above premise is based on the belief that one can create stimulation in the economy by increasing government spending or reducing taxes, and that one can save money by cutting spending or increasing taxes. But how much of it is true? Are the policies that help the country’s balance sheet hurt the economy’s growth? This article attempts to answer both questions.

It is always the case in economics, that an action generates more than one effect and often times these effects move in opposite directions. This is the case also here. Let us start with the alleged austerity measures and their effects.

Austerity Measures

Spending Cuts
Effect on Output: Output may decline.
Effect on Balance Sheet: Interest rates may decline.

Tax Hikes
Effect on Output: It may decline.
Effect on Revenues: Collected taxes may go up or down.
Spending Effect on Output

In what follows the consequences of spending cuts will be discussed, or increasing spending, on output. The current economic situation is described by anemic growth and high debts. Currently the discussion has focused on whether one, for example the U.S., should engage in tight fiscal policy, and more specifically, in cutting spending. This week FT hosts a debate on the same topic inviting articles from renowned economists.

Whether spending has an effect on output is summarized by the value of the spending multiplier. This is a number that stands for the number of dollars is generated in output by one dollar spent by the government. Advocates of spending policies justify their opinions on spending multiplier greater than 1.0. How much of it is true?

The answer is that, at best, the academic community has been inconclusive about the effectiveness of spending on stimulating output. This means that there is a lot of doubt, in the academic community, that spending works, i.e. that spending has a multiplier value greater than one.

For example, Barro and Redlick (paper link, WSJ article) find that defense spending has a multiplier of 0.6-0.7 at the median unemployment rate – while holding fixed average marginal income-tax rates – and there is some evidence that the spending multiplier rises with the extent of economic slack and reaches 1.0 when the unemployment rate is 12%. Estimating spending multipliers for non-defense spending is problematic as the nondefense government purchases are positively correlated with the business cycle and it is difficult to establish causality. Is it the spending that created growth or the growth that spurred government into spending? Barro and Redlick think the latter.

The same ideas are reiterated also in an FT article by Kenneth Rogoff. He believes that:

“At the same time, the stimulus benefits of massive fiscal deficits are not nearly so certain as proponents of a new surge of spending maintain. The academic evidence on Keynesian growth effects of fiscal deficits is thoroughly inconclusive. Ironically, a lot of the newfound conviction comes from the casual empiricism on the growth effects of the Bush tax cuts, evidence that few academics consider sufficient to outweigh the mass of previous results. Indeed, it will take researchers many years, perhaps decades, to sort out the effects of the massive fiscal stimulus that many countries undertook during the crisis. My guess is that scholars will ultimately decide that fiscal policy was far less important than monetary policy and measures to stabilize the banking system.”

In addition, a rough method I employ gives me a spending multiplier of 0.6, less than 1.0, rendering spending an ineffective policy. Finally, there are people who argue that the multiplier is negative, in which case, spending by the government decreases the output. This is also called crowding out.

There are however economists who argue that the multiplier is greater than one. Christina Romer, head of the President Obama’s Council of Economic Advisers, and Mark Zandi, from Moody’s, claim that the multiplier is 1.6. Note that, Keynes believed that the U.S. multiplier in the 1930s was 2.5.

Policy Implications

It is clear, now, that if the value of the multiplier is what the consensus has it in the academic community, around 0.6 or lower, cutting spending will have a small effect on output, as it is also the case that giving another stimulus package will generate little additional growth in the economy. Clearly, the opposite is true if the multiplier is 1.6 or higher, like some people advocate. However, the benefits of any policy have to be weighed with the benefits or costs of contingency scenarios. A policy creates repercussions that also need to be evaluated. For example, spending cuts may or may not decline the economy’s output, but it also has an effect on the country’s balance sheet, the expectations of both the bond investors and the consumers. A policy decision is an act of balancing the fears of all the groups that are involved in a given situation. (Prof. Antonios Sangvinatsos, elaborates in an article the big number of factors that affect the value of debt.)

One may conclude that the effectiveness of either austerity or stimulus will be largely determined by the economic sectors that are targeted by authorities to invoke their policies. Ultimately, some areas of government cuts or spending will have a greater impact than others.