1 C A Pissarides - London School of Economics 2011 Risks and Rewards in Financial Markets Christopher A Pissarides London School of Economics Pension Funds

1C A Pissarides - London School of Economics 2011

Risks and Rewards in Financial Markets

Christopher A Pissarides

London School of Economics

Pension Funds Conference, Rome30 November 2011

1


Introduction

• Financial markets have been in turmoil since 2008

• Asset prices have fallen, and despite some early signs of recovery, volatility is still the problem

• The financial crisis has been succeeded by the debt crisis

• What are the risks and opportunities offered today?

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Financial and debt crises

• The financial crisis required repair of the financial system. Some progress has been made but still a lot of uncertainty

• The debt crisis requires changes to fiscal policy and structural reforms

• Will markets recover or is there need for another big correction?

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Focus on debt

• I focus on the debt crisis in Europe and the recovery of the European economy

• Recovery in Europe requires mainly domestic reforms but can also be helped by the international economy

• Especially important is the state of the US and China

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C A Pissarides - London School of Economics 20115

Survival of the Eurozone


Eurozone

• Some claim eurozone not viable as it is – some countries must leave

• But the introduction of euro was part of the process of European integration

• Not a club where one can join or leave depending on individual circumstances

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Difference from previous system

• Main difference between the euro and the dollar-based (Bretton Woods) system that it replaced is that in the former system infrequent devaluations were allowed

• In the Eurozone they are not

• The idea was to remove all speculation about exchange rate adjustments

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Entry and exit

• In view of this, entry into the euro is allowed but exit is not

• Talk of Greece or other countries leaving the euro to gain advantage of devaluation is irrelevant: it means a failure of one key mechanism in the process of European integration

• It destabilises markets unnecessarily

• Exit would isolate Greece and put it outside the core of European Union

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A digression on those outside

• Britain and some other countries remained outside the euro and they are likely to continue outside

• But they understand the role of the Euro

• Cameron wanted to take active part in the recent Brussels summit on the debt crisis and strongly emphasized that it is necessary for the Eurozone to find a quick and lasting solution to its debt problems

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British views

• He never suggested that perhaps countries would consider leaving it and join Britain outside.

• It is also why, when agreement was reached, the British Tory press was so concerned about Britain being “left behind” in a united Europe led by the core of the Eurozone

• It is important to stabilize financial markets with a stronger Eurozone, not with exit of the weakest members

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Risks from Eurozone crisis

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Risks

• Markets in Europe are volatile because it is still not clear where the solution to the debt crisis lies

• Problems are different across countries

• Greece: 50% haircut removed liquidity from the financial system. Some banks paying costs with low share prices and no prospect of dividend payment

• It needs structural reforms urgently, can it do it?

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Italy and Spain

• Italy: needs to raise a lot of money to pay interest on the debt. Can it do it?

• Italy needs reform to its labour market but most importantly it needs to make its system work

• Spain: large private debts, if households cannot pay banks will run into trouble and government will need to bail them out, creating sovereign debt (similar to Ireland)

• Spain also needs to reform its labour market

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Can one trust markets?

Financial markets cannot be trusted before two things took place

1. The Eurozone found a solution to its systemic fiscal problems

2. The southern countries embarked on a system of effective reform

Without them there will always be concerns of impending problems, creating uncertainty and volatility

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Fiscal coordination

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Fiscal systems

• Biggest oversight of founding fathers of euro is the need for closer fiscal cooperation

• Great attention was given to the need for common monetary policy, but fiscal policy was overlooked

• Cannot make a monetary union function without either close coordination of fiscal policies or potentially large fiscal transfers

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Fiscal transfers

• Having overlooked fiscal cooperation so far, fiscal transfers become necessary

• This much is understood (European Financial Stability Facility)

• But in future we need closer fiscal cooperation

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Fiscal cooperation

• It seems that the only way forward is to increase fiscal cooperation

• Virtually all countries oppose a centralised ministry based in Brussels taking charge of budgets

• In my view, cooperation can be achieved with the creation of a Fiscal Policy Council (FPC) for Europe

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Fiscal Policy Council

• The FPC should not have executive powers but should check the fiscal policy of each member of the Eurozone annually

• It should report if it thinks the member is reporting correctly the implications of its policy for deficits and debt

• If it is not, it should do its own calculations and make them available to the Finance Ministers

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Policy action

• The reports go to the Council of Ministers and action is agreed if it is felt that a country is putting the Eurozone at risk

• In this way the build-up of debt and the need for transfers is avoided before it’s too late

• Of course, for this to work, the membership of the FPC is completely outside politics and is made of technocrats

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Structural reforms

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Structural reforms

• Reforms necessary to make sure that the Eurozone behaves more like an optimal currency area should be undertaken urgently

• In the case of Greece the reforms are known, as they were set out by the troika

• They amount to the control of corruption, and modernisation of the labour market and the business environment

• Greece does not attract investment because its environment is not business-friendly and companies need to bribe officials to get the permits necessary for production

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Labour markets

• Italy needs to ensure that corruption and disruption of the state and market mechanism is ended

• It needs to modernise its labour market too. On OECD measures Spain, Greece, Portugal, France, Belgium and Italy have unacceptably high regulation of the labour market

• If we add powerful and not cooperating trade unions in these countries, it makes employment so regulated that companies are slow to respond to good news with job creation

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Entrepreneurship

• The environment for setting up new businesses and operating them (excluding labour market problems) has improved in most of Europe

• The exception is again Greece

• But when unemployment is high the state could help the unemployed with subsidies to start their own small businesses, as successfully tried in Germany

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Short-run prospects

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Short-run solutions?

• Previously outlined reforms will stabilize markets but not immediately

• Necessary as signals of good forward-looking plans

• Interest rates on debt should fall if implemented

• But what about the very short run?

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Stimulate domestic demand?

• Domestic demand has fallen a lot

• It is not likely to be stimulated for as long as there is uncertainty about the financial sector, sovereign risks and what policies they may require, and importantly, as long as the housing market remains subdued

• But for the housing market to revive, the loan market needs to recover, creating a vicious circle between banks and houses

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Exports

• International trade and export demand not likely to recover through the independent growth of foreign markets

• United States held back by heavy burden of debt which is proving very difficult to control

• Housing and labour markets depressed

• Consumer confidence very low

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Emerging countries

• Emerging markets, especially China, not likely to generate demand for European goods.

• Still suffering from imbalances – too high surpluses and not sufficient domestic demand

• Government trying to stimulate domestic demand but structure of industry geared to exporting

• Not likely to generate independently demand for western goods

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More on China

• China invests too much

• It needs to convert large parts of that investment to domestic consumption

• It will benefit both itself and Europe and the US if it did

• But failing to do so can keep her going at current levels only if it can discover more export markets

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Future prospects

• But where will export markets come from?

• Not a good prospect currently

• Too many risks attached to its investment rates of return

• Despite unprecedented growth recently, it is still much below West in per capita incomes and still large agricultural population, but economy is unbalanced

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Europe’s prospects

• What can be done in the short run to revive European economy given likely absence of strong export demand and domestic revival?

• Need to make European industry and services more competitive

• Euro too expensive, especially for the countries most in need of help

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ECB needs to act

• ECB can bring about depreciation through monetary easing (QE, printing money to buy bonds)

• It will ease debt burden and help European industry

• Some of it already done, but need much more!

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Alternatives?

• Strong opposition to inflating internally through ECB QE, especially from Germany

• As an alternative, we can relax temporarily EU rules on free trade and tax competition

• Countries in need, like Greece and Italy, should be allowed to subsidize exports

• Revenue could come from a temporary import levy

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Impact?

• A combination of an import levy and export subsidy has same effect as depreciation of currency

• Advantage is that it keeps countries in the euro

• It revives their economies, helps them repay foreign debts

• Going against EU rules but better than EZ exit and can be temporary – something drastic is needed!

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Another policy

• Switch from payroll tax to VAT also has beneficial effect

• Payroll tax reductions stimulate domestic production

• VAT applies to imported goods too

• So policy switch makes imports more expensive and domestic production cheaper

• Probably can be done within existing EU rules

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Concluding remarks

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Risks and rewards

• Financial markets ultimately reflect what is happening to the real economy

• Currently there is prospect of large rewards in Europe but they need brave policy action

• Without it the risks are too high

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Short run and long run

• Given the levels of debt and the sovereign risks, fiscal policy cannot do much in the short run

• Monetary expansion through a comprehensive policy of buying bonds with new money creation by the ECB will create inflation and depreciation of the euro

• It will help reviving the economy

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Need to be ruthless

• In the absence of such a policy, alternative policies that replicate depreciations and structural reforms can revive markets through improved expectations

• Prospects of revival from foreign demand remote

• And deep-rooted fiscal reforms to bring closer cooperation urgently needed

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Documents

1 C A Pissarides - London School of Economics 2011 Risks and Rewards in Financial Markets Christopher A Pissarides London School of Economics Pension Funds