Tuesday 28 January 2014

Davos in a Nutshell

I was very fortunate to have had the opportunity to attend the World Economic Forum in Davos last week, co-leading a session entitled "Making Better Decisions" on behavioral economics. My focus is mainly on microeconomics, and so I was grateful to learn about the current macroeconomic climate from leading policymakers, executives, and commentators. I wanted to create this posting to share what I learned. I will subdivide the post into different categories, but there will naturally be some overlap.

European Economy
  • General upbeat mood, as tail risks (e.g. likelihood of collapse of Euro) have been significantly reduced
    • But, more a feeling of relief (absence of negative news that people feared this time last year) than optimism (presence of definitively positive news)
    • Europe looks solid only compared to recent poor performance
    • The US has done much better than Europe. Unemployment is below the pre-crisis level, the stock market is higher, and GDP is higher. In Europe, Germany is the only country that satisfies all three criteria
  • Euro-area GDP growth at 1% is still anemic, and uneven across the Euro-zone: concentrated in the poorest countries
  • Short-term growth has resulted from monetary and fiscal stimulus. Long-term growth will depend on structural issues: technology, innovation, trade, supply-side factors, which are weak
    • Structural reforms needed to address these supply-side issues, but governments are notoriously sluggish
  • Youth unemployment is a major supply-side concern in many countries: > 50% in Spain and Italy, 25% in France. Failure to get a job a year or two after leaving school / university substantially reduces the chance of getting one later
    • Some technological changes (e.g. 3D printing) will lead to a substantial loss of jobs in some sectors, but the creation of jobs in others. Governments should be prepared
  • Short-term risks
    • European Parliament elections could see some Euro-skeptics being elected, which may have similar effects as the Tea Party in the US
    • Imminent Asset Quality Review of European Banks; some may not pass
  • Is more regulation is the optimal solution to a financial crisis?
    • Axel Weber (UBS): Some regulations (on leverage and the banking system) were indeed necessary. Taxpayers were uncomfortable with the amount of risk that was being taken. But, need to remember that the goal of the banking system is to foster growth (by lending money), so we mustn't over-regulate
      • Same applies to non-finance regulations. Freeing up access to data (e.g. medical records) can be helpful for growth
    • Sir Martin Sorrell (WPP): best regulatory change would be to increase labor market flexibility. Firms are unable to lay off workers without excessive severance pay, so they don't hire to begin with
Deflation Concerns
  • All OECD countries (except Turkey and Hungary) are below their inflation targets
    • Why is deflation bad? 
      • Households will postpone purchases if they think prices are going to fall
      • Real (i.e. inflation-adjusted) debt rises when prices fall. This makes borrowers even more in debt, and makes them less likely to spend. The government is a major borrower, and deflation increases the real amount of public debt
      • For the above reasons, low inflation may cause weak economic growth, rather than merely being a symptom of weak economic growth
    • OK, I understand that negative inflation is bad, but shouldn't we target 0% inflation, not 2% inflation?
      • Quality of goods rises over time, so 2% inflation is really 0% inflation, and this is not fully captured in updates to inflation calculations 
      • Positive inflation allows real wages to fall even if nominal wages don't fall
  • Some may argue that low "headline" inflation is because shale revolution has driven down energy prices, but "core" inflation figures (which exclude energy prices) are also low
  • Policymakers feared that Quantitative Easing would lead to inflation, but QE has had a much bigger effect on the prices of financial assets (e.g. stocks) than real goods and services
  • Major cause of deflation is debt overhang: firms have so much debt that they have few incentives to invest
    • We don't know how to cure debt overhang, we only know how to move debt from the public sector to the private sector
    • View that debt overhang is important suggests that the demand side, rather than the supply side, is key to avoiding deflation
    • Monetarists (who advocate focusing on the supply side) predicted that quantitative easing would lead to inflation. But it didn't, it only reduced downside risks. This shows that demand-side considerations are important
  • Economies only grew in the last decade due to debt. Private credit grew much faster than GDP. UK household debt/GDP was 15% in 1964 and 95% in 2008. Policymakers don't know how to growth without taking on debt
    • Germany was the only country we could think of that has grown without debt, but they have grown due to a current account surplus: China has taken on debt to buy German goods. Thus, they've also required debt to achieve growth
  • Earnings haven't yet risen, which is one of the key drivers of inflation
  • Good deflation is where prices fall relative to wages, but here we have low wage growth
    • Even though UK and US unemployment data are good, wage growth is surprisingly weak
  • Yen fell in 2012 in anticipation of QE; Pound fell in 2008 for the same reason. Led to inflation the following year since input prices rose. Similarly, it led to other countries having falling inflation. Thus, QE in one country "exports" deflation elsewhere - it passes on the problem
    • But, if all countries engage in QE together, this can stimulate the global economy.
European Bank Regulation
  • European Central Bank will be a common regulator across all European banks
  • Uncertainty over whether there will be a common deposit guarantee
  • Further political reform, and fiscal union, will further solidify Europe, but there are many opponents
  • Is the financial system safer now?
    • Anthony Jenkins (Barclays): yes, we understand risk better now, and there's closer supervision. However, whether the system is safer is not the only important question; we must also ask if it supports growth.
    • Anat Admati (Stanford): no. The changes that have happened have been like reducing the speed limit from 90 to 85. Financial crises aren't exogenous natural disasters (like hurricanes) that we can do little about; they are man-made disasters created by faulty laws
    • Paul Singer (Elliott Management): no. Banks still engage in substantial proprietary trading; they are 10 times more leveraged than his own hedge fund, and don't understand their risks (e.g. complex derivatives).
    • Douglas Flint (HSBC): Move risk into places that it's transparent and understood (e.g. banks) than leaving it with people who don't understand it (e.g. leave a small business vulnerable to exchange rate risk as it's unable to hedge itself using derivatives.)
    • Anthony Jenkins (Barclays): Northern Rock (building society), HBOS, RBS (commercial banking) failed, and these were not active in derivatives. Derivatives are socially useful for risk management. 
      • It's unrealistic to think that banks should just get rid of risk, as this is impossible. However clever people are with algorithms, you can't spin straw into gold - you can't turn risky stuff into a AAA bond. They can't eliminate risk, but they perform a useful function by taking risk off others' hands (even though this means that they end up risky themselves)
      • Thus, the goal should not be for banks to be safe, but just to understand the risks they are taking.
French Economy
  • GDP growth of 0.0% in 2012, fell 0.1% in Q3 2013
  • Weak government fiscal position
    • Government spending at 53% of GDP is highest in G7
    • Debt/GDP was 91% in mid-2012, versus the 60% target in the Stability Pact
    • Huge unfunded pensions. As US states are finding, pay-as-you-go is another word for a pyramid scheme
  • S&P downgraded France to AA, Moody's to Aa1. Fitch downgraded France and upgraded Spain at the same time
  • Since creation of Euro, France has grown 0.8%/year versus Germany's 1.3%
  • Unemployment rate of 10.9% (versus 5% in Germany), highest in 16 years. Youth unemployment of 25%
  • Rigid product and service markets according to OECD surveys
  • Rigid labor markets
    • Strong employment laws make dismissals hard. Dismissals often challenged in court; workers have long time window to contest dismissals
    • High minimum wage (€9.53/hour), beyond the productive power of many workers
    • 35 hour work week, 60 year old retirement age
    • High welfare and unemployment benefits discourage work
  • Unexpected worsening in current account deficit in November 2013. Exports weak due to
    • Rigidities in product, service, and labor markets
    • Weakness in key trading partners (Italy, Spain). France is heavily exposed to Europe due to trade linkages and banking system; Germany, in contrast, exports outside Europe
    • Due to the Euro, France can't devalue to maintain competitiveness. An increase in prices combined with a constant nominal exchange rate leads to a higher real exchange rate
  • Since Hollande's election in mid-2012, little action
    • Responded indignantly to IMF, OECD calls for France to reform its budget deficits, claiming that outsiders should not tell France how to run its economy
    • Muddled policies. Increased business tax relief, but also reversed some tax reliefs of previous government and increased income tax to 75% above €1m
    • No efforts to improve investment, innovation, eliminate 35 hour work week
  • January 2014 announced €30b of payroll tax cuts. "Responsibility Pact" that, if businesses invest in France and hire young and old workers, they will get more tax cuts and fewer constraints on business activity
    • Goal is to create 1.8m jobs to cut unemployment to 7% by 2018
    • Tax cuts are welcome, and show pragmatism (as Socialist governments are not typically associated with supply-side reforms). Big question is how to finance it. Government can't borrow, as France is already indebted. Announced €53b of spending cuts over the next three years, but few details. Hollande has shown he can raise income tax, but cutting expenditure is much harder


  1. Very interesting and thanks for sharing.

    Is there a sense at the conference of what was made the US recovery more successful than Europe?

    It seems like the biggest differences are in the labor market (much lower regulation in the US could lower youth unemployment) and the governments response. Are there other big structural differences at play?

  2. Thanks David for your interest. You're right that two reasons are flexible labor markets and a more decisive government response in the US. A third is the weak $ / strong €, which helped US exports and hurt European exports. A few other Davos session covered the US economy in more detail and I hope to share the key insights in due course.

  3. Good stuff - one question/observation/pedantic point

    "Quality of goods rises over time, so 2% inflation is really 0% inflation."

    As I understand things, inflation statistics are adjusted for improvements in quality.


  4. Thanks very much for the comment. The person who made that point argued that these adjustments for quality are imperfect - e.g. if a completely new good comes out (computers replace typewriters), they don't make the full adjustment. But, this is an important point which I forgot to include so thanks for bringing it up.

  5. Sorry - wrong link.

    Page 12 of this Pdf: http://www.ons.gov.uk/ons/guide-method/user-guidance/prices/cpi-and-rpi/consumer-price-indices--a-brief-guide.pdf

  6. As always thanks for sharing.
    I'm curious if you heard much discussion in Davos about the implications of the shale oil/gas boom. I'd expect it to be a major topic there since it has so much potential to shift global competitiveness and key geopolitical points over the next decades.

  7. Thanks James for your interest. It was mentioned briefly in the HSBC deflation breakfast (I sent a copy of their Deflation report to my Google group a few days ago) and I updated the Deflation section of my blog in just now. One implication is that the shale boom drove down energy prices and thus headline inflation.

    David Cameron separately spoke about how the UK government is supportive of shale gas (in contrast to some other governments). He said that the UK sees the US as a good example in this regard. Here's the text of his speech; just search for the word "shale". https://www.gov.uk/government/speeches/world-economic-forum-davos-2014-speech-by-david-cameron--2