Statisics, Damned Statistics and Forecasts...or should it be forecasters?

“Predictions are very difficult, especially about the future”, as  quipped one Niels Bohr, a Danish physicist once.  OK that’s my upfront caveat!

You only have to review the forecasts made a year before to see that that it really is a mug’s game to try and forecast the future. Or for that matter in years gone before..

We get the “end of history”, the “new normal , “the black swan events” narratives to help explain ex-post the changing global political economy and/or sharp deviations in trends: macro and financials - and would-be explanations for why forecasts err so greatly. And I have to say these tracts do provide fascinating reading and provide valuable insights. However, rarely do these assessments provide a game-changer in how economists and policy-makers view the world...or for the increased efficacy of forecasts!

In part we listen to these folk because of the entertainment value – they sound convincing. And the ones who are off-trend and call it right can no doubt live off this success for many years. 

More prosaically, methodologies for working out the fundamentals of National Accounts, Balance of Payments or other macro data remain unchanged – as do the basic blueprints for standard econometric models. At the end of the day we can measure and estimate what is happening or has happened (stocks and flows) and we can use statistical packages to use previous time series to project what should/might happen yonder….cateris paribus (all other things equal) ...the mother of all assumptions!

At the end of the day Economics is a social-science and changes in human behaviour cannot be pre-determined by data. The same applies to use of mathematical wizadry to create complex derivative instruments – if homosapiens are involved, then the once-in-a-million-year risk even (aka a certain Investment Bank’s explanation during the credit crunch) will more than likely happen!

And at a time of austerity and fear of losing one’s job, the herd instinct has become even more prominent for those in the trade. "The trend is your friend" as goes the mantra...

 As a practitioner with involvement in policy across developing and emerging economies I have found that it pays to be humble about the efficacy of forecasting – be it for revenue forecasting for a fiscal authority or medium-term forecasting over a cycle for key macro benchmarks more generally.  And anyone who has worked with transition economies will testify, getting a handle on macro data was hard enough in the first place with considerable chunks of the economy in the shadow sector during the 90s and naughties.

Forecasting, particularly econometric forecasting, is a useful tool to play with assumptions and scenarios but it is not a panacea - something often forgotten. And that is where narratives to explain how disparate events and changing trends can and might interact to create outcomes way off forecast/s can be useful.

As ex-colleagues at the Bank of Finland may recall – I once wrote a tongue-in-cheek article in 2000 – set in 2050, when Finland was renamed Finokia (…Finland plus Nokia that is…alas Facebook was simply a wet dream for some would-be future Olympian rowers and a computer geek/genius).I'll leave it to another day to make long-range guesstimates..

But having seen what a mess would-be kin in the dismal science have made for 2011, what are my own key themes and forecasts for 2012? Tomorrow…

Santa’s Grotto at the ECB: Liquidity financing to see banks through mid 2012

Mr Draghi’s really putting his stamp on the ECB’s Monetary Policy. The recent cut in the policy rate by 25 bps was followed today by further monetary easing – it provided a gross €489bn in 3-year loans to over 500 banks in the Eurozone. And this follows on the heel of the ECB’s dollar-swap of US 28bn earlier in the week that has also targeted on-lending to Eurozon banks shut out of dollar financing.

Lets call a spade a spade…this is QE ECB style. And its an impressive signal that the ECB means business and will do much to appease many who have queried the central bank’s agnostic stance in the crisis over the last year – although to be fair the ECB’s  been constrained by the (lack of) a cohesive Eurowide counter-part fiscal zone. And its been a long-time in coming and welcome – both in scope, scale and provisions.

Although the net impact will  be lower at around €200bn, the overall impact will be to greatly reduce the liquidity crunch in the interbank markets and across the Eurozone countries. The issuance is debt and not a TARP-like means  to tackle the solvency issues. As such the aggregate debt will need to be repaid and creates a liability for the ECB.

For many – in particular periperhal country banks – in the Eurozone, Christmas has come early…

1. Not only does the manna from Father Christmas-cum-Mr Draghi ease the immediate funding problems for banks it will be enough to help them see out most of 2012 in terms of financing needs – with many banks needing to redeem maturing bonds that will exceed €500bn. A further QE is expected in Q1 2012 so the ECB has clearly shifted its strategy towards a quasi lender-of-last-resort.
2.  Recipient banks will be able to, in effect, rebuild balance sheets by standard bank intermediation – although the source of funds is the central bank and not depositors in this instance. 
3. The ECB will hope that this QE leads to a softening in sovereign debt yields as banks park the borrowed funds with a 1% interest into high-yielding Eurozone sovereign paper, which can yield a scrumptious 5-6% on  Italian paper.
4.  There is good hope that the policy intervention also leads to at least some reversal in the credit-crunch underway in the Eurozone – although if experience in the UK is any guide, this is not guaranteed and the excess liquidity could be redirected into a temporary surge in asset markets. At the very least it will incentivise banks to reduce the pace of delveraging – and that will be a growth positive for the real economy.

Downsides?

 

5.    The goal – if not shock-and-awe – is impressive in scale and as such it will clearly mean that the quality of the collateral deposited at the ECB may suffer from a true mark-to-value exercise. On the other hand as highlighted in the US and the UK it is entirely possible that the return to liquidity and ultimately confidence in inter-bank lending leads to gains in the value of the collateral.  

6.       Monetary purists will worry about inflationary risk…but lets give the ECB credit, this at least prevents deflation at the very least and a nasty spiral of deleveraging by banks and further compression of output. I rather suspect that the standard focus on money equations may be under stress in this highly unusual part of the cycle – and that velocity of circulation which is assumed to be constant may be reducing, thereby reducing the impact of money growth on inflation.

7.       This and the next QE is not sterilised – essentially the inflation argument above. Actually a  bit of inflation may be no bad thing to deflate some of the real debt away. Whilst Germany will not want to hear this the actual risk of internal inflation is a small risk at this stage.

8.       A more interesting risk will be if things still get worse in 2012-13 and the underlying problems in the Eurozone - sovereign, banking and fiscal co-(mis) co-ordination are not resolved. The ECB’s balance sheet is now significant and will have expanded by a factor of approximately 400% between 2008-early 2012. In the event things do go pear-shaped (standard war game start-up: Greek default in move 1…) then the ECB liabilities will be apportioned to the Eurozone governments…and eventually the taxpayers.

CEE Economies, Policy Choices and likely Scenarios

Each of the 26 EU Member States bar the UK signed up to the idea of greater EU fiscal co-ordination in Brussels last. The Fiscal Compact paper is under review in the EU capitals (see http://rupinder-econ.blogspot.com/2011/12/fiscal-compact-for-eurozone-initial.html ). Even the UK will be there as an observer.

But what of the new members of the EU Club, those countries that had chased the dream of transforming themselves from the yoke of their Communist planned economy legacies to becoming members in the Western European clan of nations…the EU? 

Having made the hard graft to restructure their economies and institutional structures to the comply with the entry standards for EU accession the new EU 10 central and eastern EU states have been hit by a range of domestic and external shocks since the onset of the global financial-and-economic crises since 2008/9.

One wonders what their political elites, strategists and domestic populaces make of it all – particularly in terms of what their political leaders sign up to next as the Old guard of the EU intensify efforts to try to salvage the Euro and possibly with it the EU and the Single Market itself.

At a political level, EU Accession was the name-of-the-game and with it the acknowledgement of being recognised as a full democracy and a functioning market economy able to adhere to the rigours of the EU’s Single Market. In practice, many of the accession check-lists were signed off without true and full implementation (or transposition in EU speak )of the EU laws or Aquis Communitaire. To  be fair many of the more difficult EU chapters on things like environmental standards required up t 2 decades to update to EU benchmarks and so time extensions or derogations were agreed with the EC. 

Economically, EU accession for the former CEE bloc was about convergence – real convergence in particular, or in simple terms a catchup in living standards to the EU average. And per capita incomes have indeed narrowed since the start of transition in 1999 and with different speeds of adjustment across the region. The ex-Soviet Baltic republics are now closely tied into the Scandinavian economy although still reliant in part on the huge ex-Soviet economies to their East. The Visegrads in central Europe are now closely integrated to the German economy although Poland is sufficiently large an economy and populace to have a sizeable internal market of its own that helped to ride out the economic contraction in 2009-10 elsewhere in the EU. 

EU entry promised access to increased integration of businesses, transportation routes and inflows of external knowhow and capital flows from the EU – FDI and portfolio flows. A big draw was the promise of dollops of cash of up to 4% of GDP in the form of Structural Funds as part of the EU’s Cohesion policy.

Some wanted more than simply membership…a privileged Gold Card of full to the Euro club. Slovenia and Slovakia are members and Estonia became 17^th members of the Eurozone in 2011. 

And the promised land was indeed plentiful. 

Maybe too plentiful in some respects – a thesis for another day is whether the free flow of capital across the EU that fuelled cross-border flows of funding – and in turn the asset bubbles from Talllinn in Estonia  in the north, to the Costa del South in Spain to the South and Varna in Bulgaria on the Black Sea to the East, was too out of synch with the relative real economy differences, rigidities and differentials in productivity across the EU.

Although Poland weathered the economic storm well due to sound policy management, the size of its internal market and increasing connectivity to Germany’s growth-model, pretty much all the other CEE economies in the EU have had to undergo a mix of brutal internal fiscal adjustment coupled with lashings of EU sweetners and some IMF medicine.

Aside perhaps from Hungary which has been following what might a somewhat heterodox set of policies – or plan nutty to the rest of us – the rest of the CEE EU 8 managed to stabilise their economies reasonably well (although questions remain about the impact of potential contagion through the banking sectors).

And what now?

• In many ways these economies’ political and economic elites have almost religiously followed the gospel of free-markets that they will go with the flow, hoping that the manna of Structural Funds and soft financing via macro-financial assistance for any banking problems continues to help them along. 

• The Baltics, with strong links with Scandinavia, will toe the line and side with Germany, looking to be part of the Eurozone core or its successor – whatever and whenever. 

• There will be difficulties ahead for the other CEE 5 to navigate the implications of greater fiscal co-ordination underwritten in the Fiscal Compact: the sovereignty issue for the likes of the Czechs and Poland in particular.

• Hungary will be interesting to watch as the government wrestles with its odd mix of nationalism that was already putting it into difficulties with the EU as regards freedom of press and central bank independence and, which will force it to toe a more prudent economic stance.

•  The rest of the wanna-bees in the Balkans will continue to look to western Europe but there has been a general cooling to the EU from surveys taken recently. One wonders what the Croats make of it all – they’ll be EU member 28 in 2013. 
•  The big known-unknown, if I can put it so, is the likely impact in the region of a Greek default or the start of a bank run for any number of reasons that could very easily spread across the region’s still emerging economies.  With financial intermediation as measured by broader measures of money supply or simply as a share of GDP far lower than in mature economies in the EU, the multiplier effect on output of a credit compression could be far more severe. 

France v England (well actually the UK)..

They’re drawn in the same group G for the 2012 European Football Championships and it looks like the French politicians are trying to use the Manchester United manager Sir Alex Fergueson’s infamous “mind games” to target not our esteemed footballers but the rating agencies for the temerity to daring to even mention a possible downgrade of France (and one presumes affecting some change in their minds and decision) from the stellar triple-A rating. In particular, statements by the French governor of the central bank, Christan Noyer, and by other ministers to attack Britain’s record suggests a co-ordinated effort by the French elite. 

Why one wonders? 

Is it to prepare the domestic public for the probable downgrade, to pressurise the rating agencies to think again – for both France and the UK – or is something else afoot?

The first is probably true, its doubtful that the raters will take much note in the end – particularly if the other Eurozoners are in the pack of would-be-downgradees. 

The UK comparison is fascinating because it highlights the similarities and the differences between two comparable mature Old-Europe economies of about the same economic size. Both countries are in the grips of an economic compression coupled with headwinds which will mean a protracted period of years before a return to a Goldylocks trend-growth i.e. neither too hot nor too cold.

Both the UK and France are in synch with the flavour-of-the moment policy of austerity. With both public and private sectors in the two countries in the doldrums what will drive growth? Ahh we have the Olympics and the Queen’s Jubilee in the UK to bring some oomph in consumption and one can argue that the French private sector is probably a touch more ruddy in complexion right now.

The big difference is monetary independence. The UK is not part of the Eurozone and has an independence monetary policy. This in turn means that the Bank of England (BoE) can engage in monetary easing or Quantitative easing to give its current geeky name. It also means the Fiscal-Monetary mix can be massaged and managed more efficiently than for the eurozone where the ECB’s policy earlier this year of raising interest rates was balmy for the suffering southern part of the eurozone although right for the then robust growth in Germany.

The UK’s policy response has been broadly correct and it’s not clear, despite the political rhetoric, if a Labour government would really have done anything significantly different. The UK Chancellor (Minister of Finance) Osborne will have a Plan B up his sleeve which for credibility he could not have divulged until the current Plan A of austerity alone was shown to be not working. But this austerity has allowed the BoE to run a very loose monetary policy but without scaring the bond markets – the result being yields have remained very low, bringing in some additional fiscal space which could and should be the springboard for future fiscal easing.

Compare this with the situation in the eurozone: 17 fiscal stances and a single monetary policy…”and a partridge in a pear tree” (aka the Christmas carol “The 12 Days of Christmas”).  

France does not have control of monetary policy (no partridge) and if anything its fiscal space is being increasingly determined by the Germans through rules restricting how public finances are run.

It remains to be seen if the German-authored Fiscal Compact becomes a genuine instrument for fiscal co-ordination among the eurozone EU17 or simply another talking shop and a sense “Summit-isis” for the rest of us.

There is a separate issue – addressed by the IMF head last week – about a fear of a return to the dark days of the 1930s style recession. Convergence in business cycles and a related procyclical approach to fiscal stances is amplifying the effect of this aggregation on global output, and this is no more true than in the EU: and this is akin to the wave of competitive protectionism we saw countries adopt in periods in the late 19^th century and before the era of the Bretton Woods institutions and some form of global policy co-ordination.

The UK may be an open economy reliant on the rest of the world for trade and prosperity but it has the tools for economic management in its hands. 

One fears for France in an environment where there is no clarity as yet on broader EU-wide fiscal policy: the issue of Eurobonds is undecided, no basis for asymmetric fiscal stances based on different underlying domestic conditions across the eurozone or any real transfer mechanism (aside from structural funds for development which is more aid than genuine equalisation transfers found in federal states). 

Continuing the Cassandra-like gloominess, if the projected downturn in global and European growth is worse than expected –and last week’s downward revisions among economics houses would support this thesis – the downward amplitude in the Eurozone could be worse than forecast given the higher integration of Eurozone economies and in an environment where austerity-in-common is the theme. 

Forget the numbers but consider the bigger picture: France but particularly the likes of Italy will quickly find that the debt-overhang becomes unsustainable if nominal growth of income falls below the levels required to simply sustain the debt levels. 

The notion that the suffering southern European economies will be required to run even higher budget surpluses is simply not credible – economically or politically. More haircuts of sovereign debt? And Italy which is still having to pay close to 6% and has a huge programme of debt issuance due in 2012.

Both the UK and France are facing turbulence ahead and both need to start focussing on growth but the UK’s policy choices gives it more tools to address these challenges.

Bottom line: The Rating Agencies have got it right. 

Lets see how the England team fares against the French at footy…I forecast a draw! (it’s the opening game for both)

The Fiscal Compact for the Eurozone - Initial Assessment

So the draft Paper is out…referred to as the Fiscal Compact by the ECB head Mr Draghi…but with a more prosaic title: “International Agreement on a reinforced Economic Union”.

The document has a clear “made in Berlin” feel to it both in terms of the style and substance – anyone familiar with the style of EU regulations will spot this. The Teutonic nature of what is clearly a framework will make or break the underlying intent. A lot of the implementation arrangements have to be spelt out…and which in the muddy waters of EU-politics involving 27 States and 17 Euro-members, means a lot of uncertain weeks and Summits ahead.

What will the Compact do which is different?

The aim clearly is to deepen fiscal co-ordination from the current country-specific fiscal management in the Eurozone to something that is clearly more akin to a Fiscal Union. The nirvana would then be a single Euro-wide monetary policy coupled with a sort-of single Fiscal Policy. Bereft of a single EU fiscal policy, the second-best option would be to create binding rules with punitive measures for the miscreant.
But isn’t this the same as before? We already had the Maastricht criteria on nominal criteria for fiscal deficits, public debt and variance in terms of inflation and bond yields and the so-called Stability Pact. Criteria which France and Germany broke when it suited them…

The Fiscal Compact paper re-iterates the same criteria in essence – in particular the 3% deficit limit and government debt to a max of 60% of GDP. It is however a bit more geeky and specific on the Budget Discipline under Article 3 with aims to lock-in governments to structural deficits  by country-specific “reference values” and cyclical adjustment....all of which is as clear as mud…For the un-initiated structural and cyclical aspects are rather like pulling a piece of stretchy string and asking how long is it…
It does however mean scrutiny of national budgets by both the EC and the Council – and article 6 is two sentence-long, clear and to the point. With greater implied involvement of the European Parliament’s budgetary committee and the enforcement through the European Curt of Justice, if and when implemented this will mean a genuine shift in relative competences within the national parliaments to a mix of inter-governmental and EU institutional structures.

And that will  be key point. Whether any EU country can really accept such a potential implied or actual loss of national sovereignty is highly doubtful? Particularly at a time of austerity that may well deepen in 2012-13 and lead to louder calls for growth-enhancing (and deficit expanding) policies and further possible changes in political leadership in pending elections.

Its not a surprise that David Cameron balked at the implications and did a runner…

The EC president Barroso’s remark that this a EU 27 minus rather than an Euro 17 plus agreement is somewhat disingenuous.  The Cameron veto in effect means we now have a formalised two-speed process with the core Eurozoners and the rest – it is de facto the Euro 17 minus.

The draft agreement reinforces the latter point – the agreement becomes binding on the Eurozoners when 9 of them have ratified it. 9…not 17.

Why 9? Hmm lets see, take out the PIGS, the now-toothless tiger Ireland and maybe…say Belgium and you’re left with the..Holy Roman Empire…sorry I mean the D-Mark core plus a couple of newbies like the Estonians and Slovaks.

The document has the French flavouring of a new institutional structure with monthly Eurosummits and a President of the Euro Summit.

Bottom line:
 

·         this draft is clearly another step into a very long drawn out process even if there is sufficient critical mass of political will across the Eurozoners.

·         this is not a ‘magic bullet’ policy change that will suddenly reduce country risk for the Euro-zoners or indeed for the Euro. Expect more uncertainty and more volatility once the implications are through.

·         Not clear if the ECB sees this Fiscal Compact process as sufficient grounds for a more expansionary monetary stance – if it does under its new Chief then there’ll be an upside.

·         Ironically the current situation could strengthen the UK’s position. Chancellor Merkel has spoken to the British Prime Minister in recent days as has the European Council president Herrman von Rompuy and it is clear that the UK will have an observer status hereon.

The UK Position with the EU: at the table or on the menu?

A quip made by several sound-biters...ie if you ain't at the negotiating table then you may find that your national interests may be jeopardised through your absence at the table. But is this really the case?

The EU Summit was supposed to  be another of the last-ditch efforts in the battle to save the Euro.  In reality the modality of the EU structures and inter-government co-ordination involving 27 national states is a slow iterative process, so this summit was one more to what will now become a monthly affair.  Lovely.

The UK’s veto in Brussels suggests a failure of negotiation strategy and preparation rather than a sea-change in the UK’s relationship with the rest of the EU. Of course Mr Cameron’s position – like former Tory leaders – is more tenuous than was the case for the Blair-Brown years of Labour rule. 

David Cameron has come back to London having been outvoted 26-1 on a Treaty change that

would have in effect led, on paper, to a yet-to-be-defined greater fiscal co-ordination for Eurozoners – of which the UK is not a part. Since this doesn’t really effect the UK and given the vague nature of the proposals to which other equally zealous EU sovereigns outside the Eurozone – Sweden and Denmark and the new central European states like Poland and the Czech Republic  – all of who signed up, the UK stance smacks of bad politics. Not least since both the PM and his chancellor have been egging the Eurozone toward greater fiscal co-ordination and having “bazooka” fire-power.

Or does it?

The British PM will successfully manage the domestic politics that could have been a minefield for him. Sign-up and his 100-strong  backbenchers would have been baying for blood – he’s their Alpha-man now. 

Big plus.

Pre-Summit talk of a possible referendum is now dead. Another banana skin avoided.

The Lib-Dems coalition? A marital argument but no divorce. 

And just days into the week following the Brussels summit we already see that many other countries are already having second thoughts…either due to their own domestic political constraints or simply due to the enormous difficulty – nay impossibility – of effecting true fiscal co-ordination through loss of national sovereignty. The Swedes, Dutch, the Irish and the Czechs have been first off the blocks  but its not clear if the Hungarians with their odd-ball nationalistic macroeconomic and banking policies or the Slovaks will really buy into this. 

And whilst the “PIGS” – Portgual, Italy, Geece and Spain – are nominally going along with the process one wonders what will happen when the bail-out and liquidity support stems or when the current crop of in-essence short-term technocratic governments face a backlash for the austerity being forced. 

In retrospect, the UK PM could come out of this rather well once the noise dies down. Yes he and  his EU-friendly deputy PM and leader of the Lib-Dems will work the phones to other EU capitals to repair fences. He will also now be seen in the EU as the man with “cojones” and could in time act as a standard-bearer for a number of other countries – both outside the Eurozone 17 – and perhaps some within it. 

On the economic front, the Chancellor may well have been singing in the  bath…as was said to be the case when his Tory predecessor supposedly did so when the pound left the EMS in the 90s. Why?

Like it or not, the government’s economic blueprint of austerity and budget cuts has prioritised retaining the UK’s triple-A rating. With the EU countries on a negative watch, the US having already suffered the S&P downgrade, of the G7 this will leave Canada and the UK. 

The pound  has been gaining in the last week and the wall of sovereign wealth and global asset funds will, once the dust has settled, see the UK as a better safer bet than the Euro - and with a rise in its "flight to safety" status.

With the French elite preparing its public in the last 10 days for a loss of its triple-A rating, the UK PM could well come out of the situation in a much better position.