Another G20 summit meeting has come and gone. The heads of the eight leading industrialized nations, the G8, met first on Friday and Saturday, followed by the full G20 complement, representing the twenty most important global economies.

The primary agenda for this summit was the global financial system and the world economy. Throughout the meetings, pronouncements of shared financial goals and economic cooperation were so frequently and publicly communicated as to become cliche, …not entirely unexpected for these kinds of events.

Was meaningful progress made and consensus achieved? It’s too early to tell (see a brilliant version of the communique in the Wall Street Journal, annotated by Marc Chandler, Simon Johnson, and Arvind Subramanian).

The desire for coordinated action on the global financial system and agreement on fiscal policy is certainly admirable, but the fact remains that each nation faces a differing domestic situation, and uneven economic and political pressures at home. Considering their differences, the fact that any consensus could be reached, let alone communicated, must be considered an accomplishment.

However, the most interesting storyline of the meetings was the tension between U.S. and European approaches to fiscal policy: spending versus austerity.

The U.S. position has always been that “pulling back spending too quickly could choke off the economic recovery.” On this count, Obama’s entreaties were acknowledged, “We must recognize that our fiscal health tomorrow will rest in no small measure on our ability to create jobs and growth today. In short, we have to do everything in our power to avoid a repeat of the recent financial crisis.” Meanwhile, agreements on targets for getting economic deficits under control, credibly committing to reducing deficits in the medium-term, and pledging to cut them in half by 2013, appeased European austerity proponents.

Although the gathering did not produce a uniformly agreed-upon fiscal solution, the consensus achieved could be described as one of “broad commitment to sensible long-term austerity.” Basically, participants agreed to ease into austerity – with some advocating for a quicker pace than others, …and plenty of room for individual interpretation.

At the end of the day, growth is the primary challenge for struggling economies around the world. Renewed growth will lead to increased tax revenues and the cash flow necessary to curb deficits, and ultimately, pay down debt. Although aggressively reducing government spending and increasing taxes seem intellectually appealing as solutions to deficit problems, reducing unemployment will be a real challenge for those countries that adopt austerity measures too soon. At the end of the day, the mechanism through which painful near-term austerity measures will increase employment and foster growth remains unclear, and threatens to derail whatever fragile economic recovery is currently underway. So countries with no immediate market-mandated need to impose austerity ought tread carefully.

Regardless, the paths to which the U.S. and its European counterparts have committed will, in the end, provide ample opportunity to observe, and debate, the long term economic consequences of their divergent fiscal approaches.

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Parts of this opinion piece were co-written with Tom Cleveland, market analyst at Forex Traders, and I thank Tom for his contributions.

Just returned from a visit to Iceland, …hence the radio silence. Was there for a few days of work, followed by a few days of pleasure.

What an amazing place. The country is absolutely stunning in its beauty. And the people are absolutely wonderful. I can’t wait to go back.

That said, it’s sad, really, that the majority of Icelanders don’t seem to understand the full gravity of the debt problems that they currently face (for background see here). If they decide to go along with the current debt repayment plan they will have to accept years of sub-par growth at a minimum, and potentially, live through a few years in which they teeter on the verge of default. Refusal to pay now, however, could quickly propel Iceland into economic crisis as foreign credit dries up and hard currency becomes scarce.

What a mess!

Personally, I think that in voting down the most recent Icesave Referendum, Iceland is trying to play hardball with the UK and the Netherlands, hoping it will lead to a more favorable negotiated settlement while convincing them to shoulder some of the burden for the outstanding debt.

I hope they (the Icelanders, Brits, and Dutch) can work it out.

If not, that would make my movie choice on the flight over somewhat ironic. I found it interesting that Iceland Air would even offer “Wall Street” for its passengers as an in-flight option; but ironic how, for Iceland, Bud Fox’s sales pitch touting “extraordinary opportunities emerging in the international debt markets” might desperately be put to use.

So after Fox 5 shifted the originally planned segment from Monday to Tuesday and changed the time from 7:15am to 8:15am, they finally ran their story on the New York MTA. See the embedded video below.

If the video doesn’t work for you, feel free to visit Fox’s website (see Where the MTA Spends Money). In a story accompanying the video, Fox writes:

With an $800 million budget shortfall that has resulted in service cuts and the looming possibility of fare hikes, the MTA should look to cutting employee costs, Robert Salomon, a professor at the NYU Stern School of Business told Good Day NY on Tuesday.

“I think that’s the elephant in the room,” said Salomon.  “A full sixty cents on every dollar goes to employee costs”

From salaries, to health benefits and pensions, a significant amount of money is spent on employees.

MTA officials have said there are consolidating functions to reduce unnecessary spending, but at the end of the day, Salomon says it’s up to elected officials to force changes on the agency.

“It’s up to legislators to say enough is enough,” added Salomon.

Unfortunately I didn’t get to touch upon all the points that I came prepared to discuss, but I guess that’s what happens in a short segment.

I came armed with data. For example, not only do employee costs account for some 60% of the overall MTA budget, but its employment cost structure compares unfavorably with other large municipal transportation authorities (e.g., Boston, DC, and Chicago) and even a privately-operated transit company (e.g., Keolis). Believe it or not, the MTA spends in excess of $100,000 per employee in pay, benefits, and pensions ($7.2 Billion annually). It doesn’t even collect enough in revenue ($6 Billion in fares, tolls, etc.) to cover its employee costs.

That said, it was not my intent to bash unions on the show. I certainly hope it did not come across that way.

I am not anti-union by policy; however, the fact is that in the midst of the worst recession since the Great Depression, MTA employees are not sharing in the pain. In fact, in December 2009 the MTA was forced to grant a three year pay increase of 11% to the employees represented by the Transit Workers Union (TWU). This leaves commuters and taxpayers to shoulder the burden not only for the previously anticipated MTA budget shortfall caused by the financial crisis, but also the added shortfall caused by the mandated TWU pay increase.

This begs the question: How much more in taxes, service cuts, and fare hikes (which have significantly outstripped inflation over the years) can the commuter/taxpayer absorb???

And the worst of it is that absent the involvement of legislators, nothing can be done about the contracts that bind the MTA to overly-generous pay packages. This is why I said that simply streamlining existing operations and shedding administrative employees is not enough. It’s up to our elected officials to intervene, more equitably divide the pain among the parties involved, and say “Enough is enough!”

Given that the unions hold incredible sway with our public representatives, I am not holding my breath…

I will be appearing on Fox 5′s Good Day New York tomorrow morning (Tuesday) for a segment on the (mis)management of the New York MTA at 7:15am (changed to 8:15am). They want to discuss not just the financial trouble the MTA currently finds itself in, but also the organizational constraints that the MTA faces in trying to run as a leaner, more efficient organization.

The thing that strikes me about the MTA is how much of the organizational budget is dedicated – in some way, shape, or form – to employee costs. Nearly 60% of the total budget is comprised of payroll, overtime, benefits, and pensions. Wow!

The MTA does not compare favorably with its peers in this respect. And given the current structure of its contracts, I’m not sure there’s much the MTA can actually do about it in the near term.

Feel free to tune in if you’re interested in this topic, …and I’ll post a clip after the segment airs.

In a post several days ago (see Yuan Revaluation, Euro Weakness, and the US Recovery), I suggested that while I believe that the yuan ought to be revalued vis-a-vis the dollar, the crisis in Europe would likely put any such plans on hold. I wrote,

…although I agree that China needs to address the yuan-dollar peg, a gradual revaluation to competitive levels is probably the best outcome for the global economy. A sudden rise in the value of the yuan could come with painful near-term adjustments that derail the currently fragile global recovery.

But that said, there’s now an additional complicating factor: With the euro depreciating against both the dollar and the yuan, any plans that Chinese policymakers may have had to revalue the yuan against the dollar are likely to be put on hold…

Sure enough, there seems to be some chatter emanating from China that its policymakers are considering delaying a revaluation (see Yuan Revaluation Could Be Postponed, ht BA). According to the People’s Daily:

Worried about a depleting trade surplus and a possible slowdown of its economy later this year, China is not likely to accelerate pace to revalue its currency, the yuan, experts revealed.

The Beijing-based China Daily reported Wednesday that the chances of an early revaluation of the renminbi look unlikely and could happen much later than expected, considering that the nation’s trade surplus may see steep erosions due to the European debt crisis and the growing trade protectionist measures against China.

Interestingly, and quite compellingly, Michael Pettis argues that this is exactly the wrong response (see Don’t Misread the Euro Crisis). Instead, he argues that now is precisely the time for China to change its trade policy.

The Greek crisis, rather than reduce the urgency for China to revalue its currency and adjust its trade policy, may on the contrary require that China react much more aggressively than originally planned. Why? Because any sharp adjustment in trade or capital flows in one part of the world must automatically force a series of equally sharp adjustments elsewhere…

This need to balance implies that the problems in Europe are going to make international trade relations, and especially those between China and its largest trading partners, much tenser. In fact I worry that the sudden and unpredicted speed of the European adjustment will force a resolution of the global imbalances at a far faster pace than I, already pessimistic, was expecting.

…is there anything that China can do to head off conflict?  Yes.  It can buy euros, the more the better – just lift every offer out there. By strengthening the euro, or at least limiting its weakness, this strategy will force the brunt of the adjustment back onto European surplus countries rather than onto the US and, via the US, back onto China.  Sarkozy and other European leaders might not be very happy, of course, but they will be at least partially mollified by the net capital inflows and the reduced humiliation of a collapsing euro.

Interesting. Definitely some food for thought. And I encourage you to read his post in its entirety. But still, I can’t help but wonder whether the political will is there to follow through on such a strategy. My hunch is that policymakers will resist change until forced…

When it comes to the heavily-debated topic of yuan revaluation, I am in the camp that believes the yuan is undervalued overvalued and ought to be revalued. That said however, I have advocated caution with respect to how soon and how fast such an appreciation should take place. My main concern revolves not only around the impact of a yuan revaluation on the Chinese economy, but also its knock-on effects to the U.S. economy (see China and the Revaluation of the Yuan and Yuan Again).

In the former post I opined:

Think about the short-term shock to the Chinese economy, which depends upon exports for a good portion of its GDP. By many accounts, exports make up some 25% of Chinese GDP. A revaluation of the yuan makes Chinese exports relatively more expensive thereby decreasing foreign demand for Chinese-made goods. This negatively impacts local production and creates a feedback loop through to domestic employment and wages. In the extreme, this threatens social stability, and China is certainly not the poster-child for social stability.

Not only that, but given the foreign interests and investments in China, it is not entirely clear to me that a yuan revaluation that catapults China into recession would not result in a global contagion effect. Supply chains are so interconnected around the globe that an upward price movement for intermediate and finished goods coming out of China could have dire consequences for Western companies that rely on Chinese-sourced goods (just ask Wal*Mart).

In the latter post I added:

…the near term economic adjustments associated with a significant rise in the value of the yuan could be painful, not just for China, but for the rest of the world as well. In addition, a sudden rise of the Yuan could be socially destabilizing for China. Given China’s already tenuous political and social situation, it is therefore difficult from a policy standpoint for Chinese politicians to justify…

So basically, China has made a commitment to a production-based, export-oriented economy. Although it certainly is in the long-term interest of China to rely less on domestic investment and exports while encouraging domestic consumption, such an adjustment takes time and there are adjustment pains associated with such a shift. Similarly, any shift of the US economy from one that relies on consumption to one that is centered around production would likewise take time and require some painful adjustments.

I was therefore not surprised to see a recent article summarizing the stance of Justin Yifu Lin (chief economist of the World Bank) with regard to a yuan revaluation. He echoes the sentiment I expressed, and details the nature of some of those “painful” adjustments (see Revaluation Would Hurt U.S.).

The chief economist for the World Bank said on Saturday that if China were to revalue its currency it would actually hurt rather than help the U.S. economy.

He acknowledged that if China stopped selling renminbi and buying foreign currencies, the policy that critics say keeps the currency artificially undervalued, Chinese exports would become more expensive.

But he said because most of the products China exports to the United States are labor-intensive goods U.S. manufacturers stopped making years ago, the U.S. would only have two choices: buy the products from other countries or from the Chinese.

Either way, Lin said, the cost of those goods would rise for U.S. consumers and that would depress both consumer spending and job creation in the United States.

So again, although I agree that China needs to address the yuan-dollar peg, a gradual revaluation to competitive levels is probably the best outcome for the global economy. A sudden rise in the value of the yuan could come with painful near-term adjustments that derail the currently fragile global recovery.

But that said, there’s now an additional complicating factor: With the euro depreciating against both the dollar and the yuan, any plans that Chinese policymakers may have had to revalue the yuan against the dollar are likely to be put on hold (see Europe’s Debt Crisis Casts Shadow Over China).

The pain of the European debt crisis is spreading as the plummeting euro makes Chinese companies less competitive in Europe, their largest market, and complicates any move to break the Chinese currency’s peg to the dollar.

…in light of the euro’s nose dive, such a move could be difficult. Letting the renminbi rise against the dollar would also mean a further increase in the renminbi’s value against the euro, creating even more problems for Chinese exporters to Europe.

Some Chinese companies are already running into difficulty because of the euro’s fall against the renminbi.

“We have been receiving calls from some European clients who signed contracts with us earlier this month, and they all want to cancel their orders, since the depreciation of the euro has eroded all their margins and then some,” said Elvin Xu, the sales manager of Guangdong Ouyi Electrical Appliance in Zhongshan, China, which makes gas stoves, heaters and water heaters.

“They say they cannot increase the prices at their end to their customers, given intense competition in their marketplace,” Mr. Xu added.

In an example of just how interconnected the global economy has become, it is not just Chinese exporters that are adversely impacted by the weakness in the euro, but U.S. exporters as well.

Because American companies in particular compete in the Chinese market with European companies in many industries, the euro’s weakness against the renminbi is putting American companies at a disadvantage.

And the effects are not limited to China.

Euro weakness (dollar strength) lowers the overall profitability of American multinational corporations. It lowers profitability through the repatriation channel (each 1€ of profitability is now the equivalent of only $1.23 in profit). It also reduces the profitability of American exporters as U.S. exports become more expensive in European markets reducing demand for U.S. goods. And it makes it more difficult for American companies to compete with European companies not just in China, but in export markets worldwide as European products become relatively cheaper.

So the problems in Europe that some pundits believe are now largely contained can have serious consequences for global economic growth. And as the New York Times article rightly concludes:

…even China — the world’s fastest-growing major economy and increasingly the engine of global growth — is not immune to the crisis that started in Greece…

At this point it should come as no surprise to anyone that the European Union has committed to a large rescue package with a headline number of around $1 trillion (see EU Rescue Package for details).

With the caveat that I am not a macro-economic specialist (my specialty is in firm behavior), I share with you my initial thoughts on the bailout.

First, the good:

1. Wow! The EU countries were able to overcome their differences and react with a unified voice and purpose. They did so in a swift manner and committed an extraordinary sum of money to try to address a problem whose gravity they had, until this point, largely chosen to ignore, …or at least treat with benign neglect.
2. The capital committed, in my opinion, is large enough to help meet the short-term funding needs of the countries that might need to draw upon it (think Greece, Portugal, Spain). Greece had been largely shut out of external capital markets, and Portugal and Spain were following not too far behind. The weaker peripheral countries can now turn to the EU/ECB and IMF to raise funds that they might have trouble otherwise raising on their own.
3. The rescue package not only bails out the peripheral (PIIGS) European countries, but it also bails out the banks. For example, if you were a European bank sitting on a helping of Greek debt, imagine how your balance sheet looked on Friday given the market’s expectation for Greek default and how it looks today now that the ECB has announced that it will buy debt issued by the weaker European nations in the secondary market. Whether the banks deserve such a bailout is certainly open to debate, but the actions taken by the ECB will keep credit markets from freezing in the near term.

Now, the bad (or at least the part that gives me pause):

1. The obvious: Moral Hazard (see Go Hog Wild). How long will the richer European nations continue to allow their debt-addicted poorer brethren to behave badly?
2. Aside from the guarantees and the liquidity provisions, I am not seeing any meaningful change in the debt burdens facing Greece and the other PIIGS nations. There is no debt restructuring from what I can tell. Given that there is no debt relief for the PIIGS, it is likely that several of the PIIGS will be forced to tap the rescue packages.
3. My understanding from the rescue program is that if a country taps into the funds, it will be subject to mandated fiscal austerity programs. As we have seen in Greece, additional (and forced) fiscal austerity is likely to be poorly received, …so get ready for additional social unrest and political turmoil.
4. Assuming that the countries that agree to the mandated fiscal austerity programs are able to do so with minimal social unrest and political turmoil, the fiscal adjustments will come with negative shocks to the real economy. It will result in, at the least, lower economic growth in those countries that are forced to tap into the rescue funds, and at the worst, a severe recession that could have spillover effects even on the stronger European nations.
5. All this aid, and there’s still no guarantee that the weaker PIIGS nations will not ultimately default. So for all its benefits, all that the rescue package might achieve is to push the day of reckoning for many of these nations further into the future.

Taking stock therefore, the rescue seems to me like an attempt to buy some time for the struggling European economies while hoping that economic growth (or inflation) can emerge that will help those nations escape their debt problems.

Again, these are just my initial impressions. It will take some time for the dust to settle to see how the bailout plays out. For those of you looking for a deeper analysis from scholars whose specific interests and expertise lie in the analysis of macro-economic issues, I refer you to Simon Johnson, Paul Krugman, and Nouriel Roubini.

The Economist provided a very nice chart last week (see Still in a Spin) breaking down the foreign bank exposure to Greek sovereign debt (as compiled and reported by the BIS).

From the table, it seems that French, German, and Swiss banks have the greatest overall exposure to Greek government debt. But there is much more to it than that…

The figures presumably capture the nominal amount that foreign banks hold in Greek government debt expressed as a percentage of Greece’s total outstanding debt. However, to the extent that foreign banks have hedged their exposure through insurance purchased in the CDS market, the table will not reflect the true exposure of those banks.

We can’t quite know the extent of the exposure to Greek sovereign debt without knowing the exposure of banks (and non-bank financial institutions) to CDS positions on Greek sovereign debt. Since the CDS market is opaque and unregulated, my fear is that, aside from the obvious threat of contagion to the other PIIGS economies, the lack of transparency regarding exposure to Greek CDS contracts might result in a “credit crunch” redux. Might there be a sovereign equivalent to AIG or AMBAC out there?

With the global economy in the midst of a still fragile recovery, I certainly hope not…

It’s been a whirlwind few weeks of travel for me – beginning in Holland, then on to Paris, followed by a trip to DC. But I am now back in New York, looking forward to getting back to a more regular, regimented schedule.

In the meantime, I thought I’d share some articles that I’ve enjoyed reading over the past few weeks.

1. Canadian Pension Organization to Buy UK Lottery – Details how a Canadian Teacher’s Pension organization is trying to acquire a British lottery operator. Can someone please explain to me the logic of a pension fund running a lottery company, …in a foreign country no less? This defies just about all corporate strategy logic regarding M&A activity. What do pension funds know about running lottery companies?? And if they’re simply a financial buyer, what business discipline will they be able to impose, especially since the owners get only a small portion of the profit? Also, I can’t help but wonder how Canadian teachers will feel about owning a gambling operation.
2. The Celebrity Effect – Details research on the financial impact of appointing celebrities to a company’s Board of Directors (e.g., Evander Holyfield at Coca Cola; Michael Jordan at Oakley; Billie Jean King at Philip Morris; Gerald Ford at American Express). Although the research suggests that firms benefit from announcing celebrity directors, I remain skeptical. I have brought board members from various large public corporations to speak in my class, and they have expressed disappointment with the celebrity members of their boards, sharing stories about celebrities who typically do not pull their weight. I can understand if a celebrity has a particular expertise that lends itself to the business or if a former politician joins the board of a firm that operates in the government sector and/or for which political connections are especially important. However, by and large, I think that many of these appointments are ceremonial, and likely do not create value.
3. The Panda has Two Faces – A story from the Economist on the perils of doing business in China. They stress the political, economic, and cultural quandary facing foreign entrants (see also So You Want to Do Business in a Developing Country). A choice quote from the Economist article, “[China] regards foreign investment as a mechanism for acquiring foreign know-how rather than just jobs and capital; hence the insistence on joint ventures…political difficulties are piled on top of cultural difficulties. The Chinese emphasis on personal connections (guanxi) makes it hard to distinguish between business-as-usual and corruption. And the weakness of the legal system means that companies operate in a confusing half-light. Transparency International’s most recent Corruption Perceptions Index ranks China 79th out of 180 countries…”
4. Relax, We’re Fine – The future of the US economy according to David Brooks. Although the title of the article might be viewed as insensitive to the plight of the millions of Americans who are currently unemployed, I think that David is rightly optimistic about the long-term prospects of the US economy. And it’s nice to remind ourselves of that sometimes, …especially when things don’t feel so great at the moment. A choice quote, “…the U.S. remains a magnet for immigrants…the U.S. is among the best at assimilating them (while China is exceptionally poor). As a result, half the world’s skilled immigrants come to the U.S. As Kotkin notes, between 1990 and 2005, immigrants started a quarter of the new venture-backed public companies. The United States already measures at the top or close to the top of nearly every global measure of economic competitiveness. A comprehensive 2008 Rand Corporation study found that the U.S. leads the world in scientific and technological development. The U.S. now accounts for a third of the world’s research-and-development spending. Partly as a result, the average American worker is nearly 10 times more productive than the average Chinese worker, a gap that will close but not go away in our lifetimes.” This is exactly why I find it hard to believe some of the predictions that China will soon overtake the US as a technological super-power (see also China Attracting High-Tech Research).
5. The Return of History – A David Brooks two-fer. This Op-Ed is his critique of the field of economics. These are not necessarily new arguments (see Future of Financial Economics, Future of Financial Economics Part Deux, and Krugman on the Future of Economics). Moreover, I am not so sure I agree with David’s prediction with respect to Act V. Nevertheless, it was thought-provoking and provided an entertaining read.

Anyhow, I hope you find these articles well worth your time to read. Enjoy!

If the accounts I’ve been reading are true (see Growing Prospects for Bailout for Greece), Greece might be the beneficiary of an imminent bailout. As reported by Bloomberg:

Olli Rehn, who takes over as European Union economic affairs commissioner tomorrow, said support for Greece will be discussed in coming days. Michael Meister, a German legislator from Chancellor Angela Merkel’s Christian Democrats, said lawmakers in that country are considering financial assistance.

The EU (in particular France and Germany) ought to be very careful in how it approaches the bailout so as to prevent moral hazard. And in this case I am not referring to moral hazard in the sense that the bailout provides Greece an incentive to behave badly again in the future, but moral hazard in the sense that Portugal, Ireland (maybe Italy too), and Spain now have the incentive to continue to behave badly. After all, if France and Germany come to the rescue of Greece, it sends a signal to other fiscally troubled European nations that they are likely to receive similar treatment, …and especially for the more consequential economies of Spain and Italy (see Euro Perspective).

If the EU comes to the aid of Greece, what incentive does Spain, Portugal, Italy, or Ireland have to bring their fiscal house in order. In fact, what’s to prevent them from going on a bigger fiscal bender? For after all, although Greece represents only a small fraction of European GDP, allowing Spain and Italy to falter could be disastrous for the Union.