Jackson Hole Preview: Draghi's Plan Should Net Positive for Markets
Draghi has done the math, knows the formula, and understands the channels through which a devaluation needs to work. He knows it's not just about trade, it's about real wealth and income and effects on capital investment.
I first learned about what would become the European crisis in 2006 when on vacation with my wife on the Croatian island of Hvar in the Adriatic. We were enjoying a nice dinner in the harbor town of Sucuraj discussing politics with my wife’s very vivacious family friend named Ranka (R is rolled). The discussion was on whether Croatia should enter the EU and adopt the euro common currency. Ranka was adamant that it would be bad for Croatia, namely because it would increase the cost of living and potentially reduce tourism which was so vital to Croatia’s economy. She was comparing what happened to their neighbor Italy across the Adriatic and how expensive it was now to visit relative to pre-monetary union. I remember thinking to myself, this isn’t going to work. The euro is flawed. Italians aren’t Germans.
Then a few years later in early 2009 I was catching up with an old college friend, discussing the mortgage meltdown that was unfolding. We had a mutual friend that worked at a hedge fund that had accurately positioned for and was profiting from the chaos that had taken down the financial system. He asked if I was aware of their new fund strategy and I was not.
The Hedge Fund that Called the Euro Crisis
The most legendary hedge fund manager you’ve probably never heard of (and I think he likes it that way) is Mark Hart of Corriente Advisors in Ft. Worth, TX. In late 2007 Corriente began marketing the European Divergence Fund co-managed with macro research gurus GaveKal sporting the subtle subtitle, The Next Shoe to Drop. To my knowledge this was the first hedge fund that was positioning for what would become the European debt crisis.
I was able to obtain a copy of their presentation and it was truly mind-blowing. It was like reading a suspense novel. It seemed each page presented a stunning new conclusion with statistics, data, and charts. With sovereign spreads of what are now referred to as the PIIGS all converging with Germany juxtaposed with the respective countries’ fiscal situations it became obvious. They simply asked: How Do Countries Go Bust? They Issue Debt in a Currency They Can’t Print. I thought back to my conversation with Ranka. This is genius. This thing is going to unwind.
The rest is history and five years later the European debt crisis still consumes us every day. However upon further investigation, it’s much more complicated than what the financial media typically portrays as simply a problem of too much debt. What started as a re-pricing of sovereign credit risk premiums has evolved into something much more serious. It’s not just a sovereign debt crisis; it’s a balance of payments crisis born out of the fixed exchange rate regime.
Balance of Payments
The balance of payments is the sum of the current account (trade balance) and the capital account (investment balance). Essentially it’s the sum of domestic vs. foreign consumption and domestic vs. foreign investment.
I first began exploring this notion of a balance of payments imbalance in the eurozone last year upon stumbling across this FT Alphaville post. That led me to the Financial Times piece cited by Deutsche Bank economist Thomas Mayer titled, Euroland’s Hidden Balance-of-Payments Crisis that further defined the issues and offered potential solutions:
In a fixed exchange rate system, however balance-of-payments imbalances can emerge when the exchange rate is above or below its equilibrium value.
The path of least resistance seems to be an appreciation in creditor countries through the inflation of goods, services and asset prices...
What Mayer is alluding to is an internal devaluation. Since the individual currencies aren’t allowed to re-price against trading partners to adjust the imbalance externally, the devaluation needs to occur internally in prices of goods and services to realign purchasing power parity in order to bring it back into equilibrium.
Mayer cites the work of University of Munich Economist Hans-Werner Sinn who has been at the forefront of taking on and solving the issue of the balance of payment imbalance.
The eurozone suffers from a severe balance-of-payment crisis of the kind that ended the Bretton Woods system. Instead of merely lacking credibility, the stricken economies have lost their competitiveness. Instead of growing out of their problems, they need to shrink out of them (in nominal terms, to reduce their imports and boost their exports).
Ironically the US credit bubble, which was on the back of a weak USD, was at the core of the European crisis. The resulting stronger EUR currency helped fuel the consumption bubbles in Southern Europe because they were given more purchasing power than their local currencies would have otherwise provided.
At the heart of the balance of payments crisis are the concepts of equilibrium, purchasing power parity, and clearing prices of goods and assets. It appears Sinn has done a lot of work on and is no slouch when it comes to equilibrium theory and recently wrote a paper titled, Taxation, growth, and resource extraction: A general equilibrium approach.
Two other economists that appear to know a thing or two about equilibrium are Paul Samuelson and Robert Solow who both taught economics at MIT. I don’t want to dwell on the details of all their work but I do want to point out the connection between equilibrium theory being taught at MIT and one of its students not named Ben Bernanke.
If Europe has a balance of payments crisis that requires an internal devaluation to fix the imbalance the question is whether their authorities are qualified to address this immense challenge in a way that does not collapse the monetary union. In November 1976 Mario Draghi submitted his thesis for his PhD from MIT in what he titled Essays on Economic Theory and Applications. In Chapter 2 with some eerie foresight Draghi asks the question: Under what circumstances will a devaluation improve the balance of payments of the devaluing country?
I was expecting to read a very dovish conclusion that would imply Draghi was heading towards an eventual devaluation of the euro currency. What I found was a well delivered rather hawkish analysis to why the classical approaches to devaluation were insufficient.
Inside Draghi's Reasoning
Draghi’s reasoning is based on the interplay between the wealth effect, asset markets, and the demand for money based on equilibrium presumably due to the influences of Samuelson and Solow. In fact Solow with the Franco Modigliani (who wrote a couple of textbooks on financial markets with Frank Fabozzi) supervised Draghi’s dissertation. He also credits Bernanke’s mentor Stanley Fisher in the writing of Chapter 2.
I’m no economist so it took me five times to read (and I’m still trying to figure out what he’s talking about) but you get the impression he respects the market clearing mechanism and he truly believes there is a difference between nominal and real income and wealth. Throughout the thesis he analyzes the cost benefit of the devaluation process by addressing concepts of equilibrium, real income, the demand for money, and the clearing price for goods and assets.
He first addresses the classical models to break down the respective theorems and highlight the flaws. His main criticism of the classical economist models seems to be that they focused on the balance of payments as a whole or simply in terms of trade flows but neglected the presence of assets markets and investment flows.
Draghi offers six propositions for analyzing a devaluation that seem to support his conclusion. Throughout the thesis he explores concepts of the negative wealth effect reducing the demand for money, market equilibrium and ability for markets to clear. He addresses the short term benefit of an improved balance of payments vs. the long term cost of a reduction in the demand for money. Then when he gets to Proposition 6 he gets to the crux of his argument:
A devaluation lowers the relative price of the traded good in the devaluing country and it raises it in the other country. Furthermore it raises the domestic price level less than proportionately to the amount of the devaluation and it increases the world interest rate.
Then if we exclude interest receipts a devaluation would unambiguously decrease the trade deficit. However, a devaluation creates positive excess demand for money in the world market, that, everything else constant, can be cleared only at a higher interest rate. This creates a positive income effect that may worsen the trade balance.
He concedes that the income affect improves the capital account because of the subsequent reduction in domestic demand for foreign bonds and increased foreign demand for domestic bonds. However due to the wealth elasticities of demand for bonds there will be less real domestic demand for foreign bonds and that because foreign demand for domestic bonds would require a much lower clearing price (higher interest) there would be a negative flow affect as you would be paying out more interest than you are earning. I think.
So I think Draghi is saying that in a devaluation, in real terms the demand for foreign bonds has been reduced by the increase in domestic prices and resulting decrease in purchasing power plus due to the exchange rate the supply of domestic debt available to foreigners in real terms falls because it takes much fewer units to invest in the same stock. Therefore, in real terms, less domestic money is flowing into foreign bonds and less foreign money flowing into domestic bonds. I think.
Conclusion (emphasis mine):
It has been shown that a devaluation affects the domestic price level and the relative price of non-traded goods in terms of the traded ones in the same way as it does in the monetarist model. However given the different specifications of the demand functions for goods and for assets, the channels through which a devaluation works are different from the monetartist model. In particular it has emphasized the fact that since demand for money is a positive function of real income and real wealth, changes in relative prices or in the absolute price level—such as those caused by a devaluation—that decrease real income and real wealth may decrease the flow demand for money and therefore may not improve the balance of payments of the devaluing country.
Hmmm... Draghi’s point seems to be that yes all else equal a devaluation will adjust the trade imbalance through the rising price level positively affecting the current account but that the resulting decrease in real wealth due to higher prices will drive a decrease in capital flows which will negatively affect the capital account thus not improving the overall balance of payments.
I don’t know if Mario Draghi has the right answers but he certainly has been thinking about how to effectively tackle a balance of payments crisis for a long time. It’s quite possible he’s the most qualified man on the planet to address the crisis in Europe and I’m not sure US investors have the respect that he deserves.
In reading his dissertation it’s clear that he’s a contrarian analytical thinker with a deep understanding of all the moving parts and how they relate to one another. The very fact that he was so focused on the market side of the balance of payments equation suggests that he understands how important it is to address the market’s concerns and not just the political concerns.
Jackson Hole Symposium
The Jackson Hole symposium is shaping up to be one of the most interesting in recent memory. Scheduled over the Labor Day weekend traders will have the much anticipated Bernanke speech on Friday 8/31 but will also have to contend with Saturday’s speech by Draghi as they position for month end and the post Labor Day trade. With recent economic data improving at the margin and some more hawkish rhetoric out of Fed speak it’s quite possible that Bernanke’s speech is more muted than many expect. Maybe the focus should be on Draghi who may use the symposium as an opportunity to expound on his pledge to do what is necessary to safe the euro from collapse.
On the surface it would seem both the Fed and the ECB want their respective currencies lower.
But maybe Bernanke would actually benefit from a weaker euro if it is the best path to fixing the eurozone crisis which would improve global risk appetite. That has started to show up in the performance of Treasuries, European stocks, and European financial credit spreads. Jackson Hole could see a continuation of that trend if Bernanke backs off QE and Draghi steps up to offer concrete solutions to fixing the European imbalances.
Every time I see Super Mario I can’t help but think about the striking resemblance to one of my childhood heroes Count von Count on Sesame Street. Ah! Ah! Ah! One of my favorite episodes was when the Count plays Beat the Time hosted by Guy Smiley. They call me the Count because I love to count things. Then right on cue, the Count wins the “Impossible Stunt” by simply counting.
It seems Draghi is up against the clock himself and is playing his own version of Beat the Time. It also seems Draghi has done the math, knows the formula, and understands the channels through which a devaluation needs to work. He knows it’s not just about trade, it’s about real wealth and income and effects on capital investment. All else equal that should be net positive for markets and the future for eurozone.