The truth about € in Poland, Mr. Krugman

As a big fan of IS/LM, I have always admired Paul Krugman. He obviously knows his stuff but more importantly he has held his stance throughout the crisis and has done it in a very convincing way. This will definitely be remembered.
However, I sometimes have issues with what he says and these issues are proportional to the distance between him and the subject in question. While his views on Iceland were pretty much in line with what I think, I’ve been under the impression that he oversimplified things by conveniently ignoring the fact that there is a lot of cash trapped there, which will remain a big problem for many years to come. But this is nothing compared to what in my view is a completely misguided and superficial analysis of the Baltics. The fundamental difference between what he says and what I think is that for me just because a country that used to run significant excesses before the crisis has not returned to the previous level of output is by no means a proof of a failure of local policies. I would argue that a lot of pre-crisis GDP was, in effect, phantom and should not be treated as a benchmark. Additionally, countries like Lithuania are an example that internal devaluation can work well, which you can see looking at a rapid growth in productivity in recent years. And no, I don’t care that a lot of that has happened through reductions in employment. Not because I’m a heartless liberal but because a lot of the pre-crisis employment should not have happened in the first place. The same situation could be observed in Latvia and yet prof. Krugman keeps waving the GDP chart saying how ridiculous the policies have been.
But I wasn’t going to write about the Baltics. Today I read Paul Krugman’s latest post entitled Poland Is Not Yet Lost. The mention of Latvia aside, there is nothing in this post that would be factually incorrect – Poland did have a “nice” global recession and the zloty was an efficient corrective mechanism in 2009 and after.
However, the problem with his post is that it discusses an absolutely irrelevant issue of Poland joining the EMU. Sure, the Polish authorities have been quite vocal mentioning that in recent months but in my strong opinion it has nothing to do with the actual intention.
What’s the reason then? Polish bonds. After a spectacular rally in 2012, yields on POLGBs reached record low levels and the curve flattened dramatically as the NBP stayed way behind the curve. At the same time, standard valuation metrices like eg asset swaps or carry have become extremely tight. To the point that without assuming a paradigm shift or without classifying Poland as a safe haven it was difficult to justify further strong purchases. “Expensive” was the word most commonly used at the turn of the year. The Finance Ministry, which by the way holds a Ph.D. in public relations, realised that too and was frantically looking for a way to portray POLGBs as “still attractive”. And they quickly found one, ie the spread to Bund, which is hovering above 200bp. But in order for people to start looking at this spread they had to give them a reason. Joining the EMU was one. And believe me, this has been quite successful judging by how many requests I get about this spread these days.
Talk is cheap and Poland knows about it so if saying that eventually the zloty will be converted into € can bring us some flows then why not? Especially that there hasn’t been any commitment regarding the date or no indication on how on Earth Poland will meet the Maastricht criteria. But I guess this is a much simpler strategy of communication than trying to explain how the budget will cope with the first drop in consumption in almost 20 years or what does it mean that the budget deficit is already at 60% of the full-year plan after only two months. I guess it’s good there’s Hungary (and now Slovenia) next door who will always attract eager sellers, eh?
But coming back to prof. Krugman, I realise that my credentials are nowhere near his. Heck, I’m not even writing this under my own name. Still, I think in cases like Latvia or Poland, he lets his ideology run before the analysis of what actually is going on.

Has Britain finally cornered itself?

After a week of travelling I came back to see that Moody’s has finally pulled the trigger on the country where I currently reside. This is such a non-story that it feels stupid to even mention but I suppose it will be making headlines for a little while longer. And this is a very good thing.

Before I start, however, I would like to thank the British government for conducting a massive social experiment, which will be used in decades to come as a proof that a tight fiscal/loose monetary policy mix does not work in an environment of a liquidity trap. We sort of knew that from the theory anyway but now we have plenty of data to base that on.

Secondly, I will be referring to my favourite IS/LM model. If you want to read more about it, a very good tutorial can be found here.

So… Let’s assume for a second that the Osborne/Cameron duo is capable of taking a stop-loss on their policy. I know it is a heroic assumption when discussing any politicians but why not…

When looking at record low cost of borrowing, a severely depressed economy and a central bank that does not even pretend anymore to be independent or targeting inflation the recipe should probably be to spend more. In the standard IS/LM model an increase in government spending over taxes (i.e. boosting the deficit) pushes the IS curve to the right. Thus, both the output level and the level of interest rate will increase. Consequently, the exchange rate should appreciate as capital flows to the country in question. This in turn leads to widening of the trade deficit. Ideally, the government would want the Bank of England to step in and limit the increase in interest rates (a.k.a. QE) so that the currency does not appreciate. And, as I mentioned before, the BoE is more than willing to do so.

Let’s now have a look at the situation from another angle. I have been going through he Bank of England’s quarterly reports in reference to trade (which can be found here) and I have found two interesting charts. The first one looks at episodes of rapid moves in the British pound and the impact on the trade balance:


The relationship is pretty strong, which is why many people are calling for debasing of the sterling, particularly after G20 gave a pale-green light to such activities for countries, which are effectively in a liquidity trap.

The second chart shows why debasing of the sterling makes an awful lot of sense. It shows two measures of the International Investment Position – the standard one (i.e. with FDIs at book value) and what I would call a “market” one (i.e. with FDIs at market value).


You can see that the UK is looking quite a bit better if you take into account the actual values of FDIs. I would suggest that the recent rally in global equity prices has at least kept the blue line in the positive territory. This essentially means that GBP devaluation not only boosts the terms of trade but also makes the UK richer. Not very many countries are in such a pleasant situation (think of many emerging economies with significant external debt).

Again, weakening of the sterling does seem to be a very appealing strategy for the authorities. There is, however, one important problem – GBP devaluation is unlikely to bring extra revenues to the government and could actually make the fiscal position a bit worse. Here’s why – devaluing one’s currency and narrowing of a current account deficit means that the country’s savings are increasing in relative terms to investments. Granted, this may well have to happen considering a huge stock of private debt but this is not desirable from the growth point of view. On top of that, the J-curve effect dictates that the initial impact of currency devaluation will be actually adverse.

What I am trying to say is that while GBP devaluation has a lot of positive sides, it will probably not work on its own because it will further depress domestic demand thus putting a strain of public finances.

Therefore, I do believe that Britain has finally cornered itself into a situation where there is overwhelming evidence that Mr Osborne should really start spending. He should also assume that Mr Carney will not let that spending lead to appreciation of Real Effective Exchange Rate (a bit more on that mechanism in one of my previous posts entitled “Be careful what you target or am I in the right church?“). That is to say that the Bank of England will keep nominal and real rates very low. In my opinion this is the only rational way of the situation that we’re currently in. Then again, I am assuming the impossible here, i.e. that the politicians know what the stop-loss is.

How to trade this? I don’t normally trade anything related to the UK (except GBP/PLN) but I would assume that any sell-offs in Gilts should be used as an opportunity to buy. As far as the sterling is concerned, the fact that exports outside of the eurozone are now bigger than to the eurozone, EUR/GBP is a cross that doesn’t make that much sense. I would very much prefer the cable, or better yet selling the sterling against EM currencies as this is where the adjustment in trade balances will have to come from.