Bond vigilantes call for “Day of Rates”

Flustered by the obstinate refusal of US interest rates to move up, bond vigilantes are resorting to the revolutionary tactic du jour: Twitter!

In a thread dubbed “The Day of Rates”, the vigilantes are calling on Americans to liquidate their holdings of government bonds this Monday and help spread the word by tweeting “sell”.

The appeal is in protest against what they call the government’s "exorbitant privilege” of getting away with very low borrowing rates even while the deficit keeps ballooning.

Twitter pros attested that, within hours, the thread had attracted 4.3 million followers with profile names as diverse as @JoeThePlumber, @MsWatanabe and @Broncho_Billy.

The latter is rumored to be pseudonym for legendary bond trader Bill Gross, who only last month was reported to have sold his entire stock of US government bonds held in his $237 million Total Return Fund.

Confronted with the rumor Mr. Gross gave only an indirect response: “The behavior of US interest rates has defied economic logic” he said. “Usually, I put on a trade, publicize it on CNBC and markets follow. This time round it looks like we need to broaden our audience.”

Former Federal Reserve Chairman Alan Greenspan agreed: “It’s a conundrum”, he tweeted, when asked to comment on the path of interest rates.

Meanwhile, Republican Representative Michele Bachmann offered a potentially compelling explanation.

“Every time interest rates go up, some foreign factor intervenes to push them down again,” she observed at a recent town hall meeting. “First it was the Greeks. Then the Irish. Then the Arabs. Now the Japanese!”

“It's obvious,” she continued. “This is a global conspiracy to plunge America deeper into debt. And President Obama is biting the bait. I mean, I’m not necessarily blaming him but the Kobe earthquake also happened under a Democrat President… It's an interesting coincidence…”

Meanwhile, Federal Reserve Chairman Ben Bernanke played down the threat of excessive market volatility due to millions of “sell” tweets.

“The Fed stands ready to use all available tools to preserve financial stability,” he tweeted.

Fed pundits have interpreted the Chairman’s tweet as a sign he is bracing for what they called the "nuclear" option.

In response, Mr Bernanke regretted the term as "inopportune", saying the media must learn to settle with less sensational jargon, "like QE3". He added that recent experience has shown QE to be "a monetary policy tool 4 all seasons", though he did not elaborate, likely due to tweet constraints.

Fed insiders say Mr. Bernanke still struggles with Twitter and has enlisted pop star Lady Gaga to help him master the new medium. Reportedly, her top recommendations have been to reduce FOMC statements to 140 characters or less and to change the Chairman’s profile name from @Ben to @MoneyHoney.

>
>
>
>
>
>
>
>
and just in case you started selling.....
Happy Aprl Fool's!

Blunt or blunter? Emerging markets (try to) return in kind

The one thing we can’t accuse central banks of these days is lack of creativity. The latest gem came from the Central Bank of Turkey (CBT) last week, when, on one hand, it cut its policy rate by 50bps to 6.50%, while at the same time increased the reserve requirement ratios (RRR) for short-term bank funding (deposits and repo) to help lengthen the maturity structure of banks’ liabilities.

I don’t want to dwell exclusively on the Turkish example, which, in my view, is fraught with confusion about what exactly the authorities are trying to achieve. What I do want to do is examine under what conditions, if any, a hike in reserve requirements can be effective in tightening monetary conditions. This is particularly relevant at a time when many emerging markets think they can “get away” with avoiding raising interest rates by employing alternative tools, to avoid attracting further capital flows from abroad.

Changes in the RRR are meant to influence monetary conditions through the so-called bank-lending channel of monetary transmission. Accordingly, bank funding relies in large part on demand deposits, which are subject to reserve requirements. Raising the RRR increases banks’ demand for reserve deposits at the central bank (CB). If the CB does not accommodate that demand, short-term interest rates will rise to bring demand for reserves in line with supply. Monetary conditions then tighten because banks will pass on their higher funding costs to corporates and households, in the form of higher lending rates, in order to safeguard their profitability (interest rate margins).

Against this backdrop, for a RRR hike to be effective in tightening monetary conditions, the following have to hold:

Banks should be limited in their ability to switch to other sources of short-term funding that are not subject to reserve requirements. In the case of Turkey for example, the RRRs (which are different across different liability maturities) have been applied to both deposits and repo funding from abroad and from domestic customers. However, they do not apply to repo transactions with the CBT and among domestic banks. For this reason, it’s unclear how the hike in RRRs can materially increase banks’ cost of short-term funding, if the CBT is effectively committed to supplying enough reserves to keep its target rate at (the now lower) 6.50%.

To make things more tangible, suppose a bank has 100bn liras worth of short-term liabilities and the RRR is raised from 6% to 8%. Suddenly, demand for reserves at the CBT rises by 2bn liras. Banks would then have to sell 2bn of their other assets, to meet the requirement, putting upward pressure on interest rates and, in the process, also shrinking the quantity of credit in the economy. However, by committing to maintain the target interest rate at 6.50%, the CBT effectively commits to creating enough reserves to meet any additional demand at that rate.

How will it do that? It will go to the open market, purchase TRY2bn worth of government securities and fund the purchase with the creation of bank reserves. Alternatively, it can go to the FX market and purchase TRY2bn worth of, say, US dollars, again funded with bank reserves. In that way, banks’ reserves go up without them having to shrink their loan book. On the contrary: new liquidity has come into the system (as the cash received by the sellers of the bonds or the foreign exchange has been deposited at the banks), which can be employed for further loan creation.

Note that the measure might still be desirable from a prudential perspective—e.g. to the extent that higher RRRs on foreign repo funding might encourage a shift towards lira-denominated funds, thus avoiding undesirable currency mismatches on banks’ balance sheets. But what I’m arguing here is that the RRR hike is unlikely to restrain credit growth because (a) it would not have a material impact on the price of credit; and (b) it might even contribute to increasing the quantity of credit, if the CB commits to accommodating whatever additional demand for reserves at the going 6.50% rate (via securities purchases or unsterilized FX accumulation).

Looking beyond Turkey, my bigger point is that measures that do not materially raise the cost of capital (and, indeed, that are intended to lower it, to fend off foreign capital inflows) are unlikely to tighten monetary conditions. Not only because their impact through the bank-lending channel will be diluted; but also because they ignore other important channels of monetary transmission—notably the wealth and financial accelerator channels.

For example, if short-term interest rates remain low, cash will seek riskier assets, boosting their prices and leading to positive wealth effects. This in turn triggers pro-cyclical investment and consumption and, potentially, overheating (the wealth channel). Admittedly, when capital markets are global, low foreign interest rates can also play a big role in boosting asset prices, so an increase in the local short-term rates might not be enough to generate the desired tightening.

Similarly, rising asset prices increases the value of collateral and thus, the perceived creditworthiness of borrowers, encouraging more lending (the financial accelerator channel). Higher RRRs on domestic banks, IF binding, could restrain the extent of such an increase, but even then, in an open economy, at least part of the capital “shortfall” is likely to be covered by foreigners.

Finally, “here and there” policy measures may be ineffective or counterproductive, by creating confusion about what a central bank is trying to achieve and undermining its credibility. Is it lower credit growth to curb domestic demand and a widening of the current account deficit? Is it the promotion of financial stability through the change in the maturity structure and currency composition of banks’ liabilities? Is it the discouragement of capital inflows and the prevention of “excessive” exchange-rate appreciation? What about that price stability?

Clearly, there are no easy answers to the policy dilemmas of our times. My suspicion is that we should be bracing for blunter measures in the year ahead.

Why the tax “compromise” is a very dumb idea

First of all, my apologies for the bluntness of the title. As regular M&A readers know, I tend to be a tad more subtle in my characterization of things--only this time I had a hard time finding a better substitute for “dumb” other than “stupid”.

So, where to begin?

Let me start with a simple statistic: Real personal consumption expenditure (PCE). Since this past September, real personal consumption has exceeded the pre-crisis peak it reached in December 2007. In other words, Americans on aggregate are buying as much stuff (in volume terms) as before the official onset of the recession.

Now, this is not necessarily something to celebrate: On an annualized basis, real personal consumption has only grown 0.1% since December 2007, compared to the 3.5% during the decade leading up to the crisis. But there is still something impressive going on: Real consumption is back to its 2007 levels despite the fact that the number of people employed (in non-agricultural sectors) is some seven million less than it was back in end-2007.

In fact, (the admittedly crude measure of) real PCE per employed person has grown 1.9% annualized throughout this crisis, which is pretty close to the 2.1% we saw over the previous decade, especially considering the kind of crisis to that we’ve had to the economy and to consumer confidence.

What’s my point here? That the problem with the economy is not that (employed) Americans don’t consume enough; it is that we have too many unemployed people who can’t consume, not even the basics. And this is my first reason why giving a tax gift to employed Americans is a completely dumb policy: Not only is it unfair to the unemployed; it is questionable whether those Americans with jobs and with comfortable cash positions are going to spend this tax gift, if they are already close to reaching their long-term consumption growth. So much for a “targeted”, “efficient” fiscal “stimulus”.

Second. Let’s imagine for the moment that the American government was in a fiscally strong position, sustainable deficits and all, and hence with lots of extra cash to spend to boost the ailing labor market. Is a cut on payroll taxes really the best idea they’ve got?

No. Think of labor supply and demand. Right now, at the going wage, the supply of labor exceeds by far demand for labor (for which reason we have high unemployment).

What does the cut in the payroll tax do? If anything, it reduces labor supply. This is because employed workers could work fewer hours and still end up with the same amount of disposable dollars as before the tax cut. So, at the margin, they would reduce the hours they offer to work. (To throw a bit of jargon, the labor supply curve shifts to the left: i.e. less labor is offered for a given wage).

Now, this might (temporarily) close part of the labor supply-demand gap—i.e. reduce unemployment. But that’s a reduction for the wrong reason! What we really need is for unemployment to get reduced due to an increase in labor demand (ie policies to shift the labor demand curve to the right!). So, in theory, *if* the government had cash to spare, and *if* companies’ reluctance to hire were driven by a liquidity constraint, the appropriate policy response to raise employment (and thus, consumption, GDP growth and so on) would be to give a temporary cut in the employers’ portion of the payroll tax, not the employees’.

However, neither of these two “if’s” holds: Neither is the government in good shape, fiscally; nor is companies’ hesitation to hire the result of a liquidity constraint—at least on aggregate. As the Fed’s flow of funds data show, since end-2009, non-farm non-financial corporates’ liquidity position (proxied, very roughly, by the ratio of cash-like financial assets over credit-market liabilities) has returned to its pre-crisis level. Meanwhile, corporates are already getting a huge “stimulus” from the very low interest rates, which are reducing significantly the costs of servicing their debt. So no, companies don’t need a payroll-tax gift to raise labor demand.

Then... I mentioned interest rates. In case you missed it, the 10-year Treasury yield moved up 32 basis points (0.32%) last week, which has already caused quite a bit of bleeding in the financial community. But bankers aside, the key question here is... whither long-term borrowing rates for corporates and households? And to what extent might the Administration’s tax “compromise” undermine the recovery by raising financing costs due to perceptions of fiscal profligacy?

Let’s see. Clearly, the rise in 10-year yields was not just due to fiscal concerns. According to a survey (of traders and buy-side participants) that I saw, a bit more than a third of those surveyed thought it was due to a higher growth outlook and between a quarter and a third thought it was because of the fiscal implications.

It is my personal view that the market is overestimating the growth impact of the “stimulus.” As I explained above, the economy has heterogeneous agents: But those who are unemployed, over-indebted and cash-constrained (and who would be more likely to spend any extra cash) are getting very little help; while those with jobs and comfortable cash positions are getting most of the help. In this sense, a downward revision in the market’s perception of the growth impact might actually lower long-term borrowing rates.

On the other hand, the fiscal risks are underestimated in my view, which doesn’t bode well for borrowing costs going forward. It’s not that I have in my possession the perfect fiscal-sustainability model of the US economy. It’s because it is now clear that the American government (and I include both parties under “government”) has once again shown to be incapable of introducing targeted measures that tackle the root of the problem and that have the biggest bang for the taxpayer’s buck.

Such policies would include measures (e.g. cash transfers) to facilitate the deleveraging of underwater households; measures to support the retraining of the unemployed, and thus avoid skills-erosion due to prolonged unemployment; and a bipartisan commitment to a more predictable regulatory environment and a sustainable fiscal outlook, so that businesses can plan for the long-term, including in their hiring.

In this context, describing the measures proposed last week as a “compromise” would be laughable, if one actually had the luxury to laugh with the US fiscal outlook. But in the current situation, they are dumb at best, if not potentially damaging.

Global Imbalances and the War of Attrition

Back in 2005, Ben Bernanke, then (“just”) Governor at the Federal Reserve Board, coined the term “global savings glut” to describe the “significant increase in the global supply of saving” that, as he argued, helped explain the increase in the US current account deficit and the low level of global real interest rates.

In short, a deliberate rise in emerging market (EM) savings from c. 2000 onward flooded the world with cheap money, helping finance an ever-widening US trade deficit and contributing to the perverse lending incentives that eventually led to the 2008 financial collapse.

Five years later, Ben has a chance to restore the global savings-investment landscape; i.e. help force a “correction”, in the form of an exchange rate adjustment and/or a decline in EM net savings. The key here is to recognize that a repeat of the EM savings glut story is less feasible because of important differences between then and now. And the Fed has the capacity to make it, if not impossible, at least extremely costly.

The first difference is that, back then, crisis-ridden EMs in Asia, Latin America and Eastern Europe saw a need to raise their savings in order to pay down foreign debts acquired during their crises. Today, with the EM deleveraging more or less done (or not as urgent), this channel for absorbing any accumulation of dollar (or euro) reserves is no longer there.

Secondly, in the aftermath of the 1990s EM crises, many EMs saw a need to increase their resilience to foreign “hot money” with a commensurate increase in their foreign exchange reserves. This may have been possible then, but it’s considerably less so now, partly "thanks" to Ben's QE.

The reason is that this “asset swapping” from the US to the EMs and back can come at a cost: An EM central bank effectively borrows at the local short-term interest rate (the cost of sterilizing the inflows) to purchase medium/long-term US Treasuries.

For countries with historically high interest rates (e.g. Brazil, South Africa or Turkey), sterilization costs have always been high, so the "insurance" benefits of any additional FX reserve accumulation have had to be juxtaposed against such costs. However, for low-interest rate countries (incl. China, Malaysia, Singapore, Taiwan or even Korea) the “cost” of sterilization during the boom years was actually not a cost but a profit! Yields on, say, 5-year US Treasuries rose from around 3.2% at end-2003 to about 5% in 2007, which was above these countries’ short-term interest rates (i.e. they enjoyed a positive “carry”).

Today, the “carry” has turned negative even for coutnries like Malaysia and China, due to the extremely low nominal US rates across the US yield curve. This makes EM FX accumulation financially costly and politically unpalatable.

On top of that there is a third important difference: Back in the “2000s”, many EMs were operating at below-full capacity, either because of the crises of the late 1990s or because of a structural excess in the supply of unskilled labor (e.g. China). In that context, they saw it fit to promote export-led growth through an “undervalued” exchange rate, while domestic demand remained weak, and in the process maintain relatively loose monetary conditions at home.

Today, domestic demand in some major EMs is rising fast, putting pressure on inflation. Under normal circumstances, this would point to either an increase in imports to meet excess demand (--> a gradual closing of the imbalances) or a rise in interest rates to curtail demand—although the latter would come at the “expense” of a more costly sterilization of any FX interventions due to a more negative carry.

An alternative route of course is to respond by trying to cutrail foreign inflows through the imposition of taxes (or other controls) on foreign capital. But these can only be at best a temporary solution, not least because the EMs themselves do not want to stop all capital from entering. This creates an assortment of loopholes for willing, yield-seeking investors to find their way in. And in case one needed further evidence of the long-term ineffectiveness of capital controls, I'd say, "ask China!"

In that case, the Fed arguably holds the key for the reshaping of the global savings-investment landscape: If it could credibly commit to keep nominal US yields at ultra-low levels for a sufficiently long time, it could force EM action by turning current policies financially costly (through an increasingly negative carry) and politically difficult to sustain.

Of course, that's a big if. First because, unless low rates reflect (very weak) US economic fundamentals, the Fed will have to devote an increasing amount of resources to hold rates down. And the more Treasuries it buys, the larger the negative-carry costs on its own balance sheet, when the time comes to raise its own policy rate beyond 2.5-3%.

Second, in light of the widespread (and misinformed, I might add) outcry against QE in the US, it is questionable whether the Fed can credibly commit to mobilizing sufficient resources to keep yields low for long enough—that is, for longer than many major EMs can sustain their own distortionary policies.

Against this backdrop, global monetary policy-making has not been reduced to a global currency war, as Brazil's Finance Minister recently suggested. It is rather a war of attrition.

Cross-border deleveraging and the shifts in Europe’s bargaining game

While high-ranking eurozone bureaucrats are ruminating on the appropriate burden-sharing mechanisms of a future Europe, something potentially more momentous has been going at the background: European banks have been cutting back their intra-European exposures… fast!

The numbers are pretty stunning: Between December 2009 and June 2010 (the latest data available from the BIS), German banks cut their eurozone claims by $180bn (more than 5% of German GDP). French banks cut their own exposure by near $280bn (10%of French GDP), of which $130bn were claims on Italy and Spain. And Dutch banks cut their eurozone claims by $170bn (about 20% of Dutch GDP), with cuts across the board, from Spain, Ireland and Greece to Italy, Germany and Belgium. One can only assume that the cutbacks have continued in full force post-June.

This “deleveraging” has important implications for the core-periphery bargaining game and the future of the euro.

First, from the perspective of the stronger, core economies, a meaningful reduction in intra-European exposures means that the threat to the core’s financial stability from an adverse outcome at the periphery is smaller. In turn, this allows the core's governments to consider a more “sober” crisis resolution framework, ie one that is more discretionary and fundamentals-driven vs. one that is indiscriminate out of fear of a disorderly outcome.

What would “discretionary” really mean? Based on the ERM experience back in 1992/93, it could mean the following:

(a) For countries with no obvious fundamental misalignment (e.g. France): an explicit, large-scale and comprehensive liquidity backstop, aimed at killing any aspiring “self-fulfilling prophets.”

(b) For countries that are small (ie not systemic on their own) and in need of a sharp fiscal adjustment (e.g. Greece, Ireland, Portugal): the provision of short-term liquidity-support mechanisms conditional on the maximum possible fiscal effort, before the inevitable correction is forced upon them. (In the same way, many countries were forced to devalue their currencies back in 1992/93 in line with their fundamental misalignments, after Germany did not provide the liquidity support that would be necessary to stem the speculative attacks).

(c) For countries that are larger and, thus, a systemic threat (Spain and Italy): A strategy that buys time to allow the core economies’ private sector to exit before things escalate. This is exactly what has been happening (intentionally or not): By tackling the eurozone crisis in a piecemeal, reactive fashion, core economies have effectively bought time for their private sectors to unwind their positions in a stable environment—i.e. a common currency and an orderly payment process.

In the process, the systemic importance of Spain and Italy is gradually being reduced, improving the core governments’ ability to provide (if and when that time comes) liquidity support under their own terms.

This brings me to the second implication of cross-border deleveraging, which has to do with burden-sharing and the perspective of the peripheral countries themselves. With cross-border exposures cut, the burden of adjustment (be it fiscal consolidation and/or debt restructuring) has been shifting away from external creditors and towards the residents of the weaker peripheral countries.

This poses a natural question: What’s the appeal of eurozone membership for Greece, Ireland or Italy for that matter, in the absence of an acceptable degree of burden-sharing between debtors and creditors? And even more so, when it implies the long-term surrender of fiscal sovereignty to the “troika” of the IMF, the ECB and the European Commission? Instead, exit from the euro (with the inevitable default) would shift part of the burden to the core through an immediate improvement in the periphery's external competitiveness. It would also shift part of the debt burden to any external creditors are left, private and official (barring the IMF, which has preferred creditor status).

For these reasons, the ongoing cross-border deleveraging, and the resulting “thinning out” of the threads that tie the eurozone countries together, can mean either of two things for the euro: Either the governments of the core will demonstrate their will to share part of the burden of adjustment, in the form of a fiscal transfer rather than just liquidity support; or peripheral countries will find the unilateral assumption of the fiscal adjustment burden unacceptable, economically and politically… in which case they’ll opt out.

Under fresh light, Iceland may no longer feel too unhappy it's not Ireland.

Can there be such a thing as an “orderly” restructuring?

As EU and IMF officials set about to negotiate their second rescue package to a eurozone member in a year, more and more voices are calling for the “orderly restructuring” of peripheral countries’ debt as an integral component of a crisis resolution framework.

The idea is that, when the debt dynamic is unsustainable under most doable fiscal consolidation scenarios, pouring more official money into the problem amounts to “kicking the can down the road” rather than begetting a permanent solution.

A key advocate of this view has been Nouriel Roubini, who in a recent paper called for an “orderly, market-based approach to the restructuring of Eurozone sovereign debts” to deal with any insolvencies now, avoid the deferral of tough choices later and contain moral hazard.

My objective here is not to challenge the “kicking the can down the road” argument, which is of course correct. Neither am I going to discuss whether Greece , Ireland or, indeed, Italy are illiquid or insolvent. Instead, I want to examine whether it is at all possible to achieve the “orderly” restructuring that Nouriel and others propose in the specific case of the eurozone.

The focus on the eurozone matters: It is not particularly constructive, nor relevant, to evoke (as Nouriel does) the experiences of Pakistan, Ukraine, Uruguay or the Dominican Republic in order to shed light on what might happen if Greece or Ireland decided to “bail in” the private sector. These countries’ GDP is tiny, and so was the debt they restructured. To give you an idea, Pakistan restructured $608 million (with a “m”), the DR $1.5bn, Ukraine $3.3 billion and Uruguay around $5.5bn 1/. Greece ’s $420bn of public debt is far more prone to a disorderly outcome by virtue of its size and also due to Greece’s association with other fiscally vulnerable eurozone members.

Second, manageable initial debt-to-GDP ratios in those countries meant that sustainability could be achieved with only a small NPV reduction: Per the IMF, the NPV reduction was just 2% for the DR, 5% for Ukraine and 8% for Pakistan. In Uruguay, which had a comparable (though still smaller) debt-to-GDP ratio to Greece’s 133%, the NPV reduction was 13%. But I should point that Uruguay achieved fiscal surpluses of the order of 3-4% immediately, rather than 3 years into the IMF program, which is what is envisaged for Greece (IF ever feasible).

Let's also note that where the necessary NPV reduction was large (Argentina: 75%; Russia: 44%), the restructuring was not exactly an “orderly” one—and neither was it pre-emptive.

So much for the precedents. What can we say about the potential for an orderly restructuring in the eurozone today? First, let’s define what we mean by orderly, which, in my view, requires three elements:

1) Participation should be largely voluntary. A high degree of investor coercion can lead to a larger number of hold-outs that makes the process lengthier and messier. More importantly, a precedent of coercion in one eurozone member could prompt wary investors to stampede out of other vulnerable members, turning one country’s crisis into the self-fulfilling eurozone domino everyone dreads. This potential for contagion (through trade and financial linkages and/or by association) cannot be overstated when talking about eurozone members in my view.

2) The restructuring, along with the policy mix adopted by the debtor country, should restore debt sustainability under reasonable macroeconomic scenarios. It should also help achieve a prompt return to market financing.

3) The NPV reduction in the debtor country should not shift the crisis elsewhere in the eurozone (e.g. via the banking system).

Clearly these elements are usually conflicting—and more so in the eurozone. For a largely voluntary restructuring, the NPV reduction offered must be attractive compared to the alternative. In this context, Nouriel suggests that a restructuring be “market-based” (ie reflecting the going market value of the debt): after all, with Greece’s long-term bonds already trading at 50-something cents on the dollar, investors should voluntarily accept a 40-50% NPV reduction and do so in an orderly way, right?

In my view, such a “market-based” offer is not at all a guarantee for an orderly restructuring. First, because the “market value” can change swiftly once restructuring becomes a certainty (see what happened to peripheral spreads once Angela Merkel began to talk about bail-ins). Second, the threat of contagion cannot be overstated. What looks like a sustainable debt level in Spain (or Italy ) today might not be tomorrow, if the market decided to turn its attention there.

Third, many of the holders of the debt are banks that have yet to mark-to-market their sovereign debt holdings. Here, Nouriel’s proposal is an exchange offer that preserves the debt’s face value but prolongs the maturity and reduces the coupons. This would surely help these banks avoid immediate write-downs and the concomitant capital adequacy problems; but it would also “lock” their balance sheets with assets they cannot sell for years to come (unless they are ready to take the losses), preventing them from using their capital to lend to the productive sector. This might be “orderly” from a short-term financial-stability perspective, but it’s certainly suboptimal for the eurozone’s growth outlook.

So under what circumstances can we then have an “orderly” restructuring in the eurozone? In my view, a “pre-emptive” and “orderly” restructuring is only possible if the likes of Germany and France are ready to provide a credible commitment to backstop all the fiscally vulnerable eurozone members either directly (through a generous fiscal transfer that helps achieve debt sustainability) or indirectly (through an explicit capital backstop to their own financial sectors, which are the main holders of peripheral debt).

Note that I am *not* calling for a pre-emptive restructuring for Portugal, Spain or Italy here; nor am I talking about the establishment of a European Sovereign Debt Restructuring Mechanism or Credit Resolution Mechanism which, as Nouriel argues, is not necessary. I am talking about a credible and comprehensive backstop to cover the losses of any necessary debt restructuring, across the board, by the financially stronger governments.

Such a backstop might be anathema to the Germans, but the economic case for holding their nose and plunging into the “cesspool” can be compelling: German banks’ exposure to the PIGS (“I” for Ireland ) is around $500 billion (BIS data); that of French banks is around $400bn. This sets a clear ceiling as to the potential liability borne by the taxpayers if the crisis is contained to the PIGS.

In contrast, in the event of a piecemeal approach that leads to a systemic crisis, the size of their taxpayers’ burden becomes indeterminate: Not only will the likes of Italy be vulnerable (talking about “systemic”); but the negative wealth effects from a collapse of Europe’s financial markets would be extremely adverse for the growth outlook, especially as the global economy is still at a very fragile state.

Bottom line, it is wishful thinking to talk about an “orderly” debt restructuring when that involves a piecemeal, country-by-country approach that leaves the rest vulnerable to speculative attacks. It is also wishful thinking to talk about “market-based” approaches, given the flimsy nature of market values and the implications for the health of eurozone banks. An orderly restructuring is indeed achievable, provided it is backed by a credible backstop by the financially stronger governments. It is also desirable: the alternative won’t be pretty for anyone…

1/ Source: “Cross country experience with restructuring sovereign debt and restoring debt sustainability”, IMF 2006

The “misoverestimated” surpluses and the tax-cuts debate

One of the most stunning statements in George W Bush’s recent memoir, “Decision Points”, is his response to accusations that he squandered the budget surplus he inherited from the Clinton administration. According to an MSNBC report, Bush writes:

“Much of the surplus was an illusion, based on the mistaken assumption that the 1990s boom would continue. Once the recession and 9/11 hit, there was little surplus left.”

The irony runs deep: Back in 2001, the projected “surpluses” had been the very premise underlying the Bush tax cuts, which, supporters argued, would serve to refund to Americans the over-charge on their taxes.

But with the surplus premise now defunct even by the tax cuts’ own creator (let alone by the glaring misery of America’s fiscal outlook), are there any arguments left to support their extension beyond their scheduled expiry at year-end?

Obviously, the #1 argument made by frightened policymakers from both the right and the left is that the economic recovery is still at too fragile a stage to engage in contractionary fiscal policies such as the repeal of the Bush tax cuts. But the argument is misplaced. First, because the stimulative effect of the Bush tax cuts—as designed—is not as obvious as their multi-billion dollar cost would suggest; and second, because the alternative does not have to be the absence of any other stimulus measure.

Expanding on the first point, it is useful to consider the arguments made by William Gale and Peter Orszag in a 2004 paper, which assessed the impact of the Bush tax cuts, including as a stimulus against the 2001 recession.

The authors argued that the tax cuts were poorly designed as a stimulus measure for a number of reasons, many of which continue to apply today: First, they had a regressive nature—i.e. they were not primarily targeted to the (lower-income) households with the highest marginal propensity to consume.

Second, some of the provisions (e.g. estate tax repeal, and increases in tax-free savings allowances) were designed to increase saving, not consumption.

Third, by contributing to a large fiscal hole (to the extent they are not offset by spending cuts), they generate uncertainty about the government’s finances, which could undermine future investment by increasing volatility in capital markets.

Finally, the authors cite research by Economy.com that estimated that the measures with the highest “bang for the buck” (always from a stimulus perspective) were the extension of unemployment benefits, the aid to state governments and measures that targeted low- and moderate- income households, including the child tax credit rebate and the acceleration of the 10% bracket.

In short, the call to keep the Bush tax cuts out of fear of undermining the economic recovery has shaky economic foundations, and certainly does not stand when made by those who consider a fiscal “stimulus” as anathema. Further government support to the economy (to the extent it is politically desired) can be provided by alternative measures that are better targeted, temporary and cheaper (ie with a bigger bang for the buck).

A second argument for maintaining the Bush tax cuts is that lower revenues encourage spending restraint. Well… if only! In fact, not only is this argument disproved by the spending track record of the previous administration; steps to reduce spending can be made politically difficult by the fact that the prime beneficiaries of the tax cuts are not the same as those affected by the potential spending cuts. In other words, the bargaining game on how to restore fiscal discipline is easier when spending cuts can be “traded” for selected tax increases.

A final argument has to do with efficiency: lower taxes tend to foster incentives to increase labor supply, saving and investment. But, as argued by Gale and Orszak, the Bush tax cuts, as designed, were not ideal from an efficiency perspective. Labor supply incentives tend to increase with decreases in a worker’s marginal tax rate and, per the authors estimations, this did not change for some 40% of taxpayers. The latter is partly because the nominal cuts in the tax rates are irrelevant for households subject to the alternative minimum tax (AMT).

In addition, the Bush tax cuts have not provided a stepping stone for a true, fundamental reform of the tax system—one that is geared towards a consumption (rather than income) tax, one that broadens the tax base, one that addresses the “double taxation” on corporate profits, one that treats the interest income and expense equally, and so on. Such reform will have to wait until Congress is ready for a constructive debate on the tax code. It has little to do with the Bush tax-cut extension.

In light of the above, it is pretty baffling that voices from both the right (who supposedly care about tax efficiency, fiscal discipline, etc) and the left (who supposedly care about equity, progressive taxation, social spending, etc) have been “terrorized” into maintaining a set of measures that is faithful to none of their respective “credos”. And it will be unfortunate (and potentially explosive) if the debate on government finances does not manage to graduate into a cooler, economics-driven discussion in the months ahead.

What do the Fed's policy and poker have in common?

It is no accident that, at the last FOMC meeting, one of the “outsiders” present was NY Fed economist Gauti Eggertsson, of Eggertsson and Woodford (2003) fame—the paper he co-authored with Michael Woodford discussing a central bank’s policy options when nominal interest rates are near the zero bound.

Two of the paper’s conclusions could point to the Fed’s thinking in the months ahead, in my view. First, that quantitative easing is redundant as a tool for preventing deflation, over and above central bank commitments with regard to the interest-rate path. (Although some of the assumptions they make can be challenged, especially for situations like 2008/09, where markets were dysfunctional). In the words of the authors,

“neither the extent to which quantitative easing is employed when the zero bound binds, nor the nature of the assets that the central bank may purchase through open-market operations, has any effect on whether a deflationary price-level path will represent a rational-expectations equilibrium. Hence the notion that expansions of the monetary base represent an additional tool of policy, independent of the specification of the rule for adjusting short-term nominal interest rates, is not supported by our general-equilibrium analysis of inflation and output determination.” (my emphasis)

Second, rather than quantitative easing, the optimal policy consists of a commitment to a “history-dependent” rule driven by the price level (i.e. not the rate of inflation of the consumer price index). Under that rule, the central bank commits to a given path for the level of the price index, and undertakes to make up for past inflation shortfalls (which would drive the price level below the target) by allowing future inflation to be sufficiently higher to bring prices back up towards the target path.

The motivation behind a rule like this is to bestow the central bank the ability to manage inflation expectations (and, thus, control the level of the real interest rate), even when the nominal rate is stuck at the zero bound. By raising inflation expectations, the Fed could provide stimulus by lowering real interest rates, as well as penalizing cash holders, thus forcing them to put that cash to alternative uses—consumption or investment.

While conceptually appealing, the proposed rule is vulnerable to lack of credibility. This is because, in order to conduct policy, a central bank needs not only a rule but also a tool to implement that rule. But here, the rule and the implementation tool virtually coincide: The rule is the central bank’s intention to allow higher inflation in the future in the event of past inflation shortfalls; and the tool is simply the verbal expression of that intention.

This makes monetary policy akin to bluffing in poker: If the market buys the bluff, inflation expectations rise, real rates fall, cash gets spend, aggregate demand recovers. But why would the market buy the bluff, if, for example, it suspects that the central bank will renege on its “promise” of higher inflation in the future, and that it will “cheat” by raising interest rates once aggregate demand picks up?

In short, how can a central bank demonstrate its commitment to higher inflation, besides simply stating that this is its intention?

A number of economists have sought to address this question, including Eggertsson and Woodford (E&W) in their 2003 paper. One approach, proposed by Lars Svensson involves a price-level targeting rule combined with the pegging of the domestic currency to a foreign one after it has been depreciated by a certain amount. By pegging to the currency of a trading partner that is experiencing (positive) inflation, the central bank can demonstrate that it is serious about generating inflation at home.

Clearly, while this might be a tool available to countries like Japan or Sweden (the latter being the only country to have actually experimented with price-level targeting in the 1930s, and one that involved an eventual peg to the British pound), it is not a policy available to the Fed today.

A dollar devaluation would be unacceptable to any one of the three major economic areas (the EU, the UK and Japan), given that they face a similar economic quagmire to that of the US. And of course, a peg to a basket of emerging market currencies is not credible, given that the size of foreign asset purchases the Fed would have to make would be too large compared to the size of these markets—not to mention the capital controls (see China) that prohibit the entry of foreign players into domestic markets.

So is the Fed powerless? Not entirely. But the solution rests on calling a spade a spade—or, in the current context, calling the Fed’s large-scale asset purchases of (domestic) Treasuries (or LSAPs) “debt monetization.” In this way, the LSAPs can serve as the tool with which the Fed can make its commitment to higher future inflation credible. E&W make this point:

“[T]he tax cut can be financed by money creation, because when the zero bound binds, there is no difference between expanding the monetary base and issuing additional short-term Treasury debt at zero interest. This is essentially the kind of policy imagined when people speak of a "helicopter drop" of additional money into the economy, but here it is the fiscal consequences of such an action with which we are concerned.

[I]f the central bank also cares about reducing the social costs of increased taxation—whether because of collection costs or because of other distortions—as it ought if it really takes social welfare into account, the result is different. As Eggertsson has shown elsewhere, the tax cut will then increase inflation expectations, even if the government cannot commit to future policy.”

The bottom line here is one I’ve been arguing all along: that the only real way to boost aggregate demand at this stage is through a fiscal operation—one that is targeted towards safeguarding the economy’s productive capacity and/or facilitating the deleveraging of companies and households that remain overwhelmed with debt. (Mind you, this is not necessarily something that I, as a taxpayer, would be crazy about—I am talking strictly on economic grounds.)

The Fed’s role in this operation would be to facilitate its financing and, in the process, raise inflation expectations and help the economy avoid falling in (or escaping from) a liquidity trap. In other words, the stated motivation behind any LSAPs should not be the so-called “portfolio balance” effect (whose impact is doubtful at this juncture) but the outright monetization of government debt.

How likely is that the Fed will come out and say so on November 3rd? Don’t hold your breath—especially with a pretty nasty US midterm election a day before! In which case, the Fed’s policy will continue to resemble bluffing in poker for a little while longer.

Ben’s new rabbit: Inflation expectations

Once again, we find ourselves holding our breath for a new fluffy rabbit coming out of Ben’s hat on November 2nd (the day of the next FOMC meeting). In previous pieces I have discussed the limitations of unconventional measures (QE in particular) in stimulating aggregate demand. Here, I want to revisit this discussion in light of Bernanke’s new magic trick: that of managing inflation expectations.

The starting point is the two principal factors restraining aggregate demand currently: First, the ongoing balance-sheet repair by a certain segment of households, corporates and banks; and second, the fact that economic agents that are cash-rich maintain a strong preference for liquidity. Put differently, those with little cash and lots of debt can’t spend; and those with lots of cash and little debt won’t spend.

So the question is: What tools does the Fed have available for addressing these two problems? Pre-empting my conclusion, Large-Scale Asset Purchases (or LSAPs) of US Treasuries are an ineffective—indeed, a counterproductive—tool for addressing any of the two problems above; the kind of LSAPs that would work are *not* available to the Fed in the current political climate. But there is certainly hope in the Fed’s intention to manage inflation expectations. The issue there is where exactly inflation expectations should be guided towards, and how best to achieve that.

Starting with balance-sheet repair... I have argued before that the Fed’s LSAPs of mortgage-backed securities (MBS) and US Treasuries (ie "QE 1.0") have not been an effective tool for tackling the problem. This is because, by design, they fail to target those segments of the economy undergoing balance sheet repair.

As an example, the drop in mortgage rates that followed the Fed’s MBS purchases helped prompt an increase in mortgage refinance activity. But the cash boon from lower mortgage payments only benefited people who could afford to refinance—ie those with jobs, income and positive equity in their home, instead of the cash-strapped households facing foreclosure. Meanwhile, foreclosures kept on rising as recently as September 2010.

Ditto for corporates: Large firms with access to capital markets benefited from higher investor demand for “safer” fixed-income assets such as high-grade corporate bonds (arguably triggered by the LSAPs). But small firms with no capital market access continue to face tight lending standards.

Against this backdrop, for any new LSAPs to work, the Fed would have to be far more adventurous in terms of the assets it purchases (for more on this see here and the comments on that piece). Unfortunately, in the current US political climate such an “adventurous” LSAP program is not an available policy tool—esp. since it would require the cooperation of the Treasury. So what’s left?

Come out the new rabbit—the guidance of inflation expectations. There are two issues here: First, how does the management of inflation expectations help stimulate aggregate demand? Second, what should “managing inflation expectations” mean at this juncture and how can the Fed best achieve it?

Starting from the first question, there are two ways in which the guidance of inflation expectations can help aggregate demand at this juncture. First, by preventing real interest rates from increasing to undesirable levels: with nominal interest rates at record lows, sustained declines in inflation expectations would translate into rising real interest rates—a rise that the Fed would be unable to “fight” by cutting the nominal interest rate further. Hence the need to work on the inflation-expectations front.

But the *appropriate* management of inflation expectations can go further in my view. It can help address the second problem I mentioned in the beginning—agents’ preference for liquidity.

Currently, with inflation (and inflation expectations) at low levels, holding cash is “cheap” because of the low opportunity cost. But an increase in inflation expectations would make holding cash expensive, provided it is accompanied by a Fed commitment to keep nominal short-term rates low even if inflation eventually exceeds the Fed’s medium-term “target”. Note that in the absence of such a commitment, agents would expect the Fed to raise short-term rates as inflation moves higher. This which would in turn preserve their real return on cash, eliminating the incentive to switch into less liquid investment instruments, consumption and/or hiring (in the case of corporates).

Put simply, in order to facilitate a switch away from cash, the Fed has to commit to allowing inflation to go above its medium-term projection. Now, before you accuse me of pushing the Fed into some treacherous territory, check out what Ben said on Friday:

Recognizing the interactions between the two parts of our mandate, the FOMC has found it useful to frame our dual mandate in terms of the longer-run sustainable rate of unemployment and the mandate-consistent inflation rate.

Repeat: “mandate-consistent.”

Later in that the same speech, Bernanke added that

“The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below.”

Now that’s for the “longer-run”—i.e. beyond 2012. In my view (and that’s just *my* view), the “mandate-consistent” inflation in the nearer-term is above that level, precisely for the reason I mentioned above: Economic agents with lots of cash at hand need an incentive to part with their cash.

So much about the economic rationale. How about implementation? In my view, hints of such an approach were given by Bernanke on Friday:

A step the Committee could consider, if conditions called for it, would be to modify the language of the statement in some way that indicates that the Committee expects to keep the target for the federal funds rate low for longer than markets expect [my emphasis]. Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations.

The problem with Ben’s specification however is that “longer than markets expect” does not condition the period of low rates on the inflationary path. As such, it falls short of achieving the liquidity-preference objective I mentioned above.

But there is also a second problem (read “systemic risk”) with the Fed’s overall policy framework—one that brings me back to reiterating (for the nth time) my aversion to the LSAPs. This is the inconsistency between the Fed’s attempts to “force down” long-term yields to levels that are misaligned from the Fed’s own medium-term targets for inflation and growth!

Basically, it’s one thing to intervene in order to correct a misalignment of asset prices from fundamentals (like the Fed did with its liquidity interventions in 2008). It’s another thing to intervene in order to engineer a misalignment of asset prices away from fundamentals—the very fundamentals you (Fed) are trying hard to achieve! This latter is not only non-credible; it is also dangerous, as it creates bond-market bubbles that can unwind with potentially disruptive effects for the financial system (it’s no accident that the hot topic at the IMF meetings last weekend was when will the bond bubble burst).

So with all that in mind, my call to Ben would be “a little more inflation and a little less LSAPs please”. LSAPs of Treasuries or MBS have little power to stimulate aggregate demand but carry too many risks for the financial system. Instead, the FOMC should find the language to convince the world that a little more inflation in the near-term is the way to go.

QE and its unintended consequences

In raising the possibility of QE2 at his Jackson Hole speech, Ben Bernanke mentioned two potential costs that would have to be assessed against any benefits of a QE - round #2, before the Fed makes a decision to that effect.

One had to do with the potential rise in inflation expectations due to perceptions that the Fed would have difficulties unwinding its vastly expanded balance sheet in the future.

The second had to do with economists’ insufficient understanding of the exact impact of central bank asset purchases on financial conditions (let alone aggregate demand). As Bernanke put it, “we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. […]. [U]ncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.”

Here, I want to add a few more potential risks into the list: Are there any unintended consequences of the Fed’s asset purchases (and low-for-long interest rates more broadly), other than a possible spike in inflation expectations? For the sake of brevity I’ll just keep a list format, with the intention to elaborate on each one of the issues separately in future pieces.

So the first concern has to do with the potential systemic risks associated with the behavior of institutions such as insurers and pension funds in an environment of low (and falling) long-term interest rates. For starts, falling interest rates have increased the net present value of their liabilities (and have lengthened their duration). This does not have to have a negative balance sheet impact, provided that the asset side of these institutions benefits from matching capital gains as interest rates fall.

However, news reports and market talk suggest that this is not what has happened: Before the Fed’s hint of QE2, expectations that long-term rates had to go up from record low levels saw many institutions holding conservative duration exposures on the asset side of their balance sheet. The result has been a smaller gain on the asset side (with the concomitant increase in the funding gap) and a recent push towards long-duration positions to address the duration mismatch between assets and liabilities. The “systemic” risk here is that, if and when long-term yields begin to rise, the unwinding of these positions can lead to a much sharper rise in yields and volatility in the bond market.

A second concern has to do with the hedging behavior of mortgage/MBS investors. Low interest rates increase the probability of refinancings and, as a result, reduce the expected duration of MBS securities (and the underlying mortgages). MBS investors hedge against this prepayment risk by holding instruments of long duration, such as long-term Treasuries or interest rate swaps. Once again, if and when interest rates start going up, unwinding these positions can become destabilizing, as everyone enters the market in the same direction. (The impact of this is of course mitigated by the fact that the Fed itself holds a substantial chunk of the mortgage market).

Third on the list is the potential build-up of leveraged positions (or “carry trades”) “thanks” to the Fed’s promise of low-for-long interest rates. The risk is that crowded carry positions can unwind fast once Fed rates begin to rise, especially since the earlier leverage build-up has pushed asset valuations to stretched levels.

Now, unlike many pundits out there, I do not believe there is an empirically established causality from the Fed's policy rates to investors’ leverage. For example, the academic literature has failed to find a definitive link between the level of advanced economy interest rates and emerging market spreads (which would be obvious beneficiaries of carry trades). What does matter is investors’ risk appetite (e.g. proxied by the VIX).

And here is the challenge for the likes of the Fed: Economists do not have a complete understanding of how monetary policy affects investors’ risk-taking behavior (the so-called “risk-taking channel"). But this does not mean that it’s something to ignore, simply because it doesn’t fit into some well-established theoretical framework. More so since the framework supporting the Fed’s asset purchase program (the “portfolio balance channel”) has little to say about the build-up of leveraged positions and any associated risk from their unwinding.

A final concern—and maybe the least interesting—is the impact of low interest rates on the viability of money market funds (MMFs). Low-for-long nominal rates, combined with new regulations to increase the liquidity and reduce the maturity and riskiness of MMF investments has been squeezing the sector’s profitability. Add to that the fixed expense ratios of around 0.2-1% of assets, and the low rates can force at least some of the less efficient MMFs to closure.

The reason this is the least interesting problem in my view is that the economic impact is unlikely to be meaningful. Users of MMFs tend to be high-quality corporate borrowers who could easily tap bank or capital market financing. True, the costs of borrowing might be marginally higher, but this is most likely dwarfed by the impact of record-low interest rates thanks to the Fed's policy.

Still, I thought I should mention it, first because some economists have raised this issue in the past, and second because I was personally amused by Bernanke’s own take on this concern. Here is Ben in 2004:

“In thinking about the costs associated with a low overnight rate, one should bear in mind the message of Milton Friedman's classic essay on the optimal quantity of money (Friedman, 1969). Friedman argued that an overnight interest rate of zero is optimal, because a zero opportunity cost of liquidity eliminates the socially wasteful use of resources to economize on money balances. From this perspective, the costs of low short-term interest rates can be seen largely as adjustment costs, arising from the unwinding of schemes designed to make holding transactions balances less burdensome. These costs are real but are also largely transitory and have limited sectoral impact.”

That’s right… Bernanke (then-Fed Governor) responded by going philosophical, citing a supposed structural argument (something like, “MMFs are probably not that useful and zero interest rates can help eliminated them”), grounded on a much-debated theory (Friedman’s rule) to support a policy that is strictly cyclical in nature!

Anyway.. A mini-diversion from the main point, which is that the potential costs from further QE, and low-for-long yields more broadly, go beyond the possible rise in inflation expectations and the threat to the Fed’s credibility. Against this backdrop, any cost-benefit analysis should consider not only policymakers’ uncertainty over QE’s impact on aggregate demand but also their uncertainty about the potential risks for global financial stability.

Leaving the Plaza Accord behind

Once again, Japan’s experience post-Plaza Accord has been brought up as a mistake to be avoided, against the backdrop of the escalating pressures on China to revalue the renminbi.

This time it was Chinese economist and member of the Central Bank’s monetary policy committee Li Daokui, who said last week that "China will not go down the path that Japan did and give in to foreign pressure on the yuan's exchange rate.”

I personally find the parallel misplaced and the reason is that it confuses the legitimacy of the objective (=revalue an undervalued currency to help towards the correction of global imbalances) with the (in)appropriateness of its implementation. Still, revisiting Japan’s situation during and after the 1985 Plaza Accord can offer valuable lessons for how to do things better this time round—both for China and its trading partners.

So, the mantra linking the Plaza Accord with Japan’s subsequent economic malaise goes like this: The large revaluation of the yen prompted large amounts of speculative capital inflows into Japan which, together with a loose monetary policy, fuelled an asset bubble that then burst pretty spectacularly.

In my view, the key weakness of the argument is in its presumed causality from the yen’s appreciation to Japan’s asset bubble. Of all the factors cited in the literature as contributing to the asset price boom and then bust, the yen’s move is at best an incidental one.

First of all, the rise in asset prices, notably real estate, had been building up even before the Plaza Accord. One key reason behind the increase was the aggressive growth in credit, notably to the real estate sector. This was itself prompted by a host of structural reasons, including inter alia:

The liberalization of interest rates, which, by raising deposit rates, reduced banks’ profit margins and forced them to look for higher-yielding lending opportunities; the opening up of capital market access to corporates, which shifted part of the corporate funding away from the banks and towards the capital markets—this pushed banks to look for new clients to lend, often with higher risk characteristics; and a distorting tax regime governing the real estate sector, which encouraged the holding onto real estate assets, thus restricting supply, while demand was rising.

If there is a lesson for China here, it has little to do with exchange rate policy. Instead, it is that preventing the build-up of bubbles requires a robust regulatory framework for the financial sector—one that penalizes excessive risk-taking and dampens the procyclicality of credit (a lesson that we have come to learn yet again in the aftermath of the subprime debacle).

The second lesson from Japan’s experience has to do with the role of monetary policy in contributing to the boom and bust. And here is where the Plaza Accord deserves criticism—though not for its prescription on exchange rates!

You see, the agreement was not *just* about foreign exchange intervention to realign the nominal exchange rates; it also prescribed global coordination of macroconomic policies to correct the global BoP imbalances. This latter component was a key factor behind the Bank of Japan (BoJ)’s loosening of monetary policy during 1986-87.

As three Japanese academics document here, the BoJ had expressed concern early on about the easy money, the concomitant speculative activity in the real estate and stock markets, and the dangers of a subsequent debt deflation. However, the BoJ proceeded with rate cuts, partly in the face of pressures by its trading partners to stimulate domestic demand (these pressures were made explicit in the Louvre Accord in February 1987, under which Japan pledged another 50bp rate cut in its policy rate).

One can debate of course how big a role monetary policy in itself can play in fuelling asset bubbles of the scale experienced in Japan in the late 1980s. Indeed, those who object to the premise will find a staunch ally in Ben Bernanke! But my main criticism here is that, by calling for stimulative monetary and fiscal policies, Japan’s trading partners confused the cyclical from the structural causes of the global imbalances. The result was a monetary stance that was too loose for Japan; and the diversion of attention away from corrective measures that had to be taken by the likes of the United States.

The situation is somewhat different at the current juncture with China. First, few people dispute that the key reasons behind China’s external surpluses are structural—and, therefore, nobody is really asking China to take inappropriately stimulative measures to increase domestic demand. In the same vein, there is no doubt that structural reforms to rebalance growth domestic demand and, notably, private consumption, would be welcome by the global community.

But this is no reason to dismiss the exchange rate revaluation as *one* corrective tool: First, as I argued here, China has yet to bear the brunt of the (cyclical) correction of global imbalances since the onset of the financial crisis: Even as its own trade surplus has shrunk, the US trade deficit with China has barely moved in US GDP terms. Most of the US adjustment has been borne by other countries.

Importantly, a large exchange rate undervaluation in a country as large as China contributes to the misallocation of global resources—e.g. by prolonging the survival of inefficient companies/exporters in China and/or by encouraging the outsourcing of business to China thanks to an artificially low cost structure.

Bottom line, evoking Japan’s experience under the Plaza Accord as a reason to rebuff pressures to revalue the renminbi is misplaced, if not disingenuous. While nobody can dispute the need for a score of structural measures to fortify the financial sector and contain the formation of bubbles in China, maintaining an undervalued exchange rate can only serve mercantilistic objectives and/or protecting certain industries at the expense of a balanced, efficient and fair allocation of global resources.

QE the Sequel: Putting Ben’s Money Where His Mouth Is

A consensus is emerging among Fed watchers that the Fed is set to embark on a fresh round of “quantitative easing” (QE), faced with a subpar employment growth and a lingering threat of deflation.

Abstracting from whether the economic outlook is such as to warrant further stimulus, I wanted to focus here on what kind of “QE” might be more effective this time round, if it were to happen.

Pre-empting my conclusion, let me say that my proposal will probably sound like the mother of unconventional measures, but it’s actually a variant of what the Chairman himself proposed back in 2002, at his famous “it” speech on deflation. But let’s start from the beginning.

First of all, “QE” means the purchase by the Fed of a certain quantity of risky assets, funded by the creation of bank reserves. The intended objective is twofold: First, to boost the price (/lower the yield) of the assets purchased (in the case of the Fed’s first round of QE, these would be US Treasury bonds, agency debt and mortgage backed securities (MBS)); and second, to affect the price of other risky assets through the so-called portfolio balance effect.

For details on how the portfolio balance channel is supposed to work you can read Brian Sack’s speech at the Money Marketeers last year (here), but here is an excerpt from that speech that sums it up:

“[T]he purchases bid up the price of the asset [being purchased] and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets.” (my emphasis)

So against this theoretical backdrop, the key questions to ask when contemplating “QE, The Sequel” are two: What assets should the QE program target in order to be effective? And, critically, who should be buying those assets?

To answer the first question, we have to have in mind the endgame, which is the desire to boost aggregate demand. In other words, the true metric for success of an LSAP program is not whether it managed to lower the yield of the security targeted (e.g. mortgage rates) but whether those lower yields translated into a material increase in aggregate demand.

By that metric, the Fed’s past LSAPs have probably fallen short. Clearly, measuring the counterfactual is impossible, but there are reasons to believe that the impact on aggregate demand was small. Why? First, because the reduction in mortgage rates boosted refinancings only by people who could refinance—i.e. people with jobs and some positive equity in their home. Not exactly the most cash-strapped ones who would have spent the extra cash.

Second, the portfolio-balance effect of the LSAPs on the prices of assets like corporate bonds or equities is at best weak, if not counterproductive. The reason (which I explained in detail here) has to do with the fact that US Treasuries and MBS are not “similar in nature” to corporate debt and equities. Unlike the latter, Treasuries/MBS have more of a “safe haven” nature—so that removing them from investors’ portfolios create demand for more “safe” assets, rather than boosting the prices of equities, high yield bonds, etc.

The bottom line here is that, while the LSAPs may have helped boost the cash position of certain financially healthy households and corporates, (a) they were not targeted to achieve a big bang for the buck; and (b) they have failed to boost agents’ risk-taking behavior—in the form of stronger consumer spending or a meaningful pick-up in employment.

Put differently, the LSAPs in their first incarnation failed (as they did in Japan) to remove the right type of risk out of the market. So what should a sequel target then?

The answer is assets in the riskiest part of the portfolio spectrum—small business loans, foreclosed properties, toxic credit card debt, and so on. Now, before I have hundreds of copies of the Federal Reserve Act thrown at me, let me touch a bit on the logistics.

Logistic #1: The “QE” operation should not actually purchase the small business loans or foreclosed properties themselves from the banks. This would be a logistical nightmare for the Fed (which would have to administer those loans), as well as giving rise to unmitigated moral hazard (why would I ever pay back my credit card debt, if the Fed stood ready to buy it off for free?) Instead, the QE operation should aim at injecting capital to banks against mark-downs on existing distressed loans.

Logistic #2: Clearly, this walks and talks like a fiscal operation, right? Well, it is a fiscal operation, with winners and losers, capital allocation to “chosen” institutions and with costs to the taxpayer. As such, the Fed is not the right institution to be in charge—it should be the US Treasury instead. So what is the role of the Fed then?

Enters Ben Bernanke, 2002:

“In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. […] If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.” (my emphasis)

Call it debt monetization par excellence. You set up a “special purpose vehicle”, which funds targeted capital injections to banks with Treasury securities. The Fed then purchases an equal amount of Treasury debt, funded by bank reserves.

The advantages of this approach are that (a) it would remove the right type of risk out of the market, in effect accelerating the “deleveraging” of the economy; and (b) it would distance the Fed from the credit allocation business. A key disadvantage of course is that many people out there (myself included) loathe the idea that irresponsible bozos would end up getting bailed out of their mortgage debt with taxpayer money.

But this is precisely why “QE, The Sequel” (and any QE for that matter) should be the explicit responsibility of the fiscal authority—i.e. an elected governing body: So as to allow voters to ultimately decide the kind of path their economy should follow. This may sound like lunacy in the current political climate, but maybe another quote from that same Bernanke speech can help strike an optimistic tone:

“In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States.”

So there.. a chance for America to show that's it's not going to become Japan.

Inequality and Growth, Revisited

As politicians debate on whether to extend the Bush tax cuts and, if yes, to who, income inequality has been brought to the spotlight not just as a social plight but also as a structural impediment to growth that should be tackled—not least by repealing the tax cuts.

Inequality is all the more topical in light of data showing that the gap between America’s richest and its poorest has kept widening, and that the US is *the* most unequal country among the advanced economies.

I therefore thought of revisiting the theoretical and empirical findings on the link between inequality and growth and see what policy implications might come out of this exercise.

As is often the case in economics, the theoretical link between inequality and growth is actually ambiguous: For each argument pointing to a negative direction, there is usually an offsetting factor going in the opposite direction.

For example, one argument is that credit market imperfections lead poor households to forgo investing in higher education for their children. High inequality is then bad for growth because (given the diminishing marginal returns on education) the average productivity of the human capital in an unequal economy is low. This is because the poor under-invest in human capital even when return on their investment would have been high; while the rich “over”-invest in human capital even as the return on their investment becomes progressively lower.

Yet, the same credit market imperfections could make inequality good for growth. This can occur if investment and innovation require large start-up costs relative to a country’s median income. In that case, inequality in the form of capital concentration would help increase investment and thus raise economic growth. 1/

Empirically, this ambiguity is confirmed, in that no conclusive link is found between inequality and growth in a panel of countries. That said, as Robert Barro shows, the relationship becomes statistically significant when one splits the group into poorer and richer countries (i.e. when one controls for the level of income).

And as it turns out, the sign of the relation is different in the two groups: In countries with very low per capita incomes, Barro finds that inequality is bad for future growth. But in richer countries, higher inequality is associated with higher GDP growth. The reason for this difference may be that factors that drive the negative relation in poorer countries (such as credit market imperfections impeding higher education) are less relevant for richer countries, so that other, offsetting factors dominate the relationship in those countries.

Now, clearly, the US falls under the “rich” category. So is the rising inequality in America good for economic growth?

In attempting to answer the question, let me first throw in another economic relationship that has seen a high degree of empirical regulatiry in the data: That between the level of per capita income (not the growth) and the level of inequality.

This relationship has the shape of an inverted U (the so-called Kuznets curve): In low-income countries, economic development leads to a rise in income inequality (e.g. as some households shift from agriculture to higher-earning jobs in industry). But as the average income levels rise, inequality tends to decline again (e.g. as more and more households shift to urban areas and earn higher incomes in the industrial sector).

In theory then, the relationship between inequality and growth could be self-stabilizing: If rising inequality in the US were good for growth, the resulting increase in the level of the (average) per capita income should help bring inequality back down eventually (per the Kuznets curve).

But here are a couple of caveats: First, one of the theoretical channels between more inequality and higher growth is through a higher investment than would be achieved in a more equal society. But Barro fails to find a statistically significant empirical relationship between the level of inequality and investment growth.

Second (and perhaps a reason for the above) is the fact that studies that use national data to examine the relation between inequality and growth (within a country) ignore the impact of the globalization of labor and capital. But under globalization, the relationship could change.

For example, from the perspective of a country with a relatively low median income and with credit market imperfections, one may not longer need a high concentration of capital (ie wealth inequality) to start-up productive investments; foreign capital could fill the gap. In that case, inequality could only harm growth by adversely affecting the development of human capital (as explained earlier) and/or the political and social stability of the country.

Meanwhile, from the perspective of a richer country like the US, with sophisticated financial markets that allow its private sector to be a leading capital provider to the rest of the world, the implications may also be different: Higher inequality/concentration of capital could well lead to higher investment—but that investment may not happen inside the US, as companies now have a broader menu of opportunities to consider.

As a result, the feedback loop I conjectured above (higher inequality-->higher investment/growth-->higher average income level-->lower inequality) may not happen… at least within the US. Instead, it helps reduce the inequality between the average American household and the workers of the countries that are the beneficiaries of that investment.

What does this mean for policymakers? Globalization is hard to stop unless one is ready to face major disruptions in the global economy and setbacks in our standards of living. On top of that, you would be intellectually dishonest to be calling for its interruption, if you're the type who argues for more equality: From a strictly intellectual perspective, you shouldn’t care if the person whose income is converging with yours is American or Chinese.

Yet, one can’t deny that people (voters) care far more about their own financial situation than about China’s progress in eradicating poverty. And to the extent that dissatisfaction at home leads to legislative deadlock or even to social unrest, this would undermine the country’s productive potential, leading to lower growth, more capital flight and more inequality.

In my view, reconciling the globalization of investment opportunities with a self-stabilizing income-inequality dynamic at home need not be impossible. This should involve first and foremost a set of policies designed to making the home country a more attractive place for global investment—by raising the quality of human capital and by catalyzing the building of relevant infrastructure that facilitates the conduct of business. This goes back to my argument last week for focusing fiscal policy on increasing total factor productivity (here).

A second area for potential policy revisionism in this context (and one I’ve heard being discussed by some Washingtonians recently) is the way America taxes the profits its companies make abroad. I reserve the right for a separate piece on this as I don’t feel informed enough to have conclusive view. The one thing I would mention though is that my analysis will be heavily biased by my trust in the unfathomable creativity of American tax lawyers and accountants!



1/ For a more comprehensive account of the links between inequality and growth see Robert Barro’s “Inequality and Growth in a Panel of Countries” and Roland Benabou’s “Inequality and Growth”.

On the demand side and the supply side: The stimulus debate

The flaming debate on how to steer the economy forward and avoid America’s “Japanification” has been dominated by two seemingly irreconcilable camps:

On one hand we’ve got the demand-side guys, who claim that Japan’s “lost decade” of the 1990s was the result of a spineless government policy reaction to the post-bubble reality... ergo the US can avoid becoming Japan by keep on stimulating itself with fiscal and monetary measures until private demand recovers.

On the other hand, we’ve got a bunch of supply-siders, who attribute Japan’s quagmire to the drop in Japan’s total factor productivity (TFP) 1/—a shock in the face of which demand-side policies are impotent.

The two schools of thought are irreconcilable only insofar as they are driven by the blind ideology of those expressing them; in economic terms, they are not.

Here, I’ll start form Japan and notably with the observation that TFP growth did in fact decline during the 1990s. (See here and here).

Now, while a TFP analysis may be useful in providing the breakdown of output growth into the contributions from labor, capital and TFP (ex post facto); it is not very useful in explaining why TFP may have fallen at any given period, let alone in forecasting how TFP might move in the future. The “why” has to rest on a comprehensive structural analysis of the Japanese economy over the past three decades, which is certainly beside the scope of this piece.

The key point here is that the observed drop in Japan’s TFP during the 1990s does not have to be exogenous (to policy). Indeed, plausible explanations as to why, allow for both the supply- and demand-side frameworks to have been at work simultaneously.

One such explanation has to do with the weak state of the financial sector after the bubble burst, and the concomitant misallocation of credit to inefficient, loss-making industries The link from bank weakness to credit misallocation goes like this: Troubled bank rolls over loan to troubled firm to avoid the pain of realizing losses on that loan. Troubled/inefficient firm remains alive for too long. TFP drops. (see here).

Japan’s story can also vindicate supply-siders, however. As highlighted in a recent speech by the Bank of England’s Adam Posen (a vocal demand-side guy), Japan’s TFP growth during 2002-08 actually exceeded that of major advanced economies (the US included). Posen presents this as evidence that Japan’s potential growth was not permanently damaged by the chronic recession.

Interestingly, part of the explanation he offers has to do with (supply-side) “structural reforms undertaken over the course of the 1990s. These included, energy market deregulation, some better utilization of women in the workforce, new entrants in retail due to the rise of Chinese and Asian production and telecoms deregulation [..], as well as financial market liberalization”.

Posen adds that “[w]hat was necessary [my emphasis] was the clean-up and recapitalization of the banking system, the further loosening of monetary policy […] and the avoidance of any further premature fiscal tightening”.

Why “necessary”? One can find the answer in that same speech: Protracted periods of recession, unemployment and financial sector weakness can lead to a destruction of an economy’s production potential. Those who stay out of work for a long time lose their skills, at the cost of lower future productivity; banks that remain weak for too long impede the allocation of resources to productive firms, per the storyline above.

As Posen states, “this is why a number of central bankers, myself included, have argued for very strong immediate response to negative shocks, so as to forestall this process insofar as possible”. In other words, fiscal and monetary stimulus policies should be geared towards preserving and expanding the economy’s production potential, while the private sector remains on the defibrillator. This is particularly relevant for the US today, where (per the latest Bureau of Labor Statistics report) the TFP of the private nonfarm business sector grew by just 0.1% in 2008—the slowest rate since 1995.

So what measures fit the bill? On the fiscal side, tax breaks for companies that retain their workers during a recession (as in Germany) or programs to build up the skills of the long-term unemployed (whereby private firms would receive government support for training unemployed workers) would be more effective for safeguarding the economy’s productive potential than the mere extension of unemployment benefits.

Similarly, programs such as the first-time homebuyer credit (not to mention the multibillion dollar transfers to Fannie and Freddie) were a complete waste of taxpayer money: They provided a boon to people (with jobs) who could afford to buy a house; and they artificially supported house prices (at least temporarily) at a time when the average American household is still enjoying a substantial positive equity in its home. Instead, fiscal policy should have focused on measures to relieve those households with negative equity in a permanent way and stop the vicious circle of foreclosures-price declines-more negative equity-more foreclosures and so on.

On the monetary side, I am planning to write a more comprehensive piece but my theoretical framework is one I already laid out here. As a “preview”, the Fed wasted the sense of urgency prevailing back in March 2009 by going after the wrong type of assets (MBS) in its asset-purchase program.

So where have demand-side fanatics fallen short? In that their prescription for fiscal and monetary stimuli is, basically, “bigger is better”. There is little link between the size, type and duration of stimulus measures and the objective of safeguarding and promoting the economy’s productive potential.

Ultimately, it is hard to disagree that accommodative monetary and fiscal policies can help an economy during a recession. The question is what measures are the ones that will help the private sector reach what Larry Summers called “escape velocity” without undermining the commitment to medium-term fiscal discipline. “Not enough” is not economics; it’s a political statement.



1/ For the uninitiated, TFP measures the impact on output of technological change, reallocation of resources, economies of scale, etc after taking into account the amount of capital and labor inputs that go into the production process. (In other words, it’s the output per unit of joint labor and capital inputs).


PS And yes, I'm back after a long summer Odyssey!