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.

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

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.

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.

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!

Merkel Places Hopes in Lysistrata Initiative

In a last-ditch attempt to get Greece to fix its public finances, German Chancellor Angela Merkel has turned to the wayward country’s cultural heritage for ideas.

In a somewhat bizarre move, the Chancellor launched yesterday the so-called “Lysistrata Initiative”, named after Aristophanes’ eponymous play, which calls on the women of Greece to withhold sexual privileges from their partners until they file their tax returns.

The call comes on the heels of a European Council report showing Germany, along with Finland, trailing far behind France, Italy, Greece and Spain (or the FIGS) in the eurozone rankings for sexual activity.

“German taxpayers cannot be asked to finance the unrestrained lives of the Greeks” said an exasperated Ms Merkel.

A senior German diplomat agreed: ”All we’re asking the Greeks is to take their strikes to a more constructive level.”

Greek women have yet to come forth with an official position on the matter. But sources inside the “Hellenic Association of Female Pensioners Under 40”, a representative group, suggest they are not entirely closed to the idea.

Reportedly, a hardline faction within the Association is pushing for a pledge to renounce all sexual pleasures, including The Lioness on The Cheese Grater (a popular sexual position with ancient roots), in the name of fiscal discipline.

The pledge would be conditional on reparations from Germany of still unspecified nature, if the strike turned out to last more than a week.

Weary that any such move would hamper productivity at a sensitive time for Greece’s debt dynamics, Greek Prime Minister George Papandreou has stepped forth with a fiery response.

He accused the Council of manipulating the statistics, with the intention of presenting the lives of the Greeks as “too lovely”.

He then moved to condemn speculators for planting rumors about a “Greek brain drain”, saying that there is “absolutely no evidence” of Greeks moving to Germany to exploit the underutilized sexual landscape.

Separately, French President Nicolas Sarkozy said his country’s top showing in the European Council report gave further support to his suggestion to include “happiness” in a country’s GDP.

He added that, by this new measure, France would overtake the United States by far in GDP per capita, compared to a shortfall of 14% currently.

The euro advanced on the news.



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Happy April Fool's!!

Bringing stability to the Stability and Growth Pact

With the financial crisis bringing formerly unglamorous professions into the spotlight (economists, accountants), a new one has come to claim its share: Statistics!

Last week, a report by the European Commission (the EU’s executive arm) on the egregious shortcomings of Greek budget statistics sent Greece’s sovereign CDS spreads to levels only below those of Dubai, Vennie and Argentina!

Without wishing to belittle statisticians, I’d like to suggest that, from a policy perspective, the focus on Greece is a convenient distraction from the much bigger problem facing the eurozone: The fact that the Stability and Growth Pact (SGP), both by its design and its implementation, has failed to bring stability to the eurozone (I’ll leave “growth” aside for now). Instead, the institutional framework underpinning the European Monetary Union (EMU)—of which the SGP is a critical component—has been responsible for the imbalances within the eurozone that are now undermining its stability.

The starting point here is that, in the absence of appropriate disciplinary mechanisms, governments have a tendency to spend beyond their means. This is not some abstract conjecture but a well-established fact, validated by empirical evidence and grounded on political economy arguments widely discussed in the academic literature (e.g. by Harvard’s Alberto Alesina).

Given this “natural” propensity, there is a need for a set of disciplinary mechanisms to work at different levels:

• Reputational/Cultural: In some countries, the “culture” of (or voters’ preference for) fiscal discipline is very strong. In that case, governments have a lot to lose (reputation and elections) by not adhering to fiscally responsible policies.
• Rules-based fiscal framework: Empirical research (e.g. by Henning Bohn or James Poterba, who examine the fiscal performance of different US states) has found stricter and better enforceable budget rules to be associated with better fiscal outcomes.
• Market discipline: In theory, markets should also help impose discipline by raising the cost (pecuniary and reputational) of unrestrained policies. (In practice, however, markets often fail to provide such discipline by reacting too late and in a non-linear fashion due to myopic behavior, benchmarking, etc).
• Discipline imposed indirectly by the monetary authority. Provided that the central bank is sufficiently independent, it could help counteract the destabilizing effects of government dissaving with a monetary policy that encourages the build-up of private saving.

Unfortunately, most eurozone members have not seen any of these applied with sufficient force. For starts, governments’/voters’ preference for fiscal conservatism is highly idiosyncratic (see Finland vs. Italy or Greece) or temporary (e.g. will to adjust in the run-up to EMU accession followed by a pause/reversal). As such, it cannot possibly be taken for granted in a monetary union of 16 members (and potentially more).

In the case of monetary policy, post-EMU interest rates were way below “optimal” for countries like Spain, Ireland or Greece. Their national inflation rates were consistently above the eurozone average, while residuals from a Taylor-like rule post-EMU have been far more negative for these countries than for Germany or France (or Finland!). This is not to say that monetary policy was necessarily inconsistent with the ECB’s mandate of price stability; I’m just highlighting here the well-known fact that this particular disciplinary mechanism does not work in a monetary union.

Market “discipline”, too, has been anything but… Eurozone members’ long-term yields “miraculously” converged towards those of Germany (spreads were uniformly around 25-35 bps!) despite vast differences in fiscal positions and track records of adjustment.

With three out of four disciplinary mechanisms out or order, the burden falls on the fiscal rules. In fact, precisely because the other mechanisms are dysfunctional, a monetary union should have extra-strict fiscal rules with extra-strict enforcement mechanisms. But that’s not what Europe got for itself.

The SGP has been lame in more than one respect. In terms of design, the 3% deficit limit, which triggers the switch from the SGP’s “preventive” (and softer) recommendations to its “corrective” (and stricter) prescriptions, misses “the” point of debt sustainability.

First, by being too weak a benchmark to promote adjustment during recoveries;
Second, by invariably creating incentives to use one-off measures, creative accounting and statistical misreporting to meet the “3%” limit;
and, third, by allowing heavily indebted members to operate under the soft, “preventive” framework when they should instead be in a permanent “corrective” phase until their debt levels decline to an acceptable benchmark (say 60% of GDP… make it 80%!).

When it comes to enforcement, well, here we are entering the ultimate territory of lameness! First, once again, the process relies heavily on the corrective arm (i.e. after countries are in trouble with high deficits) rather than the preventive arm. This means that, even when/if countries eventually adjust back to a "3%" deficit, they end up there with much higher debt levels.

On top of that, a country is not automatically deemed to be in a state of excess deficit once it crosses the 3% limit; instead, the process involves first an “opinion” by the European Commission, which is then pondered about and decided upon by the European Council of Finance Ministers! Yes, that’s the very same guys whose budgets are under scrutiny!

This sham has led to all sorts of self-serving shenanigans—like, when the Council refused to issue an early warning to Germany back in 2002, or when the Council came at loggerheads with the Commission in 2003 by refusing to adopt a decision that France and Germany were running excess deficits. (The case had to go to the European Court of Justice, which vindicated the Commission).

Against this backdrop, Greece’s case is only a symptom of a broader plague of fiscal misconduct, including by “core” economies like Germany, France or Italy. While their numbers may look less provocative than Greece’s, they are far more consequential from an institutional and macro-stability perspective.

So what should change? Here are a few proposals, either from the literature or (to my knowledge) from me:

1. Enhance the SGP definition of “corrective” trigger to include debt/GDP levels. In this context, place highly indebted members under a permanent “corrective” process of adjustment until debt to GDP declines to a more acceptable level.

2. Do away with the 3% limit on the fiscal deficit, which is subject to all sorts of creative accounting, and set instead a limit on the public sector borrowing requirement. Discrepancies between Greece’s (and not just Greece’s) deficit and its borrowing requirement (after adjusting for financing items) had been raising eyebrows for years, so it’s baffling why this “cleaner” rule has not been brought to the fore. Besides, this rule would be more direct in controlling the debt/GDP level than the deficit-based rule.

3. Adopt strict, legally binding budget rules in the national legislatures, to be monitored by non-partisan fiscal councils. Governments should be made accountable to their parliaments for missing fiscal targets, both the “preventive” ones and the “corrective” ones.

4. Establish “rainy day” funds at the national level, with a rules-based contribution system that ensures a stricter enforcement of countercyclical policies, esp. in “good” times.

5. Establish a eurozone-wide “insurance-against-crisis” scheme: There may be a case for taking explicitly into account the negative externality due to misconduct by a minority of the membership. Countries could make contributions to an insurance fund, reflecting (a) their size and (b) their riskiness (debt level in excess of, say, 60% of GDP). This would boost the incentive to bring debt down, as well as establish predictability about the orderly resolution of a crisis situation.

In sum, safeguarding the “stability” objective of the SGP (and the EMU more broadly) will take bold measures focusing on stricter and more effective rules and enforcement mechanisms, In their absence, eurozone leaders and their array of supranational institutions might as well call a summit to give the Pact a different name!

The Good, and the Quick ‘n Dirty

You look at the key housing indicators and you’re probably thinking the government’s homeowner support plan has got to be working… mortgage rates at record lows, house prices stabilizing, inventories coming down, new home sales (begrudgingly) crawling upward.

Yet, it all depends on how you define “success”… there is "temporary feel good" success… "clean up now, pay later" success… "everything/everyone but the kitchen sink" success… and success as in "targeted help to the neediest" and "permanent solutions to the root problems."

I fear that only a teeny portion of taxpayer money has gone towards this latter type of success. To see why, one has to judge whether the government’s measures are geared towards tackling the root problems in the housing sector; whether they are cheaper compared to alternatives; and whether they target the neediest.

By "root problems" I mean the excessive supply of homes for sale, demonstrated by the record housing inventories back in 2007/08; and the excessive mortgage debt taken on by people who could not afford it.

By “neediest” I mean households at high risk of foreclosure with too few resources to either relocate or trade down. In turn, by “high risk” I mean households with negative equity and a meaningful cashflow problem (e.g. due to the loss of employment or the sudden increase in their monthly mortgage payments).

The "and" is critical for identifying the neediest: According to research by the Boston Fed (here and here), negative equity alone is not sufficient to prompt walk-outs, as many have argued/feared (unless it’s at egregious levels and the homeowner does not expect to return to positive equity within a reasonable horizon). A cashflow problem is also necessary.

So now let’s take a look at the government measures:

First, you have the Fed’s purchases of mortgage backed securities (MBS) (Cost: To be determined). The purchases have boosted MBS prices, allowing MBS investors to make nice profits. Higher MBS prices have also meant record-low mortgage rates, encouraging purchases of new homes or the refinancing of existing mortgages.

The scorecard? Mixed at best. For starts, the program fails to target the neediest. Those refinancing or purchasing new homes are people who can afford to do so. OK, you might say, but doesn’t this help clean up the large housing inventories? Perhaps… but inventories can also be reduced by letting house prices fall sufficiently, instead of propping them up with artificially low mortgage rates.

Indeed, I’d say that letting prices fall would be preferable, given the fiscal cost of the likely losses on the Fed’s MBS portfolio; the complications for the conduct of monetary policy; and the empirical evidence that lower house prices alone do not prompt walk-outs by the buckets, unless there is a also cashflow problem.

OK OK, but surely the profits to MBS investors can’t have hurt, given the dire state of the financial industry last year? Yeap, profits are nice, but… MBS (and other asset) prices would equally respond to measures tackling the root problem: Excessive leverage in the household and financial sectors. Financial-sector leverage was partly addressed by the capital increases dictated by the stress tests. In contrast, VERY little has been done to reduce household leverage.

Moving on to the measures by the Treasury:

First-time home buyer credit (Cost: $14 billion so far, per the CBO): Originally the scheme offered tax credits to new home buyers, but was recently expanded to also cover long-time homeowners and/or homebuyers with higher incomes! The scorecard? Thumbs down! Yet again, the measure does not target the neediest, fails to address the leverage problem and artificially props up house prices.

Support to Fannie and Freddie (Cost: $96bn of cash infusions and $43bn of subsidies in 2009 alone, per the CBO): The idea here is that Fannie and Freddie buy more mortgages from banks (thus allowing banks to extend more mortgages); and facilitate securitization and onward MBS sales to investors by providing guarantees that insulate MBS buyers from the risk of default.

The scorecard? Thumbs down… big time! The measure fails to benefit the neediest, fails to reduce household leverage and, on top of that, is aggravating the fiscal hemorrhage, since we have yet to see *a* plan for the institutional resolution of Fannie and Freddie.

The only program providing targeted help is the Home Affordable Modification Program (or HAMP). HAMP has allocated up to $75 billion to finance the modification of primary-residence mortgages owed by people in financial hardship. But progress has been painfully slow—the CBO estimates that only a tiny portion of HAMP resources have been spent this year. (The Treasury's latest progress report on HAMP shows 651,000 active trial and permanent modifications as of end-October 2009).

Part of the problem is that HAMP rests on the collaboration of mortgage servicers, which slows down the process, on top of limiting the amount of relief provided by the modification (e.g. due to “net present value rules” in the servicing agreement). The latter is crucial since, the lower the relief, the more likely a household will eventually fall back into arrears.

What I would have liked to see instead is true relief to low-income households with little home equity and a serious cashflow problem. If the hardship is due to employment loss, monthly grants would be offered to reduce a homeowner’s mortgage burden until s/he finds another job. If the cashflow problem is due to a jump in the monthly payment (e.g. due to an unaffordable ARM mortgage obtained through predatory lending), the relief should be permanent. But to avoid the risk of the homeowner pocketing the taxpayer money and then selling the home at a profit, help should take the form of monthly grants instead of one-off debt relief.

By my count, this relief would be targeted, tackle the leverage problem and would likely be swifter by avoiding the intermediation of mortgage servicers. It would be fiscally responsible by foregoing blank taxpayer checks to people with comfortable incomes. It’s also pretty obvious… which makes it all the more astounding why the government has chosen to bypass a good solution, opting instead for the quick ‘n dirty!

A stimulus we can believe in

With the inauguration fanfare over and done with, the stimulus clock has started ticking. So as we’re getting back to business, I thought I should elaborate my kitchen-sink critique of Obama’s plan, to bring the point home and address some email commentary that was so misunderstood as to, well, hurt my feelings!

So the key problem I have with the “stimulus” package in its current form is that it confuses the distinction between a (true) stimulus and the implementation of a longer-term vision that the Obama administration may have for this country.

The former must be speedy and designed to have maximum impact, by addressing the root of the mess, while providing safety nets (e.g. unemployment/health benefits) for those who suffer while they suffer. The latter cannot (and should not) be speedy—it should be a meticulously thought plan, with a clear end-game and careful consideration of the broader measures needed to catalyze private participation in this vision, once financial conditions normalize.

As a result of this confusion, I fear we’ll be getting a “stimulus package” that is ever expanding in size (already up $50 billion in a week), piecemeal in addressing the root of the problem and, in parts, potentially wasteful.

Take financial-sector restructuring first. That’s priority no.1 for getting the economy back to its feet: You can’t talk about sustainable job creation and competitiveness, if American companies cannot finance their business plans with interest rates that make sense!

What’s the new administration’s end-game in this regard, how fast can it get there and how much will it cost?

I should say, the debate has been finally moving in the right direction (see for example the recent testimony by the Fed’s Donald Kohn). And, certainly, the wish list considered at the House is ambitious (though worrisome when it comes to potential conditions on bank lending).

But if you want to use $40-100 billion to stem foreclosures; and give money to every bank that asks for it, large, small, systemic or not; and bail out the automakers; and support new consumer lending by buying up asset-backed securities (ABS); and carve out the bad assets from banks to eliminate uncertainty over counterparty risk; and keep some money in case another bank goes bust… well, you should put a more realistic number to the “financial restructuring” component of the stimulus than the TARP’s $350 billion currently budgeted for. A number you should add to the rest of the stimulus being discussed. (And let us not forget the cost of the eventual resolution of the Fannie & Freddie quandary).

Else, it won’t be long before the second $350 billion is exhausted and the Summers/ Geithner(?) duo have to rush to Congress for yet another arduous approval process of “TARP, The Sequel”… with all the concomitant consequences for investor confidence and resumption of lending.

My preference would be for a forward-looking financial restructuring package that is bold in its size and honest in its trade-offs. Evidently, a clear communication of what's needed to resolve our mess is critical for surpassing the admittedly difficult politics involved. But hey, Obama surely can!

Then consider all the proposed spending for a clean, efficient and American energy. A laudable vision no doubt. But one that would be best discussed outside the stimulus framework and, rather, in the context of a comprehensive set of reforms designed to align private sector incentives in this direction.

You can give research grants or loan guarantees for renewable energy projects for two years. But if the private sector lacks the incentives to take over the financing of these projects, the spending will be wasteful (unless the government is willing to keep up). And arguably, with oil prices as volatile as they’ve been, and currently at $35 a barrel, these incentives may well be lacking.

Mind you, I don’t feel qualified to make specific proposals in this area myself. All I’m saying is that spending on energy and the environment should not occur in haste, under the mantra of a stimulus package. Especially since, per the estimates of the CBO, the implementation of the discretionary part of the stimulus is likely to be very backloaded—meaning little truly “stimulative” effect in the near term. Such spending should therefore be considered in the context of a more comprehensive medium-term plan. Ditto for plans to spend on other competitiveness-enhancing areas such as science & technology.

Then we have the tax cuts. As I said in my earlier post, I actually think the proposed tax cuts might be a more effective “stimulative” than tax cuts usually are, if they are seen as part of a permanent plan to increase disposable income (as per Obama’s election promise). But still. I’d rather see any permanent tax cuts as part/a first stage of a broader reform of the tax code that improves incentives for saving and investment and simplifies compliance.

Importantly, I’d like to see how the Obama team plans to reconcile the economic challenges in the short-term with the fiscal challenge of the medium-term: The large fiscal deficits “for years to come” with a credible plan to repay them subsequently... in order to avoid building expectations for higher interest rates and inflation in the future... and especially in the face of a growth in entitlements (social security, Medicare/Medicaid) that already makes America’s fiscal position unsustainable.

So there you go.. the "medium" and the short of it. Let's make that distinction clear and get the ball rolling.

Obama's bang for the buck

Obama’s economic recovery plan has begun to feel like the kitchen sink approach to fiscal stimulus. Anything goes... tax credits, spending on road repair, new computers for schools or the expansion of broadband access. And just wait for Congress’ inevitable “cherry on top”!

Interestingly, the bulk of the measures announced as part of the “American Recovery and Reinvestment” plan can be found in Obama’s pre-election promise on the future of the economy. But then, may I ask, is it a stimulus we’re getting or the entire economic agenda of the Obama-Biden ticket, only unfunded?

The latter, more or less. But let's go back to the beginning. Economic theory is not conclusive on whether discretionary fiscal stimuli can counter the impact of a downturn. (The IMF summarizes why here). By “discretionary” is meant anything over and above the “automatic” fiscal expansion that tends to come with recessions (e.g. as tax revenue falls and, say, spending on unemployment benefits rises).

Still. Since it’s easier to say you’re doing something, than to try to explain the meaning of an “automatic stabilizer”, here are a few guiding principles for discretionary fiscal stimuli:

First the three T’s:

• Timely (well, we’ve kind of missed the boat on that one, but let’s assume “better late than never” applies);
• Targeted—to get the money to those who need it most and/or those likely to spend it faster.
• Temporary—with clear sunset clauses to ensure debt does not go through the roof.

On top of these, the IMF threw out a few more in a paper last week:

• Lasting—the government should promise that the measures will last until the economic begins to recover, to reassure the public that it won’t abandon ship half way through.
• Diversified—since we’re pretty clueless about what works best, the IMF suggests trying a bit of every (wise) measure in the hope that some will work.
• Sustainable—again, to avoid the undesirable consequences of skyrocketing debt, such as higher interest rates, inflation and loss of confidence.

The idea behind all of these is, of course, to get the biggest bang for the buck.

So how does Obama’s plan fare? I’ll focus on the bigger items:

Income tax cuts: A $500 rebate for individuals and $1,000 for families, first stage of Obama’s electoral promise to cut taxes for 95% of American households. Targeted? No (95%!). Temporary? No. Bang for the buck? Perhaps, by virtue of being a permanent increase in disposable income instead of a one-off tax rebate that may be saved. Sustainable? I hold my breath (for at least a couple of years) till the cuts get funded.

Tax credits to companies for losses incurred in 2008 and 2009. An appealing idea, one might think—giving companies a bit of cash at a time when it has become a scarce commodity. But... The measure is highly distortionary, favoring troubled companies over profitable/better managed ones and, indeed, those least likely to hire or make new investments. Little bang for the buck.

A (refundable) $3,000 tax credit to companies for each new worker they hire: Hard to see how a temporary tax credit would dominate a bleak economic outlook in firms’ hiring decisions. So the measure is likely to be used (and abused) by firms who would have hired people anyway. Little bang for the buck.

How about Obama’s spending plans? Like, investments in alternative fuels, a new digital electricity grid or the expansion of broadband lines across America?

In theory, government investment has a bigger bang for the buck than tax/revenue measures: It has a direct effect on demand and long-term supply-side benefits (assuming it’s not spent on bridges to nowhere). In practice, lags in project execution and the difficulty in identifying good-quality projects soon enough makes it less effective in countering a downturn.

One way to increase the “bang” is to frontload the execution of existing, productivity-enhancing projects. This is partly what Obama said he plans to do, with $25 billion going towards the repair of roads, bridges and schools.

But how about the rest? Has the Obama team had the time to identify specific “worthy” energy/infrastructure projects that could start off as early as March? Are they indeed “worthy” enough for the private sector to take over/participate in their financing once markets stabilize? Or would the government need to keep up the subsidies till death do us part?

More generally, is Obama ready to commit, along with his “stimulus” package, to a medium-term budget framework? One that explicitly shows the meaningful reduction in spending (or increase in taxes!) that would be mandatory once the economy gets on its feet, in order to keep the debt at bay?

Ultimately, what creates jobs is confidence in a brighter economic outlook, and the availability of private financing at a reasonable cost to fund productive investments and create jobs.

A crucial step to this end is a credible commitment to keep the debt under control, at a time when (per the estimates of the Congressional Budget Office) the deficit will reach at least $1.2 trillion this year, before any stimulus plan is counted. Another is to fix the financial markets.

If you ask me, I’d rather see a much smaller stimulus package. One that focuses on safety nets (e.g. health and unemployment benefits to the unemployed); and on the effort to resurrect the financial markets and reduce the cost of private financing from its current obscene levels. Throw in some money to stem foreclosures for fairness’ sake, if you please. But beyond that, I’d rather see all the PhD talent of the incoming economic team devoted to designing appropriate structural reforms that improve the incentives of the private sector to function efficiently.

Meanwhile, Barack, if you’re having trouble with the meaning of “automatic stabilizer”, I can help with the speech. I promise to make it short, succinct and simple.



Glossary: automatic stabilizer, discretionary fiscal stimulus, bang for the buck