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Updated: 2018-03-06T04:26:16.738-05:00


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!(image)

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 r[...]

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, com[...]

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[...]

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[...]

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-b[...]

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 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[...]

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 on[...]

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 [...]

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 invest[...]

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 ca[...]

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 spec[...]

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 [...]

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[...]

Can this be for real?


I don’t know if it’s just me, but there is something disturbing about the recent market behavior. If one were to proxy the state of the (real) world with the stock market index, one would have to conclude that consumers, businesses and governments have turned into schizophrenics.Surely, that’s not the case (though I’ll reserve my judgment about the latter group for later). News regarding the economic outlook has been by no means commensurate to the vertical moves we saw in the market last week. But since many have already thrown the “efficient market hypothesis” out of the window, here I’ll focus on a somewhat different question:Is it possible to get a negative feedback loop, from volatile—or declining—markets to the real economy (and back to the markets) and turn the sudden shift in investor mood into a self-fulfilling “prophecy”?To answer that, let’s first see what the possible channels of transmission are.First, we have the good old wealth effects—declines in household wealth as a result of falling stock prices would tend to be associated with a drop in consumer demand. However, typical literature estimates for wealth effects are small, implying a tiny impact, unless we see the kind of drawdown we saw back in 2008/early-09.Second, we have the “Tobin-q” link between stock prices and corporate investment, which conjectures that whenever the market value of a firm exceeds the replacement cost of its capital stock, firms will tend to invest more. Empirical support for this theory is very weak, however. One reason is that firms tend to view internally generated cashflow as the cheapest source of financing and equity as the most expensive one—so that cashflow is empirically more important in explaining investment than the equity cost of capital.In addition, corporate investment is also tied to the outlook for final demand. Not only does a robust demand outlook generate new investment opportunities; demand also generates cashflow, which in turn means additional stocks of cheap corporate financing. This does not mean that equity capital is unimportant—only that the cost of issuance is sufficiently high that it usually is not the primary source of finance.The same cannot be told of credit though, and here is where things can get tricky. Corporate spreads saw similarly vertical moves as equities last week, only upwards. Here it’s worth recalling Bernanke’s financial accelerator effect, whereby higher risk premia (due to higher volatility) lead to higher required rates of return, a deterioration in the perveiced health of borrowers balance sheet, and a drop in bank credit. On top of that, market indicators of stress in bank-funding markets (LIBOR-OIS, bank CDS spreads and so on) have also been moving in the wrong direction, raising concerns about a credit-crunch “encore” accentuated by poor bank funding conditions.Starting from the former—the general carnage notwithstanding, credit markets were not exactly closed last week. Corporate issuance did go ahead in many cases, only that investors demanded higher yields and were more selective, depending on the name. In addition, much of the negative focus has been on financials: Indicatively, commercial paper funding for non-financial corporates has remained virtually flat throughout May (including last week), while that for financials (domestic, as well as foreign) has declined by $50 billlion—some 9% of the outstanding stock.Turning to financials: Here I want to first make a distinction between cash and liquidity. Some have argued that, since financial institutions have tons of cash sitting at their respective central banks, surely funding problems can’t be the[...]

An Ode to Crisis Economics


Reading through Nouriel Roubini’s new book, “Crisis Economics”, is like tasting a sample of what Nouriel does best: Explain economics in such straightforward English that makes the intricacies of the dismal science feel like an effortless walk in the park.The team up with Stephen Mihm, a history professor (and journalist), adds a nice breeze to the walk by garnishing the analysis of the recent credit crisis with a barrage of all-too-similar parallels from the past—a reminder that financial crises are “creatures of habit”, “the norm, not the exception”, an inevitable consequence of human psychology and behavior.The reader is basically taken by the hand and given a comprehensive tour of key milestones in financial, political and regulatory history that contributed to the subprime crisis: From the origins of securitization; to financial de-regulation; to government policies to encourage home ownership; to the emergence of shadow banks; to the global savings glut and the build-up of leverage; and, finally, the “Minsky moment.”Equally effortless is the walk through the crisis itself and the vast array of policies undertaken to address it. In what amounts to a series of “crash courses” in every aspect of crisis economics, the reader is rewarded with all sorts of gems:An exhaustive account of the channels of crisis-contagion, from trade, financial and labor linkages to the currency and commodity markets; a comprehensive cataloguing of the fiscal policy toolkit to fight financial crises—from the conventional (cut-tax-spend-more) to the unconventional (guarantee, bailout and recapitalize); or (my favorite!) colloquial English explanations of such esoteric economic jargon as the “liquidity trap”: “You can lead a horse to water, but you can’t make it drink.” (Just replace “horse” with “banks”, “water” with “cash” and “drink” with “lend”).For this alone, the book is indispensable reading not just for students of economics but also for any non-specialist who has the slightest curiosity to understand why all hell broke loose back in August of 2007.Nouriel’s tone changes when it comes to policy prescriptions. Here we no longer hear “Roubini the cool minded professor” but the passionate, militant and, often, unedited policy commentator he has recently become known for. (“[..] banks have been able to pretend that their crappy assets are worth far more than any sane assessment would suggest.”)The prescriptions offered cover a wide range of policy areas and are worth the read, not least because they give a taste of what has been an intense debate among academics, policymakers and market participants about the way forward. So here I’ll just focus on two of the areas where I felt readers were left asking for more.The first has to do with putting a theoretically appealing framework for crisis resolution into practical use. According to the authors,“[..] it makes sense to follow the playbook devised by Keynes in the short-term, even if the underlying fundamentals suggest that significant portions of the economy are not only illiquid but insolvent. In the short-term, it’s best to prevent a disorderly collapse of the entire financial system […].But when it comes to the medium and long term, the Austrians have something to teach us. [..] In the long term, it is absolutely necessary for insolvent banks, firms and households to go bankrupt and emerge anew; keeping them alive indefinitely only prolongs the problem”.Pragmatic and ideologically inclusive, but… the question is how to identify the point of transition from the “short” to the “medium” term, includi[...]

The “E” and the “M” of the EMU


They say “do not believe anything until it’s been officially denied”. Just last Thursday, ECB President Jean-Claude Trichet categorically denied that the ECB had discussed buying government bonds of peripheral eurozone members.A market sell-off and a hectic weekend later, it was time for a complete about-face… Per the ECB’s press release on Sunday night, “in view of the current exceptional circumstances prevailing in the market, the Governing Council decided [among other things]To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. […]In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.”The significance of this move is huge, as far as killing speculators goes, but here I want to focus on a key policy dilemma that has emerged since the subprime (and now the eurozone) crisis ever began: The need for a separation between monetary and fiscal policy—what Trichet referred to as the difference between the “E” and the “M” of the EMU (or Economic and Monetary Union) at the ECB’s press conference on May 6th.In the US for example, this separation was all but blurred by the Fed’s decisions to put its own balance sheet at stake in the bailouts of Bear Stearns, Citi and AIG and, more bluntly, by its decision to buy US Treasuries, GSE debt and mortgage-backed securities. In the event, Congress’ disgruntlement with the AIG saga, monetarists’ concerns about “debt monetization” and valid criticisms about the Fed’s decision to favor a specific sector—housing—with cheap credit, have served to raise questions about the appropriate limits of the Fed’s independence.Does the European/ECB approach offer an alternative/better(?) route? In my view yes, notwithstanding the latest decision to purchase government bonds.Ignoring the bond purchases for the moment, recall first that, at the height of the financial crisis, all failed banks were “dealt with” by their corresponding national governments, without any participation from the ECB. To the extent that saving insolvent banks was deemed desirable form a social or financial-stability perspective, the burden was assumed by the elected governments, with ultimate responsibility going to the taxpayers (who voted for them).Meanwhile, the ECB did not remain idle—on the contrary: It was the first central bank to flood financial institutions with liquidity right at the onset of the crisis in August 2007; and in June 2009, it decided to provide as much funding as demanded by European financial institutions at a low, fixed rate for a 12-month maturity (longer than the Fed’s liquidity operations). In other words, the ECB demonstrated full flexibility and creativity when it came to preserving financial stability and fulfilling its LoLR functions (to illiquid but solvent institutions).Given the faithful delineation between fiscal and monetary responsibilities, Sunday's decision to step into the government bond market may be seen as an aberration—or worse: A betrayal to the spirit of its price[...]

Giving reform a chance


If one is to believe the popular media, economists have finally found one issue to agree on: That Greece can only get out of its atrocious fiscal quagmire through debt restructuring.Here, I’d like to argue for the opposite, even if that meant that, for once, I’d have to side with the politicians.Let’s talk contagion first. In case you’ve missed it, repo markets for Spanish, Portuguese and Irish bonds are drying up, which raises flags of alarm for their respective banks and, indeed, any bank that is using them as collateral for funding. Debt restructuring by Greece would create a precedent that would be very hard for the markets to ignore when thinking about the rest of the PIGS.Instead, avoiding a Greek restructuring (for now) gives a chance to the governments of these countries to take tougher measures to escape Greece’s fate. It also gives a chance to the European Commission and Council to prove that they have learned their lesson and can enforce fiscal discipline on a pre-emptive basis. Basically, it gives a chance to prevent a fresh round of financial instability in the eurozone, and to restore credibility in the institutions backing the entire European project.The next line of reasoning has to do with “the point” of restructuring: Even with restructuring, the need for a drastic fiscal consolidation in Greece does not go away. Neither does the need for enforcing tax collection, downsizing an over-bloated public sector, eradicating corruption and improving competitiveness.In addition, any haircut decision—and savings thereof—would have to be weighed against the new debt that would need to be issued to cover the losses of Greek financial institutions; and the much higher interest rates that Greece would be charged for its debt in the future (which would be higher the lower the recovery values and the higher the perceived probability of default).Add to that the possibility of bank runs, collapse of confidence and the ensuing disruption in people’s daily routines, and you kill all incentives for reform by transforming an economic emergency into a national calamity.Speaking of reform, it might have been easy to miss, amidst the catchy photos of rowdy anarchists parading in the middle of Athens, but.. there is actually a growing momentum for reform not only among the intellectual elite but also among the broader public—as demonstrated by the numerous self-critical op-eds and the more humble rhetoric of the Prime Minister himself.On top of that, you have a government in its first year of a 4-year mandate and an utterly discredited opposition that leaves few political options for dissenters but the Communists, the Greens or… the Party of Greek Hunters! The IMF/EU package allows this momentum to continue by providing not only cheap(er) money but also an instrument for discipline and transparency in a country that has had none for years.So much for the benefits. Now what are the risks of the IMF/EU approach?Most people see the biggest risk being that Greece fails to deliver. I disagree. The biggest risk would actually be if Portugal or Spain failed to deliver more ambitious fiscal measures in the coming months. The point here being that the massive package for Greece is more about avoiding contagion to the rest of the eurozone than salvaging some 2% of EU GDP.Then there is Greece itself. Those calling for upfront debt restructuring argue that the current package is fuelling moral hazard with the biggest “bailout” in history; and that, when the “inevitable” happens, the private sector will have to take a bigger haircut, since the official [...]

China can avoid becoming Japan


One counterpoint I often hear about the renminbi’s role in rebalancing China’s economy is “but hey, look at Japan: It’s had a flexible exchange rate for years and, yet, its growth is still reliant on external demand”.True. So let’s see what’s going on in Japan, whether there are any differences with China and whether the case for renminbi appreciation still stands from an economic rebalancing perspective.One reason behind Japan’s lackluster consumption growth has been a stagnant growth in real wages: Real wages have barely moved for more than a decade, even while labor productivity growth has actually been strong. As a result, the labor share of income in Japan has declined steadily—some 5-6% of GDP since the mid 1990s.The reasons for this were explored in a recent IMF working paper and the verdict was as follows:First, increased trade openness and competition from foreign, cheaper labor has put downward pressures on real wages in tradable sectors (notably manufacturing). This is not a phenomenon specific to Japan: Other advanced economies have also experienced similar pressures on real wages, especially as companies’ ability to relocate to take advantage of cheaper labor has improved.Apart from globalization, Japan’s economic structure and labor market regulations seem to have exacerbated the fall in labor’s share of income. Specifically, productivity in the services sector has been low, leaving little room for real wage growth there. Which means that, if I’m a manufacturing worker disgruntled with my stagnant real wage, I don’t really have anywhere better to go: Shifting to the services sector will not raise my purchasing power prospects.From a policy perspective, and to the extent that rebalancing growth towards domestic demand is an objective, the implications are clear: Steps to increase productivity in the services sector would help lift real wages there, putting pressure on the manufacturing sector to do the same and reward their employees more in line with their productivity.Turning on to China: First of all, household consumption growth in China is not at all stagnant—on the contrary. However, GDP growth has been much faster, bringing the share of household consumption to GDP down to a stunningly low 35%--a 10 percentage point reduction since the mid 1990s. Much of the reason is to be found in real wage growth: While robust, real wage growth has been slower than that of GDP, leading to a steady decline in labor’s share of income to an estimated 50%.So while the paces of underlying growth in wages and consumption differ widely between Japan and China, part of the reason behind the lackluster performance of private consumption in both countries has to do with the fact that labor has been awarded a declining share of national income.But there are important differences: First, in the case of Japan, labor’s share of income is still 60%--above the advanced-economy median of around 57%. So the fast decline in recent years has partly reflected a convergence towards advanced economy levels. In contrast, China’s labor share of income, at 50%, is far lower, and “abnormally” so at that, considering that developing economies tend to be more dependent on labor intensive industries (I’ll come back to that).More importantly, a key reason behind Japan’s (and other advanced economies’) declining labor share of income is a distinctly external shock: That of globalization, foreign competition and equalization of factor incomes through freer trade and relocation of production abroad (including by Japanese[...]

Europe’s bazooka is not enough


Back in August 2008, Hank Paulson, then US Treasury Secretary, went to Congress to request the mandate for a potential financial backstop of Fannie Mae and Freddie Mac, in the event of a loss in market confidence.Faced with the Congress’ inherent aversion to an explicit government guarantee on the two companies, Mr. Paulson’s argument was raw, yet forceful:"If you have a bazooka in your pocket and people know it, you probably won't have to use it."We all know how this ended. Less than two months later, the US government was forced to put both companies into “conservatorship”, as markets decided to test Hank’s resolve to put his powerful weapon to use.Europe’s EUR30bn financial package to Greece is the new bazooka on the block. Even the Greek Prime Minister himself, George Papandreou, seemed keen on recycling the analogy:“The gun is now loaded” he said to a Greek newspaper, perhaps unaware of the fate of its US precedent.As it happens, the European backstop alone does not provide a permanent solution. This is because it continues to treat the Greek crisis as a liquidity problem, when many in the markets believe it’s a solvency one. A permanent solution *has* to involve an IMF program, with a clear and feasible framework for swift debt reduction.So what would be the elements of an effective Fund program?The program should have two primary objectives: First, to arrest an impending liquidity crisis by restoring market confidence in Greece’s ability to service its debt; and second, to safeguard the long-term viability of the Greek economy within the context of the euro. The latter would have to involve, inter alia, substantial fiscal tightening to foster price reductions and increase competitiveness.When it comes to the first objective, the Europe’s EUR30bn package is in theory sufficient to address a potential liquidity crisis, given that it exceeds Greece’s obligations in the short-run. However, it is not enough to restore market confidence in the country’s ability to service its debt, now and in the future. This is because, by some calculations, Greece’s debt is currently not on a sustainable path, unless its fiscal effort goes beyond what the Finance Ministry has pledged under the stability and growth program it submitted to the EU.One reason is that the low interest rates assumed in the fiscal plan may not materialize for some time. Another reason is that, even with low interest rates, the current plan does not envisage a reduction in the debt/GDP from current levels until after 2013: Instead, the debt is forecast to rise until 2011, and then fall slowly from 2012 onward. This may be unacceptable to investors looking for tangible evidence of a prompt fiscal correctionThe issue of debt sustainability is also a legal one: Under the Fund’s lending guidelines, large loans (or, in Fund jargon, “exceptional access”) can only be provided if IMF economists can offer explicit assurances to the Fund’s board that a country’s debt level is on a sustainable path.It is unclear that Fund economists can provide such assurances at this juncture, without either of the following two routes: One involving tougher, frontloaded and visible fiscal measures that go beyond Greece's current commitments, aimed at restoring confidence in the country's ability to control its debt; or another involving upfront debt restructuring.In my view, the latter is not a viable alternative for Greece. First, although some two thirds of Greece’s debt is held by foreigners, the institutions with the largest exposur[...]

LSAPs: A Tale of Overkill Gone Too Far


With the Fed’s quantitative easing (QE) completed last week, I thought it might be a good time for stock-taking: Did QE achieve its intended objectives? And could the Fed have done things better?By QE I mean of course the “Large-Scale Asset Purchases” (or LSAPs) of GSE debt, mortgage-backed securities (MBS) and US Treasuries. These were first announced in November 2008, expanded in March 2009 and concluded in March 2010.So let’s start with the intended objectives first. In the case of the purchases of MBS ($1.25 trillion) and GSE debt ($200 billion), the objective was clearly stated at the November 2008 Fed statement:“[..] to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets”In other words, at the height of the crisis, the Fed decided to provide enormous support to a specific sector (housing), in the context of its efforts to “improve conditions in financial markets more generally.” As I argued at the time (here and here), by effectively getting the Fed into the credit-allocation business, the MBS purchases were an overreach of its mandate and a potential threat to its independence. They were also unnecessary, as we’ll see below.Nonetheless… There is no doubt that the Fed achieved its stated objective: Mortgage yields have shrunk since the purchases were announced and the reason is clear: When the Fed buys up an enormous share of the MBS market, it bids up MBS prices and lowers their yield—full stop.So far so good. But QE was not just intended to affect the price (/yield) of the assets purchased. Another critical objective was to affect the price of other risky assets such as equities and corporate bonds through the so-called portfolio balance effect.The clearest description of how the portfolio balance channel was thought to work was provided by the NY Fed’s Brian Sack last December (my emphases):“[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.[..] With lower prospective returns on Treasury securities and mortgage-backed securities, investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities. These effects are all part of the portfolio balance channel.”The problem with this argument is that it treats Agency MBS and Treasuries (i.e. the things the Fed bought) as assets that are “similar in nature” with corporate bonds and equities. However, as highlighted in a 2004 paper by Takeshi Kimura and (the Fed’s own) David Small, this may not be true.The reason is that the returns of equities and corporate bonds (other than high-grade) tend to be positively correlated with an investor’s consumption stream; whereas the returns of “safer” assets such as US Treasuries (and, arguably, GSE(/government)-backed MBS) tend to have a low or negative correlation with private consumption.This means that, in a portfolio context, such “safer” assets provide a hedge against a drop in consumption during bad times (i.e. during a recession and uncertainty about labor income).And for this reason, QE operations that remove “safer” assets such as Treasuries (or Agency MBS) from the market give rise to portfolios that are heavily “overweight” pro-cyclical assets (like equities and high-yield corporate bonds) compa[...]

Merkel Places Hopes in Lysistrata Initiative


(image) 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.

Happy April Fool's!!(image)

Ludicrous claims about the renminbi


With the Treasury’s verdict on global currency manipulators coming up on April 15th, the debate on the Chinese renminbi has not just been increasingly heated; it’s also turned ludicrous.The ludicrous took center stage last week after a key figure in the Chinese leadership suggested that the renminbi is not undervalued.Shortly after, two of the most loyal Ambassadors of Ludicrous—top economists at a couple of brand-name investment banks—argued that “the renminbi is not particularly undervalued…. China is importing a lot”; or that the US should mind its own business and save more.Needless to say, these claims are, well, ludicrous.Starting with the US savings argument… Since the third quarter of 2006, the US trade deficit has declined by almost 3% of US GDP—i.e. US national savings have risen by as much. And yet, the bilateral trade deficit with China has NOT. MOVED. (in US GDP terms). All the adjustment in the US external imbalance has been borne by other countries, notably oil/commodity exporters, Japan and the eurozone. China’s own contribution has been practically zero so far.On top of that, most people refer to the global imbalances as a US vs. China problem. Not true. The eurozone, which has been running a trade surplus, has seen its trade deficit with China rise almost uninterruptedly for years now. Indeed, the increase in the bilateral deficit with China accounts for 70% of the deterioration in the eurozone’s trade balance since end-2001 (when China joined the WTO) and for one third of the deterioration since mid-2005 (when China began to appreciate its currency).Both these examples show that the “need for higher savings” argument is bogus. No, I’m not saying that the US does not need to save more. The point here is that despite the recent rise in US savings, China has yet to bear the brunt of this adjustment, instead displacing other exporting countries, many of which are as poor or poorer. Yes, China is “importing more”. But clearly not *enough*. And a prompt and meaningful real exchange rate appreciation is a critical policy tool to make “enough” happen.Then you have those who say that a renminbi appreciation won’t be of much help in reducing the bilateral deficit with the US. To support this, they point to the currency’s 21% appreciation vs. the US dollar since July 2005, which, seemingly, had no impact on the US deficit with China (the deficit kept increasing in dollar terms until the crisis escalated at the end of 2008).This argument is equally bogus for at least two reasons: First, it ignores the role of domestic demand growth as a driver of imports. But more importantly, even a 20% change in the exchange rate means very little when the price and wage levels start from an extremely low base.Chinese wages remain a tiny fraction of wages in the advanced world when measured in US dollar terms. They are also much lower than many of China’s developing-country competitors in global markets for, say, textiles or manufactures (e.g. see Peru, Turkey, Mexico, Romania). Meaning that even a further 20% or 30% appreciation may not be enough to bring wages to par with competitors.Incidentally, for a country with a stated objective to reorient growth towards domestic demand, raising real wages would be an obvious starting point.But it goes beyond that. Recent press reports cite that stress tests by China to assess the resilience of its exporters to renminbi appreciation found that some firms w[...]

The end of gradualism?


Back in 2004, on the heels of the Fed’s tightening cycle, Ben Bernanke gave a speech in defense of “gradualism”—the idea that, under normal circumstances, economies are better served when central banks adjust their policy rates gradually, moving in a series of moderate steps in the same direction.Yet, current gossip has it that this thinking may be shifting.. in other words, the Fed may be open to the idea of what Bernanke called in that speech the “bang-bang” approach: Raising rates in a more aggressive manner, instead of a well-televised “measured pace”.Before I go any further, I should reiterate the word “gossip”, since I, at least, have yet to see a Fed speech expressing this view explicitly. But what I want to do here is to ask whether there is any reason to revisit the case for gradualism, esp. in the aftermath of the financial crisis.So let’s look at the rationale for gradualism in the first place… Ben’s speech lays it all out.One reason stems from the uncertainties under which policymakers operate: Uncertainty about the true state of the economy in “real time”, e.g. due to noise in the data, difficulties in measuring variables such as the output gap, etc; and also, uncertainty about the exact impact of policy actions on the economy (i.e. uncertainty about the accuracy of an economic model’s specification and/or the precision of the estimated structural parameters).Because of this, gradual policy adjustment is preferable to a more aggressive approach, as it allows policymakers to observe the impact of their actions and avoid potentially destablizing “overshootings”.A second reason has to do with the monetary authorities’ ability to influence the term structure of interest rates (and, therefore, financial conditions) in the presence of forward-looking market participants. The argument goes that, when investors are forward looking, the mere expectation of a series of small, measured interest rate increases in the future will lead to higher rates across the yield curve today—i.e. the Fed does not NEED to raise rates aggressively in one go to achieve a desired increase in long-term yields.The advantage of gradualism here is that the Fed can achieve tighter (or looser) financial conditions without prompting an unnecessary spike in the volatility of short-term interest rates.A third reason has to do with financial stability—ensuring that banks, firms and households are not exposed to large capital losses from undue swings in bond markets. Only here, the optimal policy response is not just gradualism, but gradualism combined with transparency in central bank communications about its intended policy path. As Ben put it in 2004:“the FOMC can attempt to minimize bond-market stress in at least two ways: first, through transparency, that is, by providing as much information as possible about the economic outlook and the factors that the FOMC is likely to take into account in its decisions; and second, by adopting regular and easily understood policy strategies”.So what, if anything, has changed since then that might prompt a shift in the Fed’s thinking?One possible change could be renewed attention to the so-called “risk-taking channel” of monetary transmission—the idea that monetary policy can affect agents’ risk-taking behavior, leading, for example, to potentially unsustainable increases in leverage and/or a deterioration in the quality of banks’ as[...]



With monetary authorities around the world preparing for their exit, there are fears in some circles that a new Armageddon is in sight. Volatility could shoot up, it is argued, as investors try to figure out the impact of a synchronous global tightening on their respective asset classes—let alone the difference between, say, the effective fed funds rate and the interest on excess reserves!The fears are not unjustified, so I thought of going back to see whether history, can inform us about the chances of an impending “Vola-geddon”!I’ll focus on the behavior of volatility during three “exit” precedents: (a) The Bank of Japan (BoJ)’s exit in 2006, which is the only available precedent of a central bank’s exit from quantitative easing (QE); (b) the Fed’s exit in 2004, which followed a stated commitment to a “low for long” rates policy and therefore bears similarities to the current situation; and (c) the Fed’s exit in 1994, a year that saw volatility in capital markets go up.Earlier exit episodes are not as relevant, mainly because central bank communications were much more opaque than today—e.g. prior to February 1994, the Fed did not even announce its target policy rate, while changes in the target rate were often made outside scheduled FOMC meetings, leaving markets guessing.So what does experience tell us?First “lesson” is that, under normal circumstances (and I’ll define “abnormal” below), central banks will begin their exit only after the recovery seems to be well entrenched. This moment is usually associated by a preceding period of steadily declining volatility/risk aversion.For example, by the time the Fed hiked in Feb 1994, the VIX (volatility implied from options on the S&P500) had been on a declining path for more than two years, reflecting the improving risk environment. Ditto for the Fed’s 2004 exit and the BoJ’s in March 2006. In other words, by the time the hikes begin, markets are pretty well equipped to withstand a rise in volatility, were this to occur.Now, does volatility rise during exits? Clearly my sample is minute but there is a useful qualitative comparison between the 2004 and 2006 episodes (when the VIX did not rise); and the 1994 one (when, on the day of the Feb 1994 announcement, the VIX jumped 50% and hovered around those levels throughout the year).In the case of the former two, the exit was largely anticipated by the market. You can see that by looking at the 3-month Libor expected three months forward (3m/3m). In the US, this had already begun to move up in early April, even though the first hike actually occurred end-June. In Japan, it moved as early as October 2005, around the time when the BoJ published its economic outlook, which hinted that the exit from QE was near.In contrast, in 1994, 3m/3m rates suggest that the Fed’s February hike was largely unanticipated. News items at the time also point to ongoing market uncertainty about the impact of successive rate increases on the growth outlook (Mexico’s tequila crisis also contributed to higher vol later that year).These examples provide support to the hypothesis that the improvement in the market’s understanding of central banks’ modus operandi—itself the result of enhanced central bank transparency over the years—has helped reduce policy-related uncertainty and financial market volatility. (Empirical research in the academic literature is [...]