tag:blogger.com,1999:blog-45281469695709485292024-03-13T13:54:33.972-04:00Models & Agentseconomic trends for allChevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.comBlogger129125tag:blogger.com,1999:blog-4528146969570948529.post-66937040801753100342011-03-26T09:37:00.005-04:002011-04-01T00:22:17.665-04:00Bond vigilantes call for “Day of Rates”Flustered by the obstinate refusal of US interest rates to move up, <a href="http://en.wikipedia.org/wiki/Bond_vigilante" target="_blank">bond vigilantes</a> are resorting to the revolutionary tactic <em>du jour</em>: Twitter! <br /><br />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”. <br /><br />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. <br /><br />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. <br /><br />The latter is rumored to be pseudonym for legendary bond trader Bill Gross, who only last month was <a href="http://www.bloomberg.com/news/2011-03-09/gross-drops-government-debt-from-pimco-s-flagship-fund-zero-hedge-reports.html" target="_blank">reported to have sold his entire stock of US government bonds</a> held in his $237 million Total Return Fund. <br /><br />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.” <br /><br />Former Federal Reserve Chairman Alan Greenspan agreed: “It’s a conundrum”, he tweeted, when asked to comment on the path of interest rates. <br /><br />Meanwhile, Republican Representative Michele Bachmann offered a potentially compelling explanation. <br /><br />“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!” <br /><br />“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… <a href="http://politicalhumor.about.com/od/republicans/a/michele-bachmann-quotes.htm" target="_blank">It's an interesting coincidence…</a>” <br /><br />Meanwhile, Federal Reserve Chairman Ben Bernanke played down the threat of excessive market volatility due to millions of “sell” tweets. <br /><br />“The Fed stands ready to use all available tools to preserve financial stability,” he tweeted. <br /><br />Fed pundits have interpreted the Chairman’s tweet as a sign he is bracing for what they called the "nuclear" option. <br /><br />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. <br /><br />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. <br /><br />><br />><br />><br />><br />><br />><br />><br />><br />and just in case you started selling..... <br />Happy Aprl Fool's!Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com4tag:blogger.com,1999:blog-4528146969570948529.post-39065886157179687282010-12-19T22:29:00.003-05:002010-12-19T22:40:26.385-05:00Blunt or blunter? Emerging markets (try to) return in kind<a href="http://1.bp.blogspot.com/_4P7XNSaTqgg/TQ7Pck7i_RI/AAAAAAAAAjI/g0m1UOc5GC8/s1600/Blunt%2Bhammer.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 153px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5552603480451120402" border="0" alt="" src="http://1.bp.blogspot.com/_4P7XNSaTqgg/TQ7Pck7i_RI/AAAAAAAAAjI/g0m1UOc5GC8/s200/Blunt%2Bhammer.jpg" /></a>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.<br /><br />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.<br /><br />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).<br /><br />Against this backdrop, for a RRR hike to be effective in tightening monetary conditions, the following have to hold:<br /><br /><strong>Banks should be limited in their ability to switch to other sources of short-term funding that are not subject to reserve requirements.</strong> 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%.<br /><br />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 <strong>at that rate</strong>.<br /><br />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.<br /><br />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 <strong>price of credit</strong>; and (b) it might even contribute to increasing the <strong>quantity of credit</strong>, if the CB commits to accommodating whatever additional demand for reserves at the going 6.50% rate (via securities purchases or unsterilized FX accumulation).<br /><br />Looking beyond Turkey, my bigger point is that measures that do not materially raise the cost of capital (and, indeed, that are intended to lower it, to fend off foreign capital inflows) are unlikely to tighten monetary conditions. Not only because their impact through the bank-lending channel will be diluted; but also because they ignore other important channels of monetary transmission—notably the wealth and financial accelerator channels.<br /><br />For example, if short-term interest rates remain low, cash will seek riskier assets, boosting their prices and leading to positive wealth effects. This in turn triggers pro-cyclical investment and consumption and, potentially, overheating (the wealth channel). Admittedly, when capital markets are global, low <strong>foreign </strong>interest rates can also play a big role in boosting asset prices, so an increase in the local short-term rates might not be enough to generate the desired tightening.<br /><br />Similarly, rising asset prices increases the value of collateral and thus, the perceived creditworthiness of borrowers, encouraging more lending (the financial accelerator channel). Higher RRRs on domestic banks, IF binding, could restrain the extent of such an increase, but even then, in an open economy, at least part of the capital “shortfall” is likely to be covered by foreigners.<br /><br />Finally, “here and there” policy measures may be ineffective or counterproductive, by creating confusion about what a central bank is trying to achieve and undermining its credibility. Is it lower credit growth to curb domestic demand and a widening of the current account deficit? Is it the promotion of financial stability through the change in the maturity structure and currency composition of banks’ liabilities? Is it the discouragement of capital inflows and the prevention of “excessive” exchange-rate appreciation? What about that price stability?<br /><br />Clearly, there are no easy answers to the policy dilemmas of our times. My suspicion is that we should be bracing for blunter measures in the year ahead.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com4tag:blogger.com,1999:blog-4528146969570948529.post-85088719571663211842010-12-12T14:25:00.005-05:002010-12-12T17:46:37.091-05:00Why the tax “compromise” is a very dumb idea<a href="http://1.bp.blogspot.com/_4P7XNSaTqgg/TQUkLEyx2II/AAAAAAAAAjA/qEpZ5pVlYcE/s1600/tax%2Bgifts.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 174px; FLOAT: left; HEIGHT: 200px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5549881888487889026" border="0" alt="" src="http://1.bp.blogspot.com/_4P7XNSaTqgg/TQUkLEyx2II/AAAAAAAAAjA/qEpZ5pVlYcE/s200/tax%2Bgifts.jpg" /></a>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”.<br /><br />So, where to begin?<br /><br />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.<br /><br />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 <strong>despite</strong> the fact that the number of people employed (in non-agricultural sectors) is some seven million less than it was back in end-2007.<br /><br />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.<br /><br />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 <em>can’t</em> 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 <strong>with </strong>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”.<br /><br />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?<br /><br />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).<br /><br />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).<br /><br />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 <strong>demand</strong> (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 <strong>employers’</strong> portion of the payroll tax, not the <strong>employees’.<br /></strong><br />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.<br /><br />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?<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com6tag:blogger.com,1999:blog-4528146969570948529.post-21495725773577581482010-12-05T20:23:00.003-05:002010-12-05T22:26:57.478-05:00Global Imbalances and the War of Attrition<a href="http://1.bp.blogspot.com/_4P7XNSaTqgg/TPxTmfr9kRI/AAAAAAAAAi4/2GqTa337Ynw/s1600/imbalances.png"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 184px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5547400761819631890" border="0" alt="" src="http://1.bp.blogspot.com/_4P7XNSaTqgg/TPxTmfr9kRI/AAAAAAAAAi4/2GqTa337Ynw/s200/imbalances.png" /></a>Back in 2005, Ben Bernanke, then (“just”) Governor at the Federal Reserve Board, coined the term “<a href="http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/" target="_blank">global savings glut</a>” 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.<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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 <strong>a profit</strong>! 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”).<br /><br />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. <br /><br />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.<br /><br />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.<br /><br />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 <strong>all</strong> capital from entering. This creates an assortment of loopholes for willing, yield-seeking investors to find their way in. And in case one needed further evidence of the long-term ineffectiveness of capital controls, I'd say, "ask China!"<br /><br />In that case, the Fed arguably holds the key for the reshaping of the global savings-investment landscape: <strong>If</strong> it could <em>credibly</em> commit to keep nominal US yields at ultra-low levels for a sufficiently long time, it could force EM action by turning current policies financially costly (through an increasingly negative carry) and politically difficult to sustain.<br /><br />Of course, that's a big if. First because, unless low rates reflect (very weak) US economic fundamentals, the Fed will have to devote an increasing amount of resources to hold rates down. And the more Treasuries it buys, the larger the negative-carry costs on its own balance sheet, when the time comes to raise its own policy rate beyond 2.5-3%. <br /><br />Second, in light of the widespread (and misinformed, I might add) outcry against QE in the US, it is questionable whether the Fed can credibly commit to mobilizing sufficient resources to keep yields low for long <em>enough</em>—that is, for longer than many major EMs can sustain their own distortionary policies. <br /><br />Against this backdrop, global monetary policy-making has not been reduced to a global currency war, as Brazil's Finance Minister recently suggested. It is rather a war of attrition.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com6tag:blogger.com,1999:blog-4528146969570948529.post-83236070348680959392010-11-28T18:17:00.003-05:002010-11-28T18:29:43.302-05:00Cross-border deleveraging and the shifts in Europe’s bargaining game<a href="http://1.bp.blogspot.com/_4P7XNSaTqgg/TPLlw-Z5X0I/AAAAAAAAAiw/_TLyi4P01x4/s1600/drachmi.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 142px; FLOAT: left; HEIGHT: 200px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5544746720794599234" border="0" alt="" src="http://1.bp.blogspot.com/_4P7XNSaTqgg/TPLlw-Z5X0I/AAAAAAAAAiw/_TLyi4P01x4/s200/drachmi.jpg" /></a><a href="http://4.bp.blogspot.com/_4P7XNSaTqgg/TPLjJaEuCMI/AAAAAAAAAio/7x-UX7eSuao/s1600/drachmi.jpg"></a>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!<br /><br />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.<br /><br />This “deleveraging” has important implications for the core-periphery bargaining game and the future of the euro.<br /><br />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.<br /><br />What would “discretionary” really mean? Based on the ERM experience back in 1992/93, it could mean the following:<br /><br />(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.”<br /><br />(b) For countries that are small (ie not systemic <strong>on their own</strong>) 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).<br /><br />(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.<br /><br />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.<br /><br />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.<br /><br />This poses a natural question: What’s the appeal of eurozone membership for Greece, Ireland or Italy for that matter, in the absence of an acceptable degree of burden-sharing between debtors and creditors? And even more so, when it implies the long-term surrender of fiscal sovereignty to the “troika” of the IMF, the ECB and the European Commission? Instead, exit from the euro (with the inevitable default) would shift part of the burden to the core through an immediate improvement in the periphery's external competitiveness. It would also shift part of the debt burden to any external creditors are left, private and official (barring the IMF, which has preferred creditor status).<br /><br />For these reasons, the ongoing cross-border deleveraging, and the resulting “thinning out” of the threads that tie the eurozone countries together, can mean either of two things for the euro: Either the governments of the core will demonstrate their will to share part of the burden of adjustment, in the form of a <strong>fiscal transfer</strong> rather than just <strong>liquidity support</strong>; or peripheral countries will find the unilateral assumption of the fiscal adjustment burden unacceptable, economically and politically… in which case they’ll opt out.<br /><br />Under fresh light, Iceland may no longer feel too unhappy it's not Ireland.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com4tag:blogger.com,1999:blog-4528146969570948529.post-74787934753731017012010-11-21T13:36:00.003-05:002010-11-21T18:47:15.673-05:00Can there be such a thing as an “orderly” restructuring?<a href="http://4.bp.blogspot.com/_4P7XNSaTqgg/TOlp8nJ-HZI/AAAAAAAAAig/zGO7-RDXlPc/s1600/angela.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 150px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5542077306479975826" border="0" alt="" src="http://4.bp.blogspot.com/_4P7XNSaTqgg/TOlp8nJ-HZI/AAAAAAAAAig/zGO7-RDXlPc/s200/angela.jpg" /></a>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.<br /><br />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.<br /><br />A key advocate of this view has been Nouriel Roubini, who in a recent <a href="http://www.roubini.com/analysis/138863.php" target="_blank">paper</a> 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.<br /><br />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.<br /><br />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.<br /><br />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).<br /><br />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.<br /><br />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:<br /><br /><strong>1) Participation should be largely voluntary.</strong> 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. <strong>This potential for contagion</strong> (through trade and financial linkages and/or by association)<strong> cannot be overstated</strong> <strong>when talking about eurozone members</strong> in my view.<br /><br /><strong>2) The restructuring, along with the policy mix adopted by the debtor country, should restore debt sustainability</strong> under reasonable macroeconomic scenarios. It should also help achieve a prompt return to market financing.<br /><br /><strong>3) The NPV reduction in the debtor country should not shift the crisis elsewhere in the eurozone</strong> (e.g. via the banking system).<br /><br />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?<br /><br />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.<br /><br />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.<br /><br />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).<br /><br />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 <strong>credible and comprehensive backstop</strong> to cover the losses of <strong>any</strong> necessary debt restructuring, across the board, by the financially stronger governments.<br /><br />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.<br /><br />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.<br /><br />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…<br /><br />1/ Source: “Cross country experience with restructuring sovereign debt and restoring debt sustainability”, IMF 2006Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com0tag:blogger.com,1999:blog-4528146969570948529.post-56600686265901423162010-11-07T19:17:00.002-05:002010-11-07T19:25:28.039-05:00The “misoverestimated” surpluses and the tax-cuts debate<a href="http://1.bp.blogspot.com/_4P7XNSaTqgg/TNdB99AIguI/AAAAAAAAAhY/PsytP_RWvkE/s1600/bush_tax_cuts.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 146px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5536966799478260450" border="0" alt="" src="http://1.bp.blogspot.com/_4P7XNSaTqgg/TNdB99AIguI/AAAAAAAAAhY/PsytP_RWvkE/s200/bush_tax_cuts.jpg" /></a>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 <a href="http://today.msnbc.msn.com/id/39976132" target="_blank">MSNBC report</a>, Bush writes:<br /><br />“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.”<br /><br />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.<br /><br />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?<br /><br />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.<br /><br />Expanding on the first point, it is useful to consider the arguments made by William Gale and Peter Orszag in a <a href="http://lawdigitalcommons.bc.edu/cgi/viewcontent.cgi?article=2283&context=bclr" target="_blank">2004 paper</a>, which assessed the impact of the Bush tax cuts, including as a stimulus against the 2001 recession.<br /><br />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.<br /><br />Second, some of the provisions (e.g. estate tax repeal, and increases in tax-free savings allowances) were designed to increase saving, not consumption.<br /><br />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.<br /><br />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.<br /><br />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).<br /><br />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.<br /><br />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 <em>marginal</em> 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).<br /><br />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.<br /><br />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.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com4tag:blogger.com,1999:blog-4528146969570948529.post-16645167714112320952010-10-26T13:10:00.009-04:002010-10-26T18:06:29.366-04:00What do the Fed's policy and poker have in common?<a href="http://3.bp.blogspot.com/_4P7XNSaTqgg/TMcOOBLpdvI/AAAAAAAAAhQ/tL02J9PbYT0/s1600/poker+cards.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 200px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5532406301246191346" border="0" alt="" src="http://3.bp.blogspot.com/_4P7XNSaTqgg/TMcOOBLpdvI/AAAAAAAAAhQ/tL02J9PbYT0/s200/poker+cards.jpg" /></a>It is no accident that, at the last FOMC meeting, one of the “outsiders” present was NY Fed economist Gauti Eggertsson, of <a href="http://www.ny.frb.org/research/economists/eggertsson/BrookingsPaper.pdf" target="_blank">Eggertsson and Woodford (2003)</a> 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.<br /><br />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, <strong>over and above central bank commitments with regard to the interest-rate path.</strong> (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,<br /><br /><span style="color:#6600cc;">“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, <strong>independent of the specification of the rule for adjusting short-term nominal interest rates,</strong> is not supported by our general-equilibrium analysis of inflation and output determination.” (my emphasis)<br /></span><br />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 <em>rate of inflation</em> 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.<br /><br />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.<br /><br />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.<br /><br />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?<br /><br />In short, how can a central bank demonstrate its commitment to higher inflation, besides simply stating that this is its intention?<br /><br />A number of economists have sought to address this question, including Eggertsson and Woodford (E&W) in their 2003 paper. One approach, proposed by <a href="http://www.jstor.org/pss/3216935" target="_blank">Lars Svensson</a> 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.<br /><br />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.<br /><br />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.<br /><br />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:<br /><br /><span style="color:#6600cc;">“[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.<br /><br />[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.”<br /></span><br />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.)<br /><br />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.<br /><br />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.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com0tag:blogger.com,1999:blog-4528146969570948529.post-83781378849740236822010-10-17T20:38:00.005-04:002010-10-17T20:54:34.606-04:00Ben’s new rabbit: Inflation expectations<a href="http://2.bp.blogspot.com/_4P7XNSaTqgg/TLuZvrfWiWI/AAAAAAAAAhI/Vh7-oRG3qzA/s1600/Rabbit+hat.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 170px; FLOAT: left; HEIGHT: 200px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5529182011934542178" border="0" alt="" src="http://2.bp.blogspot.com/_4P7XNSaTqgg/TLuZvrfWiWI/AAAAAAAAAhI/Vh7-oRG3qzA/s200/Rabbit+hat.jpg" /></a>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.<br /><br />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 <strong>can’t</strong> spend; and those with lots of cash and little debt <strong>won’t </strong>spend.<br /><br />So the question is: What tools does the Fed have <strong>available</strong> 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.<br /><br />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.<br /><br />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 <em>who could afford</em> to refinance—ie those with jobs, income and positive equity in their home, instead of the cash-strapped households facing foreclosure. Meanwhile, <a href="http://www.realtytrac.com/content/press-releases/q3-2010-and-september-2010-foreclosure-reports-6108" target="_blank">foreclosures kept on rising</a> as recently as September 2010.<br /><br />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.<br /><br />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 <a href="http://modelsagents.blogspot.com/2010/09/qe-sequel-putting-bens-money-where-his.html" target="_blank">here</a> 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?<br /><br />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?<br /><br />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.<br /><br />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.<br /><br />Currently, with inflation (and inflation expectations) at low levels, holding cash is “cheap” because of the low opportunity cost. But an increase in inflation expectations would make holding cash expensive, <strong><em>provided</em></strong> it is accompanied by a Fed commitment to keep nominal short-term rates low <strong>even if inflation eventually exceeds the Fed’s medium-term “target”</strong>. Note that in the absence of such a commitment, agents would expect the Fed to raise short-term rates as inflation moves higher. This which would in turn preserve their real return on cash, eliminating the incentive to switch into less liquid investment instruments, consumption and/or hiring (in the case of corporates).<br /><br />Put simply, in order to facilitate a switch away from cash, the Fed has to commit to allowing inflation to go above its medium-term projection. Now, before you accuse me of pushing the Fed into some treacherous territory, check out what Ben <a href="http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm" target="_blank">said on Friday</a>:<br /><br /><span style="color:#333399;">Recognizing the interactions between the two parts of our mandate, the FOMC has found it useful to frame our dual mandate in terms of the longer-run sustainable rate of unemployment and the mandate-consistent inflation rate.<br /><br /></span>Repeat: <strong>“mandate-consistent.”<br /><br /></strong>Later in that the same speech, Bernanke added that<br /><br /><span style="color:#333399;">“The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below.”<br /></span><br />Now that’s for the “longer-run”—i.e. beyond 2012. In my view (and that’s just *my* view), the “mandate-consistent” inflation in the nearer-term is above that level, precisely for the reason I mentioned above: Economic agents with lots of cash at hand need an incentive to part with their cash.<br /><br />So much about the economic rationale. How about implementation? In my view, hints of such an approach were given by Bernanke on Friday:<br /><br /><span style="color:#333399;">A step the Committee could consider, if conditions called for it, would be to modify the language of the statement in some way that indicates that the Committee expects to keep the target for the federal funds rate low <strong>for longer than markets expect</strong> [my emphasis]. Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations.</span><br /><br />The problem with Ben’s specification however is that “longer than markets expect” does not condition the period of low rates on the inflationary path. As such, it falls short of achieving the liquidity-preference objective I mentioned above.<br /><br />But there is also a second problem (read “systemic risk”) with the Fed’s overall policy framework—one that brings me back to reiterating (for the n<span style="font-size:85%;">th</span> time) my aversion to the LSAPs. This is the inconsistency between the Fed’s attempts to “force down” long-term yields to levels that are misaligned from the Fed’s <strong>own </strong>medium-term targets for inflation and growth!<br /><br />Basically, it’s one thing to intervene in order to <strong>correct </strong>a misalignment of asset prices from fundamentals (like the Fed did with its liquidity interventions in 2008). It’s another thing to intervene in order to <strong>engineer</strong> a misalignment of asset prices away from fundamentals—the very fundamentals you (Fed) are trying hard to achieve! This latter is not only non-credible; it is also dangerous, as it creates bond-market bubbles that can unwind with potentially disruptive effects for the financial system (it’s no accident that the hot topic at the IMF meetings last weekend was when will the bond bubble burst).<br /><br />So with all that in mind, my call to Ben would be “a little more inflation and a little less LSAPs please”. LSAPs of Treasuries or MBS have little power to stimulate aggregate demand but carry too many risks for the financial system. Instead, the FOMC should find the language to convince the world that a little more inflation in the near-term is the way to go.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com0tag:blogger.com,1999:blog-4528146969570948529.post-36538262290329435182010-10-03T21:08:00.003-04:002010-10-03T21:31:27.961-04:00QE and its unintended consequences<a href="http://1.bp.blogspot.com/_4P7XNSaTqgg/TKksAtof8tI/AAAAAAAAAhA/DwED7bWd6G8/s1600/flood.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 128px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5523994808707707602" border="0" alt="" src="http://1.bp.blogspot.com/_4P7XNSaTqgg/TKksAtof8tI/AAAAAAAAAhA/DwED7bWd6G8/s200/flood.jpg" /></a>In raising the possibility of QE2 at his <a href="http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm" target="_blank">Jackson Hole speech</a>, 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.<br /><br />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.<br /><br />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, <span style="color:#333399;">“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.”<br /></span><br />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.<br /><br />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.<br /><br />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 <em>had</em> 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.<br /><br />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).<br /><br />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.<br /><br />Now, unlike many pundits out there, I do not believe there is an empirically established causality from the Fed's policy rates to investors’ leverage. For example, the academic literature has failed to find a definitive link between the level of advanced economy interest rates and emerging market spreads (which would be obvious beneficiaries of carry trades). What does matter is investors’ risk appetite (e.g. proxied by the VIX).<br /><br />And here is the challenge for the likes of the Fed: Economists do not have a complete understanding of how monetary policy affects investors’ risk-taking behavior (the so-called “risk-taking channel"). But this does not mean that it’s something to ignore, simply because it doesn’t fit into some well-established theoretical framework. More so since the framework supporting the Fed’s asset purchase program (the “portfolio balance channel”) has little to say about the build-up of leveraged positions and any associated risk from their unwinding.<br /><br />A final concern—and maybe the least interesting—is the impact of low interest rates on the viability of money market funds (MMFs). Low-for-long nominal rates, combined with new regulations to increase the liquidity and reduce the maturity and riskiness of MMF investments has been squeezing the sector’s profitability. Add to that the fixed expense ratios of around 0.2-1% of assets, and the low rates can force at least some of the less efficient MMFs to closure.<br /><br />The reason this is the least interesting problem in my view is that the economic impact is unlikely to be meaningful. Users of MMFs tend to be high-quality corporate borrowers who could easily tap bank or capital market financing. True, the costs of borrowing might be marginally higher, but this is most likely dwarfed by the impact of record-low interest rates thanks to the Fed's policy.<br /><br />Still, I thought I should mention it, first because some economists have raised this issue in the past, and second because I was personally amused by Bernanke’s own take on this concern. Here is <a href="http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm" target="_blank">Ben in 2004</a>:<br /><br /><span style="color:#333399;">“In thinking about the costs associated with a low overnight rate, one should bear in mind the message of Milton Friedman's classic essay on the optimal quantity of money (Friedman, 1969). Friedman argued that an overnight interest rate of zero is optimal, because a zero opportunity cost of liquidity eliminates the socially wasteful use of resources to economize on money balances. From this perspective, the costs of low short-term interest rates can be seen largely as adjustment costs, arising from the unwinding of schemes designed to make holding transactions balances less burdensome. These costs are real but are also largely transitory and have limited sectoral impact.”<br /></span><br />That’s right… Bernanke (then-Fed Governor) responded by going philosophical, citing a supposed structural argument (something like, “MMFs are probably not that useful and zero interest rates can help eliminated them”), grounded on a much-debated theory (Friedman’s rule) to support a policy that is strictly cyclical in nature!<br /><br />Anyway.. A mini-diversion from the main point, which is that the potential costs from further QE, and low-for-long yields more broadly, go beyond the possible rise in inflation expectations and the threat to the Fed’s credibility. Against this backdrop, any cost-benefit analysis should consider not only policymakers’ uncertainty over QE’s impact on aggregate demand but also their uncertainty about the potential risks for global financial stability.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com3tag:blogger.com,1999:blog-4528146969570948529.post-37607884963224954172010-09-26T19:32:00.002-04:002010-09-26T19:41:43.453-04:00Leaving the Plaza Accord behind<a href="http://2.bp.blogspot.com/_4P7XNSaTqgg/TJ_ZGGC06-I/AAAAAAAAAg4/RqR0ifPftFw/s1600/plaza+accord.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 146px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5521370366904429538" border="0" alt="" src="http://2.bp.blogspot.com/_4P7XNSaTqgg/TJ_ZGGC06-I/AAAAAAAAAg4/RqR0ifPftFw/s200/plaza+accord.jpg" /></a>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.<br /><br />This time it was Chinese economist and member of the Central Bank’s monetary policy committee Li Daokui, who <a href="http://www.chinadaily.com.cn/china/2010-09/20/content_11325570.htm" target="_blank">said</a> 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.”<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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 <em>inter alia</em>:<br /><br />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.<br /><br />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).<br /><br />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!<br /><br />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.<br /><br />As three Japanese academics document <a href="http://www.iie.com/publications/chapters_preview/319/6iie289X.pdf" target="_blank">here</a>, 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).<br /><br />One can debate of course how big a role monetary policy in itself can play in fuelling asset bubbles of the scale experienced in Japan in the late 1980s. Indeed, those who object to the premise will find a staunch ally in Ben Bernanke! But my main criticism here is that, by calling for stimulative monetary and fiscal policies, Japan’s trading partners confused the cyclical from the structural causes of the global imbalances. The result was a monetary stance that was too loose for Japan; and the diversion of attention away from corrective measures that had to be taken by the likes of the United States.<br /><br />The situation is somewhat different at the current juncture with China. First, few people dispute that the key reasons behind China’s external surpluses are structural—and, therefore, nobody is really asking China to take inappropriately stimulative measures to increase domestic demand. In the same vein, there is no doubt that structural reforms to rebalance growth domestic demand and, notably, private consumption, would be welcome by the global community.<br /><br />But this is no reason to dismiss the exchange rate revaluation as *one* corrective tool: First, as I argued <a href="http://modelsagents.blogspot.com/2010/03/ludicrous-claims-about-renminbi.html" target="_blank">here</a>, China has yet to bear the brunt of the (cyclical) correction of global imbalances since the onset of the financial crisis: Even as its own trade surplus has shrunk, the US trade deficit with China has barely moved <strong>in US GDP terms</strong>. Most of the US adjustment has been borne by other countries.<br /><br />Importantly, a large exchange rate undervaluation in a country as large as China contributes to the misallocation of global resources—e.g. by prolonging the survival of inefficient companies/exporters in China and/or by encouraging the outsourcing of business to China thanks to an artificially low cost structure.<br /><br />Bottom line, evoking Japan’s experience under the Plaza Accord as a reason to rebuff pressures to revalue the renminbi is misplaced, if not disingenuous. While nobody can dispute the need for a score of structural measures to fortify the financial sector and contain the formation of bubbles in China, maintaining an undervalued exchange rate can only serve mercantilistic objectives and/or protecting certain industries at the expense of a balanced, efficient and fair allocation of global resources.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com0tag:blogger.com,1999:blog-4528146969570948529.post-38195535992172387892010-09-19T18:36:00.003-04:002010-09-19T18:46:59.852-04:00QE the Sequel: Putting Ben’s Money Where His Mouth Is<a href="http://3.bp.blogspot.com/_4P7XNSaTqgg/TJaQ9zyXBkI/AAAAAAAAAgw/lLjA1bLfZYY/s1600/money+and+mouth.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 158px; FLOAT: left; HEIGHT: 200px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5518757784936973890" border="0" alt="" src="http://3.bp.blogspot.com/_4P7XNSaTqgg/TJaQ9zyXBkI/AAAAAAAAAgw/lLjA1bLfZYY/s200/money+and+mouth.jpg" /></a>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.<br /><br />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.<br /><br />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” <a href="http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm" target="_blank">speech on deflation</a>. But let’s start from the beginning.<br /><br />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) <strong>of the assets purchased</strong> (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 <strong>other </strong>risky assets through the so-called portfolio balance effect.<br /><br />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 (<a href="http://www.newyorkfed.org/newsevents/speeches/2009/sac091202.html" target="_blank">here</a>), but here is an excerpt from that speech that sums it up:<br /><br /><span style="color:#333399;">“[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 <strong>similar in nature</strong>, to the extent that investors are willing to substitute between the assets.” (my emphasis)<br /><br /></span>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?<br /><br />To answer the first question, we have to have in mind the endgame, which is <strong>the desire to boost aggregate demand</strong>. 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.<br /><br />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 <em>could</em> 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.<br /><br />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 <a href="http://modelsagents.blogspot.com/2010/04/lsaps-tale-of-overkill-gone-too-far.html" target="_blank">here</a>) 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.<br /><br />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.<br /><br />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?<br /><br />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.<br /><br />Logistic #1: The “QE” operation should not actually purchase the small business loans or foreclosed properties <em>themselves</em> 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.<br /><br />Logistic #2: Clearly, this walks and talks like a fiscal operation, right? Well, it <strong><em>is </em></strong>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?<br /><br />Enters Ben Bernanke, 2002:<br /><br /><span style="color:#333399;">“In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. […] <strong>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.</strong>” (my emphasis)</span><br /><br />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.<br /><br />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.<br /><br />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:<br /><br /><span style="color:#333399;">“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.” </span><br /><br />So there.. a chance for America to show that's it's not going to become Japan.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com10tag:blogger.com,1999:blog-4528146969570948529.post-26141612174535675842010-09-12T21:18:00.002-04:002010-09-12T21:28:42.711-04:00Inequality and Growth, Revisited<a href="http://3.bp.blogspot.com/_4P7XNSaTqgg/TI1-D6JsPkI/AAAAAAAAAgo/DtRqFB1rXGM/s1600/inequality.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 143px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5516203724213337666" border="0" alt="" src="http://3.bp.blogspot.com/_4P7XNSaTqgg/TI1-D6JsPkI/AAAAAAAAAgo/DtRqFB1rXGM/s200/inequality.jpg" /></a>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.<br /><br />Inequality is all the more topical in light of <a href="http://www.cbpp.org/files/6-25-10inc.pdf" target="_blank">data</a> 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.<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />Yet, the same credit market imperfections could make inequality <em>good</em> 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/<br /><br />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 <a href="http://www.development.wne.uw.edu.pl/uploads/Courses/jt_de_barroinequality.pdf" target="_blank">shows</a>, 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).<br /><br />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.<br /><br />Now, clearly, the US falls under the “rich” category. So is the rising inequality in America good for economic growth?<br /><br />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 <em>level </em>of per capita income (not the growth) and the level of inequality.<br /><br />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).<br /><br />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 <em>level</em> of the (average) per capita income should help bring inequality back down eventually (per the Kuznets curve).<br /><br />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.<br /><br />Second (and perhaps a reason for the above) is the fact that studies that use <em>national</em> 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.<br /><br />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.<br /><br />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 <em>inside</em> the US, as companies now have a broader menu of opportunities to consider.<br /><br />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 <em>within the US</em>. Instead, it helps reduce the inequality <em>between</em> the average American household and the workers of the countries that are the beneficiaries of that investment.<br /><br />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 <em>more equality</em>: From a strictly intellectual perspective, you shouldn’t care if the person whose income is converging with yours is American or Chinese.<br /><br />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.<br /><br />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 (<a href="http://modelsagents.blogspot.com/2010/09/on-demand-side-and-supply-side-stimulus.html" target="_blank">here</a>).<br /><br />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!<br /><br /><br /><br />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”.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com7tag:blogger.com,1999:blog-4528146969570948529.post-74784016279748139752010-09-06T19:05:00.004-04:002010-09-06T23:37:41.276-04:00On the demand side and the supply side: The stimulus debate<a href="http://3.bp.blogspot.com/_4P7XNSaTqgg/TIV6ONBTYmI/AAAAAAAAAgY/RYKrYdAD5Lk/s1600/stimulus.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 200px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5513947703216923234" border="0" alt="" src="http://3.bp.blogspot.com/_4P7XNSaTqgg/TIV6ONBTYmI/AAAAAAAAAgY/RYKrYdAD5Lk/s200/stimulus.jpg" /></a>The flaming debate on how to steer the economy forward and avoid America’s “Japanification” has been dominated by two seemingly irreconcilable camps:<br /><br />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... <em>ergo</em> the US can avoid becoming Japan by keep on stimulating itself with fiscal and monetary measures until private demand recovers.<br /><br />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.<br /><br />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.<br /><br />Here, I’ll start form Japan and notably with the observation that TFP growth did in fact decline during the 1990s. (See <a href="http://www.minneapolisfed.org/research/wp/wp607.pdf" target="_blank">here</a> and <a href="http://www.kojin.org/papers/06_Japan_TFP.pdf" target="_blank">here</a>).<br /><br />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. <br /><br />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.<br /><br />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 <a href="http://www.cesifo-group.de/portal/page/portal/CFP_CONF/CFP_CONF_VSI/VSI%202003/ESJ_Westermann/VSI03-ESJ-PEEK.PDF" target="_blank">here</a>).<br /><br />Japan’s story can also vindicate supply-siders, however. As highlighted in a recent <a href="http://www.bankofengland.co.uk/publications/speeches/2010/speech434.pdf" target="_blank">speech</a> 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.<br /><br />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”.<br /><br />Posen adds that “[w]hat was <strong>necessary</strong> [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”.<br /><br />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.<br /><br />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 <a href="http://www.bls.gov/news.release/pdf/prod3.pdf" target="_blank">latest Bureau of Labor Statistics report</a>) the TFP of the private nonfarm business sector grew by just 0.1% in 2008—the slowest rate since 1995.<br /><br />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.<br /><br />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.<br /><br />On the monetary side, I am planning to write a more comprehensive piece but my theoretical framework is one I already laid out <a href="http://modelsagents.blogspot.com/2010/04/lsaps-tale-of-overkill-gone-too-far.html" target="_blank">here</a>. 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.<br /><br />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.<br /><br />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.<br /><br /><br /><br />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). <br /><br /><br />PS And yes, I'm back after a long summer Odyssey!Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com3tag:blogger.com,1999:blog-4528146969570948529.post-13281048011691336622010-05-24T00:02:00.002-04:002010-05-24T00:11:32.483-04:00Can 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.<br /><br />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:<br /><br />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”?<br /><br />To answer that, let’s first see what the possible channels of transmission are.<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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 issue here. Even European institutions, which have been the focus of strains recently, can’t really be said to have funding problems, since the ECB has gone all the way in helping them: Not only with unlimited long-term refinancing operations at fixed rates, but also with purchases of “toxic” ClubMed bonds. All that is true. In other words, I would personally ignore the LIBOR-OIS spread, which became very fashionable during the 2008 crisis, as a signal of an impending credit crunch.<br /><br /><strong>However...</strong> cash does not equal liquidity. As Pimco’s Paul McCulley said a few years back, liquidity is a state of mind. Banks’ holdings of large piles of cash reserves say little about their <strong>willingness</strong> to lend. One source where information about the latter can be found is the latest Senior Loan Officer Opinion Survey (SLOOS). This suggests that credit conditions remain tight for reasons including reduced tolerance for risk and a still uncertain macroeconomic outlook.<br /><br />Importantly, the cash sitting around says little about <strong>demand </strong>for credit. Here, the SLOOS points to mostly unchanged conditions in the demand for credit for non-financial firms, with the balance towards a still weakening demand. In addition, only a fraction of reporting banks believed that, for those cases where credit did actually expand, the reason was a rise in investment.<br /><br />The bottom line here is that, while market indicators may point to stress in the financial sector, (a) the stress is only theoretical, given the effective backstop by the ECB and the Fed; and (b) any spillovers to the real sector are limited. This is because, <strong>given the backstop</strong>, changes in the supply of credit have not been driven by banks’ theoretical ability to lend but by their tolerance for risk, a lukewarm credit demand and ongoing uncertainty about the economic outlook.<br /><br />So unless the momentum of improvement of the global economy (especially that of private sector demand) turns negative, it will be difficult to see a spillover from the markets <em>alone</em> to the real sector. Note that this is what makes the current case different from 2008: At that time, there was a clear negative momentum underway in the real sector, starting from a collapsing housing market that fed through to labor markets, credit markets and, eventually, the global financial system.<br /><br />Still—I said it will be difficult, but not impossible. The one channel of transmission I have not mentioned is confidence. I would have personally dismissed it as significant a while back, especially since at least one study that I’ve seen fails to find a significant impact of (transitory) bouts of market volatility on consumer confidence.<br /><br />But I would say that 2008 changed the picture. The drawdowns we saw in labor markets or in consumer spending were considerably larger than what standard economic models of consumption or unemployment would have predicted. This tells me that we can not entirely discard the impact of sharp market drawdowns on the attitudes of households and businesses. And here, one can only hope that these guys have better things to do than checking their stocks, while the markets work through their schizophrenia—alone!<br /><br /><br />PS With the official beginning of the summer next Monday (Memorial Day), I will be taking time off Models & Agents for most of the summer (with occasional breaches, when I can’t help it!). This is to accommodate a heavy load of business and vacation-related travel ahead, and my customary use of my summer months to further building my capabilities as an economics nerd. Au revoier in the Fall!Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com3tag:blogger.com,1999:blog-4528146969570948529.post-90651448284614187922010-05-16T16:38:00.006-04:002010-05-17T06:06:20.908-04:00An Ode to Crisis Economics<a href="http://4.bp.blogspot.com/_4P7XNSaTqgg/S_BZa37i2UI/AAAAAAAAAgM/b2jtcG2rhS8/s1600/Nouriel%27s+book.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 131px; FLOAT: left; HEIGHT: 200px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5471971865480321346" border="0" alt="" src="http://4.bp.blogspot.com/_4P7XNSaTqgg/S_BZa37i2UI/AAAAAAAAAgM/b2jtcG2rhS8/s200/Nouriel%27s+book.jpg" /></a>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.<br /><br />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.<br /><br />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.”<br /><br />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:<br /><br />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”: <span style="color:#6600cc;">“You can lead a horse to water, but you can’t make it drink.”</span> (Just replace “horse” with “banks”, “water” with “cash” and “drink” with “lend”).<br /><br />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.<br /><br />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. <span style="color:#6600cc;">(“[..] banks have been able to pretend that their crappy assets are worth far more than any sane assessment would suggest.”</span>)<br /><br />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.<br /><br />The first has to do with putting a theoretically appealing framework for crisis resolution into practical use. According to the authors,<br /><br /><span style="color:#6600cc;">“[..] 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 […].<br /><br />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”.</span><br /><br />Pragmatic and ideologically inclusive, but… the question is how to identify the point of transition from the “short” to the “medium” term, including in the current crisis. From the tone of the discussion about the looming dangers of public over-indebtedness or the Fed’s bloated balance sheet, you would think that the medium term is already upon us—yet, the urgency for corrective action is hard to square with Nouriel’s view that we’re stuck well inside the belly of a U-shaped recovery for years to come.<br /><br />Basically, we're missing a set of concrete signposts that would make policymakers confident that the timing for a switch from accommodative, crisis-management policies, to restrictive, structural measures is right. In its absence, the distinction between the “short” and the “medium” term feels as relativistic as the old adage that “old age is always 15 years older than I am.”<br /><br />Turning to financial regulatory reform… Here the discussion turns so militant as to potentially undermine the credibility of the proposals put on the table (some of which make a lot of sense). What is missing in my view is a rational framework to support the various elements of reform (from bankers’ compensation, to capital requirements to addressing the too-big-to-fail problem). Instead, the discussion felt more like an account of “The Thousand and One Ways to Exterminate Goldman Sachs”!<br /><br />As I’ve argued in the past, the starting point for financial reform should be a well-researched view on the appropriateness of the current competitive landscape in the financial sector—one that takes into account both economic efficiency (which calls for more competition) and prudential considerations (which, by some academics, might call for less). Reforms on bank size or even bankers' compensation should be an output of that framework, rather than autonomous ends in themselves.<br /><br />Importantly, the call to separate commercial banks from broker-dealers, hedge fund operations, etc so that <span style="color:#6600cc;">“only commercial banks would have access to deposit insurance and government safety net: Everyone else [..] would be on their own”</span>, misses the point in my view.<br /><br />First, because broker-dealers, investment banks, money-market funds, etc are equally systemic, given their critical role in intermediating finance for both companies and households. And second, because many of the services these institutions provide are very much bank-like—so the right way to go is to subsume them more effectively into the regulatory framework for banks. This should include a deposit-insurance-like scheme to internalize the costs of future bailouts.<br /><br />“Crisis Economics” puts Nouriel right in his element. It may be easy to forget, amidst the “Dr Doom” clatter, the "ladies in waiting" and the Cannes appearances, that this is a guy who has made an enormous contribution to our understanding of crisis economics for years now—from analytical frameworks as valuable as the “balance sheet approach” to financial crises, to one of the most extensive accounts of addressing crises in emerging markets in his earlier book “Bailouts or Bail-ins?”.<br /><br />The book also puts Nouriel in his element by demonstrating the huge breadth of his knowledge—from history of economic thought, to CDOs-squared to global economic governance. Indeed, the book’s most important lesson may be precisely this: That successful economic management must rest less on a compartmentalized edifice of knowledge and more on insights drawn from a holistic framework that includes history, economics, philosophy and, above all, common sense.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com1tag:blogger.com,1999:blog-4528146969570948529.post-80571841252261718682010-05-09T23:49:00.005-04:002010-05-16T22:19:22.270-04:00The “E” and the “M” of the EMU<a href="http://1.bp.blogspot.com/_4P7XNSaTqgg/S-eCarZ5RcI/AAAAAAAAAgE/VHx3JxfALD0/s1600/trichet+bernanke.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 147px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5469483667304302018" border="0" alt="" src="http://1.bp.blogspot.com/_4P7XNSaTqgg/S-eCarZ5RcI/AAAAAAAAAgE/VHx3JxfALD0/s200/trichet+bernanke.jpg" /></a>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.<br /><br />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, “<span style="color:#6600cc;">in view of the current exceptional circumstances prevailing in the market, the Governing Council decided [among other things]<br /><br />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. […]<br /><br />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.”<br /></span><br />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.<br /><br />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.<br /><br />Does the European/ECB approach offer an alternative/better(?) route? In my view yes, <em>notwithstanding</em> the latest decision to purchase government bonds.<br /><br />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).<br /><br />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).<br /><br />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-stability mandate, let alone an anathema to the Germans.<br /><br />I actually don’t think so. First of all, the interventions are described as—effectively—liquidity operations, to improve the functioning of monetary transmission. This is not a b.s. excuse for back-door debt monetization. Repo transactions using peripheral-economy debt as collateral have been increasingly dysfunctional, undermining the ability of some European financial institutions to fund themselves in private markets.<br /><br />Now, why is that so different from the Fed’s MBS purchases, which, ultimately, were also aimed to help improve conditions in financial markets? It is different in many ways. First, unlike the MBS purchases, the ECB’s operations will be sterilized—that is, the objective is not to loosen monetary policy further but to relax financial conditions from the currently tight levels by improving funding for financial institutions (and governments).<br /><br />Importantly, the Fed’s MBS purchases were <strong>unconditional</strong>: No actions were demanded on the beneficiaries of these purchases (the mortgage borrowers). In contrast, the ECB *had* to extract commitments for further fiscal consolidation from the eurozone governments, so that it could claim that (by its own judgment, rather than the now discredited rating agencies) peripheral government bonds are “safe” enough for its portfolio. We yet have to see whether such pledges will be met, but they are at least a start.<br /><br />Mind you, the point goes beyond the “narrow” objective of securing the safety of the ECB’s balance sheet. It is about securing a commitment by the eurozone governments that they still see the EMU as a desirable objective and one that is worth making sacrifices for: Namely, further fiscal measures in line with the spirit of the Stability and Growth Pact, and structural reforms to restore competitiveness.<br /><br />Trichet’s tough talk on May 6th aimed at highlighting exactly that—the limits of monetary policy in preserving financial and economic stability, when the political will to do so is lacking:<br /><br /><span style="color:#000099;">“We cannot substitute for the governments. The governments have their decisions to take while we have our own role as an independent central bank, and of course we expect each authority to fulfill its own responsibilities.”<br /></span><br />What are the lessons here, including for the U.S. of A.? The first is the realization that, unfortunately, politicians are unlikely to get their act together until things are at the brink of falling apart. And even then, political will may be hard to muster in the midst of the crisis. Trichet’s “bluff”(?) worked in finally stirring bold action. Bernanke had to step in and bail out the likes of AIG with Fed money. But once the emergency is over, any fiscal burdens must be transferred from the Fed’s books to of the US Treasury.<br /><br />The second is that there was, in fact, an alternative to the MBS/Treasury purchases... which was to buy none! Instead, like the ECB, Fed operations could have focused solely on securing ample liquidity to the financial system, in line with its mandate of safeguarding financial stability. Indeed, as I argued <a href="http://modelsagents.blogspot.com/2010/04/lsaps-tale-of-overkill-gone-too-far.html" target="_blank">here</a>, the effectiveness of the so-called “portfolio balance” channel over and above the positive impact of the MBS purchases on bank liquidity is dubious. Let alone the hoped-for impact on inflation… has anybody seen the recent US inflation numbers?! (OK, OK, we can’t know the counterfactual!)<br /><br />The third lesson is that monetary policy cannot be oblivious to fundamental imbalances in the economy, whether these take the form of fiscal imbalances, current account imbalances or large indebtedness in the household, corporate or financial sectors. This applies even to those central bankers fixated with (product price) stability. The reason is that the resolution of such imbalances is often “non-linear”—as in, abrupt and brutal and one that will tend to undermine the very price stability that the central bank claims to defend.<br /><br />The eurozone came close to its "non-linear" experience by seeing the viability of the euro falling apart. The US (along with the rest of the world) felt it first hand, in the fourth quarter of 2008 and its ugly aftermath.<br /><br />Both these instances suggest that Trichet may actually be wrong: The “M” and the “E” cannot be that separate after all.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com3tag:blogger.com,1999:blog-4528146969570948529.post-49489300152784240892010-05-02T23:20:00.004-04:002010-05-16T22:19:22.271-04:00Giving reform a chanceIf 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.<br /><br />Here, I’d like to argue for the opposite, even if that meant that, for once, I’d have to side with the politicians.<br /><br />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.<br /><br />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.<br /><br />The next line of reasoning has to do with “the point” of restructuring: Even <strong>with</strong> 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.<br /><br />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).<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />So much for the benefits. Now what are the risks of the IMF/EU approach?<br /><br />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.<br /><br />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 money disbursed would be senior to privately-held debt.<br /><br />Not entirely. First, all the package does is cover Greece’s financing need for the next three years, <strong>including</strong> debt amortizations to the private sector—<strong>in full</strong>! So whatever haircut in the future will have to be considered together with the full repayments that debt holders will receive as a result of the package today.<br /><br />When it comes to moral hazard, it is ludicrous to think at this point that the rescue package will encourage fiscal misbehavior in the rest of the eurozone or even by future Greek governments, given the painful measures that need to be adopted and the political humiliation of external monitoring.<br /><br />However.. there is clearly a moral hazard issue when it comes to the holders of Greek debt, many of whom were happy to feed the Greeks with cheap money until they decided otherwise. Here, voluntary initiatives of the type allegedly discussed by German banks are a step in the right direction, even if too timid to counter the moral hazard concern.<br /><br />But ultimately, the “rescue” of Greece (and of its debt holders) will have to be seen through the prism of avoiding contagion at a time too sensitive for the neighboring economies (and the IMF/EU) to bear.<br /><br />Mind you, timing is critical: <strong>Provided</strong> Spain, Portugal and Ireland “behave”, a Greek debt restructuring would be much easier for the eurozone to bear a year or two from today, as the economy would be in better shape and the risk of contagion lower.<br /><br />Greece may be too small (and too wayward) to bail but it’s become systemic by association. And while the rescue of an idiot who put his house on fire may be against one’s libertarian philosophy, keeping the fire from spreading elsewhere is (as we’ve painfully come to learn) sound policyChevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com1tag:blogger.com,1999:blog-4528146969570948529.post-19793555845378258282010-04-25T11:52:00.004-04:002010-05-16T22:21:40.272-04:00China can avoid becoming Japan<a href="http://2.bp.blogspot.com/_4P7XNSaTqgg/S9RnIEF_dAI/AAAAAAAAAf8/KD267mV89r8/s1600/China+vs+Japan.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 131px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5464105636142740482" border="0" alt="" src="http://2.bp.blogspot.com/_4P7XNSaTqgg/S9RnIEF_dAI/AAAAAAAAAf8/KD267mV89r8/s200/China+vs+Japan.jpg" /></a>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”.<br /><br />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.<br /><br />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.<br /><br />The reasons for this were explored in a recent <a href="http://www.imf.org/external/pubs/ft/wp/2009/wp0997.pdf" target="_blank">IMF working paper</a> and the verdict was as follows:<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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%.<br /><br />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.<br /><br />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).<br /><br />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 companies in developing Asia).<br /><br />In contrast, China <strong>*is*</strong> that shock: It is the place where many companies relocate to take advantage of cheap labor costs (as well as a potentially huge consumer base). This means that the decision not to raise the purchasing power of labor (whether it’s by raising nominal wages or through an appreciation of the renminbi) is an <strong>autonomous</strong> one—not one that is enforced by the global competitive landscape.<br /><br />Of course, things are not as simple as that. First, not all industries in China have the same degree of profitability. Arguably, there is little room to raise wages in some low-value-added industries, especially since some companies are deemed to survive only because of the undervalued exchange rate (per the government’s recent stress tests on the sensitivity of some companies to renminbi appreciation).<br /><br />Secondly, even in larger companies with fat profits (including many state-owned enterprises), profitability has been partly sustained by a slew of (what should be) temporary boons: Subsidized energy prices, land subsidies, low interest rates (partly due to controls on capital outflows) and, of course, the favorable exchange rate. Steps to remove these advantages would limit the scope for strong wages increases going forward, as profitability declines.<br /><br />The underlying issue though is the developmental objective that these distortionary policies are set to achieve: That of an overarching focus on building capital- and resource-intensive industries. This has limited the growth in the number of employed people or, more relevantly for China, in the number of people who can shift out of farming employment in the context of the country’s ongoing urbanization.<br /><br />This is where the comparison with Japan becomes very informative: If China wants to avoid Japan’s reliance on external demand, it will need to undertake policies that encourage an efficient and dynamic service sector to flourish.<br /><br />What’s the role of the exchange rate here? As noted above, the exchange rate is just one of the distortionary policies aimed at promoting the development of the tradable sector; but it’s an important one for realigning production and investment incentives.<br /><br />Renminbi appreciation would reduce the profitability of capital-intensive, export-oriented companies, limiting the recycling of corporate savings back to industrial capacity building (which is what companies have been doing). It would shift production incentives away from low-value-added, exchange-rate sensitive sectors and towards higher-value-added industries as well as the services sectors. It would raise the purchasing power of consumers by lowering the price of imported goods, freeing up income for services consumption. And it would diminish the current influx of liquidity due to the accumulation of FX reserves, raising the cost of capital and, thus, lenders' “benchmark” for efficiency and profitability in both the industrial and services sectors.<br /><br />Clearly, a change in China’s exchange rate policy is not a panacea for rebalancing growth. A multitude of other policies need to be taken in tandem. But its contribution to realigning production incentives, together with the unsustainability of what UBS economist Jon Anderson has called China’s “expropriation” of savings from the rest of the world, make it a critical and an urgent step.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com3tag:blogger.com,1999:blog-4528146969570948529.post-45101073109188389852010-04-11T14:52:00.003-04:002010-05-16T22:19:22.272-04:00Europe’s bazooka is not enough<a href="http://2.bp.blogspot.com/_4P7XNSaTqgg/S8IbCDfhnoI/AAAAAAAAAf0/wTxMkT2nCYY/s1600/Greek_bazooka.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 140px; FLOAT: left; HEIGHT: 200px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5458955420437683842" border="0" alt="" src="http://2.bp.blogspot.com/_4P7XNSaTqgg/S8IbCDfhnoI/AAAAAAAAAf0/wTxMkT2nCYY/s200/Greek_bazooka.jpg" /></a>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.<br /><br />Faced with the Congress’ inherent aversion to an explicit government guarantee on the two companies, Mr. Paulson’s argument was raw, yet forceful:<br /><br />"If you have a bazooka in your pocket and people know it, you probably won't have to use it."<br /><br />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.<br /><br />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:<br /><br />“The gun is now loaded” he said to a Greek newspaper, perhaps unaware of the fate of its US precedent.<br /><br />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.<br /><br />So what would be the elements of an effective Fund program?<br /><br />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 <strong>within</strong> the context of the euro. The latter would have to involve, inter alia, substantial fiscal tightening to foster price reductions and increase competitiveness.<br /><br />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 <strong>beyond</strong> what the Finance Ministry has pledged under the stability and growth program it submitted to the EU.<br /><br />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 correction<br /><br />The 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.<br /><br />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.<br /><br />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 exposure (as a percent of total portfolio) are Greek banks. Restructuring would bring about large losses for the banks, potentially causing bank runs, financial instability and a halt of credit. The consequences of growth would be disastrous.<br /><br />Second, in the context of the monetary union, the only way to restore Greece’s competitiveness is by forcing a reduction in its prices vs. its trading partners (ie a real depreciation). A tighter fiscal policy that includes wage cuts is instrumental for making this happen, and will have to be part of an IMF program—debt restructuring or not.<br /><br />Importantly, a tougher fiscal adjustment might look daunting on paper but is not impossible: Greece can achieve a great deal with determined steps to fight tax avoidance, the streamlining of an overbloated and inefficient public sector and penalties to those responsible for the massive expenditure “overruns” (a politically correct term for “money in the pockets of favored individuals”). The point of these measures goes beyond fiscal discipline: They are fundamental in fostering a transparent and rules-based environment for doing business.<br /><br />As Rahm Emanuel said back in February 2009, “you never want s serious crisis to go to waste.” Greece’s crisis should not go to waste; it’s a wake up call that economic growth cannot be grounded on consumption funded by (what was thought to be) free money. The IMF is a necessary partner in this phase of transition.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com3tag:blogger.com,1999:blog-4528146969570948529.post-86093648584492104632010-04-04T10:11:00.006-04:002010-04-04T20:36:01.922-04:00LSAPs: A Tale of Overkill Gone Too Far<a href="http://3.bp.blogspot.com/_4P7XNSaTqgg/S7ih169p7_I/AAAAAAAAAfs/KBgh7iFlDG4/s1600/Overkill.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 188px; FLOAT: left; HEIGHT: 200px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5456288896292351986" border="0" alt="" src="http://3.bp.blogspot.com/_4P7XNSaTqgg/S7ih169p7_I/AAAAAAAAAfs/KBgh7iFlDG4/s200/Overkill.jpg" /></a>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?<br /><br />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.<br /><br />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:<br /><br /><span style="color:#330099;">“[..] to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets”</span><br /><br />In other words, at the height of the crisis, the Fed decided to provide enormous support to a <strong>specific</strong> sector (housing), in the context of its efforts to “improve conditions in financial markets more generally.” As I argued at the time (<a href="http://modelsagents.blogspot.com/2009/01/messing-around-with-credit.html" target="_blank">here</a> and <a href="http://modelsagents.blogspot.com/2009/02/saving-fed-from-itself.html" target="_blank">here</a>), 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.<br /><br />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.<br /><br />So far so good. But QE was not <strong>just </strong>intended to affect the price (/yield) of the <strong>assets purchased</strong>. Another critical objective was to affect the price of <strong>other </strong>risky assets such as equities and corporate bonds through the so-called portfolio balance effect.<br /><br />The clearest description of how the portfolio balance channel was thought to work was provided by the NY Fed’s Brian Sack <a href="http://www.newyorkfed.org/newsevents/speeches/2009/sac091202.html" target="_blank">last December</a> (my emphases):<br /><br /><span style="color:#330099;">“[T]he purchases bid up the price of the asset [being purchased] and hence lower its yield. <strong>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</strong>.<br /><br />[..] With lower prospective returns on Treasury securities and mortgage-backed securities, <strong>investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities</strong>. These effects are all part of the portfolio balance channel.”</span><br /><br />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 <a href="http://www.ksri.org/bbs/files/research02/Quantitative....pdf" target="_blank">paper</a> by Takeshi Kimura and (the Fed’s own) David Small, this may not be true.<br /><br />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.<br /><br />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).<br /><br />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) compared to investors’ optimal allocation. In response, investors might actually shed pro-cyclical assets to rebalance their portfolios, <strong>raising </strong>their risk premium. In other words, the Fed’s LSAPs in their 2008-2010 form may have had the <strong>opposite </strong>spillover effects from what the Fed had wanted to achieve.<br /><br />What are the lessons here?<br /><br />The first thing to note is that, even at the zero bound, the Fed can achieve a great deal <strong>without</strong> LSAPs. This is via (1) the commitment to keep the policy interest rate at near-zero levels for an extended period; and (2) the ability to extend unlimited amounts of liquidity to the financial system to safeguard financial stability, thus helping address the root of the crisis (like the ECB did).<br /><br />In my view, it was these two tools (along with the bank stress tests and recapitalizations) that were instrumental for the rebound in financial markets since mid-March 2009. Specifically, the commitment to low-for-long rates helped to:<br /><br />• bring down the <strong>level</strong> of private long-term interest rates by reducing the long-term “risk-free” rate;<br />• lower credit <strong>spreads</strong>, since lower interest rate <em>levels</em> mean lower debt servicing costs and, thus, lower expected probabilities of default;<br />• improve the outlook for credit conditions and aggregate demand, which in turn has reduced risk aversion (and, thus, lifted asset prices).<br /><br />Meanwhile, the liquidity (and recapitalization) programs helped improve financial stability and lift asset prices by reducing systemic risk and volatility.<br /><br />Against this backdrop, the Fed’s asset purchases can be seen as a supplementary tool, in the context of policy overkill. However: As argued above, for LSAPs to lower the private long-term cost of capital they have to directly target pro-cyclical assets such as equities, high-yield corporate bonds and other “toxic” stuff; not Treasuries and Agency MBS!<br /><br />Now, you’ll probably say that for someone who cares about the Fed’s financial independence (and I clearly do), this is a toxic proposition. Not really! The Fed already took a large amount of risk on its balance sheet with its involvement with Bear Stearns, Citi and AIG, as well as with the MBS purchases (unless it holds them *all* to maturity).<br /><br />Once you’ve gone through that route, the case for focusing on Treasuries and MBS alone is weak at best; and it’s also counterproductive and inconsistent with its Fed mandate, as argued above.<br /><br />What matters for the portfolio balance channel to work is that the Fed removes large amounts of pro-cyclical assets from investors’ aggregate portfolio; the Fed does not need to target a specific asset class.<br /><br />In fact, had it bought a mix of equities and corporate bonds (indiscriminately, e.g. by buying equity and bond indices) it would have made tons of money AND would have also avoided the fear of causing market havoc when trying to offload these assets later—a dominant concern in the Fed’s and investors’ minds when it comes to unwinding the MBS purchases.<br /><br />Call me a purist, but I continue to see the Fed’s MBS and Treasury purchases a mistake; I did back then, and I still do now. All I can hope is that researchers can reach consensus about this before the next crisis!Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com1tag:blogger.com,1999:blog-4528146969570948529.post-17712587129568974332010-03-31T17:34:00.004-04:002010-09-06T20:26:20.842-04:00Merkel Places Hopes in Lysistrata Initiative<a href="http://3.bp.blogspot.com/_4P7XNSaTqgg/S7PBXWz4VwI/AAAAAAAAAfk/J6sIhd_TUIU/s1600/venus_milo1.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 214px; FLOAT: left; HEIGHT: 320px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5454916180680136450" border="0" alt="" src="http://3.bp.blogspot.com/_4P7XNSaTqgg/S7PBXWz4VwI/AAAAAAAAAfk/J6sIhd_TUIU/s320/venus_milo1.jpg" /></a>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.<br /><br />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.<br /><br />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.<br /><br />“German taxpayers cannot be asked to finance the unrestrained lives of the Greeks” said an exasperated Ms Merkel.<br /><br />A senior German diplomat agreed: ”All we’re asking the Greeks is to take their strikes to a more constructive level.”<br /><br />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.<br /><br />Reportedly, a hardline faction within the Association is pushing for a pledge to renounce all sexual pleasures, including <em>The Lioness on The Cheese Grater </em>(a popular sexual position with ancient roots), in the name of fiscal discipline.<br /><br />The pledge would be conditional on reparations from Germany of still unspecified nature, if the strike turned out to last more than a week.<br /><br />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.<br /><br />He accused the Council of manipulating the statistics, with the intention of presenting the lives of the Greeks as “too lovely”.<br /><br />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.<br /><br />Separately, French President Nicolas Sarkozy said his country’s top showing in the European Council report gave further support to <a href="http://www.businessinsider.com/sarkozy-happiness" target="_blank">his suggestion</a> to include “happiness” in a country’s GDP.<br /><br />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.<br /><br />The euro advanced on the news.<br /><br /><br /><br />><br />><br />><br />><br />><br />><br />><br />><br />Happy April Fool's!!Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com3tag:blogger.com,1999:blog-4528146969570948529.post-38158937818845980052010-03-21T07:50:00.009-04:002010-05-16T22:21:40.273-04:00Ludicrous claims about the renminbi<a href="http://1.bp.blogspot.com/_4P7XNSaTqgg/S6YIVMbsI6I/AAAAAAAAAfc/q6DFIMEpqgk/s1600-h/ludicrous+face.bmp"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 143px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5451053559186203554" border="0" alt="" src="http://1.bp.blogspot.com/_4P7XNSaTqgg/S6YIVMbsI6I/AAAAAAAAAfc/q6DFIMEpqgk/s200/ludicrous+face.bmp" /></a>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.<br /><br />The ludicrous took center stage last week after a key figure in the Chinese leadership suggested that <a href="http://www.ft.com/cms/s/0/d2d18014-2f34-11df-9153-00144feabdc0,dwp_uuid=9c33700c-4c86-11da-89df-0000779e2340.html" target="_blank">the renminbi is not undervalued</a>.<br /><br />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.<br /><br />Needless to say, these claims are, well, ludicrous.<br /><br />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.<br /><br />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 <em>surplus</em>, 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).<br /><br />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 <strong>despite</strong> 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.<br /><br />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).<br /><br />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 <em>levels </em>start from an extremely low base.<br /><br />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 <em>further </em>20% or 30% appreciation may not be enough to bring wages to par with competitors.<br /><br />Incidentally, for a country with a stated objective to reorient growth towards domestic demand, raising real wages would be an obvious starting point.<br /><br />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 would be very sensitive and probably go out of business. In other words, many Chinese exporters <strong>only exist</strong> because of, effectively, a subsidized exchange rate level. Apart from being unfair in the context of a global competitive landscape, it’s also detrimental for China’s own efforts to move up the value-added chain, by fomenting complacency among its firms.<br /><br />Finally, it’s amazing to suggest the renminbi is not overvalued when China has continued to accumulate FX reserves at a rate of $50 million <strong>an hour</strong> throughout the crisis! And don’t tell me it’s insurance!<br /><br />After correcting for (an estimate of) valuation effects, almost half of that accumulation in 2009 was accounted for by the trade surplus—no need for insurance there. Another 20% can be accounted for by foreign direct investment flows—the most stable form of foreign investment with little need for precautionary reserves. Even if all the remaining flows were “hot money”, insurance does not involve covering 300% of those flows with reserves, esp. when you already have another $2 trillion in your coffers!<br /><br />China’s exchange rate policy is a major distortionary force in global trade and also a key impediment for the smooth functioning of global capital markets and the conduct of monetary policy everywhere (including in China itself). As we speak, there are emerging market countries whose stage in the business cycle demands a tighter monetary policy. And yet, they don’t move because of fears of an exchange rate appreciation that would ruin their competitive edge in major markets.<br /><br />China, along with <strong>every</strong> major economy interested in participating in, and profiting from, an increasingly globalized world, has a duty to take policies that foster stability in trade and capital markets. In China’s case, exchange rate policy is the number one issue. It's irresponsible for anyone calling him/herself an economist to claim the contrary.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com6tag:blogger.com,1999:blog-4528146969570948529.post-11406140830123874732010-03-14T11:22:00.004-04:002010-03-14T18:21:10.780-04:00The end of gradualism?<a href="http://3.bp.blogspot.com/_4P7XNSaTqgg/S50A54pIoXI/AAAAAAAAAfU/NGiK2F4pO5Q/s1600-h/gradualism.jpg"><img id="BLOGGER_PHOTO_ID_5448512118645629298" style="FLOAT: left; MARGIN: 0px 10px 10px 0px; WIDTH: 150px; CURSOR: hand; HEIGHT: 200px" alt="" src="http://3.bp.blogspot.com/_4P7XNSaTqgg/S50A54pIoXI/AAAAAAAAAfU/NGiK2F4pO5Q/s200/gradualism.jpg" border="0" /></a>Back in 2004, on the heels of the Fed’s tightening cycle, Ben Bernanke gave a <a href="http://www.federalreserve.gov/boarddocs/speeches/2004/200405202/default.htm" target="_blank">speech</a> 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.<br /><br />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”.<br /><br />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.<br /><br />So let’s look at the rationale for gradualism in the first place… Ben’s speech lays it all out.<br /><br />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).<br /><br />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”.<br /><br />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.<br /><br />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.<br /><br />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:<br /><br />“<em>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</em>”.<br /><br />So what, if anything, has changed since then that might prompt a shift in the Fed’s thinking?<br /><br />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’ assets.<br /><br />In my view, attention to the risk-taking channel would be a very welcome development, especially in light of the recent experience and the destabilizing effects of careless risk-taking by both banks and households. However... I have a feeling that the implications for monetary policy have little to do with the <strong>pace</strong> of adjustment (ie the gradualism vs. bang-bang debate) and more to do with the <strong>level</strong> of policy rates.<br /><br />To see this, one has to examine the channels through which monetary policy affects risk-taking behavior. To this effect, a recent <a href="http://www.bis.org/publ/qtrpdf/r_qt0912f.htm" target="_blank">BIS paper</a> discussing this link seems to suggest that it’s the levels of interest rates that matter for risk-taking behavior.<br /><br />For example, low interest rates raise asset prices (through lower discount rates), increasing the value of collateral and, in turn, the willingness of banks to extend more credit to the non-financial sector (the financial accelerator effect). Similar effects can lead to perceptions that bank balance sheets are healthier, making bank funding cheaper and encouraging them to raise their leverage to potentially damaging levels (esp. if they can “creatively” bypass capital requirement restrictions by shifting risky assets off balance sheet!).<br /><br />In addition, low interest rates for an extended period could encourage investors to search for yield by shifting capital towards higher-risk investments. This may be because of inertia in asset managers’ performance targets, which often focus on nominal returns (e.g. for institutional/contractual reasons); and/or “money illusion”—ie when investors are slow to absorb the fact that lower interest rates are simply a response to lower inflation.<br /><br />Note that little has been said here about the effect of a given pace of change in interest rates on risk-taking behavior. It’s all about the levels.<br /><br />So what are the implications for policy?<br /><br />Well, for starts, emphasis on the risk-taking channel of monetary transmission throws fresh light on the (in)appropriateness of the Fed’s monetary stance back in 2003-06. First, by keeping rates low for a long period, the Fed likely contributed to the "search for yield" cult defining that period. More importantly, even when the Fed did raise rates, the impact on financial conditions (and risk-taking behavior) was very limited: Volatility declined steadily to historic lows, while long-term yields only rose temporarily in 2004, only to resume their decline later in 2005.<br /><br />Now, to anyone as familiar with monetary theory as the Fed Chairman and his entourage, this should have raised the red flags about the workings of the transmission mechanism. Instead, the Fed was busy making up names for this new wonderful state of affairs: The Great Moderation… the conundrum… etc.<br /><br />Criticisms aside, the point is that, given that the level of interest rates affects risk-taking behavior (with potentially damaging effects, if left untamed), monetary policy would have to be “blunter” (to use Bernanke’s expression) when the risk environment is exceptionally benign.<br /><br />But back to gradualism... For all the implications for the level of interest rates, the inter-linkages between monetary policy and risk-taking behavior seem to say little about the appropriateness of the gradualist approach. So in the absence of a compelling framework that associates a transparent and steady (if not *that* measured) pace of policy adjustment with risk-taking behavior, I have a hard time understanding why the Fed would wish to change tack vis-à-vis gradualism.<br /><br />Maybe it is just gossip after all. But if it’s not, I hope we get a darn good explanation beforehand.Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com0tag:blogger.com,1999:blog-4528146969570948529.post-47070389609000309272010-03-08T20:46:00.004-05:002010-03-08T21:06:19.237-05:00Vola-geddon<a href="http://1.bp.blogspot.com/_4P7XNSaTqgg/S5WrlXwUagI/AAAAAAAAAes/XgoMt8hVhv4/s1600-h/Volageddon.jpg"><img style="MARGIN: 0px 10px 10px 0px; WIDTH: 200px; FLOAT: left; HEIGHT: 150px; CURSOR: hand" id="BLOGGER_PHOTO_ID_5446447982894672386" border="0" alt="" src="http://1.bp.blogspot.com/_4P7XNSaTqgg/S5WrlXwUagI/AAAAAAAAAes/XgoMt8hVhv4/s200/Volageddon.jpg" /></a>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!<br /><br />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”!<br /><br />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.<br /><br />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.<br /><br />So what does experience tell us?<br /><br />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.<br /><br />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.<br /><br />Now, <strong>does</strong> 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).<br /><br />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.<br /><br />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).<br /><br />These examples provide support to the hypothesis that the improvement in the market’s understanding of central banks’ <em>modus operandi</em>—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 consistent with this view).<br /><br />Against this backdrop, both the Fed and the ECB are going at great lengths to explain the sequencing of their exit to the markets. This tells me that investors should take their words at face value when forming rates forecasts, rather than bracing for a nasty surprise.<br /><br />Turning specifically to bond market volatility… Monetary policy can help contain it in (at least) two ways: First, with a credible commitment to low inflation, which anchors expectations and reduces the volatility of inflation forecasts; and second, by reducing uncertainty about the path of monetary policy itself.<br /><br />The former calls for a strong emphasis on the path of inflation expectations as a guide to policy (an emphasis the Fed has explicitly affirmed in its FOMC statements); the latter calls (once again) for clear communication on the rationale and sequencing of the exit process.<br /><br />So let’s what happened during the three exit episodes. In what follows, I’ll proxy uncertainty about the monetary policy path by the volatility in money markets, in line with a 1996 BIS <a href="http://www.bis.org/publ/econ45.pdf?noframes=1" target="_blank">paper</a> by Borio and McCauley (volatility measured as the standard deviation in the daily change of the 3m/3m rate, over a 3-month period). The “test” then is to see whether money market volatility was “passed-through” to volatility in bonds of long-term maturities.<br /><br />Turns out Japan is not a very informative case: Volatility in money markets was elevated during 2006 but remained within the bounds seen in late '04 and throughout '05. Importantly, the pass-through from money markets to long-term bond volatility was limited, especially for longer tenors (e.g. 10-year). I should mention that the BoJ did a good job explaining its exit plan ahead of time, in late-2005/early 2006. It’s just that the data do not seem to provide a conclusive link between monetary policy uncertainty (so defined) and bond market volatility.<br /><br />In the US, volatility increased in both tightening episodes, though in 2004 the rise was shorter-lived—a brief interruption to a downward path in the context of a benign global risk environment. What differs from the Japanese case is that there is a clearer pass-through from money market to bond market volatility. In other words, *assuming* money market volatility can be interpreted as uncertainty about monetary policy, central bank communication may have more influence on bond market volatility in the US than in Japan.<br /><br />So when could things go really wrong? I mentioned earlier I would define “abnormal” so here we go—a few “tail” events with Vola-geddon potential:<br /><br />One has to do with the impact on long-term rates of the Fed’s downsizing of its balance sheet. Part of the reason is uncertainty about (a) how much impact the Fed’s MBS/Treasury purchases have had on long-term rates in the first place; and (b) whether it was the stock or the flow of Fed purchases that mattered (the Fed’s current thinking seems to be leaning towards the stock theory).<br /><br />I personally expect a limited impact here, simply because the Fed is taking a very cautious approach—indicating it will opt for a passive downsizing in the short run (ie allowing its assets to mature), with active purchases only much later in the exit process. Note that the ECB did not really enter the asset purchase game (except for covered bonds) so that’s not an issue for them (but it’s a big issue for the Brits).<br /><br />Another “tail” risk is a sudden shift in investor perceptions of sovereigns’ ability to service their debt (including the US). Unfortunately, triggers for such shifts are often “exogenous”: Sovereigns can be vulnerable for years (see Greece) before markets decide it’s time to pull the plug. So I have little to contribute in trying to predict the timing of this.<br /><br />Finally, you could have a scenario where goldbugs and monetarist nutheads gain vogue, prompting a spike in inflation expectations that would force the Fed to act earlier and more forcefully on the rates front. Given the chatter in some circles, I can’t say that’s impossible, but in light of the dynamics in the real economy I’ll say just this: The probability I assign to this risk is exactly equal to the probability of Ben topping the charts with a song titled “I’m a printing machine”… you pick the number!Chevellehttp://www.blogger.com/profile/10769905202655777736noreply@blogger.com1