CPI, Empire State Survey, Philly Fed, Brent Crude Price, Previous Banking Post

CPI, Empire State Survey, Philly Fed, Brent Crude Price, Previous Banking Post

Consumer Price Index
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Empire State Mfg Survey

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Highlights
Minus signs sweep the Empire State report with the headline at minus 11.36 which is more than 1 point below Econoday’s low end estimate. Looking at individual readings, new orders are in very deep trouble at minus 18.92 for a fifth straight month of contraction. And manufacturers in the region are not going to be able to turn to unfilled orders to keep busy with this reading extending a long string of contraction at minus 15.09 in September.

Lack of orders is showing up in shipments, which are at minus 13.61 for a third straight contraction, and in employment which is in a second month of contraction at minus 8.49. The workweek is down and delivery times are shortening, both consistent with weakening conditions. Price data show a second month of contraction for finished goods, which is another negative signal, and a narrowing and only marginal rise for prices of raw materials.

This report opens up the October look at manufacturing, and the results will raise talk that weak export markets may be taking an increasing toll on the sector. Watch later this morning for the Philly Fed report at 10:00 a.m. ET where contraction is also expected.

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Philadelphia Fed Business Outlook Survey

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Highlights
Contraction is seeping into the Mid-Atlantic manufacturing sector. The Philly Fed’s index for October, at minus 4.5, came in just below Econoday’s low-end estimate. This is the second drop in a row but, more importantly, contraction is now appearing in many of the report’s specific indexes including new orders which, at minus 10.6, fell 20.0 points from September. Unfilled orders, at minus 11.7, are extending their long contraction while shipments, at minus 6.1, are down 19.9 points from September. Employment, at minus 1.7, is now in contraction and down 11.9 points in the month. This report confirms the Empire State report released earlier this morning and points to accelerating declines for manufacturing, a sector that appears to be getting hit harder and harder by weak foreign markets.

And look when it peaked:
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Brent still going lower. Probably keeps going down until Saudis alter their discounts:
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I posted this Dec 14, 2014, and seems it’s coming into play:

Banking

Deflation is highly problematic for banks. Here’s what happened at my bank to illustrate the principle:

We had a $6.5 million loan on the books with $11 million of collateral backing it. Then, in 2009 the properties were appraised at only $8 million. This caused the regulators to ‘classify’ the loan and give it only $4 million in value for purposes of calculating our assets and capital. So our stated capital was reduced by $2.5 million, even though the borrower was still paying and there was more than enough market value left to cover us.

So the point is, even with conservative loan to value ratios of the collateral, a drop in collateral values nonetheless reduces a banks reported capital. In theory, that means if the banking system needs an 8% capital ratio, and is comfortably ahead at 10%, with conservative loan to value ratios, a 10% across the board drop in assets prices introduces the next ‘financial crisis’. It’s only a crisis because the regulators make it one, of course, but that’s today’s reality.

Additionally, making new loans in a deflationary environment is highly problematic in general for similar reasons. And the reduction in ‘borrowing to spend’ on energy and related capital goods and services is also a strong contractionary bias.

German Trade, Japan

Exports down but so are imports, indicating a weak global economy and continued euro support from trade net flows:

Germany : Merchandise Trade
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German exports plunge at fastest pace since global financial crisis

Oct 8 (Reuters) — German exports plunged in August. Data from the Federal Statistics Office showed seasonally-adjusted exports sliding by 5.2 percent to 97.7 billion euros month-on-month, the steepest drop since January 2009. Imports tumbled by 3.1 percent to 78.2 billion euros, the biggest one-month decline since November 2012. Germany’s trade surplus narrowed to 19.6 billion euros. Germany’s auto industry accounts for roughly one in five jobs. It accounted for 17.9 percent of Germany’s 1.1 trillion euros ($1.25 trillion) in exported goods last year.

Out of the frying pan and into the fire:

Japan : Machine Orders
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Highlights
Core machine orders retreated for a third month in August. Core machine orders sank 5.7 percent on the month – expectations were for an increase of 3.2 percent. The monthly decline followed drops of 3.6 percent in July and 7.9 percent in June. On the year, orders were 5.2 percent lower. Total orders plunged 14.6 percent.

Manufacturing orders slid 3.2 percent while nonmanufacturing orders dropped 6.1 percent on the month. In an indication of weak international trade, overseas orders plummeted 26.1 percent on the month.

Needless to say, the government downgraded its view – said orders are marking time. Core machine orders are considered a proxy for private capital expenditures.

Japan out of deflation, Kuroda says

Oct 8 (Nikkei) — Japan has exited deflation and the overall inflation trend has risen steadily, Bank of Japan Gov. Haruhiko Kuroda said Wednesday. Kuroda emphasized price hikes, arguing that daily and weekly price indexes show a significant change from last year. Growth in the UTokyo Daily Price Index, which tracks changes in supermarket prices using data from Nikkei Inc., is hovering near 1.5%. Companies are passing higher labor and other costs on to customers, who are accepting the resulting price increases. Kuroda hinted that even a cut to inflation projections caused by the slump in crude oil would not be enough to merit more stimulus.

Japan’s August core machinery orders down 5.7% on month

Oct 8 (Kyodo) — Japan’s core private sector machinery orders fell a seasonally adjusted 5.7 percent in August from the previous month to 759.4 billion yen ($6.33 billion). The government cut its basic assessment, saying core machinery orders are “at a standstill.” Orders from the manufacturing sector dropped 3.2 percent to 347.9 billion yen in August, down for the third straight month, while those from the nonmanufacturing sector slid 6.1 percent to 422.1 billion yen for the second straight monthly fall. Overseas demand for Japanese machinery, an indicator of future exports, plunged 26.1 percent to 872.3 billion yen.

Japan service sector sentiment worsens in September

Oct 8 (Economic Times) — Japan’s service sector sentiment index fell to 47.5 in September, a Cabinet Office survey showed on Thursday. The survey of workers such as taxi drivers, hotel workers and restaurant staff – called “economy watchers” for their proximity to consumer and retail trends – showed their confidence about current economic conditions slipped from 49.3 in August. The outlook index, indicating the level of confidence in future conditions, rose to 49.1 in September from 48.2 the previous month. The Cabinet Office started compiling the data in comparative form in August 2001.

Krugman on debt

Debt Is Good

By Paul Krugman

Aug 21 (NYT) — Rand Paul said something funny the other day. No, really — although of course it wasn’t intentional. On his Twitter account he decried the irresponsibility of American fiscal policy, declaring, “The last time the United States was debt free was 1835.”


Which consequently was followed by the worst depression in US history.

Wags quickly noted that the U.S. economy has, on the whole, done pretty well these past 180 years, suggesting that having the government owe the private sector money might not be all that bad a thing. The British government, by the way, has been in debt for more than three centuries, an era spanning the Industrial Revolution, victory over Napoleon, and more.

But is the point simply that public debt isn’t as bad as legend has it? Or can government debt actually be a good thing?

Believe it or not, many economists argue that the economy needs a sufficient amount of debt out there to function well.


Yes, to offset desires to not spend income (save) when private sector borrowing to spend isn’t sufficient, as evidenced by unemployment.

And how much is sufficient? Maybe more than we currently have. That is, there’s a reasonable argument to be made that part of what ails the world economy right now is that governments aren’t deep enough in debt.


Yes, it’s called unemployment, which is the evidence that deficit spending is insufficient to offset desires to not spend income. Something economists have known by identity for at least 300 years.

I know that may sound crazy. After all, we’ve spent much of the past five or six years in a state of fiscal panic, with all the Very Serious People declaring that we must slash deficits and reduce debt now now now or we’ll turn into Greece, Greece I tell you.

But the power of the deficit scolds was always a triumph of ideology over evidence, and a growing number of genuinely serious people — most recently Narayana Kocherlakota, the departing president of the Minneapolis Fed — are making the case that we need more, not less, government debt.

Why?


This is the right answer- because the US public debt, for example, is nothing more than the dollars spent by the govt that haven’t yet been used to pay taxes. Those dollars constitute the net financial dollar assets of the global economy (net nominal savings), as actual cash, or dollar balances in bank accounts at the Federal Reserve Bank called reserve accounts and securities accounts. Functionally, it is not wrong to call these dollars the ‘monetary base’. And a growing economy that generates increasing quantities of unspent income likewise needs an increasing quantity of spending that exceeds income- private or public- for a growing output to get sold.

One answer is that issuing debt is a way to pay for useful things, and we should do more of that when the price is right.


Wrong answer. It’s never about ‘when the price is right’. It is always a political question regarding resource allocation between the public sector and private sector.

The United States suffers from obvious deficiencies in roads, rails, water systems and more; meanwhile, the federal government can borrow at historically low interest rates.


Wrong answer. Yes, there is a serious infrastructure deficiency. The right question, however, is whether the US has the available resources and whether it wants to allocate them for that purpose.

So this is a very good time to be borrowing and investing in the future, and a very bad time for what has actually happened: an unprecedented decline in public construction spending adjusted for population growth and inflation.


I agree it’s a good time to fund infrastructure investment, due to said deficiencies.

However, whether or not it’s a good time to increase deficit spending is a function of how much slack is in the economy, as evidenced by the unemployment rates, participation rates, etc. And not by infrastructure needs.

And my read based on that criteria is that it’s a good time for proactive fiscal expansion.

Nor in any case is deciding whether or not to increase deficit spending rightly about whether or not to increase borrowing per se for a government that, under close examination, from inception necessarily spends or lends first, and then borrows. As Fed insiders say, ‘you can’t do a reserve drain without first doing a reserve add.’

Beyond that, those very low interest rates are telling us something about what markets want.


Wrong, they are telling is something about what level market participants think the fed will target the Fed funds rate over time.

I’ve already mentioned that having at least some government debt outstanding helps the economy function better. How so?


Right answer- deficit spending adds income and net financial assets to the economy to support sufficient spending to get the output sold.

The answer, according to M.I.T.’s Ricardo Caballero and others, is that the debt of stable, reliable governments provides “safe assets” that help investors manage risks, make transactions easier and avoid a destructive scramble for cash.


Wrong answer. Net govt spending provides in the first instance provides dollars (tax credits) in the form of dollar deposits in reserve accounts at the Federal Reserve Bank. Treasury securities are nothing more than alternative deposits in securities accounts at the Federal Reserve Bank for those dollars. Both are equally ‘safe’.

Now, in principle the private sector can also create safe assets, such as deposits in banks that are universally perceived as sound. In the years before the 2008 financial crisis Wall Street claimed to have invented whole new classes of safe assets by slicing and dicing cash flows from subprime mortgages and other sources.

But all of that supposedly brilliant financial engineering turned out to be a con job: When the housing bubble burst, all that AAA-rated paper turned into sludge. So investors scurried back into the haven provided by the debt of the United States and a few other major economies. In the process they drove interest rates on that debt way down.


Rates went down in anticipation of future rate setting by the fed.

What investors did was reprice financial assets. Investors can’t change total financial assets. The total only changes with new issues and redemptions/maturities.

And those low interest rates, Mr. Kocherlakota declares, are a problem. When interest rates on government debt are very low even when the economy is strong, there’s not much room to cut them when the economy is weak, making it much harder to fight recessions.


True, but cutting rates doesn’t fight recessions. In fact low rates reduce interest income paid by govt to the economy, thereby weakening it.

There may also be consequences for financial stability: Very low returns on safe assets may push investors into too much risk-taking — or for that matter encourage another round of destructive Wall Street hocus-pocus.


That would be evidenced by an increase in the issuance of higher risk securities, but there has been no evidence of that. In fact, it was $100 oil that at the margin drove the credit expansion that supported GDP growth, as evidenced by the collapse when prices fell.

What can be done? Simply raising interest rates, as some financial types keep demanding (with an eye on their own bottom lines), would undermine our still-fragile recovery.


It would more likely very modestly strengthen it from the increase in the govt deficit due to the increased interest income paid by govt to the economy. However, I’d prefer a tax cut and/or spending increase to support GDP, rather than an interest rate increase. But that’s just me…

What we need are policies that would permit higher rates in good times without causing a slump. And one such policy, Mr. Kocherlakota argues, would be targeting a higher level of debt.


Mr. K isn’t wrong, but again I’d rather just have a larger tax cut to get to the same point, but, again, that’s just me…

In other words, the great debt panic that warped the U.S. political scene from 2010 to 2012, and still dominates economic discussion in Britain and the eurozone, was even more wrongheaded than those of us in the anti-austerity camp realized.


True, and this author…

Not only were governments that listened to the fiscal scolds kicking the economy when it was down, prolonging the slump; not only were they slashing public investment at the very moment bond investors were practically pleading with them to spend more; they may have been setting us up for future crises.


True but for differing reasons. It’s never about investors pleading. It’s always about the public purpose behind the policies.

And the ironic thing is that these foolish policies, and all the human suffering they created, were sold with appeals to prudence and fiscal responsibility.


The larger problem with this editorial is that the wrong reasons it gives for what’s largely the right policy are out of paradigm reasons that the opposition routinely shoots down and shouts down, easily convincing the electorate that they are correct and the ‘headline left’ is wrong.

Feel free to distribute

Fed white paper, building permits, transport charts, Japan trade


So someone on high sees it much like I do…

;)

In a white paper dissecting the U.S. central bank’s actions to stem the financial crisis in 2008 and 2009, Stephen D. Williamson, vice president of the St. Louis Fed, finds fault with three key policy tenets.

Specifically, he believes the zero interest rates in place since 2008 that were designed to spark good inflation actually have resulted in just the opposite. And he believes the “forward guidance” the Fed has used to communicate its intentions has instead been a muddle of broken vows that has served only to confuse investors. Finally, he asserts thatquantitative easing, or the monthly debt purchases that swelled the central bank’s balance sheet past the $4.5 trillion mark, have at best a tenuous link to actual economic improvements.

Remember last month cautioning about how a spike up in building permits has sometimes been followed by recession?
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And the NY benefits that expired June 15 were supporting the total numbers and are likely to be followed by much lower numbers:
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Once again Varoufakis reconfirms he’s clueless with regard to public finance:

Varoufakis Proposal for Eurozone Sovereign Debt

August 18 (Econintersect) — Former Greek finance minister Yanis Varoufakis has proposed a debt restructuring process for over-indebted Eurozone countries that does not involve writing down debt or bailing out insolvent countries. It is based on an idea proposed by Varoufakis with Stuart Holland and James K. Galbraith (link below).

The proposal is for a complex and costly process functionally identical to a simple, no cost, ECB guarantee.

DB Charts:

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Exports growing though at a slower rate, imports declining at a faster rate:

Japan : Merchandise Trade
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Redbook Retail Sales, Case-Shiller House Prices, PMI Services, Consumer Confidence, Richmond Fed, Oil Capex, Truck Tonnage

Still bad:

source: Econoday.com
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Softening:

source: Econoday.com
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I don’t put much weight on Markit surveys, but the optimism comment is interesting:


source: Econoday.com
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Highlights

Service sector growth is strengthening slightly this month based on Markit’s July flash index which is up 4 tenths to a very solid 55.2. New orders are at a 3-month high and are getting a boost from both consumer spending and from business customers, the latter a welcome signal of strength for business investment. Backlogs are up and so is hiring. But optimism in the 12-month outlook, perhaps shaken by the outlook for the global economy, is the softest it’s been in three years. Input prices continue to rise but final prices are flat. This report is mostly upbeat and, despite the easing in the outlook, points to solid contribution from the service sector.

This kind of drop is concerning, and I’ve been watching for employment, a lagging indicator, to take a dive:

source: Econoday.com
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Highlights

Consumer confidence has weakened substantially this month, to 90.9 which is more than 6 points below Econoday’s low estimate. Weakness is centered in the expectations component which is down nearly 13 points to 79.9 and reflects sudden pessimism in the jobs outlook where an unusually large percentage, at 20 percent even, see fewer jobs opening up six months from now.

Less severe is weakness in the present situation component which is down nearly 3 points to 107.4. Here, slightly more, at 26.7 percent, say jobs are hard to get but this is still low for this reading.

A striking negative in the report is a drop in buying plans for autos which confirms weakness elsewhere in the report. Inflation expectations are steady at 5.1 percent which is soft for this reading.

This report is citing problems in Greece and China as possible factors for the decline in expectations, but US consumers are typically insulated from international events. The decline in expectations, mirrored earlier this morning by a similar decline in the service-sector outlook, may be sending early hints of second-half slowing, slowing that could push back of course the Fed’s expected rate hike.

A bit better, but another reference to softening employment. And note the volatility of this series, with moves up often followed quickly with moves down:

source: Econoday.com
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Highlights

The Richmond Fed is reporting the best strength of any manufacturing region this month, at 13 which is above the Econoday top-end estimate. New orders are especially strong, up 7 points to 17, with backlog orders also rising, up 7 points to 10. Shipments are strong, capacity utilization is up and inventories, because of the activity, are being drawn down. Hiring, however, is slowing. Price data show slight pressure for inputs but no pressure for finished goods.

This report contrasts with much slower rates of growth in the New York and Philadelphia Fed regions and sharply contrasts with recent data from the Dallas and Kansas City Feds where manufacturing, due to the energy sector, is in deep contraction. But today’s result is a welcome positive, suggesting that manufacturing may yet pick up this year and a reminder of strength in yesterday’s durable goods report.

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This had been estimated at $100 billion:

source: Financial Times
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labor market index, consumer credit, China trade, BIS on oil and debt

This is the Fed’s new indicator:

Labor Market Conditions Index
lm-conditions
Definition
The U.S. labor market is large and multifaceted. Often-cited indicators such as the unemployment rate or payroll employment, measure a particular dimension of labor market activity. It is not uncommon for different indicators to send conflicting signals about labor market conditions. The Fed’s research department has created a labor market conditions index (LMCI) based on 19 labor market indicators. It is not an official report. However, the monthly publication is carefully noted by Fed Chair Janet Yellen and has gained market attention.

Misleading at best as the two month average was just that, average:

Consumers swipe way to largest increase in revolving credit since March (WSJ) Total outstanding consumer credit expanded at a 5.37% seasonally adjusted annual rate to $3.31 trillion in December. That was a slight acceleration from November’s 4.92% gain. Revolving credit grew at a 7.85% pace in December, a turnaround from November’s 1.28% decline. December’s expansion in revolving credit was the largest since March. Nonrevolving credit, such as auto and student loans, grew at a 4.46% pace during the month, the smallest monthly increase since October 2011. November’s nonrevolving balances grew 7.21%. Revolving credit tends to be volatile, but nonrevolving credit has consistently expanded since August 2011.

No acceleration in growth whatsoever:
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The revolving is volatile but doesn’t look to be going anywhere:
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January data always suspect but sometimes indicative:

China’s imports slump, capping dismal January trade performance (Reuters) China exports fell 3.3 percent in January from year-ago levels while imports tumbled 19.9 percent. Last year the new year holiday idled factories and financial markets for a week in January, but this year the holiday comes in late February and January was a full month of business as usual. Coal imports dropped nearly 40 percent to 16.78 million tonnes, down from December’s 27.22 million tones. Crude oil imports slid by 7.9 percent in volume terms. While exports to the United States rose by 4.8 percent year-on-year to $35 billion, exports to the European Union slid 4.6 percent to $33 billion in the same period. Exports to Hong Kong, South Korea and Japan were also down, with exports to Japan slumping over 20 percent.

China’s Exports Post Surprise Drop in January (WSJ) Exports fell 3.3% in January from a year earlier, a sharp deterioration from December’s 9.7% rise. In January, exports to Southeast Asia and the U.S. were stronger, while shipments to the European Union, Japan and Hong Kong were all weaker in dollar terms. In a statement accompanying the trade data, China’s customs authorities said that a survey showed weaker confidence among exporters for the fourth consecutive month. “This shows that exports will be facing downward pressure in the first quarter as well as the beginning of the second quarter,” the statement said. Year-ago data for January may have been inflated by over-invoicing by exporters. Exports climbed nearly 11% year over year in January last year.

This is a lot more threatening than I had been led to believe:

Box: Oil and debt

Note the rate of energy debt growth over the last few years, and that these charts don’t include all energy related debt. Looks to have been about 1% of GDP and added about that much plus ‘multipliers’, filling in for the tax hikes and sequesters of 2013.

And now it’s over.

Two things as price fell in half from $100/barrel.

1. Credit expansion slows and maybe reverses.

2. The value of the collateral behind the loans has been halved, which is highly problematic for the lenders.
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These are just initial BIS findings. The full report comes out in March.

And not to forget there’s now a new King of Saudia Arabia who decides what the price will be.

A Modest Response

A Modest Proposal for Resolving the Eurozone Crisis

By Y. Varoufakis, S. Holland AND J.K. Galbraith

1. Prologue
Europe is fragmenting. While in the past year the European Central Bank has managed to stabilise the bond markets, the economies of the European core and its periphery are drifting apart. As this happens, human costs mount and disintegration becomes an increasing threat.

It is not just a matter for the Eurozone. The fallout from a Eurozone breakup would destroy the European Union, except perhaps in name. And Europe’s fragmentation poses a global danger.

Following a sequence of errors and avoidable delays Europe’s leadership remains in denial about the nature of the crisis, and continues to pose the false choice between draconian austerity and a federal Europe.

By contrast, we propose immediate solutions, feasible within current European law and treaties.

There are in this crisis four sub-crises: a banking crisis, a public debt crisis, a crisis of under-investment, and now a social crisis – the result of five years of policy failure. Our Modest Proposal therefore now has four elements. They deploy existing institutions and require none of the moves that many Europeans oppose, such as national guarantees or fiscal transfers. Nor do they require treaty changes, which many electorates anyway could reject. Thus we propose a European New Deal which, like its American forebear would lead to progress within months, yet through measures that fall entirely within the constitutional framework to which European governments have already agreed.

2. The nature of the Eurozone crisis
The Eurozone crisis is unfolding on four interrelated domains. Banking crisis: There is a common global banking crisis, which was sparked off mainly by the catastrophe in American finance. But the Eurozone has proved uniquely unable to cope with the disaster, and this is a problem of structure and governance. The Eurozone features a central bank with no government, and national governments with no supportive central bank, arrayed against a global network of mega-banks they cannot possibly supervise. Europe’s response has been to propose a full Banking Union – a bold measure in principle but one that threatens both delay and diversion from actions that are needed immediately.

Better understood as a lack of credible deposit insurance, which logically requires that the entity that provides the insurance- the ECB in this case- is responsible for the regulation and supervision of its banks.

Debt crisis: The credit crunch of 2008 revealed the Eurozone’s principle of perfectly separable public debts to be unworkable. Forced to create a bailout fund that did not violate the no-bailout clauses of the ECB charter and Lisbon Treaty, Europe created the temporary European Financial Stability Facility (EFSF) and then the permanent European Stability Mechanism (ESM). The creation of these new institutions met the immediate funding needs of several member-states, but retained the flawed principle of separable public debts and so could not contain the crisis. One sovereign state, Cyprus, has now de facto gone bankrupt, imposing capital controls even while remaining inside the euro.

During the summer of 2012, the ECB came up with another approach: the Outright Monetary Transactions’ Programme (OMT). OMT succeeded in calming the bond markets for a while. But it too fails as a solution to the crisis, because it is based on a threat against bond markets that cannot remain credible over time. And while it puts the public debt crisis on hold, it fails to reverse it; ECB bond purchases cannot restore the lending power of failed markets or the borrowing power of failing governments.

Better understood as failure of the ECB to explicitly guarantee national govt bonds against default. It was only when Mario Draghi said the ECB would ‘do what it takes to prevent default of national govt debt’ that spreads narrowed and the national funding crisis faded. And it is only the threat that Greece will be allowed to default that is causing the current Greek funding crisis.

Investment crisis: Lack of investment in Europe threatens its living standards and its international competitiveness.

He doesn’t differentiate between public investment in public infrastructure, vs private investment that responds to prospects for profits.

As Germany alone ran large surpluses after 2000, the resulting trade imbalances ensured that when crisis hit in 2008, the deficit zones would collapse.

How is ‘collapse’ defined here? The funding crisis was a function of ECB policy that presumably would allow member nations to default, as when Draghi said that would not happen that crisis ended.

And the burden of adjustment fell exactly on the deficit zones, which could not bear it.

However, there were and remain alternatives to said ‘adjustments’ including the permission to run larger budget deficits than the current, arbitrary, 3% limit. Note that this ‘remedy’ is never even suggested or seriously discussed.

Nor could it be offset by devaluation or new public spending, so the scene was set for disinvestment in the regions that needed investment the most. Thus, Europe ended up with both low total investment and an even more uneven distribution of that investment between its surplus and deficit regions.

True, however it is not recognized that the fundamental cause is that the 3% deficit limit is too low.

Social crisis: Three years of harsh austerity have taken their toll on Europe’s peoples.

From Athens to Dublin and from Lisbon to Eastern Germany, millions of Europeans have lost access to basic goods and dignity. Unemployment is rampant. Homelessness and hunger are rising. Pensions have been cut; taxes on necessities meanwhile continue to rise. For the first time in two generations, Europeans are questioning the European project, while nationalism, and even Nazi parties, are gaining strength.

True

3. Political constraints for any solution.
Any solution to the crisis must respect realistic constraints on political action. This is why grand schemes should be shunned. It is why we need a modest proposal.

But immodest enough to do more than rearrange the deck chairs on the titanic.

Four constraints facing Europe presently are: (a) The ECB will not be allowed to monetise sovereigns directly.

Not necessary

There will be no ECB guarantees of debt issues by member-states,

They already said they will do what it takes to prevent default, meaning at maturity and when interest payments are due the ECB will make sure the appropriate accounts are credited. However this policy is discretionary, with threats Greece would be allowed to default.

no ECB purchases of government bonds in the primary market,

Not necessary

no ECB leveraging of the EFSF-ESM to buy sovereign debt from either the primary or secondary markets.

Not necessary

(b) The ECB’s OMT programme has been tolerated insofar as no bonds are actually purchased. OMT is a policy that does not match stability with growth and, sooner or later, will be found wanting.

And accomplishes nothing of consequence for the real economy.

(c) Surplus countries will not consent to ‘jointly and severally’ guaranteed Eurobonds to mutualise debt and deficit countries will resist the loss of sovereignty that would be demanded of them without a properly functioning federal transfer union which Germany, understandably, rejects.

Said eurobonds not necessary for fiscal transfers.

(d) Europe cannot wait for federation. If crisis resolution is made to depend on federation, the Eurozone will fail first.

Probably true.

The treaty changes necessary to create a proper European Treasury, with the powers to tax, spend and borrow, cannot, and must not, be held to precede resolution of this crisis.

Nor are they necessary to sustain full employment.

The next section presents four policies that recognise these constraints.

4. THE MODEST PROPOSAL – Four crises, four policies The Modest Proposal introduces no new EU institutions and violates no existing treaty. Instead, we propose that existing institutions be used in ways that remain within the letter of European legislation but allow for new functions and policies.

These institutions are:

· The European Central Bank – ECB

· The European Investment Bank – EIB

· The European Investment Fund – EIF

· The European Stability Mechanism – ESM

Policy 1 – Case-by-Case Bank Programme (CCBP)

For the time being, we propose that banks in need of recapitalisation from the ESM be turned over to the ESM directly – instead of having the national government borrow on the bank’s behalf.

‘In need of recapitalization’ is not defined. With credible deposit insurance banks can function in the normal course of business without capital, for example. That means ‘need of capital’ is a political and not an operational matter.

Banks from Cyprus, Greece and Spain would likely fall under this proposal. The ESM, and not the national government, would then restructure, recapitalize and resolve the failing banks dedicating the bulk of its funding capacity to this purpose.

Those banks are necessarily already ‘funded’ via either deposits or central bank credits, unless their equity capital is already negative and not simply below regulatory requirements, as for every asset there is necessarily a liability. And I have not been aware of the banks in question have negative capital accounts.

The Eurozone must eventually become a single banking area with a single banking authority.

Yes, with the provider of deposit insurance, the ECB, also doing the regulation and supervision.

But this final goal has become the enemy of good current policy. At the June 2012 European Summit direct bank recapitalisation was agreed upon in principle, but was made conditional on the formation of a Banking Union. Since then, the difficulties of legislating, designing and implementing a Banking Union have meant delay and dithering. A year after that sensible decision, the deadly embrace between insolvent national banking systems and insolvent member-states continues.

Today the dominant EU view remains that banking union must be completed before the ESM directly recapitalises banks.

Again, I don’t recall the problem being negative bank capital, but merely capital that may fall short of required minimums, in which case not only is no ‘public funding’ is required with regard to capital, but the concept itself is inapplicable as adding public capital doesn’t alter the risk to ‘public funds’

And that when it is complete, the ESM’s contribution will be partial and come only after a bail in of depositors in the fiscally stressed countries of the periphery. That way, the banking crisis will either never be resolved or its resolution be delayed for years, risking a new financial implosion.

Our proposal is that a national government should have the option of waiving its right to supervise and resolve a failing bank.

This carries extreme moral hazard, as it removes the risk of inadequate supervision from the national govt, and instead rewards lax supervision. Instead that right to supervise and regulate should immediately be transferred to the ECB for the entire national banking system in exchange for ECB deposit insurance.

Shares equivalent to the needed capital injection will then pass to the ESM, and the ECB and ESM will appoint a new Board of Directors. The new board will conduct a full review of the bank’s position and will recommend to the ECB-ESM a course for reform of the bank. Reform may entail a merger, downsizing, even a full resolution of the bank, with the understanding that steps will be taken to avoid, above all, a haircut of deposits.

That is functionally what I call sustaining credible deposit insurance which largely eliminates bank liquidity issues.

Once the bank has been restructured and recapitalised, the ESM will sell its shares and recoup its costs.

I agree with the resolution process.

The above proposal can be implemented today, without a Banking Union or any treaty changes.

The experience that the ECB and the ESM will acquire from this case-by-case process will help hone the formation of a proper banking union once the present crisis recedes.

POLICY 2 – Limited Debt Conversion Programme (LDCP)
The Maastricht Treaty permits each European member-state to issue sovereign debt up to 60% of GDP. Since the crisis of 2008, most Eurozone member-states have exceeded this limit. We propose that the ECB offer member-states the opportunity of a debt conversion for their Maastricht Compliant Debt (MCD), while the national shares of the converted debt would continue to be serviced separately by each member-state.

The ECB, faithful to the non-monetisation constraint (a) above, would not seek to buy or guarantee sovereign MCD debt directly or indirectly. Instead it would act as a go-between, mediating between investors and member-states. In effect, the ECB would orchestrate a conversion servicing loan for the MCD, for the purposes of redeeming those bonds upon maturity.

The conversion servicing loan works as follows. Refinancing of the Maastricht compliant share of the debt, now held in ECB-bonds, would be by member-states but at interest rates set by the ECB just above its bond yields. The shares of national debt converted to ECB-bonds are to be held by it in debit accounts. These cannot be used as collateral for credit or derivatives creation.6 Member states will undertake to redeem bonds in full on maturity, if the holders opt for this rather than to extend them at lower, more secure rates offered by the ECB.

Governments that wish to participate in the scheme can do so on the basis of Enhanced Cooperation, which needs at least nine member-states.7 Those not opting in can keep their own bonds even for their MCD. To safeguard the credibility of this conversion, and to provide a backstop for the ECB-bonds that requires no ECB monetisation, member-states agree to afford their ECB debit accounts super-seniority status, and the ECB’s conversion servicing loan mechanism may be insured by the ESM, utilising only a small portion of the latter’s borrowing capacity. If a member-state goes into a disorderly default before an ECB-bond issued on its behalf matures, then that ECB-bond payment will be covered by insurance purchased or provided by the ESM.

This can more readily be accomplished by formalizing and making permanent the ‘do what it takes to prevent default’ policy that’s already in place, and it will immediately lower the cost of new securities as well.

Why not continue with the ECB’s OMT? The ECB has succeeded in taming interest rate spreads within the Eurozone by means of announcing its Outright Monetary Transactions’ programme (OMT). OMT was conceived as unlimited support of stressed Euro-Area bonds – Italy’s and Spain’s in particular – so as to end the contagion and save the euro from collapse.

Instead I give credit for the low rates to the ‘do what it takes’ policy.

However, political and institutional pressures meant that the threat against bond dealers, which was implicit in the OMT announcement, had to be diluted to a conditional programme. The conditionality involves troika-supervision over the governments to be helped by the OMT, who are obliged to sign a draconian memorandum of understanding before OMT takes effect. The problem is not only that this of itself does nothing to address the need for both stability and growth, but that the governments of Spain and Italy would not survive signing such a memorandum of understanding, and therefore have not done so.

Thus OMT’s success in quelling the bond markets is based on a non-credible threat. So far, not one bond has been purchased. This constitutes an open invitation to bond dealers to test the ECB’s resolve at a time of their choosing. It is a temporary fix bound to stop working when circumstances embolden the bond dealers. That may happen when volatility returns to global bond markets once the Federal Reserve and the Bank of Japan begin to curtail their quantitative easing programmes.

There will be no funding issues while ‘do what it takes to prevent default’ policy is in force.

POLICY 3 – An Investment-led Recovery and Convergence Programme (IRCP)
In principle the EU already has a recovery and convergence strategy in the European Economic Recovery Programme 2020. In practice this has been shredded by austerity. We propose that the European Union launch a new investment programme to reverse the recession, strengthen European integration, restore private sector confidence and fulfill the commitment of the Rome Treaty to rising standards of living and that of the 1986 Single European Act to economic and social cohesion.

The Investment-led Recovery and Convergence Programme (IRCP) will be cofinanced by bonds issued jointly by the European Investment Bank (EIB) and the European Investment Fund (EIF). The EIB has a remit to invest in health, education, urban renewal, urban environment, green technology and green power generation, while the EIF both can co-finance EIB investment projects and should finance a European Venture Capital Fund, which was part of its original design.

A key principle of this proposal is that investment in these social and environmental domains should be europeanised. Borrowing for such investments should not count on national debt anymore than US Treasury borrowing counts on the debt of California or Delaware. The under-recognised precedents for this are (1) that no major European member state counts EIB borrowing against national debt, and (2) that the EIB has successfully issued bonds since 1958 without national guarantees.

EIB-EIF finance of an IRCP therefore does not need national guarantees or a common fiscal policy. Instead, the joint bonds can be serviced directly by the revenue streams of the EIB-EIF-funded investment projects. This can be carried out within member states and will not need fiscal transfers between them.

A European Venture Capital Fund financed by EIF bonds was backed unanimously by employers and trades unions on the Economic and Social Committee in their 2012 report Restarting Growth. Central European economies (Germany and Austria) already have excellent finance for small and medium firms through their Mittelstandpolitik. It is the peripheral economies that need this, to build new sectors, to foster convergence and cohesion and to address the growing imbalances of competitiveness within the Eurozone.

Rationale

The transmission mechanism of monetary policy to the periphery of Europe has broken down. Mr Mario Draghi admits this. He has gone on record to suggest that the EIB play a active role in restoring investment financing in the periphery. Mr Draghi is right on this point.

But, for the IRCP to reverse the Eurozone recession and stop the de-coupling of the core from the periphery, it must be large enough to have a significant effect on the GDP of the peripheral countries.

If EIB-EIF bonds are to be issued on this scale, some fear that their yields may rise. But this is far from clear. The world is awash in savings seeking sound investment outlets. Issues of EIF bonds that co-finance EIB investment projects should meet these demands, supporting stability and working to restore growth in the European periphery. We therefore submit that joint EIB-EIF bond issues can succeed without formal guarantees. Nonetheless, in fulfillment of its remit to support “the general economic policies in the Union”, the ECB can issue an advance or precautionary statement that it will partially support EIB-EIF bonds by means of standard central bank refinancing or secondary market operations. Such a statement should suffice to allow the EIB-EIF funded IRCP to be large enough for the purposes of bringing about Europe’s recovery.

Misleading arguments and unworkable alternatives:

There are calls for bonds to finance infrastructure, neglecting the fact that this has been happening through the European Investment Bank (EIB) for more than half a century. An example is a recent European Commission proposal for ‘Project Bonds’ to be guaranteed by member states. This assures opposition from many of them, not least Germany, while ignoring the fact that the EIB has issued project bonds successfully since 1958, without such guarantees.10

There is no high-profile awareness that EIB investment finance does not count on the national debt of any major member state of the EU nor need count on that of smaller states.11

There is a widespread presumption that public investment drains the private sector when in fact it sustains and supports it. There is similar presumption that one cannot solve the crisis by ‘piling debt on debt’. It depends on which debt for which purpose, and at what rates. Piling up national debt at interest rates of up to seven per cent or more without recovery is suicidal. Funding inflows from global surpluses to Europe to promote economic recovery through joint EIB-EIF bonds at interest rates which could be less than two per cent is entirely sustainable.

There is little awareness of the EIB’s sister organisation, the European Investment Fund (EIF), which has a large potential for investment funding of SMEs, high technology clusters and a variety of other projects, which it can cofinance with bonds, issued jointly with the EIB (see note 9). Why aren’t the EIB-EIF doing this now? Until the onset of the Eurozone crisis the EIB had succeeded in gaining national co-finance, or co-finance from national institutions, for its investments. But with the crisis and constraints on co-finance, total annual EIB financing fell from over €82bn in 2008 to only €45bn last year. The EIF can counterpart and thereby countervail this. It is a sister institution of the EIB within the EIB Group. Like EIB bonds, EIF bonds need not count on national debt nor need national guarantees. The EIB would retain control over project approval and monitoring. In sum, we recommend that:

The IRCP be funded by means of jointly issued EIB and EIF bonds without any formal guarantees or fiscal transfers by member states.

Both EIB and EIF bonds be redeemed by the revenue stream of the investment • projects they fund, as EIB bonds always have been.

If needed, the ECB should stand by to assist in keeping yields low, through direct purchases of EIB-EIF bonds in the secondary market.

I agree the role of the EIB could be expanded, however the political difficulties are substantial and the time to initial implementation will likely be a year or more- time the EU may not have.

POLICY 4 – An Emergency Social Solidarity Programme (ESSP)

We recommend that Europe embark immediately on an Emergency Social Solidarity Programme that will guarantee access to nutrition and to basic energy needs for all Europeans, by means of a European Food Stamp Programme modelled on its US equivalent and a European Minimum Energy Programme. These programmes would be funded by the European Commission using the interest accumulated within the European system of central banks, from TARGET2 imbalances, profits made from government bond transactions and, in the future, other financial transactions or balance sheet stamp duties that the EU is currently considering.

These revenues currently are returned to the member nations and without them compliance with the 3% deficit limit will reduce other spending and/or require additional taxes.

Rationale

Europe now faces the worst human and social crisis since the late 1940s. In member-states like Greece, Ireland, Portugal, but also elsewhere in the Eurozone, including core countries, basic needs are not being met. This is true especially for the elderly, the unemployed, for young children, for children in schools, for the disabled, and for the homeless. There is a plain moral imperative to act to satisfy these needs. In addition, Europe faces a clear and present danger from extremism, racism, xenophobia and even outright Nazism – notably in countries like Greece that have borne the brunt of the crisis. Never before have so many Europeans held the European Union and its institutions in such low esteem. The human and social crisis is turning quickly into a question of legitimacy for the European Union.

Reason for TARGET2 funding

TARGET2 is a technical name for the system of internal accounting of monetary flows between the central banks that make up the European System of Central Banks. In a well balanced Eurozone, where the trade deficit of a member state is financed by a net flow of capital to that same member-state, the liabilities of that state’s central bank to the central banks of other states would just equal its assets.

Not true. Target 2 is about clearing balances that can cause banks to gain or lose liquidity independent of national trade balances.

Such a balanced flow of trade and capital would yield a TARGET2 figure near zero for all member-states.

Again, it’s not trade per se that alters bank liquidity issues.

And that was, more or less, the case throughout the Eurozone before the crisis.

However, the crisis caused major imbalances that were soon reflected in huge TARGET2 imbalances.

The clearing imbalances were caused by lack of credible deposit insurance exacerbated by potential bank failures, not trade per se.

As inflows of capital to the periphery dried up, and capital began to flow in the opposite direction, the central banks of the peripheral countries began to amass large net liabilities and the central banks of the surplus countries equally large net assets.

Yes, but not to confuse capital, which is bank equity/net worth, and liquidity which is the funding of assets and is sometimes casually called ‘capital’ the way ‘money’ is casually called capital.

The Eurozone’s designers had attempted to build a disincentive within the intraEurosystem real-time payments’ system, so as to prevent the build-up of huge liabilities on one side and corresponding assets on the other. This took the form of charging interest on the net liabilities of each national central bank, at an interest rate equal to the ECB’s main refinancing level.

The purpose of this policy rate is to make sure the ECB’s policy rate is the instrument of monetary policy, reflected as the banking system’s cost of funds.

These payments are distributed to the central banks of the surplus member-states, which then pass them on to their government treasury.

In practice, one bank necessarily has a credit balance at the ECB when another has a debit balance, and net debit balances exist to the extent there is actual cash in circulation that banks get in exchange for clearing balances. This keeps the banking system ‘net borrowed’ which provides the ECB with interest income. Additionally buying securities that yield more than deposit rates adds income to the ECB.

Thus the Eurozone was built on the assumption that TARGET2 imbalances would be isolated, idiosyncratic events, to be corrected by national policy action.

The system did not take account of the possibility that there could be fundamental structural asymmetries and a systemic crisis.

Today, the vast TARGET2 imbalances are the monetary tracks of the crisis. They trace the path of the consequent human and social disaster hitting mainly the deficit regions. The increased TARGET2 interest would never have accrued if the crises had not occurred. They accrue only because, for instance, risk averse Spanish and Greek depositors, reasonably enough, transfer their savings to a Frankfurt bank.

Yes, my point exactly, and somewhat counter to what was stated previously. Depositors can shift banks for a variety of reasons, with or without trade differentials.

As a result, under the rules of the TARGET2 system, the central bank of Spain and of Greece have to pay interest to the Bundesbank – to be passed along to the Federal Government in Berlin.

Which then pays interest to its depositors. The ECB profits to the extent it establishes a spread between the rate it lends at vs the rate paid to depositors. That spread is a political decision.

This indirect fiscal boost to the surplus country has no rational or moral basis. Yet the funds are there, and could be used to deflect the social and political danger facing Europe.

There is a strong case to be made that the interest collected from the deficit member-states’ central banks should be channelled to an account that would fund our proposed Emergency Social Solidarity Programme (ESSP). Additionally, if the EU introduces a financial transactions’ tax, or stamp duty proportional to the size of corporate balance sheets, a similar case can be made as to why these receipts should fund the ESSP. With this proposal, the ESSP is not funded by fiscal transfers nor national taxes.

The way I see it, functionally, it is a fiscal transfer, and not that I am against fiscal transfers!

My conclusion is that any improvement in the economy from these modest proposals, and as I’ve qualified above, will likewise be at least as modest. That is, the time and effort to attempt to implement these proposals, again, as qualified, will make little if any progress in fixing the economy as another generation is left to rot on the vine.

5. CONCLUSION: Four realistic policies to replace of five false choices Three years of crisis have culminated in a Europe that has lost legitimacy with its own citizens and credibility with the rest of the world. Europe is unnecessarily back in recession. While the bond markets were placated by the ECB’s actions in the summer of 2012, the Eurozone remains on the road toward disintegration.

While this process eats away at Europe’s potential for shared prosperity, European governments are imprisoned by false choices:

between stability and growth

between austerity and stimulus

between the deadly embrace of insolvent banks by insolvent governments, and an admirable but undefined and indefinitely delayed Banking Union

between the principle of perfectly separable country debts and the supposed need to persuade the surplus countries to bankroll the rest

between national sovereignty and federalism. These falsely dyadic choices imprison thinking and immobilise governments. They are responsible for a legitimation crisis for the European project. And they risk a catastrophic human, social and democratic crisis in Europe.

By contrast the Modest Proposal counters that:

The real choice is between beggar-my-neighbour deflation and an investmentled recovery combined with social stabilisation. The investment recovery will be funded by global capital, supplied principally by sovereign wealth funds and by pension funds which are seeking long-term investment outlets. Social stabilisation can be funded, initially, through the Target2 payments scheme.

Taxpayers in Germany and the other surplus nations do not need to bankroll the 2020 European Economic Recovery Programme, the restructuring of sovereign debt, resolution of the banking crisis, or the emergency humanitarian programme so urgently needed in the European periphery.

Neither an expansionary monetary policy nor a fiscal stimulus in Germany and other surplus countries, though welcome, would be sufficient to bring recovery to Europe.

Treaty changes for a federal union may be aspired by some, but will take too long , are opposed by many, and are not needed to resolve the crisis now. On this basis the Modest Proposal’s four policies are feasible steps by which to deal decisively with Europe’s banking crisis, the debt crisis, underinvestment, unemployment as well as the human, social and political emergency.

Version 4.0 of the Modest Proposal offers immediate answers to questions about the credibility of the ECB’s OMT policy, the impasse on a Banking Union, financing of SMEs through EIF bonds enabling a European Venture Capital Fund, green energy and high tech start-ups in Europe’s periphery, and basic human needs that the crisis has left untended.

It is not known how many strokes Alexander the Great needed to cut the Gordian knot. But in four strokes, Europe could cut through the knot of debt and deficits in which it has bound itself.

In one stroke, Policy 1, the Case-by-Case Bank Programme (CCBP), bypasses the impasse of Banking Union (BU), decoupling stressed sovereign debt and from banking recapitalisation, and allowing for a proper BU to be designed at leisure

By another stroke, Policy 2, the Limited Debt Conversion Programme (LDCP), the Eurozone’s mountain of debt shrinks, through an ECB-ESM conversion of Maastricht Compliant member-state Debt

By a third stroke, Policy 3, the Investment-led Recovery and Convergence Programme (IRCP) re-cycles global surpluses into European investments

By a fourth stroke, Policy 4, the Emergency Social Solidarity Programme (ESSP), deploys funds created from the asymmetries that helped cause the crisis to meet basic human needs caused by the crisis itself.

At the political level, the four policies of the Modest Proposal constitute a process of decentralised europeanisation, to be juxtaposed against an authoritarian federation that has not been put to European electorates, is unlikely to be endorsed by them, and, critically, offers them no assurance of higher levels of employment and welfare.

We propose that four areas of economic activity be europeanised: banks in need of ESM capital injections, sovereign debt management, the recycling of European and global savings into socially productive investment and prompt financing of a basic social emergency programme.

Our proposed europeanisation of borrowing for investment retains a large degree of subsidiarity. It is consistent with greater sovereignty for member-states than that implied by a federal structure, and it is compatible with the principle of reducing excess national debt, once banks, debt and investment flows are europeanised without the need for national guarantees or fiscal transfers.

While broad in scope, the Modest Proposal suggests no new institutions and does not aim at redesigning the Eurozone. It needs no new rules, fiscal compacts, or troikas. It requires no prior agreement to move in a federal direction while allowing for consent through enhanced cooperation rather than imposition of austerity.

It is in this sense that this proposal is, indeed, modest.

EU Commission- more of same

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Latvia’s Dombrovskis Brings Fiscal Hawk Record to EU Commission

By Mathew Dalton

Oct 5 (WSJ) — The budget hawk who steered Latvia out of economic collapse with a bruising austerity program is poised to get one of the EU’s top economic-policy jobs as Europe is heading toward a clash over austerity.

Former Prime Minister Valdis Dombrovskis is nominated to join the European Commission, the European Union’s executive arm, as one of its top economic policy makers. When he appears before the European Parliament for his confirmation hearing on Monday, one of the main questions will likely be whether he plans to bring the tough policies he used in Latvia to a much bigger stage.

A host of Europe’s deep-seated economic problems await him. They include anemic growth, high unemployment and the threat of deflation, all of which may haunt the region for years to come.

The 43-year-old Mr. Dombrovskis, whose portfolio will include oversight of national budgets, will be at the center of the debate now raging in Europe about whether tight budgets will exacerbate those problems and fuel the rise of extremist, anti-EU political parties.

His most immediate problem will be how to bring the finances of the French and Italian governments back in line with the EU’s budget rules. Paris and Rome argue the dismal shape of their economies means they should be granted more time to hit EU budget targets.

Wielding degrees in economics and physics, Mr. Dombrovskis brings formidable technical skills to the debates that lie ahead, say people who have worked with him, along with a free-market—some would say right-wing—economic philosophy and a direct personal style. “He’s very focused on fiscal rigor,” said Olli Rehn, a member of the European Parliament and the EU’s previous economics commissioner, who worked with Mr. Dombrovskis on an international bailout for Latvia in 2009. “He’s quite blunt and quite straightforward. I don’t know if that is being right-wing or not.”

Under Mr. Dombrovskis’s leadership, Latvia adopted sharp spending cuts to win emergency loans from the EU and the International Monetary Fund. His government kept the Latvian currency pegged to the euro, a measure that many economists say deepened the country’s pain.

The economy ultimately shrank by 25%. Poverty soared, as did emigration. The IMF sometimes chided Mr. Dombrovskis’s government for not doing enough to shield poorer Latvians from the hardship of the crisis.

Mr. Dombrovskis said that Latvia had no other choice but to cut deeply and that he wouldn’t necessarily recommend the Latvian solution for other countries. “I don’t think we can say that something is mechanically applicable from one situation to another,” he said.But he does argue that cutting the budget deficit quickly, as Latvia did in 2009 and 2010, is the best way to stabilize government finances. That puts him at odds with some economists and European officials, who have argued that sharp cuts can actually widen the deficit by throwing the economy into a deep recession. Mr. Dombrovskis also sought to temper his image as a hard-core budget hawk: “I see my task as balancing the economic and financial side, with the social side,” he said.

Einars Repše, Mr. Dombrovskis’s finance minister, said that Mr. Dombrovskis often mediated between competing forces in the government on budget questions.

“I recollect him being more on the cautious side than myself,” Mr. Repše said. “I was much more a supporter of radical and immediate consolidation.”

Starting in 2011, Latvia posted some of the highest growth rates in the EU. Its bailout program has been hailed a success by officials in Brussels and Washington, burnishing Mr. Dombrovskis’s international profile. Yet the unemployment rate is still 11% and many of the country’s younger and better-educated workers have emigrated, facts that often go unmentioned by Latvia’s boosters.

“There is still much more to do in Latvia,” Mr. Dombrovskis acknowledges.

In the next commission, with Jean-Claude Juncker as president, Mr. Dombrovskis is expected to be the hawkish foil to Pierre Moscovici, the dovish former French finance minister with whom he will share decision-making powers over national budgets. Mr. Rehn said the turmoil of the Latvian bailout, when his government occasionally came to the brink of collapse, should serve him well as he navigates the commission’s internal debates.

“He has cool nerves and strong composure,” Mr. Rehn said, “and he can intellectually handle difficult situations under pressure.”

Comments on Professor John Cochrane’s – A Few Things the Fed Has Done Right

A Few Things the Fed Has Done Right

The Fed’s plan to maintain a large balance sheet and pay interest on bank reserves is good for financial stability.

By John H. Cochrane

Aug 21 (WSJ) — As Federal Reserve officials lay the groundwork for raising interest rates, they are doing a few things right. They need a little cheering, and a bit more courage of their convictions.

The Fed now has a huge balance sheet. It owns about $4 trillion of Treasury bonds and mortgage-backed securities. It owes about $2.7 trillion of reserves (accounts banks have at the Fed), and $1.3 trillion of currency. When it is time to raise interest rates, the Fed will simply raise the interest it pays on reserves. It does not need to soak up those trillions of dollars of reserves by selling trillions of dollars of assets.

Correct!

The Fed’s plan to maintain a large balance sheet and pay interest on bank reserves, begun under former Chairman Ben Bernanke and continued under current Chair Janet Yellen, is highly desirable for a number of reasons—the most important of which is financial stability. Short version: Banks holding lots of reserves don’t go under.

Not true.
Confusing reserves with capital to some extent.
Banks can fail via losses that wipe out capital even with plenty of liquidity.

This policy is new and controversial. However, many arguments against it are based on fallacies. People forget that when the Fed creates a dollar of reserves, it buys a dollar of Treasurys or government-guaranteed mortgage-backed securities. A bank gives the Fed a $1 Treasury, the Fed flips a switch and increases the bank’s reserve account by $1. From this simple fact, it follows that:

• Reserves that pay market interest are not inflationary. Period. Now that banks have trillions more reserves than they need to satisfy regulations or service their deposits, banks don’t care if they hold another dollar of interest-paying reserves or another dollar of Treasurys. They are perfect substitutes at the margin. Exchanging red M&Ms for green M&Ms does not help your diet. Commenters have seen the astonishing rise in reserves—from $50 billion in 2007 to $2.7 trillion today—and warned of hyperinflation to come. This is simply wrong as long as reserves pay market interest.

Yes and no.

Yes, the mix of Fed liabilities per se isn’t inflationary.

No, even if they didn’t pay interest it wouldn’t be inflationary. In fact, it would mean a reduction in govt interest payments which is a contractionary bias.

And his point is best stated by stating that both reserves and tsy secs are simply dollar denominated ‘bank accounts’ at the Fed, the difference being the duration and rates, directly or indirectly selected by ‘govt’.

• Large reserves also aren’t deflationary. Reserves are not “soaking up money that could be lent.” The Fed is not “paying banks not to lend out the money” and therefore “starving the economy of investment.”

True.

Every dollar invested in reserves is a dollar that used to be invested in a Treasury bill.

Wrong statement of support. He should state that the causation goes from loans to deposits. ‘Loanable funds’ applies to fixed fx, not floating fx.

A large Fed balance sheet has no effect on funds available for investment.

True, they are infinite in any case. Bank lending is constrained only in the short term by capital, as there is always infinite capital available with time at a price that gets reflected in lending charges.

• The Fed is not “subsidizing banks” by paying interest on reserves.

It is to the extent that paying interest is subsidizing the economy in general, as govt is a net payer of interest.

The interest that the Fed will pay on reserves will come from the interest it receives on its Treasury securities.

Sort of. Better said that the interest received on the tsy’s will equal/exceed/etc. the interest paid on reserves. ‘Come from’ is a poor choice of words.

If the Fed sold its government securities to banks, those banks would be getting the same interest directly from the Treasury.

True.

The Fed has started a “reverse repurchase” program that will allow nonbank financial institutions effectively to have interest-paying reserves. This program was instituted to allow higher interest rates to spread more quickly through the economy.

True.

Again, I see a larger benefit in financial stability. The demand for safe, interest-paying money expressed so far in overnight repurchase agreements, short-term commercial paper, auction-rate securities and other vehicles that exploded in the financial crisis can all be met by interest-paying reserves.

Sort of. The term structure of rates constantly adjusts to indifference levels is how I’d say it.

Encouraging this switch is the keystone to avoiding another crisis. The Treasury should also offer fixed-value floating-rate electronically transferable debt.

Why??? Indexed to what? The one’s they are doing indexed to T bills make no logical sense at all.

This Fed reverse-repo program spawns many unfounded fears, even at the Fed. The July minutes of the Federal Open Market Committee revealed participants worried that “in times of financial stress, the facility’s counterparties could shift investments toward the facility and away from financial and nonfinancial corporations.”

This fear forgets basic accounting.

True.

The Fed controls the quantity of reserves. Reserves can only expand if the Fed chooses to buy assets—which is exactly what the Fed does in financial crises.

Furthermore, this fear forgets that investors who want the safety of Treasurys can buy them directly. Or they can put money in banks that in turn can hold reserves. The existence of the Fed’s program has minuscule effects on investors’ options in a crisis. Interest-paying reserves are just a money-market fund 100% invested in Treasurys with a great electronic payment mechanism.

Available to banks.

That’s exactly what we should encourage for financial stability.

The Open Market Committee minutes also said that, “Participants noted that a relatively large [repurchase] facility had the potential to expand the Federal Reserve’s role in financial intermediation and reshape the financial industry.”

Not really.

It always has been about offsetting operating factors one functionally identical way or another.

Yes, and that’s a feature not a bug. The financial industry failed and the Fed is reshaping it under the 2010 Dodd-Frank financial-reform law. Allowing money previously invested in run-prone shadow banking to be invested in 100%-safe reserves is the best thing the Fed could do to reshape the industry.

They can only do that if they reduce the institutional additions to the bank’s cost of funds/lower risk restrictions to make the banks more competitive with non bank lenders.

Temptations remain. For example, with trillions of reserves in excess of regulatory reserve requirements, the Fed loses what was left of its control over bank lending and deposit creation. The Fed will be tempted to use direct regulation and capital ratios to try to micromanage lending.

That’s all it ever had. Lending was never reserve constrained.

It should not. The big balance sheet is a temptation for the Fed to buy all sorts of assets other than short-term Treasurys, and to meddle in many markets, as it is already supporting the mortgage market. It should not.

I see precious little difference apart from option vol considerations.

The Fed is making no promises about the stability of these arrangements—a large balance sheet and market interest on reserves available to non-banks. It should. In particular, it should clarify whether it will allow its balance sheet to shrink as long-term assets run off, or reinvest the proceeds as I would prefer.

It doesn’t matter for what he’s talking about.

Most of the financial stability benefits only occur if these arrangements are permanent and market participants know it. We can debate whether interest rate policy should follow rules or discretion, be predictable or adapt to each day’s Fed desire. But the basic structures and institutions of monetary policy should be firm rules.

The remaining short-term question is when to raise rates. Ms. Yellen has already made an important decision: The Fed will not, for now, use interest-rate policy for “macroprudential” tinkering. This too is wise. We learned in the last crisis that the Fed is only composed of smart human beings. They are not clairvoyant and cannot tell a “bubble” from a boom in real time any better than the banks and hedge funds betting their own money on the difference. Manipulating interest rates to stabilize inflation is hard enough. Stabilizing inflation and unemployment is harder still.

Especially when they have it backwards.

Additionally chasing will-o-wisp “bubbles,” “imbalances” and “crowded trades” will only lead to greater macroeconomic and financial instability.

Here too a firm commitment would help. Otherwise market participants will be constantly looking over their shoulders for the Fed to start meddling in home and asset prices.

Plenty of uncertainties, challenges and temptations remain. Tomorrow, we can go back to investigating, arguing and complaining. Today let’s cheer a few big things done right.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution, and an adjunct scholar at the Cato Institute.

Doesn’t mention/forgets that the Fed buying secs is functionally identical to the tsy not selling them in the first place, etc.

Comments on Stanlely Fisher’s ‘Lessons from Crises, 1985-2014’

Lessons from Crises, 1985-2014

Stanley Fischer[1]


It is both an honor and a pleasure to receive this years SIEPR Prize. Let me list the reasons. First, the prize, awarded for lifetime contributions to economic policy, was started by George Shultz. I got my start in serious policy work in 1984-85, as a member of the advisory group on the Israeli economy to George Shultz, then Secretary of State. I learned a great deal from that experience, particularly from Secretary Shultz and from Herb Stein, the senior member of the two-person advisory group (I was the other member). Second, it is an honor to have been selected for this prize by a selection committee consisting of George Shultz, Ken Arrow, Gary Becker, Jim Poterba and John Shoven. Third, it is an honor to receive this prize after the first two prizes, for 2010 and for 2012 respectively, were awarded to Paul Volcker and Marty Feldstein. And fourth, it is a pleasure to receive the award itself.

When John Shoven first spoke to me about the prize, he must have expected that I would speak on the economic issues of the day and I would have been delighted to oblige. However, since then I have been nominated by President Obama but not so far confirmed by the Senate for the position of Vice-Chair of the Federal Reserve Board. Accordingly I shall not speak on current events, but rather on lessons from economic crises I have seen up close during the last three decades and about which I have written in the past starting with the Israeli stabilization of 1985, continuing with the financial crises of the 1990s, during which I was the number two at the IMF, and culminating (I hope) in the Great Recession, which I observed and with which I had to deal as Governor of the Bank of Israel between 2005 and 2013.

This is scheduled to be an after-dinner speech at the end of a fine dinner and after an intensive conference that started at 8 a.m. and ran through 6 p.m. Under the circumstances I shall try to be brief. I shall start with a list of ten lessons from the last twenty years, including the crises of Mexico in 1994-95, Asia in 1997-98, Russia in 1998, Brazil in 1999-2000, Argentina in 2000-2001, and the Great Recession. I will conclude with one or two-sentence pieces of advice I have received over the years from people with whom I had the honor of working on economic policy. The last piece of advice is contained in a story from 1985, from a conversation with George Shultz.


I. Ten lessons from the last two decades.[2]


Lesson 1: Fiscal policy also matters macroeconomically. It has always been accepted that fiscal policy, in the sense of the structure of the tax system and the composition of government spending, matters for the behavior of the economy. At times in the past there has been less agreement about whether the macroeconomic aspects of fiscal policy, frequently summarized by the full employment budget deficit, have a significant impact on the level of GDP. As a result of the experience of the last two decades, it is once again accepted that cutting government spending and raising taxes in a recession to reduce the budget deficit is generally recessionary. This was clear from experience in Asia in the 1990s.[3] The same conclusion has been reached following the Great Recession.

Who would have thought?…

At the same time, it needs to be emphasized that there are circumstances in which a fiscal contraction can be expansionary particularly for a country running an unsustainable budget deficit.

Unsustainable?
He doesn’t distinguish between floating and fixed fx policy. At best this applies to fixed fx policy, where fx reserves would be exhausted supporting the peg/conversion. And as a point of logic, with floating fx this can only mean an unsustainable inflation, whatever that means.

More important, small budget deficits and smaller rather than larger national debts are preferable in normal times in part to ensure that it will be possible to run an expansionary fiscal policy should that be needed in a recession.

Again, this applies only to fixed fx regimes where a nation might need fx reserves to support conversion at the peg. With floating fx nominal spending is in no case revenue constrained.

Lesson 2: Reaching the zero interest lower bound is not the end of expansionary monetary policy. The macroeconomics I learned a long time ago, and even the macroeconomics taught in the textbooks of the 1980s and early 1990s, proclaimed that more expansionary monetary policy becomes either impossible or ineffective when the central bank interest rate reaches zero, and the economy finds itself in a liquidity trap. In that situation, it was said, fiscal policy is the only available expansionary tool of macroeconomic policy.

Now the textbooks should say that even with a zero central bank interest rate, there are at least two other available monetary policy tools. The first consists of quantitative easing operations up and down the yield curve, in particular central bank market purchases of longer term assets, with the intention of reducing the longer term interest rates that are more relevant than the shortest term interest rate to investment decisions.

Both are about altering the term structure of rates. How about the lesson that the data seems to indicate the interest income channels matter to the point where the effect is the reverse of what the mainstream believes?

That is, with the govt a net payer of interest, lower rates lower the deficit, reducing income and net financial assets credited to the economy. For example, QE resulted in some $90 billion of annual Fed profits returned to the tsy that otherwise would have been credited to the economy. That, with a positive yield curve, QE functions first as a tax.

The second consists of central bank interventions in particular markets whose operation has become significantly impaired by the crisis. Here one thinks for instance of the Feds intervening in the commercial paper market early in the crisis, through its Commercial Paper Funding Facility, to restore the functioning of that market, an important source of finance to the business sector. In these operations, the central bank operates as market maker of last resort when the operation of a particular market is severely impaired.

The most questionable and subsequently overlooked ‘bailout’- the Fed buying, for example, GE commercial paper when it couldn’t fund itself otherwise, with no ‘terms and conditions’ as were applied to select liquidity provisioning to member banks, AIG, etc. And perhaps worse, it was the failure of the Fed to provide liquidity (not equity, which is another story/lesson) to its banking system on a timely basis (it took months to get it right) that was the immediate cause of the related liquidity issues.

However, and perhaps the most bizarre of what’s called unconventional monetary policy, the Fed did provide unlimited $US liquidity to foreign banking systems with its ‘swap lines’ where were, functionally, unsecured loans to foreign central banks for the further purpose of bringing down Libor settings by lowering the marginal cost of funds to foreign banks that otherwise paid higher rates.

Lesson 3: The critical importance of having a strong and robust financial system. This is a lesson that we all thought we understood especially since the financial crises of the 1990s but whose central importance has been driven home, closer to home, by the Great Recession. The Great Recession was far worse in many of the advanced countries than it was in the leading emerging market countries. This was not what happened in the crises of the 1990s, and it was not a situation that I thought would ever happen. Reinhart and Rogoff in their important book, This Time is Different,[4] document the fact that recessions accompanied by a financial crisis tend to be deeper and longer than those in which the financial system remains operative. The reason is simple: the mechanisms that typically end a recession, among them monetary and fiscal policies, are less effective if households and corporations cannot obtain financing on terms appropriate to the state of the economy.

The lesson should have been that the private sector is necessarily pro cyclical, and that a collapse in aggregate demand that reduces the collateral value of bank assets and reduces the income required to support the credit structure triggers a downward spiral that can only be reversed with counter cyclical fiscal policy.

In the last few years, a great deal of work and effort has been devoted to understanding what went wrong and what needs to be done to maintain a strong and robust financial system. Some of the answers are to be found in the recommendations made by the Basel Committee on Bank Supervision and the Financial Stability Board (FSB). In particular, the recommendations relate to tougher and higher capital requirements for banks, a binding liquidity ratio, the use of countercyclical capital buffers, better risk management, more appropriate remuneration schemes, more effective corporate governance, and improved and usable resolution mechanisms of which more shortly. They also include recommendations for dealing with the clearing of derivative transactions, and with the shadow banking system. In the United States, many of these recommendations are included or enabled in the Dodd-Frank Act, and progress has been made on many of them.

Everything except the recognition of the need for immediate and aggressive counter cyclical fiscal policy, assuming you don’t want to wait for the automatic fiscal stabilizers to eventually turn things around.

Instead, what they’ve done with all of the above is mute the credit expansion mechanism, but without muting the ‘demand leakages’/’savings desires’ that cause income to go unspent, and output to go unsold, leaving, for all practical purposes (the export channel isn’t a practical option for the heaving lifting), only increased deficit spending to sustain high levels of output and employment.

Lesson 4: The strategy of going fast on bank restructuring and corporate debt restructuring is much better than regulatory forbearance. Some governments faced with the problem of failed financial institutions in a recession appear to believe that regulatory forbearance giving institutions time to try to restore solvency by rebuilding capital will heal their ills. Because recovery of the economy depends on having a healthy financial system, and recovery of the financial system depends on having a healthy economy, this strategy rarely works.

The ‘problem’ is bank lending to offset the demand leakages when the will to use fiscal policy isn’t there.

And today, it’s hard to make the case that us lending is being constrained by lack of bank capital, with the better case being a lack of credit worthy, qualifying borrowers, and regulatory restrictions- called ‘regulatory overreach’ on some types of lending as well. But again, this largely comes back to the understanding that the private sector is necessarily pro cyclical, with the lesson being an immediate and aggressive tax cut and/or spending increase is the way go.

This lesson was evident during the emerging market crises of the 1990s. The lesson was reinforced during the Great Recession, by the contrast between the response of the U.S. economy and that of the Eurozone economy to the low interest rate policies each implemented. One important reason that the U.S. economy recovered more rapidly than the Eurozone is that the U.S. moved very quickly, using stress tests for diagnosis and the TARP for financing, to restore bank capital levels, whereas banks in the Eurozone are still awaiting the rigorous examination of the value of their assets that needs to be the first step on the road to restoring the health of the banking system.

The lesson remaining unlearned is that with a weaker banking structure the euro zone can implement larger fiscal adjustments- larger tax cuts and/or larger increases in public goods and services.

Lesson 5: It is critical to develop now the tools needed to deal with potential future crises without injecting public funds.

Yes, it seems the value of immediate and aggressive fiscal adjustments remains unlearned.

This problem arose during both the crises of the 1990s and the Great Recession but in different forms. In the international financial crises of the 1990s, as the size of IMF packages grew, the pressure to bail in private sector lenders to countries in trouble mounted both because that would reduce the need for official financing, and because of moral hazard issues. In the 1980s and to a somewhat lesser extent in the 1990s, the bulk of international lending was by the large globally active banks. My successor as First Deputy Managing Director of the IMF, Anne Krueger, who took office in 2001, mounted a major effort to persuade the IMF that is to say, the governments of member countries of the IMF to develop and implement an SDRM (Sovereign Debt Restructuring Mechanism). The SDRM would have set out conditions under which a government could legally restructure its foreign debts, without the restructuring being regarded as a default.

The lesson is that foreign currency debt is to be avoided, and that legal recourse in the case of default should be limited.

Recent efforts to end too big to fail in the aftermath of the Great Recession are driven by similar concerns by the view that we should never again be in a situation in which the public sector has to inject public money into failing financial institutions in order to mitigate a financial crisis. In most cases in which banks have failed, shareholders lost their claims on the banks, but bond holders frequently did not. Based in part on aspects of the Dodd-Frank Act, real progress has been made in putting in place measures to deal with the too big to fail problem. Among them are: the significant increase in capital requirements, especially for SIFIs (Systemically Important Financial Institutions) and the introduction of counter-cyclical capital buffers for banks; the requirement that banks hold a cushion of bail-in-able bonds; and the sophisticated use of stress tests.

The lesson is that the entire capital structure should be explicitly at full risk and priced accordingly.

Just one more observation: whenever the IMF finds something good to say about a countrys economy, it balances the praise with the warning Complacency must be avoided. That is always true about economic policy and about life. In the case of financial sector reforms, there are two main concerns that the statement about significant progress raises: first, in designing a system to deal with crises, one can never know for sure how well the system will work when a crisis situation occurs which means that we will have to keep on subjecting the financial system to tough stress tests and to frequent re-examination of its resiliency; and second, there is the problem of generals who prepare for the last war the financial system and the economy keep evolving, and we need always to be asking ourselves not only about whether we could have done better last time, but whether we will do better next time and one thing is for sure, next time will be different.

And in any case an immediate and aggressive fiscal adjustment can always sustain output and employment. There is no public purpose in letting a financial crisis spill over to the real economy.

Lesson 6: The need for macroprudential supervision. Supervisors in different countries are well aware of the need for macroprudential supervision, where the term involves two elements: first, that the supervision relates to the financial system as a whole, and not just to the soundness of each individual institution; and second, that it involves systemic interactions. The Lehman failure touched off a massive global financial crisis, a reflection of the interconnectedness of the financial system, and a classic example of systemic interactions. Thus we are talking about regulation at a very broad level, and also the need for cooperation among regulators of different aspects of the financial system.

The lesson are that whoever insures the deposits should do the regulation, and that independent fiscal adjustments can be immediately and aggressively employed to sustain output and employment in any economy.

In practice, macroprudential policy has come to mean the deployment of non-monetary and non-traditional instruments of policy to deal with potential problems in financial institutions or a part of the financial system. For instance, in Israel, as in other countries whose financial system survived the Great Recession without serious damage, the low interest rate environment led to uncomfortably rapid rates of increase of housing prices. Rather than raise the interest rate, which would have affected the broader economy, the Bank of Israel in which bank supervision is located undertook measures whose effect was to make mortgages more expensive. These measures are called macroprudential, although their effect is mainly on the housing sector, and not directly on interactions within the financial system. But they nonetheless deserve being called macroprudential, because the real estate sector is often the source of financial crises, and deploying these measures should reduce the probability of a real estate bubble and its subsequent bursting, which would likely have macroeconomic effects.

And real effects- there would have been more houses built. The political decision is the desire for real housing construction.

The need for surveillance of the financial system as a whole has in some countries led to the establishment of a coordinating committee of regulators. In the United States, that group is the FSOC (Financial Stability Oversight Council), which is chaired by the Secretary of the Treasury. In the United Kingdom, a Financial Policy Committee, charged with the responsibility for oversight of the financial system, has been set up and placed in the Bank of England. It operates under the chairmanship of the Governor of the Bank of England, with a structure similar but not identical to the Bank of Englands Monetary Policy Committee.

Lesson 7: The best time to deal with moral hazard is in designing the system, not in the midst of a crisis.

Agreed!
Moral hazard is about the future course of events.

At the start of the Korean crisis at the end of 1997, critics including friends of mine told the IMF that it would be a mistake to enter a program with Korea, since this would increase moral hazard. I was not convinced by their argument, which at its simplest could be expressed as You should force Korea into a greater economic crisis than is necessary, in order to teach them a lesson. The issue is Who is them? It was probably not the 46 million people living in South Korea at the time. It probably was the policy-makers in Korea, and it certainly was the bankers and others who had invested in South Korea. The calculus of adding to the woes of a country already going through a traumatic experience, in order to teach policymakers, bankers and investors a lesson, did not convince the IMF, rightly so to my mind.

Agreed!
Nor did they need an IMF program!

But the question then arises: Can you ever deal with moral hazard? The answer is yes, by building a system that will as far as possible enable policymakers to deal with crises in a way that does not create moral hazard in future crisis situations. That is the goal of financial sector reforms now underway to create mechanisms and institutions that will put an end to too big to fail.

There was no too big to fail moral hazard issue. The US banks did fail when shareholders lost their capital. Failure means the owners lose and are financially punished, and new owners with new capital have a go at it.

Lesson 8: Dont overestimate the benefits of waiting for the situation to clarify.


Early in my term as Governor of the Bank of Israel, when the interest rate decision was made by the Governor alone, I faced a very difficult decision on the interest rate. I told the advisory group with whom I was sitting that my decision was to keep the interest rate unchanged and wait for the next monthly decision, when the situation would have clarified. The then Deputy Governor, Dr. Meir Sokoler, commented: It is never clear next time; it is just unclear in a different way. I cannot help but think of this as the Tolstoy rule, from the first sentence of Anna Karenina, every unhappy family is unhappy in its own way.

It is not literally true that all interest rate decisions are equally difficult, but it is true that we tend to underestimate the lags in receiving information and the lags with which policy decisions affect the economy. Those lags led me to try to make decisions as early as possible, even if that meant that there was more uncertainty about the correctness of the decision than would have been appropriate had the lags been absent.

The lesson is to be aggressive with fiscal adjustments when unemployment/the output gap starts to rise as the costs of waiting- massive quantities of lost output and negative externalities, particularly with regard to the lives of those punished by the government allowing aggregate demand to decline- are far higher than, worst case, a period of ‘excess demand’ that can also readily be addressed with fiscal policy.

Lesson 9: Never forget the eternal verities lessons from the IMF. A country that manages itself well in normal times is likely to be better equipped to deal with the consequences of a crisis, and likely to emerge from it at lower cost.

Thus, we should continue to believe in the good housekeeping rules that the IMF has tirelessly promoted. In normal times countries should maintain fiscal discipline and monetary and financial stability. At all times they should take into account the need to follow sustainable growth-promoting macro- and structural policies. And they need to have a decent regard for the welfare of all segments of society.

Yes, at all times they should sustain full employment policy as the real losses from anything less far exceed any other possible benefits.

The list is easy to make. It is more difficult to fill in the details, to decide what policies to
follow in practice. And it may be very difficult to implement such measures, particularly when times are good and when populist pressures are likely to be strong. But a country that does not do so is likely to pay a very high price.

Lesson 10.

In a crisis, central bankers will often find themselves deciding to implement policy actions they never thought they would have to undertake and these are frequently policy actions that they would have preferred not to have to undertake. Hence, a few final words of advice to central bankers (and to others):

Lesson for all bankers:
Proposals for the Banking System, Treasury, Fed, and FDIC

Never say never


II. The Wisdom of My Teachers

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Feel free to distribute, thanks.

Over the years, I have found myself remembering and repeating words of advice that I first heard from my teachers, both academics and policymakers. Herewith a selection:


1. Paul Samuelson on econometric models: I would rather have Bob Solow than an econometric model, but Id rather have Bob Solow with an econometric model than Bob Solow without one.

2. Herb Stein: (a) After listening to my long description of what was happening in the Israeli economy in 1985: Yes, but what do we want them to do?”

(b) The difference between a growth rate of 2% and a growth rate of 3% is 50%.

(c) If something cannot go on forever, it will stop.
3. Michel Camdessus (former head of the IMF):

(a) At 7 a.m., in his office, on the morning that the U.S. government turned to the IMF to raise $20 billion by 9:30 a.m: Gentlemen, this is a crisis, and in a crisis you do not panic

(b) When the IMF was under attack from politicians or the media, in response to my asking Michel, what should we do?, his inevitable answer was We must do our job.

(c) His response when I told him (his official title was Managing Director of the IMF) that life would be much easier for all of us if he would only get himself a cell phone: Cell phones are for deputy managing directors.

(d) On delegation: In August, when he was in France and I was acting head of the IMF in Washington, and had called him to explain a particularly knotty problem and ask him for a decision, You have more information than me, you decide.

4. George Shultz: This event happened in May 1985, just before Herb Stein and I were due to leave for Israel to negotiate an economic program which the United States would support with a grant of $1.5 billion. I was a professor at MIT, and living in the Boston area. Herb and I spoke on the phone about the fact that we had no authorization to impose any conditions on the receipt of the money. Herb, who lived in Washington, volunteered to talk to the Secretary of State to ask him for authorization to impose conditions. He called me after his meeting and said that the Secretary of State was not willing to impose any conditions on the aid.

We agreed this was a problem and he said to me, Why dont you try. A meeting was hastily arranged and next morning I arrived at the Secretary of States office, all ready to deliver a convincing speech to him about the necessity of conditionality. He didnt give me a chance to say a word. You want me to impose conditions on Israel? I said yes. He said I wont. I asked why not. He said Because the Congress will give them the money even if they dont carry out the program and I do not make threats that I cannot carry out.

This was convincing, and an extraordinarily important lesson. But it left the negotiating team with a problem. So I said, That is very awkward. Were going to say To stabilize the economy you need to do the following list of things. And they will be asking themselves, and if we dont? Is there anything we can say to them?

The Secretary of State thought for a while and said: You can tell them that if they do not carry out the program, I will be very disappointed.

We used that line repeatedly. The program was carried out and the program succeeded.

Thank you all very much.

[1] Council on Foreign Relations. These remarks were prepared for presentation on receipt of the SIEPR (Stanford Institute for Economic Policy Research) Prize at Stanford University on March 14, 2014. The Prize is awarded for lifetime contributions to economic policy. I am grateful to Dinah Walker of the Council on Foreign Relations for her assistance.

[2] I draw here on two papers I wrote based on my experience in the IMF: Ten Tentative Conclusions from the Past Three Years, presented at the annual meeting of the Trilateral Commission in 1999, in Washington, DC; and the Robbins Lectures, The International Financial System: Crises and Reform Several other policy-related papers from that period appear in my book: IMF Essays from a Time of Crisis (MIT Press, Cambridge, MA, 2004). For the period of the Great Recession, I draw on Central bank lessons from the global crisis, which I presented at a conference on Lessons of the Global Crisis at the Bank of Israel in 2011.

[3] This point was made in my 1999 statement Ten Tentative Conclusions referred to above, and has of course received a great deal of focus in analyses of the Great Recession.

[4] Carmen Reinhart and Kenneth Rogoff, This Time is Different, Princeton University Press, Princeton, NJ, 2009.