A Modest Response

Posted on February 3, 2015 @ 6:07 pm (Tuesday) by WARREN MOSLER

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.

durable goods, Case Shiller, new home sales, Consumer Confidence, Richmond Fed, PMI services flash, GDP comments, 10 yr vs Fed

Posted on January 27, 2015 @ 11:47 am (Tuesday) by WARREN MOSLER

Down hard and revisions down hard as well, and year over year growth up less than 1%:

Durable Goods Orders

Highlights
Durables orders unexpectedly fell 3.4 percent in December after dropping 2.1 percent in November. Analysts projected a 0.7 percent rise.

Excluding transportation, the core slipped 0.8 in December following a decline of 1.3 percent in November. Market expectations were for a 0.8 percent boost in December. Transportation plunged a monthly 9.2 percent after dropping 3.9 percent in November. Motor vehicles rose 2.7 percent, nondefense aircraft plunged 55.5 percent, and defense aircraft fell 19.9 percent.

Outside of transportation, weakness was mixed. Industries posting gains were fabricated metals, electrical equipment, and “other.” Declines were seen in primary metals, machinery, and computers & electronics.

Nondefense capital goods orders excluding aircraft dropped 0.6 percent after a decline of 0.6 percent in November. Shipments of this series eased 0.2 percent in December after dropping 0.6 percent the month before.

Overall, manufacturing is soft. The outlook is questionable with the recently sharp boost in the value of the dollar.

Equity futures dropped very sharply on the news. However, earnings concerns also weighed on futures.

Housing still looking like it’s rolling over?

New home sales better than expected!

New Home Sales

Consumer confidence up as well! But don’t forget this is about ‘head count’. That is, consumer confidence can be up for the hundreds of millions saving $11/week on gas, while the cutbacks from those losing high paying jobs and from capex reductions reduce the confidence of far fewer people initially, but the spending lost to the economy is far higher.

Consumer Confidence

Richmond Fed- DC area doing better than Texas…

Richmond Fed Manufacturing Index

Recent History Of This Indicator
The Richmond Fed manufacturing index for December picked up to 7 from 4 in November. New orders showed relative strength, at 4 versus November’s 1, but were still on the soft side. Order backlogs, however, showed outright contraction for a second month, at minus 5 vs minus 2 in November. Shipments showed relative strength to November, at 5 vs 1, but, like new orders, were still on the soft side. A definitive sign of strength, however, came from employment which was up 3 points to a very solid 13 in a reading that points to underlying confidence among the region’s manufacturers. Price data were soft in line with declining fuel costs.

PMI Services Flash

Highlights
Growth in the nation’s service sector is accelerating but only very slightly this month based on Markit’s sample where the flash index is at 54.0 vs December’s final reading and 10-month low of 53.3 and December’s flash reading of 53.6. The report ties the gain in part to a pick up in consumer spending though new business growth this month continues to moderate and is at a new low in the 5-year history of the report. Amid the slowing, service providers in the sample continue to add to payrolls though at the slowest rate in 9 months. Growth in backlogs is at a 6-month low. Price data show only fractional pressure for inputs and only fractional pricing power for outputs.

Look what spiked up in Q3, and could come down in Q4?

And the 10 year note is now down to 1.75%, which you could say is at odds with the Fed’s forecasts for higher rates.

Wonder who will be correct?

FYI:

Norfolk Southern Revenue Slips on Coal Weakness (WSJ) Norfolk Southern Corp. profit totaled $511 million, off from $513 million in the same quarter a year earlier. Demand for electricity in the railroad’s territory fell 1% last year, executives said. The railroad’s coal revenue fell 15% to $543 million, while its coal volume declined 6%. In the fourth quarter, Norfolk Southern’s fuel-surcharge revenue declined $45 million compared with the same quarter in 2013.

Siemens Profit Hurt by Weak Economy, Oil (WSJ) Net profit in the three months to Dec. 31 fell to €1.08 billion ($1.21 billion) from €1.43 billion in the same period last year, Siemens said on Tuesday. Revenue rose 5% to €17.42 billion, helped by the euro’s weakness against major currencies. Siemens reiterated that it expects to notch up 15% growth in earnings per share in the year to end-September on unchanged revenue. Still, an 11% decline in new orders to €18.01 billion underscored the pressure Siemens is facing as customers placed fewer large orders at its mobility, wind power and renewables business as well as its process industries and drives unit. The power and gas division’s profit margin shrank to 11.3% from 18.2% in the same period last year, Siemens said.

Aso seeks swift passage of extra budget to expand economy (Kyodo) Finance Minister Taro Aso on Monday called for swift passage of the fiscal 2014 supplementary budget to eradicate prolonged deflation and allow Japan’s economy to move onto an expansionary path. “The economy remains on a moderate recovery track, but weakness can be seen in private spending and economic recovery is uneven across regions,” Aso said in a speech. “Immediate passage of the extra budget is necessary,” Aso said, pledging to spur domestic demand by bolstering local economies and supporting households — both plagued by price rises following last April’s consumption tax hike and the weaker yen.

Housing starts, Japan discussion, China, US pmi, store sales

Posted on December 17, 2014 @ 9:24 am (Wednesday) by WARREN MOSLER

Looks bad to me. Remember, for GDP to grow at last year’s rate, all the pieces on average have to contribute that much. And, as previously discussed, hard to see how starts and sales can grow with cash buyers and mtg purchase apps declining year over year.

The charts look like we are well past this cycle’s peak and headed into negative territory. Not to mention multifamily had been leading the way and those units tend to be smaller/cheaper, so if you were to look at the $ being invested vs prior cycles it would look even worse.

Housing Starts

Highlights
Housing remains on a flat trajectory. Single-family starts and multifamily starts moved in opposite directions. Housing starts dipped 1.6 percent after rebounding 1.7 percent in October. Analysts projected a 1.038 million pace for November. The 1.028 million unit pace was down 7.0 percent on a year-ago basis.

November strength was in the volatile multifamily component. Multifamily starts rebounded 6.7 percent after declining 9.9 percent in October. In contrast, single-family starts fell 5.4 percent in November after gaining 8.0 percent in October.

Housing permits declined a monthly 5.2 percent, following a 5.9 percent jump in October. The 1.035 million unit pace was down 0.2 percent on a year-ago basis. Market expectations were for 1.060 million units annualized.

Overall, recent housing numbers have oscillated notably. October was relatively good but November was not. On average, housing growth appears to be flat to modestly positive.

And how about this headline? Make any sense to you?

Japan’s got issues, but ability to ‘service it’s yen debt’ isn’t one of them, as it’s just a matter of debiting securities accounts at the BOJ/by the BOJ and crediting member bank accounts also at the BOJ. But markets don’t seem to quite believe that:

Meanwhile, Japan’s ‘depreciate your currency to prosperity’ policy combined with tax hikes on domestic consumers- about as ‘pro exporter at the expense of most everyone else’- is producing the outcomes previously discussed. They include falling real domestic incomes/real standards of living, increased exporter margins/sales/profits, etc. And more to come, seems, under the ‘no matter how much I cut off it’s still too short, said the carpenter’ mantra now practiced globally.

A few anecdotes:

The day after his ruling coalition secured more than two-thirds of the seats in parliament’s lower house, Mr. Abe acknowledged at a news conference that higher stock prices and corporate profits under his administration have yet to translate into worker gains.

“As I toured around the nation during the election, I heard the opinions of ordinary citizens who are suffering from price increases and small-business owners in difficulties due to price hikes in raw materials,” Mr. Abe said, adding that he will draft an economic stimulus package by the end of the year.

For the second year in a row, the conservative prime minister and his historically pro-business Liberal Democratic Party find themselves in the position of imploring corporations to cut into their profits and give workers more. Mr. Abe said he would summon executives and labor leaders to a meeting Tuesday to make his pitch ahead of next spring’s annual wage talks.

The reason: If wages don’t rise as quickly as prices, households could cut back on spending, endangering an economic recovery. There have only been four months since Mr. Abe took power in December 2012 when real wages—the value of paychecks after accounting for inflation—have risen. A weaker yen has made imported food and other goods more expensive, and a rise in the national sales tax to 8% in April from 5% hit consumers further.

While wages have gone up in nominal terms this year, rising prices — partly the result of a consumption tax hike in April — have negated those gains. Adjusted for inflation, total cash earnings fell 2.8% on the year in October, dropping for a 16th straight month. Unions hope that with this month’s lower house election shaping up to be partly a referendum on Abenomics, the prime minister’s plan for ending deflation, Japan will see a serious debate on wage growth.

The corporate sector is coming to terms with the need to raise pay to some degree next spring.

“What is important is escaping the deflation that has persisted for 15 years,” Sadayuki Sakakibara, chairman of the Keidanren business lobby, told reporters Wednesday.

“Companies that have succeeded in growing their profits ought to reflect that success in their wage increases,” he added.

For the second year in a row, Keidanren will explicitly encourage member companies to raise wages in its guidance for the spring’s “shunto” negotiations.

But even as big export-driven manufacturers cruise toward record profits, many smaller companies, particularly those dependent on domestic demand, are suffering the side effects of a weak yen and still waiting for consumer spending to recover from the tax hike.

China continues to go down the tubes and the western educated hot shots keep pushing the tight fiscal and what they think is ‘loose monetary’ policy that’s failed every time it’s been tried in the history of the galaxy:

Operating conditions deteriorate for the first time since May

(Markit) — Flash China Manufacturing PMI slipped to 49.5 in December from 50.0 in November. Manufacturing Output Index ticked up to 49.7 from 49.6. New Orders decreased while New Export Orders increased at a faster rate. “The HSBC China Manufacturing PMI dropped to a seven-month low of 49.5 in the flash reading for December, down from 50.0 in November. Domestic demand slowed considerably and fell below 50 for the first time since April 2014. Price indices also fell sharply. The manufacturing slowdown continues in December and points to a weak ending for 2014. The rising disinflationary pressures, which fundamentally reflect weak demand, warrant further monetary easing in the coming months.”

Not good here either:

PMI Manufacturing Index Flash

And this came out. Note the year over year trend.

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

Posted on March 18, 2014 @ 1:34 pm (Tuesday) by WARREN MOSLER

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

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.

Remember all the talk about the deficit causing rates to go up in Japan?

Posted on February 24, 2014 @ 12:05 pm (Monday) by WARREN MOSLER

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Yes, the Fed can set mortgage rates if it wants to!

Posted on December 20, 2013 @ 10:55 am (Friday) by WARREN MOSLER

One of the main reasons for the Fed’s (near) 0 rate policy is to support the housing market. And after nearly 5 years of 0 rates, and mortgage rates dipping below 3.5%, though ‘off the bottom’ housing remains far below what would be considered ‘normal’.

And then, not long ago, and immediately after the Fed first hinted at reducing its QE purchases, mortgage rates spike by over 1%:

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And, since then, mortgage refinance activity has all but vanished, and the number of mortgage applications for the purchase of homes swung from increasing nicely to decreasing alarmingly:

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The ‘Fed speak’ for this rise in rates ‘tightening financial conditions’. And one of the Fed’s concerns about tapering QE purchases was the concern that higher mortgage rates would slow the recovery. Therefore, in addition to announcing the reduction in purchases of Treasury securities and mortgage backed securities, they were careful to emphasize what’s called their ‘forward guidance’ with regard to the Fed funds rate. That is, they stated that they expected to be keeping short term rates low for the next couple of years or so, and maybe even longer than that, maybe even after unemployment goes below 6.5%, and presuming their inflation measure stops decelerating and moves back up towards their target.

Unfortunately for the Fed mortgage rates moved higher after the announcement, and not due to a burst of mortgage applications (see above charts), and not due to any immediate drop in Fed purchases, which continue in large size. Instead, what the Fed sees is a market that believes the Fed changed course because it believes the economy is recovering, and with recovery just around the corner rate hikes will come sooner rather than later. And with rate hikes on the way, investors would rather wait for the higher yields they believe are just down the road, than take the lower yields today.

Therefore, if you want to borrow today to buy a house, you have to pay investors a higher interest rate. And if you don’t want to pay the higher rate today, investors are willing to wait for those higher rates, and the house doesn’t get sold. And when the house doesn’t get sold the Fed leaves rates low for that much longer and their forecast again (they’ve been over estimating growth for 5 years now) turns out to be wrong.

So with ‘forward guidance’ not doing the trick, is there anything else can the Fed can do if it wants mortgage rates back down? Yes!

First, they can simply announce that they are buyers of 10 year treasury notes at, say, a yield of 2%, in unlimited quantities.

This would immediately bring the 10 year yield down from 2.92% to no more than 2%, and most likely the Fed would buy few if any at that price. That’s because when people know the Fed will buy at a price, they know they can then buy at a slightly lower interest rate, knowing that ‘worst case’ they can always sell to the Fed at a very small loss. That way they can earn the, say, 1.99% yield for as long as they hold the 10 year Treasury note. And there’s always a chance yields come down further as well, which means their securities increased in value as well.

And the lower 10 year rate would quickly translate into much lower mortgage rates as well. And, of course, the Fed could also do the same thing with the mortgage backed securities its already buying, which more directly targets mortgage rates.

So why isn’t the Fed doing this? Probably out of fear of offering to buy unlimited quantities might lead to them buying ‘too many’ Treasury securities. This fear, unfortunately, stems from their lack of understanding of their own monetary operations. Treasury securities are simply dollar balances in securities accounts at the Fed. When the Fed buys these securities they just debit the owner’s securities account and credit the reserve account of his bank. And when the Treasury issues and sells new securities, the Fed debits the buyer’s bank’s reserve account and credits his securities account. Whether the dollars are in reserve accounts or securities accounts is of no operational consequence and imposes no particular risk for the Fed, so those fears are groundless.

Second, the Fed (or Treasury or the Federal Financing Bank) could lend directly to the housing agencies at a fixed rate of say, 3% for the further purpose of funding their mortgage portfolio of newly originated agency mortgages. The agencies would then pass along this fixed rate, with some permitted ‘markup’ and fees to the borrowers. The Fed would then be repaid by the pass through of the monthly payments including prepayments made by the new mortgages. This would target mortgage rates directly and, as these mortgages would be held by the agencies and not sold in the market place, dramatically reduce what I call parasitic secondary market activity.

Has any of this been discussed? Not publicly or seriously that I know of.

Here’s a piece I wrote several years ago on these and other proposals:
Proposals for the Banking System, Treasury, Fed, and FDIC

And this which includes why it’s the Fed that sets rates, and not markets:
The Natural Rate of Interest Is Zero

Bernanke and Yellen pushing back on higher mortgage rates

Posted on November 20, 2013 @ 7:50 am (Wednesday) by WARREN MOSLER

Seems to me the Fed is making an all out effort to push back on the higher longer term rates, particularly mortgage rates. However, at least so far those rates remain elevated and at least so far mortgage purchase applications remain down year over year.

Again, seems to me it comes down to the notion that if forward guidance works to firm the economy, rates will move higher/sooner than if it doesn’t work to firm the economy.

This means forward guidance works to bring long rates down only if markets don’t believe it helps the economy.

So what’s a Fed to do to bring long rates down?
Seems to me the only tool left is unconditional guidance or purchasing securities on a price basis, rather than a quantity basis. Which does of course work, to the basis point.

That is, if the Fed announced it had a 2% bid for unlimited quantities of 10 year notes they would not trade higher than 2% while that bid was active. My recollection was that this was done during WWII.

And that we didn’t lose.
;)

U.S. to Sell $10 Billion to $15 Billion in Floating Notes

Posted on November 6, 2013 @ 12:51 pm (Wednesday) by WARREN MOSLER

Morons
:(

U.S. to Sell $10 Billion to $15 Billion in Floating Notes

Fama’s Fallacy

Posted on October 15, 2013 @ 11:37 am (Tuesday) by WARREN MOSLER

Here’s how you have to think to win a Nobel prize:

Fama’s Fallacy:

There is an identity in macroeconomics… private investment [PI] must equal the sum of private savings [PS], corporate savings (retained earnings) [CS], and government savings [GS]…. (1) PI = PS + CS + GS…. Government bailouts and stimulus plans seem attractive when there are idle resources – unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt…. The added debt absorbs savings that would otherwise go to private investment…. [G]overnment infrastructure investments must be financed — more government debt. The new government debt absorbs private and corporate savings, which means private investment goes down by the same amount…. Suppose the stimulus plan takes the form of lower taxes… lower tax receipts must be financed dollar for dollar by more government borrowing. The government gives with one hand but takes them back with the other, with no net effect on current incomes…

Eugene Fama

good grief!!!
:(

New home sales hammered, prompting doubts about recovery

Posted on August 24, 2013 @ 11:13 am (Saturday) by WARREN MOSLER

Down and both prior months revised down as well. And this was before mtg rates spiked, and before mass layoffs were announced by mortgage originators, etc. And ‘months supply’ rose to a somewhat ‘normal’ 5.2 months of supply at the current sales pace, taking some wind out of the ‘supply shortage’ story. And a measure of price declined from last month softening that story as well. All still up some from the same month last year, but the year over year gains are decelerating post fiscal tightening

It’s now hard to say housing has improved since the last Fed meeting.

The August employment report will be telling, as the initial report of July job increase dropped to 160,000. A lower number means that series would be worse than what the Fed was expecting as well

Two things:

First, this report and the revisions, like the revisions to Q1, fit the narrative that austerity works to slow the economy. And so do the ‘revised’ numbers such as Q1 GDP. It’s the 200+ year old identity that in a monetary economy the demand leakages (agents spending less then their incomes) have to be overcome by others spending more than their incomes, or the output doesn’t get sold. So last year’s growth included the govt spending maybe 7% more than it’s income for that GDP to be posted. And this year, through automatic and proactive measures, govt is limited to spending 3% more than it’s income. That means the difference has to come from other agents spending more than their incomes or that much output doesn’t get sold. Yes, that kind of private sector credit expansion is possible, but I sure don’t see any evidence of that kind of credit expansion. So I don’t see growth increasing until that does happen. It’s not about ‘the govt cuts subtracted from GDP, so when that effect passes growth resumes’ Instead, it’s ‘govt was adding 7%, and now it’s adding only 3%, and growth will cause that to fall further via the automatic stabilizers until the cycle ends.’ That’s why they are called ‘stabilizers’- they cause the deficit to grow in a down turn until they cause the deficit to get large enough to reverse the decline, and they cut net govt spending until it’s too small to support the credit structure and it all goes into reverse.

And, of course, no one of political consequence sees it that way, as Congress and most others continue to judge deficit reduction as success that will somehow
lead to prosperity. So I only see it getting worse.

Also, as previously discussed, I see growth of industrial production as a sign of duress. Globally, for the most part that kind of thing goes to the nation that can feed its workers the fewest calories, in a brutal race to the bottom. Like Japan’s recent currency depreciation initiative taking a 25% bite out of real wages followed by export growth, etc.

Second, the whole QE thing is ‘perverse’ in that it doesn’t actually do anything of further economic consequence but market participants, and the Fed, act as if it does matter for the macro economy. And it also has some what can be called ‘supply side’ effects as it shifts available private sector assets between reserves, tsy secs, and agency mortgage backed securities.

So, for example, if tapering is on, stocks fall as its presumed the reason stocks went up was QE, and tsy and mbs yields rise as the Fed will be buying fewer of those things. And mixed into all that is the notion that the Fed tapers because it thinks the economy is strong, which should be good for stocks, but also cause yields to rise, which is bad for stocks. So the entire thing is a confusion of reaction functions and misperceptions.

It’s all something like the Keynesian beauty contest but with all the judges legally blind.

So if it goes ‘tapering off’ due to weak employment numbers from a weakening economy, is that good for stocks because QE continues, or bad because the economy is faltering?

And it will result in lower yields for both reasons.

One last thing.
The Fed minutes stated, as they always do, is that one of the reasons supporting their ‘improving growth’ forecast is the positive effect from ‘monetary accommodation’ that, in my humble opinion, as in Japan that has done far more far longer than we have, has failed to materialize going 5 years now. And all they have it the counterfactual using the same methodology that shows how much worse it would have been otherwise .

Again, in my humble opinion, history will not be kind to any of these people.

Mosler Economics / Modern Monetary Theory

The Site of Economist Warren Mosler

Category Archives: Bonds

A Modest Response

A Modest Proposal for Resolving the Eurozone Crisis

durable goods, Case Shiller, new home sales, Consumer Confidence, Richmond Fed, PMI services flash, GDP comments, 10 yr vs Fed

Housing starts, Japan discussion, China, US pmi, store sales

Operating conditions deteriorate for the first time since May

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

Remember all the talk about the deficit causing rates to go up in Japan?

Yes, the Fed can set mortgage rates if it wants to!

Bernanke and Yellen pushing back on higher mortgage rates

U.S. to Sell $10 Billion to $15 Billion in Floating Notes

U.S. to Sell $10 Billion to $15 Billion in Floating Notes

Fama’s Fallacy

New home sales hammered, prompting doubts about recovery