ECB, Jobless Claims, Sea Container Counts, Housing Starts, Purchase apps, Architecture Billings, miles driven, Redbook sales, my take on consequences of $50 oil

Like the carpenter with the piece of wood “no matter how much I cut off it’s still too short”

Draghi has yet to realize rate cuts/QE/etc. are a deflationary/contractionary bias:

*DRAGHI SAYS WILL BUY UNTIL SEE SUSTAINED INFLATION IMPROVEMENT

Jobless Claims
claims-1-17
Highlights
Jobless claims have been inching higher and are not pointing to increasing strength for the January employment report. Initial claims did fall 10,000 in the January 17 week but to a 307,000 level that is just outside the high end of the Econoday consensus range (289,000 to 305,000).

The January 17 week is the sample week for the monthly employment report and a comparison with the December sample week shows a sizable 18,000 increase. The current 4-week average at 306,500 is up 6,500 from the prior week for the highest reading since way back in July. A sample-week to sample-week comparison for the average shows a 7,750 increase this month.

Continuing claims, which are reported with a 1-week lag, have also been on the increase. Continuing claims for the January 10 week rose 15,000 to 2.443 million with the 4-week average up 9,000 to 2.427 million. This average has also been on the rise and is up 8,000 from the month-ago comparison. The unemployment rate for insured workers is unchanged at 1.8 percent.
claims-1-17-graph

December 2014 Sea Container Counts Continue to Show Softness in Trade

By Steven Hansen

Export container counts continue to weaken, which is usually awarning that the global economy is slowing. Export three month rolling averages continue to decelerate – being in negative territory year-over-year. However, there are serious labor issues at all West Coast ports, and it is hard to understand the effect on the container counts. One should also consider that exports have been decelerating most of 2014 – well before the labor disputes.
containers

Housing Starts
starts-dec
starts-dec-graph

Permits lead housing:
permits-dec

MBA Purchase Applications
mba-apps-1-16
mba-apps-1-16-graph

private-permits
This isn’t going anywhere:
architecture-billings-index-dec
Miles driving per capital even worse than this:
miles-driven

This isn’t supposed to be soft with the consumer saving so much on gas and oil:
red-book-1-17
So here’s the latest ‘back of the envelope’ mainstream take on oil:

Consumer saves $200 billion, but
Capex down by $100 billion =
Unambiguous Net Gain of $100 billion

Except they all left out the fact that if the consumer is saving $200 billion other agents are losing $200 billion of income.

And that foreign capex that totaled over $500 billion in 2014 is being cut back as well, with some of those cutbacks translating into reduced US exports.

Not to mention the US consumer only spends part of that $200 billion saved, and what is spent on imports doesn’t add to US GDP.

So my back of the envelope remains:

Consumers who save $200 billion spend only $120 billion on domestic output. Agents who lose $200 billion of income cut spending on domestic output by $120 billion That all nets to 0, consistent with weak December retail sales, for example.

Additionally, US capex falls $100 billion, and US exports fall $50 billion, both also supported by recent data releases.

Therefore $50 oil is an unambiguous negative for the US economy.

Comments on Greece

A couple of ‘fundamentals’

A default/restructure/debt reduction of any form removes euro financial assets and is a contractionary/deflationary bias that makes euro ‘harder to get’ and thereby firms the currency.

Also, Greece has been running a budget deficit, which adds net euro the global economy, making euro easier to get, etc. so if Greece leaves the euro that source of net euro financial assets goes away as well, also fundamentally firming the euro.

And any Greek contribution to the euro trade surplus would be lost, which would work to weaken the euro.

Not that markets would initially react this way!!!
;)

As we had been expecting, the third and final round of the Greek parliamentary vote to elect a new President failed this morning and the country is now headed for a general election. The most likely date for this is January 25th (+/- a week, elections are always held on a Synday), with the constitution stipulating that parliament has to now be dissolved within ten days (most likely tomorrow) and elections held as soon as possible after. With Greek banks still reliant on the ECB for funding and bond maturities ongoing throughout 2015, a significant period of political and financial uncertainty now opens up for Greece and the Eurozone as a whole. Here are the three major questions that need to be answered as we enter the New Year:

1. What will the European response to early elections be?
Greece now has to deal with exceptionally pressing deadlines from its creditors. The current financing programme has been extended to the end of February to allow Troika negotiations to conclude and disburse the remaining 1.8bn EFSF funding before transitioning into a new financing arrangement (most likely an ECCL). If this deadline lapses without agreement, Greece will legally no longer be “under a program” and the undisbursed amounts will cease to exist. The European position across three fronts will therefore need to be clarified.

First, how “hard” is the February headline? Assuming the election takes place on January 25th, it will take around another 10 days to elect a new president (three 5-day distance parliamentary rounds are required, but the second round only requires 150 MP majority), and probably at least a week to form a new governing coalition.* With at best a few weeks left for a new government to negotiate the disbursement of the final tranche and a new credit line, completing talks will be a tall order. European partners will need to discuss if they would be open to another program extension, or if talks would have to start on a blank slate. Both avenues would require fresh approval of the extension or new funding from national parliaments.

The second question relates to ECB funding of Greek banks. We estimate that at least a third of the current 42bn EUR of Eurosystem financing is reliant on collateral that currently benefits from a credit rating threshold suspension from the ECB. It would become ineligible in the event the Greek program expires in February without a financing umbrella. Where the program to lapse after February, part of Greek bank funding would have to shift to Emergency Lending Assistance (ELA) at the Bank of Greece. With the size and scope of ELA financing being under bi-weekly review and press reports suggesting that the Governing Council is considering a broader re-think of its terms and conditions, ECB policy on Greek bank funding remains a key source of uncertainty as well as the most direct means of putting pressure on a new Greek government.

The third and final question relates to the Troika’s broader willingness to negotiate and compromise with a new government. As with the negotiations this year, the primary source of disagreement is likely to remain the fiscal gap for 2015, with the Troika’s current demands standing at a 3 percent primary balance target equivalent to a 2bn fiscal gap versus the current government’s budgeted measures. Our prior is that with a new government in place and a fresh 4-year mandate, the Troika would be more willing to give leeway to authorities to assess budget execution over the course of 2015 rather than voting a large number of proposed fiscal measures upfront, if not revising the primary balance target lower. Still, the timing and extent of such concessions remains highly uncertain, if at all possible.

Despite the pressing nature of the above questions, we would not expect full clarity from European authorities on any of the three fronts above while the election period in Greece is in full swing. The Eurogroup next meets on January 18th where local press reports that the European Commission will present a preliminary report on the terms and conditions which Greece would need to satisfy to remain eligible for an ECCL as well as complete the final review of the current program. A further extension of the latter in any case requires a formal request from the Greek government, and we would expect international creditors to remain quiet on most fronts until a new Greek government has emerged.

2. Who will win the Greek election?

The ability to meet the deadlines above in large part depends on the outcome of the general election and the position of the new government. Opinion polls have been showing a consistent lead for the Radical Left SYRIZA party over ruling New Democracy in the last few months, and our baseline remains that SYRIZA wins the elections. Still, the parliamentary and governmental outcome is not a foregone conclusion. First, SYRIZA’s opinion poll lead over New Democracy has narrowed from 4-6 percentage points over the last few months to 3-4 percent currently. With the political environment remaining particularly fluid (and polls unreliable), the outcome on voting day is not a done deal. Second, a SYRIZA first does not guarantee a parliamentary majority. Greek electoral law operates under an enhanced representation system that allocates the first 50 parliamentary seats as a bonus to the first party, with the rest split proportionately. This in practice requires a party to win 34-38 percent of the national vote to gain an absolute majority. As things stand, SYRIZA would win around 140 MPs in parliament and be required to form a coalition* with at least one of the following four smaller parties that are projected to enter parliament:

The River (“To Potami”) – this is a newly founded moderate left-off-centre party that has been founded by journalist Stavros Theodorakis a few months ago. We would consider this the most likely coalition partner, given that the party has openly expressed a desire for coalition-making. The party is currently polling around 7pct.

Independent Greeks – this is a radical populist party sitting on the right of the current government, whose main policy plank has been opposing current “memorandum policies”. While the party stands at the opposite end of the spectrum from SYRIZA on a number of non-economic issues (eg. immigration, separation of church and state), both sides have indicated they would be open to discussions on a governmental program. The party is currently polling at the fringe of the 3 percent threshold required to enter parliament.

PASOK – the current junior coalition party member, the stigma attached to this party would make it a more difficult coalition candidate for SYRIZA. Still, it is possible that the party is faced with internal pressure in coming weeks that forces a leadership change making coalition-making easier. Indeed, local press is reporting that former prime minister Papandreou (whose father founded the party) is considering running under his own separate platform.

Communists – with the agenda of this party being firmly against EU membership, it is the least likely coalition partner of the above.

As things stand, our baseline remains that either a SYRIZA-Potami or SYRIZA- Independent Greek coalition remain the most likely outcomes after a Greek election.

3. What will the new government’s position be?

A New Democracy win is likely to lead to a relatively swift agreement with the Troika by the end of February, likely meeting the relevant deadlines. In contrast, a SYRIZA government has the potential to create a much wider set of possible outcomes. Even more so that international creditors, the negotiating position of a new SYRIZA government is highly uncertain, and not yet fully clarified within the party itself.

Speaking in a Reuters interview a few days ago, SYRIZA leader Alexis Tsipras stated that the party is fully committed to Eurozone membership, and has no intention of making unilateral moves on the existing agreements “unless forced”. Ultimately however, the party’s position is likely to be dependent on a number of factors: (i) the internal political dynamics within the party, which is composed of a number of competing groups. Most vocal of these is the “left platform” led by current parliamentary spokesperson Panagiotis Lafazanis, who sits to the left of the leadership and favours a more confrontational stance versus international lenders; (ii) the outcome of the general election and the potential partner that emerges, with a “River” or PASOK coalition having a much greater moderating influence on the party than Independent Greeks or an outright SYRIZA majority; (iii) market pressure in the run-up to the election.

Ultimately, the party’s position on Europe is unlikely to be fully fleshed out until February, most likely formulated by the leadership team that emerges around party leader Tsipras, inclusive of the person that is appointed to lead the finance ministry. Nikos Pappas (party leader’s chief of staff), Yannis Milios (responsible for economic policy), George Stathakis (responsible for development policy), Yannis Dragasakis (current deputy Speaker of parliament) and Dimitris Papadimoulis (current member of the European parliament) all stand out as potential influential members of a new SYRIZA-led government.

Conclusion
To sum up, markets are likely to be left with more questions than answers until the domestic political progress in Greece plays out more fully over the next two months. In the meantime Greek financing needs over the course of 2015 are ongoing, with large uncertainty on when the government will lose its ability to repay maturing obligations. We estimate this would take place at some point in the second quarter of next year, with a 1.4bn IMF maturity being due in March, another 2.5bn due to the IMF over Q2 and a large 4.2bn GGB payment due to the ECB in July. Ahead of that the role of the ECB – in particular the willingness to tolerate ELA financing of Greek banks in the face of potential renewed deposit pressure on the financial system – will be a key pressure point between Europe and a new Greek government.

Ultimately, we see a consensual outcome between a SYRIZA-led government and its creditors as achievable, but it would require a moderation from both sides. On the European front, it would consist of a lowered primary balance target for this and coming years and an offer of additional official sector debt-relief via maturity extensions – we would consider neither impossible given the adjustments in fiscal targets already granted to other peripheral economies and the low political cost of maturity extensions. On the SYRIZA side, agreement would require the party to give up on its pledges to reverse structural reforms as well as a commitment to maintaining a path of fiscal prudence.

This notwithstanding, convergence is not currently apparent and is unlikely to become so until well after January. It requires both sides to shift to a consensual rather than confrontational approach, in turn perhaps dependent on greater market pressure. Either way, large uncertainty and path-dependent outcomes suggest damaging confrontation cannot be ruled out, which in turn has the potential to generate much greater destabilizing outcomes for Greece and the Eurozone as a whole in 2015. The New Year welcomes Europe with renewed challenges.

George

*If a government does not win an outright 151 majority of MPs, the leader whose party leader comes first is given a 3-day mandate to explore the possibility of a coalition government with other parties. If this fails, the mandate is passed to the second largest party and so on. If all three largest parties fail to secure a coalition, the country goes to a new general election

**The rating threshold exemption is apparent in the ECB document detailing GGB haircuts here: https://www.ecb.europa.eu/ecb/legal/pdf/en_ecb_2014_46_f_sign.pdf

EU Commission- more of same

:(

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.”

ECB relying export driven growth through euro depreciation

Note below that he states it’s the fx channel that the ECB is relying on to support aggregate demand.

Good luck to them, it doesn’t work that way!!!

From the speech by Mario Draghi, President of the ECB, Annual central bank symposium in Jackson Hole, 22 August 2014:

Boosting aggregate demand

On the demand side, monetary policy can and should play a central role, which currently means an accommodative monetary policy for an extended period of time. I am confident that the package of measures we announced in June will indeed provide the intended boost to demand, and we stand ready to adjust our policy stance further.

We have already seen exchange rate movements that should support both aggregate demand and inflation, which we expect to be sustained by the diverging expected paths of policy in the US and the euro area (Figure 7). We will launch our first Targeted Long-Term Refinancing Operation in September, which has so far garnered significant interest from banks. And our preparation for outright purchases in asset-backed security (ABS) markets is fast moving forward and we expect that it should contribute to further credit easing. Indeed, such outright purchases would meaningfully contribute to diversifying the channels for us to generate liquidity.

Draghi on the euro

Draghi says a stronger euro would trigger looser ECB policy (Reuters)

Except by my calculations he has it backwards, as lower rates make a currency like the euro stronger, not weaker, via the interest income channels, etc.

ECB President Mario Draghi said that euro appreciation over the last year was an important factor in bringing euro zone inflation down to its current low levels, accounting for 0.4-0.5 percentage point of decline in the annual rate, which stood at 0.5 percent year-on-year in March. “I have always said that the exchange rate is not a policy target, but it is important for price stability and growth. And now, what has happened over the last few months is that is has become more and more important for price stability,” Draghi said at a news conference. “So the strengthening of the exchange rate would require further monetary policy accommodation.

As above.

If you want policy to remain accommodative as now, a further strengthening of the exchange rate would require further stimulus,” he said.

I agree, except I’d propose leaving rates at 0 fiscal relaxation to the point of domestic full employment, etc.

Furthermore, their policy of depressing domestic demand to drive exports/competitiveness has successfully resulted in growing net exports. However, unless combined with buying fx reserves of the targeted market areas, the euro appreciates until the net exports reverse, regardless of ‘monetary policy.’

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.

ECB proposals to buy loans to households and companies

This is highly problematic.

If the ECB takes the risk, there is extreme moral hazard. If they don’t, lending won’t likely increase:

ECB poised for battle to ward off deflation

January 26 (FT) — Mario Draghi has signalled that he would be prepared for the ECB fight deflation in Europe by buying packages of bank loans to households and companies. Since the corporate bond market was small and working well, he said, there is no need to do something in that field. As the ECB does not issue debt and a decline in net lending remains a deep problem in peripheral eurozone countries, Mr Draghi said he favoured looking at a way to package bank loans to the private sector and for the ECB to buy them if economic conditions got worse. Mr Draghi said: What other assets would we buy? One thing is bank loans?.?.?.?the issue for further thinking in the future is to have an asset that would capture and package bank loans in the proper way. Right now securitisation is pretty dead, he said adding, that there was a possibility of buying asset backed securities if they were easy to understand, price and trade and rate.

More on EU Private Sector Credit Expansion

ECB Says Bank Loans to Private Sector Shrink Most on Record

By Jeff Black

July 25 (BN) — Lending to companies and households in the 17-member euro area fell the most on record in June in a sign the region is still struggling to shake off its longest-ever recession.

Loans to the private sector dropped 1.6 percent from a year earlier, the Frankfurt-based European Central Bank said today. That’s the 14th monthly decline and the biggest since the start of the single currency in 1999.

The rate of growth in M3 money supply, which the ECB uses as an indicator for future inflation, fell to 2.3 percent in June from 2.9 percent in May, according to today’s data. That’s below all 30 estimates in a Bloomberg survey of economists.

M3 grew 2.8 percent in past three months from the same period a year earlier. M3 is the broadest gauge of money supply and includes cash in circulation, some forms of savings and money-market holdings.