Tag Archives: Martin Wolf

Fiscal and monetary policy in a liquidity trap

Posted on by

Not bad, but let’s take it up to the next level.

Comments below:

Fiscal and monetary policy in a liquidity trap

By Martin Wolf

With floating fx, it’s always a ‘liquidity trap’ in that adding liquidity to a system necessarily not liquidity constrained is moot.

Part 1

What is the correct approach to fiscal and monetary policy when an economy is depressed and the central bank’s rate of interest is close to zero? Does the independence of the central bank make it more difficult to reach the right decisions? These are two enormously important questions raised by current circumstances in the US, the eurozone, Japan and the UK.

With floating fx, it’s always about a fiscal adjustment, directly or indirectly.

Broadly speaking, I can identify three macroeconomic viewpoints on these questions:
1. The first is the pre-1930 belief in balanced budgets and the gold standard (or some other form of a-political money).

Yes, actual fixed fx policy, where the monetary system is continuously liquidity constrained by design.

2. The second is the religion of balanced budgets and managed money, with Milton Friedman’s monetarism at the rules-governed end of the spectrum and independent inflation-targeting central banks at the discretionary end.

Yes, the application of fixed fx logic to a floating fx regime.

3. The third demands a return to Keynesian ways of thinking, with “modern monetary theory” (in which monetary policy and central banks are permanently subservient to fiscal policy) at one end of the policy spectrum, and temporary resort to active fiscal policy at the other.

MMT recognizes the difference in monetary dynamics between fixed and floating fx regimes.

In this note, I do not intend to address the first view, though I recognise that it has substantial influence, particularly in the Republican Party. I also do not intend to address Friedman’s monetarism, which has lost purchase on contemporary policy-makers, largely because of the views that the demand for money is unstable and the nature of money ill-defined. Finally, I intend to ignore “modern monetary theory” which would require a lengthy analysis of its own.

This leaves us with the respectable contemporary view that the best way to respond to contemporary conditions is via fiscal consolidation and aggressive monetary policy, and the somewhat less respectable view that aggressive fiscal policy is essential when official interest rates are close to zero.

Two new papers bring light from the second of these perspectives. One is co-authored by Paul McCulley, former managing director of Pimco and inventor of the terms “Minsky moment” and “shadow banking”, and Zoltan Pozsar, formerly at the Federal Reserve Bank of New York and now a visiting scholar at the International Monetary Fund.* The other is co-authored by J. Bradford DeLong of the university of California at Berkeley, and Lawrence Summers, former US treasury secretary and currently at Harvard university. **

Unfortunately, and fully understood, is the imperative for you to select from ‘celebrity’ writers regardless of the quality of the content.

The paper co-authored by Mr McCulley and Mr Pozsar puts the case for aggressive fiscal policy. The US, they argue, is in a “liquidity trap”: even with official interest rates near zero, the incentive for extra borrowing, lending and spending in the private sector is inadequate.

An output gap is the evidence that total spending- public plus private- is inadequate. And yes, that can be remedied by an increase in private sector borrowing to spend, and/or a fiscal adjustment by the public sector towards a larger deficit via either an increase in spending and/or tax cut, depending on one’s politics.

The explanation for this exceptional state of affairs is that during the credit boom and asset-price bubble that preceded the crisis, large swathes of the private sector became over-indebted. Once asset prices fell, erstwhile borrowers were forced to reduce their debts. Financial institutions were also unwilling to lend. They needed to strengthen their balance sheets. But they also confronted a shortage of willing and creditworthy borrowers.

Yes, for any reason if private sector spending falls short of full employment levels, a fiscal adjustment can do the trick.

This raises an interesting question:

Is it ‘better’, for example, to facilitate the increase in spending through a private sector credit expansion, or through a tax cut that allows private sector spending to increase via increased income, or through a government spending increase?

The answer is entirely political. The output gap can be closed with any/some/all of those options.

In such circumstances, negative real interest rates are necessary, but contractionary economic conditions rule that out.

I see negative nominal rates as a tax that will reduce income and net financial assets of the non govt sectors, even as it may increase some private sector credit expansion. And the reduction of income and net financial assets works to reduce the credit worthiness of the non govt sectors reducing their ability to borrow to spend.

Instead, there is a danger of what the great American economist, Irving Fisher called “debt deflation”: falling prices raise the real burden of debt, making the economic contraction worse.

Yes, though he wrote in the context of fixed fx policy, where that tends to happen as well, though under somewhat different circumstances and different sets of forces.

A less extreme (and so more general) version of the idea is “balance-sheet recession”, coined by Richard Koo of Nomura. That is what Japan had to manage in the 1990s.

With floating fx they are all balance sheet recessions. There is no other type of recession.

This is how the McCulley-Pozsar paper makes the point: “deleveraging is a beast of burden that capitalism cannot bear alone. At the macroeconomic level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction . . . by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.

Correct, in the context of today’s floating fx. With fixed fx that option carries the risk of rising rates for the govt and default/devaluation.

“Fiscal austerity does not work in a liquidity trap and makes as much sense as putting an anorexic on a diet. Yet ‘diets’ are the very prescriptions that fiscal ‘austerians’ have imposed (or plan to impose) in the US, UK and eurozone. Austerians fail to realise, however, that everyone cannot save at the same time and that, in liquidity traps, the paradox of thrift and depression are fellow travellers that are functionally intertwined.”

Agreed for floating fx. Fixed fx is another story, where forced deflation via austerity does make the maths work, though most often at an impossible social cost.

Confronted by this line of argument, austerians (a term coined by Rob Parenteau, a research associate at the Levy Economics Institute of Bard College), make three arguments:

1. additional borrowing will add heavily to future debt and so be an unreasonable burden on future generations;
2. increased borrowing will crowd out private borrowing;
3. bond investors will stop buying and push yields up.

Which does happen with fixed fx policy.

In a liquidity trap, none of these arguments hold.

With floating fx, none of these hold in any scenario.

Experience over the last four years (not to mention Japan’s experience over the past 20 years) has demonstrated that governments operating with a (floating) currency do not suffer a constraint on their borrowing. The reason is that the private sector does not wish to borrow, but wants to cut its debt, instead. There is no crowding out.

Right, because floating fx regimes are by design not liquidity constrained.

Moreover, adjustment falls on the currency, not on the long-term rate of interest.

Right, and again, unlike fixed fx.

In the case of the US, foreigners also want to lend, partly in support of their mercantilist economic policies.

Actually, they want to accumulate dollar denominated financial assets, which we call lending.

Note that both reserve balances at the Fed and securities account balances at the Fed (treasury securities) are simply dollar deposits at the Fed.

Alas, argue Mr McCulley and Mr Pozsar, “held back by concerns borne out of these orthodoxies, . . . governments are not spending with passionate purpose. They are victims of intellectual paralysis borne out of inertia of dogma . . . As a result, their acting responsibly, relative to orthodoxy, and going forth with austerity may drag economies down the vortex of deflation and depression.”

Right. Orthodoxy happens to be acting as if one was operating under a fixed fx regime even though it’s in fact a floating fx regime.

Finally, they note, “the importance of fiscal expansion and the impotence of conventional monetary policy measures in a liquidity trap have profound implications for the conduct of central banks. This is because in a liquidity trap, the fat-tail risk of inflation is replaced by the fat-tail risk of deflation.”

The risk of excess aggregate demand is replaced by the risk of inadequate aggregate demand.

And the case can be made that lower rates reduce aggregate demand via the interest income channels, as the govt is a net payer of interest.

In this situation, we do not need independent central banks that offset – and so punish – fiscally irresponsible governments. We need central banks that finance – and so encourage – economically responsible (though “fiscally irresponsible”) governments.

Not the way I would say it but understood.

When private sector credit growth is constrained, monetisation of public debt is not inflationary.

While I understand the point, note that ‘monetisation’ is a fixed fx term not directly applicable to floating fx in this context.

Indeed, it would be rather good if it were inflationary, since that would mean a stronger recovery, which would demand swift reversal of the unorthodox policy mix.

The conclusion of the McCulley-Pozsar paper is, in brief, that aggressive fiscal policy does work in the unusual circumstances of a liquidity trap, particularly if combined with monetisation. But conventional wisdom blocks full use of the unorthodox tool kit. Historically, political pressure has destroyed such resistance. Political pressure drove the UK off gold in 1931. But it also brought Hitler to power in Germany in 1933. The eurozone should take note.

Remarkably, in the circumstances of a liquidity trap, enlarged fiscal deficits are likely to reduce future levels of privately held public debt rather than raise them.

As if that aspect matters?

The view that fiscal deficits might provide such a free lunch is the core argument of the paper by DeLong and Summers, to which I will turn in a second post.

Free lunch entirely misses the point.

Why does the size the balances in Fed securities accounts matter as suggested, with floating fx policy?

Share

The Political Genius of Supply-Side Economics

Posted on by

Where am I wrong, if at all?

I agree with the political analysis.

I know Bruce Bartlett and he’ll be the first to tell you he does NOT understand monetary operations. Even simple statements like ‘China keeps its dollars in its reserve account at the Fed’ seem to cause him to glass over. He can only repeat headline rhetoric and has no interest in drilling down through it.

Krugman’s column a week ago, however, may have been a major breakthrough. He conceded the issue of long term deficits was inflation and not solvency. And while his maths and graphs disqualified him from participating in the inflation debate, it so far seems to have shifted the deficit dove position to much firmer ground.

A Congressman might vote to cut Social Security due to fear of Federal insolvency, with all ‘noted’ economists arguing only how far down the road it may be, along with dependence on foreign creditors.

However, I doubt most Congressman would vote to cut Social Security based on some economists predicting possible inflation in 20 years.

So even though Krugman’s reasoning was simply ‘they can always print the money’ followed by highly suspect graphs and statements about how someday that could cause hyper inflation, hopefully it did shift the discussion from solvency to inflation, where it belongs.

So now the hawk/dove question is, as it should be, whether long term deficits imply long term run away inflation. And while the correct answer is: depends on the offsetting demand leakages/unspent income like pension contributions and other nominal savings desires. Just the fact that the debate shifts away from solvency should be enough for a change of global political attitude.

And, if so, this opens the door to a new era of prosperity as yet unimagined.


The political genius of supply-side economics

By Martin Wolf

July 25 (FT) – The future of fiscal policy was intensely debated in the FT last week. In this Exchange, I want to examine what is going on in the US and, in particular, what is going on inside the Republican party. This matters for the US and, because the US remains the world’s most important economy, it also matters greatly for the world.

My reading of contemporary Republican thinking is that there is no chance of any attempt to arrest adverse long-term fiscal trends should they return to power. Moreover, since the Republicans have no interest in doing anything sensible, the Democrats will gain nothing from trying to do much either. That is the lesson Democrats have to draw from the Clinton era’s successful frugality, which merely gave George W. Bush the opportunity to make massive (irresponsible and unsustainable) tax cuts. In practice, then, nothing will be done.

Indeed, nothing may be done even if a genuine fiscal crisis were to emerge. According to my friend, Bruce Bartlett, a highly informed, if jaundiced, observer, some “conservatives” (in truth, extreme radicals) think a federal default would be an effective way to bring public spending they detest under control. It should be noted, in passing, that a federal default would surely create the biggest financial crisis in world economic history.

To understand modern Republican thinking on fiscal policy, we need to go back to perhaps the most politically brilliant (albeit economically unconvincing) idea in the history of fiscal policy: “supply-side economics”. Supply-side economics liberated conservatives from any need to insist on fiscal rectitude and balanced budgets. Supply-side economics said that one could cut taxes and balance budgets, because incentive effects would generate new activity and so higher revenue.

The political genius of this idea is evident. Supply-side economics transformed Republicans from a minority party into a majority party. It allowed them to promise lower taxes, lower deficits and, in effect, unchanged spending. Why should people not like this combination? Who does not like a free lunch?

How did supply-side economics bring these benefits? First, it allowed conservatives to ignore deficits. They could argue that, whatever the impact of the tax cuts in the short run, they would bring the budget back into balance, in the longer run. Second, the theory gave an economic justification – the argument from incentives – for lowering taxes on politically important supporters. Finally, if deficits did not, in fact, disappear, conservatives could fall back on the “starve the beast” theory: deficits would create a fiscal crisis that would force the government to cut spending and even destroy the hated welfare state.

In this way, the Republicans were transformed from a balanced-budget party to a tax-cutting party. This innovative stance proved highly politically effective, consistently putting the Democrats at a political disadvantage. It also made the Republicans de facto Keynesians in a de facto Keynesian nation. Whatever the rhetoric, I have long considered the US the advanced world’s most Keynesian nation – the one in which government (including the Federal Reserve) is most expected to generate healthy demand at all times, largely because jobs are, in the US, the only safety net for those of working age.

True, the theory that cuts would pay for themselves has proved altogether wrong. That this might well be the case was evident: cutting tax rates from, say, 30 per cent to zero would unambiguously reduce revenue to zero. This is not to argue there were no incentive effects. But they were not large enough to offset the fiscal impact of the cuts (see, on this, Wikipedia and a nice chart from Paul Krugman).

Indeed, Greg Mankiw, no less, chairman of the Council of Economic Advisers under George W. Bush, has responded to the view that broad-based tax cuts would pay for themselves, as follows: “I did not find such a claim credible, based on the available evidence. I never have, and I still don’t.” Indeed, he has referred to those who believe this as “charlatans and cranks”. Those are his words, not mine, though I agree. They apply, in force, to contemporary Republicans, alas,

Since the fiscal theory of supply-side economics did not work, the tax-cutting eras of Ronald Reagan and George H. Bush and again of George W. Bush saw very substantial rises in ratios of federal debt to gross domestic product. Under Reagan and the first Bush, the ratio of public debt to GDP went from 33 per cent to 64 per cent. It fell to 57 per cent under Bill Clinton. It then rose to 69 per cent under the second George Bush. Equally, tax cuts in the era of George W. Bush, wars and the economic crisis account for almost all the dire fiscal outlook for the next ten years (see the Center on Budget and Policy Priorities).

Today’s extremely high deficits are also an inheritance from Bush-era tax-and-spending policies and the financial crisis, also, of course, inherited by the present administration. Thus, according to the International Monetary Fund, the impact of discretionary stimulus on the US fiscal deficit amounts to a cumulative total of 4.7 per cent of GDP in 2009 and 2010, while the cumulative deficit over these years is forecast at 23.5 per cent of GDP. In any case, the stimulus was certainly too small, not too large.

The evidence shows, then, that contemporary conservatives (unlike those of old) simply do not think deficits matter, as former vice-president Richard Cheney isreported to have told former treasury secretary Paul O’Neill. But this is not because the supply-side theory of self-financing tax cuts, on which Reagan era tax cuts were justified, has worked, but despite the fact it has not. The faith has outlived its economic (though not its political) rationale.

So, when Republicans assail the deficits under President Obama, are they to be taken seriously? Yes and no. Yes, they are politically interested in blaming Mr Obama for deficits, since all is viewed fair in love and partisan politics. And yes, they are, indeed, rhetorically opposed to deficits created by extra spending (although that did not prevent them from enacting the unfunded prescription drug benefit, under President Bush). But no, it is not deficits themselves that worry Republicans, but rather how they are caused: deficits caused by tax cuts are fine; but spending increases brought in by Democrats are diabolical, unless on the military.

Indeed, this is precisely what John Kyl (Arizona), a senior Republican senator,has just said:

“[Y]ou should never raise taxes in order to cut taxes. Surely Congress has the authority, and it would be right to — if we decide we want to cut taxes to spur the economy, not to have to raise taxes in order to offset those costs. You do need to offset the cost of increased spending, and that’s what Republicans object to. But you should never have to offset the cost of a deliberate decision to reduce tax rates on Americans”

What conclusions should outsiders draw about the likely future of US fiscal policy?

First, if Republicans win the mid-terms in November, as seems likely, they are surely going to come up with huge tax cut proposals (probably well beyond extending the already unaffordable Bush-era tax cuts).

Second, the White House will probably veto these cuts, making itself even more politically unpopular.

Third, some additional fiscal stimulus is, in fact, what the US needs, in the short term, even though across-the-board tax cuts are an extremely inefficient way of providing it.

Fourth, the Republican proposals would not, alas, be short term, but dangerously long term, in their impact.

Finally, with one party indifferent to deficits, provided they are brought about by tax cuts, and the other party relatively fiscally responsible (well, everything is relative, after all), but opposed to spending cuts on core programmes, US fiscal policy is paralysed. I may think the policies of the UK government dangerously austere, but at least it can act.

This is extraordinarily dangerous. The danger does not arise from the fiscal deficits of today, but the attitudes to fiscal policy, over the long run, of one of the two main parties. Those radical conservatives (a small minority, I hope) who want to destroy the credit of the US federal government may succeed. If so, that would be the end of the US era of global dominance. The destruction of fiscal credibility could be the outcome of the policies of the party that considers itself the most patriotic.

In sum, a great deal of trouble lies ahead, for the US and the world.

Where am I wrong, if at all?

Share

And the Wolf responds..

Posted on by


[Skip to the end]

(email exchange – in response to previous email)

 
>   
>   On Thu, Jan 15, 2009 at 5:09 PM, Martin Wolf wrote:
>   
>   
>   Inflation is default.
>   

I respectfully do not agree.

Default is failure to make payment as agreed.

There is no zero inflation contract.

In fact, most every currency has inflation most years.

>   
>   Surely that is obvious to everybody.
>   

Credit default contracts don’t include inflation, nor does any other default provision.

>   
>   When the economy finally recovers, the government will end up with a very large debt.
>   

It will be some % of GDP that you may consider ‘very large’.

>   
>   Such debt is owed to bond-holders and serviced by taxpayers.
>   

In the first instance it is serviced by crediting accounts on the Fed’s own spread sheet.

If aggregate demand is deemed too high at that time future governments may opt to raise taxes.

If future govts desire to alter the distribution of real output to those then alive they will be free to do that via the usual fiscal and monetary measures.

>   
>   Politicians who are elected by the latter will want to default on liabilities to the former
>   (particularly if many of them are foreigners) and provide taxpayers with goodies, instead.
>   

Very possible!

>   
>   A burst of inflation is how they have always done it.
>   

Yes.

>   
>   End of story.
>   

As above. If you mean to say deficits will cause inflation, then do that.
Default is the wrong word for an international financial column.
Surely that’s obvious to everyone.

>   
>   I suggest you study the history of Argentina or indeed of the post-first-world-war inflations.
>   

And you can study what the ratings agencies have considered to be defaults.

 
All the best,
Warren

>   
>   Martin Wolf
>   


[top]

Share

FT.com The Economists’ Forum: Why Washington’s rescue cannot end the crisis story

Posted on by

Why Washington’s rescue cannot end the crisis story



by Martin Wolf

Last week’s column on the views of New York University’s Nouriel Roubini (February 20) evoked sharply contrasting responses: optimists argued he was ludicrously pessimistic; pessimists insisted he was ridiculously optimistic. I am closer to the optimists: the analysis suggested a highly plausible worst case scenario, not the single most likely outcome.

Those who believe even Prof Roubini’s scenario too optimistic ignore an inconvenient truth: the financial system is a subsidiary of the state. A creditworthy government can and will mount a rescue. That is both the advantage – and the drawback – of contemporary financial capitalism.

Any government with its own non-convertible currency can readily support nominal domestic aggregate demand at any desired level and, for example, sustain full employment as desired.

The ‘risk’ is ‘inflation’ as currently defined, not solvency.

In an introductory chapter to the newest edition of the late Charles Kindleberger’s classic work on financial crises, Robert Aliber of the University of Chicago Graduate School of Business argues that “the years since the early 1970s are unprecedented in terms of the volatility in the prices of commodities, currencies, real estate and stocks, and the frequency and severity of financial crises”*. We are seeing in the US the latest such crisis.

Yes, price volatility has seemingly substituted for output gap volatility.

All these crises are different. But many have shared common features. They begin with capital inflows from foreigners seduced by tales of an economic El Dorado.

With floating fx/non-convertible currency ‘capital inflows’ do not exist in the same sense they do with a gold standard and other fixed fx regimes.

This generates low real interest rates and a widening current account deficit.

The current account deficit is a function of non-resident desires to accumulate your currency. These desires are functions of a lot of other variables.

Non-residents can only increase their net financial assets of foreign currencies by net exports.

This is all an accounting identity.

Domestic borrowing and spending surge, particularly investment in property. Asset prices soar, borrowing increases and the capital inflow grows. Finally, the bubble bursts, capital floods out and the banking system, burdened with mountains of bad debt, implodes.

With variations, this story has been repeated time and again. It has been particularly common in emerging economies. But it is also familiar to those who have followed the US economy in the 2000s.

The US did not get here by that casual path.

Foreign CB accumulation of $US financial assets to support their export industries supported the US trade deficit at ever higher levels.

The budget surpluses of the late 1990s drained exactly that much net financial equity from then non-government sectors (also by identity).

As this financial equity that supports the credit structure was reduced via government budget surpluses, non-government leverage was thereby increased.

This meant increasing levels of private sector debt were necessary to sustain aggregate demand as evidenced by the increasing financial obligations ratio.

Y2K panic buying and credit extended to funding of improbably business plans came to a head with the equity peak and collapse in 2000.

Aggregate demand fell, GDP languished, and the countercyclical tax structure began to reverse the surplus years and equity enhancing government deficits emerged.

Interest rates were cut to 1% with little effect.

The economy turned in Q3 2003 with the retroactive fiscal package that got the budget deficit up to about 8% of GDP for Q3 2003, replenishing non-government net financial assets and fueling the credit boom expansion that followed.

Again, counter cyclical tax policy began bringing the federal deficit down, and that tail wind diminished with time.

Aggregate demand was sustained by increasing growth rates of private sector debt, however it turns out that much of that new debt was coming from lender fraud (subprime borrowers that qualified with falsified credit information).

By mid 2006, the deficit was down to under 2% of GDP (history tells us over long periods of time we need a deficit of maybe 4% of GDP to sustain aggregate demand, due to demand ‘leakages’ such as pension fund contributions, etc.), and the subprime fraud was discovered.

With would-be-subprime borrowers no longer qualifying for home loans, that source of aggregate demand was lost, and housing starts have since been cut in half.

This would have meant negative GDP had not exports picked up the slack as non-residents (mainly CBs) stopped their desire to accumulate $US financial assets. This was Paulson’s work as he began calling any CB that bought $US a currency manipulator and used China as his poster child. Bernanke helped with his apparent ‘inflate your way out of debt/beggar thy neighbor policy’. Bush also helped by giving oil producers ideological reasons not to accumulate $US financial assets.

Our own pension funds also helped sustain GDP and push up prices with their policy of allocating to passive commodity strategies as an asset class.

The fiscal package will add about $170 billion to non-government net financial assets, and non-residents reducing their accumulation of $US financial assets via buying US goods and services will also continue to help the US domestic sector replenish its lost financial equity. This will continue until domestic demand recovers, as in all past post World War II cycles.

When bubbles burst, asset prices decline, net worth of non-financial borrowers shrinks and both illiquidity and insolvency emerge in the financial system. Credit growth slows, or even goes negative, and spending, particularly on investment, weakens. Most crisis-hit emerging economies experienced huge recessions and a tidal wave of insolvencies. Indonesia’s gross domestic product fell more than 13 per cent between 1997 and 1998. Sometimes the fiscal cost has been over 40 per cent of GDP (see chart).

Yes, interesting that this time with the boom in resource demand, emerging markets seem to be doing well.

By such standards, the impact on the US will be trivial. At worst, GDP will shrink modestly over several quarters.

Yes, that is the correct way to measure the real cost. Still high, as growth is path dependent, but not catastrophic.

The ability to adjust monetary and fiscal policy insures this. George Magnus of UBS, known for his “Minsky moment”, agrees with Prof Roubini that losses might end up as much as $1,000bn (FT.com, February 25). But it is possible that even this would fall on private investors and sovereign wealth funds.

Those are nominal losses: rearranging of financial assets. The real losses are the lost output/unemployment/etc.

In any case, the business of banks is to borrow short and lend long.

Not US banks – that’s called gap risk, and it’s highly regulated.

Provided the Federal Reserve sets the cost of short-term money below the return on long-term loans, as it has for much of the past two decades, banks can hardly fail to make money.

As above. In fact, with low rates, banks make less on free balances.

If the worst comes to the worst, the government can mount a bail-out similar to the one of the bankrupt savings and loan institutions in the 1980s. The maximum cost would be 7 per cent of GDP.

Again, that’s only a nominal cost, a rearranging of financial assets.

That would raise US public debt to 70 per cent to GDP and would cost the government a mere 0.2 per cent of GDP, in perpetuity.

Whatever that means..

That is a fiscal bagatelle.

Because the US borrows in its own currency,

Spends first, and then borrows to support interest rates, actually

(See Soft Currency Economics.)

it is free of currency mismatches that made the balance-sheet effects of devaluations devastating for emerging economies.

True. ‘External debt’ is not my first choice for any nation.

Devaluation offers, instead, a relatively painless way out of a slowdown: an export surge.

Wrong in the real sense!

Exports are real costs; imports are real benefits. So, a shift as the US has been doing is actually the most costly way to ‘fix things’ in real terms.

And it’s obvious the real standard of living in the US is taking a hit – ‘well anchored’ incomes and higher prices are cutting into real consumption that’s being replaced by real exports/declining real terms of trade, etc.

Between the fourth quarter of 2006 and the fourth quarter of 2007, the improvement in US net exports generated 30 per cent of US growth.

Yes, we work and export the fruits of our labor. In real terms, that’s a negative for our standard of living.

The bottom line, then, is that even if things become as bad as I discussed last week, the US government is able to rescue the financial system and the economy. So what might endanger the US ability to act?

The biggest danger is a loss of US creditworthiness.

Solvency is never an issue. I think he recognizes this but not sure.

In the case of the US, that would show up as a surge in inflation expectations. But this has not happened. On the contrary, real and nominal interest rates have declined and implied inflation expectations are below 2.5 per cent a year.

I think they are much higher now, but in any case, inflation expectations are a lagging indicator, and in my book cause nothing.

An obvious danger would be a decision by foreigners, particularly foreign governments, to dump their enormous dollar holdings.

The desire to accumulate $US financial assets by foreigners is already falling rapidly, as evidenced by the falling $ and increased US exports. The only way to get rid of $ financial assets is ultimately to ‘spend them’ on US goods, services, and US non-financial assets, which is happening and accelerating. Exports are growing at an emerging market like 13% clip and heading higher.

But this would be self-destructive. Like the money-centre banks, the US itself is much “too big to fail”.

Statements like that make me think he still has some kind of solvency based model in mind.

Yet before readers conclude there is nothing to worry about, after all, they should remember three points.

The first is that the outcome partly depends on how swiftly and energetically the US authorities act. It is still likely that there will be a significant slowdown.

If so, the tax structure will rapidly increase the budget deficit and restore aggregate demand, as in past cycles.

The second is that the global outcome also depends on action in the rest of the world aimed at sustaining domestic demand in response to a US shift in spending relative to income. There is little sign of such action.

True, budget deficits are down all around the world except maybe China and India, especially if you count lending by state supported banks, which is functionally much the same as government deficit spending.

The third point is the one raised by Harvard’s Dani Rodrik and Arvind Subramanian, of the Peterson Institute for International Economics in Washington DC, (this page, February 26), namely the dysfunctional way capital flows have worked, once again.

I would broaden their point. This is not a crisis of “crony capitalism” in emerging economies, but of sophisticated, rules-governed capitalism in the world’s most advanced economy. The instinct of those responsible will be to mount a rescue and pretend nothing happened. That would be a huge error.

Those who do not learn from history are condemned to repeat it.

And those who keep saying that seem to be the worst violators.

One obvious lesson concerns monetary policy. Central banks must surely pay more attention to asset prices in future. It may be impossible to identify bubbles with confidence in advance. But central bankers will be expected to exercise their judgment, both before and after the fact.

While asset prices are probably for the most part a function of interest rates via present value calculations, my guess is that other more powerful variables are always present.

A more fundamental lesson still concerns the way the financial system works. Outsiders were already aware it was a black box. But they were prepared to assume that those inside it at least knew what was going on. This can hardly be true now. Worse, the institutions that prospered on the upside expect rescue on the downside.

I’d say demand rather than expect. Can’t blame them – whatever it takes – profits often go to the shameless.

They are right to expect this. But this can hardly be a tolerable bargain between financial insiders and wider society. Is such mayhem the best we can expect? If so, how does one sustain broad public support for what appears so one-sided a game?

Watch it and weep.

Yes, the government can rescue the economy. It is now being forced to do so. But that is not the end of this story. It should only be the beginning.

‘should’ ???

Fiscal costs of bank bailouts

US yield curve

US inflation expectations

* Manias, Panics and Crashes, Palgrave, 2005.

martin.wolf@ft.com

February 27th, 2008 in US economy | Permalink

4 Responses to “Why Washington’s rescue cannot end the crisis story”

Comments

  1. Kent Janér (guest): Largely, I agree with Martin Wolf’s analysis of what went wrong and what should be done in the future to prevent the by now very familiar pattern of boom and bust in regulated financial systems.There is one aspect that I think merits more attention than it has been given, an aspect that also has some important short term effects – the equity base of the financial system. I think the equity base is currently being mismanaged, and regulators could have some tools to improve the situation.

    As everyone knows, there are much more losses in the financial system than have so far been declared. I think close to USD 150 bn has been reported at this stage. That could be compared to for example the G7 comment of 400 bn in mortgage related losses, and 400-1000 bn in total losses probably covering most private sector forecasts. At the same time new risk capital has been raised to the tune of roughly 90 bn USD (ballpark number).

    A back of the envelope calculation shows that a large part of the equity of the financial system has been wiped out, much more than has been reported. The market knows, the regulators know and the banks themselves certainly know that even though they are far from bankrupt, they are on average in truth operating at equity/capital adequacy ratios clearly below both legal requirements and sound banking practices.

    Currently, the banks are responding by reporting losses little by little, keeping up the appearance of reasonable capitalization. At the same time, they try to reduce their balance sheet, especially from items that carry a high charge to capital. This way they hope (but hope is never a strategy) that time will heal their balance sheet; earnings will over time be able to offset continued writedowns. High vulnerability to negative surprises, but no formal problems with minimum capital adequacy ratios and control of the bank, “only” weak earnings for some time.

    That is all very nice and cosy for bank´s directors, but not for the economy in general. If a small part of the banking sector has specific problems and rein in lendig, so be it. That probably has little impact on the rest of the economy. However, if the entire financial sector postpone reported losses and contract their balance sheet, that is another question altogether. The cost to rest of the economy could be very high indeed.

I am less concerned about ‘loanable funds’ with today’s non-convertible currency. I see the issues on the demand side rather than the supply side of funding. Capital ’emerges’ endogenously as a supply side response to potential profits. The reducing lending is largely a function of increased perception of risks.

So, what should be done? Pretending that banks are OK and sweat it out over time is dangerous to economy as a whole, but so is being too harsh on the banks right now.

I actually think there is an answer – the banks should be made to recapitalize quickly and aggressively. Accepting new equity capital would minimize social cost of their current mistakes. There is an obvious practical problem with that, the price at which that capital is available is not necessarily the price at which current shareholders want to be diluted. So, in essence, the banking system continues to push the cost of their mistakes to others by not coming clean on their losses and recapitalize, rather they try to muddle through by not declaring their losses in full and pull in lending to the rest of the economy.

You hit on my initial reaction here. It’s up to the shareholders to supply market discipline via their desire to add equity, and it’s up to the regulators to make sure their funds – the insured deposits (most of the liability side, actually, when push comes to shove) – are protected by adequate capital and regulated bank assets. I think they are doing this, and, if not, the laws are in place and the problem is lax regulation.

I think regulators should be tougher here, banks that clearly are below formal capital adequacy ratios with proper mark to market should be armtwisted to accept new money.

Yes, as above.

I am also looking with dismay on the fact that even some of the weaker banks are still paying dividends to their shareholders – on a global scale I think the financial system has paid out more in dividends since the start of the crisis than they have raised in new capital.

Also, a regulatory matter. Regulators are charged with protecting state funds that insure the bank liabilities.

My proposals have been to not use the liability side of banks for market discipline. Instead, do as the ECB has done and fund all legal bank assets for bank in compliance with capital regulations.

So, a likely situation is that banks with failed business models in the first part of the crisis distribute capital to their owners and somewhat later asks the taxpayer for help…

Kent Janer runs the Nektar hedge fund at Brummer & Partners AB in Sweden Posted by: Kent Janér | February 27th, 2008 at 3:06 pm |

Share