Argentina: From the “confidence fairy” to the (still devilish) IMF

Guest post by Pablo Bortz and Nicolás Zeolla, Researchers at the Centre of Studies on Economics and Development, IDAES, National University of San Martín, and CONICET, Argentina.

In recent days, it has become customary to recall the issuance of a USD 2.75 billion 100-year bond in June 2017. This was the most colourful event of the short-lived integration of Argentina into international capital markets, beginning in December 2015. Last week, Argentina returned to the front pages of the financial press when the government requested financial assistance to the IMF amidst capital flight and a run against the peso that authorities were struggling to stop.

This is the most recent episode in the typical cycle of an emerging economy entering financial markets, suffering a balance of payments crisis and adopting an IMF-sponsored stabilization program. It starts with the claim that we are now a respected member of the international community, with presence in the Davos forum, and the promise that this time, finally, the international “confidence fairy” will awaken and investment will flood the country because of all the profit opportunities this forgotten economy has to offer. When the fairy proves to be an hallucination, we find ourselves at the steps of the IMF, facing demands, as always, for fiscal consolidation and structural reform.

When explaining this story, it is important to have some background on the Argentineans’ fascination with the dollar, and on some very recent political history. Because of its history of financial crises and its underdeveloped capital markets, there are very few savings instruments available to the non-sophisticated investor: real estate, term deposits, and dollars. Real estate prices are denominated in dollars, but you need a lot of dollars (relative to income) to buy a house. So buying dollars is pretty much a straightforward investment in uncertain times, i.e. most of the time.

Added to that, Argentina has a higher degree of exchange rate pass-through than other developing countries. The main exporters also dominate the domestic market for cooking oil and flour; oil and energy prices are dollarized; and exchange rate movements are very closely followed at times of wage bargaining. Unlike other emerging countries, and despite the sneering of some government officials, in a semi-dollarized (or bimonetary) economy such as Argentina exchange-rate pass-through is alive and kicking, which discourages large devaluations.

It is important to remember that the previous administration of Cristina Fernandez de Kirchner had implemented pervasive capital and exchange controls, which led to the development of a (relatively small) parallel market, with almost a 60% gap between the official and the parallel exchange rate. As soon as the Macri government took power in December 2015, it lifted all exchange rate controls. The official exchange rate (10 pesos per dollar) moved towards the parallel (16 pesos per dollar), and it is one of the reasons for the increase in the inflation rate, from 24% in 2015 to 41% by the end of 2016.

The new authorities also made two big moves. One was cancelling all the debt with vulture funds with new borrowing. This officially marked the return of Argentina to international capital markets. The second move, by the central bank (now lead by Federico Sturzenegger, an MIT graduate and disciple of Rudi Dornbusch), was the adoption of an inflation-targeting regime, with a mind-set that preferred freely floating exchange rates, and not much concern for current account deficits[1].

But looking at the external front, one may even be forgiven for asking: why did this crisis take so long to burst? Argentina was haemorrhaging dollars for many years, and with no sign of reversal: since 2016 the domestic non-financial sector acquired an accumulated amount of USD 41 billion in external assets. During the same period, the current account deficit totalled another USD 30 billion, in the form of trade deficit, tourism deficit, profit remittances by foreign companies and increasing interest payments.

The well-known factor that allowed all these trends to last until now is the foreign borrowing spree that involved the government, provinces, firms, and the central bank, including the inflow from short-term investors for carry trade operations. In the case of debt issuance, since 2016 the central government, provinces and private companies, have issued a whopping USD 88 billion of new foreign debt (13% of GDP).  In the case of carry trade operations, since 2016 the economy recorded USD 14 billon of short-term capital inflows (2% of GDP). The favourite peso-denominated asset for this operations were the debt liabilities of the central bank called LEBAC (Letters of the Central Bank).  Because of this, the outstanding stock of this instrument has now become the centre of all attention.

It is important to understand the LEBACs. They were originally conceived as an inter-bank and central bank liquidity management instrument. Since the lifting of foreign exchange and capital controls and the adoption of inflation targeting, the stock of LEBACs grew by USD 18 billion. Moreover, the composition of holders has changed significantly since 2015: At that time, domestic banks held 71% of the stock, and other investors held 29%. In 2018 that proportion has reverted to 38% banks/62% to other non-financial institution holders, which includes other non-financial public institutions (such as the social security administration) (17%), domestic mutual investment funds (16%), firms (14%), individuals (9%), and foreign investors (5%). This is shown in Graph 1 and Table 1. That means that a large part of all the new issuance of LEBAC is held by investors outside the regulatory scope of the central bank, especially individuals and foreign investors. This represents a potential source of currency market turbulence because these holdings could easily be converted into foreign currency, causing a large FX depreciation.

LEBACs

Holders of LEBACs, May 2018 %
Financial institutions 39%
Non-financial public sector 17%
Mutual Investment Funds 16%
Firms 14%
Individuals 9%
Foreign investors 5%

Source: Authors’ calculation based on Central Bank of Argentina

What was the trigger of the recent sudden stop and reversal of capital flows? Supporters of the central bank authorities point towards the change in the inflation target last December, when the Chief of Staff Marcos Peña (the most powerful person in cabinet) and the Economy Minister Nicolas Dujovne moved the target from 10% to 15%. In light of the change in the target, the central bank started to gradually lower interest rates from as high as 28,75% to 26.5%, while inflation remained unabated, giving rise to rumours about the government’s internal political disputes. However, inflation remained stubbornly high even before the change in the target; and there were also some minor foreign exchange runs both before and after that announcement. In the meantime, the government did reduce the budget deficit. The problem is not of fiscal origin: one has to look to the external front.

Other analysts point towards the reversal of the global financial cycle of cheap credit, which has led to devaluation of emerging markets’ currencies across the board. The turning point, in this interpretation, was when the 10-year rate on US Treasury bonds reached the 3% threshold. In a similar vein, others highlight a tax on non-residents’ financial profits that was going to come into place on May 1st, that triggered the sell-off by foreign investors. Indeed, the run was primarily driven by foreign hedge funds and big banks (notably, JP Morgan) closing their positions in pesos and acquiring dollars. However, the impact on Argentina dwarfed the devaluations, reserve losses and interest rate increments in other developing countries.

Finally, some blame the patently disastrous response of the central bank to the first indicators of a capital flight. The run accelerated in the last three weeks. The CB initially sold all the dollars that foreign banks demanded, in an attempt to control the exchange rate, without increasing interest rates. Then the devaluation accelerated, and the central bank started to increase the interest rate, to 30, to 33, and finally to 42%. Its intervention in the exchange market was equally erratic.[2]

These points have some validity, but are insufficient to explain the full extent of the run.  The reason is that investors could enter the country and could leave it without no restriction whatsoever. The main problem is the total deregulation of the financial account and the foreign exchange market, for domestic and foreign investors. The government borrowed heavily in international markets and the central bank offered large financial gains, while the external front deteriorated and domestic non-sophisticated investors were demanding dollars at increasing speed. The most infamous and egregious measure of all is the abolition of the requirement that exporters sell their foreign currency in the foreign exchange market. Instead of having an assured supply of dollars, the central bank is now forced to lure them with a high interest rate. In such a context, where capital can move freely, anything and everything is an excuse to cash in and get out. It is therefore a mistake to focus only on individual issues. The problem is the setting – the whole policy framework.  Now, the central bank is caught between only two alternatives when choosing interest rates: either to encourage carry-trade operations, or to suffer steep devaluations.

The decision to ask for an IMF loan was in the offing for some time but was rushed during the run against the peso. The government’s first intention was to obtain a Flexible Credit Line, the best (or the least evil) of all the IMF facilities, because it provides a decent amount of money with few conditionalities, or at least its minor cousin, the Precautionary and Liquidity Line (PLL), with less money but still not many conditionalities. The IMF, instead, told Argentine negotiators that there was no room for the PLL, and they would have to apply instead for the dreaded Stand-By Arrangements. All the international support and “credibility” that the Argentine government claimed to have was of no use when it came to the moment for banking on it.

But resorting to an IMF loan was not an unavoidable decision.[3] There were other ways to obtain dollars and to cap the foreign exchange run. The government could have forced exporters to sell their foreign currencies; they could have negotiated a swap agreement with some major central bank; or they could have erected barriers to capital outflows.

The report also shows what is to be expected from now on. The IMF will ask for tough measures on labour market flexibility (which was already on the government table), further cuts to public employment, wages, transfers and pensions, and lifting of the greatly reduced trade barriers. The devaluation has already happened, but it should be mentioned that previous devaluations failed to encourage exports, while they only fostered inflation.

It is impossible to forecast what will happen in 2019. On the economic front, there are at least four big risks. The first is a recession, because of the negative impact of devaluation on private consumption. The second refers to an acceleration in the inflation rate and its distributive effects. Nobody expects now that the 2018 inflation rate will be below the 2017 number (25%), and with further devaluations, inflation could spiral to new highs. A third risk, which will be persistent throughout the year, is the eventual demand for dollars by the non-bank LEBAC holders. The fourth one is a possible (though not likely) bank run. Banks have USD 22 billion of deposits denominated in dollars. Any bank-run will directly hit reserves.

This very short experience is another example of the typical boom-and-bust cycle of emerging economies borrowing heavily in foreign currency with totally deregulated financial flows and foreign exchange markets, while experiencing growing current account imbalances. If one were to obtain some “new” corollaries, we would have to point to the failure of the inflation-targeting policy framework in a semi-dollarized economy with no capital controls. The IT regime did not reduce contract indexation; exchange rate flexibility did not reduce the pass-through. And relying on the “confidence fairy” is no path to development; it is rather a highway to hellish institutions. We Argentineans thought we had rid ourselves of that devil.

 

[1] The inflation target, however, was set at very optimistic levels, was never achieved in the two years since the adoption of the IT regime, and was changed last December, something that many say had an influence in recent events.

[2] Some say that this behaviour was not a bug but a feature, since it allowed foreign banks to profit in their investments and leave the country at favourable interest rates. Others, in a less conspirative but equally perverse logic of action, say that the erratic initial response was an attempt by the central bank to prove the wrongfulness of the Ministry of Economy’s approach and regain full control of monetary policy. The unfolding of events is consistent with this argument, with the caveat that even after regaining political power, the central bank proved to be still unable of stopping the run for three weeks.

[3] In fact, when the news of the SBA came, the run actually accelerated, because one of the expected IMF conditions was a devaluation of between 10 to 25%, according to the last Article 4 Consultation Report. That might help to explain why the government wasted a loan from the BIS in less than 2 weeks.

 

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The global dollar footprint – larger than you think?

Following a long and brain-fog inducing Twitter conversation (as one participant put it)  triggered by this excellent post by Brad Setser on the role of institutional investors in Taiwan’s indirect fx management regime, I remembered I had a pretty wonkish draft blog critiquing a BIS paper on fx swaps and missing dollar debt. In our twitter conversation, we were trying to work through the steps taken by Taiwanese insurance companies to hold USD assets while hedging fx risks, and the implications for BoP positions. The examples in the BIS paper are, I think, useful to order that sequence.

The BIS paper, by Claudio Borio and co-authors, argues that currency derivatives have allowed large volumes of Eurodollars to go missing from the balance sheets of financial institutions outside the US. If we were to properly account for this missing debt, then non-banks’ global dollar debt would double to USD 21 trillion. This is roughly equal to the value of global trade in 2017.  How do USD 10 trillion go missing?

The BIS paper builds on the following example the following. An investor wishes to buy foreign currency securities with domestic cash (the Taiwanese insurance companies in Brad’s post) but does not wish to run fx risk. That say Japanese (substitute Taiwanese if you wish)  investor  has three options:

  1. Spot + forward: buy USD spot with yen, use USD to purchase the US corporate bonds, and sell the same amount of USD forward.
  2. FX swap: swap yen for USD with a promise to reverse the transaction at a later point, purchase the US corporate bonds.
  3. USD Repo: keep the yen, finance USD corporate bonds by borrowing in the USD repo market, incurring outright debt.

The BIS paper warns that the first two strategies generate ‘missing debt’. Accounting rules demand repos to be recorded on the balance sheet do not impose the same recording requirements on fx swaps/forwards, except for mark-to-market values that capture the move in exchange rates[1]. This obscures the picture of global (dollar) liquidity, with serious implications for a future where central banks increase interest rates and unwind unconventional monetary policy measures.

The BIS paper provides a clear analytical framework for tracing how global dollar liquidity is created through cross-border interactions between banks and shadow banks, often in the underbelly of Eurodollar markets.

Yet I believe it is wrong in arguing that the global dollar footprint is larger than you think. Accounting conventions rightly treat repos as new debt because repos are special monetary instruments, shadow money created in the process of lending via securities markets. FX swaps are not. Treating fx swaps as hidden debt, as BIS does, leads to double-counting, while simultaneously it obscures the central role that private banks play in creating global dollar liquidity, wielding their power to create bank money via fx swaps and shadow money via repos.

Fx swaps are not new funding, repo is

The BIS paper illustrates the argument with balance sheets, where gross and net are carefully distinguished (figure 1). The gross shows rights and obligations to pay explicitly. In cases 1 and 2, the Japanese investor swaps Yen cash (C) for USD, with a promise to reverse the transaction later, that is, to pay back USD (Fx) and receive yen (F). Accounting rules render that promise invisible in net terms, simply showing on the balance sheet that the Japanese investor funds USD corporate bonds with net worth (E). In contrast, the repo promise to pay back USD (by repurchasing the corporate bonds) remains on the balance sheet.

These are three repo-like transactions with different collateral – yen cash (1&2), and USD corporate bonds (3) – raising USD funding for USD securities. The problem, BIS argues, is that only the USD repo is recognized on the balance sheet.

Figure 1 BIS illustration of fx swaps and repos, gross and net

Screen Shot 2018-05-03 at 14.38.08At first sight, this is a compelling argument, in Mehrling’s money view tradition that ‘an obligation to repay is a form of debt’. But not all obligations to pay are created equal or have the same monetary role.

Surprisingly, in the example above, there is no repo on the balance sheet. Instead of representing the repo as new IOU, the example shows the corporate bond (Ax) as a liability against yen cash (C). Yet repos are not strictly reducible to the collateral security because the corporate bond is an (encumbered) asset for the investor, financed via a new IOU repo liability (figure 2). If bank deposits are the money of financial systems organised around relationship banking, repo deposits are the money of global financial systems organised around securities markets.

Screen Shot 2018-05-03 at 14.39.15

The repo is a securities financing transaction structured legally as a sale and promise to repurchase corporate bonds, and in accounting terms as a new IOU issued to borrow cash against corporate bond collateral. Critically, the collateral securities do not leave the investor’s balance sheet. She marks these encumbered and books the transaction as financing. It is this separation between the legal and economic treatment of collateral that allows the Japanese investor to remain the economic owner of the corporate bond (Ax), entitled to (any) coupon payments and bearing the risks associated with it. The buyer of collateral treats the repo IOU as a cash-equivalent (a safe asset), whose par value is preserved by mark-to-market of collateral and margin calls. Accounting for repos on the balance sheet allows regulators and market participants to get a clear idea of the Japanese investor’s leverage (see the notorious Lehman’s Repo 105).

The fx swap does not have a similar monetary role. Compare the gross positions in the fx swap and repo in Figure 2. Both record promises to pay back USD. But there is no yen (F) asset at the investor’s disposal for the life of the fx swap – F simply records the yen that will return to the Japanese investor when the swap matures. In contrast, with the repo, the investor still has yen cash (C) at her disposal to invest in other assets. Only the repo gives investors access to new funding via money creation. In contrast, the fx swap involves (twice) exchanging IOUs already created by institutions other than the Japanese investor.

Is the difference here just (subtle) semantics? Through the swap, the investor gets the dollar corporate bonds that can be repo-ed. Is yen cash (C) in Case 3 different from the repo-able corporate bonds in Cases 1&2? Both can be used for further investment. Yet the investor can only use Ax it obtained via the fx swap if it repos it out. The now encumbered A*x remains on the balance sheet, and the investor has new cash against a repo liability (see Figure 3). It is the repo that generates additional balance sheet capacity from the unencumbered Ax. No repo, no leverage.

Screen Shot 2018-05-03 at 14.40.43

This matters more broadly for our understanding of money in modern financial systems. Monetary thinking going back to Keynes and Hayek via Minsky stresses that capitalism is a system characterized by continuous efforts to invent new liabilities that credibly promise par convertibility into money without state support. State support for par convertibility between private promises to pay (think bank deposits) and higher forms of money (banknotes, gold) is costly. It comes with constraints (bank regulation) and shifting price incentives (interest rate policies). It is against these constraints that capitalist finance constantly seeks to economize on money proper. In that sense, repos are the innovation of a financial system increasingly organised around securities markets and business models reliant on daily variation in the price of securities. Repos are shadow money that allows the Japanese investor to economise on her yen cash, to fund securities by issuing a new liability, shadow dollars. The moneyness of repo IOUs rests on an intricate process of collateral mark-to-market valuation that preserves par convertibility between repo deposit and bank deposits. While the fx swap may rely on similar margining practices to preserve the agreed exchange rate between the two currencies, at its core it is swap of assets, of IOUs created by someone else (yen for dollar cash).

The BIS paper recognizes this: ‘in case 3, the agent has the freedom to use the domestic currency cash to buy another domestic currency asset rather than having it tied up in a forward claim’. Precisely. With the fx swap, the investor has given up yen for USD, and will get it back at par when the swap matures. While the repo allows the investor to take position in dollar securities without prior funding, the fx swap does not generate additional balance sheet capacity, but rather, a series of transformations of the yen cash. If the investor had to borrow that yen cash via say commercial paper – it already had to leverage to get the yen it would swap for dollars. Counting the fx swap as leverage would be double counting.

What if the Japanese investor is a bank?

The BIS paper identifies three types of institutions in the fx swap/fwd markets: non-financial customers, financial customers and dealer banks. Dealer banks trading with financial customers generate the largest volumes (around USD 25.5 trillion), followed by interdealer (USD 25 trillion) and dealers trading with non-financial customers (USD 7.5 trillion). What changes if the investor above is a Japanese bank (see Pozsar for a money view discussion of the hierarchy of market-making in the fx swap market)?

Japanese bank swapping with a non-bank customer

Assume that a Japanese bank agrees an fx swap with a dollar-rich Japanese corporation (Figure 4). Its starting position, is yen cash – since this is the bank, cash means Bank of Japan reserves. The Japanese bank wields its power to create yen money in the fx swap market: in exchange for dollars, it creates a yen bank deposit for the Japanese corporation. It holds the dollars with its New York bank until it purchases the corporate bonds. The fx swap means a deposit swap a la Pozsar**.

 

Screen Shot 2018-05-03 at 14.56.18

On a net basis, the fx swap has expanded the balance sheet of the Japanese bank, and the yen money supply, solely because the bank uses its money creating power to execute the swap. When the swap matures, the yen money supply contracts. It is the money creation power of the Japanese bank that makes the fx swap and the repo equivalent in their impact on the balance sheet. In one case, Ax is funded with shadow dollars, in the other with new yen bank money.

Japanese bank with a US office swapping with US bank (interdealer)

 In this case, the Japanese bank’s office in the US swaps its yen cash (held in Bank of Japan reserves) for dollar cash (US Fed reserves), thus acquiring means of payment for the dollar corporate bonds (Ax). Note here that the fx swap involves swapping IOUs issued by central banks. FX swaps in this case means a reserve swap a la Pozsar.

Screen Shot 2018-05-03 at 14.59.10 

An example

Compare the behaviour of Japanese and Australian banks in dollar swap markets, pictured in the BIS paper and the graph below (which infers swap positions as residual once dollar net positions are extracted from banks’ balance sheet statements). Japanese banks are the largest borrowers of dollars via fx swaps, whereas Australian banks are among the largest lenders of dollars via fx swaps.

Screen Shot 2018-05-03 at 15.00.42

Japanese banks’ search for yield has increasingly targeted dollar assets. Rich with yen liquidity from Bank of Japan’s QE, they swapped yen into dollars to lend directly, through capital markets, and until recently, through (repo) interbank markets. With the reform of US money market funds in October 2016, Japanese banks have started to use repos for net funding of their dollar assets. In contrast, Australian banks’ dollar footprint, driven by carry trades, manifests as a form of match-book dealing in the repo-swap space. Australian banks first borrow dollars through (repo) interbank markets to lend these via swap markets in exchange for Australian dollars (AUD). This carry allows them to fund high-yielding AUD assets with cheap USD and hedge fx risk via the swap. Here the problems with the ‘fx swaps are functionally equivalent to repos’ argument become immediately apparent. Australian banks need to borrow USD first to swap into AUD.

Japanese banks’ growing swap positions raises another important, if mostly neglected question. How do their swap counterparts use their increasingly sizable yen holdings? BoJ paper identified several USD suppliers in the yen/usd swap market: sovereign wealth funds, reserve managers of emerging countries, asset managers. For these, there is a simple safe-asset arithmetic: yen obtained via swaps, even if placed in negative yielding Japanese government bonds, can provide similar or higher returns than US government securities. Yet BoJ worries that this is not a crisis-proof arithmetic. Dollar swap lenders are not a stable source of dollar funding. Taper-tantrum like tensions prompt reserve managers to shift their dollars from swaps to US Treasury bills or the Fed’s Reverse Repo Facility, whose immediate liquidity they require to defend their own currencies. Japan has already experienced sharp declines in inward bond investments when dollar swap lenders withdraw from the swap market. In a future where Bank of Japan reduces its footprint in the JGB market, the pro-cyclicality of fx swap-related demand will pose significant challenges.

In sum, fx swaps and repos are not equivalent transactions. At first sight, they seem to be the same animal: promises to pay at par supported by a similar process of preserving par via collateral management that creates mark-to-market funding pressures, firesales and liquidity spirals. The FX swap exposes investors to liquidity and rollover risk where the maturity of the asset purchased and the swap differ. The BIS is right to worry about such systemic issues, and what these imply for the Federal Reserve’s role in global dollar markets. But the similarities end there. Repos generate new funding for securities, whereas fx swaps do not, except when banks use their power to create settlement-money in the fx swap market.

* Henceforth, the text uses fx swaps as shorthand for both fx swaps and forwards.

**It is worth noting that although Pozsar shows fx swaps on the balance sheets of the various actors involved in the fx swap market, this is poetic licence. His discussion demonstrates clearly that fx swaps involve swaps of money proper rather than the creation of new liabilities.

[1] These are typically small, increasing to 15 % of notional amounts in moments of crisis.

“A remarkable national effort”: the dismal arithmetic of austerity

Rob Calvert Jump and Jo Michell

In a recent tweet, George Osborne celebrated the fact that the UK now has a surplus on the government’s current budget. Osborne cited an FT article noting that “… deficit reduction has come at the cost of an unprecedented squeeze in public spending. That squeeze is now showing up in higher waiting times in hospitals for emergency treatment, worse performance measures in prisons, severe cuts in many local authorities and lower satisfaction ratings for GP services.”

It is a measure of how far the debate has departed from reality that widespread degradation of essential public services can be regarded as cause for celebration.

The official objective of fiscal austerity was to put the public finances back on a sustainable path. According to this narrative, government borrowing was out of control as a result of the profligacy of the Labour government. Without a rapid change of policy, the UK faced a fiscal crisis caused by bond investors taking fright and interest rates rising to unsustainable levels.

Is this plausible? To answer, we present alternative scenarios in which actual and projected austerity is significantly reduced and examine the resulting outcomes for national debt.

Public sector net debt (the headline government debt figure) in any year is equal to the debt at the end of the previous year plus the deficit plus adjustments,

jump-deficit-eqn

where PSND  is the public sector net debt at the end of financial year, PSNB is total public sector borrowing (the deficit) over the same year, and ADJ is any non-borrowing adjustment. This adjustment can be inferred from the OBR’s figures for both actual data and projections. In our simulations, we simply take the OBR adjustment figures as constants. Given an assumption about the nominal size of the deficit in each future year, we can then calculate the implied size of the debt over the projection period.

What matters is not the size of the debt in money terms, but as a share of GDP. We therefore also need to know nominal GDP for each future year in our simulations. This is less straightforward because nominal GDP is affected by government spending and taxation. Estimates of the magnitude of this effect – known as the fiscal multiplier – vary significantly. The OBR, for instance, assumes a value of 1.1 for the effect of current government spending.  In order to avoid debate on the correct size of the nominal multiplier, we assume it is equal to zero.[1] This is a very conservative estimate and, like the OBR, we believe the correct value is greater than one. The advantage of this approach is that we can use OBR projections for nominal GDP in our simulations without adjustment.

We simulate three alternative scenarios in which the pace of actual and predicted deficit reduction is slowed by a third, a half and two thirds respectively.[2] The evolution of the public debt-to-GDP ratio in each scenario is shown below, alongside actual figures and current OBR projections based on government plans.

jump-deficit2

jump-deficit

Despite the fact that the deficit is substantially higher in our alternative scenarios, there is little substantive variation in the implied time paths for debt-to-GDP ratios.  In our scenarios, the point at which the debt-to-GDP ratio reaches a peak is delayed by around two years. If the speed of deficit reduction is halved, public debt peaks at around 97% of GDP in 2019-20, compared to the OBR’s projected peak of 86% in the current fiscal year. Given the assumption of zero nominal multipliers, these projections are almost certainly too high: relaxing austerity would have led to higher growth and lower debt-to-GDP ratios.

Now consider the difference in spending.

Halving the speed of deficit reduction would have meant around £10 billion in extra spending in 2011-12, £8 billion in 2012-13, £19 billion in 2013-14, £21 billion in 2014-15, £29 billion extra in 2015-16, and £37 billion extra in 2016-17.  To put these figures into context, £37 billion is around 30% of total health expenditure in 2016-17.  The bedroom tax, on the other hand, was initially estimated to save less than £500 million per year.  These are large sums of money which would have made a material difference to public expenditure.

Would this extra spending have led to a fiscal crisis, as supporters of austerity argue? It is hard to see how a plausible argument can be made that a crisis is substantially more likely with a debt-to-GDP ratio of 97% than of 86%. Several comparable countries maintain higher debt ratios without any hint of funding problems: in 2017, the US figure was around 108%, the Belgian figure around 104%, and the French figure around 97%.

It is now beyond reasonable doubt that austerity led to increases in mortality rates – government cuts caused otherwise avoidable deaths. These could have been avoided without any substantial effect on the debt-to-GDP ratio. The argument that cuts were needed to avoid a fiscal crisis cannot be sustained.

 

[1] There is surprisingly little research on the size of nominal multipliers – most work focuses on real (i.e. inflation adjusted) multipliers.

[2] We calculate the actual (past years) or projected (future years) percentage change in the nominal deficit from the OBR figures and reduce this by a third, a half and two thirds respectively. The table below provides details of the middle projection where the pace of nominal deficit reduction is reduced by half.

jump-deficit-table

MMT meets Rey’s dilemma: a balance sheet view of capital flight (coming soon to an EM country near you)

Recently, a colleague emailed with the following set of questions: ‘a balance sheet approach to defending currencies. Do you know literature that explains in detail the globally interlocking balance sheets between central banks, commercial banks and what happens when a national government has to defend its currency? What is the role of national and foreign reserves and how do they travel these balance sheets in the process of trying to defend a currency? I came back to this question when discussing the Swedish fight to defend the Dollar-pegged Krona in the early 90s and the promise of MMT? Most particularly we wondered to what extent national governments can just issue Krona and use them to buy foreign reserves or what sets the limits exactly to this attempt?’

My MMT friends do have answers to these questions (and they do spend a lot of time defending MMT from critiques that it doesnt consider balance of payment constraints to monetary sovereignty). I thought I would answer these questions a la Minsky, with balance sheets, since that’s how I teach my undegrad students about exchange rate management in emerging/developing countries. I teach by setting those questions within the broader conversations about global liquidity, global financial cycles and Rey’s dilemma – independent monetary policy is only possible if countries manage capital flows (capital controls).

  1. Start with an economy in autarchy: central bank issues reserves to banking sector for settlement purposes (banks pay each other in reserves), banks lend, create bank deposits in the process.

Screen Shot 2018-02-14 at 15.45.46

2a. Commercial bank borrows abroad from parent bank/interbank market (USD/EUR/JPY)

Screen Shot 2018-02-14 at 15.55.58

(this scenario played out in Eastern Europe before Lehman, when foreign-owned banks would borrow from parent/interbank markets – ending up with the Vienna Initiative)

2.b Commercial bank funding via fx swap with non-residents

Screen Shot 2018-02-14 at 15.55.16

Step 1 occurs where local banks are allowed to lend retail in foreign currency. If it looks like MMT 2.0, it is not exactly that – without legal restrictions, the only constraint on banks creating foreign money (eurodollars) is their foreign currency reserves (an exogenous money story a la monetarism).

Even with restrictions on the lending in foreign currency (skipping steps 1&2), banks typically intermediate non-resident demand for local currency bonds via fx swaps (see my paper here on growing appetite for EM securities as part of shadow banking reform agenda). This is big enough that BIS has recently proposed to approach fx swaps as missing debt. Note that this is a global liquidity story:  without capital controls, non-resident demand/bank borrowing abroad reflects funding conditions in US money markets (see Bruno and Shin’s risk taking channel of monetary policy).

3. Rey’s dilemma kicks in: central bank intervenes to stem currency appreciation (for mercantilist or macroprudential reasons)

Screen Shot 2018-02-14 at 15.05.09

For this commercial bank, the central bank’s policy rate is no longer a binding constraint, since it obtains local base money (reserves) by selling its fx liquidity to the central bank, rather than in the local interbank money market. When interest rate differentials are significant, this eases cost of funding (in the macro literature, this is part of the debate on the effect of financial globalisation on the effectiveness of inflation targeting central banks).  It’s global liquidity, not domestic liquidity, that determines short-term money market rates.

4. To regain monetary control, central banks issue own debt.

Screen Shot 2018-02-14 at 15.14.11

This operation is known as sterilisation: that is, ‘sterilising’ the impact of fx market interventions on domestic money market rates. Central bank issues own securities (or sells government bonds, or takes deposits) in order to absorb back the reserves it created when it paid for the fx liquidity it bought from banks. Note here that this does not solve Rey’s dilemma, since banks have full discretion over how much to place in central bank securities. Rather, for banks this is an attractive carry – borrowing cheap abroad, placing it in risk-free local securities (banks can hedge fx risk).

If you think this is a theoretical exercise, think again.

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5. The limits to monetary sovereignty: global liquidity conditions tighten, capital flight ensues.

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In step 1, non-residents sell local securities – potentially triggering liquidity spirals if large, unregulated local repo market exists.  Note that by step 5, local banks with no direct links to global finance also start to suffer as interbank liquidity tightens. Cant the central bank mitigate this by reverse sterilisations, that is, by again insulating fx market interventions from domestic money market dynamics? The lessons from the 1997 Asian crisis, according to the IMF, is to segment domestic money markets, that is, to prevent local banks from lending to (non-resident) speculators:

Because a speculative attack requires the establishment of a net short position in the domestic currency, countries have employed a number of tactics to raise the costs of short positions. When sterilized intervention fails to stem capital outflows, short-term interest rates are allowed to rise, tightening conditions in financial markets and making it more costly for speculators to obtain a net short position by borrowing domestic currency. Frequently, however, an increase in short-term money market rates is transmitted quickly to the rest of the economy; it may therefore be difficult to sustain for an extended period, especially if there are weaknesses in either the financial system or the nonfinancial sector. When high short-term interest rates impose an unacceptable burden on domestic residents, countries may “split” the markets for domestic currency by requesting that domestic financial institutions not lend to speculators. Foreign exchange transactions associated with trade flows, foreign direct investment, and equity investments are usually excluded from such restrictions. In essence, a two-tier system is created that prevents speculators from getting domestic credit while allowing nonspeculative domestic credit demand to be satisfied at normal market rates. (IMF 1997)

Even if the central bank successfully protects local banks  from cross-border volatility triggered by global financial cycles, it can only defend the currency to the extent that it has foreign reserves. It will most likely not wait until it runs out. In the happy scenario, it draws on its swap lines to weather capital flight – but few central banks have that luxury (and ask yourself, how many will actually have it when Donald Trump needs to be consulted on this). The worst case scenario:  IMF/Troika/whoever will lend  – with heavy conditionality.

The future of money – UWE student takes for Bristol Festival of Economics (alongside mine)

Daniela Gabor

Last month, I participated in an excellent panel on the Future of Money at the Bristol Festival of Economics.  In preparation for the event, UWE undegraduate students taking my course on Economic Theory and Policy worked together to produce two-sided briefs on what they thought to be the most interesting questions for the future of money, and distributed them in advance of the panel.   These briefs provided a great background to our conversation, exploring questions of digital money, endogenous money (and its heretics) and shadow money.

Given that we are economists with a certain respect for the power of (fair) competition, we had a contest for the best brief. The quality was excellent, so I chose three out of the seven to be distributed (see Money1 (1), Money2 and Money3).  Given the size of the audience, we could have easily distributed the rest as well (see Money Brief 4 , Money Brief 5Money at a glance 6Money Brief 7).

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My opening remarks focused on shadow money. Read them below.

Modern controversies about money typically focus on two topics – the power of banks to create money and the threats to this power posed by crypto-currencies. We suspect banks of yielding too much political power, having convinced states to enter a social contract that makes bank deposits into the ultimate money of the financial system. Bank of England recently confirmed this suspicion, in a widely discussed paper that confirmed what heterodox economists – Steve Keen here a famous example – have been saying for a long time.

There is somewhat of a paradox in this. If we consider the regulations that central banks have introduced since the crisis, they have not sought to limit banks’ power to create money. Rather, the new rules introduce by the Basel committee, and by the newly created Financial Stability Board, want banks to issue more of traditional bank deposits, and less of a new type of money, that I will call shadow money.

What is this shadow money? It is money created by banks and other financial institutions through the mysterious universe of shadow banking. If we accept the argument that a society’s money reflects the way in which the credit system is organised, then I think the future is shadow money.

Shadow money is, like all credit money, an IOU. Bank money is an IOU through which the bank promises to pay you a pound of cash for each pound in our bank deposit. You trust the bank that it will convert the deposit into cash at par if you wish to. The difference, however, is that the IOU in shadow money does not rely on trust, but on collateral. When a bank issues shadow money, it issues an IOU backed by tradable securities like government bonds, or corporate bonds, or other securities issued in shadow banking, like the famous CDOs.

Let me give you an example. You and I keep some of our wealth in a bank deposit because we trust the bank, or the deposit guarantee behind it, and because it is convenient for our daily payment routines. This is not the case for a pension fund, or an insurance company or what we call institutional investors and their asset managers. For them, traditional bank money is not an attractive option. The deposit guarantee is too small for what they consider ‘pocket money’. So the bank says ‘look, I will issue you an IOU that gives you the same kind of safety a bank deposit gives a small depositor. To create that safety, I will give you government bond collateral. I still get the interest payments on that bond but I will allow you to become the legal owner of that bond so you can sell it if I go bankrupt’. See how this clever legal arrangement behind shadow money is also advantageous for the bank – it can now fund that government bond with an IOU held by the pension fund.

The issuer of that bond – the government in our case – is also benefitting. Surely if banks and shadow banks have an IOU that allows them to borrow from institutional investors, it creates more demand and more liquidity for their government bonds. Liquidity is the magic word for governments wanting low and stable funding costs to run fiscal policies (at least until we get an MMT-inspired government). The seductive appeal of liquidity  applies to securities markets and their issuers more broadly – what we have here is clever system of organizing credit creation via capital markets. And it’s a big system – the cyryto-currency universe is worth roughly USD 200 bn. Shadow dollars, shadow euros and shadow yuan together amount to USD 20 trillion. That is, 100 times more (remember I wrote this before the Bitcoin frenzy).

This shadow money sounds really safe, you may be thinking. Why would regulators seek to limit its creation? The politics of this shadow money is both exceedingly intricate and fundamental to modern financial markets. Shadow money comes with two words that keep regulators awake at nights: leverage and interconnectedness. Going back to my example, it often occurs that the bank would be an intermediary between the pension fund who wants a safe IOU and a hedge fund who wants to borrow more to buy more securities. The hedge funds issued shadow dollars to the bank, and the bank issues shadow dollars to the pension fund. In this way, collateral has changed hands twice, it belongs to the hedge funds, but sits with the pension fund in case of default. They are all interconnected, and dependent on the hedge funds’ leverage decisions. If something goes wrong with the hedge fund, then everyone else stands to suffer.We get runs on shadow money.

Indeed, if you look close at how the global financial crisis unfolded, it started as a run on shadow dollars triggered by the collapse of Lehman Brothers – the familiar Gorton and Metrick story that proved influential in shaping how regulators think about regulating global (shadow) banking.  The run then travelled to shadow euros, where it evolved quietly but powerfully to engulf what we now call ‘periphery countries’ under the impotent eyes of the ECB, forced by its mandate to use the wrong cure (looking at you L-TROs) and make the crisis worse. Yes, this crisis is not a simple story of naive investors, fiscally irresponsible governments and European politics unable to credibly enforce rules stoping these governments. It was a crisis of shadow euros, despite ECB protestations.  It may soon resurge again in China, who is liberalising the production of shadow money in a bid to attract foreign investors and further RMB internationalisation (paper coming soon).

The future of shadow money is uncertain. One thing we know is that it takes a lot of room for manoeuvre for central banks to expand their crisis framework in order to stabilise shadow money. It is not a coincidence that the only that has done so formally – the Bank of England – is led by Mark Carney, who is also head of the Financial Stability Board. Bank of England has now formally assumed role of market-maker of last resort for systemic collateral markets (very different from lender of last resort), the only solution to stabilise shadow money outside prohibiting it all together (something the European Commission nearly – and accidentally – proposed when it planed to slap an FTT on shadow euros). The FSB & Basel III rules constrain it – and so the Trump administration is quietly making plans to free securities markets from the shackles of international regulation. To reduce the Minsky-type vulnerabilities, significantly magnified in this new world, we need a social contract around shadow money. It wont be a panacea, but it will make life a bit easier. This is not a mere question of better plumbing – it goes to the heart of ongoing discussions about the welfare state, inequality and our capacity to collectively provision for an uncertain future through the state, rather than through markets.

 

 

Austerity and household debt: a macro link?

For some time now I’ve been arguing that not only does austerity have real effects but also financial implications.

When the government runs a deficit, it produces a flow supply of safe assets: government bonds. If the desired saving of the private sector exceeds the level of capital investment, it will absorb these assets without government spending inducing inflationary tendencies.

This was the situation in the aftermath of the 2008 crisis. Attempted deleveraging led to increased household saving, reduced spending and lower aggregate demand. Had the government not run a deficit of the size it did, the recession would have been more severe and prolonged.

When the coalition came to power in 2010 and austerity was introduced, the flow supply of safe assets began to contract. What happens if those who want to accumulate financial assets — wealthy households for the most part — are not willing to reduce their saving rate? If there is an unchanged flow demand for financial assets at the same time as the government reduces the supply, what is the result?

Broadly speaking there are two possible outcomes: one is lower demand and output: a recession. If growth is to be maintained, the only option is that some other group must issue a growing volume of financial liabilities, to offset the reduction in supply by the government.

In the UK, since 2010, this group has been households — mostly households on lower incomes. As the government cut spending, incomes fell and public services were rolled back. Unsurprisingly, many households fell back on borrowing to make ends meet.

The graph below shows the relationship between the government deficit and the annual increase in gross household debt (both series are four quarter rolling sums deflated to 2015 prices).

hh2

From 2010 onwards, steady reduction in the government deficit was accompanied by a steady increase in the rate of accumulation of household debt. The ratio is surprisingly steady: every £2bn of deficit reduction has been accompanied by an additional £1bn per annum increase in the accumulation of household debt.

Note that this is the rate at which gross household debt is accumulated — not the “net financial balance” of the household sector. The latter is highlighted in discussions of “sectoral balances”, and in particular the accounting requirement that a reduction in the government deficit be accompanied by either an increase in the deficit of the private sector or a reduction in the deficit with the foreign sector.

Critics of the sectoral balances argument make the point that the net financial balance of the household sector is not the relevant indicator. Most household borrowing takes place within the household sector, mediated by the financial system. Savers hold bank deposits and pension fund claims, while other households borrow from the banks. The gross indebtedness of the household sector can therefore either increase or decrease without any change in the net position. Critics therefore see the sectoral balances argument argue as incoherent because it displays a failure to understand basic national accounting. This view has been articulated by Chris Giles and Andrew Lilico, among others.

For the UK, at least, this criticism appears misplaced. The chart below plots four measures of the household sector financial position along with the government deficit. The indicators for the household sector are the net financial balance, gross household debt as a share of both GDP and household disposable income, and the household saving ratio. The correlation between the series is evident.

hh3

The relationship between the government deficit and the change in gross household debt is surprisingly stable. The figure below plots the series for the full period for which data are available from the ONS: from 1987 until 2017. With the exception of the period 2001-2008, where there is a clear structural break, the relationship is persistent.

hh1

Why should this be the case? One needs to be careful with apparently stable relationships between macroeconomic variables — they have a habit of breaking down. One reason for caution is that the composition of household debt has changed over the period shown: in the pre-2008 period most of the increase was mortgage borrowing, while post-crisis, consumer debt in the form of credit cards, car loans and so on has played an increasing role. Nonetheless, a hypothesis can be advanced:

If one group of households saves a relatively constant share of income — and this represents the majority of total saving in the household sector — then variance in the supply of assets issued by public sector must be matched either by variations in output and employment or by variance in the issuance of financial liabilities by other sectors. If monetary policy is used to maintain steady inflation and therefore relatively stable output and employment, changes in the cost of borrowing may induce other (non-saver) households to adjust their consumption decisions in such a way that stabilises output.

Put another way, if the contribution of government deficit spending to total demand varies and saving among some households is relatively inelastic, avoiding recessions requires another sector (or sub-sector) to go into deficit in order that total demand be maintained.

This hypothesis fits with the observation that the household saving ratio falls as the rate of gross debt accumulation increases. Paradoxically, the problem is not too little household saving but too much, given the volume of investment. If inelastic savers were willing to reduce their saving and increase consumption in response to lower government spending, then recession could be avoided without an increase in household debt. A better solution would be an increase in the business investment of the private sector: it is the difference between saving and investment that matters.

There is a clear structural break in the relationship between the deficit and household debt, starting around 2001. This is likely the result of the global credit boom which gathered pace after Alan Greenspan cut the target federal funds rate from 6.5% in 1999 to 1% in 2001. During this period, the financial position of the corporate sector shifted from deficit to surplus, matched by large rises in the accumulation of household debt. With the outbreak of crisis in 2008, the previous relationship appears to re-emerge.

Careful econometrics work is required to try and disentangle the drivers of rising household debt. But relationships between macroeconomic variables with this degree of stability are unusual. Something interesting is going on here.

EDIT: 22 November

Toby Nangle left a comment suggesting that it would be good to show the data on borrowing by different income levels. It’s a good point, and raises a complex issue about the distribution of lending and borrowing within the household sector. This is something that J. W. Mason and others have been discussing. I need another post to fully explain my thinking on this, but for now, I’ll include the following graph:

hh4

This is calculated using an experimental new dataset compiled by the ONS which uses micro data source to try and produce disaggregated macro datasets. Data are currently only available for three years — 2008, 2012, and 2013 — but I understand that the ONS are working on a more complete dataset.

What this shows is that in 2008, at the end of the 2000s credit boom, only the top two income quintiles were saving: the bottom 60% of the population was dissaving. In 2012 and 2013, the household saving ratio and financial balance had increased substantially and this shows up in the disaggregated figures as positive saving for all but the bottom quintile.

I suspect that as the saving ratio and net financial balance have subsequently declined, and gross debt has increased, the distributional pattern is reverting to what it looked like in 2008: saving at the top of the income distribution and dissaving in the lower quintiles.

Dilettantes Shouldn’t Get Excited

A new paper on DSGE modelling has caused a bit of a stir. It’s not so much the content of the paper — a thorough but unremarkable survey of the DSGE literature and a response to recent criticism — as the tone that has caught attention. The paper begins:

“People who don’t like dynamic stochastic general equilibrium (DSGE) models are dilettantes. By this we mean they aren’t serious about policy analysis… Dilettantes who only point to the existence of competing forces at work – and informally judge their relative importance via implicit thought experiments – can never give serious policy advice.”

The authors, Lawrence Christiano, Martin Eichenbaum and Mathias Trabandt, make a number of claims, most eye-catchingly: “the only place that we can do experiments is in dynamic stochastic general equilibrium (DSGE) models.” They then list a number of policy questions that are probably best answered using a combination of time series econometrics and careful thinking. After their survey of the literature, the authors conclude — without recourse to evidence — “… DSGE models will remain central to how macroeconomists think about aggregate phenomena and policy. There is simply no credible alternative to policy analysis in a world of competing economic forces.”

The authors seem to have been exercised in particular by recent comments from Joseph Stiglitz, who wrote:

“I believe that most of the core constituents of the DSGE model are flawed—sufficiently badly flawed that they do not provide even a good starting point for constructing a good macroeconomic model. These include (a) the theory of consumption; (b) the theory of expectations—rational expectations and common knowledge; (c) the theory of investment; (d) the use of the representative agent model (and the simple extensions to incorporate heterogeneity that so far have found favor in the literature): distribution matters;(e) the theory of financial markets and money; (f) aggregation—excessive aggregation hides much that is of first order macroeconomic significance; (g) shocks—the sources of perturbation to the economy and (h) the theory of adjustment to shocks—including hypotheses about the speed of and mechanism for adjustment to equilibrium or about out of equilibrium behavior.”

Stiglitz is not the only dilettante in town. He’s not even the only Nobel prize-winning dilettante — Robert Solow has been making these points for decades now. The Nobels are not alone. Brad Delong takes a similar view, writing that “DSGE macro has … proven a degenerating research program and a catastrophic failure: thirty years of work have produced no tools for useful forecasting or policy analysis”. (You should also read his response to the new paper, and some of the comments on his blog).

Back in 2010, John Mulbaer wrote that “While DSGE models are useful research tools for developing analytical insights, the highly simplified assumptions needed to obtain tractable general equilibrium solutions often undermine their usefulness. As we have seen, the data violate key assumptions made in these models, and the match to institutional realities, at both micro and macro levels, is often very poor.”

This is how a well-mannered economist politely points out that something is very wrong.

The abstract from Paul Romer’s recent paper on DSGE macro summarises the attitude of Christiano at. al.:

“For more than three decades, macroeconomics has gone backwards… Macroeconomic theorists dismiss mere facts … Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes. [This] hints at a general failure mode of science that is triggered when respect for highly regarded leaders evolves into a deference to authority that displaces objective fact from its position as the ultimate determinant of scientific truth.”

What is the “scientific” argument for DSGE? It goes something like this. In the 1970s, macroeconomics mostly consisted of a set of relationships which were assumed to be stable enough to inform policy. The attitude taken to underlying microeconomic behaviour was, broadly, “we don’t have an exact model which tells us how this combination of microeconomic behavours produces the aggregate relationship but we think this is both plausible and stable enough to be useful”.

When the relationships that had previously appeared stable broke down at the end of the 1970s — as macroeconomic relationships have a habit of doing — this opened the door for the Freshwater economists to declare all such theorising to be invalid and instead insist that all macro models be built on the basis of Walrasian general equilibrium. Only then, they argued, could we be sure that the macro relationships were truly structural and therefore not invariant to government policy.

There was also a convenient side-effect for the Chicago School libertarians: state-of-the-art Walrasian general equilibrium had reached the point where the best that could be managed was to build very simple models in which all markets, including the labour market, cleared continuously — basically a very crude “economics 101” model with an extra dimension called “time”, and a bit of dice-rolling thrown in for good measure. The result — the so-called “Real Business Cycle model” — is something like a game of Dungeons and Dragons with the winner decided in advance and the rules replaced by an undergrad micro textbook. The associated policy recommendations were ideologically agreeable to the Freshwater economists.

Economics was declared a science and the problems of involuntary unemployment, business cycles and financial instabilty were solved at the stroke of a pen. There were a few awkward details: working out what would happen if there were lots of different individuals in the system was a bit tricky — so it was easier just to assume one big person. This did away with much of the actual microeconomic “foundations” and just replaced one sort of assumed macro relationship with another — but this didn’t seem to bother anyone unduly. There were also some rather inconvenient mathematical results about the properties of aggregate production functions that nobody likes to talk about. But aside from these minor details it was all very scientific. A great discovery had been made: business cycles were driven by the unexplained residual from an internally inconsistent aggregate production function. A new consensus emerged — aside from sniping from Robert Solow and a few heterodox cranks — that this was the only way to do scientific macroeconomics.

if you wanted to get away from the Econ 101 conclusions and argue, for example, that monetary policy could have some short-run effects, you now had no choice other than to start with the new model and add “frictions” or “imperfections” — anything else was dilettantism. The best-known of these epicycle-like modifications is the “Calvo Fairy” — the assumption that not all prices adjust instantly following a policy change. This allowed those less devoted to extreme free-market politics to derive old favourites such as the expectations-augmented Phillips curve in this strange new world.

Simon Wren-Lewis describes this hard reset of the discipline as follows: “Freshwater created a revolution and won, and were in a position to declare Year Zero: only things done properly (i.e consistently microfounded) are true macro. That was good for a new generation, who could rediscover past knowledge but because they (re)did it ‘properly’ avoid any acknowledgement of what had come before.” The implication is that all pre-DSGE macro is invalid and, from Year Zero onwards, anyone doing macro without DSGE is not doing it “properly”.

This is where the story gets really odd. If, for instance, the Freshwater people had said “there are some problems with your models not fitting the data, and by the way, we’ve managed to add a time dimension to Walrasian general equilibrium, cool huh?” things might have turned out OK. The Freshwater people could have amused themselves playing optimising Dungeons and Dragons while everyone else tryed to work out why the Phillips curve had broken down.

Instead, somehow, the Freshwater economists managed to create Year Zero: everyone now has to play by their rules. For the next 30 years or so, instead of investigating how economies actually functioned, macroeconomists worked out how to get the new model to reproduce the few results that were already well known and had some degree of stability — basically the Phillips Curve. What they didn’t do was produce any new understanding of how economies worked, or develop models with any out of sample predictive power.

On what basis do Christiano et al. then argue that DSGE is the only game in town for making macro policy and,  more bizarrely, the only place where we can do “experiments”? One can certainly do experiments with a DSGE model — but you are experimenting on a DSGE model, not the economy. And it’s fairly well established by now that the economy doesn’t behave much like any benchmark DSGE model.

What Christiano et. al. are attempting to do is reimpose the Year Zero rules: anyone doing macro without DSGE is not doing it “properly”. But on what basis is DSGE macro “done properly”? What is the empirical evidence?

There are two places to look for empirical validation — the micro data and the macro data. Why look at micro data for validation of a macro model? The answer is that Year Zero imposed the requirement that all macro models be deduced — one logical step after another — from microeconomic assumptions. As Lucas, the leading revolutionary put it, “If these developments succeed, the term ‘macroeconomic’ will simply disappear from use and the modifier ‘micro’ will become superfluous. We will simply speak, as did Smith, Ricardo, Marshall and Walras of economic theory”

Is the microeconomic theory correct? The answer is “we don’t know”. It is a set of assumptions about how individuals and firms behave which is all but impossible to either validate or falsify.

The use of the deductive method in economics originated with Ricardo’s Principles of Political Economy in 1819 and is summarised by Nassau Senior in 1836:

“The economist’s premises consist of a very few general propositions, the result of observation, or consciousness, and scarely requiring proof … which every man, as soon as he hears them, admits as familiar to his thoughts … [H]is inferences are nearly as general, and, if he has reasoned correctly, as certain, as his premises”

Nearly two hundred years later, Simon Wren-Lewis’ description of the method of DSGE macro is remarkably similar:

“Microeconomics is built up in a deductive manner from a small number of basic axioms of human behaviour. How these axioms are validated is controversial, as are the implications when they are rejected. Many economists act as if they are self evident.”

What of the macroeconomic results — perhaps we shouldn’t worry whether the microfoundations are correct if the macro models fit the data?

The Freshwater version of the model concluded that all government policy has no effect and that any changes are driven by an unexplained residual. The more moderate Saltwater version, with added Calvo fairy, allowed a rediscovery of Milton Friedman’s main results: an expectations-augmented Phillips Curve and short-run demand effects from monetary policy. The model has two basic equations: aggregate demand (the IS relationship) and aggregate supply (the Phillips curve) along with a policy response rule.

The first, the aggregate demand relationship, is based on an underlying assumption about how households behave in response to changes in the rate of interest. Unfortunately, not only does the equation not fit the data, the sign of the main coefficient appears to be wrong. This is likely because, rather than trying to understand the emergent properties of many interacting agents, modellers took the short-cut of assuming that the one big person assumed to represent the economy would simply replicate the behaviour of a single textbook-rational individual — much like assuming that the behaviour of an ant colony would be the same as that of one big textbook ant. It’s hard to see how one can make an argument that this has advanced knowledge beyond what you could glean from a straightforward Keynesian or Modigliani consumption function. What if, instead, we’d spent 30 years looking at the data and trying to work out how people actually make consumption and investment decisions?

What of the other relationship, the Phillips Curve? The Financial Times has recently published a series of articles on the growing, and awkward, realisation that the Phillips Curve relationship appears to have once again broken down. This was the theme of a recent all-star conference at the Peterson Institute. Gavyn Davies summarises the problem: “Without the Phillips Curve, the whole complicated paraphernalia that underpins central bank policy suddenly looks very shaky. For this reason, the Phillips Curve will not be abandoned lightly by policy makers.”

The “complicated paraphernalia” Davies refers to are the two basic equations just described. More complex versions of the model do exist, which purport to capture further stylised macro relationships beyond the standard pair. This is done, however, by adding extra degrees of freedom — justified as essentially arbitrary “frictions” — and then over fitting the model to the data. The result is that the models are pretty good at “predicting” the data they are trained on, and hopeless at anything else.

30 years of DSGE research have produced exactly one empirically plausible result — the expectations-augmented Phillips Curve. It was already well known. There is an ironic twist here: the breakdown of the Phillips Curve in the 1970s gave the Freshwater economists their breakthrough. The breakdown of the Phillips Curve now — in the other direction — leaves DSGE with precisely zero verifiable achievements.

Christiano et al.’s paper is welcome in one respect. It confirms what macroeconomists at the top of the discipline think about those lower down the academic pecking order — particularly those who take a critical view. They have made public what many of us long suspected was said behind closed doors.

The best response I can think of once again comes from Simon Wren-Lewis, who seems to have seen Christiano et. al coming:

“That some macroeconomists (I call them microfoundations purists) can argue that you should model and give policy advice based not on what you see but on what you can microfound represents something that I cannot imagine any philosopher of science taking seriously (after they had stopped laughing).”

 

China’s shadow banking: New growth model or the next Lehman Brothers?

A debate between Christopher Balding and Daniela Gabor, moderated by Jo Michell

 

Thursday November 2nd 2017, 4-5.30 pm                                                                                    Faculty of Business and Law building Room 2X242                                                                      UWE Bristol, Frenchay Campus

Since the global financial crisis, shadow banking in China has grown rapidly as a result of financial repression, macro policy, and the politics of local-central government relationships. Is this the financial Wild West, the escape valve of a financial system repressed by the long hand of the state or a carefully engineered process to bring market forces into the financial system? How successful are China’s policies to transform shadow banking into securities-market based finance? Have they really addressed concerns about implicit state guarantees? And how do reforms fit with the need for deep and liquid securities markets if Reminibi internationalisation is to succeed?

Christopher Balding is an Associate Professor in Business and Economics at the HSBC Business School of Peking University Graduate School in Shenzhen, China. One of the leading experts on the Chinese economy and financial markets, he is a Bloomberg View contributor and advises governments, central banks, and investors around the world. He has contributed to Bloomberg, the Wall Street Journal, the Financial Times, BBC, CNBC, and Al-Jazeera. He tweets at @BaldingsWorld

Daniela Gabor is Professor of Economics and Macrofinance at UWE Bristol. Her research project ‘Managing shadow money’, funded by the Institute for New Economic Thinking since 2015, explores shadow banking in the US, Europe and China. One of the project papers, ‘Goodbye (Chinese) shadow banking, hello market-based finance’, will be published in Development and Change in December 2017. She is finalising a book manuscript on Shadow Money. She blogs at criticalfinance.org and tweets at @DanielaGabor

Jo Michell is Associate Professor in Economics at UWE Bristol. He has a PhD in Economics on from SOAS University of London, written about the Chinese banking and financial system. His research interests include macroeconomics, money and banking, and income distribution. He has published on macroeconomics and finance in peer reviewed journals including the Cambridge Journal of Economics and Metroeconomica. He co-edited the Handbook of Critical Issues in Finance with Jan Toporowski (Elgar, 2012).

For further inquiries, please email daniela.gabor@uwe.ac.uk

Strong and stable? The Conservatives’ economic record since 2010

In a recent interview, Theresa May was asked by Andrew Neil how the Conservatives would fund their manifesto commitments on NHS spending. Given that the Conservatives chose not to cost their manifesto pledges, May was unable to answer. Instead she simply repeated that the Conservatives are the only party that can deliver the economic growth and stability required to pay for essential public services. When pressed, May’s response was simple: ‘our economic credibility is not in doubt’.

Does the record of the last seven years support May’s claim?

The first statistic always quoted in such discussions is GDP growth. A lot has been made of the latest quarterly GDP figures, showing the UK at the bottom of the G7 league with quarterly GDP growth of just 0.2%. But these numbers actually tell us very little: they refer to a single quarter and are still subject to revision.

It is more useful to look at real GDP per capita over a longer period of time. This tells us the additional ‘real’ income available per person that has been generated. The performance of the G7 countries since the pre-crisis peak in 2007 is shown in the chart below, with the series indexed to 1 in 2007 for each country. (Data are taken from the most recent IMF WEO database.)

G7 GDP per capita, 2007-2016

GDP per capita in the UK only surpassed its pre-crisis level in 2015. By 2016, GDP per capita relative to the pre-crisis level was less than 2% higher than in 2007, putting the UK behind Japan, Germany, the US and Canada, slightly ahead of France, and well ahead of the Italian economy which remains mired in a deep depression. On this measure, the UK’s performance is not particularly impressive.

For most people, wages are a more important gauge of economic performance than GDP per capita. Here, the UK is an outlier. Relative real wage growth in the G7 economies is shown in the table below, alongside the changes in GDP per capita for the period 2007-2015.

Country

% change in GDP per capita, 2007-2015

% change in average real wage, 2007-2015

Canada 3.2 0.8
France -0.2 0.6
Germany 6.3 0.9
Italy -11.7 -0.7
Japan 3.0 -0.2
United Kingdom 0.7 -1.0
United States 3.7 0.5

Despite coming mid-table in terms of GDP per capita, the UK has the worst performance in terms of real wages, which have fallen by an average of 1% per year over the period. Even in depression-struck Italy, wages did not fall so far.

This translates into a fall of almost five percent in the real wage of the typical (median) worker since the crisis, as the chart below shows. This LSE paper, from which the chart is taken, finds that while almost everyone is worse off since the crisis, the youngest have seen the largest falls in income with 18-21-year-olds facing a fall in real wages of over 15%

Chart-3-LSE

With the value of the pound falling since the Brexit vote, inflation is once again eating into real wages and the latest figures show that, after a period of a couple of years in which wages had been recovering, real wages are now falling again and are likely to do so for the next few years. Average earnings are not projected to reach 2007 levels again until 2022 – by then the UK will have gone fifteen years without a pay rise.

A related issue is the UK’s desperately poor productivity performance. ‘Productivity’ here refers to the amount produced per worker on average. As the chart below from the Resolution Foundation shows, the UK has now experienced a decade without any increase in productivity — something which is historically unprecedented.

CHART-productivity

What causes productivity growth is a controversial topic among economists. Until recently, the majority view was that productivity is not affected by government macroeconomic policy. This position (which I disagree with) is increasingly hard to defend. As Simon Wren-Lewis argues here, evidence is mounting that the UK’s productivity disaster is the result of government policy: the Conservatives’ austerity policies have caused flatlining productivity.

Austerity — or, as it was branded at the time, the ‘Long Term Economic Plan‘ — was the central plank of Osborne’s policy from 2010 until the Brexit referendum vote in 2015.

As I and others have argued at length elsewhere, austerity was based on two false premises — ‘lies’ might be more accurate. The first was that excessive spending by Labour was a cause of the 2008 crisis. The second was that the size of the UK’s government debt posed serious and immediate risks that outweighed other concerns.

One thing that almost all macroeconomists agree on is that when recovering from a severe downturn such as 2008 — and with interest rates at nearly zero — the deficit should not be the target of policy. Instead, it should be allowed to expand until the economy has recovered.

Simply put, the deficit should not be used as a yardstick for successful management of an economy in the aftermath of a major economic crisis such as 2008. But since eliminating the deficit was the single most important target of the Conservatives’ so-called Long Term Economic Plan, we should examine the record.

In 2010, Osborne stated that the deficit would be eliminated by 2015. Two years after that deadline passed, the current Conservative manifesto states — in a passage that would not pass any undergraduate economics exam — that they will ‘aim to’ eliminate the deficit by 2025.

Even on their own entirely misguided terms, they have failed completely.

FIG-LTEP

While the dangers of the public debt have been vastly exaggerated by the Conservatives, they have had little to say about private sector debt. It is now widely accepted that the only remaining motor of economic growth is consumption spending. But with wages stagnant, continued growth of consumption cannot be sustained without rising levels of household debt.

This is the reason given when economists are asked why their predictions of post-referendum recession were so wrong: they didn’t anticipate the current credit-driven consumption burst. But this trend has been apparent for at least the last two years. It shouldn’t have been too hard to see this coming.

Chart-Credit-Cards

Just as the Tories tend to stay quiet on private debt, they also have little to say about the ‘other’ deficit — the current account deficit. This is a measure of how much the country is reliant on foreigners to finance our spending. The deficit expanded from 2011 onward to reach almost 5% of GDP. This is an important source of vulnerability for a country which is about to try and extricate itself from economic integration with its closest neighbours.

CHART-BoP- current account balance as per cent of GDP

Overall, the Tories economic record is far from impressive: stagnant wages and productivity, weak investment and manufacturing, rising household debt, and a large external deficit.

Now, a reasonable response might be that these are long-standing issues with the UK economy and are not the fault of the Conservatives. There is some truth to this. But if this is the case, Theresa May should identify and acknowledge these issues and provide a clear outline of how her policies will address them. This is not what she has done. Instead, she simply repeats her mantra that only the Conservatives will deliver on the economy, without providing any evidence to support her claim.

And then there is the decision to call a referendum on Brexit. It is hard to think of a more economically reckless move. Household analogies for government economic policy should be avoided — but I can’t think of an alternative in this case.

Following up on an austerity programme with the Brexit referendum is like sending the children to school without lunch money for six years and allowing the house to fall into serious disrepair in order to needlessly over-pay a zero-interest mortgage — and then gambling the house on a dice game.

Given this record, it is astonishing that the Conservatives present themselves, with a straight face, as the party of economic competence — and the media dutifully echoes the message. The truth is that the Conservatives have mismanaged the economy for the last seven years, needlessly imposing austerity, choking off growth in productivity, wages and incomes. They then called an entirely unnecessary referendum, gambling the future prosperity of the country for political gain.

Theresa May is correct — there is little doubt about the economic credibility of the Conservatives. It is in short supply.

Thoughts on the NAIRU

Simon Wren-Lewis’s post attacking Matthew Klein’s critique of the NAIRU provoked some strong reactions. On reflection, my initial response was wide of the mark. Matthew responded saying he agreed with most of Simon’s piece.

So are we all in agreement? I think there are differences, but we need to first clarify the issues.

Matthew’s main point was empirical: if you want to use a relationship between employment and inflation as a policy target it needs to be relatively stable. The evidence suggests it is not.

But there is a deeper question of what the NAIRU actually means – what is a NAIRU? The simple definition is straightforward: it is the rate of unemployment at which inflation is stable. If policy is used to increase demand, reducing unemployment below the NAIRU, inflation will rise until excess demand is removed and unemployment allowed to increase again.

At first glance this appears all but identical to the ‘natural rate of unemployment’, a concept originating with Friedman’s monetarism and inherited by some New Keynesian models – in particular the ‘standard’ sticky-price DSGE model of Woodford and others. In this view, the economy has ‘natural rates’ of output and employment, beyond which any attempt by policy makers to increase demand becomes futile, leading only to ever-higher inflation. Since there is a direct correspondence between stabilizing inflation and fixing output and employment at their ‘natural’ rates, policy makers should simply adjust interest rates to hit an inflation target. In typically modest fashion, economists refer to this as the ‘Divine Coincidence‘ – despite the fact it is essentially imposed on the models by assumption.

Matthew’s piece skips over this part of the history, jumping straight from Bill Phillips’s empirical relationship to the NAIRU. But the NAIRU is a weaker claim than the natural rate. As Simon says, all that is required for a NAIRU is a relationship of the form inf = f(U, E[inf]), i.e. current inflation is some function of unemployment and expected inflation. At its simplest, agents could just assume inflation will be the same in the current period as the last period. Then, employment above some level would causing rising inflation and vice versa.

More sophisticated New Keynesian formulations of the NAIRU are a good distance removed from the ‘natural rate’ theory – these models include imperfections in the labour and product markets and a bargaining process between workers and firms. As a result, they incorporate (at least short-run) involuntary unemployment and see inflation as driven by competing claims on output rather than the ‘too much nominal demand chasing too few goods’ story of the monetarists and simple DSGE models.

It is also the case that such a relationship is found in many heterodox models. Engelbert Stockhammer explores heterodox views on the NAIRU in a provocatively-titled paper, ‘Is the NAIRU Theory a Monetarist, New Keynesian, Post Keynesian or Marxist Theory?’. He doesn’t identify a clear heterodox position – some Post-Keynesians reject the NAIRU outright, while others present models which incorporate NAIRU-like relationships.

Engelbert notes that arguably the earliest definition of the NAIRU is to be found in Joan Robinson’s 1937 Essays in the Theory of Employment:

In any given conditions of the labour market there is a certain more or less definite level of employment at which money wages will rise … there is a certain level of employment, determined by the general strategical position of the Trade Unions, at which money wages rise, and at that level of employment there is a certain level of real wages, determined by the technical conditions of production and the degree of monopoly’ (Robinson, 1937, pp. 4-5)

Recent Post-Keynesian models also include NAIRU-like relationships. For example, Godley and Lavoie’s textbook includes a model in which workers and firms compete by attempting to impose money-wage and price increases respectively. The size of wage increases demanded by workers is a function of the employment rate relative to some ‘full employment’ level. That sounds a lot like a NAIRU – but that isn’t how Godley and Lavoie see it:

Inflation under these assumptions does not necessarily accelerate if employment stays in excess of its ‘full employment’ level. Everything depends on the parameters and whether they change … An implication of the story proposed here is that there is no vertical long-run Phillips curve. There is no NAIRU. (Godley and Lavoie, 2007, p. 304, my emphasis)

The authors summarise their view with a quote from an earlier work by Godley:

Indeed if it is true that there is a unique NAIRU, that really is the end of discussion of macroeconomic policy. At present I happen not to believe it and that there is no evidence of it. And I am prepared to express the value judgment that moderately higher inflation rates are an acceptable price to pay for lower unemployment. But I do not accept that it is a foregone conclusion that inflation will be higher if unemployment is lower (Godley 1983: 170, my emphasis).

This highlights a key difference between Post-Keynesian and neoclassical approaches to the NAIRU: where Post-Keynesian models do include NAIRU-like relationships, the relevent employment level is endogenous, due to hysteresis effects for example. In other words, the NAIRU moves around and is influenced by demand-management policy. As such, the NAIRU is not an attractor for the unemployment rate as in many neoclassical models.

Marxist theory also contains something which looks a lot like a NAIRU: the ‘industrial reserve army’ of the unemployed. Marx argued that unemployment is the mechanism by which capitalists discipline workers and prevent wage claims rising to the point at which profits and capital accumulation are depleted. Periodic recessions are therefore a necessary part of the capitalist development process.

This led Nicholas Kaldor to describe Margaret Thatcher as ‘our first Marxist Prime Minister’ – not because she was an advocate of socialist revolution but because she understood the reserve army mechanism: ‘They have managed to create a pool – or a “reserve army” as Marx would have called it – of 3 million unemployed … the British working classes have been thoroughly cowed and frightened.’ (This point is passed over rather quickly in Simon’s piece. In the 1980s, he writes, ‘policy changed and increased unemployment and inflation fell.’)

So we should be careful about blanket dismissals of the NAIRU. Instead, we must be clear how our analysis differs: what are the mechanisms which generate inflationary pressure at low levels of unemployment – conflicting claims or excess nominal demand? Is the NAIRU stable and exogenous? Does it act as an attractor for the unemployment rate, and over what time period? What are the implications for policy?

Ultimately, I think this breaks down into an issue about semantics. How far from the unique, stable, vertical long-run Phillips curve can we get and still have something we call a NAIRU? Simon adopts a very loose definition:

There is a relationship between inflation and unemployment, but it is just very difficult to pin down. For most macroeconomists, the concept of the NAIRU really just stands for that basic macroeconomic truth.

I’d like to believe this were true. But I suspect most macroeconomists, trained on New Keynesian DSGE models, have a narrower view: they tend to think in terms of a stable short-run sticky-price Phillips curve and a unique long-run Phillips curve at the ‘natural’ rate of employment.

There is one other aspect to consider. Engelbert Stockhammer distinguishes between the New Keynesian NAIRU theory and the New Keynesian NAIRU story. He argues (writing in 2007, just before the crisis) that the NAIRU has been used as the basis for an account of unemployment which blames inflexible labour markets, over-generous welfare states, job protection measures and strong unions. The policy prescriptions are then straightforward: labour markets should be deregulated and welfare states scaled back. Demand management should not be used to reduce unemployment.

While economists have changed their tune substantially in the decade since the financial crisis, I suspect that the NAIRU story is one reason that defence of the NAIRU theory generates such strong reactions.

EDIT: Bruno Bonizzi points me to this piece at the INET blog with has an excellent discussion of the empirical evidence and theoretical implications of hysteresis effects and an unstable NAIRU.

 

Image reproduced from Wikipedia: https://en.wikipedia.org/wiki/File:NAIRU-SR-and-LR.svg