Do economists need to talk about consumption?

Chart showing measures of CO2 emissions for high-income countries

This post was originally published here, as part of a series titled Demanding change by changing demand produced by environmental charity Global Action Plan. Some similar themes are explored in more technical detail in the context of lower- and middle- income countries in a recent working paper for the ILO, co-authored with Adam Aboobaker.

For much of the last thirty years or so, progressive economists have argued that macroeconomic policy is too tight. In simpler terms, this means that some combination of higher government spending, lower taxation, and lower interest rates will lead to more jobs and higher incomes.

Such arguments are sometimes presented as part of advocacy for initiatives responding to the environmental crisis, such as the Green New Deal. For the most part, however, the environmental implications of higher near-term economic activity in rich countries do not attract much attention – it is taken as given that higher economic activity, as measured by gross domestic product (GDP), is unequivocally positive.

The current situation of high inflation, driven by energy shortages, war and climate change, serves as a sharp reminder that there is something missing in analysis which sees higher growth as an entirely free lunch. Almost all economic activity depletes scarce physical resources and generates carbon emissions. Higher employment usually comes at the cost of higher emissions. Furthermore, it is possible that we are now also reaching the end of the historic period in which physical resources were usually immediately available – so that economic activity could quickly rise in response to higher overall spending. The era of the Keynesian free lunch may be ending, replaced by a regime characterised by recurring inflationary episodes.

This puts progressive economists, like myself, who believe that the economies of rich countries are predominantly demand driven – meaning that higher overall spending means more jobs and higher incomes – in an uncomfortable position.

This view relies partly on the idea of the “multiplier”. This is the claim, which is well supported by empirical evidence, that every pound of new spending in the economy will generate additional income and spending over and above the initial pound spent. The mechanism works, to a large extent, by stimulating consumption spending: if a new government investment project is initiated – to provide additional green energy, for example – the money spent on the project – on wages, transport and materials – will be received by individuals and businesses as income. Some of this additional income will be spent on consumption, generating a second round of additional new incomes.

Similarly, the argument that redistribution from those on higher incomes to those on lower incomes is good for growth relies on the fact that those on lower incomes spend a greater proportion of their incomes on consumption goods – redistribution from rich to poor thus raises total consumption expenditure and economic activity.

How are progressive economists to respond to the now inescapable fact that current resource use greatly exceeds planetary limits, and “decoupling” – the trend for energy and resource use per dollar of spending to fall as GDP rises – will not be sufficient to stay within planetary boundaries if steady GDP growth continues?

There is no single answer to this question – the appropriate response will require action on many fronts simultaneously. However, economists are beginning to consider whether we need to introduce constraints on consumption, at least for those on higher incomes in rich countries, as part of the solution. Rather than relying only on voluntary consumer choice and natural shifts in consumption patterns – such as the trend towards lower consumption of meat in some rich countries – it may be that state intervention is required to influence both overall levels of consumption and its distribution.

There are two main arguments in favour of constraining consumption. The first is straightforward: all consumption, whether of food, transport, clothing or shelter, involves carbon emissions and resource depletion. Reduced consumption growth should translate directly into lower emissions growth.

The other relates to the need to reallocate current resources, including labour, towards the investment needed to fundamentally reshape our economic systems. Lower consumption means fewer people working in industries which provide for consumption spending, and fewer raw materials devoted to the production of consumption goods. This frees up resources for green investment: people and materials can be re-deployed towards the investment projects which are urgently needed.

This raises some thorny questions: what policy tools can be used to shift the composition and scale of consumption? Which groups should face incentives – or compulsion – to reduce consumption and what form should these measures take? How will voluntary shifts in consumption interact with more direct measures to reduce consumption? And crucially, how can jobs and incomes be protected without relying on consumption as a key driver of macroeconomic dynamism?

Much of this comes down to issues of distribution. Statistics on poverty make clear that large numbers of people in rich nations are unable to consume sufficient basic necessities. Basic justice dictates that the average incomes and consumption of those in lower income countries be allowed to catch up with those of richer countries. The need for redistribution of income within countries, and income catch-up across countries is undeniable – yet such redistribution, if it were to occur without other changes, will lead to increased overall consumption and emissions.

It is therefore hard to avoid the conclusion that taxation and regulation will be required to limit some part of the energy-intensive consumption of those on higher incomes in rich countries, particularly consumption which can be considered “luxury” consumption.

One plausible response to such suggestions is to claim that voluntary shifts in the kinds of things produced and consumed will naturally lead to reduced emissions, even while “consumption”, as measured by the national accounts, continues to grow. This kind of voluntary behavioural and consumption change – buying fewer cheap clothes, holidaying by rail rather than plane, switching to electric cars – will have a part to play in the transition to a low carbon economy, alongside reorientation from goods consumption to a more services-driven “foundational” economy. It is unlikely, however, that such changes will be sufficient.

The politics of consumption constraints are daunting. Managing competing distributional claims in the face of opposition from increasingly concentrated wealth and power is hard enough when the overall pie is growing. As we move towards a world of potential genuine scarcity, the politics of redistribution will become even more malign. This only emphasises the importance of getting the economics right.

Any successful response to the climate crisis will inevitably involve action and change at all levels – from local organising and “organic” shifts in consumption to reform of financial systems and action to tame corporate power and concentrated wealth. Constraints on the consumption of the relatively well off should be part of such a response. A debate about the economics and politics of these constraints is overdue.

How pension funds shape financialisation in emerging economies in Colombia and Peru

Guest post: Bruno Bonizzi, Jennifer Churchill and Diego Guevara

In early spring 2020 emerging economies (EEs) were hit by the largest ever episode of portfolio outflows. Stock and bonds were sold as investors fled to safer investments in Europe and the United States, showing once again the fragile nature of EEs’ financial integration. To overcome this problem, one suggested solution is to allow for a larger base of domestic institutional investors, such as pension funds, which can stabilise financial markets. While having a large institutional investor base can be a source of demand for domestic financial securities, it is important to review the evidence from the experience of those EEs where pension funds have existed for more than two decades.

As we show in our forthcoming article, the experience of Colombia and Peru can be instructive. Their pension system, while maintaining a significant parallel public Pay-As-You-Go structure, has a sizeable funded private component with assets that have grown to over 20% of GDP. These were established as part of the Washington Consensus reforms in the 1990s, following the prior example of Chile.

However, more than two decades since the creation of private pension funds, capital markets in the two countries, as in the rest of Latin America, remain small and underdeveloped. It is perhaps for this reason that the experience of pension funds in Latin America remains under-researched by financialisation scholarship. However, recent literature has put forward the idea that financialisation patterns, while having common tendencies, can present “variegated” forms. Pension funds play a role in this process by exerting an important role in shaping the demand for financial assets, even if this does not occur, as in typical “Liberal Market Economies” by fuelling domestic capital markets.

Some key characteristics of Colombia and Peru’s political economy have acted as the distinct determinants of pension fund demand for assets, shaping a specific form of financialisation. Firstly, pension funds in these countries reflect the characteristics of Hierarchical Market Economies, the Latin American variety of capitalism. Workers and unions have very limited control over how pension fund assets are invested, as pension funds are provided by private companies as pure individual retirement accounts. Investment policy is therefore heavily shaped by the interest of the financial industry, which was also key in promoting their establishment and in shaping their regulation since.

But next to these considerations, pension fund asset demand in Colombia and Peru has been structurally constrained by the limited by limited effective space in domestic capital markets. These two countries have a highly “extraverted” growth regime, where commodity exports play a key role in determining aggregate demand. As a result of the 2000-2014 commodity price boom, companies had substantial financing coming from export proceeds and foreign direct investment, therefore limiting their issuance of securities in domestic capital markets. Governments too limited their net borrowing during this period, thanks to booming revenues and limited increases in public spending. Additionally, the countries have attracted considerable interest by foreign financial investors, whose weight in domestic bond and stock markets increased. These characteristics reflect the status of Colombia and Peru of as subordinate emerging economies in global financial markets.

Pension funds in Colombia and Peru have looked for other investments. Supported once again by the domestic and international financial industry, these have been found in “alternative assets”, most typically private equity, infrastructure and real-estate funds, as well as in foreign investment, which now account for more than a third and more than 40% of total assets in Colombia and Peru respectively. The latter have been important in stimulating a derivative market to hedge foreign currency positions, mostly vis-á-vis US dollars.

Therefore, pension funds have been important in shaping the financialisation trajectory in these two countries, despite the limited development of domestic capital markets. This can serve as an important lesson to calls for the promotion of private pensions to stabilise capital markets. In emerging economies subject to subordinate forms of economic and financial integration, and where the interests represented are those of a highly concentrated financial industry, pension funds may fail to act as catalysts for deep, liquid and stable domestic capital markets. They may instead contribute to finance privatised forms of infrastructure and real estate and reinforce the hierarchies of global finance.

Developing and emerging countries need capital controls to prevent financial catastrophe

A shorter version of this letter was published in the Financial Times on 25 March 2020.

All countries currently face the unprecedented threat of a simultaneous and global health crisis, economic recession and financial meltdown. But unlike rich nations, emerging and developing countries (DECs) lack the policy autonomy needed to confront these crises. The global currency hierarchy places DECs in the periphery of global financial markets, exposing them to sudden stops caused by triggers such as the COVID-19 crisis. The US Federal Reserve announced it would lend up to USD 60bn to the central banks of Mexico, Brazil, South Korea and Singapore. But this is not enough. Immediate capital controls, coordinated by the IMF, are needed to prevent financial disaster.

In a global financial crisis, there is a rush to hold liquid assets denominated in safe currencies, especially US dollars. This enables rich countries to respond to crises with the necessary fiscal and monetary tools. The opposite is true for DECs. Since the outbreak of the COVID-19 crisis, international investors have withdrawn large sums from DEC assets, leading to dramatic currency depreciation, especially for those exposed to falling commodity prices.

Over the past decade, ample global liquidity driven by rich country central banks, alongside sustained demand for liquid assets, has led to enormous flows of credit and equity investment into DECs, where bond and stock markets grew from about 15 trillion to 33 trillion US dollars between 2008 and 2019. ‘Frontier economies’ and DECs corporations have issued substantial volumes of foreign currency debt. With G20 encouragement, DECs opened their domestic currency bond markets to international investors. In what has been termed the second phase of global liquidity, new financial instruments and institutions, such as international funds and exchange-traded funds (ETFs), have enabled easy global trading of DECs assets, cementing the illusion of liquidity.

DECs are now confronted with a sudden stop as global liquidity conditions tighten and investors flee from risk: exposure to DECs remains a high-risk/high-return strategy, to be liquidated in times of crisis. In consequence, DECs face severe macroeconomic adjustment at precisely the moment when all available tools should be used to counter the public health crisis presented by COVID-19: some countries may be forced to tighten monetary policy in an attempt to retain access to the US dollar, while fiscal action may be constrained by fear of losing access to global markets. Foreign exchange reserves are unlikely to provide a sufficient buffer in all countries. This would have profound consequences for the global economy: DECs, both in the G20 and beyond, are now far more important for global growth and markets than even a decade ago. The failure of a large sovereign or quasi-sovereign borrower could trigger significant contagion.

There is an urgent need for action to prevent this crisis reaching catastrophic proportions in DECs. Despite long-standing calls for action, there is still no international lender of last resort. The only instruments currently available are IMF lending and foreign exchange (FX) swap lines between central banks. IMF loans typically impose fiscal tightening, which would be disastrous under current conditions. The US Federal Reserve stands ready to provide US dollars to a handful of major central banks: among DECs, only Mexico can access Fed and US Treasury swap lines under NAFTA provisions, and South Korea and Brazil have just had their arrangements re-opened. But these ad-hoc arrangements exclude a large proportion of DECs’ need for dollar liquidity.

We call for decisive action to constrain the financial flows currently transmitting the crisis to EMs. Capital controls should be introduced to curtail the surge in outflows, to reduce illiquidity driven by sell-offs in DECs’ markets, and to arrest declines in currency and asset prices. Implementation should be coordinated by the IMF to avoid stigma and prevent contagion. FX swap lines should be extended to include more DECs, in order to ensure access to US dollars. Finally, we concur with recent calls for greater provision of liquidity by the IMF using special drawing rights (SDRs) – but this must take place without the imposition of pro-cyclical fiscal adjustment.

The unfolding crisis is one of the most serious in economic history. We must ensure that governments can do everything possible to protect their citizens. In our globally integrated economy, coordinated action is needed to minimise the externally-imposed constraints on developing and emerging countries as they face the triple threat of pandemic, recession and financial crisis.

Organising Signatories

Nelson Barbosa, Sao Paolo School of Economics

Richard Kozul-Wright, UNCTAD

Kevin Gallagher, Boston University

Jayati Ghosh, Jawaharlal Nehru University

Stephany Griffith-Jones, Columbia University

Adam Tooze, Columbia University

Bruno Bonizzi, University of Hertfordshire

Daniela Gabor, UWE Bristol

Annina Kaltenbrunner, University of Leeds

Jo Michell, UWE Bristol

Jeff Powell, University of Greenwich

Signatories

Adam Aboobaker, University of Massachusetts Amherst

Kuat Akizhanov, University of Birmingham and University of Bath

Siobhán Airey, University College Dublin

Ilias Alami, Maastricht University

Alejandro Alvarez, UNAM, México

Donatella Alessandrini, University of Kent

Jeffrey Althouse, University of Sorbonne Paris Nord

Carolina Alves, Girton College – University of Cambridge

Paul Anand, Open University and CPNSS London School of Economics

Phil Armstrong, University of Southampton Solent and York College

Paul Auerbach, Kingston University

Basani Baloyi, South Africa

Frauke Banse, University of Kassel, Germany

Benoît Barthelmess, Le Club Européen

Pritish Behuria, University of Manchester

Kinnari Bhatt, Erasmus University Rotterdam

Samuele Bibi, Goldsmiths University

Joerg Bibow, Skidmore College

Pablo Bortz, National University of San Martín

Alberto Botta, University of Greenwich

Benjamin Braun, Institute for Advanced Study, Princeton

Louison Cahen-Fourot, Vienna University of Economics and Business

Jimena Castillo, University of Leeds, UK

Eugenio Caverzasi, Università degli Studi dell’Insubria

Jennifer Churchill, Kingston University, London

M Kerem Coban, GLODEM, Koc University, Turkey

Andrea Coveri, University of Urbino, Italy

Moritz Cruz, UNAM, Mexico

Florence Dafe, HfP/TUM School of Governance, Munich

Yannis Dafermos, SOAS University of London

Daria Davitti, Lund University, Sweden

Adam Dixon, Maastricht University

Cédric Durand, Université Sorbonne Paris Nord

Chandni Dwarkasing, University of Siena, Italy

Gary Dymski, University of Leeds

Ilhan Dögüs, University of Rostock, Germany

Carlo D’Ippoliti, Sapienza University of Rome

Dirk Ehnts, Technical University of Chemnitz

Luis Eslava, Kent Law School, University of Kent

Trevor Evans, Berlin School of Economics and Law

Andreas Exner, University of Graz

Karina Patricio Ferreira Lima, Durham University

José Bruno Fevereiro, The Open University Business School

Andrew M. Fischer, Erasmus University Rotterdam

Giorgos Galanis, Goldsmiths, University of London

Santiago José Gahn, Università degli studi Roma Tre

Jorge Garcia-Arias, University of Leon, Spain and SOAS, University of London

Alicia Girón – UNAM-MEXICO

Thomas Goda, Universidad EAFIT, Colombia

Antoine Godin, University Sorbonne Paris Nord

Gabriel Gómez, UNAM, México

Jesse Griffiths, Overseas Development Institute

Diego Guevara, National University of Colombia

Alexander Guschanski, University of Greenwich

Sarah Hall, University of Nottingham

James Harrison, Prof, University of Warwick

Nicolas Hernan Zeolla, National University of San Martin, Argentina

Hansjörg Herr, Berlin School of Economics and Law

Elena Hofferberth, University of Leeds

Jens Holscher, Bournemouth University

Peter Howard-Jones, Bournemouth University

Bruno Höfig, SOAS, University of London

Roberto Iacono, Norwegian University of Science and Technology

Stefanos Ioannou, University of Oxford

Andrew Jackson, University of of Surrey

Juvaria Jafri, City University of London

Frederico G. Jayme, Jr, Federal University of Minas Gerais, Brazil

Emily Jones, University of Oxford

Ewa Karwowski, University of Hertfordshire

Y.K. Kim, University of Massachusetts Boston

Stephen Kinsella, University of Limerick

Kai Koddenbrock, University of Frankfurt

George Krimpas, University of Athens

Sophia Kuehnlenz, Manchester Metropolitan University

Ingrid Harvold Kvangraven, University of York

Annamaria La Chimia, University of Nottingham

Dany Lang, Université Sorbonne Paris Nord

Jean Langlois, Le Club Européen

Christina Laskaridis, SOAS, University of London

Lyla Latif, University of Nairobi

Thibault Laurentjoye, École des Hautes Études en Sciences Sociales (EHESS), Paris

Dominik A. Leusder, London School of Economics

Noemi Levy-Orlik, UNAM, Mexico

Gilberto Libanio, Federal University of Minas Gerais, Brazil

Duncan Lindo, Vrije Universiteit Brussel

Lorena Lombardozzi, Open University

Anne Löscher, University of Siegen, Germany; University of Leeds

Birgit Mahnkopf, Prof.i.R., Berlin School of Economy and Law

Pedro Mendes Loureiro, University of Cambridge

Victor Isidro Luna, UNAM

Jonathan Marie, Université Sorbonne Paris Nord

Norberto Montani Martins, Federal University of Rio de Janeiro, Brazil

Olivia Bullio Mattos, St. Francis College, New York, USA

Andrew Mearman, University of Leeds

Monika Meireles, UNAM

Thorvald Grung Moe, Levy Economics Institute

Lumkile Mondi, University of the Witwatersrand, South Africa

Thanti Mthanti, University of the Witwatersrand, South Africa

Susan Newman, Open University

Howard Nicholas, International Institute of Social Studies, Erasmus University Rotterdam

Maria Nikolaidi, University of Greenwich

Patricia Northover, University of the West Indies, Jamaica

Cem Oyvat, University of Greenwich

Oktay Özden, Marmara University, Turkey

Vishnu Padayachee, University of the Witwatersrand

Rafael Palazzi, PUC-Rio, Brazil

José Gabriel Palma, Cambridge University and USACH

Marco Veronese Passarella, University of Leeds

Jonathan Perraton, University of Sheffield

Nicolás M. Perrone, Universidad Andres Bello, Viña del Mar

Keston K. Perry, UWE Bristol

Mate Pesti, UWE Bristol

Karl Petrick, Western New England University

Christos Pierros, University of Athens

Leonhard Plank, TU Wien

Jose Pérez-Montiel, University of the Balearic Islands, Spain

Hao Qi, Renmin University of China

Mzukisi Qobo, Wits Business School, University of Witwarsrand

Joel Rabinovich, University of Leeds

Dubravko Radosevic, University of Zagreb

Miriam Rehm, University of Duisburg-Essen

Marco Flávio da Cunha Resende, Federal University of Minas Gerais, Brazil

Lena Rethel, University of Warwick

Sergio Rossi, C University of Fribourg, Switzerland

Maria Jose Romero, Eurodad

Roy Rotheim, Skidmore College

Josh Ryan-Collins, UCL Institute for Innovation and Public Purpose

Alfredo Saad Filho, King’s College London

Lino Sau, University of Torino, Italy

Malcolm Sawyer. Emeritus Professor of Economics, University of Leeds

Anil Shah, University of Kassel

Dawa Sherpa, Jawaharlal Nehru University

Hee-Young Shin, Wright State University

Farwa Sial, Global Development Institute, University of Manchester

Crystal Simeoni, FEMNET, Nairobi, Kenya

Engelbert Stockhammer, King’s College London

Ndongo Samba Sylla, Dakar

Carolyn Sissoko, UWE Bristol

Celine Tan, University of Warwick

Gyekye Tanoh, Accra

Daniela Tavasci, School of Economics and Finance, Queen Mary University of London

Andrea Terzi, Franklin University Switzerland

Daniele Tori, Open University Business School

Gamze Erdem Türkelli, University of Antwerp

Esra Ugurlu, University of Massachusetts Amherst

Ezgi Unsal, Kadir Has University

Tara Van Ho, University of Essex

Sophie Van Huellen, SOAS University of London

Frank Van Lerven, New Economics Foundation

Elisa Van Waeyenberge, SOAS University of London

Paolo Vargiu, University of Leicester

Luigi Ventimiglia, School of Economics and Finance, Queen Mary University of London

Apostolos Vetsikas, University of Thessaly, Greece

Davide Villani, The Open University and Goldsmiths, University of London

Camila Villard Duran, University of Sao Paulo

Pablo Wahren, University of Buenos Aires

Neil Warner, London School of Economics

Mary Wrenn, UWE Bristol

Joscha Wullweber, University of Witten/Herdecke

Devrim Yilmaz, Université Sorbonne Paris Nord

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.


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 1^st, 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.

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).

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.

Screen Shot 2018-02-14 at 15.20.55

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

Screen Shot 2018-02-14 at 15.29.04

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.

Philanthrocapitalists meet the world’s poor: international development in the fintech era

Daniela Gabor and Sally Brooks

“Within the global development landscape, few funding areas are hotter right now than financial inclusion” (Inside Philanthropy, May 2016)

“The significant progress in moving away from cash that Bangladesh has made in such a short amount of time is due to the government’s strong leadership, the innovation of the private sector and citizens’ openness to a digital future” (The Better Than Cash Alliance)

On day one of this year’s World Economic Forum at Davos, OXFAM named US philanthropists Bill Gates and Mark Zuckerberg on the list of ‘just eight men own as much wealth as half of humanity’. Why, the question was then raised, are we bashing ‘philanthrocapitalists’ like Gates who had donated so much of their wealth to tackling global poverty?

Philanthropists, we argue in a new paper, are far more influential in international development than commonly understood. After the 2008 crisis, international development has embraced financial inclusion as the new development paradigm. With this, development interventions are increasingly organised through a new alliance of developing countries, international financial organisations, ‘philanthropic investment firms’ and fintech companies, what we term the fintech-philanthropy-development (FPD) complex. The FPD version of financial inclusion – know thy (irrational) customer – celebrates the power of technology to simultaneously achieve positive returns, philantrophy and human development.

‘Transform mobile behaviour into financial opportunity’

The premise is simple. Poverty can be tackled faster if the poor have better access to finance. And something unpredecented is happening with the world’s poor in Sub-Saharan Africa, Asia, Latin America and the Caribbean. Roughly 1.7 billion of the 2 billion without formal access to finance have a mobile phone. These generate ‘digital footprints’ that can be harnessed by big data and predictive algorithms to better understand, and thus include, the ‘unbankable’. Transforming mobile behaviour into financial opportunity.

The FPD origins can be traced back to the Alliance for Financial Inclusion. Created in 2011 with funding from the Bill and Melinda Gates Foundation (BMGF) and endorsement from G20 as key to achieving the sustainable development goals, AFI brought together policy makers from ninety developing countries united in their commitment to work with private actors and international development organisations (the World Bank) in order to ‘reach the world’s 2.5 billion unbanked’. By 2014, the Omidyar Network (backed by Ebay founder Pierre Omidyar) would become the second philanthropic investment organization officially partnered with AFI. That same year, AFI launched the Public Private Dialogue Platform (PPD), promising the private sector ‘an unprecedented opportunity’ to connect to policy makers who are regulating new and high growth markets. In 2015, Mastercard, Visa and the Spanish bank BBVA have become AFI members, with more partnerships to be formalized in the future. Meanwhile, the AFI acts an umbrella and incubator for a growing number of global and regional FI programmes such as the UNDP-Funded ‘Mobile Money for the Poor’ (MM4P) and ‘Shaping Inclusive Finance Transformations’ (SHIFT), among others.

Thus, the FPD complex sees the growing influence of a digital elite in development interventions. The public-private partnerships are predicated on the idea that technology and big data can play a critical role in advancing financial inclusion. For example, the Omidyar Network is investing in fintech companies whose strategic goal is to ‘disrupt traditional risk assessment’ by, for example, predicting customers ‘appetite for risk’ based on ‘patterns of calls and text messages’, or even inviting them to participate in online games and quizzes that generate behavioural data that can be fed into predictive algorithms. The promise is to connect lenders to upwardly mobile customers. Through these strategies of what Izabella Kaminska has called ‘financial intrusion’, consumers’ ‘digital footprints’ are being created, without their knowledge, and used or stored for future commercial use.

A cash-lite future

India’s recent demonetization initiative has received global attention. Widely judged as a misstep, the decision to withdraw 86% of all cash from circulation is typically explained as fight again shadow economy. But there is more to India’s initiative. It represents one (important) element of its adoption of the FPD approach to development.

Indeed, the state agreed to play an important role in the harvesting and commodification of digital footprints, by opening up its direct relationship with the poor to fintech. A spinoff from the AFI, the Better than Cash Alliance, encourages developing countries to digitalize social transfers, thus reaching the ‘unbankable’ at a stroke through the long arm of the state. Housed at the UN as implementing partner for the G20 Global Partnership for Financial Inclusion, the Better than Cash Alliance promises that a ‘cash lite’ Finance for Development agenda would put the UN’s Sustainable Development Goals within reach (Goodwin-Groen 2015).

The Better than Alliance has proved adept at illustrating the benefits of a cash-lite future. Digitizing payments from government to people can save the government of Bangladesh US 146 million per year across 6 social safety net programs. India, a member since 2015, saves USD 2billion by paying cooking gas subsidies digitally.

While such savings appeal immediately to governments worldwide, a Bankable Frontier Associates report made clear what is at stake in the ‘journey towards cash lite’. For financial service providers, the opportunities for FI via digital payments do not arise from increasing use of bank deposits by the previously unbanked, since bank accounts are not ‘daily relevant’. Rather, opportunities ‘come from financial service providers using the digital information generated by e-payments and receipts to form a profile for each individual customer’. This digital profiling then enables providers to offer more appropriate and relevant products.

Thus, data and algorithms become critical to pushing the risk frontier in low-income countries, as fintech companies create, collect and commodify behavioral data, within an ‘ecosystem’ fostered by networks of philanthropic investors, development finance institutions and donors and policy makers in participating countries.

Another, potentially more problematic issue arises in this process. Traditional microfinance lenders mobilised peer pressure in ‘solidarity groups’ to discipline borrowers to be ‘good financial citizens’. In the fintech era of international development, the mantra is ‘know thy irrational customer’ via algorithms. Cignifi for instance promises to continuously track changes in customers’ mobile behaviour, as mobile phones generate data that capture users moving from ‘one behavioural state to another’. This would allow lenders to create choice architectures that nudge customers in the direction of desired behaviours to preserve mobile-data-based credit score.

While the ethics of nudge are increasingly being debated, digital financial inclusion combines the inherent opacity of nudge techniques with that of predictive algorithm design, technically complex and subject to commercial confidentiality, in ways that have remained remarkably free from scrutiny.

While these programmes have adopted the language of inclusion and access, the question is who is actually accessing whom? Since the 2008 financial crisis a tendency to see its victims, rather than the system that created it as most in need of correction, has become entrenched. Meanwhile the possibilities of ‘fintech’ together with discovery of the ‘nudge’ toolbox has created new opportunities for financial capital to reach ever more remote consumers. As if the crisis never happened, this is the sub-prime ‘moment’ recast, perversely, as development policy, turning poverty in the developing world into a new frontier for profit making and accumulation.