It’s Hard To Make That German Export Wiener Without PIIGS — And That Goes For Chinese Dumplings, Too.

October 27th, 2011

With all the flack Angela Merkel has taken at home for agreeing to help bail out Greece, one could be forgiven for wondering why the Chancellor would want to yolk Germany’s seeming paragon of export-driven economic strength to the Hellenic basket case, let alone to the fortunes of those other peripheral euro states that, with Greece, are collectively known as PIIGS (Portugal, Ireland, Italy, Greece and Spain). Perhaps counter-intuitively, part of the answer lies in the fact that German exports are actually made more competitive because of the weakening of the euro caused by the participation of the PIIGS in that currency.

A weaker euro means relatively cheaper prices for German goods in the currency of non-Eurozone trading partners, giving German exporters an edge in world markets. To understand this effect, one must first consider two histories: that of the euro since its birth, and of German exports prior and subsequent to that introduction.

For all its troubles, the euro has strengthened considerably since its first day of trading, January 5, 1999. It hit $1.19 that day, but by December 3 of the same year it fell below parity with the dollar. The currency has since risen over 40% to $1.4172 as of this writing (it hit a high of $1.5892 on July 7, 2008). Now this appreciation versus the greenback has occurred despite the presence of the PIIIGS in the eurozone, with all the systemic risk that their potential sovereign defaults pose to European banking and economic growth. Imagine how much higher the euro might trade were the PIIGS to exit Euroland’s pen, remaking the euro into something more in the image of the old German mark!

So how did German exports fare before and after it traded marks for euros? From January 1991 to January 1999, under the old mark (1991 being the first full year following reunification) German monthly exports rose from around 30 to 40 billion euros, an increase of about 4% per year. By contrast, in the euro period from January 1999 to January 2011 Germany’s exports rose to over 80 billion euros per month, an increase of over 6% per year (German exports dropped sharply during the ’08-’09 financial crisis but have subsequently more than rebounded, hitting 97 billion euros in April 2011 before easing to 85 billion in September).

Would German exports have risen as sharply were the nation still using a mark, reflecting solely that nation’s monetary policy, as opposed to a euro in whose valuation German export strength, traditionally tight postwar German monetary policy and relatively conservative German fiscal policy are diluted by the PIIGS’ trade weakness and profligate budget policy, not to mention power sharing in the European Central Bank? I strongly doubt it.

To be sure, 60% of German exports still go to the EU, where the euro’s exchange strength would be irrelevant. But it is trade with China that is providing the growth in German exports, having risen four fold over the last ten years to rival the US as Germany’s largest single national market at 5.6% of the nation’s foreign sales, a figure that may triple by the end of this decade. This ballooning China trade is in turn driving German economic growth. Without the squealing PIIGS of the Eurozone’s periphery, a stronger euro could make German goods less competitive and have serious consequences for continued China-trade driven economic expansion.

There is perhaps some irony that, in addition to a “voluntary” 50% markdown in Greek bank debt, Europe is turning to China in hopes of having that nation finance some of the expanded $1.4 trillion European Financial Stabilization Fund, perhaps directly or through the IMF. Like Germany, China’s expansion is dependent on exports, and the global slowdown that could come in the wake of a euro collapse would threaten those sales. Meanwhile, Chinese inflation is still running high, driven by an undervalued yuan and tight commodity markets, so Beijing may also find continued euro-discounted German manufactured imports not unwelcome. And investment in euro assets provides China with some diversification from its substantial dollar holdings.

Chinese investment could at least lessen the need for debt monetization (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility”) and/or the issuance of Eurobonds directly backed by German taxpayers, perhaps under some kind of Eurozone fiscal union. That would be welcome news for Merkel. The former is anathema to a nation whose prewar experience with inflation had the darkest of consequences. As to the latter, Germany’s 83% debt-to-GDP ratio (it may hit 87% in short order, jumping from approximately 67% in 2007) is not at Greek or even American levels, but still speaks to Germany’s own bloated welfare state, which combined with past and potential bank bailouts, stimulus and Eurobond exposure to the PIIGS could yet make even German borrowing unsustainable, bringing us back to monetization and inflation.

So fortunately for Merkel, China seems to realize PIIGS are a desirable ingredient in dumplings as well as wieners. It remains to be seen if Beijing’s investments will eliminate or merely forestall the need for stronger measures. The Chancellor recently warned that the issuance of Eurozone debt and fiscal union would lead to “solidarity in mediocrity.” Yet when your export-led economy is partially built on the weakness of your currency partners, some economic convergence may be inevitable; a cruel truth, perhaps, but  then they don’t call it reversion to the “mean” for nothing.

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Downgrading Democracy

August 7th, 2011

Standard & Poor’s lowering of the United States’ Treasury rating from AAA to AA+ seems to represent as much an expression of no confidence in the democratic process as it is a rejection of the recent deal to cut the deficit and raise the debt ceiling.

The Wall Street Journal reports a Treasury Department claim that, prior to its decision to downgrade, S&P erred by essentially using a CBO “alternative” scenario for projecting the rate of deficits, as opposed to the “standard” baseline scenario. The result was a $2 trillion increase in the projected national debt over ten years (but hey, what’s a couple of trillion between friends?). This assumption would effectively counterbalance all but $400 billion of the $2.4 trillion in deficit reduction under the pact, providing only 10% of the $4 trillion increase S&P had warned would be necessary to avoid a downgrade.

According to the WSJ, when Treasury pointed out what it considered a “glaring mistake” to the rating agency, a “jarred” S&P decided to downgrade anyway, but changed the emphasis of their argument from the agreed-upon level of deficit reduction to “dysfunctional Washington political culture” and the “political setting.” In particular, S&P noted their pessimism regarding the challenge of making further progress in light of the difficulty of finding the narrow common ground achieved in the agreement.

Now one could be forgiven if one’s visceral sense of confidence in the republic is not bolstered by watching the President and Congressional leaders put on their version of a fiscal policy cage match. Yet realistically, had the debt ceiling’s increase been delayed, Treasury could have prioritized, servicing the debt and delaying payments for entitlements, employees, contractors and so forth. More to the point, a nation that borrows in its own currency and thus can print money to pay its debts presents little risk of default. This is precisely the difference between the United States and the individual members of the Eurozone.

To be sure, if monetizing the debt results in higher inflation, my view is that this constitutes a kind of real default (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility” and “The “Pained” Consumer Price Index”) but the risk reflected in credit ratings meant to be that of nominal default, of not getting back the currency you’ve loaned with the promised interest. What that currency’s future purchasing power or value in terms of other currencies might be for the future is an issue of great economic importance but beyond the scope of credit ratings, and for good reason. The nominal default of inflation and devaluation leaves the lender paid in the debased currency to service its own prior obligations fixed in that currency. The institutional and systemic risks of a “real” default are not present. Thus, as inflation and devaluation ravaged the value of the dollar during the 1970’s, for example, no downgrade of US debt occurred, and the global financial system continued to rely on the greenback as its reserve currency without skipping a beat.

With the US able to print its debt service, complaints over the speed of America’s democracy reaching consensus and that demand for an immediate $4 trillion deal seem curious at best. Some clue to the underlying logic might lie in the UK’s retention of its AAA rating despite a higher debt to GDP ratio than the US. Standard and Poor’s justifies this by stating its greater faith in the UK’s political process and Downing Street’s ability to execute its deficit-reduction plan. It is true that Great Britain’s parliamentary system gives far less power to the opposition party than that allowed by the US constitution. Implicitly, it strikes me that what S&P longs for is the stronger hand of an executive, with less of the debate and consensus-building America’s system demands in the name of freedom.

For two centuries and more critics have doubted that America’s raucous democracy could govern, let alone face the challenge of determined rivals. At various times those voices were heard in Kabul, Moscow, Beijing (reprising that song today) Berlin, Tokyo, and long ago even Whitehall. We’ve heard them from our own as well; Joseph P. Kennedy’s “democracy is finished” edict comes to mind. Yet I would argue that the genius of our system is to be found in moments like this, when such disparate and diametrically opposed world views as those of Barack Obama and Eric Cantor can be reconciled to produce agreement – partial, imperfect and requiring further work bur agreement none the less, and, in the end, with the consent of the representatives of the vast majority of the electorate rather than only of a majority ruling by narrow margin over its opponents, let alone of an absolute ruler.

That genius of American democracy can be hard to discern sometimes, over strident partisan voices on CNN and Fox (and today perhaps CNBC and Bloomberg). Perhaps to appreciate this brilliance one might paraphrase Swift’s famous observation, noting that when true genius appears in the world, it may be known by this sign, that the dunces are all in confederacy against it.

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The “Pained” Consumer Price Index

July 20th, 2011

With tax hikes being anathema to many Republicans, and Democrats similarly loath to cut entitlements, some in Congress and the White House are embracing a way to do both without admitting to either. The idea is to change the index used to measure inflation, employing what is known as the chain-weighted or “chained” consumer price index to determine cost of living entitlement adjustments and changes in tax brackets. It turns out this would slow the pace of growth in government programs while increasing taxes, albeit in a manner subtle enough that it may be hoped to go unnoticed by the bases of both parties.

To appreciate the elegance of this bit of statistical legerdemain, one has to understand the difference between the currently-used unadjusted CPI and the chained CPI. The traditional index is often criticized by economists for not taking into account changes in consumer behavior, such as switching purchases from one type of computer to another as technology and/or prices change, or from steak to chicken as the price of beef rises relative to poultry. Historically, measured inflation would have been suppressed by such substitution (by about 0.38% less per year by some estimates), and therefore so would cost-of-living adjustments to entitlement payouts and the CPI-driven ratcheting up of tax-brackets. The prevailing guess seems to be that a shift to the chained CPI would save the government in excess of $200 billion over the next ten years.

Now while swapping chicken for beef may reduce the rate of increase of the index, it does not reflect how happy consumers are about having been forced by prices and budget constraints to make such substitutions – what economists refer to as the change in utility of consumption. All else being equal, so long as consumers can find something to else to eat as beef prices rise – chicken, Spam, Soylent Green (Gen Y readers: look it up) – the government gets to count no increase in inflation nor any diminution in the quality of life*. Thus, under the chained CPI, the cost of living can be re-defined as the cost of surviving, begging the age-old question: “this is living?”

This indifference to reductions in lifestyle means the usefulness of the chained CPI goes beyond allowing a less than courageous Administration and Congress to effectively cut entitlements and raise taxes without admitting to doing so. As I’ve noted before, inflation represents a real default on the debt of the currency-debasing sovereign or sovereigns (see “Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility”). Should a sovereign’s central bank (e.g. the U.S. Federal Reserve) monetize the debt by purchasing government bonds and issuing currency to do so, then defining inflation downward insulates the budget from the upward spending and tax-bracket adjustments that would otherwise occur. This nominal fiscal sterilization of monetizing the debt may be accompanied by some degree of political cover, at least until the electorate gets tired of eating canned tuna instead of salmon filet, or the markets decide the jig is up and start selling off the bonds and/or currency in question. Given the growth path of the U.S. national debt and a Fed balance sheet already bloated with Treasuries purchased under “quantitative easing,” the “soft” default of monetization becomes that much more tempting when the attending inflation is made statistically stealthier.

To be sure, we should give the chain-weighted CPI credit for adjustments it might be getting right, such as changes in the purchase of goods due to technological advancement. However, here too the devil is in the details, for while not including new technology goods fast enough might bias the unadjusted CPI up by neglecting rapid early price declines, some tech purchases reflect the coercive nature of needing to keep up with the state of the art in order to function in society, as with a new television standard or operating system. Many innovation-driven purchases should be regarded not as the ongoing acquisition of ever cheaper, higher quality gadgets but as shocks; that is, sporadic and, to varying degrees, unanticipated additional forced expenditures increasing the real cost of living. After all, while the price of new computers may reflect a decline in the cost of a byte of memory and digital television look better than analog, one cannot function in society with 64K of RAM and an old-standard TV any more than one could now get by using the stone tools of a neolithic hunter-gatherer. The issue is not just improvements in quality but the social context in which they occur, i.e., the cost of living in modern society. Further, a shift in, say, video display buying from 60” flat-screens to cheap tablets might be driven by constrained budgets as much as innovation, and consequently reflect diminished lifestyle. Quality improvement can be in the eye of the beholder, and their subjective nature may give policymakers leeway to define away inflation even as it becomes more acute.

Just to keep government and central banks honest, economists may have to pay more attention to “pain-weighted” adjustments to CPI – the “pained” CPI, if you will, measuring the cost of getting back to the higher standard of living the chained CPI’s calculation assumes we don’t miss.

As the saying goes, there are three kinds of falsehoods: lies, damned lies, and statistics. That aphorism’s origin is disputed but generally dated to the nineteenth century. The Bureau of Labor Statistics, which calculates the CPI, was founded in 1884.

*N.B. for my economist friends: of course a formerly constant utility under a budget constraint (e.g., achieved under minimized expenditure a la Hicksian demand) may be made unobtainable if the price vector changes sufficiently, excluding the prior indifference curve from the feasible consumption set.

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BRICs, Not Homes, Did Break Our Loans, And Empty Words Will Hurt Us

May 23rd, 2011

The prevailing narrative of the recent global financial crisis holds there was nothing more afoot than the machinations of greedy bankers, reckless subprime borrowers, and supposedly pernicious products of financial engineering like credit-default swaps and securitized loans. This toxic stew of risk is generally presented as a purely American dish, though some add a continental side, such as a Greek salad of bad debt, tossed of course by American banks.

Yet risk represents a chance of something happening, not a certainty. A crisis requires more than risk – it needs something to transform the chance of catastrophe into a reality. Given the public debate’s failure to clearly identify the crisis’ ultimate cause, we should look for something of such enormity it might be missed by those inclined to believe all ills are to be found in the petty mendacities of bankers or borrowers, and so frightening that those with understanding dare not speak its name for fear not of some hidden hand’s reprisal but rather of the actions that populaces and nations might take were that understanding to become commonplace.

As its title suggests, this essay argues that a crucial and largely neglected cause of the recent and continuing economic crises is the unprecedented disruption created by the rise of the BRIC powers (Brazil, Russia, and for our purposes especially India and China) and other emerging nations. What I am arguing is that the market rout of 2008-2009 reflected not just a crisis in banking or finance but the first of what may well be many shocks in a noisy process of discounting our collision with resource supply limits to the rate of national and global growth, constraints that are becoming ever more binding, and ever more geopolitically risky, with the continued expansion of the BRICs.

It is true that the two years prior to the market crash of 2008-2009 saw a significant increase in the issuance of US subprime mortgages. By the middle of 2008, these stood at around 10% of an over-$10-trillion US mortgage market. From August 2008 to September 2009 the MBAA reports the percentage of all US mortgages in delinquency or foreclosure rose from 9.2% to 14.4%, or about $ 1.4 trillion. In June of 2010 Fitch put the percentage of subprimes in delinquency at about 45%, or $450 million (yes, the majority were actually not delinquent). This figure implies approximately $1 trillion of non-subprime delinquent mortgages, which is to say more than twice the amount of subpime delinquencies occurred in ostensibly well-documented loans to good credits. Thus the question is begged: what triggered the defaults?

In a similar vein, the repackaging of risky loans by banks who then short those bonds may move risk around to the detriment of some hapless investors, but this does not necessarily increase the riskiness of the financial system as a whole (indeed, that banks get these loans off their books can make them more stable). Likewise, credit-default swaps are essentially insurance against the failure of a borrower to service its debt; these re-allocate default risk between market participants but cannot trigger default any more than taking out auto insurance, in and of itself, can cause a car to crash.

So for some period of time, risky loans were being serviced, swaps, CDOs and all manner of financial beasts were on the books and the sky failed to fall. Then something happened.

If one is willing to look, one can easily find that something. The over two and a half billion inhabitants of China, India, and other emerging nations, possessed of the same aspirations as those dwelling in developed North America and Europe, comprise economies expanding at eight to ten percent per year. Their appetites for inputs to production – fuel, ore, grains, indeed almost any imaginable commodity, are growing accordingly. The emerging powers’ consumption of many of these raw materials is now approaching or exceeding that of either the US or EU, which basically means that in coming years the demand for these commodities will have been increased by half with little or no counterbalancing increase in supply. Simultaneously, the rise of the BRICs has explosively increased the global labor supply, and that worker pool is becoming increasingly skilled.

By 2008, the markets, which, after all, are discounting mechanisms, began seriously reflecting not just current but future demand for raw materials, as it became clear that, contrary to their track record in the twentieth century, the BRICs were now serious about growing into first-world status. Commodities, notably oil, spiked, developed nations’ corporate margins compressed and their equity markets began to fall. In the US, the weakest, most-overextended borrowers found simultaneously filling their gas tanks and making their mortgage payments increasingly difficult, especially as they were laid off by firms attempting to compensate for higher raw input prices by cutting payrolls and outsourcing to the cheaper labor of the emerging economies. Default rates rose, squeezing lenders and tightening credit, which begot more distressed firms and borrowers, accelerated defaults, and closed a vicious recessionary circle.

That circle was also briefly deflationary; as global growth turned to contraction, the price of petroleum and other commodities was driven down. Yet less than two years after the peaks of the summer of 2008, with only a relatively anemic recovery underway, we’ve seen the prices of these same raw materials approach or exceed those earlier highs. This rebound, despite tighter regulation, exchange rules and margin requirements, should give great pause to those who’d ascribe that earlier run-up solely to mere speculation.

And indeed that’s the point: the fundamental issue of the rapidly rising demand for raw materials on the part of China, India and others is still with us. (Fortunately the B and R in BRIC are net exporters of key raw materials, and Brazil’s Tupi oil find may keep it that way in the case of the former, at least as far as petroleum is concerned. But this production is swamped by the commodity appetites of India and China.) The effect is a linkage of economic and geopolitical risk that continues to evince itself. For example, increased BRIC demand for grains (for human and livestock consumption as well as fuel) helped drive severe food price inflation in much of the developing world, helping to spark the “Arab Spring” revolutions in Egypt and elsewhere, which in turn increased the risk premium in the the price of oil, further driving inflation risks that now confront central bankers, especially in India and China themselves.

As emerging economies continue to expand, finite commodity supplies constitute ever tighter constraints to growth, limiting the global economy’s expansion rate and creating trade-offs between growth and inflation in individual nations as well as competition between nations for the resources they need to grow. Add downward wage pressure from a vast and increasingly educated emerging nation labor force to international competition for raw materials and you have a recipe for protectionism, militarism and a variety of other unpleasant “isms” that make the world a more conflict-prone and dangerous place (China isn’t building a blue water navy to cruise the Yangtze, nor is its new “over-the-horizon” anti-ship missile some sort of New Year’s firecracker). This potential may explain the reticence among leaders to address these issues in a forthright manner, but avoidance, circumlocution, focus on tangential issues and scapegoating rhetoric will only make it harder to solve the problem and increase the danger of it spiraling out of control.

To be sure, dubious risk control and the failure of key financial institutions, notably Lehman Brothers, needlessly exacerbated the disruption, augmenting it with a liquidity crisis. Note to regulators and taxpayers: when a big bank goes bust, the markets need to know the shareholders will get wiped out (attenuating moral hazard) but credit will be extended so the firm does not default on its liabilities. Otherwise, banks question each others’ solvency, and soon interbank lending and the global credit markets dry up, meaning no one can get a loan. As we’ve seen, with the return of confidence, the capital necessary to accomplish such rescues generally gets paid back quite quickly and with interest.

Likewise, monetary intervention and fiscal stimulus eventually softened the blow. Inevitably, however, the anticipation of the unwinding of these methods limits their long-term efficacy.

All of this, however, pales in comparison to the secular macroeconomic change represented by the emergence of the new economies, not only as regards the causality of the recent crisis but the challenge of managing the international system in a world where finite resources could pit nations against one another, vying for the raw materials necessary for growth while billions of new workers come into the labor force. These are not problems that can be solved solely through financial regulation or even unilateral monetary and fiscal policy. Technology and innovation may eventually relax commodity constraints through the discovery of substitutes and new supplies, while the growth of the emerging economies’ internal demand may eventually absorb much of the new labor forces’ production. This evolution could take decades, however, and in the meantime I suspect unprecedented international coordination and cooperation may be necessary to manage growth and even preserve peace. This will be a process of great complexity, but surely the first step is recognizing the problem.

What of all those risky loans, the US subprime mortgages, distressed assets on the books of German landsbanks, Irish commercial lenders, Spanish cajas and even Greek and other troubled sovereigns? It’s easy to say any asset or investment that winds up performing badly was “too risky” after the fact. Some of these financings may well have been unwise, but we must ask what happened in the world to make them implode. If the cause of the collapse is not understood even after the fact, it’s hardly surprising that the risk of it was not appreciated beforehand.

As the old saying goes, when the tide goes out it reveals all the trash left on the beach. But it is the moon that drives the tide and not the detritus left in its wake. If we fail to grasp the ongoing disruptive and potentially destabilizing effects of the emergence of China, India and other new economic powers, we may find ourselves gazing up at a very bad moon rising.

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The “Crowding-In” Effect, Or, If Washington Wants To Help Small Businesses, Maybe It Should Borrow On Their Behalf

September 22nd, 2010

As I write this the US Treasury market seems to be providing a way for the government to put some money where its mouth is and do something meaningful for small business.

First, we’ll need some background. Throughout the debate on extending tax cuts to individuals making over $200K, many prior to this writing have pointed out that to not do so amounts to a tax hike on small businesses, with such firms accounting for around 60% of recent job creation in the United States (the increase would kick in at $250K for couples, about the combined salaries of two professors in a major metropolitan area, who would I’m sure be surprised and excited to learn they are now considered among the mega-rich). Indeed, by some estimates, to not extend the cuts would in fact raise the tax on half of all small enterprise income in the country Some argue, a bit disingenuously, that only 3% of small business would be affected, but that’s only because most small firms make little or no money at all; the tax increase would hit hardest that minority of entrepreneurs who in this anemic economy are doing well enough to have some hope of hiring.

And while there is a case to be made that tax cuts for lower earners more efficiently translate into short-term stimulative spending, it’s the saved and invested tax cut dollars of higher earners that tend to fuel longer-term growth in business and hence job creation.

Those in favor of this tax increase point to the ballooning national debt, arguing the country can ill afford tax relief for the entrepreneurial. Using some numbers to put this claim into context might be helpful. Not raising taxes on the so-called higher earners would cost an average of $70 billion per year over 10 years, or $700 billion. That’s about 23% of the $3 billion 10 year cost of extending the cut to the rest of the country (as proposed by the Administration), and well under the $814 billion cost of the stimulus package whose efficacy has been, shall we say, underwhelming.

Given how small the cost of tax relief on those most likely to invest would be when compared to the giant debt rung up over the past two years and the massive borrowing currently proposed, there is little logic in raising taxes on people managing some level of entrepreneurial success in this difficult environment. The truth of this is made especially clear upon consideration of one of the few silver linings to be found in the dark clouds of our economy, that being the government’s remarkably low cost of borrowing.

While risk aversion has abated since the depths of the crisis, many market participants continue to seek the safety of US Treasuries, thanks to a witches’ brew of fear including that of European sovereign and US municipal defaults, real estate overhangs, malfeasance real and imagined and yes, expanded regulation and higher taxes. Pervasive dread has pushed vast capital out of risk markets and into US government debt. You can think of this as the causal obverse of the famous “crowding out” effect, in which increasing government indebtedness pushes other would-be borrowers and those seeking equity investment out of the market. In the present case, the withdrawal of fearful capital from other forms of finance has created a vacuum into which ever vaster quantities of Treasury debt are sucked in, allowing the debt of the nation to be financed at rates at which most small businesses can only dream of borrowing. The past and potential purchases of Treasuries by the Federal Reserve under the banner of stimulative “quantitative easing” has (so far) served to further lower the yields on Treasuries. As of this writing, yields on 10 and 30 year Treasuries are about 2.5% and 3.75%, respectively, and this at a time when the implied inflation rate based on inflation-protected “TIPS” bonds is between 1.75% and 2.25%, making the expected real return on Treasuries slim indeed.

Thus the Treasury could fund tax relief for small businesses by effectively borrowing on their behalf at long-term fixed rates unattainable by them on their own, allowing the income of those enterprises to be reinvested. At these low fixed rates, with luck and limited further economic mischief in both the public and private sectors, there’s a reasonable chance the return on that capital will substantially exceed the cost of financing, facilitating the service of the added debt through the taxation of profits.

Some will complain this prescription further elevates a borrowing trend which is long-term unsustainable. I agree, but the increase is slight compared to the overall growth in the debt, which will in the end have to be addressed by other measures, including (dare I speak its name?) spending cuts, even in entitlements. Others will note the increase in Treasury issuance and the Fed’s purchases of same raise the specter of debt monetization, potentially driving up rates, weakening the dollar, and increasing inflation. Again that is true, but, the fact remains right now the world is willing to let the US lock in its financing at rates that seem to ignore this possibility.

Finally, there are those who will say I propose using the public credit to gamble on American entrepreneurship. Perhaps so, but given that we just bet over eight hundred billion dollars on, amongst other things, Amtrak and a combination of Chrysler and Fiat, I’d say my proposed wager is hardly the most speculative the nation has been presented with. Its time to give small business a chance.

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Test Stressed

July 23rd, 2010

By ignoring much of the potential impact of a sovereign debt crisis on the solvency of Europe’s banks, perhaps the regulators who ran the so-called stress tests released today were trying to send the world the message that they don’t take the possibility of a eurozone sovereign default seriously, and neither should the markets.

In conducting the tests, the Committee of European Banking Regulators and the European Central Bank assumed various haircuts on the values of Greek, Portuguese, Spanish and German debt, but applied these only to the trading books of the examined banks, not to their loan portfolios. In effect, this assumes that the impact of a contemplated crisis will be limited to a short-term liquidity discount on national obligations, but that any bonds held to maturity will in fact pay off in full. Indeed, Bloomberg quotes ECB vice president Vitor Constancio as saying a sovereign default scenario was not included because “we don’t believe there will be a default.”

As a result of this and other arguably dubious assumptions (apparently including parallel shifts in the yield curves of eurozone members – one would think such movements might be quite different for a defaulter as opposed to other euro nations) only seven of the ninety-one banks examined failed the tests and will be required to raise more capital.

Now the eurozone regulators’ gambit only works if the markets are convinced that member nations’ governments really have the will and means to prevent a true sovereign default. In fairness, recent EU and IMF lending initiatives combined with fiscal restructuring in nations including Ireland, Spain and to some extent Greece have lent support to the euro and European debt markets. However, by banishing true sovereign default from their realm of contemplated possibility, the CEBR and ECB have put far more of the responsibility for European (and global) banking stability back in the hands of Europe’s politicians. Banking on the vicissitudes of political capitals as opposed to increased bank capital might itself be a potentially risky move.

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Europe Learns To Default The American Way, Restoring Transatlantic Balance Of Irresponsibility

May 13th, 2010

The game-changing aspect of the eurozone member states’ plan to stabilize the euro is not the $139 billion Greek bailout or the trillion-dollar currency stabilization fund per se, but rather the about-face of the European Central Bank, which will now reverse a longstanding policy and purchase the debt of euro states. In doing so, the ECB and its president Jean-Claude Trichet, have opened the door the the monetization of euro sovereign debt, which is to say the effective real default implied by inflation and currency debasement.

In essence, the ECB can now create euros to buy Greek or other European debt, including cross-eurozone bonds issued to finance the euro stabilization war-chest. Since that fund could borrow to support the euro and the ECB can purchase that debt as well as the bonds of individual euro nations, the net effect is to allow the assumption of a distressed member state’s debt by the entire euro membership and the inflating away of that debt through euro creation on the part of the ECB.

If all this sounds familiar to American ears, it should, since the power to monetize dollar-denominated debt has long been possessed by the central bank of the “dollar zone,” that being of course the Federal Reserve. Indeed, most central banks around the world have the ability to inflate away debt denominated in the currencies they create. A crucial difference between the ECB and its brethren has been that sovereign borrowing in the currency over which it presides has been done by sixteen individual states, and that debt has until now been off limits for purchase and thus monetization. The analogous situation in the U.S. would be if all government borrowing were done by the individual states through municipal bonds.

Now, monetization with its attendant inflation and devaluation is indeed a form of default, since in real terms debt holders are paid back in money which will now buy less goods, services and foreign currency than it did when it was lent. Yet even if bondholders are burnt in terms of purchasing power , there are certain systemic advantages of real default over the nominal variety, in which lenders are paid only a fraction of the currency (euros, for example) which they are owed.

Consider banks borrowing from depositors in euros and lending to eurozone governments by buying their bonds. In a nominal sovereign default, the bank might not have enough euros to pay back its depositors, which is the kind of thing that tends to lead to bank runs. But in a monetization-driven real default, the bank gets paid in full and so do the depositors, albeit in a debased currency. Banks’ and depositors’ euros might not be worth much but they get each and every one they are owed. Financial institutions’ balance sheets may shrivel in real value but they continue to balance, avoiding runs and some types of systemic shocks.

Similarly, and rather paradoxically, the certainty of nominal payment under real default has at least one “operational” advantage in the creation of the reserve currency the eurozone members would like their currency to become: knowing the ECB can print euros to pay off euro debt, the world’s central banks can invest the currency in assets whose nominal return can be calculated with more certainty, as can future holdings of the currency itself. Again, the future value of that currency may be in question but not the amount of it to be received.

The balance sheet stabilizing aspects of real default can come at a high price, including the destruction of savings’ buying power, growth-killing price uncertainty and, as demonstrated in the Europe of the 1930’s, social unrest and war (this has something to do with the reticence of Germany in regard to the euro rescue, as evinced recently in the Westphalia vote). Inflating away debt is a treatment best administered sparingly, if at all. How much tolerance electorates of more solvent euro nations have for being taxed to pay the bills of their less productive, more profligate neighbors may well end up the determining factor for the euro’s survival, at least in its current form.

One silver lining for the Europeans (at current prices a golden one would be too much to ask for): with both the U.S. and Japan up to their eyeballs in government borrowing, the real default risks of dollar, euro and yen sovereign debt could at least partially negate each other in a rough balance of fiscal and monetary irresponsibility. And if these currencies’ mutual risk of debasement puts more pressure on China to revalue the yuan, I can almost hear a chorus of finance minsters singing hallelujah.

It’s worth mentioning that, in the wake of the Fed’s recent broad-spectrum asset purchase programs, we may yet see the day munis are added to that central bank’s balance sheet. After all, even a casual observer of the disconnect between California’s entitlement-driven spending and any realistic projection of its tax revenues could be forgiven for viewing Athens as simply Sacramento on the Aegean.

Addendum: Those of you who enjoyed my rather skeptical remarks on the role of swaps in the Greek crisis (“Greece And The Zen Of Credit Default Swaps”) may also enjoy a similarly-minded piece by Stefan Schultz in Der Spiegel, in which I’m quoted extensively. One caveat: it’s much more enjoyable if you happen to read German; if not, should you paste it into a translator program, note the amusing fact that Trester is the German word for wines otherwise known as marc or grappa, which is how my surname may be automatically translated.

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Greece And The Zen Of Credit Default Swaps

February 25th, 2010

If a nation is insolvent and no one knows about it, will it still default?

The implication of arguments in an article in today’s New York Times (“Banks Bet Greece Defaults on Debt They Helped Hide”) appears to be that the answer is no. The idea seems to be that because investors can use credit default swaps to insure against insolvency and learn from the price of that insurance what the market’s perception of default risk is, that default itself becomes more likely: “As banks and others rush into these swaps, the cost of insuring Greece’s debt rises. Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow. That, in turn, adds to the anxiety — and the whole thing starts over again.”

The key word here is anxiety, because the CDSs themselves can’t cause a default – they’re not an obligation of Greece. It’s the information they reveal about the riskiness of Greek debt that’s the issue – as the price of CDS insurance goes up, investors know the market believes the probability of insolvency has increased.

As the title of the ‘Times piece indicates, banks and the Greek government have been under fire for supposedly concealing the extent of Greek debt and thus hiding form the world the odds of Greek default. Now financial institutions are simultaneously being slammed for doing exactly the opposite: revealing to the public the riskiness of Greek bonds through the pricing of insurance against their default. That’s a bit too much hypocrisy for one financial crisis.

Indeed, if one were to blame the information revealed by CDS pricing for the sell-off of Greek debt, one might as well also blame the credit rating agencies for threatening to downgrade that nation’s debt rating, which has had the same effect. Aren’t these the same folks we were criticizing a few months ago for not ringing alarm bells fast enough?

The truth is much of the extent of Athens’ debt has been known for years, so when recession hit the market questioned Greece’s ability to pay. As the Greek economy has slowed, banks and other investors quite reasonably concluded that a county whose national deficit exceeds a staggering 13% of GDP (more than four times the EU limit!) is spending far beyond it’s means, with insufficient productivity, national income and tax revenues to cover it’s vast social spending. This is why the EU has also shied away from committing to a bailout of Greece; and, after all, many other European nations have similarly unsustainable spending and debt levels relative to national income.

If governments are ever to get their fiscal houses in order, they must not be allowed to obfuscate their irresponsible actions by pointing fingers at those who lent them money, insured against their failure or simply informed the world of the chance of default. If we allow them to confuse the issue in this way we do them, and ourselves, a great disservice.

Addendum: In a spot-on piece, Shannon D. Harrington of Bloomberg points out that “Greece Credit Swaps ‘Cabal’ May Be Just Sideshow”, arguing that credit default swaps spreads were more an “canary in a coal mine” as opposed to a cause of the crisis, and that “The credit-default swaps traders being blamed by German and French leaders for fueling fears of sovereign debt crises would be doing so with less than 1 percent of the governments’ outstanding debt being wagered…In Greece, where the heaviest complaints about credit-swaps trading have been leveled, bets of $9 billion compare with $267 billion of debt.”

I’d go even further, noting that the ability of the notional value of bets on the occurrence of a credit event to actually change the odds of the event is itself at least questionable. Even if the notional amount were on the same order as the debt itself this may simply reflect the borrower’s precarious position as opposed to influencing it. Some argue the CDS amount (and price) dissuade potential lenders, but even if investors couldn’t bet on a default it hardly implies they wouldn’t learn about the risk by other means much less turn around and lend to a risky credit. To the contrary, the fact that they can lay off that risk in a CDS or similar hedge may be the only reason they’d even consider additional lending.

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To Stimulate Job Creation, Try Helping People Who Actually Create Jobs

January 26th, 2010

First, a simple fact: according to the Small Business Administration firms with less than 500 employees created 64 percent of all new jobs in the U.S. during the fifteen years up to 2008, and employ over half of all private sector employees in the country. So, naturally, when Washington looks to allocate bailout and stimulus funding, the largess goes straight to bloated, uncompetitive layoff champs like General Motors.

So here’s a crazy thought: how about a little help for folks who actually have some idea how to employ people and make a profit doing it? The potential bang for the buck would be considerably higher in aiding small, innovative firms, or at least in getting out of their way. To do so, however, one has to craft solutions that acknowledge the special problems small firms have in this economy. Here are three approaches:

1) Cut small business payroll taxes. Tax cuts are part of the answer, but recognize that the recent downturn has sharply reduced or eliminated profits for many small businesses, and that early-stage firms usually operate at a loss or “burn rate” even in the best of economic conditions. (Note this last point is also true for older small firms reinventing themselves – a critical ability in an era of both innovation and financial stress – which is why focusing only on new firms would be a mistake). What this means is that while an income tax break for small business is certainly advisable, it will be of limited short term help to firms with little or no current taxable income. This is even more true for the administration’s proposed capital gains cuts for small companies, since such firms rarely have earnings in this form. If we want to help small business, a reduction or moratorium on the payroll taxes small business must pay regardless of profitability is probably the surest way to quickly aid struggling yet promising firms. Because the first priority should be to prevent layoffs and allow retention of the people needed to expand the enterprise and set the stage for future hiring, this cut should apply to the current payroll, not just the new employees the Senate jobs bill targets for tax credits.

2) Provide seed grants for small business in hard-hit urban centers. Cities are natural incubators for small business, providing extensive infrastructure and facilitating networking with an energy efficiency far higher than most suburban or rural locations. But these also tend to be high local tax and cost of living environments, partly because of their disproportionate role in addressing national social issues. In an anemic economy this higher cost structure can drive struggling firms out of town or out of business before they get strong enough to help sustain the city – for example, consider the demise of New York’s Silicon Alley. Federal “urban angel grants” could be used to counterbalance this effect, especially in formerly expanding new business districts that have recently fallen into decline.

3) Encourage venture capital. Access to capital is also critical for small business, and especially for start-ups. Surveys have shown that lack of bank loan availability, while an issue for such firms, is not at the top of their list of current problems. This is partly due to the fact that, with demand for their products and services having fallen so sharply, funding expansion is less of a priority. However, for early stage companies, debt is not the dominant means of financing. In fact, most early stage venture capital is provided in the form of equity, especially convertible preferred (this is a point a few of my economist friends will recall I demonstrated in a paper attributing the phenomenon to problems with debt’s foreclosure option under high probability of “asymmetric information” i.e when entrepreneurs are more likely to know more about the condition of their start-up than venture capitalists). Because this type of funding plays so key a role in backing new and innovative firms, venture capital financing needs to be encouraged right now, and care must be taken to make sure any new taxes and rules do nothing to harm venture capital formation. This means exempting venture capital investments from any coming increases in long term capital gains rates (indeed, cutting this rate would help) as well as from costly regulation contemplated for other financial activities (VC firms had nothing to do with the current crisis and what limited hedging they may do in the securities markets constitutes little systemic risk).

One might reasonably and even urgently ask where the money to do any of this would come from. The answer is from reallocation of some of the funds in the stimulus plan, much of which is slated to be spent sub-optimally. Alternatively, some of the unexpectedly high returns on TARP funds paid back by large banks might be used. Of course, there would be some merit in using these funds to simply reduce the deficit, but if the political winds cannot be prevented from blowing money off Capital Hill, at least let those gusts help fill the sails of a vessel of hope for real job creation. The name of that ship is small business.

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If Washington Won’t Regulate Like Capitalists, How About Like Chinese Communists?

January 22nd, 2010

The recent spasm of White House and Congressional initiatives to limit bank risk taking flies in the face of demands for more loan origination, and for good reason: lending is all about taking risk. This point may be lost inside the Beltway, but not in Beijing.

For example, the Obama Administration’s proposal to eliminate bank’s proprietary trading would sharply reduce the ability to take positions offsetting exposure created by a variety of customer financings, potentially increasing the riskiness of banks. Further, driving banks out of trading deprives them of a revenue stream which may have low or even negative correlation with returns on lending, removing a stabilizing counterbalance. Case in point: Phibro, the commodity trading firm formerly owned by Citigroup, produced earnings that lowered the funds Citi required from the TARP by hundreds of millions of dollars (regulators pushed the bank into selling Phibro to Occidental Petroleum for less than one year’s earnings, so we as Citi’s taxpayer-shareholders no longer have the benefit of that diversification – see “Taxpayers Saved from Morally Corrosive Profits As Citi Sells Phibro”). Private equity and hedge funds, two other businesses from which Obama would bar banks, also played no significant role in banks’ losses in the crisis, in some cases offsetting hits to loan portfolios.

Meanwhile, the White House plans to tax banks assets less Tier 1 capital and FDIC-insured deposits, which in plain English means a levy on the banks’ lending risk. The President claims his aim is to recover TARP funds. Leaving aside the fact that the big banks have already repaid those funds with interest, why would you tax lending at a tine when you are trying to increase it? As I’ve noted before, there’s a strong rationale for taxing banks to fund deposit insurance (see “You Don’t Want To Pay Deposit Insurance Premiums A Year In Advance? Fine – Then Pay Three Years Worth! You Wanna Try For Six?”). But both experience and academic research (including my own) demonstrate the time to increase that tax is when the economy is strong and lending risk is high, since it’s during a boom that a downturn is most likely. Increasing levies a period of economic weakness and low risk-taking delays and attenuates recovery. This crisis demonstrated a need to insure banks against runs on short-term liabilities beyond deposits, meaning a broader financial stabilization fund is in order, but the time to tax remains the same: during expansions, reigning in risk when banks are not undercapitalized, as they are now. Of course, the President’s tax would be used not for systemic insurance but to fuel federal spending, drawing capital out of banks just when more of it is needed to fund the lending required for recovery.

Then of course there’s the Congressional proposal to force lenders to retain a piece of every mortgage they originate. The idea is that they’ll be more careful in their lending if they have to keep some of every loan they make. But as demonstrated in a study I co-authored, the effect of restricting loan sales is ambiguous: origination may be more cautious, but when a downturn inevitably does come, those loans the banks were forced to retain will still go south, meaning a bigger bailout than if those assets had been sold. Restricting sales can thus actually lead to riskier banks.

How should bank risk-taking be regulated? The key is to recognize control is achieved not by eliminating risk taking but by making sure institutions are in a position to manage the risk they take on, and that means properly using tools like trading and secutization now under attack from Washington. It also means being responsive to economic conditions. For a more constructive approach, one might look across the Pacific, where China’s central bank waited until that nation’s recovery was in full swing (growth hit 10.7% last month according to Beijing) before increasing bank reserve requirements and tightening lending standards so as to dial down risk and deflate nascent bubbles.

Perhaps it’s unrealistic to expect this Administration and Congress to listen to council from capitalists (even the liberal-leaning Warren Buffet criticized Obama’s bank tax); populist bank-bashing is just too tempting, especially in the wake of a rebuke like that the President received in Massachusetts this week/ All I’m really asking for is regulatory policy less wrong-headed than that of the Communist Party of the People’s Republic of China.

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