Normative Narratives


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Economic Outlook: As U.S. Debt-Ceiling Battle Continues, China Seizes Opportunity

Original article:

China accelerated plans to internationalize its currency on Thursday by agreeing to swap euros and yuan with the European Central Bank in a deal that is set to be China’s second-largest to date.

The bilateral currency swap agreement between the European Central Bank (ECB) and the People’s Bank of China (PBOC) is valid for three years and has a maximum size of 350 billionyuan, or 45 billion euros ($60.8 billion).

The deal is the latest of a string of currency swaps that China has created with other nations to promote usage of the yuan in global commercial and financial transactions, with the ultimate goal of rivaling the dollar as a reserve currency.

“The emphasis is on renminbi internationalization,” said Louis Kuijs, an RBS economist in Hong Kong.

The yuan is now the world’s eighth most-traded currency, financial services provider SWIFT said this week, with a market share of 1.5 percent and overtaking the Swedish krona, the South Korean won and the Russian rouble.

To be sure, the Chinese renminbi is still a long way from rivaling the USD as the worlds primary reserve currency. While the renminbi has become the 8th most traded currency in the world at a 1.5% market share, the USD is still the undisputed king, accounting for 61.9% of foreign reserves according to the IMF. One of the main factors holding back the renminbi’s attractiveness as a reserve currency is the fact that it’s value is not determined on the open market but rather set by the People’s Bank of China. A free-floating renminbi is unlikely any time soon, as it’s low value is a crucial element of China’s export driven economy.

However, recent events point to increased attractiveness of the renminbi, and troubling signs for the USD as a reserve currency. The Federal government does not have to default on it’s debt obligations in order to hurt the standing of U.S. debt as the ultimate “safe-asset”; just the threat of a default led to the first ever downgrade of U.S. credit rating in the summer of 2011.

Furthermore, there are signs that markets are beginning to shy away from U.S. debt, leading to higher borrowing costs:

In good times and bad, the world’s financial system has long been able to rely on one thing: that the United States government would pay back its debt on time.

This assumption has made short-term government debt the most basic building block of the financial system, as reliable as a dollar bill.

In recent days, however, the fiscal impasse in Congress has been testing investors’ confidence. As a result, investors have been shifting their money out of the $1.7 trillion market for the short-term government debt known as Treasury bills, worried, for the moment at least, that they may not be the risk-free asset they have known.

The clearest sign of the changing perceptions has come in the prices for the bills that the Treasury Department is supposed to repay in the days right after the debt ceiling is set to be reached.

Normally, as the day of repayment for a Treasury bill gets closer, the chances of getting repaid go up and the bill becomes worth more to investors. Now, however, the opposite is happening, and the bills are becoming worth less than they were previously, making them available for a discount on their face value.

The discount on bills to be paid on Oct. 24 has grown by 400 percent since the beginning of the month; on Wednesday, it jumped 24 percent. That has brought the price that the government has to pay to borrow money for a month to three times what the average AA-rated American company has to pay, according to Federal Reserve data. Typically, the United States government can borrow money for less than big corporations.

Confidence in investments widely considered to have little or no risk has been periodically shattered in the recent past. Until 2008, most investors thought they could not lose money on mortgage-backed bonds that carried a rating of AAA. Last year, investors were forced to rethink their belief that countries in the European Union would always repay their debt.

In the longer term, the fear is that a default would dent the willingness of foreign investors to use Treasury bonds as a place to park their money. Their desire to do so today has made the dollar the world’s most widely used currency.

In remarks prepared for a hearing on Thursday, the head of the industry group for mutual funds, Paul Schott Stevens, said that if a payment was delayed for as little as a few days, “investors will learn a lesson that cannot and will not be unlearned.”

“That lesson is simple: Treasury securities are no longer as good as cash,” Mr. Schott Stevens said.

Let me be clear, the sky is not falling–yet; it seems that politicians on both sides of the political spectrum understand the importance of not defaulting on U.S. debt obligations. However, one has to question the long term effects of even the threat of a debt default. The G.O.P has proposed a temporary debt ceiling increase in exchange for negotiations over budgetary issues. This is not a good compromise, kicking the can down the road will just lead to another debt-ceiling showdown a few weeks from now; one has to wonder at what point global markets will begin to question the USD as it’s main reserve currency. Surely, every-time we have this debate, we risk a credit rating downgrade and further damage the sterling reputation of U.S. Federal debt. As a nation, we literally cannot afford to lurch from one debt showdown to another.

Perhaps investors, fed-up with American political gridlock and uncertainty, will begin to see China, with its insulated and unified leadership, as a safer place to park its money–surely China’s rulers would not even entertain the idea of a default on their debts. 

The debt limit is not a political bargaining chip; it must be raised in the very short-term, while entitlement and tax reform are longer term issues (which have been unsuccessfully negotiated for the better part of the past two decades, is it realistic to believe we will be able to reach a grand bargain in a few weeks?!). As the NYT editorial board put it, “First End the Crisis, Then Talk“. 

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Economic Outlook: Quantitative Easing, Monetary Policy Coordination, and the IMF

I was going to write a  conflict watch about the chemical gas attack in Syria, but as different actors are aligning with their interest and using mostly circumstantial evidence (Russia / Assad Regime: rebels did it, why would we launch chem weapons while U.N inspectors here?; Opposition / Western governments: Assad did it, emboldened by lack of international intervention after previous chem attacks, Assad subsequently shelled area so time would pass, now UN inspectors cannot get reliable results), I will refrain from speculating on these troubling events until more information emerges.

Continuing the narrative that has come to the forefront since G-20 finance talks in Moscow and the focus surrounding extra-territorial consequences of loose monetary policy at the Fed’s annual Jackson Hole meeting, policy coordination between central banks and new policy responses by IMF are needed to ensure as smooth as possible a transition from Q.E. to Fed monetary policy tightening (exactly when this will occur is uncertain, I am of the mind that it will be later rather than sooner).

Original articles:

Reuters:

Central banks should coordinate to avoid unwanted side effects as they exit from ultra-easy monetary policies that have left the world awash in cheap money, top policymakers were told on Saturday.

“The main challenge will be to manage the consequences of monetary policies, and their evolutions, on cross-border liquidity movements,” Jean-Pierre Landau concluded in a paper he presented to an audience that included top central bankers from advanced as well as emerging market economies.

The Fed’s bond buying, or so-called quantitative easing, has been at the heart of its aggressive efforts to revive U.S. economic growth after it cut interest rates to nearly zero in 2008. Interest rates in Europe and Japan are also ultra-low.

However, the purchases have spurred massive capital inflows into faster growing emerging economies, which are now suffering as investors anticipate an end to the easy money.

But he lamented that the necessary coordination on monetary policy was unlikely, and warned of the potential for the “fragmentation” of global capital markets.

Stocks and currencies plunged in India, IndonesiaBrazil and Turkey this week as investors fretted over a looming reduction in the U.S. Federal Reserve’s monthly bond purchases.

Landau acknowledged that central bankers dislike the idea of coordinating monetary policy because their job is to focus on domestic goals. But they worked well together during the 2007-2009 financial crisis, when the Fed, European Central Bank, Bank of Japan and other central banks coordinated rate cuts and currency swap lines.

As cross-border liquidity pressures build, they will find it productive to do so again, although cooperation is more likely through regulatory and financial structures aimed at preventing excessive leverage or harmful asset bubbles, he said.

In an ideal world, the cooperation would extend to monetary policy because policies in major economies such as the United States can have an international impact that amplifies their magnitude with domestic implications, Landau argued.

“The system itself is producing more accommodative monetary conditions than warranted by the situation,” he said. “In a reverse environment, when monetary policies need tightening, the effects could be symmetrical and complicate the exit from non-conventional measures.”

In addition, much could be gained through an international “lender of last resort,” which would remove the motive for some nations to maintain massive foreign exchange reserves, he added.

“All countries have a common interest in finding ways to disconnect reserve accumulation from exchange-rate management,” Landau said. “The need for national reserves could be reduced if credible mechanisms exist to provide for the supply of official liquidity on a multilateral basis.”

Economix:

The stimulus campaigns of the Federal Reserve and the central banks of Europe and Japan, by depressing domestic interest rates, have helped to push trillions of dollars into developing markets in recent years.

The question of what central banks are supposed to do about it dominated the formal agenda here at the Kansas City Fed’s annual monetary policy conference.

The answers were surprisingly mellow. The rest of the world would like the Fed to explain its plans clearly, and then to travel slowly. Bankers from developing nations said they might need to impose some restrictions on the outflow of capital, but expressed little concern over the potential for serious economic disruptions.

Christine Lagarde, the managing director of the International Monetary Fund, struck the same sanguine tone in a Friday speech, declaring that “Central banks handled entry well, and we see no reason why they should not handle exit equally well.”

She added that the fund – and by extension, the major economies – accepted that some developing countries might need to impose some financial controls. “In some circumstances, capital flow management measures have been useful,” she said.

This is not the way that policymakers used to talk. The big countries and the I.M.F. spent the last few decades pushing for the liberalization of financial markets. They argued that developing nations were creating their own problems by failing to take the painful steps necessary to moderate capital inflows, notably by allowing their currencies to appreciate. And they showed no tolerance for capital controls.

The argument for global monetary policy coordination– mainly that in today’s globalized world, where unfathomable amounts of money can and do flow at the click of a mouse, that a large countries monetary policy choices have a direct impact on other countries–has already been explored in depth.One of the most important developments in monetary policy over the last generation is the conclusion that central banks can increase the power of their actions by talking about their goals, thereby shaping the expectations of investors.” Managing expectations and policy coordination are logically related and present a synergy point for global monetary policy coherence. 

Central banks historically have served a dual mandate, to manage unemployment and inflation. A 3rd (secondary) mandate has emerged since the Great Recession; to manage the extra-territorial effects of monetary policy decisions.

Two other interesting points are raised in these articles; the issue of capital controls and flexible credit lines.

Capital Controls:

International  capital investments are necessary for helping least developed countries (LDCs) escape poverty traps / expedite their development process. However, the mobility and liquidity of capital in today’s digital and globalized age make capital flows intrinsically volatile–capital controls help temper this volatility. IMF managing director Christie Lagarde has endorsed the use of capital controls in certain instances, which represents a complete 180 from the IMFs “Washington Consensus” policies of the 1980s and 90s. When money is “cheap” (as it is now), it flows to places that offer a higher rate of return (i.e. developing countries). Capital controls provide a buffer from capital flight when monetary policy tightens (which is inevitably as the global economy recovers), which can otherwise have devastating standard of living / human rights implications.

Capital flight may lead to less investment / higher “risk premium” (investors will not like the idea of not having complete control over their investment), but it is surely should be a countries own decision what investments it allows in its country and under what conditions, considering the destabilizing nature of unchecked financial inflows. If speculative money does not wish to come into a country, that may be in that countries best long term interests anyways. The failure of “Washington Consensus” policies, culminating in global financial contagion during the Great Recession, has led the international financial community (headed by the IMF) to reverse it’s previous stance on capital controls.

Flexible Credit Lines:

Jean Pierre-Landau alluded to flexible credit lines with this comment;

In addition, much could be gained through an international “lender of last resort,” which would remove the motive for some nations to maintain massive foreign exchange reserves, he added.

“All countries have a common interest in finding ways to disconnect reserve accumulation from exchange-rate management,” Landau said. “The need for national reserves could be reduced if credible mechanisms exist to provide for the supply of official liquidity on a multilateral basis.”

Flexible Credit Lines are available to countries through the IMF if they meet certain preconditions (a shift by the IMF from imposing constitutionality on loans to having countries reach certain thresholds for eligibility, but after that providing assistance without conditions that can sometimes undermine development (see “Washington Consensus”). Countries gain access to funding by the IMF at an agreed upon rate (which is fairly low). By having this IMF insurance policies, countries are able to pursue policies in their best long-term interests (for example capital controls, or fiscal investments in public goods), as opposed to the short-term interests of speculative investors.

The existence of a FCL eases concerns of financial actors. The overall experience with FCL countries (to date Mexico, Columbia, and Poland, evidence suggests that Ireland will be next) has been overwhelmingly positive. These countries have been able to borrow at a lower risk premium without ever having to access FCL money–no FCL country has ever had to draw on FCL funds. The efficacy of FCLs is only amplified against the backdrop of the European Debt Crisis.

I am a strong advocate of both FCLs and capital controls for developing countries. Both policies are fully consistent with a human rights based approach to sustainable human development. Both policies can temper the destabilizing effects of capital inflows, giving governments the capital, policy, and fiscal space needed to respond to crisis situations. It is encouraging to see high level policy makers are of the same mind when it comes to monetary policy coordination, FCLs, and capital controls.

I invite my readers to view a PPT presentation (FCL Final) I did last year on FCLs. The study shows graphically the experiences of Mexico, Columbia and Poland before, during, and after the Great Recession (these three countries all performed very well compared to comparable countries). It concludes by arguing for “scaling-up” of FCLs by offering them to more countries as a potential development tool.

 


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Economic Outlook: (Hopefully Learning) Lessons From Japan

Japanese economic policy, named “Abeconomics” after Japan’s Prime Minister Shinzo Abe, offers a natural experiment from which the U.S. can draw lessons. There is a much more obvious natural experiment for the U.S., which is U.S. economic policy, but those against “Quantitative Easing” are never short on reasons for why QE hasn’t debased the dollar / led to soaring interest rates on U.S. bonds (but soon will ahhtheskyisfallingmoralhazard!!!!!). Perhaps Japan’s experience, which is further removed from the U.S., can allow us to be more objective in our analysis.

The basis for expansionary monetary policy is due to “liquidity trap” macroeconomics. When the Fed cut’s interest rates near zero, non-traditional means of using monetary policy are the only policy choice left to stimulate aggregate demand and reduce unemployment (as far as monetary policy goes, fiscal policy is another story to be addressed shortly).

Both the U.S. and Japan have greatly increased the supply of money in attempt to revive the economy. QE in the U.S. has basically quadrupled the Feds holdings since 2008, while Abeconomics has doubled Bank of Japan’s (BoJs) holdings. In the U.S., the dollar has remained strong despite QE. In Japan, the Yen has slid in value (and this is a desired result, to increase export competitiveness):

“Normally a weakening exchange rate might be taken as a sign of decline. The yen has fallen nearly 14 percent against the dollar this year, and no currency has fallen more except the Venezuelan bolívar.

In Japan’s case, it is a sign that the policies put in place by Mr. Abe and Haruhiko Kuroda, chairman of the Bank of Japan, are starting to work. A weaker yen makes Japanese exports more competitive around the world.”

The U.S. probably benefit from a slightly weaker dollar, making exports more competitive which could help revive U.S. manufacturing and renewable energy industries (among others). I believe the USD role as primary international reserve currency (60% of international holdings) are keeping the dollar strong despite QE. Foreign holders do not want to see the value of their reserves go down, so the dollar continues to be the safe-haven for investments despite unprecedented monetary stimulus.

How effective have these policies been? U.S. unemployment has dropped to 7.5%, although underemployment and people dropping out of the labor market may be producing a rate that doesn’t capture the stagnation in the job market in the U.S. Japanese unemployment sits at 4.1%, a rate that for the U.S. would currently constitute an economic pipe-dream.

Japan certainly has its issues, but it is not letting doomsayers dictate its economic policy. Despite much higher gross government debt to GDP (Japan has roughly 235% debt to GDP ratio, while the U.S. is at about 107%) Japan is pursuing fiscal stimulus. Abeconomics includes a 2-2.5% of GDP stimulus plan for Japan. Compare that with the fiscal contraction in the U.S.

So the U.S. and Japanese economic policies give us a natural experiment. Both are advanced countries with highly skilled labor forces and strong financial markets. Both are pursuing monetary expansion. One of the countries, despite a much higher debt-to-GDP ratio, is also pursuing fiscal stimulus, while the other is pursuing fiscal contraction. Granted Japan went through years if not decades of stagnant growth before flipping the script to “Abeconomics”. The U.S. is “only” 5 years removed from the Great Recession. Do we really need to wait decades before we pursue policy that we know will stimulate the economy and reduce unemployment / the output gap?

As Keynes said, “In the long run, we’re all dead”. It is not enough to say give it time and things will get better. Peoples skills and confidence in their abilities are deteriorating in the U.S.. The output gap is large and growing, and spending on safety-net policies will not decrease until unemployment goes down (hence “automatic stabilizers”). Hopefully Japan’s successes will inspire confidence in fiscal stimulus; if a country with twice as high of a debt-to-GDP ratio (and an unemployment rate almost half as low) can benefit from fiscal stimulus, surely the U.S. can as well.


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Economic Outlook: Defending Bernanke’s Defense of Fed Stimulus Policy

Yesterday, Federal Reserve Chairman Ben Bernanke went before Senate to defend the Federal Reserves loose monetary policy. The Federal Reserve has engaged in “Quantitative Easing“, pumping “cheap money” (because the fed can borrow at basically 0% interest rates) into the economy to stimulate consumption and investment (and therefore reduce unemployment).

It is important for the Federal Reserve to partake in unconventional monetary policy. Usually, the Fed adjusts the interest rate to stimulate the economy in one direction or another (speed up a slumping economy or “cool down” an over-leveraged economy). But up against the “zero-bound“, the Fed has to use less conventional policy as the interest rate cannot be lowered below 0 to stimulate the economy.

“The Fed, which has amassed almost $3 trillion in Treasury and mortgage-backed securities to promote more borrowing and lending, is expanding those holdings by $85 billion a month until it sees clear improvement in the labor market. It plans to hold short-term interest rates near zero even longer, at least until the unemployment rate falls below 6.5 percent.”

The Fed is going to keep buying assets until the economy recovers, measured either by an unemployment rate below 6.5% or an inflation rate above 2%. As Inflation does not seem to be an issue currently (despite greatly increasing the supply of money in the economy, the USD has remained stable), the unemployment target seems to be the one that the Fed has focused on.

Exactly why the dollar has remained stable despite greatly increasing the monetary base is up for debate. The main argument is that since we are in a “liquidity crisis”, newly printed Fed money is simply taking the place of private sector money (which is being horded, see corporate profits). Therefore, even though the overall money supplied by the Fed has increased, the actual amount of dollars available to the market has not really increased.

Another explanation is that the USD is a global reserve currency (about 60% of global reserves are denominated in dollars). Not only does the US have stake in a strong dollar, but every other country does as well. Other countries have no interest in seeing their real reserve levels fall, and export-based economies have no interest in competing against a weaker dollar (which would make their imports cheaper and exports more expensive).

Therefore, a concerted global effort has kept the dollar stable despite the expansion of the monetary base. It is probably some combination of these two forces, along with other forces, that has kept the dollar stable. It should be heartening to see that the world still believes in the USD as a reserve currency post-Great Recession, a signal that the U.S. BOP and Federal deficits are sustainable (even if they are higher than politically popular).

Back to Bernanke being grilled by Senate: ” Mr. Corker [Senator, R, Tennessee] then accused Mr. Bernanke of insufficient concern about potential inflation, saying, ‘I don’t think there’s any question that you would be the biggest dove since World War II,’ using the term “dove” to denote a Fed official who is more concerned about unemployment than higher inflation.

Mr. Bernanke, clearly piqued, responded, ‘You call me a dove, but my inflation record is the best of any chairman in the postwar period.'”

Mr. Bernanke is simply using the policy tools available to him that fit the current situation. If inflation was high and unemployment was low, his policies would be very irresponsible. But given the current economic climate, the Fed’s policies make sense. Mr. Bernanke understands the monetary system better than most; his academic work revolves mainly around monetary policy during and after the Great Depression (and liquidity crisis monetary policy). His knowledge of monetary policy in face of economic downturns is amongst the best in the world, and I for one believe having Bernanke as the chairman of the Fed has helped an otherwise weak economic recovery.

But might the Feds actions disrupt markets, causing asset bubbles instead of helping the real economy?

“Jeremy C. Stein, a member of the Fed’s Board of Governors, and some other Fed officials have expressed concern in recent months that low interest rates were encouraging excessive risk-taking by investors pursuing higher returns. Mr. Stein in a recent speech highlighted rising demand for junk bonds and certain kinds of real estate investments, and shifts in bank balance sheets, as areas of potential concern.

Mr. Bernanke said the Fed took these concerns “very seriously,” noting that the central bank had significantly expanded its efforts to monitor financial markets, as well as giving greater priority to financial regulation.”

One could argue that the Fed should be lending directly to business and individuals instead of using the financial system as an intermediary (after all, the financial system by-and-large got us into the mess we are currently in). There is a strong argument here, but this is simply not how the Fed functions (and drastically changing the policy of a major institution takes time, this cannot be a short term fix but perhaps an idea to consider going forward). This time around, it is up to strengthened financial regulation and adequate capital market taxation to ensure bubbles are not a byproduct of loose monetary policy (hopefully the sequester doesn’t hit the SEC too hard, or this job will prove even more difficult than it already is):

Monetary policy cannot shoulder the whole load of this economic recovery, as Bernanke himself has stated. However, while fiscal policy remains deadlocked in partisan bickering (it seems that fiscal stimulus is unlikely anytime soon; it would be a victory if the U.S. could avoid fiscal austerity, a.k.a. the “sequester”). It is therefore even more important than usual to have loose monetary policy (both because of the reality of a global liquidity crisis and the inability to address economic concerns via fiscal policy).

Bernanke has made it part of his mission to make the Fed more transparent and engaged with the American people. This is a noble pursuit, as members of the Fed are not elected but instead appointed by elected officials. Monetary policy is inherently confusing, even to trained economists; the ability of Bernanke to make people feel more engaged in the process is a difficult proposition. I hope I am in some small way doing my part to help explain why the Fed is doing what it is doing. People have to forget any Econ 101 they may know or think they know (increasing the supple of something reduces it’s value), as we are currently in a very specific situation which calls for a very specific policy response.

It seems Bernanke’s words have had a calming effect on the global economy, as assurance that the Fed will not abandon it’s bond buying program drew a favorable response from markets. It would be nice if people agreed with what Bernanke was doing, but it is unrealistic to expect the lay-man to understand liquidity crisis monetary policy (even I, and people with more training than me, have trouble with it). It is a great benefit to the U.S. and global economy to have someone as knowledgeable as Ben Bernanke running the Federal Reserve.

 

 

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