Wednesday, January 28, 2009

On Debt to GDP

Martin Wolf (hat tip S) has put out a piece describing the massive levels of debt outstanding in major economies and the options available to them in resolving that debt overhang.  What does debt to GDP really mean, though?

It seems like a meaningless ratio on its own: as he notes, debt nets to zero.  A highly financial economy might have a lot of credit outstanding, as individuals choose to obtain mortgages with one hand while investing in corporate debt with the other.  A less financial economy may involve individuals paying cash for houses.

But there are likely very important structural changes when debt to GDP increases.  It generally coincides with financial deepening.  The real economy becomes more responsive to changes in financial conditions, and the financial system becomes more responsive to changes in growth.

Financial Deepening and Stability

Well-developed financial systems are tightly interwoven with the real economy.  Some degree of financial service is very beneficial for an economy, helping investment and growth occur.  Without intermediation of savings and investment funding, a lot of opportunities would be missed.

But dangerous instability arises when there is too much financial servicing, and as a general consequence, too much debt.  The overgrown financial system becomes extremely sensitive to changes in trust, securitization, interest rates, risk preferences, credit availability, and so forth.  Because this financial system has also become deeply connected to the real economy, booms and busts become much more likely.

Current levels of debt are apparently associated with severe financial frailty.  I don't know where the right level is, but around 130% debt to GDP is a historically stable ratio.

The level may well be different for different economies and different financial systems, giving us leeway to believe we were in a brave new financial world.  All the esoterica being traded and the general stability of output and inflation made that transition more credible.

Investment Finance or Consumption Finance?

Banks are not simple intermediaries between saving and investment.  Through fractional reserve lending, they can finance many projects on a small base of savings.  From a Keynesian perspective, this means the bank is effectively replacing current savings with investment finance.  Whether a loan will be issued depends on the anticipated proceeds from the loan and the cost of the lending, not whether there's actually savings to lend from.

This means that a growing debt-to-GDP ratio indicates that the financial system is funding a lot of current consumption and investment, in anticipation of a future increase in production resulting from that consumption and investment.

In essence, the bank is a recursive bridge between the current supply of saving and anticipated future production.  If future production fails to reach the levels anticipated, someone has to take damage.  Savings act as a cushion for that damage, which is why RRR's and leverage limits are important, even though they're difficult to enforce.

But most investment in modern economies comes from retained earnings.  Since corporations saw little better to do with their earnings during the best of times than buy back stock and pay dividends, and most GDP growth was consumption anyway, I'm a little doubtful that there will be much in the way of new production resulting from this accumulation of debt.  I strongly suspect it went via HELOC's and other channels towards current consumption.

With these details in hand, the debt-to-GDP ratio looks a little more ominous.

Reducing Debt Levels

To cut debt-to-GDP, either defaults occur, inflation rises, or we wait for that future production to arise, the three options Wolf lays out.  He concludes it's best to drag the repayment out long enough that the debtor promises can eventually be repaid.

If the projects that have received the funding can indeed grow production eventually, then lenders will be made mostly whole.  Funding available to new projects will be limited for awhile, as resources are dedicated to the old projects.

But implicit in that selection is an assumption that sustaining the projects that were funded will lead to more GDP growth than would the tedious process of bankrupting the old debtors and funding new ones with the newly vacated resources.

I'm skeptical.  First, I don't trust zombies.  I am fond of creative destruction and controlled default.  Second, most of this borrowing probably went towards consumption, with a bit to residential investment.  These claims on individual households aren't likely to result in future production unless we have a major outbreak of productivity.  I see little reason to spare households from bankruptcy for their own good: bankruptcy is very kind to them.  There's a much stronger incentive to prevent bankruptcies for the owners of the claims on the households.

On that point, I've got two more posts coming on how I believe, based on the rise in financial depth and debt-to-GDP, the concentration of wealth in the hands of the few and the tilt towards consumption were inevitable.  For now, count me as a Mellonite.

Tuesday, January 27, 2009

Bad Bank Recapitalization

Further details are now leaking on the good bank/bad bank plan.  It smells awfully similar to the first version of the TARP, which was abandoned because it was very difficult to put into practice.  This version is just as bad for the taxpayer and about as nonsensical as the original.

Does the strategy itself even make sense?

Banks are still lending as much as would be expected from experiences in prior recessions.  But that's not enough for our credit-dependent modern economy, so we want them to lend more.  Despite having $843 billion in excess reserves, they are unwilling to do so.  In an environment with excess consumption and excess investment, that may be a perfectly reasonable decision.  Banks want a better risk/reward proposition.

We have done a lot to force the reward prospects down in order to make borrowing more appealing to businesses and consumers.  The interest available on mortgages and commercial paper, for example, is far less than that which would clear the market without government intervention.

We've also done a lot to limit risk faced by banks, such as FDIC-guaranteed bonds, loss absorption by the Fed, and implicit guarantees.  The new offer to pay full book for grossly mismarked assets, despite some issuance of common as a token gesture, would be a risk reduction significantly larger than those already announced.

This should make the risk/reward ratio look more appealing, but this is just a mirage.  It does not reduce the total risk; it only diverts some of the bank's risk to the Treasury and taxpayer.  This diversion might be large enough, in which case loans will be made against the banks' better judgment.

The IMF has found recapitalization of this sort to be conducive to better economic outcomes.  The Austrian in me is skeptical.  I find it very hard to believe that further extension of uneconomical loans at abnormally low interest rates is beneficial either to the economy or sovereign credit.

One thing is certain: this will reinvigorate our climb ever higher on the debt-to-GDP mountain, a far more complex and interesting crag than I would ever have guessed.  More on that later.

Saturday, January 24, 2009

Pondering Sino-American Economic Tension

Because this is contentious territory, let me disclose up front my biases.  I'm a proud American who has visited many parts of China.  I've got endless affection for both countries and the extraordinary contrast between them.  Here are my views on the underlying imbalances.  I strongly advocate trade and mutually beneficial solutions.  This post is solely intended to assess choices I see available to involved parties and the ramifications of those choices.

America's Policy Preferences: Herehere, and here.
China's Policy Preferences: Here, here, here, and here.
While prepared for public consumption, I believe they reflect internally held views well.

Each side clearly holds the other to blame for this crisis, while the reality probably falls somewhere in between.  Regardless of the root issue, the preferences for adjustment in trading terms are not at all congruent, and friction can be expected.  What could each party do to improve the chances that their preferences are realized?

Trade Provisions: China is unlikely to impose further tariffs to protect domestic industry from international competitors, though it may increase export subsidies.

The US has a higher propensity to impose import tariffs or limitations, particularly under the Obama administration.  But the US does not have large domestic industries that compete with Chinese industry.  The US economy is heavily services based, while China primarily exports goods, particularly textiles and machinery.  Imposing tariffs on Chinese exports could eventually foster domestic US industry in those categories, but consumers would face stiff cost increases on necessary goods at a time when disposable income is at an absolute premium.

Subsidizing US exports would be an alternative.  China has complained that the US is unwilling to export high technology products.  However, a large proportion of China's own exports are high technology.  The remaining sectors may be entirely off limits for reasons of national security or other political aims.

I'm not convinced that there is sufficient export volume in categories where the US is competitive for tariffs to be even a net win for the American worker.

American Capital Controls: Some commentators have suggested the US impose capital controls.  I have to confess to not understanding how this could help.  Any implementation would be a severe shock to the global financial system and the immediate end of the USD as a reserve currency.

The US could try to prevent capital from coming in, or prevent capital from going out.

On the outbound side, the US faces no capital flight by private investors at present.  Much of China's investment is already basically trapped in USD, as using it for any practical purpose over a reasonable period of time is basically impossible.  Such capital controls could be used in a true emergency, but I don't anticipate that eventuality at present.

Could they be used to prevent the PBoC from sustaining its peg?  Probably not: China is receiving an excess of dollars not through capital flows, but through trade flows.  Exporters want to convert USD to CNY.  We can't help them do that, and even if we could, the PBoC would offer a better rate.

China Dumping Treasuries or letting the CNY appreciate: This has long been held as China's "nuclear" option.  Revaluation of the CNY upwards may have been an option in better days, with inflation and the cost of raw commodities soaring along with exports, but now with every trend reversed it's a distinctly unsavory prospect.

China could still sell its long treasuries and agencies, which would drive long interest rates higher.  But central banks have already been moving aggressively into shorter-dated paper, while interest rates have been maintained at very low levels as the Fed steps in to purchase the agencies and treasuries that China no longer wants.  This option has thus far been a paper tiger, at best somewhat reducing China's exposure to a resurgence of US inflation.

China "Diversifying":  I think this is China's real nuclear option.  Rather than letting the CNY appreciate or float, China could purchase EUR, commodities, etc. with USD.  This would force the USD down and the pegged CNY down along with it, driving down the price of exports to Europe or securing a large base of commodities for future domestic use.  Such a move would be harmful to European exporters or countries that depend on commodity imports to maintain economic growth, but beneficial to China.

The optics for such a move are very good.  Who, after all, could blame China for wanting to diversify their vast dollar holdings at a time when the US appears unstable and uncooperative?

China Weakening the CNY Further: As the ultimate in beggaring thy neighbor, China has pledged to avoid further devaluing the CNY in this environment.  Whether temptation will prove too much is unclear.  If this were performed, some version of Bretton Woods 2 would revive itself for a little while, increasing China's exports and growth and providing more credit to the US, but all the imbalances built up to this point would be worsened.  It's no permanent fix, and may not even be a temporary solution now that the US consumer is collectively puking its guts up in an alley somewhere off Fifth Avenue.

The most important point is one I haven't touched on here.  There are many nations in the world.  China may be the Saudi Arabia of manufacturing, and the US may be, well, the US of consumption, but there are many other manufacturers and consumers, leading to the OPEC problem redux.  Any action may be foiled by other desperate countries less willing to play nice.

I see few productive steps available to individual countries with the restrictions of current policy goals.  Counterproductive actions, by contrast, abound.  I hope earnest negotiations are performed to reach a better outcome, but heck if I know how to get from this A to that B.

Thursday, January 22, 2009

Why Would a Strong Dollar be in America's National Interest?

The comments from Geithner's confirmation hearings have been very interesting to me, because officials with good information or policy insights often state things between the lines.  There were two particularly interesting currency tidbits that emerged: that Obama considers China to be a currency manipulator, and that a strong dollar is in the US national interest.

Here are two key speeches Geithner gave in 2006 containing very prescient thoughts on the vendor financing and global imbalances that have since given way into a collapse in trade.

Currency Manipulator

The US has repeatedly refrained from accusing China of currency manipulation in the past, presumably out of any reluctance to rock the boat by calling a spade a spade.  Geithner has taken a more confrontational approach already.

This opens China to a spate of possible actions, but it's unlikely to inspire China to consentingly float its currency, and directly triggers no meaningful action.  It's mostly interesting as an indicator of a little more abrasion between the nations than the relatively harmonious relationship that Paulson fostered.

I predict some fairly heated arguments at the WTO at some point in the future, since the parties have apparently failed to reach agreement in the back rooms.  The alignment of other nations in such WTO disputes will be interesting.

This is arguably a good step towards healing the world, and I commend Geithner for taking it.

Strong Dollar?

Geithner said in oral testimony that confidence in a currency is critical, a point with which I heartily agree.  This was escalated in more considered written response to the Senate panel to the old strong dollar policy, however.

That baffled me.  A strong dollar is a potent deflationary force by its very nature, making American employees, goods, and services less competitive without slashed prices and wages.  It also tends to worsen trade deficits.  That's bad, right?

It also seems to work contrary to aggressively stated goals of the FOMC to ease as much as they can ease, where Geithner has worked for awhile.  That strange melange matches Summers' earlier policy prescriptions for Japan during his stint as Treasury Secretary:
An ideal Japan a la Summers/Krugman would have a high yen, ultra-low short-term interest rates, low long-term rates, and lots more money in circulation.
However, as Martin Wolf points out, the US is a terrible analogue for itself in the Great Depression or Japan in the 1990's, making the policy seem at first blush totally wrong.  So why this move here and now?

Here are some possibilities I ran through my head:

1.  Wards of the state, like Citigroup, have significant liabilities, such as bank deposits, that are denominated in foreign currencies.
2.  We'd like to return to the vendor financing world as an expedient towards more overt reform once stabilization occurs through a return to that bad equilibrium.
3.  Scared creditors to the US strong-armed the Obama administration into a hollow statement.
4.  Geithner wants a stronger USD against EUR, GBP, and commodities, and a weaker USD against the CNY and JPY, to directly target the bilateral trade deficit.

I can't systemically square #1 well with the NIIP data, though it's sure to be a problem in specific cases. #2 and #3 are not convincing to me in light of the manipulator statement.  I find #4 to be plausible and fascinating, and it fits with my earlier narrative on vendor financing.  I need to think it through.  Does anyone have alternative suggestions?

Monday, January 19, 2009

Financial Evolution and Zombies

Bailouts affect more than simply the company being rescued.  They also have an impact on the economy as a whole, particularly on the sector in which the new zombie lives.  What are the macro effects of our new undead friends?

Financial Evolution

I'm not sure whether the concept is raised elsewhere -- and would appreciate better-read readers informing me here -- but I'm fond of an idea I call financial evolution.  I think it lies outside Minsky's work, but I haven't read enough original text to know.

Let's imagine a world where risk is underpriced, and those firms and individuals more willing to assume risk also receive outsized rewards.  Over time, as the risk premium adjusts to its normal level, these daredevils will receive just compensation for their gambling proclivities in two crucial forms: higher profits, and a greater propensity to stay employed.

Minsky made the key observation that as the risk premium subsides, more businesses and individuals will be comfortable assuming more and more risk.

Financial evolution is the second order here: the survivors, and particularly the survivors with the most capital, are the units who were most predisposed to risktaking.  More profits accruing to risktakers gives them more raw capital to work with, and hence control over a greater portion of the financial system.  In tandem, exceedingly cautious individuals risk firing for repeatedly missing profit targets.  Together, there's a strong cyclical reinforcement in not just the Minskian risktaking of individuals and firms, but which individuals and firms are strongest.

At the end of a boom, capital will be excessively controlled by people who base jump on the weekend.  Conversely, at the end of a bust, those who spend their weekends hovering over 10-Q's and doom-mongering on eschatological financial blogs will command too much of the economy.  I believe this forcing function is a strong component of the business cycle.

The Rise of the Zombies

As our present business cycle reverses itself sharply, we would normally expect to see a culling of the excessively bullish and a reassertion of balance.  Those who were too optimistic lose all their money, those who were too cynical are wealthy -- but still cynical -- and a lot of firms go under.

Government intervention, ostensibly to save the system, introduces a deus ex machina to our story.  This is true to a lesser degree with common interest rate setting, but more evident today.

The unfit are not culled by their own bad decisions in our too-big-to-fail world.  Instead, they're given a fresh breath of un-life.  These zombies return only as caricatures of their original selves, with the notable institutional aspect of willingness to assume risk at a low cost exacerbated by extraordinarily deep capital pools, an exemption from P&L considerations, and political rules that trump economic rules.

Taxation is another feedback loop.  Governments and their undead minions are generally unconcerned with profits, as their revenue comes primarily from seigniorage and direct taxation of profitable concerns.  As the ranks of zombies grow, the burden of supporting them on surviving enterprises grows heavier.  This parasitic behavior is another feedback loop damaging healthy companies and bolstering the zombies.

We must particularly look at the international ramifications of this strategy.  Having healthy, efficient industry is a strong benefit to any nation in good times; competition is good for a country.  However, during times of deficient aggregate demand such as a severe recession, the temptation will always exist to devalue and export your way out of the problem.  Put another way, in times of excessive competition, a little collaboration will be very appealing.

Governments and corporations have strong mutual interests to collaborate in those times.  Countries that are accessible to foreign zombies will generally need to zombify themselves, as they otherwise risk destruction of their domestic competitors by these artificially strong rivals.  Eventually, a country that is sufficiently undead is likely to fall, but that can take some time, and take a lot of healthy entities out with it.


Prudent businesses face now not only the lingering competition from careless competitors, but their stronger reincarnate forms.  Countries that enforced vigilant regulation now face those competitors too.

AIG has been repeatedly accused of undercutting competitors with offers that are simply not profitable or viable for private sector enterprise.  It will be exceptionally difficult for anyone to match a public sector insurer with such deep capital.  From the government's perspective, rebuilding AIG into a viable enterprise is key to its offloading, so these Faustian bargains will appear cheap.  All insurers who are not state-sponsored will face extraordinary battles to survive.

GM and Chrysler, joining a long parade of global auto bailouts, will reinforce the excess capacity worldwide in car production and exacerbate the un-viability of the entire sector.  Fitter competitors not accessories to the groveling, such as Tesla, first protest the unfair advantage, then stoop to their level out of pure economic necessity.

The same issue is strongly present in banking.  Competitors without sovereign backing will eventually find it difficult to compete, and many may either fold into the government or fold entirely.

Financial evolution will cause competitors with no access to government funding, or a reluctance to accept it, to gradually fall victim to the zombies or become undead themselves.  In the end, the nationalized system will create an entire breed of unfit competitors.  This will allowing truly efficient profit-oriented private enterprise to regrow eventually.  It will just happen far later and far worse than it ever had to.

The Icelandic economy, and probably that of the UK, are likely to collapse soon, but the zombie US and Eurozone will probably survive a lot longer, with reanimation and collapse both possible outcomes.

As noted by many commentators, Ayn Rand and Karl Marx appear more prescient than they ever did in any previous time.  When two philosophers with such different takes are so harmonically prescient, it may be time to listen.

Friday, January 16, 2009

Inflation Expectations and Trepidation

The theoretically correct approach to most flavors of the liquidity trap is not fiscal stimulus.  Nor is it, unless the economy is in an abnormally depressed equilibrium requiring a face slap, quantitative or qualitative monetary policy.  The foolproof solution is to explicitly commit to inflation, prove that you're serious through aggressive action, and demonstrate that you know what to do once you've succeeded.

This is the Fed's playbook, and they are playing by it, coming through both verbally and in action.  The populace is listening, as consumers expect 3.0% annual inflation over the coming 5 years, although down from 5.2% in May.  But Japanese households expected 7% domestic inflation in June, and we know how that worked out.

Those surly bond vigilantes are giving less creed to the Fed's efforts, expecting zero inflation over the same period.  Some inflation expectations are a little less anchored in the blogosphere, to put it gently.

A Better Fool

The world has a way of humbling theories, particularly the foolproof ones.  So far, the operations of the Treasury and Fed have done little to resuscitate market and economic activity or create inflation.  The braggadocio Fed has had precious little traction, though theory would predict immediate and significant impact on market pricing.

The limited impact thus far might not surprise readers.  What good are inflationary expectations in an environment where inflation is not possible?  Regardless of the intent of the US government, the successful reflation of our economy rests not in its hands, but instead in the hands of those who peg their currencies to the dollar, unless and until the US takes some aggressive international actions with significant associated drawbacks.

International investors in the US have myriad strong reasons to resist this reflation.  They expect, for some reason that's beyond me, to be paid back for their extensive reinvestment in the US economy.  They would not enjoy the severe and destabilizing domestic inflation required for US reflation without revaluation.  They also don't want the partial default and export collapse resulting from a revaluation of their currency upwards.

The inertia is powerful, and domestic inflation expectations can't trump this global reality.  But let's assume these inflationary threats do impact the expectations and actions of some actors in the US economy.  What might we expect as a result?

Investors and lenders, who generally receive a fixed coupon on their investment, would naturally demand a higher interest rate to compensate for this expected reflation.  Borrowers expecting similar reflation might be tolerant of that expectation, or they might look at the realistic returns and competition facing their investment and be reluctant to accede to those terms.

Regardless, it's the increased uncertainty about the trajectory of future inflation that causes the most trouble.  The wider the divergence between present reality, natural expectations, and imposed expectations, and the more variability in all these rates, the higher the term premium embedded in a longer loan.  This will put an upward pressure on long real interest rates, which is precisely the opposite of what we wanted to accomplish in the first place.

So much for expectations.  But the supporting action of the US' credibly crazy government for inflation, economic growth, or bust might similarly do harm.  Such dramatic expansion of the Fed's balance sheet, sporadic intervention in myriad markets, and massive deficit spending would seem to me to decrease the confidence in the dollar as a medium of exchange and a store of value.  That should cause the private sector to seek a higher return to justify this additional risk, leading to a negative impact on economic activity.  Who knows who gets sprung next, and what the effect will be on your investment?

Some economic models and empirical work view concerted government intervention positively, even during crisis.  If we had an organized, consistent, and scoped response to this crisis, I would find that outcome plausible.  

We, however, are playing financial Calvinball.  This is never good, as initial assessments reveal.

In short, I think the focus on inflation expectations and the associated, requisite demonstrated willingness to intervene whenever and wherever necessary are self-defeating at best, and quite likely deleterious in our current world.

Wednesday, January 14, 2009

Vendor Financing, Real Interest Rates, and the USD

The Fall of the Dollar

Over the last decade, a number of countries have forced their currencies to be abnormally weak against the dollar.  This resulted in two major effects.

First, there was rapid growth in exports across Asia with a concurrent rise in their trade surplus.  These goods and services were artificially cheap to US consumers.  This export surge also occurred in major commodity producing countries as they revved up to support the export-driven industrial boom occurring.  Some commodity producers directly pegged themselves to the dollar, like the Middle East, resulting in further recycling flows.

The second effect, caused by the first, was a tremendous accumulation of dollar reserves by pegging countries.  These dollars were invested by those countries into risk-free assets, driving down real interest rates on longer Treasuries and leading to Greenspan's famous conundrum.  Private investors moved to spread assets and bid them far beyond rational prices, compressing spreads and interest rates across the risk spectrum.

These recycling flows were vendor financing on a massive scale.  Without the pegs, US real interest rates would have soared, halting the process.  Instead, a tremendous drop in real interest rates caused by this vendor financing enabled US consumers and corporations to take out stunning amounts of debt via HELOC's, asset bubbles, cov-lite loans, and so forth.

Through this financial intermediation, more and more money was available to the US to purchase commodities and finished goods from the rest of the world.  The rest of the world bought more Treasuries and other safe debt, causing asset values to soar and interest rates to drop.  This was all a positive feedback loop.

A lot of people saw the massive deficits being run by the US and thought the USD must inevitably crash.  The consensus was that the USD would crash should China cease its massive reinvestment of its surplus.  Indeed, the USD weakened gradually for many years in a row.

Compiling this, I posit a completely different explanation.  The weak USD was a result of the vendor financing.  As real interest rates were abnormally compressed by return-insensitive central banks, private capital fled the US to other destinations in search of higher real returns.  Because USD was unable to weaken against CNY, it weakened against other currencies instead, making the real returns available even worse.

The strength of EUR and GBP was partially an export valve for some of the pressure on USD/CNY.  As EUR and GBP strengthened against the USD, the asset bubble spread, and they picked up the consumer of last resort role from America's weary citizens.

The Rise of the Dollar

I first became concerned in February that the Earth's magnetic pole had flipped, making this powerful engine turn in reverse.

The weakness of the USD did begin to turn around in March, as the financial crisis began to affect trade in finished goods.  It finally truly reversed upwards with the final bursting of the commodity bubble, and it's strengthened ever since.

Everyone is terrified the USD will continue to fall, mainly as a result of the massive quantitative and qualitative easing schemes underway by the Fed, the persistent current account deficit, the U.S. NIIP position, and so forth.  I'm scared too, and I want to remain that way.  But I can't justify my fear, and haven't been able to for awhile.

The USD cannot weaken against the CNY or JPY, and I'm very skeptical that there is any positive traction whatsoever from the fiscal and monetary programs underway.  While there is a great deal of disagreement about what determines exchange rates, it's probable that relative real interest rates matter far more than money supply.  And those are only moving in the USD's favor right now.

Indeed, government deficits raise real interest rates, rather than suppressing them.  This is intuitively obvious and empirically demonstrable, but theoretically indeterminate, which confuses economists everywhere.  Whether that is true in a liquidity trap environment, or whether we're in a liquidity trap now, remains up for debate.  But I don't see any reason to believe, outside a stylized AD/AS curve and baseless Keynesian multipliers, that the rules should not still hold.
The effects of an insolvent Fed's debt load are the same as that for Treasury debt, which means that all these stimulus and rescue programs, including direct monetization, should only lead to higher real interest rates.  Since the dollar can't lose value right now by imposition of the pegging countries, and nominal interest rates have hit the zero bound, I conclude that fiscal stimulus and debt monetization will strengthen the dollar and worsen deflation.  Until the pegs are broken or serious inflation erupts in the rest of the world, this is the only possible outcome.

We have seen a further collapse in trade since September which is only worsening, lessening the odds of these pegs breaking, and reducing further the vendor financing that can be recycled.  I expect to see further increases in US real interest rates.

The USD should continue to strengthen until serious inflation occurs in China, Japan, and other countries, or the pegs break.  Until such a time, due to the increase in real interest rates and the damage inflicted by deflation, most assets, and particularly longer-dated ones, will decline in value.

If the pegs never break, and inflation never erupts overseas, then we can expect a massive wave of defaults in the US, possibly including Treasury.  So, in perhaps the most likely outcome, USD assets could crash while the USD pulls through just fine.

Sunday, January 11, 2009

Should You Care if the Fed is Broke?

Are there any practical implications of central bank insolvency?  Should we even care?  This is a tough question for me.

In Buiter's magnum opus on all the ways a central bank can stuff an economy to the gills with currency, he discusses the balance sheet of a central bank.  Historically, the equity of the bank that issued the currency helped make the currency sound and valuable.  This was once very important, and the US has had many different currencies over the years, sometimes many at once, all with colorful histories.

It had become almost a historical relic before the Fed's new high-wire act.  Buiter details some of the risks the Fed is exposing itself to today, and mentions the need for the bank to recapitalize itself.  He doesn't go deep into why this recapitalization is necessary and how it is important, so we will.


Inflation risk and credit risk are the two really important risks the Fed is facing.

Inflation risk decribes the likelihood that inflation will rise too far during the term of the loan, and is greater for longer loans.  Should there be any resurgence of inflation over the next multiple years, the Fed will suffer at least a mark-to-market loss.

Credit risk describes the likelihood that the deadbeats will fail to pay you back.  Should it turn out that the Fed bought some toxic paper(I know, right?), then the Fed will suffer a capital loss.  More of this paper is likely to be bad if deflation persists.

A mark-to-market loss or a capital loss might seem like it doesn't really matter.  But as Sims pointed out at the beginning of this fiasco, it can actually be quite a big deal.  We will look at the Fed's three main tools for stopping inflation: open market operations, paying interest on excess reserves, and raising the required reserves ratio.  Suffering a either loss limits its capacity for open market operations, which is why Buiter discusses recapitalization as required, but there are other creative approaches.

Standard OMO

When the Fed wants to take dollars out of the system to curb inflation, it has to get its dollars back from people.  It traditionally sold off some of the Treasury securities on its balance sheet in exchange for these dollars.  This removed the dollars from circulation, hypothetically limiting the amount of credit that can be created, shadow banking system notwithstanding, controlling inflation.

But what happens if the assets it owns are no longer Treasury securities, but a hodgepodge of pier loans, bad credit card receivables, MBS IO strips, and more?  It would have to resort to selling those, and it's quite probable that those would be bought by the private sector only at a significant discount.  The Fed would be left with a negative equity position.

This negative equity position could be quite large, but only in severe inflation should it become a real problem: when the Fed needed to sell more assets than it actually had.  That's only when recapitalization with quality assets through outright taxation would be explicitly necessary.  If things didn't get that bad, the Fed might be able to simply sit there with the hole on its books, waiting eternally for seigniorage to fill its pockets once more.  The Treasury loses the small revenue from seigniorage, and that's the end of that.

Interest on Excess Reserves

Some of the clever readers in the blogosphere have suggested an alternative solution.  The Fed now pays interest on deposits.  If the Fed were able to increase that interest rate arbitrarily, it would quickly become more appealing to deposit funds at the Fed than loan them out.  This would give the Fed another way to effectively take dollars out of circulation and curb inflation.

A key problem with this idea is that the Fed's balance sheet grows gradually worse.  Just like anyone's favorite Ponzi -- or Madoff -- scheme, the Fed would be paying out more in interest on its good liabilities than it takes in on its bum assets.  It's fun to call the Fed a Ponzi scheme, but in this case it would actually be true: it would gradually grow more broke.

This might be a temporary state of affairs as it acquires more assets that yield more than it must pay out in the future, but that really depends on the state of the economy, and how much inflation it's willing to suffer.

Thus, even if the Fed ran out of assets to sell, it still isn't completely powerless.  In fact, the things that normally cause a Ponzi scheme to fail, like excessive redemption requests, are by definition not at play here.  Could it go on indefinitely?

Required Reserve Ratios

The Fed can also simply change by mandate how many dollars are deposited on its books by depository institutions.  It increases the required reserve ratio, which should mean the bank can create fewer dollars.  Unfortunately, banks are pretty talented at getting around regulations designed to limit their aggressive risk taking.  The shadow banking system and other leveraging mechanisms would probably flourish.

The RRR is currently roughly 10%.  It could easily be raised or lowered from there.  It might not have much tangible impact, and it would crimp bank profitability.  However, if enforced well, it would be a way to curb money creation with little risk to the Fed.


Even if the Fed is in the hole, there are still a lot of things the Fed can do.  I don't think the Fed will run out of options for controlling inflation.

Are there lesser risks than hyperinflation or collapse of the currency?

If either of the first two options were used, there would be more dollars outstanding than there would naturally be, which would be somewhat more inflationary, and require somewhat higher interest rates to combat it.  That's probably not a really big deal.

The one risk that I have sympathy for is a general loss of confidence in the currency.  Holders may anticipate the need for the bank to recapitalize itself, through inflation or taxation of dollars, and desire to escape this.  They may also not really enjoy Ponzi schemes.  This loss of confidence should lead to an increase in the level of interest rates or the amount of inflation that would occur.  It's a long-term drag either way.

The only way I could see a real hyperinflationary collapse happen is if the Fed were politically restricted from fighting aggressively, or there were simply a widespread collapse of confidence in the currency altogether.

Complex topic, and I'm sure I missed a lot of things.  What are your thoughts?

Zen and the Art of Printing Confidence

I was in the middle of writing a piece explaining what I mean when I said there's no such thing as "just printing money," when Willem Buiter totally scooped me.  Go there and read the masterpiece on printing money in its entirety.  Once you've finished, you can read this appendix on how printed money might, or might not, turn into economic activity.

Just as in Zen, this post is mostly questions intended to lead to enlightenment or confusion.

Buiter describes the two major goals in our current round of printing:

1)  Prevent the system, and entities with such large tendrils they might as well be the system, from collapsing under their own weight.  Mission accomplished, for now.
2)  Get private credit creation started again, generally by inspiring risk-taking by private market participants as currency becomes a poor store of value and long or risky interest rates fall.

Confidence in Traction

Number two, the generation of private confidence, is where our financial market policies would lead to real economic traction.  Buiter writes:
When fear and panic eventually desist, however, it is essential that the central bank stand ready to take back the injection of liquidity provided since September 2008.
There is an explicit supposition here that the reluctance of the private sector to extend credit and create money is simply a matter of fear, panic, and a lack of confidence.  Krugman calls this the slap in the face principle: clearly, everyone has lost their minds in a collective hyperventilation, and with a couple shots of whiskey and a paper bag, we can go back to trading as usual.

We've tried slapping this particular pig a lot of times over the last two years, and yet, nobody seems to wake up, no matter how large a slap is delivered.  The TAF, the PDCF/TSLF, the TARP, FDIC-backed bonds, and so forth, yet nothing much has happened.  All the money we've created is surging forth like a cypress swamp in Florida as excess reserves sitting on deposit at the Fed.

Forced Investment

So why has none of this led to increased private credit creation, or increased confidence?  Well, what if the private market is not being completely irrational as it fails to fund further investment?  Can we be in a situation where there are not enough appealing risk/return opportunities on our zero bound, resulting in no good reason to extend or borrow cash for investment?

I think it's possible.  We've seen very little investment in tradeables in the US for many years, and strong investment in areas like residential real estate, a sectoral mix probably resulting from our exceedingly strong currency relative to other nations.  Most of our GDP has been allocated towards consumer spending.  There is major overcapacity in most sectors resulting from the rapid global growth of the last ten years.

Forced further investment through somehow getting real interest rates sufficiently negative, while a temporary palliative, will only make structural oversupply and misalignment worse.

We've successfully rolled the dead whales back into the ocean and reduced the nominal cost of funding somewhat.  But without fixing the fundamental misalignments that have led to unbalanced global growth, I'm not sure successfully forcing further investment or consumption represents victory.

Printing Uncertainty

Getting slapped in the face doesn't generally build confidence, and can lead to uncertainty of pick-up line quality.  Quantitative and qualitative easing do not necessarily lead to a risk-taking appetite in the private sector, nor do they necessarily lead to serious inflation, which depends on many factors.

Intervention clouds economic signals, the ones the private hand uses to direct us in the right endeavors.  It's very hard for anyone to get a handle on relative pricing in the near future and present, or judge a worthy risk, when second-round effects from deflation, credit creation, and strenuous government intervention must be factored in.  This can lead us to do the wrong thing, or more likely in our modern day and age, do nothing at all.

Banks might be worried about Buiter's sudden resurgence in inflation creaming them on a long-term loan they make for development.  Borrowers might take a sober assessment of pricing power and expenses in their industry, look at end unit sales projections, and fear deflation will persist.  While strong inflation would be good for the borrower, and strong deflation might sorta possibly be good for the lender, both face extreme uncertainty in their projections, and paralysis results.

The slaps themselves might actually be contributing to the paralysis in the financial markets, too.  The Fed and the government can crowd the private sector out of these marketplaces by setting artificial clearing prices.  Imagine there's a lender who sees a 10% risk of default by a borrower.  They then might be willing to lend out money at 12%.  However, if the government intervenes to drive the rate down to 8% forcibly, that loan will not be made by the private sector at all.

If I knew I were trading in a market where the Fed were present, I would have precisely one strategy: front-run the Fed.  This front-running makes intervention more expensive for the Fed, and is profitable for the front-runners, but it doesn't encourage the private sector to take the reins again.  As the most visible example, the Fed now owns roughly 20.5% of the commercial paper outstanding.  The latest release shows this has little to do with year-end effects, and the percentage has been gradually increasing since the program was initiated.  The government will gradually issue or own more and more loans, and the private sector could continue to recede.

Finally, just to throw in one more feedback loop, let's imagine we hit moderate to high inflation.  As readers observed on my last post, the value of a phenomenal amount of longer-dated fixed coupon assets outstanding would get crushed, destroying a lot of players and money.  That -- or even its credible possibility -- isn't good for real investment or certainty either, and would require even more rescues by the government.

The paralysis and uncertainty engendered by our intervention are, in my opinion, worse even than the alternatives.  People must have faith in currency as a mechanism for accurate pricing information and storing wealth.  If we destroy that in our quest to inflate our way to victory, what have we won?

I'll write a separate post on the other issue Buiter raises, central bank solvency, at some point in the future.

Friday, January 9, 2009

The US Can't Unilaterally Inflate

Many people are either worried that all the excessive money creation and bailouts will create inflation, or hope that the Fed will create the necessary inflation to gradually reduce the burden debtors face.

There is little chance either will come to pass right now.

The US can't create or sustain moderate inflation without a little help from its friends.  This insight falls more into the category of "accounting identity" than "brilliant reasoning".

The Story

There are many countries that peg their currencies to the dollar in some form, but China is by far the biggest, most important, and most notorious.  But even Japan has a ceiling beyond which they won't let the JPY rise.  These pegs are not difficult to defend because their currencies are pegged too cheap, rather than too rich.  In fact, China absorbs massive amounts of USD in their interventions to enforce that peg.  Should they ever need to fight the other way, they can sell off USD and buy CNY until the crisis has passed, and the permanent, underlying current account surplus takes care of the problem.

Japan and China do not have any lasting inflation problem either, though both caught an inflationary wave during the commodity bubble.  They have certainly both experienced deflation in the recent past.  The economies survived, with a little discomfort.  There is very strong structural deflation in both economies, with extraordinarily deep capital, and in China's case at least, virtually limitless labor.  Deflation appears to be returning and it probably doesn't present a severe threat to either economy.

Deflation does pose a dire threat to the US economy.  With immense debt outstanding to GDP, far higher than anything seen before, the US economy may have approached the Chandrasekhar limit of debt.  Debt-deflationary spirals are not fun.  Even worse, we have very large, persistent trade deficits and a poor NIIP.

The US has also invested very little in tradeable sectors.  When we had all the cheap funding in the world, we built houses in the Inland Empire and bought a lot of cars.  Why did America choose to consume or invest in residential real estate, rather than a machine shop in Michigan?  Many ascribe that to avarice or stupidity, but it's unfortunately more likely a result of American workers and capital being totally uncompetitive at current and envisioned pricing.  As evidence, American exports did finally start to respond a bit when the dollar index sunk a long way, but they've begun to fall again now during the recession, while the dollar's rising again.  American goods and services need to be cheaper in other countries to be desirable.

The dollar can't weaken against major competitors, though.  China, Japan, and other pegging nations prevent it.  China probably can't really break their peg without bankrupting the PBoC, which holds dollars as assets and yuan as liabilities.  Much of the world, if revalued, could no longer rely on exports to America and Europe for growth, sinking into deeper -- more deflationary -- recessions of their own.  They will probably not revalue any time soon.

China has also demonstrated the ability to sterilize, effectively or at least marginally so, extremely high levels of intervention.  Enough for real exports and hot money when the global economy was fine, and certainly enough in our trade depressed world.  I believe that through greater bond issuance and raised required reserves, they can effectively sterilize a really, really big pile of yuan.  Japan has started running a trade deficit.

Why Inflation's Impossible

Now, let's imagine Bernanke has a magic wand that he can wave to set the US inflation rate to 12%, in order to increase wages and revenues and make debt and prices manageable.

A year passes.  Everyone charges 12% more dollars for everything: labor, haircuts, cheeseburgers, and so on.  That's okay, because everyone earns more too.

But every USD is still worth 6.83 CNY, and there was no inflation in China.  That means the price of US labor, haircuts, and cheeseburgers is 12% higher in real terms in China.  They can't buy as much.  That also means the price of Chinese t-shirts is 10.8% seems lower than it was last year, because Americans are all earning more.  I'll be more likely to buy things made in China.

China now exports much more to the US.  With the proceeds from these exports and the intervention, they would buy more US assets, but less relatively expensive US goods and services.  The trade balance worsens, the imbalances worsen, US workers and plants become even less competitive, China invests more in tradeables, US consumers go further into debt, and so forth.  Less employment, less exports, more debt, stronger deflationary forces.  Next year, things grow exponentially worse.

Unless the US miraculously becomes more efficient and productive, to avoid this scenario, the US must have a weakening real exchange rate (REER).  Because currency pegs prevent revaluation, that means China and Japan must run higher inflation rates than the US.  Twisting it around, in current conditions, the US cannot run a higher sustained inflation rate than China, Japan, and others.

The US must either:

1)  Persuade China, Japan, and others to allow their currencies to appreciate dramatically so the US can abruptly default on some of its debt to them, and reduce their exports considerably;
2)  Persuade China, Japan, and others to allow high domestic inflation.  If the US wanted 12% inflation domestically, it might ask for 16% or 17% inflation in China, if not a bit more;
3)  Do something crazy, like enact Smoot-Hawley Mark II and beat each other up at the WTO;
4)  Suffer through deflation.