Capital Mobility as Trojan Horse

In my Jacobin piece on finance, I observed in passing that financial commitments across borders — what’s sometimes called capital mobility — enforce the logic of markets on national governments. This disciplining role has been on vivid display in the euro area over the past few years. Here, courtesy of yesterday’s Financial Times, is a great example of the obverse: If a state does want to resist liberal “reforms”, it needs to limit financial flows across the border.

The headline in the online edition spells it right out:

Renminbi stalls on road to being a global currency. New capital controls lead to doubt, especially over hopes of forcing economic reform.

The print edition is wordier but even clearer:

Renminbi reaches its high water mark. Fresh capital controls cast doubt over the push to increase the global use of its global currency. But what does that mean for the Chinese policymakers who saw it as a ‘Trojan horse’ to force through economic reform?

The whole article is fascinating. On the substance it’s really quite good — anyone who teaches international finance or open-economy macroeconomics should bookmark it to share with students. Along with the political-economy question I’m interested in here, it touches on almost all the most important points you’d want to make about what determines exchange rates. [1]

The article’s starting point is that for most of the past decade, international use of the Chinese renminbi (Rmb) has been steadily increasing. Some people even saw a future rival to the dollar. For most of the period, the renminbi was appreciating against the dollar, and the Chinese government was loosening restrictions on cross-border financial transactions. But recently those trends have reversed:

The share of China’s foreign trade settled in its own currency has shrunk from 26 per cent to 16 per cent over the past year while renminbi deposits in Hong Kong — the currency’s largest offshore centre — are down 30 per cent from a 2014 peak of Rmb1tn. Foreign ownership of Chinese domestic financial assets peaked at Rmb4.6tn in May 2015; it now stands at just Rmb3.3tn. In terms of turnover on global foreign exchange markets, the renminbi is only the world’s eighth most-traded currency — squeezed between the Swiss franc and Swedish krona — barely changed from ninth position in 2013.

What appeared to be structural drivers supporting greater international use of the Chinese currency now appear more like opportunism and speculation.

Large financial outflows — including capital flight by Chinese wealthholders and currency speculators reversing their bets — have led the renminbi to lose 10 percent of its value against the dollar over the past year or so. The Chinese central bank (the People’s Bank of China, or PBoC) has had to use a substantial part of its dollar reserves to keep the renminbi from depreciating even further.

… the PBoC remains active in the foreign exchange market as buyer and seller. Over the past 18 months, this has mostly meant selling dollars from foreign exchange reserves to counteract the depreciation pressure weighing on the renminbi.

This strategy has been expensive, contributing to a decline in reserves from $4tn in June 2014 to $3.1tn at the end of November. Defenders of the PBoC believe such aggressive action to curb depreciation has been worth the price because it prevented panic selling by global investors. Critics counter that costly forex intervention has merely delayed an inevitable exchange-rate adjustment.

For years, the IMF, US Treasury and other outside experts have urged China to embrace a floating exchange rate. In theory, such a step should eliminate the need to tighten capital controls or to spend precious foreign reserves on propping up the exchange rate. Instead, the currency would weaken until inflows and outflows balance.

In the age of Trump, it’s worth stressing this point: The Chinese central bank has been intervening to make the renminbi stronger, not weaker — to keep Chinese goods relatively expensive, not cheap. This has been true for a while, actually, although you can still find prominent liberals complaining about China boosting its exports through “currency manipulation”.  Also, as the article notes, the Washington Consensus line has been that China should end foreign-exchange interventions and abolish capital controls, allowing the renminbi to depreciate even further.

For most countries, continuing to spend down reserves would be the only alternative to uncontrolled depreciation. But China, unlike most countries, has maintained effective controls over cross-border financial flows, so it has another option: limiting the ability of households and businesses to trade renminbi claims for dollar ones.

The State Administration of Foreign Exchange, the regulator, last week said it would continue to encourage outbound investment deals that support the country’s efforts to transform its economy… But the agency said it would apply tighter scrutiny to acquisitions of real estate, hotels, Hollywood studios and sport teams.

That will probably mean fewer food-additive tycoons buying second-tier UK football clubs. It also suggests a crackdown on fake trade invoices, Hong Kong insurance purchases and gambling losses in Macau — all channels used to spirit money out of China. …

“They are trying to squeeze out all the low quality or suspicious or fraudulent outbound investment. But they have also made it clear they support genuine high-quality investment,” says Mr Qu.

These moves come on top of other limits on financial outflows. This passage highlights a couple additional points. First, effective controls on financial flows require controls on cross-border transactions in general. Second, there’s no sharp line between macro policy aimed at the exchange rate or other monetary aggregates, and micro-interventions aimed at channeling credit in particular directions.

Now to the political economy point:

China’s recent moves to tighten approvals for foreign acquisitions by Chinese companies, as well as other transactions that require selling renminbi for foreign currency, cast further doubt on China’s commitment to currency internationalisation.

“There is a fundamental conflict between preserving stability and allowing the freedom and flexibility required of a global currency,” says Brad Setser, senior fellow at the Council on Foreign Relations and a former US Treasury official. “Now that the cost is becoming clear, Chinese policymakers may be realising they are not willing to do what it takes to maintain a global currency. Capital controls certainly set back the cause of renminbi internationalisation but they may well be the appropriate step given the outflow pressures.”

As a topic for banking conferences and think-tank seminars, renminbi internationalisation could not be beaten. It offered a way to express dissatisfaction with the US dollar-dominated monetary system, as laid bare by the 2008 financial crisis, while signalling an eagerness to do business with China’s large, fast-growing economy.

For China’s reform-minded central bank, however, renminbi internationalisation … offered something else: a Trojan horse that could be used to persuade Communist party leaders in Beijing and financial elites to accept reforms that were, in reality, more important for China’s domestic financial system than for the renminbi’s international status. Since 2010, when the internationalisation drive began, many of those reforms have been adopted…

This is the dynamic we’ve seen over and over. Real or imagined pressure from the outside — from international creditors , institutions like the IMF, “the markets” in general — is needed to push through a liberal agenda that would not be accepted on its own merits. This is true in China, with its multiple competing power centers and effective if disorganized popular protests, just as it is for countries with more formally democratic political systems. What’s unusual about China’s case is that the “reform” side may no longer be winning.

What’s  unusual about this article is that it’s spelled out so clearly. “Trojan horse”: Their words, not mine.

The article continues:

The totem of currency internationalisation also served as justification for China’s moves over the past half-decade to open up its domestic financial markets to foreign investment, a process known as capital account liberalisation, that has been crucial to the global push of the renminbi. If foreign investors are to hold large quantities of China’s currency, they must have access to a deep and diverse pool of renminbi assets — and the peace of mind of knowing that they are free to sell those assets and convert proceeds back into their home currency as needed.

Again, thinking of classroom use, this is a nice illustration of liquidity preference.

Until last week, regulators had also steadily loosened approval requirements for foreign direct investment, in to and out of the country.  But those reforms occurred at a time when capital inflows and outflows were roughly balanced, which meant that liberalisation did not create strong pressure on the exchange rate. Now, the situation is very different. Beijing faces a stark choice. Either row back on freeing up capital flows — as it has already begun to do this year — or relinquish control of the exchange rate and accept a hefty devaluation.

We used to talk about a trilemma: A country cannot simultaneously peg its currency, set interest rates at the level required by the domestic economy, and allow free financial flows across its borders. At most you can manage two of the three. But it’s becoming clear that for most countries it’s  more of a dilemma: If you allow free capital mobility, you can’t control either the exchange rate or domestic credit conditions. International financial shifts are so large, and so unpredictable, that for most central banks they’ll overwhelm anything that can be done with conventional tools.

And when you accept free capital mobility, with its dubious rewards, it’s not just control over interest rates and exchange rates you’re giving up. In the absence of  controls over international financial flows, the whole range of economic policy — of public decisions in general — is potentially subject to the veto of finance. If you need foreign wealth-owners to voluntarily hold your assets, the only way to keep them happy — so goes the approved catechism — is to adopt the full range of market-friendly reforms. The FT again:

Economists argue that the fate of renminbi internationalisation ultimately depends on far-reaching economic reforms rather than short-term responses to rising capital outflows.

The list of course starts with privatization of state-owned companies and continues with deregulating finance.

“When you reimpose capital controls after having rolled them back, it can sometimes have a perverse effect,” says Mr Prasad… “What they need to do is something much harder — actually to get started on the broader reform agenda and show that they are serious about it. Right now the sense is that there is very little happening on other reforms.”

This is what it comes down to: If China is going to reach the grail of international-currency status, it is going to have to focus on the “reform” agenda dictated by financial markets — it’s going to have to earn their trust and prove it is “serious.” What exactly are the benefits of that status for China? It’s far from clear. (Of course it’s an attractive prospect for Chinese individuals who own lots of renminbi-denominated assets.) But it doesn’t matter as long as it serves as a seemingly objective basis for continued liberalization, which otherwise might face serious resistance.

“The question is which is to be the master — that’s all.”

 


 

[1] It doesn’t, of course, mention uncovered interest parity, the idea that interest rate differences between currencies exactly offset expected exchange rate changes. This doctrine dominates textbook discussion of exchange rate movements but plays no role in any real-life discussion of them.

What Is Foreign Investment For?

The top of the front page in today’s Financial Times shows Steve Forbes’ scowling face with the caption, “We want our money!” Really, that should be there every day — it could be their new logo.

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Further down the page, the big story is the election of the opposition candidate Mauricio Macri as president of Argentina. I’ll wait to see what Marc Weisbrot has to say before guessing what this means substantively for the direction of the Argentine state. What I want to call attention to now is the consistent theme of the coverage.

The front page headline in the FT is “Markets cheer Argentina’s new order”; the opening words of the article are “Investors hailed the election of Mauricio Macri….” After mentioning his call for the leaders of Argentina’s central bank to step down — the apparent unobjectionableness of which is evidence on the real content of central bank “independence” — the first substantive claims of the article are that “markets reacted positively” and that “Macri has promised to eliminate strict exchange controls” — evidently the most important policy issue from the perspective of the FT reporter.

Over the fold, we learn again that “Investors yesterday cheered the election of Mauricio Macri”; that “dollar bonds issued by Argentina … extended their winning streak”; and that “markets have hoped for an end to ‘Kirchnerismo’.” The only people quoted in the article other than Macri himself are three European investment bankers. One says that “Macri understands what the country needs to do to regain the confidence of international investors and get the country back on its feet” — presumably in that order. Another instructs the new government that “Argentina must normalise relations with the capital markets and start attracting the all- important foreign investors”.

The accompanying think piece explains that among the “most pressing issues” for Macri are that “the country is shut out of international markets by its long court case with holdout creditors” and that “the economy suffers from a web of distortions, including energy subsidies that can shrink a household’s monthly energy bill to the price of a cup of coffee.” (The horror!) It emphasizes again that Macri’s only firm policy commitment at this point is to remove capital controls, and suggests that “Argentina will need to have recourse to multilateral financial support.” The conclusion: “The biggest area where Macri needs to effect change is the investment climate. Investors have cheered his rise … but Mr Macri’s job is to convert Argentina into a destination for real money investment rather than hedge fund speculation … a decisive change for a country that … is unique in having lost its ‘rich nation status’.”

So that’s the job of the president of Argentina, making the country a destination for real money. Good to have that clear!

Now, you might say, if you don’t want to read every story through the frame of “Is it good for the bondholders,” then why are you reading the FT? Fair enough — but the FT is a good newspaper. (The Forbes story is fascinating.) Anyway, it’s worth being reminded every so often that in the higher consciousness of the bourgeoisie, nations and all other social arrangements exist only in order to generate payments to owners of financial assets. [1]

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The question I’m interested in, though, is the converse one — are the bondholders good for Argentina? The claim that foreign investors are “all-important” is obviously an expression of the extraordinary narcissism of finance. But is there a rational core to it? Are foreign investors at least somewhat important?

This is a question that critical economists need to investigate more systematically. Even among heterodox writers, there’s a disproportionate focus on the development of the financial superstructure and the ways in which it can break down. [2] The importance of this superstructure for the concrete activities of social production and reproduction is too often taken for granted. Or else we make the case against free cross-border financial commitments too quickly, without assessing what might be the arguments for them.

So, concretely, what is the benefit to Argentina of regaining “access to the markets,” to enjoying the goodwill of foreign investors, to being a destination for real money? To answer this properly would involve citing lots of literature and looking at data. I’m not going to do that. The rest of this post is just me thinking through this issue, without directly referring to the literature. One result of this is that the post is too long.

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Let’s start by distinguishing foreign direct investment (FDI) from portfolio investment.

The case for FDI is essentially that there are productive processes that can be carried out successfully only if owned and managed by foreigners. Now, obviously there are real advantages to the ways in which production is organized in rich countries, which poorer countries can benefit from adopting. But the idea that the only way this technical knowledge can reach poorer countries is via foreign ownership rests, I think, on racism, that simple. The claim that domestically-owned firms cannot adopt foreign technology is contradicted by, basically, the entire history of industrialization.

A more plausible advantage of foreign ownership is that foreign companies have more favorable access to markets and supply networks. It would be at least defensible to claim that Polish manufacturing has benefited from integration into the German auto industry — not because German management has any inherent superiority, but because German car companies are more likely to source from their own subsidiaries than from independent Polish firms. I don’t see this kind of argument being made for Argentina. When we hear about “regaining the confidence of international investors,” that pretty clearly means owners of financial wealth considering whether to include Argentine assets in their portfolios, not multinational corproations considering expanding their operations there. In other words, we are interested in portfolio investment.

So what are the benefits that are supposed to come from attracting portfolio inflows? I wonder if the people quoted in the FT piece, or the author of it, ever even ask this question. This may be a case where the debate over what “capital” means is not just academic. If financial wealth is conflated with concrete means of production, then it’s natural to think that the goodwill of the owners of the first is all-important, since obviously no productive activity can take place without the second. But purchasers of Argentine stocks and bonds are not, in fact, providing the country with new machines or software or engineers or land. (For this reason, I prefer to avoid the terms “capital flows” and “capital mobility”.) What then are the bond buyers providing?

Macroeconomically, it seems to me that there are really only two arguments to be made for portfolio inflows. First, they allow a current account deficit to be financed. Second, they might allow the interest rate to be lower. Beyond macro considerations, we might also want to keep international investors happy because of their political influence, or because they control access to the international (or even domestic) payments system. And of course, if a country is already committed to free financial flows then this commitment will only be sustainable if net financial inflows are kept above a certain level. But that just begs the question of why you would make such a commitment in the first place.

Let’s consider these arguments in turn.

‘The first benefit, that portfolio inflows allow a country to have a deficit on current account, is certainly real. I think this is the only generally credible macroeconomic story for the benefits of capital account liberalization.

In a world with no international financial flows, countries would have to a balanced current account (or in practice balanced trade, since most income flows are the result of past financial flows) in every period. But there might be good reasons for some countries. to have transitory or persistent trade imbalances If a country’s trade balance moves toward deficit for whatever reason, the ability to reduce foreign assets and increase foreign liabilities allows the movement back toward balance to be deferred. If faster growth would lead to higher import demand (which cannot be limited otherwise) or requires specific imported intermediate or capital goods (that cannot be financed otherwise) then the foreign exchange provided by portfolio inflows can allow faster growth than would otherwise be possible.

There are good reasons to be skeptical about the practical value of portfolio inflows as finance of current account deficits. But there’s nothing wrong with the argument in principle. If that is the argument you are making, though, you have to be clear about the implications.

First, if this is your argument, then saying that Argentina has suffered because of its lack of access to foreign capital markets, is equivalent to saying that Argentina suffered because of its inability to run a trade deficit. I don’t think this is what people are saying — and it would not be plausible if they were, since Argentina has had a large trade surplus over the whole Kirchner period. No help from foreign investors would have been needed to reduce that surplus.

Second, if the benefit of portfolio flows is to finance current account imbalances, then only the net flows matter. There is no purpose to the large offsetting gross flows — you could just as well have the central bank alone borrow from abroad, and then sell the resulting foreign exchange at the market price (or distribute it in some other way). That would deliver all the macroeconomic benefits of international financial flows and avoid one of the major costs — the central bank’s inability to act as lender of last resort or resolve financial crises when financial institutions have liabilities that cannot be settled with central bank’ money.

Again, the only unambiguous macroeconomic reason to support capital-account liberalization, or to make attracting portfolio inflows a priority, is if you want to see larger current account deficits. In an undergraduate textbook, this is the whole story — to say that international lending permits countries to substitute present for future expenditure, or to raise investment above domestic saving, are just different ways of saying it permits current account deficits. If you think larger current account imbalances are unnecessary or dangerous, then, it’s not clear what the macroeconomic function of portfolio investment is supposed to be. The only thing that portfolio investment directly provides is foreign exchange.

The second possible macroeconomic benefit is that foreign portfolio investment allows the interest rate to be lower than it otherwise could be. This is certainly possible as a matter of logic. Let’s imagine a firm with an investment project that will generate income in the future. The firm needs to issue liabilities in order to exercise claims on the labor and other inputs it needs to carry out the project. Wealth owners must be willing to hold the liabilities of entrepreneur on terms that make the project viable; if they demand a yield that is too high, the project won’t go forward. But there may be some foreign intermediary that is both willing to hold entrepreneur’s liabilities on more favorable terms, and issues liabilities that wealth owners are more willing to hold. In this case, the creation of financial claims across borders is a necessary condition for the project to go forward. Note that this case covers all the macroeconomic benefits of diversification, risk-bearing, etc. — the ability to hold an internationally diversified portfolio may be very valuable to wealth owners, but that matters to the rest of us only insofar as that value allows real activity to be financed on more favorable terms.

That story makes sense where there is no domestic financial system, or a very underdeveloped one; it’s a good reason why financial self-sufficiency is not a realistic goal for small subnational units. But it’s not clear to me how it applies to a country with its own banking system and its own central bank. Is it plausibly the case that in the absence of financial flows, the Argentine central bank would be unable to achieve an interest rate as low as would be macroeconomically desirable? Is it plausibly the case that there are productive enterprises in Argentina that are unable to secure domestic-currency loans from the local banking system even given expansionary policy by the central bank, but would be able to do so from foreign lenders?  [3]

If this is your argument, you should at least be able to identify the kinds of firms (or I suppose households) that you think should be borrowing more, are unable to secure loans from the domestic banking system, but would be able to borrow internationally. (Or that would be able to borrow more from domestic banks, if the banks themselves could borrow internationally.)

It’s hard for me to see how a reasonably developed banking system with a central bank could be constrained in its ability to provide domestic-currency liquidity by a lack of portfolio inflows. And I doubt that’s what the gentlemen from Credit Suisse etc. are saying. On the contrary, the usual claim is that portfolio flows reduce the feasible range of domestic interest rates. Of course the people saying this never explain why it is desirable — the ability to conduct financial transactions across borders is just presented as a fact of life, to which policy must adapt. [4]

In any case, my goal here isn’t to dispute the arguments for the importance of portfolio inflows, but to clarify what they are, and their logical implications. Do you think that the benefits of portfolio flows are that they finance current account deficits and allow easier credit than the domestic bank system could provide? Then you can’t, for instance, turn around and blame the euro crisis on current account deficits and too-easy credit. Or at least, you can’t do that and still hold up “free movement of capital” as one of the central virtues of the system.

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There are two other non-macroeconomic arguments you sometimes hear for the importance of foreign investors, focused less on what they offer than with what they can threaten. First, the political importance of international creditors in the US and other states may allow them to use the power of those states against government they are unhappy with.

Historically, this is the decisive argument in factor of keeping foreign investors happy. Through most of the period from the 1870s through the 1950s, the possible consequences of a poor “investment climate” included gunboats in your harbor, the surrender of tariff collection and other basic state functions to creditor governments, military coups, even the end of your national existence. [5] (Let’s not forget that the pretext for the war in which the United States claimed half of Mexico’s territory was the mistreatment of American businessmen there.)

That sort of direct state violence in support of foreign creditors has been less common in recent decades, though of course we shouldn’t exclude the possibility of its revival. But there are less overt versions. The extraordinary steps taken by the Judge Griesa on behalf of Argentina’s holdout creditors go far beyond anything the investors could have done on their own. If the point of the FT pieces is that Argentina needs to settle with its creditors because otherwise it will face endless, escalating harassment from the US legal system, then they may have a point. I’d just like them to come out and say it.

A related argument is that failure to get on good terms with finance as a cartel of asset owners, will mean loss of access to finance as a routine service. The version of this you hear most often is that defaulting on or otherwise annoying foreign investors will result in loss of access to trade finance. So that even if the country has a current account in overall balance, its imports and/or exports will be restricted by a sudden need to conduct trade on a pure cash basis. I’ve seen this claim made much more than I’ve seen any evidence for it — which doesn’t mean it’s wrong, of course. But who are the providers of trade finance? Are they so resolutely class-conscious that they would refuse otherwise profitable transactions out of solidarity with their investor brethren? It doesn’t seem terribly likely — if foreign investors are willing to continue buying sovereign bonds post-default, as they unequivocally are, it’s hard to see them refusing this basic financial service to private businesses. Or coming back to Argentina, is there any evidence that the demand for Argentine exports was reduced by the default, or that Argentina was unable to convert its foreign exchange earnings into imports because foreign exporters couldn’t finance the usual 60- or 90- or whatever-day delay before receiving payment?

Another version of this argument — which Nathan Cedric Tankus in particular made in the case of Greece — is that a country that breaks with its creditors will lose access to the routine payment system — credit cards and so on — since it is all administered by foreign banks. In the case of a eurosystem country this may have some plausibility, at least as an acute problem of the transition — over a longer term, I can’t see any reason why this is a service that can’t be provided domestically. But leave aside how plausible they are, let’s be clear what these claims mean. They are arguments that foreign investors matter not because of anything of value they themselves provide, but because of their ability to provoke a sort of secondary strike or embargo by other segments of finance if they don’t get what they want. These are political arguments, not economic ones. In the longer view, they also support Keynes’ argument that finance should be “homespun” wherever possible. If trade finance really is so critical, and so readily withdrawn, wouldn’t it be wise to develop those facilities yourself?

The final argument is that, if you have committed yourself to permitting the free creation of cross-border payment commitments, you will be unable to honor those commitments without a sufficient willingness of foreign units to take net long positions in your country’s assets. [6]

This one is correct. If, let’s say, banks in Argentina have accumulated large foreign currency liabilities (on their own, or more likely, as counterparties to other units accumulating net foreign asset positions) then their ability to meet their survival constraint will at some point depend on the willingness of foreign units to continue holding their liabilities. And unlike in the case of a bank with only domestic-currency liabilities, the central bank cannot act as lender of resort. In other words, the central bank can always maintain the integrity of the payment system as long as its own liabilities serve as the ultimate means of settlement; but it loses this ability insofar as the balance sheets of the domestic financial system includes commitments to pay foreign moneys. [7]

This, probably, is the real practical content of stories about how important it is to maintain the goodwill of footloose capital. If you don’t honor your promises to foreign investors, you won’t be able to honor your promises to foreign investors. The weird circularity is part of the fact of the matter.

 

[1] Needless to say, not every political development is covered this way. The fact that the bondholder’s view of the world so dominates coverage of Argentine politics is evidently related to the specific way that Argentina is integrated into the global circuits of capital.

[2] I really wish people would stop talking about “the crisis” as some kind of watershed or vindication for radical ideas.

[3] I emphasize domestic currency. Of course domestic banks cannot provide foreign -currency loans. But again, this is only a macroeconomic issue if the country is running a trade deficit. Otherwise, the foreign exchange needed for imports will, in the aggregate, be provided by exports. The same goes for arguments that portfolio flows allow the central bank to target a lower interest rate, as opposed to achieving one.

[4] It would be worth going back and seeing what positive arguments the original framers of the policy trilemma made in favor of “capital mobility.” Or is it just treated as unavoidable?

[5] In the 19th century, “default might even be welcomed as a way of enhancing political influence.”

[6] It would be more conventional to express this thought in the language of capital mobility or international financial flows, but I think the metaphor of “capital” as a fluid “flowing” from one country to another is particularly misleading here.

[7] The capacity of the central bank to maintain payments integrity by substituting its own liabilities for impaired institutions’ is preserved even in the case of foreign-currency liabilities insofar as the central bank’s liabilities are accepted by foreign units. So the development of unlimited swap lines between major central banks represents, at least potentially, an important relaxation of the external constraint and a closer approximation of at least the rich-country portion of the global economy to an ideal closed economy. I’m glad to see that the question of swap lines is being taken up by MMT.

Mixed Messages from The Fed and the Bond Markets

It’s conventional opinion that the Fed will begin to raise its policy rate by the end of 2015, and continue raising rates for the next couple years. In the FT, Larry Summers argues that this will be a mistake. And he observes that bond markets don’t seem to share the conventional wisdom: “Long term bond markets are telling us that real interest rates are expected to be close to zero in the industrialised world over the next decade.”

The Summers column inspired me to take a look at bond prices and flesh out this observation. It is straightforward to calculate how much the value of a bond change in response to a change in interest rates. So by looking at the current yields on bonds of different maturities, we can see what expectations of future rate changes are consistent with profit-maximizing behavior in bond markets. [1]

The following changes shows the yields of Treasury bonds of various maturities, and the capital loss for each bond from a one-point rise in yield over the next year. (All values are in percentage points.)

Maturity Yield as of July 2015 Value Change from 1-Point Rise
30 year 3.07 -17.1
20 year 2.77 -13.9
10 year 2.32 -8.4
5 year 1.63 -4.6
1 year 0.30 -0.0

So if the 30-year rate rises by one point over the next year, someone who just bought a 30-year bond will suffer a 17 percent capital loss.

It’s clear from these numbers that Summers is right. If, over the next couple of years, interest rates were to “normalize” to their mid-90s levels (about 3 points higher than today), long bonds would lose half their value. Obviously, no one would hold bonds at today’s yields if they thought there was an appreciable chance of that happening.

We can be more precise. For any pair of bonds, the ratio of the difference in yields to the difference in capital losses from a rate increase, is a measure of the probability assigned by market participants to that increase. For example, purchasing a 20-year bond rather than a 30-year bond means giving up 0.3 percentage points of yield over the next year, in return for losing only 14 percent rather than 17 percent if there’s a general 1-point increase in rates. Whether that looks like a good or bad tradeoff will depend on how you think rates are likely to change.

For any pair of bonds, we can calculate the change in interest rates (across the whole yield curve) that would keep the overall return just equal between them. Using the average yields for July, we get:

30-year vs 20-year: +0.094%

30-year vs. 10-year: +0.086%

30-year vs. 5-year: +0.115%

20-year vs. 10-year +0.082%

20-year vs. 5 year: + 0.082%

Treasury bonds seem to be priced consistent with an expected tenth of a percent or so increase in interest rates over the next year.

In other words: If you buy a 30 year bond rather than a 20-year one, or a 20-year rather than 10-year, you will get a higher interest rate. But if it turns out that market rates rise by about 0.1 percentage points (10 basis points) over the next year, the greater capital losses on longer bonds will just balance their higher yields. So if you believe that interest rates in general will be about 10 basis points higher a year from now than they are now, you should be just indifferent between purchasing Treasuries of different maturities. If you expect a larger increase in rates, long bonds will look overpriced and you’ll want to sell them; if you expect a smaller increase in rates than this, or a decrease, then long bonds will look cheap to you and you’ll want to buy them. [2]

A couple of things to take from this.

First, there is the familiar Keynesian point about the liquidity trap. When long rates are low, even a modest increase implies very large capital losses for holders of long bonds. Fear of these losses can set a floor on long rates well above prevailing short rates. This, and not the zero lower bound per se, is the “liquidity trap” described in The General Theory.

Second,  compare the implied forecast of a tenth of a point increase in rates implied by today’s bond prices, to the forecasts in the FOMC dot plot. The median member of the FOMC expects an increase of more than half a point this year, 2 points by the end of 2016, and 3 points by the end of 2017. So policymakers at the Fed are predicting a pace of rate increases more than ten times faster than what seems to be incorporated into bond prices.

FOMC dotplot

If the whole rate structure moves in line with the FOMC forecasts, the next few years will see the biggest losses in bond markets since the 1970s. Yet investors are still holding bonds at what are historically very low yields. Evidently either bond market participants do not believe that Fed will do what it says it will, or they don’t believe that changes in policy rate will have any noticeable effect on longer rates.

And note: The belief that long rates unlikely to change much, may itself prevent them from changing much. Remember, for a 30-year bond currently yielding 3 percent, a one point change in the prevailing interest rate leads to a 17 point capital loss (or gain, in the case of a fall in rates). So if you have even a moderately strong belief that 3 percent is the most likely or “normal” yield for this bond, you will sell or buy quickly when rates depart much from this. Which will prevent such departures from happening, and validate beliefs about the normal rate. So we shouldn’t necessarily expect to see the whole rate structure moving up and down together. Rather, long rates will stay near a conventional level (or at least above a conventional floor) regardless of what happens to short rates.

This suggests that we shouldn’t really be thinking about a uniform shift in the rate structure. (Though it’s still worth analyzing that case as a baseline.) Rather, an increase in rates, if it happens, will most likely be confined to the short end. The structure of bond yields seems to fit this prediction. As noted above, the yield curve at longer maturities implies an expected rate increase on the order of 10 basis points (a tenth of a percentage point), the 10-year vs 5 year, 10 year vs 1 year, and 5 year vs 1 year bonds imply epected increases of 18, 24 and 29 basis points respectively. This is still much less than dot plot, but it is consistent with idea that bond markets expect any rate increase to be limited to shorter maturities.

In short: Current prices of long bonds imply that market participants are confident that rates will not rise substantially over the next few years. Conventional wisdom, shared by policymakers at the Fed, says that they will. The Fed is looking at a two point increase over the next year and half, while bond rates imply that it will take twenty years. So either Fed won’t do what it says it will, or it won’t affect long rates, or bondholders will get a very unpleasant surprise. The only way everyone can be right is if trnasmission from policy rate to long rates is very slow — which would make the policy rate an unsuitable tool for countercyclical policy.

This last point is something that has always puzzled me about standard accounts of monetary policy. The central bank is supposed to be offsetting cyclical fluctuations by altering the terms of loan contracts whose maturities are much longer than typical business cycle frequencies. Corporate bonds average about 10 years, home mortgages, home mortgages of course close to 30. (And housing seems to be the sector most sensitive to policy changes.) So either policy depends on systematically misleading market participants, to convince them that cyclical rate changes are permanent; or else monetary policy must work in some completely different way than the familiar interest rate channel.

 

 

[1] In the real world things are more complicated, both because the structure of expectations is more complex than a scalar expected rate change over the next period, and because bonds are priced for their liquidity as well as for their return.

[2] I should insist in passing, for my brothers and sisters in heterodoxy, that this sort of analysis does not depend in any way on “consumers” or “households” optimizing anything, or on rational expectations. We are talking about real markets composed of profit-seeking investors, who certainly hold some expectations about the future even if they are mistaken.

Default ≠ Drachma

I’ve been saying for a while that people should stop assuming that a Greek default implies leaving the euro for a new currency. Much of the media coverage of the negotiations continues to assume that the two are inseparable — that, in effect, the negotiations are over Greece remaining in the euro system. But there is no logical necessity for a default to be followed by the creation of a new currency; indeed it’s hard to see any reason why the former should lead to the latter.

Finally the consensus that default must mean exit seems to be breaking down. Here’s John Cochrane:

Please can we stop passing along this canard — that Greece defaulting on some of its bonds means that Greece must must change currencies. Greece no more needs to leave the euro zone than it needs to leave the meter zone and recalibrate all its rulers, or than it needs to leave the UTC+2 zone and reset all its clocks to Athens time. When large companies default, they do not need to leave the dollar zone. When cities and even US states default they do not need to leave the dollar zone.

Cochrane’s political views are one thing, but he is a very smart guy. And in this case, I think the Walrasian view of money as numéraire is helpful. It’s important to remember that euros are not physical things, they are simply units in which contractual commitments are denominated.

And now in today’s FT, Wolfgang Munchau writes:

The big question — whether Greece will leave the eurozone or not — remains unanswerable. But I am now fairly certain it will default. My understanding is that some eurozone officials are at least contemplating the possibility of a Greek default but without Grexit. … 

On whom could, or should, Greece default? It could default on its citizens by not paying public-sector wages or pensions. That would be morally repugnant and politically suicidal… it could default on the two loans it received from its EU partners, though it is not due to start repaying those until 2020… Defaulting on the IMF and ECB is the only option that would bring genuine financial relief in the short term. … 

Default is not synonymous with exit. There is no EU ruling that says you have to leave the eurozone when you default on your debt. The link between default and exit is indirect; if a country defaults, its defaulting securities are no longer eligible as IOUs for the country’s banks to tender at ECB money auctions.… 

So to default “inside the eurozone” one only needs to devise another way to keep the banking system afloat. If someone could concoct a brilliant answer, there would be no need for Grexit. 

… The economic case for a debt default is overwhelming. … Full servicing would require huge primary surpluses — that is, surpluses before payment of interest on debt. It would leave Greece trapped in a debt depression for a long time. The scheduled primary surplus for 2016 is 4.5 per cent, which is bordering on the insane. Athens absolutely needs to default. At the same time, there is a strong case for remaining in the eurozone.

This hits all the key points. First, there is no logical connection between defaulting and creating a new currency. (Probably better to use that wording, rather than “exit.”) Second, default would open up significant space in Greece’s fiscal position, and would not hurt the its external position. This follows from the fact that Greece currently has a substantial primary surplus and a slight positive trade balance. [1] Third, the only reason there is any link is that default might cause the ECB to cease accepting new liabilities from Greek banks, and it might be hard for the Bank of Greece and/or Greek government to take the ECB’s place under the existing rules of the eurosystem. So, fourth, the real problem with default is the need to ensure that the Greek payments system continues to operate even if the ECB tries to sabotage it. 
The phrasing of that last point might seem hyperbolic. But imagine if, during the Detroit bankruptcy negotiations, the Fed had announced that if the city did not pay off its creditors in full, the Fed would use all its regulatory tools to shut down any banks operating in the city. That’s a close analogy to the situation in Europe.
Maintaining interbank payments within Greece does not necessarily require the Greek government to issue any new liabilities. And it certainly doesn’t require that Greek bank accounts be redenominated. All that is necessary is that if someone with a deposit in Greek bank A wants to make a payment to someone with an account at Greek bank B, there is some system by which bank A can transfer a settlement asset to bank B, acquiring the asset if necessary by issuing a new liability. The technical aspect of this is not challenging, and even the practical aspect, since the Bank of Greece already performs exactly this function. As far as I can tell, the only problem is a political one — given that the Bank of Greece is run by holdovers from the former Greek government, it’s possible that if the ECB told them to stop facilitating payments between Greek banks they would listen, even if the Greek government said to carry on. 
Now some people will say, “oh but the Treaties! oh but the Bank of Greece isn’t allowed to accept the liabilities of Greek banks if Brussels says no! oh but the ELA rules!” [2] Obviously I think this is silly. In the first place, the “rules” are hopelessly vague, so if the ECB’s does shut off liquidity to Greek banks in the event of a default, that will be a political choice. And on the other side, Greece is a sovereign nation. It may have delegated decisionmaking at the Bank of Greece to the ECB, but that also was a political choice, which can be reversed. More to the point, the rules definitely don’t allow for exit. Nor for that matter do they allow for default — and as Munchau correctly points out, cuts to the salaries and pensions of public employees are also a form of default. Rules are going to be broken, whether Greece creates a new currency or not. And it is not at all clear to me that the demands on the Greek state from recreating the drachma, are any less than the demands from maintaining payments between Greek banks in the absence of ECB support — which is all it takes to default and continue using the euro. If anything, the former seems strictly more demanding than the latter, since Greece will need its own central bank either way.
This all may seem pedantic, but it is important: The threat of ejection from the euro is one of the most powerful weapons the creditors have. And let’s remember, the only direct consequence of a breakdown in negotiations, is a default on Greek government debt.
Now there is another argument, which is that exit is positively desirable since a flexible currency would allow Greece to reliably achieve current account balance even once income growth resumes. I think that is wrong — but that’s a topic for another post. (I discussed the issue a couple years ago here.) But even if, unlike me, you think that a flexible exchange rate would be helpful for Greece, it  doesn’t follow that that decision is bound up with the debt negotiations.
[1] It is possible that the apparent primary surplus is due to manipulation of the budget numbers by the previous government. I think that the arguments here would still apply if there were really a primary deficit, but it would complicate things.
[2] Or, “oh but that would be ungrateful.” In one of its more disingenuous editorials I can recall, the FT last month wept crocodile tears over the fact that “default on Greek debts would deter wealthier voters from ever again helping their neighbours in financial distress.” Apparently German banks didn’t care about the interest on all the Greek government bonds they bought; they only lent so long out of kindness, I suppose. Also, it doesn’t seem to have occurred to the editorialists that deterring the financing of large current account deficits might be a good thing.

UPDATE: This seems important:

A country that defaults would not have to leave the euro, the European Central Bank’s vice president said on Monday…  

Vitor Constancio discussed the possibility of a debt default and controls on the movement of money, saying neither necessarily meant a departure from the currency bloc. “If a default will happen … the legislation does not allow that a country that has a default … can be expelled from the euro,” he told the European Parliament… 

Constancio also touched on the possibility of capital controls. “Capital controls can only be introduced if the Greek government requests,” he said, adding that they should be temporary and exceptional. “As you saw in the case of Cyprus, capital controls did not imply getting out of the euro.” … 

“We are convinced at the ECB that there will be no Greek exit,” he said. “The (European Union) treaty does not foresee that a country can be formally, legally expelled from the euro. We think it should not happen.” … 

“If the state defaults, that has no automatic implications regarding the banks, if the banks have not defaulted, if the banks are solvent and if the banks have collateral that is accepted,” Constancio said.

Maybe they were worried that Greece would call their bluff. Or who knows, maybe the culture of the place has changed under Draghi and they are no longer ready to serve as austerity’s battering ram. In any case, it’s hard to see this as anything but a big step back by the ECB.

UPDATE 2: Martin Wolf is on board as well. (Though he doesn’t like my Detroit analogy.)

The Mirage of Devaluation

The papers are full of the rupee crisis. India’s worst economy in decades, supposedly.

The silver lining, according to this morning’s FT, is that the fall in the rupee should eventually boost exports. After all, after the the 1997 Asian crisis, “countries like Thailand and Malaysia enjoyed export-led recoveries following wrenching devaluations.” Is that so?

The devaluation part is right — all these countries saw their currencies fall steeply when they abandoned their pegs in the second half of 1997, typically losing about half their value against the dollar. The supposed export-led recoveries are a different story.

Annual growth of export volumes and average rates for the decades before and after 1997, Malaysia and Thailand. Source: IMF.

The solid lines in the figure above are the annual growth rates of export volumes. The dotted lines are the average rates for the ten years prior to and following the 1997 crisis. As you can see, export growth was substantially slower after the crisis than before — in both Malaysia and Thailand, export growth after devaluation was about half the previous pace. In Indonesia, whose currency fell even more, export growth essentially ceased — from 8 percent annual rates before 1997 to less than 1 percent in the decade following. And these are volumes; given the devaluation, foreign exchange earnings did even worse. In Thailand, for instance, exports earnings in dollars were still lower in early in 2002 than they had been before the crisis, almost five years before. For Indonesia, export earnings were still at their pre-crisis levels as late as 2004. This is about as far from an export boom as you can get.

You can argue, I suppose, that without the devaluations export performance would have been even worse. But you cannot claim that faster export growth following the devaluations boosted demand, because no such faster growth occurred.

It’s really remarkable how much the devaluation-export growth link is taken for granted in discussions of foreign trade. But in the real world, for whatever reason, the link is often weak or nonexistent.

Practical policymakers seem to have an easier time grasping this than economists. There’s a reason why falling currencies are seen as major problems in much of the developing world, even though they supposedly should boost exports. And there’s a reason, presumably, why the leaders of Syriza, hardly slaves to conventional wisdom, have ignored the advice from progressive American economists that Greece would be better off out of the Euro.

The Cash and I

Martin Wolf in the FT the other day:

The third challenge is over the longer-term sources of demand. I look at this issue in terms of the sectoral financial balances – the balances between income and spending – in the household, business, external and government sectors. The question, then, is where expansion will come from. In the first quarter of this year the principal offset to fiscal contraction was the declining household surplus. 

What is needed, as well, is a big swing towards surplus in the US current account or a jump in corporate investment, relative to retained profits. Neither seems imminent, though the second seems more likely than the first. The worry is that the only way to balance the economy will be via big new bubbles. If so, this is not the fault of the Fed. It is the fault of structural features of the domestic and global economies…

This is a good point, which should be made more. If we compare aggregate expenditure today to expenditure just before the recession, it is clear that the lower level of demand today is all about lower  consumption. But maybe that’s not the best comparison, because during the housing boom period, consumption was historically high. If we take a somewhat longer view, what’s unusually low today is not household consumption, but business investment. Weak demand is about I, not C.

This is especially clear when we compare investment by businesses to what they are receiving in the form of profits, or, better cashflow from operations — after-tax profits plus depreciation. [1] Here is the relationship over the past 40 years:

Corporate Investment and Cashflow from Operations as Fraction of Total Assets, 1970-2012

The graph shows annualized corporate investment and cashflow, normalized by total assets. Each dot is data from one quarter; to keep the thing legible, I’ve only labeled the fourth quarter of each year. As you can see, there used to be a  clear relationship between corporate profitability and corporate investment. For every additional $150, more or less, that a corporation took in from operations, it would increase capital expenditures by $100. This relationship held consistently through the 1960s (not shown), the 1970s, the 1980s and 1990s.

But now look at the past ten years, the period after 2001Q4.  Corporate investment rates are substantially lower throughout this period than at any earlier time (averaging around 3.5% of total assets, compared with 5% of assets for 1960-2001). And the relationship between aggregate profit and investment rates has simply disappeared.

Some people might say that the problem is in the financial system, that even profitable businesses can’t borrow because of a breakdown in intermediation, a shortage of liquidity, an unwillingness of risk-averse investors to hold their debt, etc. I don’t buy this story for a number of reasons, some of which I’ve laid out in recent posts here. But it at least has some certain prima facie plausibility for the period following the great financial crisis. Not for for the whole decade-plus since 2001. Saying that investment is low today because businesses can’t find anyone to buy their bonds is merely wrong. Saying that’s why investment was low in 2005 is absurd.

(And remember, these are aggregates, so they mainly reflect the largest corporations, the ones that should have the least problems borrowing.)

So what’s a better story?

I am going to save my full answer for another post. But regular readers will not be surprised that I think the key is a shift in the relationship between corporations and shareholders. I think there’s a sense in which the binding constraint on investment has changed from the terms on which management can get funds into the corporation, from profits or borrowing, to the terms are on which they can keep them from going out, to investors. But the specific story doesn’t matter so much here. You can certainly imagine other explanations. Like, “the China price” — even additional capacity that would be profitable today won’t be added if it there’s a danger of lower-cost imports entering that market.

The point of this post is just that corporate investment is historically low, both in absolute terms and relative to profitability. And because this has been true for a decade, it is hard to attribute this weakness to credit constraints, or believe that it will be responsive to monetary policy. (This is even more true when you recall that the link between corporate borrowing and investment has also essentially disappeared.) By contrast, household consumption remains high. I have the highest respect for Steve Fazzari, and agree that high income inequality is a key metric of the fucked-upness of our economy. But I don’t think it makes sense to think of the current situation in terms of a story where high inequality reduces demand by holding down consumption.

Consumption is red, on the right scale; investment is blue, on the left. Both as shares of GDP.

As I say, I’ll come back in a future post to my on preferred explanation for why a comparably profitable firm, facing comparable credit conditions, will invest less today than 20 or 30 years ago.

In the meantime, one other thing. That first graph is a nice tool for showing how a Marxist thinks about business cycles.

If you look at the graph carefully, you’ll see the points follow counterclockwise loops. It’s natural to see this as cycles. Like this:

Start from the bottom of a cycle, at a point like 1992. A rise in profits from whatever source leads to higher investment, mainly as a source of funds and but also because it raises expectations of future profitability. That’s the lower right segment of the cycle. High investment eventually runs into supply constraints, typically in the form of a rising wage share.[1] At that point profits begin to fall. Investment, however, continues high for a while, as the credit system allows firms to bridge a growing financing gap. That’s the upper right segment of the cycle. Eventually, though, if profits don’t recover, investment will follow them downward. This turning point often involves a financial crisis and/or abrupt fall in asset values, like the collapse of tech stocks in 2000. This is the upper left segment of the cycle.  Finally, in the  lower left, both profits and investment are low. But after some time the conditions for profitability are restored, and we move toward the right and begin a new cycle. This last step is less reliable than the others. It’s quite possible for the economy to come to rest at the lower left and wobble there for a while without any sustained change in either profits or investment. We see this in 2002-2003 and in 1988-1991.

(I think the investment boom of the late 70s and the persistent slump of the early 1990s are two of the more neglected episodes in recent economic history. The period around 1990, in particular, seems to have all the features that are supposed to be distinctive to the current macroeconomic conjuncture. At the time, people even called it a balance-sheet recession!)

For now, though, we’re not interested in the general properties of cycles. We’re interested in how flat and low the most recent two are, compared with earlier ones. That is the structural feature that Martin Wolf is pointing to. And it’s not a new feature of the post financial crisis period, it’s been the case for a dozen years at least, only temporarily obscured by the housing bubble.

UPDATE: In comments, Seth Ackerman asks if maybe using total assets to normalize investment and profits is distorting the picture. It’s a good question, but the answer is no. Here’s the same thing, with trend GDP in the denominator instead:

As you can see, the picture is basically the same. Investment in the 200s is still visibly depressed compared with earlier decades, and the relationship between profits and investment is much weaker. Of course, it’s always possible that current high profits will lead an investment boom in the next few years…

[1] Cash from operations is better than profits for at least two reasons. First, from the point of view of aggregate demand, we are interested in gross not net investment. A dollar of investment stimulates demand just as much whether it’s replacing old equipment or adding new. So our measure of income should also be gross of depreciation. Second, there are major practical and conceptual issues with measuring depreciation. Changes in accounting standards may result in very different official depreciation numbers in economically identical situations. By combining depreciation and profits, we avoid the problem of the fuzzy and shifting line between them, making it more likely that we are comparing equivalent quantities.

[2] A rising wage share need not, and often does not, take the form of rising real wages. In recent cycles especially, it’s more likely to combine flat real wages with a rising relative cost of wage goods.

Tell Me About that “Safe Asset Shortage” Again

From today’s FT:

US Junk Debt Yield Hits Historic Low

The average yield on US junk-rated debt fell below 5 per cent for the first time on Monday, setting yet another milestone in a multiyear rally and illustrating the massive demand for fixed income returns as central banks suppress interest rates. 

Junk bonds and equities often move in tandem, and with the S&P 500 rising above 1,600 points for the first time and sitting on a double digit gain this year, speculative rated corporate bonds are also on a tear. … With corporate default rates below historical averages, investors are willing to overlook the weaker credit quality in exchange for higher returns on the securities, analysts said. … The demand for yield has become the major driver of investor behaviour this year, as they downplay high valuations for junk bonds and dividend paying stocks. 

“Maybe the hurdles of 6 per cent and now 5 per cent on high-yield bonds are less relevant given the insatiable demand for income,” said Jim Sarni, managing principal at Payden & Rygel. “People need income and they are less concerned about valuations.”

In other words, the demand for risky assets is exceptionally high, and this has driven up their price. Or to put it the other way, if you are a high-risk corporate borrower, now is a very good time to be looking for a loan.

Here’s the same thing in a figure. Instead of their absolute yield, this shows the spread of junk bonds over AAA:

Difference between CCC- and AAA bond yields

See how high it is now, over on the far right? Yeah, me neither. But if the premium for safe assets is currently quite low, how can you say that it is a shortage of safe assets that is holding back the recovery? If financial markets are willing to lend money to risky borrowers on exceptionally generous terms, how can you say the problem is a shortage of risk-bearing capacity?

Now, the shortage-of-safe-assets story does fit the acute financial crisis period. There was a period in late 2008 and early 2009 when banks were very wary of holding risky assets, and this may have had real effects. (I say “may” because some large part of the apparent fall in the supply of credit in the crisis was limited to banks’ unwillingness to lend to each other.) But by the end of 2009, the disruptions in the financial markets were over, and by all the obvious measures credit was as available as before the crisis. The difference is that now households and firms wished to borrow less. So, yes, there was excess demand for safe assets in the crisis itself; but since then, it seems to me, we are in a situation where all markets clear, just at a lower level of activity.

This is a perfect illustration of the importance of the difference between the intertemporal optimization vision of modern macro, and the income-expenditure vision of older Keynesian macro. In modern macro, it is necessarily true that a shortfall of demand for currently produced goods and services is equivalent to an excess demand for money or some other asset that the private sector can’t produce. Or as DeLong puts it:

If you relieve the excess demand for financial assets, you also cure the excess supply of goods and services (the shortfall of aggregate demand) and the excess supply of labor (mass unemployment).

Because what else can people spend their (given, lifetime) income on, except currently produced stuff or assets? If they want less of one, that must mean they want more of the other.

In the Keynesian vision, by contrast, there’s no fixed budget — no endowment — to be allocated. People don’t know their lifetime income; indeed, there is no true expected value of future income out there for them to know. So households and businesses adjust current spending based on current income. Which means that all markets can clear at a various different levels of aggregate activity. Or in other words, people can rationally believe they are on their budget constraint at different levels of expenditure, so there is no reason that a decline in desired expenditure in one direction (currently produced stuff) has to be accompanied by an increase in some other direction (safe assets or money).

(This is one reason why fundamental uncertainty is important to the Keynesian system.)

For income-expenditure Keynesians, it may well be true that the financial meltdown triggered the recession. But that doesn’t mean that an ongoing depression implies an ongoing credit crisis. Once underway, a low level of activity is self-reinforcing, even if financial markets return to a pristine state and asset markets all clear perfectly. Modern macro, on the other hand, does need a continued failure in financial markets to explain output continuing to fall short of potential. So they imagine a “safe asset shortage” even when the markets are shouting “safe asset glut.”

EDIT: I made this same case, more convincingly I think, in this post from December about credit card debt. The key points are (1) current low demand is much more a matter of depressed consumption than depressed investment; (2) it’s nonsense to say that households suffer from a shortage of safe assets since they face an infinitely-elastic supply of government-guaranteed bank deposits, the safest, most liquid asset there is; (3) while it’s possible in principle for a safe-asset shortage to show up as an unwillingness of financial intermediaries to hold household debt, the evidence is overwhelming that the fall in household borrowing is driven by demand, not supply. The entire fall in credit card debt is accounted for by defaults and reduced applications; the proportion of credit card applications accepted, and the average balance per card, have not fallen at all.

Pain Is the Agenda: The Method in the ECB’s Madness

Krugman is puzzled by the European Central Bank:

I’ve been hearing various attempts to explain the ECB’s utterly bizarre refusal to cut interest rates… The most popular story seems to be that the ECB wants to “hold politicians’ feet to the fire”, letting them know that they won’t get relief unless they do what’s necessary (whatever that is). This really doesn’t make any sense. If we’re talking about enforcing austerity and wage cuts in the periphery, how much more incentive do these economies need?

He is certainly right that if the goal is resolving the crisis, or even price stability, then refusing further rate cuts is mighty strange. But who says those are the goals? His final question is meant to be rhetorical, but it really isn’t. Because the more austerity you want, the more enforcement you need.

I met someone the other day with a fairly senior position at the Greek tax authority; her salary had just been cut by 40 percent. When, outside of an apocalyptic crisis, do you see pay cuts like that? Which, for you or me or Paul Krugman, is an argument to End This Depression Now. But if you are someone who sees pay cuts as the goal, then it could be an argument for not quite yet.

It’s a tenet of liberalism — and a premise of the conversation Krugman is part of — that there are conflicting opinions, but not conflicting interests. But sometimes, when people seem to keep doing things with the wrong outcome, it’s because that’s the outcome they actually want. Paranoid? Conspiracy theory? Maybe. On the other hand, here’s Deutsches Bundsbank president Jens Weidmann:

Relieving stress in the sovereign bond markets eases imminent funding pain but blurs the signal to sovereigns about the precarious state of public finances and the urgent need to act. Macroeconomic imbalances and unsustainable public and private debt in some member states lie at the heart of the sovereign debt crisis. It may appeal to politicians to abstain from unpopular decisions and try to solve problems through monetary accommodation. However, it is up to monetary policymakers to fend off these pressures.

That seems pretty clear. From the perspective of the central banker, resolving the crisis too painlessly would be bad, because that would allow governments to “avoid unpopular decisions.” And it’s true: If there’s something you really want governments to do, but you don’t think they will make the necessary decisions except in a crisis, then it is perfectly rational to prolong the crisis until you see the right decisions being made.

So, what kind of decision are we talking about, exactly? Krugman professes bafflement — “whatever that is” — but it’s not really such a mystery. Here’s an editorial in the FT on the occasion of last summer’s ECB intervention to support the market for Italy’s public debt:

Structural reform is the quid pro quo for the European Central Bank’s purchases last week of Italian government bonds, an action that bought Italy breathing space by driving down yields. … As the government belatedly recognises, boosting Italy’s growth prospects requires a liberalisation of rigid labour markets and a bracing dose of competition in the economy’s sheltered service sectors. This is where the unions and professional bodies must play their part. Susanna Camusso, leader of the CGIL, Italy’s biggest trade union, is threatening to call a general strike to block the proposed labour law reforms. She would be better advised to co-operate with the government and employers… The government’s austerity measures are sure to curtail economic growth in the short run. Only if long overdue structural reforms take root will the pain be worthwhile.

A couple of things worth noting here. First the explicit language of the quid pro quo — the ECB was not just doing what was needed to stabilize the Italian bond market, but offering stabilization as a bargaining chip in order to achieve its other goals. If ECB was selling expansionary policy last year, why be surprised they’re not giving it away for free today? Note also the suggestion that a sacrifice of short-term output is potentially worthwhile — this isn’t some flimflam about expansionary austerity, but an acknowledgement that expansion is being give up to achieve some other goal. And third, that other goal: Everything mentioned is labor market reform, it’s all about concessions by labor (including professionals). No mention of more efficient public services, better regulation of the financial system, or anything like that.

The FT editorialist is accurately presenting the ECB’s view. My old teacher Jerry Epstein has a good summary at TripleCrisis of the conditions for intervention; among other things, the ECB demanded “full liberalisation of local public services…. particularly… the provision of local services through large scale privatizations”; “reform [of] the collective wage bargaining system … to tailor wages and working conditions to firms’ specific needs…”;  “thorough review of the rules regulating the hiring and dismissal of employees”; and cuts to private as well as public pensions, “making more stringent the eligibility criteria for seniority pensions” and raising the retirement age of women in the private sector. Privatization, weaker unions, more employer control over hiring and firing, skimpier pensions. This is well beyond what we normally think of as the remit of a central bank.

So what Krugman presents as a vague, speculative story about the ECB’s motives — that they want to hold politicians’ feet to the fire — is, on the contrary, exactly what they say they are doing.

It’s true that the conditions imposed by the ECB on Italy and Greece were in the context of programs relating specifically to those countries’ public debt, while here we are talking about a rate cut. But there’s no fundamental difference — cutting rates and buying bonds are two ways of describing the same basic policy. If there’s conditions for one, we should expect conditions for the other, and in fact we find the same “quid pro quo” language is being used now as then.

Here’s a banker in the FT:

The future of Europe will therefore be determined by the interests of the ECB. Self-preservation suggests that it will prevent complete collapse. If necessary, it will overrule Germany to do this, as the longer-term refinancing operations and government bond purchase programme suggest. But self-preservation and preventing collapse do not amount to genuine cyclical relief and policy stimulus. Indeed, the ECB appears to believe that in addition to price stability it has a mandate to impose structural reform. To this extent, cyclical pain is part of its agenda.

Again, there’s nothing irrational about this. If you really believe that structural reform is vital, and that democratic governments won’t carry it out except under the pressure of a crisis, then what would be irrational would be to relieve the crisis before the reforms are carried out. In this context, an “irrational” moralism can be an advantage. While one can take a hard line in negotiations and still be ready to blink if the costs of non-agreement get too high, it’s best if the other side believes that you’ll blow it all up if you don’t get what you want.  Fiat justitia et pereat mundus, says Martin Wolf, is a dangerous motto. Yes; but it’s a strong negotiating position.

But this invites a question: Why does the ECB regard labor market liberalization (aka structural reform) as part of its mandate? Or perhaps more precisely, when the ECB negotiates with national governments, on whose behalf is it negotiating?

The answer the ECB itself might give is, society as a whole. After all, this is the consensus view of central banks’ role. Elected governments are subject to time inconsistency, or are captured by rent seekers, or just don’t work, so an “independent” body is needed to take the long view. It’s never been clear why this should apply only to monetary policy, and in fact there’s a well-established liberal view that the independent central bank model should be extended to other areas of policy. Alan Blinder:

We have drawn the line in the wrong place, leaving too many policy decisions in the realm of politics and too few in the realm of technocracy. … the argument for the Fed’s independence applies just as forcefully to many other areas of government policy. Many policy decisions require complex technical judgments and have consequences that stretch into the distant future. Think of decisions on health policy (should we spend more on cancer or aids research?), tax policy (should we reduce taxes on capital gains?), or environmental policy (how should we cope with damage to the ozone layer?). Yet in such cases, elected politicians make the key decisions. Why should monetary policy be different? … The justification for central bank independence is valid. Perhaps the model should be extended to other arenas. … The tax system would surely be simpler, fairer, and more efficient if … left to an independent technical body like the Federal Reserve rather than to congressional committees.

I’m sure there are plenty of people at the ECB who think along the same lines as the former Fed Vice-Chair. Indeed, that central banks want what’s best for everyone is practically an axiom of modern economics. Still, it’s funny, isn’t it, that “structural reform” so consistently turns out to mean lower wages?

Martin Wolf’s stuff on the European crisis has been essential. But it has one blind spot: The only conflicts he sees are between nations. What perplexes him is “the riddle of German self-interest.” But maybe the answer to the riddle is that national interests are not the only ones in play.

It’s hard not to think here of Perry Anderson’s thesis, developed (alongside other themes) in The New Old World, that the EU project is fundamentally a response by European elites to their inability to roll back social democracy at the national level. The new supra-national institutions of the EU have allowed them to bypass political cultures that remain stubbornly (if incompletely) egalitarian and solidaristic. In Alain Supiot’s summary:

In Anderson’s view, the European project has engendered neither a federation nor an intergovernmental organization; rather it is the most fully realized form of Hayek’s ultraliberal ‘catallaxy’. … Like a secular version of faith in divine providence, belief in the spontaneous order of the markets entails a desire to protect it from the untimely interventions of people seeking ‘a just distribution’ which, according to Hayek, is nothing more than ‘an atavism, based on primordial emotions’. Hence the need to ‘dethrone the political’ by means of constitutional steps which create ‘a functioning market in which nobody can conclusively determine how well-off particular groups or individuals will be’. In other words, it is necessary to put the division of labour and the distribution of its fruits beyond the reach of the electorate. This is the dream that the European institutions have turned into a reality. Beneath the chaste veil of what is conventionally known as the EU’s ‘democratic deficit’ lies a denial of democracy.

Jerry Epstein puts it more bluntly. The ECB’s insistence on structural reform “represents a cynical raw power calculus to destroy worker and citizen protections  without any real belief in the underlying neo-liberal economics they use to justify it.” (If you prefer your political economy in audiovisual form, he has a video talking about this stuff.)

This kind of language makes people uncomfortable. Rather than acknowledge that the behavior of people in power could represent a particular interest — let alone that of the top against the bottom, or capital against labor — much better to throw your hands up and profess bafflement: their choices are “bizarre,” a “riddle.” This isn’t, let’s be clear, a personal failing. If you or I occupied the same kind of positions as Krugman or Wolf, we’d be subject to the same constraints. And I anyway don’t want to find myself talking to no one but a handful of grumpy old Marxists.

But on the other hand, as Doug Henwood likes to quote our late friend Bob Fitch, “vulgar Marxism explains 90 percent of what happens in the world.” And then, I keep looking back through FT articles on the crisis, and finding stuff like this:

The central bank has long called for eurozone economies to press ahead with structural reforms. That the ‘E’ in EMU, or Economic and Monetary Union, has not occurred is a complaint often voiced by ECB officials. On this score, the central bank has managed to win an important concession in forcing Italy to sign up to liberalising its economy. Some may see this as a pyrrhic victory for the damage that the bond purchases have done to the central bank’s independence. But there was a significant threat to stability if the central bank did not act. …That Mr Trichet, always among the more politically savvy of central bankers, managed to get some concessions on structural reform was all that could be hoped for.

One has to wonder: What does it mean for the ECB to “win an important concession” from an elected government? Who is it winning the concession for? And if the problem with the ECB is just an ideological fixation on its inflation-fighting credibility, why would it be willing to sacrifice some of that credibility to advance this other goal?

It’s hard to suppress a lingering suppression that central bankers are, after all, bankers. And then you think, isn’t there an important sense in which finance embodies the interests of the capitalist class as a whole? (In an anodyne way, this is even sort of what its conventional capital-allocation function means) You wonder if the only reason Karl Marx called “the modern executive is a committee for managing the common affairs of the whole bourgeoisie,” is that central banks didn’t yet exist.

Imagine you’re a European capitalist, or business owner if you prefer the sound of that. You look at the United States and see the promised land. Employment at will — imagine, no laws limiting your ability to fire whoever you want. Private pensions, gone. Unions almost gone, strikes a thing of the past. Meanwhile, in 2002, 95 out of every 1,000 workers in the Euro area — nearly ten percent — was on strike at some point during the year. (In Spain, it was 270 out of every 1,000. In Italy, over 300.) And of course there’s the vastly greater share of income going to your American peers. Look at it from their point of view: Why wouldn’t they want what their American cousins have?

It seems to me that what would really be bizarre, would be if European capitalists did not see the crisis as a once-in-a-lifetime opportunity. They’d be crazy — they’d be betraying their own interests — if, given the ECB’s suddenly increased power vis-a-vis national governments, they didn’t insist that it extract all the concessions it can.

Isn’t that what they’re doing? Moreover, isn’t it what they say they’re doing? When the “Global Head of Market Economics” at the world’s biggest bank says that the ECB should only cut rates “as part of a quid pro quo with governments agreeing to more far-reaching structural reform,” what do you think he means?

Get Your Gaman On

The other day, I quoted Howard Davies explaining the big macroeconomic advantage of a country like Latvia over a country like Greece:

Latvia could make austerity work because they’d been in the USSR for 50 years, they were used to unpleasant and dramatic things happening. The population would accept incredible privation. 

As a sort of followup, here’s a letter from one Mr. Zachary Pessin, in yesterday’s FT:

I have often thought that acclimatisation to a depressed economic environment is a state of mind that the Japanese have adjusted to… I first went to Japan in 1995 to live for a semester, then lived there full-time from 1999 to 2002. I have been every year since, save the last two. So, for 15 years I have seen how a generation of Japanese lost pride in their country, lost hope of an inspiring life and came to terms with the drudgery.

“Yikes,” you’re probably thinking, “Lost pride, lost hope and drudgery? That sounds awful — we’d better figure out fast how to avoid it.” Well, if that is what you’re thinking, then you’d better think again. Losing hope is the whole point. The Japanese, Pessin says, are

a decade ahead of us in dealing with the world we now live in. … Perhaps you know the Japanese term gaman, which is effectively translated as “to persevere valiantly through pain or difficulty; stoic determination”. This too will be another import from Japan, because they have been living in the House of Gaman for almost 20 years now, and we Americans are just arriving. And make no mistake, the deleveraging that must continue across the US economy for at least another five to eight years at best will keep us walking the precipice of deflation for at least that long. There will be a need for gaman.

I don’t know how much pain or drudgery is in store for Zac Pessin personally, given that he is President and Chief Executive of the Distributed Capital Group; you can find him here crowing about double-digit returns on his investments in sub-Saharan Africa. But it’s nice of our masters to let us know about the sacrifices we will be expected to make on their behalf.

Those who take the meat from the table
Teach contentment.
Those for whom the taxes are destined
Demand sacrifice.
Those who eat their fill speak to the hungry
Of wonderful times to come.
Those who lead the country into the abyss
Call ruling too difficult
For ordinary men.

The Capitalist Wants an Exit, Facebook Edition

In today’s FT, John Gapper reads the Facebook prospectus. [1] And he doesn’t like what he sees:

There is still time to cancel its IPO and the filing provides plenty of reasons why it ought to… It begs a question if a company trying to raise capital from investors cannot think of anything to do with the money. Yet this is Facebook’s predicament – as it admitted in its filing on Wednesday, its cash flow and credit “will be sufficient to meet our operational needs for the foreseeable future”. … So what are its plans for the additional $5bn it may raise from an IPO? It intends to put the cash into US government bonds and savings accounts…

Gapper, looking at the IPO from the perspective of what it does for Facebook the enterprise, understandably thinks this is nuts. Why incur the costs of an IPO and the ongoing requirements of a public listing, if you have so little need for the cash that you are literally just planning to leave it in a savings account. But of  course, the purpose of the IPO has nothing to do with Facebook the enterprise.

Given that it doesn’t need capital…, why the IPO? … Facebook’s motivation is clear: to gratify its venture capital investors and employees. This is not a cynical statement; it is a quote from Mr Zuckerberg’s letter to new shareholders. “We’re going public for our employees and our investors,” he writes. “We made a commitment to them when we gave them equity that we’d work hard to make it worth a lot and make it liquid, and this IPO is fulfilling our commitment.”

In terms of Silicon Valley’s logic, it makes sense… For the company itself, however, the logic is far less obvious. As a corporate entity, Facebook could clearly thrive without seeking new shareholders, whose main purpose is to allow the insiders to get rich and eventually exit.

 As I’ve written before, the function of the stock market in modern capitalism is to get money out of corporations, not put money into them. The social problem they are solving is not society’s need to allocate scarce savings to the most promising investments, but wealth-owners desire to free their fortunes from particular firm or industry and keep them as claims on the social product as a whole.

[1] It’s been said before, but can I just point out how unbearably stupid is the FT’s policy of actively discouraging people from excerpting their articles?