the money view – Page 4

Links for June 15, 2016

“Huge foreign demand for Treasuries”. Via Across the Curve, here’s the Wall Street Journal:

The global hunger for U.S. government debt is intensifying as investors seek better returns from the negative yields and record-low rates found in Japan and Europe. On Thursday, an auction of 30-year Treasury debt attracted some of the highest demand ever from overseas buyers…

Thirty-year bonds typically attract a specialized audience, largely pension funds and other investors trying to buy assets to match long-term liabilities. There are few viable alternatives for such buyers around the world. The frenzy of buying has sparked warnings about the potential of large losses if interest rates rise. …

One auction is hardly dispositive, but that huge foreign demand is worth keeping in mind when we think about the US fiscal and external deficits. A point that Ryan Cooper also makes well.

You get the debt, I get the cash. When I pointed out Minsky’s take on Trump on this blog a few months ago, there were some doubts. How exactly, did Trump extract equity from his businesses? Why didn’t the other investors sue? In its fascinating long piece on Trump’s adventures in Atlantic City, the Times answers these questions in great detail. Rread the whole thing. But if you don’t, Trump himself has the tl;dr:

“Early on, I took a lot of money out of the casinos with the financings and the things we do,” he said in a recent interview. “Atlantic City was a very good cash cow for me for a long time.”

Unto the tenth generation. If you are going to make an argument for Britain leaving the euro, it seems to me that Steve Keen has the right one. The fundamental issue is not the direct economic effects of membership in the EU (which are probably exaggerated in any case.) The issue is the political economy. First, the EU lacks democratic legitimacy, it effectively shifts power away from elected national governments, while Europe-wide democracy remains an empty shell. And second, European institutions are committed to an agenda of liberalization and austerity.

From the other side, we get this:

I wish I knew where this sort of thing came from. Maybe Brexit would reduce employment in the UK, maybe it wouldn’t — this is not the sort of thing that can be asserted as an unambiguous matter of fact. Whether it’s EU membership or taxes or trade or the minimum wage, everyone claims their preferred policy will lead to higher living standards than the alternatives. Chris Bertram seems like a reasonable person, I doubt that, in general, he wishes suffering on the children of people who see policy questions differently than he does. But on this one, disagreement is impermissible. Why?

I like hanging out in coffeehouses. Over at Bloomberg, Noah Smith offers a typology of macroeconomics:

The first is what I call “coffee-house macro,” and it’s what you hear in a lot of casual discussions. It often revolves around the ideas of dead sages — Friedrich Hayek, Hyman Minsky and John Maynard Keynes.

The second is finance macro. This consists of private-sector economists and consultants who try to read the tea leaves on interest rates, unemployment, inflation and other indicators in order to predict the future of asset prices (usually bond prices). It mostly uses simple math, … always includes a hefty dose of personal guesswork.

The third is academic macro. This traditionally involves professors making toy models of the economy — since the early ’80s, these have almost exclusively been DSGE models … most people outside the discipline who take one look at these models immediately think they’re kind of a joke.

The fourth type I call Fed macro…

It’s fair to say a lot of us here in the coffeehouses were pleased by this piece. Obviously, you can quibble with the details of his list. But it gets a couple of big things right. First, the fundamental problem with academic macroeconomics is not that it’s a study of the concrete phenomena of “the economy” that has gone wrong in some way, but a self-contained activity. The purpose of models isn’t to explain anything, it’s just to satisfy the aesthetic standards of the profession. As my friend Suresh put it once, the best way to think about economics is a kind of haiku with Euler equations. I think a lot of people on the left miss this — they think that you can criticize economic by pointing out some discrepancy with the real world. But that’s like saying that chess is flawed because in medieval Europe there were many more knights than bishops.

The other thing I think Noah’s piece gets right is there is no such thing as “economic orthodoxy.” There are various different orthodoxies — the orthodoxy of the academy, the orthodoxy of business and finance, the orthodoxy of policymakers — and they don’t agree with each other. On some important dimensions they hardly even make contact.

Merijn Knibbe also likes the Bloomberg piece. (He’s doing very good work exploring these same cleavages.) Noah follows up on his blog. Justin Wolfers rejects basically everything taught as macroeconomics in grad school. DeLong makes a distinction between good and bad academic economics which to me, frankly, looks like wishful thinking. Brian Romanchuk has some interesting thoughts on this conversation.

Are there really excess reserves? I’ve just been reading Zoltan Pozsar’s Global Money Notes for Credit Suisse. Man they are good. If you’re interested in money, finance, central banks, monetary policy, any of that, you should be reading this guy. Anyway, in this one he makes a provocative argument that I think is right:

Contrary to conventional wisdom, there are no excess reserves – not one penny. Labelling the trillions of reserves created as a byproduct of QE as “excess” was appropriate only until the Liquidity Coverage Ratio (LCR) went live, but not after. …

Before the LCR, banks were required to hold reserves only against demand deposits issued in the U.S. … As banks went about their usual business of making loans and creating deposits, they routinely fell short of reserve requirements. To top up their reserve balances, banks with a shortfall of reserves … borrowed fed funds from banks with a surplus of reserves… These transactions comprised the fed funds market.

Under the LCR, banks are required to hold reserves (and more broadly, high-quality liquid assets) not only against overnight deposits, but all short-term liabilities that mature in less than 30 days, regardless of whether those liabilities were issued by a bank subsidiary, a broker-dealer subsidiary or a holding company onshore or offshore …

The idea is this: Under the new Basel III rules, which the US has adopted, banks are required to hold liquid assets equal to their total liabilities due in 30 days or less. This calculation is supposed to include liabilities of all kinds, across all the bank’s affiliates and subsidiaries, inside and outside the US. Most of this requirement must be satisfied with a short list of “Tier I” assets, which includes central bank reserves. So reserves that are excess with respect to the old (effectively moot) reserve requirements, will not be to the extent that they are held to satisfy these new rules.

Pozsar’s discussion of these issues is extremely informative. But his “no one penny” language may be a bit exaggerated. While the exact rules are still being finalized, it looks like current reserve holdings could still be excessive under LCR. Whie banks have to hold unencumbered liquid assets equal to thier short-term liabilities, the fraction that has to be reserves specifically is still being determined — Pozsar suggests the most likely fraction is 15 percent. He gives data for six big banks, four of which hold more reserves than required by that standard — though on the other hand, five of the six hold less total Tier I liquid assets than they will need. (That’s the “max” line in the figure — the “min” line is 15 percent.) But even if current reserve holdings turn out to be more than is required by LCR, it’s clear that there are far less excess reserves than one would think using the old requirements.

Liquid assets as a share of short-term liabilities. Source: Credit Suisse — Liquid assets as a share of short-term liabilities, selected banks. Source: Credit Suisse

Pozsar draws several interesting conclusions from these facts. First, the Federal Funds rate is dead for good as a tool of policy. (I wonder how long it will take textbook writers to catch up.) Second, central bank balance sheets are not going to shrink back to “normal” any time in the foreseeable future. Third, this is a step along the way to the Fed becoming the world’s central bank, de facto in even in a sense de jure. (Especially in conjunction with the permanent swap lines with other central banks, another insitutional evolution that has not gotten the attention it deserves.) A conclusion that he does not draw, but perhaps should have, is that this is another reason not to worry about demand for Treasury debt. There are good prudential reasons for requiring banks to hold government liabilities, but in effect it is also a form of financial repression.

This is also a good illustration of Noah’s point about the disconnect between academic economics and policy/finance economics. Academic economists are obsessed with “the” interest rate, which they map to the entirely unrelated intertemporal price called “interest rate” in the Walrasian system. Fundamentally what central banks do is determine the pace of credit expansion, which historically has involved a great variety of policy tools. Yes, for a while the tool of choice was an overnight interbank rate. But not anymore. And whatever the mix of immediate targets and instruments will be going forward, it’s a safe bet it won’t return to what it was in the past.

What to Do about the Trade Deficit: Nothing

Roosevelt Institute has a new roundup of policy advice for the next administration. There is a lot of useful stuff in there, which perhaps I’ll post more on later. My own contribution is on international trade. Here’s the summary:

It is natural to look to measures to improve the trade balance — through a weaker dollar, or through tariffs or other direct limits on imports — as a way to raise demand and boost output and employment. While the U.S. has done little to boost net exports in recent decades, there is increasing public discussion of such measures today…

We argue that while the orthodox view is wrong about trade being macroeconomically neutral, measures to improve the U.S. trade balance would nonetheless be a mistake. All else equal, a more favorable trade balance will raise demand and boost employment. But all else
is not equal, thanks to the special role of the U.S. in the world economy. The global economy today operates on what is effectively a dollar standard: The U.S. dollar serves as the international currency, the way gold did under under the gold standard. In part for this reason, the U.S. can finance trade deficits indefinitely while most other countries cannot. For many of our trade partners, any reduction of net exports would imply unsustainable trade deficits. So policies intended to improve the U.S. trade balance are likely to instead lead to lower growth elsewhere, imposing large costs on the rest of the world with little or no benefits here.

We do not deny that the trade deficit has negative effects on demand and employment in the U.S., but we argue this is only a reason to redouble efforts to boost domestic demand. The solution to the contractionary effects of the trade deficit is not a costly, and probably futile, effort to move toward a trade surplus, but rather measures to boost investment in both the public and private sector.

You can read the rest of my piece here.

There were a couple figures that didn’t make it into the final piece. Here is one, showing the stability of the international role of the dollar over the past 20 years.

The dotted line shows the share of central bank reserves held in dollars (source). The heavy line shows the share of foreign-exchange transactions that involve the dollar (source). About two-thirds of foreign exchange reserves are held in dollars, and close to 90 percent of foreign-exchange transactions involve the dollar and some other currency. These shares have not diminished at all over the past 20 years, despite continuous US trade deficits.

In my opinion, the international role of the dollar makes it exceedingly unlikely that the US could face a sudden outflow of foreign investment. (And given that US liabilities are overwhelmingly dollar-denominated, it is not clear what the costs of such an outflow would be.) It also makes it highly unlikely that the US can achieve balanced trade through conventional measures, unless we come up with some other mechanism to provide the rest of the world with dollar liquidity.

Links for May 11

My dinner with Axel. Last fall, Arjun Jayadev and I had a series of conversations with Axel Leijonhufvud at his home in California; videos and transcript are now up at the INET site, along with a collection of his writings. I’m very grateful to have had this chance to talk with him; Leijonhufvud is one of two or three economists who’ve most influenced my thinking. He’s also a charming and delightful storyteller, which I hope comes through in the interviews. I’ll be writing something soon, I hope, about Axel’s work and its significance, but in the meantime, check out the interview.

The mind of Draghi. This speech by Mario Draghi offers a nice glimpse into the thinking of central bankers circa 2016. The fundamental point is the idea of a long run “real” or “natural” rate of interest, which policy cannot affect. This idea, and the corollary that the economic world we actually observe is in some sense a false, unreal, artificial or “distorted” sublunary version of the true ideal, is, I think, the central site of tension between economic ideology and economic reality today. But there are other particular points of interest in the speech. First, the frank acknowledgement that the big problem with zero rates is that they reduce the profitability of financial institutions. (By the same logic, Draghi should want to do away with public education since it reduces the profitability of private schools, and with law enforcement since it reduces the profitability of private security firms.) And second, the claim that one reason for the problem of low interest rates is … excessive government debt!

A temporary period of policy rates being close to zero or even negative in real terms is not unprecedented by any means. Over the past decades, however, we have seen long-term yields trending down in real terms as well, independent of the cyclical stance of monetary policy.

The drivers behind this have been, among others, rising net savings as ageing populations plan for retirement, relatively less public capital expenditure in a context of high public indebtedness, and a slowdown in productivity growth reducing the profitability of investment.

Yes, for years we have been warned that excessive government debt is that interest rates will get too high, increasing borrowing costs for the government and crowding out of private investment. But now it turns out that excessive government debt is also responsible for rates that are too low. Truly, to be a central banker in these times one must be a Zen master.

Business cycle measurement ahead of theory … or heading in an entirely different direction. I’m very excited about a series of posts Merijn Knibbe is doing for the World Economics Association. They are on the incompatibility of the concepts used in the construction of national accounts and other macroeconomic data, with the concepts used in macroeconomic theory. I’ve wanted for a while to make the case for a consistent economic nominalism, meaning that we should treat the money payments we actually observe as fundamental or primitive, and not merely as manifestations of some deeper “real” economy. Knibbe is now doing it. The first installment is here.

Kaminska on “deglobalization”. Izabella Kaminska is always worth reading, but this piece from last week is even more worth reading than usual. I particularly like her point that the international role of the dollar means that the US is to the world as Germany is to the eurozone:

the dollarisation of the global economy … has created a sort of worldwide Eurozone effect, wherein every country whose own currency isn’t strong or reputable enough to be used for trade settlement with commodity producers is at the mercy of dollar flows into its own country. Just like Greece, they can’t print the currency that affords them purchasing power on the global market.

The logical corollary, which she doesn’t quite spell out, is that the US, thanks to its willingness to run trade deficits that supply dollars to the rest of the world, has fulfilled its international role much more responsibly than Germany has.

Only the Debt Is National

Imagine this set of transactions.

1. A bank in rich country A makes a loan of X to the government of poor country B. Let’s say for concreteness that A is the United States, B is Nigeria, and X is $1 billion. So now we have a liability of $1 billion of the Nigerian government to the US bank, and deposit of $1 billion at the US bank owned by the government of Nigeria.

(Nigeria might just as well be Egypt or Mexico or Argentina or Greece or Turkey or Indonesia. And the United States might just as well be Germany or the UK. )

2. The deposit at the bank is transferred from ownership of the government to ownership of some private individual. It’s easy to imagine ways this can be done.

3. The residents of Nigeria, via their government, still have a liability of $1 billion to the bank, obliging them to make annual payments equal to the interest rate times the principal. In this case, let’s say the interest rate is 5%, so debt service is $50 million.

4. The payments can be met by running an annual export surplus of $50 million. As long as this $50 million annual payment is maintained, interest payments can be made and the principal rolled over; the debt will remain forever.

5. The private individual from step 2 moves from Nigeria to the United States, eventually becoming a citizen there.

The result of this: a family in the United States has wealth of $1 billion (plus whatever they already had, of course). Meanwhile, the people of Nigeria make payments of $50 million each year to the United States forever, in the form of uncompensated exports. In their important book Africa’s Odious Debts and related work, Boyce and Ndikumana demonstrate that this story describes much of sub-Saharan Africa’s foreign debt. It applies elsewhere in the world as well.

I wonder how various people evaluate this scenario. Do we agree there is something wrong here? And if so, what, and what is the solution?

The orthodox view, as far as I can tell, is: what’s the problem? People should pay their debts. Nigeria (or Argentina etc.) is a person, it has borrowed, it must pay. The fact that some private individual chooses to hold their wealth in one country rather than another has nothing to do with it.

More generally, the dominant view today is that the ability to carry transactions like those describe above is an unmixed blessing; in fact it’s the whole point of the international system. The three pillars of the European union are free movement of people, free movement of goods, and free movement of finance. Argentina’s Macri is hailed as a hero — by Obama among others — for removing capital controls. If you are committed to capital mobility, then it’s hard to see where the objection would be. Third World governments and New York banks are consenting adults and can contract on any terms they choose. And of course the fact that a possessor of wealth happens to be located in one country cannot, in a liberal order, be an objection to them owning an asset somewhere else.

Maybe it’s the last step that is the issue? Outside of Europe, the free movement of people does not have the same place in the economic catechism as the free movement of money or goods. And even in Europe it’s a bit shaky. Still, most governments are happy enough to welcome rich immigrants. (A few months ago, my FT dislodged a glossy pamphlet, a racially ambiguous woman in a bikini on the cover, advertising citizenship by investment in various Caribbean countries.) This post was provoked by a Crooked Timber post by Chris Bertram; I’d be curious what he, or other open-borders advocates like my friend Suresh Naidu, would say about this scenario. Does an unrestricted right of human beings to cross borders imply an unrestricted right to transfer property claims across them also?

If the solution is not limits on movement of people, perhaps it is limits on cross-order transfers of financial claims, that is, capital controls. This used to be common sense. It’s not entirely straightforward where capital controls would operate in the sequence above; the metaphor of “capital” as a substance that moves across borders is unhelpful. But in some way or other capital controls would prevent the individual in country B from coming into possession of the bank deposit in country A.

There are two problems with this solution, one practical and the other more fundamental. The practical problem is that many routine transactions — payment for imports say — involve the creation of bank deposits in one country payable to some entity in another. It is hard to distinguish prohibited financial transactions from permitted payments for goods and services — and as Boyce and Ndikumana document, capital flight is usually disguised as current account transactions, for instance by over-invoicing for imports. Eric Helleiner [1] quotes Jacob Viner: “Because of the difficulty of distinguishing between capital account and current account transactions, capital controls could be made effective only by ‘censorship of communications and by crushing penalties for violation.'” [2]

The more fundamental problem is that these transactions — and capital flight in general – may be perfectly legal by the rules in force when they take place. Or if formally illegal, they are usually carried out by high government officials and/or members of the country’s elite. So the government of the poor country is unlikely to aggressively apply any restrictions that do exist. A subsequent government might well feel differently — but what claim do they have on a private bank account in a foreign country?

The problems with making capital controls effective were recognized clearly in the runup to Bretton Woods. In White’s 1942 draft for the agreements — again quoting Helleiner — “governments were required (a) not to accept or permit deposits or investments from any member country except with the permission of the government of that country, and (b) to make available to the government of any member country at its request all property in form of deposits, investments or securities of the nationals of the member country.” Even this wouldn’t be enough, of course, in the case where the wealthowner ceases to be a national. And it might not help in the case of a corrupt government that doesn’t want to repatriate private funds — though it might, if (as was also discussed) countries with balance of payments problems were required to draw on foreign exchange in private hands before being granted official assistance. In any case, it seems challenging to impose effective capital controls without granting the government control of all foreign assets — which will often require the cooperation of the country where those assets are held.

Needless to say nothing like this was included in the Bretton Woods agreements as signed. The US government would not even accept its allies’ pleas to assist in repatriating flight capital to help with the acute balance of payments difficulties following the war. Now it’s true, Second Circuit Judge Griesa recently claimed even more extensive authority that the government of Argentina would have had under White’s proposals, seizing the US assets of third parties who’d received payments from the Argentine government. But that was strictly to make payments to creditors. No such access to foreign assets is generally available.

This situation can arise even if governments themselves don’t even have to borrow abroad. As we recently saw in the case of Ireland, a government can strictly limit its debt and still find itself with unmanageable foreign liabilities. If private institutions — especially banks, but potentially nonfinancial corporations as well — borrow abroad, government that wishes to keep them operational in a crisis may have to assume their liabilities. Or at least, they will be strongly urged to do so by all the guardians of orthodoxy. What, are you going to just let the banks fail? Meanwhile, any foreign claims generated by the activities of the banks before they failed are out of reach.

Financial commitments create obligations; when circumstances change, sometimes they can’t be met. Someone isn’t going to get what they were promised. In modern economies, the state (often in the guise of the central bank) steps in to assume or redenominate claims, to impose an ex post consistency on the inconsistent contracts signed by private agents. But with foreign-currency commitments to foreigners the authorities’ usual tools aren’t available. And just as important, there are other authorities — the ECB in the case of Greece, the US federal court system in the case of Argentina — that are ready to use their privileged position in the larger payments system to enforce the claims of creditors. In effect, while domestic contracts are always subject to political renegotiation, foreign contracts are — or can be made to seem — objective fact.

What we’ve ended up with is a situation in which private parties have an absolute right to make whatever financial commitments they choose, and national governments have an absolute duty to honor the resulting balance sheet commitments. Wealth belongs to individuals, but debt belongs to the people. They are bound by past government commitments forever.

Or as Marx observed, “The only part of the so-called national wealth that actually enters into the collective possession of modern peoples is their national debt. …in England all public institutions are designated ‘royal’; as compensation for this, however, there is the ‘national’ debt. ”

[1] The Helleiner book, along with Fred Block’s Origins of International Economic Disorder, is still the best thing I know on the evolution of international monetary arrangements since World War II. Has anything better been written in the 20 years since it came out?

[2] This brings out two general points on financial regulation that I’d like to develop more. First, it is one thing to establish different rules for different kinds of activity, but the classification has to actually match up with the legal and accounting categories in which actual economic transactions are organized. The category of “banks” is a currently relevant example. This is part of the larger issue of what I call the money view, or economic nominalism — we need a perspective that regards money payments and the labels they bear as fundamental, rather than seeing them as reflections of some underlying structure. Second, and relatedly, it is hard for individual regulations to be effective in a setting in which anything that is not explicitly forbidden is permitted, since for any regulated transaction there will normally be unregulated ones that are economically equivalent.

How to Think about the Balance of Payments: The US Position 2012-2013

In the previous post, I suggested that we should think of the various trade and financial flows in the balance of payments as evolving more or less independently, with imbalances between them normally accommodated by passive buffers rather than being closed by any kind of price adjustment. In that post I focused on the prewar gold standard. Here is a more recent example of what I’m talking about.

From 2012 to 2013 there was a general “risk on” shift in financial markets, with fears of a new crisis receding and investors focusing more on yield and less on safety and liquidity. In a risk-off environment investors prefer the safety of US assets even if yields are very low; in a risk-on environment, as we were moving toward in 2013, they prefer higher-yielding non-US assets.

Now, how was this shift in asset demand accommodated in the balance of payments? Orthodox theory suggests that there should be some offsetting change in interest rates and/or exchange rate expectations to keep demand for US and non-US assets balanced. But this didn’t happen — interest rate differentials didn’t close, and “risk-on” is associated with a falling rather than a rising dollar. And in fact, there was a large net outflow of portfolio investment: Net acquisition of foreign assets was $250 billion higher in 2013 than 2012, and net foreign acquisition of US assets by foreigners was $250 billion lower. Orthodox theory also says that if there is a net shift in investment flows, there should be an offsetting change in the current account. But the US current account shifted only $60 billion toward surplus, compared with the $500 billion net shift in portfolio flows. In a country with a fixed exchange rate, we would expect the remaining portfolio outflow to be accommodated by a fall in foreign exchange reserves. but of course the dollar floats, and the Fed does not hold significant reserves.

In fact, the entire shift was accommodated within the US banking system, most importantly by a rise in foreign-held deposits of $400 billion. Now this is an increase in US foreign liabilities, but it does not reflect a decision by anyone to borrow from abroad. It simply reflects the mechanics of international financial transactions. When an American spends money to purchase a foreign asset, the “money” they are using is a deposit at an American bank. When the asset is purchased, that deposit is transferred to the foreign asset-seller (or some intermediary), turning the deposit into a foreign liability of the bank. So the shift of portfolio investment out of the US does not require any change in prices (or incomes) to generate an offsetting flow into the US. The foreign liabilities that finance the purchase of foreign assets are generated mechanically in the course of the transaction itself.

Eventually, the effort to close out this residual long dollar position might produce downward pressure on the value of the dollar. And if the dollar does depreciate, that may increase demand for other US assets or for US exports sufficient to absorb the deposits. But there is no guarantee that either of these things will happen. And certainly they will not happen quickly. What we know for sure is that buffering within the banking system can offset quite large flows for substantial periods of time — in this case, a shift in portfolio flows of a couple percent of GDP sustained over a year. It might be that, with sufficient time, net sales of US assets might be large enough to push their price down, raising the yield enough to compensate for the lower safety premium. Or it might be that the downward pressure on the dollar will eventually lead to a big enough depreciation to raise US net exports enough to balance the portfolio outflow — but this will be a very long process, if it happens at all. It’s quite likely the portfolio will reverse for its own reasons (like a shift back toward “risk off”) before these adjustments even get started. Alternatively, liquidity constraints within the banking system may exhaust its buffering capacity before any other adjustment mechanism comes into play, requiring active intervention by the state or a catastrophic adjustment of the current account. (Presumably not in the case of the US, but often enough elsewhere.)

In practice, where we see payments balance maintained smoothly, it’s more likely because the underlying patterns of trade and investment are balanced and stable enough to not strain the buffering capacity of the banking system, rather than thanks to the operation of any adjustment mechanism.

“The Money Has to Go Somewhere” – 1

A common response to concerns about high payouts and the short-term orientation of financial markets is that money paid out to shareholders will just be reinvested elsewhere.

Some defenders of the current American financial system claim this as one of its major virtues — investment decisions are made by participants in financial markets, rather than managers at existing firms. In the words of Michael Jensen, an important early theorist of the shareholder revolution,

Wall Street can allocate capital among competing businesses and monitor and discipline management more effectively than the CEO and headquarters staff of the typical diversified company. [Private equity fund] KKR’s New York offices … are direct substitutes for corporate headquarters in Akron or Peoria.

But while private equity funds do indeed replace exiting management at corporations they buy shares in, this form of active investment is very much the minority. The vast majority of “investment” by private shareholders does not directly contribute any funding to the companies being invested in. Rather, it involves the purchase of existing assets from other owners of financial assets.

Suppose a wealthy investor receives $1 million from increased dividends on shares they own. Now ask: what do they do? Their liquidity has increased. So has their net wealth, since the higher dividends are unlikely to reduce the market value of the shares and may well increase them. The natural use of this additional liquidity and wealth is to purchase more shares. (If the shares are owned indirectly, through a mutual fund or similar entity, this reinvestment happens automatically). But this purchases of additional shares does not provide any funding for the companies “invested” in, it simply bids up the prices of existing shares and increases the liquidity of the sellers. Those sellers in turn may purchase more shares or other financial assets, bidding up their prices and passing the liquidity to their sellers; and so on.

Of course, this process does not continue indefinitely; at each stage people may respond to their increased wealth by increasing their cash holdings, or by increasing their consumption; and each transaction involves some payments to the financial industry. Eventually, the full payout will leak out through these three channels, and share prices will stop rising. In the end, the full $1 million will be absorbed by the higher consumption and cash holdings induced by the higher share prices, and by the financial-sector incomes generated by the transactions.

Now, not every share purchase involves an existing share. But the vast majority do. In 2014, there were $90 billion of new shares issued through IPOs on American markets — an exceptionally high number. By comparison, daily transactions on the main US stock markets average around $300 billion. Given around 260 trading days in a year, this implies that only one trade in a thousand on an American stock exchange involves the purchase of a newly issued share. And that is not counting the many “stock market” transactions other than outright share purchases (closed-end mutual funds, derivative contracts, etc.) all of which allow income from shareholder payouts to be reinvested and none of which provide any new funding for businesses.

External financing for businesses is much more likely to take the form of debt than new shares. But here, again, we can’t assume that there is any direct link between shareholder payouts and funding for other firms. Corporate bonds are issue by the same established corporations that are making the payouts. Meanwhile, smaller and younger firms, both listed and unlisted, are dependent on bank loans. And the fundamental fact about modern banks is that their lending is in no way dependent on prior saving. There is no way for higher payouts to increase the volume of bank lending. Banks’ funding costs are closely tied to the short-term interest rate set by the Federal Reserve, while their willingness to lend depends on the expected riskiness of the loan; there is no way for increased payouts to increase the availability of bank loans.

New bonds, on the other hand, do need to be purchase by wealthowners, and it is possible that the market liquidity created by high payouts has helped hold down longer interest rates. But many other factors — especially the beliefs of market participants about the future path of interest rates — also affect these rates, so is hard to see any direct link between payouts by some corporations and increased bond financing for others. Nor do new bonds necessarily finance investment. Indeed, since the mid-1980s corporate borrowing has been more tightly correlated with shareholder payouts than with investment. So if payouts do spill over into the bond market, to a large extent they are simply financing themselves.

Defenders of the financial status quo suggest that it’s wrong to accuse the markets as a whole of short-termism, since for every established company being pressured to increase payouts, there is a startup getting funded despite even when any profits are years away. I certainly wouldn’t deny that financial markets do often fund startups and other small- financially-constrained firms; and these firms do sometimes undertake socially useful investment that established corporations for whatever reason do not. And in principle, shareholder payouts can support this kind of funding both directly, as shareowners put money into venture capital funds, IPOs, etc.; and indirectly, as higher share prices make it easier to raise funds through new offerings. But the optimistic view of shareholder payouts not sustainable once we look at the magnitudes involved. It is mathematically impossible for the additional funds directed to new firms, to offset what they drain from established ones.

Again, IPOs in 2014 raised a record $90 billion for newly listed firms. (Over the past ten years, the average annual funds raised by IPOs was $45 billion.) Secondary offerings by listed firms totaled $180 billion, but some large fraction of these involved stock-option exercise by executives rather than new funding for the corporation. Prior to an IPO, the most important non-bank source of external funding for new companies is venture capital funds. In 2014, VC funds invested approximately $50 billion, but only $30 billion of this represented new commitments by investors; the remaining $20 billion came from the funds’ own retained profits. (And there is some double-counting between VC commitments and IPOs, since one of the main functions of IPOs today is to cash out earlier investors.) Net commitments to private equity funds might come to another $200 billion, but very little of this represents funding for the businesses they invest in — private equity specializes, rather, in buying control of corporations from existing shareholders. All told, flows of money from investors to businesses through these channels was probably less than $100 billion.

Meanwhile, total shareholder payouts in 2014 were over $1.2 trillion. So at best less than one dollar in ten flowing out of publicly-traded corporations went to fund some startup. And this assumes that shareholder payouts are the only source of funds for IPOs and venture capital; but of course people also invest in these out of labor income (salaries are a significant fraction of even the highest incomes in the US) and other sources. So the real fraction of payouts flowing to startups must be much less. There simply isn’t enough room in the limited financial pipelines flowing into new businesses, to accommodate the immense gusher of cash coming from established ones. Apple alone paid out $56 billion to shareholders last year, or nearly twice total commitments to VC funds. Intel, Oracle, IBM, Cisco and AT&T together paid out another $70 billion. [1] It’s hard to understand why, if finance is able to identify such wonderful investment opportunities for its cash, the management at these successful technology companies is unable to. You would have to have a profound faith in the unicorn hunters at Andreesen Horowitz to believe that the $1 billion they invested last year will produce more social value than $10 or $20 or $50 billion invested by established companies — or an equally profound pessimism about the abilities of professional managers. If this is what people like James Surowiecki really believe, they should not be writing about the dynamism of American financial markets, but about whatever pathology they believe has crippled the ability of mangers at existing corporations to identify viable investment projects.

[1] These numbers are taken from the Compustat database of filings by publicly traded corporations.

Reallocation Continued: Profits, Payouts, Investment and Borrowing

In a previous post, I pointed out that if capital means real investment, then the place where capital is going these days is fossil fuels, not the industries we usually think of as high tech. I want to build on that now by looking at some other financial flows across these same sectors.

As I discussed in the previous post, any analysis of investment and profits has to deal with the problem of R&D, and IP-related spending in general. If we want to be consistent with the national accounts and, arguably, economic theory, we should add R&D to investment, and therefore also to cashflow from operations. (It’s obvious why you have to do this, right?) But if we want to be consistent with the accounting principles followed by individual businesses, we must treat R&D as a current expense. For many purposes, it doesn’t end up making a big difference, but sometimes it does.

Below, I show the four major sources and uses of funds for three subsets of corporations. The flows are: cashflow from operations — that is, profits plus depreciation, plus R&D if that is counted in investment; profits; investment, possibly including R&D; and net borrowing. The universes are publicly traded corporations: first all of them; second the high tech sector, defined as in the previous post, and third fossil fuels, also as defined previously. Here I am using the broad measure of investment, including R&D, and the corresponding measure of cashflow from operations. At the end of the post, I show the same figures using the narrow measure of investment, and with profits as well as cashflow.

all_broad

For the corporate sector as a whole, we have the familiar story. Over the past twenty-five years annual shareholder payouts (dividends plus share repurchases) have approximately doubled, rising from around 3 percent of sales in the 1950s, 60s and 70s to around 6 percent today. Payouts have also become more variable, with periods of high and low payouts corresponding with high and low borrowing. (This correlation between payouts and borrowing is also clearly visible across firms since the 1990s, but not previously, as discussed here.) There’s also a strong upward trend in cashflow from operations, especially in the last two expansions, rising from about 10 percent of sales in the 1970s to 15 percent today. Investment spending, however, shows no trend; since 1960, it’s stayed around 10 percent of sales. The result is an unprecedented gap between corporate earnings and and investment.

Here’s one way of looking at this. Recall that, if these were the only cashflows into and out of the corporate sector, then cash from operations plus net borrowing (the two sources) would have to equal investment plus payouts (the two uses). In the real world, of course, there are other important flows, including mergers and acquisitions, net acquisition of financial assets, and foreign investment flows. But there’s still a sense in which the upper gap in the figure is the mirror image or complement of the lower gap. The excess of cash from operations over investment shows that corporate sector’s real activities are a net source of cash, while the excess of payouts over borrowing suggests that its financial activities are a net use of cash.

Focusing on the relationship between cashflow and investment suggests a story with three periods rather than two. Between roughly 1950 and 1970, the corporate sector generated significantly more cash than it required for expansion, leaving a surplus to be paid out through the financial system in one form or another. (While payouts were low compared with today, borrowing was also quite low, leaving a substantial net flow to owners of financial assets.) Between 1970 and 1985 or so, the combination of higher investment and weaker cashflow meant that, in the aggregate all the funds generated within the corporate sector were being used there, with no net surplus available for financial claimants. This is the situation that provoked the “revolt of the rentiers.” Finally, from the 1990s and especially after 2000, we see the successful outcome of the revolt.

This is obviously a simplified and speculative story. It’s important to look at what’s going on across firms and not just at aggregates. It’s also important to look at various flows I’ve ignored here; cashflow ideally should be gross, rather than net, of interest and taxes, and those two flows along with net foreign investment, net acquisition of financial assets, and cash M&A spending, should be explicitly included. But this is a start.

Now, let’s see how things look in the tech sector. Compared with publicly-traded corporations as a whole, these are high-profit and high-invewtment industries. (At least when R&D is included in investment — without it, things look different.) It’s not surprising that high levels of these two flows would go together — firms with higher fixed costs will only be viable if they generate larger cashflows to cover them.

tech_broad

But what stands out in this picture is how the trends in the corporate sector as a whole are even more visible in the tech industries. The gap between cashflow and investment is always positive here, and it grows dramatically larger after 1990. In 2014, cashflow from operations averaged 30 percent of sales in these industries, and reported profits averaged 12 percent of sales — more than double the figures for publicly traded corporations as a whole. So to an even greater extent than corporations in general, the tech industries have increasingly been net sources of funds to the financial system, not net users of funds from it. Payouts in the tech industries have also increased even faster than for publicly traded corporations in general. Before 1985, shareholder payouts in the tech industries averaged 3.5 percent of sales, very close to the average for all corporations. But over the past decade, tech payouts have averaged full 10 percent of annual sales, compared with just a bit over 5 percent for publicly-traded corporations as a whole.

In 2014, there were 15 corporations listed on US stock markets with total shareholder payouts of $10 billion or more, as shown in the table below. Ten of the 15 were tech companies, by the definition used here. Computer hardware and software are often held out as industries in which US capitalism, with its garish inequality and fierce protections of property rights, is especially successful at fostering innovation. So it’s striking that the leading firms in these industries are not recipients of funds from financial markets, but instead pay the biggest tributes to the lords of finance.

	Dividends	Repurchases	Total Payouts
APPLE INC	11,215	45,000	56,215
EXXON MOBIL CORP	11,568	13,183	24,751
IBM	4,265	13,679	17,944
INTEL CORP	4,409	10,792	15,201
ROYAL DUTCH SHELL PLC	11,843	3,328	15,171
JOHNSON & JOHNSON	7,768	7,124	14,892
NOVARTIS AG	6,810	6,915	13,725
CISCO SYSTEMS INC	3,758	9,843	13,601
MERCK & CO	5,156	7,703	12,859
CHEVRON CORP	7,928	4,412	12,340
PFIZER INC	6,691	5,000	11,691
AT&T INC	9,629	1,617	11,246
BP PLC	5,852	4,589	10,441
ORACLE CORP	2,255	8,087	10,342
GENERAL ELECTRIC CO	8,949	1,218	10,167

2014. Values in millions of dollars. Tech firms in bold.

It’s hard to argue that Apple and Merck represent mature industries without significant growth prospects. And note that, apart from GE (which is not listed in the the high-tech sector as defined here, but perhaps should be), all the other members of the $10 billion club are in the fast-growing oil industry. It’s hard to shake the feeling that what distinguishes high-payout corporations is not the absence of investment opportunities, but rather the presence of large monopoly rents.

Finally, let’s quickly look at the fossil-fuel industries. Up through the 1980s, the picture here is not too different from publicly-traded corporations in general, though with more variability — the collapse in fossil-fuel earnings and dividends in the 1970s is especially striking. But it’s interesting that, despite very high payouts in several big oil companies, there has been no increase in payouts for the sector in general. And in the most recent oil and gas boom, new investment has been running ahead of internal cashflow, making the sector a net recipient of funds from financial markets. (This trend seems to have intensified recently, as falling profits in the sector have not (yet) been accompanied with falling investment.) So the capital-reallocation story has some prima facie plausibility as applied to the oil and gas boom.

In the next, and final, post in this series, I’ll try to explain why I don’t think it makes sense to think of shareholder payouts as a form of capital reallocation. My argument has two parts. First, I think these claims often rest on an implicit loanable-funds framework that is logically flawed. There is not a fixed stock of savings available for investment; rather, changes in investment result in changes in income that necessarily produce the required (dis)saving. So if payouts in one company boost investment in another, it cannot be by releasing real resources, but only by relieving liquidity constraints. And that’s the second part of my argument: While it is possible for higher payouts to result in greater liquidity, it is hard to see any plausible liquidity channel by which more than a small fraction of today’s payouts could be translated into higher investment elsewhere.

Finally, here are the same graphs as above but with investment counted as it is businesses’ own financial statements, with R&D spending counted as current costs. The most notable difference is the strong downward trend in tech-sector investment when R&D is excluded.

all_narrow tech_narrow oil_narrow

Is Capital Being Reallocated to High-Tech Industries?

Readers of this blog are familiar with the “short-termism” position: Because of the rise in shareholder power, the marginal use of funds for many corporations is no longer fixed investment, but increased payouts in the form of dividends and sharebuybacks. We’re already seeing some backlash against this view; I expect we’ll be seeing lots more.

The claim on the other side is that increased payouts from established corporations are nothing to worry about, because they increase the funds available to newer firms and sectors. We are trying to explore the evidence on this empirically. In a previous post, I asked if the shareholder revolution had been followed by an increase in the share of smaller, newer firms. I concluded that it didn’t look like it. Now, in this post and the following one, we’ll look at things by industry.

In that earlier post, I focused on publicly traded corporations. I know some people don’t like this — new companies, after all, aren’t going to be publicly traded. Of course in an ideal world we would not limit this kind of analysis to public traded firms. But for the moment, this is where the data is; by their nature, publicly traded corporations are much more transparent than other kinds of businesses, so for a lot of questions that’s where you have to go. (Maybe one day I’ll get funding to purchase access to firm-level financial data for nontraded firms; but even then I doubt it would be possible to do the sort of historical analysis I’m interested in.) Anyway, it seems unlikely that the behavior of privately held corporations is radically different from publicly traded one; I have a hard time imagining a set of institutions that reliably channel funds to smaller, newer firms but stop working entirely as soon as they are listed on a stock market. And I’m getting a bit impatient with people who seem to use the possibility that things might look totally different in the part of the economy that’s hard to see, as an excuse for ignoring what’s happening in the parts we do see.

Besides, the magnitudes don’t work. Publicly traded corporations continue to account for the bulk of economic activity in the US. For example, we can compare the total assets of the nonfinancial corporate sector, including closely held corporations, with the total assets of publicly traded firms listed in the Compustat database. Over the past decade, the latter number is consistently around 90 percent of the former. Other comparisons will give somewhat different values, but no matter how you measure, the majority of corporations in the US are going to be publicly traded. Anyway, for better or worse, I’m again looking at publicly-traded firms here.

In the simplest version of the capital-reallocation story, payouts from old, declining industries are, thanks to the magic of the capital markets, used to fund investment in new, technology-intensive industries. So the obvious question is, has there in fact been a shift in investment from the old smokestack industries to the newer high-tech ones?

One problem is defining investment. The accounting rules followed by American businesses generally allow an expense to be capitalized only when it is associated with a tangible asset. R&D spending, in particular, must be treated as a current cost. The BEA, however, has since 2013 treated R&D spending, along with other forms of intellectual property production, as a form of investment. R&D does have investment-like properties; arguably it’s the most relevant form of investment for some technology-intensive sectors. But the problem with redefining investment this way is that it creates inconsistencies with the data reported by individual companies, and with other aggregate data. For one thing, if R&D is capitalized rather than expensed, then profits have to be increased by the same amount. And then some assumptions have to be made about the depreciation rate of intellectual property, resulting in a pseudo asset in the aggregate statistics that is not reported on any company’s books. I’m not sure what the best solution is. [1]

Fortunately, companies do report R&D as a separate component of expenses, so it is possible to use either definition of investment with firm-level data from Compustat. The following figure shows the share of total corporate investment, under each definition, of a group of six high-tech industries: drugs; computers; communications equipment; medical equipment; scientific equipment other electronic goods; and software and data processing. [2]

As you can see, R&D spending is very important for these industries; for the past 20 years, it has consistently exceed investment spending as traditionally defined. Using the older, narrow definition, these industries account for no greater share of investment in the US than they did 50 years ago; with R&D included, their share of total investment has more than doubled. But both measures show the high-tech share of investment peaking in the late 1990s; for the past 15 years, it has steadily declined.

Obviously, this doesn’t tell us anything about why investment has stalled in these industries since the end of the tech boom. But it does at least suggest some problems with a simple story in which financial markets reallocate capital from old industries to newer ones.

The next figure breaks out the industries within the high-tech group. Here we’re looking at the broad measure of investment, which incudes R&D.

As you can see, the decline in high-tech investment is consistent across the high-tech sectors. While the exact timing varies, in the 1980s and 1990s all of these sectors saw a rising share of investment; in the past 15 years, none have. [3] So we can safely say: In the universe of publicly traded corporations, the sectors we think would benefit from reallocation of capital were indeed investing heavily in the decades before 2000; but since then, they have not been. The decline in investment spending in the pharmaceutical industry — which, again, includes R&D spending on new drugs — is especially striking.

Where has investment been growing, then? Here:

The red lines show broad and narrow investment for oil and gas and related industries — SICs 101-138, 291-299, and 492. Either way you measure investment, the increase over the past 15 years has dwarfed that in any other industry. Note that oil and gas, unlike the high-tech industries, is less R&D-intensive than the corporate sector as a whole. Looking only at plant and equipment, fossil fuels account for 40 percent of total corporate investment; by this measure, in some recent years, investment here has exceeded that of all manufacturing together. With R&D included, by contrast, fossil fuels account for “only” a third of US investment.

In the next post, I’ll look at the other key financial flows — cashflow from operations, shareholder payouts, and borrowing — for the tech industries, compared with corporations in general. As we’ll see, while at one point payouts were lower in these industries than elsewhere, over the past 15 years they have increased even faster than for publicly traded corporations as a whole. In the meantime:

Very few of the people talking about the dynamic way American financial markets reallocate capital have, I suspect, a clear idea of the actual reallocation that is taking place. Save for another time the question of whether this huge growth in fossil fuel extraction is a good thing for the United States or the world. (Spoiler: It’s very bad.) I think it’s hard to argue with a straight face that shareholder payouts at Apple or GE are what’s funding fracking in North Dakota.

[1] This seems to be part of a larger phenomenon of the official statistical agencies being pulled into the orbit of economic theory and away from business accounting practices. It seems to me that allowing the official statistics to drift away from the statistics actually used by households and businesses creates all kinds of problems.

[2] Specifically, it is SICs 83, 357, 366, 367, 382, 384, and 737. I took this specific definition from Brown, Fazzari and Petersen. It seems to be standard in the literature.

[3] Since you are probably wondering: About two-thirds of that spike in software investment around 1970 is IBM, with Xerox and Unisys accounting for most of the rest.

Greece Thoughts and Links

Like everyone sympathetic to Greece in the current crisis, I was pleased by the size of the “No” vote in last weekend’s referendum. Even taking into account support from the far right, the 62% for No represents a significant increase in support from the 36% of the vote SYRIZA got in January.

But, I’m not sure how the vote changes the situation in any substantive way. Certainly it hasn’t led to any softening of the creditors’ position. The situation remains what it was before: Greece must comply with the full list of policy changes demanded by the creditors, and any further changes demanded in the future, or else the central bank will keep the Greek banking system shut down. The debt itself is just a pretext on both sides — repayment is not really what the creditors want, and default isn’t really what they are threatening.

I continue to think that the Bank of Greece is the key strategic terrain in this contest. If the elected government can regain control of the central bank — in defiance of eurosystem norms if need be — then it removes the source of the creditors’ power over the Greek economy. There is no need for a new currency in this scenario. If the Bank of Greece simply goes back to performing the usual functions of a central bank, instead of engaging in what is, in effect, a politically-motivated strike, then Greek banks can reopen and the Greek government can finance needed spending without the consent of the official creditors.

More broadly, I think we cannot understand the economics of the situation unless we clearly understand that “money,” in modern economies, refers to a network of promises between banks and not a set of tokens. In this sense, I don’t think it makes sense to think of being in or out of a currency as a simple binary. As Perry Mehrling emphasizes, there have always been overlapping networks of money-contracts, with various economic units participating in multiple networks to different degrees.

Here are a few relevant links, some spelling out my thoughts more, some useful background material.

1. Here is an interview with me on the podcast RadioDispatch. If you don’t mind listening rather than reading, this is my fullest attempt to explain the logic of the crisis.

RadioDispatch interview June 2015

2. I had a productive discussion with Dan Davies on this Crooked Timber thread. Since my last comment there got stuck in moderation for some reason, I’m reposting it here:

From my point of view, the key question is whether the ECB is constrained by, or at least acting in accordance with, the normal principles of central banking, or if it is deliberately withholding support from the Greek banking system in order to advance a political agenda.

Obviously, I think it’s the second. (And I think this is really the only leverage the creditors have — there is no reason that a default in itself should be particularly costly to Greece.) On whether it is plausible that the ECB would (ab)use its authority this way, I think that is unequivocally demonstrated by the letters sent to the governments of Italy, Spain and Ireland during those countries’ sovereign debt crises in 2011. In return for support of those countries’ sovereign debt markets, the ECB demanded a long list of unrelated reforms, mainly focused on labor-market liberalization. There is no credible case that many of these reforms (for instance banning cost-of-living clauses in private employment contracts) were connected with the immediate crisis or even with public budgets at all. I think it can be taken as proven that the EC has, in the past, deliberately refused to perform its function of stabilizing the financial system, in order to put pressure on elected governments.

We can debate how exactly this precedent fits Greece. But I don’t think a central bank that allows its country’s banking system to collapse can ever be said to be doing its job. Every modern central bank — including the ECB with respect to every euro-area country except Greece — will go to heroic lengths, bending or ignoring rules as need be, to keep the payments system operating.

3. Over at The Week, I talk with Jeff Spross about the idea that changes in private financial flows between euro-area countries can be passively offset by balances between the national central banks in the TARGET2 system, avoiding the need to mangle the real economy to produce rapid adjustment of trade flows.

Like many critics of the euro system, I used to think that they had succeeded in creating something like a modern gold standard, and that the only way crises could be avoided was with a fiscal union, so that public flows could offset shifts in financial flows. But I no longer think this is correct, I think that the TARGET2 system can, and has, offset changes in private financial flows without the need for any fiscal payments.

(The Week also had a nice writeup of the Reagan-debt post.)

4. I reached this conclusion after reading several pieces by Philippine Cour-Thimann, who is the source for understanding TARGET2 and its role both in the normal operations of the euro system and in the crisis. I recommend this one to start with. (Incidentally it was my friend Enno Schröder who told me about Cour-Thimann.)

5. One topic I’ve wanted to get into more is the (in my view) limited capacity of relative-price adjustments to balance trade even when exchange rates are flexible. In the past, I’ve made this argument on the crude empirical grounds that Greece had large trade deficits continuously for decades before it joined the euro. I’ve also pointed out Enno’s work showing that the growth of European trade imbalances owes nothing to expenditure switching toward German products and away from Greek, Spanish, etc., but is entirely explained by the more rapid income growth in the latter countries. Now here is another interesting piece of evidence on this question from the ECB, a big new study finding that while there is a substantial fall in exports in response to large appreciations, there is no discernible growth in exports in response to depreciations. This fits with the idea, which I attribute to Robert Blecker, that in a world where prices are mainly set in destination markets rather than by producer costs, changes in exchange rates show up in exporter profit margins rather than directly in sales volumes. And while large losses will certainly cause some exporting firms to exit or fail, large (potential) profits are only one of a number of conditions required for exporters to grow, let alone for the creation of new exporting industries.

6. This is a great post by Steve Randy Waldman.

7. Here’s an interesting find from a friend: In the 1980s, Fidel Castro proposed “a cartel of debtor nations” that would require their creditors to negotiate with them as a group. See pages 278-285 of this anthology.

UPDATE: Re item 2, here’s Martin Wolf today (his links):

The European Central Bank could expand its emergency lending to the Greek banking system. If the ECB were a normal central bank that is exactly what it would do. Greece has a run on its banks. As the lender of last resort, the central bank ought to lend into such a run. If the ECB believes the banks are solvent, it must lend. If the ECB believes the banks are insolvent, it should arrange recapitalisation — by converting non-insured liabilities into equity, by selling banks to new owners or by securing funding from the European Stability Mechanism (ESM).

Unfortunately, the ECB is not a normal central bank…

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.)