The Good, the Bad, and the Ugly: 100 Years of Public Debt Overhang

By Don Alexander, MBA
Associate, RSD Solutions Inc.
(Mr. Alexander also lectures at NYU and SunySB

Throughout the past century, numerous economies have faced public debt burdens (debt/GDP) as high, or higher, than those prevailing today.  History offers lessons for countries struggling with high public debt levels.  Already, a number of countries are approaching a debt to GDP ratio of 100%, which is especially worrying because of the low growth that usually follows, persistent budget deficits, and rising liabilities due to ageing populations.  This can result in a downgrade of debt ratings and higher borrowing costs.

The IMF reviews 100 years of historical experiences of countries with high sovereign debt levels and the policies they used to make the necessary adjustments.  This is done in the third chapter of the World Economic Outlook (WEO) chapter 3 entitled The Good, the Bad, and the Ugly: 100 Years of Dealing with Public Debt Overhang (Sept. 2012).

There is widespread debate about the best way to reduce public debt. Some advocate strict budgets or fiscal austerity; others suggest growth through spending, or fiscal stimulus; and others cite the post–World War II U.S. strategy of “financial repression”—governments channeling funds to themselves.  The IMF research looks at the policy responses and outcomes in each case, and draws three lessons for countries battling high public debt today.

The first lesson is that fiscal consolidation efforts need to be complemented by measures that support growth: structural issues need to be addressed and with supportive monetary conditions.  The implications vary for countries dealing with high debt levels today. For some, such as the United States, where financial sector weakness has been addressed and monetary policy is supportive, it would suggest conditions are in place for fiscal consolidation. In others, such as the European periphery, where financial sectors remain weak and fundamental issues relating to monetary union remain unresolved, progress is limited.  Financial repression may not work for countries facing high debt burdens today. The consequences of historically low sovereign interest rates are unknown, but the inflationary consequences of financial repression could threaten the structures that have been in place in recent decades to prevent inflation.

A second lesson is that consolidation plans should emphasize persistent, structural reforms over temporary or short-lived measures. Belgium and Canada were ultimately much more successful than Italy in reducing debt, and a key difference between these cases is the relative weight placed on structural improvements versus temporary efforts. Moreover, both Belgium and Canada put in place fiscal frameworks in the 1990s that preserved the improvement in the fiscal balance and mitigated consolidation fatigue.

A third lesson is that fiscal repair and debt reduction take time—with the exception of postwar episodes, primary deficits are not quickly reversed. A corollary is that this increases the vulnerability to significant setbacks when shocks hit. The sharp increases in public debt since the Great Recession— including in the relatively successful cases of Belgium and Canada—exemplify such vulnerability.  Furthermore, the external environment has been an important contributor to past outcomes. The implications are sobering—widespread fiscal consolidation efforts, deleveraging pressures from the private sector, adverse demographic trends, and the aftermath of the financial crisis are unlikely to provide a favorable environment present in previous episodes of debt reduction. Expectations about what can be achieved need to be set realistically.

Based on these lessons, a road map for successful resolution of the current public debt overhangs is possible. First, support for growth is essential to cope with the contractionary effects of fiscal consolidation.  Policies must emphasize the resolution of underlying structural problems within the economy, and monetary policy must be supportive. Policy support is particularly important since all major economies must address public debt overhangs, and cannot always rely on favorable external conditions. Second, because debt reduction takes time, fiscal consolidation should focus on enduring structural change. In this respect, fiscal institutions can help. Third, while realism is needed when it comes to expectations about future debt trajectories and setting debt targets in a relatively weaker global growth environment, the case of Italy in the 1990s suggests that debt reduction is still possible even without strong growth.  The failure to control public debt growth can have costly consequences.

www.imf.org/external/np/tr/2012/tr092712.htm

Risks to Long-Term US Growth

By Don Alexander, MBA
Associate, RSD Solutions Inc.
(Mr. Alexander is also a lecturer at NYU and SunySB)

Global growth is slowing – especially in advanced-technology economies and the outlook according to the IMF’s semi-annual World Economic Outlook forecasts confirm this trend.  Regardless of cyclical trends, long-term economic growth may grind to a halt in developed countries.  The recent two hundred fifty years of per-capita income growth maybe a mirage.

 

A basic tenet of economic theory is that economic growth is a continuous process that will persist over time.  Robert Gordon claims that the rapid growth progress made over the past 250 years could well turn out to be a unique episode in human history because economic growth was a one-time occurrence centered on 1750-2000.  He questions whether this assumption about growth is true.  He examines this question in a recent study Is US Economic Growth Over? Faltering Innovation Confronts the Six Headwinds  (VOXEU, Sept. 11^th).  He also writes a longer version Center for Economic Policy Research Policy Insight 63 (Sept. 2012) and NBER WP 15834 (March 2010).

 

Gordon notes that cycles are not continuous.  In particular, there was minimal growth before 1750 and there is no guarantee that growth will continue.  He argues that the rapid progress made over the past 250 years could well turn out to be a unique episode in human history.  Growth in the frontier economy gradually accelerated after 1750, reached a peak in the middle of the 20th century, and has been slowing since.

 

The big peak in US growth came between 1928 and 1950, the years that span the Great Depression and WWII. The cause this economic growth spurt is subject to debate, but growth has steadily declined in intervals plotted since 1950.  He notes the importance of innovations during the initial US growth spurt on per-capita consumption and productivity growth, especially before 1972.

 

However, the process of innovation may be battering its head against the wall of diminishing returns, facing six headwinds that are in the process of dragging long-term growth to half or less of the 1.9% annual rate experienced between 1860 and 2007.  Given the diminishing returns from innovation, it may take 2070-2100 to see a doubling of US per-capita consumption from 2007 levels, given the slowdown in the cycle.

 

Even if innovation were to continue into the future at the rate of the two decades before 2007, the US faces six headwinds that are in the process of dragging long-term growth to half or less of the 1.9% annual rate experienced between 1860 and 2007. These include demography, education, inequality, globalization, energy/environment, and the overhang of consumer and government debt. A provocative 'exercise in subtraction' suggests that future growth in consumption per capita for the bottom 99% of the income distribution could fall below 0.5% per year for an extended period of decades.  The numbers in the 'exercise in subtraction' have been chosen to reduce growth to that of the UK for 1300-1700.

The pessimistic/provocative view adopted by Gordon suggests that it may take almost a century for income per capita to double from its 2007 level.  The outcome may turn out to be much better than that. But the point of this paper is that it is likely to be much worse than any epoch of US growth since the civil war.  It raises questions for policymakers on job creation and for creation of risk scenarios.

http://www.voxeu.org/article/us-economic-growth-over

Financial Reform Agenda: An Interim Report

By Don Alexander, MBA
Associate, RSD Solutions Inc.
(Mr. Alexander is also a lecturer at NYU and SunySB)

Five years after start of crisis, the global financial system is still under stress.  A host of regulatory reforms are under way to make the financial system safer, and are aimed to make markets and institutions more transparent, less complex, and less leveraged.  However, policymakers have failed to address other issues such as "shadow banks" and "too important to fail" institutions.

The IMF in its latest Global Financial Stability Report (GFSR) summarizes current reform progress in The Reform Agenda: An Interim Report on Progress Toward a Safer Financial System (Sept. 25^th).  The report suggests that there is still a lot of work to do and some difficult issues left to tackle. 

Most reforms are in the banking sector and impose higher costs to encourage banks to reduce risky activities. Basel III requirements of better-quality capital and liquidity buffers should enable institutions to better withstand financial distress.  The new banking standards may encourage certain activities to move to the nonbank sector, where those standards do not apply. Alternatively, big banking groups with advantages of scale may be better able to absorb the costs; as a result, they may become even more prominent in certain markets, making these markets more concentrated.

Although the intentions of policymakers are clear and positive, the reforms have yet to effect a safer set of financial structures, in part because, in some economies and regions, the intervention measures needed to deal with the prolonged crisis are delaying a ‘reboot’ of the system. These intervention measures are aimed at preventing a collapse of the financial system and supporting the real economy, but can provide time to allow damaged financial systems to recover. 

The report added that despite improvements along some dimensions and economies, the structure of intermediation remains unchanged.   Financial systems remain overly complex, banking assets are concentrated, with strong domestic interbank linkages, and the too-important-to-fail issues are unresolved.  reforms in some areas still need to be further refined, far more work needs to be done to implement them, and that the system, in many cases, remains vulnerable, overly complex, and activities are too concentrated in large institutions. Reliance on non-deposit funding is very high, linkages across domestic financial institutions are very strong and complex, innovative financial products are taking on new forms to circumvent regulations.

Other issues to address include: the pros and cons of the restrictions of certain bank business activities, monitoring systemic risk and supervising shadow banking, the need to simplify products and reduce complex organization structures, the regulation of over-the-counter derivatives, and cross-border regulation and resolution for large financial institutions.  In addition, the report noted the success of the current and prospective reforms depends on enhanced supervision, incentives for the private sector to adhere to the reforms, the political will to implement regulations, and the resources necessary for the task of making the financial system simpler and safer.

The low interest rate environment is crucial for now; however, it may also be creating new vulnerabilities in the future.  Regulators and supervisors must be alert about the possible side-effects of these crisis-related measures so that they do not wake up to new risks down the road, due to long implementation lags and the crisis is ongoing.  Have you evaluated your exposure?

www.imf.org/external/pubs/ft/gfsr/index.htm -

The Law of Unintended Consequences

Don Alexander
RSD Solutions Inc.
NYU
SunySB

“This long run is a misleading guide to current affairs.
In the long run we are all dead”.

John Maynard Keynes

Central banks have embarked upon one of the greatest economic experiments of all time ‐ ultra easy monetary policy. In the aftermath of the economic and financial crisis which began in the summer of 2007, they lowered policy rates effectively to the zero lower bound (ZLB). In addition, they took various actions which not only caused their balance sheets to swell enormously, but also increased the riskiness of the assets they chose to purchase as well as creating long-term risks that are not fully understood.

William White, in a recent paper, Ultra Easy Monetary Policy and the Law of Unintended Consequences (Dallas Fed WP 126, Sept. 2012) evaluates the cost-benefit analysis of ultra-easy monetary policy by weighing the balance of the desirable short run effects and the undesirable longer run effects – the unintended consequences. 

The case for ultra-easy monetary policies is well known to convince the central banks of most AMEs (advanced market economies) to follow such polices. They have succeeded in avoiding a collapse of both the global economy and the financial system.

Nevertheless, White argues, that the capacity of such policies to stimulate “strong, sustainable and balanced growth” is limited. Moreover, ultra easy monetary policies create medium term effects ‐ the unintended consequences.  Hence the view, central banks have limited options.  One reason for believing this is that monetary stimulus, operating through traditional channels, might be less effective in stimulating aggregate demand. Further, cumulative effects provide negative feedback mechanisms that over time may distort traditional supply and demand relationships.

These policies may create real economy investment distortions, threaten the health of financial institutions and the functioning of financial markets, constrain the “independent” pursuit of price stability by central banks, encourage governments to refrain from confronting sovereign debt problems in a timely manner, and can regressively distort income/wealth.  The medium term effects can be questioned, considered together, they support strongly that aggressive monetary easing in downturns is not “a free lunch”.

When this crisis is over, the principal lesson for central banks is they should lean more aggressively against credit driven upswings, and prepare to tolerate the subsequent downswings helping avoid future crises of the current sort.  The current crisis is not yet over, and the principal lesson to be drawn from this paper concerns governments rather more than central banks.  Central banks have bought time to allow governments to follow the policies likely to lead to a resumption of “strong, sustainable and balanced “global growth. If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize. 

http://www.dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf

“Puts” in the Shadows

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

(Mr. Alexander is also a lecturer at NYU and SunySB)

 

It is been four years since Lehman went under. There have been important initiatives on the regulatory front to minimize taxpayer bailouts to the financial sector (aimed at the banking sector).  The payouts (i.e., taxpayer bailouts) in various forms were provided by governments to a variety of financial institutions and markets that were outside the regulatory perimeter—the ―shadow‖ banking system, although, a few recent regulatory proposals attempt to reduce these ― imputed puts.

 

These issues are examined in a recent IMF working party called “Puts” in the Shadows by Manmohan Singh (Sept. 2012).  This study provides examples from non-banking activities within a bank, money market funds, Triparty repo, OTC derivatives market, collateral with central banks, and issuance of floating rate notes etc., that these risks remain. The results suggest that a regulatory environment where puts are not ambiguous will likely lower the cost of bail-outs after a crisis.

 

There are a plethora of views on reducing systemic risks at banks, including reverting to the Glass Steagall Act that separates commercial banking (i.e., depository type of business) with the non-depository business. Intermediate solutions like the Vickers and Volcker Rule that insulate (or provide buffers) to the depository part of the banks, or push out riskier activities outside the BHC (Bank Holding Companies) have gained momentum in various key jurisdictions. However, proposed regulation (via Basel III, Dodd Frank Act etc.), is unlikely to remove all the puts within the BHC, as it is one legal entity. The recent FSB (Financial Stability Board) list of SIFIs (Systemically Important Financial Institutions) acknowledges that the overall BHC is systemic.

 

The nonbank/bank nexus is an important part of financial system. However, nonbanks are separate legal entities outside a bank and thus the puts do not legally pass from the bank to the nonbank (and they shouldn‘t). There is sound economics behind the existence of nonbanks and these entities should not be driven only by regulatory arbitrage due to the puts. On non-bank resolution, no country has a comprehensive regime for addressing non-bank SIFIs, mostly because until recently nonbanks were rarely considered systemic. Thus, resolution of non-banks has become an increasing priority aside from the push for ―living wills. Regulators are starting to address this and the U.K.‘s Treasury and EC intend to publish consultation papers on this issue.

 

A less ambiguous regulatory environment will lower moral hazard; this will likely reduce cost to taxpayer if/when bailing out the shadow banking system. However, by intent, or political/policy choice, or by limited foresight, if ―puts are not removed ex-ante a crisis, there will always be room for bailouts. An example of an intended (but implicit) put is the creation of CCPs (Central Counter Party)―despite earnest efforts to reduce the size of SIFIs, the creation of new SIFIs (i.e. CCPs) is not clear. Another example is the political/policy choice not to explicitly remove the put from the MMFs industry in the U.S―it continues to offer par NAV (net asset value) with no capital supporting the business. Similarly, an example of limited foresight is bailing out money-like collateral at subsidized haircuts―recall Fed‘s PDCF (Primary Dealer Credit Facility), and the ECB‘s LTROs (Longer-Term Refinancing Operations) and the respective Eurozone national bank‘s ELA (Emergency Liquidity Assistance) efforts.

 

There will always remain some (unintended) puts ex-post a crisis. However, the puts that can be removed ex-ante should be addressed; otherwise "shadow banking" will continue to be a pejorative term and the issue of systemic risk is not fully addressed in reform proposals.

 

For more on this follow the link:  www.imf.org/external/pubs/ft/wp/2012/wp12229.pdf

The Cost & Effectiveness of Regulation

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Reforming the regulation of financial institutions and markets is critically important and should provide large benefits to society. The recent financial crisis underlined the huge economic costs produced by recessions associated with severe financial crises. However, adding safety margins and more complex financial regulations to the financial system comes at a price and can have predictable consequences.  The costs of this regulatory edifice are small if it improved regulators’ ability to avert future financial crises. Financial crises can be as costly as wars and waged with the weapons of the past.  The ideal for regulating a complex system is simplify the control framework and make sure the benefits of regulation outweigh the costs.

 

However, adding safety margins in the financial system comes at a price.  Most notably, the substantially stronger capital and liquidity requirements created under the new Basel III accord have economic costs during the good years, analogous to insurance payments.  There is serious disagreement about how much the additional safety margins will cost. The Institute of International Finance (IIF, 2011), bank lobbying group, project that the proposed reforms will reduce annual output in the advanced economies by approximately 3 percent by 2015. Official estimates, particularly those from the Bank for International Settlements (BIS), suggest a far smaller reduction.  The recent IMF recent Staff Discussion Paper, Estimating the Cost of Financial Regulation, by Andres Santos and Douglas Elliott (September, 2012) come closer to the BIS estimates.

 

The IMF study shows that financial reform will likely result in a modest increase in bank lending rates in the United States, Europe, and Japan in the long term. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders’ operating costs, affecting bank customers, employees, and investors. Yet banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy. In response to the estimated rise in regulatory costs, average bank lending rates are likely to increase by 28 bps in the United States, 17 bps in Europe, and 8 bps in Japan in the long term. By comparison, the smallest increment by which major central banks adjust their short-term policy rates is 25 bps, which tends to have a small effect on economic growth. A simple framework is used to estimate the likely increase in lending rates. These rates reflect the cost of allocated capital, other funding costs, credit losses, administrative costs, and several other factors.

 

There are some important limitations to the analysis presented here. Transition costs are not examined, a number of regulatory reforms are not modeled, judgment has been required in making many of the estimates, the overall modeling approach is relatively simple, and regulatory implementation is assumed to be appropriate, not creating unnecessary costs.

 

Financial reform comes at a price. Higher safety margins, particularly in terms of greater capital and liquidity, do add operating costs for lenders. Those costs will be passed on, at least partially, to the wider economy. There is considerable uncertainty about the true cost levels, but the sensitivity analysis demonstrates that reasonable changes in assumptions would not dramatically alter the conclusions.

 

The relatively low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs of regulatory reforms in the long run, although this study does not attempt to estimate the economic benefits of the regulatory changes. Put another way, banks around the world appear to have a considerable ability to adapt to the regulatory changes without radical actions that would harm the wider economy.  The alternative outcome is a new financial crisis with severe wealth destruction, lost output and jobs.

 

For more on this, follow the link: www.imf.org/external/pubs/ft/sdn/2012/sdn1211.pdf

Veil of Conceptions

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

The Scottish philosopher Thomas Reid claimed that “We see the world not as it is but through a veil of conceptions.”  What is the veil of conceptions that your organization works from?