Monetary alchemy, fiscal science

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

2013 marks the 100th anniversary of the US federal income tax and the establishment of the Federal Reserve. Jeffrey Frankel asks, in a recent VOXEU communique (Jan. 29^th), what lessons have we learnt about macroeconomic policy since then? This note assesses the postwar lessons and argues that fiscal expansion is much more likely to be effective in the short term than any monetary expansion stimulus. Indeed, compared with fiscal policy, monetary policy seems more alchemy than science.

It took time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy respectively. It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macroeconomy. John Maynard Keynes, of course, pointed out the advantages of expansionary fiscal policy in circumstances like the Great Depression. Milton Friedman blamed the Depression on the Fed for reducing money supply.

In subsequent debates: Keynes was associated with support for activist or discretionary policy. The aim was a countercyclical response to economic fluctuations; and Friedman opposed activist or discretionary policy, believing that government institutions – were unable to time their interventions effectively.

After the second world war, the lessons of the 1930s were incorporated into all macroeconomic textbooks and, to some extent, permeated the beliefs and actions of policymakers. But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by other major economic phenomena, such as the high-inflation 1970s.

The austerity-versus-stimulus debate continues with proponents of austerity point out that the long-term consequences of permanent expansionary macroeconomic policy – both fiscal and monetary – are unsustainable deficits, debt and inflation. Conversely, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt-to-GDP ratios that go up rather than down. Less thoroughly aired recently is the question of whether, given recent conditions, monetary or fiscal expansion is the more effective instrument.

Under the circumstances that held in the 1930s and again today – conditions of high unemployment and low inflation but also of near-zero interest rates – stimulus in the specific form of fiscal expansion is much more likely to be effective in the short term than stimulus in the form of monetary expansion. Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero.

Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries.  Introductory economics textbooks talk about the Keynesian multiplier effect: the recipients of federal spending – or of consumer spending stimulated by tax cuts or transfers – respond to the increase in their incomes by spending more as well. Again, the multiplier is much more relevant under current conditions than in more normal situations.

A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others. Needless to say, the effects of fiscal policy are subject to substantial uncertainty. Nevertheless, if the question is whether it is monetary policy or fiscal policy that can more reliably deliver demand expansion under current conditions, the answer is the latter. One might even dramatize the contrast by speaking of ‘monetary alchemy and fiscal science’.

Eric Leeper characterized monetary policy as science and fiscal policy as alchemy. It is true that the state of knowledge and practice at central banks, which actually set the instruments of monetary policy, is close to the best that modern society has to offer. It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state of economic knowledge and largely motivated by politicians’ desire to be re-elected.

Alchemists were not stupid or selfish. Rather, alchemy fell far short of modern chemistry. The term alchemy could be applied to pre-Keynesians like US officials whose Depression prescription was “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate ... it will purge the rottenness out of the system”. But in light of all that was learned in the 1930s, it would be misleading to characterize the current state of fiscal policy knowledge as ‘alchemy’.  Perhaps, someone in Washington might learn something.

http://www.voxeu.org/article/monetary-alchemy-fiscal-science

Bank capital requirements: Are they costly?

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

There exists a view that having banks use more equity capital (and relatively less debt) to finance the assets they hold creates substantial costs, costs that may be so great as to make more capital infeasible. David Miles, in a VOXEU communique (Jan. 17^th), believes that these costs are exaggerated. But the benefits of having banks that are far more robust – in the sense of having a balance sheet structure that makes them much less likely to come near to insolvency once actual and suspected losses on their assets come along – are likely to be large.

Banks used to finance a very much higher part of their activities with equity than is considered acceptable today. Bank leverage before 1970 in the UK was, on average, about half the level of recent decades. Spreads between reference rates of interest and the rates charged on bank loans were not obviously higher then when banks made very much greater use of equity funding. 

There is no clear link between the cost of US bank loans and the leverage of US banks. The significant increase in leverage of the US banking sector over the 20th Century was not accompanied by a decrease in lending spreads, indeed the two series are mildly positively correlated so that as banks used less equity to finance lending, the spread between the rate charged on bank loans to companies and a reference rate actually increased.

Miles made some assumptions about bank returns to determine their cost of capital.  If the required return on equity is set at 15% with a cost of debt of 5%, the weighted average cost of capital would have risen to 5.66% and leverage of 30 times.  If capital is doubled and leverage reduced to 15 times, it might cause the cost of bank funding to rise by between 17bp and 33bp. These numbers are nontrivial but hardly enough to do substantial damage to banks.

A rather more subtle argument is that, while in some circumstances equity is not an exceptionally costly form of finance for banks, today it is because bank equity is trading at a huge discount. One version of this argument is that because the ratio of the market value of equity to its book value is well beneath unity, a bank which raises equity is imposing huge costs on those that provide it.

Another interpretation of the price to book argument is that it shows that required returns on new equity are very high. But a far more natural interpretation is that investors believe that existing assets on a bank’s balance sheet are worth less than their acquisition cost rather than that the required return on new investment is very high.  The fair value of loans should reflect the present value of expected cash flows.

The argument as to why raising more equity capital is problematic for banks is that the benefit of extra capital may substantially accrue to those with debt claims, making it unattractive to new shareholders. This is a debt overhang problem: first, failure to raise more equity is a huge obstacle to a bank being able to function properly with a cushion against losses too low to make it able to raise debt easily; and second, one way to handle the debt overhang problem is to have some debt convert to equity.

What are the people that run banks really saying if they argue that it is very costly – even unfeasible – to use more equity funding? One interpretation is that this argument is an admission that they cannot run a private enterprise in a way which makes people willing to provide finance whose returns share in the downside and the upside. In other words, they are people who will face the full consequences of their commercial decisions to provide funding. It is as if banks cannot play by the same rules as other enterprises in a capitalist economy – after all, capitalists are supposed to use capital. You might expect that if this is the assessment of many people who currently run banks, then they would not wish to proclaim it so loudly. The upside is that bank risks might be priced correctly without a government subsidy.

http://www.voxeu.org/article/bank-capital-requirements-are-they-costly

Interim IMF Update for Global Growth Outlook

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

Global growth is projected to increase moderately during 2013, as the factors underlying soft global activity are expected to subside. Policy actions have temporarily reduced crisis risks in the euro area and the United States. But in the euro area, the return to recovery after a protracted contraction is delayed. While Japan has slid into recession, stimulus is expected to boost growth in the near term. At the same time, policies have supported a modest growth pickup in some emerging market economies, although others struggle with weak external demand and potential bottlenecks. If crisis risks do not materialize and financial conditions continue to improve, global growth could be stronger than projected. However, downside risks remain significant, including renewed setbacks in the euro area and risks of excessive near-term fiscal consolidation in the United States. Policy action must urgently address these risks.

Economic conditions improved modestly in the last half of 2012 with global growth increasing to 3 percent. The main sources of acceleration were emerging market economies and the United States, where growth surprised on the upside. Financial conditions stabilized. Bond spreads in the euro area periphery declined, while prices for many risky assets, notably equities, rose globally. Capital flows to emerging markets remained strong. However, a broad set of indicators suggests that global growth upside not strengthen further near-term.

Growth in the United States is forecast to average 2 percent in 2013, rising above trend in the second half of the year. In particular, a supportive financial market environment and the turnaround in the housing market have helped to improve household balance sheets and should underpin firmer consumption growth in 2013, but fiscal policy outlook is uncertain.

The near-term outlook for the euro area has been revised downward, with activity now expected to contract by 0.2 percent in 2013. This reflects delays in the transmission of lower sovereign spreads and improved bank liquidity to private sector borrowing conditions, and still-high uncertainty about the ultimate resolution of the crisis despite recent progress. However, euro-area prospects remain a global risk until long-term structural issues such as banking union and fiscal consolidation are addressed.

The near-term growth outlook for Japan has not been downgraded despite renewed recession concerns, but is expected to be short-lived because the effects of temporary factors. A sizeable fiscal stimulus package and further monetary easing will give growth at least a near-term boost, with support from a pickup in external demand and a weaker yen. There will need to be further reforms on fiscal policy.

Growth in emerging market and developing economies is on track to build to 5.5 percent in 2013. Nevertheless, growth is not projected to rebound to the high rates recorded in 2010–11. Supportive policies have underpinned much of the recent acceleration in activity in many economies. But weakness in advanced economies will weigh on external demand, as well as on the terms of trade of commodity exporters, given the assumption of lower commodity prices.

The policy requirements outlined in 2012 remain relevant. Most advanced economies face two challenges. First, they need steady and sustained fiscal consolidation. Second, financial sector reform must continue to decrease risks in the financial system.  n China, ensuring sustained rapid growth requires continued progress with market-oriented structural reforms and rebalancing of the economy toward private consumption. In other emerging market and developing economies, requirements differ. The general challenge is to rebuild macroeconomic policy toward a more favorable growth environment. 

www.imf.org/external/pubs/ft/weo/2013/update/01/index.htm

Why financial markets are inefficient

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

The efficient market hypothesis – in various forms – is at the heart of modern finance and macroeconomics.  Roger Farmer argues in a recent VOXEU communique (Jan. 22^nd) that market efficiency is extremely unlikely even without frictions or irrationality.  Why?  Because there are multiple equilibria, only one of which is Pareto efficient.  For all other equilibria, the whims of market participants cause the welfare of the young to vary substantially in a way they would prefer to avoid, if given the choice.  This invalidates the first welfare theorem and the idea of financial market efficiency.  Central banks should thus dampen excessive market fluctuations.

Richard Thaler has drawn attention to two dimensions of the efficient markets hypothesis, what he refers to as: ‘no free lunch’, what economists refer to as ‘informational efficiency’; and ‘the price is right’, what economists refer to as ‘Pareto efficiency’.

Farmer argues that while there are strong reasons for believing there are no free lunches left uneaten by bonus-hungry market participants, there are no reasons for believing this will lead to Pareto efficiency, except, by chance.  There are policy implications of this, showing that the Pareto inefficiency of financial markets provides strong grounds to support central bank intervention to dampen excessive market fluctuations.

Some economists believe that financial markets experience substantial frictions.  For example, agents are irrational, households are borrowing constrained or prices are sticky.  Although there may be some truth to all of these claims, direct central bank intervention in the financial markets does not rest on any of these alleged market imperfections.

A number of economists suggest competitive financial markets will not function properly by government intervention.  This assertion has been formalized in the first welfare theorem of economics.  The theorem provides conditions under which free trade in competitive markets leads to a Pareto efficient outcome, a situation where there is no way of reallocating resources that makes one person better off without making someone else worse off.  Farmer indicates why the conditions that are necessary for the theorem to hold do not characterize the real world.

The standard assumptions include: households are rational and plan for the future; they have rational expectations of all future prices; there are complete financial markets in which agents are free to make trades contingent on future observable events; and no agent can influence prices.  In this approach, there are two types of people who discount the future at different rates; patient and impatient agents.  Both types share common beliefs, which can independently influence what occurs.  This follows an important idea called ‘sunspots’, or a ‘self-fulfilling prophecy’.

What can go wrong when agents are rational, hold rational expectations, there are no frictions, and markets are complete?  Well, the first welfare theorem does not account for the fact that people die and new people are born.  In our world: patient and impatient agents each recognize that the financial markets are fickle and equity markets can be volatile; if the markets boom then the patient savers will lend more to the impatient borrowers; and if the markets crash, then the savers will recall their loans.

Financial booms and crashes occur as a consequence of the animal spirits of market participants.  Why should we care if there are big movements in the asset markets?  After all, the borrowers and lenders are rational and they have made bets with each other in full knowledge that these large asset movements might occur.  The problem is that the next generation is unable to insure against swings in wealth that have a big influence on their lives.

Recent research indicates that the present value of lifetime income of new entrants to the labor market can differ substantially depending on whether their first job occurs in a boom or a recession.  As a result, the lifetime income of the young can differ markedly.  Young agents prefer to avoid the risk of a sharp variation in lifetime wealth.  There is a feasible way of allocating resources that would insure them against this risk, but financial markets cannot achieve this allocation, except by chance.  The inability of our children to trade in prenatal financial markets is sufficient to invalidate the first welfare theorem of economics.  In short, sunspots matter.

Farmer notes financial markets cannot work well in the real world except by chance because: there are many equilibria; only one of them is Pareto efficient; for all other equilibria, the whims of market participants cause the welfare of the young to vary substantially.  Agents are rational, they have rational expectations and there are no financial frictions. Even when agents are rational, markets are not.

www.voxeu.org/article/why-financial-markets-are-inefficient

Eurozone crisis: It ain’t over yet

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

As the famous American philosopher Yogi Berra noted “It ain’t over till it’s over”.  All G7 economies are struggling in the post-crisis climate, but US GDP has recovered to pre-crisis levels, while the Eurozone lags.  Paolo Manasse in a VOXEU communique (Jan. 17^th) portrays the global crisis as a transitory shock for the US, but as a quasi-permanent shock for Europe.

The policies needed to get the Eurozone back on track are not politically feasible.  As tension rises with every quarter of stagnation, prospects for the survival of the euro are not improving, but getting worse.  Calmness settled when Mario Draghi pledged that the euro was an irreversible project.  Yet, the forces that could eventually break up the Eurozone are not only untamed but are growing due to serious policy mistakes.

A useful starting point is to compare how the US and Eurozone have been affected by, and have responded to the recent financial crisis.  These comparisons include: a comparison of permanent versus transitory consequences of shocks; active versus passive policy responses; and symmetric versus asymmetric shocks.

The financial crisis originated in the US and later spread to the Eurozone:  the fall in output is larger on impact in the Eurozone than the US; the US economy started recovering 2009 and continues, while in the Eurozone recovery has been short-lived, and stagnates.

The labor market comparison tells an interesting story.  First, note that the rise in unemployment in the US is an impact much larger than in the Eurozone.  Second, following the sharp rise in the unemployment rate, the US rate starts to decline.  Third, the European unemployment rate rises slowly, but shows no sign of reversal.  The evidence points to much more persistent contractionary effects in the Eurozone than in the US.  The global crisis seems to have been a quasi-permanent shock for the Eurozone but a transitory shock for the US.

A look at fiscal and monetary policies in the two reveals important differences.  The rise in deficit/GDP ratio in the US – is far more pronounced than in the Eurozone.  This occurs despite the fact that Europe experienced a deeper recession, which reduces GDP and raises the deficit due to automatic stabilizers.  The ‘expansionary’ stance in the Eurozone is short-lived, and reverts as soon as 2009 while the deficit/GDP ratio in the US improves only from 2010.  As a consequence, the debt/GDP ratios that was approximately at 70% in both the US and the Eurozone start diverging since 2007, with a much larger rise in the US.

In considering central bank policies, the size of the ECB interventions is about one fifth of that of the Fed, about 4% of GDP compared to over 20%.  The difference in fiscal stances between the US and the Eurozone goes a long way in accounting for the worse performance of the Eurozone compared to the US.  This suggests that Eurozone problems are largely homemade.  Other explanations include different labor markets, country specific shocks, different institutions and policy responses.

The Eurozone policy response to the crisis, fiscal tightening and reinforced constraints on Eurozone national borrowing to prevent moral hazard, is not only imparting a recessionary impact on the Eurozone, but it is also aggravating the ‘original sin’ of the euro: asymmetry.  Thus, in a context of scarce international labor mobility and lack of wage and price flexibility in some Eurozone countries, the lack of an operative ex-post transfer/insurance scheme becomes more serious.

The problem is a very difficult one.  A centralized ‘ex-post’ transfer scheme is necessary, but does not seem to be politically feasible.  The adopted Macroeconomic Imbalances procedure, a mere ‘ex-ante’ monitoring device – akin to a score board – for detecting ‘asymmetries’ is probably counter-productive.  Instead of transferring resources to countries suffering shocks, it punishes them.  The longer-term prospects for the survival of the euro not only are not improving, they are getting worse.

www.voxeu.org/article/eurozone-crisis-it-ain-t-over-yet

Have we solved 'too big to fail'?

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

The Subprime Crisis became the global crisis when one too-big-to-fail bank was allowed to fail. Andrew Haldane argues in a recent VOXEU communique (Jan. 17^th) that too-big-to-fail is far from gone despite reform efforts. Further analytical work, weighing the costs and benefits of different structural reform proposals, would help keep memories fresh and policies on the right track. No!

That is not a pessimistic verdict; it is the markets. Prior to the crisis, the 29 largest global banks benefitted from just over one notch of uplift from the ratings agencies due to expectations of state support. Today, this is now around three notches of implied support. Expectations of state support have risen threefold since the crisis began.

This translates into a large implicit subsidy for large banks in the form of lower funding costs and higher profits. Prior to 2007, this amounted to tens of billions of dollars each year. Today, it is hundreds of billions. In other words, the regulatory response to the crisis has not plugged the 'too-big-to-fail' sink.

The regulation to quell the too-big-to-fail reform effort falls into roughly three categories:

(a) Systemic surcharges: of additional capital levied on the world’s largest banks according to their size and connectivity. The highest surcharge was set at 2.5% of capital.  However, a charge levied at this rate would leave the majority of the systemic externalities associated with large banks untouched. The reduction in default probabilities associated with lowering leverage by a percentage point or two would not offset the higher system-wide loss-given-default associated with the world’s largest banks.

(b) Resolution regimes: In principle, orderly resolution regimes for banks could lower the collateral costs of a big bank defaulting, thereby tackling at source these systemic externalities. A key component of these plans is the ability to impose losses on private creditors – so-called 'bail-in' – rather than have those losses borne by taxpayers.

As with systemic surcharges, the issue here is not to so much the bail-in principle, but its application. Bail-in, faces an acute time-consistency problem. Policymakers face a trade-off between placing losses on a narrow set of tax-payers today (bail-in) or spreading that risk across a wider set of tax-payers today and tomorrow (bail-out). A risk-averse, tax-smoothing government may tend towards the latter path.

(c) Structural reform: One way of lessening that dilemma may be to act on the scale and structure of banking directly. Several recent regulatory reform initiatives have sought to do just that, where each of these proposals shares a common objective: a degree of separation or segregation between investment and commercial banking activities.

These ring fencing initiatives confer both ex-post (improved resolution) and ex-ante (improved risk management) benefits. Because they act on banking structure, they have a greater chance of proving time-consistent. While this is a clear step forward, those benefits are only as credible as the ring fence itself.

If these initiatives are necessary but none are sufficient to tackle too-big-to-fail, what can be done? One solution might lie in strengthening these proposals. For example, re-sizing the capital surcharge, perhaps in line with quantitative estimates of the 'optimal' capital ratio, would be one option for bearing down further on systemic externalities.  Another option would be to place size limits on banks, either in relation to the financial system or relative to GDP.

Proposals of this type face two sets of criticism. The first, practical issue is how to calibrate an appropriate limit. Recent research on the link between and financial depth and growth provides a way into this question. The second, empirical issue is whether size limits would erode the economies of scale and scope which might otherwise be associated with big banks.  Recent research suggests economies of scale for banks with balance sheets in excess of $1 trillion.

This evidence needs to be interpreted cautiously, because it fails to recognize the implicit subsidies associated with too-big-to-fail. They lower funding costs and boost measured valued-added for the big banks. Consequently, the implicit subsidy would show up as economies of scale. Bank of England research indicates, once those subsidies are accounted for, evidence of scale economies for banks with assets in excess of $100 billion tends to disappear.  There may even be evidence of scale diseconomies, perhaps consistent with big banks being 'too big to manage'.

Too-big-to-fail is far from gone. Further analytical work, weighing the costs and benefits of different structural reform proposals, would help keep memories fresh and policies on the right track.  It will continue to be a challenging environment for risk management

www.voxeu.org/article/have-we-solved-too-big-fail

Happy 2013?

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

Financial market quiescence has removed pressure for immediate policy action on the Eurozone crisis. Charles Wyplosz, in a recent (Jan. 4^th) VOXEU communique, argues that while important repairs were made in 2012, there are serious problems ahead. Things will have to get worse before they get better, especially if politicians delay making critical decisions.

The situation of the Eurozone is now becoming clearer. This note lists ten observations and draws five consequences. The bottom line is that, even though some important steps were taken in 2012, the most difficult ones still lie ahead.

The observations for the Eurozone problems include: 

·       Prolonged austerity policies have contractionary effects.

·       Debt reduction is a very long process; that takes years or decades

·       The debt-to-GDP ratio is best reduced through sustained nominal GDP growth.

·       In a fiscal union whereby an agency would both coordinate national fiscal policies to achieve a good Eurozone policy mix and organize transfers from the countries that achieve their lowest unemployment rates.

·       The crisis has delivered a surprising degree of wage flexibility and labor mobility.

·       The long-hoped-for awakening of the ECB has produced several miracles, especially a major relaxation of market anguish.

·       In most Eurozone countries, structural reforms are as needed now as they were before the crisis.

·       Banks are at the heart of a negative feedback loop: bank holdings of their national public debts.

·       Massive forbearance has allowed many banks to not fully account for the losses that they incurred in 2007-8, if they deleverage, which leads to a credit crunch, which slows growth down. As the recession spreads and deepens, bank loan quality is quickly deteriorating. This second diabolic loop links banks and the real economy.

·       The ECB is the lender of last resort both to banks and to governments.  This involves massive moral hazard. Moral hazard can be sharply reduced with appropriate institutional measures.

What are the policy implications from these observations? Wyplosz draws five different lessons:

• Sustained real growth should be the number one priority.
• Austerity policies must stop, now.
• Growth will not return unless bank lending is adequately available (1) they must stop lending to their own governments, and (2) they must be shut down if they are unable to raise the capital needed for them to lend to the private sector. But their governments may not have the resources to carry out resolution.
• The ECB may act as lender in last resort to banks and governments, but who will bear the residual costs, as current temporary facilities are too small?
• The only remaining option is public debt restructuring, a purging of the legacy.

This will lead to bank failures. This means that debt reductions must be deep enough to make it possible for governments to then borrow, to shift to expansionary fiscal policies and to bail out the banks that they destroyed in the first place, in effect undoing the negative feedback loop. The ECB is the only institution in the world that can help out. That means massive losses on its balance sheet and therefore negative capital, which is not an economic problem but a potentially severe political one.

There is no easy option for the Eurozone after three years of deep mismanagement. Governments will not accept drastic action unless forced to. This means another round of crisis worsening and since the eventual costs are rising as public debts keep growing, the best hope is that it happens in 2013 rather than in 2014.  It will be a challenging period for risk management.

www.voxeu.org/article/happy-2013