It is wrong to push the old into a quicksand

Francesco Giavazzi – the distinguished economist from Bocconi University, Milan, a frequent visitor to MIT – made two gaffes around September last year: about Lehman Brothers, and about derivatives markets. Then he lay low for about a year, to re-emerge now with two more gaffes: one on targeting the aged in order to cover the cost of fiscal stimulus, and one on a wishful drive towards global recovery. This just goes to show that the judgment of engineers who turn to economics should be seen as that of engineers.

Lehman Brothers

On 16 September 2008, the day after Lehman Brothers went bankrupt, Francesco Giavazzi expressed great enthusiasm for the US authorities’ decision not to bail it out. “Yesterday has been a good day for capitalism” (sic!), he wrote on LaVoce.info, adding that “Now the liquidity cushion needed by AIG will also be provided by the market”. First he had to add a postscript to his piece, acknowledging that the US government had bailout AIG only a couple of hours later. Then he had to recognize – in a joint book with Alberto Alesina on the global economic crisis – that “ex-post, the failure to save Lehman Brothers probably was a mistake” (La crisi. Può la politica salvare il mondo? 2008, p. 49), rather than the “victory of the market” he had hailed earlier. Compare with Chris Giles, in the FT of 13 September 2009: “The collapse of Lehman Brothers transformed an expected global slowdown into the worst recession since the second world war. Though the direct losses from the Lehman bankruptcy caused little trouble, the ensuing panic that engulfed financial markets, banks and companies hit the global economy harder than the Opec oil crises of the mid-1970s, the loss of control over inflation in the late 1970s or the dotcom crash at the turn of the millennium”.

Derivatives markets

Expressed enthusiasm for the inordinate growth of the derivatives market, on the ground that derivative products allow Indian farmers to reduce the risks surrounding their crops, and enable the homeless to buy their homes, was another economic error. According to the Basel-based Bank of International Settlements, the global outstanding derivatives – bets on the value of assets, and bets on those bets – have been growing exponentially and at their peak earlier in 2009, when their total began to decline slowly, they had reached 1.14 quadrillion dollars (more precisely: $548 trillion in Exchange Traded Derivatives plus $596 trillion in notional Over-The-Counter derivatives). By comparison, the Gross Domestic Product of all the countries in the world is only 60 trillion dollars. What was supposed to be an instrument to distribute risk turned into a multiplication of risk. Or else those Indian farmers and US homeless have been exercising a lot of leverage.

But clearly the statute of limitations leaves errors unpunished in economics. Giavazzi has now reappeared to fire two more shots, though his aim has not improved over last year.

Targeting the aged

In a post on Vox.eu asking “What’s the proper exit strategy from the crisis?”, Giavazzi argues that the exit will take a long time, probably a matter of years, and the real co-ordination necessary is not across countries, but between monetary and fiscal policy. What should be rescinded first, exceptional monetary accommodation or the fiscal deficit?

Jean Pisani-Ferry argued recently that first should come structural reforms, then the gradual withdrawal of fiscal stimulus, then monetary policy could be reined in. He feared that Central Banks would not accept a secondary role, and was right: on 11 September, at a Bank of Italy Conference in Rome, ECB Board member Lorenzo Bini Smaghi said: “The more delayed the fiscal exit, ceteris paribus, the more the monetary policy exit might have to be brought forward. Indeed, given the level of the debt accumulated in most advanced economies, any delay in the fiscal exit is likely to have an effect on inflation expectations, and may even disanchor them.
This is a risk that monetary policy cannot take, as it would undermine its overall strategy.” (Bini Smaghi 2009 “An ocean apart? Comparing transatlantic responses to the financial crisis”; I was there and could not believe my failing ears).

Now, this does not sound like co-ordination, more like blackmail. Giavazzi likens the strategies of Central Banks and fiscal authorities to a game of chicken, whereby two car drivers on a collision course may both refuse to give way and crash – a patently inferior solution to a cooperative one. Giavazzi instead recommends that Euro-zone governments should commit themselves irrevocably to future spending cuts, in order to stabilize expectations and allow central banks to wait longer before they remove monetary accommodation. This would avoid the demand contraction that earlier fiscal cuts would cause.

True, but Giavazzi singles out for future cuts the ageing-related spending over the next 15 years. According to The 2009 Ageing Report issued by the European Commission (2008), ageing related spending amounts to 7% of GDP per year in Holland, 5% in Spain, 3.5% in Germany, and 3.3% in the EU27. Thus the budgetary effects of ageing are several orders of magnitude larger than the fiscal cost of the crisis. In terms of present value of total age-related expenditure (note: over 15 years), the present value of fiscal stimulus (temporary, over only 2 years) naturally is much lower, comparatively negligible (see Giavazzi’s Fig. 1, from IMF data).

Figure 1. The fiscal costs of the crisis compared to age-related spending

Source: IMF

The trouble is that all these figures are utterly misleading. The incidence of pension expenditure, on GDP or on total government expenditure, is not comparable across countries because of different statistical conventions (for instance in the treatment of golden handshakes and of payments to invalids), and even less comparable across countries with different incidence of so called distributive, Pay As You Go (PAYG) systems, versus capitalized, fully funded pension systems. Necessarily countries with a dominant PAYG system look as if they were more generous towards the aged than they actually are, because pension contributions should, but usually are not, counted as government revenue against pension expenditure. Conversely, an entirely funded system will appear as making no claim on government expenditure at all, because pension contributions are credited to the pension funds financing pension expenditure: but there is no reason why PAYG pension expenditure and revenue should be accounted for any differently. Only for uniform statistical conventions and for a comparable incidence of redistributive/funded pension systems will government expenditure on pension indicate – as the IMF figure produced by Giavazzi suggests – governments’ relative generosity towards old-age pensioners. Reflect on the fact that in 2006 the Italian pension system actually showed a surplus of 0.8% of GDP which therefore made a positive, significant contribution to the funding of public deficit (See R.F. Pizzuti, Rapporto sullo Stato Sociale, 2008, p.21), rather than wrecking social accounts from now to Kindom Come. See also three earlier posts on this Blog, of 13 June, 23 June, and 30 June, as well as the theoretical backing of Nick Barr and Peter Diamond, Reforming Pensions: Principles and Policy Choices, Oxford UP, 2008, and Pension Reform: A short Guide, Oxford UP (2009).

The same considerations apply to the additional expenditure due to population ageing, although its funding is not spelled out in the data quoted by Giavazzi. It is simply wicked to compare two item of expenditure in terms of their present value – two years in one case, 15 years in another. Besides, you cannot single out ageing as a specific source of expenditure, that can be cut at will regardless of the means provided by the recipients to finance the pension system as a whole. You might as well resort to the method – probably apocryphal but telling – that Federico Caffè used to quote when he discussed pensions: in some primitive society apparently the young brandish long pointed poles to decisively push into quicksand the aged no longer able to look after themselves. At the time of the Italian pension reform of 1995 the satirical magazine Cuore published a poster saying: “Your Government Needs YOU: Kill an Old-Age Pensioner”. Is this the Giavazzi solution? After all, it appears to be seriously considered by the IMF (2009).

The drive towards global recovery

In the September issue of the latest IMF publication, Development and Finance, there is a piece on “Growth after the Crisis”. If the world economy is to recover, a replacement must be found for the newly frugal U.S. consumer. Giavazzi calculates a consumption shortfall of about 3% of US GDP (i.e. a 4% increase in the saving rate from zero, of over 70% GDP being disposable income, = 2.8%), that cannot be compensated by the growth of China India and Brasil. China in particular will need to improve the provision of finance to the private sector, introduce a public safety net and risk-sharing financial products (this time we are talking about health and life insurance, and pensions, not derivatives…) before the Chinese saving rate is reduced. Europe – and particularly an export-led Germany, cannot or is not willing to do much (especially after the German elections).

So, Giavazzi argues, “the only way to maintain full employment is through higher investment.” This cannot be higher public investment, given the limited opportunities especially in the United States (where it is about 3% of GDP) and the “high probability that some of it will be wasted rather than contributing to raising the productive level of the capital stock”. Private investment (which is close to 20% in the USA) then must be the answer. But what would induce firms to raise investment spending in the middle of a sharp recession, and without any prospect of a likely technological breakthrough?

Elementary: “the realization that the crisis will change the composition of world demand for the long term. To address such a change, the structure of world output would have to adjust, which requires industrial restructuring and, as a consequence, new investment.” Because the crisis has brought about “a change in the composition of world consumption”, which “cannot happen without substantial restructuring, and, therefore, substantial investment.” What would prompt firms to invest is “the anticipation of a change in both the geographic allocation and the composition of consumption—relatively more consumption in China, relatively less in the United States; higher demand for such things as basic appliances and relatively lower demand for high-end automobiles.”

At this point the production of a long list of instruments of industrial policy, powerful enough to promote this kind of investment in restructuring, might be expected. But no, Giavazzi candidly relies on the incentive that “Those countries that do the restructuring—and get it right, including the portion that happens through public investment—will come out of the crisis richer.” Thus Giavazzi's pronouncements on the crisis range from applauding the Lehman disaster to misunderstanding the size role and danger of derivative markets; from the targeting of social welfare provisions for the old to the rosiest, starriest-eyed version of economic planning, not via public investment because of its presumed inefficiency, but presumably through the resurrection of French-type indicative planning that never worked and never will. Since when, in this century, do western governments take national investment decisions as they appear to do in Giavazzi’s world? Are private enterprises really enlightened and optimistic to the extent of selflessly investing in the hope of collectively implementing a balanced plan, starting from a large scale, tangible imbalance?

Giavazzi’s article appears in a prestigious official IMF publication; are his views shared by Dominique Strauss-Khan and/or Olivier Blanchard? The mind boggles.

Fiscal stimulus: larger, more balanced, co-ordinated

A United Nations source (World Economic and Social Prospects-Update as of Mid-2009) estimates that, since September 2008, Governments worldwide have made available massive public funding (amounting to $18 trillion, or almost 30 per cent of WGP [World Gross Product]) to recapitalize banks, to acquire ownership stakes in ailing financial institutions, and to provide ample guarantees on bank deposits and other financial assets. Further, recognizing the inadequacy of these monetary and financial measures to stave off a recession, many countries have also adopted fiscal stimulus plans, totalling about $2.6 trillion (about 4 per cent of WGP), to be spent over 2009-2011. ”While significant, this may still fall somewhat short of the stimulus of 2 to 3 per cent of WGP per year that would be required to make up for the estimated decline in global aggregate demand. “ (Ibidem).

In the same document the UN makes a number of recommendations of preconditions affecting fiscal stimulus effectiveness: the adequate recapitalisation of banks; the “fundamental reforms of the international financial system… to overcome the systemic flaws which caused this crisis” (a “macro-prudential regulatory system”, “counter-cyclical capital provisioning”, supervision of all financial market segments in which systemic risk is concentrated, including hedge funds and cross-border flows); “a new framework for global economic governance”, attributing to the IMF the role taken until now by the “Group of 7, the Group of 8, the Group of 20 or other ad hoc forums, lacking the participation or representation of important parts of the international community, especially from developing countries.”

These preconditions would produce spillovers such as the reduction of tax evasion (enhancing development resources), of corruption, of drug trafficking and the financing of terrorism. The UN document stresses the need for mechanisms of debt restructuring, and for “a new global reserve system which no longer relies on national or regional currencies, as the major reserve currency must be created.”

But the most important policy recommendation of this UN document is that of a co-ordinated stimulus, “with global sustainable development objectives”. In truth this is understood to involve more than just co-ordination, and to include an increase and redistribution of the stimulus, 80% of which is coming at present from developed, deficit countries. Greater efforts are expected of surplus countries in order to reduce global imbalances and to contribute “about $500 billion extra over 2009-2012, compared with the uncoordinated scenario” to middle and low-income developing countries, strengthening their social protection systems and making long-term investments in sustainable development. “The additional resource transfers needed would include about $50 billion for the least developed countries.”

Global coordination should also eliminate unfair trading practices associated with many stimulus packages that provide subsidies to domestic firms, in order to benefit through trade those countries that cannot afford domestic subsidies and fiscal stimulus. There would be “concerted efforts to provide countries with greater access to developed country markets as envisaged in a truly developmental Doha round of multilateral trade negotiations.”

The WESP-Update reports that the UN Department of Economic and Social Affairs has made simulations with their global policy model, which suggests that the proposed larger, more balanced and coordinated global macroeconomic stimulus would yield significant gains in terms of global growth, compared with the existing scenario of uncoordinated fiscal stimulus being individually undertaken by national Governments. The simulations are summarised in the figures below. (Click to enlarge).


The figures illustrate economic recovery under coordinated and uncoordinated global stimulus, 2009-2015. Source: United Nations/Department of Economic and Social Affairs, based on policy simulation within the UN Global Policy Model. From: UN WESP-World Economic Situation and Prospects, Update as of Mid-2009, New York.

In such a coordinated, development-oriented policy scenario, the world economy would recover at an annual growth rate of around 4 to 5 per cent in 2010-2015, led by robust growth of about 7 per cent per year in developing countries. In the uncoordinated scenario, developing countries - including transition economies - would recover at only 3 to 4 per cent per year.

Developed countries would also gain from the proposed policy broadening and coordination, with their GDP growth accelerating to about 4 per cent per year, up from 2 to 3 per cent in the uncoordinated scenario. “Furthermore, the simulation results for the coordinated policy scenario predict a benign unwinding of global imbalances, keeping external asset and liability positions of major economies in check, which would, in turn, support greater exchange-rate stability.” Coordination would require monitoring mechanisms. There would be net gains all round.

All this might be considered as “pie in the sky”, but - especially at a time of generalised discussions of premature “exit strategies” it is a timely reminder of the generalised, large-scale additional gains, and the possible improvement in global imbalances, that are within the grasp of a slightly larger, more balanced, co-ordinated stimulus package.

Ronald McKinnon: a concerted modest increase in interest rates?

Ronald McKinnon (Stanford), by way of comment to my post on exit strategies [Exit Wounds, 3 August] sent me an article of his, "Liquidity Traps and the Credit Crunch", that appeared in the Financial Times Forum of 14 August and "emphasizes the importance of getting out of the liquidity trap in order to restore the normal flow of credit even before full 'exit'".

In brief, "...starting from a position where interest rates are already low, say 2 per cent, reducing them to zero has only a second-order effect on expanding aggregate demand. But going from 2 per cent to zero leads to a tightening of the credit constraint on the supply side. Although there may be a “dead cat bounce” to the economy on the demand side in 2009, leaving the Fed funds rate at zero makes it impossible for the resumption of “normal” bank credit to support growth in future. A condition for restoring normal borrowing and lending in the interbank market is to have positive rates of interest at all terms to maturity. Only then will banks that are liquid lend to those that are illiquid. But if the risk free (i.e. federal funds) rate is close to zero, banks with excess reserves will not bother parting with them for a derisory yield." This - he argues - might lead to a trade contraction by causing supply constraints in the export sector, starved of credit.

I readily accept Ronald's general concern for the implications of low interest rates; I never thought - unlike Willem Buiter - that negative interest rates were the right policy to get out of recession, not least because they could not survive in globalised financial markets. But there are two points in RMcK's argument that I found difficult to accept. (1) While undoubtedly he is right on the importance of foreign trade credit, I could not bring myself to consider the cut in trade due to stricter credit constraints as a supply constraint (which term I would reserve for capacity constraints); (2) I could not see why low policy interest rates should deter banks from raising their margins between lending rates and policy rates to the point that it pays them to lend.

Faced with these objections, Ronald sent me an excellent reply, and developed the second point into a full-fledged argument that I reproduce below with his permission, for which I am most grateful. The bottom line of Ronald's argument is that "The Exit Problem: When to Reduce Monetary and Fiscal Stimuli?", has a "Partial Solution: concerted modest increase in interest rates?" [from his paper on "The Global Credit Crunch: China and the United States", Beijing 29 August 2009, which he also kindly sent me but is not reproduced here other than for figures 9 and 10 below].

"On your two points: (1) it is a matter of semantics. You may or may not like my referring to a credit constraint as a "supply" constraint. But credit is an input into working capital. If working capital is unavailable or restricted, then dumping more liquidity into the system will not increase output as if there was a constraint on physical capacity.

(2) Your second point: in the liquidity trap, why don't banks just raise their interest rates to final (retail) borrowers to maintain their profit margins and willingness to lend? This is an important and very subtle point which I did not explain very well in my FT post.

The willingness of banks to make forward commitments to lend at "retail ", to nonbank firms and households, depends very much on the wholesale interbank market. If the wholesale interbank market works smoothly without counter party risk, then even currently illiquid banks can make forward loan commitments--say 3 months in advance--to their retail customers. These banks know that if they are still illiquid when three months are up, then they can always bid for funds in the wholesale market at close to the "risk-free" interest rate to cover their retail commitment.

Now suppose some upsetting event, such as a crash in home prices that makes all mortgage related assets on bank balance sheets suspect. Then counter party risk becomes acute, and banks become less willing to lend to each other unsecured. The LIBOR market is unsecured. So illiquid banks become less willing to lend forward at retail because they don't know what their wholesale cost of capital will be 3 months hence. Indeed if any one bank tries to bid more than the going interbank rate of interest for funds, it is immediately suspected of being a more risky counter party!

Now enter the central bank concerned with the drying up of retail bank credit. It reacts in a text book fashion of flooding the interbank market with liquidity so that the interest rate on federal funds is driven to zero. Bank trading in federal funds is collateralized--usually through short-term re-po agreements, where the collateral is usually U.S. Treasury bonds.

Normally, without significant counter party risk in banks, there isn't much of a difference between the interest rate on federal funds and LIBOR. (See Figure 9 for January 2006 to July 2007 [reproduced below with RMcK's permission, from his Beijing paper quoted above, 29 August 2009]). Then when the crisis struck beginning in July 2007, LIBOR increased substantially above the Fed funds rate indicating the reluctance of banks to lend unsecured. This inhibited banks from making forward retail commitments .

(Incidentally, we could do a similar parallel analysis for foreign exchange transacting. Forward foreign exchange contracting in "wholesale" inter bank markets becoming difficult when bank counter party risk rises. The constriction in the forward market increases currency risk for both exporters and importers and inhibits the granting of trade credit--including letters of credit. Whence the surprising crash in foreign trade.)

However, by August 2009, we are in a purer form of the liquidity trap where both interest rates have been driven toward zero (Figure 9). Now we are in the situation referred to in my FT paper that liquid banks, those with excess reserves, won't bother parting with them for a derisory return. So I would guess (without knowing) that interbank trading is now at a low level .

The implication for all of this is that retail lending in the U.S. has stagnated (or fallen slightly) since August 2008 even when base money in the U.S. has skyrocketed--as shown in Figure 10 [also reproduced below, from the Beijing paper of 29 August 2009].

Figure 9. U.S. Short-term Interest Rates in the Liquidity Trap


Source: FRED and globalfinancialdata.com. From: Ronald McKinnon, "The Global Credit Crunch: China and the United States", Summer Palace Dialogue, Aug 29, 2009, Beijing

Fig. 10. Loans of U.S. commercial banks, Base Money and M2 (2006 Jan = 100)
Source: FRED. From: Ronald McKinnon, 2009, cited.