Conjectures about the post-crisis future of the global economy are path-dependent, i.e. they necessarily depend on the course of events envisaged for getting out of the crisis.
The current global crisis was the consequence of financial de-regulation and the general dominance of hyper-liberal policies in the United States, in the UK and in the global economy. It started around August 2007 as a US banking crisis arising from toxic sub-prime assets in banks’ balance sheets; it turned into a credit crisis that depressed enterprise investment; it spread globally through the decline of foreign trade and the slowdown and often reversal of capital flows, including Foreign Direct Investment; and then - with the large scale cost of rescuing financial institutions by government budgets, the rising cost of labour unemployment and the decline in governments revenue - it grew into a fiscal crisis and, ultimately, a widespread crisis of sovereign debt, particularly in the Euro-zone.
Initially the decline in industrial output, foreign trade volume and stock exchange values replicated the scale and the pattern of the 1929-32 crisis. Soon the impact of the crisis and cross-country contagion were mitigated by simultaneous, internationally co-ordinated, monetary expansion and fiscal stimulus, introduced at the end of 2008 and early 2009. But monetary expansion failed to re-launch economic growth, while concern about fiscal sustainability soon led to a simultaneous, premature exit from fiscal stimulus in most countries. Current prospects - apart from those of BRICS (China, Russia, India, Brasil, South Africa, now accounting for 18% of world GDP and the bulk of its growth) - are of widespread stagnation and double-dip, indeed of a second and even more serious recession.
The macroeconomic policies followed appeared to have a keynesian flavour, stimulating aggregate demand via tax cuts, monetary expansion and low interest rates. But keynesian remedies would have required public investment instead, whereas tax cuts temporarily fuelled private consumption, and the effectiveness of low interest rates - which mostly were not passed on to borrowers and simply involved higher profits for financial intermediaries - was limited by liquidity preference.
The rescue of financial institutions involved a massive transfer of wealth from taxpayers to bank creditors, including depositors and shareholders. This solution was clearly inferior to any of the alternatives, whether support for bank debtors, or partial nationalization of supported financial institutions, or outright loss-taking by imprudent lenders. Income inequality, whose depressive effect on effective demand had been reduced by credit expansion - one of the contributory factors of the crisis - increased further as a result of labour unemployment and continued payment of managerial super-bonuses awarded mostly to those responsible for the financial debacle not by markets but by a semi-feudal process of self-serving decisions by a managerial caste.
The current generalized advocacy of strict fiscal discipline, demanded by international financial institutions and often enshrined in national constitutions as a balanced budget obligation, is particularly anti-keynesian, and is bound to be counter-productive in the middle of a recession.
First, a balanced budget is neither sufficient nor necessary to the sustainability of government debt, because a primary surplus (net of interest payments) may or may not be necessary to debt sustainability - depending on whether the economy grows at a rate slower or faster than the average interest paid on government debt.
Second, the keynesian lesson has been forgotten or ignored, that the balance of government expenditures minus revenues, plus the balance of private investment minus savings, plus the external balance of exports minus imports, must necessarily add up to zero as a matter not of theory but of accounting consistency. Therefore the budget balance cannot be a policy instrument, but only a target that may or may not be achievable depending heavily also on the behavior of national economic agents and of global trade partners (including the elimination or large reduction of Germany’s trade surplus vis-à-vis the rest of Europe, and China’s gigantic trade surplus). Generalized efforts by all governments to balance their budgets simultaneously might actually result in a perverse combination of budgetary (and trade) imbalances as well as a lower level of employment and income worldwide than would be the case without such efforts.
By the same token, generalized efforts to promote employment and growth via higher international competitiveness - whether achieved by external devaluations or by domestic deflation of wages and prices - can also be competitively self-defeating: another clear keynesian lesson is that lower wages can raise employment through higher exports in one country, but cannot resolve unemployment as a world problem. Nor can world unemployment necessarily be reduced by a generalized reduction of employment tenure and other labour welfare provisions, or the replacement of collective bargaining by firm-level bargaining: the only certain effect of such policies, also very popular in anti-crisis policy packages under the pretext of “structural reforms” (e.g. see the European Central Bank’s guidelines to the Italian government in their letter of 5 August 2011) is the deterioration of the quality of work and labour incentives.
Often it is believed that the impelling necessity of environmental improvements, required by the reduction of global warming and of general pollution, and the forthcoming exhaustion of natural resources, will create a new important opportunity for investment and growth. However - apart from the observably controversial nature of global warming - these are all opportunities for public or public-funded investment, desirable in itself (not absolutely but up to some point) but competing with alternative uses of scarce public funds whose expenditure today is supposed to be kept under control in the interests of fiscal sustainability.
The chances of world leaders suddenly learning keynesian lessons, and implementing them with the speed and on a scale adequate to propel the global economy out of stagnation are remote, indeed would amount to a miracle. Even those who would like to do it are prevented by the electoral challenge of populist competitors (as is Barack Obama by his Tea-Party Republican challengers). By comparison the prospect of Wealth Sovereign Funds coming to the rescue of highly indebted governments might seem a more normal occurrence, but this would be the true miracle and is simply not going to happen: it worked in 2008 to the advantage of financial stabilization, but now WSFs have run out of trust.
The fact that the US can always “print” the dollars it owns to pay its creditors does not make the US debt indefinitely sustainable: at some point the resulting dollar inflation will make dollar bonds unpalatable at less than crippling interest rates so high that they would necessarily involve eventual insolvency. Other countries face even stricter debt sustainability conditions, without the same initial room for manoeuvre. Where private wealth largely exceeds the difference between current debt and its sustainable level, it is always possible to apply a once-and-for-all or recurring wealth surcharge to achieve solvency. Italy, for instance, has a public debt of euro 1,900 bn, but in 2008 it had a household wealth of euro 8,600 bn, 45% of which was concentrated in the top 10% of households; but wealth taxation is unpopular and the political will to introduce it is scarce. Privatization of public assets is often considered as a way to reduce sovereign debt, but the potential revenue obtainable from this source is usually overstated with respect to the depressed values realizable during a crisis, when it is infelicitously timed.
An insolvent country, like Greece, has only three alternative options: 1) instant orderly default with significant “hair-cuts” negotiated with creditors; or 2) instant dis-orderly default; or 3) delayed default, whether orderly or dis-orderly, preceded by roll-over of debt with the assistance of international financial organizations (like the IMF, or the European Financial Stability Fund soon to become the European Stability Mechanism, or the European Central Bank with its controversial purchases of government bonds in secondary markets) followed eventually by actual default, as in all schemes of pyramid banking, to which such rollover of uncovered debt has been likened.
The three default options are ranked above in order of increasing cost. However it should be remembered that non-default by insolvent debtors is also very expensive, as witnessed for instance in the large scale fall (of the order of 25%-30% in just one quarter in mid-2011) in the capitalization value of stock exchanges in temporarily solvent Euro-zone countries with uncertain longer-term solvency.
Partly the probability of default, assessed by Rating Agencies (like the oligopolistic three: Standard and Poor’s, Moody’s, Fitch), reflected in the interest spreads with respect of bonds regarded as totally secure (like German Bunds) and in the price of insuring bonds against default by buying Credit Default Swaps, expresses political as well as economic judgments (as in the recent case of Italy, handicapped by a corrupt, disreputable and divided government short on credibility).
Of course Rating Agencies have proven to be highly fallible and often biased, for they have their own agendas to drive forward, have positions of conflict of interests (“issuer pays” instead of “buyer pays”) and opportunities for insider trading. Alternative, public Rating Agencies have been advocated, for instance in Europe, but such institutions could not be regarded as independent and therefore their credibility would be low. Better still, “the use of ratings in financial regulations should be significantly reduced over time” (as was suggested in the de Larosière Report of 2009 under Recommendation 3, but never acted upon by European authorities).
In order to contain the unavoidable disruption and turmoil involved by a country’s default, it would be essential to anticipate its adverse effects and counteract them beforehand, by re-capitalizing commercial banks exposed to the cross-effects of default, including central banks and above all the European Central Bank that has been acting (probably exceeding its mandate) as Lender of Last Resort to the governments of “peripheral” (meaning “high spread”) countries. An experience of default is bound to depress the price of, and thus raise yields on, old and new government bonds for the whole area; therefore contagion would worsen the sustainability conditions of debt, and therefore slow down the speed of subsequent recovery.
Furthermore, a post-crisis global economy should have renewed efforts to establish some form of global governance rather than have in place the many and inadequate ad hoc institutions cobbled together to, at present, provide some semblance of governance. But in order to be established global government now would have to be universally accepted not only in its initial form, but also in all its rules for the continuous adjustment to future, unforeseen and unforeseeable, circumstances: such acceptance now is probably out of the question. Besides, the demotion of the nation state is not necessarily desirable. For the nation state provides a layer of authority that can protect citizens from global corporations as well as from a necessarily monopolistic global governance authority that could easily misbehave out of democratic control, and without any remaining territory to which one could run for cover.
Eventually the post-crisis economy - sooner or later - will begin to recover, thanks to the profitability of production and investment being raised by depressed wages (due to mass unemployment), the accumulation of new profitable technical inventions and opportunities, the progressive depletion of existing inventories and production capacity. Once started, recovery would tend to be amplified by indirect effects, such as the usual interaction between multiplier and accelerator, until potential capacity constraints are met again and some cyclical mechanism is set in motion again in reverse. Such is the inexorable logic of the market economy. But reliance simply on market self-regulation will most probably lead to recovery much later than possible with government intervention and jump-starting. It is unfortunate that the inadequate policy responses of 2008 and their premature withdrawal should have grossly diluted their effectiveness thus making the implementation of growth policies harder today.
Changes must also be attempted in order to prevent the operation of factors that facilitated the last global crisis, or to better cope with them. The increase in banks’ capitalization, envisaged by the Basel-3 new rules, will have an initial adverse effect on the volume of lending but longer term benefits for financial stability. A new composite currency is bound to emerge, in place of the US dollar or the euro.
Regulations on the separation of credit and investment operations of banks (à la Glass-Steagall Act) are bound to be reintroduced, as already proposed in the UK by the Vickers Commission. The Over The Counter derivatives trade might be subjected to stricter regulations, such as the requirement of an underlying “insurable” interest for taking up a position in that market, or the prohibition of short-selling, temporarily introduced in the European Union on shares and government bonds. The traditional principle of Central Bank independence in the exclusive pursuit of inflation targeting - based on the now discredited theory of rational expectations and the consequent de-coupling of inflation and unemployment - is bound to change into the even more independent pursuit of multiple targets including employment and competitiveness. We might witness attempts to protect domestic industries and stop immigration - largely unsuccessful in view of the irresistible force of underlying trends.
Currently, by and large, the economic system emerging from the crisis is bound to be substantially very similar to the pre-crisis one, improved in some respects, but worsened by large scale cuts in welfare expenditure made necessary by the (debatable) purpose of achieving fiscal balance. The post-crisis system will be more conflictual and insecure, more unequal and less cohesive, less rather than more “green” - basically a more unpleasant world in which to live. It need not be so.
Showing posts with label global crisis. Show all posts
Showing posts with label global crisis. Show all posts
Monday, October 3, 2011
Wednesday, March 16, 2011
Inequality and the Global Crisis
This is a Guest Post contributed by Branko Milanovic, a Lead economist in the World Bank's research department. Branko - at present a Visiting Fellow of All Souls College, Oxford - spent over a quarter century working on poverty and inequality and made original, pioneering contributions to this subject, including: Worlds Apart. Measuring International and Global Inequality, 2005, Princeton/Oxford; The Haves and the Have-Nots: A Short and Idiosyncratic History of Global Inequality, 2011, Basic Books (DMN)
The current financial crisis is generally blamed on feckless bankers, financial deregulation, crony capitalism and the like. While all of these elements may be true, this purely financial explanation of the crisis overlooks its fundamental reasons. They lie in the real sector, and more exactly in the distribution of income across individuals and social classes. Deregulation, by helping irresponsible behavior, just exacerbated the crisis; it did not create it.
To go to the origins of the crisis, one needs to go to rising income inequality within practically all countries in the world, and the United States in particular, over the last thirty years. In the United States, the top 1 percent of the population doubled its share in national income from around 8 percent in the mid-1970s to almost 16 percent in the early 2000s. That eerily replicated the situation that existed just prior to the crash of 1929, when the top 1 percent share reached its previous high watermark American income inequality over the last hundred years thus basically charted a gigantic U, going down from its 1929 peak all the way to the late 1970s, and then rising again for thirty years.
What did the increase mean? Such enormous wealth could not be used for consumption only. There is a limit to the number of Dom Pérignons and Armani suits one can drink or wear. And, of course, it was not reasonable either to “invest” solely in conspicuous consumption when wealth could be further increased by judicious investment. So, a huge pool of available financial capital—the product of increased income inequality—went in search of profitable opportunities into which to invest.
But the richest people and the hundreds of thousands somewhat less rich, could not invest the money themselves. They needed intermediaries, the financial sector. Overwhelmed with such an amount of funds, and short of good opportunities to invest the capital as well as enticed by large fees attending each transaction, the financial sector became more and more reckless, basically throwing money at anyone who would take it. While one cannot prove that investible resources eventually exceeded the number of safe and profitable investment opportunities (since nobody knows a priori how many and where there are good investment opportunities), this is strongly suggested by the increasing riskiness of investments that the financiers had to undertake.
But this is only one part of the equation: how and why large amounts of investable money went in a search of a return on that money. The second part of the equation explains who borrowed that money. There again we go back to the rising inequality. The increased wealth at the top was combined with an absence of real economic growth in the middle. Real median wage in the United States has been stagnant for twenty five years, despite an almost doubling of GDP per capita. About one-half of all real income gains between 1976 and 2006 accrued to the richest 5 percent of households. The new “gilded age” was understandably not very popular among the middle classes that saw their purchasing power not budge for years. Middle class income stagnation became a recurrent theme in the American political life, and an insoluble political problem for both Democrats and Republicans. Politicians obviously had an interest to make their constituents happy for otherwise they may not vote for them. Yet they could not just raise their wages. A way to make it seem that the middle class was earning more than it did was to increase its purchasing power through broader and more accessible credit. People began to live by accumulating ever rising debts on their credit cards, taking on more car debts or higher mortgages. President George W. Bush famously promised that every American family, implicitly regardless of its income, will be able to own a home. Thus was born the great American consumption binge which saw the household debt increase from 48 percent of GDP in the early 1980s to 100 percent of GDP before the crisis.
The interests of several large groups of people became closely aligned. High net-worth individuals and the financial sector were, as we have seen, keen to find new lending opportunities. Politicians were eager to “solve” the irritable problem of middle class income stagnation. The middle class and those poorer than them were happy to see their tight budget constraint removed as if by magic wand, consume all the fine things purchased by the rich, and partake in the longest US post World War II economic expansion. Suddenly, the middle class too felt like the winners.
This is what more than two centuries ago, the great French philosopher Montesquieu mocked when he described the mechanism used by the creators of paper money in France (an experiment that eventually crumbled with a thud): ‘People of Baetica”, wrote Montesquieu, “do you want to be rich? Imagine that I am very much so, and that you are very rich also; every morning tell yourself that your fortune has doubled during the night; and if you have creditors, go pay them with what you have imagined, and tell them to imagine it in their turn”.
The credit-fueled system was further helped by the ability of the US to run large current account deficits; that is, to have several percentage points of its consumption financed by foreigners. The consumption binge also took the edge off class conflict and maintained the American dream of a rising tide that lifts all the boats. But it was not sustainable. Once the middle class began defaulting on its debts, it collapsed.
We should not focus on the superficial aspects of the crisis, on the arcane of how “derivatives” work. If “derivatives” they were, they were the “derivatives” of the model of growth pursued over the last quarter a century. The root cause of the crisis is not to be found in hedge funds and bankers who simply behaved with the greed to which they are accustomed (and for which economists used to praise them). The real cause of the crisis lies in huge inequalities in income distribution which generated much larger investable funds than could be profitably employed. The political problem of insufficient economic growth of the middle class was then “solved” by opening the floodgates of the cheap credit. And the opening of the credit floodgates, to placate the middle class, was needed because in a democratic system, an excessively unequal model of development cannot coexist with political stability.
Could it have worked out differently? Yes, without thirty years of rising inequality, and with the same overall national income, income of the middle class would have been greater. People with middling incomes have many more priority needs to satisfy before they become preoccupied with the best investment opportunities for their excess money. Thus, the structure of consumption would have been different: probably more money would have been spent on home-cooked meals than on restaurants, on near-home vacations than on exotic destinations, on kids’ clothes than on designer apparel. More equitable development would have removed the need for the politicians to look around in order to find palliatives with which to assuage the anger of the middle-class constituents. In other words, there would have been more equitable and stable development which would have spared the United States, and increasingly the world, an unnecessary crisis.
The current financial crisis is generally blamed on feckless bankers, financial deregulation, crony capitalism and the like. While all of these elements may be true, this purely financial explanation of the crisis overlooks its fundamental reasons. They lie in the real sector, and more exactly in the distribution of income across individuals and social classes. Deregulation, by helping irresponsible behavior, just exacerbated the crisis; it did not create it.
To go to the origins of the crisis, one needs to go to rising income inequality within practically all countries in the world, and the United States in particular, over the last thirty years. In the United States, the top 1 percent of the population doubled its share in national income from around 8 percent in the mid-1970s to almost 16 percent in the early 2000s. That eerily replicated the situation that existed just prior to the crash of 1929, when the top 1 percent share reached its previous high watermark American income inequality over the last hundred years thus basically charted a gigantic U, going down from its 1929 peak all the way to the late 1970s, and then rising again for thirty years.
What did the increase mean? Such enormous wealth could not be used for consumption only. There is a limit to the number of Dom Pérignons and Armani suits one can drink or wear. And, of course, it was not reasonable either to “invest” solely in conspicuous consumption when wealth could be further increased by judicious investment. So, a huge pool of available financial capital—the product of increased income inequality—went in search of profitable opportunities into which to invest.
But the richest people and the hundreds of thousands somewhat less rich, could not invest the money themselves. They needed intermediaries, the financial sector. Overwhelmed with such an amount of funds, and short of good opportunities to invest the capital as well as enticed by large fees attending each transaction, the financial sector became more and more reckless, basically throwing money at anyone who would take it. While one cannot prove that investible resources eventually exceeded the number of safe and profitable investment opportunities (since nobody knows a priori how many and where there are good investment opportunities), this is strongly suggested by the increasing riskiness of investments that the financiers had to undertake.
But this is only one part of the equation: how and why large amounts of investable money went in a search of a return on that money. The second part of the equation explains who borrowed that money. There again we go back to the rising inequality. The increased wealth at the top was combined with an absence of real economic growth in the middle. Real median wage in the United States has been stagnant for twenty five years, despite an almost doubling of GDP per capita. About one-half of all real income gains between 1976 and 2006 accrued to the richest 5 percent of households. The new “gilded age” was understandably not very popular among the middle classes that saw their purchasing power not budge for years. Middle class income stagnation became a recurrent theme in the American political life, and an insoluble political problem for both Democrats and Republicans. Politicians obviously had an interest to make their constituents happy for otherwise they may not vote for them. Yet they could not just raise their wages. A way to make it seem that the middle class was earning more than it did was to increase its purchasing power through broader and more accessible credit. People began to live by accumulating ever rising debts on their credit cards, taking on more car debts or higher mortgages. President George W. Bush famously promised that every American family, implicitly regardless of its income, will be able to own a home. Thus was born the great American consumption binge which saw the household debt increase from 48 percent of GDP in the early 1980s to 100 percent of GDP before the crisis.
The interests of several large groups of people became closely aligned. High net-worth individuals and the financial sector were, as we have seen, keen to find new lending opportunities. Politicians were eager to “solve” the irritable problem of middle class income stagnation. The middle class and those poorer than them were happy to see their tight budget constraint removed as if by magic wand, consume all the fine things purchased by the rich, and partake in the longest US post World War II economic expansion. Suddenly, the middle class too felt like the winners.
This is what more than two centuries ago, the great French philosopher Montesquieu mocked when he described the mechanism used by the creators of paper money in France (an experiment that eventually crumbled with a thud): ‘People of Baetica”, wrote Montesquieu, “do you want to be rich? Imagine that I am very much so, and that you are very rich also; every morning tell yourself that your fortune has doubled during the night; and if you have creditors, go pay them with what you have imagined, and tell them to imagine it in their turn”.
The credit-fueled system was further helped by the ability of the US to run large current account deficits; that is, to have several percentage points of its consumption financed by foreigners. The consumption binge also took the edge off class conflict and maintained the American dream of a rising tide that lifts all the boats. But it was not sustainable. Once the middle class began defaulting on its debts, it collapsed.
We should not focus on the superficial aspects of the crisis, on the arcane of how “derivatives” work. If “derivatives” they were, they were the “derivatives” of the model of growth pursued over the last quarter a century. The root cause of the crisis is not to be found in hedge funds and bankers who simply behaved with the greed to which they are accustomed (and for which economists used to praise them). The real cause of the crisis lies in huge inequalities in income distribution which generated much larger investable funds than could be profitably employed. The political problem of insufficient economic growth of the middle class was then “solved” by opening the floodgates of the cheap credit. And the opening of the credit floodgates, to placate the middle class, was needed because in a democratic system, an excessively unequal model of development cannot coexist with political stability.
Could it have worked out differently? Yes, without thirty years of rising inequality, and with the same overall national income, income of the middle class would have been greater. People with middling incomes have many more priority needs to satisfy before they become preoccupied with the best investment opportunities for their excess money. Thus, the structure of consumption would have been different: probably more money would have been spent on home-cooked meals than on restaurants, on near-home vacations than on exotic destinations, on kids’ clothes than on designer apparel. More equitable development would have removed the need for the politicians to look around in order to find palliatives with which to assuage the anger of the middle-class constituents. In other words, there would have been more equitable and stable development which would have spared the United States, and increasingly the world, an unnecessary crisis.
Thursday, October 29, 2009
Last Rites
On 2 October the IMF General Director Dominique Strauss-Kahn, in Istanbul ahead of the 2009 Annual Meetings of the World Bank Group and IMF, gave a speech at the Central Bank of Turkey entitled “Making the Most of a Historic Opportunity”. “Countries are diverse, but civilization is one, and it is necessary to participate in this single civilization for the progress of the nation”, he said, quoting a magnificent but very ambiguous sentence uttered 75 years ago by Kemal Atatürk, the founder of the Republic of Turkey. One could argue that civilization's progress is the result of different countries and cultures sorting out their differences in peaceful dialogue, and that the best path for civilization can only be assessed afterwards by results.
In his speech, Strauss-Kahn takes – rightly – a positive view of the global macroeconomic policy response to the current crisis, and outlines “three principles that can frame our efforts to re-shape the post-crisis world…: First, international policy collaboration is essential. Second, financial stability demands better regulation and supervision. And third, the international monetary system must be more stable, and anchored by a global lender of last resort.” No question about the soundness of the first two principles. The third principle – which naturally envisages the IMF taking on the expanded role of “International Lender of Last Resort”, is so sketchy as not to mean very much at all.
Traditionally a National Central Bank acts as a Lender of Last resort by providing unlimited liquidity on demand, in the currency it manages, to banks within its currency area, at a penal rate against good quality financial assets. Thus for instance on Black Monday (19 October 1987) the Fed immediately announced its readiness to act in that capacity. Or, the Bank of England made the same announcement in July 1991 at the time of the BCCI (Bank of Credit and Commerce International) collapse. The statements alone were sufficient to calm down financial markets.
More recently the Governor of the Bank of England, Mervyn King, in his letter to the Treasury Committee on 12 September 2007, discussed the rescue of Northern Rock in these terms:
“Central banks, in their traditional lender of last resort (LOLR) role, can lend “against good collateral at a penalty rate” to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent. The rationale would be that the failure of such a bank would lead to serious economic damage, including to the customers of the bank. The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the tripartite arrangements set out in the MOU [Memorandum of Understanding] between the Treasury, Financial Services Authority and the Bank of England. Because they are made to individual institutions, they are flexible with respect to type of collateral and term of the facility. LOLR operations remain in the armoury of all central banks.”
It should be immediately clear that “Lender of Last Resort” is an inappropriate label for any role that the IMF might take in providing global liquidity in a crisis. Presumably it would provide finance denominated in the currency basket known as Special Drawing Rights. But to whom? To commercial banks throughout the world (as the label suggests), including investment banks, and hedge funds, or only Central Banks, and/or governments? And against what? Government paper, illiquid but marketable assets, toxic assets, or in the form of an unsecured loan? If against nothing, on what scale? At what interest rates and, above all, subject to what conditionality? Clearly before even beginning to talk about an international lender of last resort there is a very great deal of detail that need to be considered and settled. As we all know “The devil is in the detail.”
In his speech, Strauss-Kahn takes – rightly – a positive view of the global macroeconomic policy response to the current crisis, and outlines “three principles that can frame our efforts to re-shape the post-crisis world…: First, international policy collaboration is essential. Second, financial stability demands better regulation and supervision. And third, the international monetary system must be more stable, and anchored by a global lender of last resort.” No question about the soundness of the first two principles. The third principle – which naturally envisages the IMF taking on the expanded role of “International Lender of Last Resort”, is so sketchy as not to mean very much at all.
Traditionally a National Central Bank acts as a Lender of Last resort by providing unlimited liquidity on demand, in the currency it manages, to banks within its currency area, at a penal rate against good quality financial assets. Thus for instance on Black Monday (19 October 1987) the Fed immediately announced its readiness to act in that capacity. Or, the Bank of England made the same announcement in July 1991 at the time of the BCCI (Bank of Credit and Commerce International) collapse. The statements alone were sufficient to calm down financial markets.
More recently the Governor of the Bank of England, Mervyn King, in his letter to the Treasury Committee on 12 September 2007, discussed the rescue of Northern Rock in these terms:
“Central banks, in their traditional lender of last resort (LOLR) role, can lend “against good collateral at a penalty rate” to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent. The rationale would be that the failure of such a bank would lead to serious economic damage, including to the customers of the bank. The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the tripartite arrangements set out in the MOU [Memorandum of Understanding] between the Treasury, Financial Services Authority and the Bank of England. Because they are made to individual institutions, they are flexible with respect to type of collateral and term of the facility. LOLR operations remain in the armoury of all central banks.”
It should be immediately clear that “Lender of Last Resort” is an inappropriate label for any role that the IMF might take in providing global liquidity in a crisis. Presumably it would provide finance denominated in the currency basket known as Special Drawing Rights. But to whom? To commercial banks throughout the world (as the label suggests), including investment banks, and hedge funds, or only Central Banks, and/or governments? And against what? Government paper, illiquid but marketable assets, toxic assets, or in the form of an unsecured loan? If against nothing, on what scale? At what interest rates and, above all, subject to what conditionality? Clearly before even beginning to talk about an international lender of last resort there is a very great deal of detail that need to be considered and settled. As we all know “The devil is in the detail.”
Saturday, October 17, 2009
Transition economies: a worse nosedive than anticipated
“At the start of this year, the global economic crisis was hitting central and eastern Europe with unimaginable force. Any illusion that this region was somehow immune from the “western” credit crunch and the subsequent financial squeeze was definitively quashed. Output was declining at startling rates that would only become apparent much later in the Spring.”
“But the danger signs were everywhere. There was real risk of a genuine emerging market crisis – that financial systems in a number of countries would collapse entirely, that currencies would run out of control, that there could be sovereign defaults.” (Anthony Williams, EBRD Head of Media Relations, The road to a fragile recovery, 16 October 2009)
Now they tell us
I don’t remember the EBRD ever signaling any such danger. Slowdown, yes, in their forecasts for 2009 and 2010, that from optimistic growth expected in May 2008 got progressively worse to insignificant growth in January 2009 and an average 5.2% contraction for the 29 countries of EBRD operation in May 2009. I suppose it is part of the institutional duties of the EBRD not to encourage pessimistic expectations that may become self-fulfilling, but then we should note this for future reference and remember that, when the EBRD forecasts a significant slowdown, what they really mean is an impending disaster.
How was the disaster averted? “That this horror scenario didn’t happen – Anthony Williams continues – was a result partly of unprecedented international support, with the EU and organizations like the IMF providing huge macroeconomic packages that were flexible and tailored to specific country needs [to Latvia, as well as Hungary, Ukraine, Romania and other CEE]. Other IFIs, including the EBRD, stepped in to provide micro support to banking groups and corporates with little or no access to liquidity. Crucially western banks, a dominant force in financial sectors in many countries in central and eastern Europe, did not retrench as feared. The authorities in eastern Europe responded with policies aimed at dealing promptly and effectively with the crisis, even though those responses were in some cases immensely painful and politically unpopular.”
At least in Latvia, it is not at all clear that a systemic crisis has been averted. And evidence that western banks “did not retrench as feared” has not been provided by the EBRD; perhaps they will in due course, in their Transition Report 2009 due in November 2009 or elsewhere. Did western banks really not retrench at all, or on average? Did they retrench less than feared, and how much were they feared to retrench and by whom? Certainly not by the EBRD. And recently Swedbank, the largest Swedish lender in the Baltic region, “has threatened to scale back its presence in crisis-hit Latvia if the country goes ahead with controversial plans to limit the amount lenders can collect from mortgage-holders” (Stefan Wagstyl, 28 September 2009).
Otherwise, is everything fine now in transition economies? It might be in the Czech economy, which has been taken off the list of EBRD countries of operation because it no longer needs its credit – the first to deserve this upgrade – and, most annoyingly, off EBRD statistics. Not fine at all in the 28 EBRD remaining client countries (including Turkey since last year), where the average nosedive now expected for 2009 turns out to be more pronounced than the Bank anticipated in May 2009: a contraction of 6.3% instead of 5.2%, with Estonia, Latvia, Lithuania, Armenia and Ukraine expected to decline by well over 10%.
“Signs of positive growth in the third quarter of 2009 suggest that the recession is now bottoming out in many countries of the EBRD region. However, any upturn in 2010 is likely to be fragile and patchy.” (EBRD press report, 15 October 2009) For 2010 the EBRD now forecasts an average growth for the region of about 2.5%, which is 1% higher than it forecast in May 2009, but since it starts from a level which is now 1.1% lower than it was expected then, the higher growth forecast for 2010 actually masks a lower absolute level of GDP than previously anticipated. And “There are likely to be significant cross-country differences in output growth in 2010”, with Latvia, Lithuania, Hungary and Bulgaria expected to continue to contract until 2011. “It is also clear that the social costs of the global economic crisis are only likely to be felt in earnest next year, when corporate bankruptcies and unemployment will continue to rise”, said EBRD Chief Economist Erik Berglof (Ibidem)
.
The same factors that transmitted the global crisis to transition economies – the contraction in world trade and tight credit conditions – are now causing its continuation. “The Institute for International Finance, a bankers’ group, estimates that in 2007 $382bn – more than 40 per cent of the financial flows into all emerging markets – went into CEE. The IIF forecast in June that even with all the extra support the IMF, the EU and the EBRD are putting into the region, this year’s figure would be about zero” (Stefan Wagstyl, FT, 28 September 2009).
Heterogeneity
Transition countries with a fixed exchange rate regime – excluding euro-zone members but including Bulgaria, Latvia or Lithuania – are facing a slower and more painful adjustment, the burden of which falls on wages and prices and therefore ultimately demand and employment. Other factors explaining country heterogeneity are the differences in their fiscal positions, the weakness of banking systems, and dependence on commodity exports. The full set of the EBRD October forecasts is reproduced below, or can be downloaded from the EBRD website ).
“Russia’s economy is expected to shrink by 8.5 per cent on a year-on-year basis in 2009, followed by a rebound in late 2009 and growth of about 3 per cent in 2010 year-on-year. Kazakhstan will suffer a much milder output decline this year (of about 1.5 per cent) but the recovery is expected to be weak, in the order of +1.5 per cent.”
“Relatively faster 2010 growth, in the order of between about 2 and 5 per cent is expected in some internationally competitive countries with relatively sound pre-crisis banking systems, such as Albania, Poland, Slovakia, and Slovenia.”
“Some commodity rich countries including Azerbaijan, Mongolia, Turkmenistan, and Uzbekistan, whose financial systems were smaller and less affected by the crisis, and whose growth is mostly driven by commodities, are also expected to grow faster in 2010, in the order of 5 per cent or more.”
“In Hungary, which was hit particularly hard at the start of the crisis, the crisis has been contained thanks to strong international support as well as sound domestic policies. However, its growth is expected to remain slow in 2010 due to necessary fiscal adjustment and a continued credit crunch. It is expected to show slightly negative growth next year, driven by a weak economy in late 2009 and early 2010” (EBRD press report, 15 October 2009, cited above).
Divergence?
The crisis spells – at least temporarily – a reversal in the convergence process that had accompanied EU enlargement. In 1999-2008 income per head in the EU (15) grew at an average yearly rate of 1.41%, and in the Euro-zone at 1.47%, while in the new member states it grew at 2.00% (Poland) or more (from 2.29% in Hungary to 4.17 in Romania). “Growth over the medium term in the EBRD region is also likely to be below the trend experienced over the last decade” (Erik Berglof, quoted). The crisis is reinforcing the heterogeneity of national performances among transition economies and within the EU.
It is true that some of the factors making for vulnerability to external shocks – such as trade openness, economic and financial integration – are also factors that will reinforce recovery trends in an upturn. But there are other vulnerability factors – such as weak banking systems, fiscal over-stretching, or high private and public indebtedness made worse by mismatching of assets and liabilities – that need tackling before the global upturn can be expected to pull national economies out of recession or stagnation. And membership of a single currency area can make countries more resilient to a downturn but cannot be a cure after the event: a rush to a precipitous euro-zone enlargement today – necessarily preceded by a devaluation – apart from being against the Maastricht rules would not make any sense.
EBRD capital increase
Before the crisis the EBRD was confronted with demands from the US, its largest shareholder, to reduce the scale of its activities in transition economies. Now, as anticipated last May, the Bank is seeking a 50 per cent capital increase, an extra €10bn, from its shareholders – some 60 governments, including European Union members, the US and Japan – to compensate for the decline and reversal of capital inflows into the area. Thomas Mirow, the EBRD president, in a letter to shareholders warns that working with its current €20bn capital, the Bank would have to limit its annual lending to about €8bn in 2009-10 and reduce it to €6bn thereafter. “Activity would shrink while the recovery is still precarious,” while “raising the capital by €10bn to allow the bank [would] commit €9bn-€10bn annually, or €20bn in total extra funding in 2010-15. By mobilizing extra capital from private investors, the total additional funds raised could reach €60bn” (Stefan Wagstyl, FT, 28 September 2009). A final decision will be taken at the EBRD’s next annual meeting in Zagreb, in May 2010.
Mr Mirow states that “The region will need to change its growth model – away from reliance on easy finance and commodities, and towards the development of domestic financial markets, strong institutions and a diversified production base.” If conditions improve “further and faster than is currently expected”, the extra capital might not be needed and could be returned after a review in 2015. Not a chance, regardless.
“But the danger signs were everywhere. There was real risk of a genuine emerging market crisis – that financial systems in a number of countries would collapse entirely, that currencies would run out of control, that there could be sovereign defaults.” (Anthony Williams, EBRD Head of Media Relations, The road to a fragile recovery, 16 October 2009)
Now they tell us
I don’t remember the EBRD ever signaling any such danger. Slowdown, yes, in their forecasts for 2009 and 2010, that from optimistic growth expected in May 2008 got progressively worse to insignificant growth in January 2009 and an average 5.2% contraction for the 29 countries of EBRD operation in May 2009. I suppose it is part of the institutional duties of the EBRD not to encourage pessimistic expectations that may become self-fulfilling, but then we should note this for future reference and remember that, when the EBRD forecasts a significant slowdown, what they really mean is an impending disaster.
How was the disaster averted? “That this horror scenario didn’t happen – Anthony Williams continues – was a result partly of unprecedented international support, with the EU and organizations like the IMF providing huge macroeconomic packages that were flexible and tailored to specific country needs [to Latvia, as well as Hungary, Ukraine, Romania and other CEE]. Other IFIs, including the EBRD, stepped in to provide micro support to banking groups and corporates with little or no access to liquidity. Crucially western banks, a dominant force in financial sectors in many countries in central and eastern Europe, did not retrench as feared. The authorities in eastern Europe responded with policies aimed at dealing promptly and effectively with the crisis, even though those responses were in some cases immensely painful and politically unpopular.”
At least in Latvia, it is not at all clear that a systemic crisis has been averted. And evidence that western banks “did not retrench as feared” has not been provided by the EBRD; perhaps they will in due course, in their Transition Report 2009 due in November 2009 or elsewhere. Did western banks really not retrench at all, or on average? Did they retrench less than feared, and how much were they feared to retrench and by whom? Certainly not by the EBRD. And recently Swedbank, the largest Swedish lender in the Baltic region, “has threatened to scale back its presence in crisis-hit Latvia if the country goes ahead with controversial plans to limit the amount lenders can collect from mortgage-holders” (Stefan Wagstyl, 28 September 2009).
Otherwise, is everything fine now in transition economies? It might be in the Czech economy, which has been taken off the list of EBRD countries of operation because it no longer needs its credit – the first to deserve this upgrade – and, most annoyingly, off EBRD statistics. Not fine at all in the 28 EBRD remaining client countries (including Turkey since last year), where the average nosedive now expected for 2009 turns out to be more pronounced than the Bank anticipated in May 2009: a contraction of 6.3% instead of 5.2%, with Estonia, Latvia, Lithuania, Armenia and Ukraine expected to decline by well over 10%.
“Signs of positive growth in the third quarter of 2009 suggest that the recession is now bottoming out in many countries of the EBRD region. However, any upturn in 2010 is likely to be fragile and patchy.” (EBRD press report, 15 October 2009) For 2010 the EBRD now forecasts an average growth for the region of about 2.5%, which is 1% higher than it forecast in May 2009, but since it starts from a level which is now 1.1% lower than it was expected then, the higher growth forecast for 2010 actually masks a lower absolute level of GDP than previously anticipated. And “There are likely to be significant cross-country differences in output growth in 2010”, with Latvia, Lithuania, Hungary and Bulgaria expected to continue to contract until 2011. “It is also clear that the social costs of the global economic crisis are only likely to be felt in earnest next year, when corporate bankruptcies and unemployment will continue to rise”, said EBRD Chief Economist Erik Berglof (Ibidem)
.
The same factors that transmitted the global crisis to transition economies – the contraction in world trade and tight credit conditions – are now causing its continuation. “The Institute for International Finance, a bankers’ group, estimates that in 2007 $382bn – more than 40 per cent of the financial flows into all emerging markets – went into CEE. The IIF forecast in June that even with all the extra support the IMF, the EU and the EBRD are putting into the region, this year’s figure would be about zero” (Stefan Wagstyl, FT, 28 September 2009).
Heterogeneity
Transition countries with a fixed exchange rate regime – excluding euro-zone members but including Bulgaria, Latvia or Lithuania – are facing a slower and more painful adjustment, the burden of which falls on wages and prices and therefore ultimately demand and employment. Other factors explaining country heterogeneity are the differences in their fiscal positions, the weakness of banking systems, and dependence on commodity exports. The full set of the EBRD October forecasts is reproduced below, or can be downloaded from the EBRD website ).
“Russia’s economy is expected to shrink by 8.5 per cent on a year-on-year basis in 2009, followed by a rebound in late 2009 and growth of about 3 per cent in 2010 year-on-year. Kazakhstan will suffer a much milder output decline this year (of about 1.5 per cent) but the recovery is expected to be weak, in the order of +1.5 per cent.”
“Relatively faster 2010 growth, in the order of between about 2 and 5 per cent is expected in some internationally competitive countries with relatively sound pre-crisis banking systems, such as Albania, Poland, Slovakia, and Slovenia.”
“Some commodity rich countries including Azerbaijan, Mongolia, Turkmenistan, and Uzbekistan, whose financial systems were smaller and less affected by the crisis, and whose growth is mostly driven by commodities, are also expected to grow faster in 2010, in the order of 5 per cent or more.”
“In Hungary, which was hit particularly hard at the start of the crisis, the crisis has been contained thanks to strong international support as well as sound domestic policies. However, its growth is expected to remain slow in 2010 due to necessary fiscal adjustment and a continued credit crunch. It is expected to show slightly negative growth next year, driven by a weak economy in late 2009 and early 2010” (EBRD press report, 15 October 2009, cited above).
Divergence?
The crisis spells – at least temporarily – a reversal in the convergence process that had accompanied EU enlargement. In 1999-2008 income per head in the EU (15) grew at an average yearly rate of 1.41%, and in the Euro-zone at 1.47%, while in the new member states it grew at 2.00% (Poland) or more (from 2.29% in Hungary to 4.17 in Romania). “Growth over the medium term in the EBRD region is also likely to be below the trend experienced over the last decade” (Erik Berglof, quoted). The crisis is reinforcing the heterogeneity of national performances among transition economies and within the EU.
It is true that some of the factors making for vulnerability to external shocks – such as trade openness, economic and financial integration – are also factors that will reinforce recovery trends in an upturn. But there are other vulnerability factors – such as weak banking systems, fiscal over-stretching, or high private and public indebtedness made worse by mismatching of assets and liabilities – that need tackling before the global upturn can be expected to pull national economies out of recession or stagnation. And membership of a single currency area can make countries more resilient to a downturn but cannot be a cure after the event: a rush to a precipitous euro-zone enlargement today – necessarily preceded by a devaluation – apart from being against the Maastricht rules would not make any sense.
EBRD capital increase
Before the crisis the EBRD was confronted with demands from the US, its largest shareholder, to reduce the scale of its activities in transition economies. Now, as anticipated last May, the Bank is seeking a 50 per cent capital increase, an extra €10bn, from its shareholders – some 60 governments, including European Union members, the US and Japan – to compensate for the decline and reversal of capital inflows into the area. Thomas Mirow, the EBRD president, in a letter to shareholders warns that working with its current €20bn capital, the Bank would have to limit its annual lending to about €8bn in 2009-10 and reduce it to €6bn thereafter. “Activity would shrink while the recovery is still precarious,” while “raising the capital by €10bn to allow the bank [would] commit €9bn-€10bn annually, or €20bn in total extra funding in 2010-15. By mobilizing extra capital from private investors, the total additional funds raised could reach €60bn” (Stefan Wagstyl, FT, 28 September 2009). A final decision will be taken at the EBRD’s next annual meeting in Zagreb, in May 2010.
Mr Mirow states that “The region will need to change its growth model – away from reliance on easy finance and commodities, and towards the development of domestic financial markets, strong institutions and a diversified production base.” If conditions improve “further and faster than is currently expected”, the extra capital might not be needed and could be returned after a review in 2015. Not a chance, regardless.
Wednesday, July 22, 2009
We should be so lucky to have a double dip
The global crisis of 2008-2009 was abrupt, rooted in the financial markets of advanced countries where it went through synchronised stages that sometimes can be pinpointed to the day, then spreading to the real economy in different ways, timing and speeds in different countries. It is a seismic crisis as deep – so far – as that of 1929-32. In the end it may turn out to be shorter, and therefore less deep than that, thanks to the more appropriate, large scale and synchronised – also so far – policy responses by world governments and international financial institutions.
The suddenness, financial origins and stages of the crisis are best synthesised and illustrated by the evolution of Interbank Market Spreads, i.e. the difference between 12-month Euribor/Libor and Overnight Index Swap rates, in basis points (from “The ECB Enhanced Credit Support”, a keynote Address by the European Central Bank President, Jean-Claude Trichet, given on 13 July 2009 at the University of Munich; Figure 1 below).
Figure 1
All was well in the euro, sterling and US dollar markets until August 2007, the “Beginning of the Turmoil”, when the US crisis of subprime mortgages erupted. The Turmoil worsened gradually until September 2008 (on 15 September, Lehman Brothers went bankrupt) when it began to intensify reaching a peak in November 2008; the spreads have declined gradually since then but are still as high in July 2009 as they were around July 2008.
It is best to let Jean-Claude Trichet speak: “…we have to acknowledge that there was a dramatic shift in focus in large parts of the financial sector – away from facilitating trade and real investment towards unfettered speculation and financial gambling. Hans-Werner Sinn has called these deviations “ Kasino-Kapitalismus”. Of course, we all know that financial liberalisation and financial innovation have made important contributions to the overall productivity of our economies. The securitisation of loans, for example, had tremendous potential for the diversification and efficient management of economic risk. But securitisation was implemented in a precarious way. Banks and non-banks were able not only to sell loans, but also to place them fully off-balance sheet as soon as they had been granted. This resulted in weak underwriting standards and a lack of incentives for lenders to conduct prudent screening of loans. “ …
“The credit boom leading up to the crisis was exacerbated by three multipliers:
- first, incentives: ill-designed compensation schemes for loan managers and traders that reinforced the shortening of their time horizons;
- second, complexity: increasingly complicated and opaque financial instruments that made it difficult for holders of securities to assess the quality of the underlying investments; and
- third, global macroeconomic imbalances: a chronic shortage of savings in some industrialised economies was made possible by an excess of savings in other parts of the world."
"In mid-2007 the turmoil erupted. This was sudden, but not entirely unexpected. Indeed, as long ago as January 2007, I myself expressed the views of my fellow central bankers, when I indicated that markets would need to prepare for a general reassessment and repricing of risk, which was clearly underestimated at that time. [1] Some months later, this repricing occurred very suddenly, triggering turbulences in the interbank market. The consequences of this very sharp repricing threw the credit boom into reverse. The asset cycle turned, and many of the missing links in the financial chain were exposed.
The collapse in mid-September of last year of a major financial institution [Lehman Brothers] transformed the financial turmoil into a global financial crisis. Immediately, financial intermediaries restored liquidity buffers, scaled down their balance sheets and tightened lending conditions. They dramatically reduced exposure to the risks that they had imprudently accumulated during the period of financial euphoria. Collectively, they engaged in a large-scale “deleveraging” process. Banks’ intermediation was sharply reduced, and loans to companies were curtailed.
A long-term trend that had brought credit risk spreads on loans extended by international financial intermediaries to historical lows was suddenly reversed. A credit squeeze ensued which took a severe toll on the real economy.”
Barry Eichengreen of Berkeley and Kevin O’Rourke of Dublin have tracked down the course of the current crisis against that of the 1929-32 global crisis, in terms of industrial output, Stock Exchange values and international trade volume (Vox.eu 6 April, updated 4 June 2009). They have taken as the respective starting points of the two crisis the earlier peaks in world industrial production, which occurred respectively in June 1929 and April 2008. Month after month, our current recession replicates the trends of 1929-32 or is worse. Signs of improvement appeared in the 9 June update, but do not alter the basic picture: the latest levels to which our recession has plunged in 2008-2009 are still below the corresponding levels reached at the equivalent time in 1929-30. “Today's crisis is at least as bad as the Great Depression” (cit). See Figures 2-4.
Figure 2. World Industrial Output, Now vs Then (update in green)
Source: Eichengreen and O’Rourke (2009) and IMF.
Figure 3. World Stock Markets, Now vs Then (update in green)
Source: Global Financial Database. From: Eichengreen and O’Rourke (2009)
Figure 4. The Volume of World Trade, Now vs Then (update in green)
Source: League of Nations Monthly Bulletin of Statistics. From : Eichengreen and O’Rourke (2009).
This “trade destruction” appears to have been much worse than in the corresponding months of 1929-32; it is one of the most worrying aspect of our recession. As recently as May 2008 the IMF External Relations Department could still issue a paper “Globalization: A Brief Overview”(“By IMF Staff”), saying that “Globalisation is irreversible: In the long run, globalization is likely to be an unrelenting phenomenon” (italics in the original). Six month later an important episode of de-globalisation was already under way.
“To sum up, – Eichengreen and O’Rourke conclude – globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event. That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline.”
The hope is that the massive macroeconomic intervention jointly set in motion in particular by the G-20 of April 2009 but also before and after, eventually will reverse the course of our recession. Monetary policy has responded faster and more strongly in the present crisis: in 7 major countries interest rates have been cut more rapidly, from a lower level, down to unprecedented low levels. In 19 major countries money supplies in the run up to the beginning of the current crisis had been growing faster than before 1929, but the expansion has continued faster in the current crisis, moreover without any prospect of the money supply contraction of 1929-32. Government budgets have been running consistently higher deficits than in 1929-32, on a world basis, especially in the advanced countries, but also in emerging countries.
At the latest count the overall global stimuli – fiscal and monetary, national and international – appear to have reached a previously unimaginable scale of the order of $15 trillion. We have grown indifferent to inconceivably large sums, and the arithmetic of government finance has fundamentally altered (“Is Trillion the New Billion?”, asked Robert Hahn and Peter Fassel, Economist Voice, http://www.bepress.com/ev, January 2009. Italian readers are easier to stun if they think of a trillion dollars as 1.4 million billions of old Italian liras). But most of those trillions are only on paper or are not yet getting spent. It is arguable whether the small improvements noted by Eichengreen and O’Rourke amount to “green shoots of recovery” (they deny it). Yet there have been premature calls for an exit strategy (for instance by the German Chancellor Angela Merkel and the ECB President Jean-Claude Trichet). Worse, a collective exit strategy was considered – though rejected for the time being – by the latest G-8. We should be so lucky to have a double dip, a W-shaped pattern of GNP instead of an L-shaped one or worse.
The suddenness, financial origins and stages of the crisis are best synthesised and illustrated by the evolution of Interbank Market Spreads, i.e. the difference between 12-month Euribor/Libor and Overnight Index Swap rates, in basis points (from “The ECB Enhanced Credit Support”, a keynote Address by the European Central Bank President, Jean-Claude Trichet, given on 13 July 2009 at the University of Munich; Figure 1 below).
Figure 1
All was well in the euro, sterling and US dollar markets until August 2007, the “Beginning of the Turmoil”, when the US crisis of subprime mortgages erupted. The Turmoil worsened gradually until September 2008 (on 15 September, Lehman Brothers went bankrupt) when it began to intensify reaching a peak in November 2008; the spreads have declined gradually since then but are still as high in July 2009 as they were around July 2008.It is best to let Jean-Claude Trichet speak: “…we have to acknowledge that there was a dramatic shift in focus in large parts of the financial sector – away from facilitating trade and real investment towards unfettered speculation and financial gambling. Hans-Werner Sinn has called these deviations “ Kasino-Kapitalismus”. Of course, we all know that financial liberalisation and financial innovation have made important contributions to the overall productivity of our economies. The securitisation of loans, for example, had tremendous potential for the diversification and efficient management of economic risk. But securitisation was implemented in a precarious way. Banks and non-banks were able not only to sell loans, but also to place them fully off-balance sheet as soon as they had been granted. This resulted in weak underwriting standards and a lack of incentives for lenders to conduct prudent screening of loans. “ …
“The credit boom leading up to the crisis was exacerbated by three multipliers:
- first, incentives: ill-designed compensation schemes for loan managers and traders that reinforced the shortening of their time horizons;
- second, complexity: increasingly complicated and opaque financial instruments that made it difficult for holders of securities to assess the quality of the underlying investments; and
- third, global macroeconomic imbalances: a chronic shortage of savings in some industrialised economies was made possible by an excess of savings in other parts of the world."
"In mid-2007 the turmoil erupted. This was sudden, but not entirely unexpected. Indeed, as long ago as January 2007, I myself expressed the views of my fellow central bankers, when I indicated that markets would need to prepare for a general reassessment and repricing of risk, which was clearly underestimated at that time. [1] Some months later, this repricing occurred very suddenly, triggering turbulences in the interbank market. The consequences of this very sharp repricing threw the credit boom into reverse. The asset cycle turned, and many of the missing links in the financial chain were exposed.
The collapse in mid-September of last year of a major financial institution [Lehman Brothers] transformed the financial turmoil into a global financial crisis. Immediately, financial intermediaries restored liquidity buffers, scaled down their balance sheets and tightened lending conditions. They dramatically reduced exposure to the risks that they had imprudently accumulated during the period of financial euphoria. Collectively, they engaged in a large-scale “deleveraging” process. Banks’ intermediation was sharply reduced, and loans to companies were curtailed.
A long-term trend that had brought credit risk spreads on loans extended by international financial intermediaries to historical lows was suddenly reversed. A credit squeeze ensued which took a severe toll on the real economy.”
Barry Eichengreen of Berkeley and Kevin O’Rourke of Dublin have tracked down the course of the current crisis against that of the 1929-32 global crisis, in terms of industrial output, Stock Exchange values and international trade volume (Vox.eu 6 April, updated 4 June 2009). They have taken as the respective starting points of the two crisis the earlier peaks in world industrial production, which occurred respectively in June 1929 and April 2008. Month after month, our current recession replicates the trends of 1929-32 or is worse. Signs of improvement appeared in the 9 June update, but do not alter the basic picture: the latest levels to which our recession has plunged in 2008-2009 are still below the corresponding levels reached at the equivalent time in 1929-30. “Today's crisis is at least as bad as the Great Depression” (cit). See Figures 2-4.
Figure 2. World Industrial Output, Now vs Then (update in green)
Source: Eichengreen and O’Rourke (2009) and IMF.Figure 3. World Stock Markets, Now vs Then (update in green)
Source: Global Financial Database. From: Eichengreen and O’Rourke (2009)
Figure 4. The Volume of World Trade, Now vs Then (update in green)
Source: League of Nations Monthly Bulletin of Statistics. From : Eichengreen and O’Rourke (2009).
This “trade destruction” appears to have been much worse than in the corresponding months of 1929-32; it is one of the most worrying aspect of our recession. As recently as May 2008 the IMF External Relations Department could still issue a paper “Globalization: A Brief Overview”(“By IMF Staff”), saying that “Globalisation is irreversible: In the long run, globalization is likely to be an unrelenting phenomenon” (italics in the original). Six month later an important episode of de-globalisation was already under way.
“To sum up, – Eichengreen and O’Rourke conclude – globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event. That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline.”
The hope is that the massive macroeconomic intervention jointly set in motion in particular by the G-20 of April 2009 but also before and after, eventually will reverse the course of our recession. Monetary policy has responded faster and more strongly in the present crisis: in 7 major countries interest rates have been cut more rapidly, from a lower level, down to unprecedented low levels. In 19 major countries money supplies in the run up to the beginning of the current crisis had been growing faster than before 1929, but the expansion has continued faster in the current crisis, moreover without any prospect of the money supply contraction of 1929-32. Government budgets have been running consistently higher deficits than in 1929-32, on a world basis, especially in the advanced countries, but also in emerging countries.
At the latest count the overall global stimuli – fiscal and monetary, national and international – appear to have reached a previously unimaginable scale of the order of $15 trillion. We have grown indifferent to inconceivably large sums, and the arithmetic of government finance has fundamentally altered (“Is Trillion the New Billion?”, asked Robert Hahn and Peter Fassel, Economist Voice, http://www.bepress.com/ev, January 2009. Italian readers are easier to stun if they think of a trillion dollars as 1.4 million billions of old Italian liras). But most of those trillions are only on paper or are not yet getting spent. It is arguable whether the small improvements noted by Eichengreen and O’Rourke amount to “green shoots of recovery” (they deny it). Yet there have been premature calls for an exit strategy (for instance by the German Chancellor Angela Merkel and the ECB President Jean-Claude Trichet). Worse, a collective exit strategy was considered – though rejected for the time being – by the latest G-8. We should be so lucky to have a double dip, a W-shaped pattern of GNP instead of an L-shaped one or worse.
Tuesday, June 30, 2009
OECD Misrepresentation Of Public Pensions
The recent OECD Report Pensions at a Glance 2009: Retirement-Income Systems in OECD Countries (Paris, June 2009) uses and misuses the concept of “public spending on pensions”. In OECD countries “The public-pension budget has been increasingly rapidly, growing at a rate 17% faster than the national income between 1990 and 2005. Pensions account for 17% of total public spending, on average… Typically, only health and education are more expensive items in the government’s budget”. “OECD countries currently [in 2005] spend an average of 7.2% of national income on public pensions”, but half of the 30 open advanced economies that are OECD members are above this average, with Italy at the top with almost a double share at 14% (30% of the government budget, compared with an OECD average of 16%, and a rise 23% higher than income growth in 1990-2005). Austria, France, Greece, Poland, Germany and Portugal are all above 10%. The United States and the United Kingdom are at 5.7% and 5.4% respectively, Iceland at 2%, Korea at 1.6%, Mexico the lowest at 1.3%. The full picture is given in Figure 1 below.
Figure 1. Public pension expenditure 2005
The implication drawn by the OECD is that the higher the share of “public spending on pensions”, the worse is a country’s performance, for three reasons: 1) affordability and fiscal sustainability; 2) “The risk … that public pension spending crowds out other desirable expenditure, both in social policy (on benefits for children and parents) and elsewhere (on education, for example)” [OECD Report, commenting on Italy]; 3) the desirable “shift towards funding and private sector management within statutory pension systems” that has taken place in recent years – a trend that “has been especially strong in Latin America and Central and Eastern Europe, but it also extends to OECD countries such as Australia, Finland, Iceland, Norway, Switzerland and Sweden”.
Public and private pensions
International differences in “public spending on pensions” are due to many reasons.
First, accounting conventions. For instance, Italian pension expenditure includes items that have nothing whatever to do with pensions, such as lump-sum, golden handshakes on employment termination or retirement (a “deferred wage”, corresponding to 1.3% of GDP), and the cost of persons accompanying invalids. Also, Italian pensions are subject to standard income tax, equivalent to 3.6% of GDP, while in other countries such as Germany they enjoy a particularly favourable treatment, with tax corresponding to only 1.5% of GDP (1.3% in the UK, until the recent tax rise on low incomes Gordon Brown perversely introduced). When differences in tax treatment are taken into consideration, Italy’s position with respect to Germany improves by 2.1% of GDP (See R.F. Pizzuti, Rapporto sullo Stato Sociale 2008, UTET Università, Roma 2008, pp. 70-71). Once these accounting peculiarities are taken into account Italy loses top ranking on public pensions among OECD countries, while retaining a low ranking for social provisions other than pensions (6.8% of GDP against the European average of 7.5%).
Second, international rankings depend on specific features of the public pension systems, such as the pension/earnings replacement ratio, and other circumstances also common to private pension systems, such as: population ageing. contributions relative to earnings, retiring age, the average period spent on retirement (life expectancy minus retirement age).
But there is a third, major explanation of international differences in the share of GDP (or of government budget) earmarked for pensions: namely, the relative weight of Pay As You Go (=public) and funded (=private) pension schemes. A country with 100% PAYG pension schemes will have all pensions classed as a charge solely on public expenditure, whereas a country with a 100% fully funded, private pension system will have a zero incidence of pensions on the public budget regardless of all the other factors mentioned above; all factors will be relevant in intermediate cases. Thus “public spending on pensions“ is not really comparable across countries. A fuller picture is given below, in a table available for 2006 from the OECD Factbook 2009 (Paris, pp. 22-23).
Figure 2. Public and Private Pension Expenditure, 2006 
Affordability and Fiscal Sustainability
It is incomprehensible why a compulsory pension contribution compulsorily invested in pension funds should be regarded as private saving, in spite of its undeniable forced saving nature, while an identical pension contribution that gives an entitlement to a public pension should be regarded as a tax, and such a pension treated as a net claim on public expenditure competing with health and education as if it was not financed out of pension contributions that are not normally available for alternative uses. And if the public pension contributions replicate the performance of pension funds (as in the Funded Notional individual Accounts discussed by Nick Barr in a comment to the previous post) there is no reason whatever to treat the two systems any differently.
For the public purse, the true net claim of public pensions on public expenditure is not the total pension expenditure but the difference – if any – between current total pensions and total current pension contributions. If pension payments match current contributions, or exceed them by an amount that the government regards as affordable and sustainable, then the entire public pension system is affordable and sustainable. And – as Paul de Grauwe recently reminded us – the fact that a policy is not sustainable from now to the end of time is no reason for not adopting it for a while, especially at a time of crisis.
There is a cherry on the Italian public pensions cake, a gold coin baked inside it, an Easter Egg surprise that OECD officials should consider and ponder: in 2006, the last year for which final budgetary data are available, Italy’s public pensions exceeded pension contributions by almost €17billion, the smallest deficit in the last 15 years except for 2001. But considering that almost €29billion were returned to the budget as taxes on pensions, the actual budgetary cost was lower than pension contributions by over €11billion. Thus in 2006 the public pension system actually made a positive, significant contribution to Italy’s government budget, by 0.8% (Rapporto sullo Stato Sociale 2008, cited, p.21). For the future, in spite of the serious ageing of the Italian population, doubling by 2050 the ratio between the over-65s and the population aged 16-65, on current trends it is expected that “public spending on pensions” should fall slightly until 2015, rising towards 15.3% around 2038, then falling back to the current values of around 14% in 2050 (ibidem).
Public versus Private Pensions
From the viewpoint of the pensioner the relevant difference between the two isystems (PAYG and fully funded) s the yield obtained on the funded system relatively to the notional yield implicit in the PAYG system. The maximum yield obtainable on a balanced PAYG system corresponds to the growth rate of total wages (for a constant rate of contributions); the actual PAYG yield may will be lower if the system yields a surplus as in Italy, or higher if the government budget devotes net resources to its subsidisation.
At the end of World War II the Italian pension system, that was then fully funded, left pensioners with a hatful of rain. In the current global crisis the assets of pension funds lost a very great deal of their value, according to the OECD between 8% (Mexico) and 38% (Ireland) in 2008, most probably more in 2009. Iceland in 2006 was at the bottom of the OECD “public spending on pensions” league, with under 0.5% of GDP (see Figure 2; reportedly penultimate at 2% in 2005, see Figure 1) and its not terribly generous pension system (with total public and private pensions corresponding only to 4% of GDP, Figure 2) relied massively on private funded pensions. Given the country’s state of near bankruptcy since mid-2008, it is going to be very interesting, though probably distressing, to see how Icelandic pensioners will have fared relatively to their Italian contemporaries in the next couple of years – even allowing for differential contributions. The OECD parrots the World Bank in claiming, in exactly the same words, that “No pension system is immune to the crisis”, in total denial about differential performance (this may be unfair, for it is not clear who parrots whom; maybe there was collusion, which would be even worse).
Ageing, Retiring Age, Life Expectancy
The above reflections are not meant to suggest that all is well in the world of public – or for that matter private – pensions. Population ageing is a secular trend that has been getting all the publicity (see Figure 3; the latest issue of The Economist also has a report on Ageing). But there are two other factors that combine with population ageing to create serious problems for pension systems in general and public pensions in particular. One has been the reduction of retiring age since the 1950s for men and since 1970 for women, amplifying the impact of ageing on the viability of public pensions until 1999, when the trend was reversed (see Figure 4). The other factor is the rise in life expectancy which, in spite of the rise in retirement age postulated to continue until 2050, is expected to be faster than the rise in retirement age and therefore raises the expected retirement duration. It turns out that after the once-and-for-all gradual drop of such duration in the current decade, associated with the reversal in 1999 of the earlier strong reduction in retiring age, the expected retirement duration resumed its inexorable growth (see Figure 5).
These are real problems. The questions arise of how much of public and private pension expenditure deserves a government subsidy. Or whether in anticipation of adverse trends some reserve should be built up in the public pension system. And which of the pension parameters – retiring age, minimum years of service, pension levels, pension contributions – are best adjusted to balance the books or at least to contain their imbalance. And whether the switch from PAYG to a funded system, and the associated surfacing of a the “implicit” pension debt of the PAYG system, is worth the transition to a system less vulnerable to demographic factors but more vulnerable to a systemic crisis like the current one. These issues warrant a serious, profound and extended debate. But the pretence – today spectacularly falsified – of an alleged superiority of funded private pensions over public ones, and the use and misuse of the notion of “public spending on pensions”, are a most unsound foundation for such a debate.
Figure 3. A century of population ageing
Figure 4. Pension Ages in the OECD, 1960-20050
Figure 5. Expected time in retirement 1960-2050
Note: expected retirement duration calculated at normal pension age for each country based on national life expectancy data and projections. Source: OECD, Pensions at a Glance, cit.
Saturday, June 13, 2009
First You Pay Then You Go
Innocent victims of the current global financial crisis include – next to the gullible millionaires who greedily entrusted their riches to Bernie Madoff; the shareholders of bankrupt companies and the millions of workers made unemployed in the last year – a larger group of less visible, less vocal but undeserving losers: old age pensioners.
The Pension Crisis
On 27 May 2009 the Financial Times ran a major feature (multimedia, interactive) on "The Pension Crisis”, by Cynthia O’Murchu, Helen Warrell, Steve Bernard and Norma Cohen . ”The financial crisis has wreaked havoc on retirement plans of all varieties, inflicting particular damage to employer-based and private retirement savings, which have gradually come to replace state pension provision [emphasis added]. Meanwhile workers themselves, who have built up a lifetime of savings in pension funds, are being forced to rethink their pension plans and even defer their retirement.” VIDEO See also Sharlene Goff, “Pensions warning over bet on shares”, FT 20 May 2009.
A leading independent pensions adviser, Dr Ros Altman, last May published a report Planning for Retirement: You're On Your Own, warning that the credit crisis had "hugely damaged" the UK's pensions system and destroyed the widespread belief that long-term stock market investment would produce generous pensions. "Essentially the entire UK pensions system has been based on a bet that equities would always do well enough over the long term to deliver reliably good pensions," she says in her report, "The old idea that stock markets can always be relied on to deliver strong returns has left millions facing an impoverished old age." (Goff, cited). In fact, over the past 10 years, equity returns have averaged just 1.2 per cent, compared with 16.1 per cent in the previous 10 years. The UK is a good illustration of what today is a universal problem.
The replacement of “state pension provision” with “private retirement savings” was pioneered in Pinochet’s Chile, championed by the World Bank in its countries of operation (especially in the economies of post-socialist transition), and became fashionable throughout the world over the last twenty years. The current pension “time-bomb” (O’Murchu et al., cited) is a pre-announced crisis, rooted in the hyper-liberal ideology of the Reagan-Thatcher years, and based on faulty economic theory. Nobody has the right to be surprised.
Pay As You Go …
There are two main alternative approaches to the provision of pensions. The first, traditional system is unfunded: pensions are paid, at a level of pre-defined benefits, out of the current pension contributions made by current employees. It is also called a re-distributive, or PAYG-Pay As You Go system. It is typical of the old socialist model.
PAYG is a kind of pyramid banking scheme, where pensions are paid out of current employee contributions just like Bernie Madoff paid interest out of new deposits. Except that the standard banking pyramid goes bust when deposits unavoidably at some point stop growing at least as fast as the rate of interest paid out; and before it happens Mr Ponzi runs away with the loot. Whereas the pension pyramid can be perfectly sustainable, since there are always new depositors (current employees making pension contributions) and there are gradual and orderly withdrawals (pensions paid only after reaching retirement age, and gradually, month after month).
The unfunded system is sustainable as long as the number of old age pensioners multiplied by their individual average pension is no greater than the number of current employees multiplied by their individual average pension contribution. Otherwise the uncovered difference is a claim on current government expenditure, and the present value of such uncovered differences is an explicit “pension debt” which should be counted as part of the government debt; its sustainability depends not on the specific characteristics of the pension system but on whether that overall government debt is sustainable.
Suppose the two sides – pension outlays and pension contributions revenues – balance. All future pensions are currently unfunded, and formally there is an implicit pension debt today equal to today's pensioners' pensions for the rest of their lives (plus the future pensions matured so far by current employees). But the day of reckoning never comes; that debt is buried and – as long as the balance between pensions and contributions is kept – it never surfaces nor need ever to surface. The government ability to run such a pension system is a kind of seigniorage, as long as the unfunded system is universal. Only if the two sides are not in equilibrium and pensions amount to more than current contributions, can that shortfall, cumulated and discounted over the residual lifetime of current pensioners, be regarded as today's "true", explicit component of public debt on account of pensions.
If current contributions are higher than current pensions you can set aside the difference as a reserve for the possible aging of the population, or for later pension rises. If the population does age and such reserve is not there or is exhausted, then pensions must be reduced, or contributions raised, or retirement age delayed, or some combination of all three, until balance is restored. Or the imbalance can be financed by the state budget, if the burden is bearable and sustainable.
… or Fully Funded?
The second kind of pension system is funded, with defined contributions but with benefits depending on the yield earned on the accumulation of individual contributions over time. In this case there is no problem with ageing, or with retiring age, since what you get always depends on what you put in, and on the success of the investment to which your cumulative contributions were put, by you or by a pension fund of your choice. Choice is reputed to be one of the advantages of the system. The other advantage claimed for it is the development of financial markets, which is regarded as a good thing in itself.
Does this funded system ensure a zero explicit and implicit pension debt? Yes, normally – until such a time as 2008-9 when insurance companies and banks go bust and stock exchange values fall by over a half. Then funded schemes end up with vanishing yields and capital values, i.e. pensions literally tend to vanish. “First You Pay and Then You Go”, they used to say in the pension crisis in Russia in the 1990s. Ultimately the government will have to look after the pensioners no longer covered by their nominally "funded" but shrinking pension schemes. The pension burden will ultimately fall on the public budget – inexorably and regardless of whether pensions are funded or unfunded.
Steady States and Transition
The funded system may or may not be superior to the PAYG system when both are compared in a steady state, but even if it were that would not necessarily mean that the transition from PAYG to funded is a good thing. For if and when you move to a funded system you make the buried, hidden, implicit pension debt behind the PAYG (today's pensioners' pensions for the rest of their lives), surface unnecessarily as an explicit real claim on current government resources. Whereas, as long as the balance is kept between pension outlays and pension contributions revenues, the unfunded system implicit debt remains buried and is of no consequence whatever. So much so that, if you wished to privatise a balanced funded pension system, there should be no shortage of takers without having to pay them the value of the implicit, buried, pension debt.
Therefore the best option is to keep PAYG but adjust pensions/contributions/retiring age so as to make the system – if not balanced – at least maintain the imbalance at levels that can be a reasonable and sustainable burden on the state budget. If you still want to change from PAYG to a fully funded system, you should consider the unnecessary cost surfacing into public accounts, and not necessarily expect the eternal boom needed to validate its alleged superiority, which depends on the yield on pension investments being consistently higher than the growth rate of the wage bill.
Alternatively, instead of moving from PAYG to a fully funded system, it is preferable to mimic the functioning of a funded system, with the state continuing to cash in the pension contributions of the currently employed, crediting them to contributors in personalised accounts yielding a rate of return equal to that of a chosen investment fund or even basket of securities, eventually determining future pension benefits. In this way the explicit burden on the government budget is not the total contributions of the currently employed otherwise lost in the transition to a funded system, but only the difference between pensions mimicking a funded system and what pension payments would have been under the standard PAYG.
The World Bank: No Pillars of Wisdom and Little Support for the Three They Claim
The World Bank advocates a Three Pillars pension system, composed of a PAYG (Pay As You Go) publicly managed, tax-financed minimum pension for all; a privately managed funded scheme; and additional voluntary retirement savings. The third, voluntary, pillar is neither here nor there, or rather is always possibly there regardless: voluntary savings can be encouraged by tax incentives but otherwise are nobody’s business other than the saver's. The other two are the real alternative; and it is clearly a question of relative proportions between the two pillars, rather than strictly an alternative between the two.
The World Bank’s favour of funded pension schemes is enshrined in two classic documents: Averting the old age crisis – Policies to protect the old and promote growth, 1994, and Social Protection Sector Strategy: from Safety to Springboard, 2001. A great deal of favour, well bias, is hidden behind the three pillars, but the insistence with which the World Bank urged the downsizing the PAYG pillar already in existence, and urged the introduction of a totally new funded system alongside an already existing rudimentary voluntary pillar should not fool anyone: “multi-pillar” is a cosmetic euphemism for the emphatic introduction of a funded pillar, and on a large scale.
But now the wind has changed. In 2006 the World Bank conducted an “Independent Evaluation” of the its own assistance to pension design: "Pension reform and the development of pension systems", see also “Pension Reform: How to Strengthen World Bank assistance”, in IEG Reach, 2 February 2006. The assessment finds that “… in a number of instances the Bank supported multi-pillar reform [read: funded systems] even though there were clearly weaknesses in the country’s underlying economic and financial structure. Moreover the Bank did not always fully consider non-contributory options to expand the social safety net to the populace outside the formal system”. “… despite expectations, in many countries with multi-pillar system, funded pensions remain poorly diversified and pension coverage has not been increased. In addition, the secondary objective of funded pillars – to increase savings, develop capital markets and improve labor flexibility – remains largely unrealised.” The Bank comes under bland but firm criticism for “overselling” the benefits of funded pensions in its countries of operation.
Nicholas Barr of LSE and Peter Diamond of MIT have now finally destroyed the theoretical foundations of the World Bank penchant for funded pensions and other aspects of its policies towards poverty and the aged, in their Reforming Pensions: Principles and Policy Choices, Oxford UP, 2008, and Pension Reform: A short Guide, Oxford UP (forthcoming June 2009).
But the writing had been on the wall for sometime. See for instance John Eatwell, Michael Ellman, Mats Karlsson, D. Mario Nuti and Judith Shapiro, Soft Budget, Hard Choices: the Future of the Welfare State in Central Eastern Europe, IPPR, London 2000, Ch. 8 on pensions. Or Nicholas Barr, "Reforming pensions: myths, truths, and policy choices", IMF Working Paper 00/139, August 2000. Or P. Orszag e Joseph E. Stiglitz, "Rethinking Pension Reform: Ten Myths About Social Security Systems", in: R. Holman e J. Stiglitz (Eds), New Ideas About Old Age Security, Washington: World Bank, 2001, pp. 17-56.
In most countries, mis-selling pension plans is a prosecutable offence. In the UK “several pension companies are expected to be investigated and fined for advising customers to switch into a personal pension or self-invested personal pension (Sipp) against their best interests” (The Times, 5 December 2008). Why should the World Bank get away with mis-selling entire pension systems? It has become fashionable for all kind of institutions and governments to apologise for their past or recent misdeeds. They include Pope Benedict XVI, apologising for pedophile priests; the Anglican Church apologising to Darwin; the Canadian government to Inuit Indians; the Australian to Aborigines. Former Royal Bank of Scotland chief executive Sir Fred Goodwin told MPs on the Treasury Committee he "could not be more sorry" for what had happened (BBC, 10 February 2009).
It’s time for the World Bank President Robert B. Zoellick to at least say “Sorry” to the old-age pensioners for their loss of protection at such a difficult time.
The Pension Crisis
On 27 May 2009 the Financial Times ran a major feature (multimedia, interactive) on "The Pension Crisis”, by Cynthia O’Murchu, Helen Warrell, Steve Bernard and Norma Cohen . ”The financial crisis has wreaked havoc on retirement plans of all varieties, inflicting particular damage to employer-based and private retirement savings, which have gradually come to replace state pension provision [emphasis added]. Meanwhile workers themselves, who have built up a lifetime of savings in pension funds, are being forced to rethink their pension plans and even defer their retirement.” VIDEO See also Sharlene Goff, “Pensions warning over bet on shares”, FT 20 May 2009.
A leading independent pensions adviser, Dr Ros Altman, last May published a report Planning for Retirement: You're On Your Own, warning that the credit crisis had "hugely damaged" the UK's pensions system and destroyed the widespread belief that long-term stock market investment would produce generous pensions. "Essentially the entire UK pensions system has been based on a bet that equities would always do well enough over the long term to deliver reliably good pensions," she says in her report, "The old idea that stock markets can always be relied on to deliver strong returns has left millions facing an impoverished old age." (Goff, cited). In fact, over the past 10 years, equity returns have averaged just 1.2 per cent, compared with 16.1 per cent in the previous 10 years. The UK is a good illustration of what today is a universal problem.
The replacement of “state pension provision” with “private retirement savings” was pioneered in Pinochet’s Chile, championed by the World Bank in its countries of operation (especially in the economies of post-socialist transition), and became fashionable throughout the world over the last twenty years. The current pension “time-bomb” (O’Murchu et al., cited) is a pre-announced crisis, rooted in the hyper-liberal ideology of the Reagan-Thatcher years, and based on faulty economic theory. Nobody has the right to be surprised.
Pay As You Go …
There are two main alternative approaches to the provision of pensions. The first, traditional system is unfunded: pensions are paid, at a level of pre-defined benefits, out of the current pension contributions made by current employees. It is also called a re-distributive, or PAYG-Pay As You Go system. It is typical of the old socialist model.
PAYG is a kind of pyramid banking scheme, where pensions are paid out of current employee contributions just like Bernie Madoff paid interest out of new deposits. Except that the standard banking pyramid goes bust when deposits unavoidably at some point stop growing at least as fast as the rate of interest paid out; and before it happens Mr Ponzi runs away with the loot. Whereas the pension pyramid can be perfectly sustainable, since there are always new depositors (current employees making pension contributions) and there are gradual and orderly withdrawals (pensions paid only after reaching retirement age, and gradually, month after month).
The unfunded system is sustainable as long as the number of old age pensioners multiplied by their individual average pension is no greater than the number of current employees multiplied by their individual average pension contribution. Otherwise the uncovered difference is a claim on current government expenditure, and the present value of such uncovered differences is an explicit “pension debt” which should be counted as part of the government debt; its sustainability depends not on the specific characteristics of the pension system but on whether that overall government debt is sustainable.
Suppose the two sides – pension outlays and pension contributions revenues – balance. All future pensions are currently unfunded, and formally there is an implicit pension debt today equal to today's pensioners' pensions for the rest of their lives (plus the future pensions matured so far by current employees). But the day of reckoning never comes; that debt is buried and – as long as the balance between pensions and contributions is kept – it never surfaces nor need ever to surface. The government ability to run such a pension system is a kind of seigniorage, as long as the unfunded system is universal. Only if the two sides are not in equilibrium and pensions amount to more than current contributions, can that shortfall, cumulated and discounted over the residual lifetime of current pensioners, be regarded as today's "true", explicit component of public debt on account of pensions.
If current contributions are higher than current pensions you can set aside the difference as a reserve for the possible aging of the population, or for later pension rises. If the population does age and such reserve is not there or is exhausted, then pensions must be reduced, or contributions raised, or retirement age delayed, or some combination of all three, until balance is restored. Or the imbalance can be financed by the state budget, if the burden is bearable and sustainable.
… or Fully Funded?
The second kind of pension system is funded, with defined contributions but with benefits depending on the yield earned on the accumulation of individual contributions over time. In this case there is no problem with ageing, or with retiring age, since what you get always depends on what you put in, and on the success of the investment to which your cumulative contributions were put, by you or by a pension fund of your choice. Choice is reputed to be one of the advantages of the system. The other advantage claimed for it is the development of financial markets, which is regarded as a good thing in itself.
Does this funded system ensure a zero explicit and implicit pension debt? Yes, normally – until such a time as 2008-9 when insurance companies and banks go bust and stock exchange values fall by over a half. Then funded schemes end up with vanishing yields and capital values, i.e. pensions literally tend to vanish. “First You Pay and Then You Go”, they used to say in the pension crisis in Russia in the 1990s. Ultimately the government will have to look after the pensioners no longer covered by their nominally "funded" but shrinking pension schemes. The pension burden will ultimately fall on the public budget – inexorably and regardless of whether pensions are funded or unfunded.
Steady States and Transition
The funded system may or may not be superior to the PAYG system when both are compared in a steady state, but even if it were that would not necessarily mean that the transition from PAYG to funded is a good thing. For if and when you move to a funded system you make the buried, hidden, implicit pension debt behind the PAYG (today's pensioners' pensions for the rest of their lives), surface unnecessarily as an explicit real claim on current government resources. Whereas, as long as the balance is kept between pension outlays and pension contributions revenues, the unfunded system implicit debt remains buried and is of no consequence whatever. So much so that, if you wished to privatise a balanced funded pension system, there should be no shortage of takers without having to pay them the value of the implicit, buried, pension debt.
Therefore the best option is to keep PAYG but adjust pensions/contributions/retiring age so as to make the system – if not balanced – at least maintain the imbalance at levels that can be a reasonable and sustainable burden on the state budget. If you still want to change from PAYG to a fully funded system, you should consider the unnecessary cost surfacing into public accounts, and not necessarily expect the eternal boom needed to validate its alleged superiority, which depends on the yield on pension investments being consistently higher than the growth rate of the wage bill.
Alternatively, instead of moving from PAYG to a fully funded system, it is preferable to mimic the functioning of a funded system, with the state continuing to cash in the pension contributions of the currently employed, crediting them to contributors in personalised accounts yielding a rate of return equal to that of a chosen investment fund or even basket of securities, eventually determining future pension benefits. In this way the explicit burden on the government budget is not the total contributions of the currently employed otherwise lost in the transition to a funded system, but only the difference between pensions mimicking a funded system and what pension payments would have been under the standard PAYG.
The World Bank: No Pillars of Wisdom and Little Support for the Three They Claim
The World Bank advocates a Three Pillars pension system, composed of a PAYG (Pay As You Go) publicly managed, tax-financed minimum pension for all; a privately managed funded scheme; and additional voluntary retirement savings. The third, voluntary, pillar is neither here nor there, or rather is always possibly there regardless: voluntary savings can be encouraged by tax incentives but otherwise are nobody’s business other than the saver's. The other two are the real alternative; and it is clearly a question of relative proportions between the two pillars, rather than strictly an alternative between the two.
The World Bank’s favour of funded pension schemes is enshrined in two classic documents: Averting the old age crisis – Policies to protect the old and promote growth, 1994, and Social Protection Sector Strategy: from Safety to Springboard, 2001. A great deal of favour, well bias, is hidden behind the three pillars, but the insistence with which the World Bank urged the downsizing the PAYG pillar already in existence, and urged the introduction of a totally new funded system alongside an already existing rudimentary voluntary pillar should not fool anyone: “multi-pillar” is a cosmetic euphemism for the emphatic introduction of a funded pillar, and on a large scale.
But now the wind has changed. In 2006 the World Bank conducted an “Independent Evaluation” of the its own assistance to pension design: "Pension reform and the development of pension systems", see also “Pension Reform: How to Strengthen World Bank assistance”, in IEG Reach, 2 February 2006. The assessment finds that “… in a number of instances the Bank supported multi-pillar reform [read: funded systems] even though there were clearly weaknesses in the country’s underlying economic and financial structure. Moreover the Bank did not always fully consider non-contributory options to expand the social safety net to the populace outside the formal system”. “… despite expectations, in many countries with multi-pillar system, funded pensions remain poorly diversified and pension coverage has not been increased. In addition, the secondary objective of funded pillars – to increase savings, develop capital markets and improve labor flexibility – remains largely unrealised.” The Bank comes under bland but firm criticism for “overselling” the benefits of funded pensions in its countries of operation.
Nicholas Barr of LSE and Peter Diamond of MIT have now finally destroyed the theoretical foundations of the World Bank penchant for funded pensions and other aspects of its policies towards poverty and the aged, in their Reforming Pensions: Principles and Policy Choices, Oxford UP, 2008, and Pension Reform: A short Guide, Oxford UP (forthcoming June 2009).
But the writing had been on the wall for sometime. See for instance John Eatwell, Michael Ellman, Mats Karlsson, D. Mario Nuti and Judith Shapiro, Soft Budget, Hard Choices: the Future of the Welfare State in Central Eastern Europe, IPPR, London 2000, Ch. 8 on pensions. Or Nicholas Barr, "Reforming pensions: myths, truths, and policy choices", IMF Working Paper 00/139, August 2000. Or P. Orszag e Joseph E. Stiglitz, "Rethinking Pension Reform: Ten Myths About Social Security Systems", in: R. Holman e J. Stiglitz (Eds), New Ideas About Old Age Security, Washington: World Bank, 2001, pp. 17-56.
In most countries, mis-selling pension plans is a prosecutable offence. In the UK “several pension companies are expected to be investigated and fined for advising customers to switch into a personal pension or self-invested personal pension (Sipp) against their best interests” (The Times, 5 December 2008). Why should the World Bank get away with mis-selling entire pension systems? It has become fashionable for all kind of institutions and governments to apologise for their past or recent misdeeds. They include Pope Benedict XVI, apologising for pedophile priests; the Anglican Church apologising to Darwin; the Canadian government to Inuit Indians; the Australian to Aborigines. Former Royal Bank of Scotland chief executive Sir Fred Goodwin told MPs on the Treasury Committee he "could not be more sorry" for what had happened (BBC, 10 February 2009).
It’s time for the World Bank President Robert B. Zoellick to at least say “Sorry” to the old-age pensioners for their loss of protection at such a difficult time.
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