Maradona's Monetary Policy

There's a really nice read in the FT by Claire Jones on the parallels between Central Bank monetary policy and football. Back in 2005, Sir Mervyn King, the outgoing BoE governor, gave a monetary policy speech in London in which he stated the following, 

"This is what I call the Maradona theory of interest rates....Maradona’s first “hand of God” goal  was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates....The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do.  Because they expected Maradona to move either left or right, he was able to go straight on."

Essentially, the premise is this - how people perceive the central bank will react is what determines market interest rates. Which means, according to Jones, that Draghi might have to morph into Cruyff if his OMT is to work contrary to market sentiment. 

In any case, I'm not the greatest-of-greatest-fans of the goal. It's because I wasn't there, I'm not a Maradona fan, and I'm really really surprised no English defender took him down. Maybe investors will be nice enough to central banks too. If they are perceived to be moving in a credible direction, they might not have to actually be snapping up all those mortgages/bonds etc. 

Fiscally Flat

The October Fiscal Monitor from the IMF is out and it provides ample analysis on fiscal adjustments and their impacts. It also has a few graphs and charts on fiscal adjustment in relation to Gini measures. 

I'll try and limit myself 9 countries (for 2012) and incorporate the main constituents of the equation - namely the interest rate, the growth (differential between the two) and the primary balance contrasted with the overall balance. This provides a broader status update kind of glance at the economies in question.

Just a quick reminder that assuming the time period as fixed (so that i can get the 't' out of the equation), then:

If the primary balance is p, and the real interest rate is r, where (1+i) = (1+r)(1+pi) and 
suppose x = (i-n)/(1+n) therefore x = (r-g)/(1+g) therefore 1+x = (1+r)/(1+g) 
then my stock of debt at t time period is given by :
d(t) = (1+x)d(t-1) - p

where 
n is my nominal growth rate between t and t-1
pi is my change in the GDP deflator between t and t-1
g is my real growth rate between t and t-1
i is my nominal interest rate in period t, paid in t, on debt stock outstanding of t-1

This is why the interest rate-growth differential matters, because holding p constant with an existing debt stock, we depend on the value of (1+x) which is essentially (1+r)/(1+g). Alternatively, the value of x is (r-g)/(1+g) and therefore, for x or 1+x to be smaller, g has to be greater than r. If the reverse is true then you have a multiplier > 1.

Some observations on the graph:

 - Greece is the outlier as far as the differential is concerned. Think of high borrowing costs (high nominal i not offset by pi) and no growth (g). Japan, the US and Germany have a differential close to zero even though growth is minimal because of the safe have haven of the treasuries, bunds and jgbs. 

 - Italy, predictably is the only country (apart from Germany) with a positive primary balance yet negative overall balance, it's borrowing costs at the mercy of investors and it's current gross debt level being about 126% of GDP.

 - The UK too, is running a primary deficit of over 5% and doesn't have a favourable differential. It hasn't suffered at the hands of investors (the BoE has control over its printing press) and its borrowing costs aren't out of control but growth is anemic at best debt levels are uncomfortably high.

 - Lastly, China's gross debt stands at about 20% of GDP with a minor primary and overall deficit. Both India and China have their own internal macroeconomic imbalances and causes for concern but they still have emerging market growth rates. India's fiscal deficit is uncomfortably high which is why the government has been trying to take steps towards subsidy reform among other policy measures. 

Recovery has suffered yet again and the outlook seems bleaker than it did earlier in the year. Synchronized fiscal consolidation has clearly made growth stall more than expected and external situations/scenarios (EZ crisis, China's hard/soft landing, US fiscal impasse) have left so many interconnected economies at the mercy of shockingly bad policy. 

It was Dickens who wrote and Pip who said, "Whitewash on the forehead hardens the brain into a state of obstinacy". Perhaps it's time for more than a few policy makers and politicians to reflect, change direction, and ditch a dogma that does more harm than good.

A for Austerity, B for Bye-Bye

More than a few words on that little box from the WEO that's set off the econosphere. Before I get to it, there are some bits from DeLong and Krugman that should be thrown in for perspective. Before I get to them, here's an excerpt from the Summers-DeLong paper back in March, "Fiscal Policy in a Depressed Economy":


"Unless the real interest rate at which the government borrows on the left-hand side is greater than the right-hand side of (2.9)*, fiscal expansion now improves the government’s budget balance later. Arguments that economies cannot afford expansionary fiscal policy now because they should not raise their future debt financing burdens then have little purchase."

*2.9 is the equation that relates the real interest rate to the sum of the growth rate of the tax base and the short-term multiplier, the fraction of the depth by which the economy is depressed and the marginal tax-and-transfer rate. 

Essentially, if the fiscal multiplier is larger than 1, suppose 1.5, and the marginal tax share is 0.33, and the economy can borrow at zero in real terms, then in the medium term, there's is no long-run cost to the budget. The thing here, as DeLong re-emphasizes, is that there is no short-term exit from the ZLB, which means that there is still time for governments to act. 

Krugman makes it simpler to explain this "multiplier-mea-culpa". To him, it's the asymmetry in the effects of leveraging as opposed to deleveraging. Essentially:

1) Leveraging = higher AD, but this can be offset by tighter monetary policy
2) Deleveraging = lower AD, but the offset isn't as easy because of the ZLB and the uncertain impact of unconventional monetary policy measures. 

This deleveraging constraint is responsible for the liquidity trap and hence the larger (>1) multiplier. 

Kate Mackenzie has this to say about how the consensus was built over the range of the multiplier and how it gradually shifted and shifted further perhaps.

And finally, this is what the actual box in the WEO (written by Blanchard (Director) and Leigh (Senior Economist) of the Research department)) had to say:

"Based on data for 28 economies...the multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2...

...Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7."

Think about that for a moment. It's big.

And this is based on hard data. Austerity is damaging, now more than ever. How else could you explain (for example) UK growth over the past few years? Look at the numbers:

The estimated equation is y = a + bx + e where:
y is the forecast growth of error = difference in actual cumulative real GDP growth ('10-'11) and the April 2010 WEO forecast.
x is the forecast of fiscal consolidation = forecast of the change in the structural fiscal balance ('10-'11) as of 
the April 2010 WEO

Mathematically, if the multipliers used in the forecasting have been accurate in retrospect, then the equation should be y = a + e and we should get a zero coefficient. 

Of course that's not the case. 

Instead, the co-efficient is found to be "large, negative, and significant. The baseline estimate suggests that a planned fiscal consolidation of 1% (of GDP) is associated with a growth forecast error of about 1%...indicates that the multipliers underlying growth projections have been too low by about 1."

Furthermore, naturally other variables are analysed as possible triggers to consolidation and weaker-than-expected growth. Among these are the debt-to-GDP ratio, the sovereign CDS spreads, the impact of banking crises, the consolidation of trading partners, the external balance.

They conclude by commenting that more work is warranted yet unequivocally, "in today's environment of substantial economic slack, monetary policy constrained by the ZLB, and synchronized fiscal adjustment across numerous economies, multipliers may be well above 1".

As a Bloomberg editorial justifiably says, "...the new pragmatic IMF is the voice of reason. It’s impressive to see such a culturally conservative institution leading this change, rather than being reluctantly dragged along. We’ll be even more impressed when governments start acting on its advice"

About time. It's about time.

Eurominbi

With reference to the global role of the dollar, I decided to go through reading the Eichengreen white paper, the remainder of which focused on the sorry state of the euro and the rapid yet confusing rise of the renminbi.

The euro-matter is predictable enough, for what can be said about the euro that hasn't already been said enough? Essentially, when the very existence of a currency is oft called into question, what hope can there be for a more 'global' role? 

But Eichengreen is wise about this and instead of dwelling on the myriad of problems plaguing the euro, he looks to the future. 

If anything, the EZ crisis illustrated the difference between the US and the Euro bond markets. When european governments at one point looked to the east for funds, there was naturally a sense of indifference and lack of desire from most central banks and sovereign funds. 

In fact, Li Diaoku a Chinese monetary policy committee member in the PBC stated, "The last thing China wants is to throw away the country's wealth and be seen as just a source of dumb money". 
Words indeed!

But what if the Euro survives and emerges with reparable scars? What if public finances stabilize, economies start growing and labour conditions improve? What if Germany takes the high road because:

1) For every inept borrower (south), there is an inept lender (north)
2) German exports (automobiles, machinery etc.) have benefited enormously from sharing the same currency as other Southern countries - a competitive exchange rate has been an integral factor in their economic renaissance
3) The shock of a euro abandonment - bond dumping, capital flight, bank runs etc and the accompanying contagion effect that could knock over economies like dominos (think east-asia '97)
4) The ideal of European integration would be severely undermined if the euro doesn't survive.

If the euro's flaws are fixed and tough decisions are made, we might have some essential systems in play such as centralized regulation, a common deposit-insurance scheme - i.e: a legitimate banking union. Perhaps if debts are partially guaranteed there might be some semblance of a pseudo yet effective fiscal union. 

Eichengreen quotes Jean Monet, who famously stated that, "Europe is forged in crises, and will be the sum of the solutions adopted for those crises". 

And while historically that may be true it doesn't change one crucial part - There are solutions, the challenge is to apply them. 

Everyone would love to cling to the safe knowledge that Europe will do what is necessary to save the union but the longer the delay, the lesser the chances. It's a long, dreary road ahead.

--------------------

The renminbi, on the other hand, has been on an opposite trajectory. China's implementation of the trilemma is simple - independent monetary policy and a severely restricted capital account by which they can keep the renminbi pegged to the dollar. While that does wonders for export-driven growth it cannot be a model for a reserve currency. And this leads us to its internationalization. Invariably, minor measures to liberalize capital flows cannot lead to a coherent globalization of the currency. Barriers have to be broken and flexibility needs to be induced. Eichengreen mentions a few instances from policy makers in China:

 - In August 2010, a pilot scheme was introduced that allowed select offshore FI's to invest in China's bond market using renminbi funds
- In 2011, regulators permitted offshore renminbi to be used by investors i the Chinese stock market. 
- In early 2012, HM Treasury and the Hong Kong MA agreed to permit the trading of offshore renminbi in London.

The key, as he argues, is the private financial market and their adoption of the renminbi. This will lead to central banks diversifying their reserves and participating in bilateral swap agreements (eg. the Chiang Mai initiative). And so there exists a broad step-by-step framework from China's perspective:

Use in invoices and trade transactions -> facilitate use in a range of international financial transactions -> encourage its adoption as a reserve currency.

The problem is this (both charts are for China): 

The trading volume has grown extremely fast but the size has stabilized and is in slight decline. Moreover, if the outstanding stock is rapidly growing, the trading volume fails to provide a good enough measure of liquidity. A more relevant metric is the turnover ratio, which is basically the ratio of the value of the bonds traded and the average outstanding amount of bonds; and China's bond turnover ratio for government debt is extremely low. 

The Chinese economy is enormous, but it's bond market isn't. Even without comparison to the US, it is neither deep enough nor liquid enough to complement a global role of the renminbi. Moreover, most of the bonds of the government and corporations are held to maturity (hence not actively traded) which leads to an extremely low turn-over and the fact that it won't take a large transaction to affect prices. 

Inevitably, China cannot proceed without real reform. If the renminbi has to be accepted in a more international role, these are a few steps that must be implemented:

1) Capital account liberalization and hence the halt of dollar-pegging - a willingness to accept the inability to keep the renminbi artificially low and provide an export boost.
2) Bank reform, so that foreign investors can place deposits freely in Chinese banks and banks are no longer directed towards lending to local governments for projects, or to property developers in order to achieve construction objectives. 
3) A more liberal corporate environment and strict implementation of law and property rights. 

Point 1) is the anti-thesis to the Chinese growth-model. Dependence on exports, a monitored and pegged renminbi, and bank lending that can be adjusted and directed to whims and wills all have to be eroded and erased for the currency to be accepted. 

Essentially, as Chinese policy makers have often claimed, the economy needs to be rebalanced. In a fragile, post-crisis world characterized by dampened external demand, this could be much required by removing significant vulnerabilities of the export sector to global shocks and externalities.

Eichengreen's view is that such a monumental paradigm shift in theory, even if accepted, will not happen overnight - which is why the dollar is the only alternative on the table even though the renminbi is fast catching up and the US fiscal doldrums might exacerbate such a process.

Even if those statements hold some truth, it is still immensely difficult to dislodge an incumbent for poor performance when the alternative either isn't ready or isn't up to the mark - just look to the US presidential race!

The Exorbitant Dollar

Barry Eichengreen has a white paper out at the DWS Global Financial Institute. I thought it would be somewhat of an epilogue, or just some minor reflections on his book "Exorbitant Privilege". And in some ways, it is. By the way, you can't not have read the book - it's just a fascinating read infused with historical perspective, reality checks and substantive solutions.

A few facts beforehand, lifted from the paper:

1) 85% of all foreign exchange trades worldwide are "dollar-trades".
2) The dollar accounts for 60% of the reported foreign exchange reserves of central banks and governments around the world.
3) The dollar also accounts for 45% of all international debt securities.

There aren't just two sides to this debate (What are we debating?). It's a multi-faceted and multi-polar issue with no visible solutions. Is there a problem? No, but there might be. Are there solutions? Yes, but there are problems with the solutions. It's not as easy as it seems.

One would think that in the long run (in which we're all dead), this would make sense. The US economy is relatively nowhere near the behemoth it was post World War II. Naturally, this relative decline in output (to the world) would lessen the global 'need' and 'convenience' of the dollar. In fact, today most estimates put the US economy as accounting for about a quarter of the global economy and a lesser fraction of global trade.

Eichengreen mentions two other points of note that could lead one to question the role of the dollar and the first is far more obvious than the second. He says that the depth and liquidity of the US financial markets are simply no longer a hallmark of the US alone. I think this is debatable because while true, it still doesn't change the fact that there is simply no comparable alternative to the US financial market especially in terms of liquidity. But more on this later.

Furthermore, the first-mover advantage, the incumbency factor or changing the status quo (whatever you call it), is less of a hindrance now than it ever has been. This refers to the convenience of the dollar - that everyone uses it - so everyone will continue to use it. The ease of transaction is immense but newer technology, systems and frameworks could lead to a scenario where multiple operating systems could exist.

Lastly, a less intrinsic factor and something that has gained rapid traction recently, is the US fiscal situation. This brings the Triffin dilemma into play - that just as the expanding global economy needs a growing supply of dollars, we mustn't forget that the liquidity of the 'international reserve asset', i.e: the US treasury bill, is backed by the full faith of the United States government. Cue fiscal impasse.

If the world economy is expanding faster than the US economy, logically the capacity of the US government to keep providing safe assets will, at some point, be "overwhelmed by the scale" of this expansion. The key point here, is that the full faith of the government simply refers to its "power to tax". This thought gathers even more steam when the polarity of the American political situation comes into light.

The bottom line is that one could envision multiple scenarios but these are the ones that stand out:

a) The US gets it fiscal house in order and the exorbitant privilege continues though gradually losing its monopoly and sharing international space with the euro (yes, it will survive! or wait...no it won't!) and the renminbi. This perhaps, is the essence of the book - that inevitably, China and Europe will catch up through their financial markets' own depth and liquidity.

b) The adverse scenario, which is undoubtedly one which anyone and everyone has replayed in their mind and thought of - is that the US indulges in major fiscal folly and general confidence in the dollar is severely undermined and tested. While this is adverse, it's something that no one could risk writing off. The amount of political drama between the left and the right is at times suffocating, and their paths are theoretically polar. The last thing one would want is a looming fiscal cliff but that's exactly what's around the corner...

Anyways, the paper also has a section on international hostility to the Fed's unconventional and easy monetary policies. In accordance with the trilemma, and in a world of free capital flows, the near-zero interest rate environment in many advanced economies, coupled with higher interest rates in emerging markets forces capital out and into markets that may not be well equipped enough to handle such a 'tsunami of capital'. Unchecked capital flows of course, can rapidly create asset bubbles, stoke inflation fears and put immense pressure on a float. While true, I'm not quite sure what the viable alternative is. If domestic monetary policy is of paramount importance (and naturally it is!), then the Fed obviously cannot sit still or in reverse gear while the domestic economy suffers from no growth and severe unemployment. Zero sum game indeed!

I don't have any charts but i'll try and create one with events, of the dollar's reaction to the downgrade and the central bank announcements etc. but it's clear that the 'safe-haven' tag has never been questioned as investors have time and time again sought comfort in treasuries. Eichengreen provides three reasons for this:

1) The US financial markets are simply way, way, way more liquid than any other market anywhere, ever. In an uncertain environment, naturally investors crave liquidity the most.

2) There has been no attempt at debt monetization, no attempt to inflate away the debt. Monetization occurs when the treasury issues debt to finance spending, and the central bank purchases it thereby increasing base money. While cash and credit in circulation must have gone up, inflation has not reared its head one bit. But that's because of the liquidity trap and the depressed economy and not because monetizing debt is a "bad thing" necessarily!

3) Lastly, and most funnily as well as obviously, in an environment like the one we live in today, Eichengreen states that "despite its warts", the dollar "is still the least unattractive belle at the ball".
Bill Gross has stated that it's the "least dirty shit in the pile". You get the point. It's the outright lack of viable alternatives.

Of course this leads us to a discussion on the alternatives which is, I suppose the crux of the paper. What comes next? Essentially, what is the fate of the euro and what exactly is the status of the internationalization of the renminbi? And thus, what is the fate of the dollar?

More on that later, maybe.

What Am I Reading?

The effervescent Wolfgang Munchau emphasizes, as so many millions have again and again and again. That the 'solutions' are proving to be worse than the problems. He has a bit for a third of the troika too, 
"One wonders sometimes whether this is the same IMF that in its latest World Economic Outlook produced a very thoughtful analysis of past debt crises. It came to the conclusion that deficit reduction programmes can function only under certain auspicious conditions and must not be pursued in a blind, mechanistic sort of way."


Interested in how the US Senate and Congress handles their wealth? Are they suffering? Nope. Here's the WP with  Capitol Assets.

James Surowiecki has a short piece in the New Yorker on the looming fiscal cliff that ends with this gem of a line, 

"The fact that Congress was foolish enough to create the fiscal cliff doesn’t mean it also has to be foolish enough to drive us off it."

The narrative Robert Shiller has a piece in the NYT on the double-edged nature of the housing fever - the booms and the busts, and the seemingly extravagant expectations people had of the market.

Keeping in line with a favourite Republican nominee pastime of euro-bashing, here's a piece focusing on Romney playing to his base by attempting to distinguish America from...well....the rest of them (in this case, Spain). Funny thing is anyone can tell you that Europe did not spend its way into this crisis - that's not the cause. But obviously Romney knows that. Which means - that this is yet another case of intentional dishonesty. 

And finally, here's Mankiw's thoughts on the whole BLS 'truther' controversy (controversy?? really?). And Krugman's blurb on constant-demography based unemployment data. What it's all trying to come down to is of course, is this a real recovery or not. Election year you see...

And finally finally, Acemoglu, Robinson and Verdier came out with a paper on different forms of capitalism. This, from the abstract - "some countries will opt for a type of cut-throat capitalism that generates greater inequality and more innovation and will become the technology leaders, while others will free-ride on the cut throat incentives of the leaders and choose a more cuddly form of capitalism. Paradoxically, those with cuddly reward structures, though poorer, may have higher welfare than cut-throat capitalists but in the world equilibrium, it is not a best response for the cut-throat capitalists to switch to a more cuddly form of capitalism."

I'm going to read it and get back on this. 

Technically...

The Singapore numbers don't look good. A bit surprising perhaps and no reason to panic, but definitely a cause for concern in the short-term future. Some highlights:

- The PMI (Purchasing Managers' Index) was down about 0.8%, that's contraction for 3 consecutive months
- Industrial Production down by 2.2% yoy in August surprisingly?
- Exports for August plunged 10.7%.

Although Singapore's economy is not over-exposed to electronics demand and the sector as a whole should see a slight boost ahead of the holiday season, the electronics PMI still fell by 0.7 points.

The problem is the not-so-short-term. Three bogeymen of varying impact - 

The ever-faithful eurozone crisis, 
A potential fiscal cliff in the US 
The should-be-considered-more slowdown (slowdown?) in China. 

Q3 for Singapore is definitely not good but it's possible that global easing measures have somewhat of an impact on the real economy thereby helping slowing economic activity a fair bit. More importantly, the MAS's focus on inflation is likely to ease and result in an easing of monetary policy. It's a bit confusing from what I've been reading. For the most part, it seems everyone thinks it likely but I've heard a few say it's almost a coin-flip. I don't think there's any question. Firstly, inflation data looks more promising which it most certainly didn't not too long ago:

Clearly, the divergence has held back (July '11 and Feb '12), perhaps reflecting accommodation cost changes. 

Secondly, exports have clearly been suffering and the effective exchange rate, it seems, has appreciated a bit too rapidly:

It's not the differential that's worrying, but rather the rapid pace of appreciation since the start of the year. Which leads me to believe that it's still very possible that the MAS goes with what they decided in their last review. 

The general talk seems a bit morose, to be honest. Generally, the SGD should act as somewhat of a safe-haven currency with international investors, more-so given the global easing announcements from the three major central banks. 

External demand conditions are damp and strengthening global headwinds (declining PMI's in key export markets), as DBS pointed out, are relatively strong indicators for the manufacturing sector. There's no need to use the 'R' word at all no matter how probable it technically is. 

The next two or three months seem pretty important. And the next week or so will be quite important for the MAS which seems to be stuck in a conundrum because it could seem a bit too soon to ease off under a false sense of bringing inflation under check. According to an economist at Mitzuho, "there is no easy policy response to fragile demand conditions with supply side inflation risks". 

I think a policy redress might be a bit premature. A slight easing might help but it might also help in undoing the hard work been put in to tackle a stubborn inflationary trend. The greater issue is the vulnerability and downside risks in major global economies and that's something that domestic monetary policy cannot account for. 

It's just a bit too soon for some easing, but most may not quite see it that way.