Monthly Archives: May 2009

Don’t Montetize the Debt

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From the WSJ Journal-in-Education Program: 

The president of the Dallas Fed speaks about inflation risk and central bank independence 

This is an excellent article to use to illustrate the relationship between fiscal and monetary policies and the inflation risks associated with the Fed's direct purchases of bonds.

QUESTIONS:

1. What is the "perception of risk" that has been created by the Fed's purchases of Treasury bonds, mortgage-backed securities, and Fannie Mae paper?

2. What are the economic consequences of monetizing the debt?

3. According to Dallas Fed President Fisher, what role did the Fed play in contributing to the current crisis?

4. According to Dallas Fed President Fisher, what role did regulators play in contributing to the current crisis?

5. According to Dallas Fed President Fisher, what role did "government-anointed rating agencies" play in contributing to the current crisis?

(suggested by Edward Gamber, Lafayette College)

A New World Order?

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Times change: development advice will never be the same again. Why would any country buy the bitter medicine to limit goverment debt or forgo purchases of goverment debt by the country's central bank? Industrialized countries, who have strongly pushed such strong medicine, now instruct their central banks to purchase goverment debt and generate unprecedented fiscal deficits. The justification: extraordinary economic times. I would bet that any finance minister of a country where the majority of citizens lives on a dollar would argue that s/he is facing extraordinary times…  

The response to industrialized countries' policies has been swift. Credit rating agencies warn the UK goverment that it is in danger of loosing its pristene bond rating (because of excessive debt) and the US is being lectured about the dangers of printing money (by a developing country).

Interest parity can help us predict the future value of the British Pound (what is your prediction of the forward premium?). The Mundell Fleming Model (augmented to include price changes, see Chapter 19) or the Dornbush Overshooting Model (Chapter 20) come in handy to understand fluctuations in output, prices, and exchange rates as the US Central Bank engages in purchases of massive amounts of treasury bills to inject liqudity into the US economy. 

Back to development advice: the events remind me of the cafeteria at the IMF's Washington D.C. headquarters in the 1980s, where meals were ridiculously subsidized, but every IMF program advised developing countries against subsidizing food.  

Use, Reuse, Recycle

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A wonderful discussion of recent financial flows is provided by Brad Setser. The reserve flow dynamics can be worked out nicely with the aid of a Fixed and Flexible Exchange Rate Mundell Flemming model (Chapter 18 and 19). However, the Setser's piece does have some jargon, so if you have a life and dont want to slug though the IMF report (he criticizes) and his own theory, here are the key paragraphs: 

 

When the US slowed and the global economy (and the European economy) didn’t, private money moved from the slow growing US to the fast growing emerging world in a big way. The IMF’s data suggests that capital flows to the emerging world more than doubled in 2007 – and 2006 wasn’t a shabby year. Net private inflows to emerging economies went from around $200 billion in 2006 to $600 billion in 2007. Private investors wanted to finance deficits in the emerging world, not the US – especially when US rates were below rates globally. Normally, that would force the US to adjust – i.e. reduce its (large) current account deficit. That didn’t really happen. Why? Simple: The money flooding the emerging world was recycled back into the US by emerging market central banks. European countries generally let their currencies float against the dollar. But many emerging economies didn’t let their currencies float freely. A rise in demand for their currency leads to a rise in reserves, not a rise in [the price of the currency]. As a result, there has been a strong correlation between a rise in the euro (i.e. a fall in the dollar) and a rise in the reserves of the world’s emerging economies. Consider this chart – which plots [the 3 months sum of] emerging market [EM] dollar reserve growth from the IMF [official foreign currency reserve] data against the euro. 

 

 

If the rise in reserve growth in the emerging world is a sign of the amount of pressure on the dollar, then the dollar was under tremendous pressure from late 2006 on. It central banks had broke – and lost their willingness to add to their dollar holdings then – there likely would have been a dollar crisis. A fall in inflows would have forced the US to adjust well before September 2008… Last week felt a more like the fourth quarter of 2007 than the fourth quarter of 2008. For whatever reason — an end to deleveraging and a rise in the world’s appetite for emerging market risk or concern that the Fed’s desire to avoid deflation would, in the context of a large fiscal deficit, would lead to a rise in inflation and future dollar weakness – demand for US assets fell. In some sense, the dollar’s fall shouldn’t be a surprise. Low interest rates typically help to stimulate an economy is by bringing the value of the currency down and thus helping exports. 

 

 

Thawing Dollars

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There is some evidence that international financial markets are thawing.

– The "Ted Spread" (the difference between interest rates on interbank loans and U.S. goverment debt) is declining. The financial crisis had driven up the Ted Spread as investors cared most about the return of their investment and the panic induced a flight to quality. 

So much for the good news.

The 10% decline of the dollar in the past 5 weeks signals that carry trade is back again in full force since it weakens the target currency (in this case the dollar) when investors sell domestic currency to purchase foreign assets (The Fed also provides an assessment of carry trading). As recently as 6 months ago, carry trades unraveled at lightening speed (driving up the Ted Spread) as financial institutions were force to deleverage to meet their capital requirements. 

What is Deleveraging?

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Lets start with the definition of financial leverage,  which is simply a fancy expression that says you borrow funds against your existing assets to invest. Essentially you load up your company with debt because presumably you know a great way to make money and easily pay back the loan in years to come. So your proceeds from financial leverage better earn a greater rate of return than the cost of interest.

Leverage allows greater potential returns to the investor because it allows for an increase in the size of the investment. On the other hand, the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.

Deleveraging is then simply the reduction of debt, in the context of the crisis, it is associated with rapid repayment of existing deb. Of course that implies that banks can no longer use these funds to make new loans… Here are example of the leverage ratios (assets/capital).

 

 hatziusetal1.jpg

From David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin  

The End Of Free Fall – Now What?

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 "The economy appeared to be in free fall, much like a ball rolling off the side of a table,in October. Today, no one will describe the economy in that way" Larry Summers 4/9/09 (President Obama's Top Economic Advisor).

At first sight, the quote does seem to instill hope. Here are a couple of thoughts:

1) do we know (or care) how far the ball dropped?

2) Is it time to celebrate — or do we care how the ball gets back up onto the table?

Today there are some answers: Floyd Norris reports that, as of May 21, 2009, it is now official: the US has entered the worst recessionin five decades (this is how as long as we happen to have data).

Jeff Frankel notes that, as of April 29, 2009, the current recession is also tied for the longest recession since the great depression.  On the other hand, another economic measure (the index of leading indicators) reversed its downward trend for the first time in about a year. Time to pop the champagne?

Not so fast: Barry Eichengreen and Kevin H. O’Rourke document that even during the great depression, the ride was never monotonically down hill. Their report (especially their figure/discussion on global tradeflows) is well worth reading.

Paul Krugman explains lucidly why the news that we may havehit bottom is probably only an "inventory bounce." That not the type of data we associate with "getting the ball back up onto the table."

Export Contagion

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Stunning: has any industrialized country ever experienced income reductions of -14% and -15% (annualized) in successive quarters?

But now the good news (from Bloomberg): The consensus forecast had been a 16% reduction in Japanese income… This gives a whole new meaning to the Brad Sester's comment that the US is exporting the crisis by not importing. Below is a picture from GCaptain's blog. Of course, all this is captured succinctly by the Baltic Dry Index that shows the collapse of shipping as the price for container capacity has tanked in the face of huge excess capacity. A wonderful application of the locomotive effect discussed in Chapter 15. It is an interesting exercise to work through Figure 15.9, how a drop in imports hurts the rest of the world.  

 

Deja Vu All Over Again.

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The great depression brought us the American Smoot-Hawley Tariff Act (enacted June 17, 1930). Most nations reciprocated and imposed their own trade restrictions, raised existing ones, or set quotas on foreign imports. The effect of these measures was to greatly reduce the volume of international trade: by 1932 the total value of world trade had fallen by more than half. Try the simplest open economy trade model you can write down (see chapter 14) to see if you can reproduce the effects and identify the effect on output…

The Stimulus Package (aka “the American Recovery and Reinvestment Act” passed on Tuesday February 17, 2009) has a whole new set of “Buy American” expenditure switching provisions (chapter 15)…

Stressed but Healthy?

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Only yesterday did the Fed announce that the 19 major banks are basically ok. Well, half of them have to raise capital, but they won’t be allowed to fail, and with the stroke of some accounting trick (converting preferred stock to common stock) the top 20 banks would be not-so-stressed.  

Bad timing. Today's labor report shows that over 500,000jobs were lost in April. This raises the unemployment rate to 8.9% from 8.4%,and there are no signs that future months will generate significantly smaller job losses. Here is the issue: 8.9% was already the worst case scenario assumed by the "Stress Test" administered by the Fed to the Banks. The FED guidelines are in Table 1 

Table 1: Economic Scenarios: Baseline and More Adverse Alternatives

    

  

2009   

  

2010   

Real  GDP  1)  

Average  Baseline2) 

‐2.0  

2.1    

     Consensus  Forecasts   

‐2.1  

2.0    

     Blue  Chip   

‐1.9  

2.1    

     Survey  of  Professional  Forecasters  

‐2.0  

2.2    

Alternative  More  Adverse   

‐3.3  

0.5    

Civilian  unemployment  rate3)

Average  Baseline2)

8.4    

8.8    

    Consensus  Forecasts   

8.4    

9.0    

    Blue  Chip   

8.3    

8.7    

    Survey  of  Professional  Forecasters  

8.4    

8.8    

Alternative  More  Adverse   

8.9    

10.3    

House  prices4)

Baseline   

‐14  

‐4  

Alternative  More  Adverse    

‐22  

‐7  

 Notes: 1)  Percent  change  in  annual  average.   2) Baseline  forecasts  for  real  GDP and  the  unemployment  rate  equal  the average  of  projections  released  by  Consensus Forecasts,  Blue  Chip,  and  Survey  of Professional  Forecasters  in  February.   3) Annual  average.   4) Case‐Shiller  10‐City  Composite,  percent  change,  fourth quarter  of  the  previous  year  to fourth  quarter  of  the  year  indicated.  

 It is a bit worrysome that practitioners, who are required to do do stress tests on a regular basis, judge the whole exercise was more like a spa treatment than a workout.