Financial repression German style

Last weekend I attended the American Economic Association meetings in Chicago where I had been asked to discuss a paper on historical lessons lessons on government debt reduction. The paper is written by Carmen Reinhart and Belén Sbrancia and the title is "The Liquidation of Government Debt". The paper presents a historical review of episodes where governments paid interest rates on their debt below market rates. This reduction in financial expenses can be seen as a source of revenue that can keep the debt under control or reduce it.

The paper focuses on periods where real interest rates on government debt were negative which were common in the pre-1980 period. Here is a chart from their paper

They refer to the pre-1980 period as the era of "financial repression" because on average real interest rates were negative driven by the behavior during the 1945-1955 period and the early 70s. Financial repression comes from two sources: financial market regulation (e.g. ceilings on interest rates, legal conditions that favor government debt holdings by institutional investors) and surprises in inflation. The early years of the sample are characterized by capital controls and strong regulations on interest rates. The real negative interest rates of the early 70's are more driven by inflation being higher than expectations  (although controls on capital flows and distortions on interest rates were also present).

A quick calculation shows the importance of this channel during the 1945-1980 period. For example, for the US and UK economies, negative real interest rates allowed a reduction of government debt equivalent to about 2-3% of GDP per year. This is a large amount compared to their ratios of taxes to GDP (this amounts to 14% of the average tax revenues for the US during these years). What this suggests is that the reduction in government debt that advanced economies witnessed in the post-second world war period was partly driven by unusually low (even negative) real interest rates.

The authors argue that we might see something similar going forward. A combination of financial repression (regulation, moral suasion) and inflation could produce negative real interest rates.

Today, the German government issued for the first time debt with a negative (nominal!) yield. This is not financial repression as the authors of the paper describe it. It is more about risk aversion, flight to quality and a reaction of what is happening in other Euro countries, but it has the same effect on the German government. It finances its debt at negative real interest rate (this is one of the benefits of the Euro for the German economy...). Same is true for the US government where over the last years nominal yields have been close to zero while inflation remained positive. Of course, not all governments (Greece, Italy or Spain) are as lucky and can benefit from fear and perceptions of risk, their real interest rates remain positive and high.

Antonio Fatás

Learning from 2011, hoping for a better 2012.

Here is a summary of two very interesting articles that look back at the economic developments in 2011, what we have learned and what to look forward in 2012.

Charles Wyplosz looks at the Eurozone crisis and how it deepened during the second half of 2011. He asks the question of why governments, the European Commission and the ECB do not seem to learn from their mistakes. He suggests several hypothesis:

1. ignorance and lack of understanding
2. the obsession of the French President and the German Chancellor to find a political solution
3. the "quasi-religious" beliefs at the ECB on economic policy options
4. the crisis as a strategic option chosen by the ECB and some countries to teach a lesson to those who misbehave

Number 4 is what Charles Wyplosz calls the "kind interpretation" of the crisis. I am afraid that the other explanations matter as well. Lack of understanding of the economics behind the crisis. an obsession with certain standard recipes (austerity and confidence) as well as the belief that it is all about politics were behind the lack of a proper response to the events in the second half of the year.

Olivier Blanchard, Economic Counsellor at the IMF, summarizes four lessons ("hard truths") from 2011. The article not only provides some great insights about the year but it also offers a very honest and fresh view on some of the hard lessons that policy makers and academics have learned. He stresses something that rarely gets attention in academic research: the importance of multiple equilibria and self-fulfilling crises of confidence. Quoting from the article:

Multiple equilibria are not new. We have known for a long time about self-fulfilling bank runs; this is why deposit insurance was created... And we learned early on in the crisis that wholesale funding could have the same effects, and that runs could affect banks and non-banks alike. This is what led central banks to provide liquidity to a much larger set of financial institutions.

What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. 

Right or wrong, conceptual frames change with events. And once they have changed, there is no going back. For example, nothing much happened in Italy over the summer. But, once Italy was perceived as at risk, this perception did not go away. And perceptions matter: once the “real money’’ investors have left a market, they do not come back overnight.
A further example: not much happened to change the economic situation in the Euro zone in the second half of the year. But once markets and commentators started to mention the possible breakup of Euro, the perception remained and it also will not easily go away.  Many financial investors are busy constructing strategies in case it happens.

Perceptions matter and, what it worse, once they are formed, it is hard to influenced them.

Olivier Blanchard also discusses what he calls the "schizophrenic" reaction of financial markets towards fiscal policy. In his words:

They (financial markets) react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds.  To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.

This was one of the most interesting developments during the second half of 2011. The notion that austerity was going to help governments address their imbalances lost support during the sumer (because of the evidence) and led to a situation where governments had no good options. If they promised a quick adjustment they would be penalized for the negative growth consequences that they would cause; but if they did not adjust they would be penalized because of their lack of discipline.

So now it is time to digest all the 2011 lessons and have a better 2012. As Olivier Blanchard says in his last comment "The alternative is just too unattractive".

Antonio Fatás

Debt does not matter. Spending and taxes do.

Paul Krugman makes the point that government debt matters less than most people think because in some cases we simply owe money to ourselves. He is right and what he has in mind is the notion that government debt is (in many countries) mostly held domestically. Japan is an extreme case where more than 90% of the government debt is held by its nationals but even in the US the majority of government debt is held by US citizens or institutions. For some it is debt but for others it is an asset, they cancel out from a national point of view.

We can think of an extreme case where government bonds are held by all taxpayers in proportion to their income - in a way that mimics tax rates. In that case, government debt is not imposing a future burden on anyone, it simply cancels out with the assets that all investors/taxpayers have.

How do future generations enter into this analysis? What if we try to pass the bill to future generations? Let's start with the case of a closed economy/system. In a closed system (the world, no international trade or capital flows) the debt that the current generation has will end up in the hands of the future generation in one of two ways: either it gets simply passed to the next generation as a bequest or, alternatively, the current generation could try to sell their assets and spend all their wealth if they do not want to leave a bequest to their children. But the debt must be bought by someone. And given that this is a closed economy, it can only be bought by the future generations. In both cases the bond holders are also the taxpayers.

If we bring other countries into the picture then the analysis is different. The government debt that other countries hold is a claim on our current and future income and as such it is a financial burden that either the current generation or the future one will have to pay for. But Krugman's point, which is correct, is that many make the mistake of assuming that government debt is equivalent to external debt and they overestimate the burden that it imposes on a country.

Let's go back to the case of a closed economy: is it really true that debt does not matter? Not quite, because there are distributional issues of two types: first there is no perfect match between bond holders and taxpayers so it is not quite true that we owe money to ourselves. Some citizens owe money to others. The second distributional issue is about generations and here we need to go back to the example above to understand how difficult the analysis can get. The best way to understand the argument is to stop talking about debt and talk about spending and taxes, which is what really matters. A government spends some income today (builds a road, provides health services to the population). It decides not to tax anyone but instead it issues debt bought by the current generation. The government decides that it will only pay back the debt in the future when it raise taxes on the next generation, not the current one. Are we passing a burden to the next generation? It all depends on what the current generation does. If they decide to spend all their income and leave no bequests for their children then the answer is a clear yes. The current generation enjoyed services that they did not pay for themselves and did not compensate the next generation in any way for the future taxes they will have to pay. Just to be clear, the future generation will be holding the debt that the previous generation sold to them when they were spending their inheritance, but this is not a transfer of resources, the asset was sold at market price. So the fact that in the future bondholders are also the taxpayers does not mean that we are not passing a burden to the next generation.

There is a second scenario where there is no burden passed to the next generation. It can be that the current generation is responsible, understands that the government is asking future generations to pay for the goods and services that they enjoyed and they decide to leave a larger-than-planned bequest to their children so that they have resources to pay for all the taxes (you can think about the bequest being the government debt itself). In this case no burden is passed to the next generation.

This simple example (*) makes it clear that answering the question of what distributional impact government debt has across generations requires an understanding of the patterns of spending, taxes and saving of different generations. What matters is not debt but who enjoys the spending that the government does and who pays for it. Debt is just a vehicle that can be used to transfer resources across different individuals or generations. Debt is not a problem, the problem, from a generational point of view, is the potential mismatch between spending and taxes (even if future taxpayers are also the holders of government bonds when they are paid back).

Antonio Fatás


(*) The example ignores many issues: the type of goods government buy, the possibility of default, the possibility of crowding out (government bonds displacing other forms of saving),...

Running out of words?

The Euro crisis is stretching for such a long period of time that it is difficult to know what is news and what is not. Yields go up and then they go down. The ECB is buying bonds or maybe they are not.

Today there was yet another auction of Spanish government bonds and CNBC must have run out of words to describe what happened. See below the description of the news as it appeared on their web site (should we interpret the fact that there was no second paragraph planned as good news?)

Antonio Fatás

The discipline of Financial Markets

John Kay writes an interesting article on the FT today about the limited effect of fiscal rules on fiscal discipline. This is related to out last blog entry and I agree with most of his arguments although I am less pessimistic, there are some fiscal rules that work better than others. What I found surprising is one of the last sentences in his article (a sentence that was highlighted in the title of the article):

Financial markets are an effective discipline on profligate individuals and states because markets cannot easily be bullied or lobbied, and their threat to make the cost of funds prohibitive is effective. 

Financial markets are NOT effective when it comes to providing discipline to governments. Yes, occassionally they do bring governments down and they push governments that misbehave towards default, but they do so in the last minute. They are completely absent in the years where discipline could really matter, when things go well and governments should work hard at generating a large surplus. This is the experience of European countries since the launch of the Euro when all governments were seen as identical and their bonds were priced as risk-free assets. Where was the discipline of financial markets then?

Antonio Fatás

The European Instability and Stagnation Pact

There is a story in the movie "The Inside Job" about a paper that Fred Mishkin (a Professor at Columbia University and former member of the Board of Governors of the US Federal Reserve) had written on the Icelandic banking system before the crisis. The original title of the paper was "Financial Stability in Iceland" but the paper appeared in his CV as "Financial Instability in Iceland" after the crisis had taken place (and after the movie was released the title was changed back to the original one -- here is a clip of the interview). This clip made me think of the European Stability and Growth Pact that seems to be delivering exactly the opposite of what the name of the title suggests: Instability and lack of growth.

European countries agreed to limit their government deficits and government debt (to 3% and 60% respectively) as part of the Maastricht Treaty that led to the creation of the Euro. The limits were not strictly enforced when the membership decision was made. Some countries (Belgium or Italy) were allowed to be members of EMU with debt levels that were double the established limit (the way this worked was through a loose interpretation of a footnote in the Treaty that allowed countries to be accepted even if their debt was above 60% if the level was close to 60% and there was enough progress in the prior years -- how is 120% close to 60%???).

The constraints on fiscal policy were made more explicit through the Stability and Growth Pact that took the numerical limits one step further and developed a set of more specific interpretations of the limits as well as a process to deal with deviations from the rule. The Pact was a failure with many countries (including Germany) going above the deficit and debt limits. The rules were then rewritten once and just las weekend, during the European summit, there has been a proposal to rewrite them once again. This is what some have referred to as a proposal to create a fiscal union, which is clearly not the case. The proposal is simply about changing the enforcement rules of the Pact.

Academics have written extensively on how the Stability and Growth Pact was poorly designed and could not work (my own work can be found here, here or here. The criticisms can be summarized by the following three points:
- simple numerical limits are "too simple" to deal with fiscal policy. Applying the same rules to every country and every year makes no sense. And the moment you open the door for exceptions then the rules lose their meaning.
- enforcement of the Stability and Growth Pact does not work because the enforcers is the same group as the sinners. The ones imposing fines are the ones who pay for them and collect them. As it has been the case before when many countries are above the limit, fines should be paid by all and collected by all. There is no real sanction here.
- but even if fines are applied, what would happen to a country in trouble (Italy today) if the other European countries imposed a fine on the Italian government? That their deficit would be even larger and it would simply make things worse.

The decision over the weekend was to improve the enforcement of the Stability and Growth Pact and it tries to address the second issue while it ignores the other two. What is worst is that it might not even addressed that issue. The proposal (to be approved) makes the fines automatic. They can only be overturned if a qualified majority of countries agree to it. This is a marginal change that is unlikely to work if many (more so the large) countries are the ones violating the rules. And the proposal ignores the fundamental problems of the Pact.

What is more concerning is that there is still no clarity on the goals of the Pact. The Pact and more so its implementation has always mixed goals such as sustainability with other goals such as coordination of fiscal policy and growth-oriented reforms. But there is no clarity on how these things mix together, and some times they do not. Long-term sustainability is a valid goal, more so given what we are seeing these days. But this does not imply that all countries should have the same fiscal policy all the time. In fact, we want fiscal policy in the short run to be different across countries. Coordination of fiscal policy (understood as one policy stance for all all the time) makes no sense in a monetary union.

And here is where we are today: starting with the concern about long-term sustainability we conclude that short-term austerity is the right policy for all European countries. But imposing coordination combined with a short-term focus on what should be a long-term goal will not deliver stability or growth. It will lead to stagnation in the region and instability in some countries as fiscal policy is not allowed to play a proper countercyclical role.

Antonio Fatás

What can the ECB do?

It seems that many economists agree that the ECB has to get more involved in dealing with the current crisis in the Euro area. Politicians (at least some of them) disagree. They cite fear of inflation, take moral stance on past recklessness, argue that sinners have to repent and repay, etc. By now, hundreds of articles have been written on the potential damages from the collapse of the euro area, so I am not going to repeat them here. I want to focus on what the ECB can do to stop the self-fulfilling collapse of several European economies.

The standard view on ECB is that they have to print money in order to buy bonds of governments in trouble like Greece, Italy, Portugal, etc. But there is another thing that they can do. About 18 months ago, the chief economist of Citigroup, Willem Buiter, wrote an article in which he noted that the ECB can use its future profits to stop the acceleration of these negative dynamics on the bonds market. According to his estimates, the ECB has a “non-inflationary loss absorption capacity of … at least €2.4trn and more likely over €3.4trn.” In other words, the ECB can put credibly on the market a firewall of over €2.4 trillion. Certainly this ought to stop the ever-increasing yields on Spanish and Italian debt from rising further.

How does this work? Central banks run very profitable operations – they issue pieces of paper that we call money on which they pay us no interest. With the printed money they buy interest-bearing securities like government bonds. Because of the interest rate differential between the 0% rate on currency and the yield on bonds, central banks generate profits every year. Well, the actual calculation of the profit (seigniorage) is a bit more complicated (see Buiter’s article), but the mechanics are not changed much. This profit is generated even if inflation is 2% (ECB’s mandate).

One way to imagine Buiter’s proposal is the following: Suppose that the ECB issues bonds worth €2.4 trillion (note that they do NOT print money equal to €2.4 trillion). These bonds would most likely have a yield close to the yield on German bonds (2.6% for 30-year bonds) because one can expect that if the euro is alive, the ECB will be mechanically generating this revenue from their activities. After issuing these bonds, the ECB can make an announcement that for countries which are solvent when the yield is 5%, they will not allow these yields to go above 5% (one can adjust the numbers for the state of the cycle, but the idea is that they restrict the yields from increasing due to the lack of confidence). If yields are above 5%, they buy the bonds with the revenue generated through their own issue. If this announcement happens, and if the ECB just starts with some symbolic purchases, yields will go down quite rapidly and yields on Italian debt for example will return to sustainable levels.

Notice that if the ECB has to buy the bonds, then they will be generating yet another profit stream from the difference between their 30-year bond (at 2.6%) and the Italian yield (currently at 6.5%). But even if Italy fails and does not repay the bonds bought by the ECB, the ECB can fully absorb the loss. This is why Buiter calls this quantity the “non-inflationary loss-absorbing capacity” of the ECB.

Is there any magic or a free lunch here? Not really. The seigniorage of central banks has to be transferred by law to the governments of the euro zone. So, effectively what the ECB does is that it takes future government revenues and puts them today to create a firewall. They can commit to having this revenue in the future because of the nature of their operations. Governments – even though they are the eventual recipients of this flow – cannot commit today because the markets do not trust them anymore. The essential role played by the ECB in this case is to put the certain revenue stream on the table and to tell the markets – this future revenues will be used to absorb losses or to repay debt and not for other spending. It is quite likely that they will never have to buy even one government bond out of this facility.

Will the ECB do it? I am somewhat skeptical. It does require a bit of resolve to go beyond the standard thinking.

Ilian Mihov

P.S. On November 16, 2011 Willem Buiter also gave an interview on Bloomberg TV where he talks again about this proposal.