Sense on deficits & deleveraging: Koo & Varoufakis
on July 4th, 2011 at 12:43 am
My focus is and will remain on explaining how the crisis came about, but in the middle of the crisis, government policies have the potential to either lessen the crisis or make it more extreme. Two of the best commentators on sensible policies to lessen the crisis are Yanis Varoufakis and Richard Koo.
Yanis (together with Stuart Holland) has authored the “Modest Proposal” to overcome the European crisis (the latest version is here in PDF: “The Modest Proposal“). Richard Koo recounts the Japanese experience with the bursting of its Bubble Economy and the many policy twists and turns afterwards in the Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession.
Richard argues this case with the empirical data provided by the unfortunate experiment that Japan has run in macroeconomics since its Bubble Economy burst back in 1990. Richard gave a keynote presentation at the Central Bank of Argentina conference last week, which I have posted on YouTube and reproduce below.
Both Yanis and Richard argue that government austerity at a time when the private sector is in a debt crisis is counterproductive. If the private sector is reducing its expenditure by deleveraging, then the same behavior by a government intent on “balancing the budget” will amplify the depressing impact of reduced private expenditure, thus deepening the crisis. Unfortunately this is precisely what the EU proposals for the PIGS are likely to do. Richard’s historically based analysis predicts that these austerity measures will deepen the crisis, and quite possibly result in increased rather than reduced government deficits, on the experience of Japan.
Yanis’s alternative Modest Proposal is to effectively have the European Central Bank behave as a true Central Bank. At present the ECB acts more like a financial disciplinarian than a Central Bank, since the only debt it directly funds is that of the EU itself–which is at the trivial level of about 1% of European GDP–while it imposes strict standards on how much public debt member states can carry on their own books (no more than 60% of their GDP) and how fast that debt can grow (budget deficits cannot exceed 3% of GDP). Member states are responsible for issuing and financing any debt they issue themselves.
In practice, these standards have been imposed very laxly, but in the current crisis they are being imposed with a vengeance on the PIGS, with Greece the country most in the firing line right now. Since it is almost universally acknowledged that Greece can’t meet these terms, the cost of Greek debt has blown out dramatically–further guaranteeing that it will fail to meet the conditions of the EU “bailout”–which of course is a means of paying Greek’s creditors, rather than Greece itself.
This is very different to the situation in the USA. If the European situation were imposed on the US, then each State in the USA would have to issue and fund its own debt for any budget deficit greater than 3% of GDP: there would be Californian bonds, Florida bonds, etc. You can imagine what the ratings agencies would do to those bonds, which would in turn guarantee that California and Florida would go bankrupt. Though the US States are in a parlous position, they are not formally bankrupt, while the US Federal Government is able to raise debt finance for itself and its States at near zero rates.
Yanis’s proposal is for the ECB to adopt the debt of its member states up to the 60% ceiling allowed by the Maastricht Treaty, and then to issue bonds to finance this debt which would then be serviced by the relevant member states. On the precedent of the US itself, this would result in highly rated bonds that would need very low interest rates, resulting in servicing costs that could be met by the PIGS–even by Greece (Greece would need special further arrangements since its public debt, when the last version of the Modest Proposal was published, was 87% of its GDP).
The Modest Proposal goes well beyond this single detail, and I suggest reading the full document since I don’t have the time to outline it in full here. It includes provisions to properly stress test the commercial banks that caused this crisis in the first place, to impose the pain of adjustment on the banks and their shareholders via equity transfers for any recapitalization needed to maintain solvency in the face of their toxic debts, and to finance infrastructure investment in Europe so that it can grow its way out of this crisis rather than deepening it by misplaced austerity.
Anyone who thinks that austerity is the way to go, on the basis of simplistic analogies to the situation of a household having to balance its budget or the like, should watch the presentation below by Richard Koo.
Mahaish,
Just because my point is consistent with NeoClassic thought does not make it wrong, anymore than being inconsistent with NeoClassic dogma makes it wrong. The only reason interest rates are low is because the demand for US Sovereign debt is higher than a unmanipulated free market value due to QE. Price discovery via fair and free market valuation is being intentionally perverted. I agree that if “enough” QE and market manipulaion is performed then the interest on Sovereign debt can be maintained at any level desired. This is NOT COST FREE however. This will clearly significantly increase the money supply, and that will result in a decrease in value. Additionally there is real cost in the misallocation of capital due to the resulting mispricing of risk resulting from the manipulation of the Sovereign debt risk pricing (interest).
So the choices are end interest rate level manipulation which will result in an increase in interest, or a continuation or QE which will result in currency collapse. Neither of these are good options.
…does this mean government now has to match that money (created out of nothing for no good purpose) with it’s own money creation (out of nothing for it’s own purposes)? Myopia
No. The government should simply take over the money creating and regulatory mechanism and abolish privately owned and operated usurious economic system.
There is no sane reason why governments should need to borrow money when they can create it by themselves.
Of course, no system can be ideal unless we have ideal people who operate it. But that doesn’t even have to be the goal. It makes more sense to create such a system which minimises the harm done by the people who run it.
The present system contains one certain evil (the bankers) and one uncertain evil (the government). It’s impossible to get rid of the government since even in a direct democracy there would be some kind of administrative body. Therefore, the only option that can be removed is the private banking part (including central banks, IMF, BIS, etc.).
While there is no guarantee of a paradise – there never is – at least there would be a chance of an improvement. On the other hand, there is no point repairing a system that cannot be repaired (current system).
An economy that is based on debt, demanding never ending growth – which is needed to offset both the principal and interest, creating a natural inflationary pressure and at the same time a bizarre attempt to limit it – has only one type of end waiting for it, the dead kind.
Steve, sorry to be pedantic but I don’t think it is, an additional ‘debt tax’ to quote the literature needs to be built in to cover the risk of default.
Investment isnt just a function of profits minus debt repayments
Its a function of profits – debt repayments*a factor based on debt as a proportion of total capitalised value.
The debt overhang effect is when debt levels are so high equity owners wont let firms lever any higher, even for profitable investments, as it increases the default value of firms.
See myers paper 1976 ‘Determinates of Corporate Borrowing’
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.139.4370&rep=rep1&type=pdf
@Mich
“Bailing out a criminalized bankster class.”
Really ? “Criminalized” ? These are fine members of our communities that you are talking about.
I am sure that if these people were seen as criminals by general public, then the general public would be up in arms and calling for them crimin’ls to be brought to trial.
“”Why do I see more and more “clever” economists showing fancy graphs to just ignore the underlying problem and “go from here”.”"
I assume that question is rhetorical ?
“The over leveraged and, according the time proved rules now discarded, insolvent institutions should go bankrupt.”
Could it possible be that the “system was a fraud” long before the “economic outburst” brought it to the attention of a few more people. (I mean if you go and ask anybody in the street about the “criminal” bankers they will likely not even have a clue what you are talking about and tend to walk away from you. They think nothing of going into a bank and enjoying all the “great offers” that they may take advantage of.
It is poignant to think then to at least pose the question “Who are the real criminals?”
Tell me have you ever seen Chris Martenson’s “Crash Course” video series ?
Thus…
The decision of what to do with all that confronts you is upto you.
p.s. I do understand “where you are coming from” – been there myself – still am “there” to some extent – but I have opened my lenses to see a “bigger picture”.
From a book I am reading…
“In my opinion, God always calls the shots in the end, but it’s our responsibility to change the things that are with our means. You can’t blame God or fate for personal laziness and lack of responsibility”.
I would add…
With freedom comes the need to be responsible. (Are “we” responsible?).
Read between the lines because even though something is true, not everything is allowed to appear on these blogs.
I hope what I have written helps but I appreciate that it may not have helped at all.
Fair point Andrew.
how is Federal US govt funding debt of US states at almost not cost. Fed specifically refuse to lend to states while discount window handing out nearly zero interest money to banks and corporations.
States also have to keep reserves, that are untouchable even in their biggest crises…maybe they would be allowed to be cracked open after nuclear armageddon but if LA can’t use reserves after Katrina, CA can’t use after implosion of most of their FIRE economy adn +15 percen UI, reserves are ridiculous. And so States have to borrow on open market and pay high interest while US big banks buy Treasuries with discount window loans.
States are not allowed to run deficits or have long term debt.
at Kadlck – agreed, to the anarchists and libertarians, I say, in a complex society, someone will always have power, our only option in my mind are will the power be in the hands of the people with checks or balances or will it be in the hands of an elite, a dictator, a military etc…if people don’t take power via some democratic goverment, then richest or most thuggish guy will.
Can a democratic govt be corrupted and the state then used as a tool of rich thugs, sure….but I say what works on a local level is true on global level. If the local cops are corrupt, is the solution to abolish your criminal justice system and rule of law and just arm all the private citizens and have them be vigilantes, evitably leading to some gang taking over. Or do you fire all the cops, put in new systems to keep force clean, try again with democratically controlled govt police? But if you give up on the idea of the people uniting, forming a union that has strength and power, then you have already lost to some small minority interest, some rich guy, some thug.
In the wild west, the town preyed on by criminals, always calls in a tough sherriff. If the sheriff becomes corrupt, do you say forget it, lets just let the “ornery boys” gang take over again? Of do you elect a new sheriff?
Thanks Steve, you might have a pciture of Oliver Blanchard you throw darts at but its really the same point he made earlier this year
‘The crisis made it clear that there are many distortions relevant for macroeconomics, many more than we thought earlier. We had ignored them, thinking they were the province of the micro-economist. As we integrate finance into macroeconomics, we’re discovering distortions within finance are macro-relevant.’
think you have answered your own question here attitude check,
and precisely the point
igbc argues that the markets control the yield curve,
some of us beg to differ, and argue the fed ultimately has the choke chain around the markets neck due to the in elastic nature of the demand for funds on the interbank lending market.
and besides its a discretionary policy option to issue treasury securities.
the government need not incure any debt at all , in a sovereign currency regime.
a government financial deficit unbacked by bond issuance, will end up as either reserves/deposits, currency in hand or treasury securities.
the increase in the deposit base and reserve position of a bank may theoretically provide greater lending opportunities for a bank, but it can do bugger all lending,
if there arent any customers worthy or willing enough to borrow.
the build up of base money , doesnt amount to a hill of beans in terms of the inflationary impact on the currency.
if the supporters of igbc were right the bond markets would have come to there senses a while back and imposed a hefty premium on government debt.
not a rate rise in sight as far as i can see.
and we are still waiting for a hyper inflationary currency collapse in places like japan and the US.
what do we have instead, a carry trade,
so much for the undesirability of the currency of these countries.
Mahaish,
“the government need not incur any debt at all , in a sovereign currency regime.”
Absolutely, that is what makes them a Sovereign
“a government financial deficit unbacked by bond issuance, will end up as either reserves/deposits, currency in hand or treasury securities.”
Yep, so let’s think about what happens to the currency created by unbacked debt that has been monetized. If the debt is being used to fund government budgets (it is), the the government spends it into the economy, which goes directly into the money supply, and the underlying debt is effectively erased. SOME of that money spent into the domestic economy will go into all three listed area’s, but you missed and important 4th area, Euro/Petro dollars/FX holdings. As long as a country is running a deficit, then it’s currency will end up in the exporting nations CB, which will have a very low velocity, but if this money isn’t borrowed back, the build-up of excess reserves will eventually drive the CBs top divest some of this currency, back into the international market, which will drive the FX value down. This scenario is exactly happening.
“the increase in the deposit base and reserve position of a bank may theoretically provide greater lending opportunities for a bank, but it can do bugger all lending,”
True, this hides the domestic inflationary effect, instead it enters through the back-door via FX weakness and commodity prices — exactly what we are seeing globally.
“if there arent any customers worthy or willing enough to borrow.”
There are few, but again this isn’t the primary channel this time.
“the build up of base money , doesn’t amount to a hill of beans in terms of the inflationary impact on the currency.”
Wrong, as described above you have to look at the global flows, not a myopic domestic focus in the new globalized economy
“if the supporters of igbc were right the bond markets would have come to there senses a while back and imposed a hefty premium on government debt.”
I’m not sure you read my post. The bond market price signals and discovery are broken due to the artificial bond demand from QE and other monetization effects. Although there is some leakage, seen in CDS spreads, and the walking wounded of Europe (Greece, Portugal, etc.)
There is no magical perpetual money machine. Eventually what we consume has to be produced. Issuance of unbacked credit is reasonable so long as this growth is equal to economic growth. The farther out of line this new “issueance” is, the more the loose money policy will result in anumber of bad outcomes
1. Minskian Ponzi speculatation
2. Inflation (either through the front door or the back door)
3. FX weakness (linked to 2)
4. Misalocation of Capital to non-productive efforts (see 1)
5. Increased economic volatility as described by Minsky
None of these are desirable.
Attitude_Check,
Let me reinterpret what you have written.
“As long as a country is running a deficit, then it’s currency will end up in the exporting nations CB, which will have a very low velocity, but if this money isn’t borrowed back, the build-up of excess reserves will eventually drive the CBs top divest some of this currency, back into the international market, which will drive the FX value down. This scenario is exactly happening.”
Perfectly right but this divesting is what could restore the negative feedback loop related to currency exchange rates and current account deficits, eventually stabilising the system (but after a commodity prices adjustment).
It should work like that in the global monetary system based on fiat floating currencies:
1. current account deficit of country X is rising against country Y
2. the exchange rate curr. X/ curr. Y is falling due to the supply/demand imbalance
3. foreign holders in Y spend their curr. X currency holdings (selling bonds and spending currency) to avoid losses what accelerates process from 2
4. products from X are becoming more competitive in Y
5. trade balance is restored and current account deficit reduced (of course prices of commodities in country X denominated in curr. X may rise what may or may not lead to cost-push inflation depending on the policy in country X)
Element 2 has been disabled by the surplus countries hoarding USD or AUD and all what deficit countries can do is to keep running budget deficits large enough to compensate for the gap, knowing that the overstretched rubber band must snap one day. So what? It will snap anyway! The more it is overstretched the stronger it will snap.
Another solution probably more damaging to the domestic economies in both X and Y is to reintroduce protectionism.
One of the factors affecting the scale of the recession in the US is the imbalance in their foreign trade not offset by a big enough government deficit. The surplus countries are perfectly happy to sacrifice the real value of goods exported to deficit countries because this seems to be a neat way of cranking up their economic growth by stimulating investment – this seems to be counter-intuitive but it works perfectly well in the current global system.
Defending strong AUD, USD (or Euro) because of the non-existing threat of an inflationary spiral is an act of economic sabotage in the context of policies of developing countries running surpluses. It is an assisted economic suicide committed by the West.
It is often stated that higher oil prices in the US will inevitably lead to a recession. I disagree. The recession can be stopped on its tracks by the government if they ditch their obsession with reducing budget deficits – provided that the economy still has real capacities. It is persisting with the status quo with the distorted commodity and energy pricing structure where oil is artificially cheap what traps the American economy in the ruts of the 20th century energy inefficient development model. That growth opportunity has died out long time ago. Now it’s time to make hybrid or electric cars, nuclear reactors, renewable energy sources, fast railways, etc. The Chinese are doing all of these. The Americans “have run out of money” because they don’t want to dilute the value of the financial assets in the dysfunctional finance sector – the brain cancer killing the West.
Wrong! They should spend 5% or 10% of the GDP on building the new infrastructure. The only way to kill the parasitic finance sector is to take away their monopoly – just print fiat money instead of borrowing credit money from the banks and other houses of usury.
Currently we are entering the post-oil phase. How ready are we to buy petrol for 5 or 10 dollars per litre? So we should allow the market forces to do their job now even if this might be painful to the quality of living in the short term rather than wake up in 10 or 20 years time without any real productive capacities, when everything is made in China, India or Mexico and when the Russians and the Saudis tell the West to go away with the worthless “reserve” currency we have worshipped for so long because it is not backed by any real products made in the US.
That collapse of the value of American currency will be the final one and Australia will be just a semi-colony with the economy reduced to mining and some agriculture, operated remotely by the new masters:
http://www.smh.com.au/business/china-nervous-over-mining-tax-20110706-1h2fn.html
They know perfectly well what’s our place in the new global pecking order.
“As long as a country is running a deficit, then it’s currency will end up in the exporting nations CB, which will have a very low velocity, but if this money isn’t borrowed back, the build-up of excess reserves will eventually drive the CBs top divest some of this currency, back into the international market, which will drive the FX value down. This scenario is exactly happening.”
yes back into dollar denominated assetts
as long as the US runs a trade deficit with the rest of the world , there will be demand for dollar denominated assetts , given the reserve currency status of the dollar.
and besides , thats what the yanks are trying to do, weaken the dollar, but thats a long way off from a hyper inflationary scenario.
and i dont see anyone around the world putiing there hands up to run a surplus against the yanks.
the long term value of the dollar is underpinned by this process.
secondly the assumption that bond issuance can soak up liquidity and nulify the inflationary impact, is a false dichotomy in my view,
since treasury securities are only marginally less lquid than the currency itself, and can be easlly converted back into the currency itself, not withstanding the leveraging power of such assetts.
have more to say about the second half of your post , will have to do tonight.
Attitude_Check July 8, 2011 at 2:25 am
You certainly make more sense than a lot of theoretical nonsense asserted here, unsupported by any empirical evidence. Do we at least agree that despite the global reserve currency status of the US dollar, it is the FX weakness you referred to. Below is a 25 year chart of the US Dollar Index (DX), where it recently peaked at around 120 (in 2002) at the start of Greenspan’s low interest rate policy era. After nearly 10 years of the current policy, DX is at 75, about 38 percent decline, in spite of competitive currency devaluations by other countries.
hey lyonwiss,
yes i was waiting for someone to drag out this chart
lets see where the next long term cyclical run for the dollar ends up.
especailly given the mess in europe
the fx position will be dragged kicking and screaming back to fundamentals.
fundamentals are,
internal value of the currency determines the external value,
despite current fx position.
fx position will ultimately bow to the investment capital flow position,
right now the internal economy is weak and the trade balance is around 33% down on the high water mark of 2006, so less demand for dollar denominated assetts, so currency is weak,
and yes there is a danger if congressional and admin stupidity
leads to prolonged periods less than satisfactory agregate demand, we may see the currency get weaker,
when we have europe in termoil, a yuan without a legal system to back it,
when people talk about the dollars demise, should always ask as oppossed to what.
lets see where we are in 3 to 5 years time shall we.
I have been a long time follower of this site. While a thorough understanding of the mechanics of the current local and global economic/financial systems is in my opinion absolutely critical to our future, I just had to say “bravo” to those who also recognize that absolute fault here for what we face is rooted firmly in human behavior.
There certainly is no utopia. There is no “perfect” system. The same for systems of governance as for systems of credit.
What is happening now is a system(s) failure created by unchecked human vices – not just at the banker/finance level – but across the board.
Searching for solutions within the context of the current systems is futile – as the macro-level mathematics dictate/demand unsustainable growth. The current credit system was designed for capture and paradoxically finite.
The greater criminals herein are those who know this and willingly continue to rape and pillage the underclasses regardless of the underclasses desire to also “game the system” rather than honor productive work and care for others.
In my opinion, the predictability of human nature – and patent disregard over long enough periods of time for history – leads to inevitable cycles. Without at all intending to bring EWT or M.Armstrong terms to directly to bear on this… it does appear we at the apex of supercycle… this time a convergence of fiat/usury system failure, peak oil, peak global population, etc.
I doubt anyone is really going to like doing what is necessary to create a soft landing. There are some who are willing. But the majority are not for various reasons including dependency. Most importantly, it is system capture that will dictate we experience a hard landing. Thus, the exploration of the mechanics of the current system(s) is more likely to be post mortem at some point.
Keep up the fantastic work Steve!
Mahaish,
I would not go as far as to say a hyper-inflationary move in the USD is a long way off.
The fundamental differences between Japan and the US are quite striking – and dynamics of the situation are now global.
Also, a hyper-inflationary event is not entirely a monetary event. While we tend to think of it in terms of the relevant currency, it is in fact a self-reinforcing loss of confidence event (or lack thereof). A chain reaction, much like a deflationary feedback loop – which is precisely what is created by austerity measures.
Given the worldwide trouble, I agree that alternatives to the USD are weak. Thus, reserve currency status is not at immediate risk from any one potential alternative currency.
But, it is the reserve currency status that allows the US to readily export inflation. The more this process continues, the greater the risk that an alternative will be necessary in order to avoid overheating of foreign economies. The carry trade only continues as long there is sufficient yield of course. These are harbingers of war and economic collapse unfortunately.
I agree that we can likely see the current dislocations, bubble, malinvestments, carry trades, etc. continuing for quite some time – but am cautious of events unforeseen that have the potential to alter perception towards the USD.
Richard Koo at least in the initial part of his presentation makes the case that as asset prices built in the bubble come back debt is retired which contracts the economy because the money is “stuck” in the banking system.
How do we get that stuck money out of the banking system and into productive investment?”
Lyonwiss,
Yes that represents the FX weakness, but only poorly. Remember the currencies in the USDX have also been generally weakening during the time period. The more tangible measure of FX weakness is $-based commodity prices. Of course those prices are also effected by supply/demand dynamics which complicates simple analysis and regression.
The US Fed actually has a broad $ index http://www.federalreserve.gov/releases/h10/summary/indexbc_m.txt this shows the effect of FX weakness even more clearly and unambiguously.
Mahaish you have FX evaluation fundamentals exactly backward. Its is supply and demand – pure and simple. Increasing supply will not result in increased demand.
Steve hi.
Richard Koo has an agenda as every banker/politician out there. He is only looking at half of the picture. How did we get here in first place? Where did the fiscal stimulus in 2008/2009 go to? Why gov officials are always more aggressive taking expansionary measures than contractive? Why are they incapable of acting before and not when it is too late??? Why is Koo only looking at fows data and not other variables?!?!?!?!?!?????!!!!
US, Japanese & European governments have been taking incorrect choices for years. There is no simple soft landing now. For soft problems you can have soft landings. For severe global banking and soverreign crisis there are no easy choices as Koo wants us to believe.
If japan took the correct path, why are they changing one prime minister every year for the past 5? They got it completely wrong, as Koo, as politicians, etc.
I am from Argentina and believe me, Gov. and central bankers have the fault for every crisis we have over here. They might have been really happy listening to Richard Koo as they love applying all this fiscal recipes (even when they are not necessary).
great blog!