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Daniel LacalleDespite Massive QE And Congress Bill, The US Dollar Shortage Intensifiesobject(stdClass)#13833 (59) { ["id"]=> string(4) "5795" ["title"]=> string(72) "Despite Massive QE And Congress Bill, The US Dollar Shortage Intensifies" ["alias"]=> string(71) "despite-massive-qe-and-congress-bill-the-us-dollar-shortage-intensifies" ["introtext"]=> string(187) "How can the Fed launch an “unlimited” monetary stimulus with congress approving a $2 trillion package and the dollar index remain strong?
" ["fulltext"]=> string(9201) "The answer lies in the rising global dollar shortage, and should be a lesson for monetary alchemists around the world.
The $2 trillion stimulus package agreed by Congress is around 10% of GDP and, if we include the Fed borrowing facilities for working capital, it means $6 trillion in liquidity for consumers and firms over the next nine months.
The stimulus package approved by Congress is made up of the next key items: Permanent fiscal transfers to households and firms of almost $5 trillion. Individuals will receive a $1,200 cash payment ($300 billion in total). The loans for small businesses, which become grants if jobs are maintained ($367 billion). Increase in unemployment insurance payments which now cover 100% of lost wages for four months ($200 billion). $100 billion for the healthcare system, as well as $150bn for state and local governments. The remainder of the package comes from temporary liquidity support to households and firms, including tax delays and waivers. Finally, the use of the Treasury’s Exchange Stabilization Fund for $500bn of loans for non-financial firms.
To this, we must add the massive quantitative easing program announced by the Fed.
First, we must understand that the word “unlimited” is only a communication tool. It is not unlimited. It is limited by the confidence and demand of US dollars.
I have had the pleasure of working with several members of the Federal Reserve, and the truth is that it is not unlimited. But they know that communication matters.
FED BALANCE SHEET 25TH MARCH 2020
The Federal Reserve has identified the Achilles heel of the world economy: the enormous global shortage of dollars. The global dollar shortage is estimated to be $ 13 trillion now, if we deduct dollar-based liabilities from money supply including reserves.
How did we reach such a dollar shortage? In the past 20 years, dollar-denominated debt in emerging and developed economies, led by China, has exploded. The reason is simple, domestic and international investors do not accept local currency risk in large quantities knowing that, in an event like what we are currently experiencing, many countries will decide to make huge devaluations and destroy their bondholders.
According to the Bank of International Settlements, the outstanding amount of dollar-denominated bonds issued by emerging and European countries in addition to China has doubled from $30 to $60 trillion between 2008 and 2019. Those countries now face more than $2 trillion of dollar-denominated maturities in the next two years and, in addition, the fall in exports, GDP and the price of commodities has generated a massive hole in dollar revenues for most economies.
If we take the US dollar reserves of the most indebted countries and deduct the outstanding liabilities with the estimated foreign exchange revenues in this crisis. The global dollar shortage may rise from 13 trillions of dollars in March 2020 to $ 20 trillion in December and that is if we do not estimate a lasting global recession.
China maintains $3 trillion of reserves and is one of the best-prepared countries, but still, those total reserves cover around 60% of existing commitments. If export revenues collapse, dollar scarcity increases. In 2019, Chinese issuers increased their dollar-denominated debt by $ 200 billion as exports slowed.
Gold reserves are not enough. If we look at the main economies’ gold reserves, they account for less than 2% of money supply. Russia has the largest gold reserves vs money supply. China’s gold reserves: 0.007% of its money supply (M2), Russia’s gold reserves: c9% of its money supply. As such, there is no “gold-backed” currency in the world, and the best protected -in gold- the Ruble, suffers the same volatility in commodity slump and recession times as others due to the same issue of US dollar scarcity, although not even close to the volatility of those LatAm countries that face both falling US dollar reserves and a collapse in demand from their own citizens of their domestic currency (as Argentina)..
The Federal Reserve knows that it has the largest bazooka at its disposal because the rest of the world needs at least $ 20 trillion by the end of the year, so it can increase the balance sheet and support a large deficit increase of $10 trillion and the US dollar shortage would remain.
The US dollar does not weaken excessively because the rest of the countries are facing a huge loss of reserves while at the same time increasing their monetary base in local currency much faster than the Federal Reserve, but without being a global reserve currency.
Second, the accumulation of gold reserves of the central banks of the past years has been more than offset in a few months by the increase in the monetary base of the world-leading countries. In other words, the gold reserves of many countries have increased but at a much slower rate than their monetary base.
The Federal Reserve knows something else: In the current circumstances and with a global crisis on the horizon, global demand for bonds from emerging countries in local currency will likely collapse, far below their financing needs. Dependence on the US dollar increases. Why? When hundreds of countries try to copy the Federal Reserve printing and cutting rates without having the legal, investment and financial security of the United States, they fall into the trap that I comment in my book Escape from the Central Bank Trap (BEP): ignoring the true demand for their domestic currency.
A country cannot expect to have a global reserve currency and maintain capital controls and investment security gaps at the same time.
The ECB will likely understand this shortly when the huge trade surplus that supports the euro collapses in the face of a crisis. Japan learned that lesson by turning the yen into a currency backed by huge dollar savings and increased its legal and investment security to the standards of the US or UK, despite its own monetary madness.
The race to zero of central banks in their monetary madness is not to see who wins, but who loses first. And those that fail are always the ones who play at being the Fed and the US without their economic freedom, legal certainty, and investor security.
The Federal Reserve can be criticized, and rightly so, for its monetary madness, but at least it is the only central bank that truly analyzes the global demand for US dollars and knows that its money supply must increase a lot less than its total currency demand. In reality, the Fed QE is not unlimited, it is limited by the real demand for US currency, something that other central banks ignore or prefer to forget. Can the US dollar lose its global reserve position? Sure it can, but never to a country that decides to commit the same monetary follies as the Fed without their analysis of real demand for the currency they manage.
This should be a lesson for all countries. If you fall into the trap of playing reserve currency and endless printing without understanding demand, your US dollar dependence will intensify.
A version of this article first appeared here.
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Timothy TaylorCOVID-19: Can the Economy Just Be Put on Hold for a Few Months?object(stdClass)#13832 (59) { ["id"]=> string(4) "5765" ["title"]=> string(63) "COVID-19: Can the Economy Just Be Put on Hold for a Few Months?" ["alias"]=> string(61) "covid-19-can-the-economy-just-be-put-on-hold-for-a-few-months" ["introtext"]=> string(142) "The COVID-19 pandemic is an intertwined public health and economic event.
" ["fulltext"]=> string(10830) "Here are some comments from Richard Baldwin and Beatrice Weder di Mauro: "The social distancing policies are purposefully inducing an economic slowdown. ... The recession, so to speak, is a necessary public health measure. ... The recession is a medical necessity. That’s a given. But governments can and should try to flatten the economic recession curve. ... The key is to reduce the accumulation of ‘economic scar tissue’ – reduce the number of unnecessary personal and corporate bankruptcies, make sure people have money to keep spending even if they are not working."
The comments are from the "Introduction" to an e-book containing 24 short essays edited by Baldwin and Weder di Mauro, and just released by VoxEU: Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes. This is a follow-up to the ebook they produced less than two weeks ago, which I commented on in "Some Coronavirus Economics" (March 11, 2020). The collection has a lot of interesting analysis about fiscal and monetary policy in the current setting, along with specific discussions of the European Union, the European Central Bank, Italy, Germany, China, Singapore, South Korea, and so on.
Here, I want to focus a bit on a theme that comes up in a number of the essays: the idea that sensible economic policy can put the economy in the freezer for a few months, and the pull the economy out of the freezer, thaw it out, and restart it. I find myself in the awkward position here of largely being in agreement with this policy as a short-run approach, and at the same time also feeling that the ultimate consequences of the policy are going to be more difficult than a number of authors are envisaging.
As one example of this theme in the book, Luis Garicano writes: "[A]t this point standard demand management is useless. Governments do not want to stimulate economic activity —they are doing all they can to stop it (they are asking people to stay at home!). Instead, economic policy is needed to ensure that the economy survives a ‘freeze’ of (hopefully, no more than) three to six months."
As another, Pierre-Olivier Gourinchas writes:
[I]n the short run, flattening the infection curve inevitably steepens the macroeconomic recession curve. Consider China, or Italy: increasing social distances has required closing schools, universities, most non-essential businesses, and asking ost of the working-age population to stay at home. While some people may be able to work from home, this remains a small fraction of the overall labour force. Even if working from home is an option, the short-term disruption to work and family routines is major and likely to affect productivity. In short, the – appropriate – public health policy plunges the economy into a sudden stop. ... A modern economy is a complex web of interconnected parties: employees, firms, suppliers, consumers, banks and financial intermediaries… Everyone is someone else’s employee, customer, lender, etc. A sudden stop like the one described above can easily trigger a cascading chain of events, fuelled by individually rational, but collectively catastrophic, decisions. ... To a first-order approximation, I would consider that governments may need to provide income support on a scale roughly comparable to the output lost.
Rather than quote from a number of other authors, I'll try to sum up the economic policy goal in my own words. Sure, in normal times, it makes sense to have a dynamic economy where firms rise and fall depending on whether customers are willing to pay for what they produce, and it makes sense for a churning labor market to reallocate workers back and forth across these companies.
But the novel coronavirus isn't a normal time. There is no reason to believe that it is a socially useful mechanism for sorting out which firms should expand or contract, or that it is a useful mechanism for reallocating labor across the economy. Instead, the goal of public policy should be to prevent firms from needing to fire workers permanently as a response to the pandemic. If firms need to use short-term layoffs, then government can help to replace lost income until workers get the call-back to return to work. The financial sector should be encouraged or subsidized to hold back on calling in loans or foreclosures. In some broad sense, the costs of an economic "freeze" due the coronavirus pandemic should be socialized. In the US, for example, perhaps the debt/GDP of the federal government rises by 5 percentage points of GDP, as the government provides support for the lost income across the economy.
As I said earlier, I broadly share this vision of aggressive government action to ease the immediate economic burden of the pandemic. If the issue was as simple as whether to cut interest rates and raise government debt by 5 percentage points, then the policy choice would be simple for me. But ti's not that simple.
1) As a matter of public health, there's no guarantee that COVID-19 is a one-time event. For example, the Great Influenza Epidemic of 1918-20 happened over three cycles. There is some reason for concern that in a globalized world, outbreaks of pandemics may be more common and spread faster than in the past. Even as we plunge into the immediate economic rescue, it's worth asking: Is this a pattern of public health and economic actions we are planning to repeat each year for the next 2-3 years? If such pandemics recur more frequently, is the the set of policies we are planning to follow once or twice a decade into the foreseeable future? For example, if very large fiscal policy actions to soften the economic blow of pandemics are going to be a recurrent and standard policy moving ahead, governments need to start planning ahead for them.
2) The proposed plan as a matter of practical politics and legislation, will be able to turn on the rescue and then turn it off? For example, Olivier Blanchard offers this advice in the book: "[S]pend what you must on crisis containment and commit to wind down everything once the crisis is over. Full stop." The commitment to turning off the support is easy to say, but often hard to do, and the "winding down" process can extend a considerable time.
3) As another matter of practical politics, support for business often tends to favor the big and the prominent. For example, in a US context there has been talk of assisting the airlines, which are big prominent companies, often with unionized employees, and thus lots of political clout. However, the tourism, entertainment, and restaurant industry is made up of much smaller firms, although as a group, they employ vastly more people.
4) It's easy to say that companies shouldn't be forced into bankruptcy by the coronavirus, and by and large, I agree. But we all know that some economic actors are more prudent than others. Some companies take on very high levels of debt, and some don't. Some people make sure to an amount equal to several months of income on hand, and others (who have similar levels of income) are rolling over large credit-card bills and paying interest from month to month. Yes, the pandemic was unexpected, but some firms and people build in a cushion deal with the unexpected, and some don't. Whenever government steps in to help those who are blindsided by an unexpected event, it benefits those who were not prudent over those who tried to be.
5) Finally, I'll add that any economy is not just a machine that can be switched off and on again. Helping households and firms to limp through the economic effects of this pandemic is worth doing, even at high costs to governments. But the economic disruption has costs of its own. Some number of the projects that companies were working on will be forever uncompleted. Relationships within and across organizations have been disrupted. It seems unlikely that customers and supply chains will simply restart their old patterns after a substantial disruption. Trust in providers will be shaken, sometimes for good reasons and sometimes for trivial ones. There may be jump-starts toward companies doing more work online, or encouraging telecommuting. In health care, there may be shifts toward virtual consultations, or pharmacists providing more services, or how tests and treatments are approved and used. There may be surge to online education: after all, if online education is good enough for grades and credit at Harvard, Stanford, doesn't that show that it could be online at lots of other places after the pandemic passes? These pattern shifts and many more will outlast the pandemic itself, and will cause economic disruptions and costs of their own.
A version of this article first appeared on Conversable Economist.
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Daniel LacalleGlobal GDP Growth Estimates Are Plummetingobject(stdClass)#13835 (59) { ["id"]=> string(4) "5760" ["title"]=> string(42) "Global GDP Growth Estimates Are Plummeting" ["alias"]=> string(42) "global-gdp-growth-estimates-are-plummeting" ["introtext"]=> string(390) "In February, the general consensus between large investment banks and supranational entities was that there would be a one-time hit on GDP in the first quarter from the coronavirus impact, followed by a stronger, V-shaped recovery. IMF expected a modest correction of global GDP of 0.1%, and the largest cut on estimates for 2020 growth was 0.4%.
" ["fulltext"]=> string(6864) "Those days are gone.
The latest round of global growth revisions includes a slash of growth estimates for the first and second quarters and a very modest recovery in the third and fourth. Average GDP estimates are now down 0.7%, and JP Morgan expects the eurozone to enter into a deep recession in the next two quarters (-1.8% and -3.3% in the first and second quarters) followed by a very poor recovery that would still leave the full-year 2020 estimate in contraction. The investment bank also assumes a slump in the United States of 2% and 3% respectively, but a full-year modest growth. Capital Economics estimates a hit on the U.S. economy for the full-year that would cut 0.8% off previous estimates, with the U.S. still growing, but a larger impact on the eurozone, with full-year 2020 growth at -1.2%, led by a -2% in Italy. This, unfortunately, looks like just the beginning of a downgrade cycle that adds to an already slowing economy in 2019.
The decision to shut down air travel and close all non-essential businesses is now a reality in major global economies. The United States has banned all European flights at the same time as Italy enters into a complete lockdown, Spain declares state of emergency and France closes all non-essential activity. These decisions are key to contain the spread of the virus and try to prevent the collapse of healthcare systems, and our thoughts are with all of those infected and the victims. Shutting down travel and businesses generates a negative ripple effect on the economy. It is an important measure to avoid rapid spread and there will be more cancellations of events and activity.
By now, we can at least get a clearer picture of the severity of the pandemic and in this blog we discuss economic consequences, so I believe it is important to remind of a few important factors:
- We cannot assume that the above-mentioned estimates are too pessimistic. If we have learned anything from the history of global growth estimates is that most of us tend to be more optimistic than realistic even in crisis periods. Most analysts did not see a crisis in 2008 and, even more importantly, a majority still did not see it in 2009, when it was evident. It is true that 80% of estimates at the beginning of any given year have to be revised, but not because they are too pessimistic, rather the opposite.
- Calls for large fiscal packages to offset the pandemic may be useless Allen-Reynolds at Capital Economics warned that “even if governments agreed on a larger tax and spending package, the economic impact would be much smaller than it would have been in the past, particularly if the fiscal stimulus was concentrated in Germany”, because output gaps are almost inexistent. This is not a demand problem, it is a supply shock, and you don’t address supply shocks with bricks, mortar and deficit spending.
- A third-quarter rapid recovery is now virtually impossible. The shutdown of developed economies is now granted and will likely take us more than a couple of weeks. The shutdown of emerging economies is likely to start in May, and impact 2020 and 2021 estimates. Every analysis we have seen so far only factors a 2020 recession, not a crisis and even less a 2021 large hit to the economy, but the financial implications in an already over-leveraged world add a strong of credit events to an economic shutdown.
- The latest wave of downgrades already assumes a large-scale stimulus, rate cuts, and quantitative easing. The diminishing returns of monetary easing were already evident in 2018 and especially in 2019, with global manufacturing PMIs in contraction and growth estimates that came down significantly throughout the year. Average growth downward revisions by country averaged 20% between January and December in the middle of a massive coordinated central bank injection operation that injected up to 170 billion USD a month in the economy (considering PBOC, BOJ, ECB, and Fed) and saw widespread rate cuts.
- The economic implications of a pandemic are not solved with massive spending increases. Governments will implement large demand-side policies that are the wrong answer to a shutdown of the economy. Most businesses will suffer from the collapse in sales and subsequent working capital build and none of that will be solved with deficit spending. You cannot mitigate a supply shock with demand policies, which increase debt and overcapacity in the already indebted and bloated sectors and do not help the sectors that suffer an abrupt collapse in activity.
- A forced temporary shutdown must also include a shutdown of the tax collection system. Governments already finance themselves at negative rates. They must eliminate (not defer) tax payments for companies in the period of crisis to avoid a massive unemployment increase and a domino of bankruptcies, and facilitate working capital lines at zero rates to allow businesses and self-employed workers to navigate a shutdown. Governments that make the mistake of maintaining the current tax structure or just prolong the payment period for six months will see the massive negative consequences of a shutdown in the next nine months.
If, as expected, the shutdown is extended to more countries every week, the negative effects on the economy will be longer and exponential, and the mirage of a third-quarter recovery even more difficult.
It is very likely that the shutdown of the major developed economies will be followed by a shutdown of emerging markets, creating a supply shock as we have not seen in decades. Taking massive inflationary and demand-driven measures in a supply shock is not only a mistake, it is the recipe for stagflation and guarantee of a multi-year negative impact generated by rising debt, weakening productivity, rising inflation in non-replicable goods while deflation creeps in official headlines, and economic stagnation.
A version of this article first appeared here.
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IMF expected a modest correction of global GDP of 0.1%, and the largest cut on estimates for 2020 growth was 0.4%." 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["secure"]=> int(0) ["page_description"]=> string(126) "BBN Times provides the latest insights from experts in technology, healthcare, leadership, entrepreneurship and global economy" ["page_rights"]=> NULL ["robots"]=> NULL ["page_heading"]=> string(14) "Global Economy" ["access-view"]=> bool(true) } ["initialized":protected]=> bool(true) ["separator"]=> string(1) "." } ["displayDate"]=> string(0) "" ["slug"]=> string(47) "5760:global-gdp-growth-estimates-are-plummeting" ["catslug"]=> string(18) "103:global-economy" ["link"]=> string(58) "/global-economy/global-gdp-growth-estimates-are-plummeting" ["active"]=> string(0) "" ["displayCategoryLink"]=> string(15) "/global-economy" ["displayCategoryTitle"]=> string(0) "" ["displayHits"]=> string(0) "" ["displayAuthorName"]=> string(14) "Daniel Lacalle" ["displayIntrotext"]=> string(0) "" ["displayReadmore"]=> NULL }- We cannot assume that the above-mentioned estimates are too pessimistic. If we have learned anything from the history of global growth estimates is that most of us tend to be more optimistic than realistic even in crisis periods. Most analysts did not see a crisis in 2008 and, even more importantly, a majority still did not see it in 2009, when it was evident. It is true that 80% of estimates at the beginning of any given year have to be revised, but not because they are too pessimistic, rather the opposite.
4
Timothy TaylorInterview with Deidre McCloskey on Economic Growth and Liberal Valuesobject(stdClass)#13840 (59) { ["id"]=> string(4) "3563" ["title"]=> string(69) "Interview with Deidre McCloskey on Economic Growth and Liberal Values" ["alias"]=> string(69) "interview-with-deidre-mccloskey-on-economic-growth-and-liberal-values" ["introtext"]=> string(569) "Eric Wallach offers "An Interview with Deidre McCloskey, Distinguished Professor Emerita of Economics and of History, UIC" in The Politic, Yale's undergraduate journal of politics and culture (February 10, 2019). McCloskey is characteristically thought-provoking and quotable. Here are a few comments of her many comments that caught my eye:
" ["fulltext"]=> string(6514) ""Liberty is liberty, and is meaningless by parts."
The central misconception is to think that one can claim the honorable title of “liberal” if one approves of one form of liberty, such as mutual consent in sexual partners or the ability to drill for oil where you wish, but excludes the other form. Liberty is liberty, and is meaningless by parts. You are still a slave if only on odd days of the month.
In Latin America, for example, the word “liberal,” once meaningful there, has long been appropriated by conservatives who like to drill for oil where they wish, but hate gays. In the United States, it has been appropriated by sweet, or not so sweet, slow socialists, who celebrate diversity, but regard economic liberty as not worthy of much consideration. ...
I used to think freedom was freedom of speech, freedom of the press, freedom of conscience. Here is what it amounts to: you have to have the right to show what you wish to, to make shoes or coats, to bake into bread the flour ground from the grain you have sown, and to sell it or not sell it as you wish; for the lathe-operator, the steelworker, and the artist it’s a matter of being able to live as you wish and work as you wish and not as they order you.
"Put me down for 10 percent slavery to government."
It’s unwise to turn the issue of helping the poor into an on/off, none/perfect, exist/not question. We need to be seriously quantitative about such matters. On/off doesn’t answer the important question, which is always more/less. People think they are making a clever remark against liberalism by saying, “Well, we need some government.” Yes, certainly. But how much? (Will Rogers in the 1920s used to say, “Just be glad you don’t get the government you pay for.”) ...
So here’s what a Liberalism 2.0 favors. It favors a social safety net, which is to say a clean transfer of money from you and me to the very poor in distress, a hand up so they can take care of their families. It favors financing pre- and post-natal care and nursery schools for poor kids, which would do more to raise health and educational standards than almost anything we can do later. It favors compulsory measles vaccination, to prevent the big spillover of contagion that is happening now in Clark County, Washington. It favors compulsory school attendance, financed by you and me, though not the socialized provision of public schools. The Swedes have since the 1990s had a national voucher system, liberal-style. It favors a small army/coast-guard to protect as against the imminent threat of invasion by Canada and Mexico, and a pile of nuclear weapons and delivery systems to prevent the Russians or Chinese or North Koreans from extorting us. All this is good, and would result in the government at all levels taking and regulating perhaps 10 percent of the nation’s production. Put me down for 10 percent slavery to government. Not the 30 to 55 percent at present that rich countries enslave.
"The Nordics ... are not thoroughly socialist, and in fact they are reasonably close to the U.S., and in some ways more anti-socialist."
Americans of good will have long been persuaded, on the basis of breathless articles in the Sunday New York Times Magazine, that the Nordics are thoroughly “socialist” ... No, they are not thoroughly socialist, and in fact they are reasonably close to the U.S., and in some ways more anti-socialist. They are in fact highly liberal in their economies (and their fastest rates of growth since 1850 were in fact when they were even more liberal). Almost all prices in Sweden and the rest, for example, are determined by supply and demand, and are nothing like the disastrous socialist interventions by way of price controls in, say, Venezuela. Setting up a business is not hard. Inherited wealth in Scandinavia and Finland is not honored. Innovation is (for example Svenska Kullagerfabriken, SKF, a pioneer in ball bearings, out of which in the 1920s rolled Volvo [Latin for “I roll”]).
And government ownership of the means of production is trivial in all the Nordic countries. When Saab Motors went bankrupt, it came to the Swedish government hat in hand, and the government said, “Get lost.” When Volvo recently became a Chinese company, the government said, “So what?” You don’t have to exercise much imagination about what the American government would do if General Motors was so threatened: “Here are billions of tax dollars, and so the Federal Government owns part of you.” The American government in 2008 of course did precisely that.
"Give this gentleman sixteen cents. That’s his share of the wealth."
[Andrew] Carnegie himself is said to have made the same point in another way. A socialist came to his office and argued to him that the wealthy should redistribute their wealth to the poor of the earth. Carnegie asked an assistant to go get him a rough estimate of his current wealth and of the population of the earth. The assistant returned shortly with the figures, and according to the anecdote Carnegie performed a calculation, then turned to the assistant and said, “Give this gentleman sixteen cents. That’s his share of the wealth.” And then he gave every dime of his wealth away, in accord with his Gospel of Wealth. Another businesslike Scot, Adam Smith, by the way, also gave away his considerable fortune, though, unlike Carnegie, he did not sound a trumpet before him when he did his alms.
A version of this article first appeared on Conversable Economist.
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Colin lloydCentral Bank Balance Sheet Reductions – Will Anyone Follow the Fed?object(stdClass)#13839 (59) { ["id"]=> string(4) "3562" ["title"]=> string(69) "Central Bank Balance Sheet Reductions – Will Anyone Follow the Fed?" ["alias"]=> string(64) "central-bank-balance-sheet-reductions-will-anyone-follow-the-fed" ["introtext"]=> string(444) "The next wave of quantitative easing (QE) will be different, credit spreads will be controlled. The Federal Reserve (FED) may continue to tighten but few other central banks can follow. The European Central Bank (ECB) balance sheet reduction might occur if a crisis does not arrive first. Interest rates are likely to remain structurally lower than before 2008.
" ["fulltext"]=> string(12011) "The Federal Reserve’s response to the great financial recession of 2008/2009 was swift by comparison with that of the ECB; the BoJ was reticent, too, due to its already extended balance sheet. Now that the other developed economy central banks have fallen into line, the question which dominates markets is, will other central banks have room to reverse QE?
Last month saw the publication of a working paper from the BIS - Risk endogeneity at the lender/investor-of-last-resort – in which the authors investigate the effect of ECB liquidity provision, during the Euro crisis of 2010/2012. They also speculate about the challenge balance sheet reduction poses to systemic risk. Here is an extract from the non-technical summary (the emphasis is mine):
The Eurosystem’s actions as a large-scale lender- and investor-of-last-resort during the euro area sovereign debt crisis had a first-order impact on the size, composition, and, ultimately, the credit riskiness of its balance sheet. At the time, its policies raised concerns about the central bank taking excessive risks. Particular concern emerged about the materialization of credit risk and its effect on the central bank’s reputation, credibility, independence, and ultimately its ability to steer inflation towards its target of close to but below 2% over the medium term.
Against this background, we ask: Can central bank liquidity provision or asset purchases during a liquidity crisis reduce risk in net terms? This could happen if risk taking in one part of the balance sheet (e.g., more asset purchases) de-risks other balance sheet positions (e.g., the collateralized lending portfolio) by a commensurate or even larger amount. How economically important can such risk spillovers be across policy operations? Were the Eurosystem’s financial buffers at all times sufficiently high to match its portfolio tail risks? Finally, did past operations differ in terms of impact per unit of risk?...
We focus on three main findings. First, we find that (Lender of last resort) LOLR- and (Investor of last resort) IOLR-implied credit risks are usually negatively related in our sample. Taking risk in one part of the central bank’s balance sheet (e.g., the announcement of asset purchases within the Securities Market Programme - SMP) tended to de-risk other positions (e.g., collateralized lending from previous - longer-term refinancing operations LTROs). Vice versa, the allotment of two large-scale (very long-term refinancing operations) VLTRO credit operations each decreased the one-year-ahead expected shortfall of the SMP asset portfolio. This negative relationship implies that central bank risks can be nonlinear in exposures. In bad times, increasing size increases risk less than proportionally. Conversely, reducing balance sheet size may not reduce total risk by as much as one would expect by linear scaling. Arguably, the documented risk spillovers call for a measured approach towards reducing balance sheet size after a financial crisis.
Second, some unconventional policy operations did not add risk to the Eurosystem’s balance sheet in net terms. For example, we find that the initial OMT announcement de-risked the Eurosystem’s balance sheet by e41.4 bn in 99% expected shortfall (ES). As another example, we estimate that the allotment of the first VLTRO increased the overall 99% ES, but only marginally so, by e0.8 bn. Total expected loss decreased, by e1.4 bn. We conclude that, in extreme situations, a central bank can de-risk its balance sheet by doing more, in line with Bagehot’s well-known assertion that occasionally “only the brave plan is the safe plan.” Such risk reductions are not guaranteed, however, and counterexamples exist when risk reductions did not occur.
Third, our risk estimates allow us to study past unconventional monetary policies in terms of their ex-post ‘risk efficiency’. Risk efficiency is the notion that a certain amount of expected policy impact should be achieved with a minimum level of additional balance sheet risk. We find that the ECB’s Outright Monetary Transactions - OMT program was particularly risk efficient ex-post since its announcement shifted long-term inflation expectations from deflationary tendencies toward the ECB’s target of close to but below two percent, decreased sovereign benchmark bond yields for stressed euro area countries, while lowering the risk inherent in the central bank’s balance sheet. The first allotment of VLTRO funds appears to have been somewhat more risk-efficient than the second allotment. The SMP, despite its benefits documented elsewhere, does not appear to have been a particularly risk-efficient policy measure.
This BIS research is an important assessment of the effectiveness of ECB QE. Among other things, the authors find that the ‘shock and awe’ effectiveness of the first ‘quantitative treatment’ soon diminished. Liquidity is the methadone of the market, for QE to work in future, a larger and more targeted dose of monetary alchemy will be required.
The paper provides several interesting findings, for example, the Federal Reserve ‘taper-tantrum’ of 2013 and the Swiss National Bank decision to unpeg the Swiss Franc in 2015, did not appear to influence markets inside the Eurozone, once ECB president, Mario Draghi, had made its intensions plain. Nonetheless, the BIS conclude that (emphasis, once again, is mine): -
…collateralized credit operations imply substantially less credit risks (by at least one order of magnitude in our crisis sample) than outright sovereign bond holdings per e1 bn of liquidity owing to a double recourse in the collateralized lending case. Implementing monetary policy via credit operations rather than asset holdings, whenever possible, therefore appears preferable from a risk efficiency perspective. Second, expanding the set of eligible assets during a liquidity crisis could help mitigate the procyclicality inherent in some central bank’s risk protection frameworks.
In other words, rather than exacerbate the widening of credit spreads by purchasing sovereign debt, it is preferable for central banks to lean against the ‘flight to quality’ tendency of market participants during times of stress.
The authors go on to look at recent literature on the stress-testing of central bank balance sheets, mainly focussing on analysis of the US Federal Reserve. Then they review ‘market-risk’ methods as a solution to the ‘credit-risk’ problem, employing non-Gaussian methods - a prescient approach after the unforeseen events of 2008.
Bagehot thou shouldst be living at this hour (with apologies to Wordsworth)
The BIS authors refer on several occasions to Bagehot. I wonder what he would make of the current state of central banking? Please indulge me in this aside.
Walter Bagehot (1826 to 1877) was appointed by Richard Cobden as the first editor of the Economist. He is also the author of perhaps the best known book on the function of the 19th century money markets, Lombard Street (published in 1873). He is famed for inventing the dictum that a central bank should ‘lend freely, at a penalty rate, against good collateral.’ In fact he never actually uttered these words, they have been implied. Even the concept of a ‘lender of last resort’, to which he refers, was not coined by him, it was first described by Henry Thornton in his 1802 treatise - An Enquiry into the Nature and Effects of the Paper Credit of Great Britain.
To understand what Bagehot was really saying in Lombard Street, this essay by Peter Conti-Brown - Misreading Walter Bagehot: What Lombard Street Really Means for Central Banking – provides an elegant insight:
Lombard Street was not his effort to argue what the Bank of England should do during liquidity crises, as almost all people assume; it was an argument about what the Bank of England should openly acknowledge that it had already done.
Bagehot was a classical liberal, an advocate of the gold standard; I doubt he would approve of the nature of central banks today. He would, I believe, have thrown his lot in with the likes of George Selgin and other proponents of Free Banking.
Conclusion and Investment Opportunities
Given the weakness of European economies it seems unlikely that the ECB will be able to follow the lead of the Federal Reserve and raise interest rates in any meaningful way. The unwinding of, at least a portion of, QE might be easier, since many of these refinancing operations will naturally mature. For arguments both for and against CB balance sheet reduction this paper by Charles Goodhart - A Central Bank’s optimal balance sheet size? is well worth reviewing. A picture, however, is worth a thousand words, although I think the expected balance sheet reduction may be overly optimistic: -
Source: IMF, Haver Analytics, Fulcrum Asset Management
Come the next crisis, I expect the ECB to broaden the range of eligible securities and instruments that it is prepared to purchase. The ‘Draghi Put’ will gain greater credence as it encompasses a wider array of credits. The ‘Flight to Quality’ effect, driven by swathes of investors forsaking equities and corporate bonds, in favour of ‘risk-free’ government securities, will be shorter-lived and less extreme. The ‘Convergence Trade’ between the yields of European government bonds will regain pre-eminence; I can conceive the 10yr BTP/Bund spread testing zero.
None of this race to zero will happen in a straight line, but it is important not to lose sight of the combined power of qualitative and quantitative easing. The eventual ‘socialisation’ of common stock is already taking place in Japan. Make no mistake, it is already being contemplated by a central bank near you, right now.
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The Dominance of Peoria in the Processed Pumpkin Market
As I prepare for a season of pumpkin pie, pumpkin bread (made with cornmeal and pecans), pumpkin soup (especially nice wish a decent champagne) and perhaps a pumpkin ice cream pie (graham cracker crust, of course), I have been mulling over why the area around Peoria, Illinois, so dominates the production of processed pumpkin.
Workplace Wellness Policies: Disappointing Evidence
The idea behind workplace wellness policies is straightforward. Many workers could use a nudge toward adopting healthier lives, including diet and exercise. Employer are paying for health insurance anyway, and also experiencing costs of lower productivity and sick days for their employees. If a workplace wellness program can improve health, it could be a win for both workers and employers. However, a couple of recent studies from this year suggest that such programs don't pay off.
Leveraged Loans – History Rhyming?
· Despite three Federal Reserve rate cuts, leveraged loan credit quality is rapidly declining. · Covenant-lite issues now account for more than 80% of US$ issues. · CLO managers, among others, may need to sell, but few buyers are evident.
Why Has China's Trade Surplus Gone Away?
China's trade surpluses exploded in size after 2001, when China joined the World Trade Organization and its exports soared. But those trade surpluses peaked back before the Great Recession and have dwindled since then to near-zero. Indeed, the IMF predicts that China is likely to have small trade deficits in the next few years. What happened? Pragyan Deb, Albe Gjonbalaj, and Swarnali A. Hannan tell the story in "The Drivers, Implications and Outlook for China’s Shrinking Current Account Surplus" (IMF Working Paper WP/19/244, November 8, 2019).
The Return of the Patent Thicket
Back in the early 1970s, Xerox had figured out a strategy to block competitors in the photocopying business. It took out lots of patents, more than 1,000 of them, on every aspect of the photocopy machine. As old patents expired, new ones kicked in at a rate of several hundred new patents each year. Some of the patents were actually used by Xerox in producing the photocopy machine; some were not. There was no serious complaint about the validity of any individual patent. But taken as a whole, Xerox seemed to be using the patent system to lock up its monopoly position in perpetuity. Under antitrust pressure from the Federal Trade Commission, Xerox in 1975 signed a consent decree which, along with a number of other steps, required licensing its 1,700 photocopier patents to other firms. (Here's a later retrospective on the case, including some of the other issues, the 1975 FTC consent decree, and what happened with follow-up litigation.)
Interview with Cass Sunstein: On Abrupt and Unpredictable Social Change
Consider some examples of social movements that led to rapid change: the French Revolution, Russian revolution/ collapse of Soviet Union, the Iranian revolution, the civil rights movements of the 1960s, the rise of environmentalist movement in the 1960s, Brexit, #MeToo, gay marriage, and others. Robert Wiblin and Keiran Harris at the "80,000 Hours" website have a podcast interview: "Prof. Cass Sunstein on how social change happens, and why it’s so often abrupt & unpredictable" (June 17, 2019). A transcript is also available.
Enhancing Federal Tax Collections by $100 Billion Annually
Maybe instead of arguing over whether or how much to raise tax rates on those with high incomes, we could start by making more of an effort to enforce the actual existing tax laws? Natasha Sarin and Lawrence H. Summers explore what's possible in "Shrinking the Tax Gap: Approaches and Revenue Potential" (Tax Notes, November 18, 2019).
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