Author: The Fat Tails

In Defence of OMT

The German Constitutional Court’s recent ruling to rein in the ECB operations known as “Outright Monetary Transactions” (OMT) as unconstitutional, has elated many German politicians and Euro-sceptic economists. But this is a pyrrhic victory for Germany, and a sad week for the European periphery.

Princeton University economist Ashoka Mody for example has labelled the OMT as economically “ill-conceived” in his recent Project Syndicate article. The argument goes that ECB claims that risk premiums reflect unfounded fear were based on “Cherry-picked evidence” and that the OMT program by definition conceded that “assessments of creditworthiness reflected a real default risk”. Thus, one should let the market price this risk adequately to create an optimal solution. In other words, the ECB has given periphery Europe a free lunch, and distorted the sovereign bond pricing system in the Eurozone.

An implicit notion in this argument however is that causality between finance and fundamentals is a one-way street. Financial feed-back loops, either do not affect the real economy, or they are completely rational and optimise results. This is clearly fallacious. The risk of Sovereign default is almost purely a function of the interest rates that must be paid on their debt. In addition, risky markets do not operate anything like their safer financial and real counterparts in reducing volatility and allocating capital.

In financial markets optimal results requires a balance of speculators and fundamentals traders (value investors). The speculators, supply liquidity to the market and trade in line with trends. The value investors however, absorb this liquidity and tend to trade against trends. The result is a stable asset pricing system, where small shocks do not get blown out of proportion and liquidity is sufficient.

So who are the value traders in Sovereign debt markets? When it’s high grade, there are sovereign wealth funds, superannuation funds, etc. that all use these low-risk assets to hedge against adverse economic shocks. The problem is though, that periphery European debt markets nowadays are no longer high-grade. Indeed, risk premiums have consumed a major part of debt repayments from peripheral Eurozone countries and many of the historical value investors have moved away. Thus the speculative component of these markets is probably too high.

And so the periphery of Europe is faced with a double dilemma. Two positive feedback loops that can cause the downfall of the Eurozone. If individual country risk premiums reach a point where they begin to threaten national solvency, then speculative component of the asset holders will do the rest. They will begin shorting the debt and creating higher interest rates whilst pulling back liquidity lines. Any sizeable shift in fundamentals therefore (such as an elimination of OMT) will cause carnage.

For example, Spain’s public debt still only hovers at around 90% of annualised GDP, and risk premiums are far higher than in the US where debt as a percentage of GDP is around 130%. Risk premiums cause default risk, and more risk premiums. This is an equilibrium reached under artificial circumstances, and it should not be tolerated. It is clearly a market flaw. If Sovereigns are able to repay their debt reasonably, that should be strived for. OMT facilitates this by a reduction in national stress, and reduces actual risk in a very real sense. It breaks the speculative loop and changes the fundamental solvency of the beneficiaries.

Attempts at destroying OMT are thus almost wholly political, and are not astute economic policies. Attempts at diluting it are even worse. To date, OMT has managed to avoid speculative attacks on the ECB’s commitment to do “whatever it takes”, and premia have been meaningfully reduced. If the German High Court, and the European Court of Justice however, choose to dilute the OMT program then a very different scenario could emerge, and the ECB could lose the credibility it’s fought so hard for these past few years.

Fighting Capital Account Whiplash- ‘National Hedging’

On December 20, 1994 the government of Mexico suddenly announced a 13 percent devaluation in the ‘crawling band’ currency peg to the U.S dollar, following intense capital outflows beginning earlier in the year. In doing so, the currency regime organised by money doctors and IMF leaders that had reigned in inflation and expanded domestic liquidity for 7 years, was abandoned. The result of the 1994 devaluation however, was disastrous- setting off what has since been known as the Tequila crisis.

Mexican corporations and the government at this time had borrowed an immense amount of dollar denominated debt, and the devaluation immediately pushed up repayment costs and insolvency pressures. As investor nervousness grew and interest rates soared, the short-term funding strategies of Mexican commercial leaders proved detrimental; turning illiquid corporations into insolvency. Within a week the peso dropped another 19% whilst the large speculator investment base threw the country into a cycle of massive asset sell-offs. Debt burdens grew, and asset values plummeted. In the end, the collective scramble to raise liquidity and protect balance sheets pushed the country into a self-reinforcing disaster.

Such a positive feedback loop has been the subject of much financial analysis, and the Tequila crisis has served as one of the primary empirical bulwarks of Soros’ “Theory of ‘Reflexivity’”. In this context, small exogenous shocks can push nations and markets to brink of collapse without any real change in economic fundamental. Indeed, the same thing is happening today in a number of large emerging markets that have managed to attract foreign capital inflows from the Fed’s QE operations. Just in September last year, Bernanke’s mere announcement of QE tapering (not even an end to ZIRP) was enough to push the Indian Rupee into freefall and crush Indonesia’s dreams of price stability. (This sudden reversal of capital inflows is what I call ‘Capital Account Whiplash’)

Nevertheless, a situation of financial freefall after currency defaults is by no means certain. The British Pound Sterling’s withdrawal from the European Exchange Rate Mechanism in 1992 for example served to calm markets and boost competitiveness. Furthermore, if the devaluation had not been postponed by Bank of England interventions (which lowered foreign reserves) the result would have been an outright profit on the public account.

Why then did the British example provide such a different result to that of today’s emerging markets, and 1994 Mexico? To my mind, contrasting results (and consequently, a refutation to ‘Reflexivity’ Theory’s proposition that crises are behavioural in nature) can be explained by the way debt markets can reduce or add volatility to growth fundamentals, and thereby create positive or negative feedback loops.

In 1990’s Mexico, borrowing had two fundamental characteristics:
a) It was short-term, needing to be rolled over constantly.
b) It was denominated in foreign currency.

Hence, as Mexican markets stalled and firms were placed under revenue-side constraints, they also felt a sharp stab of pain on the lending side. As the peso devalued, the peso-cost of dollar debt exploded, and the price of avoiding liquidity crises was immense as interest rates soared on the short-term markets. The nature of Mexican leverage and debt indexation thus can be seen to have predictably exacerbated the impact an exogenous shock, as it was inversely correlated to revenues. Debt was automatically indexed so that as revenues expanded, debt costs fell; but when the economy was placed under pressure, debt costs also exploded. Mexican finance, therefore, was mechanically pushed into a positive feed-back loop by the liability managers of the economy.

In Great Britain during the 1990’s by comparison, the story of debt indexation is a very different one. Debt burdens here, were directly correlated to revenues, i.e loans were typically long term with fixed rates, credit was denominated in pounds, and speculators were balanced by institutional ‘vulture’ purchasers that bought against trends. (Sovereign wealth funds etc.) So, as the nation was bogged down by asset revaluations, rising inflation and falling terms of trade, corporations found themselves cushioned by increasing competitiveness, and falling real interest rates. The net result for borrowers pending a fixed exchange withdrawal was thus beneficial.

It is important to note at this point that the Tequila crisis under this framework was neither a result of fundamentals that were papered over, nor irrational exuberance.

So, what are the lessons for current economies facing the prospect of sharp external liquidity contractions in the very near future? Commercial leaders and politicians must reform the national capital structure, and make sure that debt is directly correlated to growth and revenues. If QE is expected to put sudden downward pressure on Emerging Market currencies then, foreign denominated public, and private debt must be replaced by local currency denominations now. Similarly, central banks should strive to reform the liquidity and regulatory environment (get rid of withholding taxes where possible for example) in debt markets so that fixed-rate, long term borrowings are encouraged over variable, short-term borrowings.

Although this is easier said than done. Politically, a project involving re-indexation of debt so that it is long-term and local will imply significantly higher interest rates up-front. Sovereigns will essentially be swapping their lending out of the US financial sector into smaller, less advanced local centres with higher spreads and smaller capacities for dispersing risk. Merely developing a local debt market liquid enough to absorb public borrowing is a huge task for Developing and Emerging markets whose volatile monetary conditions systematically exacerbate inflation and other currency risks for lenders.

But with time, global lenders and investors will recognise the improving capital stability resulting from financial reform. In the meantime Emerging and Developing Market Central Banks should adopt ‘Forward Guidance’ interventions to minimise currency risk expectations, and pray that U.S unemployment warrants continuations of QE for a while longer.

Explaining Slow Growth: Turning Away from the Stale “Lessons from Japan”

For the past 3 years, macroeconomists and central bankers have grappled fiercely over the topic of developed market economic stagnation, pending a true recovery from the financial implosions of 2008. Many influential “macro guys” and financial analysts now see stark similarities with the Japanese post 1990 experience and the current forecasts given for much of the developed world. Paul Krugman in a recent Op—Ed piece in his New York Times Blog for example stated emphatically that “Nowadays, we are all Japan”, whilst Richard Koo’s (highly informative) “The Holy Grail of Macroeconomics: Lessons from Japan” attempted to empirically relate the current financial position of the US to that of Japan during the lost decade. Nevertheless, I see a number of structural differences between the Japanese economy leading up to 1990 and the other indebted developed markets of today.

Essentially, if China’s economic model is a mirror of Japan’s, and thus awaits an equally daunting “Long Landing” as is expected (See Pettis, China Financial Markets), then surely the U.S and Europe who run a functionally obverse economic model shouldn’t intuitively be in the midst of a Japanese styled slump. To my mind, much of the debate amongst the macroeconomists misses this point and is therefore muddled and wonky. To my mind, a viable opponent to the Japanese analysis, is one based upon the international Balance of Payments (BoP).

I have long found it curious and odd, that even at the height of sub-prime lending in the U.S combined with excessively low interest rates after 2001, that the U.S economy remained on its long term average growth path. Surely the asset bubble and leveraging cycle should have propelled growth. Similarly, the 3 rounds of QE in the post-crisis era should have also stimulated growth and investment. (I share the opinion of Richard Koo in the idea that the US financial sector, contrary to popular sentiment is indeed healthy) One explanation for lacklustre growth is that the US economy has lost much of its comparative advantage, and that without constant monetary pump priming growth would be even slower. Another idea is that of Richard Koo and those of the Japan school, who now believe that the U.S economy is caught in a fierce deleveraging cycle that may take decades to resolve. And yet both of these theories, as intuitive as they may be, are muddled by inconsistent empirical evidence and strange contradictions.

What if however, the U.S and European economies were plagued by a very different type of problem? One which monetary pump-priming and asset bubbles could not solve. What if, the U.S and peripheral European demand over the past 20 years had simply been bled out by distortions in the external account? In this case, the US crisis was driven by external trade policies, and not, by a statist investment orgy as in Japan.

This situation at first glance seems to be supported by simple facts and intuition. The persistent current account deficits of developed markets, specifically the US, to my mind have caused both the inflated asset prices leading up to 2008, and also the below trend equilibrium (rather than actual) growth rates experienced since roughly 1997.

The late nineties were indeed a tumultuous period, and can be seen hence, as crucial to the development of instability within the US financial system. In 1997-8 a few things happened:

  1. East-Asian financial markets, stunned by a sequence of currency devaluations, began to run targeted trade surpluses.
  2. The US capital inflows soared (functionally the equivalent of a rising trade deficit that balanced the East-Asian surpluses)
  3. Lending and credit within the US expanded, funnelled largely into real estate.
  4. Housing prices and volumes began their ominous ascent.

The East-Asian surpluses then, can be seen to have (either directly or indirectly) penetrated the American trade account. Consequently, East-Asian markets served to change the composition of the American economy. The U.S tradable sector, due to financial repression and increasing savings in East-Asia, was beaten to a pulp and workers quickly made redundant. With a contracting tradable sector, the only possible way to redeploy labour is through a surge in foreign-financed debt which expands domestic consumption and investment. In addition, when the economy is balancing away from the tradeable sector most investment becomes speculative and in this case was inevitably funnelled towards the increasingly liquid real estate sector.

Therefore, the capital inflows (functionally current account deficits) can be seen to have both slowed equilibrium growth, as productive workers were redeployed and fired, and simultaneously fuelling a speculative binge. (The impending crisis’ magnitude was of course also amplified by the irresponsible lending techniques rampant within US financial markets which increased the probability of insolvency).

Even to this day, East-Asian capital exports have continued to increase, with China probably consuming a mere 35% of production (GDP) in comparison to the US’ 72% and Europe’s 65% (Rough estimates). The effect of such Underconsumption on the national savings rate is immense and if the US is to bear the brunt of the resultant capital inflows and Chinese production overload (As the PBoC reserve account holdings of USD implies it does) then it means the U .S is being bled white through the gaping hole in the external account.

With the financial crisis having largely capped the private sector’s willingness to further leverage-up and accumulate debt, there thus remains only one natural way for the U.S economy to absorb foreign excess capacity- unemployment and slower growth. Of course also there are a few politically unlikely ways too though. The US could become competitive through devaluation, higher VAT tax or equivalent, labour market reforms, tariffs etc. But the point is that China and East-Asia have purposely pushed their surplus savings onto the US. The US must absorb this excess by either more consumption, more investment (both imply less savings) or by intervening in trade and stopping the central bank purchases of so many treasuries (remember for every net $1 of Treasuries that are bought by foreigners, that is by economic law $1 added to the trade deficit). Since debt financed consumption and investment is not really an option without significant fiscal stimulus from the public sector (the private sector seems unwilling to leverage up further) and intervening in trade is politically unlikely the only other way to reduce savings is to reduce production by an amount more than the reduction in consumption. ie unemployment. This is basically an accounting necessity

Spain is an exaggerated version and perhaps a better example to see why. Spain can’t devalue due to it’s Eurozone membership. It also has a very limited capacity to load up on leverage (Look at sovereign bond risk premiums and the imploding banking sector) and so if Germany’s surplus continues to be pushed onto it, what can the Spanish administration do? All it can do is lower domestic savings by jacking up unemployment or try to become competitive and push it’s own savings out onto the rest of the world. (Like a Vampire state, sucking away at foreign demand to keep employment high). Coincidentally, the quickest way to regain competitiveness without intervening in trade is to grind down wages via unemployment. This is referred to the “internal devaluation” mode of recovery.

It is in this context that the anomalous predicament of the U.S and other developed markets is neither surprising nor complex. Unemployment will remain high until the trade interventions in surplus nations are eliminated, and the deficit ones are allowed to compete on an equal basis. In a situation where demand is being haemorrhaged to foreigners, fiscal stimulus will also need to be focused on innovative investments and cannot be allowed to stimulate consumption as is optimal Japan. In this world we must draw very different conclusions from those of the 90s.

The Redundancy of Supply-Side Economics in Abe’s Japan

Great expectations surrounded the announcement of Shinzo Abe’s economic revolution in Japan to pull the economy out of its 20 year slump. The revolution involved a huge overhaul of public policy, with a three-pronged attack on the macroeconomic conditions beleaguering the nation.

The first prong, a tsunami of monetary stimulus and cheap credit released by the Bank of Japan’s new governor Haruhiko Kuroda was designed to end the deflationary spiral. The second was a similarly immense fiscal stimulus package worth $116 billion designed to offset lacklustre investment from the private sector. But it was the third arrow, a series of supply-side reforms, that was perceived to be key to improving the competitiveness of Japanese firms and bolster long-term growth.

At best, these supply-side measures will prove to be only mildly stimulative to the Japanese economy if it begins to recover from its 20 year slump. By contrast, if the economy falls into another recession and the continued deregulation of Japanese labour markets is pursued aggressively, the result could be damaging.

 So let’s star our analysis by looking at the channels through which labour market reforms increase productivity. The first channel allows low-productivity sectors and unprofitable enterprises to shed labour more easily. The second channel is then designed to allow firms to hire workers more easily, and consequently pick up the previously fired workers. Therefore, in a healthy economy, structural reform redistributes labour from unproductive employment towards productive employment.

In conditions of economic malaise however, the second channel operates rather weakly. It is easy to see why. When aggregate demand is depressed even productive firms may be saturating the market with unsellable produce and as a result, they are hardly likely to increase employment until aggregate demand recovers. Thus, only the first channel operates at full capacity, and labour is fired at increasing rates. Synthesising these two channels in dampened economic conditions therefore results in heightened levels of unemployment, whilst aggregate demand is depressed even further.

If Abe’s supply-side plan is to recognise any success in this case it will have to hope that the effects of monetary and fiscal stimulus hit the economy before the labour market deregulations do. But even in this event (which admittedly is the more likely one), the third arrow of growth will inevitably fail to boost growth substantially.

The fact of the matter is that Japan’s crisis is one of a huge debt-deflation overhang, and one of depressed demand. That is; it is cyclical in nature, not structural. The huge time-frame and multitude of bogus recoveries would seem to imply that the recession is not a normal one, and the implication is correct; the problems are odd. But the peculiarity of the problems does not make them structural.

In an economy suffering from supply-side malaise, firms are unable to compete internationally and produce anything of meaningful values. In this situation, the current account deficit will rise due to domestic inefficiencies (since domestic production will be unable to compete with imports, and exports will falter).When the current account deficit rises, the currency devalues by the natural mechanisms. When the currency devalues imported inflation will rise. And when inflation rises the central bank will attempt to remedy the problem via contractionary monetary policy. Thus an economy suffering from supply-side inefficiencies should be characterised by having:

  • A deficit on the current account.
  • A weak currency
  • High levels of inflation
  • Contractionary monetary policy

These symptoms validate the experience of the USA in the 1970s, when it suffered from stagflation. Indeed, the problems in that situation were supply-side, and the required response was microeconomic in nature. But 1970s America is very different to 2000s Japan.

The Japanese economy for the past 20 years has shared none of the symptoms of stagflation. It has enjoyed persistent current account surpluses, a strong currency (the government has had to step in on numerous occasions to weaken the Yen in the past 20 years), persistent deflation and the most expansive monetary policy seen in history.

This should all point to the fact that Japanese firms are highly competitive on an international-scale. Whilst many academic economists may not realise this reality, one merely has to look in their own home to validate the reality. Japan’s firms are at the forefront of global innovation, and export their products vigorously to western households and businesses.

If Japan’s economy thus does not suffer from supply-side ails, and an economy stifled by over regulation then Shinzo Abe’s measures will be largely fruitless. If the demand-side stimulus measures hit the economy fast, the microeconomic reforms will be redundant. If however, implementation of the fiscal and monetary attacks wavers, the microeconomic reforms could cripple the situation and prolong the pain even further.

The reality stabs policymakers in the face every day. Japan’s problems are demand-side, failing to recognise this jeopardises the livelihood of millions of people.

A Quick Note on Quantitative Easing- The Portfolio Composition is More Important than the Reserve Levels.

So I was recently engaged in a debate with a close friend of mine over what the repercussions of continued Quantitative Easing (QE) would be, and what the inflationary effects of QE would be. The debate began with agreement, with both of us acknowledging that the current program was largely ineffectual due to the huge amount of excess reserves in the US financial system. Differences did soon become apparent however when my friend expressed his concern over the inflationary effects of the program if it went on indefinitely. This was because of the difficulties of retracting the program if it were allowed to go on for too long. Retracting $2 trillion dollars is easier than retracting $20 trillion. With the reserves just sitting there in huge excess, surely Bernanke could taper the constant injections, but leave the money already there as is. Money at the moment is just sitting in the system floating about, so what’s the point of putting more in if it just makes the retraction harder? Surely the huge monetary base would keep liquidity high and interest rates low across the board. There is so much excess, why do we need more? Stop the program, leave the reserves there, and lending growth should be unchanged. The analogy is “If the shops can’t sell 10 apples, giving them 100 isn’t going to help them sell any more if the price doesn’t change”. And in other words again, people seem to think that as the money multiplier declines banks ‘park’ their money with the Fed, and do not ‘Lend it out’

This line of thinking however overlooks the actual mechanisms that drive the operations behind QE, and its theoretical framework. The fact is that QE works to drive specifically Long-term interest rates down with the purchase of Long-term assets. The answer lies in the fact that banks have strict portfolio norms that they follow, and that reserves don’t simply get “lent out”.

So let’s briefly address the “Lending-Out Misconception” first. This common misconception holds that when commercial banks hold too much cash in their reserve accounts with the central bank, they can expand their lending operations. They simply lend out this extra cash to the private sector and real economy. This is simply not true. The commercial bank has no actual control over reserve levels, and the link is indirect. (see for more

So, on to the more substantial point. If it’s reserves that matter and if there are excess reserves, what is the point of pushing even more into the system? The money is not being used as it is!

The point however is that it’s not the reserves nor the liquidity that expand lending. Rather, lending comes from individual banks changing their portfolio composition. In reality, when the Fed implements QE, what it does is buy long-term securities (henceforth simplified to be mortgages). Buying these mortgages helps to increase lending activity, not because the banks now have money in their checking accounts that they can lend out, but rather because banks strive to have a consistent level of long-term assets and liabilities relative to short term ones. When the Fed buys mortgages off of a bank. The bank will find itself with a more cash assets, and less mortgage assets. It’s portfolio’s composition will have changed. In order to address this the bank will strive to correct the portfolio and buy up mortgage contracts and assets off of the private sector. It will then credit the private sector with cash. Hence, when the Fed buys mortgages off of the banks, portfolio corrections means that it is really accumulating them off of the private sector. The private sector will then find itself with excess cash and the money should theoretically be invested or used.

Where the ‘flow’ of QE becomes important is in distorting the banking sector’s portfolio. As it stands, the banks are not inclined to correct their portfolios, and lending rates are not rising. But corrections back to normality DO nevertheless happen slowly, and the more balance sheets become liquid with cash exceeding mortgages, the more the banks will strive to correct their balance sheets, buying up mortgages off of the private sector.

Thus, QE works through the norms of the financial sector, and no matter how redundant inflating the monetary base through reserves may seem, it incentivises lending expansion regardless. Why are banks not so keen to rebalance their distorted portfolios? Is this situation permanent? The answer is a resounding no to the latter. Banks simply do not want to rebalance their portfolios because the returns on long-term assets have not been deemed valuable enough relative to those of highly liquid assets at the moment. In addition, the 0.25% interest rate payment that the Fed gives the sector for excess reserves provides an incentive to keep the asset compositions highly liquid. This means keeping the portfolios at above equilibrium levels of liquidity. That doesn’t mean that banks will completely disregard the portfolio norms however. Indeed, the more the Fed increases the liquidity of the balance sheets, the more the banks will strive to accumulate mortgages off of the private sector. Thus the private sector’s holdings of loanable funds increases, and interest rates fall.


*Disclaimer: I think I’m wrong

Understanding Sovereign Bonds- Foreign Financing of Fiscal Deficits

The rise of Neo-Mercantilism’s export-led growth in countries such as China and Japan has brought a host of Balance of Payments (BoP) and Sovereign Debt problems to the fore. These problems are paramount to the international economy, but experts and policymakers alike demonstrate ignorance of the mechanisms behind the BoP through counterproductive proposals.

Sovereign Debt Markets and the Balance of Payments are one of the most counterintuitive and complex themes that policymakers face, fallacies are therefore riddled throughout the public debate. Not even the US Secretary of State Hillary Clinton is immune to frequent blunders when engaging in the sphere of international macroeconomics. In February, 2009 for example she made a famous imploration to China that they continue their purchases of US treasuries. This simple (and fallacious) request to the Jintao administration received almost no academic criticism; despite the detrimental effect that the Secretary of State’s policy goals would have on the US economy. An analysis of Chinese purchases of US dollar-assets is therefore required in order to address the unforeseen issues associated with foreign financing of sovereign bonds.

There are two main problems with Clinton’s imploration to the Chinese- namely the nondiscretionary nature the Bank of China’s treasury purchases, and the manner in which these purchases fail to alleviate fiscal deficit serviceability.

Firstly, the Bank of China (BoC), and Chinese Sovereign Wealth Funds do not simply decide to purchase huge quantities of US dollar-assets (in the form of bonds for now) based on whimsical choices of investment hubs. The decisions are not arbitrary; they are natural. The Bank of China’s decision to keep the RMB devalued means that they acquire huge foreign exchange reserves primarily in the form of US dollars. These dollars must be invested somewhere, and the only two markets large enough to absorb this influx of liquidity are the Eurozone and the US. Of these two options the US financial sector’s development and reputation of a safer investment location makes it the obvious choice.

Even if the Chinese decided to shift their exchange reserves to the Eurozone, they would have to undergo huge and costly transactions changing their accumulated dollars to Euros, in the process making huge losses in arbitrage as the dollars were devalued. It is clear with this in mind that Clinton’s beggary to the Chinese was completely ineffectual. The only way the Secretary of State could get her wish of increased foreign purchases of dollar-assets would be through the BoC devaluing the RMB even more, acquiring more reserves, before shoving them back into the bloated US treasuries market.

This leads us to the second (and far more important) fallacy underlying the Secretary of State’s understanding of foreign financing. The only way for China to unilaterally increase its purchase of US bonds would be to increase the volume of its capital exports to the US, thereby forcing a larger current account surplus as well (By definition the quantity of capital that is imported or exported is equal to the quantity of goods that are imported or exported respectively). The influx of demand for dollars would inflate the value of the currency, increasing the trade deficit by an even larger amount, and consumption on imports would boom leading to an even more indebted household sector.

In addition, interest rates on bonds would be largely unaffected and the government’s debt would become no more serviceable than before. This is due to the fact that with an appreciation of the dollar, many tradable sector firms would be adversely affected, and workers would be made redundant quite quickly. As a consequence, the US fiscal deficit would rise in a quantity roughly equal to the initial influx of Chinese bond purchases which caused the appreciation or by contrast the US would have endure higher levels of unemployment (The change in the capital deficit will be exactly equal to the trade deficit).

The point is that the Obama administration would have to issue an amount of bonds roughly equal to or in excess (A few economists have tried to calculate the exact relationship with little success) of the amount purchased by the Chinese. The influx of supply would equal the influx of demand, and the price (in the form of interest) would have no net effect. The difference for the American economy would be that both the current account deficit and the fiscal deficit would have grown. Americans, in essence, would be forced into an even larger imbalance between consumption and production.

Hillary Clinton’s imploration to the Chinese in this light is clearly opposed to American interests, and yet the entire economics profession remained largely apathetic to her announcements. Today, the profession continues to be mute when confronted by similar policies that flout textbook macroeconomics.

The Distorted Nature of Global Trade Imbalances

Drawing from the theories of Ludwig von Mises and Friedrich August Hayek, from the Austrian school of Economics, many market economists have viewed the US and Spanish trade deficits as healthy reflections of the comparative advantages enjoyed by different economies.

A deeper look at the economic structures of surplus and deficit trading countries alike however highlights how external imbalances are often a reflection of internal imbalances and/or distortions. Policy makers therefore should not overlook trade imbalances and assume that they are reflections of optimum market performance and global comparative advantages.

The ECB famously noted in 2004 that “A widening of the household sector deficit was a pattern not seen in earlier episodes of current account deficit widening”. The implication here was that the rising deficit on the current accounts of periphery Euro zone countries and the US was accompanied directly by foreign borrowings from the household sector to fund consumption rather than investment.

This should not however lead to the simplistic belief that American and Spanish households are directly responsible for their indebtedness, and should stop consuming to ease the imbalances. The true causes of excessive trade imbalances are more complicated, and much of the fault lies with the financially crippled and regulated surplus nations such as China and Germany.

With the ascent of globalisation and financial innovation it suddenly became much easier for nations such as the US, Spain and Greece to run persistent deficits with access to easy credit. The US was able more than ever to attract international credit flows due to its reputation as a secure investment market, coupled with a large financial sector able to create collateralised debt obligations (CDOs) which spread individually crippling risks across multiple investors.

Other nations such as Spain and Greece found easy access to credit streams from the European Central Bank, lending on distorted Value at Risk (VAR) calculations, which were supported by the easy transfer of savings across Euro Zone borders. With the artificial access to German savings, Spanish and periphery markets proved to be much more lucrative sources of consumption than their German counterparts.

This is largely due to the history of the German export-led development model. Under government direction of resources away from household consumption and towards export-oriented firms, domestic sources of consumption had historically been handicapped. This was due to distorted interest rates, high levels of government protection, and a crippled financial sector unable to adequately evaluate investment opportunities. The financial sector, unable to efficiently apportion savings towards local investment, instead relied upon established ‘crony’ relationships with exporting firms and government bureaucracies to allocate funding across the economy. The German economy grew at two speeds under this export-led growth strategy, with a super efficient manufacturing sector and an inefficient services sector unable to attract domestic demand.

With no attractive outlet for their savings appropriated by high-end exports, German households instead poured their savings into the Euro Zone’s financial sector- injecting billions of dollars into economies where domestic demand was healthier and more competitive. This influx of easy credit flows kept periphery interest rates low, and household consumption boomed in housing and similar activities that had experienced widespread deregulation. This was most famously seen in the Spanish President Aznar’s “Ley de Suelo” and similar reforms, which deregulated financial transactions and encouraged housing construction.

China’s domestic imbalances had a similar financial structure to that of Germany, but were also compounded by government industrial policy. With the Yuan undervalued by the Jintao administration, exports yielded higher returns relative to domestically geared production, and the structural trade surpluses similar to Germany were deliberately exacerbated by government policy.

As a result of this trade surplus the Jintao and Jinping administrations built up enormous reserves of US dollars. If these dollars were to be converted back to Yuan however, it would create a large demand influx for the Yuan, thereby revaluing the currency at its natural value. Instead, the Chinese government opted to return their foreign currency reserves (FCRs) back into the US economy- buying government bonds and providing the financial sector with high liquidity. With the competitive nature of American finance and household consumption, these funds again led to an influx of demand (and therefore supply) for housing projects and similar household investments and consumer items.

The obvious correlation between trade deficits and economic busts should provide enough empirical support to refute the notion that trade deficits are healthy reflections of global competition, but it isn’t. Market fundamentalism is intoxicatingly simple to cite, but the assumptions that underlie its arguments are baseless.

The build-up of household debt and consumption seen in domestically geared economies was not a healthy manifestation of global comparative advantages. Instead, it symbolised a sinister allocation of resources in surplus nations, which fuelled household debt accumulation in deficit nations.

Unnecesary Blunders in the GFC- Revising the Role of Government

The collapse of Lehman Bros. on September, 15, 2008 precipitated a global collapse in confidence among creditors and depositors alike; but whilst the heavily indebted economies of Europe and the United States were structurally unsound (with production geared against export-led growth), extreme economic slowdown was not a necessary condition for the subsequent structural adjustment. The behaviour of the US treasury during the crisis epitomized the ineffectual and indecisive policymaking deemed largely responsible for the exacerbated nature of an otherwise mild cyclical downturn.

It is now common knowledge that nearly all developed economies had become highly indebted before the winding up of Bear Stearns in March 2008. One commonly overlooked aspect however, was that this debt was largely illusory, and was a result of complex financial swaps and hedges that expanded credit, leverage, and the broader money supply. Much of the debt counted in the US economy was a result of inter-bank lending, where banks created complex chains of borrowing. For example, J.P Morgan would lend $1 to a hedge fund, which lends $1 to an investment bank, which lends $1 to a broker, which lends $1 to a mortgage bank, which lends $1 to the homeowner. The total financial leverage therefore becomes $5, but the actual indebtedness of the household (real economy) is only $1. The virtue with this structure, known as Fractional Reserve Banking, is that as long as all the links are safely capitalised and secure, debt can be quickly deleveraged without serious repercussions on the non-financial economy. The longer the chains are however, the more pronounced the effects are if one link breaks. In the US, the chains were extremely long (in some cases chains reached leverage ratios of 30:1) and the situation quickly became an untenable deleveraging nightmare.

This is exactly what happened with the bankruptcy of Lehman Bros, and the US treasury’s decision to not guarantee creditors and lenders. The chain was allowed to break, and otherwise modest losses in the financial sector matured into system-wide threats to the world financial system. But why were the banks so poorly capitalised in the first place? Was it because they expected government aid in conditions of system wide failure? Or was there some other fault line in the system? Many commentators do indeed simplistically blame “crony capitalist” relationships between congress, the Federal Reserve, and Wall Street; where an implicit promise from congress to socialise losses if they are systemic encourages the mass accumulation of tail-risk (financial jargon for risks that are rare, but catastrophic, and systemic if realised). But a more technical approach towards the problem of poorly capitalised institutions points the finger towards accounting standards stipulating transparency.

The new accounting standards (Known as “Mark to Market” accounting standards) took discretionary power away from regulators and banking officials, and handed it over to the forces of the market. Institutions were required to report their solvency as a function of the market value of their assets. During a boom period, with rapidly rising asset values, these institutions witnessed enormous profits and were able to reward large bonuses to their employers and run down their capital reserves. But when values began to fall, losses built up, and to maintain “official” solvency they were required to liquidate their assets en masse with virtually non-existent capital reserves and anxious depositors. This drove down the value of their previously profitable assets, and a positive feedback loop spiralling downwards compounded the problems yet again, and financial balance sheets did not recover until the suspension of the new accounting standards in March 15, 2009.

The relevance for both of these points is that financial sector losses were compounded by the government’s reluctance to intervene in Wall Street, and instead rely upon the efficiency of the market to allocate resources. The Federal Reserve was even forced to increase interest rates early 2008 during the deleveraging process, and winding up of Bear Stearns due to an unsubstantiated attack on commodity prices (and specifically oil) leading to an increase in cost-pushed inflation. With the monetarist paradigm stressing inflation control over demand-management the Federal Reserve hiked up interest rates, despite the contraction in the money supply as a result of deleveraging. The effects were again ruinous, as the money supply contracted rapidly as a result of monetary policy plus the necessary structural adjustment. If the treasury had instead intervened in commodity speculation directly, and regulated oil hoarding in the typical post-war Keynesian approach, the money supply could have expanded and supplementarily supported the deleveraging process, which would otherwise have been deflationary.

Yet even despite the difficulties imposed on the deleveraging process by accounting madness and artificially high interest rates, the non-financial economy was acting with typical flexibility moving employment away from the bloated domestic-demand sectors towards exporting sectors throughout the credit crunch. The trade deficit from 2006-2009 almost halved for example, whilst the current account deficit narrowed from $974 billion in 2006 to a mere $189 billion in 2009. This path had already begun before the collapse of Lehman- and the excessive output gaps experienced alongside stagnant growth could have been avoided if the US Treasury was more willing to consider its full role in the management of economic affairs.

This argument leads on to the topic of financial life-support by government which I will analyse in another piece, citing the Third World mass defaults on debt from 1982-1989, the Swedish crisis of 1992 and Japan’s lost decade.

Outline of Australian economic trends

*The following outline of Australia’s economic trends is an addition to Systemdestroyer’s analysis of Australian economic performance. Hopefully the data/analysis provided will be useful to readers*

Systemdestroyer’s article can be found here-

Australia’s annually adjusted growth in Gross Domestic product (GDP) since 1990 has been relatively stable. Despite negative growth in 1991, the economy has been growing steadily reaching a climax of 5% in 1999. This robust growth expedited by the Freemarketeer reforms implemented by the Hawke-Keating government has been accompanied by rising income inequalities however.

The value of the gini coeficient (a common measurement of income inequality) has risen from 0.28 in 1990 to 0.33 as of 2013. Many Keynesian and progressive economists have blamed Free market ideology for such income differentials, but the general consensus is that the rise is a natural result of globalisation, which introduces more Labour market competition and labour replacing capital, undermining the wealth share of the lower classes.

Services and commodities have accounted for an increasingly large share of GDP and employment in the domestic economy since the sweeping economic rationalist reforms of the Hawke-Keating era eliminated the protection previously given to manufacturing. Although the initial devaluation of the Australian dollar following its float in 1983 initially helped exporting manufacturing sectors grow more quickly than their tertiary industry counterparts, their market share has fallen at an accelerating rate, reflecting more efficient use of organisational capital relative to wages in Asia (specifically China), and an appreciated currency. The effect on GDP of the declining manufacturing sector however has been minimal, since Asia’s shift towards manufacturing has precipitated an increase in Australian commodity exports, where there is a strong comparative advantage. As a result, the shift away from manufacturing represents a major structural adjustment in Australia’s economy in favour of sectors where our comparative advantage in human capital and natural resources is more apparent. This structural adjustment has become one of the factors contributing to Australia’s stable growth rates despite fluctuating global trade conditions.

Australia’s current account deficit since these structural reforms has been in a healthy condition. After the credit dry up of 2007, and subsequent bust after 15, September 2008 with the collapse of Lehman bros, Australia fared well relative to other OECD countries, with the lowest public debt rates and sturdy economic growth despite a single quarter of contraction in 2009. The maintenance of employment and healthy terms of trade is largely attributed to the ascent of bilateral and multilateral trade agreements alongside the reforms mentioned with the Asia-Pacific region which has experienced sturdy growth using the export subsidy growth strategy, and through protectionism, shifted production away from commodities and low-demand-elasticity industries towards manufacturing. Trade with China for example has grown from $113 million dollars in 1973 to over $85 billion dollars in 2009 (despite sluggish growth conditions), reflecting an enormous increase in trade with the region facilitated by trade agreements and structural reform. This represents an ongoing long-term geopolitical-economic shift towards the region, and away from debt laden developed markets.

An interesting anomaly in Australian economic trends is a reversal of the prediction of Wagner’s law. This economic law states that government spending as a percentage of GDP is inclined to rise as a result of increasingly dangerous technological monopoly, and public demands. Following the ascent of Milton Friedman’s monetarism and Reaganist ideology, both the Liberal and Labor parties have extensively privatised existing public enterprises such as QANTAS and TELSTRA, and any R & D investment is usually open to usage by private enterprise (as seen by the implementation of the National Broadband Network). This privatisation under third-way ideology has consequently led to a lot less government regulation of sectors deemed important, and competition has flourished under the laissez-faire growth model. Cuts in subsidisation have also strengthened the government’s revenue base despite remnants of protectionist subsidisation aimed at low skill manufacturing under pressure from an appreciated currency.

All of these trends have been driven by the general economic and philosophical structure of the world since the 1970s. Such “Megatrends” (as referred to by the UK political commentator Anatole Kaletsky), have encompassed economic thinking and been practiced widely. Multilateral trade agreements, domestic and foreign structure, open market policies, and income equities have all been changed in the Australian economy since 1990 within the paradigm of the free market fundamentalists. Whether these changes will finish in flourishing growth and competition, or disaster is still to be seen.

Failure of the neoclassical synthesis-Long term unemployment

Despite enormously high deficits,  apocalyptic C.A.D levels and mountains public debt, western democracies by and large are still finding themselves in the midst of sluggish growth rates, high unemployment and record levels of income inequality. The U.S public debt levels have been steadily growing, with notable periods of exception, since the advent of fiat money allowed politicians to effectively spend indefinitely (or so they thought)­­ creating money out of thin air. With over 9 trillion dollars artificially circulating in the economy the problems still remain. How is it that even the most vigorous stimulus programs have failed to see noticeable gains in economic growth since the early 1970’s? Surely, with Keynesian logic, we should have seen exponential levels of growth accompanying the public debt. Instead we have seen incrementing deficits and lacklustre growth.

I do not claim to have all (or even any) answers to these problems. I am writing out of the desire to expand my thought and network with others who are passionate about these issues. I am hoping that by exploring these ideas online in a blogging format, I can start a dialogue and prematurely avoid the mistakes that come alongside solitary thinking, and if I get good responses, I will also translate the blogs into Spanish. (As was the motivation of John Maynard Keynes when he wrote ‘The General Theory of Employment, Interest and Money’). In my intended exploration of the failure of current employment theory, I am going to briefly go through the orthodox theories that have encapsulated economics over the past century, and analyse them one by one.

In classical economics, or supply side theory (according to Keynes), a recession cannot logically exist. The logic here is that basically in Say’s law, supply creates its own demand (Again, the definition has been changed, but this was Keynes’ interpretation). There is no such thing as diminishing returns, or levels of production efficiency, and an economy should constantly experience full employment levels (the only unemployment being voluntary and frictional). When demand falls, there will be excess supply, and so, prices as a result will fall until supply matches demand (In basic macroeconomics, lower prices increase demand for an individual item, this is one of the fundamental economic propositions). This can be applied to labour markets, so that when there is high unemployment (In Keynesian jargon- high factor cost competition), there is an excess supply of labour; therefore wages will fall, and businesses will be able to cut the wages of their employees, and lower the cost of their product assuming the industry isn’t monopolised. From here, production costs are lower, and demand is restored, so the employment should start to rise again straight away, and no recession should occur because prices and wages are flexible.

(Please note this is the cynical Keynesian version of the theory, if any Neoliberals out there could correct my interpretation of the classical theory, please do!!)

Keynes’ theory on the other hand, accepts many of these assumptions but refutes the idea that wages and prices are flexible. In Keynesian thought, wages and prices are “sticky” due to a host of external political factors, such as the influence of trade unions, wage agreements and reluctance of businesses to lower prices enormously and witness immediate losses. As a result, the only way for businesses to reach efficient levels of production to meet the decreased demand is to cut employment levels until the workers and businesses accept lower wages and prices respectively. Therefore the duration of a recession depends upon the flexibility of the system.

This may all seem quite intuitive but the modern textbooks have acknowledged a problem, that the ‘neoclassical synthesis’ addresses. In demand-side economics, as opposed to supply-side, the problem is low aggregate demand and insufficient sales. The problem stems from the fact that the initial problem is low aggregate demand. If wages fall to increase supply, demand is not likely to increase, and may fall. How are lower wages across all sectors going lead to increased consumption?! The only compensating factor will be increased profits for the firm. Prices also work differently than is thought at first sight. Whilst lower prices lead to increased demand in individual sectors and firms, lower aggregate prices could react differently. There is no alternative for lower/higher consumption patterns when price changes are universal and so demand again will not be restored disproportionately. Where the neoclassical synthesis comes in is next, and it is a little hard to summarize but basically, the higher utility of the currency leads to smaller demand for cash in hand, since the same product can be purchased with less physical money. As a result there is less demand for currency and so the ‘price’ falls. The price of money is the interest rate. This encourages increased borrowing and investment, stimulating growth. Another accompanying factor is a psychological “wealth effect”. Whereby the relative return on assets becomes more valuable and so consumption temporarily increases because people feel they are wealthier, although this is offset by something else which I am about to raise, and has not been addressed by orthodox thinkers. With these theories considered, long term unemployment should not occur, even in highly debt ridden countries such as Japan. How then, have these countries managed to muck up their growth prospects so much?

Well, one of the most important effects of wage adjustment has simply been ignored by politicians internationally; and a number of economists (Both Peter Schiff monetarily and Paul Krugman fiscally) also fail to see these effects that destabilise the economic environment and lead to hampered long term growth. Indeed, it appears the only institutions that have embraced the theory wholeheartedly are the central banks of the world, especially the Federal Reserve. The ignored effects are the ones of deflation, or more accurately in the modern economic environment, disinflation (Lower than expected levels of inflation, not falling into deflation). With disinflation, people are earning less than they normally would, but their debts have remained constant. This leads to an opposite effect to that of a ‘wealth effect’; only the effects are permanent if the economy does not return to pre-recession levels of inflation, or reduce debt levels substantially. The borrowers will often reduce borrowing and spending as a result of disinflation making debts more burdensome, or close down their enterprises, whilst lenders may also be less inclined to loan funds due to the riskier return rates (The ‘too-big-to-fail’ policies will reduce this lending tendency, but cause even worse problems down the line which I will address in another blog article). This factor helps to explain in macroeconomic terms, why countries heavily involved in credit activities have had slowing recovery rates over the past 40 years, and why constrained aggregate demand seems so persistent in many areas of the Western world despite policies designed to remedy it. Employment rates if this theory is correct, will be largely dependent upon the credit composition of an economy.

Evidence can be seen in the lacklustre stimulus performance of Japan in the past 2 decades, despite all efforts to ramp up activity; and also in the sluggish recovery of the USA and Southern Europe right now. If these factors are taken into account, it appears the European fiscal policies are ahead of those in the USA, putting long-term growth ahead of short-term viability, but it is unfortunate that it requires the bust on sovereign debt to have been so severe before proper action to reduce the deficit is taken. Monetary-base expansion (As proposed in Japan by Paul Krugman) could be another way to reduce the burden of disinflation, and explains why the short-term inflationary policies of the Federal Reserve may actually be working in the medium-long term (SHOCK!), that is not to say we should advocate Central Banking monetary policy on the whole, but rather give Bernanke a little credit for understanding the effects of disinflation on a heavily indebted country. The mixture of fiscal austerity, with monetary expansion seems very unpopular and indeed counter intuitive, but if debt has a significant impact upon employment levels, as many well known economists believe, action must be taken in both monetary and fiscal policy to reduce it.

Sovereigns and international leaders alike need to completely reform their frame for economic policies and look even further into monetary economics (and all social science fields) if we want to see real and sustainable global development. The neoclassical synthesis has historically failed its adherents, and economists need to start looking at the economy as an aggregate again, and not focus solely on labour markets. Macroeconomics requires subtle analysis of the economy as a whole and her components, we have lost touch with it, and we need to find it again if we seriously expect and desire sustainable global development.