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.

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.