Martin Wolf writes on “unorthodox” fiscal and monetary policy responses to the recession in this morning’s FT. The article highlights the work of Agustin Benetrix, Kevin O’Rourke and co-authors (IIIS Discussion Paper version here).
Author: John McHale
Paul Krugman continues his campaign against the expansionary fiscal contraction hypothesis here. In making his case, he links to a 2007 paper by UCC’s John Considine and University of Portsmouth’s David Duffy. I don’t think the paper provides the slam-dunk evidence Krugman contends, but it is a very interesting read.
Abstract:
It is ironic that the potential expansionary effects of fiscal contractions have become known as non-Keynesian effects. This paper highlights the fact that Keynes and his contemporaries were aware of such potential perverse effects. It is clear that the important indirect effects of budgetary policy via expectation were known in the 1930s. Moreover, the economists of the time recognised the possibilities before they occurred. This paper supplements the existing research on the Expansionary Fiscal Contraction hypothesis by comparing two periods in economic history, Britain in 1930/1 and Ireland 1986/7, and the accompanying economic thought.
University of Chicago economist Raghuram Rajan made news recently for his perplexing call on major central banks to raise interest rates (see here and a response from Paul Krugman here). While his monetary policy advice might be a bit unorthodox, his recent book on the financial crisis stands out from the recent crop of titles as an important read. The book is Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press). The introduction is available for free download from the publisher’s website.
What makes the book stand out is his attempt to look beyond the usual proximate causes to deeper determinants – or what he calls “fault lines”. One may not always agree, but he is always provocative. His fault lines include: the use of expansionary macro policies to (cheaply) ease distributional tensions in response to rising income inequality; an export-driven growth model in emerging economies that made it hard to absorb capital in non-traded sectors; and the legacy of the Asian crisis that convinced emerging-economy governments to build war chests of foreign reserves. He also puts great emphasis on the role of implicit government guarantees in incentivising the taking of “tail risks”.
I think the book is a good complement to the Honohan and Regling & Watson reports. With differing emphases, the reports rightly point to the failures of key agents – bank managements, regulators and government. But while the reports are good at describing what happened, the why was largely beyond their briefs.
Rajan’s book is helpful in part because it makes us look beyond the more obvious agency failures to the failures of key principals – bank shareholders, politicians and voters (including their fourth-estate watchdogs). What would the shareholders of the big two banks have done if management had refused to get involved in highly profitable development lending in the lead up to 2007? What would politicians – government and opposition – have done if regulators had moved to curb credit expansion and prick a suspected property bubble? What would voters have done if the government had moved to tighten fiscal policy while running budget surpluses? There is a bit too much wisdom after the fact.
A couple of extracts from the introduction give a flavour of the argument:
[T]he central problem of free- enterprise capitalism in a modern democracy has always been how to balance the role of the government and that of the market. While much intellectual energy has been focused on defining the appropriate activities of each, it is the interaction between the two that is a central source of fragility. In a democracy, the government (or central bank) simply cannot allow ordinary people to suffer collateral damage as the harsh logic of the market is allowed to play out. A modern, sophisticated financial sector understands this and therefore seeks ways to exploit government decency, whether it is the government’s concern about inequality, unemployment, or the stability of the country’s banks. The problem stems from the fundamental incompatibility between the goals of capitalism and those of democracy. And yet the two go together, because each of these systems softens the deficiencies of the other. (p.18)
We also have to recognize that good economics cannot be divorced from good politics: this is perhaps a reason why the field of economics was known as political economy. The mistake economists made was to believe that once countries had developed a steel frame of institutions, political influences would be tempered: countries would graduate permanently from developing-country status. We should now recognize that institutions such as regulators have influence only so long as politics is reasonably well balanced. Deep imbalances such as inequality can create the political groundswell that can overcome any constraining institutions. Countries can return to developing-country status if their politics become imbalanced, no matter how well developed their institutions. (p.19)
In an Irish Times article that must have much of the country talking, Morgan Kelly calls for a Special Resolution authority to force bank creditors to swap €65 billion of debt for equity (link in Greg’s post below). The number is €50 billion less than called for in his V0X article earlier in the week, and critically calls for the losses to be imposed after the original guarantee expires in September. He is thus, as far as I understand, not calling for default on the “quasi-sovereign” guarantee.
I am sympathetic to the idea of forcing the funders of Ireland’s banking binge to bear a fair share of the resulting losses (some thoughts here). But if Morgan’s policy suggestion is not to be dismissed, we need more specificity on the source of the €65 billion. The Anglo accounts revealed that roughly €7 billion of bonds will mature post September. He must have the big two in his sights.
Even with Special Resolution authority in place, the proposed debt-equity swap could only be triggered if capital adequacy falls below some critical threshold. But the two “technocrats” Morgan lauds appear to believe that Bank of Ireland and AIB are on course to reach the new capital adequacy requirements. Patrick Honohan had this to say in a recent speech:
Over the previous few months, we at the Central Bank have been making a careful assessment of the likely bank loan-losses that are in prospect over the next few years. This is over and above the valuation work being carried out by NAMA, and which gives us a good fix on the likely recoverable value of the larger property loans. We have been working on the non-NAMA loans and figuring out their likely performance as they suffer from the impact of the overall economic downturn – part of it of course attributable to the global crisis, and not just to the bursting of our own bubble. This exercise involved working with the banks, but challenging their estimates of loan-loss based on our own more realistic – some may say pessimistic – credit analysis. (I am over-simplifying the exercise, as it also looked at other elements of the profit and loss account over the coming years). The conclusions of this exercise are worth emphasizing.
To my relief, and slight surprise, it turns out that most of the banks started the boom with such a comfortable cushion of shareholders’ funds that they would be able to repay their debts on the basis of their own resources. This includes the two big banks. It is because of this fact – that their shareholders’ funds will remain positive through the cycle – that one of them, Bank of Ireland, has already been able to tap the private market for an additional equity injection. Of course they do need additional capital to move forward, but, as has happened in the US and elsewhere, the Government’s capital injections of last year into these two institutions looks like being well-remunerated.
The €65 billion number needs more explanation.
Update (Sunday, May 23)
In correspondence, Karl Whelan has provided maturity information for the outstanding bonds of the major banks. The information is drawn from the 2009 accounts, and is based on bonds that mature more than one year after December 31, 2009. Thus, it does not include bonds that mature in the last quarter of this year. (It is not clear what fraction of the bonds were issued based on the extended guarantee.)
The numbers are as follows (billions of euro):
BOI: Senior, 18.5; Subordinated, 5.3; Total, 23.8
AIB: Senior, 8.5; Subordinated, 4.6; Total, 13.1
Anglo: Senior, 4.1; Subordinated, 2.7; Total, 6.8
INBS: Senior, 1.2; Subordinated, 0.2; Total, 1.4
ILP: Senior, 5.1; Subordinated, 1.6; Total, 6.7
Totals: Senior, 37.4; Subordinated, 14.4; Total, 51.8
These numbers suggest that Morgan’s €65 billion is in the right ballpark. But they also highlight the extent to which the money relates to the big two, and especially Bank of Ireland. The most natural sequence for implementing the loss imposition strategy that Morgan proposes would be: (1) legislate a resolution regime; (2) apply comprehensive stress tests to determine capital adequacy; and (3) trigger resolution tools as required. Based on the stress tests that have been done so far, which we are told have been quite comprehensive and conservative, the big two would not be put into resolution. Of course, it is evident that Morgan does not believe these tests were comprehensive or conservative enough, with AIB probably being more suspect than BOI. Even so, I think it is important not to expect too much in the way of loss imposition on creditors from a resolution regime. Yet it is still worthwhile to pursue a regime even if the savings to the taxpayer are just a fraction of the €65 billion.
Even as Greece appears willing to accept a larger austerity package in return for a much-expanded financing package, some leading economists are contemplating radical alternatives.
Paul Krugman no longer sees a euro exit as impossible (NYT article here):
So what will happen to the euro? Until recently, most analysts, myself included, considered a euro breakup basically impossible, since any government that even hinted that it was considering leaving the euro would be inviting a catastrophic run on its banks. But if the crisis countries are forced into default, they’ll probably face severe bank runs anyway, forcing them into emergency measures like temporary restrictions on bank withdrawals. This would open the door to euro exit.
Nouriel Roubini and Arnab Das argue in the Financial Times for a Plan B that involves a pre-emptive debt restructuring:
Continuing on the path of least resistance – a “Plan A” of official financing banking on a mix of deep fiscal cuts, inadequate structural reforms and hopes that markets will stay open, with growth doing much of the heavy lifting – is a risky bet that is very likely to fail. Already this week, financial markets and credit rating agencies have voted against this approach and started to price in a high probability that Greece will need to restructure its public debt coercively, with contagion to the rest of the eurozone periphery now a serious risk. Augmenting the programme for Greece alone – up to €100-€120bn as suggested by the IMF – will not work either.
Far better to move to Plan B. This would involve a pre-emptive debt restructuring for Greece; a strengthened fiscal adjustment plan in the eurozone periphery; far-reaching structural reforms; a larger IMF/European Union programme to help Greece and prevent contagion to others; further monetary easing by the European Central Bank; fiscal and domestic demand stimulus in Germany; and a co-ordinated effort to address the institutional weaknesses of Europe’s economic and monetary union.