The IMF: Fountain Of Bad Advice

“The day will come when this period of exceptionally loose monetary policy, both conventional and unconventional, must end. In the long-term it is clear that exit will involve phasing out, and ultimately reversing all of these policies.”

--Christine Lagarde, Managing Director, IMF, Aug. 23rd, 2013

It is the IMF’s position that:

1. Monetary policy has been exceptionally loose for the past five years.

2. That this monetary stimulus has provided “breathing space” for the accomplishment of structural and fiscal reform.

3. That, in the long run, it is the reforms that are important, while the unconventional monetary policies must be brought to an end.

4. That central banks will need to cease providing loose money, and will have to manage the risks associated with “exit”.

Each of these statements is completely wrong, and on many levels.

First of all, there is no evidence that monetary policy has been loose since Lehman. Money growth since the crash has averaged in the mid-single digits for the US, the UK and the EZ, and in the low single digits for Japan. Not only is such growth not rapid, it is a bit low by the measures of the past thirty years. Should you look at a graph of money growth since the crash for the major economies, you will see no evidence of exceptional looseness. Further, if money policy were exceptionally loose, wouldn’t we be seeing inflation? Inflation in the major economies is near an all-time low. The statistical evidence is that money policy has been overly restrictive since the crash, so there is nothing to exit from.

Secondly, rapid money growth would indeed have provided breathing space for reforms that improved competitiveness. But rapid money growth did not occur. Instead, the IMF has forced the PIIGS to perform surgery on themselves in the middle of a depression, thus producing high unemployment. You can’t breathe when you’re drowning.

Thirdly, the prioritization of structural reform over nominal growth is utterly misguided. The world’s problem is the output gap caused by inadequate aggregate demand, not labor market rigidities or budget deficits. Policies that create unemployment hurt aggregate demand. What the world needs right now is an end to structural reform and budget austerity until growth returns to a more normal level. Reform and austerity are killing the patient.

Fourth, it is fallacious to say that monetary stimulus must be brought to an end when it has not been tried. Since there is nothing to “exit”, there are no risks to manage. The risks emanate from the deliberate continuation of restrictive monetary and fiscal policies resulting in inadequate demand. The IMF has the gall to talk about the risk of inflation when the real and present danger is deflation.

The principal risk facing the world economy today is the market’s realization that the monetary authorities lack the ability to stimulate aggregate demand because they falsely believe that they are already providing stimulus--indeed too much stimulus. That means a future of ultra-low inflation, inadequate demand, and a growing output gap. It also means ongoing fiscal pressure as debt rises while government revenue stalls.

Ms. Lagarde says that thinking about global economic and financial stability is the IMF’s raison d'être. That’s a lot of money the world is spending for bad advice.

Market Discipline Requires Honest Accounting

Yesterday I wrote about the iffy credit outlook for Dexia. Today I’d like to write about Dexia as an example of the quality and usefulness of European bank accounting for investors and creditors.

Here are Dexia’s reported earnings for the past seven years (billions in euro):

2006: 2.7

2007: 2.5

2008: (3.3)

2009: 1.0

2010: .7

2011: (11.6)

2012: (2.9)

1H13: (.9)

Notice anything odd? Dexia reported profits of 723M at yearend 2010, only to be followed by a loss of 11.6B in 2011. Think about that: Dexia’s management and auditors signed off on the 2010 financial statements in March of 2011 and presented them to Dexia’s shareholders in May of 2011, only to report a loss of (oops!) 11.6B for 2011.  The same saga was true in March of 2008, when management reported a 2.5B profit for 2007, only to report a 3.3B loss for 2008.

How can management report a profit in the same year that it is heading towards a massive loss? Is that incompetence, or legerdemain?

It is one thing to “manage” the reporting of massive credit losses so that they bleed out over a multi-year period. That enables a bank to match its credit expense with its operating income. Everyone does that, or tries to. But it is quite another to punctuate the recognition of catastrophic losses with periods of reported profitability. Wouldn’t an honest bank consume that supposed profitability with an addition to reserves? If you’re going to lose 12B euro, you might just put that 723M into the provision, as “an overabundance of caution”.

And it isn’t just Dexia. Banca MPS in Italy is the same story: it reported a 946M “profit” for 2010, followed by a 4.7B loss for 2011. Shouldn’t that 964M “profit” have been added to reserves, given what followed?

Why does it matter whether bank financial reporting is truthful?  For three reasons: (1) shareholders; (2) bondholders; and (3) depositors. Shareholder bought the shares of these banks in 2007 for high prices, only now to find that they are worth a few cents. Retail investors bought the subordinated debt of the cajas that now constitute Bankia, only to be wiped out. And finally depositors, such as those with deposits in the two largest Cypriot banks, who have been wiped out substantially if not totally.

It is now European policy that depositors are expected to take losses because they “contributed” to the problem. They “contributed” to the problem by irresponsibly placing their deposits with insolvent banks. Had they been responsible, they would have known that these banks’ financial statements were fictitious.

Market discipline depends on honest financial reporting. As long as European bank managements can decide whether to make or lose money in a given accounting period, shareholders and creditors will be stumbling in the dark.

That means that it is only a matter of time until another credit event reveals to depositors in Club Med banks that they have made a big mistake. Can you imagine that Daimler or Siemens or Nestle are likely to leave a lot of money on deposit at Banca MPS or Banco Espiritu Santo for more than about ten seconds?

Dexia: An Interesting Case

Moody’s introduced “market implied ratings” about a decade ago. These allow investors to compare Moody’s ratings with the opinions embedded in bond, CDS and stock prices. Because bond ratings are methodology driven and rely to a great extent on historical data, they tend to be stable, lagging and path-dependent, whereas market-implied ratings are unstable and immediate, without path-dependency.

I find it instructive to compare Moody’s bond ratings with bond-price implied ratings. When the disparity is great--in either direction--it is a signal to dig deeper. One example is Caisse Autonome de Refinancement, which Moody’s sees as Aa, but which the bond market sees as Baa. That would suggest that someone needs to take a second look, probably the bond market.

Another big outlier is Dexia Credit Local, the French-Belgian-Luxembourg municipal lender that melted down after 2008. Dexia is a big one: 356B euro. The rating differential between Moody’s (Baa) and the bond market (Caa) is very wide. The bank itself is insolvent, illiquid and opaque, but there is an elaborately designed multinational Rube-Goldberg-type support mechanism with many moving parts. Some instructive excerpts from Moody’s rating rationale:

“DCL's BCA of ca, equivalent to a standalone bank financial strength rating of E, reflects our view that the entity, which will be managed in a run-off mode, has highly speculative standalone strength and has avoided default through the provision of extraordinary support from the three aforementioned governments. Moreover, we note that there is material risk that the entity will need additional support during its prolonged run-off period.

“Going forward, in our central scenario, the need to draw on the guarantee scheme is expected to remain below the [85B] ceiling of the programme. This scenario assumes the natural amortisation of assets and assuming the existing secured and unsecured market funding, except for repurchase transactions, is not rolled over at maturity. We also believe the EUR 85 billion provides reasonable room to absorb potential stress situations that may result, for example, from an increase in collateral posting needs on hedging derivatives due to a fall in interest rates, or higher haircuts imposed in repurchase transactions. We assume DCL will continue to operate with almost full asset encumbrance during the whole run-off period.

“We nevertheless anticipate that the main constraints are likely to come from DCL's ability to place huge volumes of state-guaranteed debt in the markets at a reasonable cost. These constraints are likely to be all the more challenging as the bank is expected to increase direct market funding as a result of a commitment to progressively reducing its reliance on the Eurosystem for the refinancing of both its own state-guaranteed debt and the portfolio of eligible assets. Depending on the evolution of the sovereign debt crisis in the euro area as well as investors' appetite for state-guaranteed debt, DCL's access to the market could prove more difficult than is anticipated, which may require the use of costlier alternative measures including the ELA, and result in overall higher funding costs.”

Well, there you are. You have a big insolvent, illiquid bank with a rather complicated and limited support scheme, in a conext where Europe has embraced the “no bailout principle”. This is what you call "story paper", which is not popular with credit committees these days. My take is that if the support scheme works, then you're OK, but if it doesn’t, there may not be a second bailout. 

Is Dexia a Baa risk or a Caa risk? Let’s put it this way: if I could really be paid a Caa risk premium, then I’d take the bet--inside my speculative allocation.

The Euro Is A Form Of Original Sin

For those of us who experienced the Latin American debt crisis of the nineteen eighties, there is the familiar term “original sin”. Original sin is borrowing dollars, as opposed to a currency that you can print. Many Latin countries had (for good reason) nonexistent capital markets. If such governments wanted to borrow, it had to be in dollars.

The reason this is a sin is because at some point you will lose market access and default. Many Latin and Asian countries learned this lesson, and are now quite cautious about taking on dollar debt. They have developed their local debt market and have also built up big dollar reserves.

But there was another response to these crises, which was the panacea of dollarization. The theory of dollarization was that, by converting the entire economy into dollars, the country could import American monetary policy, and provide the economy with a stable non-inflationary medium of exchange.

The most spectacular example of this was Argentina, which dollarized in 1991. Everything was denominated in dollars or in convertible pesos. The central bank abdicated monetary policy to become a currency board. The idea was that 100% of the convertible pesos in circulation would be backed by dollars at the central bank. What could go wrong?

What went wrong was that the Argentine government didn’t play by the rules and ran big fiscal deficits. It financed these deficits with tricks and theft. The system lost credibility, and bank depositors panicked and drove cartloads of dollars across the river to Uruguay. Crucially, the currency board system provided unlimited convertibility from pesos to dollars, which greatly facilitated capital flight. The money supply contracted automatically. Credit evaporated and, in 2001, the government defaulted and repudiated. A big mess, and not a good day for the cause of dollarization. The world learned something.

But Europe learned nothing from the Argentine fiasco. Instead, it decided to repeat the experiment. Europe required every member of the eurozone to surrender its monetary sovereignty and to import the “hard euro” instead. Overnight, Euroland was euroized. Every government was required to borrow in a currency it couldn’t print, and every banking system was required to accept deposits in foreign currency (the euro, printed in Frankfurt by an independent central bank).

The whole idea of dollarization is to impose market discipline on both the government and the banks. Unable to print money, governments would balance their budgets. To maintain depositor confidence, banks would have to remain strong and liquid because they had given up their local sugar daddy in exchange for the cold indifference of the ECB.

Dollarization is an extremely dangerous policy because it depends on market confidence and market access. Supposedly, market discipline will operate to force governments to maintain the confidence of the market. In fact, as Minsky reminds us, confidence can evaporate rapidly, and without an adjustment period: "The revaluation

of accept­able debt struc­tures, when any­thing goes wrong, can be quite sud­den and quick. Quite sud­denly a panic can develop as pres­sure to lower debt ratios increases.”

Once a dollarized government or bank has lost market access, there is no escape. The choice is between foreign aid or default and financial collapse. At present, the peripherals have chosen to seek foreign aid, which is keeping them alive, somewhat. But their debt ratios keep going up, which is not sustainable. Like Argentina, they will eventually have to default, repudiate and redenominate.

It was not just Club Med which made the mistake of euroization. France did too, and it too will face the remorseless logic of confidence-sensitivity. France still has the confidence of the bond market, as do her banks. But France’s debt ratio keeps going up, and its banks will face a through asset-quality review this winter. The clock is ticking.

Germany’s Eurozone Policy Is Completely Incoherent

The whole world wonders: “What Does Germany Want?” No, I’m not talking about 1938, I’m talking about 2013. Here are your choices:

1. Germany wants to purify the eurozone by purging the debtor states.

2. Germany wants to exit the eurozone in a polite way.

3. Germany wants the eurozone’s current policies to succeed, and to forge a new Europe on the Germanic model.

4. Germany has no idea what it really wants.

I vote for #4. Everything that comes out of Germany is incoherent. I could compile for you a list of statements from Merkel, Schaeuble, Weidmann and Amussen that would illustrate the incoherence, but I will spare you that.

Suffice it to say that, to analogize, Germany is running a hospital where the patients are required to run around the track all day: “Exercise will make you healthy!” The patients are not allowed to leave the hospital (because they owe it a lot of money), nor are they allowed to step off the treadmill. Already four of the patients are on life-support--but still on the track.

We are in the middle of the German parliamentary election, and no country is coherent during an election. But I think that whether the conservative coalition is returned to power or if there is a grand coalition, Germany’s eurozone policy will remain incoherent. Germany wants to (a) maintain the hard euro; (b) keep the eurozone going; and (c) not have to donate any more money. Which is impossible. Only one of these desires can be met.

Here is what the German voter is likely to get over the next 18 months: (1) more bailouts and re-bailouts, starting with Greece Part IV; (2) a major expansion of the ESM’s “lending” capacity; (3) huge ongoing debt write-offs and bail-ins; (4) Draghi’s resignation; and (5) the formation of an anti-austerity bloc within the zone and on the ECB governing board. That’s as far ahead as my crystal ball can see. The tragedy is that all of this could be easily and instantly cured with massive deficit monetization and  5% inflation evenly spread throughout the zone.

Bernanke in 2002:

“Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress.”

In Dramatic Gesture, Bernanke Drops Money From Helicopter

“Prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation. Deflation is always reversible under a fiat money system.”

--Ben Bernanke, 2002

“Mysterious benefactor arranges for $10,000 to be dropped from a helicopter onto unassuming crowd”

--Daily Mail

“Helicopter rains cash on Delaware marina”

--NY Daily News, Aug. 21, 2013

Economists have known for some time about Chairman Ben Bernanke’s deep frustration with the Fed’s inability to achieve its inflation and employment mandates. Insiders say that Bernanke is particularly concerned about the falling rates of inflation and nominal growth, despite the massive expansion of the Fed’s balance sheet.

Bernanke is said to be deeply embarrassed about his failure to follow his own professorial advice in 2002 or, more accurately, deeply frustrated with his inability to create a consensus on the FOMC in favor of more radical policy tools. As his second term as chairman comes to an end, Bernanke is leaving with a rate of inflation below that which prevailed when be became chairman in 2006, and a rate of unemployment considerably higher.

However,  Fed-watchers were surprised by the dramatic money-drop. There was no immediate announcement from the Fed, and it is not known if the money dropped from the helicopter belonged to the Fed, or to the chairman himself. One observer heard him shout “I printed it myself!”.

Inflation doves welcomed Bernanke’s dramatic gesture, while hawks denounced it as reckless. Reporters on the scene in Lewes, Delaware, reported that, following the money drop, aggregate demand  rose sharply in the immediate area, as predicted by Bernanke’s “helicopter theory”.

Despite the positive economic reaction, it is not known whether the chairman’s stunt will be able to convince the FOMC hawks to embrace more unconventional policy tools.

Republican Monetary Reform

“A separate idea of Ron Paul’s is being promoted by a Republican congressman from Georgia, Paul Broun. It is a bill called the Free Competition in Currency Act, which is brilliant in its simplicity. It is but a page long and would repeal the legal tender laws and end any capital gains taxes on gold and silver coins. All currencies, government- or privately-issued, would be allowed to compete...

The states are stirring. At least 13 of them are considering laws to grant legal tender status to gold or silver coins.”

--Seth Lipsky, “Fed Up Yet?”, Am. Spectator, September 2013

On the 100th anniversary of the Federal Reserve, the GOP’s monetary alchemists are hard at work on “monetary reform”, which generally means:

1. End the Fed.

2. Return to the metallic standard.

3. Allow free coinage and competitive currencies.

4. Execute Bernanke for treason, or something.

Their latest brainstorms are embodied in various bills languishing in committee, and in state legislatures. One of the funniest of these proposals is to make gold and silver coins into legal tender, as a parallel currency alongside the greenback.

I enjoy thinking through stupid ideas like this.

In a fiat money world, commodity prices fluctuate in their value in fiat money. The prices of gold and silver fluctuate hourly (just take a peek at GLD and SLV). Gold and silver coins are valued by their weight, fineness and the current price of gold and silver. A law that transform bits of metal into legal tender would be difficult to implement. Such coins could not have a face value, only a statement (or assertion) of weight and fineness. Businesses, banks and private citizens dealing in the myriad of private, state and foreign coins would require a mass spectrometer and an online source of real-time price quotations for every coin. This would be quite cumbersome, unless you already own a mass spectrometer and are familiar with its use. And what if our spectrometers disagree?

If coins are legal tender and valued by metallic content, perhaps they could be deposited into a bank account whose value would fluctuate, and against which “gold checks” could be written. The value of such checks would, of course, fluctuate with the prices of the coins in your account. The merchant would have to take the risk that the check will be worth the same amount of dollars when presented to your bank, but it would obviate the need to carry around a lot of metal in your pocket. Would your bank pay interest on your coin collection? Unlikely: they are more likely to charge a custodial fee.

So long as coins have no face value in fiat money, the old problem of bimetallism is obviated, because there would be no fixed parity between the two metals. When gold and silver coins and certificates were legal tender, there was a constant problem of over and under valuation, because of the fixed parity. Many books (and speeches) have been written on the challenges of bimetallism.

Another drawback to a metallic co-currency is that we might also have a problem of “Gresham’s Law in Reverse”. The law would suggest a generalized preference for receiving gold and paying with paper. But my hunch is that your local gas station and dry cleaner will refuse to accept your Krugerrands, and will desire a credit card or a $20 bill instead.

The whole exercise of parallel currencies is entertaining to contemplate. The problem that a metallic currency is supposed to solve is the fluctuating value of the paper dollar. It solves this problem by giving you a coin with no face value, which fluctuates in value every minute, and which would make the business of purse-snatching considerably more lucrative. Let’s try it.

Nominal Growth Is Declining

You don’t have to be a market monetarist to recognize the urgent need for a higher level of nominal growth in the US economy. Higher nominal growth would result in lower unemployment, higher government revenues, lower social expenditure, a lower deficit, and a higher denominator for the debt ratio. Most importantly, it would create private-sector jobs, something our leaders supposedly care about.

If we would like to see, say, 4-5% real growth, then we need 6-7% nominal growth. The US economy performed at that level for most of the past thirty years. Recessions occurred, but were followed by a resumption of strong nominal and real growth. That isn’t happening this time.

We have heard many reasons suggested for the weakness of the current recovery. We can debate that subject. But what we can’t debate is the fact that nominal growth has been slowing for the past 18 months:

1Q12: 5.2%

2Q12: 4.5%

3Q12: 4.8%

4Q12: 3.8%

1Q13: 3.1%

2Q13: 2.9%

As I have said before, you can’t get 4-5% real growth with 3% nominal growth--not in this universe. The current level of nominal growth is dangerously low, and falling. Here is what the Fed has to say about this situation: “The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate.”

That complacent forecast is surprising, considering the fact that economic growth is declining, and that neither of the Fed’s mandates are anywhere near being achieved after four years of “recovery”. The Fed’s prescription is to do more of the same, or maybe a bit less. These cycles are natural; be patient.

There is no acknowledgement that weak economic growth is a result of incorrect monetary policy. It is amazing to me that in all the public drama about the next Fed chairman, there is almost no discussion of the fact that the Fed has dropped the ball, and what it might do to get things moving again. Fed policy is a much more important topic than whether Larry Summers needs gender sensitivity training. The Fed needs a wake-up call.

“There is compelling evidence that the Japanese economy is suffering today from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult.”

--Ben Bernanke, Tokyo, 1999

Should Central Banks Forgive Government Debt?

AEP at the Telegraph wrote a very provocative article last week*, in which he argued that the BoJ should forgive a big chunk of the Japanese government’s debt. I have been thinking hard about this for the past week. Is this the Holy Grail, a costless way to deal with excessive government indebtedness, as well as a costless way to finance fiscal stimulus?

Under the gold standard, central banks were established in order to issue currency notes and maintain their gold content; to provide liquidity to commercial banks; and to maintain a liquid market for the government’s paper. They were QANGOs, not owned by the government but by their members. In order to operate, CBs needed to hold very substantial resources in both gold and/or foreign currency. They had to not only be solvent but also to look solvent, in order to prevent excessive demands for currency redemption. No gold, no credibility; they could not print money.

But that was before President Nixon took the world off of the gold standard.  Today, under the fiat standard, a CB is nothing more than a printing press issuing Monopoly Money. It doesn’t need assets or capital, because it can print its own liabilities. If you present a $100 bill to the Fed for redemption, it will be promptly redeemed with a newly-printed $100 bill.

The Fed has lent a few trillion to the U.S. government since the Crash, but that money was lent, not given. Supposedly those bonds will have to be sold back into the market someday, which will supposedly cause interest rates to rise and credit to contract.

But why can’t the Fed just write it all off? It would render the Fed “insolvent”, but how can a money printing press go bankrupt? The Fed can never default on dollar liabilities. There would be no impact on the monetary aggregates (which are the Fed’s liabilities, not assets). 

The Fed would suffer a big loss both in terms of the amount written off and in terms of future interest income, but so what? The Fed has an uncapitalized intangible on its balance sheet called “license to print money”. That intangible is worth a lot more than a few trillion dollars. As MasterCard would say, it’s priceless.

This discussion raises a second question: Why can’t the government have a checking account at the Fed funded by the Fed? Chairman Bernanke: “When we buy securities from a private citizen, we create a deposit in their bank”. Well, why can’t the Fed create enough deposits for the government to pay its bills? Why lend money when you can print money?

Obviously, the Fed must fulfill both of its mandates, which means that it can only give so much money to the government without creating excess inflation. But aside from that constraint, there should be no limit on how much money the Fed can give the government. If the Fed is delivering 2% inflation, full employment, good growth and a balanced federal budget, what else matters?

Japan is the extreme example of a heavily indebted government with a fiat currency. Japan cannot repay all of that debt. It will have to be inflated away or defaulted upon--or forgiven. The commercial banks need to be repaid, but the BoJ doesn’t: it prints yen.

The Keynesians have been arguing that the most direct way to revive aggregate demand in a recession is via fiscal stimulus. The Right argues that this increases the government’s debt ratios. But what if, instead of paying for the stimulus with debt, we paid for it with free money from the Fed (until we hit the inflation ceiling, which is far above where we are now)? Is there something immoral about free money? Don’t forget that it was free money that FDR used to get us out of the Great Deflation.

I need to think a lot more about the possible drawbacks to this idea. But I haven’t heard them yet. If the Fed can fulfill its mandates and fund the government at the same time, why not? I think I may need to read another biography of John Law.

_______________________________________________________

*“Just set fire to Japan's quadrillion debt”, Ambrose Evans-Pritchard, Daily Telegraph, Aug. 9th, 2013

Early Readouts From The Cyprus Experiment

“The no bail-out principle means that everyone should face the consequences of their own actions.”

--Jens Weidmann, president of the Bundesbank

Thank goodness for Cyprus. We don’t want to perform economic experiments using the entire population of Europe: what if it went wrong? But tiny,  powerless Cyprus is a perfect laboratory for testing theories such as the “no bail-out” principle.

Europe plans to implement the “no bail-out” principle on a continental scale in a couple of years. From then on, eurozone governments and banks will be allowed to default on their liabilities. Wonderful. But luckily, Europe can play with the  Cypriot economy for a while before it rolls out the policy for everyone else.

Here is the Cyprus experiment: What are the economic consequences of a banking collapse unmediated by a central bank? (This is the same game that Hoover played in the early thirties, but it’s a good idea to rerun these exercises every eighty years or so. People have short memories, on both sides of the Atlantic.)

The Cypriot experiment just occurred this spring, and it takes time for the experiment to play out. It will take a full year for us to have definitive data, but we are already starting to get some early telemetry. My data sources are the Central Bank of Cyprus, the ECB and TradingEconomics.

Bank deposits have fallen from 70 billion to 50 billion, a decline of 30%. I can only imagine that the money supply has declined by a similar proportion. As we know from the quantity theory, a big decline in M usually results in a big decline in output. RGDP is declining at a 5% annual rate, but I expect that to accelerate. Industrial production is declining at a 17% annual rate, which is more like it. Unemployment is 17% and rising. The twin deficits (budget and current account) are both running at 6% of GDP (uh-oh!). Prices are declining, as we would expect.

So there you have it. The economy is in free-fall. Isn’t this a fun experiment? Just imagine if we could do this to all of Europe.