Milton Friedman On Government

An educational video providing material for thought. The bright professor Milton Friedman in an interview about taxation, government intervention and many more.

Selective Default Definition

First, note that the term “Selective Default” (SD) exists only in S&P’s terminology. The other houses have no corresponding term and they only consider “Default” (D). According to the Bankers Almanac, S&P defines Selective Default as:

“An obligor rated 'SD' (Selective Default) or 'D' has failed to pay one or more of its financial obligations (rated or unrated) when it became due. A 'D' rating is assigned when Standard & Poor's believes that the default will be a general default and that the obligor will fail to pay all or substantially all of its obligations as they become due. An 'SD' rating is assigned when Standard & Poor's believes that the obligor has selectively defaulted on a specific issue or class of obligations but it will continue to meet its payment obligations on other issues or classes of obligations in a timely manner. Please see Standard & Poor's issue credit ratings for a more detailed description of the effects of a default on specific issues or classes of obligations.”

Links to the published definitions of credit rating classifications can be found here and here.

Trillion Dollar Bet

This is a very educational documentary about the development of finance as a science – especially what has to do with derivatives pricing – and a very famous application of it, the creation of the LTCM fund and what brought it down. Events that were repeated after 10 years in 2008. The documentary is in Youtube in 5 pieces.

Part 1, Part 2, Part 3, Part 4, Part 5.

The transcript of the movie can be found here.

What Are Special Drawing Rights (SDRs)?

“The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation that took effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs increased from SDR 21.4 billion to SDR 204 billion (equivalent to about $308 billion, converted using the rate of August 31, 2010).”

Here is the official factsheet of SDRs at the IMF’s website.

Reserve Currencies

Even though dethroning the dollar from its current status as the primary reserve currency is not something that can happen in the current setup, there is discussion about what being a reserve currency means and what are the alternatives to a dollar reserve currency.

FT published an article on the subject and can be found here. It considers a few alternatives like (a) the renminbi, (b) the euro, (c) SDRs (Special Drawing Rights), (d) pegging to gold price. A lot of research has been done on these issues and some thoughts are presented in this article about the pros and cons of being a reserve currency or having one of the alternatives as reserve currency. Bellow are some passages taken from the article together with some of my own thoughts on the matters. The parts taken from the article are in quotation marks.

One reserve currency?

“In truth, the benefits to the US, in terms of support for its currency and its financial assets, are uncertain. Also unproved is the wider case that having just one reserve currency is inherently unstable, contributing to the global current account imbalances that are widening again as the world economy recovers from recession.”

Is one reserve currency an unstable structure because it leads to the currency’s devaluation according to the Triffin’s dilemma?

“On the face of it, a modern version of the Triffin critique explains recent persistent American current account deficits; they have been funded largely by foreign governments buying dollar bonds. But the causation is not straightforward. Under a floating exchange rate system, as long as countries accumulate only moderate amounts of currency reserves allowing them to intervene in any future crisis, the demand for dollar-denominated assets should be limited.”

Are SDRs a good alternative to one reserve currency?

“The SDR is closer to an accounting unit than a currency.”

“In order for the SDR to work as a proper global currency, Prof Eichengreen says, some organisation – probably the IMF – would need systematically to control its issuance beyond the current system of ad hoc one-off distributions. Any such proposal to globalise monetary policy would provoke explosions of disbelief in legislatures worldwide. As Prof Eichengreen concludes: “No global government, which means no global central bank, means no global currency. Full stop.”

Linking currencies to the price of gold?

“An even less likely option is linking currencies to the price of gold, recreating one of the models of international gold standard used in the past few centuries. Following the rapid rise of the gold price in recent years, a phenomenon some investors claim is driven by fears about fiat currencies (those not backed by a physical commodity) being debased by inflation, interest in the subject was revived last year by Robert Zoellick. The World Bank president raised the eyebrows of economic policymakers – before rushing to clarify that he was not in favour of a strict gold standard – by arguing that the metal had become an “alternative monetary asset” and that governments should consider using its price as an “international reference point of market expectations” for inflation and currency values.”

“However, economists have long argued that linking currencies and price levels to the value of a fixed or nearly fixed stock of precious metal means forcing real variables such as growth and employment to bear the brunt of economic shocks – a socially and politically unacceptable outcome. Prof Eichengreen, in response to Mr Zoellick’s speech, pointed out that targeting the domestic price of gold would have caused the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England to have tightened monetary policy sharply in recent years. “It is lunacy to suggest that in circumstances of weak growth and deflation risk, key central banks should simultaneously tighten [policy],”

How about the Euro or the Renminbi?

For these two currencies to be used as reserve currencies they need to strengthen. By that is meant, to strengthen their institutions. For the Euro, Europe has to overcome its current debt crisis, and to emerge from it stronger. In this case Euro may gain some power as a reserve currency.

As far as the Renminbi is concerned, this is a more remote possibility. Perhaps in 30 or more years Renminbi could play a role as one of the reserve currencies. Until then, the Chinese institutions should have to strengthen and be accepted from the rest of the world. It is not just the size of the market that matters but also the stability of its institutions and the trust of the rest of world on them. This is by far the most important determinant of a currency in order to gain its reserve status. 

Why Does The Economy Fall To Pieces After A Financial Crisis?

Here is Robert Hall’s paper published in the Journal of Economic Perspectives.

Inflation and TIPS 101

I am very concerned about inflation and this is a theme that I plan to be coming back to it regularly. Here, I want to first give, for those who are not familiar with, some definitions of inflation and then to introduce a class of assets that provide (perhaps) a hedge against inflation, the Treasury Inflation-Protected Securities (TIPS). The reason is to clarify some differences among different inflation measures and where perhaps each of them is used and also to dispel the misunderstanding that exists with respect to which measure of inflation do TIPS use and more specifically whether food and energy prices are included in it.

Unfortunately, there are many inflation measures and they differ on the composition of the asset basket for which prices are used in order to find the level of the Price Index, which then will result to the corresponding inflation measure. Inflation is the rate of change of the Price Index of each corresponding basket. Usually inflation is measured in a monthly frequency, as it is not feasible and perhaps it is not necessary to measure at a higher frequency.

The two inflation measures that matter for us are the Core Inflation and the Headline Inflation (CPI-U). What matters for us, as consumers, is the Headline Inflation because it incorporates the prices of more consumption goods – and goods that are broadly used – than the Core Inflation. Notably, the Core Inflation does not include food and energy prices. This is done because their prices are more volatile and they are more susceptible to short term supply shocks that can make a measure that includes them deviate substantially in the short term from a long term trend. Economists, and especially FED macro-economists, who want to gauge inflation dynamics in order to form monetary policy, need to base their policies on stable price trends and not on transitory effects, filter out these deviations – or “noise” around the trend – by focusing on the Core Inflation measure.

Why does the FED focus on Core CPI?

Different websites and even popular press takes this wrong hinting on negligence or conspiracy. The truth is far from that. The answer is that transitory deviations from the true CPI trend would give a lot of false signals to the monetary authorities and this would result to a huge distraction of value in the economy. This can be understood better with the help of the following example that I borrow from an anonymous source.

Suppose that the Federal Reserve had a mandate to stabilize the full Consumer Price Index, and that food prices suddenly doubled. To keep the CPI at a stable level, other prices would need to decrease. The problem, however, is that many prices are sticky, meaning that they do not instantaneously respond to changes in monetary and macroeconomic conditions. This is especially true in the service industry (which comprises the bulk of both GDP and the CPI).

To create these compensating price changes within a relatively short timespan, the Fed would have to impose extremely tight monetary policy, with sky-high nominal interest rates. And as we saw in the early 1980s, a large increase in nominal interest rates is extremely destructive to the real economy, leading to a massive increase in unemployment. Given our already weak economic conditions, such a policy would be even more damaging today.

Core CPI is a way to prevent this kind of needless suffering and unemployment. By targeting a more stable set of prices, the Fed avoids the wild swings in monetary policy that would inevitably arise from targeting an index that includes commodity prices. In other words, the demagogues who assail core CPI have it all wrong: the average American would be much, much worse off if the Fed targeted a volatile measure like headline CPI.

For more on CPI’s and their performance see here, here, here and here.

What are TIPS?

TIPS are Treasury Inflation-Protected Securities. They are bonds that have a fixed interest rate (coupon rate) which is determined at their auction, but they differ from Treasury bonds, in that their face value fluctuates positively one-to-one with the CPI. What I want to clarify here that is confusing to a lot of people is what is the CPI measure that is used for the face value. Several people spread around that this is the core CPI which is not correct. It is the CPI-U or Headline CPI that is used – that includes food and energy – in order to compute the TIPS face value. This is stated explicitly on the Treasury’s website. A question one may have is how does the Treasury come up with the future face values since they announce ahead of time the Daily Index Ratio for the next month. The answer to that is that they do a three month rolling average, extrapolating for the next one month period. The interesting remaining question is, how do they come up with daily CPI-U? I will respond to that when I find the answer.

To conclude, there is no cheating in the way TIPS have been constructed, as the belief that TIPSs face values do not reflect real inflation is not correct.

Those At The Nucleus May Not Have The Best View

A really great article, full of truths about different things. The article is here, written by John Kay of FT. Here are some quotes from the article that I find worth mentioning .

“I was disappointed to find that the most distinguished of my lecturers, the economist Sir John Hicks, had never mastered how to hold the attention of a class. But clarity of thought and clarity of expression tend to go together. The best textbooks are often written by the best researchers: Richard Feynman could not only do physics brilliantly but also brought it alive with words.”

“… few people are as irritating as those whose combination of ignorance and arrogance is so profound that they claim to understand things they do not even know they do not know. The world of business and finance, which values confidence and certainty, is full of such people. “It isn’t really like that,” they will say; and when you ask what it is really like, they will tell you it is too complicated for you to apprehend. What they really mean, but do not recognize, is that it is too complicated for them to apprehend.

The bad financier, or businessman, like the bad scientist, pursues complexity almost willfully because he believes such complexity demonstrates his knowledge and sophistication. So the blind lead the blind through the mysteries of structured financial products and the jargon-ridden thickets of corporate strategy. People sell securities whose properties they only dimly appreciate to people who do not understand them at all. Consultants describe the business world in language – and, of course, PowerPoint presentations – whose elaboration disguises the banality of the thought.”

“Perhaps Henry Ford and Bill Gates were the men who really understood the automobile and computer industries, or perhaps they were just the people whose opinions turned out to be right, which is not the same at all.”

Bar Stool Economics

This fictitious story has circulated a lot through emails, however I find it worthwhile to be posted here. 

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

So, that's what they decided to do. The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve.
"Since you are all such good customers", he said, "I'm going to reduce the cost of your daily beer by $20". Drinks for the ten now cost just $80.
The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free. But what about the other six men - the paying customers? How could they divide the $20 windfall so that everyone would get his "fair share?"
They realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man's bill by roughly the same amount, and he proceeded to work out the amounts each should pay.

And so:
The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33%savings).
The seventh now pay $5 instead of $7 (28%savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.
"I only got a dollar out of the $20," declared the sixth man. He pointed to the tenth man, "but he got $10!"
"Yeah, that's right," exclaimed the fifth man. "I only saved a dollar, too. It's unfair that he got ten times more than I!"
"That's true!!" shouted the seventh man. "Why should he get $10 back when I got only two? The wealthy get all the breaks!"
"Wait a minute," yelled the first four men in unison. "We didn't get anything at all. The system exploits the poor!"
The nine men surrounded the tenth and beat him up.
The next night the tenth man didn't show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

I Am Not Alone

Krugman annoys others, too. Not just me. I just came across a piece by David Backus, a professor at NYU Stern, which describes his irritation by Krugman. I cannot agree more with David when he says that.

“And to be fair, there are two Paul Krugmans.  I admire the brilliant expositor of economic ideas.  I’m less enchanted with the political partisan who can’t resist using cheap debating tricks in what could be a useful exchange of ideas.  Even worse, he sometimes mixes the two, disguising politics as economic analysis.”

Negative TIPS Yields!

Indeed it sounds as impossible, but it is a reality. Even though it initially sounds as a very-very bad thing about the economy, it is the opposite. It means that investors believe that we will have inflation and they even accept a negative yield. So strong is their belief that prices will increase. This may prove right or wrong. This conviction is definitely due to the QE2. TIPS investors bet that the program will work and we will have inflation. Remember that for TIPS the face value is not fixed, like in Treasuries. The face value increases or decreases according to the inflation rate. Hence, negative yields can exist and it can be rationalized by a big probability of inflation, or higher values of inflation than previously thought, or both of the above.

Here I give some articles on this phenomenon. Article in Yahoo!Finance, in Bloomberg, in Reuters and in FT.

A Greek Cypriot Along With Two Americans To Receive The Nobel Prize In Economics

Christopher Pissarides, a Greek Cypriot born in Nicosia and faculty at LSE was awarded the Nobel prize in economics for 2010, along with Peter Diamond from MIT, and Dale Mortensen from Northwestern University, for their contributions in search theory and its applications. The Swedish Royal Academy of Sciences stated that they are nominated the prize “for their analysis of markets with frictions”.

Here is the link to the official announcement and here is the official document from the prize committee highlighting the contributions of the prize recipients.

Socialism vs Free Trade Incentives

I came across the following extremely enlightening story which I republish exactly as I read it. The message of the story speaks directly on the main flaw of socialistic and communistic systems. Apart from the one flaw that all economic systems share, that are run by normal people with all the sins they have – greed, pride, fear, wrath, sloth, lust, envy and gluttony, the socialistic systems cannot motivate people to produce wealth. They encourage sloth and lazy behavior and they discourage hard work. No surprise why countries that adopted these policies ended up ones of the poorest in the world and they fell apart. So, here is the story:

An economics professor at a local college made a statement that he had never failed a single student before, but had once failed an entire class.

That class had insisted that Obama’s socialism worked and that no one would be poor and no one would be rich, a great equalizer.

The professor then said, “OK, we will have an experiment in this class on Obama’s plan”.

All grades would be averaged and everyone would receive the same grade so no one would fail and no one would receive an A.

After the first test, the grades were averaged and everyone got a B.
The students who studied hard were upset and the students who studied little were happy.

As the second test rolled around, the students who studied little had studied even less and the ones who studied hard decided they wanted a free ride too so they studied little. The second test average was a D! No one was happy. When the 3rd test rolled around, the average was an F.

The scores never increased as bickering, blame and name-calling all resulted in hard feelings and no one would study for the benefit of anyone else.

All failed, to their great surprise, and the professor told them that socialism would also ultimately fail because when the reward is great, the effort to succeed is great but when government takes all the reward away, no one will try or want to succeed.

Could not be any simpler than that.

Unemployment Or Employment

In contrast to the better-known unemployment rate, which measures the percentage of working-age Americans who are actively seeking jobs but do not have one, the civilian employment-population ratio measures the percentage of working-age Americans who have a job, whether they are seeking one or not.

This distinction matters because the state of an economy affects whether someone looks for a job at all. Bad times discourage potential workers from seeking jobs; boom times encourage marginal workers to seek them. As our population grows, we have more working-age adults who need work. A growing economy needs to replace the jobs we have lost and add new ones to accommodate these added potential workers.

The following graph describes the bleak employment outlook. The drop in employment during the 2007 downturn has been unprecedented. The employment ratio has fallen from the 63% pre-crisis level to 58.5%, and it has constantly been declining during the last three months, at the time that the unemployment rate has remained constant at 9.5%.  No other time in the history has seen such a steep decline in employment.

Interest Rates, The Income Effect, And The Substitution Effect

John Michaelson published today on WSJ a piece entitled “The high costs of very low interest rates”, in which he first gives reasons why the policy of keeping the short term interest rate to its current near zero levels is not productive, and then he explains what he sees as benefits of raising the short term rate. This article constitutes a good piece for thought. Let’s discuss its merits. In short, the consequences of the near zero rate policy, as stated by Mr. Michaelson, are:

• Negligible returns on savings. This hurts consumers who “have less to spend” (the income effect), “and those nearing retirement have to save more”. Also, “the owners or managers of pension plans, foundations, trusts and the like must also make higher contributions to make up for lower investment earnings in order to meet their obligations. In the case of public pension plans, these higher contributions contribute to local and state fiscal crises.”
• Banks are not forced to lend to the real economy, rather they enjoy the benefits of a riskless yield curve arbitrage, by borrowing at near zero and buying long-term Treasuries or high grade corporates.

Mr. Michaelson acknowledges that the FED’s policy was intended to revitalize consumption and lending. However, he points that the beneficiaries of this policy, the consumers, the banks, and the companies do not play by the book, i.e., they do not consume, they do not lend, and they do not invest. He also warns against the near zero interest rate policy, citing the example of Japan in the nineties and its lost decade.

Turning onto the benefits of increasing the short term rate, he sees that this could lead to:

• “More funds will flow to borrowers who will invest them in job-creating activities and increase consumption”, ending the carry trade on dollar and the yield curve arbitrage.
• “Will cause Americans to feel more confident about their economic future”.

Hence, raising the short-term interest rate to a merely low level, than the near zero current level, it will make banks “less tolerant  of underperforming assets and seek to move those assets more swiftly to superior owners and operators, creating additional efficiencies and job-creating growth”.

Mr. Michaelson’s argument is indeed well structured and it may actually be, very succinctly, describing the current problem and its solution. However, I would like to make a few comments. First, in reference to the Japan’s lost decade, this is not a result of the near-zero interest rate policy, alone. The author seems to suggest that the failure of the Japanese economy in the nineties, is solely due to this policy, however, one could not forget that it is never one policy that is only implemented, and other policies could have contributed to this result. For example, regarding Japan, one could also cite the lack of nerve from the side of the authorities in forcing their banks to come clean fast enough. Rather, they chose to hide the problems that the banks’ portfolios had, effectively undermining their efforts for recovery.

In addition, I would like to emphasize that there are some moving parts in Mr. Michaelson’s argument. Even though an increase in the rate will discourage the carry trade and the yield curve arbitrage, and at the same time will encourage undertaking more risky and job-creating investments, the effect of raising interest rates on consumers and the firms is not as clear. And in Mr. Michaelson’s argument the behavior of the consumers is very critical. The consumers, in his argument, encouraged by the income effect, will increase current consumption and this will also encourage the firms – who currently sit on piles of cash – to invest more, hence create more jobs, which will lead to more consumption, and so on.  This is based on the presumption that the income effect is stronger than the substitution effect – the tendency of the consumers to save more when interest rates are higher, given that it will result to higher future consumption. Even though the debate on which effect is stronger is still alive, the widely accepted conclusion seems to be that the substitution effect wins. This goes against Mr. Michaelson’s argument. However, there is a silver lining in that the win of the substitution effect over the income effect is not very strong, hence it could be that this time around the income effect could dominate.

This is indeed a suggestion contrary to the conventional wisdom, but it could as well be right, this time.  

More on Debt-To-GDP Measures

Here, I would like to come back to a topic also raised in a previous article, the debt-to-GDP measures, and their use as indicators of the fiscal state. That article was devoted to the different debt-to-GDP measures that can be constructed by using different measures of debt (external, internal, public, private, net or gross). At that article I focused on the numerator of these measures. Here, I will question the plausibility of even using any of the debt-to-GDP measures. Hence, I am focusing on the denominator of such measures.

The debt-to-GDP measure is a number that reveals how much bigger is the debt relative to the country’s GDP, or how many years of output are required to payoff all the debt. But, the assumption itself that the country’s output is used in order to payoff all the public debt is impractical. This assumption could be implemented only if the government confiscated all the private sector.

In less extreme periods, though, we expect the government to pay back its liabilities with less dramatic measures. Notably, by using the revenues. Therefore, a natural measure of the fiscal state is the ratio of debt-to-revenues or debt-to-tax collections, and it shows how many years are needed in order to be paid back all the debt by giving all the revenues in retiring the debt. This is, also, something that governments never do, as they always face, even minimal, spending needs. 

Another measure that have been constructed by Auerbach and Kotlikoff is the fiscal gap. This is measured as the difference between the present value of all the receipts minus the present value of all the obligations for a long period in the future. Both numbers are measured as percentage of GDP, thus, their difference is a percentage of GDP. The fiscal gap can be interpreted as the percentage increase in revenues or reduction of expenditures necessary to balance spending and revenues in the long run.

These two measures, the debt-to-revenues ratio and the fiscal gap are much better measures of measuring the fiscal state than the debt-to-GDP measure, for which a lot of confusion exists, and it also corresponds to an implausible scenario.

Trade Can Be A Non-Zero-Sum Game

I, like John Kay, think that reiterating what seems to be obvious to economists, has value, as it may not, and in this case it is not, at all obvious to non-economists. There are people, in some cases populations, who still think that engaging in commerce is a zero-sum game. One benefits only in the loss of the other. The benefit of one is due to tricking the other counterparty to accept a not good deal for him. In order to change this fundamental misconception, that still exists after centuries since it was proved wrong; I started this blog with an article on mercantilism. Today, John Kay on “It may be a Rembrandt to you, but markets can beg to differ” writes about the same subject providing examples where trade is not a zero sum game. It is a good read for everybody.

Greece, A Country That Never Graduated From The Group Of Emerging Countries

Perhaps it has become clearer now, after the crisis in Greece’s debt has become a headline in all the news media, that Greece never graduated from the group of emerging economies. Nevertheless, Greece was treated as a country belonging to the group of developed countries for nearly a decade, contributing to the developing economic woes throughout this period.

First let us start with the definition of emerging markets, and then it may become clearer why confusion about Greece’s quality may have occurred. And, yes now it is clear. There is no such definition!

Different organizations use different criteria and this results to grouping the countries in different ways. Not only, though, different institutions categorize differently the same countries, but also within the same institution’s reports the same country may appear to belong in different categories. This is shown very eloquently in Kvint’s article in which he shows the confusion that exists between the classification of the emerging and the developing economies. There is, however, one thing that different sources seem to agree upon and this is the names of the different classes, which are: developed economies, emerging, developing, and under-developed economies.

Greece on the other hand is an example of an emerging country that was mistakenly taken as a developed one. By entering in the club of the Euro area countries but also during the 1990s still in the process of entering the union, it received the benefits of the monetary union like decreasing interest rates. At the time of the entrance in the monetary union Greece’s interest rates collapsed to the rates Germany was paying at 2% allowing the imprudent Greeks to borrow and spend beyond their means.

Partly, the misconception was that Greece will converge to the other countries, and especially those of the north, but without strict monitoring from the monetary union this could never happen. This is exactly what distinguishes a developed from an emerging market: the discipline. The discipline to implement measures that will shield the economy for years to come and will not just focus on the ephemeral today. In my view, this also shows that Greece could also not be considered emerging as it was not and still is not decisively on the path of reforming and modernizing the economy. The tendency is towards the past, towards more nationalization and controls.

Still, the public as well as the authorities are very reluctant of taking new measures. Their movements are very slow and the people’s attitude is that in short time, when things improve, they will be able to go back to business as usual. The government also does not want to disturb the establishment as this is the establishment the governments of the last 30 years created. The corruption is sky high and there are a lot of people who benefit from it, including the policy makers. For this reason the government does not put effort to fight tax evasion but it raises the taxes for the middle and lower class. It does not want to break the monopolies and open the labor markets, but it wants to maintain the distorted benefits of the few privileged. All these things make real changes all the more difficult. If this is not an emerging or even a developing country’s behavior then what is?[1]

---

[1] For a definition of emerging markets look here and also here.

Making Comparisons? Be Aware! Factors That Affect The Value Of Sovereign Debt

In this article, I will outline the different factors that affect the value of sovereign debt. In general, the valuation of defaultable debt depends mainly on interest rate risk, inflation risk and credit risk. However, these days the main influence – concern – of debt valuations is the credit risk or solvency of the organization. In the rest of the article I focus on the factors that determine the credit quality of firms or sovereign entities.

The goal of summarizing the factors that determine the quality of debt is to highlight the complexity of debt valuations and that the comparative approach people employ due to its simplicity, can give misleading conclusions. This is for the simple reason that it is very hard to find two sovereign entities with exactly the same factor loadings. The factors I am going to give bellow can be separated in many groups.

One separation is between factors that describe the state of the domestic economy and the state of the foreign or world's economy. Clearly, open economies are affected by the foreign or global environment as much as they are affected by their local conditions.

Another separation is between factors whose values are currently known, which describe the current state of the economy, and factors whose values are forecasted based on assumptions, which describe the future path of the economy, the evolution of the insolvency measures or the (in)ability of the organization to repay its debts. The current state of credit quality is measured by variables like the Debt-to-GDP ratios and variants of it. The future evolution of the credit quality of the organization depends on estimates (forecasts) of the growth prospects in the immediate as well as longer term future. The main statistic of this sort is the growth rate. Therefore, in total there are four groups of factors – domestic-current, domestic-future, foreign-current, foreign-future.

One more important factor people look at, that is closely connected with the future estimates of factors, is the velocity or rate-of-change with which these numbers are expected to change in the future. For example, a bad current state which is expected to deteriorate fast is different from a current bad state which is expected to deteriorate slowly; therefore there is time for the policy makers to act.

Bellow I separate the factors only in local and foreign, but one should always have in mind that there are two estimates associated with them; the current, and the future.

Domestic Economy's Factors

Let me start with the factors that describe the state of the domestic economy.

1. Debt Statistics: This includes measures like[1]
   1. Debt-to-GDP ratios
   2. Aggregates of public debt (net, or gross)
   3. Aggregates of private debt

1. Growth estimates: Growth is the single most important factor in determining the quality and value of sovereign debt. Estimates of it though depend on a number of other factors and conditions like the type of growth:
   1. Stimulus packages vs healthy growth: Growth rates can be similar in value between two economies but there can be big qualitative differences between them. For example a debt driven growth is very different from a non-debt driven growth. Also, a growth fuelled by monetary easing, like in our days, is very different from a growth driven by a healthy private sector. For one reason, the government cannot keep injecting money into the economy indefinitely. There is an upper limit in this kind of activity.
   2. Types of projects: In addition what matters for the long term growth of a country is the type of projects that the public and private sector in this country is undertaking. Here comes the ingenuity of the businessmen and that of the policy makers -- are very important factors in determining the value and quality of the debt. The competence of these two groups of people is reflected in the valuations.

1. Government Spending & Government Investments: Government spending has proven to be one of the most important factors that resulted to overblown debts across all countries. This is shown by the actions many countries take to reduce their government spending in order to bring down their balance sheets.

1. Competitiveness: Competitiveness is an extremely important factor that determines the growth rate that certain projects can deliver. This measure describes the ability of the labor force. The more competitive the labor force of a country the higher the growth rate as lower cost per unit of production implies higher output.

1. Legislation: The current and expected laws of a country constitute a first order determinant of future growth. The clarity, simplicity and stability of the Laws that have to do with the labor, pensions, and taxes encourages foreign and domestic investments, hence promote output.

1. Ethics: Alternative this factor could be called corruption. The business ethics of both the labor force and businessmen is another factor that influences investments. By ethics we mean all the unwritten cultural influences that affect the behavior and attitude of a country’s citizens. Here I also include the tendency to pay or avoid paying taxes, as well as the tendency to conduct business in the underground economy, to collude, and to manipulate the markets. For example, there are clear differences between the ethical standards between Japanese and Greeks, or between Germans and Italians.

1. Size: The size of the economy and the history of the country clearly affect the investors’ perspective. U.S. is different from Holland, Belgium and Luxemburg. Even if the fundamentals of these two groups of countries are not very different, the U.S. is considered more stable since its fate depends on the success of many more projects than the success of any of the other countries. In other words, U.S. is a more diversified “corporation”. The same is shown by comparing Japan with Greece. Japan may actually have more debt than Greece relative to GDP, nevertheless, forgetting other factors that are different between the two countries, Japan has way more projects active than Greece. The history finally of the economy is important.

1. Emerging or developed: A clear distinction between the world’s economies is between those who are developed or matured countries, meaning countries that have been experiencing a stable economic environment for the last 60 years at least, and developing or emerging markets which have been facing currency and debt crises periodically and still work towards industrialization and greater economic reforms (openness). Emerging markets are associated with greater risk in reversing the growing path they have embarked upon, therefore undermining investments and output.

1. People’s psychology: This category wants to differentiate between optimism and pessimism of country’s citizens as well as their attitude towards saving and consuming.

1. Exchange Rate Mechanism: An extremely important determinant of future growth and investments is the exchange rate mechanism of the domestic country. Monetary policy is one of the policy tools (the other being fiscal policy) that each sovereign entity has in order to control and navigate the economy. In times of crises, when the country wants to improve its competitiveness, one possible action is to devalue its currency. This is what all the Euro Area countries cannot do now, even though they would like to be able to, like Greece, Italy, Spain and Portugal. Having stable and credible monetary authorities that can act decisively in helping the local economy is a first order factor in determining the quality of a country’s credit.

1. Business Cycle Phase: The current phase of the business cycle describes the prospects of the local economy. A booming economy is treated differently than a collapsing economy. The real (fundamental) prospects are different, and also the investors’ psychology is different, between these two cases, blinding them sometimes from easily forecastable problems.
   

World Economy's Factors

The world economy’s factors are consisted of all the above mentioned factors for all the foreign countries. For example, the other countries’ Debt-to-GDP ratios, the world economy’s GDP growth, the consumers’ sentiment in these other markets, the exchange rate mechanisms in the rest of the world, and the phase of the global market’s business cycle. It is very important for any country what happens in the world economy, as any shock or event taking place abroad can have strong repercussions in the domestic economy. In the current environment of strong links across all countries, no events can go unnoticed. The attractiveness of one country’s debt depends on the relative attractiveness of all foreign countries’ debts.

In the scale of the world’s economy what matters is everything that describes the structure of the global economy. Like, who are the consumers and who are the producers in the world economy; what the phase of different countries’ business cycles are; foreign countries’ balance sheets; foreign fiscal and monetary policies; foreign savings and investments decisions. In addition to the already mentioned factors I would like to highlight the following:

1. Correlation of business cycles: The more the local business cycle is correlated with the global business cycle the higher the risks to be priced. In general investors seek positions that can deliver returns as well as to reduce the overall riskiness of their portfolio.

1. Correlation of shocks: The higher the magnitude of the correlation among shocks in different markets the higher the priced risk.

1. Trade imbalances: Clearly trade imbalances affect the balance sheets of foreign countries and the relative attractiveness of foreign debt to domestic debt. There is a lot of discussion the last months regarding the imbalances between China, Germany, U.S., U.K. and the other countries.

 

To conclude, as it is evident by the long list of factors that affect the attractiveness of sovereign debt, it is very difficult to make comparisons between the debts of different sovereign entities both today and across time. This also raises a lot of questions about the studies who claim that they have studied phenomena in the past and attempt to draw conclusions about the current time. It is always challenging to account for all the possible different factors that do affect sovereign debt’s attractiveness. Something to always have in mind.

---

[1] As I describe in Economic Data and Manufactured Confusion there are many seemingly similar measures of debt one can look at. One has to be careful and consistent with the measures he uses.

Economic Data And Manufactured Confusion

The first step an economist has to take in order to analyze a situation is to decide what data is more relevant. These days, the talk is on the debt burdens of sovereign countries and where these will lead. In short, after Greece, who is next? Are we going to see a similar debt crisis for the U.K. and U.S. debt?

It is natural in this environment for people to try to understand the situation. Especially, if the snowstorm catches them unguarded, like in Greece. People there wonder what hit them and why they are going through what they are going through. Ignorance makes them blame the markets, the bad speculators, their bad luck, and some even attribute their debt crisis to a plan of superior centers of power for extinction of the Greek people. Others, more calmly, try to find a rational explanation and there the confusion begins. What numbers to look at?

This confusion is fed by the media, who in their own ignorance pick any set of numbers that support one or the other story, depending on the conclusion they want to make. Sometimes though, even the specialized economists do not unanimously agree on the measures that best describe a situation. One reason for this potential disagreement can be that there is more than one proposed story/explanation which are based on looking at different variables.

In our case the question is, what debt measures are relevant? For example, some think that figures on private debt are important to bond vigilantes and perhaps in an environment were money markets are in stalemate the potential inability of firms to rollover their debt may make them turn into the governments for help, like many banks have already done, whereas others strongly feel that using figures of aggregate external debt is misleading, feeding into a doom-mania. This disagreement would not exist if the numbers in public debt and external debt were the same. However, they are very different with each other, (compare estimates of 2009 public debt by country with 2009 estimates of external debt by country). The short answer to the posed question in the beginning of the paragraph is that all measures can be important, which is determined by the proposed explanation. But let's analyze the possible scenarios and the complexity of making comparisons between one country's current crisis with another country's current or older crisis.

Positive Analysis of Sovereign Debt

Choosing between these two approaches is not straightforward. First, it requires a detailed knowledge of the specific country's economic structure. Second, and most importantly, it depends on the tastes, in each specific period and case, of the bondholders. Understanding what matters in the bond markets entails guessing the behavior of the bondholders and how they perceive the economic outlook of the country under consideration. Each of the two components by itself is an aggregate of other forces or pieces of information which can be categorized into fundamental or psychological factors.

1. Debt Outlook

Let us start with the first by saying that there are four possible combinations of the debt outlook of each country: The best scenario is that both the public and private debt are small, the worst scenario is that both the public and private debt for a country are big, and in between situations that one of two is big and the other small. In the first scenario it is clear that the country has a big problem. Perhaps the crisis is very near and the authorities should take immediate abrupt steps to bypass it if they can, or choose to default. In the second scenario there is really no problem. A lot of debate though exists about the two in-between cases.

If the public debt is small and the private debt big, it could pose a problem for the country. In this case it all depends on whether the debt markets function, on the state of the world economy, on the size of the sovereign economy, and on the phase of the business cycle we are in, which largely dictates the economic soundness of the firms themselves. This is the case about Spain, which has a low public debt of 53% of Spain's GDP and a relatively high private debt resulting to an external debt of 165% of Spain's GDP.

Greece, on the other hand is an example of a country with high public debt, estimated at 113% of GDP for 2009, and a relatively low private debt, given that its external debt is estimated at 167% of GDP for 2009. However, in the current state of the world economy the relatively low private debt cannot help insight of the ballooned public debt, the lack of entrepreneurship, the lack of profitable projects, the tax evasion, and the corruption in the public and private sector. These examples highlight the importance of differences in the structure of economy.

2. Bondholders' Identity

Finally, we turn our attention in the identity and tastes of the bondholders which is a component of equal if not bigger importance than the economic outlook of each country. A clear contrast of the different impact different groups of investors can have is provided by comparing Greece and Japan. Japan's public debt is the second in the world estimated to be 189% of GDP for 2009, whereas its external debt of both the private and public sector is estimated to be just 42% of GDP for 2009. This means that all Japanese debt is held by Japanese hands, whereas most of Greece's debt is held by foreign investors, mainly European banks. Given that Japanese have no interest in bringing down their own country, as well as their known habits for saving, which makes them very patient, clearly contrasts this group of investors with the foreign investors who invest in Greek debt.

Different Debt Measures

Even though the logic of analyzing each case -- positive economics -- used above is sound, the data used are not exactly comparable. This does not mean that the conclusions are not valid, as the correct data may be very close to the ones available. But the point I want to make is that there are a lot of different ways one can construct data numbers that measure quantities that sound almost the same but they are not and that the specific construction can be very important in determining the conclusions we reach.

For example, apart from the crude distinction I used above, between public and private debt, which people these days use freely and sometimes interchangeably, there are other more subtle separations of debt. In this fashion, we have Gross Public debt[1] and Net Public debt[2] here. In addition, there is Internal debt (the total public and private debt owed to residents) and External debt (the total public and private debt owed to nonresidents repayable in estimates for which one can find foreign currency, goods, or services).

The bottom line of all this is that which measure one uses is extremely important as different measures have very different values. So one has to first decide which measure is most relevant, and then in order to make comparisons between two countries, one has to make sure that the structures of the two economies are similar in a huge array of other dimensions, that we analyzed above. In short, making comparisons is extremely tricky, but at least we should be aware of the complexity of the problem and the differences of the existed measures.

---

BACK TO POST1. Gross debt consists of all liabilities that require payment or payments of interest and/or principal by the debtor to the creditor at a date or dates in the future. This includes debt liabilities in the form of SDRs, currency and deposits, debt securities, loans, insurance, pensions and standardized guarantee schemes, and other accounts payable. Thus, all liabilities in the GFSM 2001 system are debt, except for equity and investment fund shares and financial derivatives and employee stock options. Debt can be valued at current market, nominal, or face values (GFSM 2001, paragraph 7.110).

BACK TO POST2. Net debt is calculated as gross debt minus financial assets corresponding to debt instruments. These financial assets are: monetary gold and SDRs, currency and deposits, debt securities, loans, insurance, pension, and standardized guarantee schemes, and other accounts receivable.