Two Opposite Articles On WSJ

Here are two opposite articles on WSJ published on the same day. The first one, accuses the FED’s policy for bringing into a difficult position Brazil and the rest of the world, and even accuses the U.S. for mindlessness and purposeful action to damage the other countries. The second one, explains that buying medium to long-term Treasuries is a valid monetary policy of the FED in order to stimulate the economy. The first one is written by a journalist. The second one by Alan Blinder, economics professor at Princeton. Who speaks logic is your call. Just read them.

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.  

Why Increasing China’s Labor Costs Is Good For Everyone (Almost)

The featured article on Economist is about the rising power of the Chinese worker. Indeed. A long waited increase in Chinese workers salaries will have many good implications for China itself and the rest of the world. This article analyzes some of these benefits. In addition to the mentioned benefits in the article, which I summarize briefly bellow, there is one more.

This is that an increase in Chinese workers salaries will improve the competitiveness of other countries, like the Europe’s south, who now suffer, from the abundance of cheap labor in motherland China. In sort, the benefits from increasing China’s labor costs are:

1. Increase the ability for the Chinese workers to enjoy the fruits of their labor.
2. Balance the Chinese economy which is currently heavily depended upon investment.
3. Boost the world economy, by increasing consumption.
4. Balance the China’s trade imbalances with the rest of the world.
5. Adjustment in the Juan’s exchange rate.
6. Increase the employment in the rest of the world, as less jobs from the other countries are going to be lost to China.
7. Improve the competitiveness of other countries.

The main cost from this increase, will be the increase in the price of Chinese products, but this is counterbalanced with all the above benefits, especially that of increasing employment in other countries, and also the fact that at this time a little inflation is not bad.  The ones who may lose more form this rise, is going to be the shareholders of the big corporations who have factories in China.

Do The U.S. Need Austerity Measures?

The current state of the U.S. economy is described by an anemic growth and a huge debt that is increasing in a fast rate. This situation has led economists and policy makers to debate on the necessity of taking austerity measures, especially in light of countries like Germany and U.K. who proactively and willfully have taken tough austerity measures.

But do we really have two hot potatoes in our hands? My short answer is no. We definitely have one, the anemic economic growth, and, at least until now, we do not really have a U.S. debt problem, if the U.S. debt holders would require higher interest rates or if the CDSs on U.S. debt would start to get dangerously high. However, the last months we have seen the exact opposite. If nothing else, the last debt crisis in the eurozone has helped the U.S. by bringing the long term yields down to extremely low levels. Let me remind you that a few months ago long term yields touched, and even exceeded, the psychological threshold of 4%. At the time, everybody was nervous about it and people started circulating stories about the unattractiveness of the U.S. debt.

The flight to quality (quality meant in relative sense) that started with the resurgence of the eurozone debt fears reversed that trend and since then the long term interest rates have been constantly declining. Today the 10-year yield is a stunning 2.89%. Really, how bad can the outlook out there be so that there are people willing to get a 2.89% for the next 10 years?

At the same time the supposingly inflation protected assets, like gold, silver and other commodities, have not increased in value during this last period. Gold reached a new high at almost $1257.2 per pound and since then it has declined to 1191.6 today. This tells us that the markets do not fear inflation as much, which would be the case if they anticipated that the U.S. would not be able to tackle its debt and resort to printing money.[1] In addition the yield on TIPS is 1.29% for a 10-year security and 1.95% for a 30-year security. If anything else, the markets are telling us that there are big problems out there, but the U.S. pilling debt is not one of them. At least not for now.

Three Schools of Action

And the question is: should we wait until it really becomes a problem? Should we wait until the bond vigilantes take notice of the bad debt outlook of the U.S. and start requiring higher rates? There are three schools of thought about it.

The first wants everybody who even silently thinks on the issue to stop thinking! This is the most extreme view and the loudest of the three schools out there. There are people who get annoyed by even thinking or talking about it, which is incomprehensible to me.

Some of the people in the first group argue that we have time in the following grounds. For the U.S. to start having problems investors have to dislike the U.S. debt and to also like other securities, like other countries’ debt, stocks, commodities, cash and TIPS. Since this is not on the horizon right now we can wait.

This approach is risky. It basically relies on optimally timing the behavior of the investors, something that it is not very easy to do. Also, it requires we know and monitor the return behavior and flows to all the assets that could be substitutes to U.S. bonds.

The second line of thought is consisted of people who stand on the other extreme, demanding measures on fighting the mounting debt. According to my understanding, they are not so many or forceful about their views.

And the third school is consisted of people who want to start thinking and discussing the policies that eventually we will need to take at some point, sooner or later. These people encourage a healthy dialogue that will get us prepared and ready to face the Armageddon that is coming. There is a consensus among the people in this school that the mounting debt is an issue that we cannot ignore. On the contrary, it is an issue we need to start addressing right now.

The last group advocates that deciding on and laying out the policies that we will have to take when time comes, has many benefits. By having the policy makers committing on a set of policies to fight debt, will (a) alleviate the fears of bond vigilantes, therefore interest rates will not skyrocket, (b) calm the central bankers that the government will not go on with an inflationary policy, and (c) will alleviate the concerns of the public sector and hopefully they will not hold on on consumption and investment more than it is necessary based on the plan to fight debt. The performance of the economy is based on expectations. Therefore, laying out the plan, showing sternness and sturdiness in solving the problem, is as important as actually fighting it.

My view is closer to the one described by the third group. It is more prudent to, at least, start thinking about the problem, even though we may not have a problem right here right now. Since the problem is lurking, growing at a fast pace, and since we do not know how far from today the problem is going to arise, therefore how much time we have, it is sounder to decide on the policies and actions to be taken when time comes. The benefits from doing it are great, the risks from not doing it are even greater and there is no reason not to decide on policies now.

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[1] I do not include the strengthening of the dollar during this period in my calculations which could explain some of the decline in the price of gold in dollars.

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]

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

Why It Is Right For Central Banks To Keep Printing

Martin Wolf from Financial Times wrote a thought provoking article with title "Why it is right for Central Banks to keep printing". The article speaks directly on the hot topic of the right balance of monetary and fiscal policy. Wolf is against fiscal tightening right now and in favor of a continuing monetary easing, To support his belief he sites a paper that refers to Milton Friedman's ideas. It is a paper by Randall Wray which according to Wolf it proposes a harmonized coordination of Fiscal and Monetary policy so that none of the two does the heavy lifting alone. Even though I have not read Wray's paper and I cannot comment on it, I promise to comment on it in due time.

Back on Wolf's article, it sparked a lot of discussion, as evidenced by the long list of comments following the article. Questions begging for an answer: What is the right balance between fiscal and monetary policy? Quantitative easing or not? Do Debt-to-GDP measures matter and when are they "too" high?

On the quantitative easing front Wolf cites Charles Bean's, Governor at the Bank of England, talk on the subject.