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.

“Inside Job” Documentary

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.

Credit Crisis Explained

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.”

A Paper on Greece’s Woes

My appointment at NYU has taken a toll on my time devoted on this blog. However, here is a paper I meant to include in the information about Greece’s economic problems. The article, written by well known academics Meghir, Vayanos and Vettas, not only identifies the causes of the Greek crisis but also proposes measures in order to get out of it as fast as possible. Hope you enjoy it.

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.

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.

The Real Estate and Credit Meltdown Discussion From USC

A good discussion that took place before I start my blog but I think it is good to include in order to get a better understanding of what happened, where we are, and where we are heading.

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.  

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.

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.

Past Performance, Future Forecasts, And Taxes

Not surprisingly, the central piece in the talk continues to be the mounting debt and policies that could address that, and more specifically the taxes. The Bush tax-cuts are perhaps going to be the coming election’s campaign theme.

Related to the talk on taxes, WSJ today publishes an article “The Democratic Fisc” which uses the White House’s budget office numbers, published on Friday last week, to have a look at the past performance and future outlook of the U.S. economy. WSJ says “the main message is that tax revenues are smaller, spending is greater, and the deficits are thus larger than the White House has been saying”.

The article compares the current period with the 1981-82 recession which is similar in its severity with the one the current administration inherited. What strikes me are the following differences between these two periods:

	1981-1987	2009-20012
Budget Deficit:	less than 6% of GDP	current 9.9% of GDP, it is expected to rise to 10%, before it declines to 5.6% of GDP
Revenues:	17.3% of GDP, despite pro-growth tax cuts	14.5% of GDP, expected to increase to 15.8% in 2011 when big tax increases hit
Policy:	tax cuts across-the-board	spending, temporary tax rebates, jobless benefits

The findings, from the above table, clearly raise the long debated question about the effectiveness of spending and tax cuts. I will return to this later.

Some other factors that enhance the bleak future economic outlook are described by (1) the expectation that deficits will not shrink bellow 3.4% of GDP over the next ten years, (2) the ratio of debt-to-GDP will continue to increase over the same period, (3) there is no plan yet to fight debt, (4) spending is expected to increase and (5) taxes are increasing -- this is not a request of the fiscal commission, which means that perhaps more taxes are coming.