rajakorman

[rajakorman]

Ratings and Hegemony

This is the original English version of a piece that appeared in LIMES, the Italian Journal of Geopolitics in the March 2017 edition. The link to the original is here. They asked for something on the rule of the ratings agencies in their “who rules the world” issue.  

http://www.limesonline.com/cartaceo/legemonia-gramsciana-delle-agenzie-di-rating?prv=true

Posting now because it seemed of some interest given my persistent complaints about how local currency ratings work, but also because it also contains some thoughts on the application of ratings to the Eurozone. Fully prepared for tl;dr.  

The Gramscian Hegemony of the Ratings Agencies

Karthik Sankaran

 Historians have long understood that the link between the fiscal capacity of the state and its ability to engage in and sustain its position in interstate competition is an essential element in the sinews of power. Beginning with the early modern period, fiscal capacity went beyond just the ability to raise taxes but to include ability to issue debt to investors with those investors displaying the confidence that these debts would be repaid – a confidence that in turn was reflected in both the availability and the price of debt.

 Fiscal sinews have historically meant the ability to raise money at home. But in a world marked by immense cross-border capital flows, the ability to deny rivals access to global capital or alternately to funnel global capital to allies becomes another aspect of power. As global capital is predominantly owned and mediated by private individuals and institutions, such an ability can take the form of state suasion targeted at investors or at the gatekeepers that influence the disposition and direction of private capital flows. In our world, the rating agencies play a critical role in this regard, insofar as their assessment and calibration of the risks faced by lenders influences not just private investors but also the behavior of regulators who use ratings as an input in determining the safety and soundness of financial institutions. Ratings agencies thus have enormous power. The question is whether this power is exercised as an overt geopolitical instrument, or whether the geopolitical consequences of ratings power reflect rather a Gramscian concept of hegemony, wherein purportedly neutral judgements in fact reflect deeply rooted values, ideologies and beliefs. I would suggest that the latter interpretation is more correct for most discussions of the geopolitical power of ratings agencies.

 One of the oddities of this world is the extent to which ratings agencies are concentrated in the Anglo-American world despite the fact that both the US and the UK are actually a large net borrower from the rest of the world. By various calculations the “Big Three” dominant ratings agencies, Moodys and S&P (both headquartered in the US) and Fitch ((jointly headquartered in the US and UK), account for more than 95% of all global ratings activity, with the first two accounting for roughly 80%.

 This in turn is the result of several historical factors. The first is that the US and UK experienced the disintermediation of finance earlier than and to a greater degree than other countries did—i.e., rather than banks channeling funds to companies that they understood well, US and UK financial intermediation were focused to a greater degree on the issuance of corporate bonds to a broader investor base. This in turn put a greater premium on the need for information for investors less familiar with underlying business models than closely linked banks might have been, allowing for the rise of the ratings agencies.

 The information infrastructure that grew out of these factors became even more important as the US rose to global prominence in the post 1945 world. By the early 1970s, US financial predominance was reflected not in the US status as a creditor to the world (unlike the model of the UK before 1915), but rather as a large debtor, whose preeminence stemmed from an elaborate quid-pro-quo whereby dollars generated by US trade deficits were readily accepted overseas in exchange for the US provision of a defense umbrella and the US provision of ready markets to absorb excess global capacity. This in turn made the dollar the dominant currency of international finance, a status that it still occupies today, with roughly 60% of all cross-border lending conducted in US dollars (This figure does not count cross-border lending within the same currency area as is the case within the Eurozone). contracted in dollars. Globalized dollar lending made US based ratings agencies a central part of the global system of gatekeepers for finance.

 What is interesting that Europe was the first (and only) large economic area to try to extricate itself from its dollar linkage when the collapse of the Bretton Woods system in 1971 led to excessive intra-European currency volatility. This in turn inaugurated a long series of arrangements to limit such volatility that culminated in the creation of the Euro. The deutsche Mark and eventually the Euro replaced the dollar has long replaced as the dominant invoice currency in the region. The Euro has also a moderately high degree of internationalization (albeit less than the dollar), with the Euro accounting for a bit more than 20 % of out of area international lending. Meanwhile, the sheer size of the banking sector means that European banks are dominant players in much of the world. As a region with large net savings, Europe is also a net provider of savings to the rest of the world via its private sector. Notwithstanding all of this, European (or more precisely Eurozone-based) ratings agencies have little influence in the world. The same is even more true of the other large suppliers of global savings –China and (until the Shale revolution in the US) the major oil exporters. It is a commonly pointed out as a flaw that the ratings agencies are compensated by issuers rather than by investors, which may in turn create conflicts of interest. There is also a less remarked meta-issue that the dominant suppliers of credit ratings are headquartered in the sinks for global savings rather than in their source.

 Do these factors have geopolitical consequences? Undoubtedly yes, but in a less obvious way than might be believed. It is not too often the case that purely geopolitical calculations (or political pressure to consider the same) influence the extent to which agencies tailor their reviews. Like many modern professional cadres, ratings personnel adhere to a certain standard of technocratic autonomy that is governed by its own rules. They are largely recruited from the group of universities that the dominant institutions of globalized finance themselves patronize. This is an international fraternity (and sorority) largely schooled in orthodox economics (with the usual doctrinal schisms within that orthodoxy), and a set of substantially internalized beliefs on the interactions among institutions and economics.

 There certainly are instances in which old-fashioned geopolitics plays a part. For example, sanctions meant that Iran was substantially excluded from ratings by the dominant agencies for several years (though there are reports it may seek to renew its ratings as attempts to access capital markets again following the conclusion of the nuclear deal). But even in the case of sanctions, market power matters. For example, the sheer size of Russian integration with global capital markets (with roughly 700 bio dollars owed to Western financial institutions) may have been one factor that meant sanctions after the invasion of Ukraine were calibrated in such a way as to fall well short of Iranian levels of exclusion from markets. Nevertheless, the experience did mean that Russia (like other countries) is trying to set up its own ratings agencies. It remains to be seen how much purchase some ratings will have with investors outside Russia where the advantages of incumbency will likely be very strong.

 However, rather than considering ratings agencies through the prism of pure geopolitics, I would argue that it makes more sense to focus on the rules, ideologies, and beliefs that influence ratings, which then have geopolitical and geoeconomic consequences. It does some quite clear that there are issues of internal consistency across the ratings landscape that seem particularly problematic in the case of emerging markets ratings.

 The basic metrics that inform creditworthiness include public sector debt to GDP ratios, the currency composition of debt, the extent of private indebtedness in the economy, particularly in the financial system (which in turn may swell sovereign contingent liabilities), and the extent of net overseas holdings of assets (which in turn may be drawn down by domestic citizens to fund their local government). The issue is that the interaction among these factors is somewhat opaque and not necessarily scaled. So some countries would seem to be unequivocally AAA credits, such as Norway with a debt/GDP ratio of 31% and a positive net international position of 170% of GDP. But so are Canada with a gov't debt/GDP ratio of 92% and an NIIP that is essentially 0% of GDP, and Australia with a government debt/GDP ratio of 40% and an NIIP of -60% of GDP. Conversely, emerging markets sovereigns with much lower debt/GDP ratios and higher NIIPs are rated much lower – for example China's gross general government debt is 42%, its NIIP is +15%, it has virtually no sovereign external debt owed to private creditors, and yet its rating is in the AA-/A+ area. While this might be justified by large increases in private sector indebtedness in the recent past, developed sovereigns with substantially higher government debt ratios, worse NIIPs, larger banking systems (implying a larger contingent liability problem), and possibly greater medium-term political uncertainty (such as the UK) are rated higher than China.

 The overall impression is that a hegemonic ideal of high-income democratic neo-liberalism automatically qualifies a country for high creditworthiness despite numerical indicators to the country. The most clamorous example of this was the overrating of Iceland in the 2000s. A tiny country with an immense, internationally active and very risky banking system (whose assets were roughly 9 times GDP) not only achieved the highest rating from one of the agencies, but saw its banks also upgraded (on the assumption of sovereign support) despite the obvious fact that the sovereign was too far small to actually tender such support. Indeed as late as mid-2009, after a crisis had seen the failure of the entire Icelandic banking system and the imposition of capital controls, the country was still rated higher than Brazil by the same agency, though Brazil had largely weathered the2008-2009 crisis and still had ahead of it a few years of a tailwind from a commodity boom.

 As stated before, I do not believe that this reflects geopolitical preferences or influences—that Iceland was a NATO member had to less to do with the decision than a more ideological disposition within international capital more broadly. This is the belief that capitalist democracies that respect neo-liberal tropes of “supply side efficiencies” are inherently likely to have better prospects for economic growth and political stability, which makes them better credit risks, even when the numerical indicators of creditworthiness point the other way. To reiterate, this suggests the operation of hegemony in a Gramscian sense as a set of highly influential beliefs (and rules flowing therefrom) that is both widely shared and rarely questioned, rather than in a more “political science” sense of an exercise of state power by a hegemon that seeks to push private entities in a favorable direction during the course of interstate competition.

 Nevertheless, these factors can have political and geopolitical consequences. To return to the years before 2008, the major feature of that period was the sharp rise in so-called global imbalances, as current account deficits in both the US and in the Eurozone periphery exploded alongside large surpluses in the eurozone core, East Asia and among the oil exporters. Among the latter two, the task of accumulating and recycling these surpluses savings was undertaken more by the sovereign than by the private sector. The quest for high-quality assets that could absorb those savings led to the creation of synthetic securities grounded in the US real estate market whose putatively high credit ratings proved famously illusory. An important point here is that the effects on US labor of China's epochal reentry into the circuits of the world capitalist economy were hidden for a while as US consumption levels were cushioned by increases in US household leverage enabled longer than they would otherwise have been by the operations of the ratings agencies. The broader geopolitical implications of this—the accommodation of China's rise, the widening rift between globalized capital and national labor in the US and other developed markets (which in turn has led to the Trumpist retreat from globalism) are profound, but once again they seem to stem more from the operations of unconscious rules than from overt pressure to turn the ratings agencies into geopolitical instruments.

 The other major node of global imbalances (between the surplus capital exporting core and the deficit capital importing periphery) was the Eurozone, and it is here that the interaction of politics, economics and geopolitics becomes most clear. The decisions of the ratings during the crisis reflected a procyclical pattern observed during the Asian crisis of 1997 of excessively high pre-crisis rating followed by excessively sharp downgrades once the crisis began, which in turn may have contributed to amplifying market responses that exacerbated the crisis. These patterns during the Eurozone crisis (as they did after the Asian crisis of 1997-98) have occasioned a great deal of criticism, but I would argue that that ambiguities in the economic and political governance of the Eurozone may well have heightened the procyclicality of ratings behavior.

 As is well known, the central ambiguity of the Eurozone lies in the fact that it is a monetary union that is not also a fiscal union. This in turn creates questions about whether national debts in the Eurozone are contracted in a foreign currency or in a local currency, and simultaneously about the extent to which single countries in the Eurozone can be said to enjoy full monetary sovereignty. These facts have led many market observers to make analogies between the Eurozone and the classical gold standard and to countries that failed to maintain their currency boards (such as Argentina in 1998-2001). Yet even these analogies are in my view, very likely misplaced. The reason is that unlike the classical gold standard, the Eurozone has shared control of a fiat money producing central bank that is capable and substantially (but not unconditionally) willing to moderate the rises in credit risk premia that arise from downturns in the business cycle. The common payment system Target 2 provides unlimited absorption of very large drops in investor appetite for assets from troubled countries. The classical gold standard enjoyed neither of these features nor did hapless countries like Argentina.

 At the heart of this difference is precisely the fact that the EU's creation and evolution is a consequence of geopolitical imperatives. The evolution of the EU and the Eurozone reflects first a desire to escape a history of intra-European wars, then the desire to anchor a reunified Germany to its Western neighbors in 1990 and more recently the desire to create an economic and financial unit that gave Europe a semblance of geopolitical and geoeconomic parity with China and the US. These factors are very different from the highly asymmetric motivations that led Argentina for example to import credibility by its peg to the US dollar, even while there was correspondingly relatively little concern on the US side when Argentina finally exited it calamitously.

 But what complicates matters further is these geopolitical desires at a pan-Eurozone level have to negotiated against a backdrop of national preferences where there are political constraints on pooling sovereignty (or at least at the pace of such pooling); protests against perceived transfers (whether overtly fiscal or resulting from central bank action) among some countries; and protests against the fact that such transfers are conditional (and consequently seen as a constraint on the exercise of democratic choice) in still others. Political ambiguity is compounded by legal ambiguity—the language of “irrevocable conversion parities” to the Euro is not compatible with Article 50, which explicitly recognizes a right to leave the EU (a right the UK has chosen to exercise). Periodic political messaging around the prospect that Greece might leave the Eurozone, but still stay in the EU clouds matters further.

 Recent history suggests an interplay between domestic political constraints and a revealed preference of European leaders to keep the Eurozone alive for geopolitical and geoconomic reasons by agreeing in moments of crisis to hitherto unthinkable expedients such as the creation of fiscal backstop (EFSF and then the ESM,) and the creation of a conditional monetary financing tool (OMT). Against this backdrop, whatever their historic misjudgments it is probably harder for the ratings agencies to get the Eurozone “right” at all times precisely because the fundamental categories of sovereignty and local versus foreign currency debt are more politically fluid as a result of the unique construction (and the ongoing evolution) of the Eurozone. The dominance in the ratings markets of English speaking countries with a particular culture of political economy might well exacerbate ratings misjudgments in the case of the emerging markets. However in the case of the EU in particular, some portion of the blame ascribed to the ratings agencies must also fall on the fact that the financial and political architecture of the Eurozone is in itself a work in creation, with the maximum creativity displayed only in the moments of crisis.  

[rajakorman]

But wait, there’s more limericks

I’m guessing most people saw the alphaville post here. https://ftalphaville.ft.com/2017/02/07/2184030/guest-post-karthik-sankarans-guide-to-macroeconomics-in-verse/

But after Matt’s commission, I realized I had more in me, especially regarding bugbears, bete noires & beebonnets such as Italy, the Wilson problem and America’s urban rural divide

Even Eurooptimists worry about Italy

There is 1 slow-burn powder keg.

It’s the country that looks like a leg.

Its SMEs are a fright

Poujadists dominate the right

And even when stagnant, it needs a crawling peg.

 Not all inequality is the same

Rawlsian increases in Ginis

Means food security, not just lamborghinis.

Raising bottom quintile ability

Increases regime stability.

Otherwise, inequality just brings out the meanies.

 The Electoral College Blues

America’s interoceanic immensity

Is leavened by rich oases of density

Though these won a plurality

They were swamped by rurality

Throwing the election to passionate intensity.

 All about the Wilsons

Two Wilsons, Woodrow and Charlie

Are to blame for why the world is so gnarly

Unleashing ethnolinguistic Calibans

Spreading a profusion of Talibans

And white nationalists riding their Harley

^

[rajakorman]

Make Multilateral Intervention Great Again

This grows out of a discussion with Matt Klein, when we are talking about the discrepancy between trump fiscal exchange rate and trade policies where he jokingly suggested that the Fed should sell all its USTs and buy Bunds. I thought about it overnight and it struck me that the underlying idea actually makes a great deal of sense.  As longtime followers know, I've been insistently pounding the table for a few years now on three related topics-that the combination of floating and large open capital accounts is more destabilizing than stabilizing; that exchange rates frequently overshoot driven by large, instantaneous shifts in desired portfolio balances; and that the interaction of borrowing (domestic vs. foreign currency) and investment behavior ( tradeable vs. nontradeable sector) during such overshoots invalidates the idea that large current account imbalances are an automatic intertemporal smoothing mechanism. Another way to think about this is that in two of four quadrants of a kind of Swan Diagram (that plots Internal and External balance) THERE WILL BE A FUNDAMENTAL CONTRADICTION BETWEEN THE INTEREST RATE REQUIRED TO RESTORE INTERNAL BALANCE AND THE EXCHANGE RATE REQUIRED TO RESTORE EXTERNAL BALANCE. 

Sorry to scream, but I'm astounded at how often I've had to explain this to people in the course of a day job. Anyway, this is why I'm increasingly a proponent of capital controls. Nothing new so far for people who have been subjected to real or virtual harangues on this from me. What is new (and the reason for this post), is the idea (2nd best in my view, but potentially best in practice) that maybe the worlds major systemic central banks -- Fed, PBoC, BoJ, ECB (for a start, but think this could eventually make sense at the G20 level)-- should routinely engage in dialogue and coordinated bi-or multilateral interventions whenever a country is identified as being in one of those problematic Swan quadrants where a country might need higher interest rates but a weaker currency or lower interest rates but a stronger currency  Right now we have a world in which CBs do indeed have massive balance sheets, but there's a huge difference between EM and DM CBs, with the massive EM CB balance sheets composed to a large extent of foreign assets, while the balance sheets of the Fed and the ECB are composed almost exclusively of domestic assets. This distinction reflects two things--greater financial depth in DMs (i.e. more domestic assets to buy) vs. EMs, but also a preconception among the Fed and the ECB in particular that market set exchange rates are superior to administered ones. This is, of course, ironic on so many levels, starting with the fact that the Euro is a culmination of a 3 decade long project by Europeans to (justifiably in my view) limit and eventually eliminate the impact of the post 1971 forex market on intra-European exchange rates in what was and remains a tightly connected series of small open markets with deeply interlinked supply chains. For those reeling in horror and disbelief at this point, I direct you to my post on why the Euro crisis might not really have been caused by the Euro. ;). http://rajakorman.tumblr.com/post/79194706949/what-might-the-eurozone-crisis-have-looked-like

But it is also ironic because one of the obvious purposes of large domestic balance sheet expansion in DM CBs is precisely to influence the exchange rate. The same goes for negative interest rates. All I'm saying is "Cut the crap." I'm arguing that all major CBs should be prepared to use shifts in the relative size of their domestic and foreign balance sheets as a signaling device (alongside interest rates) as a way to signal not just the aggregate monetary conditions they think of as appropriate, but also the relative contribution of domestic interest rates, the shape of the yield curve, and critically of the exchange rate in determining said monetary conditions.

In other words, central banks should be prepared to use their balance sheets to accommodate and mitigate precisely those large shifts in the private sector's desired foreign portfolio balances that can be inherently destabilizing for both real and financial outcomes. I also think that if CBs do this, they should do it collectively rather than singly, in a coordinated fashion and according to a set of guidelines where it is easy to differentiate purely mercantilist impulses from ones where there is genuine incompatibility between the needs of internal balance and external balance. This also seems to me a much preferable situation to governments messing around with goods market via tariffs and trade barriers when these external balance issues become political Kryptonite. The state of the US-China relationship where divergent cyclical impulses threaten exchange rate behavior that blows up an already fraught politics of trade strikes me as a classic case for such an approach.  Market purists will be horrified by the suggestion of routine central bank intervention in yet another market but longtime followers already know I've pinned my flag to the superiority of technocratically driven outcomes over purely market-driven ones. I realize there are technical issues regarding sterilized vs. unsterilized intervention, but coordinated multilateral intervention, even when sterilized, has historically had a pretty strong record of signaling inflection  points.  See, for example, https://research.stlouisfed.org/publications/review/11/09/303-324Neely.pdf

One other benefit of such an approach is that it would confer the imprimatur of the Fed and the ECB and a broader range of assets (in particular  the sovereign liabilities of systemic emerging markets sovereigns denominated in their own currency) as being safe assets. I do not think this is a problem. The dollar's long history of the dominant international safe asset owes a great deal more to geopolitical factors than to its inherent superiority as a store of international value. And perhaps the best thing about such an approach of routine rule-bound multilateral coordinated forex intervention in order to achieve G20 exchange rate target zones is that makes it more possible to return to at least some of the underlying financial conditions of the Bretton Woods 1 era, but in a world with large private portfolio capital flows and large central bank balance sheets (and per the work of Zoltan Poszar, I think there's a compelling case that such large balance sheets are here to stay).  What I'm suggesting is that there is a case for using the central bank balance sheets as a way to offset the instability inherent in large private capital flows.

Vive les 30 Glorieuses.

Related posts.

http://rajakorman.tumblr.com/post/102531405985/niip-sustainability-and-the-case-for-capital

http://rajakorman.tumblr.com/post/84527845240/on-spillovers-exchange-rates-and-monetary

http://rajakorman.tumblr.com/post/79194706949/what-might-the-eurozone-crisis-have-looked-like

http://rajakorman.tumblr.com/post/139151237270/tired-of-nirp-try-intervention?is_related_post=1

http://rajakorman.tumblr.com/post/128277678675/on-spillovers-and-the-case-against-giving-in-to

http://rajakorman.tumblr.com/post/114124758065/the-fed-never-talks-about-the-dollar-and-other

.

And if anyone makes it this far.

http://rajakorman.tumblr.com/post/80683018566/ramblings-on-international-inside-money-and

[rajakorman]

Capital, the Nation-State and the Crisis of the Right

Nothing like a nice title that uses the word Capital, is there? This post picks up on about two years'  worth of conversations, tweets, storms, etc. But the original thought goes back at least to the 2008 election—specifically the Sarah Palin pick for Veep, acclaimed (and allegedly masterminded by) by Bill Kristol--when it became clear that the most loyal and most highly engaged voters of the GOP were the losers from globalization. Ever since then, the dichotomy “nationalism” vs. “globalism” seems to have become the dominant  ideological organizing principle for this group of GOP loyalists. I don't think it's a coincidence that Tea Party members describe themselves as Patriots.

The question is how this dichotomy interacts with the elite interests that the GOP has historically represented. I take the cynical view that political parties need both hearts and pocket books. Over time, they need a coherent intersection of  elite interests,popular interest and ideology in order to survive. And I think that in a two party system, the logical elite interest for the party of the right to represent is the interest of capital. At the same time, parties of the center right in capitalist democracies have historically finessed the issues of popular interest and ideology by appeals to nationalism and the claim that they have delivered mass prosperity to their constituents, precisely because they are the party of capital.

This was easy enough to do during the Cold War, when the opposing global system defined itself as an international party of labor and presided over a system which delivered far less in the way of mass prosperity. As I've joked, it's really hard to be a materialist party when you do a crappy job of providing material goods. Conversely, those signs pointing out that The American Worker Has The Highest Standard of Living in the World were not just true, but also hit a trifecta, connecting the interests of capital with those of labor in the context of a single country—the US.

All that began to change, less because of things that happened in the US, and more because of what happened in the rest of the world.  (I recognize this part is controversial, but I'd still locate the dominant impetus behind the current predicament of the GOP in what happened in China to a greater degree than the limited capacity of the US welfare state to cope with it). Anyway, once huge populations in China, Eastern Europe and South Asia gradually stepped away from socialism (and in the Chinese case, hit upon the genius idea of Leninist post-Marxism, rather than the failed Gorbachevian expedient of Post-Leninist Marxism), metropolitan capital naturally took advantage of the opportunity, inaugurating the second great age of globalization, with the distributional results anyone who has heard of Branko Milanovic can now see.

Capital and capitalism became global, and so did its interests. That portion of the elite (like me) who were involved in the managing, mediating, explaining, commenting on the flow of capital away from the old center of the global economy benefited. So did the recipients of such capital, predominantly in Asia, while the losers (at least in relative terms) were those whose labor metropolitan capital no longer needed, or at least not at the same price.

The problem is that this created a serious rift between elite and mass interests, and elite and mass ideologies that is particularly acute on the center-right. As I've said in another context, what we're seeing now is the next phase in a series of long changes in the ideological-material contours of the global economy, at least as seen from the North Atlantic. The years roughly between 1650-1800 (arbitrarily using the Peace of Westphalia as a dividing line) saw the end of a broad civilizational/sectarian identity among elites in the North Atlantic and the inauguration of a period where elites became “national”. The years after 1800 (you could pick 1776 or 1789 if you wanted) saw a period in which elites remained national but a vast ideological/political/material enterprise was devoted to nationalizing the masses through conscription, education, the gradual expansion of suffrage and eventually the expansion of the welfare state.

But in the world since 1990, the interests of capital  (and of capitalism) and of a portion of the elite have become much more globalized, even as labor has remained stubbornly national. Of course, this is a tribute to the  ideological success of the anti-Socialist and anti-Communist efforts of North Atlantic capital and its associated parties in that 1800-1990 period (and many historians would see 1865-70 as the real inflection point in this regard). But it still presents a huge problem for center-right parties precisely because the claims of capital and the claims of nationalism are ever more tenuously linked. The issue is less problematic for center-left parties for two reasons—ideologically (and to different degrees in Europe and North America) they have been somewhat more comfortable with an identity that is internationalist, but this would be less effective were it not also for the fact that their sociology to an ever greater degree  reflects their appeal to the beneficiaries of this wave of globalization—the mediators of these flows of capital, and those possessors of  the kind of cultural capital that either acquires greater value in a global marketplace or is more resistant to global labor arbitrage. It is these facts that seem to explain the US political landscape right now (and with some changes, can help make sense of Brexit too). Center-right ideologies centered on capitalism and the nation state were the dominant forces defining the North Atlantic for the last couple of 100 years, and interestingly, may well play an ever larger part in defining ideology and politics in China and India, both of which seem to be solidly in the “nationalization of the masses” phase.  But  in old heartlands of capitalism, as the coherence of the capitalism = nation state identity becomes ever more frayed, a new ideological landscape is opening up, on the right above all.

This is a long-winded and likely pompous attempt to explain what must by now seem self-evident but I promised @conorsen I'd do it. If you haven't seen them already, I do recommend these two recent articles in the New York Times http://www.nytimes.com/2015/10/07/opinion/how-did-the-democrats-become-favorites-of-the-rich.html?_r=2

and the Wall Street Journal. http://www.wsj.com/articles/republicans-rode-waves-of-populism-until-it-crashed-the-party-1477492356 that put some more meat on my bloviation.

[rajakorman]

Not that anyone asked me, but if I were a Sherpa....

In the continuing series--unsolicited complaints and advice from me to global monetary authorities---see, e.g. 

http://rajakorman.tumblr.com/post/139151237270/tired-of-nirp-try-intervention

http://rajakorman.tumblr.com/post/114124758065/the-fed-never-talks-about-the-dollar-and-other  or

here’s an effort at writing the key exchange rate paragraph from the upcoming G20 statement. I don’t think we’re actually there yet, and I would be very surprised if something like this made it into the statement this coming weekend. At the same time, I think something like this would actually make some sense, with the second half in particular reflecting one of my longstanding bugbears about the way the international monetary and financial system works right now. If, somehow, you have escaped my persistent online buttonholing about this subject, see here.  http://rajakorman.tumblr.com/post/84527845240/on-spillovers-exchange-rates-and-monetary

Anyway, here’s what I would draft if I were a Sherpa. 

“The members of the G20 welcome the inclusion of the renminbi in the IMF's Special Drawings Rights basket. They urge and commit to further prudent liberalization of China's capital account and the gradual process of renminbi internationalization in a manner that enhances that global stability.  Members’ central bank reserve portfolios will continue to be modified opportunistically to reflect the renminbi's inclusion in the SDR as a currency that is freely usable by the official sector. The members acknowledge recent research from the BIS and the IMF on instabilities stemming from the current configuration of the international monetary and financial system and welcome efforts by the IMF to study and  eventually to promote safer cross-border capital flows. Members are aware that there are circumstances in which large, quasi-instantaneous shifts in desired portfolio balances can be self-reinforcing and lead both to substantial divergences from medium-term equilibrium exchange rates and to substantial negative international spillovers. They stand ready to cooperate with each other as appropriate to prevent such disequilibria from destabilizing the global economy”.

[rajakorman]

Tired of NIRP? Try Intervention.

Right now, there are two dominant concerns about the international economy that are closely intertwined

The first is the worry that developed market monetary policy is played out, with several major developed market central banks operating benchmark rates at or below the zero lower bound, which in turn has contributed to worries about the health of the banking system under negative interest rate regimes or even with extremely flat yield curves.  My sense is that some of these worries might be overstated as negative rates have existed for a while in Sweden, but the impact on bank equity there is a relatively recent phenomenon.  Nevertheless these worries exist, and can become self-reinforcing, particularly in Europe, where the feedback loops linking bank debt/equity prices, risk aversion among banks, an impaired credit channel, lower economic growth and rising NPLs can be particularly nasty given the absence of fiscal headroom in some countries. The market's worry seems to be that we have reached a particular point in competitive monetary easing among the major DM  central banks where returns are not only diminishing but might even be negative.

At the same time, there is also a worry that under current circumstances, even as DM central banks engage in competitive monetary easing, the benefits of this are not filtering through in a sustained way to EM. Indeed, the concern in EM is that many CBs might find themselves unable to engage in sufficient monetary easing precisely because the scale of monetary expansion required to restore growth and/or financial stability would weaken their currencies to the point that it might create a financial crisis either at home or abroad. For some emerging markets, the concerns focus on foreign currency debt  that will lead to a tightening of financial conditions; in others  the worry is high inflation passthroughs from exchange rate weakness that limit the ability to cut rates. In the case of China, the biggest and most important EM of all, the worry is more inchoate, with worries that the operation of the trilemma will lead to runaway Renminbi depreciation resulting from capital flight (a term that in the Chinese case includes many flows that in DM would be regarded as portfolio diversification, tax arbitrage or simple asset-liability management). Even among relative optimists who concede that the size of the tradeable sector and the liablity structure of Chinese debt mean that the  weak Renminbi doesn't hurt China, the concern is that Renminbi weakness can or will spill over into other markets that might be more vulnerable.

In sum, the worries can be captured by the dichotomy that in DM—monetary easing is believed to be ineffective; while in EM it is believed to be impossible.

I'm not convinced of either of the above, but to the extent that markets believe either one or both of these things, the answer is obvious to me. The way to make monetary easing effective in DM and possible in EM is for DM to focus its monetary easing efforts not on interest rates, but on exchange rates directly. In other words, instead of using negative interest rates to try to get the exchange rate channel to work (the channel that partisans of NIRP believe to be most effective anyway), resort to directly to unsterilized foreign exchange intervention to weaken DM currencies against EM currencies, specifically the Renminbi, which has become the anchor EM currency. Such a move would represent a happy congruence of interests—it would ease DM monetary policies via CB balance sheet expansion, only such expansion would be focused on the acquisition of foreign assets, rather than domestic assets (at a point when people looking at 10 year Treasuries, Bunds or JGBs are questioning the value of such expansion).  At the same time it would alleviate worries stemming from the market's focus on China's monthly reserve drawdowns as participants (mistakenly in my view) gauge the pace of PboC foreign asset drawdown as being more problematic for Chinese financial stability than the pace of PboC domestic asset expansion.  The dollars that Chinese banks and corporations are buying wouldn't come from the PboC; they would come from the Fed (same applies to Yen from the BoJ and Euros from the ECB). As I've said before, the excuse to do so is pretty straightforward—the inclusion of the Renminbi in the SDR basket can serve as justification for its inclusion in G7 reserve portfolios and such an excuse would also salve Chinese dignity.  And insofar as it represents intervention by the US and other DMs to strengthen the renminbi rather than Chinese intervention to weaken it (or prevent such strengthening) it can also be spun positively before Congress.

The impact of such moves on market confidence would be profound, in my view, precisely because this would help negate the narratives of inefficacy and uncoordinated policies that animate much of the sentiment in the market these days.  Someday, maybe we can even get DM fiscal policy to help out, but in the meantime, this seems to me like a pretty good place to start.

[rajakorman]

Two ages of globalization, Trump and Fitzgerald

This post follows on a recent poll I held on whether the Pax Americana since 1945 was a net subsidy from or to the US. For what it's worth, the poll (with 76 respondents) came out 55% -45% in favor of the idea that the Pax Americana was a US subsidy to the rest of world. This is my view as well, and I'm surprised it was as close as it was. About 18 hours into the poll, I actually realized that a more interesting (and in my view, truer) formulation might have been that the Pax Americana (at least since 1990) is a subsidy from the US working class to global capital and to the labor aristocracy in the emerging markets (I'm using labor aristocracy loosely, but here's a useful link http://richardjohnbr.blogspot.com/2011/06/what-was-aristocracy-of-labour.html ). This view obviously reflects Branko Milanovic's great work on the narrowing of cross-national (specifically DM vs. China) inequality, alongside the rise in within-DM inequality.

  One of the many fascinating things about Milanovic's work is that it suggests a huge contrast between two ages of globalization that are frequently compared with each other—the first, between 1870-1914, and the second, between 1990-2015.  

 Although the first period, before the Great War, saw an increase in within-country inequality within the developed world, it also saw huge improvements in living standards for developed world (DM—to stay with the financial world’s conventions) working classes alongside an increase in the divergence between mass living standards in the DM and in their colonial empires on the other (EM for shorthand, though the term is obviously anachronistic). I'm going to chicken out of the debate on whether levels of colonial immiseration actually increased in absolute terms in this period (or just relative to DM), focusing instead on just what was happening in W. Europe, where the evidence on real improvements seems more clearcut (and which was also arguably the bigger driver of the global divergence). But the real point of this is political--this improvement in mass living standards (notwithstanding widening inequality) contributed to the sense of a national identity that existed alongside the rise of class identity that grew with industrialization. These material phenomena together help to explain developments such as the rise of revisionist socialism, tacit working class support for empire and above all, the so-called puzzle of August 1914, when socialist parties across Europe supported their national governments at the start of war. 

 Contrast these material and economic developments in that first age of globalization with material and economic developments in the second age of globalization that we are living through right now.  In this phase of globalization, pace Milanovic, inequality within DM has begun to widen even as there begun a convergence of East Asian and DM working class living standards. The gains of globalization are accruing to working classes in EM (China above all) rather than to the working class in the developed world. China now looks like Western Europe/US in the Belle Epoque/Gilded Age in that we are seeing a rise in inequality, but in the context of a rise in living standards as well.

 By analogy with the European experience, it seems plausible that China experiences not just social stresses, but also a surprising (to skeptical observers) rise in systemic resilience, as was the case in August 1914 in Europe. Conversely, even as elite/working class fortunes become more closely tied in the case of China or other “successful” EMs, Milanovic’s work suggests that they becoming more divergent in the case of the DMs. If so, the problems of interest group aggregation at a national level in DMs become much more problematic  now as they rely on party structures and a legacy of of elite-working class linkages that were forged during the dawn of DM mass politics in happier economic times, first in the run-up to 1914 and in a modified form between 1945-73. To make a point that's been made before, it is this disjunction between elite and mass interests within single Western countries  that brings us the Tea Party  and other attempts to “emigrate in time rather than space” to use Ryszard Kapuscinski's wonderful phrase.

 I'm jumping all over the place here, but a related area of inquiry is to what extent the contours of this age of globalization follow from the necessary compromises made to keep Western democratic capitalism sustainable (I.e., both relatively democratic and relatively capitalist) after 1945. Did the development of the DM capitalist welfare state put sufficient pressure on profitability that capacity expansion overseas (in the EM) became essential to maintain profitability? That is the essence of the Robert Brenner argument here. http://www.sscnet.ucla.edu/issr/cstch/papers/BrennerCrisisTodayOctober2009.pdf

But the destination of DM capital exports now is also an interesting contrast with the first age of globalization. Many EM states are stronger than their pre-colonial counterparts, and judging from the FDI statistics, capital-export driven capacity expansion has been the most intense in the strongest states. --China now, as compared to the China of the Boxer Rebellion era, e.g. This is likely because capital in our era has gravitated to strong states with an indigenous “steel frame” (the phrase used to describe the Indian Civil Service of the Raj) of bureaucratic and technocratic governance, precisely because it was unthinkable to return to direct colonial experiments that provided such governance.. But the strength of such a steel frame would necessarily reflect grounding in the local polity and local legitimacy that was far stronger than what a comprador bourgeoise would have enjoyed. And such legitimacy would be greatest precisely in countries that  are enjoying a period of economic development that looks like Europe in the Belle Epoque. 

If I’m right, the argument is that this age of globalization could do for national cohesion and identity across class lines in successful EM ( China, above all) precisely what the last period of globalization that ended in 1914 did for national cohesion in Western Europe and the US.  The obverse is that the economic consequences of this age of globailization contribute to an unwinding of national cohesion in DM, precisely because the beneficiaries of globalization (all of finance Twitter, most of my TL, bicoastal white collar Americans --or the European equivalent-- engaged in symbolic manipulation) have more shared economic interests with c. 400 million people in China or India than they do with a majority of their own conationals. 

For those who've followed thus far—the reward is one of the most beautiful passages I've ever read—it comes from Chapter 13 of F. Scott Fitzgerald's Tender is the Night.

“See that little stream — we could walk to it in two minutes. It took the British a month to walk to it — a whole empire walking very slowly, dying in front and pushing forward behind. And another empire walked very slowly backward a few inches a day, leaving the dead like a million bloody rugs. No Europeans will ever do that again in this generation.”

“Why, they’ve only just quit over in Turkey,” said Abe. “And in Morocco —”

“That’s different. This western-front business couldn’t be done again, not for a long time. The young men think they could do it but they couldn’t. They could fight the first Marne again but not this. This took religion and years of plenty and tremendous sureties and the exact relation that existed between the classes. The Russians and Italians weren’t any good on this front. You had to have a whole-souled sentimental equipment going back further than you could remember. You had to remember Christmas, and postcards of the Crown Prince and his fiancée, and little cafés in Valence and beer gardens in Unter den Linden and weddings at the mairie, and going to the Derby, and your grandfather’s whiskers.”

“General Grant invented this kind of battle at Petersburg in sixty- five.”

“No, he didn’t — he just invented mass butchery. This kind of battle was invented by Lewis Carroll and Jules Verne and whoever wrote Undine, and country deacons bowling and marraines in Marseilles and girls seduced in the back lanes of Wurtemburg and Westphalia. Why, this was a love battle — there was a century of middle-class love spent here. This was the last love battle.”

To me, this is an extraordinarily evocative distillation of the social and economic forces that made Europe in that period (and the forces that may be at work in other parts of the world right now).This was the passage that got me about 90% of the way through a Ph.D in European history, and the first paper I wrote in graduate school was about the peacetime experience of conscription of German Social Democrats in the Empire.  But the reason I mention it here is also because of the peculiarly American twist that Fitzgerald brings to it—he refers to a “century of middle-class love.” Of course, he was unable to bring himself to say  “working class.”

Have a great holiday and all the best for 2016.

[rajakorman]

Man is evil but Americans are good: Reconciling US domestic and foreign policy philosophies

This post falls in the category of a) things that are so obvious that someone must have written about it, only I haven't come across it and I don't know the literature b) so interesting/provocative that if noone has done it , I better get it out there. If it's a) let me know—I'd like to find out.

Anyway, people who've been reading my blog or following me on Twitter probably know that I'm quite perplexed by what I see as one persistent tendency in American politics/ideology. This the coexistence (in the same people's heads) of the idea that American domestic public policy should be run on the basis of dog-eat-dog winner-take-all competition, alongside the idea that American foreign policy should be run on the basis of idealistic altruism. 

I've dealt with this schematically here (the US policy quadrant) https://twitter.com/RajaKorman/status/389132368914550784 and in my blogpost here http://rajakorman.tumblr.com/post/84927622370/the-chicago-school-and-foreign-policy-story-of-a which expresses wonderment that the Chicago school's vision of Homo Oeconomicus, applied as a critique of US domestic public policy in the Great Society years was never applied to American foreign policy.

Anyway, what all of this perplexity comes down to is my difficulty in reconciling the dominant ideology of our domestic political economy—that Men are selfish--with the dominant ideology of our foreign policy—that Americans are good. In thinking more about this, I went back to one of the founding documents of American political philosophy—the Federalist Papers, especially Federalist 51 (by either Hamilton or Madison). The document sets out America's political architecture as a response to a problem rooted inherently in human nature.

“Ambition must be made to counteract ambition. The interest of the man must be connected with the constitutional rights of the place. It may be a reflection on human nature, that such devices should be necessary to control the abuses of government. But what is government itself, but the greatest of all reflections on human nature? If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary...... This policy of supplying, by opposite and rival interests, the defect of better motives, might be traced through the whole system of human affairs, private as well as public.”

If this were a doctrine applied to foreign policy, it would read like Metternich or Castlereagh as a theory of the balance of powers. And indeed the entire intellectual (and practical) architecture of American domestic politics is based on the idea that self-interest is such a dominant force that it can only be curtailed by harnessing and dissipating it, rather than concentrating it in the hands of an overweening sovereign. Why then does this mistrust of human nature and the associated fear of such a sovereign have such a limited echo in a foreign policy predicated on the idea that an all-powerful America can be a force for global good? There are, of course,  two towering thinkers and practitioners who have taken a more “Federalist 51″ view of foreign policy--Kissinger and Kennan--but it is in large part such a skeptical view of human nature that accounts for the combination of admiration and mistrust with which they continue to be viewed across the political spectrum. 

The simplest answer (which might well make it the right answer) is hypocrisy. But that's not the most interesting answer, not to mention that the depth and breadth of conviction about America’s exceptionalism as a benevolent global power suggests that the contradiction described above reflects  mass delusion rather than hypocrisy. 

Insofar as the vision of human nature embodied in Federalist 51 owes to Calvin, the answer I propose (which I think of as more interesting) is grounded in Max Weber's thesis on the transformation of Calvinist theology into the Protestant ethic. At the heart of Weber’s Protestant Ethic is the idea that the existential anxiety inherent in the idea of inherently fallen human nature predestined for damnation was resolved by the conviction (and the spur) that worldly success was a sign of Grace and redemption from the Fall. 

Transposed to the arena of foreign policy, I wonder if it is possible that Americans treat both the country's success and the seeming perfection of its political institutions (tAmericans view the Constitution as a document of Cartesian excellence) as a sign of redemption or election. Assured, thus of the Grace that informs our intentions, we find it possible to embark on foreign crusades even as our ideology of fallen nature makes us suspicious of domestic ones. It is this transference that makes it possible for us to reconcile a domestic public policy based on irredeemable nature, with a foreign policy that sees ourselves as a force for global redemption. 

I like think I've resolved something (elegantly, I hope) to my own satisfaction here.  Apologies are, of course, due to scholars in several fields--Protestant theology, Weberian sociology, and the histories of American political thought and American foreign policy, to name just the most obvious ones, for all the errors in here. That said, any blogpost that allows me to cherrypick the three thinkers I venerate most (on largely superficial acquaintance) --Hume, Hamilton and Weber-- to explore a minor hobbyhorse is a trifecta for me. 

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[rajakorman]

Not that anyone asked me, but here’s what I would say if I were the Fed

Not that anyone asked me, but here's what I would say in September if I were the Fed. I also think such an outcome (essentially, a one and done for a while, or a hovercraft liftoff) would be better for most markets than a hold that then leaves people guessing about when liftoff actually occurs, rather than shifting their attention to the pace and altitude of rate hikes in this cycle.

The Federal Reserve has decided to raise the target interest rate from a range of 0-25 bps to 25-50 bps.

This measure recognizes the significant recovery in the US economy and its emergence from the Global Financial Crisis that began in 2008

This rate increase follows other elements of the normalization of the Federal Reserve's monetary posture, including the end of Large Scale Asset Purchases

The Federal Reserve is increasingly confident that it is on track towards reaching its mandate of full employment, but considerable uncertainties remain as to when it will reach its inflation mandate, operationally defined as an long-term annual rate of PCE inflation close to and averaging 2.0%.  The Federal Reserve is also uncertain that attainment of its full employment target will necessarily lead to the the attainment of its inflation target, with the potential for very significant lags between attainment of the employment target and attainment of the inflation target.

These uncertainties stem from the interaction of international and financial developments as well as dynamics within US labor markets, which, together suggest that the 2.0% inflation target will be achieved later than previously believed, and may, over the two-year horizon, be subject to downside risks.

Internationally, the presence of large amounts of global slack in tradeable goods markets owing to the interaction of a slow speed of recovery in Europe;  a massive supply-side response in global commodities markets; a slowing China; and recessionary conditions in other significant portions of the emerging markets will exercise a disinflationary or deflationary impact on the tradeable goods sector in the US. Such disinflationary pressures in the US tradeable goods sector will not only exert downward pressures on measures of aggregate inflation but will also likely serve to moderate wage demands in those segments of the US economy that are currently experiencing a tightening of labor markets.

Among the supply-side responses in global commodity markets, the most critical from the point of the US employment and inflation outlook is the development of unconventional shale oil production in the US. This development has led to a substantial decrease in US trade and current account deficits, with the effect that for any given level of consumption growth in the US, the US has a lower external financing requirement than it would have had in prior economic cycles over the last four decades. In a context of asynchronous global recovery, this will increase appreciation pressures on the US dollar on a broad trade-weighted basis.

A stronger dollar will tighten monetary conditions for the US economy with each 10% appreciation of the US dollar having a growth and inflation impact that is roughly commensurate to a 1% increase in the Fed Funds rate. On this basis, the appreciation of the real broad trade-weighted dollar over the last year has already had tightening impact roughly equivalent to a 100 bps rise in the Fed Funds rate.

Estimations of the impact of the dollar's rise on US growth are complicated to a considerable extent by the international role of the dollar. While most G10 countries experience domestic currency weakness and dollar strength as an unequivocal easing of financial conditions, there are portions of the emerging markets universe where foreign exchange asset-liability mismatches (particularly in the corporate sector) can mean the negative financial effects of dollar strength outweigh the positive impact on net exports. While the Federal Reserve will continue to make policy solely on the basis of its domestic mandates for inflation and employment, it recognizes additional downside risks to the US growth and inflation outlook that may stem from the impact of dollar strength on global growth.

Beyond the financial tightening that may proceed from the appreciation of the dollar exchange rate, and the associated trade and financial consequences in the US and in the rest of the world, additional tightening may be felt as securities acquired during the program of Large Scale Asset Purchases mature over the course of 2016 and 2017. Accordingly, the Federal Reserve is conscious of the potential for a tightening of financial conditions that proceeds from factors independent of movements in the Fed Funds rate.

Given the considerable progress in the US economy since December 2008, the Federal Reserve believes that a further step towards the normalization of monetary policy as embodied by a rise in the Fed Funds rate from the zero-lower-nominal bound is warranted. At the same time, the Federal Reserve believes that the risks of undue haste in further removal of monetary accommodation via the Fed Funds rate significantly exceed any inflationary risks that may stem from a more judicious pace of rate hikes that is cognizant of domestic, international and financial developments.

[rajakorman]

On spillovers and the case against giving in to trilemmas

As regular readers know, I ‘ve been thinking for some time that there are good reasons to favor some  restrictions on capital account convertibility. I’ve expressed these views here in bullet points, http://rajakorman.tumblr.com/post/102531405985/niip-sustainability-and-the-case-for-capital, and in longer form here http://rajakorman.tumblr.com/post/84527845240/on-spillovers-exchange-rates-and-monetary. I’ve dealt with these issues primarily from the point of view of the domestic economy (especially in the first, shorter post), but now, I’ve also gotten to thinking about this from the point of the international economy and wider spillovers, particularly when it comes to China and the potential ill-effects of demanding full capital account convertibility from China at this particular point in the local and international cycle.  This post also picks up on some of the excellent arguments made by @Hcmacro here https://ello.co/horatius_cocles/post/xOnNchXW8jZuR1k59_NmDw.

 So here goes.  China seems to be in a place where it has been before, particularly during the Asian crisis of 1997-98. You have an economy in which considerations of external balance (the current account and the NIIP) do not make a strong case for significant exchange rate weakness. However, considerations of internal balance, specifically, the prevalence of acute disinflationary/deflationary pressures (slowing NGDP grpwth in an economy that has recently taken on a lot of debt) suggest a strong need for monetary easing via the interest rate channel.  Meanwhile, it is possible that the financial effects of exchange rate weakness could actually tighten conditions for some portions of the economy--$ indebted borrowers, and expose the liability side of some portions of the shadow banking system susceptible to outflows of hot money. Of course, as the theory of the trilemma states, a country cannot simultaneously control both its interest rate and its exchange rate as long as it has full capital account convertibility. Now, China does not have a completely open capital account, but since a) the capital account is porous and b) China has stated that it will be opening the capital account further in coming years, it does become more exposed to the trilemma.

 As a result, there is now a pretty widespread consensus that RMB will face depreciation pressure stemming from the need for lower interest rates, but opinions are divided as to the extent to which those pressures will be accommodated or fought (via reserve decumulation and/or administrative suasion) by the PBoC.  My question here is somewhat different, however. It is the question of whether or not the world is actually well-served by having a country with an immense tradeable sector, a current account surplus and a large positive NIIP be forced into nominal exchange rate depreciation when what it really needs are just lower interest rates, credit easing to clear up gummed up transmission channels, and possibly some targeted fiscal expansion. In this sense, China is arguably like Sweden on supersteroids (where I’ve been criticizing the spillovers for the rest of the EU of the Swedish fiscal/monetary mix for a long time).

 I recognize that I’ve said before that it’s odd to think that China only exports deflation when it devalues its currency, when in fact, it has always been exporting deflation as long as it has experienced deflation in some portions of its tradeable goods sector (about 3 years and counting). But as I thought about, it struck me that the spillovers are likely different. If China is exporting deflation through real (but not nominal) exchange rate depreciation, it is possible that other competitor countries experience deflationary pressures too, but not necessarily depreciation pressures. The reason this distinction matters is because I think it is easier for national central banks to counter the financial stability effects of deflation (especially in cases of domestic currency indebtedness) than it is for them to control the financial stability effects of nominal depreciation in a context of foreign currency indebtedness.  Insofar as this latter worry seems to be a bigger concern afflicting some of the EM competitors of China, I think there is a case that the spillover effects of a Renminbi depreciation might be more deleterious than those of onshore Chinese deflation that is countered by the combination of monetary easing and credit easing.

 If I’m right about this, this then strengthens the case I’ve already made (or I like to think I’ve made) here, http://rajakorman.tumblr.com/post/102531405985/niip-sustainability-and-the-case-for-capital, on why it is entirely rational for countries to wish to control the exchange rate and interest rate legs of monetary conditions separately.  In that post, I went over the reasons from the point of view of domestic sustainability. Here, I’m making the case that such control of exchange rate and interest rate legs also makes sense from the point of view of international spillovers. Both in cases, the conclusion is the same---it makes sense to enhance the ability of countries to do precisely that and move away from a doctrinaire insistence on full capital account convertibility. In the Chinese case, there is one very practical implication—it suggests that the US should NOT insist on full capital account convertibility as a precondition for RMB entry into the SDR. Of course, as I tweeted before, merely such an admission might get the US what it wants—a somewhat more open Chinese capital account and less (net) depreciation pressure on the RMB from that capital account.

[rajakorman]

The Fed never talks about the Dollar and other nonsensical pieties

When I first got into FX in 1997, one of the first things I learned was “The Fed never talks about the Dollar; only theTreasury talks about the Dollar.” I absorbed this piece of wisdom and parroted it, and remarked on the rare occasions when this rule was breached (usually by Ben Bernanke in a speech, but as far as I can recall, never in an FOMC statement). Over the last couple of days, since the Fed press conference, I've been thinking more about this rule and I've come to the following conclusions below, but most importantly, this rule makes no sense at all

I'm not sure but this division of “verbal labor” probably originated during Bretton Woods 1, when exchange rates were fixed, capital accounts were relatively closed and re- or devaluations were discussed in a transatlantic + Japan version of Eurogroup all-nighters. (Incidentally, Paul Volcker and Toyoo Gyohten's book Changing Fortunes is great on this).

In an era of floating exchange rates and open capital accounts, this rule makes a lot less sense. Capital is mobile and exchange rates respond to interest rate differentials (and expectations of changes in rate differentials) more than to just about anything else. Yes, I know FX prediction is far from perfect, but there's a reason people pay up for overnight vol ahead of central bank meetings or unemployment days.

Most modern central banks do not have exchange rate targets in their mandate; instead they have inflation targets and in the case of the Fed, an employment target as well. The exchange rate is an important variable that determines the ability of a central bank to reach one (or both) targets in its mandate. The exchange rate is not a target, but it is a tool, which can make it an intermediate “target,” in much the same way that loan spreads are, for example. Yet noone has ever said to me, “the Fed never talks about loans spreads, only the Comptoller of the Currency and the FDIC do.”

The importance of the exchange rate as tool or “intermediate target” (and I'm going to use them as synonyms) will depend on how large the external sector of any given economy is, but it has some degree of importance everywhere. This includes the US, for all of the protestations that the US is a largely closed economy (which is true, but probably less true than many think—more below). Indeed, things may have changed, but among Investment Banks that have financial conditions indices for the US, the exchange rate is typically in the top three variables. Ask your sell-side coverage to tell you about the weight of the Dollar in their proprietary FCIs.

In any economy that has a tradeable sector (which I think of is comprising not just its export sector but also its import substitutable sector), the exchange rate will play a part in determining growth conditions, employment conditions and consequently, the inflation outlook. The currency composition of assets and liabilities (and flows stemming therefrom) will play a role in determining asset valuations, leading to wealth effects. Both these facts are true of the US. The exchange rate may matter less in the US than in Canada, but it will  nonetheless matter.

It is also probably the case that what we think about as tradeable encompasses a larger group of things than before. The girding of the globe by cheap fiber-optic cable in the early 2000s has made some portion of hitherto nontradeable services tradeable—accountancy, legal services, back office sectors of financial intermediation, medical diagnostics, design, programming, animation (take a look at the credits of Nick Jr. cartoons next time you're watching).

Under these circumstances, what matters is not just national slack but global slack in tradeables because that will moderate (or exacerbate) the extent to which national slack impinges on inflationary pressures.

Accordingly, I would argue that NAIRU is not a static thing, but it can move around. It moves around in response to domestic variables such as the participation rate, but also should move around in response to the size of the tradeable sector (exports and import substitutables as laid out above); the amount of global slack; and critically, the exchange rate—which will determine the extent to which (and the price at which) a country can import from or add to global slack.

One interesting thing in the newest dots on a chart (our secular equivalent of heads on a pin) is the 2017 dots show the unemployment rate at or below NAIRU, but show Fed Funds below the long run equilibrium Fed Funds rate. This might be because the Fed expects downward pressure on prices as U6 continuing to drop, but could also reflect some ability to import disinflation from the level of global slack.  Interestingly, a move to push the Fed to a single inflation mandate under these circumstances (if I'm right) could lead to policy being looser than it would be under a national full employment mandate.

Anyway, the big point in all this is the Fed should, in my view, be talking about the Dollar a lot more. It should not be a shock when it does, but rather a normal practice. For an institution that prides itself on transparency, the least transparent thing about it is its view on the interaction between the exchange rate and domestic growth and inflation conditions. That's just ridiculous and needs to change.

[rajakorman]

When should carry trades work?

Following on the Matt Klein, Paul Krugman thing on currencies and forwards, thought I could formalize some circumstances in which carry trades SHOULD work due to macroeconomic fundamentals, and not just momentum, etc. I suspect this is not new, but still might be useful . Basically, I think there are at least four separate sets of circumstances in which high rate currencies should justifiably outperform their forwards (other things being equal).

  a) If a country is undergoing significant improvements in tradeable sector productivity and the call on resources closes the output gap, interest rates will go up, but the improvement in tradeable sector productivity will lead to a rise in the equilibrium exchange rate. In such an instance, the currency will not depreciate as much as priced into the forward. This might well require governmental action to ensure that foreign capital inflows encouraged by the higher interest rates are directed to the tradable sector. See http://rajakorman.tumblr.com/post/102531405985/niip-sustainability-and-the-case-for-capital 

b) If a country has just undergone or is currently undergoing a recent transition to inflation-targeting and central bank independence, it is likely that term premia will remain high in the yield curve. As time goes on, and central bank independence is established, gains in central banking credibility will erode the term premium, allowing the currency to outperform the forward price that reflected such high term premia.

  c) Somewhat akin to a) in terms of the effects on the equilibrium exchange rate, a long-lasting shift in global terms of trade is also likely to allow a country's exchange rate to outperform its forward. However, unlike a) this will reverse as the terms of trade shock reverses. 

  d) A fiscal devaluation that leaves the aggregate fiscal stance (and consequently monetary policy) unchanged but changes the effective exchange rate for the tradeable versus the non-tradeable sector will also allow  a currency to outperform its forward.

  I think one result of this is that a) and b) are particularly likely to apply to EM currencies rather than G10 currencies, precisely because EM is more likely to be in a phase of both institutional and productivity catchup.  So I'm not sure of the literature on this, but I strongly suspect EM carry will outperform G10 carry, since structural shifts in equilibrium exchange rates are less common inside a group of countries at a similar level of development. 

[rajakorman]

10 things more useful than ECB sovereign QE that QE won't accomplish

1.Coordinated fiscal expansion across the Eurozone.

2. Wage rises in Germany that allow incomes to catchup to past German labor productivity gains.

3. Ensure that in the event of a fall in the Euro, peripheral (especially Italian) imported inflation rises more slowly than German imported inflation.

4. Lead to a sufficient compression of spreads between SME lending and single country sovereign bond yields in the periphery.

5. Denationalize bank lending in the Eurozone, breaking a vicious circle that connects asymmetric shocks, credit supply and credit demand in the periphery.

6. Lead to SME consolidation and increased firm size, especially in Italy, where enterprises are trapped in another vicious circle of small size, low investment and loss of market share.

7. Curtail the power of small professional groups (lawyers e.g) who constitute major structural bottlenecks to higher trend growth. 

8. Turn around either the Chinese investment cycle or sanctions on Russia that drag on Eurozone capital goods exports.

9. Improve educational levels in Portugal.

10,Improve tax collection in Greece.

Etc, etc., etc. .

Bottom line, sovereign QE in the absence of fiscal expansion, removal of impairments in the credit channel, structural reforms to raise trend growth and, critically, different levels of intra-EZ vulnerability to fx-induced imported inflation is just not going to have that much of an effect. 

I

[rajakorman]

NIIP Sustainability and the Case for Capital Controls

I've said a lot of this before in a more long-winded way elsewhere on this blog but tried to tighten it up. Presumably, this is all obvious, but still.... 

1. Macroeconomic sustainability can be gauged by the current level of inflation and the current level of current account balance and Net International Investment Position (NIIP).  This is because domestic constraints on supply that might be inflationary can be eased by imports that widen current account deficits.

2. Over the course of a business cycle it is important to maintain NIIP at a sustainable level rather than permit a trend increase or decrease in NIIP.

3. This means getting the balance of tradeable vs. non-tradeable investment right over the cycle.

4. This in turn means that for purposes of targeting both axes of sustainability (inflation and NIIP), central banks need control of both short term interest rates and the exchange rate.

5. The reason for central bank control of the exchange rate is behavioral--an episode of exchange rate appreciation driven by a cyclically appropriate interest rate rise is more likely to lead to nontradeable rather than tradeable investments as agents typically do not assume that the future path of exchange rate will follow the depreciation embedded in the forward curve.

6. An excess of non-tradeable investment during a period of currency appreciation and widening current account deficits reduces the economy's ability to benefit from subsequent exchange rate depreciation, and consequently fails to smooth the NIIP over the cycle.

 7. This suggests that NIIP sustainability requires that a central bank be able to control both components of domestic monetary conditions--interest rates and the exchange rate.

8. Since the "trilemma" postulate holds that a country can control either the exchange rate or short-term interest rates with a completely open capital account, this suggests that some kind of capital controls might be necessary for a central bank to target broad macroeconomic sustainability.  

9. Two forms of capital controls that might be particularly helpful are: a) forcing foreign investment in countries with large negative NIIPs exclusively into the tradeable sector (thus helping the cause of current account smoothing or NIIP sustainability described above or b) forcing foreign investment to take the form of equity rather than debt, so that even if misdirected, it is lower in the capital structure and associated liabilities (dividends) depend on the business cycle of the recipient of capital inflows rather than on the business cycle of the source of the inflow.

10. Although it is undoubtedly true that capital controls distort investment allocation questions, the real question is whether capital controls are more or less distortionary than unrestricted cross-border flows. The above argument (and recent experience) suggests there are sound reasons to believe that intelligently-framed capital controls are more supportive of macreconomic sustainability than completely open capital accounts.  

[rajakorman]

Can we please have a proper capitalist theory of the state?

Over the course of several recent online and real-life interactions (about Ex-Im Bank e.g.), I've come to the conclusion that markets people have a real problem with the concept of the state. This, of course, takes its most extreme form among libertarians in the US, who would like to see the state wither away but still retain its essential (for them) functions of granting, adjudicating and enforcing property rights both at home and abroad. This “minimal” state is expected (by them) to protect not just real property, but also financial and intellectual property and is expected to do so around the world, through the exercise of extraordinary extra-territorial powers.

A corollary of that view is that interventions by the state in the areas set out above are lauded by libertarians as being consonant with a general, rather than a (or, indeed, their) particular interest. However, economic interventions of other types are routinely condemned as crony capitalism reflecting the capture of the state by vested interests. I have many beefs with the kind of libertarianism portrayed above, but in this post, I'm more concerned with the sweeping generalizations that see all forms of state intervention as nothing other state capture.

In these generalizations, I see something reminiscent of Second International Marxist view that “The executive of the modern state is nothing but a committee for managing the common affairs of the whole bourgeoisie,” to quote the Communist Manifesto. Even this formulation has at least the virtue of treating the bourgeoisie as a unit, rather than the vulgar anti-Marxist (or ideological libertarian capitalist) formulation that sees state intervention as representing nothing more than the interests of particularly well-connected factions of the bourgeoisie. The interesting thing is that already with Bernstein's revisionism of the 1890s, and especially in the post-1945 period, Marxism actually managed to develop a theory of the relative autonomy of the state from dominant social classes that treated the state with more respect than the classic formulation (which dates back to 1848).

These theories of state autonomy recognize several interdependent factors that are conducive to the relative independence of the state's bureaucratic/technocratic apparatus from the dominant classes of society. First of all, even Marxists who are convinced that capitalist states are essentially capitalist (I know that's a tautology) recognize that measures to stabilize capitalism as a system (e.g., unemployment insurance, welfare, central banking and its lender of last resort function) can be (and were) against the preference of single capitalists or even all of them. Secondly, those who have a slightly Weberian bent acknowledge the role of an ideology (even if it represents “false consciousness”) of impartiality that animates state officials. Finally, and perhaps most importantly, in my view, they recognize the role of inter-state competition, whether peaceful or bellicose, as a factor that can lead the state apparatus to act in a fashion that maximizes its own survivability, power and prestige vis-a-vis other states even at the expense of otherwise dominant private interest groups.

Anyway, what I'm saying here is that the above paragraph actually represents a considerably more sophisticated (and realistic) view of the function and operation of the state than I usually hear or read among many market folk (this is why I own a “I hate Rick Santelli T-shirt”). I don't deny that crony capitalism exists and that extensive state intervention in the economy can further it, but to pretend that there's no difference between Suharto's Indonesia and Lee Kuan Yew's Singapore is just plain idiotic. I think that far more useful than identifying state intervention or decrying it, market practitioners would be much, much better served by identifying degrees of state capture versus state autonomy and then investigating the purposes that such state autonomy serves. There's money to be made in learning from the Marxists. 

[rajakorman]

France, Germany and the incommunicability of a shared project

I'm going to start this off with the story of something that I witnessed in the summer of 1988. I was a grad student at Columbia then, sitting at their outdoor cafe next to a group of French and German students who were at the university for a summer English language program. Now, from my own experience,one of the awkward things about these onsite foreign language programs is that the only language all students share is one that none of them speak well, which can lead to droll results. Anyway, these students were discussing what they were going to do over the weekend and this is what followed.

French student: I am going to take that boat, that boat Melanie Griffith took to her house in the film Working Girl (referring to the Staten Island Ferry).

Discussion of Working Girl and Melanie Griffith's career follows.

German student: I don't like her so much.I like that other woman, Signe Wiever.

Excited discussion of merits of Signe Wiever.

French student: Yes, she is fantastic—especially in that movie—Les Singes dans la Brouillard.

Another German student: What is that film?

French student: Les singes is monkeys. Brouillard is like a cloud, only it doesn't rain and it's on the earth.

German student jumping up and down excitedly—Nebel, Nebel, Nebel...

All the students reach for their dictionaries and shout out their answers pretty much at the same time.

MONKEYS IN THE FOG. MONKEYS IN THE FOG....

THE END.

You can just stop here, because the rest is mostly stuff I've said or implied before. I've trotted this story out over the years and I'm doing so once again, mostly because I can hang some polemical points about the EP elections, particularly the FN's results, on this story.

Some weeks ago, I said that one of the mysteries of 19th century European history (and one of my orals questions) was why France had such a turbulent political history during that period despite what by Western European standards was a relatively sedate trajectory in economics, demography and political geography. At the time, I also said that it seemed possible that despite a relatively “good” Eurozone crisis, France might experience a more turbulent political outcome. This does indeed seem to have been the case. Why is that?

I think one partial answer, at least in the current conjuncture, is both a fetishization and a misunderstanding of the notion of sovereignty in France. I would maintain that political culture and discourse in France (manifest most obviously in the FN, but which seems to be true across the political spectrum) overestimates both the extent to which it has ceded sovereignty within Europe AND the extent of sovereignty it would enjoy vis-as-vis markets were it outside the EZ. A decade before James Carville told Bill Clinton that he wanted to come back as the bond market, we had the Mitterand experiment of 1981-83, when the French left discovered the limits of sovereignty in the face of market pressure. Conversely, I think there is a one a strong case (which I've made here) http://rajakorman.tumblr.com/post/64120246373/why-emu-has-been-very-good-for-france

that what France gets from EMU membership is the presumption in markets that BECAUSE FRANCE IS TREATED BY GERMANY PART OF EMU'S GEOPOLITICAL CORE, IT NEED NOT BE TREATED BY MARKETS AS PART OF EMU'S ECONOMIC SEMI-CORE. Conversely, I think there is a very strong case that France (even more than other large sovereigns) tends to be treated with kid gloves by the Commission when it comes to handing out yellow cards and red cards on economic policy. More importantly, French policy preferences are accorded a level of respect by Germany that no other country benefits from. Even when France and Germany disagree, the results are hammered out a due, not in consultation with the Italians or the Spaniards or the Poles. It is this case about how much sovereignty (as construed by freedom of action) France has gained inside EMU that I think French elites have failed to communicate to their countrymen. They have in effect left them to be “monkeys in the fog.” (And now I have an excuse for that story).

[rajakorman]

The Chicago school and foreign policy--story of a silence?

While reading the obituaries of Gary Becker, I got to thinking about the “intellectual imperialism” of the Chicago enterprise, in the sense of trying to take a particular set of assumptions and a view of the world that arise in one field of study and applying it to areas outside that field. Now, I don't have a particular problem with this kind of intellectual ambition, even if I don't agree politically with many of the results that have stemmed from this way of thinking about the world. However, at this particular juncture, when the cover story of The Economist is entitled “What would America fight for?” it struck me that to the best of my knowledge, that formidable (if ultimately limited) intellectual apparatus was not applied by them to the question The Economist asks, i.e., to the domain of foreign policy.

I could be wrong about this, but I don't know that any of those practitioners at the University of Chicago School of Economics ever applied their assumptions/methods/judgments to what is not just a vast area of human intellectual endeavor, but also a very large component of the Federal Budget and results in an enormous exercise of governmental power. I may be completely ignorant about this, but I got to wondering why it is that we don't have a Chicago economic model that assumes or concludes (just to give a few examples) that a) all states act rationally in the pursuit of their interests b) that interstate activities should be governed by the principle that in the pursuit of said interests, some other states are assets, while others are liabilities c) that states can and should order these interests hierarchically (critical, desirable, expendable, e.g.) and expend resources in attaining them according to this rank order. d) that while there may be game-theoretic reasons for maintaining a credible posture in terms of military commitments (whether hot or cold), it also makes sense to consider these issues in accordance with the logic of sunken costs, etc, etc.

The assertions laid out above are what I would characterize broadly as the school of foreign policy “realism” and would also seem in accordance with the kind of behavior that the Chicago economists would consider optimal for both individuals and for corporations. There is a considerable political science literature on the subject, and arguments between realists and idealists are a staple of elite US foreign policy debate (unfortunately, this is not true of wider political discourse, where there seems to be a real lack of debate on defining and ordering American interests). Nevertheless, I don't think there has actually been an actual intervention by Chicago economists on these specific questions, notwithstanding their very influential interest in remaking the American the legal and welfare systems. A (very cursory) search on the Chicago School or Becker and or Friedman AND foreign policy just brings up the famous stories of the remaking of the Chilean economy under Pinochet and not much else.

This then seems to be the story of a silence on a large, interesting, and important part of the activity of the US and specifically the US government, which was otherwise an intellectual and political preoccupation of the members of this school. If I am right about this, the question is why? The most obvious answer is that large and influential sections of the mainstream American right, both in government and outside it, occupy an intellectually incongruous position that prefers state abstention at home and intervention abroad. Was the Chicago economists' silence on foreign policy (or rather, a seeming reluctance to apply their chosen tools to an analysis of foreign policy) a way to gain backing for the furtherance of a domestic agenda that they supported? I don't know, but I'm guessing yes.