Category: Debt

Buying time for Italy

Buying time can be useful if you get something useful with it, otherwise it is a waste of time and money. Italy needs to borrow less domestically to finance its government’s expenditures (reduce its fiscal deficit) and to borrow less abroad to finance its imports in excess of its exports (reduce its trade deficit). The lower interest cost of the IMF and/or EU lending money to the governments of Italy and Spain at German sovereign debt interest rates can buy them time to enact and implement government spending cuts, tax increases, and market reforms that improve productivity and reduce labor costs before they need to borrow in the market at potentially much higher interest rates. Why might the IMF and the EU’s European Financial Stability Facility (EFSF) be willing to lend money at German rates when market investors aren’t? That is a good question without a clear answer, though most commentators seem to assume it without much question.

The pay off from the measures Italy needs to implement will take time to materialize. Liberalizing markets takes years to actually improve productivity and exports. Some domestic wage and price deflation will probably be needed as well. Reforms to the tax system take time to produce revenue. Above all it will be difficult for the Italian economy to grow (the essential ingredient of financial sustainability) while the rest of Europe, if not the world, is stagnating. In the interim, Italy’s deficits will remain above the levels expected to result from current reforms in the future (say two to four years down the line). If they cannot be financed at “reasonable” interest rates, Italy will be forced to default on its fiscal debt of about 2 trillion U.S. dollars (of which about $500 billion falls due and needs to be refinanced in 2012). The impact on the banks, pension funds, and others that hold this debt would be devastating beyond our experience.

Thus IMF et al financing can be useful if a) Italy actually enacts and implements now the reforms needed to become viable in the future, and b) if the IMF is more confident that Italy will achieve the desired outcome than are market lenders. Without condition “a”, buying time is a waste of time because Italy would default anyway only somewhat later after running up even more debt. With regard to “b”, it may be that the IMF is better able to assess and enforce Italy’s reforms than the market (the IMF reviews progress every quarter against agreed performance criteria before authorizing the next quarterly tranche of its loan), but it is not obvious that this is so. Market lenders can see any reforms actually undertaken and the result almost as easily as the IMF can. If these measures are credible and convincing, market lenders will reduce their risk premiums for lending to Italy. If so, no funds from the IMF would be needed.

On the other hand, lenders may have become risk averse in the conditions now existing in Europe and the U.S. and world economy. If so, they will demand an interest rate to lend to Italy that is more than the premium needed to cover the expected loss from default. In these conditions IMF/EU financing could make the difference between success or failure. Undermining confidence in the ECB and the purchasing power of the Euro would be bad under all scenarios. While more rapid growth in the supply of Euros as the result of ECB purchases of Italian and Spanish debt might not be expected to be inflationary in today’s depressed economies, the effect on Euro interest rates will depend heavily on public confidence in the ECB’s anti-inflation commitment (i.e. inflationary expectation. See my earlier note on the role of the ECB: https://wcoats.wordpress.com/2011/11/17/saving-italy-and-the-euro/).

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Comments:

Here are some interesting comments from friends on my earlier note on the use of the ECB to buy Italian debt.

Thanks Warren, it is hard to be optimistic that the politicians and technocrats of Europe will stumble on the only thing that will work.

Thought experiments: why do we never see calls for “break up of the $ zone” such as when Puerto Rico got into fiscal troubles (see Stossel and Cal Thomas or recent reforms)?  Why don’t El Salvador, Ecuador and Caribbean Islands “leave the $ zone” so they can devalue to prosperity?  So far, we have a credible “no bailout policy” so even Harrisburg must go into bankruptcy.  In the US $ zone, counter-party risk is still important.

What if: instead of a “euro zone” we had seen 16 countries in the EU unilaterally adopt the DM?  The Frankfurt-managed currency would have appreciated sharply in recent years compared to the US $, much like the C$, Aus$, et. al.  The adopting countries would then have been in the position of Chile 1981.  When pegged to a weak US $ during the Carter years, Chile thought pegging was great.  Then, on the first Tuesday of November 1980 the US $ started to appreciate, and Chile found themselves holding the tail of a tiger until they rediscovered the virtues of floating.

If Italy and others are to stay on the “paper-gold standard” of Frankfurt, they will have to reduce real wages (& pensions etc.) the old fashioned way.  If that is too painful politically, and if Frankfurt refuses to abandon administration of “paper gold”, then Italy, et. al. must remain the Appalachia of the euro zone.

Why would Cameron want the ECB to monetize euro-zone debts?  Is it because more inflation in the euro zone as well as the US will take the pressure off the UK pound?

Jerry [Jordan, former President of the Federal Reserve Bank of Cleveland]

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Warren,

You make a very elegant and compelling case. But I’m not convinced that it will work. The likelihood of the ECB remaining politically independent is slight. And the only way Germany will be able to enforce the kind of austerity it’s promoting will be to invade and occupy these countries’ finance ministries (which has already begun, but without decisive popular support). Just as in the US, the people who need to bear the brunt of a recovery–the largest banks (in this case, the French banks which are the most exposed) and the bond markets–are the least likely to do it, and so hold a near monopoly on the recovery. At some point the people really bearing the brunt—the people least able to do it–may just give up: on the ECB, on the Euro, on the EU. Russia in the 1990s is a case in point. How many European Putins are there waiting in the wings? So long as the US and China and nearly every other power is dealing with this crisis publicly at the other end of a ten foot pole, I find your, and any other positive, outcome, very unlikely at the present moment. Sacred tenets of central banking aside, from where I sit this looks like little else besides beggar thy neighbor. On every level.

Ken [Weisbrode, in Boston]

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Hi Warren,

I don’t have the time these days to read your lengthy blog essays, alas, but I did want to make an admittedly superficial comment or two.  I really wish somebody would actually treat a sovereign borrower like an ordinary client some time.  These Greek demonstrations are disgusting. Your country doesn’t have money, and you’re insisting that it keep the generous welfare taps wide open.  Just where is the budget supposed to get the money to pay you to shut you up?  It would be wonderful if the Greek demonstrators were given what they want, the country would default in a few days, and then the banks would take over the bankrupt estate and liquidate it.  Not that banks are such wise and nice entities, but I just feel the Greek demonstrators deserve exactly this.  It’s the logical consequence of their irrational demands.

Next topic:  I’ve never understood the phrase (one that I have translated you saying many a time, I might add) that “of course, interest rates can’t go negative, so central banks are seriously constrained in their ability to loosen the money supply once the rates are down near zero already”.  Why can’t they go negative?  If the economy is so moribund that banks aren’t lending any more, only fuelling the moribundity further (not that you can fuel moribundity…), why can’t/shouldn’t the central bank loan money to the banks at negative interest in order to kick start lending and economic activity in general?  It’s Keynesian deficit spending by other means – monetary instead of fiscal.

Just having a rare moment of economic musing, sorry to bother you with my infantile thoughts.  Hope all is well with you, and that you have a good Thanksgiving.  Nailya and I will be passing through DC in the next month or so, but literally passing.  If plans change and we end up staying a little while, I’ll let you know and perhaps we can get together for a bit of socializing.  Nailya’s gotten quite interested in economic and political affairs (she never had been in Russia, because there’s no point in getting excited about something that gets arbitrarily decided by the corrupt suits in the Kremlin without regard for anybody else), so I know she’d make a lively conversationalist.

Steve [Lang, former personal Russian/English translator for Mikhail Khodorkovsky after being the same for me and the IMF]

Thinking about the Public Debt

The U.S. Federal Government spent $1.7 trillion dollars last year more than its tax revenue. It had to borrow that amount. This increased the outstanding public debt of the Federal government to 14.2 trillion dollars or 96 percent of GDP. This includes that part owned by the Social Security trust fund and the Federal Reserve but does not include the unfunded liabilities of Medicare, Medicaid and Social Security, which will add an additional $46 trillion to the deficit in present value terms over the next 75 years.

This year’s federal deficit is expected to be 1.4 trillion. Interest payments on this debt are forecast to be $287 billion this year (almost 8% of total outlays) and are expected to grow to three or four times that over the next decade as the stock of debt grows and interest rates rise.

This is not sustainable. Without spending cuts and/or tax increases this amount will not only continue growing without end but will increase as a share of GDP until bond holders are no longer willing to trust the government’s ability to pay the interest required. At that point they will dump U.S. Treasuries and the U.S. will be forced to default. Standard & Poors has already downgraded its “credit outlook” for the U.S. to negative.

All of this is by now well-known as is the fact that there is no longer any choice about the need to cut spending and/or raise taxes. But that is just the beginning of the search for responsible and effective governance by our representatives here in Washington. It makes a big difference which expenditures are cut and which taxes are raised. The deficit will fall and our ability to finance it will increase with the growth of our output/income. Specific spending cuts and tax increases effect income growth differently.

The job of our political representatives is to determine what the government should be doing within the set of things it is permitted to do by the Constitution and the resources the public wishes to make available. Their job is to carefully and wisely set priorities on the use of the limited resources available to them.

David Ignatius provides one of many examples that I strongly agree with: “Today, the United States is allocating about $110 billion annually for the Afghan war, about $3.2 billion for military and economic aid to Pakistan, and about $0.15 billion in special assistance to help Egypt’s democratic revolution. In terms of U.S. national interests, those spending levels don’t make sense. The pyramid is upside down.”[1]

The budget for the Defense Department in 2010, including our several wars, was $664 billion while the State Department (including all foreign aid) was $52 billion.  We have the best fighting machine the world has ever seen and rather mediocre diplomatic capabilities. Better and more extensive use of diplomacy and less use of drones and lesser-guided bombs can often produce better results (improved security for the U.S.). Spending more to develop well-trained (history, culture, language) Foreign Service officers and less to manufacture more munitions might be a good idea. It is hard to imagine that spending less on DOD and more on DOS wouldn’t improve our security for less money.

All spending should pass a strict cost benefit analysis but setting a cap on total spending relative to GDP (e.g., 18 or 19 percent) would be a useful disciplining tool for forcing more careful prioritization. So we must cut deeply but not evenly. We can and should spend less and get more benefit by better prioritizing what is really important to our safety and quality of life. This will not be an easy debate.

The same must be said for taxes. Not all taxes have the same effect on the economic growth that lifts our standard of living and makes a given debt easer to service. And not all taxes are equally fair.  So while the revenue generated by taxes should match the level of government spending over the business cycle, how that revenue is raised is as important as how it is spent.

The primary standards for judging tax systems are neutrality and fairness. Neutrality means that the tax does not distort business and spending decisions so that the allocation of investment and economic resources are not distorted. A neutral tax damages economic growth less than, say, a tax that falls largely on investments. A neutral income tax, for example, treats all sources of income the same.

If tax revenue is raised in ways that do not discourage economic growth, income growth itself will increase tax revenue and reduce a given debt as a share of national income (an indicator of the government’s ability to services it). The arguments in favor of the most neutral possible tax structures are well-known and broadly accepted by economists across the political spectrum. The tax base (whether income or consumption) should be comprehensive making the marginal tax rate as low as possible.

Business income taxation double taxes the same income (by the business and again by the shareholders as individuals) and introduces wasteful and risky corporate behavior in their effort to minimize the tax. Everyone agrees that the corporate profits tax in the U.S. should be lowered more in line with the rates in other countries, but in fact the corporate tax should be abolished. It raises only modest revenue and causes great damage. I favor complete reliance on a flat comprehensive consumption tax (VAT) because it does not tax saving and thus encourages more investment and growth, is simpler to collect and is fairer. [2]

There is less agreement about what is fair. Everyone agrees that the rich should pay more taxes than the poor but how much more. Actually, under the existing tax code those with incomes in the top 1 per cent paid 40 per cent of all income tax revenue in 2006 and earned only 22 per cent of all income, the top 10 per cent paid 71 per cent and the bottom 50 per cent less than 3 per cent.

President Obama thinks that this is not progressive enough and wants to tax high income families even more and the Republicans think it is already too progressive both in terms of fairness and in discouraging investment that promotes faster growth.

A “flat” income tax, the same marginal tax rate for everyone with incomes large enough to pay taxes at all, is the most neutral rate structure when applied to a comprehensive income (or consumption) base. But it is also a good benchmark for discussing fairness. A flat rate means basically that someone with twice the income pays twice as much tax. I consider that fair, but of course our existing rate structure increases with income so that tax payments would more than double when income doubles. Increasing marginal rates is a rather open field. Where should you stop? Clearly our tax system needs to be made more neutral and more fair. The debate over how to do that will not be easy either.

[1] “Time to up the ante on Egypt”, The Washington Post, April 20, 2011, A17.

[2] Warren Coats, “U.S. Federal Tax Policy” , Cayman Financial Review, July 7, 2009