Monday, March 11, 2013

Hamilton on the Fiscal Crunch

The third post in a row about this important subject. According to James Hamilton:
A fiscal crunch would force a central bank to pursue inflationary policies, a situation that's called fiscal dominance. If the Federal Reserve does not monetize the government debt (by purchasing it or, in other words, by printing money), then interest rates will rise sharply as private lenders demand a higher rate. These higher interest rates will cause the economy to contract. Indeed, without monetization, the government could end up defaulting on its debt, which would lead to a financial crisis, producing an even more severe economic contraction. The central bank would be forced to purchase ever increasing quantities of government debt by printing money, eventually leading to a surge in inflation.  ... The grave scenarios we outline here do not have to happen. Since the debt-to-GDP ratio is likely to stabilize over the next few years, there is time to avoid the dire potential problems we have highlighted. But with the gross-debt-to-GDP ratio already well above the 80% threshold-- and likely to resume a steady climb by the end of this decade-- the clock is ticking.

Friday, March 8, 2013

The Effects of a Large Government Debt on Monetary Policy

John Cochrane wrote an insightful article on the subject. It made me think of very similar problems that Brazil faced while I worked with the country's Treasury and later with its Central Bank during hyperinflation. I had the opportunity to observe similar institutional games taking place from both perspectives. Here's a sample of his article:
Monetary policy depends on fiscal policy in an era of large debts and deficits. Suppose that the Fed raises interest rates to 5% over the next few years. This is a reversion to normal, not a big tightening. Yet with $18 trillion of debt outstanding, the federal government will have to pay $900 billion more in annual interest. Will Congress and the public really agree to spend $900 billion a year for monetary tightening? Or will Congress simply command the Fed to keep down interest payments, as it did after World War II, reasoning that "Fed independence" isn't worth that huge sum of money?
This additional expenditure would double the deficit, which tempts a tipping point. Bond markets can accept fairly big temporary deficits without charging higher interest rates—buyers understand that bigger deficits for a few years can be made up by slightly larger tax revenues or spending cuts over decades to follow. But once markets sense that deficits may be unsustainable, and that bond buyers may face default, restructuring or inflation, they will demand still-higher interest rates. Higher rates mean higher deficits—leading to a fiscal death spiral.

Thursday, March 7, 2013

Le vin a civilisé l'homme

« L'homme a domestiqué la vigne, mais le vin a civilisé l'homme. ... La vie sans bonheur, sans plaisir, est un voyage interminable. » David Khayat, oncologue et œnophile.

Latin America: Social Development or Dutch Disease?

Augusto de la Torre and Julián Messina solve a Latin-American puzzle (the combination of lowering income inequality and low labor productivity growth):
Dutch disease? This hypothesis may be stated as follows. The extended boom in commodity prices induced, through the appreciation of the real exchange rate, a substantial reallocation of resources (including labour) from non-commodity tradeable sectors to non-tradeable sectors. Provided that the latter are relatively less intensive in skilled labor, this reallocation would reduce the skill premium and the returns to education, bringing down wage inequality. ... Undoubtedly, this is a luminous and welcome fact for a region historically scarred by excessive inequality. This positive news, however, seems to hide a dark side: the specialisation of the region’s economies in activities that are relatively low in skill intensity and that therefore tend to be of lower productivity.

Wednesday, March 6, 2013

Unsustainably High TIPS Prices: What's Next?

As was anticipated in this blog last October: TIPS funds have paid an annualized return rate of around 2.5% during the last six months, and more recently the return rate has been closer to zero and even negative. It now underperforms nominally-guaranteed fixed income funds such as Minnesota Life (3% in fixed dollars) and nominally-guaranteed long-term savings accounts in Europe, which pay 2.5% or above in euros or Swiss francs. To put it short, real interest rates are so low that they cannot fall further even under a future scenario of financial repression and high inflation. Much on the contrary: if inflation rises, real interest rates will have to rise, no mattering how accommodative is the central bank policy.

To make things worse, this situation is financially and fiscally unsustainable, causing nominally-guaranteed funds to become insolvent or to need massive government subsidies to private savings, the latest leading to all kinds of obvious financial and fiscal distortions. This phenomenon took place from time to time in Brazil during the years of financial repression that preceded hyperinflation and fiscal chaos.

How to Avoid the "Resource Curse"

Excellent article on how resource-rich nations can avoid the "resource curse." According to Francisco Carneiro:
Resource wealth will not be successfully used to promote wealth and shared prosperity if institutional quality is neglected. Remember that the extractive industries, due to their enclave characteristics, can be operated in weak institutional environments. This is not the case for most other industries that require an adequate investment climate to thrive. In these cases, achieving success will depend not only on human capital development, but to a greater extent, on strong enforcement of contracts, laws, and a generally strong business environment.