The new report from the Social Security trustees is out, and it has the very serious people in a tizzy. 2034, oh the dreaded 2034, is the year that the "trust" supposedly runs out of money. The results will necessarily be draconian cuts to benefits or large tax increases. Yeah, if only that were true. As I and countless other have shown time and time again, government budgets for nations with free floating currencies are not like private budgets. But let's go down the rabbit hole with these crazies for a while. Suppose we turn back the clock to before 1971 when the US severed the last vestige of the old gold standard and suspended international convertibility of the US dollar into gold. In this case, the Federal Government, which the Social Security Administration is a part of, would be subject to the same inter-temporal budget constraint as households and firms. Namely, that the present value of all future spending (including interest payments) must equal the present value of all future revenue. Would the amount of money in the trust affect the capacity of the US government to pay benefits? No! Since the trust holds non-marketable US Treasury bonds, it could only raise the funds by redeeming these bonds. The Treasury for its part would meet this redemption by selling securities or raising taxes. So the the capacity of the SSA to pay benefits in our gold standard world is directly tied the capacity of US Government to tax or sell bonds. Or in other words, the assets of the trust are a liability of the Treasury, and since both are part of the US Government, every dollar in the trust is cancelled out by a liability at the Treasury. Similarly, it would be patently absurd to contend that moving money from my right pock to my left pocket somehow affects my capacity to pay my mortgage. The level of the trust fund is irrelevant.
The trust is nothing more than an intra-governmental accounting tool to track payroll tax receipts and benefit outlays. All the 2.8 trillion dollars in the trust represent is the cumulative payroll taxes collected since creation of the program minus cumulative benefits paid. Again, even under a gold standard/neo-classical framework where the government is like a household, the trust cannot be thought of as a financial resource for the Federal Government precisely because redemption of the bonds held in it would be drawn on the Treasury!
Hilariously, many of the lobbyists in Washington don't even understand their own flawed framework. This whopper comes from the Committee for a Responsible Federal Budget:
Currently, the Social Security trust fund holds $2.8 trillion in bonds —
meaning the program can run the equivalent of nearly $3 trillion worth
of deficits going forward before the trust fund runs out [in 2034].
Huh? So in 2034 the computer software which manages the Treasury's payment systems will crash because there aren't any securities left in some obscure intra-government account? Its Y2K all over again.
Tuesday, June 28, 2016
Saturday, June 25, 2016
Commentary: How to Fix the Eurozone without Killing It
The recent Brexit vote has Euro-skeptics crowing that the EU and Euro are in their death throws. I will be the first to acknowledge that the Euro has served many members of the currency bloc poorly, particularly Spain and Italy. The essence of the European crisis is a balance of payments crisis, not a debt crisis. Large structural trade imbalances developed within Eurozone, with the most productive nations like Germany and the Netherlands running huge current account surpluses. This meant that deficit countries like Spain and Greece were placed in an untenable position. Under a floating exchange rate regime, the Spanish Peseta and Greek Drachma would have depreciated against the Deutsche Mark, raising the cost of German goods in these countries and helping to bring the balance of payments back to a healthy equilibrium. With the fixed exchange rate of the Euro however, these countries faced two bad choices. They could:
1) Borrow from a abroad to finance the current account deficit. In the boom years of the 2000s, this is basically what most countries did.
2) Engage in fiscal austerity to deflate their economies to achieve the real devaluation sufficient enough to balance the current account. This has been going on since about 2010 with disastrous results. It's an idea that works in theory, but in practice prices can't fall fast enough.
Of course, Spain and Greece and other poorer Eurozone nations could implement "structural reforms" to try to boost their productivity and make them competitive with Germany and the rest of Northern Europe. However, these initiatives, such as investments in education, take decades to bear fruit and aren't much for solving an immediate crisis.
Also, the richer European nations like Germany could engage in fiscal transfers to help the Greeks and Spaniards finance their current account deficits, much like California subsidizes Mississippi in the United States. However, after six long years, and the vote last Thursday, it is clear that Europe is far away from becoming a federal state. Thus, a radical solution must be implemented.
The Eurozone should contract to include only five or six core members, most likely Germany, France, the Netherlands, Belgium, Luxembourg, and Austria. Automatic fiscal transfers between nations in the would be triggered if current account imbalances between countries occurred. This would prevent balance of payment crises from developing and would make sure that no nation would be put in the unenviable position of having to borrow heavily or implement deflationary policies. While it is true that fiscal transfers have so far proved politically untenable, a smaller bloc of nations which share borders would have a much easier time hammering out the details of such an arrangement than the current 19 member Eurozone. The six nations I have proposed also have similar levels of productivity and thus any fiscal transfers would be small. Greece or Spain however, or even Italy, would probably require much larger fiscal transfers to remain viable, and that would most likely sink any negotiations.
The currency bloc would have supranational deposit insurance backstopped explicitly by the European Central Bank. This would prevent the kind of bank runs we saw in Greece and other crisis countries as people began to doubt the credibility of national deposit insurance. Because national governments have abdicated the power to print money, the EBC is the only entity which can make an iron clad, unquestionable promise to guarantee Euro-denominated bank deposits by virtue of being the sole issuer of the Euro.
The Eurozone is a victim of its own ambitions. It was designed without fiscal transfers or any mechanism to solve balance of payment issues, but it can't work without them. The Eurozone must therefore narrow its scope and size to serve those nations it can serve best. Failure to act will see the disorderly withdrawal of several of the weaker members, which will no doubt roil financial markets may result in a complete collapse of the Eurozone.
1) Borrow from a abroad to finance the current account deficit. In the boom years of the 2000s, this is basically what most countries did.
2) Engage in fiscal austerity to deflate their economies to achieve the real devaluation sufficient enough to balance the current account. This has been going on since about 2010 with disastrous results. It's an idea that works in theory, but in practice prices can't fall fast enough.
Of course, Spain and Greece and other poorer Eurozone nations could implement "structural reforms" to try to boost their productivity and make them competitive with Germany and the rest of Northern Europe. However, these initiatives, such as investments in education, take decades to bear fruit and aren't much for solving an immediate crisis.
Also, the richer European nations like Germany could engage in fiscal transfers to help the Greeks and Spaniards finance their current account deficits, much like California subsidizes Mississippi in the United States. However, after six long years, and the vote last Thursday, it is clear that Europe is far away from becoming a federal state. Thus, a radical solution must be implemented.
The Eurozone should contract to include only five or six core members, most likely Germany, France, the Netherlands, Belgium, Luxembourg, and Austria. Automatic fiscal transfers between nations in the would be triggered if current account imbalances between countries occurred. This would prevent balance of payment crises from developing and would make sure that no nation would be put in the unenviable position of having to borrow heavily or implement deflationary policies. While it is true that fiscal transfers have so far proved politically untenable, a smaller bloc of nations which share borders would have a much easier time hammering out the details of such an arrangement than the current 19 member Eurozone. The six nations I have proposed also have similar levels of productivity and thus any fiscal transfers would be small. Greece or Spain however, or even Italy, would probably require much larger fiscal transfers to remain viable, and that would most likely sink any negotiations.
The currency bloc would have supranational deposit insurance backstopped explicitly by the European Central Bank. This would prevent the kind of bank runs we saw in Greece and other crisis countries as people began to doubt the credibility of national deposit insurance. Because national governments have abdicated the power to print money, the EBC is the only entity which can make an iron clad, unquestionable promise to guarantee Euro-denominated bank deposits by virtue of being the sole issuer of the Euro.
The Eurozone is a victim of its own ambitions. It was designed without fiscal transfers or any mechanism to solve balance of payment issues, but it can't work without them. The Eurozone must therefore narrow its scope and size to serve those nations it can serve best. Failure to act will see the disorderly withdrawal of several of the weaker members, which will no doubt roil financial markets may result in a complete collapse of the Eurozone.
Friday, June 24, 2016
Commentary: Why British Rates Fell on Brexit
This one is going to be short but sweet. Many of the 'very serious people' warned that an affirmative vote to leave the EU would result in higher interest rates . Chancellor of the Exchequer George Osborned warned of higher mortgage rates. But its almost a full 24 hours since the polls closed and the yield on the 10 year UK gilt (and bond yields globally) has plunged close to 30 basis points despite a looming S&P credit downgrade of the British government. What gives? Why were so many of the economic and policy elite so fantastically wrong?
With a proper understanding of the monetary system, it was easy predict the direction in rates upon Brexit. Because the UK borrows exclusively in British Pounds, investors understand that a nominal default on gilts is impossible. That's why nobody took the S&P threat to downgrade the UK seriously. But even so, perhaps foreign investors in gilts would worry about the pound vis-a vi their local currencies. So they sell their gilts and receive British pounds. Because they are worried about the pound they sell GBP for local currency on the FX market. This sends the pound lower against other currencies. But why don't British rates rise as gilts are sold? Because the pounds which foreign investors sold on the currency market have to go somewhere. If foreigners are selling the UK pound, its not a heroic assumption to make that the UK domestic market is being a net buyer of the pound. Furthermore because the domestic market is taxed in GBP, it will look for GBP-denominated financial assets to invest in, and during times of stress, what's better than risk free government bonds? So as pounds held by foreigners flowed out of the gilt market, domestic investors flooded in. Some spooked equity investors clearly dumped stocks and bought gilts, as evidenced by the near 6 percent sell off in the FTSE and simultaneous bond rally.
Of course, if the UK used the Euro or had a fixed exchange rate, money exiting the country would have to cause interest rates to rise, as it did in Spain and Italy during the worst moments of the ongoing Eurozone debt crisis. But in reality, the floating exchange rate regime adopted by the UK since 1992 means that pounds essentially live in the UK financial system, and "capital flight" manifests as a drop in exchange rate, not a rise in interest rates.
The pound did take a beating last night, but its not even clear that was due to do "capital flight." I suspect that it was due to the unwinding of bullish GBP bets made earlier in the day as it appeared that the Remain side would win. In any event, the pound appears to have stabilized. If the Bank of England does not adjust its policy stance, I expect the pound to appreciate in the coming weeks. One interesting area of research for academic economists might be the phenomenon of "market dislocation." Eg, what if foreigners sell bonds faster than domestic investors snap them up, or certain classes of investors respond to news at different speeds. This appears to have happened in the case of the Polish credit downgrade. Foreign investors pulled out, and the zloty took a beating. Rates rose domestically for a few days before plunging back down below pre-downgrade levels and the zloty regained ground. Anyway, Keep Calm and Carry On!
With a proper understanding of the monetary system, it was easy predict the direction in rates upon Brexit. Because the UK borrows exclusively in British Pounds, investors understand that a nominal default on gilts is impossible. That's why nobody took the S&P threat to downgrade the UK seriously. But even so, perhaps foreign investors in gilts would worry about the pound vis-a vi their local currencies. So they sell their gilts and receive British pounds. Because they are worried about the pound they sell GBP for local currency on the FX market. This sends the pound lower against other currencies. But why don't British rates rise as gilts are sold? Because the pounds which foreign investors sold on the currency market have to go somewhere. If foreigners are selling the UK pound, its not a heroic assumption to make that the UK domestic market is being a net buyer of the pound. Furthermore because the domestic market is taxed in GBP, it will look for GBP-denominated financial assets to invest in, and during times of stress, what's better than risk free government bonds? So as pounds held by foreigners flowed out of the gilt market, domestic investors flooded in. Some spooked equity investors clearly dumped stocks and bought gilts, as evidenced by the near 6 percent sell off in the FTSE and simultaneous bond rally.
Of course, if the UK used the Euro or had a fixed exchange rate, money exiting the country would have to cause interest rates to rise, as it did in Spain and Italy during the worst moments of the ongoing Eurozone debt crisis. But in reality, the floating exchange rate regime adopted by the UK since 1992 means that pounds essentially live in the UK financial system, and "capital flight" manifests as a drop in exchange rate, not a rise in interest rates.
The pound did take a beating last night, but its not even clear that was due to do "capital flight." I suspect that it was due to the unwinding of bullish GBP bets made earlier in the day as it appeared that the Remain side would win. In any event, the pound appears to have stabilized. If the Bank of England does not adjust its policy stance, I expect the pound to appreciate in the coming weeks. One interesting area of research for academic economists might be the phenomenon of "market dislocation." Eg, what if foreigners sell bonds faster than domestic investors snap them up, or certain classes of investors respond to news at different speeds. This appears to have happened in the case of the Polish credit downgrade. Foreign investors pulled out, and the zloty took a beating. Rates rose domestically for a few days before plunging back down below pre-downgrade levels and the zloty regained ground. Anyway, Keep Calm and Carry On!
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