Financial Markets

For those interested in policy coordination and exchange rate policy, last week was both entertaining and informative.  U.S. Treasury official Lael Brainard’s G-20 background briefing last Monday, interpreted by some as signaling a green light to Japan for further yen depreciation in support of growth, was followed by statements that seemed to repudiate, support, then reinterpret the statement. The result was significant volatility in foreign exchange markets.  I suspect that was the opposite of what was intended.  Beyond the noise, events last week signal a policy environment where countries have great latitude to take measures that have significant effects on exchange rates.  “Currency wars” is hyperbole, but it’s capturing something real. On the surface, policy appears unchanged.  The G-7 statement on Tuesday reiterated established policy–a commitment to market determined exchange rates, a call to not target specific rates, and a willingness to act when there are excessive volatility and disorderly movements:   We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates and to consult closely in regard to actions in foreign exchange markets. We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates. We are agreed that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will continue to consult closely on exchange markets and cooperate as appropriate. --Statement by G-7 Finance Ministers and Central Bank Governors, February 12, 2013.   The G-7 doesn’t always issue statements, so it was reasonable to assume that this time: (1) there was concern that the yen’s depreciation had gone far enough, for now, and that Japan shouldn’t use the bully pulpit to further talk down the currency or use foreign currency instruments to intervene; (2) concern that discussion about “currency wars” was building momentum; and (3) a desire to put down a marker that exchange rate policy coordination is primarily the domain of the G-7, not the G-20 (with U.S.-China exchange rate issues handled bilaterally). In this regard, it succeeded.  The key paragraph from the G-20 communique, along with comments from participants, signaled a tamping down of the debate:   5.  We reaffirm our commitment to cooperate for achieving a lasting reduction in global imbalances, and pursue structural reforms affecting domestic savings and improving productivity. We reiterate our commitments to move more rapidly toward more market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals, and avoid persistent exchange rate misalignments and in this regard, work more closely with one another so we can grow together. We reiterate that excess volatility of financial flows and disorderly movements in exchange rates have adverse implications for economic and financial stability. We will refrain from competitive devaluation. We will not target our exchange rates for competitive purposes, will resist all forms of protectionism and keep our markets open. --G-20 communique, February 16, 2013.   But context matters.  In a world where the major countries are enacting unorthodox policies to spur their economies, where the new Washington consensus allows for a greater role for capital controls and other macro-prudential measures, and where the United States arguably has less leverage on countries’ policies, these words take on different meaning.  My take is that, looking ahead, any country that can make a domestic case for measures that weaken the exchange rate can do so without concern for sanction from the G-7.  The country shouldn’t talk down the currency, or use a foreign currency instrument that specifically targets exchange rates, but otherwise the door is more open than it has been for some time. Of course, the lines on what is acceptable are fuzzy and will be debated.  When monetary operating systems differ, one country’s unorthodox monetary policy is another’s exchange rate intervention.  For example, it appears unacceptable in any circumstance for Japan to buy foreign currency bonds for yen, while at the same time it’s ok for countries to buy mortgage backed securities in their own currency.  Also, while fixing exchange rates is not allowed, China’s commitment to incremental, managed yuan appreciation remains acceptable. If we do have a new policy, it may be first seen in capital controls in emerging markets to stem hot money inflows.   Large scale Quantitative Easing (QE) programs, though motivated by domestic considerations, have the result that some of the newly created money will flow overseas.  This is particularly true when QE creates an expectation of currency depreciation. As these flows make their way to emerging markets, we should expect them to react.  Speculation revolves around Korea and Taiwan, given both stated hot money concerns and the importance of their trade relationship with Japan.  The hot-money story was well captured by Mexican Central Bank Governor Augustin Carstens in Singapore earlier this month (as reported by the Wall Street Journal): "Today my fear is that a perfect storm might be forming as the result of massive capital flows to some emerging-market economies and some strong performing advanced economies," Mr. Carstens said in his speech. "This could lead to bubbles characterized by asset mispricing. [Countries could] then face a reversal in flows as the major advanced economies start exiting their accommodative monetary policy stance." Carstens called for more work on when macroprudential policies should be used to address these concerns.  Carstens has strong market credentials so when he warns of a problem, his words catch attention. It may be that, within the G-20, current monetary policies are broadly appropriate for domestic considerations, and there is little reason in the near term to expect an outbreak of competitive depreciation.  But if pressures continue to build, it may become clearer that the debate over exchange rates has entered a new phase.  

What does 2013 have in store for the global economy? We asked five distinguished experts to identify the most important trends, challenges, and opportunities in the upcoming year.

Back in March, we showed that the $1.4 trillion in U.S. direct federal student loans that will be outstanding by 2020 will amount to roughly 7.7% of the country’s gross debt. This is 6.3 percentage points higher than it would have been had the scheme not been nationalized in President Obama’s first term. The government’s net debt was not directly affected by the move, as the government acquires assets when it issues student loans. The problem is that projected default rates on such loans have been climbing as the volume issued has increased, as shown in the graphic above. If we apply the projected default rate on loans originated in 2009 to the amount of student loans outstanding in 2012, we find that defaults on federal student loans currently outstanding are likely to cost taxpayers almost $80 billion. And the cost is projected to increase rapidly over the next decade as default rates continue to rise and the amount of student debt the federal government owns soars. There is more than a whiff of resemblance between the rise of the federal government’s student debt liability and the mortgage bubble – the detritus debt of which wound up nationalized. There is little in the way of credit checks carried out, and no evaluation of future earnings prospects. In the ten years to 2008, the amount of mortgage debt tripled: $3.2 trillion to $9.3 trillion. The CBO projects that student loans on the government’s balance sheet will rise just as fast: $453 billion in 2011 to $1.4 trillion in 2020. A 17.3% default rate on $1.4 trillion in loans would cost taxpayers about $240 billion. This is equivalent to 1% of the CBO’s GDP projection for 2020. It is also more than three times the 2013 federal funding level for the Department of Education, and just slightly less than ten times the amount the president requested for science, technology, engineering, and mathematics (STEM) programs in his most recent budget. It is surely worth asking, therefore, whether this $240 billion could be used more effectively than it will be in writing off defaulted student loans. Department of Education: Default Rates Bloomberg.com: Student Loans Go Unpaid, Burden U.S. Economy Wall Street Journal: Federal Student Lending Swells Geo-Graphics: Will Student Debt Add to America’s Fiscal Woes?

The United States marches solemnly towards its fiscal cliff, awaiting only the command from the Goddess of Reason to halt. Unfortunately for Greece, that country plugged its ears back in March. Like the United States, Greece made prior commitments on spending and taxation in order to bind itself to the mission of deficit reduction. Unlike the United States, Greece left itself little means to unbind itself. As shown in the graphic above, its massive debt restructuring in March only reduced its debt-to-GDP ratio from 170% to 150%, but in the process made further significant restructuring much more difficult. Before the March restructuring, Greece owed private sector creditors €177 billion in obligations governed by Greek law and only €30 worth governed by international law, the latter being vastly more difficult to walk away from. After the restructuring, Greece owed private sector creditors only €86 billion, but all of it was now governed by international law (31.5%*177 + 30). And it also added €75 billion to its €124 billion stock of official sector (EU and IMF) obligations, bringing that total to a whopping €200 billion. Though Greece desperately needs to shed more debt, it faces the problem that its private sector creditors are now all shielded by international law, and its public sector creditors are protected by the power to hurl it into unsplendid economic and political isolation. This suggests strongly that Greece should simply have repudiated all its Greek-law private sector debt back in March, when it had the chance. Why didn’t it? Many reasons, some of which flimsy – such as fears of triggering credit default swaps if the restructuring were “involuntary.” But the most pressing reason was to avoid crushing the Greek banking sector, which was exposed to Greek sovereign debt to the tune of about €50 billion. The €25 billion lent to Greece by the so-called European Financial Stability Facility (EFSF) in order to recapitalize its banks would then have to have been a much higher €50 billion. Still, Greece would be at considerably less risk of hurtling over the fiscal cliff today had it avoided taking on the additional €56 billion worth of nonrepudiable private sector IOUs in March. In contrast, the United States can avoid its looming cliff by Congress and the president agreeing just to keep on adding to the prodigious national tab. It’s good to be the king of reserve-currency issuers - at least until the market cuts your head off. European Financial Stability Fund: Questions and Answers IMF: Greece's Financial Position in the Fund as of Sept. 30 BIS: Consolidated Banking Statistics Geo-Graphics: The IMF Is Shocked, Shocked at Greece's Fiscal Failure. Should It Be?

A massive cyberattack this summer on Saudi Aramco, Riyadh’s energy giant, left some 30,000-plus of the company’s computers lifeless, making a rather futuristic threat to the oil and gas industry front page news. U.S. Secretary of Defenese Leon Panetta called the attack “probably the most destructive…that the business sector has seen to date.” The Saudis weren’t the only targets. RasGas, a Qatari natural gas company, was also hit. Months later, investigators are still trying to get to the bottom of what happened, and more importantly, why it did, and what can stop it from happening again. In a piece for The National Interest, I argue that cyberattacks on oil assets around the world pose a real risk to energy prices, and hence the U.S. economy. They also jeopardize the competitiveness of American firms abroad. It’s an issue where national security and economic well-being meet. And it’s a challenge that’s not going away. The risks of hackers penetrating the country’s electrical grid have been widely discussed for years. Less so what cyber means for oil and gas companies and markets. U.S. officials and the global energy industry have their hands full in coming to terms with this new virtual landscape. Check out the piece here.

President Obama is committed to pursuing a “[renewable-energy] strategy that’s cleaner, cheaper, and full of new jobs” (January 24, 2012). He highlighted the job point during the October 16 presidential debate: “I expect those new energy sources to be built right here in the United States. That’s going to help [young graduates] get a job.” Green may be good, but this week’s Geo-Graphic shows that the jobs come at a hefty cost. The Joint Committee on Taxation estimates that energy-related tax preferences will cost Americans $5.4 billion this year. Half of this, $2.7 billion, will benefit green sectors: $1 billion in nuclear subsidies, $1.3 billion in wind-energy credits for electricity production, and $400 million in solar-energy property credits. So-called “section 1603” renewable energy grants, part of the 2009 fiscal stimulus package, will cost taxpayers a further $5.8 billion. If we assume that the grants are awarded across sectors in the last five months of this year as they were in the first seven, then the nuclear, solar, and wind energy sectors will receive $4 billion of this, boosting total green-sector subsidies to $6.7 billion this year. Taxpayers will also provide $700 million in energy-efficient property credits. The credits apply mainly to solar, though we don’t know the precise allocation – so we leave it out of the figure, which therefore understates the cost of solar-backed jobs. Dividing the total wind, solar, and nuclear subsidies by the number of Americans employed in these sectors (252,000), they are currently generating jobs at an average annual cost to taxpayers of over $29,000. Wind jobs cost taxpayers nearly $47,000 per job per year. By way of comparison, the coal, oil, and gas sectors receive $2.7 billion in subsidies annually, and employ about 1.4 million Americans. The taxpayer-cost per job in these sectors is therefore just over $1,900. The bottom line is that green-energy jobs cost taxpayers, on average, 15 times more than oil, gas, and coal jobs. Wind-backed jobs cost 25 times more. Given the current state of energy-production technology, green jobs don’t come cheap. Romil Chouhan contributed to this post. NYTimes.com: Transcript of the Second Presidential Debate Treasury: Overview and Status Update of the Section 1603 Program Bloomberg.com: U.S. Solar Jobs Face Bright Future, Wind Posts Flutter Foreign Affairs: Tough Love for Renewable Energy

While a new round of U.S. quantitative easing will have a negative impact on emerging markets like Brazil, the country should not blame U.S. monetary policy for the structural flaws in its economy, says expert Bernardo Wjuniski.

In last week’s vice-presidential debate, Republican Paul Ryan defended the fiscal prudence of lowering top marginal income tax rates by arguing that it would be accompanied by “forego[ing] about $1.1 trillion in loopholes and deductions . . . deny[ing] those loopholes and deductions to higher-income taxpayers.” The $1.1 trillion he refers to is actually an amalgam of specific “tax expenditures” – benefits distributed through reductions in taxes otherwise owed – identified by the Joint Committee on Taxation.  We break out the largest 10 of these graphically in the figure above. The full list is available here: http://subsidyscope.org/data/ The red bars indicate items that Romney and Ryan had previously promised not to touch: exclusion of employer contributions for health care, deductions for mortgage interest, reduced tax rates on dividends and long-term capital gains, and deductions for charitable giving.  These four items constitute a massive 30% of the $1.1 trillion.  Therefore the Ryan pledge to cut loopholes and deductions cannot, mathematically, be worth more than $770 billion. And note some of the other big-ticket “loopholes and deductions” on the list.  Social security and other retirement income constitute three of the top ten items, together making up 13% of the total, and the earned income credit, which benefits the poor, represents another 5% of the total.  Would Romney and Ryan eliminate those deductions?  We’ll speculate here: no.  A quick skim of the remainder shows that few of these items constitute “loopholes” in the public’s mind – they are items few imagine could or should be taxed. In short, Romney and Ryan cannot, logically, keep the pledge to cut $1.1 trillion in tax shields for the rich, because (1) they have already ruled out eliminating the biggest of such shields, and (2) much of the $1.1 trillion is actually derived from tax expenditures targeted at lower and middle income taxpayers – not tax shields for the rich.  This almost surely means that only a small fraction of the $1.1 trillion is actually in play. Sensitive to the charge that his numbers are not adding up, Romney proposed at Tuesday night’s presidential debate capping deductions at $25,000.  This would raise $1.3 trillion in revenues over the next ten years, according to the Tax Policy Center.  But that figure is only slightly above what Ryan said they would raise each year.  A $1 trillion a year hole remains in their budget math. Transcript: The 2012 Vice Presidential Debate Pew: Subsidyscope Tax Expenditure Database Romney: Tax Plan Ryan: Sept. 30 Appearance on Fox News Sunday