# Videos: Famous Professors On Fiscal Stimulus vs Austerity

I wanted to compile a collection of past TV debates and interviews with famous professors on their thoughts around the current issue of fiscal stimulus versus austerity. Unfortunately, only a handful of the great professors out there possess the required appetite for publicity to make themselves available to this sort of thing. I tried to give a fair voice to each side of the aisle, and ended up with a single representative of the “stimulus” side (Krugman), one representative of a more balanced approach (Rogoff) and three representatives from the “austerity” side (Cochrane, Taylor and Mankiw). Personally I find myself positioned in the center, and tend to agree with the views of Rogoff. If you know of any other videos that should be included in the list, please leave a link in the comments section!

Paul Krugman vs John Taylor (CNN, June 2009):

via CNN

Paul Krugman vs Kenneth Rogoff (CNN, August 2011):

via CNN

Paul Krugman (CNN, June 2013)

via CNN

John Cochrane (Bloomberg, September 2009)

Greg Mankiw (Bloomberg, March 2012)

John Taylor (Bloomberg, June 2010)

# An introduction to SA bank balance sheets (graphs)

To get a sense of the credit market in South Africa, it is useful to see who funds whom. Most credit in SA is extended via the banking sector. The banks act as intermediaries: savers deposit cash in checking or savings accounts and the bank then lends the majority of these deposits to other individuals or businesses who demand credit. The bank earns a profit by charging a higher rate on the lending than it pays on its borrowing (in SA, banks appear to earn profit on their borrowing as well, by paying a rate on deposits below inflation). The following graphs plot the different components of the aggregate balance sheet for all South African banks.

I first plot the total liabilities of South African banks. This adds up to a bit more than 3 trillion rand, of which 2.7 trillion is deposits. The remainder consists of repo transactions (Borrowed Funds), foreign currency funding, and subordinated debt securities (Other Liabilities).

Deposits in checking and savings accounts as well as money market funds is the channel through which we ordinary citizens lend money to banks. Banks can then lend the funds to other households and businesses. However, a closer look reveals that deposits include much more than just household savings. The figure below illustrates the importance of both financial firms (fund managers, money market funds, pension funds, insurers etc) and non-financial corporations. Household deposits only account for a fifth of total deposits. The role of fund managers and money market funds have clearly become a very important channel of directing savings onto bank balance sheets. The remaining liabilities of banks are categorised as “Other Borrowed Funds”, “Foreign Currency Funding” and “Other Liabilities”. The “Other Borrowed Funds” are mainly repurchase transactions, typically short term debt where the borrower submits collateral for the entire amount. This is typically used to cover short term needs for cash, often to cover the required reserve ratio with the South African Reserve Bank. Banks can also use this as temporary financing to extend loans without having to wait for customer deposits to fund the lending.

It is slightly surprising to see that repo borrowing actually increased to a higher permanent level after the global financial crisis. It was this type of borrowing, on a much larger scale, that enabled US financial institutions to build massive leverage with an extreme maturity mismatch. The maturity mismatch refers to the short term nature of the debt, often overnight funding, combined with the long term nature of their assets, often household mortgages with maturity over several years. This is not a major concern in South Africa – despite the increased use of repo funding it still only accounts for approximately R100 billion out of an aggregate balance sheet of R3000 billion.

Foreign currency funding, plotted above saw a huge leap during the financial crisis, and has stayed high ever since. But as was the case with repo funding, foreign currency funding still accounts for only R100 billion out of a total balance sheet of R3000 billion.

The figure below plots “Other Liabilities” which consists mainly of subordinated debt securities. Here we see the same pattern again, of a sharp increase in recent years. This type of lending adds up to approximately R200 billion out of the total R3000 billion. Again not a very large amount.

As one would expect from ordinary banks, we have seen that deposits account for the vast majority of their funding. We call this “core liabilities”. The more unconventional funding of banks, mainly repo transactions, foreign currency funding and subordinated debt securities were each of less significance. However, if we add up all these “non core liabilities” we see that the use of such alternative funding has greatly increased in recent years. This may be a consequence of a strong demand for credit combined with low rates of savings. It also indicates that banks are eager to lend out money; so eager that they choose not to wait for deposits to come in, but rather use alternative borrowing to fund such credit extension. This may be a good thing in an economy with lackluster growth, but this is a risky business and a crash in these markets will have dire consequences for the real economy. So keep watching these numbers, they do give a good sense of how South Africa is doing.

# Timing the Taper – are markets overreacting?

This week the markets are again hit by a fresh round of tapering fear. The odd thing about these tapering induced market swings is that the end of QE is certain to happen at some point and must have been priced in already. The only uncertain factor here is the timing. But can the timing of tapering really explain these violent market moves?

To begin with, QE can affect stock prices in two ways:

1. QE pushes down bond yields and so it pushes down the discount rate. This makes the present value of future dividends greater, and thus the stock prices are higher.
2. QE (i.e. lower borrowing costs) will increase demand in the economy and thus increase profits by firms. This increases expected dividends.

Of these, it seems likely that the first effect, via the discount rate, is the one that would be most prone to daily volatility due to tapering timing revisions. But how does the timing of the end to QE affect today’s stock price? And can this explain the volatility in the market today?

Below I do a simplistic back of the envelope analysis which will illustrate that the market has very good reason to be sensitive to the timing of QE tapering. I use a standard dividend discount model calibrated to current data. First we begin with the basic price equation:

$P_t=E \bigg( \sum_{i=1}^{\infty}{\frac{D_{t+i}}{(1+d)^i}} \bigg)$

For simplicity, assume that QE will end abruptly at period N, and that the discount rate then changes from $d_1$ to $d_2$. This gives a price equation as follows:

$P_t=E\bigg( \sum_{i=1}^{N}{\frac{D_{t+i}}{(1+d_1)^i}} + \frac{1}{(1+d_1)^N} \sum_{j=N+1}^{\infty}{\frac{D_{t+j}}{(1+d_2)^j-N}} \bigg)$

Which gives:

$P_t=E\bigg( \sum_{i=1}^{N}{\frac{D_{t+i}}{(1+d_1)^i}} + \frac{P_{t+N}}{(1+d_1)^N} \bigg)$

Now, let us do a rough calibration to the current market by looking at the S&P 500. Today’s price is approximately $1700, the dividend yield is approximately 2%, and thus we have a monthly dividend of approximately$3. For now, we assume a discount rate of 0.5% per month during QE. Once QE ends, this is assumed to increase to 0.8% per month (I will show results for different assumptions later). If QE is expected to end after 12 months, we simply get:

$1700=E\bigg( \sum_{i=1}^{12}{\frac{3}{(1.005)^i}} +\frac{P_{t+12}}{(1.005)^12} \bigg)$

This implies a forecasted price in 12 months of 1765. We will stick to this implied forecast going forward. Now, if Bernanke makes an announcement that QE will end in 11 months, rather than the expected 12 months, the new price will be: $P_t=E\bigg( \sum_{i=1}^{11}{\frac{3}{(1.005)^i}} + {\frac{3}{(1.005)^{11}*(1.008)^1}}+ \frac{1765}{((1.005)^{11}*(1.008)^1} \bigg)=1689$ Thus, if markets expected the end of QE in 12 months, and news suddenly revealed it would end in 11 months, the current stock price would fall by approximately 0.49%. Simulations I wrote a little program in Matlab that repeats this simulation for an announced end to QE in everything from 1 month up to 12 months compared to an expected end varying between 1 month and 12 months. Some results are plotted in the figure below. Figure 1: Discount rate during QE = 0.5% per month. Discount rate after QE = 0.8% per month. The simulations suggest that if the market expects QE to end in for example three months (top left panel) and a surprise announcement by the FED states that it will actually end QE in 2 months, the current stock prices will fall by approximately 0.3%. The fall is fully caused by the revelation that discount rates will increase one month sooner than expected. Remember, here I have assumed that QE keeps the discount rate artificially low at 0.5% per month instead of 0.8% per month. If I change the assumptions so that the end of QE will see a much smaller increase from 0.5% to 0.55% per month, we get the results below: Figure 2: Discount rate during QE = 0.5% per month. Discount rate after QE = 0.55% per month. As you see, if QE is assumed to keep monthly discount rates only 5 basis points lower than what they would otherwise be, the current price is still relatively sensitive to the timing of the end to QE. Under this scenario, if we assume the market expects QE to end in 3 months and an announcement today states it will end in 2 months, the current price will fall by 0.1%. If the market expects QE to end in 12 months, and an announcement states it will end in 2 months, the current price will fall by 0.5% (bottom right panel). On the other hand, if the market expects QE to end in 6 months, and an announcement states it will end in 12 months, the current price will increase by 0.3% (top right panel). Thus, all together, despite the fact that the end to QE is already priced in the market, the market has good reason to be sensitive to its timing. It is easy to say the market is overreacting to news (the reason I started writing this post is because I thought this was the case), but this analysis shows that the current market swings may be completely justified. Any surprises here is guaranteed to induce volatility as markets readjust their expectations of when the FED will begin tapering. PS: Also note that the day tapering actually begins, the market is practically guaranteed to fall as long as at least one market participant failed to predict the taper to start that day. The simple reason being that no participants will expect taper to begin on a past date (as they would have observed this if it happened), and thus any expectations of tapering to begin on a future date must pull the average expected taper beginning to a future date. This average expectation means that stock prices will never price in an immediate end to QE, no matter how imminent it is. (Of course, the effect of this may be negligible). # Keynes vs Austerians: Is inflation the solution? Inflation with fiscal deficits is the last remaining tool to get our economies back on track. That is; if the goal is to increase GDP and reduce unemployment, these economies can no longer rely on monetary stimulus alone. A short revisit to basic economic theory may refresh our understanding before I lay out a brief (and admittedly simplistic) argument. Remember first that we have two sides to any market; supply and demand. The supply side is not the problem this time around: GDP is not low because we lack capacity to produce. The high unemployment rates give ample evidence that there is plenty of spare capacity around. What is needed here is demand. Thus, if you care about getting the economy back to its long run sustainable level, you must for now accept some Keynesian thinking and leave your supply side arguments for the different discussion of how to maximize long term growth (yes this is just as important, but not the focus of this post). The disagreement is not whether demand needs stimulus (it does), but how it can be achieved. So, this leaves us with two schools of thought to battle this out: The traditional Keynesian would suggest the use of fiscal deficits (i.e. government spending) to kick start demand directly, and thereby increase the income of consumers who then will increase their demand; and so the multiplier goes. This will increase both debt and GDP, but because the Keynesian multiplier is assumed to be greater than one, we will see GDP growing faster than the stock of debt. Conveniently, this leaves us with a lower debt to GDP ratio, and we are all happy. The counter argument is that of the now so-called “Austerians” who have little faith in the government’s ability to stimulate demand. They will argue that there is no Keynesian multiplier. The reasoning tends to take one of the following shapes: (1) Consumers are not stupid and understand that government debt is just another name for future taxes. And if we expect higher future taxes, we must start saving now in order to maintain a smooth (and optimal) inter-temporal consumption pattern. This implies Ricardian Equivalence: an increase in Government spending will be met by an equal off-setting increase in private saving – leading to higher government debt and zero net change in GDP. (2) Debt itself is damaging to the economy. It increases risks and interest rates which hurts private investment. It makes us pessimistic about the future which has a negative impact on consumer confidence. And last but not least, it is unfair to future generations. (It also implies more tax-payer money to be distributed by politicians whose incentives may not be perfectly aligned with the needs of our economy). Personally, I do believe fiscal stimulus could give a strong boost if combined with further rounds of QE, both in the US and in Europe. However, I am also worried about the potential risks of rapidly increasing debt to GDP levels. Thus, I have no intentions to close this debate. All I have to say is: More inflation will make the pain easier. And I strongly suspect inflation is the outcome our policy makers are aiming for. We will continue to see economists with a taste for easy money to be placed in the driver’s seat of our central banks (think of Carney at the Bank of England, Kuroda at the Bank of Japan and possibly Yellen at the Fed). And I think that’s a good thing. Easy money will make the expansive fiscal policy more powerful and less costly. This even neutralizes the Ricardian equivalence argument: If consumers see the fiscal deficits today and expects higher inflation tomorrow, they will see that the real value of future taxes is lower than the real value of spending today. Thus the increase in government spending will be met by a less than one-for-one increase in private savings, and there is a net positive impact on demand today. There will of course be pockets of pundits who predict widespread hyperinflation as a consequence. And yes, that is a real risk, but the question is with what probability? And then the next question is: what is the highest probability of hyperinflation we are willing to accept in order to get our economy back on track today? # Banking: Where is the rumored consumer credit boom in South Africa? Just posting a quick note on a novelty in SA markets. There has been much talk about the unprecedented consumer credit boom (and much feared bust) in South Africa. See for example Bloomberg’s “South Africa: Unsecured credit boom may not bust” or an older piece on Moneyweb referring to assurances from the SA Reserve Bank that the unsecured credit boom is no bubble. The figure below illustrates the total credit card debt owed to banks operating in South Africa. The next figure plots credit card debt owed to the top five banks separately: And the last figure illustrates the credit card debt owed the top five banks as a ratio of their total assets: I will leave the long story for someone else to tell, but I have a couple of comments. The first figure clearly shows that South African households and corporates do have an increasing amount of credit card debt to SA banks. Most strikingly is the sharp jump in November 2012. Prior to November 2012, we saw a healthy growth in credit card debt, though not nearly as rapid as prior to the global financial crisis. Adjusted for inflation, this growth seems rather modest and does not give much reason for concern. Now, back to the spike in November 2012. This looks a lot more dangerous and does warrant a minor investigation. Now, the investigation is very simple: if you have paid attention to the markets recently, you would perhaps have picked up on the news that ABSA acquired Edcon’s account receivables, including all purchases made on credit at Edgars, Jet and Boardmans. This purchase is clearly reflected in the second and third figures where you will see that the entire jump in November 2012 was driven by Absa’s balance sheet. In other words, there was no jump in credit indebtedness, this was rather a move of existing credit from the balance sheet of retailers onto the balance sheet of banks. This number gives no indication of how much credit is still outstanding to the retail sector in South Africa. It does however remind us that the retail sector has become a huge player in the unsecured credit market, where the debt of one retail group makes a great impact on the total credit outstanding to South African banks. The conclusion to draw from this is that bank balance sheets give us a surprisingly poor view of the indebtedness of the population. The purchase of Edcon’s credit receivables had a huge impact on the total credit card debt owed to banks. If there is such a thing as an unsecured credit bubble in South Africa, it is not caused by bank’s recklessness, but rather by the retail sector’s trust in its own ability to judge the consumers’ creditworthiness. Absa is now the odd bank out, with credit card debt accounting for 3,5% of its’ total assets and 4,6% of its total equity. # FX market intervention by central banks UPDATE: The Wall Street Journal just commented on the rumors discussed below in the article “SNB in strong position to raise Euro floor“. The piece argues in favor or raising the floor in order to stimulate export led economic growth. It does not comment on the issues I raise below, and my view remains unchanged. A higher floor may not cost the SNB much at the moment, but by pushing the exchange rate further from its underlying value, the potential profit from holding the CHF when the peg breaks becomes greater, thus attracting more flows into the Swiss Franc (see graphs below). Central Banking, or monetary policy, can at times be surprisingly exciting. The Swiss National Bank (SNB) and the Hong Kong Monetary Authority (HKMA) both have made some bold moves in the past and at present. The HKMA was arguably the most successful central bank to resist the extreme pressure on Asian currency pegs during the Asian crisis. This defense did not merely include purchasing its own currency to support its value, the HKMA is also believed to have intervened directly in equity markets. At the peak of the crisis in October 2007, they supposedly purchased vast amounts of equities where short sellers were trying to profit from a double bet on a weaker HK and lower equity prices in the crisis expected to follow. The end result was a great victory to the HKMA, and an expensive defeat to the shorts. (A great book about this particular event is Intervention to Save Hong Kong: Counter Speculation in Financial Markets by Goodhard and Lu.)

Given the HKMA’s track record in FX intervention, one should perhaps not be surprised that they are again intervening (this time in a conventional manner) to defend their peg to the US dollar. The difference is that this time the market is pushing the HK dollar up and the HKMA intervenes to weaken its currency. According to Reuters, the HKMA sold 6.2 billion HK dollars today (Tuesday 11 dec) in the open market (800 mill USD). This came on top of an additional 1.5 billion HK $sold since October 2012. It should be noted that defending currency weakness is much easier than defending its strength. The HKMA can sell as many HK$ as its heart desires, the only consequence being a growing portfolio of foreign reserves. However, at some point printing too much of your own currency may be problematic. The Swiss National Bank may soon learn this lesson.

The market chatter today has spread a rumor regarding a potential raising of the CHF-EUR floor. In 2011, the SNB unexpectedly (and somewhat controversially) imposed a floor on the Swiss Franc’s exchange rate to the Euro at 1.2 CHF/EUR. A higher floor would imply a weaker CHF, thus profits for the shorts and loss for the holders of CHF. The source of the rumor is unclear, and very little if any has been written about this. Some seem to think is is caused by a recent recommendation by UBS warning its clients against holding large amounts of CHF. In other words, they see a risk of CHF depreciation. Personally, I don’t see this to be a significant risk at the moment. The SNB is already forced to expand its foreign reserves (by printing CHF) at an extreme rate in order to defend the artificially weak exchange rate (see figure below).

This is a clear sign that market forces alone are not going to let the CHF depreciate. The only way this can happend is via SNB intervention such as raising the floor to, say, 1.25 CHF/EUR. But why would they do this?

The reason would be to support its exporters and stimulate growth. But the SNB has already forecasted positive inflation in 2013 (albeit conditional on their policy, which may potentially include such an intervention). And the benefits of a slightly weaker CHF will not necessarily justify the risk they take. The money base has exploded and this growth cannot be sustained indefinitely. Based on this picture (see below), one would rather expect the SNB to be forced to abandon its floor rather than raising it. Of course the SNB will not comment on rumors like these, because the rumor works very much to the benefit of the SNB. The more traders expect the CHF to weaken, the less CHF the SNB needs to print. The SNB would in fact benefit from spreading rumors like these, then lean back and let the short sellers to the job for them.

Data referred to above is available here on the SNB Statistics website.

HK moves again to halt currency rise – FT.com

# South African Reserve Bank Quarterly Bulletin: Foreign Financing Still Strong in Q3

THE LAST South African Reserve Bank (henceforth ‘SARB’ or ‘the Bank’) Quarterly Bulletin for 2012 was released today. The main story is a low GDP growth rate (1.2% annualised) cut in half compared to the preceding quarter. The blame for this goes to the violent strikes in the mining sector and its spillovers into other industries. On this blog I will aim the focus on what the bulletin has to say about cross-border capital flows.

The South African consumer demand is still strong, but SA manufacturing is struggling to keep up. Hence, a continued current account deficit of 6.4%, similar to the second quarter. This deficit was funded by financial inflows that were still strong in Q3 (if this will last into Q4 is unclear given the net non-resident portfolio outflows in October). The SARB explains portfolio inflows in Q3 by international bond investors attracted to a favorable interest rate spread against advanced economies. My personal opinion is that these flows are more likely to be explained by the lower price of risk and / or higher risk appetite in the same quarter (the VIX averaged 17 in the quarter, compared to 18 in the year to date, or 22 since January 2010). This low price of risk is possibly caused by the highly accommodative monetary policies in Europe and the US, and thus correlated to their interest rate differential with South Africa. Thus, one would expect easy monetary policy in these countries to increase flows to SA, but it is a tricky task to determine whether it is via the price of risk or carry trade profitability.

Increased direct investments in the third quarter is explained by the Bank as foreign investors (companies) increasing their equity stake in existing investments and by parent companies extending loans to South African subsidiaries. Current research (eg Shin and Bruno 2012) would suggest that such lending is also a product of lower price of risk globally and low policy rates in the source economies. The recent depreciation of the rand will make these loan porfolios more risky if they are extended in terms of the creditor’s currency, and will adversely affect their willingness to provide further loans to SA business. The Bank explains the weaker rand by labor unrest and illegal strikes, downgrading of Sovereign debt, rising trade deficit and upwards pressure on inflation.

My prediction is that South Africa’s trade balance will remain unchanged in Q4, but demand for South African assets (and indirectly the rand) will fall short of current account deficit at the current exchange rate. This will require a further rand depreciation to allow South African’s to maintain their current consumption level. Given the low growth rate in Q3, one may have reason to hope that the Bank does not respond to rand induced inflation pressure by raising rates.

The full bulletin is available here on SARB’s website.

# A view on Capital Flows: IMF changes its mind

YESTERDAY the International Monetary Fund (IMF) adopted its reviewed institutional view of Capital Flow management and policy. An FT editorial more or less praises this “U-turn” by the IMF. The FT says:

“On Monday, after a thorough three-year review, the fund has accepted institutionally that direct controls can play a useful role in calming volatile, international capital flows [...]

As the IMF rightly argues, the first line of defence against financial instability should always be more conventional macroeconomic tools. When an emerging market is facing a precipitate inflow of hot money, cutting the interest rate and tightening fiscal policy can be more effective than direct controls.”

Initially this view seems very easy to agree with. However, I suspect that a problem for many emerging markets will be the fact that domestic conditions and economic policy does not play a major role in the decision making of global investors. American and European banks buy South African assets because they look for EM exposure, not necessarily because the yield is high. It is very difficult to find statistical evidence that higher policy rates in SA have increased non-resident purchases of SA bonds. On the other hand, the one consistently significant explanatory variable of all non-resident purchases of SA assets is the VIX (the current situation seems to be an anomaly) . That is, capital flows to SA when global risk is low (or risk appetite is high). In such a scenario, a lower policy rate will not do much to reduce this flow of capital.

My favorite current academic research on the topic of global capital flows is being done by Hyun Song Shin at Princeton University. He has presented his observations at multiple conferences, including the 2011 High-Level Conference by the Brazilian Authorities and the IMF on Managing Capital Flows in Emerging Markets. In the audience at this conference sat Dr. Olivier Blanchard, Economic Counsellor and Director of the Research Department of the IMF. In a blog post Dr. Blanchard summarized what he took away from this conference, here is a selection of his notes:

None of the tools—be they reserve accumulation, prudential measures, or capital controls—are water-tight. So we should move away from strict policy orderings toward a more fluid approach of using “many or most of the tools most of the time” instead of “this now, that later”.

This lesson seems to have made an impression on Dr. Blanchard, as it nicely summarizes the general feel of the new institutional IMF view published now (more than a year later). Unfortunately Dr. Blanchard does not mention what lessons he took from Prof. Shin’s presentation. Shin’s research has pointed out that many of these capital flows are in fact caused by cross-border banking: A US or Europe based bank lending directly to emerging market clients, or through a local affiliate. Shin’s model predicts that these flows will be determined by US monetary policy and the VIX (price of risk). The model does not allocate any role to domestic policy in the recipient country other assuming capital flows are completely liberalized.

Such a view does not correspond well to the notion that domestic interest rates can be influential in affecting EM capital flows. In that case, if capital flows are deemed to be too costly (risky), regulation may be the only option. Regulation can effectively reduce or stabilize capital flows into a country, but they carry a substantial cost in terms of lost efficiency, competitiveness, and diversification of idiosyncratic country risks. I personally tend to support the idea of liberal capital flows with monetary policy focused on the domestic economy: that is – raise rates when the economy is overheating, even if the overheating is caused by capital inflows.