The Econometrix

Following up: The Debt Ceiling Negotiation and its Consequences - pos.org  (http://pos.org/documents/a_pivot_point_in_american_opinion_the_debt_ceiling_negotiation_and_its_consequences.pdf)

Fact #1: There are losses embedded in the system and someone is going to have to write them down.

Fact #2: The intuitional costs of default or bankruptcy are sufficiently large that no one goes through it for a small write-down.

Fact #3: Sovereign countries whose debts are denominated in nominal terms over which the country has control, have the ability to decrease the real value of the debt without going through default, by either inflation or devaluation (usually both).

There are basically four options in responding to Fact #1: they can be mixed together, but I'm not sure that mixing the choices makes them more palatable. 

A) Germany can take all the losses onto their balance sheet, with or without the common fiscal union, which might protect them from having this happen again.

B ) The private sector can be forced to take the write downs via default.

C) Devaluation/Dissolution: Germany and the ECB can toss Greece out of the club.

D) Devaluation/Inflation: Germany and the ECB can inflate away the debt overhang of the debtor countries in nominal terms.

The European banks like option A, but the Germans have been reluctant to take on all the debt overhang of the debtor countries of the Euro, with good reason.  The amount of debt is enormous, and only the Germans (with help from France and the IMF) would be able to do so. This is the path that Europe has been going down so far, but as some point Germany may well hit its Not-Another-Pfennig limit.

Everybody is afraid of the knock-on effects of option B. What if the Greek default is just the first of a series?  This is what the market has been pricing into bond interest rates.  I am not convinced that this option is made easier or cheaper by waiting to pull the trigger.  The European financial system is very afraid of this one, because while they have been off-loading their debt to the Germans (directly and via the ECB and EFSF) and the IMF, many financial institutions will be technically insolvent. So in this event many billions of dollars would be needed to bail out the European financial system.

Option C would be a complete disaster. There would be bank runs in not only Greece, but also in any country that might eventually be in the same position, causing cascading financial system failures.  This would be Very, Very ugly.  Another ugly possibility would be that Germany leaves the Euro.  It is usually the strongest member that breaks up a currency union.  If they really consider kicking Greece out of the club, they may want to suddenly (without warning) dissolve the whole thing, so there is less time to have Euros slosh into Germany.

Option D is the least painful option.  This option is the reason why sovereign debt denominated in the borrower's currency is generally rated more highly than other sovereign debt.  If you don't face the default threshold problem, you can write it down by small increments of 5% a year instead of 25% all at once. The problem with any default is that once you pay the reputational cost of a default, you might as well really write it down.  Nobody goes through bankruptcy to get a 5% write-down.

The problem with option D is that Germany controls the ECB and they are serious inflation-phobes.  Otherwise, they would have bailed out Greece last year and Helicopter Jean-Claude, would have promptly monetized the bailout....problem solved.  All the other seriously-indebted countries would have benefited by having the real value of their debts decrease and the Euro economy would have benefited from the resulting devaluation. 

So 11 out of 30 days I failed to workout, which is not bad. Essentially, it is one day better than I had expected of myself. I have already paid my ‘penalty’ through the donation matching program at work, so the net effect for the beneficiary is even better.

As a challenge it has been a very good thing all around. I probably went to the gym a total 5 times when I otherwise would have on margin slacked. On total, I went from say an average of 2.5 days a week to much closer to 4 times a week. And I finally donated to a charity that I have been meaning to donate to for a long time. I listen to NPR more than any other station on my fairly long commute.

Interestingly to me, it was more the embarrassment factor, rather than the money, that got me up out of the chair. I am still considering whether to do it again.

A web site that combined these pick-your-charity and costly-commitment ideas might be a very good way to both raise money for charity and get people to actually make good on their resolutions. Hmmm….

Since the financial crisis began, Ken Rogoff has been advocating that the Fed target inflation, in this case substantially more inflation than we currently enjoy. In early 2009, he suggested 6% for a couple of years.  And from recent articles it looks as though he is still of that opinion. Given that fiscal policy is now no longer going to be able to help pull us out of the economic swamp, we are going to need whatever policy tools are still available, which is the Fed, basically.

Why does inflation work to stimulate the economy? There are many mechanisms, but two that I think would be particularly powerful in this economy, are that it would induce the banks to start lending, and it would inflate away some of the remaining debt overhang.

But the hard part of being in a liquidity trap is that monetary policy is not very effective. Once the Fed took short term interest rates down to 0% interest, all they can do is quantitative easing, which has kept longer term interest rates down and put more cash in banks, but with the banks unwilling to lend, it hasn’t really had much effect.

How do you get inflation, if you are the Fed Chairman in the middle of a liquidity trap and fiscal policy has been shut down? You have to make a credible commitment to inflate, to poor money into the system, not just now, when the money goes into the black hole of a liquidity trap, but even after inflation starts to kick in. You have to give people the expectation of inflation on the other side of when you would normally start soaking up the excess liquidity.

Therefore, I think this statement, “exceptionally low levels for the federal funds rate at least through mid-2013” has more meaning than commentators have so far ascribed to it.

S&P Downgrade

The opinion of S&P only matters because we gave them, and continue to give them, special status as a Nationally Recognized Statistical Rating Organizations (NRSRO). The Securities and Exchange Commission conferred this special status on a number of private companies in the 70’s, effectively creating a government sanctioned oligopoly.

What we need to do is remove S&P from the list of NRSROs.  Sure it would look punitive, and political, but so does the downgrade…and it might literally kill them.

And it is not as though S&P has such a fabulous track record.

As this NYT piece points out, S&P ratings have negative value. Debt-to-GDP ratio alone is a better predictor than S&P sovereign debt ratings.  And if you have the current credit default swap information (public info) you can make money betting against S&P ratings.  This article is a beautiful piece of econometric analysis; I wish I had written it. 

Maybe we should de-list all NRSROs that cannot show that they add value compared to simple metrics available from public information.