Dollarize Argentina - Barokong

August 23, 2020    Comment   

Dollarize Argentina - Barokong

Argentina should dollarize, says Mary Anastasia O'Grady in the Wall Street Journal -- not a peg, not a currency board, not an IMF plan, just give up and use dollars.

Another currency crisis is roiling Argentina... The peso has lost half its value against the U.S. dollar since January. Inflation expectations are soaring.

The central bank has boosted its overnight lending rate to an annual 60% to try to stop capital flight. But Argentines are bracing for spiraling prices and recession.

...the troubles have been brewing for some time. On a trip to Buenos Aires in February, I got an earful from worried economists who said Mr. Macri was moving too slowly to reconcile fiscal accounts.

In 2016 and 2017 the government continued spending beyond its means and borrowing dollars in the international capital markets to finance the shortfall. That put pressure on the central bank to print money so as not to starve the economy of low-priced credit ahead of midterm elections in 2017....

A sharp selloff of the peso in May was followed by a new $50 billion standby loan from the International Monetary Fund in June. With a monetary base that is up over 30% since last year, in a nation that knows something about IMF intervention, that was like waving a red cape in front of a bull.

The peso was thus vulnerable when currency speculators launched an attack on the Turkish lira last month and the flight to the dollar spilled over into other emerging markets, including Argentina. After decades of repeated currency crises, Argentines can smell monetary mischief. A peso rout ensued.

Conventional Wisdom these days -- the standard view around the Fed, IMF, OECD, BIS, ECB, and at NBER conferences -- says that countries need their own currencies, so they can quickly devalue to address negative "shocks." For example, conventional wisdom says that Greece would have been far better off with its own currency to devalue rather than as part of the euro. I have long been skeptical.

It's not working out so great for Argentina. As Mary points out, short term financing means there can be "speculative attacks" on the currencies of highly indebted countries that run their own currencies, just as there can be runs on banks. And Conventional Wisdom, silent on this issue advocating a Greek return to Drachma, was full in that the Asian crises of the late 1990s were due to "sudden stops," and such speculative machinations of international "hot money."

Well, says CW, including the IMF's "institutional view," that means countries need "capital flow management," i.e. governments need to control who can buy and sell their currency and and who can buy or sell assets internationally.  Yet Venezuela and Iran are crashing too, and not for lack of capital flow "management." My understanding is Argentina does not allow free capital either. Moreover, if there is a chance you can't take your money out, you don't put it in in the first place. There is a reason the post Bretton Woods international consensus drove out capital restrictions.

So I agree with Mary -- dollarize. Just get it over with. What possible benefit is Argentina getting from clever central bank currency manipulation, if you want a dark word, or management, if you want a good one? Use the meter and the kilogram too.

There is a catch, however, not fully explicit in Mary's article. The underlying problem is fiscal, not monetary. To repeat,

"Mr. Macri was moving too slowly to reconcile fiscal accounts. ...In 2016 and 2017 the government continued spending beyond its means and borrowing dollars in the international capital markets to finance the shortfall."

So, I think it's a bit unfair for Mary to complain that Argentina's problem is that it "has a central bank." I don't know what any central banker could do, given the fiscal problems, to stop the currency from crashing.

If the government dollarizes, it can no longer inflate or devalue to get out of fiscal trouble. Argentina has pretty much already lost that option anyway. If the government borrows Pesos, inflating or devaluing eliminates that debt. But if the government borrows in dollars, a devaluation or inflation taxes a much smaller base of peso holders to try to pay back the dollar debt.

Still, a dollarized government must either pay back its bills or default. That's how the Euro was supposed to work too, until Europe's leaders, seeing how much Greek debt was stuffed into French and German banks, burned the rule book.

So the underlying problem is fiscal. With abundant fiscal resources, the government could have borrowed abroad to stop a run on the Peso. And without those resources, dollarization will not solve its debt and deficit problem. Dollarization will force the government to shape up fast, which may be Mary's point.

Dollarization will insulate the private economy from government fiscal troubles. This is a great, perhaps the greatest, point in its favor. Even if the government defaults, companies in a fully dollarized, free capital flow economy, can shrug it off and go about their business. Forced to use pesos, subject to sharp inflation, devaluation, capital and trade restrictions, the government's problems infect the rest of the economy.

Last, CW likes devaluation and inflation because it supposedly "stimulates" the economy through its troubles surrounding a crisis. That strikes me as giving a cancer patient an espresso. Argentina is getting both inflation and recession, not a stimulative boom out of its inflation.

Dollarization is not a currency board, which Argentina also tried and failed. A currency board is a promise to keep the peso equal to the dollar, and to keep enough dollars around to back the pesos. Alas, it does not keep dollars around to back all the governments' debts, so the government soon enough will see the kitty of dollars and grab them, abrogating the currency board. Dollarization means the economy uses dollars, period, and there is no pool of assets sitting there to be grabbed.

Europe's Banks - Barokong

August 20, 2020    Comment   

Europe's Banks - Barokong

My visit to Europe resulted in many interesting conversations. There was a stark contrast between the complex regulatory vision of formal presentations and papers, and the lunch and coffee discussion reflecting experience of people involved in actually regulating banks. They seemed to be quite frustrated by the state of things. Disclaimer: this is all completely unverified gossip, and remembered through a fog of jet lag. If commenters have better facts, I'm hungry to hear them.

Risk weights are ungodly complex, and not many people actually understand them, or the layers of buffers and how they are applied.

Risk weights are suspiciously low. Big banks are allowed to use their own models, calibrated on 10 years of data. That means the data have, now, 10 years of stable growth and very low default. Look, say the banks, our investments are nearly risk free.

"Micro" regulators who look at the specifics of an individual bank are prone to offset the "systemic" and "macro-prudential" efforts. Look, say the banks, we have to fulfill all these macro-prudential rules, give us a break. Regulators do.

The financial regulatory community has been preoccupied with writing reports about one thing after another. Meanwhile, the elephant remains in the room:  Italy may default or leave the euro.

Italian banks remain stuffed with Italian government bonds. I learned some new words for this: a "doom loop." If the government defaults, the banks go with it.  Some smaller foreign banks still have large investments in Italian bonds. Another new word: "Moral suasion," governments encouraging banks to buy a lot of their bonds.  I imagine the Godfather had more colorful words for it. On the other hand, Italian banks are reportedly happy for the moment, since as long as Italy doesn't actually default, they make a bundle from high interest rates. Government debt is still treated with low or no risk weights.

In case it isn't obvious here's the problem. A sovereign default is bad enough. But if the banks are stuffed with government debt, then a sovereign default brings down the banking system. Depositors lose their shirts, and the banks, who know how to distinguish good from bad borrowers, are shut down. A calamity becomes a catastrophe. And an economy with failing banks will be bringing in a lot less tax revenue and more likely to default.  Government debt in a currency union without banking union is a singularly bad investment, because as currently construed governments give deposit insurance (explicit or implicit).

All this is obvious to anyone looking at it, and leads to a big sigh about "political pressure." 10 years on, and Europe can't quite bring itself to say that sovereign debts are risky. Understandably. This is a club of equals, and it's awfully hard to say that some debts are better than others.

But this elephant has been careening around the room for 10 years. There was a Greek crisis which should have gotten some attention!

Some want a full banking union, breaking local bank regulation and allowing large transnational  banks to operate fully, breaking the doom loop. Some want full fiscal union to go with monetary union. The current model, pressure from the rest of Europe for governments not to borrow so much, and thus to never face a potential sovereign default, has clearly failed.

In my view, monetary union without fiscal union works fine, so long as we all understand that governments can default, and their debt should be treated just as risky (and sometimes junk) corporate debt on bank balance sheets. And, of course, if capital requirements were doubled, tripled, or more, so that banks could sail through a sovereign default, the problem would solve itself.

It occurs to me that simply removing risky local government debt from banks would go a long way to solving the problem. Defaultable government debt should be held via floating-NAV mutual funds, not via bank accounts.

Additionally, there is a big kerfuffle going on that Italy's central bank owes Germany's a lot of money.   Italians see this coming, and there is a lot of capital flight out of Italy. When an Italian writes a check from an Italian bank to buy an apartment in Germany, the money flows from Italian bank to Italian central bank, to German central bank, to German bank. Except the Italian central bank essentially makes a promise to pay rather than actually paying. Italy is basically expanding government debt in this way. I don't totally understand it, nor did most people I talked to about it, and there is a wide disagreement whether this is another debt or just an accounting glitch. Still, that most people at a financial regulation conference know this is a big problem and nobody is quite sure what it means is telling.

With this background of lunchtime and coffee conversations, the written products of the financial regulation community have a surreal quality. The illusion of technocratic competence is always present in bank regulation discussions, but even more stark with this backdrop.

Look for example at the website of theFinanical Stability Board and the issues it thinks are important. As one example, the summary of FSB priorities for the Argentine G20 Presidency. It starts well enough, "Vigilant monitoring to identify, assess and address new and emerging risks." But what's the number one such risk? You would think, in honor of the Argentine presidency, with Italy the number one topic of conversation at lunch, and with who knows who owes who what in China, it would be "sovereign risk." Nope. Crypto-assets is number 1: "The FSB will identify metrics for enhanced monitoring of the financial stability risks posed by crypto-assets and update the G20 as appropriate." Then,

Disciplined completion of the G20’s outstanding financial reform priorities....During the course of the year the deliverables to the G20 will include the following areas: the correspondent banking Action Plan including improving the access of remittance providers to banking services; a toolkit for firms and supervisors on the use governance frameworks to reduce misconduct in the financial sector; leverage measures for investment funds to support resilient market-based finance; guidance on financial resources available to support central counterparty (CCP) resolution to deliver resilient and resolvable CCPs; a cyber security lexicon to support consistency in the work of the FSB, standard-setting bodies, authorities and private sector participants; and the private sector-led Task Force on Climate-related Financial Disclosures’ report on voluntary implementation of its recommendations to highlight good practice and foster wider adoption.

Sovereign risk is not mentioned once in this document. And I did not find it anywhere on the FSB website.

If you read between the lines, there is a very worthy reaction to this tendency to produce complex hot air that changes with each presidency:

Pivoting to policy evaluation to ensure the reform programme is efficient, coherent and effective. The FSB is increasingly pivoting away from design of new policy initiatives towards dynamic implementation and rigorous evaluation of the effects of the agreed G20 reforms.

Floating rates? - Barokong

July 25, 2020    Comment   

Floating rates? - Barokong

I was interested to read in the Financial Times, "Iceland weighs plan to peg krona to another currency":

Iceland’s finance minister has admitted it is untenable for the country to maintain its own freely floating currency....Benedikt Johannesson told the Financial Times that the Nordic island of just 330,000 people would look at options to link Iceland’s krona to another currency, most likely the euro or pound.

“Is the status quo untenable? Yes. Everybody agrees on that. We’d like to have a policy that would stabilise the currency. It’s really not good when a currency fluctuates by 10 per cent in the two months since we took over,” said Mr Johannesson, who became finance minister in January.

The main thing is if you want to peg against a currency, do it against a currency where you do business. Once you decide on a currency, that will also change the future. You will do more business with that area,” he added, pointing to Denmark’s experience of doing more business with Germany after pegging its currency first to the Deutschmark and then the euro.

This is interesting in the context of Conventional Wisdom, which says the euro is a bad idea, and every tiny country needs its own currency, to devalue any time there is a "shock." In this view, Iceland is a great success because it did devalue after its banking crisis. I am a skeptic, largely favoring a common standard of value. Greece did not become a growth tiger from its previous umpteen devaluations. I'm interested that even the supposed success story for devaluation does not see it that way.

Update (via marginal revolution) here at Bloomberg. The idea is controversial.

Everyone wants a float after the fact, to devalue their way out of trouble. But everyone should also want a peg before the fact; the firm commitment that you will not devalue your way out of trouble makes international investment and trade flow much better.

Long Run Lira? - Barokong

July 23, 2020    Comment   

Long Run Lira? - Barokong

Luigi Zingales inaugurated a series of essays in Il Sole 24 Ore, an Italian newspaper, on whether Italy should stay in or get out of the Euro, and graciously asked me to contribute. My view, here in English, here in Italian.

To be clear, I kept to Luigi's terms of the debate. This piece is only about whether Italy is better off in the long run, with a common currency. Whether it gets anything out of an exit, a devaluation, a default now is for another day. And this is just about currency, not about leaving the EU, not about debt or austerity, not about whether europe needs a fiscal union, or the rest of it. (Some subsequent correspondence verifies the wisdom, but also the difficulty, of talking about one thing at a time.)

Return to the Lira? A long-run view (Not very good English title)

The euro isn't perfect, but it isn't bad. (Much better Italian title)

Should Italy have her own currency, and run her own monetary policy? For today, let's focus on the long-run question, leaving out for now the transition and any immediate benefits and costs. When contemplating a divorce, it is wise to focus on what life will be like when everything is settled, not just who will have to wash today's stack of dirty dishes.

Remember first that monetary policy cannot substantially improve long-run growth. Long-run growth comes from people and productivity, how much each person can produce per hour of work. In turn, productivity comes from innovation, new companies, new ways doing business, and new products. Like Uber, consumers benefit and existing producers are disrupted. Improvements in long-run growth come only from structural reform, not monetary machination. Money is like oil in a car. Bad monetary policy, like too little oil, can drag an economy down. But after a point more oil will not help you to go faster — you need a bigger engine.

In the short run, monetary policy can also “stimulate” an economy. It's like an afternoon espresso — good when you're feeling a little sluggish, but not wise to drink all the time, and in the end no substitute for diet and exercise. And that is the major advantage offered for an independent currency and monetary policy — the possibility that a wise monetary authority can offset bad shocks with occasional bursts of devaluation and inflation.

But “wise” is a major caution. When the central bank lowers interest rates, inflates, or devalues, that helps exporters, but hurts importers; it helps government finances, but lowers the real amount the government pays its workers, pensioners, and bond-holders; it helps borrowers but hurts those who lent money to the government, homes and businesses.

Once hurt, they wise up. Anticipating the next devaluation and inflation, workers and pensioners demand indexed wages and pensions. Bond investors demand higher interest rates.

So having your own currency really only works for a government whose finances are in sound shape, and whose public institutions are strong enough to resist the constant clamor for one more inflation. Just this once. Again and again.

Staying in the euro thus represents an important pre-commitment. By forswearing the ability to easily devalue and inflate ex-post, Italy benefits from much better credit and investment ex-ante. It is up to her to use this credit wisely, as Greece so notably did not.

Devaluing and inflating is said to work because prices and wages are “sticky,” and do not quickly adapt to inflation. Thus people are fooled into working harder than they would otherwise, or into accepting wage and price declines they would refuse if they could see them directly. But, if used often, they too will wake up and stickiness vanishes.

Furthermore, devaluation and inflation to exploit such stickiness can address an overall level of wages or prices that is too high, but it cannot address an industry or a region that is too high while another is too low. And variation across industries and regions is larger than variation across countries. If stickiness is the problem, it would be much better to remove all the policies that encourage sticky prices and wages in the first place. For Italy in particular, the arguments for one currency are really arguments for two currencies, one for the North and one for the South.

If that sounds unappealing, perhaps one currency is unappealing too.

Italy will face tight limits on what it can accomplish with wise monetary policy. Let us hope that having its own currency means Italy still somehow remains a member of the European Union, or at least its somewhat free-trade and free-investment area, like Denmark, Norway, or pre-Brexit UK. Let us hope that Italians can still buy and sell goods freely across Europe, they can conduct their business in euro or lira, own bank accounts in both currencies, freely buy and sell securities, work in Europe and hire whom they please.

Do not take all of this for granted. The first thing many governments do, faced with weak currencies and government debt problems, or noticing their monetary stimulus efforts have little effect, is to force their citizens to use that weak currency, to ban foreign bank accounts, to limit citizens' rights to buy and sell euros or to borrow or invest abroad. They limit foreign banks, in order to prop up domestic banks who must hold domestic currency and debt. They limit the interest citizens get at banks, and allocate bank credit.

All this passes under bureaucratic bromides like “capital controls.” Economists call it “financial repression,” which gives a better sense of its effect. This is the kind of monetary policy that, like removing oil from a car, really can slow it down. And it is not clear that Italy even can leave the euro without leaving the EU.

If Italy remains open, as she must to grow, monetary policy will always be constrained by the exchange rate and competition from the euro. Too much loosening will cut the exchange rate too much, and vice versa. Wild exchange rate fluctuations are bad for business and investment all around. Italians will just use euros instead, undermining the value of a domestic currency, leading to capital controls. Even Iceland is now thinking it should peg to the euro. Switzerland and to a lesser extent Denmark are fighting hard to keep their currencies from rising.

So will Italy be better off in the long-run, back with her old sweetheart, the Lira? A well-managed currency within an economy open to trade, capital, and people, can have some benefits. The experience of pre-Brexit UK, Denmark, Switzerland, Norway, or Sweden offers small advantages, some challenges, and no particular disasters so far. The experience of pre-euro Italy is less encouraging, that of pre-euro Greece less so, and that of many small countries challenged by debt and growth less so still. Round after round of inflation and devaluation did not produce prosperity, and capital and exchange controls hurt growth substantially.

In the end, no monetary machination can substitute for a dynamic real economy. The Euro, while not perfect, is pretty good, and it offers an important pre-commitment against bad policy. The dangers and temptations of a Lira do not, in my view, compensate for the loss of an occasional afternoon espresso of stimulus.