Interfluidity has an excellent post on Greece and I don’t wish to repeat what he’s written much more fluently than I could. But I want to use something he said as a segue into a deeper conversation about how we should think about Greece (and sovereign default in general):

I’ll end this ramble with a discussion of a fashionable view that in fact, the Greece crisis is not about the money at all, it is merely about creditors wresting political control from the concededly fucked up Greek state in order to make reforms in the long term interest of the Greek public. Anyone familiar with corporate finance ought to be immediately skeptical of this claim. A state cannot be liquidated. In bankruptcy terms, it must be reorganized. Corporate bankruptcy laws wisely limit the control rights of unconverted creditors during reorganizations, because creditors have no interest in maximizing the value of firm assets. Their claim to any upside is capped, their downside is large, they seek the fastest possible exit that makes them mostly whole. The incentives of impaired creditors are simply not well aligned with maximizing the long-term value of an enterprise.

There’s no getting around the fact that Greece needs debt relief. The IMF has made this clear in no uncertain terms. If the fundamental purpose of finance is to align asymmetric incentives in an efficient way, creating an environment of trust, and hence lending and development, the Greek dilemma is more than a failure of European integration. It’s a failure of finance itself.

Where Steve Randy Waldman channels his fury at the political failure of European authorities, Michael Pettis has an extraordinarily prescient essay – from February! – begging Europeans to pay attention to financial distress and poorly aligned incentives. You have two ways of doing this. You can either tell Greece that you won’t roll over its debt unless it engages in a series of politically unpalatable policies to secure your principal or you can recognize that success is shared and create a debt structure that reflects this mutual enterprise.

Quite simply, the Greek government should sell optionality on its prosperity. As much as countries are not corporations one of the purposes of Chapter 11 is to ensure that senior creditors do not force an inefficient liquidation on the entire corporate structure. For example, selling assets to meet financing requirements even if the company has a really good ten-year plan. Or, for example, forcing a degree of austerity that would wreck domestic agency to make your initial investments whole.

And whatever you think about fiscal policy, that’s exactly what this is. Whether you like Syriza or not, that is the democratically-elected government of Greece and hence its representative. And, therefore, by proposing a restructuring scheme that forces the other party into capital controls that asphyxiate domestic business you are partaking in precisely the form of liquidation that Chapter 11 seeks to avoid.

At least in the case of a distressed shipping company – or whatever – it’s possible to see why someone would want this. The number of senior creditors are small, the upside is capped, and the benefits to immediate liquidation are obvious. In the case of forcing Greece to make whole its current capital commitments the benefits are distributed across millions of European tax payers, the costs are concentrated among the Greeks, and that’s not even considering the spillovers of financial distress and turmoil generated by the plan.

And don’t kid yourself that the referendum changes things. A “no” vote only exacerbates the above and the “yes” vote seems to be the precise definition of “kicking the can”. As I’ve written before, if you eventually default (and Greece will, in some fashion or form, default) it will always have been better to default one day before after the fact.

Senior creditors are, when they cannot be made whole, given the option to buy equity (at what would be a discounted price relative to normal liquidity conditions). Some will sell these and write-off their losses, furnishing a lucrative industry in special situations investing. Regardless, creditors painfully recognize their losses, and move to align their incentives with the firm, gaining optionality in the process.

One obvious way to do this is to exchange a meaningful portion of the principal for GDP-indexed bonds. These have been discussed in detail elsewhere. It’s not clear that these are a bad idea, but it’s certainly not clear they’re a good idea, either – or the quickest and most obvious way to align European incentives. Argentina sold GDP-warrents in 2002 and investors were recognizing dramatic losses years after the fact (that’s not necessarily an indictment of the idea as much as that they are a straightforward salve). Not to mention Greece actually offered something like a GDP-bond in 2012 without any of the benefits proponents advocated (again, this might be an issue of magnitude but that’s not really the question).

Rather, Greece can sell calls on its export revenue. For one, this isn’t subject to the same measurement complexities that plague GDP (and when we’re talking billions of dollars in coupon payments, this matters). More importantly, exports are a much quicker and sensitive guide to adjustment performance than GDP, which can years to reflect structural improvements. Now the obvious flaw of export calls by themselves is that it’s not clear that the Greece government really cares about higher exports (even if its population does).

Here we can incorporate German sensibilities. Exports that fall below some benchmark on which the option is indexed incur a penalty in proportion to outstanding debt that would come out of a pool of “optional austerity” consisting of pensions, national assets, and defense spending. This would ensure that authorities engage in the sort of reforms – removing red tape, reallocating taxes, subsidizing the right things, and encouraging devaluation over unemployment – in a way that austerity resulting from failure would be predictable.

The final part is important. The IMF wants to give Greece a 20-year grace period before requiring any debt payments. What if we cut that in half, and indexed the coupon payments by an reverse exponential weighted average of net export performance over the next 10 years. This would allow Greece the freedom to implement policy that is responsible but not too responsible.

Maybe austerity is necessary and maybe it’s not. We can recognize the corruption of the Greek government without making a claim on how much austerity it needs. Michael Pettis has the key point:

The same process occurs within any economic entity, including a national economy. It is not an accident that in nearly every case in history in which countries have excessively high debt levels or have undergone debt crises, policymakers have never been able to keep their promise that, with forbearance from creditors and the implementation of the right reforms, the country can grow its way back into full solvency. Historical precedents are pretty clear on this point. Countries suffering from debt crises never regain growth until debt has been partially forgiven — explicitly or implicitly — and the uncertainty associated with its resolution has either been sharply reduced or eliminated.

And we shouldn’t expect Greece be any different. Without growth any Greek repayment schedule is doomed. Economically yes, but politically certainly. By opening a market determined pool of austerity as Greece misses its export (or other benchmark) targets, and offering the upside on any growth above that benchmark over the next 10 years, authorities will be forced to focus on a long-term economic salve. And, in this world, we let Greece grow and pay back what it can first, if that doesn’t work take a cut from its optional austerity pool, and if that doesn’t work let it default once and for all. And that’s basically what Eurocrats should have done decades ago.

Addendum: Tyler Cowen doesn’t agree with the Steve Randy Waldman post on what I think is weak reasoning. Germany is trying to maximize its return as senior creditor. In a Chapter 11 (not that this is the same, but follow the logic), the court’s responsibility is to maximize stakeholder value. To the extent this is more than a plain wealth transfer – that it will further depress demand in a region already rife with unemployment and poverty – further austerity does not meet the criterion. Sure, the German government has a responsibility to its taxpayers, but the per capita cost of a “stakeholder maximizing” agreement, I suspect, is not meaningfully important. (Yes, folks, the ECB’s monetary policy very likely had fiscal risks).

For Germans maybe it’s about setting precedent. For one, it really isn’t clear that Greek is strategically defaulting because it doesn’t feel like it (the austerity it has endured remains testament to its commitment to a European project). As IMF reports I’ve linked to before suggest, in most cases default isn’t costly precisely because markets don’t believe it sets some sort of precedent of irresponsibility.

Regardless, to the extent setting precedent is about the continuity of the European project, one can’t seriously argue that recent brinkmanship (on either side) has served greater service to further unity. Germany should allow this because there seems to be near-unanimous consensus that its preferred policy landscape is not maximizing the value of the European enterprise.

(On the criticism of American economists, he is right. Capital controls are a form of austerity – granted maybe an ideal form of austerity – requiring much short-term pain for potential long-term payoffs. It is easy to sit at Princeton and suggest that this is a good idea, when trade credit dries up and importers cannot purchase energy to turn on the lights it is quite a different matter).

On what might be the eve of capital controls in Greece – bifurcating the unified currency zone – I want to bring some attention to an 2008 IMF paper and literature review of the costs of sovereign default. The most interesting result is… well, I’ll let the authors speak for themselves:

Perhaps the most robust and striking finding is that the effect of defaults is short lived, as we almost never can detect effects beyond one or two years.

Of course, the paper is richly caveated and many of the regressions performed include Latin American countries which occupy a different role in world trade and the international financial system than Greece, not the least the dual dynamics of default and Grexit that complicate any simple analysis, especially given the beyond monetary interest implicit creditors (i.e. the ECB) have in maintaining the Euro.

The authors, Borensztein and Panizza, identify four primary casualties of default: reputation, freedom to trade, the domestic banking system, and the incumbent government. These can be measured by credit rating or spread, trade balance, currency dynamics, and political upheaval respectively. Their conclusion points to an important pattern in historical defaults (including voluntary restructuring) – they were necessary and, more importantly, markets agreed.

Necessary in contrast to strategic – whereby the government elects to shortchange its financial creditors instead of its political creditors on the expectation that the former will be more forgiving than the latter (such as pensioners who vote). Part of the question might be what qualifies as strategic, and we’ll get to that. For now, the question of Greek default can be captured as:

The “default point” for a sovereign should be the point at which the cost of servicing debt in its full contractual terms is higher than the costs incurred from seeking a restructuring of those terms, when these costs are comprehensively measured.

Here is where the Syriza negotiating position becomes tenuous. If we define strategic default as any default that could be avoided by another negotiating party that could realistically realize general support from the electorate, it’s not clear the Varoufakis argument that Greece has made 75% of the compromise and creditors ought to yield on the rest is correct. With over two-thirds of the population favoring a deal over “rift with Europe”, and approval ratings falling by some 35 percentage points since April – Syriza seems to be overplaying its hand with respect to how much more Greek’s are willing to give up.

This conversation should be divorced from your moral calculus of Greek’s obligation – whether that be from the Left that Greek’s have realized more peacetime austerity, unemployment, and pain than any other nation and cannot reasonably give up more or whether it be from the Right that it’s incredulous Greece can pay out pensioners and maintain living standards well above some implicit creditors like Latvia where living standards are lower. The only thing that matters is the divergence between what the government will give up and what the people are willing to give up – and the people seem to be saying “make that deal now”.

Syriza is, of course, well aware of this and hence delaying default to the latest extent possible (in hope of extracting a deal without further concessions). As the IMF paper suggests, this is generally not a good thing:

High political costs have two important implications. On the positive side, a high political cost would increase the country’s willingness to pay and hence its level of sustainable debt. On the negative side, politically costly defaults might lead to “gambles for redemption” and possibly amplify the eventual economic costs of default if the gamble does not pay off and results in larger economic costs. Delaying default might be costly for at least three reasons: (i) Non-credible restrictive fiscal policies are ineffective in avoiding default and lead to output contractions; (ii) Delayed defaults may prolong the climate of uncertainty and high interest rates and thus have a negative effect on investment and banks’ balance sheets; (iii) Delayed default may have direct harmful effects on the financial sector.

Many of the costs outline here seem to identify precisely the problem Greece is facing today – in extending its negotiation (gamble?) rather than defaulting. I’m an outsider. Maybe Varoufakis really thinks he can get his creditors to eat the rest of burden but it’s important to note here that this would still be default – at this point it really is only a question of partial versus complete default.

Europe really would want to accept this deal – partial capital loss would be much preferable to whatever restructuring Syriza would exact in the absence of a deal – but there is the natural concern of other peripheral countries asking for a similar deal. While I am more optimistic on Greece than some – like Larry Summers – I don’t fully share the confidence that most of the credibility problems would be gone in 2 years.

For one, let’s consider the third cost of default: freedom to trade. They divide this into two categories: (1) the emergence of retaliatory embargoes against defaulters and (2) the evaporation of trade credit necessary for importers to function. (1) is basically a theoretical concern at this point – something international macro papers use in their models but not a real or credible threat, especially with an EU country. (2), the authors find, doesn’t have a genuine long-run impact on existence of trade creditors.

I’d push back against this for Greece, and we don’t need to look further than 2012 to see why. In the first Euro crisis, trade credit insurers uniformly reduced their coverage of Greek debt on the risk that importers would still be obligated to repay their credit in Euros even when Greece gets on the drachma – and no one wants to be exposed to risk of external debt default. This is bad. Headlines such as “Greece Struggles To Keep The Lights On As Trade Credit Crunch Bites” weren’t figurative – energy exporters were no longer comfortable with Greek importers with the absence of trade credit insurance.

Therefore, unlike other countries which would default on their own currencies, Greece faces the legitimate struggle of feeding itself with baklava and olive oil – further escalating the political incentive to delay default.

You might reply that default need not imply Grexit and you might well be right, but that’s not the point. Default will with certainty bring about harsh capital controls on real and financial assets. A Euro in Greece will no longer be a real Euro and, unless importers have huge foreign balances with which to collateralize their purchases, the depreciation of the Greek Euro versus the Euro Euro will unleash similar dynamics on trade credit insurers as in 2011.

Unless, of course, investors have a credible schedule of when capital controls would be relaxed but if the government was in any position to give markets that relief it’s highly unlikely they would need capital controls in the first place.

But I’m less pessimistic than someone like Summers because my key reading of the IMF paper is that reputational costs remain small in the medium-term. If Greece defaults there’s no reason – after extensive depreciation of the drachma – why Greece couldn’t credibly commit to increasing revenues given the rapid external devaluation of its labor and obtain financing to scale those revenues and invest in, well, whatever.

I’m not as sanguine as Krugman, with his exception that he cannot think of “any examples that fit this story”. The trade credit disaster in 2011 is enough to provide one of an example of what might happen in a drachma world. And here economic recovery stands in one-to-one contrast with financial stability, i.e. to what extent can Greece dramatically undervalue the drachma.

If Greece defaults this will be the important dynamic it needs to figure out. One good bet might be to determine a drachma level that is sufficiently weak – but strong enough to finance highly price-inelastic imports such as energy inputs without entering into another fiscal death-spiral – and use its Eurosystem collateral (which would be expropriated in the event of default) to guarantee that level. By definition, there has to be an optimal level, and if Greece comes close enough to this, markets should have faith that it will defend against further devaluation. This would be a critical first step in reentering international debt markets.

There would be little margin of error here, as it works in the same sense that a one-time wealth tax “works” (as they are, in principle, the same thing). Further devaluation, or inflation that puts pressure on Greece’s FX reserves, could result in a currency crisis that is much harder to solve the second time around.

I’m not nearly an expert on the subject, but I imagine if the right thing happens, it will happen in the next 2 days. If and when Greece defaults and imposes capital controls it will always have been better, after the fact, for it to have happened before it actually did. Barclays noted that capital controls could provoke a political crisis bringing a moderate, Eurocrat party into power – “default without EA exit”, it wrote.

This might be necessary, if not sufficient, given the bargaining platform of Syriza – which seems to be leverage Europe’s commitment to the Euro and preference of partial over complete default to minimize its concessions – over a maximal commitment not to default. Krugman likes to denounce VSPs, but if default happens (as the IMF paper confirms) it is better it be supervised by a internationally credible party that would default only in the worst of circumstances.

Regardless who is in power, it will be prudent for the Greek government, if forced into default (i.e. involuntary restructuring), to offer a restructuring no worse than that to which it has already committed in negotiations – this may at least temper future market turmoil.

A few weeks ago I wrote about the unusually strong US net international position. I missed Brad Delong’s rejoinder:

Where Ashok Rao shies at the jump here is in failing to specify where he thinks the market failure is, and how to correct it. Is the demand by foreigners for safe dollar-denominated assets an improper one? And why today is it only the U.S. government–rather than, say, Apple or Wal-Mart–that can tap this funding source? Or is there a deeper problem in that Apple and Wal-Mart could tap this funding source but really do not want to–that they already have all the capital and funding that they think they can use? These are the questions that people are worrying…

I’m going to shoot at the hip here because the honest answer is that I’m really not sure.

To define the terms, I’m not really sure “market failure” is the right concept to think about here. We are talking about certain events led by single actors with a lot of agency and market power (foreign central banks, state owned exporters, finance ministry policy directives, among others). But we can begin to answer the question: are Treasuries unfairly valued given a concerted foreign interest in maintaining high dollar reserves.

There are multiple equilibria here, and that’s exactly what China doesn’t like. On the one hand, China (and its less reserve-oriented neighbors) would like to be free of the “dollar trap” – and yet any move that would motivate such a shift would open domestic central banks to incredible balance sheet risk. So the current equilibrium is maintained by foreign taxpayers who are unwilling to eat the fiscalized risk of prevailing monetary policies.

The next question becomes why aren’t other liquidity providers offering competition to the US Treasury (which, per my argument, would be “undersupplied” in some sense). The simple answer is US corporations with the credibility to offer safe, liquid debt are already sitting on piles of cash without any meaningful investment opportunities – they themselves are funders, and do not need any funding source. Moreover, for risk and liquidity reasons these bonds are undesirable from a central bank perspective. US Treasuries are traded 8-10 times as frequently as all AAA corporate debt, on a volume basis. The liquidity and risk is reflected in a historically high AAA10Y spread:

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The spread spiked in the late-1990s for the reasons previously outlined – Asian markets suddenly rocked by the instability of large external debts and low dollar reserves instituting policies to maintain defensive central bank positions. The mid-2000s decline is a little puzzling – as Asian countries continued to pour into Agencies and Treasuries – “reach for yield” hypotheses and a declining trade position might serve to explain the decline in spread – though this is still an open question.

The important point is that we’ve returned, and never really recovered from, the 1990s environment of relatively high spreads.

So the first question is whether this spread by itself is a “market” failure. From a Chinese perspective, I can’t answer the question – though I imagine the freedom to trade huge quantities without rattling the markets is part of the problem, especially since all AAA credit isn’t really securitized into a hyper-safe and hyper-liquid AAA tranche.

The simpler answer seems to be that people want the US government to be a bank. This is a role it fulfilled with glee in the mid-2000s – not just through its fiscal deficit, but the flurry of agency-backed mortgage origination which, in a foreign investors eye, was a guaranteed dollar deposit (the high liquidity basically means it was always callable). This is a role it didn’t play before 2002 and is one it hasn’t played since 2007. In a sense spreads are returning to the old normal in which the US government is refusing to be a bank. (Note this would also be politically hard to maintain without the guise of Agencies as it effectively requires the issuance of debt without any corresponding increase in spending or decreases in taxes).

In that case, there’s nothing fundamentally improper about the situation today – the big change isn’t an attitude from Asian central banks as much as the withdrawal of US liquidity provision thereof.

This doesn’t answer the question of whether Asian policy is correct, but it does make the question sort of irrelevant – foreign demand (i.e. the alleged global saving glut) isn’t what seems to matter here as much as the decrease in government-guaranteed securities. (Or, more accurately, in their expected stock some n years from now).

Here’s a tangential puzzle. Equity prices are relatively high (implying, given a constant risk preference, an increase in expected earnings growth rate) and yields are relatively low (implying, given a constant capital share of output, a decrease in expected earnings growth rate). So one of the “givens” must be incorrect. Yet if risk premium really fell meaningfully a number of previously unprofitable investments should be in the black, on the margin, encouraging further spending and borrowing by the Apples and Walmarts of the world. That’s not what happened. Maybe, as Tyler Cowen has prompted (if not advocated) to me, it was a fall in labor’s share – but that’s a decades-long process and probably can’t explain short-run dynamics.

More on this soon.

Steve Schwarzman has an op-ed more or less arguing that capital requirements magnify procyclical financial dynamics forcing banks to stop lending when the economy needs it the most. A lot of his points don’t seem wholly unreasonable – if a little unlikely, though we’re obviously talking about tail risk situations – though I find it implausible that this isn’t better than what we had before.

Regardless I want to offer a simpler framework to debate the topic. In short, we need market regulation of risk. This isn’t to say we need an unfettered free market as much as a market informed and credible policy towards regulation. In theory one could potentially achieve this by truly committing against any bailout. Actually achieving such a commitment seems impossible (short of a Rand Paul White House, Elizabeth Warren Senate, and Allen West House). Nothing I’m about to say is especially new, I’m sure it’s been written by a number of commentators before – but it is worth rehashing what a market-determined regulatory system would look like.

A pure market pricing of risk is hard, especially when noting that bank events don’t follow a normal distribution. (One could otherwise imagine banks facing a penalty if their CDS spread breaches a pre-set value). To keep it simple lets restrict acceptable capital to paid-in equity. The core of a market mechanism for regulation must somehow make it easy for a bank to issue equity in a liquidity crisis without paying a steep discount.

Of course there’s nothing free in this world and this discount must be financed by some haircut on the value of its debt as an insurance premium. Further, this discounting mechanism ought to kick in only in a “crisis” situation. One simple solution would require a bank to buy very far out of the money barrier puts on its shares struck at a reasonable measure of its value proportional to its risk-weighted debt.

“Reasonable measure” can be defined in any number of ways and doesn’t really change the theme of the framework. It could be a moving average of closing prices over the past two years. It could be some credible and formulaic measure of the capital it needs to finance its current liabilities. It could be some function of its price-to-book value. The measure doesn’t matter so long as it is well-correlated with general financial health, as the market will price and adjust for any relative discrepancies.

If the puts kick in at some predetermined, low fraction of the bank’s “reasonable value” it can sell its shares for a large premium to current prices – transferring wealth from insurers to shareholders in an elastic and predetermined manner. Because the number of puts it holds is proportional to its relevant, current liabilities, it can in principle finance itself through any liquidity shortages without systematic distortions.

Further, the maturity of the puts it sells should match one-to-one with the debt it issues (and hence, obviously, doesn’t work for deposits) – forcing the bank to constantly be cognizant that it finance its current liabilities without any problems.

These puts can even be traded between banks to stabilize and spread risk in an even and efficient manner. Since the writer of the put obligation owns the right to buy bank shares this – in a fundamental sense – represents high-quality equity (as they will be called upon only in the times when equity matters). So if the barrier kicks in at 50% of current value, and the bank’s “reasonable value” is its current value, the put represents (at worst) one share of the bank to its writer. (Since the bank would obviously sell it at a premium – though I still haven’t fully teased through this, it might be easier to consider as a convertibility clause though I’ll leave that for another post – in theory it really shouldn’t be very different. I can’t find it now but I think someone at either PIIE or AEI has written about this: links would be appreciated).

The government a requirement like the one outlined above would achieve three things:

  • Dampen (maybe even counter) procyclicality.  Banks are able to issue shares at a premium in bad times compared to a steep discount they would face today. It becomes easier to raise capital in a crisis relative to balance sheet than any other time. The worse the crash the bigger the premium.
  • Incentivize better risk allocation. Because banks are forced to buy puts that effectively gauge the probability the bank and financial system will fail to the extent that its share price falls below the barrier, they will actively mitigate risk in a manner convincing to markets (not just regulators) and hence be rewarded for prudence and punished for recklessness. Because of this, we wouldn’t need crazy Basal rules to judge “risk-weighted debt” and have meaningless Tiers of capital, as the market will discount each to the extent necessary. (And, so, limiting the actual procedure to equity capital doesn’t render the other stuff meaningless but channels their value through a simpler avenue).
  • Actively reduce the need for outside (government) assistance during a crisis.

This doesn’t mean relegating any genuine regulatory decisions to the market, but rather only helps government policymakers to focus on the questions that matter: not how various assets should be discounted by risk, but what role is the government willing to take in financial stability and when will it act. In this sense, we can sort of explicate the too-big-too-fail subsidy. Therefore government can make important decisions such as what “reasonable value” means, and the extent to which a bank needs to be able to finance itself in any situation (that is the high level situation we are trying to answer now, anyway, but this leaves the hard work up to the competence of the market).

The government can even play simpler but more powerful role – require banks to hold capital in whatever manner such that the option-implied probability of crisis (as defined over the barrier range) is below some, small n percent. Indeed, perhaps this should be the inspiration for such regulation: banks issue disaster puts on its stock and by government diktat must keep the price of these low enough to keep the probability of said disaster below a socially acceptable level (which could be determined by correlation of failure – that, again, is for another post).

One thing you won’t find in the array of pro-TPP articles and soundbites is the enthusiasm and excitement with which many in the business and finance community embraced NAFTA. That’s reflective of a world with less low hanging fruit, at least as far as easy trade deals are concerned and an America much more cautious about free trade and investment and less concerned about the world beyond its shores.

Advocates, however, are making a mistake arguing in favor of TPP on free trade lines. For one, the deal will likely do little to liberalize the current account in most participatory countries – but substantially improve capital account flexibility that would, in principle, increase gross international investment positions and encourage a globalization of firm activity if not trade itself.

This is an order of magnitude less important than trade itself, but still has a host of benefits for Americans (especially workers) without the same concerns many on the left suggest plague other free trade deals. And while current and capital account flows go hand-in-hand with each other, the literature has generally been much kinder to the former than the latter. As Bhagwati (no enemy of free markets, indeed the “world’s leading trade scholar”, according to some) wrote more than 15 years ago, free trade of widgets isn’t the same as the free trade of dollars, making some of the same arguments that opponents extend today:

In short, when we penetrate the fog of implausible assertions that surrounds the case for free capital mobility, we realize that the idea and the ideology of free trade and its benefits — and this extends to the continuing liberalization of trade in goods and financial and other services at the World Trade Organization — have, in effect, been hijacked by the proponents of capital mobility. They have been used to bamboozle us into celebrating the new world of trillions of dollars moving about daily in a borderless world, creating gigantic economic gains, rewarding virtue and punishing profligacy. The pretty face presented to us is, in fact, a mask that hides the warts and wrinkles underneath.

Bhagwati hasn’t really changed his mind about TPP, citing it as the product of self-interested corporate lobbies and a national strategy framework focused on containing, rather than cooperating, with China.

But what few realize is that the most concerted and powerful lobbies in the TPP negotiations aren’t Goldman Sachs or Monsanto but the trade unions with an bottomless wallet ready to wage war against this deal at any cost (ask yourself – if you have even a mildly public choice inspired view of politics – why Democrats would have otherwise so uniformly voted against their own president and constituents en masse). As Mike Allen wrote in Playbook a few weeks ago, the business lobby, is completely cash constrained:

Good Monday morning. TOP TALKER – “GOP: Business lobby blowing it on trade: Frustration is mounting among GOP leaders that Big Business is getting outfoxed by Big Labor,” by Anna Palmer and Jake Sherman: “Top House Republicans believe the business community is blowing its chance to clinch a trade deal. Unlike unions, they say, Big Business advocates aren’t flooding Capitol phone lines. … David Stewart, a top aide to Speaker John Boehner, voiced the frustration of Boehner’s office during a meeting Friday with officials from business lobby groups, telling them their effort is falling short. …

“[T]he bill is expected to clear the Senate late this week or perhaps after the Memorial Day recess. Democrats are looking to stall final passage in the hopes of giving opponents more time to mobilize for the closer fight in the House, where the legislation currently lacks the votes to pass. Another GOP aide said the ratio of opposing calls to those in favor of the trade agreement is … 25 to 1 or worse. … [T]he Business Roundtable, the National Association of Manufacturers, the Chamber and others formed a coalition called Trade Benefits America to push fast-track …

“The business alliance has said it’s … spent more than $1 million on TV ads in 26 markets on broadcast and cable, in addition to Internet, radio and print ads in 30 states. The coalition’s spokesman, Kevin Madden, … said the business community needs to be ‘unrelenting and keep improving our efforts.'”

This verifies two realities. Foremost that TPP (in practice, if not symbolism) isn’t a big deal. It will hardly revitalize Clinton-era economic growth and the popular excitement spirited by the ultimate victory of the market. But, more importantly to the actual evaluation of the deal, the benefits are small and disperse rather than large and concentrated. This is generally a good thing, and stands in contrast with other poor trade concessions such as sugar, corn, and soy subsidies which cost Americans maybe two dollars a year but award a few, rich contract farmers increased profits a factor of tens of hundreds of millions as much.

This creates a situation where no single citizen really cares about lobbying against a horrible subsidy, but a few, rich farmers can coalesce to create a public policy nightmare rivaled only by the defense industry. Mancur Olson dubbed this the problem of “concentrated benefits vs. diffused costs”). The donor consensus on TPP seems to be a reflection of diffused benefits and concentrated costs.

Let’s talk a few specifics – this is not a trade deal that will in any meaningful way reduce existing barriers to commerce and promote increased competition in highly protected industries (chiefly agriculture + aerospace and defense). Similarly, it will not in any detrimental way accelerate the offshoring of widget manufacturing (to the extent it even exists anymore) to foreign countries at the expense of the middle-income American.

Indeed Bhagwati’s concerns should be further tempered by the fact that the capital account liberalization realized by TPP would focus on making safe, long-term equity investments more palatable to risk-averse investors rather than the sort of short-term portfolio flows he (correctly) judges as unnecessarily risky for emerging countries. Indeed, we can outline a clear environment in which the post-TPP world would be safer and less volatile for emerging market currencies.

For example, macro investments in foreign countries are more about exposure to an uncorrelated and diversified source of growth than bets on the future of any single firm. Indeed, it is this impulse that propelled Jim O’Neil’s otherwise irrelevant acronym to thought leader vernacular, with the boom of an alphabet soup of global ETFs designed to help retail investors get exposure to international growth.

In most cases, regulatory and structural, debt investments are perceived as safer. Not just because debt inherently concentrates risk on the borrower whereas equity shares it between all parties, but also because international contractual frameworks make enforcing most debt contracts an easy and predictable process, and because bankruptcy laws tend to be well-defined in most countries. If TPP can successfully improve investor confidence in direct equity financing (especially FDI – which, of all all forms of capital inflows, is the safest and most beneficial, by bringing foreign expertise and knowledge, increasing the pace of global “catching up”) and thereby increase the relative portion of all gross capital flows that are FDI instead of portfolio financing, it would stand to benefit poor countries and poorer workers by increasing accessibility to high-paying jobs.

The last point is crucial. MNCs, for all the hate they receive from liberals and conservatives alike are, as the above link points out, objectively better than domestic firms. They spend more on R&D. They pay higher wages and offer better jobs (a fact independent of origin nation). And, certainly for catch-up countries and potentially for rich countries, offer a source of horizontal knowledge integration which sounds like sketchy op-ed speak but is also demonstrated in the literature.

So why do we need TPP? Maybe in one word: Japan. Two years ago, the country regained its place as the top foreign investor in America after two decades of falling behind. In an era of wage stagnation and inequality, Japanese MNCs in the US increased the average wage they paid from below $50,000 in 1998 to almost $80,000 in 2013. And as the government mindlessly slashes R&D investment in basic research, Japanese firms (over the same time period) increased research per worker from just over $2,000 to $10,000 in 2013.

A free capital account meant that Honda could open a manufacturing plant in East Liberty, Ohio instead of exporting the same Accord to an American who would have bought it anyway saving relatively high-paying jobs, increasing the trade balance, and affording higher wages to middle-class Americans.

The fundamental logic is this. Countries trade because they have different comparative advantages but principle extends to firms, workers, and consumers and comparative advantage stretches to historical research advantages, brand name, and tradition. This means some people will always buy Hondas and that Japan really is better at certain small electronic innovations than we are and that supply-chain logistics in parts of China put the  US to change – and there’s nothing HBS or any capital account protection can do about it.

By definition of the fact we trade, there are comparative advantages certain foreign firms (from all TPP countries) have above and beyond American capacity. And yet, there are also an array of pluses we have such as the world’s strongest consumer market, quality transportation infrastructure, a somewhat lenient regulatory environment, and academic talent nonpareil. Rather than banning the matching of such comparative advantages, at the expense of workers who would be employed by quality foreign firms,

In a better world the TPP would also improve the flow of immigrants (skilled and unskilled) where they are much needed in pockets of this country. This may still happen through the channel of transfer visas, but the full benefits cannot be realized without total H1B reform.

Regardless, there aren’t many low-hanging fruit that are also politically feasible, at least as far as international business and finance goes. This deal isn’t about freer trade but safer, greater, and more long-term capital flows that could, if structured properly, benefit middle-income Americans (who may also benefit doubly by become net investors abroad).

Received wisdom among India watchers holds that gold imports are a threat to Indian economic development, the rupee, the current account, and everything else we hold economically dear. This fear manifested itself in an outright (if ineffective) ban for the better part of the country’s history post-Independence, and has more recently involved all sorts of quirky taxes and duties to prevent the import of gold.

A few things are clear. Indians are crazy about gold. Last year India overtook China as the world’s largest consumer, which was particularly detrimental to the official balance of payments, where gold was 3% of the country’s 4.7% trade deficit. This frenzy reached a point where, this April, an executive director of the RBI proposed a loony scheme of a government gold monetization plan arguing that the government wouldn’t invest the capital in other schemes as it would open itself to delta risk unless it is perfectly hedged (as, astonishingly, financial transactions tend to work…)

The Indian financial commentary hive mind would be better off understanding the systematic reason for gold imports (and fixing that) rather than obsessing over imports using terms that make little sense in this context, such as current account deficit. Even the Economist seems to completely miss the context of such “imports”:

Some argue that India’s gold imports should be reclassified as a capital flow, which would make the current-account deficit look less scary. But the official fear of gold is rational. Whatever the accounting treatment, money flowing out of India to buy bullion strains its balance of payments. And wealth stored in ingots or jewellery rather than bank deposits or shares is unavailable for investment. India’s household savings rate is high, but as much as half is now squirrelled away in physical form.

Pune’s wide boys aside, the traditional gold consumers are southern peasants buying jewellery. They have no access to formal finance; gold requires no paperwork, incurs no tax and is liquid. But over the past decade the mania has spread. By weight consumption has doubled, for several reasons: a surge in money earned on the black market; investors chasing the gold price; and the dismal returns savers get from deposit accounts. Real interest rates are low, reflecting high inflation and a repressed financial system that is geared to helping the state finance itself.

Unfortunately that’s just now how savings works (indeed, by identity, savings are investment – not necessarily business investment, but investment nonetheless and the heart of this debate is whether gold purchases imply deferred consumption and hence greater inventory accumulation, accounted for as investment in national income accounts). In fact, just reading the emphasized, there should be no fear of gold: since deposits seem to be highly oversubscribed and therefore a poor investment, gold seems like a fair alternative for store of value.

But let’s dispel fears of “money flowing out of India” first. Let’s say an Indian exporter sells canonical widgets to an American producer, receiving dollars in return. That is a current account inflow. It can do a few things with this income. Let’s explore three common alternatives:

  1. Reinvestment in US Treasuries,
  2. Purchase of gold, then repatriated to India (though physical location really doesn’t matter),
  3. Investment in India (let’s say a national infrastructure bond).

Surely the accounting effect of the first two options is the same. In the former case India is exporting capital directly to the US government and in the latter case it is exporting capital to the American bank from which it purchased its gold which is then recycling that capital back into the American economy. These are indisputable accounting relations that hold in every transaction.

Now the Economist wants to blindly compare (1) and (2) with (3) without detailing a third transaction in the process. Say the firm wants to “invest in India” and purchase government-issued bonds to build a high-speed rail service between Bangalore and Bombay. That would be rather noble of them, indeed. Unfortunately, having exported to a US firm, the firm has no INR with which to participate in this auction. Therefore, it first needs to identify a US exporter that sold goods to India and received INR in return. Even after it does this, and trades its USD for INR at USDINR, it’s not like investment in India suddenly improves – indeed the original INR was already invested in India in the first place. (Of course, this doesn’t mean both investments are equal and one might perform much better than the other. If this is your anti-gold argument I suggest you open a hedge fund shorting gold rather than writing for the Economic Times).

A household buying gold really is no different. It either has to buy it in rupees or dollars, but ultimately someone ends up with the rupee which is in some form invested in India. A current account surplus is a capital account deficit – that’s how these things work.

The question we’re implicitly answering is whether gold constitutes deferred consumption (investment) or not. To the extent there is a strong consumption aspect to gold (and there might well be) the fear is self-contradictory as it reflects nothing about inability to invest the savings as the Economist reports: indeed in this case these purchases wouldn’t be savings at all.

But the more likely situation is that gold does, in many ways, confer deferred savings and many other attributes of wealth including:

  1. A store of value,
  2. A source of liquidity – as gold-collateralized loans are an effective means by which an otherwise underbanked population can access financing,
  3. A source of wealth effect consumption increases.

Indeed the official fear about gold treats it as if it is a poor investment, which ipso facto means it shouldn’t be included in the current account. Even then, for many poorer Indians gold offers access to a banking system that otherwise requires 10th grade board exam results to borrow money at reasonable rates. Gold is an investment in an alternative source of financing to loan sharks that charge annualized rates north of 60% on a good day. Gold also doesn’t depreciate or perish. It might loose value but that is completely a capital loss.

This is a mistake that anyone who doesn’t understand why S = I might be prone to make. Business investment, i.e. a firm investing in machinery or platform development, isn’t the only form of investment. If I earn $1000 and place it under a mattress that is an interest-free investment in the form of deferred consumption (indeed if I burn it, it will be an investment to that amount rolled over in perpetuity, with an ultimate value of (1/discount rate)*1000).

This isn’t intuitive to most people. It’s very, very common to hear that gold is an unproductive investment or that “Americans are saving too much and not investing enough”. In fact, what they really mean to say is that interest rates as they stand are creating an investment situation in which an inefficient amount of funds are invested in very low return areas (such as inventory) and are not optimally productive.

In India this means opening up sources of safe, high quality investment allowing just the sort of liquidity transformation that finances the “development” everyone wants. In fact, if anything, gold import bans and taxes worsen the current amount by the premium one has to pay for smuggled gold, which in some part accrues to foreign smugglers and miners who have some claim on the delta between black market and open market gold. That is a pure current account loss and one which Indian policymakers need to address by removing import controls completely.

Paul Krugman has a post discussing America’s net international investment position. Basically, the outputs of domestic production (i.e. GDP) aren’t owned entirely by Americans and an increasing share of assets are owned by foreigners. The central reason for this imbalance is persistent current account deficits – when Chinese exporters recycle their dollar earnings back into the US, they earn an increasing claim to our production.

So the typical reason why a country’s net investment position would deteriorate is a declining current account balance but, as Krugman points out, the US has basically cut its current account deficit in half since its peak in 2006. Therefore he suggests the superior performance of American assets might be the culprit. As far as an explanation for our net investment position is concerned, I think he’s right. But I don’t think that’s the right metric to look at.

We know, since 1999 or so, foreigners have been tripping over themselves to hold Treasury and agency-backed debt. Part of the plan never to have an Asian crisis again was to hoard safe dollar-denominated debt and run a current account surplus. In general, I don’t think equities are the item to look at (and I think Krugman’s percent-of-GDP portrayal of this fact might exaggerate their importance):

Screen Shot 2015-05-03 at 11.19.32 PM

Screen Shot 2015-05-03 at 11.18.50 PM

I’ll get back to the corporate bond market later but it’s obvious all the action since 1999 or so has been in the Treasury and agency market. And note these are “percent of total market” figures – America’s bond market is just under twice as large as its equity market. So when you think about the fact that foreigners have been crowding into assets that pay basically nothing nominally and less than nothing really, you have to wonder what we’re getting in return. That’s not an easy question and probably deserves a post of its own, but here’s a good first approximation:

Screen Shot 2015-05-03 at 11.29.11 PM

So GNP = GDP + US returns on foreign assets – foreign returns on US assets. A few things to note:

  1. GNP has always been larger than GDP, at least in US recorded history.
  2. After a nadir in 1999 or so, this ratio has gone up (probably hand-in-hand with global saving glut-ish reasons).
  3. It’s been coming down a bit since 2012, but remains well above average.

And I’ll completely admit this is a crude, but quick, way of getting to the point that the return on capital for American investors is just much, much higher than it is for foreign investors. This, by itself, doesn’t mean much. Presumably our earnings are much riskier and are hence discounted in valuation and maybe we should be worried about the net investment position after all.

But here’s an interesting thought experiment. What if China committed to a new policy of recycling its trade surplus into American gold, which has no nominal return whatsoever. What if, with the financing provided by selling that gold, Americans invested in riskier international companies and corporate paper. Then, in a world where emerging markets perform much worse than the US – in fact, in a world where emerging markets consistently produce negative returns on capital – our investments are rotten. But in pretty much every conceivable world – i.e. a world where technology diffuses from rich countries to poor countries – the US investment will have a better holding-period return. And, nowadays, Treasuries are kind of like gold.

In fact, that’s why growth theorists might be a little puzzled by this turn of events. Capital is supposed to flow from rich countries to poor countries to finance development abroad, just like water should roll down a hill. Clearly that doesn’t square with the incredible amounts of cheap cash flowing into America, and the safe-asset squeeze (whether something that’s an actual market reality, or something that is an artifact of mercantilist/crisis-weary state policy) has a lot to do with it.

This still doesn’t explain valuations, however, unless we adjust for the fact that US and foreign investors have very different risk profiles. Foreign investors (see the first chart) are largely official, and have a single-minded interest in preventing the 1999 sort of debacle where a shortage of dollars resulted in currency havoc and financial crisis. American investors are almost exclusively private corporations that don’t have a shortage of dollar-assets, that almost never borrow in a foreign currency, and live in a world of really, really cheap basis trades.

So private, social, and market valuations diverge.

In some cases, that doesn’t matter. If foreigners suddenly called all their assets and stopped rolling over our debt, it would be a disaster (and we certainly couldn’t fund our liabilities with our foreign assets alone). But that doesn’t matter – the whole premise of the safe asset squeeze is this scenario is highly improbable (otherwise valuations would not have – could not have – been what they are). The more simple description of the entire argument is that US treasuries provide a liquidity service to foreign governments and there is an inefficient shortage thereof. Or, even simpler, the US is a classical bank earning a profit on the spread between its borrowing and lending rates.

Sometimes returns paint a more useful picture than valuations.


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