Topic: Finance, Banking & Monetary Policy

The Misery Index: A Look Back at Bulgaria’s Elections

With Bulgaria’s May 12th election fast approaching, it is useful to reflect on past elections and the resulting economic performance of each elected government. To do this, I have developed a Misery Index inspired by the late Prof. Arthur Okun, a distinguished economist who served as an adviser to U.S. President Lyndon Johnson.

The Misery Index measures the level of “misery” in the economy. My modified Misery Index is equal to the inflation rate, plus the bank lending rate, plus the unemployment rate, minus the annual percent change in GDP.

An increase in the Misery Index indicates that things are getting worse: misery is increasing. A decrease in the Misery Index indicates that things are improving: misery is decreasing. The accompanying chart shows the evolution of Bulgaria’s Misery Index over time.  

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The Socialist Party government of Prime Minister Zhan Videnov created hyperinflation and a lot of misery. The Misery Index under the Videnov government’s watch peaked at 2138 in the first quarter of 1997. That number isn’t shown on the accompanying chart—if it was, the chart would take up an entire page of Trud.

So, the chart starts in the second quarter of 1997, with the Kostov government. Shortly after Kostov took power, Bulgaria installed a Currency Board System, based on a draft Currency Board Law, which I authored at the request of President Petar Stoyanov. The Currency Board brought an end to Bulgaria’s hyperinflation, which peaked with a monthly inflation rate of 242%, in February 1997.

Dollarize Argentina Now

Argentina is once again wrestling with its long-time enemy, inflation. Now, it appears history may soon repeat itself, as Argentina teeters on the verge of another currency crisis. As of Tuesday morning, the black-market exchange rate for Argentine pesos (ARS) to the U.S. dollar (USD) hit 9.87, meaning the peso’s value now sits 47.3% below the official exchange rate. This yields an implied annual inflation rate of 98.3%. For now, the effects of this elevated inflation rate are being subdued somewhat by Argentina’s massive price control regime. But these price controls are not sustainable in the long term. Indeed, the short-term “lying prices” only distort the economic reality, ultimately leading to scarcity. There is, however, a simple solution to Argentina’s monetary problems: dollarization. I have advocated dollarization in Argentina for over two decades, well before the blow up of their so-called “currency board.” To put the record straight, Argentina did not have a true currency board from 1991 to 2002. Rather, as I anticipated in 1991, the “convertibility system” acted more like a central bank than a currency board. This pegged exchange rate system was bound to fail—and fail, it did. The 2001-02 Argentine Crisis could have easily been avoided if the country had simply dollarized. Argentina had more than sufficient foreign assets to dollarize their economy even late into 2001. But the Argentine government, through a series of policy blunders, ended up “floating” the currency. Not surprisingly, Argentina is now back to where it was in the late 1980s. So, how can Argentina dollarize? In short, the Banco Central de la Republica Argentina (BCRA) would take all of the assets and liabilities on its balance sheet denominated in foreign currency and convert them to U.S. dollars. The Central Bank would then exchange these dollars for all the pesos in circulation (monetary base), at a fixed exchange rate. By my calculation, the BCRA would need at least $56.36 billion to dollarize at the official exchange rate (as of April 23, 2013).

Regulator to the World? Not the SEC…

I don’t often commend regulators, but for those interested in preserving national sovereignty, new SEC chairwomen, Mary Jo White, is off to a good start if yesterday’s New York Times’ editorial is anything to go by. The Times criticized White for approving new SEC derivatives regulations that defer oversight of foreign security-based swap transactions, including those relating to the foreign subsidiaries of U.S. banks, to foreign regulators. The Times also derided White for approving rules that were “weaker” than the similar rules released by the Commodity Futures Trading Association.

Like the CFTC, the Times’ editorial board has clearly not heard of the concept of international comity, which it seems to confuse with “weakness”. In particular, it is not clear why the Times believes that unelected U.S. regulators should have the right to be self-appointed derivatives tsars to the rest of the world. The Times also appears to have overlooked the recent letter, signed by the finance ministers of nine of the United States’ largest trading partners and addressed to their U.S. counterpart Jack Lew. The letter was a thinly-veiled attack on the CFTC’s so called “extra-territorial” application of its cross-border swap rules and noted that an approach “in which jurisdictions require that their own domestic regulatory rules be applied to their firms’ derivatives transactions taking place in broadly equivalent regulatory regimes abroad is not sustainable.”

Of course, the Times does raise one important point: that it is undesirable to have two agencies releasing different rules on what amounts to the same topic. But the arbitrary distinction in the oversight of security-based swaps (regulated by the SEC) and OTC derivatives (regulated by the CFTC) is just one of Dodd-Frank’s many design flaws. Moreover, the SEC is under no obligation, pursuant to Dodd-Frank or otherwise, to follow the CFTC’s approach just because the CFTC released its regulations first. Especially as those regulations have proven to be so contentious (and not just with U.S. banks who legitimately fear being shut of international derivatives markets, but, more importantly, the foreign regulators on whom the U.S. may have to rely in a crisis).

It has become an unwelcome trend for U.S. regulatory agencies to overreach their jurisdictional and geographical boundaries. This began with the IRS’ FATCA implementation and has continued in the financial regulatory space. That White does not wish to follow her CFTC counterpart, Gary Gensler, down the rabbit hole and alienate the U.S.’s trading partners and allies is commendable, even if the Times is disappointed.

Brown-Vitter: More Hot Air

Today’s New York Times article by Senators Brown and Vitter (the preview of their much-touted “bank break-up” bill) starts with a very encouraging line: “governments shouldn’t pick economic winners and losers.”

Senator Brown, in particular, seems to have learned this important lesson fairly recently (auto bailout, anyone?). But putting this aside (and also ignoring the ongoing debate about the purported subsidy to large banking organizations, which should be eliminated, if it indeed exists), Senators Brown and Vitter display some disturbing, though not uncommon, misconceptions about U.S. and global banking. And, as is always the case, poorly understood and inaccurate facts create bad policy suggestions.

The first problem is the implicit assumption that large size and diversity of operations are negative traits. In fact, diversity is the key to managing risk in banking. Part of the reason why US banking has had such a checkered history relative to many other countries is because of its historical lack of geographical and product diversity – a result of the long-standing prohibitions on inter-state banking and branch banking and limitations on combining investment and commercial banking activities. One of the single biggest causes of the banking crisis in the late 1920s was a lack of geographical diversity (and, as congressional records show, States that prohibited branch banking fared the worst). Similarly, one of the primary causes of the 2008 financial crisis was a lack of asset diversity - too many banks holding too many securitized sub-prime mortgages.

Second, is the implicit assumption that investment banking and underwriting activity are inherently more risky than loan activities. Certainly, imprudent investment banking can be disastrous. So can making risky loans. And the 2008 crisis was, at its core, a loan origination problem (a fact largely ignored by Congress because of the uncomfortable questions it raises about the two GSE’s - Fannie and Freddie).

Third, is the belief that the 2008 bank bailouts were somehow linked to the FDIC deposit insurance scheme and that if we ‘narrow’ the safety net, all future bailouts will be avoided. I am no fan of federal deposit insurance, but the bailouts were unrelated to it. TARP was a Treasury creation, passed by Members of Congress under extraordinary circumstances. The only way to ensure it doesn’t happen in future is to rein in Congress and limit their ability to (in the words of Brown and Vitter) “pick economic winners and losers”.

As it turns out, the Brown-Vitter Bill is less about bank ‘break-up’ and more a U.S. variant of the FSB’s G-SIFI surcharge – which raises the question why it is necessary at all, except to put the U.S.’s global banks at a disadvantage, even though they are already disproportionately affected by the surcharge. Brown and Vitter’s calls for higher capital requirements are not objectionable per se, but as the ongoing problems with the Basel Accord shows, the devil is always in the details. And if you get it wrong, you risk creating exactly the systemic problems – such as an excessive reliance on sovereign bonds or mortgage-backed securities – that you were trying to avoid.

Essentially, the only way to end the perception of a government backstop is to put in place a credible system to allow large firms to fail if they make poor decisions. To this end, the Brown-Vitter Bill doesn’t add anything except more confusion.

Price Controls: A Troubling Trend in Latin America

Argentina, Venezuela, and now even Ecuador have all embraced an unfortunate, if familiar, economic craze currently sweeping the region – price controls. In a wrong-headed attempt to “suppress” inflation, the respective governments have attempted to fix prices at artificially low levels. As any economist worth his salt knows, this will ultimately lead to scarcity.

Consider Venezuela, where the government sets the price of a number of goods, including premium gasoline, which is fixed at only 5.8 U.S. cents per gallon. As the accompanying chart shows, 20.4% of goods are simply not available in stores.

While price controls ostensibly keep the prices of goods on official markets low, they ultimately lead to empty shelves, depriving many consumers access to essential goods (such as toilet paper). This, in turn, leads to “repressed” inflation – given the price controls that exist, the “true” rate of inflation is held down, or repressed through Soviet-style government intervention. As the accompanying chart shows, the implied annual inflation rate for Venezuela (using changes in the black-market VEF/USD exchange rate) puts the “repressed” inflation rate at 153%.

Likewise, Argentina is facing a similar dilemma (see the accompanying chart).

In addition to scarcity and repressed inflation, price controls can lead to unintended political consequences down the road. Once price controls are implemented it is very difficult to remove them without generating popular unrest – just consider the 1989 riots in Venezuela when President Carlos Perez attempted to remove price controls. 

Hopefully, Ecuador – which, thanks to its dollarization, is experiencing an annual inflation rate of only 3% – will see this folly and abandon its expirement with price controls.

If countries like Venezuela are really interested in keeping inflation under control, they should follow Ecuador’s lead – simply junk their domestic currencies and “dollarize”.

A Tax Haven Primer for the New York Times

I could only use 428 words, but I highlighted the main arguments for tax havens and tax competition in a “Room for Debate” piece for the New York Times.

I hope that my contribution is a good addition to the powerful analysis of experts such as Allister Heath and Pierre Bessard.

I started with the economic argument.

[T]ax havens are very valuable because they discourage anti-growth tax policy. Simply stated, it is very difficult for governments to impose and enforce confiscatory tax rates when investors and entrepreneurs can shift their economic activity to jurisdictions with better tax policy. Particularly if those nations have strong policies on financial privacy, thus making it difficult for uncompetitive high-tax nations to track and tax flight capital. Thanks to this process of tax competition, with havens playing a key role, top personal income tax rates have dropped from an average of more than 67 percent in 1980 to about 42 percent today. Corporate tax rates also have plummeted, falling from an average of 48 percent to 24 percent.

…Lawmakers also were pressured to lower or eliminate death taxes and wealth taxes, as well as to reduce the double taxation of interest, dividends and capital gains. Once again, tax havens deserve much of the credit because politicians presumably would not have implemented these pro-growth reforms if they didn’t have to worry that the geese with the golden eggs might fly away to a confidential account in a well-run nation like Luxembourg or Singapore.

Since I didn’t have much space, I couldn’t go into much greater detail. Below the jump is a video that elaborates on the economic benefits of tax havens, including an explanation of why fiscal sovereignty is a big part of the debate.

Yay Authoritarianism!

Cato-at-Liberty readers who are enjoying—or, at least, chronicling—our nation’s slide down The Road to Serfdom will have to add Neil Irwin’s Washington Post Outlook piece, “Why the financial crisis was bad for democracy,” to their travelogue:

In a democratic society, there will always be tension over which decisions should be made by expert appointees, and which by those with the legitimacy and accountability that come with competing for citizens’ votes. The technocrats can make complex decisions quickly, quietly and efficiently. The words “quick, “quiet” and “efficient” are rarely applied to the U.S. Senate or the Italian Parliament — but these institutions are imbued with an authority that comes directly from the people, the explicit consent of the governed.

So, in a crisis, which do you want: unaccountable decisiveness or inefficient accountability?

Consciously or not, we’ve made our choice: The financial crisis and its long, ugly aftermath have marked the triumph of the technocrats…

None of this is a great way to run a society. Like most journalists, I believe in transparency and accountability. I wish the Federal Reserve’s policy meetings were broadcast on C-SPAN. Instead, we get written transcripts five years later. (That still beats Europe, where such information is under lock and key for 30 years.)

Yet, when the world is on the brink, decisive problem-solving trumps the niceties of democratic process. I won’t like it much — but I’ll take it.

Authoritarianism cannot take hold without intellectual support, and Friedrich Hayek couldn’t have described the rationale better himself. Just equally well. Almost verbatim, actually.

For more, see my paper (with Diane Cohen) on IPAB and this Cato policy forum on IPAB and Dodd-Frank. And of course, read Hayek’s The Road to Serfdom while it’s still legal.