Latest Cato Research on Financial Crises and the Global Financial System en Slippery Slope Ahead for RBA’s Yield Management Strategy James A. Dorn <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Federal Reserve officials are fond of touting the importance of independence in the conduct of monetary policy. In theory, they want to avoid politicisation and maintain a&nbsp;firm boundary line between monetary and fiscal policy in pursuing their dual mandate of full employment and price stability.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>In reality, however, the Fed is an agent of Congress — or more precisely, a&nbsp;fiscal agent — and, in a&nbsp;crisis, is subservient to the Treasury.</p> <p>During World War II, for example, the Fed supported the prices of US securities and pegged interest rates at artificially low levels to finance government deficits. The pegged rate system didn’t end until 1953, even though the Treasury‐​Fed Accord was announced in 1951.</p> <p>Today, in response to COVID-19, <a href="">the Fed has once again become a&nbsp;major player in funding massive increases in government deficits.</a> It has promised to more than double the size of its balance sheet by engaging in large‐​scale asset purchases of Treasuries and mortgage‐​backed securities.</p> <p>The Fed also has created off‐​balance sheet entities — special purpose vehicles — backstopped by the US Treasury with funds appropriated by Congress under the CARES Act (Coronavirus Aid Relief and Economic Security Act).</p> <p>Congress has provided the Treasury with $US454 billion ($700 billion) to cover potential losses from the Fed’s emergency lending programs. That backstop will allow the Fed to lend as much as $US4.54 trillion.</p> <p>Although the Fed — unlike the Bank of Japan and, more recently, the Reserve Bank of Australia — has not officially pegged interest rates on government debt, there has been talk of establishing “yield curve control”. The idea is to have the Fed commit to buy longer‐​terms bonds to support their prices, and thus peg their yields at whatever rate is decided upon, most likely under consultation with the Treasury.</p> <p>Although the Fed may see this as a&nbsp;way to stimulate the economy, it could also be a&nbsp;way to fund fiscal deficits at an artificially low rate.</p> <p>According to <a href="">Sage Belz and David Wessel</a>, of the Brookings Institution, “a major risk associated with yield‐​curve policies is that they put the central bank’s credibility on the line” — that is, if the Fed promises to peg rates, it runs the risk of straying from its inflation target.</p> <p>In the case of Australia, the central bank has set a&nbsp;0.25 per cent target for the yield on three‐​year government bonds, which meshes with the cut in its cash rate target.</p> <p>The Reserve Bank distinguishes its<a href=""> yield control</a> approach from quantitative easing. Rather than announce a&nbsp;target for the quantity of bonds it plans to buy, it says it will buy an unlimited quantity of government bonds to keep the bond yield at its targeted low rate.</p> </div> , <aside class="aside--right aside--large aside pb-lg-0 pt-lg-2"> <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>The real economy has a&nbsp;mind of its own and central bank forecasts have a&nbsp;poor track record.</p> </div> </div> </aside> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Governor Philip Lowe has also promised that the board “will not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band”.</p> <p>He expects the cash rate “will remain at its current level for some years”. The problem is, central bankers don’t have perfect information. Consequently, forward guidance has not worked very well.</p> <p>The real economy has a&nbsp;mind of its own and central bank forecasts have a&nbsp;poor track record.</p> <p>When central banks peg rates and try to control the yield curve, they may reduce the quantity of bonds they need to purchase in the short run, if the central bank has credibility, but investors will be incentivised to search for yield by moving to longer‐​term securities.</p> <p>This shift increases duration risk — that is, when the economy starts to recover and interest rates rise, holders of longer‐​term securities will suffer large losses.</p> <p>By engineering lower rates and promising to keep them low for several years, the central bank encourages politicians to continue to run fiscal deficits.</p> <p>Pegged rates also distort the allocation of credit by diminishing the role of private markets. Placing legal ceilings on interest rates (i.e. not allowing them to rise above the maximum rate targeted by the authorities) — and thus supporting bond prices — is not a&nbsp;panacea for creating a&nbsp;robust economy.</p> <p>Most importantly, once rates are pegged at artificially low levels, they can be difficult to exit.</p> <p>Politicisation of central bank policy will diminish independence and harm credibility. If inflation increases, there is always the danger of wage‐​price controls and a&nbsp;loss of economic freedom. Future economic growth will suffer.</p> <p>Those adverse consequences of pegged rates should not be lost sight of in fighting the COVID-19 pandemic.</p> <p>The pandemic was not the fault of central banks, nor was the political decision to lock down the economy and put millions of people out of work. In such a&nbsp;situation, the <a href="">Fed and other central banks had to act quickly and decisively to provide liquidity -</a> to prevent financial instability from leading to further deterioration of the real economy.</p> <p>Yet unconventional monetary policies are meant to be temporary, not permanent. Ensuring long‐​run economic growth necessary to restore economic wellbeing will require adapting to new realities via markets, not manipulating interest rates to finance government deficits and providing cheap credit to favoured groups.</p> </div> Wed, 13 May 2020 09:36:35 -0400 James A. Dorn Emergency Regulations Often Make the Next Emergency Worse Walter Olson <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>During a&nbsp;crisis, governments often impose new regulations that wind up making things worse when the next crisis strikes from some other direction. The TSA checkpoint system adopted after Sept. 11, for example, is now the one point in air travel where a&nbsp;virus‐​fearing traveler is least able to avoid prolonged physical or face‐​to‐​face contact with a&nbsp;stranger, as well as the handling and commingling of high‐​touch personal items on communal trays.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Another set of regulations that took off after Sept. 11 was imposed on the financial sector to combat “money laundering” — that is to say, transfers of funds with little or no documentation. Terror groups were portrayed as having a&nbsp;special proclivity for anonymous payments even though all sorts of innocent persons used them too. Under&nbsp;<a href="" target="_blank" data-saferedirecturl=";source=gmail&amp;ust=1586890689629000&amp;usg=AFQjCNG1QDUjxFFmq32zBTT87NiWOIYsOA">the Bank Secrecy Act</a>, banks&nbsp;<a href="" target="_blank" data-saferedirecturl=";source=gmail&amp;ust=1586890689629000&amp;usg=AFQjCNFByIwkONC3-Th7-rVXJ0QpeUlsQQ">must follow</a>&nbsp;cumbersome “know your customer” rules meant to tease out customers’ identities and roles in the economy and also must monitor and report so‐​called suspicious transactions — anything out of the ordinary for the kind of customer revealed by the profile.</p> </div> , <aside class="aside--right aside--large aside pb-lg-0 pt-lg-2"> <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>There are many good reasons for deregulation. One of them is that it bolsters resilience when systems are asked to cope with complex new perils.</p> </div> </div> </aside> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Now that banks are expected to respond quickly to&nbsp;<a href="" target="_blank">the COVID-19 crisis</a>, the old rules are causing all sorts of problems. For example, the economic shutdown and its resulting uncertainties have combined with stranded family members to jolt many account holders&nbsp;<a href="" target="_blank" data-saferedirecturl=";source=gmail&amp;ust=1586890689629000&amp;usg=AFQjCNGIqLjlO6OOrJBcd4Q7jrBKheeh5Q">into completely new transaction patterns</a> — asking for sudden cash withdrawals, using only online banking when they’d never used it before, and so forth.</p> <p>Banks can sort through some of those problems by readjusting the rules for what they count as abnormal and thus suspicious. But another set of holdover anti‐​terror rules is not so easy to work around.</p> <p>Under the CARES Act relief law, banks suddenly find themselves the point of contact for processing hundreds of thousands of small‐​business applications for short‐​term funds. Unfortunately, under the Bank Secrecy Act, this will require slamming through a&nbsp;huge number of know your customer inquiries. For individuals, these inquiries may be relatively short and routine, but they can be considerably more burdensome for small‐​business applicants, as&nbsp;<em><a href="" target="_blank" data-saferedirecturl=";source=gmail&amp;ust=1586890689629000&amp;usg=AFQjCNFT-i5h4pSkNE_8Yva5fExDsmKDsQ">Bloomberg Law</a></em><a href="" target="_blank" data-saferedirecturl=";source=gmail&amp;ust=1586890689629000&amp;usg=AFQjCNFT-i5h4pSkNE_8Yva5fExDsmKDsQ">&nbsp;explains</a>:</p> </div> , <blockquote class="blockquote"> <div> <p>“Banks must check the identity of each person who owns more than 25% of the company, as well as any person that has control of its operations. That involves getting corporate documents as well as the standard information for individuals.</p> <p>“The industry says obtaining these details can add between 40&nbsp;minutes and 120&nbsp;minutes to the application intake process. And, depending on the complexity of the business’s ownership, it can require up to 30 more days for verification.”</p> </div> </blockquote> <cite> </cite> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>It doesn’t help that many owners now find themselves stranded away from key files. While many banks previously used an in‐​person meeting at a&nbsp;branch office to walk a&nbsp;first‐​time business client through the know your customer and Bank Secrecy Act process, much can go wrong or get delayed if a&nbsp;teleconference substitute is needed on both ends.</p> <p>Because banks had already gone through know your customer filing for existing small‐​business accounts, the U.S. Treasury&nbsp;<a href="" target="_blank" data-saferedirecturl=";source=gmail&amp;ust=1586890689629000&amp;usg=AFQjCNGXnGTynYjkgQMV6_nTIAhwo48FyA">put out word confirming</a>&nbsp;that they didn’t need to do so again. So at least a&nbsp;bit of good news: Existing customers could proceed at once to assembling their federal requests.</p> <p>Bad optics! Senators&nbsp;<a href="" target="_blank" data-saferedirecturl=";source=gmail&amp;ust=1586890689629000&amp;usg=AFQjCNFT-i5h4pSkNE_8Yva5fExDsmKDsQ">promptly blasted banks</a>&nbsp;for supposed favoritism toward their own customers. After all, what could be more evocative of wartime fairness than to make everyone wait in the same queue for needed paperwork, whether or not they’ve already cleared it. Right?</p> <p>There are many good reasons for deregulation. One of them is that it bolsters resilience when systems are asked to cope with complex new perils.</p> </div> Mon, 13 Apr 2020 09:01:56 -0400 Walter Olson Could ‘Lombardy Bonds’ Be the Answer to the Eurozone Debt Puzzle? Alberto Mingardi <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>At the last Eurogroup meeting, Eurozone finance ministers agreed to set up a ‘Recovery Fund’ to help trigger an economic rebound once the lockdowns are over. But the vexed question of whether some shared ‘European’ debt should be issued has not been solved.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>In the last few weeks, the German and Dutch governments have been criticised for opposing the idea of issuing European ‘Coronabonds’. Meanwhile, Italy is responding to the crisis by offering banks public guarantees to cover 90%-100% of their lending. With the lockdown continuing, Giusepppe Conte’s government has little choice but to increase spending. Given its high debt to GDP ratio (135%) and the likely need for a&nbsp;lot of extra public spending, the only way for Italy to borrow at reasonable rates is to mutualise this new debt with other Eurozone members.</p> <p>Perhaps unsurprisingly, the German and Dutch governments are wary of committing resources to shore up Italy’s position. A&nbsp;few days ago, Rome’s measures to cope with the health emergency included the nationalisation of Alitalia, a&nbsp;long‐​standing candidate for bankrupcty. An Italian minister has also spoken about the need to support those who work in the informal economy during the lockdown. Lack of income is as serious an issue for unregistered domestic workers and unlicensed street sellers as it is for anybody, but German and Dutch households may feel unwilling to support these people. Yet given the scale of Italy’s suffering during this crisis —&nbsp;with the death toll now over 18,000 — it is easy to accuse northern European states of insensitivity.</p> </div> , <aside class="aside--right aside--large aside pb-lg-0 pt-lg-2"> <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>Supporting Lombardy, not Italy as a&nbsp;whole, may be the best route for the Eurozon</p> </div> </div> </aside> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Perhaps, however, there is another way to pursue the same goals — lowering the interest rate on debt and developing some sort of European solidarity. Let the Lombardy government, instead of the Italian one, be the issuer of new debt, which is then guaranteed by all Eurozone states acting together. The creditworthiness of Lombardy is strong and northern European countries will see it as such.</p> <p>Bear in mind that it is the north of Italy that has born the brunt of the crisis, with Lombardy accounting for over 10,000 deaths. Milan and its environs entered the lockdown earlier than the rest of the country, and since productive activity is concentrated there, so too will the economic costs of the lockdowns be.</p> <p>The North of Italy has for centuries been one of the most enterprising areas in Europe. Not for nothing was the bankers’ street in London named ‘Lombard street’ (whence too the title of Walter Bagehot’s book).</p> <p>Nor is Lombardy’s prosperity and entrepreneurial spirit a&nbsp;thing of the past. It remains Italy’s Bavaria, and its cornucopia of small and medium businesses are fully integrated into international supply chains. In 2008–2018, Italian exports grew by 16,9%, largely thanks to northern businesses which have made the most of globalisation. Lombardy accounts for 22% of Italy’s GDP. Combine Lombardy and Veneto, the region which includes Venice, and it’s a&nbsp;third.</p> <p>With that in mind, public guarantees for business borrowing will be more sustainable if regional governments bear some downside risk, while also looking like an attempt to pool the debt of northern Italian companies. As many of those companies are very small, defaults are certainly likely, but the region’s history of success also suggests big opportunities will be grabbed by others. Non‐​conventional instruments may be less controversial if new debt is better targeted.</p> <p>This new spending is also likely to be more effective, as it is localised: besides keeping businesses alive during the lockdown, it may be needed to properly equip companies with personal safety devices, so they can get back to work,&nbsp;as well as helping them to reallocate resources in the post‐​crisis world.</p> <p>As it stands, the Italian constitution provides that regional governments can only borrow for the sake of investment spending. All of the spending detailed above could conceivably be described as such, particularly in the unprecedented situation the country is in.</p> <p>Italian local governments have limited fiscal capacity. But from the point of view of monetary sovereignty — that is, the ability to print money to repay debt — if Lombardy issues bonds in euros it will be in exactly the same position as Italy as a&nbsp;whole, or Germany for that matter.</p> <p>The Italian central government should therefore commit to giving regions more fiscal capacity in the future, allowing them to repay this new debt with regional taxation. Certainly, the Italian government will need additional resources too, but if most of the cost of keeping businesses afloat is born by ‘Lombardy bonds’, Rome will be free to focus on welfare problems in the parts of the country so far less affected by Covid‐​19, and moderately increase spending and debt to that end. The very issuance of Lombardy Bonds would also act as a&nbsp;handbrake on the inordinate growth of Italy’s public spending, which other Eurozone countries rightly fear.</p> <p>Northern European countries are concerned about lending money to Italians to allow for earlier retirement, and they are right. Lending money to keep the productive heart of Europe pumping is, however, quite another thing.</p> </div> Fri, 10 Apr 2020 10:35:24 -0400 Alberto Mingardi Painful Choices Will Have to Be Made the Longer This Goes On Ryan Bourne <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>“Whatever it takes.” Just in case&nbsp;you didn’t hear the intended government message of reassurance to businesses, Chancellor Rishi Sunak repeated the&nbsp;mantra five times through Tuesday’s speech and in answering subsequent questions.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>As the coronavirus ravages demand across the food, <a href="" target="_blank">&nbsp;transport and hospitality sectors</a>, and subdues demand in other industries, the Chancellor offered up to £330bn in zero‐​interest loans to businesses, business rates relief and cash grants to retail, hospitality and leisure companies, and £10,000 grants to small firms. Further subsidies for employment are reportedly to be announced.</p> <p>The Chancellor’s rationale for such action is more clear‐​headed than the US response, with president Trump promising cheques to every American.&nbsp;Rather than targeting consumption, Sunak wants instead to ease cashflow problems and curb layoffs from companies labouring under a&nbsp;necessary partial shutdown of&nbsp;the economy. His desire is to preserve capacity.</p> </div> , <aside class="aside--right aside--large aside pb-lg-0 pt-lg-2"> <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>We can support business if disruption is short, but after several months it becomes actively wasteful.</p> </div> </div> </aside> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>A collapse in spending arising from “social distancing” and government‐​imposed containment measures risks killing many firms by holding back revenues, while costs such as rent, debt payments and payrolls persist.</p> <p>Sunak’s goal here isn’t to “stimulate the economy”, as such. He doesn’t want to risk speeding up the virus’s transmission. No, the aim, at least, is for taxpayer support to help companies to bridge the time until the virus passes.</p> <p>Taxpayers, so the thinking goes, are paying out or supporting activity in lieu of a&nbsp;missing insurance market. Households and businesses couldn’t feasibly have foreseen a&nbsp;global pandemic and if the state didn’t step in, thousands of normally viable businesses could be wiped out, so creating a&nbsp;deep recession and financial&nbsp;crisis.</p> <p>Now, we can all debate whether the&nbsp;measures will prevent that outcome. A&nbsp;lot of self‐​employed and gig economy workers seem precarious.&nbsp;<a href="" target="_blank">Markets seem sceptical about the effectiveness of the business measures</a>. Aside from the scale, one reason might be that this strategy requires the effective economic shutdown to be brief. Policymakers ideally want it to become like an extended Christmas week or “bad season”, from which rapid bounce‐​back occurs, even if some economic activity disappears forever.</p> <p>But the truth is we simply don’t know the duration of this crisis yet. Epidemic modelling from Imperial College has suggested that we might need suppression policies for 55pc to 96pc of time over the next 18 months. Even when government controls are relaxed, workers and customers might still be reluctant to return to activities or establishments where fear of catching or spreading the virus is greatest. Until widespread testing and/​or a&nbsp;vaccine are available, this is the huge uncertainty.</p> <p>Reassuring businesses then, in principle, doesn’t require just committing to do “whatever it takes” but to do it for “however long it takes”. Yet such a&nbsp;promise would neither be believable, nor desirable. If we are really talking about 12 to 18 months of disruption, trying to hibernate much of the economy of February 2020 to “reawaken” it in mid‐​2021 becomes no strategy at all.</p> <p>Such an approach would require a&nbsp;gargantuan commitment from taxpayers. Zero‐​interest loans from government won’t help many firms with this duration of mothballing. As the Office for Budget Responsibility’s Sir Charles Bean explained on Tuesday, the longer this crisis rolls on, the more loans have to become cash grants, lest firms loaded with debts become insolvent. Many will be reluctant to take on loans anyway without certainty about the duration of disruption. So direct taxpayer support will ratchet.</p> <p>If longer than a&nbsp;year, up to a&nbsp;fifth of the economy being replaced by government transfers for no activity starts becoming actively wasteful. As the economy adjusts to its new reality, novel forms of business, new attitudes to teleworking, altered tastes, and alternative supply chains, will develop, making it less and less desirable or feasible to try to return to the economy of yesterday.</p> <p>And we see seeds of economic adjustment already. Supply chains for supermarkets are running on overtime. Amazon is hiring and raising wages. Demands have understandably shifted to certain coronavirus‐​related products and, before long, certain workers, who really need the income, will divert into delivery, supermarkets, and care work.</p> <p>Many families might re‐​examine too their preferences about having two income earners as childcare becomes scarcer. Paying firms to maintain the same workforces&nbsp;as today, in light of all this, becomes destructive.</p> <p>Cost‐​benefit analyses are always uncomfortable to think about during the heat of a&nbsp;crisis. But there must logically come a&nbsp;point when the rise in cost and the falling benefits of “bridging to recovery” makes a&nbsp;change of approach optimal.</p> <p>We are certainly not there yet and, given the flashing warning signs of an imminent output recession, the Government’s framework of thinking is sensible enough, for now. This genuine public health crisis must mean we all temporarily rethink the role of government.</p> <p>Highly targeted provisions of income support for households and businesses deeply affected by the downturn have a&nbsp;much clearer justification than expensive universal schemes such as a&nbsp;temporary “basic income”, although deciding on deserving targets is always fraught with difficulty.</p> <p>The key point is that the Government should avoid making promises it can’t keep. Bills currently in the US Congress for business support are good until June. By that time, the trajectory of the virus’s transmission should be much clearer. Programmes can always be renewed, if necessary. But promising “whatever it takes, for however long it takes” would be foolhardy.</p> <p>In what’s left of the market economy during this time, change occurs quickly. Governments could relax certain regulations, particularly the licensing of occupations and business “types”, to make transition easier still. What we cannot do is try to freeze the economy for years.</p> <p>Let us hope that the end of this current crunch then comes sooner rather than later. Otherwise we are looking at huge destruction, be it to livelihoods or our health.</p> </div> Thu, 19 Mar 2020 08:47:42 -0400 Ryan Bourne Iran Is Not Hyperinflating Steve H. Hanke <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Each and every day we read that Iran is hyperinflating or about to hyperinflate. The same is written about Zimbabwe and Venezuela, as well as a&nbsp;potpourri of other countries that are experiencing inflation flare‐​ups. While Iran came close to hyperinflating in the fall of 2012, it has never experienced an episode of hyperinflation. And while Zimbabwe experienced episodes of hyperinflation in 2007-08 and in 2017, it is not experiencing one now. At present, Venezuela is the only country experiencing hyperinflation.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>It’s clear that journalists and those they interview tend to play fast and loose with the word “hyperinflation.” To clean up the hyperinflation landscape, we must define the word. So, just what is the definition of the oft‐​misused word “hyperinflation?” The convention adopted in the scientific literature is to classify an inflation as a&nbsp;hyperinflation if the monthly inflation rate exceeds 50 percent. This definition was adopted in 1956, after Phillip Cagan published his seminal analysis of hyperinflation, which appeared in a&nbsp;book edited by Milton Friedman, <a href=";tag=x_gr_w_bb_sout-20&amp;linkCode=as2&amp;camp=1789&amp;creative=9325&amp;creativeASIN=0226264068&amp;SubscriptionId=1MGPYB6YW3HWK55XCGG2" rel="noopener noreferrer" target="_blank"><em>Studies in the Quantity Theory of Money</em></a><em>.</em></p> <p>Since I&nbsp;use high‐​frequency data to measure inflation in countries where inflation is elevated, I&nbsp;have been able to refine Cagan’s 50 percent per month hyperinflation hurdle. With improved measurement techniques that I&nbsp;developed when I&nbsp;was studying Zimbabwe’s record hyperinflation, I&nbsp;now define a&nbsp;hyperinflation as an inflation in which the monthly rate exceeds 50 percent per month for at least thirty consecutive days.</p> </div> , <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>While Iran came close to hyperinflating in the fall of 2012, it has never experienced an episode of hyperinflation.</p> </div> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>After years of research with the help of many assistants, I&nbsp;have documented and ranked 58 episodes of hyperinflation, which are presented in the <a href="" rel="noopener noreferrer" target="_blank"><em>Routledge Handbook of Major Events in Economic History</em></a>. Hungary holds down the top spot. Its peak hyperinflation occurred in July 1946, when prices were doubling every 15&nbsp;hours. Zimbabwe’s November 2008 hyperinflation peak is second highest, but way behind Hungary’s. At their peaks, the daily inflation rates were 207 percent in Hungary and 98 percent in Zimbabwe. The most memorable hyperinflation was Germany’s in 1923. But, it only ranks as the fifth highest, with a&nbsp;peak daily inflation rate of 20.9 percent — way lower than the top four rates.</p> <p>Now, let’s turn to the world’s only current hyperinflation: Venezuela. It ranks as the 14th most severe episode in history. Today, the annual rate of inflation is 2,986 percent. While this rate is modest by hyperinflation standards, the duration of Venezuela’s episode, as of today, is long: 38 months. Only two episodes of hyperinflation have been more long‐​lived.</p> <p>Even though we can measure hyperinflation very accurately, no one has ever been able to forecast the magnitudes or durations of hyperinflations. But that hasn’t stopped the International Monetary Fund (IMF) from producing forecasts for hyperinflation in Venezuela. Even though the IMF does not <em>measure</em> Venezuela’s hyperinflation, something that can be reliably done, the IMF does <em>forecast</em> hyperinflation, something that cannot be reliably done.</p> <p>Surprisingly, the press dutifully reports the IMF’s forecasts for Venezuela’s annual inflation rate. For example, as late as October 2019, the IMF was forecasting that Venezuela’s annual inflation rate would hit a&nbsp;whopping 200,000 percent by the end of the year. Well, the IMF’s “guestimation” was a&nbsp;bit off. I&nbsp;measured Venezuela’s annual inflation rate on December 31, 2019, and it was 6,869 percent.</p> <p>But it turns out that the IMF isn’t the only one making finger‐​in‐​the‐​wind forecasts of hyperinflation. The Trump administration’s special envoy for Iran, Brian Hook, recently asserted that U.S. sanctions against Iran would fuel a&nbsp;hyperinflation. Well, even though Iran came close to a&nbsp;hyperinflation in October 2012, it failed to jump over the hurdle. And today, Iran isn’t even close to the hyperinflation threshold. Indeed, since the New Year, the Iranian rial has been very stable against the greenback on the black market, and the official annual inflation rate is 38.6 percent. And, according to my most recent measurements, Iran’s inflation rate is falling.</p> </div> Thu, 06 Feb 2020 10:00:34 -0500 Steve H. Hanke Policy News and Stock Market Volatility Scott R. Baker, Nicholas Bloom, Steven J. Davis, Kyle Kost <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Volatility in aggregate equity returns is difficult to interpret in a&nbsp;convincing manner. Classic work shows that stock market ups and downs cannot be rationalized by realized future dividends discounted at a&nbsp;constant rate. Partly motivated by this demonstration, one major line of research stresses time‐​varying expected returns in asset pricing models with rational agents. Another prominent line stresses nonrational beliefs, limits to arbitrage, and fads that move equity prices in ways not fully tethered to real investment opportunities.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>We develop new data and evidence that inform rational and behavioral interpretations of the volatility in equity returns. In a&nbsp;first step, we identify articles about stock market volatility in leading U.S. newspapers and use them to construct an equity market volatility (EMV) tracker. Our measure runs from January 1985 to October 2018 and is scaled to match the mean value of the Chicago Board Options Exchange Volatility Index (VIX) from 1985 to 2015. Our EMV tracker moves closely with the VIX and the realized volatility of daily returns on the S&amp;P 500, with correlations of about 0.8 (0.85) in monthly (quarterly) data. A&nbsp;narrower EMV tracker tailored to news about petroleum markets correlates well with the implied and realized volatility of oil prices. Another EMV tracker, which we tailor to macroeconomic news, surges in the wake of episodes that involve unusually high uncertainty about the near‐​term macroeconomic outlook (e.g., the October 1987 stock market crash, the 9/11 terrorist attacks, the March 2003 invasion of Iraq, the 2008 financial crisis, and the U.S. debt‐​ceiling crisis in the summer of 2011). These results suggest that our EMV trackers capture important drivers of EMV fluctuations.</p> <p>In a&nbsp;second step, we parse the text in the EMV articles to quantify journalist perceptions about the news items, developments, concerns, and anticipations that drive volatility in equity returns. We classify these drivers into about 30 categories, many of which pertain to particular types of policy. This approach lets us assess the importance of each category to the average level of stock market volatility and its movements over time. An immediate result is the importance of news about the macroeconomic outlook, broadly defined, which receives attention in 72 percent of all articles that enter into our EMV tracker. Most EMV articles discuss multiple topics. Thus, we also find that 44 percent mention commodity market developments, 31 percent mention interest rates, and 8&nbsp;percent mention financial crises.</p> <p>The policy share of EMV articles rises over time, reaching peaks in the 2001–2003 period (9/11 and the invasion of Iraq), the 2011–2012 period (the U.S. debt‐​ceiling crisis and the “fiscal cliff”), and the period since Donald Trump’s election in November 2016. Parsing the role of policy more finely, we find that 35 percent of EMV articles refer to fiscal policy (mostly tax policy), 30 percent mention monetary policy, 25 percent mention regulation, and 13 percent mention national security matters. We also construct EMV trackers tailored to these policy categories and find that each one fluctuates markedly over time. For example, our national security EMV trackeris low in most periods but highly elevated during the GulfWar, after the 9/11 terrorist attacks, and during the Iraq War. Trade policy matters went from a&nbsp;virtual nonfactor for equity market volatility in the 20&nbsp;years before Trump’s election to aleading source afterward, especially since the intensification of U.S.-China trade tensions from March 2018.</p> <p>How should we interpret these findings? According to the efficient‐​market hypothesis, equity price movements reflect genuine news that alters rationally grounded forecasts of future earnings and discount factors. Under this view, it’s natural to interpret news reports as a&nbsp;catalog of the rational forces that drive the volatility of equity returns.</p> <p>Economist Robert Shiller articulates a&nbsp;rather different view: “The market fluctuates as the sweep of history produces different mindsets at different points of time, different zeitgeists.… Aggregate stock market price changes reflect inconstant perceptions, changes that [John] Keynes referred to with the term ‘animal spirits.’&nbsp;” Under this view, we expect newspaper articles to (imperfectly) mirror these mindsets and their shifts over time. Under either view, we see our methods and measures as helpful in efforts to quantify the perceived drivers of stock market volatility.</p> <p>Our EMV trackers have several noteworthy attributes: First, their construction is straightforward, transparent, easy to refine, and simple to replicate. Second, the frequency and volume of newspaper text afford much scope for granular characterizations of the forces that underlie EMV and its movements over time. We develop several tailored EMV trackers that exploit this granular richness. Third, our text‐​based approach is useful for assessing the role of wars, policy risks, and other hard‐​to‐​quantify sources of stock market volatility. Fourth, our measurement methods are highly scalable among countries and over time. Although we focus on the volatility of aggregate U.S. equity markets from 1985 onward, our methods extend readily to any country or time period with digital newspaper archives and data on aggregate equity returns. Finally, we update our EMV trackers monthly in real time. These real‐​time updates facilitate efforts to assess the out‐​of‐​sample performance of our measures.</p> <p>There are several natural directions for future research. First, we are currently using our category‐​specific EMV trackers to explain and interpret the distribution of firm‐​level stock price volatilities and its movements over time. Second, by developing EMV trackers for multiple countries, we can explore the specific global and national forces that underlie stock market volatilities around the world. Third, our basic approach could be usefully applied to construct and parse newspaper‐​based trackers for other concepts. It would be straightforward, for example, to adapt our methods to construct newspaper‐​based trackers of consumer confidence, business sentiment, and the like and to delve into the specific forces that drive their movements.</p> <p><strong>NOTE:</strong><br> This research brief is based on Scott R. Baker et al., “Policy News and Stock Market Volatility,” March 25, 2019, <a href="" target="_blank">https://​ssrn​.com/​a​b​s​t​r​a​c​t​=​3​3​63862</a>.</p> </div> Wed, 05 Feb 2020 13:06:48 -0500 Scott R. Baker, Nicholas Bloom, Steven J. Davis, Kyle Kost The Economists’ Hour: How the False Prophets of Free Markets Fractured Our Society by Binyamin Applebaum Ryan Bourne <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>A decade after the financial crisis, and in the wake of President Trump’s election and Brexit, one might expect Left‐​wing critiques of the “era of neoliberalism” and the Anglo‐​Saxon “economic model” to be ten a&nbsp;penny. But as political tectonic plates shift, criticism of free market economics is no longer confined to the Left.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>In the United States, many Republicans and, here in Britain, some Conservatives, buoyed by shifting voting demographics, now demand industrial strategies, regional regeneration, protectionism and state aid.</p> <p>“The free market has been sorting it out and America’s been losing,” Mike Pence, the Vice‐​President of the US, said back in 2016, signifying this turn.&nbsp;Binyamin Appelbaum, a&nbsp;member of the <em>New York Times</em> editorial board, could hardly have hoped for a&nbsp;more receptive political environment for his first book, <em>The Economists’ Hour: How the False Prophets of Free Markets Fractured Our Society</em>.</p> <p>It promises to tell the tale of how “a new breed of economists … gained in influence and power” after the Sixties to push a&nbsp;free‐​market policy revolution. Professional economists placed much too much faith in the market to deliver “steady growth and broad prosperity,” we are told. Their influence permeated “too far,” resulting in policy outcomes that came “at the expense of economic equality, of the health of liberal democracy, and of future generations”.</p> <p>This central stated thesis of <em>The Economists’ Hour</em>’s sleeve is seemingly threaded together awkwardly through the book as an afterthought, but the read is better for its lack of centrality. Instead, at its core, and at its best, this is instead a&nbsp;highly readable, exhilaratingly detailed biographical account of the intellectual catalysts of major policy change in America over five decades, whose influence, of course, filtered into policy change in Britain.</p> <p>Appelbaum walks us through the debates that led to the shift to the macroeconomic primacy of monetary policy, the adoption of consumer welfare as the standard for competition policy decisions, the supply‐​side tax‐​cutting revolution, the adoption of cost‐​benefit analysis for regulation, and more. His brisk sweep shows an impeccable understanding of the issues and their intellectual history.</p> <p>Accounts are made richer through focus and detail on the personal role of economists in turning the policy tides. We enjoy a&nbsp;biographical account of Milton Friedman’s crucial role in the abolition of the American military draft and in slaying Keynesian economics; Thomas Schelling, who drove “the value of a&nbsp;human life” into policy analysis; and Robert Mundell, who made the case for supply‐​side economics. In the UK, their ideas were fed primarily through free‐​market think tanks to politicians such as Keith Joseph, Nigel Lawson, and, of course, Margaret Thatcher.</p> <p>Economists really did help shift certain policy towards more market‐​friendly ideas then, as Applebaum documents, on both sides of the Atlantic. But his nuanced account of these changes is spoiled by top‐​and‐​tailing his scholarly study with a&nbsp;tortured Left‐​wing narrative about the supposed disaster wrought — with economists held up as the bogeymen for all society’s ills.</p> <p>First, he hugely exaggerates what free‐​market economists, overall, achieved. He ignores the huge growth in the welfare state that is leading western countries into a&nbsp;fiscal demographic time bomb, dysfunctional housing markets, and the severe disruption caused by Mr Trump’s misguided trade war. In all these areas, free market economists oppose the “consensus,” and ignoring them has brought clear negative consequences.</p> <p>He is also too quick to attribute economic thought to ideology, when most policy developments trailed new knowledge or, at least, the clear and obvious failure of the status quo. Milton Friedman’s monetarist criticism of Keynesian government spending was first seen as heretical, for example. It was only accepted when his model appeared to explain the stagflation (high and rising inflation and high unemployment) of the Seventies. Since then, macroeconomic understanding has developed further.</p> <p>In fact, Appelbaum’s own accounts show the Keynesian‐​monetarist debates of the Sixties and Seventies, the battles over the efficacy of tax cuts, and the recent stimulus vs. austerity debate of 2008–2012, were debates between prominent economists as much as anything else.&nbsp;It goes too far to suggest there was a&nbsp;broad “neoliberal” consensus among economists, and where one did exist (for example, against rent controls or tariffs), it was because theory and the best available empirical evidence pointed in a&nbsp;clear direction. Britain’s political class adopted ideas from America because they were regarded as best practice, not because our politics was captured by economists.</p> <p>This book would therefore be stronger if it were pitched as a&nbsp;narrower critique of the influence of&nbsp;<em>some</em>&nbsp;economists in&nbsp;<em>some</em>&nbsp;policy areas. Even then, though, it would disappoint against its advertised narrative. That’s because all government policy decisions are ultimately economic and though Appelbaum complains free‐​market policies were destructive, he offers no framework to weigh up these supposed failures against alternatives.</p> <p>The shift towards prioritising low consumer prices in competition for example, for example, has taken “a toll on democracy” through the creation of big and powerful firms, according to Appelbaum. But no explanation is given on how an explicit effort to stop the creation of these firms might have led to the break‐​up of companies otherwise delivering lower prices and innovation to consumers.</p> <p>In fact, no reader could ascertain in which areas Appelbaum believes it obviously true that free‐​market ideas went “too far” or where, instead, they should have stopped. Does he favour the return of a&nbsp;U.S. military draft? Does he think it’s wrong for regulatory analysis to seek to value a&nbsp;human life? Does he think the 70s and 80s U.S. transport deregulations that improved customer outcomes were a&nbsp;mistake? Reading the book leaves you none the wiser — but that they are written about extensively in a&nbsp;tome promising to expose how economists took things too far suggests he well might.</p> <p>Opportunity cost — the cost associated with the next best alternative forgone — is a&nbsp;central pillar of economics. In denouncing economists’ influence, Appelbaum doesn’t attempt to assess what we missed out on, and how we should weigh these alternative worlds against what we’ve actually experienced. The result is that an otherwise excellent tale of how economists’ ideas changed the world is sullied by throwaway claims about their supposed negative consequences. It turns out it’s easier to bash professional economists than engage in the hard scenario analysis that they undertake every day.</p> </div> Sun, 02 Feb 2020 11:36:18 -0500 Ryan Bourne Short‐​Sale Constraints and Stock Price Crash Risk: Causal Evidence from a Natural Experiment Xiaohu Deng, Lei Gao, Jeong-Bon Kim <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Anecdotal evidence often claims that short‐​selling of stocks triggers financial crises or exacerbates marketwide stock price crash risk. Therefore, short sellers are often treated as scapegoats and held responsible for the occurrence of stock price crashes, especially during periods of financial market turmoil. This observation is one important reason why short sales are often banned when the market is volatile—for example, the United States banned short sales in 2008.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>We argue that short‐​sale constraints do not reduce, and in fact exacerbate, the likelihood of an abrupt, large‐​scale decline in stock prices (stock price crash risk). Lifting of short‐​sale constraints reduces the likelihood of stock price crashes because short sellers serve as a&nbsp;monitoring function and provide stock market feedback. Because most of the short sellers are sophisticated institutional investors and thus have the ability to detect bad news promptly or to gain privileged access to private information, they can help expedite the price‐​discovery process and improve the informational efficiency of stock prices via their shorting activities. By facilitating a&nbsp;timelier incorporation of information (especially negative news) into market prices, their trading activities can deter or slow down the within‐​firm hoarding of bad news, which in turn decreases a&nbsp;firm’s stock price crash risk.</p> <p>In 1977, economist Edward M. Miller Jr. theorized that when investors’ beliefs about a&nbsp;firm’s value are heterogeneous and short sales are forbidden, the firm’s share price is inflated. In efficient markets, observed market prices fully reflect publicly available information. Short sellers, who are able to identify overvalued stocks based on their private information, should earn abnormal returns when the prices of currently overvalued stocks are corrected later through their shorting activities. However, because of market frictions (such as short‐​sale constraints), outside investors are unable to observe the (negative) information short sellers have. Since Miller’s seminal research on short sales was published, many economists have attempted to address the consequences of the equity overvaluation problem induced by short‐​sale constraints. Because of these constraints, pessimistic investors are sidelined from the market until market declines are flushed out when hidden (negative) information is revealed. This triggers an abrupt, large‐​scale decline in stock prices, thereby leading us to more negatively skewed returns.</p> <p>Most of the theoretical studies predict a&nbsp;positive relation between short‐​sale constraints and stock price crash risk. However, the empirical findings are mixed. Endogeneity problems are the most important obstacle to reaching a&nbsp;consensus on the role that short sellers play in the stock market. A&nbsp;few studies attempt to alleviate concerns about endogeneity by studying short‐​sale regulations among countries or examining the short‐​sale regulation changes in mainland China and Hong Kong. However, they still fail to reach a&nbsp;consensus because of vast differences in institutions, investor protection, and law enforcement among countries.</p> <p>Our research exploits the Securities and Exchange Commission’s Regulation SHO (RegSHO) pilot program as a&nbsp;natural experiment in which to examine the causal impact of short sales (i.e., an increase in short sales due to the temporary removal of short‐​sale constraints) on stock price crash risk. Announced in 2004, RegSHO concerns short‐​sale activities in U.S. equity markets. It contained the Rule 202T pilot program, in which one‐​third of the largest stocks, ranked by trading volume within each exchange, were randomly selected into a&nbsp;pilot group in order to test the impact of removing short‐​sale constraints. During the period from May 2, 2005, to August 6, 2007, the pilot stocks were exempted from the uptick rule, which prohibits the short sale of stocks except when the price of the stock is increasing.</p> <p>RegSHO provides us with a&nbsp;natural experimental setting in which to investigate the role of short sales in a&nbsp;capital market. First, the pilot program initiated a&nbsp;significant decrease in the cost of shorting among the pilot stocks, suggesting that the use of this regulation as an exogenous shock to short‐​sale activities is economically meaningful.</p> <p>Second, under RegSHO, the list of stocks in the pilot group was randomly selected from among the exchanges, and thus the program created two comparable groups: the treatment sample of firms affected by RegSHO and the control sample of firms unaffected by RegSHO.</p> <p>Third, the RegSHO pilot program had specific start and end dates. The known end date allows us to investigate whether the effect of lifting short‐​sale constraints is reversed when constraints are reimposed, which can serve as a&nbsp;validity test.</p> <p>Our analysis reveals that increased short sales of the pilot stocks induced by RegSHO reduced stock price crash risk. In other words, relaxing or removing short‐​sale constraints, which increases shorting activities, decreases the likelihood of a&nbsp;stock price crash occurrence.</p> <p>In addition, we also study the channels through which short‐​sale constraints affect crash risk. First, we contend that short sales play an essential role in alleviating the information asymmetry between inside managers and outside investors. Short sellers engage in gathering private information, particularly about bad news or unfavorable performance, and increase the cost to managers of bad‐​news hoarding. In this process, short sellers can deter managers from hiding bad news or information about unfavorable performance. When the information asymmetry is high, stock prices may not reflect all available information, and some stocks may be overvalued. Short sellers are interested in those overvalued stocks and take a&nbsp;short position on such stocks to make trading profits. Once a&nbsp;short position is taken, the overvalued stocks will return to their fundamental value. As such, more‐​intense shorting activities can contribute to lowering the likelihood of stock price crashes, thereby leading us to observe an inverse relation between short sales and the risk of a&nbsp;stock price crash. We expect that this inverse relation is more pronounced for firms with a&nbsp;weaker information environment. As existing literature shows, management intending to hoard more bad news is more prone to crash risk. When short‐​sale constraints are removed and thus external monitoring by short sellers becomes more intense, managers from opaque firms are less able to hide unfavorable information. The consequence is that the stock price crash risk decreases due to the reduction in bad‐​news hoarding.</p> <p>Secondly, we contend that lifting short‐​sale constraints reduces distortions in corporate investment, in particular by reducing an overinvestment problem. Overvaluation, due to short‐​selling constraints, can incentivize managers to engage in overinvestment by artificially reducing the firm’s cost of equity, which increases the probability of stock price crashes. Short sales can ease the corporate overinvestment problem and thus reduce the likelihood of stock price crashes. Our findings confirm this hypothesis. We find that the short‐​sale impact on reducing crash risk is more pronounced for firms that are more likely to overinvest.</p> <p><strong>NOTE</strong>:<br> This research brief is based on Xiaohu Deng, Lei Gao, and Jeong‐ Bon Kim, “Short‐​Sale Constraints and Stock Price Crash Risk: Causal Evidence from a&nbsp;Natural Experiment,” Journal of Corporate Finance, forthcoming, <a href="" target="_blank">https://​papers​.ssrn​.com/​s​o​l​3​/​p​a​p​e​r​s​.​c​f​m​?​a​b​s​t​r​a​c​t​_​i​d​=​2​7​82559</a>.</p> </div> Wed, 29 Jan 2020 00:00:00 -0500 Xiaohu Deng, Lei Gao, Jeong-Bon Kim Making the Lira “as Good as Gold” Tue, 21 Jan 2020 09:34:23 -0500 Steve H. Hanke Farewell to the CFA Franc: Macron and Ouattara End a Colonial Relic Steve H. Hanke <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>French President Emmanuel Macron and Alassane Ouattara, president of the Ivory Coast, have delivered the coup de grâce to a&nbsp;colonial relic: the CFA franc. Created in 1945, the CFA franc is the only colonial currency arrangement still in existence. Fourteen African countries constitute the CFA franc zone. These countries in West and Central Africa are split into two separate economic and monetary unions in which the CFA franc is the coin of the realm. But the two presidents announced Dec. 21 that when the new year is rung in, the currency will disappear in the eight countries of the West African zone—home to 130 million people—and be replaced by a&nbsp;new one, the eco.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>While other colonial moneys met their demise long ago, the CFA franc has survived and thrived. It is convertible across the countries that are members of the CFA franc monetary zone, with no capital controls existing among members. Paris still plays a&nbsp;pivotal role in setting the zone’s policies. France guarantees the convertibility of the CFA franc at a&nbsp;fixed rate to the euro and influences decisions in the zone with an “operations account” at the French Treasury. Paris has subsidized the system, but also imposes discipline by controlling member states’ access to credit at the French Treasury.</p> <p>The CFA franc system has worked well compared with central banking practiced in other African countries. Fiscal deficits and sovereign debt levels are lower, reflecting the discipline that the fixed exchange rate imposes on member countries. Inflation and unemployment rates have been lower in CFA countries than in other African economies.</p> <p>So why did the CFA franc become a&nbsp;hot potato for Mr. Macron? As in the past, colonial politics have entered the arena. This past summer, for example, Luigi Di Maio, Italy’s foreign affairs minister and leader of the antiestablishment 5&nbsp;Star Movement, took direct aim at Mr. Macron. Mr. Di Maio attacked France’s foreign policy for, among other things, using the CFA franc to exploit its former colonies. In those former colonies, some activists and leaders agree with Mr. Di Maio’s assessment.</p> <p>To lower the temperature, Mr. Macron decided to remove the West African CFA franc from the marquee and replace it on Jan. 1&nbsp;with the eco. In addition to the currency’s name change, France will close the CFA franc’s “operating account” at the French Treasury. The requirement that the Central Bank of West African States deposit 50% of its foreign reserves at the Banque de France will also be eliminated and French representation on the West African central bank’s board will be terminated. But Paris will continue to guarantee convertibility of the new eco with the euro at a&nbsp;fixed rate.</p> <p>These changes are mostly cosmetic. The introduction of the eco is mainly a&nbsp;strategic move by Messrs. Macron and Ouattara. For some two decades, the Economic Community of West African States has debated and planned a&nbsp;new currency, to be called the eco, for use in a&nbsp;large interstate union. This union would have a&nbsp;natural center of gravity in Nigeria, the region’s largest economy and most populous country. The new, primarily Francophone eco throws a&nbsp;wrench in the works of the original Nigeria‐​centric eco monetary union.</p> <p>Now that one version of the eco is moving forward, what should be the next move of the countries it covers? The best option would be to transform the eco zone into a&nbsp;superior currency‐​board system. A&nbsp;currency board would issue notes and coins convertible on demand into a&nbsp;foreign anchor currency, the euro, at a&nbsp;fixed rate of exchange. The board would hold anchor‐​currency reserves equal to 100% of its monetary liabilities, and it would generate profits from the difference between the interest it earns on its reserve assets and the expense of maintaining its liabilities.</p> <p>By design, the currency board would have no discretionary monetary powers and could not issue money on its own credit. It would have only an exchange‐​rate policy: The exchange rate would be fixed. The sole function of the currency board would be to exchange the ecos it issues for euros. Consequently, the quantity of ecos in circulation would be determined entirely by demand. The eco would be a&nbsp;clone of its anchor—the euro.</p> <p>Currency boards have existed in some 70 countries. No currency board has failed to maintain its currency’s convertibility at a&nbsp;fixed rate to its anchor currency. This illustrious record includes many currency boards in Africa, notably those in former British colonies.</p> <p>Despite their exemplary record, currency boards were replaced with central banks throughout most states over the past century. There were three main reasons for the shift. First, influential economists praised central banking’s flexibility and capacity for fine‐​tuning. Second, newly independent states were trying to cut their ties to former imperial powers. Third, administrators were anxious to obtain new clients and “jobs for the boys” at the International Monetary Fund and the World Bank, and they lent their weight and money to the establishment of new central banks. In the end, the Bank of England was the only major institutional voice to speak up for currency boards.</p> <p>A new currency board in West Africa would allow the eight countries in the eco zone to issue the soundest currency in Africa. They would benefit from the hard budget constraint and fiscal discipline the system would impose. And if that wasn’t enough, a&nbsp;currency board would generate a&nbsp;profit and allow the member states to become totally independent of Paris in the currency sphere.</p> </div> Mon, 30 Dec 2019 13:06:30 -0500 Steve H. Hanke Venezuela’s Hyperinflation Drags on for a Near Record — 36 Months Steve H. Hanke <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Venezuela is the only country in the world that is suffering from the ravages of hyperinflation. But, you wouldn’t know it from reading the press, where playing fast and loose with words is commonplace. Indeed, the word “hyperinflation” is thrown around carelessly and misused frequently, with claims that multiple countries are suffering from hyperinflation. The debasement of language in the popular press has gone to such lengths that the word “hyperinflation” has almost lost its meaning.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>So, just what is the definition of this oft‐​misused word? The convention adopted in the scientific literature is to classify an inflation as a&nbsp;hyperinflation if the monthly inflation rate exceeds 50%. This definition was adopted in 1956, after Phillip Cagan published his seminal analysis of hyperinflation, which appeared in a&nbsp;book, edited by Milton Friedman, <a href=";tag=x_gr_w_bb_sout-20&amp;linkCode=as2&amp;camp=1789&amp;creative=9325&amp;creativeASIN=0226264068&amp;SubscriptionId=1MGPYB6YW3HWK55XCGG2" target="_blank"><em>Studies in the Quantity Theory of Money.</em></a></p> <p>Since I&nbsp;use high‐​frequency data to measure inflation in countries where inflation is elevated, I&nbsp;have been able to refine Cagan’s 50% per month hyperinflation hurdle. With improved measurement techniques, I&nbsp;now define a&nbsp;hyperinflation as an inflation in which the inflation rate exceeds 50% per month for at least thirty consecutive days.</p> <p>Just what is Venezuela’s inflation rate? Today, the annual inflation rate is 10,398% per year. How do I&nbsp;measure elevated inflation? The most important price in an economy is the exchange rate between the local currency – in this case, the bolivar – and the world’s reserve currency, the U.S. dollar. As long as there is an active black market (read: free market) for currency and the black‐​market data are available, changes in the black‐​market exchange rate can be reliably transformed into accurate measurements of countrywide inflation rates. The economic principle of purchasing power parity (PPP) allows for this transformation. The application of PPP to measure elevated inflation rates is both simple and very accurate.</p> <p>Evidence from Germany’s 1920–23 hyperinflation episode – as reported by Jacob Frenkel in the July 1976 issue of the <a href="" target="_blank"><em>Scandinavian Journal of Economics</em></a><em> </em>– confirms the accuracy of PPP during hyperinflations. Frenkel plotted the Deutschmark/U.S. dollar exchange rate against both the German wholesale price index and the consumer price index (CPI). The correlations between Germany’s exchange rate and the two price indices were very close to unity throughout the period, with the correlations moving to unity as the inflation rate increased.</p> <p>Beyond the theory of PPP, the intuition of why PPP represents the “gold standard” for measuring inflation during episodes of hyperinflation is clear. Virtually all goods and services are either priced in a&nbsp;stable foreign currency (the U.S. dollar) or a&nbsp;local currency (the bolivar). In Venezuela, bolivar prices are determined by referring to the dollar prices of goods, and then converting them to local bolivar prices after observing the black‐​market exchange rate. When the price level is increasing rapidly and erratically on a&nbsp;day‐​by‐​day, hour‐​by‐​hour, or even minute‐​by‐​minute basis, exchange rate quotations are the only source of information on how fast inflation is actually proceeding. That is why PPP holds and why I&nbsp;can use high‐​frequency data to calculate Venezuela’s inflation rate.</p> <p>Just how severe is Venezuela’s episode of hyperinflation? Well, that depends on the metrics used to measure severity. If one looks at the rate of inflation itself, Venezuela’s hyperinflation fails to make the Top Ten. Of the world’s fifty‐​eight episodes of hyperinflation that Nick Krus and I&nbsp;documented in the <a href="" target="_blank"><em>Routledge Handbook of Major Events in Economic History</em></a>, Venezuela ranks as the 14th most severe hyperinflation. This is shown below in the frequency distribution of the days required for prices to double in the world’s hyperinflation episodes. At the peak of Venezuela’s inflation, which occurred in January 2019, it took 14.8&nbsp;days for prices to double. This puts its rate at the upper‐​end of the mid‐​range of hyperinflation severity.</p> </div> , <figure class="figure overflow-hidden figure--default figure--no-caption responsive-embed-no-margin-wrapper"> <div class="figure__media"> <img width="700" height="475" alt="Hanke November 13, 2019 - Chart 1" class="lozad component-image" data-srcset="/sites/ 1x, /sites/ 1.5x" data-src="/sites/" typeof="Image" /> </div> </figure> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>If one measures severity by the duration of a&nbsp;hyperinflation, Venezuela’s hyperinflation, which started in November of 2016 and has yet to end, is severe. It has lasted for thirty‐​six months and counting. As the frequency distribution and table below show, there have only been two hyperinflations that have lasted longer than Venezuela’s.</p> </div> , <figure class="figure overflow-hidden figure--default figure--no-caption responsive-embed-no-margin-wrapper"> <div class="figure__media"> <img width="700" height="408" alt="Hanke November 13, 2019 - Chart 2" class="lozad component-image" data-srcset="/sites/ 1x, /sites/ 1.5x" data-src="/sites/" typeof="Image" /> </div> </figure> , <figure class="figure overflow-hidden figure--default figure--no-caption responsive-embed-no-margin-wrapper"> <div class="figure__media"> <img width="700" height="241" alt="Hanke November 13, 2019 - Chart 3" class="lozad component-image" data-srcset="/sites/ 1x, /sites/ 1.5x" data-src="/sites/" typeof="Image" /> </div> </figure> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>So much for the definition and accurate measurement of Venezuela’s hyperinflation. What about forecasts for the course and duration of Venezuela’s episode? Well, you can’t reliably forecast what heights a&nbsp;hyperinflation will reach, or when those heights will be reached.</p> <p>Surprisingly, that impossibility hasn’t stopped the International Monetary Fund (IMF) from throwing economic science to the winds. Yes, the IMF has regularly been reporting what are, in fact, absurd inflation forecasts for Venezuela. The table below presents the IMF’s finger‐​in‐​the‐​wind forecasts (read: nonsensical folly). Indeed, the IMF’s forecasting folly should be apparent to the naked eye. Just look at the table below. The IMF’s forecasts for 2019’s year‐​end inflation have ranged from 200,000% to a&nbsp;whopping 10,000,000%.</p> </div> , <figure class="figure overflow-hidden figure--default figure--no-caption responsive-embed-no-margin-wrapper"> <div class="figure__media"> <img width="700" height="409" alt="Hanke November 13, 2019 - Chart 4" class="lozad component-image" data-srcset="/sites/ 1x, /sites/ 1.5x" data-src="/sites/" typeof="Image" /> </div> </figure> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Never mind. You can bet your boots that the financial press will continue to dutifully report the nonsense coming from the IMF citadel. When it comes to hyperinflation, both the IMF and the press are immune from economic science and the facts.</p> </div> Wed, 13 Nov 2019 14:03:01 -0500 Steve H. Hanke On Extending the Currency Board Principle in Bulgaria: Long Live the Currency Board Tue, 12 Nov 2019 10:06:20 -0500 Steve H. Hanke Latin America Sinks under the Weight of its Third‐​Rate Currencies Steve H. Hanke <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Latin America is plagued with many endemic economic problems. As a&nbsp;result, slow growth and economic instability are the order of the day. Latin America is sinking. In the grand scheme of things, it’s become irrelevant.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>When it comes to listing culprits that account for the zombie growth rates in Latin America, the laundry list usually includes: high levels of corruption, a&nbsp;weak application of the rule of law, poor public services, a&nbsp;lack of public safety, and so on.</p> <p>A quick look at the International Monetary Fund’s (IMF) most recent <a href="" target="_blank">World Economic Outlook</a> tells the tale. Six months ago, the IMF predicted that the region would grow at an anemic 1.4% this year. Now, the IMF has downgraded Latin America’s growth rate for 2019 to a&nbsp;measly 0.2%. Given the recent turmoil in Ecuador, Bolivia, and Chile, I&nbsp;think the IMF’s most recent forecast might be too rosy. And, if that’s not bad enough, the IMF forecasts for the next five years indicate that the prospects for the region are bleak. Indeed, the IMF’s five‐​year forecasts indicate that most of the countries in Latin America will grow below the global average for emerging market economies</p> <p>The real problem that plagues most Latin American countries is the fact that they have central banks that issue half‐​baked local currencies. Although widespread today, central banks are relatively new institutional arrangements. In 1900, there were only 18 central banks in the world. By 1940, the number had grown to 40. Today, there are over 150.</p> <p>Before the rise of central banking, the world was dominated by unified currency areas, or blocs, the largest of which was the sterling bloc. As early as 1937, the great Austrian economist Friedrich von Hayek warned that the central banking fad, if it continued, would lead to currency chaos and the spread of banking crises. His forebodings were justified. With the proliferation of central banking and independent local currencies, currency and banking crises have engulfed the international financial system with ever‐​increasing severity and frequency. What to do?</p> <p>The obvious answer is for vulnerable emerging‐​market countries, like those in Latin America, to do away with their central banks and domestic currencies, replacing them with a&nbsp;sound foreign currency. Panama is a&nbsp;prime example of the benefits from employing this type of monetary system. Since 1904, it has used the U.S. dollar as its official currency. Panama’s dollarized economy is, therefore, officially part of the world’s largest currency bloc.</p> <p>The results of Panama’s dollarized monetary system and internationally integrated banking system have been excellent (see the table below).</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p align="center"><img data-src="" class=" lozad" /></p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <ul><li>Panama’s GDP growth rates have been relatively high. Since 1994, when the Mexican tequila crisis commenced, real GDP growth has averaged 5.7% per year.</li> <li>Inflation rates have been somewhat lower than those in the U.S. Since 1994, CPI inflation has averaged only 2.2% per year.</li> <li>Since Panama’s fiscal authorities can’t borrow from a&nbsp;central bank, the fiscal accounts face a “hard” budget constraint dictated by the bond markets. In consequence, fiscal discipline is imposed, and since 1994, Panama’s fiscal deficit as percent of GDP has averaged 1.6% per year.</li> <li>Interest rates have mirrored world market rates, adjusted for transaction costs and risk.</li> <li>Panama’s real exchange rate has been very stable and on a&nbsp;slightly depreciating trend vis‐​à‐​vis that of the U.S.</li> <li>Panama’s banking system, which operates without a&nbsp;central bank lender of last resort, has proven to be extremely resilient. Indeed, it weathered a&nbsp;major political crisis between Panama and the United States in 1988 and made a&nbsp;strong comeback by early 2000.</li> </ul><p>To avoid the pain described in the IMF’s World Economic Outlook, Latin American countries should dump their central banks and local currencies. They should follow Panama’s lead and adopt the greenback.</p> </div> Fri, 25 Oct 2019 13:05:10 -0400 Steve H. Hanke Veronique de Rugy discusses debt and deficits on NPR’s Marketplace Tue, 01 Oct 2019 10:32:43 -0400 Veronique de Rugy The 1948 German Currency and Economic Reform: Lessons for European Monetary Policy Gunther Schnabl <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>The European Monetary Union (EMU) is at a&nbsp;crossroads. Following the outbreak of the European financial and debt crisis in 2008, the European Central Bank (ECB) took unconventional measures to stabilize the common currency, cutting interest rates below zero and inflating its balance sheet via several asset purchase programs. While the ECB terminated these programs at the end of 2018, a&nbsp;new era of financial turmoil is on the horizon. Political instability and distrust are mounting in the face of economic unrest, and the proper policy regime for economic recovery remains murky.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>This article explains the different views on European central bank policymaking from a&nbsp;historical perspective. It begins by describing the economic principles and monetary regime that constituted ordoliberalism, the political‐​economic theory credited for stabilizing postwar Germany and advancing European economic competition and integration. It then explains how the rise of the EMU and its recent crisis‐​era policies negated several of Germany’s primary economic principles and initiated a&nbsp;dramatic turnaround of the nation’s economic order. It concludes by offering a&nbsp;new set of economic policy recommendations for the EMU that will help reverse this new round of fiscal and political uncertainty.</p> </div> Tue, 01 Oct 2019 09:36:00 -0400 Gunther Schnabl Modern Monetary Theory: Cautionary Tales from Latin America Sebastian Edwards <div class="mb-3 spacer--nomargin--last-child text-default"> <p id="note-1_2">During the last few years an apparently new and revolutionary idea has emerged in economic policy circles in the United States: “Modern Monetary Theory” (MMT). The central tenet of this view is that it is possible to use expansive monetary policy — money creation by the central bank (i.e., the Federal Reserve) — to finance large fiscal deficits, and create a “jobs guarantee” program that will ensure full employment and good jobs for everyone.<sup><a href="#fn03-1">1</a></sup> This view is related to Abba Lerner’s (<a href="#ch03_ref29">1943</a>) “functional finance” idea, and has become very popular in progressive spheres. According to MMT supporters, this policy would not result in crowding out of private investment, nor would it generate a&nbsp;public debt crisis or inflation outbursts.<sup><a href="#fn03-2">2</a></sup></p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>MMT runs against received wisdom among economists, and has been resisted by Keynesians and monetarists alike. Respected and influential academics such as Paul Krugman, Kenneth Rogoff, and Larry Summers, among others, have stated that MMT makes little sense. Krugman (<a href="#ch03_ref26">2019b</a>) has written that the principles behind MMT are “indefensible,” and that the arguments made by its supporters are “sophistry.” According to Rogoff (<a href="#ch03_ref35">2019</a>), MMT is “nonsense” based “on some fundamental misconceptions.” And Summers (<a href="#ch03_ref37">2019</a>) has contended that embracing “modern monetary theory is a recipe for disaster.”</p> <p id="note-3_4">MMT supporters have responded by saying that their critics don’t truly understand how modern monetary economies work. According to them, in countries with a currency of their own, governments don’t face a hard budget constraint; the government can always print additional money to pay for higher expenditures.<sup><a href="#fn03-3">3</a></sup> According to Stephanie Kelton (<a href="#ch03_ref21">2019</a>), “The government budget is not like a household budget because the government prints its own money.” Along similar lines, Forstater and Mosler (<a href="#ch03_ref17">2005</a>) have argued that in a “fiat money” system the natural rate of interest is zero; the role of the monetary authority is to push the actual rate to zero, through the purchase of government securities. If long‐​term equilibrium interest rates are equal to zero, then <em>r</em> &lt; <em>g</em> in growing economies — that is, the rate of interest is lower than the rate of growth of GDP — and there would be no explosion of government debt.<sup><a href="#fn03-4">4</a></sup></p> <p>MMT supporters have argued that, in order for these policies to work, the country in question does not need to have a “convertible currency”; all is needed is sovereign fiat money that economic agents have to use to pay taxes. Thus, MMT would still work in emerging countries with a currency of their own, including in many of the nations of Asia and Latin America. Wray (<a href="#ch03_ref43">2015</a>: 127–28) makes this point explicitly, when he writes:</p> <blockquote>The United States (and other developed nations to varying degrees) is special but all is not hopeless for the nations that are “less special.” To the extent that the domestic population must pay taxes and other obligations in the government’s currency, the government will be able to spend its own currency into circulation. And where the foreign demand for domestic currency assets is limited, there still is the possibility of nongovernment borrowing in foreign currency to promote economic development that will increase the ability to export.</blockquote> <p>MMT supporters have also posited that their policies would work best in countries that do not have a fixed exchange rate (<a href="#ch03_ref43">Wray 2015</a>: 124–29).</p> <p id="note-5">Efforts to evaluate the merits of MMT have run into two types of difficulties. First, there is no unified and generally accepted description of how the MMT model is supposed to work in detail. This is not due to a lack of publications. In fact, MMTers are prolific authors, and have published a large number of papers, pamphlets, and books, including some primers. However, these works contain very few (if any) equations or diagrams; MMT authors have generally avoided the language that, for better or for worse, has become dominant in scholarly conversations among professional economists.<sup><a href="#fn03-5">5</a></sup> By doing this, MMTers have left themselves open to the criticism that their views and models lack clarity. According to Paul Krugman (<a href="#ch03_ref25">2019a</a>) MMT supporters “tend to be unclear about what exactly their differences with conventional views are, and also have a strong habit of dismissing out of hand any attempt to make sense of what they’re saying.”</p> <p id="note-6">A second difficulty in evaluating MMT is that its supporters have offered very little empirical evidence on how the policy would function, especially in the medium and longer run.<sup><a href="#fn03-6">6</a></sup> Although some authors have argued that Japan during the last decade or so provides evidence that the approach works, most critics — including the governor of the Bank of Japan, Haruhiko Kuroda — disagree with that contention (<a href="#ch03_ref33">Reynolds and Nobuhiro 2019</a>). When discussing the applicability of MMT to the United States, Irwin (<a href="#ch03_ref20">2019</a>) has argued that it is important to have the policies first implemented in a small country, as an experiment. He wrote:</p> <blockquote>It would be nice to have some proof of concept before it is put in place in the largest economy in the world — also home to the world’s reserve currency… . It would be genuinely fascinating to watch a small country — with its own currency — govern itself according to the [MMT] theory’s principles… . If those smaller countries can work out the kinks of economic governance in an MMT world, and achieve a higher standard of living, maybe then scale it up to a midsize country?</blockquote> <p id="note-7">It turns out that MMT — or some version of it — has been tried in a number of emerging countries. Although most cases have taken place in Latin America, there have also been episodes in other parts of the world, including in Turkey and Israel. MMT‐​type policies were also attempted in France during the Mitterrand presidency. Almost every one of the Latin American experiments with major central bank–financed fiscal expansions took place under populist regimes, and all of them ended up badly, with runaway inflation, huge currency devaluations, and precipitous real wage declines. In most of these episodes — Argentina, Bolivia, Brazil, Chile, Ecuador, Nicaragua, Peru, and Venezuela — policymakers used arguments similar to those made by MMTers to justify extensive use of money creation to finance very large increases in public expenditures.<sup><a href="#fn03-7">7</a></sup></p> <p>In this article, I analyze some of Latin America’s episodes with MMT‐​related policies and show that all these cases ended up in major macroeconomic disasters. The analysis uses the framework developed by Dornbusch and Edwards (<a href="#ch03_ref10">1990</a>, <a href="#ch03_ref11">1991</a>) for studying macroeconomic populism. The rest of the article is organized as follows: First, I present the basic principles of Latin American populism and compare them to MMT. Next, I analyze three specific Latin American episodes with major central bank–financed fiscal expansions: Chile during President Salvador Allende’s socialist experiment (1970–73), Peru during the first Alan García presidency (1985–90), and Venezuela under Hugo Chávez and Nicolás Maduro (1998–present). These are the “cautionary tales” referred to in the title of this article. Finally, I provide some concluding remarks, including a brief discussion of MMTs weakest points.</p> <h2>Latin American Populism</h2> <p id="note-8">Macroeconomic populism is usually defined as a set of policies aimed at redistributing income by running high fiscal deficits, financed through an expansive monetary policy.<sup><a href="#fn03-8">8</a></sup></p> <h3>The Mechanics of Latin American Populism and MMT</h3> <p id="note-9_10">In the language of textbook macroeconomics, these are policies where the government shifts simultaneously, and significantly, the IS and the LM curves.<sup><a href="#fn03-9">9</a></sup> In every Latin American experience with populist policies the government granted wage increases — both public‐​sector and minimum wages — that exceeded significantly what was justified by improvements in productivity. Just as MMTers, populist politicians present heterodoxy as the solution to the nation’s ills, and in particular to the suffering of the middle and lower classes.<sup><a href="#fn03-10">10</a></sup></p> <p id="note-11">For populists, one of the features of capitalist economies is the existence of substantial idle capacity. Thus, in their view, large and persistent fiscal deficits financed through money creation do not result in serious imbalances, high inflation, and, eventually, crises. For populists the contrary is true: large fiscal deficits expand demand and encourage output, allowing firms to exploit economies of scale and to use resources fully. For them the combination of large deficits with redistributive policies results in a decline in inflation. Populists tend to dismiss possible collapses in the demand for domestic money, and increases in the velocity of circulation; in this, their perspective is, again, very similar to that of MMT supporters.<sup><a href="#fn03-11">11</a></sup></p> <p>These views are clearly captured by the following quote from Daniel Carbonetto (<a href="#ch03_ref05">1987</a>: 82), the economist behind Alan García’s populist policies in Peru in the second half of the 1980s: “If it were necessary to summarize the strategy adopted by the government since August 1985 with two words, they are control (meaning control of prices and costs) and spend, transferring resources to the poor so that they increase consumption.” Carbonetto (<a href="#ch03_ref05">1987</a>: 83) then added that budget constraints had to be ignored: “It is necessary to spend, even at the cost of a large fiscal deficit, because, when this deficit transfers public resources to increase consumption of the poorest, they demand more goods and this will bring about a reduction in unit costs. Thus the deficit is not inflationary.”</p> <p>This statement is very similar to what Stephanie Kelton, one of the most prominent supporters of MMT, stated: “The government budget is not like a household budget because the government prints its own money” (<a href="#ch03_ref41">Walsh 2018</a>). It is also similar to what Wray (<a href="#ch03_ref43">2015</a>: 104) writes in his primer on MMT: “The following statements do not apply to a sovereign currency issuing government… . Governments have a budget constraint … Government deficits drive interest rates up, crowd out the private sector, and lead to inflation.”</p> <p id="note-12">In addition to rejecting fiscal balance and sound monetary policy, Latin American populists reject markets, competition, and globalization. They believe in price and exchange controls, high minimum wages, high import tariffs, and large subsidies, mostly for food and public transportation. They support state‐​owned enterprises and favor nationalizing large multinationals (often associated with natural resources, such as oil and mining). In some instances, Latin American populists have borrowed from Marxist ideology, as was the case with Hugo Chávez’s “socialism of the 21st century” program.<sup><a href="#fn03-12">12</a></sup></p> <p id="note-13_15">It would be a mistake, however, to believe that populists “like” or “favor” inflation. They don’t. In fact, before taking power, populist politicians usually declare that one of their fundamental objectives is to reduce or eliminate inflation. They state that price increases benefit large monopolistic firms and hurt the working class. For instance, in Chile, the Unidad Popular electoral platform of 1970 stated that a main goal of the “popular government” was to achieve “price stability.“<sup><a href="#fn03-13">13</a></sup> In speech after speech President Salvador Allende pointed out that price controls would play a key role in defeating inflation.<sup><a href="#fn03-14">14</a></sup> Even though the quantity of money increased by 124 percent during his first year in office, he did not see that as a problem. On the contrary, for him monetary expansion played a key role in helping finance Chile’s move toward Socialism.<sup><a href="#fn03-15">15</a></sup> MMT supporters also assert that one of their main goals is to achieve price stability. According to Wray (<a href="#ch03_ref43">2015</a>: 244), “MMTers fear inflation… . Indeed, price stability has always been one of the two key missions of [the MMT approach].”</p> <p>In sum, there are a number of coincidences between the policy recommendations (and actions) of Latin American populists and MMT supporters. In order to further organize the discussion, <a href="#ch03-table-1">Table 1</a> presents a systematic comparison of both perspectives on a number of key policies.</p> <p><img data-src="" class=" lozad" /></p> <p><img data-src="" class=" lozad" /></p> <p><img data-src="" class=" lozad" /></p> <p><img data-src="" class=" lozad" /></p> <h3>The Four Phases of Latin American Populism</h3> <p id="note-16">Most macroeconomic populist experiments go through four distinct phases that span from euphoria to collapse. The length of the cycle depends on a number of factors, including the evolution of the terms of trade, political institutions, the availability of foreign financing by friendly nations, and the degree of political repression.<sup><a href="#fn03-16">16</a></sup> In the vast majority of Latin American populist episodes, the leader comes to power after a major crisis. In many cases, the IMF has been called to bring order into the economy. In every case, the IMF imposed an “austerity‐​based” adjustment program, which exacerbated the sense of frustration among the country’s citizens, and in particular among the middle and lower classes. Although a structurally unequal distribution of income is not a requirement for the emergence of populism, populist rhetoric is more attractive in countries with significant income disparities, or in countries where inequality has increased during the immediate past (<a href="#ch03_ref13">Edwards 2010</a>: chap. 1).</p> <p>Dornbusch and Edwards (<a href="#ch03_ref11">1991</a>) identify the following four phases of populism.</p> <p><em>Phase 1</em>. Policies very similar to those espoused by MMT are first put in place. Government expenditures increase rapidly, and massive income transfers are implemented. Public‐​sector wages and minimum wages are raised, and large public‐​sector investment projects enacted. These policies are financed by a combination of easy money that flows from the central bank, and foreign resources that come from the country’s international reserves. During this early phase growth and wages increase, and the populist views appear to be vindicated. The populist leader repeatedly makes the point that orthodox economics and its supporters are wrong.</p> <p><em>Phase 2.</em> The consequences of the overly expansive heterodox policies begin to show up, and bottlenecks and imbalances emerge. Foreign exchange becomes scarce and there is significant pressure for the currency to depreciate rapidly. Exchange controls are introduced — France under Mitterrand, in 1984, is a good example of this development from outside of Latin America. In some cases, traditional exports are taxed. In spite of these measures, prices continue to rise. The populist response is to decree generalized price controls. Unions ask for higher salaries, and indexation practices are adopted. The central bank continues to lend vast amounts to the public sector, helping maintain the experiment. The economy enters into an inflationary spiral. A black market for necessities, and a parallel market for foreign exchange, usually appears.</p> <p id="note-17"><em>Phase 3</em>. There is a deepening of imbalances and inflation accelerates, generally moving to the three‐ or four‐​digit terrain. “Fiscal dominance” becomes more acute, as the central bank continues to finance the government. The frequency of price adjustments, through indexation, increases — first to quarterly and then to monthly intervals. Pervasive indexation tends to worsen the fiscal accounts through the so‐​called Olivera‐​Tanzi effect. Government expenditures increase according to the indexation formula, while tax revenues are collected based on lagged income figures. Consumers ditch domestic money, and foreign exchange becomes the medium of exchange. However, since the government requires that taxes be paid in domestic currency, the local monies (pesos, soles, escudos, bolívares, and córdobas) do not disappear completely. Demand for domestic money, however, falls very rapidly, with velocity of circulation increasing significantly. The disparity between inflation (very high) and exchange rates (depreciating more slowly) intensifies the extent of real exchange rate overvaluation.<sup><a href="#fn03-17">17</a></sup></p> <p><em>Phase 4.</em> The populist regime is finally replaced. The new post‐​populism government faces a very fragile economy and frequently a mess. Inflation is usually (very) high, international reserves are non‐​existent, exports are at an all‐​time low, the government debt is in default, and the real economy is replete with distortions. When the new government comes into power, real incomes and wages are often below what they were at the beginning of the experiment.</p> <h2>Three Populist Episodes in Latin America: Lessons for MMT Supporters</h2> <p id="note-18">In this section I analyze three of Latin America’s best known populist episodes: Chile during Salvador Allende’s socialist experiment from 1970 through 1973, Peru during the first Alan García administration (1985–90), and Venezuela during the Hugo Chávez and Nicolás Maduro governments (1998–present). Although each of these cases is unique, the three of them share the populist pattern discussed above, and followed policies similar to those espoused by MMT. Also, the three of them ended up in major crises. The case of Chile is possibly the most dramatic one, as the experiment with populist‐​socialist policies of President Salvador Allende ended up in a violent coup that was followed by a 17‐​year dictatorship. In Chile, inflation exceeded 500 percent in 1973. In both Peru and Venezuela, the central bank–financed fiscal expansions ended up in hyperinflation. In Peru the rate of inflation peaked at almost 8,000 percent, and the International Monetary Fund has forecasted that inflation in Venezuela will be almost 1 million percent by the end of 2019.<sup><a href="#fn03-18">18</a></sup></p> <p id="note-19">The three countries studied in this section had a sovereign currency, and thus could (and did) follow the type of policies recommended by MMT economists. In addition, in all cases the exchange rate was not strictly fixed; the price of foreign currency was adjusted frequently (in some cases daily) through a crawling rate regime or a “dirty float” system.<sup><a href="#fn03-19">19</a></sup> In every one of the episodes, exchange controls of one type or another were eventually put in place in an effort to slow down currency depreciation (<a href="#ch03_ref13">Edwards 2010</a>).</p> <p>I begin the discussion by presenting data on economic growth. I then discuss the expansion of public sector expenditures financed by central bank money creation, and the resulting inflation outbursts. The section ends with an analysis of the evolution of social conditions. I show that in the three cases, when the populist regime was replaced, real wages were lower than when the populist leader took over.</p> <h3>Growth and Populism Phases</h3> <p>In <a href="#ch03-figure-1">Figures 1</a>–<a href="#ch03-figure-3">3</a>, I present data on GDP growth for the three episodes. There are two dashed vertical lines in these graphs. The first one corresponds to the initial year of the populist episode; the second one refers to the first year of the post‐​populist regime. The similarities across cases are quite remarkable; the different phases of populist experiments are easy to detect in each one of these figures.</p> <p id="note-20_21">• In the three episodes it is possible to see that the initial conditions are characterized by either very low or negative growth. As noted, these depressed circumstances give the populist leader the opportunity to present his/​her nationalistic, anti‐​globalization and anti‐​elite program, and to get to power. In Chile, growth in 1970 was 2 percent, which meant that per capita growth was slightly negative.<sup><a href="#fn03-20">20</a></sup> In Peru, there was an IMF program at the time Alan García was inaugurated. Economic conditions were also negatively affected by the El Niño climatic phenomenon, which resulted in some of the worst flooding in the country’s history.<sup><a href="#fn03-21">21</a></sup> In Venezuela, growth was negative the year Chávez won the elections. Depressed initial conditions in Venezuela were the result of a succession of failed adjustment programs — some supported by the IMF — and a decline in the price of oil. Memories of the repression and deaths during the <em>Caracazo</em> demonstrations and riots also contributed to the support of Hugo Chávez and his program (<a href="#ch03_ref13">Edwards 2010</a>).</p> <p><img data-src="" class=" lozad" /></p> <p><img data-src="" class=" lozad" /></p> <p><img data-src="" class=" lozad" /></p> <p class="BL">• As may be seen from these figures, Phase 1, with its booming growth, follows the launching of the populist programs. In Chile the economy grew at an impressive 9 percent during the first year of President Salvador Allende’s Unidad Popular government. Peru saw its GDP growth jump to 12 percent in 1986, one year after Alan García’s election. In Venezuela there was also important GDP recovery after the accession to power of the new leader. In Venezuela it is possible to detect the negative effect of the global financial crisis of 2008-09. However, there is a recovery, and the good times continued for a few additional years. In Venezuela, the positive‐​growth phase (Phase 1) was rather longer than usual. This was thanks to very positive terms of trade; the prices of oil and soybeans were very high during the early years of this episode (<a href="#ch03_ref14">Edwards 2019</a>).</p> <p class="BL">• Eventually, in every one of the three countries, the day of reckoning arrives, and Phase 3, with the collapse in growth, becomes a reality. As may be seen, in Chile there was negative growth in 1972, the second year of the Allende administration. In Peru growth was negative 9 percent in 1989, toward the end of the Alan García presidency. In Venezuela the economy collapsed in 2014. During Phase 4 the new postpopulist government had to put in place policies aimed at reducing inflation and reigniting growth.</p> <h3>Monetary Policy, Fiscal Imbalances, and Inflation</h3> <p>As noted, in all of these episodes there were massive fiscal expansions financed by money creation by the central bank. In Chile, the Unidad Popular government also nationalized the banking sector, as a way to facilitate the flow of credit to newly nationalized companies and major public infrastructure projects. In Peru, President Alan García tried to follow Allende’s footsteps and nationalize the banking and financial sectors. However, there was a massive popular opposition, and, after weeks of protests led by novelist and future Nobel Prize winner Mario Vargas Llosa, the government gave up on the attempt (<a href="#ch03_ref28">Larraín and Meller 1991</a>; <a href="#ch03_ref15">Edwards and Edwards 1991</a>). In Venezuela, the central bank came under significant political pressure, and in the early years of the Chávez administration its degree of independence was greatly reduced. During the populist experiment, the central bank’s main goal was to help the government achieve its political and social development goals (<a href="#ch03_ref06">Carrière‐​Swallow et. al. 2016</a>).</p> <p>In <a href="#ch03-table-2">Tables 2</a> through <a href="#ch03-table-4">4</a>, I present data on a number of key macroeconomic variables: public sector balance as percentage of GDP, rate of growth of the monetary base, annual inflation rate, current account balance over GDP, and real GDP growth. In addition to the boom and bust dynamics of growth already discussed, several results stand out from these tables.</p> <p><img data-src="" class=" lozad" /></p> <p><img data-src="" class=" lozad" /></p> <p><img data-src="" class=" lozad" /></p> <p><em>Fiscal Expansion</em>. In all cases the fiscal deficit becomes very large during the episode. In two of the cases (Chile and Peru), a large imbalance develops immediately after the populist leader takes over. In Venezuela, it takes some time for the deficits to explode, but eventually it does happen. This delay is due to the extraordinarily high export prices during the early years of this experiment (<a href="#ch03_ref14">Edwards 2019</a>).</p> <p>In the case of Chile, I present two series for fiscal balance. The first one refers to the central government accounts, and shows that in 1973, the last year of the Allende administration, the deficit was almost 25 percent of GDP. The next column presents data for the “consolidated public sector” for 1970–73, and includes state‐​owned enterprises. As may be seen, in 1973 this measure of the deficit reached an astonishing 30 percent of GDP.</p> <p>In Peru, in 1983, two years before Alan García got to power, there was a huge deficit: 11.6 percent of GDP (<a href="#ch03-table-3">Table 3</a>). In 1984, President Fernando Belaúnde decided to call in the IMF, and an orthodox stabilization program was put in place. The data in <a href="#ch03-table-3">Table 3</a> show that between 1983 and 1985 there was a draconian fiscal adjustment that amounted to 8 percent of GDP. This drastic fiscal correction generated a substantial jump in unemployment and a precipitous decline in real wages — 39 percent between 1982 and 1985 — and paved the way to Alan García’s electoral success in 1985. One of the first measures taken by García was to suspend the IMF program and to go back to very expansive fiscal policies. As may be seen in <a href="#ch03-table-3">Table 3</a>, in Peru the deficit exceeded 10 percent of GDP in 1987, 1988, and 1989. In 1990 it was slightly down to 8 percent of GDP. Throughout these years it was mostly financed by money creation by the central bank (<a href="#ch03_ref31">Martinelli and Vega 2018</a>).</p> <p>The picture for Venezuela, in <a href="#ch03-table-4">Table 4</a>, shows that during the early years of the Chávez administration the public sector ran a surplus. With the exceptions of 1998 and 2001, and thanks to a very high international price of oil, the early years of the Bolivarian Revolution were characterized by (relatively) balanced public‐​sector finances. However, the fiscal deficit surpassed the 3 percent of GDP mark in 2008, and from that point onward increased markedly every year, reaching a remarkable 31 percent of GDP in 2017. The initial fiscal imbalance in 2008-10 coincided with a sharp decline in oil prices in the global marketplace. However, when oil prices recovered in 2011, Venezuela made no attempt to adjust public finances. The decision was made to finance the deficit with money created by the central bank. In 2017 the deficit reached almost 32 percent of GDP, even higher than the consolidated fiscal deficits for Chile in the last year of the Allende administration.</p> <p id="note-22"><em>Money Supply Growth</em>. The data in these tables show a clear connection between the eruption of very large fiscal deficits and a jump in the rate of growth of the money supply. This, of course, reflects the fact that in every one of these cases the central bank financed the expansion of public expenditures through the purchase of government debt. This was a deliberate component of these populist economic programs. This is illustrated by the following quote from García (<a href="#ch03_ref19">1972</a>: 102, 104), one of the economists behind President Salvador Allende’s economic program in Chile: “[The policy] was based on the simultaneous control of prices, wage increases, and increase in the public sector deficit… . [M]onetary and credit policy provided the financing for fiscal expansion and the deficit.“<sup><a href="#fn03-22">22</a></sup> In Venezuela, the chairman of the Finance Committee of the National Assembly declared in 2010 that the central bank’s role was to finance the government. “It should support the development and social program approved [by the government]” (<a href="#ch03_ref03">America Economía 2010</a>). It is precisely this close relationship between fiscal deficits and money creation that makes these episodes particularly germane to the debate on the merits and prospects of MMT.</p> <p id="note-23"><em>Inflation.</em> The data in these tables show that inflation was, eventually, extremely high in the four episodes. In Chile it surpassed 500 percent in 1973; in Peru, it reached hyperinflation levels — it exceeded 7,000 percent in 1990 — and in Venezuela it surpassed 130,000 percent in 2018. The IMF expects inflation in Venezuela to reach the 1,000,000 percent annual mark in 2019. As noted earlier, very high inflation feeds back into the fiscal deficit through the Tanzi‐​Olivera effect. When inflation is very high, indexation tends to become generalized, and wages are adjusted at increasingly shorter intervals. This means that the government wage bill — which in all of these countries was very substantial — increased rapidly, while taxes were assessed and paid based on lagged (and much lower) prices. In all of these cases a collapse in the demand for domestic money (or an increase in velocity) contributed significantly to the explosion of inflation. In Chile, for example, velocity in 1973, at the end of the Allende government, was 24 “times” per year, which was two times higher than the historical pre‐​Allende average of 12 times.<sup><a href="#fn03-23">23</a></sup> Interestingly, during the last decade, velocity in Chile has been around 3 times.</p> <p>One of the most serious weaknesses of MMT is that it ignores the role played by the demand for money in macroeconomic outcomes. Economists have known for a long time that, as Patinkin (<a href="#ch03_ref32">1965</a>) masterfully emphasized, what matters is the excess supply (demand) in different markets. In his MMT <em>Primer</em>, Wray (<a href="#ch03_ref43">2015</a>: 254) declares that he is surprised by the notion that during a hyperinflation economic agents reduce their holdings of domestic money to a minimum. The absence of a prominent role for the demand for money (and changes in velocity) in the theoretical construct of MMT is, indeed, surprising. In Chapter 13 of the <em>General Theory</em>, Keynes explains that people hold money for three motives: transactions‐​motive, precautionary‐​motive, and speculative‐​motives (Keynes 1936: 168). He further argues that the demand for money (or liquidity preference) is a function of the rate of interest. He explicitly writes <em>M</em> = <em>L</em>(<em>r</em>). Economists have known, since at least Irving Fisher, that higher inflation results in higher <em>r</em>. Thus, a rapid increase in inflation will generate a greater excess supply for money, which will be mirrored by an excess demand for goods and bonds (here I am following Patinkin’s analysis); the excess demand for goods, in turn, will put pressure on prices. MMTers believe that because taxes have to be paid in domestic currency the demand for local money cannot decline precipitously. The experiences of the three countries discussed here show that this is not the case. Indeed, and as a large number of economists have pointed out throughout history, when the value of the local currency erodes quickly, holdings of it are reduced to a minimum and velocity increases rapidly.</p> <p id="note-24"><em>External Balance.</em> The data in these tables show that current account deficits were not very large. In fact, in Venezuela there are surpluses until 2014. This absence of major external imbalances was due to a combination of factors, including the high price of exports in Venezuela during most of the episodes, and the difficulty, in the three cases, of finding international sources of financing. One of the realities of most populist regimes is that capital flows reverse soon after investors realize that the policy stance is inconsistent.<sup><a href="#fn03-24">24</a></sup> Once the country runs out of international reserves its currency depreciates at an increasingly rapid pace. Depreciation is passed through to prices, making the inflationary problem more acute. This external constraint, which is particularly important for countries with nonconvertible currencies — the type of country that Wray (<a href="#ch03_ref43">2015</a>: 127) calls “less special” — is either ignored or minimized by MMT supporters. Wray (<a href="#ch03_ref43">2015</a>: 286), for example, writes that a country with its own nonconvertible currency “cannot be forced into involuntary default on its obligations denominated in its own currency. It can ‘afford’ to buy anything for sale that is priced in its own currency. It might be able to buy things for sale in foreign currency by offering up its own currency in exchange — but that is not certain.”</p> <p id="note-25_26">The data presented above show that the duration of the three episodes is different. Chile’s Unidad Popular government lasted only three years. On September 11, 1973, president Salvador Allende was overthrown by a violent coup led by General Augusto Pinochet. The Peruvian experiment lasted five years; and in Venezuela it is still going on after two decades. There are political and economic reasons for these disparities. The most important economic factors are the external environment and export prices. The Allende government was affected by a sharp decline in the price of copper. During the Peruvian experiment, the international price of fishmeal, Peru’s main export, fell from USD 1,024 per metric ton in the third quarter of 1983, to USD 614 per metric ton in the first quarter in 1989, a decline of 40 percent. Chile and Peru contrast markedly with the case of Venezuela. The price of crude oil, Venezuela’s main export, jumped from USD 20 per barrel in 2002 to USD 130 in 2008.From a political point of view there are two main reasons behind the longer duration of more recent episodes. First, since the 1990s, new constitutions approved in a number of Latin American countries — Colombia, Venezuela, Ecuador, Bolivia, and Nicaragua — have made it is easier for the head of state to be reelected for multiple periods in office.<sup><a href="#fn03-25">25</a></sup> Second, in some of these experiments — most notably in Venezuela and Nicaragua — the political regime became increasingly authoritarian and resorted to repressive tactics in order to suppress political dissent. Human rights organizations, such as Amnesty International, decried these practices.<sup><a href="#fn03-26">26</a></sup></p> <h3>Real Wages and Exchange Rates</h3> <p>An important question is what happened to real wages during these episodes. The answer is summarized in <a href="#ch03-table-5">Table 5</a>. As may be seen, in the three cases there were steep declines. In Chile, average real wages fell by 39 percent between 1970 and 1973. In Peru real wages went down by 41 percent between 1985 and 1989. In Venezuela real wages declined 21 percent between 1999 and 2013; more recent reliable data are not available, but given the hyperinflation and generalized black markets for almost every item, including food and medicines, most experts have argued that there has been further precipitous deterioration.</p> <p><img data-src="" class=" lozad" /></p> <p>In all of these cases there were also very severe currency devaluations. In Chile, for example, the peso lost 93 percent of its value in 1973 alone, and the price of the foreign exchange increased at a three‐​digit pace until 1977. In Peru the price of foreign currency jumped by more than 8,000 percent in 1989–90. In 1991, there was a need to introduce a new currency, with fewer zeros. In Venezuela the loss of value of the Bolivar has been absolute, and the government has tried to introduce a new cryptocurrency that would replace it. In all cases currency depreciation helped fuel inflation by putting upward pressure on the price of tradables. Interestingly, this regularity of Latin American experiments is not considered a serious problem by MMTers. In their writings MMT theorists mostly ignore issues related to exchange rate “pass through,” a question that has been at the forefront of studies on macroeconomic policy and inflation in open economies for many decades.</p> <h2>Conclusion</h2> <p>A full assessment of the weaknesses of MMT is beyond the scope of this article. However, the fact that, as documented in <a href="#ch03-table-1">Table 1</a>, most of its policy recommendations are similar to those of Latin American populists should be a cause for concern to observers of the global economy. As pointed out, the easiest way to think conceptually about MMT is that it suggests policies that simultaneously shift the IS and LM curves to the right. Of course, that is a possibility that all undergraduate students of macroeconomics, at one point or another, contemplate as a theoretical possibility. Although that policy mix — expansive fiscal and monetary policies — may seem attractive to the novice, it is full of dangers that have been identified through the years by successive scholars. Such policies are not only likely to generate inflationary pressures once aggregate demand exceeds supply constraints, but they are also expected to generate higher interest rates. In addition, it is highly probable that they will result in a higher risk premium and in currency depreciation. The latter will be passed through to prices, further fueling inflation.</p> <p>The fact that, by law, taxes have to be paid with local currency — a point emphasized time and again by MMT supporters, on the basis of work done by German economist G. F. Knapp in 1904 — does not mean that the demand for local currency is insensitive to rapid losses in value. Indeed, as the histories of the countries analyzed in this article show, once inflation reaches a certain threshold there is usually a rapid collapse in the demand for cash and bank deposits, or what economists know as M1.</p> <p>Some may argue that I deliberately picked the worst possible cases in Latin America to illustrate the shortcomings of MMT, episodes where macroeconomic excesses were the order of the day. However, this is not so. As is documented in the volume by Dornbusch and Edwards (<a href="#ch03_ref11">1991</a>), similar experiments in Argentina, Bolivia, Ecuador, Mexico, Nicaragua, and Uruguay led to very similar results — namely, runaway inflation, currency depreciation, income collapse, and lower wages. More recently, similar policies have been tried in Argentina (again) and in Ecuador; the pattern discussed in this article was, not surprisingly, present in those cases (<a href="#ch03_ref14">Edwards 2019</a>). Experience with these types of policies outside of Latin America, in places such as Turkey, Israel, and France during the Mitterrand administration, also ended up badly.</p> <p>A short and partial list of limitations of MMT would include the following:</p> <p>• There is no serious attempt to integrate different markets and sectors into a general equilibrium macroeconomic perspective, in the tradition of Patinkin (<a href="#ch03_ref32">1965</a>). More specifically, MMT fails to recognize that what really matters are excess demands or excess supplies in specific markets, which spill over (with the opposite sign) to the rest of the economy. Indeed, it is important to realize that situations of sizable excess supplies of money, which are translated into excess demands for bonds and goods, may arise because of the collapse of the demand for domestic money.</p> <p class="BL">• MMT ignores (or minimizes) the role of expectations on interest rates. As is well established by empirical research, expected inflation is translated into higher interest rates through the so‐​called Fisher effect. In addition, MMT ignores the role of expectations of currency depreciation and of credit events. MMT supporters repeatedly make the point that countries with a currency of their own don’t ever have to default on their debts, as long as they are denominated in local currency. What this perspective ignores is that hyperinflation — the outcome of many MMT‐​type policies — is a form of default. In Argentina, for example, there is even a term used for this mechanism for not paying the sovereign debt as initially contracted — “liquefying the debt” (<a href="#ch03_ref13">Edwards 2010</a>).</p> <p class="BL">• MMT, essentially, offers a closed economy view of the world. This is the case even though a number of MMT authors have written about exchange rate regimes. As noted, a straightforward way of interpreting MMT is as a policy mix that simultaneously shifts to the right the IS and LM curves. Of course, open economy models of that vintage include, since at least the work of Robert Mundell, a third schedule, often called the FF curve, which captures the combination of interest rates and income compatible with external balance. Every time a domestic policy moves the economy away from the FF curve there will be a currency depreciation or appreciation to reestablish external equilibrium. A well‐​established empirical fact in international economics is that currency depreciation tends to be passed onto prices. The extent of this transmission is an empirical question and varies from country to country. MMTers, however, minimize (or ignore) this mechanism.</p> <p class="BL">• MMT does not delve into the intricacies of modern financial markets. Among other things there is no inkling of portfolio decisions by investors and households, or how those tend to affect the way in which policies interact with the key economic variables. More specifically, there is no role for risk premium in these models. In MMT conceptual models interest rates are determined in the simplest possible way by the central bank. There is no theory of the term structure of interest rates or of the transmission mechanism of monetary policy. There is no consideration for the fact that the demand for sovereign debt may shift as a result of changes in expectations.</p> <p class="BL">• MMT ignores the strategic interaction of different economic agents and institutions in a modern economy. No game theory considerations are included in these models. There is no discussion about credibility or lack thereof. In MMT models there is no reason why a central bank may want to be independent of political forces. However, the evidence stemming from Latin America indicates that as soon as central bank independence is weakened, and the central bank begins to work for the government, inflation expectations take off, as does inflation proper.</p> <p class="BLL">• MMT supporters believe that supply constraints are soft. Increases in aggregate demand will usually be accommodated by increases in output. In addition, MMT believes that large current account deficits are beneficial, because the rest of the world is willing to provide real resources in exchange for IOUs. At the core of these beliefs is the notion that economic authorities can fine‐​tune macroeconomic policy — that is, it is possible for the central bank to finance large increases in government expenditure and still keep things under control. If there is a threshold beyond which it is advisable to increase aggregate demand, policymakers will recognize it. They will stop just short of it, and, if necessary, will implement a restrictive fiscal policy. The experiences of the Latin American countries discussed in this article (and of other cases) indicate that that type of fine‐​tuning is extremely difficult, and that, once politicians capture the central bank, they will continue to use its money creation authority well past that threshold.</p> <p>The historical episodes presented in this article provide a clear cautionary tale for MMT enthusiasts. <em>New York Times</em> reporter Neil Irwin asked to see some evidence on how MMT‐​type policies worked in small countries. The stories presented here show that, in a variety of Latin American countries over the period 1970–2019, things did not turnout as policymakers who followed MMT‐​type policies had promised. It is true that these countries are not like the United States, the United Kingdom, or Australia. 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(2008) “An Empty Revolution: The Unfulfilled Promises of Hugo Chávez.” <em>Foreign Affairs</em> 87 (2): 49–58, 60–62.</p> <p><a id="ch03_ref35"></a>Rogoff, K. (2019) “Modern Monetary Nonsense.” <em>Project Syndicate</em> (March 4).</p> <p><a id="ch03_ref36"></a>Schumpeter, J. A. (1954) <em>History of Economic Analysis</em>. New York: Oxford University Press.</p> <p><a id="ch03_ref37"></a>Summers, L. (2019) “The Left’s Embrace of Modern Monetary Theory Is a Recipe for Disaster.” <em>Washington Post</em> (March 4).</p> <p><a id="ch03_ref38"></a>Sumner, S., and Horan, P. (2019) “How Reliable Is Modern Monetary Theory as a Guide to Policy?” Arlington, Va.: Mercatus Center, George Mason University (March 11).</p> <p><a id="ch03_ref39"></a>Tymoigne, É., and Wray, L. R. (2013) “Modern Money Theory 101: A Reply to Critics.” Levy Economics Institute, Working Paper No. 778.</p> <p><a id="ch03_ref40"></a>__________ (2015) “Modern Monetary Theory: A Reply to Palley.” <em>Review of Political Economy</em> 27 (1): 24–44.</p> <p><a id="ch03_ref41"></a>Walsh, B. (2018) “Stephanie Kelton Wants You to Rethink the Deficit.” <em>Barron’s</em> (September 13).</p> <p><a id="ch03_ref42"></a>Williamson, E. (1992) <em>The Penguin History of Latin America.</em> London: Penguin.</p> <p><a id="ch03_ref43"></a>Wray, L. R. (2015) <em>Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems</em>. 2nd ed. London: Palgrave Macmillan.</p> <p><a id="ch03_ref44"></a>__________ (2018) “How I Came to MMT and What Do I Include in MMT.” Remarks at the 2018 MMT Conference, September 28–30, New York City. Available at <a href="">http://​mul​ti​pli​er​-effect​.org/​m​o​d​e​r​n​-​m​o​n​e​y​-​t​h​e​o​r​y​-​h​o​w​-​i​-​c​a​m​e​-​t​o​-​m​m​t​-​a​n​d​-​w​h​a​t​-​i​-​i​n​c​l​u​d​e​-​i​n-mmt</a>.</p> <p><sup><a id="fn03-1">1</a></sup> See Wray (<a href="#ch03_ref43">2015</a>) for details. The term “modern” is supposed to be an inside joke, and refers to a statement made by Keynes in <em>A Treatise on Money</em> (<a href="#ch03_ref22">1930</a>: 4), where he says that, for at least 4,000 years, money has been the creation of the state. Money is whatever the state accepts in payment of taxes (see <a href="#ch03_ref24">Knapp [1904] 1924</a>).</p> <p><sup><a id="fn03-2">2</a></sup> See, for example, Forstater and Mosler (<a href="#ch03_ref17">2005</a>), Tymoigne and Wray (<a href="#ch03_ref39">2013</a>, <a href="#ch03_ref40">2015</a>), and Wray (<a href="#ch03_ref43">2015</a>) and the literature cited therein. Scott Sumner has discussed MMT in depth in his blog. See Sumner and Horan (<a href="#ch03_ref38">2019</a>).</p> <p><sup><a id="fn03-3">3</a></sup> MMT has also been called “Neo‐​Chartalism.” The term “Chartalism” was introduced by German economist G. F. Knapp in 1905 to refer to a theory where the value of money is not tied to the value of a commodity, such as gold. It is interesting to notice that Schumpeter (<a href="#ch03_ref36">1954</a>: 288) spelled the term as “Cartalism.”</p> <p><sup><a id="fn03-4">4</a></sup> For a skeptical view see, for instance, Sumner and Horan (<a href="#ch03_ref38">2019</a>).</p> <p><sup><a id="fn03-5">5</a></sup> See, for example, Forstater and Mosler (<a href="#ch03_ref17">2005</a>), Tymoigne and Wray (<a href="#ch03_ref39">2013</a>), and Wray (<a href="#ch03_ref43">2015</a>, <a href="#ch03_ref44">2018</a>) and the literature cited therein.</p> <p><sup><a id="fn03-6">6</a></sup> There seems to be agreement that in the short run, and under special circumstances, such as a severe crisis similar to the one triggered by the subprime mortgages collapse, a short‐​run policy based on massive purchases of government paper by the central bank would make sense.</p> <p><sup><a id="fn03-7">7</a></sup> For analyses of populist experiences in Latin America, see, for example, Dornbusch and Edwards (<a href="#ch03_ref11">1991</a>) and Edwards (<a href="#ch03_ref13">2010</a>).</p> <p><sup><a id="fn03-8">8</a></sup> Edwin Williamson (<a href="#ch03_ref42">1992</a>: 347), defined populism as “the phenomenon where a politician tries to win power by courting mass popularity with sweeping promises of benefit and concessions to the lower classes.” Political scientist Michael L. Conniff (<a href="#ch03_ref07">1982</a>: 82) pointed out that “populist programs frequently overlapped with those of socialism.” More recently, Acemoglu, Egorov, and Sonin (<a href="#ch03_ref01">2013</a>: 771) stated that populist “politicians use a rhetoric that aggressively defends the interests of the common man against the privileged elite.” Eichengreen (<a href="#ch03_ref16">2018</a>: 1) wrote that populism is a “political movement with anti‐​elite, authoritarian, and nativist tendencies.” Parts of this section draw on Edwards (<a href="#ch03_ref14">2019</a>).</p> <p><sup><a id="fn03-9">9</a></sup> Frenkel (<a href="#ch03_ref18">2006</a>) discusses a heterodox monetary policy geared at maximizing employment. He presents his proposal as an alternative to orthodox inflation targeting policies.</p> <p><sup><a id="fn03-10">10</a></sup> In Dornbusch and Edwards (<a href="#ch03_ref11">1991</a>), case studies for Argentina, Chile, Peru, Colombia, Brazil, and Nicaragua are presented.</p> <p><sup><a id="fn03-11">11</a></sup> See Chapter 8 in Edwards (<a href="#ch03_ref13">2010</a>).</p> <p><sup><a id="fn03-12">12</a></sup> Many of their views are associated with the traditional “structuralism approach” to economic development, espoused by thinkers such as Raul Prebisch.</p> <p><sup><a id="fn03-13">13</a></sup> See <a href="">www​.abacq​.net/​i​m​a​g​i​n​e​r​i​a​/​f​r​a​m​e​5​b​.​h​tm#05</a>.</p> <p><sup><a id="fn03-14">14</a></sup> Abba Lerner, an inspiration for MMTers, argued that the most efficient way to deal with inflationary pressures was the use of price controls.</p> <p><sup><a id="fn03-15">15</a></sup> See the various speeches on the economy in Allende (<a href="#ch03_ref02">1989</a>).</p> <p><sup><a id="fn03-16">16</a></sup> A formal model that captures these cycles is presented in Dornbusch and Edwards (<a href="#ch03_ref10">1990</a>). Acemoglu, Egorov, and Sonin (<a href="#ch03_ref01">2013</a>) develop a more general model that generates this type of populist dynamics.</p> <p><sup><a id="fn03-17">17</a></sup> In some cases, such as Venezuela under Nicolás Maduro, economic conditions become so bleak that the population becomes undernourished and outmigration increases significantly. Rodríguez (<a href="#ch03_ref34">2008</a>).</p> <p><sup><a id="fn03-18">18</a></sup> In Edwards (<a href="#ch03_ref13">2010</a>), I discuss Chile, Argentina, and Venezuela. For Peru, see Dornbusch and Edwards (<a href="#ch03_ref10">1990</a>) and Lago (<a href="#ch03_ref27">1991</a>). For Chile, see also Edwards and Edwards (<a href="#ch03_ref15">1991</a>).</p> <p><sup><a id="fn03-19">19</a></sup> Wray (<a href="#ch03_ref43">2015</a>) has stated that MMT policies work better if the central bank does not make a firm commitment to exchanging the sovereign money into a commodity (gold) or another currency.</p> <p><sup><a id="fn03-20">20</a></sup> As will be seen below, in 1970 inflation in Chile was a very high 35 percent. This was an important component of the sense of crisis in the country. In fact, as mentioned earlier, achieving price stability was one of President Allende’s more important goals. See Edwards and Edwards (<a href="#ch03_ref15">1991</a>).</p> <p><sup><a id="fn03-21">21</a></sup> Alan García became President in July 1985. A year earlier Peru signed an IMF program, for 104 million SDRs. Peru stopped making payments to the IMF in 1987. Venezuela obtained IMF support in 1996 (300 million SDR), under the presidency of Rafael Caldera, Hugo Chávez’s predecessor.</p> <p><sup><a id="fn03-22">22</a></sup> The original is in Spanish. This is my own translation.</p> <p><sup><a id="fn03-23">23</a></sup> These numbers refer to the number of times the stock of money turns over every year. An alternative way of looking at this problem is to calculate what fraction of nominal GDP is held in the form of domestic money. This, of course, corresponds to “Cambridge’s <em>k</em>.” When inflation is very high, this ratio collapses. For the data on Chile, see, Díaz, Lüders, and Wagner (<a href="#ch03_ref09">2010</a>).</p> <p><sup><a id="fn03-24">24</a></sup> On reversals of capital flows and crises (including populist crises) and the imposition of controls, see, for example, Cowan et al. (2005), and Edwards (<a href="#ch03_ref12">2004</a>). MMTers believe that this is unlikely. Wray (2015: 127) acknowledges that interest rates paid by the government of a “less special” country in the international market may go up, but doesn’t acknowledge that the country in question may be completely cut off from foreign finance sources.</p> <p><sup><a id="fn03-25">25</a></sup> On neopopulist constitutions in Venezuela, Ecuador, and Bolivia, see Edwards (<a href="#ch03_ref13">2010</a>).</p> <p><sup><a id="fn03-26">26</a></sup> In its 2017/2018 report of human rights Amnesty International states: “In Venezuela, hundreds of people were arbitrarily detained and many more suffered the consequences of excessive and abusive force used by security forces in response to widespread public protests against rising inflation and shortages of food and medical supplies.” Repressive policies were also implemented by Nicaragua’s Daniel Ortega after 2017.</p> </div> Mon, 30 Sep 2019 03:00:00 -0400 Sebastian Edwards George Selgin discusses a possible recession on SiriusXM’s Press Pool Thu, 12 Sep 2019 11:56:29 -0400 George Selgin Worried About A Recession? Relax. Steve H. Hanke <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Everyone seems to be wringing their hands about what they fear is an oncoming recession. Indeed, as a&nbsp;sign of the level of the public’s angst,&nbsp;<a href="" target="_blank"><em>The Economist&nbsp;</em>magazine reports</a>&nbsp;that Google searches related to the word “recession” have surged.</p> </div> , <aside class="aside--right aside pb-lg-0 pt-lg-2"> <div class="pullquote pullquote--default"> <div class="pullquote__content h2"> <p>While the daily drumbeat of negative news—particularly that which is related to President Trump’s counter‐​productive and futile trade war with China—is worth paying attention to, it is somewhat of a&nbsp;sideshow.</p> </div> </div> </aside> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>If that wasn’t enough evidence of the hand wringing, the Chairman of President Trump’s Council of Economic Advisers, the respected Tomas Philipson, recently indicated that he was worried about the steady negative drumbeat in the press: that a&nbsp;recession might be just around the corner. Philipson put his finger on the problem when he said, “The way the media reports the weather won’t impact whether the sun shines tomorrow. But the way the media reports on our economy weighs on consumer sentiment, which feeds into consumer purchases and investments.”</p> <p>Philipson understands very well that negative news can become part of a&nbsp;negative feedback loop that can result in a&nbsp;plunge in the public’s state of confidence and a&nbsp;recession. He also knows how to follow metrics that gauge the public’s expectations and confidence in the economy, like the University of Michigan’s Consumer Sentiment index. The chart below shows the course of that index. The last reading on the chart is for August. It is notable that Consumer Sentiment took a&nbsp;dive, falling from 98.4&nbsp;in July to 89.8&nbsp;in August. That’s the lowest reading since October 2016. It’s clear that the President’s Council of Economic Advisers took note, causing Chairman Philipson to spring into action.</p> </div> , <figure class="figure overflow-hidden figure--default figure--no-caption responsive-embed-no-margin-wrapper"> <div class="figure__media"> <img width="700" height="304" alt="hanke-market-1-img" class="lozad component-image" data-srcset="/sites/ 1x, /sites/ 1.5x" data-src="/sites/" typeof="Image" /> </div> </figure> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>The state of confidence argument which sometimes flies under the “animal spirits” rubric goes back to earlier ideas about the business cycle; ideas that stress the importance of changes in business sentiment. For example, members of the Cambridge School of Economics, which was founded by Alfred Marshall (1842–1924), all concluded that fluctuations in business confidence are the essence of the business cycle. As John Maynard Keynes argued in the&nbsp;<em>General Theory</em>:</p> </div> , <blockquote class="blockquote"> <div> <p>“The state of confidence, as they term it, is a&nbsp;matter to which practical men always pay the closest and most anxious attention. But economists have not analyzed it carefully and have been content, as a&nbsp;rule, to discuss it in general terms.”</p> </div> </blockquote> <cite> </cite> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Frederick Lavington (1881–1927), a&nbsp;Fellow of Emmanuel College and the most orthodox of the Cambridge economists, went even further than Keynes. In his 1922 book,&nbsp;<em>The Trade Cycle</em>. Lavington concluded that, without a “tendency for confidence to pass into errors of optimism or pessimism,” there would not be a&nbsp;business cycle.</p> <p>But, this animal spirits approach to the business cycle, while it contains a&nbsp;grain of salt, fails to offer much of a&nbsp;theory of national income determination, as Keynes himself concluded. The monetary approach fills that void.</p> <p>The monetary approach posits that changes in the money supply, broadly determined, cause changes in nominal national income and the price level. Sure enough, the growth in the supply of broad money and nominal GDP are closely linked.</p> <p>So, just where do things stand in the U.S.? As shown in the chart below, the growth rate of the money supply, broadly measured by Divisia M4, is growing at 5.04%/yr. That puts it above the trend rate since 2003 of 3.81%/yr. And what’s more, the broad money growth rate is right in line with the “golden growth” rate. That’s the rate of growth in the money supply that would allow the Fed to hit its inflation target of 2%/yr. The money supply, broadly measured, is in the sweet spot: not too hot, not too cold. Also, private credit is growing at 5.57%/yr, which is very close to its trend rate since 2003 of 5.63%/yr.</p> </div> , <figure class="figure overflow-hidden figure--default figure--no-caption responsive-embed-no-margin-wrapper"> <div class="figure__media"> <img width="700" height="506" alt="hanke-market-2-2-img" class="lozad component-image" data-srcset="/sites/ 1x, /sites/ 1.5x" data-src="/sites/" typeof="Image" /> </div> </figure> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>While the daily drumbeat of negative news—particularly that which is related to President Trump’s counter‐​productive and futile trade war with China—is worth paying attention to, it is somewhat of a&nbsp;sideshow. The main event is money. Money dominates, and at present, it’s not too hot, not too cold—about right. Perhaps that’s why Fed Chairman Jerome Powell, while in Zurich yesterday, confidently said, “Our main expectation is not at all that there will be a&nbsp;recession.” Powell could have added the word: “Relax.”</p> </div> Sat, 07 Sep 2019 10:14:46 -0400 Steve H. Hanke Steve H. Hanke discusses the Argentine peso on The Gold Newsletter podcast Tue, 03 Sep 2019 11:02:00 -0400 Steve H. Hanke Hayek on Argentina’s Capital Controls Steve H. Hanke <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Yesterday, President Mauricio Macri chose to impose capital controls on Argentina. Since being elected, Macri has been reluctant to reform — a&nbsp;gradualist, “do‐​nothing” president. But, when backed into a&nbsp;corner of his own making, he acts as if he is bent on committing political suicide. First, he called in the firemen from the International Monetary Fund — a&nbsp;rightfully despised organization in Argentina. And now, he has pulled the trigger on capital controls.</p> <p>What would Nobelist Friedrich Hayek say about the imposition of capital controls and restrictions on the convertibility of Argentina’s junk currency—the peso?</p> <p>Currency convertibility is a&nbsp;simple concept. It means residents and nonresidents are free to exchange domestic currency for foreign currency. However, there are many degrees of convertibility, with each denoting the extent to which governments impose controls on the exchange and use of currency.</p> <p>The pedigree of exchange controls can be traced back to Plato, the father of statism. Inspired by Lycurgus of Sparta, Plato embraced the idea of an inconvertible currency as a&nbsp;means to preserve the autonomy of the state from outside interference.</p> <p>So, the temptation to turn to exchange controls in the face of disruptions caused by hot money flows is hardly new. Tsar Nicholas II first pioneered limitations on convertibility in modern times, ordering the State Bank of Russia to introduce, in 1905-06, a&nbsp;limited form of exchange control to discourage speculative purchases of foreign exchange. The bank did so by refusing to sell foreign exchange, except where it could be shown that it was required to buy imported goods.</p> <p>Otherwise, foreign exchange was limited to 50,000 German marks per person. The Tsar’s rationale for exchange controls was that of limiting hot money flows, so that foreign reserves and the exchange rate could be maintained. The more things change, the more they remain the same.</p> <p>Before more politicians come under the spell of exchange controls, they should reflect on the following passage from Hayek’s 1944 classic,<a href="" target="_blank"><em>The Road to Serfdom</em></a>:</p> </div> , <blockquote class="blockquote"> <div> <p>“The extent of the control over all life that economic control confers is nowhere better illustrated than in the field of foreign exchanges. Nothing would at first seem to affect private life less than a&nbsp;state control of the dealings in foreign exchange, and most people will regard its introduction with complete indifference. Yet the experience of most Continental countries has taught thoughtful people to regard this step as the decisive advance on the path to totalitarianism and the suppression of individual liberty. It is, in fact, the complete delivery of the individual to the tyranny of the state, the final suppression of all means of escape‐​not merely for the rich but for everybody.”</p> </div> </blockquote> <cite> </cite> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>Hayek’s message about convertibility has regrettably been overlooked by Argentina’s economists, who have a&nbsp;fatal attraction to nutty ideas. Exchange controls are nothing more than a&nbsp;ring fence within which governments can expropriate their subjects’ property. Open exchange and capital markets, in fact, protect the individual from exactions, because governments must reckon with the possibility of capital flight.</p> <p>From this it follows that the imposition of exchange controls leads to an instantaneous reduction in the wealth of the country, because all assets decline in value. To see why, it is important to understand how assets are priced. The value of any asset is the sum of the expected future installments of income it generates discounted to the present value. For example, the price of a&nbsp;stock represents the value to the investor now of his share of the company’s future cash flows, whether issued as dividends or reinvested. The present value of future income is calculated using an appropriate interest rate that is adjusted for the various risks that the income may not materialize.</p> <p>When convertibility is restricted, risk increases, because property is held hostage and is subject to a&nbsp;potential ransom through expropriation. As a&nbsp;result, the risk‐​adjusted interest rate employed to value assets is higher than it would be with full convertibility. Investors are willing to pay less for each dollar of prospective income, and the value of property is less than it would be with full convertibility.</p> <p>This result, incidentally, is the case even when convertibility is allowed for profit remittances. With less than full convertibility, there is still a&nbsp;danger the government will confiscate property without compensation. That explains why foreign investors are less willing to invest new money in a&nbsp;country with such controls, even with guarantees on profit remittances.</p> <p>Investors become justifiably nervous when they expect that a&nbsp;government may impose exchange controls. Settled money becomes “hot” and capital flight occurs. Asset owners liquidate their property and get out while the getting is good. Contrary to popular wisdom, restrictions on convertibility do not retard capital flight, they promote it. Macri’s capital controls have destroyed vast amounts of Argentina’s wealth and further damaged the country’s dead‐​beat reputation.</p> </div> Mon, 02 Sep 2019 10:27:56 -0400 Steve H. Hanke What Could Cause the Next Housing Crash? Diego Zuluaga, Caleb O. Brown <p>Are rules governing housing finance setting the stage for the next crash? If so, what ought to change? Diego Zuluaga comments.</p> Tue, 27 Aug 2019 11:31:00 -0400 Diego Zuluaga, Caleb O. Brown Macri’s Kiss of Death: Argentina’s Peso and the IMF Steve H. Hanke <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Yesterday, the ticket of Alberto Fernandez and Christina Kirchner crushed the hapless President of the Argentine Republic Mauricio Macri in a&nbsp;primary election. Their victory virtually guarantees that the Fernandez‐​Kirchner team will occupy the Casa Rosada after the presidential election scheduled for October.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>For many, including the pollsters, Sunday’s results were a stunner. Not for me. I have been warning for over a year that gradualism, which is Macri’s mantra, is a formula for political disaster. If that wasn’t enough, the Argentine peso is another time bomb that has sent many politicians in Argentina into early retirement. And, to add insult to injury, Macri called in the “firefighters” from the International Monetary Fund (IMF) to salvage the peso. These three factors sealed Macri’s fate.</p> <p>As it turns out, this movie has been played over-and-over again in Argentina. Argentina has seen many political gradualists bite the dust. What makes Macri unique is that he advertised gradualism as a virtue. Macri and his advisers obviously never studied the history of economic gradualism. When presidents are faced with a mountain of economic problems, it’s the Big Bangers who succeed.</p> <p>As for the venom that can be injected by a peso crisis, the instances of the poison delivered by that snake bite are almost too numerous to count. To list but a few of Argentina’s major peso collapses: 1876, 1890, 1914, 1930, 1952, 1958, 1967, 1975, 1985, 1989, 2001, and 2018.</p> <p>It is noteworthy that the frequency of peso crises picked up after the establishment of the Central Bank of Argentina (BCRA) in 1935. With that, serial monetary mismanagement ensued. The chart below tells the BCRA story. Before the BCRA, Argentina (the peso) held its own against the United States (the dollar), with the respective per capita GDPs being roughly equal in 1935. But, after the BCRA entered the picture, a great divergence began. Now, the U.S. GDP per capita is roughly three times higher than that of Argentina.</p> <p align="center"> </p><div data-embed-button="image" data-entity-embed-display="view_mode:media.full" data-entity-type="media" data-entity-uuid="dadd81eb-a612-40d8-9e38-7ebfb87a96e5" data-langcode="en" class="embedded-entity"> <img width="700" height="557" alt="GDP" class="lozad component-image lozad" data-srcset="/sites/ 1x, /sites/ 1.5x" data-src="/sites/" typeof="Image" /></div> <p>The BCRA’s most recent monetary mishap occurred last year, when the poor peso lost 58% of its value against the greenback from the start of 2018 until the end of May 2019. What was behind that collapse? On Macri’s watch, no less, the BCRA had been surreptitiously financing the government’s deficit spending. It did this through the sterilization of increases in the net foreign asset component of Argentina’s monetary base. This was done via the sale of bonds issued by the BCRA (LEBACS). The sterilization (and financing of the government’s deficit) was on a massive scale. In the January 2017—May 2018 period, the BCRA sterilized 50% of the total increase in the foreign asset component of the monetary base. In consequence, the BCRA was the largest source of financing for Argentina’s sizable primary fiscal deficit. These typical Argentine monetary-fiscal shenanigans were an invitation for yet another currency disaster.</p> <p align="center"> </p><div data-embed-button="image" data-entity-embed-display="view_mode:media.full" data-entity-type="media" data-entity-uuid="32860419-165e-4c40-91ff-7c6a9961d9b8" data-langcode="en" class="embedded-entity"> <img width="700" height="497" alt="FX" class="lozad component-image lozad" data-srcset="/sites/ 1x, /sites/ 1.5x" data-src="/sites/" typeof="Image" /></div> <p>After the peso rout, Macri went hat in hand to the IMF. This was the dagger in the heart of Macri’s political career. For one thing, the Argentine public distrusts, if not despises, the IMF—and for good reasons: namely, the IMF’s record of failure in Argentina. Yes, the IMF’s prescriptions have turned out to be the wrong medicine. To stabilize a half-baked currency’s (read: the Argentine peso) exchange rate, the IMF orders sky-high interest rates. With these rates, the economy collapses, as does the local currency that the IMF is trying to stabilize.</p> <p>As Harvard University’s Robert Barro put it, the IMF reminds him of Ray Bradbury’s <em>Fahrenheit 451 </em>“in which the fire department’s mission is to start fires.” Barro’s basis for that conclusion is his own extensive research. His damning evidence finds that:</p> <ul><li>A higher IMF loan participation rate reduces economic growth.</li> <li>IMF lending lowers investment.</li> <li>A greater involvement in IMF programs lowers the level of the rule of law and democracy.</li> </ul><p>And, if that’s not bad enough, countries that participate in IMF programs tend to be recidivists. The IMF programs don’t provide cures, but create addicts.</p> <p>For a clear picture of the addiction problem (read: recidivism), review the chart below. It lists the number of IMF programs that 146 countries have participated in. Haiti leads the pack with 27 programs since joining the IMF in 1953. Argentina is a heavy hitter, too. It joined the IMF in 1956 and is now hooked on its 22nd IMF program. That’s a new program every 2.8 years on average. </p><div> <div data-embed-button="image" data-entity-embed-display="view_mode:media.full" data-entity-type="media" data-entity-uuid="db6d1d13-2845-4909-b4d7-ea22a4674d86" data-langcode="en" class="embedded-entity"> <img width="700" height="1294" alt="IMF" class="lozad component-image lozad" data-srcset="/sites/ 1x, /sites/ 1.5x" data-src="/sites/" typeof="Image" /></div> </div> <p>Armed with this weekend’s election results, Argentines are exchanging pesos for greenbacks as fast as they can. The peso has shed a stunning 20.5% against the preferred greenback since last Friday. And, by my measure, which uses high-frequency data, Argentina’s inflation rate has exploded to 103%/yr (see the chart below). </p><div> <div data-embed-button="image" data-entity-embed-display="view_mode:media.full" data-entity-type="media" data-entity-uuid="960dc4da-54be-4af1-a6d2-985c4bf372b6" data-langcode="en" class="embedded-entity"> <img width="700" height="535" alt="ANnual inflation" class="lozad component-image lozad" data-srcset="/sites/ 1x, /sites/ 1.5x" data-src="/sites/" typeof="Image" /></div> </div> <p>To end Argentina’s never-ending monetary nightmare, the Central Bank of Argentina, along with the peso, should be mothballed and put in a museum. The peso should be replaced with the U.S. dollar. Argentina’s government should do officially what all Argentines do in times of trouble: dollarize. It’s time for the elites in Argentina to wake up and face reality.</p> </div> Tue, 20 Aug 2019 14:37:00 -0400 Steve H. Hanke James A. Dorn discusses China and the Yuan on CNBC’s The Exchange Tue, 13 Aug 2019 13:56:00 -0400 James A. Dorn U.S. Currency Wars with China–Past and Present Steve H. Hanke <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>In a&nbsp;purely political move, the Trump administration (read: the U.S. Treasury) has branded China as a&nbsp;currency manipulator. This is an act of war. After President Trump announced that even more tariffs would be imposed on China, the markets took the value of the Chinese yuan down a&nbsp;notch or two. So, who was “manipulating” the yuan, Beijing or Washington? Well, it looks like Washington is engaging in yet another Asian currency war.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>As it turns out, the United States has a&nbsp;long history of waging currency wars in Asia. We all know the sad case of Japan. The U.S. claimed that unfair Japanese trading practices were ballooning its bilateral trade deficit with Japan. To “correct” the so‐​called problem, the U.S. demanded that Japan adopt an ever‐​appreciating yen policy. The Japanese complied and the yen appreciated against the greenback from 360&nbsp;in 1971 to 80&nbsp;in 1995 (and 106, today). But, this didn’t close the U.S. trade deficit with Japan. Indeed, Japan’s contribution to the overall U.S. trade deficit reached almost 60% in 1991. And, if that wasn’t enough, the yen’s appreciation pushed Japan’s economy into a&nbsp;deflationary quagmire.</p> <p>Today, the U.S. is playing the same baseless blame game with China. And why not? After all, China’s contribution to the overall U.S. trade deficit has surged to 47%.</p> <p>America’s recent declaration of economic war against China isn’t the first time the U.S. has used currency as a&nbsp;weapon to destabilize the Middle Kingdom. In the early 1930s, China was still on the silver standard, and the United States was not. Accordingly, the Chinese yuan-U.S. dollar exchange rate was determined by the U.S. dollar price of silver.</p> <p>During his first term, President Franklin D. Roosevelt delivered on his Chinese currency stabilization “plan.” It was wrapped in the guise of doing something to help U.S. silver producers and, of course, the Chinese.</p> <p>Using the authority granted by the Thomas Amendment of 1933 and the Silver Purchase Act of 1934, the Roosevelt Administration bought silver. This, in addition to bullish rumors about U.S. silver policies, helped push the price of silver up by 128% (calculated as an annual average) in the 1932–35 period.</p> <p>Bizarre arguments contributed to the agitation for high silver prices. One centered on the fact that China was on the silver standard. Silver interests asserted that higher silver prices — which would bring with them an appreciation of the yuan against the U.S. dollar — would benefit the Chinese by increasing their purchasing power.</p> <p>As a&nbsp;special committee of the U.S. Senate reported in 1932: “silver is the measure of their wealth and purchasing power; it serves as a&nbsp;reserve, their bank account. This is wealth that enables such peoples to purchase our exports.” But, things didn’t work as Washington advertised. They worked as “planned,” however. As the dollar price of silver shot up, the yuan appreciated against the dollar. In consequence, China was thrown into the jaws of the Great Depression. In the 1932–34 period, China’s gross domestic product fell by 26% and wholesale prices in the capital city, Nanjing, fell by 20%.</p> <p>In an attempt to secure relief from the economic hardships imposed by U.S. silver policies, China sought modifications in the U.S. Treasury’s silver‐​purchase program. But, its pleas fell on deaf ears. After many evasive replies, the Roosevelt Administration finally indicated on October 12, 1934 that it was merely carrying out a&nbsp;policy mandated by the U.S. Congress. Realizing that all hope was lost, China was forced to effectively abandon the silver standard on October 14, 1934, though an official statement was postponed until November 3, 1935. The abandonment of silver spelled the beginning of the end for Chiang Kai-shek’s Nationalist government. America’s “plan” worked like a&nbsp;charm — Chinese monetary chaos ensued. This gave the communists an opening that they exploited — one that contributed mightily to their overthrow of the Nationalists.</p> <p>Today’s currency war with China promises to deliver what currency wars always deliver: instability and uncertainty. And with that, it’s becoming clearer with each passing day that President Trump will not be the 2020 “Peace and Prosperity” candidate.</p> </div> Tue, 06 Aug 2019 12:37:00 -0400 Steve H. Hanke Bailouts, Capital, or CoCos: Can Contingent Convertible Bonds Help Banks Cope with Financial Stress? Robert A. Eisenbeis <div class="lead mb-3 spacer--nomargin--last-child text-default"> <p>Since the 2008 financial crisis, banking regulators’ capital enhancement efforts have focused on permitting systemically important financial institutions to issue alternative forms of debt and quasi‐​debt instruments as a&nbsp;means of meeting their Basel III primary capital (Tier 1) and secondary capital (Tier 2) requirements. Among these alternatives are so‐​called contingent convertible capital securities (CoCos). Financial institutions are able to issue CoCos to investors as bonds with the stipulation that they will convert into equity if the institution fails to meet a&nbsp;given capital ratio.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>This policy analysis evaluates two types of CoCos—“write-down” and “going‐​concern” CoCos—on the bases of the different metrics and mechanisms each uses to convert bonds into equity. It shows that so far, few (if any) of the CoCos that institutions have used to satisfy their countries’ capital requirements—many of which were issued prior to robust research on how to structure CoCos effectively—have met the standards necessary for them to achieve their intended purposes. Most of the CoCos issued to date have been write‐​down CoCos, which rely on backward‐​looking accounting measures to evaluate an institution’s creditworthiness and use risk‐​based capital standards to trigger a&nbsp;bond‐​equity conversion. Rarer are going‐​concern CoCos, whose market‐​based conversion triggers incentivize businesses and bank managers to take on increased leverage and more risk.</p> <p>This policy analysis draws lessons from recent European experiences with both write‐​down and going‐​concern&nbsp;CoCos and concludes that, given their deficiencies, neither includes the design elements necessary to help financial institutions meet Basel III Tier 1&nbsp;or Tier 2&nbsp;capital standards. As a&nbsp;result, U.S. regulators should continue to approach CoCos with skepticism and caution. One alternative to CoCos they might consider is a&nbsp;modified version of the regulatory “off‐​ramp” provision of the 2017 Financial CHOICE Act, which holds the potential to increase bank capital while providing significant regulatory relief.</p> </div> , <div class="mb-3 spacer--nomargin--last-child text-default"> <h2>Introduction</h2> <p>The 2008 financial crisis revealed fundamental flaws in the way regulators handled financial distress in large, complex financial institutions that often led to delays in containing and correcting those problems. In several cases, the ultimate result was that the government injected massive amounts of taxpayer monies into troubled institutions, forced them to merge with somewhat stronger institutions (also with the help of taxpayer support), or placed them into conservatorship.</p> <p>A major factor behind regulators’ slow response to these institutions’ distress was that they took a&nbsp;flawed approach to measuring the capital adequacy of financial institutions. Rather than examine the current market value of an institution’s equity, many regulators relied on backward‐​looking book values of equity, which delayed their recognition of a&nbsp;firm’s true financial condition. For example, a&nbsp;2009 study found that each of the five largest banks that either failed or was merged during the financial crisis had reported Tier 1&nbsp;Basel regulatory capital ratios in excess of 12 percent—considerably more than the regulatory minimum of&nbsp;8&nbsp;percent—one quarter before failure.<sup><span id="endnote-001-backlink"><a href="#endnote-001">1</a></span></sup></p> <p>Some observers argue that such problems could be avoided by having the Basel requirements refer to market rather than book values of capital.<sup><span id="endnote-002-backlink"><a href="#endnote-002">2</a></span></sup>&nbsp;In times of financial distress, however—in which the market value of equity can plunge rapidly—such a&nbsp;policy change could compel firms that were already suffering from market capital shortages to meet the new&nbsp;Basel&nbsp;requirements through asset fire sales. These sales could accelerate the decline of multiple firms’ asset values and increase the severity of their capital losses. Furthermore, rewriting the Basel capital requirements so that they refer only to market values would not address any of the process or procedural issues related to measuring hard‐​to‐​value and nontraded assets. Indeed, predicating the Basel requirements on market values would simply trade one set of measurement problems for another.</p> <p>In the aftermath of the 2008 financial crisis, both U.S. and international regulators tried to address some of these regulatory issues and limit problems associated with systemic risk through a&nbsp;combination of increased regulation and legislation.<sup><span id="endnote-003-backlink"><a href="#endnote-003">3</a></span></sup>&nbsp;In particular, they imposed higher minimum book‐​capital requirements and applied stiffer regulations to certain systemically important financial institutions (SIFIs). According to conventional measures, these efforts have substantially increased SIFIs’ capital ratios. However, many of the weaknesses of the previous regulatory and supervisory regime, including its flawed approach to measuring capital adequacy, have remained unaddressed. Consequently, many experts believe that the new regulatory regime, with its higher capital requirements, will not suffice to rule out future bailouts.<sup><span id="endnote-004-backlink"><a href="#endnote-004">4</a></span></sup></p> <p>As a&nbsp;further means for bolstering bank capital, more recent reform proposals would allow alternative forms of debt and quasi‐​debt instruments to count toward financial institutions’ primary capital (Tier 1) and secondary capital (Tier 2) requirements. Most prominent among these have been proposals that would encourage SIFIs to issue contingent convertible capital securities (CoCos) and use them to meet some part of their regulatory capital requirements.<sup><span id="endnote-005-backlink"><a href="#endnote-005">5</a></span></sup>&nbsp;European regulators in particular have embraced CoCos and have incorporated certain types into their Basel III capital standards. In contrast, U.S. regulators have been reluctant to allow CoCos to qualify toward their regulatory capital standards.</p> <p>This policy analysis examines how effective CoCos have been at resolving the challenges they were designed to address and whether an alternative policy measure would better fulfill the same ends. First, it describes the most common types of CoCos that financial institutions have issued since the 2008 crisis. Next, it evaluates the argument that CoCos can play an important role in promoting financial stability, especially by ensuring that SIFIs remain adequately capitalized during times of financial distress. After reviewing three of&nbsp;Europe’s&nbsp;most significant postcrisis experiences with CoCos, it finds that historically they have failed to perform as regulators had intended. As a&nbsp;result, this analysis concludes by proposing a&nbsp;simple alternative to CoCos—one capable of accomplishing their objectives while avoiding their shortcomings.</p> <h2>What Are CoCos?</h2> <p>Sold to shareholders as bonds, CoCos convert into equity if the issuing financial institution’s Tier 1&nbsp;capital ratio (the value of its equity and reserve‐​based capital to the value of its risk‐​weighted assets) drops below a&nbsp;certain threshold. They are therefore considered hybrid securities and are designed to provide an additional source of equity capital for banks and SIFIs to use in times of financial distress.<sup><span id="endnote-006-backlink"><a href="#endnote-006">6</a></span></sup>&nbsp;As this policy analysis shows, CoCos can also enhance market discipline and address problems associated with the “too‐​big‐​to‐​fail” paradigm, in which regulators, believing that SIFIs cannot be allowed to collapse, feel compelled to inject massive amounts of taxpayer funds into struggling institutions.</p> <p>There are three basic forms of CoCos. One type, commonly called “going‐​concern” or “bail‐​in” CoCos, convert existing debt into common equity when a&nbsp;specific conversion event, or “trigger,” occurs.<sup><span id="endnote-007-backlink"><a href="#endnote-007">7</a></span></sup>&nbsp;Going‐​concern CoCos do not result in the injection of new funds into a&nbsp;troubled institution. Instead, they simply convert existing debt instruments on a&nbsp;firm’s balance sheet into common equity, thereby increasing its capital, facilitating deleveraging, and restoring capital adequacy.</p> <p>The second form, “write‐​down” or “bail‐​out” CoCos, are debt instruments whose values are written down when a&nbsp;trigger is breached.<sup><span id="endnote-008-backlink"><a href="#endnote-008">8</a></span></sup>&nbsp;Write‐​down CoCos simultaneously reduce a&nbsp;firm’s assets and its liabilities, thereby facilitating the firm’s reorganization at the point of&nbsp;<a id="_idTextAnchor001"></a>nonviability. The resulting bailout can be permanent, temporary, partial, or total. Because write‐​down CoCos reward stockholders at the expense of the CoCo investors, they reverse the traditional rules of seniority, placing shareholders’ interests ahead of those of a&nbsp;particular set of debt holders.</p> <p>The third form of CoCos, capital access bonds, resemble option securities in that they permit firms to issue new equity to their bondholders on prenegotiated terms when a&nbsp;triggering event occurs. Capital access bonds commit the investors who hold these bonds to injecting new funds into a&nbsp;troubled institution. Because such securities have not been widely issued, however, they will not be discussed here.</p> <h3>Problems That CoCos Attempt to Address</h3> <p>CoCos aim to resolve four systemic issues that the 2008 financial crisis revealed within the global financial system. First, the crisis showed that highly levered firms have an incentive to take on greater risk, which can distort the pricing of that risk. Second, it showed that a&nbsp;firm’s shareholders are often reluctant to issue new equity when that firm is experiencing financial distress. Although new equity capital helps protect a&nbsp;bank’s creditors, it harms existing shareholders (and helps debt holders) by diluting the value of the bank’s equity. Third, the crisis showed that although troubled institutions can reduce their leverage by selling assets, doing so can lead to fire‐​sale losses (in which institutions attempt to sell off assets at dramatically reduced prices, reducing their overall value to dangerously low levels). Cumulative fire sales can also result in a “death spiral,” where depreciating asset holdings lead to more and more fire sales. If several institutions experience distress at once, asset prices can plummet across the board, afflicting an entire sector of the financial system at once. This was certainly the case in 2008, when multiple death spirals led the asset‐​backed securities markets to experience particularly severe contagion effects.</p> <p>Fourth, the crisis showed that regulatory delays in addressing financial distress tend to contribute to the perception that some institutions are “too big to fail”—that is, that regulators or political leaders must provide outsized protection to certain financial institutions rather than suffer the economic consequences of allowing them to fail.</p> <p>Many believe that CoCos, if properly designed, could help solve all four of these problems. Indeed, the twofold attraction of CoCos is that they could help financial firms meet regulatory capital requirements and automatically absorb losses in times of financial distress—independent of government intervention. In addition, many&nbsp;European&nbsp;countries grant CoCos more favorable tax treatment than they do common equity. If CoCos were to receive a&nbsp;similar tax treatment in the United States, they would likely be more appealing to&nbsp;American&nbsp;issuers.<sup><span id="endnote-009-backlink"><a href="#endnote-009">9</a></span></sup>&nbsp;CoCos can also be attractive to investors because they typically have higher interest rates than ordinary bank debt securities and because their returns correlate more strongly with returns on other debt securities than with returns on equity.<sup><span id="endnote-010-backlink"><a href="#endnote-010">10</a></span></sup></p> <p>Proponents also argue that properly designed CoCos would induce stockholders and managers to operate a&nbsp;company responsibly in hopes of avoiding a&nbsp;conversion altogether. Furthermore, in the case of going‐​concern CoCos, any conversion that does occur results in an automatic&nbsp;<a id="_idTextAnchor002"></a>recapitalization, which helps the institution absorb any losses on its own. Not only does automatic recapitalization reduce the likelihood of taxpayers’ needing to sponsor a&nbsp;government‐​issued bailout, it also lowers any further costs that arise due to regulatory inaction or poor oversight. In short—and in theory—automatic recapitalization increases a&nbsp;firm’s access to its own sources of funding and liquidity, allowing it to continue operating independently.<sup><span id="endnote-011-backlink"><a href="#endnote-011">11</a></span></sup></p> <p>The validity of the above argument hinges on two central questions. The first is whether the threat of a&nbsp;<a id="_idTextAnchor003"></a>bond–equity conversion would in fact incentivize management and shareholders to take the steps necessary to avoid triggering one. The second is whether CoCos would sufficiently restore an institution’s capital adequacy in the event of a&nbsp;conversion. In short, effective CoCos should help provide financial institutions with a&nbsp;sufficient cushion following a&nbsp;conversion, thereby assuring both market participants and regulators of those institutions’ ability to continue in business even after experiencing a&nbsp;significant loss of capital. The objectives of the conversion itself should be to minimize the probability of contagion and mitigate the risk of spillover effects across other institutions.</p> <p>Satisfying the above objectives requires addressing three principal categories of CoCo design: the choice and structure of a&nbsp;conversion trigger, the capital ratio necessary to trigger a&nbsp;conversion, and the equity value that a&nbsp;CoCo bond should assume upon conversion. Each of these issues is considered in the following sections.</p> <h2>CoCo Design</h2> <p>Several factors are involved in structuring an optimal conversion trigger. The first relates to whether the bond–equity conversion trigger should be automatic or discretionary (and, if it is discretionary, whether such discretion should be exercised by management or by regulators). The second is whether the trigger’s threshold should refer to an&nbsp;accounting‐​based or a&nbsp;market‐​based measure of a&nbsp;firm’s financial condition. The third is whether the capital ratio necessary to trigger a&nbsp;conversion should be relatively high (when the institution remains solvent) or low (when the institution is close to failure).<sup><span id="endnote-012-backlink"><a href="#endnote-012">12</a></span></sup>&nbsp;The final considerations relate to the value that CoCo bonds should take upon conversion and the amount of capital that an institution should receive post‐​conversion. Each of these features can critically affect the extent to which the&nbsp;CoCos&nbsp;achieve their intended effects.</p> <h3>Automatic vs. Discretionary Triggers</h3> <p>Many of the CoCos issued to date have had discretionary triggers, leaving the decision of whether or not to trigger a&nbsp;conversion to either financial regulators or the financial institution’s management. Both parties appreciate having the discretion to initiate a&nbsp;conversion because it gives them the flexibility to determine when, and under what circumstances, to recapitalize or close the institution.</p> <p>However, granting both regulators and management the discretion to trigger a&nbsp;conversion carries unique risks.<sup><span id="endnote-013-backlink"><a href="#endnote-013">13</a></span></sup>&nbsp;In the first place, it can introduce unnecessary uncertainty into the process. As history has demonstrated (most recently through the experiences of the Great&nbsp;Recession), regulatory discretion can lead to costly delays in addressing financial distress, especially in the absence of the appropriate regulatory oversight.<sup><span id="endnote-014-backlink"><a href="#endnote-014">14</a></span></sup>&nbsp;Additionally, relying on regulatory discretion undermines the information content of a&nbsp;firm’s asset prices, which are meant to inform such discretion.<sup><span id="endnote-015-backlink"><a href="#endnote-015">15</a></span></sup>Finally, regulatory discretion can fail if regulators have insufficient information about an institution’s financial health, if they fail to supervise or examine an institution properly, or if they encounter political pressures to save an institution. There is also the risk that regulators will become unduly concerned about any potential contagion effects that might result from their “permitting” a&nbsp;large financial institution to fail.<sup><span id="endnote-016-backlink"><a href="#endnote-016">16</a></span></sup></p> <p>Similar issues are involved in allowing bank management the discretion to trigger a&nbsp;conversion.<sup><span id="endnote-017-backlink"><a href="#endnote-017">17</a></span></sup>&nbsp;Management can face incentives to delay a&nbsp;conversion out of fear that conversion would come at the expense of their jobs or their institution’s investment capital. There is also the risk that management would delay conversion because of the possibility that it would dilute the equity of existing shareholders and board members. Management may even choose to avoid conversion entirely, gambling instead on the chance of a&nbsp;government‐​issued, taxpayer‐​funded bailout.<sup><span id="endnote-018-backlink"><a href="#endnote-018">18</a></span></sup></p> <h3>Accounting‐​Based vs. Market‐​Based Triggers</h3> <p>Because of the weaknesses of discretionary triggers, CoCo proponents have typically favored automatic (nondiscretionary) triggers determined according to either&nbsp;accounting‐​based or market‐​based values of a&nbsp;firm’s equity. These proponents argue that because contingent capital would convert to common equity, it is the only security that is junior to common equity.<sup><span id="endnote-019-backlink"><a href="#endnote-019">19</a></span></sup></p> <p>Those who favor nondiscretionary triggers also tend to prefer ones that rely on market‐​based, rather than accounting‐​based, measures of capital, since the latter are lagging indicators of a&nbsp;firm’s financial condition.<sup><span id="endnote-020-backlink"><a href="#endnote-020">20</a></span></sup>&nbsp;Accounting‐​based measures are also easier for a&nbsp;firm’s management to manipulate, and their retroactive nature can exacerbate regulatory delays in addressing any severe financial problems, especially ones likely to cause contagion effects.<sup><span id="endnote-021-backlink"><a href="#endnote-021">21</a></span></sup>&nbsp;In contrast, market‐​based measures are more readily available, timely, and forward‐​looking than accounting‐​based measures. They are also harder to manipulate, and their integrity is less likely to be compromised, because they are not subject to regulatory or managerial discretion.<sup><span id="endnote-022-backlink"><a href="#endnote-022">22</a></span></sup></p> <p>There are, however, problems with relying on both accounting‐​based and market‐​based measures of equity. Market‐​based triggers can cause unnecessary conversions, whereas accounting‐​based triggers can avoid causing necessary conversions.<sup><span id="endnote-023-backlink"><a href="#endnote-023">23</a></span></sup>&nbsp;Interestingly, almost all of today’s regulator‐​approved CoCos have had accounting‐​based triggers, which mainly refer to risk‐​based capital ratios.</p> <p>Despite the supposed benefits of market‐​based triggers, there are circumstances in which conflicts between equity holders and CoCo investors make it uncertain whether, or under what terms, a&nbsp;conversion will occur.<sup><span id="endnote-024-backlink"><a href="#endnote-024">24</a></span></sup>&nbsp;Such conflicts are mainly due to the fact that equity holders, unlike investors, tend to prefer either a&nbsp;delayed conversion or no conversion at all. Moreover, equity holders have an incentive to manipulate the firm’s stock price upward to avoid conversion. In contrast, CoCo investors have an incentive to prefer earlier conversions and may have an incentive to manipulate a&nbsp;firm’s stock price downward. These conflicting interests can also complicate decisions related to the post‐​conversion value of a&nbsp;CoCo’s equity, making the final outcome of a&nbsp;conversion uncertain.<sup><span id="endnote-025-backlink"><a href="#endnote-025">25</a></span></sup></p> <p>To address the conflict of interest between CoCo investors and equity holders, economists Charles W. Calomiris and Richard J. Herring propose a&nbsp;conversion policy based on a&nbsp;90‐​day average of the ratio between the market value of a&nbsp;firm’s equity and the sum of that same market value and the book value of the firm’s debt. They claim this policy would clarify the price that CoCo equity should assume upon conversion.<sup><span id="endnote-026-backlink"><a href="#endnote-026">26</a></span></sup>&nbsp;However, the hybrid nature of this metric, which averages a&nbsp;forward‐​looking indicator (the market value of a&nbsp;bond’s equity) with a&nbsp;backward‐​looking one (the book value of an institution’s debt) over a&nbsp;90‐​day&nbsp;period is incredibly complex. If anything, their proposal seems to substitute one set of problems for another—or two others, since their metric is vulnerable to the weaknesses of both lagging accounting‐​based measures and volatile market‐​based ones.</p> <p>Other CoCo design proposals are similarly complex. For example, the Squam Lake Group suggests implementing a&nbsp;dual‐​trigger CoCo, which would require regulators to determine both that a&nbsp;financial system was experiencing a&nbsp;systemic crisis and that an individual firm had violated its debt covenant (for instance, by allowing its risk‐​based capital to drop below a&nbsp;predetermined threshold) prior to conversion.<sup><span id="endnote-027-backlink"><a href="#endnote-027">27</a></span></sup>&nbsp;Yet this proposal lacks sufficient details necessary for its implementation. It also suffers from the same flaws as Calomiris and Herring’s proposal, in that it includes all the weaknesses of both discretionary triggers and accounting‐​based triggers.<sup><span id="endnote-028-backlink"><a href="#endnote-028">28</a></span></sup></p> <h3>Trigger Level</h3> <p>The ratio of the conversion trigger threshold to a&nbsp;firm’s existing or expected capital levels can critically influence shareholders’ and managers’ incentives to ward off a&nbsp;conversion. It can also affect the likelihood of a&nbsp;firm retaining (or restoring) its viability post‐​conversion. In general, high trigger levels (where conversion occurs after a&nbsp;firm has lost a&nbsp;relatively small amount of capital) tend to encourage more responsible banking practices and increase the chances that a&nbsp;firm will be able to&nbsp;<a id="_idTextAnchor004"></a>recapitalize itself in the event of a&nbsp;conversion. In particular, capital trigger levels at or above&nbsp;7&nbsp;percent&nbsp;are a&nbsp;typical feature of going‐​concern CoCos, which primarily aim to prevent firms from ever reaching the point of insolvency. A&nbsp;high trigger should motivate management to raise more capital before the firm experiences significant problems or loses access to financial markets.</p> <p>The threat of a&nbsp;triggering event should also cause management and shareholders to curtail leverage and reduce risk taking.<sup><span id="endnote-029-backlink"><a href="#endnote-029">29</a></span></sup>&nbsp;High‐​trigger CoCos make the threat of share value dilution more imminent, encouraging shareholders and management alike to reduce risk, deleverage, and raise more capital.<sup><span id="endnote-030-backlink"><a href="#endnote-030">30</a></span></sup>&nbsp;As the proximity of a&nbsp;firm’s capital ratio to the trigger threshold increases, the market value of its equity decreases, and a&nbsp;post‐​conversion wealth transfer—from management to CoCo bondholders—becomes more likely.</p> <p>High triggers can also minimize the chance that shareholders will create an abrupt drop in share value by switching from a&nbsp;low‐​risk, low‐​probability‐​of‐​default portfolio to a&nbsp;high‐​risk, high‐​probability‐​of‐​default portfolio. However, if a&nbsp;debt‐​induced downward spiral in equity value does occur when CoCos are on the balance sheet, then shareholders can either reduce leverage and increase capital as intended or opt to declare bankruptcy before conversion.<sup><span id="endnote-031-backlink"><a href="#endnote-031">31</a></span></sup></p> <p>In contrast, CoCos with relatively low capital ratio triggers (for example, 5&nbsp;percent) are better suited for facilitating an orderly, private‐​sector failure resolution process in the event that an institution approaches the point of nonviability. Low triggers provide management and stockholders with relatively weak incentives to control risk, and some researchers have raised concerns about runs and negative spillovers if a&nbsp;firm’s capital ratio nears an extremely low threshold, which can signal bankruptcy.<sup><span id="endnote-032-backlink"><a href="#endnote-032">32</a></span></sup></p> <h3>Conversion Price</h3> <p>A CoCo’s conversion price and the number of shares converted can also influence both shareholders’ and managers’ incentives. In general, the outcome of a&nbsp;conversion depends on whether that conversion affects a&nbsp;predetermined number of shares, based on an ex ante fixed price; an ex post number of shares, based on their market price at the time of conversion; or some combination of the two.<sup><span id="endnote-033-backlink"><a href="#endnote-033">33</a></span></sup></p> <p>Ex post pricing, which sets the value of a&nbsp;CoCo’s equity at its market price upon conversion, can significantly dilute stock value for existing shareholders, since a&nbsp;CoCo’s&nbsp;ex post market price is often much lower than its original purchase price. This dilution can have the positive effect of incentivizing shareholders and management to avoid unnecessary risk taking in the interest of reducing the likelihood of a&nbsp;conversion.</p> <p>In contrast, CoCos with an ex ante fixed price (one set prior to conversion) will clearly limit stock dilution and significantly reduce incentives to avoid a&nbsp;triggering event. Indeed, it is virtually impossible to avoid situations in which going‐​concern CoCos will not cause at least some wealth transfer from CoCo holders to existing shareholders.<sup><span id="endnote-034-backlink"><a href="#endnote-034">34</a></span></sup>&nbsp;In the case of write‐​down CoCos, however, no wealth transfer occurs, because in most cases, the subsequent write‐​down wipes out any preexisting equity claims. As a&nbsp;result, some researchers suggest that write‐​down CoCos are better at mitigating management and shareholder risk taking because they provide greater incentives to reduce leverage.<sup><span id="endnote-035-backlink"><a href="#endnote-035">35</a></span></sup>&nbsp;This factor could explain the preponderance of write‐​down CoCos relative to going‐​concern CoCos among institutions today.</p> <h3>Summary of Design Issues</h3> <p>When it comes to CoCo design, if the goal is to minimize the likelihood of a&nbsp;trigger event while motivating management and stockholders to reduce both leverage and risk‐​taking, then the evolving literature tends to favor going‐​concern CoCos with high, fixed, market‐​based triggers and a&nbsp;sharply diluting conversion rule at the then‐​market price. If the intent is for CoCos to facilitate a&nbsp;modified bankruptcy at the point of an institution’s nonviability, however, write‐​down CoCos remain a&nbsp;plausible option. However, the literature also suggests that although neither type of CoCo design is foolproof, write‐​down&nbsp;CoCos&nbsp;in particular provide minimal incentives to reduce the likelihood of conversion and are clearly the least desirable alternative.</p> <p>Finally, the extensive research on CoCo triggers and related structures remains largely silent on the exact administrative mechanism that should initiate the conversion of a&nbsp;CoCo bond into equity. Who monitors the CoCos: investors or regulators? How should the trigger mechanism be enforced? By the courts or through some other legal action? The literature on discretionary CoCos addresses these issues somewhat. Yet even in these cases, the design process is rife with uncertainty and open to conflicts of interest. This situation further complicates the problems inherent in pricing CoCos with different structures and features.</p> <h2>CoCos in Practice</h2> <p>To examine how well CoCos have fulfilled their objectives in recent practice, we should first review the quantity, category, and origin of the CoCos that have been issued over the past several years. Although regulators in many nations allow CoCos to satisfy some part of banks’ regulatory capital requirements, the $521 billion of CoCos employed for this purpose thus far remains quite small compared to the approximately&nbsp;$5.3 trillion&nbsp;of bank equity capital worldwide.<sup><span id="endnote-036-backlink"><a href="#endnote-036">36</a></span></sup>&nbsp;Figure 1&nbsp;shows the dollar value of outstanding CoCos of institutions headquartered in various countries from 2009 through 2015.</p> <div class="infogram-embed" data-id="7cda5753-c2a0-49b6-aa91-8405aea73fa4" data-type="interactive" data-title="Figure 1A CoCo PA (Eisenbeis)"></div> //--&gt; <div class="infogram-embed" data-id="8a02d07e-786f-45ec-94e5-3d262c795a14" data-type="interactive" data-title="Figure 1B CoCo PA (Eisenbeis)"></div> //--&gt; <p>There are two easy explanations for why most CoCos have so far originated mainly outside the United States. First, European and Asian‐​Pacific regulators have proactively incorporated CoCos into their Basel II,&nbsp;Basel&nbsp;III, and home‐​country capital standards, whereas U.S. regulators have yet to embrace CoCos in the same way. Second, and probably most important, European tax authorities have determined that interest expenses on CoCos are tax‐​deductible (as interest payments on other bank‐​issued debt instruments are), whereas the U.S.&nbsp;Internal&nbsp;Revenue&nbsp;Service&nbsp;has not yet ruled the same.<sup><span id="endnote-037-backlink"><a href="#endnote-037">37</a></span></sup>&nbsp;According to a&nbsp;2013 survey,&nbsp;64 percent&nbsp;of&nbsp;CoCos&nbsp;originated in countries where their interest payments were tax‐​deductible, while about 20 percent originated in countries where their interest payments were not tax‐​deductible. (The survey did not determine the tax status of the remaining 16 percent.)<sup><span id="endnote-038-backlink"><a href="#endnote-038">38</a></span></sup></p> <p>Figure 2&nbsp;shows the estimated breakdown of CoCos issued by type as of 2016. Note that fewer than one‐​third of all CoCos issued during that period were going‐​concern CoCos that would convert debt into equity. The remaining 70 percent provided for some form of write‐​down of the CoCo debt as a&nbsp;loss‐​absorbing&nbsp;mechanism.</p> <div class="infogram-embed" data-id="0c82d247-156f-44a6-9a8a-22f3a33d44af" data-type="interactive" data-title="Figure 2 CoCo PA (Eisenbeis)"></div> //--&gt; <p>The high proportion of write‐​down CoCos relative to going‐​concern ones may seem odd, considering that the latter are more effective at curtailing management and shareholder risk‐​taking. This predominance can be largely explained, however, by the fact that European and Asian‐​Pacific regulators generally had incorporated write‐​down CoCos into their&nbsp;Basel&nbsp;II and Basel III country capital standards before researchers had revealed either the weaknesses of those standards or the incentive problems associated with write‐​down CoCos.</p> <p>In Europe, Basel III capital standards explicitly provide for CoCos to count toward Tier 1&nbsp;and Tier 2&nbsp;capital, but only in limited amounts and only when those CoCos possess certain characteristics.<sup><span id="endnote-039-backlink"><a href="#endnote-039">39</a></span></sup>&nbsp;The Basel III capital requirements are now extremely complex and continue to evolve. The revised framework has increased from 2&nbsp;ratios under Basel II capital rules (based on risk‐​weighted assets) to more than 12 ratios under Basel III rules. The Basel III standards are also based on risk‐​weighted assets, with total capital requirements ranging from 8.5 percent to&nbsp;16.5 percent&nbsp;of total risk‐​weighted assets. (The&nbsp;8.5 percent&nbsp;figure applied until 2016 and increases to&nbsp;10.5 percent&nbsp;in 2019.)<sup><span id="endnote-040-backlink"><a href="#endnote-040">40</a></span></sup></p> <p>Figure 3&nbsp;categorizes the CoCos issued between 2009 and 2015 according to their trigger types. The majority rely on either low book‐​value triggers or triggers that initiate conversions only when an institution nears the point of nonviability, when it is extremely unlikely that the institution will be able to restore its own capital following conversion.</p> <div class="infogram-embed" data-id="c0124402-7af5-4699-92c3-a4d294fb7d0a" data-type="interactive" data-title="Figure 3 CoCo PA (Eisenbeis)"></div> //--&gt; <p>Roughly 90 percent of all the CoCos issued between 2011 and 2016 used the Common Equity Tier 1&nbsp;capital ratio (common equity plus retained earnings‐​to‐​risk assets) as their trigger. Another 8&nbsp;percent of the CoCos issued used the Tier 1&nbsp;capital ratio (common equity plus retained earnings and preferred stock) and a&nbsp;high trigger of at least 7&nbsp;percent. The remaining 2&nbsp;percent of the CoCos issued used the total risk‐​based capital ratio (the ratio of Tier 1&nbsp;and Tier 2&nbsp;capital to risk‐​based assets).<sup><span id="endnote-041-backlink"><a href="#endnote-041">41</a></span></sup></p> <h3>Recent European Experiences with CoCos</h3> <p>Problems at three major European banks, two of which had outstanding CoCos at the time of distress, can provide clues as to how effective these securities are at achieving their intended purposes. These problems began in early 2016 with Germany’s Deutsche Bank and culminated the following summer with the resolution of Spain’s Banco Popular Español and the Italian government’s rescue of Monte dei Paschi di Siena in June.</p> <p><strong>Deutsche Bank.</strong>&nbsp;Concerns about the health of Deutsche Bank first surfaced in early January 2016 after the bank reported a&nbsp;loss for 2015. That loss heightened investors’ fears that the bank might not be able to make coupon payments on its outstanding CoCos, which were write‐​down securities with a&nbsp;low trigger (5.125 percent of the bank’s Tier 1&nbsp;capital ratio). As European capital standards required, payments on these CoCos would occur at the issuer’s discretion, missed coupon payments would not be cumulative, and regulators retained the authority to trigger a&nbsp;bailout at any time.<sup><span id="endnote-042-backlink"><a href="#endnote-042">42</a></span></sup></p> <p>Deutsche Bank’s reported loss initiated an abrupt decline in the prices of its CoCo bonds the following year. Evidence suggests that this decline may have provoked a&nbsp;contagion effect, with other major European banks experiencing a&nbsp;similar decline in the value of their CoCo bonds at the same time.<sup><span id="endnote-043-backlink"><a href="#endnote-043">43</a></span></sup>&nbsp;Prices also became increasingly volatile as uncertainty about Deutsche Bank’s financial condition persisted, compounded by fears that it would miss a&nbsp;coupon payment. Interestingly, in late December 2016, regulators issued an opinion (one largely favorable to Deutsche Bank) that attempted to clarify when a&nbsp;bank could make coupon payments after failing to meet capital adequacy standards. Despite this, the value of Deutsche Bank’s CoCos remained low until September of the following year. After a&nbsp;brief upward spike, however, they fell sharply again, partly in response to the U.S. Department of Justice’s decision to fine Deutsche Bank&nbsp;$14 billion&nbsp;for its role in the fraudulent sales of risky mortgage‐​backed securities in the years leading up to the financial crisis. (That fine was subsequently reduced to $7.2 billion.)</p> <p>The prices of the bank’s credit default swaps on both its senior and junior debt followed a&nbsp;similar pattern, as did the prices of other banks’ CoCos. Deutsche Bank’s CEO John Cryan went public on September 30, 2016, to defend the bank’s condition, while several other analysts also confirmed that the bank was liquid and basically sound.<sup><span id="endnote-044-backlink"><a href="#endnote-044">44</a></span></sup></p> <p>Deutsche Bank’s recent experience illustrates the asset death spiral associated with poorly structured CoCos and the uncertainties they can create. It also validates several academics’ concerns that the discretionary aspect of write‐​down CoCos could increase the possibility of missed coupon payments and heighten confusion regarding the degree of regulatory intervention necessary to trigger a&nbsp;partial or total write‐​down.<sup><span id="endnote-045-backlink"><a href="#endnote-045">45</a></span></sup></p> <p><strong>Banco Popular Español.</strong>&nbsp;The European Central Bank’s decision in June 2017 to declare Banco Popular Español (or Banco Popular for short) a&nbsp;failing or likely to fail institution prompted Europe’s recently established Single Resolution Board to merge it with Banco Santander, which purchased all the shares of Banco Popular for a&nbsp;total price of €1.<sup><span id="endnote-046-backlink"><a href="#endnote-046">46</a></span></sup>&nbsp;Banco Popular’s troubles were a&nbsp;result of its having accumulated bad mortgage debt prior to the 2008 crisis. Making matters worse, the bank’s management easily papered over its losses, taking advantage of the fact that Spanish banking authorities had encouraged their practice of relying on book‐​value accounting and had a&nbsp;long‐​standing habit of putting off recognizing any new losses.</p> <p>Banco Popular had foundered for several years after the 2008 financial crisis. In May 2016, it announced that it would have to raise €2.5 billion in additional funding to bolster its sagging capital, but this value was actually far lower than the €6.7 billion that JPMorgan Chase estimated the bank would need to support both its stock and CoCo bond prices.<sup><span id="endnote-047-backlink"><a href="#endnote-047">47</a></span></sup>&nbsp;In just two days—from May 27 to May 28, 2016—the bank’s stock fell 32 percent. In April 2017, Banco Popular itself made downward adjustments to its 2016 financial statement, while Moody’s downgraded its senior unsecured debt, triggering another sharp drop in the value of both its shares and its bonds.</p> <p>Like Deutsche Bank, Banco Popular’s CoCo bonds had qualified as Additional&nbsp;Tier 1&nbsp;(AT1) capital. Unlike Deutsche Bank, however, these were high‐​trigger (7 percent), going‐​concern CoCos, which were set to convert into equity at a&nbsp;price not lower than €1.549 per share. The 7&nbsp;percent trigger ratio was based on the Common Equity Tier 1&nbsp;risk‐​based capital ratio. Like all CoCos that qualified for AT1 capital status, Banco Popular’s contract included a&nbsp;cancellation clause, and missed coupon payments were noncumulative.</p> <p>On June 6, 2017, however—before conversion ever took place—the European Central Bank (ECB) declared Banco Popular in danger of failing. The next day, Europe’s Single&nbsp;Resolution&nbsp;Board merged the bank into Banco Santander, cutting short any conversion of the bank’s CoCos into equity. The move altogether eliminated its subordinated debt, along with any claim its equity holders or CoCo investors had to that debt. As in Deutsche Bank’s case, the CoCo bond and equity prices exhibited a&nbsp;death spiral, with hedgers taking short positions against those assets and triggering further sales of stock.<sup><span id="endnote-048-backlink"><a href="#endnote-048">48</a></span></sup>&nbsp;In Banco Popular’s case, therefore, going‐​concern CoCos did not function as envisioned, insofar as they failed to induce management and shareholders to reduce risk, curtail leverage, and raise more capital.</p> <p><strong>Monte dei Paschi di Siena.</strong>&nbsp;In December 2016, the Italian government and the ECB put forward a “precautionary recapitalization” of Monte dei Paschi di Siena (or Monte), Italy’s oldest bank. Like many other Italian banks, Monte had been suffering since the 2008 financial crisis, plagued by significant asset quality problems, difficulties in passing recent regulatory stress tests, and a&nbsp;capital shortage. Indeed, more than 35 percent of Monte’s gross loans were nonperforming for the first three quarters of 2016.<sup><span id="endnote-049-backlink"><a href="#endnote-049">49</a></span></sup></p> <p>Although the bank had no outstanding CoCo bonds, it did have subordinated debt. As part of its recapitalization effort, the&nbsp;Italian&nbsp;government provided Monte&nbsp;€6.6 billion&nbsp;in support and wrote down its investors’ claims by €2.2 billion. The government’s support program followed on the heels of an announcement it had made the week prior, in which it voiced its intent to provide a €20 billion support package to the entire Italian banking system.</p> <p>Monte’s condition was undeniably deteriorating. It needed capital and had failed in its attempts to raise more funds and find a&nbsp;merger partner. Like Banco Popular, its asset quality problems had reached the point at which it began experiencing a&nbsp;drop in liquidity: during the first nine months of 2016, it lost&nbsp;€20 billion&nbsp;in deposits, and between November and December, deposits fell from&nbsp;7.6 percent&nbsp;to&nbsp;4.8 percent&nbsp;of its total activities. In the final month of that year, Monte lost an additional €2 billion in deposits.<sup><span id="endnote-050-backlink"><a href="#endnote-050">50</a></span></sup></p> <p>The Italian government’s official rationale for using taxpayer funds to support Monte was that without doing so, investors would take an even bigger hit under the European Union’s new Bank Recovery and Resolution Directive, which specifies the order in which creditors are prioritized to take losses but prohibits such prioritization of losses for insolvent banks.<sup><span id="endnote-051-backlink"><a href="#endnote-051">51</a></span></sup>&nbsp;Part of the reasoning behind this unusual structure was the EU’s concern about potential contagion effects on other Italian banks, since they had asset quality problems as well.</p> <p>Monte’s experiences demonstrate that, at least in Europe, regulators are still inclined to protect financial institutions with policies that treat them as though they are “too big to fail.” Given the emergency provisions in place across the EU (like the ones that the ECB and the Italian government implemented in the cases above), the prospect of government intervention and supervisory discretion will likely continue to undermine the role that CoCo bonds are meant to play in institutions’ capital structures. This outcome, in turn, could weaken the discipline that CoCo bonds are supposed to provide.</p> <p>Given the deficiencies inherent in CoCo design and implementation, U.S. regulators should continue to regard these securities with skepticism and caution. Other alternatives—ones not subject to the shortcomings discussed above—could better satisfy the objectives that many have tried—and failed—to accomplish through CoCos.</p> <h2>An Amended Financial CHOICE Act: A&nbsp;Better Way?</h2> <p>One of the principal attractions of most CoCo proposals is that their favorable tax treatment (which, at least outside the United States, they share with other forms of debt) makes them a&nbsp;lower‐​cost debt option to equity.<sup><span id="endnote-052-backlink"><a href="#endnote-052">52</a></span></sup>&nbsp;Yet given their myriad vulnerabilities and complexities, there may be a&nbsp;better way to achieve CoCos’ intended effects—one that is not driven by tax provisions.</p> <p>U.S. regulators should look instead at revising Title VI of the Financial CHOICE Act of 2017, which the House of Representatives passed that June. As written, the act provides regulatory relief from some of the Dodd‐​Frank Act’s most burdensome regulations in addition to certain Basel III regulations.<sup><span id="endnote-053-backlink"><a href="#endnote-053">53</a></span></sup>&nbsp;Specifically, it exempts institutions with a&nbsp;capital ratio of at least 10 percent (defined as Tier 1&nbsp;equity capital divided by total on– and off–balance sheet assets) from:</p> </div> , <blockquote class="blockquote"> <div> <p>(1) any federal law or regulation addressing capital or liquidity requirements or standards; (2) any federal law, rule, or regulation that allows a&nbsp;federal financial agency to object to a&nbsp;capital distribution; (3) specified considerations as to whether the banking organization poses a&nbsp;risk to the stability of the financial system of the United States; and (4) other specified federal laws, rules, and regulations.<sup><span id="endnote-054-backlink"><a href="#endnote-054">54</a></span></sup></p> </div> </blockquote> <cite> </cite> , <div class="mb-3 spacer--nomargin--last-child text-default"> <p>The act’s regulatory off‐​ramp provision measures capital according to book value, making it vulnerable to some of the same criticisms that apply to CoCos with accounting‐​based triggers. Yet with suitable modifications, the off‐​ramp provision could provide a&nbsp;genuine alternative to costly prudential regulations.<sup><span id="endnote-055-backlink"><a href="#endnote-055">55</a></span></sup>&nbsp;An amended off‐​ramp provision should differ from the House version in the following ways:</p> <ul><li>It should measure a&nbsp;consolidated financial institution’s equity by its market value, not by its book value. A&nbsp;market‐​based equity‐​to‐​asset ratio would capture the risk signals that accounting‐​based measurements can mask, such as fluctuations in monetary policy, shifts in stock or commodity prices, and other standard market risk measures.<sup><span id="endnote-056-backlink"><a href="#endnote-056">56</a></span></sup></li> <li>The current act’s 10 percent capital ratio exemption threshold is too low. As of 2018, 10.5 percent is the current Basel III minimum capital ratio. Institutions should not be afforded relief just because they meet this minimum.</li> <li>Instead of the act’s present all‐​or‐​nothing&nbsp;approach to regulatory relief, a&nbsp;modified off‐​ramp provision should allow for incremental regulatory relief depending on a&nbsp;bank’s capital level. As an example, banks with capital ratios between 15 percent and 18 percent could qualify for marginal regulatory exemptions. Those with capital ratios between 18 percent and 20 percent could also be exempt from stress tests and related liquidity requirements.</li> <li>The plan should also impose increasingly strict regulatory requirements whenever a&nbsp;firm’s capital ratio declines below the regulatory relief tranches.</li> <li>The plan should require regulators to demonstrate how they plan to monitor risk taking among institutions that are transitioning between off‐​ramp capital thresholds. Regulators, not institutions, should bear the cost of these monitoring and enforcement measures.</li> </ul><p>The proposed tiered regulatory relief program responds to the critical question: When do we want intervention to occur? The answer is: long before a&nbsp;severe problem presents itself or an institution comes close to bankruptcy. As to the form that intervention should take, the above proposal assumes that intervention can (and often should) begin as freedom&nbsp;<em>from</em>&nbsp;intervention, and it contains several complementary attributes related to that assumption.</p> <p>First, the plan creates a&nbsp;positive financial incentive for institutions to have higher capital ratios. Higher capital ratios allow institutions of various sizes to make more informed choices about how to balance the cost of their regulatory burden with the cost of their capital holdings. Smaller institutions, for example, may choose to hold higher levels of capital to avoid large compliance costs. (Estimates show that regulatory costs for small banks with fewer than $100 million in assets amount to 9.8 percent of their noninterest operating expenses, whereas those costs drop to&nbsp;5.5 percent&nbsp;for banks with assets between $1 billion and $10 billion.)<sup><span id="endnote-057-backlink"><a href="#endnote-057">57</a></span></sup></p> <p>Second, the plan would subject well‐​capitalized&nbsp;institutions to less burdensome regulations than undercapitalized institutions. Doing so would provide institutions that were better off with a&nbsp;competitive advantage in the marketplace, since their exemptions would signal that they were low‐​risk and highly capitalized. Healthy, less regulated, well‐​capitalized, and viable institutions should, all else being equal, have a&nbsp;lower cost of funding overall. Additionally, it is hard to imagine that management and boards of directors would want massive increases in regulation owing to an erosion of their capital. The opportunity for regulatory relief would provide management with ample incentive to act in ways that would protect their institution’s regulatory independence.</p> <p>Third, the above changes would make regulators responsible for monitoring an institution’s capital position and determining whether to continue granting regulatory relief if that position declined. Regulators would also need to justify those decisions publicly. In addition, because firms with fewer regulations would have higher levels of capital, regulators would be better able to react to warning signals and reimpose prudential regulations long before those institutions reached critically low capital levels. Under the current regulatory environment, the government must wait until banks demonstrate a&nbsp;critical need for capital before intervening. Often, these late‐​stage interventions are far more burdensome, not to mention costlier, than earlier ones.</p> <p>Fourth, tying an institution’s capital ratio to regulatory costs would make it easier for the public to monitor regulatory oversight, which would in turn improve regulatory accountability. If an institution’s capital ratio fell below the regulatory relief tranches and regulators failed to act, their lack of response would be public and transparent.</p> <p>Fifth, the plan would modify the procedure for reexempting formerly eligible institutions whose capital had fallen below the necessary off‐​ramp threshold. Section 601 of the&nbsp;Financial&nbsp;CHOICE Act requires that an institution qualifying for the off‐​ramp provision maintain a&nbsp;quarterly capital ratio of&nbsp;10 percent. The responsible federal regulator has the discretion to declare an institution in noncompliance, giving it a&nbsp;year to recomply or lose its exemption status. As written, however, this requirement is too lenient, gives too much discretion to the regulator, and provides institutions with too much time to comply before losing their off‐​ramp status. To correct these weaknesses, the act should require that a&nbsp;market‐​based trigger determine an institution’s compliance and that institutions whose capital declines below a&nbsp;certain threshold lose their exemptions immediately. The act should also implement a&nbsp;one‐​year waiting period before allowing an institution to re‐​petition for off‐​ramp relief.</p> <p>Although the above modifications would tighten Title VI’s current provisions, they would still provide institutions with enough flexibility to make choices that would help them avoid costly regulations. As a&nbsp;result, the best way to view this program is as a&nbsp;refined effort to incentivize lower risk taking on behalf of financial institutions and to prompt corrective action and early intervention from regulators, in line with the aims of the Federal Deposit Insurance Corporation&nbsp;Improvement&nbsp;Act. If an institution falls below the capital requirements necessary for regulatory relief, the first step should be to revoke its relief status. Furthermore, by setting those capital requirements above the Basel III minimum, the act would allow regulatory intervention to occur long before an institution became insolvent. Whereas CoCos historically have functioned more as an instrument for reinjecting capital into an institution at or past the point of failure, this proposal focuses on preventing an institution from ever reaching that stage.</p> <p>Finally, the costs of structuring and implementing this modified off‐​ramp program would fall principally upon the regulators, not upon the financial institutions, whose main expenses would include only those related to assessing the tradeoffs between regulatory compliance and the loss of capital. At present, institutions have had to make these determinations by devoting a&nbsp;significant number of their staff members solely to regulatory compliance. Smaller institutions have struggled to meet these burdens, regardless of their actual capital or compliance levels, and many have been forced to merge into larger institutions as a&nbsp;result. This modified proposal would grant these and other firms the level of regulatory protection they need and—with prudent conduct—the level of regulatory relief they deserve.</p> <h2>Conclusion</h2> <p>A 2012 report by the Financial&nbsp;Stability&nbsp;Oversight Council succinctly summarized the benefits and problems with using&nbsp;CoCos&nbsp;as a&nbsp;means for enhancing financial stability.<sup><span id="endnote-058-backlink"><a href="#endnote-058">58</a></span></sup>&nbsp;CoCos&nbsp;can help a&nbsp;struggling financial institution raise additional equity, absorb losses, and remain liquid. They can also encourage its managers to raise capital, and they can facilitate an orderly and timely resolution of any failure. But CoCos also have their drawbacks. Their complexity can make them difficult to price and create uncertainty as to whether conversion will actually occur soon enough to absorb losses. Once initiated, a&nbsp;conversion might also trigger a&nbsp;run on its issuer by raising doubts about the issuer’s health, as shown in the cases of Deutsche Bank and Banco&nbsp;Popular. In other cases, uncertainty surrounding the likelihood of a&nbsp;conversion has become a&nbsp;source of contagion and systemic risk.<sup><span id="endnote-059-backlink"><a href="#endnote-059">59</a></span></sup></p> <p>The current regulatory approach to incorporating CoCos into capital requirements, which predated much of the recent work on how&nbsp;CoCos&nbsp;should be structured, does not meet the standards of optimal design that would enable them to function effectively. Most of the CoCos issued thus far have been of the write‐​down form and are based on backward‐​looking accounting measures with triggers geared to risk‐​based capital standards. Few are going‐​concern CoCos with market‐​based triggers, which would discourage owners and managers from taking on increased leverage and risk.</p> <p>Given Europe’s experiences with CoCos, and considering the conceptual difficulties involved in designing CoCos that would avoid similar problems in the future, U.S. regulators should continue to approach CoCos with skepticism and caution. An alternative worth considering is a&nbsp;modified version of the regulatory off‐​ramp proposal contained in the&nbsp;Financial&nbsp;CHOICE Act, which would provide greater relief from burdensome regulations as an institution’s capital increases.</p> <h2>Notes</h2> <p><sup><span id="endnote-001"><a href="#endnote-001-backlink">1</a>.</span></sup> Andrew Kuritzkes and Hal Scott, “Markets Are the Best Judge of Bank Capital,”&nbsp;<em>Financial Times</em>, September 23, 2009. For the required Basel II Tier 1&nbsp;minimum standard, see “Basel II,” Investopedia,&nbsp;<a href="" target="_blank">https://​www​.investo​pe​dia​.com/​t​e​r​m​s​/​b​/​b​a​s​e​l​i​i.asp</a>.</p> <p><sup><span id="endnote-002"><a href="#endnote-002-backlink">2</a>.</span></sup> Shadow Financial Regulatory Committee, “Reforming Bank Capital Regulation,” Shadow Statement no. 160, March 2, 2000.</p> <p><sup><span id="endnote-003"><a href="#endnote-003-backlink">3</a>.</span></sup> In the United States, Congress concluded that regulators had perpetuated the “too big to fail” paradigm and responded by passing the Dodd‐​Frank Act in 2010.</p> <p><sup><span id="endnote-004"><a href="#endnote-004-backlink">4</a>.</span></sup> Neel Kashkari, “New Bailouts Prove ‘Too‐​Big‐​to‐​Fail’ Is Alive and Well,”&nbsp;<em>Wall Street Journal</em>, July 9, 2017.</p> <p><sup><span id="endnote-005"><a href="#endnote-005-backlink">5</a>.</span></sup> Mark Flannery was one of the first to propose such an instrument. Mark J. Flannery, “No Pain, No Gain? Effecting Market Discipline via ‘Reverse Convertible Debentures,’” in&nbsp;<em>Capital Adequacy Beyond Basel: Banking, Securities, and Insurance</em>, ed. Hal S. Scott (Oxford: Oxford University Press, 2005), pp. 171–95. For a&nbsp;more recent article, see Mark J. Flannery, “Stabilizing Large Financial Institutions with Contingent Capital Certificates,”&nbsp;<em>Quarterly Journal of Finance</em>&nbsp;6, no. 2 (2016): 1–26.</p> <p><sup><span id="endnote-006"><a href="#endnote-006-backlink">6</a>.</span></sup> George M. von Furstenberg,&nbsp;<em>Contingent Convertibles (CoCos): A&nbsp;Potent Instrument for Financial Reform&nbsp;</em>(Singapore: World Scientific Publishing, 2014).</p> <p><sup><span id="endnote-007"><a href="#endnote-007-backlink">7</a>.</span></sup> Patrick Bolton and Frédéric Samama, “Capital Access Bonds: Contingent Capital with an Option to Convert,”&nbsp;<em>Economic Policy</em>&nbsp;27, no. 70 (2012): 275–317. For a&nbsp;comprehensive discussion of the case for CoCos and the key criteria they must satisfy, see George M. von Furstenberg, “Contingent Capital to Strengthen the Private Safety Net for Financial Institutions: Cocos to the Rescue?” Bundesbank Series 2&nbsp;Discussion Paper no. 2011,01 (2011); and&nbsp;Financial Stability Oversight Council, “Report to Congress on Study of Contingent Capital Requirement for Certain Nonbank Financial Companies and Bank Holding Companies,” Washington, July 2012.</p> <p><sup><span id="endnote-008"><a href="#endnote-008-backlink">8</a>.</span></sup> Stan Maes and Wim Schoutens, “Contingent Capital: An In‐​Depth Discussion,”&nbsp;<em>Economic Notes by Banca Monte dei Paschi di&nbsp;</em>Siena<em>&nbsp;SpA</em>&nbsp;41, no. 1–2 (2012): 59–79; John C. Coffee, “Bail‐​Ins Versus Bail‐​Outs: Using Contingent Capital to Mitigate Systemic Risk,” Columbia Law and Economics Working Paper no. 380, October 2010; and Mark J. Flannery, “Contingent Capital Instruments for Large Financial Institutions: A&nbsp;Review of the Literature,”&nbsp;<em>Annual Review of Financial Economics</em>&nbsp;6, no. 1 (2014): 225–40.</p> <p><sup><span id="endnote-009"><a href="#endnote-009-backlink">9</a>.</span></sup> Stefan Avdjiev, Anastasia Kartasheva, and Bilyana Bogdanova, “CoCos: A&nbsp;Primer,”<em>&nbsp;BIS&nbsp;Quarterly Review</em>&nbsp;(September 2013): 43–56.</p> <p><sup><span id="endnote-010"><a href="#endnote-010-backlink">10</a>.</span></sup> In&nbsp;<em>Contingent Convertibles (CoCos)</em>, von Furstenberg argues that for CoCos to be attractive capital market investments, they must be able to help meet regulatory capital requirements, be rated investment grade, and have tax‐​deductible interest payments.</p> <p><sup><span id="endnote-011"><a href="#endnote-011-backlink">11</a>.</span></sup> Researchers have devoted significant attention to this issue. See, for example, Boris Albul, Dwight M. Jaffee, and Alexei Tchistyi, “Contingent Convertible Bonds and Capital Structure Decisions,”&nbsp;<em>SSRN Electronic Journal</em>, January 2015; Bolton and Samama, “Capital Access Bonds”; Charles W. Calomiris and Richard J. Herring, “How to Design a&nbsp;Contingent Convertible Debt Requirement That Helps Solve Our Too‐​Big‐​to‐​Fail Problem,”&nbsp;<em>Journal of Applied Corporate Finance&nbsp;</em>25, no. 2 (2013): 39–62; Christopher L. Culp, “Contingent Capital vs. Contingent Reverse Convertibles for Banks and Insurance Companies,”<em>&nbsp;Journal of Applied Corporate Finance</em>&nbsp;21, no. 4 (2009): 17–27; Flannery, “No Pain, No Gain?”; Flannery, “Stabilizing Large Financial Institutions”; George Pennacchi, Theo Vermaelen, and Christian C. P. Wolff, “Contingent Capital: The Case for COERCs,”&nbsp;<em>Journal of Financial and&nbsp;Quantitative Analysis</em>&nbsp;49, no. 3 (2014): 541–74; Surexh Sundaresan and Zhenyu Wang, “On the Design of Contingent Capital with a&nbsp;Market Trigger,”&nbsp;<em>Journal of Finance</em>&nbsp;70, no. 2 (2015): 881–920; and von Furstenberg,&nbsp;<em>Contingent Convertibles (CoCos)</em>.</p> <p><sup><span id="endnote-012"><a href="#endnote-012-backlink">12</a>.</span></sup> Christoph Henkel and Wulf A. Kaal, “Contingent Capital in European Union Bank Restructuring,”&nbsp;<em>Northwestern Journal of International Law and Business</em>&nbsp;32, no. 2 (2012): 191–262. Henkel and Kaal propose distinct trigger types that are either transaction based, automatic, statute based, or regulation based.</p> <p><sup><span id="endnote-013"><a href="#endnote-013-backlink">13</a>.</span></sup> Julie Dickson, “Too‐​Big‐​to‐​Fail and Embedded Contingent Capital,” remarks at the Financial Services Invitational Forum, Cambridge, Ontario, May 6, 2010,&nbsp;<a href="" target="_blank">http://​www​.osfi​-bsif​.gc​.ca/​E​n​g​/​D​o​c​s​/​j​d​l​h​2​0​1​0​0​5​0​6.pdf</a>.</p> <p><sup><span id="endnote-014"><a href="#endnote-014-backlink">14</a>.</span></sup> Calomiris and Herring, “How to Design a&nbsp;Contingent Convertible Debt Requirement.”</p> <p><sup><span id="endnote-015"><a href="#endnote-015-backlink">15</a>.</span></sup> Sundaresan and Wang, “On the Design of Contingent Capital.”</p> <p><sup><span id="endnote-016"><a href="#endnote-016-backlink">16</a>.</span></sup> Sundaresan and Wang, “On the Design of Contingent&nbsp;Capital.”</p> <p><sup><span id="endnote-017"><a href="#endnote-017-backlink">17</a>.</span></sup> Bolton and Samama, “Capital Access Bonds.”</p> <p><sup><span id="endnote-018"><a href="#endnote-018-backlink">18</a>.</span></sup> Similar gambling took place by Lehman Brothers management prior to its failure.</p> <p><sup><span id="endnote-019"><a href="#endnote-019-backlink">19</a>.</span></sup> Stefan Avdjiev et al., “The Real Consequences of CoCo Issuance: A&nbsp;First Comprehensive Analysis,” Vox CEPR Policy Portal, December 22, 2017.</p> <p><sup><span id="endnote-020"><a href="#endnote-020-backlink">20</a>.</span></sup> In “How to Design a&nbsp;Contingent Convertible Debt Requirement,” Calomiris and Herring note that regulatory capital requirements employ a&nbsp;mixture of book‐​value and fair‐​value measures of capital when determining compliance.</p> <p><sup><span id="endnote-021"><a href="#endnote-021-backlink">21</a>.</span></sup> For a&nbsp;detailed discussion of the various kinds of manipulation that can be involved with different CoCo structures, see Robert L. McDonald, “Contingent Capital with a&nbsp;Dual Price Trigger,”&nbsp;<em>Journal of Financial Stability</em>&nbsp;9, no. 2 (2013): 230–41. For a&nbsp;description of recent CoCos issued by Lloyds, Rabobank, and Credit Suisse, see Michalis Ioannides and Frank S. Skinner, “Contingent Capital Securities: Problems and Solutions,” in&nbsp;<em>Derivative Securities Pricing and Modelling</em>, ed. Jonathan Batten and Niclas Wagner (Castle Hill, Australia: Emerald Press, 2011).</p> <p><sup><span id="endnote-022"><a href="#endnote-022-backlink">22</a>.</span></sup> See Sundaresan and Wang, “On the Design of Contingent Capital.” The loss‐​of‐​information argument is a&nbsp;variant of Goodhart’s law, which says, in paraphrased form, that when a&nbsp;measure becomes a&nbsp;target, it ceases to be a&nbsp;good measure. Charles Goodhart, “Problems of Monetary Management: The U.K. Experience,” in<em>&nbsp;Papers in Monetary Economics</em>&nbsp;(Sydney: Reserve Bank of Australia, 1975). See also Urs W. Birchler and Matteo Facchinetti, “Self‐​Destroying Prophecies? The Endogeneity Pitfall in Using Market Signals for Prompt Corrective Action,” Working Paper, Swiss National Bank, 2007.</p> <p><sup><span id="endnote-023"><a href="#endnote-023-backlink">23</a>.</span></sup> A&nbsp;similar argument can be found in Philip Bond, Itay Goldstein, and Edward Simpson Prescott, “Market‐​Based Corrective Actions,”&nbsp;<em>Review of Financial Studies</em>&nbsp;23, no. 2 (2010): 781–820.</p> <p><sup><span id="endnote-024"><a href="#endnote-024-backlink">24</a>.</span></sup> Sundaresan and Wang, “On the Design of Contingent Capital,” argue that for a&nbsp;unique equilibrium price of the bank’s stock to exist, there can be no transfer of value between initial shareholders and CoCo investors either prior to or at the time of conversion. However, George Pennacchi and Alexei Tchistyi, “On Equilibrium When Contingent Capital Has a&nbsp;Market Trigger: A&nbsp;Correction to Sundaresan and Wang,”&nbsp;<em>Journal of Finance&nbsp;</em>74,&nbsp;no. 3&nbsp;(2019): 1559–76, point out an error in Sundaresan and Wang’s analysis, indicating that the wealth‐​transfer restriction need only apply at the time of conversion. See also Natalya Martynova and Enrico C. Perotti, “Convertible Bonds and Bank Risk‐​Taking,”&nbsp;De Nederlandsche&nbsp;Bank Working Paper no. 480, August 2015, for a&nbsp;similar argument about conflicting incentives.</p> <p><sup><span id="endnote-025"><a href="#endnote-025-backlink">25</a>.</span></sup> Martynova and Perotti, “Convertible Bonds.”</p> <p><sup><span id="endnote-026"><a href="#endnote-026-backlink">26</a>.</span></sup> Calomiris and Herring, “How to Design a&nbsp;Contingent Convertible Debt Requirement.”</p> <p><sup><span id="endnote-027"><a href="#endnote-027-backlink">27</a>.</span></sup> Kenneth R. French et al.,&nbsp;<em>The Squam Lake Report: Fixing the Financial System</em>&nbsp;(Princeton: Princeton University Press, 2010).</p> <p><sup><span id="endnote-028"><a href="#endnote-028-backlink">28</a>.</span></sup> In “Contingent Capital with a&nbsp;Dual Price Trigger,” McDonald also argues for a&nbsp;dual‐​trigger approach, but unlike the approach taken in&nbsp;<em>The Squam Lake Report</em>, his proposal uses both a&nbsp;market‐​based stock price and a&nbsp;broad‐​based financial firm market index.</p> <p><sup><span id="endnote-029"><a href="#endnote-029-backlink">29</a>.</span></sup> Ceyla Pazarbasioglu et al., “Contingent Capital: Economic Rationale and Design Features,” staff discussion note, International Monetary Fund, January 25, 2011,&nbsp;<a href="" target="_blank">https://​www​.imf​.org/​e​x​t​e​r​n​a​l​/​p​u​b​s​/​f​t​/​s​d​n​/​2​0​1​1​/​s​d​n​1​1​0​1.pdf</a>.</p> <p><sup><span id="endnote-030"><a href="#endnote-030-backlink">30</a>.</span></sup> Coffee, “Bail‐​Ins Versus Bail‐​Outs.”</p> <p><sup><span id="endnote-031"><a href="#endnote-031-backlink">31</a>.</span></sup> Non Chen et al., “Contingent Capital, Tail Risk, and Debt‐​Induced Collapse,”&nbsp;<em>Review of Financial Studies</em>&nbsp;30, no. 11 (2017): 3722–58,&nbsp;<a href="" target="_blank">https://​doi​.org/​1​0​.​1​0​9​3​/​r​f​s​/​h​hx067</a>. Indeed, the Swiss regulatory authority in 2010 proposed that a&nbsp;dual CoCo structure for capital with high‐​trigger securities (7 percent) should serve as a&nbsp;buffer to Tier 1&nbsp;capital and that additional low‐​trigger&nbsp;securities (5 percent) should serve as loss‐​absorbing capital in the event of distress.</p> <p><sup><span id="endnote-032"><a href="#endnote-032-backlink">32</a>.</span></sup> Financial Stability Oversight Council, “Report to Congress.”</p> <p><sup><span id="endnote-033"><a href="#endnote-033-backlink">33</a>.</span></sup> Avdjiev, Kartasheva, and Bogdanova, “CoCos: A&nbsp;Primer.”</p> <p><sup><span id="endnote-034"><a href="#endnote-034-backlink">34</a>.</span></sup> Martynova and Perotti, “Convertible Bonds.”</p> <p><sup><span id="endnote-035"><a href="#endnote-035-backlink">35</a>.</span></sup> Martynova and Perotti, “Convertible Bonds.”</p> <p><sup><span id="endnote-036"><a href="#endnote-036-backlink">36</a>.</span></sup> Stefan Avdjiev et al., “CoCo Issuance and Bank Fragility,” Bank for International Settlements Working Paper no. 678, November 2017. It is estimated that worldwide banking assets are about $27 trillion and capital is about $5.3 trillion. See&nbsp;<a href="" target="_blank">http://​stats​.bis​.org/​s​t​a​t​x​/​s​r​s​/​t​a​b​le/b1.</a></p> <p><sup><span id="endnote-037"><a href="#endnote-037-backlink">37</a>.</span></sup> To put this tax issue in perspective, U.S. banks had a&nbsp;tax rate of 35 percent and in 2016 paid about $303 billion in dividends. If all dividends were tax‐​deductible, the total loss to the Treasury would have been about $32 billion, which is less than the estimated cost of banking regulation and substantially greater than the anticipated loss in revenue if payments on CoCos were to be deemed tax‐​deductible. Federal Deposit Insurance Corporation, “Commercial Banks: Historical Statistics on Banking,”&nbsp;<a href="" target="_blank">https://​www5​.fdic​.gov/​h​s​o​b​/​H​S​O​B​R​p​t.asp</a>. Admati et al. argue that the cost of capital versus debt is overestimated. Anat R. Admati et al., “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive,” Stanford University Business School Working Paper no. 2065, October 22, 2013. In “CoCos: a&nbsp;Primer,” Avdjiev, Kartasheva, and Bogdanova suggest that as of 2016, about 64 percent of CoCos in circulation had been issued in countries that regarded interest on CoCos as tax‐​deductible, while about 20 percent had been issued in countries where CoCo interest payments were not tax‐​deductible. They did not determine the tax status of the remainder.</p> <p><sup><span id="endnote-038"><a href="#endnote-038-backlink">38</a>.</span></sup> Avdjiev, Kartasheva, and Bogdanova, “CoCos: A&nbsp;Primer.”</p> <p><sup><span id="endnote-039"><a href="#endnote-039-backlink">39</a>.</span></sup> Bank for International Settlements, “Basel III: A&nbsp;Global Regulatory Framework for More Resilient Banks and Banking Systems,” June 2011.</p> <p><sup><span id="endnote-040"><a href="#endnote-040-backlink">40</a>.</span></sup> The Shadow Financial Regulatory Committee has long argued against relying on risk‐​weighted assets as a&nbsp;measurement criterion. See, for example, Shadow Financial Regulatory Committee, “Alternatives to the Proposed Risk‐​Based Capital Standards,” Statement no. 323, February 13, 2013. For a&nbsp;detailed discussion of the Shadow Committee’s view, see Robert A. Eisenbeis, “The Shadow Financial Regulatory Committee’s Views on Systemic and Payments System Risks,” paper presented at the 91st Annual Conference of the Western Economic Association, Portland, Oregon, June 2016. The same remarks also appear in Robert A. Eisenbeis, “The Shadow Financial Regulatory Committee’s Views on Systemic and Payments System Risks,” in&nbsp;<em>Innovative Federal Reserve Policies during the Great Financial Crisis</em>, ed. George G. Kaufman, Douglas D. Evanoff, and A. G. Malliaris (Singapore: World Scientific Publishing, 2019), pp. 285–302.</p> <p><sup><span id="endnote-041"><a href="#endnote-041-backlink">41</a>.</span></sup> Maryka Daubricourt, “Contingent Capital Instruments: Pricing Behaviour,” ESCP Europe Applied Research Paper no. 6, October 2016.</p> <p><sup><span id="endnote-042"><a href="#endnote-042-backlink">42</a>.</span></sup> See “Additional Tier 1 (AT1) RegS May 2014,” Deutsche Bank,&nbsp;<a href="" target="_blank">https://​www​.db​.com/​i​r​/​e​n​/​a​t​1​-​r​e​g​s​-​m​a​y​-​2​0​1​4.htm</a>.</p> <p><sup><span id="endnote-043"><a href="#endnote-043-backlink">43</a>.</span></sup> “Europe’s CoCos Provide a&nbsp;Lesson on Uncertainty,” Office of Financial Research Working Paper 17–02, April 2017<a href="http://">.</a></p> <p><sup><span id="endnote-044"><a href="#endnote-044-backlink">44</a>.</span></sup> William Canny and Donal Griffin, “Deutsche Bank CEO John Cryan Defends Bank as Some Clients Pare Exposure,”&nbsp;<em>LiveMint</em>, September 30, 2016.</p> <p><sup><span id="endnote-045"><a href="#endnote-045-backlink">45</a>.</span></sup> William R. Cline, “Systemic Implications of Problems at a&nbsp;Major European Bank,” Peterson Institute for International Economics Policy Brief no. 16–19, October 2016.</p> <p><sup><span id="endnote-046"><a href="#endnote-046-backlink">46</a>.</span></sup> Mark Russell, “The Resolution of Banco Popular,” UK Finance, June 22, 2017.</p> <p><sup><span id="endnote-047"><a href="#endnote-047-backlink">47</a>.</span></sup> Don Quijones, “The Banking Crisis in Spain Is Back,”&nbsp;<em>Wolf Street</em>, May 28, 2016.</p> <p><sup><span id="endnote-048"><a href="#endnote-048-backlink">48</a>.</span></sup> “FAQ: EU’s Differing Treatment of Ailing Banks,” Moody’s, June 21, 2017,&nbsp;<a href="" target="_blank">–PBC_1077213.</a></p> <p><sup><span id="endnote-049"><a href="#endnote-049-backlink">49</a>.</span></sup> Jim Edwards, “Italy’s Banks Might Need €52 Billion Bailout,” Business Insider, November 29, 2016<a href="http://">.</a></p> <p><sup><span id="endnote-050"><a href="#endnote-050-backlink">50</a>.</span></sup>&nbsp;James David Spellman, “Italy Shores Up Failing Bank: A&nbsp;Template for Rescuing Europe’s Other Weak Banks?,”&nbsp;European Institute,&nbsp;January 2, 2017.</p> <p><sup><span id="endnote-051"><a href="#endnote-051-backlink">51</a>.</span></sup> See “Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 Establishing a&nbsp;Framework for the Recovery and Resolution of Credit Institutions and Investment Firms,”&nbsp;<em>Official Journal of the European Union</em>, December 6, 2014; and European Commission, “EU Bank Recovery and Resolution Directive (BRRD): Frequently Asked Questions,” news release, April 15, 2014.</p> <p><sup><span id="endnote-052"><a href="#endnote-052-backlink">52</a>.</span></sup> Depending on their features, however, certain CoCos may be harder to price and tend to be somewhat more expensive than other forms of debt.</p> <p><sup><span id="endnote-053"><a href="#endnote-053-backlink">53</a>.</span></sup> The “off‐​ramp” concept is outlined in Title VI of the Financial CHOICE Act of 2017 and was endorsed in a&nbsp;modified form by the Financial Economists Roundtable that same year.</p> <p><sup><span id="endnote-054"><a href="#endnote-054-backlink">54</a>.</span></sup> Financial CHOICE Act of 2017, H.R. 10, 115th Cong., 2017.</p> <p><sup><span id="endnote-055"><a href="#endnote-055-backlink">55</a>.</span></sup> Financial Economists Roundtable, “Statement on Bank Capital as a&nbsp;Substitute for Prudential Regulation,” September 20, 2017,&nbsp;<a href="" target="_blank">http://​www​.finan​ciale​con​o​mist​sround​table​.com</a>.</p> <p><sup><span id="endnote-056"><a href="#endnote-056-backlink">56</a>.</span></sup> The Shadow Financial Regulatory Committee has criticized the use of such measures on many occasions, and the 2008 financial crisis proved how deficient such measures were in reflecting an institution’s soundness. See Kuritzkes and Scott,&nbsp;“Markets Are the Best Judge of Bank Capital”; and Financial Economists Roundtable, “Bank Capital as a&nbsp;Substitute for Prudential Regulation.”</p> <p><sup><span id="endnote-057"><a href="#endnote-057-backlink">57</a>.</span></sup> See Drew Dahl et al., “Compliance Costs, Economies of Scale and Compliance Performance: Evidence from a&nbsp;Survey of Community Banks,” Federal Reserve Bank of St. Louis, April 2018, Chart 3,&nbsp;<a href="" target="_blank"><br>20and%20compliance%20performance.pdf</a>.</p> <p><sup><span id="endnote-058"><a href="#endnote-058-backlink">58</a>.</span></sup> Financial Stability Oversight Council, “Report to Congress.”</p> <p><sup><span id="endnote-059"><a href="#endnote-059-backlink">59</a>.</span></sup> Robert A. Eisenbeis, “The Fed and Structural Reforms to Reduce Interconnectedness and Promote Financial Stability,” in&nbsp;<em>Public Policy &amp;&nbsp;Financial Economics: Essays in Honor of Professor George G. Kaufman for His Lifelong Contributions to the Profession</em>, ed. Douglas D. Evanoff, A. G. Malliaris, and George G. Kaufman (Singapore: World Scientific Publishing, 2018), pp. 117–46.</p> <p>osts%20economies%20of%20scale%20and%20compliance%20performance.pdf.</p> <p><sup><span id="endnote-058"><a href="#endnote-058-backlink">58</a>.</span></sup> Financial Stability Oversight Council, “Report to Congress.”</p> <p><sup><span id="endnote-059"><a href="#endnote-059-backlink">59</a>.</span></sup> Robert A. Eisenbeis, “The Fed and Structural Reforms to Reduce Interconnectedness and Promote Financial Stability,” in&nbsp;<em>Public Policy &amp;&nbsp;Financial Economics: Essays in Honor of Professor George G. Kaufman for His Lifelong Contributions to the Profession</em>, ed. Douglas D. Evanoff, A. G. Malliaris, and George G. Kaufman (Singapore: World Scientific Publishing, 2018), pp. 117–46.</p> </div> Tue, 30 Jul 2019 00:00:00 -0400 Robert A. Eisenbeis