Archive for June 18th, 2009

Rising Government debts are unsustainable but are desirable

June 18, 2009

Paul de Grauwe et al have an interesting article in eurointelligence which points to the dilemma facing fiscal policymakers.  

There is no doubt that government debts and deficits are unsustainable. The US, the UK and other industrialized countries now have budget deficits of more than 10% of GDP. With such deficits, government debts are exploding rapidly. Simple extrapolations into the future lead to the conclusion that these debt and deficit levels are unsustainable and that they will have to be reversed to avoid insolvency.

However, the problem is not as easy as it sounds:

The fact that government debts and deficits are unsustainable does not however imply that they are undesirable today. There is no contradiction in the statement that government debts are both unsustainable and desirable. Why is that?

The stark increase in government debts today is a natural consequence of the unsustainable debt explosion in the private sector during the last ten years….With the bursting of the bubble, consumers and financial institutions started a painful process of reducing their debt levels. This process of “deleveraging” is necessary to kick start the economy again. At the same time it is only possible if governments are willing to increase their debt levels.  

The fundamental insight that private debt levels can only decline if government debt is allowed to increase….

Then they use the approach developed by Grauwe as explained here:

This follows from two mechanisms, uncovered long ago by Irving Fisher and Keynes. Once the private sector has accumulated excessive debt and suddenly all want to reduce their debt levels at the same time, this will not work. The reason is that they all want to reduce their debt burdens through either asset sales or increased savings or both. But asset sales lower asset prices, thus increasing the solvency problems for the private sector.

In sum, we are facing both stock and flow deflations and govt has to step in. This is also what Paul Krugman has been saying (though in other words) but is being opposed by a number of economists.

Ok all this is given now. Whether econs like it or not, we are only going to see rise in deficits going ahead. The question is what next as crisis eases (whenever that happens)? How do we unwind/manage such huge deficit levels? The govts will simply keep issuing more and more bonds and hope all getsubscribed. The cost will be crowding out of savings and less capital available for private investments.

The other options for govts as Mankiw et al explains– either  inflate or default. The second is not really a option as it would lead to a disaster.  Central banks will not like first happening so it will be interesting to see the battle.

The govt is bailing out the private sector right now. Will private sector bail out the govt by agreeing to pay higher taxes? Even if they do, would it be enough? How will govts deleverage their debts?

Whatever country experiences I have read (see this, this) of managing govt debts, it is a big big battle. It has other linking problems of high inflation, crowding out, high int rates, etc etc. It does not look good at all.

Thinking about Ministry of Finance/Treasury

June 18, 2009

We have plenty of literature on central banks, their set-up, their institutional structure etc etc ( see this, this , this, this, this etc for some literature).

However, I was earlier thinking – what about similar literature on Ministries of Finance/Treasury (MOF/T)? Central Banks get much of the focus wrt economic institutions but I have always believed MoF/T is as important (perhaps more). This crisis has thrown them in limelight for all the wrong reasons but a sound MoF/T is as important to an economy as a central banker.

How are MoF/T organised? What are the differences in different MoF/T across countries ? What are the similarities? The differences between developed and developing? Are they converging towards some standard? How do MoF/T and Central Banks coordinate policies in their economies ( we focus too much attention on central banks)? What also interests me tremendously is what made MoF/T give up much of their power to central banks as stature of mentary policy grew? What were the causes? What were the processes? How do they keep a check on central banks?

 We usually get literature on MoF/T as an autobiography of some insider (Swagel points to some ideas) but not much like the research we get on central banks.

Actually what promoted me to write this post is this superb post from Tej Prakash of IMF.  he does provide some insights to above questions like:

While there is no standard model for the organizational structure of a MOF, it is generally agreed that there is a set of core tasks that any MOF should fulfill. This includes (1) budget formulation and implementation, (2) collection, custody, management, accounting, control and disbursement of public monies, (3) management of public assets and liabilities, (4) revenue and expenditure policy and management, and (5) design and implementation of macroeconomic and fiscal policies of  government. MOFs have also added many other tasks such as donor coordination, oversight of domestic financial markets (often by establishing regulatory bodies) [2], managing fiscal risks arising from various sources, financial oversight of public enterprises, and relations with international organizations such as the World Bank and the IMF.

The organizational structure of MOFs is also linked to the political-economy and to the governance structure of the country. Countries with presidential or parliamentary systems will likely have different organizational roles and structures of the MOF

The MOF as an institution also reflects the historical legacy of countries. Many formerly colonized countries inherited the institutional systems of their former rulers.

In many small, developing countries MOFs have been struggling with the increased requirements of their core role as well as of more complex processes and other innovations. MOFs in such economies also lack professional staff in many skill areas, such as treasury management and accounting.

It then looks at some suggestions for small developing economies. Excellent stuff. I need to do some literature survey on this. Anybody knows of such research do let me know.

Obama’s Financial System Fix plan – Version?

June 18, 2009

As pointed earlier, Obama has released the white paper (89 pages long) on what is being said as the most ambitious reform proposal for financial sector.

The President’s plan will:

Require that all financial firms that pose a significant risk to the financial system at large are subjected to strong consolidated supervision and regulation

Increase market discipline and transparency to make our markets strong enough to withstand system-wide stress and the potential failure of one or more large financial institutions

Rebuild trust in our markets by creating the Consumer Financial Protection Agency to focus exclusively on protecting consumers in credit, savings, and payment markets.

Provide the government with the tools needed to manage financial crises so it is not forced to choose between bailouts and financial collapse

Raise international regulatory standards and improve international coordination

We have heard all that so many times.  Hope there is more substance to it. WSJ BLog points out to economists’ views which are mixed really. I haven’t read the report so no comments.

Ezra Klein points to an excellent glossary to help you understand all the fancy terms 🙂

I am happy to see third suggestion getting through- Consumer Financial Protection Agency. It is proposed by Liz Warren and ME  had pointedthis long back (in Dec 2007). Let me admit, at that time, I didn’t think the proposal would ever go through. The reason was not as the idea was impractical etc but I thought it would never be accepted within academia, regulators and above all financial players.

I also thought the idea is pretty useful for developing economies in particular.If people find finance difficult in developed econs and need an agency, developing economies need it more urgently. I am all for financial literacy but knowing ABC of finance is just not enough to keep up with the fin world.

Look at India, we have financial products with huge variety coming out left right and centre (and people want more). With no such independent agency in place, people mostly choose products which the distributors push at them without any understanding of so called risks and return. 

But yeah, next time developing economies have a report on their financial sector, we can hope to find this suggestion. Till now it must have sounded stupid but is going to become a reality in US of A. And financial players have little choice now but to accept it. Let’s see how this one is set up in US as it is not going to be easy.

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