Iraq's Debt Three Years Later

Three years ago, a study of low and declining prices on Iraq's debt by Michael Greenstone of MIT helped paint a bleak picture of the effectiveness of the surge, as, for example, in this November 2007 New York Times op-ed by Austan Goolsbee "In the Bond Market, a Bleak Prognosis for Iraq." But as reported in this week's Boston Globe piece "Gambling on Iraq’s Slow Rise from Ruin," a re-examination of Iraq's debt now leads Greenstone to change his view. Greenstone now says "The market’s assessment is that the prospects for a functioning Iraqi state in the future have improved dramatically.’’ The good news in this recent story is tempered a bit, at least for Californians, by the comparable assessment Iraq's debt and California's debt.

Quantitative Easing at the Fed and the Bank of Japan

Next Thursday March 25 the House Financial Services Committee will hold a hearing on how the Fed should exit from its quantitative easing. This past week I was in Japan discussing the Japanese experience with QE with traders and experts in the financial sector and in the Bank of Japan. A simple graphical comparison between QE at the Fed and at the BOJ puts the exit strategy in a useful perspective.

The two graphs show the monetary base—currency plus bank reserves—in the United States and Japan as reported by the Fed and the Bank of Japan. (The BOJ reports units of 100 million yen; thus the monetary base in Japan is now slightly below 1,000,000 units of 100 million yen or 100 trillion yen).

The big bulges in the monetary base are measures of quantitative easing because the monetary base would have continued to grow at relatively steady pace without QE. Japan’s experience with QE was from 2001 to 2006; during those years the monetary base increased from about 65 trillion yen to 110 trillion yen, or by about 70 percent. While QE lasted for a long time it ended very quickly, and the quick exit seemed to go smoothly without volatility in the markets. Note that the post 2008 quantitative easing in Japan is very small compared to 2001-2006; thus Japan does not have an exit problem right now though it is still struggling with a deflation problem and will likely continue with its QE. Unlike the Fed, the BOJ did not think a big quantitative easing was appropriate in the recent crisis.

Moreover, the Fed’s recent QE is quite different from the BOJ’s QE in 2001-2006:

First, the monetary base in the United States increased by twice as much in percentage terms (140 percent) compared with Japan.

Second, QE came on much quicker in the United States, with most of the increase in the base concentrated in the last few months of 2008, though increases have continued since then.

Third, the Fed entered into QE when the interest rate target was 2 percent, while the BOJ started QE when the interest rate was already essentially zero at 0.1 percent.

Fourth, the Fed’s quantitative easing has largely been caused by the need to finance its purchase of mortgage backed securities, bailouts of AIG and Bear Stearns and other loans and securities purchases.

Fifth, and most important for the exit strategy issue: the BOJ exited from QE much more quickly than the Fed is now signaling its exit will be. Japan’s experience suggests that a quicker exit for the Fed might be considered.

Was the “Considerable Period” or the “Measured Pace” More At Fault?

In his recent review in The New York Review of Books of my book Getting Off Track, Roger Alcaly makes a very interesting point about the “too low for too long” hypothesis, according to which the Fed helped cause the housing boom. I hear that some policymakers at the Fed have been thinking the same way in recent weeks. If so, then when the Fed starts increasing the interest rate, it is likely to do so faster than in 2004-2005. But first consider Roger Alcaly’s argument.

Alcaly agrees that the Fed held the federal funds interest rate too low for too long in 2003-2005, but he emphasizes the slow measured pace at which the Fed raised the rate (once it started raising it) rather than the long considerable period during which it held the rate low at one percent. Alcaly puts it this way: “Taylor's general contention that low rates after 2003 encouraged the housing bubble is largely persuasive, although mostly for different reasons than he provides.” Alcaly points out that “the Fed raised rates only in increments of a quarter of a percentage point…. Fourteen of these "measured" rate rises were attributable to Greenspan and three to Bernanke, who replaced him in February 2006. Raising interest rates so slowly and steadily promoted excessive risk-taking, and should have concerned Greenspan, according to his stated views.”

Can one assess quantitaively whether the measured pace period was more to blame than the considerable period period? In my research, I use the deviations between the actual federal funds rate and the Taylor rule to measure whether rates were “too low for too long” as shown in the chart below. This same approach provides a metric to determine whether the deviations were larger before or after the interest rate started rising, and thereby assess which period was more to blame for the “too low rates.”

I have drawn in a red line in the chart below to indicate when the Fed started increasing the funds rate. Note that there is a big gap on both sides of the line. The cumulative deviations to the right of the red line (13.9 percentage points) are indeed sizeable as Alcaly argues. However, they are slightly smaller than the cumulative deviation on the left of the red line (15.5 percentage points). So at least by this measure there is no reason to be more concerned about a repeat of the “measured pace” period as there is a repeat of the “considerable period” period.

Milton Friedman Had It Right All Along

The following is a reasonable summary, in my view, of the available evidence on the impacts of discretionary fiscal and monetary policy actions taken before, during, and after the recent financial crisis:

The available evidence…casts grave doubt on the possibility of producing any fine adjustments in economic activity by fine adjustments in monetary policy....and much danger that such a policy may make matters worse rather than better…The basic difficulties and limitations of monetary policy apply with equal force to fiscal policy.

Political pressures to ‘do something’ …are clearly very strong indeed in the existing state of public attitudes.

The main moral to be had from these two preceding points is that yielding to these pressures may frequently do more harm than good. There is a saying that the best is often the enemy of the good, which seems highly relevant. The attempt to do more than we can will itself be a disturbance that may increase rather than reduce instability.

But this is not actually my summary; it is Milton Friedman’s summary of the available evidence 52 years ago (as presented in testimony to the Joint Economic Committee in 1958 and quoted later in his famous debate with Walter Heller, published in Monetary vs. Fiscal Policy: A Dialogue, W.W. Norton, 1969, p. 48.)

The same issues, again and again. How little things have changed.

Why Did Macro Policy in Emerging Market Countries Improve?

The resilience of emerging market economies severely hit by the panic of 2008 is amazing, especially in comparison with the long emerging market crisis period of a decade ago.

I have written that the main explanation for this resilience is improved macroeconomic policy which was put in place in the years before the crisis in many of these countries: higher foreign reserves, lower inflation, reduced borrowing in foreign currencies, and a better fiscal position. But what was the underlying reason for these improvements? Certainly policy makers in the countries deserve credit, but changes in international economic “rules of the game” provided the necessary political and economic incentives.

Recall that the Mexican crisis of 1994-95 lead to large bailouts of the holders of Mexican dollar-linked government bonds by the IMF and the U.S. Treasury. At the time, many expressed concern about the moral hazard and the policy unpredictability caused by these bailouts. Expectations of such bailouts would increase risk taking on the part of investors and reduce incentives for emerging market countries to take steps to avoid circumstances that might lead to crisis. Some worried that the bailout philosophy could lead to more severe crises in the future, and they made proposals to establish a new international framework for limiting bailouts. The British and Canadian governments proposed putting limits on access to large scale loans from the IMF, but the United States resisted their proposals, so no agreement could be reached.

Without such a framework interventions were erratic. Emerging market crises got worse and continued for another eight years. There was the Asian financial crisis and the Asian contagion with Korea, Thailand, Indonesia, and Malaysia. There was the Russian crisis with global contagion to Brazil and Argentina and even the United States as the Fed cut the interest rates in response. The erratic nature of the interventions was very visible in the case of Russia. After several years of support, loans were suddenly pulled in August 1998.

But eventually a solution to the impasse was found in the creation of an alternative to IMF bailouts. The alternative was to add new clauses to the sovereign bonds—collective action clauses—which allowed for orderly workouts of sovereign debt problems between a country and its creditors. The alternative made it credible for the IMF to impose limits and abide by them.

People were skeptical that such clauses could be put into the bonds, but Mexico proved the naysayers wrong and went ahead and issued such bonds on February 26, 2003 (seven years ago last Friday) and many others countries followed Mexico. Agustin Carstens, now Finance Minister of Mexico, played a key role in the effort. As soon as these clauses were put into the bonds, the IMF and its shareholders agreed to establish a new “exceptional access framework.” Soon after the emerging markets moved into a new era of stability. Crises generated by emerging market countries diminished sharply. The countries became more resilient to shocks from abroad, as we saw in the recent crisis. It is hard to prove cause and effect in economics, but in my view these limits played a role by making large scale bailouts less likely and thereby providing incentives to emerging market countries to follow policies which would reduce the chance of crisis.